[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2020 Edition]
[From the U.S. Government Publishing Office]
[[Page i]]
Title 26
Internal Revenue
________________________
Part 1 (Sec. Sec. 1.1001 to 1.1400)
Revised as of April 1, 2020
Containing a codification of documents of general
applicability and future effect
As of April 1, 2020
Published by the Office of the Federal Register
National Archives and Records Administration as a
Special Edition of the Federal Register
[[Page ii]]
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[[Page iii]]
Table of Contents
Page
Explanation................................................. v
Title 26:
Chapter I--Internal Revenue Service, Department of
the Treasury (Continued) 3
Finding Aids:
Table of CFR Titles and Chapters........................ 971
Alphabetical List of Agencies Appearing in the CFR...... 991
Table of OMB Control Numbers............................ 1001
List of CFR Sections Affected........................... 1019
[[Page iv]]
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Cite this Code: CFR
To cite the regulations in
this volume use title,
part and section number.
Thus, 26 CFR 1.1001-1
refers to title 26, part
1, section 1001-1.
----------------------------
[[Page v]]
EXPLANATION
The Code of Federal Regulations is a codification of the general and
permanent rules published in the Federal Register by the Executive
departments and agencies of the Federal Government. The Code is divided
into 50 titles which represent broad areas subject to Federal
regulation. Each title is divided into chapters which usually bear the
name of the issuing agency. Each chapter is further subdivided into
parts covering specific regulatory areas.
Each volume of the Code is revised at least once each calendar year
and issued on a quarterly basis approximately as follows:
Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1
The appropriate revision date is printed on the cover of each
volume.
LEGAL STATUS
The contents of the Federal Register are required to be judicially
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie
evidence of the text of the original documents (44 U.S.C. 1510).
HOW TO USE THE CODE OF FEDERAL REGULATIONS
The Code of Federal Regulations is kept up to date by the individual
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together to determine the latest version of any given rule.
To determine whether a Code volume has been amended since its
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Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative
List of Parts Affected,'' which appears in the Reader Aids section of
the daily Federal Register. These two lists will identify the Federal
Register page number of the latest amendment of any given rule.
EFFECTIVE AND EXPIRATION DATES
Each volume of the Code contains amendments published in the Federal
Register since the last revision of that volume of the Code. Source
citations for the regulations are referred to by volume number and page
number of the Federal Register and date of publication. Publication
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Code a note has been inserted to reflect the future effective date. In
those instances where a regulation published in the Federal Register
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inserted following the text.
OMB CONTROL NUMBERS
The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires
Federal agencies to display an OMB control number with their information
collection request.
[[Page vi]]
Many agencies have begun publishing numerous OMB control numbers as
amendments to existing regulations in the CFR. These OMB numbers are
placed as close as possible to the applicable recordkeeping or reporting
requirements.
PAST PROVISIONS OF THE CODE
Provisions of the Code that are no longer in force and effect as of
the revision date stated on the cover of each volume are not carried.
Code users may find the text of provisions in effect on any given date
in the past by using the appropriate List of CFR Sections Affected
(LSA). For the convenience of the reader, a ``List of CFR Sections
Affected'' is published at the end of each CFR volume. For changes to
the Code prior to the LSA listings at the end of the volume, consult
previous annual editions of the LSA. For changes to the Code prior to
2001, consult the List of CFR Sections Affected compilations, published
for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.
``[RESERVED]'' TERMINOLOGY
The term ``[Reserved]'' is used as a place holder within the Code of
Federal Regulations. An agency may add regulatory information at a
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used
editorially to indicate that a portion of the CFR was left vacant and
not dropped in error.
INCORPORATION BY REFERENCE
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This material, like any other properly issued regulation, has the force
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What is a proper incorporation by reference? The Director of the
Federal Register will approve an incorporation by reference only when
the requirements of 1 CFR part 51 are met. Some of the elements on which
approval is based are:
(a) The incorporation will substantially reduce the volume of
material published in the Federal Register.
(b) The matter incorporated is in fact available to the extent
necessary to afford fairness and uniformity in the administrative
process.
(c) The incorporating document is drafted and submitted for
publication in accordance with 1 CFR part 51.
What if the material incorporated by reference cannot be found? If
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CFR INDEXES AND TABULAR GUIDES
A subject index to the Code of Federal Regulations is contained in a
separate volume, revised annually as of January 1, entitled CFR Index
and Finding Aids. This volume contains the Parallel Table of Authorities
and Rules. A list of CFR titles, chapters, subchapters, and parts and an
alphabetical list of agencies publishing in the CFR are also included in
this volume.
An index to the text of ``Title 3--The President'' is carried within
that volume.
[[Page vii]]
The Federal Register Index is issued monthly in cumulative form.
This index is based on a consolidation of the ``Contents'' entries in
the daily Federal Register.
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the revision dates of the 50 CFR titles.
REPUBLICATION OF MATERIAL
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INQUIRIES
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The e-CFR is a regularly updated, unofficial editorial compilation
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of the Federal Register and the Government Publishing Office. It is
available at www.ecfr.gov.
Oliver A. Potts,
Director,
Office of the Federal Register
April 1, 2020.
[[Page ix]]
THIS TITLE
Title 26--Internal Revenue is composed of twenty-two volumes. The
contents of these volumes represent all current regulations issued by
the Internal Revenue Service, Department of the Treasury, as of April 1,
2020. The first fifteen volumes comprise part 1 (Subchapter A--Income
Tax) and are arranged by sections as follows: Sec. Sec. 1.0-1.60;
Sec. Sec. 1.61-1.139; Sec. Sec. 1.140-1.169; Sec. Sec. 1.170-1.300;
Sec. Sec. 1.301-1.400; Sec. Sec. 1.401-1.409; Sec. Sec. 1.410-1.440;
Sec. Sec. 1.441-1.500; Sec. Sec. 1.501-1.640; Sec. Sec. 1.641-1.850;
Sec. Sec. 1.851-1.907; Sec. Sec. 1.908-1.1000; Sec. Sec. 1.1001-
1.1400; Sec. Sec. 1.1401-1.1550; and Sec. 1.1551 to end of part 1. The
sixteenth volume containing parts 2-29, includes the remainder of
subchapter A and all of Subchapter B--Estate and Gift Taxes. The last
six volumes contain parts 30-39 (Subchapter C--Employment Taxes and
Collection of Income Tax at Source); parts 40-49; parts 50-299
(Subchapter D--Miscellaneous Excise Taxes); parts 300-499 (Subchapter
F--Procedure and Administration); parts 500-599 (Subchapter G--
Regulations under Tax Conventions); and part 600 to end (Subchapter H--
Internal Revenue Practice).
The OMB control numbers for title 26 appear in Sec. 602.101 of this
chapter. For the convenience of the user, Sec. 602.101 appears in the
Finding Aids section of the volumes containing parts 1 to 599.
For this volume, Susannah C. Hurley was Chief Editor. The Code of
Federal Regulations publication program is under the direction of John
Hyrum Martinez, assisted by Stephen J. Frattini.
[[Page 1]]
TITLE 26--INTERNAL REVENUE
(This book contains part 1, Sec. Sec. 1.1001 to 1.1400)
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Part
chapter i--Internal Revenue Service, Department of the
Treasury (Continued)...................................... 1
[[Page 3]]
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
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Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980,
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the
corresponding sections of the IRS Code of 1954 or to the appropriate
regulations sections. When either such change produced a redundancy, the
cross-reference has been deleted. For further explanation, see 45 FR
20795, Mar. 31, 1980.
SUBCHAPTER A--INCOME TAX (CONTINUED)
Part Page
1 Income taxes (Continued).................... 5
Supplementary Publications: Internal Revenue Service Looseleaf
Regulations System.
Additional supplementary publications are issued covering Alcohol and
Tobacco Tax Regulations, and Regulations Under Tax Conventions.
[[Page 5]]
SUBCHAPTER A_INCOME TAX (CONTINUED)
PART 1_INCOME TAXES (CONTINUED)--Table of Contents
Normal Taxes and Surtaxes (Continued)
Gain or Loss on Disposition of Property
Determination of Amount of and Recognition of Gain or Loss
Sec.
1.1001-1 Computation of gain or loss.
1.1001-2 Discharge of liabilities.
1.1001-3 Modifications of debt instruments.
1.1001-4 Modifications of certain derivative contracts.
1.1001-5 European Monetary Union (conversion to the euro).
1.1002-1 Sales or exchanges.
Basis Rules of General Application
1.1011-1 Adjusted basis.
1.1011-2 Bargain sale to a charitable organization.
1.1012-1 Basis of property.
1.1012-2 Transfers in part a sale and in part a gift.
1.1013-1 Property included in inventory.
1.1014-1 Basis of property acquired from a decedent.
1.1014-2 Property acquired from a decedent.
1.1014-3 Other basis rules.
1.1014-4 Uniformity of basis; adjustment to basis.
1.1014-5 Gain or loss.
1.1014-6 Special rule for adjustments to basis where property is
acquired from a decedent prior to his death.
1.1014-7 Example applying rules of Sec. Sec. 1.1014-4 through 1.1014-6
to case involving multiple interests.
1.1014-8 Bequest, devise, or inheritance of a remainder interest.
1.1014-9 Special rule with respect to DISC stock.
1.1015-1 Basis of property acquired by gift after December 31, 1920.
1.1015-2 Transfer of property in trust after December 31, 1920.
1.1015-3 Gift or transfer in trust before January 1, 1921.
1.1015-4 Transfers in part a gift and in part a sale.
1.1015-5 Increased basis for gift tax paid.
1.1016-1 Adjustments to basis; scope of section.
1.1016-2 Items properly chargeable to capital account.
1.1016-3 Exhaustion, wear and tear, obsolescence, amortization, and
depletion for periods since February 28, 1913.
1.1016-4 Exhaustion, wear and tear, obsolescence, amortization, and
depletion; periods during which income was not subject to tax.
1.1016-5 Miscellaneous adjustments to basis.
1.1016-6 Other applicable rules.
1.1016-10 Substituted basis.
1.1017-1 Basis reductions following a discharge of indebtedness.
1.1019-1 Property on which lessee has made improvements.
1.1020-1 Election as to amounts allowed in respect of depreciation,
etc., before 1952.
1.1021-1 Sale of annuities.
Common Nontaxable Exchanges
1.1031-0 Table of contents.
1.1031(a)-1 Property held for productive use in trade or business or for
investment.
1.1031(a)-2 Additional rules for exchanges of personal property.
1.1031(b)-1 Receipt of other property or money in tax-free exchange.
1.1031(b)-2 Safe harbor for qualified intermediaries.
1.1031(c)-1 Nonrecognition of loss.
1.1031(d)-1 Property acquired upon a tax-free exchange.
1.1031(d)-1T Coordination of section 1060 with section 1031 (temporary).
1.1031(d)-2 Treatment of assumption of liabilities.
1.1031(e)-1 Exchange of livestock of different sexes.
1.1031(j)-1 Exchanges of multiple properties.
1.1031(k)-1 Treatment of deferred exchanges.
1.1032-1 Disposition by a corporation of its own capital stock.
1.1032-2 Disposition by a corporation of stock of a controlling
corporation in certain triangular reorganizations.
1.1032-3 Disposition of stock or stock options in certain transactions
not qualifying under any other nonrecognition provision.
1.1033(a)-1 Involuntary conversions; nonrecognition of gain.
1.1033(a)-2 Involuntary conversion into similar property, into money or
into dissimilar property.
1.1033(a)-3 Involuntary conversion of principal residence.
1.1033(b)-1 Basis of property acquired as a result of an involuntary
conversion.
1.1033(c)-1 Disposition of excess property within irrigation project
deemed to be involuntary conversion.
1.1033(d)-1 Destruction or disposition of livestock because of disease.
1.1033(e)-1 Sale or exchange of livestock solely on account of drought.
1.1033(g)-1 Condemnation of real property held for productive use in
trade or business or for investment.
[[Page 6]]
1.1033(h)-1 Effective date.
1.1035-1 Certain exchanges of insurance policies.
1.1036-1 Stock for stock of the same corporation.
1.1037-1 Certain exchanges of United States obligations.
1.1038-1 Reacquisitions of real property in satisfaction of
indebtedness.
1.1038-2 Reacquisition and resale of property used as a principal
residence.
1.1038-3 Election to have section 1038 apply for taxable years beginning
after December 31, 1957.
1.1039-1 Certain sales of low-income housing projects.
1.1041-1T Treatment of transfer of property between spouses or incident
to divorce (temporary).
1.1041-2 Redemptions of stock.
1.1042-1T Questions and answers relating to the sales of stock to
employee stock ownership plans or certain cooperatives
(temporary).
1.1044(a)-1 Time and manner for making election under the Omnibus Budget
Reconciliation Act of 1993.
1.1045-1 Application to partnerships.
Special Rules
1.1051-1 Basis of property acquired during affiliation.
1.1052-1 Basis of property established by Revenue Act of 1932.
1.1052-2 Basis of property established by Revenue Act of 1934.
1.1052-3 Basis of property established by the Internal Revenue Code of
1939.
1.1053-1 Property acquired before March 1, 1913.
1.1054-1 Certain stock of Federal National Mortgage Association.
1.1055-1 General rule with respect to redeemable ground rents.
1.1055-2 Determination of amount realized on the transfer of the right
to hold real property subject to liabilities under a
redeemable ground rent.
1.1055-3 Basis of real property held subject to liabilities under a
redeemable ground rent.
1.1055-4 Basis of redeemable ground rent reserved or created in
connection with transfers of real property before April 11,
1963.
1.1059(e)-1 Non-pro rata redemptions.
1.1059A-1 Limitation on taxpayer's basis or inventory cost in property
imported from related persons.
1.1060-1 Special allocation rules for certain asset acquisitions.
Changes To Effectuate F.C.C. Policy
1.1071-1 Gain from sale or exchange to effectuate policies of Federal
Communications Commission.
1.1071-2 Nature and effect of election.
1.1071-3 Reduction of basis of property pursuant to election under
section 1071.
1.1071-4 Manner of election.
Exchanges in Obedience to S.E.C. Orders
1.1081-1 Terms used.
1.1081-2 Purpose and scope of exception.
1.1081-3 Exchanges of stock or securities solely for stock or
securities.
1.1081-4 Exchanges of property for property by corporations.
1.1081-5 Distribution solely of stock or securities.
1.1081-6 Transfers within system group.
1.1081-7 Sale of stock or securities received upon exchange by members
of system group.
1.1081-8 Exchanges in which money or other nonexempt property is
received.
1.1081-9 Requirements with respect to order of Securities and Exchange
Commission.
1.1081-10 Nonapplication of other provisions of the Internal Revenue
Code of 1954.
1.1081-11 Records to be kept and information to be filed with returns.
1.1082-1 Basis for determining gain or loss.
1.1082-2 Basis of property acquired upon exchanges under section 1081
(a) or (e).
1.1082-3 Reduction of basis of property by reason of gain not recognized
under section 1081(b).
1.1082-4 Basis of property acquired by corporation under section
1081(a), 1081(b), or 1081(e) as contribution of capital or
surplus, or in consideration for its own stock or securities.
1.1082-5 Basis of property acquired by shareholder upon tax-free
distribution under section 1081(c) (1) or (2).
1.1082-6 Basis of property acquired under section 1081(d) in
transactions between corporations of the same system group.
1.1083-1 Definitions.
Wash Sales of Stock or Securities
1.1091-1 Losses from wash sales of stock or securities.
1.1091-2 Basis of stock or securities acquired in ``wash sales''.
1.1092(b)-1T Coordination of loss deferral rules and wash sale rules
(temporary).
1.1092(b)-2T Treatment of holding periods and losses with respect to
straddle positions (temporary).
1.1092(b)-3T Mixed straddles; straddle-by-straddle identification under
section 1092(b)(2)(A)(i)(I) (Temporary).
1.1092(b)-4T Mixed straddles; mixed straddle account (temporary).
1.1092(b)-5T Definitions (temporary).
1.1092(b)-6 Mixed straddles; accrued gain and loss associated with a
position that becomes part of a section 1092(b)(2) identified
mixed straddle that is established after August 18, 2014.
[[Page 7]]
1.1092(c)-1 Qualified covered calls.
1.1092(c)-2 Equity options with flexible terms.
1.1092(c)-3 Qualifying over-the-counter options.
1.1092(c)-4 Definitions.
1.1092(d)-1 Definitions and special rules.
1.1092(d)-2 Personal property.
CAPITAL GAINS AND LOSSES
Treatment of Capital Gains
1.1201-1 Alternative tax.
1.1202-0 Table of contents.
1.1202-1 Deduction for capital gains.
1.1202-2 Qualified small business stock; effect of redemptions.
Treatment of Capital Losses
1.1211-1 Limitation on capital losses.
1.1212-1 Capital loss carryovers and carrybacks.
General Rules for Determining Capital Gains and Losses
1.1221-1 Meaning of terms.
1.1221-2 Hedging transactions.
1.1221-3 Time and manner for electing capital asset treatment for
certain self-created musical works.
1.1222-1 Other terms relating to capital gains and losses.
1.1223-1 Determination of period for which capital assets are held.
1.1223-3 Rules relating to the holding periods of partnership interests.
Special Rules for Determining Capital Gains and Losses
1.1231-1 Gains and losses from the sale or exchange of certain property
used in the trade or business.
1.1231-2 Livestock held for draft, breeding, dairy, or sporting
purposes.
1.1232-1 Bonds and other evidences of indebtedness; scope of section.
1.1232-2 [Reserved]
1.1232-3 Gain upon sale or exchange of obligations issued at a discount
after December 31, 1954.
1.1232-3A Inclusion as interest of original issue discount on certain
obligations issued after May 27, 1969.
1.1233-1 Gains and losses from short sales.
1.1233-2 Hedging transactions.
1.1234-1 Options to buy or sell.
1.1234-2 Special rule for grantors of straddles applicable to certain
options granted on or before September 1, 1976.
1.1234-3 Special rules for the treatment of grantors of certain options
granted after September 1, 1976.
1.1234-4 Hedging transactions.
1.1235-1 Sale or exchange of patents.
1.1235-2 Definition of terms.
1.1236-1 Dealers in securities.
1.1237-1 Real property subdivided for sale.
1.1238-1 Amortization in excess of depreciation.
1.1239-1 Gain from sale or exchange of depreciable property between
certain related taxpayers after October 4, 1976.
1.1239-2 Gain from sale or exchange of depreciable property between
certain related taxpayers on or before October 4, 1976.
1.1240-1 Capital gains treatment of certain termination payments.
1.1241-1 Cancellation of lease or distributor's agreement.
1.1242-1 Losses on small business investment company stock.
1.1243-1 Loss of small business investment company.
1.1244(a)-1 Loss on small business stock treated as ordinary loss.
1.1244(b)-1 Annual limitation.
1.1244(c)-1 Section 1244 stock defined.
1.1244(c)-2 Small business corporation defined.
1.1244(d)-1 Contributions of property having basis in excess of value.
1.1244(d)-2 Increases in basis of section 1244 stock.
1.1244(d)-3 Stock dividend, recapitalizations, changes in name, etc.
1.1244(d)-4 Net operating loss deduction.
1.1244(e)-1 Records to be kept.
1.1245-1 General rule for treatment of gain from dispositions of certain
depreciable property.
1.1245-2 Definition of recomputed basis.
1.1245-3 Definition of section 1245 property.
1.1245-4 Exceptions and limitations.
1.1245-5 Adjustments to basis.
1.1245-6 Relation of section 1245 to other sections.
1.1248-1 Treatment of gain from certain sales or exchanges of stock in
certain foreign corporations.
1.1248-2 Earnings and profits attributable to a block of stock in simple
cases.
1.1248-3 Earnings and profits attributable to stock in complex cases.
1.1248-4 Limitation on tax applicable to individuals.
1.1248-5 Stock ownership requirements for less developed country
corporations.
1.1248-6 Sale or exchange of stock in certain domestic corporations.
1.1248-7 Taxpayer to establish earnings and profits and foreign taxes.
1.1248-8 Earnings and profits attributable to stock following certain
non-recognition transactions.
1.1248(f)-1 Certain nonrecognition distributions.
1.1248(f)-2 Exceptions for certain distributions and attribution rules.
1.1248(f)-3 Reasonable cause and effective/applicability dates.
[[Page 8]]
1.1249-1 Gain from certain sales or exchanges of patents, etc., to
foreign corporations.
1.1250-1 Gain from dispositions of certain depreciable realty.
1.1250-2 Additional depreciation defined.
1.1250-3 Exceptions and limitations.
1.1250-4 Holding period.
1.1250-5 Property with two or more elements.
1.1251-1 General rule for treatment of gain from disposition of property
used in farming where farm losses offset nonfarm income.
1.1251-2 Excess deductions account.
1.1251-3 Definitions relating to section 1251.
1.1251-4 Exceptions and limitations.
1.1252-1 General rule for treatment of gain from disposition of farm
land.
1.1252-2 Special rules.
1.1254-0 Table of contents for section 1254 recapture rules.
1.1254-1 Treatment of gain from disposition of natural resource
recapture property.
1.1254-2 Exceptions and limitations.
1.1254-3 Section 1254 costs immediately after certain acquisitions.
1.1254-4 Special rules for S corporations and their shareholders.
1.1254-5 Special rules for partnerships and their partners.
1.1254-6 Effective/applicability date.
1.1256(e)-1 Identification of hedging transactions.
1.1258-1 Netting rule for certain conversion transactions.
1.1271-0 Original issue discount; effective date; table of contents.
1.1271-1 Special rules applicable to amounts received on retirement,
sale, or exchange of debt instruments.
1.1272-1 Current inclusion of OID in income.
1.1272-2 Treatment of debt instruments purchased at a premium.
1.1272-3 Election by a holder to treat all interest on a debt instrument
as OID.
1.1273-1 Definition of OID.
1.1273-2 Determination of issue price and issue date.
1.1274-1 Debt instruments to which section 1274 applies.
1.1274-2 Issue price of debt instruments to which section 1274 applies.
1.1274-3 Potentially abusive situations defined.
1.1274-4 Test rate.
1.1274-5 Assumptions.
1.1274A-1 Special rules for certain transactions where stated principal
amount does not exceed $2,800,000.
1.1275-1 Definitions.
1.1275-2 Special rules relating to debt instruments.
1.1275-3 OID information reporting requirements.
1.1275-4 Contingent payment debt instruments.
1.1275-5 Variable rate debt instruments.
1.1275-6 Integration of qualifying debt instruments.
1.1275-7 Inflation-indexed debt instruments.
1.1286-1 Tax treatment of certain stripped bonds and stripped coupons.
1.1286-2 Stripped inflation-protected debt instruments.
1.1287-1 Denial of capital gains treatment for gains on registration-
required obligations not in registered form.
1.1288-1 Adjustment of applicable Federal rate for tax-exempt
obligations.
1.1291-0 Treatment of shareholders of certain passive foreign investment
companies; table of contents.
1.1291-1 Taxation of U.S. persons that are shareholders of section 1291
funds.
1.1291-9 Deemed dividend election.
1.1291-10 Deemed sale election.
1.1293-0 Table of contents.
1.1293-1 Current taxation of income from qualified electing funds.
1.1294-0 Table of contents.
1.1294-1T Election to extend the time for payment of tax on
undistributed earnings of a qualified electing fund
(temporary).
1.1295-0 Table of contents.
1.1295-1 Qualified electing funds.
1.1295-3 Retroactive elections.
1.1296-1 Mark to market election for marketable stock.
1.1296-2 Definition of marketable stock.
1.1297-0 Table of contents.
1.1297-3 Deemed sale or deemed dividend election by a U.S. person that
is a shareholder of a section 1297(e) PFIC.
1.1298-0 Passive foreign investment company--table of contents.
1.1298-1 Section 1298(f) annual reporting requirements for United States
persons that are shareholders of a passive foreign investment
company.
1.1298-3 Deemed sale or deemed dividend election by a U.S. person that
is a shareholder of a former PFIC.
Income Averaging
1.1301-1 Averaging of farm and fishing income.
READJUSTMENT OF TAX BETWEEN YEARS AND SPECIAL LIMITATIONS
Mitigation of Effect of Limitations and Other Provisions
1.1311(a)-1 Introduction.
1.1311(a)-2 Purpose and scope of section 1311.
1.1311(b)-1 Maintenance of an inconsistent position.
1.1311(b)-2 Correction not barred at time of erroneous action.
1.1311(b)-3 Existence of relationship in case of adjustment by way of
deficiency assessment.
[[Page 9]]
1.1312-1 Double inclusion of an item of gross income.
1.1312-2 Double allowance of a deduction or credit.
1.1312-3 Double exclusion of an item of gross income.
1.1312-4 Double disallowance of a deduction or credit.
1.1312-5 Correlative deductions and inclusions for trusts or estates and
legatees, beneficiaries, or heirs.
1.1312-6 Correlative deductions and credits for certain related
corporations.
1.1312-7 Basis of property after erroneous treatment of a prior
transaction.
1.1312-8 Law applicable in determination of error.
1.1313(a)-1 Decision by Tax Court or other court as a determination.
1.1313(a)-2 Closing agreement as a determination.
1.1313(a)-3 Final disposition of claim for refund as a determination.
1.1313(a)-4 Agreement pursuant to section 1313(a)(4) as a determination.
1.1313(c)-1 Related taxpayer.
1.1314(a)-1 Ascertainment of amount of adjustment in year of error.
1.1314(a)-2 Adjustment to other barred taxable years.
1.1314(b)-1 Method of adjustment.
1.1314(c)-1 Adjustment unaffected by other items.
Involuntary Liquidation and Replacement of Lifo Inventories
1.1321-1 Involuntary liquidation of lifo inventories.
1.1321-2 Liquidation and replacement of lifo inventories by acquiring
corporations.
War Loss Recoveries
1.1331-1 Recoveries in respect of war losses.
1.1332-1 Inclusion in gross income of war loss recoveries.
1.1333-1 Tax adjustment measured by prior benefits.
1.1334-1 Restoration of value of investments.
1.1335-1 Elective method; time and manner of making election and effect
thereof.
1.1336-1 Basis of recovered property.
1.1337-1 Determination of tax benefits from allowable deductions.
Claim of Right
1.1341-1 Restoration of amounts received or accrued under claim of
right.
1.1342-1 Computation of tax where taxpayer recovers substantial amount
held by another under claim of right; effective date.
Other Limitations
1.1346-1 Recovery of unconstitutional taxes.
1.1347-1 Tax on certain amounts received from the United States.
1.1348-1 Fifty-percent maximum tax on earned income.
1.1348-2 Computation of the fifty-percent maximum tax on earned income.
1.1348-3 Definitions.
Small Business Corporations and Their Shareholders
1.1361-0 Table of contents.
1.1361-1 S corporation defined.
1.1361-2 Definitions relating to S corporation subsidiaries.
1.1361-3 QSub election.
1.1361-4 Effect of QSub election.
1.1361-5 Termination of QSub election.
1.1361-6 Effective date.
1.1362-0 Table of contents.
1.1362-1 Election to be an S corporation.
1.1362-2 Termination of election.
1.1362-3 Treatment of S termination year.
1.1362-4 Inadvertent terminations and inadvertently invalid elections.
1.1362-5 Election after termination.
1.1362-6 Elections and consents.
1.1362-7 Effective dates.
1.1362-8 Dividends received from affiliated subsidiaries.
1.1363-1 Effect of election on corporation.
1.1363-2 Recapture of LIFO benefits.
1.1366-0 Table of contents.
1.1366-1 Shareholder's share of items of an S corporation.
1.1366-2 Limitations on deduction of passthrough items of an S
corporation to its shareholders.
1.1366-3 Treatment of family groups.
1.1366-4 Special rules limiting the passthrough of certain items of an S
corporation to its shareholders.
1.1366-5 Effective/applicability date.
1.1367-0 Table of contents.
1.1367-1 Adjustments to basis of shareholder's stock in an S
corporation.
1.1367-2 Adjustments to basis of indebtedness to shareholder.
1.1367-3 Effective/Applicability date.
1.1368-0 Table of contents.
1.1368-1 Distributions by S corporations.
1.1368-2 Accumulated adjustments account (AAA).
1.1368-3 Examples.
1.1368-4 Effective date and transition rule.
1.1374-0 Table of contents.
1.1374-1 General rules and definitions.
1.1374-2 Net recognized built-in gain.
1.1374-3 Net unrealized built-in gain.
1.1374-4 Recognized built-in gain or loss.
1.1374-5 Loss carryforwards.
1.1374-6 Credits and credit carryforwards.
1.1374-7 Inventory.
1.1374-8 Section 1374(d)(8) transactions.
1.1374-9 Anti-stuffing rule.
1.1374-10 Effective date and additional rules.
[[Page 10]]
1.1375-1 Tax imposed when passive investment income of corporation
having subchapter C earnings and profits exceed 25 percent of
gross receipts.
1.1377-0 Table of contents.
1.1377-1 Pro rata share.
1.1377-2 Post-termination transition period.
1.1377-3 Effective dates.
1.1378-1 Taxable year of S corporation.
Section 1374 Before the Tax Reform Act of 1986
1.1374-1A Tax imposed on certain capital gains.
COOPERATIVES AND THEIR PATRONS
Tax Treatment of Cooperatives
1.1381-1 Organizations to which part applies.
1.1381-2 Tax on certain farmers' cooperatives.
1.1382-1 Taxable income of cooperatives; gross income.
1.1382-2 Taxable income of cooperatives; treatment of patronage
dividends.
1.1382-3 Taxable income of cooperatives; special deductions for exempt
farmers' cooperatives.
1.1382-4 Taxable income of cooperatives; payment period for each taxable
year.
1.1382-5 Taxable income of cooperatives; products marketed under pooling
arrangements.
1.1382-6 Taxable income of cooperatives; treatment of earnings received
after patronage occurred.
1.1382-7 Special rules applicable to cooperative associations exempt
from tax before January 1, 1952.
1.1383-1 Computation of tax where cooperative redeems nonqualified
written notices of allocation.
Tax Treatment by Patrons of Patronage Dividends
1.1385-1 Amounts includible in patron's gross income.
Definitions; Special Rules
1.1388-1 Definitions and special rules.
1.1394-0 Table of contents.
1.1394-1 Enterprise zone facility bonds.
Empowerment Zone Employment Credit
1.1396-1 Qualified zone employees.
1.1397E-1 Qualified zone academy bonds.
Rules Relating to Individuals' Title 11 Cases
1.1398-1 Treatment of passive activity losses and passive activity
credits in individuals' title 11 cases.
1.1398-2 Treatment of section 465 losses in individuals' title 11 cases.
1.1398-3 Treatment of section 121 exclusion in individuals' title 11
cases.
1.1400L(b)-1 Additional first year depreciation deduction for qualified
New York Liberty Zone property.
1.1400Z2-0 Table of contents.
1.1400Z2(a)-1 Deferring tax on capital gains by investing in opportunity
zones.
1.1400Z2(b)-1 Inclusion of gains that have been deferred under section
1400Z-2(a).
1.1400Z2(c)-1 Investments held for at least 10 years.
1.1400Z2(d)-1 Qualified opportunity funds and qualified opportunity zone
businesses.
1.1400Z2(d)-2 Qualified opportunity zone business property.
1.1400Z2(e)-1 [Reserved]
1.1400Z2(f)-1 Administrative rules--penalties, anti-abuse, etc.
Authority: 26 U.S.C. 7805, unless otherwise noted.
Section 1.1036-1 also issued under 26 U.S.C. 351(g)(4).
Section 1.1059(e)-1 also issued under 26 U.S.C. 1059 (e)(1) and
(e)(2).
Section 1.1060-1 also issued under 26 U.S.C. 1060.
Sections 1.1092(b)-1T and 1.1092(b)-2T also issued under 26 U.S.C.
1092 (b)(1).
Section 1.1092(b)-4T also issued under 26 U.S.C. 1092(b)(2).
Section 1.1092(b)-6 also issued under 26 U.S.C. 1092(b)(1).
Section 1.1092(b)-6 also issued under 26 U.S.C. 1092(b)(2).
Section 1.1092(c)-1 also issued under 26 U.S.C. 1092(c)(4)(H).
Section 1.1092(c)-2 also issued under 26 U.S.C. 1092(c)(4)(H).
Section 1.1092(c)-3 also issued under 26 U.S.C. 1092(c)(4)(H).
Section 1.1092(c)-4 also issued under 26 U.S.C. 1092(c)(4)(H).
Section 1.1092(d)-1 also issued under 26 U.S.C. 1092(b)(1).
Section 1.1092(d)-2 also issued under 26 U.S.C. 1092(d)(3)(B).
Section 1.1202-2 is also issued under 26 U.S.C. 1202(k).
Section 1.1221-2 also issued under 26 U.S.C. 1221(b)(2)(A)(iii),
(b)(2)(B), and (b)(3); 1502 and 6001.
Section 1.1244(e)-1 also issued under 26 U.S.C. 1244(e).
Section 1.1248-8 also issued under 26 U.S.C. 1248(a) and (c)(1) and
(2).
Section 1.1254-1 also issued under 26 U.S.C. 1254(b).
Section 1.1254-2 also issued under 26 U.S.C. 1254(b).
Section 1.1254-3 also issued under 26 U.S.C. 1254(b).
Section 1.1254-4 also issued under 26 U.S.C. 1254(b).
Section 1.1254-5 also issued under 26 U.S.C. 1254(b).
[[Page 11]]
Section 1.1254-6 also issued under 26 U.S.C. 1254(b).
Section 1.1271-1 also issued under 26 U.S.C. 1275(d).
Section 1.1272-1 also issued under 26 U.S.C. 1275(d).
Section 1.1272-2 also issued under 26 U.S.C. 1275(d).
Section 1.1272-3 also issued under 26 U.S.C. 1275(d).
Section 1.1273-1 also issued under 26 U.S.C. 1275(d).
Section 1.1273-2 also issued under 26 U.S.C. 1275(d).
Section 1.1274-1 also issued under 26 U.S.C. 1275(d).
Section 1.1274-2 also issued under 26 U.S.C. 1275(d).
Section 1.1274-3 also issued under 26 U.S.C. 1275(d).
Section 1.1274-4 also issued under 26 U.S.C. 1275(d).
Section 1.1274-5 also issued under 26 U.S.C. 1275(d).
Section 1.1274A-1 also issued under 26 U.S.C. 1274A(e) and 26 U.S.C.
1275(d).
Section 1.1275-1 also issued under 26 U.S.C. 1275(d).
Section 1.1275-2 also issued under 26 U.S.C. 1275(d).
Section 1.1275-3 also issued under 26 U.S.C. 1275(d).
Section 1.1275-4 also issued under 26 U.S.C. 1275(d).
Section 1.1275-5 also issued under 26 U.S.C. 1275(d).
Section 1.1275-6 also issued under 26 U.S.C. 1275(d).
Section 1.1275-7 also issued under 26 U.S.C. 1275(d).
Section 1.1286-1 also issued under 26 U.S.C. 1275(D) and 1286(f).
Section 1.1286-2 also issued under 26 U.S.C. 1286(f).
Section 1.1287-1 also issued under 26 U.S.C. 165 (j)(3).
Section 1.1291-1 also issued under 26 U.S.C. 1291.
Section 1.1291-1 also issued under 26 U.S.C. 1298(a) and (g).
Section 1.1291-9, also issued under 26 U.S.C. 1298(a) and (g).
Section 1.1298-1 also issued under 26 U.S.C. 1298(f).
Sections 1.1291-1T, 1.1291-9, 1.1291-9T, and 1.1298-1T also issued
under 26 U.S.C. 1298(a) and (g).
Section 1.1291-9 also issued under 26 U.S.C. 1291(d)(2).
Section 1.1291-10 also issued under 26 U.S.C. 1291(d)(2).
Section 1.1293-1 also issued under 26 U.S.C. 1293.
Section 1.1294-1T also issued under 26 U.S.C. 1294.
Section 1.1295-1 also issued under 26 U.S.C. 1295.
Section 1.1295-3 also issued under 26 U.S.C. 1295.
Section 1.1296-1 also issued under 26 U.S.C. 1296(g) and 26 U.S.C.
1298(f).
Section 1.1296(e)-1 also issued under 26 U.S.C. 1296(e).
Section 1.1297-3T also issued under 26 U.S.C. 1297(b)(1).
Section 1.1298-1T also issued under 26 U.S.C. 1298(f) and (g).
Section 1.1301-1 also issued under 26 U.S.C. 1301(c).
Section 1.1301-1T also issued under 26 U.S.C. 1301(c).
Section 1.1361-1(j) (6), (10) and (11) also issued under 26 U.S.C.
1361(d)(2)(B)(iii).
Section 1.1361-1(l) also issued under 26 U.S.C. 1361(c)(5)(C).
Sections 1.1362-1, 1.1362-2, 1.1362-3, 1.1362-4, 1.1362-5, 1.1362-6,
1.1362-7, and 1.1363-1 also issued under 26 U.S.C. 1377.
Section 1.1363-2 also issued under 26 U.S.C. 337(d).
Section 1.1368-1(f) and (g) also issued under 26 U.S.C. 1377(c).
Section 1.1368-2(b) also issued under 26 U.S.C. 1368(c).
Section 1.1374-1 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-2 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-3 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-4 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-5 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-6 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-7 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-8 also issued under 26 U.S.C. 337(d) and 1374(e).
Section 1.1374-8 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-8T also issued under 26 U.S.C. 337(d) and 1374(e).
Section 1.1374-9 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-10 also issued under 26 U.S.C. 337(d) and 1374(e).
Section 1.1374-10 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-10T also issued under 26 U.S.C. 337(d) and 1374(e).
Section 1.1377-1 also issued under 26 U.S.C. 1377(a)(2) and (c).
Section 1.1394-1 also issued under 26 U.S.C. 1397D.
Section 1.1396-1 also issued under 26 U.S.C. 1397D.
Section 1.1397E-1 also issued under 26 U.S.C. 1397E.
Section 1.1400Z2(a)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(b)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
[[Page 12]]
Section 1.1400Z2(c)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(d)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(d)-2 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(f)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Editorial Note: At 72 FR 51705, Sept. 11, 2007, the authority
citation was amended by removing Sec. 1.1060-T; however, the amendment
could not be incorporated due to inaccurate amendatory instruction.
Source: T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31,
1960, unless otherwise noted.
GAIN OR LOSS ON DISPOSITION OF PROPERTY
Determination of Amount of and Recognition of Gain or Loss
Sec. 1.1001-1 Computation of gain or loss.
(a) General rule. Except as otherwise provided in subtitle A of the
Code, the gain or loss realized from the conversion of property into
cash, or from the exchange of property for other property differing
materially either in kind or in extent, is treated as income or as loss
sustained. The amount realized from a sale or other disposition of
property is the sum of any money received plus the fair market value of
any property (other than money) received. The fair market value of
property is a question of fact, but only in rare and extraordinary cases
will property be considered to have no fair market value. The general
method of computing such gain or loss is prescribed by section 1001 (a)
through (d) which contemplates that from the amount realized upon the
sale or exchange there shall be withdrawn a sum sufficient to restore
the adjusted basis prescribed by section 1011 and the regulations
thereunder (i.e., the cost or other basis adjusted for receipts,
expenditures, losses, allowances, and other items chargeable against and
applicable to such cost or other basis). The amount which remains after
the adjusted basis has been restored to the taxpayer constitutes the
realized gain. If the amount realized upon the sale or exchange is
insufficient to restore to the taxpayer the adjusted basis of the
property, a loss is sustained to the extent of the difference between
such adjusted basis and the amount realized. The basis may be different
depending upon whether gain or loss is being computed. For example, see
section 1015(a) and the regulations thereunder. Section 1001(e) and
paragraph (f) of this section prescribe the method of computing gain or
loss upon the sale or other disposition of a term interest in property
the adjusted basis (or a portion) of which is determined pursuant, or by
reference, to section 1014 (relating to the basis of property acquired
from a decedent), section 1015 (relating to the basis of property
acquired by gift or by a transfer in trust), or section 1022 (relating
to the basis of property acquired from certain decedents who died in
2010).
(b) Real estate taxes as amounts received. (1) Section 1001(b) and
section 1012 state rules applicable in making an adjustment upon a sale
of real property with respect to the real property taxes apportioned
between seller and purchaser under section 164(d). Thus, if the seller
pays (or agrees to pay) real property taxes attributable to the real
property tax year in which the sale occurs, he shall not take into
account, in determining the amount realized from the sale under section
1001(b), any amount received as reimbursement for taxes which are
treated under section 164(d) as imposed upon the purchaser. Similarly,
in computing the cost of the property under section 1012, the purchaser
shall not take into account any amount paid to the seller as
reimbursement for real property taxes which are treated under section
164(d) as imposed upon the purchaser. These rules apply whether or not
the contract of sale calls for the purchaser to reimburse the seller for
such real property taxes paid or to be paid by the seller.
(2) On the other hand, if the purchaser pays (or is to pay) an
amount representing real property taxes which are treated under section
164(d) as imposed upon the seller, that amount shall be taken into
account both in determining the amount realized from the sale under
section 1001(b) and in computing the cost of the property under section
1012. It is immaterial whether or not the contract of sale specifies
that the sale price has been
[[Page 13]]
reduced by, or is in any way intended to reflect, the taxes allocable to
the seller. See also paragraph (b) of Sec. 1.1012-1.
(3) Subparagraph (1) of this paragraph shall not apply to a seller
who, in a taxable year prior to the taxable year of sale, pays an amount
representing real property taxes which are treated under section 164(d)
as imposed on the purchaser, if such seller has elected to capitalize
such amount in accordance with section 266 and the regulations
thereunder (relating to election to capitalize certain carrying charges
and taxes).
(4) The application of this paragraph may be illustrated by the
following examples:
Example 1. Assume that the contract price on the sale of a parcel of
real estate is $50,000 and that real property taxes thereon in the
amount of $1,000 for the real property tax year in which occurred the
date of sale were previously paid by the seller. Assume further that
$750 of the taxes are treated under section 164(d) as imposed upon the
purchaser and that he reimburses the seller in that amount in addition
to the contract price. The amount realized by the seller is $50,000.
Similarly, $50,000 is the purchaser's cost. If, in this example, the
purchaser made no payment other than the contract price of $50,000, the
amount realized by the seller would be $49,250, since the sales price
would be deemed to include $750 paid to the seller in reimbursement for
real property taxes imposed upon the purchaser. Similarly, $49,250 would
be the purchaser's cost.
Example 2. Assume that the purchaser in example (1), above, paid all
of the real property taxes. Assume further that $250 of the taxes are
treated under section 164(d) as imposed upon the seller. The amount
realized by the seller is $50,250. Similarly, $50,250 is the purchaser's
cost, regardless of the taxable year in which the purchaser makes actual
payment of the taxes.
Example 3. Assume that the seller described in the first part of
example (1), above, paid the real property taxes of $1,000 in the
taxable year prior to the taxable year of sale and elected under section
266 to capitalize the $1,000 of taxes. In such a case, the amount
realized is $50,750. Moreover, regardless of whether the seller elected
to capitalize the real property taxes, the purchaser in that case could
elect under section 266 to capitalize the $750 of taxes treated under
section 164(d) as imposed upon him, in which case his adjusted basis
would be $50,750 (cost of $50,000 plus capitalized taxes of $570).
(c) Other rules. (1) Even though property is not sold or otherwise
disposed of, gain is realized if the sum of all the amounts received
which are required by section 1016 and other applicable provisions of
subtitle A of the Code to be applied against the basis of the property
exceeds such basis. Except as otherwise provided in section 301(c)(3)(B)
with respect to distributions out of increase in value of property
accrued prior to March 1, 1913, such gain is includible in gross income
under section 61 as ``income from whatever source derived''. On the
other hand, a loss is not ordinarily sustained prior to the sale or
other disposition of the property, for the reason that until such sale
or other disposition occurs there remains the possibility that the
taxpayer may recover or recoup the adjusted basis of the property. Until
some identifiable event fixes the actual sustaining of a loss and the
amount thereof, it is not taken into account.
(2) The provisions of subparagraph (1) of this paragraph may be
illustrated by the following example:
Example: A, an individual on a calendar year basis, purchased
certain shares of stock subsequent to February 28, 1913, for $10,000. On
January 1, 1954, A's adjusted basis for the stock had been reduced to
$1,000 by reason of receipts and distributions described in sections
1016(a)(1) and 1016(a)(4). He received in 1954 a further distribution of
$5,000, being a distribution covered by section 1016(a)(4), other than a
distribution out of increase of value of property accrued prior to March
1, 1913. This distribution applied against the adjusted basis as
required by section 1016(a)(4) exceeds that basis by $4,000. The $4,000
excess is a gain realized by A in 1954 and is includible in gross income
in his return for that calendar year. In computing gain from the stock,
as in adjusting basis, no distinction is made between items of receipts
or distributions described in section 1016. If A sells the stock in 1955
for $5,000, he realizes in 1955 a gain of $5,000, since the adjusted
basis of the stock for the purpose of computing gain or loss from the
sale is zero.
(d) Installment sales. In the case of property sold on the
installment plan, special rules for the taxation of the gain are
prescribed in section 453.
(e) Transfers in part a sale and in part a gift. (1) Where a
transfer of property is in part a sale and in part a gift, the
transferor has a gain to the extent that the amount realized by him
exceeds his
[[Page 14]]
adjusted basis in the property. However, no loss is sustained on such a
transfer if the amount realized is less than the adjusted basis. For the
determination of basis of property in the hands of the transferee, see
Sec. 1.1015-4. For the allocation of the adjusted basis of property in
the case of a bargain sale to a charitable organization, see Sec.
1.1011-2.
(2) Examples. The provisions of subparagraph (1) may be illustrated
by the following examples:
Example 1. A transfers property to his son for $60,000. Such
property in the hands of A has an adjusted basis of $30,000 (and a fair
market value of $90,000). A's gain is $30,000, the excess of $60,000,
the amount realized, over the adjusted basis, $30,000. He has made a
gift of $30,000, the excess of $90,000, the fair market value, over the
amount realized, $60,000.
Example 2. A transfers property to his son for $30,000. Such
property in the hands of A has an adjusted basis of $60,000 (and a fair
market value of $90,000). A has no gain or loss, and has made a gift of
$60,000, the excess of $90,000, the fair market value, over the amount
realized, $30,000.
Example 3. A transfers property to his son for $30,000. Such
property in A's hands has an adjusted basis of $30,000 (and a fair
market value of $60,000). A has no gain and has made a gift of $30,000,
the excess of $60,000, the fair market value, over the amount realized,
$30,000.
Example 4. A transfers property to his son for $30,000. Such
property in A's hands has an adjusted basis of $90,000 (and a fair
market value of $60,000). A has sustained no loss, and has made a gift
of $30,000, the excess of $60,000, the fair market value, over the
amount realized, $30,000.
(f) Sale or other disposition of a term interest in property--(1)
General rule. Except as otherwise provided in paragraph (f)(3) of this
section, for purposes of determining gain or loss from the sale or other
disposition after October 9, 1969, of a term interest in property (as
defined in paragraph (f)(2) of this section), a taxpayer shall not take
into account that portion of the adjusted basis of such interest that is
determined pursuant, or by reference, to section 1014 (relating to the
basis of property acquired from a decedent), section 1015 (relating to
the basis of property acquired by gift or by a transfer in trust), or
section 1022 (relating to the basis of property acquired from certain
decedents who died in 2010) to the extent that such adjusted basis is a
portion of the adjusted uniform basis of the entire property (as defined
in Sec. 1.1014-5). Where a term interest in property is transferred to
a corporation in connection with a transaction to which section 351
applies and the adjusted basis of the term interest:
(i) Is determined pursuant to sections 1014, 1015, or 1022; and
(ii) Is also a portion of the adjusted uniform basis of the entire
property, a subsequent sale or other disposition of such term interest
by the corporation will be subject to the provisions of section 1001(e)
and this paragraph (f) to the extent that the basis of the term interest
so sold or otherwise disposed of is determined by reference to its basis
in the hands of the transferor as provided by section 362(a). See
paragraph (f)(2) of this section for rules relating to the
characterization of stock received by the transferor of a term interest
in property in connection with a transaction to which section 351
applies. That portion of the adjusted uniform basis of the entire
property that is assignable to such interest at the time of its sale or
other disposition shall be determined under the rules provided in Sec.
1.1014-5. Thus, gain or loss realized from a sale or other disposition
of a term interest in property shall be determined by comparing the
amount of the proceeds of such sale with that part of the adjusted basis
of such interest that is not a portion of the adjusted uniform basis of
the entire property.
(2) Term interest defined. For purposes of section 1001(e) and this
paragraph, a term interest in property means--
(i) A life interest in property,
(ii) An interest in property for a term of years, or
(iii) An income interest in a trust.
Generally, subdivisions (i), (ii), and (iii) refer to an interest,
present or future, in the income from property or the right to use
property which will terminate or fail on the lapse of time, on the
occurrence of an event or contingency, or on the failure of an event or
contingency to occur. Such divisions do not refer to remainder or
reversionary interests in the property itself or other interests in the
property which will
[[Page 15]]
ripen into ownership of the entire property upon termination or failure
of a preceding term interest. A term interest in property also includes
any property received upon a sale or other disposition of a life
interest in property, an interest in property for a term of years, or an
income interest in a trust by the original holder of such interest, but
only to the extent that the adjusted basis of the property received is
determined by reference to the adjusted basis of the term interest so
transferred.
(3) Exception. Paragraph (1) of section 1001(e) and subparagraph (1)
of this paragraph shall not apply to a sale or other disposition of a
term interest in property as a part of a single transaction in which the
entire interest in the property is transferred to a third person or to
two or more other persons, including persons who acquire such entire
interest as joint tenants, tenants by the entirety, or tenants in
common. See Sec. 1.1014-5 for computation of gain or loss upon such a
sale or other disposition where the property has been acquired from a
decedent or by gift or transfer in trust.
(4) Illustrations. For examples illustrating the application of this
paragraph, see paragraph (d) of Sec. 1.1014-5.
(g) Debt instruments issued in exchange for property--(1) In
general. If a debt instrument is issued in exchange for property, the
amount realized attributable to the debt instrument is the issue price
of the debt instrument as determined under Sec. 1.1273-2 or Sec.
1.1274-2, whichever is applicable. If, however, the issue price of the
debt instrument is determined under section 1273(b)(4), the amount
realized attributable to the debt instrument is its stated principal
amount reduced by any unstated interest (as determined under section
483).
(2) Certain debt instruments that provide for contingent payments--
(i) In general. Paragraph (g)(1) of this section does not apply to a
debt instrument subject to either Sec. 1.483-4 or Sec. 1.1275-4(c)
(certain contingent payment debt instruments issued for nonpublicly
traded property).
(ii) Special rule to determine amount realized. If a debt instrument
subject to Sec. 1.1275-4(c) is issued in exchange for property, and the
income from the exchange is not reported under the installment method of
section 453, the amount realized attributable to the debt instrument is
the issue price of the debt instrument as determined under Sec. 1.1274-
2(g), increased by the fair market value of the contingent payments
payable on the debt instrument. If a debt instrument subject to Sec.
1.483-4 is issued in exchange for property, and the income from the
exchange is not reported under the installment method of section 453,
the amount realized attributable to the debt instrument is its stated
principal amount, reduced by any unstated interest (as determined under
section 483), and increased by the fair market value of the contingent
payments payable on the debt instrument. This paragraph (g)(2)(ii),
however, does not apply to a debt instrument if the fair market value of
the contingent payments is not reasonably ascertainable. Only in rare
and extraordinary cases will the fair market value of the contingent
payments be treated as not reasonably ascertainable.
(3) Coordination with section 453. If a debt instrument is issued in
exchange for property, and the income from the exchange is not reported
under the installment method of section 453, this paragraph (g) applies
rather than Sec. 15a.453-1(d)(2) to determine the taxpayer's amount
realized attributable to the debt instrument.
(4) Effective date. This paragraph (g) applies to sales or exchanges
that occur on or after August 13, 1996.
(h) Severances of trusts--(1) In general. The severance of a trust
(including without limitation a severance that meets the requirements of
Sec. 26.2642-6 or of Sec. 26.2654-1(b) of this chapter) is not an
exchange of property for other property differing materially either in
kind or in extent if--
(i) An applicable state statute or the governing instrument
authorizes or directs the trustee to sever the trust; and
(ii) Any non-pro rata funding of the separate trusts resulting from
the severance (including non-pro rata funding as described in Sec.
26.2642-6(d)(4) or Sec. 26.2654-1(b)(1)(ii)(C) of this chapter),
whether mandatory or in the discretion
[[Page 16]]
of the trustee, is authorized by an applicable state statute or the
governing instrument.
(2) Effective/applicability date. This paragraph (h) applies to
severances occurring on or after August 2, 2007. Taxpayers may apply
this paragraph (h) to severances occurring on or after August 24, 2004,
and before August 2, 2007.
(i) Effective/applicability date. Except as provided in paragraphs
(g) and (h) of this section, this section applies on and after January
19, 2017. For rules before January 19, 2017, see Sec. 1.1001-1 as
contained in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7142, 36 FR
18950, Sept. 24, 1971; T.D. 7207, 37 FR 20797, Oct. 5, 1972; T.D. 7213,
37 FR 21992, Oct. 18, 1972; T.D. 8517, 59 FR 4807, Feb. 2, 1994; T.D.
8674, 61 FR 30139, June 14, 1996; T.D. 9348, 72 FR 42293, Aug. 2, 2007;
T.D. 9729, 80 FR 48250, Aug. 12, 2015; T.D. 9811, 82 FR 6240, Jan. 19,
2017]
Sec. 1.1001-2 Discharge of liabilities.
(a) Inclusion in amount realized--(1) In general. Except as provided
in paragraph (a) (2) and (3) of this section, the amount realized from a
sale or other disposition of property includes the amount of liabilities
from which the transferor is discharged as a result of the sale or
disposition.
(2) Discharge of indebtedness. The amount realized on a sale or
other disposition of property that secures a recourse liability does not
include amounts that are (or would be if realized and recognized) income
from the discharge of indebtedness under section 61(a)(12). For
situations where amounts arising from the discharge of indebtedness are
not realized and recognized, see section 108 and Sec. 1.61-12(b)(1).
(3) Liability incurred on acquisition. In the case of a liability
incurred by reason of the acquisition of the property, this section does
not apply to the extent that such liability was not taken into account
in determining the transferor's basis for such property.
(4) Special rules. For purposes of this section--
(i) The sale or other disposition of property that secures a
nonrecourse liability discharges the transferor from the liability;
(ii) The sale or other disposition of property that secures a
recourse liability discharges the transferor from the liability if
another person agrees to pay the liability (whether or not the
transferor is in fact released from liability);
(iii) A disposition of property includes a gift of the property or a
transfer of the property in satisfaction of liabilities to which it is
subject;
(iv) Contributions and distributions of property between a partner
and a partnership are not sales or other dispositions of property; and
(v) The liabilities from which a transferor is discharged as a
result of the sale or disposition of a partnership interest include the
transferor's share of the liabilities of the partnership.
(b) Effect of fair market value of security. The fair market value
of the security at the time of sale or disposition is not relevant for
purposes of determining under paragraph (a) of this section the amount
of liabilities from which the taxpayer is discharged or treated as
discharged. Thus, the fact that the fair market value of the property is
less than the amount of the liabilities it secures does not prevent the
full amount of those liabilities from being treated as money received
from the sale or other disposition of the property. However, see
paragraph (a)(2) of this section for a rule relating to certain income
from discharge of indebtedness.
(c) Examples. The provisions of this section may be illustrated by
the following examples. In each example assume the taxpayer uses the
cash receipts and disbursements method of accounting, makes a return on
the basis of the calendar year, and sells or disposes of all property
which is security for a given liability.
Example 1. In 1976 A purchases an asset for $10,000. A pays the
seller $1,000 in cash and signs a note payable to the seller for $9,000.
A is personally liable for repayment with the seller having full
recourse in the event of default. In addition, the asset which was
purchased is pledged as security. During the years 1976 and 1977, A
takes depreciation deductions on the asset in the amount of $3,100.
During this same time period A reduces the outstanding principal on the
note to $7,600. At the beginning of 1978 A sells the asset. The buyer
pays A $1,600 in cash and assumes
[[Page 17]]
personal liability for the $7,600 outstanding liability. A becomes
secondarily liable for repayment of the liability. A's amount realized
is $9,200 ($1,600 + $7,600). Since A's adjusted basis in the asset is
$6,900 ($10,000 - $3,100) A realizes a gain of $2,300 ($9,200 - $6,900).
Example 2. Assume the same facts as in example (1) except that A is
not personally liable on the $9,000 note given to the seller and in the
event of default the seller's only recourse is to the asset. In
addition, on the sale of the asset by A, the purchaser takes the asset
subject to the liability. Nevertheless, A's amount realized is $9,200
and A's gain realized is $2,300 on the sale.
Example 3. In 1975 L becomes a limited partner in partnership GL. L
contributes $10,000 in cash to GL and L's distributive share of
partnership income and loss is 10 percent. L is not entitled to receive
any guaranteed payments. In 1978 M purchases L's entire interest in
partnership GL. At the time of the sale L's adjusted basis in the
partnership interest is $20,000. At that time L's proportionate share of
liabilities, of which no partner has assumed personal liability, is
$15,000. M pays $10,000 in cash for L's interest in the partnership.
Under section 752(d) and this section, L's share of partnership
liabilities, $15,000, is treated as money received. Accordingly, L's
amount realized on the sale of the partnership interest is $25,000
($10,000 + $15,000). L's gain realized on the sale is $5,000 ($25,000 -
$20,000).
Example 4. In 1976 B becomes a limited partner in partnership BG. In
1978 B contributes B's entire interest in BG to a charitable
organization described in section 170(c). At the time of the
contribution all of the partnership liabilities are liabilities for
which neither B nor G has assumed any personal liability and B's
proportionate share of which is $9,000. The charitable organization does
not pay any cash or other property to B, but takes the partnership
interest subject to the $9,000 of liabilities. Assume that the
contribution is treated as a bargain sale to a charitable organization
and that under section 1011(b) $3,000 is determined to be the portion of
B's basis in the partnership interest allocable to the sale. Under
section 752(d) and this section, the $9,000 of liabilities is treated by
B as money received, thereby making B's amount realized $9,000. B's gain
realized is $6,000 ($9,000 - $3,000).
Example 5. In 1975 C, an individual, creates T, an irrevocable
trust. Due to certain powers expressly retained by C, T is a ``grantor
trust'' for purposes of subpart E of part 1 of subchapter J of the code
and therefore C is treated as the owner of the entire trust. T purchases
an interest in P, a partnership. C, as owner of T, deducts the
distributive share of partnership losses attributable to the partnership
interest held by T. In 1978, when the adjusted basis of the partnership
interest held by T is $1,200, C renounces the powers previously and
expressly retained that initially resulted in T being classified as a
grantor trust. Consequently, T ceases to be a grantor trust and C is no
longer considered to be the owner of the trust. At the time of the
renunciation all of P's liabilities are liabilities on which none of the
partners have assumed any personal liability and the proportionate share
of which of the interest held by T is $11,000. Since prior to the
renunciation C was the owner of the entire trust, C was considered the
owner of all the trust property for Federal income tax purposes,
including the partnership interest. Since C was considered to be the
owner of the partnership interest, C not T, was considered to be the
partner in P during the time T was a ``grantor trust''. However, at the
time C renounced the powers that gave rise to T's classification as a
grantor trust, T no longer qualified as a grantor trust with the result
that C was no longer considered to be the owner of the trust and trust
property for Federal income tax purposes. Consequently, at that time, C
is considered to have transferred ownership of the interest in P to T,
now a separate taxable entity, independent of its grantor C. On the
transfer, C's share of partnership liabilities ($11,000) is treated as
money received. Accordingly, C's amount realized is $11,000 and C's gain
realized is $9,800 ($11,000 - $1,200).
Example 6. In 1977 D purchases an asset for $7,500. D pays the
seller $1,500 in cash and signs a note payable to the seller for $6,000.
D is not personally liable for repayment but pledges as security the
newly purchased asset. In the event of default, the seller's only
recourse is to the asset. During the years 1977 and 1978 D takes
depreciation deductions on the asset totaling $4,200 thereby reducing
D's basis in the asset to $3,300 ($7,500 - $4,200). In 1979 D transfers
the asset to a trust which is not a ``grantor trust'' for purposes of
subpart E of part 1 of subchapter J of the Code. Therefore D is not
treated as the owner of the trust. The trust takes the asset subject to
the liability and in addition pays D $750 in cash. Prior to the transfer
D had reduced the amount outstanding on the liability to $4,700. D's
amount realized on the transfer is $5,450 ($4,700 + $750). Since D's
adjusted basis is $3,300, D's gain realized is $2,150 ($5,450 - $3,300).
Example 7. In 1974 E purchases a herd of cattle for breeding
purposes. The purchase price is $20,000 consisting of $1,000 cash and a
$19,000 note. E is not personally liable for repayment of the liability
and the seller's only recourse in the event of default is to the herd of
cattle. In 1977 E transfers the herd back to the original seller thereby
satisfying the indebtedness pursuant to a provision in the original
sales agreement. At the time of the transfer the fair market value of
the herd is $15,000 and the remaining principal balance
[[Page 18]]
on the note is $19,000. At that time E's adjusted basis in the herd is
$16,500 due to a deductible loss incurred when a portion of the herd
died as a result of disease. As a result of the indebtedness being
satisfied, E's amount realized is $19,000 notwithstanding the fact that
the fair market value of the herd was less than $19,000. E's realized
gain is $2,500 ($19,000 - $16,500).
Example 8. In 1980, F transfers to a creditor an asset with a fair
market value of $6,000 and the creditor discharges $7,500 of
indebtedness for which F is personally liable. The amount realized on
the disposition of the asset is its fair market value ($6,000). In
addition, F has income from the discharge of indebtedness of $1,500
($7,500 - $6,000).
[T.D. 7741, 45 FR 81744, Dec. 12, 1980]
Sec. 1.1001-3 Modifications of debt instruments.
(a) Scope--(1) In general. This section provides rules for
determining whether a modification of the terms of a debt instrument
results in an exchange for purposes of Sec. 1.1001-1(a). This section
applies to any modification of a debt instrument, regardless of the form
of the modification. For example, this section applies to an exchange of
a new instrument for an existing debt instrument, or to an amendment of
an existing debt instrument. This section also applies to a modification
of a debt instrument that the issuer and holder accomplish indirectly
through one or more transactions with third parties. This section,
however, does not apply to exchanges of debt instruments between
holders.
(2) Qualified tender bonds. This section does not apply for purposes
of determining whether tax-exempt bonds that are qualified tender bonds
are reissued for purposes of sections 103 and 141 through 150.
(b) General rule. For purposes of Sec. 1.1001-1(a), a significant
modification of a debt instrument, within the meaning of this section,
results in an exchange of the original debt instrument for a modified
instrument that differs materially either in kind or in extent. A
modification that is not a significant modification is not an exchange
for purposes of Sec. 1.1001-1(a). Paragraphs (c) and (d) of this
section define the term modification and contain examples illustrating
the application of the rule. Paragraphs (e) and (f) of this section
provide rules for determining when a modification is a significant
modification. Paragraph (f) of this section also provides rules for
determining whether the modified instrument received in an exchange will
be classified as an instrument or property right that is not debt for
federal income tax purposes. Paragraph (g) of this section contains
examples illustrating the application of the rules in paragraphs (e) and
(f) of this section.
(c) Modification defined--(1) In general--(i) Alteration of terms. A
modification means any alteration, including any deletion or addition,
in whole or in part, of a legal right or obligation of the issuer or a
holder of a debt instrument, whether the alteration is evidenced by an
express agreement (oral or written), conduct of the parties, or
otherwise.
(ii) Alterations occurring by operation of the terms of a debt
instrument. Except as provided in paragraph (c)(2) of this section, an
alteration of a legal right or obligation that occurs by operation of
the terms of a debt instrument is not a modification. An alteration that
occurs by operation of the terms may occur automatically (for example,
an annual resetting of the interest rate based on the value of an index
or a specified increase in the interest rate if the value of the
collateral declines from a specified level) or may occur as a result of
the exercise of an option provided to an issuer or a holder to change a
term of a debt instrument.
(2) Exceptions. The alterations described in this paragraph (c)(2)
are modifications, even if the alterations occur by operation of the
terms of a debt instrument.
(i) Change in obligor or nature of instrument. An alteration that
results in the substitution of a new obligor, the addition or deletion
of a co-obligor, or a change (in whole or in part) in the recourse
nature of the instrument (from recourse to nonrecourse or from
nonrecourse to recourse) is a modification.
(ii) Property that is not debt. An alteration that results in an
instrument or property right that is not debt for Federal income tax
purposes is a modification unless the alteration occurs pursuant to a
holder's option under the terms of the instrument to convert the
instrument into equity of the issuer
[[Page 19]]
(notwithstanding paragraph (c)(2)(iii) of this section). The rules of
paragraph (f)(7) of this section apply to determine whether an
alteration or modification results in an instrument or property right
that is not debt.
(iii) Certain alterations resulting from the exercise of an option.
An alteration that results from the exercise of an option provided to an
issuer or a holder to change a term of a debt instrument is a
modification unless--
(A) The option is unilateral (as defined in paragraph (c)(3) of this
section); and
(B) In the case of an option exercisable by a holder, the exercise
of the option does not result in (or, in the case of a variable or
contingent payment, is not reasonably expected to result in) a deferral
of, or a reduction in, any scheduled payment of interest or principal.
(3) Unilateral option. For purposes of this section, an option is
unilateral only if, under the terms of an instrument or under applicable
law--
(i) There does not exist at the time the option is exercised, or as
a result of the exercise, a right of the other party to alter or
terminate the instrument or put the instrument to a person who is
related (within the meaning of section 267(b) or section 707(b)(1)) to
the issuer;
(ii) The exercise of the option does not require the consent or
approval of--
(A) The other party;
(B) A person who is related to that party (within the meaning of
section 267(b) or section 707(b)(1)), whether or not that person is a
party to the instrument; or
(C) A court or arbitrator; and
(iii) The exercise of the option does not require consideration
(other than incidental costs and expenses relating to the exercise of
the option), unless, on the issue date of the instrument, the
consideration is a de minimis amount, a specified amount, or an amount
that is based on a formula that uses objective financial information (as
defined in Sec. 1.446-3(c)(4)(ii)).
(4) Failure to perform--(i) In general. The failure of an issuer to
perform its obligations under a debt instrument is not itself an
alteration of a legal right or obligation and is not a modification.
(ii) Holder's temporary forbearance. Notwithstanding paragraph
(c)(1) of this section, absent a written or oral agreement to alter
other terms of the debt instrument, an agreement by the holder to stay
collection or temporarily waive an acceleration clause or similar
default right (including such a waiver following the exercise of a right
to demand payment in full) is not a modification unless and until the
forbearance remains in effect for a period that exceeds--
(A) Two years following the issuer's initial failure to perform; and
(B) Any additional period during which the parties conduct good
faith negotiations or during which the issuer is in a title 11 or
similar case (as defined in section 368(a)(3)(A)).
(5) Failure to exercise an option. If a party to a debt instrument
has an option to change a term of an instrument, the failure of the
party to exercise that option is not a modification.
(6) Time of modification--(i) In general. Except as provided in this
paragraph (c)(6), an agreement to change a term of a debt instrument is
a modification at the time the issuer and holder enter into the
agreement, even if the change in the term is not immediately effective.
(ii) Closing conditions. If the parties condition a change in a term
of a debt instrument on reasonable closing conditions (for example,
shareholder, regulatory, or senior creditor approval, or additional
financing), a modification occurs on the closing date of the agreement.
Thus, if the reasonable closing conditions do not occur so that the
change in the term does not become effective, a modification does not
occur.
(iii) Bankruptcy proceedings. If a change in a term of a debt
instrument occurs pursuant to a plan of reorganization in a title 11 or
similar case (within the meaning of section 368(a)(3)(A)), a
modification occurs upon the effective date of the plan. Thus, unless
the plan becomes effective, a modification does not occur.
(d) Examples. The following examples illustrate the provisions of
paragraph (c) of this section:
Example 1. Reset bond. A bond provides for the interest rate to be
reset every 49 days through an auction by a remarketing agent.
[[Page 20]]
The reset of the interest rate occurs by operation of the terms of the
bond and is not an alteration described in paragraph (c)(2) of this
section. Thus, the reset of the interest rate is not a modification.
Example 2. Obligation to maintain collateral. The original terms of
a bond provide that the bond must be secured by a certain type of
collateral having a specified value. The terms also require the issuer
to substitute collateral if the value of the original collateral
decreases. Any substitution of collateral that is required to maintain
the value of the collateral occurs by operation of the terms of the bond
and is not an alteration described in paragraph (c)(2) of this section.
Thus, such a substitution of collateral is not a modification.
Example 3. Alteration contingent on an act of a party. The original
terms of a bond provide that the interest rate is 9 percent. The terms
also provide that, if the issuer files an effective registration
statement covering the bonds with the Securities and Exchange
Commission, the interest rate will decrease to 8 percent. If the issuer
registers the bond, the resulting decrease in the interest rate occurs
by operation of the terms of the bond and is not an alteration described
in paragraph (c)(2) of this section. Thus, such a decrease in the
interest rate is not a modification.
Example 4. Substitution of a new obligor occurring by operation of
the terms of the debt instrument. Under the original terms of a bond
issued by a corporation, an acquirer of substantially all of the
corporation's assets may assume the corporation's obligations under the
bond. Substantially all of the corporation's assets are acquired by
another corporation and the acquiring corporation becomes the new
obligor on the bond. Under paragraph (c)(2)(i) of this section, the
substitution of a new obligor, even though it occurs by operation of the
terms of the bond, is a modification.
Example 5. Defeasance with release of covenants. (i) A corporation
issues a 30-year, recourse bond. Under the terms of the bond, the
corporation may secure a release of the financial and restrictive
covenants by placing in trust government securities as collateral that
will provide interest and principal payments sufficient to satisfy all
scheduled payments on the bond. The corporation remains obligated for
all payments, including the contribution of additional securities to the
trust if necessary to provide sufficient amounts to satisfy the payment
obligations. Under paragraph (c)(3) of this section, the option to
defease the bond is a unilateral option.
(ii) The alterations occur by operation of the terms of the debt
instrument and are not described in paragraph (c)(2) of this section.
Thus, such a release of the covenants is not a modification.
Example 6. Legal defeasance. Under the terms of a recourse bond, the
issuer may secure a release of the financial and restrictive covenants
by placing in trust government securities that will provide interest and
principal payments sufficient to satisfy all scheduled payments on the
bond. Upon the creation of the trust, the issuer is released from any
recourse liability on the bond and has no obligation to contribute
additional securities to the trust if the trust funds are not sufficient
to satisfy the scheduled payments on the bond. The release of the issuer
is an alteration described in paragraph (c)(2)(i) of this section, and
thus is a modification.
Example 7. Exercise of an option by a holder that reduces amounts
payable. (i) A financial institution holds a residential mortgage. Under
the original terms of the mortgage, the financial institution has an
option to decrease the interest rate. The financial institution
anticipates that, if market interest rates decline, it may exercise this
option in lieu of the mortgagor refinancing with another lender.
(ii) The financial institution exercises the option to reduce the
interest rate. The exercise of the option results in a reduction in
scheduled payments and is an alteration described in paragraph
(c)(2)(iii) of this section. Thus, the change in interest rate is a
modification.
Example 8. Conversion of adjustable rate to fixed rate mortgage. (i)
The original terms of a mortgage provide for a variable interest rate,
reset annually based on the value of an objective index. Under the terms
of the mortgage, the mortgagor may, upon the payment of a fee equal to a
specified percentage of the outstanding principal amount of the
mortgage, convert to a fixed rate of interest as determined based on the
value of a second objective index. The exercise of the option does not
require the consent or approval of any person or create a right of the
holder to alter the terms of, or to put, the instrument.
(ii) Because the required consideration to exercise the option is a
specified amount fixed on the issue date, the exercise of the option is
unilateral as defined in paragraph (c)(3) of this section. The
conversion to a fixed rate of interest is not an alteration described in
paragraph (c)(2) of this section. Thus, the change in the type of
interest rate occurs by operation of the terms of the instrument and is
not a modification.
Example 9. Holder's option to increase interest rate. (i) A
corporation issues an 8-year note to a bank in exchange for cash. Under
the terms of the note, the bank has the option to increase the rate of
interest by a specified amount if certain covenants in the note are
breached. The bank's right to increase the interest rate is a unilateral
option as described in paragraph (c)(3) of this section.
[[Page 21]]
(ii) A covenant in the note is breached. The bank exercises its
option to increase the rate of interest. The increase in the rate of
interest occurs by operation of the terms of the note and does not
result in a deferral or a reduction in the scheduled payments or any
other alteration described in paragraph (c)(2) of this section. Thus,
the change in interest rate is not a modification.
(iii) Applicability date. This Example 9 applies to modifications
occurring on or after July 6, 2011.
Example 10. Issuer's right to defer payment of interest. A
corporation issues a 5-year note. Under the terms of the note, interest
is payable annually at the rate of 10 percent. The corporation, however,
has an option to defer any payment of interest until maturity. For any
payments that are deferred, interest will compound at a rate of 12
percent. The exercise of the option, which results in the deferral of
payments, does not result from the exercise of an option by the holder.
The exercise of the option occurs by operation of the terms of the debt
instrument and is not a modification.
Example 11. Holder's option to grant deferral of payment. (i) A
corporation issues a 10-year note to a bank in exchange for cash.
Interest on the note is payable semi-annually. Under the terms of the
note, the bank may grant the corporation the right to defer all or part
of the interest payments. For any payments that are deferred, interest
will compound at a rate 150 basis points greater than the stated rate of
interest.
(ii) The corporation encounters financial difficulty and is unable
to satisfy its obligations under the note. The bank exercises its option
under the note and grants the corporation the right to defer payments.
The exercise of the option results in a right of the corporation to
defer scheduled payments and, under paragraph (c)(3)(i) of this section,
is not a unilateral option. Thus, the alteration is described in
paragraph (c)(2)(iii) of this section and is a modification.
Example 12. Alteration requiring consent. The original terms of a
bond include a provision that the issuer may extend the maturity of the
bond with the consent of the holder. Because any extension pursuant to
this term requires the consent of both parties, such an extension does
not occur by the exercise of a unilateral option (as defined in
paragraph (c)(3) of this section) and is a modification.
Example 13. Waiver of an acceleration clause. Under the terms of a
bond, if the issuer fails to make a scheduled payment, the full
principal amount of the bond is due and payable immediately. Following
the issuer's failure to make a scheduled payment, the holder temporarily
waives its right to receive the full principal for a period ending one
year from the date of the issuer's default to allow the issuer to obtain
additional financial resources. Under paragraph (c)(4)(ii) of this
section, the temporary waiver in this situation is not a modification.
The result would be the same if the terms provided the holder with the
right to demand the full principal amount upon the failure of the issuer
to make a scheduled payment and, upon such a failure, the holder
exercised that right and then waived the right to receive the payment
for one year.
(e) Significant modifications. Whether the modification of a debt
instrument is a significant modification is determined under the rules
of this paragraph (e). Paragraph (e)(1) of this section provides a
general rule for determining the significance of modifications not
otherwise addressed in this paragraph (e). Paragraphs (e) (2) through
(6) of this section provide specific rules for determining the
significance of certain types of modifications. Paragraph (f) of this
section provides rules of application, including rules for modifications
that are effective on a deferred basis or upon the occurrence of a
contingency.
(1) General rule. Except as otherwise provided in paragraphs (e)(2)
through (e)(6) of this section, a modification is a significant
modification only if, based on all facts and circumstances, the legal
rights or obligations that are altered and the degree to which they are
altered are economically significant. In making a determination under
this paragraph (e)(1), all modifications to the debt instrument (other
than modifications subject to paragraphs (e) (2) through (6) of this
section) are considered collectively, so that a series of such
modifications may be significant when considered together although each
modification, if considered alone, would not be significant.
(2) Change in yield--(i) Scope of rule. This paragraph (e)(2)
applies to debt instruments that provide for only fixed payments, debt
instruments with alternative payment schedules subject to Sec. 1.1272-
1(c), debt instruments that provide for a fixed yield subject to Sec.
1.1272-1(d) (such as certain demand loans), and variable rate debt
instruments. Whether a change in the yield of other debt instruments
(for example, a contingent payment debt instrument) is a significant
modification is determined under paragraph (e)(1) of this section.
(ii) In general. A change in the yield of a debt instrument is a
significant
[[Page 22]]
modification if the yield computed under paragraph (e)(2)(iii) of this
section varies from the annual yield on the unmodified instrument
(determined as of the date of the modification) by more than the greater
of--
(A) \1/4\ of one percent (25 basis points); or
(B) 5 percent of the annual yield of the unmodified instrument (.05
x annual yield).
(iii) Yield of the modified instrument--(A) In general. The yield
computed under this paragraph (e)(2)(iii) is the annual yield of a debt
instrument with--
(1) An issue price equal to the adjusted issue price of the
unmodified instrument on the date of the modification (increased by any
accrued but unpaid interest and decreased by any accrued bond issuance
premium not yet taken into account, and increased or decreased,
respectively, to reflect payments made to the issuer or to the holder as
consideration for the modification); and
(2) Payments equal to the payments on the modified debt instrument
from the date of the modification.
(B) Prepayment penalty. For purposes of this paragraph (e)(2)(iii),
a commercially reasonable prepayment penalty for a pro rata prepayment
(as defined in Sec. 1.1275-2(f)) is not consideration for a
modification of a debt instrument and is not taken into account in
determining the yield of the modified instrument.
(iv) Variable rate debt instruments. For purposes of this paragraph
(e)(2), the annual yield of a variable rate debt instrument is the
annual yield of the equivalent fixed rate debt instrument (as defined in
Sec. 1.1275-5(e)) which is constructed based on the terms of the
instrument (either modified or unmodified, whichever is applicable) as
of the date of the modification.
(3) Changes in timing of payments--(i) In general. A modification
that changes the timing of payments (including any resulting change in
the amount of payments) due under a debt instrument is a significant
modification if it results in the material deferral of scheduled
payments. The deferral may occur either through an extension of the
final maturity date of an instrument or through a deferral of payments
due prior to maturity. The materiality of the deferral depends on all
the facts and circumstances, including the length of the deferral, the
original term of the instrument, the amounts of the payments that are
deferred, and the time period between the modification and the actual
deferral of payments.
(ii) Safe-harbor period. The deferral of one or more scheduled
payments within the safe-harbor period is not a material deferral if the
deferred payments are unconditionally payable no later than at the end
of the safe-harbor period. The safe-harbor period begins on the original
due date of the first scheduled payment that is deferred and extends for
a period equal to the lesser of five years or 50 percent of the original
term of the instrument. For purposes of this paragraph (e)(3)(ii), the
term of an instrument is determined without regard to any option to
extend the original maturity and deferrals of de minimis payments are
ignored. If the period during which payments are deferred is less than
the full safe-harbor period, the unused portion of the period remains a
safe-harbor period for any subsequent deferral of payments on the
instrument.
(4) Change in obligor or security--(i) Substitution of a new obligor
on recourse debt instruments--(A) In general. Except as provided in
paragraph (e)(4)(i) (B), (C), or (D) of this section, the substitution
of a new obligor on a recourse debt instrument is a significant
modification.
(B) Section 381(a) transaction. The substitution of a new obligor is
not a significant modification if the acquiring corporation (within the
meaning of section 381) becomes the new obligor pursuant to a
transaction to which section 381(a) applies, the transaction does not
result in a change in payment expectations, and the transaction (other
than a reorganization within the meaning of section 368(a)(1)(F)) does
not result in a significant alteration.
(C) Certain asset acquisitions. The substitution of a new obligor is
not a significant modification if the new obligor acquires substantially
all of the assets of the original obligor, the transaction does not
result in a change in payment
[[Page 23]]
expectations, and the transaction does not result in a significant
alteration.
(D) Tax-exempt bonds. The substitution of a new obligor on a tax-
exempt bond is not a significant modification if the new obligor is a
related entity to the original obligor as defined in section
168(h)(4)(A) and the collateral securing the instrument continues to
include the original collateral.
(E) Significant alteration. For purposes of this paragraph (e)(4), a
significant alteration is an alteration that would be a significant
modification but for the fact that the alteration occurs by operation of
the terms of the instrument.
(F) Section 338 election. For purposes of this section, an election
under section 338 following a qualified stock purchase of an issuer's
stock does not result in the substitution of a new obligor.
(G) Bankruptcy proceedings. For purposes of this section, the filing
of a petition in a title 11 or similar case (as defined in section
368(a)(3)(A)) by itself does not result in the substitution of a new
obligor.
(ii) Substitution of a new obligor on nonrecourse debt instruments.
The substitution of a new obligor on a nonrecourse debt instrument is
not a significant modification.
(iii) Addition or deletion of co-obligor. The addition or deletion
of a co-obligor on a debt instrument is a significant modification if
the addition or deletion of the co-obligor results in a change in
payment expectations. If the addition or deletion of a co-obligor is
part of a transaction or series of related transactions that results in
the substitution of a new obligor, however, the transaction is treated
as a substitution of a new obligor (and is tested under paragraph
(e)(4)(i)) of this section rather than as an addition or deletion of a
co-obligor.
(iv) Change in security or credit enhancement--(A) Recourse debt
instruments. A modification that releases, substitutes, adds or
otherwise alters the collateral for, a guarantee on, or other form of
credit enhancement for a recourse debt instrument is a significant
modification if the modification results in a change in payment
expectations.
(B) Nonrecourse debt instruments. (1) A modification that releases,
substitutes, adds or otherwise alters a substantial amount of the
collateral for, a guarantee on, or other form of credit enhancement for
a nonrecourse debt instrument is a significant modification. A
substitution of collateral is not a significant modification, however,
if the collateral is fungible or otherwise of a type where the
particular units pledged are unimportant (for example, government
securities or financial instruments of a particular type and credit
quality). In addition, the substitution of a similar commercially
available credit enhancement contract is not a significant modification,
and an improvement to the property securing a nonrecourse debt
instrument does not result in a significant modification.
(2) Applicability date. Paragraph (e)(4)(iv)(B)(1) of this section
applies to modifications occurring on or after July 6, 2011.
(v) Change in priority of debt. A change in the priority of a debt
instrument relative to other debt of the issuer is a significant
modification if it results in a change in payment expectations.
(vi) Change in payment expectations--(A) In general. For purposes of
this section, a change in payment expectations occurs if, as a result of
a transaction--
(1) There is a substantial enhancement of the obligor's capacity to
meet the payment obligations under a debt instrument and that capacity
was primarily speculative prior to the modification and is adequate
after the modification; or
(2) There is a substantial impairment of the obligor's capacity to
meet the payment obligations under a debt instrument and that capacity
was adequate prior to the modification and is primarily speculative
after the modification.
(B) Obligor's capacity. The obligor's capacity includes any source
for payment, including collateral, guarantees, or other credit
enhancement.
(5) Changes in the nature of a debt instrument--(i) Property that is
not debt. A modification of a debt instrument that results in an
instrument or property
[[Page 24]]
right that is not debt for Federal income tax purposes is a significant
modification. The rules of paragraph (f)(7) of this section apply to
determine whether a modification results in an instrument or property
right that is not debt.
(ii) Change in recourse nature--(A) In general. Except as provided
in paragraph (e)(5)(ii)(B) of this section, a change in the nature of a
debt instrument from recourse (or substantially all recourse) to
nonrecourse (or substantially all nonrecourse) is a significant
modification. Thus, for example, a legal defeasance of a debt instrument
in which the issuer is released from all liability to make payments on
the debt instrument (including an obligation to contribute additional
securities to a trust if necessary to provide sufficient funds to meet
all scheduled payments on the instrument) is a significant modification.
Similarly, a change in the nature of the debt instrument from
nonrecourse (or substantially all nonrecourse) to recourse (or
substantially all recourse) is a significant modification. If an
instrument is not substantially all recourse or not substantially all
nonrecourse either before or after a modification, the significance of
the modification is determined under paragraph (e)(1) of this section.
(B) Exceptions--(1) Defeasance of tax-exempt bonds. A defeasance of
a tax-exempt bond is not a significant modification even if the issuer
is released from any liability to make payments under the instrument if
the defeasance occurs by operation of the terms of the original bond and
the issuer places in trust government securities or tax-exempt
government bonds that are reasonably expected to provide interest and
principal payments sufficient to satisfy the payment obligations under
the bond.
(2) Original collateral. (i) A modification that changes a recourse
debt instrument to a nonrecourse debt instrument is not a significant
modification if the instrument continues to be secured only by the
original collateral and the modification does not result in a change in
payment expectations. For this purpose, if the original collateral is
fungible or otherwise of a type where the particular units pledged are
unimportant (for example, government securities or financial instruments
of a particular type and credit quality), replacement of some or all
units of the original collateral with other units of the same or similar
type and aggregate value is not considered a change in the original
collateral.
(ii) Applicability date. Paragraph (e)(5)(ii)(B)(2)(i) of this
section applies to modifications occurring on or after July 6, 2011.
(6) Accounting or financial covenants. A modification that adds,
deletes, or alters customary accounting or financial covenants is not a
significant modification.
(f) Rules of application--(1) Testing for significance--(i) In
general. Whether a modification of any term is a significant
modification is determined under each applicable rule in paragraphs (e)
(2) through (6) of this section and, if not specifically addressed in
those rules, under the general rule in paragraph (e)(1) of this section.
For example, a deferral of payments that changes the yield of a fixed
rate debt instrument must be tested under both paragraphs (e) (2) and
(3) of this section.
(ii) Contingent modifications. If a modification described in
paragraphs (e) (2) through (5) of this section is effective only upon
the occurrence of a substantial contingency, whether or not the change
is a significant modification is determined under paragraph (e)(1) of
this section rather than under paragraphs (e) (2) through (5) of this
section.
(iii) Deferred modifications. If a modification described in
paragraphs (e) (4) and (5) of this section is effective on a
substantially deferred basis, whether or not the change is a significant
modification is determined under paragraph (e)(1) of this section rather
than under paragraphs (e) (4) and (5) of this section.
(2) Modifications that are not significant. If a rule in paragraphs
(e) (2) through (4) of this section prescribes a degree of change in a
term of a debt instrument that is a significant modification, a change
of the same type but of a lesser degree is not a significant
modification under that rule. For example, a 20 basis point change in
the
[[Page 25]]
yield of a fixed rate debt instrument is not a significant modification
under paragraph (e)(2) of this section. Likewise, if a rule in paragraph
(e)(4) of this section requires a change in payment expectations for a
modification to be significant, a modification of the same type that
does not result in a change in payment expectations is not a significant
modification under that rule.
(3) Cumulative effect of modifications. Two or more modifications of
a debt instrument over any period of time constitute a significant
modification if, had they been done as a single change, the change would
have resulted in a significant modification under paragraph (e) of this
section. Thus, for example, a series of changes in the maturity of a
debt instrument constitutes a significant modification if, combined as a
single change, the change would have resulted in a significant
modification. The significant modification occurs at the time that the
cumulative modification would be significant under paragraph (e) of this
section. In testing for a change of yield under paragraph (e)(2) of this
section, however, any prior modification occurring more than 5 years
before the date of the modification being tested is disregarded.
(4) Modifications of different terms. Modifications of different
terms of a debt instrument, none of which separately would be a
significant modification under paragraphs (e) (2) through (6) of this
section, do not collectively constitute a significant modification. For
example, a change in yield that is not a significant modification under
paragraph (e)(2) of this section and a substitution of collateral that
is not a significant modification under paragraph (e)(4)(iv) of this
section do not together result in a significant modification. Although
the significance of each modification is determined independently, in
testing a particular modification it is assumed that all other
simultaneous modifications have already occurred.
(5) Definitions. For purposes of this section:
(i) Issuer and obligor are used interchangeably and mean the issuer
of a debt instrument or a successor obligor.
(ii) Variable rate debt instrument and contingent payment debt
instrument have the meanings given those terms in section 1275 and the
regulations thereunder.
(iii) Tax-exempt bond means a state or local bond that satisfies the
requirements of section 103(a).
(iv) Conduit loan and conduit borrower have the same meanings as in
Sec. 1.150-1(b).
(6) Certain rules for tax-exempt bonds--(i) Conduit loans. For
purposes of this section, the obligor of a tax-exempt bond is the entity
that actually issues the bond and not a conduit borrower of bond
proceeds. In determining whether there is a significant modification of
a tax-exempt bond, however, transactions between holders of the tax-
exempt bond and a borrower of a conduit loan may be an indirect
modification under paragraph (a)(1) of this section. For example, a
payment by the holder of a tax-exempt bond to a conduit borrower to
waive a call right may result in an indirect modification of the tax-
exempt bond by changing the yield on that bond.
(ii) Recourse nature--(A) In general. For purposes of this section,
a tax-exempt bond that does not finance a conduit loan is a recourse
debt instrument.
(B) Proceeds used for conduit loans. For purposes of this section, a
tax-exempt bond that finances a conduit loan is a recourse debt
instrument unless both the bond and the conduit loan are nonrecourse
instruments.
(C) Government securities as collateral. Notwithstanding paragraphs
(f)(6)(ii) (A) and (B) of this section, for purposes of this section a
tax-exempt bond that is secured only by a trust holding government
securities or tax-exempt government bonds that are reasonably expected
to provide interest and principal payments sufficient to satisfy the
payment obligations under the bond is a nonrecourse instrument.
(7) Rules for determining whether an alteration or modification
results in an instrument or property right that is not debt--(i) In
general. Except as provided in paragraph (f)(7)(ii) of this section, the
determination of whether an instrument resulting from an alteration or
modification of a debt instrument
[[Page 26]]
will be recharacterized as an instrument or property right that is not
debt for Federal income tax purposes shall take into account all of the
factors relevant to such a determination.
(ii) Financial condition of the obligor--(A) Deterioration in
financial condition of the obligor generally disregarded. Except as
provided in paragraph (f)(7)(ii)(B) of this section, in making a
determination as to whether an instrument resulting from an alteration
or modification of a debt instrument will be recharacterized as an
instrument or property right that is not debt, any deterioration in the
financial condition of the obligor between the issue date of the debt
instrument and the date of the alteration or modification (as it relates
to the obligor's ability to repay the debt instrument) is not taken into
account. For example, any decrease in the fair market value of a debt
instrument (whether or not the debt instrument is publicly traded)
between the issue date of the debt instrument and the date of the
alteration or modification is not taken into account to the extent that
the decrease in fair market value is attributable to the deterioration
in the financial condition of the obligor and not to a modification of
the terms of the instrument.
(B) Substitution of a new obligor; addition or deletion of co-
obligor. If there is a substitution of a new obligor or the addition or
deletion of a co-obligor, the rules in paragraph (f)(7)(ii)(A) of this
section do not apply.
(g) Examples. The following examples illustrate the provisions of
paragraphs (e) and (f) of this section:
Example 1. Modification of call right. (i) Under the terms of a 30-
year, fixed-rate bond, the issuer can call the bond for 102 percent of
par at the end of ten years or for 101 percent of par at the end of 20
years. At the end of the eighth year, the holder of the bond pays the
issuer to waive the issuer's right to call the bond at the end of the
tenth year. On the date of the modification, the issuer's credit quality
is approximately the same as when the bond was issued, but market rates
of interest have declined from that date.
(ii) The holder's payment to the issuer changes the yield on the
bond. Whether the change in yield is a significant modification depends
on whether the yield on the modified bond varies from the yield on the
original bond by more than the change in yield as described in paragraph
(e)(2)(ii) of this section.
(iii) If the change in yield is not a significant modification, the
elimination of the issuer's call right must also be tested for
significance. Because the specific rules of paragraphs (e)(2) through
(e)(6) of this section do not address this modification, the
significance of the modification must be determined under the general
rule of paragraph (e)(1) of this section.
(iv) Applicability date. This Example 1 applies to modifications
occurring on or after July 6, 2011.
Example 2. Extension of maturity and change in yield. (i) A zero-
coupon bond has an original maturity of ten years. At the end of the
fifth year, the parties agree to extend the maturity for a period of two
years without increasing the stated redemption price at maturity (i.e.,
there are no additional payments due between the original and extended
maturity dates, and the amount due at the extended maturity date is
equal to the amount due at the original maturity date).
(ii) The deferral of the scheduled payment at maturity is tested
under paragraph (e)(3) of this section. The safe-harbor period under
paragraph (e)(3)(ii) of this section starts with the date the payment
that is being deferred is due. For this modification, the safe-harbor
period starts on the original maturity date, and ends five years from
this date. All payments deferred within this period are unconditionally
payable before the end of the safe-harbor period. Thus, the deferral of
the payment at maturity for a period of two years is not a material
deferral under the safe-harbor rule of paragraph (e)(3)(ii) of this
section and thus is not a significant modification.
(iii) Even though the extension of maturity is not a significant
modification under paragraph (e)(3)(ii) of this section, the
modification also decreases the yield of the bond. The change in yield
must be tested under paragraph (e)(2) of this section.
Example 3. Change in yield resulting from reduction of principal.
(i) A debt instrument issued at par has an original maturity of ten
years and provides for the payment of $100,000 at maturity with interest
payments at the rate of 10 percent payable at the end of each year. At
the end of the fifth year, and after the annual payment of interest, the
issuer and holder agree to reduce the amount payable at maturity to
$80,000. The annual interest rate remains at 10 percent but is payable
on the reduced principal.
(ii) In applying the change in yield rule of paragraph (e)(2) of
this section, the yield of the instrument after the modification
(measured from the date that the parties agree to the modification to
its final maturity date) is computed using the adjusted issue price of
$100,000. With four annual payments of $8,000, and a payment of $88,000
at maturity, the yield on the instrument after the modification for
purposes of determining if there has
[[Page 27]]
been a significant modification under paragraph (e)(2)(i) of this
section is 4.332 percent. Thus, the reduction in principal is a
significant modification.
Example 4. Deferral of scheduled interest payments. (i) A 20-year
debt instrument issued at par provides for the payment of $100,000 at
maturity with annual interest payments at the rate of 10 percent. At the
beginning of the eleventh year, the issuer and holder agree to defer all
remaining interest payments until maturity with compounding. The yield
of the modified instrument remains at 10 percent.
(ii) The safe-harbor period of paragraph (e)(3)(ii) of this section
begins at the end of the eleventh year, when the interest payment for
that year is deferred, and ends at the end of the sixteenth year.
However, the payments deferred during this period are not
unconditionally payable by the end of that 5-year period. Thus, the
deferral of the interest payments is not within the safe-harbor period.
(iii) This modification materially defers the payments due under the
instrument and is a significant modification under paragraph (e)(3)(i)
of this section.
Example 5. Assumption of mortgage with increase in interest rate.
(i) A recourse debt instrument with a 9 percent annual yield is secured
by an office building. Under the terms of the instrument, a purchaser of
the building may assume the debt and be substituted for the original
obligor if the purchaser is equally or more creditworthy than the
original obligor and if the interest rate on the instrument is increased
by one-half percent (50 basis points). The building is sold, the
purchaser assumes the debt, and the interest rate increases by 50 basis
points.
(ii) If the purchaser's acquisition of the building does not satisfy
the requirements of paragraph (e)(4)(i)(B) or paragraph (e)(4)(i)(C) of
this section, the substitution of the purchaser as the obligor is a
significant modification under paragraph (e)(4)(i)(A) of this section.
(iii) If the purchaser acquires substantially all of the assets of
the original obligor, the assumption of the debt instrument will not
result in a significant modification if there is not a change in payment
expectations and the assumption does not result in a significant
alteration.
(iv) The change in the interest rate, if tested under the rules of
paragraph (e)(2) of this section, would result in a significant
modification. The change in interest rate that results from the
transaction is a significant alteration. Thus, the transaction does not
meet the requirements of paragraph (e)(4)(i)(C) of this section and is a
significant modification under paragraph (e)(4)(i)(A) of this section.
(v) Applicability date. This Example 5 applies to modifications
occurring on or after July 6, 2011.
Example 6. Assumption of mortgage. (i) A recourse debt instrument is
secured by a building. In connection with the sale of the building, the
purchaser of the building assumes the debt and is substituted as the new
obligor on the debt instrument. The purchaser does not acquire
substantially all of the assets of the original obligor.
(ii) The transaction does not satisfy any of the exceptions set
forth in paragraph (e)(4)(i) (B) or (C) of this section. Thus, the
substitution of the purchaser as the obligor is a significant
modification under paragraph (e)(4)(i)(A) of this section.
(iii) Section 1274(c)(4), however, provides that if a debt
instrument is assumed in connection with the sale or exchange of
property, the assumption is not taken into account in determining if
section 1274 applies to the debt instrument unless the terms and
conditions of the debt instrument are modified in connection with the
sale or exchange. Because the purchaser assumed the debt instrument in
connection with the sale of property and the debt instrument was not
otherwise modified, the debt instrument is not retested to determine
whether it provides for adequate stated interest.
Example 7. Substitution of a new obligor in section 381(a)
transaction. (i) The interest rate on a 30-year debt instrument issued
by a corporation provides for a variable rate of interest that is reset
annually on June 1st based on an objective index.
(ii) In the tenth year, the issuer merges (in a transaction to which
section 381(a) applies) into another corporation that becomes the new
obligor on the debt instrument. The merger occurs on June 1st, at which
time the interest rate is also reset by operation of the terms of the
instrument. The new interest rate varies from the previous interest rate
by more than the greater of 25 basis points and 5 percent of the annual
yield of the unmodified instrument. The substitution of a new obligor
does not result in a change in payment expectations.
(iii) The substitution of the new obligor occurs in a section 381(a)
transaction and does not result in a change in payment expectations.
Although the interest rate changed by more than the greater of 25 basis
points and 5 percent of the annual yield of the unmodified instrument,
this alteration did not occur as a result of the transaction and is not
a significant alteration under paragraph (e)(4)(i)(E) of this section.
Thus, the substitution meets the requirements of paragraph (e)(4)(i)(B)
of this section and is not a significant modification.
Example 8. Substitution of credit enhancement contract. (i) Under
the terms of a recourse debt instrument, the issuer's obligations are
secured by a letter of credit from a specified
[[Page 28]]
bank. The debt instrument does not contain any provision allowing a
substitution of a letter of credit from a different bank. The specified
bank, however, encounters financial difficulty. The issuer and holder
agree that the issuer will substitute a letter of credit from another
bank.
(ii) Under paragraph (e)(4)(iv)(A) of this section, the substitution
of a different credit enhancement contract is not a significant
modification of a recourse debt instrument unless the substitution
results in a change in payment expectations. While the substitution of a
new letter of credit by a different bank does not itself result in a
change in payment expectations, such a substitution may result in a
change in payment expectations under certain circumstances (for example,
if the obligor's capacity to meet payment obligations is dependent on
the letter of credit and the substitution substantially enhances that
capacity from primarily speculative to adequate).
(iii) Applicability date. This Example 8 applies to modifications
occurring on or after July 6, 2011.
Example 9. Improvement to collateral securing nonrecourse debt. A
parcel of land and its improvements, a shopping center, secure a
nonrecourse debt instrument. The obligor expands the shopping center
with the construction of an additional building on the same parcel of
land. After the construction, the improvements that secure the
nonrecourse debt include the new building. The building is an
improvement to the property securing the nonrecourse debt instrument and
its inclusion in the collateral securing the debt is not a significant
modification under paragraph (e)(4)(iv)(B) of this section.
(h) Effective/applicability date--(1) In general. Except as
otherwise provided in paragraph (h)(2) of this section, this section
applies to alterations of the terms of a debt instrument on or after
September 24, 1996. Taxpayers, however, may rely on this section for
alterations of the terms of a debt instrument after December 2, 1992,
and before September 24, 1996.
(2) Exception. Paragraph (f)(7) of this section applies to an
alteration of the terms of a debt instrument on or after January 7,
2011. A taxpayer, however, may rely on paragraph (f)(7) of this section
for alterations of the terms of a debt instrument occurring before that
date.
[T.D. 8675, 61 FR 32930, June 26, 1996; 61 FR 47822, Sept. 11, 1996; 76
FR 1064, Jan. 7, 2011; T.D. 9533, 76 FR 39282, July 6, 2011; T.D. 9637,
78 FR 54760, Sept. 6, 2013]
Sec. 1.1001-4 Modifications of certain derivative contracts.
(a) Certain assignments. For purposes of Sec. 1.1001-1(a), the
transfer or assignment of a derivative contract is not treated by the
nonassigning counterparty as a deemed exchange of the original contract
for a modified contract that differs materially either in kind or in
extent if--
(1) Both the party transferring or assigning its rights and
obligations under the derivative contract and the party to which the
rights and obligations are transferred or assigned are either a dealer
or a clearinghouse;
(2) The terms of the derivative contract permit the transfer or
assignment of the contract, whether or not the consent of the
nonassigning counterparty is required for the transfer or assignment to
be effective; and
(3) The terms of the derivative contract are not otherwise modified
in a manner that results in a taxable exchange under section 1001.
(b) Definitions--(1) Dealer. For purposes of this section, a dealer
is a taxpayer who meets the definition of a dealer in securities in
section 475(c)(1) or is a dealer in commodities derivative contracts.
(2) Clearinghouse. For purposes of this section, a clearinghouse is
a derivatives clearing organization (as such term is defined in section
1a of the Commodity Exchange Act (7 U.S.C. 1a)) or a clearing agency (as
such term is defined in section 3 of the Securities Exchange Act of 1934
(15 U.S.C. 78c(a))) that is registered, or exempt from registration,
under each respective Act.
(3) Derivative contract. For purposes of this section, a derivative
contract is a contract described in--
(i) Section 475(c)(2)(D), 475(c)(2)(E), or 475(c)(2)(F) without
regard to the last sentence of section 475(c)(2) referencing section
1256;
(ii) Section 475(e)(2)(B), 475(e)(2)(C), or 475(e)(2)(D); or
(iii) Section 1.446-3(c)(1).
(c) Consideration for the assignment. Any payment between a party
transferring or assigning its rights and obligations under the contract
and the party to which the rights and obligations are transferred or
assigned pursuant to a transfer or assignment described in
[[Page 29]]
paragraph (a) of this section will not affect the treatment of the
nonassigning counterparty for purposes of this section. A payment
described in the preceding sentence made or received to transfer or
assign rights and obligations under a notional principal contract (as
defined in Sec. 1.446-3(c)(1)) is not subject to Sec. 1.446-3(g)(4).
(d) Effective/applicability date. This section applies to transfers
or assignments of derivative contracts on or after July 22, 2011.
[T.D. 9639, 78 FR 66640, Nov. 6, 2013]
Sec. 1.1001-5 European Monetary Union (conversion to the euro).
(a) Conversion of currencies. For purposes of Sec. 1.1001-1(a), the
conversion to the euro of legacy currencies (as defined in Sec. 1.985-
8(a)(1)) is not the exchange of property for other property differing
materially in kind or extent.
(b) Effect of currency conversion on other rights and obligations.
For purposes of Sec. 1.1001-1(a), if, solely as the result of the
conversion of legacy currencies to the euro, rights or obligations
denominated in a legacy currency become rights or obligations
denominated in the euro, that event is not the exchange of property for
other property differing materially in kind or extent. Thus, for
example, when a debt instrument that requires payments of amounts
denominated in a legacy currency becomes a debt instrument requiring
payments of euros, that alteration is not a modification within the
meaning of Sec. 1.1001-3(c).
(c) Effective date. This section applies to tax years ending after
July 29, 1998.
[T.D. 8927, 66 FR 2218, Jan. 11, 2001]
Sec. 1.1002-1 Sales or exchanges.
(a) General rule. The general rule with respect to gain or loss
realized upon the sale or exchange of property as determined under
section 1001 is that the entire amount of such gain or loss is
recognized except in cases where specific provisions of subtitle A of
the code provide otherwise.
(b) Strict construction of exceptions from general rule. The
exceptions from the general rule requiring the recognition of all gains
and losses, like other exceptions from a rule of taxation of general and
uniform application, are strictly construed and do not extend either
beyond the words or the underlying assumptions and purposes of the
exception. Nonrecognition is accorded by the Code only if the exchange
is one which satisfies both (1) the specific description in the Code of
an excepted exchange, and (2) the underlying purpose for which such
exchange is excepted from the general rule. The exchange must be germane
to, and a necessary incident of, the investment or enterprise in hand.
The relationship of the exchange to the venture or enterprise is always
material, and the surrounding facts and circumstances must be shown. As
elsewhere, the taxpayer claiming the benefit of the exception must show
himself within the exception.
(c) Certain exceptions to general rule. Exceptions to the general
rule are made, for example, by sections 351(a), 354, 361(a), 371(a)(1),
371(b)(1), 721, 1031, 1035 and 1036. These sections describe certain
specific exchanges of property in which at the time of the exchange
particular differences exist between the property parted with and the
property acquired, but such differences are more formal than
substantial. As to these, the Code provides that such differences shall
not be deemed controlling, and that gain or loss shall not be recognized
at the time of the exchange. The underlying assumption of these
exceptions is that the new property is substantially a continuation of
the old investment still unliquidated; and, in the case of
reorganizations, that the new enterprise, the new corporate structure,
and the new property are substantially continuations of the old still
unliquidated.
(d) Exchange. Ordinarily, to constitute an exchange, the transaction
must be a reciprocal transfer of property, as distinguished from a
transfer of property for a money consideration only.
Basis Rules of General Application
Sec. 1.1011-1 Adjusted basis.
The adjusted basis for determining the gain or loss from the sale or
other disposition of property is the cost or other basis prescribed in
section 1012 or
[[Page 30]]
other applicable provisions of subtitle A of the code, adjusted to the
extent provided in sections 1016, 1017, and 1018 or as otherwise
specifically provided for under applicable provisions of internal
revenue laws.
Sec. 1.1011-2 Bargain sale to a charitable organization.
(a) In general. (1) If for the taxable year a charitable
contributions deduction is allowable under section 170 by reason of a
sale or exchange of property, the taxpayer's adjusted basis of such
property for purposes of determining gain from such sale or exchange
must be computed as provided in section 1011(b) and paragraph (b) of
this section. If after applying the provisions of section 170 for the
taxable year, including the percentage limitations of section 170(b), no
deduction is allowable under that section by reason of the sale or
exchange of the property, section 1011(b) does not apply and the
adjusted basis of the property is not required to be apportioned
pursuant to paragraph (b) of this section. In such case the entire
adjusted basis of the property is to be taken into account in
determining gain from the sale or exchange, as provided in Sec. 1.1011-
1(e). In ascertaining whether or not a charitable contributions
deduction is allowable under section 170 for the taxable year for such
purposes, that section is to be applied without regard to this section
and the amount by which the contributed portion of the property must be
reduced under section 170(e)(1) is the amount determined by taking into
account the amount of gain which would have been ordinary income or
long-term capital gain if the contributed portion of the property had
been sold by the donor at its fair market value at the time of the sale
or exchange.
(2) If in the taxable year there is a sale or exchange of property
which gives rise to a charitable contribution which is carried over
under section 170(b)(1)(D)(ii) or section 170(d) to a subsequent taxable
year or is postponed under section 170(a)(3) to a subsequent taxable
year, section 1011(b) and paragraph (b) of this section must be applied
for purposes of apportioning the adjusted basis of the property for the
year of the sale or exchange, whether or not such contribution is
allowable as a deduction under section 170 in such subsequent year.
(3) If property is transferred subject to an indebtedness, the
amount of the indebtedness must be treated as an amount realized for
purposes of determining whether there is a sale or exchange to which
section 1011(b) and this section apply, even though the transferee does
not agree to assume or pay the indebtedness.
(4)(i) Section 1011(b) and this section apply where property is sold
or exchanged in return for an obligation to pay an annuity and a
charitable contributions deduction is allowable under section 170 by
reason of such sale or exchange.
(ii) If in such case the annuity received in exchange for the
property is nonassignable, or is assignable but only to the charitable
organization to which the property is sold or exchanged, and if the
transferor is the only annuitant or the transferor and a designated
survivor annuitant or annuitants are the only annuitants, any gain on
such exchange is to be reported as provided in example (8) in paragraph
(c) of this section. In determining the period over which gain may be
reported as provided in such example, the life expectancy of the
survivor annuitant may not be taken into account. The fact that the
transferor may retain the right to revoke the survivor's annuity or
relinquish his own right to the annuity will not be considered, for
purposes of this subdivision, to make the annuity assignable to someone
other than the charitable organization. Gain on an exchange of the type
described in this subdivision pursuant to an agreement which is entered
into after December 19, 1969, and before May 3, 1971, may be reported as
provided in example (8) in paragraph (c) of this section, even though
the annuity is assignable.
(iii) In the case of an annuity to which subdivision (ii) of this
subparagraph applies, the gain unreported by the transferor with respect
to annuity payments not yet due when the following events occur is not
required to be included in gross income of any person where--
[[Page 31]]
(a) The transferor dies before the entire amount of gain has been
reported and there is no surviving annuitant, or
(b) The transferor relinquishes the annuity to the charitable
organization.
If the transferor dies before the entire amount of gain on a two-life
annuity has been reported, the unreported gain is required to be
reported by the surviving annuitant or annuitants with respect to the
annuity payments received by them.
(b) Apportionment of adjusted basis. For purposes of determining
gain on a sale or exchange to which this paragraph applies, the adjusted
basis of the property which is sold or exchanged shall be that portion
of the adjusted basis of the entire property which bears the same ratio
to the adjusted basis as the amount realized bears to the fair market
value of the entire property. The amount of such gain which shall be
treated as ordinary income (or long-term capital gain) shall be that
amount which bears the same ratio to the ordinary income (or long-term
capital gain) which would have been recognized if the entire property
had been sold by the donor at its fair market value at the time of the
sale or exchange as the amount realized on the sale or exchange bears to
the fair market value of the entire property at such time. The terms
ordinary income and long-term capital gain, as used in this section,
have the same meaning as they have in paragraph (a) of Sec. 1.170A-4.
For determining the portion of the adjusted basis, ordinary income, and
long- term capital gain allocated to the contributed portion of the
property for purposes of applying section 170(e)(1) and paragraph (a) of
Sec. 1.170A-4 to the contributed portion of the property, and for
determining the donee's basis in such contributed portion, see paragraph
(c) (2) and (4) of Sec. 1.170A-4. For determining the holding period of
such contributed portion, see section 1223(2) and the regulations
thereunder.
(c) Illustrations. The application of this section may be
illustrated by the following examples, which are supplemented by other
examples in paragraph (d) of Sec. 1.170A-4:
Example 1. In 1970, A, a calendar-year individual taxpayer, sells to
a church for $4,000 stock held for more than 6 months which has an
adjusted basis of $4,000 and a fair market value of $10,000. A's
contribution base for 1970, as defined in section 170(b)(1)(F), is
$100,000, and during that year he makes no other charitable
contributions. Thus, A makes a charitable contribution to the church of
$6,000 ($10,000 value -$4,000 amount realized). Without regard to this
section, A is allowed a deduction under section 170 of $6,000 for his
charitable contribution to the church, since there is no reduction under
section 170(e)(1) with respect to the long-term capital gain.
Accordingly, under paragraph (b) of this section the adjusted basis for
determining gain on the bargain sale is $1,600 ($4,000 adjusted basis x
$4,000 amount realized / $10,000 value of property). A has recognized
long-term capital gain of $2,400 ($4,000 amount realized - $1,600
adjusted basis) on the bargain sale.
Example 2. The facts are the same as in example (1) except that A
also makes a charitable contribution in 1970 of $50,000 cash to the
church. By reason of section 170(b)(1)(A), the deduction allowed under
section 170 for 1970 is $50,000 for the amount of cash contributed to
the church; however, the $6,000 contribution of property is carried over
to 1971 under section 170(d). Under paragraphs (a)(2) and (b) of this
section the adjusted basis for determining gain for 1970 on the bargain
sale in that year is $1,600 ($4,000 x $4,000 / $10,000). A has a
recognized long-term capital gain for 1970 of $2,400 ($4,000 - $1,600)
on the sale.
Example 3. In 1970, C, a calendar-year individual taxpayer, makes a
charitable contribution of $50,000 cash to a church. In addition, he
sells for $4,000 to a private foundation not described in section
170(b)(1)(E) stock held for more than 6 months which has an adjusted
basis of $4,000 and a fair market value of $10,000. Thus, C makes a
charitable contribution of $6,000 of such property to the private
foundation ($10,000 value - $4,000 amount realized). C's contribution
base for 1970, as defined in section 170(b)(1)(F), is $100,000, and
during that year he makes no other charitable contributions. By reason
of section 170(b)(1)(A), the deduction allowed under section 170 for
1970 is $50,000 for the amount of cash contributed to the church. Under
section 170(e)(1)(B)(ii) and paragraphs (a)(1) and (c)(2)(i) of Sec.
1.170A-4, the $6,000 contribution of stock is reduced to $4,800 ($6,000
- [50% x ($6,000 value of contributed portion of stock - $3,600 adjusted
basis)]). However, by reason of section 170(b)(1)(B)(ii), applied
without regard to section 1011(b), no deduction is allowed under section
170 for 1970 or any other year for the reduced contribution of $4,800 to
the private foundation. Accordingly, paragraph (b) of this section does
not apply for purposes of apportioning the adjusted basis of the stock
sold to the private foundation, and under section 1.1011-1(e) the
recognized gain on the bargain sale is $0
[[Page 32]]
($4,000 amount realized - $4,000 adjusted basis).
Example 4. In 1970, B, a calendar-year individual taxpayer, sells to
a church for $2,000 stock held for not more than 6 months which has an
adjusted basis of $4,000 and a fair market value of $10,000. B's
contribution base for 1970, as defined in section 170(b)(1)(F), is
$20,000 and during such year B makes no other charitable contributions.
Thus, he makes a charitable contribution to the church of $8,000
($10,000 value - $2,000 amount realized). Under paragraph (b) of this
section the adjusted basis for determining gain on the bargain sale is
$800 ($4,000 adjusted basis x $2,000 amount realized / $10,000 value of
stock). Accordingly, B, has a recognized short-term capital gain of
$1,200 ($2,000 amount realized - $800 adjusted basis) on the bargain
sale. After applying section 1011(b) and paragraphs (a)(1) and (c)(2)(i)
of Sec. 1.170A-4, B is allowed a charitable contributions deduction for
1970 of $3,200 ($8,000 value of gift - [$8,000 - ($4,000 adjusted basis
of property x $8,000 value of gift / $10,000 value of property)]).
Example 5. The facts are the same as in Example 4 except that B
sells the property to the church for $4,000. Thus, B makes a charitable
contribution to the church of $6,000 ($10,000 value -$4,000 amount
realized). Under paragraph (b) of this section the adjusted basis for
determining gain on the bargain sale is $1,600 ($4,000 adjusted basis x
$4,000 amount realized / $10,000 value of stock). Accordingly, B has a
recognized short-term capital gain of $2,400 ($4,000 amount realized -
$1,600 adjusted basis) on the bargain sale. After applying section
1011(b) and paragraphs (a)(1) and (c)(2)(i) of Sec. 1.170A-4, B is
allowed a charitable contributions deduction for 1970 of $2,400 ($6,000
value of gift - [$6,000 - ($4,000 adjusted basis of property x $6,000
value of gifts / $10,000 value of property)]).
Example 6. The facts are the same as in Example 4 except that B
sells the property to the church for $6,000. Thus, B makes a charitable
contribution to the church of $4,000 ($10,000 value -$6,000 amount
realized). Under paragraph (b) of this section the adjusted basis for
determining gain on the bargain sale is $2,400 ($4,000 adjusted basis x
$6,000 amount realized/$10,000 value of stock). Accordingly, B has a
recognized short-term capital gain of $3,600 ($6,000 amount realized -
$2,400 adjusted basis) on the bargain sale. After applying section
1011(b) and paragraphs (a)(1) and (c)(2)(i) of Sec. 1.170A-4, B is
allowed a charitable contributions deduction for 1970 of $1,600 ($4,000
value of gift -[$4,000 -($4,000 adjusted basis of property x $4,000
value of gift/$10,000 value of property]).
Example 7. In 1970, C, a calendar-year individual taxpayer, sells to
a church for $4,000 tangible personal property used in his business for
more than 6 months which has an adjusted basis of $4,000 and a fair
market value of $10,000. Thus, C makes a charitable contribution to the
church of $6,000 ($10,000 value -$4,000 adjusted basis). C's
contribution base for 1970, as defined in section 170(b)(1)(F) is
$100,000 and during such year he makes no other charitable
contributions. If C had sold the property at its fair market value at
the time of its contribution, it is assumed that under section 1245
$4,000 of the gain of $6,000 ($10,000 value -$4,000 adjusted basis)
would have been treated as ordinary icome. Thus, there would have been
long-term capital gain of $2,000. It is also assumed that the church
does not put the property to an unrelated use, as defined in paragraph
(b)(3) of Sec. 1.170A-4. Under paragraph (b) of this section the
adjusted basis for determining gain on the bargain sale is $1,600
($4,000 adjusted basis x $4,000 amount realized/$10,000 value of
property). Accordingly, C has a recognized gain of $2,400 ($4,000 amount
realized -$1,600 adjusted basis) on the bargain sale, consisting of
ordinary income of $1,600 ($4,000 ordinary income x $4,000 amount
realized/$10,000 value of property) and of long-term capital gain of
$800 ($2,000 long-term gain x $4,000 amount realized/$10,000 value of
property). After applying section 1011(b) and paragraphs (a) and
(c)(2)(i) of Sec. 1.170A-4, C is allowed a charitable contributions
deduction for 1970 of $3,600 ($6,000 gift -[$4,000 ordinary income x
$6,000 value of gift/$10,000 value of property]).
Example 8. (a) On January 1, 1970, A, a male of age 65, transfers
capital assets consisting of securities held for more than 6 months to a
church in exchange for a promise by the church to pay A a nonassignable
annuity of $5,000 per year for life. The annuity is payable monthly with
the first payment to be made on February 1, 1970. A's contribution base
for 1970, as defined in section 170(b)(1)(F), is $200,000, and during
that year he makes no other charitable contributions. On the date of
transfer the securities have a fair market value of $100,000 and an
adjusted basis to A of $20,000.
(b) The present value of the right of a male age 65 to receive a
life annuity of $5,000 per annum, payable in equal installments at the
end of each monthly period, is $59,755 ($5,000 x [11.469 + 0.482]),
determined in accordance with section 101(b) of the Code, paragraph
(e)(1)(iii)(b)(2) of Sec. 1.101-2, and section 3 of Rev. Rul. 62-216,
C.B. 1962-2, 30. Thus, A makes a charitable contribution to the church
of $40,245 ($100,000 -$59,755). See Rev. Rul. 84-162, 1984-2 C.B. 200,
for transfers for which the valuation date falls after November 23,
1984. (See Sec. 601.601(d)(2)(ii)(b) of this chapter). For the
applicable valuation tables in connection therewith, see Sec. 20.2031-
7(d)(6) of this chapter. See, however, Sec. 1.7520-3(b) (relating to
exceptions to the use of standard actuarial factors in certain
circumstances).
[[Page 33]]
(c) Under paragraph (b) of this section, the adjusted basis for
determining gain on the bargain sale is $11,951 ($20,000 x $59,755 /
$100,000). Accordingly, A has a recognized long-term capital gain of
$47,804 ($59,755 - $11,951) on the bargain sale. Such gain is to be
reported by A ratably over the period of years measured by the expected
return multiple under the contract, but only from that portion of the
annual payments which is a return of his investment in the contract
under section 72 of the Code. For such purposes, the investment in the
contract is $59,755, that is, the present value of the annuity.
(d) The computation and application of the exclusion ratio, the
gain, and the ordinary annuity income are as follows, determined by
using the expected return multiple of 15.0 applicable under table I of
Sec. 1.72-9:
A's expected return (annual payments of $5,000 x 15)........ $75,000.00
Exclusion ratio ($59,755 investment in contract divided by 79.7%
expected return of $75,000)................................
Annual exclusion (annual payments of $5,000 x 79.7%)........ $3,985.00
Ordinary annuity income ($5,000-$3,985)..................... $1,015.00
Long-term capital gain per year ($47,804/15) with respect to $3,186.93
the annual exclusion.......................................
(e) The exclusion ratio of 79.7 percent applies throughout the life
of the contract. During the first 15 years of the annuity, A is required
to report ordinary income of $1,015 and long-term capital gain of
$3,186.93 with respect to the annuity payments he receives. After the
total long-term capital gain of $47,804 has been reported by A, he is
required to report only ordinary income of $1,015.00 per annum with
respect to the annuity payments he receives.
(d) Effective date. This section applies only to sales and exchanges
made after December 19, 1969.
(e) Cross reference. For rules relating to the treatment of
liabilities on the sale or other disposition or encumbered property, see
Sec. 1.1001-2.
[T.D. 7207, 37 FR 20798, Oct. 5, 1972, as amended by T.D. 7741, 45 FR
81745, Dec. 12, 1980; T.D. 8176, 53 FR 5570, Feb. 25, 1988; 53 FR 11002,
Apr. 4, 1988; T.D. 8540, 59 FR 30148, June 10, 1994]
Sec. 1.1012-1 Basis of property.
(a) General rule. In general, the basis of property is the cost
thereof. The cost is the amount paid for such property in cash or other
property. This general rule is subject to exceptions stated in
subchapter O (relating to gain or loss on the disposition of property),
subchapter C (relating to corporate distributions and adjustments),
subchapter K (relating to partners and partnerships), and subchapter P
(relating to capital gains and losses), chapter 1 of the code.
(b) Real estate taxes as part of cost. In computing the cost of real
property, the purchaser shall not take into account any amount paid to
the seller as reimbursement for real property taxes which are treated
under section 164(d) as imposed upon the purchaser. This rule applies
whether or not the contract of sale calls for the purchaser to reimburse
the seller for such real estate taxes paid or to be paid by the seller.
On the other hand, where the purchaser pays (or assumes liability for)
real estate taxes which are treated under section 164(d) as imposed upon
the seller, such taxes shall be considered part of the cost of the
property. It is immaterial whether or not the contract of sale specifies
that the sale price has been reduced by, or is in any way intended to
reflect, real estate taxes allocable to the seller under section 164(d).
For illustrations of the application of this paragraph, see paragraph
(b) of Sec. 1.1001-1.
(c) Sale of stock--(1) In general. (i) Except as provided in
paragraph (e)(2) of this section (dealing with stock for which the
average basis method is permitted), if a taxpayer sells or transfers
shares of stock in a corporation that the taxpayer purchased or acquired
on different dates or at different prices and the taxpayer does not
adequately identify the lot from which the stock is sold or transferred,
the stock sold or transferred is charged against the earliest lot the
taxpayer purchased or acquired to determine the basis and holding period
of the stock. If the earliest lot purchased or acquired is held in a
stock certificate that represents multiple lots of stock, and the
taxpayer does not adequately identify the lot from which the stock is
sold or transferred, the stock sold or transferred is charged against
the earliest lot included in the certificate. See paragraphs (c)(2),
(c)(3), and (c)(4) of this section for rules on what constitutes an
adequate identification.
(ii) A taxpayer must determine the basis of identical stock (within
the meaning of paragraph (e)(4) of this section) by averaging the cost
of each
[[Page 34]]
share if the stock is purchased at separate times on the same calendar
day in executing a single trade order and the broker executing the trade
provides a single confirmation that reports an aggregate total cost or
an average cost per share. However, the taxpayer may determine the basis
of the stock by the actual cost per share if the taxpayer notifies the
broker in writing of this intent. The taxpayer must notify the broker by
the earlier of the date of the sale of any of the stock for which the
taxpayer received the confirmation or one year after the date of the
confirmation. A broker may extend the one-year period but the taxpayer
must notify the broker no later than the date of sale of any of the
stock.
(2) Identification of stock. An adequate identification is made if
it is shown that certificates representing shares of stock from a lot
which was purchased or acquired on a certain date or for a certain price
were delivered to the taxpayer's transferee. Except as otherwise
provided in subparagraph (3) or (4) of this paragraph, such stock
certificates delivered to the transferee constitute the stock sold or
transferred by the taxpayer. Thus, unless the requirements of
subparagraph (3) or (4) of this paragraph are met, the stock sold or
transferred is charged to the lot to which the certificates delivered to
the transferee belong, whether or not the taxpayer intends, or instructs
his broker or other agent, to sell or transfer stock from a lot
purchased or acquired on a different date or for a different price.
(3) Identification on confirmation document. (i) Where the stock is
left in the custody of a broker or other agent, an adequate
identification is made if--
(a) At the time of the sale or transfer, the taxpayer specifies to
such broker or other agent having custody of the stock the particular
stock to be sold or transferred, and
(b) Within a reasonable time thereafter, confirmation of such
specification is set forth in a written document from such broker or
other agent.
Stock identified pursuant to this subdivision is the stock sold or
transferred by the taxpayer, even though stock certificates from a
different lot are delivered to the taxpayer's transferee.
(ii) Where a single stock certificate represents stock from
different lots, where such certificate is held by the taxpayer rather
than his broker or other agent, and where the taxpayer sells a part of
the stock represented by such certificate through a broker or other
agent, an adequate identification is made if--
(a) At the time of the delivery of the certificate to the broker or
other agent, the taxpayer specifies to such broker or other agent the
particular stock to be sold or transferred, and
(b) Within a reasonable time thereafter, confirmation of such
specification is set forth in a written document from such broker or
agent.
Where part of the stock represented by a single certificate is sold or
transferred directly by the taxpayer to the purchaser or transferee
instead of through a broker or other agent, an adequate identification
is made if the taxpayer maintains a written record of the particular
stock which he intended to sell or transfer.
(4) Stock held by a trustee, executor, or administrator. (i) A
trustee or executor or administrator of an estate holding stock (not
left in the custody of a broker) makes an adequate identification if the
trustee, executor, or administrator--
(a) Specifies in writing in the books and records of the trust or
estate the particular stock to be sold, transferred, or distributed;
(b) In the case of a distribution, furnishes the distributee with a
written document identifying the particular stock distributed; and
(c) In the case of a sale or transfer through a broker or other
agent, specifies to the broker or agent the particular stock to be sold
or transferred, and within a reasonable time thereafter the broker or
agent confirms the specification in a written document.
(ii) The stock the trust or estate identifies under paragraph
(c)(4)(i) of this section is the stock treated as sold, transferred, or
distributed, even if the trustee, executor, or administrator delivers
stock certificates from a different lot.
(5) Subsequent sales. If stock identified under subparagraph (3) or
(4) of
[[Page 35]]
this paragraph as belonging to a particular lot is sold, transferred, or
distributed, the stock so identified shall be deemed to have been sold,
transferred, or distributed, and such sale, transfer, or distribution
will be taken into consideration in identifying the taxpayer's remaining
stock for purposes of subsequent sales, transfers, or distributions.
(6) Bonds. Paragraphs (1) through (5), (8), and (9) of this section
apply to the sale or transfer of bonds.
(7) Book-entry securities. (i) In applying the provisions of
subparagraph (3)(i)(a) of this paragraph in the case of a sale or
transfer of a book-entry security (as defined in subdivision (iii) (a)
of this subparagraph) which is made after December 31, 1970, pursuant to
a written instruction by the taxpayer, a specification by the taxpayer
of the unique lot number which he has assigned to the lot which contains
the securities being sold or transferred shall constitute specification
as required by such subparagraph. The specification of the lot number
shall be made either--
(a) In such written instruction, or
(b) In the case of a taxpayer in whose name the book entry by the
Reserve Bank is made, in a list of lot numbers with respect to all book-
entry securities on the books of the Reserve Bank sold or transferred on
that date by the taxpayer, provided such list is mailed to or received
by the Reserve Bank on or before the Reserve Bank's next business day.
This subdivision shall apply only if the taxpayer assigns lot numbers in
numerical sequence to successive purchases of securities of the same
loan title (series) and maturity date, except that securities of the
same loan title (series) and maturity date which are purchased at the
same price on the same date may be included within the same lot.
(ii) In applying paragraph (c)(3)(i)(b) of this section to a sale or
transfer of a book-entry security pursuant to a taxpayer's written
instruction, a confirmation is made by furnishing to the taxpayer a
written advice of transaction from the Reserve Bank or other person
through whom the taxpayer sells or transfers the securities. The
confirmation document must describe the securities and specify the date
of the transaction and amount of securities sold or transferred.
(iii) For purposes of this paragraph (c)(7):
(a) The term book-entry security means a transferable Treasury bond,
note, certificate of indebtedness, or bill issued under the Second
Liberty Bond Act (31 U.S.C. 774(2)), as amended, or other security of
the United States (as defined in paragraph (c)(7)(iii)(b) of this
section) in the form of an entry made as prescribed in 31 CFR Part 306,
or other comparable Federal regulations, on the records of a Reserve
Bank.
(b) The term other security of the United States means a bond, note,
certificate of indebtedness, bill, debenture, or similar obligation
which is subject to the provisions of 31 CFR part 306 or other
comparable Federal regulations and which is issued by (1) any department
or agency of the Government of the United States, or (2) the Federal
National Mortgage Association, the Federal Home Loan Banks, the Federal
Home Loan Mortgage Corporation, the Federal Land Banks, the Federal
Intermediate Credit Banks, the Banks for Cooperatives, or the Tennessee
Valley Authority;
(c) The term serially-numbered advice of transaction means the
confirmation (prescribed in 31 CFR 306.116) issued by the Reserve Bank
which is identifiable by a unique number and indicates that a particular
written instruction to the Reserve Bank with respect to the deposit or
withdrawal of a specified book-entry security (or securities) has been
executed; and
(d) The term Reserve Bank means a Federal Reserve Bank and its
branches acting as Fiscal Agent of the United States.
(8) Time for making identification. For purposes of this paragraph
(c), an adequate identification of stock is made at the time of sale,
transfer, delivery, or distribution if the identification is made no
later than the earlier of the settlement date or the time for settlement
required by Rule 15c6-1 under the Securities Exchange Act of 1934, 17
CFR 240.15c6-1 (or its successor). A standing order or instruction for
the specific identification of stock is treated as an adequate
identification made
[[Page 36]]
at the time of sale, transfer, delivery, or distribution.
(9) Method of writing. (i) A written confirmation, record, document,
instruction, notification, or advice includes a writing in electronic
format.
(ii) A broker or agent may include the written confirmation required
under this paragraph (c) in an account statement or other document the
broker or agent periodically provides to the taxpayer if the broker or
agent provides the statement or other document within a reasonable time
after the sale or transfer.
(10) Method for determining basis of stock. A method of determining
the basis of stock, including a method of identifying stock sold under
this paragraph (c) and the average basis method described in paragraph
(e) of this section, is not a method of accounting. Therefore, a change
in a method of determining the basis of stock is not a change in method
of accounting to which sections 446 and 481 apply.
(11) Effective/applicability date. Paragraphs (c)(1), (c)(4),
(c)(6), (c)(7)(ii), (c)(7)(iii)(a), (c)(8), (c)(9), and (c)(10) of this
section apply for taxable years beginning after October 18, 2010.
(d) Obligations issued as part of an investment unit. For purposes
of determining the basis of the individual elements of an investment
unit (as defined in paragraph (b)(2)(ii)(a) of Sec. 1.1232-3)
consisting of an obligation and an option (which is not an excluded
option under paragraph (b)(1)(iii)(c) of Sec. 1.1232-3), security, or
other property, the cost of such investment unit shall be allocated to
such individual elements on the basis of their respective fair market
values. In the case of the initial issuance of an investment unit
consisting of an obligation and an option, security, or other property,
where neither the obligation nor the option, security, or other property
has a readily ascertainable fair market value, the portion of the cost
of the unit which is allocable to the obligation shall be an amount
equal to the issue price of the obligation as determined under paragraph
(b)(2)(ii)(a) of Sec. 1.1232-3.
(e) Election to use average basis method--(1) In general.
Notwithstanding paragraph (c) of this section, and except as provided in
paragraph (e)(8) of this section, a taxpayer may use the average basis
method described in paragraph (e)(7) of this section to determine the
cost or other basis of identical shares of stock if--
(i) The taxpayer leaves shares of stock in a regulated investment
company (as defined in paragraph (e)(5) of this section) or shares of
stock acquired after December 31, 2010, in connection with a dividend
reinvestment plan (as defined in paragraph (e)(6) of this section) with
a custodian or agent in an account maintained for the acquisition or
redemption, sale, or other disposition of shares of the stock; and
(ii) The taxpayer acquires identical shares of stock at different
prices or bases in the account.
(2) Determination of method. (i) If a taxpayer places shares of
stock described in paragraph (e)(1)(i) of this section acquired on or
after January 1, 2012, in the custody of a broker (as defined by section
6045(c)(1)), including by transfer from an account with another broker,
the basis of the shares is determined in accordance with the broker's
default method, unless the taxpayer notifies the broker that the
taxpayer elects another permitted method. The taxpayer must report gain
or loss using the method the taxpayer elects or, if the taxpayer fails
to make an election, the broker's default method. See paragraphs
(e)(9)(i) and (e)(9)(v), Example 2, of this section.
(ii) The provisions of this paragraph (e)(2) are illustrated by the
following example:
Example. (i) In connection with a dividend reinvestment plan,
Taxpayer B acquires 100 shares of G Company in 2012 and 100 shares of G
Company in 2013, in an account B maintains with R Broker. B notifies R
in writing that B elects to use the average basis method to compute the
basis of the shares of G Company. In 2014, B transfers the shares of G
Company to an account with S Broker. B does not notify S of the basis
determination method B chooses to use for the shares of G Company, and
S's default method is first-in, first-out. In 2015, B purchases 200
shares of G Company in the account with S. In 2016, B instructs S to
sell 150 shares of G Company.
(ii) Because B does not notify S of a basis determination method for
the shares of G Company, under paragraph (e)(2)(i) of this section, the
basis of the 150 shares of G Company S sells for B in 2016 must be
determined under S's default method, first-in, first-out.
[[Page 37]]
(3) Shares of stock. For purposes of this paragraph (e), securities
issued by unit investment trusts described in paragraph (e)(5) of this
section are treated as shares of stock and the term share or shares
includes fractions of a share.
(4) Identical stock. For purposes of this paragraph (e), identical
shares of stock means stock with the same Committee on Uniform Security
Identification Procedures (CUSIP) number or other security identifier
number as permitted in published guidance of general applicability, see
Sec. 601.601(d)(2) of this chapter.
(5) Regulated investment company. (i) For purposes of this
paragraph, a regulated investment company means any domestic corporation
(other than a personal holding company as defined in section 542) which
meets the limitations of section 851(b) and Sec. 1.851-2, and which is
registered at all times during the taxable year under the Investment
Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2), either as a
management company, or as a unit investment trust.
(ii) Notwithstanding subdivision (i), this paragraph shall not apply
in the case of a unit investment trust unless it is one--
(a) Substantially all of the assets of which consist (1) of
securities issued by a single management company (as defined in such
Act) and securities acquired pursuant to subdivision (b) of this
subdivision (ii), or (2) securities issued by a single other
corporation, and
(b) Which has no power to invest in any other securities except
securities issued by a single other management company, when permitted
by such Act or the rules and regulations of the Securities and Exchange
Commission.
(6) Dividend reinvestment plan--(i) In general. For purposes of this
paragraph (e), the term dividend reinvestment plan means any written
plan, arrangement, or program under which at least 10 percent of every
dividend (within the meaning of section 316) on any share of stock is
reinvested in stock identical to the stock on which the dividend is
paid. A plan is a dividend reinvestment plan if the plan documents
require that at least 10 percent of any dividend paid is reinvested in
identical stock even if the plan includes stock on which no dividends
have ever been declared or paid or on which an issuer ceases paying
dividends. A plan that holds one or more different stocks may permit a
taxpayer to reinvest a different percentage of dividends in the stocks
held. A dividend reinvestment plan may reinvest other distributions on
stock, such as capital gain distributions, non-taxable returns of
capital, and cash in lieu of fractional shares. The term dividend
reinvestment plan includes both issuer administered dividend
reinvestment plans and non-issuer administered dividend reinvestment
plans.
(ii) Acquisition of stock. Stock is acquired in connection with a
dividend reinvestment plan if the stock is acquired under that plan,
arrangement, or program, or if the dividends and other distributions
paid on the stock are subject to that plan, arrangement, or program.
Shares of stock acquired in connection with a dividend reinvestment plan
include the initial purchase of stock in the dividend reinvestment plan,
transfers of identical stock into the dividend reinvestment plan,
additional periodic purchases of identical stock in the dividend
reinvestment plan, and identical stock acquired through reinvestment of
the dividends or other distributions paid on the stock held in the plan.
(iii) Dividends and other distributions paid after reorganization.
For purposes of this paragraph (e)(6), dividends and other distributions
declared or announced before or pending a corporate action (such as a
merger, consolidation, acquisition, split-off, or spin-off) involving
the issuer and subsequently paid and reinvested in shares of stock in
the successor entity or entities are treated as reinvested in shares of
stock identical to the shares of stock of the issuer.
(iv) Withdrawal from or termination of plan. If a taxpayer withdraws
stock from a dividend reinvestment plan or the plan administrator
terminates the dividend reinvestment plan, the shares of identical stock
the taxpayer acquires after the withdrawal or termination are not
acquired in connection with a dividend reinvestment plan. The taxpayer
may not use the average basis
[[Page 38]]
method after the withdrawal or termination but may use any other
permissible basis determination method. See paragraph (e)(7)(v) of this
section for the basis of the shares after withdrawal or termination.
(7) Computation of average basis--(i) In general. Average basis is
determined by averaging the basis of all shares of identical stock in an
account regardless of holding period. However, for this purpose, shares
of stock in a dividend reinvestment plan are not identical to shares of
stock with the same CUSIP number that are not in a dividend reinvestment
plan. The basis of each share of identical stock in the account is the
aggregate basis of all shares of that stock in the account divided by
the aggregate number of shares. Unless a single-account election is in
effect, see paragraph (e)(11) of this section, a taxpayer may not
average together the basis of identical stock held in separate accounts
that the taxpayer sells, exchanges, or otherwise disposes of on or after
January 1, 2012.
(ii) Order of disposition of shares sold or transferred. In the case
of the sale or transfer of shares of stock to which the average basis
method election applies, shares sold or transferred are deemed to be the
shares first acquired. Thus, the first shares sold or transferred are
those with a holding period of more than 1 year (long-term shares) to
the extent that the account contains long-term shares. If the number of
shares sold or transferred exceeds the number of long-term shares in the
account, the excess shares sold or transferred are deemed to be shares
with a holding period of 1 year or less (short-term shares). Any gain or
loss attributable to shares held for more than 1 year constitutes long-
term gain or loss, and any gain or loss attributable to shares held for
1 year or less constitutes short-term gain or loss. For example, if a
taxpayer sells 50 shares from an account containing 100 long-term shares
and 100 short-term shares, the shares sold or transferred are all long-
term shares. If, however, the account contains 40 long-term shares and
100 short-term shares, the taxpayer has sold 40 long-term shares and 10
short-term shares.
(iii) Transition rule from double-category method. This paragraph
(e)(7)(iii) applies to stock for which a taxpayer uses the double-
category method under Sec. 1.1012-1(e)(3) (April 1, 2010), that the
taxpayer acquired before April 1, 2011, and that the taxpayer sells,
exchanges, or otherwise disposes of on or after that date. The taxpayer
must calculate the average basis of this stock by averaging together all
identical shares of stock in the account on April 1, 2011, regardless of
holding period.
(iv) Wash sales. A taxpayer must apply section 1091 and the
associated regulations (dealing with wash sales of substantially
identical securities) in computing average basis regardless of whether
the stock or security sold or otherwise disposed of and the stock
acquired are in the same account or in different accounts.
(v) Basis after change from average basis method. Unless a taxpayer
revokes an average basis method election under paragraph (e)(9)(iii) of
this section, if a taxpayer changes from the average basis method to
another basis determination method (including a change resulting from a
withdrawal from or termination of a dividend reinvestment plan), the
basis of each share of stock immediately after the change is the same as
the basis immediately before the change. See paragraph (e)(9)(iv) of
this section for rules for changing from the average basis method.
(vi) The provisions of this paragraph (e)(7) are illustrated by the
following examples:
Example 1. (i) In 2011, Taxpayer C acquires 100 shares of H Company
and enrolls them in a dividend reinvestment plan administered by T
Custodian. C elects to use the average basis method for the shares of H
Company enrolled in the dividend reinvestment plan. T also acquires for
C's account 50 shares of H Company and does not enroll these shares in
the dividend reinvestment plan.
(ii) Under paragraph (e)(7)(i) of this section, the 50 shares of H
Company not in the dividend reinvestment plan are not identical to the
100 shares of H Company enrolled in the dividend reinvestment plan, even
if they have the same CUSIP number. Accordingly, under paragraphs (e)(1)
and (e)(7)(i) of this section, C may not average the basis of the 50
shares of H Company with the basis of the 100 shares of H Company. Under
paragraph (e)(1)(i) of this section, C may not use the average basis
method for the 50 shares of H
[[Page 39]]
Company because the shares are not acquired in connection with a
dividend reinvestment plan.
Example 2. (i) Taxpayer D enters into an agreement with W Custodian
establishing an account for the periodic acquisition of shares of L
Company, a regulated investment company. W acquires for D's account
shares of L Company stock on the following dates and amounts:
------------------------------------------------------------------------
Number of
Date shares Cost
------------------------------------------------------------------------
January 8, 2010................................... 25 $200
February 8, 2010.................................. 24 200
March 8, 2010..................................... 20 200
April 8, 2010..................................... 20 200
------------------------------------------------------------------------
(ii) At D's direction, W sells 40 shares from the account on January
15, 2011, for $10 per share or a total of $400. D elects to use the
average basis method for the shares of L Company. The average basis for
the shares sold on January 15, 2011, is $8.99 (total cost of shares,
$800, divided by the total number of shares, 89).
(iii) Under paragraph (e)(7)(ii) of this section, the shares sold
are the shares first acquired. Thus, D realizes $25.25 ($1.01 * 25)
long-term capital gain for the 25 shares acquired on January 8, 2010,
and $15.15 ($1.01 * 15) short-term capital gain for 15 of the shares
acquired on February 8, 2010.
Example 3. (i) The facts are the same as in Example 2, except that
on February 8, 2011, D changes to the first-in, first-out basis
determination method. W purchases 25 shares of L Company for D on March
8, 2011, at $12 per share. D sells 40 shares on May 8, 2011, and 34
shares on July 8, 2012.
(ii) Because D uses the first-in, first-out method, the 40 shares
sold on May 8, 2011 are 9 shares purchased on February 8, 2010, 20
shares purchased on March 8, 2010, and 11 shares purchased on April 8,
2010. Because, under paragraph (e)(7)(v) of this section, the basis of
the shares D owns when D changes from the average basis method remains
the same, the basis of the shares sold on May 8, 2011, is $8.99 per
share, not the original cost of $8.33 per share for the shares purchased
on February 8, 2010, or $10 per share for the shares purchased on March
8, 2010, and April 8, 2010. The basis of the shares sold on July 8,
2012, is $8.99 per share for 9 shares purchased on April 8, 2010, and
$12 per share for 25 shares purchased on March 8, 2011.
Example 4. (i) The facts are the same as in Example 2, except that D
uses the first-in, first-out method for the 40 shares sold on January
15, 2011. W purchases 25 shares of L Company for D on March 8, 2011, at
$12 per share. D sells 40 shares on May 8, 2011, and elects the average
basis method.
(ii) Because D uses the first-in, first-out method for the sale on
January 15, 2011, the 40 shares sold are the 25 shares acquired on
January 8, 2010, for $200 (basis $8 per share) and 15 of the 24 shares
purchased on February 8, 2010, for $200 (basis $8.33 per share).
(iii) Under paragraph (e)(7)(i) of this section, under the average
basis method, the basis of all of the shares of identical stock in D's
account is averaged. Thus, the basis of each share D sells on May 8,
2011, after electing the average basis method, is $10.47. This figure is
the total cost of the shares in D's account ($74.97 for the 9 shares
acquired on February 8, 2010, $200 for the 20 shares acquired on March
8, 2010, $200 for the 20 shares acquired on April 8, 2010, and $300 for
the 25 shares acquired on March 8, 2011) divided by 74, the total number
of shares ($774.97/74).
(8) Limitation on use of average basis method for certain gift
shares. (i) Except as provided in paragraph (e)(8)(ii) of this section,
a taxpayer may not use the average basis method for shares of stock a
taxpayer acquires by gift after December 31, 1920, if the basis of the
shares (adjusted for the period before the date of the gift as provided
in section 1016) in the hands of the donor or the last preceding owner
by whom the shares were not acquired by gift was greater than the fair
market value of the shares at the time of the gift. This paragraph
(e)(8)(i) does not apply to shares the taxpayer acquires as a result of
a taxable dividend or capital gain distribution on the gift shares.
(ii) Notwithstanding paragraph (e)(8)(i) of this section, a taxpayer
may use the average basis method if the taxpayer states in writing that
the taxpayer will treat the basis of the gift shares as the fair market
value of the shares at the time the taxpayer acquires the shares. The
taxpayer must provide this statement when the taxpayer makes the
election under paragraph (e)(9) of this section or when transferring the
shares to an account for which the taxpayer has made this election,
whichever occurs later. The statement must be effective for any gift
shares identical to the gift shares to which the average basis method
election applies that the taxpayer acquires at any time and must remain
in effect as long as the election remains in effect.
(iii) The provisions of this paragraph (e)(8) are illustrated by the
following examples:
Example 1. (i) Taxpayer E owns an account for the periodic
acquisition of shares of M
[[Page 40]]
Company, a regulated investment company. On April 15, 2010, E acquires
identical shares of M Company by gift and transfers those shares into
the account. These shares had an adjusted basis in the hands of the
donor that was greater than the fair market value of the shares on that
date. On June 15, 2010, E sells shares from the account and elects to
use the average basis method.
(ii) Under paragraph (e)(8)(ii) of this section, E may elect to use
the average basis method for shares sold or transferred from the account
if E includes a statement with E's election that E will treat the basis
of the gift shares in the account as the fair market value of the shares
at the time E acquired them. See paragraph (e)(9)(ii) of this section.
Example 2. (i) The facts are the same as in Example 1, except E
acquires the gift shares on April 15, 2012, transfers those shares into
the account, and used the average basis method for sales of shares of M
Company before acquiring the gift shares. E sells shares of M Company on
June 15, 2012.
(ii) Under paragraph (e)(8)(ii) of this section, the basis of the
gift shares may be averaged with the basis of the other shares of M
Company in E's account if, when E transfers the gift shares to the
account, E provides a statement to E's broker that E will treat the
basis of the gift shares in the account as the fair market value of the
shares at the time E acquired them. See paragraph (e)(9)(i) of this
section.
(9) Time and manner for making the average basis method election--
(i) In general. A taxpayer makes an election to use the average basis
method for shares of stock described in paragraph (e)(1)(i) of this
section that are covered securities (within the meaning of section
6045(g)(3)) by notifying the custodian or agent in writing by any
reasonable means. For purposes of this paragraph (e), a writing may be
in electronic format. A taxpayer has not made an election within the
meaning of this section if the taxpayer fails to notify a broker of the
taxpayer's basis determination method and basis is determined by the
broker's default method under paragraph (e)(2) of this section. A
taxpayer may make the average basis method election at any time,
effective for sales or other dispositions of stock occurring after the
taxpayer notifies the custodian or agent. The election must identify
each account with that custodian or agent and each stock in that account
to which the election applies. The election may specify that it applies
to all accounts with a custodian or agent, including accounts the
taxpayer later establishes with the custodian or agent. If the election
applies to gift shares, the taxpayer must provide the statement required
by paragraph (e)(8)(ii) of this section, if applicable, to the custodian
or agent with the taxpayer's election.
(ii) Average basis method election for securities that are
noncovered securities. A taxpayer makes an election to use the average
basis method for shares of stock described in paragraph (e)(1)(i) of
this section that are noncovered securities (as described in Sec.
1.6045-1(a)(16)) on the taxpayer's income tax return for the first
taxable year for which the election applies. A taxpayer may make the
election on an amended return filed no later than the time prescribed
(including extensions) for filing the original return for the taxable
year for which the election applies. The taxpayer must indicate on the
return that the taxpayer used the average basis method in reporting gain
or loss on the sale or other disposition. A taxpayer must attach to the
return the statement described in paragraph (e)(8)(ii) of this section,
if applicable. A taxpayer making the election must maintain records
necessary to substantiate the average basis reported.
(iii) Revocation of election. A taxpayer may revoke an election
under paragraph (e)(9)(i) of this section by the earlier of one year
after the taxpayer makes the election or the date of the first sale,
transfer, or disposition of that stock following the election. A
custodian or agent may extend the one-year period but a taxpayer may not
revoke an election after the first sale, transfer, or disposition of the
stock. A revocation applies to all stock the taxpayer holds in an
account that is identical to the shares of stock for which the taxpayer
revokes the election. A revocation is effective when the taxpayer
notifies, in writing by any reasonable means, the custodian or agent
holding the stock to which the revocation applies. After revocation, the
taxpayer's basis in the shares of stock to which the revocation applies
is the basis before averaging.
(iv) Change from average basis method. A taxpayer may change basis
determination methods from the average
[[Page 41]]
basis method to another method prospectively at any time. A change from
the average basis method applies to all identical stock the taxpayer
sells or otherwise disposes of before January 1, 2012, that was held in
any account. A change from the average basis method applies on an
account by account basis (within the meaning of paragraph (e)(10) of
this section) to all identical stock the taxpayer sells or otherwise
disposes of on or after January 1, 2012. The taxpayer must notify, in
writing by any reasonable means, the custodian or agent holding the
stock to which the change applies. Unless paragraph (e)(9)(iii) of this
section applies, the basis of each share of stock to which the change
applies remains the same as the basis immediately before the change. See
paragraph (e)(7)(v) of this section.
(v) Examples. The provisions of this paragraph (e)(9) are
illustrated by the following examples:
Example 1. (i) Taxpayer F enters into an agreement with W Custodian
establishing an account for the periodic acquisition of shares of N
Company, a regulated investment company. W acquires for F's account
shares of N Company on the following dates and amounts:
------------------------------------------------------------------------
Number of
Date shares Cost
------------------------------------------------------------------------
January 8, 2012................................... 25 $200
February 8, 2012.................................. 24 200
March 8, 2012..................................... 20 200
------------------------------------------------------------------------
(ii) F notifies W that F elects, under paragraph (e)(9)(i) of this
section, to use the average basis method for the shares of N Company. On
May 8, 2012, under paragraph (e)(9)(iii) of this section, F notifies W
that F revokes the average basis method election. On June 1, 2012, F
sells 60 shares of N Company using the first-in, first-out basis
determination method.
(iii) Under paragraph (e)(9)(iii) of this section, the basis of the
N Company shares upon revocation, and for purposes of determining gain
on the sale, is $8.00 per share for each of the 25 shares purchased on
January 8, 2012, $8.34 per share for each of the 24 shares purchased on
February 8, 2012, and $10 per share for the remaining 11 shares
purchased on March 8, 2012.
Example 2. (i) The facts are the same as in Example 1, except that F
does not notify W that F elects a basis determination method. W's
default basis determination method is the average basis method and W
maintains an averaged basis for F's shares of N Company on W's books and
records.
(ii) F has not elected the average basis method under paragraph
(e)(9)(i) of this section. Therefore, F's notification to W on May 8,
2012, is not an effective revocation under paragraph (e)(9)(iii) of this
section. F's attempted revocation is, instead, notification of a change
from the average basis method under paragraph (e)(9)(iv) of this
section. Accordingly, the basis of each share of stock F sells on June
1, 2012, is the basis immediately before the change, $8.70 (total cost
of shares, $600, divided by the total number of shares, 69).
(10) Application of average basis method account by account--(i) In
general. For sales, exchanges, or other dispositions on or after January
1, 2012, of stock described in paragraph (e)(1)(i) of this section, the
average basis method applies on an account by account basis. A taxpayer
may use the average basis method for stock in a regulated investment
company or stock acquired in connection with a dividend reinvestment
plan in one account but use a different basis determination method for
identical stock in a different account. If a taxpayer uses the average
basis method for a stock described in paragraph (e)(1)(i) of this
section, the taxpayer must use the average basis method for all
identical stock within that account. The taxpayer may use different
basis determination methods for stock within an account that is not
identical. Except as provided in paragraph (e)(10)(ii) of this section,
a taxpayer must make separate elections to use the average basis method
for stock held in separate accounts.
(ii) Account rule for stock sold before 2012. A taxpayer's election
to use the average basis method for shares of stock described in
paragraph (e)(1)(i) of this section that a taxpayer sells, exchanges, or
otherwise disposes of before January 1, 2012, applies to all identical
shares of stock the taxpayer holds in any account.
(iii) Separate account. Unless the single-account election described
in paragraph (e)(11)(i) of this section applies, stock described in
paragraph (e)(1)(i) of this section that is a covered security (within
the meaning of section 6045(g)(3)) is treated as held in a separate
account from stock that is a noncovered security (as described in
[[Page 42]]
Sec. 1.6045-1(a)(16)), regardless of when acquired.
(iv) Examples. The provisions of this paragraph (e)(10) are
illustrated by the following examples:
Example 1. (i) In 2012, Taxpayer G enters into an agreement with Y
Broker establishing three accounts (G-1, G-2, and G-3) for the periodic
acquisition of shares of P Company, a regulated investment company. Y
makes periodic purchases of P Company for each of G's accounts. G elects
to use the average basis method for account G-1. On July 1, 2013, G
sells shares of P Company from account G-1.
(ii) G is not required to use the average basis method for the
shares of P Company that G holds in accounts G-2 and G-3 because, under
paragraph (e)(10)(i) of this section, the average basis method election
applies to shares sold after 2011 on an account by account basis.
Example 2. The facts are the same as in Example 1, except that G
also instructs Y to acquire shares of Q Company, a regulated investment
company, for account G-1. Under paragraph (e)(10)(i) of this section, G
may use any permissible basis determination method for the shares of Q
Company because, under paragraph (e)(4) of this section, the shares of Q
Company are not identical to the shares of P Company.
Example 3. (i) The facts are the same as in Example 1, except that G
establishes the accounts in 2011 and Y sells shares of P Company from
account G-1 on July 1, 2011.
(ii) For sales before 2012, under paragraph (e)(10)(ii) of this
section, G's election applies to all accounts in which G holds identical
stock. G must average together the basis of the shares in all accounts
to determine the basis of the shares sold from account G-1.
Example 4. (i) In 2011, Taxpayer H acquires 80 shares of R Company
and enrolls them in R Company's dividend reinvestment plan. In 2012, H
acquires 50 shares of R Company in the dividend reinvestment plan. H
elects to use the average basis method for the shares of R Company in
the dividend reinvestment plan. R Company does not make the single-
account election under paragraph (e)(11)(i) of this section.
(ii) Under section 6045(g)(3) and Sec. 1.6045-1(a)(16), the 80
shares acquired in 2011 are noncovered securities and the 50 shares
acquired in 2012 are covered securities. Therefore, under paragraph
(e)(10)(iii) of this section, the 80 shares are treated as held in a
separate account from the 50 shares. H must make a separate average
basis method election for each account and must average the basis of the
shares in each account separately from the shares in the other account.
Example 5. (i) B Broker maintains an account for Taxpayer J for the
periodic acquisition of shares of S Company, a regulated investment
company. In 2013, B purchases shares of S Company for J's account that
are covered securities within the meaning of section 6045(g)(3). On
April 15, 2014, J inherits shares of S Company that are noncovered
securities and transfers the shares into the account with B.
(ii) Under paragraph (e)(10)(iii) of this section, J must treat the
purchased shares and the inherited shares of S Company as held in
separate accounts. J may elect to apply the average basis method to all
the shares of S Company, but must make a separate election for each
account, and must average the basis of the shares in each account
separately from the shares in the other account.
Example 6. (i) In 2010, Taxpayer K purchases stock in T Company in
an account with C Broker. In 2012, K purchases additional T Company
stock and enrolls that stock in a dividend reinvestment plan maintained
by C. K elects the average basis method for the T Company stock. In
2013, K transfers the T Company stock purchased in 2010 into the
dividend reinvestment plan.
(ii) Under paragraphs (e)(1)(i) and (e)(6)(ii) of this section, the
stock purchased in 2010 is not stock acquired after December 31, 2010,
in connection with a dividend reinvestment plan before transfer into the
dividend reinvestment plan. Therefore, the stock is not eligible for the
average basis method at that time.
(iii) Once transferred into the dividend reinvestment plan in 2013,
the stock K purchased in 2010 is acquired after December 31, 2010, in
connection with a dividend reinvestment plan within the meaning of
paragraph (e)(6)(ii) of this section and is eligible for the average
basis method. Because stock purchased in 2010 is a noncovered security
under Sec. 1.6045-1(a)(16), under paragraph (e)(10)(iii) of this
section, the 2010 stock and the 2012 stock must be treated as held in
separate accounts. Under paragraph (e)(7)(i) of this section, the basis
of the 2010 shares may not be averaged with the basis of the 2012
shares.
Example 7. The facts are the same as in Example 6, except that K
purchases the initial T Company stock in January 2011. Because this
stock is a covered security under section 6045(g)(3) and Sec. 1.6045-
1(a)(15)(iv)(A), the 2011 stock and the 2012 stock are not required
under paragraph (e)(10)(iii) of this section to be treated as held in
separate accounts. Under paragraph (e)(7)(i) of this section, the basis
of the 2011 shares must be averaged with the basis of the 2012 shares.
Example 8. (i) The facts are the same as in Example 7, except that K
purchases the additional T Company stock and enrolls in the dividend
reinvestment plan in March 2011. In September 2011, K transfers the T
Company stock purchased in January 2011 into the dividend reinvestment
plan. K sells some of the T Company stock in 2012.
[[Page 43]]
(ii) Under section 6045(g)(3) and Sec. 1.6045-1(a)(16), the stock K
purchases in January 2011 is a covered security at the time of purchase
but the stock K purchases and enrolls in the dividend reinvestment plan
in March 2011 is a noncovered security. However, under Sec. 1.6045-
1(a)(15)(iv)(A), the stock purchased in January 2011 becomes a
noncovered security after it is transferred to the dividend reinvestment
plan. Because all the shares in the dividend reinvestment plan in
September 2011 are noncovered securities, when K sells stock in 2012,
the January 2011 stock and the March 2011 stock are not required under
paragraph (e)(10)(iii) of this section to be treated as held in separate
accounts. Under paragraph (e)(7)(i) of this section, the basis of the
January 2011 shares must be averaged with the basis of the March 2011
shares.
(11) Single-account election--(i) In general. Paragraph (e)(10)(iii)
of this section does not apply if a regulated investment company or
dividend reinvestment plan elects to treat all identical shares of stock
described in paragraph (e)(1)(i) of this section as held in a single
account (single-account election). The single-account election applies
only to stock for which a taxpayer elects to use the average basis
method that is held in separate accounts or treated as held in separate
accounts maintained for the taxpayer and only to accounts with the same
ownership. If a broker (as defined by section 6045(c)(1)) holds the
stock as a nominee, the broker, and not the regulated investment company
or dividend reinvestment plan, makes the election. The single-account
election is irrevocable, but is void if the taxpayer revokes the average
basis election under paragraph (e)(9)(iii) of this section.
(ii) Scope of election. A company, plan, or broker may make a
single-account election for one or more taxpayers for which it maintains
an account, and for one or more stocks it holds for a taxpayer. The
company, plan, or broker may make the election only for the shares of
stock for which it has accurate basis information. A company, plan, or
broker has accurate basis information if the company, plan, or broker
neither knows nor has reason to know that the basis information is
inaccurate. See also section 6724 and the associated regulations
regarding standards for relief from information reporting penalties.
Stock for which accurate basis information is unavailable may not be
included in the single-account election and must be treated as held in a
separate account.
(iii) Effect of single-account election. If a company, plan, or
broker makes the single-account election, the basis of all identical
shares of stock to which the election applies must be averaged together
regardless of when the taxpayer acquires the shares, and all the shares
are treated as covered securities. The single-account election applies
to all identical stock a taxpayer later acquires in the account that is
a covered security (within the meaning of section 6045(g)(3)). A
company, plan, or broker may make another single-account election if,
for example, the broker later acquires accurate basis information for a
stock, or a taxpayer acquires identical stock in the account that is a
noncovered security (as described in Sec. 1.6045-1(a)(16)) for which
the company, plan, or broker has accurate basis information.
(iv) Time and manner for making the single-account election. A
company, plan, or broker makes the single-account election by clearly
noting it on its books and records. The books and records must reflect
the date of the election; the taxpayer's name, account number, and
taxpayer identification number; the stock subject to the election; and
the taxpayer's basis in the stock. The company, plan, or broker must
provide copies of the books and records regarding the election to the
taxpayer upon request. A company, plan, or broker may make the single-
account election at any time.
(v) Notification to taxpayer. A company, plan, or broker making the
single-account election must use reasonable means to notify the taxpayer
of the election. Reasonable means include mailings, circulars, or
electronic mail sent separately to the taxpayer or included with the
taxpayer's account statement, or other means reasonably calculated to
provide actual notice to the taxpayer. The notice must identify the
securities subject to the election and advise the taxpayer that the
securities will be treated as covered securities regardless of when
acquired.
[[Page 44]]
(vi) Examples. The provisions of this paragraph (e)(11) are
illustrated by the following examples:
Example 1. (i) E Broker maintains Accounts A and B for Taxpayer M
for the acquisition and disposition of shares of T Company, a regulated
investment company. In 2011, E purchases 100 shares of T Company for M's
Account A. E has accurate basis information for these shares. In 2012, E
purchases 150 shares of T Company for M's Account A and 80 shares of T
Company for M's Account B. M elects to use the average basis method for
all shares of T Company. E makes a single-account election for M's T
Company stock.
(ii) The shares of T Company in Accounts A and B are held in
separate accounts. Under section 6045(g)(3) and Sec. 1.6045-1(a)(16),
of the shares purchased in Account A, the 100 shares purchased in 2011
are noncovered securities and the 150 shares purchased in 2012 are
covered securities. Under paragraph (e)(10)(iii) of this section, the
100 shares are treated as held in a separate account from the 150
shares. Under paragraph (e)(11)(i) of this section, the single-account
election applies to all 330 shares of T Company in Accounts A and B.
Thus, under paragraph (e)(11)(iii) of this section, the basis of the 330
shares of stock is averaged together and all the shares are treated as
covered securities.
Example 2. The facts are the same as in Example 1, except that M
owns Account B jointly with Taxpayer N. E may make a single-account
election for the 250 shares of stock in M's Account A. However, under
paragraph (e)(11)(i) of this section, E may not make a single-account
election for Accounts A and B because the accounts do not have the same
ownership.
Example 3. (i) C Broker maintains an account for Taxpayer K for the
acquisition and disposition of shares of T Company, a regulated
investment company, and shares of V Company that K enrolls in C's
dividend reinvestment plan. In 2011, C purchases for K's account 100
shares of T Company in multiple lots and 80 shares of V Company in
multiple lots that are enrolled in the dividend reinvestment plan. C has
accurate basis information for all 100 shares of T Company and 80 shares
of V Company. In 2012, C acquires for K's account 150 shares of T
Company and 160 shares of V Company that are enrolled in the dividend
reinvestment plan. K elects to use the average basis method for all the
shares of T Company and V Company.
(ii) Under paragraphs (e)(11)(i) and (ii) of this section, C may
make a single-account election for the T Company stock or the V Company
stock, or both. After making a single-account election for each stock,
under paragraph (e)(11)(iii) of this section, the basis of all T Company
stock is averaged together and the basis of all V Company stock is
averaged together, regardless of when acquired, and all the shares of T
Company and V Company are treated as covered securities.
Example 4. The facts are the same as in Example 3, except that K
transfers the 100 shares of T Company acquired in 2011 from an account
with another broker into K's account with C. C does not have accurate
basis information for 30 of the 100 shares of T Company, which K had
acquired in two lots. Under paragraph (e)(11)(ii) of this section, C may
make the single-account election only for the 70 shares of T Company
stock for which C has accurate basis information. C must treat the 30
shares of T Company for which C does not have accurate basis information
as held in a separate account. K may use the average basis method for
the 30 shares of T Company, but must make a separate average basis
method election for these shares and must average the basis of these
shares separately from the 70 shares subject to C's single-account
election.
Example 5. The facts are the same as in Example 3, except that C has
made the single-account election and in 2013 K acquires additional
shares of T Company that are covered securities in K's account with C.
Under paragraph (e)(11)(iii) of this section, these shares of T Company
are subject to C's single-account election.
Example 6. The facts are the same as in Example 3, except that C has
made the single-account election and in 2013 K inherits shares of T
Company that are noncovered securities and transfers the shares into the
account with C. C has accurate basis information for these shares. Under
paragraph (e)(11)(iii) of this section, C may make a second single-
account election to include the inherited T Company shares.
Example 7. (i) Between 2002 and 2011, Taxpayer L acquires 1,500
shares of W Company, a regulated investment company, in an account with
D Broker, for which L uses the average basis method, and sells 500
shares. On January 5, 2012, based on accurate basis information, the
averaged basis of L's remaining 1,000 shares of W Company is $24 per
share. On January 5, 2012, L acquires 100 shares of W Company for $28
per share and makes an average basis election for those shares under
paragraph (e)(9)(i) of this section.
(ii) On February 1, 2012, D makes a single-account election that
includes all 1,100 of L's shares in W Company. Thereafter, the basis of
L's shares of W Company is $24.36 per share (($24,000 + $2,800)/1,100).
On September 12, 2012, under paragraph (e)(9)(iii) of this section, L
revokes the average basis election for the 100 shares acquired on
January 5, 2012.
(iii) Under paragraph (e)(11)(i) of this section, D's single-account
election is void. Therefore, the basis of the 1,000 shares of W Company
that L acquires before 2012 is $24 per share and the basis of the 100
shares of W
[[Page 45]]
Company that L acquires in 2012 is $28 per share.
(12) Effective/applicability date. Except as otherwise provided in
paragraphs (e)(1), (e)(2), (e)(7), (e)(9), and (e)(10) of this section,
this paragraph (e) applies for taxable years beginning after October 18,
2010.
(f) Special rules. For special rules for determining the basis for
gain or loss in the case of certain vessels acquired through the
Maritime Commission (or its successors) or pursuant to an agreement with
the Secretary of Commerce, see sections 510, 511, and 607 of the
Merchant Marine Act, 1936, as amended (46 U.S.C. 1160, 1161) and parts 2
and 3 of this chapter. For special rules for determining the unadjusted
basis of property recovered in respect of war losses, see section 1336.
For special rules with respect to taxable years beginning before January
1, 1964, for determining the basis for gain or loss in the case of a
disposition of a share of stock acquired pursuant to the timely exercise
of a restricted stock option where the option price was between 85
percent and 95 percent of the fair market value of the stock at the time
the option was granted, see paragraph (b) of Sec. 1.421-5. See section
423(c)(1) or 424(c)(1), whichever is applicable, for special rules with
respect to taxable years ending after December 31, 1963, for determining
the basis for gain or loss in the case of the disposition of a share of
stock acquired pursuant to the timely exercise of a stock option
described in such sections. See section 422(c)(1) for special rules with
respect to taxable years ending after December 31, 1963, for determining
the basis for gain or loss in the case of an exercise of a qualified
stock option.
(g) Debt instruments issued in exchange for property--(1) In
general. For purposes of paragraph (a) of this section, if a debt
instrument is issued in exchange for property, the cost of the property
that is attributable to the debt instrument is the issue price of the
debt instrument as determined under Sec. 1.1273-2 or Sec. 1.1274-2,
whichever is applicable. If, however, the issue price of the debt
instrument is determined under section 1273(b)(4), the cost of the
property attributable to the debt instrument is its stated principal
amount reduced by any unstated interest (as determined under section
483).
(2) Certain tax-exempt obligations. This paragraph (g)(2) applies to
a tax-exempt obligation (as defined in section 1275(a)(3)) that is
issued in exchange for property and that has an issue price determined
under Sec. 1.1274-2(j) (concerning tax-exempt contingent payment
obligations and certain tax-exempt variable rate debt instruments
subject to section 1274). Notwithstanding paragraph (g)(1) of this
section, if this paragraph (g)(2) applies to a tax-exempt obligation,
for purposes of paragraph (a) of this section, the cost of the property
that is attributable to the obligation is the sum of the present values
of the noncontingent payments (as determined under Sec. 1.1274-2(c)).
(3) Effective date. This paragraph (g) applies to sales or exchanges
that occur on or after August 13, 1996.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960]
Editorial Note: For Federal Register citations affecting Sec.
1.1012-1, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
Sec. 1.1012-2 Transfers in part a sale and in part a gift.
For rules relating to basis of property acquired in a transfer which
is in part a gift and in part a sale, see Sec. Sec. 1.170A-4(c),
1.1011-2(b), and Sec. 1.105-4.
[T.D. 7207, 37 FR 20799, Oct. 5, 1972]
Sec. 1.1013-1 Property included in inventory.
The basis of property required to be included in inventory is the
last inventory value of such property in the hands of the taxpayer. The
requirements with respect to the valuation of an inventory are stated in
subpart D (section 471 and following), part II, subchapter E, chapter 1
of the Code, and the regulations thereunder.
Sec. 1.1014-1 Basis of property acquired from a decedent.
(a) General rule. The purpose of section 1014 is, in general, to
provide a basis for property acquired from a decedent that is equal to
the value placed upon such property for purposes of the federal estate
tax. Accordingly, the
[[Page 46]]
general rule is that the basis of property acquired from a decedent is
the fair market value of such property at the date of the decedent's
death, or, if the decedent's executor so elects, at the alternate
valuation date prescribed in section 2032, or in section 811(j) of the
Internal Revenue Code (Code) of 1939. However, the basis of property
acquired from certain decedents who died in 2010 is determined under
section 1022, if the decedent's executor made an election under section
301(c) of the Tax Relief, Unemployment Insurance Reauthorization, and
Job Creation Act of 2010, Public Law 111-312 (124 Stat. 3296, 3300
(2010)). See section 1022. Property acquired from a decedent includes,
principally, property acquired by bequest, devise, or inheritance, and,
in the case of decedents dying after December 31, 1953, property
required to be included in determining the value of the decedent's gross
estate under any provision of the Code of 1954 or the Code of 1939. The
general rule governing basis of property acquired from a decedent, as
well as other rules prescribed elsewhere in this section, shall have no
application if the property is sold, exchanged, or otherwise disposed of
before the decedent's death by the person who acquired the property from
the decedent. For general rules on the applicable valuation date where
the executor of a decedent's estate elects under section 2032, or under
section 811(j) of the Code of 1939, to value the decedent's gross estate
at the alternate valuation date prescribed in such sections, see Sec.
1.1014-3(e).
(b) Scope and application. With certain limitations, the general
rule described in paragraph (a) of this section is applicable to the
classes of property described in paragraphs (a) and (b) of Sec. 1.1014-
2, including stock in a DISC or former DISC. In the case of stock in a
DISC or former DISC, the provisions of this section and Sec. Sec.
1.1014-2 through 1.1014-8 are applicable, except as provided in Sec.
1.1014-9. Special basis rules with respect to the basis of certain other
property acquired from a decedent are set forth in paragraph (c) of
Sec. 1.1014-2. These special rules concern certain stock or securities
of a foreign personal holding company and the surviving spouse's one-
half share of community property held with a decedent dying after
October 21, 1942, and on or before December 31, 1947. In this section
and Sec. Sec. 1.1014-2 to 1.1014-6, inclusive, whenever the words
property acquired from a decedent are used, they shall also mean
property passed from a decedent, and the phrase person who acquired it
from the decedent shall include the person to whom it passed from the
decedent.
(c) Property to which section 1014 does not apply. Section 1014
shall have no application to the following classes of property:
(1) Property which constitutes a right to receive an item of income
in respect of a decedent under section 691; and
(2) Restricted stock options described in section 421 which the
employee has not exercised at death if the employee died before January
1, 1957. In the case of employees dying after December 31, 1956, see
paragraph (d)(4) of Sec. 1.421-5. In the case of employees dying in a
taxable year ending after December 31, 1963, see paragraph (c)(4) of
Sec. 1.421-8 with respect to an option described in part II of
subchapter D.
(d) Effective/applicability date. This section applies on and after
January 19, 2017. For rules before January 19, 2017, see Sec. 1.1014-1
as contained in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6527, 26 FR
413, Jan. 19, 1961; T.D. 6887, 31 FR 8812, June 24, 1966; T.D. 7283, 38
FR 20825, Aug. 3, 1973; T.D. 9811, 82 FR 6240, Jan. 19, 2017]
Sec. 1.1014-2 Property acquired from a decedent.
(a) In general. The following property, except where otherwise
indicated, is considered to have been acquired from a decedent and the
basis thereof is determined in accordance with the general rule in Sec.
1.1014-1:
(1) Without regard to the date of the decedent's death, property
acquired by bequest, devise, or inheritance, or by the decedent's estate
from the decedent, whether the property was acquired under the
decedent's will or under the law governing the descent and distribution
of the property of decedents. However, see paragraph (c)(1) of this
section if the property was acquired by bequest or inheritance from a
[[Page 47]]
decedent dying after August 26, 1937, and if such property consists of
stock or securities of a foreign personal holding company.
(2) Without regard to the date of the decedent's death, property
transferred by the decedent during his lifetime in trust to pay the
income for life to or on the order or direction of the decedent, with
the right reserved to the decedent at all times before his death to
revoke the trust.
(3) In the case of decedents dying after December 31, 1951, property
transferred by the decedent during his lifetime in trust to pay the
income for life to or on the order or direction of the decedent with the
right reserved to the decedent at all times before his death to make any
change in the enjoyment thereof through the exercise of a power to
alter, amend, or terminate the trust.
(4) Without regard to the date of the decedent's death, property
passing without full and adequate consideration under a general power of
appointment exercised by the decedent by will. (See section 2041(b) for
definition of general power of appointment.)
(5) In the case of decedents dying after December 31, 1947, property
which represents the surviving spouse's one-half share of community
property held by the decedent and the surviving spouse under the
community property laws of any State, Territory, or possession of the
United States or any foreign country, if at least one-half of the whole
of the community interest in that property was includible in determining
the value of the decedent's gross estate under part III, chapter 11 of
the Internal Revenue Code of 1954 (relating to the estate tax) or
section 811 of the Internal Revenue Code of 1939. It is not necessary
for the application of this subparagraph that an estate tax return be
required to be filed for the estate of the decedent or that an estate
tax be payable.
(6) In the case of decedents dying after December 31, 1950, and
before January 1, 1954, property which represents the survivor's
interest in a joint and survivor's annuity if the value of any part of
that interest was required to be included in determining the value of
the decedent's gross estate under section 811 of the Internal Revenue
Code of 1939. It is necessary only that the value of a part of the
survivor's interest in the annuity be includible in the gross estate
under section 811. It is not necessary for the application of this
subparagraph that an estate tax return be required to be filed for the
estate of the decedent or that an estate tax be payable.
(b) Property acquired from a decedent dying after December 31,
1953--(1) In general. In addition to the property described in paragraph
(a) of this section, and except as otherwise provided in subparagraph
(3) of this paragraph, in the case of a decedent dying after December
31, 1953, property shall also be considered to have been acquired from
the decedent to the extent that both of the following conditions are
met: (i) The property was acquired from the decedent by reason of death,
form of ownership, or other conditions (including property acquired
through the exercise or non-exercise of a power of appointment), and
(ii) the property is includible in the decedent's gross estate under the
provisions of the Internal Revenue Code of 1954, or the Internal Revenue
Code of 1939, because of such acquisition. The basis of such property in
the hands of the person who acquired it from the decedent shall be
determined in accordance with the general rule in Sec. 1.1014-1. See,
however, Sec. 1.1014-6 for special adjustments if such property is
acquired before the death of the decedent. See also subparagraph (3) of
this paragraph for a description of property not within the scope of
this paragraph.
(2) Rules for the application of subparagraph (1) of this paragraph.
Except as provided in subparagraph (3) of this paragraph, this paragraph
generally includes all property acquired from a decedent, which is
includible in the gross estate of the decedent if the decedent died
after December 31, 1953. It is not necessary for the application of this
paragraph that an estate tax return be required to be filed for the
estate of the decedent or that an estate tax be payable. Property
acquired prior to the death of a decedent which is includible in the
decedent's gross estate, such as property transferred by a decedent in
contemplation of death, and property held by a taxpayer and the decedent
as
[[Page 48]]
joint tenants or as tenants by the entireties is within the scope of
this paragraph. Also, this paragraph includes property acquired through
the exercise or nonexercise of a power of appointment where such
property is includible in the decedent's gross estate. It does not
include property not includible in the decedent's gross estate such as
property not situated in the United States acquired from a nonresident
who is not a citizen of the United States.
(3) Exceptions to application of this paragraph. The rules in this
paragraph are not applicable to the following property:
(i) Annuities described in section 72;
(ii) Stock or securities of a foreign personal holding company as
described in section 1014(b)(5) (see paragraph (c)(1) of this section);
(iii) Property described in any paragraph other than paragraph (9)
of section 1014(b). See paragraphs (a) and (c) of this section.
In illustration of subdivision (ii), assume that A acquired by gift
stock of a character described in paragraph (c)(1) of this section from
a donor and upon the death of the donor the stock was includible in the
donor's estate as being a gift in contemplation of death. A's basis in
the stock would not be determined by reference to its fair market value
at the donor's death under the general rule in section 1014(a).
Furthermore, the special basis rules prescribed in paragraph (c)(1) of
this section are not applicable to such property acquired by gift in
contemplation of death. It will be necessary to refer to the rules in
section 1015(a) to determine the basis.
(c) Special basis rules with respect to certain property acquired
from a decedent--(1) Stock or securities of a foreign personal holding
company. The basis of certain stock or securities of a foreign
corporation which was a foreign personal holding company with respect to
its taxable year next preceding the date of the decedent's death is
governed by a special rule. If such stock was acquired from a decedent
dying after August 26, 1937, by bequest or inheritance, or by the
decedent's estate from the decedent, the basis of the property in the
hands of the person who so acquired it (notwithstanding any other
provision of section 1014) shall be the fair market value of such
property at the date of the decedent's death or the adjusted basis of
the stock in the hands of the decedent, whichever is lower.
(2) Spouse's interest in community property of decedent dying after
October 21, 1942, and on or before December 31, 1947. In the case of a
decedent dying after October 21, 1942, and on or before December 31,
1947, a special rule is provided for determining the basis of such part
of any property, representing the surviving spouse's one-half share of
property held by the decedent and the surviving spouse under the
community property laws of any State, Territory, or possession of the
United States or any foreign country, as was included in determining the
value of the decedent's gross estate, if a tax under chapter 3 of the
Internal Revenue Code of 1939 was payable upon the decedent's net
estate. In such case the basis shall be the fair market value of such
part of the property at the date of death (or the optional valuation
elected under section 811(j) of the Internal Revenue Code of 1939) or
the adjusted basis of the property determined without regard to this
subparagraph, whichever is the higher.
Sec. 1.1014-3 Other basis rules.
(a) Fair market value. For purposes of this section and Sec.
1.1014-1, the value of property as of the date of the decedent's death
as appraised for the purpose of the Federal estate tax or the alternate
value as appraised for such purpose, whichever is applicable, shall be
deemed to be its fair market value. If no estate tax return is required
to be filed under section 6018 (or under section 821 or 864 of the
Internal Revenue Code of 1939), the value of the property appraised as
of the date of the decedent's death for the purpose of State inheritance
or transmission taxes shall be deemed to be its fair market value and no
alternate valuation date shall be applicable.
(b) Property acquired from a decedent dying before March 1, 1913. If
the decedent died before March 1, 1913, the fair market value on that
date is taken in lieu of the fair market value on the
[[Page 49]]
date of death, but only to the same extent and for the same purposes as
the fair market value on March 1, 1913, is taken under section 1053.
(c) Reinvestments by a fiduciary. The basis of property acquired
after the death of the decedent by a fiduciary as an investment is the
cost or other basis of such property to the fiduciary, and not the fair
market value of such property at the death of the decedent. For example,
the executor of an estate purchases stock of X company at a price of
$100 per share with the proceeds of the sale of property acquired from a
decedent. At the date of the decedent's death the fair market value of
such stock was $98 per share. The basis of such stock to the executor or
to a legatee, assuming the stock is distributed, is $100 per share.
(d) Reinvestments of property transferred during life. Where
property is transferred by a decedent during life and the property is
sold, exchanged, or otherwise disposed of before the decedent's death by
the person who acquired the property from the decedent, the general rule
stated in paragraph (a) of Sec. 1.1014-1 shall not apply to such
property. However, in such a case, the basis of any property acquired by
such donee in exchange for the original property, or of any property
acquired by the donee through reinvesting the proceeds of the sale of
the original property, shall be the fair market value of the property
thus acquired at the date of the decedent's death (or applicable
alternate valuation date) if the property thus acquired is properly
included in the decedent's gross estate for Federal estate tax purposes.
These rules also apply to property acquired by the donee in any further
exchanges or in further reinvestments. For example, on January 1, 1956,
the decedent made a gift of real property to a trust for the benefit of
his children, reserving to himself the power to revoke the trust at
will. Prior to the decedent's death, the trustee sold the real property
and invested the proceeds in stock of the Y company at $50 per share. At
the time of the decedent's death, the value of such stock was $75 per
share. The corpus of the trust was required to be included in the
decedent's gross estate owing to his reservation of the power of
revocation. The basis of the Y company stock following the decedent's
death is $75 per share. Moreover, if the trustee sold the Y Company
stock before the decedent's death for $65 a share and reinvested the
proceeds in Z company stock which increased in value to $85 per share at
the time of the decedent's death, the basis of the Z company stock
following the decedent's death would be $85 per share.
(e) Alternate valuation dates. Section 1014(a) provides a special
rule applicable in determining the basis of property described in Sec.
1.1014-2 where--
(1) The property is includible in the gross estate of a decedent who
died after October 21, 1942, and
(2) The executor elects for estate tax purposes under section 2032,
or section 811(j) of the Internal Revenue Code of 1939, to value the
decedent's gross estate at the alternate valuation date prescribed in
such sections.
In those cases, the value applicable in determining the basis of the
property is not the value at the date of the decedent's death but (with
certain limitations) the value at the date one year after his death if
not distributed, sold, exchanged, or otherwise disposed of in the
meantime. If such property was distributed, sold, exchanged, or
otherwise disposed of within one year after the date of the decedent's
death by the person who acquired it from the decedent, the value
applicable in determining the basis is its value as of the date of such
distribution, sale, exchange, or other disposition. For illustrations of
the operation of this paragraph, see the estate tax regulations under
section 2032.
Sec. 1.1014-4 Uniformity of basis; adjustment to basis.
(a) In general. (1) The basis of property acquired from a decedent,
as determined under section 1014(a) or section 1022, is uniform in the
hands of every person having possession or enjoyment of the property at
any time under the will or other instrument or under the laws of descent
and distribution. The principle of uniform basis means that the basis of
the property (to which proper adjustments must, of course, be made) will
be the same, or
[[Page 50]]
uniform, whether the property is possessed or enjoyed by the executor or
administrator, the heir, the legatee or devisee, or the trustee or
beneficiary of a trust created by a will or an inter vivos trust. In
determining the amount allowed or allowable to a taxpayer in computing
taxable income as deductions for depreciation or depletion under section
1016(a)(2), the uniform basis of the property shall at all times be used
and adjusted. The sale, exchange, or other disposition by a life tenant
or remainderman of his interest in property will, for purposes of this
section, have no effect upon the uniform basis of the property in the
hands of those who acquired it from the decedent. Thus, gain or loss on
sale of trust assets by the trustee will be determined without regard to
the prior sale of any interest in the property. Moreover, any adjustment
for depreciation shall be made to the uniform basis of the property
without regard to such prior sale, exchange, or other disposition.
(2) Under the law governing wills and the distribution of the
property of decedents, all titles to property acquired by bequest,
devise, or inheritance relate back to the death of the decedent, even
though the interest of the person taking the title was, at the date of
death of the decedent, legal, equitable, vested, contingent, general,
specific, residual, conditional, executory, or otherwise. Accordingly,
there is a common acquisition date for all titles to property acquired
from a decedent within the meaning of section 1014 or section 1022, and,
for this reason, a common or uniform basis for all such interests. For
example, if distribution of personal property left by a decedent is not
made until one year after his death, the basis of such property in the
hands of the legatee is its fair market value at the time when the
decedent died, and not when the legatee actually received the property.
If the bequest is of the residue to trustees in trust, and the executors
do not distribute the residue to such trustees until five years after
the death of the decedent, the basis of each piece of property left by
the decedent and thus received, in the hands of the trustees, is its
fair market value at the time when the decedent dies. If the bequest is
to trustees in trust to pay to A during his lifetime the income of the
property bequeathed, and after his death to distribute such property to
the survivors of a class, and upon A's death the property is distributed
to the taxpayer as the sole survivor, the basis of such property, in the
hands of the taxpayer, is its fair market value at the time when the
decedent died. The purpose of the Code in prescribing a general uniform
basis rule for property acquired from a decedent is, on the one hand, to
tax the gain, in respect of such property, to him who realizes it
(without regard to the circumstances that at the death of the decedent
it may have been quite uncertain whether the taxpayer would take or gain
anything); and, on the other hand, not to recognize as gain any element
of value resulting solely from the circumstance that the possession or
enjoyment of the taxpayer was postponed. Such postponement may be, for
example, until the administration of the decedent's estate is completed,
until the period of the possession or enjoyment of another has
terminated, or until an uncertain event has happened. It is the increase
or decrease in the value of property reflected in a sale or other
disposition which is recognized as the measure of gain or loss.
(3) The principles stated in subparagraphs (1) and (2) of this
paragraph do not apply to property transferred by an executor,
administrator or trustee, to an heir, legatee, devisee or beneficiary
under circumstances such that the transfer constitutes a sale or
exchange. In such a case, gain or loss must be recognized by the
transferor to the extent required by the revenue laws, and the
transferee acquires a basis equal to the fair market value of the
property on the date of the transfer. Thus, for example, if the trustee
of a trust created by will transfers to a beneficiary, in satisfaction
of a specific bequest of $10,000, securities which had a fair market
value of $9,000 on the date of the decedent's death (the applicable
valuation date) and $10,000 on the date of the transfer, the trust
realizes a taxable gain of $1,000 and the basis of the securities in the
hands of the beneficiary would be $10,000. As a further example, if the
executor of an estate
[[Page 51]]
transfers to a trust property worth $200,000, which had a fair market
value of $175,000 on the date of the decedent's death (the applicable
valuation date), in satisfaction of the decedent's bequest in trust for
the benefit of his wife of cash or securities to be selected by the
executor in an amount sufficient to utilize the marital deduction to the
maximum extent authorized by law (after taking into consideration any
other property qualifying for the marital deduction), capital gain in
the amount of $25,000 would be realized by the estate and the basis of
the property in the hands of the trustees would be $200,000. If, on the
other hand, the decedent bequeathed a fraction of his residuary estate
to a trust for the benefit of his wife, which fraction will not change
regardless of any fluctuations in value of property in the decedent's
estate after his death, no gain or loss would be realized by the estate
upon transfer of property to the trust, and the basis of the property in
the hands of the trustee would be its fair market value on the date of
the decedent's death or on the alternate valuation date.
(b) Multiple interests. Where more than one person has an interest
in property acquired from a decedent, the basis of such property shall
be determined and adjusted without regard to the multiple interests. The
basis of computing gain or loss on the sale of any one of such multiple
interests shall be determined under Sec. 1.1014-5. Thus, the deductions
for depreciation and for depletion allowed or allowable, under sections
167 and 611, to a legal life tenant as if the life tenant were the
absolute owner of the property, constitute an adjustment to the basis of
the property not only in the hands of the life tenant, but also in the
hands of the remainderman and every other person to whom the same
uniform basis is applicable. Similarly, the deductions allowed or
allowable under sections 167 and 611, both to the trustee and to the
trust beneficiaries, constitute an adjustment to the basis of the
property not only in the hands of the trustee, but also in the hands of
the trust beneficiaries and every other person to whom the uniform basis
is applicable. See, however, section 262. Similarly, adjustments in
respect of capital expenditures or losses, tax-free distributions, or
other distributions applicable in reduction of basis, or other items for
which the basis is adjustable are made without regard to which one of
the persons to whom the same uniform basis is applicable makes the
capital expenditures or sustains the capital losses, or to whom the tax-
free or other distributions are made, or to whom the deductions are
allowed or allowable. See Sec. 1.1014-6 for adjustments in respect of
property acquired from a decedent prior to his death.
(c) Records. The executor or other legal representative of the
decedent, the fiduciary of a trust under a will, the life tenant and
every other person to whom a uniform basis under this section is
applicable, shall maintain records showing in detail all deductions,
distributions, or other items for which adjustment to basis is required
to be made by sections 1016 and 1017, and shall furnish to the district
director such information with respect to those adjustments as he may
require.
(d) Effective/applicability date. This section applies on and after
January 19, 2017. For rules before January 19, 2017, see Sec. 1.1014-4
as contained in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. , 45 FR 6089, 1980; T.D. 9811, 82 FR 6241, Jan. 19,
2017]
Sec. 1.1014-5 Gain or loss.
(a) Sale or other disposition of a life interest, remainder
interest, or other interest in property acquired from a decedent. (1)
Except as provided in paragraph (b) or (c) of this section with respect
to the sale or other disposition after October 9, 1969, of a term
interest in property, gain or loss from a sale or other disposition of a
life interest, remainder interest, or other interest in property
acquired from a decedent is determined by comparing the amount of the
proceeds with the amount of that part of the adjusted uniform basis
which is assignable to the interest so transferred. The adjusted uniform
basis is the uniform basis of the entire property adjusted to the date
of sale or other disposition of any such interest as required by
sections 1016 and 1017. The uniform basis is the unadjusted basis of
[[Page 52]]
the entire property determined immediately after the decedent's death
under the applicable sections of part II of subchapter O of chapter 1 of
the Code.
(2) Except as provided in paragraph (b) of this section, the proper
measure of gain or loss resulting from a sale or other disposition of an
interest in property acquired from a decedent is so much of the increase
or decrease in the value of the entire property as is reflected in such
sale or other disposition. Hence, in ascertaining the basis of a life
interest, remainder interest, or other interest which has been so
transferred, the uniform basis rule contemplates that proper adjustments
will be made to reflect the change in relative value of the interests on
account of the passage of time.
(3) The factors set forth in the tables contained in Sec. 20.2031-7
or, for certain prior periods, Sec. 20.2031-7A, of part 20 of this
chapter (Estate Tax Regulations) shall be used in the manner provided
therein in determining the basis of the life interest, the remainder
interest, or the term certain interest in the property on the date such
interest is sold. The basis of the life interest, the remainder
interest, or the term certain interest is computed by multiplying the
uniform basis (adjusted to the time of the sale) by the appropriate
factor. In the case of the sale of a life interest or a remainder
interest, the factor used is the factor (adjusted where appropriate)
which appears in the life interest or the remainder interest column of
the table opposite the age (on the date of the sale) of the person at
whose death the life interest will terminate. In the case of the sale of
a term certain interest, the factor used is the factor (adjusted where
appropriate) which appears in the term certain column of the table
opposite the number of years remaining (on the date of sale) before the
term certain interest will terminate.
(b) Sale or other disposition of certain term interests--(1) In
general. In determining gain or loss from the sale or other disposition
after October 9, 1969, of a term interest in property (as defined in
Sec. 1.1001-1(f)(2)) the adjusted basis of which is determined
pursuant, or by reference, to section 1014 (relating to the basis of
property acquired from a decedent), section 1015 (relating to the basis
of property acquired by gift or by a transfer in trust), or section 1022
(relating to the basis of property acquired from certain decedents who
died in 2010), that part of the adjusted uniform basis assignable under
the rules of paragraph (a) of this section to the interest sold or
otherwise disposed of shall be disregarded to the extent and in the
manner provided by section 1001(e) and Sec. 1.1001-1(f).
(2) Effective/applicability date. The provisions of paragraph (b)(1)
of this section relating to section 1022 are effective on and after
January 19, 2017. For rules before January 19, 2017, see Sec. 1.1014-5
as contained in 26 CFR part 1 revised as of April 1, 2016.
(c) Sale or other disposition of a term interest in a tax-exempt
trust--(1) In general. In the case of any sale or other disposition by a
taxable beneficiary of a term interest (as defined in Sec. 1.1001-
1(f)(2)) in a tax-exempt trust (as defined in paragraph (c)(2) of this
section) to which section 1001(e)(3) applies, the taxable beneficiary's
share of adjusted uniform basis, determined as of (and immediately
before) the sale or disposition of that interest, is--
(i) That part of the adjusted uniform basis assignable to the term
interest of the taxable beneficiary under the rules of paragraph (a) of
this section reduced, but not below zero, by
(ii) An amount determined by applying the same actuarial share
applied in paragraph (c)(1)(i) of this section to the sum of--
(A) The trust's undistributed net ordinary income within the meaning
of section 664(b)(1) and Sec. 1.664-1(d)(1)(ii)(a)(1) for the current
and prior taxable years of the trust, if any; and
(B) The trust's undistributed net capital gains within the meaning
of section 664(b)(2) and Sec. 1.664-1(d)(1)(ii)(a)(2) for the current
and prior taxable years of the trust, if any.
(2) Tax-exempt trust defined. For purposes of this section, the term
tax-exempt trust means a charitable remainder annuity trust or a
charitable remainder unitrust as defined in section 664.
(3) Taxable beneficiary defined. For purposes of this section, the
term taxable beneficiary means any person other
[[Page 53]]
than an organization described in section 170(c) or exempt from taxation
under section 501(a).
(4) Effective/applicability date. This paragraph (c) and paragraph
(d) Example 7 and Example 8 of this section apply to sales and other
dispositions of interests in tax-exempt trusts occurring on or after
January 16, 2014, except for sales or dispositions occurring pursuant to
a binding commitment entered into before January 16, 2014.
(d) Illustrations. The application of this section may be
illustrated by the following examples, in which references are made to
the actuarial tables contained in part 20 of this chapter (Estate Tax
Regulations):
Example 1. Securities worth $500,000 at the date of decedent's death
on January 1, 1971, are bequeathed to his wife, W, for life, with
remainder over to his son, S. W is 48 years of age when the life
interest is acquired. The estate does not elect the alternate valuation
allowed by section 2032. By reference to Sec. 20.2031-7A(c), the life
estate factor for age 48, female, is found to be 0.77488 and the
remainder factor for such age is found to be 0.22512. Therefore, the
present value of the portion of the uniform basis assigned to W's life
interest is $387,440 ($500,000 x 0.77488), and the present value of the
portion of the uniform basis assigned to S's remainder interest is
$112,560 ($500,000 x 0.22512). W sells her life interest to her nephew,
A, on February 1, 1971, for $370,000, at which time W is still 48 years
of age. Pursuant to section 1001(e), W realizes no loss; her gain is
$370,000, the amount realized from the sale. A has a basis of $370,000
which he can recover by amortization deductions over W's life
expectancy.
Example 2. The facts are the same as in example (1) except that W
retains the life interest for 12 years, until she is 60 years of age,
and then sells it to A on February 1, 1983, when the fair market value
of the securities has increased to $650,000. By reference to Sec.
20.2031-7A(c), the life estate factor for age 60, female, is found to be
0.63226 and the remainder factor for such age is found to be 0.36774.
Therefore, the present value on February 1, 1983, of the portion of the
uniform basis assigned to W's life interest is $316,130 ($500,000 x
0.63226) and the present value on that date of the portion of the
uniform basis assigned to S's remainder interest is $183,870 ($500,000 x
0.36774). W sells her life interest for $410,969, that being the
commuted value of her remaining life interest in the securities as
appreciated ($650,000 x 0.63226). Pursuant to section 1001(e), W's gain
is $410,969, the amount realized. A has a basis of $410,969 which he can
recover by amortization deductions over W's life expectancy.
Example 3. Unimproved land having a fair market value of $18,800 at
the date of the decedent's death on January 1, 1970, is devised to A, a
male, for life, with remainder over to B, a female. The estate does not
elect the alternate valuation allowed by section 2032. On January 1,
1971, A sells his life interest to S for $12,500. S is not related to A
or B. At the time of the sale, A is 39 years of age. By reference to
Sec. 20.2031-7A(c), the life estate factor for age 39, male, is found
to be 0.79854. Therefore, the present value of the portion of the
uniform basis assigned to A's life interest is $15,012.55 ($18,800 x
0.79854). This portion is disregarded under section 1001(e). A realizes
no loss; his gain is $12,500, the amount realized. S has a basis of
$12,500 which he can recover by amortization deductions over A's life
expectancy.
Example 4. The facts are the same as in example (3) except that on
January 1, 1971, A and B jointly sell the entire property to S for
$25,000 and divide the proceeds equally between them. A and B are not
related, and there is no element of gift or compensation in the
transaction. By reference to Sec. 20.2031-7A(c), the remainder factor
for age 39, male, is found to be 0.20146. Therefore, the present value
of the uniform basis assigned to B's remainder interest is $3,787.45
($18,800 x 0.20146). On the sale A realizes a loss of $2,512.55
($15,012.55 less $12,500), the portion of the uniform basis assigned to
his life interest not being disregarded by reason of section 1001(e)(3).
B's gain on the sale is $8,712.55 ($12,500 less $3,787.45). S has a
basis in the entire property of $25,000, no part of which, however, can
be recovered by amortization deductions over A's life expectancy.
Example 5. (a) Nondepreciable property having a fair market value of
$54,000 at the date of decedent's death on January 1, 1971, is devised
to her husband, H, for life and, after his death, to her daughter, D,
for life, with remainder over to her grandson, G. The estate does not
elect the alternate valuation allowed by section 2032. On January 1,
1973, H sells his life interest to D for $32,000. At the date of the
sale, H is 62 years of age, and D is 45 years of age. By reference to
Sec. 20.2031-7A(c), the life estate factor for age 62, male, is found
to be 0.52321. Therefore, the present value on January 1, 1973, of the
portion of the adjusted uniform basis assigned to H's life interest is
$28,253 ($54,000 x 0.52321). Pursuant to section 1001(e), H realizes no
loss; his gain is $32,000, the amount realized from the sale. D has a
basis of $32,000 which she can recover by amortization deductions over
H's life expectancy.
(b) On January 1, 1976, D sells both life estates to G for $40,000.
During each of the years 1973 through 1975, D is allowed a deduction for
the amortization of H's life interest. At the date of the sale H is 65
years of age, and D is 48 years of age. For purposes of determining gain
or loss on the sale by D, the
[[Page 54]]
portion of the adjusted uniform basis assigned to H's life interest and
the portion assigned to D's life interest are not taken into account
under section 1001(e). However, pursuant to Sec. 1.1001-1(f)(1), D's
cost basis in H's life interest, minus deductions for the amortization
of such interest, is taken into account. On the sale, D realizes gain of
$40,000 minus an amount which is equal to the $32,000 cost basis (for
H's life estate) reduced by amortization deductions. G is entitled to
amortize over H's life expectancy that part of the $40,000 cost which is
attributable to H's life interest. That part of the $40,000 cost which
is attributable to D's life interest is not amortizable by G until H
dies.
Example 6. Securities worth $1,000,000 at the date of decedent's
death on January 1, 1971, are bequeathed to his wife, W, for life, with
remainder over to his son, S. W is 48 years of age when the life
interest is acquired. The estate does not elect the alternate valuation
allowed by section 2032. By reference to Sec. 20.2031-7A(c), the life
estate factor for age 48, female, is found to be 0.77488, and the
remainder factor for such age is found to be 0.22512. Therefore, the
present value of the portion of the uniform basis assigned to W's life
interest is $774,880 ($1,000,000 x 0.77488), and the present value of
the portion of the uniform basis assigned to S's remainder interest is
$225,120 ($1,000,000 x 0.22512). On February 1, 1971, W transfers her
life interest to corporation X in exchange for all of the stock of X
pursuant to a transaction in which no gain or loss is recognized by
reason of section 351. On February 1, 1972, W sells all of her stock in
X to S for $800,000. Pursuant to section 1001(e) and Sec. 1.1001-
1(f)(2), W realizes no loss; her gain is $800,000, the amount realized
from the sale. On February 1, 1972, X sells to N for $900,000 the life
interest transferred to it by W. Pursuant to section 1001(e) and Sec.
1.1001-1(f)(1), X realizes no loss; its gain is $900,000, the amount
realized from the sale. N has a basis of $900,000 which he can recover
by amortization deductions over W's life expectancy.
Example 7. (a) Grantor creates a charitable remainder unitrust
(CRUT) on Date 1 in which Grantor retains a unitrust interest and
irrevocably transfers the remainder interest to Charity. Grantor is an
individual taxpayer subject to income tax. CRUT meets the requirements
of section 664 and is exempt from income tax.
(b) Grantor's basis in the shares of X stock used to fund CRUT is
$10x. On Date 2, CRUT sells the X stock for $100x. The $90x of gain is
exempt from income tax under section 664(c)(1). On Date 3, CRUT uses the
$100x proceeds from its sale of the X stock to purchase Y stock. On Date
4, CRUT sells the Y stock for $110x. The $10x of gain on the sale of the
Y stock is exempt from income tax under section 664(c)(1). On Date 5,
CRUT uses the $110x proceeds from its sale of Y stock to buy Z stock. On
Date 5, CRUT's basis in its assets is $110x and CRUT's total
undistributed net capital gains are $100x.
(c) Later, when the fair market value of CRUT's assets is $150x and
CRUT has no undistributed net ordinary income, Grantor and Charity sell
all of their interests in CRUT to a third person. Grantor receives $100x
for the retained unitrust interest, and Charity receives $50x for its
interest. Because the entire interest in CRUT is transferred to the
third person, section 1001(e)(3) prevents section 1001(e)(1) from
applying to the transaction. Therefore, Grantor's gain on the sale of
the retained unitrust interest in CRUT is determined under section
1001(a), which provides that Grantor's gain on the sale of that interest
is the excess of the amount realized, $100x, over Grantor's adjusted
basis in the interest.
(d) Grantor's adjusted basis in the unitrust interest in CRUT is
that portion of CRUT's adjusted uniform basis that is assignable to
Grantor's interest under Sec. 1.1014-5, which is Grantor's actuarial
share of the adjusted uniform basis. In this case, CRUT's adjusted
uniform basis in its sole asset, the Z stock, is $110x. However,
paragraph (c) of this section applies to the transaction. Therefore,
Grantor's actuarial share of CRUT's adjusted uniform basis (determined
by applying the factors set forth in the tables contained in Sec.
20.2031-7 of this chapter) is reduced by an amount determined by
applying the same factors to the sum of CRUT's $0 of undistributed net
ordinary income and its $100x of undistributed net capital gains.
(e) In determining Charity's share of the adjusted uniform basis,
Charity applies the factors set forth in the tables contained in Sec.
20.2031-7 of this chapter to the full $110x of basis.
Example 8. (a) Grantor creates a charitable remainder annuity trust
(CRAT) on Date 1 in which Grantor retains an annuity interest and
irrevocably transfers the remainder interest to Charity. Grantor is an
individual taxpayer subject to income tax. CRAT meets the requirements
of section 664 and is exempt from income tax.
(b) Grantor funds CRAT with shares of X stock having a basis of
$50x. On Date 2, CRAT sells the X stock for $150x. The $100x of gain is
exempt from income tax under section 664(c)(1). On Date 3, CRAT
distributes $10x to Grantor, and uses the remaining $140x of net
proceeds from its sale of the X stock to purchase Y stock. Grantor
treats the $10x distribution as capital gain, so that CRAT's remaining
undistributed net capital gains amount described in section 664(b)(2)
and Sec. 1.664-1(d) is $90x.
(c) On Date 4, when the fair market value of CRAT's assets, which
consist entirely of the Y stock, is still $140x, Grantor and Charity
sell all of their interests in CRAT to a third person. Grantor receives
$126x for the
[[Page 55]]
retained annuity interest, and Charity receives $14x for its remainder
interest. Because the entire interest in CRAT is transferred to the
third person, section 1001(e)(3) prevents section 1001(e)(1) from
applying to the transaction. Therefore, Grantor's gain on the sale of
the retained annuity interest in CRAT is determined under section
1001(a), which provides that Grantor's gain on the sale of that interest
is the excess of the amount realized, $126x, over Grantor's adjusted
basis in that interest.
(d) Grantor's adjusted basis in the annuity interest in CRAT is that
portion of CRAT's adjusted uniform basis that is assignable to Grantor's
interest under Sec. 1.1014-5, which is Grantor's actuarial share of the
adjusted uniform basis. In this case, CRAT's adjusted uniform basis in
its sole asset, the Y stock, is $140x. However, paragraph (c) of this
section applies to the transaction. Therefore, Grantor's actuarial share
of CRAT's adjusted uniform basis (determined by applying the factors set
forth in the tables contained in Sec. 20.2031-7 of this chapter) is
reduced by an amount determined by applying the same factors to the sum
of CRAT's $0 of undistributed net ordinary income and its $90x of
undistributed net capital gains.
(e) In determining Charity's share of the adjusted uniform basis,
Charity applies the factors set forth in the tables contained in Sec.
20.2031-7 of this chapter to determine its actuarial share of the full
$140x of basis.
[T.D. 7142, 36 FR 18951, Sept. 24, 1971, as amended by T.D. 8540, 59 FR
30102, June 10, 1994; T.D. 9729, 80 FR 48250, Aug. 12, 2015; T.D. 9811,
82 FR 6241, Jan. 19, 2017]
Sec. 1.1014-6 Special rule for adjustments to basis where property
is acquired from a decedent prior to his death.
(a) In general. (1) The basis of property described in section
1014(b)(9) which is acquired from a decedent prior to his death shall be
adjusted for depreciation, obsolescence, amortization, and depletion
allowed the taxpayer on such property for the period prior to the
decedent's death. Thus, in general, the adjusted basis of such property
will be its fair market value at the decedent's death, or the applicable
alternate valuation date, less the amount allowed (determined with
regard to section 1016(a)(2)(B)) to the taxpayer as deductions for
exhaustion, wear and tear, obsolescence, amortization, and depletion for
the period held by the taxpayer prior to the decedent's death. The
deduction allowed for a taxable year in which the decedent dies shall be
an amount properly allocable to that part of the year prior to his
death. For a discussion of the basis adjustment required by section
1014(b)(9) where property is held in trust, see paragraph (c) of this
section.
(2) Where property coming within the purview of subparagraph (1) of
this paragraph was held by the decedent and his surviving spouse as
tenants by the entirety or as joint tenants with right of survivorship,
and joint income tax returns were filed by the decedent and the
surviving spouse in which the deductions referred to in subparagraph (1)
were taken, there shall be allocated to the surviving spouse's interest
in the property that proportion of the deductions allowed for each
period for which the joint returns were filed which her income from the
property bears to the total income from the property. Each spouse's
income from the property shall be determined in accordance with local
law.
(3) The application of this paragraph may be illustrated by the
following examples:
Example 1. The taxpayer acquired income-producing property by gift
on January 1, 1954. The property had a fair market value of $50,000 on
the date of the donor's death, January 1, 1956, and was included in his
gross estate at that amount for estate tax purposes as a transfer in
contemplation of death. Depreciation in the amount of $750 per year was
allowable for each of the taxable years 1954 and 1955. However, the
taxpayer claimed depreciation in the amount of $500 for each of these
years (resulting in a reduction in his taxes) and his income tax returns
were accepted as filed. The adjusted basis of the property as of the
date of the decedent's death is $49,000 ($50,000, the fair market value
at the decedent's death, less $1,000, the total of the amounts actually
allowed as deductions).
Example 2. On July 1, 1952, H purchased for $30,000 income-producing
property which he conveyed to himself and W, his wife, as tenants by the
entirety. Under local law each spouse was entitled to one-half of the
income therefrom. H died on January 1, 1955, at which time the fair
market value of the property was $40,000. The entire value of the
property was included in H's gross estate. H and W filed joint income
tax returns for the years 1952, 1953, and 1954. The total depreciation
allowance for the year 1952 was $500 and for each of the other years
1953 and 1954 was $1,000. One-half of the $2,500 depreciation will be
allocated to W. The adjusted basis of the property in W's hands of
January 1, 1955, was $38,750 ($40,000, value on the date of H's
[[Page 56]]
death, less $1,250, depreciation allocated to W for periods before H's
death). However, if, under local law, all of the income from the
property was allocable to H, no adjustment under this paragraph would be
required and W's basis for the property as of the date of H's death
would be $40,000.
(b) Multiple interests in property described in section 1014(b)(9)
and acquired from a decedent prior to his death. (1) Where more than one
person has an interest in property described in section 1014(b)(9) which
was acquired from a decedent before his death, the basis of such
property and of each of the several interests therein shall, in general,
be determined and adjusted in accordance with the principles contained
in Sec. Sec. 1.1014-4 and 1.1014-5, relating to the uniformity of basis
rule. Application of these principles to the determination of basis
under section 1014(b)(9) is shown in the remaining subparagraphs of this
paragraph in connection with certain commonly encountered situations
involving multiple interests in property acquired from a decedent before
his death.
(2) Where property is acquired from a decedent before his death, and
the entire property is subsequently included in the decedent's gross
estate for estate tax purposes, the uniform basis of the property, as
well as the basis of each of the several interests in the property,
shall be determined by taking into account the basis adjustments
required by section 1014(a) owing to such inclusion of the entire
property in the decedent's gross estate. For example, suppose that the
decedent transfers property in trust, with a life estate to A, and the
remainder to B or his estate. The transferred property consists of 100
shares of the common stock of X Corporation, with a basis of $10,000 at
the time of the transfer. At the time of the decedent's death the value
of the stock is $20,000. The transfer is held to have been made in
contemplation of death and the entire value of the trust is included in
the decedent's gross estate. Under section 1014(a), the uniform basis of
the property in the hands of the trustee, the life tenant, and the
remainderman, is $20,000. If immediately prior to the decedent's death,
A's share of the uniform basis of $10,000 was $6,000, and B's share was
$4,000, then, immediately after the decedent's death, A's share of the
uniform basis of $20,000 is $12,000, and B's share is $8,000.
(3)(i) In cases where, due to the operation of the estate tax, only
a portion of property acquired from a decedent before his death is
included in the decedent's gross estate, as in cases where the decedent
retained a reversion to take effect upon the expiration of a life estate
in another, the uniform basis of the entire property shall be determined
by taking into account any basis adjustments required by section 1014(a)
owing to such inclusion of a portion of the property in the decedent's
gross estate. In such cases the uniform basis is the adjusted basis of
the entire property immediately prior to the decedent's death increased
(or decreased) by an amount which bears the same relation to the total
appreciation (or diminution) in value of the entire property (over the
adjusted basis of the entire property immediately prior to the
decedent's death) as the value of the property included in the
decedent's gross estate bears to the value of the entire property. For
example, assume that the decedent creates a trust to pay the income to A
for life, remainder to B or his estate. The trust instrument further
provides that if the decedent should survive A, the income shall be paid
to the decedent for life. Assume that the decedent predeceases A, so
that, due to the operation of the estate tax, only the present value of
the remainder interest is included in the decedent's gross estate. The
trust consists of 100 shares of the common stock of X Corporation with
an adjusted basis immediately prior to the decedent's death of $10,000
(as determined under section 1015). At the time of the decedent's death,
the value of the stock is $20,000, and the value of the remainder
interest in the hands of B is $8,000. The uniform basis of the entire
property following the decedent's death is $14,000, computed as follows:
Uniform basis prior to decedent's death....................... $10,000
plus
Increase in uniform basis (determined by the following 4,000
formula).....................................................
[Increase in uniform basis (to be determined)/$10,000 (total
appreciation)]=
[$8,000 (value of property included in gross estate)/$20,000
(value of entire property)]
---------
Uniform basis under section 1014(a)........................... 14,000
[[Page 57]]
(ii) In cases of the type described in subdivision (i) of this
subparagraph, the basis of any interest which is included in the
decedent's gross estate may be ascertained by adding to (or subtracting
from) the basis of such interest determined immediately prior to the
decedent's death the increase (or decrease) in the uniform basis of the
property attributable to the inclusion of the interest in the decedent's
gross estate. Where the interest is sold or otherwise disposed of at any
time after the decedent's death, proper adjustment must be made in order
to reflect the change in value of the interest on account of the passage
of time, as provided in Sec. 1.1014-5. For an illustration of the
operation of this subdivision, see step 6 of the example in Sec.
1.1014-7.
(iii) In cases of the type described in subdivision (i) of this
subparagraph (cases where, due to the operation of the estate tax, only
a portion of the property is included in the decedent's gross estate),
the basis for computing the depreciation, amortization, or depletion
allowance shall be the uniform basis of the property determined under
section 1014(a). However, the manner of taking into account such
allowance computed with respect to such uniform basis is subject to the
following limitations:
(a) In cases where the value of the life interest is not included in
the decedent's gross estate, the amount of such allowance to the life
tenant under section 167(h) (or section 611(b)) shall not exceed (or be
less than) the amount which would have been allowable to the life tenant
if no portion of the basis of the property was determined under section
1014(a). Proper adjustment shall be made for the amount allowable to the
life tenant, as required by section 1016. Thus, an appropriate
adjustment shall be made to the uniform basis of the property in the
hands of the trustee, to the basis of the life interest in the hands of
the life tenant, and to the basis of the remainder in the hands of the
remainderman.
(b) Any remaining allowance (that is, the increase in the amount of
depreciation, amortization, or depletion allowable resulting from any
increase in the uniform basis of the property under section 1014(a))
shall not be allowed to the life tenant. The remaining allowance shall,
instead, be allowed to the trustee to the extent that the trustee both
(1) is required or permitted, by the governing trust instrument (or
under local law), to maintain a reserve for depreciation, amortization,
or depletion, and (2) actually maintains such a reserve. If, in
accordance with the preceding sentence, the trustee does maintain such a
reserve, the remaining allowance shall be taken into account, under
section 1016, in adjusting the uniform basis of the property in the
hands of the trustee and in adjusting the basis of the remainder
interest in the hands of the remainderman, but shall not be taken into
account, under section 1016, in determining the basis of the life
interest in the hands of the life tenant. For an example of the
operation of this subdivision, see paragraph (b) of Sec. 1.1014-7.
(4) In cases where the basis of any interest in property is not
determined under section 1014(a), as where such interest (i) is not
included in the decedent's gross estate, or (ii) is sold, exchanged or
otherwise disposed of before the decedent's death, the basis of such
interest shall be determined under other applicable provisions of the
Code. To illustrate, in the example shown in subparagraph (3)(i) of this
paragraph the basis of the life estate in the hands of A shall be
determined under section 1015, relating to the basis of property
acquired by gift. If, on the other hand, A had sold his life interest
prior to the decedent's death, the basis of the life estate in the hands
of A's transferee would be determined under section 1012.
(c) Adjustments for deductions allowed prior to the decedent's
death. (1) As stated in paragraph (a) of this section, section
1014(b)(9) requires a reduction in the uniform basis of property
acquired from a decedent before his death for certain deductions allowed
in respect of such property during the decedent's lifetime. In general,
the amount of the reduction in basis required by section 1014(b)(9)
shall be the aggregate of the deductions allowed in respect of the
property, but shall not include deductions allowed in respect of the
property to the decedent himself. In cases where, owing to the operation
of the
[[Page 58]]
estate tax, only a part of the value of the entire property is included
in the decedent's gross estate, the amount of the reduction required by
section 1014(b)(9) shall be an amount which bears the same relation to
the total of all deductions (described in paragraph (a) of this section)
allowed in respect of the property as the value of the property included
in the decedent's gross estate bears to the value of the entire
property.
(2) The application of this paragraph may be illustrated by the
following examples:
Example 1. The decedent creates a trust to pay the income to A for
life, remainder to B or his estate. The property transferred in trust
consists of an apartment building with a basis of $50,000 at the time of
the transfer. The decedent dies 2 years after the transfer is made and
the gift is held to have been made in contemplation of death.
Depreciation on the property was allowed in the amount of $1,000
annually. At the time of the decedent's death the value of the property
is $58,000. The uniform basis of the property in the hands of the
trustee, the life tenant, and the remainderman, immediately after the
decedent's death is $56,000 ($58,000, fair market value of the property
immediately after the decedent's death, reduced by $2,000, deductions
for depreciation allowed prior to the decedent's death).
Example 2. The decedent creates a trust to pay the income to A for
life, remainder to B or his estate. The trust instrument provides that
if the decedent should survive A, the income shall be paid to the
decedent for life. The decedent predeceases A and the present value of
the remainder interest is included in the decedent's gross estate for
estate tax purposes. The property transferred consists of an apartment
building with a basis of $110,000 at the time of the transfer. Following
the creation of the trust and during the balance of the decedent's life,
deductions for depreciation were allowed on the property in the amount
of $10,000. At the time of decedent's death the value of the entire
property is $150,000, and the value of the remainder interest is
$100,000. Accordingly, the uniform basis of the property in the hands of
the trustee, the life tenant, and the remainderman, as adjusted under
section 1014(b)(9), is $126,666, computed as follows:
Uniform basis prior to decedent's death...................... $100,000
plus
Increase in uniform basis--before reduction (determined by 33,333
the following formula)......................................
[Increase in uniform basis (to be determined)/$50,000 (total
appreciation of property since time of transfer)]=
[$100,000 (value of property included in gross estate)/
$150,000 (value of entire property)]
----------
less 133,333
Deductions allowed prior to decedent's death--taken into 6,667
account under section 1014(b)(9) (determined by the
following formula)..........................................
[Prior deductions taken into account (to be determined)
$10,000 (total deductions allowed prior to decedent's
death)]=
[$100,000 (value of property included in gross estate)
$150,000 (value of entire property)]
----------
Uniform basis under section 1014............................. 126,666
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6712, 29 FR
3656, Mar. 24, 1964; T.D. 7142, 36 FR 18952, Sept. 24, 1971]
Sec. 1.1014-7 Example applying rules of Sec. Sec. 1.1014-4 through
1.1014-6 to case involving multiple interests.
(a) On January 1, 1950, the decedent creates a trust to pay the
income to A for life, remainder to B or his estate. The trust instrument
provides that if the decedent should survive A, the income shall be paid
to the decedent for life. The decedent, who died on January 1, 1955,
predeceases A, so that, due to the operation of the estate tax, only the
present value of the remainder interest is included in the decedent's
gross estate. The trust consists of an apartment building with a basis
of $30,000 at the time of transfer. Under the trust instrument the
trustee is required to maintain a reserve for depreciation. During the
decedent's lifetime depreciation is allowed in the amount of $800
annually. At the time of the decedent's death the value of the apartment
building is $45,000. A, the life tenant, is 43 years of age at the time
of the decedent's death. Immediately after the decedent's death, the
uniform basis of the entire property under section 1014(a) is $32,027;
A's basis for the life interest is $15,553; and B's basis for the
remainder interest is $16,474, computed as follows:
Step 1. Uniform basis (adjusted) immediately prior to
decedent's death:
Basis at time of transfer................................... $30,000
less
Depreciation allowed under section 1016 before decedent's 4,000
death ($800 x 5)...........................................
-----------
26,000
Step 2. Value of property included in decedent's gross estate:
0.40180 (remainder factor, age 43) x $45,000 (value of $18,081
entire property)...........................................
[[Page 59]]
Step 3. Uniform basis of property under section 1014(a),
before reduction required by section 1014(b)(9):
Uniform basis (adjusted) prior to decedent's death.......... 26,000
Increase in uniform basis (determined by the following 7,634
formula)...................................................
Increase in uniform basis (to be determined) $19,000 (total
appreciation, $45,000-$26,000)]=
$18,081 (value of property included in gross estate) $45,000
(value of entire property)]
-----------
33,634
Step 4. Uniform basis reduced as required by section
1014(b)(9) for deductions allowed prior to death:
Uniform basis before reduction.............................. $33,634
less
Deductions allowed prior to decedent's death--taken into 1,607
account under section 1014(b)(9) (determined by the
following formula).........................................
Prior deductions taken into account (to be determined) $4,000
(total deductions allowed prior to decedent's death)]=
$18,081 (value of property included in gross estate) $45,000
(value of entire property)
-----------
32,027
Step 5. A's basis for the life interest at the time of the 15,553
decedent's death, determined under section 1015: 0.59820
(life factor, age 43) x $26,000
Step 6. B's basis for the remainder interest, determined under
section 1014(a): Basis prior to the decedent's death:
0.40180 (remainder factor, age 43) x $26,000................ 10,447
plus
Increase in uniform basis owing to decedent's death:
Increase in uniform basis....................... $7,634
plus
Reduction required by section 1014(b)(9)........ 1,607
----------
........ 6,027
---------
........ 16,474
(b) Assume the same facts as in paragraph (a) of this section.
Assume further, that following the decedent's death depreciation is
allowed in the amount of $1,000 annually. As of January 1, 1964, when
A's age is 52, the adjusted uniform basis of the entire property is
$23,027; A's basis for the life interest is $9,323; and B's basis for
the remainder interest is $13,704, computed as follows:
Step 7. Uniform basis (adjusted) as of January 1, 1964:
Uniform basis determined under section 1014(a), reduced as $32,027
required by section 1014(b)(9).............................
less
Depreciation allowed since decedent's death ($1,000 x 9).... 9,000
---------
23,027
Step 8. Allocable share of adjustment for depreciation
allowable in the nine years since the decedent's death:
A's interest
0.49587 (life factor, age 52) x $7,200 ($800, depreciation 3,570
attributable to uniform basis before increase under section
1014(a), x 9)..............................................
B's interest
0.50413 (remainder factor, age 52) x $7,200 ($800, 3,630
depreciation attributable to uniform basis before increase
under section 1014(a), x 9)................................
plus
$200 (annual depreciation attributable to increase in 1,800
uniform basis under section 1014(a)) x 9...................
---------
5,430
Step 9. Tentative bases of A's and B's interests as of January
1, 1964 (before adjustment for depreciation).
A's interest
0.49587 (life factor, age 52) x $26,000 (adjusted uniform 12,893
basis immediately before decedent's death).................
B's interest
0.50413 (remainder factor, age 52) x $26,000 (adjusted 13,107
uniform basis immediately before decedent's death).........
plus
Increase in uniform basis owing to inclusion of remainder in 6,027
decedent's gross estate....................................
---------
19,134
Step 10. Bases of A's and B's interests as of January 1, 1964.
A
Tentative basis (Step 9).................................... 12,893
less
Allocable depreciation (Step 8)............................. 3,570
---------
9,323
B
Tentative basis (Step 9).................................... 19,134
less
Allocable depreciation (Step 8)............................. 5,430
---------
13,704
Sec. 1.1014-8 Bequest, devise, or inheritance of a remainder interest.
(a)(1) Where property is transferred for life, with remainder in
fee, and the remainderman dies before the life tenant, no adjustment is
made to the uniform basis of the property on the death of the
remainderman (see paragraph (a) of Sec. 1.1014-4). However, the basis
of the remainderman's heir, legatee, or devisee for the remainder
interest is determined by adding to (or subtracting from) the part of
the adjusted uniform basis assigned to the remainder interest
(determined in accordance with the principles set forth in Sec. Sec.
1.1014-4 through 1.1014-6) the difference between--
(i) The value of the remainder interest included in the
remainderman's estate, and
[[Page 60]]
(ii) The basis of the remainder interest immediately prior to the
remainderman's death.
(2) The basis of any property distributed to the heir, legatee, or
devisee upon termination of a trust (or legal life estate) or at any
other time (unless included in the gross income of the legatee or
devisee) shall be determined by adding to (or subtracting from) the
adjusted uniform basis of the property thus distributed the difference
between--
(i) The value of the remainder interest in the property included in
the remainderman's estate, and
(ii) The basis of the remainder interest in the property immediately
prior to the remainderman's death.
(b) The provisions of paragraph (a) of this section are illustrated
by the following examples:
Example 1. Assume that, under the will of a decedent, property
consisting of common stock with a value of $1,000 at the time of the
decedent's death is transferred in trust, to pay the income to A for
life, remainder to B or to B's estate. B predeceases A and bequeaths the
remainder interest to C. Assume that B dies on January 1, 1956, and that
the value of the stock originally transferred is $1,600 at B's death.
A's age at that time is 37. The value of the remainder interest included
in B's estate is $547 (0.34185, remainder factor age 37, x $1,600), and
hence $547 is C's basis for the remainder interest immediately after B's
death. Assume that C sells the remainder interest on January 1, 1961,
when A's age is 42. C's basis for the remainder interest at the time of
such sale is $596, computed as follows:
Basis of remainder interest computed with respect to uniform $391
basis of entire property (0.39131, remainder factor age 42, x
$1,000, uniform basis of entire property)....................
plus
Value of remainder interest included in B's estate.. $547
less
Basis of remainder interest immediately prior to B's 342
death (0.34185, remainder factor age 37, x $1,000).
___ 205
---------
Basis of C's remainder interest at the time of sale........... 596
Example 2. Assume the same facts as in example (1), except that C
does not sell the remainder interest. Upon A's death terminating the
trust, C's basis for the stock distributed to him is computed as
follows:
Uniform basis of the property, adjusted to date of termination $1,000
of the trust.................................................
plus
Value of remainder interests in the property at the $547
time of B's death..................................
less
B's share of uniform basis of the property at the 342
time of his death..................................
___ 205
---------
C's basis for the stock distributed to him upon the 1,205
termination of the trust.....................................
Example 3. Assume the same facts as in example (2), except that the
property transferred is depreciable. Assume further that $100 of
depreciation was allowed prior to B's death and that $50 of depreciation
is allowed between the time of B's death and the termination of the
trust. Upon A's death terminating the trust, C's basis for the property
distributed to him is computed as follows:
Uniform basis of the property, adjusted to date of
termination of the trust:
Uniform basis immediately after decedent's death.. $1,000
Depreciation allowed following decedent's death... 150
----------
........ $350
plus
Value of remainder interest in the property at the 547
time of B's death..................................
less
B's share of uniform basis of the property at the 308
time of his death (0.34185 x $900, uniform basis at
B's death).........................................
----------
___ 239
---------
C's basis for the property distributed to him upon the 1,089
termination of the trust.....................................
(c) The rules stated in paragraph (a) of this section do not apply
where the basis of the remainder interest in the hands of the
remainderman's transferee is determined by reference to its cost to such
transferee. See also paragraph (a) of Sec. 1.1014-4. Thus, if, in
example (1) of paragraph (b) of this section B sold his remainder
interest to C for $547 in cash, C's basis for the stock distributed to
him upon the death of A terminating the trust is $547.
Sec. 1.1014-9 Special rule with respect to DISC stock.
(a) In general. If property consisting of stock of a DISC or former
DISC (as defined in section 992(a) (1) or (3) as the case may be) is
considered to have been acquired from a decedent (within the meaning of
paragraph (a) or (b) of Sec. 1.1014-2), the uniform basis of such stock
under section 1014, as determined pursuant to Sec. Sec. 1.1014-1
through 1.1014-8 shall be reduced as provided in this section. Such
uniform basis shall be reduced by the amount (hereinafter referred to in
this section as the amount
[[Page 61]]
of reduction), if any, which the decedent would have included in his
gross income under section 995(c) as a dividend if the decedent had
lived and sold such stock at its fair market value on the estate tax
valuation date. If the alternate valuation date for Federal estate tax
purposes is elected under section 2032, in computing the gain which the
decedent would have had if he had lived and sold the stock on the
alternate valuation date, the decedent's basis shall be determined with
reduction for any distributions with respect to the stock which may have
been made, after the date of the decedent's death and on or before the
alternate valuation date, from the DISC's previously taxed income (as
defined in section 996(f)(2)). For this purpose, the last sentence of
section 996(e)(2) (relating to reductions of basis of DISC stock) shall
not apply. For purposes of this section, if the corporation is not a
DISC or former DISC at the date of the decedent's death but is a DISC
for a taxable year which begins after such date and on or before the
alternate valuation date, the corporation will be considered to be a
DISC or former DISC only if the alternate valuation date is elected. The
provisions of this paragraph apply with respect to stock of a DISC or
former DISC which is included in the gross estate of the decedent,
including but not limited to property which--
(1) Is acquired from the decedent before his death, and the entire
property is subsequently included in the decedent's gross estate for
estate tax purposes, or
(2) Is acquired property described in paragraph (d) of Sec. 1.1014-
3.
(b) Portion of property acquired from decedent before his death
included in decedent's gross estate--(1) In general. In cases where, due
to the operation of the estate tax, only a portion of property which
consists of stock of a DISC or former DISC and which is acquired from a
decedent before his death is included in the decedent's gross estate,
the uniform basis of such stock under section 1014, as determined
pursuant to Sec. Sec. 1.1014-1 through 1.1014-8, shall be reduced by an
amount which bears the same ratio to the amount of reduction which would
have been determined under paragraph (a) of this section if the entire
property consisting of such stock were included in the decedent's gross
estate as the value of such property included in the decedent's gross
estate bears to the value of the entire property.
(2) Example. The provisions of this paragraph may be illustrated by
the following example:
Example: The decedent creates a trust during his lifetime to pay the
income to A for life, remainder to B or his estate. The trust instrument
further provides that if the decedent shall survive A, the income shall
be paid to the decedent for life. The decedent predeceases A, so that,
due to the operation of the estate tax, only the present value of the
remainder interest is included in the decedent's gross estate. The trust
consists of 100 shares of the stock of X corporation (which is a DISC at
the time the shares are transferred to the trust and at the time of the
decedent's death) with an adjusted basis immediately prior to the
decedent's death of $10,000 (as determined under section 1015). At the
time of the decedent's death the value of the stock is $20,000, and the
value of the remainder interest in the hands of B is $8,000. Applying
the principles of paragraph (b)(3)(i) of Sec. 1.1014-6, the uniform
basis of the entire property following the decedent's death, prior to
reduction pursuant to this paragraph, is $14,000. The amount of
reduction which would have been determined under paragraph (a) of this
section if the entire property consisting of such stock of X corporation
were included in the decedent's gross estate is $5,000. The uniform
basis of the entire property following the decedent's death, as reduced
pursuant to this paragraph, is $12,000, computed as follows:
Uniform basis under section 1014(a), prior to $14,000
reduction pursuant to this paragraph..............
Less decrease in uniform basis (determined by the 2,000
following formula)................................
--------------------
[Reduction in uniform basis (to be determined)/
$5,000 (amount of reduction if paragraph (a)
applied)] =
[$8,000 (value of property included in gross estate/
$20,000 (value of entire property)]
Uniform basis under section 1014(a) reduced 12,000
pursuant to this paragraph........................
(c) Estate tax valuation date. For purposes of section 1014(d) and
this section, the estate tax valuation date is the date of the
decedent's death or, in the case of an election under section 2032, the
applicable valuation date prescribed by that section.
(d) Examples. The provisions of this section may be illustrated by
the following examples:
[[Page 62]]
Example 1. At the date of A's death, his DISC stock has a fair
market value of $100. The estate does not elect the alternate valuation
allowed by section 2032, and A's basis in such stock is $60 at the date
of his death. The person who acquires such stock from the decedent will
take as a basis for such stock its fair market value at A's death
($100), reduced by the amount which would have been included in A's
gross income under section 995(c) as a dividend if A had sold stock on
the date he died. Thus, if the amount that would have been treated as a
dividend under section 995(c) were $30, such person will take a basis of
$70 for such stock ($100, reduced by $30). If such person were
immediately to sell the DISC stock so received for $100, $30 of the
proceeds from the sale would be treated as a dividend by such person
under section 995(c).
Example 2. Assume the same facts as in example (1) except that the
estate elects the alternate valuation allowed by section 2032, the DISC
stock has a fair market value of $140 on the alternate valuation date,
the amount that would have been treated as a dividend under section
995(c) in the event of a sale on such date is $50 and the DISC has $20
of previously taxed income which accrued after the date of the
decedent's death and before the alternate valuation date. The basis of
the person who acquires such stock will be $90 determined as follows:
(1) Fair market value of DISC stock at alternate $140
valuation date.......................................
(2) Less: Amount which would have been treated as a 50
dividend under section 995(c)........................
-----------------
(3) Basis of person who acquires DISC stock........... 90
If a distribution of $20 attributable to such previously taxed
income had been made by the DISC on or before the alternate valuation
date (with the DISC stock having a fair market value of $120 after such
distribution), the basis of the person who acquires such stock will be
$70 determined as follows:
(1) Fair market value of DISC stock at alternate $120
valuation date.......................................
(2) Less: Amount which would have been treated as a 50
dividend under section 995(c)........................
-----------------
(3) Basis of person who acquires DISC stock........... 70
[T.D. 7283, 38 FR 20825, Aug. 3, 1973]
Sec. 1.1015-1 Basis of property acquired by gift after
December 31, 1920.
(a) General rule. (1) In the case of property acquired by gift after
December 31, 1920 (whether by a transfer in trust or otherwise), the
basis of the property for the purpose of determining gain is the same as
it would be in the hands of the donor or the last preceding owner by
whom it was not acquired by gift. The same rule applies in determining
loss unless the basis (adjusted for the period prior to the date of gift
in accordance with sections 1016 and 1017) is greater than the fair
market value of the property at the time of the gift. In such case, the
basis for determining loss is the fair market value at the time of the
gift.
(2) The provisions of subparagraph (1) of this paragraph may be
illustrated by the following example.
Example: A acquires by gift income-producing property which has an
adjusted basis of $100,000 at the date of gift. The fair market value of
the property at the date of gift is $90,000. A later sells the property
for $95,000. In such case there is neither gain nor loss. The basis for
determining loss is $90,000; therefore, there is no loss. Furthermore,
there is no gain, since the basis for determining gain is $100,000.
(3) If the facts necessary to determine the basis of property in the
hands of the donor or the last preceding owner by whom it was not
acquired by gift are unknown to the donee, the district director shall,
if possible, obtain such facts from such donor or last preceding owner,
or any other person cognizant thereof. If the district director finds it
impossible to obtain such facts, the basis in the hands of such donor or
last preceding owner shall be the fair market value of such property as
found by the district director as of the date or approximate date at
which, according to the best information the district director is able
to obtain, such property was acquired by such donor or last preceding
owner. See paragraph (e) of this section for rules relating to fair
market value.
(b) Uniform basis; proportionate parts of. Property acquired by gift
has a single or uniform basis although more than one person may acquire
an interest in such property. The uniform basis of the property remains
fixed subject to proper adjustment for items under sections 1016 and
1017. However, the value of the proportionate parts of the uniform basis
represented, for instance, by the respective interests of the life
tenant and remainderman are adjustable to reflect the change in the
relative values of such interest on account of the lapse of time. The
portion
[[Page 63]]
of the basis attributable to an interest at the time of its sale or
other disposition shall be determined under the rules provided in Sec.
1.1014-5. In determining gain or loss from the sale or other disposition
after October 9, 1969, of a term interest in property (as defined in
Sec. 1.1001-1(f)(2)) the adjusted basis of which is determined
pursuant, or by reference, to section 1015, that part of the adjusted
uniform basis assignable under the rules of Sec. 1.1014-5(a) to the
interest sold or otherwise disposed of shall be disregarded to the
extent and in the manner provided by section 1001(e) and Sec. 1.1001-
1(f).
(c) Time of acquisition. The date that the donee acquires an
interest in property by gift is when the donor relinquishes dominion
over the property and not necessarily when title to the property is
acquired by the donee. Thus, the date that the donee acquires an
interest in property by gift where he is a successor in interest, such
as in the case of a remainderman of a life estate or a beneficiary of
the distribution of the corpus of a trust, is the date such interests
are created by the donor and not the date the property is actually
acquired.
(d) Property acquired by gift from a decedent dying after December
31, 1953. If an interest in property was acquired by the taxpayer by
gift from a donor dying after December 31, 1953, under conditions which
required the inclusion of the property in the donor's gross estate for
estate tax purposes, and the property had not been sold, exchanged, or
otherwise disposed of by the taxpayer before the donor's death, see the
rules prescribed in section 1014 and the regulations thereunder.
(e) Fair market value. For the purposes of this section, the value
of property as appraised for the purpose of the Federal gift tax, or, if
the gift is not subject to such tax, its value as appraised for the
purpose of a State gift tax, shall be deemed to be the fair market value
of the property at the time of the gift.
(f) Reinvestments by fiduciary. If the property is an investment by
the fiduciary under the terms of the gift (as, for example, in the case
of a sale by the fiduciary of property transferred under the terms of
the gift, and the reinvestment of the proceeds), the cost or other basis
to the fiduciary is taken in lieu of the basis specified in paragraph
(a) of this section.
(g) Records. To insure a fair and adequate determination of the
proper basis under section 1015, persons making or receiving gifts of
property should preserve and keep accessible a record of the facts
necessary to determine the cost of the property and, if pertinent, its
fair market value as of March 1, 1913, or its fair market value as of
the date of the gift.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6693, 28 FR
12818, Dec. 3, 1963; T.D. 7142, 36 FR 18952, Sept. 24, 1971]
Sec. 1.1015-2 Transfer of property in trust after December 31, 1920.
(a) General rule. (1) In the case of property acquired after
December 31, 1920, by transfer in trust (other than by a transfer in
trust by a gift, bequest, or devise) the basis of property so acquired
is the same as it would be in the hands of the grantor increased in the
amount of gain or decreased in the amount of loss recognized to the
grantor upon such transfer under the law applicable to the year in which
the transfer was made. If the taxpayer acquired the property by a
transfer in trust, this basis applies whether the property be in the
hands of the trustee, or the beneficiary, and whether acquired prior to
the termination of the trust and distribution of the property, or
thereafter.
(2) The principles stated in paragraph (b) of Sec. 1.1015-1
concerning the uniform basis are applicable in determining the basis of
property where more than one person acquires an interest in property by
transfer in trust after December 31, 1920.
(b) Reinvestment by fiduciary. If the property is an investment made
by the fiduciary (as, for example, in the case of a sale by the
fiduciary of property transferred by the grantor, and the reinvestment
of the proceeds), the cost or other basis to the fiduciary is taken in
lieu of the basis specified in paragraph (a) of this section.
[[Page 64]]
Sec. 1.1015-3 Gift or transfer in trust before January 1, 1921.
(a) In the case of property acquired by gift or transfer in trust
before January 1, 1921, the basis of such property is the fair market
value thereof at the time of the gift or at the time of the transfer in
trust.
(b) The principles stated in paragraph (b) of Sec. 1.1015-1
concerning the uniform basis are applicable in determining the basis of
property where more than one person acquires an interest in property by
gift or transfer in trust before January 1, 1921. In addition, if an
interest in such property was acquired from a decedent and the property
had not been sold, exchanged, or otherwise disposed of before the death
of the donor, the rules prescribed in section 1014 and the regulations
thereunder are applicable in determining the basis of such property in
the hands of the taxpayer.
Sec. 1.1015-4 Transfers in part a gift and in part a sale.
(a) General rule. Where a transfer of property is in part a sale and
in part a gift, the unadjusted basis of the property in the hands of the
transferee is the sum of--
(1) Whichever of the following is the greater:
(i) The amount paid by the transferee for the property, or
(ii) The transferor's adjusted basis for the property at the time of
the transfer, and
(2) The amount of increase, if any, in basis authorized by section
1015(d) for gift tax paid (see Sec. 1.1015-5).
For determining loss, the unadjusted basis of the property in the hands
of the transferee shall not be greater than the fair market value of the
property at the time of such transfer. For determination of gain or loss
of the transferor, see Sec. 1.1001-1(e) and Sec. 1.1011-2. For special
rule where there has been a charitable contribution of less than a
taxpayer's entire interest in property, see section 170(e)(2) and Sec.
1.170A-4(c).
(b) Examples. The rule of paragraph (a) of this section is
illustrated by the following examples:
Example 1. If A transfers property to his son for $30,000, and such
property at the time of the transfer has an adjusted basis of $30,000 in
A's hands (and a fair market value of $60,000), the unadjusted basis of
the property in the hands of the son is $30,000.
Example 2. If A transfers property to his son for $60,000, and such
property at the time of transfer has an adjusted basis of $30,000 in A's
hands (and a fair market value of $90,000), the unadjusted basis of such
property in the hands of the son is $60,000.
Example 3. If A transfers property to his son for $30,000, and such
property at the time of transfer has an adjusted basis in A's hands of
$60,000 (and a fair market value of $90,000), the unadjusted basis of
such property in the hands of the son is $60,000.
Example 4. If A transfers property to his son for $30,000 and such
property at the time of transfer has an adjusted basis of $90,000 in A's
hands (and a fair market value of $60,000), the unadjusted basis of the
property in the hands of the son ins $90,000. However, since the
adjusted basis of the property in A's hands at the time of the transfer
was greater than the fair market value at that time, for the purpose of
determining any loss on a later sale or other disposition of the
property by the son its unadjusted basis in his hands is $60,000.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6693, 28 FR
12818, Dec. 3, 1963; T.D. 7207, 37 FR 20799, Oct. 5, 1972]
Sec. 1.1015-5 Increased basis for gift tax paid.
(a) General rule in the case of gifts made on or before December 31,
1976. (1)(i) Subject to the conditions and limitations provided in
section 1015(d), as added by the Technical Amendments Act of 1958, the
basis (as determined under section 1015(a) and paragraph (a) of Sec.
1.1015-1) of property acquired by gift is increased by the amount of
gift tax paid with respect to the gift of such property. Under section
1015(d)(1)(A), such increase in basis applies to property acquired by
gift on or after September 2, 1958 (the date of enactment of the
Technical Amendments Act of 1958). Under section 1015(d)(1)(B), such
increase in basis applies to property acquired by gift before September
2, 1958, and not sold, exchanged, or otherwise disposed of before such
date. If section 1015(d)(1)(A) applies, the basis of the property is
increased as of the date of the gift regardless of the date of payment
of the gift tax. For example, if the property was acquired by gift on
September 8, 1958, and sold by the donee on October 15, 1958, the basis
of the property would be increased (subject to the limitation of section
1015(d))
[[Page 65]]
as of September 8, 1958 (the date of the gift), by the amount of gift
tax applicable to such gift even though such tax was not paid until
March 1, 1959. If section 1015(d)(1)(B) applies, any increase in the
basis of the property due to gift tax paid (regardless of date of
payment) with respect to the gift is made as of September 2, 1958. Any
increase in basis under section 1015(d) can be no greater than the
amount by which the fair market value of the property at the time of the
gift exceeds the basis of such property in the hands of the donor at the
time of the gift. See paragraph (b) of this section for rules for
determining the amount of gift tax paid in respect of property
transferred by gift.
(ii) With respect to property acquired by gift before September 2,
1958, the provisions of section 1015(d) and this section do not apply
if, before such date, the donee has sold, exchanged, or otherwise
disposed of such property. The phrase sold, exchanged, or otherwise
disposed of includes the surrender of a stock certificate for corporate
assets in complete or partial liquidation of a corporation pursuant to
section 331. It also includes the exchange of property for property of a
like kind such as the exchange of one apartment house for another. The
phrase does not, however, extend to transactions which are mere changes
in form. Thus, it does not include a transfer of assets to a corporation
in exchange for its stock in a transaction with respect to which no gain
or loss would be recognizable for income tax purposes under section 351.
Nor does it include an exchange of stock or securities in a corporation
for stock or securities in the same corporation or another corporation
in a transaction such as a merger, recapitalization, reorganization, or
other transaction described in section 368(a) or 355, with respect to
which no gain or loss is recognizable for income tax purposes under
section 354 or 355. If a binding contract for the sale, exchange, or
other disposition of property is entered into, the property is
considered as sold, exchanged, or otherwise disposed of on the effective
date of the contract, unless the contract is not subsequently carried
out substantially in accordance with its terms. The effective date of a
contract is normally the date it is entered into (and not the date it is
consummated, or the date legal title to the property passes) unless the
contract specifies a different effective date. For purposes of this
subdivision, in determining whether a transaction comes within the
phrase sold, exchanged, or otherwise disposed of, if a transaction would
be treated as a mere change in the form of the property if it occurred
in a taxable year subject to the Internal Revenue Code of 1954, it will
be so treated if the transaction occurred in a taxable year subject to
the Internal Revenue Code of 1939 or prior revenue law.
(2) Application of the provisions of subparagraph (1) of this
paragraph may be illustrated by the following examples:
Example 1. In 1938, A purchased a business building at a cost of
$120,000. On September 2, 1958, at which time the property had an
adjusted basis in A's hands of $60,000, he gave the property to his
nephew, B. At the time of the gift to B, the property had a fair market
value of $65,000 with respect to which A paid a gift tax in the amount
of $7,545. The basis of the property in B's hands at the time of the
gift, as determined under section 1015(a) and Sec. 1.1015-1, would be
the same as the adjusted basis in A's hands at the time of the gift, or
$60,000. Under section 1015(d) and this section, the basis of the
building in B's hands as of the date of the gift would be increased by
the amount of the gift tax paid with respect to such gift, limited to an
amount by which the fair market value of the property at the time of the
gift exceeded the basis of the property in the hands of A at the time of
gift, or $5,000. Therefore, the basis of the property in B's hands
immediately after the gift, both for determining gain or loss on the
sale of the property, would be $65,000.
Example 2. C purchased property in 1938 at a cost of $100,000. On
October 1, 1952, at which time the property had an adjusted basis of
$72,000 in C's hands, he gave the property to his daughter, D. At the
date of the gift to D, the property had a fair market value of $85,000
with respect to which C paid a gift tax in the amount of $11,745. On
September 2, 1958, D still held the property which then had an adjusted
basis in her hands of $65,000. Since the excess of the fair market value
of the property at the time of the gift to D over the adjusted basis of
the property in C's hands at such time is greater than the amount of
gift tax paid, the basis of the property in D's hands would be increased
as of September 2, 1958, by the amount of the gift tax paid, or $11,745.
The adjusted basis of
[[Page 66]]
the property in D's hands, both for determining gain or loss on the sale
of the property, would then be $76,745 ($65,000 plus $11,745).
Example 3. On December 31, 1951, E gave to his son, F, 500 shares of
common stock of the X Corporation which shares had been purchased
earlier by E at a cost of $100 per share, or a total cost of $50,000.
The basis in E's hands was still $50,000 on the date of the gift to F.
On the date of the gift, the fair market value of the 500 shares was
$80,000 with respect to which E paid a gift tax in the amount of
$10,695. In 1956, the 500 shares of X Corporation stock were exchanged
for 500 shares of common stock of the Y Corporation in a reorganization
with respect to which no gain or loss was recognized for income tax
purposes under section 354. F still held the 500 shares of Y Corporation
stock on September 2, 1958. Under such circumstances, the 500 shares of
X Corporation stock would not, for purposes of section 1015(d) and this
section, be considered as having been sold, exchanged, or otherwise
disposed of by F before September 2, 1958. Therefore, the basis of the
500 shares of Y Corporation stock held by F as of such date would, by
reason of section 1015(d) and this section, be increased by $10,695, the
amount of gift tax paid with respect to the gift to F of the X
Corporation stock.
Example 4. On November 15, 1953, G gave H property which had a fair
market value of $53,000 and a basis in the hands of G of $20,000. G paid
gift tax of $5,250 on the transfer. On November 16, 1956, H gave the
property to J who still held it on September 2, 1958. The value of the
property on the date of the gift to J was $63,000 and H paid gift tax of
$7,125 on the transfer. Since the property was not sold, exchanged, or
otherwise disposed of by J before September 2, 1958, and the gift tax
paid on the transfer to J did not exceed $43,000 ($63,000, fair market
value of property at time of gift to J, less $20,000, basis of property
in H's hands at that time), the basis of property in his hands is
increased on September 2, 1958, by $7,125, the amount of gift tax paid
by H on the transfer. No increase in basis is allowed for the $5,250
gift tax paid by G on the transfer to H, since H had sold, exchanged, or
otherwise disposed of the property before September 2, 1958.
(b) Amount of gift tax paid with respect to gifts made on or before
December 31, 1976. (1)(i) If only one gift was made during a certain
calendar period (as defined in Sec. 25.2502-1(c)(1)), the entire amount
of the gift tax paid under chapter 12 or the corresponding provisions of
prior revenue laws for that calendar period is the amount of the gift
tax paid with respect to the gift.
(ii) If more than one gift was made during a certain calendar
period, the amount of the gift tax paid under chapter 12 or the
corresponding provisions of prior revenue laws with respect to any
specified gift made during that calendar period is an amount, A, which
bears the same ratio to B (the total gift tax paid for that calendar
period) as C (the amount of the gift, computed as described in this
paragraph (b)(1)(ii)) bears to D (the total taxable gifts for the
calendar period computed without deduction for the gift tax specific
exemption under section 2521 (as in effect prior to its repeal by the
Tax Reform Act of 1976) or the corresponding provisions of prior revenue
laws). Stated algebraically, the amount of the gift tax paid with
respect to a gift equals:
[Amount of the gift (C) / Total taxable gifts, plus specific exemption
allowed (D)] x Total gift tax paid (B)
For purposes of the ratio stated in the preceding sentence, the amount
of the gift referred to as factor ``C'' is the value of the gift reduced
by any portion excluded or deducted under section 2503(b) (annual
exclusion), 2522 (charitable deduction), or 2523 (marital deduction) of
the Code or the corresponding provisions of prior revenue laws. In
making the computations described in this paragraph, the values to be
used are those finally determined for purposes of the gift tax.
(iii) If a gift consists of more than one item of property, the gift
tax paid with respect to each item shall be computed by allocating to
each item a proportionate part of the gift tax paid with respect to the
gift, computed in accordance with the provisions of this paragraph.
(2) For purposes of this paragraph, it is immaterial whether the
gift tax is paid by the donor or the donee. Where more than one gift of
a present interest in property is made to the same donee during a
calendar period (as defined in Sec. 25.2502-1(c)(1)), the annual
exclusion shall apply to the earliest of such gifts in point of time.
(3) Where the donor and his spouse elect under section 2513 or the
corresponding provisions of prior law to have any gifts made by either
of them
[[Page 67]]
considered as made one-half by each, the amount of gift tax paid with
respect to such a gift is the sum of the amounts of tax (computed
separately) paid with respect to each half of the gift by the donor and
his spouse.
(4) The method described in section 1015(d)(2) and this paragraph
for computing the amount of gift tax paid in respect of a gift may be
illustrated by the following examples:
Example 1. Prior to 1959 H made no taxable gifts. On July 1, 1959,
he made a gift to his wife, W, of land having a value for gift purposes
of $60,000 and gave to his son, S, certain securities valued at $60,000.
During the year 1959, H also contributed $5,000 in cash to a charitable
organization described in section 2522. H filed a timely gift tax return
for 1959 with respect to which he paid gift tax in the amount of $6,000,
computed as follows:
Value of land given to W.................. ........ $60,000 ........
Less: Annual exclusion.................... $3,000 ........ ........
Marital deduction......................... 30,000 33,000 ........
--------------------
Included amount of gift................... ........ ........ $27,000
=========
Value of securities given to S............ ........ 60,000 ........
Less: Annual exclusion.................... ........ 3,000 ........
----------
Included amount of gift................... ........ ........ 57,000
Gift to charitable organization........... ........ 5,000 ........
Less: Annual exclusion.................... 3,000 ........ ........
Charitable deduction...................... 2,000 5,000 ........
--------------------
Included amount of gift................... ........ ........ 0
Total included gifts...................... ........ ........ 84,000
Less: Specific exemption allowed.......... ........ ........ 30,000
---------
Taxable gifts for 1959.................... ........ ........ 54,000
=========
Gift tax on $54,000....................... ........ ........ 6,000
In determining the gift tax paid with respect to the land given to W,
amount C of the ratio set forth in subparagraph (1)(ii) of this
paragraph is $60,000, value of property given to W, less $33,000 (the
sum of $3,000, the amount excluded under section 2503(b), and $30,000,
the amount deducted under section 2523), or $27,000. Amount D of the
ratio is $84,000 (the amount of taxable gifts, $54,000, plus the gift
tax specific exemption, $30,000). The gift tax paid with respect to the
land given to W is $1,928.57, computed as follows:
$27,000(C) / $84,000(D) x $6,000(B)
Example 2. The facts are the same as in example (1) except that H
made his gifts to W and S on July 1, 1971, and that prior to 1971, H
made no taxable gifts. Furthermore, H made his charitable contribution
on August 12, 1971. These were the only gifts made by H during 1971. H
filed his gift tax return for the third quarter of 1971 on November 15,
1971, as required by section 6075(b). With respect to the above gifts H
paid a gift tax in the amount of $6,000 on total taxable gifts of
$54,000 for the third quarter of 1971. The gift tax paid with respect to
the land given to W is $1,928.57. The computations for these figures are
identical to those used in example (1).
Example 3. On January 15, 1956, A made a gift to his nephew, N, of
land valued at $86,000, and on June 30, 1956, gave N securities valued
at $40,000. On July 1, 1956, A gave to his sister, S, $46,000 in cash. A
and his wife, B, were married during the entire calendar year 1956. The
amount of A's taxable gifts for prior years was zero although in
arriving at that amount A had used in full the specific exemption
authorized by section 2521. B did not make any gifts before 1956. A and
B elected under section 2513 to have all gifts made by either during
1956 treated as made one-half by A and one-half by B. Pursuant to that
election, A and B each filed a gift tax return for 1956. A paid gift tax
of $11,325 and B paid gift tax of $5,250, computed as follows:
------------------------------------------------------------------------
A B
------------------------------------------------------------------------
Value of land given to N............................ $43,000 $43,000
Less: exclusion..................................... 3,000 3,000
-------------------
Included amount of gift......................... 40,000 40,000
===================
Value of securities given to N...................... 20,000 20,000
Less: exclusion..................................... None None
-------------------
Included amount of gift......................... 20,000 20,000
===================
Cash gift to S...................................... 23,000 23,000
Less: exclusion..................................... 3,000 3,000
-------------------
Included amount of gift......................... 20,000 20,000
===================
Total included gifts............................ 80,000 80,000
Less: specific exemption............................ None 30,000
-------------------
Taxable gifts for 1956.......................... 80,000 50,000
===================
Gift tax for 1956................................... 11,325 5,250
------------------------------------------------------------------------
The amount of the gift tax paid by A with respect to the land given to N
is computed as follows:
$40,000(C) / $80,000(D) x $11,325(B) = $5,662.50
The amount of the gift tax paid by B with respect to the land given to N
is computed as follows:
$40,000(C) / $80,000(D) x $5,250(B) = $2,625
The amount of the gift tax paid with respect to the land is $5,662.50
plus $2,625, or $8,287.50. Computed in a similar manner, the amount of
gift tax paid by A with respect to the securities given to N is
$2,831.25, and the amount of gift tax paid by B with respect thereto is
$1,312.50, or a total of $4,143.75.
Example 4. The facts are the same as in example (3) except that A
gave the land to N on
[[Page 68]]
January 15, 1972, the securities to N on February 3, 1972, and the cash
to S on March 7, 1972. As in example (3), the amount of A's taxable
gifts for taxable years prior to 1972 was zero, although in arriving at
that amount A had used in full the specific exemption authorized by
section 2521. B did not make any gifts before 1972. Pursuant to the
election under section 2513, A and B treated all gifts made by either
during 1972 as made one-half by A and one-half by B. A and B each filed
a gift tax return for the first quarter of 1972 on May 15, 1972, as
required by section 6075(b). A paid gift tax of $11,325 on taxable gifts
of $80,000 and B paid gift tax of $5,250 on taxable gifts of $50,000.
The amount of the gift tax paid by A and B with respect to the land
given to N is $5,662.50 and $2,625, respectively. The computations for
these figures are identical to those used in example (3).
(c) Special rule for increased basis for gift tax paid in the case
of gifts made after December 31, 1976--(1) In general. With respect to
gifts made after December 31, 1976 (other than gifts between spouses
described in section 1015(e)), the increase in basis for gift tax paid
is determined under section 1015(d)(6). Under section 1015(d)(6)(A), the
increase in basis with respect to gift tax paid is limited to the amount
(not in excess of the amount of gift tax paid) that bears the same ratio
to the amount of gift tax paid as the net appreciation in value of the
gift bears to the amount of the gift.
(2) Amount of gift. In general, for purposes of section
1015(d)(6)(A)(ii), the amount of the gift is determined in conformance
with the provisions of paragraph (b) of this section. Thus, the amount
of the gift is the amount included with respect to the gift in
determining (for purposes of section 2503(a)) the total amount of gifts
made during the calendar year (or calendar quarter in the case of a gift
made on or before December 31, 1981), reduced by the amount of any
annual exclusion allowable with respect to the gift under section
2503(b), and any deductions allowed with respect to the gift under
section 2522 (relating to the charitable deduction) and section 2523
(relating to the marital deduction). Where more than one gift of a
present interest in property is made to the same donee during a calendar
year, the annual exclusion shall apply to the earliest of such gifts in
point of time.
(3) Amount of gift tax paid with respect to the gift. In general,
for purposes of section 1015(d)(6), the amount of gift tax paid with
respect to the gift is determined in conformance with the provisions of
paragraph (b) of this section. Where more than one gift is made by the
donor in a calendar year (or quarter in the case of gifts made on or
before December 31, 1981), the amount of gift tax paid with respect to
any specific gift made during that period is the amount which bears the
same ratio to the total gift tax paid for that period (determined after
reduction for any gift tax unified credit available under section 2505)
as the amount of the gift (computed as described in paragraph (c)(2) of
this section) bears to the total taxable gifts for the period.
(4) Qualified domestic trusts. For purposes of section 1015(d)(6),
in the case of a qualified domestic trust (QDOT) described in section
2056A(a), any distribution during the noncitizen surviving spouse's
lifetime with respect to which a tax is imposed under section
2056A(b)(1)(A) is treated as a transfer by gift, and any estate tax paid
on the distribution under section 2056A(b)(1)(A) is treated as a gift
tax. The rules under this paragraph apply in determining the extent to
which the basis in the assets distributed is increased by the tax
imposed under section 2056A(b)(1)(A).
(5) Examples. Application of the provisions of this paragraph (c)
may be illustrated by the following examples:
Example 1. (i) Prior to 1995, X exhausts X's gift tax unified credit
available under section 2505. In 1995, X makes a gift to X's child Y, of
a parcel of real estate having a fair market value of $100,000. X's
adjusted basis in the real estate immediately before making the gift was
$70,000. Also in 1995, X makes a gift to X's child Z, of a painting
having a fair market value of $70,000. X timely files a gift tax return
for 1995 and pays gift tax in the amount of $55,500, computed as
follows:
------------------------------------------------------------------------
------------------------------------------------------------------------
Value of real estate transferred to Y........... $100,000 ..........
Less: Annual exclusion.......................... 10,000 ..........
------------
Included amount of gift (C)..................... .......... $90,000
Value of painting transferred to Z.............. $70,000 ..........
Less: annual exclusion.......................... 10,000 ..........
------------
Included amount of gift......................... .......... 60,000
-----------
Total included gifts (D).................... .......... $150,000
[[Page 69]]
Total gift tax liability for 1995 gifts (B). .......... $55,500
------------------------------------------------------------------------
(ii) The gift tax paid with respect to the real estate transferred
to Y, is determined as follows:
[GRAPHIC] [TIFF OMITTED] TR22AU95.005
(iii)(A) The amount by which Y's basis in the real property is
increased is determined as follows:
[GRAPHIC] [TIFF OMITTED] TR22AU95.006
(B) Y's basis in the real property is $70,000 plus $11,100, or
$81,100. If X had not exhausted any of X's unified credit, no gift tax
would have been paid and, as a result, Y's basis would not be increased.
Example 2. (i) X dies in 1995. X's spouse, Y, is not a United States
citizen. In order to obtain the marital deduction for property passing
to X's spouse, X established a QDOT in X's will. In 1996, the trustee of
the QDOT makes a distribution of principal from the QDOT in the form of
shares of stock having a fair market value of $70,000 on the date of
distribution. The trustee's basis in the stock (determined under section
1014) is $50,000. An estate tax is imposed on the distribution under
section 2056A(b)(1)(A) in the amount $38,500, and is paid. Y's basis in
the shares of stock is increased by a portion of the section 2056A
estate tax paid determined as follows:
[GRAPHIC] [TIFF OMITTED] TR22AU95.007
(ii) Y's basis in the stock is $50,000 plus $11,000, or $61,000.
(6) Effective date. The provisions of this paragraph (c) are
effective for gifts made after August 22, 1995.
(d) Treatment as adjustment to basis. Any increase in basis under
section 1015(d) and this section shall, for purposes of section 1016(b)
(relating to adjustments to a substituted basis), be treated as an
adjustment under section 1016(a) to the basis of the donee's property to
which such increase applies. See paragraph (p) of Sec. 1.1016-5.
[T.D. 6693, 28 FR 12818, Dec. 3, 1963, as amended by T.D. 7238, 37 FR
28715, Dec. 29, 1972; T.D. 7910, 48 FR 40372, Sept. 7, 1983; T.D. 8612,
60 FR 43537, Aug. 22, 1995]
Sec. 1.1016-1 Adjustments to basis; scope of section.
Section 1016 and Sec. Sec. 1.1016-2 to 1.1016-10, inclusive,
contain the rules relating to the adjustments to be made to the basis of
property to determine the adjusted basis as defined in section 1011.
However, if the property was acquired from a decedent before his death,
see Sec. 1.1014-6 for adjustments on account of certain deductions
allowed the taxpayer for the period between the date of acquisition of
the property and the date of death of the decedent. If an election has
been made under the Retirement-Straight Line Adjustment Act of 1958 (26
U.S.C. 1016 note), see Sec. 1.9001-1 for special rules for determining
adjusted basis in the case of a taxpayer who has changed from the
retirement to the straight-line method of computing depreciation
allowances.
Sec. 1.1016-2 Items properly chargeable to capital account.
(a) The cost or other basis shall be properly adjusted for any
expenditure, receipt, loss, or other item, properly chargeable to
capital account, including the cost of improvements and betterments made
to the property. No adjustment shall be made in respect of any item
which, under any applicable provision of law or regulation, is treated
as an item not properly chargeable to capital account but is allowable
as a deduction in computing net or taxable
[[Page 70]]
income for the taxable year. For example, in the case of oil and gas
wells no adjustment may be made in respect of any intangible drilling
and development expense allowable as a deduction in computing net or
taxable income. See the regulations under section 263(c).
(b) The application of the foregoing provisions may be illustrated
by the following example:
Example: A, who makes his returns on the calendar year basis,
purchased property in 1941 for $10,000. He subsequently expended $6,000
for improvements. Disregarding, for the purpose of this example, the
adjustments required for depreciation, the adjusted basis of the
property is $16,000. If A sells the property in 1954 for $20,000, the
amount of his gain will be $4,000.
(c) Adjustments to basis shall be made for carrying charges such as
taxes and interest, with respect to property (whether real or personal,
improved or unimproved, and whether productive or unproductive), which
the taxpayer elects to treat as chargeable to capital account under
section 266, rather than as an allowable deduction. The term taxes for
this purpose includes duties and excise taxes but does not include
income taxes.
(d) Expenditures described in section 173 to establish, maintain, or
increase the circulation of a newspaper, magazine, or other periodical
are chargeable to capital account only in accordance with and in the
manner provided in the regulations under section 173.
Sec. 1.1016-3 Exhaustion, wear and tear, obsolescence, amortization,
and depletion for periods since February 28, 1913.
(a) In general--(1) Adjustment where deduction is claimed. (i) For
taxable periods beginning on or after January 1, 1952, the cost or other
basis of property shall be decreased for exhaustion, wear and tear,
obsolescence, amortization, and depletion by the greater of the
following two amounts:
(a) The amount allowed as deductions in computing taxable income, to
the extent resulting in a reduction of the taxpayer's income taxes, or
(b) The amount allowable for the years involved.
See paragraph (b) of this section. Where the taxpayer makes an
appropriate election the above rule is applicable for periods since
February 28, 1913, and before January 1, 1952. See paragraph (d) of this
section. For rule for such periods where no election is made, see
paragraph (c) of this section.
(ii) The determination of the amount properly allowable for
exhaustion, wear and tear, obsolescence, amortization, and depletion
must be made on the basis of facts reasonably known to exist at the end
of the taxable year. A taxpayer is not permitted to take advantage in a
later year of the taxpayer's prior failure to take any such allowance or
the taxpayer's taking an allowance plainly inadequate under the known
facts in prior years. In the case of depreciation, if in prior years the
taxpayer has consistently taken proper deductions under one method, the
amount allowable for such prior years may not be increased, even though
a greater amount would have been allowable under another proper method.
For rules governing losses on retirement or disposition of depreciable
property, including rules for determining basis, see Sec. 1.167(a)-8,
1.168(i)-1(e), or 1.168(i)-8, as applicable. The application of this
paragraph is illustrated by the following example (for purposes of this
example, assume section 167(f)(1) as in effect on September 19, 2013,
applies to taxable years beginning on or after January 1, 2014):
Example. On July 1, 2014, A, a calendar-year taxpayer, purchased and
placed in service ``off-the-shelf'' computer software at a cost of
$36,000. This computer software is not an amortizable section 197
intangible. Pursuant to section 167(f)(1), the useful life of the
computer software is 36 months. It has no salvage value. Computer
software placed in service in 2014 is not eligible for the additional
first year depreciation deduction provided by section 168(k). A did not
deduct any depreciation for the computer software for 2014 and deducted
depreciation of $12,000 for the computer software for 2015. As a result,
the total amount of depreciation allowed for the computer software as of
December 31, 2015, was $12,000. However, the total amount of
depreciation allowable for the computer software as of December 31,
2015, is $18,000 ($6,000 for 2014 + $12,000 for 2015). As a result, the
unrecovered cost of the computer software as of December 31, 2015, is
$18,000 (cost of $36,000 less the depreciation allowable of
[[Page 71]]
$18,000 as of December 31, 2015). Accordingly, depreciation for 2016 for
the computer software is $12,000 (unrecovered cost of $18,000 divided by
the remaining useful life of 18 months as of January 1, 2016, multiplied
by 12 full months in 2016).
(2) Adjustment for amount allowable where no depreciation deduction
claimed. (i) If the taxpayer has not taken a depreciation deduction
either in the taxable year or for any prior taxable year, adjustments to
basis of the property for depreciation allowable shall be determined by
using the straight-line method of depreciation. (See Sec. 1.1016-4 for
adjustments in the case of persons exempt from income taxation.)
(ii) For taxable years beginning after December 31, 1953, and ending
after August 16, 1954, if the taxpayer with respect to any property has
taken a deduction for depreciation properly under one of the methods
provided in section 167(b) for one or more years but has omitted the
deduction in other years, the adjustment to basis for the depreciation
allowable in such a case will be the deduction under the method which
was used by the taxpayer with respect to that property. Thus, if A
acquired property in 1954 on which he properly computed his depreciation
deduction under the method described in section 167(b)(2) (the
declining-balance method) for the first year of its useful life but did
not take a deduction in the second and third year of the asset's life,
the adjustment to basis for depreciation allowable for the second and
third year will be likewise computed under the declining-balance method.
(3) Adjustment for depletion deductions with respect to taxable
years before 1932. Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery value or a
percentage of income, then the adjustment for depletion for such year
shall not exceed a depletion deduction which would have been allowable
for such year if computed without reference to discovery value or a
percentage of income.
(b) Adjustment for periods beginning on or after January 1, 1952.
The decrease required by paragraph (a) of this section for deductions in
respect of any period beginning on or after January 1, 1952, shall be
whichever is the greater of the following amounts:
(1) The amount allowed as deductions in computing taxable income
under subtitle A of the Code or prior income tax laws and resulting (by
reason of the deductions so allowed) in a reduction for any taxable year
of the taxpayer's taxes under subtitle A of the Code (other than chapter
2, relating to tax on self-employment income) or prior income, war-
profits, or excess-profits tax laws; or
(2) The amount properly allowable as deductions in computing taxable
income under subtitle A of the Code or prior income tax laws (whether or
not the amount properly allowable would have caused a reduction for any
taxable year of the taxpayer's taxes).
(c) Adjustment for periods since February 28, 1913, and before
January 1, 1952, where no election made. If no election has been
properly made under section 1020, or under section 113(d) of the
Internal Revenue Code of 1939 (see paragraph (d) of this section), the
decrease required by paragraph (a) of this section for deductions in
respect of any period since February 28, 1913, and before January 1,
1952, shall be whichever of the following amounts is the greater:
(1) The amount allowed as deductions in computing net income under
chapter 1 of the Internal Revenue Code of 1939 or prior income tax laws;
(2) The amount properly allowable in computing net income under
chapter 1 of the Internal Revenue Code of 1939 or prior income tax laws.
For the purpose of determining the decrease required by this paragraph,
it is immaterial whether or not the amount under subparagraph (1) of
this paragraph or the amount under subparagraph (2) of this paragraph
would have resulted in a reduction for any taxable year of the
taxpayer's taxes.
(d) Adjustment for periods since February 28, 1913, and before
January 1, 1952, where election made. If an election has been properly
made under section 1020, or under section 113(d) of the Internal Revenue
Code of 1939, the decrease required by paragraph (a) of this section for
deductions in respect of any period
[[Page 72]]
since February 28, 1913, and before January 1, 1952, shall be whichever
is the greater of the following amounts:
(1) The amount allowed as deductions in computing net income under
chapter 1 of the Internal Revenue Code of 1939 or prior income tax laws
and resulting (by reason of the deductions so allowed) in a reduction
for any taxable year of the taxpayer's taxes under such chapter 1 (other
than subchapter E, relating to tax on self-employment income),
subchapter E, chapter 2, of the Internal Revenue Code of 1939, or prior
income, war-profits, or excess-profits tax laws;
(2) The amount properly allowable as deductions in computing net
income under chapter 1 of the Internal Revenue Code of 1939 or prior
income tax laws (whether or not the amount properly allowable would have
caused a reduction for any taxable year of the taxpayer's taxes).
(e) Determination of amount allowed which reduced taxpayer's taxes.
(1) As indicated in paragraphs (b) and (d) of this section, there are
situations in which it is necessary to determine (for the purpose of
ascertaining the basis adjustment required by paragraph (a) of this
section) the extent to which the amount allowed as deductions resulted
in a reduction for any taxable year of the taxpayer's taxes under
subtitle A (other than chapter 2 relating to tax on self-employment
income) of the Code, or prior income, war-profits, or excess-profits tax
laws. This amount (amount allowed which resulted in a reduction of the
taxpayer's taxes) is hereinafter referred to as the tax-benefit amount
allowed. For the purpose of determining whether the tax-benefit amount
allowed exceeded the amount allowable, a determination must be made of
that portion of the excess of the amount allowed over the amount
allowable which, if disallowed, would not have resulted in an increase
in any such tax previously determined. If the entire excess of the
amount allowed over the amount allowable could be disallowed without any
such increase in tax, the tax-benefit amount allowed shall not be
considered to have exceeded the amount allowable. In such a case (if
paragraph (b) or (d) of this section is applicable) the reduction in
basis required by paragraph (a) of this section would be the amount
properly allowable as a deduction. If only part of such excess could be
disallowed without any such increase in tax, the tax-benefit amount
allowed shall be considered to exceed the amount allowable to the extent
of the remainder of such excess. In such a case (if paragraph (b) or (d)
of this section is applicable), the reduction in basis required by
paragraph (a) of this section would be the amount of the tax-benefit
amount allowed.
(2) For the purpose of determining the tax-benefit amount allowed
the tax previously determined shall be determined under the principles
of section 1314. The only adjustments made in determining whether there
would be an increase in tax shall be those resulting from the
disallowance of the amount allowed. The taxable years for which the
determination is made shall be the taxable year for which the deduction
was allowed and any other taxable year which would be affected by the
disallowance of such deduction. Examples of such other taxable years are
taxable years to which there was a carryover or carryback of a net
operating loss from the taxable year for which the deduction was
allowed, and taxable years for which a computation under section 111 or
section 1333 was made by reference to the taxable year for which the
deduction was allowed. In determining whether the disallowance of any
part of the deduction would not have resulted in an increase in any tax
previously determined, proper adjustment must be made for previous
determinations under section 1311, or section 3801 of the Internal
Revenue Code of 1939, and for any previous application of section
1016(a)(2)(B), or section 113(b) (1)(B)(ii) of the Internal Revenue Code
of 1939.
(3) If a determination under section 1016(a)(2)(B) must be made with
respect to several properties for each of which the amount allowed for
the taxable year exceeded the amount allowable, the tax-benefit amount
allowed with respect to each of such properties shall
[[Page 73]]
be an allocated portion of the tax-benefit amount allowed determined by
reference to the sum of the amounts allowed and the sum of the amounts
allowable with respect to such several properties.
(4) In the case of property held by a partnership or trust, the
computation of the tax-benefit amount allowed shall take into account
the tax benefit of the partners or beneficiaries, as the case may be,
from the deduction by the partnership or trust of the amount allowed to
the partnership or the trust. For this purpose, the determination of the
amount allowed which resulted in a tax benefit to the partners or
beneficiaries shall be made in the same manner as that provided above
with respect to the taxes of the person holding the property.
(5) A taxpayer seeking to limit the adjustment to basis to the tax-
benefit amount allowed for any period, in lieu of the amount allowed,
must establish the tax-benefit amount allowed. A failure of adequate
proof as to the tax-benefit amount allowed with respect to one period
does not preclude the taxpayer from limiting the adjustment to basis to
the tax-benefit amount allowed with respect to another period for which
adequate proof is available. For example, a corporate transferee may
have available adequate records with respect to the tax effect of the
deduction of erroneous depreciation for certain taxable years, but may
not have available adequate records with respect to the deduction of
excessive depreciation for other taxable years during which the property
was held by its transferor. In such case the corporate transferee shall
not be denied the right to apply this section with respect to the
erroneous depreciation for the period for which adequate proof is
available.
(f) Determination of amount allowable in prior taxable years. (1)
One of the factors in determining the adjustment to basis as of any date
is the amount of depreciation, depletion, etc., allowable for periods
prior to such date. The amount allowable for such prior periods is
determined under the law applicable to such prior periods; all
adjustments required by the law applicable to such periods are made in
determining the adjusted basis of the property for the purpose of
determining the amount allowable. Provisions corresponding to the rules
in section 1016(a)(2)(B) described in paragraphs (d) and (e) of this
section, which limit adjustments to the tax-benefit amount allowed where
an election is properly exercised, were first enacted by the Act of July
14, 1952 (66 Stat. 629). That law provided that corresponding rules are
deemed to be includible in all revenue laws applicable to taxable years
ending after December 31, 1931. Accordingly, those rules shall be taken
into account in determining the amount of depreciation, etc., allowable
for any taxable year ending after December 31, 1931. For example, if the
adjusted basis of property held by the taxpayer since January 1, 1930,
is determined as of January 1, 1955, and if an election was properly
made under section 1020, or section 113(d) of the Internal Revenue Code
of 1939, then the amount allowable which is taken into account in
computing the adjusted basis as of January 1, 1955, shall be determined
by taking those rules into account for all taxable years ending after
December 31, 1931. The Act of July 14, 1952, made no change in the law
applicable in determining the amount allowable for taxable years ending
before January 1, 1932. If there was a final decision of a court prior
to the enactment of the Act of July 14, 1952, determining the amount
allowable for a particular taxable year, such determination shall be
adjusted. In such case the adjustment shall be made only for the purpose
of taking the provision of that law into account and only to the extent
made necessary by such provisions.
(2) Although the Act of July 14, 1952, amended the law applicable to
all taxable years ending after December 31, 1931, the amendment does not
permit refund, credit, or assessment of a deficiency for any taxable
year for which such refund, credit, or assessment was barred by any law
or rule of law.
(g) Property with transferred basis. The following rules apply in
the determination of the adjustments to basis of property in the hands
of a transferee, donee, or grantee which are required by section
1016(b), or section 113(b)(2) of the Internal Revenue Code of 1939, with
[[Page 74]]
respect to the period the property was held by the transferor, donor, or
grantor:
(1) An election or a revocation of an election under section 1020,
or section 113(d) of the Internal Revenue Code of 1939, by a transferor,
donor, or grantor, which is made after the date of the transfer, gift,
or grant of the property shall not affect the basis of such property in
the hands of the transferee, donee, or grantee. An election or a
revocation of an election made before the date of the transfer, gift, or
grant of the property shall be taken into account in determining under
section 1016(b) the adjustments to basis of such property as of the date
of the transfer, gift, or grant, whether or not an election or a
revocation of an election under section 1020, or section 113(d) of the
Internal Revenue Code of 1939, was made by the transferee, donee, or
grantee.
(2) An election by the transferee, donee, or grantee or a revocation
of such an election shall be applicable in determining the adjustments
to basis for the period during which the property was held by the
transferor, donor, or grantor, whether or not the transferor, donor, or
grantor had made an election or a revocation of an election, provided
that the property was held by the transferee, donee, or grantee at any
time on or before the date on which the election or revocation was made.
(h) Application to a change in method of accounting. For purposes of
determining whether a change in depreciation or amortization for
property subject to section 167, 168, 197, 1400I, 1400L(c), to section
168 prior to its amendment by the Tax Reform Act of 1986 (100 Stat.
2121) (former section 168), or to an additional first year depreciation
deduction provision of the Internal Revenue Code (for example, section
168(k), 1400L(b), or 1400N(d)) is a change in method of accounting under
section 446(e) and the regulations under section 446(e), section
1016(a)(2) does not permanently affect a taxpayer's lifetime income.
(i) Examples. The application of section 1016(a) (1) and (2) may be
illustrated by the following examples:
Example 1. The case of Corporation A discloses the following facts:
The cost or other basis is to be adjusted by $16,500 with respect to the
years 1952-54, that is, by the amount allowable but not less than the
amount allowed which reduced the taxpayer's taxes. An adjustment must
also be made with respect to the years 1949-1951, the amount of such
adjustment depending upon whether an election was properly made under
section 1020, or section 113(d) of the Internal Revenue Code of 1939. If
no such election was made, the amount of the adjustment with respect to
the years 1949-1951 is $19,500, that is, the amount allowed but not less
than the amount allowable. If an election was properly made, the amount
of the adjustment with respect to the years 1949-1951 is $19,000, that
is, the amount allowable but not less than the amount allowed which
reduced the taxpayer's taxes.
--------------------------------------------------------------------------------------------------------------------------------------------------------
(6)--Amount
(3)--Amount (5)--Amount allowable but not
(2)--Amount allowed which (4)--Amount allowable but not less than amount
(1)--Year allowed reduced allowable less than amount allowed which
taxpayer's taxes allowed reduced
taxpayer's taxes
--------------------------------------------------------------------------------------------------------------------------------------------------------
1949..................................................... $6,000 $5,500 $5,000 $6,000 $5,500
1950..................................................... 7,000 7,000 6,500 7,000 7,000
1951..................................................... 5,000 4,000 6,500 6,500 6,500
----------------------------------------------------------------------------------------------
Total, 1949-1951....................................... ................. ................. ................. 19,500 19,000
==============================================================================================
1952..................................................... 6,500 6,500 6,000 ................. 6,500
1953..................................................... 5,000 4,000 4,000 ................. 4,000
1954..................................................... 4,500 4,500 6,000 ................. 6,000
----------------------------------------------------------------------------------------------
Total, 1952-1954....................................... ................. ................. ................. ................. 16,500
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 2. Corporation A, which files its returns on the basis of a
calendar year, purchased a building on January 1, 1950, at a cost of
$100,000. On the basis of the facts reasonably known to exist at the end
of 1950, a period of 50 years should have been used as
[[Page 75]]
the correct useful life of the building; nevertheless, depreciation was
computed by Corporation A on the basis of a useful life of 25 years, and
was allowed for 1950 through 1953 as a deduction in an annual amount of
$4,000. The building was sold on January 1, 1954. Corporation A did not
make an election under section 1020, or section 113(d) of the Internal
Revenue Code of 1939. No part of the amount allowed Corporation A for
any of the years 1950 through 1953 resulted in a reduction of
Corporation A's taxes. The adjusted basis of the building as of January
1, 1954, is $88,166, computed as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adjustments to
basis as of Adjusted basis on Remaining life on Depreciation Depreciation
Taxable year beginning of January 1 January 1 allowable allowed
taxable year
--------------------------------------------------------------------------------------------------------------------------------------------------------
1950..................................................... ................. $100,000 50 $2,000 $4,000
1951..................................................... $4,000 96,000 49 1,959 4,000
1952..................................................... 8,000 92,000 48 1,917 4,000
1953..................................................... 9,917 90,083 47 1,917 4,000
1954..................................................... 11,834 88,166 ................. ................. .................
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 3. The facts are the same as in example (2), except that
Corporation A made a proper election under section 1020. In such case,
the adjusted basis of the building as of January 1, 1954, is $92,000
computed as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adjustments to
basis as of Adjusted basis on Remaining life on Depreciation Depreciation
Taxable year beginning of January 1 January 1 allowable allowed
taxable year
--------------------------------------------------------------------------------------------------------------------------------------------------------
1950..................................................... ................. $100,000 50 $2,000 $4,000
1951..................................................... $2,000 98,000 49 2,000 4,000
1952..................................................... 4,000 96,000 48 2,000 4,000
1953..................................................... 6,000 94,000 47 2,000 4,000
1954..................................................... 8,000 92,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 4. If it is assumed that in example (2), or in example (3),
all of the deduction allowed Corporation A for 1953 had resulted in a
reduction of A's taxes, the adjustment to the basis of the building for
depreciation for 1953 would reflect the entire $4,000 deduction. In such
case, the adjusted basis of the building as of January 1, 1954, would be
$86,083 in example (2), and $90,000 in example (3).
Example 5. The facts are the same as in example (2), except that for
the year 1950 all of the $4,000 amount allowed Corporation A as a
deduction for depreciation for that year resulted in a reduction of A's
taxes. In such case, the adjustments to the basis of the building remain
the same as those set forth in example (2).
Example 6. The facts are the same as in example (3), except that for
the year 1950 all of the $4,000 amount allowed Corporation A as a
deduction for depreciation resulted in a reduction of A's taxes. In such
case, the adjusted basis of the building as of January 1, 1954, is
$90,123, computed as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adjustments to
basis as of Adjusted basis on Remaining life on Depreciation Depreciation
Taxable year beginning of January 1 January 1 allowable allowed
taxable year
--------------------------------------------------------------------------------------------------------------------------------------------------------
1950..................................................... ................. $100,000 50 $2,000 $4,000
1951..................................................... $4,000 96,000 49 1,959 4,000
1952..................................................... 5,959 94,041 48 1,959 4,000
1953..................................................... 7,918 92,082 47 1,959 4,000
1954..................................................... 9,877 90,123
--------------------------------------------------------------------------------------------------------------------------------------------------------
(j) Effective/applicability dates--(1) In general. Except as
provided in paragraphs (j)(2) and (j)(3) of this section, this section
applies on or after December 30, 2003. For the applicability of
regulations before December 30, 2003, see Sec. 1.1016-3 in effect prior
to December 30, 2003 (Sec. 1.1016-3 as contained in 26 CFR part 1
edition revised as of April 1, 2003).
(2) Depreciation or amortization changes. Paragraph (h) of this
section applies to a change in depreciation or amortization for property
subject to
[[Page 76]]
section 167, 168, 197, 1400I, 1400L(c), to former section 168, or to an
additional first year depreciation deduction provision of the Internal
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)) for
taxable years ending on or after December 30, 2003.
(3) Application of Sec. 1.1016-3T(a)(1)(ii)--(i) In general.
Paragraph (a)(1)(ii) of this section applies to taxable years beginning
on or after January 1, 2014. Except as provided in paragraphs (j)(3)(ii)
and (j)(3)(iii) of this section, Sec. 1.1016-3(a)(1)(ii) as contained
in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable
years beginning before January 1, 2014.
(ii) Early application of Sec. 1.1016-3(a)(1)(ii). A taxpayer may
choose to apply paragraph (a)(1)(ii) of this section to taxable years
beginning on or after January 1, 2012.
(iii) Optional application of TD 9564. A taxpayer may choose to
apply Sec. 1.1016-3T(a)(1)(ii) as contained in TD 9564 (76 FR 81060)
December 27, 2011, to taxable years beginning on or after January 1,
2012, and before January 1, 2014.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 9105, 69 FR 12, Jan. 2, 2004; T.D. 9307, Dec. 28, 2006;
T.D. 9564, 76 FR 81126, Dec. 27, 2011; T.D. 9636, 78 FR 57746, Sept. 19,
2013; T.D. 9689, 79 FR 48684, Aug. 18, 2014]
Sec. 1.1016-4 Exhaustion, wear and tear, obsolescence, amortization,
and depletion; periods during which income was not subject to tax.
(a) Adjustments to basis must be made for exhaustion, wear and tear,
obsolescence, amortization, and depletion to the extent actually
sustained in respect of:
(1) Any period before March 1, 1913,
(2) Any period since February 28, 1913, during which the property
was held by a person or organization not subject to income taxation
under chapter 1 of the Code or prior income tax laws,
(3) Any period since February 28, 1913, and before January 1, 1958,
during which the property was held by a person subject to tax under part
I, subchapter L, chapter 1 of the Code, or prior income tax law, to the
extent that section 1016(a)(2) does not apply, and
(4) Any period since February 28, 1913, during which such property
was held by a person subject to tax under part II of subchapter L,
chapter 1 of the Code, or prior income tax law, to the extent that
section 1016(a)(2) does not apply.
(b) The amount of the adjustments described in paragraph (a) of this
section actually sustained is that amount charged off on the books of
the taxpayer where such amount is considered by the Commissioner to be
reasonable. Otherwise, the amount actually sustained will be the amount
that would have been allowable as a deduction:
(1) During the period described in paragraph (a) (1) or (2) of this
section, had the taxpayer been subject to income tax during those
periods, or
(2) During the period described in paragraph (a) (3) or (4) of this
section, with respect to property held by a taxpayer described in that
paragraph, to the extent that section 1016(a)(2) was inapplicable to
such property during that period.
In the case of a taxpayer subject to the adjustment required by
subparagraph (1) or (2) of this paragraph, depreciation shall be
determined by using the straight line method.
[T.D. 6681, 28 FR 11131, Oct. 17, 1963]
Sec. 1.1016-5 Miscellaneous adjustments to basis.
(a) Certain stock distributions. (1) In the case of stock, the cost
or other basis must be diminished by the amount of distributions
previously made which, under the law applicable to the year in which the
distribution was made, either were tax free or were applicable in
reduction of basis (not including distributions made by a corporation
which was classified as a personal service corporation under the
provisions of the Revenue Act of 1918 (40 Stat. 1057) or the Revenue Act
of 1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the Revenue
Act of 1918 or the Revenue Act of 1921). For adjustments to basis in the
case of certain corporate distributions, see section 301 and the
regulations thereunder.
(2) The application of subparagraph (1) of this paragraph may be
illustrated by the following example:
[[Page 77]]
Example: A, who makes his returns upon the calendar year basis,
purchased stock in 1923 for $5,000. He received in 1924 a distribution
of $2,000 paid out of earnings and profits of the corporation
accumulated before March 1, 1913. The adjusted basis for determining the
gain or loss from the sale or other disposition of the stock in 1954 is
$5,000 less $2,000, or $3,000, and the amount of the gain or loss from
the sale or other disposition of the stock is the difference between
$3,000 and the amount realized from the sale or other disposition.
(b) Amortizable bond premium--(1) In general. A holder's basis in a
bond is reduced by the amount of bond premium used to offset qualified
stated interest income under Sec. 1.171-2. This reduction occurs when
the holder takes the qualified stated interest into account under the
holder's regular method of accounting.
(2) Special rules for taxable bonds. A holder's basis in a taxable
bond is reduced by the amount of bond premium allowed as a deduction
under Sec. 1.171-3(c)(5)(ii) (relating to the issuer's call of a
taxable bond) or under Sec. 1.171-2(a)(4)(i)(A) (relating to excess
bond premium).
(3) Special rule for tax-exempt obligations. A holder's basis in a
tax-exempt obligation is reduced by the amount of excess bond premium
that is treated as a nondeductible loss under Sec. 1.171-2(a)(4)(ii).
(c) Municipal bonds. In the case of a municipal bond (as defined in
section 75(b)), basis shall be adjusted to the extent provided in
section 75 or as provided in section 22(o) of the Internal Revenue Code
of 1939, and the regulations thereunder.
(d) Sale or exchange of residence. Where the acquisition of a new
residence results in the nonrecognition of any part of the gain on the
sale, or exchange, or involuntary conversion of the old residence, the
basis of the new residence shall be reduced by the amount of the gain
not so recognized pursuant to section 1034(a), or section 112(n) of the
Internal Revenue Code of 1939, and the regulations thereunder. See
section 1034(e) and the regulations thereunder.
(e) Loans from Commodity Credit Corporation. In the case of property
pledged to the Commodity Credit Corporation, the basis of such property
shall be increased by the amount received as a loan from such
corporation and treated by the taxpayer as income for the year in which
received under section 77, or under section 123 of the Internal Revenue
Code of 1939. The basis of such property shall be reduced to the extent
of any deficiency on such loan with respect to which the taxpayer has
been relieved from liability.
(f) Deferred development and exploration expenses. Expenditures for
development and exploration of mines or mineral deposits treated as
deferred expenses under sections 615 and 616, or under the corresponding
provisions of prior income tax laws, are chargeable to capital account
and shall be an adjustment to the basis of the property to which they
relate. The basis so adjusted shall be reduced by the amount of such
expenditures allowed as deductions which results in a reduction for any
taxable year of the taxpayer's taxes under subtitle A (other than
chapter 2 relating to tax on self-employment income) of the Code, or
prior income, war-profits, or excess-profits tax laws, but not less than
the amounts allowable under such provisions for the taxable year and
prior years. This amount is considered as the tax-benefit amount allowed
and shall be determined in accordance with paragraph (e) of Sec.
1.1016-3. For example, if a taxpayer purchases unexplored and
undeveloped mining property for $1,000,000 and at the close of the
development stage has incurred exploration and development costs of
$9,000,000 treated as deferred expenses, the basis of such property at
such time for computing gain or loss will be $10,000,000. Assuming that
the taxpayer in this example has operated the mine for several years and
has deducted allowable percentage depletion in the amount of $2,000,000
and has deducted allowable deferred exploration and development
expenditures of $2,000,000, the basis of the property in the taxpayer's
hands for purposes of determining gain or loss from a sale will be
$6,000,000.
(g) Sale of land with unharvested crop. In the case of an
unharvested crop which is sold, exchanged, or involuntarily converted
with the land and which is considered as property used in the trade or
business under section
[[Page 78]]
1231, the basis of such crop shall be increased by the amount of the
items which are attributable to the production of such crop and which
are disallowed, under section 268, as deductions in computing taxable
income. The basis of any other property shall be decreased by the amount
of any such items which are attributable to such other property,
notwithstanding any provisions of section 1016 or of this section to the
contrary. For example, if the items attributable to the production of an
unharvested crop consist only of fertilizer costing $100 and $50
depreciation on a tractor used only to cultivate such crop, and such
items are disallowed under section 268, the adjustments to the basis of
such crop shall include an increase of $150 for such items and the
adjustments to the basis of the tractor shall incude a reduction of $50
for depreciation.
(h) Consent dividends. (1) In the case of amounts specified in a
shareholder's consent to which section 28 of the Internal Revenue Code
of 1939 applies, the basis of the consent stock shall be increased to
the extent provided in subsection (h) of such section.
(2) In the case of amounts specified in a shareholder's consent to
be treated as a consent dividend to which section 565 applies, the basis
of the consent stock shall be increased by the amount which, under
section 565(c)(2), is treated as contributed to the capital of the
corporation.
(i) Stock in foreign personal holding company. In the case of the
stock of a United States shareholder in a foreign personal holding
company, basis shall be adjusted to the extent provided in section
551(f) or corresponding provisions of prior income tax laws.
(j) Research and experimental expenditures. Research and
experimental expenditures treated as deferred expenses under section
174(b) are chargeable to capital account and shall be an adjustment to
the basis of the property to which they relate. The basis so adjusted
shall be reduced by the amount of such expenditures allowed as
deductions which results in a reduction for any taxable year of the
taxpayer's taxes under subtitle A (other than chapter 2 relating to tax
on self-employment income) of the Code, or prior income, war-profits, or
excess-profits tax laws, but not less than the amounts allowable under
such provisions for the taxable year and prior years. This amount is
considered as the tax-benefit amount allowed and shall be determined in
accordance with paragraph (e) of Sec. 1.1016-3.
(k) Deductions disallowed in connection with disposal of coal or
domestic iron ore. Basis shall be adjusted by the amount of the
deductions disallowed under section 272 with respect to the disposal of
coal or domestic iron ore covered by section 631.
(l) Expenditures attributable to grants or loans covered by section
621. In the case of expenditures attributable to a grant or loan made to
a taxpayer by the United States for the encouragement of exploration
for, or development or mining of, critical and strategic minerals or
metals, basis shall be adjusted to the extent provided in section 621,
or in section 22(b)(15) of the Internal Revenue Code of 1939.
(m) Trademark and trade name expenditures. Trademark and trade name
expenditures treated as deferred expenses under section 177 are
chargeable to capital account and shall be an adjustment to the basis of
the property to which they relate. The basis so adjusted shall be
reduced by the amount of such expenditures allowed as deductions which
results in a reduction for any taxable year of the taxpayer's taxes
under subtitle A (other than chapter 2, relating to tax on self-
employment income) of the Code, but not less than the amounts allowable
under such section for the taxable year and prior years. This amount is
considered as the tax-benefit amount allowed and shall be determined in
accordance with paragraph (e) of Sec. 1.1016-3.
(n) Life insurance companies. In the case of any evidence of
indebtedness referred to in section 818(b), the basis shall be adjusted
to the extent of the adjustments required under section 818(b) (or the
corresponding provisions of prior income tax laws) for the taxable year
and all prior taxable years. The basis of any such evidence of
indebtedness shall be reduced by the amount of the adjustment required
under section 818(b) (or the corresponding provision of prior income
[[Page 79]]
tax laws) on account of amortizable premium and shall be increased by
the amount of the adjustment required under section 818(b) on account of
accruable discounts.
(o) Stock and indebtedness of electing small business corporation.
In the case of a shareholder of an electing small business corporation,
as defined in section 1371(b), the basis of the shareholder's stock in
such corporation, and the basis of any indebtedness of such corporation
owing to the shareholder, shall be adjusted to the extent provided in
Sec. Sec. 1.1375-4, 1.1376-1, and 1.1376-2.
(p) Gift tax paid on certain property acquired by gift. Basis shall
be adjusted by that amount of the gift tax paid in respect of property
acquired by gift which, under section 1015(d), is an increase in the
basis of such property.
(q) Section 38 property. In the case of property which is or has
been section 38 property (as defined in section 48(a)), the basis shall
be adjusted to the extent provided in section 48(g) and in section
203(a)(2) of the Revenue Act of 1964.
(r) Stock in controlled foreign corporations and other property. In
the case of stock in controlled foreign corporations (or foreign
corporations which were controlled foreign corporations) and of property
by reason of which a person is considered as owning such stock, the
basis shall be adjusted to the extent provided in section 961.
(s) Original issue discount. In the case of certain corporate
obligations issued at a discount after May 27, 1969, the basis shall be
increased under section 1232(a)(3)(E) by the amount of original issue
discount included in the holder's gross income pursuant to section
1232(a)(3).
(t) Section 23 credit. In the case of property with respect to which
a credit has been allowed under section 23 or former section 44C
(relating to residential energy credit), basis shall be adjusted as
provided in paragraph (k) of Sec. 1.23-3.
(u) Gas guzzler tax. In the case of an automobile upon which the gas
guzzler tax was imposed, the basis shall be reduced as provided in
section 1016 (d).
[T.D. 6500, 25 FR 11910, Nov. 26, 1960]
Editorial Note: For Federal Register citations affecting Sec.
1.1016-5, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
Sec. 1.1016-6 Other applicable rules.
(a) Adjustments must always be made to eliminate double deductions
or their equivalent. Thus, in the case of the stock of a subsidiary
company, the basis thereof must be properly adjusted for the amount of
the subsidiary company's losses for the years in which consolidated
returns were made.
(b) In determining basis, and adjustments to basis, the principles
of estoppel apply, as elsewhere under the Code, and prior internal
revenue laws.
Sec. 1.1016-10 Substituted basis.
(a) Whenever it appears that the basis of property in the hands of
the taxpayer is a substituted basis, as defined in section 1016(b), the
adjustments indicated in Sec. Sec. 1.1016-1 to 1.1016-6, inclusive,
shall be made after first making in respect of such substituted basis
proper adjustments of a similar nature in respect of the period during
which the property was held by the transferor, donor, or grantor, or
during which the other property was held by the person for whom the
basis is to be determined. In addition, whenever it appears that the
basis of property in the hands of the taxpayer is a substituted basis,
as defined in section 1016(b)(1), the adjustments indicated in
Sec. Sec. 1.1016-7 to 1.1016-9, inclusive, and in section 1017 shall
also be made, whenever necessary, after first making in respect of such
substituted basis a proper adjustment of a similar nature in respect of
the period during which the property was held by the transferor, donor,
or grantor. Similar rules shall also be applied in the case of a series
of substituted bases.
(b)cation of this section may be illustrated by the following
example:
Example: A, who makes his returns upon the calendar year basis, in
1935 purchased the X Building and subsequently gave it to his son B. B
exchanged the X Building for the Y Building in a tax-free exchange, and
then gave the Y Building to his wife C. C, in determining the gain from
the sale or disposition of the Y Building in 1954, is required to reduce
the basis of the building by deductions
[[Page 80]]
for depreciation which were successively allowed (but not less than the
amount allowable) to A and B upon the X Building and to B upon the Y
Building, in addition to the deductions for depreciation allowed (but
not less than the amount allowable) to herself during her ownership of
the Y Building.
Sec. 1.1017-1 Basis reductions following a discharge of indebtedness.
(a) General rule for section 108(b)(2)(E). This paragraph (a)
applies to basis reductions under section 108(b)(2)(E) that are required
by section 108(a)(1) (A) or (B) because the taxpayer excluded discharge
of indebtedness (COD income) from gross income. A taxpayer must reduce
in the following order, to the extent of the excluded COD income (but
not below zero), the adjusted bases of property held on the first day of
the taxable year following the taxable year that the taxpayer excluded
COD income from gross income (in proportion to adjusted basis):
(1) Real property used in a trade or business or held for
investment, other than real property described in section 1221(1), that
secured the discharged indebtedness immediately before the discharge;
(2) Personal property used in a trade or business or held for
investment, other than inventory, accounts receivable, and notes
receivable, that secured the discharged indebtedness immediately before
the discharge;
(3) Remaining property used in a trade or business or held for
investment, other than inventory, accounts receivable, notes receivable,
and real property described in section 1221(1);
(4) Inventory, accounts receivable, notes receivable, and real
property described in section 1221(1); and
(5) Property not used in a trade or business nor held for
investment.
(b) Operating rules--(1) Prior tax-attribute reduction. The amount
of excluded COD income applied to reduce basis does not include any COD
income applied to reduce tax attributes under sections 108(b)(2) (A)
through (D) and, if applicable, section 108(b)(5). For example, if a
taxpayer excludes $100 of COD income from gross income under section
108(a) and reduces tax attributes by $40 under sections 108(b)(2) (A)
through (D), the taxpayer is required to reduce the adjusted bases of
property by $60 ($100-$40) under section 108(b)(2)(E).
(2) Multiple discharged indebtednesses. If a taxpayer has COD income
attributable to more than one discharged indebtedness resulting in the
reduction of tax attributes under sections 108(b)(2) (A) through (D)
and, if applicable, section 108(b)(5), paragraph (b)(1) of this section
must be applied by allocating the tax-attribute reductions among the
indebtednesses in proportion to the amount of COD income attributable to
each discharged indebtedness. For example, if a taxpayer excludes $20 of
COD income attributable to secured indebtedness A and excludes $80 of
COD income attributable to unsecured indebtedness B (a total exclusion
of $100), and if the taxpayer reduces tax attributes by $40 under
sections 108(b)(2) (A) through (D), the taxpayer must reduce the amount
of COD income attributable to secured indebtedness A to $12 ($20 - ($20
/ $100 x $40)) and must reduce the amount of COD income attributable to
unsecured indebtedness B to $48 ($80 - ($80 / $100 x $40)).
(3) Limitation on basis reductions under section 108(b)(2)(E) in
bankruptcy or insolvency. If COD income arises from a discharge of
indebtedness in a title 11 case or while the taxpayer is insolvent, the
amount of any basis reduction under section 108(b)(2)(E) shall not
exceed the excess of--
(i) The aggregate of the adjusted bases of property and the amount
of money held by the taxpayer immediately after the discharge; over
(ii) The aggregate of the liabilities of the taxpayer immediately
after the discharge.
(4) Transactions to which section 381 applies. If a taxpayer
realizes COD income that is excluded from gross income under section
108(a) either during or after a taxable year in which the taxpayer is
the distributor or transferor of assets in a transaction described in
section 381(a), the basis of property acquired by the acquiring
corporation in the transaction must reflect the reductions required by
section 1017 and this section. For this purpose, the basis of property
of the distributor or transferor corporation immediately prior to the
transaction described in
[[Page 81]]
section 381(a), but after the determination of tax for the year of the
distribution or transfer of assets, will be available for reduction
under section 108(b)(2). However, the basis of stock or securities of
the acquiring corporation, if any, received by the taxpayer in exchange
for the transferred assets shall not be available for reduction under
section 108(b)(2). See Sec. 1.108-7. This paragraph (b)(4) applies to
discharges of indebtedness occurring on or after May 10, 2004.
(c) Modification of ordering rules for basis reductions under
sections 108(b)(5) and 108(c)--(1) In general. The ordering rules
prescribed in paragraph (a) of this section apply, with appropriate
modifications, to basis reductions under sections 108(b)(5) and (c).
Thus, a taxpayer that elects to reduce basis under section 108(b)(5)
may, to the extent that the election applies, reduce only the adjusted
basis of property described in paragraphs (a) (1), (2), and (3) of this
section and, if an election is made under paragraph (f) of this section,
paragraph (a) (4) of this section. Within paragraphs (a) (1), (2), (3)
and (4) of this section, such a taxpayer may reduce only the adjusted
bases of depreciable property. A taxpayer that elects to apply section
108(c) may reduce only the adjusted basis of property described in
paragraphs (a) (1) and (3) of this section and, within paragraphs (a)(1)
and (3) of this section, may reduce only the adjusted bases of
depreciable real property. Furthermore, for basis reductions under
section 108(c), a taxpayer must reduce the adjusted basis of the
qualifying real property to the extent of the discharged qualified real
property business indebtedness before reducing the adjusted bases of
other depreciable real property. The term qualifying real property means
real property with respect to which the indebtedness is qualified real
property business indebtedness within the meaning of section 108(c)(3).
See paragraphs (f) and (g) of this section for elections relating to
section 1221(1) property and partnership interests.
(2) Partial basis reductions under section 108(b)(5). If the amount
of basis reductions under section 108(b)(5) is less than the amount of
the COD income excluded from gross income under section 108(a), the
taxpayer must reduce the balance of its tax attributes, including any
remaining adjusted bases of depreciable and other property, by following
the ordering rules under section 108(b)(2). For example, if a taxpayer
excludes $100 of COD income from gross income under section 108(a) and
elects to reduce the adjusted bases of depreciable property by $10 under
section 108(b)(5), the taxpayer must reduce its remaining tax attributes
by $90, starting with net operating losses under section 108(b)(2).
(3) Modification of fresh start rule for prior basis reductions
under section 108(b)(5). After reducing the adjusted bases of
depreciable property under section 108(b)(5), a taxpayer must compute
the limitation on basis reductions under section 1017(b)(2) using the
aggregate of the remaining adjusted bases of property. For example, if,
immediately after the discharge of indebtedness in a title 11 case, a
taxpayer's adjusted bases of property is $100 and its undischarged
indebtedness is $70, and if the taxpayer elects to reduce the adjusted
bases of depreciable property by $10 under section 108(b)(5), section
1017(b)(2) limits any further basis reductions under section
108(b)(2)(E) to $20 (($100 - $10) - $70).
(d) Changes in security. If any property is added or eliminated as
security for an indebtedness during the one-year period preceding the
discharge of that indebtedness, such addition or elimination shall be
disregarded where a principal purpose of the change is to affect the
taxpayer's basis reductions under section 1017.
(e) Depreciable property. For purposes of this section, the term
depreciable property means any property of a character subject to the
allowance for depreciation or amortization, but only if the basis
reduction would reduce the amount of depreciation or amortization which
otherwise would be allowable for the period immediately following such
reduction. Thus, for example, a lessor cannot reduce the basis of leased
property where the lessee's obligation in respect of the property will
restore to the lessor the loss due to depreciation during the term of
the lease, since the lessor cannot take depreciation in respect of such
property.
[[Page 82]]
(f) Election to treat section 1221(1) real property as depreciable--
(1) In general. For basis reductions under section 108(b)(5) and basis
reductions relating to qualified farm indebtedness, a taxpayer may elect
under sections 1017(b) (3)(E) and (4)(C), respectively, to treat real
property described in section 1221(1) as depreciable property. This
election is not available, however, for basis reductions under section
108(c).
(2) Time and manner. To make an election under section 1017(b)
(3)(E) or (4)(C), a taxpayer must enter the appropriate information on
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness
(and Section 1082 Basis Adjustment), and attach the form to a timely
filed (including extensions) Federal income tax return for the taxable
year in which the taxpayer has COD income that is excluded from gross
income under section 108(a). An election under this paragraph (f) may be
revoked only with the consent of the Commissioner.
(g) Partnerships--(1) Partnership COD income. For purposes of
paragraph (a) of this section, a taxpayer must treat a distributive
share of a partnership's COD income as attributable to a discharged
indebtedness secured by the taxpayer's interest in that partnership.
(2) Partnership interest treated as depreciable property--(i) In
general. For purposes of making basis reductions, if a taxpayer makes an
election under section 108(b)(5) (or 108(c)), the taxpayer must treat a
partnership interest as depreciable property (or depreciable real
property) to the extent of the partner's proportionate share of the
partnership's basis in depreciable property (or depreciable real
property), provided that the partnership consents to a corresponding
reduction in the partnership's basis (inside basis) in depreciable
property (or depreciable real property) with respect to such partner.
(ii) Request by partner and consent of partnership--(A) In general.
Except as otherwise provided in this paragraph (g)(2)(ii), a taxpayer
may choose whether or not to request that a partnership reduce the
inside basis of its depreciable property (or depreciable real property)
with respect to the taxpayer, and the partnership may grant or withhold
such consent, in its sole discretion. A request by the taxpayer must be
made before the due date (including extensions) for filing the
taxpayer's Federal income tax return for the taxable year in which the
taxpayer has COD income that is excluded from gross income under section
108(a).
(B) Request for consent required. A taxpayer must request a
partnership's consent to reduce inside basis if, at the time of the
discharge, the taxpayer owns (directly or indirectly) a greater than 50
percent interest in the capital and profits of the partnership, or if
reductions to the basis of the taxpayer's depreciable property (or
depreciable real property) are being made with respect to the taxpayer's
distributive share of COD income of the partnership.
(C) Granting of request required. A partnership must consent to
reduce its partners' shares of inside basis with respect to a discharged
indebtedness if consent is requested with respect to that indebtedness
by partners owning (directly or indirectly) an aggregate of more than 80
percent of the capital and profits interests of the partnership or five
or fewer partners owning (directly or indirectly) an aggregate of more
than 50 percent of the capital and profits interests of the partnership.
For example, if there is a cancellation of partnership indebtedness that
is secured by real property used in a partnership's trade or business,
and if partners owning (in the aggregate) 90 percent of the capital and
profits interests of the partnership elect to exclude the COD income
under section 108(c), the partnership must make the appropriate
reductions in those partners' shares of inside basis.
(iii) Partnership consent statement--(A) Partnership requirement. A
consenting partnership must include with the Form 1065, U.S. Partnership
Return of Income, for the taxable year following the year that ends with
or within the taxable year the taxpayer excludes COD income from gross
income under section 108(a), and must provide to the taxpayer on or
before the due date of the taxpayer's return (including extensions) for
the taxable year in which the taxpayer excludes COD income from gross
income, a statement that--
[[Page 83]]
(1) Contains the name, address, and taxpayer identification number
of the partnership; and
(2) States the amount of the reduction of the partner's
proportionate interest in the adjusted bases of the partnership's
depreciable property or depreciable real property, whichever is
applicable.
(B) Taxpayer's requirement. For taxable years beginning before
January 1, 2003, statements described in Sec. 1.1017-1(g)(2)(iii)(A)
must be attached to a taxpayer's timely filed (including extensions)
Federal income tax return for the taxable year in which the taxpayer has
COD income that is excluded from gross income under section 108(a). For
taxable years beginning after December 31, 2002, taxpayers must retain
the statements and keep them available for inspection in the manner
required by Sec. 1.6001-1(e), but are not required to attach the
statements to their returns.
(iv) Partner's share of partnership basis--(A) In general. For
purposes of this paragraph (g), a partner's proportionate share of the
partnership's basis in depreciable property (or depreciable real
property) is equal to the sum of--
(1) The partner's section 743(b) basis adjustments to items of
partnership depreciable property (or depreciable real property); and
(2) The common basis depreciation deductions (but not including
remedial allocations of depreciation deductions under Sec. 1.704-3(d))
that, under the terms of the partnership agreement effective for the
taxable year in which the discharge of indebtedness occurs, are
reasonably expected to be allocated to the partner over the property's
remaining useful life. The assumptions made by a partnership in
determining the reasonably expected allocation of depreciation
deductions must be consistent for each partner. For example, a
partnership may not treat the same depreciation deductions as being
reasonably expected by more than one partner.
(B) Effective date. This paragraph (g)(2)(iv) applies to elections
made under sections 108(b)(5) and 108(c) on or after December 15, 1999.
(v) Treatment of basis reduction--(A) Basis adjustment. The amount
of the reduction to the basis of depreciable partnership property
constitutes an adjustment to the basis of partnership property with
respect to the partner only. No adjustment is made to the common basis
of partnership property. Thus, for purposes of income, deduction, gain,
loss, and distribution, the partner will have a special basis for those
partnership properties the bases of which are adjusted under section
1017 and this section.
(B) Recovery of adjustments to basis of partnership property.
Adjustments to the basis of partnership property under this section are
recovered in the manner described in Sec. 1.743-1.
(C) Effect of basis reduction. Adjustments to the basis of
partnership property under this section are treated in the same manner
and have the same effect as an adjustment to the basis of partnership
property under section 743(b). The following example illustrates this
paragraph (g)(2)(v):
Example. (i) A, B, and C are equal partners in partnership PRS,
which owns (among other things) Asset 1, an item of depreciable property
with a basis of $30,000. A's basis in its partnership interest is
$20,000. Under the terms of the partnership agreement, A's share of the
depreciation deductions from Asset 1 over its remaining useful life will
be $10,000. Under section 1017, A requests, and PRS agrees, to decrease
the basis of Asset 1 with respect to A by $10,000.
(ii) In the year following the reduction of basis under section
1017, PRS amends its partnership agreement to provide that items of
depreciation and loss from Asset 1 will be allocated equally between B
and C. In that year, A's distributive share of the partnership's common
basis depreciation deductions from Asset 1 is now $0. Under Sec. 1.743-
1(j)(4)(ii)(B), the amount of the section 1017 basis adjustment that A
recovers during the year is $1,000. A will report $1,000 of ordinary
income because A's distributive share of the partnership's common basis
depreciation deductions from Asset 1 ($0) is insufficient to offset the
amount of the section 1017 basis adjustment recovered by A during the
year ($1,000).
(iii) In the following year, PRS sells Asset 1 for $15,000 and
recognizes a $12,000 loss. This loss is allocated equally between B and
C, and A's share of the loss is $0. Upon the sale of Asset 1, A recovers
its entire remaining section 1017 basis adjustment ($9,000). A will
report $9,000 of ordinary income.
(D) Effective date. This paragraph (g)(2)(v) applies to elections
made under sections 108(b)(5) and 108(c) on or after December 15, 1999.
[[Page 84]]
(3) Partnership basis reduction. The rules of this section
(including this paragraph (g)) apply in determining the properties to
which the partnership's basis reductions must be made.
(h) Special allocation rule for cases to which section 1398 applies.
If a bankruptcy estate and a taxpayer to whom section 1398 applies
(concerning only individuals under Chapter 7 or 11 of title 11 of the
United States Code) hold property subject to basis reduction under
section 108(b) (2)(E) or (5) on the first day of the taxable year
following the taxable year of discharge, the bankruptcy estate must
reduce all of the adjusted bases of its property before the taxpayer is
required to reduce any adjusted bases of property.
(i) Effective date. This section applies to discharges of
indebtedness occurring on or after October 22, 1998.
[T.D. 8787, 63 FR 56563, Oct. 22, 1998, as amended by T.D. 8847, 64 FR
69921, Dec. 15, 1999; T.D. 9080, 68 FR 42593, July 18, 2003; T.D. 9100,
68 FR 70705, Dec. 19, 2003; T.D. 9100, 69 FR 5017, Feb. 3, 2004; T.D.
9127, 69 FR 26039, May 11, 2004; T.D. 9300, 71 FR 71042, Dec. 8, 2006]
Sec. 1.1019-1 Property on which lessee has made improvements.
In any case in which a lessee of real property has erected buildings
or made other improvements upon the leased property and the lease is
terminated by forfeiture or otherwise resulting in the realization by
such lessor of income which, were it not for the provisions of section
109, would be includible in gross income of the lessor, the amount so
excluded from gross income shall not be taken into account in
determining the basis or the adjusted basis of such property or any
portion thereof in the hands of the lessor. If, however, in any taxable
year beginning before January 1, 1942, there has been included in the
gross income of the lessor an amount representing any part of the value
of such property attributable to such buildings or improvements, the
basis of each portion of such property shall be properly adjusted for
the amount so included in gross income. For example, A leased in 1930 to
B for a period of 25 years unimproved real property and in accordance
with the terms of the lease B erected a building on the property. It was
estimated that upon expiration of the lease the building would have a
depreciated value of $50,000, which value the lessor elected to report
(beginning in 1931) as income over the term of the lease. This method of
reporting was used until 1942. In 1952 B forfeits the lease. The amount
of $22,000 reported as income by A during the years 1931 to 1941,
inclusive, shall be added to the basis of the property represented by
the improvements in the hands of A. If in such case A did not report
during the period of the lease any income attributable to the value of
the building erected by the lessee and the lease was forfeited in 1940
when the building was worth $75,000, such amount, having been included
in gross income under the law applicable to that year, is added to the
basis of the property represented by the improvements in the hands of A.
As to treatment of such property for the purposes of capital gains and
losses, see subchapter P (section 1201 and following), chapter 1 of the
Code.
Sec. 1.1020-1 Election as to amounts allowed in respect
of depreciation, etc., before 1952.
(a) In general. (1) Any person may elect to have the adjustments to
the cost or other basis of property under section 1016(a)(2) determined
in accordance with subparagraph (B) of such section by filing a
statement of election in accordance with the requirements set forth in
paragraph (b) of this section. Any election made after 1952 shall be
irrevocable when made. Any election made after 1952 shall apply with
respect to all property held by the person making the election at any
time on or before December 31, 1952, and shall apply to all periods
since February 28, 1913, and before January 1, 1952, during which such
person held such property or for which adjustments must be made under
section 1016(b). For rules with respect to an election made on or before
December 31, 1952, see paragraph (c) of this section.
(2) An election by a partner on his own behalf is not an election
for the partnership of which he is a member. A separate election must be
made on behalf of the partnership. (See section
[[Page 85]]
703(b) (relating to elections of the partnership).) An election on
behalf of the partnership applies only with respect to the partnership,
and does not apply to the separate property of the partners. A similar
rule applies with respect to elections by trusts and beneficiaries of
trusts. These rules also apply with respect to a revocation of an
election where such election was made on or before December 31, 1952.
(b) Rules applicable to making of election. The following rules are
applicable to the making of an election under section 1020:
(1) Form of election. The election shall be in the form of a
statement in writing, shall state the name and address of the taxpayer
making the election, and shall contain a statement that such taxpayer
elects to have the provisions of section 1016(a)(2)(B) apply in respect
of all periods since February 28, 1913, and before January 1, 1952.
(2) Signature. The statement shall be signed by the taxpayer making
the election, if an individual, or, if the taxpayer making the election
is not an individual, the statement shall be signed by the person or
persons required to sign the income return of such taxpayer.
(3) Filing. The statement must be filed on or before December 31,
1954, in the office of the district director for the internal revenue
district in which the income tax return for the year of the election is
required to be filed. For rules as to when timely mailing will be
treated as timely filing of the statement see section 7502.
(4) Filing of duplicate. A copy of the statement of election must be
filed with the first return, amended return, or claim for refund filed
on or after the date on which the election is made.
(c) Election made on or before December 31, 1952. An election made
on or before December 31, 1952, in accordance with the provisions of
section 113(d) of the Internal Revenue Code of 1939, may be revoked by
filing on or before December 31, 1954, in the same office in which the
election was filed, a statement of revocation signed in the same manner
as the election. Such statement made by any person is irrevocable when
made with respect to such person, and no new election may thereafter be
made by such person. A copy of the revocation must be filed with the
first return, amended return, or claim for refund, filed after the date
of the revocation. For additional rules with respect to election made on
or before December 31, 1952, see 26 CFR (1939) 39.113(b)(1)-1
(Regulations 118).
(d) Validity of elections or revocation of elections. An election or
revocation of an election which conforms in substance to the provisions
of this section will not be deemed invalid solely because it was filed
before the date on which the regulations in this section were
promulgated.
(e) Effect of election. For rules relating to the effect of an
election under this section, see section 1016(a)(2) and the regulations
thereunder.
Sec. 1.1021-1 Sale of annuities.
In the case of a transfer for value of an annuity contract to which
section 72(g) and paragraph (a) of Sec. 1.72-10 apply, the transferor
shall adjust his basis in such contract as of the time immediately prior
to such transfer by subtracting from the premiums or other consideration
he has paid or is deemed to have paid for such contract all amounts he
has received or is deemed to have received under such annuity contract
to the extent that such amounts were not includible in the gross income
of the transferor or other recipient under the applicable income tax
law. In any case where the amounts which were not includible in the
gross income of the recipient were received or deemed to have been
received by such transferor exceed the amounts paid or deemed paid by
him, the adjusted basis of the contract shall be zero. The income
realized by the transferor on such a transfer shall not exceed the total
of the amounts received as consideration for the transfer.
Common Nontaxable Exchanges
Sec. 1.1031-0 Table of contents.
This section lists the captions that appear in the regulations under
section 1031.
Sec. 1.1031(a)-1 Property held for productive use in a trade or
business or for investment.
(a) In general.
(b) Definition of ``like kind.''
[[Page 86]]
(c) Examples of exchanges of property of a ``like kind.''
(d) Examples of exchanges not solely in kind.
(e) Effective date.
Sec. 1.1031(a)-2 Additional rules for exchanges of personal property.
(a) Introduction.
(b) Depreciable tangible personal property.
(c) Intangible personal property and nondepreciable personal
property.
Sec. 1.1031(b)-1 Receipt of other property or money in tax-free
exchange.
Sec. 1.1031(b)-2 Safe harbor for qualified intermediaries.
Sec. 1.1031(c)-1 Nonrecognition of loss.
Sec. 1.1031(d)-1 Property acquired upon a tax-free exchange.
Sec. 1.1031(d)-1T Coordination of section 1060 with section 1031
(temporary).
Sec. 1.1031(d)-2 Treatment of assumption of liabilities.
Sec. 1.1031(e)-1 Exchanges of livestock of different sexes.
Sec. 1.1031(j)-1 Exchanges of multiple properties.
(a) Introduction.
(b) Computation of gain recognized.
(c) Computation of basis of properties received.
(d) Examples.
(e) Effective date.
Sec. 1.1031(K)-1 Treatment of deferred exchanges.
(a) Overview.
(b) Identification and receipt requirements.
(c) Identification of replacement property before the end of the
identification period.
(d) Receipt of identified replacement property.
(e) Special rules for identification and receipt of replacement
property to be produced.
(f) Receipt of money or other property.
(g) Safe harbors.
(h) Interest and growth factors.
(i) [Reserved]
(j) Determination of gain or loss recognized and the basis of
property received in a deferred exchange.
(k) Definition of disqualified person.
(l) [Reserved]
(m) Definition of fair market value.
(n) No inference with respect to actual or constructive receipt
rules outside of section 1031.
(o) Effective date.
[T.D. 8346, 56 FR 19937, May 1, 1991]
Sec. 1.1031(a)-1 Property held for productive use in trade or
business or for investment.
(a) In general--(1) Exchanges of property solely for property of a
like kind. Section 1031(a)(1) provides an exception from the general
rule requiring the recognition of gain or loss upon the sale or exchange
of property. Under section 1031(a)(1), no gain or loss is recognized if
property held for productive use in a trade or business or for
investment is exchanged solely for property of a like kind to be held
either for productive use in a trade or business or for investment.
Under section 1031(a)(1), property held for productive use in a trade or
business may be exchanged for property held for investment. Similarly,
under section 1031(a)(1), property held for investment may be exchanged
for property held for productive use in a trade or business. However,
section 1031(a)(2) provides that section 1031(a)(1) does not apply to
any exchange of--
(i) Stock in trade or other property held primarily for sale;
(ii) Stocks, bonds, or notes;
(iii) Other securities or evidences of indebtedness or interest;
(iv) Interests in a partnership;
(v) Certificates of trust or beneficial interests; or
(vi) Choses in action.
Section 1031(a)(1) does not apply to any exchange of interests in a
partnership regardless of whether the interests exchanged are general or
limited partnership interests or are interests in the same partnership
or in different partnerships. An interest in a partnership that has in
effect a valid election under section 761(a) to be excluded from the
application of all of subchapter K is treated as an interest in each of
the assets of the partnership and not as an interest in a partnership
for purposes of section 1031(a)(2)(D) and paragraph (a)(1)(iv) of this
section. An exchange of an interest in such a partnership does not
qualify for nonrecognition of gain or loss under section 1031 with
respect to any asset of the partnership that is described in section
1031(a)(2) or to the extent the exchange of assets of the partnership
does not otherwise satisfy the requirements of section 1031(a).
[[Page 87]]
(2) Exchanges of property not solely for property of a like kind. A
transfer is not within the provisions of section 1031(a) if, as part of
the consideration, the taxpayer receives money or property which does
not meet the requirements of section 1031(a), but the transfer, if
otherwise qualified, will be within the provisions of either section
1031 (b) or (c). Similarly, a transfer is not within the provisions of
section 1031(a) if, as part of the consideration, the other party to the
exchange assumes a liability of the taxpayer (or acquires property from
the taxpayer that is subject to a liability), but the transfer, if
otherwise qualified, will be within the provisions of either section
1031 (b) or (c). A transfer of property meeting the requirements of
section 1031(a) may be within the provisions of section 1031(a) even
though the taxpayer transfers in addition property not meeting the
requirements of section 1031(a) or money. However, the nonrecognition
treatment provided by section 1031(a) does not apply to the property
transferred which does not meet the requirements of section 1031(a).
(b) Definition of ``like kind.'' As used in section 1031(a), the
words like kind have reference to the nature or character of the
property and not to its grade or quality. One kind or class of property
may not, under that section, be exchanged for property of a different
kind or class. The fact that any real estate involved is improved or
unimproved is not material, for that fact relates only to the grade or
quality of the property and not to its kind or class. Unproductive real
estate held by one other than a dealer for future use or future
realization of the increment in value is held for investment and not
primarily for sale. For additional rules for exchanges of personal
property, see Sec. 1.1031 (a)-2.
(c) Examples of exchanges of property of a ``like kind.'' No gain or
loss is recognized if (1) a taxpayer exchanges property held for
productive use in his trade or business, together with cash, for other
property of like kind for the same use, such as a truck for a new truck
or a passenger automobile for a new passenger automobile to be used for
a like purpose; or (2) a taxpayer who is not a dealer in real estate
exchanges city real estate for a ranch or farm, or exchanges a leasehold
of a fee with 30 years or more to run for real estate, or exchanges
improved real estate for unimproved real estate; or (3) a taxpayer
exchanges investment property and cash for investment property of a like
kind.
(d) Examples of exchanges not solely in kind. Gain or loss is
recognized if, for instance, a taxpayer exchanges (1) Treasury bonds
maturing March 15, 1958, for Treasury bonds maturing December 15, 1968,
unless section 1037(a) (or so much of section 1031 as relates to section
1037(a)) applies to such exchange, or (2) a real estate mortgage for
consolidated farm loan bonds.
(e) Effective date relating to exchanges of partnership interests.
The provisions of paragraph (a)(1) of this section relating to exchanges
of partnership interests apply to transfers of property made by
taxpayers on or after April 25, 1991.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6935, 32 FR
15822, Nov. 17, 1967; T.D. 8343, 56 FR 14854, Apr. 12, 1991; T.D. 8346,
56 FR 19937, May 1, 1991]
Sec. 1.1031(a)-2 Additional rules for exchanges of personal property.
(a) Introduction. Section 1.1031(a)-1(b) provides that the
nonrecognition rules of section 1031 do not apply to an exchange of one
kind or class of property for property of a different kind or class.
This section contains additional rules for determining whether personal
property has been exchanged for property of a like kind or like class.
Personal properties of a like class are considered to be of a ``like
kind'' for purposes of section 1031. In addition, an exchange of
properties of a like kind may qualify under section 1031 regardless of
whether the properties are also of a like class. In determining whether
exchanged properties are of a like kind, no inference is to be drawn
from the fact that the properties are not of a like class. Under
paragraph (b) of this section, depreciable tangible personal properties
are of a like class if they are either within the same General Asset
Class (as defined in paragraph (b)(2) of this section) or within the
same Product Class (as defined in paragraph (b)(3) of this section).
Paragraph (c) of this
[[Page 88]]
section provides rules for exchanges of intangible personal property and
nondepreciable personal property.
(b) Depreciable tangible personal property--(1) General rule.
Depreciable tangible personal property is exchanged for property of a
``like kind'' under section 1031 if the property is exchanged for
property of a like kind or like class. Depreciable tangible personal
property is of a like class to other depreciable tangible personal
property if the exchanged properties are either within the same General
Asset Class or within the same Product Class. A single property may not
be classified within more than one General Asset Class or within more
than one Product Class. In addition, property classified within any
General Asset Class may not be classified within a Product Class. A
property's General Asset Class or Product Class is determined as of the
date of the exchange.
(2) General Asset Classes. Except as provided in paragraphs (b)(4)
and (b)(5) of this section, property within a General Asset Class
consists of depreciable tangible personal property described in one of
asset classes 00.11 through 00.28 and 00.4 of Rev. Proc. 87-56, 1987-2
C.B. 674. These General Asset Classes describe types of depreciable
tangible personal property that frequently are used in many businesses.
The General Asset Classes are as follows:
(i) Office furniture, fixtures, and equipment (asset class 00.11),
(ii) Information systems (computers and peripheral equipment) (asset
class 00.12),
(iii) Data handling equipment, except computers (asset class 00.13),
(iv) Airplanes (airframes and engines), except those used in
commercial or contract carrying of passengers or freight, and all
helicopters (airframes and engines) (asset class 00.21),
(v) Automobiles, taxis (asset class 00.22),
(vi) Buses (asset class 00.23),
(vii) Light general purpose trucks (asset class 00.241),
(viii) Heavy general purpose trucks (asset class 00.242),
(ix) Railroad cars and locomotives, except those owned by railroad
transportation companies (asset class 00.25),
(x) Tractor units for use over-the-road (asset class 00.26),
(xi) Trailers and trailer-mounted containers (asset class 00.27),
(xii) Vessels, barges, tugs, and similar water-transportation
equipment, except those used in marine construction (asset class 00.28),
and
(xiii) Industrial steam and electric generation and/or distribution
systems (asset class 00.4).
(3) Product classes. Except as provided in paragraphs (b)(4) and (5)
of this section, or as provided by the Commissioner in published
guidance of general applicability, property within a product class
consists of depreciable tangible personal property that is described in
a 6-digit product class within Sectors 31, 32, and 33 (pertaining to
manufacturing industries) of the North American Industry Classification
System (NAICS), set forth in Executive Office of the President, Office
of Management and Budget, North American Industry Classification System,
United States, 2002 (NAICS Manual), as periodically updated. Copies of
the NAICS Manual may be obtained from the National Technical Information
Service, an agency of the U.S. Department of Commerce, and may be
accessed on the internet. Sectors 31 through 33 of the NAICS Manual
contain listings of specialized industries for the manufacture of
described products and equipment. For this purpose, any 6-digit NAICS
product class with a last digit of 9 (a miscellaneous category) is not a
product class for purposes of this section. If a property is listed in
more than one product class, the property is treated as listed in any
one of those product classes. A property's 6-digit product class is
referred to as the property's NAICS code.
(4) Modifications of NAICS product classes. The product classes of
the NAICS Manual may be updated or otherwise modified from time to time
as the manual is updated, effective on or after the date of the
modification. The NAICS Manual generally is modified every five years,
in years ending in a 2 or 7 (such as 2002, 2007, and 2012). The
applicability date of the modified NAICS Manual is announced in the
Federal Register and generally is
[[Page 89]]
January 1 of the year the NAICS Manual is modified. Taxpayers may rely
on these modifications as they become effective in structuring exchanges
under this section. Taxpayers may rely on the previous NAICS Manual for
transfers of property made by a taxpayer during the one-year period
following the effective date of the modification. For transfers of
property made by a taxpayer on or after January 1, 1997, and on or
before January 1, 2003, the NAICS Manual of 1997 may be used for
determining product classes of the exchanged property.
(5) Administrative procedures for revising general asset classes and
product classes. The Commissioner may, through published guidance of
general applicability, supplement, modify, clarify, or update the
guidance relating to the classification of properties provided in this
paragraph (b). (See Sec. 601.601(d)(2) of this chapter.) For example,
the Commissioner may determine not to follow (in whole or in part) a
general asset class for purposes of identifying property of like class,
may determine not to follow (in whole or in part) any modification of
product classes published in the NAICS Manual, or may determine that
other properties not listed within the same or in any product class or
general asset class nevertheless are of a like class. The Commissioner
also may determine that two items of property that are listed in
separate product classes or in product classes with a last digit of 9
are of a like class, or that an item of property that has a NAICS code
is of a like class to an item of property that does not have a NAICS
code.
(6) No inference outside of section 1031. The rules provided in this
section concerning the use of general asset classes or product classes
are limited to exchanges under section 1031. No inference is intended
with respect to the classification of property for other purposes, such
as depreciation.
(7) Examples. The application of this paragraph (b) may be
illustrated by the following examples:
Example 1. Taxpayer A transfers a personal computer (asset class
00.12) to B in exchange for a printer (asset class 00.12). With respect
to A, the properties exchanged are within the same General Asset Class
and therefore are of a like class.
Example 2. Taxpayer C transfers an airplane (asset class 00.21) to D
in exchange for a heavy general purpose truck (asset class 00.242). The
properties exchanged are not of a like class because they are within
different General Asset Classes. Because each of the properties is
within a General Asset Class, the properties may not be classified
within a Product Class. The airplane and heavy general purpose truck are
also not of a like kind. Therefore, the exchange does not qualify for
nonrecognition of gain or loss under section 1031.
Example 3. Taxpayer E transfers a grader to F in exchange for a
scraper. Neither property is within any of the general asset classes.
However, both properties are within the same product class (NAICS code
333120). The grader and scraper are of a like class and deemed to be of
a like kind for purposes of section 1031.
Example 4. Taxpayer G transfers a personal computer (asset class
00.12), an airplane (asset class 00.21) and a sanding machine (NAICS
code 333210), to H in exchange for a printer (asset class 00.12), a
heavy general purpose truck (asset class 00.242) and a lathe (NAICS code
333210). The personal computer and the printer are of a like class
because they are within the same general asset class. The sanding
machine and the lathe are of a like class because they are within the
same product class (although neither property is within any of the
general asset classes). The airplane and the heavy general purpose truck
are neither within the same general asset class nor within the same
product class, and are not of a like kind.
(8) Transition rule. Properties within the same product classes
based on the 4-digit codes contained in Division D of the Executive
Office of the President, Office of Management and Budget, Standard
Industrial Classification Manual (1987), will be treated as property of
a like class for transfers of property made by taxpayers on or before
May 19, 2005.
(c) Intangible personal property and nondepreciable personal
property--(1) General rule. An exchange of intangible personal property
of nondepreciable personal property qualifies for nonrecognition of gain
or loss under section 1031 only if the exchanged properties are of a
like kind. No like classes are provided for these properties. Whether
intangible personal property is of a like kind to other intangible
personal property generally depends on the nature or character of the
rights
[[Page 90]]
involved (e.g., a patent or a copyright) and also on the nature or
character of the underlying property to which the intangible personal
property relates.
(2) Goodwill and going concern value. The goodwill or going concern
value of a business is not of a like kind to the goodwill or going
concern value of another business.
(3) Examples. The application of this paragraph (c) may be
illustrated by the following examples:
Example 1. Taxpayer K exchanges a copyright on a novel for a
copyright on a different novel. The properties exchanged are of a like
kind.
Example 2. Taxpayer J exchanges a copyright on a novel for a
copyright on a song. The properties exchanged are not of a like kind.
(d) Effective date. Except as otherwise provided in this paragraph
(d), this section applies to exchanges occurring on or after April 11,
1991. Paragraphs (b)(3) through (b)(6), Example 3 and Example 4 of
paragraph (b)(7), and paragraph (b)(8) of this section apply to
transfers of property made by taxpayers on or after August 12, 2004.
However, taxpayers may apply paragraphs (b)(3) through (b)(6), and
Example 3 and Example 4 of paragraph (b)(7) of this section to transfers
of property made by taxpayers on or after January 1, 1997, in taxable
years for which the period of limitation for filing a claim for refund
or credit under section 6511 has not expired.
[T.D. 8343, 56 FR 14854, Apr. 12, 1991, as amended by T.D. 9151, 69 FR
50068, Aug. 13, 2004; T.D. 9202, 70 FR 28819, May 19, 2005]
Sec. 1.1031(b)-1 Receipt of other property or money in tax-free
exchange.
(a) If the taxpayer receives other property (in addition to property
permitted to be received without recognition of gain) or money--
(1) In an exchange described in section 1031(a) of property held for
investment or productive use in trade or business for property of like
kind to be held either for productive use or for investment,
(2) In an exchange described in section 1035(a) of insurance
policies or annuity contracts,
(3) In an exchange described in section 1036(a) of common stock for
common stock, or preferred stock for preferred stock, in the same
corporation and not in connection with a corporate reorganization, or
(4) In an exchange described in section 1037(a) of obligations of
the United States, issued under the Second Liberty Bond Act (31 U.S.C.
774 (2)), solely for other obligations issued under such Act, the gain,
if any, to the taxpayer will be recognized under section 1031(b) in an
amount not in excess of the sum of the money and the fair market value
of the other property, but the loss, if any, to the taxpayer from such
an exchange will not be recognized under section 1031(c) to any extent.
(b) The application of this section may be illustrated by the
following examples:
Example 1. A, who is not a dealer in real estate, in 1954 exchanges
real estate held for investment, which he purchased in 1940 for $5,000,
for other real estate (to be held for productive use in trade or
business) which has a fair market value of $6,000, and $2,000 in cash.
The gain from the transaction is $3,000, but is recognized only to the
extent of the cash received of $2,000.
Example 2. (a) B, who uses the cash receipts and disbursements
method of accounting and the calendar year as his taxable year, has
never elected under section 454(a) to include in gross income currently
the annual increase in the redemption price of non-interest-bearing
obligations issued at a discount. In 1943, for $750 each, B purchased
four $1,000 series E U.S. savings bonds bearing an issue date of March
1, 1943.
(b) On October 1, 1963, the redemption value of each such bond was
$1,396, and the total redemption value of the four bonds was $5,584. On
that date B submitted the four $1,000 series E bonds to the United
States in a transaction in which one of such $1,000 bonds was reissued
by issuing four $100 series E U.S. savings bonds bearing an issue date
of March 1, 1943, and by considering six $100 series E bonds bearing an
issue date of March 1, 1943, to have been issued. The redemption value
of each such $100 series E bond was $139.60 on October 1, 1963. Then, as
part of the transaction, the six $100 series E bonds so considered to
have been issued and the three $1,000 series E bonds were exchanged, in
an exchange qualifying under section 1037(a), for five $1,000 series H
U.S. savings bonds plus $25.60 in cash.
(c) The gain realized on the exchange qualifying under section
1037(a) is $2,325.60, determined as follows:
Amount realized:
Par value of five series H bonds........................... $5,000.00
[[Page 91]]
Cash received.............................................. 25.60
------------
Total realized............................................ 5,025.60
Less: Adjusted basis of series E bonds surrendered in the
exchange:
Three $1,000 series E bonds.................... $2,250.00
Six $100 series E bonds at $75 each............ 450.00
-----------
......... 2,700.00
----------
Gain realized................................. ......... 2,325.60
(d) Pursuant to section 1031(b), only $25.60 (the money received) of
the total gain of $2,325.60 realized on the exchange is recognized at
the time of exchange and must be included in B's gross income for 1963.
The $2,300 balance of the gain ($2,325.60 less $25.60) must be included
in B's gross income for the taxable year in which the series H bonds are
redeemed or disposed of, or reach final maturity, whichever is earlier,
as provided in paragraph (c) of Sec. 1.454-1.
(e) The gain on the four $100 series E bonds, determined by using
$75 as a basis for each such bond, must be included in B's gross income
for the taxable year in which such bonds are redeemed or disposed of, or
reach final maturity, whichever is earlier.
Example 3. (a) The facts are the same as in example (2), except
that, as part of the transaction, the $1,000 series E bond is reissued
by considering ten $100 series E bonds bearing an issue date of March 1,
1943, to have been issued. Six of the $100 series E bonds so considered
to have been issued are surrendered to the United States as part of the
exchange qualifying under section 1037(a) and the other four are
immediately redeemed.
(b) Pursuant to section 1031(b), only $25.60 (the money received) of
the total gain of $2,325.60 realized on the exchange qualifying under
section 1037(a) is recognized at the time of the exchange and must be
included in B's gross income for 1963. The $2,300 balance of the gain
($2,325.60 less $25.60) realized on such exchange must be included in
B's gross income for the taxable year in which the series H bonds are
redeemed or disposed of, or reach final maturity, whichever is earlier,
as provided in paragraph (c) of Sec. 1.454-1.
(c) The redemption on October 1, 1963, of the four $100 series E
bonds considered to have been issued at such time results in gain of
$258.40, which is then recognized and must be included in B's gross
income for 1963. This gain of $258.40 is the difference between the
$558.40 redemption value of such bonds on the date of the exchange and
the $300 (4 x $75) paid for such series E bonds in 1943.
Example 4. On November 1, 1963, C purchased for $91 a marketable
U.S. bond which was originally issued at its par value of $100 under the
Second Liberty Bond Act. On February 1, 1964, in an exchange qualifying
under section 1037(a), C surrendered the bond to the United States for
another marketable U.S. bond, which then had a fair market value of $92,
and $1.85 in cash, $0.85 of which was interest. The $0.85 interest
received is includible in gross income for the taxable year of the
exchange, but the $2 gain ($93 less $91) realized on the exchange is
recognized for such year under section 1031(b) to the extent of $1 (the
money received). Under section 1031(d), C's basis in the bond received
in exchange is $91 (his basis of $91 in the bond surrendered, reduced by
the $1 money received and increased by the $1 gain recognized).
(c) Consideration received in the form of an assumption of
liabilities (or a transfer subject to a liability) is to be treated as
other property or money for the purposes of section 1031(b). Where, on
an exchange described in section 1031(b), each party to the exchange
either assumes a liability of the other party or acquires property
subject to a liability, then, in determining the amount of other
property or money for purposes of section 1031(b), consideration given
in the form of an assumption of liabilities (or a receipt of property
subject to a liability) shall be offset against consideration received
in the form of an assumption of liabilities (or a transfer subject to a
liability). See Sec. 1.1031(d)-2, examples (1) and (2).
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6935, 32 FR
15822, Nov. 17, 1967]
Sec. 1.1031(b)-2 Safe harbor for qualified intermediaries.
(a) In the case of simultaneous transfers of like-kind properties
involving a qualified intermediary (as defined in Sec. 1.1031(k)-
1(g)(4)(iii)), the qualified intermediary is not considered the agent of
the taxpayer for purposes of section 1031(a). In such a case, the
transfer and receipt of property by the taxpayer is treated as an
exchange.
(b) In the case of simultaneous exchanges of like-kind properties
involving a qualified intermediary (as defined in Sec. 1.1031(k)-
1(g)(4)(iii)), the receipt by the taxpayer of an evidence of
indebtedness of the transferee of the qualified intermediary is treated
as the receipt of an evidence of indebtedness of the person acquiring
property from the taxpayer for purposes of section 453 and Sec.
15a.453-1(b)(3)(i) of this chapter.
(c) Paragraph (a) of this section applies to transfers of property
made by taxpayers on or after June 10, 1991.
[[Page 92]]
(d) Paragraph (b) of this section applies to transfers of property
made by taxpayers on or after April 20, 1994. A taxpayer may choose to
apply paragraph (b) of this section to transfers of property made on or
after June 10, 1991.
[T.D. 8346, 56 FR 19937, May 1, 1991, as amended by T.D. 8535, 59 FR
18749, Apr. 20, 1994]
Sec. 1.1031(c)-1 Nonrecognition of loss.
Section 1031(c) provides that a loss shall not be recognized from an
exchange of property described in section 1031(a), 1035(a), 1036(a), or
1037(a) where there is received in the exchange other property or money
in addition to property permitted to be received without recognition of
gain or loss. See example (4) of paragraph (a)(3) of Sec. 1.1037-1 for
an illustration of the application of this section in the case of an
exchange of U.S. obligations described in section 1037(a).
[T.D. 6935, 32 FR 15822, Nov. 17, 1967]
Sec. 1.1031(d)-1 Property acquired upon a tax-free exchange.
(a) If, in an exchange of property solely of the type described in
section 1031, section 1035(a), section 1036(a), or section 1037(a), no
part of the gain or loss was recognized under the law applicable to the
year in which the exchange was made, the basis of the property acquired
is the same as the basis of the property transferred by the taxpayer
with proper adjustments to the date of the exchange. If additional
consideration is given by the taxpayer in the exchange, the basis of the
property acquired shall be the same as the property transferred
increased by the amount of additional consideration given (see section
1016 and the regulations thereunder).
(b) If, in an exchange of properties of the type indicated in
section 1031, section 1035(a), section 1036(a), or section 1037(a), gain
to the taxpayer was recognized under the provisions of section 1031(b)
or a similar provision of a prior revenue law, on account of the receipt
of money in the transaction, the basis of the property acquired is the
basis of the property transferred (adjusted to the date of the
exchange), decreased by the amount of money received and increased by
the amount of gain recognized on the exchange. The application of this
paragraph may be illustrated by the following example:
Example: A, an individual in the moving and storage business, in
1954 transfers one of his moving trucks with an adjusted basis in his
hands of $2,500 to B in exchange for a truck (to be used in A's
business) with a fair market value of $2,400 and $200 in cash. A
realizes a gain of $100 upon the exchange, all of which is recognized
under section 1031(b). The basis of the truck acquired by A is
determined as follows:
Adjusted basis of A's former truck...................... $2,500
Less: Amount of money received.......................... 200
---------------
Difference........................................... 2,300
Plus: Amount of gain recognized......................... 100
---------------
Basis of truck acquired by A......................... 2,400
(c) If, upon an exchange of properties of the type described in
section 1031, section 1035(a), section 1036(a), or section 1037(a), the
taxpayer received other property (not permitted to be received without
the recognition of gain) and gain from the transaction was recognized as
required under section 1031(b), or a similar provision of a prior
revenue law, the basis (adjusted to the date of the exchange) of the
property transferred by the taxpayer, decreased by the amount of any
money received and increased by the amount of gain recognized, must be
allocated to and is the basis of the properties (other than money)
received on the exchange. For the purpose of the allocation of the basis
of the properties received, there must be assigned to such other
property an amount equivalent to its fair market value at the date of
the exchange. The application of this paragraph may be illustrated by
the following example:
Example: A, who is not a dealer in real estate, in 1954 transfers
real estate held for investment which he purchased in 1940 for $10,000
in exchange for other real estate (to be held for investment) which has
a fair market value of $9,000, an automobile which has a fair market
value of $2,000, and $1,500 in cash. A realizes a gain of $2,500, all of
which is recognized under section 1031(b). The basis of the property
received in exchange is the basis of the real estate A transfers
($10,000) decreased by the amount of money received ($1,500) and
increased in the amount of gain that was recognized ($2,500), which
results in a basis for the property received of $11,000. This basis of
$11,000 is allocated between the automobile and the real estate received
by
[[Page 93]]
A, the basis of the automobile being its fair market value at the date
of the exchange, $2,000, and the basis of the real estate received being
the remainder, $9,000.
(d) Section 1031(c) and, with respect to section 1031 and section
1036(a), similar provisions of prior revenue laws provide that no loss
may be recognized on an exchange of properties of a type described in
section 1031, section 1035(a), section 1036(a), or section 1037(a),
although the taxpayer receives other property or money from the
transaction. However, the basis of the property or properties (other
than money) received by the taxpayer is the basis (adjusted to the date
of the exchange) of the property transferred, decreased by the amount of
money received. This basis must be allocated to the properties received,
and for this purpose there must be allocated to such other property an
amount of such basis equivalent to its fair market value at the date of
the exchange.
(e) If, upon an exchange of properties of the type described in
section 1031, section 1035(a), section 1036(a), or section 1037(a), the
taxpayer also exchanged other property (not permitted to be transferred
without the recognition of gain or loss) and gain or loss from the
transaction is recognized under section 1002 or a similar provision of a
prior revenue law, the basis of the property acquired is the total basis
of the properties transferred (adjusted to the date of the exchange)
increased by the amount of gain and decreased by the amount of loss
recognized on the other property. For purposes of this rule, the
taxpayer is deemed to have received in exchange for such other property
an amount equal to its fair market value on the date of the exchange.
The application of this paragraph may be illustrated by the following
example:
Example: A exchanges real estate held for investment plus stock for
real estate to be held for investment. The real estate transferred has
an adjusted basis of $10,000 and a fair market value of $11,000. The
stock transferred has an adjusted basis of $4,000 and a fair market
value of $2,000. The real estate acquired has a fair market value of
$13,000. A is deemed to have received a $2,000 portion of the acquired
real estate in exchange for the stock, since $2,000 is the fair market
value of the stock at the time of the exchange. A $2,000 loss is
recognized under section 1002 on the exchange of the stock for real
estate. No gain or loss is recognized on the exchange of the real estate
since the property received is of the type permitted to be received
without recognition of gain or loss. The basis of the real estate
acquired by A is determined as follows:
Adjusted basis of real estate transferred.......... $10,000
Adjusted basis of stock transferred................ 4,000
--------------------
14,000
Less: Loss recognized on transfer of stock......... 2,000
--------------------
Basis of real estate acquired upon the exchange 12,000
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6935, 32 FR
15823, Nov. 17, 1967]
Sec. 1.1031(d)-1T Coordination of section 1060 with section 1031
(temporary).
If the properties exchanged under section 1031 are part of a group
of assets which constitute a trade or business under section 1060, the
like-kind property and other property or money which are treated as
transferred in exchange for the like-kind property shall be excluded
from the allocation rules of section 1060. However, section 1060 shall
apply to property which is not like-kind property or other property or
money which is treated as transferred in exchange for the like-kind
property. For application of the section 1060 allocation rules to
property which is not part of the like-kind exchange, see Sec. 1.1060-
1(b), (c), and (d) Example 1 in Sec. 1.338-6(b), to which reference is
made by Sec. 1.1060-1(c)(2).
[T.D. 8215, 53 FR 27044, July 18, 1988, as amended by T.D. 8858, 65 FR
1237, Jan. 7, 2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001]
Sec. 1.1031(d)-2 Treatment of assumption of liabilities.
For the purposes of section 1031(d), the amount of any liabilities
of the taxpayer assumed by the other party to the exchange (or of any
liabilities to which the property exchanged by the taxpayer is subject)
is to be treated as money received by the taxpayer upon the exchange,
whether or not the assumption resulted in a recognition of gain or loss
to the taxpayer under the law applicable to the year in which the
exchange was made. The application of
[[Page 94]]
this section may be illustrated by the following examples:
Example 1. B, an individual, owns an apartment house which has an
adjusted basis in his hands of $500,000, but which is subject to a
mortgage of $150,000. On September 1, 1954, he transfers the apartment
house to C, receiving in exchange therefor $50,000 in cash and another
apartment house with a fair market value on that date of $600,000. The
transfer to C is made subject to the $150,000 mortgage. B realizes a
gain of $300,000 on the exchange, computed as follows:
Value of property received................................. $600,000
Cash....................................................... 50,000
Liabilities subject to which old property was transferred.. 150,000
--------------
Total consideration received........................... 800,000
Less: Adjusted basis of property transferred............... 500,000
--------------
Gain realized.......................................... 300,000
==============
Under section 1031(b), $200,000 of the $300,000 gain is 500,000
recognized. The basis of the apartment house acquired by B
upon the exchange is $500,000, computed as follows:
Adjusted basis of property transferred....................
Less: Amount of money received:
Cash........................................ $50,000
Amount of liabilities subject to which 150,000
property was transferred...................
___ 200,000
------------
Difference................................ ........... 300,000
Plus: Amount of gain recognized upon the exchange.......... 200,000
--------------
Basis of property acquired upon the exchange........... 500,000
Example 2. (a) D, an individual, owns an apartment house. On
December 1, 1955, the apartment house owned by D has an adjusted basis
in his hands of $100,000, a fair market value of $220,000, but is
subject to a mortgage of $80,000. E, an individual, also owns an
apartment house. On December 1, 1955, the apartment house owned by E has
an adjusted basis of $175,000, a fair market value of $250,000, but is
subject to a mortgage of $150,000. On December 1, 1955, D transfers his
apartment house to E, receiving in exchange therefore $40,000 in cash
and the apartment house owned by E. Each apartment house is transferred
subject to the mortgage on it.
(b) D realizes a gain of $120,000 on the exchange, computed as
follows:
Value of property received...................... .......... $250,000
Cash........................................................ 40,000
Liabilities subject to which old property was transferred... 80,000
-------------
Total consideration received............................ 370,000
Less:
Adjusted basis of property transferred........ $100,000
Liabilities to which new property is subject.. 150,000
____ 250,000
-----------
Gain realized............................... .......... 120,000
For purposes of section 1031(b), the amount of other property or money
received by D is $40,000. (Consideration received by D in the form of a
transfer subject to a liability of $80,000 is offset by consideration
given in the form of a receipt of property subject to a $150,000
liability. Thus, only the consideration received in the form of cash,
$40,000, is treated as other property or money for purposes of section
1031(b).) Accordingly, under section 1031(b), $40,000 of the $120,000
gain is recognized. The basis of the apartment house acquired by D is
$170,000, computed as follows:
Adjusted basis of property transferred............ $100,000
Liabilities to which new property is subject...... 150,000
-----------------------
Total......................................... 250,000
Less: Amount of money $40,000
received: Cash.............
Amount of liabilities 80,000
subject to which property
was transferred............
____ 120,000
---------------------
Difference.................................... 130,000
Plus: Amount of gain recognized upon the exchange. 40,000
-----------------------
Basis of property acquired upon the exchange.. 170,000
(c) E realizes a gain of $75,000 on the exchange, computed as
follows:
Value of property received........................ $220,000
Liabilities subject to which old property was 150,000
transferred......................................
-----------------------
Total consideration received.................. 370,000
Less:
Adjusted basis of property $175,000
transferred..............
Cash...................... 40,000
Liabilities to which new 80,000
property is subject......
____ 295,000
---------------------
Gain realized................................. 75,000
For purposes of section 1031(b), the amount of other property or money
received by E is $30,000. (Consideration received by E in the form of a
transfer subject to a liability of $150,000 is offset by consideration
given in
[[Page 95]]
the form of a receipt of property subject to an $80,000 liability and by
the $40,000 cash paid by E. Although consideration received in the form
of cash or other property is not offset by consideration given in the
form of an assumption of liabilities or a receipt of property subject to
a liability, consideration given in the form of cash or other property
is offset against consideration received in the form of an assumption of
liabilities or a transfer of property subject to a liability.)
Accordingly, under section 1031(b), $30,000 of the $75,000 gain is
recognized. The basis of the apartment house acquired by E is $175,000,
computed as follows:
Adjusted basis of property transferred............ $175,000
Cash.............................................. 40,000
Liabilities to which new property is subject...... 80,000
-----------------------
Total......................................... 295,000
Less: Amount of money $150,000
received: Amount of
liabilities subject to
which property was
transferred................
____ 150,000
---------------------
Difference.................................... 145,000
Plus: Amount of gain recognized upon the exchange. 30,000
-----------------------
Basis of property acquired upon the exchange.. 175,000
Sec. 1.1031(e)-1 Exchange of livestock of different sexes.
Section 1031(e) provides that livestock of different sexes are not
property of like kind. Section 1031(e) and this section are applicable
to taxable years to which the Internal Revenue Code of 1954 applies.
[T.D. 7141, 36 FR 18792, Sept. 22, 1971]
Sec. 1.1031(j)-1 Exchanges of multiple properties.
(a) Introduction--(1) Overview. As a general rule, the application
of section 1031 requires a property-by-property comparison for computing
the gain recognized and basis of property received in a like-kind
exchange. This section provides an exception to this general rule in the
case of an exchange of multiple properties. An exchange is an exchange
of multiple properties if, under paragraph (b)(2) of this section, more
than one exchange group is created. In addition, an exchange is an
exchange of multiple properties if only one exchange group is created
but there is more than one property being transferred or received within
that exchange group. Paragraph (b) of this section provides rules for
computing the amount of gain recognized in an exchange of multiple
properties qualifying for nonrecognition of gain or loss under section
1031. Paragraph (c) of this section provides rules for computing the
basis of properties received in an exchange of multiple properties
qualifying for nonrecognition of gain or loss under section 1031.
(2) General approach. (i) In general, the amount of gain recognized
in an exchange of multiple properties is computed by first separating
the properties transferred and the properties received by the taxpayer
in the exchange into exchange groups in the manner described in
paragraph (b)(2) of this section. The separation of the properties
transferred and the properties received in the exchange into exchange
groups involves matching up properties of a like kind of like class to
the extent possible. Next, all liabilities assumed by the taxpayer as
part of the transaction are offset by all liabilities of which the
taxpayer is relieved as part of the transaction, with the excess
liabilities assumed or relieved allocated in accordance with paragraph
(b)(2)(ii) of this section. Then, the rules of section 1031 and the
regulations thereunder are applied separately to each exchange group to
determine the amount of gain recognized in the exchange. See Sec. Sec.
1.1031(b)-1 and 1.1031(c)-1. Finally, the rules of section 1031 and the
regulations thereunder are applied separately to each exchange group to
determine the basis of the properties received in the exchange. See
Sec. Sec. 1.1031(d)-1 and 1.1031(d)-2.
(ii) For purposes of this section, the exchanges are assumed to be
made at arms' length, so that the aggregate fair market value of the
property received in the exchange equals the aggregate fair market value
of the property transferred. Thus, the amount realized with respect to
the properties transferred in each exchange group is assumed to equal
their aggregate fair market value.
[[Page 96]]
(b) Computation of gain recognized--(1) In general. In computing the
amount of gain recognized in an exchange of multiple properties, the
fair market value must be determined for each property transferred and
for each property received by the taxpayer in the exchange. In addition,
the adjusted basis must be determined for each property transferred by
the taxpayer in the exchange.
(2) Exchange groups and residual group. The properties transferred
and the properties received by the taxpayer in the exchange are
separated into exchange groups and a residual group to the extent
provided in this paragraph (b)(2).
(i) Exchange groups. Each exchange group consists of the properties
transferred and received in the exchange, all of which are of a like
kind or like class. If a property could be included in more than one
exchange group, the taxpayer may include the property in any of those
exchange groups. Property eligible for inclusion within an exchange
group does not include money or property described in section 1031(a)(2)
(i.e., stock in trade or other property held primarily for sale, stocks,
bonds, notes, other securities or evidences of indebtedness or interest,
interests in a partnership, certificates of trust or beneficial
interests, or choses in action). For example, an exchange group may
consist of all exchanged properties that are within the same General
Asset Class or within the same Product Class (as defined in Sec.
1.1031(a)-2(b)). Each exchange group must consist of at least one
property transferred and at least one property received in the exchange.
(ii) Treatment of liabilities. (A) All liabilities assumed by the
taxpayer as part of the exchange are offset against all liabilities of
which the taxpayer is relieved as part of the exchange, regardless of
whether the liabilities are recourse or nonrecourse and regardless of
whether the liabilities are secured by or otherwise relate to specific
property transferred or received as part of the exchange. See Sec. Sec.
1.1031 (b)-1(c) and 1.1031(d)-2. For purposes of this section,
liabilities assumed by the taxpayer as part of the exchange consist of
liabilities of the other party to the exchange assumed by the taxpayer
and liabilities subject to which the other party's property is
transferred in the exchange. Similarly, liabilities of which the
taxpayer is relieved as part of the exchange consist of liabilities of
the taxpayer assumed by the other party to the exchange and liabilities
subject to which the taxpayer's property is transferred.
(B) If there are excess liabilities assumed by the taxpayer as part
of the exchange (i.e., the amount of liabilities assumed by the taxpayer
exceeds the amount of liabilities of which the taxpayer is relieved),
the excess is allocated among the exchange groups (but not to the
residual group) in proportion to the aggregate fair market value of the
properties received by the taxpayer in the exchange groups. The amount
of excess liabilities assumed by the taxpayer that are allocated to each
exchange group may not exceed the aggregate fair market value of the
properties received in the exchange group.
(C) If there are excess liabilities of which the taxpayer is
relieved as part of the exchange (i.e., the amount of liabilities of
which the taxpayer is relieved exceeds the amount of liabilities assumed
by the taxpayer), the excess is treated as a Class I asset for purposes
of making allocations to the residual group under paragraph (b)(2)(iii)
of this section.
(D) Paragraphs (b)(2)(ii) (A), (B), and (C) of this section are
applied in the same manner even if section 1031 and this section apply
to only a portion of a larger transaction (such as a transaction
described in section 1060(c) and Sec. 1.1060-1T(b)). In that event, the
amount of excess liabilities assumed by the taxpayer or the amount of
excess liabilities of which the taxpayer is relieved is determined based
on all liabilities assumed by the taxpayer and all liabilities of which
the taxpayer is relieve as part of the larger transaction.
(iii) Residual group. If the aggregate fair market value of the
properties transferred in all of the exchange groups differs from the
aggregate fair market value of the properties received in all of the
exchange groups (taking liabilities into account in the manner described
in paragraph (b)(2)(ii) of this section), a residual group is created.
The residual group consists of an amount of money or other property
[[Page 97]]
having an aggregate fair market value equal to that difference. The
residual group consists of either money or other property transferred in
the exchange or money or other property received in the exchange, but
not both. For this purpose, other property includes property described
in section 1031(a)(2) (i.e., stock in trade or other property held
primarily for sale, stocks, bonds, notes, other securities or evidences
of indebtedness or interest, interests in a partnership, certificates of
trust or beneficial interests, or choses in action), property
transferred that is not of a like kind or like class with any property
received, and property received that is not of a like kind or like class
with any property transferred. The money and properties that are
allocated to the residual group are considered to come from the
following assets in the following order: first from Class I assets, then
from Class II assets, then from Class III assets, and then from Class IV
assets. The terms Class I assets, Class II assets, Class III assets, and
Class IV assets have the same meanings as in Sec. 1.338-6(b), to which
reference is made by Sec. 1.1060-1(c)(2). Within each Class, taxpayers
may choose which properties are allocated to the residual group.
(iv) Exchange group surplus and deficiency. For each of the exchange
groups described in this section, an ``exchange group surplus'' or
``exchange group deficiency,'' if any, must be determined. An exchange
group surplus is the excess of the aggregate fair market value of the
properties received (less the amount of any excess liabilities assumed
by the taxpayer that are allocated to that exchange group), in an
exchange group over the aggregate fair market value of the properties
transferred in that exchange group. An exchange group deficiency is the
excess of the aggregate fair market value of the properties transferred
in an exchange group over the aggregate fair market value of the
properties received (less the amount of any excess liabilities assumed
by the taxpayer that are allocated to that exchange group) in that
exchange group.
(3) Amount of gain recognized. (i) For purposes of this section, the
amount of gain or loss realized with respect to each exchange group and
the residual group is the difference between the aggregate fair market
value of the properties transferred in that exchange group or residual
group and the properties' aggregate adjusted basis. The gain realized
with respect to each exchange group is recognized to the extent of the
lesser of the gain realized and the amount of the exchange group
deficiency, if any. Losses realized with respect to an exchange group
are not recognized. See section 1031 (a) and (c). The total amount of
gain recognized under section 1031 in the exchange is the sum of the
amount of gain recognized with respect to each exchange group. With
respect to the residual group, the gain or loss realized (as determined
under this section) is recognized as provided in section 1001 or other
applicable provision of the Code.
(ii) The amount of gain or loss realized and recognized with respect
to properties transferred by the taxpayer that are not within any
exchange group or the residual group is determined under section 1001
and other applicable provisions of the Code, with proper adjustments
made for all liabilities not allocated to the exchange groups or the
residual group.
(c) Computation of basis of properties received. In an exchange of
multiple properties qualifying for nonrecognition of gain or loss under
section 1031 and this section, the aggregate basis of properties
received in each of the exchange groups is the aggregate adjusted basis
of the properties transferred by the taxpayer within that exchange
group, increased by the amount of gain recognized by the taxpayer with
respect to that exchange group, increased by the amount of the exchange
group surplus or decreased by the amount of the exchange group
deficiency, and increased by the amount, if any, of excess liabilities
assumed by the taxpayer that are allocated to that exchange group. The
resulting aggregate basis of each exchange group is allocated
proportionately to each property received in the exchange group in
accordance with its fair market value. The basis of each property
received within the residual group (other than money) is equal to its
fair market value.
[[Page 98]]
(d) Examples. The application of this section may be illustrated by
the following examples:
Example 1. (i) K exchanges computer A (asset class 00.12) and
automobile A (asset class 00.22), both of which were held by K for
productive use in its business, with W for printer B (asset class 00.12)
and automobile B (asset class 00.22), both of which will be held by K
for productive use in its business. K's adjusted basis and the fair
market value of the exchanged properties are as follows:
------------------------------------------------------------------------
Fair market
Adjusted basis value
------------------------------------------------------------------------
Computer A.............................. $375 $1,000
Automobile A............................ 1,500 4,000
Printer B............................... .............. 2,050
Automobile B............................ .............. 2,950
------------------------------------------------------------------------
(ii) Under paragraph (b)(2) of this section, the properties
exchanged are separated into exchange groups as follows:
(A) The first exchange group consists of computer A and printer B
(both are within the same General Asset Class) and, as to K, has an
exchange group surplus of $1050 because the fair market value of printer
B ($2050) exceeds the fair market value of computer A ($1000) by that
amount.
(B) The second exchange group consists of automobile A and
automobile B (both are within the same General Asset Class) and, as to
K, has an exchange group deficiency of $1050 because the fair market
value of automobile A ($4000) exceeds the fair market value of
automobile B ($2950) by that amount.
(iii) K recognizes gain on the exchange as follows:
(A) With respect to the first exchange group, the amount of gain
realized is the excess of the fair market value of computer A ($1000)
over its adjusted basis ($375), or $625. The amount of gain recognized
is the lesser of the gain realized ($625) and the exchange group
deficiency ($0), or $0.
(B) With respect to the second exchange group, the amount of gain
realized is the excess of the fair market value of automobile A ($4000)
over its adjusted basis ($1500), or $2500. The amount of gain recognized
is the lesser of the gain realized ($2500) and the exchange group
deficiency ($1050), or $1050.
(iv) The total amount of gain recognized by K in the exchange is the
sum of the gains recognized with respect to both exchange groups ($0 +
$1050), or $1050.
(v) The bases of the property received by K in the exchange, printer
B and automobile B, are determined in the following manner:
(A) The basis of the property received in the first exchange group
is the adjusted basis of the property transferred within the exchange
group ($375), increased by the amount of gain recognized with respect to
that exchange group ($0), increased by the amount of the exchange group
surplus ($1050), and increased by the amount of excess liabilities
assumed allocated to that exchange group ($0), or $1425. Because printer
B was the only property received within the first exchange group, the
entire basis of $1425 is allocated to printer B.
(B) The basis of the property received in the second exchange group
is the adjusted basis of the property transferred within that exchange
group ($1500), increased by the amount of gain recognized with respect
to that exchange group ($1050), decreased by the amount of the exchange
group deficiency ($1050), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($0), or $1500.
Because automobile B was the only property received within the second
exchange group, the entire basis of $1500 is allocated to automobile B.
Example 2. (i) F exchanges computer A (asset class 00.12) and
automobile A (asset class 00.22), both of which were held by F for
productive use in its business, with G for printer B (asset class 00.12)
and automobile B (asset class 00.22), both of which will be held by F
for productive use in its business, and corporate stock and $500 cash.
The adjusted basis and fair market value of the properties are as
follows:
------------------------------------------------------------------------
Fair market
Adjusted basis value
------------------------------------------------------------------------
Computer A.............................. $375 $1,000
Automobile A............................ 3,500 4,000
Printer B............................... .............. 800
Automobile B............................ .............. 2,950
Corporate stock......................... .............. 750
Cash.................................... .............. 500
------------------------------------------------------------------------
(ii) Under paragraph (b)(2) of this section, the properties
exchanged are separated into exchange groups as follows:
(A) The first exchange group consists of computer A and printer B
(both are within the same General Asset Class) and, as to F, has an
exchange group deficiency of $200 because the fair market value of
computer A ($1000) exceeds the fair market value of printer B ($800) by
that amount.
(B) The second exchange group consists of automobile A and
automobile B (both are within the same General Asset Class) and, as to
F, has an exchange group deficiency of $1050 because the fair market
value of automobile A ($4000) exceeds the fair market value of
automobile B ($2950) by that amount.
(C) Because the aggregate fair market value of the properties
transferred by F in the exchange groups ($5,000) exceeds the aggregate
fair market value of the properties received by F in the exchange groups
($3750) by $1250, there is a residual group in that amount consisting of
the $500 cash and the $750 worth of corporate stock.
[[Page 99]]
(iii) F recognizes gain on the exchange as follows:
(A) With respect to the first exchange group, the amount of gain
realized is the excess of the fair market value of computer A ($1000)
over its adjusted basis ($375), or $625. The amount of gain recognized
is the lesser of the gain realized ($625) and the exchange group
deficiency ($200), or $200.
(B) With respect to the second exchange group, the amount of gain
realized is the excess of the fair market value of automobile A ($4000)
over its adjusted basis ($3500), or $500. The amount of gain recognized
is the lesser of the gain realized ($500) and the exchange group
deficiency ($1050), or $500.
(C) No property transferred by F was allocated to the residual
group. Therefore, F does not recognize gain or loss with respect to the
residual group.
(iv) The total amount of gain recognized by F in the exchange is the
sum of the gains recognized with respect to both exchange groups ($200 +
$500), or $700.
(v) The bases of the properties received by F in the exchange
(printer B, automobile B, and the corporate stock) are determined in the
following manner:
(A) The basis of the property received in the first exchange group
is the adjusted basis of the property transferred within that exchange
group ($375), increased by the amount of gain recognized with respect to
that exchange group ($200), decreased by the amount of the exchange
group deficiency ($200), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($0), or $375.
Because printer B was the only property received within the first
exchange group, the entire basis of $375 is allocated to printer B.
(B) The basis of the property received in the second exchange group
is the adjusted basis of the property transferred within that exchange
group ($3500), increased by the amount of gain recognized with respect
to that exchange group ($500), decreased by the amount of the exchange
group deficiency ($1050), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($0), or $2950.
Because automobile B was the only property received within the second
exchange group, the entire basis of $2950 is allocated to automobile B.
(C) The basis of the property received within the residual group
(the corporate stock) is equal to its fair market value or $750. Cash of
$500 is also received within the residual group.
Example 3. (i) J and H enter into an exchange of the following
properties. All of the property (except for the inventory) transferred
by J was held for productive use in J's business. All of the property
received by J will be held by J for productive use in its business.
----------------------------------------------------------------------------------------------------------------
J Transfers: H Transfers:
----------------------------------------------------------------------------------------------------------------
Adjusted Fair market Fair market
Property basis value Property value
----------------------------------------------------------------------------------------------------------------
Computer A................................ $1,500 $5,000 Computer Z................... $4,500
Computer B................................ 500 3,000 Printer Y.................... 2,500
Printer C................................. 2,000 1,500 Real Estate X................ 1,000
Real Estate D............................. 1,200 2,000 Real Estate W................ 4,000
Real Estate E............................. 0 1,800 Grader V..................... 2,000
Scraper F................................. 3,300 2,500 Truck T...................... 1,700
Inventory................................. 1,000 1,700 Cash......................... 1,800
-------------------------- ------------
Total............................... 9,500 17,500 ............................. 17,500
----------------------------------------------------------------------------------------------------------------
(ii) Under paragraph (b)(2) of this section, the properties
exchanged are separated into exchange groups as follows:
(A) The first exchange group consists of computer A, computer B,
printer C, computer Z, and printer Y (all are within the same General
Asset Class) and, as to J, has an exchange group deficiency of $2500
(($5000 + $3000 + $1500) - ($4500 + $2500)).
(B) The second exchange group consists of real estate D, E, X and W
(all are of a like kind) and, as to J, has an exchange group surplus of
$1200 (($1000 + $4000) - ($2000 + $1800)).
(C) The third exchange group consists of scraper F and grader V
(both are within the same Product Class (NAICS code 333120)) and, as to
J, has an exchange group deficiency of $500 ($2500 - $2000).
(D) Because the aggregate fair market value of the properties
transferred by J in the exchange groups ($15,800) exceeds the aggregate
fair market value of the properties received by J in the exchange groups
($14,000) by $1800, there is a residual group in that amount consisting
of the $1800 cash (a Class I asset).
(E) The transaction also includes a taxable exchange of inventory
(which is property described in section 1031 (a)(2)) for truck T (which
is not of a like kind or like class to any property transferred in the
exchange).
(iii) J recognizes gain on the transaction as follows:
[[Page 100]]
(A) With respect to the first exchange group, the amount of gain
realized is the excess of the aggregate fair market value of the
properties transferred in the exchange group ($9500) over the aggregate
adjusted basis ($4000), or $5500. The amount of gain recognized is the
lesser of the gain realized ($5500) and the exchange group deficiency
($2500), or $2500.
(B) With respect to the second exchange group, the amount of gain
realized is the excess of the aggregate fair market value of the
properties transferred in the exchange group ($3800) over the aggregate
adjusted basis ($1200), or $2600. The amount of gain recognized is the
lesser of the gain realized ($2600) and the exchange group deficiency
($0), or $0.
(C) With respect to the third exchange group, a loss is realized in
the amount of $800 because the fair market value of the property
transferred in the exchange group ($2500) is less than its adjusted
basis ($3300). Although a loss of $800 was realized, under section 1031
(a) and (c) losses are not recognized.
(D) No property transferred by J was allocated to the residual
group. Therefore, J does not recognize gain or loss with respect to the
residual group.
(E) With respect to the taxable exchange of inventory for truck T,
gain of $700 is realized and recognized by J (amount realized of $1700
(the fair market value of truck T) less the adjusted basis of the
inventory ($1000)).
(iv) The total amount of gain recognized by J in the transaction is
the sum of the gains recognized under section 1031 with respect to each
exchange group ($2500 + $0 + $0) and any gain recognized outside of
section 1031 ($700), or $3200.
(v) The bases of the property received by J in the exchange are
determined in the following manner:
(A) The aggregate basis of the properties received in the first
exchange group is the adjusted basis of the properties transferred
within that exchange group ($4000), increased by the amount of gain
recognized with respect to that exchange group ($2500), decreased by the
amount of the exchange group deficiency ($2500), and increased by the
amount of excess liabilities assumed allocated to that exchange group
($0), or $4000. This $4000 of basis is allocated proportionately among
the assets received within the first exchange group in accordance with
their fair market values: Computer Z's basis is $2571 ($4000 x $4500/
$7000); printer Y's basis is $1429 ($4000 x $2500/$7000).
(B) The aggregate basis of the properties received in the second
exchange group is the adjusted basis of the properties transferred
within that exchange group ($1200), increased by the amount of gain
recognized with respect to that exchange group ($0), increased by the
amount of the exchange group surplus ($1200), and increased by the
amount of excess liabilities assumed allocated to that exchange group
($0), or $2400. This $2400 of basis is allocated proportionately among
the assets received within the second exchange group in accordance with
their fair market values: Real estate X's basis is $480 ($2400 x $1000/
$5000); real estate W's basis is $1920 ($2400 x $4000/$5000).
(c) The basis of the property received in the third exchange group
is the adjusted basis of the property transferred within that exchange
group ($3300), increased by the amount of gain recognized with respect
to that exchange group ($0), decreased by the amount of the exchange
group deficiency ($500), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($0), or $2800.
Because grader V was the only property received within the third
exchange group, the entire basis of $2800 is allocated to grader V.
(D) Cash of $1800 is received within the residual group.
(E) The basis of the property received in the taxable exchange
(truck T) is equal to its cost of $1700.
Example 4. (i) B exchanges computer A (asset class 00.12),
automobile A (asset class 00.22) and truck A (asset class 00.241), with
C for computer R (asset class 00.12), automobile R (asset class 00.22),
truck R (asset class 00.241) and $400 cash. All properties transferred
by either B or C were held for productive use in the respective
transferor's business. Similarly, all properties to be received by
either B or C will be held for productive use in the respective
recipient's business. Automobile A, automobile R and truck R are each
secured by a nonrecourse liability and are transferred subject to such
liability. The adjusted basis, fair market value, and liability secured
by each property, if any, are as follows:
------------------------------------------------------------------------
Fair
Adjusted market Liability
basis value
------------------------------------------------------------------------
B transfers:
Computer A........................... $800 $1,500 $0
Automobile A......................... 900 2,500 500
Truck A.............................. 700 2,000 0
C transfers:
Computer R........................... 1,100 1,600 0
Automobile R......................... 2,100 3,100 750
Truck R.............................. 600 1,400 250
Cash................................. ......... 400 .........
------------------------------------------------------------------------
(ii) The tax treatment to B is as follows:
(A)(1) The first exchange group consists of computers A and R (both
are within the same General Asset Class).
(2) The second exchange group consists of automobiles A and R (both
are within the same General Asset Class).
(3) The third exchange group consists of trucks A and R (both are in
the same General Asset Class).
[[Page 101]]
(B) Under paragraph (b)(2)(ii) of this section, all liabilities
assumed by B ($1000) are offset by all liabilities of which B is
relieved ($500), resulting in excess liabilities assumed of $500. The
excess liabilities assumed of $500 is allocated among the exchange
groups in proportion to the fair market value of the properties received
by B in the exchange groups as follows:
(1) $131 of excess liabilities assumed ($500 x $1600/$6100) is
allocated to the first exchange group. The first exchange group has an
exchange group deficiency of $31 because the fair market value of
computer A ($1500) exceeds the fair market value of computer R less the
excess liabilities assumed allocated to the exchange group ($1600-$131)
by that amount.
(2) $254 of excess liabilities assumed ($500 x $3100/$6100) is
allocated to the second exchange group. The second exchange group has an
exchange group surplus of $346 because the fair market value of
automobile R less the excess liabilities assumed allocated to the
exchange group ($3100-$254) exceeds the fair market value of automobile
A ($2500) by that amount.
(3) $115 of excess liabilities assumed ($500 x $1400/$6100) is
allocated to the third exchange group. The third exchange group has an
exchange group deficiency of $715 because the fair market value of truck
A ($2000) exceeds the fair market value of truck R less the excess
liabilities assumed allocated to the exchange group ($1400-$115) by that
amount.
(4) The difference between the aggregate fair market value of the
properties transferred in all of the exchange groups, $6000, and the
aggregate fair market value of the properties received in all of the
exchange groups (taking excess liabilities assumed into account), $5600,
is $400. Therefore there is a residual group in that amount consisting
of $400 cash received.
(C) B recognizes gain on the exchange as follows:
(1) With respect to the first exchange group, the amount of gain
realized is the excess of the fair market value of computer A ($1500)
over its adjusted basis ($800), or $700. The amount of gain recognized
is the lesser of the gain realized ($700) and the exchange group
deficiency ($31), or $31.
(2) With respect to the second exchange group, the amount of gain
realized is the excess of the fair market value of automobile A ($2500)
over its adjusted basis ($900), or $1600.
The amount of gain recognized is the lesser of the gain realized
($1600) and the exchange group deficiency ($0), or $0.
(3) With respect to the third exchange group, the amount of gain
realized is the excess of the fair market value of truck A ($2000) over
its adjusted basis ($700), or $1300. The amount of gain recognized is
the lesser of gain realized ($1300) and the exchange group deficiency
($715), or $715.
(4) No property transferred by B was allocated to the residual
group. Therefore, B does not recognize gain or loss with respect to the
residual group.
(D) The total amount of gain recognized by B in the exchange is the
sum of the gains recognized under section 1031 with respect to each
exchange group ($31 + $0 + $715), or $746.
(E) the bases of the property received by B in the exchange
(computer R, automobile R, and truck R) are determined in the following
manner:
(1) The basis of the property received in the first exchange group
is the adjusted basis of the property transferred within that exchange
group ($800), increased by the amount of gain recognized with respect to
that exchange group ($31), decreased by the amount of the exchange group
deficiency ($31), and increased by the amount of excess liabilities
assumed allocated to that exchange group ($131), or $931. Because
computer R was the only property received within the first exchange
group, the entire basis of $931 is allocated to computer R.
(2) The basis of the property received in the second exchange group
is the adjusted basis of the property transferred within that exchange
group ($900), increased by the amount of gain recognized with respect to
that exchange group ($0), increased by the amount of the exchange group
surplus ($346), and increased by the amount of excess liabilities
assumed allocated to that exchange group ($254), or $1500. Because
automobile R was the only property received within the second exchange
group, the entire basis of $1500 is allocated to automobile R.
(3) The basis of the property received in the third exchange group
is the adjusted basis of the property transferred within that exchange
group ($700), increased by the amount of gain recognized with respect to
that exchange group ($715), decreased by the amount of the exchange
group deficiency ($715), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($115), or $815.
Because truck R was the only property received within the third exchange
group, the entire basis of $815 is allocated to truck R.
(F) Cash of $400 is also received by B.
(iii) The tax treatment to C is as follows:
(A) (1) The first exchange group consists of computers R and A (both
are within the same General Asset Class).
(2) The second exchange group consists of automobiles R and A (both
are within the same General Asset Class).
(3) The third exchange group consists of trucks R and A (both are in
the same General Asset Class).
(B) Under paragraph (b)(2)(ii) of this section, all liabilities of
which C is relieved ($1000) are offset by all liabilities assumed by
[[Page 102]]
C ($500), resulting in excess liabilities relieved of $500. This excess
liabilities relieved is treated as cash received by C.
(1) The first exchange group has an exchange group deficiency of
$100 because the fair market value of computer R ($1600) exceeds the
fair market value of computer A ($1500) by that amount.
(2) The second exchange group has an exchange group deficiency of
$600 because the fair market value of automobile R ($3100) exceeds the
fair market value of automobile A ($2500) by that amount.
(3) The third exchange group has an exchange group surplus of $600
because the fair market value of truck A ($2000) exceeds the fair market
value of truck R ($1400) by that amount.
(4) The difference between the aggregate fair market value of the
properties transferred by C in all of the exchange groups, $6100, and
the aggregate fair market value of the properties received by C in all
of the exchange groups, $6000, is $100. Therefore, there is a residual
group in that amount, consisting of excess liabilities relieved of $100,
which is treated as cash received by C.
(5) The $400 cash paid by C and $400 of the excess liabilities
relieved which is treated as cash received by C are not within the
exchange groups of the residual group.
(C) C recognizes gain on the exchange as follows:
(1) With respect to the first exchange group, the amount of gain
realized is the excess of the fair market value of computer R ($1600)
over its adjusted basis ($1100), or $500. The amount of gain recognized
is the lesser of the gain realized ($500) and the exchange group
deficiency ($100), or $100.
(2) With respect to the second exchange group, the amount of gain
realized is the excess of the fair market value of automobile R ($3100)
over its adjusted basis ($2100), or $1000. The amount of gain recognized
is the lesser of the gain realized ($1000) and the exchange group
deficiency ($600), or $600.
(3) With respect to the third exchange group, the amount of gain
realized is the excess of the fair market value of truck R ($1400) over
its adjusted basis ($600), or $800. The amount of gain recognized is the
lesser of gain realized ($800) and the exchange group deficiency ($0),
or $0.
(4) No property transferred by C was allocated to the residual
group. Therefore, C does not recognize any gain with respect to the
residual group.
(D) The total amount of gain recognized by C in the exchange is the
sum of the gains recognized under section 1031 with respect to each
exchange group ($100 + $600 + $0), or $700.
(E) The bases of the properties received by C in the exchange
(computer A, automobile A, and truck A) are determined in the following
manner:
(1) The basis of the property received in the first exchange group
is the adjusted basis of the property transferred within that exchange
group ($1100), increased by the amount of gain recognized with respect
to that exchange group ($100), decreased by the amount of the exchange
group deficiency ($100), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($0), or $1100.
Because computer A was the only property received within the first
exchange group, the entire basis of $1100 is allocated to computer A.
(2) The basis of the property received in the second exchange group
is the adjusted basis of the property transferred within that exchange
group ($2100), increased by the amount of gain recognized with respect
to that exchange group ($600), decreased by the amount of the exchange
group deficiency ($600), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($0), or $2100.
Because automobile A was the only property received within the second
exchange group, the entire basis of $2100 is allocated to automobile A.
(3) The basis of the property received in the third exchange group
is the adjusted basis of the property transferred within that exchange
group ($600), increased by the amount of gain recognized with respect to
that exchange group ($0), increased by the amount of the exchange group
surplus ($600), and increased by the amount of excess liabilities
assumed allocated to that exchange group ($0), or $1200. Because truck A
was the only property received within the third exchange group, the
entire basis of $1200 is allocated to truck A.
Example 5. (i) U exchanges real estate A, real estate B, and grader
A (NAICS code 333120) with V for real estate R and railroad car R
(General Asset Class 00.25). All properties transferred by either U or V
were held for productive use in the respective transferor's business.
Similarly, all properties to be received by either U or V will be held
for productive use in the respective recipient's business. Real estate R
is secured by a recourse liability and is transferred subject to that
liability. The adjusted basis, fair market value, and liability secured
by each property, if any, are as follows:
------------------------------------------------------------------------
Adjusted Fair market
basis value Liability
------------------------------------------------------------------------
U Transfers:
Real Estate A.................. $2000 $5000 ...........
Real Estate B.................. 8000 13,500 ...........
Grader A....................... 500 2000 ...........
V Transfers:
Real Estate R.................. $20,000 $26,500 $7000
Railroad car R................. 1200 1000
------------------------------------------------------------------------
(ii) The tax treatment to U is as follows:
(A) The exchange group consists of real estate A, real estate B, and
real estate R.
[[Page 103]]
(B) Under paragraph (b)(2)(ii) of this section, all liabilities
assumed by U ($7000) are excess liabilities assumed. The excess
liabilities assumed of $7000 is allocated to the exchange group.
(1) The exchange group has an exchange group surplus of $1000
because the fair market value of real estate R less the excess
liabilities assumed allocated to the exchange group ($26,500-$7000)
exceeds the aggregate fair market value of real estate A and B ($18,500)
by that amount.
(2) The difference between the aggregate fair market value of the
properties received in the exchange group (taking excess liabilities
assumed into account), $19,500, and the aggregate fair market value of
the properties transferred in the exchange group, $18,500, is $1000.
Therefore, there is a residual group in that amount consisting of $1000
(or 50 percent of the fair market value) of grader A.
(3) The transaction also includes a taxable exchange of the 50
percent portion of grader A not allocated to the residual group (which
is not of a like kind or like class to any property received by U in the
exchange) for railroad car R (which is not of a like kind or like class
to any property transferred by U in the exchange).
(C) U recognizes gain on the exchange as follows:
(1) With respect to the exchange group, the amount of the gain
realized is the excess of the aggregate fair market value of real estate
A and B ($18,500) over the aggregate adjusted basis ($10,000), or $8500.
The amount of the gain recognized is the lesser of the gain realized
($8500) and the exchange group deficiency ($0), or $0.
(2) With respect to the residual group, the amount of gain realized
and recognized is the excess of the fair market value of the 50 percent
portion of grader A that is allocated to the residual group ($1000) over
its adjusted basis ($250), or $750.
(3) With respect to the taxable exchange of the 50 percent portion
of grader A not allocated to the residual group for railroad car R, gain
of $750 is realized and recognized by U (amount realized of $1000 (the
fair market value of railroad car R) less the adjusted basis of the 50
percent portion of grader A not allocated to the residual group ($250)).
(D) The total amount of gain recognized by U in the transaction is
the sum of the gain recognized under section 1031 with respect to the
exchange group ($0), any gain recognized with respect to the residual
group ($750), and any gain recognized with respect to property
transferred that is not in the exchange group or the residual group
($750), or $1500.
(E) The bases of the property received by U in the exchange (real
estate R and railroad car R) are determined in the following manner:
(1) The basis of the property received in the exchange group is the
aggregate adjusted basis of the property transferred within that
exchange group ($10,000), increased by the amount of gain recognized
with respect to that exchange group ($0), increased by the amount of the
exchange group surplus ($1000), and increased by the amount of excess
liabilities assumed allocated to that exchange group ($7000), or
$18,000. Because real estate R is the only property received within the
exchange group, the entire basis of $18,000 is allocated to real estate
R.
(2) The basis of railroad car R is equal to its cost of $1000.
(iii) The tax treatment to V is as follows:
(A) The exchange group consists of real estate R, real estate A, and
real estate B.
(B) Under paragraph (b)(2)(ii) of this section, the liabilities of
which V is relieved ($7000) results in excess liabilities relieved of
$7000 and is treated as cash received by V.
(1) The exchange group has an exchange group deficiency of $8000
because the fair market value of real estate R ($26,500) exceeds the
aggregate fair market value of real estate A and B ($18,500) by that
amount.
(2) The difference between the aggregate fair market value of the
properties transferred by V in the exchange group, $26,500, and the
aggregate fair market value of the properties received by V in the
exchange group, $18,500, is $8000. Therefore, there is a residual group
in that amount, consisting of the excess liabilities relieved of $7000,
which is treated as cash received by V, and $1000 (or 50 percent of the
fair market value) of grader A.
(3) The transaction also includes a taxable exchange of railroad car
R (which is not of a like kind or like class to any property received by
V in the exchange) for the 50 percent portion of grader A (which is not
of a like kind or like class to any property transferred by V in the
exchange) not allocated to the residual group.
(C) V recognizes gain on the exchange as follows:
(1) With respect to the exchange group, the amount of the gain
realized is the excess of the fair market value of real estate R
($26,500) over its adjusted basis ($20,000), or $6500. The amount of the
gain recognized is the lesser of the gain realized ($6500) and the
exchange group deficiency ($8000), or $6500.
(2) No property transferred by V was allocated to the residual
group. Therefore, V does not recognize gain or loss with respect to the
residual group.
(3) With respect to the taxable exchange of railroad car R for the
50 percent portion of grader A not allocated to the exchange group or
the residual group, a loss is realized and recognized in the amount of
$200 (the excess of the $1200 adjusted basis of railroad car R over the
amount realized of $1000 (fair market value of the 50 percent portion of
grader A)).
[[Page 104]]
(D) The basis of the property received by V in the exchange (real
estate A, real estate B, and grader A) are determined in the following
manner:
(1) The basis of the property received in the exchange group is the
adjusted basis of the property transferred within that exchange group
($20,000), increased by the amount of gain recognized with respect to
that exchange group ($6500), and decreased by the amount of the exchange
group deficiency ($8000), or $18,500. This $18,500 of basis is allocated
proportionately among the assets received within the exchange group in
accordance with their fair market values: real estate A's basis is $5000
($18,500 x $5000/$18,500); real estate B's basis is $13,500 ($18,500 x
$13,500/$18,500).
(2) The basis of grader A is $2000.
(e) Effective date. Section 1.1031 (j)-1 is effective for exchanges
occurring on or after April 11, 1991.
[T.D. 8343, 56 FR 14855, Apr. 12, 1991, as amended by T.D. 8858, 65 FR
1237, Jan. 7, 2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001; T.D. 9202, 70
FR 28820, May 19, 2005]
Sec. 1.1031(k)-1 Treatment of deferred exchanges.
(a) Overview. This section provides rules for the application of
section 1031 and the regulations thereunder in the case of a ``deferred
exchange.'' For purposes of section 1031 and this section, a deferred
exchange is defined as an exchange in which, pursuant to an agreement,
the taxpayer transfers property held for productive use in a trade or
business or for investment (the ``relinquished property'') and
subsequently receives property to be held either for productive use in a
trade or business or for investment (the ``replacement property''). In
the case of a deferred exchange, if the requirements set forth in
paragraphs (b), (c), and (d) of this section (relating to identification
and receipt of replacement property) are not satisfied, the replacement
property received by the taxpayer will be treated as property which is
not of a like kind to the relinquished property. In order to constitute
a deferred exchange, the transaction must be an exchange (i.e., a
transfer of property for property, as distinguished from a transfer of
property for money). For example, a sale of property followed by a
purchase of property of a like kind does not qualify for nonrecognition
of gain or loss under section 1031 regardless of whether the
identification and receipt requirements of section 1031(a)(3) and
paragraphs (b), (c), and (d) of this section are satisfied. The transfer
of relinquished property in a deferred exchange is not within the
provisions of section 1031(a) if, as part of the consideration, the
taxpayer receives money or property which does not meet the requirements
of section 1031(a), but the transfer, if otherwise qualified, will be
within the provisions of either section 1031 (b) or (c). See Sec.
1.1031(a)-1(a)(2). In addition, in the case of a transfer of
relinquished property in a deferred exchange, gain or loss may be
recognized if the taxpayer actually or constructively receives money or
property which does not meet the requirements of section 1031(a) before
the taxpayer actually receives like-kind replacement property. If the
taxpayer actually or constructively receives money or property which
does not meet the requirements of section 1031(a) in the full amount of
the consideration for the relinquished property, the transaction will
constitute a sale, and not a deferred exchange, even though the taxpayer
may ultimately receive like-kind replacement property. For purposes of
this section, property which does not meet the requirements of section
1031(a) (whether by being described in section 1031(a)(2) or otherwise)
is referred to as ``other property.'' For rules regarding actual and
constructive receipt, and safe harbors therefrom, see paragraphs (f) and
(g), respectively, of this section. For rules regarding the
determination of gain or loss recognized and the basis of property
received in a deferred exchange, see paragraph (j) of this section.
(b) Identification and receipt requirements--(1) In general. In the
case of a deferred exchange, any replacement property received by the
taxpayer will be treated as property which is not of a like kind to the
relinquished property if--
(i) The replacement property is not ``identified'' before the end of
the ``identification period,'' or
(ii) The identified replacement property is not received before the
end of the ``exchange period.''
[[Page 105]]
(2) Identification period and exchange period. (i) The
identification period begins on the date the taxpayer transfers the
relinquished property and ends at midnight on the 45th day thereafter.
(ii) The exchange period begins on the date the taxpayer transfers
the relinquished property and ends at midnight on the earlier of the
180th day thereafter or the due date (including extensions) for the
taxpayer's return of the tax imposed by chapter 1 of subtitle A of the
Code for the taxable year in which the transfer of the relinquished
property occurs.
(iii) If, as part of the same deferred exchange, the taxpayer
transfers more than one relinquished property and the relinquished
properties are transferred on different dates, the identification period
and the exchange period are determined by reference to the earliest date
on which any of the properties are transferred.
(iv) For purposes of this paragraph (b)(2), property is transferred
when the property is disposed of within the meaning of section 1001(a).
(3) Example. This paragraph (b) may be illustrated by the following
example.
Example: (i) M is a corporation that files its Federal income tax
return on a calendar year basis. M and C enter into an agreement for an
exchange of property that requires M to transfer property X to C. Under
the agreement, M is to identify like-kind replacement property which C
is required to purchase and to transfer to M. M transfers property X to
C on November 16, 1992.
(ii) The identification period ends at midnight on December 31,
1992, the day which is 45 days after the date of transfer of property X.
The exchange period ends at midnight on March 15, 1993, the due date for
M's Federal income tax return for the taxable year in which M
transferred property X. However, if M is allowed the automatic six-month
extension for filing its tax return, the exchange period ends at
midnight on May 15, 1993, the day which is 180 days after the date of
transfer of property X.
(c) Identification of replacement property before the end of the
identification period--(1) In general. For purposes of paragraph
(b)(1)(i) of this section (relating to the identification requirement),
replacement property is identified before the end of the identification
period only if the requirements of this paragraph (c) are satisfied with
respect to the replacement property. However, any replacement property
that is received by the taxpayer before the end of the identification
period will in all events be treated as identified before the end of the
identification period.
(2) Manner of identifying replacement property. Replacement property
is identified only if it is designated as replacement property in a
written document signed by the taxpayer and hand delivered, mailed,
telecopied, or otherwise sent before the end of the identification
period to either--
(i) The person obligated to transfer the replacement property to the
taxpayer (regardless of whether that person is a disqualified person as
defined in paragraph (k) of this section); or
(ii) Any other person involved in the exchange other than the
taxpayer or a disqualified person (as defined in paragraph (k) of this
section).
Examples of persons involved in the exchange include any of the parties
to the exchange, an intermediary, an escrow agent, and a title company.
An identification of replacement property made in a written agreement
for the exchange of properties signed by all parties thereto before the
end of the identification period will be treated as satisfying the
requirements of this paragraph (c)(2).
(3) Description of replacement property. Replacement property is
identified only if it is unambiguously described in the written document
or agreement. Real property generally is unambiguously described if it
is described by a legal description, street address, or distinguishable
name (e.g., the Mayfair Apartment Building). Personal property generally
is unambiguously described if it is described by a specific description
of the particular type of property. For example, a truck generally is
unambigously described if it is described by a specific make, model, and
year.
(4) Alternative and multiple properties. (i) The taxpayer may
identify more than one replacement property. Regardless of the number of
relinguished properties transferred by the taxpayer as part of the same
deferred exchange, the maximum number of replacement properties that the
taxpayer may identify is--
[[Page 106]]
(A) Three properties without regard to the fair market values of the
properties (the ``3-property rule''), or
(B) Any number of properties as long as their aggregate fair market
value as of the end of the identification period does not exceed 200
percent of the aggregate fair market value of all the relinguished
properties as of the date the relinguished properties were transferred
by the taxpayer (the ``200-percent rule'').
(ii) If, as of the end of the identification period, the taxpayer
has identified more properties as replacement properties than permitted
by paragraph (c)(4)(i) of this section, the taxpayer is treated as if no
replacement property had been identified. The preceding sentence will
not apply, however, and an identification satisfying the requirements of
paragraph (c)(4)(i) of this section will be considered made, with
respect to--
(A) Any replacement property received by the taxpayer before the end
of the identification period, and
(B) Any replacement property identified before the end of the
identification period and received before the end of the exchange
period, but only if the taxpayer receives before the end of the exchange
period identified replacement property the fair market vlaue of which is
at least 95 percent of the aggregate fair market value of all identified
replacement properties (the ``95-percent rule'').
For this purpose, the fair market value of each identified replacement
property is determined as of the earlier of the date the property is
received by the taxpayer or the last day of the exchange period.
(iii) For purposes of applying the 3-property rule, the 200-percent
rule, and the 95-percent rule, all identifications of replacement
property, other than identifications of replacement property that have
been revoked in the manner provided in paragraph (c)(6) of this section,
are taken into account. For example, if, in a deferred exchange, B
transfers property X with a fair market value of $100,000 to C and B
receives like-kind property Y with a fair market value of $50,000 before
the end of the identification period, under paragraph (c)(1) of this
section, property Y is treated as identified by reason of being received
before the end of the identification period. Thus, under paragraph
(c)(4)(i) of this section, B may identify either two additional
replacement properties of any fair market value or any number of
additional replacement properties as long as the aggregate fair market
value of the additional replacement properties does not exceed $150,000.
(5) Incidental property disregarded. (i) Solely for purposes of
applying this paragraph (c), property that is incidental to a larger
item of property is not treated as property that is separate from the
larger item of property. Property is incidental to a larger item of
property if--
(A) In standard commercial transactions, the property is typically
transferred together with the larger item of property, and
(B) The aggregate fair market value of all of the incidental
property does not exceed 15 percent of the aggregate fair market value
of the larger item of property.
(ii) This paragraph (c)(5) may be illustrated by the following
examples.
Example 1. For purposes of paragraph (c) of this section, a spare
tire and tool kit will not be treated as separate property from a truck
with a fair market value of $10,000, if the aggregate fair market value
of the spare tire and tool kit does not exceed $1,500. For purposes of
the 3-property rule, the truck, spare tire, and tool kit are treated as
1 property. Moreover, for purposes of paragraph (c)(3) of this section
(relating to the description of replacement property), the truck, spare
tire, and tool kit are all considered to be unambiguously described if
the make, model, and year of the truck are specified, even if no
reference is made to the spare tire and tool kit.
Example 2. For purposes of paragraph (c) of this section, furniture,
laundry machines, and other miscellaneous items of personal property
will not be treated as separate property from an apartment building with
a fair market value of $1,000,000, if the aggregate fair market value of
the furniture, laundry machines, and other personal property does not
exceed $150,000. For purposes of the 3-property rule, the apartment
building, furniture, laundry machines, and other personal property are
treated as 1 property. Moreover, for purposes of paragraph (c)(3) of
this section (relating to the description of replacement property), the
apartment building, furniture, laundry machines, and other personal
[[Page 107]]
property are all considered to be unambiguously described if the legal
description, street address, or distinguishable name of the apartment
building is specified, even if no reference is made to the furniture,
laundry machines, and other personal property.
(6) Revocation of identification. An identification of replacement
property may be revoked at any time before the end of the identification
period. An identification of replacement property is revoked only if the
revocation is made in a written document signed by the taxpayer and hand
delivered, mailed, telecopied, or othewise sent before the end of the
identification period to the person to whom the identification of the
replacement property was sent. An identification of replacement property
that is made in a written agreement for the exchange of properties is
treated as revoked only if the revocation is made in a written amendment
to the agreement or in a written document signed by the taxpayer and
hand delivered, mailed, telecopied, or othewise sent before the end of
the identification period to all of the parties to the agreement.
(7) Examples. This paragraph (c) may be illustrated by the following
examples. Unless otherwise provided in an example, the following facts
are assumed: B, a calendar year taxpayer, and C agree to enter into a
deferred exchange. Pursuant to their agreement, B transfers real
property X to C on May 17, 1991. Real property X, which has been held by
B for investment, is unencumbered and has a fair market value on May 17,
1991, of $100,000. On or before July 1, 1991 (the end of the
identification period), B is to identify replacement property that is of
a like kind to real property X. On or before November 13, 1991 (the end
of the exchange period), C is required to purchase the property
identified by B and to transfer that property to B. To the extent the
fair market value of the replacement property transferred to B is
greater or less than the fair market value of real property X, either B
or C, as applicable, will make up the difference by paying cash to the
other party after the date the replacement property is received by B. No
replacement property is identified in the agreement. When subsequently
identified, the replacement property is described by legal description
and is of a like kind to real property X (determined without regard to
section 1031(a)(3) and this section). B intends to hold the replacement
property received for investment.
Example 1. (i) On July 2, 1991, B identifies real property E as
replacement property by designating real property E as replacement
property in a written document signed by B and personally delivered to
C.
(ii) Because the identification was made after the end of the
identification period, pursuant to paragraph (b)(1)(i) of this section
(relating to the identification requirement), real property E is treated
as property which is not of a like kind to real property X.
Example 2. (i) C is a corporation of which 20 percent of the
outstanding stock is owned by B. On July 1, 1991, B identifies real
property F as replacement property by designating real property F as
replacement property in a written document signed by B and mailed to C.
(ii) Because C is the person obligated to transfer the replacement
property to B, real property F is identified before the end of the
identification period. The fact that C is a ``disqualified person'' as
defined in paragraph (k) of this section does not change this result.
(iii) Real property F would also have been treated as identified
before the end of the identification period if, instead of sending the
identification to C, B had designated real property F as replacement
property in a written agreement for the exchange of properties signed by
all parties thereto on or before July 1, 1991.
Example 3. (i) On June 3, 1991, B identifies the replacement
property as ``unimproved land located in Hood County with a fair market
value not to exceed $100,000.'' The designation is made in a written
document signed by B and personally delivered to C. On July 8, 1991, B
and C agree that real property G is the property described in the June
3, 1991 document.
(ii) Because real property G was not unambiguously described before
the end of the identification period, no replacement property is
identified before the end of the identification period.
Example 4. (i) On June 28, 1991, B identifies real properties H, J,
and K as replacement properties by designating these properties as
replacement properties in a written document signed by B and personally
delivered to C. The written document provides that by August 1, 1991, B
will orally inform C which of the identified properties C is to transfer
to B. As of July 1, 1991, the fair market values of real properties H,
J, and K are $75,000, $100,000, and $125,000, respectively.
[[Page 108]]
(ii) Because B did not identify more than three properties as
replacement properties, the requirements of the 3-property rule are
satisfied, and real properties H, J, and K are all identified before the
end of the identification period.
Example 5. (i) On May 17, 1991, B identifies real properties L, M,
N, and P as replacement properties by designating these properties as
replacement properties in a written document signed by B and personally
delivered to C. The written document provides that by July 2, 1991, B
will orally inform C which of the identified properties C is to transfer
to B. As of July 1, 1991, the fair market values of real properties L,
M, N, and P are $30,000, $40,000, $50,000, and $60,000, respectively.
(ii) Although B identified more than three properties as replacement
properties, the aggregate fair market value of the identified properties
as of the end of the identification period ($180,000) did not exceed 200
percent of the aggregate fair market value of real property X (200% x
$100,000 = $200,000). Therefore, the requirements of the 200-percent
rule are satisfied, and real properties L, M, N, and P are all
identified before the end of the identification period.
Example 6. (i) On June 21, 1991, B identifies real properties Q, R,
and S as replacement properties by designating these properties as
replacement properties in a written document signed by B and mailed to
C. On June 24, 1991, B identifies real properties T and U as replacement
properties in a written document signed by B and mailed to C. On June
28, 1991, B revokes the identification of real properties Q and R in a
written document signed by B and personally delivered to C.
(ii) B has revoked the identification of real properties Q and R in
the manner provided by paragraph (c)(6) of this section. Identifications
of replacement property that have been revoked in the manner provided by
paragraph (c)(6) of this section are not taken into account for purposes
of applying the 3-property rule. Thus, as of June 28, 1991, B has
identified only replacement properties S, T, and U for purposes of the
3-property rule. Because B did not identify more than three properties
as replacement properties for purposes of the 3-property rule, the
requirements of that rule are satisfied, and real properties S, T, and U
are all identified before the end of the identification period.
Example 7. (i) On May 20, 1991, B identifies real properties V and W
as replacement properties by designating these properties as replacement
properties in a written document signed by B and personally delivered to
C. On June 4, 1991, B identifies real properties Y and Z as replacement
properties in the same manner. On June 5, 1991, B telephones C and
orally revokes the identification of real properties V and W. As of July
1, 1991, the fair market values of real properties V, W, Y, and Z are
$50,000, $70,000, $90,000, and $100,000, respectively. On July 31, 1991,
C purchases real property Y and Z and transfers them to B.
(ii) Pursuant to paragraph (c)(6) of this section (relating to
revocation of identification), the oral revocation of the identification
of real properties V and W is invalid. Thus, the identification of real
properties V and W is taken into account for purposes of determining
whether the requirements of paragraph (c)(4) of this section (relating
to the identification of alternative and multiple properties) are
satisfied. Because B identified more than three properties and the
aggregate fair market value of the identified properties as of the end
of the identification period ($310,000) exceeds 200 percent of the fair
market value of real property X (200% x $100,000 = $200,000), the
requirements of paragraph (c)(4) of this section are not satisfied, and
B is treated as if B did not identify any replacement property.
(d) Receipt of identified replacement property--(1) In general. For
purposes of paragraph (b)(1)(ii) of this section (relating to the
receipt requirement), the identified replacement property is received
before the end of the exchange period only if the requriements of this
paragraph (d) are satisfied with respect to the replacement property. In
the case of a deferred exchange, the identified replacement property is
received before the end of the exchange period if--
(i) The taxpayer receives the replacement property before the end of
the exchange period, and
(ii) The replacement property received is substantially the same
property as identified.
If the taxpayer has identified more than one replacement property,
section 1031(a)(3)(B) and this paragraph (d) are applied separately to
each replacement property.
(2) Examples. This paragraph (d) may be illustrated by the following
examples. The following facts are assumed: B, a calendar year taxpayer,
and C agree to enter into a deferred exchange. Pursuant to their
agreement, B transfers real property X to C on May 17, 1991. Real
property X, which has been held by B for investment, is unencumbered and
has a fair market value on May 17, 1991, of $100,000. On or before July
1, 1991 (the end of the identification period), B is to identify
replacement property that is of a like
[[Page 109]]
kind to real property X. On or before November 13, 1991 (the end of the
exchange period), C is required to purchase the property identified by B
and to transfer that property to B. To the extent the fair market value
of the replacement property transferred to B is greater or less than the
fair market value of real property X, either B or C, as applicable, will
make up the difference by paying cash to the other party after the date
the replacement property is received by B. The replacement property is
identified in a manner that satisfies paragraph (c) of this section
(relating to identification of replacement property) and is of a like
kind to real property X (determined without regard to section 1031(a)(3)
and this section). B intends to hold any replacement property received
for investment.
Example 1. (i) In the agreement, B identifies real properties J, K,
and L as replacement properties. The agreement provides that by July 26,
1991, B will orally inform C which of the properties C is to transfer to
B.
(ii) As of July 1, 1991, the fair market values of real properties
J, K, and L are $75,000, $100,000, and $125,000, respectively. On July
26, 1991, B instructs C to acquire real property K. On October 31, 1991,
C purchases real property K for $100,000 and transfers the property to
B.
(iii) Because real property K was identified before the end of the
identification period and was received before the end of the exchange
period, the identification and receipt requirements of section
1031(a)(3) and this section are satisfied with respect to real property
K.
Example 2. (i) In the agreement, B identifies real property P as
replacement property. Real property P consists of two acres of
unimproved land. On October 15, 1991, the owner of real property P
erects a fence on the property. On November 1, 1991, C purchases real
property P and transfers it to B.
(ii) The erection of the fence on real property P subsequent to its
identification did not alter the basic nature or character of real
property P as unimproved land. B is considered to have received
substantially the same property as identified.
Example 3. (i) In the agreement, B identifies real property Q as
replacement property. Real property Q consists of a barn on two acres of
land and has a fair market value of $250,000 ($187,500 for the barn and
underlying land and $87,500 for the remaining land). As of July 26,
1991, real property Q remains unchanged and has a fair market value of
$250,000. On that date, at B's direction, C purchases the barn and
underlying land for $187,500 and transfers it to B, and B pays $87,500
to C.
(ii) The barn and underlying land differ in basic nature or
character from real property Q as a whole, B is not considered to have
received substantially the same property as identified.
Example 4. (i) In the agreement, B identifies real property R as
replacement property. Real property R consists of two acres of
unimproved land and has a fair market value of $250,000. As of October
3, 1991, real property R remains unimproved and has a fair market value
of $250,000. On that date, at B's direction, C purchases 1\1/2\ acres of
real property R for $187,500 and transfers it to B, and B pays $87,500
to C.
(ii) The portion of real property R that B received does not differ
from the basic nature or character of real property R as a whole.
Moreover, the fair market value of the portion of real property R that B
received ($187,500) is 75 percent of the fair market value of real
property R as of the date of receipt. Accordingly, B is considered to
have received substantially the same property as identified.
(e) Special rules for identification and receipt of replacement
property to be produced--(1) In general. A transfer of relinquished
property in a deferred exchange will not fail to qualify for
nonrecognition of gain or loss under section 1031 merely because the
replacement property is not in existence or is being produced at the
time the property is identified as replacement property. For purposes of
this paragraph (e), the terms ``produced'' and ``production'' have the
same meanings as provided in section 263A(g)(1) and the regulations
thereunder.
(2) Identification of replacement property to be produced. (i) In
the case of replacement property that is to be produced, the replacement
property must be identified as provided in paragraph (c) of this section
(relating to identification of replacement property). For example, if
the identified replacement property consists of improved real property
where the improvements are to be constructed, the description of the
replacement property satisfies the requirements of paragraph (c)(3) of
this section (relating to description of replacement property) if a
legal description is provided for the underlying land and as much detail
is provided regarding construction of the improvements
[[Page 110]]
as is practicable at the time the identification is made.
(ii) For purposes of paragraphs (c)(4)(i)(B) and (c)(5) of this
section (relating to the 200-percent rule and incidental property), the
fair market value of replacement property that is to be produced is its
estimated fair market value as of the date it is expected to be received
by the taxpayer.
(3) Receipt of replacement property to be produced. (i) For purposes
of paragraph (d)(1)(ii) of this section (relating to receipt of the
identified replacement property), in determining whether the replacement
property received by the taxpayer is substantially the same property as
identified where the identified replacement property is property to be
produced, variations due to usual or typical production changes are not
taken into account. However, if substantial changes are made in the
property to be produced, the replacement property received will not be
considered to be substantially the same property as identified.
(ii) If the identified replacement property is personal property to
be produced, the replacement property received will not be considered to
be substantially the same property as identified unless production of
the replacement property received is completed on or before the date the
property is received by the taxpayer.
(iii) If the identified replacement property is real property to be
produced and the production of the property is not completed on or
before the date the taxpayer receives the property, the property
received will be considered to be substantially the same property as
identified only if, had production been completed on or before the date
the taxpayer receives the replacement property, the property received
would have been considered to be substantially the same property as
identified. Even so, the property received is considered to be
substantially the same property as identified only to the extent the
property received constitutes real property under local law.
(4) Additional rules. The transfer of relinquished property is not
within the provisions of section 1031(a) if the relinquished property is
transferred in exchange for services (including production services).
Thus, any additional production occurring with respect to the
replacement property after the property is received by the taxpayer will
not be treated as the receipt of property of a like kind.
(5) Example. This paragraph (e) may be illustrated by the following
example.
Example: (i) B, a calendar year taxpayer, and C agree to enter into
a deferred exchange. Pursuant to their agreement, B transfers improved
real property X and personal property Y to C on May 17, 1991. On or
before November 13, 1991 (the end of the exchange period), C is required
to transfer to B real property M, on which C is constructing
improvements, and personal property N, which C is producing. C is
obligated to complete the improvements and production regardless of when
properties M and N are transferred to B. Properties M and N are
identified in a manner that satisfies paragraphs (c) (relating to
identification of replacement property) and (e)(2) of this section. In
addition, properties M and N are of a like kind, respectively, to real
property X and personal property Y (determined without regard to section
1031(a)(3) and this section). On November 13, 1991, when construction of
the improvements to property M is 20 percent completed and the
production of property N is 90 percent completed, C transfers to B
property M and property N. If construction of the improvements had been
completed, property M would have been considered to be substantially the
same property as identified. Under local law, property M constitutes
real property to the extent of the underlying land and the 20 percent of
the construction that is completed.
(ii) Because property N is personal property to be produced and
production of property N is not completed before the date the property
is received by B, property N is not considered to be substantially the
same property as identified and is treated as property which is not of a
like kind to property Y.
(iii) Property M is considered to be substantially the same property
as identified to the extent of the underlying land and the 20 percent of
the construction that is completed when property M is received by B.
However, any additional construction performed by C with respect to
property M after November 13, 1991, is not treated as the receipt of
property of a like kind.
(f) Receipt of money or other property--(1) In general. A transfer
of relinquished property in a deferred exchange is not within the
provisions of section 1031(a)
[[Page 111]]
if, as part of the consideration, the taxpayer receives money or other
property. However, such a transfer, if otherwise qualified, will be
within the provisions of either section 1031 (b) or (c). See Sec.
1.1031(a)-1(a)(2). In addition, in the case of a transfer of
relinquished property in a deferred exchange, gain or loss may be
recognized if the taxpayer actually or constructively receives money or
other property before the taxpayer actually receives like-kind
replacement property. If the taxpayer actually or constructively
receives money or other property in the full amount of the consideration
for the relinquished property before the taxpayer actually receives
like-kind replacement property, the transaction will constitute a sale
and not a deferred exchange, even though the taxpayer may ultimately
receive like-kind replacement property.
(2) Actual and constructive receipt. Except as provided in paragraph
(g) of this section (relating to safe harbors), for purposes of section
1031 and this section, the determination of whether (or the extent to
which) the taxpayer is in actual or constructive receipt of money or
other property before the taxpayer actually receives like-kind
replacement property is made under the general rules concerning actual
and constructive receipt and without regard to the taxpayer's method of
accounting. The taxpayer is in actual receipt of money or property at
the time the taxpayer actually receives the money or property or
receives the economic benefit of the money or property. The taxpayer is
in constructive receipt of money or property at the time the money or
property is credited to the taxpayer's account, set apart for the
taxpayer, or otherwise made available so that the taxpayer may draw upon
it at any time or so that the taxpayer can draw upon it if notice of
intention to draw is given. Although the taxpayer is not in constructive
receipt of money or property if the taxpayer's control of its receipt is
subject to substantial limitations or restrictions, the taxpayer is in
constructive receipt of the money or property at the time the
limitations or restrictions lapse, expire, or are waived. In addition,
actual or constructive receipt of money or property by an agent of the
taxpayer (determined without regard to paragraph (k) of this section) is
actual or constructive receipt by the taxpayer.
(3) Example. This paragraph (f) may be illustrated by the following
example.
Example: (i) B, a calendar year taxpayer, and C agree to enter into
a deferred exchange. Pursuant to the agreement, on May 17, 1991, B
transfers real property X to C. Real property X, which has been held by
B for investment, is unencumbered and has a fair market value on May 17,
1991, of $100,000. On or before July 1, 1991 (the end of the
identification period), B is to identify replacement property that is of
a like kind to real property X. On or before November 13, 1991 (the end
of the exchange period), C is required to purchase the property
identified by B and to transfer that property to B. At any time after
May 17, 1991, and before C has purchased the replacement property, B has
the right, upon notice, to demand that C pay $100,000 in lieu of
acquiring and transferring the replacement property. Pursuant to the
agreement, B identifies replacement property, and C purchases the
replacement property and transfers it to B.
(ii) Under the agreement, B has the unrestricted right to demand the
payment of $100,000 as of May 17, 1991. B is therefore in constructive
receipt of $100,000 on that date. Because B is in constructive receipt
of money in the full amount of the consideration for the relinquished
property before B actually receives the like-kind replacement property,
the transaction constitutes a sale, and the transfer of real property X
does not qualify for nonrecognition of gain or loss under section 1031.
B is treated as if B received the $100,000 in consideration for the sale
of real property X and then purchased the like-kind replacement
property.
(iii) If B's right to demand payment of the $100,000 were subject to
a substantial limitation or restriction (e.g., the agreement provided
that B had no right to demand payment before November 14, 1991 (the end
of the exchange period)), then, for purposes of this section, B would
not be in actual or constructive receipt of the money unless (or until)
the limitation or restriction lapsed, expired, or was waived.
(g) Safe harbors--(1) In general. Paragraphs (g)(2) through (g)(5)
of this section set forth four safe harbors the use of which will result
in a determination that the taxpayer is not in actual or constructive
receipt of money or other property for purposes of section 1031 and this
section. More than one safe harbor can be used in the same deferred
[[Page 112]]
exchange, but the terms and conditions of each must be separately
satisfied. For purposes of the safe harbor rules, the term ``taxpayer''
does not include a person or entity utilized in a safe harbor (e.g., a
qualified intermediary). See paragraph (g)(8), Example 3(v), of this
section.
(2) Security or guarantee arrangements. (i) In the case of a
deferred exchange, the determination of whether the taxpayer is in
actual or constructive receipt of money or other property before the
taxpayer actually receives like-kind replacement property will be made
without regard to the fact that the obligation of the taxpayer's
transferee to transfer the replacement property to the taxpayer is or
may be secured or guaranteed by one or more of the following--
(A) A mortgage, deed of trust, or other security interest in
property (other than cash or a cash equivalent),
(B) A standby letter of credit which satisfies all of the
requirements of Sec. 15A.453-1 (b)(3)(iii) and which may not be drawn
upon in the absence of a default of the transferee's obligation to
transfer like-kind replacement property to the taxpayer, or
(C) A guarantee of a third party.
(ii) Paragraph (g)(2)(i) of this section ceases to apply at the time
the taxpayer has an immediate ability or unrestricted right to receive
money or other property pursuant to the security or guarantee
arrangement.
(3) Qualified escrow accounts and qualified trusts. (i) In the case
of a deferred exchange, the determination of whether the taxpayer is in
actual or constructive receipt of money or other property before the
taxpayer actually receives like-kind replacement property will be made
without regard to the fact that the obligation of the taxpayer's
transferee to transfer the replacement property to the taxpayer is or
may be secured by cash or a cash equivalent if the cash or cash
equivalent is held in a qualified escrow account or in a qualified
trust.
(ii) A qualified escrow account is an escrow account wherein--
(A) The escrow holder is not the taxpayer or a disqualified person
(as defined in paragraph (k) of this section), and
(B) The escrow agreement expressly limits the taxpayer's rights to
receive, pledge, borrow, or otherwise obtain the benefits of the cash or
cash equivalent held in the escrow account as provided in paragraph
(g)(6) of this section.
(iii) A qualified trust is a trust wherein--
(A) The trustee is not the taxpayer or a disqualified person (as
defined in paragraph (k) of this section, except that for this purpose
the relationship between the taxpayer and the trustee created by the
qualified trust will not be considered a relationship under section
267(b)), and
(B) The trust agreement expressly limits the taxpayer's rights to
receive, pledge, borrow, or otherwise obtain the benefits of the cash or
cash equivalent held by the trustee as provided in paragraph (g)(6) of
this section.
(iv) Paragraph (g)(3)(i) of this section ceases to apply at the time
the taxpayer has an immediate ability or unrestricted right to receive,
pledge, borrow, or otherwise obtain the benefits of the cash or cash
equivalent held in the qualified escrow account or qualified trust.
Rights conferred upon the taxpayer under state law to terminate or
dismiss the escrow holder of a qualified escrow account or the trustee
of a qualified trust are disregarded for this purpose.
(v) A taxpayer may receive money or other property directly from a
party to the exchange, but not from a qualified escrow account or a
qualified trust, without affecting the application of paragraph
(g)(3)(i) of this section.
(4) Qualified intermediaries. (i) In the case of a taxpayer's
transfer of relinquished property involving a qualified intermediary,
the qualified intermediary is not considered the agent of the taxpayer
for purposes of section 1031(a). In such a case, the taxpayer's transfer
of relinquished property and subsequent receipt of like-kind replacement
property is treated as an exchange, and the determination of whether the
taxpayer is in actual or constructive receipt of money or other property
before the taxpayer actually receives like-kind replacement property is
made as if the qualified intermediary is not the agent of the taxpayer.
[[Page 113]]
(ii) Paragraph (g)(4)(i) of this section applies only if the
agreement between the taxpayer and the qualified intermediary expressly
limits the taxpayer's rights to receive, pledge, borrow, or otherwise
obtain the benefits of money or other property held by the qualified
intermediary as provided in paragraph (g)(6) of this section.
(iii) A qualified intermediary is a person who--
(A) Is not the taxpayer or a disqualified person (as defined in
paragraph (k) of this section), and
(B) Enters into a written agreement with the taxpayer (the
``exchange agreement'') and, as required by the exchange agreement,
acquires the relinquished property from the taxpayer, transfers the
relinquished property, acquires the replacement property, and transfers
the replacement property to the taxpayer.
(iv) Regardless of whether an intermediary acquires and transfers
property under general tax principals, solely for purposes of paragraph
(g)(4)(iii)(B) of this section--
(A) An intermediary is treated as acquiring and transferring
property if the intermediary acquires and transfers legal title to that
property,
(B) An intermediary is treated as acquiring and transferring the
relinquished property if the intermediary (either on its own behalf or
as the agent of any party to the transaction) enters into an agreement
with a person other than the taxpayer for the transfer of the
relinquished property to that person and, pursuant to that agreement,
the relinquished property is transferred to that person, and
(C) An intermediary is treated as acquiring and transferring
replacement property if the intermediary (either on its own behalf or as
the agent of any party to the transaction) enters into an agreement with
the owner of the replacement property for the transfer of that property
and, pursuant to that agreement, the replacement property is transferred
to the taxpayer.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of
this section, an intermediary is treated as entering into an agreement
if the rights of a party to the agreement are assigned to the
intermediary and all parties to that agreement are notified in writing
of the assignment on or before the date of the relevent transfer of
property. For example, if a taxpayer enters into an agreement for the
transfer of relinquished property and thereafter assigns its rights in
that agreement to an intermediary and all parties to that agreement are
notified in writing of the assignment on or before the date of the
transfer of the relinquished property, the intermediary is treated as
entering into that agreement. If the relinquished property is
transferred pursuant to that agreement, the intermediary is treated as
having acquired and transferred the relinquished property.
(vi) Paragraph (g)(4)(i) of this section ceases to apply at the time
the taxpayer has an immediate ability or unrestricted right to receive,
pledge, borrow, or otherwise obtain the benefits of money or other
property held by the qualified intermediary. Rights conferred upon the
taxpayer under state law to terminate or dismiss the qualified
intermediary are disregarded for this purpose.
(vii) A taxpayer may receive money or other property directly from a
party to the transaction other than the qualified intermediary without
affecting the application of paragraph (g)(4)(i) of this section.
(5) Interest and growth factors. In the case of a deferred exchange,
the determination of whether the taxpayer is in actual or constructive
receipt of money or other property before the taxpayer actually receives
the like-kind replacement property will be made without regard to the
fact that the taxpayer is or may be entitled to receive any interest or
growth factor with respect to the deferred exchange. The preceding
sentence applies only if the agreement pursuant to which the taxpayer is
or may be entitled to the interest or growth factor expressly limits the
taxpayer's rights to receive the interest or growth factor as provided
in paragragh (g)(6) of this section. For additional rules concerning
interest or growth factors, see paragraph (h) of this section.
(6) Additional restrictions on safe harbors under paragraphs (g)(3)
through
[[Page 114]]
(g)(5). (i) An agreement limits a taxpayer's rights as provided in this
paragraph (g)(6) only if the agreement provides that the taxpayer has no
rights, except as provided in paragraph (g)(6)(ii) and (g)(6)(iii) of
this section, to receive, pledge, borrow, or otherwise obtain the
benefits of money or other property before the end of the exchange
period.
(ii) The agreement may provide that if the taxpayer has not
identified replacement property by the end of the identification period,
the taxpayer may have rights to receive, pledge, borrow, or othewise
obtain the benefits of money or other property at any time after the end
of the identification period.
(iii) The agreement may provide that if the taxpayer has identified
replacement property, the taxpayer may have rights to receive, pledge,
borrow, or otherwise obtain the benefits of money or other property upon
or after--
(A) The receipt by the taxpayer of all of the replacement property
to which the taxpayer is entitled under the exchange agreement, or
(B) The occurrence after the end of the identification period of a
material and substantial contingency that--
(1) Relates to the deferred exchange,
(2) Is provided for in writing, and
(3) Is beyond the control of the taxpayer and of any disqualified
person (as defined in paragraph (k) of this section), other than the
person obligated to transfer the replacement property to the taxpayer.
(7) Items disregarded in applying safe harbors under paragraphs
(g)(3) through (g)(5). In determining whether a safe harbor under
paragraphs (g)(3) through (g)(5) of this section ceases to apply and
whether the taxpayer's rights to receive, pledge, borrow, or otherwise
obtain the benefits of money or other property are expressly limited as
provided in paragraph (g)(6) of this section, the taxpayer's receipt of
or right to receive any of the following items will be disregarded--
(i) Items that a seller may receive as a consequence of the
disposition of property and that are not included in the amount realized
from the disposition of property (e.g., prorated rents), and
(ii) Transactional items that relate to the disposition of the
relinquished property or to the acquisition of the replacement property
and appear under local standards in the typical closing statements as
the responsibility of a buyer or seller (e.g., commissions, prorated
taxes, recording or transfer taxes, and title company fees).
(8) Examples. This paragraph (g) may be illustrated by the following
examples. Unless otherwise provided in an example, the following facts
are assumed: B, a calendar year taxpayer, and C agree to enter into a
deferred exchange. Pursuant to their agreement, B is to transfer real
property X to C on May 17, 1991. Real property X, which has been held by
B for investment, is unencumbered and has a fair market value on May 17,
1991, of $100,000. On or before July 1, 1991 (the end of the
identification period), B is to identify replacement property that is of
a like kind to real property X. On or before November 13, 1991 (the end
of the exchange period), C is required to purchase the property
identified by B and to transfer that property to B. To the extent the
fair market value of the replacement property transferred to B is
greater or less than the fair market value property X, either B or C, as
applicable, will make up the difference by paying cash to the other
party after the date the replacement property is received by B. The
replacement property is identified as provided in paragraph (c) of this
section (relating to identification of replacement property) and is of a
like kind to real property X (determined without regard to section
1031(a)(3) and this section). B intends to hold any replacement property
received for investment.
Example 1. (i) On May 17, 1991, B transfers real property X to C. On
the same day, C pays $10,000 to B and deposits $90,000 in escrow as
security for C's obligation to perform under the agreement. The escrow
agreement provides that B has no rights to receive, pledge, borrow, or
otherwise obtain the benefits of the money in escrow before November 14,
1991, except that:
(A) if B fails to identify replacement property on or before July 1,
1991, B may demand the funds in escrow at any time after July 1, 1991;
and
(B) if B identifies and receives replacement property, then B may
demand the balance of
[[Page 115]]
the remaining funds in escrow at any time after B has received the
replacement property.
The funds in escrow may be used to purchase the replacement
property. The escrow holder is not a disqualified person as defined in
paragraph (k) of this section. Pursuant to the terms of the agreement, B
identifies replacement property, and C purchases the replacement
property using the funds in escrow and tranfers the replacement property
to B.
(ii) C's obligation to transfer the replacement property to B was
secured by cash held in a qualified escrow account because the escrow
holder was not a disqualified person and the escrow agreement expressly
limited B's rights to receive, pledge, borrow, or otherwise obtain the
benefits of the money in escrow as provided in paragraph (g)(6) of this
section. In addition, B did not have the immediate ability or
unrestricted right to receive money or other property in escrow before B
actually received the like-kind replacement property. Therefore, for
purposes of section 1031 and this section, B is determined not to be in
actual or constructive receipt of the $90,000 held in escrow before B
received the like-kind replacement property. The transfer of real
property X by B and B's acquisition of the replacement property qualify
as an exchange under section 1031. See paragraph (j) of this section for
determining the amount of gain or loss recognized.
Example 2. (i) On May 17, 1991, B transfers real property X to C,
and C deposits $100,000 in escrow as security for C's obligation to
perform under the agreement. Also on May 17, B identifies real property
J as replacement property. The escrow agreement provides that no funds
may be paid out without prior written approval of both B and C. The
escrow agreement also provides that B has no rights to receive, pledge,
borrow, or otherwise obtain the benefits of the money in escrow before
November 14, 1991, except that:
(A) B may demand the funds in escrow at any time after the later of
July 1, 1991, and the occurrence of any of the following events--
(1) real property J is destroyed, seized, requisitioned, or
condemned, or
(2) a determination is made that the regulatory approval necessary
for the transfer of real property J cannot be obtained in time for real
property J to be transferred to B before the end of the exchange period;
(B) B may demand the funds in escrow at any time after August 14,
1991, if real property J has not been rezoned from residential to
commercial use by that date; and
(C) B may demand the funds in escrow at the time B receives real
property J or any time thereafter.
Otherwise, B is entitled to all funds in escrow after November 13,
1991. The funds in escrow may be used to purchase the replacement
property. The escrow holder is not a disqualified person as described in
paragraph (k) of this section. Real property J is not rezoned from
residential to commercial use on or before August 14, 1991.
(ii) C's obligation to transfer the replacement property to B was
secured by cash held in a qualified escrow account because the escrow
holder was not a disqualified person and the escrow agreement expressly
limited B's rights to receive, pledge, borrow, or otherwise obtain the
benefits of the money in escrow as provided in paragraph (g)(6) of this
section. From May 17, 1991, until August 15, 1991, B did not have the
immediate ability or unrestricted right to receive money or other
property before B actually received the like-kind replacement property.
Therefore, for purposes of section 1031 and this section, B is
determined not to be in actual or constructive receipt of the $100,000
in escrow from May 17, 1991, until August 15, 1991. However, on August
15, 1991, B had the unrestricted right, upon notice, to draw upon the
$100,000 held in escrow. Thus, the safe harbor ceased to apply and B was
in constructive receipt of the funds held in escrow. Because B
constructively received the full amount of the consideration ($100,000)
before B actually received the like-kind replacement property, the
transaction is treated as a sale and not as a deferred exchange. The
result does not change even if B chose not to demand the funds in escrow
and continued to attempt to have real property J rezoned and to receive
the property on or before November 13, 1991.
(iii) If real property J had been rezoned on or before August 14,
1991, and C had purchased real property J and transferred it to B on or
before November 13, 1991, the transaction would have qualified for
nonrecognition of gain or loss under section 1031(a).
Example 3. (i) On May 1, 1991, D offers to purchase real property X
for $100,000. However, D is unwilling to participate in a like-kind
exchange. B thus enters into an exchange agreement with C whereby B
retains C to facilitate an exchange with respect to real property X. C
is not a disqualified person as described in paragraph (k) of this
section. The exchange agreement between B and C provides that B is to
execute and deliver a deed conveying real property X to C who, in turn,
is to execute and deliver a deed conveying real property X to D. The
exchange agreement expressly limits B's rights to receive, pledge,
borrow, or otherwise obtain the benefits of money or other property held
by C as provided in paragraph (g)(6) of this section. On May 3, 1991, C
enters into an agreement with D to transfer real property X to D for
$100,000. On May 17, 1991, B executes and delivers to C a deed conveying
real property X to C. On the same date, C executes
[[Page 116]]
and delivers to D a deed conveying real property X to D, and D deposits
$100,000 in escrow. The escrow holder is not a disqualified person as
defined in paragraph (k) of this section and the escrow agreement
expressly limits B's rights to receive, pledge, borrow, or otherwise
obtain the benefits of money or other property in escrow as provided in
paragraph (g)(6) of this section. However, the escrow agreement provides
that the money in escrow may be used to purchase replacement property.
On June 3, 1991, B identifies real property K as replacement property.
On August 9, 1991, E executes and delivers to C a deed conveying real
property K to C and $80,000 is released from the escrow and paid to E.
On the same date, C executes and delivers to B a deed conveying real
property K to B, and the escrow holder pays B $20,000, the balance of
the $100,000 sale price of real property X remaining after the purchase
of real property K for $80,000.
(ii) B and C entered into an exchange agreement that satisfied the
requirements of paragraph (g)(4)(iii)(B) of this section. Regardless of
whether C may have acquired and transferred real property X under
general tax principles, C is treated as having acquired and transferred
real property X because C acquired and transferred legal title to real
property X. Similarly, C is treated as having acquired and transferred
real property K because C acquired and transferred legal title to real
property K. Thus, C was a qualified intermediary. This result is reached
for purposes of this section regardless of whether C was B's agent under
state law.
(iii) Because the escrow holder was not a disqualified person and
the escrow agreement expressly limited B's rights to receive, pledge,
borrow, or otherwise obtain the benefits of money or other property in
escrow as provided in paragraph (g)(6) of this section, the escrow
account was a qualified escrow account. For purposes of section 1031 and
this section, therefore, B is determined not to be in actual or
constructive receipt of the funds in escrow before B received real
property K.
(iv) The exchange agreement between B and C expressly limited B's
rights to receive, pledge, borrow, or otherwise obtain the benefits of
any money held by C as provided in paragraph (g)(6) of this section.
Because C was a qualified intermediary, for purposes of section 1031 and
this section B is determined not to be in actual or constructive receipt
of any funds held by C before B received real property K. In addition,
B's transfer of real property X and acquisition of real property K
qualify as an exchange under section 1031. See paragraph (j) of this
section for determining the amount of gain or loss recognized.
(v) If the escrow agreement had expressly limited C's rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or
other property in escrow as provided in paragraph (g)(6) of this
section, but had not expressly limited B's rights to receive, pledge,
borrow, or otherwise obtain the benefits of that money or other
property, the escrow account would not have been a qualified escrow
account. Consequently, paragraph (g)(3)(i) of this section would not
have been applicable in determining whether B was in actual or
constructive receipt of that money or other property before B received
real property K.
Example 4. (i) On May 1, 1991, B enters into an agreement to sell
real property X to D for $100,000 on May 17, 1991. However, D is
unwilling to participate in a like-kind exchange. B thus enters into an
exchange agreement with C whereby B retains C to facilitate an exchange
with respect to real property X. C is not a disqualified person as
described in paragraph (k) of this section. In the exchange agreement
between B and C, B assigns to C all of B's rights in the agreement with
D. The exchange agreement expressly limits B's rights to receive,
pledge, borrow, or otherwise obtain the benefits of money or other
property held by C as provided in paragraph (g)(6) of this section. On
May 17, 1991, B notifies D in writing of the assignment. On the same
date, B executes and delivers to D a deed conveying real property X to
D. D pays $10,000 to B and $90,000 to C. On June 1, 1991, B identifies
real property L as replacement property. On July 5, 1991, B enters into
an agreement to purchase real property L from E for $90,000, assigns its
rights in that agreement to C, and notifies E in writing of the
assignment. On August 9, 1991, C pays $90,000 to E, and E executes and
delivers to B a deed conveying real property L to B.
(ii) The exchange agreement entered into by B and C satisfied the
requirements of paragraph (g)(4)(iii)(B) of this section. Because B's
rights in its agreements with D and E were assigned to C, and D and E
were notified in writing of the assignment on or before the transfer of
real properties X and L, respectively, C is treated as entering into
those agreements. Because C is treated as entering into an agreement
with D for the transfer of real property X and, pursuant to that
agreement, real property X was transferred to D, C is treated as
acquiring and transferring real property X. Similarly, because C is
treated as entering into an agreement with E for the transfer of real
property K and, pursuant to that agreement, real property K was
transferred to B, C is treated as acquiring and transferring real
property K. This result is reached for purposes of this section
regardless of whether C was B's agent under state law and regardless of
whether C is considered, under general tax principles, to have acquired
title or beneficial ownership of the properties. Thus, C was a qualified
intermediary.
[[Page 117]]
(iii) The exchange agreement between B and C expressly limited B's
rights to receive, pledge, borrow, or otherwise obtain the benefits of
the money held by C as provided in paragraph (g)(6) of this section.
Thus, B did not have the immediate ability or unrestricted right to
receive money or other property held by C before B received real
property L. For purposes of section 1031 and this section, therefore, B
is determined not to be in actual or constructive receipt of the $90,000
held by C before B received real property L. In addition, the transfer
of real property X by B and B's acquisition of real property L qualify
as an exchange under section 1031. See paragraph (j) of this section for
determining the amount of gain or loss recognized.
Example 5. (i) On May 1, 1991, B enters into an agreement to sell
real property X to D for $100,000. However, D is unwilling to
participate in a like-kind exchange. B thus enters into an agreement
with C whereby B retains C to facilitate an exchange with respect to
real property X. C is not a disqualified person as described in
paragraph (k) of this section. The agreement between B and C expressly
limits B's rights to receive, pledge, borrow, or otherwise obtain the
benefits of money or other property held by C as provided in paragraph
(g)(6) of this section. C neither enters into an agreement with D to
transfer real property X to D nor is assigned B's rights in B's
agreement to sell real property X to D. On May 17, 1991, B transfers
real property X to D and instructs D to transfer the $100,000 to C. On
June 1, 1991, B identifies real property M as replacement property. On
August 9, 1991, C purchases real property L from E for $100,000, and E
executes and delivers to C a deed conveying real property M to C. On the
same date, C executes and delivers to B a deed conveying real property M
to B.
(ii) Because B transferred real property X directly to D under B's
agreement with D, C did not acquire real property X from B and transfer
real property X to D. Moreover, because C did not acquire legal title to
real property X, did not enter into an agreement with D to transfer real
property X to D, and was not assigned B's rights in B's agreement to
sell real property X to D, C is not treated as acquiring and
transferring real property X. Thus, C was not a qualified intermediary
and paragraph (g)(4))(i) of this section does not apply.
(iii) B did not exchange real property X for real property M.
Rather, B sold real property X to D and purchased, through C, real
property M. Therefore, the transfer of real property X does not qualify
for nonrecognition of gain or loss under section 1031.
(h) Interest and growth factors--(1) In general. For purposes of
this section, the taxpayer is treated as being entitled to receive
interest or a growth factor with respect to a deferred exchange if the
amount of money or property the taxpayer is entitled to receive depends
upon the length of time elapsed between transfer of the relinquished
property and receipt of the replacement property.
(2) Treatment as interest. If, as part of a deferred exchange, the
taxpayer receives interest or a growth factor, the interest or growth
factor will be treated as interest, regardless of whether it is paid to
the taxpayer in cash or in property (including property of a like kind).
The taxpayer must include the interest or growth factor in income
according to the taxpayer's method of accounting. For rules under
section 468B(g) relating to the current taxation of qualified escrow
accounts, qualified trusts, and other escrow accounts, trusts, and funds
used during deferred exchanges of like-kind property, see Sec. 1.468B-
6.
(i) [Reserved]
(j) Determination of gain or loss recognized and the basis of
property received in a deferred exchange--(1) In general. Except as
otherwise provided, the amount of gain or loss recognized and the basis
of property received in a deferred exchange is determined by applying
the rules of section 1031 and the regulations thereunder. See Sec. Sec.
1.1031(b)-1, 1.1031(c)-1, 1.1031(d)-1, 1.1031(d)-1T, 1.1031(d)-2, and
1.1031(j)-1.
(2) Coordination with section 453--(i) Qualified escrow accounts and
qualified trusts. Subject to the limitations of paragraphs (j)(2) (iv)
and (v) of this section, in the case of a taxpayer's transfer of
relinquished property in which the obligation of the taxpayer's
transferee to transfer replacement property to the taxpayer is or may be
secured by cash or a cash equivalent, the determination of whether the
taxpayer has received a payment for purposes of section 453 and Sec.
15a.453-1(b)(3)(i) of this chapter will be made without regard to the
fact that the obligation is or may be so secured if the cash or cash
equivalent is held in a qualified escrow account or a qualified trust.
This paragraph (j)(2)(i) ceases to apply at the earlier of--
(A) The time described in paragraph (g)(3)(iv) of this section; or
(B) The end of the exchange period.
[[Page 118]]
(ii) Qualified intermediaries. Subject to the limitations of
paragraphs (j)(2) (iv) and (v) of this section, in the case of a
taxpayer's transfer of relinquished property involving a qualified
intermediary, the determination of whether the taxpayer has received a
payment for purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this
chapter is made as if the qualified intermediary is not the agent of the
taxpayer. For purposes of this paragraph (j)(2)(ii), a person who
otherwise satisfies the definition of a qualified intermediary is
treated as a qualified intermediary even though that person ultimately
fails to acquire identified replacement property and transfer it to the
taxpayer. This paragraph (j)(2)(ii) ceases to apply at the earlier of--
(A) The time described in paragraph (g)(4)(vi) of this section; or
(B) The end of the exchange period.
(iii) Transferee indebtedness. In the case of a transaction
described in paragraph (j)(2)(ii) of this section, the receipt by the
taxpayer of an evidence of indebtedness of the transferee of the
qualified intermediary is treated as the receipt of an evidence of
indebtedness of the person acquiring property from the taxpayer for
purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter.
(iv) Bona fide intent requirement. The provisions of paragraphs
(j)(2) (i) and (ii) of this section do not apply unless the taxpayer has
a bona fide intent to enter into a deferred exchange at the beginning of
the exchange period. A taxpayer will be treated as having a bona fide
intent only if it is reasonable to believe, based on all the facts and
circumstances as of the beginning of the exchange period, that like-kind
replacement property will be acquired before the end of the exchange
period.
(v) Disqualified property. The provisions of paragraphs (j)(2) (i)
and (ii) of this section do not apply if the relinquished property is
disqualified property. For purposes of this paragraph (j)(2),
disqualified property means property that is not held for productive use
in a trade or business or for investment or is property described in
section 1031(a)(2).
(vi) Examples. This paragraph (j)(2) may be illustrated by the
following examples. Unless otherwise provided in an example, the
following facts are assumed: B is a calendar year taxpayer who agrees to
enter into a deferred exchange. Pursuant to the agreement, B is to
transfer real property X. Real property X, which has been held by B for
investment, is unencumbered and has a fair market value of $100,000 at
the time of transfer. B's adjusted basis in real property X at that time
is $60,000. B identifies a single like-kind replacement property before
the end of the identification period, and B receives the replacement
property before the end of the exchange period. The transaction
qualifies as a like-kind exchange under section 1031.
Example 1. (i) On September 22, 1994, B transfers real property X to
C and C agrees to acquire like-kind property and deliver it to B. On
that date B has a bona fide intent to enter into a deferred exchange.
C's obligation, which is not payable on demand or readily tradable, is
secured by $100,000 in cash. The $100,000 is deposited by C in an escrow
account that is a qualified escrow account under paragraph (g)(3) of
this section. The escrow agreement provides that B has no rights to
receive, pledge, borrow, or otherwise obtain the benefits of the cash
deposited in the escrow account until the earlier of the date the
replacement property is delivered to B or the end of the exchange
period. On March 11, 1995, C acquires replacement property having a fair
market value of $80,000 and delivers the replacement property to B. The
$20,000 in cash remaining in the qualified escrow account is distributed
to B at that time.
(ii) Under section 1031(b), B recognizes gain to the extent of the
$20,000 in cash that B receives in the exchange. Under paragraph
(j)(2)(i) of this section, the qualified escrow account is disregarded
for purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter
in determining whether B is in receipt of payment. Accordingly, B's
receipt of C's obligation on September 22, 1994, does not constitute a
payment. Instead, B is treated as receiving payment on March 11, 1995,
on receipt of the $20,000 in cash from the qualified escrow account.
Subject to the other requirements of sections 453 and 453A, B may report
the $20,000 gain in 1995 under the installment method. See section
453(f)(6) for special rules for determining total contract price and
gross profit in the case of an exchange described in section 1031(b).
Example 2. (i) D offers to purchase real property X but is unwilling
to participate in a like-kind exchange. B thus enters into an exchange
agreement with C whereby B retains C to facilitate an exchange with
respect to real property X. On September 22,
[[Page 119]]
1994, pursuant to the agreement, B transfers real property X to C who
transfers it to D for $100,000 in cash. On that date B has a bona fide
intent to enter into a deferred exchange. C is a qualified intermediary
under paragraph (g)(4) of this section. The exchange agreement provides
that B has no rights to receive, pledge, borrow, or otherwise obtain the
benefits of the money held by C until the earlier of the date the
replacement property is delivered to B or the end of the exchange
period. On March 11, 1995, C acquires replacement property having a fair
market value of $80,000 and delivers it, along with the remaining
$20,000 from the transfer of real property X to B.
(ii) Under section 1031(b), B recognizes gain to the extent of the
$20,000 cash B receives in the exchange. Under paragraph (j)(2)(ii) of
this section, any agency relationship between B and C is disregarded for
purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter in
determining whether B is in receipt of payment. Accordingly, B is not
treated as having received payment on September 22, 1994, on C's receipt
of payment from D for the relinquished property. Instead, B is treated
as receiving payment on March 11, 1995, on receipt of the $20,000 in
cash from C. Subject to the other requirements of sections 453 and 453A,
B may report the $20,000 gain in 1995 under the installment method.
Example 3. (i) D offers to purchase real property X but is unwilling
to participate in a like-kind exchange. B enters into an exchange
agreement with C whereby B retains C as a qualified intermediary to
facilitate an exchange with respect to real property X. On December 1,
1994, pursuant to the agreement, B transfers real property X to C who
transfers it to D for $100,000 in cash. On that date B has a bona fide
intent to enter into a deferred exchange. The exchange agreement
provides that B has no rights to receive, pledge, borrow, or otherwise
obtain the benefits of the cash held by C until the earliest of the end
of the identification period if B has not identified replacement
property, the date the replacement property is delivered to B, or the
end of the exchange period. Although B has a bona fide intent to enter
into a deferred exchange at the beginning of the exchange period, B does
not identify or acquire any replacement property. In 1995, at the end of
the identification period, C delivers the entire $100,000 from the sale
of real property X to B.
(ii) Under section 1001, B realizes gain to the extent of the amount
realized ($100,000) over the adjusted basis in real property X
($60,000), or $40,000. Because B has a bona fide intent at the beginning
of the exchange period to enter into a deferred exchange, paragraph
(j)(2)(iv) of this section does not make paragraph (j)(2)(ii) of this
section inapplicable even though B fails to acquire replacement
property. Further, under paragraph (j)(2)(ii) of this section, C is a
qualified intermediary even though C does not acquire and transfer
replacement property to B. Thus, any agency relationship between B and C
is disregarded for purposes of section 453 and Sec. 15a.453-1(b)(3)(i)
of this chapter in determining whether B is in receipt of payment.
Accordingly, B is not treated as having received payment on December 1,
1994, on C's receipt of payment from D for the relinquished property.
Instead, B is treated as receiving payment at the end of the
identification period in 1995 on receipt of the $100,000 in cash from C.
Subject to the other requirements of sections 453 and 453A, B may report
the $40,000 gain in 1995 under the installment method.
Example 4. (i) D offers to purchase real property X but is unwilling
to participate in a like-kind exchange. B thus enters into an exchange
agreement with C whereby B retains C to facilitate an exchange with
respect to real property X. C is a qualified intermediary under
paragraph (g)(4) of this section. On September 22, 1994, pursuant to the
agreement, B transfers real property X to C who then transfers it to D
for $80,000 in cash and D's 10-year installment obligation for $20,000.
On that date B has a bona fide intent to enter into a deferred exchange.
The exchange agreement provides that B has no rights to receive, pledge,
borrow, or otherwise obtain the benefits of the money or other property
held by C until the earlier of the date the replacement property is
delivered to B or the end of the exchange period. D's obligation bears
adequate stated interest and is not payable on demand or readily
tradable. On March 11, 1995, C acquires replacement property having a
fair market value of $80,000 and delivers it, along with the $20,000
installment obligation, to B.
(ii) Under section 1031(b), $20,000 of B's gain (i.e., the amount of
the installment obligation B receives in the exchange) does not qualify
for nonrecognition under section 1031(a). Under paragraphs (j)(2) (ii)
and (iii) of this section, B's receipt of D's obligation is treated as
the receipt of an obligation of the person acquiring the property for
purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter in
determining whether B is in receipt of payment. Accordingly, B's receipt
of the obligation is not treated as a payment. Subject to the other
requirements of sections 453 and 453A, B may report the $20,000 gain
under the installment method on receiving payments from D on the
obligation.
Example 5. (i) B is a corporation that has held real property X to
expand its manufacturing operations. However, at a meeting in November
1994, B's directors decide that real property X is not suitable for the
planned expansion, and authorize a like-kind exchange of this property
for property that would be
[[Page 120]]
suitable for the planned expansion. B enters into an exchange agreement
with C whereby B retains C as a qualified intermediary to facilitate an
exchange with respect to real property X. On November 28, 1994, pursuant
to the agreement, B transfers real property X to C, who then transfers
it to D for $100,000 in cash. The exchange agreement does not include
any limitations or conditions that make it unreasonable to believe that
like-kind replacement property will be acquired before the end of the
exchange period. The exchange agreement provides that B has no rights to
receive, pledge, borrow, or otherwise obtain the benefits of the cash
held by C until the earliest of the end of the identification period, if
B has not identified replacement property, the date the replacement
property is delivered to B, or the end of the exchange period. In early
January 1995, B's directors meet and decide that it is not feasible to
proceed with the planned expansion due to a business downturn reflected
in B's preliminary financial reports for the last quarter of 1994. Thus,
B's directors instruct C to stop seeking replacement property. C
delivers the $100,000 cash to B on January 12, 1995, at the end of the
identification period. Both the decision to exchange real property X for
other property and the decision to cease seeking replacement property
because of B's business downturn are recorded in the minutes of the
directors' meetings. There are no other facts or circumstances that
would indicate whether, on November 28, 1994, B had a bona fide intent
to enter into a deferred like-kind exchange.
(ii) Under section 1001, B realizes gain to the extent of the amount
realized ($100,000) over the adjusted basis of real property X
($60,000), or $40,000. The directors' authorization of a like-kind
exchange, the terms of the exchange agreement with C, and the absence of
other relevant facts, indicate that B had a bona fide intent at the
beginning of the exchange period to enter into a deferred like-kind
exchange. Thus, paragraph (j)(2)(iv) of this section does not make
paragraph (j)(2)(ii) of this section inapplicable, even though B fails
to acquire replacement property. Further, under paragraph (j)(2)(ii) of
this section, C is a qualified intermediary, even though C does not
transfer replacement property to B. Thus, any agency relationship
between B and C is disregarded for purposes of section 453 and Sec.
15a.453-1(b)(3)(i) of this chapter in determining whether B is in
receipt of payment. Accordingly, B is not treated as having received
payment until January 12, 1995, on receipt of the $100,000 cash from C.
Subject to the other requirements of sections 453 and 453A, B may report
the $40,000 gain in 1995 under the installment method.
Example 6. (i) B has held real property X for use in its trade or
business, but decides to transfer that property because it is no longer
suitable for B's planned expansion of its commercial enterprise. B and D
agree to enter into a deferred exchange. Pursuant to their agreement, B
transfers real property X to D on September 22, 1994, and D deposits
$100,000 cash in a qualified escrow account as security for D's
obligation under the agreement to transfer replacement property to B
before the end of the exchange period. D's obligation is not payable on
demand or readily tradable. The agreement provides that B is not
required to accept any property that is not zoned for commercial use.
Before the end of the identification period, B identifies real
properties J, K, and L, all zoned for residential use, as replacement
properties. Any one of these properties, rezoned for commercial use,
would be suitable for B's planned expansion. In recent years, the zoning
board with jurisdiction over properties J, K, and L has rezoned similar
properties for commercial use. The escrow agreement provides that B has
no rights to receive, pledge, borrow, or otherwise obtain the benefits
of the money in the escrow account until the earlier of the time that
the zoning board determines, after the end of the identification period,
that it will not rezone the properties for commercial use or the end of
the exchange period. On January 5, 1995, the zoning board decides that
none of the properties will be rezoned for commercial use. Pursuant to
the exchange agreement, B receives the $100,000 cash from the escrow on
January 5, 1995. There are no other facts or circumstances that would
indicate whether, on September 22, 1994, B had a bona fide intent to
enter into a deferred like-kind exchange.
(ii) Under section 1001, B realizes gain to the extent of the amount
realized ($100,000) over the adjusted basis of real property X
($60,000), or $40,000. The terms of the exchange agreement with D, the
identification of properties J, K, and L, the efforts to have those
properties rezoned for commercial purposes, and the absence of other
relevant facts, indicate that B had a bona fide intent at the beginning
of the exchange period to enter into a deferred exchange. Moreover, the
limitations imposed in the exchange agreement on acceptable replacement
property do not make it unreasonable to believe that like-kind
replacement property would be acquired before the end of the exchange
period. Therefore, paragraph (j)(2)(iv) of this section does not make
paragraph (j)(2)(i) of this section inapplicable even though B fails to
acquire replacement property. Thus, for purposes of section 453 and
Sec. 15a.453-1(b)(3)(i) of this chapter, the qualified escrow account
is disregarded in determining whether B is in receipt of payment.
Accordingly, B is not treated as having received payment on September
22, 1994, on D's deposit of the $100,000 cash into the qualified escrow
account. Instead, B is treated as receiving payment on
[[Page 121]]
January 5, 1995. Subject to the other requirements of sections 453 and
453A, B may report the $40,000 gain in 1995 under the installment
method.
(vii) Effective date. This paragraph (j)(2) is effective for
transfers of property occurring on or after April 20, 1994. Taxpayers
may apply this paragraph (j)(2) to transfers of property occurring
before April 20, 1994, but on or after June 10, 1991, if those transfers
otherwise meet the requirements of Sec. 1.1031(k)-1. In addition,
taxpayers may apply this paragraph (j)(2) to transfers of property
occurring before June 10, 1991, but on or after May 16, 1990, if those
transfers otherwise meet the requirements of Sec. 1.1031(k)-1 or follow
the guidance of IA-237-84 published in 1990-1, C.B. See Sec.
601.601(d)(2)(ii)(b) of this chapter.
(3) Examples. This paragraph (j) may be illustrated by the following
examples. Unless otherwise provided in an example, the following facts
are assumed: B, a calendar year taxpayer, and C agree to enter into a
deferred exchange. Pursuant to their agreement, B is to transfer real
property X to C on May 17, 1991. Real property X, which has been held by
B for investment, is unencumbered and has a fair market value on May 17,
1991, of $100,000. B's adjusted basis in real property X is $40,000. On
or before July 1, 1991 (the end of the identification period), B is to
identify replacement property that is of a like kind to real property X.
On or before November 13, 1991 (the end of the exchange period), C is
required to purchase the property identified by B and to transfer that
property to B. To the extent the fair market value of the replacement
property transferred to B is greater or less than the fair market value
of real property X, either B or C, as applicable, will make up the
difference by paying cash to the other party after the date the
replacement property is received. The replacement property is identified
as provided in paragraph (c) of this section and is of a like kind to
real property X (determined without regard to section 1031(a)(3) and
this section). B intends to hold any replacement property received for
investment.
Example 1. (i) On May 17, 1991, B transfers real property X to C and
identifies real property R as replacement property. On June 3, 1991, C
transfers $10,000 to B. On September 4, 1991, C purchases real property
R for $90,000 and transfers real property R to B.
(ii) The $10,000 received by B is ``money or other property'' for
purposes of section 1031 and the regulations thereunder. Under section
1031(b), B recognizes gain in the amount of $10,000. Under section
1031(d), B's basis in real property R is $40,000 (i.e., B's basis in
real property X ($40,000), decreased in the amount of money received
($10,000), and increased in the amount of gain recognized ($10,000) in
the deferred exchange).
Example 2. (i) On May 17, 1991, B transfers real property X to C and
identifies real property S as replacement property, and C transfers
$10,000 to B. On September 4, 1991, C purchases real property S for
$100,000 and transfers real property S to B. On the same day, B
transfers $10,000 to C.
(ii) The $10,000 received by B is ``money or other property'' for
purposes of section 1031 and the regulations thereunder. Under section
1031(b), B recognizes gain in the amount of $10,000. Under section
1031(d), B's basis in real property S is $50,000 (i.e., B's basis in
real property X ($40,000), decreased in the amount of money received
($10,000), increased in the amount of gain recognized ($10,000), and
increased in the amount of the additional consideration paid by B
($10,000) in the deferred exchange).
Example 3. (i) Under the exchange agreement, B has the right at all
times to demand $100,000 in cash in lieu of replacement property. On May
17, 1991, B transfers real property X to C and identifies real property
T as replacement property. On September 4, 1991, C purchases real
property T for $100,000 and transfers real property T to B.
(ii) Because B has the right on May 17, 1991, to demand $100,000 in
cash in lieu of replacement property, B is in constructive receipt of
the $100,000 on that date. Thus, the transaction is a sale and not an
exchange, and the $60,000 gain realized by B in the transaction (i.e.,
$100,000 amount realized less $40,000 adjusted basis) is recognized.
Under section 1031(d), B's basis in real property T is $100,000.
Example 4. (i) Under the exchange agreement, B has the right at all
times to demand up to $30,000 in cash and the balance in replacement
propertry instead of receiving replacement property in the amount of
$100,000. On May 17, 1991, B transfers real property X to C and
identifies real property U as replacement property. On September 4,
1991, C purchases real property U for $100,000 and transfers real
property U to B.
(ii) The transaction qualifies as a deferred exchange under section
1031 and this section. However, because B had the right on May 17, 1991,
to demand up to $30,000 in cash, B is in constructive receipt of $30,000
on that date. Under section 1031(b), B recognizes gain in
[[Page 122]]
the amount of $30,000. Under section 1031(d), B's basis in real property
U is $70,000 (i.e., B's basis in real property X ($40,000), decreased in
the amount of money that B received ($30,000), increased in the amount
of gain recognized ($30,000), and increased in the amount of additional
consideration paid by B ($30,000) in the deferred exchange).
Example 5. (i) Assume real property X is encumbered by a mortgage of
$30,000. On May 17, 1991, B transfers real property X to C and
identifies real property V as replacement property, and C assumes the
$30,000 mortgage on real property X. Real property V is encumbered by a
$20,000 mortgage. On July 5, 1991, C purchases real property V for
$90,000 by paying $70,000 and assuming the mortgage and transfers real
property V to B with B assuming the mortgage.
(ii) The consideration received by B in the form of the liability
assumed by C ($30,000) is offset by the consideration given by B in the
form of the liability assumed by B ($20,000). The excess of the
liability assumed by C over the liability assumed by B, $10,000, is
treated as ``money or other property.'' See Sec. 1.1031(b)-1(c). Thus,
B recognizes gain under section 1031(b) in the amount of $10,000. Under
section 1031(d), B's basis in real property V is $40,000 (i.e., B's
basis in real property X ($40,000), decreased in the amount of money
that B is treated as receiving in the form of the liability assumed by C
($30,000), increased in the amount of money that B is treated as paying
in the form of the liability assumed by B ($20,000), and increased in
the amount of the gain recognized ($10,000) in the deferred exchange).
(k) Definition of disqualified person. (1) For purposes of this
section, a disqualified person is a person described in paragraph
(k)(2), (k)(3), or (k)(4) of this section.
(2) The person is the agent of the taxpayer at the time of the
transaction. For this purpose, a person who has acted as the taxpayer's
employee, attorney, accountant, investment banker or broker, or real
estate agent or broker within the 2-year period ending on the date of
the transfer of the first of the relinquished properties is treated as
an agent of the taxpayer at the time of the transaction. Solely for
purposes of this paragraph (k)(2), performance of the following services
will not be taken into account--
(i) Services for the taxpayer with respect to exchanges of property
intended to qualify for nonrecognition of gain or loss under section
1031; and
(ii) Routine financial, title insurance, escrow, or trust services
for the taxpayer by a financial institution, title insurance company, or
escrow company.
(3) The person and the taxpayer bear a relationship described in
either section 267(b) or section 707(b) (determined by substituting in
each section ``10 percent'' for ``50 percent'' each place it appears).
(4)(i) Except as provided in paragraph (k)(4)(ii) of this section,
the person and a person described in paragraph (k)(2) of this section
bear a relationship described in either section 267(b) or 707(b)
(determined by substituting in each section ``10 percent'' for ``50
percent'' each place it appears).
(ii) In the case of a transfer of relinquished property made by a
taxpayer on or after January 17, 2001, paragraph (k)(4)(i) of this
section does not apply to a bank (as defined in section 581) or a bank
affiliate if, but for this paragraph (k)(4)(ii), the bank or bank
affiliate would be a disqualified person under paragraph (k)(4)(i) of
this section solely because it is a member of the same controlled group
(as determined under section 267(f)(1), substituting ``10 percent'' for
``50 percent' where it appears) as a person that has provided investment
banking or brokerage services to the taxpayer within the 2-year period
described in paragraph (k)(2) of this section. For purposes of this
paragraph (k)(4)(ii), a bank affiliate is a corporation whose principal
activity is rendering services to facilitate exchanges of property
intended to qualify for nonrecognition of gain under section 1031 and
all of whose stock is owned by either a bank or a bank holding company
(within the meaning of section 2(a) of the Bank Holding Company Act of
1956 (12 U.S.C. 1841(a)).
(5) This paragraph (k) may be illustrated by the following examples.
Unless otherwise provided, the following facts are assumed: On May 1,
1991, B enters into an exchange agreement (as defined in paragraph
(g)(4)(iii)(B) of this section) with C whereby B retains C to facilitate
an exchange with respect to real property X. On May 17, 1991, pursuant
to the agreement, B executes and delivers to C a deed conveying real
property X to C. C has no
[[Page 123]]
relationship to B described in paragraph (k)(2), (k)(3), or (k)(4) of
this section.
Example 1. (i) C is B's accountant and has rendered accounting
services to B within the 2-year period ending on May 17, 1991, other
than with respect to exchanges of property intended to qualify for
nonrecognition of gain or loss under section 1031.
(ii) C is a disqualified person because C has acted as B's
accountant within the 2-year period ending on May 17, 1991.
(iii) If C had not acted as B's accountant within the 2-year period
ending on May 17, 1991, or if C had acted as B's accountant within that
period only with respect to exchanges intended to qualify for
nonrecognition of gain or loss under section 1031, C would not have been
a disqualified person.
Example 2. (i) C, which is engaged in the trade or business of
acting as an intermediary to facilitate deferred exchanges, is a wholly
owned subsidiary of an escrow company that has performed routine escrow
services for B in the past. C has previously been retained by B to act
as an intermediary in prior section 1031 exchanges.
(ii) C is not a disqualified person notwithstanding the intermediary
services previously provided by C to B (see paragraph (k)(2)(i) of this
section) and notwithstanding the combination of C's relationship to the
escrow company and the escrow services previously provided by the escrow
company to B (see paragraph (k)(2)(ii) of this section).
Example 3. (i) C is a corporation that is only engaged in the trade
or business of acting as an intermediary to facilitate deferred
exchanges. Each of 10 law firms owns 10 percent of the outstanding stock
of C. One of the 10 law firms that owns 10 percent of C is M. J is the
managing partner of M and is the president of C. J, in his capacity as a
partner in M, has also rendered legal advice to B within the 2-year
period ending on May 17, 1991, on matters other than exchanges intended
to qualify for nonrecognition of gain or loss under section 1031.
(ii) J and M are disqualified persons. C, however, is not a
disqualified person because neither J nor M own, directly or indirectly,
more than 10 percent of the stock of C. Similarly, J's participation in
the management of C does not make C a disqualified person.
(l) [Reserved]
(m) Definition of fair market value. For purposes of this section,
the fair market value of property means the fair market value of the
property without regard to any liabilities secured by the property.
(n) No inference with respect to actual or constructive receipt
rules outside of section 1031. The rules provided in this section
relating to actual or constructive receipt are intended to be rules for
determining whether there is actual or constructive receipt in the case
of a deferred exchange. No inference is intended regarding the
application of these rules for purposes of determining whether actual or
constructive receipt exists for any other purpose.
(o) Effective date. This section applies to transfers of property
made by a taxpayer on or after June 10, 1991. However, a transfer of
property made by a taxpayer on or after May 16, 1990, but before June
10, 1991, will be treated as complying with section 1031 (a)(3) and this
section if the deferred exchange satisfies either the provision of this
section or the provisions of the notice of proposed rulemaking published
in the Federal Register on May 16, 1990 (55 FR 20278).
[T.D. 8346, 56 FR 19938, May 1, 1991, as amended by T.D. 8535, 59 FR
18749, Apr. 20, 1994; T.D. 8982, 67 FR 4909, Feb. 1, 2002; T.D. 9413, 73
FR 39622, July 10, 2008]
Sec. 1.1032-1 Disposition by a corporation of its own capital stock.
(a) The disposition by a corporation of shares of its own stock
(including treasury stock) for money or other property does not give
rise to taxable gain or deductible loss to the corporation regardless of
the nature of the transaction or the facts and circumstances involved.
For example, the receipt by a corporation of the subscription price of
shares of its stock upon their original issuance gives rise to neither
taxable gain nor deductible loss, whether the subscription or issue
price be equal to, in excess of, or less than, the par or stated value
of such stock. Also, the exchange or sale by a corporation of its own
shares for money or other property does not result in taxable gain or
deductible loss, even though the corporation deals in such shares as it
might in the shares of another corporation. A transfer by a corporation
of shares of its own stock (including treasury stock) as compensation
for services is considered, for purposes of section 1032(a), as a
disposition by the corporation of such shares for money or other
property.
(b) Section 1032(a) does not apply to the acquisition by a
corporation of
[[Page 124]]
shares of its own stock except where the corporation acquires such
shares in exchange for shares of its own stock (including treasury
stock). See paragraph (e) of Sec. 1.311-1, relating to treatment of
acquisitions of a corporation's own stock. Section 1032(a) also does not
relate to the tax treatment of the recipient of a corporation's stock.
(c) Where a corporation acquires shares of its own stock in exchange
for shares of its own stock (including treasury stock) the transaction
may qualify not only under section 1032(a), but also under section
368(a)(1)(E) (recapitalization) or section 305(a) (distribution of stock
and stock rights).
(d) For basis of property acquired by a corporation in connection
with a transaction to which section 351 applies or in connection with a
reorganization, see section 362. For basis of property acquired by a
corporation in a transaction to which section 1032 applies but which
does not qualify under any other nonrecognition provision, see section
1012.
Sec. 1.1032-2 Disposition by a corporation of stock of a controlling
corporation in certain triangular reorganizations.
(a) Scope. This section provides rules for certain triangular
reorganizations described in Sec. 1.358-6(b) when the acquiring
corporation (S) acquires property or stock of another corporation (T) in
exchange for stock of the corporation (P) in control of S.
(b) General nonrecognition of gain or loss. For purposes of Sec.
1.1032-1(a), in the case of a forward triangular merger, a triangular C
reorganization, or a triangular B reorganization (as described in Sec.
1.358-6(b)), P stock provided by P to S, or directly to T or T's
shareholders on behalf of S, pursuant to the plan of reorganization is
treated as a disposition by P of shares of its own stock for T's assets
or stock, as applicable. For rules governing the use of P stock in a
reverse triangular merger, see section 361.
(c) Treatment of S. S must recognize gain or loss on its exchange of
P stock as consideration in a forward triangular merger, a triangular C
reorganization, or a triangular B reorganization (as described in Sec.
1.358-6(b)), if S did not receive the P stock from P pursuant to the
plan of reorganization. See Sec. 1.358-6(d) for the effect on P's basis
in its S or T stock, as applicable. For rules governing S's use of P
stock in a reverse triangular merger, see section 361.
(d) Examples. The rules of this section are illustrated by the
following examples. For purposes of these examples, P, S, and T are
domestic corporations, P and S do not file consolidated returns, P owns
all of the only class of S stock, the P stock exchanged in the
transaction satisfies the requirements of the applicable reorganization
provisions, and the facts set forth the only corporate activity.
Example 1. Forward triangular merger solely for P stock. (a) Facts.
T has assets with an aggregate basis of $60 and fair market value of
$100 and no liabilities. Pursuant to a plan, P forms S by transferring
$100 of P stock to S and T merges into S. In the merger, the T
shareholders receive, in exchange for their T stock, the P stock that P
transferred to S. The transaction is a reorganization to which sections
368(a)(1)(A) and (a)(2)(D) apply.
(b) No gain or loss recognized on the use of P stock. Under
paragraph (b) of this section, the P stock provided by P pursuant to the
plan of reorganization is treated for purposes of Sec. 1.1032-1(a) as
disposed of by P for the T assets acquired by S in the merger.
Consequently, neither P nor S has taxable gain or deductible loss on the
exchange.
Example 2. Forward triangular merger solely for P stock provided in
part by S. (a) Facts. T has assets with an aggregate basis of $60 and
fair market value of $100 and no liabilities. S is an operating company
with substantial assets that has been in existence for several years. S
also owns P stock with a $20 adjusted basis and $30 fair market value. S
acquired the P stock in an unrelated transaction several years before
the reorganization. Pursuant to a plan, P transfers additional P stock
worth $70 to S and T merges into S. In the merger, the T shareholders
receive $100 of P stock ($70 of P stock provided by P to S as part of
the plan and $30 of P stock held by S previously). The transaction is a
reorganization to which sections 368(a)(1)(A) and (a)(2)(D) apply.
(b) Gain or loss recognized by S on the use of its P stock. Under
paragraph (b) of this section, the $70 of P stock provided by P pursuant
to the plan of reorganization is treated as disposed of by P for the T
assets acquired by S in the merger. Consequently, neither P nor S has
taxable gain or deductible loss on the exchange of those shares. Under
paragraph (c) of this section, however, S recognizes $10 of gain on the
exchange of its P
[[Page 125]]
stock in the reorganization because S did not receive the P stock from P
pursuant to the plan of reorganization. See Sec. 1.358-6(d) for the
effect on P's basis in its S stock.
(e) Stock options. The rules of this section shall apply to an
option to buy or sell P stock issued by P in the same manner as the
rules of this section apply to P stock.
(f) Effective dates. This section applies to triangular
reorganizations occurring on or after December 23, 1994, except for
paragraph (e) of this section, which applies to transfers of stock
options occurring on or after May 16, 2000.
[T.D. 8648, 60 FR 66081, Dec. 21, 1995, as amended by T.D. 8883, 65 FR
31076, May 16, 2000]
Sec. 1.1032-3 Disposition of stock or stock options in certain
transactions not qualifying under any other nonrecognition provision.
(a) Scope. This section provides rules for certain transactions in
which a corporation or a partnership (the acquiring entity) acquires
money or other property (as defined in Sec. 1.1032-1) in exchange, in
whole or in part, for stock of a corporation (the issuing corporation).
(b) Nonrecognition of gain or loss--(1) General rule. In a
transaction to which this section applies, no gain or loss is recognized
on the disposition of the issuing corporation's stock by the acquiring
entity. The transaction is treated as if, immediately before the
acquiring entity disposes of the stock of the issuing corporation, the
acquiring entity purchased the issuing corporation's stock from the
issuing corporation for fair market value with cash contributed to the
acquiring entity by the issuing corporation (or, if necessary, through
intermediate corporations or partnerships). For rules that may apply in
determining the issuing corporation's adjustment to basis in the
acquiring entity (or, if necessary, in determining the adjustment to
basis in intermediate entities), see sections 358, 722, and the
regulations thereunder.
(2) Special rule for actual payment for stock of the issuing
corporation. If the issuing corporation receives money or other property
in payment for its stock, the amount of cash deemed contributed under
paragraph (b)(1) of this section is the difference between the fair
market value of the issuing corporation stock and the amount of money or
the fair market value of other property that the issuing corporation
receives as payment.
(c) Applicability. The rules of this section apply only if, pursuant
to a plan to acquire money or other property--
(1) The acquiring entity acquires stock of the issuing corporation
directly or indirectly from the issuing corporation in a transaction in
which, but for this section, the basis of the stock of the issuing
corporation in the hands of the acquiring entity would be determined, in
whole or in part, with respect to the issuing corporation's basis in the
issuing corporation's stock under section 362(a) or 723 (provided that,
in the case of an indirect acquisition by the acquiring entity, the
transfers of issuing corporation stock through intermediate entities
occur immediately after one another);
(2) The acquiring entity immediately transfers the stock of the
issuing corporation to acquire money or other property (from a person
other than an entity from which the stock was directly or indirectly
acquired);
(3) The party receiving stock of the issuing corporation in the
exchange specified in paragraph (c)(2) of this section from the
acquiring entity does not receive a substituted basis in the stock of
the issuing corporation within the meaning of section 7701(a)(42); and
(4) The issuing corporation stock is not exchanged for stock of the
issuing corporation.
(d) Stock options. The rules of this section shall apply to an
option issued by a corporation to buy or sell its own stock in the same
manner as the rules of this section apply to the stock of an issuing
corporation.
(e) Examples. The following examples illustrate the application of
this section:
Example 1. (i) X, a corporation, owns all of the stock of Y
corporation. Y reaches an agreement with C, an individual, to acquire a
truck from C in exchange for 10 shares of X stock with a fair market
value of $100. To effectuate Y's agreement with C,X transfers to Y the X
stock in a transaction in which, but for this section, the basis of the
X stock in the hands of Y would be determined with
[[Page 126]]
respect to X's basis in the X stock under section 362(a). Y immediately
transfers the X stock to C to acquire the truck.
(ii) In this Example 1, no gain or loss is recognized on the
disposition of the X stock by Y. Immediately before Y's disposition of
the X stock, Y is treated as purchasing the X stock from X for $100 of
cash contributed to Y by X. Under section 358, X's basis in its Y stock
is increased by $100.
Example 2. (i) Assume the same facts as Example 1, except that,
rather than X stock, X transfers an option with a fair market value of
$100 to purchase X stock.
(ii) In this Example 2, no gain or loss is recognized on the
disposition of the X stock option by Y. Immediately before Y's
disposition of the X stock option, Y is treated as purchasing the X
stock option from X for $100 of cash contributed to Y by X. Under
section 358, X's basis in its Y stock is increased by $100.
Example 3. (i) X, a corporation, owns all of the outstanding stock
of Y corporation. Y is a partner in partnership Z. Z reaches an
agreement with C, an individual, to acquire a truck from C in exchange
for 10 shares of X stock with a fair market value of $100. To effectuate
Z's agreement with C, X transfers to Y the X stock in a transaction in
which, but for this section, the basis of the X stock in the hands of Y
would be determined with respect to X's basis in the X stock under
section 362(a). Y immediately transfers the X stock to Z in a
transaction in which, but for this section, the basis of the X stock in
the hands of Z would be determined under section 723. Z immediately
transfers the X stock to C to acquire the truck.
(ii) In this Example 3, no gain or loss is recognized on the
disposition of the X stock by Z. Immediately before Z's disposition of
the X stock, Z is treated as purchasing the X stock from X for $100 of
cash indirectly contributed to Z by X through an intermediate
corporation, Y. Under section 722, Y's basis in its Z partnership
interest is increased by $100, and, under section 358, X's basis in its
Y stock is increased by $100.
Example 4. (i) X, a corporation, owns all of the outstanding stock
of Y corporation. B, an individual, is an employee of Y. Pursuant to an
agreement between X and Y to compensate B for services provided to Y, X
transfers to B 10 shares of X stock with a fair market value of $100.
Under Sec. 1.83-6(d), but for this section, the transfer of X stock by
X to B would be treated as a contribution of the X stock by X to the
capital of Y, and immediately thereafter, a transfer of the X stock by Y
to B. But for this section, the basis of the X stock in the hands of Y
would be determined with respect to X's basis in the X stock under
section 362(a).
(ii) In this Example 4, no gain or loss is recognized on the deemed
disposition of the X stock by Y. Immediately before Y's deemed
disposition of the X stock, Y is treated as purchasing the X stock from
X for $100 of cash contributed to Y by X. Under section 358, X's basis
in its Y stock is increased by $100.
Example 5. (i) X, a corporation, owns all of the outstanding stock
of Y corporation. B, an individual, is an employee of Y. To compensate B
for services provided to Y, B is offered the opportunity to purchase 10
shares of X stock with a fair market value of $100 at a reduced price of
$80. B transfers $80 and Y transfers $10 to X as partial payment for the
X stock.
(ii) In this Example 5, no gain or loss is recognized on the deemed
disposition of the X stock by Y. Immediately before Y's deemed
disposition of the X stock, Y is treated as purchasing the X stock from
X for $100, $80 of which Y is deemed to have received from B, $10 of
which originated with Y, and $10 of which is deemed to have been
contributed to Y by X. Under section 358, X's basis in its Y stock is
increased by $10.
Example 6. (i) X, a corporation, owns stock of Y. To compensate Y's
employee, B, for services provided to Y, X issues 10 shares of X stock
to B, subject to a substantial risk of forfeiture. B does not have an
election under section 83(b) in effect with respect to the X stock. X
retains the only reversionary interest in the X stock in the event that
B forfeits the right to the stock. Several years after X's transfer of
the X shares, the stock vests. At the time the stock vests, the 10
shares of X stock have a fair market value of $100. Under Sec. 1.83-
6(d), but for this section, the transfer of the X stock by X to B would
be treated, at the time the stock vests, as a contribution of the X
stock by X to the capital of Y, and immediately thereafter, a
disposition of the X stock by Y to B. The basis of the X stock in the
hands of Y, but for this section, would be determined with respect to
X's basis in the X stock under section 362(a).
(ii) In this Example 6, no gain or loss is recognized on the deemed
disposition of X stock by Y when the stock vests. Immediately before Y's
deemed disposition of the X stock, Y is treated as purchasing X's stock
from X for $100 of cash contributed to Y by X. Under section 358, X's
basis in its Y stock is increased by $100.
Example 7. (i) Assume the same facts as in Example 6, except that Y
(rather than X) retains a reversionary interest in the X stock in the
event that B forfeits the right to the stock. Several years after X's
transfer of the X shares, the stock vests.
(ii) In this Example 7, this section does not apply to Y's deemed
disposition of the X shares because Y is not deemed to have transferred
the X stock to B immediately after receiving the stock from X. For the
tax consequences to Y on the deemed disposition of the X stock, see
Sec. 1.83-6(b).
[[Page 127]]
Example 8. (i) X, a corporation, owns all of the outstanding stock
of Y corporation. In Year 1, X issues to Y's employee, B, a nonstatutory
stock option to purchase 10 shares of X stock as compensation for
services provided to Y. The option is exercisable against X and does not
have a readily ascertainable fair market value (determined under Sec.
1.83-7(b)) at the time the option is granted. In Year 2, B exercises the
option by paying X the strike price of $80 for the X stock, which then
has a fair market value of $100.
(ii) In this Example 8, because, under section 83(e)(3), section
83(a) does not apply to the grant of the option, paragraph (d) of this
section also does not apply to the grant of the option. Section 83 and
Sec. 1.1032-3 apply in Year 2 when the option is exercised; thus, no
gain or loss is recognized on the deemed disposition of X stock by Y in
Year 2. Immediately before Y's deemed disposition of the X stock in Year
2, Y is treated as purchasing the X stock from X for $100, $80 of which
Y is deemed to have received from B and the remaining $20 of which is
deemed to have been contributed to Y by X. Under section 358, X's basis
in its Y stock is increased by $20.
Example 9. (i) A, an individual, owns a majority of the stock of X.
X owns stock of Y constituting control of Y within the meaning of
section 368(c). A transfers 10 shares of its X stock to B, a key
employee of Y. The fair market value of the 10 shares on the date of
transfer was $100.
(ii) In this Example 9, A is treated as making a nondeductible
contribution of the 10 shares of X to the capital of X, and no gain or
loss is recognized by A as a result of this transfer. See Commissioner
v. Fink, 483 U.S. 89 (1987). A must allocate his basis in the
transferred shares to his remaining shares of X stock. No gain or loss
is recognized on the deemed disposition of the X stock by Y. Immediately
before Y's disposition of the X stock, Y is treated as purchasing the X
stock from X for $100 of cash contributed to Y by X. Under section 358,
X's basis in its Y stock is increased by $100.
Example 10. (i) In Year 1, X, a corporation, forms a trust which
will be used to satisfy deferred compensation obligations owed by Y, X's
wholly owned subsidiary, to Y's employees. X funds the trust with X
stock, which would revert to X upon termination of the trust, subject to
the employees' rights to be paid the deferred compensation due to them.
The creditors of X can reach all the trust assets upon the insolvency of
X. Similarly, Y's creditors can reach all the trust assets upon the
insolvency of Y. In Year 5, the trust transfers X stock to the employees
of Y in satisfaction of the deferred compensation obligation.
(ii) In this Example 10, X is considered to be the grantor of the
trust, and, under section 677, X is also the owner of the trust. Any
income earned by the trust would be reflected on X's income tax return.
Y is not considered a grantor or owner of the trust corpus at the time X
transfers X stock to the trust. In Year 5, when employees of Y receive X
stock in satisfaction of the deferred compensation obligation, no gain
or loss is recognized on the deemed disposition of the X stock by Y.
Immediately before Y's deemed disposition of the X stock, Y is treated
as purchasing the X stock from X for fair market value using cash
contributed to Y by X. Under section 358, X's basis in its Y stock
increases by the amount of cash deemed contributed.
(f) Effective date. This section applies to transfers of stock or
stock options of the issuing corporation occurring on or after May 16,
2000.
[T.D. 8883, 65 FR 31076, May 16, 2000; 65 FR 37482, June 15, 2000]
Sec. 1.1033(a)-1 Involuntary conversions; nonrecognition of gain.
(a) In general. Section 1033 applies to cases where property is
compulsorily or involuntarily converted. An involuntary conversion may
be the result of the destruction of property in whole or in part, the
theft of property, the seizure of property, the requisition or
condemnation of property, or the threat or imminence of requisition or
condemnation of property. An involuntary conversion may be a conversion
into similar property or into money or into dissimilar property. Section
1033 provides that, under certain specified circumstances, any gain
which is realized from an involuntary conversion shall not be
recognized. In cases where property is converted into other property
similar or related in service or use to the converted property, no gain
shall be recognized regardless of when the disposition of the converted
property occurred and regardless of whether or not the taxpayer elects
to have the gain not recognized. In other types of involuntary
conversion cases, however, the proceeds arising from the disposition of
the converted property must (within the time limits specified) be
reinvested in similar property in order to avoid recognition of any gain
realized. Section 1033 applies only with respect to gains; losses from
involuntary conversions are recognized or not recognized without regard
to this section.
[[Page 128]]
(b) Special rules. For rules relating to the application of section
1033 to involuntary conversions of a principal residence with respect to
which an election has been made under section 121 (relating to gain from
sale or exchange of residence of individual who has attained age 65),
see paragraph (g) of Sec. 1.121-5. For rules applicable to involuntary
conversions of a principal residence occurring before January 1, 1951,
see Sec. 1.1033(a)-3. For rules applicable to involuntary conversions
of a principal residence occurring after December 31, 1950, and before
January 1, 1954, see paragraph (h)(1) of Sec. 1.1034-1. For rules
applicable to involuntary conversions of a personal residence occurring
after December 31, 1953, see Sec. 1.1033(a)-3. For special rules
relating to the election to have section 1034 apply to certain
involuntary conversions of a principal reisdence occurring after
December 31, 1957, see paragraph (h)(2) of Sec. 1.1034-1. For special
rules relating to certain involuntary conversions of real property held
either for productive use in trade or business or for investment and
occurring after December 31, 1957, see Sec. 1.1033(g)-1. See also
special rules applicable to involuntary conversions of property sold
pursuant to reclamation laws, livestock destroyed by disease, and
livestock sold on account of drought provided in Sec. Sec. 1.1033(c)-1,
1.1033(d)-1, and 1.1033(e)-1, respectively. For rules relating to basis
of property acquired through involuntary conversions, see Sec.
1.1033(b)-1. For determination of the period for which the taxpayer has
held property acquired as a result of certain involuntary conversions,
see section 1223 and regulations issued thereunder. For treatment of
gains from involuntary conversions as capital gains in certain cases,
see section 1231(a) and regulations issued thereunder. For portion of
war loss recoveries treated as gain on involuntary conversion, see
section 1332(b)(3) and regulations issued thereunder.
(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26
U.S.C. 7805))
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6856, 30 FR
13318, Oct. 20, 1965; T.D. 7625, 44 FR 31013, May 30, 1979; T.D. 7758,
46 FR 6925, Jan. 22, 1981]
Sec. 1.1033(a)-2 Involuntary conversion into similar property,
into money or into dissimilar property.
(a) In general. The term disposition of the converted property means
the destruction, theft, seizure, requisition, or condemnation of the
converted property, or the sale or exchange of such property under
threat or imminence of requisition or condemnation.
(b) Conversion into similar property. If property (as a result of
its destruction in whole or in part, theft, seizure, or requisition or
condemnation or threat or imminence thereof) is compulsorily or
involuntarily converted only into property similar or related in service
or use to the property so converted, no gain shall be recognized. Such
nonrecognition of gain is mandatory.
(c) Conversion into money or into dissimilar property. (1) If
property (as a result of its destruction in whole or in part, theft,
seizure, or requisition or condemnation or threat or imminence thereof)
is compulsorily or involuntarily converted into money or into property
not similar or related in service or use to the converted property, the
gain, if any, shall be recognized, at the election of the taxpayer, only
to the extent that the amount realized upon such conversion exceeds the
cost of other property purchased by the taxpayer which is similar or
related in service or use to the property so converted, or the cost of
stock of a corporation owning such other property which is purchased by
the taxpayer in the acquisition of control of such corporation, if the
taxpayer purchased such other property, or such stock, for the purpose
of replacing the property so converted and during the period specified
in subparagraph (3) of this paragraph. For the purposes of section 1033,
the term control means the ownership of stock possessing at least 80
percent of the total combined voting power of all classes of stock
entitled to vote and at least 80 percent of the total number of shares
of all other classes of stock of the corporation.
(2) All of the details in connection with an involuntary conversion
of property at a gain (including those relating to the replacement of
the converted property, or a decision not to replace, or the expiration
of the period
[[Page 129]]
for replacement) shall be reported in the return for the taxable year or
years in which any of such gain is realized. An election to have such
gain recognized only to the extent provided in subparagraph (1) of this
paragraph shall be made by including such gain in gross income for such
year or years only to such extent. If, at the time of filing such a
return, the period within which the converted property must be replaced
has expired, or if such an election is not desired, the gain should be
included in gross income for such year or years in the regular manner. A
failure to so include such gain in gross income in the regular manner
shall be deemed to be an election by the taxpayer to have such gain
recognized only to the extent provided in subparagraph (1) of this
paragraph even though the details in connection with the conversion are
not reported in such return. If, after having made an election under
section 1033(a)(2), the converted property is not replaced within the
required period of time, or replacement is made at a cost lower than was
anticipated at the time of the election, or a decision is made not to
replace, the tax liability for the year or years for which the election
was made shall be recomputed. Such recomputation should be in the form
of an amended return. If a decision is made to make an election under
section 1033(a)(2) after the filing of the return and the payment of the
tax for the year or years in which any of the gain on an involuntary
conversion is realized and before the expiration of the period within
which the converted property must be replaced, a claim for credit or
refund for such year or years should be filed. If the replacement of the
converted property occurs in a year or years in which none of the gain
on the conversion is realized, all of the details in connection with
such replacement shall be reported in the return for such year or years.
(3) The period referred to in subparagraphs (1) and (2) of this
paragraph is the period of time commencing with the date of the
disposition of the converted property, or the date of the beginning of
the threat or imminence of requisition or condemnation of the converted
property, whichever is earlier, and ending 2 years (or, in the case of a
disposition occurring before December 31, 1969, 1 year) after the close
of the first taxable year in which any part of the gain upon the
conversion is realized, or at the close of such later date as may be
designated pursuant to an application of the taxpayer. Such application
shall be made prior to the expiration of 2 years (or, in the case of a
disposition occurring before December 31, 1969, 1 year) after the close
of the first taxable year in which any part of the gain from the
conversion is realized, unless the taxpayer can show to the satisfaction
of the district director--
(i) Reasonable cause for not having filed the application within the
required period of time, and
(ii) The filing of such application was made within a reasonable
time after the expiration of the required period of time. The
application shall contain all of the details in connection with the
involuntary conversion. Such application shall be made to the district
director for the internal revenue district in which the return is filed
for the first taxable year in which any of the gain from the involuntary
conversion is realized. No extension of time shall be granted pursuant
to such application unless the taxpayer can show reasonable cause for
not being able to replace the converted property within the required
period of time.
See section 1033(g)(4) and Sec. 1.1033(g)-1 for the circumstances under
which, in the case of the conversion of real property held either for
productive use in trade or business or for investment, the 2-year period
referred to in this paragraph (c)(3) shall be extended to 3 years.
(4) Property or stock purchased before the disposition of the
converted property shall be considered to have been purchased for the
purpose of replacing the converted property only if such property or
stock is held by the taxpayer on the date of the disposition of the
converted property. Property or stock shall be considered to have been
purchased only if, but for the provisions of section 1033(b), the
unadjusted basis of such property or stock would be its cost to the
taxpayer within the
[[Page 130]]
meaning of section 1012. If the taxpayers unadjusted basis of the
replacement property would be determined, in the absence of section
1033(b), under any of the exceptions referred to in section 1012, the
unadjusted basis of the property would not be its cost within the
meaning of section 1012. For example, if property similar or related in
service or use to the converted property is acquired by gift and its
basis is determined under section 1015, such property will not qualify
as a replacement for the converted property.
(5) If a taxpayer makes an election under section 1033(a)(2), any
deficiency, for any taxable year in which any part of the gain upon the
conversion is realized, which is attributable to such gain may be
assessed at any time before the expiration of three years from the date
the district director with whom the return for such year has been filed
is notified by the taxpayer of the replacement of the converted property
or of an intention not to replace, or of a failure to replace, within
the required period, notwithstanding the provisions of section 6212(c)
or the provisions of any other law or rule of law which would otherwise
prevent such assessment. If replacement has been made, such notification
shall contain all of the details in connection with such replacement.
Such notification should be made in the return for the taxable year or
years in which the replacement occurs, or the intention not to replace
is formed, or the period for replacement expires, if this return is
filed with such district director. If this return is not filed with such
district director, then such notification shall be made to such district
director at the time of filing this return. If the taxpayer so desires,
he may, in either event, also notify such district director before the
filing of such return.
(6) If a taxpayer makes an election under section 1033(a)(2) and the
replacement property or stock was purchased before the beginning of the
last taxable year in which any part of the gain upon the conversion is
realized, any deficiency, for any taxable year ending before such last
taxable year, which is attributable to such election may be assessed at
any time before the expiration of the period within which a deficiency
for such last taxable year may be assessed, notwithstanding the
provisions of section 6212(c) or 6501 or the provisions of any law or
rule of law which would otherwise prevent such assessment.
(7) If the taxpayer makes an election under section 1033(a)(2), the
gain upon the conversion shall be recognized to the extent that the
amount realized upon such conversion exceeds the cost of the replacement
property or stock, regardless of whether such amount is realized in one
or more taxable years.
(8) The proceeds of a use and occupancy insurance contract, which by
its terms insured against actual loss sustained of net profits in the
business, are not proceeds of an involuntary conversion but are income
in the same manner that the profits for which they are substituted would
have been.
(9) There is no investment in property similar in character and
devoted to a similar use if--
(i) The proceeds of unimproved real estate, taken upon condemnation
proceedings, are invested in improved real estate.
(ii) The proceeds of conversion of real property are applied in
reduction of indebtedness previously incurred in the purchase or a
leasehold.
(iii) The owner of a requisitioned tug uses the proceeds to buy
barges.
(10) If, in a condemnation proceeding, the Government retains out of
the award sufficient funds to satisfy special assessments levied against
the remaining portion of the plot or parcel of real estate affected for
benefits accruing in connection with the condemnation, the amount so
retained shall be deducted from the gross award in determining the
amount of the net award.
(11) If, in a condemnation proceeding, the Government retains out of
the award sufficient funds to satisfy liens (other than liens due to
special assessments levied against the remaining portion of the plot or
parcel of real estate affected for benefits accruing in connection with
the condemnation) and mortgages against the property, and itself pays
the same, the amount so retained shall not be deducted from the gross
award in determining the
[[Page 131]]
amount of the net award. If, in a condemnation proceeding, the
Government makes an award to a mortgagee to satisfy a mortgage on the
condemned property, the amount of such award shall be considered as a
part of the amount realized upon the conversion regardless of whether or
not the taxpayer was personally liable for the mortgage debt. Thus, if a
taxpayer has acquired property worth $100,000 subject to a $50,000
mortgage (regardless of whether or not he was personally liable for the
mortgage debt) and, in a condemnation proceeding, the Government awards
the taxpayer $60,000 and awards the mortgagee $50,000 in satisfaction of
the mortgage, the entire $110,000 is considered to be the amount
realized by the taxpayer.
(12) An amount expended for replacement of an asset, in excess of
the recovery for loss, represents a capital expenditure and is not a
deductible loss for income tax purposes.
(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26
U.S.C. 7805)
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6679, 28 FR
10515, Oct. 1, 1963; T.D. 7075, 35 FR 17996, Nov. 24, 1970; T.D. 7625,
44 FR 31013, May 30, 1979; T.D. 7758, 46 FR 6925, Jan. 22, 1981]
Sec. 1.1033(a)-3 Involuntary conversion of principal residence.
Section 1033 shall apply in the case of property used by the
taxpayer as his principal residence if the destruction, theft, seizure,
requisition, or condemnation of such residence, or the sale or exchange
of such residence under threat or imminence thereof, occurs before
January 1, 1951, or after December 31, 1953. However, section 1033 shall
not apply to the seizure, requisition, or condemnation (but not
destruction), or the sale or exchange under threat or imminence thereof,
of such residence property if the seizure, requisition, condemnation,
sale, or exchange occurs after December 31, 1957, and if the taxpayer
properly elects under section 1034(i) to treat the transaction as a sale
(see paragraph (h)(2)(ii) of Sec. 1.1034-1). See section 121 and
paragraphs (d) and (g) of Sec. 1.121-5 for special rules relating to
the involuntary conversion of a principal residence of individuals who
have attained age 65.
[T.D. 6856, 30 FR 13319, Oct. 20, 1965. Redesignated and amended by T.D.
7625, 44 FR 31013, May 30, 1979]
Sec. 1.1033(b)-1 Basis of property acquired as a result of an
involuntary conversion.
(a) The provisions of the first sentence of section 1033(b) may be
illustrated by the following example:
Example: A's vessel which has an adjusted basis of $100,000 is
destroyed in 1950 and A receives in 1951 insurance in the amount of
$200,000. If A invests $150,000 in a new vessel, taxable gain to the
extent of $50,000 would be recognized. The basis of the new vessel is
$100,000; that is, the adjusted basis of the old vessel ($100,000) minus
the money received by the taxpayer which was not expended in the
acquisition of the new vessel ($50,000) plus the amount of gain
recognized upon the conversion ($50,000). If any amount in excess of the
proceeds of the conversion is expended in the acquisition of the new
property, such amount may be added to the basis otherwise determined.
(b) The provisions of the last sentence of section 1033(b) may be
illustrated by the following example:
Example: A taxpayer realizes $22,000 from the involuntary conversion
of his barn in 1955; the adjusted basis of the barn to him was $10,000,
and he spent in the same year $20,000 for a new barn which resulted in
the nonrecognition of $10,000 of the $12,000 gain on the conversion. The
basis of the new barn to the taxpayer would be $10,000--the cost of the
new barn ($20,000) less the amount of the gain not recognized on the
conversion ($10,000). The basis of the new barn would not be a
substituted basis in the hands of the taxpayer within the meaning of
section 1016(b)(2). If the replacement of the converted barn had been
made by the purchase of two smaller barns which, together, were similar
or related in service or use to the converted barn and which cost $8,000
and $12,000, respectively, then the basis of the two barns would be
$4,000 and $6,000, respectively, the total basis of the purchased
property ($10,000) allocated in proportion to their respective costs
(8,000/ 20,000 of $10,000 or $4,000; and 12,000/20,000 of $10,000, or
$6,000).
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960.
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979]
[[Page 132]]
Sec. 1.1033(c)-1 Disposition of excess property within irrigation
project deemed to be involuntary conversion.
(a) The sale, exchange, or other disposition occurring in a taxable
year to which the Internal Revenue Code of 1954 applies, of excess lands
lying within an irrigation project or division in order to conform to
acreage limitations of the Federal reclamation laws effective with
respect to such project or division shall be treated as an involuntary
conversion to which the provisions of section 1033 and the regulations
thereunder shall be applicable. The term excess lands means irrigable
lands within an irrigation project or division held by one owner in
excess of the amount of irrigable land held by such owner entitled to
receive water under the Federal reclamation laws applicable to such
owner in such project or division. Such excess lands may be either (1)
lands receiving no water from the project or division, or (2) lands
receiving water only because the owner thereof has executed a valid
recordable contract agreeing to sell such lands under terms and
conditions satisfactory to the Secretary of the Interior.
(b) If a disposition in order to conform to the acreage limitation
provisions of Federal reclamation laws includes property other than
excess lands (as, for example, where the excess lands alone do not
constitute a marketable parcel) the provisions of section 1033(d) shall
apply only to the part of the disposition that relates to excess lands.
(c) The provisions of Sec. 1.1033(a)-2 shall be applicable in the
case of dispositions treated as involuntary conversions under this
section. The details in connection with such a disposition required to
be reported under paragraph (c)(2) of Sec. 1.1033(a)-2 shall include
the authority whereby the lands disposed of are considered excess lands,
as defined in this section, and a statement that such disposition is not
part of a plan contemplating the disposition of all or any nonexcess
land within the irrigation project or division.
(d) The term involuntary conversion, where it appears in subtitle A
of the Code or the regulations thereunder, includes dispositions of
excess property within irrigation projects described in this section.
(See, e.g., section 1231 and the regulations thereunder.)
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960.
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979]
Sec. 1.1033(d)-1 Destruction or disposition of livestock because
of disease.
(a) The destruction occurring in a taxable year to which the
Internal Revenue Code of 1954 applies, of livestock by, or on account
of, disease, or the sale or exchange, in such a year, of livestock
because of disease, shall be treated as an involuntary conversion to
which the provisions of section 1033 and the regulations thereunder
shall be applicable. Livestock which are killed either because they are
diseased or because of exposure to disease shall be considered destroyed
on account of disease. Livestock which are sold or exchanged because
they are diseased or have been exposed to disease, and would not
otherwise have been sold or exchanged at that particular time shall be
considered sold or exchanged because of disease.
(b) The provisions of Sec. 1.1033(a)-2 shall be applicable in the
case of a disposition treated as an involuntary conversion under this
section. The details in connection with such a disposition required to
be reported under paragraph (c)(2) of Sec. 1.1033(a)-2 shall include a
recital of the evidence that the livestock were destroyed by or on
account of disease, or sold or exchanged because of disease.
(c) The term involuntary conversion, where it appears in subtitle A
of the Code or the regulations thereunder, includes disposition of
livestock described in this section. (See, e.g., section 1231 and the
regulations thereunder.)
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960.
Redesignated by T.D. 7625, 44 FR 31013, May 30, 1979]
Sec. 1.1033(e)-1 Sale or exchange of livestock solely on account
of drought.
(a) The sale or exchange of livestock (other than poultry) held for
draft, breeding, or dairy purposes in excess of the number the taxpayer
would sell or exchange during the taxable year if he followed his usual
business practices
[[Page 133]]
shall be treated as an involuntary conversion to which section 1033 and
the regulations thereunder are applicable if the sale or exchange of
such livestock by the taxpayer is solely on account of drought. Section
1033(e) and this section shall apply only to sales and exchanges
occurring after December 31, 1955.
(b) To qualify under section 1033(e) and this section, the sale or
exchange of the livestock need not take place in a drought area. While
it is not necessary that the livestock be held in a drought area, the
sale or exchange of the livestock must be solely on account of drought
conditions the existence of which affected the water, grazing, or other
requirements of the livestock so as to necessitate their sale or
exchange.
(c) The total sales or exchanges of livestock held for draft,
breeding, or dairy purposes occurring in any taxable year which may
qualify as an involuntary conversion under section 1033(e) and this
section is limited to the excess of the total number of such livestock
sold or exchanged during the taxable year over the number that the
taxpayer would have sold or exchanged if he had followed his usual
business practices, that is, the number he would have been expected to
sell or exchange under ordinary circumstances if there had been no
drought. For example, if in the past it has been a taxpayer's practice
to sell or exchange annually one-half of his herd of dairy cows, only
the number sold or exchanged solely on account of drought conditions
which is in excess of one-half of his herd, may qualify as an
involuntary conversion under section 1033(e) and this section.
(d) The replacement requirements of section 1033 will be satisfied
only if the livestock sold or exchanged is replaced within the
prescribed period with livestock which is similar or related in service
or use to the livestock sold or exchanged because of drought, that is,
the new livestock must be functionally the same as the livestock
involuntarily converted. This means that the new livestock must be held
for the same useful purpose as the old was held. Thus, although dairy
cows could be replaced by dairy cows, a taxpayer could not replace draft
animals with breeding or dairy animals.
(e) The provisions of Sec. 1.1033(a)-2 shall be applicable in the
case of a sale or exchange treated as an involuntary conversion under
this section. The details in connection with such a disposition required
to be reported under paragraph (c)(2) of Sec. 1.1033(a)-2 shall
include:
(1) Evidence of the existence of the drought conditions which forced
the sale or exchange of the livestock;
(2) A computation of the amount of gain realized on the sale or
exchange;
(3) The number and kind of livestock sold or exchanged; and
(4) The number of livestocks of each kind that would have been sold
or exchanged under the usual business practice in the absence of the
drought.
(f) The term involuntary conversion, where it appears in subtitle A
of the Code or the regulations thereunder, includes the sale or exchange
of livestock described in this section.
(g) The provisions of section 1033(e) and this section apply to
taxable years ending after December 31, 1955, but only in the case of
sales or exchange of livestock after December 31, 1955.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960.
Redesignated by T.D. 7625, 44 FR 31013, May 30, 1979]
Sec. 1.1033(g)-1 Condemnation of real property held for productive
use in trade or business or for investment.
(a) Special rule in general. This section provides special rules for
applying section 1033 with respect to certain dispositions, occurring
after December 31, 1957, of real property held either for productive use
in trade or business or for investment (not including stock in trade or
other property held primarily for sale). For this purpose, disposition
means the seizure, requisition, or condemnation (but not destruction) of
the converted property, or the sale or exchange of such property under
threat or imminence of seizure, requisition, or condemnation. In such
cases, for purposes of applying section 1033, the replacement of such
property with property of like kind to be held either for productive use
in trade or business or for investment shall be treated as property
similar or related in service or use
[[Page 134]]
to the property so converted. For principles in determining whether the
replacement property is property of like kind, see paragraph (b) of
Sec. 1.1031(a)-1.
(b) Election to treat outdoor advertising displays as real
property--(1) In general. Under section 1033(g)(3) of the Code, a
taxpayer may elect to treat property which constitutes an outdoor
advertising display as real property for purposes of chapter 1 of the
Code. The election is available for taxable years beginning after
December 31, 1970. In the case of an election made on or before July 21,
1981, the election is available whether or not the period for filing a
claim for credit or refund under section 6511 has expired. No election
may be made with respect to any property for which (i) the investment
credit under section 38 has been claimed, or (ii) an election to expense
certain depreciable business assets under section 179(a) is in effect.
The election once made applies to all outdoor advertising displays of
the taxpayer which may be made the subject of an election under this
paragraph, including all outdoor advertising displays acquired or
constructed by the taxpayer in a taxable year after the taxable year for
which the election is made. The election applies with respect to
dispositions during the taxable year for which made and all subsequent
taxable years (unless an effective revocation is made pursuant to
paragraph (b)(2) (ii) or (iii)).
(2) Election--(i) Time and manner of making election--(A) In
general. Unless otherwise provided in the return or in the instructions
for a return for a taxable year, any election made under section
1033(g)(3) shall be made by attaching a statement to the return (or
amended return if filed on or before July 21, 1981) for the first
taxable year to which the election is to apply. Any election made under
this paragraph must be made not later than the time, including
extensions thereof, prescribed by law for filing the income tax return
for such taxable year or July 21, 1981, whichever occurs last. If a
taxpayer makes an election (or revokes an election under subdivision
(ii) or (iii) of this subparagraph (b) (2)) for a taxable year for which
he or she has previously filed a return, the return for that taxable
year and all other taxable years affected by the election (or
revocation) must be amended to reflect any tax consequences of the
election (or revocation). However, no return for a taxable year for
which the period for filing a claim for credit or refund under section
6511 has expired may be amended to make any changes other than those
resulting from the election (or revocation). In order for the election
(or revocation) to be effective, the taxpayer must remit with the
amended return any additional tax due resulting from the election (or
revocation), notwithstanding the provisions of section 6212(c) or 6501
or the provisions of any other law which would prevent assessment or
collection of such tax.
(B) Statement required when making election. The statement required
when making the election must clearly indicate that the election to
treat outdoor advertising displays as real property is being made.
(ii) Revocation of election by Commissioner's consent. Except as
otherwise provided in paragraph (b)(2)(iii) of this section, an election
under section 1033(g)(3) shall be irrevocable unless consent to revoke
is obtained from the Commissioner. In order to secure the Commissioner's
consent to revoke an election, the taxpayer must file a request for
revocation of election with the Commissioner of Internal Revenue,
Washington, DC 20224. The request for revocation shall include--
(A) The taxpayer's name, address, and taxpayer identification
number,
(B) The date on which and taxable year for which the election was
made and the Internal Revenue Service office with which it was filed,
(C) Identification of all outdoor advertising displays of the
taxpayer to which the revocation would apply (including the location,
date of purchase, and adjusted basis in such property),
(D) The effective date desired for the revocation, and
(E) The reasons for requesting the revocation.
The Commissioner may require such other information as may be necessary
in order to determine whether the requested revocation will be
permitted. The Commissioner may prescribe administrative procedures
(subject to
[[Page 135]]
such limitations, terms and conditions as he deems necessary) to obtain
his consent to permit the taxpayer to revoke the election. The taxpayer
may submit a request for revocation for any taxable year for which the
period of limitations for filing a claim for credit or refund or
overpayment of tax has not expired.
(iii) Revocation where election was made on or before December 11,
1979. In the case of an election made on or before December 11, 1979,
the taxpayer may revoke such election provided such revocation is made
not later than March 23, 1981. The request for revocation shall be made
in conformity with the requirements of paragraph (b)(2)(ii), except
that, in lieu of the information required by paragraph (b)(2)(ii)(E),
the taxpayer shall state that the revocation is being made pursuant to
this paragraph. In addition, the taxpayer must forward, with the
statement of revocation, copies of his or her tax returns, including
both the original return and any amended returns, for the taxable year
in which the original election was made and for all subsequent years and
must remit any additional tax due as a result of the revocation.
(3) Definition of outdoor advertising display. The term outdoor
advertising display means a rigidly assembled sign, display, or device
that constitutes, or is used to display, a commercial or other
advertisement to the public and is permanently affixed to the ground or
permanently attached to a building or other inherently permanent
structure. The term includes highway billboards affixed to the ground
with wood or metal poles, pipes, or beams, with or without concrete
footings.
(4) Character of replacement property. For purposes of section
1033(g), an interest in real property purchased as replacement property
for a compulsorily or involuntarily converted outdoor advertising
display (with respect to which an election under this section is in
effect) shall be considered property of a like kind as the property
converted even though a taxpayer's interest in the replacement property
is different from the interest held in the property converted. Thus, for
example, a fee simple interest in real estate acquired to replace a
converted billboard and a 5-year leasehold interest in the real property
on which the billboard was located qualifies as property of a like kind
under this section.
(c) Special rule for period within which property must be replaced.
In the case of a disposition described in paragraph (a) of this section,
section 1033(a)(2)(B) and Sec. 1.1033(a)-2(c)(3) (relating to the
period within which the property must be replaced) shall be applied by
substituting 3 years for 2 years. This paragraph shall apply to any
disposition described in section 1033(f)(1) and paragraph (a) of this
section occurring after December 31, 1974, unless a condemnation
proceeding with respect to the property was begun before October 4,
1976. Thus, regardless of when the property is disposed of, the taxpayer
will not be eligible for the 3-year replacement period if a condemnation
proceeding was begun before October 4, 1976. However, if the property is
disposed of after December 31, 1974, and the condemnation proceeding was
begun (if at all) after October 4, 1976, then the taxpayer is eligible
for the 3-year replacement period. For the purposes of this paragraph,
whether a condemnation proceeding is considered as having begun is
determined under the applicable State or Federal procedural law.
(d) Limitation on application of special rule. This section shall
not apply to the purchase of stock in the acquisition of control of a
corporation described in section 1033(a)(2)(A).
(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26
U.S.C. 7805))
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960.
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979; 44 FR
38458, July 2, 1979. Further redesignated and amended by T.D. 7758, 46
FR 6925, Jan. 22, 1981; T.D. 7758, 46 FR 23235, Apr. 24, 1981; T.D.
8121, 52 FR 414, Jan. 6, 1987]
[[Page 136]]
Sec. 1.1033(h)-1 Effective date.
Except as provided otherwise in Sec. 1.1033(e)-1 and Sec.
1.1033(g)-1, the provisions of section 1033 and the regulations
thereunder are effective for taxable years beginning after December 31,
1953, and ending after August 16, 1954.
(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26
U.S.C. 7805))
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960.
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979.
Further redesignated and amended by T.D. 7758, 46 FR 6925, Jan. 22,
1981]
Sec. 1.1035-1 Certain exchanges of insurance policies.
Under the provisions of section 1035 no gain or loss is recognized
on the exchange of:
(a) A contract of life insurance for another contract of life
insurance or for an endowment or annuity contract (section 1035(a)(1));
(b) A contract of endowment insurance for another contract of
endowment insurance providing for regular payments beginning at a date
not later than the date payments would have begun under the contract
exchanged, or an annuity contract (section 1035(a)(2)); or
(c) An annuity contract for another annuity contract (section
1035(a)(3)), but section 1035 does not apply to such exchanges if the
policies exchanged to not relate to the same insured. The exchange,
without recognition of gain or loss, of an annuity contract for another
annuity contract under section 1035(a)(3) is limited to cases where the
same person or persons are the obligee or obligees under the contract
received in exchange as under the original contract. This section and
section 1035 do not apply to transactions involving the exchange of an
endowment contract or annuity contract for a life insurance contract,
nor an annuity contract for an endowment contract. In the case of such
exchanges, any gain or loss shall be recognized. In the case of
exchanges which would be governed by section 1035 except for the fact
that the property received in exchange consists not only of property
which could otherwise be received without the recognition of gain or
loss, but also of other property or money, see section 1031 (b) and (c)
and the regulations thereunder. Such an exchange does not come within
the provisions of section 1035. Determination of the basis of property
acquired in an exchange under section 1035(a) shall be governed by
section 1031(d) and the regulations thereunder.
Sec. 1.1036-1 Stock for stock of the same corporation.
(a) Section 1036 permits the exchange, without the recognition of
gain or loss, of common stock for common stock, or of preferred stock
for preferred stock, in the same corporation. Section 1036 applies even
though voting stock is exchanged for nonvoting stock or nonvoting stock
is exchanged for voting stock. It is not limited to an exchange between
two individual stockholders; it includes a transaction between a
stockholder and the corporation. However, a transaction between a
stockholder and the corporation may qualify not only under section
1036(a), but also under section 368(a)(1)(E) (recapitalization) or
section 305(a) (distribution of stock and stock rights). The provisions
of section 1036(a) do not apply if stock is exchanged for bonds, or
preferred stock is exchanged for common stock, or common stock is
exchanged for preferred stock, or common stock in one corporation is
exchanged for common stock in another corporation. See paragraph (l) of
section 1301-1 for certain transactions treated as distributions under
section 301. See paragraph (e)(5) of Sec. 1.368-2 for certain
transactions which result in deemed distributions under section 305(c)
to which sections 305(b)(4) and 301 apply.
(b) For rules relating to recognition of gain or loss where an
exchange is not wholly in kind, see subsections (b) and (c) of section
1031. For rules relating to the basis of property acquired in an
exchange described in paragraph (a) of this section, see subsection (d)
of section 1031.
(c) A transfer is not within the provisions of section 1036(a) if as
part of the consideration the other party to the exchange assumes a
liability of the taxpayer (or if the property transferred is subject to
a liability), but the transfer, if otherwise qualified, will be within
the provisions of section 1031(b).
[[Page 137]]
(d) Nonqualified preferred stock. See Sec. 1.356-7(a) for the
applicability of the definition of nonqualified preferred stock in
section 351(g)(2) for stock issued prior to June 9, 1997, and for stock
issued in transactions occurring after June 8, 1997, that are described
in section 1014(f)(2) of the Taxpayer Relief Act of 1997, Public Law
105-34 (111 Stat. 788, 921).
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7281, 38 FR
18540, July 12, 1973; T.D. 8904, 65 FR 58652, Oct. 2, 2000]
Sec. 1.1037-1 Certain exchanges of United States obligations.
(a) Nonrecognition of gain or loss--(1) In general. Section 1037(a)
provides for the nonrecognition of gain or loss on the surrender to the
United States of obligations of the United States issued under the
Second Liberty Bond Act (31 U.S.C. 774(2)) when such obligations are
exchanged solely for other obligations issued under that Act and the
Secretary provides by regulations promulgated in connection with the
issue of such other obligations that gain or loss is not to be
recognized on such exchange. It is not necessary that at the time of the
exchange the obligation which is surrendered to the United States be a
capital asset in the hands of the taxpayer. For purposes of section
1037(a) and this subparagraph, a circular of the Treasury Department
which offers to exchange obligations of the United States issued under
the Second Liberty Bond Act for other obligations issued under that Act
shall constitute regulations promulgated by the Secretary in connection
with the issue of the obligations offered to be exchanged if such
circular contains a declaration by the Secretary that no gain or loss
shall be recognized for Federal income tax purposes on the exchange or
grants the privilege of continuing to defer the reporting of the income
of the bonds exchanged until such time as the bonds received in the
exchange are redeemed or disposed of, or have reached final maturity,
whichever is earlier. See, for example, regulations of the Bureau of the
Public Debt, 31 CFR part 339, or Treasury Department Circular 1066, 26
FR 8647. The application of section 1037(a) and this subparagraph will
not be precluded merely because the taxpayer is required to pay money on
the exchange. See section 1031 and the regulations thereunder if the
taxpayer receives money on the exchange.
(2) Recognition of gain or loss postponed. Gain or loss which has
been realized but not recognized on the exchange of a U.S. obligation
for another such obligation because of the provisions of section 1037(a)
(or so much of section 1031 (b) or (c) as related to section 1037(a))
shall be recognized at such time as the obligation received in the
exchange is disposed of, or redeemed, in a transaction other than an
exchange described in section 1037(a) (or so much of section 1031 (b) or
(c) as relates to section 1037(a)) or reaches final maturity, whichever
is earlier, to the extent gain or loss is realized on such later
transaction.
(3) Illustrations. The application of this paragraph may be
illustrated by the following examples, in which it is assumed that the
taxpayer uses the cash receipts and disbursements method of accounting
and has never elected under section 454(a) to include in gross income
currently the annual increase in the redemption price of non-interest-
bearing obligations issued at a discount. In addition, it is assumed
that the old obligations exchanged are capital assets transferred in an
exchange in respect of which regulations are promulgated pursuant to
section 1037(a):
Example 1. A, the owner of a $1,000 series E U.S. savings bond
purchased for $750 and bearing an issue date of May 1, 1945, surrenders
the bond to the United States in exchange solely for series H U.S.
savings bonds on February 1, 1964, when the series E bond has a
redemption value of $1,304.80. In the exchange A pays an additional
$195.20 and obtains three $500 series H bonds. None of the $554.80 gain
($1,304.80 less $750) realized by A on the series E bond is recognized
at the time of the exchange.
Example 2. In 1963, B purchased for $97 a marketable U.S. bond which
was originally issued at its par value of $100. In 1964 he surrenders
the bond to the United States in exchange solely for another marketable
U.S. bond which then has a fair market value of $95. B's loss of $2 on
the old bond is not recognized at the time of the exchange, and his
basis for the new bond is $97 under section 1031(d). If it has been
necessary for B to pay $1 additional consideration in the exchange, his
basis in the new bond would be $98.
[[Page 138]]
Example 3. The facts are the same as in example (2) except that B
also receives $1 interest on the old bond for the period which has
elapsed since the last interest payment date and that B does not pay any
additional consideration on the exchange. As in example (2), B has a
loss of $2 which is not recognized at the time of the exchange and his
basis in the new bond is $97. In addition, the $1 of interest received
on the old bond is includible in gross income. B holds the new bond 1
year and sells it in the market for $99 plus interest. At this time he
has a gain of $2, the difference between his basis of $97 in the new
bond and the sales price of such bond. In addition, the interest
received on the new bond is includible in gross income.
Example 4. The facts are the same as in example (2), except that in
addition to the new bond B also receives $1.85 in cash, $0.85 of which
is interest. The $0.85 interest received is includible in gross income.
B's loss of $1 ($97 less $96) on the old bond is not recognized at the
time of the exchange by reason of section 1031(c). Under section 1031(d)
B's basis in the new bond is $96 (his basis of $97 in the old bond,
reduced by the $1 cash received in the exchange).
Example 5. (a) For $975 D subscribes to a marketable U.S. obligation
which has a face value of $1,000. Thereafter, he surrenders this
obligation to the United States in exchange solely for a 10-year
marketable $1,000 obligation which at the time of exchange has a fair
market value of $930, at which price such obligation is initially
offered to the public. At the time of issue of the new obligation there
was no intention to call it before maturity. Five years after the
exchange D sells the new obligation for $960.
(b) On the exchange of the old obligation for the new obligation D
sustains a loss of $45 ($975 less $930), none of which is recognized
pursuant to section 1037(a).
(c) The basis of the new obligation in D's hands, determined under
section 1031(d), is $975 (the same basis as that of the old obligation).
(d) On the sale of the new obligation D sustains a loss of $15 ($975
less $960), all of which is recognized by reason of section 1002.
Example 6. (a) The facts are the same as in example (5), except that
five years after the exchange D sells the new obligation for $1,020.
(b) On the exchange of the old obligation for the new obligation D
sustains a loss of $45 ($975 less $930), none of which is recognized
pursuant to section 1037(a).
(c) The basis of the new obligation in D's hands, determined under
section 1031(d), is $975 (the same basis as that of the old obligation).
The issue price of the new obligation under section 1232(b)(2) is $930.
(d) On the sale of the new obligation D realizes a gain of $45
($1,020 less $975), all of which is recognized by reason of section
1002. Of this gain of $45, the amount of $35 is treated as ordinary
income and $10 is treated as long-term capital gain, determined as
follows:
(1) Ordinary income under first sentence of section
1232(a)(2)(B) on sale of new obligation:
Stated redemption price of new obligation at maturity........ $1,000
Less: Issue price of new obligation under section 1232(b)(2). 930
--------
Original issue discount on new obligation.................... 70
========
Proration under section 1232(a)(2)(B)(ii): ($70 x 60 months/ 35
120 months).................................................
(2) Long-term capital gain ($45 less $35)...................... 10
Example 7. (a) The facts are the same as in example (5), except that
D retains the new obligation and redeems it at maturity for $1,000.
(b) On the exchange of the old obligation for the new obligation D
sustains a loss of $45 ($975 less $930), none of which is recognized
pursuant to section 1037(a).
(c) The basis of the new obligation in D's hands, determined under
section 1031(d), is $975 (the same basis as that of the old obligation).
The issue price of the new obligation is $930 under section 1232(b)(2).
(d) On the redemption of the new obligation D realizes a gain of $25
($1,000 less $975), all of which is recognized by reason of section
1002. Of this gain of $25, the entire amount is treated as ordinary
income, determined as follows:
Ordinary income under first sentence of section 1232(a)(2)(B)
on redemption of new obligation:
Stated redemption price of new obligation at maturity........ $1,000
Less: Issue price of new obligation under section 1232(b)(2). 930
--------
Original issue discount on new obligation.................... 70
========
Proration under section 1232(a)(2)(B)(ii): ($70 x 120 months/ 25
120 months), but such amount not to exceed the $25 gain
recognized on redemption....................................
(b) Application of section 1232 upon disposition or redemption of
new obligation--(1) Exchanges involving nonrecognition of gain on
obligations issued at a discount. If an obligation, the gain on which is
subject to the first sentence of section 1232(a)(2)(B), because the
obligation was originally issued at a discount, is surrendered to the
United States in exchange for another obligation and any part of the
gain realized on the exchange is not then recognized because of the
provisions of section 1037(a) (or because of so much of section 1031(b)
as relates to section 1037(a)), the first sentence of section
1232(a)(2)(B) shall apply to so much of such unrecognized
[[Page 139]]
gain as is later recognized upon the disposition or redemption of the
obligation which is received in the exchange as though the obligation so
disposed of or redeemed were the obligation surrendered, rather than the
obligation received, in such exchange. See the first sentence of section
1037(b)(1). Thus, in effect that portion of the gain which is
unrecognized on the exchange but is recognized upon the later
disposition or redemption of the obligation received from the United
States in the exchange shall be considered as ordinary income in an
amount which is equal to the gain which, by applying the first sentence
of section 1232(a)(2)(B) upon the earlier surrender of the old
obligation to the United States, would have been considered as ordinary
income if the gain had been recognized upon such earlier exchange. Any
portion of the gain which is recognized under section 1031(b) upon the
earlier exchange and is treated at such time as ordinary income shall be
deducted from the gain which is treated as ordinary income by applying
the first sentence of section 1232(a)(2)(B) pursuant to this
subparagraph upon the disposition or redemption of the obligation which
is received in the earlier exchange. This subparagraph shall apply only
in a case where on the exchange of United States obligations there was
some gain not recognized by reason of section 1037(a) (or so much of
section 1031(b) as relates to section 1037(a)); it shall not apply
where, only loss was unrecognized by reason of section 1037(a).
(2) Rules to apply when a nontransferable obligation is surrendered
in the exchange. For purposes of applying both section 1232(a)(2)(B) and
subparagraph (1) of this paragraph to the total gain realized on the
obligation which is later disposed of or redeemed, if the obligation
surrendered to the United States in the earlier exchange is a
nontransferable obligation described in section 454 (a) or (c)--
(i) The aggregate amount considered, with respect to the obligation
so surrendered in the earlier exchange, as ordinary income shall not
exceed the difference between the issue price of the surrendered
obligation and the stated redemption price of the surrendered obligation
which applied at the time of the earlier exchange, and
(ii) The issue price of the obligation which is received from the
United States in the earlier exchange shall be considered to be the
stated redemption price of the surrendered obligation which applied at
the time of the earlier exchange, increased by the amount of other
consideration (if any) paid to the United States as part of the earlier
exchange.
If the obligation received in the earlier exchange is a nontransferable
obligation described in section 454(c) and such obligation is partially
redeemed before final maturity or partially disposed of by being
partially reissued to another owner, the amount determined by applying
subdivision (i) of this subparagraph shall be determined on a basis
proportional to the total denomination of obligations redeemed or
disposed of. See paragraph (c) of Sec. 1.454-1.
(3) Long-term capital gain. If, in a case where both subparagraphs
(1) and (2) of this paragraph are applied, the total gain realized on
the redemption or disposition of the obligation which is received from
the United States in the exchange to which section 1037(a) (or so much
of section 1031(b) as related to section 1037(a)) applies exceeds the
amount of gain which, by applying such subparagraphs, is treated as
ordinary income, the gain in excess of such amount shall be treated as
long-term capital gain.
(4) Illustrations. The application of this paragraph may be
illustrated by the following examples, in which it is assumed that the
taxpayer uses the cash receipts and disbursements method of accounting
and has never elected under section 454(a) to include in gross income
currently the annual increase in the redemption price of non-interest-
bearing obligations issued at a discount. In addition, it is assumed
that the old obligations exchanged are capital assets transferred in an
exchange in respect of which regulations are promulgated pursuant to
section 1037(a):
Example 1. (a) A purchased a noninterest-bearing nontransferable
U.S. bond for $74 which was issued after December 31, 1954, and
redeemable in 10 years for $100. Several years later, when the stated
redemption value of such bond is $94.50, A surrenders it to the
[[Page 140]]
United States in exchange for $1 in cash and a 10-year marketable bond
having a face value of $100. On the date of exchange the bond received
in the exchange has a fair market value of $96. Less than one month
after the exchange, A sells the new bond for $96.
(b) On the exchange of the old bond for the new bond A realizes a
gain of $23, determined as follows:
Amount realized (a new bond worth $96 plus $1 cash).............. $97
Less: Adjusted basis of old bond................................. 74
------
Gain realized................................................ 23
Pursuant to so much of section 1031(b) as applies to section
1037(a), the amount of such gain which is recognized is $1 (the money
received). Such recognized gain of $1 is treated as ordinary income. On
the exchange of the old bond a gain of $22 ($23 less $1) is not
recognized.
(c) The basis of the new bond in A's hands, determined under section
1031(d) is $74 (the basis of the old bond, decreased by the $1 received
in cash and increased by the $1 gain recognized on the exchange).
(d) On the sale of the new bond A realizes a gain of $22 ($96 less
$74), all of which is recognized by reason of section 1002. Of this gain
of $22, the amount of $19.50 is treated as ordinary income and $2.50 is
treated as long-term capital gain, determined as follows:
(1) Ordinary income, treating sale of new bond as though
a sale of old bond and applying section 1037(b)(1)(A):
Stated redemption price of old bond................... $94.50
Less: Issue price of old bond......................... 74.00
-----------------
Aggregate gain under section 1037(b)(1)(A) (not to 20.50
exceed $22 not recognized at time of exchange).....
Less: Amount of such gain recognized at time of 1.00
exchange...........................................
-----------------
Ordinary income....................................... 19.50
=================
(2) Ordinary income under first sentence of section
1232(a)(2)(B), applying section 1037(b)(1)(B) to sale
of new bond:
Stated redemption price of new bond at $100.00
maturity.............................
Less: Issue price of new bond under 94.50
section 1037(b)(1)(B) ($94.50 plus $0
additional consideration paid on
exchange)............................
----------------
Original issue discount on new bond... 5.50
================
Proration under section .............. 0
1232(a)(2)(B)(ii): ($5.50 x 0 months/
120 months)..........................
---------------
(3) Total ordinary income (sum of subparagraphs (1) and 19.50
(2))...................................................
(4) Long-term capital gain ($22 less $19.50)............ 2.50
Example 2. (a) The facts are the same as in example (1), except
that, less than one month after the exchange of the old bond, the new
bond is sold for $92.
(b) On the sale of the new bond A realizes a gain of $18 ($92 less
$74), all of which is recognized by reason of section 1002. Of this
gain, the entire amount of $18 is treated as ordinary income. This
amount is determined as provided in paragraph (d)(1) of example (1)
except that the ordinary income of $19.50 is limited to the $18
recognized on the sale of the new bond.
Example 3. (a) The facts are the same as in example (1), except that
2 years after the exchange of the old bond A sells the new bond for $98.
(b) On the sale of the new bond A realizes a gain of $24 ($98 less
$74), all of which is recognized by reason of section 1002. Of this gain
of $24, the amount of $20.60 is treated as ordinary income and $3.40 is
treated as long-term capital gain, determined as follows:
(1) Ordinary income applicable to old bond (determined as $19.50
provided in paragraph (d)(1) of example (1)).................
(2) Ordinary income applicable to new bond (determined as 1.10
provided in paragraph (d)(2) of example (1), except that the
proration of the original issue discount under section
1232(a)(2)(B)(ii) amounts to $1.10 ($5.50 x 24 months/120
months)......................................................
---------
(3) Total ordinary income (sum of subparagraphs (1) and (2)).. 20.60
(4) Long-term capital gain ($24 less $20.60).................. 3.40
Example 4. (a) The facts are the same as in example (1), except that
A retains the new bond and redeems it at maturity for $100.
(b) On the redemption of the new bond A realizes a gain of $26 ($100
less $74), all of which is recognized by reason of section 1002. Of this
gain of $26, the amount of $25 is treated as ordinary income and $1 is
treated as long-term capital gain, determined as follows:
(1) Ordinary income applicable to old bond (determined as $19.50
provided in paragraph (d)(1) of example (1)).................
(2) Ordinary income applicable to new bond (determined as 5.50
provided in paragraph (d)(2) of example (1), except that the
proration of the original issue discount under section
1232(a)(2)(B)(ii) amounts to $5.50 ($5.50 x 120 months/120
months)).....................................................
---------
(3) Total ordinary income (sum of subparagraphs (1) and (2)).. 25.00
(4) Long-term capital gain ($26 less $25)..................... 1.00
Example 5. (a) In 1958 B purchased for $7,500 a series E United
States savings bond having a face value of $10,000. In 1965 when the
stated redemption value of the series E bond is $9,760, B surrenders it
to the United States in exchange solely for a $10,000 series H U.S.
savings bond, after paying $240 additional consideration. B retains the
series H bond and redeems it at maturity in 1975 for $10,000, after
receiving all the semiannual interest payments thereon.
[[Page 141]]
(b) On the exchange of the series E bond for the series H bond, B
realizes a gain of $2,260 ($9,760 less $7,500), none of which is
recognized at such time by reason of section 1037(a).
(c) The basis of the series H bond in B's hands, determined under
section 1031(d), is $7,740 (the $7,500 basis of the series E bond, plus
$240 additional consideration paid for the series H bond).
(d) On the redemption of the series H bond, B realizes a gain of
$2,260 ($10,000 less $7,740), all of which is recognized by reason of
section 1002. This entire gain is treated as ordinary income by treating
the redemption of the series H bond as though it were a redemption of
the series E bond and by applying section 1037(b)(1)(A).
(e) Under section 1037(b)(1)(B) the issue price of the series H
bonds is $10,000 ($9,760 stated redemption price of the series E bond at
time of exchange, plus $240 additional consideration paid). Thus, with
respect to the series H bond, there is no original issue discount to
which section 1232(a)(2)(B) might apply.
Example 6. (a) The facts are the same as in example (5), except that
in 1970 B submits the $10,000 series H bond to the United States for
partial redemption in the amount of $3,000 and for reissuance of the
remainder in $1,000 series H savings bonds registered in his name. On
this transaction B receives $3,000 cash and seven $1,000 series H bonds,
bearing the original issue date of the $10,000 bond which is partially
redeemed. The $1,000, series H bonds are redeemed at maturity in 1975
for $7,000.
(b) On the partial redemption of the $10,000 series H bond in 1970 B
realizes a gain of $678 ($3,000 less $2,322 [$7,740 x $3,000/$10,000]),
all of which is recognized at such time by reason of section 1002 and
paragraph (c) of Sec. 1.454-1. This entire gain is treated as ordinary
income, by treating the partial redemption of the series H bond as
though it were a redemption of the relevant denominational portion of
the series E bond and by applying section 1037(b)(1)(A).
(c) On the redemption at maturity in 1975 of the seven $1,000 series
H bonds B realizes a gain of $1,582 ($7,000 less $5,418 [$7,740 x
$7,000/$10,000]), all of which is recognized at such time by reason of
section 1002 and paragraph (c) of Sec. 1.454-1. This entire gain is
treated as ordinary income, determined in the manner described in
paragraph (b) of this example.
Example 7. (a) The facts are the same as in example (5), except that
in 1970 B requests the United States to reissue the $10,000 series H
bond by issuing two $5,000 series H bonds bearing the original issue
date of such $10,000 bond. One of such $5,000 bonds is registered in B's
name, and the other is registered in the name of C, who is B's son. Each
$5,000 series H bond is redeemed at maturity in 1975 for $5,000.
(b) On the issuing in 1970 of the $5,000 series H bond to C, B
realizes a gain of $1,130 ($5,000 less $3,870 [$7,740 x $5,000/
$10,000]), all of which is recognized at such time by reason of section
1002 and paragraph (c) of Sec. 1.454-1. This entire gain is treated as
ordinary income by treating the transaction as though it were a
redemption of the relevant denominational portion of the series E bond
and by applying section 1037(b)(1)(A).
(c) On the redemption at maturity in 1975 of the $5,000 series H
bond registered in his name B realizes a gain of $1,130 ($5,000 less
$3,870 [$7,740 x $5,000/$10,000]), all of which is recognized at such
time by reason of section 1002 and paragraph (c) of Sec. 1.454-1. This
entire gain is treated as ordinary income, determined in the manner
described in paragraph (b) of this example.
(d) On the redemption at maturity in 1975 of the $5,000 series H
bond registered in his name C does not realize any gain, since the
amount realized on redemption does not exceed his basis in the property,
determined as provided in section 1015.
(5) Exchanges involving nonrecognition of gain or loss on
transferable obligations issued at not less than par--(i) In general. If
a transferable obligation of the United States which was originally
issued at not less than par is surrendered to the United States for
another transferable obligation in an exchange to which the provisions
of section 1037(a) (or so much of section 1031 (b) or (c) as relates to
section 1037(a)) apply, the issue price of the obligation received from
the United States in the exchange shall be considered for purposes of
applying section 1232 to gain realized on the disposition or redemption
of the obligation so received, to be the same as the issue price of the
obligation which is surrendered to the United States in the exchange,
increased by the amount of other consideration, if any, paid to the
United States as part of the exchange. This subparagraph shall apply
irrespective of whether there is gain or loss unrecognized on the
exchange and irrespective of the fair market value, at the time of the
exchange, of either the obligation surrendered to, or the obligation
received from, the United States in the exchange.
(ii) Illustrations. The application of this subparagraph may be
illustrated by the following examples, in which it is assumed that the
taxpayer uses the
[[Page 142]]
cash receipts and disbursements method of accounting and that the old
obligations exchanged are capital assets transferred in an exchange in
respect of which regulations are promulgated pursuant to section
1037(a):
Example 1. (a) A purchases in the market for $85 a marketable U.S.
bond which was originally issued at its par value of $100. Three months
later, A surrenders this bond to the United States in exchange solely
for another $100 marketable U.S. bond which then has a fair market value
of $88. He holds the new bond for 5 months and then sells it on the
market for $92.
(b) On the exchange of the old bond for the new bond A realizes a
gain of $3 ($88 less $85), none of which is recognized by reason of
section 1037(a).
(c) The basis of the new bond in A's hands, determined under section
1031(d), is $85 (the same as that of the old bond). The issue price of
the new bond for purposes of section 1232(a)(2)(B) is considered under
section 1037(b)(2) to be $100 (the same issue price as that of the old
bond).
(d) On the sale of the new bond A realizes a gain of $7 ($92 less
$85), all of which is recognized by reason of section 1002. Of this gain
of $7, the entire amount is treated as long-term capital gain,
determined as follows:
(1) Ordinary income under first sentence of
section 1232(a)(2)(B), applicable to old bond:
Stated redemption price of old bond at maturity. $100
Less: Issue price of old bond................... 100
-----------
Original issue discount on old bond........................ 0
(2) Ordinary income under first sentence of section
1232(a)(2)(B), applying section 1037(b)(2) to sale of new
bond:
Stated redemption price of new bond at maturity. 100
Less: Issue price of new bond under section 100
1037(b)(2).....................................
-----------
Original issue discount on new bond........................ 0
(3) Long-term capital gain ($7 less sum of subparagraphs (1) $7
and (2))....................................................
Example 2. The facts are the same as in example (1), except that A
retains the new bond and redeems it at maturity for $100. On the
redemption of the new bond, A realizes a gain of $15 ($100 less $85),
all of which is recognized under section 1002. This entire gain is
treated as long-term capital gain, determined in the same manner as
provided in paragraph (d) of example (1).
Example 3. (a) For $1,000 B subscribes to a marketable U.S. bond
which has a face value of $1,000. Thereafter, he surrenders this bond to
the United States in exchange solely for a 10-year marketable $1,000
bond which at the time of exchange has a fair market value of $930, at
which price such bond is initially offered to the public. Five years
after the exchange, B sells the new bond for $950.
(b) On the exchange of the old bond for the new bond, B sustains a
loss of $70 ($1,000 less $930), none of which is recognized pursuant to
section 1037(a).
(c) The basis of the new bond in A's hands, determined under section
1031(d), is $1,000 (the same basis as that of the old bond).
(d) On the sale of the new bond B sustains a loss of $50 ($1,000
less $950), all of which is recognized by reason of section 1002.
Example 4. (a) The facts are the same as in example (3), except that
5 years after the exchange B sells the new bond for $1,020.
(b) On the exchange of the old bond for the new bond B sustains a
loss of $70 ($1,000 less $930), none of which is recognized pursuant to
section 1037(a).
(c) The basis of the new bond in B's hands, determined under section
1031(d), is $1,000 (the same basis as that of the old bond). The issue
price of the new bond for purposes of section 1232(a)(2)(B) is
considered under section 1037(b)(2) to be $1,000 (the same issue price
as that of the old bond).
(d) On the sale of the new bond B realizes a gain of $20 ($1,020
less $1,000), all of which is recognized by reason of section 1002. This
entire gain is treated as long-term capital gain, determined in the same
manner as provided in paragraph (d) of example (1).
(6) Other rules for applying section 1232. To the extent not
specifically affected by the provisions of section 1037(b) and
subparagraphs (1) through (5) of this paragraph, any gain realized on
the disposition or redemption of any obligation received from the United
States in an exchange to which section 1037(a) (or so much of section
1031 (b) or (c) as relates to section 1037(a)) applies shall be treated
in the manner provided by section 1232 if the facts and circumstances
relating to the acquisition and disposition or redemption of such
obligation require the application of section 1232.
(c) Holding period of obligation received in the exchange. The
holding period of an obligation received from the United States in an
exchange to which the provisions of section 1037(a) (or so much of
section 1031 (b) or (c) as relates to section 1037(a)) apply shall
include the period for which the obligation which was surrendered to the
United States in the exchange was held by the taxpayer, but only if the
obligation so surrendered was at the time of the exchange a capital
asset in the hands of
[[Page 143]]
the taxpayer. See section 1223 and the regulations thereunder.
(d) Basis. The basis of an obligation received from the United
States in an exchange to which the provisions of section 1037(a) (or so
much of section 1031 (b) or (c) as relates to section 1037(a)) apply
shall be determined as provided in section 1031(d) and the regulations
thereunder.
(e) Effective date. Section 1.1037 and this section shall apply only
for taxable years ending after September 22, 1959.
[T.D. 6935, 32 FR 15824, Nov. 17, 1967, as amended by T.D. 7154, 36 FR
24998, Dec. 28, 1971]
Sec. 1.1038-1 Reacquisitions of real property in satisfaction
of indebtedness.
(a) Scope of section 1038--(1) General rule on gain or loss. If a
sale of real property gives rise to indebtedness to the seller which is
secured by the real property which is sold, and the seller of such
property reacquires such property in a taxable year beginning after
September 2, 1964, in partial or full satisfaction of such indebtedness,
then, except as provided in paragraphs (b) and (f) of this section, no
gain or loss shall result to the seller from such reacquisition. The
treatment so provided is mandatory; however, see Sec. 1.1038-3 for an
election to apply the provisions of this section to certain taxable
years beginning after December 31, 1957. It is immaterial, for purposes
of applying this subparagraph, whether the seller realized a gain or
sustained a loss on the sale of the real property, or whether it can be
ascertained at the time of the sale whether gain or loss occurs as a
result of the sale. It is also immaterial what method of accounting the
seller used in reporting gain or loss from the sale of the real property
or whether at the time of reacquisition such property has depreciated or
appreciated in value since the time of the original sale. Moreover, the
character of the gain realized on the original sale of the property is
immaterial for purposes of applying this subparagraph. The provisions of
this section shall apply, except as provided in Sec. 1.1038-2, to the
reacquisition of real property which was used by the seller as his
principal residence and with respect to the sale of which an election
under section 121 is in effect or with respect to the sale of which gain
was not recognized under section 1034.
(2) Sales giving rise to indebtedness--(i) Sale defined. For
purposes of this section, it is not necessary for title to the property
to have passed to the purchaser in order to have a sale. Ordinarily, a
sale of property has occurred in a transaction in which title to the
property has not passed to the purchaser, if the purchaser has a
contractual right to retain possession of the property so long as he
performs his obligations under the contract and to obtain title to the
property upon the completion of the contract. However, a sale may have
occurred even if the purchaser does not have the right to possession
until he partially or fully satisfies the terms of the contract. For
example, if S contracts to sell real property to P, and if S promises to
convey title to P upon the completion of all of the payments due under
the contract and to allow P to obtain possession of the property after
10 percent of the purchase price has been paid, there has been a sale on
the date of the contract for purposes of this section. This section
shall not apply to a disposition of real property which constituted an
exchange of property or was treated as a sale under section 121(d)(4) or
section 1034(i); nor shall it apply to a sale of stock in a cooperative
housing corporation described in section 121(d)(3) or section 1034(f).
(ii) Secured indebtedness defined. An indebtedness to the seller is
secured by the real property for purposes of this section whenever the
seller has the right to take title or possession of the property or both
if there is a default with respect to such indebtedness. A sale of real
property may give rise to an indebtedness to the seller although the
seller is limited in his recourse to the property for payment of the
indebtedness in the case of a default.
(3) Reacquisitions in partial or full satisfaction of indebtedness--
(i) Purpose of reacquisition. This section applies only where the seller
reacquires the real property in partial or full satisfaction of the
indebtedness to him that arose from the sale of the real property and
was secured by the property. That is,
[[Page 144]]
the reacquisition must be in furtherance of the seller's security rights
in the property with respect to indebtedness to him that arose at the
time of the sale. Accordingly, if the seller in reacquiring the real
property does not pay consideration in addition to discharging the
purchaser's indebtedness to him that arose from the sale and was secured
by such property, this section shall apply to the reacquisition even
though the purchaser has not defaulted in his obligations under the
contract or such a default is not imminent. If in addition to
discharging the purchaser's indebtedness to him that arose from the sale
the seller pays consideration in reacquiring the real property, this
section shall generally apply to the reacquisition if the reacquisition
and the payment of additional consideration is provided for in the
original contract for the sale of the property. This section generally
shall apply to a reacquisition of real property if the seller reacquires
the property either when the purchaser has defaulted in his obligations
under the contract or when such a default is imminent. This section
generally shall not apply to a reacquisition of real property where the
seller pays consideration in addition to discharging the purchaser's
indebtedness to him that arose from the sale if the reacquisition and
payment of additional consideration was not provided for in the original
contract for the sale of the property and if the purchaser has not
defaulted in his obligations under the contract or such a default is not
imminent. Thus, for example, if the purchaser is in arrears on the
payment of interest or principal or has in any other way defaulted on
his contract for the purchase of the property, or if the facts of the
case indicate that the purchaser is unable satisfactorily to perform his
obligations under the contract, and the seller reacquires the property
from the purchaser in a transaction in which the seller pays
consideration in addition to discharging the purchaser's indebtedness to
him that arose from the sale and was secured by the property, this
section shall apply to the reacquisition. Additional consideration paid
by the seller includes money and other property paid or transferred by
the seller. Also, the reacquisition by the seller of real property
subject to an indebtedness (or the assumption, upon the reacquisition,
of indebtedness) which arose subsequent to the original sale shall be
considered as a payment by the seller of additional consideration.
However, the reacquisition by the seller of real property subject to an
indebtedness (or the assumption, upon the reacquisition, of an
indebtedness) which arose prior to or arose out of the original sale
shall not be considered as a payment by the seller of additional
consideration.
(ii) Manner of reacquisition. For purposes of applying section 1038
and this section there must be a reacquisition by the seller of the real
property itself, but the manner in which the seller so reduces the
property to ownership or possession, as the case may be, shall generally
be immaterial. Thus, the seller may reduce the real property to
ownership or possession or both, as the case may require, by agreement
or by process of law. The reduction of the real property to ownership or
possession by agreement includes, where valid under local law, such
methods as voluntary conveyance from the purchaser and abandonment to
the seller. The reduction of the real property to ownership or
possession by process of law includes foreclosure proceedings in which a
competitive bid is entered, such as foreclosure by judicial sale or by
power of sale contained in the loan agreement without recourse to the
courts, as well as those types of foreclosure proceedings in which a
competitive bid is not entered, such as strict foreclosure and
foreclosure by entry and possession, by writ of entry, or by publication
or notice.
(4) Persons from whom real property may be reacquired. The real
property reacquired in satisfaction of the indebtedness need not be
reacquired from the purchaser but may be reacquired from the purchaser's
transferee or assignee, or from a trustee holding title to such property
pending the purchaser's satisfaction of the terms of the contract, so
long as the indebtedness that is partially or completely satisfied in
the reacquisition of such property arose in the original sale of the
property and was secured by the property so reacquired. In such a case,
a reference in
[[Page 145]]
this section to the purchaser shall, where appropriate, include the
purchaser's transferee or assignee. Thus, for example, this section will
apply if the seller reacquires the property from a purchaser from the
original purchaser and either the property is subject to, or the
subsequent purchaser assumes, the liability to the seller on the
indebtedness.
(5) Reacquisitions not included. This section shall not apply to
reacquisitions of real property by mutual savings banks, domestic
building and loan associations, and cooperative banks, described in
section 593(a).
(b) Amount of gain resulting from a reacquisition--(1) Determination
of amount--(i) In general. As a result of a reacquisition to which
paragraph (a) of this section applies gain shall be derived by the
seller to the extent that the amount of money and the fair market value
of other property (other than obligations of the purchaser arising with
respect to the sale) which are received by the seller, prior to such
reacquisition, with respect to the sale of the property exceed the
amount of the gain derived by the seller on the sale of such property
which is returned as income for periods prior to the reacquisition.
However, the amount of gain so determined shall in no case exceed the
amount determined under paragraph (c) of this section with respect to
such reacquisition.
(ii) Amount of gain returned as income for prior periods. For
purposes of this subparagraph and paragraph (c)(1) of this section, the
amount of gain on the sale of the property which is returned as income
for periods prior to the reacquisition of the real property does not
include any amount of income determined under paragraph (f)(2) of this
section which is considered to be received at the time of the
reacquisition of the property. However, the amount of gain on the sale
of the property which is returned as income for such periods does
include gain on the sale resulting from payments received in the taxable
year in which the date of reacquisition occurs if such payments are
received prior to such reacquisition. The application of this
subdivision may be illustrated by the following example:
Example: In 1965 S, who uses the calendar year as the taxable year,
sells to P for $10,000 real property which has an adjusted basis of
$3,000. S properly elects under section 453 to report the income from
the sale on the installment method. In 1965 and 1966, S receives a total
of $4,000 on the contract. On May 15, 1967, S receives $1,000 on the
contract. Because of P's default, S reacquires the property on August
31, 1967. The gain on the sale which is returned as income for periods
prior to the reacquisition is $3,500 ($5,000 x $7,000/$10,000).
(2) Amount of money and other property received with respect to the
sale--(i) In general. Amounts of money and other property received by
the seller with respect to the sale of the property include payments
made by the purchaser for the seller's benefit, as well as payments made
and other property transferred directly to the seller. If the purchaser
of the real property makes payments on a mortgage or other indebtedness
to which the property is subject at the time of the sale of such
property to him, or on which the seller was personally liable at the
time of such sale, such payments are considered amounts received by the
seller with respect to the sale. However, if after the sale the
purchaser borrows money and uses the property as security for the loan,
payments by the purchaser in satisfaction of the indebtedness are not
considered as amounts received by the seller with respect to the sale,
although the seller does in fact receive some indirect benefit when the
purchaser makes such payments.
(ii) Payments by purchaser at time of reacquisition. All payments
made by the purchaser at the time of the reacquisition of the real
property that are with respect to the original sale of the property
shall be treated, for purposes of subparagraph (1) of this paragraph, by
the seller as having been received prior to the reacquisition with
respect to such sale. For example, if the purchaser, at the time of the
reacquisition by the seller, pays money or other property to the seller
in partial or complete satisfaction of the purchaser's indebtedness on
the original sale, the seller shall treat such amounts as having been
received prior to the reacquisition with respect to the sale.
[[Page 146]]
(iii) Interest received. For purposes of this subparagraph and
paragraph (c)(1) of this section any amounts received by the seller as
interest, stated or unstated, are excluded from the computation of gain
on the sale of the property and are not considered amounts of money or
other property received with respect to the sale.
(iv) Amounts received on sale of purchaser's indebtedness. Money or
other property received by the seller on the sale of the purchaser's
indebtedness that arose at the time of the sale of the real property are
amounts received by the seller with respect to the sale of such real
property, except that the amounts so received from the sale of such
indebtedness shall be reduced by the amount of money and the fair market
value of other property paid or transferred by the seller, before the
reacquisition of the real property, to reacquire such indebtedness. For
example, if S sells real property to P for $25,000, and under the
contract receives $10,000 down and a note from P for $15,000, S would
receive $22,000 with respect to the sale if he were to discount the note
for $12,000. If before the reacquisition of the real property S were to
reacquire the discounted note for $8,000, he would receive $14,000 with
respect to the sale.
(3) Obligations of the purchaser arising with respect to the sale.
The term obligations of the purchaser arising with respect to the sale
of the real property includes, for purposes of subparagraph (1) of this
paragraph, only that indebtedness on which the purchaser is liable to
the seller and which arises out of the sale of such property. Thus, the
term does not include any indebtedness in respect of the property that
the seller owes to a third person which the purchaser assumes, or to
which the property is subject, at the time of the sale of the property
to the purchaser. Nor does the term include any indebtedness on which
the purchaser is liable to the seller if such indebtedness arises
subsequent to the sale of such property.
(c) Limitation upon amount of gain--(1) In general. Except as
provided by subparagraph (2) of this paragraph, the amount of gain on a
reacquisition of real property, as determined under paragraph (b) of
this section, shall in no case exceed--
(i) The amount by which the price at which the real property was
sold exceeded its adjusted basis at the time of the sale, as determined
under Sec. 1.1011-1, reduced by
(ii) The amount of gain on the sale of such real property which is
returned as income for periods prior to the reacquisition, and by
(iii) The amount of money and the fair market value of other
property (other than obligations of the purchaser to the seller which
are secured by the real property) paid or transferred by the seller in
connection with the reacquisition of such real property.
(2) Cases where limitation does not apply. The limitation provided
by subparagraph (1) of this paragraph shall not apply in a case where
the selling price of property is indefinite in amount and cannot be
ascertained at the time of the reacquisition of such property, as, for
example, where the selling price is stated as a percentage of the
profits to be realized from the development of the property which is
sold. Moreover, the limitation so provided shall not apply to a
reacquisition of real property occurring in a taxable year beginning
before September 3, 1964, to which the provisions of this section are
applied pursuant to an election under Sec. 1.1038-3.
(3) Determination of sales price. The price at which the real
property was sold shall be, for purposes of subparagraph (1) of this
paragraph, the gross sales price reduced by the selling commissions,
legal fees, and other expenses incident to the sale of such property
which are properly taken into account in determining gain or loss on the
sale. For example, the amount of selling commissions paid by a nondealer
will be deducted from the gross sales price in determining the price at
which the real property was sold; on the other hand, selling commissions
paid by a real estate dealer will be deducted as a business expense.
Examples of other expenses incident to the sale of the property are
expenses for appraisal fees, advertising expense, cost of preparing
maps, recording fees, and documentary
[[Page 147]]
stamp taxes. Payments on indebtedness to the seller which are for
interest, stated or unstated, are not included in determining the price
at which the property was sold. See paragraph (b)(2)(iii) of this
section.
(4) Determination of amounts paid or transferred in connection with
a reacquisition--(i) In general. Amounts of money or property paid or
transferred by the seller of the real property in connection with the
reacquisition of such property include payments of money, or transfers
of property, to persons from whom the real property is reacquired as
well as to other persons. Payments or transfers in connection with the
reacquisition of the property do not include money or property paid or
transferred by the seller to reacquire obligations of the purchaser to
the seller which were received by the seller with respect to the sale of
the property or which arose subsequent to the sale. Amounts of money or
property paid or transferred by the seller in connection with the
reacquisition of the property include payments or transfers for such
items as court costs and fees for services of an attorney, master,
trustee, or auctioneer, or for publication, acquiring title, clearing
liens, or filing and recording.
(ii) Assumption of indebtedness. The assumption by the seller, upon
reacquisition of the real property, of any indebtedness to another
person which at such time is secured by such property will be considered
a payment of money by the seller in connection with the reacquisition.
Also, if at the time of reacquisition such property is subject to an
indebtedness which is not an indebtedness of the purchaser to the
seller, the seller shall be considered to have paid money, in an amount
equal to such indebtedness, in connection with the reacquisition of the
property. Thus, for example, if at the time of the sale the purchaser
executes in connection with the sale a first mortgage to a bank and a
second mortgage to the seller and at the time of reacquisition the
seller reacquires the property subject to the first mortgage which he
does not assume, the seller will be considered to have paid money, in an
amount equal to the unpaid amount of the first mortgage, in connection
with the reacquisition.
(d) Character of gain resulting from a reacquisition. Paragraphs (b)
and (c) of this section set forth the extent to which gain shall be
derived from a reacquisition to which paragraph (a) of this section
applies, but the rule provided by section 1038 and this section do not
affect the character of the gain so derived. The character of the gain
resulting from such a reacquisition is determined on the basis of
whether the gain on the original sale was returned on the installment
method or, if not, on the basis of whether title to the real property
was transferred to the purchaser; and, if title was transferred to the
purchaser in a deferred-payment sale, whether the reconveyance of the
property to the seller was voluntary. For example, if the gain on the
original sale of the reacquired property was returned on the installment
method, the character of the gain on reacquisition by the seller shall
be determined in accordance with the rules provided in paragraph (a) of
Sec. 1.453-9. If the original sale was not on the installment method
but was a deferred-payment sale, as described in Sec. 1.453-6(a), where
title to the real property was transferred to the purchaser and the
seller accepts a voluntary reconveyance of the property, the gain on the
reacquisition shall be ordinary income; however, if the obligations
satisfied are securities (as defined in section 165(g)(2)(C)), any gain
resulting from the reacquisition is capital gain subject to the
provisions of subchapter P of chapter 1 of the Code.
(e) Recognition of gain. The entire amount of the gain determined
under paragraphs (b) and (c) of this section with respect to a
reacquisition to which paragraph (a) of this section applies shall be
recognized notwithstanding any other provisions of subtitle A (relating
to income taxes) of the Code.
(f) Special rules applicable to worthless indebtedness--(1)
Worthlessness resulting from reacquisition. No debt of the purchaser to
the seller which was secured by the reacquired real property shall be
considered as becoming worthless or partially worthless as a result of a
reacquisition of such real property to
[[Page 148]]
which paragraph (a) of this section applies. Accordingly, no deduction
for a bad debt and no charge against a reserve for bad debts shall be
allowed, as a result of the reacquisition, in order to reflect the
noncollectibility of any indebtedness of the purchaser to the seller
which at the time of reacquisition was secured by such real property.
(2) Indebtedness treated as worthless prior to reacquisition--(i)
Prior taxable years. If for any taxable year ending before the taxable
year in which occurs a reacquisition of real property to which paragraph
(a) of this section applies the seller of such property has treated any
indebtedness of the purchaser which is secured by such property as
having become worthless or partially worthless by taking a bad debt
deduction under section 166(a), he shall be considered as receiving, at
the time of such reacquisition, income in an amount equal to the amount
of such indebtedness previously treated by him as having become
worthless. The amount so treated as income received shall be treated as
a recovery of a bad debt previously deducted as worthless or partially
worthless. Accordingly, the amount of such income shall be excluded from
gross income, as provided in Sec. 1.111-1, to the extent of the
recovery exclusion with respect to such item. For purposes of Sec.
1.111-1, if the indebtedness was treated as partially worthless in a
prior taxable year, the amount treated under this subparagraph as a
recovery shall be considered to be with respect to the part of the
indebtedness that was previously deducted as worthless. The seller shall
not be considered to have treated an indebtedness as worthless in any
taxable year for which he took the standard deduction under section 141
or paid the tax imposed by section 3 if a deduction in respect of such
indebtedness was not allowed in determining adjusted gross income for
such year under section 62.
(ii) Current taxable year. No deduction shall be allowed under
section 166 (a), for the taxable year in which occurs a reacquisition of
real property to which paragraph (a) of this section applies, in respect
of any indebtedness of the purchaser secured by such property which has
been treated by the seller as having become worthless or partially
worthless in such taxable year but prior to the date of such
reacquisition.
(3) Basis adjustment. The basis of any indebtedness described in
subparagraph (2)(i) of this paragraph shall be increased (as of the date
of the reacquisition) by an amount equal to the amount which, under such
subparagraph of this paragraph, is treated as income received by the
seller with respect to such indebtedness, but only to the extent the
amount so treated as received is not excluded from gross income by
reason of the application of Sec. 1.111-1.
(g) Rules for determining gain or loss on disposition of reacquired
property--(1) Basis of reacquired real property. The basis of any real
property acquired in a reacquisition to which paragraph (a) of this
section applies shall be the sum of the following amounts, determined as
of the date of such reacquisition:
(i) The amount of the adjusted basis, determined under sections 453
and 1011, and the regulations thereunder, of all indebtedness of the
purchaser to the seller which at the time of reacquisition was secured
by such property, including any increase by reason of paragraph (f)(3)
of this section,
(ii) The amount of gain determined under paragraphs (b) and (c) of
this section with respect to such reacquisition, and
(iii) The amount of money and the fair market value of other
property (other than obligations of the purchaser to the seller which
are secured by the real property) paid or transferred by the seller in
connection with the reacquisition of such real property, determined as
provided in paragraph (c) of this section even though such paragraph
does not apply to the reacquisition.
(2) Basis of undischarged indebtedness. The basis of any
indebtedness of the purchaser to the seller which was secured by the
reacquired real property described in subparagraph (1) of this
paragraph, to the extent that such indebtedness is not discharged upon
the reacquisition of such property, shall be zero. Therefore, to the
extent not discharged upon the reacquisition of the real property,
indebtedness on the original obligation of the purchaser, a
[[Page 149]]
substituted obligation of the purchaser, a deficiency judgment entered
in a court of law into which the purchaser's obligation has merged, or
any other obligation of the purchaser to the seller, shall be zero if
such indebtedness constitutes an indebtedness to the seller which was
secured by such property.
(3) Holding period of reacquired property. Since the reacquisition
described in subparagraph (1) of this paragraph is in a sense considered
a nullification of the original sale of the real property, for purposes
of determining gain or loss on a disposition of such property after its
reacquisition the period for which the seller has held the real property
at the time of such disposition shall include the period for which such
property is held by him prior to the original sale. However, the holding
period shall not include the period of time commencing with the date
following the date on which the property is originally sold to the
purchaser and ending with the date on which the property is reacquired
by the seller. The period for which the property was held by the seller
prior to the original sale shall be determined as provided in Sec.
1.1223-1. For example, if under paragraph (a) of Sec. 1.1223-1 real
property, which was acquired as the result of an involuntary conversion,
has been held for five months on January 1, 1965, the date of its sale,
and such property is reacquired on July 2, 1965, and resold on July 3,
1965, the seller will be considered to have held such property for five
months and one day for purposes of this subparagraph.
(h) Illustrations. The application of this section may be
illustrated by the following examples in which it is assumed that the
reacquisition is in satisfaction of secured indebtedness arising out of
the sale of the real property:
Example 1. (a) S purchases real property for $20 and sells it to P
for $100, the property not being mortgaged at the time of sale. Under
the contract P pays $10 down and executes a note for $90, with stated
interest at 6 percent, to be paid in nine annual installments. S
properly elects to report the gain on the installment method. After the
second $10 annual payment P defaults and S accepts a voluntary
reconveyance of the property in complete satisfaction of the
indebtedness. S pays $5 in connection with the reacquisition of the
property. The fair market value of the property at the time of the
reacquisition is $110.
(b) The gain derived by S on the reacquisition of the property is
$6, determined as follows:
Gain before application of limitation:
Money with respect to the sale received by S prior to the $30
reacquisition.............................................
Less: Gain returned by S as income for periods prior to the 24
reacquisition ($30 x [ ($100-$20)/$100])..................
------------
Gain before application of limitation...................... 6
============
Limitation on amount of gain:
Sales price of real property............................... 100
Less:
Adjusted basis of the property at the time of $20
sale.........................................
Gain returned by S as income for periods prior 24
to the reacquisition.........................
Amount of money paid by S in connection with 5 49
the reacquisition............................
---------------------
Limitation on amount of gain............................... 51
============
Gain resulting from the reacquisition of the property........ 6
(c) The basis of the reacquired real property at the date of the
reacquisition is $25, determined as follows:
Adjusted basis of P's indebtedness to S ($70-[$70 x $80/ $14
$100])......................................................
Gain resulting from the reacquisition of the property........ 6
Amount of money paid by S in connection with the 5
reacquisition...............................................
----------
Basis of reacquired property............................. 25
Example 2. (a) The facts are the same as in example (1) except that
S purchased the property for $80.
(b) The gain derived by S on the reacquisition of the property is
$9, determined as follows:
Gain before application of limitation:
Money with respect to the sale received by S prior to the $30
reacquisition.............................................
Less: Gain returned by S as income for periods prior to the $6
reacquisition ($30 x [($100-$80)/$100])...................
------------
Gain before application of limitation...................... 24
============
Limitation on amount of gain:
Sales price of real property............................... 100
Less:
Adjusted basis of the property at the time of $80
sale.........................................
Gain returned by S as income for periods prior 6
to the reacquisition.........................
Amount of money paid by S in connection with 5 91
the reacquisition............................
---------------------
Limitation on amount of gain............................... 9
============
Gain resulting from the reacquisition of the property...... 9
[[Page 150]]
(c) The basis of the reacquired real property at the date of the
reacquisition is $70, determined as follows:
Adjusted basis of P's indebtedness to S ($70-[$70 x $20/ $56
$100])......................................................
Gain resulting from the reacquisition of the property........ 9
Amount of money paid by S in connection with the 5
reacquisition...............................................
----------
Basis of reacquired property............................. 70
==========
Example 3. (a) S purchases real property for $70 and sells it to P
for $100, the property not being mortgaged at the time of sale. Under
the contract P pays $10 down and executes a note for $90, with stated
interest at 6 percent, to be paid in nine annual installments. S
properly elects to report the gain on the installment method. After the
first $10 annual payment P defaults and S accepts a voluntary
reconveyance of the property in complete satisfaction of the
indebtedness. S pays $5 in connection with the reacquisition of the
property. The fair market value of the property at the time of the
reacquisition is $50.
(b) The gain derived by S on the reacquisition of the property is
$14, determined as follows:
Gain before application of limitation:
Money with respect to the sale received by S prior to the $20
reacquisition.............................................
Less: Gain returned by S as income for periods prior to the 6
reacquisition ($20 x [($100-$70)/$100])...................
------------
Gain before application of limitation...................... 14
============
Limitation on amount of gain:
Sales price of real property............................... 100
Less:
Adjusted basis of the property at time of sale $70
Gain returned by S as income for periods prior 6
to the reacquisition.........................
Amount paid by S in connection with the 5 81
reacquisition................................
---------------------
Limitation on amount of gain............................... 19
============
Gain resulting from the reacquisition of the property...... 14
(c) The basis of the reacquired real property at the date of the
reacquisition is $75, determined as follows:
Adjusted basis of P's indebtedness to S ($80-[$80 x $30/ $56
$100])......................................................
Gain resulting from the reacquisition of the property........ 14
Amount of money paid by S in connection with the 5
reacquisition...............................................
----------
Basis of reacquired property............................. 75
Example 4. (a) S purchases real property for $20 and sells it to P
for $100, the property not being mortgaged at the time of sale. Under
the contract P pays $10 down and executes a note for $90, with stated
interest at 6 percent, to be paid in nine annual installments. S
properly elects to report gain on the installment method. After the
second $10 annual payment P defaults and S accepts from P in complete
satisfaction of the indebtedness a voluntary reconveyance of the
property plus cash in the amount of $20. S does not pay any amount in
connection with the reacquisition of the property. The fair market value
of the property at the time of the reacquisition is $30.
(b) The gain derived by S on the reacquisition of the property is
$10, determined as follows:
Gain before application of the limitation:
Money with respect to the sale received by S prior to the $50
reacquisition ($30 + $20).................................
Less: Gain returned by S as income for periods prior to the 40
reacquisition ($50 x [($100-$20)/$100])...................
------------
Gain before application of limitation...................... 10
============
Limitation on amount of gain:
Sales price of real property............................... 100
Less:
Adjusted basis of the property at time of sale $20
Gain returned by S as income for periods prior 40 60
to the reacquisition.........................
---------------------
Limitation on amount of gain............................... 40
============
Gain resulting from the reacquisition of the property........ 10
(c) The basis of the reacquired real property at the date of the
reacquisition is $20, determined as follows:
Adjusted basis of P's indebtedness to S ($50-[$50 x $80/ $10
$100])......................................................
Gain resulting from the reacquisition of the property........ 10
----------
Basis of reacquired property............................. 20
Example 5. (a) S purchases real property for $80 and sells it to P
for $100, the property not being mortgaged at the time of sale. Under
the contract P pays $10 down and executes a note for $90, with stated
interest at 6 percent, to be paid in nine annual installments. At the
time of sale P's note has a fair market value of $90. S does not elect
to report the gain on the installment method but treats the transaction
as a deferred-payment sale. After the third $10 annual payment P
defaults and S forecloses. Under the foreclosure sale S bids in the
property at $70, cancels P's obligation of $60, and pays $10 to P. There
are no other amounts paid by S in connection with the reacquisition of
the property. The fair market value of the property at the time of the
reacquisition is $70.
(b) The gain derived by S on the reacquisition of the property is
$0, determined as follows:
[[Page 151]]
Gain before application of the limitation:
Money with respect to the sale received by S prior to the $40
reacquisition.............................................
Less: Gain returned by S as income for periods prior to the 20
reacquisition ([$10 + $90]-$80)...........................
------------
Gain before application of limitation...................... 20
============
Limitation on amount of gain:
Sales price of real property.................... ......... 100
Less:
Adjusted basis of the property at the time of $80
sale.........................................
Gain returned by S as income for periods prior 20
to the reacquisition.........................
Amount of money paid by S in connection with 10 110
the reacquisition............................
---------------------
Limitation on amount of gain (not to be less than zero).... 0
============
Gain resulting from the reacquisition of the property........ 0
(c) The basis of the reacquired real property at the date of the
reacquisition is $70, determined as follows:
Adjusted basis of P's indebtedness to S (face value at time $60
of reacquisition)...........................................
Gain resulting from the reacquisition of the property........ 0
Amount of money paid by S in connection with the 10
reacquisition...............................................
----------
Basis of reacquired property............................. 70
[T.D. 6916, 32 FR 5925, Apr. 13, 1967; 32 FR 6971, May 6, 1967; T.D.
9849, 84 FR 9237, Mar. 14, 2019]
Sec. 1.1038-2 Reacquisition and resale of property used as
a principal residence.
(a) Application of special rules--(1) In general. If paragraph (a)
of Sec. 1.1038-1 applies to the reacquisition of real property which
was used by the seller as his principal residence and with respect to
the sale of which an election under section 121 is in effect or with
respect to the sale of which gain was not recognized under section 1034,
the provisions of Sec. 1.1038-1 (other than paragraph (a) thereof)
shall not, and this section shall, apply to the reacquisition of such
property if the property is resold by the seller within one year after
the date of the reacquisition. For purposes of this section an election
under section 121 shall be considered to be in effect with respect to
the sale of the property if, at the close of the last day for making
such an election under section 121(c) with respect to such sale, an
election under section 121 has been made and not revoked. Thus, a
taxpayer who properly elects, subsequent to the reacquisition, to have
section 121 apply to a sale of his residence may be eligible for the
treatment provided in this section. The treatment provided by this
section is mandatory; however, see Sec. 1.1038-3 for an election to
apply the provisions of this section to certain taxable years beginning
after December 31, 1957.
(2) Sale and resale treated as one transaction. In the case of a
reacquisition to which this section applies, the resale of the
reacquired property shall be treated, for purposes of applying sections
121 and 1034, as part of the transaction constituting the original sale
of such property. In effect, the reacquisition is generally disregarded
pursuant to this section and, for purposes of applying sections 121 and
1034, the resale of the property is considered to constitute a sale of
such property occurring on the date of the original sale of such
property.
(b) Transactions not included. (1) If with respect to the original
sale of the property there was no nonrecognition of gain under section
1034 and an election under section 121 is not in effect, the provisions
of Sec. 1.1038-1, and not this section, shall apply to the
reacquisition. Thus, for example, if in the case of a taxpayer not
entitled to the benefit of section 121 there is no gain on the original
sale of the property, the provisions of Sec. 1.1038-1, and not this
section, shall apply even though a redetermination of gain under this
section would result in the nonrecognition of gain on the sale under
section 1034. Also, if in the case of such a taxpayer there was gain on
the original sale of the property but after the application of section
1034 all of such gain was recognized, the provisions of Sec. 1.1038-1,
and not this section, shall apply to the reacquisition.
(2) If the original sale of the property was not eligible for the
treatment provided by section 121 and section 1034, the provisions of
Sec. 1.1038-1, and not this section, shall apply to the reacquisition
of the property even though the resale of such property is eligible for
the treatment provided by either or both of sections 121 and 1034.
[[Page 152]]
(c) Redetermination of gain required--(1) Sale of old residence. The
amount of gain excluded under section 121 on the sale of the property
and the amount of gain recognized under section 1034 on the sale of the
property shall be redetermined under this section by recomputing the
adjusted sales price and the adjusted basis of the property, and any
adjustments resulting from the redetermination of the gain on the sale
of such property shall be reflected in the income of the seller for his
taxable year in which the resale of the property occurs.
(2) Sale of new residence. If gain was not recognized under section
1034 on the original sale of the property, the adjusted basis of the new
residence shall be redetermined under this section. If the new residence
has been sold, the amount of gain returned on such sale of the new
residence which is affected by the redetermination of the recognized
gain on the sale of the old residence shall be redetermined under this
section, and any adjustments resulting from the redetermination of the
gain on the sale of the new residence shall be reflected in income of
the seller for his taxable year in which the resale of the old residence
occurs.
(d) Redetermination of adjusted sales price. For purposes of
applying sections 121 and 1034 pursuant to this section, the adjusted
sales price of the reacquired real property shall be redetermined by
taking into account both the sale and the resale of the property and
shall be--
(1) The amount realized, which for purposes of section 1001 shall
be--
(i) The amount realized on the resale of the property, as determined
under paragraph (b)(4) of Sec. 1.1034-1, plus
(ii) The amount realized on the original sale of the property,
determined as provided in paragraph (b)(4) of Sec. 1.1034-1, less that
portion of any obligations of the purchaser arising with respect to such
sale which at the time of reacquisition is secured by such property and
is unpaid, less
(iii) The amount of money and the fair market value of other
property (other than obligations of the purchaser to the seller secured
by the real property) paid or transferred by the seller in connection
with the reacquisition of such real property,
reduced by
(2) The total of the fixing-up expenses (as defined in par. (b)(6)
of Sec. 1.1034-1) incurred for work performed on such real property to
assist in both its original sale and its resale.
For purposes of applying paragraph (b)(6) of Sec. 1.1034-1, there shall
be two 90-day periods, the first ending on the day on which the contract
to sell is entered into in connection with the original sale of the
property, and the second ending on the day on which the contract to sell
is entered into in connection with the resale of the property. There
shall also be two 30-day periods for such purposes, the first ending on
the 30th day after the date of the original sale, and the second ending
on the 30th day after the date of the resale. For determination of the
obligations of the purchaser arising with respect to the original sale
of the property, see paragraph (b)(3) of Sec. 1.1038-1. For
determination of amounts paid or transferred by the seller in connection
with the reacquisition of the property, see paragraph (c)(4) of Sec.
1.1038-1.
(e) Determination of adjusted basis at time of resale. For purposes
of applying sections 121 and 1034 pursuant to this section, the adjusted
basis of the reacquired real property at the time of its resale shall
be--
(1) The sum of--
(i) The adjusted basis of such property at the time of the original
sale, with proper adjustment under section 1016(a) in respect of such
property for the period occurring after the reacquisition of such
property, and
(ii) Any indebtedness of the purchaser to the seller which arose
subsequent to the original sale of such property and which at the time
of reacquisition was secured by such property,
reduced by
(2) Any indebtedness of the purchaser to the seller which at the
time of reacquisition was secured by the reacquired real property and
which, for any taxable year ending before the taxable year in which
occurs the reacquisition to the seller which was secured by the seller
as having become worthless or
[[Page 153]]
partially worthless by taking a bad debt deduction under section 166(a).
The reduction under the preceding sentence by reason of having treated
indebtedness as worthless or partially worthless shall not exceed the
amount by which there would be an increase in the basis of such
indebtedness under paragraph (f)(3) of Sec. 1.1038-1 if section 1038(d)
had been applicable to the reacquisition of such property.
(f) Treatment of indebtedness secured by the property--(1) Year of
reacquisition. No debt of the purchaser to the seller which was secured
by the reacquired real property shall be considered as becoming
worthless or partially worthless as a result of a reacquisition of such
real property to which this section applies. Accordingly, no deduction
for a bad debt shall be allowed, as a result of the reacquisition, in
order to reflect the noncollectibility of any indebtedness of the
purchaser to the seller which at the time of reacquisition was secured
by such real property. In addition, no deduction shall be allowed, for
the taxable year in which occurs a reacquisition of real property to
which this section applies, in respect of any indebtedness of the
purchaser secured by such property which has been treated by the seller
as having become worthless or partially worthless in such taxable year
but prior to the date of such reacquisition.
(2) Prior taxable years. For reduction of the basis of the real
property for indebtedness treated as worthless or partially worthless
for taxable years ending before the taxable year in which occurs the
reacquisition, see paragraph (e) of this section.
(3) Basis of indebtedness. The basis of any indebtedness of the
purchaser to the seller which was secured by the reacquired real
property, to the extent that such indebtedness is not discharged upon
the reacquisition of such property, shall be zero.
(g) Date of sale. Since the resale of the property, by being treated
as part of the transaction constituting the original sale of the
property, is treated as having occurred on the date of the original
sale, in determining whether any of the time requirements of section 121
or section 1034 are satisfied for purposes of this section the date of
the original sale is used, except to the extent provided in paragraph
(d)(2) of this section.
(h) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. (a) On June 30, 1964, S, a single individual over 65
years of age, sells his principal residence to P for $25,000, the
property not being mortgaged at the time of sale. S properly elects to
apply the provisions of section 121 to the sale. Under the contract, P
pays $5,000 down and executes a note for $20,000 with stated interest at
6 percent, the principal being payable in installments of $5,000 each on
January 1 of each year and the note being secured by the real property
which is sold. At the time of sale P's note has a fair market value of
$20,000. S does not elect to report the gain on the installment method
but treats the transaction as a deferred-payment sale, title to the
property being transferred to P at the time of sale. S uses the calendar
year as the taxable year and the cash receipts and disbursements method
of accounting. After making two annual payments of $5,000 each on the
note, P defaults on the contract, and on March 1, 1967, S reacquires the
real property in full satisfaction of P's indebtedness, title to the
property being voluntarily reconveyed to S. On November 1, 1967, S sells
the property to T for $35,000. The assumption is made that no fixing-up
expenses are incurred for work performed on the principal residence in
order to assist in the sale of the property in 1964 or in the resale of
the property in 1967. At the time of sale in 1964 the property has an
adjusted basis of $15,000. S does not treat any indebtedness with
respect to the sale in 1964 as being worthless or partially worthless or
make any capital expenditures with respect to the property after such
sale. In his return for 1964, S includes in income $2,000 capital gain
from the sale of his residence.
(b) The results obtained before and after the reacquisition of the
property are as follows:
------------------------------------------------------------------------
Before After
reacquisition reacquisition
------------------------------------------------------------------------
Adjusted sales price:
$5,000 + $20,000........................ $25,000 .............
$15,000 + $35,000....................... ............. $50,000
Less: Adjusted basis of property at time 15,000 15,000
of sale..................................
-----------------------------
Gain on sale.............................. 10,000 35,000
=============================
Gain excluded from income under section
121:.....................................
$10,000 x $20,000/$25,000............... 8,000 .............
$35,000 x $20,000/$50,000............... ............. 14,000
Gain included in income after applying
section 121:
$10,000-$8,000.......................... 2,000 .............
[[Page 154]]
$35,000-$14,000......................... ............. 21,000
------------------------------------------------------------------------
(c) S is required to show the additional inclusion of $19,000
capital gain ($21,000 -$2,000) in income on his return for 1967.
Example 2. (a) The facts are the same as in example (1) except that
on April 1, 1965, S purchases a new residence at a cost of $30,000 and
qualifies for the nonrecognition of gain under section 1034 in respect
of the sale of his principal residence on June 30, 1964. In his return
for 1964, S does not include any capital gain in income as a result of
the sale of the old residence.
(b) The results obtained before and after the reacquisition of the
property are as follows:
------------------------------------------------------------------------
Before After
reacquisition reacquisition
------------------------------------------------------------------------
Application of section 121 (see example
(1)):
Adjusted sales price.................... $25,000 $50,000
Less: Adjusted basis of property at time 15,000 15,000
of sale................................
-----------------------------
Gain on sale............................ 10,000 35,000
=============================
Gain excluded from income under section 8,000 14,000
121....................................
Gain not excluded from income under 2,000 21,000
section 121............................
Application of section 1034: Adjusted
sales price:
$25,000-$8,000.......................... 17,000 .............
$50,000-$14,000......................... ............. 36,000
Less: Cost of new residence............... 30,000 30,000
-----------------------------
Gain recognized under section 1034 on sale 0 6,000
of old residence.........................
=============================
Gain not recognized under section 1034 on
sale of old residence:
($10,000-[$8,000 + $0])................. 2,000 .............
($35,000-[$14,000 + $6,000])............ ............. 15,000
Adjusted basis of new residence on April
1, 1965:
$30,000-$2,000.......................... 28,000 .............
$30,000-$15,000......................... ............. 15,000
------------------------------------------------------------------------
(c) The $6,000 of capital gain on the sale of the old residence is
required to be included in income on the return for 1967. The adjusted
basis on April 1, 1965, for determining gain on a sale or exchange of
the new residence at any time on or after that date is $15,000, after
taking into account the reacquisition and resale of the old residence.
Example 3. The facts are the same as in example (2) except that S
sells the new residence on June 20, 1965, for $40,000 and includes
$12,000 of capital gain ($40,000- $28,000) on its sale in his income on
the return for 1965. S is required to include the additional capital
gain of $13,000 ([$40,000- $15,000]-$12,000) on the sale of the new
residence in his income on the return for 1967. For this purpose, the
assumption is also made that there are no additional adjustments to the
basis of the new residence after April 1, 1965.
[T.D. 6916, 32 FR 5929, Apr. 13, 1967; 32 FR 6971, May 6, 1967]
Sec. 1.1038-3 Election to have section 1038 apply for taxable years
beginning after December 31, 1957.
(a) In general. If an election is made in the manner provided by
paragraph (b) of this section, the applicable provisions of Sec. Sec.
1.1038-1 and 1.1038-2 shall apply to all reacquisitions of real property
occurring in each and every taxable year beginning after December 31,
1957, and before September 3, 1964, for which the assessment of a
deficiency, or the credit or refund of an overpayment, is not prevented
on September 2, 1964, by the operation of any law or rule of law. The
election so made shall apply to all taxable years beginning after
December 31, 1957, and before September 3, 1964, for which the
assessment of a deficiency, or the credit or refund of an overpayment,
is not prevented on September 2, 1964, by the operation of any law or
rule of law and shall apply to every reacquisition occurring in such
taxable years. The fact that the assessment of a deficiency, or the
credit or refund of an overpayment, is prevented for any other taxable
year or years affected by the election will not prohibit the making of
an election under this section. For example, if an individual who uses
the calendar year as the taxable year were to sell in 1960 real property
used as his principal residence in respect of the sale of which gain is
not recognized under section 1034, and if such property were reacquired
by the seller in 1962 and resold within 1 year, he would be permitted to
make an election under this section with respect to such reacquisition
even though on September 2, 1964, the period of limitations on
assessment or refund has run for 1960. An election under this section
shall be deemed a consent to the application of the provisions of this
section.
(b) Time and manner of making election--(1) In general. (i) An
election to have the provisions of Sec. 1.1038-2 apply to
reacquisitions of real property occurring in taxable years beginning
[[Page 155]]
after December 31, 1957, and before September 3, 1964, shall be made by
filing on or before September 3, 1965, a return, an amended return, or a
claim for refund, whichever is proper, for each taxable year in which
the resale of such real property occurs. If the return for any such year
is not due on or before such date and has not been filed, the election
with respect to such taxable year shall be made by filing on or before
such date the statement described in subparagraph (2) of this paragraph.
(ii) An election to have the provisions of Sec. 1.1038-1 apply to
reacquisitions of real property occurring in taxable years beginning
after December 31, 1957, and before September 3, 1964, shall be made by
filing on or before September 3, 1965, a return, an amended return, or a
claim for refund, whichever is proper, for each taxable year in which
such reacquisitions occur. If the return for any such year is not due on
or before such date and has not been filed, the election with respect to
such taxable year shall be made by filing on or before such date the
statement described in subparagraph (2) of this paragraph.
(iii) If the facts are such that Sec. 1.1038-2 applies to a
reacquisition of property except that the reacquisition occurs in a
taxable year beginning after December 31, 1957, and before September 3,
1964, an election may not be made under this paragraph to have the
provisions of Sec. 1.1038-1 apply to such reacquisition.
(iv) Once made, an election under this paragraph may not be revoked
after September 3, 1965. To any return, amended return, or claim for
refund filed under this subparagraph there shall be attached the
statement described in subparagraph (2) of this paragraph.
(2) Statement to be attached. The statement described in
subparagraph (1) of this paragraph shall indicate--
(i) The name, address and account number of the taxpayer, and the
fact that the taxpayer is electing to have the provisions of section
1038 apply to the reacquisitions of real property,
(ii) The taxable years in which the reacquisitions of property occur
and any other taxable year or years the tax for which is affected by the
application of section 1038 to such reacquisitions,
(iii) The office of the district director where the return or
returns for such taxable year or years were or will be filed,
(iv) The dates on which such return or returns were filed and on
which the tax for such taxable year or years was paid,
(v) The type of real property reacquired, the terms under which such
property was sold and reacquired, and an indication of whether the
taxpayer is applying the provisions of Sec. 1.1038-2 to the
reacquisition of such property,
(vi) If Sec. 1.1038-2 is being applied to the reacquisition, the
terms under which the old residence was resold and, if applicable, the
terms under which the new residence was sold, and
(vii) The office where, and the date when, the election to apply
section 121 in respect to any sale of such property was or will be made.
(3) Place for filing. Any claim for refund, amended return, or
statement, filed under this paragraph in respect of any taxable year,
whether the taxable year in which occurs the reacquisition of property
or the taxable year in which occurs the resale of the old residence,
shall be filed in the office of the district director in which the
return for such taxable year was or will be filed.
(c) Extension of period of limitations on assessment or refund--(1)
Assessment of tax. If an election is properly made under paragraph (b)
of this section and the assessment of a deficiency for the taxable years
to which such election applies is not prevented on September 2, 1964, by
the operation of any law or rule of law, the period within which a
deficiency for such taxable years may be assessed shall, to the extent
such deficiency is attributable to the application of section 1038, not
expire prior to one year after the date on which such election is made.
(2) Refund of tax. If an election is properly made under paragraph
(b) of this section and the credit or refund of any overpayment for the
taxable years to which such election applies is not prevented on
September 2, 1964, by the operation of any law or rule of law, the
period within which a claim for credit
[[Page 156]]
or refund of an overpayment for such taxable years may be filed shall,
to the extent such overpayment is attributable to the application of
section 1038, not expire prior to one year after the date on which such
election is made.
(d) Payment of interest for period prior to September 2, 1964. No
interest shall be payable with respect to any deficiency attributable to
the application of the provisions of section 1038, and no interest shall
be allowed with respect to any credit or refund of any overpayment
attributable to the application of such section, for any period prior to
September 2, 1964. See section 2(c)(3) of the Act of September 2, 1964
(Pub. L. 88-750, 78 Stat. 856).
[T.D. 6916, 32 FR 5930, Apr. 13, 1967]
Sec. 1.1039-1 Certain sales of low-income housing projects.
(a) Nonrecognition of gain. Section 1039 provides rules under which
the taxpayer may elect not to recognize gain in certain cases where a
qualified housing project is sold or disposed of after October 9, 1969,
in an approved disposition and another such qualified housing project or
projects (referred to as the replacement project) is acquired,
constructed, or reconstructed within a specified reinvestment period. If
the requirements of section 1039 are met, and if the taxpayer makes an
election in accordance with the provisions of paragraph (b)(4) of this
section, then the gain realized upon the sale or disposition is
recognized only to the extent that the net amount realized on such sale
or disposition exceeds the cost of the replacement project. However,
notwithstanding section 1039, gain may be recognized by reason of the
application of section 1245 or 1250 to the sale or disposition. (See
Sec. 1.1245-6(b) and Sec. 1.1250-3(h). The terms qualified housing
project, approved disposition, reinvestment period, and net amount
realized are defined in paragraph (c) of this section.
(b) Rules of application--(1) In general. The election under section
1039(a) may be made only by the taxpayer owning the qualified housing
project disposed of. Thus, if the qualified housing project disposed of
is owned by a partnership, the partnership must make the election. (See
section 703(b).) Similarly, if the qualified housing project disposed of
is owned by a corporation or trust, the corporation or trust must make
the election. In addition, the reinvestment of the taxpayer must be in
such a manner that the taxpayer would be entitled to a deduction for
depreciation on the replacement project. Thus, if the qualified housing
project disposed of is owned by individual A, the purchase by A of stock
in a corporation owning or constructing such a project or of an interest
in a partnership owning or constructing such a project will not be
considered as the purchase or construction by A of such a project.
(2) Special rules. (i) The cost of a replacement project acquired
before the approved disposition of a qualified housing project shall be
taken into account under section 1039 only if such property is held by
the taxpayer on the date of the approved disposition.
(ii) Except as provided in section 1039 (d), no property acquired by
the taxpayer shall be taken into account for purposes of section
1039(a)(2) unless the unadjusted basis of such property is its cost
within the meaning of section 1012. For example, if a qualified housing
project is acquired in an exchange under section 1031, relating to
exchange of property held for productive use or investment, such
property will not be taken into account under section 1039(a)(2) because
its basis is determined by reference to the basis of the property
exchanged. (See section 1031(d).)
(3) Cost of replacement project. The taxpayer's cost for the
replacement project includes only amounts properly treated as capital
expenditures by the taxpayer that are attributable to acquisition,
construction, or reconstruction made within the reinvestment period (as
defined in paragraph (c)(4) of this section). See section 263 for rules
as to what constitutes capital expenditures. Thus, assume that a
calendar year taxpayer realizes gain in 1970 upon the approved
disposition of a qualified housing project occurring on January 1, 1970.
If the taxpayer had begun construction of another qualified housing
project on January 1, 1969, and completes such construction on June 1,
1972, only that portion of the cost attributable to the period before
January
[[Page 157]]
1, 1972, constitutes the cost of the replacement project for purposes of
section 1039. For purposes of determining the cost of a replacement
project attributable to a particular period, the total cost of the
project may be allocated to such period on the basis of the portion of
the total project actually constructed during such period.
(4) Election. (i) An election not to recognize the gain realized
upon an approved disposition of a qualified housing project to the
extent provided in section 1039(a) may be made by attaching a statement
to the income tax return filed for the first taxable year in which any
portion of the gain on such disposition is realized. Such a statement
shall contain the information required by subdivision (iii) of this
subparagraph. If the taxpayer does not file such a statement for the
first taxable year in which any portion of the gain is realized, but
fails to report a portion of the gain realized upon the approved
disposition as income for such year or for any subsequent taxable year,
then an election shall be deemed to be made under section 1039 (a) with
respect to that portion of the gain not reported as income.
(ii) An election may be made under section 1039(a) even though the
replacement project has not been acquired or constructed at the time of
election. However, if an election has been made and (a) a replacement
project is not constructed, reconstructed, or acquired, (b) the cost of
the replacement project is lower than the net amount realized from the
approved disposition, or (c) a decision is made not to construct,
reconstruct, or acquire a replacement project, then the tax liability
for the year or years for which the election was made shall be
recomputed and an amended return filed. An election may be made even
though the taxpayer has filed his return and recognized gain upon the
disposition provided that the period of limitation on filing claims for
credit or refund prescribed by section 6511 has not expired. In such
case, a statement containing the information required by subdivision
(iii) of this subparagraph should be filed together with a claim for
credit or refund for the taxable year or years in which gain was
recognized.
(iii) The statement referred to in subdivisions (i) and (ii) of this
subparagraph shall contain the following information:
(a) The date of the approved disposition;
(b) If a replacement project has been acquired, the date of
acquisition and cost of the project;
(c) If a replacement project has been constructed or reconstructed
by or for the taxpayer, the date construction was begun, the date
construction was completed, and the percentage of construction completed
within the reinvestment period;
(d) If no replacement project has been constructed, reconstructed,
or acquired prior to the time of filing of the statement, the estimated
cost of such construction, reconstruction, or acquisition;
(e) The adjusted basis of the project disposed of; and
(f) The amount realized upon the approved disposition and a
description of the expenses directly connected with the disposition and
the taxes (other than income taxes) attributable to the disposition.
(c) Definitions--(1) General. The definitions contained in
subparagraphs (2) through (5) of this paragraph shall apply for purposes
of this section.
(2) Qualified housing project. The term qualified housing project
means a rental or cooperative housing project for lower income families
that has been constructed, reconstructed, or rehabilitated pursuant to a
mortgage which is insured under section 221(d)(3) or 236 of the National
Housing Act, provided that with respect to the housing project disposed
of and the replacement project constructed, reconstructed, or acquired,
the owner of the project at the time of the approved disposition and
prior to the close of the reinvestment period is, under such sections or
regulations issued thereunder,
(i) Limited as to rate of return on his investment in the project,
and
(ii) Limited as to rentals or occupancy charges for units in the
project.
If the owner of the project is organized and operated as a nonprofit
cooperative or other nonprofit organization, then such owner shall be
considered to meet
[[Page 158]]
the requirement of subdivision (i) of this subparagraph.
(3) Approved disposition. The term approved disposition means a sale
or other disposition of a qualified housing project to the tenants or
occupants of units in such project, or to a nonprofit cooperative or
other nonprofit organization formed and operated solely for the benefit
of such tenants or occupants, provided that it is approved by the
Secretary of Housing and Urban Development or his delegate under section
221 (d)(3) or 236 of the National Housing Act or regulations issued
under such sections. Evidence of such approval should be attached to the
tax return or statement in which the election under section 1039 is
made.
(4) Reinvestment period. (i) The term reinvestment period means the
period beginning 1 year before the date of the disposition and ending 1
year after the close of the first taxable year in which any part of the
gain from such disposition is realized, or at such later date as may be
designated pursuant to an application made by the taxpayer. Such
application shall be made before the expiration of one year after the
close of the first taxable year in which any part of the gain from such
disposition is realized, unless the taxpayer can show to the
satisfaction of the district director that--
(a) Reasonable cause exists for not having filed the application
within the required period, and
(b) The filing of such application was made within a reasonable time
after the expiration of the required period.
The application shall contain all the information required by paragraph
(b)(4) of this section and shall be made to the district director for
the internal revenue district in which the return is filed for the first
taxable year in which any of the gain from the approved disposition is
realized.
(ii) Ordinarily, requests for extension of the reinvestment period
will not be granted until near the end of such period and any extension
will usually be limited to a period not exceeding one year. Although
granting of an extension depends upon the facts and circumstances of a
particular case, if a predominant portion of the construction of the
replacement project has been completed or is reasonably expected to be
completed within the reinvestment period (determined without regard to
any extension thereof), an extension of the reinvestment period will
ordinarily be granted. The fact that there is a scarcity of replacement
property for acquisition will not be considered sufficient grounds for
granting an extension.
(5) Net amount realized. (i) The net amount realized from the
approved disposition of a qualified housing project is the amount
realized from such disposition, reduced by--
(a) The expenses paid or incurred by the taxpayer which are directly
connected with the approved disposition, and
(b) The amount of taxes (other than income taxes) paid or incurred
by the taxpayer which are attributable to the approved disposition.
(ii) Examples of expenses directly connected with an approved
disposition of a qualified housing project include amounts paid for
sales or other commissions, advertising, and for the preparation of a
deed or other legal services in connection with the disposition. An
amount paid for a repair to the building will be considered as an
expense directly connected with the approved disposition under
subdivision (i)(a) of this subparagraph only if such repair is required
as a condition of sale, or is required by the Secretary of Housing and
Urban Development or his delegate as a condition of approval of the
disposition.
(iii) Examples of taxes that are attributable to the approved
disposition include local property transfer taxes and stamp taxes. A
local real property tax is not so attributable.
(d) Basis and holding period of replacement project--(1) Basis. If
the taxpayer makes an election under section 1039, the basis of the
replacement housing project shall be its cost (including costs incurred
subsequent to the reinvestment period) reduced by the amount of gain not
recognized under section 1039 (a). If the replacement consists of more
than one housing project, the basis determined under this subparagraph
shall be allocated to the properties in proportion to their respective
costs.
[[Page 159]]
(2) Holding period. The holding period of the replacement housing
project shall begin on the date the taxpayer acquires such project, that
is, on the date the taxpayer first acquires possession or control of
such project and bears the burdens and enjoys the benefits of ownership
of the replacement project. (For special rule regarding the holding
period of property for purposes of section 1250, see section
1250(e)(4).)
(e) Assessment of deficiencies--(1) Deficiency attributable to gain.
If a taxpayer makes an election under section 1039(a) with respect to an
approved disposition, any deficiency attributable to the gain on such
disposition, for any taxable year in which any part of such gain is
realized, may be assessed at any time before the expiration of 3 years
after the date the district director or director of the regional service
center with whom the return for such year has been filed is notified by
the taxpayer of the acquisition or the completion of construction or
reconstruction of the replacement qualified housing project or of the
failure to acquire, construct, or reconstruct a replacement qualified
housing project, as the case may be. Such a deficiency may be assessed
before the expiration of such 3-year period notwithstanding the
provisions of section 6212(c) or the provisions of any other law or rule
of law which would otherwise prevent such assessment. If replacement has
been made, such notification shall contain the information required by
paragraph (b)(4)(iii) of this section. Such notification shall be
attached to the return filed for the taxable year or years in which the
replacement occurs, or in which the period for the replacement expires,
and a copy of such notification shall be filed with the district
director or director of regional service center with whom the election
under section 1039(a) was required to be filed, if the return is not
filed with such director.
(2) Deficiency attributable to election. If gain upon an approved
disposition is realized in two (or more) taxable years, and the
replacement qualified housing project was acquired, constructed, or
reconstructed before the beginning of the last such year, any
deficiency, for any taxable year before such last year, which is
attributable to an election by the taxpayer under section 1039(a) may be
assessed at any time before the expiration of the period within which a
deficiency for such last taxable year may be assessed, notwithstanding
the provisions of section 6212(c) or 6501 or the provisions of any law
or rule of law which would otherwise prevent such assessment. Thus, if
gain upon an approved disposition is realized in 1971 and 1975, and if a
replacement project is purchased in 1971, any deficiency for 1971 may be
assessed within the period for assessing a deficiency for 1975.
[T.D. 7191, 37 FR 12951, June 30, 1972; 37 FR 14385, July 20, 1972, as
amended by T.D. 7400, 41 FR 5101, Feb. 4, 1976]
Sec. 1.1041-1T Treatment of transfer of property between spouses
or incident to divorce (temporary).
Q-1: How is the transfer of property between spouses treated under
section 1041?
A-1: Generally, no gain or loss is recognized on a transfer of
property from an individual to (or in trust for the benefit of) a spouse
or, if the transfer is incident to a divorce, a former spouse. The
following questions and answers describe more fully the scope, tax
consequences and other rules which apply to transfers of property under
section 1041.
(a) Scope of section 1041 in general.
Q-2: Does section 1041 apply only to transfers of property incident
to divorce?
A-2: No. Section 1041 is not limited to transfers of property
incident to divorce. Section 1041 applies to any transfer of property
between spouses regardless of whether the transfer is a gift or is a
sale or exchange between spouses acting at arm's length (including a
transfer in exchange for the relinquishment of property or marital
rights or an exchange otherwise governed by another nonrecognition
provision of the Code). A divorce or legal separation need not be
contemplated between the spouses at the time of the transfer nor must a
divorce or legal separation ever occur.
Example 1. A and B are married and file a joint return. A is the
sole owner of a condominium unit. A sale or gift of the condominium from
A to B is a transfer which is subject to the rules of section 1041.
[[Page 160]]
Example 2. A and B are married and file separate returns. A is the
owner of an independent sole proprietorship, X Company. In the ordinary
course of business, X Company makes a sale of property to B. This sale
is a transfer of property between spouses and is subject to the rules of
section 1041.
Example 3. Assume the same facts as in example (2), except that X
Company is a corporation wholly owned by A. This sale is not a sale
between spouses subject to the rules of section 1041. However, in
appropriate circumstances, general tax principles, including the step-
transaction doctrine, may be applicable in recharacterizing the
transaction.
Q-3: Do the rules of section 1041 apply to a transfer between
spouses if the transferee spouse is a nonresident alien?
A-3: No. Gain or loss (if any) is recognized (assuming no other
nonrecognition provision applies) at the time of a transfer of property
if the property is transferred to a spouse who is a nonresident alien.
Q-4: What kinds of transfers are governed by section 1041?
A-4: Only transfers of property (whether real or personal, tangible
or intangible) are governed by section 1041. Transfers of services are
not subject to the rules of section 1041.
Q-5: Must the property transferred to a former spouse have been
owned by the transferor spouse during the marriage?
A-5: No. A transfer of property acquired after the marriage ceases
may be governed by section 1041.
(b) Transfer incident to the divorce.
Q-6: When is a transfer of property incident to the divorce?
A-6: A transfer of property is incident to the divorce in either of
the following 2 circumstances--
(1) The transfer occurs not more than one year after the date on
which the marriage ceases, or
(2) The transfer is related to the cessation of the marriage.
Thus, a transfer of property occurring not more than one year after the
date on which the marriage ceases need not be related to the cessation
of the marriage to qualify for section 1041 treatment. (See A-7 for
transfers occurring more than one year after the cessation of the
marriage.)
Q-7: When is a transfer of property related to the cessation of the
marriage?
A-7: A transfer of property is treated as related to the cessation
of the marriage if the transfer is pursuant to a divorce or separation
instrument, as defined in section 71(b)(2), and the transfer occurs not
more than 6 years after the date on which the marriage ceases. A divorce
or separation instrument includes a modification or amendment to such
decree or instrument. Any transfer not pursuant to a divorce or
separation instrument and any transfer occurring more than 6 years after
the cessation of the marriage is presumed to be not related to the
cessation of the marriage. This presumption may be rebutted only by
showing that the transfer was made to effect the division of property
owned by the former spouses at the time of the cessation of the
marriage. For example, the presumption may be rebutted by showing that
(a) the transfer was not made within the one- and six-year periods
described above because of factors which hampered an earlier transfer of
the property, such as legal or business impediments to transfer or
disputes concerning the value of the property owned at the time of the
cessation of the marriage, and (b) the transfer is effected promptly
after the impediment to transfer is removed.
Q-8: Do annulments and the cessations of marriages that are void ab
initio due to violations of state law constitute divorces for purposes
of section 1041?
A-8: Yes.
(c) Transfers on behalf of a spouse.
Q-9: May transfers of property to third parties on behalf of a
spouse (or former spouse) qualify under section 1041?
A-9: Yes. There are three situations in which a transfer of property
to a third party on behalf of a spouse (or former spouse) will qualify
under section 1041, provided all other requirements of the section are
satisfied. The first situation is where the transfer to the third party
is required by a divorce or separation instrument. The second situation
is where the transfer to the third party is pursuant to the written
request of the other spouse (or former spouse). The third situation is
where the transferor receives from the other spouse (or former spouse) a
written
[[Page 161]]
consent or ratification of the transfer to the third party. Such consent
or ratification must state that the parties intend the transfer to be
treated as a transfer to the nontransferring spouse (or former spouse)
subject to the rules of section 1041 and must be received by the
transferor prior to the date of filing of the transferor's first return
of tax for the taxable year in which the transfer was made. In the three
situations described above, the transfer of property will be treated as
made directly to the nontransferring spouse (or former spouse) and the
nontransferring spouse will be treated as immediately transferring the
property to the third party. The deemed transfer from the
nontransferring spouse (or former spouse) to the third party is not a
transaction that qualifies for nonrecognition of gain under section
1041. This A-9 shall not apply to transfers to which Sec. 1.1041-2
applies.
(d) Tax consequences of transfers subject to section 1041.
Q-10: How is the transferor of property under section 1041 treated
for income tax purposes?
A-10: The transferor of property under section 1041 recognizes no
gain or loss on the transfer even if the transfer was in exchange for
the release of marital rights or other consideration. This rule applies
regardless of whether the transfer is of property separately owned by
the transferor or is a division (equal or unequal) of community
property. Thus, the result under section 1041 differs from the result in
United States v. Davis, 370 U.S. 65 (1962).
Q-11: How is the transferee of property under section 1041 treated
for income tax purposes?
A-11: The transferee of property under section 1041 recognizes no
gain or loss upon receipt of the transferred property. In all cases, the
basis of the transferred property in the hands of the transferee is the
adjusted basis of such property in the hands of the transferor
immediately before the transfer. Even if the transfer is a bona fide
sale, the transferee does not acquire a basis in the transferred
property equal to the transferee's cost (the fair market value). This
carryover basis rule applies whether the adjusted basis of the
transferred property is less than, equal to, or greater than its fair
market value at the time of transfer (or the value of any consideration
provided by the transferee) and applies for purposes of determining loss
as well as gain upon the subsequent disposition of the property by the
transferee. Thus, this rule is different from the rule applied in
section 1015(a) for determining the basis of property acquired by gift.
Q-12: Do the rules described in A-10 and A-11 apply even if the
transferred property is subject to liabilities which exceed the adjusted
basis of the property?
A-12: Yes. For example, assume A owns property having a fair market
value of $10,000 and an adjusted basis of $1,000. In contemplation of
making a transfer of this property incident to a divorce from B, A
borrows $5,000 from a bank, using the property as security for the
borrowing. A then transfers the property to B and B assumes, or takes
the property subject to, the liability to pay the $5,000 debt. Under
section 1041, A recognizes no gain or loss upon the transfer of the
property, and the adjusted basis of the property in the hands of B is
$1,000.
Q-13: Will a transfer under section 1041 result in a recapture of
investment tax credits with respect to the property transferred?
A-13: In general, no. Property transferred under section 1041 will
not be treated as being disposed of by, or ceasing to be section 38
property with respect to, the transferor. However, the transferee will
be subject to investment tax credit recapture if, upon or after the
transfer, the property is disposed of by, or ceases to be section 38
property with respect to, the transferee. For example, as part of a
divorce property settlement, B receives a car from A that has been used
in A's business for two years and for which an investment tax credit was
taken by A. No part of A's business is transferred to B and B's use of
the car is solely personal. B is subject to recapture of the investment
tax credit previously taken by A.
(e) Notice and recordkeeping requirement with respect to
transactions under section 1041.
Q-14: Does the trasnsferor of property in a transaction described in
section
[[Page 162]]
1041 have to supply, at the time of the transfer, the transferee with
records sufficient to determine the adjusted basis and holding period of
the property at the time of the transfer and (if applicable) with notice
that the property transferred under section 1041 is potentially subject
to recapture of the investment tax credit?
A-14: Yes. A transferor of property under section 1041 must, at the
time of the transfer, supply the transferee with records sufficient to
determine the adjusted basis and holding period of the property as of
the date of the transfer. In addition, in the case of a transfer of
property which carries with it a potential liability for investment tax
credit recapture, the transferor must, at the time of the transfer,
supply the transferee with records sufficient to determine the amount
and period of such potential liability. Such records must be preserved
and kept accessible by the transferee.
(f) Property settlements--effective dates, transitional periods and
elections.
Q-15: When does section 1041 become effective?
A-15: Generally, section 1041 applies to all transfers after July
18, 1984. However, it does not apply to transfers after July 18, 1984
pursuant to instruments in effect on or before July 18, 1984. (See A-16
with respect to exceptions to the general rule.)
Q-16: Are there any exceptions to the general rule stated in A-15
above?
A-16: Yes. Two transitional rules provide exceptions to the general
rule stated in A-15. First, section 1041 will apply to transfers after
July 18, 1984 under instruments that were in effect on or before July
18, 1984 if both spouses (or former spouses) elect to have section 1041
apply to such transfers. Second, section 1041 will apply to all
transfers after December 31, 1983 (including transfers under instruments
in effect on or before July 18, 1984) if both spouses (or former
spouses) elect to have section 1041 apply. (See A-18 relating to the
time and manner of making the elections under the first or second
transitional rule.)
Q-17: Can an election be made to have section 1041 apply to some,
but not all, transfers made after December 31, 1983, or some but not
all, transfers made after July 18, 1984 under instruments in effect on
or before July 18, 1984?
A-17: No. Partial elections are not allowed. An election under
either of the two elective transitional rules applies to all transfers
governed by that election whether before or after the election is made,
and is irrevocable.
(g) Property settlements--time and manner of making the elections
under section 1041.
Q-18: How do spouses (or former spouses) elect to have section 1041
apply to transfers after December 31, 1983, or to transfers after July
18, 1984 under instruments in effect on or before July 18, 1984?
A-18: In order to make an election under section 1041 for property
transfers after December 31, 1983, or property transfers under
instruments that were in effect on or before July 18, 1984, both spouses
(or former spouses) must elect the application of the rules of section
1041 by attaching to the transferor's first filed income tax return for
the taxable year in which the first transfer occurs, a statement signed
by both spouses (or former spouses) which includes each spouse's social
security number and is in substantially the form set forth at the end of
this answer.
In addition, the transferor must attach a copy of such statement to
his or her return for each subsequent taxable year in which a transfer
is made that is governed by the transitional election. A copy of the
signed statment must be kept by both parties.
The election statements shall be in substantially the following
form:
In the case of an election regarding transfers after 1983:
Section 1041 Election
The undersigned hereby elect to have the provisions of section 1041
of the Internal Revenue Code apply to all qualifying transfers of
property after December 31, 1983. The undersigned understand that
section 1041 applies to all property transferred between spouses, or
former spouses incident to divorce. The parties further understand that
the effects for Federal income tax purposes of having section 1041 apply
are that (1) no gain or loss is recognized by the transferor spouse or
former spouse as a result of this transfer; and (2) the basis of the
transferred property in the hands of the transferee is the
[[Page 163]]
adjusted basis of the property in the hands of the transferor
immediately before the transfer, whether or not the adjusted basis of
the transferred property is less than, equal to, or greater than its
fair market value at the time of the transfer. The undersigned
understand that if the transferee spouse or former spouse disposes of
the property in a transaction in which gain is recognized, the amount of
gain which is taxable may be larger than it would have been if this
election had not been made.
In the case of an election regarding preexisting decrees:
Section 1041 Election
The undersigned hereby elect to have the provisions of section 1041
of the Internal Revenue Code apply to all qualifying transfers of
property after July 18, 1984 under any instrument in effect on or before
July 18, 1984. The undersigned understand that section 1041 applies to
all property transferred between spouses, or former spouses incident to
the divorce. The parties further understand that the effects for Federal
income tax purposes of having section 1041 apply are that (1) no gain or
loss is recognized by the transferor spouse or former spouse as a result
of this transfer; and (2) the basis of the transferred property in the
hands of the transferee is the adjusted basis of the property in the
hands of the transferor immediately before the transfer, whether or not
the adjusted basis of the transferred property is less than, equal to,
or greater than its fair market value at the time of the transfer. The
undersigned understand that if the transferee spouse or former spouse
disposes of the property in a transaction in which gain is recognized,
the amount of gain which is taxable may be larger than it would have
been if this election had not been made.
(Secs. 1041(d)(4), (98 Stat. 798, 26 U.S.C. 1041(d)(4)), 152(e)(2)(A)
(98 Stat. 802, 26 U.S.C. 152(e)(2)(A)), 215(c) (98 Stat. 800, 26 U.S.C.
215(c)) and 7805 (68A Stat. 917, 26 U.S.C. 7805) of the Internal Revenue
Code of 1954))
[T.D. 7973, 49 FR 34452, Aug. 31, 1984; T.D. 9035, 68 FR 1536, Jan. 13,
2003]
Sec. 1.1041-2 Redemptions of stock.
(a) In general--(1) Redemptions of stock not resulting in
constructive distributions. Notwithstanding Q&A-9 of Sec. 1.1041-1T(c),
if a corporation redeems stock owned by a spouse or former spouse
(transferor spouse), and the transferor spouse's receipt of property in
respect of such redeemed stock is not treated, under applicable tax law,
as resulting in a constructive distribution to the other spouse or
former spouse (nontransferor spouse), then the form of the stock
redemption shall be respected for Federal income tax purposes.
Therefore, the transferor spouse will be treated as having received a
distribution from the corporation in redemption of stock.
(2) Redemptions of stock resulting in constructive distributions.
Notwithstanding Q&A-9 of Sec. 1.1041-1T(c), if a corporation redeems
stock owned by a transferor spouse, and the transferor spouse's receipt
of property in respect of such redeemed stock is treated, under
applicable tax law, as resulting in a constructive distribution to the
nontransferor spouse, then the redeemed stock shall be deemed first to
be transferred by the transferor spouse to the nontransferor spouse and
then to be transferred by the nontransferor spouse to the redeeming
corporation. Any property actually received by the transferor spouse
from the redeeming corporation in respect of the redeemed stock shall be
deemed first to be transferred by the corporation to the nontransferor
spouse in redemption of such spouse's stock and then to be transferred
by the nontransferor spouse to the transferor spouse.
(b) Tax consequences--(1) Transfers described in paragraph (a)(1) of
this section. Section 1041 will not apply to any of the transfers
described in paragraph (a)(1) of this section. See section 302 for rules
relating to the tax consequences of certain redemptions; redemptions
characterized as distributions under section 302(d) will be subject to
section 301 if received from a Subchapter C corporation or section 1368
if received from a Subchapter S corporation.
(2) Transfers described in paragraph (a)(2) of this section. The tax
consequences of each deemed transfer described in paragraph (a)(2) of
this section are determined under applicable provisions of the Internal
Revenue Code as if the spouses had actually made such transfers.
Accordingly, section 1041 applies to any deemed transfer of the stock
and redemption proceeds between the transferor spouse and the
nontransferor spouse, provided the requirements of section 1041 are
otherwise satisfied with respect to such deemed transfer. Section 1041,
however, will not apply to any deemed transfer
[[Page 164]]
of stock by the nontransferor spouse to the redeeming corporation in
exchange for the redemption proceeds. See section 302 for rules relating
to the tax consequences of certain redemptions; redemptions
characterized as distributions under section 302(d) will be subject to
section 301 if received from a Subchapter C corporation or section 1368
if received from a Subchapter S corporation.
(c) Special rules in case of agreements between spouses or former
spouses--(1) Transferor spouse taxable. Notwithstanding applicable tax
law, a transferor spouse's receipt of property in respect of the
redeemed stock shall be treated as a distribution to the transferor
spouse in redemption of such stock for purposes of paragraph (a)(1) of
this section, and shall not be treated as resulting in a constructive
distribution to the nontransferor spouse for purposes of paragraph
(a)(2) of this section, if a divorce or separation instrument, or a
valid written agreement between the transferor spouse and the
nontransferor spouse, expressly provides that--
(i) Both spouses or former spouses intend for the redemption to be
treated, for Federal income tax purposes, as a redemption distribution
to the transferor spouse; and
(ii) Such instrument or agreement supersedes any other instrument or
agreement concerning the purchase, sale, redemption, or other
disposition of the stock that is the subject of the redemption.
(2) Nontransferor spouse taxable. Notwithstanding applicable tax
law, a transferor spouse's receipt of property in respect of the
redeemed stock shall be treated as resulting in a constructive
distribution to the nontransferor spouse for purposes of paragraph
(a)(2) of this section, and shall not be treated as a distribution to
the transferor spouse in redemption of such stock for purposes of
paragraph (a)(1) of this section, if a divorce or separation instrument,
or a valid written agreement between the transferor spouse and the
nontransferor spouse, expressly provides that--
(i) Both spouses or former spouses intend for the redemption to be
treated, for Federal income tax purposes, as resulting in a constructive
distribution to the nontransferor spouse; and
(ii) Such instrument or agreement supersedes any other instrument or
agreement concerning the purchase, sale, redemption, or other
disposition of the stock that is the subject of the redemption.
(3) Execution of agreements. For purposes of this paragraph (c), a
divorce or separation instrument must be effective, or a valid written
agreement must be executed by both spouses or former spouses, prior to
the date on which the transferor spouse (in the case of paragraph (c)(1)
of this section) or the nontransferor spouse (in the case of paragraph
(c)(2) of this section) files such spouse's first timely filed Federal
income tax return for the year that includes the date of the stock
redemption, but no later than the date such return is due (including
extensions).
(d) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. Corporation X has 100 shares outstanding. A and B each
own 50 shares. A and B divorce. The divorce instrument requires B to
purchase A's shares, and A to sell A's shares to B, in exchange for
$100x. Corporation X redeems A's shares for $100x. Assume that, under
applicable tax law, B has a primary and unconditional obligation to
purchase A's stock, and therefore the stock redemption results in a
constructive distribution to B. Also assume that the special rule of
paragraph (c)(1) of this section does not apply. Accordingly, under
paragraphs (a)(2) and (b)(2) of this section, A shall be treated as
transferring A's stock of Corporation X to B in a transfer to which
section 1041 applies (assuming the requirements of section 1041 are
otherwise satisfied), B shall be treated as transferring the Corporation
X stock B is deemed to have received from A to Corporation X in exchange
for $100x in an exchange to which section 1041 does not apply and
sections 302(d) and 301 apply, and B shall be treated as transferring
the $100x to A in a transfer to which section 1041 applies.
Example 2. Assume the same facts as Example 1, except that the
divorce instrument provides as follows: ``A and B agree that the
redemption will be treated for Federal income tax purposes as a
redemption distribution to A.'' The divorce instrument further provides
that it ``supersedes all other instruments or agreements concerning the
purchase, sale, redemption, or other disposition of the stock that is
the subject of the redemption.'' By virtue of the special rule of
paragraph (c)(1) of this section and under paragraphs (a)(1)
[[Page 165]]
and (b)(1) of this section, the tax consequences of the redemption shall
be determined in accordance with its form as a redemption of A's shares
by Corporation X and shall not be treated as resulting in a constructive
distribution to B. See section 302.
Example 3. Assume the same facts as Example 1, except that the
divorce instrument requires A to sell A's shares to Corporation X in
exchange for a note. B guarantees Corporation X's payment of the note.
Assume that, under applicable tax law, B does not have a primary and
unconditional obligation to purchase A's stock, and therefore the stock
redemption does not result in a constructive distribution to B. Also
assume that the special rule of paragraph (c)(2) of this section does
not apply. Accordingly, under paragraphs (a)(1) and (b)(1) of this
section, the tax consequences of the redemption shall be determined in
accordance with its form as a redemption of A's shares by Corporation X.
See section 302.
Example 4. Assume the same facts as Example 3, except that the
divorce instrument provides as follows: ``A and B agree the redemption
shall be treated, for Federal income tax purposes, as resulting in a
constructive distribution to B.'' The divorce instrument further
provides that it ``supersedes any other instrument or agreement
concerning the purchase, sale, redemption, or other disposition of the
stock that is the subject of the redemption.'' By virtue of the special
rule of paragraph (c)(2) of this section, the redemption is treated as
resulting in a constructive distribution to B for purposes of paragraph
(a)(2) of this section. Accordingly, under paragraphs (a)(2) and (b)(2)
of this section, A shall be treated as transferring A's stock of
Corporation X to B in a transfer to which section 1041 applies (assuming
the requirements of section 1041 are otherwise satisfied), B shall be
treated as transferring the Corporation X stock B is deemed to have
received from A to Corporation X in exchange for a note in an exchange
to which section 1041 does not apply and sections 302(d) and 301 apply,
and B shall be treated as transferring the note to A in a transfer to
which section 1041 applies.
(e) Effective date. Except as otherwise provided in this paragraph,
this section is applicable to redemptions of stock on or after January
13, 2003, except for redemptions of stock that are pursuant to
instruments in effect before January 13, 2003. For redemptions of stock
before January 13, 2003 and redemptions of stock that are pursuant to
instruments in effect before January 13, 2003, see Sec. 1.1041-1T(c),
A-9. However, these regulations will be applicable to redemptions
described in the preceding sentence of this paragraph (e) if the spouses
or former spouses execute a written agreement on or after August 3, 2001
that satisfies the requirements of one of the special rules in paragraph
(c) of this section with respect to such redemption. A divorce or
separation instrument or valid written agreement executed on or after
August 3, 2001, and before May 13, 2003 that meets the requirements of
the special rule in Regulations Project REG-107151-00 published in 2001-
2 C.B. 370 (see Sec. 601.601(d)(2) of this chapter) will be treated as
also meeting the requirements of the special rule in paragraph (c)(2) of
this section.
[T.D. 9035, 68 FR 1536, Jan. 13, 2003]
Sec. 1.1042-1T Questions and answers relating to the sales of
stock to employee stock ownership plans or certain cooperatives
(temporary).
Q-1: What does section 1042 provide?
A-1: (a) Section 1042 provides rules under which a taxpayer may
elect not to recognize gain in certain cases where qualified securities
are sold to a qualifying employee stock ownership plan or worker-owned
cooperative in taxable years of the seller beginning after July 18,
1984, and qualified replacement property is purchased by the taxpayer
within the replacement period. If the requirements of Q&A-2 of this
section are met, and if the taxpayer makes an election under section
1042(a) in accordance with Q&A-3 of this section, the gain realized by
the taxpayer on the sale of the qualified securities is recognized only
to the extent that the amount realized on such sale exceeds the cost to
the taxpayer of the qualified replacement property.
(b) Under section 1042, the term qualified securities means employer
securities (as defined in section 409(l)) with respect to which each of
the following requirements is satisfied: (1) The employer securities
were issued by a domestic corporation; (2) for at least one year before
and immediately after the sale, the domestic corporation that issued the
employer securities (and each corporation that is a member of a
controlled group of corporations with such corporation for purposes of
section 409(l)) has no stock outstanding
[[Page 166]]
that is readily tradeable on an established market; (3) as of the time
of the sale, the employer securities have been held by the taxpayer for
more than 1 year; and (4) the employer securities were not received by
the taxpayer in a distribution from a plan described in section 401(a)
or in a transfer pursuant to an option or other right to acquire stock
to which section 83, 422, 422A, 423, or 424 applies.
(c) The term replacement period means the period which begins 3
months before the date on which the sale of qualified securities occurs
and which ends 12 months after the date of such sale. A replacement
period may include any period which occurs prior to July 19, 1984.
(d) The term qualified replacement property means any securities (as
defined in section 165(g)(2)) issued by a domestic corporation which
does not, for the taxable year of such corporation in which the
securities are purchased by the taxpayer, have passive investment income
(as defined in section 1362(d)(3)(D)) that exceeds 25 percent of the
gross receipts of such corporation for the taxable year preceding the
taxable year of purchase. In addition, securities of the domestic
corporation that issued the employer securities qualifying under section
1042 (and of any corporation that is a member of a controlled group of
corporations with such corporation for purposes of section 409(l)) will
not qualify as qualified replacement property.
(e) For purposes of section 1042(a), there is a purchase of
qualified replacement property only if the basis of such property is
determined by reference to its cost to the taxpayer. If the basis of the
qualified replacement property is determined by reference to its basis
in the hands of the transferor thereof or another person, or by
reference to the basis of property (other than cash or its equivalent)
exchanged for such property, then the basis of such property is not
determined solely by reference to its cost to the taxpayer.
Q-2: What is a sale of qualified securities for purposes of section
1042(b)?
A-2: (a) Under section 1042(b), a sale of qualified securities is
one under which all of the following requirements are met:
(1) The qualified securities are sold to an employee stock ownership
plan (as defined in section 4975(e)(7)) maintained by the corporation
that issued the qualified securities (or by a member of the controlled
group of corporations with such corporation for purposes of section
409(l)) or to an eligible worker-owned cooperative (as defined in
section 1042(c)(2));
(2) The employee stock ownership plan or eligible worker-owned
cooperative owns, immediately after the sale, 30 percent or more of the
total value of the employer securities (within the meaning of section
409(l) outstanding as of such time;
(3) No portion of the assets of the employee stock ownership plan or
eligible worker-owned cooperative attributable to qualified securities
that are sold to the plan or cooperative by the taxpayer or by any other
person in a sale with respect to which an election under section 1042(a)
is made accrue under the plan or are allocated by the cooperative,
either directly or indirectly and either concurrently with or at any
time thereafter, for the benefit of (i) the taxpayer; (ii) any person
who is a member of the family of the taxpayer (within the meaning of
section 267(c)(4)); or (iii) any person who owns (after the application
of section 318(a)), at any time after July 18, 1984, and until
immediately after the sale, more than 25 percent of in value of the
outstanding portion of any class of stock of the corporation that issued
the qualified securities (or of any member of the controlled group of
corporations with such corporation for purposes of section 409(l)). For
purposes of this calculation, stock that is owned, directly or
indirectly, by or for a qualified plan shall not be treated as
outstanding.
(4) The taxpayer files with the Secretary (as part of the required
election described in Q&A-3 of this section) a verified written
statement of the domestic corporation (or corporations) whose employees
are covered by the plan acquiring the qualified securities or of any
authorized officer of the eligible workerowned cooperative, consenting
to the application of section 4978(a) with respect to such corporation
or cooperative.
[[Page 167]]
(b) For purposes of determining whether paragraph (a)(2) of this
section is satisfied, sales of qualified securities by two or more
taxpayers may be treated as a single sale if such sales are made as part
of a single, integrated transaction under a prearranged agreement
between the taxpayers.
(c) For purposes of determining whether paragraph (a)(3) of this
section is satisfied with respect to the prohibition against an accrual
or allocation of qualified securities, the accrual or allocation of any
benefits or contributions or other assets that are not attributable to
qualified securities sold to the employee stock ownership plan or
eligible worker-owned cooperative in a sale with respect to which an
election under section 1042(a) is made (including any accrual or
allocation under any other plan or arrangement maintained by the
corporation or any member of the controlled group of corporations with
such corporation for purposes of section 409(l)) must be made without
regard to the allocation of such qualified securities. Paragraph (a)(3)
of this section above may be illustrated in part by the following
example: Individuals A, B, and C own 50, 25, and 25, respectively, of
the 100 outstanding shares of common stock of Corporation X. Such shares
constitute qualified securities as defined in Q&A-1 of this section. A
and B, but not C, are employees of Corporation X. For the benefit of all
its employees, Corporation X establishes an employee stock ownership
plan that obtains a loan meeting the exemption requirements of section
4975(d)(3). The loan proceeds are used by the plan to purchase the 100
shares of qualified securities from A, B, and C, all of whom elect
nonrecognition treatment under section 1042(a) with respect to the gain
realized on their sale of such securities. Under the requirements of
paragraph (a)(3) of this section, no part of the assets of the plan
attributable to the 100 shares of qualified securities may accrue under
the plan (or under any other plan or arrangement maintained by
Corporation X) for the benefit of A or B or any person who is a member
of the family of A or B (as determined under section 267(c)(4)).
Furthermore, no other assets of the plan or assets of the employer may
accrue for the benefit of such individuals in lieu of the receipt of
assets attributable to such qualified securities.
(d) A sale under section 1042(a) shall not include any sale of
securities by a dealer or underwriter in the ordinary course of its
trade or business as a dealer or underwriter, whether or not guaranteed.
Q-3: What is the time and manner for making the election under
section 1042(a)?
A-3: (a) The election not to recognize the gain realized upon the
sale of qualified securities to the extent provided under section
1042(a) shall be made in a statement of election attached to the
taxpayer's income tax return filed on or before the due date (including
extensions of time) for the taxable year in which the sale occurs. If a
taxpayer does not make a timely election under this section to obtain
section 1042(a) nonrecognition treatment with respect to the sale of
qualified securities, it may not subsequently make an election on an
amended return or otherwise. Also, an election once made is irrevocable.
(b) The statement of election shall provide that the taxpayer elects
to treat the sale of securities as a sale of qualified securities under
section 1042(a), and shall contain the following information:
(1) A description of the qualified securities sold, including the
type and number of shares;
(2) The date of the sale of the qualified securities;
(3) The adjusted basis of the qualified securities;
(4) The amount realized upon the sale of the qualified securities;
(5) The identity of the employee stock ownership plan or eligible
worker-owned cooperative to which the qualified securities were sold;
and
(6) If the sale was part of a single, interrelated transaction under
a prearranged agreement between taxpayers involving other sales of
qualified securities, the names and taxpayer identification numbers of
the other taxpayers under the agreement and the number of shares sold by
the other taxpayers. See Q&A-2 of this section.
If the taxpayer has purchased qualified replacement property at the time
of
[[Page 168]]
the election, the taxpayer must attach as part of the statement of
election a statement of purchase describing the qualified replacement
property, the date of the purchase, and the cost of the property, and
declaring such property to be the qualified replacement property with
respect to the sale of qualified securities. Such statement of purchase
must be notarized by the later of thirty days after the purchase or
March 6, 1986. In addition, the statement of election must be
accompanied by the verified written statement of consent required under
Q&A-2 of this section with respect to the qualified securities sold.
(c) If the taxpayer has not purchased qualified replacement property
at the time of the filing of the statement of election, a timely
election under this Q&A shall not be considered to have been made unless
the taxpayer attaches the notarized statement of purchase described
above to the taxpayer's income tax return filed for the taxable year
following the year for which the election under section 1042(a) was
made. Such notarized statement of purchase shall be filed with the
district director or the director of the regional service center with
whom such election was originally filed, if the return is not filed with
such director.
Q-4: What is the basis of qualified replacement property?
A-4: If a taxpayer makes an election under section 1042(a), the
basis of the qualified replacement property purchased by the taxpayer
during the replacement period shall be reduced by an amount equal to the
amount of gain which was not recognized. If more than one item of
qualified replacement property is purchased, the basis of each of such
items shall be reduced by an amount determined by multiplying the total
gain not recognized by reason of the application of section 1042(a) by a
fraction, the numerator of which is the cost of such item of property
and the denominator of which is the total cost of all such items of
property. For the rule regarding the holding period of qualified
replacement property, see section 1223(13).
Q-5: What is the statute of limitations for the assessment of a
deficiency relating to the gain on the sale of qualified securities?
A-5: (a) If any gain is realized by the taxpayer on the sale of any
qualified securities and such gain has not been recognized under section
1042(a) in accordance with the requirements of this section, the
statutory period provided in section 6501(a) for the assessment of any
deficiency with respect to such gain shall not expire prior to the
expiration of 3 years from the date of receipt, by the district director
or director of regional service center with whom the statement of
election under 1042(a) was originally filed, of:
(1) A notarized statement of purchase as described in Q&A-3;
(2) A written statement of the taxpayer's intention not to purchase
qualified replacement property within the replacement period; or
(3) A written statement of the taxpayer's failure to purchase
qualified replacement property within the replacement period.
In those situations when a taxpayer is providing a written statement of
an intention not to purchase or of a failure to purchase qualified
replacement property, the statement shall be accompanied, where
appropriate, by an amended return for the taxable year in which the gain
from the sale of the qualified securities was realized, in order to
reflect the inclusion in gross income for that year of gain required to
be recognized in connection with such sale.
(b) Any gain from the sale of qualified securities which is required
to be recognized due to a failure to meet the requirements under section
1042 shall be included in the gross income for the taxable year in which
the gain was realized. If any gain from the sale of qualified securities
is not recognized under section 1042(a) in accordance with the
requirements of this section, any deficiency attributable to any portion
of such gain may be assessed at any time before the expiration of the 3-
year period described in this Q&A, notwithstanding the provision of any
law or rule of law which would otherwise prevent such assessment.
Q-6: When does section 1042 become effective?
[[Page 169]]
A-6: Section 1042 applies to sales of qualified securities in
taxable years of sellers beginning after July 18, 1984.
[T.D. 8073, 51 FR 4333, Feb. 4, 1986]
Sec. 1.1044(a)-1 Time and manner for making election under the
Omnibus Budget Reconciliation Act of 1993.
(a) Description. Section 1044(a), as added by section 13114 of the
Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66, 107 Stat.
430), generally allows individuals and C corporations that sell publicly
traded securities after August 9, 1993, to elect not to recognize
certain gain from the sale if the taxpayer purchases common stock or a
partnership interest in a specialized small business investment company
(SSBIC) within the 60-day period beginning on the date the publicly
traded securities are sold.
(b) Time and manner for making the election. The election under
section 1044(a) must be made on or before the due date (including
extensions) for the income tax return for the year in which the publicly
traded securities are sold. The election is to be made by reporting the
entire gain from the sale of publicly traded securities on Schedule D of
the income tax return in accordance with instructions for Schedule D,
and by attaching a statement to Schedule D showing--
(1) How the nonrecognized gain was calculated;
(2) The SSBIC in which common stock or a partnership interest was
purchased;
(3) The date the SSBIC stock or partnership interest was purchased;
and
(4) The basis of the SSBIC stock or partnership interest.
(c) Revocability of election. The election described in this section
is revocable with the consent of the Commissioner.
(d) Effective date. The rules set forth in this section are
effective December 12, 1996.
[T.D. 8688, 61 FR 65322, Dec. 12, 1996]
Sec. 1.1045-1 Application to partnerships.
(a) Overview of section. A partnership that holds qualified small
business stock (QSB stock) (as defined in paragraph (g)(1) of this
section) for more than 6 months, sells such QSB stock, and purchases
replacement QSB stock (as defined in paragraph (g)(2) of this section)
may elect to apply section 1045. An eligible partner (as defined in
paragraph (g)(3) of this section) of a partnership that sells QSB stock,
may elect to apply section 1045 if the eligible partner purchases
replacement QSB stock directly or through a purchasing partnership (as
defined in paragraph (c)(1)(i) of this section). A taxpayer (other than
a C corporation) that holds QSB stock for more than 6 months, sells such
QSB stock and purchases replacement QSB stock through a purchasing
partnership may elect to apply section 1045. A section 1045 election is
revocable only with the prior written consent of the Commissioner. To
obtain the Commissioner's prior written consent, the person who made the
section 1045 election must submit a request for a private letter ruling.
(For further guidance, see Rev. Proc. 2007-1, 2007-1 CB 1 (or any
applicable successor) and Sec. 601.601(d)(2)(ii)(b) of this chapter.)
Paragraph (b) of this section provides rules for partnerships that elect
to apply section 1045. Paragraph (c) of this section provides rules for
certain taxpayers other than C corporations and for eligible partners
that elect to apply section 1045. Paragraph (d) of this section provides
a limitation on the amount of gain that an eligible partner does not
recognize under section 1045. Paragraph (e) of this section provides
rules for partnership distributions of QSB stock to an eligible partner.
Paragraph (f) of this section provides rules for contributions of QSB
stock or replacement QSB stock to a partnership. Paragraph (g) of this
section provides definitions of certain terms used in section 1045 and
this section. Paragraph (h) of this section provides reporting rules for
partnerships and partners that elect to apply section 1045. Paragraph
(i) of this section provides examples illustrating the provisions of
this section. Paragraph (j) of this section contains the effective/
applicability date.
(b) Partnership election--(1) Partnership purchase of replacement
QSB stock. A partnership that holds QSB stock for more than 6 months,
sells such QSB stock, and purchases replacement QSB
[[Page 170]]
stock may elect in accordance with paragraph (h) of this section to
apply section 1045. If the partnership elects to apply section 1045,
then, subject to the provisions of paragraphs (b)(4) and (d) of this
section, each eligible partner shall not recognize its distributive
share of any partnership section 1045 gain (as determined under
paragraph (b)(2) of this section). For this purpose, partnership section
1045 gain equals the partnership's gain from the sale of the QSB stock
reduced by the greater of--
(i) The amount of the gain from the sale of the QSB stock that is
treated as ordinary income; or
(ii) The excess of the amount realized by the partnership on the
sale over the total cost of all replacement QSB stock purchased by the
partnership (excluding the cost of any replacement QSB stock purchased
by the partnership that is otherwise taken into account under section
1045).
(2) Partner's distributive share of partnership section 1045 gain. A
partner's distributive share of partnership section 1045 gain shall be
in the same proportion as the partner's distributive share of the
partnership's gain from the sale of the QSB stock. For this purpose, the
partnership's gain from the sale of QSB stock and the partner's
distributive share of that gain are determined without regard to basis
adjustments under section 743(b) and paragraph (b)(3)(ii) of this
section.
(3) Basis adjustments--(i) Partner's interest in a partnership. The
adjusted basis of an eligible partner's interest in a partnership shall
not be increased under section 705(a)(1) by gain from a partnership's
sale of QSB stock that is not recognized by the partner as the result of
a partnership election under paragraph (b)(1) of this section.
(ii) Partnership's replacement QSB stock--(A) Rule. The basis of a
partnership's replacement QSB stock is reduced (in the order acquired)
by the amount of gain from the partnership's sale of QSB stock that is
not recognized by an eligible partner as a result of the partnership's
election under section 1045. The basis adjustment with respect to any
amount described in this paragraph (b)(3)(ii) constitutes an adjustment
to the basis of the partnership's replacement QSB stock with respect to
that partner only. The effect of such a basis adjustment is determined
under the principles of Sec. 1.743-1(g), (h), and (j) except as
modified in this paragraph (b)(3)(ii)(A). If a partnership sells QSB
stock with respect to which a basis adjustment has been made under this
paragraph (b)(3)(ii), and the partnership makes an election under
paragraph (b)(1) of this section with respect to the sale and purchases
replacement QSB stock, the basis adjustment shall carry over to the
replacement QSB stock except to the extent otherwise provided in this
paragraph (b)(3)(ii). The basis adjustment that carries over to the
replacement QSB stock shall be reduced (but not below zero) by the
eligible partner's distributive share of the excess, if any, of the
greater of the amount determined under paragraph (b)(1)(i) or (ii) of
this section from the sale of the QSB stock, over the partnership's gain
from the sale of the QSB stock (determined without regard to basis
adjustments under section 743 or paragraph (b)(3)(ii) of this section).
The excess amount that reduces the basis adjustment shall be accounted
for as gain in accordance with Sec. 1.743-1(j)(3). See Example 5 of
paragraph (i) of this section. For purposes of this paragraph
(b)(3)(ii), a partnership must presume that a partner did not recognize
that partner's distributive share of the partnership section 1045 gain
as a result of the partnership's section 1045 election unless the
partner notifies the partnership to the contrary as described in
paragraph (b)(5)(ii) of this section. However, if a partnership knows
that a particular partner is classified, for Federal tax purposes, as a
C corporation, then the partnership may presume that the partner did not
defer recognition of its distributive share of the partnership section
1045 gain, even in the absence of a notification by the partner. If a
partnership makes an election under section 1045, but an eligible
partner opts out of the election under paragraph (b)(4) of this section
and provides to the partnership the notification required under
paragraph (b)(5)(ii) of this section, no basis adjustments under this
paragraph (b)(3)(ii) are required with respect to that partner as a
result
[[Page 171]]
of the section 1045 election by the partnership.
(B) Tiered-partnership rule. If a partnership (upper-tier
partnership) holds an interest in another partnership (lower-tier
partnership) that makes an election under section 1045, the portion of
the lower-tier partnership's basis adjustment as provided in paragraph
(b)(3)(ii)(A) of this section in the replacement QSB stock must be
segregated and allocated to the upper-tier partnership and any eligible
partner as defined in paragraph (g)(3)(iii) of this section. Similarly,
that portion of the basis of the upper-tier partnership's interest in
the lower-tier partnership attributable to the basis adjustment as
provided in paragraph (b)(3)(ii)(A) of this section in the lower-tier
partnership's replacement QSB stock must be segregated and allocated
solely to any eligible partner as defined in paragraph (g)(2)(iii) of
this section.
(C) Statement of adjustments. A partnership that must adjust the
basis of replacement QSB stock under this paragraph (b) must attach a
statement to the partnership return for the taxable year in which the
partnership purchases replacement QSB stock setting forth the
computation of the adjustment, the replacement QSB stock to which the
adjustment has been made, the date(s) on which such QSB stock was
acquired by the partnership, and the amount of the adjustment that is
allocated to each partner.
(4) Eligible partners may opt out of partnership's section 1045
election. An eligible partner may opt out of the partnership's section
1045 election with respect to QSB stock either by recognizing the
partner's distributive share of the partnership section 1045 gain, or by
making a partner section 1045 election under paragraph (c) of this
section with respect to the partner's distributive share of the
partnership section 1045 gain. See paragraph (b)(5)(ii) of this section
for applicable notification requirements. Opting out of a partnership's
section 1045 election under this paragraph (b)(4) does not constitute a
revocation of the partnership's election, and such election shall
continue to apply to other partners of the partnership.
(5) Notice requirements--(i) Partnership notification to partners. A
partnership that makes an election under paragraph (b)(1) of this
section must notify all of its partners of the election and the purchase
of replacement QSB stock, in accordance with the applicable forms and
instructions, and separately state each partner's distributive share of
partnership section 1045 gain from the sale of QSB stock under section
702. Each partner shall determine whether the partner is an eligible
partner within the meaning of paragraph (g)(3) of this section and
report the partner's distributive share of partnership section 1045 gain
from the partnership's sale of QSB stock, including gain not recognized,
in accordance with the applicable forms and instructions.
(ii) Partner notification to partnership. Any partner that must
recognize all or part of the partner's distributive share of partnership
section 1045 gain must notify the partnership, in writing, of the amount
of partnership section 1045 gain that is recognized by the partner.
Similarly, an eligible partner that opts out of a partnership's section
1045 election under paragraph (b)(4) of this section must notify the
partnership, in writing, that the partner is opting out of the
partnership's section 1045 election.
(c) Partner election--(1) In general--(i) Rule. An eligible partner
of a partnership that sells QSB stock (selling partnership) may elect in
accordance with paragraph (h) of this section to apply section 1045 if
replacement QSB stock is purchased by the eligible partner. An eligible
partner of a selling partnership may elect in accordance with paragraph
(h) of this section to apply section 1045 if replacement QSB stock is
purchased by a partnership in which the taxpayer is a partner (directly
or through an upper-tier partnership) on the date on which the
partnership acquires the replacement QSB stock (purchasing partnership).
A taxpayer other than a C corporation that sells QSB stock held for more
than 6 months at the time of the sale may elect in accordance with
paragraph (h) of this section to apply section 1045 if replacement QSB
stock is purchased by a purchasing partnership (including a selling
partnership).
[[Page 172]]
(ii) Partner purchase of replacement QSB stock. Subject to paragraph
(d) of this section, an eligible partner of a selling partnership that
elects to apply section 1045 with respect to the eligible partner's
purchase of replacement QSB stock must recognize its distributive share
of gain from the sale of QSB stock by the selling partnership only to
the extent of the greater of--
(A) The amount of the eligible partner's distributive share of the
selling partnership's gain from the sale of the QSB stock that is
treated as ordinary income; or
(B) The excess of the eligible partner's share of the selling
partnership's amount realized (as determined under paragraph (c)(2) of
this section) on the sale by the selling partnership of the QSB stock
(excluding the cost of any replacement QSB stock purchased by the
selling partnership) over the cost of any replacement QSB stock
purchased by the eligible partner (excluding the cost of any replacement
QSB stock that is otherwise taken into account under section 1045).
(iii) Partnership purchase of replacement QSB stock--(A) Partner of
a selling partnership. Subject to paragraph (d) of this section, an
eligible partner that treats its interest in QSB stock purchased by a
purchasing partnership as a purchase of replacement QSB stock by the
eligible partner and that elects to apply section 1045 with respect to
such purchase must recognize its total gain (the eligible partner's
distributive share of gain from the selling partnership's sale of QSB
stock and any gain taken into account under paragraph (c)(5) of this
section from the sale of replacement QSB stock) only to the extent of
the greater of--
(1) The amount of the eligible partner's distributive share of the
selling partnership's gain from the sale of the QSB stock that is
treated as ordinary income; or
(2) The excess of the eligible partner's share of the selling
partnership's amount realized (as determined under paragraph (c)(2) of
this section) on the sale by the selling partnership of the QSB stock
(excluding the cost of any replacement QSB stock purchased by the
selling partnership) over the eligible partner's share of the purchasing
partnership's cost of the replacement QSB stock, as determined under
paragraph (c)(3) of this section (excluding the cost of any QSB stock
that is otherwise taken into account under section 1045).
(B) Taxpayer other than a C corporation. Subject to paragraph (d) of
this section, a taxpayer other than a C corporation that treats its
interest in QSB stock purchased by a purchasing partnership with respect
to which the taxpayer is a partner as a purchase of replacement QSB
stock by the taxpayer must recognize its gain from the sale of the QSB
stock only to the extent of the greater of--
(1) The amount of gain from the sale of the QSB stock that is
treated as ordinary income; or
(2) The excess of the amount realized by the taxpayer on the sale of
the QSB stock over the partner's share of the purchasing partnership's
cost of the replacement QSB stock, as determined under paragraph (c)(3)
of this section (excluding the cost of any QSB stock that is otherwise
taken into account under section 1045).
(2) Eligible partner's share of amount realized by partnership--(i)
General rule. The eligible partner's share of the amount realized by the
selling partnership is the amount realized by the partnership on the
sale of the QSB stock (excluding the cost of any replacement QSB stock
otherwise taken into account under section 1045) multiplied by the
following fraction--
(A) The numerator of which is the eligible partner's distributive
share of the partnership's realized gain from the sale of the QSB stock;
and
(B) The denominator of which is the partnership's realized gain on
the sale of the QSB stock.
(ii) General rule modified for determining eligible partner's share
of amount realized by purchasing partnership upon a sale of replacement
QSB stock in certain situations--(A) No gain realized or loss realized
on sale of replacement QSB stock. If a purchasing partnership does not
realize a gain or realizes a loss from the sale of replacement QSB stock
for which an election under this section was made for purposes of
applying paragraph (c)(1)(iii)(A) of this section,
[[Page 173]]
the eligible partner's share of the amount realized is--
(1) The greater of--
(i) The amount determined in paragraph (c)(2)(i) of this section
from a prior sale of QSB stock (that is not otherwise taken into account
under paragraph (c)(2) of this section) in which the eligible partner
had a distributive share of gain allocated to the eligible partner that
was not recognized under paragraph (c)(1)(iii)(A) of this section; or
(ii) The amount realized by a taxpayer other than a C corporation
from a prior sale of QSB stock (that is not otherwise taken into account
under paragraph (c)(2) of this section) in which the taxpayer realized
gain that was not recognized under paragraph (c)(1)(iii)(B) of this
section; less
(2) The eligible partner's distributive share of any loss recognized
on the sale of replacement QSB stock, if applicable.
(B) Eligible partner's interest in purchasing partnership is reduced
and gain realized on sale of replacement QSB stock. If an eligible
partner's interest in a purchasing partnership is reduced subsequent to
the sale of QSB stock and the purchasing partnership realizes a gain
from the sale of the replacement QSB stock, the eligible partner's share
of the amount realized upon a sale of replacement QSB stock must be
determined under paragraph (c)(2)(i) of this section based on the
distributive share of the partnership's realized gain that would have
been allocated to the eligible partner if the eligible partner's
interest in the partnership had not been reduced.
(iii) Eligible partner's share of the amount realized. For purposes
of determining the eligible partner's share of the amount realized by
the partnership, the partnership's realized gain from the sale of QSB
stock and the eligible partner's distributive share of that gain are
determined without regard to basis adjustments under section 743(b) and
paragraphs (b)(3)(ii) and (c) of this section.
(3) Partner's share of the cost of QSB stock purchased by a
purchasing partnership. The partner's share of the cost (adjusted basis)
of replacement QSB stock purchased by a purchasing partnership is the
percentage of the partnership's future income and gain, if any, that is
reasonably expected to be allocated to the partner (determined without
regard to any adjustment under section 1045) with respect to the
replacement QSB stock that was purchased by the partnership, multiplied
by the cost of that replacement QSB stock. The assumptions made by a
partnership in determining the reasonably expected allocation of income
and gain must be consistent for each partner. For example, a partnership
may not treat the same item of income or gain as being reasonably
expected to be allocated to more than one partner.
(4) Basis adjustments--(i) Eligible partner's interest in selling
partnership. Under section 705(a)(1), the adjusted basis of an eligible
partner's interest in a selling partnership that sells QSB stock is
increased by the partner's distributive share of gain without regard to
paragraph (c)(1) of this section. However, if the selling partnership is
also a purchasing partnership, the adjusted basis of an eligible
partner's interest in a partnership that sells QSB stock may be reduced
under paragraph (c)(4)(iii) of this section.
(ii) Replacement QSB stock. A partner's basis in any replacement QSB
stock that is purchased by the partner, as well as the adjusted basis of
any replacement QSB stock that is purchased by a purchasing partnership
and that is treated as the partner's replacement QSB stock must be
reduced (in the order replacement QSB stock is acquired by the partner
and purchasing partnership, as applicable) by the partner's distributive
share of the gain on the sale of the selling partnership's QSB stock
that is not recognized by the partner under paragraph (c)(1) of this
section, or by the gain on a sale of QSB stock by the partner that is
not recognized by the partner under section 1045, as applicable. If
replacement QSB stock is purchased by the purchasing partnership, the
purchasing partnership shall maintain its adjusted basis in the
replacement QSB stock without regard to any basis adjustments required
by this paragraph (c)(4)(ii). The eligible partner, however, shall in
computing its distributive
[[Page 174]]
share of income, gain, loss and deduction from the purchasing
partnership with respect to the replacement QSB stock take into account
the variation between the adjusted basis in the QSB stock as determined
under this paragraph (c)(4)(ii) and the adjusted basis determined
without regard to this paragraph (c)(4)(ii). A partner must retain
records setting forth the computation of this basis adjustment, the
replacement QSB stock to which the adjustment has been made, and the
date(s) on which such stock was acquired. See Examples 7 and 8 of
paragraph (i) of this section.
(iii) Partner's basis in purchasing partnership interest. A partner
that treats the partner's interest in QSB stock purchased by a
purchasing partnership as the partner's replacement QSB stock must
reduce (in the order replacement QSB stock is acquired) the adjusted
basis of the partner's interest in the purchasing partnership by the
partner's distributive share of the gain on the sale of the selling
partnership's QSB stock that is not recognized by the partner pursuant
to paragraph (c)(1) of this section, or by the gain on a sale of QSB
stock by the partner that is not recognized by the partner under section
1045, as applicable. Similarly, a partner of an upper-tier partnership
that treats the partner's interest in QSB stock purchased by a lower-
tier purchasing partnership as the partner's replacement QSB stock must
reduce (in the order replacement QSB stock is acquired) the adjusted
basis of the partner's interest in the upper-tier partnership by the
partner's distributive share of the gain on the sale of the selling
partnership's QSB stock that is not recognized by the partner pursuant
to paragraph (c)(1) of this section, or by the gain on a sale of QSB
stock by the partner that is not recognized by the partner under section
1045, as applicable.
(iv) Increase in basis on sale of QSB stock by purchasing
partnership. A partner that recognizes gain under paragraph (c)(5) of
this section must increase the adjusted basis of the partner's interest
in the purchasing partnership under section 705(a)(1) by the amount of
the gain recognized by that partner. Similarly, a partner in an upper-
tier partnership that recognizes gain under paragraph (c)(5) of this
section must increase the adjusted basis of the partner's interest in
the upper-tier partnership under section 705(a)(1) by the amount of the
gain recognized by that partner.
(5) Partner recognition of gain. At the time that either the partner
or the purchasing partnership (whichever applies) sells or exchanges
replacement QSB stock, the amount recognized by the partner is
determined by taking into account the basis adjustments described in
paragraph (c)(4)(ii) of this section. Similarly, a partner of an upper-
tier partnership that owns an interest in a lower-tier partnership that
holds replacement QSB stock must take into account the basis adjustments
described in paragraph (c)(4)(ii) of this section in determining the
amount recognized by the partner on a sale of the interest in the lower-
tier partnership by the upper-tier partnership or the partner's
distributive share of gain from the upper-tier partnership. See
paragraph (e)(4) of this section for rules applicable to certain
distributions of replacement QSB stock.
(d) Nonrecognition limitation--(1) In general. For purposes of this
section, the amount of gain that an eligible partner does not recognize
under paragraphs (b)(1) and (c)(1) of this section cannot exceed the
nonrecognition limitation. Except as otherwise provided in paragraph
(d)(2) of this section, the nonrecognition limitation is equal to the
product of--
(i) The partnership's realized gain from the sale of the QSB stock,
determined without regard to any basis adjustment under section 734(b)
or section 743(b) (other than basis adjustments described in paragraph
(b)(3)(ii) of this section); and
(ii) The eligible partner's smallest percentage interest in
partnership capital as determined in paragraph (d)(2) of this section.
See Example 9 of paragraph (i) of this section.
(2) Eligible partner's smallest percentage interest in partnership
capital. An eligible partner's smallest percentage interest in
partnership capital is the eligible partner's percentage share of
capital determined at the time of the acquisition of the QSB stock as
adjusted
[[Page 175]]
prior to the time the QSB stock is sold to reflect any reduction in the
capital of the eligible partner including a reduction as a result of a
disproportionate capital contribution by other partners, a
disproportionate capital distribution to the eligible partner or the
transfer of an interest by the eligible partner, but excluding income
and loss allocations.
(3) Special rule for tiered partnerships. For purposes of paragraph
(d)(1)(ii) of this section, if an eligible partner is treated as owning
an interest in a lower-tier purchasing partnership through an upper-tier
partnership, the eligible partner's percentage interest in the
purchasing partnership shall be proportionately adjusted to reflect the
eligible partner's percentage interest in the upper-tier partnership.
(e) Partnership distribution of QSB stock to a partner--(1) In
general. Subject to paragraphs (e)(2) and (3) of this section, in the
case of a partnership distribution of QSB stock to a partner, the
partner shall be treated for purposes of this section as--
(i) Having acquired such stock in the same manner as the
partnership; and
(ii) Having held such stock during any continuous period immediately
preceding the distribution during which it was held by the partnership.
See Examples 10 and 11 of paragraph (i) of this section.
(2) Eligibility under section 1202(c). Paragraph (e)(1) of this
section does not apply unless all eligibility requirements with respect
to QSB stock as defined in section 1202(c) are met by the distributing
partnership with respect to its investment in QSB stock.
(3) Distribution nonrecognition limitation--(i) Generally. The
amount of gain that an eligible partner does not recognize under this
section on the sale of QSB stock that was distributed by the partnership
to the partner cannot exceed the distribution nonrecognition limitation.
For this purpose, the distribution nonrecognition limitation is--
(A) The partner's section 1045 amount realized (determined under
paragraph (e)(3)(ii) of this section); reduced by
(B) The partner's section 1045 adjusted basis (determined under
paragraph (e)(3)(iii) of this section).
(ii) Section 1045 amount realized--(A) QSB stock received in
liquidation of partner's interest and in certain nonliquidating
distributions. If a partner receives QSB stock from the partnership in a
distribution in liquidation of the partner's interest in the partnership
or as part of a series of related distributions by the partnership in
which the partnership distributes all of the partnership's QSB stock of
a particular type, then the partner's section 1045 amount realized is
the partner's amount realized from the sale of the distributed QSB
stock, multiplied by a fraction--
(1) The numerator of which is the partner's smallest percentage
interest in partnership capital determined under paragraph (e)(3)(ii)(B)
of this section; and
(2) The denominator of which is the partner's percentage interest in
that type of QSB stock immediately after the distribution (determined
under paragraph (e)(3)(iv) of this section).
(B) Partner's smallest percentage interest in partnership capital. A
partner's smallest percentage interest in partnership capital is the
partner's percentage share of capital determined at the time of the
acquisition of the QSB stock as adjusted prior to the time the QSB stock
is distributed to the partner to reflect any reduction in the capital of
the partner including a reduction as a result of a disproportionate
capital contribution by other partners, a disproportionate capital
distribution to the partner, or the transfer of a capital interest by
the partner, but excluding income and loss allocations.
(C) QSB stock received in other distributions. If a partner receives
QSB stock in a distribution from the partnership that is not described
in paragraph (e)(3)(ii)(A) of this section, the partner's section 1045
amount realized is the partner's amount realized from the sale of the
distributed QSB stock multiplied by the partner's smallest percentage
interest in partnership capital determined under paragraph (e)(3)(ii)(B)
of this section.
(iii) Section 1045 adjusted basis--(A) QSB stock received in
liquidation of partner's interest and in certain nonliquidating
distributions. If a partner receives QSB stock from the partnership
[[Page 176]]
in a distribution in liquidation of the partner's interest in the
partnership or as part of a series of related distributions by the
partnership in which the partnership distributes all of the
partnership's QSB stock of a particular type, then the partner's section
1045 adjusted basis is the product of--
(1) The partnership's basis in all of the QSB stock of the type
distributed (without regard to basis adjustments under section 734(b) or
section 743(b), other than basis adjustments described in paragraphs
(b)(3)(ii) and (c)(4)(ii) of this section);
(2) The partner's smallest percentage interest in partnership
capital determined under paragraph (e)(3)(ii)(B) of this section; and
(3) The proportion of the distributed QSB stock that was sold by the
partner.
(B) QSB stock received in other distributions. If a partner receives
QSB stock in a distribution from the partnership that is not described
in paragraph (e)(3)(iii)(A) of this section, the partner's section 1045
adjusted basis is the product of--
(1) The partnership's basis in the QSB stock sold by the partner
(without regard to basis adjustments under section 734(b) or section
743(b), other than basis adjustments described in paragraphs (b)(3)(ii)
and (c)(4)(ii) of this section); and
(2) The partner's smallest percentage interest in partnership
capital determined under paragraph (e)(3)(ii)(B) of this section.
(iv) Partner's percentage interest in distributed QSB stock. For
purposes of this paragraph (e)(3), a partner's percentage interest in a
type of QSB stock immediately after a partnership distribution is the
value (as of the date of the distribution) of the QSB stock distributed
to the partner divided by the value (as of the date of the distribution)
of all of that type of QSB stock that was acquired by the partnership.
(v) QSB stock of the same type. For purposes of this paragraph
(e)(3), QSB stock will be of the same type as the distributed QSB stock
if it has the same issuer and the same rights and preferences as the
distributed QSB stock and was acquired by the partnership at original
issue.
(4) Distribution of replacement QSB stock to a partner that reduces
another partner's interest in the replacement QSB stock. For purposes of
this section, a partner must recognize gain upon a distribution of
replacement QSB stock to another partner that reduces the partner's
share of the replacement QSB stock held by a partnership. The amount of
gain that the partner must recognize is determined based on the amount
of gain that the partner would recognize upon a sale of the distributed
replacement QSB stock for its fair market value on the date of the
distribution but not to exceed the amount that was previously not
recognized by the partner under section 1045 with respect to the
distributed replacement QSB stock. Any gain recognized by a partner
whose interest is reduced must be taken into account in determining the
adjusted basis of the partner's interest in the partnership and also
taken into account in determining the partnership's adjusted basis in
the QSB stock distributed to another partner under paragraph (e)(3) of
this section.
(f) Contribution of QSB stock or replacement QSB stock to a
partnership. Section 721 applies to a contribution of QSB stock to a
partnership. Except as provided in section 721(b), any gain that was not
recognized by the taxpayer under section 1045 is not recognized when the
taxpayer contributes QSB stock to a partnership in exchange for a
partnership interest. Stock that is contributed to a partnership is not
QSB stock in the hands of the partnership. See Example 12 of paragraph
(i) of this section.
(g) Definitions. For purposes of section 1045 and this section, the
following terms are defined as follows:
(1) Qualified small business stock. The term qualified small
business stock (QSB stock) has the meaning provided in section 1202(c).
The term ``QSB stock'' does not include an interest in a partnership
that purchases or holds QSB stock. See Example 1 of paragraph (i) of
this section.
(2) Replacement QSB stock. The term replacement QSB stock is any QSB
stock purchased within 60 days beginning on the date of a sale of QSB
stock.
(3) Eligible partner--(i) In general. Except as provided in
paragraphs (e)(1),
[[Page 177]]
(g)(3)(ii), (iii) and (iv) of this section, an eligible partner with
respect to QSB stock is a taxpayer other than a C corporation that holds
an interest in a partnership on the date the partnership acquires the
QSB stock and at all times thereafter for more than 6 months until the
partnership sells or distributes the QSB stock.
(ii) Acquisition by gift or at death. For purposes of paragraph
(g)(3)(i) of this section, a taxpayer who acquires from a partner (other
than a C corporation) by gift or at death an interest in a partnership
that holds QSB stock is treated as having held the acquired interest in
the partnership during the period the partner (other than a C
corporation) held the interest in the partnership.
(iii) Tiered partnership. For purposes of paragraph (g)(3)(i) of
this section, if a partnership (upper-tier partnership) holds an
interest in another partnership (lower-tier partnership) that holds QSB
stock, then the upper-tier partnership's ownership of the lower-tier
partnership is disregarded and each partner of the upper-tier
partnership is treated as owning the interest in the lower-tier
partnership directly. The partner of the upper-tier partnership is
treated as owning the interest in the lower-tier partnership during the
period in which both--
(A) The partner of the upper-tier partnership held an interest in
the upper-tier partnership; and
(B) The upper-tier partnership held an interest in the lower-tier
partnership. See Examples 3 and 4 of paragraph (i) of this section.
(iv) Multiple tiers of partnerships. Principles similar to those
described in paragraph (g)(3)(iii) of this section apply where a
taxpayer holds an interest in a lower-tier partnership through multiple
tiers of partnerships.
(4) Month(s). For purposes of this section, the term month(s) means
a period commencing on the same numerical day of any calendar month as
the day on which the QSB stock is sold and ending with the close of the
day preceding the numerically corresponding day of the succeeding
calendar month or, if there is no corresponding day, with the last day
of the succeeding calendar month.
(h) Reporting and election rules--(1) Time and manner of making
election. A partnership making an election under section 1045 (as
described under paragraph (b)(1) of this section) must do so on the
partnership's timely filed (including extensions) Federal income tax
return for the taxable year during which the sale of QSB stock occurs. A
partner making an election under section 1045 (as described under
paragraph (c)(1) of this section) must do so on the partner's timely
filed (including extensions) Federal income tax return for the taxable
year during which the partner's distributive share of the partnership's
gain from the sale of the QSB stock is taken into account by such
partner under section 706. In addition, a partnership or partner making
an election under section 1045 must make such election in accordance
with the applicable forms and instructions.
(2) Purchases, distributions, and sales of QSB stock or replacement
QSB stock by partnerships. A partnership that purchases, distributes to
a partner, or sells or exchanges QSB stock or replacement QSB stock must
provide information to the Commissioner and to the partnership's
partners to the extent provided by the applicable forms and
instructions.
(3) Nonrecognition of gain by eligible partners. An eligible partner
that does not recognize gain under section 1045 must provide information
to the Commissioner to the extent provided by the applicable forms and
instructions.
(i) Examples. The provisions of this section are illustrated by the
following examples:
Example 1. Sale of a partnership interest. On January 1, 2008, A, an
individual, X, a C corporation, and Y, a C corporation, form PRS, a
partnership. A, X, and Y each contribute $250 to PRS and agree to share
all partnership items equally. PRS purchases QSB stock for $750 on
February 1, 2008. On November 4, 2008, A sells A's interest in PRS for
$500, realizing $250 of capital gain. Under paragraph (g)(1) of this
section, an interest in a partnership that holds QSB stock is not
treated as QSB stock. Therefore, the sale of an interest in a
partnership that holds QSB stock is not treated as a sale of QSB stock,
and A may not elect to apply section 1045 with respect to A's $250 gain
from the sale of A's interest in PRS.
Example 2. Election by partner; replacement by partnership. (i)
Assume the same facts as
[[Page 178]]
in Example 1, except that A does not sell A's interest in PRS. Instead,
PRS sells the QSB stock (QSB1 stock) for $1,500 on November 3, 2008. PRS
realizes $750 of gain from the sale of the QSB1 stock (none of which is
treated as ordinary income) and allocates $250 of gain to each of A, X,
and Y. PRS does not make a section 1045 election. On November 30, 2008,
A contributes $500 to ABC, a partnership, in exchange for a 10 percent
interest in ABC. ABC then purchases QSB stock (QSB2 stock) for $5,000 on
December 1, 2008. ABC has no other assets. A makes an election under
paragraph (c)(1) of this section and treats A's percentage interest in
ABC's QSB2 stock as replacement QSB stock under paragraph (c)(1)(iii) of
this section with respect to the $250 gain PRS allocated to A. Under
paragraph (c)(3) of this section, A's share of the cost of QSB2 stock
purchased by ABC is $500 (A's reasonably expected income and gain with
respect to QSB2 stock, or 10 percent multiplied by the cost of the QSB2
stock, $5,000). Under paragraph (c)(1)(iii) of this section, A will not
recognize the $250 gain PRS allocated to A, because A's share of the
amount realized by PRS, $500 (the total amount realized by the
partnership on the sale of the QSB1 stock ($1,500) multiplied by A's
share of the gain from the sale of the QSB1 stock ($250) over the total
gain realized by the partnership on the sale of the QSB1 stock ($750)),
does not exceed A's share of ABC's cost of the QSB2 stock acquired by
ABC, $500. Under paragraph (c)(4)(ii) of this section, A must reduce A's
share of ABC's basis in the QSB2 stock by $250. Under paragraph
(c)(4)(iii) of this section, A must reduce A's basis in A's interest in
ABC by $250. Under paragraph (c)(4)(i) of this section, A's basis in A's
interest in PRS is increased by $250.
(ii) Assume the same facts as in paragraph (i) of this Example 2,
except that A does not contribute $500 to ABC in exchange for a
partnership interest. Instead, on November 30, 2008, EFG, a partnership
in which A has an existing 10 percent partnership interest, purchases
QSB stock for $5,000. Under paragraph (c)(1) of this section, A may
treat A's 10 percent interest in EFG's QSB stock as replacement QSB
stock with respect to the $250 of gain PRS allocated to A.
(iii) Assume the same facts as in paragraph (i) of this Example 2,
except that ABC owns QSB stock that ABC purchased on November 10, 2008,
and ABC does not purchase QSB stock on December 1, 2008. Under paragraph
(c)(1) of this section, ABC is not a purchasing partnership with respect
to A for the QSB stock ABC purchased on November 10, 2008. A may not
treat A's percentage interest in ABC's QSB stock as replacement QSB
stock to defer the $250 gain PRS allocated to A, because A acquired its
interest in ABC after ABC acquired the QSB stock.
(iv) Assume the same facts as in paragraph (i) of this Example 2,
except that ABC sells QSB2 stock on July 30, 2009, for $5,000. ABC
realizes no gain or loss on the sale of QSB2 stock. A desires to
continue to rollover the $250 gain from the sale of QSB1 stock. Under
paragraph (c)(2)(ii)(A) of this section, A's share of the amount
realized is $500, which was A's share of the amount realized on the
prior sale of QSB1 stock. Accordingly, A must elect to apply section
1045 and purchase $500 of replacement QSB stock either directly or
through a purchasing partnership to continue to defer the $250 gain from
the sale of QSB1 stock.
Example 3. Tiered partnerships; partnership election. (i) On January
1, 2008, A, an individual, and B, an individual, each contribute $500 to
UTP (upper-tier partnership) for equal partnership interests. On
February 1, 2008, UTP and C, an individual, each contribute $1,000 to
LTP (lower-tier partnership) for equal partnership interests. On March
1, 2008, LTP purchases QSB stock for $500. On April 1, 2008, D, an
individual, joins UTP by contributing $500 to UTP for a \1/3\ interest
in UTP. On December 1, 2008, LTP sells the QSB stock for $2,000. Under
paragraph (g)(3)(iii) of this section, A, B, and D are treated as owning
an interest in LTP during the period in which each of the partners held
an interest in UTP and UTP held an interest in LTP. Therefore, under
paragraphs (g)(3)(i) and (iii) of this section, A and B are eligible
partners, and D and UTP are not eligible partners with respect to the
QSB stock sold by LTP. Under paragraph (g)(3)(i) of this section, C is
also an eligible partner with respect to the QSB stock sold by LTP.
(ii) Assume the same facts as in paragraph (i) of this Example 3.
LTP realizes a gain of $1,500 on the December 1, 2008, sale of QSB
stock. LTP allocates $750 of gain to each of UTP and C. UTP, in turn,
allocates $250 (of the $750 of gain allocated to UTP) to each of A, B,
and D. LTP makes a section 1045 election. On January 1, 2009, LTP
purchases replacement QSB stock for $2,000. Under paragraph (b)(5)(ii)
of this section, D notifies UTP that it recognizes $250 of gain and UTP
notifies LTP. Because A, B, and C are eligible partners with respect to
the QSB stock sold by LTP, A and B may each defer $250 of LTP's section
1045 gain and C may defer $750 of LTP's section 1045 gain. LTP must
decrease its basis in the replacement QSB stock by the $750 of
partnership section 1045 gain that was allocated to C and by $500 of the
partnership section 1045 gain that was allocated to UTP. These basis
reductions are with respect to UTP (A and B) and C only. Under paragraph
(b)(3)(ii)(B) of this section, the basis of UTP's interest in LTP
attributable to the LTP's replacement QSB stock must be segregated and
allocated to A and B.
[[Page 179]]
In addition, A and B each have a $250 negative basis adjustment in their
respective interests in UTP. If UTP sells its interest in LTP for
$1,250, A and B would each recognize $250 of gain from the sale of the
LTP interest. D would not recognize any gain or loss from the sale.
Example 4. Tiered partnerships; partner election. (i) On January 1,
2008, A, an individual, and X, a C corporation, form UTP, a partnership.
A and X each contribute $250 to UTP and agree to share all partnership
items equally. Also, on January 1, 2008, UTP and Y, a C corporation,
form LTP, a partnership. UTP and Y contribute $500 and $250,
respectively, to LTP. UTP and Y agree to share all partnership items
equally. LTP purchases QSB stock for $750 on February 1, 2008. On
November 3, 2008, LTP sells the QSB stock for $1,500. LTP realizes $750
of gain from the sale of the QSB stock (none of which is treated as
ordinary income) and allocates $250 gain to Y and $500 gain to UTP. Of
the $500 gain allocated to UTP from the sale of QSB stock, $250 is
allocated to A and $250 is allocated to X. LTP purchases replacement QSB
stock (replacement QSB1 stock) for $1,350 on December 15, 2008. LTP does
not make an election under section 1045. Under the rules provided in
paragraph (c) of this section, A makes an election under section 1045 on
its timely filed return for the taxable year for which the distributive
share of gain from the sale of QSB stock is taken into account by A
under section 706. Under paragraph (c)(1)(iii) of this section, A treats
A's interest in replacement QSB1 stock as replacement stock with respect
to A's distributive share of LTP's section 1045 gain. On March 30, 2009,
LTP sells replacement QSB1 stock for $1,650. LTP realizes $300 of gain
from the sale of replacement QSB1 stock (none of which is treated as
ordinary income) and allocates $100 to Y and $200 to UTP.
(ii) Under paragraph (c)(1)(iii) of this section, A must recognize
its distributive share of gain from LTP's sale of QSB stock ($250) only
to the extent of the greater of A's distributive share of LTP's gain
from the sale of QSB stock that is treated as ordinary income ($0) or
the amount by which A's share of the amount realized by LTP's sale of
QSB stock exceeds A's share of LTP's cost of the replacement QSB1 stock,
$50 (\1/3\ of $1,500, or $500, minus \1/3\ of $1,350, or $450). Because
Y is not an eligible partner of LTP under paragraph (g)(3) of this
section, Y must recognize its $250 distributive share of partnership
gain from the sale of the QSB stock. Also, X is not an eligible partner
under paragraph (g)(3) of this section, and it must recognize its $250
distributive share of gain from UTP attributable to UTP's distributive
share of $500 of LTP's gain from the sale of QSB stock.
(iii) Under section 705(a)(1), the adjusted basis of Y's interest in
LTP is increased by $250, and the adjusted basis of UTP's interest in
LTP is increased by $500. Under section 705(a)(1), the adjusted basis of
X's interest in UTP is increased by $250, and the adjusted basis of A's
interest in UTP is increased by $250. However, under paragraph
(c)(4)(iii) of this section, the adjusted basis of A's interest in UTP
is reduced by the $200 of partnership section 1045 gain that was not
recognized by A.
(iv) Under paragraph (c)(4)(ii) of this section, the LTP's adjusted
basis in replacement QSB1 stock is reduced by the $200 of gain from the
sale of QSB stock that is not recognized by A, as a result of A's
election under section 1045. A must retain records setting forth the
computation of this basis adjustment, the replacement QSB stock to which
the adjustment is made, and dates the stock was acquired. LTP's adjusted
basis in the replacement QSB1 stock is maintained without regard to the
eligible partner's adjustment provided in paragraph (c)(4)(ii) of this
section.
(v) On the sale of replacement QSB1 stock, LTP realizes a gain of
$300, $100 of which is allocated to Y and $200 of which is allocated to
UTP. UTP allocates $100 of this gain to A. Under paragraph (c)(5) of
this section, in determining A's amount recognized upon the sale of
replacement QSB1 stock by LTP, A must take into account A's basis
adjustment of $200. Accordingly, A recognizes a total gain of $300 upon
the sale of replacement QSB1 stock, absent an additional section 1045
election by A or LTP. Under paragraph (c)(4)(iv) of this section, the
adjusted basis of A's interest in UTP is increased by $300 under section
705(a)(1).
(vi) Assume the same facts as in paragraph (i) of this Example 4,
except that UTP sells its entire interest in LTP on March 30, 2009, for
$1,200. UTP realizes a gain of $200 on the sale of its interest in LTP
($1,200 amount realized less $1,000 adjusted basis) and allocates $100
of this gain to A. Under paragraph (c)(5) of this section, in
determining A's amount recognized upon the sale of UTP's interest in
LTP, A must take into account A's basis adjustment of $200. Accordingly,
A recognizes a total gain of $300 upon the sale of the interest in LTP.
Under paragraph (c)(4)(iv) of this section, the adjusted basis in A's
interest in UTP is increased by $300 under section 705(a)(1).
Example 5. Partnership sale of QSB stock and purchase and sale of
replacement QSB stock. (i) On January 1, 2008, A, an individual, X, a C
corporation, and Y, a C corporation, form PRS, a partnership. A, X, and
Y each contribute $250 to PRS and agree to share all partnership items
equally. PRS purchases QSB stock for $750 on February 1, 2008. On
November 3, 2008, PRS sells the QSB stock for $1,500. PRS realizes $750
of gain from the sale of the QSB stock (none of which is treated as
ordinary income) and allocates $250 of gain to each of A, X, and Y. PRS
purchases
[[Page 180]]
replacement QSB stock (replacement QSB1 stock) for $1,350 on December
15, 2008. On its timely filed return for the taxable year during which
the sale of the QSB stock occurs, PRS makes an election to apply section
1045. A does not make an election to apply section 1045 with respect to
the November 3, 2008, sale of QSB stock. PRS knows that X and Y are C
corporations. On March 30, 2009, PRS sells replacement QSB1 stock for
$1,650. PRS realizes $300 of gain from the sale of replacement QSB1
stock (none of which is treated as ordinary income) and allocates $100
of gain to each of A, X, and Y. A does not make an election to apply
section 1045 with respect to the March 30, 2009, sale of replacement
QSB1 stock.
(ii) Under paragraph (b)(1) of this section, the partnership section
1045 gain from the November 3, 2008, sale of QSB stock is $600 ($750
gain less $150 ($1,500 amount realized on the sale of QSB stock less
$1,350 cost of replacement QSB1 stock)). This amount must be allocated
among the partners in the same proportions as the entire gain from the
sale of QSB stock is allocated to the partners, \1/3\ ($200) to A, \1/3\
($200) to X, and \1/3\ ($200) to Y.
(iii) Because neither X nor Y is an eligible partner under paragraph
(g)(3) of this section, X and Y must each recognize its $250
distributive share of partnership gain from the sale of QSB stock.
Because A is an eligible partner under paragraph (g)(3) of this section,
A may defer recognition of A's $200 distributive share of partnership
section 1045 gain. A is not required to separately elect to apply
section 1045. A must recognize A's remaining $50 distributive share of
the partnership's gain from the sale of QSB stock.
(iv) Under section 705(a)(1), the adjusted bases of X's and Y's
interests in PRS are each increased by $250. Under section 705(a)(1) and
paragraph (b)(3)(i) of this section, the adjusted basis of A's interest
in PRS is not increased by the $200 of partnership section 1045 gain
that was not recognized by A, but is increased by A's remaining $50
distributive share of gain.
(v) PRS must decrease its basis in the replacement QSB1 stock by the
$200 of partnership section 1045 gain that was allocated to A. This
basis reduction is a reduction with respect to A only. PRS then adjusts
A's distributive share of gain from the sale of replacement QSB1 stock
to reflect the effect of A's basis adjustment under paragraph (b)(3)(ii)
of this section. In accordance with the principles of Sec. 1.743-
1(j)(3), the amount of A's gain from the March 30, 2009, sale of
replacement QSB1 stock in which A has a $200 negative basis adjustment
equals $300 (A's share of PRS' gain from the sale of replacement QSB1
stock ($100), increased by the amount of A's negative basis adjustment
for replacement QSB1 stock ($200)). Accordingly, upon the sale of
replacement QSB1 stock, A recognizes $300 of gain, and X and Y each
recognize $100 of gain.
(vi) Assume the same facts as in paragraph (i) of this Example 5,
except that PRS purchases replacement QSB stock (replacement QSB2 stock)
on April 15, 2009, for $1,150 and PRS makes an election to apply section
1045 with respect to the March 30, 2009, sale of replacement QSB1 stock.
Under paragraph (b)(3)(ii)(A) of this section, PRS' $200 basis
adjustment in QSB1 stock relating to the November 3, 2008, sale of QSB
stock carries over to the basis adjustment for QSB2 stock. This basis
adjustment is an adjustment with respect to A only. The $200 basis
adjustment is reduced by A's distributive share of the excess of $500
(the greater of the amount determined under paragraph (b)(1)(i), $0, or
(ii) of this section, $500 ($1,650 amount realized on the sale of QSB1
stock less $1,150 cost of replacement QSB2 stock)) over $300 (PRS' gain
from the sale of QSB1 stock), or $67 ($200 ($500 minus $300) divided by
3). Under paragraph (b)(3)(ii)(A), A must account for the $67 excess
amount that reduces PRS' basis adjustment in QSB2 stock as gain in
accordance with Sec. 1.743-1(j)(3). Therefore, A now has a $133
negative basis adjustment with respect to replacement QSB2 stock (($200)
negative basis adjustment from the November 3, 2008, sale of QSB stock
plus $67 positive basis adjustment from the March 30, 2009, sale of QSB1
stock). A also recognizes the $100 of gain allocated by PRS to A from
the March 30, 2009, sale of replacement QSB1 stock for total gain
recognition of $167 ($100 plus $67).
Example 6. Partnership sale of QSB stock; election by eligible
partner; replacement QSB stock purchased by purchasing partnership. (i)
Assume the same facts as in Example 5 except that PRS does not make an
election under section 1045 with respect to the sale of either the QSB
stock on November 3, 2008, or the QSB1 stock on March 30, 2009. However,
A makes an election under section 1045 with respect to the sale of QSB
stock and treats the purchase of QSB1 stock on December 15, 2008, by
PRS, as the purchase of replacement QSB stock. Additionally, A makes an
election under section 1045 with respect to the sale of QSB1 stock and
treats the purchase of QSB2 stock on April 15, 2009, by PRS, as the
purchase of replacement QSB stock.
(ii) A's distributive share of gain from the November 3, 2008, sale
of QSB stock is $250 (A's \1/3\ interest in $750 of total PRS gain).
Under paragraph (c)(1)(iii) of this section, A must recognize only $50
of A's distributive share of PRS' gain of $250, that is the excess of
A's share of the amount realized on the sale of QSB stock, or $500 (the
total amount realized by PRS on the sale of QSB stock ($1,500)
multiplied by A's share of the gain from the sale of QSB stock ($250)
over the total gain realized by PRS on the sale of QSB stock ($750)),
minus A's share of PRS' cost of QSB1 stock, or $450 (\1/3\ of $1,350).
[[Page 181]]
Under section 705(a)(1) and paragraph (c)(4)(i) of this section, A's
adjusted basis in its interest in PRS is increased by $250. However,
under paragraph (c)(4)(iii) of this section, because PRS is a purchasing
partnership, A's adjusted basis of its interest in PRS is then reduced
by the deferred gain of $200. Also under paragraph (c)(4)(ii) of this
section, PRS' adjusted basis in QSB1 stock is reduced by the gain not
recognized of $200 and A must take into account such adjusted basis in
computing A's income, gain, loss or deduction with respect to QSB1
stock. A must retain records setting forth the computation of this basis
adjustment, the replacement QSB stock to which the adjustment is made,
and dates the stock was acquired.
(iii) A's distributive share of gain from the March 30, 2009, sale
of QSB1 stock is $100 (A's \1/3\ interest in $300 of total PRS gain) and
under paragraph (c)(5) of this section, A must take into account A's
$200 basis adjustment with respect to the QSB1 stock that was sold.
Accordingly, A's total gain from the sale of QSB1 stock is $300. Under
paragraph (c)(1)(iii) of this section, A must recognize only $167 of A's
total gain of $300, that is, the excess of A's share of the amount
realized on the sale of QSB1 stock, or $550 (the total amount realized
by PRS on the sale of QSB1 stock ($1,650) multiplied by A's share of the
gain from the sale of QSB1 stock ($100) over the total gain realized by
PRS on the sale of QSB1 stock ($300)) minus A's share of PRS' cost of
QSB2 stock, or $383 (\1/3\ of $1,150). Under section 705(a)(1), A's
adjusted basis in A's interest in PRS is increased by A's $100
distributive share of gain from the sale of QSB1 stock. Under paragraph
(c)(4)(iv) of this section, A's adjusted basis of A's interest in PRS is
increased by the additional $67 of gain recognized under paragraph
(c)(5) of this section. Also, under paragraph (c)(4)(ii) of this
section, PRS' adjusted basis in QSB2 stock is reduced by the gain not
recognized of $133 ($300 minus $167) and A must take into account such
adjusted basis in computing A's income, gain, loss or deduction with
respect to QSB2 stock. A must retain records setting forth the
computation of this basis adjustment, the replacement QSB stock to which
the adjustment is made, and dates the stock was acquired.
Example 7. Partnership sale of QSB stock and partner purchase of
replacement QSB stock. (i) Assume the same facts as in paragraph (i) of
Example 5, except that PRS does not make an election under section 1045
with respect to the sale of the QSB stock and does not purchase
replacement QSB stock. On November 30, 2008, A, an eligible partner
under paragraph (g)(3) of this section, purchases replacement QSB stock
for $500. A elects pursuant to paragraph (c) of this section to apply
section 1045 on A's timely filed return for the taxable year that A is
required to include A's distributive share of PRS' gain from the sale of
the QSB stock.
(ii) Under paragraph (c)(2) of this section, A's share of the amount
realized from PRS' sale of the QSB stock is $500 (the total amount
realized by the partnership on the sale of the QSB stock ($1,500)
multiplied by A's share of the gain from the sale of the QSB stock
($250) over the total gain realized by the partnership on the sale of
the QSB stock ($750)). Because A purchased, within 60 days of PRS' sale
of the QSB stock, replacement QSB stock for a cost equal to A's share of
the partnership's amount realized on the sale of the QSB stock, and
because A made an election pursuant to paragraph (c) of this section to
apply section 1045, A defers recognition of A's $250 distributive share
of gain from PRS' sale of the QSB stock. Under section 705(a)(1) and
paragraph (c)(4)(i) of this section, the adjusted basis of A's interest
in PRS is increased by $250. Under paragraph (c)(4)(ii) of this section,
A's adjusted basis in the replacement QSB stock is $250 ($500 cost minus
$250 nonrecognition amount).
Example 8. Partial replacement by partnership; partial replacement
by partner. (i) On January 1, 2008, A, an individual, and X, a C
corporation, form PRS, a partnership. A and X each contribute $500 to
PRS and agree to share all partnership items equally. PRS purchases QSB
stock on February 1, 2008, for $1,000 and subsequently sells the QSB
stock on January 31, 2010, for $3,000. PRS realizes $2,000 of gain from
the sale of the QSB stock (none of which is treated as ordinary income)
and allocates $1,000 of gain to each of A and X. On February 10, 2010,
PRS purchases replacement QSB stock for $2,200. On March 20, 2010, A
purchases replacement QSB stock for $400. PRS makes an election to apply
section 1045 under paragraph (b)(1) of this section with respect to the
partnership section 1045 gain from the sale of QSB stock and A does not
opt out of PRS' section 1045 election under paragraph (b)(4) of this
section. Also, A makes an election under paragraph (c)(1) of this
section with respect to the remaining gain from the sale of the QSB
stock.
(ii) Under paragraph (b)(1) of this section, partnership section
1045 gain is $1,200 ($2,000 less $800 ($3,000 amount realized on the
sale of the QSB stock minus $2,200 cost of the replacement QSB stock)).
This amount is allocated among the partners in the same proportions as
the entire gain from the sale of the QSB stock is allocated to the
partners, \1/2\ to A ($600), and \1/2\ to X ($600). Because A is an
eligible partner, A defers recognition of A's $600 distributive share of
partnership section 1045 gain.
(iii) A also made an election under section 1045 and purchased,
within 60 days of PRS' sale of the QSB stock, replacement QSB stock for
$400. Therefore, under paragraph (c)(1) of this section, A may defer a
portion of A's distributive share of the remaining
[[Page 182]]
gain from the partnership's sale of the QSB stock. A must recognize that
remaining gain to the extent that A's share of the amount realized by
PRS on the sale of the QSB stock (excluding the cost of the QSB stock
that was replaced by PRS) exceeds the cost of the replacement QSB stock
purchased by A during the 60-day period following the sale of the QSB
stock. The amount realized by PRS on the sale of the QSB stock
(excluding the cost of the QSB stock that was replaced by PRS) is $800
($3,000 minus $2,200). Under paragraph (c)(2) of this section, A's share
of that amount realized is $400 ($1,000 (A's share of the realized gain
from the sale of the QSB stock) / $2,000 (PRS total realized gain from
the sale of the QSB stock) multiplied by $800). Because the replacement
QSB stock purchased by A cost $400, A defers recognition of all of the
remaining gain from the sale of the QSB stock.
(iv) The adjusted basis of A's interest in PRS is not increased by
the $600 gain that was not recognized pursuant to paragraph (b)(1) of
this section, but is increased by the $400 gain that was not recognized
pursuant to paragraph (c)(1) of this section. See paragraphs (b)(3)(i)
and (c)(4)(i) of this section. PRS must decrease its basis in the
replacement QSB stock by the $600 of partnership section 1045 gain that
was allocated to A. See paragraph (b)(3)(ii) of this section. A must
decrease A's basis in the replacement QSB stock purchased by A by the
$400 not recognized pursuant to paragraph (c)(1) of this section. See
paragraph (c)(4)(ii) of this section.
Example 9. Change in partner's interest in partnership while
partnership holds QSB stock. (i) On January 1, 2008, A, an individual,
and X, a C corporation, form PRS, a partnership. A and X each contribute
$500 to PRS and agree to share all partnership items equally. PRS
purchases QSB stock on February 1, 2008, for $1,000. On August 2, 2008,
A sells a 25 percent interest in PRS to Z. On July 10, 2009, A
repurchases the 25 percent interest from Z for $500. PRS makes a timely
election under section 754 for the 2008 taxable year. Under section
743(b), A has a positive basis adjustment of $250. On January 31, 2011,
PRS sells the QSB stock for $3,000. PRS realizes $2,000 of gain from the
sale of the QSB stock (none of which is treated as ordinary income) and
allocates $1,000 of gain to each of A and X. On February 10, 2010, PRS
purchases replacement QSB stock for $3,000. PRS makes an election to
apply section 1045 under paragraph (b)(1) of this section with respect
to the partnership section 1045 gain from the sale of QSB stock.
(ii) Of the $2,000 of realized gain from the sale of the QSB stock,
PRS allocates $1,000 to A and $1,000 to X. However, A has a positive
basis adjustment of $250 under section 743(b) as a result of the
purchase of the 25 percent interest in PRS from Z; therefore, A's share
of the gain is reduced to $750. Because A is an eligible partner under
paragraph (g)(3) of this section, A may defer recognition of A's
distributive share of gain from the sale of the QSB stock subject to the
nonrecognition limitation described in paragraph (d) of this section.
The smallest percentage interest that A held in PRS capital during the
time that PRS held the QSB stock is 25 percent. Under the nonrecognition
limitation, A may not defer more than 25 percent of the partnership gain
realized from the sale of the QSB stock (determined without regard to
any basis adjustment under section 734(b) or section 743(b), other than
a basis adjustment described in paragraph (b)(3)(ii) of this section).
Because the partnership's realized gain determined without regard to A's
basis adjustment under section 743(b) is $2,000, A may defer recognition
of $500 (25 percent of $2,000) of the gain from the sale of the QSB
stock. A must recognize the remaining $250 of that gain.
Example 10. Sale by partner of QSB stock received in a liquidating
distribution. (i) On January 1, 2008, A, an individual, and X, a C
corporation, form PRS, a partnership. A and X each contribute $1,500 to
PRS and agree to share all partnership items equally. PRS purchases QSB
stock on February 1, 2008, for $3,000. On May 1, 2008, when the QSB
stock has appreciated in value to $4,000, A contributes $1,000 to PRS,
increasing A's interest in PRS capital to 60 percent. On June 1, 2011,
when the QSB stock is still worth $4,000, PRS makes a liquidating
distribution of $3,000 worth of QSB stock to A. Under section 732, A's
basis in the distributed QSB stock is $2,500. A sells the QSB stock on
August 4, 2011, for $6,000, realizing a gain of $3,500 (none of which is
treated as ordinary income). A purchases replacement QSB stock on August
30, 2011, for $5,500, and makes an election under section 1045 with
respect to the August 4, 2011, sale of QSB stock.
(ii) A is an eligible partner under paragraph (g)(3) of this
section. Therefore, under paragraph (e)(1) of this section, A is treated
as having acquired the distributed QSB stock in the same manner as PRS
and as having held the QSB stock since February 1, 2008, its original
issue date. Because A purchased, within 60 days of A's sale of the QSB
stock, replacement QSB stock, A is eligible to defer a portion of A's
gain from the sale of the QSB stock. A must recognize gain, however, to
the extent that A's amount realized on the sale of the QSB stock,
$6,000, exceeds the cost of the replacement QSB stock purchased by A
during the 60-day period beginning on the date of the sale of the QSB
stock, $5,500. Accordingly, A must recognize $500 of the gain from the
sale of the QSB stock. A defers recognition of the remaining $3,000 of
gain to the extent that such gain does not exceed the distribution
nonrecognition limitation under paragraph (e)(3) of this section.
[[Page 183]]
(iii) Under paragraph (e)(3)(i) of this section, A's nonrecognition
limitation with respect to the sale of the QSB stock is A's section 1045
amount realized with respect to the stock, reduced by A's section 1045
adjusted basis with respect to the stock. A's amount realized from the
sale is the product of A's amount realized from the sale, $6,000; and a
fraction--
(1) The numerator of which is A's smallest percentage interest in
PRS capital with respect to such stock, 50 percent; and
(2) The denominator of which is A's percentage interest in that type
of partnership QSB stock immediately after the distribution, 75 percent
(the value of the stock distributed to A, $3,000, divided by the value
of all QSB stock of that type acquired by PRS, $4,000).
(iv) Therefore, A's section 1045 amount realized is $4,000 ($6,000
multiplied by 50/75). Because PRS distributed the QSB stock to A in
liquidation of A's interest in PRS, A's section 1045 adjusted basis is
the product of PRS' basis in all of the QSB stock of the type
distributed, $3,000; A's smallest percentage interest in PRS capital
with respect to QSB stock of the type distributed, 50 percent; and the
percentage of the distributed QSB stock that was sold by A, 100 percent.
Therefore, A's section 1045 adjusted basis is $1,500 (the product of
$3,000, 50 percent, and 100 percent)) and A's nonrecognition limitation
amount on the sale of the QSB stock is $2,500 ($4,000 section 1045
amount realized minus $1,500 section 1045 adjusted basis). Accordingly,
A defers recognition of $2,500 of the remaining $3,000 gain from the
sale of the QSB stock and must recognize $500 of the remaining $3,000
gain. Accordingly, A's total gain recognized from the sale of the QSB
stock is $1,000.
(v) A's basis in the replacement QSB stock is $3,000 (cost of the
replacement QSB stock, $5,500, reduced by the gain not recognized under
section 1045, $2,500).
Example 11. Sale by partner of QSB stock received in a
nonliquidating distribution. (i) The facts are the same as in Example
10, except that, on June 1, 2011, PRS distributes only $2,000 of the QSB
stock to A, reducing A's interest in PRS capital from 60 percent to 33
percent. PRS' basis in the distributed QSB stock is $1,500. On November
1, 2011, A sells for $2,500 the QSB stock distributed by PRS to A and
purchases, within 60 days of the date of sale of the QSB stock,
replacement QSB stock for $2,500. A makes a timely election to apply
section 1045 with respect to A's sale of the distributed QSB stock.
(ii) Under section 732, A's basis in the distributed QSB stock is
$1,500. Therefore, A realizes a gain on the sale of the distributed QSB
stock of $1,000. Because A made an election to apply section 1045 to the
sale, and because A purchased, within 60 days of A's sale of the QSB
stock, replacement QSB stock at a cost equal to the amount realized on
the sale of the distributed QSB stock, A defers recognition of the gain
from the sale of the QSB stock to the extent that such gain does not
exceed the distribution nonrecognition limitation.
(iii) Under paragraph (e)(3) of this section, the nonrecognition
limitation with respect to A's sale of the QSB stock is A's section 1045
amount realized reduced by A's section 1045 adjusted basis. Because PRS
did not distribute all of the particular type of QSB stock and the
distribution of the QSB stock to A was not in liquidation of A's
interest in PRS, under paragraph (e)(3)(ii)(C) of this section A's
section 1045 amount realized is $1,250 (A's amount realized from the
sale of the distributed QSB stock, $2,500, multiplied by A's smallest
percentage interest in PRS capital with respect to such stock, 50
percent). Under paragraph (e)(3)(iii)(B) of this section, A's section
1045 adjusted basis is the product of the partnership's basis in the QSB
stock sold by the partner, $1,500, and A's smallest percentage interest
in the partnership capital with respect to such stock, 50 percent.
Therefore, A's section 1045 adjusted basis is $750 (50 percent of
$1,500), and A's nonrecognition limitation amount on the sale of the QSB
stock is $500 ($1,250 section 1045 amount realized minus $750 section
1045 adjusted basis). As this amount is less than the amount of gain
that A is eligible to defer under section 1045, $1,000, A defers
recognition of only $500 of the gain from the sale of the QSB stock. A
must recognize the remaining $500 of that gain.
(iv) A's basis in the replacement QSB stock is $2,000 (cost of the
replacement QSB stock, $2,500, reduced by the gain not recognized under
section 1045, $500).
Example 12. Contribution of replacement QSB stock to a partnership.
(i) On January 1, 2008, A, an individual, B, an individual, and X, a C
corporation, form PRS, a partnership. A, B, and X each contribute $250
to PRS and agree to share all partnership items equally. On February 1,
2008, PRS purchases QSB stock for $750. PRS sells the QSB stock on
November 3, 2008, for $1,050. PRS realizes $300 of gain from the sale of
the QSB stock (none of which is treated as ordinary income) and
allocates $100 of gain to each of its partners. PRS informs the partners
that it does not intend to make an election under section 1045 with
respect to the sale of the QSB stock. Each partner's share of the amount
realized from the sale of the QSB stock is $350. On November 30, 2008,
A, an eligible partner within the meaning of paragraph (g)(3) of this
section, purchases replacement QSB stock for $350 and makes a section
1045 election under paragraph (c)(1) of this section. Subsequently, A
transfers the replacement QSB stock to ABC, a partnership, in exchange
for an interest in ABC.
[[Page 184]]
(ii) Because A purchased within 60 days of PRS' sale of the QSB
stock, replacement QSB stock for a cost equal to A's share of the
partnership's amount realized on the sale of the QSB stock, and because
A made a valid election to apply section 1045 with respect to A's share
of the gain from PRS' sale of the QSB stock, A does not recognize A's
$100 distributive share of the gain from PRS' sale of the QSB stock.
Before the contribution of the replacement QSB stock to ABC, A's
adjusted basis in the replacement QSB stock is $250 ($350 cost minus
$100 nonrecognition amount). A does not recognize gain upon the
contribution of QSB stock to ABC under section 721(a). Upon the
contribution of the replacement QSB stock to ABC, A's basis in the ABC
partnership interest is $250, and ABC's basis in the replacement QSB
stock is $250. However, the replacement QSB stock does not qualify as
QSB stock in ABC's hands. Neither A nor ABC will be eligible to defer
gain under section 1045 on a subsequent sale of the replacement QSB
stock.
(j) Effective date/applicability--In general. This section applies
to sales of QSB stock on or after August 14, 2007.
[T.D. 9353, 72 FR 45349, Aug. 14, 2007, as amended by T.D. 9353, 72 FR
57487, Oct. 10, 2007]
Special Rules
Sec. 1.1051-1 Basis of property acquired during affiliation.
(a)(1) The basis of property acquired by a corporation during a
period of affiliation from a corporation with which it was affiliated
shall be the same as it would be in the hands of the corporation from
which acquired. This rule is applicable if the basis of the property is
material in determining tax liability for any year, whether a separate
return or a consolidated return is made in respect of such year. For the
purpose of this section, the term period of affiliation means the period
during which such corporations were affiliated (determined in accordance
with the law applicable thereto), but does not include any taxable year
beginning on or after January 1, 1922, unless a consolidated return was
made, nor any taxable year after the taxable year 1928.
(2) The application of subparagraph (1) of this paragraph may be
illustrated by the following example:
Example: The X Corporation, the Y Corporation, and the Z Corporation
were affiliated for the taxable year 1920. During that year the X
Corporation transferred assets to the Y Corporation for $120,000 cash,
and the Y Corporation in turn transferred the assets during the same
year to the Z Corporation for $130,000 cash. The assets were acquired by
the X Corporation in 1916 at a cost of $100,000. The basis of the assets
in the hands of the Z Corporation is $100,000.
(b) The basis of property acquired by a corporation during any
period, in the taxable year 1929 or any subsequent taxable year, in
respect of which a consolidated return was made or was required under
the regulations governing the making of consolidated returns, shall be
determined in accordance with such regulations. The basis in the case of
property held by a corporation during any period, in the taxable year
1929 or any subsequent taxable year, in respect of which a consolidated
return is made or is required under the regulations governing the making
of consolidated returns, shall be adjusted in respect of any items
relating to such period in accordance with such regulations.
(c) Except as otherwise provided in the regulations promulgated
under section 1502 of the Internal Revenue Code of 1954 or the
regulations under section 141 of the Internal Revenue Code of 1939 or
the Revenue Act of 1938 (52 Stat. 447), 1936 (49 Stat. 1652), 1934 (48
Stat. 683), 1932 (47 Stat. 169), or 1928 (45 Stat. 791), the basis of
property after a consolidated return period shall be the same as the
basis immediately prior to the close of such period.
Sec. 1.1052-1 Basis of property established by Revenue Act of 1932.
Section 1052(a) provides that if property was acquired after
February 28, 1913, in any taxable year beginning before January 1, 1934,
and the basis of the property, for the purposes of the Revenue Act of
1932 (47 Stat. 169), was prescribed by section 113(a) (6), (7), or (9)
of that act, then for purposes of subtitle A of the Code, the basis
shall be the same as the basis prescribed in the Revenue Act of 1932.
For the rules applicable in determining the basis of stocks or
securities under section 113(a)(9) of the Revenue Act of 1932 in case of
certain distributions after December 31, 1923, and in any taxable year
beginning before January 1, 1934, see 26 CFR (1939) 39.113 (a)(12)-1
(Regulations 118).
[[Page 185]]
Sec. 1.1052-2 Basis of property established by Revenue Act of 1934.
Section 1052(b) provides that if property was acquired after
February 28, 1913, in any taxable year beginning before January 1, 1936,
and the basis of the property for the purposes of the Revenue Act of
1934 (48 Stat. 683) was prescribed by section 113(a) (6), (7), or (8) of
that act, then for purposes of subtitle A of the Code, the basis shall
be the same as the basis prescribed in the Revenue Act of 1934. For
example, if after December 31, 1920, and in any taxable year beginning
before January 1, 1936, property was acquired by a corporation by the
issuance of its stock or securities in connection with a transaction
which is not described in section 112(b)(5) of the Internal Revenue Code
of 1939 but which is described in section 112(b)(5) of the Revenue Act
of 1934, the basis of the property so acquired shall be the same as it
would be in the hands of the transferor, with proper adjustments to the
date of the exchange.
Sec. 1.1052-3 Basis of property established by the Internal Revenue
Code of 1939.
Section 1052(c) provides that if property was acquired after
February 28, 1913, in a transaction to which the Internal Revenue Code
of 1939 applied and the basis thereof was prescribed by section 113(a)
(6), (7), (8), (13), (15), (18), (19) or (23) of such Code, then for
purposes of subtitle A of the Internal Revenue Code of 1954, the basis
shall be the same as the basis prescribed in the Internal Revenue Code
of 1939. In such cases, see section 113(a) of the Internal Revenue Code
of 1939 and the regulations thereunder.
Sec. 1.1053-1 Property acquired before March 1, 1913.
(a) Basis for determining gain. In the case of property acquired
before March 1, 1913, the basis as of March 1, 1913, for determining
gain is the cost or other basis, adjusted as provided in section 1016
and other applicable provisions of chapter 1 of the Code, or its fair
market value as of March 1, 1913, whichever is greater.
(b) Basis for determining loss. In the case of property acquired
before March 1, 1913, the basis as of March 1, 1913, for determining
loss is the basis determined in accordance with part II (section 1011
and following), subchapter O, chapter 1 of the Code, or other applicable
provisions of chapter 1 of the Code, without reference to the fair
market value as of March 1, 1913.
(c) Example. The application of paragraphs (a) and (b) of this
section may be illustrated by the following example:
Example: (i) On March 1, 1908, a taxpayer purchased for $100,000,
property having a useful life of 50 years. Assuming that there were no
capital improvements to the property, the depreciation sustained on the
property before March 1, 1913, was $10,000 (5 years @ $2,000), so that
the original cost adjusted, as of March 1, 1913, for depreciation
sustained prior to that date is $90,000. On that date the property had a
fair market value of $94,500 with a remaining life of 45 years.
(ii) For the purpose of determining gain from the sale or other
disposition of the property on March 1, 1954, the basis of the property
is the fair market value of $94,500 as of March 1, 1913, adjusted for
depreciation allowed or allowable after February 28, 1913, computed on
$94,500. Thus, the substituted basis, $94,500, is reduced by the
depreciation adjustment from March 1, 1913, to February 28, 1954, in the
aggregate of $86,100 (41 years @ $2,100), leaving an adjusted basis for
determining gain of $8,400 ($94,500 less $86,100).
(iii) For the purpose of determining loss from the sale or other
disposition of such property on March 1, 1954, the basis of the property
is its cost, adjusted for depreciation sustained before March 1, 1913,
computed on cost, and the amount of depreciation allowed or allowable
after February 28, 1913, computed on the fair market value of $94,500 as
of March 1, 1913. In this example, the amount of depreciation sustained
before March 1, 1913, is $10,000 and the amount of depreciation
determined for the period after February 28, 1913, is $86,100.
Therefore, the aggregate amount of depreciation for which the cost
($100,000) should be adjusted is $96,100 ($10,000 plus $86,100), and the
adjusted basis for determining loss on March 1, 1954, is $3,900
($100,000 less $96,100).
(d) Fair market value. The determination of the fair market value of
property on March 1, 1913, is generally a question of fact and shall be
established by competent evidence. In determining the fair market value
of stock or other securities, due regard shall be given to the fair
market value of the corporate assets as of such date, and other
pertinent factors. In the case of property traded in on public
exchanges,
[[Page 186]]
actual sales on or near the basic date afford evidence of value. In
general, the fair market value of a block or aggregate of a particular
kind of property is not to be determined by a forced-sale price, or by
an estimate of what a whole block or aggregate would bring if placed
upon the market at one and the same time. In such a case the value
should be determined by ascertaining as the basis the fair market value
of each unit of the property. All relevant facts and elements of value
as of the basic date should be considered in each case.
Sec. 1.1054-1 Certain stock of Federal National Mortgage Association.
(a) In general. The basis in the hands of the initial holder of a
share of stock which is issued pursuant to section 303(c) of the Federal
National Mortgage Association Charter Act (12 U.S.C., section 1718) in a
taxable year beginning after December 31, 1959, shall be an amount equal
to the issuance price of the stock reduced by the amount, if any,
required by section 162(d) to be treated (with respect to such share) as
an ordinary and necessary business expense. See section 162(d) and Sec.
1.162-19. For purposes of this section the initial holder is the
original purchaser who is issued stock of the Federal National Mortgage
Association (FNMA) pursuant to section 303(c) of the Act and who appears
on the books of FNMA as the initial holder. See Sec. 1.162-19.
(b) Example. The provisions of this section may be illustrated by
the following example:
Example: Pursuant to section 303(c) of the Federal National Mortgage
Association Charter Act a certificate of FNMA stock is issued to A as of
January 1, 1961. The issuance price of the stock was $100 and the fair
market value of the stock on the date of issue was $69. A was required
by section 162(d) to treat $31 as a business expense for the year 1961.
The basis of the share of stock in the hands of A, the initial holder,
shall be $69, the amount paid for the stock ($100) reduced by $31.
[T.D. 6690, 28 FR 12254, Nov. 19, 1963]
Sec. 1.1055-1 General rule with respect to redeemable ground rents.
(a) Character of a redeemable ground rent. For purposes of subtitle
A of the Code (1) a redeemable ground rent (as defined in section
1055(c) and paragraph (b) of this section) shall be treated as being in
the nature of a mortgage, and (2) real property held subject to
liabilities under such a redeemable ground rent shall be treated as held
subject to liabilities under a mortgage. Thus, under section 1055(a) and
this paragraph, the transfer of property subject to a redeemable ground
rent has the same effect as the transfer of property subject to a
mortgage, the acquisition of property subject to a redeemable ground
rent is to be treated the same as the acquisition of property subject to
a mortgage, and the holding of property subject to a redeemable ground
rent is to be treated in the same manner as the holding of property
subject to a mortgage. See section 163(c) for the treatment of any
annual or periodic rental payment under a redeemable ground rent as
interest.
(b) Definition of redeemable ground rent. For purposes of subtitle A
of the Code, the term redeemable ground rent means only a ground rent
with respect to which all the following conditions are met:
(1) There is a lease of land which is assignable by the lessee
without the consent of the lessor.
(2) The term of the lease is for a period in excess of 15 years,
taking into account all periods for which the lease may be renewed at
the option of the lessee.
(3) The lessee has a present or future right to terminate the lease
and to acquire the lessor's interest in the land (i.e., to redeem the
ground rent) by the payment of a determined or determinable amount,
which amount is referred to in Sec. Sec. 1.1055-2, 1.1055-3, and
1.1055-4 as a redemption price. Such right must exist by virtue of State
or local law. If the lessee's right to terminate the lease and to
acquire the lessor's interest is not granted by State or local law but
exists solely by virtue of a private agreement or privately created
condition, the ground rent is not a redeemable ground rent.
(4) The lessor's interest in the land subject to the lease is
primarily a security interest to protect the payment to him of the
annual or periodic rental payments due under the lease.
[[Page 187]]
(c) Effective date. In general, the provisions of section 1055 and
paragraph (a) of this section take effect on April 11, 1963, and apply
with respect to taxable years ending on or after such date. See Sec.
1.1055-3 for rules for determining the basis of real property acquired
subject to liabilities under a redeemable ground rent regardless of when
such property was acquired. See also Sec. 1.1055-4 for rules for
determining the basis of a redeemable ground rent in the hands of a
holder who reserved or created such ground rent in connection with a
transfer, occurring before April 11, 1963, of the right to hold real
property subject to liabilities under such ground rent.
[T.D. 6821, 30 FR 6216, May 4, 1965]
Sec. 1.1055-2 Determination of amount realized on the transfer
of the right to hold real property subject to liabilities under
a redeemable ground rent.
In determining the amount realized from a transfer, occurring on or
after April 11, 1963, of the right to hold real property subject to
liabilities under a redeemable ground rent, such ground rent shall be
accounted for in the same manner as a mortgage for an amount of money
equal to the redemption price of the ground rent. The provisions of this
section apply in respect of any such transfer even though such ground
rent was created prior to April 11, 1963. For provisions relating to the
determination of the amount of and recognition of gain or loss from the
sale or other disposition of property, see section 1001 and the
regulations thereunder.
[T.D. 6821, 30 FR 6217, May 4, 1965]
Sec. 1.1055-3 Basis of real property held subject to liabilities
under a redeemable ground rent.
(a) In general. The provisions of section 1055(a) and paragraph (a)
of Sec. 1.1055-1 are applicable in determining the basis of real
property held on or after April 11, 1963, in any case where the property
at the time of acquisition was subject to liabilities under a redeemable
ground rent. (See section 1055(b)(2).) Thus, if on or after April 11,
1963, a taxpayer holds real property which was subject to liabilities
under a redeemable ground rent at the time he acquired it, the basis of
such property in the hands of such taxpayer, regardless of when the
property was acquired, will include the redeemable ground rent in the
same manner as if it were a mortgage in an amount equal to the
redemption price of such ground rent. Likewise, if on or after April 11,
1963, a taxpayer holds real property which was subject to liabilities
under a redeemable ground rent at the time he acquired it and which has
a substituted basis in his hands, the basis of the property in the hands
of the taxpayer's predecessor in interest is to be determined by
treating the redeemable ground rent in the same manner as a mortgage in
an amount equal to the redemption price of such ground rent.
(b) Illustrations. The provisions of this section may be illustrated
by the following examples:
Example 1. On April 11, 1963, taxpayer A held residential property
which he acquired on January 15, 1963, for a purchase price of $10,000
and which, at the time he acquired it, was subject to a ground rent
redeemable for a redemption price of $1,600. A's basis for the property
includes the purchase price ($10,000) plus the redeemable ground rent in
the same manner as if it were a mortgage for $1,600.
Example 2. In 1962, taxpayer X, a corporation, acquired real
property subject to a redeemable ground rent in a transfer to which
section 351 (relating to transfer of property to corporation controlled
by transferor) applied and in which the basis of the property to X was
the transferor's basis. X still held the property on April 11, 1963. The
transferor's basis in the property is to be determined by treating the
redeemable ground rent to which it was subject in the transferor's hands
as if it were a mortgage.
[T.D. 6821, 30 FR 6217, May 4, 1965]
Sec. 1.1055-4 Basis of redeemable ground rent reserved or created
in connection with transfers of real property before April 11, 1963.
(a) In general. In the case of a redeemable ground rent created or
reserved in connection with a transfer, occurring before April 11, 1963,
of the right to hold real property subject to liabilities under such
ground rent, the basis of such ground rent on or after April 11, 1963,
in the hands of the person who reserved or created the ground rent is
the amount which was taken into account in respect of such ground rent
in computing the amount realized
[[Page 188]]
from the transfer of such real property. Thus, if no such amount was
taken into account, such basis shall be determined without regard to
section 1055. (See section 1055(b)(3).)
(b) The provisions of this section may be illustrated by the
following examples:
Example 1. The taxpayer, who was in the business of building houses,
purchased an undeveloped lot of land for $500 and built a house thereon
at a cost of $10,000. Subsequently, he transferred the right to hold the
lot improved by the house for a consideration of $12,000, and an annual
ground rent for such property of $120 which was redeemable for a
redemption price of $2,000. The taxpayer reported a $2,000 gain on the
transfer, treating the amount realized as $12,000 and his cost allocable
to the interest transferred as $10,000. Since the builder did not take
the redeemable ground rent into account in computing gain on the
transfer, his basis for such ground rent is $500 (the cost of the land
not offset against the consideration received for the transfer). Thus,
if he subsequently sells the redeemable ground rent (or if it is
redeemed from him) for $2,000, he has no gain of $1,500 in the year of
sale (or redemption).
Example 2. Assume the same facts as in Example 1 except that the
builder reported a gain of $3,500 on the transfer, treating the amount
realized as $14,000 ($12,000 cash plus $2,000 for the redeemable ground
rent) and his costs as $10,500 ($10,000 for the house and $500 for the
lot). Since the taxpayer took the entire amount of the redeemable ground
rent into account in computing his gain, his basis for such ground rent
is $2,000. Thus, if he subsequently sells the redeemable ground rent (or
if it is redeemed from him) for $2,000, he has no gain or loss on the
transaction.
Example 3. Assume the same facts as in Example 1 except that the
builder reported a gain of $3,000 on the transfer. He computed this gain
by treating the amount realized as $12,000 but treating his cost
allocable to the interest transferred as $12,000/$14,000ths of his total
$10,500 cost, or $9,000. Since the builder still has remaining $1,500 of
unallocated cost, his basis for the redeemable ground rent is $1,500.
Thus, if he subsequently sells the redeemable ground rent (or if it is
redeemed from him) for $2,000, he has a gain of $500 in the year of sale
(or redemption).
[T.D. 6821, 30 FR 6217, May 4, 1965]
Sec. 1.1059(e)-1 Non-pro rata redemptions.
(a) In general. Section 1059(d)(6) (exception where stock held
during entire existence of corporation) and section 1059(e)(2)
(qualifying dividends) do not apply to any distribution treated as an
extraordinary dividend under section 1059(e)(1). For example, if a
redemption of stock is not pro rata as to all shareholders, any amount
treated as a dividend under section 301 is treated as an extraordinary
dividend regardless of whether the dividend is a qualifying dividend.
(b) Reorganizations. For purposes of section 1059(e)(1), any
exchange under section 356 is treated as a redemption and, to the extent
any amount is treated as a dividend under section 356(a)(2), it is
treated as a dividend under section 301.
(c) Effective date. This section applies to distributions announced
(within the meaning of section 1059(d)(5)) on or after June 17, 1996.
[T.D. 8724, 62 FR 38028, July 16, 1997]
Sec. 1.1059A-1 Limitation on taxpayer's basis or inventory cost
in property imported from related persons.
(a) General rule. In the case of property imported into the United
States in a transaction (directly or indirectly) by a controlled
taxpayer from another member of a controlled group of taxpayers, except
for the adjustments permitted by paragraph (c) (2) of this section, the
amount of any costs taken into account in computing the basis or
inventory cost of the property by the purchasing U.S. taxpayer and which
costs are also taken into account in computing the valuation of the
property for customs purposes may not, for purposes of the basis or
inventory cost, be greater than the amount of the costs used in
computing the customs value. For purposes of this section, the terms
controlled taxpayer and group of controlled taxpayers shall have the
meaning set forth in Sec. 1.482-1(a).
(b) Definitions--(1) Import. For purposes of section 1059A and this
section only, the term import means the filing of the entry
documentation required by the U.S. Customs Service to secure the release
of imported merchandise from custody of the U.S. Customs Service.
(2) Indirectly. For purposes of this section, indirectly refers to a
transaction between a controlled taxpayer and another member of the
controlled group whereby property is imported through a person acting as
an agent of,
[[Page 189]]
or otherwise on behalf of, either or both related persons, or as a
middleman or conduit for transfer of the property between a controlled
taxpayer and another member of the controlled group. In the case of the
importation of property indirectly, an adjustment shall be permitted
under paragraph (c)(2) of this section for a commission or markup paid
to the person acting as agent, middleman, or conduit, only to the extent
that the commission or markup: is otherwise properly included in cost
basis or inventory cost; was actually incurred by the taxpayer and not
remitted, directly or indirectly, to the taxpayer or related party; and
there is a substantial business reason for the use of a middleman,
agent, or conduit.
(c) Customs value--(1) Definition. For purposes of this section
only, the term customs value means the value required to be taken into
account for purposes of determining the amount of any customs duties or
any other duties which may be imposed on the importation of any
property. Where an item or a portion of an item is not subject to any
customs duty or is subject to a free rate of duty, such item or portion
of such item shall not be subject to the provisions of section 1059A or
this section. Thus, for example, the portion of an item that is an
American good returned and not subject to duty (items 806.20 and 806.30,
Tariff Schedules of the United States, 19 U.S.C. 1202); imports on which
no duty is imposed that are valued by customs for statistical purposes
only; and items subject to a zero rate of duty (19 U.S.C. 1202, General
Headnote 3) are not subject to section 1059A or this section. Also,
items subject only to the user fee under 19 U.S.C. 58(c), or the harbor
maintenance tax imposed by 26 U.S.C. 4461, or only to both, are not
subject to section 1059A or this section. This section imposes no
limitation on a claimed basis or inventory cost in property which is
less than the value used to compute the customs duty with respect to the
same property. Section 1059A and this section have no application to
imported property not subject to any customs duty based on value,
including property subject only to a per item duty or a duty based on
volume, because there is no customs value, within the meaning of this
paragraph, with respect to such property.
(2) Adjustments to customs value. To the extent not otherwise
included in customs value, a taxpayer, for purposes of determining the
limitation on claimed basis or inventory cost of property under this
section, may increase the customs value of imported property by the
amounts incurred by it and properly included in inventory cost for--
(i) Freight charges,
(ii) Insurance charges,
(iii) The construction, erection, assembly, or technical assistance
provided with respect to, the property after its importation into the
United States, and
(iv) Any other amounts which are not taken into account in
determining the customs value, which are not properly includible in
customs value, and which are appropriately included in the cost basis or
inventory cost for income tax purposes. See Sec. 1.471-11 and section
263A.
Appropriate adjustments may also be made to customs values when the
taxpayer has not allocated the value of assists to individual articles
but rather has reported the value of assists on a periodic basis in
accordance with 19 CFR 152.103(e). When 19 CFR 152.103(e) has been
utilized for customs purposes, the taxpayer may adjust his customs
values by allocating the value of the assists to all imported articles
to which the assists relate. To the extent that an amount attributable
to an adjustment permitted by this section is paid by a controlled
taxpayer to another member of the group of controlled taxpayers, an
adjustment is permitted under this section only to the extent that the
amount incurred represents an arm's length charge within the meaning of
Sec. 1.482-1(d)(3).
(3) Offsets to adjustments. To the extent that a customs value is
adjusted under paragraph (c)(2) of this section for purposes of
calculating the limitation on claimed cost basis or inventory cost under
this section, the amount of the adjustments must be offset (reduced) by
amounts that properly reduce the cost basis of inventory and
[[Page 190]]
that are not taken into account in determining customs value, such as
rebates and other reductions in the price actually incurred, effected
between the purchaser and related seller after the date of importation
of the property.
(4) Application of section 1059A to property having dutiable and
nondutiable portions. When an item of imported property is subiect to a
duty upon the full value of the imported article, less the cost or value
of American goods returned, and the taxpayer claims a basis or inventory
cost greater than the customs value reported for the item, the claimed
tax basis or inventory cost in the dutiable portion of the item is
limited under section 1059A and this section to the customs value of the
dutiable portion under paragraph (c)(1). The claimed tax basis or
inventory cost in the nondutiable portion of the item is determined by
multiplying the customs value of the nondutiable portion by a fraction
the numerator of which is the amount by which the claimed basis or
inventory cost of the item exceeds the customs value of the item and the
denominator of which is the customs value of the item and adding this
amount to the customs value of the nondutiable portion of the item. The
claimed tax basis or inventory cost in the dutiable portion is
determined by multiplying the customs value of the dutiable portion by a
fraction the numerator of which is the amount by which the claimed basis
or inventory cost of the item exceeds the customs value of the item and
the denominator of which is the customs value of the item and adding
this amount to the customs value of the dutiable portion of the item.
However, the taxpayer may not claim a tax basis or inventory cost in the
dutiable portion greater than the customs value of this portion of the
item.
(5) Allocation of adjustments to property having dutiable and
nondutiable portions. When an item of imported property is subject to a
duty upon the full value of the imported article, less the cost or value
of American goods returned, and the taxpayer establishes that the
customs value may be increased by adjustments permitted under paragraph
(c)(2) of this section for purposes of the section 1059A limitation, the
taxpayer's basis or inventory cost of the dutiable portion of the item
is determined by multiplying the customs value of the dutiable portion
times the percentage that the adjustments represent of the total customs
value of the item and adding this amount to the customs value of the
dutiable portion of the item. The taxpayer's basis or inventory cost of
the nondutiable portion of the item is determined in the same manner.
The amount so determined for the dutiable portion of the item is the
section 1059A limitation for this portion of the item.
(6) Alternative method of demonstrating compliance. In lieu of
calculating all adjustments and offsets to adjustments to customs value
for an item of property pursuant to paragraph (c) (2) and (3) of this
section, a taxpayer may demonstrate compliance with this section and
section 1059A by comparing costs taken into account in computing basis
or inventory costs of the property and the costs taken into account in
computing customs value at any time after importation, provided that in
any such comparison the same costs are included both in basis or
inventory costs and in customs value. If, on the basis of such
comparison, the basis or inventory cost is equal to or less than the
customs value, the taxpayer shall be deemed to have met the requirements
of this section and section 1059A.
(7) Relationship of section 1059A to section 482. Neither this
section nor section 1059A limits in any way the authority of the
Commissioner to increase or decrease the claimed basis or inventory cost
under section 482 or any other appropriate provision of law. Neither
does this section or section 1059A permit a taxpayer to adjust upward
its cost basis or inventory cost for property appropriately determined
under section 482 because such basis or inventory cost is less than the
customs value with respect to such property.
(8) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. Corporation X, a United States taxpayer, and Y
Corporation are members of a group of controlled corporations. X pays
$2,000 to Y for merchandise imported into the United States and an
additional $150 for ocean freight and insurance. The customs
[[Page 191]]
value of the shipment is determined to be the amount actually paid by X
($2,000) and does not include the charges for ocean freight and
insurance. For purposes of computing the limitation on its inventory
cost for the merchandise under section 1059A and this section, X is
permitted, under paragraph (c)(2) of this section, to increase the
customs value ($2,000) by amounts it paid for ocean freight and
insurance charges ($150). Thus, the inventory cost claimed by X in the
merchandise may not exceed $2,150.
Example 2. Assume the same facts as in Example 1 except that,
subsequent to the date of importation of the merchandise, Y grants to X
a rebate of $200 of the purchase price. At the time of sale, the rebate
was contingent upon the volume of merchandise ultimately bought by X
from Y. The value of the merchandise, for customs purposes, is not
decreased by the rebate paid to X by Y. Therefore, the customs value,
for customs purposes, of the merchandise remains the same ($2,000). For
purposes of computing its inventory cost, X was permitted, under
paragraph (c)(2) of this section, to increase the customs value for
purposes of section 1059A of $2,000 by the amounts it paid for ocean
freight and insurance charges ($150). However, under paragraph (c)(3) of
this section, X is required to reduce the amount of the customs value by
the lesser of the amount of the rebate or the amount of any positive
adjustments to the original customs value. The inventory price claimed
by X may not exceed $2,000 ($2,000 customs value, plus $150
transportation adjustment, less $150 offsetting rebate adjustment).
While X's limitation under section 1059A is $2,000, X may not claim a
basis or inventory cost in the merchandise in excess of $1,950. See
I.R.C. section 1012; and section 1.471-2.
Example 3. Corporation X, a United States taxpayer, and Y
Corporation are members of a group of controlled corporations. X pays
$10,000 to Y for merchandise imported into the United States. The
merchandise is composed, in part, of American goods returned. The
customs value of the merchandise, on which a customs duty is imposed, is
determined to be $8,000 ($10,000, the amount declared by X, less $2,000,
the value of the American goods returned). For income tax purposes, X
claims a cost basis in the merchandise of $11,000. None of the
adjustments permitted by paragraph (c)(2) of this section is applicable.
The portion of the merchandise constituting American goods returned
represented 20 percent of the total customs value of the merchandise.
Since the cost basis claimed by X for income tax purposes represents a
10 percent increase over the customs valuation (before reduction for
American goods returned), the claimed tax basis in the dutiable content
is considered to be $8,800 and in the portion constituting American
goods returned is $2,200. Since a customs duty was imposed only on the
dutiable content of the merchandise, the limitation in section 1059A and
this section is applicable only to the claimed tax basis in this portion
of the merchandise. Accordingly, under paragraph (a) of this section, X
is limited to a cost basis of $10,200 in the merchandise. This amount
represents a cost basis of $8,000 in the dutiable content and of $2,200
in the portion of the merchandise constituting American goods returned.
Example 4. Assume the same facts as in Example 3 except that X
establishes that it is entitled to increase its customs value by $1,000
in adjustments permitted by paragraph (c)(2) of this section. Since the
adjustments to customs value that X is entitled to under paragraph
(c)(2) of this section are 10 percent of the customs value, for purposes
of determining the limitation under section 1059A and this section, both
the dutiable content and the portion of the merchandise constituting
American goods returned shall be increased to an amount 10 percent
greater than the respective values determined for customs purposes, or
$8,800 for the dutiable content and $2,200 for the portion of the
merchandise constituting American goods returned. Accordingly, under
paragraph (a) of this section, X is limited to a cost basis of $11,000
in the merchandise.
Example 5. Corporation X, a United States taxpayer, and Y
Corporation are members of a group of controlled corporations. X pays
$10,000 to Y for merchandise imported into the United States. The
customs value of the merchandise, on which a customs duty is imposed, is
determined to be $10,000. Subsequent to the date of importation of the
merchandise, Y grants to X a rebate of $1,000 of the purchase price. The
value of the merchandise, for customs purposes, is not decreased by the
rebate paid to X by Y. Notwithstanding the fact that X correctly
reported and paid customs duty on a value of $10,000 and that its
limitation on basis or inventory cost under this section is $10,000, X
may not claim a basis or inventory cost in the merchandise in excess of
$9,000. See I.R.C. section 1012; and section 1.471-2.
Example 6. Corporation X, a United States taxpayer, and Y
Corporation are members of a group of controlled corporations. X pays
$5,000 to Y for merchandise imported into the United States. The
merchandise is not subject to a customs duty or is subject to a free
rate of duty and is valued by customs solely for statistical purposes.
Accordingly, pursuant to paragraph (c)(1) of this section, the
merchandise is not subject to the provisions of section 1059A or this
section.
Example 7. Assume the same facts as in Example 6, except that the
merchandise is subject to a customs duty based on value and that the
customs value (taking into account no costs other than the value of the
goods) is determined to be $5,000. Assume further that
[[Page 192]]
the $5,000 payment is only for the value of the goods, no other cost is
reflected in that payment, and only the $5,000 payment to Y is reflected
in X's inventory cost or basis prior to inclusion of any other amounts
properly included in inventory or cost basis. Pursuant to paragraph
(c)(6) of this section, X, by demonstrating these facts is deemed to
meet the requirements of this section and section 1059A.
Example 8. Corporation X, a United States taxpayer, and Y
Corporation are members of a group of controlled corporations. X pays $9
to Y for merchandise imported into the United States and an additional
$1 for ocean freight. The customs value of the article does not include
the $l paid for ocean freight. Furthermore, for customs purposes the
value is calculated pursuant to computed value and is determined to be
$8. For purposes of computing the limitation on its inventory cost for
the article under section 1059A and this section, X is permitted, under
paragraph (c)(2) of this section, to increase the customs value ($8) by
the amount it paid for ocean freight ($1). Thus, the inventory cost
claimed by X in the article may not exceed $9.
(9) Averaged customs values. In cases of transactions in which (i)
an appropriate transfer price is properly determined for tax purposes by
reference to events occurring after importation, (ii) the value for
customs purposes of one article is higher and of a second article is
lower than the actual transaction values, (iii) the relevant articles
have been appraised on the basis of a value estimated at the time of
importation in accordance with customs regulations, and (iv) the entries
have been liquidated upon importation, the section 1059A limitation on
the undervalued article may be increased up to the amount of actual
transaction value by the amount of the duty overpaid on the overvalued
article times a fraction the numerator of which is ``1'' and the
denominator of which is the rate of duty on the undervalued article.
This paragraph (c)(9) applies exclusively to cases of property imported
in transactions that are open for tax purposes in which the actual
transaction value cannot be determined and the entry has been liquidated
for customs purposes on the basis of a value estimated at the time of
importation in accordance with customs regulations; in these cases, the
property is appropriately valued for tax purposes by reference to a
formula, in existence at the time of importation, based on subsequent
events and valued for customs purposes by a different formula. This
paragraph (c)(9) does not apply where customs value is correctly
determined for purposes of liquidating the entry and where the customs
value is subsequently adjusted for tax purposes, for example by a
rebate, under paragraph (c)(2) of this section. The application of
paragraph (c)(9) may be illustrated by the following example:
Example: Corporation X, a United States taxpayer, and Y Corporation
are members of a group of controlled corporations. X purchases Articles
A and B from Y on consignment and imports the Articles into the United
States. The purchase price paid by X will be determined as a percentage
of the sale prices that X realizes. Rather than deferring liquidation,
customs liquidates the entry on the basis of estimated values and the
customs duties are paid by X. Ultimately, it is determined that Article
A was undervalued and Article B was overvalued by X for customs
purposes. The section 1059A limitation for Article A is computed as
follows:
------------------------------------------------------------------------
Article A Article B
------------------------------------------------------------------------
Finally-determined customs value................ $9 $9
Transaction value............................... $10 $5
Duty rate....................................... 10% 5%
Customs duty paid............................... $.90 $.45
Duty overpaid or (underpaid).................... ($.10) $.20
------------------------------------------------------------------------
The section 1059A limitation on Article A may be increased by the
amount of the duty over-paid on Article B, $.20, times 1/.10, up to the
amount of the transaction value. Therefore, the section 1059A limitation
on Article A is $9.00 plus $1.00, or a total of $10.00. The section
1059A limitation on Article B is reduced (but never below transaction
value) by $2.00 to $7.00.
(d) Finality of customs value and of other determinations of the
U.S. Customs Service. For purposes of section 1059A and this section, a
taxpayer is bound by the finally-determined customs value and by every
final determination made by the U.S. Customs Service, including, but not
limited to, dutiable value, the value attributable to the cost or value
of products of the United States, and classification of the product for
purposes of imposing any duty. The customs value is considered to be
finally determined, and all U.S. Customs Service determinations are
considered final, when liquidation of the entry becomes final. For this
purpose,
[[Page 193]]
the term liquidation means the ascertainment of the customs duties
occurring on the entry of the property, and liquidation of the entry is
considered to become final after 90 days following notice of liquidation
to the importer, unless a protest is filed. If the importer files a
protest, the customs value will be considered finally determined and all
other U.S. Customs Service determinations will be considered final
either when a decision by the Customs Service on the protest is not
contested after expiration of the period allowed to contest the decision
or when a judgment of the Court of International Trade becomes final.
For purposes of this section, any adjustments to the customs value
resulting from a petition under 19 U.S.C. section 1516 (requests by
interested parties unrelated to the importer for redetermination of the
appraised value, classification, or the rate of duty imposed on imported
merchandise) or reliquidation under 19 U.S.C. section 1521
(reliquidation by the Customs Service upon a finding that fraud was
involved in the original liquidation) will not be taken into account.
However, reliquidation under 19 U.S.C. section 1501 (voluntary
reliquidation by the Customs Service within 90 days of the original
liquidation to correct errors in appraisement, classification, or any
element entering into a liquidation or reliquidation) or reliquidation
under 19 U.S.C. section 1520(c)(1) (to correct a clerical error, mistake
of fact, or other inadvertance within one year of a liquidation or
reliquidation) will be taken into account in the same manner as, and
take the place of, the original liquidation in determining customs
value.
(e) Drawbacks. For purposes of this section, a drawback, that is, a
refund or remission (in whole or in part) of a customs duty because of a
particular use made (or to be made) of the property on which the duty
was assessed or collected, shall not affect the determination of the
customs value of the property.
(f) Effective date. Property imported by a taxpayer is subject to
section 1059A and this section if the entry documentation required to be
filed to obtain the release of the property from the custody of the
United States Customs Service was filed after March 18, 1986. Section
1059A and this section will not apply to imported property where (1) the
entry documentation is filed prior to September 3, 1987; and (2) the
importation was liquidated under the circumstances described in
paragraph (c)(9) of this section.
[T.D. 8260, 54 FR 37311, Sept. 8, 1989]
Sec. 1.1060-1 Special allocation rules for certain asset
acquisitions.
(a) Scope--(1) In general. This section prescribes rules relating to
the requirements of section 1060, which, in the case of an applicable
asset acquisition, requires the transferor (the seller) and the
transferee (the purchaser) each to allocate the consideration paid or
received in the transaction among the assets transferred in the same
manner as amounts are allocated under section 338(b)(5) (relating to the
allocation of adjusted grossed-up basis among the assets of the target
corporation when a section 338 election is made). In the case of an
applicable asset acquisition described in paragraph (b)(1) of this
section, sellers and purchasers must allocate the consideration under
the residual method as described in Sec. Sec. 1.338-6 and 1.338-7 in
order to determine, respectively, the amount realized from, and the
basis in, each of the transferred assets. For rules relating to
distributions of partnership property or transfers of partnership
interests which are subject to section 1060(d), see Sec. 1.755-2T.
(2) Effective dates--(i) In general. The provisions of this section
apply to any asset acquisition occurring after March 15, 2001. However,
paragraphs (b)(9) and (c)(5) of this section apply only to applicable
asset acquisitions occurring on or after April 10, 2006. A purchaser or
a seller may make an irrevocable election to apply the rules in
Sec. Sec. 1.338-11 (including the applicable provisions in Sec. Sec.
1.197-2(g)(5), 1.381(c)(22)-1, 846 and 1060) to an applicable asset
acquisition occurring before April 10, 2006. Paragraph (a)(2)(ii) of
this section describes the time and manner of the election for the
purchaser and paragraph (a)(2)(iii) of this section prescribes the time
and manner of the election for the seller. The seller may make the
election to apply the regulations retroactively
[[Page 194]]
without regard to whether the purchaser also makes the election. For
rules applicable to asset acquisitions on or before March 15, 2001, see
Sec. 1.1060-1T in effect before March 16, 2001 (see 26 CFR part 1
revised April 1, 2000).
(ii) Time and manner of making the election for the purchaser. The
purchaser may make an election described in this paragraph (a)(2) by
attaching a statement to its original or amended income tax return for
the taxable year that includes the applicable asset sale. The statement
must be entitled ``Election to Retroactively Apply the Rules in Sec.
1.338-11 (Including the Applicable Provisions in Sec. Sec. 1.197-
2(g)(5), 1.381(c)(22)-1, 846 and 1060) to an Applicable Asset
Acquisition Completed Before April 10, 2006'' and must include the
following information--
(A) The name and E.I.N. for the purchaser; and
(B) The following declaration (or a substantially similar
declaration): The purchaser has amended its income tax returns for the
taxable year that includes the applicable asset acquisition and for all
affected subsequent years to reflect the rules in Sec. 1.338-11
(Including the Applicable Provisions in Sec. Sec. 1.197-2(g)(5),
1.381(c)(22)-1,846 and 1060).
(iii) Time and manner of making the election for the seller. The
seller may make an election described in this paragraph (a)(2) by
attaching a statement to its original or amended income tax return for
the taxable year that includes the applicable asset sale. The statement
must be entitled ``Election to retroactively apply the rules in Sec.
1.338-11 (including the applicable provisions in Sec. Sec. 1.197-
2(g)(5), 1.381(c)(22)-1, 846 and 1060) to an applicable asset
acquisition completed before April 10, 2006'' and must include the
following information--
(A) The name and E.I.N. for the seller; and
(B) The following declaration (or a substantially similar
declaration): The seller has amended its income tax returns for the
taxable year that includes the applicable asset acquisition and for all
affected subsequent years to reflect the rules in Sec. 1.338-11
(including the applicable provisions in Sec. Sec. 1.197-2(g)(5),
1.381(c)(22)-1, 846 and 1060).
(3) Outline of topics. In order to facilitate the use of this
section, this paragraph (a)(3) lists the major paragraphs in this
section as follows:
(a) Scope.
(1) In general.
(2) Effective date.
(3) Outline of topics.
(b) Applicable asset acquisition.
(1) In general.
(2) Assets constituting a trade or business.
(i) In general.
(ii) Goodwill or going concern value.
(iii) Factors indicating goodwill or going concern value.
(3) Examples.
(4) Asymmetrical transfers of assets.
(5) Related transactions.
(6) More than a single trade or business.
(7) Covenant entered into by the seller.
(8) Partial non-recognition exchanges.
(9) Insurance business.
(c) Allocation of consideration among assets under the residual method.
(1) Consideration.
(2) Allocation of consideration among assets.
(3) Certain costs.
(4) Effect of agreement between parties.
(5) Insurance business.
(d) Examples.
(e) Reporting requirements.
(1) Applicable asset acquisitions.
(i) In general.
(ii) Time and manner of reporting.
(A) In general.
(B) Additional reporting requirement.
(C) Election described in Sec. 1.338-6(c)(5).
(2) Transfers of interests in partnerships.
(b) Applicable asset acquisition--(1) In general. An applicable
asset acquisition is any transfer, whether direct or indirect, of a
group of assets if the assets transferred constitute a trade or business
in the hands of either the seller or the purchaser and, except as
provided in paragraph (b)(8) of this section, the purchaser's basis in
the transferred assets is determined wholly by reference to the
purchaser's consideration.
(2) Assets constituting a trade or business--(i) In general. For
purposes of this section, a group of assets constitutes a trade or
business if--
(A) The use of such assets would constitute an active trade or
business under section 355; or
(B) Its character is such that goodwill or going concern value could
under any circumstances attach to such group.
[[Page 195]]
(ii) Goodwill or going concern value. Goodwill is the value of a
trade or business attributable to the expectancy of continued customer
patronage. This expectancy may be due to the name or reputation of a
trade or business or any other factor. Going concern value is the
additional value that attaches to property because of its existence as
an integral part of an ongoing business activity. Going concern value
includes the value attributable to the ability of a trade or business
(or a part of a trade or business) to continue functioning or generating
income without interruption notwithstanding a change in ownership. It
also includes the value that is attributable to the immediate use or
availability of an acquired trade or business, such as, for example, the
use of the revenues or net earnings that otherwise would not be received
during any period if the acquired trade or business were not available
or operational.
(iii) Factors indicating goodwill or going concern value. In making
the determination in this paragraph (b)(2), all the facts and
circumstances surrounding the transaction are taken into account.
Whether sufficient consideration is available to allocate to goodwill or
going concern value after the residual method is applied is not relevant
in determining whether goodwill or going concern value could attach to a
group of assets. Factors to be considered include--
(A) The presence of any intangible assets (whether or not those
assets are section 197 intangibles), provided, however, that the
transfer of such an asset in the absence of other assets will not be a
trade or business for purposes of section 1060;
(B) The existence of an excess of the total consideration over the
aggregate book value of the tangible and intangible assets purchased
(other than goodwill and going concern value) as shown in the financial
accounting books and records of the purchaser; and
(C) Related transactions, including lease agreements, licenses, or
other similar agreements between the purchaser and seller (or managers,
directors, owners, or employees of the seller) in connection with the
transfer.
(3) Examples. The following examples illustrate paragraphs (b)(1)
and (2) of this section:
Example 1. S is a high grade machine shop that manufactures
microwave connectors in limited quantities. It is a successful company
with a reputation within the industry and among its customers for
manufacturing unique, high quality products. Its tangible assets consist
primarily of ordinary machinery for working metal and plating. It has no
secret formulas or patented drawings of value. P is a company that
designs, manufactures, and markets electronic components. It wants to
establish an immediate presence in the microwave industry, an area in
which it previously has not been engaged. P is acquiring assets of a
number of smaller companies and hopes that these assets will
collectively allow it to offer a broad product mix. P acquires the
assets of S in order to augment its product mix and to promote its
presence in the microwave industry. P will not use the assets acquired
from S to manufacture microwave connectors. The assets transferred are
assets that constitute a trade or business in the hands of the seller.
Thus, P's purchase of S's assets is an applicable asset acquisition. The
fact that P will not use the assets acquired from S to continue the
business of S does not affect this conclusion.
Example 2. S, a sole proprietor who operates a car wash, both leases
the building housing the car wash and sells all of the car wash
equipment to P. S's use of the building and the car wash equipment
constitute a trade or business. P begins operating a car wash in the
building it leases from S. Because the assets transferred together with
the asset leased are assets which constitute a trade or business, P's
purchase of S's assets is an applicable asset acquisition.
Example 3. S, a corporation, owns a retail store business in State X
and conducts activities in connection with that business enterprise that
meet the active trade or business requirement of section 355. P is a
minority shareholder of S. S distributes to P all the assets of S used
in S's retail business in State X in complete redemption of P's stock in
S held by P. The distribution of S's assets in redemption of P's stock
is treated as a sale or exchange under sections 302(a) and 302(b)(3),
and P's basis in the assets distributed to it is determined wholly by
reference to the consideration paid, the S stock. Thus, S's distribution
of assets constituting a trade or business to P is an applicable asset
acquisition.
Example 4. S is a manufacturing company with an internal financial
bookkeeping department. P is in the business of providing a financial
bookkeeping service on a contract basis. As part of an agreement for P
to begin providing financial bookkeeping services to
[[Page 196]]
S, P agrees to buy all of the assets associated with S's internal
bookkeeping operations and provide employment to any of S's bookkeeping
department employees who choose to accept a position with P. In addition
to selling P the assets associated with its bookkeeping operation, S
will enter into a long term contract with P for bookkeeping services.
Because assets transferred from S to P, along with the related contract
for bookkeeping services, are a trade or business in the hands of P, the
sale of the bookkeeping assets from S to P is an applicable asset
acquisition.
(4) Asymmetrical transfers of assets. A purchaser is subject to
section 1060 if--
(i) Under general principles of tax law, the seller is not treated
as transferring the same assets as the purchaser is treated as
acquiring;
(ii) The assets acquired by the purchaser constitute a trade or
business; and
(iii) Except as provided in paragraph (b)(8) of this section, the
purchaser's basis in the transferred assets is determined wholly by
reference to the purchaser's consideration.
(5) Related transactions. Whether the assets transferred constitute
a trade or business is determined by aggregating all transfers from the
seller to the purchaser in a series of related transactions. Except as
provided in paragraph (b)(8) of this section, all assets transferred
from the seller to the purchaser in a series of related transactions are
included in the group of assets among which the consideration paid or
received in such series is allocated under the residual method. The
principles of Sec. 1.338-1(c) are also applied in determining which
assets are included in the group of assets among which the consideration
paid or received is allocated under the residual method.
(6) More than a single trade or business. If the assets transferred
from a seller to a purchaser include more than one trade or business,
then, in applying this section, all of the assets transferred (whether
or not transferred in one transaction or a series of related
transactions and whether or not part of a trade or business) are treated
as a single trade or business.
(7) Covenant entered into by the seller. If, in connection with an
applicable asset acquisition, the seller enters into a covenant (e.g., a
covenant not to compete) with the purchaser, that covenant is treated as
an asset transferred as part of a trade or business.
(8) Partial non-recognition exchanges. A transfer may constitute an
applicable asset acquisition notwithstanding the fact that no gain or
loss is recognized with respect to a portion of the group of assets
transferred. All of the assets transferred, including the non-
recognition assets, are taken into account in determining whether the
group of assets constitutes a trade or business. The allocation of
consideration under paragraph (c) of this section is done without taking
into account either the non-recognition assets or the amount of money or
other property that is treated as transferred in exchange for the non-
recognition assets (together, the non-recognition exchange property).
The basis in and gain or loss recognized with respect to the non-
recognition exchange property are determined under such rules as would
otherwise apply to an exchange of such property. The amount of the money
and other property treated as exchanged for non-recognition assets is
the amount by which the fair market value of the non-recognition assets
transferred by one party exceeds the fair market value of the non-
recognition assets transferred by the other (to the extent of the money
and the fair market value of property transferred in the exchange). The
money and other property that are treated as transferred in exchange for
the non-recognition assets (and which are not included among the assets
to which section 1060 applies) are considered to come from the following
assets in the following order: first from Class I assets, then from
Class II assets, then from Class III assets, then from Class IV assets,
then from Class V assets, then from Class VI assets, and then from Class
VII assets. For this purpose, liabilities assumed (or to which a non-
recognition exchange property is subject) are treated as Class I assets.
See Example 1 in paragraph (d) of this section for an example of the
application of section 1060 to a single transaction which is, in part, a
non-recognition exchange.
(9) Insurance business. The mere reinsurance of insurance contracts
by an
[[Page 197]]
insurance company is not an applicable asset acquisition, even if it
enables the reinsurer to establish a customer relationship with the
owners of the reinsured contracts. However, a transfer of an insurance
business is an applicable asset acquisition if the purchaser acquires
significant business assets, in addition to insurance contracts, to
which goodwill and going concern value could attach. For rules regarding
the treatment of an applicable asset acquisition of an insurance
business, see paragraph (c)(5) of this section.
(c) Allocation of consideration among assets under the residual
method--(1) Consideration. The seller's consideration is the amount, in
the aggregate, realized from selling the assets in the applicable asset
acquisition under section 1001(b). The purchaser's consideration is the
amount, in the aggregate, of its cost of purchasing the assets in the
applicable asset acquisition that is properly taken into account in
basis.
(2) Allocation of consideration among assets. For purposes of
determining the seller's amount realized for each of the assets sold in
an applicable asset acquisition, the seller allocates consideration to
all the assets sold by using the residual method under Sec. Sec. 1.338-
6 and 1.338-7, substituting consideration for ADSP. For purposes of
determining the purchaser's basis in each of the assets purchased in an
applicable asset acquisition, the purchaser allocates consideration to
all the assets purchased by using the residual method under Sec. Sec.
1.338-6 and 1.338-7, substituting consideration for AGUB. In allocating
consideration, the rules set forth in paragraphs (c)(3) and (4) of this
section apply in addition to the rules in Sec. Sec. 1.338-6 and 1.338-
7.
(3) Certain costs. The seller and purchaser each adjusts the amount
allocated to an individual asset to take into account the specific
identifiable costs incurred in transferring that asset in connection
with the applicable asset acquisition (e.g., real estate transfer costs
or security interest perfection costs). Costs so allocated increase, or
decrease, as appropriate, the total consideration that is allocated
under the residual method. No adjustment is made to the amount allocated
to an individual asset for general costs associated with the applicable
asset acquisition as a whole or with groups of assets included therein
(e.g., non-specific appraisal fees or accounting fees). These latter
amounts are taken into account only indirectly through their effect on
the total consideration to be allocated. If an election described in
Sec. 1.338-6(c)(5) is made with respect to an applicable asset
acquisition, any allocation of costs pursuant to this paragraph (c)(3)
shall be made as if such election had not been made. The preceding
sentence applies to applicable asset acquisitions occurring on or after
September 11, 2007. For applicable asset acquisitions occurring before
September 11, 2007, and on or after September 15, 2004, see Sec.
1.1060-1T as contained in 26 CFR Part 1 in effect on April 1, 2007. For
applicable asset acquisitions occurring before September 15, 2004, see
Sec. Sec. 1.338-6 and 1.1060-1 as contained in 26 CFR Part 1 in effect
on April 1, 2004.
(4) Effect of agreement between parties. If, in connection with an
applicable asset acquisition, the seller and purchaser agree in writing
as to the allocation of any amount of consideration to, or as to the
fair market value of, any of the assets, such agreement is binding on
them to the extent provided in this paragraph (c)(4). Nothing in this
paragraph (c)(4) restricts the Commissioner's authority to challenge the
allocations or values arrived at in an allocation agreement. This
paragraph (c)(4) does not apply if the parties are able to refute the
allocation or valuation under the standards set forth in Commissioner v.
Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967) (a
party wishing to challenge the tax consequences of an agreement as
construed by the Commissioner must offer proof that, in an action
between the parties to the agreement, would be admissible to alter that
construction or show its unenforceability because of mistake, undue
influence, fraud, duress, etc.).
(5) Insurance business. If the trade or business transferred is an
insurance business, the rules of this paragraph (c) are modified by the
principles of Sec. 1.338-11(a) through (d). However, in transactions
governed by section 1060, such principles apply even if the transfer of
[[Page 198]]
the trade or business is effected in whole or in part through indemnity
reinsurance rather than assumption reinsurance, and, for the insurer or
reinsurer, an insurance contract (including an annuity or reinsurance
contract) is a Class VI asset regardless of whether it is a section 197
intangible. In addition, the principles of Sec. 1.338-11(f) through (h)
apply if the transfer occurs in connection with the complete liquidation
of the transferor.
(d) Examples. The following examples illustrate this section:
Example 1. (i) On January 1, 2001, A transfers assets X, Y, and Z to
B in exchange for assets D, E, and F plus $1,000 cash.
(ii) Assume the exchange of assets constitutes an exchange of like-
kind property to which section 1031 applies. Assume also that goodwill
or going concern value could under any circumstances attach to each of
the DEF and XYZ groups of assets and, therefore, each group constitutes
a trade or business under section 1060.
(iii) Assume the fair market values of the assets and the amount of
money transferred are as follows:
------------------------------------------------------------------------
Fair
Asset market
value
------------------------------------------------------------------------
By A:
X........................................................... $ 400
Y........................................................... 400
Z........................................................... 200
---------
Total..................................................... 1,000
=========
By B:
D........................................................... 40
E........................................................... 30
F........................................................... 30
Cash (amount)............................................... 1,000
---------
Total..................................................... 1,100
------------------------------------------------------------------------
(iv) Under paragraph (b)(8) of this section, for purposes of
allocating consideration under paragraph (c) of this section, the like-
kind assets exchanged and any money or other property that are treated
as transferred in exchange for the like-kind property are excluded from
the application of section 1060.
(v) Since assets X, Y, and Z are like-kind property, they are
excluded from the application of the section 1060 allocation rules.
(vi) Since assets D, E, and F are like-kind property, they are
excluded from the application of the section 1060 allocation rules.
Thus, the allocation rules of section 1060 do not apply in determining
B's gain or loss with respect to the disposition of assets D, E, and F,
and the allocation rules of section 1060 and paragraph (c) of this
section are not applied to determine A's bases of assets D, E, and F. In
addition, $900 of the $1,000 cash B gave to A for A's like-kind assets
(X, Y, and Z) is treated as transferred in exchange for the like-kind
property in order to equalize the fair market values of the like-kind
assets. Therefore, $900 of the cash is excluded from the application of
the section 1060 allocation rules.
(vii) $100 of the cash is allocated under section 1060 and paragraph
(c) of this section.
(viii) A received $100 that must be allocated under section 1060 and
paragraph (c) of this section. Since A transferred no Class I, II, III,
IV, V, or VI assets to which section 1060 applies, in determining its
amount realized for the part of the exchange to which section 1031 does
not apply, the $100 is allocated to Class VII assets (goodwill and going
concern value).
(ix) B gave A $100 that must be allocated under section 1060 and
paragraph (c) of this section. Since B received from A no Class I, II,
III, IV, V, or VI assets to which section 1060 applies, the $100
consideration is allocated by B to Class VII assets (goodwill and going
concern value).
Example 2. (i) On January 1, 2001, S, a sole proprietor, sells to P,
a corporation, a group of assets that constitutes a trade or business
under paragraph (b)(2) of this section. S, who plans to retire
immediately, also executes in P's favor a covenant not to compete. P
pays S $3,000 in cash and assumes $1,000 in liabilities. Thus, the total
consideration is $4,000.
(ii) On the purchase date, P and S also execute a separate agreement
that states that the fair market values of the Class II, Class III,
Class V, and Class VI assets S sold to P are as follows:
------------------------------------------------------------------------
Fair
Asset class Asset market
value
------------------------------------------------------------------------
II......................... Actively traded securities....... $500
---------
Total Class II................ 500
=========
III........................ Accounts receivable.............. 200
---------
Total Class III............... 200
=========
V.......................... Furniture and fixtures........... 800
Building......................... 800
Land............................. 200
Equipment........................ 400
---------
Total Class V................. 2,200
=========
VI......................... Covenant not to compete.......... 900
---------
Total Class VI................ 900
------------------------------------------------------------------------
(iii) P and S each allocate the consideration in the transaction
among the assets transferred under paragraph (c) of this section in
accordance with the agreed upon fair market values of the assets, so
that $500 is allocated to Class II assets, $200 is allocated
[[Page 199]]
to the Class III asset, $2,200 is allocated to Class V assets, $900 is
allocated to Class VI assets, and $200 ($4,000 total consideration less
$3,800 allocated to assets in Classes II, III, V, and VI) is allocated
to the Class VII assets (goodwill and going concern value).
(iv) In connection with the examination of P's return, the
Commissioner, in determining the fair market values of the assets
transferred, may disregard the parties' agreement. Assume that the
Commissioner correctly determines that the fair market value of the
covenant not to compete was $500. Since the allocation of consideration
among Class II, III, V, and VI assets results in allocation up to the
fair market value limitation, the $600 of unallocated consideration
resulting from the Commissioner's redetermination of the value of the
covenant not to compete is allocated to Class VII assets (goodwill and
going concern value).
(e) Reporting requirements--(1) Applicable asset acquisitions--(i)
In general. Unless otherwise excluded from this requirement by the
Commissioner, the seller and the purchaser in an applicable asset
acquisition each must report information concerning the amount of
consideration in the transaction and its allocation among the assets
transferred. They also must report information concerning subsequent
adjustments to consideration.
(ii) Time and manner of reporting--(A) In general. The seller and
the purchaser each must file asset acquisition statements on Form 8594,
``Asset Allocation Statement,'' with their income tax returns or returns
of income for the taxable year that includes the first date assets are
sold pursuant to an applicable asset acquisition. This reporting
requirement applies to all asset acquisitions described in this section.
For reporting requirements relating to asset acquisitions occurring
before March 16, 2001, as described in paragraph (a)(2) of this section,
see the temporary regulations under section 1060 in effect prior to
March 16, 2001 (see 26 CFR part 1 revised April 1, 2000).
(B) Additional reporting requirement. When an increase or decrease
in consideration is taken into account after the close of the first
taxable year that includes the first date assets are sold in an
applicable asset acquisition, the seller and the purchaser each must
file a supplemental asset acquisition statement on Form 8594 with the
income tax return or return of income for the taxable year in which the
increase (or decrease) is properly taken into account.
(C) Election described in Sec. 1.338-6(c)(5)--(1) Availability. The
election described in Sec. 1.338-6(c)(5) is available in respect of an
applicable asset acquisition provided that the requirements of that
section are satisfied. Such election may be made by the seller,
regardless of whether the purchaser also makes the election, and may be
made by the purchaser, regardless of whether the seller also makes the
election.
(2) Time and manner of making election. The election described in
Sec. 1.338-6(c)(5) is made by taking a position on a timely filed
original tax return for the taxable year of the applicable asset
acquisition that is consistent with having made the election.
(3) Irrevocability of election. The election described in Sec.
1.338-6(c)(5) is irrevocable.
(4) Effective/applicability date. This paragraph (e)(1)(ii)(C)
applies to applicable asset acquisitions occurring on or after September
11, 2007. For applicable asset acquisitions occurring before September
11, 2007 and on or after September 15, 2004, see Sec. 1.1060-1T as
contained in 26 CFR Part 1 in effect on April 1, 2007. For applicable
asset acquisitions occurring before September 15, 2004, see Sec. Sec.
1.338-6 and 1.1060-1 as contained in 26 CFR Part 1 in effect on April 1,
2004.
(2) Transfers of interests in partnerships. For reporting
requirements relating to the transfer of a partnership interest, see
Sec. 1.755-1(d).
[T.D. 8940, 66 FR 9954, Feb. 13, 2001, as amended by T.D. 9059, 68 FR
34299, June 9, 2003; T.D. 9158, 69 FR 55742, Sept. 16, 2004; T.D. 9257,
71 FR 18006, Apr. 10, 2006; T.D. 9358, 72 FR 51706, Sept. 11, 2007; T.D.
9377, 73 FR 3874, Jan. 23, 2008; T.D. 9377, 73 FR 14386, Mar. 18, 2008]
Changes To Effectuate F.C.C. Policy
Sec. 1.1071-1 Gain from sale or exchange to effectuate policies
of Federal Communications Commission.
(a)(1) At the election of the taxpayer, section 1071 postpones the
recognition of the gain upon the sale or exchange of property if the
Federal Communications Commission grants the taxpayer a certificate with
respect to the ownership and control of radio broadcasting stations
which is in accordance with
[[Page 200]]
subparagraph (2) of this paragraph. Any taxpayer desiring to obtain the
benefits of section 1071 shall file such certificate with the
Commissioner of Internal Revenue, or the district director for the
internal revenue district in which the income tax return of the taxpayer
is required to be filed.
(2)(i) In the case of a sale or exchange before January 1, 1958, the
certificate from the Federal Communications Commission must clearly
identify the property and show that the sale or exchange is necessary or
appropriate to effectuate the policies of such Commission with respect
to the ownership and control of radio broadcasting stations.
(ii) In the case of a sale or exchange after December 31, 1957, the
certificate from the Federal Communications Commission must clearly
identify the property and show that the sale or exchange is necessary or
appropriate to effectuate a change in a policy of, or the adoption of a
new policy by, such Commission with respect to the ownership and control
of radio broadcasting stations.
(3) The certificate shall be accompanied by a detailed statement
showing the kind of property, the date of acquisition, the cost or other
basis of the property, the date of sale or exchange, the name and
address of the transferee, and the amount of money and the fair market
value of the property other than money received upon such sale or
exchange.
(b) Section 1071 applies only in the case of a sale or exchange made
necessary by reason of the Federal Communications Commission's policies
as to ownership or control of radio facilities. Section 1071 does not
apply in the case of a sale or exchange made necessary as a result of
other matters, such as the operation of a broadcasting station in a
manner determined by the Commission to be not in the public interest or
in violation of Federal or State law.
(c) An election to have the benefits of section 1071 shall be made
in the manner prescribed in Sec. 1.1071-4.
(d) For purposes of section 1071, the term radio broadcasting
includes telecasting.
Sec. 1.1071-2 Nature and effect of election.
(a) Alternative elections. (1) A taxpayer entitled to the benefits
of section 1071 in respect of a sale or exchange of property may elect--
(i) To treat such sale or exchange as an involuntary conversion
under the provisions of section 1033; or
(ii) To treat such sale or exchange as an involuntary conversion
under the provisions of section 1033, and in addition elect to reduce
the basis of property, in accordance with the regulations prescribed in
Sec. 1.1071-3, by all or part of the gain that would otherwise be
recognized under section 1033; or
(iii) To reduce the basis of property, in accordance with the
regulations prescribed in Sec. 1.1071-3, by all or part of the gain
realized upon the sale or exchange.
(2) The effect of the provisions of subparagraph (1) of this
paragraph is, in general, to grant the taxpayer an election to treat the
proceeds of the sale or exchange as the proceeds of an involuntary
conversion subject to the provisions of section 1033, and a further
election to reduce the basis of certain property owned by the taxpayer
by the amount of the gain realized upon the sale or exchange to the
extent of that portion of the proceeds which is not treated as the
proceeds of an involuntary conversion.
(3) An election in respect to a sale or exchange under section 1071
shall be irrevocable and binding for the taxable year in which the sale
or exchange takes place and for all subsequent taxable years.
(b) Application of section 1033. (1) If the taxpayer elects, under
either paragraph (a)(1) (i) or (ii) of this section, to treat the sale
or exchange as an involuntary conversion, the provisions of section
1033, as modified by section 1071, together with the regulations
prescribed under such sections, shall be applicable in determining the
amount of recognized gain and the basis of property required as a result
of such sale or exchange. For the purposes of section 1071 and the
regulations thereunder, stock of a corporation operating a radio
broadcasting station shall be treated as property similar or related in
service or use to the property sold or
[[Page 201]]
exchanged. Securities of such a corporation other than stock, or
securities of a corporation not operating a radio broadcasting station,
do not constitute property similar or related in service or use to the
property sold or exchanged. If the taxpayer exercises the election
referred to in paragraph (a)(1)(i) of this section, the gain realized
upon such sale or exchange shall be recognized to the extent of that
part of the money received upon the sale or exchange which is not
expended in the manner prescribed in section 1033 and the regulations
thereunder. If, however, the taxpayer exercises the elections referred
to in paragraph (a)(1)(ii) of this section, the amount of the gain which
would be recognized, determined in the same manner as in the case of an
election under paragraph (a)(1)(i) of this section, shall not be
recognized but shall be applied to reduce the basis of property,
remaining in the hands of the taxpayer after such sale or exchange or
acquired by him during the same taxable year, which is of a character
subject to the allowance for depreciation under section 167. Such
reduction of basis shall be made in accordance with and under the
conditions prescribed by Sec. 1.1071-3.
(2) In the application of section 1033 to determine the recognized
gain and the basis of property acquired as a result of a sale or
exchange pursuant to an election under paragraph (a)(1) (i) or (ii) of
this section, the entire amount of the proceeds of such sale or exchange
shall be taken into account.
(c) Example. The application of the provisions of section 1071 may
be illustrated by the following example:
Example: A, who makes his return on a calendar year basis, sold in
1954, for $100,000 cash, stock of X Corporation, which operates a radio
broadcasting station. A's basis of this stock was $75,000. The sale was
certified by the Federal Communications Commission as provided in
section 1071. Soon after, in the same taxable year, A used $50,000 of
the proceeds of the sale to purchase stock in Y Corporation, which
operates a radio broadcasting station. A elected in his 1954 return to
treat such sale and purchase as an involuntary conversion subject to the
provisions of section 1033. He also elected at the same time to reduce
the basis of depreciable property by the amount of the gain that
otherwise would be recognized under the provisions of section 1033, as
made applicable by section 1071. The sale results in a recognized gain
of $25,000 under section 1033. However, this gain is not recognized in
this case because the taxpayer elected to reduce the basis of other
property by the amount of the gain. This may be shown as follows:
(1) Sale price of X Corporation stock.............. $100,000
Basis for gain or loss............................. 75,000
--------------------
Gain realized.................................... 25,000
====================
Proceeds of sale................................... 100,000
Amount expended to replace property sold........... 50,000
--------------------
Amount not expended in manner prescribed in 50,000
section 1033....................................
====================
Realized gain, recognized under section 1033 (not 25,000
to exceed the unexpended portion of proceeds of
sale).............................................
Less: Amount applied as a reduction of basis of 25,000
depreciable property..............................
--------------------
Recognized gain for tax purposes................. None
(2) The basis of Y Corporation stock in the hands of A is $50,000,
computed in accordance with section 1033 and the regulations prescribed
under that section. The $50,000 basis is computed as follows:
Basis of property sold (converted)................. $75,000
Less: Amount of proceeds not expended.............. 50,000
--------------------
Balance.......................................... 25,000
Plus amount of gain recognized under section 1033.. 25,000
--------------------
Basis of Y Corporation stock in A's hands........ 50,000
Sec. 1.1071-3 Reduction of basis of property pursuant to election
under section 1071.
(a) General rule. (1) In addition to the adjustments provided in
section 1016 and other applicable provisions of chapter 1 of the Code
which adjustments are required to be made with respect to the cost or
other basis of property, a further adjustment shall be made in the
amount of the unrecognized gain under section 1071, if the taxpayer so
elects. Such further adjustment shall be made only with respect to the
cost or other basis of property which is of a character subject to the
allowance for depreciation under section 167 (whether or not used in
connection with a broadcasting business), and which remains in the hands
of the taxpayer immediately after the sale or exchange in respect of
which the election is made, or which is acquired by the taxpayer in the
same taxable year in which such sale or exchange occurs. If the property
is in the hands of the
[[Page 202]]
taxpayer immediately after the sale or exchange, the time of reduction
of the basis is the date of the sale or exchange; in all other cases the
time of reduction of the basis is the date of acquisition.
(2) The reduction of basis under section 1071 in the amount of the
unrecognized gain shall be made in respect of the cost or other basis,
as of the time prescribed, of all units of property of the specified
character. The cost or other basis of each unit shall be decreased in an
amount equal to such proportion of the unrecognized gain as the adjusted
basis (for determining gain, determined without regard to this section)
of such unit bears to the aggregate of such adjusted bases of all units
of such property, but the amount of the decrease shall not be more than
the amount of such adjusted basis. If in the application of such rule
the adjusted basis of any unit is reduced to zero, the process shall be
repeated to reduce the adjusted basis of the remaining units of property
by the portion of the unrecognized gain which is not absorbed in the
first application of the rule. For such purpose the adjusted basis of
the remaining units shall be the adjusted basis for determining gain
reduced by the amount of the adjustment previously made under this
section. The process shall be repeated until the entire amount of the
unrecognized gain has been absorbed.
(3) The application of the provisions of this section may be
illustrated by the following example:
Example: Using the facts given in the example set forth in Sec.
1.1071-2(c), except that the taxpayer elects to reduce the basis of
depreciable property in accordance with paragraph (a)(1)(iii) of Sec.
1.1071-2, the computation may be illustrated as follows:
Sale price of X Corporation stock.................. $100,000
Basis for gain or loss............................. 75,000
--------------------
Realized gain (recognized except for the election $25,000
under Sec. 1.1071-1)............................
====================
Adjusted basis of other depreciable property in
hands of A immediately after sale:
Building........................................ 80,000
Transmitter..................................... 16,000
Fixtures........................................ 4,000
--------------------
Total......................................... 100,000
====================
Computation of reduction:
Building (80,000/100,000) x $25,000 (gain)....... 20,000
Transmitter (16,000/100,000) x $25,000........... 4,000
Fixtures (4,000/100,000) x $25,000............... 1,000
--------------------
Total reduction................................ 25,000
====================
New basis of assets:
Building ($80,000 minus $20,000)................. 60,000
Transmitter ($16,000 minus $4,000)............... 12,000
Fixtures ($4,000 minus $1,000)................... 3,000
--------------------
Total adjusted basis after reduction under 75,000
section 1071..................................
====================
Realized gain upon sale of X Corporation stock..... 25,000
Less: Amount applied as a reduction to basis of 25,000
depreciable property..............................
--------------------
Recognized gain for tax purposes............... None
(b) Special cases. With the consent of the Commissioner, the
taxpayer may, however, have the basis of the various units of property
of the class specified in section 1071 and this section adjusted in a
manner different from the general rule set forth in paragraph (a) of
this section. Variations from such general rule may, for example,
involve adjusting the basis of only certain units of such property. The
request for variations from such general rule should be filed by the
taxpayer with his return for the taxable year in which he elects to have
the basis of property reduced under section 1071. Agreement between the
taxpayer and the Commissioner as to any variations from such general
rule shall be effective only if incorporated in a closing agreement
entered into under the provisions of section 7121.
Sec. 1.1071-4 Manner of election.
(a) An election under the provisions of section 1071 shall be in the
form of a written statement and shall be executed and filed in
duplicate. Such statement shall be signed by the taxpayer or his
authorized representative. In the case of a corporation, the statement
shall be signed with the corporate name, followed by the signature and
title of an officer of the corporation empowered to sign for the
corporation, and the corporate seal must be affixed. An election under
section 1071 to reduce the basis of property and an
[[Page 203]]
election under such section to treat the sale or exchange as an
involuntary conversion under section 1033 may be exercised independently
of each other. An election under section 1071 must be filed with the
return for the taxable year in which the sale or exchange occurs. Where
practicable, the certificate of the Federal Communications Commission
required by Sec. 1.1071-1 should be filed with the election.
(b) If, in pursuance of an election to have the basis of its
property adjusted under section 1071, the taxpayer desires to have such
basis adjusted in any manner different from the general rule set forth
in paragraph (a) of Sec. 1.1071-3, the precise method (including
allocation of amounts) should be set forth in detail on separate sheets
accompanying the election. Consent by the Commissioner to any departure
from such general rule shall be effected only by a closing agreement
entered into under the provisions of section 7121.
Exchanges in Obedience to S.E.C. Orders
Sec. 1.1081-1 Terms used.
The following terms, when used in this section and Sec. Sec.
1.1081-2 to 1.1083-1, inclusive, shall have the meanings assigned to
them in section 1083: Order of the Securities and Exchange Commission;
registered holding company; holding company system; associate company;
majority-owned subsidiary company; system group; nonexempt property; and
stock or securities. Any other term used in this section and Sec. Sec.
1.1081-2 to 1.1083-1, inclusive, which is defined in the Internal
Revenue Code of 1954, shall be given the respective definition contained
in such Code.
Sec. 1.1081-2 Purpose and scope of exception.
(a) The general rule is that the entire amount of gain or loss from
the sale or exchange of property is to be recognized (see section 1002)
and that the entire amount received as a dividend is to be included in
gross income. (See sections 61 and 301.) Exceptions to the general rule
are provided elsewhere in subchapters C and O, chapter 1 of the Code,
one of which is that made by section 1081 with respect to exchanges,
sales, and distributions specifically described in section 1081. Section
1081 provides the extent to which gain or loss is not to be recognized
on (1) the receipt of a distribution described in section 1081(c)(2), or
(2) an exchange or sale, or the receipt of a distribution, made in
obedience to an order of the Securities and Exchange Commission, which
is issued to effectuate the provisions of section 11 (b) of the Public
Utility Holding Company Act of 1935 (15 U.S.C. 79k (b)). Section 331
provides that a distribution in liquidation of a corporation shall be
treated as an exchange. Such distribution is to be treated as an
exchange under the provisions of sections 1081 to 1083, inclusive. The
order of the Securities and Exchange Commission must be one requiring or
approving action which the Commission finds to be necessary or
appropriate to effect a simplification or geographical integration of a
particular public utility holding company system. For specific
requirements with respect to an order of the Securities and Exchange
Commission, see section 1081 (f).
(b) The requirements for nonrecognition of gain or loss as provided
in section 1081 are precisely stated with respect to the following
general types of transactions:
(1) The exchange that is provided for in section 1081 (a), in which
stock or securities in a registered holding company or a majority-owned
subsidiary company are exchanged for stock or securities.
(2) The exchange that is provided for in section 1081 (b), in which
a registered holding company or an associate company of a registered
holding company exchanges property for property.
(3) The distribution that is provided for in section 1081 (c)(1), in
which stock or securities are distributed to a shareholder in a
corporation which is a registered holding company or a majority-owned
subsidiary company, or the distribution that is provided for in section
1081 (c)(2), in which a corporation distributes to a shareholder, rights
to acquire common stock in a second corporation.
[[Page 204]]
(4) The transfer that is provided for in section 1081 (d), in which
a corporation which is a member of a system group transfers property to
another member of the same system group.
Certain rules with respect to the receipt of nonexempt property on an
exchange described in section 1081 (a) are prescribed in section 1081
(e).
(c) These exceptions to the general rule are to be strictly
construed. Unless both the purpose and the specific requirements of
sections 1081 to 1083, inclusive, are clearly met, the recognition of
gain or loss upon the exchange, sale, or distribution will not be
postponed under those sections. Moreover, even though a taxable
transaction occurs in connection or simultaneously with a realization of
gain or loss to which nonrecognition is accorded, nevertheless,
nonrecognition will not be accorded to such taxable transaction. In
other words, the provisions of section 1081 do not extend in any case to
gain or loss other than that realized from and directly attributable to
a disposition of property as such, or the receipt of a corporate
distribution as such, in an exchange, sale, or distribution specifically
described in section 1081.
(d) The application of the provisions of part VI (section 1081 and
following), subchapter O, chapter 1 of the Code, is intended to result
only in postponing the recognition of gain or loss until a disposition
of property is made which is not covered by such provisions, and, in the
case of an exchange or sale subject to the provisions of section 1081
(b), in the reduction of basis of certain property. The provisions of
section 1082 with respect to the continuation of basis and the reduction
in basis are designed to effect these results. Although the time of
recognition may be shifted, there must be a true reflection of income in
all cases, and it is intended that the provisions of such part VI, shall
not be construed or applied in such a way as to defeat this purpose.
Sec. 1.1081-3 Exchanges of stock or securities solely for stock
or securities.
The exchange, without the recognition of gain or loss, that is
provided for in section 1081 (a) must be one in which stock or
securities in a corporation which is a registered holding company or a
majority-owned subsidiary company are exchanged solely for stock or
securities other than stock or securities which constitute nonexempt
property. An exchange is not within the provisions of section 1081 (a)
unless the stock or securities transferred and those received are stock
or securities as defined by section 1083 (f). The stock or securities
which may be received without the recognition of gain or loss are not
limited to stock or securities in the corporation from which they are
received. An exchange within the provisions of section 1081 (a) may be a
transaction between the holder of stock or securities and the
corporation which issued the stock or securities. Also the exchange may
be made by a holder of stock or securities with an associate company
(i.e., a corporation in the same holding company system with the issuing
corporation) which is a registered holding company or a majority-owned
subsidiary company. In either case, the nonrecognition provisions of
section 1081 (a) apply only to the holder of the stock or securities.
However, the transferee corporation must be acting in obedience to an
order of the Securities and Exchange Commission directed to such
corporation, if no gain or loss is to be recognized to the holder of the
stock or securities who makes the exchange with such corporation. See
also section 1081(b), in case the holder of the stock or securities is a
registered holding company or an associate company of a registered
holding company. An exchange is not within the provisions of section
1081(a) if it is within the provisions of section 1081(d), relating to
transfers within a system group. For treatment when nonexempt property
is received, see section 1081(e); for further limitations, see section
1081(f).
Sec. 1.1081-4 Exchanges of property for property by corporations.
(a) Application of section 1081(b). Section 1081(b) applies only to
the transfers specified therein with respect to which section 1081(d) is
inapplicable, and deals only with such transfers if gain is realized
upon the sale or other disposition effected by such transfers.
[[Page 205]]
If loss is realized section 1081(b) is inapplicable and the application
of other provisions of subtitle A of the Code must be determined. See
section 1081(g). If section 1081(b) is applicable, the other provisions
of subchapters C and O, chapter 1 of the Code, relating to the
nonrecognition of gain are inapplicable, and the conditions under which,
and the extent to which, the realized gain is not recognized are set
forth in paragraphs (b), (c), (d), (e), and (f) of this section.
(b) Nonrecognition of gain; no nonexempt proceeds. No gain is
recognized to a transferor corporation upon the sale or other
disposition of property transferred by such transferor corporation in
exchange solely for property other than nonexempt property, as defined
in section 1083(e), but only if all of the following requirements are
satisfied:
(1) The transferor corporation is, under the definition in section
1083 (b), a registered holding company or an associate company of a
registered holding company;
(2) Such transfer is in obedience to an order of the Securities and
Exchange Commission (as defined in section 1083 (a)) and such order
satisfies the requirements of section 1081 (f);
(3) The transferor corporation has filed the required consent to the
regulations under section 1082(a)(2) (see paragraph (g) of this
section); and
(4) The entire amount of the gain, as determined under section 1001,
can be applied in reduction of basis under section 1082(a)(2).
(c) Nonrecognition of gain; nonexempt proceeds. If the transaction
would be within the provisions of paragraph (b) of this section if it
were not for the fact that the property received in exchange consists in
whole or in part of nonexempt property (as defined in section 1083 (e)),
then no gain is recognized if such nonexempt property, or an amount
equal to the fair market value of such nonexempt property at the time of
the transfer.
(1) Is expended within the required 24-month period for property
other than nonexempt property; or
(2) Is invested within the required 24-month period as a
contribution to the capital, or as paid-in surplus, of another
corporation;
but only if the expenditure or investment is made
(3) In accordance with an order of the Securities and Exchange
Commission (as defined in section 1083 (a)) which satisfies the
requirements of section 1081 (f) and which recites that such expenditure
or investment by the transferor corporation is necessary or appropriate
to the integration or simplification of the holding company system of
which the transferor corporation is a member; and
(4) The required consent, waiver, and bond have been executed and
filed. See paragraphs (g) and (h) of this section.
(d) Recognition of gain in part; insufficient expenditure or
investment in case of nonexempt proceeds. If the transaction would be
within the provisions of paragraph (c) of this section if it were not
for the fact that the amount expended or invested is less than the fair
market value of the nonexempt property received in exchange, then the
gain, if any, is recognized, but in an amount not in excess of the
amount by which the fair market value of such nonexempt property at the
time of the transfer exceeds the amount so expended and invested.
(e) Items treated as expenditures for the purpose of paragraphs (c)
and (d) of this section. For the purposes of paragraphs (c) and (d) of
this section, the following are treated as expenditures for property
other than nonexempt property:
(1) A distribution in cancellation or redemption (except a
distribution having the effect of a dividend) of the whole or a part of
the transferor's own stock (not acquired on the transfer);
(2) A payment in complete or partial retirement or cancellation of
securities representing indebtedness of the transferor or a complete or
partial retirement or cancellation of such securities which is a part of
the consideration for the transfer; and
(3) If, on the transfer, a liability of the transferor is assumed,
or property of the transferor is transferred subject to a liability, the
amount of such liability.
(f) Recognition of gain in part; inability to reduce basis. If the
transaction would be within the provisions of paragraph
[[Page 206]]
(b) or (c) of this section, if it were not for the fact that an amount
of gain cannot be applied in reduction of basis under section
1082(a)(2), then the gain, if any, is recognized, but in an amount not
in excess of the amount which cannot be so applied in reduction of
basis. If the transaction would be within the provisions of paragraph
(d) of this section, if it were not for the fact that an amount of gain
cannot be applied in reduction of basis under section 1082(a)(2), then
the gain, if any, is recognized, but in an amount not in excess of the
aggregate of--
(1) The amount of gain which would be recognized under paragraph (d)
of this section if there were no inability to reduce basis under section
1082(a)(2); and
(2) The amount of gain which cannot be applied in reduction of basis
under section 1082(a)(2).
(g) Consent to regulations under section 1082(a)(2). To be entitled
to the benefits of the provisions of section 1081(b), a corporation must
file with its return for the taxable year in which the transfer occurs a
consent to have the basis of its property adjusted under section
1082(a)(2) (see Sec. 1.1082-3), in accordance with the provisions of
the regulations in effect at the time of filing of the return for the
taxable year in which the transfer occurs. Such consent shall be made on
Form 982 in accordance with these regulations and instructions on the
form or issued therewith.
(h) Requirements with respect to expenditure or investment. If the
full amount of the expenditure or investment required for the
application of paragraph (c) of this section has not been made by the
close of the taxable year in which such transfer occurred, the taxpayer
shall file with the return for such year an application for the benefit
of the 24-month period for expenditure and investment, reciting the
nature and time of the proposed expenditure or investment. When
requested by the district director, the taxpayer shall execute and file
(at such time and in such form) such waiver of the statute of
limitations with respect to the assessment of deficiencies (for the
taxable year of the transfer and for all succeeding taxable years in any
of which falls any part of the period beginning with the date of the
transfer and ending 24 months thereafter) as the district director may
specify, and such bond with such surety as the district director may
require, in an amount not in excess of double the estimated maximum
income tax which would be payable if the corporation does not make the
required expenditure or investment within the required 24-month period.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6751, 29 FR
11356, Aug. 6, 1964; T.D. 7517, 42 FR 58935, Nov. 14, 1977]
Sec. 1.1081-5 Distribution solely of stock or securities.
(a) In general. If, without any surrender of his stock or securities
as defined in section 1083(f), a shareholder in a corporation which is a
registered holding company or a majority-owned subsidiary company
receives stock or securities in such corporation or owned by such
corporation, no gain to the shareholder will be recognized with respect
to the stock or securities received by such shareholder which do not
constitute nonexempt property, if the distribution to such shareholder
is made by the distributing corporation in obedience to an order of the
Securities and Exchange Commission directed to such corporation. A
distribution is not within the provisions of section 1081(c)(1) if it is
within the provisions of section 1081(d), relating to transfers within a
system group. A distribution is also not within the provisions of
section 1081(c)(1) if it involves a surrender by the shareholder of
stock or securities or a transfer by the shareholder of property in
exchange for the stock or securities received by the shareholder. For
further limitations, see section 1081(f).
(b) Special rule. (1) If there is distributed to a shareholder in a
corporation rights to acquire common stock in a second corporation, no
gain to the shareholder from the receipt of the rights shall be
recognized, but only if all the following requirements are met:
(i) The rights are received by the shareholder without the surrender
by the shareholder of any stock in the distributing corporation,
(ii) Such distribution is in accordance with an arrangement forming
a ground for an order of the Securities
[[Page 207]]
and Exchange Commission issued pursuant to section 3 of the Public
Utility Holding Company Act of 1935 (15 U. S. C. 79c) that the
distributing corporation is exempt from any provision or provisions of
such act, and
(iii) Before January 1, 1958, the distributing corporation disposes
of all the common stock in the second corporation which it owns.
(2) The distributing corporation shall, as soon as practicable,
notify the district director in whose district the corporation's income
tax return and supporting data was filed (see paragraph (g) of Sec.
1.1081-11), as to whether or not the requirement of subparagraph
(1)(iii) of this paragraph has been met. If such requirement has not
been met, the periods of limitation (sections 6501 and 6502) with
respect to any deficiency, including interest and additions to the tax,
resulting solely from the receipt of such rights to acquire stock, shall
include one year immediately following the date of such notification;
and assessment and collection shall be made notwithstanding any
provisions of law or rule of law which would otherwise prevent such
assessment and collection.
Sec. 1.1081-6 Transfers within system group.
(a) The nonrecognition of gain or loss provided for in section
1081(d)(1) is applicable to an exchange of property for other property
(including money and other nonexempt property) between corporations
which are all members of the same system group. The term system group is
defined in section 1083 (d).
(b) Section 1081 (d)(1) also provides for nonrecognition of gain to
a corporation which is a member of a system group if property (including
money or other nonexempt property) is distributed to such corporation as
a shareholder in a corporation which is a member of the same system
group, without the surrender by such shareholder of stock or securities
in the distributing corporation.
(c) As stated in Sec. 1.1081-2, nonrecognition of gain or loss will
not be accorded to a transaction not clearly provided for in part VI
(section 1081 and following), subchapter O, chapter 1 of the Code, even
though such transaction occurs simultaneously or in connection with an
exchange, sale, or distribution to which nonrecognition is specifically
accorded. Therefore, nonrecognition will not be accorded to any gain or
loss realized from the discharge, or the removal of the burden, of the
pecuniary obligations of a member of a system group, even though such
obligations are acquired upon a transfer or distribution specifically
described in section 1081 (d)(1); but the fact that the acquisition of
such obligations was upon a transfer or distribution specifically
described in section 1081 (d)(1) will, because of the basis provisions
of section 1082 (d), affect the cost to the member of such discharge or
its equivalent. Thus, section 1081 (d)(1) does not provide for the
nonrecognition of any gain or loss realized from the discharge of the
indebtedness of a member of a system group as the result of the
acquisition in exchange, sale, or distribution of its own bonds, notes,
or other evidences of indebtedness which were acquired by another member
of the same system group for a consideration less or more than the
issuing price thereof (with proper adjustments for amortization of
premiums or discounts).
(d) The provisions of paragraph (c) of this section may be
illustrated by the following example:
Example: Suppose that the A Corporation and the B Corporation are
both members of the same system group; that the A Corporation holds at a
cost of $900 a bond issued by the B Corporation at par, $1,000; and that
the A Corporation and the B Corporation enter into an exchange subject
to the provisions of section 1081 (d)(1) in which the $1,000 bond of the
B Corporation is transferred from the A Corporation to the B
Corporation. The $900 basis reflecting the cost to the A Corporation
which would have been the basis available to the B Corporation if the
property transferred to it had been something other than its own
securities (see Sec. 1.1082-6) will, in this type of transaction,
reflect the cost to the B Corporation of effecting a retirement of its
own $1,000 bond. The $100 gain of the B Corporation reflected in the
retirement will therefore be recognized.
(e) No exchange or distribution may be made without the recognition
of gain or loss as provided for in section 1081 (d)(1), unless all the
corporations which are parties to such exchange or
[[Page 208]]
distribution are acting in obedience to an order of the Securities and
Exchange Commission. If an exchange or distribution is within the
provisions of section 1081 (d)(1) and also may be considered to be
within some other provisions of section 1081, it shall be considered
that only the provisions of section 1081 (d)(1) apply and that the
nonrecognition of gain or loss upon such exchange or distribution is by
virtue of that section.
Sec. 1.1081-7 Sale of stock or securities received upon exchange
by members of system group.
(a) Section 1081(d)(2) provides that to the extent that property
received upon an exchange by corporations which are members of the same
system group consists of stock or securities issued by the corporation
from which such property was received, such stock or securities may,
under certain specifically described circumstances, be sold to a party
not a member of the system group, without the recognition of gain or
loss to the selling corporation. The nonrecognition of gain or loss is
limited, in the case of stock, to a sale of stock which is preferred as
to both dividends and assets. The stock or securities must have been
received upon an exchange with respect to which section 1081(d)(1)
operated to prevent recognition of gain or loss to any party to the
exchange. Nonrecognition of gain or loss upon the sale of such stock or
securities is permitted only if the proceeds derived from the sale are
applied in retirement or cancellation of stock or securities of the
selling corporation which were outstanding at the time the exchange was
made. It is also essential to nonrecognition of gain or loss upon the
sale that both the sale of the stock or securities and the application
of the proceeds derived therefrom be made in obedience to an order of
the Securities and Exchange Commission. If any part of the proceeds
derived from the sale is not applied in making the required retirement
or cancellation of stock or securities and if the sale is otherwise
within the provisions of section 1081 (d)(2), the gain resulting from
the sale shall be recognized, but in an amount not in excess of the
proceeds which are not so applied. In any event, if the proceeds derived
from the sale of the stock or securities exceed the fair market value of
such stock or securities at the time of the exchange through which they
were acquired by the selling corporation, the gain resulting from the
sale is to be recognized to the extent of such excess. Section 1081
(d)(2) does not provide for the nonrecognition of any gain resulting
from the retirement of bonds, notes, or other evidences of indebtedness
for a consideration less than the issuing price thereof. Also, that
section does not provide for the nonrecognition of gain or loss upon the
sale of any stock or securities received upon a distribution or
otherwise than upon an exchange.
(b) The application of paragraph (a) of this section may be
illustrated by the following example:
Example: The X Corporation and the Y Corporation, both of which make
their income tax returns on a calendar year basis, are members of the
same system group. As part of an exchange to which section 1081 (d)(1)
is applicable the Y Corporation on June 1, 1954, issued to the X
Corporation 1,000 shares of class A stock, preferred as to both
dividends and assets. The fair market value of such stock at the time of
issuance was $90,000 and its basis to the X Corporation was $75,000. On
December 1, 1954, in obedience to an appropriate order of the Securities
and Exchange Commission, the X Corporation sells all of such stock to
the public for $100,000 and applies $95,000 of this amount to the
retirement of its own bonds, which were outstanding on June 1, 1954. The
remaining $5,000 is not used to retire any of the X Corporation's stock
or securities. Of the total gain of $25,000 realized on the disposition
of the Y Corporation stock, only $10,000 is recognized (the difference
between the fair market value of the stock when acquired and the amount
for which it was sold), since such amount is greater than the portion
($5,000) of the proceeds not applied to the retirement of the X
Corporation's stock or securities. If in this example the stock acquired
by the X Corporation had not been stock of the Y Corporation issued to
the X Corporation or if it had been stock not preferred as to both
dividends and assets, the full amount of the gain ($25,000) realized
upon its disposition would have been recognized, regardless of what was
done with the proceeds.
[[Page 209]]
Sec. 1.1081-8 Exchanges in which money or other nonexempt property
is received.
(a) Under section 1081(e)(1), if in any exchange (not within any of
the provisions of section 1081(d)) in which stock or securities in a
corporation which is a registered holding company or a majority-owned
subsidiary are exchanged for stock or securities as provided for in
section 1081 (a), there is received by the taxpayer money or other
nonexempt property (in addition to property permitted to be received
without recognition of gain), then--
(1) The gain, if any, to the taxpayer is to be recognized in an
amount not in excess of the sum of the money and the fair market value
of the other nonexempt property, but
(2) The loss, if any, to the taxpayer from such an exchange is not
to be recognized to any extent.
(b) If money or other nonexempt property is received from a
corporation in an exchange described in paragraph (a) of this section
and if the distribution of such money or other nonexempt property by or
on behalf of such corporation has the effect of the distribution of a
taxable dividend, then, as provided in section 1081 (e)(2), there shall
be taxed to each distributee (1) as a dividend, such an amount of the
gain recognized on the exchange as is not in excess of the distributee's
ratable share of the undistributed earnings and profits of the
corporation accumulated after February 28, 1913, and (2) the remainder
of the gain so recognized shall be taxed as a gain from the exchange of
property.
Sec. 1.1081-9 Requirements with respect to order of Securities
and Exchange Commission.
The term order of the Securities and Exchange Commission is defined
in section 1083(a). In addition to the requirements specified in that
definition, section 1081(f) provides that, except in the case of a
distribution described in section 1081(c)(2), the provisions of section
1081 shall not apply to an exchange, expenditure, investment,
distribution, or sale unless each of the following requirements is met:
(a) The order of the Securities and Exchange Commission must recite
that the exchange, expenditure, investment, distribution, or sale is
necessary or appropriate to effectuate the provisions of section 11(b)
of the Public Utility Holding Company Act of 1935 (15 U. S. C. 79k (b)).
(b) The order shall specify and itemize the stocks and securities
and other property (including money) which are ordered to be acquired,
transferred, received, or sold upon such exchange, acquisition,
expenditure, distribution, or sale and, in the case of an investment,
the investment to be made, so as clearly to identify such property.
(c) The exchange, acquisition, expenditure, investment,
distribution, or sale shall be made in obedience to such order and shall
be completed within the time prescribed in such order.
These requirements were not designed merely to simplify the
administration of the provisions of section 1081, and they are not to be
considered as pertaining only to administrative matters. Each one of the
three requirements is essential and must be met if gain or loss is not
to be recognized upon the transaction.
Sec. 1.1081-10 Nonapplication of other provisions of the Internal
Revenue Code of 1954.
The effect of section 1081(g) is that an exchange, sale, or
distribution which is within section 1081 shall, with respect to the
nonrecognition of gain or loss and the determination of basis, be
governed only by the provisions of part VI (section 1081 and following),
subchapter O, chapter 1 of the Code, the purpose being to prevent
overlapping of those provisions and other provisions of subtitle A of
the Code. In other words, if by virtue of section 1081 any portion of a
person's gain or loss on any particular exchange, sale, or distribution
is not to be recognized, then the gain or loss of such person shall be
nonrecognized only to the extent provided in section 1081, regardless of
what the result might have been if part VI (section 1081 and following),
subchapter O, chapter 1 of the Code, had not been enacted; and
similarly, the basis in the hands of such person of the property
received by him in such transaction shall be the
[[Page 210]]
basis provided by section 1082, regardless of what the basis of such
property might have been under section 1011 if such part VI had not been
enacted. On the other hand, if section 1081 does not provide for the
nonrecognition of any portion of a person's gain or loss (whether or not
such person is another party to the same transaction referred to above),
then the gain or loss of such person shall be recognized or
nonrecognized to the extent provided for by other provisions of subtitle
A of the Code as if such part VI had not been enacted; and similarly,
the basis in his hands of the property received by him in such
transaction shall be the basis provided by other provisions of subtitle
A of the Code as if such part VI had not been enacted.
Sec. 1.1081-11 Records to be kept and information to be filed
with returns.
(a) Distributions and exchanges; significant holders of stock or
securities. Every significant holder must include a statement entitled,
``STATEMENT PURSUANT TO Sec. 1.1081-11(a) BY [INSERT NAME AND TAXPAYER
IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A SIGNIFICANT HOLDER,'' on
or with such holder's income tax return for the taxable year in which
the distribution or exchange occurs. If a significant holder is a
controlled foreign corporation (within the meaning of section 957), each
United States shareholder (within the meaning of section 951(b)) with
respect thereto must include this statement on or with its return. The
statement must include--
(1) The name and employer identification number (if any) of the
corporation from which the stock, securities, or other property
(including money) was received by such significant holder;
(2) The aggregate basis, determined immediately before the exchange,
of any stock or securities transferred by the significant holder in the
exchange, and the aggregate fair market value, determined immediately
before the distribution or exchange, of the stock, securities or other
property (including money) received by the significant holder in the
distribution or exchange; and
(3) The date of the distribution or exchange.
(b) Distributions and exchanges; corporations subject to Commission
orders. Each corporation which is a party to a distribution or exchange
made pursuant to an order of the Commission must include on or with its
income tax return for its taxable year in which the distribution or
exchange takes place a statement entitled, ``STATEMENT PURSUANT TO Sec.
1.1081-11(b) BY [INSERT NAME AND EMPLOYER IDENTIFICATION NUMBER (IF ANY)
OF TAXPAYER], A DISTRIBUTING OR EXCHANGING CORPORATION.'' If the
distributing or exchanging corporation is a controlled foreign
corporation (within the meaning of section 957), each United States
shareholder (within the meaning of section 951(b)) with respect thereto
must include this statement on or with its return. The statement must
include--
(1) The date and control number of the Commission order, pursuant to
which the distribution or exchange was made;
(2) The names and taxpayer identification numbers (if any) of the
significant holders;
(3) The aggregate fair market value and basis, determined
immediately before the distribution or exchange, of the stock,
securities, or other property (including money) transferred in the
distribution or exchange; and
(4) The date of the distribution or exchange.
(c) Sales by members of system groups. Each system group member must
include a statement entitled, ``STATEMENT PURSUANT TO Sec. 1.1081-11(c)
BY [INSERT NAME AND EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF
TAXPAYER], A SYSTEM GROUP MEMBER,'' on or with its income tax return for
the taxable year in which the sale is made. If any system group member
is a controlled foreign corporation (within the meaning of section 957),
each United States shareholder (within the meaning of section 951(b))
with respect thereto must include this statement on or with its return.
The statement must include--
(1) The dates and control numbers of all relevant Commission orders;
[[Page 211]]
(2) The aggregate fair market value and basis, determined
immediately before the sale, of all stock or securities sold; and
(3) The date of the sale.
(d) Definitions. (1) For purposes of this section, Commission means
the Securities and Exchange Commission.
(2) For purposes of this section, significant holder means a person
that receives stock or securities from a corporation (the distributing
corporation) pursuant to an order of the Commission, if, immediately
before the transaction, such person--
(i) In the case of stock--
(A) Owned at least five percent (by vote or value) of the total
outstanding stock of the distributing corporation if the stock owned by
such person is publicly traded, or
(B) Owned at least one percent (by vote or value) of the total
outstanding stock of the distributing corporation if the stock owned by
such person is not publicly traded; or
(ii) In the case of securities, owned securities of the distributing
corporation with a basis of $1,000,000 or more.
(3) Publicly traded stock means stock that is listed on--
(i) A national securities exchange registered under section 6 of the
Securities Exchange Act of 1934 (15 U.S.C. 78f); or
(ii) An interdealer quotation system sponsored by a national
securities association registered under section 15A of the Securities
Exchange Act of 1934 (15 U.S.C. 78o-3).
(4) For purposes of paragraph (b) of this section, exchange means
exchange, expenditure, or investment.
(5) For purposes of paragraph (c) of this section, system group
member means each corporation which is a member of a system group and
which, pursuant to an order of the Commission, sells stock or securities
received upon an exchange (pursuant to an order of the Commission) and
applies the proceeds derived therefrom in retirement or cancellation of
its own stock or securities.
(e) Substantiation information. Under Sec. 1.6001-1(e), taxpayers
are required to retain their permanent records and make such records
available to any authorized Internal Revenue Service officers and
employees. In connection with the distribution or exchange described in
this section, these records should specifically include information
regarding the amount, basis, and fair market value of all property
distributed or exchanged, and relevant facts regarding any liabilities
assumed or extinguished as part of such distribution or exchange.
(f) Effective/applicability date. This section applies to any
taxable year beginning on or after May 30, 2006. However, taxpayers may
apply this section to any original Federal income tax return (including
any amended return filed on or before the due date (including
extensions) of such original return) timely filed on or after May 30,
2006. For taxable years beginning before May 30, 2006, see Sec. 1.1081-
11 as contained in 26 CFR part 1 in effect on April 1, 2006.
[T.D. 9329, 72 FR 32803, June 14, 2007]
Sec. 1.1082-1 Basis for determining gain or loss.
(a) For determining the basis of property acquired in a taxable year
beginning before January 1, 1942, in any manner described in section 372
of the Internal Revenue Code of 1939 prior to its amendment by the
Revenue Act of 1942 (56 Stat. 798), see such section (before its
amendment by such Act).
(b) If the property was acquired in a taxable year beginning after
December 31, 1941, in any manner described in section 1082 (other than
subsection (a)(2)), or section 372 (other than subsection (a)(2)) of the
Internal Revenue Code of 1939 after its amendments, the basis shall be
that prescribed in section 1082 with respect to such property. However,
in the case of property acquired in a transaction described in section
1081(c)(2), this paragraph is applicable only if the property was
acquired in a distribution made in a taxable year subject to the
Internal Revenue Code of 1954.
(c) Section 1082 makes provisions with respect to the basis of
property acquired in a transfer in connection with which the recognition
of gain or loss is prohibited by the provisions of section 1081 with
respect to the whole or any part of the property received. In general,
and except as provided in Sec. 1.1082-3, it is intended that the basis
[[Page 212]]
for determining gain or loss pertaining to the property prior to its
transfer, as well as the basis for determining the amount of
depreciation or depletion deductible and the amount of earnings or
profits available for distribution, shall continue notwithstanding the
nontaxable conversion of the asset in form or its change in ownership.
The continuance of the basis may be reflected in a shift thereof from
one asset to another in the hands of the same owner, or in its transfer
with the property from one owner into the hands of another. See also
Sec. 1.1081-2.
Sec. 1.1082-2 Basis of property acquired upon exchanges under section
1081 (a) or (e).
(a) In the case of an exchange of stock or securities for stock or
securities as described in section 1081 (a), if no part of the gain or
loss upon such exchange was recognized under section 1081, the basis of
the property acquired is the same as the basis of the property
transferred by the taxpayer with proper adjustments to the date of the
exchange.
(b) If, in an exchange of stock or securities as described in
section 1081 (a), gain to the taxpayer was recognized under section 1081
(e) on account of the receipt of money, the basis of the property
acquired is the basis of the property transferred (adjusted to the date
of the exchange), decreased by the amount of money received and
increased by the amount of gain recognized upon the exchange. If, upon
such exchange, there were received by the taxpayer money and other
nonexempt property (not permitted to be received without the recognition
of gain), and gain from the transaction was recognized under section
1081 (e), the basis (adjusted to the date of the exchange) of the
property transferred by the taxpayer, decreased by the amount of money
received and increased by the amount of gain recognized, must be
apportioned to and is the basis of the properties (other than money)
received on the exchange. For the purpose of the allocation of such
basis to the properties received, there must be assigned to the
nonexempt property (other than money) an amount equivalent to its fair
market value at the date of the exchange.
(c) Section 1081(e) provides that no loss may be recognized on an
exchange of stock or securities for stock or securities as described in
section 1081(a), although the taxpayer receives money or other nonexempt
property from the transaction. However, the basis of the property (other
than money) received by the taxpayer is the basis (adjusted to the date
of the exchange) of the property transferred, decreased by the amount of
money received. This basis must be apportioned to the properties
received, and for this purpose there must be allocated to the nonexempt
property (other than money) an amount of such basis equivalent to the
fair market value of such nonexempt property at the date of the
exchange.
(d) Section 1082 (a) does not apply in ascertaining the basis of
property acquired by a corporation by the issuance of its stock or
securities as the consideration in whole or in part for the transfer of
the property to it. For the rule in such cases, see section 1082 (b).
(e) For purposes of this section, any reference to section 1081
shall be deemed to include a reference to corresponding provisions of
prior internal revenue laws.
Sec. 1.1082-3 Reduction of basis of property by reason of gain not
recognized under section 1081(b).
(a) Introductory. In addition to the adjustments provided in section
1016 and other applicable provisions of chapter 1 of the Code, and the
regulations relating thereto, which are required to be made with respect
to the cost or other basis of property, section 1082(a)(2) provides that
a further adjustment shall be made in any case in which there shall have
been a nonrecognition of gain under section 1081(b). Such further
adjustment shall be made with respect to the basis of the property in
the hands of the transferor immediately after the transfer and of the
property acquired within 24 months after such transfer by an expenditure
or investment to which section 1081(b) relates, and on account of which
expenditure or investment gain is not recognized. If the property is in
[[Page 213]]
the hands of the transferor immediately after the transfer, the time of
reduction is the day of the transfer; in all other cases the time of
reduction is the date of acquisition. The effect of applying an amount
in reduction of basis of property under section 1081 (b) is to reduce by
such amount the basis for determining gain upon sale or other
disposition, the basis for determining loss upon sale or other
disposition, the basis for depreciation and for depletion, and any other
amount which the Code prescribes shall be the same as any of such bases.
For the purposes of the application of an amount in reduction of basis
under section 1081(b), property is not considered as having a basis
capable of reduction if--
(1) It is money, or
(2) If its adjusted basis for determining gain at the time the
reduction is to be made is zero, or becomes zero at any time in the
application of section 1081 (b).
(b) General rule. (1) Section 1082 (a)(2) sets forth seven
categories of property, the basis of which for determining gain or loss
shall be reduced in the order stated.
(2) If any of the property in the first category has a basis capable
of reduction, the reduction must first be made before applying an amount
in reduction of the basis of any property in the second or in a
succeeding category, to each of which in turn a similar rule is applied.
(3) In the application of the rule to each category, the amount of
the gain not recognized shall be applied to reduce the cost or other
basis of all the property in the category as follows: The cost or other
basis (at the time immediately after the transfer or, if the property is
not then held but is thereafter acquired, at the time of such
acquisition) of each unit of property in the first category shall be
decreased (but the amount of the decrease shall not be more than the
amount of the adjusted basis at such time for determining gain,
determined without regard to this section) in an amount equal to such
proportion of the unrecognized gain as the adjusted basis (for
determining gain, determined without regard to this section) at such
time of each unit of property of the taxpayer in that category bears to
the aggregate of the adjusted basis (for determining gain, computed
without regard to this section) at such time of all the property of the
taxpayer in that category. When such adjusted basis of the property in
the first category has been thus reduced to zero, a similar rule shall
be applied, with respect to the portion of such gain which is unabsorbed
in such reduction of the basis of the property in such category, in
reducing the basis of the property in the second category. A similar
rule with respect to the remaining unabsorbed gain shall be applied in
reducing the basis of the property in the next succeeding category.
(c) Special cases. (1) With the consent of the Commissioner, the
taxpayer may, however, have the basis of the various units of property
within a particular category specified in section 1082(a)(2) adjusted in
a manner different from the general rule set forth in paragraph (b) of
this section. Variations from such general rule may, for example,
involve adjusting the basis of only certain units of the taxpayer's
property within a given category. A request for variations from the
general rule should be filed by the taxpayer with its income tax return
for the taxable year in which the transfer of property has occurred.
(2) Agreement between the taxpayer and the Commissioner as to any
variations from such general rule shall be effective only if
incorporated in a closing agreement entered into under the provisions of
section 7121. If no such agreement is entered into by the taxpayer and
the Commissioner, then the consent filed on Form 982 shall (except as
otherwise provided in this subparagraph) be deemed to be a consent to
the application of such general rule, and such general rule shall apply
in the determination of the basis of the taxpayer's property. If,
however, the taxpayer specifically states on such form that it does not
consent to the application of the general rule, then, in the absence of
a closing agreement, the document filed shall not be deemed a consent
within the meaning of section 1081(b)(4).
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7517, 42 FR
58935, Nov. 14, 1977]
[[Page 214]]
Sec. 1.1082-4 Basis of property acquired by corporation under section
1081(a), 1081(b), or 1081(e) as contribution of capital or surplus,
or in consideration for its own stock or securities.
If, in connection with an exchange of stock or securities for stock
or securities as described in section 1081(a), or an exchange of
property for property as described in section 1081(b), or an exchange as
described in section 1081(e), property is acquired by a corporation by
the issuance of its stock or securities, the basis of such property
shall be determined under section 1082(b). If the corporation issued its
stock or securities as part or sole consideration for the property
acquired, the basis of the property in the hands of the acquiring
corporation is the basis (adjusted to the date of the exchange) which
the property would have had in the hands of the transferor if the
transfer had not been made, increased in the amount of gain or decreased
in the amount of loss recognized under section 1081 to the transferor
upon the transfer. If any property is acquired by a corporation from a
shareholder as paid-in surplus, or from any person as a contribution to
capital, the basis of the property to the corporation is the basis
(adjusted to the date of acquisition) of the property in the hands of
the transferor.
Sec. 1.1082-5 Basis of property acquired by shareholder upon tax-free
distribution under section 1081(c) (1) or (2).
(a) Stock or securities. If there was distributed to a shareholder
in a corporation which is a registered holding company or a majority-
owned subsidiary company, stock or securities (other than stock or
securities which are nonexempt property), and if by virtue of section
1081 (c)(1) no gain was recognized to the shareholder upon such
distribution, then the basis of the stock in respect of which the
distribution was made must be apportioned between such stock and the
stock or securities so distributed to the shareholder. The basis of the
old shares and the stock or securities received upon the distribution
shall be determined in accordance with the following rules:
(1) If the stock or securities received upon the distribution
consist solely of stock in the distributing corporation and the stock
received is all of substantially the same character and preference as
the stock in respect of which the distribution is made, the basis of
each share will be the quotient of the cost or other basis of the old
shares of stock divided by the total number of the old and the new
shares.
(2) If the stock or securities received upon the distribution are in
whole or in part stock in a corporation other than the distributing
corporation, or are in whole or in part stock of a character or
preference materially different from the stock in respect of which the
distribution is made, or if the distribution consists in whole or in
part of securities other than stock, the cost or other basis of the
stock in respect of which the distribution is made shall be apportioned
between such stock and the stock or securities distributed in
proportion, as nearly as may be, to the respective values of each class
of stock or security, old and new, at the time of such distribution, and
the basis of each share of stock or unit of security will be the
quotient of the cost or other basis of the class of stock or security to
which such share or unit belongs, divided by the number of shares or
units in the class. Within the meaning of this subparagraph, stocks or
securities in one corporation are different in class from stocks or
securities in another corporation, and, in general, any material
difference in character or preference or terms sufficient to distinguish
one stock or security from another stock or security, so that different
values may properly be assigned thereto, will constitute a difference in
class.
(b) Stock rights. If there was distributed to a shareholder in a
corporation rights to acquire common stock in a second corporation, and
if by virtue of section 1081 (c)(2) no gain was recognized to the
shareholder upon such distribution, then the basis of the stock in
respect of which the distribution was made must be apportioned between
such stock and the stock rights so distributed to the shareholder. The
basis of such stock and the stock rights received upon the distribution
shall be determined in accordance with the following:
[[Page 215]]
(1) The cost or other basis of the stock in respect of which the
distribution is made shall be apportioned between such stock and the
stock rights distributed, in proportion to the respective values thereof
at the time the rights are issued.
(2) The basis for determining gain or loss from the sale of a right,
or from the sale of a share of stock in respect of which the
distribution is made, will be the quotient of the cost or other basis,
properly adjusted, assigned to the rights or the stock, divided, as the
case may be, by the number of rights acquired or by the number of shares
of such stock held.
(c) Cross reference. As to the basis of stock or securities
distributed by one member of a system group to another member of the
same system group, see Sec. 1.1082-6.
Sec. 1.1082-6 Basis of property acquired under section 1081(d)
in transactions between corporations of the same system group.
(a) If property was acquired by a corporation which is a member of a
system group, from a corporation which is a member of the same system
group, upon a transfer or distribution described in section 1081 (d)(1),
then as a general rule the basis of such property in the hands of the
acquiring corporation is the basis which such property would have had in
the hands of the transferor if the transfer or distribution had not been
made. Except as otherwise indicated in this section, this rule will
apply equally to cases in which the consideration for the property
acquired consists of stock or securities, money, and other property, or
any of them, but it is contemplated that an ultimate true reflection of
income will be obtained in all cases, notwithstanding any peculiarities
in form which the various transactions may assume. See the example in
Sec. 1.1081-6.
(b) An exception to the general rule is provided for in case the
property acquired consists of stock or securities issued by the
corporation from which such stock or securities were received. If such
stock or securities were the sole consideration for the property
transferred to the corporation issuing such stock or securities, then
the basis of the stock or securities shall be (1) the same as the basis
(adjusted to the time of the transfer) of the property transferred for
such stock or securities, or (2) the fair market value of such stock or
securities at the time of their receipt, whichever is the lower. If such
stock or securities constituted only part consideration for the property
transferred to the corporation issuing such stock or securities, then
the basis shall be an amount which bears the same ratio to the basis of
the property transferred as the fair market value of such stock or
securities on their receipt bears to the total fair market value of the
entire consideration received, except that the fair market value of such
stock or securities at the time of their receipt shall be the basis
therefor, if such value is lower than such amount.
(c) The application of paragraph (b) of this section may be
illustrated by the following examples:
Example 1. Suppose the A Corporation has property with an adjusted
basis of $600,000 and, in an exchange in which section 1081 (d)(1) is
applicable, transfers such property to the B Corporation in exchange for
a total consideration of $1,000,000, consisting of (1) cash in the
amount of $100,000, (2) tangible property having a fair market value of
$400,000 and an adjusted basis in the hands of the B Corporation of
$300,000, and (3) stock or securities issued by the B Corporation with a
par value and a fair market value as of the date of their receipt in the
amount of $500,000. The basis to the B Corporation of the property
received by it is $600,000, which is the adjusted basis of such property
in the hands of the A Corporation. The basis to the A Corporation of the
assets (other than cash) received by it is as follows: Tangible
property, $300,000, the adjusted basis of such property to the B
Corporation, the former owner; stock or securities issued by the B
Corporation, $300,000, an amount equal to 550,000/ 1,000,000ths of
$600,000.
Example 2. Suppose that in example (1) the property of the A
Corporation transferred to the B Corporation had an adjusted basis of
$1,100,000 instead of $600,000, and that all other factors in the
example remain the same. In such case, the basis to the A Corporation of
the stock or securities in the B Corporation is $500,000, which was the
fair market value of such stock or securities at the time of their
receipt by the A Corporation, because this amount is less than the
amount established as 500,000/1,000,000ths of $1,100,000 or $550,000.
[[Page 216]]
Sec. 1.1083-1 Definitions.
(a) Order of the Securities and Exchange Commission. (1) An order of
the Securities and Exchange Commission as defined in section 1083(a)
must be issued after May 28, 1938 (the date of the enactment of the
Revenue Act of 1938 (52 Stat. 447)), and must be issued under the
authority of section 11(b) or 11(e) of the Public Utility Holding
Company Act of 1935 (15 U.S.C. 79k (b), (e)), to effectuate the
provisions of section 11(b) of such Act. In all cases the order must
become or have become final in accordance with law; i.e., it must be
valid, outstanding, and not subject to further appeal. See further
sections 1083(a) and 1081(f).
(2) Section 11 (b) of the Public Utility Holding Company Act of 1935
provides:
Sec. 11. Simplification of holding company systems.* * *
(b) It shall be the duty of the Commission, as soon as practicable
after January 1, 1938:
(1) To require by order, after notice and opportunity for hearing,
that each registered holding company, and each subsidiary company
thereof, shall take such action as the Commission shall find necessary
to limit the operations of the holding-company system of which such
company is a part to a single integrated public-utility system, and to
such other businesses as are reasonably incidental, or economically
necessary or appropriate to the operations of such integrated public-
utility system: Provided, however, That the Commission shall permit a
registered holding company to continue to control one or more additional
integrated public-utility systems, if, after notice and opportunity for
hearing, it finds that--
(A) Each of such additional systems cannot be operated as an
independent system without the loss of substantial economies which can
be secured by the retention of control by such holding company of such
system;
(B) All of such additional systems are located in one State, or in
adjoining States, or in a contiguous foreign country; and
(C) The continued combination of such systems under the control of
such holding company is not so large (considering the state of the art
and the area or region affected) as to impair the advantages of
localized management, efficient operation, or the effectiveness of
regulation.
The Commission may permit as reasonably incidental, or economically
necessary or appropriate to the operations of one or more integrated
public-utility systems the retention of an interest in any business
(other than the business of a public-utility company as such) which the
Commission shall find necessary or appropriate in the public interest or
for the protection of investors or consumers and not detrimental to the
proper functioning of such system or systems.
(2) To require by order, after notice and opportunity for hearing,
that each registered holding company, and each subsidiary company
thereof, shall take such steps as the Commission shall find necessary to
ensure that the corporate structure or continued existence of any
company in the holding-company system does not unduly or unnecessarily
complicate the structure, or unfairly or inequitably distribute voting
power among security holders, of such holding-company system. In
carrying out the provisions of this paragraph the Commission shall
require each registered holding company (and any company in the same
holding-company system with such holding company) to take such action as
the Commission shall find necessary in order that such holding company
shall cease to be a holding company with respect to each of its
subsidiary companies which itself has a subsidiary company which is a
holding company. Except for the purpose of fairly and equitably
distributing voting power among the security holders of such company,
nothing in this paragraph shall authorize the Commission to require any
change in the corporate structure or existence of any company which is
not a holding company, or of any company whose principal business is
that of a public-utility company. The Commission may by order revoke or
modify any order previously made under this subsection, if, after notice
and opportunity for hearing, it finds that the conditions upon which the
order was predicated do not exist. Any order made under this subsection
shall be subject to judicial review as provided in section 24.
(3) Section 11(e) of the Public Utility Holding Company Act of 1935
provides:
Sec. 11. Simplification of holding company systems. * * *
(e) In accordance with such rules and regulations or order as the
Commission may deem necessary or appropriate in the public interest or
for the protection of investors or consumers, any registered holding
company or any subsidiary company of a registered holding company may,
at any time after January 1, 1936, submit a plan to the Commission for
the divestment of control, securities, or other assets, or for other
action by such company or any subsidiary company thereof for the purpose
of enabling such company or any subsidiary company thereof to comply
with the provisions of subsection (b). If, after notice and opportunity
for hearing, the Commission shall find such plan, as submitted or as
modified, necessary to effectuate the provisions of subsection (b) and
fair and equitable to the persons affected by
[[Page 217]]
such plan, the Commission shall make an order approving such plan; and
the Commission, at the request of the company, may apply to a court, in
accordance with the provisions of subsection (f) of section 18, to
enforce and carry out the terms and provisions of such plan. If, upon
any such application, the court, after notice and opportunity for
hearing, shall approve such plan as fair and equitable and as
appropriate to effectuate the provisions of section 11, the court as a
court of equity may, to such extent as it deems necessary for the
purpose of carrying out the terms and provisions of such plan, take
exclusive jurisdiction and possession of the company or companies and
the assets thereof, wherever located; and the court shall have
jurisdiction to appoint a trustee, and the court may constitute and
appoint the Commission as sole trustee, to hold or administer, under the
direction of the court and in accordance with the plan theretofore
approved by the court and the Commission, the assets so possessed.
(b) Registered holding company, holding-company system, and
associate company. (1) Under section 5 of the Public Utility Holding
Company Act of 1935 (15 U.S.C. 79e), any holding company may register by
filing with the Securities and Exchange Commission a notification of
registration, in such form as the Commission may by rules and
regulations prescribe as necessary or appropriate in the public interest
or for the protection of investors or consumers. A holding company shall
be deemed to be registered upon receipt by the Securities and Exchange
Commission of such notification of registration. As used in this part,
the term registered holding company means a holding company whose
notification of registration has been so received and whose registration
is still in effect under section 5 of the Public Utility Holding Company
Act of 1935. Under section 2 (a)(7) of the Public Utility Holding
Company Act of 1935 (15 U.S.C. 79b (a)(7)), a corporation is a holding
company (unless it is declared not to be such by the Securities and
Exchange Commission), if such corporation directly or indirectly owns,
controls, or holds with power to vote 10 percent or more of the
outstanding voting securities of a public-utility company (i.e., an
electric utility company or a gas utility company as defined by such
act) or of any other holding company. A corporation is also a holding
company if the Securities and Exchange Commission determines, after
notice and opportunity for hearing, that such corporation directly or
indirectly exercises (either alone or pursuant to an arrangement or
understanding with one or more other persons) such a controlling
influence over the management or policies of any public-utility company
(i.e., an electric utility company or a gas utility company as defined
by such act) or holding company as to make it necessary or appropriate
in the public interest or for the protection of investors or consumers
that such corporation be subject to the obligations, duties, and
liabilities imposed upon holding companies by the Public Utility Holding
Company Act of 1935 (15 U.S.C. ch. 2C). An electric utility company is
defined by section 2 (a)(3) of the Public Utility Holding Company Act of
1935 (15 U.S.C. 79b (a)(3)) to mean a company which owns or operates
facilities used for the generation, transmission, or distribution of
electrical energy for sale, other than sale to tenants or employees of
the company operating such facilities for their own use and not for
resale; and a gas utility company is defined by section 2 (a)(4) of such
act (15 U.S.C. 79b (a)(4)), to mean a company which owns or operates
facilities used for the distribution at retail (other than distribution
only in enclosed portable containers, or distribution to tenants or
employees of the company operating such facilities for their own use and
not for resale) of natural or manufactured gas for heat, light, or
power. However, under certain conditions the Securities and Exchange
Commission may declare a company not to be an electric utility company
or a gas utility company, as the case may be, in which event the company
shall not be considered an electric utility company or a gas utility
company.
(2) The term holding company system has the meaning assigned to it
by section 2 (a)(9) of the Public Utility Holding Company Act of 1935
(15 U.S.C. 79b (a)(9)), and hence means any holding company, together
with all its subsidiary companies (i.e., subsidiary companies within the
meaning of section 2(a)(8) of such act (15 U.S.C. 79b (a)(8)), which in
general include all companies 10 percent of whose outstanding voting
[[Page 218]]
securities is owned directly or indirectly by such holding company) and
all mutual service companies of which such holding company or any
subsidiary company thereof is a member company. The term mutual service
company means a company approved as a mutual service company under
section 13 of the Public Utility Holding Company Act of 1935 (15 U.S.C.
79m). The term member company is defined by action 2 (a)(14) of such act
(15 U.S.C. 79b (a)(14)), to mean a company which is a member of an
association or group of companies mutually served by a mutual service
company.
(3) The term associate company has the meaning assigned to it by
section 2 (a)(10) of the Public Utility Holding Company Act of 1935 (15
U.S.C. 79b (a)(10)), and hence an associate company of a company is any
company in the same holding-company system with such company.
(c) Majority-owned subsidiary company. The term majority-owned
subsidiary company is defined in section 1083 (c). Direct ownership by a
registered holding company of more than 50 percent of the specified
stock of another corporation is not necessary to constitute such
corporation a majority-owned subsidiary company. To illustrate, if the H
Corporation, a registered holding company, owns 51 percent of the common
stock of the A Corporation and 31 percent of the common stock of the B
Corporation, and the A Corporation owns 20 percent of the common stock
of the B Corporation (the common stock in each case being the only stock
entitled to vote), both the A Corporation and the B Corporation are
majority-owned subsidiary companies.
(d) System group. The term system group is defined in section 1083
(d) to mean one or more chains of corporations connected through stock
ownership with a common parent corporation, if at least 90 percent of
each class of stock (other than (1) stock which is preferred as to both
dividends and assets, and (2) stock which is limited and preferred as to
dividends but which is not preferred as to assets but only if the total
value of such stock is less than 1 percent of the aggregate value of all
classes of stock which are not preferred as to both dividends and
assets) of each of the corporations (except the common parent
corporation) is owned directly by one or more of the other corporations,
and if the common parent corporation owns directly at least 90 percent
of each class of stock (other than stock preferred as to both dividends
and assets) of at least one of the other corporations; but no
corporation is a member of a system group unless it is either a
registered holding company or a majority-owned subsidiary company. While
the type of stock which must, for the purpose of this definition, be at
least 90 percent owned may be different from the voting stock which must
be more than 50 percent owned for the purpose of the definition of a
majority-owned subsidiary company under section 1083(c), as a general
rule both types of ownership tests must be met under section 1083(d),
since a corporation, in order to be a member of a system group, must
also be a registered holding company or a majority-owned subsidiary
company.
(e) Nonexempt property. The term nonexempt property is defined by
section 1083(e) to include--
(1) The amount of any consideration in the form of a cancellation or
assumption of debts or other liabilities of the transferor (including a
continuance of encumbrances subject to which the property was
transferred). To illustrate, if in obedience to an order of the
Securities and Exchange Commission the X Corporation, a registered
holding company, transfers property to the Y Corporation in exchange for
property (not nonexempt property) with a fair market value of $500,000,
the X Corporation receives $100,000 of nonexempt property, if for
example--
(i) The Y Corporation cancels $100,000 of indebtedness owed to it by
the X Corporation;
(ii) The Y Corporation assumes an indebtedness of $100,000 owed by
the X Corporation to another company, the A Corporation; or
(iii) The Y Corporation takes over the property conveyed to it by
the X Corporation subject to a mortgage of $100,000.
(2) Short-term obligations (including notes, drafts, bills of
exchange, and
[[Page 219]]
bankers' acceptances) having a maturity at the time of issuance of not
exceeding 24 months, exclusive of days of grace.
(3) Securities issued or guaranteed as to principal or interest by a
government or subdivision thereof (including those issued by a
corporation which is an instrumentality of a government or subdivision
thereof).
(4) Stock or securities which were acquired from a registered
holding company which acquired such stock or securities after February
28, 1938, or an associate company of a registered holding company which
acquired such stock or securities after February 28, 1938, unless such
stock or securities were acquired in obedience to an order of the
Securities and Exchange Commission (as defined in section 1083 (a)) or
were acquired with the authorization or approval of the Securities and
Exchange Commission under any section of the Public Utility Holding
Company Act of 1935, and are not nonexempt property within the meaning
of section 1083(e) (1), (2), or (3).
(5) Money, and the right to receive money not evidenced by a
security other than an obligation described as nonexempt property in
section 1083 (e) (2) or (3). The term the right to receive money
includes, among other items, accounts receivable, claims for damages,
and rights to refunds of taxes.
(f) Stock or securities. The term stock or securities is defined in
section 1083(f) for the purposes of part VI (section 1081 and
following), subchapter O, chapter 1 of the Code. As therein defined, the
term includes voting trust certificates and stock rights or warrants.
Wash Sales of Stock or Securities
Sec. 1.1091-1 Losses from wash sales of stock or securities.
(a) A taxpayer cannot deduct any loss claimed to have been sustained
from the sale or other disposition of stock or securities if, within a
period beginning 30 days before the date of such sale or disposition and
ending 30 days after such date (referred to in this section as the 61-
day period), he has acquired (by purchase or by an exchange upon which
the entire amount of gain or loss was recognized by law), or has entered
into a contract or option so to acquire, substantially identical stock
or securities. However, this prohibition does not apply (1) in the case
of a taxpayer, not a corporation, if the sale or other disposition of
stock or securities is made in connection with the taxpayer's trade or
business, or (2) in the case of a corporation, a dealer in stock or
securities, if the sale or other disposition of stock or securities is
made in the ordinary course of its business as such dealer.
(b) Where more than one loss is claimed to have been sustained
within the taxable year from the sale or other disposition of stock or
securities, the provisions of this section shall be applied to the
losses in the order in which the stock or securities the disposition of
which resulted in the respective losses were disposed of (beginning with
the earliest disposition). If the order of disposition of stock or
securities disposed of at a loss on the same day cannot be determined,
the stock or securities will be considered to have been disposed of in
the order in which they were originally acquired (beginning with the
earliest acquisition).
(c) Where the amount of stock or securities acquired within the 61-
day period is less than the amount of stock or securities sold or
otherwise disposed of, then the particular shares of stock or securities
the loss from the sale or other disposition of which is not deductible
shall be those with which the stock or securities acquired are matched
in accordance with the following rule: The stock or securities acquired
will be matched in accordance with the order of their acquisition
(beginning with the earliest acquisition) with an equal number of the
shares of stock or securities sold or otherwise disposed of.
(d) Where the amount of stock or securities acquired within the 61-
day period is not less than the amount of stock or securities sold or
otherwise disposed of, then the particular shares of stock or securities
the acquisition of which resulted in the nondeductibility of the loss
shall be those with which the stock or securities disposed of are
matched in accordance with the following rule: The stock or securities
sold or otherwise disposed of will be
[[Page 220]]
matched with an equal number of the shares of stock or securities
acquired in accordance with the order of acquisition (beginning with the
earliest acquisition) of the stock or securities acquired.
(e) The acquisition of any share of stock or any security which
results in the nondeductibility of a loss under the provisions of this
section shall be disregarded in determining the deductibility of any
other loss.
(f) The word acquired as used in this section means acquired by
purchase or by an exchange upon which the entire amount of gain or loss
was recognized by law, and comprehends cases where the taxpayer has
entered into a contract or option within the 61-day period to acquire by
purchase or by such an exchange.
(g) For purposes of determining under this section the 61-day period
applicable to a short sale of stock or securities, the principles of
paragraph (a) of Sec. 1.1233-1 for determining the consummation of a
short sale shall generally apply except that the date of entering into
the short sale shall be deemed to be the date of sale if, on the date of
entering into the short sale, the taxpayer owns (or on or before such
date has entered into a contract or option to acquire) stock or
securities identical to those sold short and subsequently delivers such
stock or securities to close the short sale.
(h) The following examples illustrate the application of this
section:
Example 1. A, whose taxable year is the calendar year, on December
1, 1954, purchased 100 shares of common stock in the M Company for
$10,000 and on December 15, 1954, purchased 100 additional shares for
$9,000. On January 3, 1955, he sold the 100 shares purchased on December
1, 1954, for $9,000. Because of the provisions of section 1091, no loss
from the sale is allowable as a deduction.
Example 2. A, whose taxable year is the calendar year, on September
21, 1954, purchased 100 shares of the common stock of the M Company for
$5,000. On December 21, 1954, he purchased 50 shares of substantially
identical stock for $2,750, and on December 27, 1954, he purchased 25
additional shares of such stock for $1,125. On January 3, 1955, he sold
for $4,000 the 100 shares purchased on September 21, 1954. There is an
indicated loss of $1,000 on the sale of the 100 shares. Since, within
the 61-day period, A purchased 75 shares of substantially identical
stock, the loss on the sale of 75 of the shares ($3,750-$3,000, or $750)
is not allowable as a deduction because of the provisions of section
1091. The loss on the sale of the remaining 25 shares ($1,250-$1,000, or
$250) is deductible subject to the limitations provided in sections 267
and 1211. The basis of the 50 shares purchased December 21, 1954, the
acquisition of which resulted in the nondeductibility of the loss ($500)
sustained on 50 of the 100 shares sold on January 3, 1955, is $2,500
(the cost of 50 of the shares sold on January 3, 1955) + $750 (the
difference between the purchase price ($2,750) of the 50 shares acquired
on December 21, 1954, and the selling price ($2,000) of 50 of the shares
sold on January 3, 1955), or $3,250. Similarly, the basis of the 25
shares purchased on December 27, 1954, the acquisition of which resulted
in the nondeductibility of the loss ($250) sustained on 25 of the shares
sold on January 3, 1955, is $1,250 + $125, or $1,375. See Sec. 1.1091-
2.
Example 3. A, whose taxable year is the calendar year, on September
15, 1954, purchased 100 shares of the stock of the M Company for $5,000.
He sold these shares on February 1, 1956, for $4,000. On each of the
four days from February 15, 1956, to February 18, 1956, inclusive, he
purchased 50 shares of substantially identical stock for $2,000. There
is an indicated loss of $1,000 from the sale of the 100 shares on
February 1, 1956, but, since within the 61-day period A purchased not
less than 100 shares of substantially identical stock, the loss is not
deductible. The particular shares of stock the purchase of which
resulted in the nondeductibility of the loss are the first 100 shares
purchased within such period, that is, the 50 shares purchased on
February 15, 1956, and the 50 shares purchased on February 16, 1956. In
determining the period for which the 50 shares purchased on February 15,
1956, and the 50 shares purchased on February 16, 1956, were held, there
is to be included the period for which the 100 shares purchased on
September 15, 1954, and sold on February 1, 1956, were held.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6926, 32 FR
11468, Aug. 9, 1967]
Sec. 1.1091-2 Basis of stock or securities acquired in ``wash sales''.
(a) In general. The application of section 1091(d) may be
illustrated by the following examples:
Example 1. A purchased a share of common stock of the X Corporation
for $100 in 1935, which he sold January 15, 1955, for $80. On February
1, 1955, he purchased a share of common stock of the same corporation
for $90. No loss from the sale is recognized under section 1091. The
basis of the new share is $110; that is, the basis of the old share
($100)
[[Page 221]]
increased by $10, the excess of the price at which the new share was
acquired ($90) over the price at which the old share was sold ($80).
Example 2. A purchased a share of common stock of the Y Corporation
for $100 in 1935, which he sold January 15, 1955, for $80. On February
1, 1955, he purchased a share of common stock of the same corporation
for $70. No loss from the sale is recognized under section 1091. The
basis of the new share is $90; that is, the basis of the old share
($100) decreased by $10, the excess of the price at which the old share
was sold ($80) over the price at which the new share was acquired ($70).
(b) Special rule. For a special rule as to the adjustment to basis
required under section 1091(d) in the case of wash sales involving
certain regulated investment company stock for which there is an average
basis, see paragraph (e)(3)(iii) (c) and (d) of Sec. 1.1012-1.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7129, 36 FR
12738, July 7, 1971]
Sec. 1.1092(b)-1T Coordination of loss deferral rules and wash sale
rules (temporary).
(a) In general. Except as otherwise provided, in the case of the
disposition of a position or positions of a straddle, the rules of
paragraph (a)(1) of this section apply before the application of the
rules of paragraph (a)(2) of this section.
(1) Any loss sustained from the disposition of shares of stock or
securities that constitute positions of a straddle shall not be taken
into account for purposes of this subtitle if, within a period beginning
30 days before the date of such disposition and ending 30 days after
such date, the taxpayer has acquired (by purchase or by an exchange on
which the entire amount of gain or loss was recognized by law), or has
entered into a contract or option so to acquire, substantially identical
stock or securities.
(2) Except as otherwise provided, if a taxpayer disposes of less
than all of the positions of a straddle, any loss sustained with respect
to the disposition of that position or positions (hereinafter referred
to as loss position) shall not be taken into account for purposes of
this subtitle to the extent that the amount of unrecognized gain as of
the close of the taxable year in one or more of the following
positions--
(i) Successor positions,
(ii) Offsetting positions to the loss position, or
(iii) Offsetting positions to any successor position,
exceeds the amount of loss disallowed under paragraph (a)(1) of this
section. See Sec. 1.1092(b)-5T relating to definitions.
(b) Carryover of disallowed loss. Any loss that is disallowed under
paragraph (a) of this section shall, subject to any further application
of paragraph (a)(1) of this section and the limitations under paragraph
(a)(2) of this section, be treated as sustained in the succeeding
taxable year. However, a loss disallowed in Year 1, for example, under
paragraph (a)(1) of this section will not be allowed in Year 2 unless
the substantially identical stock or securities, the acquisition of
which caused the loss to be disallowed in Year 1, are disposed of during
Year 2 and paragraphs (a)(1) and (a)(2) of this section do not apply in
Year 2 to disallow the loss.
(c) Treatment of disallowed loss--(1) Character. If the disposition
of a loss position would (but for the application of this section)
result in a capital loss, the loss allowed under paragraph (b) of this
section with respect to the disposition of the loss position shall be
treated as a capital loss. In any other case, a loss allowed under
paragraph (b) of this section shall be treated as an ordinary loss. For
example, if the disposition of a loss position would, but for the
application of paragraph (a) of this section, give rise to a capital
loss, that loss when allowed pursuant to paragraph (b) of this section
will be treated as a capital loss on the date the loss is allowed
regardless of whether any gain or loss with respect to one or more
successor positions would be treated as ordinary income or loss.
(2) Section 1256 contracts. If the disposition of a loss position
would (but for the application of this section) result in 60 percent
long-term capital loss and 40 percent short-term capital loss, the loss
allowed under paragraph (b) of this section with respect to the
disposition of the loss position shall be treated as 60 percent long-
term capital
[[Page 222]]
loss and 40 percent short-term capital loss regardless of whether any
gain or loss with respect to one or more successor positions would be
treated as 100 percent long-term or short-term capital gain or loss.
(d) Exceptions. (1) This section shall not apply to losses
sustained--
(i) With respect to the disposition of one or more positions that
constitute part of a hedging transaction;
(ii) With respect to the disposition of a loss position included in
a mixed straddle account (as defined in paragraph (b) of Sec.
1.1092(b)-4T); and
(iii) With respect to the disposition of a position that is part of
a straddle consisting only of section 1256 contracts.
(2) Paragraph (a)(1) of this section shall not apply to losses
sustained by a dealer in stock or securities if such losses are
sustained in a transaction made in the ordinary course of such business.
(e) Coordination with section 1091. Section 1092(b) applies in lieu
of section 1091 to losses sustained from the disposition of positions in
a straddle. See example (18) of paragraph (g) of this section.
(f) Effective date. The provisions of this section apply to
dispositions of loss positions on or after January 24, 1985.
(g) Examples. This section may be illustrated by the following
examples. It is assumed in each example that the following positions are
the only positions held directly or indirectly (through a related person
or flowthrough entity) by an individual calendar year taxpayer during
the taxable year and none of the exceptions contained in paragraph (d)
of this section apply.
Example 1. On December 1, 1985, A enters into offsetting long and
short positions. On December 10, 1985, A disposes of the short position
at an $11 loss, at which time there is $5 of unrealized gain in the
offsetting long position. At year-end there is still $5 of unrecognized
gain in the offsetting long position. Under these circumstances, $5 of
the $11 loss will be disallowed for 1985 because there is $5 of
unrecognized gain in the offsetting long position; the remaining $6 of
loss, however, will be taken into account in 1985.
Example 2. Assume the facts are the same as in example (1), except
that at year-end there is $11 of unrecognized gain in the offsetting
long position. Under these circumstances, the entire $11 loss will be
disallowed for 1985 because there is $11 of unrecognized gain at year-
end in the offsetting long position.
Example 3. Assume the facts are the same as in example (1), except
that at year-end there is no unrecognized gain in the offsetting long
position. Under these circumstances, the entire $11 loss will be allowed
for 1985.
Example 4. On November 1, 1985, A enters into offsetting long and
short positions. On November 10, 1985, A disposes of the long position
at a $10 loss, at which time there is $10 of unrealized gain in the
short position. On November 11, 1985, A enters into a new long position
(successor position) that is offsetting with respect to the retained
short position but is not substantially identical to the long position
disposed of on November 10, 1985. A holds both positions through year-
end, at which time there is $10 of unrecognized gain in the successor
long position and no unrecognized gain in the offsetting short position.
Under these circumstances, the entire $10 loss will be disallowed for
1985 because there is $10 of unrecognized gain in the successor long
position.
Example 5. Assume the facts are the same as in example (4), except
that at year-end there is $4 of unrecognized gain in the successor long
position and $6 of unrecognized gain in the offsetting short position.
Under these circumstances, the entire $10 loss will be disallowed for
1985 because there is a total of $10 of unrecognized gain in both the
successor long position and offsetting short position.
Example 6. Assume the facts are the same as in example (4), except
that at year-end A disposes of the offsetting short position at a $2
loss. Under these circumstances, $10 of the total $12 loss will be
disallowed because there is $10 of unrecognized gain in the successor
long position.
Example 7. Assume the facts are the same as in example (4), and on
January 10, 1986, A disposes of the successor long position at no gain
or loss. A holds the offsetting short position until year-end, at which
time there is $10 of unrecognized gain. Under these circumstances, the
$10 loss will be disallowed for 1986 because there is $10 of
unrecognized gain in an offsetting position at year-end.
Example 8. Assume the facts are the same as in example (4), except
at year-end there is $8 of unrecognized gain in the successor long
position and $8 of unrecognized loss in the offsetting short position.
Under these circumstances, $8 of the total $10 realized loss will be
disallowed because there is $8 of unrecognized gain in the successor
long position.
Example 9. On October 1, 1985, A enters into offsetting long and
short positions. Neither
[[Page 223]]
the long nor the short position is stock or securities. On October 2,
1985, A disposes of the short position at a $10 loss and the long
position at a $10 gain. On October 3, 1985, A enters into a long
position identical to the original long position. At year-end there is
$10 of unrecognized gain in the second long position. Under these
circumstances, the $10 loss is allowed because the second long position
is not a successor position or offsetting position to the short loss
position.
Example 10. On November 1, 1985, A enters into offsetting long and
short positions. On November 10, 1985, there is $20 of unrealized gain
in the long position and A disposes of the short position at a $20 loss.
By November 15, 1985, the value of the long position has declined
eliminating all unrealized gain in the position. On November 15, 1985, A
establishes a second short position (successor position) that is
offsetting with respect to the long position but is not substantially
identical to the short position disposed of on November 10, 1985. At
year-end there is no unrecognized gain in the offsetting long position
or in the successor short position. Under these circumstances, the $20
loss sustained with respect to the short loss position will be allowed
for 1985 because at year-end there is no unrecognized gain in the
successor short position or the offsetting long position.
Example 11. Assume the facts are the same as in example (10), except
that the second short position was established on November 8, 1985, and
there is $20 of unrecognized gain in the second short position at year-
end. Since the second short position was entered into within 30 days
before the disposition of the loss position, the second short position
is considered a successor position to the loss position. Under these
circumstances, the $20 loss will be disallowed because there is $20 of
unrecognized gain in a successor position.
Example 12. Assume the facts are the same as in example (10), except
that at year-end there is $18 of unrecognized gain in the offsetting
long position and $18 of unrecognized gain in the successor short
position. Under these circumstances, the entire loss will be disallowed
because there is more than $20 of unrecognized gain in both the
successor short position and offsetting long position.
Example 13. Assume the facts are the same as in example (10), except
that there is $20 of unrecognized gain in the successor short position
and no unrecognized gain in the offsetting long position at year-end.
Under these circumstances, the entire $20 loss will be disallowed
because there is $20 of unrecognized gain in the successor short
position.
Example 14. On January 2, 1986, A enters into offsetting long and
short positions. Neither the long nor the short position is stock or
securities. On March 3, 1986, A disposes of the long position at a $10
gain. On March 10, 1986, A disposes of the short position at a $10 loss.
On March 14, 1986, A enters into a new short position. On April 10,
1986, A enters into an offsetting long position. A holds both positions
to year-end, at which time there is $10 of unrecognized gain in the
offsetting long position and no unrecognized gain or loss in the short
position. Under these circumstances, the $10 loss will be allowed
because (1) the rules of paragraph (a)(1) of this section are not
applicable; and (2) the rules of paragraph (a)(2) of this section do not
apply, since all positions of the straddle that contained the loss
position were disposed of.
Example 15. On December 1, 1985, A enters into offsetting long and
short positions. On December 4, 1985, A disposes of the short position
at a $10 loss. On December 5, 1985, A establishes a new short position
that is offsetting to the long position, but is not substantially
identical to the short position disposed of on December 4, 1985. On
December 6, 1985, A disposes of the long position at a $10 gain. On
December 7, 1985, A enters into a second long position that is
offsetting to the new short position, but is not substantially identical
to the long position disposed of on December 6, 1985. A holds both
positions to year-end at which time there is no unrecognized gain in the
second short position and $10 of unrecognized gain in the offsetting
long position. Under these circumstances, the entire $10 loss will be
disallowed for the 1985 taxable year because the second long position is
an offsetting position with respect to the second short position which
is a successor position.
Example 16. On September 1, 1985, A enters into offsetting positions
consisting of a long section 1256 contract and short non-section 1256
position. No elections under sections 1256(d)(1) or 1092(b)(2)(A),
relating to mixed straddles, are made. On November 1, 1985, at which
time there is $20 of unrecognized gain in the short non-section 1256
position, A disposes of the long section 1256 contract at a $20 loss and
on the same day acquires a long non-section 1256 position (successor
position) that is offsetting with respect to the short non-section 1256
position. But for the application of this section, A's disposition of
the section 1256 contract would give rise to a capital loss. At year-end
there is a $20 of unrecognized gain in the offsetting short non-section
1256 position and no unrecognized gain in the successor long position.
Under these circumstances, the entire $20 loss will be disallowed for
1985 because there is $20 unrecognized gain in the offsetting short
position. In 1986, A disposes of the successor long non-section 1256
position and there is no unrecognized gain at year-end in the offsetting
short position. Under these circumstances, the $20 loss disallowed in
1985 with respect to the section 1256 contract will be treated in 1986
as 60 percent long-term capital loss and 40 percent short-term capital
loss.
Example 17. On January 2, 1986, A, not a dealer in stock or
securities, acquires stock
[[Page 224]]
in X Corporation (X stock) and an offsetting put option. On March 3,
1986, A disposes of the X stock at a $10 loss. On March 10, 1986, A
disposes of the put option at a $10 gain. On March 14, 1986, A acquires
new X stock that is substantially identical to the X stock disposed of
on March 3, 1986. A holds the X stock to year-end. Under these
circumstances, the $10 loss will be disallowed for 1986 under paragraph
(a)(1) of this section because A, within a period beginning 30 days
before March 3, 1986 and ending 30 days after such date, acquired stock
substantially identical to the X stock disposed of.
Example 18. On June 2, 1986, A, not a dealer in stock or securities,
acquires stock in X Corporation (X stock). On September 2, 1986, A
disposes of the X stock at a $100 loss. On September 15, 1986, A
acquires new X stock that is substantially identical to the X stock
disposed of on September 2, 1986, and an offsetting put option. A holds
these straddle positions to year-end. Under these circumstances, section
1091, rather than section 1092(b), will apply to disallow the $100 loss
for 1986 because the loss was not sustained from the disposition of a
position that was part of a straddle. See paragraph (e) of this section.
Example 19. On November 1, 1985, A, not a dealer in stock or
securities, acquires stock in Y Corporation (Y stock) and an offsetting
put option. On November 12, 1985, there is $20 of unrealized gain in the
put option and A disposes of the Y stock at a $20 loss. By November 15,
1985, the value of the put option has declined eliminating all
unrealized gain in the position. On November 15, 1985, A acquires a
second Y stock position that is substantially identical to the Y stock
disposed of on November 12, 1985. At year-end there is no unrecognized
gain in the put option or the Y stock. Under these circumstances, the
$20 loss will be disallowed for 1985 under paragraph (a)(1) of this
section because A, within a period beginning 30 days before November 12,
1985 and ending 30 days after such date, acquired stock substantially
identical to the Y stock disposed of.
Example 20. Assume the facts are the same as in Example 19 and that
on December 31, 1986, A disposes of the put option at a $40 gain and
there is $20 of unrecognized loss in the Y stock. Under these
circumstances, the $20 loss which was disallowed in 1985 also will be
disallowed for 1986 under the rules of paragraph (a)(1) of this section
because A has not disposed of the stock substantially identical to the Y
stock disposed of on November 12, 1985.
Example 21. Assume the facts are the same as in example (19), except
that on December 31, 1986, A disposes of the Y stock at a $20 loss and
there is $40 of unrecognized gain in the put option. Under these
circumstances, A will not recognize in 1986 either the $20 loss
disallowed in 1985 or the $20 loss sustained with respect to the
December 31, 1986 disposition of Y stock. Paragraph (a)(1) of this
section does not apply to disallow the losses in 1986 since the
substantially identical Y stock was disposed of during the year (and no
substantially identical stock or securities was acquired by A within the
61 day period). However, paragraph (a)(2) of this section applies to
disallow for 1986 the $40 of losses sustained with respect to the
dispositions of positions in the straddle because there is $40 of
unrecognized gain in the put option, an offsetting position to the loss
positions.
Example 22. On January 2, 1986, A, not a dealer in stock or
securities, acquires stock in X Corporation (X stock) and an offsetting
put option. On March 3, 1986, A disposes of the X stock at a $10 loss.
On March 17, 1986, A acquires new X stock that is substantially
identical to the X stock disposed of on March 3, 1986. On December 31,
1986, A disposes of the X stock at a $5 gain, at which time there is $5
of unrecognized gain in the put option. Under these circumstances, the
$10 loss sustained with respect to the March 3, 1986, disposition of X
stock will be allowed under paragraph (a) (1) of this section since the
substantially identical X stock acquired on March 17, 1986, was disposed
of by year-end (and no substantially identical stock or securities were
acquired by A within the 61 day period). However, $5 of the $10 loss
will be disallowed under paragraph (a)(2) of this section because there
is $5 of unrecognized gain in the put option, an offsetting position to
the loss position.
Example 23. Assume the facts are the same as in example (22), except
that on December 31, 1986, A disposes of the offsetting put option at a
$5 loss and there is $5 of unrecognized gain in the X stock acquired on
March 17, 1986. Under these circumstances, the $10 loss sustained with
respect to the X stock disposed of on March 3, 1986, will be disallowed
for 1986 under paragraph (a)(1) of this section. The $5 loss sustained
upon the disposition of the put option will be allowed because (1) the
rules of paragraph (a)(1) of this section are not applicable; and (2)
the rules of paragraph (a)(2) of this section allow the loss, since the
unrecognized gain in the X stock ($5) is not in excess of the loss ($10)
disallowed under paragraph (a)(1) of this section.
Example 24. On January 2, 1986, A, not a dealer in stock or
securities, acquires 200 shares of Z Corporation stock (Z stock) and 2
put options on Z stock (giving A the right to sell 200 shares of Z
stock). On September 2, 1986, there is $200 of unrealized gain in the
put option positions and A disposes of the 200 shares of Z stock at a
$200 loss. On September 10, 1986, A acquires 100 shares of Z stock
(substantially identical to the Z stock disposed of on September 2,
1986), and a call option that is offsetting to the put options
[[Page 225]]
on Z stock and that is not an option to acquire property substantially
identical to the Z stock disposed of on September 2, 1986. At year-end,
there is $80 of unrecognized gain in the Z stock position, $80 of
unrecognized gain in the call option position, and no unrecognized gain
or loss in the offsetting put option positions. Under these
circumstances, $40 of the $200 loss sustained with respect to the
September 2, 1986 disposition of Z stock will be recognized by A in 1986
under paragraph (a) of this section, as set forth below. Paragraph
(a)(1) of this section applies first to disallow $100 of the loss (\1/2\
of the loss), since 100 shares of substantially identical Z stock (\1/2\
of the stock) were acquired within the 61 day period. Paragraph (a)(2)
of this section then applies to disallow that portion of the loss
allowed under paragraph (a)(1) of this section ($200-$100 = $100) equal
to the excess of the total unrecognized gain in the Z stock and call
option positions (successor positions to the loss position) ($80 + $80 =
$160) over the $100 loss disallowed under paragraph (a)(1) of this
section ($160-$100 = $60; $100-$60 = $40).
Example 25. Assume the facts are the same as in example (24), except
that at year-end there is $110 of unrecognized gain in the Z stock
position, $78 of unrecognized gain in the call option position, and $10
of unrecognized gain in the offsetting put option positions. Under these
circumstances, $2 of the $200 loss sustained with respect to the
September 2, 1986 disposition of Z stock will be allowed in 1986 under
paragraph (a) of this section, as set forth below. Paragraph (a)(1) of
this section applies first to disallow $100 of the loss (\1/2\ of the
loss) since 100 shares of substantially identical Z stock (\1/2\ of the
stock) were acquired within the 61 day period. Paragraph (a)(2) of this
section then applies to disallow that portion of the loss allowed under
paragraph (a)(1) of this section ($200-$100 = $100) equal to the excess
of the total unrecognized gain in the Z stock and call option positions
(successor positions to the loss position) and the put option positions
(offsetting positions to the loss position) ($110 + $78 + $10 = $198)
over the $100 loss disallowed under paragraph (a)(1) of this section
($198-$100 = $98; $100-$98 = $2).
Example 26. Assume the facts are the same as in example (24), except
that at year-end there is $120 of unrecognized gain in the Z stock
position, $88 of unrecognized gain in the call option position, and $10
of unrecognized loss in one of the offsetting put option positions. At
year-end A disposes of the other put option position at a $10 loss.
Under these circumstances, $2 of the $210 loss sustained with respect to
the September 2, 1986 disposition of Z stock ($200) and the year-end
disposition of a put option ($10) will be allowed in 1986 under
paragraph (a) of this section, as set forth below. Paragraph (a)(1) of
this section applies first to disallow $100 of the loss from the
disposition of Z stock (\1/2\ of the loss), since 100 shares of
substantially identical Z stock (\1/2\ of the stock) were acquired
within the 61 day period. Paragraph (a)(2) of this section then applies
to disallow that portion of the loss allowed under paragraph (a)(1) of
this section ($210-$100 = $110) equal to the excess of the total
unrecognized gain in the Z stock and call option positions (successor
positions to the Z stock loss position, and offsetting positions to the
put option loss position) ($120 + $88 = $208) over the $100 loss
disallowed under paragraph (a)(1) of this section ($208-$100 = $108;
$110-$108 = $2).
Example 27. On January 27, 1986, A enters into offsetting long (L1)
and short (S1) positions. Neither L1 nor S1 nor any other positions
entered into by A in 1986 are stock or securities. On February 3, 1986,
A disposes of L1 at a $10 loss. On February 5, 1986, A enters into a new
long position (L2) that is offsetting to S1. On October 15, 1986, A
disposes of S1 at an $11 loss. On October 17, 1986, A enters into a new
short position (S2) that is offsetting to L2. On December 30, 1986, A
disposes of L2 at a $12 loss. On December 31, 1986, A enters into a new
long position (L3) that is offsetting to S2. At year-end, S2 has an
unrecognized gain of $33. Paragraph (a)(1) of this section does not
apply since none of the positions were shares of stock or securities.
However, all $33 ($10 + $11 + $12) of the losses sustained with respect
to L1, S1 and L2 will be disallowed under paragraph (a)(2) because there
is $33 of unrecognized gain in S2 at year-end. The $10 loss from the
disposition of L1 is disallowed because S2 is or was an offsetting
position to a successor long position (L2 or L3). The $11 loss from the
disposition of S1 is disallowed because S2 is a successor position to
S1. The $12 loss from the disposition of L2 is disallowed because S2 was
an offsetting position to L2.
(Secs. 1092(b) and 7805 of the Internal Revenue Code of 1954 (68A Stat.
917, 95 Stat. 324, 26 U.S.C. 1092(b), 7805) and sec. 102(h) of the Tax
Reform Act of 1984 (98 Stat. 625))
[T.D. 8007, 50 FR 3319, Jan. 24, 1985, as amended by T.D. 8070, 51 FR
1786, Jan. 15, 1986; 51 FR 3773, Jan. 30, 1986; 51 FR 5516, Feb. 14,
1986]
Sec. 1.1092(b)-2T Treatment of holding periods and losses with
respect to straddle positions (temporary).
(a) Holding period--(1) In general. Except as otherwise provided in
this section, the holding period of any position that is part of a
straddle shall not begin earlier than the date the taxpayer no longer
holds directly or indirectly (through a related person or
[[Page 226]]
flowthrough entity) an offsetting position with respect to that
position. See Sec. 1.1092(b)-5T relating to definitions.
(2) Positions held for the long-term capital gain holding period (or
longer) prior to establishment of the straddle. Paragraph (a)(1) of this
section shall not apply to a position held by a taxpayer for the long-
term capital gain holding period (or longer) before a straddle that
includes such position is established. The determination of whether a
position has been held by a taxpayer for the long-term capital gain
holding period (or longer) shall be made by taking into account the
application of paragraph (a)(1) of this section. See section 1222(3)
relating to the holding period for long-term capital gains.
(b) Treatment of loss--(1) In general. Except as provided in
paragraph (b)(2) of this section, loss on the disposition of one or more
positions (loss position) of a straddle shall be treated as a long-term
capital loss if--
(i) On the date the taxpayer entered into the loss position the
taxpayer held directly or indirectly (through a related person or
flowthrough entity) one or more offsetting positions with respect to the
loss position; and
(ii) All gain or loss with respect to one or more positions in the
straddle would be treated as long-term capital gain or loss if such
positions were disposed of on the day the loss position was entered
into.
(2) Special rules for non-section 1256 positions in a mixed
straddle. Loss on the disposition of one or more positions (loss
position) that are part of a mixed straddle and that are non-section
1256 positions shall be treated as 60 percent long-term capital loss and
40 percent short-term capital loss if--
(i) Gain or loss from the disposition of one or more of the
positions of the straddle that are section 1256 contracts would be
considered gain or loss from the sale or exchange of a capital asset;
(ii) The disposition of no position in the straddle (other than a
section 1256 contract) would result in a long-term capital gain or loss;
and
(iii) An election under section 1092(b)(2)(A)(i)(I) (relating to
straddle-by-straddle identification) or 1092(b)(2)(A)(i)(II) (relating
to mixed straddle accounts) has not been made.
(c) Exceptions--(1) In general. This section shall not apply to
positions that--
(i) Constitute part of a hedging transaction;
(ii) Are included in a straddle consisting only of section 1256
contracts; or
(iii) Are included in a mixed straddle account (as defined in
paragraph (b) of Sec. 1.1092(b)-4T).
(2) Straddle-by-straddle identification. Paragraphs (a)(2) and (b)
of this section shall not apply to positions in a section 1092(b)(2)
identified mixed straddle. See Sec. 1.1092(b)-3T.
(d) Special rule for positions held by regulated investment
companies. For purposes of section 851(b)(3) (relating to the definition
of a regulated investment company), the holding period rule of paragraph
(a) of this section shall not apply to positions of a straddle. However,
if section 1233(b) (without regard to sections 1233(e)(2)(A) and
1092(b)) would have applied to such positions, then for purposes of
section 851(b)(3) the rules of section 1233(b) shall apply. Similarly,
the effect of daily marking-to-market provided under Sec. 1.1092(b)-
4T(c) will be disregarded for purposes of section 851(b)(3).
(e) Effective date--(1) In general. Except as provided in paragraph
(e)(2) of this section, the provisions of this section apply to
positions in a straddle established after June 23, 1981, in taxable
years ending after such date.
(2) Special effective date for mixed straddle positions. The
provisions of paragraph (b)(2) of this section shall apply to positions
in a mixed straddle established on or after January 1, 1984.
(f) Examples. Paragraphs (a) through (e) may be illustrated by the
following examples. It is assumed in each example that the following
positions are the only positions held directly or indirectly (through a
related person or flowthrough entity) by an individual calendar year
taxpayer during the taxable year and none of the exceptions in paragraph
(c) of this section apply.
Example 1. On October 1, 1984, A acquires gold. On January 1, 1985,
A enters into an offsetting short gold forward contract. On April 1,
1985, A disposes of the short gold forward contract at no gain or loss.
On April 10, 1985,
[[Page 227]]
A sells the gold at a gain. Since the gold had not been held for more
than 6 months before the offsetting short position was entered into, the
holding period for the gold begins no earlier than the time the straddle
is terminated. Thus, the holding period of the original gold purchased
on October 1, 1984, and sold on April 10, 1985, begins on April 1, 1985,
the date the straddle was terminated. Consequently, gain recognized with
respect to the gold will be treated as short-term capital gain.
Example 2. On January 1, 1985, A enters into a long gold forward
contract. On May 1, 1985, A enters into an offsetting short gold
regulated futures contract. A does not make an election under section
1256(d) or 1092(b)(2)(A). On August 1, 1985, A disposes of the gold
forward contract at a gain. Since the forward contract had not been held
by A for more than 6 months prior to the establishment of the straddle,
the holding period for the forward contract begins no earlier than the
time the straddle is terminated. Thus, the gain recognized on the
closing of the gold forward contract will be treated as short-term
capital gain.
Example 3. Assume the facts are the same as in example (2), except
that A disposes of the short gold regulated futures contract on July 1,
1985, at no gain or loss and the forward contract on November 1, 1985.
Since the forward contract had not been held for more than 6 months
before the mixed straddle was established, the holding period for the
forward contract begins July 1, 1985, the date the straddle terminated.
Thus, the gain recognized on the closing of the forward contract will be
treated as short-term capital gain.
Example 4. On January 1, 1985, A enters into a long gold forward
contract and on August 4, 1985, A enters into an offsetting short gold
forward contract. On September 1, 1985, A disposes of the short position
at a loss. Since an offsetting long position had been held by A for more
than 6 months prior to the acquisition of the offsetting short position,
the loss with respect to the closing of the short position will be
treated as long-term capital loss.
Example 5. On March 1, 1985, A enters into a long gold forward
contract and on July 17, 1985, A enters into an offsetting short gold
regulated futures contract. A does not make an election under section
1256(d) or 1092(b)(2)(A). On August 10, 1985, A disposes of the long
gold forward contract at a loss. Since the gold forward contract was
part of a mixed straddle, and the disposition of no position in the
straddle (other than the regulated futures contract) would give rise to
a long-term capital loss, the loss recognized on the termination of the
gold forward contract will be treated as 40 percent short-term capital
loss and 60 percent long-term capital loss.
Example 6. Assume the facts are the same as in example (5), except
that on August 11, 1985, A disposes of the short gold regulated futures
contract at a gain. Under these circumstances, the gain will be treated
as 60 percent long-term capital gain and 40 percent short-term capital
gain since the holding period rules of paragraph (a) of this section are
not applicable to section 1256 contracts.
Example 7. Assume the facts are the same as in example (5), except
that A enters into the long gold forward contract on January 1, 1985,
and does not dispose of the long gold forward contract but instead on
August 10, 1985, disposes of the short gold regulated futures contract
at a loss. Under these circumstances, the loss will be treated as a
long-term capital loss since A held an offsetting non-section 1256
position for more than 6 months prior to the establishment of the
straddle. However, such loss may be subject to the rules of Sec.
1.1092(b)-1T.
(Secs. 1092(b) and 7805 of the Internal Revenue Code of 1954 (68A Stat.
917, 95 Stat. 324, 26 U.S.C. 1092(b), 7805) and sec. 102(h) of the Tax
Reform Act of 1984 (98 Stat. 625))
[T.D. 8007, 50 FR 3320, Jan. 24, 1985, as amended by T.D. 8070, 51 FR
1788, Jan. 15, 1986]
Sec. 1.1092(b)-3T Mixed straddles; straddle-by-straddle identification
under section 1092(b)(2)(A)(i)(I) (Temporary).
(a) In general. Except as otherwise provided, a taxpayer shall treat
in accordance with paragraph (b) of this section gains and losses on
positions that are part of a mixed straddle for which the taxpayer has
made an election under paragraph (d) of this section (hereinafter
referred to as a section 1092(b)(2) identified mixed straddle). No
election may be made under this section for any straddle composed of one
or more positions that are includible in a mixed straddle account (as
defined in paragraph (b) of Sec. 1.1092(b)-4T) or for any straddle for
which an election under section 1256(d) has been made. See Sec.
1.1092(b)-5T relating to definitions.
(b) Treatment of gains and losses from positions included in a
section 1092(b)(2) identified mixed straddle--(1) In general. Gains and
losses from positions that are part of a section 1092(b)(2) identified
mixed straddle shall be determined and treated in accordance with the
rules of paragraph (b) (2) through (7) of this section.
[[Page 228]]
(2) All positions of a section 1092(b)(2) identified mixed straddle
are disposed of on the same day. If all positions of a section
1092(b)(2) identified mixed straddle are disposed of (or deemed disposed
of) on the same say, gains and losses from section 1256 contracts in the
straddle shall be netted, and gains and losses from non-section 1256
positions in the straddle shall be netted. Net gain or loss from the
section 1256 contracts shall then be offset against net gain or loss
from the non-section 1256 positions to determine the net gain or loss
from the straddle. If net gain or loss from the straddle is attributable
to the positions of the straddle that are section 1256 contracts, such
gain or loss shall be treated as 60 percent long-term capital gain or
loss and 40 percent short-term capital gain or loss. If net gain or loss
from the straddle is attributable to the positions of the straddle that
are non-section 1256 positions, such gain or loss shall be treated as
short-term capital gain or loss. This paragraph (b)(2) may be
illustrated by the following examples. It is assumed in each example
that the positions are the only positions held directly or indirectly
(through a related person or flowthrough entity) by an individual
calendar year taxpayer during the taxable year.
Example 1. On April 1, 1985, A enters into a non-section 1256
position and an offsetting section 1256 contract and makes a valid
election to treat such straddle as a section 1092(b)(2) identified mixed
straddle. On April 10, 1985, A disposes of the non-section 1256 position
at a $600 loss and the section 1256 contract at a $600 gain. Under these
circumstances, the $600 loss on the non-section 1256 position will be
offset against the $600 gain on the section 1256 contract and the net
gain or loss from the straddle will be zero.
Example 2. Assume the facts are the same as in example (1), except
that the gain on the section 1256 contract is $800. Under these
circumstances, the $600 loss on the non-section 1256 position will be
offset against the $800 gain on the section 1256 contract. The net gain
of $200 from the straddle will be treated as 60 percent long-term
capital gain and 40 percent short-term capital gain because it is
attributable to the section 1256 contract.
Example 3. Assume the facts are the same as in example (1), except
that the loss on the non-section 1256 position is $800. Under these
circumstances, the $600 gain on the section 1256 contract will be offset
against the $800 loss on the non-section 1256 position. The net loss of
$200 from the straddle will be treated as short-term capital loss
because it is attributable to the non-section 1256 position.
Example 4. On May 1, 1985, A enters into a straddle consisting of
two non-section 1256 positions and two section 1256 contracts and makes
a valid election to treat the straddle as a section 1092(b)(2)
identified mixed straddle. On May 10, 1985, A disposes of the non-
section 1256 positions, one at a $700 loss and the other at a $500 gain,
and disposes of the section 1256 contracts, one at a $400 gain and the
other at a $300 loss. Under these circumstances, the gain and losses
from the section 1256 contracts and non-section 1256 positions will
first be netted, resulting in a net gain of $100 ($400-$300) on the
section 1256 contracts and a net loss of $200 ($700-$500) on the non-
section 1256 positions. The net gain of $100 from the section 1256
contracts will then be offset against the $200 net loss on the non-
section 1256 positions. The net loss of $100 from the straddle will be
treated as short-term capital loss because it is attributable to the
non-section 1256 positions.
Example 5. On December 30, 1985, A enters into a section 1256
contract and an offsetting non-section 1256 position and makes a valid
election to treat such straddle as a section 1092(b)(2) identified mixed
straddle. On December 31, 1985, A disposes of the non-section 1256
position at a $2,000 gain. A also realizes a $2,000 loss on the section
1256 contract because it is deemed disposed of under section 1256(a)(1).
Under these circumstances, the $2,000 gain on the non-section 1256
position will be offset against the $2,000 loss on the section 1256
contract, and the net gain or loss from the straddle will be zero.
Example 6. Assume the facts are the same as in example (5), except
that the section 1092(b)(2) identified mixed straddle was entered into
on November 12, 1985, A realizes a $2,200 loss on the section 1256
contract, and on December 15, 1985, A enters into a non-section 1256
position that is offsetting to the non-section 1256 gain position of the
section 1092(b)(2) identified mixed straddle. At year-end there is $200
of unrecognized gain in the non-section 1256 position that was entered
into on December 15. Under these circumstances, the $2,200 loss on the
section 1256 contract will be offset against the $2,000 gain on the non-
section 1256 position. The net $200 loss from the straddle will be
treated as 60 percent long-term capital loss and 40 percent short-term
capital loss because it is attributable to the section 1256 contract.
The net loss of $200 from the straddle will be disallowed in 1985 under
the loss deferral rules of section 1092(a) because there is $200 of
unrecognized gain in a successor position (as defined in paragraph (n)
of Sec. 1.1092(b)-5T) at year-end. See paragraph (c) of this section.
(3) All of the non-section 1256 positions of a section 1092(b)(2)
identified mixed
[[Page 229]]
straddle disposed of on the same day. This paragraph (b)(3) applies if
all of the non-section 1256 positions of a section 1092(b)(2) identified
mixed straddle are disposed of on the same day or if this paragraph
(b)(3) is made applicable by paragraph (b)(5) of this section. In the
case to which this paragraph (b)(3) applies, gain and loss realized from
non-section 1256 positions shall be netted. Realized and unrealized gain
and loss with respect to the section 1256 contracts of the straddle also
shall be netted on that day. Realized net gain or loss from the non-
section 1256 positions shall then be offset against net gain or loss
from the section 1256 contracts to determine the net gain or loss from
the straddle on that day. Net gain or loss from the straddle that is
attributable to the non-section 1256 positions shall be realized and
treated as short-term capital gain or loss on that day. Net gain or loss
from the straddle that is attributable to realized gain or loss with
respect to section 1256 contracts shall be realized and treated as 60
percent long-term capital gain or loss and 40 percent short-term capital
gain or loss. Any gain or loss subsequently realized on the section 1256
contracts shall be adjusted (through an adjustment to basis or
otherwise) to take into account the extent to which gain or loss was
offset by unrealized gain or loss on the section 1256 contracts on that
day. This paragraph (b)(3) may be illustrated by the following examples.
It is assumed in each example that the positions are the only positions
held directly or indirectly (through a related person or flowthrough
entity) by an individual calendar year taxpayer during the taxable year.
Example 1. On July 20, 1985, A enters into a section 1256 contract
and an offsetting non-section 1256 position and makes a valid election
to treat such straddle as a section 1092(b)(2) identified mixed
straddle. On July 27, 1985, A disposes of the non-section 1256 position
at a $1,500 loss, at which time there is $1,500 of unrealized gain in
the section 1256 contract. A holds the section 1256 contract at year-end
at which time there is $1,800 of gain. Under these circumstances, on
July 27, 1985, A offsets the $1,500 loss on the non-section 1256
position against the $1,500 gain on the section 1256 contract and
realizes no gain or loss. On December 31, 1985, A realizes a $300 gain
on the section 1256 contract because the position is deemed disposed of
under section 1256(a)(1). The $300 gain is equal to $1,800 of gain less
a $1,500 adjustment for unrealized gain offset against the loss realized
on the non-section 1256 position on July 27, 1985, and the gain will be
treated as 60 percent long-term capital gain and 40 percent short-term
capital gain.
Example 2. Assume the facts are the same as in example (1), except
that on July 27, 1985, A realized a $1,700 loss on the non-section 1256
position. Under these circumstances, on July 27, 1985, A offsets the
$1,700 loss on the non-section 1256 position against the $1,500 gain on
the section 1256 contract. A realizes a $200 loss from the straddle on
July 27, 1985, which will be treated as short-term capital loss because
it is attributable to the non-section 1256 position. On December 31,
1985, A realizes a $300 gain on the section 1256 contract, computed as
in example (1), which will be treated as 60 percent long-term capital
gain and 40 percent short-term capital gain.
Example 3. On March 1, 1985, A enters into a straddle consisting of
two non-section 1256 positions and two section 1256 contracts and makes
a valid election to treat such straddle as a section 1092(b)(2)
identified mixed straddle. On March 11, 1985, A disposes of the non-
section 1256 positions, one at a $100 loss and the other at a $150 loss,
and disposes of one section 1256 contract at a $100 loss. On that day
there is $100 of unrealized gain on the section 1256 contract retained
by A. A holds the remaining section 1256 contract at year-end, at which
time there is $150 of gain. Under these circumstances, on March 11,
1985, A will first net the gains and losses from the section 1256
contracts and net the gains and losses from the non-section 1256
positions resulting in no gain or loss on the section 1256 contracts and
a net loss of $250 on the non-section 1256 positions. Since there is no
gain or loss to offset against the non-section 1256 positions, the net
loss of $250 will be treated as short-term capital loss because it is
attributable to the non-section 1256 positions. On December 31, 1985, A
realizes a $50 gain on the remaining section 1256 contract because the
position is deemed disposed of under section 1256(a)(1). The $50 gain is
equal to $150 gain less a $100 adjustment to take into account the $100
unrealized gain that was offset against the $100 loss realized on the
section 1256 contract on March 11, 1985.
Example 4. Assume the facts are the same as in example (3), except
that A disposes of the section 1256 contract at a $500 gain. As in
example (3), A has a net loss of $250 on the non-section 1256 positions
disposed of. In this example, however, A has net gain of $600 ($500 +
$100) on the section 1256 contracts on March 11, 1985. Therefore, of the
net gain from the straddle of $350 ($600-$250), $250 ($500-$250) is
treated as 60 percent long-term
[[Page 230]]
capital gain and 40 percent short-term capital gain because only $250 is
attributable to the realized gain from the section 1256 contract. In
addition, because none of the $100 unrealized gain from the remaining
section 1256 contract was offset against gain or loss on the non-section
1256 positions, no adjustment is made under paragraph (b)(3) of this
section and the entire $150 gain on December 31 with respect to that
contract is realized on that date.
(4) All of the section 1256 contracts of a section 1092(b)(2)
identified mixed straddle disposed of on the same day. This paragraph
(b)(4) applies if all of the section 1256 contracts of a section
1092(b)(2) identified mixed straddle are disposed of (or deemed disposed
of) on the same day or if this paragraph (b)(4) is made applicable by
paragraph (b)(5) of this section. In the case to which this paragraph
(b)(4) applies, gain and loss realized from section 1256 contracts shall
be netted. Realized and unrealized gain and loss with respect to the
non-section 1256 positions of the straddle also shall be netted on that
day. Realized net gain or loss from the section 1256 contracts shall be
treated as short-term capital gain or loss to the extent of net gain or
loss on the non-section 1256 positions on that day. Net gain or loss
with respect to the section 1256 contracts that exceeds the net gain or
loss with respect to the non-section 1256 positions of the straddle
shall be treated as 60 percent long-term capital gain or loss and 40
percent short-term capital gain or loss. See paragraph (b)(7) of this
section relating to the gain or loss on such non-section 1256 positions.
This paragraph (b)(4) may be illustrated by the following examples. It
is assumed in each example that the positions are the only positions
held directly or indirectly (through a related person or flowthrough
entity) by an individual calendar year taxpayer during the taxable year.
Example 1. On December 30, 1985, A enters into a section 1256
contract and an offsetting non-section 1256 position and makes a valid
election to treat such straddle as a section 1092(b)(2) identified mixed
straddle. On December 31, 1985, A disposes of the section 1256 contract
at a $1,000 gain, at which time there is $1,000 of unrealized loss in
the non-section 1256 position. Under these circumstances, the $1,000
gain realized on the section 1256 contract will be treated as short-term
capital gain because there is a $1,000 loss on the non-section 1256
position.
Example 2. Assume the facts are the same as in example (1), except
that A realized a $1,500 gain on the disposition of the section 1256
contract. Under these circumstances, $1,000 of the gain realized on the
section 1256 contract will be treated as short-term capital gain because
there is a $1,000 loss on the non-section 1256 position. The net gain of
$500 from the straddle will be treated as 60 percent long-term capital
gain and 40 percent short-term capital gain because it is attributable
to the section 1256 contract.
Example 3. Assume the facts are the same as in example (1), except
that A realized a $1,000 loss on the section 1256 contract and there is
$1,000 of unrecognized gain on the non-section 1256 position. Under
these circumstances, the $1,000 loss on the section 1256 contract will
be treated as short-term capital loss because there is a $1,000 gain on
the non-section 1256 position. Such loss, however, will be disallowed in
1985 under the loss deferral rules of section 1092(a) because there is
$1,000 of unrecognized gain in an offsetting position at year-end. See
paragraph (c) of this section.
Example 4. Assume the facts are the same as in example (1), except
that the section 1256 contract and non-section 1256 position were
entered into on December 1, 1985, and the section 1256 contract is
disposed of on December 19, 1985, for a $1,000 gain, at which time there
is $1,000 of unrealized loss on the non-section 1256 position. At year-
end there is only $800 of unrealized loss in the non-section 1256
position. Under these circumstances, the result is the same as in
example (1) because there was $1,000 of unrealized loss on the non-
section 1256 position at the time of the disposition of the section 1256
contract.
Example 5. On July 15, 1985, A enters into a straddle consisting of
two non-section 1256 positions and two section 1256 contracts and makes
a valid election to treat such straddle as a section 1092(b)(2)
identified mixed straddle. On July 20, 1985, A disposes of one non-
section 1256 position at a gain of $1,000 and both section 1256
contracts at a net loss of $1,000. On the same day there is $200 of
unrealized loss on the non-section 1256 position retained by A. Under
these circumstances, realized and unrealized gain and loss with respect
to the non-section 1256 positions is netted, resulting in a net gain of
$800. Thus, $800 of the net loss on the section 1256 contracts disposed
of will be treated as short-term capital loss because there is $800 of
net gain on the non-section 1256 positions. In addition, the net loss of
$200 from the straddle will be treated as 60 percent long-term capital
loss and 40 percent short-term capital loss because it is attributable
to the section 1256 contract.
[[Page 231]]
(5) Disposition of one or more, but not all, positions of a section
1092(b)(2) identified mixed straddle on the same day. If one or more,
but not all, of the positions of a section 1092(b)(2) identified mixed
straddle are disposed of on the same day, and paragraphs (b) (3) and (4)
of this section are not applicable (without regard to this paragraph
(b)(5)), the gain and loss from the non-section 1256 positions that are
disposed of on that day shall be netted, and the gain and loss from the
section 1256 contracts that are disposed of on that day shall be netted.
In order to determine whether the rules of paragraph (b)(3) or (b)(4) of
this section apply, net gain or loss from the section 1256 contracts
disposed of shall then be offset against net gain or loss from the non-
section 1256 positions disposed of to determine net gain or loss from
such positions of the straddle. If net gain or loss from the disposition
of such positions of the straddle is attributable to the non-section
1256 positions disposed of, the rules prescribed in paragraph (b)(3) of
this section apply. If net gain or loss from the disposition of such
positions is attributable to the section 1256 contracts disposed of, the
rules prescribed in paragraph (b)(4) of this section apply. If the net
gain or loss from the netting of non-section 1256 positions disposed of
and the netting of section 1256 contracts disposed of are either both
gains or losses, the rules prescribed in paragraph (b)(3) of this
section shall apply to net gain or loss from such non-section 1256
positions, and the rules prescribed in paragraph (b)(4) of this section
shall apply to net gain or loss from such section 1256 contracts.
However, for purposes of determining the treatment of gain or loss
subsequently realized on a position of such straddle, to the extent that
unrealized gain or loss on other positions was used to offset realized
gain or loss on a non-section 1256 position under paragraph (b)(3) of
this section, or was used to treat realized gain or loss on a section
1256 contract as short-term capital gain or loss under paragraph (b)(4)
of this section, such amount shall not be used for such purposes again.
This paragraph (b)(5) may be illustrated by the following examples. It
is assumed that the positions are the only positions held directly or
indirectly (through a related person or flowthrough entity) by an
individual calendar year taxpayer during the taxable year.
Example 1. On July 15, 1985, A enters into a straddle consisting of
four non-section 1256 positions and four section 1256 contracts and
makes a valid election to treat such straddle as a section 1092(b)(2)
identified mixed straddle. On July 20, 1985, A disposes of one non-
section 1256 position at a gain of $800 and one section 1256 contract at
a loss of $300. On the same day there is $400 of unrealized net loss on
the section 1256 contracts retained by A and $100 of unrealized net loss
on the non-section 1256 positions retained by A. Under these
circumstances, the loss of $300 on the section 1256 contract disposed of
will be offset against the gain of $800 on the non-section 1256 position
disposed of. The net gain of $500 is attributable to the non-section
1256 position. Therefore, the rules of paragraph (b)(3) of this section
apply. Under the rules of paragraph (b)(3) of this section, the net loss
of $700 on the section 1256 contracts is offset against the net gain of
$800 attributable to the non-section 1256 position disposed of. The net
gain of $100 will be treated as short-term capital gain because it is
attributable to the non-section 1256 position disposed of. Gain or loss
subsequently realized on the section 1256 contracts will be adjusted to
take into account the unrealized loss of $400 that was offset against
the $800 gain attributable to the non-section 1256 position disposed of.
Example 2. Assume the facts are the same as in Example 1, except
that A disposes of the non-section 1256 position at a gain of $300 and
the section 1256 contract at a loss of $800, and there is $200 of
unrealized net gain in the non-section 1256 positions retained by A.
Under these circumstances, the gain of $300 on the non-section 1256
position disposed of will be offset against the loss of $800 on the
section 1256 contract disposed of. The net loss of $500 is attributable
to the section 1256 contract. Therefore, the rules of paragraph (b)(4)
of this section apply. Under the rules of paragraph (b)(4) of this
section, $500 of the net loss realized on the section 1256 contract will
be treated as short-term capital loss because there is $500 of realized
and unrealized gain in the non-section 1256 positions. The remaining net
loss of $300 will be treated as 60 percent long-term capital loss and 40
percent short-term capital loss because it is attributable to a section
1256 contract disposed of. In addition, A realizes a $300 short-term
capital gain attributable to the disposition of the non-section 1256
position.
Example 3. (i) Assume the facts are the same as in example (1),
except that the section 1256 contract was disposed of at a $500 gain.
Under these circumstances, there is
[[Page 232]]
gain of $500 attributable to the section 1256 contact disposed of and a
gain of $800 attributable to the non-section 1256 position. Therefore,
the rules of both paragraphs (b) (3) and (4) of this Sec. 1.1092(b)-3T
apply.
(ii) Under paragraph (b)(3) of this section, the realized and
unrealized gains and losses on the section 1256 contracts are netted,
resulting in a net gain of $100 ($500-$400). The section 1256 contract
net gain does not offset the gain on the non-section 1256 position
disposed of. Therefore, the gain of $800 on the non-section 1256
position disposed of will be treated as a short-term capital gain
because there is no net loss on the section 1256 contracts.
(iii) Under paragraph (b)(4) of this section, the realized and
unrealized gains and losses on the non-section 1256 positions are
netted, resulting in a non-section 1256 position net gain of $700 ($800-
$100). Because there is no net loss on the non-section 1256 positions,
the $500 gain realized on the section 1256 contract will be treated as
60 percent long-term capital gain and 40 percent short-term capital
gain.
(6) Accrued gain and loss with respect to positions of a section
1092(b)(2) identified mixed straddle established on or before August 18,
2014. The rules of this paragraph (b)(6) apply to all section 1092(b)(2)
identified mixed straddles established on or before August 18, 2014; see
Sec. 1.1092(b)-6 for section 1092(b)(2) identified mixed straddles
established after August 18, 2014. If one or more positions of a section
1092(b)(2) identified mixed straddle were held by the taxpayer on the
day prior to the day the section 1092(b)(2) identified mixed straddle is
established, such position or positions shall be deemed sold for their
fair market value as of the close of the last business day preceding the
day such straddle is established. See Sec. Sec. 1.1092(b)-1T and
1.1092(b)-2T for application of the loss deferral and wash sale rules
and for treatment of holding periods and losses with respect to such
positions. An adjustment (through an adjustment to basis or otherwise)
shall be made to any subsequent gain or loss realized with respect to
such to such position or positions for any gain or loss recognized under
this paragraph (b)(6). This paragraph (b)(6) may be illustrated by the
following examples. It is assumed in each example that the positions are
the only positions held directly or indirectly (through a related person
or flowthrough entity) by an individual calendar year taxpayer during
the taxable year.
Example 1. On January 1, 1985, A enters into a non-section 1256
position. As of the close of the day on July 9, 1985, there is $500 of
unrealized long-term capital gain in the non-section 1256 position. On
July 10, 1985, A enters into an offsetting section 1256 contract and
makes a valid election to treat the straddle as a section 1092(b)(2)
identified mixed straddle. Under these circumstances, on July 9, 1985, A
will recognize $500 of long-term capital gain on the non-section 1256
position.
Example 2. On February 1, 1985, A enters into a section 1256
contract. As of the close of the day on February 4, 1985, there is $500
of unrealized gain on the section 1256 contract. On February 5, 1985, A
enters into an offsetting non-section 1256 position and makes a valid
election to treat the straddle as a section 1092(b)(2) identified mixed
straddle. Under these circumstances, on February 4, 1985, A will
recognize a $500 gain on the section 1256 contract, which will be
treated as 60 percent long-term capital gain and 40 percent short-term
capital gain.
Example 3. Assume the facts are the same as in example (2) and that
on February 10, 1985, there is $2,000 of unrealized gain in the section
1256 contract. A disposes of the section 1256 contract at a $2,000 gain
and disposes of the offsetting non-section 1256 position at a $1,000
loss. Under these circumstances, the $2,000 gain on the section 1256
contract will be reduced to $1,500 to take into account the $500 gain
recognized when the section 1092(b)(2) identified mixed straddle was
established. The $1,500 gain on the section 1256 contract will be offset
against the $1,000 loss on the non-section 1256 position. The net $500
gain from the straddle will be treated as 60 percent long-term capital
gain and 40 percent short-term capital gain because it is attributable
to the section 1256 contract.
Example 4. On March 1, 1985, A enters into a non-section 1256
position. As of the close of the day on March 2, 1985, there is $400 of
unrealized short-term capital gain in the non-section 1256 position. On
March 3, 1985, A enters into an offsetting section 1256 contract and
makes a valid election to treat the straddle as a section 1092(b)(2)
identified mixed straddle. On March 10, 1985, A disposes of the section
1256 contract at a $500 loss and the non-section 1256 position at a $500
gain. Under these circumstances, on March 2, 1985, A will recognize $400
of short-term capital gain attributable to the gain accrued on the non-
section 1256 position prior to the day the section 1092(b)(2) identified
mixed straddle was established. On March 10, 1985, the gain of $500 on
the non-section 1256 position will be reduced to $100 to take into
account the $400 of gain recognized when the section
[[Page 233]]
1092(b)(2) identified mixed straddle was established. The $100 gain on
the non-section 1256 position will be offset against the $500 loss on
the section 1256 contract. The net loss of $400 from the straddle will
be treated as 60 percent long-term capital loss and 40 percent short-
term capital loss because it is attributable to the section 1256
contract.
(7) Treatment of gain and loss from non-section 1256 positions after
disposition of all section 1256 contracts. Gain or loss on a non-section
1256 position that is part of a section 1092(b)(2) identified mixed
straddle and that is held after all section 1256 contracts in the
straddle are disposed of shall be treated as short-term capital gain or
loss to the extent attributable to the period when the positions were
part of such straddle. See Sec. 1.1092(b)-2T for rules concerning the
holding period of such positions. This paragraph (b)(7) may be
illustrated by the following example. It is assumed that the positions
are the only positions held directly or indirectly (through a related
person or flowthrough entity) during the taxable years.
Example: On December 1, 1985, A, an individual calendar year
taxpayer, enters into a section 1256 contract and an offsetting non-
section 1256 position and makes a valid election to treat such straddle
as a section 1092(b)(2) identified mixed straddle. On December 31, 1985,
A disposes of the section 1256 contract at a $1,000 loss. On the same
day, there is $1,000 of unrecognized gain in the non-section 1256
position. The $1,000 loss on the section 1256 contract is treated as
short-term capital loss because there is a $1,000 gain on the non-
section 1256 position, but the $1,000 loss is disallowed in 1985 because
there is $1,000 of unrecognized gain in the offsetting nonsection 1256
position. See section 1092(a) and Sec. 1.1092(b)-1T. On July 10, 1986,
A disposes of the non-section 1256 position at a $1,500 gain, $500 of
which is attributable to the post-straddle period. Under these
circumstances, $1,000 of the gain on the non-section 1256 position will
be treated as short-term capital gain because that amount of the gain is
attributable to the period when the position was part of a section
1092(b)(2) identified mixed straddle. The remaining $500 of the gain
will be treated as long-term capital gain because the position was held
for more than six months after the straddle was terminated. In addition,
the $1,000 short-term capital loss disallowed in 1985 will be taken into
account at this time.
(c) Coordination with loss deferral and wash sale rules of Sec.
1.1092(b)-1T. This section shall apply prior to the application of the
loss deferral and wash sale rules of Sec. 1.1092(b)-1T.
(d) Identification required--(1) In general. To elect the provisions
of this section, a taxpayer must clearly identify on a reasonable and
consistently applied economic basis each position that is part of the
section 1092(b)(2) identified mixed straddle before the close of the day
on which the section 1092(b)(2) identified mixed straddle is
established. If the taxpayer disposes of a position that is part of a
section 1092(b)(2) identified mixed straddle before the close of the day
on which the straddle is established, such identification must be made
at or before the time that the taxpayer disposes of the position. In the
case of a taxpayer who is an individual, the close of the day is
midnight (local time) in the location of the taxpayer's principal
residence. In the case of all other taxpayers, the close of the day is
midnight (local time) in the location of the taxpayer's principal place
of business. Only the person or entity that directly holds all positions
of a straddle may make the election under this section.
(2) Presumptions. A taxpayer is presumed to have identified a
section 1092(b)(2) identified mixed straddle by the time prescribed in
paragraph (d)(1) of this section if the taxpayer receives independent
verification of the identification (within the meaning of paragraph
(d)(4) of this section). The presumption referred to in this paragraph
(d)(2) may be rebutted by clear and convincing evidence to the contrary.
(3) Corroborating evidence. If the presumption of paragraph (d)(2)
of this section does not apply, the burden shall be on the taxpayer to
establish that an election under paragraph (d)(1) of this section was
made by the time specified in paragraph (d)(1) of this section. If the
taxpayer has no evidence of the time when the identification required by
paragraph (d)(1) of this section is made, other than the taxpayer's own
testimony, the election is invalid unless the taxpayer shows good cause
for failure to have evidence other than the taxpayer's own testimony.
(4) Independent verification. For purposes of this section, the
following constitute independent verification:
[[Page 234]]
(i) Separate account. Placement of one or more positions of a
section 1092(b)(2) identified mixed straddle in a separate account
designated as a section 1092(b)(2) identified mixed straddle account
that is maintained by a broker (as defined in Sec. 1.6045-1(a)(1)),
futures commission merchant (as defined in 7 U.S.C. 2 and 17 CFR
1.3(p)), or similar person and in which notations are made by such
person identifying all positions of the section 1092(b)(2) identified
mixed straddle and stating the date the straddle is established.
(ii) Confirmation. A written confirmation from a person referred to
in paragraph (d)(4)(i) of this section, or from the party from which one
or more positions of the section 1092(b)(2) identified mixed straddle
are acquired, stating the date the straddle is established and
identifying the other positions of the straddle.
(iii) Other methods. Such other methods of independent verification
as the Commissioner may approve at the Commissioner's discretion.
(5) Section 1092 (b)(2) identified mixed straddles established
before February 25, 1985. Notwithstanding the provisions of paragraph
(d)(1) of this section, relating to the time of identification of a
section 1092(b)(2) identified mixed straddle, a taxpayer may identify
straddles that were established before February 25, 1985 as section
1092(b)(2) identified mixed straddles after the time specified in
paragraph (d)(1) of this section if the taxpayer adopts a reasonable and
consistent economic basis for identifying the positions of such
straddles.
(e) Effective date--(1) In general. The provisions of this section
shall apply to straddles established on or after January 1, 1984.
(2) Pre-1984 accrued gain. If the last business day referred to in
paragraph (b)(6) of this section is contained in a period to which
paragraph (b)(6) does not apply, the gains and losses from the deemed
sale shall be included in the first period to which paragraph (b)(6)
applies.
(Secs. 1092(b)(1), 1092(b)(2) and 7805 of the Internal Revenue Code of
1954 (68A Stat. 917, 98 Stat. 627; 26 U.S.C. 1092(b)(1), 1092(b)(2),
7805))
[T.D. 8008, 50 FR 3325, Jan. 24, 1985; 50 FR 12243, Mar. 28, 1985; 50 FR
19344, May 8, 1985; T.D. 9627, 78 FR 46808, Aug. 2, 2013; 78 FR 64397,
Oct. 29, 2013; T.D. 9678, 79 FR 41888, July 18, 2014]
Sec. 1.1092(b)-4T Mixed straddles; mixed straddle account (temporary).
(a) In general. A taxpayer may elect (in accordance with paragraph
(f) of this section) to establish one or more mixed straddle accounts
(as defined in paragraph (b) of this section). Gains and losses from
positions includible in a mixed straddle account shall be determined and
treated in accordance with the rules set forth in paragraph (c) of this
section. A mixed straddle account is treated as established as of the
first day of the taxable year for which the taxpayer makes the election
or January 1, 1984, whichever is later. See Sec. 1.1092(b)-5T relating
to definitions.
(b) Mixed straddle account defined--(1) In general. The term mixed
straddle account means an account for determining gains and losses from
all positions held as capital assets in a designated class of activities
by the taxpayer at the time the taxpayer elects to establish a mixed
straddle account. A separate mixed straddle account must be established
for each separate designated class of activities.
(2) Permissible designations. Except as otherwise provided in this
section, a taxpayer may designate as a class of activities the types of
positions that a reasonable person, on the basis of all the facts and
circumstances, would ordinarily expect to be offsetting positions. This
paragraph (b)(2) may be illustrated by the following example. It is
assumed in the example that the positions are the only positions held
directly or indirectly (through a related person or flowthrough entity)
during the taxable year, and that gain or loss from the positions is
treated as gain or loss from a capital asset.
Example: B engages in transactions in dealer equity options on XYZ
Corporation stock, stock in XYZ Corporation, dealer equity options on
UVW Corporation stock, and stock
[[Page 235]]
in UVW Corporation. A reasonable person, on the basis of all the facts
and circumstances, would not expect dealer equity options on XYZ
Corporation stock and stock in XYZ Corporation to offset any dealer
equity options on UVW Corporation stock or any stock in UVW Corporation.
If B makes the mixed straddle account election under this section for
all such positions, B must designate two separate classes of activities,
one consisting of transactions in dealer equity options on XYZ
Corporation stock and stock in XYZ Corporation, and the other consisting
of transactions in dealer equity options on UVW Corporation stock and
stock in UVW Corporation, and maintain two separate mixed straddle
accounts.
(3) Positions that offset positions in more than one mixed straddle
account. Gains and losses from positions that a reasonable person, on
the basis of all the facts and circumstances, ordinarily would expect to
be offsetting with respect to positions in more than one mixed straddle
account shall be allocated among such accounts under a reasonable and
consistent method that clearly reflects income. This paragraph (b)(2)
may be illustrated by the following example. It is assumed that the
positions are the only positions held directly or indirectly (through a
related person or flowthrough entity) during the taxable year, and that
gain or loss from the positions is treated as gain or loss from a
capital asset.
Example: B holds stock in XYZ Corporation, UVW Corporation, and RST
Corporation, and options on a broad based stock index future. A
reasonable person, on the basis of all the facts and circumstances,
would expect the stock in XYZ Corporation, UVW Corporation, and RST
Corporation to be offsetting positions with respect to the options on
the broad based stock index future. A reasonable person, on the basis of
all the facts and circumstances, would not expect that stock in XYZ
Corporation, UVW Corporation, or RST Corporation would be offsetting
positions with respect to each other. If B makes the mixed straddle
account election under this section for all such positions, B must
designate three separate classes of activities: one consisting of stock
in XYZ Corporation; one consisting of stock in UVW Corporation; and one
consisting of stock in RST Corporation, and maintain three separate
mixed straddle accounts. Options on the broad based stock index future
must be designated as part of all three classes of activities and gains
and losses from such options must be allocated among such accounts under
a reasonable and consistent method that clearly reflects income, because
such options are a type of position expected to be offsetting with
respect to the positions in all three mixed straddle accounts.
(4) Impermissible designations--(i) Types of positions that are not
offsetting included in designated class of activities. If the
Commissioner determines, on the basis of all the facts and
circumstances, that a class of activities designated by a taxpayer
includes types of positions that a reasonable person, on the basis of
all the facts and circumstances, ordinarily would not expect to be
offsetting positions with respect to other types of positions in the
account, the Commissioner may--
(A) Amend the class of activities designated by the taxpayer and
remove positions from the account that are not within the amended
designated class of activities; or
(B) Amend the class of activities designated by the taxpayer to
establish two or more mixed straddle accounts.
(ii) Types of positions that are offsetting not included in
designated class of activities. If the Commissioner determines, on the
basis of all the facts and circumstances, that a designated class of
activities does not include types of positions that are offsetting with
respect to types of positions within the designated class, the
Commissioner may--
(A) Amend the class of activities designated by the taxpayer to
include types of positions that are offsetting with respect to the types
of positions within the designated class and place such positions in the
account; or
(B) Amend the class of activities designated by the taxpayer to
exclude types of positions that are offsetting with respect to the types
of positions that are not in the account.
(iii) Treatment of positions removed from or included in the
account. (A) Positions removed from a mixed straddle account will be
subject to the rules of taxation generally applicable to such positions.
Thus, for example, if the positions removed from the account are
offsetting positions with respect to other positions outside the
account, the rules of Sec. Sec. 1.1092(b)-1T and 1.1092(b)-2T apply.
(B) If the taxpayer acted consistently and in good faith in
designating the
[[Page 236]]
class of activities of the account and in placing positions in the
account, the rules of Sec. 1.1092(b)-2T(b)(2) shall not apply to any
mixed straddles resulting from the removal of such positions from the
account and the Commissioner, at the Commissioner's discretion, may
identify such mixed straddles as section 1092(b)(2) identified mixed
straddles and apply the rules of Sec. 1.1092(b)-3T(b) to such
straddles.
(C) If positions are placed in a mixed straddle account, such
positions shall be treated as if they were originally included in the
mixed straddle account in which they are placed.
(5) Positions included in a mixed straddle account that are not
within the designated class of activities. The Commissioner may remove
one or more positions from a mixed straddle account if, on the basis of
all the facts and circumstances, the Commissioner determines that such
positions are not within the designated class of activities of the
account. See paragraph (b)(4)(iii) of this section for rules concerning
the treatment of such positions.
(6) Positions outside a mixed straddle account that are within the
designated class of activities. If a taxpayer holds types of positions
outside of a mixed straddle account (including positions in another
mixed straddle account) that are within the designated class of
activities of a mixed straddle account, the Commissioner may require the
taxpayer to include such types of positions in the mixed straddle
account, move positions from one account to another, or remove from the
mixed straddle account types of positions that are offsetting with
respect to the types of positions held outside the account. See
paragraph (b)(4)(iii) of this section for the treatment of such
positions.
(c) Treatment of gains and losses from positions in a mixed straddle
account--(1) Daily account net gain or loss. Except as provided in
paragraphs (d) and (e) of this section (relating to positions in a mixed
straddle account before January 1, 1985) as of the close of each
business day of the taxable year, gain or loss shall be determined for
each position in a mixed straddle account that is disposed of during the
day. Positions in a mixed straddle account that have not been disposed
of as of the close of the day shall be treated as if sold for their fair
market value at the close of each business day. Gains and losses for
each business day from non-section 1256 positions in each mixed straddle
account shall be netted to determine net non-section 1256 position gain
or loss for the account, and gains and losses for each business day from
section 1256 contracts in each mixed straddle account shall be netted to
determine net section 1256 contract gain or loss for the account. Net
non-section 1256 position gain or loss from the account is then offset
against net section 1256 contract gain or loss from the same mixed
straddle account to determine the daily account net gain or loss for the
account. If daily account net gain or loss is attributable to the net
non-section 1256 position gain or loss, daily account net gain or loss
for such account shall be treated as short-term capital gain or loss. If
daily account net gain or loss is attributable to the net section 1256
contract gain or loss, daily account net gain or loss for such account
shall be treated as 60 percent long-term capital gain or loss and 40
percent short-term capital gain or loss. If net non-section 1256
position gain or loss and net section 1256 contract gain or loss are
either both gains or both losses, that portion of the daily account net
gain or loss attributable to net non-section 1256 position gain or loss
shall be treated as short-term capital gain or loss and that portion of
the daily account net gain or loss attributable to net section 1256
contract gain or loss shall be treated as 60 percent long-term capital
gain or loss and 40 percent short-term capital gain or loss. An
adjustment (through an adjustment to basis or otherwise) shall be made
to any subsequent gain or loss determined under this paragraph (c)(1) to
take into account any gain or loss determined for prior business days
under this paragraph (c)(1).
(2) Annual account net gain or loss; total annual account net gain
or loss. On the last business day of the taxable year, the annual
account net gain or loss for each mixed straddle account established by
the taxpayer shall be determined by netting the daily account net gain
or loss for each business day in
[[Page 237]]
the taxable year for each account. Annual account net gain or loss for
each mixed straddle account shall be adjusted pursuant to paragraph
(c)(3) of this section. The total annual account net gain or loss shall
be determined by netting the annual account net gain or loss for all
mixed straddle accounts established by the taxpayer, as adjusted
pursuant to paragraph (c)(3) of this section. Total annual account net
gain or loss is subject to the limitations of paragraph (c)(4) of this
section. See paragraphs (d) and (e) of this section for determining the
annual account net gain or loss for mixed straddle accounts established
for taxable years beginning before January 1, 1985.
(3) Application of section 263(g) to mixed straddle accounts. No
deduction shall be allowed for interest and carrying charges (as defined
in section 263(g)(2)) properly allocable to a mixed straddle account.
Interest and carrying charges properly allocable to a mixed straddle
account means the excess of--
(i) The sum of--
(A) Interest on indebtedness incurred or continued during the
taxable year to purchase or carry any position in the account; and
(B) All other amounts (including charges to insure, store or
transport the personal property) paid or incurred to carry any position
in the account; over
(ii) The sum of--
(A) The amount of interest (including original issue discount)
includible in gross income for the taxable year with respect to all
positions in the account;
(B) Any amount treated as ordinary income under section
1271(a)(3)(A), 1278, or 1281(a) with respect to any position in the
account for the taxable year; and
(C) The excess of any dividends includible in gross income with
respect to positions in the account for the taxable year over the amount
of any deduction allowable with respect to such dividends under section
243, 244, or 245.
For purposes of paragraph (c)(3)(i) of this section, the term interest
includes any amount paid or incurred in connection with positions in the
account used in a short sale. Any interest and carrying charges
disallowed under this paragraph (c)(3) shall be capitalized by treating
such charges as an adjustment to the annual account net gain or loss and
shall be allocated pro rata between net short-term capital gain or loss
and net long-term capital gain or loss.
(4) Limitation on total annual account net gain or loss. No more
than 50 percent of total annual account net gain for the taxable year
shall be treated as long-term capital gain. Any long-term capital gain
in excess of the 50 percent limit shall be treated as short-term capital
gain. No more than 40 percent of total annual account net loss for the
taxable year shall be treated as short-term capital loss. Any short-term
capital loss in excess of the 40 percent limit shall be treated as long-
term capital loss.
(5) Accrued gain and loss with respect to positions includible in a
mixed straddle account. Positions includable in a mixed straddle account
that are held by a taxpayer on the day prior to the day the mixed
straddle account is established shall be deemed sold for their fair
market value as of the close of the last business day preceding the day
such mixed straddle account is established. See Sec. Sec. 1.1092(b)-1T
and 1.1092(b)-2T for application of the loss deferral and wash sale
rules and for treatment of holding periods and losses with respect to
such positions. An adjustment (through an adjustment to basis or
otherwise) shall be made to any subsequent gain or loss realized with
respect to such positions for any gain or loss recognized under this
paragraph (c)(5).
(6) Examples. This paragraph (c) may be illustrated by the following
examples. It is assumed in each example that the positions are the only
positions held directly or indirectly (through a related person or
flowthrough entity) by an individual calendar year taxpayer during the
taxable year, and that gain or loss from the positions is treated as
gain or loss from a capital asset.
Example 1. A establishes a mixed straddle account for a class of
activities consisting of transactions in stock of XYZ Corporation and
dealer equity options on XYZ Corporation stock. Assume that A enters
into no transactions in XYZ Corporation stock or dealer equity options
on XYZ Corporation stock prior to December 26, 1985. Thus, the net non-
section 1256 position gain or loss and the net section 1256 contract
gain or loss for
[[Page 238]]
the account are zero for each business day except the following days:
------------------------------------------------------------------------
Net section
Net non-section 1256 contract
1256 position gain or loss
gain or loss (XYZ
(XYZ corporation
corporation dealer equity
stock) options)
------------------------------------------------------------------------
December 26, 1985..................... $1,000 $20,000
December 27, 1985..................... (9,000) 3,000
December 30, 1985..................... (5,000) 15,000
December 31, 1985..................... 7,000 (2,000)
------------------------------------------------------------------------
The daily account net gain or loss is as follows:
----------------------------------------------------------------------------------------------------------------
Daily account Treatment of daily account net gain or Long- Short-
net gain or loss loss term term
----------------------------------------------------------------------------------------------------------------
December 26, 1985.............. $21,000 $1,000 short-term capital gain, $20,000 $12,000 $9,000
60 percent long-term capital gain and
40 percent short-term capital gain.
December 27, 1985.............. (6,000) Short-term capital loss................. ........ (6,000)
December 30, 1985.............. 10,000 60 percent long-term capital gain and 40 6,000 4,000
percent short-term capital gain.
December 31, 1985.............. 5,000 Short-term capital gain................. ........ 5,000
----------------------------------------------------------------------------------------------------------------
The annual account net gain or loss is $18,000 of long-term capital gain
and $12,000 of short-term capital gain. Because A has no other mixed
straddle accounts, total annual account net gain or loss is also $18,000
long-term capital gain and $12,000 short-term capital gain. Because more
than 50 percent of the total annual account net gain is long-term
capital gain, $3,000 of the $18,000 long-term capital gain will be
treated as short-term capital gain.
Example 2. Assume the facts are the same as in example (1), except
that interest and carrying charges in the amount of $6,000 are allocable
to the mixed straddle account and are capitalized under paragraph (c)(3)
of this section. Under these circumstances, $3,600 (($18,000/$30,000) x
$6,000) of the interest and carrying charges will reduce the $18,000
long-term capital gain to $14,400 long-term capital gain and $2,400
(($12,000/$30,000) x $6,000) of the interest and carrying charges will
reduce the $12,000 short-term capital gain to $9,600 short-term capital
gain. Because more than 50 percent of the total annual account net gain
is long-term capital gain, $2,400 of the $14,400 long-term capital gain
will be treated as short-term capital gain.
Example 3. Assume the facts are the same as in example (1), except
that A has a second mixed straddle account, which has an annual account
net loss of $14,000 of long-term capital loss and $6,000 of short-term
capital loss. Under these circumstances, the total annual account net
gain is $4,000 ($18,000-$14,000) of long-term capital gain and $6,000
($12,000-$6,000) of short-term capital gain. Because not more than 50
percent of the total annual account net gain is long-term capital gain,
none of the long-term capital gain will be treated as short-term capital
gain.
Example 4. Assume the facts are the same as in example (3), except
that interest and carrying charges in the amount of $4,000 are allocable
to the second mixed straddle account and are capitalized under paragraph
(c)(3) of this section. Under these circumstances, $2,800 (($14,000/
$20,000) x $4,000)) of the interest and carrying charges will increase
the $14,000 long-term capital loss to $16,800 of long-term capital loss
and $1,200 (($6,000/$20,000) x $4,000)) of the interest and carrying
charges will increase the $6,000 short-term capital loss to $7,200
short-term capital loss. The total annual account net gain is $1,200 of
long-term capital gain ($18,000 $16,800) and $4,800 ($12,000-$7,200) of
short-term capital gain. Because not more than 50 percent of the total
annual account net gain is long-term capital gain, none of the $1,200
long-term capital gain will be treated as short-term capital gain.
Example 5. Assume the facts are the same as in example (1), except
that A has a second mixed straddle account, which has an annual account
net loss of $20,000 of long-term capital loss and $15,000 of short-term
capital loss. Under these circumstances, the total annual account net
loss is $2,000 ($20,000-$18,000) of long-term capital loss and $3,000
($15,000-$12,000) of short-term capital loss. Because more than 40
percent of the total annual account net loss is short-term capital loss,
$1,000 of the short-term capital loss will be treated as long-term
capital loss.
Example 6. A establishes two mixed straddle accounts. Account 1 has
an annual account net gain of $5,000 short-term capital gain, which
results from netting $5,000 of long-term capital loss and $10,000 of
short-term capital gain. Account 2 has an annual account net loss of
$2,000 long-term capital loss, which results from netting $3,000 of
long-term capital loss against $1,000 of short-term capital gain. The
total annual account net gain is $3,000 short-term capital gain, which
results from netting the annual account net gain of $5,000 short-term
capital
[[Page 239]]
gain from Account 1 against the annual account net loss of $2,000 long-
term capital loss from Account 2.
(d) Treatment of gains and losses from positions in a mixed straddle
account established on or before December 31, 1984, in taxable years
ending after December 31, 1984; pre-1985 account net gain or loss. For
mixed straddle accounts established on or before December 31, 1984, in
taxable years ending after December 31, 1984, the taxpayer on December
31, 1984, shall determine gain or loss for each position in the mixed
straddle account that has been disposed of on any day during the period
beginning on the first day of the taxpayer's taxable year that includes
December 31, 1984, and ending on December 31, 1984. Positions in the
mixed straddle account that have not been disposed of as of the close of
December 31, 1984, shall be treated as if sold for their fair market
value as of the close of December 31, 1984. Gains and losses for such
period from non-section 1256 positions in each mixed straddle account
shall be netted to determine pre-1985 net non-section 1256 position gain
or loss and gains and losses for such period from section 1256 contracts
in each mixed straddle account shall be netted to determine pre-1985 net
section 1256 contract gain or loss. Pre-1985 net non-section 1256
position gain or loss is then offset against pre-1985 net section 1256
contract gain or loss from the same mixed straddle account to determine
the pre-1985 account net gain or loss for the period. If the pre-1985
account net gain or loss is attributable to pre-1985 net non-section
1256 position gain or loss, the pre-1985 account net gain or loss from
such account shall be treated as short-term capital gain or loss. If the
pre-1985 account net gain or loss is attributable to pre-1985 net
section 1256 contract gain or loss, the pre-1985 account net gain or
loss from such account shall be treated as 60 percent long-term capital
gain or loss and 40 percent short-term capital gain or loss. If pre-1985
net non-section 1256 position gain or loss and pre-1985 net section 1256
contract gain or loss are either both gains or losses, that portion of
the pre-1985 account net gain or loss attributable to pre-1985 net non-
section 1256 position gain or loss shall be treated as short-term
capital gain or loss and that portion of the pre-1985 account net gain
or loss attributable to pre-1985 net section 1256 contract gain or loss
shall be treated as 60 percent long-term capital gain or loss and 40
percent short-term capital gain or loss. An adjustment (through an
adjustment to basis or otherwise) shall be made to any subsequent gain
or loss realized with respect to such positions for any gain or loss
recognized under this paragraph (d). To determine the annual account net
gain or loss for such account, the pre-1985 account net gain or loss
shall be treated as daily account net gain or loss for purposes of
paragraph (c)(2) of this section. See paragraph (c)(5) of this section
for treatment of accrued gain or loss with respect to positions
includible in a mixed straddle account.
(e) Treatment of gains and losses from positions in a mixed straddle
account for taxable years ending on or before December 31, 1984--(1) In
general. For mixed straddle accounts established on or before December
31, 1984, in taxable years ending on or before December 31, 1984, the
taxpayer at the close of the taxable year shall determine gain or loss
for each position in the mixed straddle account that has been disposed
of on any day during the period beginning on the later of the first day
of the taxable year or January 1, 1984, and ending on the last day of
the taxable year. Positions in the mixed straddle account that have not
been disposed of as of the close of the last business day of the taxable
year shall be treated as if sold for their fair market value at the
close of such day. Gains and losses from non-section 1256 positions in
each mixed straddle account shall be netted to determine 1984 net non-
section 1256 position gain or loss for the account and gains and losses
from section 1256 contracts shall be netted to determine 1984 net
section 1256 contract gain or loss for the account. The 1984 net non-
section 1256 position gain or loss is then offset against 1984 net
section 1256 contract gain or loss from the same mixed straddle account
to determine annual account net gain or loss for the account. If annual
account net gain or loss is attributable to 1984 net non-section 1256
position gain or loss, annual account net gain or loss shall be treated
as
[[Page 240]]
short-term capital gain or loss. If annual account net gain or loss is
attributable to 1984 net section 1256 contract gain or loss, annual
account net gain or loss shall be treated as 60 percent long-term
capital gain or loss and 40 percent short-term capital gain or loss. If
1984 net non-section 1256 position gain or loss and 1984 net section
1256 contract gain or loss are either both gains or both losses, that
portion of annual account net gain or loss attributable to 1984 net non-
section 1256 position gain or loss shall be treated as short-term
capital gain or loss and that portion of annual account net gain or loss
attributable to 1984 net section 1256 contract gain or loss shall be
treated as 60 percent long-term capital gain or loss and 40 percent
short-term capital gain or loss. An adjustment (through an adjustment to
basis or otherwise) shall be made to any subsequent gain or loss
realized with respect to such positions for any gain or loss recognized
under this paragraph (e). See paragraph (c) (2) through (5) of this
section relating to determining the total annual account net gain or
loss, application of section 263(g) to mixed straddle accounts, the
limitation on the total annual account net gain or loss, and treatment
of accrued gain or loss with respect to positions includible in a mixed
straddle account.
(2) Pre-1984 accrued gain. If the last business day referred to in
paragraph (c)(5) of this section is contained in a period to which such
paragraph (c)(5) does not apply, the gains and losses from the deemed
sale shall be included in the first period to which paragraph (c)(5)
applies.
(f) Election--(1) Time for making the election. Except as otherwise
provided, the election under this section to establish one or more mixed
straddle accounts for a taxable year must be made by the due date
(without regard to automatic and discretionary extensions) of the
taxpayer's income tax return for the immediately preceding taxable year
(or part thereof). For example, an individual taxpayer on a calendar
year basis must make the election by April 15, 1986, to establish one or
more mixed straddle accounts for taxable year 1986. Similarly, a
calendar year corporate taxpayer must make its election by March 15,
1986, to establish one or more mixed straddle accounts for 1986. If a
taxpayer begins trading or investing in positions in a new class of
activities during a taxable year, the election under this section with
respect to the new class of activities must be made by the taxpayer by
the later of the due date of the taxpayer's income tax return for the
immediately preceding taxable year (without regard to automatic and
discretionary extensions), or 60 days after the first mixed straddle in
the new class of activities is entered into. Similarly, if on or after
the date the election is made with respect to an account, the taxpayer
begins trading or investing in positions that are includible in such
account but were not specified in the original election, the taxpayer
must make an amended election as prescribed in paragraph (f)(2)(ii) of
this section by the later of the due date of the taxpayer's income tax
return for the immediately preceding taxable year (without regard to
automatic and discretionary extensions), or 60 days after the
acquisition of the first of the positions. If an election is made after
the times specified in this paragraph (f)(1), the election will be
permitted only if the Commissioner concludes that the taxpayer had
reasonable cause for failing to make a timely election. For example, if
a calendar year taxpayer holds few positions in one class of activities
prior to April 15 of a taxable year, and the taxpayer greatly increases
trading activity with respect to positions in the class of activities
after April 15, then the Commissioner may conclude that the taxpayer had
reasonable cause for failing to make a timely election and allow the
taxpayer to make a mixed straddle account election for the taxable year.
See paragraph (f)(2) of this section for rules relating to the manner
for making these elections.
(2) Manner for making the election--(i) In general. A taxpayer must
make the election on Form 6781 in the manner prescribed by such Form,
and by attaching the Form to the taxpayer's income tax return for the
immediately preceding taxable year (or request for an automatic
extension). In addition, the taxpayer must attach a statement
[[Page 241]]
to Form 6781 designating with specificity the class of activities for
which a mixed straddle account is established. The designation must
describe the class of activities in sufficient detail so that the
Commissioner may determine, on the basis of the designation, whether
specific positions are includible in the mixed straddle account. In the
case of a taxpayer who elects to establish more than one mixed straddle
account, the Commissioner must be able to determine, on the basis of the
designations, that specific positions are placed in the appropriate
account. The election applies to all positions in the designated class
of activities held by the taxpayer during the taxable year.
(ii) Elections for new classes of activities and expanded elections.
Amended elections and elections made with respect to a new class of
activities that the taxpayer has begun trading or investing in during a
taxable year, shall be made on Form 6781 within the times prescribed in
paragraph (f)(1) of this section. A statement must be attached to the
Form containing the information required in paragraph (f)(2)(i) of this
section, with respect to the new or expanded designated class of
activities.
(iii) Special rule. The Commissioner may disregard a mixed straddle
account election if the Commissioner determines, on the basis of all the
facts and circumstances, that the principal purpose for making the mixed
straddle account election with respect to a class of activities was to
avoid the rules of Sec. 1.1092(b)-1T (a). For example, if a taxpayer
holds stock that is not part of a straddle and that would generate a
loss if sold or otherwise disposed of, and the taxpayer both acquires
offsetting option positions with respect to the stock and makes a mixed
straddle account election with respect to the stock and stock options
near the end of a taxable year, the Commissioner may disregard the mixed
straddle account election.
(3) Special rule for taxable years ending after 1983 and before
September 1, 1986. An election under this section to establish one or
more mixed straddle accounts for any taxable year that includes July 17,
1984, and any taxable year that ends before September 1, 1986 (or, in
the case of a corporation, October 1, 1986), must be made by the later
of--
(i) December 31, 1985, or
(ii) The due date (without regard to automatic and discretionary
extensions) of the return for the taxpayer's taxable year that begins in
1984 if the due date of the taxpayer's return for such year (without
regard to automatic and discretionary extensions) is after December 31,
1985.
The election shall be made by attaching Form 6781 together with a
statement to the taxpayer's income tax return, amended return, or other
appropriate form that is filed on or before the deadline determined in
the preceding sentence. The attached statement must designate with
specificity, in accordance with paragraph (f)(2)(i) of this section, the
class of activities for which a mixed straddle account is established.
For example, if a fiscal year taxpayer's return (for its taxable year
ending September 30, 1985) is due (without regard to extensions) on
January 15, 1986, and the taxpayer intends to obtain an automatic
extension to file the return, the election under this section for any or
all of the fiscal years ending in 1984, 1985 or 1986 must be made on or
before January 15, 1986, with the request for an automatic extension.
Similarly, a calendar year taxpayer (whether or not such taxpayer has
obtained an automatic extension of time to file) who has filed its 1984
income tax return before October 15, 1985, without making a mixed
straddle account election for either 1984 or 1985, or both, may make the
mixed straddle account election under this section for either or for
both of such years with an amended return filed on or before December
31, 1985. The mixed straddle account elected on this amended return will
be effective for all positions in the designated class of activities
even if the taxpayer had elected straddle-by-straddle identification as
provided under Sec. 1.1092(b)-3T for purposes of the previously filed
1984 income tax return. For taxable years beginning in 1984 and 1985,
the election under this paragraph (f)(3) is effective for the entire
taxable year. For taxable years beginning in 1983, an election shall be
effective for that part of the year beginning after
[[Page 242]]
December 31, 1983, for which the election under Sec. 1.1256(h)-1T or
1.1256(h)-2T is made. See Sec. 1.6081-1T regarding an extension of time
to file certain individual income tax returns.
(4) Period for which election is effective. For taxable years
beginning on or after January 1, 1984, an election under this section,
including an amendment to the election pursuant to paragraph (f)(1) of
this section, shall be effective only for the taxable year for which the
election is made. This election may be revoked during the taxable year
for the remainder of the taxable year only with the consent of the
Commissioner. An application for consent to revoke the election shall be
filed with the service center with which the election was filed and
shall--
(i) Contain the name, address, and taxpayer identification number of
the taxpayer;
(ii) Show that the volume or nature of the taxpayer's activities has
changed substantially since the election was made, and that the
taxpayer's activities no longer warrant the use of such mixed straddle
account; and
(iii) Any other relevant information.
If a taxpayer's election for a taxable year is revoked, the taxpayer may
not make a new election for the same class of activities under paragraph
(f)(1) of this section during the same taxable year.
(g) Effective date. The provisions of this section apply to
positions held on or after January 1, 1984.
(Secs. 1092(b)(1), 1092(b)(2) and 7805 of the Internal Revenue Code of
1954 (68A Stat. 917, 98 Stat. 627; 26 U.S.C. 1092(b)(1), 1092(b)(2),
7805))
[T.D. 8008, 50 FR 3329, Jan. 24, 1985; 50 FR 12243, Mar. 28, 1985, as
amended by T.D. 8058, 50 FR 42013, Oct. 17, 1985]
Sec. 1.1092(b)-5T Definitions (temporary).
The following definitions apply for purposes of Sec. Sec.
1.1092(b)-1T through 1.1092(b)-4T.
(a) Disposing, disposes, or disposed. The term disposing, disposes,
or disposed includes the sale, exchange, cancellation, lapse,
expiration, or other termination of a right or obligation with respect
to personal property (as defined in section 1092(d)(1)).
(b) Hedging transaction. The term hedging transaction means a
hedging transaction as defined in section 1256(e).
(c) Identified straddle. The term identified straddle means an
identified straddle as defined in section 1092(a)(2)(B).
(d) Loss. The term loss means a loss otherwise allowable under
section 165(a) (without regard to the limitation contained in section
165(f)) and includes a write-down in inventory.
(e) Mixed straddle. The term mixed straddle means a straddle--
(1) All of the positions of which are held as capital assets;
(2) At least one (but not all) of the positions of which is a
section 1256 contract;
(3) For which an election under section 1256(d) has not been made;
and
(4) Which is not part of a larger straddle.
(f) Non-section 1256 position. The term non-section 1256 position
means a position that is not a section 1256 contract.
(g) Offsetting position. The term offsetting position means an
offsetting position as defined in section 1092(c)(2).
(h) Position. The term position means a position as defined in
section 1092(d)(2).
(i) [Reserved]
(j) Related person or flowthrough entity. The term related person or
flowthrough entity means a related person or flowthrough entity as
defined in sections 1092(d)(4) (B) and (C) respectively.
(k) Section 1256 contract. The term section 1256 contract means a
section 1256 contract as defined in section 1256(b).
(l) [Reserved]
(m) Straddle. The term straddle means a straddle as defined in
section 1092(c)(1).
(n) Successor position. The term successor position means a position
(``P'') that is or was at any time offsetting to a second position if--
(1) The second position was offsetting to any loss position disposed
of; and
(2) P is entered into during a period commencing 30 days prior to,
and ending 30 days after, the disposition of the loss position referred
to in paragraph (n)(1) of this section.
(o) Unrecognized gain. The term unrecognized gain means unrecognized
gain as defined in section 1092(a)(3)(A).
[[Page 243]]
(p) Substantially identical. The term substantially identical has
the same meaning as substantially identical in section 1091(a).
(q) Securities. The term security means a security as defined in
section 1236(c).
(Secs. 1092(b) and 7805 of the Internal Revenue Code of 1954 (68A Stat.
917, 95 Stat. 324, 26 U.S.C. 1092(b), 7805) and sec. 102(h) of the Tax
Reform Act of 1984 (98 Stat. 625))
[T.D. 8007, 50 FR 3321, Jan. 24, 1985, as amended by T.D. 8070, 51 FR
1788, Jan. 15, 1986]
Sec. 1.1092(b)-6 Mixed straddles; accrued gain and loss associated
with a position that becomes part of a section 1092(b)(2) identified
mixed straddle that is established after August 18, 2014.
(a) Treatment of unrealized gain or loss that arose before a
position becomes part of an identified mixed straddle. Except as
otherwise provided, if one or more positions of a straddle that is an
identified mixed straddle described in section 1092(b)(2)(A)(i)(I)
(identified mixed straddle) were held by the taxpayer on the day prior
to the day the identified mixed straddle is established, any unrealized
gain or loss on the day prior to the day the identified mixed straddle
is established with respect to such position or positions is taken into
account at the time, and has the character, provided by the provisions
of the Internal Revenue Code that would apply to the gain or loss if the
identified mixed straddle were not established. Thus, if a non-section
1256 capital asset was held for the long-term capital gain holding
period before the identified mixed straddle was established, any
unrealized gain or loss on that asset on the day prior to the day the
identified mixed straddle was established will be long-term capital gain
or loss when that asset is sold or otherwise disposed of in a taxable
transaction. Unrealized gain or loss on a section 1256 contract that
accrued prior to the day the contract became part of an identified mixed
straddle will be recognized no later than the last business day of the
taxpayer's taxable year. For each position, unrealized gain or loss is
the difference between the fair market value of the position at the
close of the day before the day the identified mixed straddle is
established and the taxpayer's basis in that position. See Sec.
1.1092(b)-2T and paragraph (b) of this section for the treatment of
holding periods with respect to such positions. Changes in value of the
position or positions that occur on or after the identified mixed
straddle is established are accounted for under the provisions of Sec.
1.1092(b)-3T (other than Sec. 1.1092(b)-3T(b)(6)). The definitions in
Sec. 1.1092(b)-5T apply for purposes of this section.
(b) Holding period after a position becomes part of an identified
mixed straddle. Section 1.1092(b)-2T(a)(1) applies to any position that
becomes part of an identified mixed straddle, and the long-term or
short-term character of any gain or loss on that position that arises on
or after the day the position has become a position in an identified
mixed straddle will be determined by beginning the taxpayer's holding
period on the day after the identified mixed straddle ceases to exist.
(c) Application of the loss deferral rules of section 1092(a). When
applying section 1092(a) and Sec. 1.1092(b)-3T(b) (other than Sec.
1.1092(b)-3T(b)(6)) to any loss that arises while a position is part of
an identified mixed straddle, the amount of unrecognized gain includes
both unrecognized gains described in paragraph (a) of this section that
accrued prior to the day the identified mixed straddle is established
and unrecognized gains that arise on or after the day the identified
mixed straddle identification was made for the position.
(d) Examples. The rules of this section may be illustrated by the
following examples. It is assumed in each example that the positions
described are the only positions held directly or indirectly (through a
related person or flowthrough entity) by an individual calendar year
taxpayer during the taxable year, and no successor positions are
acquired or entered into. It is also assumed that gain or loss
recognized on any position in the straddle would be capital gain or
loss. The following examples assume that the identified mixed straddle
is established after the applicability date of this section.
Example 1. (i) Facts. On January 13, Year 1, A enters into a section
1256 contract. As of the close of the day on January 15, Year 1, there
is $500 of unrealized loss on the section
[[Page 244]]
1256 contract. On January 16, Year 1, A enters into an offsetting non-
section 1256 position and makes a valid election to treat the straddle
as an identified mixed straddle. A continues to hold both positions of
the identified mixed straddle on January 1, Year 2, and there are no
further changes to the value of either position in Year 1.
(ii) Analysis. On the last business day of Year 1, A recognizes the
$500 loss on the section 1256 contract that accrued prior to
establishing the identified mixed straddle because the section 1256
contract is treated as sold on December 31, Year 1 (the last business
day of the taxable year) under section 1256(a). The loss recognized in
Year 1 will be treated as 60% long-term capital loss and 40% short-term
capital loss. All gains and losses that arise on or after the identified
mixed straddle is established are accounted for under the rules of
Sec. Sec. 1.1092(b)-2T (and paragraph (b) of this section), 1.1092(b)-
3T(b) (other than Sec. 1.1092(b)-3T(b)(6)), and paragraph (c) of this
section.
Example 2. (i) Facts. On December 3, Year 1, A purchases a non-
section 1256 position for $100. As of the close of the day on January
22, Year 2, the non-section 1256 position has a fair market value of
$500. On January 23, Year 2, A enters into an offsetting section 1256
contract and makes a valid election to treat the straddle as an
identified mixed straddle. On February 10, Year 2, A closes out the
section 1256 contract at a $500 loss and disposes of the non-section
1256 position for $975.
(ii) Analysis of pre-straddle gain. A has $400 of unrealized short-
term capital gain attributable to the non-section 1256 position prior to
the day the identified mixed straddle was established. This $400 gain is
recognized on February 10, Year 2, when the non-section 1256 position is
disposed of. Under paragraph (a) of this section, the gain is short-term
capital gain because that would have been the character of the gain if
the non-section 1256 position had been disposed of on the day prior to
establishing the identified mixed straddle.
(iii) Analysis of straddle gain and loss. On February 10, Year 2,
the gain of $475 ($975 proceeds minus $500 fair market value on the day
prior to entering into the identified mixed straddle) on the non-section
1256 position attributable to the identified mixed straddle period is
offset by the $500 loss on the section 1256 contract. The net loss of
$25 from the identified mixed straddle is recognized and treated as 60%
long-term capital loss and 40% short-term capital loss because it is
attributable to the section 1256 contract. See Sec. 1.1092(b)-3T(b)(4).
Example 3. (i) Facts. On January 3, Year 1, A purchases 100 shares
of Index Fund for $1,000 ($10 per share). The Index Fund shares are
actively traded personal property and are not section 1256 contracts. As
of the close of the day on June 24, Year 2, the fair market value of 100
shares of Index Fund is $1,200. On June 25, Year 2, A enters into a
short regulated futures contract (Futures Contract) referenced to the
same index referenced by Index Fund. Futures Contract is a section 1256
contract and A makes a valid election to treat the shares of Index Fund
and Futures Contract as an identified mixed straddle. On December 31,
Year 2, the fair market value of A's shares of Index Fund is $1,520 and
Futures Contract has lost $300. On January 10, Year 3, A closes out
Futures Contract at a loss of $400 when the fair market value of 100
shares of Index Fund is $1,590. On November 20, Year 3, A disposes of
all 100 shares of Index Fund for $1,600.
(ii) Year 2 analysis. On June 24, Year 2, A has held the Index Fund
shares for longer than the long-term holding period, and the $200 of
unrecognized gain on the Index Fund shares as of June 24, Year 2, will
be characterized as long-term gain under paragraph (a) of this section
when the gain is recognized. On December 31, Year 2, Futures Contract is
marked to market under section 1256(a)(1). Under paragraph (a) of this
section and Sec. 1.1092(b)-3T(b)(4), the loss on Futures Contract of
$300 is netted with the $320 unrecognized gain on the Index Fund shares
that arose while the identified mixed straddle was in place. Because
this unrecognized gain is greater than the deemed realized section 1256
loss, the loss on Futures Contract is treated as a short-term capital
loss. The loss, however, will be disallowed in Year 2 under paragraph
(c) of this section and the loss deferral rules of section 1092(a)
because the unrecognized gain in the Index Fund shares that arose while
the identified mixed straddle was in place exceeds the deemed realized
loss. Even if this gain were only $250 on December 31, Year 2, the
deemed realized loss on Futures Contract would be disallowed because
there is $200 of unrecognized gain in the Index Fund shares from the
time A held the shares prior to establishing the identified mixed
straddle.
(iii) Year 3 analysis. When A closes out the Futures Contract on
January 10, Year 3, the entire amount of the section 1256 $300 loss that
was disallowed on December 31, Year 2, continues to be deferred under
paragraph (c) of this section. On November 20, Year 3, A recognizes $200
long-term capital gain from the pre-identified mixed straddle period,
and $400 short-term capital gain, $390 of which arose during the
identified mixed straddle period and $10 of which arose after the
identified mixed straddle was closed. See Sec. 1.1092(b)-2T(a)(1) and
paragraph (b) of this section. In Year 3, A recognizes the $300 short-
term capital loss from Futures Contract disallowed in Year 2 and the
$100 loss accrued on Futures Contract in Year 3 because A no longer
holds any positions that were part of an identified mixed straddle.
[[Page 245]]
Example 4. (i) Facts. On March 1, Year 1, A purchases a 10-year U.S.
Treasury Note (Note) at original issue for $100, which is the stated
redemption price at maturity of Note. As of the close of the day on
March 1, Year 3, Note has a fair market value of $105. On March 2, Year
3, A enters into a regulated futures contract (Futures Contract) that
provides A with a short position in U.S. Treasury Notes and A makes a
valid election to treat Note and Futures Contract as an identified mixed
straddle. A closes her position in Futures Contract on April 15, Year 3,
at a $2 loss. On April 15, Year 3, Note has a fair market value of $108.
On December 31, Year 3, Note has a fair market value of $106. A holds
Note until it matures on February 28, Year 10.
(ii) Year 3 analysis. A has $5 of unrealized gain attributable to
Note prior to the day the identified mixed straddle was established.
Because A acquired a long-term holding period in Note by March 1, Year
3, the $5 of gain will be characterized as long-term capital gain under
paragraph (a) of this section when it is recognized. Under Sec.
1.1092(b)-3T(b)(4), when A closes out Futures Contract on April 15, Year
3, the loss of $2 on Futures Contract is netted with the gain of $3 on
Note that arose while the identified mixed straddle was in place.
Because this gain on Note exceeds the realized loss on Futures Contract,
the loss on Futures Contract is disallowed in Year 3 under paragraph (c)
of this section. Further, under paragraph (c) of this section and
section 1092(a)(1), on December 31, Year 3, the disallowed loss of $2 on
Futures Contract cannot be recognized because it is less than the total
unrecognized gain of $6 on Note on December 31, Year 3.
(iii) Year 10 analysis. When Note matures in Year 10, the $5 of
unrecognized long-term capital gain that arose prior to the identified
mixed straddle is recognized. Because A receives $100 upon the maturity
of Note, A also recognizes a $5 long-term capital loss on Note, for a
net gain of $0 (zero). In addition, the termination of all positions in
the identified mixed straddle releases the $2 loss disallowed in Year 3
on Futures Contract. The loss on Futures Contract is treated as short-
term capital loss in Year 10 under Sec. 1.1092(b)-3T(b)(4).
(e) Effective/applicability date. The rules of this section apply to
all section 1092(b)(2) identified mixed straddles established after
August 18, 2014.
[T.D. 9678, 79 FR 41888, July 18, 2014]
Sec. 1.1092(c)-1 Qualified covered calls.
(a) In general. Section 1092(c) defines a straddle as offsetting
positions with respect to personal property. Under section
1092(d)(3)(B)(i)(I), stock is personal property if the stock is part of
a straddle that involves an option on that stock or substantially
identical stock or securities. Under section 1092(c)(4), however,
writing a qualified covered call option and owning the optioned stock is
not treated as a straddle under section 1092 if certain conditions,
described in section 1092(c)(4)(B), are satisfied. Section 1092(c)(4)(H)
authorizes the Secretary to modify these conditions to carry out the
purposes of section 1092(c)(4) in light of changes in the marketplace.
(b) Term limitation--(1) General rule. Except as provided in
paragraph (b)(2) of this section, an option is not a qualified covered
call unless it is granted not more than 12 months before the day on
which the option expires or satisfies term limitation and qualified
benchmark requirements established by the Commissioner in guidance
published in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii)(b) of this chapter).
(2) Special benchmark rule for an option granted not more than 33
months before the day on which the option expires--(i) In general. The
12-month limitation described in paragraph (b)(1) of this section is
extended to 33 months provided the lowest qualified benchmark is
determined using the adjusted applicable stock price, as defined in
Sec. 1.1092(c)-4(e).
(ii) Examples. The following examples illustrate the rules set out
in paragraph (b)(2)(i) of this section:
Example 1. Taxpayer owns stock in Corporation X. Taxpayer writes an
equity option with standardized terms on Corporation X stock through a
national securities exchange with a term of 21 months. The applicable
stock price for Corporation X stock is $100. The bench marks for a 21-
month equity option with standardized terms with an applicable stock
price of $100 will be based upon the adjusted applicable stock price.
Using the table at Sec. 1.1092(c)-4(e), the applicable stock price of
$100 is multiplied by the adjustment factor 1.12, resulting in an
adjusted applicable stock price of $112. Using the bench marks for an
equity option with standardized terms with an adjusted applicable stock
price of $112, the highest available strike price less than the adjusted
applicable stock price is $110, and the second highest strike price less
than the adjusted applicable stock price is $105. Therefore, a 21-month
equity call option with standardized terms on Corporation X stock will
not be deep in the
[[Page 246]]
money if the strike price is not less than $105.
Example 2. Taxpayer owns stock in Corporation Y. Taxpayer writes an
equity option with standardized terms on Corporation Y stock through a
national securities exchange with a term of 21 months. The applicable
stock price for Corporation Y stock is $13.25. The bench marks for a 21-
month equity option with standardized terms with an applicable stock
price of $13.25 will be based upon the adjusted applicable stock price.
Using the table at Sec. 1.1092(c)-4(e), the applicable stock price of
$13.25 is multiplied by the adjustment factor 1.12, resulting in an
adjusted applicable stock price of $14.84. Using the bench marks for an
equity option with standardized terms with an adjusted applicable stock
price of $14.84, the highest available strike price less than the
adjusted applicable stock price is $12.50. However, under section
1092(c)(4)(D), the lowest qualified bench mark can be no lower than 85%
of the applicable stock price, which for Corporation Y stock is $12.61
(85% of the adjusted applicable stock price of $14.84). Thus, because
the highest available strike price less than the adjusted applicable
stock price for an equity option with standardized terms is lower than
the lowest qualified bench mark under section 1092(c)(4)(D), the lowest
strike price at which a qualified covered call option can be written is
the next higher strike price, or $15.00. Therefore, a 21-month equity
call option with standardized terms on Corporation Y stock will not be
deep in the money if the strike price is not less than $15.
(c) Effective date. This section applies to qualified covered call
options entered into on or after July 29, 2002.
[67 FR 20899, Apr. 29, 2002]
Sec. 1.1092(c)-2 Equity options with flexible terms.
(a) In general. Section 1092(c)(4) provides an exception to the
general rule that a straddle exists if a taxpayer holds stock and writes
a call option on that stock. Under section 1092(c)(4), the ownership of
stock and the issuance of a call option meeting certain requirements
result in a qualified covered call, which is exempted from the general
straddle rules of section 1092. This section addresses the consequences
of the availability of equity options with flexible terms under the
qualified covered call rules.
(b) No effect on lowest qualified bench mark for standardized
options. The availability of strike prices for equity options with
flexible terms does not affect the determination of the lowest qualified
bench mark, as defined in section 1092(c)(4)(D), for an equity option
with standardized terms.
(c) Qualified covered call option status--(1) Requirements. An
equity option with flexible terms is a qualified covered call option
only if--
(i) The option meets the requirements of section 1092(c)(4)(B) and
Sec. 1.1092(c)-1 (taking into account paragraph (c)(2) of this
section);
(ii) The only payments permitted with respect to the option are a
single fixed premium paid not later than 5 business days after the day
on which the option is granted, and a single fixed strike price, as
defined in Sec. 1.1092(c)-4(d), that is payable entirely at (or within
5 business days of) exercise;
(iii) An equity option with standardized terms is outstanding for
the underlying equity; and
(iv) The underlying security is stock in a single corporation.
(2) Lowest qualified bench mark--(i) In general. For purposes of
determining whether an equity option with flexible terms is deep in the
money within the meaning of section 1092(c)(4)(C), the lowest qualified
bench mark under section 1092(c)(4)(D) is the same for an equity option
with flexible terms as the lowest qualified bench mark for an equity
option with standardized terms on the same stock having the same
applicable stock price.
(ii) Examples. The following examples illustrate the rules set out
in paragraph (c)(2)(i) of this section:
Example 1. Taxpayer owns stock in Corporation X. Taxpayer writes an
equity call option with flexible terms on Corporation X stock through a
national securities exchange for a term of not more than 12 months. The
applicable stock price for Corporation X stock is $73.75. Using the
bench marks for an equity option with standardized terms with an
applicable stock price of $73.75, the highest available strike price
less than the applicable stock price is $70, and the second highest
strike price less than the applicable stock price is $65. Therefore, an
equity call option with flexible terms on Corporation X stock with a
term of 90 days or less will not be deep in the money if the strike
price is not less than $70. If the term is greater than 90 days, an
equity call option with flexible terms on Corporation X will not be deep
in the money if the strike price is not less than $65.
[[Page 247]]
Example 2. Taxpayer owns stock in Corporation Y. Taxpayer writes a
9-month equity call option with flexible terms on Corporation Y stock
through a national securities exchange. The applicable stock price for
Corporation Y stock is $14.75. Using the bench marks for an equity
option with standardized terms with an applicable stock price of $14.75,
the highest available strike price less than the applicable stock price
is $12.50. However, under section 1092(c)(4)(D), the lowest qualified
bench mark can be no lower than 85% of the applicable stock price, which
for Corporation Y stock is $12.54. Thus, because the highest available
strike price less than the applicable stock price for an equity option
with standardized terms is lower than the lowest qualified bench mark
under section 1092(c)(4)(D), the lowest strike price at which a
qualified covered call option can be written is the next higher strike
price, or $15.00. This $15.00 strike price requirement for a qualified
covered call option applies to equity options with flexible terms,
equity options with standardized terms, and qualifying over-the-counter
options.
Example 3. Taxpayer owns stock in Corporation Z. On May 8, 2003,
Taxpayer writes a 21-month equity call option with flexible terms on
Corporation Z stock through a national securities exchange. The
applicable stock price for Corporation Z stock is $100. The bench marks
for a 21-month equity option with standardized terms with an applicable
stock price of $100 will be based upon the adjusted applicable stock
price. Using the table at Sec. 1.1092(c)-4(e), the applicable stock
price of $100 is multiplied by the adjustment factor 1.12, resulting in
an adjusted applicable stock price of $112. The highest available strike
price less than the adjusted applicable stock price is $110, and the
second highest strike price less than the adjusted applicable stock
price is $105. Therefore, a 21-month equity call option with flexible
terms on Corporation Z stock will not be deep in the money if the strike
price is not less than $105.
(d) Effective date--(1) In general. Except as provided in paragraph
(d)(2) of this section, this section applies to equity options with
flexible terms entered into on or after January 25, 2000.
(2) Effective date for paragraphs (b) and (c) of this section.
Paragraphs (b) and (c) of this section apply to equity options with
flexible terms entered into on or after July 29, 2002.
[T.D. 8866, 65 FR 3813, Jan. 25, 2000; Redesignated at 67 FR 20899, Apr.
29, 2002]
Sec. 1.1092(c)-3 Qualifying over-the-counter options.
(a) In general. Under section 1092(c)(4)(B)(i), an equity option is
not a qualified covered call option unless it is traded on a national
securities exchange that is registered with the Securities and Exchange
Commission or other market that the Secretary determines has rules
adequate to carry out the purposes of section 1092(c)(4). In accordance
with section 1092(c)(4)(H), this requirement is modified as provided in
paragraph (b) of this section.
(b) Qualified covered call option status. A qualifying over-the-
counter option, as defined in Sec. 1.1092(c)-4(c), is a qualified
covered call option if it meets the requirements of Sec. Sec.
1.1092(c)-1 and 1.1092(c)-2(c) after using the language ``qualifying
over-the-counter option'' in place of ``equity option with flexible
terms''. For purposes of this paragraph (b), a qualifying over-the-
counter option is deemed to satisfy the requirements of section
1092(c)(4)(B)(i).
(c) Effective date. This section applies to qualifying over-the-
counter options entered into on or after July 29, 2002.
[67 FR 20900, Apr. 29, 2002]
Sec. 1.1092(c)-4 Definitions.
The following definitions apply for purposes of Sec. Sec.
1.1092(c)-1 through 1.1092(c)-3:
(a) Equity option with flexible terms means an equity option--
(1) That is described in any of the following Securities Exchange
Act Releases--
(i) Self-Regulatory Organizations; Order Approving Proposed Rule
Changes and Notice of Filing and Order Granting Accelerated Approval of
Amendments by the Chicago Board Options Exchange, Inc. and the Pacific
Stock Exchange, Inc., Relating to the Listing of Flexible Equity Options
on Specified Equity Securities, Securities Exchange Act Release No. 34-
36841 (Feb. 21, 1996); or
(ii) Self-Regulatory Organizations; Order Approving Proposed Rule
Changes and Notice of Filing and Order Granting Accelerated Approval of
Amendment Nos. 2 and 3 to the Proposed Rule Change by the American Stock
Exchange, Inc., Relating to the
[[Page 248]]
Listing of Flexible Equity Options on Specified Equity Securities,
Securities Exchange Act Release No. 34-37336 (June 27, 1996); or
(iii) Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval of
Amendment Nos. 2, 4 and 5 to the Proposed Rule Change by the
Philadelphia Stock Exchange, Inc., Relating to the Listing of Flexible
Exchange Traded Equity and Index Options, Securities Exchange Act
Release No. 34-39549 (Jan. 23, 1998); or
(iv) Any changes to the Security Exchange Act Releases described in
paragraphs (a)(1)(i) through (iii) of this section that are approved by
the Securities and Exchange Commission; or
(2) That is traded on any national securities exchange that is
registered with the Securities and Exchange Commission (other than those
described in the Security Exchange Act Releases set forth in paragraph
(a)(1) of this section) and is--
(i) Substantially identical to the equity options described in
paragraph (a)(1) of this section; and
(b) Equity option with standardized terms means an equity option--
(1) That is traded on a national securities exchange registered with
the Securities and Exchange Commission;
(2) That, on the date the option is written, expires on the Saturday
following the third Friday of the month of expiration;
(3) That has a strike price that is set at a uniform minimum strike
price interval, that is established by the applicable national
securities exchange registered with the Securities and Exchange
Commission, and that is not less than $1.00; and
(4) That has stock in a single corporation as its underlying
security.
(c) Qualifying over-the-counter option means an equity option that--
(1) Is not traded on a national securities exchange registered with
the Securities and Exchange Commission; and
(2) Is entered into with--
(i) A broker-dealer, acting as principal or agent, who is registered
with the Securities and Exchange Commission under section 15 of the
Securities Act of 1934 (15 U.S.C. 78a through 78mm) and the regulations
thereunder and who must comply with the recordkeeping requirements of 17
CFR 240.17a-3; or
(ii) An alternative trading system under 17 CFR 242.300 through 17
CFR 242.303; or
(iii) A person, acting as principal or agent, who must comply with
the recordkeeping requirements for securities transactions described in
12 CFR 12.3, 12 CFR 208.34, or 12 CFR 344.4.
(d) Single fixed strike price means a strike price that is fixed,
determinable, and stated as a dollar amount on the date the option is
written. An option will not fail to have a single fixed strike price if,
after the date the option is written, the strike price is adjusted to
account for the effects of a dividend, stock dividend, stock
distribution, stock split, reverse stock split, rights offering,
distribution, reorganization, recapitalization, or reclassification with
respect to the underlying security, or a merger, consolidation,
dissolution, or liquidation of the issuer of the underlying security.
(e) Adjusted applicable stock price means the applicable stock
price, as defined in section 1092(c)(4)(G), adjusted for time. To
determine the adjusted applicable stock price, the applicable stock
price, which is determined in accordance with the rules in section
1092(c)(4)(G), is multiplied by an adjustment factor. The adjustment
factor table is as follows:
------------------------------------------------------------------------
Option term (in months)
------------------------------------------------------------ Adjustment
Greater than Not more than factor
------------------------------------------------------------------------
12................................. 15.................... 1.08
15................................. 18.................... 1.10
18................................. 21.................... 1.12
21................................. 24.................... 1.14
24................................. 27.................... 1.16
27................................. 30.................... 1.18
30................................. 33.................... 1.20
------------------------------------------------------------------------
(f) Securities Exchange Act Release means a release issued by the
Securities and Exchange Commission. To determine identifying information
for releases referenced in paragraph (d)(1) of this section, including
release titles, identification numbers, and issue dates, contact the
Office of the Secretary, Securities and Exchange Commission, 450 5th
Street, NW., Washington, DC 20549. To obtain a copy of a
[[Page 249]]
Securities Exchange Act Release, submit a written request, including the
specific release identification number, title, and issue date, to
Securities and Exchange Commission, Attention Public Reference, 450 5th
Street, NW., Washington, DC 20549.
(g) Effective dates. (1) Except for paragraph (a)(2) of this
section, paragraph (a) of this section applies to equity options with
flexible terms entered into on or after January 25, 2000. Paragraph
(a)(2) of this section applies to equity options with flexible terms
entered into on or after July 29, 2002.
(2) Paragraphs (b), (c), (d), and (e) of this section apply to
equity options entered into on or after July 29, 2002.
(3) Paragraph (f) of this section applies to equity options entered
into on or after January 25, 2000.
[67 FR 20900, 20901, Apr. 29, 2002]
Sec. 1.1092(d)-1 Definitions and special rules.
(a) Actively traded. Actively traded personal property includes any
personal property for which there is an established financial market.
(b) Established financial market--(1) In general. For purposes of
this section, an established financial market includes--
(i) A national securities exchange that is registered under section
6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f);
(ii) An interdealer quotation system sponsored by a national
securities association registered under section 15A of the Securities
Exchange Act of 1934;
(iii) A domestic board of trade designated as a contract market by
the Commodities Futures Trading Commission;
(iv) A foreign securities exchange or board of trade that satisfies
analogous regulatory requirements under the law of the jurisdiction in
which it is organized (such as the London International Financial
Futures Exchange, the Marche a Terme International de France, the
International Stock Exchange of the United Kingdom and the Republic of
Ireland, Limited, the Frankfurt Stock Exchange, and the Tokyo Stock
Exchange);
(v) An interbank market;
(vi) An interdealer market (as defined in paragraph (b)(2)(i) of
this section); and
(vii) Solely with respect to a debt instrument, a debt market (as
defined in paragraph (b)(2)(ii) of this section).
(2) Definitions--(i) Interdealer market. An interdealer market is
characterized by a system of general circulation (including a computer
listing disseminated to subscribing brokers, dealers, or traders) that
provides a reasonable basis to determine fair market value by
disseminating either recent price quotations (including rates, yields,
or other pricing information) of one or more identified brokers,
dealers, or traders or actual prices (including rates, yields, or other
pricing information) of recent transactions. An interdealer market does
not include a directory or listing of brokers, dealers, or traders for
specific contracts (such as yellow sheets) that provides neither price
quotations nor actual prices of recent transactions.
(ii) Debt market. A debt market exists with respect to a debt
instrument if price quotations for the instrument are readily available
from brokers, dealers, or traders. A debt market does not exist with
respect to a debt instrument if--
(A) No other outstanding debt instrument of the issuer (or of any
person who guarantees the debt instrument) is traded on an established
financial market described in paragraph (b)(1)(i), (ii), (iii), (iv),
(v), or (vi) of this section (other traded debt);
(B) The original stated principal amount of the issue that includes
the debt instrument does not exceed $25 million;
(C) The conditions and covenants relating to the issuer's
performance with respect to the debt instrument are materially less
restrictive than the conditions and covenants included in all of the
issuer's other traded debt (e.g., the debt instrument is subject to an
economically significant subordination provision whereas the issuer's
other traded debt is senior); or
(D) The maturity date of the debt instrument is more than 3 years
after the latest maturity date of the issuer's other traded debt.
[[Page 250]]
(c) Notional principal contracts. For purposes of section 1092(d)--
(1) A notional principal contract (as defined in Sec. 1.446-
3(c)(1)) constitutes personal property of a type that is actively traded
if contracts based on the same or substantially similar specified
indices are purchased, sold, or entered into on an established financial
market within the meaning of paragraph (b) of this section; and
(2) The rights and obligations of a party to a notional principal
contract are rights and obligations with respect to personal property
and constitute an interest in personal property.
(d) Debt instrument linked to the value of personal property. If a
taxpayer is the obligor under a debt instrument one or more payments on
which are linked to the value of personal property or a position with
respect to personal property, then the taxpayer's obligation under the
debt instrument is a position with respect to personal property and may
be part of a straddle.
(e) Effective/applicability dates--(1) Paragraphs (a) and (b) of
this section apply to positions entered into on or after October 14,
1993.
(2) Paragraph (c) of this section applies to positions entered into
on or after July 8, 1991.
(3) Paragraph (d) of this section applies to straddles established
on or after January 17, 2001.
[T.D. 8491, 58 FR 53135, Oct. 14, 1993, as amended by T.D. 9635, 78 FR
54569, Sept. 5, 2013; T.D. 9691, 79 FR 51091, Aug. 27, 2014]
Sec. 1.1092(d)-2 Personal property.
(a) Special rules for stock. Under section 1092(d)(3)(B), personal
property includes any stock that is part of a straddle, at least one of
the offsetting positions of which is a position with respect to
substantially similar or related property (other than stock). For
purposes of this rule, the term substantially similar or related
property is defined in Sec. 1.246-5 (other than Sec. 1.246-5(b)(3)).
The rule in Sec. 1.246-5(c)(6) does not narrow the related party rule
in section 1092(d)(4).
(b) Effective date--(1) In general. This section applies to
positions established on or after March 17, 1995.
(2) Special rule for certain straddles. This section applies to
positions established after March 1, 1984, if the taxpayer substantially
diminished its risk of loss by holding substantially similar or related
property involving the following types of transactions--
(i) Holding offsetting positions consisting of stock and a
convertible debenture of the same corporation where the price movements
of the two positions are related; or
(ii) Holding a short position in a stock index regulated futures
contract (or alternatively an option on such a regulated futures
contract or an option on the stock index) and stock in an investment
company whose principal holdings mimic the performance of the stocks
included in the stock index (or alternatively a portfolio of stocks
whose performance mimics the performance of the stocks included in the
stock index).
[T.D. 8590, 60 FR 14641, Mar. 20, 1995]
capital gains and losses
Treatment of Capital Gains
Sec. 1.1201-1 Alternative tax.
(a) Corporations--(1) In general. (i) If for any taxable year a
corporation has net capital gain (net section 1201 gain for taxable
years beginning before January 1, 1977) (as defined in section 1222(11))
section 1201(a) imposes an alternative tax in lieu of the tax imposed by
sections 11 and 511, but only if such alternative tax is less than the
tax imposed by sections 11 and 511. The alternative tax is not in lieu
of the personal holding company tax imposed by section 541 or of any
other tax not specifically set forth in section 1201(a).
(ii) In the case of an insurance company, the alternative tax
imposed by section 1201(a) is also in lieu of the tax imposed by
sections 821 (a) or (c) and 831 (a), except that for taxable years
beginning before January 1, 1963, the reference to section 821 (a) or
(c) is to be read as reference to section 821 (a)(1) or (b). For taxable
years beginning after December 31, 1954, and before January 1, 1958, the
alternative tax imposed by section 1201(a) shall also be in lieu of the
tax imposed by section 802(a), as amended by the Life Insurance Company
Tax Act for 1955 (70 Stat. 38), if such alternative tax is less
[[Page 251]]
than the tax imposed by such section. See section 802(e), as added by
the Life Insurance Company Tax Act for 1955 (70 Stat. 39). However, for
taxable years beginning after December 31, 1958, and before January 1,
1962, section 802(a)(2), as amended by the Life Insurance Company Income
Tax Act of 1959 (73 Stat. 115), imposes a separate tax equal to 25
percent of the amount by which the net long-term capital gain of any
life insurance company (as defined in section 801(a) and paragraph (b)
of Sec. 1.801-3) exceeds its net short-term capital loss. See paragraph
(f) of Sec. 1.802-3. For alternative tax for life insurance companies
in the case of taxable years beginning after December 31, 1961, see
section 802(a)(2) and the regulations thereunder.
(iii) See section 56 and the regulations thereunder for provisions
relating to the minimum tax for tax preferences.
(2) Alternative tax. The alternative tax is the sum of:
(i) A partial tax computed at the rates provided in sections 11,
511, 821 (a) or (c), and 831(a), on the taxable income of the taxpayer
reduced by the amount of the net capital gain (net section 1201 gain for
taxable years beginning before January 1, 1977), and
(ii) An amount equal to the tax determined under subparagraph (3) of
this paragraph.
For taxable years beginning after December 31, 1954, and before January
1, 1958, the partial tax under subdivision (i) of this subparagraph
shall also be computed at the rates provided in section 802(a). For
taxable years beginning before January 1, 1963, the reference in such
subdivision to section 821 (a) or (c) is to be read as a reference to
section 821 (a) or (b).
(3) Tax on capital gains. For purposes of subparagraph (2)(ii) of
this paragraph, the tax shall be:
(i) In the case of a taxable year beginning after December 31, 1974,
a tax of 30 percent of the net section 1201 gain (net capital gain for
taxable years beginning after December 31, 1976),
(ii) In the case of a taxable year beginning after December 31,
1969, and before January 1, 1975:
(a) A tax of 25 percent of the lesser of the amount of the
subsection (d) gain (as defined in section 1201(d) and paragraph (f) of
this section) or the amount of the net section 1201 gain (net capital
gain for taxable years beginning after December 31, 1976), plus
(b) A tax of 30 percent (28 percent in the case of a taxable year
beginning after December 31, 1969, and before January 1, 1971) of the
excess, if any, of the net section 1201 gain (net capital gain for
taxable years beginning after December 31, 1976) over the subsection (d)
gain,
(iii) In the case of a taxable year beginning before January 1,
1970, and after March 31, 1954, a tax of 25 percent of the net section
1201 gain (net capital gain for taxable years beginning after December
31, 1976), or
(iv) In the case of a taxable year beginning before April 1, 1954, a
tax of 26 percent of the net section 1201 gain (net capital gain for
taxable years beginning after December 31, 1976).
(4) Determination of special deductions. In the computation of the
partial tax described in subparagraph (2)(i) of this paragraph the
special deductions provided for in sections 243, 244, 245, 247, 922, and
941 shall not be recomputed as the result of the reduction of taxable
income by the net capital gain (net section 1201 gain for taxable years
beginning before January 1, 1977).
(b) Other taxpayers--(1) In general. If for any taxable year a
taxpayer (other than a corporation) has net capital gain (net section
1201 gain for taxable years beginning before January 1, 1977) (as
defined in section 1222(11)) section 1201(b) imposes an alternative tax
in lieu of the tax imposed by sections 1 and 511, but only if such
alternative tax is less than the tax imposed by sections 1 and 511. The
alternative tax is not in lieu of any other tax not specifically set
forth in section 1201(b). See section 56 and the regulations thereunder
for provisions relating to the minimum tax for tax preferences.
(2) Alternative tax. The alternative tax is the sum of:
(i) A partial tax computed at the rates provided by sections 1 and
511 on the taxable income reduced by an amount equal to 50 percent of
the net capital gain (net section 1201 gain for taxable years beginning
before January 1, 1977), and
[[Page 252]]
(ii) In the case of a taxable year beginning after December 31,
1969:
(a) A tax of 25 percent of the lesser of the amount of the
subsection (d) gain (as defined in section 1201(d) and paragraph (f) of
this section) or the amount of the net capital gain (net section 1201
gain for taxable years beginning before January 1, 1977), plus
(b) A tax computed as provided in section 1201(c) and paragraph (e)
of this section on the excess, if any, of the net capital gain (net
section 1201 gain for taxable years beginning before January 1, 1977)
over the subsection (d) gain, or
(iii) In the case of a taxable year beginning before January 1,
1970, a tax of 25 percent of the net section 1201 gain (net capital gain
for taxable years beginning after December 31, 1976).
(3) Cross references. See Sec. 1.1-2(a) for rule relating to the
computation of the limitation on tax in cases where the alternative tax
is imposed. See Sec. 1.34-2 (a) for rule relating to the computation of
the dividend received credit under section 34 (for dividends received on
or before December 31, 1964), and Sec. 1.35-1 (a) for rule relating to
the computation of credit for partially tax-exempt interest under
section 35 in cases where the alternative tax is imposed.
(c) Tax-exempt trusts and organizations. In applying section 1201 in
the case of tax-exempt trusts or organizations subject to the tax
imposed by section 511, the only amount which is taken into account as
capital gain or loss is that which is taken into account in computing
unrelated business taxable income under section 512. Under section 512,
the only amount taken into account as capital gain or loss is that
resulting from the application of section 631(a), relating to the
election to treat the cutting of timber as a sale or exchange.
(d) Joint returns. In the case of a joint return, the excess of any
net long-term capital gain over any net short-term capital loss is to be
determined by combining the long-term capital gains and losses and the
short-term capital gains and losses of the spouses.
(e) Computation of tax on capital gain in excess of subsection (d)
gain--(1) In general. The tax computed for purposes of section
1201(b)(3) and paragraph (b) (2)(ii)(b) of this section shall be the
amount by which a tax determined under section 1 or 511 on an amount
equal to the taxable income (but not less than 50 percent of the net
capital gain (net section 1201 gain for taxable years beginning before
January 1, 1977)) for the taxable year exceeds a tax determined under
section 1 or 511 on an amount equal to the sum of (i) the amount subject
to tax under section 1201 (b)(1) and paragraph (b)(2)(i) of this section
for such year plus (ii) an amount equal to 50 percent of the subsection
(d) gain for such year.
(2) Limitation. Notwithstanding subparagraph (1) of this paragraph,
the tax computed for purposes of section 1201(b) (3) and paragraph
(b)(2)(ii)(b) of this section shall not exceed an amount equal to the
following percentage of the excess of the net capital gain (net section
1201 gain for taxable years beginning before January 1, 1977) over the
subsection (d) gain for the taxable year:
(i) 29\1/2\ percent, in the case of a taxable year beginning after
December 31, 1969, and before January 1, 1971, or
(ii) 32\1/2\ percent, in the case of a taxable year beginning after
December 31, 1970, and before January 1, 1972.
(f) Definition of subsection (d) gain--(1) In general. For purposes
of section 1201 and this section, the term subsection (d) gain means the
sum of the long-term capital gains for the taxable year arising:
(i) In the case of amounts received or accrued, as the case may be,
before January 1, 1975 (other than any gain from a transaction described
in section 631 or 1235), from:
(a) Sales or other dispositions on or before October 9, 1969,
including sales or other dispositions the income from which is returned
as provided in section 453 (a)(1) or (b)(1), or
(b) Sales or other dispostions after October 9, 1969, pursuant to
binding contracts entered into on or before that date, including sales
or other dispositions the income from which is returned as provided in
section 453 (a)(1) or (b)(1),
(ii) From liquidating distributions made by a corporation which are
made (a) before October 10, 1970, and (b) pursuant to a plan of complete
liquidation adopted on or before October 9, 1969, or
[[Page 253]]
(iii) In the case of a taxpayer (other than a corporation), from any
other source not described in subdivision (i) or (ii) of this
subparagraph, but the amount taken into account from such other sources
shall be limited to the amount, if any, by which $50,000 ($25,000 in the
case of a married individual filing a separate return) exceeds the sum
of the gains to which subdivisions (i) and (ii) of this subparagraph
apply.
(2) Special rules. For purposes of subparagraph (1) of this
paragraph:
(i) A binding contract entered into on or before October 9, 1969,
means a contract, whether written or unwritten, which on or before that
date was legally enforceable against the taxpayer under applicable law.
If on or before October 9, 1969, a taxpayer grants an irrevocable option
or irrevocable contractual right to another party to buy certain
property and such other party exercises that option or right after
October 9, 1969, the sale of such property is a sale pursuant to a
binding contract entered into on or before October 9, 1969. The
application of this subdivision may be illustrated by the following
example:
Example: During 1964, A, B, and C formed a closely held corporation,
and A was appointed as president of the organization. On July 1, 1964, A
received for consideration 100 shares of common stock in the corporation
subject to the agreement that, if A should retire from the management of
the corporation or die, A or his estate would first offer his shares of
stock to the corporation for purchase and that, if the corporation did
not buy the stock within 60 days, the stock could be sold to any party
other than the corporation. On September 1, 1970, A retired from the
management of the corporation and offered his shares to the corporation
for purchase. Pursuant to the agreement, the corporation purchased A's
stock on September 30, 1970. A's sale of such stock was pursuant to a
binding contract entered into on or before October 9, 1969.
(ii) A contract which pursuant to subdivision (i) of this
subparagraph constitutes a binding contract entered into on or before
October 9, 1969, does not cease to qualify as such a contract by reason
of the fact that after October 9, 1969, there is a modification of the
terms of the contract such as a change in the time of performance, or in
the amount of the debt or in the terms and mode of payment, or in the
rate of interest, or there is a change in the form or nature of the
obligation or the character of the security, so long as the taxpayer is
at all times on and after October 9, 1969, legally bound by such
contract. The application of this subdivision may be illustrated by the
following examples:
Example 1. On August 1, 1969, A sold certain capital assets to B on
the installment plan and elected to return the gain therefrom under
section 453, the agreement providing for payments over a period of 2
years. At the time of the sale these assets had been held by A for more
than 6 months. On July 31, 1970, A and B agreed to a modification of the
terms of payment under the sales agreement, the only change in the
contract being that the installment payments due after July 31, 1970,
would be paid over a 3-year period. For purposes of this paragraph the
payments received by A after July 31, 1970, are considered amounts
received from the sale on August 1, 1969. (See section 483 for rules
with respect to interest on deferred payments.)
Example 2. On April 1, 1969, A sold certain capital assets to B on
the installment plan and elected to return the gain therefrom under
section 453, the agreement providing for payments over a period of 3
years. At the time of the sale these assets had been held by A for more
than 6 months. On March 31, 1970, C assumed B's obligation to pay the
balance of the installments which were due after that date. For purposes
of this paragraph any installment payments received by A after March 31,
1970, from C are considered amounts received from a sale made on or
before October 9, 1969.
Example 3. On May 1, 1969, A offers to sell certain capital assets
to B if B accepts the offer within 1 year, unless it is previously
withdrawn by A. B accepts the offer on November 1, 1969, and the
transaction is consummated shortly thereafter. For purposes of this
paragraph, any payment received by A pursuant to the sale is not
considered an amount received from a sale made on or before October 9,
1969, or from a sale pursuant to a binding contract entered into on or
before that date.
(iii) An amount which is considered under section 402(a)(2) or
403(a)(2) as gain of the taxpayer from the sale or exchange of a capital
asset held for more than 6 months shall be treated as gain subject to
the provisions of section 1201 (d)(1) and subdivision (i) of such
subparagraph, but only if on or before October 9, 1969, (a) the employee
with respect to whom such amount is
[[Page 254]]
distributed or paid, died or was otherwise separated from the service,
and (b) the terms of the plan required, or the employee elected, that
total distributions or amounts payable be paid to the taxpayer within 1
taxable year.
(iv) Gain described in section 1201(d) (1) or (2) with respect to a
partnership, estate, or trust, which is required to be included in the
gross income of a partner in such partnership, or of a beneficiary of
such estate or trust, shall be treated as such gain with respect to such
partner or beneficiary. Thus, for example, if during 1974 a partnership
which uses the calendar year as its taxable year receives amounts which
give rise to section 1201(d)(1) gain, a partner who uses the fiscal year
ending June 30 as his taxable year shall treat his distributive share of
such gain as subsection (d) gain for his taxable year ending June 30,
1975, even though such share is distributed to him after December 31,
1974. See Sec. 1.706-1.
(v) An individual shall be considered married for purposes of
subdivision (iii) of such subparagraph if for the taxable year he may
elect with his spouse to make a joint return under section 6013(a).
(vi) In applying such subparagraph for purposes of section 21(a) (1)
long-term capital gains arising from amounts received before January 1,
1970, shall be taken into account if such amounts are received during
the taxable year.
(g) Illustrations. The application of this section may be
illustrated by the following examples in which the assumption is made
that section 56 (relating to minimum tax for tax preferences) does not
apply:
Example 1. A, a single individual, has for the calendar year 1954
taxable income (exclusive of capital gains and losses) of $99,400. He
realizes in 1954 a gain of $50,000 on the sale of a capital asset held
for 19 months and sustains a loss of $20,000 on the sale of a capital
asset held for 5 months. He had no other capital gains or losses. Since
the alternative tax is less than the tax otherwise computed under
section 1, the tax payable is the alternative tax, that is $74,298. The
tax is computed as follows:
Tax Under Section 1
Taxable income exclusive of capital gains and losses......... $99,400
Net long-term capital gain (100 percent of $50,000
$50,000).........................................
Net short-term capital loss (100 percent of 20,000
$20,000).........................................
-----------
Excess of net long-term capital gain over the net short-term 30,000
capital loss................................................
------------
129,400
Deduction of 50 percent of excess of net long-term capital 15,000
gain over the net short-term capital loss (section 1202)....
------------
Taxable income............................................... 114,400
------------
Tax under section 1.......................................... 80,136
Alternative Tax Under Section 1201(b)
Taxable income............................................... $114,400
Less 50 percent of excess of net long-term capital gain over 15,000
net short-term capital loss (section 1201(b)(1))............
------------
Taxable income exclusive of capital gains and losses......... 99,400
============
Partial tax (tax on $99,400)................................. 66,798
Plus 25 percent of $30,000................................... 7,500
------------
Alternative tax under section 1201(b)........................ 74,298
Example 2. A husband and wife, who file a joint return for the
calendar year 1970, have taxable income (exclusive of capital gains and
losses) of $100,000. In 1970 they realize $200,000 of net long-term
capital gain in excess of net short-term capital loss, including long-
term capital gains of $100,000 arising from sales consummated in 1968
the income from which is returned on the installment method under
section 453, and long-term capital gains of $50,000, arising in respect
of distributions from X corporation made before October 10, 1970, which
were pursuant to a plan of complete liquidation adopted on October 9,
1969. Since the alternative tax under section 1201(b) is less than the
tax otherwise computed under section 1, the tax payable for 1970 is the
alternative tax, that is, $97,430 plus the tax surcharge under section
51. The tax (without regard to the tax surcharge) is computed as
follows:
Tax Under Section 1
Taxable income exclusive of capital gains and losses......... $100,000
Net section 1201 gain (net capital gain for taxable years 200,000
beginning after December 31, 1976) (excess of net long-term
capital gain over the net short-term capital loss)..........
------------
Total.................................................... 300,000
Deduction of 50 percent of net section 1201 (net capital gain 100,000
for taxable years beginning after December 31, 1976) gain
(section 1202)..............................................
------------
Taxable income........................................... 200,000
============
Tax under section 1.......................................... 110,980
Alternative Tax Under Section 1201(b)
(1) Net section 1201 gain (net capital gain for taxable years $200,000
beginning after December 31, 1976)..........................
------------
(2) Subsection (d) gain:
Section 1201(d)(1)......................................... 100,000
Section 1201(d)(2)......................................... 50,000
------------
[[Page 255]]
Total subsection (d) gain................................ 150,000
============
(3) Net section 1201 (net capital gain for taxable years 50,000
beginning after December 31, 1976) gain in excess of
subsection (d) gain ($200,000 less $150,000)................
------------
(4) Tax under section 1201(b)(1):
(i) Taxable income.............................. $200,000
(ii) Less: 50% of item (1)...................... 100,000
------------
(iii) Amount subject to tax under section 100,000
1201(b)(1).....................................
===========
Partial tax (computed under section 1)................... 45,180
(5) Tax under section 1201(b)(2): (25% of item (1) or of item 37,500
(2), whichever is lesser [25% of $150,000]).................
(6) Tax under section 1201(b)(3) on item (3):
Tax under section 1 on taxable income ($200,000) $110,980
Less: Tax under section 1 on sum of item 93,780
(4)(iii)(c) ($100,000) plus 50% of item (2)
($75,000) (Total $175,000).....................
-----------
Tax under section 1201(c)(1).................. 17,200
-----------
Limitation under section........................
1201(c)(2)(A) (29\1/2\% of item (3)).......... 14,750 14,750
(7) Alternative tax under section 1201(b).................... 97,430
Example 3. A husband and wife, who file a joint return for the
calendar year 1971, have taxable income (exclusive of capital gains and
losses) of $80,000. In 1971 they realize long-term capital gain of
$30,000 arising from a sale consummated on July 1, 1969, the income from
which is returned on the installment method under section 453. From
securities transactions in 1971 they have long-term capital gains of
60,000 and a short-term capital loss of $10,000. Since the alternative
tax under section 1201(b) is less than the tax otherwise computed under
section 1, the tax payable is the alternative tax, that is, $55,140. The
tax is computed as follows:
Tax Under Section 1
Taxable income exclusive of capital gains and losses......... $80,000
Net long-term capital gains (100% of $90,000)..... $90,000
Net short-term capital loss (100% of $10,000)... 10,000
-----------
Net section 1201 gain (net capital gain for taxable years 80,000
beginning after December 31, 1976)........................
------------
Total.................................................... 160,000
Deduction of 50% of net section 1201 gain (net capital gain 40,000
for taxable years beginning after December 31, 1976)
(section 1202)..............................................
------------
Taxable income........................................... 120,000
============
Tax under section 1.......................................... 57,580
Alternative Tax Under Section 1201(b)
(1) Net section 1201 gain (net capital gain for taxable years $80,000
beginning after December 31, 1976)..........................
------------
(2) Subsection (d) gain:
Section 1201(d)(1)......................................... 30,000
Section 1201(d)(2).........................................
Section 1201(d)(3) ($50,000 less $30,000).................. 20,000
------------
Total subsection (d) gain................................ 50,000
============
(3) Net section 1201 (net capital gain for taxable years 30,000
beginning after December 31, 1976) gain in excess of
subsection (d) gain ($80,000 less $50,000)..................
------------
(4) Tax under section 1201(b)(1):
(i) Taxable income.............................. $120,000
(ii) Less: 50% of item (1)...................... 40,000
-----------
(iii) Amount subject to tax under section 80,000
1201(b)(1).....................................
===========
Partial tax (computed under section 1)................... 33,340
(5) Tax under section 1201(b)(2): (25% of item (1) or of item 12,500
(2), whichever is lesser [25% of $50,000])..................
(6) Tax under section 1201 (b)(3) on item (3):
Tax under section 1 on taxable income ($120,000) $57,580
Less: Tax under sec. 1 on sum of item (4) (iii) $48,280
($80,000) plus 50% of item (2) ($25,000) (Total
$105,000)........................................
-----------
Tax under section 1201(c)(1).................. 9,300
===========
Limitation under section 1201(c) (2)(B) (32\1/ 9,750 $9,300
2\% of item (3)).............................
---------------------
(7) Alternative tax under section 1201(b).................... 55,140
Example 4. A husband and wife, who file a joint return for the
calendar year 1973, have taxable income (exclusive of capital gains and
losses) of $250,000. In 1973 they realize long-term capital gains (not
described in section 1201(d) (1) or (2)) of $140,000 and a short-term
capital loss of $50,000. Since the alternative tax under section 1201(b)
is less than the tax otherwise computed under section 1, the tax payable
is the alternative tax, that is, $172,480. The tax is computed as
follows:
Tax Under Section 1
Taxable income exclusive of capital gains and losses......... $250,000
Net long-term capital gains (100% of $140,000).... $140,000
Net short-term capital loss (100% of $50,000)..... 50,000
-----------
Net section 1201 gain (net capital gain for taxable years 90,000
beginning after December 31, 1976)..........................
------------
Total.................................................... 340,000
Deduction of 50% of net section 1201 gain (net capital gain 45,000
for taxable years beginning after December 31, 1976)
(section 1202)..............................................
------------
Taxable income........................................... 295,000
============
Tax under section 1.......................................... 177,480
Alternative Tax Under Section 1201(b)
(1) Net section 1201 gain (net capital gain for taxable years $90,000
beginning after December 31, 1976)..........................
------------
(2) Subsection (d) gain:
Section 1201(d)(1)......................................... .........
[[Page 256]]
Section 1201(d)(2)......................................... .........
Section 1201(d)(3)......................................... 50,000
------------
Total subsection (d) gain................................ 50,000
============
(3) Net section 1201 gain (net capital gain for taxable years 40,000
beginning after December 31, 1976) in excess of subsection
(d) gain ($90,000 less $50,000).............................
------------
(4) Tax under section 1201(b)(1):
(i) Taxable income.............................. $295,000
(ii) Less: 50% of item (1)...................... 45,000
-----------
(iii) Amount subject to tax under section 250,000
1201(b)(1).....................................
-----------
Partial tax (computed under section 1)................... 145,980
(5) Tax under section 1201(b)(2): (25% of item (1) or of item $12,500
(2), whichever is lesser [25% of $50,000])..................
(6) Tax under section 1201(b)(3) on item (3):
Tax under section 1 on taxable income ($295,000) $177,480
Less: Tax under section 1 on sum of item (4) 163,480 14,000
(iii) ($250,000) plus 50% of item (2) ($25,000)
(Total $275,000)...............................
(7) Alternative tax under section 1201(b).................... 172,480
[T.D. 7337, 39 FR 44975, Dec. 30, 1974, as amended by T.D. 7728, 45 FR
72651, Nov. 3, 1980]
Sec. 1.1202-0 Table of contents.
This section lists the major captions that appear in the regulations
under Sec. 1.1202-2.
Sec. 1.1202-2 Qualified small business stock; effect of redemptions.
(a) Redemptions from taxpayer or related person.
(1) In general.
(2) De minimis amount.
(b) Significant redemptions.
(1) In general.
(2) De minimis amount.
(c) Transfers by shareholders in connection with the performance of
services not treated as purchases.
(d) Exceptions for termination of services, death, disability or
mental incompetency, or divorce.
(1) Termination of services.
(2) Death.
(3) Disability or mental incompetency.
(4) Divorce.
(e) Effective date.
[T.D. 8749, 62 FR 68166, Dec. 31, 1997]
Sec. 1.1202-1 Deduction for capital gains.
(a) In computing gross income, adjusted gross income, taxable
income, capital gain net income (net capital gain for taxable years
beginning before January 1, 1977) and net capital loss, 100 percent of
any gain or loss (computed under section 1001, recognized under section
1002, and taken into account without regard to subchapter P (section
1201 and following), chapter 1 of the Code) upon the sale or exchange of
a capital asset shall be taken into account regardless of the period for
which the capital asset has been held. Nevertheless, the net short-term
capital gain or loss and the net long-term capital gain or loss must be
separately computed. In computing the adjusted gross income or the
taxable income of a taxpayer other than a corporation, if for any
taxable year the net long-term capital gain exceeds the net short-term
capital loss, 50 percent of the amount of the excess is allowable as a
deduction from gross income under section 1202.
(b) For the purpose of computing the deduction allowable under
section 1202 in the case of an estate or trust, any long-term or short-
term capital gains which, under sections 652 and 662, are includible in
the gross income of its income beneficiaries as gains derived from the
sale or exchange of capital assets must be excluded in determining
whether, for the taxable year of the estate or trust, its net long-term
capital gain exceeds its net short-term capital loss. To determine the
extent to which such gains are includible in the gross income of a
beneficiary, see the regulations under sections 652 and 662. For
example, during 1954 a trust realized a gain of $1,000 upon the sale of
stock held for 10 months. Under the terms of the trust instrument all of
such gain must be distributed during the taxable year to A, the sole
income beneficiary. Assuming that under section 652 or 662 A must
include all of such gain in his gross income, the trust is not entitled
to any deduction with respect to such gain under section 1202. Assuming
A had no other capital gains or losses for 1954, he would be entitled to
a deduction of $500 under section 1202. For purposes of this section, an
income beneficiary shall be any beneficiary to whom an amount is
required to be distributed, or is paid or credited, which is includible
in his gross income.
(c) The provisions of this section may be illustrated by the
following example:
[[Page 257]]
Example: A, an individual, had the following transactions in 1954:
Long-term capital gain............................ $6,000
Long-term capital loss............................ 4,000
-----------
Net long-term capital gain........................ ......... $2,000
Short-term capital loss........................... 1,800
Short-term capital gain........................... 300
===========
Net short-term capital loss.................................. 1,500
------------
Excess of net long-term capital gain over net short-term 500
capital loss................................................
Since the net long-term capital gain exceeds the net short-term capital
loss by $500, 50 percent of the excess, or $250, is allowable as a
deduction under section 1202.
[T.D. 6500, 25 FR 12001, Nov. 26, 1960, as amended by T.D. 7728, 45 FR
72650, Nov. 3, 1980]
Sec. 1.1202-2 Qualified small business stock; effect of redemptions.
(a) Redemptions from taxpayer or related person--(1) In general.
Stock acquired by a taxpayer is not qualified small business stock if,
in one or more purchases during the 4-year period beginning on the date
2 years before the issuance of the stock, the issuing corporation
purchases (directly or indirectly) more than a de minimis amount of its
stock from the taxpayer or from a person related (within the meaning of
section 267(b) or 707(b)) to the taxpayer.
(2) De minimis amount. For purposes of this paragraph (a), stock
acquired from the taxpayer or a related person exceeds a de minimis
amount only if the aggregate amount paid for the stock exceeds $10,000
and more than 2 percent of the stock held by the taxpayer and related
persons is acquired. The following rules apply for purposes of
determining whether the 2-percent limit is exceeded. The percentage of
stock acquired in any single purchase is determined by dividing the
stock's value (as of the time of purchase) by the value (as of the time
of purchase) of all stock held (directly or indirectly) by the taxpayer
and related persons immediately before the purchase. The percentage of
stock acquired in multiple purchases is the sum of the percentages
determined for each separate purchase.
(b) Significant redemptions--(1) In general. Stock is not qualified
small business stock if, in one or more purchases during the 2-year
period beginning on the date 1 year before the issuance of the stock,
the issuing corporation purchases more than a de minimis amount of its
stock and the purchased stock has an aggregate value (as of the time of
the respective purchases) exceeding 5 percent of the aggregate value of
all of the issuing corporation's stock as of the beginning of such 2-
year period.
(2) De minimis amount. For purposes of this paragraph (b), stock
exceeds a de minimis amount only if the aggregate amount paid for the
stock exceeds $10,000 and more than 2 percent of all outstanding stock
is purchased. The following rules apply for purposes of determining
whether the 2-percent limit is exceeded. The percentage of the stock
acquired in any single purchase is determined by dividing the stock's
value (as of the time of purchase) by the value (as of the time of
purchase) of all stock outstanding immediately before the purchase. The
percentage of stock acquired in multiple purchases is the sum of the
percentages determined for each separate purchase.
(c) Transfers by shareholders in connection with the performance of
services not treated as purchases. A transfer of stock by a shareholder
to an employee or independent contractor (or to a beneficiary of an
employee or independent contractor) is not treated as a purchase of the
stock by the issuing corporation for purposes of this section even if
the stock is treated as having first been transferred to the corporation
under Sec. 1.83-6(d)(1) (relating to transfers by shareholders to
employees or independent contractors).
(d) Exceptions for termination of services, death, disability or
mental incompetency, or divorce. A stock purchase is disregarded if the
stock is acquired in the following circumstances:
(1) Termination of services--(i) Employees and directors. The stock
was acquired by the seller in connection with the performance of
services as an employee or director and the stock is purchased from the
seller incident to the seller's retirement or other bona fide
termination of such services;
(ii) Independent contractors. [Reserved]
(2) Death. Prior to a decedent's death, the stock (or an option to
acquire the stock) was held by the decedent or the
[[Page 258]]
decedent's spouse (or by both), by the decedent and joint tenant, or by
a trust revocable by the decedent or the decedent's spouse (or by both),
and--
(i) The stock is purchased from the decedent's estate, beneficiary
(whether by bequest or lifetime gift), heir, surviving joint tenant, or
surviving spouse, or from a trust established by the decedent or
decedent's spouse; and
(ii) The stock is purchased within 3 years and 9 months from the
date of the decedent's death;
(3) Disability or mental incompetency. The stock is purchased
incident to the disability or mental incompetency of the selling
shareholder; or
(4) Divorce. The stock is purchased incident to the divorce (within
the meaning of section 1041(c)) of the selling shareholder.
(e) Effective date. This section applies to stock issued after
August 10, 1993.
[T.D. 8749, 62 FR 68166, Dec. 31, 1997]
Treatment of Capital Losses
Sec. 1.1211-1 Limitation on capital losses.
(a) Corporations--(1) General rule. In the case of a corporation,
there shall be allowed as a deduction an amount equal to the sum of:
(i) Losses sustained during the taxable year from sales or exchanges
of capital assets, plus
(ii) The aggregate of all losses sustained in other taxable years
which are treated as a short-term capital loss in such taxable year
pursuant to section 1212(a)(1),
but only to the extent of gains from such sales or exchanges of capital
assets in such taxable year.
(2) Banks. See section 582(c) for modification of the limitation
under section 1211(a) in the case of a bank, as defined in section 581.
(b) Taxpayers other than corporations--(1) General rule. In the case
of a taxpayer other than a corporation, there shall be allowed as a
deduction an amount equal to the sum of:
(i) Losses sustained during the taxable year from sales or exchanges
of capital assets, plus
(ii) The aggregate of all losses sustained in other taxable years
which are treated either as a short-term capital loss or as a long-term
capital loss in such taxable year pursuant to section 1212(b), but only
to the extent of gains from sales or exchanges of capital assets in such
taxable year, plus (if such losses exceed such gains) the additional
allowance or transitional additional allowance deductible under section
1211(b) from ordinary income for such taxable year. The additional
allowance deductible under section 1211(b) shall be determined by
application of subparagraph (2) of this paragraph, and the transitional
additional allowance by application of subparagraph (3) of this
paragraph.
(2) Additional allowance. Except as otherwise provided by
subparagraph (3) of this paragraph, the additional allowance deductible
under section 1211(b) for taxable years beginning after December 31,
1969, shall be the least of:
(i) The taxable income for the taxable year reduced, but not below
zero, by the zero bracket amount (in the case of taxable years beginning
before January 1, 1977, the taxable income for the taxable year);
(ii) $3,000 ($2,000 for taxable years beginning in 1977; $1,000 for
taxable years beginning before January 1, 1977); or
(iii) The sum of the excess of the net short-term capital loss over
the net long-term capital gain, plus one-half of the excess of the net
long-term capital loss over the net short-term capital gain.
(3) Transitional additional allowance--(i) In general. If, pursuant
to the provisions of Sec. 1.1212-1(b) and subdivision (iii) of this
subparagraph, there is carried to the taxable year from a taxable year
beginning before January 1, 1970, a long-term capital loss, and if for
the taxable year there is an excess of net long-term capital loss over
net short-term capital gain, then, in lieu of the additional allowance
provided by subparagraph (2) of this paragraph, the transitional
additional allowance deductible under section 1211(b) shall be the least
of:
(a) The taxable income for the taxable year reduced, but not below
zero, by the zero bracket amount (in the case of taxable years beginning
before January 1, 1977, the taxable income for the taxable year);
[[Page 259]]
(b) $3,000 ($2,000 for taxable years beginning in 1977; $1,000 for
taxable years beginning before January 1, 1977); or
(c) The sum of the excess of the net short-term capital loss over
the net long-term capital gain; that portion of the excess of the net
long-term capital loss over the net short-term capital gain computed as
provided in subdivision (ii) of this subparagraph; plus one-half of the
remaining portion of the excess of the net long-term capital loss over
the net short-term capital gain.
(ii) Computation of specially treated portion of excess long-term
capital loss over net short-term capital gain. In determining the
transitional additional allowance deductible as provided by this
subparagraph, there shall be applied thereto in full on a dollar-for-
dollar basis the excess of net long-term capital loss over net short-
term capital gain (computed with regard to capital losses carried to the
taxable year) to the extent that the long-term capital losses carried to
the taxable year from taxable years beginning before January 1, 1970, as
provided by Sec. 1.1212-1(b) and subdivision (iii) of this
subparagraph, exceed the sum of (a) the portion of the capital gain net
income (net capital gain for taxable years beginning before January 1,
1977) actually realized in the taxable year (i.e., computed without
regard to capital losses carried to the taxable year) which consists of
net long-term capital gain actually realized in the taxable year, plus
(b) the amount by which the portion of the capital gain net income (net
capital gain for taxable years beginning before January 1, 1977)
actually realized in the taxable year (i.e., computed without regard to
capital losses carried to the taxable year) which consists of net short-
term capital gain actually realized in the taxable year exceeds the
total of short-term capital losses carried to the taxable year from
taxable years beginning before January 1, 1970, as provided by Sec.
1.1212-1(b) and subdivision (iv) of this subparagraph.
The amount by which the net long-term capital losses carried to the
taxable year from taxable years beginning before January 1, 1970,
exceeds the sum of (a) plus (b) shall constitute the transitional net
long-term capital loss component for the taxable year for the purpose of
this subparagraph.
(iii) Carryover of certain long-term capital losses not utilized in
computation of transitional additional allowance. If for a taxable year
beginning after December 31, 1969, the transitional net long-term
capital loss component determined as provided in subdivision (ii) of
this subparagraph exceeds the amount of such component applied to the
transitional additional allowance for the taxable year as provided by
subdivision (i) of this subparagraph and subparagraph (4)(ii) of this
paragraph, then such excess shall for the purposes of this subparagraph
be carried to the succeeding taxable year as long-term capital losses
from taxable years beginning before January 1, 1970, for utilization in
the computation of the transitional additional allowance in the
succeeding taxable year as provided in subdivisions (i) and (ii) of this
subparagraph. In no event, however, shall the amount of such component
carried to the following taxable year as otherwise provided by this
subdivision exceed the total of net long-term capital losses actually
carried to such succeeding taxable year pursuant to section 1212(b) and
Sec. 1.1212-1(b).
(iv) Carryover of certain short-term capital losses not utilized in
computation of additional allowance or transitional additional
allowance. If for a taxable year beginning after December 31, 1969, the
total short-term capital losses carried to such year from taxable years
beginning before January 1, 1970, as provided by Sec. 1.1212-1(b) and
this subdivision exceed the sum of:
(a) The portion of the capital gain net income (net capital gain for
taxable years beginning before January 1, 1977) actually realized in the
taxable year (i.e., computed without regard to capital losses carried to
the taxable year) which consists of net short-term capital gain actually
realized in the taxable year, plus
(b) The amount by which the portion of the capital gain net income
(net capital gain for taxable years beginning before January 1, 1977)
actually realized in the taxable year (i.e., computed without regard to
capital losses carried to the taxable year) which consists of
[[Page 260]]
net long-term capital gain actually realized in the taxable year exceeds
the total long-term capital losses carried to the taxable year from
taxable years beginning before January 1, 1970, as provided in Sec.
1.1212-1(b) and subdivision (iii) of this subparagraph,
then such excess shall constitute the transitional net short-term
capital loss component for the taxable year, and to the extent such
component also exceeds the net short-term capital loss applied to the
additional allowance (as provided in subparagraphs (2) and (4)(i) of
this paragraph) or the transitional additional allowance (as provided by
subdivision (i) of this subparagraph and subparagraph (4)(i) of this
paragraph) for the taxable year shall be carried to the succeeding
taxable year as short-term capital losses from taxable years beginning
before January 1, 1970, for utilization in such succeeding taxable year
in the computation of the additional allowance (as provided by
subparagraph (2) of this paragraph) or the transitional additional
allowance (as provided by subdivision (i) and (ii) of this
subparagraph). In no event, however, shall the amount of such component
so carried to the following taxable year as otherwise provided by this
subdivision exceed the total of net short-term capital losses actually
carried to such succeeding taxable year pursuant to section 1212(b) and
Sec. 1.1212-1(b).
(v) Scope of rules. The rules provided by this subparagraph are for
the purpose of computing the amount of the transitional additional
allowance deductible for the taxable year pursuant to the provisions of
section 1212(b)(3) and this subparagraph. More specifically, their
operation permits the limited use of a long-term capital loss carried to
the taxable year from a taxable year beginning before December 31, 1969,
in full on a dollar-for-dollar basis in computing the transitional
additional allowance deductible for the taxable year. These rules have
no application to, or effect upon, a determination of the character or
amount of capital gain net income (net capital gain for taxable years
beginning before January 1, 1977) reportable in the taxable year. See
paragraph (b)(1) of this section and Sec. 1.1212-1 for the
determination of the amount and character of capital gains and losses
reportable in the taxable year. Further, except to the extent that their
application may affect the amount of the transitional additional
allowance deductible for the taxable year and thus the amount to be
treated as short-term capital loss for carryover purposes under section
1212(b) and Sec. 1.1212-1(b)(2), these rules have no effect upon a
determination of the character or amount of capital losses carried to or
from the taxable year pursuant to section 1212(b) and Sec. 1.1212-1(b).
(4) Order of application of capital losses to additional allowance
or transitional additional allowance. In applying the excess of the net
short-term capital loss over the net long-term capital gain and the
excess of the net long-term capital loss over the net short-term capital
gain to the additional allowance or transitional additional allowance
deductible under section 1211(b) and this paragraph, such excesses
shall, subject to the limitations of subparagraph (2) or (3) of this
paragraph, be used in the following order:
(i) First, there shall be applied to the additional allowance or
transitional additional allowance the excess, if any, of the net short-
term capital loss over the net long-term capital gain.
(ii) Second, if such transitional additional allowance exceeds the
amount so applied thereto as provided in subdivision (i) of this
subparagraph, there shall next be applied thereto as provided in
subparagraph (3) of this paragraph the excess, if any, of the net long-
term capital loss over the net short-term capital gain to the extent of
the transitional net long-term capital loss component for the taxable
year computed as provided by subdivision (ii) of subparagraph (3) of
this paragraph.
(iii) Third, if such additional allowance or transitional additional
allowance exceeds the sum of the amounts so applied thereto as provided
in subdivisions (i) and (ii) of this subparagraph, there shall be
applied thereto one-half of the balance, if any, of the excess net long-
term capital loss not applied pursuant to the provisions of subdivision
(ii) of this subparagraph.
(5) Taxable years beginning prior to January 1, 1970. For any
taxable year
[[Page 261]]
beginning prior to January 1, 1970, subparagraphs (2) and (3) of this
paragraph shall not apply and losses from sales or exchanges of capital
assets shall be allowed as a deduction only to the extent of gains from
such sales or exchanges, plus (if such losses exceed such gains) the
taxable income of the taxpayer or $1,000, whichever is smaller.
(6) Special rules. (i) For purposes of section 1211(b) and this
paragraph, taxable income is to be computed without regard to gains or
losses from sales or exchanges of capital assets and without regard to
the deductions provided in section 151 (relating to personal exemptions)
or any deduction in lieu thereof. For example, the deductions available
to estates and trusts under section 642(b) are in lieu of the deductions
allowed under section 151, and, in the case of estates and trusts, are
to be added back to taxable income for the purposes of section 1211(b)
and this paragraph.
(ii) For taxable years beginning before January 1, 1976, in case the
tax is computed under section 3 and the regulations thereunder (relating
to optional tax tables for individuals), the term taxable income as used
in section 1211(b) and this paragraph shall be read as adjusted gross
income.
(iii) In the case of a joint return, the limitation under section
1211(b) and this paragraph, relating to the allowance of losses from
sales or exchanges of capital assets, is to be computed and the net
capital loss determined with respect to the combined taxable income and
the combined capital gains and losses of the spouses.
(7) Married taxpayers filing separate returns--(i) In general. In
the case of a husband or a wife who files a separate return for a
taxable year beginning after December 31, 1969, the $3,000, $2,000, and
$1,000 amounts specified in subparagraphs (2)(ii) and (3)(i)(b) of this
paragraph shall instead be $1,500, $1,000, and $500, respectively.
(ii) Special rule. If, pursuant to the provisions of Sec. 1.1212-
1(b) and subparagraph (3) (iii) or (iv) of this paragraph, there is
carried to the taxable year from a taxable year beginning before January
1, 1970, a short-term capital loss or a long-term capital loss, the
$1,500, $1,000 and $500 amounts specified in subdivision (i) of this
subparagraph shall instead be maximum amounts of $3,000, $2,000, and
$1,000 respectively, equal to $1,500, $1,000, and $500, respectively,
plus the total of the transitional net long-term capital loss component
for the taxable year computed as provided by subparagraph (3)(ii) of
this paragraph and the transitional net short-term capital loss
component for the taxable year computed as provided by subparagraph
(3)(iv) of this paragraph.
(8) Examples. The provisions of section 1211(b) may be illustrated
by the following examples:
Example 1. A, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1970:
Taxable income exclusive of capital gains and losses......... $4,400
Deduction provided by section 151............................ 625
------------
Taxable income for purposes of section 1211(b)............... 5,025
Long-term capital gain............................ $1,200
Long-term capital loss............................ (5,300)
-----------
Net long-term capital loss........................ (4,100)
Losses to the extent of gains..................... (1,200)
Additional allowance deductible under section 1211(b)........ 1,000
==========
The net long-term capital loss of $4,100 is deductible in 1970 only to
the extent of an additional allowance of $1,000 which is smaller than
the taxable income of $5,025. Under section 1211(b) and subparagraph (2)
of this paragraph, $2,000 of excess net long-term capital loss was
required to produce the $1,000 additional allowance. Therefore, a net
long-term capital loss of $2,100 ($4,100 minus $2,000) is carried over
under section 1212(b) to the succeeding taxable year. If A had the same
taxable income for purposes of section 1211(b) (after reduction by the
zero bracket amount) and the same transactions in 1977, the additional
allowance would be $2,000, and a net long-term capital loss of $100
would be carried over. For a taxable year beginning in 1978 or
thereafter, these facts would give rise to a $2,050 additional allowance
and no carryover.
Example 2. B, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1970:
Taxable income exclusive of capital gains and $90
losses...........................................
Deduction provided by section 151................. 625
------------
Taxable income for purposes of section 1211(b).... 715
Long-term capital gain............................ $1,200
Long-term capital loss............................ (5,200)
-----------
[[Page 262]]
Net long-term capital loss........................ (4,000)
Losses to the extent of gains..................... (1,200)
Additional allowance deductible under section 1211(b)........ 715
==========
The net long-term capital loss of $4,000 is deductible in 1970 only to
the extent of an additional allowance of $715, since the $715 of taxable
income for purposes of section 1211(b) is smaller than $1,000. Under
section 1211(b) and subparagraph (2) of this paragraph, $1,430 of net
long-term capital loss was required to produce the $715 additional
allowance. Therefore, a net long-term capital loss of $2,570 ($4,000
minus $1,430) is carried over under section 1212(b) to the succeeding
taxable year. For illustration of the result if the net capital loss for
the taxable year is smaller than both $1,000 and taxable income for the
purposes of section 1211(b), see examples (3) and (4) of this
subparagraph. For carryover of a net capital loss, see Sec. 1.1212-1.
Assuming the same taxable income for purposes of section 1211(b) (after
reduction by the zero bracket amount) and the same transations for
taxable years beginning in 1977 or thereafter, the same result would be
reached.
Example 3. A, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1971:
Taxable income exclusive of capital gains and $13,300
losses...........................................
Deduction provided by section 151................. 675
------------
Taxable income for purposes of section 1211(b).... 13,975
Long-term capital gain............................ $400
Long-term capital loss............................ ($600)
-----------
Net long-term capital loss........................ (200)
===========
Short-term capital gain........................... 900
Short-term capital loss........................... (1,400)
-----------
Net short-term capital loss....................... (500)
===========
Losses to extent of gains......................... (1,300)
Additional allowance deductible under section 1211(b)........ $600
==========
The $600 additional allowance deductible under section 1211(b) is the
least of: (i) Taxable income of $13,975, (ii) $1,000, or (iii) the sum
of the excess of the net short-term capital loss of $500 over the net
long-term capital gain, plus one-half of the excess of the net long-term
capital loss of $200 over the net short-term capital gain. The $600
additional allowance, therefore, consists of the net short-term capital
loss of $500, plus $100 (one-half of the net long-term capital loss of
$200), the total of which is smaller than both $1,000 and taxable income
for purposes of section 1211(b). No amount of net capital loss remains
to be carried over under section 1212(b) to the succeeding taxable year
since the entire amount of the net short-term capital loss of $500 plus
the entire amount of the net long-term capital loss of $200 required to
produce $100 of the deduction was absorbed by the additional allowance
deductible under section 1211(b) for 1971. Assuming the same taxable
income for purposes of section 1211(b) (after reduction by the zero
bracket amount) and the same transactions for taxable years beginning in
1977 or thereafter, the result would remain unchanged.
Example 4. A, a married individual filing a separate return with one
exemption allowable as a deduction under section 151, has the following
transactions in 1971:
Taxable income exclusive of capital gains and $12,000
losses...........................................
Deduction provided by section 151................. 675
------------
Taxable income for purposes of section 1211(b).... 12,675
Long-term capital loss............................ ($800)
Long-term capital gain............................ 300
-----------
Net long-term capital loss........................ (500)
===========
Short-term capital loss........................... (500)
Short-term capital gain........................... 600
-----------
Net short-term capital gain....................... 100
===========
Losses to the extent of gains................................ (900)
Additional allowance deductible under section 1211(b)........ 200
==========
The excess net long-term capital loss of $400 (net long-term capital
loss of $500 minus net short-term capital gain of $100) is deductible in
1971 only to the extent of an additional allowance of $200 (one-half of
$400) which is smaller than both $500 (married taxpayer filing a
separate return for a taxable year beginning after December 31, 1969)
and taxable income for purposes of section 1211(b). Since there is no
net short-term capital loss in excess of net long-term capital gains for
the taxable year, the $200 additional allowance deductible under section
1211(b) consists entirely of excess net long-term capital loss. No
amount of net capital loss remains to be carried over under section
1212(b) to the succeeding taxable year. Assuming the same taxable income
for purposes of section 1211(b) (after reduction by the zero bracket
amount) and the same transactions for taxable years beginning in 1977 or
thereafter, the result would remain unchanged.
Example 5. A, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1970:
Taxable income exclusive of capital gains and $13,300
losses...........................................
Deduction provided by section 151................. 625
------------
Taxable income for purposes of section 1211(b).... 13,925
Long-term capital loss............................ ($6,000)
Long-term capital gain............................ 2,000
-----------
[[Page 263]]
Net long-term capital loss........................ (4,000)
===========
Short-term capital gain........................... 3,000
Short-term capital loss carried to 1970 from 1969 (3,000)
under section 1212(b)(1).........................
-----------
Net short-term capital loss....................... 0
===========
Losses to the extent of gains..................... (5,000)
Additional allowance deductible under section 1,000
1211(b)..........................................
===========
The $1,000 additional allowance deductible under section 1211(b) is the
least of (i) taxable income of $13,925, (ii) $1,000, or (iii) the sum of
the net short-term capital loss ($0) plus one-half of the net long-term
capital loss of $4,000. The $1,000 additional allowance, therefore,
consists of net long-term capital loss. Since $2,000 of the net long-
term capital loss of $4,000 was required to produce the $1,000
additional allowance, the $2,000 balance of the net long-term capital
loss is carried over under section 1212(b) to 1971. Assuming the same
taxable income for purposes of section 1211(b) (after reduction by the
zero bracket amount) and the same transactions for taxable years
beginning in 1977 or thereafter, the additional allowance would be
$2,000, and there would be no carryover.
Example 6. A, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1970:
Taxable income exclusive of capital gains and losses......... $13,300
Deduction provided by section 151............................ 625
------------
Taxable income for purposes of section 1211(b)............... 13,925
Long-term capital gain............................ $5,000
Long-term capital loss............................ (7,000)
Long-term capital loss carried to 1970 from 1969 (500)
under section 1212 (b)(1)........................
===========
Net long-term capital Loss........................ (2,500)
Short-term capital gain........................... 1,100
Short-term capital loss........................... (1,400)
-----------
Net short-term capital loss....................... (300)
===========
Losses to extent of gains......................... (6,100)
Transitional additional allowance deductible under 1,000
section 1211(b)..................................
===========
Because a component of the net long-term capital loss for 1970 is a $500
long-term capital loss carried to 1970 from 1969, the transitional
additional allowance deductible under section 1211(b) and subparagraph
(3) of this paragraph is the least of (i) taxable income of $13,925,
(ii) $1,000 or (iii) the sum of the net short-term capital loss of $300,
plus the net long-term capital loss for 1970, to the extent of the $500
long-term capital loss carried to 1970 from 1969 and one-half of the
$2,000 balance of the net long-term capital loss. The entire $500 long-
term capital loss carried to 1970 from 1969 is applicable in full to the
transitional additional allowance because there was no net capital gain
(capital gain net income for taxable years beginning after December 31,
1976) actually realized in 1970. The $1,000 transitional additional
allowance, therefore, consists of the net short-term capital loss of
$300, the $500 long-term capital loss carried to 1970 from 1969, plus
one-half of enough of the balance of the 1970 net long-term capital loss
($400) to make up the $200 balance of the $1,000 transitional additional
allowance. A long-term capital loss of $1,600 ($2,500 minus $900), all
of which is attributable to 1970, is carried over under section 1212(b)
to 1971. Assuming the same taxable income for purposes of section
1211(b) (after reduction by the zero bracket amount) and the same
transactions for taxable years beginning in 1977 or thereafter, the
transitional additional allowance would be $1,800. No amount would
remain to be carried over to the succeeding taxable year.
Example 7. A, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1970:
Taxable income exclusive of capital gains and losses......... $13,300
Deduction provided by section 151............................ 625
------------
Taxable income for purposes of section 1211(b)............... 13,925
Long-term capital loss............................ ($2,000)
Long-term capital loss carried to 1970 from 1969 (500)
under section 1212 (b)(1)........................
-----------
Net long-term capital loss........................ (2,500)
===========
Short-term capital gain........................... 2,600
Short-term capital loss carried to 1970 from 1969 (3,000)
under section 1212 (b)(1)........................
-----------
Net short-term capital loss....................... (400)
===========
Losses to the extent of gains..................... (2,600)
Transitional additional allowance deductible under 1,000
section 1211(b)..................................
===========
Because a component of the net long-term capital loss for 1970 is a $500
long-term capital loss carried to 1970 from 1969, the transitional
additional allowance deductible under section 1211(b) and subparagraph
(3) of this paragraph is the least of (i) taxable income of $13,925,
(ii) $1,000, or (iii) the sum of the net short-term capital loss of
$400, plus the net long-term capital loss for 1970 to the extent of the
$500 long-term capital loss carried to 1970 from 1969, and one-half of
the $2,000 balance of the net long-term capital loss. The entire $500
long-term capital loss carried to 1970 from 1969 is applicable in full
to the transitional additional allowance because the net capital gain
(capital gain net income for taxable years beginning after December 31,
1976) for the taxable year (computed without regard to capital losses
carried to the
[[Page 264]]
taxable year) consisted entirely of net short-term capital gain not in
excess of the short-term capital loss carried to 1970 from 1969. The
$1,000 transitional additional allowance, therefore, consists of the net
short-term capital loss of $400, the $500 long-term capital loss carried
to 1970 from 1969, plus one-half of enough of the balance of the 1970
net long-term capital loss ($200) to make up the $100 balance of the
$1,000 transitional additional allowance. A long-term capital loss of
$1,800 ($2,500 minus $700), all of which is attributable to 1970, is
carried over under section 1212(b) to 1971. Assuming the same taxable
income for purposes of section 1211(b) (after reduction by the zero
bracket amount) and the same transactions for taxable years beginning in
1977 or thereafter, the transitional additional allowance would be
$1,900. No amount would remain to be carried over to the succeeding
taxable year.
Example 8. Assume the facts in Example (7) but assume that the
individual with one exemption allowable as a deduction under section 151
is married and files a separate return for 1970. The maximum
transitional additional allowance to which the individual would be
entitled for 1970 pursuant to subparagraph (7)(ii) of this paragraph
would be the sum of $500 plus (i) $2,400 of the short-term capital loss
of $3,000 carried to 1970 from 1969 (the amount by which such carryover
exceeds the $600 net capital gain (capital gain net income for taxable
years beginning after December 31, 1976) actually realized in 1970, all
of which is net short-term capital gain) and (ii) the $500 long-term
capital loss carried to 1970 from 1969. However, since this sum ($3,400)
exceeds $1,000, the maximum transitional additional allowance to which
the individual is entitled for 1970 is limited to $1,000. If for 1971,
the same married individual had taxable income of $13,925 for purposes
of section 1211(b) and no capital transactions, and filed a separate
return, the additional allowance deductible under section 1211(b) for
1971 would be limited to $500 by reason of subdivision (i) of
subparagraph (7) of this paragraph, since, as illustrated in Example 7,
no part of the capital loss carried over to 1971 under section 1212 (b)
is attributable to 1969. Assuming the same taxable income for purposes
of section 1211(b) (after reduction by the zero bracket amount) and the
same transactions as in example (7) for a married individual filing a
separate return for a taxable year beginning in 1977 or thereafter, the
transitional additional allowance would be $1,900. No amount would
remain to be carried over to the succeeding taxable year.
Example 9. B, an unmarried individual with one exemption allowable
as a deduction under section 151, has the following transactions in
1971:
Taxable income exclusive of capital gains and losses......... $10,000
Deductions provided by section 151........................... 675
------------
Taxable income for purposes of section 1211(b)............... 10,675
Long-term capital gain............................ $2,500
Long-term capital loss treated under Sec. 1.1211- (5,000)
1 (b)(3)(iii) as carried over from 1969..........
-----------
Net long-term capital loss........................ (2,500)
===========
Short-term capital gain........................... 2,700
Short-term capital loss carried to 1971 from 1970 (1,000)
under section 1212 (b)(1)........................
Short-term capital loss treated under Sec. ($2,000)
1.1211-1 (b)(3)(iv) as carried over from 1969....
-----------
Net short-term capital loss....................... (300)
===========
Losses to extent of gain.......................... (5,200)
Transitional additional allowance deductible under 1,000
section 1211(b)..................................
===========
Because a component of the net long-term capital loss for 1971 is a
long-term capital loss treated under subparagraph (3)(iii) of this
paragraph as carried over from 1969, the rules for computation of the
transitional additional allowance under subparagraph (3) (i) and (ii) of
this paragraph apply. The transitional net long-term capital loss
component for 1971 under subparagraph (3)(ii) of this paragraph is
$1,800, that is, the amount by which the $5,000 long-term loss treated
as carried over from 1969 to 1971 exceeds (a) the net long-term capital
gain of $2,500 actually realized in 1971 plus (b) the $700 excess of the
$2,700 net short-term capital gain actually realized in 1971 over the
$2,000 short-term capital loss treated as carried over to 1971 from
1969. The transitional additional allowance for 1971 consists of the
$300 net short-term capital loss plus $700 of the net long-term capital
loss attributable to 1969. A net long-term capital loss of $1,800
($2,500 minus $700) is carried over to 1972 under section 1212(b). Only
$1,100 of the $1,800 will be treated in 1972 as carried over from 1969
since under subparagraph (3)(iii) of this paragraph the transitional net
long-term capital loss component of $1,800 is reduced by the amount
($700) applied to the transitional additional allowance for 1971.
Assuming the same taxable income for purposes of section 1211(b) (after
reduction by the zero bracket amount) and the same transactions for a
taxable year beginning in 1977, the transitional additional allowance
would be $2,000. A net long-term capital loss of $800 would remain to be
carried over. Of this amount $100 would be treated as carried over from
1969. Assuming the original facts for a taxable year beginning in 1978,
the transitional additional allowance would be $2,450. No amount would
[[Page 265]]
remain to be carried over to the succeeding taxable year.
[T.D. 7301, 39 FR 964, Jan. 4, 1974; 39 FR 2758, Jan. 24, 1974, as
amended by T.D. 7597, 44 FR 12419, Mar. 7, 1979; T.D. 7728, 45 FR 72650,
Nov. 3, 1980]
Sec. 1.1212-1 Capital loss carryovers and carrybacks.
(a) Corporations; other taxpayers for taxable years beginning before
January 1, 1964--(1) Regular net capital loss sustained for taxable
years beginning before January 1, 1970. (i) A corporation sustaining a
net capital loss for any taxable year beginning before January 1, 1970,
and a taxpayer other than a corporation sustaining a net capital loss
for any taxable year beginning before January 1, 1964, shall carry over
such net loss to each of the 5 succeeding taxable years and treat it in
each of such 5 succeeding taxable years as a short-term capital loss to
the extent not allowed as a deduction against any net capital gains
(capital gain net income for taxable years beginning after December 31,
1976) of any taxable years intervening between the taxable year in which
the net capital loss was sustained and the taxable year to which
carried. The carryover is thus applied in each succeeding taxable year
to offset any net capital gain in such succeeding taxable year. The
amount of the capital loss carryover may not be included in computing a
new net capital loss of a taxable year which can be carried over to the
next 5 succeeding taxable years. For purposes of this subparagraph, a
net capital gain (capital gain net income for taxable years beginning
after December 31, 1976) shall be computed without regard to capital
loss carryovers or carrybacks. In the case of nonresident alien
individuals, see section 871 for special rules on capital loss
carryovers. For the rules applicable to the portion of a net capital
loss of a corporation which is attributable to a foreign expropriation
capital loss sustained in taxable years beginning after December 31,
1958, see subparagraph (2) of this paragraph. For the rules applicable
to a taxpayer other than a corporation in the treatment of that amount
of a net capital loss which may be carried over under section 1212 and
this subparagraph as a short-term capital loss to the first taxable year
beginning after December 31, 1963, see paragraph (b) of this section.
(ii) The practical operation of the provisions of this subparagraph
may be illustrated by the following example:
Example: (a) For the taxable years 1952 to 1956, inclusive, an
individual with one exemption allowable under section 151 (or
corresponding provision of prior law) is assumed to have a net short-
term capital loss, net short-term capital gain, net long-term capital
loss, net long-term capital gain, and taxable income (net income for
1952 and 1953) as follows:
----------------------------------------------------------------------------------------------------------------
1952 1953 1954 1955 1956
----------------------------------------------------------------------------------------------------------------
Carryover from prior years:
From 1952..................... .............. ($50,000) ($29,500) ($29,500) ..............
From 1954..................... .............. .............. .............. (19,500) ($13,000)
Net short-term loss (computed ($30,000) (5,000) (10,000) .............. ..............
without regard to the
carryovers)....................
Net short-term gain (computed .............. .............. .............. 40,000 ..............
without regard to the
carryovers)....................
Net long-term loss.............. (20,500) .............. (10,000) (5,000) ..............
Net long-term gain.............. .............. 25,000 .............. .............. 15,000
Net income or taxable income, 500 500 500 1,000 500
computed without regard to
capital gains and losses, and,
after 1953, without regard to
the deduction provided by
section 151....................
Net capital gain (capital gain .............. 20,500 .............. 36,000 ..............
net income for taxable years
beginning after December 31,
1976) (computed without regard
to the carryovers).............
Net capital loss................ (50,000) .............. (19,500) .............. ..............
Deduction allowable under .............. .............. .............. .............. 1,000
section 1202...................
Taxable income (after deductions .............. .............. .............. .............. 900
allowable under sections 151
and 1202)......................
----------------------------------------------------------------------------------------------------------------
[[Page 266]]
(b) Net capital loss of 1952. The net capital loss is $50,000. This
figure is the excess of the losses from sales or exchanges of capital
assets over the sum of (1) gains (in this case, none) from sales or
exchanges of capital assets, and (2) net income (computed without regard
to capital gains and losses) of $500. This amount may be carried forward
in full as a short-term loss to 1953. However, in 1953 there was a net
capital gain (capital gain net income for taxable years beginning after
December 31, 1976) of $20,500, as defined by section 117(a)(10)(B) of
the Internal Revenue Code of 1939, and limited by section 117(e)(1) of
the 1939 Code, against which this net capital loss of $50,000 is allowed
in part. The remaining portion--$29,500--may be carried forward to 1954
and 1955 since there was no net capital gain (capital gain net income
for taxable years beginning after December 31, 1976) in 1954. In 1955
this $29,500 is allowed in full against net capital gain of $36,000, as
defined by paragraph (d) of Sec. 1.1222-1 and limited by subdivision
(i) of this subparagraph.
(c) Net capital loss of 1954. The net capital loss is $19,500. This
figure is the excess of the losses from sales or exchanges of capital
assets over the sum of (1) gains (in this case, none) from sales or
exchanges of capital assets and (2) taxable income (computed without
regard to capital gains and losses and the deductions provided in
section 151) of $500. This amount may be carried forward in full as a
short-term loss to 1955. The net capital gain (capital gain net income
for taxable years beginning after December 31, 1976) in 1955, before
deduction of any carryovers, is $36,000. (See sections 1222(9)(B) and
1212 of the Internal Revenue Code of 1954, as it existed prior to the
enactment of the Revenue Act of 1964.) The $29,500 balance of the 1952
loss is first applied against the $36,000, leaving a balance of $6,500.
Against this amount the $19,500 loss arising in 1954 is applied, leaving
a loss of $13,000, which may be carried forward to 1956. Since this
amount is treated as a short-term capital loss in 1956 under subdivision
(i) of this subparagraph, the excess of the net long-term capital gain
over the net short-term capital loss is $2,000 ($15,000 minus $13,000).
Half of this excess is allowable as a deduction under section 1202.
Thus, after also deducting the exemption allowed as a deduction under
section 151 ($600), the taxpayer has a taxable income of $900 ($2,500
minus $1,600) for 1956.
(2) Corporations sustaining foreign expropriation capital losses for
taxable years ending after December 31, 1958--(i) In general. A
corporation sustaining a net capital loss for any taxable year ending
after December 31, 1958, any portion of which is attributable to a
foreign expropriation capital loss, shall carry over such portion of the
loss to each of the ten succeeding taxable years and treat it in each of
such succeeding taxable years as a short-term capital loss to the extent
and consistent with the manner provided in subparagraph (1) of this
paragraph. For such purposes, the portion of any net capital loss for
any taxable year which is attributable to a foreign expropriation
capital loss is the amount, not in excess of the net capital loss for
such year, of the foreign expropriation capital loss for such year. The
portion of a net capital loss for any taxable year which is attributable
to a foreign expropriation capital loss shall be treated as a separate
net capital loss for that year and shall be applied, after first
applying the remaining portion of such net capital loss, to offset any
capital gain net income (net capital gain for taxable years beginning
before January 1, 1977) in a succeeding taxable year. In applying net
capital losses of two or more taxable years to offset the capital gain
net income (net capital gain(s) for taxable years beginning before
January 1, 1977) of a subsequent taxable year, such net capital losses
shall be offset against such capital gain net income (net capital
gain(s) for taxable years beginning before January 1, 1977) in the order
of the taxable years in which the losses were sustained, beginning with
the loss for the earliest preceding taxable year, even though one or
more of such net capital losses are attributable in whole or in part to
a foreign expropriation capital loss.
(ii) Foreign expropriation capital loss defined. For purposes of
this subaparagraph the term foreign expropriation capital loss means,
for any taxable year, the sum of the losses taken into account in
computing the net capital loss for such year which are:
(a) Losses sustained directly by reason of the expropriation,
intervention, seizure, or similar taking of property by the government
of any foreign country, any political subdivision thereof, or any agency
or instrumentality of the foregoing, or
(b) Losses (treated under section 165 (g)(1) as losses from the sale
or exchange of capital assets) from securities which become worthless by
reason of the expropriation, intervention, seizure, or similar taking of
property by
[[Page 267]]
the government of any foreign country, any political subdivision
thereof, or any agency or instrumentality of the foregoing.
(iii) Illustrations. The application of this subparagraph may be
illustrated by the following examples:
Example 1. X, a domestic corporation which uses the calendar year as
the taxable year, owns as a capital asset 75 percent of the outstanding
stock of Y, a foreign corporation operating in a foreign country. In
1961, the foreign country seizes all of the assets of Y, rendering X's
stock in Y worthless and thus causing X to sustain a $40,000 foreign
expropriation capital loss for such year. In 1961, X has $30,000 of
other losses from the sale or exchange of capital assets and $50,000 of
gains from the sale or exchange of capital assets. X's net capital loss
for 1961 is $20,000 ($70,000-$50,000). Since the foreign expropriation
capital loss exceeds this amount, the entire $20,000 is a foreign
expropriation capital loss for 1961.
Example 2. Z, a domestic corporation which uses the calendar year as
the taxable year, has a net capital loss of $50,000 for 1961, $30,000 of
which is attributable to a foreign expropriation capital loss. Pursuant
to the provisions of this paragraph, $30,000 of such net capital loss
shall be carried over as a short-term capital loss to each of the 10
taxable years succeeding 1961, and the remaining $20,000 of the net
capital loss shall be carried over as a short-term capital loss to each
of the 5 taxable years succeeding 1961. Z has a $35,000 net capital gain
(capital gain net income for taxable years beginning after December 31,
1976) (determined without regard to any capital loss carryover) for
1962. In offsetting the $50,000 capital loss carryover from 1961 against
the $35,000 net capital gain (capital gain net income for taxable years
beginning after December 31, 1976) for 1962, the $30,000 portion of such
carryover which is attributable to the foreign expropriation capital
loss for 1961 is applied against the 1962 net capital gain (capital gain
net income for taxable years beginning after December 31, 1976) after
applying the $20,000 remaining portion of the carryover. Thus, there is
a capital loss carryover of $15,000 to 1963, all of which is
attributable to the foreign expropriation capital loss for 1961. Z has a
net capital loss for 1963 of $10,000, no portion of which is
attributable to a foreign expropriation capital loss. For 1964, Z has a
net capital gain (capital gain net income for taxable years beginning
after December 31, 1976) of $22,000 (determined without regard to the
capital loss carryovers from 1961 and 1963). In offsetting the capital
loss carryovers from 1961 and 1963 against Z's $22,000 net capital gain
(capital gain net income for taxable years beginning after December 31,
1976) for 1964, the $15,000 carryover from 1961 is applied against the
1964 net capital gain (capital gain net income for taxable years
beginning after December 31, 1976) before the $10,000 capital loss
carryover from 1963 is applied against such gain. Thus, $3,000 of the
1963 net capital loss remains to be carried over to 1965.
(3) Regular net capital loss sustained by a corporation for taxable
years beginning after December 31, 1969--(i) General rule. A corporation
sustaining a net capital loss for any taxable year beginning after
December 31, 1969 (hereinafter in this paragraph referred to as the loss
year), shall:
(a) Carry back such net capital loss to each of the 3 taxable years
preceding the loss year, but only to the extent that such net capital
loss is not attributable to a foreign expropriation capital loss and the
carryback of such net capital loss does not increase or produce a net
operating loss (as defined in section 172(c)) for the taxable year to
which it is carried back; and
(b) Carry over such net capital loss to each of the 5 taxable years
succeeding the loss year,
and, subject to subdivision (ii) of this subparagraph, treat such net
capital loss in each of such 3 preceding and 5 succeeding taxable years
as a short-term capital loss.
(ii) Amount treated as a short-term capital loss in each year. The
entire amount of the net capital loss for any loss year shall be carried
to the earliest of the taxable years to which such net capital loss may
be carried, and the portion of such net capital loss which shall be
carried to each of the other taxable years to which such net capital
loss may be carried shall be the excess, if any, of such net capital
loss over the total of the capital gain net income (net capital gain for
taxable years beginning before January 1, 1977) (computed without regard
to the capital loss carryback from the loss year or any taxable year
thereafter) for each of the prior taxable years to which such net
capital loss may be carried.
(iii) Special rules. (a) In the case of a net capital loss which is
not a foreign expropriation capital loss and which cannot be carried
back in full to a preceding taxable year by reason of section
1212(a)(1)(A)(ii) and subdivision
[[Page 268]]
(i)(a) of this subparagraph because such loss would produce or increase
a net operating loss in such preceding taxable year, the capital gain
net income (net capital gain for taxable years beginning before January
1, 1977) for such preceding taxable year shall in no case be treated as
greater than the amount of such net capital loss which can be carried
back to such preceding taxable year upon the application of section
1212(a)(1)(A)(ii) and subdivision (i)(a) of this subparagraph.
(b) For the rules applicable to the portion of a net capital loss of
a corporation which is attributable to a foreign expropriation capital
loss sustained in a taxable year beginning after December 31, 1958, see
section 1212(a)(2) and subparagraph (2) of this paragraph.
(c) Section 1212(a)(1)(A) and subdivision (i)(a) of this
subparagraph shall not apply to (and no carryback shall be allowed with
respect to) the net capital loss of a corporation for any taxable year
for which such corporation is an electing small business corporation
under subchapter S. See Sec. 1.1372-1.
(d) A net capital loss of a corporation for a year for which it is
not an electing small business corporation under subchapter S shall not
be carried back under section 1212(a)(1)(A) and subdivision (i)(a) of
this subparagraph to a taxable year for which such corporation is an
electing small business corporation. See section 1212(a)(3).
(e) A net capital loss of a corporation shall not be carried back
under section 1212(a)(1)(A) and subdivision (i)(a) of this subparagraph
to a taxable year for which the corporation was a foreign personal
holding company, a regulated investment company, or a real estate
investment trust, or for which an election made by the corporation under
section 1247 is applicable. See section 1212(a)(4).
(f) A taxable year to which a net capital loss of a corporation
cannot, by reason of (d) or (e) of this subdivision, be carried back
under section 1212(a) (1)(A) and subdivision (i)(a) of this subparagraph
shall nevertheless be treated as 1 of the 3 taxable years preceding the
loss year for purposes of section 1212(a)(1)(A) and such subdivision
(i)(a); but any capital gain net income (net capital gain for taxable
years beginning before January 1, 1977) for such taxable year to which
such net capital loss cannot be carried back shall be disregarded for
purposes of subdivision (ii) of this subparagraph.
(g) A regulated investment company (as defined in section 851)
sustaining a net capital loss shall carry over that loss to each of the
8 taxable years succeeding the loss year. However, the 8-year period
prescribed in the preceding sentence shall be reduced (but not to less
than 5 years) by the sum of (1) the number of taxable years to which the
net capital loss must be carried back pursuant to subdivision (i)(a) of
this subparagraph (as limited by subdivision (iii)(e) of this
subparagraph) and (2) the number of taxable years, of the 8 taxable year
succeeding the loss year, that the corporation failed to qualify as a
regulated investment company as defined in section 851. This subdivision
shall not extend the carryover period prescribed in subdivision (i)(b)
of this subparagraph to a year in which a corporation is not a regulated
investment company as defined in section 851.
(iv) The application of this subparagraph may be illustrated by the
following examples, in each of which it is assumed that the corporation
is not, and never has been, a corporation described in subdivision (iii)
(c) or (d) of this subparagraph, that the corporation files its tax
returns on a calendar year basis, and that no capital loss sustained is
a foreign expropriation capital loss:
Example 1. A corporation has a net capital loss for 1970 which
section 1212(a)(1)(A) permits to be carried back. The entire net capital
loss for 1970 may be carried back to 1967, but only to the extent that a
net operating loss for 1967 would not be produced or increased. The
amount of the carryback to 1968 is the excess of the net capital loss
for 1970 over the net capital gain (capital gain net income for taxable
years beginning after December 31, 1976) for 1967, computed without
regard to a capital loss carryback from 1970 or any taxable year
thereafter. The amount of the carryback to 1969 is the excess of the net
capital loss for 1970 over the sum of the net capital gains (capital
gain net income for taxable years beginning after December 31, 1976) for
1967 and 1968, computed without regard to a capital loss carryback from
1970 or any taxable year thereafter. The amount of the carryover to 1971
is the excess of the net
[[Page 269]]
capital loss for 1970 over the sum of the net capital gains (capital
gain net income for taxable years beginning after December 31, 1976) for
1967, 1968, and 1969, computed without regard to a capital loss
carryback from 1970 or any taxable year thereafter. Similarly, the
amount of the carryover to 1972, 1973, 1974, and 1975, respectively, is
the excess of the net capital loss for 1970 over the sum of the net
capital gains (capital gain net income for taxable years beginning after
December 31, 1976) for taxable years prior to 1972, 1973, 1974, or 1975,
as the case may be, to which the net capital loss for 1970 may be
carried, computed without regard to a capital loss carryback from 1970
or any year thereafter.
Example 2. For the taxable years 1967 to 1975, inclusive, a
corporation is assumed to have net capital loss, net capital gain
(capital gain net income for taxable years beginning after December 31,
1976), and taxable income (computed without regard to capital gains and
losses) as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
1967 1968 1969 1970 1971 1972 1973 1974 1975
--------------------------------------------------------------------------------------------------------------------------------------------------------
Taxable income (computed without regard to capital gains or $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000
losses)......................................................
Net capital loss.............................................. ........ ........ (1,000) (29,500) (16,000) (500) ........ ........ ........
Net capital gain (capital gain net income for taxable years 14,000 16,000 ........ ........ ........ ........ 8,000 7,500 6,500
beginning after December 31, 1976) (computed without regard
to carrybacks or carryovers).................................
Carryback or carryover:
From 1969................................................... ........ ........ ........ ........ ........ ........ (1,000) ........ ........
From 1970................................................... (14,000) (15,500) ........ ........ ........ ........ ........ ........ ........
From 1971................................................... ........ (500) ........ ........ ........ ........ (7,000) (7,500) (1,000)
From 1972................................................... ........ ........ ........ ........ ........ ........ ........ ........ (500)
--------------------------------------------------------------------------------------------------------------------------------------------------------
The net capital loss of 1969, under the rules of subparagraph (1) of
this paragraph, may not be carried back. Thus, the net capital loss for
1970 is carried back and partially absorbed by the net capital gain
(capital gain net income for taxable years beginning after December 31,
1976) for 1967, and a portion of the net capital losses of both 1970 and
1971 are carried back to 1968. The net capital loss for 1969 is the
oldest that may be carried to 1973, and thus, it is the first carried
over and absorbed by the net capital gain for 1973. The net capital loss
for 1972 (which is not carried back because of the net capital losses in
the 3 years preceding 1972) may be carried over to 1973.
Example 3. For the taxable years 1967 to 1970, inclusive, a
corporation which was organized on January 1, 1967, realized operating
income and net capital gains (capital gain net income for taxable years
beginning after December 31, 1976) and sustained operating losses and
net capital losses as follows:
------------------------------------------------------------------------
Operating income
or loss
(exclusive of Capital gain
capital gain or or loss
loss)
------------------------------------------------------------------------
1967.................................. $20,000 $24,000
1968.................................. 20,000 0
1969.................................. 20,000 0
1970.................................. (25,000) (20,000)
------------------------------------------------------------------------
The net capital loss of $20,000 for 1970 is carried back to 1967 and
applied against the $24,000 net capital gain (capital gain net income
for taxable years beginning after December 31, 1976) realized in that
year, reducing such net capital gain (capital gain net income for
taxable years beginning after December 31, 1976) to $4,000. The net
operating loss of $25,000 for 1970 is then carried back to 1967 and
applied first to eliminate the $20,000 of operating income for that year
and then to eliminate the net capital gain (capital gain net income for
taxable years beginning after December 31, 1976) for that year of $4,000
(as reduced by the 1970 capital loss carryback).
Example 4. Assume the same facts as in Example 3 but substitute the
following figures:
------------------------------------------------------------------------
Operating income
or loss
(exclusive of Capital gain
capital gain or or loss
loss)
------------------------------------------------------------------------
1967.................................. ($20,000) $24,000
1968.................................. 20,000 0
1969.................................. 20,000 0
1970.................................. (25,000) (20,000)
------------------------------------------------------------------------
The net capital loss of $20,000 for 1970 is carried back to 1967 and
applied against the $24,000 net capital gain (capital gain net income
for taxable years beginning after December 31, 1976) realized in that
year only to the extent of $4,000, the maximum amount to which the 1970
capital loss carryback can be applied without producing a net operating
loss for 1967. The unused $16,000 balance of the 1970 net long-term
capital loss can be
[[Page 270]]
carried forward to 1971 and subsequent taxable years to the extent
provided in subdivision (i)(b) of this subparagraph.
Example 5. Assume the same facts as in Example 3 but substitute the
following figures:
------------------------------------------------------------------------
Operating income
or loss
(exclusive of Capital gain
capital gain or or loss
loss)
------------------------------------------------------------------------
1967.................................. 0 0
1968.................................. ($20,000) 0
1969.................................. 0 $24,000
1970.................................. 20,000 (24,000)
------------------------------------------------------------------------
The net capital loss of $24,000 for 1970 is carried back to 1969 and
applied against the $24,000 net capital gain (capital gain net income
for taxable years beginning after December 31, 1976) realized in that
year to the extent of $24,000. The application of the capital loss
carryback is not limited as it was in Example 4 because such carryback
neither increases nor produces a net operating loss, as such, for 1969.
The $20,000 net operating loss for 1968 is then carried forward to 1970
to eliminate the $20,000 of operating income for that year.
Example 6. Assume the same facts as in Example 3 but substitute the
following figures:
------------------------------------------------------------------------
Operating income
or loss
(exclusive of Capital gain
capital gain or or loss
loss)
------------------------------------------------------------------------
1967.................................. 0 0
1968.................................. 0 0
1969.................................. ($20,000) ($24,000)
1970.................................. 20,000 20,000
------------------------------------------------------------------------
The net capital loss of $24,000 for 1969 is carried forward to 1970
and applied against the $20,000 net capital gain (capital gain net
income for taxable years beginning after December 31, 1976) realized in
that year. The unused $4,000 balance of the 1969 net capital loss can be
carried forward to 1971 and subsequent taxable years to the extent
provided in subdivision (i)(b) of this subparagraph.
(b) Taxpayers other than corporations for taxable years beginning
after December 31, 1963--(1) In general. If a taxpayer other than a
corporation sustains a net capital loss for any taxable year beginning
after December 31, 1963, the portion thereof which is a short-term
capital loss carryover shall be carried over to the succeeding taxable
year and treated as a short-term capital loss sustained in such
succeeding taxable year, and the portion thereof which constitutes a
long-term capital loss carryover shall be carried over to the succeeding
taxable year and treated as a long-term capital loss sustained in such
succeeding taxable year. The carryovers are included in the succeeding
taxable year in the determination of the amount of the short-term
capital loss, the net short-term capital gain or loss, the long-term
capital loss, and the net long-term capital gain or loss in such year,
the net capital loss in such year, and the capital loss carryovers from
such year. For purposes of this subparagraph:
(i) A short-term capital loss carryover is the excess of the net
short-term capital loss for the taxable year over the net long-term
capital gain for such year, and
(ii) A long-term capital loss carryover is the excess of the net
long-term capital loss for the taxable year over the net short-term
capital gain for such year.
(2) Special rules for determining a net short-term capital gain or
loss for purposes of carryover--(i) Taxable years beginning after
December 31, 1963, and before January 1, 1970. In determining a net
short-term capital gain or loss of a taxable year beginning after
December 31, 1963, and before January 1, 1970, for purposes of computing
a short-term or long-term capital loss carryover to the succeeding
taxable year, an amount equal to the additional allowance deductible
under section 1211(b) for the taxable year (determined as provided in
section 1211(b), as in effect for taxable years beginning before January
1, 1970, and Sec. 1.1211-1(b)(5)) is treated as a short-term capital
gain occurring in such year.
(ii) Taxable years beginning after December 31, 1969. In determining
a net short-term capital gain or loss of a taxable year beginning after
December 31, 1969:
(a) For purposes of computing a short-term capital loss carryover to
the succeeding taxable year, an amount equal to the additional allowance
for the taxable year (determined as provided in section 1211(b) and
Sec. 1.1211-1(b)(2)) is treated as a short-term capital gain occurring
in such year, and
(b) For purposes of computing a long-term capital loss carryover to
the succeeding taxable year, an amount equal to the sum of the
additional allowance for the taxable year (determined as
[[Page 271]]
provided in section 1211(b) and Sec. 1.1211-1(b)(2)), plus the excess
of such additional allowance over the net short-term capital loss
(determined without regard to section 1212(b)(2) for such year) is
treated as a short-term capital gain in such year.
The rules provided in this subdivision are for the purpose of taking
into account the additional allowance deductible for the current taxable
year under section 1211(b) and Sec. 1.1211-1(b)(2) in determining the
amount and character of capital loss carryovers from the current taxable
year to the succeeding taxable year. Their practical application to a
determination of the amount and character of capital loss carryovers
from the current taxable year to the succeeding taxable year involves
identification of the net long-term and net short-term capital loss
components of the additional allowance deductible in the current taxable
year as provided by Sec. 1.1211-1(b)(2)(iii). To the extent that the
additional allowance is composed of net short-term capital losses, such
losses are treated as a short-term capital gain in the current taxable
year in determining the capital loss carryovers to the succeeding year.
To the extent that the additional allowance is composed of net long-term
capital losses applied pursuant to the provisions of Sec. 1.1211-
1(b)(2)(iii), an amount equal to twice the amount of such component of
the additional allowance is treated as a short-term capital gain in the
current taxable year. See paragraph (4) of this section for transitional
rules if any part of the additional allowance is composed of net long-
term capital losses carried to the current taxable year from a taxable
year beginning before January 1, 1970.
(3) Transitional rule for net capital losses sustained in a taxable
year beginning before January 1, 1964. A taxpayer other than a
corporation sustaining a net capital loss for any taxable year beginning
before January 1, 1964, shall treat as a short-term capital loss in the
first taxable year beginning after December 31, 1963, any amount which
would be treated as a short-term capital loss in such year under
subchapter P of chapter 1 of the Code as in effect immediately before
the enactment of the Revenue Act of 1964.
(4) Transitional rule for net long-term capital losses sustained in
a taxable year beginning before January 1, 1970. In the case of a net
long-term capital loss sustained by a taxpayer other than a corporation
in a taxable year beginning prior to January 1, 1970 (referred to in
this section as a pre-1970 taxable year) which is carried over and
treated as a long-term capital loss in the first taxable year beginning
after December 31, 1969 (referred to in this section as a post-1969
taxable year), the transitional additional allowance deductible under
section 1211(b) for the taxable year shall be determined by application
of section 1211(b) as in effect for pre-1970 taxable years and Sec.
1.1211-1(b)(3), and the amount of such long-term capital loss carried
over and treated as a long-term capital loss in the succeeding taxable
year shall be determined by application of section 1212(b)(1) as in
effect for pre-1970 taxable years and subparagraph (2)(i) of this
paragraph (instead of under sections 1211(b) and 1212(b)(1) as in effect
for post-1969 taxable years and Sec. 1.1211-1(b)(2) and subparagraph
(2)(ii) of this paragraph, respectively) but only to the extent that
such pre-1970 long-term capital loss constitutes a transitional net
long-term capital loss component (determined as provided in Sec.
1.1211-1(b)(3)(ii)) in the taxable year to which such pre-1970 long-term
capital loss is carried. Thus, for purposes of paragraph (2) of this
section, to the extent that a component of the transitional additional
allowance deductible for a post-1969 taxable year under section 1211(b)
and Sec. 1.1211-1(b)(3)(i) is a transitional net long-term capital loss
component carried over to such post-1969 taxable year, such component
shall be treated as a short-term capital gain in determining the amount
and character of capital loss carryovers from such post-1969 taxable
year to the succeeding taxable year. Such component shall be so treated
as a short-term capital gain in full on a dollar-for-dollar basis and
shall not be doubled for this purpose as is provided by subdivision (ii)
of paragraph (2) of this section in the case of a component of the
additional allowance made up of net long-term capital losses applied
pursuant to the provisions of Sec. 1.1211-1(b)(2)(iii). The
[[Page 272]]
transitional rule provided in this paragraph does not apply to a
determination of the character of capital losses (as long-term or short-
term) actually deductible for the current taxable year under section
1211(b) and Sec. 1.1211-1(b).
(5) Examples. The application of this paragraph can be illustrated
by the following examples:
Example 1. For the taxable year 1971, an unmarried individual has
taxable income for purposes of section 1211(b) of $8,000, a long-term
capital loss of $2,000, and no other capital gains or losses. $1,000
(one-half) of the net long-term capital loss is deductible in 1971 as
the additional allowance deductible under section 1211(b). No amount of
capital loss remains to be carried over to the succeeding taxable year.
Example 2. For the taxable year 1972, the same unmarried individual
has taxable income for purposes of section 1211(b) of $8,000, a long-
term capital loss of $3,000 and no other capital gains or losses. $1,500
(one-half of the excess net capital loss) is deductible in 1972, but
limited to the $1,000 maximum additional allowance deductible under
section 1211(b). By application of section 1212(b)(1), he will carry
over to 1973 a long-term capital loss of $1,000 determined as follows:
Net long-term capital loss................................... ($3,000)
Additional allowance deductible under section $1,000
1211(b)..........................................
Excess of additional allowance over net short-term 1,000
capital loss (determined without regard to
section 1212(b)(2)(B)(i))........................
-----------
Total amount treated as short-term capital gain under 2,000
1212(b)(2)(B) for purposes of determining carryover.........
============
Long-term capital loss carryover to 1973..................... (1,000)
============
If, in 1973, he had taxable income for purposes of section 1211(b) of
$8,000, but no capital gains or losses, $500 (one-half) of the net long-
term capital loss carryover from 1972 would be deductible in 1973 as the
additional allowance deductible under section 1211(b). No amount of
capital loss would be carried over to 1974.
Example 3. For the taxable year 1971, an unmarried individual has
taxable income for purposes of section 1211(b) of $9,000, a $500 short-
term capital gain, a $700 short-term capital loss, a $1,000 long-term
capital gain and a $1,700 long-term capital loss. He will offset $1,500
of capital losses against capital gains. The excess net capital loss of
$900 is deductible in 1971 to the extent of a $550 additional allowance
deductible under 1211(b) which is smaller than both $1,000 and taxable
income for purposes of section 1211(b), determined as follows:
Losses allowed to the extent of gains........................ ($1,500)
============
Amount allowed under section 1211(b)(1)(C):
(i) Excess of net short-term capital loss over net long- (200)
term capital gain.........................................
(ii) One-half of the excess of net long-term capital loss (350)
over net short-term capital gain..........................
------------
Additional allowance deductible under section 1211(b)........ 550
============
The total amount treated as short-term capital gain under section
1212(b)(2)(B) for purposes of determining any carryover to the
succeeding taxable year exceeds $900. No amount of net capital loss
remains to be carried over to the succeeding taxable year.
Example 4. If in example (3) above, the long-term capital loss had
been $2,800, the taxpayer would carry over $200 of long-term capital
loss to 1972, determined as follows:
Losses allowed to extent of gains............................ ($1,500)
Amount allowed under section 1211(b)(1) (B) and (C):
(i) Excess of net short-term capital loss over net long- (200)
term capital gain.......................................
(ii) One-half the excess of net long-term capital loss (900)
over net short-term capital gain........................
as limited by 1211(b)(1)(B) to an additional allowance of $1,000.
Carryover under section 1212(b)(1):
Net long-term capital loss for 1971...................... ($1,800)
Additional allowance under section 1211(b)(1)(B)......... 1,000
Excess of additional allowance deductible under section 800
1211(b) over net short-term capital loss determined
without regard to section 1212(b)(2)(B)(i) ($1,000 less
$200)...................................................
------------
Total amount treated as short-term capital gain under 1,800
section 1212(b)(2)(B) for purposes of determining
carryover...............................................
Short-term capital gain for 1971......................... 500
------------
Total short-term capital gain............................ 2,300
Short-term capital loss for 1971......................... (700)
------------
Net short-term capital gain.............................. 1,600
============
Long-term capital loss carryover ($1,800 less $1,600).... 200
Example 5. For 1969, an unmarried individual has taxable income for
purposes of section 1211(b) of $8,000, a long-term capital loss of
$3,000, and no other capital gains or losses. He is allowed to deduct in
1969 $1,000 as the additional allowance deductible under section 1211(b)
(as in effect for pre-1970 taxable years) and to carry over to 1970, a
long-term capital loss of $2,000 under section 1212(b) (as in effect for
pre-1970 taxable years).
If, in 1970, the same unmarried individual with taxable income for
purposes of section 1211(b) of $8,000, has no capital gains or losses,
he would deduct $1,000 of his pre- 1970
[[Page 273]]
capital loss carryover as the transitional additional allowance
deductible under section 1211(b) (as in effect for pre-1970 years) and
carry over under section 1212(b)(1) (as in effect for pre-1970 taxable
years) to 1971 the remaining $1,000 as a pre-1970 long-term capital
loss.
If, in 1970, the same individual instead has a long-term capital
gain of $2,500, and a long-term capital loss of $1,500, he would net
these two items with the $2,000 carried to 1970 as a long-term capital
loss. Thus, he would have a net long-term capital loss for 1970 of
$1,000 which is deductible in 1970 as the transitional additional
allowance deductible under section 1211(b). He would have no amount to
carry over under section 1212(b)(1) to 1971.
If, in 1970, the same individual instead has a long-term capital
loss of $1,200, and a long-term capital gain of $200, resulting in a net
long-term capital loss of $3,000 when netted with the $2,000 carried to
1970 as a long-term capital loss, he would deduct $1,000 in respect of
his pre-1970 long-term capital loss carryover as the transitional
additional allowance deductible under section 1211(b) (as in effect for
pre-1970 taxable years) and carry over under section 1212(b)(1) (as in
effect for pre-1970 taxable years) to 1971 the remaining $1,000 of the
pre-1970 component of his long-term capital loss carryover, and the
$1,000 net long-term capital loss actually sustained in 1970 as the
second component of his long-term capital loss carryover.
Example 6. For 1970 a married individual filing a separate return
has taxable income of $8,000, a long-term capital loss of $3,500 and a
short-term capital gain of $3,000. He also has a pre-1970 short-term
capital loss of $2,000 which is carried to 1970. The $3,000 short-term
capital gain realized in 1970 would first be reduced by the $2,000
short-term capital loss carryover, and then the remaining $1,000 balance
of the short-term capital gain would be offset against the $3,500 long-
term capital loss, producing a net long-term capital loss of $2,500, no
part of which is a net long-term capital loss carried over from 1969.
However, under the special rule of Sec. 1.1211-1(b)(7)(ii) in 1970, the
taxpayer would deduct as the additional allowance deductible under
section 1211(b), the $500 limitation in Sec. 1.1211-1(b)(2)(ii) in the
case of a married taxpayer filing a separate return in a taxable year
ending after December 31, 1969, plus the transitional net short-term
capital loss component of $2,000 computed under Sec. 1.1211-
1(b)(3)(iv), but limited to a total deduction of $1,000. The $1,000
additional allowance deductible under section 1211(b) would absorb
$2,000 of the $2,500 net long-term capital loss, and he would carry the
unused $500 balance of such loss to 1971 for use in that year.
Example 7. For 1970, an unmarried individual filing a separate
return has taxable income for purposes of section 1211(b) of $8,000, and
a long-term capital loss of $2,000. He also has a pre-1970 long-term
capital loss of $2,500 which is carried to 1970. In 1970, the taxpayer
would deduct as the transitional additional allowance deductible under
section 1211(b) $1,000, absorbing $1,000 of the pre-1970 long-term
capital loss of $2,500. He would carry to 1971 the unused $1,500 balance
of his pre-1970 long-term capital loss plus the 1970 long-term capital
loss of $2,000, or a total of $3,500, for use in 1971.
For 1971, the same taxpayer filing a separate return with taxable
income for purposes of section 1211(b) of $8,000, has a $3,600 long-term
capital gain and a $2,200 long-term capital loss. When these gains and
losses are combined with the long-term capital loss carryover from 1970
of $3,500, a net long-term capital loss of $2,100 results. He would
deduct $1,000 as the transitional additional allowance deductible under
section 1211(b). The $1,000 additional allowance would absorb $100 of
the unused pre-1970 long-term capital loss carryover of $1,500 plus
$1,800 of the unused post-1969 long-term capital loss carryover of
$2,100 (the amount of the 1971 net long-term capital loss necessary to
make up the remaining $900 balance of the additional allowance).
Although a component of the 1971 net long-term capital loss is the
unused pre-1970 long-term capital loss carryover of $1,500, only $100 of
this carryover is available for use in full on a dollar-for-dollar basis
in computing the transitional additional allowance for 1971 since it
only exceeds by that amount the $1,400 net capital gain (capital gain
net income for taxable years beginning after December 31, 1976) actually
realized in 1971 all of which is net long-term capital gain (long-term
capital gain of $3,600 reduced by long-term capital loss of $2,200). See
Sec. 1.1221-1(b)(3)(ii). The taxpayer would carry over to 1972 as a
long-term capital loss the remaining $200 of the 1971 long-term capital
loss.
Example 8. For 1970, an unmarried individual has taxable income for
purposes of section 1211(b) of $8,000 and a short-term capital loss of
$700. He also has a pre-1970 long-term capital loss carryover of $1,200.
He would deduct $1,000 as the transitional additional allowance
deductible under section 1211(b). The $1,000 transitional additional
allowance would be composed of the 1970 short-term capital loss of $700
and $300 of the pre-1970 long-term capital loss carryover. He would
carry over to 1971 the unused $900 balance of his $1,200 pre-1970 long-
term capital loss carryover for use in 1971.
(c) Husband and wife. (1) The following rules shall be applied in
computing capital loss carryovers by husband and wife:
(i) If a husband and wife making a joint return for any taxable year
made separate returns for the preceding
[[Page 274]]
year, any capital loss carryovers of each spouse from such preceding
taxable year may be carried forward to the taxable year in accordance
with paragraph (a) or (b) of this section.
(ii) If a joint return was made for the preceding taxable year, any
capital loss carryover from such preceding taxable year may be carried
forward to the taxable year in accordance with paragraph (a) or (b) of
this section.
(iii) If a husband and wife make separate returns for the first
taxable year beginning after December 31, 1963, or any prior taxable
year, and they made a joint return for the preceding taxable year, any
capital loss carryover from such preceding taxable year shall be
allocated to the spouses on the basis of their individual net capital
loss which gave rise to such capital loss carryover. The capital loss
carryover so allocated to each spouse may be carried forward by such
spouse to the taxable year in accordance with paragraph (a) or (b) of
this section.
(iv) If a husband and wife making separate returns for any taxable
year following the first taxable year beginning after December 31, 1963,
made a joint return for the preceding taxable year, any long-term or
short-term capital loss carryovers shall be allocated to the spouses on
the basis of their individual net long-term and net short-term capital
losses for the preceding taxable year which gave rise to such capital
loss carryovers, and the portions of the long-term or short-term capital
loss carryovers so allocated to each spouse may be carried forward by
such spouse to the taxable year in accordance with paragraph (b) of this
section.
(v) If separate returns are made both for the taxable year and the
preceding taxable year, any capital loss carryover of each spouse may be
carried forward by such spouse in accordance with paragraph (a) or (b)
of this section.
(2) The provisions of subparagraph (1) (i), (iii), and (iv) of this
paragraph may be illustrated by the following examples:
Example 1. If H and W, husband and wife, make a joint return for
1955, having made separate returns for 1954 in which H had a net capital
loss of $3,000 and W had a net capital loss of $2,000, in their joint
return for 1955 they would have a short-term capital loss of $5,000 (the
sum of their separate capital loss carryovers from 1954), allowable in
accordance with paragraph (a) of this section. If, on the other hand,
they make separate returns in 1955 following a joint return in 1954 in
which their net capital loss was $5,000 allocable $3,000 to H and $2,000
to W, the carryover of H as a short-term capital loss for the purpose of
his 1955 separate return would be $3,000 and that of W for her separate
return would be $2,000, each allowable in accordance with paragraph (a)
of this section.
Example 2. H and W, husband and wife, make separate returns for 1966
following a joint return for 1965. The capital gains and losses incurred
by H and W in 1965, including those carried over by them to 1965, were
as follows:
------------------------------------------------------------------------
H W
------------------------------------------------------------------------
Long-term capital gains......................... $8,000 $9,000
Long-term capital losses........................ (15,000) (6,000)
Short-term capital gains........................ 10,000 4,000
Short-term capital losses....................... (19,000) (5,000)
------------------------------------------------------------------------
Thus, in 1965 H and W had a net capital loss of $14,000 on their joint
return. Of this amount, $4,000 was a long-term capital loss carryover,
and $10,000 was a short-term capital loss carryover, determined in
accordance paragraph (b) of this section. H's net long-term capital loss
was $7,000 for 1965. This amount was offset on the joint return by W's
net long-term capital gain of $3,000. Thus, H may carry over to his
separate return for 1966, a long-term capital loss carryover of $4,000.
H and W may carry over to their separate returns for 1966, as short-term
capital loss carryovers, the amounts of their respective net short-term
losses from 1965, $9,000 and $1,000.
[T.D. 6828, 30 FR 7806, June 17, 1965, as amended by T.D. 6867, 30 FR
15095, Dec. 7, 1965; T.D. 7301, 39 FR 968, Jan. 4, 1974; 39 FR 2758,
Jan. 24, 1974; T.D. 7659, 44 FR 73019, Dec. 17, 1979; T.D. 7728, 45 FR
72650, Nov. 3, 1980]
General Rules for Determining Capital Gains and Losses
Sec. 1.1221-1 Meaning of terms.
(a) The term capital assets includes all classes of property not
specifically excluded by section 1221. In determining whether property
is a capital asset, the period for which held is immaterial.
(b) Property used in the trade or business of a taxpayer of a
character which is subject to the allowance for depreciation provided in
section 167 and real property used in the trade or
[[Page 275]]
business of a taxpayer is excluded from the term capital assets. Gains
and losses from the sale or exchange of such property are not treated as
gains and losses from the sale or exchange of capital assets, except to
the extent provided in section 1231. See Sec. 1.1231-1. Property held
for the production of income, but not used in a trade or business of the
taxpayer, is not excluded from the term capital assets even though
depreciation may have been allowed with respect to such property under
section 23(l) of the Internal Revenue Code of 1939 before its amendment
by section 121(c) of the Revenue Act of 1942 (56 Stat. 819). However,
gain or loss upon the sale or exchange of land held by a taxpayer
primarily for sale to customers in the ordinary course of his business,
as in the case of a dealer in real estate, is not subject to the
provisions of subchapter P (section 1201 and following), chapter 1 of
the Code.
(c)(1) A copyright, a literary, musical, or artistic composition,
and similar property are excluded from the term capital assets if held
by a taxpayer whose personal efforts created such property, or if held
by a taxpayer in whose hands the basis of such property is determined,
for purposes of determining gain from a sale or exchange, in whole or in
part by reference to the basis of such property in the hands of a
taxpayer whose personal efforts created such property. For purposes of
this subparagraph, the phrase similar property includes for example,
such property as a theatrical production, a radio program, a newspaper
cartoon strip, or any other property eligible for copyright protection
(whether under statute or common law), but does not include a patent or
an invention, or a design which may be protected only under the patent
law and not under the copyright law.
(2) In the case of sales and other dispositions occurring after July
25, 1969, a letter, a memorandum, or similar property is excluded from
the term capital asset if held by (i) a taxpayer whose personal efforts
created such property, (ii) a taxpayer for whom such property was
prepared or produced, or (iii) a taxpayer in whose hands the basis of
such property is determined, for purposes of determining gain from a
sale or exchange, in whole or in part by reference to the basis of such
property in the hands of a taxpayer described in subdivision (i) or (ii)
of this subparagraph. In the case of a collection of letters,
memorandums, or similar property held by a person who is a taxpayer
described in subdivision (i), (ii), or (iii) of this subparagraph as to
some of such letters, memorandums, or similar property but not as to
others, this subparagraph shall apply only to those letters,
memorandums, or similar property as to which such person is a taxpayer
described in such subdivision. For purposes of this subparagraph, the
phrase similar property includes, for example, such property as a draft
of a speech, a manuscript, a research paper, an oral recording of any
type, a transcript of an oral recording, a transcript of an oral
interview or of dictation, a personal or business diary, a log or
journal, a corporate archive, including a corporate charter, office
correspondence, a financial record, a drawing, a photograph, or a
dispatch. A letter, memorandum, or property similar to a letter or
memorandum, addressed to a taxpayer shall be considered as prepared or
produced for him. This subparagraph does not apply to property, such as
a corporate archive, office correspondence, or a financial record, sold
or disposed of as part of a going business if such property has no
significant value separate and apart from its relation to and use in
such business; it also does not apply to any property to which
subparagraph (1) of this paragraph applies (i.e., property to which
section 1221(3) applied before its amendment by section 514(a) of the
Tax Reform Act of 1969 (83 Stat. 643)).
(3) For purposes of this paragraph, in general, property is created
in whole or in part by the personal efforts of a taxpayer if such
taxpayer performs literary, theatrical, musical, artistic, or other
creative or productive work which affirmatively contributes to the
creation of the property, or if such taxpayer directs and guides others
in the performance of such work. A taxpayer, such as corporate
executive, who merely has administrative control of writers, actors,
artists, or personnel and who does not substantially engage in
[[Page 276]]
the direction and guidance of such persons in the performance of their
work, does not create property by his personal efforts. However, for
purposes of subparagraph (2) of this paragraph, a letter or memorandum,
or property similar to a letter or memorandum, which is prepared by
personnel who are under the administrative control of a taxpayer, such
as a corporate executive, shall be deemed to have been prepared or
produced for him whether or not such letter, memorandum, or similar
property is reviewed by him.
(4) For the application of section 1231 to the sale or exchange of
property to which this paragraph applies, see Sec. 1.1231-1. For the
application of section 170 to the charitable contribution of property to
which this paragraph applies, see section 170(e) and the regulations
thereunder.
(d) Section 1221(4) excludes from the definition of capital asset
accounts or notes receivable acquired in the ordinary course of trade or
business for services rendered or from the sale of stock in trade or
inventory or property held for sale to customers in the ordinary course
of trade or business. Thus, if a taxpayer acquires a note receivable for
services rendered, reports the fair market value of the note as income,
and later sells the note for less than the amount previously reported,
the loss is an ordinary loss. On the other hand, if the taxpayer later
sells the note for more than the amount originally reported, the excess
is treated as ordinary income.
(e) Obligations of the United States or any of its possessions, or
of a State or Territory, or any political subdivision thereof, or of the
District of Columbia, issued on or after March 1, 1941, on a discount
basis and payable without interest at a fixed maturity date not
exceeding one year from the date of issue, are excluded from the term
capital assets. An obligation may be issued on a discount basis even
though the price paid exceeds the face amount. Thus, although the Second
Liberty Bond Act (31 U.S.C. 754) provides that United States Treasury
bills shall be issued on a discount basis, the issuing price paid for a
particular bill may, by reason of competitive bidding, actually exceed
the face amount of the bill. Since the obligations of the type described
in this paragraph are excluded from the term capital assets, gains or
losses from the sale or exchange of such obligations are not subject to
the limitations provided in such subchapter P. It is, therefore, not
necessary for a taxpayer (other than a life insurance company taxable
under part I (section 801 and following), subchapter L, chapter 1 of the
Code, as amended by the Life Insurance Company Tax Act of 1955 (70 Stat.
36), and, in the case of taxable years beginning before January 1, 1955,
subject to taxation only on interest, dividends, and rents) to segregate
the original discount accrued and the gain or loss realized upon the
sale or other disposition of any such obligation. See section 454(b)
with respect to the original discount accrued. The provisions of this
paragraph may be illustrated by the following examples:
Example 1. A (not a life insurance company) buys a $100,000, 90-day
Treasury bill upon issuance for $99,998. As of the close of the forty-
fifth day of the life of such bill, he sells it to B (not a life
insurance company) for $99,999.50. The entire net gain to A of $1.50 may
be taken into account as a single item of income, without allocating $1
to interest and $0.50 to gain. If B holds the bill until maturity his
net gain of $0.50 may similarly be taken into account as a single item
of income, without allocating $1 to interest and $0.50 to loss.
Example 2. The facts in this example are the same as in example (1)
except that the selling price to B is $99,998.50. The net gain to A of
$0.50 may be taken into account without allocating $1 to interest and
$0.50 to loss, and, similarly, if B holds the bill until maturity his
entire net gain of $1.50 may be taken into account as a single item of
income without allocating $1 to interest and $0.50 to gain.
[T.D. 6500, 25 FR 12003, Nov. 26, 1960, as amended by T.D. 7369, 40 FR
29840, July 16, 1975]
Sec. 1.1221-2 Hedging transactions.
(a) Treatment of hedging transactions--(1) In general. This section
governs the treatment of hedging transactions under section 1221(a)(7).
Except as provided in paragraph (g)(2) of this section, the term capital
asset does not include property that is part of a hedging transaction
(as defined in paragraph (b) of this section).
[[Page 277]]
(2) Short sales and options. This section also governs the character
of gain or loss from a short sale or option that is part of a hedging
transaction. Except as provided in paragraph (g)(2) of this section,
gain or loss on a short sale or option that is part of a hedging
transaction (as defined in paragraph (b) of this section) is ordinary
income or loss.
(3) Exclusivity. If a transaction is not a hedging transaction as
defined in paragraph (b) of this section, gain or loss from the
transaction is not made ordinary on the grounds that property involved
in the transaction is a surrogate for a noncapital asset, that the
transaction serves as insurance against a business risk, that the
transaction serves a hedging function, or that the transaction serves a
similar function or purpose.
(4) Coordination with section 988. This section does not apply to
determine the character of gain or loss realized on a section 988
transaction as defined in section 988(c)(1) or realized with respect to
any qualified fund as defined in section 988(c)(1)(E)(iii).
(b) Hedging transaction defined. Section 1221(b)(2)(A) provides that
a hedging transaction is any transaction that a taxpayer enters into in
the normal course of the taxpayer's trade or business primarily--
(1) To manage risk of price changes or currency fluctuations with
respect to ordinary property (as defined in paragraph (c)(2) of this
section) that is held or to be held by the taxpayer;
(2) To manage risk of interest rate or price changes or currency
fluctuations with respect to borrowings made or to be made, or ordinary
obligations incurred or to be incurred, by the taxpayer; or
(3) To manage such other risks as the Secretary may prescribe in
regulations (see paragraph (d)(6) of this section).
(c) General rules--(1) Normal course. Solely for purposes of
paragraph (b) of this section, if a transaction is entered into in
furtherance of a taxpayer's trade or business, the transaction is
entered into in the normal course of the taxpayer's trade or business.
This rule includes managing risks relating to the expansion of an
existing business or the acquisition of a new trade or business.
(2) Ordinary property and obligations. Property is ordinary property
to a taxpayer only if a sale or exchange of the property by the taxpayer
could not produce capital gain or loss under any circumstances. Thus,
for example, property used in a trade or business within the meaning of
section 1231(b) (determined without regard to the holding period
specified in that section) is not ordinary property. An obligation is an
ordinary obligation if performance or termination of the obligation by
the taxpayer could not produce capital gain or loss. For purposes of
this paragraph (c)(2), the term termination has the same meaning as it
does in section 1234A.
(3) Hedging an aggregate risk. The term hedging transaction includes
a transaction that manages an aggregate risk of interest rate changes,
price changes, and/or currency fluctuations only if all of the risk, or
all but a de minimis amount of the risk, is with respect to ordinary
property, ordinary obligations, or borrowings.
(4) Managing risk--(i) In general. Whether a transaction manages a
taxpayer's risk is determined based on all of the facts and
circumstances surrounding the taxpayer's business and the transaction.
Whether a transaction manages a taxpayer's risk may be determined on a
business unit by business unit basis (for example by treating particular
groups of activities, including the assets and liabilities attributable
to those activities, as separate business units), provided that the
business unit is within a single entity or consolidated return group
that adopts the single-entity approach. A taxpayer's hedging strategies
and policies as reflected in the taxpayer's minutes or other records are
evidence of whether particular transactions were entered into primarily
to manage the taxpayer's risk.
(ii) Limitation of risk management transactions to those
specifically described. Except as otherwise determined by published
guidance or by private letter ruling, a transaction that is not treated
as a hedging transaction under paragraph (d) does not manage risk.
Moreover, a transaction undertaken for speculative purposes will not be
treated as a hedging transaction.
[[Page 278]]
(d) Transactions that manage risk--(1) Risk reduction transactions--
(i) In general. A transaction that is entered into to reduce a
taxpayer's risk, manages a taxpayer's risk.
(ii) Micro and macro hedges--(A) In general. A taxpayer generally
has risk of a particular type only if it is at risk when all of its
operations are considered. Nonetheless, a hedge of a particular asset or
liability generally will be respected as reducing risk if it reduces the
risk attributable to the asset or liability and if it is reasonably
expected to reduce the overall risk of the taxpayer's operations. If a
taxpayer hedges particular assets or liabilities, or groups of assets or
liabilities, and the hedges are undertaken as part of a program that, as
a whole, is reasonably expected to reduce the overall risk of the
taxpayer's operations, the taxpayer generally does not have to
demonstrate that each hedge that was entered into pursuant to the
program reduces its overall risk.
(B) Example. The following example illustrates the rules stated in
paragraph (d)(1)(ii)(A) of this section:
Example. Corporation X manages its business operations by treating
particular groups of activities, including the assets and liabilities
attributable to those assets, as separate business units. A separate set
of books and records is maintained with respect to the activities,
assets and liabilities of separate business unit y. As part of a risk
management program that Corporation X reasonably expects to reduce the
overall risks of its business operations, Corporation X enters into
hedges to reduce the risks of separate business unit y. Corporation X
may demonstrate that the hedges reduce risk by taking into account only
the activities, assets and liabilities of business unit y.
(iii) Written options. A written option may reduce risk. For
example, in appropriate circumstances, a written call option with
respect to assets held by a taxpayer or a written put option with
respect to assets to be acquired by a taxpayer may be a hedging
transaction. See also paragraph (d)(3) of this section.
(iv) Fixed-to-floating price hedges. Under the principles of
paragraph (d)(1)(ii)(A) of this section, a transaction that economically
converts a price from a fixed price to a floating price may reduce risk.
For example, a taxpayer with a fixed cost for its inventory may be at
risk if the price at which the inventory can be sold varies with a
particular factor. Thus, for such a taxpayer a transaction that converts
its fixed price to a floating price may be a hedging transaction.
(2) Interest rate conversions. A transaction that economically
converts an interest rate from a fixed rate to a floating rate or that
converts an interest rate from a floating rate to a fixed rate manages
risk.
(3) Transactions that counteract hedging transactions. If a
transaction is entered into primarily to offset all or any part of the
risk management effected by one or more hedging transactions, the
transaction is a hedging transaction. For example, if a written option
is used to reduce or eliminate the risk reduction obtained from another
position such as a purchased option, then it may be a hedging
transaction.
(4) Recycling. A taxpayer may enter into a hedging transaction by
using a position that was a hedge of one asset or liability as a hedge
of another asset or liability (recycling).
(5) Transactions not entered into primarily to manage risk--(i)
Rule. Except as otherwise determined in published guidance or private
letter ruling, the purchase or sale of a debt instrument, an equity
security, or an annuity contract is not a hedging transaction even if
the transaction limits or reduces the taxpayer's risk with respect to
ordinary property, borrowings, or ordinary obligations. In addition, the
Commissioner may determine in published guidance that other transactions
are not hedging transactions.
(ii) Examples. The following examples illustrate the rule stated in
paragraph (d)(5)(i) of this section:
Example 1. Taxpayer borrows money and agrees to pay a floating rate
of interest. Taxpayer purchases debt instruments that bear a comparable
floating rate. Although taxpayer's interest rate risk from the floating
rate borrowing may be reduced by the purchase of the debt instruments,
the acquisition of the debt instruments is not a hedging transaction,
because the transaction is not entered into primarily to manage the
taxpayer's risk.
Example 2. Taxpayer undertakes obligations to pay compensation in
the future. The
[[Page 279]]
amount of the future compensation payments is adjusted as if amounts
were invested in a specified mutual fund and were increased or decreased
by the earnings, gains and losses that would result from such an
investment. Taxpayer invests funds in the shares of the mutual fund.
Although the investment in shares of the mutual fund reduces the
taxpayer's risk of fluctuation in the amount of its obligation to
employees, the investment was not made primarily to manage the
taxpayer's risk. Accordingly, the transaction is not a hedging
transaction.
Example 3. Taxpayer provides a nonqualified retirement plan for
employees that is structured like a defined contribution plan. Based on
a schedule that takes into account an employee's monthly salary and
years of service with the taxpayer, the taxpayer makes monthly credits
to an account for each employee. Each employee may designate that the
account will be treated as if it were used to pay premiums on a variable
annuity contract issued by the M insurance company with a value that
reflects a specified investment option. M offers a number of investment
options for its variable annuity contracts. Taxpayer invests funds in M
company variable annuity contracts that parallel the investment options
selected by the employees. The investment is not made primarily to
manage the taxpayer's risk and is not a hedging transaction.
(6) Hedges of other risks. The Commissioner may, by published
guidance, determine that hedging transactions include transactions
entered into to manage risks other than interest rate or price changes,
or currency fluctuations.
(7) Miscellaneous provision--(i) Extent of risk management. A
taxpayer may hedge all or any portion of its risk for all or any part of
the period during which it is exposed to the risk.
(ii) Number of transactions. The fact that a taxpayer frequently
enters into and terminates positions (even if done on a daily or more
frequent basis) is not relevant to whether these transactions are
hedging transactions. Thus, for example, a taxpayer hedging the risk
associated with an asset or liability may frequently establish and
terminate positions that hedge that risk, depending on the extent the
taxpayer wishes to be hedged. Similarly, if a taxpayer maintains its
level of risk exposure by entering into and terminating a large number
of transactions in a single day, its transactions may nonetheless
qualify as hedging transactions.
(e) Hedging by members of a consolidated group--(1) General rule:
single-entity approach. For purposes of this section, the risk of one
member of a consolidated group is treated as the risk of the other
members as if all of the members of the group were divisions of a single
corporation. For example, if any member of a consolidated group hedges
the risk of another member of the group by entering into a transaction
with a third party, that transaction may potentially qualify as a
hedging transaction. Conversely, intercompany transactions are not
hedging transactions because, when considered as transactions between
divisions of a single corporation, they do not manage the risk of that
single corporation.
(2) Separate-entity election. In lieu of the single-entity approach
specified in paragraph (e)(1) of this section, a consolidated group may
elect separate-entity treatment of its hedging transactions. If a group
makes this separate-entity election, the following rules apply:
(i) Risk of one member not risk of other members. Notwithstanding
paragraph (e)(1) of this section, the risk of one member is not treated
as the risk of other members.
(ii) Intercompany transactions. An intercompany transaction is a
hedging transaction (an intercompany hedging transaction) with respect
to a member of a consolidated group if and only if it meets the
following requirements--
(A) The position of the member in the intercompany transaction would
qualify as a hedging transaction with respect to the member (taking into
account paragraph (e)(2)(i) of this section) if the member had entered
into the transaction with an unrelated party; and
(B) The position of the other member (the marking member) in the
transaction is marked to market under the marking member's method of
accounting.
(iii) Treatment of intercompany hedging transactions. An
intercompany hedging transaction (that is, a transaction that meets the
requirements of paragraphs (e)(2)(ii)(A) and (B) of this section) is
subject to the following rules--
(A) The character and timing rules of Sec. 1.1502-13 do not apply
to the income,
[[Page 280]]
deduction, gain, or loss from the intercompany hedging transaction; and
(B) Except as provided in paragraph (g)(3) of this section, the
character of the marking member's gain or loss from the transaction is
ordinary.
(iv) Making and revoking the election. Unless the Commissioner
otherwise prescribes, the election described in paragraph (e)(2) of this
section must be made in a separate statement that provides, ``[INSERT
NAME AND EMPLOYER IDENTIFICATION NUMBER OF COMMON PARENT] HEREBY ELECTS
THE APPLICATION OF Sec. 1.1221-2(e)(2) (THE SEPARATE-ENTITY
APPROACH).'' The statement must also indicate the date as of which the
election is to be effective. The election must be filed by including the
statement on or with the consolidated group's income tax return for the
taxable year that includes the first date for which the election is to
apply. The election applies to all transactions entered into on or after
the date so indicated. The election may only be revoked with the consent
of the Commissioner.
(3) Definitions. For definitions of consolidated group, divisions of
a single corporation, group, intercompany transactions, and member, see
section 1502 and the regulations thereunder.
(4) Examples. General Facts. In these examples, O and H are members
of the same consolidated group. O's business operations give rise to
interest rate risk ``A,'' which O wishes to hedge. O enters into an
intercompany transaction with H that transfers the risk to H. O's
position in the intercompany transaction is ``B,'' and H's position in
the transaction is ``C.'' H enters into position ``D'' with a third
party to reduce the interest rate risk it has with respect to its
position C. D would be a hedging transaction with respect to risk A if
O's risk A were H's risk. The following examples illustrate this
paragraph (e):
Example 1. Single-entity treatment. (i) General rule. Under
paragraph (e)(1) of this section, O's risk A is treated as H's risk, and
therefore D is a hedging transaction with respect to risk A. Thus, the
character of D is determined under the rules of this section, and the
income, deduction, gain, or loss from D must be accounted for under a
method of accounting that satisfies Sec. 1.446-4. The intercompany
transaction B-C is not a hedging transaction and is taken into account
under Sec. 1.1502-13.
(ii) Identification. D must be identified as a hedging transaction
under paragraph (f)(1) of this section, and A must be identified as the
hedged item under paragraph (f)(2) of this section. Under paragraph
(f)(5) of this section, the identification of A as the hedged item can
be accomplished by identifying the positions in the intercompany
transaction as hedges or hedged items, as appropriate. Thus,
substantially contemporaneous with entering into D, H may identify C as
the hedged item and O may identify B as a hedge and A as the hedged
item.
Example 2. Separate-entity election; counterparty that does not mark
to market. In addition to the General Facts stated above, assume that
the group makes a separate-entity election under paragraph (e)(2) of
this section. If H does not mark C to market under its method of
accounting, then B is not a hedging transaction, and the B-C
intercompany transaction is taken into account under the rules of
section 1502. D is not a hedging transaction with respect to A, but D
may be a hedging transaction with respect to C if C is ordinary property
or an ordinary obligation and if the other requirements of paragraph (b)
of this section are met. If D is not part of a hedging transaction, then
D may be part of a straddle for purposes of section 1092.
[GRAPHIC] [TIFF OMITTED] TR20MR02.002
[[Page 281]]
Example 3. Separate-entity election; counterparty that marks to
market. The facts are the same as in Example 2 above, except that H
marks C to market under its method of accounting. Also assume that B
would be a hedging transaction with respect to risk A if O had entered
into that transaction with an unrelated party. Thus, for O, the B-C
transaction is an intercompany hedging transaction with respect to O's
risk A, the character and timing rules of Sec. 1.1502-13 do not apply
to the B-C transaction, and H's income, deduction, gain, or loss from C
is ordinary. However, other attributes of the items from the B-C
transaction are determined under Sec. 1.1502-13. D is a hedging
transaction with respect to C if it meets the requirements of paragraph
(b) of this section.
(f) Identification and recordkeeping--(1) Same-day identification of
hedging transactions. Under section 1221(a)(7), a taxpayer that enters
into a hedging transaction (including recycling an existing hedging
transaction) must clearly identify it as a hedging transaction before
the close of the day on which the taxpayer acquired, originated, or
entered into the transaction (or recycled the existing hedging
transaction).
(2) Substantially contemporaneous identification of hedged item--(i)
Content of the identification. A taxpayer that enters into a hedging
transaction must identify the item, items, or aggregate risk being
hedged. Identification of an item being hedged generally involves
identifying a transaction that creates risk, and the type of risk that
the transaction creates. For example, if a taxpayer is hedging the price
risk with respect to its June purchases of corn inventory, the
transaction being hedged is the June purchase of corn and the risk is
price movements in the market where the taxpayer buys its corn. For
additional rules concerning the content of this identification, see
paragraph (f)(3) of this section.
(ii) Timing of the identification. The identification required by
this paragraph (f)(2) must be made substantially contemporaneously with
entering into the hedging transaction. An identification is not
substantially contemporaneous if it is made more than 35 days after
entering into the hedging transaction.
(3) Identification requirements for certain hedging transactions. In
the case of the hedging transactions described in this paragraph (f)(3),
the identification under paragraph (f)(2) of this section must include
the information specified.
(i) Anticipatory asset hedges. If the hedging transaction relates to
the anticipated acquisition of assets by the taxpayer, the
identification must include the expected date or dates of acquisition
and the amounts expected to be acquired.
(ii) Inventory hedges. If the hedging transaction relates to the
purchase or sale of inventory by the taxpayer, the identification is
made by specifying the type or class of inventory to which the
transaction relates. If the hedging transaction relates to specific
purchases or sales, the identification must also include the expected
dates of the purchases or sales and the amounts to be purchased or sold.
(iii) Hedges of debt of the taxpayer--(A) Existing debt. If the
hedging transaction relates to accruals or payments under an issue of
existing debt of the taxpayer, the identification must specify the issue
and, if the hedge is for less than the full issue price or the full term
of the debt, the amount of the issue price and the term covered by the
hedge.
(B) Debt to be issued. If the hedging transaction relates to the
expected issuance of debt by the taxpayer or to accruals or payments
under debt that is expected to be issued by the taxpayer, the
identification must specify the following information: the expected date
of issuance of the debt; the expected maturity or maturities; the total
expected issue price; and the expected interest provisions. If the hedge
is for less than the entire expected issue price of the debt or the full
expected term of the debt, the identification must also include the
amount or the term being hedged. The identification may indicate a range
of dates, terms, and amounts, rather than specific dates, terms, or
amounts. For example, a taxpayer might identify a transaction as hedging
the yield on an anticipated issuance of fixed rate debt during the
second half of its fiscal year, with the anticipated amount of the debt
between $75 million and $125 million, and an anticipated term of
approximately 20 to 30 years.
(iv) Hedges of aggregate risk--(A) Required identification. If a
transaction
[[Page 282]]
hedges aggregate risk as described in paragraph (c)(3) of this section,
the identification under paragraph (f)(2) of this section must include a
description of the risk being hedged and of the hedging program under
which the hedging transaction was entered. This requirement may be met
by placing in the taxpayer's records a description of the hedging
program and by establishing a system under which individual transactions
can be identified as being entered into pursuant to the program.
(B) Description of hedging program. A description of a hedging
program must include an identification of the type of risk being hedged,
a description of the type of items giving rise to the risk being
aggregated, and sufficient additional information to demonstrate that
the program is designed to reduce aggregate risk of the type identified.
If the program contains controls on speculation (for example, position
limits), the description of the hedging program must also explain how
the controls are established, communicated, and implemented.
(v) Transactions that counteract hedging transactions. If the
hedging transaction is described in paragraph (d)(3) of this section,
the description of the hedging transaction must include an
identification of the risk management transaction that is being offset
and the original underlying hedged item.
(4) Manner of identification and records to be retained--(i)
Inclusion of identification in tax records. The identification required
by this paragraph (f) must be made on, and retained as part of, the
taxpayer's books and records.
(ii) Presence of identification must be unambiguous. The presence of
an identification for purposes of this paragraph (f) must be
unambiguous. The identification of a hedging transaction for financial
accounting or regulatory purposes does not satisfy this requirement
unless the taxpayer's books and records indicate that the identification
is also being made for tax purposes. The taxpayer may indicate that
individual hedging transactions, or a class or classes of hedging
transactions, that are identified for financial accounting or regulatory
purposes are also being identified as hedging transactions for purposes
of this section.
(iii) Manner of identification. The taxpayer may separately and
explicitly make each identification, or, so long as paragraph (f)(4)(ii)
of this section is satisfied, the taxpayer may establish a system
pursuant to which the identification is indicated by the type of
transaction or by the manner in which the transaction is consummated or
recorded. An identification under this system is made at the later of
the time that the system is established or the time that the transaction
satisfies the terms of the system by being entered, or by being
consummated or recorded, in the designated fashion.
(iv) Principles of paragraph (f)(4)(iii) of this section
illustrated. Paragraphs (f)(4)(iv)(A) through (C) of this section
illustrate the principles of paragraph (f)(4)(iii) of this section and
assume that the other requirements of this paragraph (f) are satisfied.
(A) A taxpayer can make an identification by designating a hedging
transaction for (or placing it in) an account that has been identified
as containing only hedges of a specified item (or of specified items or
specified aggregate risk).
(B) A taxpayer can make an identification by including and retaining
in its books and records a statement that designates all future
transactions in a specified derivative product as hedges of a specified
item, items, or aggregate risk.
(C) A taxpayer can make an identification by designating a certain
mark, a certain form, or a certain legend as meaning that a transaction
is a hedge of a specified item (or of specified items or a specified
aggregate risk). Identification can be made by placing the designated
mark on a record of the transaction (for example, trading ticket,
purchase order, or trade confirmation) or by using the designated form
or a record that contains the designated legend.
(5) Identification of hedges involving members of the same
consolidated group--(i) General rule: single-entity approach. A member
of a consolidated group must satisfy the requirements of this paragraph
(f) as if all of the members of the
[[Page 283]]
group were divisions of a single corporation. Thus, the member entering
into the hedging transaction with a third party must identify the
hedging transaction under paragraph (f)(1) of this section. Under
paragraph (f)(2) of this section, that member must also identify the
item, items, or aggregate risk that is being hedged, even if the item,
items, or aggregate risk relates primarily or entirely to other members
of the group. If the members of a group use intercompany transactions to
transfer risk within the group, the requirements of paragraph (f)(2) of
this section may be met by identifying the intercompany transactions,
and the risks hedged by the intercompany transactions, as hedges or
hedged items, as appropriate. Because identification of the intercompany
transaction as a hedge serves solely to identify the hedged item, the
identification is timely if made within the period required by paragraph
(f)(2) of this section. For example, if a member transfers risk in an
intercompany transaction, it may identify under the rules of this
paragraph (f) both its position in that transaction and the item, items,
or aggregate risk being hedged. The member that hedges the risk outside
the group may identify under the rules of this paragraph (f) both its
position with the third party and its position in the intercompany
transaction. Paragraph (e)(4) Example 1 of this section illustrates this
identification.
(ii) Rule for consolidated groups making the separate-entity
election. If a consolidated group makes the separate-entity election
under paragraph (e)(2) of this section, each member of the group must
satisfy the requirements of this paragraph (f) as though it were not a
member of a consolidated group.
(6) Consistency with section 1256(e)(2). Any identification for
purposes of section 1256(e)(2) is also an identification for purposes of
paragraph (f)(1) of this section.
(g) Effect of identification and non-identification--(1)
Transactions identified--(i) In general. If a taxpayer identifies a
transaction as a hedging transaction for purposes of paragraph (f)(1) of
this section, the identification is binding with respect to gain,
whether or not all of the requirements of paragraph (f) of this section
are satisfied. Thus, gain from that transaction is ordinary income. If
the transaction is not in fact a hedging transaction described in
paragraph (b) of this section, however, paragraphs (a)(1) and (2) of
this section do not apply and the character of loss is determined
without reference to whether the transaction is a surrogate for a
noncapital asset, serves as insurance against a business risk, serves a
hedging function, or serves a similar function or purpose. Thus, the
taxpayer's identification of the transaction as a hedging transaction
does not itself make loss from the transaction ordinary.
(ii) Inadvertent identification. Notwithstanding paragraph (g)(1)(i)
of this section, if the taxpayer identifies a transaction as a hedging
transaction for purposes of paragraph (f) of this section, the character
of the gain is determined as if the transaction had not been identified
as a hedging transaction if--
(A) The transaction is not a hedging transaction (as defined in
paragraph (b) of this section);
(B) The identification of the transaction as a hedging transaction
was due to inadvertent error; and
(C) All of the taxpayer's transactions in all open years are being
treated on either original or, if necessary, amended returns in a manner
consistent with the principles of this section.
(2) Transactions not identified--(i) In general. Except as provided
in paragraphs (g)(2)(ii) and (iii) of this section, the absence of an
identification that satisfies the requirements of paragraph (f)(1) of
this section is binding and establishes that a transaction is not a
hedging transaction. Thus, subject to the exceptions, the rules of
paragraphs (a)(1) and (2) of this section do not apply, and the
character of gain or loss is determined without reference to whether the
transaction is a surrogate for a noncapital asset, serves as insurance
against a business risk, serves a hedging function, or serves a similar
function or purpose.
(ii) Inadvertent error. If a taxpayer does not make an
identification that satisfies the requirements of paragraph (f) of this
section, the taxpayer may treat gain or loss from the transaction
[[Page 284]]
as ordinary income or loss under paragraph (a)(1) or (2) of this section
if--
(A) The transaction is a hedging transaction (as defined in
paragraph (b) of this section);
(B) The failure to identify the transaction was due to inadvertent
error; and
(C) All of the taxpayer's hedging transactions in all open years are
being treated on either original or, if necessary, amended returns as
provided in paragraphs (a)(1) and (2) of this section.
(iii) Anti-abuse rule. If a taxpayer does not make an identification
that satisfies all the requirements of paragraph (f) of this section but
the taxpayer has no reasonable grounds for treating the transaction as
other than a hedging transaction, then gain from the transaction is
ordinary. The reasonableness of the taxpayer's failure to identify a
transaction is determined by taking into consideration not only the
requirements of paragraph (b) of this section but also the taxpayer's
treatment of the transaction for financial accounting or other purposes
and the taxpayer's identification of similar transactions as hedging
transactions.
(3) Transactions by members of a consolidated group--(i) Single-
entity approach. If a consolidated group is under the general rule of
paragraph (e)(1) of this section (the single-entity approach), the rules
of this paragraph (g) apply only to transactions that are not
intercompany transactions.
(ii) Separate-entity election. If a consolidated group has made the
election under paragraph (e)(2) of this section, then, in addition to
the rules of paragraphs (g)(1) and (2) of this section, the following
rules apply:
(A) If an intercompany transaction is identified as a hedging
transaction but does not meet the requirements of paragraphs
(e)(2)(ii)(A) and (B) of this section, then, notwithstanding any
contrary provision in Sec. 1.1502-13, each party to the transaction is
subject to the rules of paragraph (g)(1) of this section with respect to
the transaction as though it had incorrectly identified its position in
the transaction as a hedging transaction.
(B) If a transaction meets the requirements of paragraphs (e)(2)(ii)
(A) and (B) of this section but the transaction is not identified as a
hedging transaction, each party to the transaction is subject to the
rules of paragraph (g)(2) of this section. (Because the transaction is
an intercompany hedging transaction, the character and timing rules of
Sec. 1.1502-13 do not apply. See paragraph (e)(2)(iii)(A) of this
section.)
(h) Effective date. The rules of this section apply to transactions
entered into on or after March 20, 2002.
(i) [Reserved]. For further guidance, see Sec. 1.1221-2T(i) through
(j)(1).
(j) Effective/applicability date. Paragraph (e)(2)(iv) of this
section applies to any original consolidated Federal income tax return
due (without extensions) after June 14, 2007. For original consolidated
Federal income tax returns due (without extensions) after May 30, 2006,
and on or before June 14, 2007, see Sec. 1.1221-2T as contained in 26
CFR part 1 in effect on April 1, 2007. For original consolidated Federal
income tax returns due (without extensions) on or before May 30, 2006,
see Sec. 1.1221-2 as contained in 26 CFR part 1 in effect on April 1,
2006.
[T.D. 8985, 67 FR 12865, Mar. 20, 2002, as amended by T.D. 9264, 71 FR
30602, May 30, 2006; T.D. 9329, 72 FR 32804, June 14, 2007]
Sec. 1.1221-3 Time and manner for electing capital asset treatment
for certain self-created musical works.
(a) Description. Section 1221(b)(3) allows an electing taxpayer to
treat the sale or exchange of a musical composition or a copyright in a
musical work created by the taxpayer's personal efforts (or having a
basis determined by reference to the basis of such property in the hands
of a taxpayer whose personal efforts created such property) as the sale
or exchange of a capital asset. As a consequence, gain or loss from the
sale or exchange is treated as capital gain or loss.
(b) Time and manner for making the election. An election described
in this section is made separately for each musical composition (or
copyright in a musical work) sold or exchanged during the taxable year.
An election must be made on or before the due date (including
extensions) of the income tax return for the taxable year of the sale or
exchange. The election is made on
[[Page 285]]
Schedule D, ``Capital Gains and Losses,'' of the appropriate income tax
form (for example, Form 1040, ``U.S. Individual Income Tax Return;''
Form 1065, ``U.S. Return of Partnership Income;'' Form 1120, ``U.S.
Corporation Income Tax Return'') by treating the sale or exchange as the
sale or exchange of a capital asset, in accordance with the form and its
instructions.
(c) Revocability of election. The election described in this section
is revocable with the consent of the Commissioner. To seek consent to
revoke the election, a taxpayer must submit a request for a letter
ruling under the applicable administrative procedures. Alternatively, an
automatic extension of 6 months from the due date of the taxpayer's
income tax return (excluding extensions) is granted to revoke the
election, provided the taxpayer timely filed the taxpayer's income tax
return and, within this 6-month extension period, the taxpayer files an
amended income tax return that treats the sale or exchange as the sale
or exchange of property that is not a capital asset.
(d) Effective/applicability date. This section applies to elections
under section 1221(b)(3) in taxable years beginning after May 17, 2006.
[T.D. 9514, 76 FR 6554, Feb. 7, 2011]
Sec. 1.1222-1 Other terms relating to capital gains and losses.
(a) The phrase short-term applies to the category of gains and
losses arising from the sale or exchange of capital assets held for 1
year (6 months for taxable years beginning before 1977; 9 months for
taxable years beginning in 1977) or less; the phrase long-term to the
category of gains and losses arising from the sale or exchange of
capital assets held for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977).
The fact that some part of a loss from the sale or exchange of a capital
asset may be finally disallowed because of the operation of section 1211
does not mean that such loss is not taken into account in computing
taxable income within the meaning of that phrase as used in sections
1222(2) and 1222(4).
(b)(1) In the definition of net short-term capital gain, as provided
in section 1222(5), the amounts brought forward to the taxable year
under section 1212 (other than section 1212(b)(1)(B)) are short-term
capital losses for such taxable year.
(2) In the definition of net long-term capital gain, as provided in
section 1222(7), the amounts brought forward to the taxable year under
section 1212(b)(1)(B) are long-term capital losses for such taxable
year.
(c) Gains and losses from the sale or exchange of capital assets
held for not more than 1 year (6 months for taxable years beginning
before 1977; 9 months for taxable years beginning in 1977) (described as
short-term capital gains and short-term capital losses) shall be
segregated from gains and losses arising from the sale or exchange of
such assets held for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977)
(described as long-term capital gains and long-term capital losses).
(d)(1) The term capital gain net income (net capital gain for
taxable years beginning before January 1, 1977) means the excess of the
gains from sales or exchanges of capital assets over the losses from
sales or exchanges of capital assets, which losses include any amounts
carried to the taxable year pursuant to section 1212(a) or section
1212(b).
(2) Notwithstanding subparagraph (1) of this paragraph, in the case
of a taxpayer other than a corporation for taxable years beginning
before January 1, 1964, the term net capital gain means the excess of
(i) the sum of the gains from sales or exchanges of capital assets, plus
the taxable income (computed without regard to gains and losses from
sales or exchanges of capital assets and without regard to the
deductions provided by section 151, relating to personal exemptions, or
any deductions in lieu thereof) of the taxpayer or $1,000, whichever is
smaller, over (ii) the losses from sales or exchanges of capital assets,
which losses include amounts carried to the taxable year by such
taxpayer under paragraph (a)(1) of Sec. 1.1212-1. Thus, in the case of
estates and trusts for taxable years beginning before January 1, 1964,
taxable
[[Page 286]]
income for the purposes of this paragraph shall be computed without
regard to gains and losses from sales or exchanges of capital assets and
without regard to the deductions allowed by section 642(b) to estates
and trusts in lieu of personal exemptions. The term net capital gain is
not applicable in the case of a taxpayer other than a corporation for
taxable years beginning after December 31, 1963, and before January 1,
1970. In the case of a taxpayer whose tax liability is computed under
section 3 for taxable years beginning before January 1, 1964, the term
taxable income, for purposes of this paragraph, shall be read as
adjusted gross income.
(e) The term net capital loss means the excess of the losses from
sales or exchanges of capital assets over the sum allowed under section
1211. However, in the case of a corporation, amounts which are short-
term capital losses under Sec. 1.1212-1(a) are excluded in determining
such net capital loss.
(f) See section 165(g) and section 166(e), under which losses from
worthless stocks, bonds, and other securities (if they constitute
capital assets) are required to be treated as losses under subchapter P
(section 1201 and following), chapter 1 of the Code, from the sale or
exchange of capital assets, even though such securities are not actually
sold or exchanged. See also section 1231 and Sec. 1.1231-1 for the
determination of whether or not gains and losses from the involuntary
conversion of capital assets and from the sale, exchange, or involuntary
conversion of certain property used in the trade or business shall be
treated as gains and losses from the sale or exchange of capital assets.
See also section 1236 and Sec. 1.1236-1 for the determination of
whether or not gains from the sale or exchange of securities by a dealer
in securities shall be treated as capital gains, or whether losses from
such sales or exchanges shall be treated as ordinary losses.
(g) In the case of nonresident alien individuals not engaged in
trade or business within the United States, see section 871 and the
regulations thereunder for the determination of the net amount of
capital gains subject to tax.
(h) The term net capital gain (net section 1201 gain for taxable
years beginning before January 1, 1977) means the excess of the net
long-term capital gain for the taxable year over the net short-term
capital loss for such year.
[T.D. 6500, 25 FR 12004, Nov. 26, 1960, as amended by T.D. 6828, 30 FR
7808, June 17, 1965; T.D. 6867, 30 FR 15096, Dec. 7, 1965; T.D. 7301, 39
FR 971, Jan. 4, 1974; T.D. 7337, 39 FR 44978, Dec. 30, 1974; T.D. 7728,
45 FR 72650, Nov. 3, 1980]
Sec. 1.1223-1 Determination of period for which capital assets
are held.
(a) The holding period of property received in an exchange by a
taxpayer includes the period for which the property which he exchanged
was held by him, if the property received has the same basis in whole or
in part for determining gain or loss in the hands of the taxpayer as the
property exchanged. However, this rule shall apply, in the case of
exchanges after March 1, 1954, only if the property exchanged was at the
time of the exchange a capital asset in the hands of the taxpayer or
property used in his trade or business as defined in section 1231(b).
For the purposes of this paragraph, the term exchange includes the
following transactions:
(1) An involuntary conversion described in section 1033, and
(2) A distribution to which section 355 (or so much of section 356
as relates to section 355) applies.
Thus, if property acquired as the result of a compulsory or involuntary
conversion of other property of the taxpayer has under section 1033(c)
the same basis in whole or in part in the hands of the taxpayer as the
property so converted, its acquisition is treated as an exchange and the
holding period of the newly acquired property shall include the period
during which the converted property was held by the taxpayer. Thus,
also, where stock of a controlled corporation is received by a taxpayer
pursuant to a distribution to which section 355 (or so much of section
356 as relates to section 355) applies, the distribution is treated as
an exchange and the period for which the taxpayer has held the stock of
the controlled corporation shall include the period for which he held
the stock of the distributing corporation with respect to which such
distribution was made.
[[Page 287]]
(b) The holding period of property in the hands of a taxpayer shall
include the period during which the property was held by any other
person, if such property has the same basis in whole or in part in the
hands of the taxpayer for determining gain or loss from a sale or
exchange as it would have in the hands of such other person. For
example, the period for which property acquired by gift after December
31, 1920, was held by the donor must be included in determining the
period for which the property was held by the taxpayer if, under the
provisions of section 1015, such property has, for the purpose of
determining gain or loss from the sale or exchange, the same basis in
the hands of the taxpayer as it would have in the hands of the donor.
Similarly, the period for which property acquired from a decedent who
died in 2010 was held by the decedent must be included in determining
the period during which the property was held by the recipient, if the
recipient's basis in the property is determined under section 1022.
(c) In determining the period for which the taxpayer has held stock
or securities received upon a distribution where no gain was recognized
to the distributee under section 1081(c) (or under section 112(g) of the
Revenue Act of 1928 (45 Stat. 818) or the Revenue Act of 1932 (47 Stat.
197)), there shall be included the period for which he held the stock or
securities in the distributing corporation before the receipt of the
stock or securities on such distribution.
(d) If the acquisition of stock or securities resulted in the
nondeductibility (under section 1091, relating to wash sales) of the
loss from the sale or other disposition of substantially identical stock
or securities, the holding period of the newly acquired securities shall
include the period for which the taxpayer held the securities with
respect to which the loss was not allowable.
(e) The period for which the taxpayer has held stock, or stock
subscription rights, received on a distribution shall be determined as
though the stock dividend, or stock right, as the case may be, were the
stock in respect of which the dividend was issued if the basis for
determining gain or loss upon the sale or other disposition of such
stock dividend or stock right is determined under section 307. If the
basis of stock received by a taxpayer pursuant to a spin-off is
determined under so much of section 1052(c) as refers to section
113(a)(23) of the Internal Revenue Code of 1939, and such stock is sold
or otherwise disposed of in a taxable year which is subject to the
Internal Revenue Code of 1954, the period for which the taxpayer has
held the stock received in such spin-off shall include the period for
which he held the stock of the distributing corporation with respect to
which such distribution was made.
(f) The period for which the taxpayer has held stock or securities
issued to him by a corporation pursuant to the exercise by him of rights
to acquire such stock or securities from the corporation will, in every
case and whether or not the receipt of taxable gain was recognized in
connection with the distribution of the rights, begin with and include
the day upon which the rights to acquire such stock or securities were
exercised. A taxpayer will be deemed to have exercised rights received
from a corporation to acquire stock or securities therein where there is
an expression of assent to the terms of such rights made by the taxpayer
in the manner requested or authorized by the corporation.
(g) The period for which the taxpayer has held a residence, the
acquisition of which resulted under the provisions of section 1034 in
the nonrecognition of any part of the gain realized on the sale or
exchange of another residence, shall include the period for which such
other residence had been held as of the date of such sale or exchange.
For purposes of this paragraph, the term sale or exchange includes an
involuntary conversion occurring after December 31, 1950, and before
January 1, 1954.
(h) If a taxpayer accepts delivery of a commodity in satisfaction of
a commodity futures contract, the holding period of the commodity shall
include the period for which the taxpayer held the commodity futures
contract, if such futures contract was a capital asset in his hands.
(i) If shares of stock in a corporation are sold from lots purchased
at different dates or at different prices and
[[Page 288]]
the identity of the lots cannot be determined, the rules prescribed by
the regulations under section 1012 for determining the cost or other
basis of such stocks so sold or transferred shall also apply for the
purpose of determining the holding period of such stock.
(j) In the case of a person acquiring property, or to whom property
passed, from a decedent (within the meaning of section 1014(b)) dying
after December 31, 1970, such person shall be considered to have held
the property for more than 1 year (6 months for taxable years beginning
before 1977; 9 months for taxable years beginning in 1977) if the
property:
(1) Has a basis in the hands of such person which is determined in
whole or in part under section 1014, and
(2) Is sold or otherwise disposed of by such person within 6 months
after the decedent's death.
The provisions of this paragraph apply to sales of such property
included in the decedent's gross estate for the purposes of the estate
tax by the executor or administrator of the estate and to sales of such
property by other persons who have acquired property from the decedent.
The provisions of this paragraph may also be applicable to cases
involving joint tenancies, community property, and properties
transferred in contemplation of death. Thus, if a surviving joint
tenant, who acquired property by right of survivorship, sells or
otherwise disposes of such property within 6 months after the date of
the decedent's death, and the basis of the property in his hands is
determined in whole or in part under section 1014, the property shall be
considered to have been held by the surviving joint tenant for more than
6 months. Similarly, a surviving spouse's share of community property
shall be considered to have been held by her for more than 6 months if
it is sold or otherwise disposed of within 6 months after the date of
the decedent's death, regardless of when the property was actually
acquired by the marital community. For the purposes of this paragraph,
it is immaterial that the sale or other disposition produces gain or
loss. If property is considered to have been held for more than 6 months
by reason of this paragraph, it also is considered to have been held for
that period for purposes of section 1231 (if that section is otherwise
applicable).
(k) Any reference in section 1223 or this section to another
provision of the Internal Revenue Code of 1954 is, where applicable, to
be deemed a reference to the corresponding provision of the Internal
Revenue Code of 1939, or prior internal revenue laws. The provisions of
prior internal revenue laws here intended are the sections referred to
in the sections of the Internal Revenue Code of 1939 which correspond to
the sections of the Internal Revenue Code of 1954 referred to in section
1223. Thus, the sections corresponding to section 1081(c) are section
371(c) of the Revenue Act of 1938 (52 Stat. 553) and section 371(c) of
the Internal Revenue Code of 1939. The sections corresponding to section
1091 are section 118 of each of the following: The Revenue Acts of 1928
(45 Stat. 826), 1932 (47 Stat. 208), 1934 (48 Stat. 715), 1936 (49 Stat.
1692), 1938 (52 Stat. 503), and the Internal Revenue Code of 1939.
(l) Effective/applicability date. This section applies January 19,
2017. For rules before January 19, 2017, see Sec. 1.1223-1 as contained
in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6500, 25 FR 12005, Nov. 26, 1960, as amended by T.D. 7238, 37 FR
28717, Dec. 29, 1972; T.D. 7728, 45 FR 72650, Nov. 3, 1980; T.D. 9811,
82 FR 6241, Jan. 19, 2017; T.D. 9849, 84 FR 9237, Mar. 14, 2019]
Sec. 1.1223-3 Rules relating to the holding periods of partnership
interests.
(a) In general. A partner shall not have a divided holding period in
an interest in a partnership unless--
(1) The partner acquired portions of an interest at different times;
or
(2) The partner acquired portions of the partnership interest in
exchange for property transferred at the same time but resulting in
different holding periods (e.g., section 1223).
(b) Accounting for holding periods of an interest in a partnership--
(1) General rule. The portion of a partnership interest to which a
holding period relates shall be determined by reference to a fraction,
the numerator of which is the fair market value of the portion of the
partnership interest received in the
[[Page 289]]
transaction to which the holding period relates, and the denominator of
which is the fair market value of the entire partnership interest
(determined immediately after the transaction).
(2) Special rule. For purposes of applying paragraph (b)(1) of this
section to determine the holding period of a partnership interest (or
portion thereof) that is sold or exchanged (or with respect to which
gain or loss is recognized upon a distribution under section 731), if a
partner makes one or more contributions of cash to the partnership and
receives one or more distributions of cash from the partnership during
the one-year period ending on the date of the sale or exchange (or
distribution with respect to which gain or loss is recognized under
section 731), the partner may reduce the cash contributions made during
the year by cash distributions received on a last-in-first-out basis,
treating all cash distributions as if they were received immediately
before the sale or exchange (or at the time of the distribution with
respect to which gain or loss is recognized under section 731).
(3) Deemed contributions and distributions. For purposes of
paragraphs (b)(1) and (2) of this section, deemed contributions of cash
under section 752(a) and deemed distributions of cash under section
752(b) shall be disregarded to the same extent that such amounts are
disregarded under Sec. 1.704-1(b)(2)(iv)(c).
(4) Adjustment with respect to contributed section 751 assets. For
purposes of applying paragraph (b)(1) of this section to determine the
holding period of a partnership interest (or portion thereof) that is
sold or exchanged, if a partner receives a portion of the partnership
interest in exchange for property described in section 751(c) or (d)
(section 751 assets) within the one-year period ending on the date of
the sale or exchange of all or a portion of the partner's interest in
the partnership, and the partner recognizes ordinary income or loss on
account of such a section 751 asset in a fully taxable transaction
(either as a result of the sale of all or part of the partner's interest
in the partnership or the sale by the partnership of the section 751
asset), the contribution of the section 751 asset during the one-year
period shall be disregarded. However, if, in the absence of this
paragraph, a partner would not be treated as having held any portion of
the interest for more than one year (e.g., because the partner's only
contributions to the partnership are contributions of section 751 assets
or section 751 assets and cash within the prior one-year period), this
adjustment is not available.
(5) Exception. The Commissioner may prescribe by guidance published
in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this
chapter) a rule disregarding certain cash contributions (including
contributions of a de minimis amount of cash) in applying paragraph
(b)(1) of this section to determine the holding period of a partnership
interest (or portion thereof) that is sold or exchanged.
(c) Sale or exchange of all or a portion of an interest in a
partnership--(1) Sale or exchange of entire interest in a partnership.
If a partner sells or exchanges the partner's entire interest in a
partnership, any capital gain or loss recognized shall be divided
between long-term and short-term capital gain or loss in the same
proportions as the holding period of the interest in the partnership is
divided between the portion of the interest held for more than one year
and the portion of the interest held for one year or less.
(2) Sale or exchange of a portion of an interest in a partnership--
(i) Certain publicly traded partnerships. A selling partner in a
publicly traded partnership (as defined under section 7704(b)) may use
the actual holding period of the portion of a partnership interest
transferred if--
(A) The ownership interest is divided into identifiable units with
ascertainable holding periods;
(B) The selling partner can identify the portion of the partnership
interest transferred; and
(C) The selling partner elects to use the identification method for
all sales or exchanges of interests in the partnership after September
21, 2000. The selling partner makes the election referred to in this
paragraph (c)(2)(i)(C) by using the actual holding period of the portion
of the partner's interest in the partnership first transferred after
September 21, 2000 in reporting the
[[Page 290]]
transaction for Federal income tax purposes.
(ii) Other partnerships. If a partner has a divided holding period
in a partnership interest, and paragraph (c)(2)(i) of this section does
not apply, then the holding period of the transferred interest shall be
divided between long-term and short-term capital gain or loss in the
same proportions as the long-term and short-term capital gain or loss
that the transferor partner would realize if the entire interest in the
partnership were transferred in a fully taxable transaction immediately
before the actual transfer.
(d) Distributions--(1) In general. Except as provided in paragraph
(b)(2) of this section, a partner's holding period in a partnership
interest is not affected by distributions from the partnership.
(2) Character of capital gain or loss recognized as a result of a
distribution from a partnership. If a partner is required to recognize
capital gain or loss as a result of a distribution from a partnership,
then the capital gain or loss recognized shall be divided between long-
term and short-term capital gain or loss in the same proportions as the
long-term and short-term capital gain or loss that the distributee
partner would realize if such partner's entire interest in the
partnership were transferred in a fully taxable transaction immediately
before the distribution.
(e) Section 751(c) assets. For purposes of this section, properties
and potential gain treated as unrealized receivables under section
751(c) shall be treated as separate assets that are not capital assets
as defined in section 1221 or property described in section 1231.
(f) Examples. The provisions of this section are illustrated by the
following examples:
Example 1. Division of holding period--contribution of money and a
capital asset. (i) A contributes $5,000 of cash and a nondepreciable
capital asset A has held for two years to a partnership (PRS) for a 50
percent interest in PRS. A's basis in the capital asset is $5,000, and
the fair market value of the asset is $10,000. After the exchange, A's
basis in A's interest in PRS is $10,000, and the fair market value of
the interest is $15,000. A received one-third of the interest in PRS for
a cash payment of $5,000 ($5,000/$15,000). Therefore, A's holding period
in one-third of the interest received (attributable to the contribution
of money to the partnership) begins on the day after the contribution. A
received two-thirds of the interest in PRS in exchange for the capital
asset ($10,000/$15,000). Accordingly, pursuant to section 1223(1), A has
a two-year holding period in two-thirds of the interest received in PRS.
(ii) Six months later, when A's basis in PRS is $12,000 (due to a
$2,000 allocation of partnership income to A), A sells the interest in
PRS for $17,000. Assuming PRS holds no inventory or unrealized
receivables (as defined under section 751(c)) and no collectibles or
section 1250 property, A will realize $5,000 of capital gain. As
determined above, one-third of A's interest in PRS has a holding period
of one year or less, and two-thirds of A's interest in PRS has a holding
period equal to two years and six months. Therefore, one-third of the
capital gain will be short-term capital gain, and two-thirds of the
capital gain will be long-term capital gain.
Example 2. Division of holding period--contribution of section 751
asset and a capital asset. A contributes inventory with a basis of
$2,000 and a fair market value of $6,000 and a capital asset which A has
held for more than one year with a basis of $4,000 and a fair market
value of $6,000, and B contributes cash of $12,000 to form a partnership
(AB). As a result of the contribution, one-half of A's interest in AB is
treated as having been held for more than one year under section
1223(1). Six months later, A transfers one-half of A's interest in AB to
C for $6,000, realizing a gain of $3,000. If AB were to sell all of its
section 751 property in a fully taxable transaction immediately before
A's transfer of the partnership interest, A would be allocated $4,000 of
ordinary income on account of the inventory. Accordingly, A will
recognize $2,000 of ordinary income and $1,000 of capital gain ($3,000-
$2,000) on account of the transfer to C. Because A recognizes ordinary
income on account of the inventory that was contributed to AB within the
one year period ending on the date of the sale, the inventory will be
disregarded in determining the holding period of A's interest in AB. All
of the capital gain will be long-term.
Example 3. Netting of cash contributions and distributions. (i) On
January 1, 2000, A holds a 50 percent interest in the capital and
profits of a partnership (PS). The value of A's PS interest is $900, and
A's holding period in the entire interest is long-term. On January 2,
2000, when the value of A's PS interest is still $900, A contributes
$100 to PS. On June 1, 2000, A receives a distribution of $40 cash from
the partnership. On September 1, 2000, when the value of A's interest in
PS is $1,350, A contributes an additional $230 cash to PS, and on
October 1, 2000, A receives another $40 cash distribution from PS. A
sells A's entire partnership interest on November 1, 2000, for $1,600.
A's adjusted basis in the PS interest at the time of the sale is $1,000.
[[Page 291]]
(ii) For purposes of netting cash contributions and distributions in
determining the holding period of A's interest in PS, A is treated as
having received a distribution of $80 on November 1, 2000. Applying that
distribution on a last-in-first-out basis to reduce prior contributions
during the year, the contribution made on September 1, 2000, is reduced
to $150 ($230-$80). The holding period then is determined as follows:
Immediately after the contribution of $100 on January 2, 2000, A's
holding period in A's PS interest is 90 percent long-term ($900/($900 +
$100)) and 10 percent short-term ($100/($900 + $100)). The contribution
of $150 on September 1, 2000, causes 10 percent of A's partnership
interest ($150/($1,350 + $150)) to have a short-term holding period.
Accordingly, immediately after the contribution on September 1, 2000,
A's holding period in A's PS interest is 81 percent long-term (.90 x
.90) and 19 percent short-term ((.10 x .90) + .10). Accordingly, $486
($600 x .81) of the gain from A's sale of the PS interest is long-term
capital gain, and $114 ($600 x .19) is short-term capital gain.
Example 4. Division of holding period when capital account is
increased by contribution. A, B, C, and D are equal partners in a
partnership (PRS), and the fair market value of a 25 percent interest in
PRS is $100. A, B, C, and D each contribute an additional $100 to
partnership capital, thereby increasing the fair market value of each
partner's interest to $200. As a result of the contribution, each
partner has a new holding period in the portion of the partner's
interest in PRS that is attributable to the contribution. That portion
equals 50 percent ($100/$200) of each partner's interest in PRS.
Example 5. Sale or exchange of a portion of an interest in a
partnership. (i) A, B, and C form an equal partnership (PRS). In
connection with the formation, A contributes $5,000 in cash and a
capital asset (capital asset 1) with a fair market value of $5,000 and a
basis of $2,000; B contributes $7,000 in cash and a capital asset
(capital asset 2) with a fair market value of $3,000 and a basis of
$3,000; and C contributes $10,000 in cash. At the time of the
contribution, A had held the contributed property for two years. Six
months later, when A's basis in PRS is $7,000, A transfers one-half of
A's interest in PRS to T for $7,000 at a time when PRS's balance sheet
(reflecting a cash receipts and disbursements method of accounting) is
as follows:
------------------------------------------------------------------------
ASSETS
-------------------
Adjusted Market
basis value
------------------------------------------------------------------------
Cash................................................ $22,000 $22,000
Unrealized Receivables.............................. 0 6,000
Capital Asset 1................................... 2,000 5,000
Capital Asset 2................................... 3,000 9,000
Capital Assets...................................... 5,000 14,000
-------------------
Total........................................... 27,000 42,000
------------------------------------------------------------------------
(ii) Although at the time of the transfer A has not held A's
interest in PRS for more than one year, 50 percent of the fair market
value of A's interest in PRS was received in exchange for a capital
asset with a long-term holding period. Therefore, 50 percent of A's
interest in PRS has a long-term holding period.
(iii) If PRS were to sell all of its section 751 property in a fully
taxable transaction immediately before A's transfer of the partnership
interest, A would be allocated $2,000 of ordinary income. One-half of
that amount ($1,000) is attributable to the portion of A's interest in
PRS transferred to T. Accordingly, A will recognize $1,000 oridnary
income and $2,500 ($3,500-$1,000) of capital gain on account of the
transfer to T of one-half of A's interest in PRS. Fifty percent ($1,250)
of that gain is long-term capital gain and 50 percent ($1,250) is short-
term capital gain.
Example 6. Sale of units of interests in a partnership. A publicly
traded partnership (PRS) has ownership interests that are segregated
into identifiable units of interest. A owns 10 limited partnership units
in PRS for which A paid $10,000 on January 1, 1999. On August 1, 2000, A
purchases five additional units for $10,000. At the time of purchase,
the fair market value of each unit has increased to $2,000. A's holding
period for one-third ($10,000/$30,000) of the interest in PRS begins on
the day after the purchase of the five additional units. Less than one
year later, A sells five units of ownership in PRS for $11,000. At the
time, A's basis in the 15 units of PRS is $20,000, and A's capital gain
on the sale of 5 units is $4,333 (amount realized of $11,000-one-third
of the adjusted basis or $6,667). For purposes of determining the
holding period, A can designate the specific units of PRS sold. If A
properly identifies the five units sold as five of the ten units for
which A has a long-term holding period and elects to use the
identification method for all subsequent sales or exchanges of interests
in the partnership by using the actual holding period in reporting the
transaction on A's Federal income tax return, the capital gain realized
will be long-term capital gain.
Example 7. Disproportionate distribution. In 1997, A and B each
contribute cash of $50,000 to form and become equal partners in a
partnership (PRS). More than one year later, A receives a distribution
worth $22,000 from PRS, which reduces A's interest in PRS to 36 percent.
After the distribution, B owns 64 percent of PRS. The holding periods of
A and B in their interests in PRS are not affected by the distribution.
[[Page 292]]
Example 8. Gain or loss as a result of a distribution. (i) On
January 1, 1996, A contributes property with a basis of $10 and a fair
market value of $10,000 in exchange for an interest in a partnership
(ABC). On September 30, 2000, when A's interest in ABC is worth $12,000
(and the basis of A's partnership interest is still $10), A contributes
$12,000 cash in exchange for an additional interest in ABC. A is
allocated a loss equal to $10,000 by ABC for the taxable year ending
December 31, 2000, thereby reducing the basis of A's partnership
interest to $2,010. On February 1, 2001, ABC makes a cash distribution
to A of $10,000. ABC holds no inventory or unrealized receivables.
(assume that A is allocated no gain or loss for the taxable year ending
December 31, 2001, so that the basis of A's partnership interest does
not increase or decrease as a result of such allocations.)
(ii) The netting rule contained in paragraph (b)(2) of this section
provides that, in determining the holding period of A's interest in ABC,
the cash contribution made on September 30, 2000, must be reduced by the
distribution made on February 1, 2001. Accordingly, for purposes of
determining the holding period of A's interest in ABC, A is treated as
having made a cash contribution of $2,000 ($12,000-$10,000) to ABC on
September 30, 2000. A's holding period in one-seventh of A's interest in
ABC ($2,000 cash contributed over the $14,000 value of the entire
interest (determined as if only $2,000 were contributed rather than
$12,000)) begins on the day after the cash contribution. A recognizes
$7,990 of capital gain as a result of the distribution. See section
731(a)(1). One-seventh of the capital gain recognized as a result of the
distribution is short-term capital gain, and six-sevenths of the capital
gain is long-term capital gain. After the distribution, A's basis in the
interest in PRS is $0, and the holding period for the interest in PRS
continues to be divided in the same proportions as before the
distribution.
(g) Effective date. This section applies to transfers of partnership
interests and distributions of property from a partnership that occur on
or after September 21, 2000.
[T.D. 8902, 65 FR 57099, Sept. 21, 2000]
Special Rules for Determining Capital Gains and Losses
Sec. 1.1231-1 Gains and losses from the sale or exchange of certain
property used in the trade or business.
(a) In general. Section 1231 provides that, subject to the
provisions of paragraph (e) of this section, a taxpayer's gains and
losses from the disposition (including involuntary conversion) of assets
described in that section as property used in the trade or business and
from the involuntary conversion of capital assets held for more than 6
months shall be treated as long-term capital gains and losses if the
total gains exceed the total losses. If the total gains do not exceed
the total losses, all such gains and losses are treated as ordinary
gains and losses. Therefore, if the taxpayer has no gains subject to
section 1231, a recognized loss from the condemnation (or from a sale or
exchange under threat of condemnation) of even a capital asset held for
more than 1 year (6 months for taxable years beginning before 1977; 9
months for taxable years beginning in 1977) is an ordinary loss. Capital
assets subject to section 1231 treatment include only capital assets
involuntarily converted. The noncapital assets subject to section 1231
treatment are (1) depreciable business property and business real
property held for more than 1 year (6 months for taxable years beginning
before 1977; 9 months for taxable years beginning in 1977) other than
stock in trade and certain copyrights and artistic property and, in the
case of sales and other dispositions occurring after July 25, 1969,
other than a letter, memorandum, or property similar to a letter or
memorandum; (2) timber, coal, and iron ore which do not otherwise meet
the requirements of section 1231 but with respect to which section 631
applies; and (3) certain livestock and unharvested crops. See paragraph
(c) of this section.
(b) Treatment of gains and losses. For the purpose of applying
section 1231, a taxpayer must aggregate his recognized gains and losses
from:
(1) The sale, exchange, or involuntary conversion of property used
in the trade or business (as defined in section 1231(b)), and
(2) The involuntary conversion (but not sale or exchange) of capital
assets held for more than 1 year (6 months for taxable years beginning
before 1977; 9 months for taxable years beginning in 1977).
If the gains to which section 1231 applies exceed the losses to which
the section applies, the gains and losses are treated as long-term
capital gains and losses and are subject to the provisions
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of parts I and II (section 1201 and following), subchapter P, chapter 1
of the Code, relating to capital gains and losses. If the gains to which
section 1231 applies do not exceed the losses to which the section
applies, the gains and losses are treated as ordinary gains and losses.
Therefore, in the latter case, a loss from the involuntary conversion of
a capital asset held for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977) is
treated as an ordinary loss and is not subject to the limitation on
capital losses in section 1211. The phrase involuntary conversion is
defined in paragraph (e) of this section.
(c) Transactions to which section applies. Section 1231 applies to
recognized gains and losses from the following:
(1) The sale, exchange, or involuntary conversion of property held
for more than 1 year (6 months for taxable years beginning before 1977;
9 months for taxable years beginning in 1977) and used in the taxpayer's
trade or business, which is either real property or is of a character
subject to the allowance for depreciation under section 167 (even though
fully depreciated), and which is not:
(i) Property of a kind which would properly be includible in the
inventory of the taxpayer if on hand at the close of the taxable year,
or property held by the taxpayer primarily for sale to customers in the
ordinary course of business;
(ii) A copyright, a literary, musical, or artistic composition, or
similar property, or (in the case of sales and other dispositions
occurring after July 25, 1969) a letter, memorandum, or property similar
to a letter or memorandum, held by a taxpayer described in section
1221(3); or
(iii) Livestock held for draft, breeding, dairy, or sporting
purposes, except to the extent included under paragraph (4) of this
paragraph, or poultry.
(2) The involuntary conversion of capital assets held for more than
1 year (6 months for taxable years beginning before 1977; 9 months for
taxable years beginning in 1977).
(3) The cutting or disposal of timber, or the disposal of coal or
iron ore, to the extent considered arising from a sale or exchange by
reason of the provisions of section 631 and the regulations thereunder.
(4) The sale, exchange, or involuntary conversion of livestock if
the requirements of Sec. 1.1231-2 are met.
(5) The sale, exchange, or involuntary conversion of unharvested
crops on land which is (i) used in the taxpayer's trade or business and
held for more than 1 year (6 months for taxable years beginning before
1977; 9 months for taxable years beginning in 1977), and (ii) sold or
exchanged at the same time and to the same person. See paragraph (f) of
this section.
For purposes of section 1231, the phrase property used in the trade or
business means property described in this paragraph (other than property
described in subparagraph (2) of this paragraph). Notwithstanding any of
the provisions of this paragraph, section 1231(a) does not apply to
gains and losses under the circumstances described in paragraph (e) (2)
or (3) of this section.
(d) Extent to which gains and losses are taken into account. All
gains and losses to which section 1231 applies must be taken into
account in determining whether and to what extent the gains exceed the
losses. For the purpose of this computation, the provisions of section
1211 limiting the deduction of capital losses do not apply, and no
losses are excluded by that section. With that exception, gains are
included in the computations under section 1231 only to the extent that
they are taken into account in computing gross income, and losses are
included only to the extent that they are taken into account in
computing taxable income. The following are examples of gains and losses
not included in the computations under section 1231:
(1) Losses of a personal nature which are not deductible by reason
of section 165 (c) or (d), such as losses from the sale of property held
for personal use;
(2) Losses which are not deductible under section 267 (relating to
losses with respect to transactions between related taxpayers) or
section 1091 (relating to losses from wash sales);
(3) Gain on the sale of property (to which section 1231 applies)
reported for any taxable year on the installment method under section
453, except to the
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extent the gain is to be reported under section 453 for the taxable
year; and
(4) Gains and losses which are not recognized under section 1002,
such as those to which sections 1031 through 1036, relating to common
nontaxable exchanges, apply.
(e) Involuntary conversion--(1) General rule. For purposes of
section 1231, the terms compulsory or involuntary conversion and
involuntary conversion of property mean the conversion of proeprty into
money or other property as a result of complete or partial destruction,
theft or seizure, or an exercise of the power of requisition or
condemnation, or the threat or imminence thereof. Losses upon the
complete or partial destruction, theft, seizure, requisition, or
condemnation of property are treated as losses upon an involuntary
conversion whether or not there is a conversion of the property into
other property or money and whether or not the property is uninsured,
partially insured, or totally insured. For example, if a capital asset
held for more than 1 year (6 months for taxable years beginning before
1977; 9 months for taxable years beginning in 1977), with an adjusted
basis of $400, but not held for the production of income, is stolen, and
the loss which is sustained in the taxable year 1956 is not compensated
for by insurance or otherwise, section 1231 applies to the $400 loss.
For certain exceptions to this subparagraph, see subparagraphs (2) and
(3) of this paragraph.
(2) Certain uninsured losses. Notwithstanding the provisions of
subparagraph (1) of this paragraph, losses sustained during a taxable
year beginning after December 31, 1957, and before January 1, 1970, with
respect to both property used in the trade or business and any capital
asset held for more than 6 months and held for the production of income,
which losses arise from fire, storm, shipwreck, or other casualty, or
from theft, and which are not compensated for by insurance in any
amount, are not losses to which section 1231(a) applies. Such losses
shall not be taken into account in applying the provisions of this
section.
(3) Exclusion of gains and losses from certain involuntary
conversions. Notwithstanding the provisions of subparagraph (1) of this
paragraph, if for any taxable year beginning after December 31, 1969,
the recognized losses from the involuntary conversion as a result of
fire, storm, shipwreck, or other casualty, or from theft, of any
property used in the trade or business or of any capital asset held for
more than 1 year (6 months for taxable years beginning before 1977; 9
months for taxable years beginning in 1977) exceed the recognized gains
from the involuntary conversion of any such property as a result of
fire, storm, shipwreck, or other casualty, or from theft, such gains and
losses are not gains and losses to which section 1231 applies and shall
not be taken into account in applying the provisions of this section.
The net loss, in effect, will be treated as an ordinary loss. This
subparagraph shall apply whether such property is uninsured, partially
insured, or totally insured and, in the case of a capital asset held for
more than 1 year (6 months for taxable years beginning before 1977; 9
months for taxable years beginning in 1977), whether the property is
property used in the trade or business, property held for the production
of income, or a personal asset.
(f) Unharvested crops. Section 1231 does not apply to a sale,
exchange, or involuntary conversion of an unharvested crop if the
taxpayer retains any right or option to reacquire the land the crop is
on, directly or indirectly (other than a right customarily incident to a
mortgage or other security transaction). The length of time for which
the crop, as distinguished from the land, is held is immaterial. A
leasehold or estate for years is not land for the purpose of section
1231.
(g) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. A, an individual, makes his income tax return on the
calendar year basis. A's recognized gains and losses for 1957 of the
kind described in section 1231 are as follows:
------------------------------------------------------------------------
Gains Losses
------------------------------------------------------------------------
1. Gain on sale of machinery, used in the business and $4,000
subject to an allowance for depreciation, held for
more than 6 months...................................
[[Page 295]]
2. Gain reported in 1957 (under section 453) on 6,000
installment sale in 1956 of factory premises used in
the business (including building and land, each held
for more than 6 months)..............................
3. Gain reported in 1957 (under section 453) on 2,000
installment sale in 1957 of land held for more than 6
months, used in the business as a storage lot for
trucks...............................................
4. Gain on proceeds from requisition by Government of 500
boat, held for more than 6 months, used in the
business and subject to an allowance for depreciation
5. Loss upon the destruction by fire of warehouse, ....... $3,000
held for more than 6 months and used in the business
(excess of adjusted basis of warehouse over
compensation by insurance, etc.).....................
6. Loss upon theft of unregistered bearer bonds, held ....... 5,000
for more than 6 months...............................
7. Loss in storm of pleasure yacht, purchased in 1950 ....... 1,000
for $1,800 and having a fair market value of $1,000
at the time of the storm.............................
---------
8. Total gains........................................ 12,500 ___
9. Total losses....................................... ....... 9,000
10. Excess of gains over losses....................... 3,500
------------------------------------------------------------------------
Since the aggregate of the recognized gains ($12,500) exceeds the
aggregate of the recognized losses ($9,000), such gains and losses are
treated under section 1231 as gains and losses from the sale or exchange
of capital assets held for more than 6 months. For any taxable year
beginning after December 31, 1957, and before January 1, 1970, the
$5,000 loss upon theft of bonds (item 6) would not be taken into account
under section 1231. See paragraph (e)(2) of this section.
Example 2. If in example (1), A also had a loss of $4,000 from the
sale under threat of condemnation of a capital asset acquired for profit
and held for more than six months, then the gains ($12,500) would not
exceed the losses ($9,000 plus $4,000, or $13,000). Neither the loss on
that sale nor any of the other items set forth in example (1) would then
be treated as gains and losses from the sale or exchanges of capital
assets, but all of such items would be treated as ordinary gains and
losses. Likewise, if A had no other gain or loss, the $4,000 loss would
be treated as an ordinary loss.
Example 3. A's yacht, used for pleasure and acquired for that use in
1945 at a cost of $25,000, was requisitioned by the Government in 1957
for $15,000. A sustained no loss deductible under section 165(c) and
since no loss with respect to the requisition is recognizable, the loss
will not be included in the computations under section 1231.
Example 4. A, an individual, makes his income tax return on a
calendar year basis. During 1970 trees on A's residential property which
were planted in 1950 after the purchase of such property were destroyed
by fire. The loss, which was in the amount of $2,000 after applying
section 165(c)(3), was not compensated for by insurance or otherwise.
During the same year A also recognized a $1,500 gain from insurance
proceeds compensating him for the theft sustained in 1970 of a diamond
brooch purchased in 1960 for personal use. A has no other gains or
losses for 1970 from the involuntary conversion of property. Since the
recognized losses exceed the recognized gains from the involuntary
conversion for 1970 as a result of fire, storm, shipwreck, or other
casualty, or from theft, of any property used in the trade or business
or of any capital asset held for more than 6 months, neither the gain
nor the loss is included in making the computations under section 1231.
Example 5. The facts are the same as in example (4), except that A
also recognized a gain of $1,000 from insurance proceeds compensating
him for the total destruction by fire of a truck, held for more than 6
months, used in A's business and subject to an allowance for
depreciation. A has no other gains or losses for 1970 from the
involuntary conversion of property. Since the recognized losses ($2,000)
do not exceed the recognized gains ($2,500) from the involuntary
conversion for 1970 as a result of fire, storm, shipwreck, or other
casualty, or from theft, of any property used in the trade or business
or of any capital asset held for more than 6 months, such gains and
losses are included in making the computations under section 1231. Thus,
if A has no other gains or losses for 1970 to which section 1231
applies, the gains and losses from these involuntary conversions are
treated under section 1231 as gains and losses from the sale or exchange
of capital assets held for more than 6 months.
Example 6. The facts are the same as in example (5) except that A
also has the following recognized gains and losses for 1970 to which
section 1231 applies:
Gains Losses
Gain on sale of machinery, used in the business $4,000
and subject to an allowance for depreciation,
held for more than 6 months....................
Gain reported in 1970 (under section 453) on 6,000
installment sale in 1969 of factory premises
used in the business (including building and
land, each held for more than 6 months)........
Gain reported in 1970 (under section 453) on $2,000
installment sale in 1970 of land held for more
than 6 months, used in the business as a
storage lot for trucks.........................
Loss upon the sale in 1970 of warehouse, used in .......... $5,000
the business and subject to an allowance for
depreciation, held for more than 6 months......
------------
Total gains................................. 12,000 _____
Total losses................................ .......... 5,000
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Since the aggregate of the recognized gains ($14,500) exceeds the
aggregate of the recognized losses ($7,000), such gains and losses are
treated under section 1231 as gains and losses from the sale or exchange
of capital assets held for more than 6 months.
Example 7. B, an individual, makes his income tax return on the
calendar year basis. During 1970 furniture used in his business and held
for more than 6 months was destroyed by fire. The recognized loss, after
compensation by insurance, was $2,000. During the same year B recognized
a $1,000 gain upon the sale of a parcel of real estate used in his
business and held for more than 6 months, and a $6,000 loss upon the
sale of stock held for more than 6 months. B has no other gains or
losses for 1970 from the involuntary conversion, or the sale or exchange
of, property. The $6,000 loss upon the sale of stock is not a loss to
which section 1231 applies since the stock is not property used in the
trade or business, as defined in section 1231(b). The $2,000 loss upon
the destruction of the furniture is not a loss to which section 1231
applies since the recognized losses ($2,000) exceed the recognized gains
($0) from the involuntary conversion for 1970 as a result of fire,
storm, shipwreck, or other casualty, or from theft, of any property used
in the trade or business or of any capital asset held for more than 6
months. Accordingly, the $1,000 gain upon the sale of real estate is
considered to be gain from the sale or exchange of a capital asset held
for more than 6 months since the gains ($1,000) to which section 1231
applies exceed the losses ($0) to which such section applies.
Example 8. The facts are the same as in example (7) except that B
also recognized a gain of $4,000 from insurance proceeds compensating
him for the total destruction by fire of a freighter, held for more than
6 months, used in B's business and subject to an allowance for
depreciation. Since the recognized losses ($2,000) do not exceed the
recognized gains ($4,000) from the involuntary conversion for 1970 as a
result of fire, storm, shipwreck, or other casualty, or from theft, of
any property used in the trade or business or of any capital asset held
for more than 6 months, such gains and losses are included in making the
computations under section 1231. Since the aggregate of the recognized
gains to which section 1231 applies ($5,000) exceeds the aggregate of
the recognized losses to which such section applies ($2,000), such gains
and losses are treated under section 1231 as gains and losses from the
sale or exchange of capital assets held for more than 6 months. The
$6,000 loss upon the sale of stock is not taken into account in making
such computation since it is not a loss to which section 1231 applies.
[T.D. 6500, 25 FR 12006, Nov. 26, 1960, as amended by T.D. 6841, 30 FR
9309, July 27, 1965; T.D. 7369, 40 FR 29841, July 16, 1975; T.D. 7728,
45 FR 72650, Nov. 3, 1980; T.D. 7829, 47 FR 38515, Sept. 1, 1982]
Sec. 1.1231-2 Livestock held for draft, breeding, dairy, or sporting
purposes.
(a)(1) In the case of cattle, horses, or other livestock acquired by
the taxpayer after December 31, 1969, section 1231 applies to the sale,
exchange, or involuntary conversion of such cattle, horses, or other
livestock, regardless of age, held by the taxpayer for draft, breeding,
dairy, or sporting purposes, and held by him:
(i) For 24 months or more from the date of acquisition in the case
of cattle or horses, or
(ii) For 12 months or more from the date of acquisition in the case
of such other livestock.
(2) In the case of livestock (including cattle or horses) acquired
by the taxpayer on or before December 31, 1969, section 1231 applies to
the sale, exchange, or involuntary conversion of such livestock,
regardless of age, held by the taxpayer for draft, breeding, or dairy
purposes, and held by him for 12 months or more from the date of
acquisition.
(3) For the purposes of section 1231, the term livestock is given a
broad, rather than a narrow, interpretation and includes cattle, hogs,
horses, mules, donkeys, sheep, goats, fur-bearing animals, and other
mammals. However, it does not include poultry, chickens, turkeys,
pigeons, geese, other birds, fish, frogs, reptiles, etc.
(b)(1) Whether or not livestock is held by the taxpayer for draft,
breeding, dairy, or sporting purposes depends upon all of the facts and
circumstances in each case. The purpose for which the animal is held is
ordinarily shown by the taxpayer's actual use of the animal. However, a
draft, breeding, dairy, or sporting purpose may be present if an animal
is disposed of within a reasonable time after its intended use for such
purpose is prevented or made undesirable by reason of accident, disease,
drought, unfitness of the animal for such purpose, or a
[[Page 297]]
similar factual circumstance. Under certain circumstances, an animal
held for ultimate sale to customers in the ordinary course of the
taxpayer's trade or business may be considered as held for draft,
breeding, dairy, or sporting purposes. However, an animal is not held by
the taxpayer for draft, breeding, dairy, or sporting purposes merely
because it is suitable for such purposes or merely because it is held by
the taxpayer for sale to other persons for use by them for such
purposes. Furthermore, an animal held by the taxpayer for other purposes
is not considered as held for draft, breeding, dairy, or sporting
purposes merely because of a negligible use of the animal for such
purposes or merely because of the use of the animal for such purposes as
an ordinary or necessary incident to the other purposes for which the
animal is held. See paragraph (c) of this section for the rules to be
used in determining when horses are held for racing purposes and,
therefore, are considered as held for sporting purposes.
(2) The application of this paragraph is illustrated by the
following examples:
Example 1. An animal intended by the taxpayer for use by him for
breeding purposes is discovered to be sterile or unfit for the breeding
purposes for which it was held, and is disposed of within a reasonable
time thereafter. This animal is considered as held for breeding
purposes.
Example 2. The taxpayer retires from the breeding or dairy business
and sells his entire herd, including young animals which would have been
used by him for breeding or dairy purposes if he had remained in
business. These young animals are considered as held for breeding or
dairy purposes. The same would be true with respect to young animals
which would have been used by the taxpayer for breeding or dairy
purposes but which are sold by him in reduction of his breeding or dairy
herd, because of, for example, drought.
Example 3. A taxpayer in the business of raising hogs for slaughter
customarily breeds sows to obtain a single litter to be raised by him
for sale, and sells these brood sows after obtaining the litter. Even
though these brood sows are held for ultimate sale to customers in the
ordinary course of the taxpayer's trade or business, they are considered
as held for breeding purposes.
Example 4. A taxpayer in the business of raising horses for sale to
others for use by them as draft horses uses them for draft purposes on
his own farm in order to train them. This use is an ordinary or
necessary incident to the purpose of selling the animals, and,
accordingly, these horses are not considered as held for draft purposes.
Example 5. The taxpayer is in the business of raising registered
cattle for sale to others for use by them as breeding cattle. It is the
business practice of this particular taxpayer to breed the offspring of
his herd which he is holding for sale to others prior to sale in order
to establish their fitness for sale as registered breeding cattle. In
such case, the taxpayer's breeding of such offspring is an ordinary and
necessary incident to his holding them for the purpose of selling them
as bred heifers or proven bulls and does not demonstrate that the
taxpayer is holding them for breeding purposes. However, those cattle
held by the taxpayer as additions or replacements to his own breeding
herd to produce calves are considered to be held for breeding purposes,
even though they may not actually have produced calves.
Example 6. A taxpayer, engaged in the business of buying cattle and
fattening them for slaughter, purchased cows with calf. The calves were
born while the cows were held by the taxpayer. These cows are not
considered as held for breeding purposes.
(c)(1) For purposes of paragraph (b) of this section, a horse held
for racing purposes shall be considered as held for sporting purposes.
Whether a horse is held for racing purposes shall be determined in
accordance with the following rules:
(i) A horse which has actually been raced at a public race track
shall, except in rare and unusual circumstances, be considered as held
for racing purposes.
(ii) A horse which has not been raced at a public track shall be
considered as held for racing purposes if it has been trained to race
and other facts and circumstances in the particular case also indicate
that the horse was held for this purpose. For example, assume that the
taxpayer maintains a written training record on all horses he keeps in
training status, which shows that a particular horse does not meet
objective standards (including, but not limited to, such considerations
as failure to achieve predetermined standards of performance during
training, or the existence of a physical or other defect) established by
the taxpayer for determining the fitness and quality of horses to be
retained in his racing stable. Under such circumstances, if the
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taxpayer disposes of the horse within a reasonable time after he
determined that it did not meet his objective standards for retention,
the horse shall be considered as held for racing purposes.
(iii) A horse which has neither been raced at a public track nor
trained for racing shall not, except in rare and unusual circumstances,
be considered as held for racing purposes.
(2) This paragraph may be illustrated by the following examples:
Example 1. The taxpayer breeds, raises, and trains horses for the
purpose of racing. Every year he culls some horses from his racing
stable. In 1971, the taxpayer decided that in order to prevent his
racing stable from getting too large to be effectively operated he must
cull six horses from it. All six of the horses culled by the taxpayer
had been raced at public tracks in 1970. Under subparagraph (1)(i) of
this paragraph, all these horses are considered as held for racing
purposes.
Example 2. Assume the same facts as in example (1). Assume further
that the taxpayer decided to cull four more horses from his racing
stable in 1971. All these horses had been trained to race but had not
been raced at public tracks. The taxpayer culled these four horses
because the training log which the taxpayer maintains on all the horses
he trains showed these horses to be unfit to remain in his racing
stable. Horse A was culled because it developed shin splints during
training. Horses B and C were culled because of poor temperament. B
bolted every time a rider tried to mount it, and C became extremely
nervous when it was placed in the starting gate. Horse D was culled
because it did not qualify for retention under one of the objective
standards the taxpayer had established for determining which horses to
retain since it was unable to run a specified distance in a minimum
time. These four horses were disposed of within a reasonable time after
the taxpayer determined that they were unfit to remain in his stable.
Under subparagraph (1)(ii) of this paragraph, all these horses are
considered as held for racing purposes.
[T.D. 7141, 36 FR 18792, Sept. 22, 1971]
Sec. 1.1232-1 Bonds and other evidences of indebtedness;
scope of section.
(a) In general. Section 1232 applies to any bond, debenture, note,
or certificate or other evidence of indebtedness (referred to in this
section and Sec. Sec. 1.1232-3 and 1.1232-3A as an obligation) which is
a capital asset in the hands of the taxpayer, and which is issued by any
corporation, or by any government or political subdivision thereof. In
general, section 1232(a)(1) provides that the retirement of an
obligation, other than certain obligations issued before January 1,
1955, is considered to be an exchange and, therefore, is usually subject
to capital gain or loss treatment. In general, section 1232(a)(2)(B)
provides that in the case of a gain realized on the sale or exchange of
certain obligations issued at a discount after December 31, 1954, which
are either corporate bonds issued on or before May 27, 1969, or
government bonds, the amount of gain equal to such discount or, under
certain circumstances, the amount of gain equal to a specified portion
of such discount, constitutes ordinary income. In the case of certain
corporate obligations issued after May 27, 1969, in general, section
1232(a)(3) provides for the inclusion as interest in gross income of a
ratable portion of original issue discount for each taxable year over
the life of the obligation, section 1232(a)(3)(E) provides for an
increase in basis equal to the original issue discount included in gross
income, and section 1232(a)(2)(A) provides that any gain realized on
such an obligation held more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977)
shall be considered gain from the sale or exchange of a capital asset
held more than 1 year (6 months for taxable years beginning before 1977;
9 months for taxable years beginning in 1977). For the requirements for
reporting original issue discount on certain obligations issued after
May 27, 1969, see section 6049(a) and the regulations thereunder.
Section 1232(c) treats as ordinary income a portion of any gain realized
upon the disposition of coupon obligations which were acquired after
August 16, 1954, and before January 1, 1958, without all coupons
maturing more than 12 months after purchase attached, and coupon
obligations which were acquired after December 31, 1957, without all
coupons maturing after the date of purchase attached.
(b) Requirement that obligations be capital assets. In order for
section 1232 to be applicable, an obligation must be a capital asset in
the hands of the taxpayer. See section 1221 and the regulations
thereunder. Obligations held by a
[[Page 299]]
dealer in securities (except as provided in section 1236) or obligations
arising from the sale of inventory or personal services by the holder
are not capital assets. However, obligations held by a financial
institution, as defined in section 582(c) (relating to treatment of
losses and gains on bonds of certain financial institutions) for
investment and not primarily for sale to customers in the ordinary
course of the financial institution's trade or business, are capital
assets. Thus, with respect ot obligations held as capital assets by such
a financial institution which are corporate obligations to which section
1232(a)(3) applies, there is ratable inclusion of original issue
discount as interest in gross income under paragraph (a) of Sec.
1.1232-3A, and gain on a sale or exchange (including retirement) may be
subject to ordinary income treatment under section 582(c) and paragraph
(a)(1) of Sec. 1.1232-3.
(c) Face-amount certificates--(1) In general. For purposes of
section 1232, this section and Sec. Sec. 1.1232-3 and 1.1232-3A, the
term other evidence of indebtedness includes face amount certificates as
defined in section 2(a)(15) and 4 of the Investment Company Act of 1940
(15 U.S.C. 80a-2 and 80a-4).
(2) Amounts received in taxable years beginning prior to January 1,
1964. Amounts received in taxable years beginning prior to January 1,
1964 under face amount certificates which were issued after December 31,
1954, are subject to the limitation on tax under section 72(e)(3). See
paragraph (g) of Sec. 1.72-11 (relating to limit on tax attributable to
receipt of a lump sum received as an annuity payment). However, section
72(e)(3) does not apply to any such amounts received in taxable years
beginning after December 31, 1963.
(3) Certificates issued after December 31, 1975. In the case of a
face-amount certificate issued after December 31, 1975 (other than such
a certificate issued pursuant to a written commitment which was binding
on such date and at all times thereafter), the provisions of section
1232(a)(3) (relating to the ratable inclusion of original issue discount
in gross income) shall apply. See section 1232-3A(f). For treatment of
any increase in basis under section 1232(a)(3)(A) as consideration paid
for purposes of computing the investment in the contract under section
72, see Sec. 1.72-6(c)(4).
(d) Certain deposits in financial institutions. For purposes of
section 1232, this section and Sec. Sec. 1.1232-3 and 1.1232-3A, the
term other evidence of indebtedness includes certificates of deposit,
time deposits, bonus plans, and other deposit arrangements with banks,
domestic building and loan associations, and similar financial
institutions. For application of section 1232 to such deposits, see
paragraph (e) of Sec. 1.1232-3A. However, section 1232, this section,
and Sec. Sec. 1.1232-2 through 1.1232-4 shall not apply to such
deposits made prior to January 1, 1971. For treatment of renewable
certificates of deposit, see paragraph (e)(4) of Sec. 1.1232-3A.
[T.D. 7154, 36 FR 25000, Dec. 28, 1971, as amended by T.D. 7311, 39 FR
11880, Apr. 1, 1974; T.D. 7365, 40 FR 27936, July 2, 1975; T.D. 7728, 45
FR 72650, Nov. 3, 1980; T.D. 9849, 84 FR 9237, Mar. 14, 2019]
Sec. 1.1232-2 [Reserved]
Sec. 1.1232-3 Gain upon sale or exchange of obligations issued
at a discount after December 31, 1954.
(a) General rule; sale or exchange--(1) Obligations issued by a
corporation after May 27, 1969--(i) General rule. Under section
1232(a)(2)(A), in the case of gain realized upon the sale or exchange of
an obligation issued at a discount by a corporation after May 27, 1969
(other than an obligation subject to the transitional rule of
subparagraph (4) of this paragraph), and held by the taxpayer for more
than 1 year (6 months for taxable years beginning before 1977; 9 months
for taxable years beginning in 1977):
(a) If at the time of original issue there was no intention to call
the obligation before maturity, such gain shall be considered as long-
term capital gain, or
(b) If at the time of original issue there was an intention to call
the obligation before maturity, such gain shall be considered ordinary
income to the extent it does not exceed the excess of:
(1) An amount equal to the entire original issue discount, over
(2) An amount equal to the entire original issue discount multiplied
by a fraction the numerator of which is the
[[Page 300]]
sum of the number of complete months and any fractional part of a month
elapsed since the date of original issue and the denominator of which is
the number of complete months and any fractional part of a month from
the date of original issue to the stated maturity date.
The balance, if any, of the gain shall be considered as long-term
capital gain. The amount described in (2) of this subdivision (b) in
effect reduces the amount of original issue discount to be treated as
ordinary income under this subdivision (b) by the amounts previously
includible (regardless of whether included) by all holders (computed,
however, as to any holder without regard to any purchase allowance under
paragraph (a)(2)(ii) of Sec. 1.1232-3A and without regard to whether
any holder purchased at a premium as defined in paragraph (d)(2) of
Sec. 1.1232-3).
(ii) Cross references. For definition of the terms original issue
discount and intention to call before maturity, see paragraphs (b) (1)
and (4) respectively of this section. For definition of the term date of
original issue, see paragraph (b)(3) of this section. For computation of
the number of complete months and any fractional portion of a month, see
paragraph (a)(3) of Sec. 1.1232-3A.
(iii) Effect of section 582(c). Gain shall not be considered to be
long-term capital gain under subdivision (i) of this subparagraph if
section 582(c) (relating to treatment of losses and gains on bonds of
certain financial institutions) applies.
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples:
Example 1. On January 1, 1970, A, a calendar-year taxpayer,
purchases at original issue for cash of $7,600, M Corporation's 10-year,
5 percent bond which has a stated redemption price at maturity of
$10,000. On January 1, 1972, A sells the bond to B, for $9,040. A has
previously included $480 of the original issue discount in his gross
income (see example (1) of paragraph (d) of Sec. 1.1232-3A) and
increased his basis in the bond by that amount to $8,080 (see paragraph
(c) of Sec. 1.1232-3A). Thus, if at the time of original issue there
was no intention to call the bond before maturity, A's gain of $960
(amount realized, $9,040, less adjusted basis, $8,080) is considered
long-term capital gain.
Example 2. (i) Assume the same facts as in example (1), except that
at the time of original issue there was an intention to call the bond
before maturity. The amount of the entire gain includible by A as
ordinary income under subparagraph (1)(i) of this paragraph is
determined as follows:
(1) Entire original issue discount (stated redemption price $2,400
at maturity, $10,000, minus issue price, $7,600)...........
(2) Less: Line (1), $2,400, multiplied by months elapsed $480
since date of original issue, 24, divided by months from
such date to stated maturity date, 120.....................
-----------
(3) Maximum amount includible by A as ordinary income....... $1,920
Since the amount in line (3) is greater than A's gain, $960, A's entire
gain is includible as ordinary income.
(ii) On January 1, 1979, B, a calendar-year taxpayer, sells the bond
to C for $10,150. Assume that B has included $120 of original issue
discount in his gross income for each taxable year he held the bond (see
example (2) of paragraph (d) of Sec. 1.1232-3A) and therefore increased
his basis by $840 (i.e., $120 each year x 7 years) to $9,880. B's gain
is therefore $270 (amount realized, $10,150, less basis, $9,880). The
amount of such gain includible by B as ordinary income under
subparagraph (1)(i) of this paragraph is determined as follows:
(1) Entire original issue discount (as determined in part $2,400
(i) of this example).......................................
(2) Less: Line (1), $2,400, multiplied by months elapsed $2,160
since date of original issue, 108, divided by months from
such date to stated maturity date, 120.....................
-----------
(3) Maximum amount includible by B as ordinary income....... $240
Since the amount in line (3) is less than B's gain, $270, only $240 of
B's gain is includible as ordinary income. The remaining portion of B's
gain, $30, is considered long-term capital gain.
(3) Obligations issued by a corporation on or before May 27, 1969,
and government obligations. Under section 1232(a)(2)(B), if gain is
realized on the sale or exchange after December 31, 1957, of an
obligation held by the taxpayer more than 6 months, and if the
obligation either was issued at a discount after December 31, 1954, and
on or before May 27, 1969, by a corporation or was issued at a discount
after December 31, 1954, by or on behalf of the United States or a
foreign country, or a political subdivision of either, then such gain
shall be considered ordinary income to the extent it does not exceed:
[[Page 301]]
(i) An amount equal to the entire original issue discount, or
(ii) If at the time of original issue there was no intention to call
the obligation before maturity, a portion of the original issue discount
determined in accordance with paragraph (c) of this section,
And the balance, if any, of the gain shall be considered as long-term
capital gain. For the definition of the terms original issue discount
and intention to call before maturity, see paragraphs (b) (1) and (4)
respectively of this section. See section 1037(b) and paragraph (b) of
Sec. 1.1037-1 for special rules which are applicable in applying
section 1232(a)(2)(B) and this subparagraph to gain realized on the
disposition or redemption of obligations of the United States which were
received from the United States in an exchange upon which gain or loss
is not recognized because of section 1037(a) (or so much of section 1031
(b) or (c) as relates to section 1037(a)).
(4) Transitional rule. Subparagraph (3) of this paragraph (in lieu
of subparagraph (1) of this paragraph) shall apply to an obligation
issued by a corporation pursuant to a written commitment which was
binding on May 27, 1969, and at all times thereafter.
(5) Obligations issued after December 31, 1954, and sold or
exchanged before January 1, 1958. Gain realized upon the sale or
exchange before January 1, 1958, of an obligation issued at a discount
after December 31, 1954, and held by the taxpayer for more than 6
months, shall be considered ordinary income to the extent it equals a
specified portion of the original issue discount, and the balance, if
any, of the gain shall be considered as long-term capital gain. The term
original issue discount is defined in paragraph (b)(1) of this section.
The computation of the amount of gain which constitutes ordinary income
is illustrated in paragraph (c) of this section.
(6) Obligations issued before January 1, 1955. Whether gain
representing original issue discount realized upon the sale or exchange
of obligations issued at a discount before January 1, 1955, is capital
gain or ordinary income shall be determined without reference to section
1232.
(b) Definitions--(1) Original issue discount--(i) In general. For
purposes of section 1232, the term original issue discount means the
difference between the issue price and the stated redemption price at
maturity. The stated redemption price is determined without regard to
optional call dates.
(ii) De minimis rule. If the original issue discount is less than
one-fourth of 1 percent of the stated redemption price at maturity
multiplied by the number of full years from the date of original issue
to maturity, then the discount shall be considered to be zero. For
example, a 10-year bond with a stated redemption price at maturity of
$100 issued at $98 would be regarded as having an original issue
discount of zero. Thus, any gain realized by the holder would be a long-
term capital gain if the bond was a capital asset in the hands of the
holder and held by him for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977).
However, if the bond were issued at $97.50 or less, the original issue
discount would not be considered zero.
(iii) Stated redemption price at maturity--(a) Definition. Except as
otherwise provided in this subdivision (iii), the term stated redemption
price at maturity means the amount fixed by the last modification of the
purchase agreement, including dividends, interest, and any other
amounts, however designated, payable at that time. If any amount based
on a fixed rate of simple or compound interest is actually payable or
will be treated as constructively received under section 451 and the
regulations thereunder either: (1) At fixed periodic intervals of one
year or less during the entire term of an obligation, or (2) except as
provided in subdivision (e) of this paragraph (b)(1)(iii), at maturity
in the case of an obligation with a term of one year or less, any such
amount payable at maturity shall not be included in determining the
stated redemption price at maturity. For purposes of subdivision (a)(2)
of this paragraph (b)(1)(iii), the term of an obligation shall include
any renewal period with respect to which, under the terms of the
obligation, the holder may either take action or refrain from taking
action which would
[[Page 302]]
prevent the actual or constructive receipt of any interest on such
obligation until the expiration of any such renewal period. To
illustrate this paragraph (b)(1)(iii), assume that a note which promises
to pay $1,000 at the end of three years provides for additional amounts
labeled as interest to be paid at the rate of $50 at the end of the
first year, $50 at the end of the second year, and $120 at the end of
the third year. The stated redemption price at maturity will be $1,070
since only $50 of the $120 payable at the end of the third year is based
on a fixed rate of simple or compound interest. If, however, the $120
were payable at the end of the second year, so that only $50 in addition
to principal would be payable at the end of the third year, then under
the rule for serial obligations contained in subparagraph (2)(iv)(c) of
this paragraph, the $1,000 note is treated as consisting of two series.
The first series is treated as maturing at the end of the second year at
a stated redemption price of $70. The second series is treated as
maturing at the end of the third year at a stated redemption price of
$1,000. For the calculation of issue price and the allocation of
original issue discount with respect to each such series, see example
(3) of subparagraph (2)(iv)(f) of this paragraph.
(b) Special rules. In the case of face -amount certificates, the
redemption price at maturity is the price as modified through changes
such as extensions of the purchase agreement and includes any dividends
which are payable at maturity. In the case of an obligation issued as
part of an investment unit consisting of such obligation and an option
(which is not excluded by (c) of this subdivision (iii)), security, or
other property, the term stated redemption price at maturity means the
amount payable on maturity in respect of the obligation, and does not
include any amount payable in respect of the option, security, or other
property under a repurchase agreement or option to buy or sell the
option, security, or other property. For application of this subdivision
to certain deposits in financial institutions, see paragraph (e) of
Sec. 1.1232-3A.
(c) Excluded option. An option is excluded by this subdivision (c)
if it is an option to which paragraph (a) of Sec. 1.61-15 applies or if
it is an option, referred to in paragraph (a) of Sec. 1.83-7, granted
in connection with performance of services to which section 421 does not
apply.
(d) Obligation issued in installments. If an obligation is issued by
a corporation under terms whereby the holder makes installment payments,
then the stated redemption price for each installment payment shall be
computed in a manner consistent with the rules contained in subparagraph
(2)(iv) of this paragraph for computing the issue price for each series
of a serial obligation. For application of this subdivision (d) to
certain open account deposit arrangements, see examples (1) and (2) of
paragraph (e)(5)(ii) of Sec. 1.1232-3A.
(e) Application of definition. Subdivision (a)(2) of this paragraph
(b)(1)(iii) shall not apply:
(1) For taxable years beginning before September 19, 1979, if for
the issuer's last taxable year beginning before September 19, 1978, the
rules of Sec. 1.163-4 were properly applied by the issuer, or
(2) In the case of an obligation with a term of six months or less
held by a nonresident alien individual or foreign corporation, but only
for purposes of the appliction of sections 871 and 881.
(iv) Carryover of original issue discount. If in pursuance of a plan
of reorganization an obligation is received in an exchange for another
obligation, and if gain or loss is not recognized in whole or in part on
such exchange of obligations by reason, for example, of section 354 or
356, then the obligation received shall be considered to have the same
original issue discount as the obligation surrendered reduced by the
amount of gain (if any) recognized as ordinary income upon such exchange
of obligations, and by the amount of original issue discount with
respect to the obligation surrendered which was included as interest
income under the ratable inclusion rules of sections 1232(a)(3) and
1.1232-3A. If inclusion as interest of the ratable monthly portion of
original issue discount is required under section 1232(a)(3) with
respect to the obligation received, see paragraph (a)(2)(iii) of Sec.
1.1232-3A for computation
[[Page 303]]
of the ratable monthly portion of original issue discount. For special
rules in connection with certain exchanges of U.S. obligations, see
section 1037.
(2) Issue price defined--(i) In general. The term issue price in the
case of obligations registered with the Securities and Exchange
Commission means the initial offering price to the public at which price
a substantial amount of such obligations were sold. For this purpose,
the term the public does not include bond houses and brokers, or similar
persons or organizations acting in the capacity of underwriters or
wholesalers. Ordinarily, the issue price will be the first price at
which the obligations were sold to the public, and the issue price will
not change if, due to market developments, part of the issue must be
sold at a different price. When obligations are privately placed, the
issue price of each obligation is the price paid by the first buyer of
the particular obligation, irrespective of the issue price of the
remainder of the issue. In the case of an obligation issued by a foreign
obligor, the issue price shall be increased by the amount, if any, of
interest equalization tax paid under section 4911 (and not credited,
refunded, or reimbursed) on the acquisition of the obligation by the
first buyer. In the case of an obligation which is convertible into
stock or another obligation, the issue price includes any amount paid in
respect of the conversion privilege. However, in the case of an
obligation issued as part of an investment unit (as defined in
subdivision (ii)(a) of this subparagraph), the issue price of the
obligation includes only that portion of the initial offering price or
price paid by the first buyer properly allocable to the obligation under
the rules prescribed in subdivision (ii) of this subparagraph. The terms
initial offering price and price paid by the first buyer include the
aggregate payments made by the purchaser under the purchase agreement,
including modifications thereof. Thus, all amounts paid by the purchaser
under the purchase agreement or a modification of it are included in the
issue price (but in the case of an obligation issued as part of an
investment unit, only to the extent allocable to such obligation under
subdivision (ii) of this subparagraph), such as amounts paid upon face-
amount certificates or installment trust certificates in which the
purchaser contracts to make a series of payments which will be
returnable to the holder with an increment at a later date.
(ii) Investment units consisting of obligations and property--(a) In
general. An investment unit, within the meaning of this subdivision (ii)
and for purposes of section 1232, consists of an obligation and an
option, security, or other property. For purposes of this subparagraph,
the initial offering price of an investment unit shall be allocated to
the individual elements of the unit on the basis of their respective
fair market values. However, if the fair market value of the option,
security, or other property is not readily ascertainable (within the
meaning of paragraph (c) of Sec. 1.421-6), then the portion of the
initial offering price or price paid by the first buyer of the unit
which is allocable to the obligation issued as part of such unit shall
be ascertained as of the time of acquisition of such unit by reference
to the assumed price at which such obligation would have been issued had
it been issued apart from such unit. The assumed price of the obligation
shall be ascertained by comparison to the yields at which obligations of
a similar character which are not issued as part of an investment unit
are sold in arm's length transactions, and by adjusting the price of the
obligation in question to this yield. The adjustment may be made by
subtracting from the face amount of the obligation the total present
value of the interest foregone by the purchaser as a result of
purchasing the obligation at a lower yield as part of an investment
unit. In most cases, assumed price may also be determined in a similar
manner through the use of standard bond tables. Any reasonable method
may be used in selecting an obligation for comparative purposes.
Obligations of the same grade and classification shall be used to the
extent possible, and proper regard shall be given, with respect to both
the obligation in question and the comparative obligation, to the
solvency of the issuer, the nature of the issuer's trade or business,
the presence and nature of
[[Page 304]]
security for the obligation, the geographic area in which the loan is
made, and all other factors relevant to the circumstances. An obligation
which is convertible into stock or another obligation must not be used
as a comparative obligation (except where the investment unit contains
an obligation convertible into stock or another obligation), since such
an obligation would not reflect the yield attributable solely to the
obligation element of the investment unit.
(b) Agreement as to assumed price. In the case of an investment unit
which is privately placed, the assumed price at which the obligation
would have been issued had it been issued apart from such unit may be
agreed to by the issuer and the original purchaser of the investment
unit in writing on or before the date of purchase. Alternatively, an
agreement between the issuer and original purchaser may specify the rate
of interest which would have been paid on the obligation if the
transaction were one not involving the issuance of options, and an
assumed issue price may be determined (in the manner described in (a) of
this subdivision) from such agreed assumed rate of interest. An assumed
price based upon such an agreement between the parties will generally be
presumed to be the issue price of the obligation with respect to the
issuer, original purchaser, and all subsequent holders: Provided, That
the agreement was made in arm's length negotiations between parties
having adverse interests: And, provided further, That such price does
not, under the rules stated in (a) of this subdivision, appear to be
clearly erroneous. An assumed issue price agreed to by the parties as
provided herein will not be considered clearly erroneous if it is not
less than the face value adjusted (in the manner described in (a) of
this subdivision) to a yield which is one percentage point greater than
the actual rate of interest payable on the obligation. Similarly, if the
agreement between the parties specifies an agreed assumed rate of
interest (in lieu of an agreed assumed issue price) and such agreed rate
is not more than 1 percentage point greater than the actual rate payable
on the obligation, an adjusted issue price based upon such agreed
assumed rate of interest will not be considered clearly erroneous.
(c) Cross references. For rules relating to the deductibility by the
issuing corporation of bond discount resulting from an allocation under
the rule stated in (a) of this subdivision, see Sec. Sec. 1.163-3 and
1.163-4. For rules relating to the basis of obligations and options,
securities, or other property acquired in investment units, see Sec.
1.1012-1(d). For rules relating to certain reporting requirements with
respect to options acquired in connection with evidences of indebtedness
and for the tax treatment of such options, see Sec. 1.61-15, and
section 1234 and the regulations thereunder. With respect to the tax
consequences to the issuing corporation upon the exercise of options
issued in connection with evidences of indebtedness to which this
section applies, see section 1032 and the regulations thereunder.
(d) Examples. The application of the principles set forth in this
subdivision (ii) may be illustrated by the following examples in each of
which it is assumed that there was no intention to call the note before
maturity:
Example 1. M Corporation is a small manufacturer of electronic
components located in the southwestern United States. On January 1,
1969, in consideration for the payment of $41,500, M issues to X its
unsecured note for $40,000 together with warrants to purchase 3,000
shares of M stock at $10 per share at any time during the term of the
note. The note is payable in 4 years and provides for interest at the
rate of 5 percent per year, payable semiannually. The fair market values
of the note and the warrants are not readily ascertainable. Assume that
companies in the same industry as M Corporation, and similarly situated
both financially and geographically, are generally able to borrow money
on their unsecured notes at an annual interest rate of 6 percent. Using
a present value table, the calculation of the issue price of a 5
percent, 4 year, $40,000 note, discounted to yield 6 percent compounded
semiannually is made as follows:
------------------------------------------------------------------------
(1) (2) (3) (2) x (3)
------------------------------------------------------------------------
Factor for present
Amount value discounted at Present
Semiannual interest period payable at 3 percent per value of
5 percent period payment
------------------------------------------------------------------------
1........................... $1,000 0.9709 $970.90
2........................... 1,000 .9426 942.60
3........................... 1,000 .9151 915.10
4........................... 1,000 .8885 888.50
5........................... 1,000 .8626 862.60
6........................... 1,000 .8375 837.50
[[Page 305]]
7........................... 1,000 .8131 813.10
8........................... 1,000 .7894 789.40
8........................... 40,000 .7804 31,576.00
------------------------------------------------------------------------
Total present value of note discounted at 6 percent, 38,595.70
compounded semiannually...................................
------------------------------------------------------------------------
The same result may be reached through the use of a standard bond
table or by the following present value calculation:
Present value of annuity of $1,000 payable over 8 periods at $7,019.70
3 percent per period = 1000 x 7.0197 =.....................
Add: Present value of principal (as calculated above)....... 31,576.00
-----------
Total................................................... $38,595.70
Accordingly, the assumed price at which M's note would have been issued
had it been issued without stock purchase warrants, i.e., that portion
of the $41,500 price paid by X which is allocable to M's note, is
$38,596 (rounded). Since the price payable on redemption of M's note at
maturity is $40,000, the original issue discount on M's note is $1,404
($40,000 minus $38,596). Under the rules stated in Sec. 1.163-3, M is
entitled to a deduction, to be prorated or amortized over the life of
the note, equal to this original issue discount on the note. The excess
of the price for the unit over the portion of such price allocable to
the note, $2,904 ($41,500 minus $38,596), is allocable to and is the
basis of the stock purchase warrants acquired by X in connection with
M's note. Upon the exercise of X's warrants, M will be allowed no
deduction and will have no income. Upon maturity of the note X will
receive $40,000 from M, of which $1,404, the amount of the original
issue discount, will be taxable as ordinary income. If X were to
transfer the note at its face amount to A 2 years after the issue date,
X would realize, under section 1232(a)(2)(B), ordinary income of $702
(one-half of $1,404).
Example 2. (1) On January 1, 1969, N Corporation negotiates with Y,
a small business investment company, for a loan in the amount of $51,500
in consideration of which N Corporation issues to Y its unsecured 5-year
note for $50,000, together with warrants to purchase 2,000 shares of N
stock at $5 per share at any time during the term of the note. The note
provides for interest of 6 percent, payable semiannually. The fair
market values of the note and warrants are not readily ascertainable.
The loan agreement between Y and N contains a provision, agreed to in
arms-length bargaining between the parties, that a rate of 7 percent
payable semiannually would have been applied to the loan if warrants
were not issued as part of the consideration for the loan. The issue
price of the note is $47,921 (rounded), determined with the use of a
standard bond table, or computed in the manner illustrated in Example 1
or in the following alternative manner:
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (4) x (5)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Interest foregone Factor for present Present value
Interest period Interest rate Principal for period (\1/ value discounted at 3\1/ of interest
differential 2\%) 2\ percent per period foregone
--------------------------------------------------------------------------------------------------------------------------------------------------------
1............................................................... 1%(7%-6%) $50,000 250 0.9662 $241.53
2............................................................... 1% 50,000 250 .9335 233.38
3............................................................... 1% 50,000 250 .9019 225.48
4............................................................... 1% 50,000 250 .8714 217.85
5............................................................... 1% 50,000 250 .8420 210.50
6............................................................... 1% 50,000 250 .8135 203.38
7............................................................... 1% 50,000 250 .7860 196.50
8............................................................... 1% 50,000 250 .7594 189.85
9............................................................... 1% 50,000 250 .7337 183.43
10.............................................................. 1% 50,000 250 .7089 177.25
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total present value of interest foregone............................................................................................ $2,079.15
===============
Principal............................................................................................................................... 50,000.00
Less: Total present value of interest foregone.......................................................................................... 2,079.15
---------------
Issue price......................................................................................................................... 47,920.85
--------------------------------------------------------------------------------------------------------------------------------------------------------
The calculation of present value of interest foregone may also be
made as follows:
Present value of annuity of $250 discounted for 10 periods at 3\1/2\
percent per period = $250 x 8.3166 = $2,079.15.
The total present value of interest foregone, $2,079, is also the
original issue discount attributable to the note ($50,000 -$47,921).
Under (b) of this subdivision, since the agreed assumed rate of interest
of 7 percent is not more than 1 percentage point greater than the actual
rate payable on the note, determination of the issue price of the note
(and original issue discount) based upon
[[Page 306]]
such assumed rate will be presumed to be correct and will not be
considered clearly erroneous, provided that both N and Y adhere to such
determination. Under the rules in Sec. 1.163-3, N is entitled to a
deduction, to be prorated or amortized over the life of the note, equal
to the original issue discount on the note. The excess of the price paid
for the unit over the portion of such price allocable to the note,
$3,579 ($51,500-$47,921) is allocable to and is the basis of the stock
purchase warrants acquired by Y in connection with N's note. Upon the
exercise or sale of the warrants by Y, N will be allowed no deduction
and will have no income. Upon maturity of the note Y will receive
$50,000 from N, of which $2,079, the amount of the original issue
discount, will be taxable as ordinary income. If Y were to transfer the
note at its face value to B 2\1/2\ years after the issue date, Y would
realize, under section 1232(a)(2)(B), ordinary income of $1,039.50 (one-
half of $2,079).
(2) Assume that instead of the parties agreeing on an assumed
interest rate at which the obligation would have been issued without the
warrants, the parties agreed that the obligation at the actual 6 percent
rate would have been issued without the warrants at a discounted price
of $48,000. In this situation the agreed assumed issue price is presumed
to be correct since it is not less than the face value adjusted (in the
manner illustrated in part (1) of this example) to a yield which is one
percentage point greater than the actual rate of interest payable on the
obligation ($47,921).
Example 3. O Corporation is a small advertising company located in
the northeastern United States. Z is a tax-exempt organization. In
consideration for the payment of $60,000, O issues to Z, in a
transaction not within the scope of section 503(b), its unsecured 5-year
note for $60,000, together with warrants to purchase 6,000 shares of O
stock at $10 per share at any time during the term of the note. The note
is subject to quarterly amortization at the rate of $3,000 per quarter,
and provides for interest on the outstanding unpaid balance at an annual
rate of 6 percent payable quarterly (1\1/2\ percent per quarter). The
fair market values of the notes and warrants are not readily
ascertainable. The loan agreement between O and Z contains a recital
that if the $60,000 note had been issued without the warrants only
$45,000 would have been paid for it. An examination of relevant facts
indicates that companies in the same industry as O Corporation, and
similarly situated both financially and geographically, are able to
borrow money on their unsecured notes at an annual interest cost of 8\1/
2\ percent payable quarterly (2\1/8\ percent per quarter). By reference
to a present value table, it is found that the present value of O's note
discounted to yield 8\1/2\ percent compounded quarterly is $56,608
(rounded). The computation is as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (6)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Present value
Principal Interest payable Total amount Factor for present of total
Quarterly interest period payable (1\1/2\ percent) payable (2) + value discounted at 2\1/ payment (4) x
(3) 8\ percent per quarter (5)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1.......................................................... $3,000 $900 $3,900 0.9792 $3,818.88
2.......................................................... 3,000 855 3,855 .9588 3,696.17
3.......................................................... 3,000 810 3,810 .9389 3,577.21
4.......................................................... 3,000 765 3,765 .9193 3,461.16
5.......................................................... 3,000 720 3,720 .9002 3,348.74
6.......................................................... 3,000 675 3,675 .8815 3,239.51
7.......................................................... 3,000 630 3,630 .8631 3,133.05
8.......................................................... 3,000 585 3,585 .8452 3,030.04
9.......................................................... 3,000 540 3,540 .8276 2,929.70
10......................................................... 3,000 495 3,495 .8104 2,832.35
11......................................................... 3,000 450 3,450 .7935 2,737.58
12......................................................... 3,000 405 3,405 .7770 2,645.69
13......................................................... 3,000 360 3,360 .7608 2,556.29
14......................................................... 3,000 315 3,315 .7450 2,469.68
15......................................................... 3,000 270 3,270 .7295 2,385.47
16......................................................... 3,000 225 3,225 .7143 2,303.62
17......................................................... 3,000 180 3,180 .6994 2,224.09
18......................................................... 3,000 135 3,135 .6849 2,147.16
19......................................................... 3,000 90 3,090 .6706 2,072.15
20......................................................... 3,000 45 3,045 .6567 1,999.65
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total............................................................................................................................... 56,608.19
--------------------------------------------------------------------------------------------------------------------------------------------------------
This amount ($56,608) is the assumed price at which the note would have
been issued had it been issued without stock purchase warrants. The
assumed price of $45,000 agreed to by the parties is not presumed to be
correct since it is less than the face value adjusted to a yield which
is one percentage point
[[Page 307]]
greater than the actual rate of interest payable on the obligation. The
parties did not have adverse interests in agreeing upon an assumed price
(since an excessively large amount of original issue discount would
benefit O, the borrower, without adversely affecting Z, an exempt
organization which would pay no tax on original issue discount income),
and the price agreed to appears to be clearly erroneous when compared to
the $56,608 assumed issue price determined under the principles of (a)
of this subdivision. Since the maturity value of O's note is $60,000,
the original issue discount on O's note is $3,392 ($60,000 minus
$56,608). Under the rules in Sec. 1.163-3, O is entitled to a
deduction, to be prorated or amortized over the life of the note, equal
to this original issue discount on the note. The excess of the price
paid for the unit over the portion of such price allocable to the note,
$3,392 ($60,000 minus $56,608), is allocable to and is the basis of the
stock purchase warrants acquired by Z in connection with O's note. Upon
the exercise or sale of the warrants by Z, O will be allowed no
deduction and will have no income.
(iii) Issuance for property after May 27, 1969--(a) In general.
Except as provided in (b) of this subdivision, if an obligation or an
investment unit is issued for property other than money, the issue price
of such obligation shall be the stated redemption price at maturity and,
therefore, no original issue discount is created as a result of the
exchange. However, in such case, there may be an amount treated as
interest under section 483. In the case of certain exchanges of
obligations of the United States for other such obligations, see section
1037 for the determination of the amount of original issue discount on
the obligation acquired in the exchange. For carryover of original issue
discount in the case of certain exchanges of obligations, see
subparagraph (1)(iv) of this paragraph.
(b) Exceptions for original issue discount. If an obligation or
investment unit is issued for property in an exchange which is not
pursuant to a plan of reorganization referred to in (d) of this
subdivision, and if:
(1) The obligation, investment unit, or an element of the investment
unit is part of an issue a portion of which is traded on an established
securities market, or
(2) The property for which such obligation or investment unit is
issued is stock or securities which are traded on an established
securities market
then the issue price of the obligation or investment unit shall be the
fair market value of the property for which such obligation or
investment unit is issued, as determined under (c) of this subdivision.
Such issue price shall control for purposes of determining the amount
realized by the person exchanging the property for the obligation or
unit issued and the bases of the property acquired by the holder and
issuer.
An obligation which is not traded on an established securities market
and which is not part of an issue or investment unit a portion of which
is so traded shall not be treated as property described in (1) of this
(b) even though the obligation is convertible into property so traded.
For purposes of this (b), an obligation, investment unit, or element of
an investment unit shall be treated as traded on an established
securities market if it is so traded on or within 10 trading days after
the date it is issued. Trading days shall mean those days on which an
established securities market is open. For purposes of this subdivision
(iii), the term established securities market shall have the same
meaning as in paragraph (d)(4) of Sec. 1.453-3 (relating to limitations
on installment method for purchaser evidences of indebtedness payable on
demand or readily tradable).
(c) Determination of fair market value in cases to which (b) of this
subdivision applies. In general, for purposes of (b) of this
subdivision, the fair market value of property for which an obligation
or investment unit is issued shall be deemed to be the same as the fair
market value of such obligation or investment unit, determined by
reference to the fair market value of that portion of the issue, of
which such obligation or unit is a part, which is traded on an
established securities market. The fair market value of such obligation
or unit shall be determined as of the first date after the date of issue
(within the meaning of section 1232(b)(3)) that such obligation or unit
is traded on an established securities market. If, however, the
obligation or investment unit is not part of an issue a portion of which
is traded on an established securities market, but the property for
which the obligation or investment
[[Page 308]]
unit is issued is stock or securities which are traded on an established
securities market, the fair market value of such property shall be the
fair market value of such stock or securities on the date such
obligation or unit is issued for such property. The fair market value of
property for purposes of this (c) shall be determined as provided in
Sec. 20.2031-2 of this chapter (Estate Tax Regulations) but without
applying the blockage and other special rules contained in paragraph (e)
thereof.
(d) Not in reorganization. An exchange which is not pursuant to a
reorganization referred to in this subdivision (d) is an exchange in
which the obligation or investment unit is not issued pursuant to a plan
of reorganization within the meaning of section 368(a)(1) or pursuant to
an insolvency reorganization within the meaning of section 371, 373, or
374. Thus, for example, no original issue discount is created on an
obligation issued in a recapitalization within the meaning of section
368(a)(1)(E). Similarly, no original issue discount is created on an
obligation issued in an exchange, pursuant to a plan of reorganization,
to which section 361 applies regardless of the income tax consequences
to any person who pursuant to such plan is the ultimate recipient of the
obligation. The application of section 351 shall not preclude the
creation of original issue discount. For carryover of original issue
discount in the case of an exchange of obligations pursuant to a plan of
reorganization, see subparagraph (1)(iv) of this paragraph.
(e) Effective date. Determinations with respect to obligations
issued on or before May 27, 1969, or pursuant to a written commitment
which was binding on that date and at all times thereafter, shall be
made without regard to this subdivision (iii).
(iv) Serial obligations--(a) In general. If an issue of obligations
which matures serially is issued by a corporation, and if on the basis
of the facts and circumstances in such case an independent issue price
for each particular maturity can be established, then the obligations
with each particular maturity shall be considered a separate series, and
the obligations of each such series shall be treated as a separate issue
with a separate issue price, maturity date, and stated redemption price
at maturity. The ratable monthly portion of original issue discount
attributable to each obligation within a particular series shall be
determined and ratably included as interest in gross income under the
rules of Sec. 1.1232-3A.
(b) Issue price not independently established. If a separate issue
price cannot be established with respect to each series of an issue of
obligations which matures serially, the issue price for each obligation
of each series shall be its stated redemption price at maturity minus
the amount of original issue discount allocated thereto in accordance
with (d) of this subdivision. The amount of original issue discount so
allocated shall be ratably included as interest in gross income under
rules of Sec. 1.1232-3A.
(c) Single obligation rule. If a single corporate obligation
provides for payments (other than payments which would not be included
in the stated redemption price at maturity under subparagraph (1)(iii)
of this paragraph) in two or more installments, the provisions of (b) of
this subdivision shall be applied by treating such obligation as an
issue of obligations consisting of more than one series each of which
matures on the due date of each such installment payment.
(d) Allocation of discount. For purposes of (b) and (c) of this
subdivision, the original issue discount with respect to each series of
an issue shall be the total original issue discount for the issue
multiplied by a fraction:
(1) The numerator of which is the product of (i) the stated
redemption price of such series and (ii) the number of complete years
(and any fraction thereof) constituting the period for such series from
the date of original issue (as defined in paragraph (b)(3) of this
section) to its stated maturity date, and
(2) The denominator of which is the sum of the products determined
in (1) of this subdivision (d) with respect to each such series.
If a series consists of more than one obligation, the original issue
discount allocated to such series shall be apportioned to such
obligations in proportion to the stated redemption price of
[[Page 309]]
each. Computations under this subdivision (d) may be made using periods
other than years, such as, for example, months or periods of 3 months.
(e) Effective date. The provisions of this subdivision (iv) shall
apply with respect to corporate obligations issued after July 22, 1971.
However, no inference shall be drawn from the preceding sentence with
respect to serial obligations issued prior to such date.
(f) Examples. The provisions of this subdivision (iv) may be
illustrated by the following examples:
Example 1. On January 1, 1972, P Corporation issued a note with a
total face value of $100,000 to B for cash of $94,000. The terms of the
note provide that $50,000 is payable on December 31, 1973, and the other
$50,000 on December 31, 1975. Each payment is treated as the stated
redemption price of a series, and the total original issue discount with
respect to the note, $6,000, is allocated to each such series as
follows:
------------------------------------------------------------------------
Year of maturity 1973 1975 Total
------------------------------------------------------------------------
(1) Stated redemption price............ $50,000 $50,000
(2) Multiply by years outstanding...... 2 4
--------------------------------
(3) Product of bond years.............. $100,000 $200,000
(4) Sum of products.................... ......... ......... $300,000
(5) Fractional portion of discount..... $100,000 $200,000
--------------------------------
$300,000 $300,000
(6) Multiply line (5) by discount for $6,000 $6,000
entire issue..........................
----------------------
(7) Discount for each series........... $2,000 $4,000
======================
(8) Issue price (line (1), minus line $48,000 $46,000
(7))..................................
------------------------------------------------------------------------
Example 2. Assume the same facts as in example (1) except that a
separate note is issued for each payment. The result is the same as in
example (1).
Example 3. On January 1, 1971, Y Bank, a corporation, issues a note
to C for $1,000 cash. The terms of the note provide that $50 will be
paid at the end of the first year, $120 at the end of the second year,
and $1,050 at the end of the third year. Under (c) of this subdivision
(iv), the $1,000 note is treated as consisting of two series, the first
of which matures at the end of the second year, and the second of which
matures at the end of the third year. The issue price and the allocation
of original issue discount with respect to each series is computed as
follows:
------------------------------------------------------------------------
Year of maturity 1972 1973 Total
------------------------------------------------------------------------
(1) Stated redemption price............ $70 $1,000
(2) Multiply by years outstanding...... 2 3
----------------------
(3) Product of bond years.............. $140 $3,000
(4) Sum of products.................... ......... ......... $3,140
(5) Fractional portion of discount..... $140 $3,000
----------------------
$3,140 $3,140
(6) Multiply line (5) by discount for $70 $70
entire issue..........................
----------------------
(7) Discount for each series........... $3.12 $66.88
======================
(8) Issue price (line 1 minus line (7)) $66.88 $933.12
------------------------------------------------------------------------
(3) Date of original issue. In the case of issues of obligations
which are registered with the Securities and Exchange Commission, the
term date of original issue means the date on which the issue was first
sold to the public at the issue price. In the case of issues which are
privately placed, the term date of original issue means the date on
which each obligation was sold to the original purchaser.
(4) Intention to call before maturity--(i) Meaning of term. For
purposes of section 1232, the term intention to call the bond or other
evidence of indebtedness before maturity means an understanding between
(a) the issuing corporation (such corporation is hereinafter referred to
as the issuer), and (b) the original purchaser of such obligation (or,
in the case of obligations constituting part of an issue, any of the
original purchasers of such obligations) that the issuer will redeem the
obligation before maturity. For purposes of this subparagraph, the term
original purchaser does not include persons or organizations acting in
the capacity of underwriters or dealers, who purchased the obligation
for resale in the ordinary course of their trade or business. It is not
necessary that the issuer's intention to call the obligation before
maturity be communicated directly to the original purchaser by the
issuer. The understanding to call before maturity need not be
unconditional; it may, for example, be dependent upon the financial
condition of the issuer on the proposed early call date.
[[Page 310]]
(ii) Proof of intent--(a) In general. Ordinarily, the existence or
non-existance of an understanding at the time of original issue that the
obligation will be redeemed before maturity shall be determined by an
examination of all of the circumstances under which the obligation was
issued and held. The fact that the obligation is issued with provisions
on its face giving the issuer the privilege of redeeming the obligation
before maturity is not determinative of an intention to call before
maturity; likewise, the absence of such provision is not determinative
of the absence of an intention to call before maturity. However, such
provision, or the absence of such provision, is one of the circumstances
to be given consideration along with other factors in determining
whether an understanding existed. If the obligation was part of an issue
registered with the Securities and Exchange Commission and was sold to
the public (whether or not sold directly to the public by the obligor)
without representation to the public that the obligor intends to call
the obligation before maturity, there shall be a presumption that no
intention to call the obligation before maturity was in existence at the
time of original issue. The existence of a provision on the face of an
obligation giving the issuer the privilege of redeeming the obligation
before maturity shall not in and of itself overcome the presumption set
forth in the preceding sentence.
(b) Circumstances indicating absence of understanding. Examples of
circumstances which would be evidence that there was no understanding at
the time of original issue to redeem the obligation before maturity are:
(1) The issue price and term of the obligation appear to be
reasonable, taking into account the interest rate, if any, on the
obligation, for a corporation in the financial condition of the issuer
at the time of issue.
(2) The original purchaser and the issuer are not related within the
meaning of section 267(b) and have not engaged in transactions with each
other (other than concerning the obligation).
(3) The original purchaser is not related within the meaning of
section 267(b) to any of the officers or directors of the issuer, and he
has not engaged in transactions with such officers or directors (other
than concerning the obligation).
(4) The officers and directors of the issuer at the time of issue of
the obligation are different from those in control at the time the
obligation is called or the taxpayer disposes of it.
(c) Gain treated as ordinary income in certain cases; computation.
The amount of gain treated as ordinary income under paragraph (a)
(3)(ii) or (5) of this section is computed by multiplying the original
issue discount by a fraction, the numerator of which is the number of
full months the obligation was held by the holder and the denominator of
which is the number of full months from the date of original issue to
the date specified as the redemption date at maturity. (See paragraph
(b)(3) of this section for definition of date of original issue.) The
period that the obligation was held by the taxpayer shall include any
period that it was held by another person if, under chapter 1 of the
Code, for the purpose of determining gain or loss from a sale or
exchange, the obligation has the same basis, in whole or in part, in the
hands of the taxpayer as it would have in the hands of such other
person. This computation is illustrated by the following examples:
Example 1. An individual purchases a 10-year, 3-percent coupon bond
for $900 on original issue on February 1, 1955, and sells it on February
20, 1960, for $940. The redemption price is $1,000. At the time of
original issue, there was no intention to call the bond before maturity.
The bond has been held by the taxpayer for 60 full months. (The
additional days amounting to less than a full month are not taken into
account.) The number of complete months from date of issue to date of
maturity is 120 (10 years). The fraction \60/120\ multiplied by the
discount of $100 is equal to $50, which represents the proportionate
part of the original issue discount attributable to the period of
ownership by the taxpayer. Accordingly, any part of the gain up to $50
will be treated as ordinary income. Therefore, in this case the entire
gain of $40 is treated as ordinary income.
Example 2. Assume the same facts in the preceding example, except
that the selling price of the bond is $970. In this case $50 of the gain
of $70 is treated as ordinary income and the balance of $20 is treated
as long-term capital gain.
Example 3. Assume the same facts as in example (1), except that the
selling price of the
[[Page 311]]
bond is $800. In this case, the individual has a long-term capital loss
of $100.
Example 4. Assume the same facts as in example (1), except that the
bond is purchased by the second holder February 1, 1960, for $800. The
second holder keeps it to the maturity date (February 1, 1965) when it
is redeemed for $1,000. Since that holder has held the bond for 60 full
months, he will, upon redemption, have $50 in ordinary income and $150
in long-term capital gain.
(d) Exceptions to the general rule--(1) In general. Section
1232(a)(2)(C) provides that section 1232(a)(2) does not apply (i) to
obligations the interest on which is excluded from gross income under
section 103 (relating to certain government obligations), or (ii) to any
holder who purchases an obligation at a premium.
(2) Premium. For purposes of section 1232, this section, and Sec.
1.1232-3A, premium means a purchase price which exceeds the stated
redemption price of an obligation at its maturity. For purposes of the
preceding sentence, if an obligation is acquired as part of an
investment unit consisting of an option, security, or other property and
an obligation, the purchase price of the obligation is that portion of
the price paid or payable for the unit which is allocable to the
obligation. The price paid for the unit shall be allocated to the
individual elements of the unit on the basis of their respective fair
market values. However, if the fair market value of the option,
security, or other property is not readily ascertainable (within the
meaning of paragraph (c) of Sec. 1.421-6), then the price paid for the
unit shall be allocated in accordance with the rules under paragraph
(b)(2)(ii) of this section for allocating the initial offering price of
an investment unit to its elements. If, under chapter 1 of the Code, the
basis of an obligation in the hands of the holder is the same, in whole
or in part, for the purposes of determining gain or loss from a sale or
exchange, as the basis of the obligation in the hands of another person
who purchased the obligation at a premium, then the holder shall be
considered to have purchased the obligation at a premium. Thus, the
donee of an obligation purchased at a premium by the doner will be
considered a holder who purchased the obligation at a premium.
(e) Amounts previously includible in income. Nothing in section
1232(a)(2) shall require the inclusion of any amount previously
includible in gross income. Thus, if an amount was previously includible
in a taxpayer's income on account of obligations issued at a discount
and redeemable for fixed amounts increasing at stated intervals, or,
under section 818(b) (relating to accrual of discount on bonds and other
evidences of indebtedness held by life insurance companies), such amount
is not again includible in the taxpayer's gross income under section
1232(a)(2). For example, amounts includible in gross income by a cash
receipts and disbursements method taxpayer who has made an election
under section 454 (a) or (c) (relating to accounting rules for certain
obligations issued at a discount to which section 1232(a)(3) does not
apply) are not includible in gross income under section 1232(a)(2). In
the case of a gain which would include, under section 1232(a)(2), an
amount considered to be ordinary income and a further amount considered
long-term capital gain, any amount to which this paragraph applies is
first used to offset the amount considered ordinary income. For example,
on January 1, 1955, A purchases a 10-year bond which is redeemable for
fixed amounts increasing at stated intervals. At the time of original
issue, there was no intention to call the bond before maturity. The
purchase price of the bond is $75, which is also the issue price. The
stated redemption price at maturity of the bond is $100. A elects to
treat the annual increase in the redemption price of the bond as income
pursuant to section 454(a). On January 1, 1960, A sells the bond for
$90. The total stated increase in the redemption price of the bond which
A has reported annually as income for the taxable years 1955 through
1959 is $7. The portion of the original issue discount of $25
attributable to this period is $12.50, computed as follows:
60 (months bond is held by A)/120 (months from date of original issue to
redemption date) x $25 (original issue discount)
However, $7, which represents the annual stated increase taken into
income, is offset against the amount of
[[Page 312]]
$12.50, leaving $5.50 of the gain from the sale to be treated as
ordinary income.
(f) Recordkeeping requirements. In the case of any obligation held
by a taxpayer which was issued at an original issue discount after
December 31, 1954, the taxpayer shall keep a record of the issue price
and issue date upon or with each obligation (if known to or reasonably
ascertainable by him). If the obligation held by the taxpayer is an
obligation of the United States received from the United States in an
exchange upon which gain or loss is not recognized because of section
1037 (a) (or so much of section 1031 (b) or (c) as relates to section
1037(a)), the taxpayer shall keep sufficient records to determine the
issue price of such obligation for purposes of applying section 1037(b)
and paragraphs (a) and (b) of Sec. 1.1037-1 upon the disposition or
redemption of such obligation. The issuer (or in the case of obligations
first sold to the public through an underwriter or wholesaler, the
underwriter or wholesaler) shall mark the issue price and issue date
upon every obligation which is issued at an original issue discount
after September 26, 1957, but only if the period between the date of
original issue (as defined in paragraph (b)(3) of this section) and the
stated maturity date is more than 6 months.
[T.D. 6500, 25 FR 12008, Nov. 26, 1960, as amended by T.D. 6984, 33 FR
19176, Dec. 21, 1968; T.D. 7154, 36 FR 25000, Dec. 28, 1971; 37 FR 527,
Jan. 13, 1972; T.D. 7213, 37 FR 21992, Oct. 18, 1972; 37 FR 22863, Oct.
26, 1972; T.D. 7663, 44 FR 76782, Dec. 28, 1979; T.D. 7728, 45 FR 72650,
Nov. 3, 1980]
Sec. 1.1232-3A Inclusion as interest of original issue discount
on certain obligations issued after May 27, 1969.
(a) Ratable inclusion as interest--(1) General rule. Under section
1232(a)(3), the holder of any obligation issued by a corporation after
May 27, 1969 (other than an obligation issued by or on behalf of the
United States or a foreign country, or a political subdivision of
either) shall include as interest in his gross income an amount equal to
the ratable monthly portion of original issue discount multiplied by the
sum of the number of complete months and any fractional part of a month
such holder held the obligation during the taxable year. For increase in
basis for amounts included as interest in gross income pursuant to this
paragraph, see paragraph (c) of this section. For requirements for
reporting original issue discount, see section 6049(a) and the
regulations thereunder.
(2) Ratable monthly portion of original issue discount--(i) General
rule. Except when subdivision (ii) of this subparagraph applies, the
term ratable monthly portion of original issue discount means an amount
equal to the original issue discount divided by the sum of the number of
complete months (plus any fractional part of a month) beginning on the
date of original issue and ending the day before the stated maturity
date of such obligation.
(ii) Reduction for purchase allowance. With respect to an obligation
which has been acquired by purchase (within the meaning of subparagraph
(4) of this paragraph), the term ratable monthly portion of original
issue discount means the lesser of the amount determined under
subdivision (i) of this subparagraph or an amount equal to:
(a) The excess (if any) of the stated redemption price of the
obligation at maturity over its cost to the purchaser divided by
(b) The sum of the number of complete months (plus any fractional
part of a month) beginning on the date of such purchase and ending the
day before the stated maturity date of such obligation.
The amount of the ratable monthly portion within the meaning of this
subdivision reflects a purchase allowance provided under section
1232(a)(3)(B) where a purchase is made at a price in excess of the sum
of the issue price plus the portion of original issue discount
previously includible (regardless of whether included) in the gross
income of all previous holders (computed, however, as to such previous
holders without regard to any purchase allowance under this subdivision
and without regard to whether any previous holder purchased at a
premium).
(iii) Ratable monthly portion upon carryover to new obligation. In
any case in which there is a carryover of original issue discount under
paragraph (b)(1)(iv) of Sec. 1.1232-3 from an obligation exchanged to
an obligation received in
[[Page 313]]
such exchange, the ratable monthly portion of original issue discount in
respect of the obligation received shall be computed by dividing the
amount of original issue discount carried over by the sum of the number
of complete months (plus any fractional part of a month) beginning on
the date of the exchange and ending the day before the stated maturity
date of the obligation received.
(iv) Cross references. For definitions of the terms original issue
discount and date of original issue, see subparagraphs (1) and (3)
respectively, of Sec. 1.1232-3(b). For definition of the term premium,
see paragraph (d)(2) of Sec. 1.1232-3.
(3) Determination of number of complete months--(i) In general. For
purposes of this section:
(a) A complete month and a fractional part of a month commence with
the date of original issue and the corresponding day of each succeeding
calendar month (or the last day of a calendar month in which there is no
corresponding day),
(b) If an obligation is acquired on any day other than the date a
complete month commences, the ratable monthly portion of original issue
discount for the complete month in which the acquisition occurs shall be
allocated between the transferor and the transferee in accordance with
the number of days in such complete month each held the obligation,
(c) In determining the allocation under (b) of this subdivision, any
holder may treat each month as having 30 days,
(d) The transferee, and not the transferor, shall be deemed to hold
the obligation during the entire day on the date of acquisition, and
(e) The obligor will be treated as the transferee on the date of
redemption.
(ii) Example. The provisions of this subparagraph may be illustrated
by the following example:
Example: On February 22, 1970, A acquires an obligation of X
Corporation for which February 1, 1970, is the date of original issue. B
acquires the obligation on June 16, 1970. A does not choose to treat
each month as having 30 days. Thus, A held the obligation for 3\3/4\
months during 1970, i.e., one-fourth of February (\7/28\ days), March,
April, May, one-half of June (\15/30\ days). The ratable monthly portion
of original issue discount for the obligation is multiplied by 3\3/4\
months to determine the amount included in A's gross income for 1970
pursuant to this paragraph.
(4) Purchase. For purposes of this section, the term purchase means
any acquisition (including an acquisition upon original issue) of an
obligation to which this section applies, but only if the basis of such
obligation is not determined in whole or in part by reference to the
adjusted basis of such obligation in the hands of the person from whom
it was acquired or under section 1014(a) (relating to property acquired
from a decedent).
(b) Exceptions--(1) Binding commitment. Section 1232(a)(3) shall not
apply to any obligation issued pursuant to a written commitment which
was binding on May 27, 1969, and at all times thereafter.
(2) Exception for 1-year obligations. Section 1232(a)(3) shall not
apply to any obligation in respect of which the period between the date
of original issue (as defined in paragraph (b)(3) of Sec. 1.1232-3) and
the stated maturity date is 1 year or less. In such case, gain on the
sale or exchange of such obligation shall be included in gross income as
interest to the extent the gain does not exceed an amount equal to the
ratable monthly portion of original issue discount multiplied by the sum
of the number of complete months and any fractional part of a month such
taxpayer held such obligation.
(3) Purchase at a premium. Section 1232(a)(3) shall not apply to any
holder who purchased the obligation at a premium (within the meaning of
paragraph (d)(2) of Sec. 1.1232-3).
(4) Life insurance companies. Section 1232(a)(3) shall not apply to
any holder which is a life insurance company to which section 818(b)
applies. However, ratable inclusion of original issue discount as
interest under section 1232(a)(3) is required by an insurance company
which is subject to the tax imposed by section 821 or 831.
(c) Basis adjustment. The basis of an obligation in the hands of the
holder thereof shall be increased by any amount of original issue
discount with respect thereto included as interest in his gross income
pursuant to paragraph (a) of this section. See section 1232(a)(3)(E).
However, the basis of an
[[Page 314]]
obligation shall not be increased by any amount that was includible as
interest in gross income under paragraph (a) of this section, but was
not actually included by the holder in his gross income.
(d) Examples. The provisions of paragraphs (a) through (c) of this
section may be illustrated by the following examples:
Example 1. On January 1, 1970, A, a calendar-year taxpayer,
purchases at original issue, for cash of $7,600, M Corporation's 10-
year, 5-percent bond which has a stated redemption price of $10,000. The
ratable monthly portion of original issue discount, as determined under
section 1232(a)(3) and this section, to be included as interest in A's
gross income for each month he holds such bond is $20, computed as
follows:
Original issue discount (stated redemption price, $2,400
$10,000, minus issue price, $7,600)..............
Divide by: Number of months from date of original 120 months
issue to stated maturity date....................
-----------
Ratable monthly portion........................... $20
Assume that A holds the bond for all of 1970 and 1971 and includes as
interest in his gross income for each such year an amount equal to the
ratable monthly portion, $20, multiplied by the number of months he held
the bond each such year, 12 months, or $240. Accordingly, on January 1,
1972, A's basis in the bond will have increased under paragraph (c) of
this section by the amount so included, $480 (i.e., $240 x 2), from his
cost, $7,600, to $8,080. For results if A sells the bond on that date,
see examples (1) and (2) of paragraph (a)(2) of Sec. 1.1282-3.
Example 2. Assume the same facts as in example (1). Assume further
that on January 1, 1972, A sells the bond to B, a calendar-year taxpayer
for $9,040.
Since B purchased the bond, he determines under paragraph (a)(2)(ii) of
this section the amount of the ratable monthly portion he must include
as interest in his gross income in order to reflect the amount of his
purchase allowance (if any). B determines that his ratable monthly
portion is $10, computed as follows:
(1) Stated redemption price at maturity........... $10,000
(2) Minus: B's cost............................... $9,040
-----------
(3) Excess........................................ $960
(4) Divide by: Number of months from date of 96 months
purchase to stated maturity date.................
(5) Tentative ratable monthly portion............. $10
-----------
(6) Ratable monthly portion as computed in example $20
(1)..............................................
Since line (5) is lower than line (6), B's ratable monthly portion is
$10. Accordingly, if B holds the bond for all of 1972, he must include
$120 (i.e., ratable monthly portion, $10 x 12 months) as interest in his
gross income.
Example 3. (1) Assume the same facts as in example (1). Assume
further that on January 1, 1975, A sells the bond to B for $10,150.
Under the exception of paragraph (b)(3) of this section, B is not
required to include any amount in respect of original issue discount as
interest in his gross income since he has purchased the bond at a
premium.
(2) On January 1, 1979, B sells the bond to C, a calendar-year
taxpayer, for $9,940. Since C is now the holder of the bond (and no
exception applies to him), he must include as interest in his gross
income the ratable monthly portion of original issue determined under
section 1232(a)(3) and this section. Since C purchased the bond he
determines under paragraph (a)(2)(ii) of this section the amount of the
ratable monthly portion he must include as interest in his gross income
in order to reflect the amount of his purchase allowance (if any). C
determines that his ratable monthly portion is $5, computed as follows:
(1) Stated redemption price at maturity........... $10,000
(2) Minus: C's cost............................... $9,940
-----------
(3) Excess........................................ $60
(4) Divide by: Number of months from date of 12 months
purchase to stated maturity date.................
-----------
(5) Tentative ratable monthly portion............. $5
(6) Ratable monthly portion as computed in example $20
(1)..............................................
Since line (5) is lower than line (6), C's ratable monthly portion is
$5. Accordingly, if C holds the bond for all of 1979, he must include
$60 (i.e., ratable monthly portion, $5, x 12 months) as interest in his
gross income. Upon maturity of the bond on January 1, 1980, C will
receive $10,000 from M, which under paragraph (c) of this section will
equal his adjusted basis (the sum of his cost, $9,940, plus original
issue discount included as interest in his gross income, $60).
Example 4. On January 1, 1968, D, a calendar-year taxpayer,
purchases at original issue, for cash of $8,000, P Corporation's 20-
year, 6 percent bond which has a stated redemption price of $10,000 and
which will mature on January 1, 1988. The original issue discount with
respect to such bond is $2,000. However, the ratable inclusion rules of
section 1232(a)(3) do not apply to D, since the bond was issued by P
before May 28, 1969. On January 1, 1973, pursuant to a plan of
reorganization as defined in section 368(a)(1)(E), and in which no gain
or loss is recognized by D under section 354, D's 20-year bond is
exchanged for a 10-year, 6 percent bond which also has a stated
redemption price of $10,000
[[Page 315]]
but will mature on January 1, 1983. Under paragraph (b)(1)(iv) of Sec.
1.1232-3, the $2,000 of original issue discount is carried over to the
new 10-year bond received in such exchange. Since the new bond is an
obligation issued after May 27, 1969, D is required to begin ratable
inclusion of the $2,000 of discount as interest in his gross income for
1973. The ratable monthly portion of original issue discount, as
determined under section 1232(a)(3) to be included as interest in gross
income is computed as follows:
Amount of original issue discount carried over.... $2,000
Divide by: Number of complete months beginning on 120 months
January 1, 1973, and ending on December 31, 1982.
-----------
Ratable monthly portion........................... $16.67
(e) Application of section 1232 to certain deposits in financial
institutions and similar arrangements--(1) In general. Under paragraph
(d) of Sec. 1.1232-1, the term other evidence of indebtedness includes
certificates of deposit, time deposits, bonus plans, and other deposit
arrangements with banks, domestic building and loan associations, and
similar financial institutions.
(2) Adjustments where obligation redeemed before maturity--(i) In
general. If an obligation described in subparagraph (1) of this
paragraph is redeemed for a price less than the stated redemption price
at maturity from a taxpayer who acquired the obligation upon original
issue, such taxpayer shall be allowed as a deduction, in computing
adjusted gross income, the amount of the original issue discount he
included in gross income but did not receive (as determined under
subdivision (ii) of this subparagraph). The taxpayer's basis of such
obligation (determined after any increase in basis for the taxable year
under section 1232(a)(3)(E) by the amount of original issue discount
included in the holder's gross income under section 1232(a)(3)) shall be
decreased by the amount of such adjustment.
(ii) Computation. The amount of the adjustment under subdivision (i)
of this subparagraph shall be an amount equal to the excess (if any) of
(a) the ratable monthly portion of the original issue discount included
in the holder's gross income under section 1232(a)(3) for the period he
held the obligation, over (b) the excess (if any) of the amount received
upon the redemption over the issue price. Under paragraph (b)(1)(iii)(a)
of Sec. 1.1232-3, if any amount based on a fixed rate of simple or
compound interest is actually payable or will be treated as
constructively received under section 451 and the regulations thereunder
at fixed periodic intervals of 1 year or less during the term of the
obligation, any such amount payable upon redemption shall not be
included in determining the amount received upon such redemption.
(iii) Partial redemption. (a) In the case of an obligation (other
than a single obligation having serial maturity dates), if a portion of
the obligation is redeemed prior to the stated maturity date of the
entire obligation, the provisions of this subdivision shall be applied
and not the provisions of subdivision (ii) of this subparagraph. In such
case, the adjusted basis of the unredeemed portion of the obligation on
the date of the partial redemption shall be an amount equal to the
adjusted basis of the entire obligation on that date minus the amount
paid upon the redemption.
(b) If the adjusted basis of the unredeemed portion (as computed
under (a) of this subdivision) is equal to or in excess of the amount to
be received for the unredeemed portion at maturity, no gain or loss
shall be recognized at the time of the partial redemption but the holder
shall be allowed a deduction, in computing adjusted gross income for the
taxable year during which such partial redemption occurs, equal to the
amount of such excess (if any), and no further original issue discount
will be includible in the holder's gross income under section 1232(a)(3)
over the remaining term of the unredeemed portion. In such case, the
holder shall decrease his basis in the unredeemed portion (as computed
under (a) of this subdivision) by the amount of such adjustment.
(c) If the adjusted basis of the unredeemed portion (as computed
under (a) of this subdivision) is less than the redemption price of the
unredeemed portion at maturity, a new
[[Page 316]]
computation shall be made under paragraph (a) of this section (without
regard to the exception for one-year obligations in paragraph (b)(2) of
this section) of the ratable monthly portion of original issue discount
to be included as interest in the gross income of the holder over the
remaining term of the unredeemed portion. For purposes of such
computation, the adjusted basis of the unredeemed portion shall be
treated as the issue price, the date of the partial redemption shall be
treated as the issue date, and the amount to be paid for the unredeemed
portion at maturity shall be treated as the stated redemption price.
(3) Examples. The application of section 1232 to obligations to
which this paragraph applies may be illustrated by the following
examples:
Example 1. A is a cash method taxpayer who uses the calendar year as
his taxable year. On January 1, 1971, he purchases a certificate of
deposit from X Bank, a corporation, for $10,000. The certificate of
deposit is not redeemable until December 31, 1975, except in an
emergency as defined in, and subject to the qualifications provided by,
Regulation Q of the Board of Governors of the Federal Reserve. See 12
CFR 217.4(d). The stated redemption price at maturity is $13,382.26. The
terms of the certificate do not expressly refer to any amount as
interest. A's certificate of deposit is an obligation to which section
1232 and this paragraph apply. A shall include the ratable portion of
original issue discount in gross income for 1971 as determined under
section 1232(a)(3). Thus, if A holds the certificate of deposit for the
full calendar year 1971, the amount to be included in A's gross income
for 1971 is $676.45, that is, \12/60\ months, multiplied by the excess
of the stated redemption price ($13,382.26) over the issue price
($10,000).
Example 2. Assume the same facts as in example (1), except that the
certificate of deposit provides for payment upon redemption at December
31, 1975, of an amount equal to ``$10,000, plus 6 percent compound
interest from January 1, 1971, to December 31, 1975.'' Thus, the total
amount payable upon redemption in both example (1) and this example is
$13,382.26. The certificate of deposit is an obligation to which section
1232 and this paragraph apply and, since the substance of the deposit
arrangement is identical to that contained in example (1), A must
include the same amount in gross income.
Example 3. Assume the same facts as in example (1), except that the
certificate provides for the payment of interest in the amount of $200
on December 31, of each year and $2,000 plus $10,000 (the original
amount) payable upon redemption at December 31, 1975. Thus, if A holds
the certificate of deposit for the full calendar year 1971, A must
include in his gross income for 1971 the $200 interest payable on
December 31, 1971, and $400 of original issue discount, that is, \12/60\
months multiplied by the excess of the stated redemption price ($12,000)
over the issue price ($10,000).
Example 4. B is a cash method taxpayer who uses the calendar year as
his taxable year. On January 1, 1971, B purchases a 4-year savings
certificate from the Y Building and Loan Corporation for $4,000,
redeemable on December 31, 1974, for $5,000. On December 31, 1973, Y
redeems the certificate for $4,660. Under section 1232(a)(3), B included
$250 of original issue discount in his gross income for 1971, $250 for
1972, and includes $250 in his gross income for 1973 for a total of
$750. Since the excess of (i) the amount received upon the redemption,
$4,660, over (ii) the issue price, $4,000, or $660, is lower than the
total amount of original issue discount ($750) included in B's gross
income for the period he held the certificate by $90, the $90 will be
treated under subparagraph (2) of this paragraph as a deduction in
computing adjusted gross income, and accordingly, will decrease the
basis of his certificate by such amount. B has no gain or loss upon the
redemption, as determined in accordance with the following computation:
Adjusted basis January 1, 1973.............................. $4,500
Increase under section 1232(a)(3)(E)........................ 250
-----------
Subtotal................................................ 4,750
Decrease under subparagraph (b)(2) of this paragraph........ 90
-----------
Basis upon redemption....................................... 4,660
Amount realized upon redemption............................. 4,660
-----------
Gain or loss............................................ 0
Example 5. On January 1, 1971, C, a cash method taxpayer who uses
the calendar year as his taxable year, opens a savings account in Z bank
with a $10,000 deposit. Under the terms of the account, interest is made
available semiannually at 6 percent annual interest, compounded
semiannually. Since all of the interest on C's account in Z Bank is made
available semiannually, the stated redemption price at maturity under
paragraph (b)(1)(iii)(a) of Sec. 1.1232-3 equals the issue price, and,
therefore, no original issue discount is reportable by C under section
1232(a)(3). However, C must include the sum of $300 (i.e., \1/2\ x 6% x
$10,000) plus $309 (i.e., \1/2\ x 6% x $10,300) or $609, of interest
made available during 1971 in his gross income for 1971.
Example 6. (i) D is a cash method taxpayer who uses the calendar
year as his taxable year. On January 1, 1971, D purchases a $10,000
deferred income certificate from M
[[Page 317]]
Bank. Under the terms of the certificate, interest accrues at 6 percent
per annum, compounded quarterly. The period of the account is 10 years.
In addition, the holder is permitted to withdraw the entire amount of
the purchase price at any time (but not interest prior to the expiration
of the 10 year term), and upon such a withdrawal of the purchase price,
no further interest accrues. If the certificate is held to maturity, the
issue price plus accrued interest will aggregate $18,140.18.
(ii) In respect of the certificate, the original issue discount is
$8,140.18, determined by subtracting the issue price of the certificate
($10,000) from the stated redemption price at maturity ($18,140.18).
Thus, under section 1232(a)(3) the ratable monthly portion of original
issue discount is $67.835 (i.e., \1/20\ months, multiplied by
$8,140.18). Under section 1232(a)(3), D includes $814.02 (i.e., 12
months, multiplied by $67.835) in his gross income for each calendar
year the certificate remains outstanding and under section 1232(a)(3)(E)
increases his basis by that amount. Thus, on December 31, 1975, D's
basis for the certificate is $14,070.10 (i.e., issue price, $10,000,
increased by product of $814.02 x 5 years).
(iii) On December 31, 1975, D withdraws the $10,000. Under the terms
of the certificate $3,468.55 cannot be withdrawn until December 31,
1980. Under the provisions of subparagraph (2)(iii) of this paragraph,
the $10,000 partial redemption shall be treated as follows:
(1) Adjusted basis of obligation at time of partial $14,070.10
redemption.................................................
(2) Amount paid upon redemption............................. 10,000.00
-----------
(3) Adjusted basis of unredeemed portion (line (1) less line 4,070.10
(2)).......................................................
(4) Amount to be paid for unredeemed portion at maturity 3,468.55
(December 31, 1980)........................................
-----------
(5) Adjustment in computing adjusted gross income (excess of 601.55
line (3) over line (4))....................................
Since the adjusted basis of the unredeemed portion exceeds the amount to
be received for the unredeemed portion at maturity, D is allowed a
deduction, in computing adjusted gross income, of $601.25 in 1975 and no
further original issue discount is includible as interest in his gross
income. In addition, D will decrease his basis in the unredeemed portion
by $601.55, the amount of such adjustment, from $4,070.10 to $3,468.55.
Example 7. E is a cash method taxpayer who uses the calendar year as
his taxable year. On January 1, 1971, E purchases a $10,000 ``Bonus
Savings Certificate'' from N Building and Loan Corporation. Under the
terms of the certificate, interest is payable at 5 percent per annum,
compounded quarterly, and the period of the account is 3 years. In
addition, the certificate provides that if the holder makes no
withdrawals of principal or interest during the term of the certificate,
a bonus payment equal to 5 percent of the purchase price of the
certificate will be paid to the holder of the certificate at maturity.
Thus, the amount of the bonus payment is $500 (i.e., 5 percent
multiplied by $10,000). Since the 5 percent annual interest is payable
quarterly, the amount of such interest is not included in determining
the stated redemption price at maturity under paragraph (b)(1)(iii) of
Sec. 1.1232-3. However, since the bonus payment is only payable at
maturity, the amount of such bonus is included as part of the stated
redemption price at maturity. Thus, the stated redemption price at
maturity equals $10,500 (purchase price, $10,000, plus bonus payment
$500). Accordingly, the original issue discount attributable to such
certificate equals $500 (stated redemption price at maturity. $10,500,
minus issue price, $10,000). Therefore, E must include as interest
$166.67 (i.e., \12/36\ months, multiplied by the original issue
discount, $500) in his gross income for each taxable year he holds the
certificate.
(4) Renewable certificates of deposit--(i) In general. The renewal
of a certificate of deposit shall be treated as a purchase of the
certificate on the date the renewal period begins regardless of any
requirement pursuant to the terms of the certificate that the holder
give notice of an intention to renew or not to renew. Thus, for example,
in the case of a certificate of deposit for which a renewal period
begins after December 31, 1970, such renewal shall be treated as a
purchase after such date whether or not the initial period began before
such date.
(ii) Computation. For purposes of computing the amount of original
issue discount to be ratably included as interest in gross income under
section 1232(a)(3) in respect of a renewable certificate of deposit for
the initial period or any renewal period, the following rules apply:
(a) The issue price on the date any renewal period begins is
considered to be in the case of a certificate of deposit initially
purchased:
(1) After December 31, 1970, the adjusted basis of the certificate
on the date such period begins,
(2) Before January 1, 1971, the amount the adjusted basis would have
been on the date such period begins had the holder included all amounts
of original issue discount as interest in gross income that would have
been includible if section 1232(a)(3) had applied
[[Page 318]]
to the certificate from the date of original purchase.
Thus, if under the terms of the certificate, no amount is forfeited upon
a failure to renew, then the issue price on the date any renewal period
begins is considered to be the amount which would have been received by
the holder on such date had it not been renewed.
(b) The date of original issue for any renewal period shall be
considered to be the date it begins.
(c) The date of maturity for the initial period or any renewal
period shall be considered to be the date it ends.
(d) The stated redemption price at maturity for the initial period
or any renewal period shall be considered to be the maximum amount which
would be received at the end of any such period, without regard to any
reduction resulting from withdrawal prior to maturity or failure to
renew at any renewal date.
(iii) Application of 1-year rule. For purposes of paragraph (b)(2)
of this section (relating to nonapplication of section 1232(a)(3) to any
obligation having a term of 1 year or less), the period between the date
of original issue (as defined in paragraph (b)(3) of Sec. 1.1232-3) of
a renewable certificate of deposit and its stated maturity date shall
include all renewal periods with respect to which, under the terms of
the certificate, the holder may either take action or refrain from
taking action which would prevent the actual or constructive receipt of
any interest on such certificate until the expiration of any such
renewal period whether or not the original date of issue is prior to
January 1, 1971.
(iv) Example. The provisions of this subparagraph may be illustrated
by the following example:
Example: (a) On May 1, 1969, A purchases a 2-year renewable
certificate of deposit from M bank, a corporation, for $10,000. Interest
will be compounded semiannually at 6 percent on May 1 and November 1.
The terms of the certificate provide that such certificate will be
automatically renewed on the anniversary date every 2 years if the
holder does not notify M of an intention not to renew prior to 60 days
before the particular anniversary date. Thus, on May 1, 1971, and May 1,
1973, the certificate may be redeemed for $11,255.09 and $12,667.60,
respectively. However, in no event shall the initial period and the
renewal periods exceed 10 years. A does not notify M of an intention not
to renew by March 1, 1971, and the certificate is automatically renewed
for an additional 2-year period on May 1, 1971.
(b) Under subdivision (i) of this subparagraph, the May 1, 1971,
renewal shall be treated as the purchase of a certificate of deposit on
that date, i.e., after December 31, 1970. Under subdivision (ii) of this
subparagraph, the issue price is considered to be $11,255.09 and the
date of maturity is considered to be May 1, 1973. Since the stated
redemption price at maturity is $12,667.60. A must include $58.85 as
interest in gross income for each month he holds the certificate during
the renewal period beginning May 1, 1971, computed as follows:
Original issue discount (stated redemption price, $1,412.51
$12,667.60, minus issue price, $11,255.09).................
Divided by: Number of months from renewal to maturity date.. 24 months
-----------
Ratable monthly portion..................................... $58.85
(5) Time deposit open account arrangements--(i) In general. The term
time deposit open account arrangement means an arrangement with a fixed
maturity date where deposits may be made from time to time and
ordinarily no interest will be paid or constructively received until
such fixed maturity date. All deposits pursuant to such an arrangement
constitute parts of a single obligation. The amount of original issue
discount to be ratably included as interest in the gross income of the
depositor for any taxable year shall be the sum of the amounts
separately computed for each deposit. For this purpose, the issue price
for a deposit is the amount thereof and the stated redemption price at
maturity is computed under paragraph (b)(1)(iii)(d) of Sec. 1.1232-3.
(ii) Obligations redeemed before maturity. In the event of a partial
redemption of a time deposit open account before maturity, the following
rules, in addition to subparagraph (2) of this paragraph, shall apply:
(a) If, pursuant to the terms of the withdrawal, the amount received
by the depositor is determined with reference to the principal amount of
a specific deposit and interest earned from the date of such deposit,
then such terms shall control for the purpose of determining which
deposit was withdrawn.
(b) If (a) of this subdivision (ii) does not apply, then the
withdrawal shall be
[[Page 319]]
deemed to be of specific deposits together with interest earned from the
date of such deposits, on a first-in, first-out basis.
(iii) Examples. The provisions of this subparagraph may be
illustrated by the following examples:
Example 1. (i) F is a cash method taxpayer who uses the calendar
year as his taxable year. On December 1, 1970, F enters into a 5-year
deposit open account arrangement with M Savings and Loan Corp. The terms
of the arrangement provide that F will deposit $100 each month for a
period of 5 years, and that interest will be compounded semiannually (on
June 1 and December 1) at 6 percent, but will be paid only at maturity.
Thus, assuming F makes deposits of $100 on the first of each month
beginning with December 1, 1970, the account will have a stated
redemption price of $6,998.20 at maturity on December 1, 1975. Since,
however, section 1232 applies only to deposits made after December 31,
1970 (see paragraph (d) of Sec. 1.1232-1), the $34.39 of compound
interest to be earned on the first deposit of $100 over the term of the
arrangement will not be subject to the ratable inclusion rules of
section 1232(a)(3). F must include such $34.39 of interest in his gross
income on December 1, 1975, the date it is paid.
(ii) For 1971, F must include $44.19 of original issue discount as
interest in gross income, to be computed as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (6) (7)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1971 original
Months to Redemption Original issue Ratable monthly Months on issue discount
Date of $100 deposit maturity price at discount portion (Col.4 / deposit in (Col.5 x
maturity (Col.3-$100) Col.2) 1971 Col.6)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1-1-71....................................................... 59 $133.73 $33.73 $0.5717 12 $6.86
2-1-71....................................................... 58 133.07 33.07 .5702 11 6.27
3-1-71....................................................... 57 132.42 32.42 .5688 10 5.69
4-1-71....................................................... 56 131.77 31.77 .5673 9 5.11
5-1-71....................................................... 55 131.12 31.12 .5658 8 4.53
6-1-71....................................................... 54 130.48 30.48 .5644 7 3.95
7-1-71....................................................... 53 129.84 29.84 .5630 6 3.38
8-1-71....................................................... 52 129.20 29.20 .5615 5 2.81
9-1-71....................................................... 51 128.56 28.56 .5600 4 2.24
10-1-71...................................................... 50 127.93 27.93 .5586 3 1.68
11-1-71...................................................... 49 127.30 27.30 .5571 2 1.11
12-1-71...................................................... 48 126.68 26.68 .5558 1 0.56
-------------
Total original issue discount to be included as interest in F's gross income for 1971............................................... 44.19
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 2. (i) G is a cash method taxpayer who uses the calendar
year as his taxable year. On February 1, 1971, G enters into a 4-year
deposit open account arrangement with T Bank, a corporation. The terms
of the deposit arrangement provide that G may deposit any amount from
time to time in multiples of $50 for a period of 4 years. The terms also
provide that G may not redeem any amount until February 1, 1975, except
in an emergency as defined in, and subject to the qualifications
provided by, Regulation Q of the Board of Governors of the Federal
Reserve System. See 12 CFR 217.4(d). Interest will be compounded
semiannually (on February 1 and August 1) at 6 percent, providing there
is no redemption prior to February 1, 1975. However, if there is a
redemption prior to such date, interest will be compounded semiannually
at 5\1/2\ percent.
(ii) The schedule of deposits made by G pursuant to the arrangement,
and computation of ratable monthly portion for each deposit, is set
forth in the table below:
----------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (6)
----------------------------------------------------------------------------------------------------------------
Redemption Original issue Ratable monthly
Date of deposit Months to Amount of price at discount portion (Col.5 /
maturity deposit maturity (Col.4-Col.3) Col.2)
----------------------------------------------------------------------------------------------------------------
2-1-71.................................. 48 100 $126.68 $26.68 0.5558
6-1-71.................................. 44 200 248.42 48.42 1.1005
12-1-71................................. 38 500 602.95 102.95 2.7092
2-1-72.................................. 36 800 955.24 155.24 4.3122
3-1-72.................................. 35 800 950.56 150.56 4.3017
7-1-72.................................. 31 600 699.00 99.00 3.1935
8-1-72.................................. 30 250 289.82 39.82 1.3273
----------------------------------------------------------------------------------------------------------------
[[Page 320]]
(iii) With respect to amounts on deposit pursuant to the
arrangement, the amounts of original issue discount G must include as
interest in his gross income for 1971 and 1972 are computed in the table
below:
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (6)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Ratable 1971 original 1972 original
Date of deposit monthly Months on deposit issue discount Months on deposit issue discount
portion in 1971 (Col.2 x Col.3) in 1972 (Col.2 x Col.5)
--------------------------------------------------------------------------------------------------------------------------------------------------------
2-1-71......................................................... $0.5558 11 $6.11 12 $6.67
6-1-71......................................................... 1.1005 7 7.70 12 13.21
12-1-71........................................................ 2.7092 1 2.71 12 32.51
2-1-72......................................................... 4.3122 ................. ................. 11 47.43
3-1-72......................................................... 4.3017 ................. ................. 10 43.02
7-1-72......................................................... 3.1935 ................. ................. 6 19.16
8-1-72......................................................... 1.3273 ................. ................. 5 6.64
------------- --------------------
Total original issue discount includible as interest in gross income for taxable year...... 16.52 ................. 168.64
--------------------------------------------------------------------------------------------------------------------------------------------------------
(6) Certain contingent interest arrangement--(i) In general. If
under the terms of a deposit arrangement:
(a) The holder cannot receive payment of any interest or
constructively receive any interest prior to a fixed maturity date,
(b) Interest is earned at a guaranteed minimum rate of compound
interest,
(c) Additional contingent interest may be earned for any year at a
rate not to exceed one percentage point above such guaranteed minimum
rate, and
(d) Any additional contingent interest is credited at least annually
to the depositor's account,
Then any contingent interest credited to the depositor shall be treated
as creating a separate obligation subject to the rules of subdivision
(ii) of this subparagraph.
(ii) Computation. For purposes of computing the original issue
discount to be included as interest in the depositor's gross income
under section 1232(a)(3) with respect to such separate obligation:
(a) The issue price shall be zero,
(b) The date of original issue shall be the date on which the
contingent interest is credited to the depositor's account and begins to
earn interest,
(c) The date of maturity shall be the fixed maturity date of the
deposit, and
(d) The stated redemption price at maturity is the sum of the amount
of such contingent interest plus any interest to be earned thereon at
the guaranteed minimum rate of compound interest between such dates of
original issue and maturity.
(7) Contingent interest arrangements other than those described in
subparagraph (6)--(i) In general. If under the terms of a deposit
arrangement, contingent interest may be earned and credited to a
depositor's account, but is neither actually or constructively received
before a fixed maturity date nor treated under subparagraph (6)(i) of
this paragraph as creating a separate obligation, then the redemption
price shall include the amount which would be credited to such account
assuming the issuer, during the term of such account, credits contingent
interest at the greater of the rate:
(a) Last credited on a similar account, or
(b) Equal to the average rate credited for the preceding 5 calendar
years on a similar account.
(ii) Adjustments for additional interest. The rate taken into
account under this subparagraph in computing the redemption price shall
be treated as the guaranteed minimum rate for purposes of applying
subparagraph (6) of this paragraph in the event the rate at which
contingent interest is actually credited to the depositor's account
exceeds such rate previously taken into account. If for any period the
actual rate at which contingent interest is credited to the account
exceeds by more than 1 percentage point the rate for the previous period
taken into account under this subparagraph in computing the redemption
price, a new
[[Page 321]]
computation shall be made to determine the ratable monthly portion of
original issue discount to be included as interest in the gross income
of the depositor over the remaining term of the account. For purposes of
such computation, the date that interest is first so credited to the
account shall be treated as the issue date, the adjusted basis of the
account on such date shall be the issue price, and the redemption price
shall equal the amount actually on deposit in the account on such date
plus the amount which would be credited to such account assuming the
issuer, during the remaining term of such account, continues to credit
contingent interest at the new rate.
(iii) Adjustment for reduced interest. If for any period the actual
rate of interest at which contingent interest is credited to the
depositor's account is less than the rate for the previous period taken
into account under this subparagraph in computing the redemption price,
the difference between the amount of interest which would have been
credited to the account at the rate for such previous period and the
amount actually credited shall be allowed as a deduction against the
amount of original issue discount with respect to such account required
to be included in the gross income of the depositor. If an account is
redeemed for a price less than the adjusted basis of the account, the
depositor shall be allowed as a deduction, in computing adjusted gross
income, the amount of the original issue discount he included in gross
income but did not receive.
(f) Application of section 1232(a)(3) to face-amount certificates--
(1) In general. Under paragraph (c)(3) of Sec. 1.1232-1, the provisions
of section 1232(a)(3) and this section apply in the case of a face-
amount certificate issued after December 31, 1975 (other than such a
certificate issued pursuant to a written commitment which was binding on
such date and at all times thereafter).
(2) Relationship with paragraph (e) of this section. Determinations
with regard to the inclusion as interest of original issue discount on,
and certain adjustments with respect to, face-amount certificates to
which this section applies shall be made in a manner consistent with the
rules of paragraph (e) of this section (relating to the application of
section 1232 to certain deposits in financial institutions and similar
arrangements). Thus, for example, if a face-amount certificate is
redeemed before maturity, the holder shall be allowed a deduction in
computing adjusted gross income computed in a manner consistent with the
rules of paragraph (e)(2) of this section. For a further example, if
under the terms of a face-amount certificate, the issuer may grant
additional credits to be paid at a fixed maturity date, computations
with respect to such additional credits shall be made in a manner
consistent with the rules of paragraphs (e) (6) and (7) of this section
(as applicable) relating to contingent interest arrangements.
[T.D. 7154, 36 FR 25005, Dec. 28, 1971; 37 FR 527, Jan. 13, 1972, as
amended by T.D. 7213, 37 FR 21993, Oct. 18, 1972; 37 FR 22863, Oct. 26,
1972; T.D. 7311, 39 FR 11880, Apr. 1, 1974; T.D. 7365, 40 FR 27936, July
2, 1975]
Sec. 1.1233-1 Gains and losses from short sales.
(a) General. (1) For income tax purposes, a short sale is not deemed
to be consummated until delivery of property to close the short sale.
Whether the recognized gain or loss from a short sale is capital gain or
loss or ordinary gain or loss depends upon whether the property so
delivered constitutes a capital asset in the hands of the taxpayer.
(2) Thus, if a dealer in securities makes a short sale of X
Corporation stock, ordinary gain or loss results on closing of the short
sale if the stock used to close the short sale was stock which he held
primarily for sale to customers in the ordinary course of his trade or
business. If the stock used to close the short sale was a capital asset
in his hands, or if the taxpayer in this example was not a dealer, a
capital gain or loss would result.
(3) Generally, the period for which a taxpayer holds property
delivered to close a short sale determines whether long-term or short-
term capital gain or loss results.
(4) Thus, if a taxpayer makes a short sale of shares of stock and
covers the short sale by purchasing and delivering shares which he held
for not more than
[[Page 322]]
1 year (6 months for taxable years beginning before 1977; 9 months for
taxable years beginning in 1977), the recognized gain or loss would be
considered short-term capital gain or loss. If the short sale is made
through a broker and the broker borrows property to make a delivery, the
short sale is not deemed to be consummated until the obligation of the
seller created by the short sale is finally discharged by delivery of
property to the broker to replace the property borrowed by the broker.
(5) For rules for determining the date of sale for purposes of
applying under section 1091 the 61-day period applicable to a short sale
of stock or securities at a loss, see paragraph (g) of Sec. 1.1091-1.
(b) Hedging transactions. Under section 1233(g), the provisions of
section 1233 and this section shall not apply to any bona fide hedging
transaction in commodity futures entered into by flour millers,
producers of cloth, operators of grain elevators, etc., for the purpose
of their business. Gain or loss from a short sale of commodity futures
which does not qualify as a hedging transaction shall be considered gain
or loss from the sale or exchange of a capital asset if the commodity
future used to close the short sale constitutes a capital asset in the
hands of the taxpayer as explained in paragraph (a) of this section.
(c) Special short sales--(1) General. Section 1233 provides rules as
to the tax consequences of a short sale of property if gain or loss from
the short sale is considered as gain or loss from the sale or exchange
of a capital asset under section 1233(a) and paragraph (a) of this
section and if, at the time of the short sale or on or before the date
of the closing of the short sale, the taxpayer holds property
substantially identical to that sold short. The term property is defined
for purposes of such rules to include only stocks and securities
(including stocks and securities dealt with on a when issued basis) and
commodity futures, which are capital assets in the hands of the
taxpayer. Certain restrictions on the application of the section to
commodity futures are provided in section 1233(e) and paragraph (d)(2)
of this section. Section 1233(f) contains special provisions governing
the operation of rule (2) in subparagraph (2) of this paragraph in the
case of a purchase and short sale of stock (as defined in subparagraph
(3) qualifying as an arbitrage operation. See paragraph (f) of this
section for detailed rules relating to arbitrage operations in stocks
and securities.
(2) Treatment of special short sales. The first two rules, which are
set forth in section 1233(b), are applicable whenever property
substantially identical to that sold short has been held by the taxpayer
on the date of the short sale for not more than 1 year (6 months for
taxable years beginning before 1977; 9 months for taxable years
beginning in 1977) (determined without regard to rule (2), contained in
this subparagraph, relating to the holding period) or is acquired by him
after the short sale and on or before the date of the closing thereof.
These rules are:
Rule (1). Any gain upon the closing of such short sale shall be
considered as a gain upon the sale or exchange of a capital asset held
for not more than 1 year (6 months for taxable years beginning before
1977; 9 months for taxable years beginning in 1977) (notwithstanding the
period of time any property used to close such short sale has been
held); and
Rule (2). The holding period of such substantially identical
property shall be considered to begin (notwithstanding the provisions of
section 1223) on the date of the closing of such short sale or on the
date of a sale, gift, or other disposition of such property, whichever
date occurs first.
(3) Options to sell. For the purpose of rule (1) and rule (2) in
subparagraph (2) of this paragraph, the acquisition of an option to sell
property at a fixed price shall be considered a short sale, and the
exercise or failure to exercise such option shall be considered as a
closing of such short sale, except that any option to sell property at a
fixed price acquired on or after August 17, 1954 (the day after
enactment of the Internal Revenue Code of 1954), shall not be considered
a short sale and the exercise or failure to exercise such option shall
not be considered as the closing of a short sale provided that the
option and property identified as intended to be used in its exercise
are acquired on the same date. This exception shall not apply, if the
option is exercised, unless
[[Page 323]]
it is exercised by the sale of the property so identified. In the case
of any option not exercised which falls within this exception, the cost
of such option shall be added to the basis of the property with which
such option is identified. If the option itself does not specifically
identify the property intended to be used in exercising the option, then
the identification of such property shall be made by appropriate entries
in the taxpayer's records within 15 days after the date such property is
acquired or before November 17, 1956, whichever expiration date later
occurs.
(4) Treatment of losses. The third rule, which is set forth in
section 1233(d), is applicable whenever property substantially identical
to that sold short has been held by the taxpayer on the date of the
short sale for more than 1 year (6 months for taxable years beginning
before 1977; 9 months for taxable years beginning in 1977). This rule
is:
Rule (3). Any loss upon the closing of such short sale shall be
considered as a loss upon the sale or exchange of a capital asset held
for more than 1 year (6 months for taxable years beginning before 1977;
9 months for taxable years beginning in 1977), not withstanding the
period of time any property used to close such short sale has been held.
For the purpose of this rule, the acquisition of an option to sell
property at a fixed price is not considered a short sale, and the
exercise or failure to exercise such option is not considered as a
closing of a short sale.
(5) Application of rules. Rules (1) and (3) contained in
subparagraphs (2) and (4) of this paragraph do not apply to the gain or
loss attributable to so much of the property sold short as exceeds in
quantity the substantially identical property referred to in section
1233 (b) and (d), respectively. Except as otherwise provided in section
1233(f), rule (2) in subparagraph (2) of this paragraph applies to the
substantially identical property referred to in section 1233(b) in the
order of the dates of the acquisition of such property, but only to so
much of such property as does not exceed the quantity sold short. If
property substantially identical to that sold short has been held by the
taxpayer on the date of the short sale for not more than 1 year (6
months for taxable years beginning before 1977; 9 months for taxable
years beginning in 1977), or is acquired by him after the short sale and
on or before the date of the closing thereof, and if property
substantially identical to that sold short has been held by the taxpayer
on the date of the short sale for more than 1 year (6 months for taxable
years beginning before 1977; 9 months for taxable years beginning in
1977), all three rules are applicable.
(6) Examples. The following examples illustrate the application of
these rules to short sales of stock in the case of a taxpayer who makes
his return on the basis of the calendar year:
Example 1. A buys 100 shares of X stock at $10 per share on February
1, 1955, sells short 100 shares of X stock at $16 per share on July 1,
1955, and closes the short sale on August 2, 1955, by delivering the 100
shares of X stock purchased on February 1, 1955, to the lender of the
stock used to effect the short sale. Since 100 shares of X stock had
been held by A on the date of the short sale for not more than 6 months,
the gain of $600 realized upon the closing of the short sale is, by
application of rule (1) in subparagraph (2) of this paragraph, a short-
term capital gain.
Example 2. A buys 100 shares of X stock at $10 per share on February
1, 1955, sells short 100 shares of X stock at $16 per share on July 1,
1955, closes the short sale on August 1, 1955, with 100 shares of X
stock purchased on that date at $18 per share, and on August 2, 1955,
sells at $18 per share the 100 shares of X stock purchased on February
1, 1955. The $200 loss sustained upon the closing of the short sale is a
short-term capital loss to which section 1233(d) has no application. By
application of rule (2) in subparagraph (2) of this paragraph, however,
the holding period of the 100 shares of X stock purchased on February 1,
1955, and sold on August 2, 1955 is considered to begin on August 1,
1955, the date of the closing of the short sale. The $800 gain realized
upon the sale of such stock is, therefore, a short-term capital gain.
Example 3. A buys 100 shares of X stock at $10 per share on February
1, 1955, sells short 100 shares of X stock at $16 per share on September
1, 1955, sells on October 1, 1955, at $18 per share the 100 shares of X
stock purchased on February 1, 1955, and closes the short sale on
October 1, 1955, with 100 shares of X stock purchased on that date at
$18 per share. The $800 gain realized upon the sale of the 100 shares of
X stock purchased on February 1, 1955, is a long-term capital gain to
which section 1233(b) has no application. Since A had held 100 shares of
X stock on the date of the short sale for more than 6 months, the $200
loss sustained upon the closing of the short sale is, by application of
rule (3) in subparagraph (4) of this paragraph, a long-term capital
loss. If, instead of purchasing 100 shares
[[Page 324]]
of X stock on October 1, 1955, A closed the short sale with the 100
shares of stock purchased on February 1, 1955, the $600 gain realized on
the closing of the short sale would be a long-term capital gain to which
section 1233(b) has no application.
Example 4. A sells short 100 shares of X stock at $16 per share on
February 1, 1955. He buys 250 shares of X stock on March 1, 1955, at $10
per share and holds the latter stock until September 2, 1955 (more than
6 months), at which time, 100 shares of the 250 shares of X stock are
delivered to close the short sale made on February 1, 1955. Since
substantially identical property was acquired by A after the short sale
and before it was closed, the $600 gain realized on the closing of the
short sale is, by application of rule (1) in subparagraph (2) of this
paragraph, a short-term capital gain. The holding period of the
remaining 150 shares of X stock is not affected by section 1233 since
this amount of the substantially identical property exceeds the quantity
of the property sold short.
Example 5. A buys 100 shares of X stock at $10 per share on February
1, 1955, buys an additional 100 shares of X stock at $20 per share on
July 1, 1955, sells short 100 shares of X stock at $30 per share on
September 1, 1955, and closes the short sale on February 1, 1956, by
delivering the 100 shares of X stock purchased on February 1, 1955, to
the lender of the stock used to effect the short sale. Since 100 shares
of X stock had been held by A on the date of the short sale for not more
than 6 months, the gain of $2,000 realized upon the closing of the short
sale is, by application of rule (1) in subparagraph (2) of this
paragraph, a short-term capital gain and the holding period of the 100
shares of X stock purchased on July 1, 1955, is considered, by
application of rule (2) in subparagraph (2) of this paragraph to begin
on February 1, 1956, the date of the closing of the short sale. If,
however, the 100 shares of X stock purchased on July 1, 1955, had been
used by A to close the short sale, then, since 100 shares of X stock had
been held by A on the date of the short sale for not more than 6 months,
the gain of $1,000 realized upon the closing of the short sale would be,
by application of rule (1) in subparagraph (2) of this paragraph, a
short-term capital gain, but the holding period of the 100 shares of X
stock purchased on February 1, 1955, would not be affected by section
1233. If, on the other hand, A purchased an additional 100 shares of X
stock at $40 per share on February 1, 1956, and used such shares to
close the short sale at that time, then, since 100 shares of X stock had
been held by A on the date of the short sale for more than 6 months, the
loss of $1,000 sustained upon the closing of the short sale would be, by
application of rule (3) in subparagraph (4) of this paragraph, a long-
term capital loss, and since 100 shares of X stock had been held by A on
the date of the short sale for not more than 6 months, the holding
period of the 100 shares of X stock purchased on July 1, 1955, would be
considered, by application of rule (2) in subparagraph (2) of this
paragraph, to begin on February 1, 1956, but the holding period of the
100 shares of X stock purchased on February 1, 1955, would not be
affected by section 1233.
Example 6. A buys 100 shares of X preferred stock at $10 per share
on February 1, 1955. On July 1, 1955, he enters into a contract to sell
100 shares of XY common stock at $16 per share when, as, and if issued
pursuant to a particular plan of reorganization. On August 2, 1955, he
receives 100 shares of XY common stock in exchange for the 100 shares of
X preferred stock purchased on February 1, 1955, and delivers such
common shares in performance of his July 1, 1955, contract. Assume that
the exchange of the X preferred stock for the XY common stock is a tax-
free exchange pursuant to section 354(a)(1), and that on the basis of
all of the facts and circumstances existing on July 1, 1955, the when
issued XY common stock is substantially identical to the X preferred
stock. Since 100 shares of substantially identical property had been
held by A for not more than 6 months on the date of entering into the
July 1, 1955, contract of sale, the gain of $600 realized upon the
closing of the contract of sale is, by application of rule (1) in
subparagraph (2) of this paragraph, a short-term capital gain.
(d) Other rules for the application of section 1233--(1)
Substantially identical property. The term substantially identical
property is to be applied according to the facts and circumstances in
each case. In general, as applied to stocks or securities, the term has
the same meaning as the term substantially identical stock or securities
used in section 1091, relating to wash sales of stocks or securities.
For certain restrictions on the term as applied to commodity futures see
subparagraph (2) of this paragraph. Ordinarily, stocks or securities of
one corporation are not considered substantially identical to stocks or
securities of another corporation. In certain situations they may be
substantially identical; for example, in the case of a reorganization
the facts and circumstances may be such that the stocks and securities
of predecessor and successor corporations are substantially identical
property. Similarly, bonds or preferred stock of a corporation are not
ordinarily considered substantially identical to the common
[[Page 325]]
stock of the same corporation. However, in certain situations, as, for
example, where the preferred stock or bonds are convertible into common
stock of the same corporation, the relative values, price changes, and
other circumstances may be such as to make such bonds or preferred stock
and the common stock substantially identical property. Similarly,
depending on the facts and circumstances, the term may apply to the
stocks and securities to be received in a corporate reorganization or
recapitalization, traded in on a when issued basis, as compared with the
stocks or securities to be exchanged in such reorganization or
recapitalization.
(2) Commodity futures. (i) As provided in section 1233(e)(2)(B), in
the case of futures transactions in any commodity on or subject to the
rules of a board of trade or commodity exchange, a commodity future
requiring delivery in one calendar month shall not be considered as
property substantially identical to another commodity future requiring
delivery in a different calendar month. For example, commodity futures
in May wheat and July wheat are not considered, for the purpose of
section 1233, substantially identical property. Similarly, futures in
different commodities which are not generally through custom of the
trade used as hedges for each other (such as corn and wheat, for
example) are not considered substantially identical property. If
commodity futures are otherwise substantially identical property, the
mere fact that they were procured through different brokers will not
remove them from the scope of the term substantially identical property.
Commodity futures procured on different markets may come within the term
substantially identical property depending upon the facts and
circumstances in the case, with the historical similarity in the price
movements in the two markets as the primary factor to be considered.
(ii) Section 1233(e)(3), relating to so-called arbitrage
transactions in commodity futures, provides that where a taxpayer enters
into two commodity futures transactions on the same day, one requiring
delivery by him in one market and the other requiring delivery to him of
the same (or substantially identical) commodity in the same calendar
month in a different market, and the taxpayer subsequently closes both
such transactions on the same day, section 1233 shall have no
application to so much of the commodity involved in either such
transaction as does not exceed in quantity the commodity involved in the
other. Section 1233(f), relating to arbitrage operations in stocks or
securities, has no application to arbitrage transactions in commodity
futures.
(iii) The following example indicates the application of section
1233 to a commodity futures transaction:
Example: A, who makes his return on the basis of the calendar year,
on February 1, 1955, enters into a contract through broker X to purchase
10,000 bushels of December wheat on the Chicago market at $2 per bushel.
On July 1, 1955, he enters into a contract through broker Y to sell
10,000 bushels of December wheat on the Chicago market at $2.25 per
bushel. On August 2, 1955, he closes both transactions at $2.50 per
bushel. The $2,500 loss sustained on the closing of the short sale is a
short-term capital loss to which section 1233(d) has no application. By
application of rule (2) in paragraph (c)(2) of this section, however,
the holding period of the futures contract entered into on February 1,
1955, is considered to begin on August 2, 1955, the date of the closing
of the short sale. The $5,000 gain realized upon the closing of such
contract is, therefore, a short-term capital gain.
(3) Husband and wife. Section 1233(e)(2)(C) provides that, in the
case of a short sale of property by an individual, the term taxpayer in
the application of subsections (b), (d), and (e) shall be read as
taxpayer or his spouse. Thus, if the spouse of a taxpayer holds or
acquires property substantially identical to that sold short by the
taxpayer, and other conditions of subsections (b), (d), and (e) are met,
then the rules set forth therein are applicable to the same extent as if
the taxpayer held or acquired the substantially identical property. For
this purpose, an individual who is legally separated from the taxpayer
under a decree of divorce or of separate maintenance shall not be
considered as the spouse of the taxpayer.
(e) Special rule for short sales by dealers in securities under
certain circumstances. In the case of a short sale of stock (as defined
in subparagraph (3)
[[Page 326]]
of this paragraph) after December 31, 1957, by a dealer in securities,
section 1233(e)(4)(A) provides that the holding period of substantially
identical stock which he has held as an investment for not more than 1
year (6 months for taxable years beginning before 1977; 9 months for
taxable years beginning in 1977) shall be determined in accordance with
section 1233(b)(2) unless such short sale is closed within 20 days of
the date on which it was made. See rule (2) in paragraph (c)(2) of this
section for the purpose of determining the holding period of such
substantially identical stock. In addition, section 1233(e)(4)(B)
provides that for the purpose of the special rule of section
1233(e)(4)(A), the acquisition of an option to sell property at a fixed
price shall be considered a short sale, and the exercise or failure to
exercise such option shall be considered a closing of such short sale.
For purposes of this paragraph:
(1) Whether or not a taxpayer is a dealer in securities shall be
determined in accordance with the meaning of the term for purposes of
section 1236;
(2) Whether or not stock is substantially identical with other
property shall be determined in accordance with the provisions of
paragraph (d)(1) of this section; and
(3) The term stock means:
(i) Any share or certificate of stock,
(ii) Any bond or other evidence of indebtedness which is convertible
into a share or certificate of stock, and
(iii) Any evidence of an interest in, or right to subscribe to or
purchase, any of the items described in subdivision (i) or (ii) of this
subparagraph.
(f) Arbitrage operations in stocks and securities and holding
periods--(1) General rule. (i) In the case of a short sale entered into
as part of an arbitrage operation, rule (2) of paragraph (c)(2) of this
section shall apply first to substantially identical property acquired
for arbitrage operations and held by the taxpayer at the close of
business on the day of the short sale. The holding period of
substantially identical property not acquired for arbitrage operations
shall be affected only to the extent that the amount of property sold
short exceeds the amount of substantially identical property acquired
for arbitrage operations and held by the tapayer at the close of
business on the day of the short sale.
(ii) If the substantially identical property acquired for arbitrage
operations is disposed of without closing the short sale so that a net
short position in assets acquired for arbitrage operations is created, a
short sale in the amount of such net short position will be deemed to
have been made on the day such net short position is created. Rule (2)
of paragraph (c)(2) of this section will then apply to substantially
identical property not acquired for arbitrage operations to the same
extent as if the taxpayer, on the day such net short position is
created, sold short an amount equal to the amount of the net short
position in a transaction not entered into as part of an arbitrage
operation.
(iii) The following examples illustrate the application of rule (2)
of paragraph (c)(2) of this section to arbitrage operations:
Example 1. On August 13, 1957, A buys 100 bonds of X Corporation for
purposes other than arbitrage operations. The bonds are convertible at
the option of the bondholders into common stock of X Corporation on the
basis of one bond for one share of stock. On November 1, 1957, A sells
short 100 shares of common stock of X Corporation in a transaction
identified and intended to be part of an arbitrage operation and on the
same day buys another 100 bonds of X Corporation in a transaction
identified and intended to be part of the same arbitrage operation. The
bonds acquired on both August 13, 1957, and November 1, 1957, are, on
the basis of all the facts and circumstances, substantially identical to
the common stock of X Corporation. On December 1, 1957, A closes the
short sale with 100 shares of common stock of X Corporation acquired on
that day. The holding period of the bonds acquired on November 1, by
application of rule (2) of paragraph (c)(2) of this section, will be
deemed to begin on December 1 and the holding period of the bonds
acquired on August 13 will be unaffected. If, instead of purchasing the
100 shares of common stock of X Corporation on December 1, 1957, A had
converted the bonds acquired on November 1 into common stock and, on
December 1, 1957, used the stock so acquired to close the short sale,
rule (2) of paragraph (c)(2) of this section would similarly have no
effect on the holding period of the bonds acquired on August 13.
Example 2. Assume the same facts as in example (1), except that A,
on December 1, sells
[[Page 327]]
the bonds acquired on November 1 (or converts such bonds into common
stock and sells the stock), but does not close the short sale. The sale
of the bonds (or stock) creates a net short position in assets acquired
for arbitrage operations which is deemed to be a short sale made on
December 1. Accordingly, the holding period of the bonds acquired on
August 13 will, by application of rule (2) of paragraph (c)(2) of this
section, begin on the date such short sale is closed or on the date of
sale, gift, or other disposition of such bonds, whichever date occurs
first.
(2) Right to receive or acquire property. (i) For purposes of
section 1233(f) (1) and (2) and subparagraph (1) of this paragraph, a
taxpayer will be deemed to hold substantially identical property
acquired for arbitrage operations at the close of any business day if,
by virtue of the ownership of other property acquired for arbitrage
operations (whether or not substantially identical) or because of any
contract entered into by the taxpayer in an arbitrage operation, he then
has the right to receive or acquire such substantially identical
property.
(ii) The application of section 1233(f)(3) and subdivision (i) of
this subparagraph may be illustrated by the following example:
Example: A acquires on August 13, 1957, 100 shares of common stock
of X Corporation for purposes other than arbitrage operations. On
November 1, A sells short, in a transaction identified and intended to
be part of an arbitrage operation, 100 shares of X common stock. On the
same day, in a transaction also identified and intended to be part of
the same arbitrage operation, A contracts to purchase 100 shares of
preferred stock of X. The preferred stock of X may be converted into
common stock of X on the basis of one share of preferred stock for one
share of common stock. The preferred stock is not actually delivered to
A until November 3. Since A has contracted before the close of business
on the date of the short sale, as part of an arbitrage operation, to
purchase property by virtue of which he has the right to receive or
acquire substantially identical property to that sold short, he will be
deemed, for purposes of section 1233(f) (1) and (2), to hold such
substantially identical property at the close of business on the date of
the short sale. For purposes of this subparagraph, it is immaterial
whether, on the basis of all the facts and circumstances, the preferred
stock of X is substantially identical to the common stock of X. The
short sale on November 1 does not affect the holding period of the 100
shares of X Corporation common stock purchased on August 13, 1957.
Because of the operation of rule (2) of paragraph (c)(2) of this
section, the holding period of the preferred stock acquired as the
result of A's contract to purchase it as part of an arbitrage operation
(or the common stock which A acquires by conversion of such preferred
stock into common stock) will not begin until the short sale entered
into in the arbitrage operation is closed.
(3) Definition of arbitrage operations. For the purpose of section
1233(f), arbitrage operations are transactions involving the purchase
and sale of property entered into for the purpose of profiting from a
current difference between the price of the property purchased and the
price of the property sold. Assets acquired for arbitrage operations
include only stocks and securities and rights to acquire stocks and
securities. The property purchased may be either identical to the
property sold or, if not so identical, such that its acquisition will
entitle the taxpayer to acquire property which is so identical. Thus,
the purchase of bonds or preferred stock convertible, at the holder's
option, into common stock and the short sale of the common stock which
may be acquired therefor, or the purchase of stock rights and the short
sale of the stock to be acquired on the exercise of such rights, may
qualify as arbitrage operations. A transaction will qualify as an
arbitrage operation under section 1233(f) only if the taxpayer properly
identifies the transaction as an arbitrage operation on his records as
soon as he is able to do so. Such identification must ordinarily be
entered in the taxpayer's records on the day of the transaction.
Property acquired in a transaction properly identified as part of an
arbitrage operation is the only property which will be deemed acquired
for an arbitrage operation. The provisions of section 1233(f) and this
paragraph shall continue to apply to property acquired in a transaction
properly identified as an arbitrage operation although, because of
subsequent events, e.g., a change in the value of bonds so acquired or
of stock into which such bonds may be converted, the taxpayer sells such
property outright rather than using it to complete the arbitrage
operation.
[[Page 328]]
(4) Effective date of section 1233(f). Section 1233(f), relating to
arbitrage operations involving short sales of property, is effective
only with respect to taxable years ending after August 12, 1955, and
only with respect to short sales made after such date.
[T.D. 6500, 25 FR 12011, Nov. 26, 1960, as amended by T.D. 6494, 25 FR
9372, Sept. 30, 1960; T.D. 6926, 32 FR 11468, Aug. 9, 1967; T.D. 7728,
45 FR 72650, Nov. 3, 1980]
Sec. 1.1233-2 Hedging transactions.
The character of gain or loss on a short sale that is (or is
identified as being) part of a hedging transaction is determined under
the rules of Sec. 1.1221-2.
[T.D. 8555, 59 FR 36367, July 18, 1994]
Sec. 1.1234-1 Options to buy or sell.
(a) Sale or exchange--(1) Capital assets. Gain or loss from the sale
or exchange of an option (or privilege) to buy or sell property which is
(or if acquired would be) a capital asset in the hands of the taxpayer
holding the option is considered as gain or loss from the sale or
exchange of a capital asset (unless, under the provisions of
subparagraph (2) of this paragraph, the gain or loss is subject to the
provisions of section 1231). The period for which the taxpayer has held
the option determines whether the capital gain or loss is short-term or
long-term.
(2) Section 1231 transactions. Gain or loss from the sale or
exchange of an option to buy or sell property is considered a gain or
loss subject to the provisions of section 1231 if, had the sale or
exchange been of the property subject to the option, held by the
taxpayer for the length of time he held the option, the sale or exchange
would have been subject to the provisions of section 1231.
(3) Other property. Gain or loss from the sale or exchange of an
option to buy or sell property which is not (or if acquired would not
be) a capital asset in the hands of the taxpayer holding the option is
considered ordinary income or loss (unless under the provisions of
subparagraph (2) of this paragraph, the gain or loss is subject to the
provisions of section 1231).
(b) Failure to exercise option. If the holder of an option to buy or
sell property incurs a loss on failure to exercise the option, the
option is deemed to have been sold or exchanged on the date that it
expired. Any such loss to the holder of an option is treated under the
general rule provided in paragraph (a) of this section. In general, any
gain to the grantor of an option arising from the failure of the holder
to exercise it, and any gain or loss realized by the grantor of an
option as a result of a closing transaction, such as repurchasing the
option from the holder, is considered ordinary income or loss. However,
for the treatment of gain or loss from a closing transaction with
respect to or gain on the lapse of an option granted in stock,
securities, commodities or commodity futures, see section 1234(b) and
Sec. 1.1234-3. For special rules for grantors of straddles applicable
to certain options granted on or before September 1, 1976, see Sec.
1.1234-2.
(c) Certain options to sell property at a fixed price. Section 1234
does not apply to a loss on the failure to exercise an option to sell
property at a fixed price which is acquired on the same day on which the
property identified as intended to be used in exercising the option is
acquired. Such a loss is not recognized, but the cost of the option is
added to the basis of the property with which it is identified. See
section 1233(c) and the regulations thereunder.
(d) Dealers in options to buy or sell. Any gain or loss realized by
a dealer in options from the sale or exchange or an option to buy or
sell property is considered ordinary income or loss under paragraph
(a)(3) of this section. A dealer in options to buy or sell property is
considered a dealer in the property subject to the option.
(e) Other exceptions. Section 1234 does not apply to gain resulting
from the sale or exchange of an option:
(1) To the extent that the gain is in the nature of compensation
(see sections 61 and 421, and the regulations thereunder, relating to
employee stock options);
(2) If the option is treated as section 306 stock (see section 306
and the regulations thereunder, relating to dispositions of certain
stock); or
[[Page 329]]
(3) To the extent that the gain is a distribution of earnings or
profits taxable as a dividend (see section 301 and the regulations
thereunder, relating to distributions of property).
(4) Acquired by the taxpayer before March 1, 1954, if in the hands
of the taxpayer such option is a capital asset (whether or not the
property to which the option relates is, or would be if acquired by the
taxpayer, a capital asset in the hands of the taxpayer).
(f) Limitations on effect of section. Losses to which section 1234
applies are subject to the limitations on losses under sections 165(c)
and 1211 when applicable. Section 1234 does not permit the deduction of
any loss which is disallowed under any other provision of law. In
addition, section 1234 does not apply to an option to lease property,
but does apply to an option to buy or sell a lease. Thus, an option to
obtain all the right, title, and interest of a lessee in leased property
is subject to the provisions of section 1234, but an option to obtain a
sublease from the lessee is not. Furthermore, if section 1234 applies to
an option to buy or sell a lease, it is the character the lease itself,
if acquired, would have in the hands of the taxpayer, and not the
character of the property leased, which determines the treatment of gain
or loss experienced by the taxpayer with respect to such an option.
(g) Examples. The rules set forth in this section may be illustrated
by the following examples:
Example 1. A taxpayer is considering buying a new house for his
residence and acquires an option to buy a certain house at a fixed
price. Although the property goes up in value, the taxpayer decides he
does not want the house for his residence and sells the option for more
than he paid for it. The gain which taxpayer realized is a capital gain
since the property, if acquired, would have been a capital asset in his
hands.
Example 2. Assume the same facts as in example (1), except that the
property goes down in value, and the taxpayer decides not to purchase
the house. He sells the option at a loss. While this is a capital loss
under section 1234, it is not a deductible loss because of the
provisions of section 165(c).
Example 3. A dealer in industrial property acquires an option to buy
an industrial site and fails to exercise the option. The loss is an
ordinary loss since he would have held the property for sale to
customers in the ordinary course of his trade or business if he had
acquired it.
[T.D. 6500, 25 FR 12013, Nov. 26, 1960, as amended by T.D. 7652, 44 FR
62282, Oct. 30, 1979]
Sec. 1.1234-2 Special rule for grantors of straddles applicable
to certain options granted on or before September 1, 1976.
(a) In general. Section 1234(c)(1) provides a special rule
applicable in the case of gain on the lapse of an option granted by the
taxpayer as part of a straddle. In such a case, the gain shall be deemed
to be gain from the sale or exchange of a capital asset held for not
more than 1 year (6 months for taxable years beginning before 1977; 9
months for taxable years beginning in 1977) on the day that the option
expired. Thus, such gain shall be treated as a short-term capital gain,
as defined in section 1222(1). Section 1234(c)(1) does not apply to any
person who holds securities (including options to acquire or sell
securities) for sale to customers in the ordinary course of his trade or
business.
(b) Definitions. The following definitions apply for purposes of
section 1234(c) and this section.
(1) Straddle. The term straddle means a simultaneously granted
combination of an option to buy (i.e., a call) and an option to sell
(i.e., a put) the same quantity of a security at the same price during
the same period of time.
(2) Security. The term security has the meaning assigned to such
term by section 1236(c) and the regulations thereunder. Thus, for
example, the term security does not include commodity futures.
(3) Grantor. The term grantor means the writer or issuer of the
option contracts making up the straddle.
(4) Multiple option. The term multiple option means a simultaneously
granted combination of an option to buy plus an option to sell plus one
or more additional options to buy or sell a security.
(c) Special rules in the case of a multiple option. (1) If, in the
case of a multiple option, the number of the options to sell and the
number of the options to buy are the same and if the terms of all of the
options are identical (as to the quantity of the security, price, and
period of time), then each of the options contained in the multiple
option
[[Page 330]]
shall be deemed to be a component of a straddle for purposes of section
1234(c)(1) and paragraph (a) of this section.
(2) If, in the case of a multiple option, the number of the options
to sell and the number of the options to buy are not the same or if the
terms of all of the options are not identical (as to the quantity of the
security, price, and period of time), then section 1234(c)(1) applies to
gain on the lapse of an option granted as part of the multiple option
only if:
(i) The grantor of the multiple option identifies the two options
which comprise each straddle contained in the multiple option in the
manner prescribed in subparagraph (3) of this paragraph; or
(ii) It is clear from the facts and circumstances that the lapsed
option was part of a straddle. See example (6) of paragraph (f) of this
section. A multiple option to which this subdivision applies may not be
regarded as consisting of a number of straddles which exceeds the lesser
of the options to sell or the options to buy as the case may be. For
example, if a multiple option of five puts and four calls is granted it
may not be regarded as consisting of more than four straddles, although
the particular facts and circumstances could dictate that the option
consists of less than four straddles.
(3) The identification required under subparagraph (2)(i) of this
paragraph shall be made by the grantor indicating in his records, to the
extent feasible, the individual serial number of, or other
characteristic symbol imprinted upon, each of the two individual options
which comprise the straddle, or by adopting any other method of
identification satisfactory to the Commissioner. Such identification
must be made before the expiration of the 15th day after the day on
which the multiple option is granted. The preceding sentence shall apply
only with respect to multiple options granted after January 24, 1972. In
computing the 15-day period prescribed by this paragraph, the first day
of such period is the day following the day on which the multiple option
is granted.
(d) Allocation of premium. The allocation of a premium received for
a straddle or a multiple option between or among the component options
thereof shall be made on the basis of the relative market value of such
component options at the time of their issuance or on any other
reasonable and consistently applied basis which is acceptable to the
Commissioner.
(e) Effective date--(1) In general. This section, relating to
special rules for grantors of straddles, shall apply only with respect
to straddle transactions entered into after January 25, 1965, and before
September 2, 1976.
(2) Special rule. For a special rule with respect to the
identification of a straddle granted as part of a multiple option, see
paragraph (c).
(f) Illustrations. The application of section 1234(c) and this
section may be illustrated by the following examples:
Example 1. On February 1, 1971, taxpayer A, who files his income tax
returns on a calendar year basis, issues a straddle for 100 shares of X
Corporation stock and receives a premium of $1,000. The options
comprising the straddle were to expire on August 10, 1971. A has
allocated $450 (45 percent of $1,000) of the premium to the put and $550
(55 percent of $1,000) to the call. On March 1, 1971, B, the holder of
the put, exercises his option. C, the holder of the call, fails to
exercise his option prior to its expiration. As a result of C's failure
to exercise his option, A realizes a short-term capital gain of $550
(that part of the premium allocated to the call) on August 10, 1971.
Example 2. Assume the same facts as in example (1), except that C
exercises his call on March 1, 1971, and B fails to exercise his put
prior to its expiration. As a result of B's failure to exercise his
option, A realizes a short-term capital gain of $450 (that part of the
premium allocated to the put) on August 10, 1971.
Example 3. Assume the same facts as in example (1), except that both
B and C fail to exercise their respective options. As a result of the
failure of B and C to exercise their options, A realizes short-term
capital gains of $1,000 (the premium for granting the straddle) on
August 10, 1971.
Example 4. On March 1, 1971, taxpayer D issues a multiple option
containing five puts and five calls. Each put and each call is for the
same number of shares of Y Corporation stock, at the same price, and for
the same period of time. Thus, each of the puts and calls is deemed to
be a component part of a straddle. The puts and calls comprising the
multiple option were to expire on September 10, 1971. All of the puts
are exercised, and all of the calls lapse. As a result of the lapse of
the calls, D realizes a short-term capital
[[Page 331]]
gain on September 10, 1971, in the amount of that part of the premium
for the multiple option which is allocable to all of the calls.
Example 5. Assume the same facts as in example (4) except that one
of the puts and two of the calls lapse and the remaining puts and calls
are exercised. As a result, on September 10, 1971, D realizes a short-
term capital gain in the amount of that part of the premium for the
multiple option which is allocable to both of the lapsed calls and the
lapsed put.
Example 6. On March 1, 1971, taxpayer E issues a multiple option
containing five puts and four calls. Each put and call is for the same
number of shares of Y Corporation stock at the same price and for the
same period of time, E does not identify the puts and calls as parts of
straddles in the manner prescribed in paragraph (c)(3) of this section.
However, because the terms of all of the puts and all of the calls are
identical four of the puts and four of the calls are deemed to be a
component part of a straddle. The puts and calls comprising the multiple
option were to expire on September 10, 1971. Four of the puts are
exercised and the four calls and one of the puts lapse. As a result, on
September 10, 1971, E realizes short-term capital gain in the amount of
that part of the premium for the multiple option which is allocable to
the four lapsed calls and realizes ordinary income in the amount of that
part of such premium which is allocable to the lapsed put. If E had
identified four of the puts and four of the calls as constituting parts
of straddles in the manner prescribed in paragraph (c)(3) of this
section and the put that lapsed constituted part of a straddle, then the
gain on the lapse of the put would also be short-term capital gain.
Example 7. Assume the same facts as in example (6) except that two
of the puts are for Y Corporation stock at a price which is greater than
that of the other puts and the other calls and that two of the calls
expire on October 10, 1971. Additionally, assume that the put which
lapses is at the lower price. The two puts offering the Y Corporation
stock at the greater price and the two calls with the later expiration
date cannot be deemed to be component parts of a straddle. Thus, only
two of the puts and two of the calls are deemed to be a component part
of a straddle. As a result, E realizes income as follows:
(i) On September 10, 1971, short-term capital gain in the amount of
that part of the premium for the multiple option which is allocable to
the two lapsed calls with the expiration date of September 10, 1971, and
ordinary income in the amount of that part of such premium which is
allocable to the lapsed put. If E had identified two of the puts at the
lower price and the two calls with the expiration date of September 10,
1971, as constituting parts of straddles in the manner prescribed in
paragraph (c)(3) of this section and if the put that lapsed was one of
those identified as constituting a part of a straddle, then the gain on
the lapse of that put would also be short-term capital gain.
(ii) On October 10, 1971, ordinary income in the amount of that part
of the premium for the multiple option which is allocable to the lapsed
calls with an expiration date of October 10, 1971.
[T.D. 7152, 36 FR 24801, Dec. 23, 1971, as amended by T.D. 7210, 37 FR
20688, Oct. 3, 1972; T.D. 7652, 44 FR 62282, Oct. 30, 1979; 44 FR 67657,
Nov. 27, 1979; T.D. 7728, 45 FR 72650, Nov. 3, 1980]
Sec. 1.1234-3 Special rules for the treatment of grantors of certain
options granted after September 1, 1976.
(a) In general. In the case of the grantor of an option (including
an option granted as part of a straddle or multiple option), gain of
loss from any closing transaction with respect to, and gain on the lapse
of, an option in property shall be treated as a gain or loss from the
sale or exchange of a capital asset held not more than 1 year. (6 months
for taxable years beginning before 1977; 9 months for taxable years
beginning in 1977).
(b) Definitions. The following definitions apply for purposes of
this section.
(1) The term closing transaction means any termination of a
grantor's obligation under an option to buy property (a call) or an
option to sell property (a put) other than through the exercise or lapse
of the option. For example, the grantor of a call may effectively
terminate his obligation under the option by either:
(i) Repurchasing the option from the holder or
(ii) Purchasing from an options exchange a call with terms identical
to the original option granted and designating the purchase as a closing
transaction.
A put or call purchased to make a closing transaction is identical as to
striking price and expiration date. Such put or call need not match the
granted option in time of creation, date of acquisition, cost of the
entire option or units therein, or number of units subject to the
option. If such put or call terminates only part of a grantor's
obligation under the granted option, a closing transaction is made as to
that part.
[[Page 332]]
(2) The term property means stocks and securities (including stocks
and securities dealt with on a when issued basis), commodities, and
commodity futures.
(3) The term grantor means the writer or issuer of an option.
(4) The term straddle means a simultaneously granted combination of
an option to buy and an option to sell the same quantity of property at
the same price during the same period of time.
(5) The term multiple option means a simultaneously granted
combination of an option to buy plus an option to sell plus one or more
additional options to buy or sell property.
(c) Nonapplicability to broker-dealers. The provisions of this
section do not apply to any option granted in the ordinary course of the
taxpayer's trade or business of granting options. However, the
provisions of this section do apply to:
(1) Gain from any closing transaction with respect to an option and
gain on lapse of an option if gain on the sale or exchange of the option
would be considered capital gain by a dealer in securities under section
1236(a) and the regulations thereunder, and
(2) Loss from any closing transaction with respect to an option if
loss on the sale or exchange of the option would not be considered
ordinary loss by a dealer in securities under section 1236(b) and the
regulations thereunder.
The preceding sentence shall be applied with respect to dealers in
property (as defined in paragraph (b)(2) of this section) and without
regard to the limitation of the applicability of section 1236 to dealers
in securities.
(d) Nonapplicability to compensatory options. Section 1234 does not
apply to options to purchase stock or other property which are issued as
compensation for services, as described in sections 61, 83, and 421 and
the regulations thereunder.
(e) Premium allocation for simultaneously granted options. The
allocation of a premium received for a straddle or multiple option
between or among the component options thereof shall be made on the
basis of the relative market value of the component options at the time
of their issuance or on any other reasonable and consistently applied
basis which is acceptable to the Commissioner.
(f) Effective date. This section, relating to special rules for the
treatment of grantors of certain options, shall apply to options granted
after September 1, 1976.
[T.D. 7652, 44 FR 62282, Oct. 30, 1979; 44 FR 67657, Nov. 27, 1979]
Sec. 1.1234-4 Hedging transactions.
The character of gain or loss on an acquired or a written option
that is (or is identified as being) part of a hedging transaction is
determined under the rules of Sec. 1.1221-2.
[T.D. 8555, 59 FR 36367, July 18, 1994]
Sec. 1.1235-1 Sale or exchange of patents.
(a) General rule. Section 1235 provides that a transfer (other than
by gift, inheritance, or devise) of all substantial rights to a patent,
or of an undivided interest in all such rights to a patent, by a holder
to a person other than a related person constitutes the sale or exchange
of a capital asset held for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977),
whether or not payments therefor are:
(1) Payable periodically over a period generally coterminous with
the transferee's use of the patent, or
(2) Contingent on the productivity, use, or disposition of the
property transferred.
(b) Scope of section 1235. If a transfer is not one described in
paragraph (a) of this section, section 1235 shall be disregarded in
determining whether or not such transfer is the sale or exchange of a
capital asset. For example, a transfer by a person other than a holder
or a transfer by a holder to a related person is not governed by section
1235. The tax consequences of such transfers shall be determined under
other provisions of the internal revenue laws.
(c) Special rules--(1) Payments for infringement. If section 1235
applies to the transfer of all substantial rights to a patent (or an
undivided interest therein), amounts received in settlement of, or as
the award of damages in, a suit for compensatory damages for
infringement of the patent shall be considered payments attributable to
a transfer to
[[Page 333]]
which section 1235 applies to the extent that such amounts relate to the
interest transferred. For taxable years beginning before January 1,
1964, see section 1304, as in effect before such date, and Sec.
1.1304A-1 for treatment of compensatory damages for patent infringement.
(2) Payments to an employee. Payments received by an employee as
compensation for services rendered as an employee under an employment
contract requiring the employee to transfer to the employer the rights
to any invention by such employee are not attributable to a transfer to
which section 1235 applies. However, whether payments received by an
employee from his employer (under an employment contract or otherwise)
are attributable to the transfer by the employee of all substantial
rights to a patent (or an undivided interest therein) or are
compensation for services rendered the employer by the employee is a
question of fact. In determining which is the case, consideration shall
be given not only to all the facts and circumstances of the employment
relationship but also to whether the amount of such payments depends
upon the production, sale, or use by, or the value to, the employer of
the patent rights transferred by the employee. If it is determined that
payments are attributable to the transfer of patent rights, and all
other requirements under section 1235 are met, such payments shall be
treated as proceeds derived from the sale of a patent.
(3) Successive transfers. The applicability of section 1235 to
transfers of undivided interest in patents, or to successive transfers
of such rights, shall be determined separately with respect to each
transfer. For example, X, who is a holder, and Y, who is not a holder,
transfer their respective two-thirds and one-third undivided interests
in a patent to Z. Assume the transfer by X qualifies under section 1235
and that X in a later transfer acquires all the rights with respect to
Y's interest, including the rights to payments from Z. One-third of all
the payments thereafter received by X from Z are not attributable to a
transfer to which section 1235 applies.
(d) Payor's treatment of payments in a transfer under section 1235.
Payments made by the transferee of patent rights pursuant to a transfer
satisfying the requirements of section 1235 are payments of the purchase
price for the patent rights and are not the payment of royalties.
(e) Effective date. Amounts received or accrued, and payments made
or accrued, during any taxable year beginning after December 31, 1953
and ending after August 16, 1954, pursuant to a transfer satisfying the
requirements of section 1235, whether such transfer occurred in a
taxable year to which the Internal Revenue Code of 1954 applies, or in a
year prior thereto, are subject to the provisions of section 1235.
(f) Nonresident aliens. For the special rule relating to nonresident
aliens who have gains arising from a transfer to which section 1235
applies, see section 871 and the regulations thereunder. For withholding
of tax from income of nonresident aliens, see section 1441 and the
regulations thereunder.
[T.D. 6500, 25 FR 12014, Nov. 26, 1960, as amended by T.D. 6885, 31 FR
7803, June 2, 1966; T.D. 7728, 45 FR 72650, Nov. 3, 1980]
Sec. 1.1235-2 Definition of terms.
For the purposes of section 1235 and Sec. 1.1235-1:
(a) Patent. The term patent means a patent granted under the
provisions of title 35 of the United States Code, or any foreign patent
granting rights generally similar to those under a United States patent.
It is not necessary that the patent or patent application for the
invention be in existence if the requirements of section 1235 are
otherwise met.
(b) All substantial rights to a patent. (1) The term all substantial
rights to a patent means all rights (whether or not then held by the
grantor) which are of value at the time the rights to the patent (or an
undivided interest therein) are transferred. The term all substantial
rights to a patent does not include a grant of rights to a patent:
(i) Which is limited geographically within the country of issuance;
(ii) Which is limited in duration by the terms of the agreement to a
period less than the remaining life of the patent;
[[Page 334]]
(iii) Which grants rights to the grantee, in fields of use within
trades or industries, which are less than all the rights covered by the
patent, which exist and have value at the time of the grant; or
(iv) Which grants to the grantee less than all the claims or
inventions covered by the patent which exist and have value at the time
of the grant.
The circumstances of the whole transaction, rather than the particular
terminology used in the instrument of transfer, shall be considered in
determining whether or not all substantial rights to a patent are
transferred in a transaction.
(2) Rights which are not considered substantial for purposes of
section 1235 may be retained by the holder. Examples of such rights are:
(i) The retention by the transferor of legal title for the purpose
of securing performance or payment by the transferee in a transaction
involving transfer of an exclusive license to manufacture, use, and sell
for the life of the patent;
(ii) The retention by the transferor of rights in the property which
are not inconsistent with the passage of ownership, such as the
retention of a security interest (such as a vendor's lien), or a
reservation in the nature of a condition subsequent (such as a provision
for forfeiture on account of nonperformance).
(3) Examples of rights which may or may not be substantial,
depending upon the circumstances of the whole transaction in which
rights to a patent are transferred, are:
(i) The retention by the transferor of an absolute right to prohibit
sublicensing or subassignment by the transferee;
(ii) The failure to convey to the transferee the right to use or to
sell the patent property.
(4) The retention of a right to terminate the transfer at will is
the retention of a substantial right for the purposes of section 1235.
(c) Undivided interest. A person owns an undivided interest in all
substantial rights to a patent when he owns the same fractional share of
each and every substantial right to the patent. It does not include, for
example, a right to the income from a patent, or a license limited
geographically, or a license which covers some, but not all, of the
valuable claims or uses covered by the patent. A transfer limited in
duration by the terms of the instrument to a period less than the
remaining life of the patent is not a transfer of an undivided interest
in all substantial rights to a patent.
(d) Holder. (1) The term holder means any individual:
(i) Whose efforts created the patent property and who would qualify
as the original and first inventor, or joint inventor, within the
meaning of title 35 U.S.C., or
(ii) Who has acquired his interest in the patent property in
exchange for a consideration paid to the inventor in money or money's
worth prior to the actual reduction of the invention to practice (see
paragraph (e) of this section), provided that such individual was
neither the employer of the inventor nor related to him (see paragraph
(f) of this section). The requirement that such individual is neither
the employer of the inventor nor related to him must be satisfied at the
time when the substantive rights as to the interest to be acquired are
determined, and at the time when the consideration in money or money's
worth to be paid is definitely fixed. For example, if prior to the
actual reduction to practice of an invention an individual who is
neither the employer of the inventor nor related to him agrees to pay
the inventor a sum of money definitely fixed as to amount in return for
an undivided one-half interest in rights to a patent and at a later
date, when such individual has become the employer of the inventor, he
pays the definitely fixed sum of money pursuant to the earlier
agreement, such individual will not be denied the status of a holder
because of such employment relationship.
(2) Although a partnership cannot be a holder, each member of a
partnership who is an individual may qualify as a holder as to his share
of a patent owned by the partnership. For example, if an inventor who is
a member of a partnership composed solely of individuals uses
partnership property in the development of his invention with the
understanding that the patent
[[Page 335]]
when issued will become partnership property, each of the inventor's
partners during this period would qualify as a holder. If, in this
example, the partnership were not composed solely of individuals,
nevertheless, each of the individual partners' distributive shares of
income attributable to the transfer of all substantial rights to the
patent or an undivided interest therein, would be considered proceeds
from the sale or exchange of a capital asset held for more than 1 year
(6 months for taxable years beginning before 1977; 9 months for taxable
years beginning in 1977).
(3) An individual may qualify as a holder whether or not he is in
the business of making inventions or in the business of buying and
selling patents.
(e) Actual reduction to practice. For the purposes of determining
whether an individual is a holder under paragraph (d) of this section,
the term actual reduction to practice has the same meaning as it does
under section 102(g) of title 35 of the United States Code. Generally,
an invention is reduced to actual practice when it has been tested and
operated successfully under operating conditions. This may occur either
before or after application for a patent but cannot occur later than the
earliest time that commercial exploitation of the invention occurs.
(f) Related person. (1) The term related person means one whose
relationship to another person at the time of the transfer is described
in section 267(b), except that the term does not include a brother or
sister, whether of the whole or the half blood. Thus, if a holder
transfers all his substantial rights to a patent to his brother or
sister, or both, such transfer is not to a related person.
(2) If, prior to September 3, 1958, a holder transferred all his
substantial rights to a patent to a corporation in which he owned more
than 50 percent in value of the outstanding stock, he is considered as
having transferred such rights to a related person for the purpose of
section 1235. On the other hand, if a holder, prior to September 3,
1958, transferred all his substantial rights to a patent to a
corporation in which he owned 50 percent or less in value of the
outstanding stock and his brother owned the remaining stock, he is not
considered as having transferred such rights to a related person since
the brother relationship is to be disregarded for purposes of section
1235.
(3) If, subsequent to September 2, 1958, a holder transfers all his
substantial rights to a patent to a corporation in which he owns 25
percent or more in value of the outstanding stock, he is considered as
transferring such rights to a related person for the purpose of section
1235. On the other hand if a holder, subsequent to September 2, 1958,
transfers all his substantial rights to a patent to a corporation in
which he owns less than 25 percent in value of the outstanding stock and
his brother owns the remaining stock, he is not considered as
transferring such rights to a related person since the brother
relationship is to be disregarded for purposes of section 1235.
(4) If a relationship described in section 267(b) exists
independently of family status, the brother-sister exception, described
in subparagraphs (1), (2), and (3) of this paragraph, does not apply.
Thus, if a holder transfers all his substantial rights to a patent to
the fiduciary of a trust of which the holder is the grantor, the holder
and the fiduciary are related persons for purposes of section 1235(d).
(See section 267(b)(4).) The transfer, therefore, would not qualify
under section 1235(a). This result obtains whether or not the fiduciary
is the brother or sister of the holder since the disqualifying
relationship exists because of the grantor-fiduciary status and not
because of family status.
[T.D. 6500, 25 FR 12014, Nov. 26, 1960, as amended by T.D. 6852, 30 FR
12730, Oct. 6, 1965; T.D. 7728, 45 FR 72650, Nov. 3, 1980]
Sec. 1.1236-1 Dealers in securities.
(a) Capital gains. Section 1236(a) provides that gain realized by a
dealer in securities from the sale or exchange of a security (as defined
in paragraph (c) of this section) shall not be considered as gain from
the sale or exchange of a capital asset unless:
(1) The security is, before the expiration of the thirtieth day
after the date of its acquisition, clearly identified in the dealer's
records as a security held for investment or, if acquired before October
20, 1951, was so identified before November 20, 1951; and
[[Page 336]]
(2) The security is not held by the dealer primarily for sale to
customers in the ordinary course of his trade or business at any time
after the identification referred to in subparagraph (1) of this
paragraph has been made.
Unless both of these requirements are met, the gain is considered as
gain from the sale of assets held by the dealer primarily for sale to
customers in the course of his business.
(b) Ordinary losses. Section 1236(b) provides that a loss sustained
by a dealer in securities from the sale or exchange of a security shall
not be considered a loss from the sale or exchange of property which is
not a capital asset if at any time after November 19, 1951, the security
has been clearly identified in the dealer's records as a security held
for investment. Once a security has been identified after November 19,
1951, as being held by the dealer for investment, it shall retain that
character for purposes of determining loss on its ultimate disposition,
even though at the time of its disposition the dealer holds it primarily
for sale to his customers in the ordinary course of his business.
However, section 1236 has no application to the extent that section
582(c) applies to losses of banks.
(c) Definitions--(1) Security. For the purposes of this section, the
term security means any share of stock in any corporation, any
certificate of stock or interest in any corporation, any note, bond,
debenture, or other evidence of indebtedness, or any evidence of any
interest in, or right to subscribe to or purchase, any of the foregoing.
(2) Dealer in securities. For definition of a dealer in securities,
see the regulations under section 471.
(d) Identification of security in dealer's records. (1) A security
is clearly identified in the dealer's records as a security held for
investment when there is an accounting separation of the security from
other securities, as by making appropriate entries in the dealer's books
of account to distinguish the security from inventories and to designate
it as an investment and by (i) indicating with such entries, to the
extent feasible, the individual serial number of, or other
characteristic symbol imprinted upon, the individual security, or (ii)
adopting any other method of identification satisfactory to the
Commissioner.
(2) In computing the 30-day period prescribed by section 1236(a),
the first day of the period is the day following the date of
acquisition. Thus, in the case of a security acquired on March 18, 1957,
the 30-day period expires at midnight on April 17, 1957.
[T.D. 6500, 25 FR 12015, Nov. 26, 1960, as amended by T.D. 6726, 29 FR
5667, Apr. 29, 1964]
Sec. 1.1237-1 Real property subdivided for sale.
(a) General rule--(1) Introductory. This section provides a special
rule for determining whether the taxpayer holds real property primarily
for sale to customers in the ordinary course of his business under
section 1221(1). This rule is to permit taxpayers qualifying under it to
sell real estate from a single tract held for investment without the
income being treated as ordinary income merely because of subdividing
the tract or of active efforts to sell it. The rule is not applicable to
dealers in real estate or to corporations, except a corporation making
such sales in a taxable year beginning after December 3l, 1954, if such
corporation qualifies under the provisions of paragraph (c)(5)(iv) of
this section.
(2) When subdividing and selling activities are to be disregarded.
When its conditions are met, section 1237 provides that if there is no
other substantial evidence that a taxpayer holds real estate primarily
for sale to customers in the ordinary course of his business, he shall
not be considered a real estate dealer holding it primarily for sale
merely because he has (i) subdivided the tract into lots (or parcels)
and (ii) engaged in advertising, promotion, selling activities or the
use of sales agents in connection with the sale of lots in such
subdivision. Such subdividing and selling activities shall be
disregarded in determining the purpose for which the taxpayer held real
property sold from a subdivision whenever it is the only substantial
evidence indicating that the taxpayer has ever held the real property
sold primarily for sale to customers in the ordinary course of his
business.
[[Page 337]]
(3) When subdividing and selling activities are to be taken into
account. When other substantial evidence tends to show that the taxpayer
held real property for sale to customers in the ordinary course of his
business, his activities in connection with the subdivision and sale of
the property sold shall be taken into account in determining the purpose
for which the taxpayer held both the subdivided property and any other
real property. For example, such other evidence may consist of the
taxpayer's selling activities in connection with other property in prior
years during which he was engaged in subdividing or selling activities
with respect to the subdivided tract, his intention in prior years (or
at the time of acquiring the property subdivided) to hold the tract
primarily for sale in his business, his subdivision of other tracts in
the same year, his holding other real property for sale to customers in
the same year, or his construction of a permanent real estate office
which he could use in selling other real property. On the other hand, if
the only evidence of the taxpayer's purpose in holding real property
consisted of not more than one of the following, in the year in
question, such fact would not be considered substantial other evidence:
(i) Holding a real estate dealer's license;
(ii) Selling other real property which was clearly investment
property;
(iii) Acting as a salesman for a real estate dealer, but without any
financial interest in the business; or
(iv) Mere ownership of other vacant real property without engaging
in any selling activity whatsoever with respect to it.
If more than one of the above exists, the circumstances may or may not
constitute substantial evidence that the taxpayer held real property for
sale in his business, depending upon the particular facts in each case.
(4) Section 1237 not exclusive. (i) The rule in section 1237 is not
exclusive in its application. Section 1237 has no application in
determining whether or not real property is held by a taxpayer primarily
for sale in his business if any requirement under the section is not
met. Also, even though the conditions of section 1237 are met, the rules
of section 1237 are not applicable if without regard to section 1237 the
real property sold would not have been considered real property held
primarily for sale to customers in the ordinary course of his business.
Thus, the district director may at all times conclude from convincing
evidence that the taxpayer held the real property solely as an
investment. Furthermore, whether or not the conditions of section 1237
are met, the section has no application to losses realized upon the sale
of realty from subdivided property.
(ii) If, owing solely to the application of section 1237, the real
property sold is deemed not to have been held primarily for sale in the
ordinary course of business, any gain realized upon such sale shall be
treated as ordinary income to the extent provided in section 1237(b) (1)
and (2) and paragraph (e) of this section. Any additional gain realized
upon the sale shall be treated as gain arising from the sale of a
capital asset or, if the circumstances so indicate, as gain arising from
the sale of real property used in the trade or business as defined in
section 1231 (b)(1). For the relationship between sections 1237 and
1231, see paragraph (f) of this section.
(5) Principal conditions of qualification. Before section 1237
applies, the taxpayer must meet three basic conditions, more fully
explained later: He cannot have held any part of the tract at any time
previously for sale in the ordinary course of his business, nor in the
year of sale held any other real estate for sale to customers; he cannot
make substantial improvements on the tract which increase the value of
the lot sold substantially; and he must have owned the property 5 years,
unless he inherited it. However, the taxpayer may make certain
improvements if they are necessary to make the property marketable if he
elects neither to add their cost to the basis of the property, or of any
other property, nor to deduct the cost as an expense, and he has held
the property at least 10 years. If the requirements of section 1237 are
met, gain (but not more than 5 percent of the selling price of each lot)
shall be treated as ordinary income in and after the year in which the
sixth lot or parcel is sold.
[[Page 338]]
(b) Disqualification arising from holding real property primarily
for sale--(1) General rule. Section 1237 does not apply to any
transaction if the taxpayer either:
(i) Held the lot sold (or the tract of which it was a part)
primarily for sale in the ordinary course of his business in a prior
year, or
(ii) Holds other real property primarily for sale in the ordinary
course of his business in the same year in which such lot is sold.
Where either of these elements is present, section 1237 shall be
disregarded in determining the proper treatment of any gain arising from
such sale.
(2) Method of applying general rule. For purposes of this paragraph,
in determining whether the lot sold was held primarily for sale in the
ordinary course of business in a prior year, the principles of section
1237 shall be applied, whether or not section 1237 was effective for
such prior year, if the sale of the lot occurs after December 31, 1953,
or, in the case of a corporation meeting the requirements of paragraph
(c)(5)(iv) of this section, if the sale of the lot occurs in a taxable
year beginning after December 31, 1954. Whether, on the other hand, the
taxpayer holds other real property for sale in the ordinary course of
his business in the same year such lot was sold shall be determined
without regard to the application of section 1237 to such other real
property.
(3) Attribution rules with respect to the holding of property. The
taxpayer is considered as holding property which he owns individually,
jointly, or as a member of a partnership. He is not generally considered
as holding property owned by members of his family, an estate or trust,
or a corporation. See, however, paragraph (c)(5) (iv)(c) of this section
for an exception to this rule. The purpose for which a prior owner held
the lot or tract, or his activities, are immaterial except to the extent
they indicate the purpose for which the taxpayer has held the lot or
tract. See paragraph (d) of this section for rules relating to the
determination of the period for which the property is held. The
principles of this subparagraph may be illustrated by the following
example:
Example: A dealer in real property held a tract of land for sale to
customers in the ordinary course of his business for 5 years. He then
made a gift of it to his son. As a result of the operation of section
1223(2) the son will have held the property for the period of time
required by section 1237. However, he will not qualify for the benefits
of section 1237 because, there being no evidence to the contrary, the
circumstances involved establish that the son holds the property for
sale to customers, as did his father.
(c) Disqualification arising from substantial improvements--(1)
General rule. Section 1237 will not apply if the taxpayer or certain
others make improvements on the tract which are substantial and which
substantially increase the value of the lot sold. Certain improvements
are not substantial within the meaning of section 1237(a)(2) if they are
necessary to make the lot marketable at the prevailing local price and
meet the other conditions of section 1237(b)(3). See subparagraph (5) of
this paragraph.
(2) Improvements made or deemed to be made by the taxpayer. Certain
improvements made by the taxpayer or made under a contract of sale
between the taxpayer and the buyer make section 1237 inapplicable.
(i) For the purposes of section 1237 (a)(2) the taxpayer is deemed
to have made any improvements on the tract while he held it which are
made by:
(a) The taxpayer's whole or half brothers and sisters, spouse,
ancestors and lineal descendants.
(b) A corporation controlled by the taxpayer. A corporation is
controlled by the taxpayer if he controls, as the result of direct
ownership, constructive ownership, or otherwise, more than 50 percent of
the corporation's voting stock.
(c) A partnership of which the taxpayer was a member at the time the
improvements were made.
(d) A lessee if the improvement takes the place of a payment of
rental income. See section 109 and the regulations thereunder.
(e) A Federal, State, or local government, or political subdivision
thereof, if the improvement results in an increase in the taxpayer's
basis for the property, as it would, for example, from a special tax
assessment for paving streets.
[[Page 339]]
(ii) The principles of subdivision (i) of this subparagraph may be
illustrated by the following example:
Example: A held a tract of land for 3 years during which he made
substantial improvements thereon which substantially enhanced the value
of every lot on the tract. A then made a gift of the tract to his son.
The son made no further improvements on the tract but held it for 3
years and then sold several lots therefrom. The son is not entitled to
the benefits of section 1237 since under section 1237(a)(2) he is deemed
to have made the substantial improvements made by his father, and under
section 1223(2) he is treated as having held the property for the period
during which his father held it. Thus, the disqualifying improvements
are deemed to have been made by the son while the tract was held by him.
See paragraph (d) of this section for rules relating to the
determination of the period for which the property is held.
(iii) The taxpayer is also charged with making any improvements made
pursuant to a contract of sale entered into between the taxpayer and the
buyer. Therefore, the buyer, as well as the taxpayer, may make
improvements which prevent the application of section 1237.
(a) If a contract of sale obligates either the taxpayer or the buyer
to make a substantial improvement which would substantially increase the
value of the lot, the taxpayer may not claim the application of section
1237 unless the obligation to improve the lot ceases (for any reason
other than that the improvement has been made) before or within the
period, prescribed by section 6511, within which the taxpayer may file a
claim for credit or refund of an overpayment of his tax on the gain from
the sale of the lot. The following example illustrates this rule:
Example: In 1956, A sells several lots from a tract he has
subdivided for sale. Section 1237 would apply to the sales of these lots
except that in the contract of sale, A agreed to install sewers, hard
surface roads, and other utilities which would increase the value of the
lots substantially. If in 1957, instead of requiring the improvements,
the buyer releases A from this obligation, A may then claim the
application of section 1237 to the sale of lots in 1956 in computing his
income tax for 1956, since the period of limitations in which A may file
a claim for credit or refund of an overpayment of his 1956 income tax
has not expired.
(b) An improvement is made pursuant to a contract if the contract
imposes an obligation on either party to make the improvement, but not
if the contract merely places restrictions on the improvements, if any,
either party may make. The following example illustrates this rule:
Example: B sells several lots from a tract which he has subdivided.
Each contract of sale prohibits the purchaser from building any
structure on his lot except a personal residence costing $15,000 or
more. Even if the purchasers build such residences, that does not
preclude B from applying section 1237 to the sales of such lots, since
the contracts did not obligate the purchasers to make any improvements.
(iv) Improvements made by a bona fide lessee (other than as rent) or
by others not described in section 1237(a) (2) do not preclude the use
of section 1237.
(3) When improvements substantially enhance the value of the lot
sold. Before a substantial improvement will preclude the use of section
1237, it must substantially enhance the value of the lot sold.
(i) The increase in value to be considered is only the increase
attributable to the improvement or improvements. Other changes in the
market price of the lot, not arising from improvements made by the
taxpayer, shall be disregarded. The difference between the value of the
lot, including improvements, when the improvement has been completed and
an appraisal of its value if unimproved at that time, will disclose the
value added by the improvements.
(ii) Whether improvements have substantially increased the value of
a lot depends upon the circumstances in each case. If improvements
increase the value of a lot by 10 percent or less, such increase will
not be considered as substantial, but if the value of the lot is
increased by more than 10 percent, then all relevant factors must be
considered to determine whether, under such circumstances, the increase
is substantial.
(iii) Improvement may increase the value of some lots in a tract
without equally affecting other lots in the same tract. Only the lots
whose value was substantially increased are ineligible
[[Page 340]]
for application of the rule established by section 1237.
(4) When an improvement is substantial. To prevent the application
of section 1237, the improvement itself must be substantial in
character. Among the improvements considered substantial are shopping
centers, other commercial or residential buildings, and the installation
of hard surface roads or utilities such as sewers, water, gas, or
electric lines. On the other hand a temporary structure used as a field
office, surveying, filling, draining, leveling and clearing operations,
and the construction of minimum all-weather access roads, including
gravel roads where required by the climate, are not substantial
improvements.
(5) Special rules relating to substantial improvements. Under
certain conditions a taxpayer, including a corporation to which
subdivision (iv) of this subparagraph applies, may obtain the benefits
of section 1237 whether or not substantial improvements have been made.
In addition, an individual taxpayer may, under certain circumstances
elect to have substantial improvements treated as necessary and not
substantial.
(i) When an improvement is not considered substantial. An
improvement will not be considered substantial if all of the following
conditions are met:
(a) The taxpayer has held the property for 10 years. The full 10-
year period must elapse, whether or not the taxpayer inherited the
property. Although the taxpayer must hold the property 10 years, he need
not hold it for 10 years after subdividing it. See paragraph (d) of this
section for rules relating to the determination of the period for which
the property is held.
(b) The improvement consists of the building or installation of
water, sewer, or drainage facilities (either surface, sub-surface, or
both) or roads, including hard surface roads, curbs, and gutters.
(c) The district director with whom the taxpayer must file his
return is satisfied that, without such improvement, the lot sold would
not have brought the prevailing local price for similar building sites.
(d) The taxpayer elects, as provided in subdivision (iii) of this
subparagraph, not to adjust the basis of the lot sold or any other
property held by him for any part of the cost of such improvement
attributable to such lot and not to deduct any part of such cost as an
expense.
(ii) Meaning of similar building site. A similar building site is
any real property in the immediate vicinity whose size, terrain, and
other characteristics are comparable to the taxpayer's property. For the
purpose of determining whether a tract is marketable at the prevailing
local price for similar building sites, the taxpayer shall furnish the
district director with sufficient evidence to enable him to compare (a)
the value of the taxpayer's property in an unimproved state with (b) the
amount for which similar building sites, improved by the installation of
water, sewer, or drainage facilities or roads, have recently been sold,
reduced by the present cost of such improvements. Such comparison may be
made and expressed in terms of dollars per square foot, dollars per
acre, or dollars per front foot, or in any other suitable terms
depending upon the practice generally followed by real estate dealers in
the taxpayer's locality. The taxpayer shall also furnish evidence, where
possible, of the best bona fide offer received for the tract or a lot
thereof just before making the improvement, to assist the district
director in determining the value of the tract or lot if it had been
sold in its unimproved state. The operation of this subdivision and
subdivision (i) of this subparagraph may be illustrated by the following
examples:
Example 1. A has been offered $500 per acre for a tract without
roads, water, or sewer facilities which he has owned for 15 years. The
adjacent tract has been subdivided and improved with water facilities
and hard surface roads, and has sold for $4,000 per acre. The estimated
cost of roads and water facilities on the adjacent tract is $2,500 per
acre. The prevailing local price for similar building sites in the
vicinity would be $1,500 per acre (i.e., $4,000 less $2,500). If A
installed roads and water facilities at a cost of $2,500 per acre, his
tract would sell for approximately $4,000 per acre. Under section
1237(b)(3) the installation of roads and water facilities does not
constitute a substantial improvement if A elects to disregard the cost
of such improvements ($2,500 per acre) in computing his cost or other
basis for the lots sold from the
[[Page 341]]
tract, and in computing his basis for any other property owned by him.
Example 2. Assume the same facts as in example (1) of this
subdivision, except that A can obtain $1,600 per acre for his property
without improvements. The installation of any substantial improvements
would not constitute a necessary improvement under section 1237(b)(3),
since the prevailing local price could have been obtained without any
improvement.
Example 3. Assume the same facts as in example (1) of this
subdivision, except that the adjacent tract has also been improved with
sewer facilities, the present cost of which is $1,200 per acre. The
installation of the substantial improvements would not constitute a
necessary improvement under section 1237(b)(3) on A's part, since the
prevailing local price ($4,000 less the sum of $1,200 plus $2,500, or
$300) could have been obtained by A without any improvement.
(iii) Manner of making election. The election required by section
1237(b) (3)(C) shall be made as follows:
(a) The taxpayer shall submit:
(1) A plat showing the subdivision and all improvements attributable
to him.
(2) A list of all improvements to the tract, showing:
(i) The cost of such improvements.
(ii) Which of the improvements, without regard to the election, he
considers substantial and which he considers not substantial.
(iii) Those improvements which are substantial to which the election
is to apply, with a fair allocation of their cost to each lot they
affect, and the amount by which they have increased the values of such
lots.
(iv) The date on which each lot was acquired and its basis for
determining gain or loss, exclusive of the cost of any improvements
listed in subdivision (iii) of this subdivision.
(3) A statement that he will neither deduct as an expense nor add to
the basis of any lot sold, or of any other property, any portion of the
cost of any substantial improvement which substantially increased the
value of any lot in the tract and which either he listed pursuant to
(a)(2)(iii) of this subdivision or which the district director deems
substantial.
(b) The election and the information required under (a) of this
subdivision shall be submitted to the district director:
(1) With the taxpayer's income tax return for the taxable year in
which the lots subject to the election were sold, or
(2) In the case of a return filed prior to August 14, 1957, either
with a timely claim for refund, where the benefits of section 1237 have
not been claimed on such return, or, independently, before November 13,
1957, where such benefits have been claimed, or
(3) If there is an obligation to make disqualifying improvements
outstanding when the taxpayer files his return, with a formal claim for
refund at the time of the release of the obligation, if it is then still
possible to file a timely claim.
(c) Once made, the election as to the necessary improvement costs
attributable to any lot sold shall be irrevocable and binding on the
taxpayer unless the district director assesses an income tax as to such
lot as if it were held for sale in the ordinary course of taxpayer's
business. Under such circumstances, in computing gain, the cost or other
basis shall be computed without regard to section 1237.
(iv) Exceptions with respect to necessary improvements and certain
corporations. For taxable years beginning after December 31, 1954,
individual taxpayers and certain corporations may obtain the benefits of
section 1237 without complying with the provisions of subdivisions (i)
(c) and (d), (ii), and (iii) of this subparagraph if the requirements of
section 1237 are otherwise met and if:
(a) The property in question was acquired by the taxpayer through
the foreclosure of a lien thereon,
(b) The lien foreclosed secured the payment of an indebtedness to
the taxpayer or (in the case of a corporation) secured the payment of an
indebtedness to a creditor who has transferred the foreclosure bid to
the taxpayer in exchange for all of the stock of the corporation and
other consideration, and
(c) In the case of a corporate taxpayer, no shareholder of the
corporation holds real property for sale to customers in the ordinary
course of his trade or business or holds a controlling interest in
another corporation which actually so holds real property, or which, but
for the application of this
[[Page 342]]
subdivision, would be considered to so hold real property.
Thus, in the case of such property, it is not necessary for the taxpayer
to satisfy the district director that the property would not have
brought the prevailing local price without improvements or to elect not
to add the cost of the improvements to his basis. In addition, if 80
percent or more of the real property owned by a taxpayer is property to
which this subdivision applies, the requirements of (a) and (b) of this
subdivision need not be met with respect to property adjacent to such
property which is also owned by the taxpayer.
(d) Holding period required--(1) General rules. To apply section
1237, the taxpayer must either have inherited the lot sold or have held
it for 5 years. Generally, the provisions of section 1223 are applicable
in determining the period for which the taxpayer has held the property.
The provisions of this subparagraph may be illustrated by the following
examples:
Example 1. A held a tract of land for 3 years under circumstances
otherwise qualifying for section 1237 treatment. He made a gift of the
tract to B at a time when the fair market value of the tract exceeded
A's basis for the tract. B held the tract for 2 more years under similar
circumstances. B then sold 4 lots from the tract. B is entitled to the
benefits of section 1237 since under section 1223(2) he held the lots
for 5 years and all the other requirements of section 1237 are met.
Example 2. C purchased all the stock in a corporation in 1955. The
corporation purchased an unimproved tract of land in 1957. In 1961 the
corporation was liquidated under section 333 and C acquired the tract of
land. For purposes of section 1237, C's holding period commenced on the
date the corporation actually acquired the land in 1957 and not on the
date C purchased the stock.
(2) Rules relating to property acquired upon death. If the taxpayer
inherited the property there is no 5-year holding period required under
section 1237. However, any holding period required by any other
provision of the Code, such as section 1222, is nevertheless applicable.
For purposes of section 1237, neither the survivor's one-half of
community property, nor property acquired by survivorship in a joint
tenancy, is property acquired by devise or inheritance. The holding
period for the surviving joint tenant begins on the date the property
was originally acquired.
(e) Tax consequences if section 1237 applies--(1) Introductory.
Where there is no substantial evidence other than subdivision and
related selling activities that real property is held for sale in the
ordinary course of taxpayer's business and section 1237 applies, section
1237(b)(1) provides a special rule for computing taxable gain. For the
relationship between sections 1237 and 1231, see paragraph (f) of this
section.
(2) Characterization of gain and its relation to selling expenses.
(i) When the taxpayer has sold less than 6 lots or parcels from the same
tract up to the end of his taxable year, the entire gain will be capital
gain. (Where the land is used in a trade or business, see paragraph (f)
of this section.) In computing the number of lots or parcels sold, two
or more contiguous lots sold to a single buyer in a single sale will be
counted as only one parcel. The following example illustrates this rule:
Example: A meets all the conditions of section 1237 in subdividing
and selling a single tract. In 1956 he sells 4 lots to B, C, D, and E.
In the same year F buys 3 adjacent lots. Since A has sold only 5 lots or
parcels from the tract, any gain A realizes on the sales will be capital
gain.
(ii) If the taxpayer has sold the sixth lot or parcel from the same
tract within the taxable year, then the amount, if any, by which 5
percent of the selling price of each lot exceeds the expenses incurred
in connection with its sale or exchange, shall, to the extent it
represents gain, be ordinary income. Any part of the gain not treated as
ordinary income will be treated as capital gain. (Where the land is used
in a trade or business, see paragraph (f) of this section.) Five percent
of the selling price of each lot sold from the tract in the taxable year
the sixth lot is sold and thereafter is, to the extent it represents
gain, considered ordinary income. However, all expenses of sale of the
lot are to be deducted first from the 5 percent of the gain which would
otherwise be considered ordinary income, and any remainder of such
expenses shall reduce the gain upon the sale or exchange which would
otherwise be considered capital gain. Such
[[Page 343]]
expenses cannot be deducted as ordinary business expenses from other
income. The 5-percent rule applies to all lots sold from the tract in
the year the sixth lot or parcel is sold. Thus, if the taxpayer sells
the first 6 lots of a single tract in one year, 5 percent of the selling
price of each lot sold shall be treated as ordinary income and reduced
by the selling expenses. On the other hand, if the taxpayer sells the
first 3 lots of a single tract in 1955, and the next 3 lots in 1956,
only the gain realized from the sales made in 1956 shall be so treated.
For the effect of a 5-year interval between sales, see paragraph (g)(2)
of this section. The operation of this subdivision may be illustrated by
the following examples:
Example 1. Assume the selling price of the sixth lot of a tract is
$10,000, the basis of the lot in the hands of the taxpayer is $5,000,
and the expenses of sale are $750. The amount of gain realized by the
taxpayer is $4,250, of which the amount of ordinary income attributable
to the sale is zero, computed as follows:
Selling price................................................ $10,000
Basis........................................................ 5,000
------------
Excess over basis........................................ 5,000
5 percent of selling price........................ 500
Expenses of sale.................................. 750
-----------
Amount of gain realized treated as ordinary income........... 0
Excess over basis............................................ 5,000
5 percent of selling price........................ 500
Excess of expenses over 5 percent of selling price 250
-----------
......... 750
----------
Amount of gain realized from sale of property not held 4,250
for sale in ordinary course of business.................
Example 2. Assume the same facts as in Example 1, except that the
expenses of sale of such sixth lot are $300. The amount of gain realized
by the taxpayer is $4,700, of which the amount of ordinary income
attributable to the sale is $200, computed as follows:
Selling price................................................ $10,000
Basis........................................................ 5,000
------------
Excess over basis........................................ 5,000
5 percent of selling price........................ $500
Expenses of sale.................................. 300
-----------
Amount of gain realized treated as ordinary income........... 200
Excess over basis............................................ 5,000
5 percent of selling price........................ 500
Excess of expenses over 5 percent of selling price 0
-----------
......... 500
----------
Amount of gain realized from sale of property not held 4,500
for sale in ordinary course of business.................
(iii) In the case of an exchange, the term selling price shall mean
the fair market value of property received plus any sum of money
received in exchange for the lot. See section 1031 for those exchanges
in which no gain is recognized. For the purpose of subsections (b) and
(c) of section 1237 and paragraphs (e) and (g) of this section, an
exchange shall be treated as a sale or exchange whether or not gain or
loss is recognized with respect to such exchange.
(f) Relationship of section 1237 and section 1231. Application of
section 1237 to a sale of real property may, in some cases, result in
the property being treated as real property used in the trade or
business, as described in section 1231(b)(1). Thus, assuming section
1237 is otherwise applicable, if the lot sold would be considered
property described in section 1231(b)(1) except for the fact that the
taxpayer subdivided the tract of which it was a part, then evidence of
such subdivision and connected sales activities shall be disregarded and
the lot sold shall be considered real property used in the trade or
business. Under such circumstances, any gain or loss realized from the
sale shall be treated as gain or loss arising from the sale of real
property used in the trade or business.
(g) Definition of tract--(1) Aggregation of properties. For the
purposes of section 1237, the term tract means either (i) a single piece
of real property or (ii) two or more pieces of real property if they
were contiguous at any time while held by the taxpayer, or would have
been contiguous but for the interposition of a road, street, railroad,
stream, or similar property. Properties are contiguous if their
boundaries meet at one or more points. The single piece of contiguous
properties need not have been conveyed by a single deed. The taxpayer
may have assembled them over a period of time and may hold them
separately, jointly, or as a partner, or in any combination of such
forms of ownership.
(2) When a subdivision will be considered a new tract. If the
taxpayer sells or exchanges no lots from the tract for a
[[Page 344]]
period of 5 years after the sale or exchange of at least 1 lot in the
tract, then the remainder of the tract shall be deemed a new tract for
the purpose of counting the number of lots sold from the same tract
under section 1237(b)(1). The pieces in the new tract need not be
contiguous. The 5-year period is measured between the dates of the sales
or exchanges.
(h) Effective date. This section shall apply only to gain realized
on sales made after December 31, 1953, or, in the case of a person
meeting the requirements of paragraph (c)(5)(iv) of this section, if the
sale of the lot occurs in a taxable year beginning after December 31,
1954. Pursuant to section 7851(a)(1)(C), the regulations prescribed in
this section (other than subdivision (iv) of paragraph (c)(5)) shall
also apply to taxable years beginning before January 1, 1954, and ending
after December 31, 1953, and to taxable years beginning after December
31, 1953, and ending before August 17, 1954, although such years are
subject to the Internal Revenue Code of 1939. Irrespective of whether
the taxable year involved is subject to the Internal Revenue Code of
1939 or the Internal Revenue Code of 1954, sales or exchanges made
before January 1, 1954, shall be taken into account to determine
whether: (1) No sales or exchanges have been made for 5 years, under
section 1237(c), and (2) more than 5 lots or parcels have been sold or
exchanged from the same tract, under section 1237(b)(1). Thus, if the
taxpayer sold 5 lots from a single tract in 1950, and another lot is
sold in 1954, the lot sold in 1954 constitutes the sixth lot sold from
the original tract. On the other hand, if the first 5 lots were sold in
1948, the sale made in 1954 shall be deemed to have been made from a new
tract.
[T.D. 6500, 25 FR 12016, Nov. 26, 1960]
Sec. 1.1238-1 Amortization in excess of depreciation.
(a) In general. Section 1238 provides that if a taxpayer is entitled
to a deduction for amortization of an emergency facility under section
168, and if the facility is later sold or exchanged, any gain realized
shall be considered as ordinary income to the extent that the
amortization deduction exceeds normal depreciation. Thus, under section
1238 gain from a sale or exchange of property shall be considered as
ordinary income to the extent that its adjusted basis is less than its
adjusted basis would be if it were determined without regard to section
168. If an entire facility is certified under section 168(e), the
taxpayer may use allowances for depreciation based on any rate and
method which would have been proper if the basis of the facility were
not subject to amortization under section 168, in determining what the
adjusted basis of the facility would be if it were determined without
regard to section 168. If only a portion of a facility is certified
under section 168(e), allowances for depreciation based on the rate and
method properly used with respect to the uncertified part of the
facility are used in determining what the adjusted basis of the facility
would be if it were determined without regard to section 168. The
principles of this paragraph may be illustrated by the following
examples:
Example 1. On December 31, 1954, a taxpayer making his income tax
returns on a calendar year basis acquires at a cost of $20,000 an
emergency facility (used in his business) 50 percent of the adjusted
basis of which has been certified under section 168(e). The facility
would normally have a useful life of 20 years and a salvage value of
$2,000 allocable equally between the certified and uncertified portions.
Under section 168 the taxpayer elects to begin the 60-month amortization
period on January 1, 1955. He takes amortization deductions with respect
to the certified portion in the amount of $4,000 for the years 1955 and
1956 (24 months). On December 31, 1956, he sells the facility for a
price of $19,000 which is allocable equally between the certified and
uncertified portions. The adjusted basis of the certified portion on
that date is $6,000 ($10,000 cost, less $4,000 amortization). With
respect to the uncertified portion, the straight line method of
depreciation is used and a deduction for depreciation in the amount of
$450 is claimed and allowed for the year 1955. The adjusted basis of the
uncertified portion on January 1, 1956, is $9,550 ($10,000 cost, less
$450 depreciation). The depreciation allowance for the uncertified
portion for the year 1956 would be limited to $50, the amount by which
the adjusted basis of such portion at the beginning of the year exceeded
its aliquot portion of the sales price. Thus, on December 31, 1956, the
adjusted basis of the uncertified portion would be $9,500. Without
regard to section
[[Page 345]]
168, and using the rate and method the taxpayer properly applied to the
uncertified portion of the facility, the adjusted basis of the certified
portion on December 31, 1956, would be $9,500, computed in the same
manner as the adjusted basis of the uncertified portion. The difference
between the facility's actual adjusted basis ($15,500) and its adjusted
basis determined without regard to section 168 ($19,000), is $3,500.
Accordingly, the entire $3,500 gain on the sale of the facility ($19,000
sale price, less $15,500 adjusted basis) is treated as ordinary income.
Example 2. Assume that the entire facility in example (1) had been
certified under section 168(e) and that, therefore, the adjusted basis
of the facility on December 31, 1956, is $12,000. Assume further that
the taxpayer adopts straight line depreciation as a proper method of
depreciation for determining the adjusted basis of the facility without
regard to section 168. Thus, the adjusted basis, without regard to
section 168, would be $19,000. This amount is $7,000 more than the
$12,000 adjusted basis under section 168. Hence, the entire $7,000 gain
on the sale of the facility ($19,000 sale price less $12,000 adjusted
basis) is treated as ordinary income.
(b) Substituted basis. If a taxpayer acquires other property in an
exchange for an emergency facility with respect to which amortization
deductions have been allowed or allowable, and if the basis in his hands
of the other property is determined by reference to the basis of the
emergency facility, then the basis of the other property is determined
with regard to section 168, and therefore the provisions of section 1238
apply with respect to gain realized on a subsequent sale or exchange of
the other property. The provisions of section 1238 also apply to gain
realized on the sale or exchange of an emergency facility (or other
property acquired, as described in the preceding sentence, in exchange
for an emergency facility) by a taxpayer in whose hands the basis of the
facility (or other property) is determined by reference to its basis in
the hands of another person to whom deductions were allowable or allowed
with respect to the facility under section 168.
[T.D. 6500, 25 FR 12020, Nov. 26, 1960, as amended by T.D. 6825, 30 FR
7281, June 2, 1965]
Sec. 1.1239-1 Gain from sale or exchange of depreciable property
between certain related taxpayers after October 4, 1976.
(a) In general. In the case of a sale or exchange of property,
directly or indirectly, between related persons after October 4, 1976
(other than a sale or exchange made under a binding contract entered
into on or before that date), any gain recognized by the transferor
shall be treated as ordinary income if such property is, in the hands of
the transferee, subject to the allowance for depreciation provided in
section 167. This rule also applies to property which would be subject
to the allowance for depreciation provided in section 167 except that
the purchaser has elected a different form of deduction, such as those
allowed under sections 169, 188, and 191.
(b) Related persons. For purposes of paragraph (a) of this section,
the term related persons means:
(1) A husband and wife,
(2) An individual and a corporation 80 percent or more in value of
the outstanding stock of which is owned, directly or indirectly, by or
for such individual, or
(3) Two or more corporations 80 percent or more in value of the
outstanding stock of each of which is owned, directly or indirectly, by
or for the same individual.
(c) Rules of construction--(1) Husband and wife. For purposes of
paragraph (b)(1) of this section, if on the date of the sale or exchange
a taxpayer is legally separated from his spouse under an interlocutory
decree of divorce, the taxpayer and his spouse shall not be treated as
husband and wife, provided the sale or exchange is made pursuant to the
decree and the decree subsequently becomes final. Thus, if pursuant to
an interlocutory decree of divorce, an individual transfers depreciable
property to his spouse and, because of this section, the gain recognized
on the transfer of the property is treated as ordinary income, the
individual may, if the interlocutory decree becomes final after his tax
return has been filed, file a claim for a refund.
(2) Sales between commonly controlled corporations. In general, in
the case of a
[[Page 346]]
sale or exchange of depreciable property between related corporations
(within the meaning of paragraph (b)(3) of this section), gain which is
treated as ordinary income by reason of this section shall be taxable to
the transferor corporation rather than to a controlling shareholder.
However, such gain shall be treated as ordinary income taxable to a
controlling shareholder rather than the transferor corporation if the
transferor corporation is used by a controlling shareholder as a mere
conduit to make a sale to another controlled corporation, or the entity
of the corporate transferor is otherwise properly disregarded for tax
purposes. Sales between two or more corporations that are related within
the meaning of paragraph (b)(3) of this section may also be subject to
the rules of section 482 (relating to allocation of income between or
among organizations, trades, or businesses which are commonly owned or
controlled), and to rules requiring constructive dividend treatment to
the controlling shareholder in appropriate circumstances.
(3) Relationship determination for transfers made after January 6,
1983--taxpayer and an 80-percent owned entity. For purposes of paragraph
(b)(2) of this section with respect to transfers made after January 6,
1983--
(i) If the transferor is an entity, the transferee and such entity
are related if the entity is an 80-percent owned entity with respect to
such transferee either immediately before or immediately after the sale
or exchange of depreciable property, and
(ii) If the transferor is not an entity, the transferee and such
transferor are related if the transferee is an 80-percent owned entity
with respect to such transferor immediately after the sale or exchange
of depreciable property.
(4) Relationship determination for transfers made after January 6,
1983--two 80-percent owned entities. For purposes of paragraph (b)(3) of
this section, with respect to transfers made after January 6, 1983, two
entities are related if the same shareholder both owns 80 percent or
more in value of the stock of the transferor before the sale or exchange
of depreciable property and owns 80 percent or more in value of the
stock of the transferee immediately after the sale or exchange of
depreciable property.
(5) Ownership of stock. For purposes of determining the ownership of
stock under this section, the constructive ownership rules of section
318 shall be applied, except that section 318(a)(2)(C) (relating to
attribution of stock ownership from a corporation) and section
318(a)(3)(C) (relating to attribution of stock ownership to a
corporation) shall be applied without regard to the 50-percent
limitation contained therein. The application of the constructive
ownership rules of section 318 to section 1239 is illustrated by the
following examples:
Example 1. A, an individual, owns 79 percent of the stock (by value)
of Corporation X, and a trust for A's children owns the remaining 21
percent of the stock. A's children are deemed to own the stock owned for
their benefit by the trust in proportion to their actuarial interests in
the trust (section 318(a)(2)(B)). A, in turn, constructively owns the
stock so deemed to be owned by his children (section 318(a)(1)(A)(ii)).
Thus, A is treated as owning all the stock of Corporation X, and any
gain A recognizes from the sale of depreciable property to Corporation X
is treated under section 1239 as ordinary income.
Example 2. Y Corporation owns 100 percent in value of the stock of Z
Corporation. Y Corporation sells depreciable property at a gain to Z
Corporation. P and his daughter, D, own 80 percent in value of the Y
Corporation stock. Under the constructive ownership rules of section
318, as applied to section 1239, P and D are each considered to own the
stock in Z Corporation owned by Y Corporation. Also, P and D are each
considered to own the stock in Y Corporation owned by the other. As a
result, both P and D constructively own 80 percent or more in value of
the stock of both Y and Z Corporations. Thus, the sale between Y and Z
is governed by section 1239 and produces ordinary income to Y.
[T.D. 7569, 43 FR 51388, Nov. 3, 1978, as amended by T.D. 8106, 51 FR
42835, Nov. 26, 1986]
Sec. 1.1239-2 Gain from sale or exchange of depreciable property
between certain related taxpayers on or before October 4, 1976.
Section 1239 provides in general that any gain from the sale or
exchange of depreciable property between a husband and wife or between
an individual and a controlled corporation on or before October 4, 1976
(and in the case of a sale or exchange occurring after that
[[Page 347]]
date if made under a binding contract entered into on or before that
date), shall be treated as ordinary income. Thus, any gain recognized to
the transferor from a sale or exchange after May 3, 1951, and on or
before October 4, 1976 (or thereafter if pursuant to a binding contract
entered into on or before that date), directly or indirectly, between a
husband and wife or between an individual and a controlled corporation,
of property which, in the hands of the transferee, is property of a
character subject to an allowance for depreciation provided in section
167 (including such property on which a deduction for amortization is
allowable under sections 168 and 169) shall be considered as gain from
the sale or exchange of property which is neither a capital asset nor
property described in section 1231. For the purpose of section 1239, a
corporation is controlled when more than 80 percent in value of all
outstanding stock of the corporation is beneficially owned by the
taxpayer, his spouse, and his minor children and minor grandchildren.
For the purpose of this section, the terms children and grandchildren
include legally adopted children and their children. The provisions of
section 1239(a)(2) are applicable whether property is transferred from a
corporation to a shareholder or from a shareholder to a corporation.
[T.D. 6500, 25 FR 12021, Nov. 26, 1960, as amended by T.D. 7569, 43 FR
51388, Nov. 3, 1978]
Sec. 1.1240-1 Capital gains treatment of certain termination
payments.
Any amounts received by an employee for the assignment or release of
all his rights to receive, after termination of his employment and for a
period of not less than five years or for a period ending with his
death, a percentage of the profits or receipts of his employer
attributable to a time subsequent to such termination, are considered
received from the sale or exchange of a capital asset held for more than
six months if the following requirements are met:
(a) The employee was employed by the employer, in whose future
profits or receipts the employee had an interest, for a period of more
than 20 years before the assignment or release by the employee of his
rights in such future profits or receipts,
(b) The full rights of the employee to the percentage of the future
profits or receipts on such employer, which rights are the subject of
the assignment or release, were incorporated in the terms of the
contract of employment between the employee and the employer for a
period of at least 12 years, and were so incorporated before August 16,
1954,
(c) The assignment or release was made after the termination of the
employee's employment with such employer,
(d) The assignment or release conveyed all the rights of the
employee in the future profits or receipts of such employer and conveyed
no other rights of the employee, and
(e) The total amount to which the employee became entitled pursuant
to the assignment or release was received by the employee after the
termination of his employment with such employer and in one taxable year
of the employee.
The requirement that the assignment or release be made after the
termination of the employee's employment contemplates a complete and
bona fide termination of the relationship of employer and employee. This
requires more than a mere termination of such relationship under the
particular contract or contracts of employment pursuant to which the
employee acquired his rights in the future profits or receipts of the
employer. The contract need not expressly provide that the employee
shall share in the future profits or receipts of the employer for a
minimum period of five years. However, if the contract does not
expressly so provide and the assignment or release is made before the
expiration of five years following the termination of employment, the
terms of the contract considered in conjunction with the facts in the
particular situation must establish that the rights of the employee to a
percentage of future profits or receipts, in all probability, will
extend to a period of not less than five years from the date of
termination of employment or for a period ending with his death. Section
1240 has application only to an assignment or release
[[Page 348]]
made by the employee who acquired the right to a percentage of future
profits or receipts of the employer, and has no application to amounts
received other than as payment for assignment or release of such right.
Section 1240 has no effect upon the determination of the income tax of
the employer making the payment to the employee.
[T.D. 6500, 25 FR 12021, Nov. 26, 1960]
Sec. 1.1241-1 Cancellation of lease or distributor's agreement.
(a) In general. Section 1241 provides that proceeds received by
lessees or distributors from the cancellation of leases or of certain
distributorship agreements are considered as amounts received in
exchange therefor. Section 1241 applies to leases of both real and
personal property. Distributorship agreements to which section 1241
applies are described in paragraph (c) of this section. Section 1241 has
no application in determining whether or not a cancellation not
qualifying under that section is a sale or exchange. Further, section
1241 has no application in determining whether or not a lease or a
distributorship agreement is a capital asset, even though its
cancellation qualifies as an exchange under section 1241.
(b) Definition of cancellation. The term cancellation of a lease or
a distributor's agreement, as used in section 1241, means a termination
of all the contractual rights of a lessee or distributor with respect to
particular premises or a particular distributorship, other than by the
expiration of the lease or agreement in accordance with its terms. A
payment made in good faith for a partial cancellation of a lease or a
distributorship agreement is recognized as an amount received for
cancellation under section 1241 if the cancellation relates to a
severable economic unit, such as a portion of the premises covered by a
lease, a reduction in the unexpired term of a lease or distributorship
agreement, or a distributorship in one of several areas or of one of
several products. Payments made for other modifications of leases or
distributorship agreements, however, are not recognized as amounts
received for cancellation under section 1241.
(c) Amounts received upon cancellation of a distributorship
agreement. Section 1241 applies to distributorship agreements only if
they are for marketing or marketing and servicing of goods. It does not
apply to agreements for selling intangible property or for rendering
personal services as, for example, agreements establishing insurance
agencies or agencies for the brokerage of securities. Further, it
applies to a distributorship agreement only if the distributor has made
a substantial investment of capital in the distributorship. The
substantial capital investment must be reflected in physical assets such
as inventories of tangible goods, equipment, machinery, storage
facilities, or similar property. An investment is not considered
substantial for purposes of section 1241 unless it consists of a
significant fraction or more of the facilities for storing,
transporting, processing, or otherwise dealing with the goods
distributed, or consists of a substantial inventory of such goods. The
investment required in the maintenance of an office merely for clerical
operations is not considered substantial for purposes of this section.
Furthermore, section 1241 shall not apply unless a substantial amount of
the capital or assets needed for carrying on the operations of a
distributorship are acquired by the distributor and actually used in
carrying on the distributorship at some time before the cancellation of
the distributorship agreement. It is immaterial for the purposes of
section 1241 whether the distributor acquired the assets used in
performing the functions of the distributorship before or after
beginning his operations under the distributorship agreement. It is also
immaterial whether the distributor is a retailer, wholesaler, jobber, or
other type of distributor. The application of this paragraph may be
illustrated by the following examples:
Example 1. Taxpayer is a distributor of various food products. He
leases a warehouse including cold storage facilities and owns a number
of motor trucks. In 1955 he obtains the exclusive rights to market
certain frozen food products in his State. The marketing is accomplished
by using the warehouse and trucks acquired before he entered into the
agreement and entails no additional capital. Payments received upon the
cancellation of
[[Page 349]]
the agreement are treated under section 1241 as though received upon the
sale or exchange of the agreement.
Example 2. Assume that the taxpayer in example (1) entered into an
exclusive distributorship agreement with the producer under which the
taxpayer merely solicits orders through his staff of salesmen, the goods
being shipped direct to the purchasers. Payments received upon the
cancellation of the agreement would not be treated under section 1241 as
though received upon the sale or exchange of the agreement.
Example 3. Taxpayer is an exclusive distributor for M city of
certain frozen food products which he distributes to frozen-food freezer
and locker customers. The terms of his distributorship do not make it
necessary for him to have any substantial investment in inventory.
Taxpayer rents a loading platform for a nominal amount, but has no
warehouse space. Orders for goods from customers are consolidated by the
taxpayer and forwarded to the producer from time to time. Upon receipt
of these goods, taxpayer allocates them to the individual orders of
customers and delivers them immediately by truck. Although it would
require a fleet of fifteen or twenty trucks to carry out this operation,
the distributor uses only one truck of his own and hires cartage
companies to deliver the bulk of the merchandise to the customers.
Payments received upon the cancellation of the distributorship agreement
in such a case would not be considered received upon the sale or
exchange of the agreement under section 1241 since the taxpayer does not
have facilities for the physical handling of more than a small fraction
of the goods involved in carrying on the distributorship and, therefore,
does not have a substantial capital investment in the distributorship.
On the other hand, if the taxpayer had acquired and used a substantial
number of the trucks necessary for the deliveries to his customers,
payments received upon the cancellation of the agreement would be
considered received in exchange therefor under section 1241.
[T.D. 6500, 25 FR 12021, Nov. 26, 1960]
Sec. 1.1242-1 Losses on small business investment company stock.
(a) In general. Any taxpayer who sustains a loss for a taxable year
beginning after September 2, 1958, as a result of the worthlessness, or
from the sale or exchange, of the stock of a small business investment
company (whether or not such stock was originally issued to such
taxpayer) shall treat such loss as a loss from the sale or exchange of
property which is not a capital asset, if at the time of such loss:
(1) The company which issued the stock is licensed to operate as a
small business investment company pursuant to regulations promulgated by
the Small Business Administration (13 CFR part 107), and
(2) Such loss would, but for the provisions of section 1242, be a
loss from the sale or exchange of a capital asset.
(b) Treatment of losses for purposes of section 172. For the
purposes of section 172 (relating to the net operating loss deduction),
any amount of loss treated by reason of section 1242 as a loss from the
sale or exchange of property which is not a capital asset shall be
treated as attributable to the trade or business of the taxpayer.
Accordingly, the limitation of section 172(d)(4) on the allowance of
nonbusiness deductions in computing a net operating loss shall not apply
to any loss with respect to the stock of a small business investment
company as described in paragraph (a) of this section. See section
172(d) and Sec. 1.172-3.
(c) Statement to be filed with return. A taxpayer claiming a
deduction for a loss on the stock of a small business investment company
shall file with his income tax return a statement containing: The name
and address of the small business investment company which issued the
stock, the number of shares, basis, and selling price of the stock with
respect to which the loss is claimed, the respective dates of purchase
and sale of such stock, or the reason for its worthlessness and
approximate date thereof. For the rules applicable in determining the
worthlessness of securities, see section 165 and the regulations
thereunder.
[T.D. 6500, 25 FR 12022, Nov. 26, 1960]
Sec. 1.1243-1 Loss of small business investment company.
(a) In general--(1) Taxable years beginning after July 11, 1969. For
taxable years beginning after July 11, 1969, a small business investment
company to which section 582(c) applies, and which sustains a loss as a
result of the worthlessness, or on the sale or exchange, of the stock of
a small business concern (as defined in section 103(5) of the Small
Business Investment Act of 1958, as amended (15 U.S.C. 662(5)) and in 13
CFR 107.3), shall treat such loss as a
[[Page 350]]
loss from the sale or exchange of property which is not a capital asset
if:
(i) The stock was issued pursuant to the conversion privilege of the
convertible debentures acquired in accordance with the provisions of
section 304 of the Small Business Investment Act of 1958 (15 U.S.C. 684)
and the regulations thereunder.
(ii) Such loss would, but for the provisions of section 1243, be a
loss from the sale or exchange of a capital asset, and
(iii) At the time of the loss, the company is licensed to operate as
a small business investment company pursuant to regulations promulgated
by the Small Business Administration (13 CFR part 107).
If section 582(c) does not apply for the taxable year, see subparagraph
(2) of this paragraph.
(2) Taxable years beginning before July 11, 1974. For taxable years
beginning after September 2, 1958, but before July 11, 1974, a small
business investment company to which section 582(c) does not apply, and
which sustains a loss as a result of the worthlessness, or on the sale
or exchange, of the securities of a small business concern (as defined
in section 103(5) of the Small Business Investment Act of 1958, as
amended (15 U.S.C. 662(5)) and in 13 CFR 107.3), shall treat such loss
as a loss from the sale or exchange of property which is not a capital
asset if:
(i) The securities are either the convertible debentures, or the
stock issued pursuant to the conversion privilege thereof, acquired in
accordance with the provisions of section 304 of the Small Business
Investment Act of 1958 (15 U.S.C. 684) and the regulations thereunder.
(ii) Such loss would, but for the provisions of this subparagraph,
be a loss from the sale or exchange of a capital asset, and
(iii) At the time of the loss, the company is licensed to operate as
a small business investment company pursuant to regulations promulgated
by the Small Business Administration (13 CFR part 107).
If section 582(c) applies for the taxable year, see subparagraph (1) of
this paragraph.
(b) Material to be filed with return. A small business investment
company which claims a deduction for a loss on the convertible
debentures (pursuant to paragraph (a)(2) of this section) or stock
(pursuant to paragraph (a) (1) or (2) of this section) of a small
business concern shall submit with its income tax return a statement
that it is a Federal licensee under the Small Business Investment Act of
1958 (15 U.S.C. chapter 14B). The statement shall also set forth: the
name and address of the small business concern with respect to whose
securities the loss was sustained, the number of shares of stock or the
number and denomination of debentures with respect to which the loss is
claimed, the basis and selling price thereof, and the respective dates
of purchase and sale of the securities, or the reason for their
worthlessness and the approximate date thereof. For the rules applicable
in determining the worthlessness of securities, see section 165 and the
regulations thereunder.
[T.D. 7171, 37 FR 5621, Mar. 17, 1972]
Sec. 1.1244(a)-1 Loss on small business stock treated as ordinary
loss.
(a) In general. Subject to certain conditions and limitations,
section 1244 provides that a loss on the sale or exchange (including a
transaction treated as a sale or exchange, such as worthlessness) of
section 1244 stock which would otherwise be treated as a loss from the
sale or exchange of a capital asset shall be treated as a loss from the
sale or exchange of an asset which is not a capital asset (referred to
in this section and Sec. Sec. 1.1244(b)-1 to 1.1244(e)-1, inclusive, as
an ordinary loss). Such a loss shall be allowed as a deduction from
gross income in arriving at adjusted gross income. The requirements that
must be satisfied in order that stock may be considered section 1244
stock are described in Sec. Sec. 1.1244(c)-1 and 1.1244(c)-2. These
requirements relate to the stock itself and the corporation issuing such
stock. In addition, the taxpayer who claims an ordinary loss deduction
pursuant to section 1244 must satisfy the requirements of paragraph (b)
of this section.
(b) Taxpayers entitled to ordinary loss. The allowance of an
ordinary loss deduction for a loss of section 1244 stock
[[Page 351]]
is permitted only to the following two classes of taxpayers:
(1) An individual sustaining the loss to whom the stock was issued
by a small business corporation, or
(2) An individual who is a partner in a partnership at the time the
partnership acquired the stock in an issuance from a small business
corporation and whose distributive share of partnership items reflects
the loss sustained by the partnership. The ordinary loss deduction is
limited to the lesser of the partner's distributive share at the time of
the issuance of the stock or the partner's distributive share at the
time the loss is sustained. In order to claim a deduction under section
1244 the individual, or the partnership, sustaining the loss must have
continuously held the stock from the date of issuance. A corporation,
trust, or estate is not entitled to ordinary loss treatment under
section 1244 regardless of how the stock was acquired. An individual who
acquires stock from a shareholder by purchase, gift, devise, or in any
other manner is not entitled to an ordinary loss under section 1244 with
respect to this stock.
Thus, ordinary loss treatment is not available to a partner to whom the
stock is distributed by the partnership. Stock acquired through an
investment banking firm, or other person, participating in the sale of
an issue may qualify for ordinary loss treatment only if the stock is
not first issued to the firm or person. Thus, for example, if the firm
acts as a selling agent for the issuing corporation the stock may
qualify. On the other hand, stock purchased by an investment firm and
subsequently resold does not qualify as section 1244 stock in the hands
of the person acquiring the stock from the firm.
(c) Examples. The provisions of paragraph (b) of this section may be
illustrated by the following examples:
Example 1. A and B, both individuals, and C, a trust, are equal
partners in a partnership to which a small business corporation issues
section 1244 stock. The partnership sells the stock at a loss. A's and
B's distributive share of the loss may be treated as an ordinary loss
pursuant to section 1244, but C's distributive share of the loss may not
be so treated.
Example 2. The facts are the same as in example (1) except that the
section 1244 stock is distributed by the partnership to partner A and he
subsequently sells the stock at a loss. Section 1244 is not applicable
to the loss since A did not acquire the stock by issuance from the small
business corporation.
[T.D. 6495, 25 FR 9675, Oct. 8, 1960, as amended by T.D. 7779, 46 FR
29467, June 2, 1981]
Sec. 1.1244(b)-1 Annual limitation.
(a) In general. Subsection (b) of section 1244 imposes a limitation
on the aggregate amount of loss that for any taxable year may be treated
as an ordinary loss by a taxpayer by reason of that section. In the case
of a partnership, the limitation is determined separately as to each
partner. Any amount of loss in excess of the applicable limitation is
treated as loss from the sale or exchange of a capital asset.
(b) Amount of loss--(1) Taxable years beginning after December 31,
1978. For any taxable year beginning after December 31, 1978, the
maximum amount that may be treated as an ordinary loss under section
1244 is:
(i) $50,000, or
(ii) $100,000, if a husband and wife file a joint return under
section 6013.
These limitations on the maximum amount of ordinary loss apply whether
the loss or losses are sustained on pre-November 1978 stock (as defined
in Sec. 1.1244 (c)-1 (a)(1)), post-November 1978 stock (as defined in
Sec. 1.1244 (c)-1 (a)(2)), or on any combination of pre-November 1978
stock and post-November 1978 stock. The limitation referred to in (ii)
applies to a joint return whether the loss or losses are sustained by
one or both spouses.
(2) Taxable years ending before November 6, 1978. For any taxable
year ending before November 6, 1978, the maximum amount that may be
treated as an ordinary loss under section 1244 is:
(i) $25,000 or
(ii) $50,000, if a husband and wife file a joint return under
section 6013.
The limitation referred to in (ii) applies to a joint return whether the
loss or losses are sustained by one or both spouses.
(3) Taxable years including November 6, 1978. For a taxable year
including November 6, 1978, the maximum amount
[[Page 352]]
that may be treated as ordinary loss under section 1244 is the sum of:
(i) The amount calculated by applying the limitations described in
subparagraph (1) of this paragraph (b) to the amount of loss, if any,
sustained during the taxable year on post-November 1978 stock, plus
(ii) The amount calculated by applying the limitations described in
subparagraph (2) of this paragraph (b) to the amount of loss, if any,
sustained during the taxable year on pre-November 1978 stock,
To the extent this sum does not exceed $50,000, or, if a husband and
wife file a joint return under section 6013 for the taxable year,
$100,000.
(4) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. A, a married taxpayer who files a joint return for the
taxable year ending December 31, 1977, sustains a $50,000 loss
qualifying under section 1244 on pre-November 1978 stock in Corporation
X and an equal amount of loss qualifying under section 1244 on pre-
November 1978 stock in Corporation Y. A is limited to $50,000 of
ordinary loss under paragraph (b)(2)(ii). The remaining $50,000 of loss
is treated as loss from the sale or exchange of a capital asset.
Example 2. For the taxable year ending December 31, 1979, B, a
married taxpayer who files a joint return, sustains a $90,000 loss on
post-November 1978 stock in Corporation X. In the same taxable year, C,
B's spouse, sustains a $25,000 loss on post-November 1978 stock in
Corporation Y. Both losses qualify under section 1244. B and C's
ordinary loss is limited to $100,000 under paragraph (b)(1)(ii). The
remaining $15,000 of loss is treated as loss from the sale or exchange
of a capital asset.
Example 3. D, a married taxpayer who files a joint return and
reports income on a fiscal year basis for the taxable year ending
November 30, 1978, sustains a $60,000 loss qualifying under section 1244
on pre-November 1978 stock and a $40,000 loss qualifying under section
1244 on post-November 1978 stock. D's ordinary loss on pre-November 1978
stock is limited to $50,000 under subparagraph (3)(ii) of this paragraph
(b). D's $40,000 loss on post-November 1978 stock is within the limit of
subparagraph (3)(i) of this paragraph (b). The total of these losses,
$90,000, is the aggregate amount deductible by D as ordinary loss under
section 1244. The remaining $10,000 of loss is treated as loss from the
sale or exchange of a capital asset.
Example 4. E, a married taxpayer who files a joint return for the
taxable year ending December 31, 1980, sustains a $75,000 loss
qualifying under section 1244 on pre-November 1978 stock and a $10,000
loss qualifying under section 1244 on post-November 1978 stock. E may
deduct the total of these losses, $85,000, as ordinary loss under
paragraph (b)(1)(ii).
Example 5. Assume the same facts as in the preceding example, except
that the losses are sustained in the taxable year beginning January 1,
1978, and ending December 31, 1978. E is limited to $60,000 of ordinary
loss ($50,000 on pre-November 1978 stock plus $10,000 on post-November
1978 stock) under paragraph (b)(3). The remaining $25,000 of loss is
treated as loss from the sale or exchange of a capital asset.
Example 6. F, a married taxpayer who files a joint return for the
taxable year beginning January 1, 1978, and ending December 31, 1978,
sustains a $75,000 loss qualifying under section 1244 on pre-November
1978 stock and a $125,000 loss qualifying under section 1244 on post-
November 1978 stock. F's loss on pre-November 1978 stock is limited to
$50,000 of ordinary loss under subparagraph (3)(ii) of this paragraph
(b). F's loss on post-November 1978 stock is limited to $100,000 of
ordinary loss under subparagraph (3)(i) of this paragraph (b). The total
of these losses, $150,000, is limited to $100,000 of ordinary loss under
paragraph (b)(3). F's aggregate amount of ordinary loss under section
1244 is $100,000. The remaining $100,000 of loss is treated as loss from
the sale or exchange of a capital asset.
[T.D. 7779, 46 FR 29467, June 2, 1981]
Sec. 1.1244(c)-1 Section 1244 stock defined.
(a) In general. For purposes of Sec. Sec. 1.1244(a)-1 to 1.1244(e)-
1, inclusive:
(1) The term pre-November 1978 stock means stock issued after June
30, 1958, and on or before November 6, 1978.
(2) The term post-November 1978 stock means stock issued after
November 6, 1978.
In order that stock may qualify as section 1244 stock, the
requirements described in paragraphs (b) through (e) of this section
must be satisfied. In addition, the requirements of paragraph (f) of
this section must be satisfied in the case of pre-November 1978 stock.
Whether these requirements have been met is determined at the time the
stock is issued, except for the requirement in paragraph (e) of this
section. Whether the requirement in paragraph (e) of this section,
relating to gross receipts of the corporation, has been satisfied is
determined at the time a loss is sustained. Therefore, at the time of
issuance it cannot be said with certainty that stock will qualify for
the benefits of section 1244.
[[Page 353]]
(b) Common stock. Only common stock, either voting or nonvoting, in
a domestic corporation may qualify as section 1244 stock. For purposes
of section 1244, neither securities of the corporation convertible into
common stock nor common stock convertible into other securities of the
corporation are treated as common stock. An increase in the basis of
outstanding stock as a result of a contribution to capital is not
treated as an issuance of stock under section 1244. For definition of
domestic corporation, see section 7701(a)(4) and the regulations under
that section.
(c) Small business corporation. At the time the stock is issued (or,
in the case of pre-November 1978 stock, at the time of adoption of the
plan described in paragraph (f)(1) of this section) the corporation must
be a small business corporation. See Sec. 1.1244(c)-2 for the
definition of a small business corporation.
(d) Issued for money or other property. (1) The stock must be issued
to the taxpayer for money or other property transferred by the taxpayer
to the corporation. However, stock issued in exchange for stock or
securities, including stock or securities of the issuing corporation,
cannot qualify as section 1244 stock, except as provided in Sec.
1.1244(d)-3, relating to certain cases where stock is issued in exchange
for section 1244 stock. Stock issued for services rendered or to be
rendered to, or for the benefit of, the issuing corporation does not
qualify as section 1244 stock. Stock issued in consideration for
cancellation of indebtedness of the corporation shall be considered
issued in exchange for money or other property unless such indebtedness
is evidenced by a security, or arises out of the performance of personal
services.
(2) The following examples illustrate situations where stock fails
to qualify as section 1244 stock as a result of the rules in
subparagraph (1) of this paragraph:
Example 1. A taxpayer owns stock of Corporation X issued to him
prior to July 1, 1958. Under a plan adopted in 1977, he exchanges his
stock for a new issuance of stock of Corporation X. The stock received
by the taxpayer in the exchange may not qualify as section 1244 stock
even if the corporation has adopted a valid plan and is a small business
corporation.
Example 2. A taxpayer owns stock in Corporation X. Corporation X
merges into Corporation Y. In exchange for his stock, Corporation Y
issues shares of its stock to the taxpayer. The stock in Corporation Y
does not qualify as section 1244 stock even if the stock exchanged by
the taxpayer did qualify.
Example 3. Corporation X transfers part of its business assets to
Corporation Y, a new corporation, and all of the stock of Corporation Y
is issued directly to the shareholders of Corporation X. Since the
Corporation Y stock was not issued to the shareholders for a transfer by
them of money or other property, none of the Corporation Y stock in the
hands of the shareholders can qualify.
(e) Gross receipts. (1)(i)(a) Except as provided in subparagraph (2)
of this paragraph, stock will not qualify under section 1244, if 50
percent or more of the gross receipts of the corporation, for the period
consisting of the five most recent taxable years of the corporation
ending before the date the loss on such stock is sustained by the
shareholders, is derived from royalties, rents, dividends, interest,
annuities, and sales or exchanges of stock or securities. If the
corporation has not been in existence for five taxable years ending
before such date, the percentage test referred to in the preceding
sentence applies to the period of the taxable years ending before such
date during which the corporation has been in existence; and if the loss
is sustained during the first taxable year of the corporation such test
applies to the period beginning with the first day of such taxable year
and ending on the day before the loss is sustained. The test under this
paragraph shall be made on the basis of total gross receipts, except
that gross receipts from the sales or exchanges of stock or securities
shall be taken into account only to the extent of gains therefrom. The
term gross receipts as used in section 1244(c)(1)(C) is not synonymous
with gross income. Gross receipts means the total amount received or
accrued under the method of accounting used by the corporation in
computing its taxable income. Thus, the total amount of receipts is not
reduced by returns and allowances, cost,
[[Page 354]]
or deductions. For example, gross receipts will include the total amount
received or accrued during the corporation's taxable year from the sale
or exchange (including a sale or exchange to which section 337 applies)
of any kind of property, from investments, and for services rendered by
the corporation. However, gross receipts does not include amounts
received in nontaxable sales or exchanges (other than those to which
section 337 applies), except to the extent that gain is recognized by
the corporation, nor does that term include amounts received as a loan,
as a repayment of a loan, as a contribution to capital, or on the
issuance by the corporation of its own stock.
(b) The meaning of the term gross receipts as used in section
1244(c)(1)(C) may be further illustrated by the following examples:
Example 1. A corporation on the accrual method sells property (other
than stock or securities) and receives payment partly in money and
partly in the form of a note payable at a future time. The amount of the
money and the face amount of the note would be considered gross receipts
in the taxable year of the sale and would not be reduced by the adjusted
basis of the property, the costs of sale, or any other amount.
Example 2. A corporation has a long-term contract as defined in
paragraph (a) of Sec. 1.451-3 with respect to which it reports income
according to the percentage-of-completion method as described in
paragraph (b)(1) of Sec. 1.451-3. The portion of the gross contract
price which corresponds to the percentage of the entire contract which
has been completed during the taxable year shall be included in gross
receipts for such year.
Example 3. A corporation which regularly sells personal property on
the installment plan elects to report its taxable income from the sale
of property (other than stock or securities) on the installment method
in accordance with section 453. The installment payments actually
received in a given taxable year of the corporation shall be included in
gross receipts for such year.
(ii) The term royalties as used in subdivision (i) of this
subparagraph means all royalties, including mineral, oil, and gas
royalties (whether or not the aggregate amount of such royalties
constitutes 50 percent or more of the gross income of the corporation
for the taxable year), and amounts received for the privilege of using
patents, copyrights, secret processes and formulas, good will,
trademarks, trade brands, franchises, and other like property. The term
royalties does not include amounts received upon the disposal of timber,
coal, or domestic iron ore with a retained economic interest to which
the special rules of section 631 (b) and (c) apply or amounts received
from the transfer of patent rights to which section 1235 applies. For
the definition of mineral, oil, or gas royalties, see paragraph (b)(11)
(ii) and (iii) of Sec. 1.543-1. For purposes of this subdivision, the
gross amount of royalties shall not be reduced by any part of the cost
of the rights under which they are received or by any amount allowable
as a deduction in computing taxable income.
(iii) The term rents as used in subdivision (i) of this subparagraph
means amounts received for the use of, or right to use, property
(whether real or personal) of the corporation, whether or not such
amounts constitute 50 percent or more of the gross income of the
corporation for the taxable year. The term rents does not include
payments for the use or occupancy of rooms or other space where
significant services are also rendered to the occupant, such as for the
use or occupancy of rooms or other quarters in hotels, boarding houses,
or apartment houses furnishing hotel services, or in tourist homes,
motor courts, or motels. Generally, services are considered rendered to
the occupant if they are primarily for his convenience and are other
than those usually or customarily rendered in connection with the rental
of rooms or other space for occupancy only. The supplying of maid
service, for example, constitutes such services; whereas the furnishing
of heat and light, the cleaning of public entrances, exits, stairways,
and lobbies, the collection of trash, etc., are not considered as
services rendered to the occupant. Payments for the use or occupancy of
entire private residences or living quarters in duplex or multiple
housing units, of offices in an office building, etc., are generally
rents under section 1244(c)(1)(C). Payments for the parking of
automobiles ordinarily do not constitute rents. Payments for the
warehousing of goods or for the use of personal property do not
constitute
[[Page 355]]
rents if significant services are rendered in connection with such
payments.
(iv) The term dividends as used in subdivision (i) of this
subparagraph includes dividends as defined in section 316, amounts
required to be included in gross income under section 551 (relating to
foreign personal holding company income taxed to United States
shareholders), and consent dividends determined as provided in section
565.
(v) The term interest as used in subdivision (i) of this
subparagraph means any amounts received for the use of money (including
tax-exempt interest).
(vi) The term annuities as used in subdivision (i) of this
subparagraph means the entire amount received as an annuity under an
annuity, endowment, or life insurance contract, regardless of whether
only part of such amount would be includible in gross income under
section 72.
(vii) For purposes of subdivision (i) of this subparagraph, gross
receipts from the sales or exchanges of stock or securities are taken
into account only to the extent of gains therefrom. Thus, the gross
receipts from the sale of a particular share of stock will be the excess
of the amount realized over the adjusted basis of such share. If the
adjusted basis should equal or exceed the amount realized on the sale or
exchange of a certain share of stock, bond, etc., there would be no
gross receipts resulting from the sale of such security. Losses on sales
or exchanges of stock or securities do not offset gains on the sales or
exchanges of other stock or securities for purposes of computing gross
receipts from such sales or exchanges. Gross receipts from the sale or
exchange of stocks and securities include gains received from such sales
or exchanges by a corporation even though such corporation is a regular
dealer in stocks and securities. For the meaning of the term stocks or
securities, see paragraph (b)(5)(i) of Sec. 1.543-1.
(2) The requirement of subparagraph (1) of this paragraph need not
be satisfied if for the applicable period the aggregate amount of
deductions allowed to the corporation exceeds the aggregate amount of
its gross income. But for this purpose the deductions allowed by section
172, relating to the net operating loss deduction, and by sections 242,
243, 244, and 245, relating to certain special deductions for
corporations, shall not be taken into account. Notwithstanding the
provisions of this subparagraph and of subparagraph (1) of this
paragraph, pursuant to the specific delegation of authority granted in
section 1244(e) to prescribe such regulations as may be necessary to
carry out the purposes of section 1244, ordinary loss treatment will not
be available with respect to stock of a corporation which is not largely
an operating company within the five most recent taxable years (or such
lesser period as the corporation is in existence) ending before the date
of the loss. Thus, for example, assume that a person who is not a dealer
in real estate forms a corporation which issues stock to him which meets
all the formal requirements of section 1244 stock. The corporation then
acquires a piece of unimproved real estate which it holds as an
investment. The property declines in value and the stockholder sells his
stock at a loss. The loss does not qualify for ordinary loss treatment
under section 1244 but must be treated as a capital loss.
(3) In applying subparagraphs (1) and (2) of this paragraph to a
successor corporation in a reorganization described in section
368(a)(1)(F), such corporation shall be treated as the same corporation
as its predecessor. See paragraph (d)(2) of Sec. 1.1244(d)-3.
(f) Special rules applicable to pre-November 1978 stock. (1)(i) Pre-
November 1978 common stock must have been issued under a written plan
adopted by the corporation after June 30, 1958, and on or before
November 6, 1978, to offer only this stock during a period specified in
the plan ending not later than 2 years after the date the plan is
adopted. The 2-year requirement referred to in the preceding sentence is
met if the period specified in the plan is based upon the date when,
under the rules or regulations of a Government agency relating to the
issuance of the stock, the stock may lawfully be sold, and it is clear
that this period will end, and in fact does end, within 2 years after
the plan is adopted. The plan must specifically state, in terms of
dollars, the maximum amount to be received by
[[Page 356]]
the corporation in consideration for the stock to be issued under the
plan. See Sec. 1.1244(c)-2 for the limitation on the amount that may be
received by the corporation under the plan.
(ii) To qualify, the pre-November 1978 stock must be issued during
the period of the offer, which period must end not later than two years
after the date the plan is adopted. Pre-November 1978 stock which is
subscribed for during the period of the plan but not issued during this
period cannot qualify as section 1244 stock. Pre-November 1978 stock
issued on the exercise of a stock right, stock warrant, or stock option
(which right, warrant, or option was not outstanding at the time the
plan was adopted) will be treated as issued under a plan only if the
right, warrant, or option is applicable solely to unissued stock offered
under the plan and is exercised during the period of the plan.
(iii) Pre-November 1978 stock subscribed for prior to the adoption
of the plan, including stock subscribed for prior to the date the
corporation comes into existence, may be considered issued under a plan
adopted by the corporation if the stock is not in fact issued prior to
the adoption of the plan.
(iv) Pre-November 1978 stock issued for a payment which, alone or
together with prior payments, exceeds the maximum amount that may be
received under the plan, is not considered issued under the plan, and
none of the stock can qualify as section 1244 stock. See Sec.
1.1244(c)-2(b) for a different rule with respect to post-November 1978
stock.
(2) Pre-November 1978 stock does not qualify as section 1244 stock
if at the time of the adoption of the plan under which it is issued
there remains unissued any portion of a prior offering of stock. Thus,
if any portion of an outstanding offering of common or preferred stock
is unissued at the time of the adoption of the plan, stock issued under
the plan will not qualify as section 1244 stock. An offer is outstanding
unless and until it is withdrawn by affirmative action before the plan
is adopted. Stock rights, stock warrants, stock options, or securities
convertible into stock, that are outstanding at the time the plan is
adopted, are considered prior offerings. The authorization in the
corporate charter to issue stock different from stock offered under the
plan or in excess of stock offered under the plan is not of itself a
prior offering.
(3)(i) Even though the plan satisfies the requirements of
subparagraph (1) of this paragraph (f), if another offering of pre-
November 1978 stock is made by the corporation subsequent to, or
simultaneous with, the adoption of the plan, pre-November 1978 stock
issued under the plan after the other offering does not qualify as
section 1244 stock. The issuance of stock options, stock rights, or
stock warrants at any time during the period of the plan, that are
exercisable on stock other than stock offered under the plan, is
considered a subsequent offering. Similarly, the issuance of pre-
November 1978 stock other than that offered under the plan is considered
a subsequent offering. Because stock issued upon exercise of a converson
privilege is stock issued for a security, and stock issued under a stock
option granted in whole or in part for services is not issued for money
or other property, the issuance of securities with a conversion
privilege and the issuance of such a stock option are subsequent
offerings, because the conversion privilege and the stock option are
exercisable with respect to stock other than that which may properly be
offered under the plan. Pre-November 1978 stock issued under the plan
before a subsequent offering is not disqualified because of the
subsequent offering. The rule of the subparagraph, together with the
rule of subparagraph (2) of this paragraph (f), relating to offers prior
to the adoption of the plan, limits pre-November 1978 section 1244 stock
to stock issued by the corporation during a period when any stock issued
by it must have been issued under the plan.
(ii) Any modification of a plan that changes the offering to include
preferred stock, or that increases the amount of pre-November 1978 stock
that may be issued under the plan to such an extent that the
requirements of paragraph (c) of this section would not have been
satisfied if determined with reference to this amount as of the date the
plan was initially adopted, or that extends the period of time during
[[Page 357]]
which stock may be issued under the plan to more than 2 years from the
date the plan was initially adopted, is considered a subsequent
offering, and no stock issued after this offering may qualify. However,
a corporation may withdraw a plan and adopt a new plan to issue stock.
To determine whether stock issued under this new plan may qualify, this
paragraph (f) must be applied with respect to the new plan as of the
date of its adoption. For example, amounts received for stock under the
prior plan must be taken into account in determining whether the
statutory requirements relating to definition of small business
corporation are satisfied. In applying the requirements of paragraph (c)
of this section, reference should be made to equity capital as of the
date the new plan is adopted. The same principles apply if the period of
the initial plan expires and the corporation adopts a new plan.
[T.D. 7779, 46 FR 29468, June 2, 1981]
Sec. 1.1244(c)-2 Small business corporation defined.
(a) In general. A corporation is treated as a small business
corporation if it is a domestic corporation that satisfies the
requirements described in paragraph (b) or (c) of this section. The
requirements of paragraph (b) of this section apply if a loss is
sustained on post-November 1978 stock. The requirements of paragraph (c)
of this section apply if a loss is sustained on pre-November 1978 stock.
If losses are sustained on both pre-November 1978 stock and post-
November 1978 stock in the same taxable year, the requirements of
paragraph (b) of this section are applied to the corporation at the time
of the issuance of the stock (as required by paragraph (b) in the case
of a loss on post-November 1978 stock) in order to determine whether the
loss on post-November 1978 stock qualifies as a section 1244 loss, and
the requirements of paragraph (c) of this section are applied to the
corporation at the time of the adoption of the plan (as required by
paragraph (c) in the case of a loss on pre-November 1978 stock) in order
to determine whether the loss on pre-November 1978 stock qualifies as a
section 1244 loss. For definition of domestic corporation, see section
7701 (a)(4) and the regulations under that section.
(b) Post-November 1978 stock--(1) Amount received by corporation for
stock. Capital receipts of a small business corporation may not exceed
$1,000,000. For purposes of this paragraph the term capital receipts
means the aggregate dollar amount received by the corporation for its
stock, as a contribution to capital, and as paid-in surplus. If the
$1,000,000 limitation is exceeded, the rules of subparagraph (2) of this
paragraph (b) apply. In making these determinations, (i) property is
taken into account at its adjusted basis to the corporation (for
determining gain) as of the date received by the corporation, and (ii)
this aggregate amount is reduced by the amount of any liability to which
the property was subject and by the amount of any liability assumed by
the corporation at the time the property was received. Capital receipts
are not reduced by distributions to shareholders, even though the
distributions may be capital distributions.
(2) Requirement of designation in event $1,000,000 limitation
exceeded. (i) If capital receipts exceed $1,000,000, the corporation
shall designate as section 1244 stock certain shares of post-November
1978 common stock issued for money or other property in the transitional
year. For purposes of this paragraph, the term transitional year means
the first taxable year in which capital receipts exceed $1,000,000 and
in which the corporation issues stock. This designation shall be made in
accordance with the rules of subdivision (iii) of this paragraph (b)(2).
The amount received for designated stock shall not exceed $1,000,000
less amounts received--
(A) In exchange for stock in years prior to the transitional year;
(B) As contributions to capital in years prior to the transitional
year; and
(C) As paid-in surplus in years prior to the transitional year.
(ii) Post-November 1978 common stock issued for money or other
property before the transitional year qualifies as section 1244 stock
without affirmative designation by the corporation. Post-November 1978
common stock issued after the transitional year does not qualify as
section 1244 stock.
[[Page 358]]
(iii) The corporation shall make the designation required by
subdivision (i) of this paragraph (b)(2) not later than the 15th day of
the third month following the close of the transitional year. However,
in the case of post-November 1978 common stock issued on or before June
2, 1981 the corporation shall make the required designation by August 3,
1981 or by the 15th day of the 3rd month following the close of the
transitional year, whichever is later. The designation shall be made by
entering the numbers of the qualifying share certificates on the
corporation's records. If the shares do not bear serial numbers or other
identifying numbers or letters, or are not represented by share
certificates, the corporation shall make an alternative designation in
writing at the time of issuance, or, in the case of post-November 1978
common stock issued on or before June 2, 1981 by August 3, 1981. This
alternative designation may be made in any manner sufficient to identify
the shares qualifying for section 1244 treatment. If the corporation
fails to make a designation by share certificate number or an
alternative written designation as described, the rules of subparagraph
(3) of this paragraph (b) apply.
(3) Allocation of section 1244 benefit in event corporation fails to
designate qualifying shares. If a corporation issues post-November 1978
stock in the transitional year and fails to designate certain shares of
post-November 1978 common stock as section 1244 stock in accordance with
the rules of subparagraph (2) of this paragraph (b), the following rules
apply:
(i) Section 1244 treatment is extended to losses sustained on post-
November 1978 common stock issued for money or other property in taxable
years before the transitional year and is withheld from losses sustained
on post-November 1978 stock issued in taxable years after the
transitional year.
(ii) Post-1958 capital received before the transitional year is
subtracted from $1,000,000.
(iii) Subject to the annual limitation described in Sec. 1.1244(b)-
1, an ordinary loss on post-November 1978 common stock issued for money
or other property in the transitional year is allowed in an amount which
bears the same ratio to the total loss sustained by the individual as:
(A) The amount described in Sec. 1.1244(c)-2(b) (3) (ii) bears to
(B) The total amount of money and other property received by the
corporation in exchange for stock, as a contribution to capital, and as
paid-in surplus in the transitional year.
(4) Examples. The provisions of this paragraph (b) may be
illustrated by the following examples:
Example 1. On December 1, 1978, Corporation W, a newly-formed
corporation, issues 10,000 shares of common stock at $125 a share for an
amount (determined under subparagraph (1) of this paragraph (b)) of
money and other property totaling $1,250,000. The board of directors
specifies that 8,000 shares are section 1244 stock and records the
certificate numbers of the qualifying shares in its minutes. Because
Corporation W issued post-November 1978 common stock in exchange for
money and other property exceeding $1,000,000, but has designated shares
of stock as section 1244 stock and the designated shares were issued in
exchange for money and other property not exceeding $1,000,000 (8,000
shares x $125 price per share = $1,000,000), the 8,000 designated shares
qualify as section 1244 stock.
Example 2. Corporation X comes into existence on June 1, 1979. On
June 10, 1979, Corporation X issues 2,500 shares of common stock at $250
per share to shareholder A and 2,500 shares of common stock at $250 per
share to shareholder B. By written agreement dated September 1, 1981,
shareholder A and shareholder B determine that 1,500 of shareholder A's
shares and all of shareholder B's shares will be treated as section 1244
stock. Although shareholder A's 1,500 shares and shareholder B's 2,500
shares were issued for money and other property not exceeding $1,000,000
(4,000 shares x $250 price per share = $1,000,000, these 4,000 shares do
not qualify as section 1244 stock under the rules of subparagraph (2) of
this paragraph (b) for three reasons: The agreement of September 1,
1979, (i) did not identify which 1,500 of shareholder A's 2,500 shares
were intended to qualify for section 1244 treatment, (ii) was made by
the shareholders and not by Corporation X, and (iii) was made later than
the 15th day of the third month following the close of the transitional
year. However, certain of the shares issued by Corporation X may qualify
as section 1244 stock under the rules of subparagraph (3) of this
paragraph (b). See example (4).
Example 3. On December 1, 1980, Corporation Y issues common stock to
shareholder A in exchange for $500,000 in cash. On August 1, 1981,
Corporation Y issues common stock to
[[Page 359]]
shareholder B in exchange for property having an adjusted basis to
Corporation Y of $500,000. On December 1, 1981, B transfers a tract of
land having a basis in B's hands of $250,000 to Corporation Y as a
contribution to capital. Under section 362(a)(2) of the Code,
Corporation Y takes a basis of $250,000 in the tract of land.
Corporation Y is a calendar year corporation. On February 15, 1982, it
designates all of shareholder B's stock as section 1244 stock by
entering the numbers of the qualifying certificates on the corporation's
records. The designation made by Corporation Y is effective because it
identifies which shares of its stock qualify for section 1244 treatment,
was made in writing before the 15th day of the 3rd month following the
close of the transitional year (1981), and because the amount received
for designated stock does not exceed $1,000,000, less amounts received
(i) in exchange for stock in years prior to the transitional year; (ii)
as contributions to capital in years prior to the transitional year; and
(iii) as paid-in surplus in years prior to the transitional year.
Nevertheless, in the event of B's sale of his stock at a loss, the
increase in basis attributable to his December, 1981, contribution to
capital will be treated as allocable to stock that is not section 1244
stock under Sec. 1.1244(d)-2.
Example 4. Corporation Z, a newly-formed corporation, issues 10,000
shares of common stock at $200 per share on July 1, 1979. In exchange
for its stock Corporation Z receives property (other than stock or
securities) having a basis to the corporation of $400,000, and
$1,600,000 in cash, for a total of $2,000,000. Corporation Z fails to
designate any of the issued shares as section 1244 stock. Shareholder C
purchases 2,500 shares of the 10,000 shares of Corporation Z stock for
$500,000 on July 1, 1979. Subsequently, shareholder C sells the 2,500
shares for $400,000. Shareholder C may treat $50,000 of the $100,000
loss as an ordinary loss under section 1244. The amount of that loss is
computed under the rule of subparagraph (3) of this paragraph (b) as
follows:
X [C's section 1244 loss] $1,000,000 [$1,000,000 -0
= $1,000,000]
=
$100,000 [C's total loss] $2,000,000 [total amount
received by Corporation Z]
X = $50,000
The remaining $50,000 is not treated as an ordinary loss under section
1244.
Example 5. (i) Corporation V, a newly-formed corporation, issues
common stock to shareholder A and shareholder B on June 15, 1980, in
exchange for $800,000 in cash ($400,000 from A and $400,000 from B). On
September 15, 1981, the corporation issues common stock to shareholder C
in exchange for $600,000 in cash. On January 1, 1982, common stock is
issued to shareholder D in exchange for $100,000 in cash. Corporation V
fails to designate any of the issued shares as section 1244 stock. A, B,
C, and D subsequently sell their Corporation Y stock at a loss.
(ii) Subject to the annual limitation discussed in Sec. 1.1244(b)-
1, A and B may treat their entire loss as an ordinary loss under section
1244. D may not treat any part of his loss as an ordinary loss under
section 1244. Subject to the annual limitation, one-third of the loss
sustained by shareholder C is treated as an ordinary loss under section
1244. These results are calculated under the rules of subparagraph (3)
of this paragraph (b) as follows: First, section 1244 treatment is
extended to post-November 1978 stock issued to A and B in 1980, a
taxable year before the transitional year (1981); section 1244 treatment
is withheld from the stock issued to D in 1982, a taxable year after the
transitional year. Second $800,000 the amount of post-1958 capital
received in taxable years before the transitional year, is subtracted
from $1,000,000 to leave $200,000. Third, subject to the annual
limitation, an ordinary loss is allowed to C in an amount which bears
the same ratio to his total loss as the amount calculated in the
preceding sentence ($200,000) bears to the total amount received by the
corporation in the transitional year in exchange for stock, as a
contribution to capital, or as paid-in surplus ($600,000).
Example 6. Corporation V comes into existence on July 1, 1982. On
that date it issues 10 shares of voting common stock to shareholder A in
exchange for $500,000 and 5 shares of voting common stock to shareholder
B in exchange for $250,000, designating the shares issued to both A and
B as section 1244 stock. On September 15, 1982, Corporation V receives a
contribution to capital from shareholders A and B having a basis in
their hands of $225,000. On February 1, 1983, Corporation V issues one
share of stock to shareholder C in exchange for $50,000. Corporation V
may designate one-half of the share issued to shareholder C as section
1244 stock under Sec. 1.1244(c)-2 (b)(2). In 1982 the corporation
received $750,000 for stock ($500,000 from A and $250,000 from B) and
$225,000 as a capital contribution, totaling $975,000 in capital
receipts. The receipt of $50,000 from shareholder C in exchange for
stock in 1983 causes capital receipts to exceed $1,000,000 and 1983 thus
becomes Corporation V's transitional year. Corporation V may receive
only $25,000 for designated stock in 1983 under the rule set forth in
Sec. 1.1244 (c)-2 (b)(2)(i), which states that the amount received for
designated stock shall not exceed $1,000,000, less amounts received (i)
in exchange for stock in years prior to the transitional year ($750,000
from A and B), (ii) as contributions to capital in years prior to the
transitional year ($225,000), and (iii) as paid-in surplus in years
prior to the transitional year ($0). Thus, one-half of C's share
(representing the receipt of
[[Page 360]]
$25,000) may be designated as section 1244 stock by Corporation V. In
the event of the sale of A's stock or B's stock at a loss, the increase
in basis attributable to their contribution to capital will be treated
as allocable to stock that is not section 1244 stock under Sec.
1.1244(d)-2.
(c) Pre-November 1978 stock--(1) Amount received by corporation for
stock. At the time of the adoption of the plan, the sum of the aggregate
dollar amount to be paid for pre-November 1978 stock that may be offered
under the plan plus the aggregate amount of money and other property
that has been received by the corporation after June 30, 1958, and on or
before November 6, 1978, for its stock, as a contribution to capital by
its shareholders, and as paid-in surplus must not exceed $500,000. In
making these determinations (i) property is taken into account at its
adjusted basis to the corporation (for determining gain) as of the date
received by the corporation, and (ii) this aggregate amount is reduced
by the amount of any liability to which the property was subject and by
the amount of any liability assumed by the corporation at the time the
property was received. For purposes of the $500,000 test, the total
amount of money and other property received for stock, as a contribution
to capital, and as paid-in surplus is not reduced by distributions to
shareholders, even though the distributions may be capital
distributions. Thus, once the total amount of money and other property
received after June 30, 1958, reaches $500,000, the corporation is
precluded from subsequently issuing pre-November 1978 stock. For a
different rule that applies to post-November 1978 stock see Sec.
1.1244(c)-2(b).
(2) Equity capital. The sum of the aggregate dollar amount to be
paid for pre-November 1978 stock that may be offered under the plan plus
the equity capital of the corporation (determined on the date of the
adoption of the plan) may not exceed $1,000,000. For this purpose,
equity capital is the sum of the corporation's money and other property
(in an amount equal to its adjusted basis for determining gain) less the
amount of the corporation's indebtedness to persons other than its
shareholders.
(3) Examples. The provisions of this paragraph (c) may be
illustrated by the following examples:
Example 1. Corporation W comes into existence on December 1, 1958.
On that date the corporation may adopt a plan to issue common stock for
an amount (determined under subparagraph (1) of this paragraph (c)) not
in excess of $500,000 during a period ending not later than November 30,
1960. Such corporation will qualify as a small business corporation as
of the date that the plan is adopted. However, if the corporation adopts
a plan to issue stock for an amount in excess of $500,000 it is not a
small business corporation at the time the plan is adopted and no stock
issued under the plan may qualify as section 1244 stock. If the cost of
organizing corporation W amounted to $1,000 and constituted paid-in
surplus or a contribution to capital, such amount must be taken into
account in determining the amount that may be received under the plan,
with the result that only $499,000 may be so received.
Example 2. On December 1, 1958, Corporation X, a newly formed
corporation, adopts a plan to issue common stock for an amount
(determined under subparagraph (1) of this paragraph (c)) not in excess
of $500,000 during a period ending not later than November 30, 1960. By
January 1, 1960, the corporation has, pursuant to the plan, issued at
par, stock having an aggregate par value of $400,000, $200,000 of which
was issued for $200,000 cash, and $200,000 of which was issued for
property (other than stock or securities) having a basis to the
corporation of $100,000 and a fair market value of $200,000. The
corporation may, prior to November 30, 1960, issue stock for an amount
not in excess of $200,000 cash or property having a basis to it not in
excess of $200,000. Stock issued for any payment which, alone or
together with any payments received after January 1, 1960, exceeds such
$200,000 amount would not qualify as section 1244 stock because it would
not be issued pursuant to the plan.
Example 3. Assume that on December 1, 1958, Corporation Y, a newly
formed corporation, adopts a plan to issue common stock for an amount
(determined under subparagraph (1) of this paragraph (c)) not in excess
of $500,000 during a period ending not later than November 30, 1960. By
January 1960 the corporation has received $400,000 cash for stock issued
pursuant to the plan, but due to business successes the equity capital
of the corporation exceeds $1,000,000. Since the equity capital test is
made as of the date that the plan is adopted, the corporation may still,
prior to November 30, 1960, issue section 1244 stock pursuant to the
plan until the full amount specified in the plan has been received.
Example 4. Subsequent to June 30, 1958, Corporation Z receives a
total of $600,000 cash on
[[Page 361]]
the issuance of its stock. In 1960 Corporation Z redeems shares of its
stock for the total amount of $300,000 and the redemptions reduce
Corporation Z's capital to substantially less than $500,000.
Notwithstanding the redemptions, pre-November 1978 stock subsequently
issued by Corporation Z will not qualify as section 1244 stock because
the $500,000 limitation has been previously exceeded.
[T.D. 7779, 46 FR 29470, June 2, 1981, as amended by T.D. 7837, 47 FR
42729, Sept. 29, 1982; 60 FR 16575, Mar. 31, 1995]
Sec. 1.1244(d)-1 Contributions of property having basis in excess
of value.
(a) In general. (1) Section 1244(d)(1) (A) provides a special rule
which limits the amount of loss on section 1244 stock that may be
treated as an ordinary loss. This rule applies only when section 1244
stock is issued by a corporation in exchange for property that,
immediately before the exchange, has an adjusted basis (for determining
loss) in excess of its fair market value. If section 1244 stock is
issued in exchange for such property and the basis of such stock in the
hands of the taxpayer is determined by reference to the basis of such
property, then for purposes of section 1244, the basis of such stock
shall be reduced by an amount equal to the excess, at the time of the
exchange, of the adjusted basis of the property over its fair market
value.
(2) The provisions of section 1244(d) (1)(A) do not affect the basis
of stock for purposes other than section 1244. Such provisions are to be
used only in determining the portion of the total loss sustained that
may be treated as an ordinary loss pursuant to section 1244.
(b) Transfer of more than one item. If a taxpayer exchanges several
items of property for stock in a single transaction so that the basis of
the property transferred is allocated evenly among the shares of stock
received, the computation under this section should be made by reference
to the aggregate fair market value and the aggregate basis of the
property transferred.
(c) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. B transfers property with an adjusted basis of $1,000 and
a fair market value of $250 to a corporation for 10 shares of section
1244 stock in an exchange that qualifies under section 351. The basis of
B's stock is $1,000 ($100 per share), but, solely for purposes of
section 1244, the total basis of the stock must be reduced by $750, the
excess of the adjusted basis of the property exchanged over its fair
market value. Thus, the basis of such stock for purposes of section 1244
is $250 and the basis of each share for such purposes is $25. If B sells
his 10 shares for $250, he will recognize a loss of $750, all of which
must be treated as a capital loss. If he sells the 10 shares for $200,
then $50 of his total loss of $800 will be treated as an ordinary loss
under section 1244, assuming the various requirements of such section
are satisfied, and the remaining $750 will be a capital loss.
Example 2. B owns property with a basis of $20,000. The fair market
value of the property unencumbered is $15,000 but the property is
subject to a $2,000 mortgage. B transfers the encumbered property to a
corporation for 100 shares of section 1244 stock in an exchange that
qualifies under section 351. The basis of the shares, determined in
accordance with section 358, is $18,000 or $180 per share, but solely
for purposes of section 1244 the basis is $13,000 ($130 per share),
which is its basis for purposes other than section 1244, reduced by
$5,000, the excess of the adjusted basis, immediately before the
exchange, of the property transferred over its fair market value.
Example 3. C transfers business assets to a corporation for 100
shares of section 1244 stock in an exchange that qualifies under section
351. The assets transferred are as follows:
------------------------------------------------------------------------
Fair
Basis market
value
------------------------------------------------------------------------
Cash............................................ $10,000 $10,000
Inventory....................................... 15,000 30,000
Depreciable property............................ 50,000 20,000
Land............................................ 25,000 10,000
-----------------------
100,000 70,000
------------------------------------------------------------------------
The basis for the shares received by C is $100,000, which is applied
$1,000 to each share. However, the basis of the shares for purposes of
section 1244 is $70,000 ($700 per share), the basis for general purposes
reduced by $30,000, the excess of the aggregate adjusted basis of the
property transferred over the aggregate fair market value of such
property.
[T.D. 6495, 25 FR 9679, Oct. 8, 1960]
Sec. 1.1244(d)-2 Increases in basis of section 1244 stock.
(a) In general. If subsequent to the time of its issuance there is
for any reason, including the operation of section 1376(a), an increase
in the basis of section 1244 stock, such increase shall be treated as
allocable to stock which
[[Page 362]]
is not section 1244 stock. Therefore, a loss on stock, the basis of
which has been increased subsequent to its issuance, must be apportioned
between the part that qualifies as section 1244 stock and the part that
does not so qualify. Only the loss apportioned to the part that so
qualifies may be treated as an ordinary loss pursuant to section 1244.
The amount of loss apportioned to the part that qualifies is the amount
which bears the same ratio to the total loss as the basis of the stock
which is treated as allocated to section 1244 stock bears to the total
basis of the stock.
(b) Example. The provisions of paragraph (a) of this section may be
illustrated by the following example:
Example: For $10,000 a corporation issues 100 shares of section 1244
stock to X. X later contributes $2,000 to the capital of the corporation
and this increases the total basis of his 100 shares to $12,000.
Subsequently, he sells the 100 shares for $9,000. Of the $3,000 loss,
$2,500 is allocated to the portion of the stock that qualifies as
section 1244 stock ($10,000/$12,000 of $3,000), and the remaining $500
is allocated to the portion of the stock that does not so qualify.
Therefore, to the extent of $2,500, the loss may be treated as an
ordinary loss assuming the various requirements of section 1244 stock
are satisfied. However, the remaining $500 loss must be treated as a
capital loss.
[T.D. 6495, 25 FR 9680, Oct. 8, 1960]
Sec. 1.1244(d)-3 Stock dividend, recapitalizations, changes in name,
etc.
(a) In general. Section 1244(c)(1) provides that stock may not
qualify for the benefits of section 1244 unless it is issued to the
taxpayer for money or other property not including stock or securities.
However, section 1244(d)(2) authorizes exceptions to this rule. The
exceptions may apply in three situations: (1) The receipt of a stock
dividend; (2) the exchange of stock for stock pursuant to a
reorganization described in section 368(a)(1)(E); and (3) the exchange
of stock for stock pursuant to a reorganization described in section
368(a)(1)(F).
(b) Stock dividends. (1) If common stock is received by an
individual or partnership in a nontaxable distribution under section
305(a) made solely with respect to stock owned by such individual or
partnership which meets the requirements of section 1244 stock
determinable at the time of the distribution, then the common stock so
received will also be treated as meeting such requirements. For purposes
of this paragraph and paragraphs (c) and (d) of this section, the
requirements of section 1244 stock determinable at the time of the
distribution or exchange are all of the requirements of section
1244(c)(1) other than the one described in subparagraph (C) thereof,
relating to the gross receipts test.
(2) If, however, such stock dividend is received by such individual
or partnership partly with respect to stock meeting the requirements of
section 1244 stock determinable at the time of the distribution, and
partly with respect to stock not meeting such requirements, then only
part of the stock received as a stock dividend will be treated as
meeting such requirements. Assuming all the shares with respect to which
the dividend is received have equal rights to dividends, such part is
the number of shares which bears the same ratio to the total number of
shares received as the number of shares owned immediately before the
stock dividend which meets such qualifications bears to the total number
of shares with respect to which the stock dividend is received. In
determining the basis of shares received in the stock dividend and of
the shares held before the stock dividend, section 307 shall apply as if
two separate nontaxable stock dividends were made, one with respect to
the shares that meet the requirements and the other with respect to
shares that do not meet the requirements.
(3) The provisions of subparagraphs (1) and (2) of this paragraph
may be illustrated by the following examples:
Example 1. Corporation X issues 100 shares of its common stock to B
for $1,000. Subsequently, in a nontaxable stock dividend B receives 5
more shares of common stock of Corporation X. If the 100 shares meet all
the requirements of section 1244 stock determinable at the time of the
distribution of the stock dividend, the 5 additional shares shall also
be treated as meeting such requirements.
Example 2. In 1959, Corporation Y issues 100 shares of its common
stock to C for $1,000 and these shares meet the requirements of section
1244 stock determinable at the time
[[Page 363]]
of the issuance. In 1960, C purchases an additional 200 shares of such
stock from another shareholder for $3,000; however, these shares do not
meet the requirements of section 1244 stock because they were not
originally issued to C by the corporation. In 1961, C receives 15 shares
of Corporation Y common stock as a stock dividend. Of the shares
received, 5 shares, the number received with respect to the 100 shares
of stock which met the requirements of section 1244 at the time of the
distribution, i.e., 100/300 x 15, shall also be treated as meeting such
requirements. The remaining 10 shares do not meet such requirements as
they are not received with respect to section 1244 stock. The basis of
such 5 shares is determined by applying section 307 as if the 5 shares
were received as a separate stock dividend made solely with respect to
shares that meet the requirements of section 1244 stock at the time of
the distribution. Thus, the basis of the 5 shares is $47.61 (\5/105\ of
$1,000).
(c) Recapitalizations. (1) If, pursuant to a recapitalization
described in section 368(a)(1)(E), common stock of a corporation is
received by an individual or partnership in exchange for stock of such
corporation meeting the requirements of section 1244 stock determinable
at the time of the exchange, such common stock shall be treated as
meeting such requirements.
(2) If common stock is received pursuant to such a recapitalization
partly in exchange for stock meeting the requirements of section 1244
stock determinable at the time of the exchange and partly in exchange
for stock not meeting such requirements, then only part of such common
stock will be treated as meeting such requirements. Such part is the
number of shares which bears the same ratio to the total number of
shares of common stock so received as the basis of the shares
transferred which meet such requirements bears to the basis of all the
shares transferred for such common stock. The basis allocable, pursuant
to section 358, to the common stock which is treated as meeting such
requirements is limited to the basis of stock that meets such
requirements transferred in the exchange.
(3) The provisions of subparagraphs (1) and (2) of this paragraph
may be illustrated by the following examples:
Example 3. A owns 500 shares of voting common stock of Corporation
X. Corporation X revises its capital structure to provide for two
classes of common stock: Class A voting and Class B nonvoting. In a
recapitalization described in subparagraph (E) of section 368(a)(1). A
exchanges his 500 shares for 750 shares of Class B nonvoting stock. If
the 500 shares meet all the requirements of section 1244 stock
determinable at the time of the exchange, the 750 shares received in the
exchange are treated as meeting such requirements.
Example 4. B owns 500 shares of common stock of Corporation X with a
basis of $5,000, and 100 shares of preferred stock of that corporation
with a basis of $2,500. Pursuant to a recapitalization described in
section 368(a)(1)(E), B exchanges all of his shares for 900 shares of
common stock of Corporation X. The 500 common shares meet the
requirements of section 1244 stock determinable at the time of the
exchange, but the 100 preferred shares do not meet such requirements
since only common stock may qualify. Of the 900 common shares received,
600 shares ($5,000/$7,500 x 900 shares) are treated as meeting the
requirements of section 1244 stock at the time of the exchange, because
they are deemed to be received in exchange for the 500 common shares
which met such requirements. The remaining 300 shares do not meet such
requirements as they are not deemed to be received in exchange for
section 1244 stock. The basis of the 600 shares is $5,000, the basis of
the relinquished shares meeting the requirements of section 1244.
(d) Change of name, etc. (1) If, pursuant to a reorganization
described in section 368(a)(1)(F), common stock of a successor
corporation is received by an individual or partnership in exchange for
stock of the predecessor corporation meeting the requirements of section
1244 stock determinable at the time of the exchange, such common stock
shall be treated as meeting such requirements. If common stock is
received pursuant to such a reorganization partly in exchange for stock
meeting the requirements of section 1244 stock determinable at the time
of the exchange and partly in exchange for stock not meeting such
requirements, the principles of paragraph (c)(2) of this section apply
in determinating the number of shares received which are treated as
meeting the requirements of section 1244 stock and the basis of those
shares.
(2) For purposes of paragraphs (1)(C) and (3)(A) of section 1244(c),
a successor corporation in a reorganization described in section
368(a)(1)(F) shall be
[[Page 364]]
treated as the same corporation as its predecessor.
[T.D. 7779, 46 FR 29472, June 2, 1981]
Sec. 1.1244(d)-4 Net operating loss deduction.
(a) General rule. For purpose of section 172, relating to the net
operating loss deduction, any amount of loss that is treated as an
ordinary loss under section 1244 (taking into account the annual dollar
limitation of that section) shall be treated as attributable to the
trade or business of the taxpayer. Therefore, this loss is allowable in
determining the taxpayer's net operating loss for a taxable year and is
not subject to the application of section 172(d)(4), relating to
nonbusiness deductions. A taxpayer may deduct the maximum of ordinary
loss permitted under section 1244(b) even though all or a portion of the
taxpayer's net operating loss carryback or carryover for the taxable
year was, when incurred, a loss on section 1244 stock.
(b) Example. The provisions of this section may be illustrated by
the following example:
Example: A, a single individual, computes a net operating loss of
$15,000 for 1980 in accordance with the rules of Sec. 1.172-3, relating
to net operating loss in case of a taxpayer other than a corporation.
Included within A's computation of this net operating loss is a
deduction arising under section 1244 for a loss on small business stock.
A had no taxable income in 1977, 1978, or 1979. Assume that A can carry
over the entire $15,000 loss under the rules of section 172. In 1981 A
has gross income of $75,000 and again sustains a loss on section 1244
stock. The amount of A's 1981 loss on section 1244 stock is $50,000. A
may deduct the full $50,000 as an ordinary loss under section 1244 and
the full $15,000 as a net operating loss carryover in 1981.
[T.D. 7779, 46 FR 29473, June 2, 1981]
Sec. 1.1244(e)-1 Records to be kept.
(a) By the corporation--(1) Mandatory records. A plan to issue pre-
November 1978 stock must appear upon the records of the corporation. Any
designation of post-November 1978 stock under Sec. 1.1244(c)-2(b)(2)
also must appear upon the records of the corporation.
(2) Discretionary records. In order to substantiate an ordinary loss
deduction claimed by its shareholders, the corporation should maintain
records showing the following:
(i) The persons to whom stock was issued, the date of issuance to
these persons, and a description of the amount and type of consideration
received from each;
(ii) If the consideration received is property, the basis in the
hands of the shareholder and the fair market value of the property when
received by the corporation;
(iii) The amount of money and the basis in the hands of the
corporation of other property received for its stock, as a contribution
to capital, and as paid-in surplus;
(iv) Financial statements of the corporation, such as its income tax
returns, that identify the source of the gross receipt of the
corporation for the period consisting of the five most recent taxable
years of the corporation, or, if the corporation has not been in
existence for 5 taxable years, for the period of the corporation's
existence;
(v) Information relating to any tax-free stock dividend made with
respect to section 1244 stock and any reorganization in which stock is
transferred by the corporation in exchange for section 1244 stock; and
(vi) With respect to pre-November 1978 stock;
(A) Which certificates represent stock issued under the plan;
(B) The amount of money and the basis in the hands of the
corporation of other property received after June 30, 1958, and before
the adoption of the plan, for its stock, as a contribution to capital,
and as paid-in surplus; and
(C) The equity capital of the corporation on the date of adoption of
the plan.
(b) By the taxpayer. A person who claims an ordinary loss with
respect to stock under section 1244 must have records sufficient to
establish that the taxpayer is entitled to the loss and satisfies the
requirements of section 1244. See also section 6001, requiring records
to be maintained.
In addition, a person who owns section 1244 stock in a corporation shall
maintain records sufficient to distinguish
[[Page 365]]
such stock from any other stock he may own in the corporation.
[T.D. 6495, 25 FR 9681, Oct. 8, 1960, as amended by T.D. 7779, 46 FR
29473, June 2, 1981; 46 FR 31881, June 18, 1981; T.D. 8594, 60 FR 20898,
Apr. 28, 1995]
Sec. 1.1245-1 General rule for treatment of gain from dispositions
of certain depreciable property.
(a) General. (1) In general, section 1245(a)(1) provides that, upon
a disposition of an item of section 1245 property, the amount by which
the lower of (i) the recomputed basis of the property, or (ii) the
amount realized on a sale, exchange, or involuntary conversion (or the
fair market value of the property on any other disposition), exceeds the
adjusted basis of the property shall be treated as gain from the sale or
exchange of property which is neither a capital asset nor property
described in section 1231 (that is, shall be recognized as ordinary
income). The amount of such gain shall be determined separately for each
item of section 1245 property. In general, the term recomputed basis
means the adjusted basis of property plus all adjustments reflected in
such adjusted basis on account of depreciation allowed or allowable for
all periods after December 31, 1961. See section 1245(a)(2) and Sec.
1.1245-2. Generally, the ordinary income treatment applies even though
in the absence of section 1245 no gain would be recognized under the
Code. For example, if a corporation distributes section 1245 property as
a dividend, gain may be recognized as ordinary income to the corporation
even though, in the absence of section 1245, section 311(a) would
preclude any recognition of gain to the corporation. For the definition
of section 1245 property, see section 1245(a)(3) and Sec. 1.1245-3. For
exceptions and limitations to the application of section 1245(a)(1), see
section 1245(b) and Sec. 1.1245-4.
(2) Section 1245(a)(1) applies to dispositions of section 1245
property in taxable years beginning after December 31, 1962, except
that:
(i) In respect of section 1245 property which is an elevator or
escalator, section 1245(a)(1) applies to dispositions after December 31,
1963, and
(ii) In respect of section 1245 property which is livestock
(described in subparagraph (4) of Sec. 1.1245-3(a)), section 1245(a)(1)
applies to dispositions made in taxable years beginning after December
31, 1969, and
(iii) [Reserved].
(3) For purposes of this section and Sec. Sec. 1.1245-2 through
1.1245-6, the term disposition includes a sale in a sale-and-leaseback
transaction and a transfer upon the foreclosure of a security interest,
but such term does not include a mere transfer of title to a creditor
upon creation of a security interest or to a debtor upon termination of
a security interest. Thus, for example, a disposition occurs upon a sale
of property pursuant to a conditional sales contract even though the
seller retains legal title to the property for purposes of security but
a disposition does not occur when the seller ultimately gives up his
security interest following payment by the purchaser.
(4) For purposes of applying section 1245, the facts and
circumstances of each disposition shall be considered in determining
what is the appropriate item of section 1245 property. A taxpayer may
treat any number of units of section 1245 property in any particular
depreciation account (as defined in Sec. 1.167(a)-7) as one item of
section 1245 property as long as it is reasonably clear, from the best
estimates obtainable on the basis of all the facts and circumstances,
that the amount of gain to which section 1245(a)(1) applies is not less
than the total of the gain under section 1245(a)(1) which would be
computed separately for each unit. Thus, for example, if 50 units of
section 1245 property X, 25 units of section 1245 property Y, and other
property are accounted for in one depreciation account, and if each such
unit is sold at a gain in one transaction in which the total gain
realized on the sale exceeds the sum of the adjustments reflected in the
adjusted basis (as defined in paragraph (a)(2) of Sec. 1.1245-2) of
each such unit on account of depreciation allowed or allowable for
periods after December 31, 1961, all 75 units may be treated as one item
of section 1245 property. If, however, 5 such units of section 1245
property Y were sold at a loss, then only 70 of such units (50 of X plus
the
[[Page 366]]
20 of Y sold at a gain) may be treated as one item of section 1245
property.
(5) In case of a sale, exchange, or involuntary conversion of
section 1245 and non-section 1245 property in one transaction, the total
amount realized upon the disposition shall be allocated between the
section 1245 property and the non-section 1245 property in proportion to
their respective fair market values. In general, if a buyer and seller
have adverse interests as to the allocation of the amount realized
between the section 1245 property and the non-section 1245 property, any
arm's length agreement between the buyer and the seller will establish
the allocation. In the absence of such an agreement, the allocation
shall be made by taking into account the appropriate facts and
circumstances. Some of the facts and circumstances which shall be taken
into account to the extent appropriate include, but are not limited to,
a comparison between the section 1245 property and all the property
disposed of in such transaction of (i) the original cost and
reproduction cost of construction, erection, or production, (ii) the
remaining economic useful life, (iii) state of obsolescence, and (iv)
anticipated expenditures to maintain, renovate, or to modernize.
(b) Sale, exchange, or involuntary conversion. (1) In the case of a
sale, exchange, or involuntary conversion of section 1245 property, the
gain to which section 1245(a)(1) applies is the amount by which (i) the
lower of the amount realized upon the disposition of the property or the
recomputed basis of the property, exceeds (ii) the adjusted basis of the
property.
(2) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. On January 1, 1964, Brown purchases section 1245 property
for use in his manufacturing business. The property has a basis for
depreciation of $3,300. After taking depreciation deductions of $1,300
(the amount allowable), Brown realizes after selling expenses the amount
of $2,900 upon sale of the property on January 1, 1969. Brown's gain is
$900 ($2,900 amount realized minus $2,000 adjusted basis). Since the
amount realized upon disposition of the property ($2,900) is lower than
its recomputed basis ($3,300, i.e., $2,000 adjusted basis plus $1,300 in
depreciation deductions), the entire gain is treated as ordinary income
under section 1245(a)(1) and not as gain from the sale or exchange of
property described in section 1231.
Example 2. Assume the same facts as in example (1) except that Brown
exchanges the section 1245 property for land which has a fair market
value of $3,700, thereby realizing a gain of $1,700 ($3,700 amount
realized minus $2,000 adjusted basis). Since the recomputed basis of the
property ($3,300) is lower than the amount realized upon its disposition
($3,700), the excess of recomputed basis over adjusted basis, or $1,300,
is treated as ordinary income under section 1245(a)(1). The remaining
$400 of the gain may be treated as gain from the sale or exchange of
property described in section 1231.
(c) Other dispositions. (1) In the case of a disposition of section
1245 property other than by way of a sale, exchange, or involuntary
conversion, the gain to which section 1245(a)(1) applies is the amount
by which (i) the lower of the fair market value of the property on the
date of disposition or the recomputed basis of the property, exceeds
(ii) the adjusted basis of the property. If property is transferred by a
corporation to a shareholder for an amount less than its fair market
value in a sale or exchange, for purposes of applying section 1245 such
transfer shall be treated as a disposition other than by way of a sale,
exchange, or involuntary conversion.
(2) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. X Corporation distributes section 1245 property to its
shareholders as a dividend. The property has an adjusted basis of $2,000
to the corporation, a recomputed basis of $3,300, and a fair market
value of $3,100. Since the fair market value of the property ($3,100) is
lower than its recomputed basis ($3,300), the excess of fair market
value over adjusted basis, or $1,100, is treated under section
1245(a)(1) as ordinary income to the corporation even though, in the
absence of section 1245, section 311(a) would preclude recognition of
gain to the corporation.
Example 2. Assume the same facts as in example (1) except that X
Corporation distributes the section 1245 property to its shareholders in
complete liquidation of the corporation. Assume further that section
1245(b)(3) does not apply and that the fair market value of the property
is $3,800 at the time of the distribution. Since the recomputed basis of
the property ($3,300) is lower than its fair market value ($3,800), the
excess of recomputed basis over adjusted basis, or
[[Page 367]]
$1,300, is treated under section 1245(a)(1) as ordinary income to the
corporation even though, in the absence of section 1245, section 336
would preclude recognition of gain to the corporation.
(d) Losses. Section 1245(a)(1) does not apply to losses. Thus,
section 1245(a)(1) does not apply if a loss is realized upon a sale,
exchange, or involuntary conversion of property, all of which is
considered section 1245 property, nor does the section apply to a
disposition of such property other than by way of sale, exchange, or
involuntary conversion if at the time of the disposition the fair market
value of such property is not greater than its adjusted basis.
(e) Treatment of partnership and partners. (1) The manner of
determining the amount of gain recognized under section 1245(a)(1) to a
partnership may be illustrated by the following example:
Example: A partnership sells for $63 section 1245 property which has
an adjusted basis to the partnership of $30 and a recomputed basis to
the partnership of $60. The partnership recognizes under section
1245(a)(1) gain of $30, i.e., the lower of the amount realized ($63) or
recomputed basis ($60), minus adjusted basis ($30). This result would
not be changed if one or more partners had, in respect of the property,
a special basis adjustment described in section 743(b) or had taken
depreciation deductions in respect of such special basis adjustment.
(2)(i) Unless paragraph (e)(3) of this section applies, a partner's
distributive share of gain recognized under section 1245(a)(1) by the
partnership is equal to the lesser of the partner's share of total gain
from the disposition of the property (gain limitation) or the partner's
share of depreciation or amortization with respect to the property (as
determined under paragraph (e)(2)(ii) of this section). Any gain
recognized under section 1245(a)(1) by the partnership that is not
allocated under the first sentence of this paragraph (e)(2)(i) (excess
depreciation recapture) is allocated among the partners whose shares of
total gain from the disposition of the property exceed their shares of
depreciation or amortization with respect to the property. Excess
depreciation recapture is allocated among those partners in proportion
to their relative shares of the total gain (including gain recognized
under section 1245(a)(1)) from the disposition of the property that is
allocated to the partners who are not subject to the gain limitation.
See Example 2 of paragraph (e)(2)(iii) of this section.
(ii)(A) Subject to the adjustments described in paragraphs
(e)(2)(ii)(B) and (e)(2)(ii)(C) of this section, a partner's share of
depreciation or amortization with respect to property equals the total
amount of allowed or allowable depreciation or amortization previously
allocated to that partner with respect to the property.
(B) If a partner transfers a partnership interest, a share of
depreciation or amortization must be allocated to the transferee partner
as it would have been allocated to the transferor partner. If the
partner transfers a portion of the partnership interest, a share of
depreciation or amortization proportionate to the interest transferred
must be allocated to the transferee partner.
(C)(1) A partner's share of depreciation or amortization with
respect to property contributed by the partner includes the amount of
depreciation or amortization allowed or allowable to the partner for the
period before the property is contributed.
(2) A partner's share of depreciation or amortization with respect
to property contributed by a partner is adjusted to account for any
curative allocations. (See Sec. 1.704-3(c) for a description of the
traditional method with curative allocations.) The contributing
partner's share of depreciation or amortization with respect to the
contributed property is decreased (but not below zero) by the amount of
any curative allocation of ordinary income to the contributing partner
with respect to that property and by the amount of any curative
allocation of deduction or loss (other than capital loss) to the
noncontributing partners with respect to that property. A
noncontributing partner's share of depreciation or amortization with
respect to the contributed property is increased by the noncontributing
partner's share of any curative allocation of ordinary income to the
contributing partner with respect to that property and by the amount of
any curative allocation of deduction or loss (other than capital loss)
to the noncontributing partner with respect
[[Page 368]]
to that property. The partners' shares of depreciation or amortization
with respect to property from which curative allocations of depreciation
or amortization are taken is determined without regard to those curative
allocations. See Example 3(iii) of paragraph (e)(2)(iii) of this
section.
(3) A partner's share of depreciation or amortization with respect
to property contributed by a partner is adjusted to account for any
remedial allocations. (See Sec. 1.704-3(d) for a description of the
remedial allocation method.) The contributing partner's share of
depreciation or amortization with respect to the contributed property is
decreased (but not below zero) by the amount of any remedial allocation
of income to the contributing partner with respect to that property. A
noncontributing partner's share of depreciation or amortization with
respect to the contributed property is increased by the amount of any
remedial allocation of depreciation or amortization to the
noncontributing partner with respect to that property. See Example 3(iv)
of paragraph (e)(2)(iii) of this section.
(4) If, under paragraphs (e)(2)(ii)(C)(2) and (e)(2)(ii)(C)(3) of
this section, the partners' shares of depreciation or amortization with
respect to a contributed property exceed the adjustments reflected in
the adjusted basis of the property under Sec. 1.1245-2(a) at the
partnership level, then the partnership's gain recognized under section
1245(a)(1) with respect to that property is allocated among the partners
in proportion to their relative shares of depreciation or amortization
(subject to any gain limitation that might apply).
(5) This paragraph (e)(2)(ii)(C) also applies in determining a
partner's share of depreciation or amortization with respect to property
for which differences between book value and adjusted tax basis are
created when a partnership revalues partnership property pursuant to
Sec. 1.704-1(b)(2)(iv)(f).
(iii) Examples. The application of this paragraph (e)(2) may be
illustrated by the following examples:
Example 1. Recapture allocations. (i) Facts. A and B each contribute
$5,000 cash to form AB, a general partnership. The partnership agreement
provides that depreciation deductions will be allocated 90 percent to A
and 10 percent to B, and, on the sale of depreciable property, A will
first be allocated gain to the extent necessary to equalize A's and B's
capital accounts. Any remaining gain will be allocated 50 percent to A
and 50 percent to B. In its first year of operations, AB purchases
depreciable equipment for $5,000. AB depreciates the equipment over its
5-year recovery period and elects to use the straight-line method. In
its first year of operations, AB's operating income equals its expenses
(other than depreciation). (To simplify this example, AB's depreciation
deductions are determined without regard to any first-year depreciation
conventions.)
(ii) Year 1. In its first year of operations, AB has $1,000 of
depreciation from the partnership equipment. In accordance with the
partnership agreement, AB allocates 90 percent ($900) of the
depreciation to A and 10 percent ($100) of the depreciation to B. At the
end of the year, AB sells the equipment for $5,200, recognizing $1,200
of gain ($5,200 amount realized less $4,000 adjusted tax basis). In
accordance with the partnership agreement, the first $800 of gain is
allocated to A to equalize the partners' capital accounts, and the
remaining $400 of gain is allocated $200 to A and $200 to B.
(iii) Recapture allocations. $1,000 of the gain from the sale of the
equipment is treated as section 1245(a)(1) gain. Under paragraph
(e)(2)(i) of this section, each partner's share of the section
1245(a)(1) gain is equal to the lesser of the partner's share of total
gain recognized on the sale of the equipment or the partner's share of
total depreciation with respect to the equipment. Thus, A's share of the
section 1245(a)(1) gain is $900 (the lesser of A's share of the total
gain ($1,000) and A's share of depreciation ($900)). B's share of the
section 1245(a)(1) gain is $100 (the lesser of B's share of the total
gain ($200) and B's share of depreciation ($100)). Accordingly, $900 of
the $1,000 of total gain allocated to A is treated as ordinary income
and $100 of the $200 of total gain allocated to B is treated as ordinary
income.
Example 2. Recapture allocation subject to gain limitation. (i)
Facts. A, B, and C form general partnership ABC. The partnership
agreement provides that depreciation deductions will be allocated
equally among the partners, but that gain from the sale of depreciable
property will be allocated 75 percent to A and 25 percent to B. ABC
purchases depreciable personal property for $300 and subsequently
allocates $100 of depreciation deductions each to A, B, and C, reducing
the adjusted tax basis of the property to $0. ABC then sells the
property for $440. ABC allocates $330 of the gain to A (75 percent of
$440) and allocates $110 of the gain to B (25 percent of $440). No gain
is allocated to C.
(ii) Application of gain limitation. Each partner's share of
depreciation with respect to
[[Page 369]]
the property is $100. C's share of the total gain from the disposition
of the property, however, is $0. As a result, under the gain limitation
provision in paragraph (e)(2)(i) of this section, C's share of section
1245(a)(1) gain is limited to $0.
(iii) Excess depreciation recapture. Under paragraph (e)(2)(i) of
this section, the $100 of section 1245(a)(1) gain that cannot be
allocated to C under the gain limitation provision (excess depreciation
recapture) is allocated to A and B (the partners not subject to the gain
limitation at the time of the allocation) in proportion to their
relative shares of total gain from the disposition of the property. A's
relative share of the total gain allocated to A and B is 75 percent
($330 of $440 total gain). B's relative share of the total gain
allocated to A and B is 25 percent ($110 of $440 total gain). However,
under the gain limitation provision of paragraph (e)(2)(i) of this
section, B cannot be allocated 25 percent of the excess depreciation
recapture ($25) because that would result in a total allocation of $125
of depreciation recapture to B (a $100 allocation equal to B's share of
depreciation plus a $25 allocation of excess depreciation recapture),
which is in excess of B's share of the total gain from the disposition
of the property ($110). Therefore, only $10 of excess depreciation
recapture is allocated to B and the remaining $90 of excess depreciation
recapture is allocated to A. A is not subject to the gain limitation
because A's share of the total gain ($330) still exceeds A's share of
section 1245(a)(1) gain ($190). Accordingly, all $110 of the total gain
allocated to B is treated as ordinary income ($100 share of depreciation
allocated to B plus $10 of excess depreciation recapture) and $190 of
the total gain allocated to A is treated as ordinary income ($100 share
of depreciation allocated to A plus $90 of excess depreciation
recapture).
Example 3. Determination of partners' shares of depreciation with
respect to contributed property. (i) Facts.C and D form partnership CD
as equal partners. C contributes depreciable personal property C1 with
an adjusted tax basis of $800 and a fair market value of $2,800. Prior
to the contribution, C claimed $200 of depreciation from C1. At the time
of the contribution, C1 is depreciable under the straight-line method
and has four years remaining on its 5-year recovery period. D
contributes $2,800 cash, which CD uses to purchase depreciable personal
property D1, which is depreciable over seven years under the straight-
line method. (To simplify the example, all depreciation is determined
without regard to any first-year depreciation conventions.)
(ii) Traditional method. C1 generates $700 of book depreciation (\1/
4\ of $2,800 book value) and $200 of tax depreciation (\1/4\ of $800
adjusted tax basis) each year. C and D will each be allocated $350 of
book depreciation from C1 in year 1. Under the traditional method of
making section 704(c) allocations, D will be allocated the entire $200
of tax depreciation from C1 in year 1. D1 generates $400 of book and tax
depreciation each year (\1/7\ of $2,800 book value and adjusted tax
basis). C and D will each be allocated $200 of book and tax depreciation
from D1 in year 1. As a result, after the first year of partnership
operations, C's share of depreciation with respect to C1 is $200 (the
depreciation taken by C prior to contribution) and D's share of
depreciation with respect to C1 is $200 (the amount of tax depreciation
allocated to D). C and D each have a $200 share of depreciation with
respect to D1. At the end of four years, C's share of depreciation with
respect to C1 will be $200 (the depreciation taken by C prior to
contribution) and D's share of depreciation with respect to C1 will be
$800 (four years of $200 depreciation per year). At the end of four
years, C and D will each have an $800 share of depreciation with respect
to D1 (four years of $200 depreciation per year).
(iii) Effect of curative allocations. (A) Year 1. If the partnership
elects to make curative allocations under Sec. 1.704-3(c) using
depreciation from D1, the results will be the same as under the
traditional method, except that $150 of the $200 of tax depreciation
from D1 that would be allocated to C under the traditional method will
be allocated to D as additional depreciation with respect to C1. As a
result, after the first year of partnership operations, C's share of
depreciation with respect to C1 will be reduced to $50 (the total
depreciation taken by C prior to contribution ($200) decreased by the
amount of the curative allocation to D ($150)). D's share of
depreciation with respect to C1 will be $350 (the depreciation allocated
to D under the traditional method ($200) increased by the amount of the
curative allocation to D ($150)). C and D will each have a $200 share of
depreciation with respect to D1.
(B) Year 4. At the end of four years, C's share of depreciation with
respect to C1 will be reduced to $0 (the total depreciation taken by C
prior to contribution ($200) decreased, but not below zero, by the
amount of the curative allocations to D ($600)), and D's share of
depreciation with respect to C1 will be $1,400 (the total depreciation
allocated to D under the traditional method ($800) increased by the
amount of the curative allocations to D ($600)). However, CD's section
1245(a)(1) gain with respect to C1 will not be more than $1,000 (CD's
tax depreciation ($800) plus C's tax depreciation prior to contribution
($200)). Under paragraph (e)(2)(ii)(C)(4) of this section, because the
partners' shares of depreciation with respect to C1 exceed the
adjustments reflected in the property's adjusted basis, CD's section
1245(a)(1) gain will be allocated in proportion to the partners'
relative shares of depreciation with respect to C1. Because C's share of
depreciation with respect to C1 is $0, and D's
[[Page 370]]
share of depreciation with respect to C1 is $1,400, all of CD's $1,000
of section 1245(a)(1) gain will be allocated to D. At the end of four
years, C and D will each have an $800 share of depreciation with respect
to D1 (four years of $200 depreciation per year).
(iv) Effect of remedial allocations. (A) Year 1. If the partnership
elects to make remedial allocations under Sec. 1.704-3(d), there will
be $600 of book depreciation from C1 in year 1. (Under the remedial
allocation method, the amount by which C1's book basis ($2,800) exceeds
its tax basis ($800) is depreciated over a 5-year life, rather than a 4-
year life.) C and D will each be allocated one-half ($300) of the total
book depreciation. As under the traditional method, D will be allocated
all $200 of tax depreciation from C1. Because the ceiling rule would
cause a disparity of $100 between D's book and tax allocations of
depreciation, D will also receive a $100 remedial allocation of
depreciation with respect to C1, and C will receive a $100 remedial
allocation of income with respect to C1. As a result, after the first
year of partnership operations, D's share of depreciation with respect
to C1 is $300 (the depreciation allocated to D under the traditional
method ($200) increased by the amount of the remedial allocation
($100)). C's share of depreciation with respect to C1 is $100 (the total
depreciation taken by C prior to contribution ($200) decreased by the
amount of the remedial allocation of income ($100)). C and D will each
have a $200 share of depreciation with respect to D1.
(B) Year 5. At the end of five years, C's share of depreciation with
respect to C1 will be $0 (the total depreciation taken by C prior to
contribution ($200) decreased, but not below zero, by the total amount
of the remedial allocations of income to C ($600)). D's share of
depreciation with respect to C1 will be $1,400 (the total depreciation
allocated to D under the traditional method ($800) increased by the
total amount of the remedial allocations of depreciation to D ($600)).
However, CD's section 1245(a)(1) gain with respect to C1 will not be
more than $1,000 (CD's tax depreciation ($800) plus C's tax depreciation
prior to contribution ($200)). Under paragraph (e)(2)(ii)(C)(4) of this
section, because the partners' shares of depreciation with respect to C1
exceed the adjustments reflected in the property's adjusted basis, CD's
section 1245(a)(1) gain will be allocated in proportion to the partners'
relative shares of depreciation with respect to C1. Because C's share of
depreciation with respect to C1 is $0, and D's share of depreciation
with respect to C1 is $1,400, all of CD's $1,000 of section 1245(a)(1)
gain will be allocated to D. At the end of five years, C and D will each
have a $1,000 share of depreciation with respect to D1 (five years of
$200 depreciation per year).
(iv) Effective date. This paragraph (e)(2) is effective for
properties acquired by a partnership on or after August 20, 1997.
However, partnerships may rely on this paragraph (e)(2) for properties
acquired before August 20, 1997 and disposed of on or after August 20,
1997.
(3)(i) If (a) a partner had a special basis adjustment under section
743(b) in respect of section 1245 property, or (b) on the date he
acquired his partnership interest by way of a sale or exchange (or upon
death of another partner) the partnership owned section 1245 property
and an election under section 754 (relating to optional adjustment to
basis of partnership property) was in effect with respect to the
partnership, then the amount of gain recognized under section 1245(a)(1)
by him upon a disposition by the partnership of such property shall be
determined under this subparagraph.
(ii) There shall be allocated to such partner, in the same
proportion as the partnership's total gain is allocated to him as his
distributive share under section 704, a portion of (a) the common
partnership adjusted basis for the property, and (b) the amount realized
by the partnership upon the disposition, or, if nothing is realized, the
fair market value of the property. There shall also be allocated to him,
in the same proportion as the partnership's gain recognized under
section 1245(a)(1) is allocated under subparagraph (2) of this paragraph
as his distributive share of such gain, a portion of the adjustments
reflected in the adjusted basis (as defined in paragraph (a)(2) of Sec.
1.1245-2) of such property. If on the date he acquired his partnership
interest by way of a sale or exchange the partnership owned such
property and an election under section 754 was in effect, then for
purposes of the preceding sentence the amount of the adjustments
reflected in the adjusted basis of such property on such date shall be
deemed to be zero. For special rules relating to the amount of
adjustments reflected in the adjusted basis of property after
partnership transactions, see paragraph (c)(6) of Sec. 1.1245-2.
(iii) The partner's adjusted basis in respect of the property shall
be deemed to be (a) the portion of the partnership's adjusted basis for
the property
[[Page 371]]
allocated to the partner under subdivision (ii) of this subparagraph,
(b) increased by the amount of any special basis adjustment described in
section 743(b)(1) (or decreased by the amount of any special basis
adjustment described in section 743(b)(2) which the partner may have in
respect of the property on the date the partnership disposed of the
property.
(iv) The partner's recomputed basis in respect of the property shall
be deemed to be (a) the sum of the partner's adjusted basis for the
property, as determined in subdivision (iii) of this subparagraph, plus
the amount of the adjustments reflected in the adjusted basis (as
defined in paragraph (a)(2) of Sec. 1.1245-2) for the property
allocated to the partner under subdivision (ii) of this subparagraph,
(b) increased by the amount by which any special basis adjustment
described in section 743(b)(1) (or decreased by the amount by which any
special basis adjustment described in section 743(b)(2)) in respect of
the property was reduced, but only to the extent such amount was applied
to adjust the amount of the deductions allowed or allowable to the
partner for depreciation or amortization of section 1245 property
attributable to periods referred to in paragraph (a)(2) of Sec. 1.1245-
2. The terms allowed or allowable, depreciation or amortization, and
attributable to periods shall have the meanings assigned to these terms
in paragraph (a) of Sec. 1.1245-2.
(4) The application of subparagraph (3) of this paragraph may be
illustrated by the following example:
Example: A, B, and C each hold a one-third interest in calendar year
partnership ABC. On December 31, 1962, the firm holds section 1245
property which has an adjusted basis of $30,000 and a recomputed basis
of $33,000. Depreciation deductions in respect of the property for 1962
were $3,000. On January 1, 1963, when D purchases C's partnership
interest, the election under section 754 is in effect and a $5,000
special basis adjustment is made in respect of D to his one-third share
of the common partnership adjusted basis for the property. For 1963 and
1964 the partnership deducts $6,000 as depreciation in respect of the
property, thereby reducing its adjusted basis to $24,000, and D deducts
$2,800, i.e., his distributive share of partnership depreciation
($2,000) plus depreciation in respect of his special basis adjustment
($800). On March 15, 1965, the partnership sells the property for
$48,000. Since the partnership's recomputed basis for the property
($33,000, i.e., $24,000 adjusted basis plus $9,000 in depreciation
deductions) is lower than the amount realized upon the sale ($48,000),
the excess of recomputed basis over adjusted basis, or $9,000, is
treated as partnership gain under section 1245(a)(1). D's distributive
share of such gain is $3,000 (\1/3\ of $9,000). However, the amount of
gain recognized by D under section 1245 (a)(1) is only $2,800,
determined as follows:
(1) Adjusted basis:
D's portion of partnership adjusted basis (\1/ $8,000
3\ of $24,000)...............................
D's special basis adjustment as of December 4,200
31, 1964 ($5,000 minus $800).................
D's adjusted basis.......................... .......... $12,200
------------
(2) Recomputed basis:
D's adjusted basis............................ 12,200
D's portion of partnership depreciation for 2,000
1963 and 1964, i.e., for periods after he
acquired his partnership interest (\1/3\ of
$6,000)......................................
Depreciation for 1963 and 1964 in respect of 800
D's special basis adjustment.................
D's recomputed basis......................
============
.......... 15,000
(3) D's portion of amount realized by partnership (\1/3\ of 16,000
$48,000)...................................................
(4) Gain recognized to D under section 1245(a)(1), i.e., the 2,800
lower of (2) or (3), minus (1).............................
[T.D. 6832, 30 FR 8576, July 7, 1965, as amended by T.D. 7084, 36 FR
268, Jan. 8, 1971; T.D. 7141, 36 FR 18793, Sept. 22, 1971; T.D. 8730, 62
FR 44216, Aug. 20, 1997]
Sec. 1.1245-2 Definition of recomputed basis.
(a) General rule--(1) Recomputed basis defined. The term recomputed
basis means, with respect to any property, an amount equal to the sum
of:
(i) The adjusted basis of the property, as defined in section 1011,
plus
(ii) The amount of the adjustments reflected in the adjusted basis.
(2) Definition of adjustments reflected in adjusted basis. The term
adjustments reflected in the adjusted basis means:
(i) With respect to any property other than property described in
subdivision (ii), (iii), or (iv) of this subparagraph, the amount of the
adjustments attributable to periods after December 31, 1961,
(ii) With respect to an elevator or escalator, the amount of the
adjustments attributable to periods after June 30, 1963,
[[Page 372]]
(iii) With respect to livestock (described in subparagraph (4) of
Sec. 1.1245-3(a)), the amount of the adjustments attributable to
periods after December 31, 1969, or
(iv) [Reserved]
which are reflected in the adjusted basis of such property on account of
deductions allowed or allowable for depreciation or amortization (within
the meaning of subparagraph (3) of this paragraph). For cases where the
taxpayer can establish that the amount allowed for any period was less
than the amount allowable, see subparagraph (7) of this paragraph. For
determination of adjusted basis of property in a multiple asset account,
see paragraph (c)(3) of Sec. 1.167(a)-8.
(3) Meaning of depreciation or amortization. (i) For purposes of
subparagraph (2) of this paragraph, the term depreciation or
amortization includes allowances (and amounts treated as allowances) for
depreciation (or amortization in lieu thereof), and deductions for
amortization of emergency facilities under section 168. Thus, for
example, such term includes a reasonable allowance for exhaustion, wear
and tear (including a reasonable allowance for obsolescence) under
section 167, an expense allowance (additional first-year depreciation
allowance for property placed in service before January 1, 1981), under
section 179, an expenditure treated as an amount allowed under section
167 by reason of the application of section 182(d)(2)(B) (relating to
expenditures by farmers for clearing land), and a deduction for
depreciation of improvements under section 611 (relating to depletion).
For further examples, the term depreciation or amortization includes
periodic deductions referred to in Sec. 1.162-11 in respect of a
specified sum paid for the acquisition of a leasehold and in respect of
the cost to a lessee of improvements on property of which he is the
lessee. However, such term does not include deductions for the periodic
payment of rent.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: On January 1, 1966, Smith purchases for $1,000, and places
in service, an item of property described in section 1245(a) (3)(A).
Smith deducts an additional first-year allowance for depreciation under
section 179 of $200. Accordingly, the basis of the property for purposes
of depreciation is $800 on January 1, 1966. Between that date and
January 1, 1974, Smith deducts $640 in depreciation (the amount
allowable) with respect to the property, thereby reducing its adjusted
basis to $160. Since this adjusted basis reflects deductions for
depreciation and amortization (within the meaning of this subparagraph)
amounting to $840 ($200 plus $640), the recomputed basis of the property
is $1,000 ($160 plus $840).
(4) Adjustments of other taxpayers or in respect of other property.
(i) For purposes of subparagraph (2) of this paragraph, the adjustments
reflected in adjusted basis on account of depreciation or amortization
which must be taken into account in determining recomputed basis are not
limited to those adjustments on account of depreciation or amortization
with respect to the property disposed of, nor are such adjustments
limited to those on account of depreciation or amortization allowed or
allowable to the taxpayer disposing of such property. Except as provided
in subparagraph (7) of this paragraph, all such adjustments are taken
into account, whether the deductions were allowed or allowable in
respect of the same or other property and whether to the taxpayer or to
any other person. For manner of determining the amount of adjustments
reflected in the adjusted basis of property immediately after certain
dispositions, see paragraph (c) of this section.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: On January 1, 1966, Jones purchases machine X for use in
his trade or business. The machine, which is section 1245 property, has
a basis for depreciation of $10,000. After taking depreciation
deductions of $2,000 (the amount allowable), Jones transfers the machine
to his son as a gift on January 1, 1968. Since the exception for gifts
in section 1245(b)(1) applies, Jones does not recognize gain under
section 1245(a)(1). The son's adjusted basis for the machine is $8,000.
On January 1, 1969, after taking a depreciation deduction of $1,000 (the
amount allowable), the son exchanges machine X for machine Y in a like
kind exchange described in section 1031. Since the exception for like
kind exchanges in section 1245(b)(4) applies, the son does not recognize
gain under section
[[Page 373]]
1245(a)(1). The son's adjusted basis for machine Y is $7,000. In 1969,
the son takes a depreciation deduction of $1,000 (the amount allowable)
in respect of machine Y. The son sells machine Y on June 30, 1970. No
depreciation was allowed or allowable for 1970, the year of the sale.
The recomputed basis of machine Y on June 30, 1970, is determined in the
following manner:
Adjusted basis.................................. $6,000
Adjustments reflected in the adjusted basis:
Depreciation deducted by Jones for 1966 and 1967 2,000
on machine X...................................
Depreciation deducted by son for 1968 on machine 1,000
X..............................................
Depreciation deducted by son for 1969 on machine 1,000
Y..............................................
Total adjustments reflected in the adjusted basis....... $4,000
-------------
Recomputed basis........................................ 10,000
(5) Adjustments reflected in adjusted basis of property described in
section 1245(a)(3)(B). For purposes of subparagraph (2) of this
paragraph, the adjustments reflected in the adjusted basis of property
described in section 1245(a)(3)(B), on account of depreciation or
amortization which must be taken into account in determining recomputed
basis, may include deductions attributable to periods during which the
property is not used as an integral part of an activity, or does not
constitute a facility, specified in section 1245(a)(3)(B) (i) or (ii).
Thus, for example, if depreciation deductions taken with respect to such
property after December 31, 1961, amount to $10,000 (the amount
allowable), of which $6,000 is attributable to periods during which the
property is used as an integral part of a specified activity or
constitutes a specified facility, then the entire $10,000 of
depreciation deductions are adjustments reflected in the adjusted basis
for purposes of determining recomputed basis. Moreover, if the property
was never so used but was acquired in a transaction to which section
1245(b)(4) (relating to like kind exchanges and involuntary conversions)
applies, and if by reason of the application of paragraph (d)(3) of
Sec. 1.1245-4 the property is considered as section 1245 property
described in section 1245(a)(3)(B), then the entire $10,000 of
depreciation deductions would also be adjustments reflected in the
adjusted basis for purposes of determining recomputed basis.
(6) Allocation of adjustments attributable to periods after certain
dates. (i) For purposes of determining recomputed basis, the amount of
adjustments reflected in the adjusted basis of property other than
property described in subparagraph (2) (ii), (iii), or (iv) of this
paragraph are limited to adjustments attributable to periods after
December 31, 1961. Accordingly, if depreciation deducted with respect to
such property of a calendar year taxpayer is $1,000 a year (the amount
allowable) for each of 10 years beginning with 1956, only the
depreciation deducted in 1962 and succeeding years shall be treated as
reflected in the adjusted basis for purposes of determining recomputed
basis. With respect to a taxable year beginning in 1961 and ending in
1962, the deduction for depreciation or amortization shall be
ascertained by applying the principles stated in paragraph (c)(3) of
Sec. 1.167(a)-8 (relating to determination of adjusted basis of retired
asset). The amount of the deduction, determined in such manner, shall be
allocated on a daily basis in order to determine the portion thereof
which is attributable to a period after December 31, 1961. Thus, for
example, if a taxpayer, whose fiscal year ends on May 31, 1962, acquires
section 1245 property on November 12, 1961, and the deduction for
depreciation attributable to the property for such fiscal year is
ascertained (under the principles of paragraph (c)(3) of Sec. 1.167(a)-
8) to be $400, then the portion thereof attributable to a period after
December 31, 1961, is $302 (\151/200\ of $400). If, however, the
property were acquired by such taxpayer after December 31, 1961, the
entire deduction for depreciation attributable to the property for such
fiscal year would be allocable to a period after December 31, 1961. For
treatment of certain normal retirements described in paragraph (e)(2) of
Sec. 1.167(a)-8, see paragraph (c) of Sec. 1.1245-6. For principles of
determining the amount of adjustments for depreciation or amortization
reflected in the adjusted basis of property upon an abnormal retirement
of property in a multiple asset account, see paragraph (c)(3) of Sec.
1.167(a)-8.
[[Page 374]]
(ii) For purposes of determining recomputed basis, the amount of
adjustments reflected in the adjusted basis of an elevator or escalator
are limited to adjustments attributable to periods after June 30, 1963.
(iii) For purposes of determining recomputed basis, the amount of
adjustments reflected in the adjusted basis of livestock (described in
subparagraph (2)(iii) of this paragraph) are limited to adjustments
attributable to periods after December 31, 1969.
(7) Depreciation or amortization allowed or allowable. For purposes
of determining recomputed basis, generally all adjustments (for periods
after Dec. 31, 1961, or, in the case of property described in
subparagraph (2) (ii), (iii), or (iv) of this paragraph, for periods
after the applicable date) attributable to allowed or allowable
depreciation or amortization must be taken into account. See section
1016(a)(2) and the regulations thereunder for the meaning of allowed and
allowable. However, if a taxpayer can establish by adequate records or
other sufficient evidence that the amount allowed for depreciation or
amortization for any period was less than the amount allowable for such
period, the amount to be taken into account for such period shall be the
amount allowed. No adjustment is to be made on account of the tax
imposed by section 56 (relating to the minimum tax for tax preferences).
See paragraph (b) of this section (relating to records to be kept and
information to be filed). For example, assume that in the year 1967 it
becomes necessary to determine the recomputed basis of property, the
$500 adjusted basis of which reflects adjustments of $1,000 with respect
to depreciation deductions allowable for periods after December 31,
1961. If the taxpayer can establish by adequate records or other
sufficient evidence that he had been allowed deductions amounting to
only $800 for the period, then in determining recomputed basis the
amount added to adjusted basis with respect to the $1,000 adjustments to
basis for the period will be only $800.
(8) Exempt organizations. In respect of property disposed of by an
organization which is or was exempt from income taxes (within the
meaning of section 501(a)), adjustments reflected in the adjusted basis
(within the meaning of subparagraph (2) of this paragraph) shall include
only depreciation or amortization allowed or allowable (i) in computing
unrelated business taxable income (as defined in section 512(a), or (ii)
in computing taxable income of the organization (or a predecessor
organization) for a period during which it was not exempt or, by reason
of the application of section 502, 503, or 504, was denied its
exemption.
(b) Records to be kept. In any case in which it is necessary to
determine recomputed basis of an item of section 1245 property, the
taxpayer shall have available permanent records of all the facts
necessary to determine with reasonable accuracy the amount of such
recomputed basis, including the following:
(1) The date, and the manner in which, the property was acquired,
(2) The taxpayer's basis on the date the property was acquired and
the manner in which the basis was determined,
(3) The amount and date of all adjustments to the basis of the
property allowed or allowable to the taxpayer for depreciation or
amortization and the amount and date of any other adjustments by the
taxpayer to the basis of the property,
(4) In the case of section 1245 property which has an adjusted basis
reflecting adjustments for depreciation or amortization taken by the
taxpayer with respect to other property, or by another taxpayer with
respect to the same or other property, the information described in
subparagraphs (1), (2), and (3) of this paragraph with respect to such
other property or such other taxpayer.
(c) Adjustments reflected in adjusted basis immediately after
certain acquisitions--(1) Zero. (i) If on the date a person acquires
property his basis for the property is determined solely by reference to
its cost (within the meaning of section 1012), then on such date the
amount of the adjustments reflected in his adjusted basis for the
property is zero.
(ii) If on the date a person acquires property his basis for the
property is
[[Page 375]]
determined solely by reason of the application of section 301(d)
(relating to basis of property received in corporate distribution) or
section 334(a) (relating to basis of property received in a liquidation
in which gain or loss is recognized), then on such date the amount of
the adjustments reflected in his adjusted basis for the property is
zero.
(iii) If on the date a person acquires property his basis for the
property is determined solely under the rules of section 334 (b)(2) or
(c) relating to basis of property received in certain corporate
liquidations), then on such date the amount of the adjustments reflected
in his adjusted basis for the property is zero.
(iv) If as of the date a person acquires property from a decedent
such person's basis is determined, by reason of the application of
section 1014(a), solely by reference to the fair market value of the
property on the date of the decedent's death or on the applicable date
provided in section 2032 (relating to alternate valuation date), then on
such date the amount of the adjustments reflected in his adjusted basis
for the property is zero.
(2) Gifts and certain tax-free transactions. (i) If property is
disposed of in a transaction described in subdivision (ii) of this
subparagraph, then the amount of the adjustments reflected in the
adjusted basis of the property in the hands of a transferee immediately
after the disposition shall be an amount equal to:
(a) The amount of the adjustments reflected in the adjusted basis of
the property in the hands of the transferor immediately before the
disposition, minus
(b) The amount of any gain taken into account under section
1245(a)(1) by the transferor upon the disposition.
(ii) The transactions referred to in paragraph (c)(2)(i) of this
section are:
(A) A disposition that is in part a sale or exchange and in part a
gift (see Sec. 1.1245-4(a)(3));
(B) A disposition (other than a disposition to which section
1245(b)(6)(A) applies) that is described in section 1245(b)(3) (relating
to certain tax-free transactions);
(C) An exchange described in Sec. 1.1245-4(e)(2) (relating to
transfers described in section 1081(d)(1)(A)); or
(D) A transfer at death where the basis of property in the hands of
the transferee is determined under section 1022.
(iii) The provisions of this subparagraph may be illustrated by the
following example:
Example: Jones transfers section 1245 property to a corporation in
exchange for stock of the corporation and $1,000 cash in a transaction
which qualifies under section 351 (relating to transfer to a corporation
controlled by transferor). Before the exchange the amount of the
adjustments reflected in the adjusted basis of the property is $3,000.
Upon the exchange $1,000 gain is recognized under section 1245(a)(1).
Immediately after the exchange, the amount of the adjustments reflected
in the adjusted basis of the property in the hands of the corporation is
$2,000 (that is, $3,000 minus $1,000).
(3) Certain transfers at death. (i) If property is acquired in a
transfer at death to which section 1245(b)(2) applies, the amount of the
adjustments reflected in the adjusted basis of property in the hands of
the transferee immediately after the transfer shall be the amount (if
any) of depreciation or amortization deductions allowed the transferee
before the decedent's death, to the extent that the basis of the
property (determined under section 1014(a)) is required to be reduced
under the second sentence of section 1014(b)(9) (relating to adjustments
to basis where property is acquired from a decedent prior to his death).
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: H purchases section 1245 property in 1965 which he
immediately conveys to himself and W, his wife, as tenants by the
entirety. Under local law each spouse is entitled to one-half the income
from the property. H and W file joint income tax returns for calendar
years 1965, 1966, and 1967. Over the 3 years, depreciation deductions
amounting to $4,000 (the amount allowable) are allowed in respect of the
property of which one-half thereof, or $2,000, is allocable to W. On
January 1, 1968, H dies and the entire value of the property at the date
of death is included in H's gross estate. Since W's basis for the
property (determined under section 1014(a)) is reduced (under the second
sentence
[[Page 376]]
of section 1014(b)(9)) by the $2,000 depreciation deductions allowed W
before H's death, the adjustments reflected in the adjusted basis of the
property in the hands of W immediately after H's death amount to $2,000.
(4) Property received in a like kind exchange, involuntary
conversion, or F.C.C. transaction. (i) If property is acquired in a
transaction described in subdivision (ii) of this subparagraph then
immediately after the acquisition (and before applying subparagraph (5)
of this paragraph, if applicable) the amount of the adjustments
reflected in the adjusted basis of the property acquired shall be an
amount equal to:
(a) The amount of the adjustments reflected in the adjusted basis of
the property disposed of immediately before the disposition, minus
(b) The sum of (1) the amount of any gain recognized under section
1245(a)(1) upon the disposition, plus (2) the amount of gain (if any)
referred to in subparagraph (5)(ii) of this paragraph.
(ii) The transactions referred to in subdivision (i) of this
subparagraph are:
(a) A disposition which is a like kind exchange or an involuntary
conversion to which section 1245(b)(4) applies, or
(b) A disposition to which the provisions of section 1071 and
paragraph (e)(1) of Sec. 1.1245-4 apply.
(iii) The provisions of subdivisions (i) and (ii) of this
subparagraph may be illustrated by the following examples:
Example 1. Smith exchanges machine A for machine B and $1,000 cash
in a like kind exchange. Gain of $1,000 is recognized under section
1245(a)(1). If before the exchange the amount of the adjustments
reflected in the adjusted basis of machine A was $5,000, the amount of
adjustments reflected in the adjusted basis of machine B after the
exchange is $4,000 (that is, $5,000 minus $1,000).
Example 2. Assume the same facts as in example (1) except that
machine A is destroyed by fire, that $5,000 in insurance proceeds are
received of which $4,000 is used to purchase machine B, and that Smith
properly elects under section 1033(a)(3)(A) to limit recognition of
gain. The result is the same as in example (1), that is, the amount of
adjustments reflected in the adjusted basis of machine B is $4,000
($5,000 minus $1,000).
(iv) If more than one item of section 1245 property is acquired in a
transaction referred to in subdivision (i) of this subparagraph, the
total amount of the adjustments reflected in the adjusted bases of the
items acquired shall be allocated to such items in proportion to their
respective adjusted bases.
(5) Property after a reduction in basis pursuant to election under
section 1071 or application of section 1082(a)(2). If the basis of
section 1245 property is reduced pursuant to an election under section
1071 (relating to gain from sale or exchange to effectuate policies of
F.C.C.), or the application of section 1082(a)(2) (relating to sale or
exchange in obedience to order of S.E.C.), then immediately after the
basis reduction the amount of the adjustments reflected in the adjusted
basis of the property shall be the sum of:
(i) The amount of the adjustments reflected in the adjusted basis of
the property immediately before the basis reduction (but after applying
subparagraph (4) of this paragraph, if applicable), plus
(ii) The amount of gain which was not recognized under section
1245(a)(1) by reason of the reduction in the basis of the property. See
paragraph (e)(1) of Sec. 1.1245-4.
(6) Partnership property after certain transactions. (i) For the
amount of adjustments reflected in the adjusted basis of property
immediately after certain distributions of the property by a partnership
to a partner, see section 1245(b)(6)(B).
(ii) If under paragraph (b)(3) of Sec. 1.751-1 (relating to certain
distributions of partnership property other than section 751 property
treated as sales or exchanges) a partnership is treated as purchasing
section 1245 property (or a portion thereof) from a distributee who
relinquishes his interest in such property (or portion), then on the
date of such purchase the amount of adjustments reflected in the
adjusted basis of such purchased property (or portion) shall be zero.
(iii) See paragraph (e)(3)(ii) of Sec. 1.1245-1 for the amount of
adjustments reflected in the adjusted basis of partnership property in
respect of a partner who acquired his partnership interest in certain
transactions when an election under section 754 (relating to optional
adjustments to basis of partnership property) was in effect.
(d) Effective/applicability date. This section applies on and after
January 19,
[[Page 377]]
2017. For rules before January 19, 2017, see Sec. 1.1245-2 as contained
in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6832, 30 FR 8578, July 7, 1965, as amended by T.D. 7084, 36 FR
268, Jan. 8, 1971; T.D. 7141, 36 FR 18793, Sept. 22, 1971; 36 FR 19160,
Sept. 30, 1971; T.D. 7564, 43 FR 40496, Sept. 12, 1978; T.D. 8121, 52 FR
414, Jan. 6, 1987; T.D. 9811, 82 FR 6241, Jan. 19, 2017]
Sec. 1.1245-3 Definition of section 1245 property.
(a) In general. (1) The term section 1245 property means any
property (other than livestock excluded by the effective date limitation
in subparagraph (4) of this paragraph) which is or has been property of
a character subject to the allowance for depreciation provided in
section 167 and which is either:
(i) Personal property (within the meaning of paragraph (b) of this
section),
(ii) Property described in section 1245(a)(3)(B) (see paragraph (c)
of this section), or
(iii) An elevator or an escalator within the meaning of subparagraph
(C) of section 48(a)(1) (relating to the definition of section 38
property for purposes of the investment credit), but without regard to
the limitations in such subparagraph (C).
(2) If property is section 1245 property under a subdivision of
subparagraph (1) of this paragraph, a leasehold of such property is also
section 1245 property under such subdivision. Thus, for example, if A
owns personal property which is section 1245 property under subparagraph
(1)(i) of this paragraph, and if A leases the personal property to B,
B's leasehold is also section 1245 property under such provision. For a
further example, if C owns and leases to D for a single lump-sum payment
of $100,000 property consisting of land and a fully equipped factory
building thereon, and if 40 percent of the fair market value of such
property is properly allocable to section 1245 property, then 40 percent
of D's leasehold is also section 1245 property. A leasehold of land is
not section 1245 property.
(3) Even though property may not be of a character subject to the
allowance for depreciation in the hands of the taxpayer, such property
may nevertheless be section 1245 property if the taxpayer's basis for
the property is determined by reference to its basis in the hands of a
prior owner of the property and such property was of a character subject
to the allowance for depreciation in the hands of such prior owner, or
if the taxpayer's basis for the property is determined by reference to
the basis of other property that in the hands of the taxpayer was
property of a character subject to the allowance for depreciation, or if
the taxpayer's basis for the property is determined under section 1022
and such property was of a character subject to the allowance for
depreciation in the hands of the decedent. Thus, for example, if a
father uses an automobile in his trade or business during a period after
December 31, 1961, and then gives the automobile to his son as a gift
for the son's personal use, the automobile is section 1245 property in
the hands of the son.
(4) Section 1245 property includes livestock, but only with respect
to taxable years beginning after December 31, 1969. For purposes of
section 1245, the term livestock includes horses, cattle, hogs, sheep,
goats, and mink and other furbearing animals, irrespective of the use to
which they are put or the purpose for which they are held.
(b) Personal property defined. The term personal property means:
(1) Tangible personal property (as defined in paragraph (c) of Sec.
1.48-1, relating to the definition of section 38 property for purposes
of the investment credit), and
(2) Intangible personal property.
(c) Property described in section 1245(a)(3)(B). (1) The term
property described in section 1245(a)(3)(B) means tangible property of
the requisite depreciable character other than personal property (and
other than a building and its structural components), but only if there
are adjustments reflected in the adjusted basis of the property (within
the meaning of paragraph (a)(2) of Sec. 1.1245-2) for a period during
which such property (or other property):
(i) Was used as an integral part of manufacturing, production, or
extraction, or as an integral part of furnishing transportation,
communications, electrical energy, gas, water, or sewage disposal
services by a person
[[Page 378]]
engaged in a trade or business of furnishing any such service, or
(ii) Constituted a research or storage facility used in connection
with any of the foregoing activities.
Thus, even though during the period immediately preceding its
disposition the property is not used as an integral part of an activity
specified in subdivision (i) of this subparagraph and does not
constitute a facility specified in subdivision (ii) of this
subparagraph, such property is nevertheless property described in
section 1245(a)(3)(B) if, for example, there are adjustments reflected
in the adjusted basis of the property for a period during which the
property was used as an integral part of manufacturing by the taxpayer
or another taxpayer, or for a period during which other property (which
was involuntarily converted into, or exchanged in a like kind exchange
for, the property) was so used by the taxpayer or another taxpayer. For
rules applicable to involuntary conversions and like kind exchanges, see
paragraph (d)(3) of Sec. 1.1245-4.
(2) The language used in subparagraph (1) (i) and (ii) of this
paragraph shall have the same meaning as when used in paragraph (a) of
Sec. 1.48-1, and the terms building and structural components shall
have the meanings assigned to those terms in paragraph (e) of Sec.
1.48-1.
(d) Effective/applicability date. This section applies on and after
January 19, 2017. For rules before January 19, 2017, see Sec. 1.1245-3
as contained in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6832, 30 FR 8580, July 7, 1965, as amended by T.D. 7141, 36 FR
18794, Sept. 22, 1971; T.D. 9811, 82 FR 6241, Jan. 19, 2017]
Sec. 1.1245-4 Exceptions and limitations.
(a) Exception for gifts--(1) General rule. Section 1245(b)(1)
provides that no gain shall be recognized under section 1245(a)(1) upon
a disposition by gift. For purposes of this paragraph (a), the term gift
means, except to the extent that paragraph (a)(3) of this section
applies, a transfer of property that, in the hands of the transferee,
has a basis determined under the provisions of section 1015(a) or
1015(d) (relating to basis of property acquired by gifts) or section
1022 (relating to basis of property acquired from certain decedents who
died in 2010). For reduction in amount of charitable contribution in
case of a gift of section 1245 property, see section 170(e) and the
regulations thereunder.
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples:
Example 1. A places section 1245 property in trust to pay the income
from the property to B for his life, and after B's death to distribute
the property to C. If the basis of the property to the fiduciary and to
C is determined under the uniform basis rules prescribed in paragraph
(b) of Sec. 1.1015-1, and under paragraph (c) of Sec. 1.1015-1 the
time the fiduciary and C acquire their interests in the property is the
time the donor relinquished dominion over the property, then section
1245(a)(1) does not apply to the transfer by A to the trust or to the
distribution to C.
Example 2. Assume the same facts as in example (1), except that the
fiduciary sells the section 1245 property and reinvests the proceeds in
other section 1245 property which is distributed to C upon B's death.
Assume further that under paragraph (f) of Sec. 1.1015-1 C's basis for
the distributed property is the cost or other basis to the fiduciary.
Section 1245(a)(1) applies to the sale but not to the distribution.
(3) Disposition in part a sale or exchange and in part a gift. Where
a disposition of property is in part a sale or exchange and in part a
gift, the gain to which section 1245(a)(1) applies is the amount by
which (i) the lower of the amount realized upon the disposition of the
property or the recomputed basis of the property, exceeds (ii) the
adjusted basis of the property. For determination of the recomputed
basis of the property in the hands of the transferee, see paragraph
(c)(2) of Sec. 1.1245-2.
(4) Example. The provisions of subparagraph (3) of this paragraph
may be illustrated by the following example:
Example: (i) Smith transfers section 1245 property, which he has
held in excess of 1 year (6 months for taxable years beginning before
1977; 9 months for taxable years beginning in 1977), to his son for
$60,000. Immediately before the transfer the property in the hands of
Smith has an adjusted basis of $30,000, a fair market value of $90,000,
and a recomputed basis of $110,000. Since the amount realized upon
disposition of the property ($60,000) is lower than its recomputed basis
($110,000), the excess of the amount realized over adjusted basis, or
$30,000, is treated as ordinary income under
[[Page 379]]
section 1245(a)(1) and not as gain from the sale or exchange of property
described in section 1231. Smith has made a gift of $30,000 ($90,000
fair market value minus $60,000 amount realized) to which section
1245(a)(1) does not apply.
(ii) Immediately before the transfer, the amount of adjustments
reflected in the adjusted basis of the property was $80,000. Under
paragraph (c)(2) of Sec. 1.1245-2, $50,000 of adjustments are reflected
in the adjusted basis of the property immediately after the transfer,
that is, $80,000 of such adjustments immediately before the transfer,
minus $30,000 gain taken into account under section 1245(a)(1) upon the
transfer. Thus, the recomputed basis of the property in the hands of the
son is $110,000.
(b) Exception for transfers at death--(1) General rule. Section
1245(b)(2) provides that, except as provided in section 691 (relating to
income in respect of a decedent), no gain shall be recognized under
section 1245(a)(1) upon a transfer at death. For purposes of this
paragraph, the term transfer at death means a transfer of property
which, in the hands of the transferee, has a basis determined under the
provisions of section 1014(a) (relating to basis of property acquired
from a decedent) because of the death of the transferor. For recomputed
basis of property acquired in a transfer at death, see paragraph
(c)(1)(iv) of Sec. 1.1245-2.
(2) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. Smith owns section 1245 property which, upon Smith's
death, is inherited by his son. Since the property is described in
section 1014(b)(1), its basis in the hands of the son is determined
under the provisions of section 1014(a). Therefore, section 1245(a)(1)
does not apply to the transfer at Smith's death.
Example 2. H purchases section 1245 property which he conveys to
himself and W, his wife, as tenants by the entirety. Upon H's death in
1970 the property (including W's share) is included in his gross estate.
Since the entire property is described in section 1014(b) (1) and (9),
its basis in the hands of W is determined under the provisions of
section 1014(a). Therefore, section 1245(a)(1) does not apply to the
transfer at H's death. For determination of the recomputed basis of the
property in the hands of W, see paragraph (c)(3) of Sec. 1.1245-2.
Example 3. Green's will provides for the bequest of section 1245
property to trustees to pay the income from the property to his wife for
her lifetime, and upon her death to distribute the property to his son.
If under paragraph (a)(2) of Sec. 1.1014-4 the son's unadjusted basis
for the property is its fair market value at the time the decedent died,
section 1245(a)(1) does not apply to the distribution of the property to
the son.
Example 4. The trustee of a trust created by will transfers section
1245 property to a beneficiary in satisfaction of a specific bequest of
$10,000. If under the principles of paragraph (a)(3) of Sec. 1.1014-4
the trust realizes a taxable gain upon the transfer, section 1245(a)(1)
applies to the transfer.
(c) Limitation for certain tax-free transactions--(1) Limitation on
amount of gain. Section 1245(b)(3) provides that upon a transfer of
property described in subparagraph (2) of this paragraph, the amount of
gain taken into account by the transferor under section 1245(a)(1) shall
not exceed the amount of gain recognized to the transferor on the
transfer (determined without regard to section 1245). For purposes of
this subparagraph, in case of a transfer of both section 1245 property
and non-section 1245 property in one transaction, the amount realized
from the disposition of the section 1245 property (as determined under
paragraph (a)(5) of Sec. 1.1245-1) shall be deemed to consist of that
portion of the fair market value of each property acquired which bears
the same ratio to the fair market value of such acquired property as the
amount realized from the disposition of the section 1245 property bears
to the total amount realized. The preceding sentence shall be applied
solely for purposes of computing the portion of the total gain
(determined without regard to section 1245) which shall be recognized as
ordinary income under section 1245(a)(1). For determination of the
recomputed basis of the section 1245 property in the hands of the
transferee, see paragraph (c)(2) of Sec. 1.1245-2. Section 1245(b)(3)
does not apply to a disposition of property to an organization (other
than a cooperative described in section 521) which is exempt from the
tax imposed by chapter 1 of the Code.
(2) Transfers covered. The transfers referred to in subparagraph (1)
of this paragraph are transfers of property in which the basis of the
property in the hands of the transferee is determined by reference to
its basis in the hands of the transferor by reason of the application of
any of the following provisions:
[[Page 380]]
(i) Section 332 (relating to distributions in complete liquidation
of an 80-percent-or-more controlled subsidiary corporation). See
subparagraph (3) of this paragraph.
(ii) Section 351 (relating to transfer to a corporation controlled
by transferor).
(iii) Section 361 (relating to exchanges pursuant to certain
corporate reorganizations).
(iv) Section 371(a) (relating to exchanges pursuant to certain
receivership and bankruptcy proceedings).
(v) Section 374(a) (relating to exchanges pursuant to certain
railroad reorganizations).
(vi) Section 721 (relating to transfers to a partnership in exchange
for a partnership interest).
(vii) Section 731 (relating to distributions by a partnership to a
partner). For special carryover basis rule, see section 1245(b)(6)(A)
and paragraph (f)(1) of this section.
(3) Complete liquidation of subsidiary. In the case of a
distribution in complete liquidation of an 80-percent-or-more controlled
subsidiary to which section 332 applies, the limitation provided in
section 1245(b)(3) is confined to instances in which the basis of the
property in the hands of the transferee is determined, under section
334(b)(1), by reference to its basis in the hands of the transferor.
Thus, for example, the limitation of section 1245(b)(3) may apply in
respect of a liquidating distribution of section 1245 property by an 80-
percent-or-more controlled corporation to the parent corporation, but
does not apply in respect of a liquidating distribution of section 1245
property to a minority shareholder. Section 1245(b)(3) does not apply to
a liquidating distribution of property by an 80-percent-or-more
controlled subsidiary to its parent if the parent's basis for the
property is determined, under section 334(b)(2), by reference to its
basis for the stock of the subsidiary.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. Section 1245 property, which is owned by Smith, has a
fair market value of $10,000, a recomputed basis of $8,000, and an
adjusted basis of $4,000. Smith transfers the property to a corporation
in exchange for stock in the corporation worth $9,000 plus $1,000 in
cash in a transaction qualifying under section 351. Without regard to
section 1245, Smith would recognize $1,000 gain under section 351(b),
and the corporation's basis for the property would be determined under
section 362(a) by reference to its basis in the hands of Smith. Since
the recomputed basis of the property disposed of ($8,000) is lower than
the amount realized ($10,000), the excess of recomputed basis over
adjusted basis ($4,000), or $4,000, would be treated as ordinary income
under section 1245(a)(1) if the provisions of section 1245(b)(3) did not
apply. However, section 1245(b)(3) limits the gain taken into account by
Smith under section 1245(a)(1) to $1,000. If, instead, Smith transferred
the property to the corporation solely in exchange for stock of the
corporation worth $10,000, then, because of the application of section
1245(b)(3), Smith would not take any gain into account under section
1245(a)(1). If, however, Smith transferred the property to the
corporation for stock worth $5,000 and $5,000 cash, only $4,000 of the
$5,000 gain under section 351(b) would be treated as ordinary income
under section 1245(a)(1).
Example 2. Assume the same facts as in example (1) except that Smith
contributes the property to a new partnership in which he has a one-half
interest. Since, without regard to section 1245, no gain would be
recognized to Smith under section 721, and by reason of the application
of section 721 the partnership's basis for the property would be
determined under section 723 by reference to its basis in the hands of
Smith, the application of section 1245(b)(3) results in no gain being
taken into account by Smith under section 1245(a)(1).
Example 3. Assume the same facts as in example (2) except that the
property is subject to a $9,000 mortgage. Since under section 752(b)
(relating to decrease in partner's liabilities) Smith is treated as
receiving a distribution in money of $4,500 (one-half of liability
assumed by partnership), and since the basis of Smith's partnership
interest is $4,000 (the adjusted basis of the contributed property), the
$4,500 distribution results in his realizing $500 gain under section
731(a) (relating to distributions by a partnership), determined without
regard to section 1245. Accordingly, the application of section
1245(b)(3) limits the gain taken into account by Smith under section
1245(a)(1) to $500.
(d) Limitation for like kind exchanges and involuntary conversions--
(1) General rule. Section 1245(b)(4) provides that if property is
disposed of and gain (determined without regard to section 1245) is not
recognized in whole or in part under section 1031 (relating to like
[[Page 381]]
kind exchanges) or section 1033 (relating to involuntary conversions),
then the amount of gain taken into account by the transferor under
section 1245(a)(1) shall not exceed the sum of:
(i) The amount of gain recognized on such disposition (determined
without regard to section 1245), plus
(ii) The fair market value of property acquired which is not section
1245 property and which is not taken into account under subdivision (i)
of this subparagraph (that is, the fair market value of non-section 1245
property acquired which is qualifying property under section 1031 or
1033, as the case may be).
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples:
Example 1. Smith exchanges machine A for machine B in a like kind
exchange as to which no gain is recognized under section 1031(a). Both
machines are section 1245 property. No gain is recognized under section
1245(a)(1) because of the limitation contained in section 1245(b)(4).
The result would be the same if machine A were involuntarily converted
into machine B in a transaction as to which no gain is recognized under
section 1033(a)(1).
Example 2. Jones owns property A, which is section 1245 property,
with an adjusted basis of $100,000 and a recomputed basis of $116,000.
The property is destroyed by fire and Jones receives $117,000 of
insurance proceeds. Thus, the amount of gain under section 1245(a)(1),
determined without regard to section 1245(b)(4), would be $16,000. He
uses $105,000 of the proceeds to purchase section 1245 property similar
or related in service or use to property A, and $9,000 of the proceeds
to purchase stock in the acquisition of control of a corporation owning
property similar or related in service or use to property A. Both
acquisitions qualify under section 1033(a)(3)(A). Jones properly elects
under section 1033(a)(3)(A) and the regulations thereunder to limit
recognition of gain to the amount by which the amount realized from the
conversion exceeds the cost of the stock and other property acquired to
replace the converted property. Since $3,000 of the gain is recognized
(without regard to section 1245) under section 1033(a)(3) (that is,
$117,000 minus $114,000), and since the stock purchased for $9,000 is
not section 1245 property and was not taken into account in determining
the gain under section 1033, section 1245(b)(4) limits the amount of the
gain taken into account under section 1245(a)(1) to $12,000 (that is,
$3,000 plus $9,000). If, instead of purchasing $9,000 in stock, Jones
purchases $9,000 worth of property which is section 1245 property
similar or related in use to the destroyed property, section 1245(b)(4)
would limit the amount of gain taken into account under section
1245(a)(1) to $3,000.
(3) Certain tangible property. If:
(i) A person disposes of section 1245 property in a transaction to
which section 1245(b)(4) applies,
(ii) Adjustments are reflected in the adjusted basis (within the
meaning of paragraph (a)(2) of Sec. 1.1245-2) of such property which
are attributable to the use of such property (or other property) as an
integral part of an activity, or as a facility, specified in section
1245(a)(3)(B) (i) or (ii), and
(iii) Property is acquired in the transaction which would be
considered as section 1245 property described in section 1245(a)(3)(B)
if such person used the acquired property as an integral part of such an
activity, or as such a facility, then (regardless of the use of the
acquired property) the acquired property shall be considered as section
1245 property described in section 1245(a)(3)(B). For definition of
property described in section 1245(a)(3)(B), see paragraph (c) of Sec.
1.1245-3. Thus, for example, if a person's section 1245 property (which
is personal property) is involuntarily converted into property A which
would qualify as section 1245 property only if it were devoted to a
specified use, and if the person had so devoted the section 1245
property disposed of, then the acquired property is considered as
section 1245 property described in section 1245(a)(3)(B) and therefore
its fair market value is not taken into account under subparagraph
(1)(ii) of this paragraph. For recomputed basis of property A, see
paragraph (a)(5) of Sec. 1.1245-2. Moreover, if property A is not
devoted to a specified use and is subsequently involuntarily converted
into property B which would qualify as section 1245 property only if it
were so devoted, then property B is also considered as section 1245
property described in section 1245(a)(3)(B).
(4) Application to disposition of section 1245 property and
nonsection 1245 property in one transaction. For purposes of this
paragraph, if both section 1245 property and nonsection 1245 property
are acquired as the result of one disposition in which both section 1245
[[Page 382]]
property and nonsection 1245 property are disposed of, then except as
provided in subparagraph (7) of this paragraph:
(i) The total amount realized upon the disposition shall be
allocated (in a manner consistent with the principles of paragraph
(a)(5) of Sec. 1.1245-1) between the section 1245 property and the
nonsection 1245 property disposed of in proportion to their respective
fair market values.
(ii) The amount realized upon the disposition of the section 1245
property shall be deemed to consist of so much of the fair market value
of the section 1245 property acquired as is not in excess of the amount
realized from the section 1245 property disposed of, and the remaining
portion (if any) of the amount realized upon the disposition of the
section 1245 property shall be deemed to consist of so much of the fair
market value of the non-section 1245 property acquired as is not in
excess of the amount of such remaining portion, and
(iii) The amount realized upon the disposition of the non-section
1245 property shall be deemed to consist of so much of the fair market
value of all the property acquired which was not taken into account in
subdivision (ii) of this subparagraph.
(5) Example. The provisions of subparagraph (4) of this paragraph
may be illustrated by the following example:
Example: (i) Smith owns section 1245 property A with a fair market
value of $30,000, and non-section 1245 property X with a fair market
value of $20,000. Properties A and X are destroyed by fire and Smith
receives insurance proceeds of $40,000. He uses all the proceeds, plus
additional cash of $10,000, to purchase in a single transaction
properties B and Y which qualify under section 1033(a)(3)(A), and he
properly elects under section 1033(a)(3)(A) and the regulations
thereunder to limit recognition of gain to the excess of the amount
realized from the conversion over the costs of the qualifying properties
acquired. Thus no gain would be recognized (without regard to section
1245) under section 1033(a)(3)(A). Property B is section 1245 property
with a fair market value of $15,000, and property Y is non-section 1245
property with a fair market value of $35,000.
(ii) The amount realized upon the disposition of A and X ($40,000)
is allocated between A and X in proportion to their respective fair
market values. Thus, the amount considered realized in respect of A is
$24,000 (that is, \30/50\ of $40,000). (The amount considered realized
in respect of X is $16,000 (that is, \20/50\ of $40,000).)
(iii) The $24,000 realized upon the disposition of A is deemed to
consist of the fair market value of B ($15,000) and $9,000 of the fair
market value of Y. (The $16,000 realized upon the disposition of X is
deemed to consist of $16,000 of the fair market value of Y. Also,
$10,000 of the fair market value of Y is attributable to the additional
cash of $10,000.)
(iv) Assume that A has an adjusted basis of $5,000, and a recomputed
basis of $40,000. Since the amount considered realized upon the
disposition of A ($24,000) is lower than its recomputed basis ($40,000),
the amount of gain which would be recognized under section 1245(a)(1),
determined without regard to section 1245(b)(4), is $19,000, that is,
the amount realized ($24,000) minus the adjusted basis ($5,000). Since
no gain is recognized (without regard to section 1245) under section
1033(a)(3), and since $9,000 of the property acquired in exchange for
section 1245 property A is non-section 1245 property Y, section
1245(b)(4) limits the amount of gain taken into account under section
1245(a)(1) to $9,000.
(6) Cross references. For the manner of determining the recomputed
basis of property acquired in a transaction to which section 1245(b)(4)
applies, see paragraph (c)(4) of Sec. 1.1245-2. For the manner of
determining the basis of such property, see paragraph (a) of Sec.
1.1245-5.
(7) Coordination with section 1250. For purposes of this paragraph,
if section 1245 property and section 1250 property are disposed of in
one transaction in which the property acquired includes section 1250
property, the allocation rules of paragraph (d)(6) of Sec. 1.1250-3
shall apply.
(e) Limitation for section 1071 and 1081 transactions--(1) Section
1071 and 1081(b) transactions. If property is disposed of and gain
(determined without regard to section 1245) is not recognized in whole
or in part because of the application of section 1071 (relating to gain
from sale or exchange to effectuate policies of F.C.C.) or section
1081(b) (relating to gain from sale or exchange in obedience to order of
S.E.C.), then the amount of gain taken into account by the transferor
under section 1245(a)(1) shall not exceed the sum of:
(i) The amount of gain recognized on such disposition (determined
without regard to section 1245),
[[Page 383]]
(ii) In the case of a transaction to which section 1071 applies, the
fair market value of property acquired which is not section 1245
property and which is not taken into account under subdivision (i) of
this subparagraph, plus
(iii) The amount by which the basis of property, other than section
1245 property, is reduced (pursuant to an election under section 1071 or
pursuant to the application of section 1082(a)(2)), and which is not
taken into account under subdivision (i) or (ii) of this subparagraph.
(2) Section 1081(d)(1)(A) transaction. No gain shall be recognized
under section 1245(a)(1) upon an exchange of property as to which gain
would not be recognized (without regard to section 1245) because of the
application of section 1081(d)(1)(A) (relating to transfers within
system group). For recomputed basis of property acquired in a
transaction referred to in this subparagraph, see paragraph (c)(2) of
Sec. 1.1245-2.
(3) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. Corporation X elects under section 1071 to treat a sale
of section 1245 property for $100,000 as an involuntary conversion
subject to the provisions of section 1033, but does not elect to reduce
the basis of depreciable property pursuant to an election under section
1071. The corporation uses $35,000 of the proceeds to purchase section
1245 property and $40,000 to purchase other property. Both properties
qualify as replacement property under section 1033. Assuming that the
amount of gain under section 1245(a)(1) (determined without regard to
this paragraph) would be $70,000, and that $25,000 of gain would be
recognized (without regard to section 1245) upon the application of
section 1071, the amount of gain taken into account under section
1245(a)(1) is $65,000 ($25,000 plus $40,000).
Example 2. (i) Assume the same facts as in example (1) except that
the corporation elects under section 1071 to reduce its basis for
property of a character subject to the allowance for depreciation under
section 167 by the amount of gain which would be recognized without
regard to the application of section 1245, that is, by $25,000. Assume
further that under section 1071 the corporation may reduce the basis of
depreciable property consisting of property A, which is section 1245
property with an adjusted basis of $30,000, and property B, which is
property other than section 1245 property with an adjusted basis of
$20,000. Under paragraph (a)(2) of Sec. 1.1071-3, the $25,000 of
unrecognized gain is applied to reduce the basis of property A by
$15,000 (30,000/50,000 of $25,000) and the basis of property B by
$10,000 (20,000/50,000 of $25,000).
(ii) The amount of gain which would be recognized (determined
without regard to section 1245) under section 1071 is zero, i.e., the
amount determined in example (1) ($25,000), minus the amount of the
reduction in basis of depreciable property pursuant to the election
($25,000). The amount of gain taken into account under section
1245(a)(1) is $50,000, i.e., the sum of (a) the gain which would be
recognized without regard to section 1245 (zero), (b) the cost of
property acquired which is not section 1245 property ($40,000), plus (c)
the amount by which the basis of property B is reduced ($10,000). For
method of increasing basis of property B, see paragraph (b)(2) of Sec.
1.1245-5, and for recomputed basis of property A, see paragraph (c)(5)
of Sec. 1.1245-2.
(f) Limitation for property distributed by a partnership--(1) In
general. For purposes of section 1245(b)(3) (relating to certain tax-
free transactions), the basis of section 1245 property distributed by a
partnership to a partner shall be deemed to be determined by reference
to the adjusted basis of such property to the partnership.
(2) Adjustments reflected in the adjusted basis. If section 1245
property is distributed by a partnership to a partner, then, for
purposes of determining the recomputed basis of the property in the
hands of the distributee, the amount of the adjustments reflected in the
adjusted basis of the property immediately after the distribution shall
be an amount equal to:
(i) The potential section 1245 income (as defined in paragraph
(c)(4) of Sec. 1.751-1) of the partnership in respect of the property
immediately before the distribution, reduced by
(ii) The portion of such potential section 1245 income which is
recognized as ordinary income to the partnership under paragraph
(b)(2)(ii) of Sec. 1.751-1.
(3) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. (i) A machine, which is section 1245 property owned by
partnership ABC, has an adjusted basis of $9,000, a recomputed basis of
$18,000, and a fair market value of $15,000. Since the fair market value
of the machine is lower than its recomputed basis, the potential section
1245 income in respect
[[Page 384]]
of the machine is the excess of fair market value over adjusted basis,
or $6,000. The partnership distributes the machine to C in a complete
liquidation of his partnership interest to which section 736(a) does not
apply. C, who had originally contributed the machine to the partnership,
has a basis for his partnership interest of $10,000. Since section
751(b)(2)(A) provides that section 751(b)(1) does not apply to a
distribution of property to the partner who contributed the property, no
gain would be recognized to the partnership under section 731(b)
(without regard to the application of section 1245). By reason of the
application of section 731, C's basis for the property would, under
section 732(b), be equal to his basis for his interest in the
partnership, or $10,000.
(ii) Since section 731 applies to the distribution, and since
subparagraph (1) of this paragraph provides that, for purposes of
section 1245(b)(3), C's basis for the property is deemed to be
determined by reference to the adjusted basis of the property to the
partnership, the gain taken into account under section 1245(a)(1) by the
partnership is limited by section 1245(b)(3) so as not to exceed the
amount of gain which would be recognized to the partnership if section
1245 did not apply. Accordingly, the partnership does not recognize any
gain under section 1245(a)(1) upon the distribution.
(iii) Immediately after the distribution, the amount of the
adjustments reflected in the adjusted basis of the property is equal to
$6,000 (that is, the potential section 1245 income of the partnership in
respect of the property before the distribution, $6,000, minus the gain
recognized by the partnership under section 751(b), zero). Accordingly,
C's recomputed basis for the property is $16,000 (that is, adjusted
basis, $10,000, plus adjustments reflected in the adjusted basis,
$6,000).
Example 2. Assume the same facts as in example (1) except that the
machine had been purchased by the partnership. Assume further that upon
the distribution, the partnership recognizes $4,000 gain as ordinary
income under section 751(b). Under section 1245(b)(3), gain to be taken
into account under section 1245(a)(1) by the partnership is limited to
$4,000. Immediately after the distribution, the amount of adjustments
reflected in the adjusted basis of the property is $2,000 (that is,
potential section 1245 income of the partnership, $6,000, minus gain
recognized to the partnership under section 751(b), $4,000). Thus, if
the adjusted basis of the machine in the hands of C were $11,333 (see,
for example, the computation in paragraph (d)(2) of example (6) of
paragraph (g) of Sec. 1.751-1), the recomputed basis of the machine
would be $13,333 ($11,333 plus $2,000).
(g) [Reserved]
(h) Timber property subject to amortization under section 194--(1)
In general. For purposes of section 1245(a)(2), in determining the
recomputed basis of property with respect to which a deduction under
section 194 was allowed for any taxable year, a taxpayer shall not take
into account amortization deductions claimed under section 194 to the
extent such deductions are attributable to the amortizable basis (within
the meaning of section 194(c)(2)) of the taxpayer acquired before the
tenth taxable year preceding the taxable year in which gain with respect
to the property is recognized.
(2) Example. The principles of paragraph (h)(1) of this section are
illustrated by the following example:
Example: Assume A owns qualified timber property (as defined in
section 194(c)(1)) with a basis of $30,000. In 1981, A incurs $12,000 of
qualifying reforestation expenditures and elects to amortize the maximum
$10,000 of such expenses under section 194. The $10,000 of deductions
are taken during the 8-year period from 1981 to 1988. If A sells the
property in 1990 for $60,000 a gain of $28,000 ($60,000--adjusted basis
of $32,000) is recognized on the sale. Since the sale took place within
10 years of the taxable year in which the reforestation expenditures
were made, $10,000 of the gain is treated as ordinary income, and the
remaining $18,000 of gain would be capital gain, if it otherwise
qualifies for capital gain treatment. In order to avoid ordinary income
treatment of the gain attributable to the reforestation expenditures
incurred in 1981, A would have to wait until 1992 to dispose of the
property.
(i) Effective/applicability date. This section applies on and after
January 19, 2017. For rules before January 19, 2017, see Sec. 1.1245-4
as contained in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 6832, 30 FR 8581, July 7, 1965, as amended by T.D. 7084, 36 FR
268, Jan. 8, 1971; T.D. 7207, 37 FR 20799, Oct. 14, 1972; T.D. 7728, 45
FR 72650, Nov. 3, 1980; T.D. 7927, 48 FR 55851, Dec. 16, 1983; T.D.
9811, 82 FR 6241, Jan. 19, 2017]
Sec. 1.1245-5 Adjustments to basis.
In order to reflect gain recognized under section 1245(a)(1), the
following adjustments to the basis of property shall be made:
(a) Property acquired in like kind exchange or involuntary
conversion. (1) If property is acquired in a transaction to which
section 1245(b)(4) applies, its basis shall be determined under the
rules of section 1031(d) or 1033(c).
[[Page 385]]
(2) The provisions of this paragraph may be illustrated by the
following example:
Example: Jones exchanges property A, which is section 1245 property
with an adjusted basis of $10,000, for property B, which has a fair
market value of $9,000, and property C, which has a fair market value of
$3,500, in a like kind exchange as to which no gain would be recognized
under section 1031(a). Upon the exchange $2,500 gain is recognized under
section 1245(a)(1), since property C is not section 1245 property. See
section 1245(b)(4). Under the rules of section 1031(d), the basis of the
properties received in the exchange is $12,500 (i.e., the basis of
property transferred, $10,000, plus the amount of gain recognized,
$2,500), of which the amount allocated to property C is $3,500 (the fair
market value thereof), and the residue, $9,000, is allocated to property
B.
(b) Sections 1071 and 1081 transactions. (1) If property is acquired
in a transaction to which section 1071 and paragraph (e)(1) of Sec.
1.1245-4 (relating to limitation for section 1071 transactions, etc.)
apply, its basis shall be determined in accordance with the principles
of paragraph (a) of this section.
(2) If the basis of property, other than section 1245 property, is
reduced pursuant to either an election under section 1071 or the
application of section 1082(a)(2), then the basis of the property shall
be increased to the extent of the gain recognized under section
1245(a)(1) by reason of the application of paragraph (e)(1)(iii) of
Sec. 1.1245-4.
[T.D. 6832, 30 FR 8584, July 7, 1965]
Sec. 1.1245-6 Relation of section 1245 to other sections.
(a) General. The provisions of section 1245 apply notwithstanding
any other provision of subtitle A of the Code. Thus, unless an exception
or limitation under section 1245(b) applies, gain under section
1245(a)(1) is recognized notwithstanding any contrary nonrecognition
provision or income characterizing provision. For example, since section
1245 overrides section 1231 (relating to property used in the trade or
business), the gain recognized under section 1245(a)(1) upon a
disposition will be treated as ordinary income and only the remaining
gain, if any, from the disposition may be considered as gain from the
sale or exchange of a capital asset if section 1231 is applicable. See
example (2) of paragraph (b)(2) of Sec. 1.1245-1. For effect of section
1245 on basis provisions of the Code, see Sec. 1.1245-5.
(b) Nonrecognition sections overridden. The nonrecognition
provisions of subtitle A of the Code which section 1245 overrides
include, but are not limited to, sections 267(d), 311(a), 336, 337,
501(a), 512(b)(5), and 1039. See section 1245(b) for the extent to which
section 1245(a)(1) overrides sections 332, 351, 361, 371(a), 374(a),
721, 731, 1031, 1033, 1071, and 1081 (b)(1) and (d)(1)(A). For
limitation on amount of adjustments reflected in adjusted basis of
property disposed of by an organization exempt from income taxes (within
the meaning of section 501(a)), see paragraph (a)(8) of Sec. 1.1245-2.
(c) Normal retirement of asset in multiple asset account. Section
1245(a)(1) does not require recognition of gain upon normal retirements
of section 1245 property in a multiple asset account as long as the
taxpayer's method of accounting, as described in paragraph (e)(2) of
Sec. 1.167(a)-8 (relating to accounting treatment of asset
retirements), does not require recognition of such gain.
(d) Installment method. (1) Gain from a disposition to which section
1245(a)(1) applies may be reported under the installment method if such
method is otherwise available under section 453 of the Code. In such
case, the income (other than interest) on each installment payment shall
be deemed to consist of gain to which section 1245(a)(1) applies until
all such gain has been reported, and the remaining portion (if any) of
such income shall be deemed to consist of gain to which section
1245(a)(1) does not apply. For treatment of amounts as interest on
certain deferred payments, see section 483.
(2) The provisions of this paragraph may be illustrated by the
following example:
Example: Jones contracts to sell an item of section 1245 property
for $10,000 to be paid in 10 equal payments of $1,000 each, plus a
sufficient amount of interest so that section 483 does not apply. He
properly elects under section 453 to report under the installment method
gain of $2,000 to which section 1245(a)(1) applies and gain of $1,000 to
which section 1231 applies. Accordingly, $300 of each
[[Page 386]]
of the first 6 installment payments and $200 of the seventh installment
payment is ordinary income under section 1245(a)(1), and $100 of the
seventh installment payment and $300 of each of the last 3 installment
payments is gain under section 1231.
(e) Exempt income. The fact that section 1245 provides for
recognition of gain as ordinary income does not change into taxable
income any income which is exempt under section 115 (relating to income
of states, etc.), 892 (relating to income of foreign governments), or
894 (relating to income exempt under treaties).
(f) Treatment of gain not recognized under section 1245. Section
1245 does not prevent gain which is not recognized under section 1245
from being considered as gain under another provision of the Code, such
as, for example, section 311(c) (relating to liability in excess of
basis), section 341(f) (relating to collapsible corporations), section
357(c) (relating to liabilities in excess of basis), section 1238
(relating to amortization in excess of depreciation), or section 1239
(relating to gain from sale of depreciable property between certain
related persons). Thus, for example, if section 1245 property, which has
an adjusted basis of $1,000 and a recomputed basis of $1,500, is sold
for $1,750 in a transaction to which section 1239 applies, $500 of the
gain would be recognized under section 1245(a)(1) and the remaining $250
of the gain would be treated as ordinary income under section 1239.
[T.D. 6832, 30 FR 8584, July 7, 1965, as amended by T.D. 7084, 36 FR
269, Jan. 8, 1971; T.D. 7400, 41 FR 5101, Feb. 4, 1976]
Sec. 1.1248-1 Treatment of gain from certain sales or exchanges
of stock in certain foreign corporations.
(a) In general. (1) If a United States person (as defined in section
7701(a)(30)) recognizes gain on a sale or exchange after December 31,
1962, of stock in a foreign corporation, and if in respect of such
person the conditions of subparagraph (2) of this paragraph are
satisfied, then the gain shall be included in the gross income of such
person as a dividend to the extent of the earnings and profits of such
corporation attributable to such stock under Sec. 1.1248-2 or 1.1248-3,
whichever is applicable, which were accumulated in taxable years of such
foreign corporation beginning after December 31, 1962, during the period
or periods such stock was held (or was considered as held by reason of
the application of section 1223, taking into account Sec. 1.1248-8) by
such person while such corporation was a controlled foreign corporation.
See section 1248(a). See Sec. 1.1248-8 for additional rules regarding
the attribution of earnings and profits to the stock of a foreign
corporation following certain nonrecognition transactions. For
computation of earnings and profits attributable to such stock if there
are any lower tier corporations, see paragraph (a) (3) and (4) of Sec.
1.1248-2 or paragraph (a) of Sec. 1.1248-3, whichever is applicable. In
general, the amount of gain to be included in a person's gross income as
a dividend under section 1248(a) shall be determined separately for each
share of stock sold or exchanged. However, such determination may be
made in respect of a block of stock if earnings and profits attributable
to the block are computed under Sec. 1.1248-2 or 1.1248-3. See
paragraph (b) of Sec. 1.1248-2 and paragraph (a)(5) of Sec. 1.1248-3.
For the limitation on the tax attributable to an amount included in an
individual's gross income as a dividend under section 1248(a), see
section 1248(b) and Sec. 1.1248-4. For the treatment, under certain
circumstances, of the sale or exchange of stock in a domestic
corporation as the sale or exchange of stock held by the domestic
corporation in a foreign corporation, see section 1248(e) and Sec.
1.1248-6. For the nonapplication of section 1248 in certain
circumstances, see section 1248(g) and paragraph (e) of this section.
For the requirement that the person establish the amount of earnings and
profits attributable to the stock sold or exchanged and, for purposes of
section 1248(b), the amount of certain taxes, see section 1248(h) and
Sec. 1.1248-7.
(2) In respect of a United States person who sells or exchanges
stock in a foreign corporation, the conditions referred to in
subparagraph (1) of this paragraph are satisfied only if (i) such person
owned, within the meaning of section 958(a), or was considered as owning
by applying the rules of ownership of section 958(b), 10 percent or
[[Page 387]]
more of the total combined voting power of all classes of stock entitled
to vote of such foreign corporation at any time during the 5-year period
ending on the date of the sale or exchange, and (ii) at such time such
foreign corporation was a controlled foreign corporation (as defined in
section 957).
(3) For purposes of subparagraph (2) of this paragraph, (i) a
foreign corporation shall not be considered to be a controlled foreign
corporation at any time before the first day of its first taxable year
beginning after December 31, 1962, and (ii) the percentage of the total
combined voting power of stock of a foreign corporation owned (or
considered as owned) by a United States person shall be determined in
accordance with the principles of section 951(b) and the regulations
thereunder.
(4) For purposes of paragraph (a)(1) of this section, if a foreign
partnership sells or exchanges stock of a corporation, the partners in
such foreign partnership shall be treated as selling or exchanging their
proportionate share of the stock of such corporation. Stock which is
considered to have been sold or exchanged by a partner by reason of the
application of this paragraph (a)(4) shall for purposes of applying such
sentence be treated as actually sold or exchanged by such partner.
(5) The application of this paragraph may be illustrated by the
following examples:
Example 1. Corporation F is a foreign corporation which has
outstanding 100 shares of one class of stock. F was a controlled foreign
corporation for the period beginning on January 1, 1963, and ending on
June 30, 1965, but was not a controlled foreign corporation at any time
thereafter. On December 31, 1965, Brown, a United States person who has
owned 15 shares of F stock since 1962, sells 7 of his 15 shares and
recognizes gain with respect to each share sold. Since Brown owned stock
representing at least 10 percent of the total combined voting power of F
at a time during the 5-year period ending on December 31, 1965, while F
was a controlled foreign corporation, the conditions of subparagraph (2)
of this paragraph are satisfied. Therefore, section 1248(a) applies to
the gain recognized by Brown to the extent of the earnings and profits
attributable under Sec. 1.1248-3 to such shares.
Example 2. Assume the same facts as in example (1). Assume further
that on February 1, 1970, Brown sells the remainder of his shares in F
Corporation and recognizes gain with respect to each share sold. Even
though Brown did not own stock representing at least 10 percent of the
total combined voting power of F on February 1, 1970, nevertheless, in
respect of each of the 8 shares of F stock which he sold on such date,
the conditions of subparagraph (2) of this paragraph are satisfied since
Brown owned stock representing at least 10 percent of such voting power
at a time during the 5-year period ending on February 1, 1970, while F
was a controlled foreign corporation. Therefore, section 1248(a) applies
to the gain recognized by Brown to the extent of the earnings and
profits attributable under Sec. 1.1248-3 to such shares. If, however,
Brown had sold the reminder of his shares in F on July 1, 1970, since
the last date on which Brown owned stock representing at least 10
percent of the total combined voting power of F while F was a controlled
foreign corporation was June 30, 1965, a date which is not within the 5-
year period ending July 1, 1970, the conditions of subparagraph (2) of
this paragraph would not be satisfied and section 1248(a) would not
apply.
Example 3. Corporation G, a foreign corporation created in 1950, has
outstanding 100 shares of one class of stock and uses the calendar year
as its taxable year. Corporation X, a United States person, owns 60
shares of G stock and has owned such stock since G was created.
Corporation Y, a United States person, owned 15 shares of the G stock
from 1950 until December 1, 1962, on which date it sold 10 of such
shares. On December 31, 1963, Y sells its remaining 5 shares of the G
stock and recognizes gain on the sale. Since G is not considered to be a
controlled foreign corporation at any time before January 1, 1963, and
since Y did not own stock representing at least 10 percent of the total
combined voting power of G at any time on or after such date, the
conditions of subparagraph (2) of this paragraph are not satisfied and
section 1248(a) does not apply.
Example 4. (i) Facts. X, a domestic corporation, and Y, a foreign
corporation that is not a controlled foreign corporation, are partners
in foreign partnership Z. X has a 60% interest in Z, and Y has a 40%
interest in Z. All parties are calendar year taxpayers. On January 1,
year 1, Z forms foreign corporation H, a controlled foreign corporation
that conducts a business in Country C. Z and H's functional currency is
the United States dollar. In years 1 and 2, H did not earn subpart F
income as defined in section 952(a). On December 31, year 2, Z sells all
of the H stock for $600 when Z's adjusted basis in the stock is $100.
Therefore, Z recognizes a gain of $500 on the sale, of which $300 is
allocable to X as a 60% partner. At the time of the sale, H had $300 of
earnings and profits, $180 of which (that is, 60% of $300) is
attributable to X's 60% share of the H stock.
[[Page 388]]
(ii) Result. Pursuant to section 1248(a) and paragraphs (a)(1) and
(4) of this section, X and Y are treated as selling 60% and 40%,
respectively, of the H stock. X includes in its gross income as a
dividend $180 of the gain recognized on the sale. Because Y is a foreign
corporation that is not a CFC, neither section 1248 nor section 964
applies to the sale of Y's 40% share of the H stock.
(iii) Alternative facts. If, instead, X owned its 60% interest in Z
through another foreign partnership, the result would be the same.
(b) Sale or exchange. For purposes of section 1248(a), the term sale
or exchange includes the receipt of a distribution which is treated as
in exchange for stock under section 302(a) (relating to distributions in
redemption of stock) or section 331(a) (relating to distributions in
complete liquidation of a corporation). For purposes of section 1248(a),
gain recognized by a shareholder under section 301(c)(3) in connection
with a distribution of property by a corporation with respect to its
stock shall be treated as gain from the sale or exchange of stock of
such corporation.
(c) Gain recognized. Section 1248(a) applies to a sale or exchange
of stock in a foreign corporation only if gain is recognized in whole or
in part upon the sale or exchange. Thus, for example, if a United States
person exchanges stock in a foreign corporation and no gain is
recognized on the exchange under section 332, 351, 354, 355, 356, or
361, taking into account the application of section 367, then no amount
is includible in the gross income of the person as a dividend under
section 1248(a). But see Sec. Sec. 1.1248(f)-1 and 1.1248(f)-2,
providing that a domestic distributing corporation must include in gross
income amounts under section 1248(f) as a result of certain foreign
stock distributed pursuant to section 337, 355(c)(1), or 361(c)(1) (in
certain cases without regard to the amount of gain realized by the
domestic distributing corporation in the distribution).
(d) Credit for foreign taxes. (1) If a domestic corporation includes
an amount in its gross income as a dividend under section 1248(a) upon a
sale or exchange of stock in a foreign corporation (referred to as a
first tier corporation), and if on the date of the sale or exchange the
domestic corporation owns directly at least 10 percent of the voting
stock of the first tier corporation:
(i) The foreign tax credit provisions of sections 901 through 908
shall apply in the same manner and subject to the same conditions and
limitations as if the first tier corporation on such date distributed to
the domestic corporation as a dividend that portion of the amount
included in gross income under section 1248(a) which does not exceed the
earnings and profits of the first tier corporation attributable to the
stock under Sec. 1.1248-2 or Sec. 1.1248-3, as the case may be, and
(ii) If on such date such first tier corporation owns directly 50
percent or more of the voting stock of a lower tier corporation
described in paragraph (a)(3) of Sec. 1.1248-2 or paragraph (a)(3) of
Sec. 1.1248-3, as the case may be (referred to as a second tier
corporation), then the foreign tax credit provisions of sections 901
through 905 shall apply in the same manner and subject to the same
conditions and limitations as if on such date (a) the domestic
corporation owned directly that percentage of the stock in the second
tier corporation which such domestic corporation is considered to own by
reason of the application of section 958(a)(2), and (b) the second tier
corporation had distributed to the domestic corporation as a dividend
that portion of the amount included in gross income under section
1248(a) which does not exceed the earnings and profits of the second
tier corporation attributable to such stock under Sec. 1.1248-2 or
Sec. 1.1248-3, as the case may be.
(2) A credit shall not be allowed under subparagraph (1) of this
paragraph in respect of taxes which are not actually paid or accrued.
For the inclusion as a dividend in the gross income of a domestic
corporation of an amount equal to the taxes deemed paid by such
corporation under section 902(a)(1), see section 78.
(3) If subparagraph (1)(ii) of this paragraph applies, and if the
amount included in gross income under section 1248(a) upon the sale or
exchange of the stock in a first tier corporation described in
subparagraph (1)(ii) of this paragraph is less than the sum of the
earnings and profits of the first tier corporation attributable to such
stock
[[Page 389]]
under Sec. 1.1248-2 or Sec. 1.1248-3, as the case may be, plus the
earnings and profits of the second tier corporation attributable to such
stock under Sec. 1.1248-2 or Sec. 1.1248-3, as the case may be, then
the amount considered distributed to the domestic corporation as a
dividend shall be determined by multiplying the amount included in gross
income under section 1248(a) by:
(i) For purposes of applying subparagraph (1)(i) of this paragraph,
the percentage that (a) the earnings and profits of the first tier
corporation attributable to such stock under Sec. 1.1248-2 or Sec.
1.1248-3, as the case may be, bears to (b) the sum of the earnings and
profits of the first tier corporation attributable to such stock under
Sec. 1.1248-2 or Sec. 1.1248-3, as the case may be, plus the earnings
and profits of the second tier corporation attributable to such stock
under Sec. 1.1248-2 or Sec. 1.1248-3, as the case may be, and
(ii) For purposes of applying subparagraph (1)(ii) of this
paragraph, the percentage that (a) the earnings and profits of the
second tier corporation attributable to such stock under Sec. 1.1248-2
or Sec. 1.1248-3, as the case may be, bears to (b) the sum referred to
in subdivision (i)(b) of this subparagraph.
(4) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. On June 30, 1964, domestic corporation D owns 10 percent
of the voting stock of controlled foreign corporation X. On such date, D
sells a share of X stock and includes $200 of the gain on the sale in
its gross income as a dividend under section 1248(a). X does not own any
stock of a lower tier corporation referred to in paragraph (a)(3) of
Sec. 1.1248-3. D uses the calendar year as its taxable year and instead
of deducting foreign taxes under section 164, D chooses the benefits of
the foreign tax credit provisions for 1964. If D had included $200 in
its gross income as a dividend with respect to a distribution from X on
June 30, 1964, the amount of the foreign income taxes paid by X which D
would be deemed to have paid under section 902(a) in respect of such
distribution would be $60. Thus, in respect of the $200 included in D's
gross income as a dividend under section 1248(a), and subject to the
applicable limitations and conditions of sections 901 through 905, D is
entitled under this paragraph to a foreign tax credit of $60 for 1964.
Example 2. On June 30, 1965, domestic corporation D owns all of the
voting stock of foreign corporation Y, and Y (the first tier
corporation) owns all of the voting stock of foreign corporation Z (a
second tier corporation). On such date, D sells a block of Y stock and
includes $400 of the gain on the sale in its gross income as a dividend
under section 1248(a). The earnings and profits attributable under Sec.
1.1248-3 to the block are $600 from Y and $1,800 from Z. D uses the
calendar year as its taxable year and instead of deducting foreign taxes
under section 164, D chooses the benefits of the foreign tax credit
provisions for 1965. For purposes of applying the foreign tax credit
provisions, Y is considered under subparagraph (3) of this paragraph to
have distributed to D a dividend of $100 ($400 x 600/2400) and Z is
considered to have so distributed to D a dividend of $300 ($400 x 1800/
2400). If D had included $100 in its gross income as a dividend with
respect to a distribution from Y on June 30, 1965, the amount of foreign
income taxes paid by Y which D would be deemed to have paid under
section 902(a) in respect of such distribution is $80. If D had owned
the stock in Z directly, and if D had included $300 in its gross income
as a dividend with respect to a distribution from Z, the amount of
foreign income taxes paid by Z which D would be deemed to have paid
under section 902(a) in respect of such distribution is $120. Thus, in
respect of the $400 included in D's gross income as a dividend under
section 1248(a), and subject to the applicable limitations and
conditions of sections 901 through 905, D is entitled under this
paragraph to a foreign tax credit of $200 ($80 plus $120) for 1965.
(e) Exceptions. Under section 1248(g), this section and Sec. Sec.
1.1248-2 through 1.1248-8 do not apply to:
(1) Distributions to which section 303 (relating to distributions in
redemption of stock to pay death taxes) applies; or
(2) Any amount to the extent that the amount is, under any other
provision of the Internal Revenue Code (Code), treated as--
(i) A dividend;
(ii) Gain from the sale of an asset which is not a capital asset; or
(iii) Gain from the sale of an asset held for not more than 1 year.
(f) Installment method. (1) Gain from a sale or exchange to which
section 1248 applies may be reported under the installment method if
such method is otherwise available under section 453 of the Code. In
such case, the income (other than interest) on each installment payment
shall be deemed to consist of gain which is included in gross income
under section 1248 as a dividend
[[Page 390]]
until all such gain has been reported, and the remaining portion (if
any) of such income shall be deemed to consist of gain to which section
1248 does not apply. For treatment of amounts as interest on certain
deferred payments, see section 483.
(2) The application of this paragraph may be illustrated by the
following example:
Example: Jones contracts to sell stock in a controlled foreign
corporation for $5,000 to be paid in 10 equal payments of $500 each,
plus a sufficient amount of interest so that section 483 does not apply.
He properly elects under section 453 to report under the installment
method gain of $1,000 which is includible in gross income under section
1248 as a dividend and gain of $500 which is a long-term capital gain.
Accordingly, $150 of each of the first 6 installment payments and $100
of the seventh installment payment are included in gross income under
section 1248 as a dividend, and $50 of the seventh installment payment
and $150 of each of the last 3 installment payments are long-term
capital gain.
(g) Effective/applicability date. (1) The third sentence in
paragraph (a)(1), paragraph (a)(4), and paragraph (a)(5), Example 4, of
this section apply to income inclusions that occur on or after July 30,
2007. A taxpayer may elect to apply paragraph (a)(4) of this section to
income inclusions in open taxable years provided that it consistently
applies paragraph (a)(4) of this section for income inclusions in the
first year for which the election is applicable and in all subsequent
years.
(2) Paragraph (b) of this section applies to distributions that
occur on or after February 10, 2009.
(3) Paragraphs (c) and (e) of this section apply to transactions
occurring on or after April 18, 2013.
[T.D. 6779, 29 FR 18130, Dec. 22, 1964, as amended by T.D. 7728, 45 FR
72650, Nov. 3, 1980; T.D. 7961, 49 FR 26225, June 27, 1984; T.D. 9345,
72 FR 41444, July 30, 2007; T.D. 9444, 74 FR 6828, Feb. 11, 2009; T.D.
9585, 77 FR 24381, Apr. 24, 2012; T.D. 9614, 78 FR 17041, Mar. 19, 2013]
Sec. 1.1248-2 Earnings and profits attributable to a block of stock
in simple cases.
(a) General--(1) Manner of computation. For purposes of paragraph
(a)(1) of Sec. 1.1248-1, if a United States person sells or exchanges a
block of stock (as defined in paragraph (b) of this section) in a
foreign corporation, and if the conditions of paragraph (c) of this
section are satisfied in respect of the block, then the earnings and
profits attributable to the block which were accumulated in taxable
years of the corporation beginning after December 31, 1962, during the
period such block was held (or was considered to be held by reason of
the application of section 1223, taking into account Sec. 1.1248-8) by
such person while such corporation was a controlled foreign corporation,
shall be computed in accordance with the steps set forth in
subparagraphs (2), (3), and (4) of this paragraph.
(2) Step 1. (i) For each taxable year of the corporation beginning
after December 31, 1962, the earnings and profits accumulated for each
such taxable year by the corporation shall be computed in the manner
prescribed in paragraph (d) of this section, and (ii) for the period the
person held (or is considered to have held by reason of the application
of section 1223, taking into account Sec. 1.1248-8) the block, the
amount of earnings and profits attributable to the block shall be
computed in the manner prescribed in paragraph (e) of this section.
(3) Step 2. If the conditions of paragraph (c)(5)(ii) of this
section must be satisfied in respect of stock in a lower tier foreign
corporation which such person owns within the meaning of section
958(a)(2), then (i) the earnings and profits accumulated for each such
taxable year by such lower tier corporation shall be computed in the
manner prescribed in paragraph (d) of this section, and (ii) for the
period the person held (or is considered to have held by reason of the
application of section 1223, taking into account Sec. 1.1248-8) the
block, the amount of earnings and profits of the lower tier corporation
attributable to the block shall be computed in the manner prescribed in
paragraph (e) of this section applied as if such person owned directly
the percentage of such stock in such lower tier corporation which such
person owns within the meaning of section 958(a)(2).
(4) Step 3. The amount of earnings and profits attributable to the
block shall be the sum of the amounts computed under steps 1 and 2.
[[Page 391]]
(b) Block of stock. For purposes of this section, the term block of
stock means a group of shares sold or exchanged in one transaction, but
only if:
(1) The amount realized, basis, and holding period are identical for
each such share, and
(2) In case, during the period the person held (or is considered to
have held by reason of the application of section 1223) such shares, any
amount was included under section 951 in the gross income of the person
(or another person) in respect of the shares, the excess under paragraph
(e)(3)(ii) of this section (computed as if each share were a block) is
identical for each such share.
(c) Conditions to application. This section shall apply only if the
following conditions are satisfied:
(1)(i) On each day of the period during which the block of stock was
held (or is considered as held by reason of the application of section
1223) by the person during taxable years of the corporation beginning
after December 31, 1962, the corporation is a controlled foreign
corporation, and
(ii) On no such day is the corporation a foreign personal holding
company (as defined in section 552) or a foreign investment company (as
defined in section 1246(b)).
(2) The corporation had only one class of stock, and the same number
of shares of such stock were outstanding, on each day of each taxable
year of the corporation beginning after December 31, 1962, any day of
which falls within the period referred to in subparagraph (1) of this
paragraph.
(3) For each taxable year referred to in subparagraph (2) of this
paragraph, the corporation is not a less developed country corporation
(as defined in section 902(d)).
(4) For each taxable year referred to in subparagraph (2) of this
paragraph, the corporation does not make any distributions out of its
earnings and profits other than distributions which, under section 316
(as modified by section 959), are considered to be out of earnings and
profits accumulated in taxable years beginning after December 31, 1962,
during the period such person held (or is considered to have held by
reason of the application of section 1223, taking into account Sec.
1.1248-8) the block while such corporation was a controlled foreign
corporation.
(5)(i) If (a) on the date of the sale or exchange such person, by
reason of his ownership of such block, owns within the meaning of
section 958(a)(2) stock in another foreign corporation (referred to as a
lower tier corporation), and (b) the conditions of paragraph (a)(2) of
Sec. 1.1248-1 would be satisfied by such person in respect of such
stock in the lower tier corporation if such person were deemed to have
sold or exchanged such stock in the lower tier corporation on the date
he actually sold or exchanged such block in the first tier corporation,
then the conditions of subdivision (ii) of this subparagraph must be
satisfied.
(ii) In respect of stock in such lower tier corporation, (a) the
conditions set forth in subparagraphs (1) through (4) of this paragraph
(applied as if such person owned directly such stock in such lower tier
corporation) must be met and (b) such person must own within the meaning
of section 958(a)(2) the same percentage of the shares of such stock on
each day which falls within the period referred to in subparagraph (1)
of this paragraph.
(d) Earnings and profits accumulated for a taxable year--(1)
General. For purposes of this section, the earnings and profits
accumulated for a taxable year of a foreign corporation shall be the
earnings and profits for such year computed in accordance with the rules
prescribed in Sec. 1.964-1 (relating to determination of earnings and
profits for a taxable year of a controlled foreign corporation) and
reduced by any distributions therefrom. If the stock in the corporation
is sold or exchanged before any action is taken by or on behalf of the
corporation under paragraph (c) of Sec. 1.964-1, the computation of
earnings and profits under Sec. 1.964-1 for purposes of this section
shall be made as if no elections had been made and no accounting method
had been adopted.
(2) Special rules. (i) The earnings and profits of the corporation
accumulated:
(a) For any taxable year beginning before January 1, 1967 (computed
without any reduction for distributions), shall not include the excess
of any item
[[Page 392]]
includible in gross income of the foreign corporation under section
882(b) as gross income derived from sources within the United States,
and
(b) For any taxable year beginning after December 31, 1966 (computed
without any reduction for distributions), shall not include the excess
of any item includible in gross income of the foreign corporation under
section 882(b)(2) as income effectively connected for that year with the
conduct by such corporation of a trade or business in the United States,
whether derived from sources within or from sources without the United
States,
Over any deductions allocable to such item under section 882(c).
However, if the sale or exchange of stock in the foreign corporation by
the United States person occurs before January 1, 1967, the provisions
of (a) of this subdivision apply with respect to such sale or exchange
even though the taxable year begins after December 31, 1966. See section
1248(d)(4). Any item which is required to be excluded from gross income,
or which is taxed at a reduced rate, under an applicable treaty
obligation of the United States shall not be excluded under this
subdivision from earnings and profits accumulated for a taxable year
(computed without any reduction for distributions).
(ii) If a foreign corporation adopts a plan of complete liquidation
in a taxable year of the corporation beginning after December 31, 1962,
and if because of the application of section 337(a) gain or loss would
not be recognized by the corporation from the sale or exchange of
property if the corporation were a domestic corporation, then the
earnings and profits of the corporation accumulated for the taxable year
(computed without any reduction for distributions) shall be determined
without regard to the amount of such gain or loss. See section
1248(d)(2). For the nonapplication of section 337(a) to a liquidation by
a collapsible corporation (as defined in section 341) and to certain
other liquidations, see section 337(c).
(e) Earnings and profits attributable to block--(1) General. Except
as provided in subparagraph (3) of this paragraph, the earnings and
profits attributable to a block of stock of a controlled foreign
corporation for the period a United States person held (or is considered
to have held by reason of the application of section 1223, taking into
account Sec. 1.1248-8) the block are an amount equal to:
(i) The sum of the earnings and profits accumulated for each taxable
year of the corporation beginning after December 31, 1962 (computed
under paragraph (d) of this section) during such period, multiplied by
(ii) The percentage that (a) the number of shares in the block,
bears to (b) the total number of shares of the corporation outstanding
during such period.
(2) Special rule. For purposes of computing the sum referred to in
subparagraph (1)(i) of this paragraph, in case the block was held (or is
considered as held by reason of the application of section 1223, taking
into account Sec. 1.1248-8) during a taxable year beginning after
December 31, 1962, but not on each day of such taxable year, there shall
be included in such sum only that portion which bears the same ratio to
(i) the total earnings and profits for such taxable year (computed under
paragraph (d) of this section), as (ii) the number of days during such
taxable year the block was held (or is considered as so held), bears to
(iii) the total number of days in such taxable year.
(3) Amounts included in gross income under section 951. (i) If,
during the period the person held (or is considered to have held by
reason of the application of section 1223, taking into account Sec.
1.1248-8) the block, any amount was included under section 951 in the
gross income of such person (or of another person whose holding of the
stock sold or exchanged is, by reason of the application of section
1223, attributed to such person) in respect of the block, then the
earnings and profits attributable to the block for such period shall be
an amount equal to (a) the earnings and profits attributable to the
block which would have been computed under subparagraph (1) of this
paragraph if this subparagraph did not apply, reduced by (b) the excess
computed under subdivision (ii) of this subparagraph. See section
1248(d)(1).
(ii) The excess computed under this subdivision is the excess (if
any) of (a)
[[Page 393]]
amounts included under section 951 in the gross income of such person
(or such other person) in respect of the block during such period, over
(b) the portion of such amounts which, in any taxable year of such
person (or such other person), resulted in an exclusion from the gross
income of such person (or such other person) under section 959(a)(1)
(relating to exclusion from gross income of distributions of previously
taxed earnings and profits).
(iii) This subparagraph shall apply notwithstanding an election
under section 962 by such person to be subject to tax at corporate
rates.
(4) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. On May 26, 1965, Green, a United States person, purchases
at its fair market value a block of 25 of the 100 outstanding shares of
the only class of stock of controlled foreign corporation F. He sells
the block on January 1, 1968. In respect of the block, Green did not
include any amount in his gross income under section 951. F uses the
calendar year as its taxable year and does not own stock in any lower
tier corporation referred to in paragraph (c)(5)(i) of this section. All
of the conditions of paragraph (c) of this section are satisfied in
respect of the block. The earnings and profits accumulated by F
(computed under paragraph (d) of this section) are $10,000 for 1965,
$13,000 for 1966, and $11,000 for 1967. The earnings and profits of F
attributable to the block are $7,500, determined as follows:
Sum of earnings and profits accumulated by F during period
block was held:
For 1965 (219/365 x $10,000)............................ $6,000
For 1966................................................ $13,000
For 1967................................................ $11,000
-----------
Sum................................................... $30,000
Multiplied by:
Number of shares in block (25), divided by total number 25%
of shares outstanding (100)............................
===========
Earnings and profits attributable to block............ $7,500
Example 2. Assume the same facts as in example (1) except that in
respect of the block Green includes in his gross income under section
951 the total amount of $2,800 for 1965 and 1966, and because of such
inclusion the amount of $2,800 which was distributed to Green by F on
January 15, 1967, is excluded from his gross income under section
959(a)(1). Accordingly, the earnings and profits of F attributable to
the block are $7,000, determined as follows:
Earnings and profits attributable to the block, as computed $7,500
in example (1).............................................
Minus:
Excess of amount included in Green's gross income under 500
section 951 ($2,800), over portion thereof which resulted
in an exclusion under section 959(a)(1) ($2,300).........
-----------
Earnings and profits attributable to block............ 7,000
Example 3. Assume the same facts as in example (1) except that on
each day beginning on January 1, 1966 (the date controlled foreign
corporation G was organized) through January 1, 1968, F owns 80 of the
100 outstanding shares of the only class of G stock. Since, by reason of
his ownership of 25 shares of F stock, Green owns within the meaning of
section 958(a)(2) the equivalent of 20 shares of G stock (\25/100\ of 80
shares), G is a lower tier corporation referred to in paragraph
(c)(5)(i)(a) of this section. If Green had sold the 20 shares of G stock
on January 1, 1968, the date he actually sold the block of F stock, the
conditions of paragraph (a)(2) of Sec. 1.1248-1 would be satisfied in
respect of the G stock, and, accordingly, the conditions of paragraph
(c)(5)(ii) of this section must be satisfied. Assume further that such
conditions are satisfied, that G uses the calendar year as its taxable
year, and that the earnings and profits accumulated by G (computed under
paragraph (d) of this section) are $19,000 for 1966 and $21,000 for
1967. The earnings and profits of F and of G attributable to the block
are $15,500, determined as follows:
Sum of earnings and profits accumulated by G for period $40,000
Green owned G stock within the meaning of section 958(a)(2)
($19,000 plus $21,000).....................................
Multiplied by:
Number of G shares deemed owned within the meaning of 20%
section 958(a)(2) by Green (20), divided by total number
of G shares outstanding (100)............................
-----------
Earnings and profits of G attributable to block........... $8,000
Earnings and profits of F attributable to block, as $7,500
determined in example (1)................................
-----------
Total earnings and profits attributable to block...... $15,000
[T.D. 6779, 29 FR 18131, Dec. 22, 1964, as amended by T.D. 7293, 38 FR
32803, Nov. 28, 1973; T.D. 9345, 72 FR 41445, July 30, 2007]
Sec. 1.1248-3 Earnings and profits attributable to stock in complex
cases.
(a) General--(1) Manner of computation. For purposes of paragraph
(a)(1) of Sec. 1.1248-1, if a United States person sells or exchanges
stock in a foreign corporation, and if the provisions of Sec. 1.1248-2
do not apply, then the earnings and profits attributable to the stock
which were accumulated in taxable years of the corporation beginning
[[Page 394]]
after December 31, 1962, during the period or periods such stock was
held (or was considered to be held by reason of the application of
section 1223, taking into account Sec. 1.1248-8) by such person while
such corporation was a controlled foreign corporation, shall be computed
in accordance with the steps set forth in subparagraphs (2), (3), and
(4) of this paragraph.
(2) Step 1. For each taxable year of the corporation beginning after
December 31, 1962, (i) the earnings and profits accumulated for such
taxable year by the corporation shall be computed in the manner
prescribed in paragraph (b) of this section, (ii) the person's tentative
ratable share of such earnings and profits shall be computed in the
manner prescribed in paragraph (c) or (d) (whichever is applicable) of
this section, and (iii) the person's ratable share of such earnings and
profits shall be computed by adjusting the tentative ratable share in
the manner prescribed in paragraph (e) of this section.
(3) Step 2. If the provisions of paragraph (f) of this section
(relating to earnings and profits of lower tier foreign corporations)
apply, the amount of the person's ratable share of the earnings and
profits accumulated by each lower tier corporation attributable to any
such taxable year (i) shall be computed in the manner prescribed by
paragraph (f) of this section, and (ii) shall be added to such person's
ratable share for such taxable year determined in step 1.
(4) Step 3. The amount of earnings and profits attributable to the
share shall be the sum of the ratable shares computed for each such
taxable year in the manner prescribed in steps 1 and 2.
(5) Share or block. In general, the computation under this paragraph
shall be made separately for each share of stock sold or exchanged,
except that if a group of shares constitute a block of stock the
computation may be made in respect of the block. For purposes of this
section, the term block of stock means a group of shares sold or
exchanged in one transaction, but only if (i) the amount realized,
basis, and holding period are identical for each such share, and (ii)
the adjustments (if any) under paragraphs (e) and (f)(5) of this section
of the tentative ratable shares would be identical for each such share
if such adjustments were computed separately for each such share.
(6) Deficit in earnings and profits. For purposes of this section
and Sec. Sec. 1.1248-2 through 1.1248-8, in respect of a taxable year,
the term earnings and profits accumulated for a taxable year (but only
if computed under paragraph (b) of this section) includes a deficit in
earnings and profits accumulated for such taxable year. Similarly, a
tentative ratable share, or a ratable share, may be a deficit.
(7) Examples. The application of the provisions of this paragraph
may be illustrated by the following examples:
Example 1. On December 31, 1967, Brown sells 10 shares of stock in
foreign corporation X, which uses the calendar year as its taxable year.
The 10 shares constitute a block of stock under subparagraph (5) of this
paragraph. Under step 1, Brown's ratable shares of the earnings and
profits of X attributable to the block are as follows:
------------------------------------------------------------------------
Ratable
Taxble year of X shares
------------------------------------------------------------------------
1963........................................................ $100
1964........................................................ 150
1965........................................................ \1\ 50
1966........................................................ 50
1967........................................................ 100
-----------
Sum..................................................... 350
------------------------------------------------------------------------
\1\ Deficit.
The amount of the earnings and profits attributable to such block under
step 3 is $350.
Example 2. Assume the same facts as in example (1), except that in
respect of X there are lower tier corporations Y and Z to which the
provisions of paragraph (f) of this section apply. Brown's ratable
shares of the earnings and profits of X, Y, and Z attributable to the
block under steps 1 and 2 for each taxable year of X are as follows:
------------------------------------------------------------------------
Ratable shares
Taxable year of X ---------------------------------------
X Y Z Total
------------------------------------------------------------------------
1963............................ $100 $40 $20 $160
1964............................ 150 40 -60 130
1965............................ -50 30 50 30
1966............................ 50 50 30 130
1967............................ 100 -40 40 100
---------------------------------------
Sum......................... 350 120 80 550
------------------------------------------------------------------------
The amount of the earnings and profits attributable to such block under
step 3 is $550.
(b) Earnings and profits accumulated for a taxable year--(1)
General. For purposes of this section, the earnings and
[[Page 395]]
profits accumulated for a taxable year of a foreign corporation shall be
the earnings and profits for such year, computed in accordance with the
rules prescribed in Sec. 1.964-1 (relating to determination of earnings
and profits for a taxable year of a controlled foreign corporation),
except that (i) the special rules of subparagraph (2) of this paragraph
shall apply, and (ii) adjustments shall be made under subparagraph (3)
of this paragraph for distributions made by the corporation during such
taxable year. If the stock in the corporation is sold or exchanged
before any action is taken by or on behalf of the corporation under
paragraph (c) of Sec. 1.964-1, the computation of earnings and profits
under Sec. 1.964-1 for purposes of this section shall be made as if no
elections had been made and no accounting method had been adopted. The
amount of earnings and profits accumulated for a taxable year of a
foreign corporation, as computed under this paragraph, is not
necessarily the same amount as the earnings and profits of the taxable
year computed under section 316(a)(1) or paragraph (d) of Sec. 1.1248-
2. Thus, for example, if a distribution with respect to stock is in
excess of the amount of earnings and profits of the taxable year
computed under section 316(a)(2), such excess is treated under section
316(a)(2), or paragraph (d) of Sec. 1.1248-2 as made out of any
earnings and profits accumulated in prior taxable years, whereas the
amount of such excess may create, or increase, a deficit in the earnings
and profits accumulated for the taxable year as computed under this
paragraph. See subparagraph (3) of this paragraph.
(2) Special rules. (i) The earnings and profits of the corporation
accumulated:
(a) For any taxable year beginning before January 1, 1967, shall not
include the excess of any item includible in gross income of the foreign
corporation under section 882(b) as gross income derived from sources
within the United States, and
(b) For any taxable year beginning after December 31, 1966, shall
not include the excess of any item includible in gross income of the
foreign corporation under section 882(b)(2) as income effectively
connected for that year with the conduct by such corporation of a trade
or business in the United States, whether derived from sources within or
from sources without the United States,
Over any deductions allocable to such item under section 882(c).
However, if the sale or exchange of stock in the foreign corporation by
the U.S. person occurs before January 1, 1967, the provisions of (a) of
this subdivision apply with respect to such sale or exchange even though
the taxable year begins after December 31, 1966. See section 1248(d)(4).
Any item which is required to be excluded from gross income, or which is
taxed at a reduced rate, under an applicable treaty obligation of the
United States shall not be excluded under this subdivision from earnings
and profits accumulated for a taxable year.
(ii) If a foreign corporation adopts a plan of complete liquidation
in a taxable year of the corporation beginning after December 31, 1962,
and if because of the application of section 337(a) gain or loss would
not be recognized by the corporation from the sale or exchange of
property if the corporation were a domestic corporation, then the
earnings and profits of the corporation accumulated for the taxable year
shall be determined without regard to the amount of such gain or loss.
See section 1248(d)(2). For the nonapplication of section 337(a) to a
liquidation by a collapsible corporation (as defined in section 341) and
to certain other liquidations, see section 337(c).
(3) Adjustment for distributions. (i) The earnings and profits of a
foreign corporation accumulated for a taxable year (computed without
regard to this subparagraph) shall be reduced (if necessary below zero
so as to create a deficit), or a deficit in such earnings and profits
shall be increased, by the amount of the distributions (other than in
redemption of stock under section 302(a) or 303) made by the corporation
in respect of its stock during such taxable year (a) out of such
earnings and profits, or (b) out of earnings and profits accumulated for
prior taxable years beginning after December 31, 1962 (computed under
this paragraph). Except for purposes of applying this subparagraph, the
application of the preceding sentence shall not affect the
[[Page 396]]
amount of earnings and profits accumulated for any such prior taxable
year.
(ii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. X Corporation, which uses the calendar year as its
taxable year, was organized on January 1, 1965, and was a controlled
foreign corporation on each day of 1965. The amount of X's earnings and
profits accumulated for 1965 (computed under this paragraph without
regard to the adjustment for distributions under this subparagraph) is
$400,000, of which $100,000 is distributed by X as dividends during
1965. The amount of X's earnings and profits accumulated for 1965
(computed under this paragraph) is $300,000 (that is, $400,000 minus
$100,000). The result would be the same even if X was not a controlled
foreign corporation on each day of 1965.
Example 2. Assume the same facts as in example (1). Assume further
that the amount of X's earnings and profits accumulated for 1966
(computed under this paragraph without regard to the adjustment for
distributions under this subparagraph) is $150,000, and that X
distributes the amount of $260,000 as dividends during 1966. Since
$150,000 of the distribution is from earnings and profits accumulated
for 1966 (computed without regard to the adjustment for distributions
under this subparagraph), and since $110,000 is from earnings and
profits accumulated for 1965, the earnings and profits of X accumulated
for 1966 are a deficit of $110,000 (that is, $150,000 minus $260,000).
However, the earnings and profits accumulated for 1965 are still
$300,000 for purposes of computing in the manner prescribed in paragraph
(c) of this section a person's tentative ratable share.
(c) Tentative ratable share if earnings and profits accumulated for
a taxable year not less than zero--(1) General rule. For purposes of
paragraph (a)(2)(ii) of this section, in respect of a share (or block)
of stock in a foreign corporation, if the amount of the earnings and
profits accumulated for a taxable year of the corporation (computed
under paragraph (b) of this section), beginning after December 31, 1962,
is not less than zero, then the person's tentative ratable share for
such taxable year shall be equal to:
(i)(a) Such amount (if the computation is made in respect of a
block, multiplied by the number of shares in the block), divided by (b)
the number of shares in the corporation outstanding, or deemed under
subparagraph (2) of this paragraph to be outstanding, on each day of
such taxable year, multiplied by
(ii) The percentage that (a) the number of days in such taxable year
of the corporation during the period the person held (or was considered
to have held by reason of the application of section 1223, taking into
account Sec. 1.1248-8) the share (or block) while the corporation was a
controlled foreign corporation, bears to (b) the total number of days in
such taxable year.
(2) Shares deemed outstanding for a taxable year. For purposes of
this section and Sec. Sec. 1.1248-4 through 1.1248-7, if the number of
shares of stock in a foreign corporation outstanding on each day of a
taxable year of the corporation is not constant, then the number of such
shares deemed outstanding on each such day shall be the sum of the
fractional amounts in respect of each share outstanding on any day of
the taxable year. The fractional amount in respect of a share shall be
determined by dividing (i) the number of days in the taxable year during
which such share was outstanding (excluding the day the share became
outstanding, but including the day the share ceased to be outstanding),
by (ii) the total number of days in such taxable year.
(3) Examples. The application of subparagraphs (1) and (2) of this
paragraph may be illustrated by the following examples:
Example 1. On each day of 1964, S owns a block consisting of 30 of
the 100 shares of the only class of stock outstanding in F Corporation,
and on each such day F is a controlled foreign corporation. F uses the
calendar year as its taxable year and F's earnings and profits
accumulated for 1964 (computed under paragraph (b) of this section) are
$10,000. S's tentative ratable share with respect to the block is
$3,000, computed as follows:
Earnings and profits accumulated for taxable year........... $10,000
Multiplied by:
Number of shares in block (30), divided by number of 30%
shares outstanding (100).................................
Multiplied by:
Number of days in 1964 S held block while F was a 100%
controlled foreign corporation (365), divided by number
of days in 1964 (365)....................................
-----------
Tentative ratable share for block....................... $3,000
Example 2. On December 31, 1964, X Corporation, a controlled foreign
corporation which uses the calendar year as its taxable
[[Page 397]]
year, had 100 shares of one class of stock outstanding, 15 of which were
owned by T. T's 15 shares were redeemed by X on March 14, 1965. On
December 31, 1965, in addition to the remaining 85 shares, 10 new shares
of stock (which were issued on May 26, 1965) were outstanding. Thus,
during 1965, 15 shares were outstanding for 73 days, 10 for 219 days,
and 85 for 365 days. The earnings and profits (computed under paragraph
(b) of this section) accumulated for X's taxable year ending on December
31, 1965, are $18,800. T's tentative ratable share with respect to one
share of stock is $40, computed as follows:
Earnings and profits accumulated for taxable year........... $18,800
Divided by:
Number of shares deemed outstanding each day
of 1965:.....................................
15 for 73 days (15 x 73/365)................ 3
10 for 219 days (10 x 219/365).............. 6
85 for 365 days (35 x 365/365).............. 85
============
Total number of shares deemed outstanding each day of 1965 94
-------------
Earnings and profits accumulated per share.................. $200
Multiplied by:
Number of days in 1965 T held his share while X was a 20%
controlled foreign corporation (73), divided by number of
days in 1965 (365).......................................
-------------
T's tentative ratable share per share of stock.......... $40
Example 3. Assume the same facts as in example (2) except that X was
not a controlled foreign corporation after January 31, 1965. T's
tentative ratable share with respect to one share of stock for 1965 is
$17, computed as follows:
Earnings and profits accumulated per share, determined in $200
example (2)................................................
Multiplied by:
Number of days in 1965 T held X stock while X was a 8.5%
controlled foreign corporation (31), divided by number of
days in 1965 (365).......................................
-------------
Tentative ratable share................................. $17
(4) More than one class of stock. If a foreign corporation for a
taxable year has more than one class of stock outstanding, then before
applying subparagraphs (1) and (2) of this paragraph the earnings and
profits accumulated for the taxable year of the corporation (computed
under paragraph (b) of this section) shall be allocated to each class of
stock in accordance with the principles of paragraph (e) (2) and (3) of
Sec. 1.951-1, applied as if the corporation were a controlled foreign
corporation on each day of such taxable year.
(d) Tentative ratable share if deficit in earnings and profits
accumulated for taxable year--(1) General rule. For purposes of
paragraph (a)(2)(ii) of this section, in respect of a share (or block)
of stock in a foreign corporation, if there is a deficit in the earnings
and profits accumulated for a taxable year of the corporation (computed
under paragraph (b) of this section) beginning after December 31, 1962,
the person's tentative ratable share for such taxable year shall be an
amount equal to the sum of the partial tentative ratable shares computed
under subparagraphs (2) and (3) of this paragraph.
(2) Operating deficit. The partial tentative ratable share under
this subparagraph is computed in 2 steps. First, compute (under
paragraph (b) of this section without regard to the adjustment for
distributions under subparagraph (3) thereof) the deficit (if any) in
earnings and profits accumulated for such taxable year. Second, compute
the partial tentative ratable share in the same manner as the tentative
ratable share for such taxable year would be computed under paragraph
(c) of this section if such deficit were the amount referred to in
paragraph (c)(1)(i)(a) of this section.
(3) Deficit from distributions. The partial tentative ratable share
under this subparagraph is computed in 2 steps. First, compute and treat
as a deficit only that portion of the adjustment for distributions under
paragraph (b)(3) of this section for such taxable year which is
attributable under subparagraph (4) of this paragraph to distributions
out of earnings and profits accumulated during prior taxable years of
the corporation beginning after December 31, 1962, during the period or
periods the corporation was a controlled foreign corporation and the
share (or block) of stock was owned by a United States shareholder (as
defined in section 951(b) and the regulations thereunder). Second,
compute the partial tentative ratable share for such taxable year in the
same manner as the tentative ratable share for such taxable year would
be computed under paragraph (c) of this section if (i) such deficit were
the amount referred to in paragraph (c)(1)(i)(a) of this section,
[[Page 398]]
and (ii) the corporation were a controlled foreign corporation on each
day of such taxable year.
(4) Order of distributions. For purposes of applying subparagraph
(3) of this paragraph only, the adjustment for distributions under
paragraph (b)(3) of this section for a taxable year of a foreign
corporation shall be treated as attributable first to distributions of
earnings and profits for the taxable year (computed under paragraph (b)
of this section without regard to such adjustment) to the extent
thereof, and then to distributions out of the most recent of earnings
and profits accumulated during prior taxable years beginning after
December 31, 1962 (computed under paragraph (b) of this section). If the
foreign corporation was a controlled foreign corporation during a prior
taxable year for a period or periods which was only part of such prior
taxable year, then for purposes of the preceding sentence (i) such
taxable year shall be divided into periods the corporation was or was
not a controlled foreign corporation, (ii) distributions of the earnings
and profits accumulated during such prior taxable year shall be
considered made from the most recent period first, and (iii) the
earnings and profits accumulated during such prior taxable year shall be
allocated to a period during such year in the same proportion as the
number of days in the period bears to the number of days in such year.
Except for purposes of applying subparagraph (3) of this paragraph, the
application of this subparagraph shall not affect the amount of earnings
and profits accumulated for any such prior taxable year (computed under
paragraph (b) of this section).
(5) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. On each day of 1965 X Corporation, which uses the
calendar year as its taxable year, was a controlled foreign corporation
having 100 shares of one class of stock outstanding, a block of 25 of
which were owned by T, who acquired them in 1962 and sold them in 1967.
The deficit in X's earnings and profits accumulated for 1965 (computed
under paragraph (b) of this section without regard to the adjustment for
distributions under subparagraph (3) thereof) is $100,000, and thus in
respect of the block T's partial tentative ratable share computed under
subparagraph (2) of this paragraph is a deficit of $25,000 (that is,
$100,000 x 25/100). During 1965 X does not make any distributions in
respect of its stock, and thus in respect of the block T's partial
tentative ratable share computed under subparagraph (3) of this
paragraph is zero. Accordingly, T's tentative ratable share in respect
of the block of X stock for 1965 is a deficit of $25,000. If, however, X
was a controlled foreign corporation for only 292 days during 1965, T's
tentative ratable share in respect of the block for 1965 would be a
deficit of $20,000 (that is, $25,000 x 292/365).
Example 2. (i) Assume the same facts as in example (1) except that
at no time during 1965 is X a controlled foreign corporation and that
during 1965 X distributes $80,000 with respect to its stock. Assume
further that X was a controlled foreign corporation on each day of 1964,
but only for the first 146 days of 1963, and that X's earnings and
profits accumulated for prior taxable years computed under paragraph (b)
of this section are $70,000 for 1964 and $20,000 for 1963.
(ii) Since X was not a controlled foreign corporation on any day of
1965, in respect of the block T's partial tentative ratable share
computed under subparagraph (2) of this paragraph is zero.
(iii) The partial tentative ratable share under subparagraph (3) of
this paragraph is computed in the following manner: For 1965 the
adjustment for distributions under paragraph (b)(3) of this section is
$80,000. Under subparagraph (4) of this paragraph $70,000 of such
adjustment is attributable to the distribution of all of the earnings
and profits accumulated during 1964, on every day of which X was a
controlled foreign corporation, and $10,000 of the adjustment is
attributable to the distribution of $10,000 of the earnings and profits
accumulated for 1963. The portion of the earnings and profits
accumulated by X in 1963 attributable to the first 146 days in 1963
during which X was a controlled foreign corporation is $8,000 (that is,
$20,000 x 146/365), and the portion attributable to the period in 1963
during which X was not a controlled foreign corporation is $12,000 (that
is, $20,000 x 219/365). Under subparagraph (4)(ii) of this paragraph,
the distribution in 1965 of $10,000 of earnings and profits accumulated
during 1963 is attributable to the more recent period in 1963, that is,
the period X was not a controlled foreign corporation. Accordingly, the
portion of the adjustment for distributions under paragraph (b)(3) of
this section attributable to earnings and profits accumulated during
periods X was a controlled foreign corporation is $70,000, and in
respect of the block T's partial tentative ratable share under
subparagraph (3) of this paragraph is a deficit of $17,500 (that is,
$70,000 x 25/100).
(iv) T's tentative ratable share in respect of the block of X stock
for 1965 is a deficit of
[[Page 399]]
$17,500 (that is, the sum of the partial tentative ratable share for the
block computed under subparagraph (2) of this paragraph, zero, plus the
partial tentative ratable share for the block computed under
subparagraph (3) of this paragraph, a deficit of $17,500).
(v) Assume that X had 100 shares of one class of stock outstanding
on each day of 1964 and 1963. Notwithstanding the distributions in 1965
of earnings and profits accumulated during 1964 and 1963 (computed under
paragraph (b) of this section), nevertheless, in respect of the block
T's tentative ratable share for 1964 is $17,500 (that is, earnings and
profits accumulated during 1964 so computed of $70,000, multiplied by 25
shares/100 shares) and in respect of the block T's tentative ratable
share for 1963 is $2,000 (that is, earnings and profits accumulated
during 1963 so computed of $20,000, multiplied by 25 shares/100 shares,
and multiplied by the percentage that the number of days in 1963 on
which X was a controlled foreign corporation bears to the total number
of days in 1963, 146/365).
Example 3. Assume the same facts as in example (2) except that X was
a controlled foreign corporation on each day of 1965. The tentative
ratable share with respect to the block of stock for 1965 is a deficit
of $42,500, that is, the sum of the partial tentative ratable share
under subparagraph (2) of this paragraph (as determined in example (1)),
a deficit of $25,000, plus the partial tentative ratable share under
subparagraph (3) of this paragraph (as determined in example (2)), a
deficit of $17,500.
(6) More than one class of stock. If a foreign corporation for a
taxable year has more than one class of stock outstanding, then before
applying subparagraph (1) of this paragraph the earnings and profits
accumulated for the taxable year of the corporation (computed under
paragraph (b) of this section) shall be allocated to each class of stock
in accordance with the principles of paragraph (e) (2) and (3) of Sec.
1.951-1, applied as if the corporation were a controlled foreign
corporation on each day of such taxable year.
(e) Ratable share of earnings and profits accumulated for a taxable
year--(1) In general. For purposes of paragraph (a)(2)(iii) of this
section, in respect of a share (or block) of stock in a foreign
corporation, the person's ratable share of the earnings and profits
accumulated for a taxable year beginning after December 31, 1962, shall
be an amount equal to the tentative ratable share computed under
paragraph (c) or (d) (as the case may be) of this section, adjusted in
the manner prescribed in subparagraphs (2) through (6) of this
paragraph.
(2) Amounts included in gross income under section 951. (i) In
respect of a share (or block) of stock in a foreign corporation, a
person's tentative ratable share for a taxable year of the corporation
(computed under paragraph (c) of this section) shall be reduced (but not
below zero) by the excess of (a) the amount, if any, included (in
respect of such corporation for such taxable year) under section 951 in
the gross income of such person or (during the period such share, or
block, was considered to be held by such person by reason of the
application of section 1223, taking into account Sec. 1.1248-8) in the
gross income of any other person who held such share (or block), over
(b) the portion of such amount which, in any taxable year of such person
or such other person, resulted in an exclusion from the gross income of
such person or such other person of an amount under section 959(a)(1)
(relating to exclusion from gross income of distributions of previously
taxed earnings and profits). See section 1248(d)(1). This subdivision
shall apply notwithstanding an election under section 962 by such person
to be subject to tax at corporate rates.
(ii) The application of this subparagraph may be illustrated by the
following example:
Example: On December 31, 1975, Brown sells one share of stock in X
Corporation, a controlled foreign corporation which has never been a
less developed country corporation (as defined in section 902(d)). Both
Brown and X use the calendar year as the taxable year. In respect of his
share, Brown's tentative ratable share for 1971 (computed under
paragraph (c) of this section) is $35. In respect of his share, Brown
included $4 in his gross income for 1971 under section 951, and the
amount of $3, which was distributed to him by X on January 15, 1972, is
excluded from Brown's gross income under section 959(a)(1). In respect
of the stock, Brown's ratable share for 1971 is $34, determined as
follows:
Tentative ratable share..................................... $35
Minus:
Excess of amount of tentative ratable share included in 1
Brown's gross income under section 951 ($4), over portion
thereof which resulted in exclusion under section
959(a)(1) ($3)...........................................
-----------
Ratable share........................................... 34
(3) Amounts included in gross income under section 551. In respect
of a share
[[Page 400]]
(or block) of stock in a foreign corporation, a person's tentative
ratable share for a taxable year of the corporation (computed under
paragraph (c) of this section) shall be reduced (but not below zero) by
the amount, if any, included (in respect of such corporation for such
taxable year) under section 551 in the gross income of such person or
(during the period such share, or block, was considered to be held by
such person by reason of the application of section 1223, taking into
account Sec. 1.1248-8) in the gross income of any other person who held
such share (or block).
(4) Less developed country corporations. (i) If the foreign
corporation was a less developed country corporation as defined in
section 902(d) for a taxable year of the corporation, and if the person
who sold or exchanged a share (or block) of stock in such corporation
satisfies the requirements of paragraph (a) of Sec. 1.1248-5 in respect
of such stock, then his ratable share for such taxable year shall be
zero. See section 1248(d)(3).
(ii) The application of this subparagraph may be illustrated by the
following example:
Example: Assume the same facts as in the example in subparagraph
(2)(ii) of this paragraph except that X was a less developed country
corporation for 1971. Assume further that Brown satisfies the
requirements of paragraph (a) of Sec. 1.1248-5. Brown's ratable share
in respect of the stock for 1971 is zero.
(5) Qualified shareholder of foreign investment company. In respect
of a share (or block) of stock in a foreign corporation which was a
foreign investment company described in section 1246 (b)(1), if the
election under section 1247(a) to distribute income currently was in
effect for a taxable year of the company, and if the person who sold or
exchanged the stock (or another person who actually owned the stock
during such taxable year and whose holding of the stock is attributed by
reason of the application of section 1223, taking into account Sec.
1.1248-8, to the person who sold or exchanged the stock) was a qualified
shareholder (as defined in section 1247(c)) for his taxable year in
which or with which such taxable year of the company ends, then the
ratable share in respect of the share (or block) for such taxable year
of the company shall be zero. See section 1248(d)(5). In case gain is
recognized under section 1246 in respect of a share (or block), see
section 1248(f)(3)(B).
(6) Adjustment for certain distributions. If (i) the person who sold
or exchanged the share or block (or another person who actually owned
the share or block and whose holding of the share or block is attributed
by reason of the application of section 1223 to such person, taking into
account Sec. 1.1248-8) received a distribution during a taxable year of
the corporation, and (ii) such distribution was not included in the
gross income of such person (or such other person) by reason of the
application of section 959(a)(1) to amounts which were included under
section 951(a)(1) in the gross income of a United States shareholder
whose holding of the share or block is not attributed by reason of the
application of section 1223 to such person, taking into account Sec.
1.1248-8 (or such other person), then the amount of such distribution
shall be added to such person's tentative ratable share for such taxable
year. Thus, for example, such tentative ratable share may be increased,
or a deficit reduced, by the amount of such distribution.
(f) Earnings and profits of subsidiaries of foreign corporations--
(1) Application of paragraph. (i) In respect of a person who sells or
exchanges stock in a foreign corporation (referred to as a first tier
corporation), the provisions of this paragraph shall apply if the
following 3 conditions exist:
(a) The conditions of paragraph (a)(2) of Sec. 1.1248-1 are
satisfied by the person in respect of such stock;
(b) By reason of his ownership of such stock, on the date of such
sale or exchange such person owned, within the meaning of section
958(a)(2), stock in another foreign corporation (referred to as a lower
tier corporation); and
(c) The conditions of paragraph (a)(2) of Sec. 1.1248-1 would be
satisfied by such person in respect of such stock in the lower tier
corporation if such person were deemed to have sold or exchanged such
stock in the lower tier corporation on the date he actually sold or
exchanged such stock in the first tier corporation.
[[Page 401]]
(ii) If the provisions of this paragraph apply, (a) the person's
tentative ratable share (or shares) of the earnings and profits
accumulated by the lower tier corporation attributable to a taxable year
of the first tier corporation shall be computed under subparagraph (2)
or (4) of this paragraph, whichever is applicable, and (b) such person's
ratable share (or shares) for the lower tier corporation attributable to
a taxable year of the first tier corporation shall be computed under
subparagraph (5) of this paragraph. For the manner of taking into
account the ratable share for a lower tier corporation, see paragraph
(a)(3) of this section.
(iii) The application of this subparagraph may be illustrated by the
following example:
Example: On each day of 1964 and 1965 corporations X and Y are
controlled foreign corporations, and each has outstanding 100 shares of
one class of stock. On January 15, 1965, T, a United States person, owns
one share of stock in X and X directly owns 20 shares of stock in Y.
Thus, T owns, within the meaning of section 958(a)(2), stock in Y. On
that date, T sells his share in X and satisfies the conditions of
paragraph (a)(2) of Sec. 1.1248-1 in respect of his stock in X.
Assuming that the conditions of paragraph (a)(2) of Sec. 1.1248-1 would
be satisfied by T in respect of the stock he indirectly owns in Y if, on
January 15, 1965, he were deemed to have sold such stock in Y, the
provisions of this paragraph apply.
(2) Tentative ratable share (of lower tier corporation attributable
to a taxable year of first tier corporation) not less than zero. If the
provisions of this paragraph apply to a sale or exchange by a United
States person of a share (or block) of stock in a first tier
corporation, and if the amount of earnings and profits accumulated
(computed under paragraph (b) of this section) for a taxable year
(beginning after December 31, 1962) of the lower tier corporation is not
less than zero, then in respect of the share (or block) such person's
tentative ratable share of the earnings and profits accumulated for such
taxable year of the lower tier corporation attributable to any taxable
year (beginning after December 31, 1962) of such first tier corporation
shall be an amount equal to:
(i)(a) Such amount of earnings and profits accumulated for such
taxable year of the lower tier corporation (if the computation is made
in respect of a block in the first tier corporation, multiplied by the
number of shares in the block), divided by (b) the number of shares in
the first tier corporation outstanding, or deemed under paragraph (c)(2)
of this section to be outstanding, on each day of such taxable year of
the first tier corporation, multiplied by
(ii) The percentage that (a) the number of days during the period or
periods in such taxable year of the first tier corporation on which such
person held (or was considered to have held by reason of the application
of section 1223, taking into account Sec. 1.1248-8) the share (or
block) in the first tier corporation while the first tier corporation
owned (within the meaning of section 958(a)) stock of such lower tier
corporation at times while such lower tier corporation was a controlled
foreign corporation, bears to (b) the total number of days in such
taxable year of the first tier corporation, multiplied by
(iii) The percentage that (a) the average number of shares in the
lower tier corporation which were owned within the meaning of section
958(a) by the first tier corporation during such period or periods
(referred to in subdivision (ii)(a) of this subparagraph), bears to (b)
the total number of such shares outstanding, or deemed under the
principles of paragraph (c)(2) of this section to be outstanding, during
such period or periods, multiplied by
(iv) The percentage that (a) the number of days in such taxable year
of the lower tier corporation which fall within the taxable year of the
first tier corporation, bears to (b) the total number of days in such
taxable year of the lower tier corporation.
(3) Examples. The application of subparagraph (2) of this paragraph
may be illustrated by the following examples:
Example 1. In a year subsequent to 1969, Brown, a United States
person, sells 5 of his shares of stock in X Corporation in a transaction
as to which the provisions of this paragraph apply. Brown had purchased
the 5 shares prior to 1969. On each day of 1969 X Corporation actually
had 100 shares of one class of stock outstanding. On each such day X
Corporation directly owned all of the shares of stock in Y Corporation,
and Y Corporation directly owned all of the shares of stock in Z
Corporation. Z Corporation on
[[Page 402]]
each such day was a controlled foreign corporation. Both X and Z use the
calendar year as the taxable year. Z's earnings and profits accumulated
for 1969 (computed under paragraph (b) of this section) are $2,000.
Brown's tentative ratable share of the earnings and profits accumulated
by Z attributable to the 1969 calendar year of X is $20 per share,
computed as follows:
(i) Z's earnings and profits for 1969 ($2,000), divided by $20
the number of shares in X deemed outstanding each day of
1969 (100)...............................................
Multiplied by:
(ii) Since on each day of 1969 Brown (by reason of owning 100%
directly his shares in X) owned, within the meaning of
section 958(a)(2), stock in Z while Z was a controlled
foreign corporation, the percentage determined under
subparagraph (2)(ii) of this paragraph equals............
Multiplied by:
(iii) Since on each day of 1969 X owned 100 percent of the 100%
stock of Y while Y owned 100 percent of the stock in Z,
the percentage determined under subparagraph (2)(iii) of
this paragraph equals....................................
Multiplied by:
(iv) Since X and Z each use the same taxable year, the 100%
percentage determined under subparagraph (2)(iv) of this
paragraph equals.........................................
-------------
Total................................................. $20
Example 2. Assume the same facts as in example (1), except that
Brown sold his stock in X on October 19, 1969. Brown's tentative ratable
share of the earnings and profits accumulated by Z attributable to the
1969 calendar year of X is $16 per share, computed as follows:
(i) The amount determined in subdivision (i) of example $20
(1)......................................................
Multiplied by:
(ii) The number of days in the period during 1969 Brown 80%
(by reason of owning directly his stock in X) owned,
within the meaning of section 958(a)(2), his stock in Z
while Z was a controlled foreign corporation (292),
divided by the number of days in 1969 (365), equals......
Multiplied by:
(iii) The percentage determined in subdivision............
(iii) of example (1).................................... 100%
Multiplied by:
(iv) The percentage determined in subdivision.............
(iv) of example (1)..................................... 100%
-------------
Total................................................. $16
Example 3. Assume the same facts as in examples (1) and (2), except
that on each day during 1969 Y owned (within the meaning of section
958(a)(2)) 81 of the 100 shares of Z's outstanding stock. Brown's
tentative ratable share of the earnings and profits accumulated by Z
attributable to the 1969 calendar year of X is $12.96 per share,
computed as follows:
(i) The amount determined in subdivision (i) of example $20
(1)......................................................
Multiplied by:
(ii) The percentage determined in subdivision (ii) of 80%
example (2)..............................................
Multiplied by:
(iii) The average number of shares in Z which were owned 81%
(within the meaning of section 958(a)) by X during the
applicable period (81), divided by the total number of
shares in Z during such period (100).....................
Multiplied by:
(iv) The percentage determined in subdivision (iv) of 100%
example (1)..............................................
=============
Total................................................. $12.96
The result would be the same if X owned (within the meaning of section
958(a)(2)) 81 percent of the stock in Y while Y so owned 100 percent of
the stock in X, or if X so owned 90 percent of the stock in Y while Y so
owned 90 percent of the stock in Z.
Example 4. Assume the same facts as in example (3), except that Z
Corporation uses a fiscal year ending June 30 as its taxable year.
Assume further that Z's earnings and profits accumulated for its fiscal
year ending June 30, 1969, and for its fiscal year ending June 30, 1970,
are $3,000 and $2,000, respectively. Brown's tentative ratable share of
the earnings and profits accumulated by Z attributable to the 1969
calendar year of X is $16.17 per share, computed as follows:
In respect of Z's
taxable year ending
June 30, June 30,
1969 1970
(i) Z's earnings and profits, divided by the
number of shares in X deemed outstanding on
each day of 1969:
$3,000/100................................ $30
$2,000/100................................ .......... $20
Multiplied by:
(ii) The percentage determined in subdivision 80% 80%
(ii) of example (2)..........................
Multiplied by:
(iii) The percentage determined in subdivision 81% 81%
(iii) of example (3).........................
Multiplied by:
(iv) Number of days in Z's taxable year which
fall within 1969, divided by total number of
days in Z's taxable year:
181/365................................... 49.6%
184/365................................... .......... 50.4%
-----------------------
Totals.................................. $9.64 $6.53
(v) Sum of tentative ratable shares of Z
attributable to X's 1969 calendar year:
For Z's taxable year ending
June 30, 1969............................. .......... $9.64
June 30, 1970............................. .......... $6.53
-------------
Sum..................................... .......... $16.17
[[Page 403]]
(4) Deficit in tentative ratable share of lower tier corporation
attributable to a taxable year of first tier corporation. (i) If there
is a deficit in the earnings and profits accumulated for a taxable year
of a lower tier corporation beginning after December 31, 1962 (computed
under paragraph (b) of this section), the person's tentative ratable
share for such taxable year of such lower tier corporation attributable
to a taxable year of a first tier corporation shall not be computed
under subparagraph (2) of this paragraph but shall be an amount equal to
the sum of the partial tentative ratable shares computed under
subdivisions (ii) and (iii) of this subparagraph.
(ii) The partial tentative ratable share under this subdivision is
computed in 2 steps. First, compute (under paragraph (b) of this section
without regard to the adjustments for distributions under subparagraph
(3) thereof) the deficit (if any) in earnings and profits accumulated
for such taxable year of such lower tier corporation. Second, compute
the partial tentative ratable share in the same manner as such tentative
ratable share would be computed under subparagraph (2) of this paragraph
if such deficit were the amount referred to in subparagraph (2)(i)(a) of
this paragraph.
(iii) The partial tentative ratable share under this subdivision is
computed in 2 steps. First, compute and treat as a deficit the portion
of the adjustment for distributions under paragraph (b)(3) of this
section for such taxable year which is attributable under paragraph
(d)(4) of this section to distributions of earnings and profits
accumulated during prior taxable years of the lower tier corporation
beginning after December 31, 1962, during the period or periods such
lower tier corporation was a controlled foreign corporation and the
percentage of the stock of such lower tier corporation (which the person
owns within the meaning of section 958(a)(2)) was owned within the
meaning of section 958(a) by a United States shareholder (as defined in
section 951(b) and the regulations thereunder). Second, compute the
partial tentative ratable share in the same manner as such tentative
ratable share would be computed under subparagraph (2) of this paragraph
if (a) such deficit were the amount referred to in subparagraph
(2)(i)(a) of this paragraph, and (b) such lower tier corporation were a
controlled foreign corporation on each day of such taxable year.
(5) Ratable share of lower tier corporation attributable to a first
tier corporation. (i) If the provisions of this paragraph apply in
respect of a share of stock in a first tier corporation, a person's
ratable share of the earnings and profits accumulated by the lower tier
corporation attributable to a taxable year of the first tier corporation
shall be an amount equal to the tentative ratable share computed under
subparagraph (2) or (4) of this paragraph, adjusted in the manner
prescribed in this subparagraph.
(ii) If the first tier corporation and the lower tier corporation
use the same taxable year, then in respect of a share (or block) of
stock in the first tier corporation the person's tentative ratable share
of the accumulated earnings and profits of the lower tier corporation
attributable to the taxable year of the first tier corporation (computed
under subparagraph (2) of this paragraph) shall be reduced (but not
below zero) by the excess of (a) the amount, if any, included (in
respect of such lower tier corporation for its taxable year) under
section 951 in the gross income of such person or (during the period
such stock was considered to be held by such person by reason of the
application of section 1223, taking into account Sec. 1.1248-8) in the
gross income of any other person who held such stock, over (b) the
portion of such amount which, in any taxable year of such person or such
other person, resulted in an exclusion from the gross income of such
person or such other person of an amount under section 959(a)(1). For an
illustration of the principles in the preceding sentence, see the
example in paragraph (e)(2)(ii) of this section.
(iii) If the first tier corporation and the lower tier corporation
do not use the same taxable year, and if there would be an excess
computed under subdivision (ii) of this subparagraph in respect of a
taxable year of the lower tier corporation (were the taxable years of
such corporations the same), then such person's tentative ratable
[[Page 404]]
share of the accumulated earnings and profits for a taxable year of the
lower tier corporation attributable to such taxable year of the first
tier corporation shall be reduced (but not below zero) by an amount
which bears the same ratio to (a) such excess, as (b) the number of days
in the taxable year of the lower tier corporation which fall within the
taxable year of the first tier corporation, bears to (c) the total
number of days in the taxable year of the first tier corporation.
(iv) If the first tier corporation and the lower tier corporation
use the same taxable year, then in respect of a share (or block) of
stock in the first tier corporation the person's tentative ratable share
of the accumulated earnings and profits of the lower tier corporation
attributable to the taxable year of the first tier corporation (computed
under subparagraph (2) of this paragraph) shall be reduced (but not
below zero) by the amount, if any, included (in respect of such
corporation for such taxable year) under section 551, by reason of the
application of section 555(b), in the gross income of such person or
(during the period such share (or block) was considered to be held by
such person by reason of the application of section 1223, taking into
account Sec. 1.1248-8) in the gross income of any other person who held
such share (or block).
(v) If the first tier corporation and the lower tier corporation do
not use the same taxable year, and if there would be a reduction in the
person's tentative ratable share of the accumulated earnings and profits
of the lower tier corporation attributable to the taxable year of the
first tier corporation by an amount computed under subdivision (iv) of
this subparagraph in respect of a taxable year of the lower tier
corporation (were the taxable years of such corporations the same), then
such person's tentative ratable share of the accumulated earnings and
profits for a taxable year of the lower tier corporation attributable to
such taxable year of the first tier corporation shall be reduced by an
amount which bears the same ratio to (a) such amount, as (b) the number
of days in the taxable year of the lower tier corporation which fall
within the taxable year of the first tier corporation, bears to (c) the
total number of days in the taxable year of the first tier corporation.
(vi) If the lower tier corporation was a less developed country
corporation as defined in section 902(d) for a taxable year of the
corporation, see paragraph (g) of this section.
(g) Lower tier corporation a less developed country corporation--(1)
General. If the lower tier corporation was a less developed country
corporation as defined in section 902(d) for a taxable year of such
corporation, and if the person who sold or exchanged a share (or block)
of stock in the first tier corporation satisfies on the date of such
sale or exchange:
(i) The requirements of paragraph (a)(1) of Sec. 1.1248-5 with
respect to such stock, and
(ii) The requirements of paragraph (d)(1) of Sec. 1.1248-5 with
respect to any stock of the lower tier corporation which such person, by
reason of his direct ownership of such stock in the first tier
corporation, owned within the meaning of section 958(a)(2),
Then such person's ratable share (or a deficit in such ratable share)
for such taxable year of the lower tier corporation attributable to a
taxable year of the first tier corporation (determined without regard to
this paragraph) shall be reduced by an amount computed by multiplying
such ratable share (so determined without regard to this paragraph) by
the percentage computed under either subparagraph (2) or (4) of this
paragraph, whichever is applicable.
(2) Percentage for second tier corporation. For purposes of
subparagraph (1) of this paragraph, if stock of a lower tier corporation
(hereinafter referred to as a second tier corporation) is owned directly
by the first tier corporation on the date of the sale or exchange
referred to in such subparagraph (1), the percentage under this
subparagraph shall be computed by dividing (i) the number of shares of
stock of the second tier corporation which the first tier corporation
has owned directly for an uninterrupted 10-year period ending on such
date, by (ii) the total number of shares of the stock of such second
tier corporation owned directly by such first tier corporation on such
date.
[[Page 405]]
(3) Examples. The provisions of subparagraph (2) of this paragraph
may be illustrated by the following examples:
Example 1. On January 1, 1966, Smith, a United States person,
recognizes gain upon the sale of one share of the only class of stock of
F Corporation, which he has owned continuously since 1955. He includes a
portion of the gain in his gross income as a dividend under section
1248(a). On January 1, 1966, F owns directly 60 shares of the 100
outstanding shares of the only class of stock of G Corporation, which F
acquired in 1955 and owned continuously until such sale. F uses a
taxable year ending June 30, and G uses the calendar year as the taxable
year. For 1964, G was a less developed country corporation, and on each
day of 1964 G was a controlled foreign corporation. Smith's ratable
share for G's taxable year ending December 31, 1964, attributable to F's
taxable year ending June 30, 1965 (determined without regard to this
paragraph) is $6.00. Since the percentage computed under subparagraph
(2) of this paragraph is 100 percent (60 shares divided by 60 shares),
Smith's ratable share for G's taxable year ending December 31, 1964,
attributable to F's taxable year ending June 30, 1965 (after the
application of subparagraph (2) of this paragraph) is zero (that is,
$6.00 reduced by 100 percent of $6.00).
Example 2. Assume the same facts as in example (1) except that of
the 60 shares of G Corporation which F Corporation owned on January 1,
1966, 20 shares were acquired in 1961. The percentage computed under
subparagraph (2) of this paragraph is 66\2/3\ percent (40 shares divided
by 60 shares). Accordingly, Smith's ratable share for G's taxable year
ending December 31, 1964, attributable to F's taxable year ending June
30, 1965 (after the application of subparagraph (2) or this paragraph)
is $2.00 (that is, $6.00 reduced by 66\2/3\ percent of $6.00).
(4) Percentage for lower tier corporations other than second tier
corporation. For purposes of subparagraph (1) of this paragraph, if
stock of a lower tier corporation (other than a second tier corporation)
is owned within the meaning of section 958(a)(2) by the first tier
corporation on the date of the sale or exchange referred to in such
subparagraph (1), the percentage under this subparagraph shall be
computed in the following manner:
(i) First, determine the percentage for the second tier corporation
in accordance with subparagraph (2) of this paragraph.
(ii) Second, determine a partial percentage for each other lower
tier corporation in the same manner as the percentage for the second
tier corporation is determined. Thus, for example, the partial
percentage for a third tier corporation is determined by dividing (a)
the number of shares of stock of the third tier corporation which the
second tier corporation has owned directly for an uninterrupted 10-year
period ending on the date of the sale or exchange referred to in
subparagraph (1) of this paragraph, by (b) the total number of shares of
stock of such third tier corporation owned directly by such second tier
corporation on such date.
(iii) Third, the percentage for a third tier corporation is the
percentage for the second tier corporation multiplied by the partial
percentage for the third tier corporation. The percentage for a fourth
tier corporation is the percentage for the third tier corporation (as
determined in the preceding sentence) multiplied by the partial
percentage for the fourth tier corporation. In a similar manner, the
percentage for any other lower tier corporation may be determined.
(5) Example. The application of subparagraph (4) of this paragraph
may be illustrated by the following example:
Example: On January 1, 1967, Brown, a United States person
recognizes gain upon the sale of one share of the only class of stock of
W Corporation, which he has owned continuously since 1955. He includes a
portion of the gain in his gross income as a dividend under section
1248(a). W is the first tier corporation of a chain of foreign
corporations W, X, Y, and Z. W and Z each use the calendar year as the
taxable year. For 1964, Z was a less developed country corporation and
on each day of 1964 Z was a controlled foreign corporation. Additional
facts are set forth in the table below:
----------------------------------------------------------------------------------------------------------------
Shares directly owned by
preceding tier--
------------------------------ Column (2)
For divided by
Corporation--(1) uninterrupted column (3)
10-year period On Jan. 1, (percent)--(4)
ending Jan. 1, 1967--(3)
1967--(2)
----------------------------------------------------------------------------------------------------------------
X................................................................. 40 60 66\2/3\
Y................................................................. 30 40 75
Z................................................................. 20 30 66\2/3\
----------------------------------------------------------------------------------------------------------------
For 1964, the percentage referred to in subparagraph (4) of this
paragraph for Z is 33\1/3\ percent (66\2/3\% x 75% x 66\2/3\%).
(6) Special rule. For purposes of applying the provisions of this
paragraph, a lower tier corporation may be treated
[[Page 406]]
as a second tier corporation with respect to any of its stock which is
owned directly by a first tier corporation whereas such lower tier
corporation may be treated as a lower tier corporation other than a
second tier corporation with respect to other stock in such lower tier
corporation which is owned (within the meaning of section 958(a)(2)) by
such first tier corporation. Thus, for example, if corporations X, Y,
and Z are foreign corporations, X is a first tier corporation owning
directly 100 percent of the stock of Y and 40 percent of the stock of Z,
and in addition Y owns directly 60 percent of the stock of Z, then the
40 percent of the Z stock (which X owns directly) is considered to be
stock in a second tier corporation and the 60 percent of the Z stock
(which Y owns directly and which X is considered to own within the
meaning of section 958(a)(2)) is considered to be stock in a third tier
corporation.
[T.D. 6779, 29 FR 18133, Dec. 22, 1964, as amended by T.D. 7293, 38 FR
32803, Nov. 28, 1973; T.D. 7545, 43 FR 19652, May 8, 1978; T.D. 9345, 72
FR 41445, July 30, 2007; T.D. 9614, 78 FR 17041, Mar. 19, 2013]
Sec. 1.1248-4 Limitation on tax applicable to individuals.
(a) General rule--(1) Limitation on tax. Under section 1248(b), if
during a taxable year an individual sells or exchanges stock in a
foreign corporation, then in respect of the stock the increase in the
individual's income tax liability for such taxable year which is
attributable (under paragraph (b) of this section) to the amount
included in his gross income as a dividend under section 1248(a) shall
not be greater than an amount equal to the sum of:
(i) The excess, computed under paragraph (c) of this section in
respect of the stock of the United States taxes which would have been
paid by the corporation over the taxes (including United States taxes)
actually paid by the corporation, plus.
(ii) An amount equal to the increase in the individual's income tax
liability which would be attributable to the inclusion in his gross
income for such taxable year, as long-term capital gain, of an amount
equal to the excess of (a) the amount included in the individual's gross
income as a dividend under section 1248(a) in respect of such stock,
over (b) the excess referred to in subdivision (i) of this subparagraph.
(2) Share or block. In general, the limitation on tax attributable
(under paragraph (b) of this section) to the amount included in an
individual's gross income as a dividend under section 1248(a) shall be
determined separately for each share of stock sold or exchanged.
However, such determination may be made in respect of a block of stock
if earnings and profits attributable to the block are computed under
Sec. 1.1248-2 or 1.1248-3. See paragraph (b) of Sec. 1.1248-2 and
paragraph (a)(5) of Sec. 1.1248-3.
(3) Application of limitation. The provisions of subparagraph (1) of
this paragraph shall not apply unless the individual establishes:
(i) In the manner prescribed in Sec. 1.1248-7, the amount of the
earnings and profits of the corporation attributable under paragraph
(a)(1) of Sec. 1.1248-2 or under paragraph (a)(1) of Sec. 1.1248-3,
whichever is applicable, to the stock, and
(ii) The amount equal to the sum described in subparagraph (1) of
this paragraph, computed in accordance with the provisions of this
section.
(4) Example. The provisions of this paragraph may be illustrated by
the following example:
Example: On December 31, 1966, Smith, a United States person, sells
a share of stock of X Corporation which he has owned continuously since
December 31, 1965, and includes $100 of the gain on the sale in his
gross income as a dividend under section 1248(a). Both X and Smith use
the calendar year as the taxable year. The increase in Smith's income
tax liability for 1966 which is attributable (under paragraph (b) of
this section) to the inclusion of the $100 in his gross income as a
dividend is $70. X was a controlled foreign corporation on each day of
1966. The excess computed under paragraph (c) of this section in respect
of the share, of the United States taxes which X would have paid over
the taxes (including United States taxes) actually paid by X is $49.
Under section 1248(b), the limitation on the tax attributable to the
$100 included by Smith in his gross income as a dividend under section
1248(a) is $61.75, computed as follows:
[[Page 407]]
(i) Excess, computed under paragraph (c) of this .......... $49.00
section, of United States taxes which X
Corporation would have paid in 1966 over the
taxes actually paid by X in 1966...............
(ii) The amount determined under subparagraph
(1)(ii) of this paragraph:
The amount Smith included in his gross income $100.00
as a dividend under section 1248(a)..........
Less the excess referred to in subdivision (i) 49.00
of this example..............................
------------
Difference.................................... 51.00
Increase in Smith's tax liability attributable .......... 12.75
to including $51 in his gross income as long-
term capital gain (25 percent of $51)..........
-----------
(iii) Limitation on tax..................................... 61.75
(b) Tax attributable to amount treated as dividend--(1) General. For
purposes of paragraph (a)(1) of this section, in respect of a share (or
block) of stock in a foreign corporation sold or exchanged by an
individual during a taxable year, the tax attributable to the amount
included in his gross income as a dividend under section 1248(a) shall
be the amount which bears the same ratio to (i) the excess of (a) his
income tax liability for the taxable year determined without regard to
section 1248(b) over (b) such tax liability determined as if the portion
of the total gain recognized during the taxable year which is treated as
a dividend under section 1248(a) had not been recognized, as (ii) the
amount included as a dividend under section 1248(a) in respect of the
share (or block), bears to (iii) the total amount included as a dividend
under section 1248(a) in the individual's gross income for such taxable
year.
(2) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. (i) During 1963, Brown, an unmarried United States
person, sells a block of stock in a controlled foreign corporation. On
the sale, he recognizes $22,000 gain, of which $18,000 is treated as a
dividend under section 1248(a) and $4,000 as long-term capital gain.
Brown computes his income tax liability for his taxable year ending
December 31, 1963, under section 1201 (relating to alternative tax) in
accordance with the additional facts assumed in the following table:
------------------------------------------------------------------------
Computation of
income tax
Computation of liability as
income tax if the gain
liability treated as a
without regard divided under
to section section
1248(b) 1248(a) had
not been
recognized
------------------------------------------------------------------------
Income from salary...................... $300,000 $300,000
Long-term capital gain resulting from 2,000 2,000
sale of stock, less deduction for
capital gains under section 1202
($4,000 less $2,000)...................
Amount treated as a dividend under 18,000 0
section 1248(a)........................
-------------------------------
Adjusted gross income................... 320,000 302,000
Charitable contribution of $100,000 to (96,000) (90,600)
church (limited under section 170(b) to
30 percent of adjusted gross income)...
Other itemized deductions and personal (7,700) (7,700)
exemption..............................
-------------------------------
Taxable income.......................... 216,300 203,700
Less 50 percent of $4,000............... 2,000 2,000
===============================
Amount subject to partial tax under 214,300 201,700
section 1201(b)(1).....................
===============================
Partial tax............................. 169,833 158,367
25 percent of $4,000.................... 1,000 1,000
-------------------------------
Tax liability........................... 170,833 159,367
------------------------------------------------------------------------
(ii) The tax attributable to the $18,000 treated as a dividend under
section 1248(a) is $11,466 ($170,833 minus $159,367).
Example 2. Assume the same facts as in example (1) except that the
$18,000 treated as a dividend under section 1248(a) is attributable to
the sale of a block of stock in X Corporation and a block of stock in Y
Corporation. Assume further that $10,000 of the gain on the block of X
stock was treated as a dividend and that $8,000 of the gain on the block
of Y stock was treated as a dividend. Thus, the tax attributable to the
amount treated as a dividend in respect of the block of X stock is
$6,370 ($10,000/$18,000 of $11,466) and the amount in respect of the
block of Y stock is $5,096 ($8,000/$18,000 of $11,466). The result would
be the same if both blocks of stock were blocks of stock in the same
corporation.
(c) Excess (of United States taxes which would have been paid over
taxes actually paid) attributable to a share (or block)--(1) General.
For purposes of paragraph (a)(1)(i) of this section:
(i) The term taxes means income, war profits, or excess profits
taxes, and
[[Page 408]]
(ii) The excess (and the portion of such excess attributable to an
individual's share or block of stock in a foreign corporation) of the
United States taxes which would have been paid by the corporation over
the taxes (including United States taxes) actually paid by the
corporation, for the period or periods the stock was held (or was
considered to be held by reason of the application of section 1223) by
the individual in taxable years of the corporation beginning after
December 31, 1962, while the corporation was a controlled foreign
corporation, shall be computed in accordance with the steps set forth in
subparagraphs (2), (3), and (4) of this paragraph.
(2) Step 1. For each taxable year of the corporation beginning after
December 31, 1962, in respect of the individual's share (or block) of
such stock (i) the taxable income of the corporation shall be computed
in the manner prescribed in paragraph (d) of this section, and (ii) the
excess (and the portion of such excess attributable to the stock of the
United States taxes which would have been paid by the corporation on
such taxable income over the taxes (including United States taxes)
actually paid by the corporation shall be computed in the manner
prescribed in paragraph (e) of this section.
(3) Step 2. If during such taxable year the corporation is a first
tier corporation to which paragraph (f) of this section applies, (i) the
excess (and the portion of such excess attributable to the individual's
share, or block, of stock in the first tier corporation) of the United
States taxes which would have been paid by any lower tier corporation
over the taxes (including United States taxes) actually paid by such
lower tier corporation shall be computed under paragraph (f) of this
section, and (ii) such portion shall be added to the portion of the
excess attributable to the individual's share (or block) of such stock
as determined in step 1 for such taxable year.
(4) Step 3. The excess, in respect of the individual's share (or
block), of the United States taxes which would have been paid by the
corporation over the taxes actually paid by the corporation shall be the
sum of the portions computed for each such taxable year in the manner
prescribed in steps 1 and 2.
(d) Taxable income. For purposes of paragraph (c)(2)(i) of this
section, taxable income shall be computed in respect of an individual's
share (or block) in accordance with the following rules:
(1) Application of principles of Sec. 1.952-2. Except as otherwise
provided in this paragraph, the principles of paragraphs (a)(1), (b)(1),
and (c) of Sec. 1.952-2 (other than subparagraphs (2)(iii)(b), (2)(v),
(5)(i), and (6) of such paragraph (c)) shall apply.
(2) Effect of elections. In respect of a taxable year of a foreign
corporation, no effect shall be given to an election or an adoption of
accounting method unless for such taxable year effect is given to such
election or adoption of accounting method under paragraph (d)(1) of
Sec. 1.1248-2 or paragraph (b)(1) of Sec. 1.1248-3, whichever is
applicable.
(3) The deductions for certain dividends received provided in
sections 243, 244, and 245 shall not be allowed.
(4) Deduction for taxes. In computing the amount of the deduction
allowed under section 164, there shall be excluded income, war profits,
or excess profits taxes paid or accrued which are imposed by the
authority of any foreign country or possession of the United States.
(5) Capital loss carryover. In determining the amount of a net
capital loss to be carried forward under section 1212 to the taxable
year:
(i) No net capital loss shall be carried forward from a taxable year
beginning before January 1, 1963.
(ii) The portion of a net capital loss or a capital gain net income
(net capital gain for taxable years beginning before January 1, 1977)
for a taxable year beginning after December 31, 1962, which shall be
taken into account shall be the amount of such loss or gain (as the case
may be), multiplied by the percentage which (a) the number of days in
such taxable year during which the individual held (or was considered to
have held by reason of the application of section 1223) the share (or
block) of stock sold or exchanged while the corporation was a controlled
foreign corporation, bears to (b) the total number of days in such
taxable year.
[[Page 409]]
(iii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. Corporation X is a foreign corporation which was created
on January 1, 1963, and which uses the calendar year as its taxable
year. X was a controlled foreign corporation on each day of the period
March 15, 1963, through December 31, 1965, but was not a controlled
foreign corporation on any day during the period January 1, 1963,
through March 14, 1963. On December 31, 1965, Smith, a United States
person, sells a share of X stock which he has owned continuously since
January 1, 1963. A portion of the gain recognized on the sale is
includible in Smith's gross income as a dividend under section 1248(a).
X had a net capital loss (determined without regard to subchapter N,
chapter 1 of the Code) of $200 for 1963. Since, however, X was a
controlled foreign corporation for only 292 days in 1963, for purposes
of determining the net capital loss carryover to 1964 the portion of the
net capital loss of $200 for 1963 which Smith takes into account under
subdivision (ii) of this subparagraph is $160 (292/365 of $200), and,
accordingly, the amount of the net capital loss carryover to 1964 is
$160.
Example 2. Assume the same facts as in example (1), except that X
was not a controlled foreign corporation on any day of the period May
26, 1964, through June 30, 1965. Assume further that X had a net capital
gain (capital gain net income for taxable years beginning after December
31, 1976) (determined without regard to subchapter N, chapter 1, of the
Code) of $160 for 1964. In computing X's taxable income for 1964 under
this paragraph, Smith applies the net capital loss carryover of $160
from 1963 to reduce the net capital gain of $160 for 1964 to zero.
Since, however, X was a controlled foreign corporation for only 146 days
in 1964, for purposes of computing the portion of the 1963 capital loss
of $160 which is a net capital loss carryover to 1965, the portion of
the 1964 capital gain which Smith takes into account under subdivision
(ii) of this subparagraph is $63.83 (\146/366\ of $160). Thus, the net
capital loss carryover to 1965 is $96.17 ($160 minus $63.83).
(6) Net operating loss deduction. (i) The individual shall reduce
the taxable income (computed under subparagraphs (1) through (5) of this
paragraph) of the corporation for the taxable year by the amount of the
net operating loss deduction of the corporation computed under section
172, as modified in the manner prescribed in this subparagraph.
(ii) The rules of subparagraphs (1) through (5) of this paragraph
shall apply for purposes of determining the excess referred to in
section 172(c) and the taxable income referred to in section 172(b)(2).
(iii) A net operating loss shall not be carried forward from, or
carried back to, a taxable year beginning before January 1, 1963.
(iv) The portion of a net operating loss incurred, or of taxable
income earned, in a taxable year beginning after December 31, 1962,
which shall be taken into account under section 172(b)(2) shall be the
amount of such loss or income (as the case may be), multiplied by the
percentage which (a) the number of days in such taxable year during
which the individual held (or was considered to have held by reason of
the application of section 1223) the share (or block) of stock sold or
exchanged while the corporation was a controlled foreign corporation,
bears to (b) the total number of days in such taxable year.
(v) For illustrations of the principles of this subparagraph, see
the examples relating to net capital loss carryovers in subparagraph
(5)(iii) of this paragraph.
(7) Adjustment for amount previously included in gross income of
United States shareholders. In respect of the individual's share (or
block) of stock sold or exchanged, the taxable income of the corporation
for the taxable year (determined without regard to this subparagraph and
subparagraph (8) of this paragraph) shall be reduced (but not below
zero) by an amount equal to the sum of the amounts included under
section 951 in the gross income of United States shareholders (as
defined in section 951(b)) of the corporation for the taxable year.
(8) Adjustment for distributions. In respect of the individual's
share (or block) of stock sold or exchanged, the taxable income of the
corporation for the taxable year (determined without regard to this
subparagraph) shall be reduced (but not below zero) by the amount of the
distributions (other than in redemption of stock under section 302(a) or
303) made by the corporation out of earnings and profits of such taxable
year (within the meaning of section 316(a)(2)). For purposes of the
preceding sentence, distributions shall
[[Page 410]]
be taken into account only to the extent not excluded from the gross
income of the United States shareholders of the corporation under
section 959.
(e) Excess attributable to a share (or block) of stock--(1) Excess
of United States taxes which would have been paid over taxes actually
paid. For purposes of paragraph (c)(2)(ii) of this section, in respect
of a taxable year of a foreign corporation, the portion of the excess
under this subparagraph which is attributable to an individual's share
(or block) of such stock shall be an amount equal to:
(i) The excess (if any) of (a) the United States taxes which would
have been paid by the corporation on its taxable income (computed under
paragraph (d) of this section) for the taxable year had it been taxed as
a domestic corporation under chapter 1 of the Code (but without regard
to subchapters F, G, H, L, M, N, S, and T thereof) for such taxable
year, over (b) the income, war profits, or excess profits taxes actually
paid by the corporation during such taxable year (including such taxes
paid to the United States),
(ii) Multiplied by the percentage that (a) the number of days in
such taxable year of the corporation during the period or periods the
share (or block) was held (or was considered as held by reason of the
application of section 1223) by the individual while the corporation was
a controlled foreign corporation, bears to (b) the total number of days
in such taxable year,
(iii) If the computation is made in respect of a block, multiplied
by the number of shares in the block, and
(iv) Divided by the number of shares in the corporation outstanding,
or deemed under paragraph (c)(2) of Sec. 1.1248-3 to be outstanding, on
each day of such taxable year.
(2) Example. The provisions of this paragraph may be illustrated by
the following example:
Example: (i) Jones, a United States person, owns on each day of 1963
10 shares of the 100 shares of the only class of outstanding stock of X
corporation. He sells one of such shares on December 31, 1963. X
corporation is a controlled foreign corporation on each day of 1963 and
Jones and X each use the calendar year as the taxable year. For 1963,
the excess of the United States taxes which would have been paid by X
had it been taxable as a domestic corporation over the taxes (including
United States taxes) actually paid by X is $23,500, computed as follows:
Amount subject to partial tax under section 1201(a)(1), as
computed by Jones:
Taxable income............................................ $300,000
Less excess of net long-term capital gain over net short- 100,000
term capital loss........................................
-------------
Amount subject to partial tax........................... 200,000
-------------
Excess determined under subparagraph (1)(i) of
this paragraph:
30 percent x $25,000.......................... $7,500
52 percent x $175,000......................... 91,000
------------
Partial tax............................................... 98,500
25 percent x $100,000..................................... 25,000
-------------
United States taxes X would have paid (alternative tax 123,500
computed under section 1201(a))........................
Less income taxes X actually paid to:
United States................................. $10,000
Foreign countries............................. 90,000
------------
Total................................................... $100,000
-------------
Excess.................................................. 23,500
Multiplied by:
Percentage determined under subparagraph (1)(ii) of this
paragraph:
Since on each day of 1963, Jones held the share of X 100%
stock while X was a controlled foreign corporation, the
percentage equals......................................
-------------
Total................................................... $23,500
(ii) The portion of the excess determined in subdivision (i) of this
example which is attributable to the share held by Jones is $235, that
is, the amount of such excess ($23,500), divided by the number of shares
of X deemed to be outstanding on each day of 1963 (100).
(3) More than one class of stock. If a foreign corporation for a
taxable year has more than one class of stock outstanding, then before
applying subparagraph (1) of this paragraph the excess (if any) which
would be determined under subparagraph (1)(i) of this paragraph shall be
allocated to each class of stock in accordance with the principles of
paragraph (e) (2) and (3) of Sec. 1.951-1, applied as if the
corporation were a controlled foreign corporation on each day of such
taxable year.
(f) Subsidiaries of foreign corporations--(1) Excess for lower tier
corporation attributable to taxable year of first tier corporation. For
purposes of paragraph (c)(3) of this section, if the provisions of
paragraph (a)(3) of Sec. 1.1248-2 or paragraph (f) of Sec. 1.1248-3
apply in the case of the sale or exchange by an individual of a share
(or block) of stock in
[[Page 411]]
a first tier corporation, then in respect of a taxable year of a lower
tier corporation (beginning after December 31, 1962) which includes at
least one day which falls within a taxable year of the first tier
corporation (beginning after December 31, 1962), the portion of the
excess under this subparagraph attributable to the share shall be an
amount equal to:
(i) The excess (if any) of (a) the United States taxes which would
have been paid by the lower tier corporation on its taxable income
(computed under paragraph (g) of this section) for such taxable year of
the lower tier corporation had it been taxed as a domestic corporatin
under chapter 1 of the Code (but without regard to subchapters F, G, H,
L, M, N, and T thereof) for such taxable year of the lower tier
corporation, over (b) the income, war profits, or excess profits taxes
actually paid by the lower tier corporation during such taxable year
(including such taxes paid to the United States),
(ii) Multiplied by each of the percentages described under paragraph
(f)(2)(ii), (iii), and (iv) of Sec. 1.1248-3 in respect of such taxable
year of the first tier corporation,
(iii) If the computation is made in respect of a block of stock,
multiplied by the number of shares in the block, and
(iv) Divided by the number of shares in the first tier corporation
outstanding, or deemed under paragraph (c)(2) of Sec. 1.1248-3 to be
outstanding, on each day of such taxable year of the first tier
corporation.
(2) More than one class of stock. If a foreign corporation for a
taxable year has more than one class of stock outstanding, then before
applying subparagraph (1) of this paragraph the principles of paragraph
(e)(3) of this section shall apply.
(g) Taxable income of lower tier corporations--(1) General. For
purposes of paragraph (f)(1)(i) of this section, in respect of the
individual's share (or block) the taxable income of a lower tier
corporation shall be computed in the manner provided in paragraph (d) of
this section, except as provided in this paragraph.
(2) Capital loss carryover. For purposes of subparagraph (1) of this
paragraph, the provisions of paragraph (d)(5)(ii) of this section shall
not apply. In determining the amount of a net capital loss to be carried
forward under section 1212 to the taxable year of a lower tier
corporation, the portion of a net capital loss or a capital gain net
income (net capital gain for taxable years beginning before January 1,
1977) for a taxable year of the lower tier corporation beginning after
December 31, 1962, which shall be taken into account shall be the amount
of such loss or gain (as the case may be), multiplied by the percentage
which (i) the number of days in such taxable year during the period or
periods the individual held (or was considered to have held by reason of
the application of section 1223) the share (or block) of stock in the
first tier corporation sold or exchanged while the first tier
corporation owned (within the meaning of section 958 (a)) stock in the
lower tier corporation while the lower tier corporation was a controlled
foreign corporation, bears to (ii) the total number of days in such
taxable year.
(3) Net operating loss deduction. For purposes of subparagraph (1)
of this paragraph, the provisions of paragraph (d)(6)(iv) of this
section shall not apply. In determining the amount of the net operating
loss deduction for a taxable year of a lower tier corporation, the
portion of a net operating loss incurred, or of taxable income earned,
in a taxable year of the lower tier corporation beginning after December
31, 1962, which shall be taken into account under section 172(b)(2)
shall be the amount of such loss or income (as the case may be)
multiplied by the percentage described in subparagraph (2) of this
paragraph for such taxable year.
[T.D. 6779, 29 FR 18139, Dec. 22, 1964, as amended by T.D. 7545, 43 FR
19653, May 8, 1978; T.D. 7728, 45 FR 72650, Nov. 3, 1980]
Sec. 1.1248-5 Stock ownership requirements for less developed
country corporations.
(a) General rule--(1) Requirements. For purposes of paragraph (e)(4)
of Sec. 1.1248-3, a United States person shall be considered as
satisfying the requirements of this paragraph with respect to a share
(or block) of stock of a foreign corporation if on the date he sells or
exchanges such share (or block):
[[Page 412]]
(i) The 10-year stock ownership requirement of paragraph (b) of this
section is met with respect to such share (or block), and
(ii) In the case of a United States person which is a domestic
corporation, the requirement of paragraph (c) of this section, if
applicable, is met.
(2) Ownership of stock. For purposes of this section:
(i) The rules for determining ownership of stock prescribed by
section 958 (a) and (b) shall apply.
(ii) Stock owned by a United States person who is an individual,
estate, or trust which was acquired by reason of the death of the
predecessor in interest of such United States person shall be considered
as owned by such United States persons during the period such stock was
owned by such predecessor in interest, and during the period such stock
was owned by any other predecessor in interest if between such United
States person and such other predecessor in interest there was no
transfer other than by reason of the death of an individual.
(b) 10-year stock ownership requirement--(1) General. A United
States person meets the 10-year stock ownership requirement with respect
to a share (or block) of stock in a foreign corporation which he sells
or exchanges only if the share (or block) was owned (under the rules of
paragraph (a)(2) of this section) by such person for a continuous period
of at least 10 years ending on the date of the sale or exchange. See the
first sentence of section 1248(d)(3). Thus, for example, if Jones, a
United States person, sells a share of stock in a foreign corporation on
January 1, 1965, the 10-year stock ownership requirement is met with
respect to a share only if the share was owned (under the rules of
paragraph (a)(2) of this section) by Jones continuously from January 1,
1955, to January 1, 1965. If a foreign corporation has not been in
existence for at least 10 years on the date of the sale or exchange of
the share, the 10-year stock ownership requirement cannot be met.
(2) Special rule. For purposes of this paragraph, a United States
person shall be considered to have owned stock during the period he was
considered to have held the stock by reason of the application of
section 1223.
(c) Disqualification of domestic corporation as a result of changes
in ownership of its stock--(1) General. (i) For purposes of paragraph
(a)(1)(ii) of this section, the requirement of this paragraph must be
met only if, on at least one day during the 10-year period ending on the
date of the sale or exchange by a domestic corporation of a share of
stock in a foreign corporation, one or more noncorporate United States
shareholders (as defined in subdivision (iii) of this subparagraph) own
more than 50 percent of the total combined voting power of all classes
of stock entitled to vote of the domestic corporation.
(ii) The requirement of this paragraph is that if one or more
persons are noncorporate United States shareholders on the first such
day (referred to in subdivision (i) of this subparagraph), such person
or persons continue after such first day, at all times during the
remainder of such 10-year period, to own in the aggregate more than 50
percent of the total combined voting power of all classes of stock
entitled to vote of the domestic corporation. For purposes of
determining whether a domestic corporation meets the requirement of this
paragraph, the stock owned by a United States person who is a
noncorporate United States shareholder of a domestic corporation on such
first day shall not be counted at any time after he ceases during such
10-year period to be a noncorporate United States shareholder of such
corporation.
(iii) For purposes of this paragraph, the term noncorporate United
States shareholder means, with respect to a domestic corporation, a
United States person who is an individual, estate, or trust and who owns
10 percent or more of the total combined voting power of all classes of
stock of such domestic corporation.
(iv) For purposes of this paragraph, the percentage of the total
combined voting power of stock of a foreign corporation owned by a
United States person shall be determined in accordance with the
principles of section 951(b) and the regulations thereunder.
[[Page 413]]
(2) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. During the entire period beginning December 31, 1954, and
ending December 31, 1964, domestic corporation N owns all the stock of
controlled foreign corporation X, a less developed country corporation.
On December 31, 1964, N recognizes gain upon the sale of all its X
stock. A, B, and C, who are unrelated individuals, were the only United
States persons owning, or considered as owning, 10 percent or more of
the total combined voting power of all classes of stock entitled to vote
of N at any time during the 10-year period December 31, 1954, through
December 31, 1964. The percentages of the total combined voting power in
N, which A, B, and C owned during such 10-year period, are as follows:
----------------------------------------------------------------------------------------------------------------
Dec. 31, 1954- Apr. 2, 1957- Oct. 2, 1959-
Owner Apr. 1, 1957 Oct. 1, 1959 Dec. 31, 1964
(Percent) (Percent) (Percent)
----------------------------------------------------------------------------------------------------------------
A.............................................................. 20 20 20
B.............................................................. 9 30 30
C.............................................................. 30 15 9
----------------------------------------------------------------------------------------------------------------
Domestic corporation N does not meet the requirement of this paragraph
with respect to the stock of controlled foreign corporation X for the
following reasons:
(i) April 2, 1957, is the first day (during the 10-year period
ending on December 31, 1964, the date N sells the X stock) on which
noncorporate United States shareholders of N own more than 50 percent of
the total combined voting power in N, and thus the requirement of this
paragraph must be met. See subparagraph (1)(i) of this paragraph.
Although A, B, and C did own, in the aggregate, more than 50 percent of
such voting power before April 2, 1957, the voting power owned by B is
not counted because B was not a noncorporate United States shareholder
of N before such date.
(ii) Although C is a noncorporate United States shareholder on April
2, 1957, C ceases to own 10 percent or more of the total combined voting
power in N on October 2, 1959. Thus, after October 1, 1959, the N stock
which C owns is not counted for purposes of determining whether the
more-than-50-percent stock ownership test is met. See subparagraph
(1)(ii) of this paragraph. Accordingly, after October 1, 1959, the
requirement of this paragraph is not met.
Example 2. Assume the same facts as in example (1), except that B's
wife owns directly 5 percent of the total combined voting power in N
from December 31, 1954, to December 31, 1964. On the basis of the
assumed facts, N meets the requirement of this paragraph with respect to
the stock of controlled foreign corporation X for the following reasons:
(i) December 31, 1954, is the first day (of the 10-year period
ending on the date N sells the X stock) on which noncorporate United
States shareholders of N own more than 50 percent of the total combined
voting power in N. B is a noncorporate United States shareholder on such
date because he owns, and is considered as owning, 14 percent of the
total combined voting power in N (9 percent directly, and, under section
958(b), 5 percent constructively). Thus, on December 31, 1954,
noncorporate United States shareholders A, B, and C own, in the
aggregate, more than 50 percent of the total combined voting power in N.
(ii) A, B, and C, the noncorporate United States shareholders of N
on December 31, 1954, own, and are considered as owning, more than 50
percent of the total voting power of N from December 31, 1954, to
October 1, 1959. Since beginning on October 2, 1959, A owns 20 percent
and B owns, and is considered as owning, 35 percent of the total
combined voting power in N, A and B owns, and are considered as owning,
more than 50 percent of the total combined voting power in N from
October 2, 1959, to December 31, 1964. Therefore, the requirement of
this paragraph is met.
(d) Application of section to lower tier corporation--(1) General.
For purposes of paragraph (g)(1)(ii) of Sec. 1.1248-3, a United States
person satisfies the requirements of this subparagraph in respect of
stock of a lower tier corporation which such person, by reason of his
direct ownership of the share (or block) of the first tier corporation
sold or exchanged, owned within the meaning of section 958(a)(2) on the
date he sold or exchanged such share (or block), if on such date:
(i) The 10-year stock ownership requirement of paragraph (b) of this
section is met by such person with respect to any stock in the lower
tier corporation which such person so owned, and
(ii) In the case of a United States person which is a domestic
corporation, the requirement of paragraph (c) of this section, if
applicable, is met.
(2) Special rule. For purposes of this paragraph, in applying
paragraphs (b) and (c) of this section, the sale or exchange of a share
(or block) of stock in a first tier corporation by a United States
person shall be deemed to be the sale or exchange of any stock in a
lower tier corporation which the person, by reason of his direct
ownership of such share (or block) of the first tier corporation, owned
within the meaning
[[Page 414]]
of section 958(a)(2) on the date he actually sold or exchanged such
share (or block) in the first tier corporation.
[T.D. 6779, 29 FR 18142, Dec. 22, 1964]
Sec. 1.1248-6 Sale or exchange of stock in certain domestic
corporations.
(a) General rule. If a United States person recognizes gain upon the
sale or exchange of a share (or block) of stock of a domestic
corporation which was formed or availed of principally for the holding,
directly or indirectly, of stock of one or more foreign corporations,
and if the conditions of paragraph (a)(2) of Sec. 1.1248-1 would be met
by such person in respect of the share (or block) if the domestic
corporation were a foreign corporation, then section 1248 shall apply in
respect of such gain in accordance with the rules provided in paragraph
(b) of this section. See paragraph (d) of this section for a rule
suspending the application of this section in certain circumstances.
(b) Application. (1) The gain referred to in paragraph (a) of this
section shall be included in the gross income of the United States
person as a dividend under section 1248(a) to the extent of the earnings
and profits attributable under Sec. 1.1248-2 or Sec. 1.1248-3,
whichever is applicable, to the share (or block), computed, however, in
accordance with the following rules:
(i) The domestic corporation shall be treated as if it were a first
tier foreign corporation;
(ii) If, after the application of subdivision (i) of this
subparagraph, the provisions of paragraph (a)(3) of Sec. 1.1248-2 or
paragraph (f) of Sec. 1.1248-3 (as the case may be) would apply in
respect of a foreign corporation the stock of which is owned (within the
meaning of section 958(a)) by the domestic corporation treated as the
first tier corporation, such foreign corporation shall be considered a
lower tier corporation;
(iii) Except to the extent provided in subdivision (iv) of this
subparagraph, the earnings and profits of the domestic corporation
treated as the first tier corporation accumulated for a taxable year, as
computed under paragraph (d) of Sec. 1.1248-2 or paragraph (b) of Sec.
1.1248-3 (as the case may be), shall be considered to be zero; and
(iv) If, during a taxable year, a domestic corporation treated as
the first tier corporation realizes gain upon the sale or exchange of
stock in a foreign corporation, and solely by reason of the application
of section 337 (relating to certain liquidations) the gain was not
recognized, then the earnings and profits of such domestic corporation
accumulated for the taxable year, as computed under paragraph (d) of
Sec. 1.1248-2 or paragraph (b) of Sec. 1.1248-3 (as the case may be),
shall be considered to be an amount equal to the portion of such gain
realized during the taxable year which, if section 337 had not applied,
would have been treated as a dividend under section 1248(a).
(2) If the person selling or exchanging the stock in the domestic
corporation is an individual, the limitation on tax attributable to the
amount included in his gross income as a dividend under subparagraph (1)
of this paragraph shall be determined, in accordance with the principles
of paragraph (f) of Sec. 1.1248-4, by treating the domestic corporation
as a first tier corporation.
(3)(i) If the earnings and profits of the foreign corporation or
corporations (or of the domestic corporation treated as a first tier
corporation) to be taken into account under subparagraph (1) of this
paragraph are not established in the manner provided in paragraph (a)(1)
of Sec. 1.1248-7, all of the gain from the sale or exchange of the
share (or block) of the domestic corporation shall be treated as a
dividend.
(ii) To the extent that the person does not establish, in the manner
provided in paragraph (c) of Sec. 1.1248-7, the foreign taxes paid by
such foreign corporation or corporations to be taken into account for
purposes of computing the limitation on tax attributable to a share,
such foreign taxes shall not be taken into account for purposes of such
computation.
(c) Corporation formed or availed of principally for holding stock
of foreign corporations. Whether or not a domestic corporation is formed
or availed of principally for the holding, directly or indirectly, of
stock of one or more foreign corporations shall be determined on the
basis of all the facts and circumstances of each particular case.
[[Page 415]]
(d) Temporary suspension of section 1248(e). Section 1248(e) and the
rules of this section do not apply to a sale, exchange, or other
disposition of the stock of a domestic corporation during a period when
capital gains are taxed at a rate that equals or exceeds the rate at
which ordinary income is taxed.
(e) Effective/applicability date. Paragraph (d) of this section
applies to a sale, exchange, or other disposition of the stock of a
domestic corporation on or after September 21, 1987.
[T.D. 6779, 29 FR 18143, Dec. 22, 1964, as amended by T.D. 9614, 78 FR
17042, Mar. 19, 2013]
Sec. 1.1248-7 Taxpayer to establish earnings and profits and foreign
taxes.
(a) In general. (1) If a taxpayer sells or exchanges stock in a
foreign corporation which was a controlled foreign corporation and the
Commissioner determines that the taxpayer has not established the amount
of the earnings and profits of the corporation attributable to the stock
under Sec. 1.1248-2 or Sec. 1.1248-3, whichever is applicable, all the
gain from such sale or exchange shall be treated as a dividend under
section 1248(a). See section 1248(h). A taxpayer shall be considered to
have established such amount if:
(i) He attaches to his income tax return, filed on or before the
last day prescribed by law (including extensions thereof) for his
taxable year in which he sold or exchanged the stock, the schedule
prescribed by paragraph (b) of this section or, if such last day is
before April 1, 1965, he files such schedule before such date with the
district director with whom such return was filed, and
(ii) He establishes in the manner prescribed by paragraph (d) of
this section the correctness of each amount shown on such schedule.
(2) Notwithstanding an omission of information from, or an error
with respect to an amount shown on, the schedule referred to in
subparagraph (1)(i) of this paragraph, a taxpayer shall be considered to
have complied with such subparagraph (1)(i) if:
(i) He establishes that such omission or error was inadvertent, or
due to reasonable cause and not due to willful neglect, and that he has
substantially complied with the requirements of this section, and
(ii) The taxpayer corrects such omission or error at the time when
he complies with paragraph (d) of this section.
(3) For the requirement to establish the amount of foreign taxes to
be taken into account for purposes of section 1248(b), see paragraph (c)
of this section.
(b) Schedule attached to return. (1) The taxpayer shall attach to
his income tax return for his taxable year in which he sold or exchanged
the stock, a schedule showing his name, address, and identifying number.
Except to the extent provided in paragraph (e) of this section, the
schedule shall also show the amount of the earnings and profits
attributable under paragraph (a) of Sec. 1.1248-2 or paragraph (a) of
Sec. 1.1248-3 (as the case may be) to the stock, and, in order to
support the computation of such amount, any additional information
required by subparagraphs (2), (3), (4), and (5) of this paragraph.
(2) The schedule shall also show for the first tier corporation, and
for each lower tier corporation as to which information is required
under subparagraph (4) of this paragraph, (i) the name of the
corporation, (ii) the country under whose laws the corporation is
created or organized, and (iii) the last day of the taxable year which
the corporation regularly uses in computing its income.
(3) If the amount of earnings and profits attributable to a block of
stock sold or exchanged are computed under Sec. 1.1248-2, the schedule
shall also show:
(i) For each taxable year of the corporation, beginning after
December 31, 1962, during the period the taxpayer held (or was
considered to have held by reason of the application of section 1223,
taking into account Sec. 1.1248-8) the block, (a) the earnings and
profits accumulated for each such taxable year computed under paragraph
(d) of Sec. 1.1248-2, and (b) the sum thereof computed under paragraph
(e) (1)(i) and (2) of Sec. 1.1248-2,
(ii) The number of shares in the block and the total number of
shares of the corporation outstanding during such period,
(iii) If during the period the person held (or is considered to have
held by
[[Page 416]]
reason of the application of section 1223, taking into account Sec.
1.1248-8) the block any amount was included under section 951 in the
gross income of such person (or another person) in respect of the block,
the computation of the excess referred to in paragraph (e)(3)(ii) of
Sec. 1.1248-2, and
(iv) If the amount of earnings and profits of a lower tier
corporation attributable to the block are computed under paragraph
(a)(3) of Sec. 1.1248-2, (a) the number of shares in the lower tier
corporation which the taxpayer owns within the meaning of section
958(a)(2)(b) the total number of shares of such lower tier corporation
outstanding during such period, and (c) in respect of such lower tier
corporation, the information prescribed in subdivisions (i) and (iii) of
this subparagraph.
(4) If the amount of earnings and profits attributable to a share
(or block) sold or exchanged are computed under Sec. 1.1248-3, the
schedule shall also show for each taxable year of the corporation
beginning after December 31, 1962, any day of which falls in a period or
periods the taxpayer held (or was considered to have held by reason of
the application of section 1223, taking into account Sec. 1.1248-8) the
stock while the corporation was a controlled foreign corporation:
(i) The number of days in such period or periods, but only if such
number is less than the total number of days in such taxable year,
(ii) The earnings and profits accumulated for the taxable year
computed under paragraph (b) of Sec. 1.1248-3,
(iii) The number of shares in the corporation outstanding, or deemed
under paragraph (c)(2) of Sec. 1.1248-3 to be outstanding, on each day
of the taxable year,
(iv) The taxpayer's tentative ratable share computed under paragraph
(c) or (d) (as the case may be) of Sec. 1.1248-3,
(v) The amount of, and a short description of each adjustment to,
the tentative ratable share under paragraph (e) of Sec. 1.1248-3, and
(vi) The amount of the ratable share referred to in paragraph (e)(1)
of Sec. 1.1248-3.
(5) In respect of a taxable year referred to in subparagraph (4) of
this paragraph of a first tier corporation, if the taxpayer is required
to compute under paragraph (f)(5) of Sec. 1.1248-3 his ratable share of
the earnings and profits for a taxable year of the lower tier
corporation attributable to such taxable year of such first tier
corporation, then for such taxable year of the lower tier corporation
the schedule shall show:
(i) The earnings and profits accumulated for the taxable year of the
lower tier corporation, computed under paragraph (b) of Sec. 1.1248-3,
(ii) Each percentage described in paragraph (f)(2) (ii), (iii), and
(iv) of Sec. 1.1248-3,
(iii) The amount of the taxpayer's tentative ratable share computed
under paragraph (f) (2) or (4) (as the case may be) of Sec. 1.1248-3,
(iv) The amount of, and a short description of each adjustment to,
the tentative ratable share under paragraph (f)(5) of Sec. 1.1248-3,
and
(v) The amount of the ratable share referred to in paragraph
(f)(5)(i) of Sec. 1.1248-3.
(c) Foreign taxes. (1) If the taxpayer fails to establish any
portion of the amount of any foreign taxes which he is required to
establish by subparagraph (2) of this paragraph, then such portion shall
not be taken into account under section 1248(b)(1)(B):
(2) The taxpayer shall establish in respect of the stock he sells or
exchanges the amount of the foreign taxes described in section
1248(b)(1)(B) paid by the first tier corporation for each taxable year
of such corporation for which the information is required under
paragraph (b) (3) or (4) of this section, and the amount of such taxes
paid by each lower tier corporation for each taxable year (as to which
information is required under paragraph (b) (3)(iv) or (5) of this
section) of each such lower tier corporation. A taxpayer shall be
considered to have established the amount of such foreign taxes if:
(i) He attaches to the schedule described in paragraph (b) of this
section a supplementary schedule which, except to the extent provided in
paragraph (e) of this section, sets forth the amount of such foreign
taxes for each taxable year (of the first tier corporation and of each
such lower tier corporation) as to which such amount
[[Page 417]]
must be established under this subparagraph, and
(ii) He establishes in the manner prescribed by paragraph (d)(2) of
this section the correctness of each amount shown on such supplementary
schedule.
(d) Establishing amounts on schedules. (1) A taxpayer shall be
considered to have established, in respect of the stock he sold or
exchanged, the correctness of an amount shown on a schedule described in
paragraph (b) of this section only if he produces or provides within 180
days after demand by the district director (or within such longer period
to which such director consents):
(i) The books of original entry, or similar systematic accounting
records maintained by any person or persons on a current basis as
supplements to such books, which establish to the satisfaction of the
district director the correctness of each such amount, and
(ii) In respect of any such books or records which are not in the
English language, either an accurate English translation of any such
records as are demanded, or the services of a qualified interpreter
satisfactory to such director.
(2) A shareholder shall be considered to have established in respect
of such stock the correctness of an amount shown on a supplementary
schedule described in paragraph (c) of this section only if he produces
or provides within 180 days after demand by the district director (or
within such longer period to which such director consents):
(i) Evidence described in paragraph (a)(2) of Sec. 1.905-2 of such
amount, or
(ii) Secondary evidence of such amount, in the same manner and to
the same extent as would be permissible under paragraph (b) of Sec.
1.905-2 in the case of a taxpayer who claimed the benefits of the
foreign tax credit in respect of such amount.
(e) Insufficient information at time return is filed. If stock in a
foreign corporation, which was a controlled foreign corporation, is sold
or exchanged by a taxpayer during a taxable year of the corporation (or
of a lower tier corporation) which ends after the last day of the
taxpayer's taxable year in which the sale or exchange occurs, and if:
(1) For the taxpayer's taxable year, the last day referred to in
paragraph (a)(1) of this section for filing his income tax return with a
schedule prescribed in paragraph (b) of this section, and, if
applicable, with a supplemental schedule prescribed in paragraph (c) of
this section, or
(2) The last day referred to in paragraph (a)(1) of this section
(that is, April 1, 1965) for filing any such schedule or schedules with
the district director with whom such return was filed,
Is not later than 90 days after the close of such taxable year of any
such corporation, then such return with such schedule or schedules may
be filed, or any such schedule or schedules may be filed, on the basis
of estimates of amounts or percentages (for any such taxable year of any
such corporation) required to be shown on any such schedule or
schedules. If any such estimate differs from the actual amount or
percentage, the taxpayer shall, within 90 days after the close of any
such taxable year of any such corporation, file (or attach to a claim
for refund or amended return filed) at the office of the district
director with whom he filed the return a new schedule or schedules
showing the actual amounts or percentages.
[T.D. 6779, 29 FR 18143, Dec. 22, 1964, as amended by T.D. 9345, 72 FR
41445, July 30, 2007: T.D. 9614, 78 FR 17041, Mar. 19, 2013]
Sec. 1.1248-8 Earnings and profits attributable to stock following
certain non-recognition transactions.
(a) Scope. This section sets forth rules for the attribution of
earnings and profits for purposes of section 1248 and Sec. 1.1248-
1(a)(1) and to supplement the rules in Sec. Sec. 1.1248-2 and 1.1248-3
with respect to--
(1) Stock that an exchanging shareholder receives, or an acquiring
corporation receives, in restructuring transactions. Except as otherwise
provided in this paragraph (a), stock of a foreign corporation that an
exchanging shareholder receives, or an acquiring corporation receives,
pursuant to a restructuring transaction (as defined in paragraph
(b)(1)(vii) of this section) in which the holding period of such stock
is determined by application of section
[[Page 418]]
1223(1) or 1223(2), whichever is appropriate. This section shall not
apply to an exchange otherwise described in this paragraph (a)(1) if, as
a result of the exchange, the exchanging shareholder is required to
include in income as a deemed dividend the section 1248 amount pursuant
to Sec. 1.367(b)-4(b). See paragraphs (b)(2) and (3) of this section;
(2) Nonexchanging shareholders. Stock of a foreign corporation that
participates in a restructuring transaction that is held by a non-
exchanging shareholder (as defined in paragraph (b)(1)(vi) of this
section) in the restructuring transaction. See paragraph (b)(4) of this
section;
(3) Section 381 transactions. Stock of a foreign corporation that
receives assets in a transfer to which section 361(a) or (b) applies in
connection with a reorganization described in section 368(a)(1)(A), (C),
(D), (F), or (G), or in a distribution to which section 332 applies, and
to which section 381(c)(2)(A) and Sec. 1.381(c)(2)-1(a) apply. See
paragraph (b)(6) of this section; or
(4) Section 332 liquidations. Stock of a foreign corporation that
receives the assets and liabilities of a foreign corporation in a
complete liquidation described in section 332 if the foreign distributee
is a foreign corporate shareholder (as defined in paragraph (b)(1)(v) of
this section) of the liquidating corporation. See paragraph (c) of this
section.
(b) Earnings and profits attributable to stock following a
restructuring transaction--(1) Definitions. The following definitions
apply for purposes of this section:
(i) Acquired corporation is a corporation whose stock or assets are
acquired in exchange for stock in (or stock in and other property of)
either the acquiring corporation or a foreign corporation that controls,
within the meaning of section 368(c), the acquiring corporation in a
restructuring transaction.
(ii) Acquiring corporation is a corporation that acquires the stock
or assets of an acquired corporation in a restructuring transaction.
(iii) Controlled foreign corporation is a corporation described in
either section 953(c)(1)(B) or section 957.
(iv) Exchanging shareholder is a person that exchanges--
(A) In a restructuring transaction qualifying as a nonrecognition
transaction within the meaning of section 7701(a)(45) and described in
section 354, 356, or 361(a) or (b), stock in an acquired corporation for
stock in either a foreign acquiring corporation or a foreign corporation
that is in control, within the meaning of section 368(c), of an
acquiring corporation (whether domestic or foreign); or
(B) In a restructuring transaction qualifying as a nonrecognition
transaction within the meaning of section 7701(a)(45) and described in
section 351, property (including stock) for stock in a foreign acquiring
corporation.
(v) Foreign corporate shareholder is a foreign corporation that--
(A) Owns stock of another foreign corporation; and
(B) Has a section 1248 shareholder that is also a section 1248
shareholder of the other foreign corporation.
(vi) Non-exchanging shareholder is, at the time the acquiring
corporation participates in a restructuring transaction, either a
section 1248 shareholder or a foreign corporate shareholder of the
acquiring corporation that is not an exchanging shareholder with respect
to that corporation.
(vii) Restructuring transaction is a transaction qualifying as a
nonrecognition transaction within the meaning of section 7701(a)(45) and
described in section 351, 354, 356, or 361.
(viii) Section 1248 shareholder is any United States person that
satisfies the ownership requirements of section 1248(a)(2) and Sec.
1.1248-1(a)(2) with respect to a foreign corporation.
(2) Earnings and profits attributable to stock that an exchanging
shareholder receives in a restructuring transaction. Where, in a
restructuring transaction, an exchanging shareholder receives stock in a
foreign corporation, the holding period of which is determined under
section 1223(1), and the exchanging shareholder is either a section 1248
shareholder or a foreign corporate shareholder with respect to that
foreign corporation immediately after the restructuring transaction, the
earnings and profits attributable to the stock the exchanging
shareholder receives
[[Page 419]]
shall be determined pursuant to the rules in paragraphs (b)(2)(i), (ii),
and (iii) of this section.
(i) Exchanging shareholder exchanges property that is not stock of a
foreign acquired corporation with respect to which the exchanging
shareholder is a section 1248 shareholder or a foreign corporate
shareholder. Except as provided in paragraph (b)(2)(iv) of this section,
where the exchanging shareholder exchanges in a restructuring
transaction property that is not stock of a foreign acquired corporation
with respect to which the exchanging shareholder is a section 1248
shareholder or a foreign corporate shareholder immediately before the
transaction, the earnings and profits attributable to the stock that the
exchanging shareholder receives in the restructuring transaction will be
determined in accordance with Sec. 1.1248-2 or Sec. 1.1248-3,
whichever is applicable, without regard to any portion of the section
1223(1) holding period in that stock that is before the restructuring
transaction. See paragraph (b)(7), Example 1 of this section.
(ii) Exchanging shareholder exchanges stock of a foreign corporation
with respect to which the exchanging shareholder is either a section
1248 shareholder or a foreign corporate shareholder. Except as provided
in paragraph (b)(2)(iii) of this section, where the exchanging
shareholder exchanges in a restructuring transaction stock of a foreign
acquired corporation with respect to which the exchanging shareholder is
either a section 1248 shareholder or a foreign corporate shareholder
immediately before such restructuring transaction, the earnings and
profits attributable to the stock that the exchanging shareholder
receives in the restructuring transaction shall be the sum of the
earnings and profits attributable to--
(A) The stock of the foreign acquired corporation exchanged
(determined in accordance with Sec. 1.1248-2 or Sec. 1.1248-3,
whichever is applicable, and this section, if applicable) that was
accumulated before the restructuring transaction; and
(B) The stock of the foreign corporation that the exchanging
shareholder receives in the restructuring transaction (determined in
accordance with Sec. 1.1248-2 or Sec. 1.1248-3, whichever is
applicable, and this section, if applicable), without regard to any
portion of the section 1223(1) holding period in that stock that is
prior to the restructuring transaction. See paragraph (b)(7) Example 2,
Example 4, and Example 6 of this section.
(iii) Exchanging shareholder receives stock in a foreign corporation
that controls a domestic acquiring corporation. Where the acquiring
corporation is a domestic corporation and the exchanging shareholder
receives in a restructuring transaction stock in a foreign corporation
that controls (within the meaning of section 368(c)) the domestic
acquiring corporation, the earnings and profits attributable to the
stock that the exchanging shareholder receives in the restructuring
transaction shall consist solely of the amount of earnings and profits
attributable to such stock (determined in accordance with Sec. 1.1248-2
or Sec. 1.1248-3, whichever is applicable, and this section, if
applicable) without regard to any portion of the section 1223(1) holding
period in that stock that is prior to the restructuring transaction. See
paragraph (b)(7) Example 5 of this section.
(iv) Exchanging shareholder exchanges stock of a domestic acquired
corporation for stock of a foreign corporation with respect to which the
exchanging shareholder is a section 1248 shareholder after the exchange.
If there is a restructuring transaction described in Sec. 1.1248(f)-
1(b)(3) to which the exception provided by Sec. 1.1248(f)-2(c) applies
with respect to a distribution by a domestic acquired corporation of
stock of a foreign corporation to one or more exchanging shareholders,
the earnings and profits attributable to a portion of a share of stock
as provided under Sec. 1.1248(f)-2(c)(2) (or a whole share, if no
division is required) will be determined pursuant to paragraphs
(b)(2)(iv)(A) and (b)(2)(iv)(B) of this section.
(A) The earnings and profits attributable to a portion of a share of
stock as provided under Sec. 1.1248(f)-2(c)(2)(i) (or a whole share, if
no division is required) will be determined in accordance with Sec.
1.1248-2 or Sec. 1.1248-3 (and this section, as applicable), without
regard to any portion of the section 1223(1) holding period in that
portion of
[[Page 420]]
a share (or whole share) that is before the restructuring transaction.
(B) The earnings and profits attributable to a portion of a share of
stock as provided under Sec. 1.1248(f)-2(c)(2)(ii) (or whole share, if
no division is required) is the amount in paragraph (b)(2)(iv)(B)(1) of
this section, increased by the amounts described in paragraph
(b)(2)(iv)(B)(2) of this section.
(1) The amount equal to the product of the ratio of the value of the
share of stock to the value of all shares of stock received by the
exchanging shareholder multiplied by the amount in paragraph
(b)(2)(iv)(B)(1)(i) of this section, reduced by the amount in paragraph
(b)(2)(iv)(B)(1)(ii) of this section.
(i) The amount equal to the product of the exchanging shareholder's
ownership interest percentage (within the meaning of Sec. 1.367(a)-
7(f)(7)) in the domestic acquired corporation multiplied by the earnings
and profits attributable to the block of stock of the foreign
corporation transferred in the section 361 exchange that relates to the
portion (or whole share), determined in accordance with Sec. 1.1248-2
or Sec. 1.1248-3 (and this section, as applicable) immediately before
the restructuring transaction (and without taking into account the
application of sections 367 and 1248 to the transfer of the stock of the
foreign corporation in the section 361 exchange).
(ii) The amount of any dividend included in the domestic acquiring
corporation's gross income under section 1248(a) on the transfer of the
block of stock of the foreign corporation, which relates to the portion
or whole share, in the section 361 exchange by reason of gain recognized
under Sec. Sec. 1.367(a)-6 or 1.367(a)-7(c)(2) attributable to the
exchanging shareholder.
(2) The earnings and profits determined in accordance with Sec.
1.1248-2 or Sec. 1.1248-3 (and this section, as applicable), without
regard to any portion of the section 1223(1) holding period in that
stock that is before the restructuring transaction. See Sec. 1.1248(f)-
2(e), Example 2 and Example 3.
(3) Earnings and profits attributable to stock in a foreign
corporation certain acquiring corporations receive in a restructuring
transaction. Where an acquiring corporation receives, in a restructuring
transaction, stock in a foreign acquired corporation, the holding period
of which is determined under section 1223(2), and the acquiring
corporation is either a section 1248 shareholder or a foreign corporate
shareholder with respect to that foreign acquired corporation
immediately after the restructuring transaction, the earnings and
profits attributable to the foreign acquired corporation stock that the
acquiring corporation receives shall be determined pursuant to the rules
in paragraphs (b)(3)(i) and (ii) of this section.
(i) Stock of a foreign corporation with respect to which the
exchanging shareholder is neither a section 1248 shareholder nor a
foreign corporate shareholder. The earnings and profits attributable to
the stock of the foreign acquired corporation that the acquiring
corporation receives in a restructuring transaction where the exchanging
shareholder is neither a section 1248 shareholder nor a foreign
corporate shareholder with respect to that foreign acquired corporation
immediately before the restructuring transaction shall be determined in
accordance with Sec. 1.1248-2 or Sec. 1.1248-3, whichever is
applicable, without regard to any portion of the section 1223(2) holding
period in that stock that is prior to the restructuring transaction.
(ii) Stock of a foreign corporation with respect to which the
exchanging shareholder is either a section 1248 shareholder or a foreign
corporate shareholder. The earnings and profits attributable to the
stock of a foreign acquired corporation that the acquiring corporation
receives in the restructuring transaction where the exchanging
shareholder is either a section 1248 shareholder or a foreign corporate
shareholder with respect to that foreign corporation immediately before
the restructuring transaction shall be determined in accordance with
Sec. 1.1248-2 or Sec. 1.1248-3, whichever is applicable, with regard
to the portion of the section 1223(2) holding period of the stock that
the exchanging shareholder took into account for purposes of attributing
earnings and profits to that stock (determined in accordance with this
section). See paragraph (b)(7) Example 3, Example 5, and Example 7 of
this section.
[[Page 421]]
(4) Earnings and profits attributable to stock held by a non-
exchanging shareholder in a foreign acquiring corporation. (i) Except to
the extent paragraph (b)(4)(ii) of this section applies, the earnings
and profits attributable to stock of a foreign acquiring corporation
held by a non-exchanging shareholder immediately prior to a
restructuring transaction continue to be attributed to such stock, and
the earnings and profits of the acquired corporation accumulated prior
to the restructuring transaction attributable to the stock of an
acquired corporation are not attributed to the non-exchanging
shareholder's stock in the foreign acquiring corporation. See Sec.
1.1248-2 or Sec. 1.1248-3 (whichever is applicable) and, as applicable,
paragraph (b)(6) of this section; see also paragraph (b)(7) Example 2
and Example 4 of this section.
(ii) Where a non-exchanging shareholder holds stock in a foreign
corporation that is also an exchanging shareholder and a foreign
acquiring corporation in the same restructuring transaction--
(A) The earnings and profits attributable to such stock shall be the
sum of the earnings and profits attributable to the stock of such
foreign corporation immediately before the restructuring transaction
(including amounts attributed under section 1248(c)(2)) and the earnings
and profits attributable to the stock of the foreign acquiring
corporation accumulated after the restructuring transaction (including
amounts attributed under section 1248(c)(2)); and
(B) Paragraph (b)(6) of this section applies. See paragraph (b)(7)
Example 8 of this section.
(iii) Where the acquiring corporation is a foreign corporate
shareholder with respect to stock of a foreign acquired corporation,
paragraph (b)(3) of this section shall not apply for purposes of
determining the earnings and profits attributable to stock in the
foreign acquiring corporation owned by a non-exchanging shareholder
thereof (see section 1248(c)(2)). See paragraph (b)(7) Example 6 of this
section.
(5) Reduction in earnings and profits attributable to stock to
prevent multiple inclusions with respect to the same earnings and
profits. To the extent consistent with the principles of section 1248,
adjustments to earnings and profits attributable to stock shall be made
such that section 1223(1) and (2) and this section are applied in a
manner that results in earnings and profits being taken into account
only once. Thus, for example, when a controlled foreign corporation
sells or exchanges all or part of the stock of another foreign
corporation to which earnings and profits are attributable pursuant to
this paragraph (b) or paragraph (c) of this section, proportionate
reductions shall be made to the earnings and profits attributed to the
stock of the selling foreign corporate shareholder owned by a section
1248 shareholder. See paragraph (b)(7) Example 7 of this section.
(6) Special rule regarding section 381. Solely for purposes of
determining the earnings and profits (or deficit in earnings and
profits) attributable to stock pursuant to this paragraph (b), the
earnings and profits of a corporation shall not include earnings and
profits that are treated as received or incurred under section
381(c)(2)(A) and Sec. 1.381(c)(2)-1(a). See paragraph (b)(7) Example 4
of this section.
(7) Examples. The application of this paragraph (b) is illustrated
by the following examples. Unless otherwise indicated, in the following
examples assume that--
(i) There is no immediate gain recognition pursuant to section
367(a)(1) and the regulations under that section (either through
operation of the rules or because the appropriate parties have entered
into a gain recognition agreement under Sec. Sec. 1.367(a)-3(b) and
1.367(a)-8);
(ii) There is no income inclusion required pursuant to section
367(b) and the regulations under that section, and all reporting
requirements in those regulations are complied with;
(iii) References to earnings and profits are to earnings and profits
that would be includible in income as a dividend under section 1248 and
the regulations under that section if stock to which the earnings and
profits are attributable were sold or exchanged by its shareholder;
(iv) Each corporation has only a single class of stock outstanding
and uses
[[Page 422]]
the calendar year as its taxable year; and
(v) Each transaction is unrelated to all other transactions.
Example 1. A section 351 exchange of property other than stock in a
foreign corporation with respect to which the exchanging shareholder is
either a section 1248 shareholder or a foreign corporate shareholder.
(i) Facts. DC1, a domestic corporation, has owned all the stock of CFC,
a foreign corporation, since CFC's formation on January 1, year 3. On
December 31, year 5, DC2, a domestic corporation unrelated to DC1,
contributes property it has held since January 1, year 1, to CFC in
exchange for voting stock of CFC in a restructuring transaction that is
an exchange under section 351. The property that DC2 contributes is not
stock in a foreign corporation with respect to which DC2 was either a
section 1248 shareholder or a foreign corporate shareholder. DC2
receives 80% of the voting stock of CFC in the restructuring transaction
and its holding period in that CFC stock, determined pursuant to section
1223(1), began on January 1, year 1. CFC has $100 of accumulated
earnings and profits on December 31, year 5. On December 31, year 7,
when the accumulated earnings and profits of CFC are $200, DC2, a
section 1248 shareholder with respect to CFC, sells its CFC stock.
(ii) Result. Under paragraph (b)(2)(i) of this section, the earnings
and profits attributable to the CFC stock sold by DC2 are $80. This
amount consists of none of the $100 of earnings and profits accumulated
by CFC before the restructuring transaction, and 80% of the $100 of
earnings and profits of CFC accumulated after the restructuring
transaction.
Example 2. A section 351 exchange of controlled foreign corporation
stock by a United States person for stock in a controlled foreign
corporation in a restructuring transaction. (i) Facts. The facts are the
same as in Example 1 except as follows. The property that DC2
contributes is 100% of the stock in CFC2, a foreign corporation. DC2 has
owned all the stock of CFC2 since CFC2's formation on January 1, year 2,
and CFC2 has $200 of earnings and profits as of December 31, year 5.
CFC2 does not accumulate any additional earnings and profits from
December 31, year 5, to December 31, year 7. On December 31, year 7,
when the accumulated earnings and profits of CFC are $200, DC2, a
section 1248 shareholder with respect to CFC, sells its CFC stock. Also
on that date, DC1 sells its CFC stock.
(ii) Result. (A) DC2 sale. Pursuant to paragraph (b)(2)(ii) of this
section, the earnings and profits attributable to the CFC stock sold by
DC2 are $280. This amount consists of all of the $200 of earnings and
profits of CFC2 accumulated before the restructuring transaction (see
also section 1248(c)(2)), none of the $100 of earnings and profits
accumulated by CFC before the restructuring transaction, and 80% of the
$100 of earnings and profits of CFC accumulated after the restructuring
transaction.
(B) DC1 sale. Pursuant to paragraph (b)(4) of this section, the
earnings and profits attributable to the CFC stock sold by DC1, a non-
exchanging shareholder in the restructuring transaction, are $120. This
amount consists of all of the $100 of earnings and profits of CFC
accumulated before the restructuring transaction, none of the $200 of
earnings and profits of CFC2 accumulated before the restructuring
transaction, and 20% of the $100 of earnings and profits of CFC
accumulated after the restructuring transaction.
Example 3. A section 351 exchange of controlled foreign corporation
stock by a United States person for stock in a domestic corporation in a
restructuring transaction. (i) Facts. DC1, a domestic corporation, has
owned all of the stock of CFC, a foreign corporation, since CFC's
formation on January 1, year 1. DC1 has also owned all the stock of DC2,
a domestic corporation, since DC2's formation on January 1, year 1. On
December 31, year 2, DC1 contributes the stock of CFC to DC2 in exchange
for stock in DC2 in a restructuring transaction that is an exchange
described in section 351. On December 31, year 2, CFC has $100 of
accumulated earnings and profits. DC2 has a basis in the CFC stock
determined under section 362, and is considered to have held the CFC
stock since January 1, year 1, pursuant to section 1223(2). On December
31, year 4, when the accumulated earnings and profits of CFC are still
$100, DC2 sells its CFC stock.
(ii) Result. Under paragraph (b)(3)(ii) of this section, $100 of
accumulated earnings and profits of CFC is attributable to the stock of
CFC sold by DC2, even though DC2 did not hold the stock of CFC during
the time CFC accumulated the earnings and profits.
Example 4. Acquisition of a controlled foreign corporation by a
controlled foreign corporation in a reorganization described in section
368(a)(1)(C) (or section 368(a)(1)(B)). (i) Facts. DC1, a domestic
corporation, has owned all the stock of CFC1, a foreign corporation,
since its formation on January 1, year 1. DC2, a domestic corporation
unrelated to DC1, has owned all of the stock of CFC2, a foreign
corporation, since its formation on January 1, year 2. On December 31,
year 3, pursuant to a restructuring transaction that is a reorganization
described in section 368(a)(1)(C), CFC1 transfers all of its assets to
CFC2 in exchange for 25% of the voting stock of CFC2. CFC1 distributes
the CFC2 stock to DC1 and the CFC1 stock is cancelled. DC1's holding
period in the CFC2 stock, determined under section 1223(1), begins on
January 1, year 1. On December 31, year 3, CFC1 has $100 of accumulated
earnings and profits
[[Page 423]]
and CFC2 has $200 of accumulated earnings and profits. CFC2 succeeds to
the $100 of CFC1 accumulated earnings and profits in the reorganization
under section 381. From January 1, year 4 to December 31, year 5, CFC2
incurred a deficit in earnings and profits in the amount of ($200). On
December 31, year 5, both DC1 and DC2 sell their stock in CFC2.
(ii) Result. (A) DC1. Pursuant to paragraph (b)(2)(ii) of this
section, $50 of earnings and profits is attributable to the CFC2 stock
sold by DC1. This amount consists of $100 of CFC1's earnings and profits
accumulated before the restructuring transaction, reduced by 25% of
CFC2's ($200) post-restructuring transaction deficit in earnings and
profits. None of the $200 of CFC2's earnings and profits accumulated by
CFC2 prior to the reorganization is attributed to the CFC2 stock sold by
DC1. Also, none of the earnings and profits CFC2 succeeded to under
section 381 is attributed to the CFC2 stock sold by DC1, pursuant to
paragraph (b)(6) of this section.
(B) DC2. Pursuant to paragraph (b)(4) of this section, there is $50
of accumulated earnings and profits attributable to the CFC2 stock sold
by DC2. This amount consists of all of the $200 of CFC2's earnings and
profits accumulated by CFC2 prior to the reorganization, reduced by 75%
of CFC2's deficit in earnings and profits in the amount of ($200)
incurred after the restructuring transaction. None of the $100 of CFC1
accumulated earnings and profits succeeded to under section 381 is
attributable to the CFC2 stock sold by DC2, pursuant to paragraph (b)(6)
of this section.
(C) Section 368(a)(1)(B) reorganization. If, instead of DC1
acquiring its 25% interest in CFC2 pursuant to a reorganization
described in section 368(a)(1)(C), DC1 had transferred the stock of CFC1
to CFC2 in exchange for 25% of the voting stock of CFC2 in a
reorganization described in section 368(a)(1)(B), the results would be
the same as described in paragraphs (ii) (A) and (B) of this Example 4.
Example 5. Acquisition of the stock of a foreign corporation that
controls a domestic acquiring corporation in a triangular reorganization
described in section 368(a)(1)(C). (i) Facts. DC1, a domestic
corporation, has owned all the stock of CFC1, a foreign corporation,
since its formation on January 1, year 1. CFC1 has owned all the stock
of CFC2, a foreign corporation, since its formation on January 1, year
1. FC, a foreign corporation that is not a controlled foreign
corporation, has owned all of the stock of DC2, a domestic corporation,
since its formation on January 1, year 2. On December 31, year 3,
pursuant to a restructuring transaction that was a triangular
reorganization described in section 368(a)(1)(C), CFC1 transfers all of
its assets, including the CFC2 stock, to DC2 in exchange for 60% of the
voting stock of FC. CFC1 transfers the voting stock of FC to DC1 and the
CFC1 stock is cancelled. Pursuant to section 1223(1), DC1 is considered
to have held the stock of FC since January 1, year 1. Under section
1223(2), DC2 is considered to have held the stock of CFC2 since January
1, year 1. On December 31, year 3, CFC1 has $100 of earnings and
profits, CFC2 has $300 of earnings and profits, and FC has $200 of
earnings and profits. DC1 includes the $100 all earnings and profits
amount attributable to its CFC1 stock in income as a deemed dividend
under Sec. 1.367(b)-3 upon the exchange of CFC1 stock for FC stock.
Pursuant to the lower-tier earnings exclusion of Sec. 1.367(b)-
2(d)(3)(ii), that amount does not include the $300 of earnings and
profits of CFC2. From January 1, year 4, until December 31, year 5, FC
(now a controlled foreign corporation) accumulates an additional $50 of
earnings and profits. From January 1, year 4 until December 31, year 5,
CFC2 accumulates an additional $100 of earnings and profits. On December
31, year 5, DC1 sells its stock in FC and DC2 sells its stock in CFC2.
(ii) Result. (A) DC1. Pursuant to paragraph (b)(2)(iii) of this
section, there is $30 of earnings and profits attributable to the stock
of FC sold by DC1. This amount consists of 60% of the $50 of earnings
and profits accumulated by FC after the restructuring transaction, and
none of the earnings and profits accumulated by CFC1, CFC2, or FC before
the restructuring transaction.
(B) DC2. Pursuant to paragraph (b)(3)(ii) of this section, there is
$400 of earnings and profits attributable to the stock of CFC2 sold by
DC2. This amount consists of all of the earnings and profits accumulated
by CFC2 during DC2's section 1223(2) holding period.
Example 6. Acquisition of the stock of a foreign corporation that
controls a foreign acquiring corporation in a reorganization described
in section 368(a)(1)(C). (i) Facts. DC1, a domestic corporation, has
owned all the stock of CFC1, a foreign corporation, since its formation
on January 1, year 1. CFC1 has owned all the stock of CFC2, a foreign
corporation, since its formation on January 1, year 1. FC, a foreign
corporation that is not a controlled foreign corporation, has owned all
of the stock of FC2, a foreign corporation, since its formation on
January 1, year 2. On December 31, year 3, pursuant to a restructuring
transaction that was a triangular reorganization described in section
368(a)(1)(C), CFC1 transfers all of its assets, including the CFC2
stock, to FC2 in exchange for 60% of the voting stock of FC. CFC1
transfers the voting stock of FC to DC1 and the CFC1 stock is cancelled.
Pursuant to section 1223(1), DC1 is considered to have held the stock of
FC since January 1, year 1. Under section 1223(2), FC2 is considered to
have held the stock of CFC2 since January 1, year 1. On December 31,
year 3, CFC1 has $100 of earnings and profits, CFC2 has $300 of earnings
and profits, FC has $200 of earnings and profits, and FC2 has no
[[Page 424]]
earnings and profits. From January 1, year 4, until December 31, year 5,
FC (now a controlled foreign corporation) accumulates an additional $50
of earnings and profits. From January 1, year 4 until December 31, year
5, CFC2 accumulates an additional $100 of earnings and profits. FC2, a
controlled foreign corporation after the restructuring transaction,
accumulates $100 of earnings and profits from January 1, year 4, until
December 31, year 5. On December 31, year 5, DC1 sells its stock in FC.
(ii) Result. Pursuant to paragraphs (b)(2)(ii) and (b)(4)(iii) of
this section, there is $550 of earnings and profits attributable to the
stock of FC sold by DC1. This amount consists of all $400 of the CFC1
and CFC2 earnings and profits accumulated before the restructuring
transaction (see also section 1248(c)(2)), and 60% of the $250 of the
earnings and profits accumulated by FC, FC2, and CFC2 after the
restructuring transaction.
Example 7. Acquisition of controlled foreign corporation stock by a
controlled foreign corporation in a reorganization described in section
368(a)(1)(B), followed by a sale of the acquired stock by the acquiring
controlled foreign corporation. (i) Facts. DC1, a domestic corporation,
has owned all of the outstanding stock of CFC1, a foreign corporation,
since its formation on January 1, year 1. CFC1 has owned all of the
outstanding stock of CFC3, a foreign corporation, since its formation on
January 1, year 1. DC2, a domestic corporation unrelated to DC1, has
owned all of the outstanding stock of CFC2, a foreign corporation, since
its formation on January 1, year 2. On December 31, year 3, pursuant to
a restructuring transaction that is a reorganization described in
section 368(a)(1)(B), CFC1 transfers all of the stock of CFC3 to CFC2 in
exchange for 40% of CFC2's stock. On December 31, year 3, CFC2 and CFC3
have, respectively, $40 and $20 of earnings and profits. On December 31,
year 5, when the accumulated earnings and profits of CFC3 are $50 ($20
of earnings and profits as of December 31, year 3, plus $30 of earnings
and profits generated from January 1, year 4, through December 31, year
5), CFC2 sells the stock of CFC3 in a transaction to which section
964(e) applies.
(ii) Result. (A) CFC2. Pursuant to paragraph (b)(3)(ii) of this
section, there is $50 of earnings and profits attributable to the CFC3
stock sold by CFC2. This amount consists of the accumulated earnings and
profits attributable to CFC2's entire section 1223(2) holding period in
the CFC3 stock.
(B) CFC1, DC2, and DC1. Under paragraph (b)(5) of this section, the
earnings and profits attributable to the CFC2 stock held by CFC1 and
DC2, and the earnings and profits attributable to the CFC1 stock held by
DC1, will be reduced (regardless of whether CFC2 recognizes gain on its
sale of CFC3 stock).
(1) CFC1. The earnings and profits attributable to the CFC2 stock
held by CFC1 will be reduced by $32, or the amount of earnings and
profits as of December 31, year 5, that would have been attributable to
the CFC2 stock held by CFC1 pursuant to paragraph (b)(2)(ii) of this
section. This amount consists of all of the $20 of earnings and profits
accumulated by CFC3 before the restructuring transaction and 40% of the
$30 of earnings and profits accumulated by CFC3 after the restructuring
transaction (.40 x $30 = $12).
(2) DC1. The earnings and profits attributable to the CFC1 stock
held by DC1 will also be reduced by $32, or the amount of earnings and
profits that would have been attributable to the CFC1 stock held by DC1
as of December 31, year 5.
(3) DC2. The earnings and profits attributable to the CFC2 stock
held by DC2 will be reduced by $18, or the amount of earnings and
profits that would have been attributable to the CFC2 stock held by DC2
as of December 31, year 5, under paragraph (b)(4) of this section. This
amount consists of 60% of the $30 (.60 x $30 = $18) of earnings and
profits accumulated by CFC3 after the restructuring transaction.
(C) Partial sale by CFC2. If, instead of selling 100% of the CFC3
stock, on December 31, year 5, CFC2 sells only 50% of its CFC3 stock,
paragraph (b)(5) of this section requires CFC1 to reduce the earnings
and profits of CFC3 attributable to its CFC2 stock to $16. Similarly,
DC1 would be required to reduce the earnings and profits of CFC3
attributable to its CFC1 stock by $16. Paragraph (b)(5) of this section
also requires DC2 to reduce the CFC3 earnings and profits attributable
to its CFC2 stock by $9. These reductions occur without regard to
whether CFC2 recognizes gain on its sale of CFC3 stock.
Example 8. Acquisition of the assets of a lower-tier controlled
foreign corporation by an upper-tier controlled foreign corporation in a
restructuring transaction described in section 368(a)(1)(C). (i) Facts.
DC, a domestic corporation, has owned all the stock of CFC1, a
controlled foreign corporation, since its formation on January 1, year
1. CFC1 is a holding company that has owned 79% of the stock of CFC2, a
controlled foreign corporation, since its formation on January 1, year
1. The other 21% of CFC2 stock is owned by X, an unrelated party. On
December 31, year 1, CFC2 has $200 of earnings and profits. On December
31, year 1, CFC1 has no accumulated earnings and profits. On December
31, year 1, pursuant to a restructuring transaction described in section
368(a)(1)(C), CFC2 transfers all its properties to CFC1. In exchange,
CFC1 assumes the liabilities of CFC2 and transfers to CFC2 voting stock
representing 21% of the stock of CFC1. CFC2 distributes the voting stock
to X and liquidates. The liabilities assumed do not exceed 20% of the
value of the properties of CFC2. From January 1, year 2, to December 31,
year 3, CFC1 accumulates
[[Page 425]]
$100 of earnings and profits. On December 31, year 3, DC sells its CFC1
stock.
(ii) Result. Pursuant to paragraph (b)(4)(ii) of this section, there
is $237 of earnings and profits attributable to DC's CFC1 stock. This
amount consists of 79% of CFC2's $200 of earnings and profits
accumulated before the restructuring transaction (see section
1248(c)(2)), and 79% of CFC1's $100 of earnings and profits accumulated
after the restructuring transaction. Pursuant to paragraph (b)(6) of
this section, none of CFC2's $200 of earnings and profits to which CFC1
succeeded under section 381 would be attributable to DC's CFC1 stock.
(c) Earnings and profits attributable to stock of a foreign
distributee corporation that is a foreign corporate shareholder with
respect to a foreign liquidating corporation--(1) General rule. If a
foreign corporation (liquidating corporation) makes a distribution of
property in complete liquidation under section 332 to a foreign
corporation (distributee), and immediately before the liquidation the
distributee was a foreign corporate shareholder with respect to the
liquidating foreign corporation, the amount of earnings and profits
attributable to the distributee stock upon its subsequent sale or
exchange will be determined under this paragraph (c)(1). The earnings
and profits attributable will be the sum of the earnings and profits
attributable to the stock of the distributee immediately before the
liquidation (including amounts attributed under section 1248(c)(2)) and
the earnings and profits attributable to the stock of the distributee
accumulated after the liquidation (including amounts attributed under
section 1248(c)(2)).
(2) Special rule regarding section 381. Solely for purposes of
determining the earnings and profits (or deficit in earnings and
profits) attributable to stock under this paragraph (c), the attributed
earnings and profits of a corporation shall not include earnings and
profits that are treated as received or incurred pursuant to section
381(c)(2)(A) and Sec. 1.381(c)(2)-1(a).
(3) Example-- (i) Facts. DC, a domestic corporation, has owned all
of the stock of CFC1, a foreign corporation, since its formation on
January 1, year 1. CFC1 is an operating company that has owned all of
the stock of CFC2, a foreign corporation, since its formation on January
1, year 1. On December 31, year 2, CFC1 has $200 of accumulated earnings
and profits and CFC2 has a ($200) deficit in earnings and profits. On
December 31, year 2, CFC2 distributes all of its assets and liabilities
to CFC1 in a liquidation to which section 332 applies. From January 1,
year 3, until December 31, year 4, CFC1 accumulates no additional
earnings and profits. On December 31, year 4, DC sells its stock in
CFC1.
(ii) Result. Pursuant to paragraph (c)(1) of this section, there are
no earnings and profits attributable to DC's CFC1 stock. This amount
consists of the sum of the earnings and profits attributable to the CFC1
stock immediately before the liquidation (100% of the $200 accumulated
earnings and profits of CFC1 and 100% of CFC2's ($200) deficit in
earnings and profits) and the amount of earnings and profits accumulated
after the section 332 liquidation (see also section 1248(c)(2)).
(d) Effective/applicability dates--(1) General rule. Except as
provided in paragraph (d)(2) of this section, this section applies to
income inclusions that occur on or after July 30, 2007.
(2) Exception. Paragraph (b)(2)(iv) of this section applies to
restructuring transactions occurring on or after April 18, 2013.
[T.D. 9345, 72 FR 41446, July 30, 2007, as amended by T.D. 9614, 78 FR
17042, Mar. 19, 2013; T.D. 9803, 81 FR 91030, Dec. 16, 2016]
Sec. 1.1248(f)-1 Certain nonrecognition distributions.
(a) Scope and purpose. This section and Sec. Sec. 1.1248(f)-2 and
1.1248(f)-3 provide rules under section 1248(f) that apply when a
domestic corporation (domestic distributing corporation) distributes
stock of a foreign corporation (foreign distributed corporation) in a
distribution to which section 337, 355(c)(1), or 361(c)(1) applies.
Paragraph (b) of this section provides the general rule that requires
the domestic distributing corporation, depending on the type of
distribution, to include in gross income either the section 1248 amount
or the total section 1248(f) amount. Paragraph (c) of this section
provides definitions that apply for purposes of this section and
Sec. Sec. 1.1248(f)-2 and 1.1248(f)-3. Section 1.1248(f)-2 provides
exceptions to the
[[Page 426]]
general rule contained in paragraph (b) of this section that apply,
depending on the type of distribution. Section 1.1248(f)-3 provides
reasonable cause relief procedures for failures to timely comply with
certain filing requirements and effective/applicability dates.
(b) General rule--(1) Section 337 distribution. This paragraph
(b)(1) applies if a domestic distributing corporation that is a section
1248 shareholder of a foreign distributed corporation distributes stock
of the foreign distributed corporation in a distribution to which
section 337 applies (section 337 distribution). Except as provided in
Sec. 1.1248(f)-2(a), the domestic distributing corporation must,
notwithstanding any other provision of subtitle A of the Internal
Revenue Code (Code), include in gross income as a dividend the section
1248 amount with respect to the stock of the foreign distributed
corporation. This paragraph (b)(1) applies only to the extent the
domestic distributing corporation does not recognize gain with respect
to the stock of the foreign distributed corporation as a result of the
section 337 distribution under another provision of subtitle A of the
Code.
(2) Existing stock distribution under section 355 or 361. This
paragraph (b)(2) applies to the extent a domestic distributing
corporation distributes stock of the foreign distributed corporation
that is not received in a section 361 exchange that is part of the plan
of distribution, provided the distribution is described in section
355(c)(1) or section 361(c)(1) (existing stock distribution). Except as
provided in Sec. 1.1248(f)-2(b), the domestic distributing corporation
must, notwithstanding any other provision of subtitle A of the Code,
include in gross income as a dividend the section 1248 amount with
respect to the stock of the foreign distributed corporation. This
paragraph (b)(2) only applies to the extent the domestic distributing
corporation does not recognize gain with respect to the stock of the
foreign distributed corporation as a result of the existing stock
distribution under another provision of subtitle A of the Code.
(3) New stock distribution under section 361. This paragraph (b)(3)
applies to the extent a domestic distributing corporation distributes
stock of the foreign distributed corporation that is received in a
section 361 exchange that is part of the plan of distribution (and, to
the extent applicable, also distributes any cash or other property),
provided the distribution is described in section 361(c)(1) (new stock
distribution). Except as provided in Sec. 1.1248(f)-2(c), the domestic
distributing corporation must, notwithstanding any other provision of
subtitle A of the Code, include in gross income as a dividend the total
section 1248(f) amount with respect to the stock of each foreign
corporation transferred in the section 361 exchange. This paragraph
(b)(3) applies without regard to the amount of gain realized by the
domestic distributing corporation in the new stock distribution.
(c) Definitions. Except as otherwise provided, the following
definitions apply for purposes of this section and Sec. Sec. 1.1248(f)-
2 and 1.1248(f)-3:
(1) 80-percent distributee is a corporation described in section
337(c).
(2) Block of stock has the meaning provided in Sec. 1.1248-2(b).
(3) Distributee is a shareholder of the domestic distributing
corporation that receives one or more shares of stock of a foreign
distributed corporation in an existing stock distribution (as defined in
paragraph (b)(2) of this section) or a new stock distribution (as
defined in paragraph (b)(3) of this section).
(4) Hypothetical section 1248 amount is, with respect to each
distributee or non-stock distributee, the amount in paragraph (c)(4)(i)
of this section, reduced by the amount in paragraph (c)(4)(ii) of this
section computed with respect to the stock of each foreign corporation
transferred in the section 361 exchange by the domestic distributing
corporation for which there is not an income inclusion under Sec.
1.367(b)-4(b)(1)(i).
(i) The amount that the domestic distributing corporation would have
included in income as a deemed dividend under Sec. 1.367(b)-4(b)(1)(i)
if the requirements of Sec. 1.367(b)-4(b)(1)(ii)(A) (involving the
receipt of foreign stock in an exchange to which Sec. 1.367(a)-7(c)
applies) had not been satisfied and that would have been attributable to
such distributee or non-stock distributee under Sec. 1.367(a)-7(e)(4)
(providing rules to attribute deemed income inclusions
[[Page 427]]
under Sec. 1.367(b)-4 to persons described in Sec. 1.367(a)-
3(e)(3)(iii)(A).
(ii) The amount of gain recognized by the domestic distributing
corporation under Sec. 1.367(a)-7(c)(2) attributable to such
distributee or non-stock distributee and allocable to the stock of such
foreign corporation under Sec. 1.367(a)-7(e)(1), but only to the extent
such gain is treated as a dividend under section 1248(a).
(5) Non-stock distributee is a shareholder of the domestic
distributing corporation that receives cash or other property but no
shares of stock of the foreign distributed corporation in a new stock
distribution (as defined in paragraph (b)(3) of this section).
(6) Postdistribution amount is the section 1248 amount with respect
to the stock (or a portion of a share of stock) of the foreign
distributed corporation received by a distributee, computed immediately
after the distribution, but without taking into account any adjustments
to the basis of the stock under Sec. 1.1248(f)-2(b)(3) (in the case of
an existing stock distribution) or adjustments to the basis of stock or
income inclusions under Sec. 1.1248(f)-2(c)(3) (in the case of a new
stock distribution). The postdistribution amount in the stock of a
foreign distributed corporation received in an existing stock
distribution is determined based on the distributee's holding period in
the stock as adjusted under Sec. 1.1248(f)-2(b)(2). The
postdistribution amount in the stock (or a portion of a share of stock,
as applicable) of a foreign distributed corporation received in a new
stock distribution is determined after applying the rules in Sec. Sec.
1.1248-8(b)(2)(iv) and 1.1248(f)-2(c)(2).
(7) Section 358 basis is the basis in stock as determined under
section 358.
(8) Section 361 exchange is an exchange described in section 361(a)
or (b).
(9) Section 1248 amount is the net positive earnings and profits (if
any) attributable to the stock of the foreign distributed corporation,
determined in accordance with Sec. 1.1248-2 or Sec. 1.1248-3 (taking
into account Sec. 1.1248-8, if applicable), and that would be included
in gross income as a dividend under section 1248(a) if the stock were
sold by the domestic distributing corporation in a transaction in which
all realized gain is recognized.
(10) Section 1248(f) amount is the amount in paragraph (c)(10)(i) of
this section, reduced by the amount in paragraph (c)(10)(ii) of this
section computed with respect to the stock of each foreign corporation
transferred in the section 361 exchange by the domestic distributing
corporation for which the domestic distributing corporation does not
have an income inclusion under Sec. 1.367(b)-4(b)(1)(i).
(i) The amount that the domestic distributing corporation would have
included in income as a dividend under Sec. 1.367(b)-4(b)(1)(i) if the
requirements of Sec. 1.367(b)-4(b)(1)(ii)(A) (involving the receipt of
foreign stock in an exchange to which Sec. 1.367(a)-7(c) applies) had
not been satisfied.
(ii) The amount of gain recognized by the domestic distributing
corporation under Sec. 1.367(a)-7(c)(2) and allocable to the stock of
such foreign corporation under Sec. 1.367(a)-7(e)(1), but only to the
extent such gain is treated as a dividend under section 1248(a).
(11) Section 1248(f) block amount is the portion of the section
1248(f) amount, as defined in paragraph (c)(10) of this section, that
relates to a block of stock of the foreign corporation if more than a
single block of stock of the foreign corporation is transferred in the
section 361 exchange.
(12) Section 1248 shareholder is a domestic corporation that
satisfies the ownership requirements of section 1248(a)(2) with respect
to a foreign corporation, except that a domestic corporation, other than
a domestic distributing corporation, that is a regulated investment
company (as defined in section 851(a)), a real estate investment trust
(as defined in section 856(a)), or an S corporation (as defined in
section 1361(a)) cannot be a section 1248 shareholder.
(13) Timely filed return is a U.S. income tax return filed on or
before the due date set forth in section 6072(b), including any
extensions of time to file the return granted under section 6081.
(14) Total section 1248(f) amount is the sum of each section 1248(f)
amount (as
[[Page 428]]
defined in paragraph (c)(10) of this section).
[T.D. 9614, 78 FR 17043, Mar. 19, 2013, as amended by T.D. 9760, 81 FR
15169, Mar. 22, 2016]
Sec. 1.1248(f)-2 Exceptions for certain distributions and
attribution rules.
(a) Section 337 stock distribution--(1) General exception. In the
case of a section 337 distribution (as defined in Sec. 1.1248-1(b)(1)),
Sec. 1.1248(f)-1(b)(1) shall not apply to the distribution of stock of
the foreign distributed corporation to the 80-percent distributee if the
conditions of paragraphs (a)(1)(i), (a)(1)(ii) and (a)(1)(iii) of this
section are satisfied.
(i) 80-percent distributee is a section 1248 shareholder.
Immediately after the section 337 distribution, the 80-percent
distributee is a section 1248 shareholder with respect to the foreign
distributed corporation.
(ii) Holding period. The 80-percent distributee is treated as
holding the stock of the foreign distributed corporation received in the
section 337 distribution for the period during which the stock was held
by the domestic distributing corporation.
(iii) Basis. The 80-percent distributee's basis in the stock of the
foreign distributed corporation received in the section 337 distribution
does not exceed the domestic distributing corporation's basis in such
stock at the time of the section 337 distribution.
(2) Elective exception. If the conditions of paragraph (a)(1)(ii) or
(a)(1)(iii) of this section are not otherwise satisfied, the domestic
distributing corporation and the 80-percent distributee may elect to
make adjustments to the 80-percent distributee's holding period or basis
in the stock of the foreign distributed corporation, as appropriate,
such that the conditions described in paragraphs (a)(1)(ii) and (iii) of
this section are satisfied. The conditions and procedures for making the
election are described in paragraph (a)(3) of this section. See
paragraphs (a)(4) and (5) of this section for adjustments that are
required as a result of making the election.
(3) Election and reporting--(i) Statement required by domestic
distributing corporation and 80-percent distributee--(A) In general. The
domestic distributing corporation and the 80-percent distributee make
the election described in paragraph (a)(2) of this section by each
including a statement, described in paragraph (a)(3)(i)(B) of this
section, with a timely filed return for the taxable year during which
the section 337 distribution occurs, and by entering into a written
agreement described in paragraph (a)(3)(ii) of this section. If the
domestic distributing corporation or the 80-percent distributee are
members of a consolidated group at the time of the section 337
distribution but not the common parent, the common parent of the
consolidated group makes the election on behalf of the domestic
distributing corporation or the 80-percent distributee. The election
described in paragraph (a)(2) of this section and made pursuant to this
paragraph (a)(3) is irrevocable.
(B) Form and content. The statement of election must be entitled,
``STATEMENT TO ELECT TO APPLY EXCEPTION UNDER Sec. 1.1248(f)-2(a)(2),''
state that the domestic distributing corporation and the 80-percent
distributee have entered into a written agreement described in paragraph
(a)(3)(ii) of this section, set forth the date of the agreement and the
names of the parties to the agreement, and the adjustments to the 80-
percent distributee's holding period and/or basis determined under
section 334 in the stock of the foreign distributed corporation received
in the section 337 distribution required under paragraphs (a)(4) and
(a)(5) of this section.
(ii) Written agreement. The domestic distributing corporation and
the 80-percent distributee must enter into a written agreement described
in this paragraph (a)(3)(ii) on or before the due date (including
extensions) of the domestic distributing corporation's U.S. income tax
return for the taxable year during which the section 337 distribution
occurs. Both the domestic distributing corporation and the 80-percent
distributee must retain the original or a copy of the agreement as part
of its records in the manner specified by Sec. 1.6001-1(e). Both the
domestic distributing corporation and the 80-percent distributee must
provide a copy of the
[[Page 429]]
agreement to the Internal Revenue Service within 30 days of the receipt
of a request for the agreement in connection with an examination of the
taxable year during which the section 337 distribution occurs. The
written agreement must--
(A) State the document is an agreement under paragraph (a)(3)(ii) of
this section;
(B) Provide the name and taxpayer identification number (if any) of
the domestic distributing corporation, the 80-percent distribute, and
the foreign distributed corporation;
(C) With respect to the 80-percent distributee, state the holding
period in the stock of the foreign distributed corporation received in
the section 337 distribution as adjusted under paragraph (a)(4) of this
section; and
(D) With respect to the 80-percent distributee, identify the basis
as determined under section 334 of the stock of the foreign distributed
corporation received in the section 337 distribution and the adjustment
(if any) to such basis under paragraph (a)(5) of this section.
(4) Holding period adjustment. For purposes of section 1248,
immediately after the section 337 distribution, the 80-percent
distributee's holding period in the stock of the foreign distributed
corporation received in the section 337 distribution shall equal the
domestic distributing corporation's holding period in such stock at the
time of the section 337 distribution.
(5) Basis adjustments. If the domestic distributing corporation's
section 1248 amount with respect to the stock of the foreign distributed
corporation received by the 80-percent distributee in the section 337
distribution exceeds the 80-percent distributee's postdistribution
amount with respect to such stock (excess amount), the 80-percent
distributee's basis as determined under section 334 in such stock shall
be reduced by the excess amount.
(b) Existing stock distribution under sections 355 or 361. In the
case of an existing stock distribution (as defined in Sec. 1.1248(f)-
1(b)(2)), Sec. 1.1248(f)-1(b)(2) shall not apply to the distribution of
stock of the foreign distributed corporation to a distributee that is a
section 1248 shareholder with respect to the foreign distributed
corporation immediately after the distribution if the domestic
distributing corporation and all distributees that are section 1248
shareholders elect to apply the provisions of this paragraph (b) in
accordance with paragraph (b)(1) of this section. See paragraphs (b)(2)
and (3) of this section for adjustments that may be required if an
election is made to apply the provisions of this paragraph (b).
(1) Election and reporting--(i) Statement required by domestic
distributing corporation and section 1248 shareholders--(A) In general.
The domestic distributing corporation and all distributees that are
section 1248 shareholders elect to apply the provisions of paragraph (b)
of this section by each including a statement, described in paragraph
(b)(1)(i)(B) of this section, with a timely filed return for the taxable
year during which the existing stock distribution occurs and by entering
into a written agreement described in paragraph (b)(1)(ii) of this
section. If the domestic distributing corporation or a section 1248
shareholder is a member of a consolidated group but not the common
parent, the common parent of the consolidated group makes the election
on behalf of the domestic distributing corporation or section 1248
shareholder. The election made under this paragraph (b)(1) is
irrevocable.
(B) Form and content. The statement of election must be entitled,
``ELECTION TO APPLY EXCEPTION UNDER Sec. 1.1248(f)-2(b),'' state that
the domestic distributing corporation and all distributees that are
section 1248 shareholders have entered into a written agreement
described in paragraph (b)(1)(ii) of this section, the date of the
agreement and the names of the parties to the agreement, and set forth
any required adjustment to each section 1248 shareholder's holding
period or section 358 basis (if any) in the stock of the foreign
distributed corporation received in the existing stock distribution
under paragraph (b)(2) or (b)(3) of this section, respectively.
(ii) Written agreement. The domestic distributing corporation and
the section 1248 shareholders must enter into a written agreement
described in this paragraph (b)(1)(ii) on or before the due
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date (including extensions) of the domestic distributing corporation's
U.S. income tax return for the taxable year during which the existing
stock distribution occurs. Each party to the agreement must retain the
original or a copy of the agreement as part of its records in the manner
specified by Sec. 1.6001-1(e). Each party to the agreement must provide
a copy of the agreement to the Internal Revenue Service within 30 days
of the receipt of a request for the agreement in connection with an
examination of the taxable year during which the existing stock
distribution occurs. The written agreement must--
(A) State the document is an agreement under paragraph (b)(1)(ii) of
this section;
(B) Provide the name and taxpayer identification number (if any) of
the domestic distributing corporation, the foreign distributed
corporation, and each section 1248 shareholder;
(C) With respect to each section 1248 shareholder, state the holding
period in the stock of the foreign distributed corporation received in
the existing stock distribution as adjusted under paragraph (b)(2) of
this section; and
(D) With respect to each section 1248 shareholder, identify the
basis under section 358 of the stock of the foreign distributed
corporation received in the existing stock distribution and the
adjustment (if any) to the basis under paragraph (b)(3) of this section.
(2) Holding period adjustments. For purposes of section 1248,
immediately after the existing stock distribution, each section 1248
shareholder's holding period in each share of stock of the foreign
distributed corporation received in the existing stock distribution will
be equal to the domestic distributing corporation's holding period in
the share of stock at the time of the existing stock distribution.
(3) Basis adjustments. If the domestic distributing corporation's
section 1248 amount with respect to a share of stock of the foreign
distributed corporation received by a section 1248 shareholder in the
existing stock distribution exceeds the section 1248 shareholder's
postdistribution amount with respect to the share of stock (excess
amount), the section 1248 shareholder's section 358 basis in the share
of stock is reduced by the excess amount. For an illustration of the
rule in this paragraph (b)(3), see paragraph (e) of this section,
Example 1 and Example 3.
(c) New stock distribution under section 361. In the case of a new
stock distribution (as defined in Sec. 1.1248(f)-1(b)(3)), the amount
that the domestic distributing corporation is required to include in
gross income as a dividend under Sec. 1.1248(f)-1(b)(3) (total section
1248(f) amount) is reduced by the sum of the portions of any section
1248(f) amount attributable under paragraph (d) of this section to stock
of the foreign distributed corporation distributed to distributees that
are section 1248 shareholders, but only if the domestic distributing
corporation and all the distributees that are section 1248 shareholders
elect to apply the provisions of this paragraph (c) in accordance with
paragraph (c)(1) of this section. See paragraphs (c)(2), (c)(3), and
(c)(4) of this section for adjustments or income inclusions that are
required if an election is made to apply the provisions of this
paragraph (c). The adjustments or income inclusions provided in
paragraphs (c)(2), (c)(3), and (c)(4) of this section apply after any
adjustments required under section 367(a)(5) and Sec. 1.367(a)-7(c).
For illustrations of this exception, see paragraph (e) of this section,
Example 2 and Example 3 and Sec. 1.367(a)-3(e)(8), Example 3.
(1) Election and reporting--(i) Statement required by domestic
distributing corporation and section 1248 shareholders--(A) In general.
The domestic distributing corporation and all distributees that are
section 1248 shareholders elect to apply the provisions of paragraph (c)
of this section by each including a statement, in the form and
containing the information listed in paragraph (c)(1)(i)(B) of this
section, with a timely filed return for the taxable year during which
the new stock distribution occurs and by entering into a written
agreement described in paragraph (c)(1)(ii) of this section. If the
domestic distributing corporation or a section 1248 shareholder is a
member of a consolidated group at the time of the new stock distribution
but is not
[[Page 431]]
the common parent, the common parent of the consolidated group makes the
election on behalf of the domestic distributing corporation or section
1248 shareholder. The election made under this paragraph (c)(1) is
irrevocable.
(B) Form and content. The statement of election must be entitled,
``ELECTION TO APPLY EXCEPTION UNDER Sec. 1.1248(f)-2(c),'' state that
the domestic distributing corporation and each distributee that is a
section 1248 shareholder have entered into a written agreement described
in paragraph (c)(1)(ii) of this section, the date of the agreement and
the names of the parties to the agreement, and describe, with respect to
each section 1248 shareholder, the extent to which the shares of stock
of the foreign distributed corporation received in the new stock
distribution are divided into portions under paragraph (c)(2) of this
section, any adjustments to the section 358 basis of the stock under
paragraph (c)(3) of this section, and the amount the domestic
distributing corporation must include in gross income as a dividend
under paragraph (c)(3) of this section.
(ii) Written agreement. The domestic distributing corporation and
all distributees that are section 1248 shareholders must enter into a
written agreement described in this paragraph (c)(1)(ii) on or before
the due date (including extensions) of the domestic distributing
corporation's U.S. income tax return for the taxable year during which
the new stock distribution occurs. Each party to the agreement must
retain the original or a copy of the agreement as part of its records in
the manner specified by Sec. 1.6001-1(e). Each party to the agreement
must provide a copy of the agreement to the Internal Revenue Service
within 30 days of the receipt of a request for the agreement in
connection with an examination of the taxable year during which the new
stock distribution occurs. The written agreement must--
(A) State the document is an agreement under paragraph (c)(1)(ii) of
this section;
(B) Provide the name and taxpayer identification number (if any) of
the domestic distributing corporation, the foreign distributed
corporation, and each section 1248 shareholder;
(C) With respect to each section 1248 shareholder, describe the
extent to which the shares of stock of the foreign distributed
corporation are divided into portions under paragraph (c)(2) of this
section;
(D) With respect to each section 1248 shareholder, state the amount
of earnings and profits attributable to the stock (or each block of
stock, as applicable) of each foreign corporation transferred in the
section 361 exchange that is attributable under Sec. 1.1248-8(b)(2)(iv)
to the stock of the foreign distributed corporation received in the new
stock distribution;
(E) With respect to each section 1248 shareholder, state the amount
of the section 1248(f) amount with respect to the stock (or each block
of stock, as applicable) of each foreign corporation transferred in the
section 361 exchange that is attributable under Sec. 1.1248(f)-2(d) to
the stock of the foreign distributed corporation received in the new
stock distribution;
(F) With respect to each section 1248 shareholder, state the amount
of the adjustment to the section 358 basis of the stock of the foreign
distributed corporation under paragraph (c)(3) of this section; and
(G) With respect to each section 1248 shareholder, state the amount
the domestic distributing corporation must include in gross income as a
dividend under paragraph (c)(3) of this section.
(2) Portions. If the domestic distributing corporation transfers
property, other than a single block of stock of a foreign corporation
with respect to which the domestic distributing corporation is a section
1248 shareholder immediately before the section 361 exchange, to the
foreign distributed corporation in the section 361 exchange that
precedes the new stock distribution, then each share of stock of the
foreign distributed corporation received by a distributee that is a
section 1248 shareholder must be divided into portions as follows:
(i) One portion attributable to all property transferred in the
section 361 exchange, other than property that is
[[Page 432]]
stock of a foreign corporation with respect to which the domestic
distributing corporation is a section 1248 shareholder immediately
before the section 361 exchange; and
(ii) One portion attributable to each block of stock of each foreign
corporation transferred in the section 361 exchange with respect to
which the domestic distributing corporation is a section 1248
shareholder immediately before the section 361 exchange. For the
determination of the earnings and profits attributable to the stock (or
block of stock, as applicable) of each foreign corporation transferred
in the section 361 exchange that are attributable to a portion of a
share of stock of the foreign distributed corporation, see Sec. 1.1248-
8(b)(2)(iv). For the determination of the section 1248(f) amount with
respect to the stock (or block of stock, as applicable) of each foreign
corporation transferred in the section 361 exchange that is attributable
to a portion of a share of stock of the foreign distributed corporation,
see paragraph (d)(2) of this section.
(3) Basis adjustments and income inclusions. If the section 1248(f)
amount attributable to a portion of a share of stock (or whole share, if
no division is required) (as determined under paragraph (d) of this
section) of the foreign distributed corporation received by a
distributee that is a section 1248 shareholder in the new stock
distribution exceeds the section 1248 shareholder's postdistribution
amount in the portion (or whole share, if no division is required)
(excess amount), then the section 1248 shareholder's section 358 basis
in the portion as determined under paragraph (c)(4) of this section (or
whole share, if no division is required), as adjusted under Sec.
1.367(a)-7(c)(3), is reduced by the excess amount, but not below zero.
To the extent the excess amount exceeds the section 358 basis in the
portion (or whole share, if no division is required), the domestic
distributing corporation must include that portion of the section
1248(f) amount attributable to the portion of the share (or whole share,
if no division is required) in gross income as a dividend. For an
illustration of this rule, see paragraph (e) of this section, Example 2,
and Sec. 1.367(a)-3(e)(8), Example 3.
(4) Divided shares of stock--(i) Basis. The basis of a portion of a
share of stock of the foreign distributed corporation created under
paragraph (c)(2) of this section is the product of the section 1248
shareholder's section 358 basis, as adjusted under Sec. 1.367(a)-
7(c)(3), in the share of stock multiplied by the ratio of the basis
determined under section 362 (taking into account any gain or deemed
dividends recognized under section 367) of the property (section 362
basis) to which the portion relates, to the aggregate section 362 basis
of all property received by the foreign distributed corporation in the
section 361 exchange. For illustrations of this rule, see paragraph (e)
of this section, Example 2, and Sec. 1.367(a)-3(e)(8), Example 3.
(ii) Fair market value. The fair market value of a portion of a
share of stock of the foreign distributed corporation created under
paragraph (c)(2) of this section is the product of the fair market value
of the share of stock multiplied by the ratio of the fair market value
of the property to which the portion relates to the aggregate fair
market value of all property received by the foreign distributed
corporation in the section 361 exchange. For illustrations of this rule,
see paragraph (e) of this section, Example 2, and Sec. 1.367(a)-
3(e)(8), Example 3.
(iii) Subsequent exchanges. For purposes of determining the gain
realized on the sale or exchange of a share of stock of the foreign
distributed corporation that has divided portions under paragraph (c)(2)
of this section, the amount realized on the sale or exchange of the
share will be allocated to each divided portion based on the relative
fair market value of the property to which the portion relates as
determined at the time of the reorganization.
(iv) Duration of divided shares. Shares of stock of the foreign
distributed corporation that are divided into portions under paragraph
(c)(2) of this section must be divided so long as section 1248(a) would
apply to a sale or exchange of the shares.
(d) Attribution of all or a portion of section 1248(f) amount to
certain stock of the foreign distributed corporation. This paragraph (d)
applies if there is a new
[[Page 433]]
stock distribution for which an election under Sec. 1.1248(f)-2(c)(1)
is made. This paragraph (d) provides rules for attributing all or a
portion, as applicable, of the section 1248(f) amount with respect to
the stock of each foreign corporation transferred in the section 361
exchange by the domestic distributing corporation to shares of stock, or
to portions of shares of stock, as applicable, received in the foreign
distributed corporation and distributed to one or more distributees that
are section 1248 shareholders with respect to the foreign distributed
corporation. Paragraph (d)(1) of this section provides rules to
attribute the applicable section 1248(f) amount among shares of stock of
the foreign distributed corporation received by one or more distributees
that are section 1248 shareholders. If shares of stock are divided into
portions under paragraph (c)(2) of this section, paragraph (d)(2) of
this section provides additional rules to attribute the applicable
section 1248 amount to portions of shares of stock received by one or
more distributees that are section 1248 shareholders.
(1) Attribution of all or a portion of section 1248(f) amount among
shares of stock. With respect to one or more shares of stock of the
foreign distributed corporation distributed to a distributee that is a
section 1248 shareholder, the portion of the section 1248(f) amount with
respect to the stock of the foreign corporation transferred in the
section 361 exchange that is equal to the distributee's hypothetical
section 1248 amount is attributed among those shares of stock of the
foreign distributed corporation based on the ratio of the value of a
share distributed to the distributee to the value of all shares of stock
distributed to the distributee (attributable share amount).
(2) Attribution of all or a portion of section 1248(f) amount to
portions of a share of stock--(i) Single block of stock. If a single
block of stock of the foreign corporation is transferred in the section
361 exchange, the attributable share amount (as determined under
paragraph (d)(1) of this section) is attributed to the portion of the
share that relates to the single block of stock of the foreign
corporation.
(ii) Multiple blocks of stock. If multiple blocks of stock of the
foreign corporation are transferred in the section 361 exchange, the
attributable share amount (as determined under paragraph (d)(1) of the
section) is attributed among the portions of the share that relate to
such multiple blocks of stock of the foreign corporation. The portion of
the attributable share amount that is attributable to a portion to which
a block of stock relates is that amount that bears the same ratio that
the section 1248(f) block amount with respect to that block of stock
bears to the section 1248(f) amount with respect to the stock of the
foreign corporation.
(e) Examples. The rules of this section are illustrated by the
following examples. See also Sec. 1.367(a)-3(e)(8), Example 3. For
purposes of the examples, unless otherwise indicated: DP and DC are
domestic corporations; X is a United States citizen; FP is a foreign
corporation; CFC1, CFC2, and FA are controlled foreign corporations;
each corporation has a single class of stock outstanding and uses the
calendar year as its taxable year; each shareholder of a corporation
owns a single block of stock in the corporation; DC owns Business A,
which consists solely of property whose fair market value exceeds its
basis and could satisfy the requirements of the active foreign trade or
business exception under section 367(a)(3) and Sec. 1.367(a)-2; DC owns
no other assets and has no liabilities; the requirements in Sec.
1.367(a)-7(c)(5) are satisfied; no earnings and profits of a foreign
corporation are described in section 1248(d); and none of the foreign
corporations in the examples is a surrogate foreign corporation (within
the meaning of section 7874) as a result of the transactions described
in the examples because one or more of the conditions of section
7874(a)(2)(B) is not satisfied.
Example 1. Existing stock distribution under section 355(c)(1); gain
recognition and adjustment to stock basis. (i) Facts. DP, FP, and X own
80%, 10%, and 10%, respectively, of the outstanding stock of DC. DP's DC
stock has a $140x basis, $160x fair market value, and a 2-year holding
period. DC wholly owns CFC1. DC's CFC1 stock has a $50x basis, $100x
fair market value (therefore a gain of $50x), $25x of earnings and
profits attributable to it for purposes of section 1248, and a $25x
section
[[Page 434]]
1248 amount (computed as the lesser of $50x gain in the CFC1 stock and
$25x of section 1248 earnings and profits), and a 3-year holding period.
On December 31, year 3, DC distributes all of the CFC1 stock to DP, FP,
and X on a pro-rata basis in a distribution to which section 355
applies. The fair market value of the CFC1 stock received by DP, FP, and
X is $80x, $10x, and $10x, respectively. After the distribution, DP's
stock in DC has a fair market value of $80x and DP's section 358 basis
in the CFC1 stock is $70x (a pro rata portion, or 50%, of DP's $140x
basis in the DC stock immediately before the distribution). See Sec.
1.358-2(a)(iv).
(ii) Result. (A) Under Sec. 1.367(e)-1(b)(1), DC must recognize $5x
gain on the distribution of CFC1 stock to FP (10% of the $50x gain in
the CFC1 stock). Under Sec. 1.367(b)-5(b)(1)(ii), DC must also
recognize $5x gain on the distribution of CFC1 stock to X (10% of the
$50x gain in the CFC1 stock). Of the aggregate $10x gain recognized by
DC, $5x is recharacterized as a dividend under section 1248(a), computed
as 20% of the $25x section 1248 amount with respect to the CFC1 stock.
See Sec. 1.1248-1 for additional consequences.
(B) DC's distribution of CFC1 stock to DP is described in section
1248(f)(1) and Sec. 1.1248(f)-1(b)(2) because the distribution is
pursuant to section 355(c)(1) (an existing stock distribution). As a
result, the general rule is that DC must include in gross income as a
dividend the section 1248 amount with respect to the CFC1 stock
distributed to DP, or $20x (computed as 80% of the $25x section 1248
amount). However, if DP and DC make the election under paragraph (b)(1)
of this section, Sec. 1.1248(f)-1(b)(2) will not apply to DC's
distribution of CFC1 stock to DP. If DP and DC make the election, then:
(1) Under paragraph (b)(2) of this section, for purposes of section
1248, immediately after the distribution DP will have a 3-year holding
period in the CFC1 stock, the same holding period DC had in the CFC1
stock at the time of the distribution.
(2) Under paragraph (b)(3) of this section, DP's section 358 basis
in the CFC1 stock ($70x) is reduced by $10x, the amount by which DC's
section 1248 amount with respect to the CFC1 stock ($20x) distributed to
DP exceeds DP's postdistribution amount with respect to the CFC1 stock
($10x). Under Sec. 1.1248(f)-1(c)(6), DP's postdistribution amount
equals the amount that DP would include in gross income as a dividend
under section 1248(a) if DP sold the CFC1 stock immediately after the
distribution, or $10x, which is computed as the lesser of the $10x gain
in the CFC1 stock ($80x fair market value, less $70x basis) and $20x of
section 1248 earnings and profits attributable to the CFC1 stock, taking
into account DP's 3-year holding period in the stock as required by
paragraph (b)(2) of this section. As adjusted under paragraph (b)(3) of
this section, DP's basis in the CFC1 stock is $60x ($70x basis, less
$10x required basis reduction).
Example 2. New stock distribution under section 361(c)(1);
adjustment to stock basis. (i) Facts. DP wholly owns DC. DP's DC stock
has a $180x basis and $200x fair market value. DC wholly owns CFC1 and
CFC2. DC's CFC1 stock has a $70x basis, $100x fair market value
(therefore a gain of $30x), $40x of earnings and profits attributable to
it for purposes of section 1248, and a section 1248 amount of $30x
(computed as the lesser of the $30x gain in CFC1 stock and $40x section
1248 earnings and profits). DC's CFC2 stock has a $130x basis, $100x
fair market value (therefore a loss of $30x), $80x of earnings and
profits attributable to it for purposes of section 1248, and a section
1248 amount of $0x (computed as the lesser of the $0x gain and $80x
section 1248 earnings and profits). On December 31, Year 1, in a
reorganization described in section 368(a)(1)(F), DC transfers the CFC1
stock and the CFC2 stock to FA, a newly formed corporation, in exchange
for 100 shares of FA stock. DC distributes the 100 shares of FA stock to
DP. DC's transfer of the CFC1 stock and CFC2 stock to FA in exchange for
FA stock qualifies as a section 361 exchange, and DC's distribution of
the 100 shares of FA stock to DP is pursuant to section 361(c)(1). DP
exchanges its DC stock for the 100 shares of FA stock pursuant to
section 354. Immediately after the transaction, DP wholly owns FA. DP
and DC elect to apply the provisions of Sec. 1.367(a)-7(c) in
accordance with Sec. 1.367(a)-7(c)(5). Pursuant to Sec. 1.367(a)-
3(e)(3)(iii)(A), DP properly files a gain recognition agreement with
respect to the CFC1 stock that satisfies the conditions of Sec. Sec.
1.367(a)-3(e)(6) and 1.367(a)-8.
(ii) Result. (A) DC does not recognize gain under Sec. 1.367(a)-
3(e)(2) with respect to the transfer of the CFC1 stock to FA because the
three conditions in Sec. 1.367(a)-3(e)(3)(i), (e)(3)(ii), and
(e)(3)(iii) are satisfied. First, Sec. 1.367(a)-3(e)(3)(i) is satisfied
because the requirements of Sec. 1.367(a)-7(c) are satisfied, including
that an election is made to apply Sec. 1.367(a)-7(c). Second, the
requirements under Sec. 1.367(a)-3(e)(3)(ii) related to transfers of
domestic stock are not applicable because CFC1 is a foreign corporation.
Third, because DC owns all the stock of FA immediately after DC's
receipt of the FA stock in the section 361 exchange but prior to, and
without taking into account, DC's distribution of the FA stock to DP,
for purposes of satisfying the requirements of Sec. 1.367(a)-
3(e)(3)(iii), DP properly files a gain recognition agreement with
respect to the CFC1 stock that satisfies the conditions of Sec. Sec.
1.367(a)-3(e)(6) and 1.367(a)-8. Furthermore, DC is not required to
recognize gain under Sec. 1.367(a)-7(c)(2)(ii), and DP is not required
to reduce its $180x section 358 basis in the FA stock under Sec.
1.367(a)-7(c)(3), because the inside gain (within the meaning of Sec.
1.367(a)-7(f)(5)) is $0x
[[Page 435]]
($200x aggregate fair market value of CFC1 stock and CFC2 stock, less
$200x aggregate basis of CFC1 stock and CFC2 stock). In addition, DC is
not required to include in income as a deemed dividend the $30x section
1248 amount with respect to the CFC1 stock under Sec. 1.367(b)-
4(b)(1)(i) because immediately after DC's receipt of the FA stock in the
section 361 exchange but prior to, and without taking into account, DC's
distribution of the FA stock to DP, CFC1 and FA are controlled foreign
corporations as to which DC is a section 1248 shareholder. See Sec.
1.367(b)-4(b)(1)(ii)(A). With respect to the transfer of the CFC2 stock
to FA, DC's section 1248 amount with respect to the CFC2 stock is $0x;
therefore, Sec. 1.367(b)-4(b)(1)(i) has no application.
(B) Under Sec. 1.1248(f)-1(b)(3), as a result of the section
361(c)(1) distribution of the FA stock to DP (a new stock distribution),
the general rule is that DC must include in gross income as a dividend
the total section 1248(f) amount (defined in Sec. 1.1248(f)-1(c)(14)).
The total section 1248(f) amount is $30x, the sum of the section 1248(f)
amount (defined in Sec. 1.1248(f)-1(c)(10)) with respect to the CFC1
stock ($30x) and CFC2 stock ($0x). The section 1248(f) amount with
respect to the CFC1 stock is the amount that DC would have included in
income as a deemed dividend under Sec. 1.367(b)-4(b)(1)(i) with respect
to the CFC1 stock if the requirements under Sec. 1.367(b)-
4(b)(1)(ii)(A) had not been satisfied ($30x), less the amount of gain
recognized by DC under Sec. 1.367(a)-7(c)(2) that is allocable to the
CFC1 stock under Sec. 1.367(a)-7(e)(1) and treated as a dividend under
section 1248(a) ($0x). Similarly, the section 1248(f) amount with
respect to the CFC2 stock is the amount that DC would have included in
income as a deemed dividend under Sec. 1.367(b)-4(b)(1)(i) with respect
to the CFC2 stock if the requirements under Sec. 1.367(b)-
4(b)(1)(ii)(A) had not been satisfied ($0x), less the amount of gain
recognized by DC under Sec. 1.367(a)-7(c)(2) that is allocable to the
CFC2 stock under Sec. 1.367(a)-7(e)(1) and treated as a dividend under
section 1248(a) ($0x).
(C) If, however, DP and DC make the election provided in paragraph
(c)(1) of this section, the amount that DC is required to include in
gross income as a dividend under Sec. 1.1248(f)-1(b)(3) (the total
section 1248(f) amount of $30x) is reduced to the extent the section
1248(f) amount with respect to the CFC1 stock ($30x) and CFC2 stock
($0x) is attributable under paragraph (d) of this section to the shares
of FA stock distributed to one or more distributees that are section
1248 shareholders of FA. The only distributee is DP, and DP is a section
1248 shareholder with respect to FA. If DP and DC elect to apply
paragraph (c) of this section, then:
(1) Under paragraph (d)(1) of this section, the portion of the
section 1248(f) amount with respect to the CFC1 stock that is attributed
to the shares of FA stock distributed to DP is equal to DP's
hypothetical section 1248 amount (as defined in Sec. 1.1248(f)-1(c)(4))
with respect to the CFC1 stock. Because DP is the only shareholder of
DC, DP's hypothetical section 1248 amount equals the section 1248(f)
amount with respect to the CFC1 stock ($30x). The $30x hypothetical
section 1248 amount is attributed pro rata (based on relative values)
among the 100 shares of FA stock distributed to DP, and the attributable
share amount (as defined in paragraph (d)(1) of this section) is $.30x.
Paragraph (d)(1) of this section has no application with respect to the
CFC2 stock because there is no section 1248(f) amount with respect to
the CFC2 stock.
(2) If the shares of FA stock are divided into portions, the rules
of paragraph (d)(2) of this section apply to attribute the attributable
share amount ($.30x) to portions of shares of FA stock distributed to
DP. Under paragraph (c)(2)(ii) of this section, the 100 shares of FA
stock are divided into two portions, one portion related to the single
block of CFC1 stock and one portion related to the single block of CFC2
stock. Under paragraph (d)(2)(i) of this section, the attributable share
amount of $.30x is attributed to the portion of the 100 shares of FA
stock that relates to the single block of CFC1 stock. Thus, all of the
$30x section 1248(f) amount with respect to the CFC1 stock is
attributable to the 100 shares of FA stock.
(3) Because the election under paragraph (c)(1) of this section is
made, the total section 1248(f) amount ($30x) that DC is otherwise
required to include in gross income as a dividend under Sec. 1.1248(f)-
1(b)(3) is reduced by $30x, the portion of the section 1248(f) amount
with respect to the CFC1 stock that is attributable under paragraph (d)
of this section to the shares of FA stock distributed to DP. Thus, the
amount DC is required to include in gross income as a dividend under
Sec. 1.1248(f)-1(b)(3) is $0x ($30x less $30x).
(4) Under paragraph (c)(4)(i) of this section, the basis of each
portion is the product of DP's section 358 basis in the share of FA
stock multiplied by the ratio of the section 362 basis of the property
(CFC1 stock or CFC2 stock, as applicable) to which the portion relates,
to the aggregate section 362 basis of all property (CFC1 stock and CFC2
stock) received by FA in the section 361 exchange. Under paragraph
(c)(4)(ii) of this section, the fair market value of each portion is the
product of the fair market value of the share of FA stock multiplied by
the ratio of the fair market value of the property (CFC1 stock or CFC2
stock, as applicable) to which the portion relates, to the aggregate
fair market value of all property (CFC1 stock and CFC2 stock) received
by FA in the section 361 exchange. The section 362 basis of the CFC1
stock and CFC2 stock is $70x and $130x, respectively, for a total
section 362 basis of
[[Page 436]]
$200x. The CFC1 stock and CFC2 stock each has a fair market value of
$100x, for a total fair market value of $200x. Therefore, the portions
attributable to the CFC1 stock have an aggregate basis of $63x ($180x
multiplied by $70x/$200x) and fair market value of $100x ($200x
multiplied by $100x/$200x), resulting in aggregate gain in such portions
of $37x (or $.37x per portion in each of the 100 shares). The portions
attributable to the CFC2 stock have an aggregate basis of $117x ($180x
multiplied by $130x/$200x) and fair market value of $100x ($200x
multiplied by $100x/$200x), resulting in aggregate losses in such
portions of $17x (or $.17x per portion in each of the 100 shares).
(5) Under Sec. 1.1248-8(b)(2)(iv), the $40x earnings and profits
attributable to the single block of CFC1 stock are attributed to the
portions of the 100 shares of FA stock that relate to the CFC1 stock.
Similarly, the $80x of earnings and profits attributable to the single
block of CFC2 stock are attributed to the portions of the 100 shares of
the FA stock that relate to the CFC2 stock. Thus, DP's postdistribution
amount (defined in Sec. 1.1248(f)-1(c)(6)) with respect to the portions
of the shares of FA attributable to the CFC1 stock is $37x, the lesser
of the aggregate gain in the portions attributable to the CFC1 stock of
$37x (computed in paragraph (ii)(C)(4) of this Example 2) and the $40x
earnings and profits attributable to such portions. Furthermore, DP's
postdistribution amount with respect to the portions of the shares of FA
attributable to the CFC2 stock is $0x, the lesser of the aggregate gain
in the portions attributable to the CFC2 stock of $0x (computed in
paragraph (ii)(C)(4) of this Example 2 to be an aggregate loss of $17x)
and the $80x earnings and profits attributable to such portions.
(6) Under paragraph (c)(3) of this section, DP's section 358 basis
in the portions of the 100 shares of FA stock attributable to the CFC1
stock ($63x, computed in paragraph (ii)(C)(4) of this Example 2) is
reduced by the amount (if any) by which the section 1248(f) amount
attributable to such portions under paragraph (d) of this section ($30x,
as computed in paragraph (ii)(C)(2) of this Example 2) exceeds DP's
postdistribution amount with respect to such portions ($37x, computed in
paragraph (ii)(C)(5) of this Example 2). Thus, there is no basis
reduction in the portions of the 100 shares of FA stock attributable to
the CFC1 stock. DP's section 358 basis in the portions of the 100 shares
of FA stock attributable to the CFC2 stock is not reduced because the
section 1248(f) amount attributable to such portions under paragraph (d)
of this section is $0x (computed in paragraph (ii)(C)(2) of this Example
2), which equals DP's postdistribution amount with respect to such
portions of $0x (as computed in paragraph (ii)(C)(5) of this Example 2).
Example 3. Combined existing stock distribution and new stock
distribution under sections 355(c)(1) and 361(c)(1). (i) Facts. DP owns
all 100 outstanding shares of stock of DC. DP's DC stock has a $180x
basis (each of the 100 shares having a basis of $18), $200x fair market
value, and 2-year holding period. DC owns all 60 shares of the
outstanding stock of CFC1; all such shares constitute a single block of
stock. DC's CFC1 stock has a $50x basis, $60x fair market value, $30x of
earnings and profits attributable to it for purposes of section 1248, a
$10x section 1248 amount (computed as the lesser of $10x gain and $30x
of section 1248 earnings and profits), and a 3-year holding period. DC
also owns all 40 shares of the outstanding stock of CFC2; all such
shares constitute a single block of stock. DC's CFC2 stock has a $30x
basis, $40x fair market value, $20x of earnings and profits attributable
to it for purposes of section 1248, and a $10x section 1248 amount
(computed as the lesser of $10x gain and $20x of section 1248 earnings
and profits). DC also owns Business A, which has a fair market value of
$100x. On December 31, year 4, in a divisive reorganization described in
section 368(a)(1)(D), DC transfers the CFC2 stock to CFC1 in exchange
for 40 shares of newly issued CFC1 stock. DC's transfer of the CFC2
stock to CFC1 qualifies as a section 361 exchange. DC then distributes
the 100 shares of CFC1 stock (60 shares held prior to the transaction
and 40 shares received in the section 361 exchange) to DP in a
transaction that qualifies under section 355. DP properly files a gain
recognition agreement with respect to the CFC2 stock that satisfies the
conditions of Sec. Sec. 1.367(a)-3(e)(6) and 1.367(a)-8. DP and DC
properly make the elections provided in Sec. 1.367(a)-7(c)(5) and
paragraphs (b) and (c) of this section.
(ii) Result. (A) DC does not recognize gain under Sec. 1.367(a)-
3(e)(2) with respect to the transfer of the CFC2 stock to CFC1 because
the three conditions in Sec. 1.367(a)-3(e)(3)(i), (e)(3)(ii), and
(e)(3)(iii) are satisfied. First, Sec. 1.367(a)-3(e)(3)(i) is satisfied
because the requirements of Sec. 1.367(a)-7(c) are satisfied, including
that an election is made to apply Sec. 1.367(a)-7(c). Second, the
requirements under Sec. 1.367(a)-3(e)(3)(ii) related to transfers of
domestic stock are not applicable because CFC2 is a foreign corporation.
Third, because DC and DP own all the stock of CFC1 for purposes of
satisfying the requirements of Sec. 1.367(a)-3(e)(3)(iii), DP properly
files a gain recognition agreement with respect to the CFC2 stock that
satisfies the conditions of Sec. Sec. 1.367(a)-3(e)(6) and 1.367(a)-8.
See paragraph (ii)(G) of this example for the computation of the amount
of gain subject to the gain recognition agreement. In addition, DC is
not required to include in income as a dividend the $10x section 1248
amount with respect to the CFC2 stock under Sec. 1.367(b)-4(b)(1)(i)
because immediately after DC's receipt of the
[[Page 437]]
CFC1 stock in the section 361 exchange but prior to, and without taking
into account, DC's distribution of the CFC1 stock to DP, CFC1 and CFC2
are controlled foreign corporations as to which DC is a section 1248
shareholder. See Sec. 1.367(b)-4(b)(1)(ii)(A).
(B) DC is not required to recognize gain under Sec. 1.367(a)-
7(c)(2)(i) because DP, a control group member (as defined in Sec.
1.367(a)-7(f)(1)), owns 100% of DC. DC is not required to recognize gain
under Sec. 1.367(a)-7(c)(2)(ii) because the amount described in Sec.
1.367(a)-7(c)(2)(ii)(A) ($10x) does not exceed the amount described in
Sec. 1.367(a)-7(c)(2)(ii)(B) ($40x). The $10x described in Sec.
1.367(a)-7(c)(2)(ii)(A) equals the product of the inside gain (as
defined in Sec. 1.367(a)-7(f)) ($10x) multiplied by DP's ownership
interest percentage (as defined in Sec. 1.367(a)-7(f)) (100%), reduced
by the sum of the amounts in Sec. 1.367(a)-7(c)(2)(ii)(A)(1),
(c)(2)(ii)(A)(2), and (c)(2)(ii)(A)(3) ($0x). Under Sec. 1.367(a)-
7(f)(5), the $10x of inside gain is the amount by which the aggregate
fair market value of the section 367(a) property (CFC2 stock with a fair
market value of $40x) exceeds the sum of the inside basis ($30x) of such
property, and $0x (the product of the section 367(a) percentage (100%)
multiplied by DC's deductible liabilities assumed by CFC1 ($0x)). Under
Sec. 1.367(a)-7(f)(4), the $30x inside basis equals the aggregate basis
of the section 367(a) property transferred in the section 361 exchange
($30x), increased by any gain or deemed dividends recognized by DC with
respect to the section 367(a) property under section 367 ($0x). The $40x
described in Sec. 1.367(a)-7(c)(2)(ii)(B) is the product of the section
367(a) percentage (100%) multiplied by the fair market value of the 40
shares of CFC1 stock received by DC in the section 361 exchange and
distributed to DP ($40x).
(C) Under section 358, DP must allocate the $180x basis in its 100
shares of DC stock between the 100 shares of DC stock (fair market value
of $100x) and the 100 shares of CFC1 stock (fair market value of $100x)
held after the distribution based on the relative fair market values of
the shares. Accordingly, after the allocation of the basis under section
358, but prior to the application of Sec. 1.367(a)-7(c)(3), the basis
of DP's DC stock is $90x and the basis of DP's CFC1 stock is $90x. With
respect to the $90x basis in the 100 shares of CFC1 stock, $36x is
attributable to the 40 shares of CFC1 stock received by DC in the
section 361 exchange ($90x multiplied by 40/100), and $54x is
attributable to the 60 shares of CFC1 stock owned by DC prior to the
section 361 exchange ($90x multiplied by 60/100). See Sec. 1.358-
2(a)(2)(iv).
(D) Pursuant to Sec. 1.367(a)-7(c)(3)(ii), any adjustment to DP's
basis in the CFC1 stock required under Sec. 1.367(a)-7(c)(3)(i) can
only be made with respect to the 40 shares of CFC1 stock received by DC
in the section 361 exchange. Under Sec. 1.367(a)-7(c)(3)(i)(A), DP must
reduce its section 358 basis ($36x) in the 40 shares of CFC1 stock by
$6x, the amount by which DP's attributable inside gain ($10x), reduced
by the sum of the amounts in Sec. 1.367(a)-7(c)(2)(ii)(A)(1),
(c)(2)(ii)(A)(2), and (c)(2)(ii)(A)(3) ($0x) (as computed in paragraph
(ii)(B) of this Example 3) exceeds DP's outside gain (as defined in
Sec. 1.367(a)-7(f)) ($4x). DP's $4x outside gain equals the product of
the section 367(a) percentage (as defined in Sec. 1.367(a)-7(f)) (100%)
multiplied by the amount by which the fair market value ($40x) of the 40
shares of CFC1 stock is greater than DP's section 358 basis in the stock
($36x). After the $6x reduction to stock basis required under Sec.
1.367(a)-7(c)(3), but before the application of Sec. 1.1248(f)-2(c)(3),
DP's basis in the 40 shares of CFC1 stock is $30x.
(E) DC's distribution of the 40 shares of newly issued CFC1 stock is
subject to Sec. 1.1248(f)-1(b)(3) (a new stock distribution). Except as
provided in Sec. 1.1248(f)-2(c), under Sec. 1.1248(f)-1(b)(3) DC must
include in gross income as a dividend the total section 1248(f) amount
(as defined in Sec. 1.1248(f)-1(c)(14)). The total section 1248(f)
amount is $10x, the sum of the section 1248(f) amount (as defined in
Sec. 1.1248(f)-1(c)(10)) with respect to the stock of each foreign
corporation transferred in the section 361 exchange. Only the CFC2 stock
is transferred in the section 361 exchange; therefore, the total section
1248(f) amount is equal to the section 1248(f) amount with respect to
the CFC2 stock ($10x). The $10x section 1248(f) amount with respect to
the CFC2 stock is the amount that DC would have included in income as a
deemed dividend under Sec. 1.367(b)-4(b)(1)(i) with respect to the CFC2
stock if the requirements of Sec. 1.367(b)-4(b)(1)(ii)(A) had not been
satisfied ($10x), reduced by the amount of gain recognized by DC under
Sec. 1.367(a)-7(c)(2) allocable to the CFC2 stock and treated as a
dividend under section 1248(a) (in this case, $0x, as described in
paragraph (ii)(B) of this Example 3).
(F) However, because DC and DP (a section 1248 shareholder of CFC1
immediately after the distribution) elect to apply the provisions of
Sec. 1.1248(f)-2(c) (as provided in Sec. 1.1248(f)-2(c)(1)), the
amount that DC is required to include in income as a dividend under
Sec. 1.1248(f)-1(b)(3) ($10x total section 1248(f) amount as computed
in paragraph (ii)(E) of this Example 3) is reduced by the sum of the
portions of the section 1248(f) amount with respect to the CFC2 stock
that is attributable (under the rules of Sec. 1.1248(f)-2(d)) to the 40
shares of CFC1 stock distributed to DP. As stated in the facts, the
election is made to apply Sec. 1.1248(f)-2(c).
(1) Under paragraph (d)(1) of this section, the portion of the
section 1248(f) amount with respect to the CFC2 stock that is attributed
to the 40 shares of CFC1 stock distributed to DP is equal to DP's
hypothetical section 1248 amount (as defined in Sec. 1.1248(f)-
[[Page 438]]
1(c)(4)) with respect to the CFC2 stock. Because DP is the only
shareholder of DC, DP's hypothetical section 1248 amount equals the
section 1248(f) amount with respect to the CFC2 stock ($10x). The $10x
hypothetical section 1248 amount is attributed pro rata (based on
relative values) among the 40 shares of CFC1 stock distributed to DP,
and the attributable share amount (as defined in paragraph (d)(1) of
this section) is $.25x.
(2) The 40 shares of CFC1 stock are not divided into portions under
paragraph (c)(2) of this section because the only property transferred
by DC to CFC1 is a single block of stock of CFC2. If the 40 shares of
CFC1 stock were required to be divided into portions, however, the rules
of paragraph (d)(2) of this section apply to attribute the attributable
share amount ($.25x) to portions of shares of CFC1 stock distributed to
DP.
(3) Because the election under paragraph (c)(1) of this section is
made, the total section 1248(f) amount ($10x) that DC is otherwise
required to include in gross income as a dividend under Sec. 1.1248(f)-
1(b)(3) is reduced by $10x, the portion of the section 1248(f) amount
with respect to the CFC2 stock that is attributable under paragraph (d)
of this section to the 40 shares of CFC1 stock distributed to DP. Thus,
the amount DC is required to include in gross income as a dividend under
Sec. 1.1248(f)-1(b)(3) is $0x ($30x less $30x).
(4) Under Sec. 1.1248-8(b)(2)(iv), the $20x earnings and profits
attributable to the single block of CFC2 stock are attributed pro rata
to the 40 shares of CFC1 stock. Thus, DP's postdistribution amount
(defined in Sec. 1.1248(f)-1(c)(6)) with respect to the 40 shares of
CFC1 stock attributable to the CFC2 stock is $10x, the lesser of the
aggregate gain in the 40 shares of CFC1 stock of $10x ($40x fair market
value, less $30x section 358 basis, as described in paragraph (ii)(D) of
this Example 3) and the $20x earnings and profits attributable to such
shares.
(5) Under paragraph (c)(3) of this section, DP's section 358 basis
in the 40 shares of CFC1 stock ($30x) is reduced by the amount (if any)
by which the section 1248(f) amount attributable to such shares under
paragraph (d) of this section ($10x, as computed in paragraph (ii)(E) of
this Example 3) exceeds DP's postdistribution amount with respect to
such shares ($10x). Thus, there is no basis reduction in the 40 shares
of CFC1 stock.
(G) Pursuant Sec. 1.367(a)-3(e)(6), the amount of gain subject to
the gain recognition agreement entered into by DP with respect to the
CFC2 stock is $10x, which is the product of DP's ownership interest
percentage (100%) multiplied by the gain realized by DC in the 361
exchange prior to taking into account the application of any other
provision of section 367 ($10x), reduced by the sum of the amounts
described in Sec. 1.367(a)-3(e)(6)(i)(A), (e)(6)(i)(B), (e)(6)(i)(C),
and (e)(6)(i)(D) ($0x).
(H) DC's distribution of the 60 shares of CFC1 stock it held before
the section 361 exchange is subject to Sec. 1.1248(f)-1(b)(2) (an
existing stock distribution); however, because DC and DP make the
election provided in paragraph (b)(1) of this section, Sec. 1.1248(f)-
1(b)(2) does not apply to the distribution.
(1) Under paragraph (b)(2) of this section, for purposes of section
1248, DP will have a 3-year holding period in the 60 shares of CFC1
stock received, the same holding period that DC had in the 60 shares of
CFC1 stock.
(2) Under paragraph (b)(3) of this section, DP's section 358 basis
in the 60 shares of CFC1 stock received ($54x, as computed in paragraph
(ii)(C) of this Example 3) is reduced by $4x, the amount by which DC's
section 1248 amount ($10x) with respect to the 60 shares of CFC1 stock
exceeds DP's postdistribution amount ($6x) with respect to the 60 shares
of CFC1 stock. Under Sec. 1.1248(f)-1(c)(6), DP's postdistribution
amount with respect to the 60 shares of CFC1 stock equals the amount
that DP would include in gross income as a dividend under section
1248(a) if DP sold the 60 shares of CFC1 stock immediately after the
distribution, or $6x, which is computed as the lesser of the $6x gain in
the such shares of CFC1 stock ($60x fair market value, less $54x basis)
and $30x of section 1248 earnings and profits attributable to the CFC1
stock, taking into account DP's 3-year holding period in the stock as
required by paragraph (b)(2) of this section. As adjusted under
paragraph (b)(3) of this section, DP's basis in the 60 shares of CFC1
stock is $50x ($54x basis, less $4x basis reduction).
(f) Applicable cross-references. For rules relating to the
attribution of earnings and profits to the stock of a foreign
corporation following certain nonrecognition transactions, see Sec.
1.1248-8. For rules relating to a transfer of property by a domestic
corporation to a foreign corporation in a section 361 exchange that
precedes a new stock distribution, see Sec. 1.367(a)-7. If the property
transferred includes stock of a corporation, see also Sec. Sec.
1.367(a)-3(e) and 1.367(b)-4. For other rules that may apply if a
domestic corporation distributes the stock of a foreign corporation in a
new stock distribution or an existing stock distribution satisfying the
requirements of section 355, see Sec. Sec. 1.367(b)-5(b)(1) and
1.367(e)-1.
[T.D. 9614, 78 FR 17044, Mar. 19, 2013, as amended by T.D. 9760, 81 FR
15169, Mar. 22, 2016; T.D. 9803, 81 FR 91031, Dec. 16, 2016]
[[Page 439]]
Sec. 1.1248(f)-3 Reasonable cause and effective/applicability dates.
(a) Reasonable cause for failure to comply--(1) Request for relief.
If an 80-percent distributee, a distributee that is a section 1248
shareholder, or the domestic distributing corporation (reporting person)
fails to timely comply with any requirement under Sec. 1.1248(f)-2, the
failure shall be deemed not to have occurred if the reporting person is
able to demonstrate that the failure was due to reasonable cause and not
willful neglect using the procedure set forth in paragraph (a)(2) of
this section. Whether the failure to timely comply was due to reasonable
cause and not willful neglect will be determined by the Director of
Field Operations, Cross Border Activities Practice Area of Large
Business & International (Director) based on all the facts and
circumstances.
(2) Procedures for establishing that a failure to timely comply was
due to reasonable cause and not willful neglect--(i) Time of submission.
A reporting person's statement that the failure to timely comply was due
to reasonable cause and not willful neglect will be considered only if,
promptly after the reporting person becomes aware of the failure, an
amended return is filed for the taxable year to which the failure
relates that includes the information that should have been included
with the original return for such taxable year or that otherwise
complies with the rules of this section, and that includes a written
statement explaining the reasons for the failure to timely comply.
(ii) Notice requirement. In addition to the requirements of
paragraph (a)(2)(i) of this section, the reporting person must comply
with the notice requirements of this paragraph (a)(2)(ii). If any
taxable year of the reporting person is under examination when the
amended return is filed, a copy of the amended return and any
information required to be included with such return must be delivered
to the Internal Revenue Service personnel conducting the examination. If
no taxable year of the reporting person is under examination when the
amended return is filed, a copy of the amended return and any
information required to be included with such return must be delivered
to the Director.
(b) Effective/applicability date--(1) General rule. Except as
provided in paragraph (b)(2)(ii) of this section, Sec. Sec. 1.1248(f)-1
and 1.1248(f)-2 apply to distributions occurring on or after April 18,
2013. The provisions of Sec. 1.1248(f)-3(a) apply to distributions
occurring on or after April 17, 2013.
(2) Transactions described in Notice 87-64--(i) Gain not otherwise
recognized. For distributions occurring on or after September 21, 1987,
and before April 18, 2013, section 1248(f)(1) shall not apply to the
extent the domestic distributing corporation recognizes gain with
respect to the stock of the foreign distributed corporation as a result
of the distribution under another provision of subtitle A of the
Internal Revenue Code.
(ii) Section 355 distributions. Taxpayers may apply the provisions
of Sec. 1.1248(f)-2(b) to distributions occurring on or after September
21, 1987.
[T.D. 9614, 78 FR 17050, Mar. 19, 2013, as amended by T.D. 9760, 81 FR
15169, Mar. 22, 2016]
Sec. 1.1249-1 Gain from certain sales or exchanges of patents, etc.,
to foreign corporations.
(a) General rule. Section 1249 provides that if gain is recognized
from the sale or exchange after December 31, 1962, of a patent, an
invention, model, or design (whether or not patented), a copyright, a
secret formula or process, or any other similar property right (not
including property such as goodwill, a trademark, or a trade brand) to
any foreign corporation by any United States person (as defined in
section 7701(a)(30)) which controls such foreign corporation, and if
such gain would (but for the provisions of section 1249) be gain from
the sale or exchange of a capital asset or of property described in
section 1231, then such gain shall be considered as gain from the sale
or exchange of property which is neither a capital asset nor property
described in section 1231. Section 1249 applies only to gain recognized
in taxable years beginning after December 31, 1962.
(b) Control. For purposes of paragraph (a) of this section, the term
control
[[Page 440]]
means, with respect to any foreign corporation, the ownership, directly
or indirectly, of stock possessing more than 50 percent of the total
combined voting power of all classes of stock entitled to vote. For
purposes of the preceding sentence, the rules for determining ownership
of stock provided by section 958 (a) and (b), and the principles for
determining percentage of total combined voting power owned by United
States shareholders provided by paragraphs (b) and (c) of Sec. 1.957-1,
shall apply.
[T.D. 6765, 29 FR 14879, Nov. 3, 1964]
Sec. 1.1250-1 Gain from dispositions of certain depreciable realty.
(a) Dispositions after December 31, 1969--(1) Ordinary income. (i)
In general, section 1250(a)(1) provides that, upon a disposition of an
item of section 1250 property after December 31, 1969, the applicable
percentage of the lower of:
(a) The additional depreciation (as defined in Sec. 1.1250-2)
attributable to periods after December 31, 1969 in respect of the
property, or
(b) The excess of the amount realized on a sale, exchange, or
involuntary conversion (or the fair market value of the property on any
other disposition) over the adjusted basis of the property,
Shall be treated as gain from the sale or exchange of property which is
neither a capital asset nor property described in section 1231 (that is,
shall be recognized as ordinary income). The amount of such gain shall
be determined separately for each item (see subparagraph (2)(ii) of this
paragraph) of section 1250 property. If the amount determined under (b)
of this subdivision exceeds the amount determined under (a) of this
subdivision, then such excess shall be treated as provided in
subdivision (ii) of this subparagraph. For relation of section 1250 to
other provisions, see paragraph (c) of this section.
(ii) If the amount determined under subdivision (i)(b) of this
subparagraph exceeds the amount determined under subdivision (i)(a) of
this subparagraph, then the applicable percentage of the lower of:
(a) The additional depreciation attributable to periods before
January 1, 1970, or
(b) Such excess,
shall also be recognized as ordinary income.
(iii) If gain would be recognized upon a disposition of an item of
section 1250 property under subdivisions (i) and (ii) of this
subparagraph, and if section 1250(d) applies, then the gain recognized
shall be considered as recognized first under subdivision (i) of this
subparagraph. (See example (3)(i) of paragraph (c)(4) of Sec. 1.1250-
3.)
(2) Meaning of terms. (i) For purposes of section 1250, the term
disposition shall have the same meaning as in paragraph (a)(3) of Sec.
1.1245-1. Section 1250 property is, in general, depreciable real
property other than section 1245 property. See paragraph (e) of this
section. See paragraph (d)(1) of this section for meaning of the term
applicable percentage. If, however, the property is considered to have
two or more elements with separate periods (for example, because units
thereof are placed in service on different dates, improvements are made
to the property, or because of the application of paragraph (h) of Sec.
1.1250-3), see the special rules of Sec. 1.1250-5.
(ii) For purposes of applying section 1250, the facts and
circumstances of each disposition shall be considered in determining
what is the appropriate item of section 1250 property. In general, a
building is an item of section 1250 property, but in an appropriate case
more than one building may be treated as a single item. For example, if
two or more buildings or structures on a single tract or parcel (or
contiguous tracts or parcels) of land are operated as an integrated unit
(as evidenced by their actual operation, management, financing, and
accounting), they may be treated as a single item of section 1250
property. For the manner of determining whether an expenditure shall be
treated as an addition to capital account of an item of section 1250
property or as a separate item of section 1250 property, see paragraph
(d)(2)(iii) of Sec. 1.1250-5.
(3) Sale, exchange, or involuntary conversion after December 31,
1969. (i) In the case of a disposition of section 1250 property by a
sale, exchange, or involuntary conversion after December 31, 1969, the
gain to which section
[[Page 441]]
1250(a)(1) applies is the applicable percentage for the property
(determined under paragraph (d)(1) of this section) multiplied by the
lower of (a) the additional depreciation in respect of the property
attributable to periods after December 31, 1969, or (b) the excess
(referred to as gain realized) of the amount realized over the adjusted
basis of the property.
(ii) In addition to gain recognized under section 1250(a)(1) and
subdivision (i) of this subparagraph, gain may also be recognized under
section 1250(a)(2) and this subdivision if the gain realized exceeds the
additional depreciation attributable to periods after December 31, 1969.
In such a case, the amount of gain recognized under section 1250(a)(2)
and this subdivision is the applicable percentage for the property
(determined under paragraph (d)(2) of this section) multiplied by the
lower of (a) the additional depreciation attributable to periods before
January 1, 1970, or (b) the excess (referred to as remaining gain) of
the gain realized over the additional depreciation attributable to
periods after December 31, 1969.
(iii) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. Section 1250 property which has an adjusted basis of
$500,000 is sold for $650,000 after December 31, 1969, and thus the gain
realized is $150,000. At the time of the sale the additional
depreciation in respect of the property attributable to periods after
December 31, 1969, is $190,000 and the applicable percentage is 100
percent (paragraph (d)(1)(i)(e) of this section). Since the gain
realized ($150,000), is lower than the additional depreciation
($190,000), the amount of gain recognized as ordinary income under
section 1250(a)(1) is $150,000 (that is, 100 percent of $150,000). No
gain is recognized under section 1250(a)(2).
Example 2. Section 1250 property which has an adjusted basis of
$440,000 is sold for $500,000 on December 31, 1974, and thus the gain
realized is $60,000. The property was acquired on March 31, 1966. At the
time of the sale, the additional depreciation attributable to periods
after December 31, 1969, is $20,000, and the additional depreciation
attributable to periods before January 1, 1970, is $60,000. The property
qualified as residential rental property for each taxable year ending
after December 31, 1969, and the applicable percentage is 95 percent
(paragraph (d)(1)(i)(c) of this section). The applicable percentage
under paragraph (d)(2) of this section is 15 percent. Since the
additional depreciation attributable to periods after December 31, 1969
($20,000), is lower than the gain realized ($60,000), the amount of gain
recognized as ordinary income under section 1250(a)(1) is $19,000 (that
is, 95 percent of $20,000). In addition, gain is recognized under
section 1250(a)(2) since there is remaining gain of $40,000 (that is,
the gain realized ($60,000) minus the additional depreciation
attributable to periods after December 31, 1969 ($20,000)). Since the
remaining gain of $40,000 is lower than the additional depreciation
attributable to periods before January 1, 1970 ($60,000), the amount of
gain recognized as ordinary income under section 1250(a)(2) is $6,000
(that is, 15 percent of $40,000). The remaining $35,000 (that is, gain
realized $60,000, minus gain recognized under section 1250(a), $25,000)
of the gain may be treated as gain from the sale or exchange of property
described in section 1231.
(4) Other dispositions after December 31, 1969. (i) In the case of a
disposition of section 1250 property after December 31, 1969, other than
by way of a sale, exchange, or involuntary conversion, the gain to which
section 1250(a)(1) applies is the applicable percentage for the property
(determined under paragraph (d)(1) of this section) multiplied by the
lower of (a) the additional depreciation in respect of the property
attributable to periods after December 31, 1969, or (b) the excess
(referred to as potential gain) of the fair market value of the property
over its adjusted basis. In addition, if the potential gain exceeds the
additional depreciation attributable to periods after December 31, 1969,
then the gain to which section 1250(a)(2) applies is the applicable
percentage for the property (determined under paragraph (d)(2) of this
section) multiplied by the lower of (c) the additional depreciation
attributable to periods before January 1, 1970, or (d) the excess
(referred to as remaining potential gain) of the potential gain over the
additional depreciation attributable to periods after December 31, 1969.
If property is transferred by a corporation to a shareholder for an
amount less than its fair market value in a sale or exchange, for
purposes of applying section 1250 such transfer shall be treated as a
disposition other than by way of a sale, exchange, or involuntary
conversion.
[[Page 442]]
(ii) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. Section 1250 property having an adjusted basis of
$500,000 and a fair market value of $550,000 is distributed by a
corporation to a stockholder in complete liquidation of the corporation
after December 31, 1969, and thus the potential gain is $50,000. At the
time of the liquidation, the additional depreciation for the property
attributable to periods after December 31, 1969, is $80,000 and the
applicable percentage is 100 percent (paragraph (d)(1)(i)(e) of this
section). Since the potential gain of $50,000 is lower than the
additional depreciation attributable to periods after December 31, 1969
($80,000), the amount of gain recognized as ordinary income under
section 1250(a)(1) is $50,000 (that is, 100 percent of $50,000) even
though in the absence of section 1250, section 336 would preclude
recognition of gain to the corporation.
Example 2. The facts are the same as in example (1) except that the
fair market value of the property is $650,000, and thus the potential
gain is $150,000. Since the additional depreciation attributable to
periods after December 31, 1969 ($80,000), is lower than the potential
gain of $150,000, the amount of gain recognized as ordinary income under
section 1250(a)(1) is $80,000 (that is, 100 percent of $80,000). In
addition, section 1250(a)(2) applies since there is remaining potential
gain of $70,000, that is, potential gain ($150,000) minus additional
depreciation attributable to periods after December 31, 1969 ($80,000).
The additional depreciation attributable to periods before January 1,
1970, is $90,000 and the applicable percentage under paragraph (d)(2) of
this section is 50 percent. Since the remaining potential gain of
$70,000 is lower than the additional depreciation attributable to
periods before January 1, 1970 ($90,000), the amount of gain recognized
as ordinary income under section 1250(a)(2) is $35,000 (that is, 50
percent of $70,000). Thus under section 1250(a), $115,000 (that is,
$80,000 under section 1250(a)(1), plus $35,000 under section 1250(a)(2))
is recognized as ordinary income, even though in the absence of section
1250, section 336 would preclude recognition of gain to the corporation.
(5) Instances of nonapplication. (i) Section 1250(a)(1) does not
apply to losses. Thus, section 1250(a)(1) does not apply if a loss is
realized upon a sale, exchange, or involuntary conversion of property,
all of which is considered section 1250 property, nor does the section
apply to a disposition of such property other than by way of sale,
exchange, or involuntary conversion if at the time of the disposition
the fair market value of such property is not greater than its adjusted
basis.
(ii) In general, in the case of section 1250 property with a holding
period under section 1223 of more than 1 year, section 1250(a)(1) does
not apply if for periods after December 31, 1969, there are no
depreciation adjustments in excess of straight line (as computed under
section 1250(b) and paragraph (b) of Sec. 1.1250-2).
(6) Allocation rules. (i) In the case of a sale, exchange, or
involuntary conversion of section 1250 property and nonsection 1250
property in one transaction after December 31, 1969, the total amount
realized upon the disposition shall be allocated between the section
1250 property and the other property in proportion to their respective
fair market values. Such allocation shall be made in accordance with the
principles set forth in paragraph (a)(5) of Sec. 1.1245-1 (relating to
allocation between section 1245 property and nonsection 1245 property).
(ii) If an item of section 1250 property has two (or more)
applicable percentages because one subdivision of paragraph (d)(1)(i) of
this section applies to one portion of the taxpayer's holding period
(determined under Sec. 1.1250-4) and another subdivision of such
paragraph applies with respect to another such portion, then the gain
realized on a sale, exchange, or involuntary conversion, or the
potential gain in the case of any other disposition, shall be allocated
to each such portion of the taxpayer's holding period after December 31,
1969, in the same proportion as the additional depreciation with respect
to such item for such portion bears to the additional depreciation with
respect to such item for the entire holding period after December 31,
1969.
(b) Dispositions before January 1, 1970--(1) Ordinary income. In
general, section 1250(a)(2) provides that, upon a disposition of an item
of section 1250 property after December 31, 1963, and before January 1,
1970, the applicable percentage of the lower of:
(i) The additional depreciation (as defined in Sec. 1.1250-2)
attributable to periods before January 1, 1970, in respect of the
property, or
(ii) The excess of the amount realized on a sale, exchange, or
involuntary
[[Page 443]]
conversion (or the fair market value of the property on any other
disposition) over the adjusted basis of the property,
shall be treated as gain from the sale or exchange of property which is
neither a capital asset nor property described in section 1231 (that is,
shall be recognized as ordinary income). The amount of such gain shall
be determined separately for each item (see subparagraph (2)(ii) of this
paragraph) of section 1250 property. For relation of section 1250 to
other provisions, see paragraph (c) of this section.
(2) Meaning of terms. (i) For purposes of section 1250, the term
disposition shall have the same meaning as in paragraph (a)(3) of Sec.
1.1245-1. Section 1250 property is, in general, depreciable real
property other than section 1245 property. See paragraph (e) of this
section. For purposes of this paragraph, the term applicable percentage
means 100 percent minus 1 percentage point for each full month the
property was held after the date on which the property was held 20 full
months. See paragraph (d)(2) of this section. If, however, the property
is considered to have two or more elements with separate holding periods
(for example, because units thereof are placed in service on different
dates, or improvements are made to the property), see the special rules
of Sec. 1.1250-5.
(ii) For purposes of applying section 1250, the facts and
circumstances of each disposition shall be considered in determining
what is the appropriate item of section 1250 property. In general, a
building is an item of section 1250 property, but in an appropriate case
more than one building may be treated as a single item. For manner of
determining whether an expenditure shall be treated as an addition to
the capital account of an item of section 1250 property or as a separate
item of section 1250 property, see paragraph (d)(2)(iii) of Sec.
1.1250-5.
(3) Sale, exchange, or involuntary conversion before January 1,
1970. (i) In the case of a disposition of section 1250 property by a
sale, exchange, or involuntary conversion before January 1, 1970, the
gain to which section 1250(a)(2) applies is the applicable percentage
for the property multiplied by the lower of (a) the additional
depreciation in respect of the property or (b) the excess (referred to
as gain realized) of the amount realized over the adjusted basis of the
property.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: Section 1250 property, which has an adjusted basis of
$200,000, is sold for $290,000 before January 1, 1970. At the time of
the sale the additional depreciation in respect of the property is
$130,000 and the applicable percentage is 60 percent. Since the gain
realized ($90,000, that is, amount realized, $290,000, minus adjusted
basis, $200,000) is lower than the additional depreciation ($130,000),
the amount of gain recognized as ordinary income under section
1250(a)(2) is $54,000 (that is, 60 percent of $90,000). The remaining
$36,000 ($90,000 minus $54,000) of the gain may be treated as gain from
the sale or exchange of property described in section 1231.
(4) Other dispositions before January 1, 1970. (i) In the case of a
disposition of section 1250 property before January 1, 1970, other than
by way of a sale, exchange, or involuntary conversion, the gain to which
section 1250(a)(2) applies is the applicable percentage for the property
multiplied by the lower of (a) the additional depreciation in respect of
the property, or (b) the excess (referred to as potential gain) of the
fair market value of the property on the date of disposition over its
adjusted basis. If property is transferred by a corporation to a
shareholder for an amount less than its fair market value in a sale or
exchange, for purposes of applying section 1250 such transfer shall be
treated as a disposition other than by way of a sale, exchange, or
involuntary conversion.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: Assume the same facts as in the example in subparagraph
(3)(ii) of this paragraph except that the property is distributed by a
corporation to a stockholder before January 1, 1970, in complete
liquidation of the corporation, and that at the time of the distribution
the fair market value of the property is $370,000. Since the additional
depreciation ($130,000) is lower than the potential gain of $170,000
(that is, fair market value, $370,000, minus adjusted basis, $200,000),
the amount of gain recognized as ordinary income under section
1250(a)(2) is $78,000 (that is, 60 percent of $130,000) even though, in
the
[[Page 444]]
absence of section 1250, section 336 would preclude recognition of gain
to the corporation.
(5) Instances of nonapplication. (i) Section 1250(a)(2) does not
apply to losses. Thus, section 1250(a)(2) does not apply if a loss is
realized upon a sale, exchange, or involuntary conversion of property,
all of which is considered section 1250 property, nor does the section
apply to a disposition of such property other than by way of sale,
exchange, or involuntary conversion if at the time of the disposition
the fair market value of such property is not greater than its adjusted
basis.
(ii) In general, in the case of section 1250 property with a holding
period under section 1223 of more than one year, section 1250(a)(2) does
not apply if for periods after December 1, 1963, there are no
depreciation adjustments in excess of straight line (as computed under
section 1250(b) and paragraph (b) of Sec. 1.1250-2).
(iii) In a case in which section 1250 property (including each
element thereof, if any) has a holding period under Sec. 1.1250-4 (or
paragraph (a)(2)(ii) of Sec. 1.1250-5) of at least 10 years, section
1250(a)(2) does not apply. If within the 10-year period preceding the
date the property is disposed of, an element is added to the property by
reason, for example, of an addition to capital account, see Sec.
1.1250-5.
(6) Allocation rule. In the case of a sale, exchange, or involuntary
conversion of section 1250 property and nonsection 1250 property in one
transaction before January 1, 1970, the total amount realized upon the
disposition shall be allocated between the section 1250 property and the
other property in proportion to their respective fair market values.
Such allocation shall be made in accordance with the principles set
forth in paragraph (a)(5) of Sec. 1.1245-1 (relating to allocation
between section 1245 property and nonsection 1245 property).
(c) Relation of section 1250 to other provisions--(1) General. The
provisions of section 1250 apply notwithstanding any other provision of
subtitle A of the Code. See section 1250(i). Thus, unless an exception
or limitation under section 1250(d) and Sec. 1.1250-3 applies, gain
under section 1250(a) is recognized notwithstanding any contrary
nonrecognition provision or income characterizing provision. For
example, since section 1250 overrides section 1231 (relating to property
used in the trade or business), the gain recognized under section
1250(a) upon a disposition will be treated as ordinary income and only
the remaining gain, if any, from the disposition may be considered as
gain from the sale or exchange of a capital asset if section 1231 is
applicable. See the example in paragraph (b)(3)(ii) of this section.
(2) Nonrecognition sections overridden. The nonrecognition
provisions of subtitle A of the Code which section 1250 overrides
include, but are not limited to, sections 267(d), 311(a), 336, 337,
501(a), and 512(b)(5). See section 1250(d) for the extent to which
section 1250(a) overrides sections 332, 351, 361, 371(a), 374(a), 721,
731, 1031, 1033, 1039, 1071, and 1081 (b)(1) and (d)(1)(A). For amount
of additional depreciation in respect of property disposed of by an
organization exempt from income taxes (within the meaning of section
501(a)), see paragraph (d)(6) of Sec. 1.1250-2.
(3) Exempt income. The fact that section 1250 provides for
recognition of gain as ordinary income does not change into taxable
income any income which is exempt under section 115 (relating to income
of States, etc.), 892 (relating to income of foreign governments), or
894 (relating to income exempt under treaties).
(4) Treatment of gain not recognized under section 1250. Section
1250 does not prevent gain which is not recognized under section 1250
from being considered as gain under another provision of the Code, such
as, for example, section 1239 (relating to gain from sale of depreciable
property between certain related persons). Thus, for example, if section
1250 property which has an adjusted basis of $10,000 is sold for $17,500
in a transaction to which section 1239 applies, and if $5,000 of the
gain would be recognized under section 1250(a) then the remaining $2,500
of the gain would be treated as ordinary income under section 1239.
(5) Normal retirement of asset in multiple asset account. Section
1250(a) does not require recognition of gain upon normal retirements of
section 1250
[[Page 445]]
property in a multiple asset account as long as the taxpayer's method of
accounting, as described in paragraph (e)(2) of Sec. 1.167(a)-8
(relating to accounting treatment of asset retirements), does not
require recognition of such gain.
(6) Installment method. Gain from a disposition to which section
1250(a) applies may be reported under the installment method if such
method is otherwise available under section 453 of the Code. In such
case, the income (other than interest) on each installment payment shall
be deemed to consist of gain to which section 1250(a) applies until all
such gain has been reported, and the remaining portion (if any) of such
income shall be deemed to consist of other gain. For treatment of
amounts as interest on certain deferred payments, see section 483.
(d) Applicable percentage--(1) Definition for purposes of section
1250(a)(1). (i) For purposes of section 1250(a)(1), the term applicable
percentage means:
(a) In the case of property disposed of pursuant to a written
contract which was, on July 24, 1969, and at all times thereafter
binding on the owner of the property, 100 percent minus 1 percentage
point for each full month the property was held after the date on which
the property was held 20 full months;
(b) In the case of property constructed, reconstructed, or acquired
by the taxpayer before January 1, 1975, with respect to which a mortgage
is insured under section 221(d)(3) or 236 of the National Housing Act,
or housing is financed or assisted by direct loan or tax abatement under
similar provisions of State or local laws, and with respect to which the
owner is subject to the restrictions described in section 1039(b)(1)(B)
(relating to approved dispositions of certain Government-assisted
housing projects), 100 percent minus 1 percentage point for each full
month of the taxpayer's holding period for the property (determined
under Sec. 1.1250-4) during which the property qualified under this
sentence, beginning after the date on which the property so qualified
for 20 full months.
(c) In the case of residential rental property (as defined in
section 167(j)(2)(B)) other than that covered by (a) and (b) of this
subdivision, 100 percent minus 1 percentage point for each full month of
the taxpayer's holding period for the property (determined under Sec.
1.1250-4) included within a taxable year for which the property
qualified as residential rental property, beginning after the date on
which the property so qualified for 100 full months.
(d) In the case of property with respect to which a deduction was
allowed under section 167(k) (relating to the depreciation of
expenditures to rehabilitate low-income rental housing), 100 percent
minus 1 percentage point for each full month of the taxpayer's holding
period (determined under Sec. 1.1250-4) beginning 100 full months after
the date on which the property was placed in service.
(e) In the case of all other property, 100 percent.
The provisions of (a), (b), and (c) of this subdivision shall not apply
with respect to additional depreciation described in section 1250(b)(4).
If the taxpayer's holding period under Sec. 1.1250-4 includes a period
before January 1, 1970, such period shall be taken into account in
applying each provision of this subdivision.
(ii) A single item of property may have two (or more) applicable
percentages under the provisions of subdivision (i) of this
subparagraph. For example, if the provision of subdivision (i) of this
subparagraph which applies to an item of section 1250 property (or to an
element of such property if the property is treated as consisting of
more than one element under Sec. 1.1250-5) in the taxable year in which
the item (or element) is disposed of did not apply to the item (or
element) in a prior taxable year which is included within the taxpayer's
holding period under Sec. 1.1250-4 and which ends after December 31,
1969, then each provision of subdivision (i) of this subparagraph shall
apply only for the period during which the property qualified under such
provision.
(iii) If the taxpayer makes rehabilitation expenditures and elects
to compute depreciation under section 167(k) with respect to the
property attributable to the rehabilitation expenditures, such property
will generally constitute a separate improvement under paragraph (c) of
Sec. 1.1250-5 and therefore
[[Page 446]]
will constitute an element of section 1250 property. For computation of
applicable percentage and gain recognized under section 1250(a) in such
a case, see paragraph (a) of Sec. 1.1250-5.
(iv) The principles of this subparagraph may be illustrated by the
following examples:
Example 1. Section 1250 property is sold on December 31, 1970,
pursuant to a written contract which was binding on the owner of the
property on July 24, 1969, and at all times thereafter. The property was
acquired on July 31, 1968. The applicable percentage for the property
under subdivision (i)(a) of this subparagraph is 91 percent, since the
property was held 29 full months.
Example 2. Section 1250 property is sold on June 30, 1978. The
property was acquired by a calendar year taxpayer on June 30, 1966.
Subdivision (i)(e) of this subparagraph applies to the property in 1977
and 1978. However, subdivision (i)(c) of this subparagraph applied to
the property for the taxable years of 1970 through 1976. Thus, the
property has two applicable percentages under this subparagraph. The
period before January 1, 1970 (42 full months), and the period from 1970
through 1976 (84 full months) are both taken into account in determining
the applicable percentage under subdivision (i)(c) of this subparagraph.
Thus, the applicable percentage is 74 percent (that is, 100 percent
minus the excess of the holding period taken into account (126 full
months) over 100 full months). The applicable percentage for the years
1977 and 1978 is 100 percent under subdivision (i)(e) of this
subparagraph.
Example 3. Section 1250 property is sold on December 31, 1978. The
property was acquired by a calendar year taxpayer on December 31, 1969.
The taxpayer made rehabilitation expenditures in 1973 and properly
elected to compute depreciation under section 167(k) on the property
attributable to the expenditures for the 60-month period beginning on
January 1, 1974, the date such property was placed in service.
Subdivision (i)(c) applies to the property (other than the property with
respect to which a deduction was allowed under section 167(k)) for the
taxable years of 1970 through 1978 (108 full months) and the applicable
percentage for such property is 92 percent. The applicable percentage
for the property with respect to which a deduction under section 167(k)
was allowed is 100 percent under subdivision (i)(d) of this
subparagraph, since the holding period for purposes of such subdivision
begins on the date such property is placed in service.
Example 4. Section 1250 property is sold by a calendar year taxpayer
on March 31, 1974. The property was transferred to the taxpayer by gift
on December 31, 1970, and under section 1250(e)(2), the taxpayer's
holding period for the property for purposes of computing the applicable
percentage includes the transferor's holding period of 80 full months.
Subdivision (i)(c) of this subparagraph applies to the property in the
years 1970 through 1974. The applicable percentage under subdivision (i)
(c) of this subparagraph is 81 percent, since the period before January
1, 1970 (68 full months), and that portion of the period after December
31, 1969, during which such subdivision applied (51 full months) are
taken into account.
(2) Definition for purposes of section 1250(a)(2). For purposes of
section 1250(a)(2), the term applicable percentage means:
(i) In case of property with a holding period of 20 full months or
less, 100 percent;
(ii) In case of property with a holding period of more than 20 full
months but less than 10 years, 100 percent minus 1 percentage point for
each full month the property is held after the date on which the
property is held 20 full months; and
(iii) In case of property with a holding period of at least 10
years, zero.
(3) Holding period. For purposes of this paragraph, the holding
period of property shall be determined under the rules of Sec. 1.1250-
4, and not under the rules of section 1223, notwithstanding that the
property was acquired on or before December 31, 1963. In the case of a
disposition of section 1250 property which consists of 2 or more
elements (within the meaning of paragraph (c) of Sec. 1.1250-5), the
holding period for each element shall be determined under the rules of
paragraph (a)(2)(ii) of Sec. 1.1250-5.
(4) Full month. For purposes of this paragraph, the term full month
(or full months) means the period beginning on a date in 1 month and
terminating on the date before the corresponding date in the next
succeeding month (or in another succeeding month), or, if a particular
succeeding month does not have such a corresponding date, terminating on
the last day of such particular succeeding month.
(5) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. Property is purchased on January 17, 1959. Under
paragraph (b)(1) of Sec. 1.1250-4, its holding period begins on January
18, 1959, and thus at any time during the period beginning on October
17, 1960, and ending on
[[Page 447]]
November 16, 1960, the property is considered held 21 full months and
has an applicable percentage under section 1250(a)(2) of 99 percent. On
and after January 17, 1969, the property has a holding period of at
least 120 full months (10 years) and, therefore, the applicable
percentage under section 1250(a)(2) for the property is zero.
Accordingly, no gain would be recognized under section 1250(a)(2) upon
disposition of the property. If, however, the property consists of two
or more elements, see the special rules of Sec. 1.1250-5.
Example 2. Property is purchased on January 31, 1968. Under
paragraph (b)(1) of Sec. 1.1250-4 its holding period begins on February
1, 1968, and thus at any time during the period beginning on February
29, 1968, and ending on March 30, 1968, the property is considered held
1 full month. At any time during the period beginning on March 31, 1970,
and ending on April 29, 1970, the property is considered held 26 full
months. At any time during the period beginning on April 30, 1970, and
ending on May 30, 1970, the property is considered held 27 full months.
(e) Section 1250 property--(1) Definition. The term section 1250
property means any real property (other than section 1245 property, as
defined in section 1245(a)(3) and Sec. 1.1245-3) which is or has been
property of a character subject to the allowance for depreciation
provided in section 167. See section 1250(c).
(2) Character of property. For purposes of subparagraph (1) of this
paragraph, the term is or has been property of a character subject to
the allowance for depreciation provided in section 167 shall have the
same meaning as when used in paragraph (a) (1) and (3) of Sec. 1.1245-
3. Thus, if a father uses a house in his trade or business during a
period after December 31, 1963, and then gives the house to his son as a
gift for the son's personal use, the house is section 1250 property in
the hands of the son. For exception to the application of section
1250(a) upon disposition of a principal residence, see section
1250(d)(7).
(3) Real property. (i) For purposes of subparagraph (1) of this
paragraph, the term real property means any property which is not
personal property within the meaning of paragraph (b) of Sec. 1.1245-3.
The term section 1250 property includes three types of depreciable real
property. The first type is intangible real property. For purposes of
this paragraph, a leasehold of land or of section 1250 property is
intangible real property, and accordingly such a leasehold is section
1250 property. However, a fee simple interest in land is not
depreciable, and therefore is not section 1250 property. The second type
is a building or its structural components within the meaning of
paragraph (c) of Sec. 1.1245-3. The third type is all other tangible
real property except (a) property described in section 1245(a)(3)(B) as
defined in paragraph (c)(1) of Sec. 1.1245-3 (relating to property used
as an integral part of a specified activity or as a specified facility),
and (b) property described in section 1245(a)(3)(D). An elevator or
escalator (within the meaning of section 1245(a)(3)(C)) is not section
1250 property.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: A owns and leases to B for a single lump-sum payment of
$100,000 property consisting of land and a fully equipped factory
building thereon. If 30 percent of the fair market value of such
property is properly allocable to the land, 25 percent to section 1250
property (the building and its structural components), and 45 percent to
section 1245 property (the equipment), then 55 percent of B's leasehold
is section 1250 property.
(4) Coordination with definition of section 1245 property. (i)
Property may lose its character as section 1250 property and become
section 1245 property. Thus, for example, if section 1250 property of
the third type described in subparagraph (3)(i)(a) of this paragraph is
converted to use as an integral part of manufacturing, the property
would lose its character as section 1250 property and would become
section 1245 property. However, once property in the hands of a taxpayer
is section 1245 property, it can never become section 1250 property in
the hands of such taxpayer. See also paragraph (a) (4) and (5) of Sec.
1.1245-2.
(f) Treatment of partnerships and partners. If a partnership
disposes of section 1250 property, the amount of gain recognized under
section 1250(a) by the partnership and by a partner shall be determined
in a manner consistent with the principles provided in paragraph (e) of
Sec. 1.1245-1. Thus, for example, a partner's distributive share of
gain recognized by the partnership
[[Page 448]]
under section 1250(a) shall be determined in the same manner as his
distributive share of gain recognized by the partnership under section
1245(a)(1) is determined, and, if required, additional depreciation in
respect of section 1250 property shall be allocated to the partner in
the same manner as the adjustments reflected in the adjusted basis of
section 1245 property are allocated to the partner. For a further
example, if on the date a partner acquires his partnership interest by
way of a sale or exchange the partnership owns section 1250 property and
an election under section 754 (relating to optional adjustment to basis
of partnership property) is in effect with respect to the partnership,
then such partner's additional depreciation in respect of such property
on such date is deemed to be zero. For limitation on the amount of gain
recognized under section 1250(a) in respect of a partnership and for the
amount of additional depreciation in respect of partnership property
after certain transactions, see paragraph (f) of Sec. 1.1250-3. For
treatment of section 1250 property as an unrealized receivable, see
section 751(c).
(g) Examples. The principles of this section may be illustrated by
the following examples:
Example 1. Section 1250 property which has an adjusted basis of
$350,000 is sold for $630,000 on December 31, 1984. The property was
acquired by a calendar year taxpayer on December 31, 1969. For the
taxable years from 1970 through 1980, the property qualified as
residential rental property and the applicable percentage for those
years is 68 percent (paragraph (d)(1)(i)(c) of this section). For
taxable years from 1981 through 1984, the property did not qualify as
residential rental property and the applicable percentage for those
years is 100 percent (paragraph (d)(1)(i)(e) of this section). The
additional depreciation for the years from 1970 through 1980 is
$120,000. The additional depreciation for the years from 1981 through
1984 is $20,000. The gain realized is $280,000 (that is, amount
realized, $630,000, minus adjusted basis $350,000). The gain recognized
as ordinary income under section 1250(a)(1) is computed in two steps.
First, since the additional depreciation attributable to the years 1970
through 1980 ($120,000) is lower than the gain realized attributable to
such years determined under paragraph (a)(6) of this section ($240,000,
that is, gain realized, $280,000, multiplied by \12/14\), the gain
recognized as ordinary income under section 1250(a)(1) in the first step
is $81,600, that is, 68 percent of $120,000. Second, since the
additional depreciation attributable to the years 1981 through 1984
($20,000) is lower than the gain realized attributable to those years
($40,000, that is, gain realized, $280,000, multiplied by \2/14\), the
gain recognized as ordinary income under section 1250(a)(1) for the
years from 1981 through 1984 is $20,000 (that is, 100 percent of
$20,000). The total gain recognized under section 1250(a)(1) is $101,600
(that is, $81,600 plus $20,000).
Example 2. Section 1250 property which has an adjusted basis of
$400,000 is sold for $472,000 on December 31, 1978. The property was
acquired on December 31, 1966. The additional depreciation attributable
to periods before January 1, 1970, is $40,000 and the applicable
percentage under paragraph (d)(2) of this section is zero percent. The
property qualifies as residential rental property for the years 1970
through 1976, but fails to qualify for 1977 and 1978. Under paragraph
(d)(1) of this section, the applicable percentage for the years 1970
through 1976 is 80 percent (paragraph (d)(1)(i)(c) of this section), and
the applicable percentage for the years 1977 and 1978 is 100 percent
(paragraph (d)(1)(i)(e) of this section). The additional depreciation
attributable to the years 1970 through 1976 is $50,000, and the
additional depreciation attributable to the years 1977 and 1978 is
$10,000. The gain recognized as ordinary income under section 1250(a)(1)
is computed in two steps. First, since the additional depreciation
attributable to the years 1970 through 1976 ($50,000) is lower than the
gain realized attributable to such years ($60,000, that is, $72,000
multiplied by \5/6\), the gain recognized under section 1250(a)(1) in
the first step is $40,000 (that is, 80 percent of $50,000). Second,
since the additional depreciation attributable to 1977 and 1978
($10,000) is lower than the gain realized attributable to such years
($12,000, that is, $72,000 multiplied by \1/6\), the gain recognized
under section 1250(a)(1) in the second step is $10,000 (that is, 100
percent of $10,000). In addition, section 1250(a)(2) applies. However,
since the applicable percentage is zero percent, none of the gain is
recognized as ordinary income under section 1250(a)(2). Thus, the
remaining $22,000 (that is, gain realized, $72,000, minus gain
recognized under section 1250(a), $50,000) of the gain may be treated as
gain from the sale or exchange of property described in section 1231.
Example 3. The facts are the same as in example (2) except that the
property is disposed of on December 31, 1980. The property qualifies as
residential rental property for the years 1979 and 1980. Thus, the
applicable percentage for years 1970 through 1976, 1979, and 1980 is 56
percent (paragraph (d)(1)(i)(c) of this section). The applicable
percentage for
[[Page 449]]
the years 1977 and 1978 is 100 percent (paragraph (d)(1)(i)(e) of this
section). The additional depreciation for the years 1979 and 1980 is
$8,000. The gain recognized under section 1250(a)(1) is computed in two
steps. First, since the additional depreciation attributable to the
years 1970 through 1976, 1979, and 1980 ($58,000) is lower than the gain
realized attributable to such years ($61,412, that is, $72,000
multiplied by $58,000/$68,000), the gain recognized under section
1250(a)(1) in the first step is $32,480 (that is, 56 percent of
$58,000). Second, since the additional depreciation attributable to 1977
and 1978 ($10,000) is lower than the gain realized attributable to such
years ($10,588, that is, $72,000 multiplied by $10,000/$68,000) the gain
recognized under section 1250(a)(1) in the second step is $10,000 (that
is, 100 percent of $10,000). In addition section 1250(a)(2) applies.
However, since the applicable percentage is zero percent, none of the
gain is recognized as ordinary income under section 1250(a)(2). Thus,
the remaining $29,520 (that is, gain realized, $72,000, minus gain
recognized under section 1250(a), $42,480) of the gain may be treated as
gain from the sale or exchange of property described in section 1231.
[T.D. 7084, 36 FR 271, Jan. 8, 1971, as amended by T.D. 7193, 37 FR
12953, June 30, 1972]
Sec. 1.1250-2 Additional depreciation defined.
(a) In general--(1) Definition for purposes of section 1250(b)(1).
Except as otherwise provided in paragraph (e) of this section, for
purposes of section 1250(b)(1), the term additional depreciation means:
(i) In the case of property which at the time of disposition has a
holding period under section 1223 of not more than 1 year, the
depreciation adjustments (as defined in paragraph (d) of this section)
in respect of such property for periods after December 31, 1963, and
(ii) In the case of property which at the time of disposition has a
holding period under section 1223 of more than 1 year, the depreciation
adjustments in excess of straight line for periods after December 31,
1963, computed under paragraph (b)(1) of this section.
(2) Definition for purposes of section 1250(b)(4). Except as
otherwise provided in paragraph (e) of this section, for purposes of
section 1250(b)(4), the term additional depreciation means:
(i) In the case of property with respect to which a deduction under
section 167(k) (relating to depreciation of expenditures to rehabilitate
low-income rental housing) was allowed, which at the time of disposition
has a holding period under section 1223 of not more than 1 year from the
time the rehabilitation expenditures were incurred, the depreciation
adjustments (as defined in paragraph (d) of this section) in respect of
the property, and
(ii) In the case of property with respect to which a deduction under
section 167(k) (relating to depreciation of expenditures to rehabilitate
low-income rental housing) was allowed, which at the time of disposition
has a holding period under section 1223 of more than 1 year from the
time the rehabilitation expenditures were incurred, the depreciation
adjustments in excess of straight line for the property, computed under
paragraph (b)(2) of this section.
For purposes of this subparagraph, all rehabilitation expenditures which
are incurred in connection with the rehabilitation of an element of
section 1250 property shall be considered incurred on the date the last
such expenditure is considered incurred under the accrual method of
accounting, regardless of the method of accounting used by the taxpayer
with regard to other items of income and expense. If the property
consists of two or more elements (for example, if the property is placed
in service at different times), then each element shall be treated as if
it were a separate property and the expenditures attributable to each
such element shall be considered incurred on the date the last such
expenditure is considered incurred.
(3) Allocation to certain periods. With respect to a taxable year
beginning in 1963 and ending in 1964, or beginning in 1969 and ending in
1970, the amount of depreciation adjustments or of depreciation
adjustments in excess of straight line (as the case may be) shall be
ascertained by applying the principles of paragraph (c)(3) of Sec.
1.167(a)-8 (relating to determination of adjusted basis of retired
asset), and the amount determined in such manner shall be allocated on a
daily basis in order to determine the portion thereof which is
attributable to a period after December 31, 1963, or after December 31,
1969, as the case may be.
[[Page 450]]
(b) Computation of depreciation adjustments in excess of straight
line--(1) General rule. For purposes of paragraph (a)(1) of this
section, depreciation adjustments in excess of straight line shall be,
in the case of any property, the excess of (i) the sum of the
depreciation adjustments (as defined in paragraph (d) of this section)
in respect of the property attributable to periods after December 31,
1963, over (ii) the sum such adjustments would have been for such
periods if such adjustments had been determined for the entire period
the property was held under the straight line method of depreciation
(or, if applicable, under the lease-renewal-period provision in
paragraph (c) of this section). Depreciation in excess of straight line
may arise, for example, if the declining balance method, the sum of the
years-digits method, or the units of production method is used, or for
another example, if the cost of a leasehold improvement or of a
leasehold is depreciated over a period which does not take into account
certain renewal periods referred to in paragraph (c) of this section.
For computations of depreciation adjustments in excess of straight line
(or a deficit therein) both on an annual basis and on the basis of the
entire period the property was held, see subparagraph (6) of this
paragraph.
(2) Depreciation under section 167(k). For purposes of paragraph
(a)(2) of this section, depreciation adjustments in excess of straight
line shall be, in the case of any property with respect to which a
deduction was allowed under section 167(k) (relating to depreciation of
expenditures to rehabilitate low-income rental housing), the excess of
(i) the sum of the depreciation adjustments (as defined in paragraph (d)
of this section) allowed in respect of the property, over (ii) the sum
such adjustments would have been if such adjustments had been determined
for the entire period the property was held under the straight line
method of depreciation permitted by section 167(b)(1).
(3) General rule for computing useful life and salvage value. For
purposes of computing under subparagraph (1)(ii) of this paragraph the
sum of the depreciation adjustments would have been under the straight
line method, if a useful life (or salvage value) was used in determining
the amount allowed as a depreciation adjustment for any taxable year,
such life (or value) shall be used in determining the amount such
depreciation adjustment would have been for such taxable year under the
straight line method. If, however, for any taxable year a method of
depreciation was used as to which a useful life was not taken into
account such as, for example, the units of production method, or as to
which salvage value was not taken into account in determining the annual
allowances, such as, for example, the declining balance method or the
amortization of a leasehold improvement over the term of a lease, then,
for the purpose of determining the amount such depreciation adjustment
would have been under the straight line method for such taxable year:
(i) There shall be used the useful life (or salvage value) which
would have been proper if depreciation had actually been determined
under the straight line method throughout the period the property was
held, and
(ii) Such useful life (or such salvage value) shall be determined by
taking into account for each taxable year the same facts and
circumstances as would have been taken into account if the taxpayer had
used such method throughout the period the property was held.
(4) Special rule for computing useful life and salvage value
(section 167(k)). For purposes of computing under subparagraph (2)(ii)
of this paragraph the sum the depreciation adjustments would have been
under the straight line method, the useful life and salvage value
permitted under section 167(k) shall not apply, the useful life of the
property shall be determined under paragraph (b) of Sec. 1.167(a)-1
(or, if applicable, under the lease-renewal-period provision of
paragraph (c) of this section), and the salvage value of the property
shall be determined under paragraph (c) of Sec. 1.167(a)-1. Such useful
life or salvage value shall be determined by taking into account for
each taxable year the same facts and circumstances as would have been
taken into account if the taxpayer had used the straight line method
permitted
[[Page 451]]
under section 167(b)(1) throughout the period the property was held.
(5) Property held before January 1, 1964. In the case of property
held before January 1, 1964:
(i) For purposes of computing under subparagraph (1)(ii) of this
paragraph the sum the depreciation adjustments would have been under the
straight line method, the adjusted basis of the property on such date
shall be the amount such adjusted basis would have been if depreciation
deductions allowed or allowable before such date had been determined
under the straight line method computed in accordance with subparagraph
(3) of this paragraph, and
(ii) The depreciation adjustments in excess of straight line in
respect of the property computed under subparagraph (1) of this
paragraph, but without regard to this subdivision, shall be reduced by
the amount of depreciation adjustments less than straight line for
periods before January 1, 1964, that is, by the excess (if any) of the
sum the depreciation adjustments would have been for periods before
January 1, 1964, under the straight line method, over the sum of the
depreciation adjustments attributable to periods before such date.
(6) Determination of additional depreciation in certain cases. If an
item of section 1250 property is subject to two (or more) applicable
percentages, a separate computation of additional depreciation shall be
made for the portion of the taxpayer's holding period subject to each
such percentage. That is, a separate computation shall be made to
determine the excess of (i) the depreciation adjustments (as defined in
paragraph (d) of this section) for each such portion of the taxpayer's
holding period after December 31, 1963, over (ii) the amount such
adjustments would have been for each such portion if such adjustments
were determined under the straight line method of depreciation (or, if
applicable, under the lease-renewal-period provision in paragraph (c) of
this section). Thus, for example, in the case of an item of section 1250
property acquired on January 1, 1968, and disposed of on January 1,
1973, if the applicable percentage for the period before January 1,
1970, were determined under paragraph (d)(2) of Sec. 1.1250-1 and the
applicable percentage for the period after December 31, 1969, were
determined under paragraph (d)(1)(i)(e) of Sec. 1.1250-1, the
additional depreciation would be computed separately for the period
before January 1, 1970, and for the period after December 31, 1969. If
the additional depreciation attributable to any such portion of the
taxpayer's holding period is a deficit (that is, if the depreciation
adjustments for that portion are less than the amount such adjustments
would have been for that portion if depreciation adjustments were
determined for the entire period the property was held under the
straight line method of depreciation, or, if applicable, under the
lease-renewal-period provision in paragraph (c) of this section), then
such deficit will be applied to reduce the additional depreciation for
other portion (or portions) of the taxpayer's holding period. (See
examples (4) and (5) of subparagraph (7) of this paragraph.)
(7) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. A calendar year taxpayer sells section 1250 property on
January 1, 1968, which he purchased for $10,000 on January 1, 1963. For
the period of 1963 through 1967 he computed depreciation deductions in
respect of the property under the declining balance method using a rate
of 200 percent of the straight line rate and a proper useful life of 10
years. Under such method salvage value is not taken into account in
computing annual allowances. For purposes of applying subparagraph (3)
of this paragraph, if the taxpayer had used the straight line method for
such period, he would have used a salvage value of $1,000, and the
depreciation under the straight line method would have been $900 each
year, that is, one-tenth of $10,000 minus $1,000. As of January 1, 1968,
the additional depreciation for the property is $1,123, as computed in
the table below:
------------------------------------------------------------------------
Additional
Year Actual Straight depreciation
depreciation line (deficit)
------------------------------------------------------------------------
1963............................ $2,000 $900 ............
=======================================
1964............................ 1,600 900 $700
1965............................ 1,280 900 380
1966............................ 1,024 900 124
1967............................ 819 900 (81)
------------------------------------------------------------------------
Sum for periods after Dec. 31, 4,723 3,600 1,123
1963.........................
------------------------------------------------------------------------
[[Page 452]]
Example 2. Assume the same facts as in example (1) except that the
taxpayer sells the section 1250 property on January 1, 1970. Assume
further that as of January 1, 1968, the taxpayer elects under section
167(e)(1) to change to the straight line method. On that date the
adjusted basis of the property is $3,277 ($10,000 minus $6,723). He
redetermines the remaining useful life of the property to be 8 years and
its salvage value to be $77, and thus takes depreciation deductions for
1968 and 1969 of $400 (the amount allowable) for each such year, that
is, one-eighth of $3,200 (that is, $3,277 minus $77). For purposes of
applying subparagraph (3) of this paragraph, if he had used the straight
line method throughout the period he held the property, the adjusted
basis of the property on January 1, 1968, would have been $5,500
($10,000 minus $4,500), and the depreciation which would have resulted
under such method for 1968 and 1969 would have been $678 for each such
year, that is, one-eighth of $5,423 ($5,500 minus $77). As of January 1,
1970, the additional depreciation for the property is $567, as computed
in the table below:
------------------------------------------------------------------------
Additional
Years Depreciation Straight depreciation
line (deficit)
------------------------------------------------------------------------
1964 through 1967............... $4,723 $3,600 $1,123
1968............................ 400 678 (278)
1969............................ 400 678 (278)
------------------------------------------------------------------------
Sum for periods after Dec. 31, 5,523 4,956 567
1963...........................
------------------------------------------------------------------------
Example 3. On January 1, 1978, a calendar year taxpayer sells
section 1250 property. The property, which is attributable to
rehabilitation expenditures of $50,000 incurred in 1970, was placed in
service on January 1, 1971. The taxpayer elected to compute depreciation
for the period of 1971 through 1975 under section 167(k). Under such
section salvage value is not taken into account in computing annual
allowances, and the useful life of the property is deemed to be 5 years.
For purposes of applying subparagraph (4) of this paragraph, if the
taxpayer had used the straight line method permitted under section
167(b)(1) for such period, he would have used a salvage value of $5,000
and a useful life of 15 years. Depreciation under the straight line
method would thus have been $3,000 each year, \1/15\ of $45,000 (that
is, $50,000 minus $5,000). As of January 1, 1978, the additional
depreciation for the property is $29,000, as computed in the table
below:
------------------------------------------------------------------------
Additional
Year Actual Straight depreciation
depreciation line (deficit)
------------------------------------------------------------------------
1971............................ $10,000 $3,000 $7,000
1972............................ 10,000 3,000 7,000
1973............................ 10,000 3,000 7,000
1974............................ 10,000 3,000 7,000
1975............................ 10,000 3,000 7,000
1976............................ ............ 3,000 (3,000)
1977............................ ............ 3,000 (3,000)
---------------------------------------
Total....................... 50,000 21,000 29,000
------------------------------------------------------------------------
Example 4. Section 1250 property which has an adjusted basis of
$108,000 is sold for $146,000 on December 31, 1972, and thus the gain
realized is $38,000. The property was acquired on December 31, 1963. The
applicable percentage for the period before January 1, 1970, is 12
percent (paragraph (d)(2) of Sec. 1.1250-1) and the applicable
percentage for the period after December 31, 1969, is 100 percent
(paragraph (d)(1)(i)(e) of Sec. 1.1250-1). The additional depreciation
must be computed separately for the period before January 1, 1970, and
for the period after December 31, 1969. Assume that the additional
depreciation for the period before January 1, 1970, is $32,000 and that
there is a deficit in additional depreciation of $2,000 for the period
after December 31, 1969. Accordingly, the additional depreciation for
the period before January 1, 1970 ($32,000) is reduced to $30,000 by the
$2,000 deficit in additional depreciation for the period after December
31, 1969. Although section 1250(a)(1) applies to the property, none of
the gain is recognized as ordinary income under that section since there
is a deficit in additional depreciation for the period after December
31, 1969. Gain is recognized under section 1250(a)(2) since there is
remaining gain of $38,000 (that is, gain realized, $38,000, minus the
additional depreciation attributable to periods after December 31, 1969,
zero). Since the additional depreciation attributable to the period
before January 1, 1970 ($30,000), is lower than the gain realized
($38,000), the amount of gain recognized under section 1250(a)(2) is
$3,600 (that is, 12 percent of $30,000).
Example 5. Section 1250 property which has an adjusted basis of
$207,000 is sold for $267,000 on February 24, 1988, and thus the gain
realized is $60,000. The property was acquired on April 30, 1970. The
applicable percentage for the period from April 30, 1970, through
December 31, 1981, is 60 percent (paragraph (d)(1)(i)(c) of Sec.
1.1250-1) and the applicable percentage for the period from January 1,
1982, through February 24, 1988, is 100 percent (paragraph (d)(1)(i)(e)
of Sec. 1.1250-1). The additional depreciation must be computed
separately for the period before January 1, 1982, and for the period
after December 31, 1981. Assume that the additional depreciation for the
period before January 1, 1982, is $43,000 and that there is a deficit in
additional depreciation of $6,000 for the period
[[Page 453]]
after December 31, 1981. Accordingly, the additional depreciation for
the period before January 1, 1982 ($43,000), is reduced to $37,000 by
the $6,000 deficit for the period after December 31, 1981. There is no
gain recognized under section 1250(a)(1) for the period after December
31, 1981, since there is a deficit in additional depreciation for that
period. The gain recognized under section 1250(a)(1) for the period
before January 1, 1982, is $22,200, that is, the lower of the gain
realized attributable to that period ($60,000) or the additional
depreciation attributable to that period ($37,000), or $37,000,
multiplied by 60 percent, the applicable percentage.
(c) Property held by lessee--(1) Amount depreciation would have
been. For purposes of paragraph (b) of this section, in case of a
leasehold which is section 1250 property, in determining the amount the
depreciation adjustments would have been under the straight line method
in respect of any building or other improvement (which is section 1250
property) erected or made on the leased property, or in respect of any
cost of acquiring the lease, the lease period shall be treated as
including all renewal periods. See section 1250(b)(2). For determination
of the extent to which a leasehold is section 1250 property, see
paragraph (e)(3) of Sec. 1.1250-1.
(2) Renewal period. (i) For purposes of this paragraph, the term
renewal period means any period for which the lease may be renewed,
extended, or continued pursuant to an option or options exercisable by
the lessee (whether or not specifically provided for in the lease)
except that the inclusion of one or more renewal periods shall not
extend the period taken into account by more than two-thirds of the
period on the basis of which the depreciation adjustments were allowed.
(ii) In respect of the cost of any building erected (or other
improvement made) on the leased property by the lessee, or in respect of
the portion of the cost of acquiring a leasehold which is attributable
to an existing building (or other improvement) on the leasehold at the
time the lessee acquires the leasehold, the inclusion of one or more
renewal periods shall not extend the period taken into account to a
period which exceeds the useful life remaining, at the time the
leasehold is disposed of, of such building (or such other improvement).
Determinations under this subdivision shall be made without regard to
the proper period under section 167 or 178 for depreciating or
amortizing a leasehold acquisition cost or improvement.
(iii) The provisions of this subparagraph may be illustrated by the
following example:
Example: Assume that a leasehold improvement with a useful life of
30 years is properly amortized on the basis of a 10-year initial lease
term. The lease is renewable for an additional 9 years. The period taken
into account is 16\2/3\ years, that is, 10 years plus two-thirds of 10
years. If, however, the leasehold improvement were disposed of at the
end of 12 years, and if its remaining useful life were only 3 years,
then the period taken into account would be 15 years.
(d) Depreciation adjustments--(1) General. For purposes of this
section, the term depreciation adjustments means, in respect of any
property, all adjustments reflected in the adjusted basis of such
property on account of deductions described in subparagraph (2) of this
paragraph allowed or allowable (whether in respect of the same or other
property) to the taxpayer or to any other person. For cases where the
taxpayer can establish that the amount allowed for any period was less
than the amount allowable, see subparagraph (4) of this paragraph. For
determination of adjusted basis of property in a multiple asset account,
see paragraph (c)(3) of Sec. 1.167(a)-8. The term depreciation
adjustments as used in this section does not have the same meaning as
the term adjustments reflected in the adjusted basis as defined in
paragraph (a)(2) of Sec. 1.1245-2.
(2) Deductions. The deductions described in this subparagraph are
allowances (and amounts treated as allowances) for depreciation or
amortization (other than amortization under section 168, 169 (as enacted
by section 704(a), Tax Reform Act of 1969 (83 Stat. 667)), or 185).
Thus, for example, such deductions include a reasonable allowance for
exhaustion, wear, and tear (including a reasonable allowance for
obsolesence) under section 167, the periodic deductions referred to in
Sec. 1.162-11 in respect of a specified sum paid for the acquisition of
a leasehold and in respect of the cost to a lessee of improvements on
property of which he
[[Page 454]]
is the lessee. However, such deductions do not include deductions for
the periodic payment of rent.
(3) Depreciation of other taxpayers or in respect of other property.
(i) The depreciation adjustments (reflected in the adjusted basis)
referred to in subparagraph (1) of this paragraph (a) are not limited to
adjustments with respect to the property disposed of, nor to those
allowed or allowable to the taxpayer disposing of such property, and (b)
except as provided in subparagraph (4) of this paragraph, are taken into
account, whether allowed or allowable in respect of the same or other
property and whether to the taxpayer or to any other person. For manner
of determining the amount of additional depreciation after certain
dispositions, see paragraph (e) of this section.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example: On January 1, 1966, a calendar year taxpayer purchases for
$100,000 a building for use in his trade or business. He takes
depreciation deductions of $20,000 (the amount allowable), of which
$3,000 is additional depreciation, and transfers the building to his son
as a gift on January 1, 1968. Since the exception for gifts in section
1250(d)(1) applies, the taxpayer does not recognize gain under section
1250(a)(2). In the son's adjusted basis of $80,000 for the building
there is reflected $3,000 of additional depreciation. On January 1,
1969, after taking a depreciation deduction of $10,000 (the amount
allowable), of which $1,000 is additional depreciation, the son sells
the building. At the time of the sale the additional depreciation is
$4,000 ($3,000 allowed the father plus $1,000 allowed the son).
(4) Depreciation allowed or allowable. (i) For purposes of
subparagraph (1) of this paragraph, generally all deductions (described
in subparagraph (2) of this paragraph) allowed or allowable shall be
taken into account. See section 1016(a)(2) and the regulations
thereunder for the meaning of allowed and allowable. However, if a
taxpayer can establish by adequate records or other sufficient evidence
that the amount allowed for any period was less than the amount
allowable for such period, the amount to be taken into account for such
period shall be the amount allowed. The preceding sentence shall not
apply for purposes of computing under paragraph (b)(1)(ii) of this
section the amount such deductions would have been under the straight
line method.
(ii) The provisions of subdivision (i) of this subparagraph may be
illustrated by the following example:
Example: In the year 1969 it becomes necessary to determine the
additional depreciation in respect of section 1250 property, the
adjusted basis of which reflects a depreciation adjustment of $1,000
with respect to depreciation deductions allowable for the calendar year
1965 under the sum of the years-digits method. Under paragraph
(b)(1)(ii) of this section, the depreciation which would have resulted
under the straight line method for 1965 is $800. If the taxpayer can
establish by adequate records or other sufficient evidence that he did
not take, and was not allowed, any deduction for depreciation in respect
of the property in 1965, then, for purposes of computing the
depreciation adjustments in excess of straight line in respect of the
property, the amount to be taken into account for 1965 as allowed or
allowable is zero, and the amount to be taken into account in computing
deductions which would have resulted under the straight line method in
1965 is $800. Thus, in effect, there is a deficit in additional
depreciation for 1965 of $800.
(5) Retired or demolished property. Depreciation adjustments
referred to in subparagraph (1) of this paragraph generally do not
include adjustments in respect of retired or demolished portions of an
item of section 1250 property. If a retired or demolished portion is
replaced in a disposition described in section 1250(d)(4)(A) (relating
to like kind exchanges and involuntary conversions), see paragraph
(d)(7) of Sec. 1.1250-3.
(6) Exempt organization. In respect of property disposed of by an
organization which is or was exempt from income taxes (within the
meaning of section 501(a), the depreciation adjustments (reflected in
the adjusted basis) referred to in subparagraph (1) of this paragraph
shall include only adjustments allowed or allowable (i) in computing
unrelated business taxable income (as defined in section 512(a)), or
(ii) in computing taxable income of the organization for a period during
which it was not exempt or, by reason of the application of section 502,
503, or 504, was denied its exemption.
[[Page 455]]
(e) Additional depreciation immediately after certain acquisitions--
(1) Zero. If on the date a person acquires property his basis for the
property is determined solely (i) by reference to its cost (within the
meaning of section 1012), (ii) by reason of the application of section
301(d) (relating to basis of property received in corporate
distribution) or section 334(a) (relating to basis of property received
in a liquidation in which gain or loss is recognized), or (iii) under
the rules of section 334 (b)(2) or (c) (relating to basis of property
received in certain corporate liquidations), then on such date the
additional depreciation for the property is zero.
(2) Transactions referred to in section 1250(d). In the case of
property acquired in a disposition described in section 1250(d)
(relating to exceptions and limitations to application of section 1250),
additional depreciation shall be computed in accordance with the rules
prescribed in Sec. 1.1250-3.
(f) Records to be kept and information to be filed--(1) Records to
be kept. In any case in which it is necessary to determine the
additional depreciation of an item of section 1250 property, the
taxpayer shall have available permanent records of all the facts
necessary to determine with reasonable accuracy the amount of such
additional depreciation, including the following:
(i) The date, and the manner in which, the property was acquired,
(ii) The taxpayer's basis on the date the property was acquired and
the manner in which the basis was determined,
(iii) The amount and date of all adjustments to the basis of the
property allowed or allowable to the taxpayer for depreciation
adjustments referred to in paragraph (d)(1) of this section and the
amount and date of any other adjustments by the taxpayer to the basis of
the property, and
(iv) In the case of section 1250 property which has an adjusted
basis reflecting depreciation adjustments referred to in paragraph
(d)(1) of this section taken by the taxpayer with respect to other
property, or by another taxpayer with respect to the same or other
property, the information described in subdivisions (i), (ii), and (iii)
of this subparagraph with respect to such other property or such other
taxpayer.
(2) Information to be filed. If a taxpayer acquires in a transaction
(other than a like kind exchange or involuntary conversion described in
section 1250(d)(4)) section 1250 property which has a basis reflecting
depreciation adjustments referred to in paragraph (d)(1) of this section
allowed or allowable to another taxpayer, then the taxpayer shall file
with its income tax return or information return for the taxable year in
which the property is acquired a statement showing all information
described in subparagraph (1) of this paragraph. See section 6012
(relating to persons required to make returns of income) and part III of
subchapter A of chapter 61 of the Code (relating to information
returns).
[T.D. 7084, 36 FR 273, Jan. 8, 1971, as amended by T.D. 7193, 37 FR
12956, June 30, 1972]
Sec. 1.1250-3 Exceptions and limitations.
(a) Exception for gifts--(1) General rule. Section 1250(d)(1)
provides that no gain shall be recognized under section 1250(a) upon a
disposition by gift. For purposes of this paragraph, the term gift shall
have the same meaning as in paragraph (a) of Sec. 1.1245-4. For
reduction in amount of charitable contribution in case of a gift of
section 1250 property, see section 170(e) and paragraph (c)(3) of Sec.
1.170-1.
(2) Disposition in part a sale or exchange and in part a gift. Where
a disposition of property is in part a sale or exchange and in part a
gift, the disposition shall be subject to the provisions of Sec.
1.1250-1 and the gain to which section 1250(a) applies, shall be
computed under that section.
(3) Treatment of property in hands of transferee. If property is
disposed of in a transaction which is a gift:
(i) The additional depreciation for the property in the hands of the
transferee immediately after the disposition shall be an amount equal to
(a) the amount of the additional depreciation for the property in the
hands of the transferor immediately before the disposition, minus (b)
the amount of any gain (in case the disposition is in part a sale or
exchange and in part a gift) which would have been taken into account
under section 1250(a) by the
[[Page 456]]
transferor upon the disposition if the applicable percentage had been
100 percent.
(ii) For purposes of computing the applicable percentage, the
holding period under section 1250(e)(2) of property received as a gift
in the hands of the transferee includes the transferor's holding period,
(iii) In case of a disposition which is in part a sale or exchange
and in part a gift, if the adjusted basis of the property in the hands
of the transferee exceeds its adjusted basis immediately before the
transfer, the excess is an addition to capital account under paragraph
(d)(2)(ii) of Sec. 1.1250-5 (relating to property with 2 or more
elements), and
(iv) If the property disposed of consists of two or more elements
within the meaning of paragraph (c) of Sec. 1.1250-5, see paragraph
(e)(1) of Sec. 1.1250-5 for the amount of additional depreciation and
holding period for each element in the hands of the transferee.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. (i) On May 15, 1967, Smith transfers section 1250
property to his son for $45,000. In the hands of Smith the property had
an adjusted basis of $40,000 and a fair market value of $70,000. Thus,
the gain realized is $5,000 (amount realized, $45,000, minus adjusted
basis, $40,000), and Smith has made a gift of $25,000 (fair market
value, $70,000, minus amount realized, $45,000).
(ii) Smith's holding period for the property is 80 full months and,
thus, the applicable percentage under section 1250(a)(2) is 40 percent.
The additional depreciation for the property is $10,000. Since the gain
realized ($5,000) is lower than the additional depreciation ($10,000),
Smith recognized as ordinary income under section 1250(a)(2) gain of
$2,000 (that is, applicable percentage, 40 percent, multiplied by gain
realized, $5,000) and the $3,000 remaining portion of the gain realized
may be treated as gain from the sale of property described in section
1231.
(iii) On the date the son receives the property, the additional
depreciation for the property in his hands is $5,000, that is, the
additional depreciation for the property in the hands of the father
immediately before the transfer ($10,000), minus the gain which would
have been recognized under section 1250(a)(2) upon the transfer if the
applicable percentage had been 100 percent ($5,000); for purposes of
computing applicable percentage his holding period is his father's
holding period of 80 full months; and under Sec. 1.1015-4 his
unadjusted basis for the property is $45,000, that is, the amount he
paid ($45,000) plus the excess (zero) of his father's adjusted basis
over such amount.
(iv) The son sells the property for $80,000 on March 15, 1968, 10
full months after he received it from his father. Thus, his holding
period is 90 full months (his father's holding period of 80 full months
plus the 10 full months the son actually owned the property) and the
applicable percentage under section 1250(a)(2) is 30 percent. Assume
that no depreciation was allowed or allowable to the son. Thus, the
son's adjusted basis and additional depreciation for the property on the
date of the sale is the same as on the date he received it. Accordingly,
the gain realized is $35,000 (selling price of $80,000, minus adjusted
basis of $45,000). Since the additional depreciation ($5,000) is lower
than the gain realized ($35,000), the son recognizes as ordinary income
under section 1250(a)(2) gain of $1,500, that is, applicable percentage
(30 percent) multiplied by additional depreciation ($5,000).
Example 2. Assume the same facts as in example (1), except that the
son sells the property on June 15, 1969, 25 full months after he
received it from his father. Thus, his holding period is 105 full months
(his father's holding period of 80 full months plus the 25 full months
the son actually owned the property) and the applicable percentage under
section 1250(a)(2) is 15 percent. Assume further that on the date of the
sale the adjusted basis of the property is $39,000, and that for the
period the son actually owned the property there is a deficit in
additional depreciation of $2,000. Accordingly, the gain realized is
$41,000 (selling price of $80,000, minus adjusted basis of $39,000), and
the additional depreciation for the property is $3,000 (that is, the
additional depreciation for the property in the hands of the son on the
date he received it, as determined in example (1), $5,000, minus the
amount of the deficit in additional depreciation for the period the son
actually owned the property, ($2,000). Since the additional depreciation
($3,000) is lower than the gain realized ($41,000), the son recognizes
as ordinary income under section 1250(a)(2) gain of $450, that is,
applicable percentage (15 percent) multiplied by additional depreciation
($3,000).
(b) Exception for transfers at death--(1) General rule. Section
1250(d)(2) provides that, except as provided in section 691 (relating to
income in respect of a decedent), no gain shall be recognized under
section 1250(a) upon a transfer at death. For purposes of this
paragraph, the term transfer at death shall have the same meaning as in
paragraph (b) of Sec. 1.1245-4.
(2) Treatment of transferee. (i) If as of the date a person acquires
property
[[Page 457]]
from a decedent such person's basis is determined, by reason of the
application of section 1014(a), solely by reference to the fair market
value of the property on the date of the decedent's death or on the
applicable date provided in section 2032 (relating to alternate
valuation date), then (a) on the date of death the additional
depreciation for the property is zero, and (b) for purposes of computing
applicable percentage the holding period of the property under section
1250(e)(1)(A) is deemed to begin on the day after the date of death.
(ii) If property is acquired in a transfer at death to which section
1250(d)(2) applies, the amount of the additional depreciation for the
property in the hands of the transferee immediately after the transfer
shall be the amount (if any) of the additional depreciation in respect
of the property allowed the transferee before the decedent's death, but
only to the extent that the basis of the property (determined under
section 1014(a)) is required to be reduced under the second sentence of
section 1014(b)(9) (relating to adjustments to basis where property is
acquired from a decedent prior to his death) by depreciation adjustments
referred to in paragraph (d)(1) of Sec. 1.1250-2 which give rise to
such additional depreciation. For treatment of such property as having a
special element with additional depreciation so computed, see paragraph
(c)(5)(i) of Sec. 1.1250-5 (relating to property with two or more
elements). For purposes of determining applicable percentage, such
special element shall have a holding period which includes the
transferee's holding period for such property for the period before the
decedent's death.
(3) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. On March 6, 1966, Smith dies owning an item of section
1250 property. On March 7, 1968, the executor distributes the property
to Smith's son pursuant to a specific bequest of the property in Smith's
will. Under section 1014(a)(2) and paragraph (a)(2) of Sec. 1.1014-4,
the unadjusted basis of the property in the hands of the son is its fair
market value on March 6, 1966 (the date Smith died), and the son is
considered to have acquired the property on such date. Under section
1250(e)(1)(A), the son's holding period for the property begins on March
7, 1966 (the day after the day he is considered to have acquired the
property). Thus, on March 7, 1968 (the date the property was distributed
to the son), the holding period for the property is 24 full months, and
the applicable percentage under section 1250(a)(2) is 96 percent. On
such date, the additional depreciation for the property includes any
additional depreciation in respect of the property for the period the
property was possessed by the estate.
Example 2. H purchases section 1250 property in 1965 which he
immediately conveys to himself and W, his wife, as tenants by the
entirety. Under local law each spouse is entitled to one-half the income
from the property. H and W file joint income tax returns for calendar
years 1965, 1966, and 1967. Over the 3 years, depreciation allowed in
respect of the property was $4,000 (the amount allowable) of which $500
is additional depreciation. One-half of these amounts are allocable to
W. Thus, depreciation deductions of $2,000, of which $250 is additional
depreciation, are allowable to W. On January 1, 1968, H dies and the
entire value of the property at the date of death is included in H's
gross estate. Since W's basis for the property (determined under section
1014(a)) is reduced (under the second sentence of section 1014(b)(9)) by
the $2,000 depreciation deductions allowed W before H's death of which
$250 is additional depreciation, the additional depreciation for the
property in the hands of W immediately after H's death is $250.
(c) Limitation for certain tax-free transactions--(1) General.
Section 1250(d)(3) provides that upon a transfer of property described
in subparagraph (2) of this paragraph, the amount of gain taken into
account by the transferor under section 1250(a) shall not exceed the
amount of gain recognized to the transferor on the transfer (determined
without regard to section 1250). For purposes of this subparagraph, in
case of a transfer of both section 1250 property and nonsection 1250
property in one transaction, the amount realized from the disposition of
the section 1250 property shall be deemed to consist of that portion of
the fair market value of each property acquired which bears the same
ratio to the fair market value of such acquired property as the amount
realized from the disposition of the section 1250 property bears to the
total amount realized. The preceding sentence shall be applied solely
for purposes of computing the portion of the total gain (determined
without regard to section 1250) which shall be recognized as ordinary
income under section
[[Page 458]]
1250(a). Section 1250(d)(3) does not apply to a disposition of property
to an organization (other than a cooperative described in section 521)
which is exempt from the tax imposed by chapter 1 of the Code.
(2) Transfers covered. The transfers described in this subparagraph
are transfers of property in which the basis of the property in the
hands of the transferee is determined by reference to its basis in the
hands of the transferor by reason of the application of any of the
following provisions:
(i) Section 332 (relating to distributions in complete liquidation
of an 80 percent or more controlled subsidiary corporation). For
application of section 1250(d)(3) to such a complete liquidation, the
principles of paragraph (c)(3) of Sec. 1.1245-4 shall apply.
(ii) Section 351 (relating to transfer to a corporation controlled
by transferor).
(iii) Section 361 (relating to exchanges pursuant to certain
corporate reorganizations).
(iv) Section 371(a) (relating to exchanges pursuant to certain
receivership and bankruptcy proceedings).
(v) Section 374(a) (relating to exchanges pursuant to certain
railroad reorganizations).
(vi) Section 721 (relating to transfers to a partnership in exchange
for a partnership interest).
(vii) Section 731 (relating to distributions by a partnership to a
partner). For special carryover basis rule, see section 1250(d)(6)(A)
and paragraph (f)(1) of this section.
(3) Treatment of property in hands of transferee. In the case of a
transfer described in subparagraph (2) (other than subdivision (vii)
thereof) of this paragraph:
(i) The additional depreciation for the property in the hands of the
transferee immediately after the disposition shall be an amount equal to
(a) the amount of the additional depreciation for the property in the
hands of the transferor immediately before the disposition, minus (b)
the amount of additional depreciation necessary to produce an amount
equal to the gain taken into account under section 1250(a) by the
transferor upon the disposition (taking into account the applicable
percentage for the property),
(ii) For purposes of computing applicable percentage, the holding
period under section 1250(e)(2) of the property in the hands of the
transferee includes the transferor's holding period,
(iii) If the adjusted basis of the property in the hands of the
transferee exceeds its adjusted basis immediately before the transferee,
the excess is an addition to capital account under paragraph (d)(2)(ii)
of Sec. 1.1250-5 (relating to property with 2 or more elements), and
(iv) If the property disposed of consists of 2 or more elements
within the meaning of paragraph (c) of Sec. 1.1250-5, see paragraph
(e)(1) of Sec. 1.1250-5 for the amount of additional depreciation and
the holding period for each element in the hands of the transferee.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. (i) Green transfers section 1250 property on March 1,
1968, to a corporation, which is not exempt from taxation, in exchange
for cash of $9,000 and stock in the corporation worth $91,000, in a
transaction qualifying under section 351. Thus, the amount realized is
$100,000 ($9,000 plus $91,000). The property has an applicable
percentage under section 1250(a)(2) of 60 percent, an adjusted basis of
$40,000, and additional depreciation of $20,000. The gain realized is
$60,000, that is, amount realized ($100,000) minus adjusted basis
($40,000). Since the additional depreciation ($20,000) is lower than the
gain realized ($60,000), the amount of gain which would be treated as
ordinary income under section 1250(a)(2) would be $12,000 (60 percent of
$20,000) if the limitation provided in section 1250(d)(3) did not apply.
Since under section 351(b) gain in the amount of $9,000 would be
recognized to the transferor without regard to section 1250, the
limitation provided in section 1250(d)(3) limits the gain taken into
account by the transferor under section 1250(a)(2) to $9,000.
(ii) The amount of additional depreciation for the property in the
hands of the transferee immediately after the transfer is $5,000, that
is, the amount of additional depreciation before the transfer ($20,000)
minus the amount of additional depreciation necessary to produce an
amount equal to the gain recognized under section 1250(a)(2) upon the
transfer ($15,000, that is, $9,000 of gain recognized divided by 60
percent, the applicable percentage). (If the property is subsequently
disposed of, and for the period after the initial transfer there is
additional depreciation in respect of the property, then at the time
[[Page 459]]
of the subsequent disposition the additional depreciation will exceed
$5,000. If, however, for the period after the initial transfer there was
a deficit in additional depreciation, then at the time of the subsequent
disposition the additional depreciation would be less than $5,000.)
Example 2. (i) Assume the same facts as in example (1) except that
the additional depreciation is $10,000. Since additional depreciation
($10,000) is lower than the gain realized ($60,000), the amount of gain
which would be treated as ordinary income under section 1250(a)(2) would
be $6,000 (60 percent of $10,000) if the limitation provided in section
1250(d)(3) did not apply. Since under section 351(b) gain in the amount
of $9,000 would be recognized to the transferor without regard to
section 1250, the limitation under section 1250(d)(3) does not prevent
treatment of the entire $6,000 as ordinary income under section
1250(a)(2). The $3,000 remaining portion of the $9,000 gain may be
treated as gain from the sale of property described in section 1231.
(ii) Immediately after the transfer, the amount of additional
depreciation is zero, that is, the amount of additional depreciation
before the transfer ($10,000) minus the amount of additional
depreciation necessary to produce an amount equal to the gain taken into
account under section 1250(a)(2) upon the transfer ($10,000) that is,
$6,000 divided by 60 percent.
Example 3. (i) Miller transfers section 1250 property after December
31, 1969, to a corporation, which is not exempt from taxation, in
exchange for cash of $9,000 and stock in the corporation worth $31,000,
in a transaction qualifying under section 351. Thus, the amount realized
is $40,000 ($9,000 plus $31,000). The property has an applicable
percentage under paragraph (d)(1)(i)(e) of this section of 100 percent
and an applicable percentage under paragraph (d)(2) of this section of
50 percent. The adjusted basis of the property on the date of the
transfer is $24,000, and the gain realized is $16,000 (that is, amount
realized, $40,000, minus adjusted basis, $24,000). The additional
depreciation attributable to periods after December 31, 1969, is $8,000
and the additional depreciation attributable to periods before January
1, 1970, is $12,000. Since the additional depreciation attributable to
periods after December 31, 1969 ($8,000), is lower than the gain
realized ($16,000), the amount of gain which would be recognized as
ordinary income under section 1250(a)(1) would be $8,000 (100 percent of
$8,000) if the limitation provided in section 1250(d)(3) did not apply.
In addition, gain is recognized under section 1250(a)(2) since there is
a remaining potential gain of $8,000 (that is, gain realized, $16,000,
minus additional depreciation attributable to periods after December 31,
1969 ($8,000)). Since the remaining potential gain ($8,000) is lower
than the additional depreciation attributable to periods before January
1, 1970 ($12,000), the amount of gain which would be recognized under
section 1250(a)(2) would be $4,000 (50 percent of $8,000) if the
limitation in section 1250(d)(3) did not apply. Since under section
351(b) gain in the amount of $9,000 would be recognized to the
transferor without regard to section 1250, the limitation in section
1250(d)(3) limits the gain taken into account by the transferor under
section 1250(a) to $9,000. Since the section 1250(a)(1) gain is
considered as recognized first under paragraph (a)(1)(iii) of Sec.
1.1250-1, of the $9,000 of gain recognized, $8,000 is recognized under
section 1250(a)(1) and $1,000 is recognized under section 1250(a)(2).
(ii) The amount of additional depreciation for the property in the
hands of the transferee immediately after the transfer is $10,000, the
amount of additional depreciation immediately before the transfer
($20,000), minus the sum of (a) the amount of additional depreciation
necessary to produce an amount equal to the gain recognized under
section 1250(a)(1) upon the transfer, $8,000 (that is, gain recognized
under section 1250(a)(1), $8,000, divided by 100 percent, the applicable
percentage under section 1250(a)(1)), plus (b) the amount of additional
depreciation necessary to produce an amount equal to the gain recognized
under section 1250(a)(2) upon the transfer, $2,000 (that is, gain
recognized under section 1250(a)(2), $1,000, divided by 50 percent, the
applicable percentage under section 1250(a)(2)). Of this amount, zero
(that is, $8,000 minus $8,000) is attributable to periods after December
31, 1969, and $10,000 ($12,000 minus $2,000) is attributable to periods
before January 1, 1970.
(d) Limitation for like kind exchanges and involuntary conversions--
(1) Limitation on gain. (i) Under section 1250(d)(4)(A), if property is
disposed of and gain (determined without regard to section 1250) is not
recognized in whole or in part under section 1031 (relating to like kind
exchanges) or section 1033 (relating to involuntary conversions), then
the amount of gain taken into account by the transferor under section
1250(a) shall not exceed the greater of the two limitations set forth in
subdivisions (ii) and (iii) of this subparagraph. Immediately after the
transfer the basis of the acquired property shall be determined under
subparagraph (2), (3), or (4) (whichever is applicable) of this
paragraph, and its additional depreciation shall be computed under
subparagraph (5) of this paragraph. The holding period of the acquired
property for purposes of computing applicable
[[Page 460]]
percentage, which is determined under section 1250(e)(1), does not
include the holding period of the property disposed of. In the case of a
disposition of section 1250 property and other property in one
transaction, see subparagraph (6) of this paragraph. In case of a
disposition described in section 1250(d)(4)(A) of a portion of this item
of property, see subparagraph (7) of this paragraph.
(ii) For purposes of this subparagraph, the first limitation is the
sum of:
(a) The amount of gain recognized on the disposition under section
1031 or 1033 (determined without regard to section 1250), plus
(b) An amount equal to the cost of any stock purchased in a
corporation which (without regard to section 1250) would result in
nonrecognition of gain under section 1033(a)(3)(A).
(iii) For purposes of this subparagraph, the second limitation is
the excess (if any) of:
(a) The amount of gain which would (without regard to section
1250(d)(4)) be taken into account under section 1250(a), over
(b) The fair market value (or cost in the case of a transaction
described in section 1033(a)(3)) of the section 1250 property acquired
in the transaction.
(iv) The provisions of this subparagraph may be illustrated by the
following example:
Example: A taxpayer receives $96,000 of insurance proceeds upon the
destruction of section 1250 property by fire. If section 1250(d)(4)(A)
did not apply to the disposition, $16,000 of gain would be recognized
under section 1250(a). In acquisitions qualifying under section
1033(a)(3)(A), he uses $90,000 of the proceeds to purchase property
similar or related in service or use to the property destroyed, of which
$42,000 is for one item of section 1250 property and $48,000 is for one
piece of land, and $5,000 of the proceeds to purchase stock in the
acquisition of control of a corporation owning property similar or
related in service or use to the property destroyed. The taxpayer
properly elects under section 1033(a)(3)(A) and the regulations
thereunder to limit recognition of gain (determined without regard to
section 1250) to $1,000, that is, the excess of the amount realized from
the conversion ($96,000) over the cost of the property acquired in
acquisitions qualifying under section 1033(a)(3)(A) ($95,000, that is,
$90,000 plus $5,000). The amount of gain recognized under section
1250(a) is $6,000, determined in the following manner:
The first limitation:
(a) Amount of gain recognized under section 1033(a)(3), $1,000
determined without regard to section 1250(a).............
(b) Fair market value of stock in a corporation which 5,000
qualifies under section 1033(a)(3)(A)....................
-----------
(c) Sum of (a) plus (b)................................... 6,000
The second limitation:
(d) Amount of gain which would be recognized under section 16,000
1250(a) if section 1250(d)(4) did not apply..............
(e) Cost of section 1250 property acquired in transaction. 42,000
===========
(f) Excess of (d) over (e).............................. 0
Since the first limitation ($6,000) exceeds the second limitation
(zero), the amount of gain recognized under section 1250(a) is $6,000.
The balance ($10,000) of the gain realized ($16,000) is not recognized.
(2) Basis of property purchased upon involuntary conversion into
money. (i) If section 1250 property is purchased in a compulsory or
involuntary conversion to which section 1033(a)(3) applies, and if by
reason of the application of section 1250(d)(4)(A) all or part of the
gain computed under section 1250(a) is not taken into account, then the
basis of the section 1250 property and other purchased property shall be
determined under the rules prescribed in this subparagraph. See section
1250(d)(4)(D).
(ii) The total basis of all purchased property, the acquisition of
which results in the nonrecognition of any part of the gain realized
upon the transaction, shall be (a) its cost, reduced by (b) the portion
of the total gain realized which was not recognized. To the extent that
section 1250(d)(4)(A)(i) prevents the purchase of stock from resulting
in nonrecognition of gain, the basis of purchased stock is its cost.
(iii) If purchased property consists of both section 1250 property
and other property, the total basis computed under subdivision (ii) of
this subparagraph shall be allocated between the section 1250 property
(treated as a class) and the other property (treated as a class) in
proportion to their respective costs, except that for purposes of this
subdivision (but not subdivision (iv) of this subparagraph) the cost of
the section 1250 property shall be deemed to be the excess of (a) its
actual cost, over (b) the gain not taken into account under section
1250(a) by
[[Page 461]]
reason of the application of section 1250(d)(4)(A).
(iv) If the property acquired consists of more than one item of
section 1250 property (or of more than one item of other property), the
total basis of the section 1250 property (or of the other property), as
computed under subdivisions (ii) and (iii) of this subparagraph, shall
be allocated to each item of section 1250 property (or other property)
in proportion to their respective actual costs.
(v) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. Assume the same facts as in the example in subparagraph
(1)(iv) of this paragraph. Assume further that the portion of the gain
realized which was not recognized under section 1033(a)(3) or 1250(a)
upon the transaction is $60,000, of which the gain computed under
section 1250(a) which is not taken into account by reason of the
application of section 1250(d)(4)(A) is $10,000, that is, the excess of
the gain which would have been recognized under section 1250(a) if
section 1250(d)(4)(A) did not apply ($16,000) over the gain recognized
under section 1250(a) ($6,000). In such example $95,000 of proceeds were
used to purchase property in acquisitions qualifying under section
1033(a)(3)(A) of which $42,000 was for section 1250 property, $48,000
for land, and $5,000 for stock in a corporation. The basis of each
acquired property is determined in the following manner:
(a) Under subdivision (ii) of this subparagraph, the total basis of
the acquired properties (other than the stock) is $30,000, that is,
their cost ($90,000, of which $42,000 is for section 1250 property and
$48,000 is for land), reduced by the portion of the total gain realized
which was not recognized ($60,000).
(b) Under subdivision (iii) of this subparagraph, such total basis
is allocated between the section 1250 property and the land in
proportion to their respective costs, and for this purpose the cost of
the section 1250 property is considered to be $32,000, that is, its
actual cost ($42,000) minus the gain not recognized under section
1250(a) by reason of the application of section 1250(d)(4)(A) ($10,000).
Thus, the basis of the section 1250 property is $12,000 (32/80 of
$30,000), and the basis of the land is $18,000 (48/80 of $30,000).
(c) The basis of the purchased stock is its cost of $5,000. See last
sentence of subdivision (ii) of this subparagraph.
Example 2. Assume the same facts as in example (1) except that the
section 1250 property purchased for $42,000 consists of 2 items of such
property ($10,500 for C, and $31,500 for D), and that the land purchased
for $48,000 consists of 2 pieces of land ($12,000 for X, and $36,000 for
Y). Under subdivision (iv) of this subparagraph, the total basis for
each class of property is allocated between the individual properties of
such class in proportion to their respective actual costs. Thus, the
total basis of $12,000, as determined in example (1), for the section
1250 property is allocated as follows:
To C: $12,000 x ($10,500/$42,000)........................... $3,000
To D: $12,000 x ($31,500/$42,000)........................... 9,000
-----------
Total................................................... 12,000
The total basis of $18,000, as determined in example (1), for the land
is allocated as follows:
To X: $18,000 x ($12,000/$48,000)........................... $4,500
To Y: $18,000 x ($36,000/$48,000)........................... 13,500
-----------
Total................................................... 18,000
(3) Basis of property acquired upon involuntary conversion into
similar property. If property is involuntarily converted into property
similar or related in service or use in a transaction to which section
1033(a)(1) applies, and if by reason of the application of section
1250(d)(4)(A) all or part of the gain computed under section 1250(a) is
not taken into account, then:
(i) The total basis of the acquired property shall be determined
under the first sentence of section 1033(c), and
(ii) If more than one item of property is acquired, such total basis
shall be allocated to the individual items of property acquired in
accordance with the principles prescribed in subparagraph (2) (iii) and
(iv) of this paragraph, except that an amount equivalent to the fair
market value of each item of property on the date acquired shall be
treated as its actual cost.
(4) Basis of property acquired in like kind exchange. If section
1250 property is transferred in an exchange described in section 1031
(a) or (b), and if by reason of the application of section 1250(d)(4)(A)
all or part of the gain computed under section 1250(a) is not taken into
account, then:
(i) The total basis of the property (including nonsection 1250
property) acquired of the type permitted to be received under section
1031 without recognition of gain or loss shall be determined under
section 1031(d), and
(ii) If more than one item of property of such type was received,
such total basis shall be allocated to the individual items of property
of such type in
[[Page 462]]
accordance with the principles prescribed in subparagraph (2) (iii) and
(iv) of this paragraph, except that an amount equivalent to the fair
market value of each such item of property on the date received shall be
treated as its actual cost.
(5) Additional depreciation for property acquired in like kind
exchange or involuntary conversion. (i) If property is disposed of in a
transaction described in section 1031 or 1033, and if by reason of the
application of section 1250(d)(4)(A) all or part of the gain computed
under section 1250(a) is not taken into account, then the additional
depreciation for the acquired property immediately after the transaction
(as computed under section 1250(d)(4)(E)) shall be an amount equal to
the amount of gain computed under section 1250(a) which was not taken
into account by reason of the application of section 1250(d)(4)(A).
(ii) In case more than one item of section 1250 property is acquired
in the transaction, the additional depreciation computed under
subdivision (i) of this subparagraph shall be allocated to each such
item of section 1250 property in proportion to their respective adjusted
bases.
(iii) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. (a) On January 15, 1969, section 1250 property X is
condemned and proceeds of $100,000 are received. On such date, X's
adjusted basis is $25,000, the additional depreciation is $10,000, and
the applicable percentage under section 1250(a)(2) is 70 percent. Since
the additional depreciation ($10,000) is less than the gain realized
($75,000, that is, $100,000 minus $25,000) the amount of gain computed
under section 1250(a)(2) (without regard to section 1250(d)(4)(A)) is
$7,000, that is, 70 percent of $10,000.
(b) On March 1, 1969, all the proceeds are used to purchase section
1250 property Y in a transaction qualifying under section 1033(a)(3)(A)
for nonrecognition of gain. Accordingly, the gain not recognized by
reason of the application of section 1033(a)(3)(A) is $75,000, of which
$7,000 is gain computed under section 1250(a)(2) which is not taken into
account by reason of the application of section 1250(d)(4)(A). See
subparagraph (1) of this paragraph.
(c) Immediately after the transaction, Y's basis is $25,000, that
is, its cost ($100,000) minus the total gain realized which was not
recognized ($75,000), and the additional depreciation (as computed under
section 1250(d)(4)(E)) is $7,000, that is, the amount of gain not taken
into account under section 1250(a)(2) by reason of the application of
section 1250(d)(4)(A).
(d) On December 15, 1969, before any depreciation deductions were
allowed or allowable in respect of Y, Y is sold for $90,000. Under
section 1250(e)(1), the holding period of Y is 9 months, and thus, under
section 1250(a)(2), the applicable percentage is 100 percent. Since the
additional depreciation ($7,000) is less than the gain realized
($65,000, that is $90,000 minus $25,000), the amount of gain recognized
under section 1250(a)(2) as ordinary income is $7,000, that is, 100
percent of $7,000.
Example 2. Assume the same facts as in example (1), except that
property Y was purchased on June 15, 1962, and that 90 full months
thereafter, or December 15, 1969, it is sold for $35,000. Thus the
applicable percentage under section 1250(a)(2) is 30 percent. Assume
further that at the time of such sale Y's adjusted basis is $5,000 and
additional depreciation in respect of Y for periods after it was
acquired is $2,500. Thus, the additional depreciation at the time of the
sale is $9,500, that is, the sum of the additional depreciation in
respect of Y attributable to X as computed under section 1250(d)(4)(E)
in (c) of example (1) ($7,000), plus the additional depreciation
attributable to periods after Y was acquired ($2,500). Since the
additional depreciation ($9,500) is less than the gain realized
($30,000, that is, $35,000 minus $5,000), the gain recognized under
section 1250(a)(2) as ordinary income is $2,850, that is, 30 percent of
$9,500.
(6) Single disposition of section 1250 property and property of
different class. (i) For purposes of this subparagraph:
(a) Section 1250 property, section 1245 property (as defined in
section 1245(a)(3)), and other property shall each be treated as a
separate class of property, and
(b) The term qualifying property means property which may be
acquired without recognition of gain under the applicable provision of
section 1031 or 1033 (applied without regard to section 1250 or 1245)
upon the disposition of property.
(ii) If upon a sale of section 1250 property gain would be
recognized under section 1250(a) and if such section 1250 property
together with property of a different class or classes are disposed of
in one transaction in which gain is not recognized in whole or in part
under section 1031 or 1033 (without regard to sections 1245 and 1250),
then:
[[Page 463]]
(a) The total amount realized shall be allocated between the
different classes of property disposed of in proportion to their
respective fair market values,
(b) The amount realized upon the disposition of property of a class
shall be deemed to consist of so much of the fair market value of
qualifying property of the same class acquired as is not in excess of
the amount realized from the property of such class disposed of,
(c) The remaining portion (if any) of the amount realized upon the
disposition of property of such class shall be deemed to consist of so
much of the fair market value of any other property acquired as is not
in excess of such remaining portion, and
(d) For purposes of applying (c) of this subdivision, the fair
market value of acquired property shall be taken into account only once
and in such manner as the taxpayer determines.
(iii) The amounts determined under this subparagraph in respect of
property shall apply for all purposes of the Code.
(iv) The application of this subparagraph may be illustrated by the
following example:
Example: (a) Green owns property consisting of land and a fully
equipped factory building thereon. The property is condemned and
proceeds of $100,000 are received. If the property were sold for
$100,000, gain of $40,000 would be recognized of which $10,000 would be
recognized as ordinary income under section 1250(a). Proceeds of $95,000
are used to purchase property similar or related in service or use to
the condemned property and under section 1033(a)(3)(A) (without regard
to sections 1245 and 1250) recognition of gain is limited to $5,000. The
fair market values by classes of the property disposed of, and of the
property acquired, are summarized in the table below:
------------------------------------------------------------------------
Fair market value of property
-------------------------------
Disposed of Acquired
------------------------------------------------------------------------
Section 1245 property................... $35,000 $55,000
Section 1250 property................... 45,000 28,000
Land.................................... 20,000 12,000
Cash.................................... .............. 5,000
-------------------------------
100,000 100,000
------------------------------------------------------------------------
(b) The allocations under subdivision (ii) of this subparagraph are
summarized in the table below:
----------------------------------------------------------------------------------------------------------------
Property acquired
Property disposed of --------------------------------------------------------------- Cash
Sec. 1245 Property Sec. 1250 Property Land Remaining
----------------------------------------------------------------------------------------------------------------
$35,000 of section 1245 property..... $35,000 ....................... ........... ..........
$45,000 of section 1250 property..... \1\ 17,000 $28,000 ........... ..........
$20,000 of land...................... \1\ 3,000 ....................... $12,000 \1\ $5,000
--------------------------------------------------------------------------
Total............................... 55,000 28,000 12,000 5,000
----------------------------------------------------------------------------------------------------------------
\1\ Determined by taxpayer pursuant to subdivision (ii)(d) of this subparagraph.
(c) Upon the disposition of the section 1245 property, only section
1245 property is acquired, and thus gain (if any) would not be
recognized under section 1245(a)(1). See section 1245(b)(4). Upon the
disposition of the section 1250 property gain under section 1250(a)
would not be recognized by reason of the application of section
1250(d)(4)(A). See subparagraph (1) of this paragraph. If the gain
realized on the disposition of the land is not less than $5,000, then
under section 1033(a)(3)(A) the gain recognized would be $5,000, that
is, an amount equal to the portion of the proceeds from the disposition
of the land ($5,000) not invested in qualifying property.
(7) Disposition of portion of property. A disposition described in
section 1250(d)(4)(A) of a portion of an item of property gives rise to
an addition to capital account described in the last sentence of
paragraph (d)(2)(i) of Sec. 1.1250-5 (relating to property with 2 or
more elements). If the addition to capital account is a separate
improvement within the meaning of paragraph (d) of Sec. 1.1250-5, and
thus an element, then immediately after the addition is made the amount
of additional depreciation for such separate improvement shall be
computed under subparagraph (5) of this paragraph by treating such
portion and such addition as separate properties. If the addition is not
a separate improvement, then immediately after the addition is made such
property is considered under paragraph (c)(5)(ii) of Sec. 1.1250-5 as
having a special
[[Page 464]]
element with the same amount of additional depreciation so computed. For
purposes of computing applicable percentage, the holding period of the
separate improvement or special element (as the case may be), which is
determined under section 1250(e)(1), does not include the holding period
of the property disposed of.
(e) Sections 1071 and 1081 transactions--(1) General. This paragraph
prescribes regulations under section 1250(d)(5) which apply in the case
of a disposition of section 1250 property in a transaction in which gain
(determined without regard to section 1250) is not recognized in whole
or in part by reason of the application of section 1071 (relating to
gain from sale or exchange to effectuate policies of FCC) or section
1081 (relating to gain from sale or exchange in obedience to order of
SEC).
(2) Involuntary conversion treatment under section 1071. If section
1250 property is disposed of and gain (determined without regard to
section 1250) is not recognized in whole or in part solely by reason of
an election under the first sentence of section 1071(a) to treat the
transaction as an involuntary conversion, the consequences of the
transaction shall be determined under the principles of paragraph (d) of
this section.
(3) Basis reduction under sections 1071 or 1082(a)(2). (i) If
section 1250 property is disposed of and gain (determined without regard
to section 1250) is not recognized in whole or in part by reason of a
reduction in basis of property pursuant to an election under section
1071(a) or the application of section 1082(a)(2), then the amount of
gain taken into account by the transferor under section 1250(a) shall
not exceed the sum of:
(a) The amount of gain recognized on such disposition (determined
without regard to section 1250), plus
(b) In case involuntary conversion treatment was also elected under
section 1071(a), an amount equal to the cost of any stock purchased in a
corporation which (without regard to section 1250) would result in
nonrecognition of gain under section 1033(a)(3), as modified by section
1071(a), plus
(c) The portion of the gain computed under section 1250(a) (without
regard to this paragraph) which is neither taken into account under (a)
or (b) of this subdivision nor applied under subdivision (ii) of this
subparagraph to reduce the basis of section 1250 property.
(ii)(a) The amount of gain computed under section 1250(a) (without
regard to this paragraph) which is not taken into account under
subdivision (i) (a) or (b) of this subparagraph shall be applied to the
amount by which the basis of the section 1250 property was reduced under
section 1071(a) or 1082(a)(2), as the case may be, before other gain
(which is not gain computed under section 1250(a)) is so applied.
(b) If the basis of more than one item of section 1250 property was
so reduced, the gain applied under (a) of this subdivision to all such
section 1250 properties shall be applied to such items in proportion to
the amounts of their respective basis reductions.
(c) Any gain not applied under (a) of this subdivision shall be
applied to the amount by which the basis of the nonsection 1250 property
was reduced.
(iii) If gain computed under section 1250 is applied under
subdivision (ii) of this subparagraph to reduce the basis of section
1250 property, the amount so applied shall be treated as additional
depreciation in respect of such section 1250 property. For treatment of
such section 1250 property as having a special element with additional
depreciation consisting of such amount, see paragraph (c)(5)(i) of Sec.
1.1250-5. For purposes of computing applicable percentage, such special
element shall have a holding period beginning on the day after the date
as of which the property's basis was so reduced.
(4) Section 1081(d)(1)(A) transaction. No gain shall be recognized
under section 1250(a) upon an exchange of property as to which gain is
not recognized (without regard to section 1250) because of the
application of section 1081(d)(1)(A) (relating to transfers within
system group). For treatment of property in the hands of a transferee,
the principles of paragraph (c)(3) of this section shall apply.
(f) Property distributed by a partnership to a partner--(1) General.
For purposes of section 1250 (d)(3) and (e)(2), the basis of section
1250 property distributed by a partnership to a partner
[[Page 465]]
shall be determined by reference to the adjusted basis of such property
to the partnership. Thus, if section 731 applies to a distribution of
section 1250 property by a partnership to a partner, then even though
the partner's basis is not determined for other purposes by reference to
the partnership's basis, (i) the amount of gain taken into account by
the partnership under section 1250(a) is limited by section 1250(d)(3)
to the amount of gain recognized to the partnership upon the
distribution (determined without regard to section 1250), and (ii) the
holding period of the property in the hands of the partner shall, under
section 1250(e)(2), include the holding period of the property in the
hands of the partnership. For nonapplication of section 1250(d)(3) to a
disposition to an organization (other than a cooperative described in
section 521) which is exempt from the tax imposed by chapter 1 of the
Code, see paragraph (c)(1) of this section.
(2) Treatment of property distributed by partnership. (i) If section
1250 property is distributed by a partnership to a partner in a
distribution in which no part of the partnership's potential section
1250 income in respect of the property was recognized as ordinary income
to the partnership under paragraph (b)(2)(ii) of Sec. 1.751-1, the
additional depreciation for the property in the hands of the distributee
attributable to periods before the distribution shall be an amount equal
to the total potential section 1250 income of the partnership in respect
of the property immediately before the distribution, recomputed as if
the applicable percentage for the property had been 100 percent. Under
paragraph (c)(4) of Sec. 1.751-1, the potential section 1250 income is,
in effect, the gain to which section 1250(a) would have applied if the
property had been sold by the partnership immediately before the
distribution at its fair market value at such time.
(ii) If upon the distribution any potential section 1250 income in
respect of the property was recognized to the partnership under
paragraph (b)(2)(ii) of Sec. 1.751-1, then after the distribution the
additional depreciation shall be an amount equal to (a) the total
potential section 1250 income in respect of the property, as recomputed
in subdivision (i) of this subparagraph, minus (b) the amount of
potential section 1250 income which would have been recognized to the
partnership under paragraph (b)(2)(ii) of Sec. 1.751-1 if the
applicable percentage for the property had been 100 percent.
(iii) If the partner's basis for the property immediately after the
transaction exceeds the partnership's adjusted basis for the property
immediately before the transaction, the excess may be an addition to
capital account under paragraph (d)(2)(ii) of Sec. 1.1250-5 (relating
to property with two or more elements).
(3) Examples. The provisions of subparagraphs (1) and (2) of this
paragraph may be illustrated by the following examples:
Example 1. (i) A partnership distributes a building to Smith on
January 1, 1969, in a complete liquidation of his partnership interest
to which section 736(a) does not apply. On the date of the distribution,
the partnership's holding period for the property is 40 full months and,
accordingly, the applicable percentage under section 1250(a)(2) is 80
percent. On such date, the partnership's additional depreciation for the
building ($6,250) is lower than the excess ($40,000) of its fair market
value ($140,000) over adjusted basis ($100,000). Thus, under paragraph
(c)(4) of Sec. 1.751-1, the partnership's potential section 1250 income
in respect of the building is $5,000 (80 percent of $6,250). Assume that
section 751(b) does not apply to the distribution. Accordingly, no gain
would be recognized to the partnership under section 731(b) (without
regard to the application of section 1250). Smith's basis for his
partnership interest was $150,000, and under section 732(b) Smith's
basis for the building is equal to his basis for his partnership
interest. Thus, Smith's basis for the building is not determined by
reference to the partnership's basis for the building. Nevertheless,
under subparagraph (1) of this paragraph, no gain is recognized to the
partnership under section 1250(a)(2) and Smith's holding period for the
property includes the partnership's holding period.
(ii) Six full months after Smith received the building in the
distribution, or July 1, 1969, he sells it for $153,000. Assume that no
depreciation was allowed or allowable to Smith for the building, and
that the special rules under Sec. 1.1250-5 for property with two or
more elements do not apply. Since Smith's holding period for the
building includes its holding period in the hands of the partnership,
his holding period is 46 full months (40 full months for the partnership
plus 6 full months for Smith) and the applicable percentage under
section 1250(a)(2) is 74 percent.
[[Page 466]]
(iii) Since no potential section 1250 income was recognized to the
partnership under paragraph (b)(2)(ii) of Sec. 1.751-1, the additional
depreciation for the building attributable to periods before the
distribution is determined under the provisions of subparagraph (2)(i)
of this paragraph. Under such provisions, the potential section 1250
income to the partnership, which was actually $5,000 (that is, 80
percent of $6,250), is recomputed as if the applicable percentage were
100 percent, and thus such additional depreciation is $6,250 (that is,
100 percent of $6,250). Since no depreciation was allowed or allowable
for the building in Smith's hands, the additional depreciation for the
building attributable to Smith's total holding period (46 full months)
is $6,250. Since the gain realized ($3,000, that is, amount realized,
$153,000, minus adjusted basis, $150,000), is lower than the additional
depreciation ($6,250), the gain recognized to Smith under section
1250(a)(2) is $2,220 (that is, 74 percent of $3,000).
Example 2. Assume the facts as in example (1) except that as a
result of the distribution the partnership recognizes under paragraph
(b)(2)(ii) of Sec. 1.751-1 potential section 1250 income of $1,000
(that is, 80 percent of $1,250). The additional depreciation
attributable to periods before the distribution, as determined under the
provisions of subparagraph (2)(ii) of this paragraph, is $5,000, that
is, (a) the total potential section 1250 income in respect of the
property, recomputed in example (1) as if the applicable percentage were
100 percent ($6,250), minus (b) the amount of potential section 1250
income which would have been recognized to the partnership under
paragraph (b)(2)(ii) of Sec. 1.751-1 if the applicable percentage for
the property had been 100 percent ($1,250, that is, 100 percent of
$1,250).
(4) Treatment of partnership property after certain transactions. If
under paragraph (b)(3) of Sec. 1.751-1 (relating to certain
distributions of partnership property other than section 751 property
treated as sales or exchanges) a partnership is treated as purchasing
section 1250 property (or a portion thereof) from a distributee who
relinquishes his interest in such property (or portion), then after the
date of such purchase the following rules shall apply:
(i) If only a portion of the property is treated as purchased, there
shall be excluded from the additional depreciation for the remaining
portion any additional depreciation in respect of the purchased portion
for periods before such purchase.
(ii) In respect of the purchased property (or portion), (a) as of
the date of purchase the amount of additional depreciation shall be
zero, and (b) for purposes of computing applicable percentage the
holding period shall begin on the day after the date of such purchase.
(5) Cross reference. See paragraph (f) of Sec. 1.1250-1 for the
amount of additional depreciation for partnership property in respect of
a partner who acquired his partnership interest in certain transactions
when an election under section 754 (relating to optional adjustments to
basis of partnership property) was in effect.
(g) Disposition of principal residence--(1) In general. (i) Section
1250(d)(7)(A) provides that section 1250(a) shall not apply to a
disposition of property by a taxpayer to the extent the property is used
by the taxpayer as his principal residence (within the meaning of
section 1034(a) and the regulations thereunder, relating to a sale or
exchange of residence). Thus, for example, if a doctor sells a house, of
which one portion was used as his principal residence within the meaning
of section 1034(a) and the other portion was properly subject to the
allowance for depreciation as property used in his trade or business,
then, by reason of the application of section 1250(d)(7)(A), section
1250(a) does not apply in respect of the disposition of the portion used
as his principal residence. The provisions of this subparagraph shall
apply regardless of whether section 1034 applies. Thus, for example, if
section 1034 did not apply to the sale because the doctor did not invest
in a new principal residence within the period specified in section
1034, nevertheless section 1250(a) would not apply to the disposition of
the portion used as a principal residence.
(ii) Section 1250(d)(7)(B) provides that section 1250(a) shall not
apply to a disposition of section 1250 property by a taxpayer who, in
respect of the property, satisfies the age and ownership requirements of
section 121 (relating to exclusion from gross income of gain on sale or
exchange of residence of individual who has attained age 65), but only
to the extent the taxpayer satisfies the use requirements of section 121
in respect of such property. Thus, if a taxpayer has attained the age of
65 before the date on which he disposes of section 1250 property, and if
during the 8-year period ending on the date of the
[[Page 467]]
disposition the property has been owned and used by the taxpayer solely
as his principal residence for periods aggregating 5 years or more, then
section 1250(a) does not apply in respect to the disposition. This
result would not be changed even if the taxpayer does not or cannot make
the election provided for in section 121 and even if section 121 applies
to only a portion of the gain because the adjusted sales price exceeds
the $20,000 limitation in section 121(b)(1). If, however, only a portion
of the property has been used as his principal residence for such
periods aggregating 5 years or more, then, by reason of the application
of section 1250(d)(7)(B), section 1250(a) is inapplicable only to the
portion so used. For special rules for determining whether the age,
ownership, and use requirements of section 121 are treated as satisfied,
and for the manner of applying such requirements, see section 121(d) and
the regulations thereunder.
(2) Concurrent operation of section 1250(d)(7) with other
provisions. Upon the disposition of a principal residence, gain computed
under section 1250(a) may not be recognized in whole or in part by
reason of the application of both the provisions of section 1250(d)(7)
and the provisions of one of the other exceptions or limitations
enumerated in section 1250(d). Thus, for example, if an entire house is
transferred as a gift, and if section 1250(d)(7) applies to only a
portion of the house, then section 1250(d)(1) excepts the disposition of
the entire house from the application of section 1250(a).
(3) Special rule. If by reason of section 1250(d)(7) a disposition
is partially excepted from the application of section 1250(a), and if no
other paragraph of section 1250(d) excepts the disposition entirely from
such application, then the gain to which section 1250(a) applies shall
be an amount which bears the same ratio to (i) the gain computed under
section 1250(a) (without regard to section 1250(d)(7)), as (ii) the fair
market value of the portion of the property to which the exception in
section 1250(d)(7) does not apply, bears to (iii) the total fair market
value of the property. Thus, for example, if under paragraph (a)(2) of
this section gain of $300 would be recognized as ordinary income under
section 1250(a) (without regard to section 1250(d)(7)) upon a combined
sale and gift of section 1250 property, and if the property has a fair
market value of $25,000 of which $10,000 is properly allocable to a
portion not used as a principal residence, then the amount of gain
recognized as ordinary income under section 1250(a) would be $120 (10/25
of $300).
(4) Treatment of property in hands of transferee. If property is
disposed of in a transaction to which section 1250(d)(7) applies, and if
its basis in the hands of the transferee is determined by reference to
its basis in the hands of the transferor by reason of the application of
section 1250(d)(1) (relating to gifts) or section 1250(d)(3) (relating
to certain tax-free transactions), then the treatment of the property in
the hands of the transferee shall be determined under paragraph (a)(3)
or (c)(3) (whichever is applicable) of this section
(5) Treatment of property acquired in like kind exchange or
involuntary conversion. If property is disposed of in a transaction to
which section 1250(d)(7) (relating to principal residence) and section
1250(d)(4) (relating to like kind exchanges and involuntary conversions)
apply, then:
(i) The basis of the property acquired shall be determined under the
applicable provisions of paragraph (d) (2), (3), or (4) of this section,
applied as if all gain computed under section 1250(a) (except any gain
not recognized solely by reason of the application of section
1250(d)(7)) were not taken into account by reason of section
1250(d)(4)(A),
(ii) The additional depreciation for the property acquired shall be
determined in the manner prescribed in paragraph (d)(5) of this section,
so applied, and
(iii) For purposes of computing the applicable percentage, the
holding period of the acquired property shall be determined under
section 1250(e)(1).
(6) Treatment of property acquired in section 1034 transaction. If a
principal residence is disposed of in a transaction to which section
1250(d)(7) applies, and if by reason of the application of section 1034
(relating to sale or exchange of residence) the basis of property
acquired in the transaction is determined by reference to the basis in
[[Page 468]]
the hands of the taxpayer of the property disposed of, then:
(i) The additional depreciation for the acquired property
immediately after the transaction shall be an amount equal to (a) the
amount of the additional depreciation for the property disposed of,
minus (b) the amount of any gain which would have been taken into
account under section 1250(a) by the transferor upon the disposition if
the applicable percentage for the property had been 100 percent,
(ii) For purposes of computing the applicable percentage, the
holding period of the acquired property includes the holding period of
the disposed of property (see section 1250(e)(3)),
(iii) If the adjusted basis of the acquired property exceeds the
adjusted basis immediately before the transfer of the property disposed
of, the excess is an addition to capital account under paragraph
(d)(2)(ii) of Sec. 1.1250-5 (relating to property with more than one
element), and
(iv) If the property disposed of consisted of two or more elements
within the meaning of paragraph (c) of Sec. 1.1250-5, see paragraph
(e)(3) of Sec. 1.1250-5 for the amount of additional depreciation and
the holding period for each element in the hands of the transferee.
(h) Limitation for disposition of qualified low-income housing--(1)
Limitation on gain. (i) Under section 1250(d)(8)(A), if section 1250
property is disposed of and gain (determined without regard to section
1250) is not recognized in whole or in part under section 1039 (relating
to certain sales of low-income housing projects), then the amount of
gain recognized by the transferor under section 1250(a) shall not exceed
the greater of:
(a) The amount of gain recognized under section 1039 (determined
without regard to section 1250), or
(b) The excess, if any, of the amount of gain which would, but for
section 1250(d)(8)(A), be taken into account under section 1250(a), over
the cost of the section 1250 property acquired in the transaction.
For purposes of this paragraph the term qualified housing project,
approved disposition, reinvestment period, and net amount realized shall
have the same meaning as in section 1039 and Sec. 1.1039-1.
(ii) The principles of this subparagraph may be illustrated by the
following examples:
Example 1. (i) Taxpayer A owns a qualified housing project and makes
an approved disposition of the project on January 1, 1971. The net
amount realized upon the disposition is $550,000, of which $475,000 is
attributable to section 1250 property. The adjusted basis of the section
1250 property is $250,000 and the gain realized on the disposition of
section 1250 property is $225,000. The additional depreciation for the
property is $100,000, the applicable percentage is 48 percent, and if
section 1250(d)(8)(A) did not apply to the disposition, $48,000 of gain
would be recognized under section 1250(a). Within the reinvestment
period, A purchases a replacement qualified housing project at a cost of
$525,000, of which $425,000 is attributable to section 1250 property. A
properly elects under section 1039(a) and the regulations thereunder to
limit the recognition of gain (determined without regard to section
1250) to $25,000, that is, the excess of the net amount realized
($550,000) over the cost of the replacement housing project ($525,000).
(ii) The amount of gain recognized under section 1250(a) is limited
to $25,000, that is, the greater of (a) the amount of gain recognized
without regard to section 1250(a) ($25,000), or (b) the excess of (1)
the amount of gain which would be taken into account under section
1250(a) if section 1250(d)(8)(A) did not apply ($225,000), over (2) the
cost of the replacement section 1250 property ($425,000), or zero.
Example 2. The facts are the same as in example (1) except that only
$180,000 of the cost of the replacement housing project is attributable
to section 1250 property. Thus, the gain recognized under section
1250(a) is limited to $45,000, the greater of (a) the excess of (1) the
amount of gain which would be taken into account under section 1250(a)
if section 1250(d)(8)(A) did not apply ($225,000), over (2) the cost of
the replacement section 1250 property ($180,000), or (b) the amount of
gain recognized without regard to section 1250 ($25,000).
(2) Replacement project consisting of more than one element. (i) If
(a) section 1250 property is disposed of, (b) any portion of the gain
which would have been recognized under section 1250(a) is not recognized
by reason of section 1250(d)(8)(A), and (c) the cost of the replacement
section 1250 property constructed, reconstructed, or acquired during the
reinvestment period exceeds the net amount realized attributable to the
section 1250 property disposed of, then the section 1250 property shall
[[Page 469]]
consist of two elements. For purposes of this paragraph, the
reinvestment element is that portion of the section 1250 property
constructed, reconstructed, or acquired during the reinvestment period
the cost of which does not exceed the net amount realized attributable
to the section 1250 property disposed of, reduced by any gain recognized
with respect to such property. The additional cost element is that
portion of the section 1250 property constructed, reconstructed, or
acquired during the reinvestment period whose cost exceeds the net
amount realized attributable to the section 1250 property disposed of.
(ii) The principles of this subparagraph may be illustrated by the
following example:
Example 1. (i) Taxpayer B disposes of a qualified housing project
consisting of section 1250 property with an adjusted basis of $500,000
and land with a basis of $100,000. The amount realized on the
disposition is $750,000 of which $650,000 is attributable to the section
1250 property. B constructs a replacement housing project at a cost of
$1,000,000 of which $850,000 is attributable to section 1250 property. B
elects in accordance with the provisions of section 1039(a) and the
regulations there under not to recognize the $150,000 gain realized.
(ii) Under section 1250(d)(8)(A) no gain is recognized under section
1250(a). The replacement section 1250 property consists of the two
elements. The reinvestment element has a cost of $650,000, i.e., that
portion of the replacement section 1250 property the cost of which does
not exceed the amount realized attributable to the section 1250 property
disposed of ($650,000), reduced by any gain recognized with respect to
such property (zero). The additional cost element has a cost of
$200,000, that is, the excess of the cost of the replacement section
1250 property ($850,000) over the amount realized attributable to the
section 1250 property disposed of ($650,000).
(3) Basis of property acquired. (i) If section 1250 property is
disposed of and gain (determined without regard to section 1250) is not
recognized in whole or in part under section 1039 (relating to certain
sales of low-income housing projects), then the basis of the section
1250 property and other property acquired in the transaction shall be
determined in accordance with the rules of this subparagraph. Generally,
the basis of the property acquired in a transaction to which section
1039(a) applies is its cost reduced by the amount of any gain not
recognized attributable to the property disposed of (see section
1039(d)). In a case where the replacement section 1250 property
constructed, reconstructed, or acquired within the reinvestment period
is treated as consisting of more than one element under section
1250(d)(8)(e), the aggregate basis of the property determined under
section 1039(d) shall be allocated as follows: first, to the
reinvestment element of the section 1250 property, in an amount equal to
the amount determined under section 1250(d)(8)(E)(i) reduced by the
amount of any gain not recognized attributable to the section 1250
property disposed of; second, to the other replacement property (other
than section 1250 property) in an amount equal to the amount of its cost
reduced (but not below zero) by any remaining amount of gain not
recognized; and finally, to the additional cost element of the section
1250 property, in an amount equal to the amount determined under section
1250(d)(8)(E)(ii) reduced by any amount of gain not recognized which has
not been taken into account in determining the basis of the reinvestment
element and the other replacement property that is not section 1250
property. See paragraph (h)(2) of this section for definition of the
terms reinvestment element and additional cost element.
(ii) The principles of this subparagraph may be illustrated by the
following examples:
Example 1. The facts are the same as in example (1) of subparagraph
(1)(ii) of this paragraph. The basis of the replacement section 1250
property is $225,000, the amount of the reinvestment element ($425,000)
minus the gain not recognized attributable to the section 1250 property
disposed of ($200,000).
Example 2. Taxpayer C disposes of a qualified housing project on
January 1, 1971. The adjusted basis for the project is $3,800,000, of
which $3,000,000 is attributable to section 1250 property and $800,000
is attributable to land. The amount realized on the disposition is
$5,000,000, of which $4,000,000 is attributable to the section 1250
property and $1,000,000 is attributable to the land. The gain realized
upon the disposition is $1,200,000, that is, amount realized
($5,000,000) minus adjusted basis ($3,800,000), of which $1,000,000 is
attributable to the section 1250 property disposed of. Within the
reinvestment period, C purchases another qualified housing project at a
cost of $5,500,000, of
[[Page 470]]
which $4,000,000 is attributable to section 1250 property and $1,500,000
is attributable to other property. C makes an election under section
1039(a) and the regulations thereunder and none of the $1,200,000 gain
realized on the disposition is recognized (determined without regard to
section 1250). Under section 1250(d)(8)(A), none of the gain realized is
recognized under section 1250(a). The basis of the replacement section
1250 property is $3,000,000, that is, the amount of the reinvestment
element ($4,000,000) less the amount of gain not recognized attributable
to section 1250 property disposed of ($1,000,000). The basis of the
other property acquired is $1,300,000, that is, its cost ($1,500,000)
reduced by the remaining gain not recognized ($200,000).
Example 3. The facts are the same as in example (2) except that the
cost of the replacement section 1250 property is $4,500,000 and the cost
of the other property is $1,000,000. Thus, the replacement section 1250
property consists of two elements under section 1250(d)(8)(E). The
reinvestment element (section 1250(d)(8)(E)(i)) has a basis of
$3,000,000, that is $4,000,000 (that portion of the section 1250
property acquired the cost of which does not exceed the net amount
realized attributable to the section 1250 property disposed of), reduced
by $1,000,000 (the gain not recognized attributable to the section 1250
property disposed of). The basis of the other property is $800,000, that
is, its cost ($1,000,000) reduced by the remaining gain not recognized
($200,000). The additional cost element (section 1250(d)(8)(E)(ii)) has
a basis of $500,000, that is, the portion of the section 1250 property
acquired the cost of which exceeds the net amount realized attributable
to the section 1250 property disposed of. This amount ($500,000) is not
reduced by any amount of gain not recognized because all of the gain not
recognized has already been taken into account in determining the basis
of the reinvestment element and the other replacement property that is
not section 1250 property.
(4) Additional depreciation for property acquired. (i) If a
qualified housing project is disposed of in a transaction to which
section 1039(a) applies, the additional depreciation for the replacement
property immediately after the transaction shall be an amount equal to
(a) the amount of additional depreciation for the property disposed of,
minus (b) the amount of additional depreciation necessary to produce the
amount of gain recognized under section 1250(a). Thus, if no gain is
recognized upon a disposition of a qualified housing project, the
additional depreciation for the property acquired will be the same as
for the property disposed of. On the other hand, if upon disposition of
a project, gain of $40,000 was recognized under section 1250(a), and if
the additional depreciation for the project and the applicable
percentage were $100,000 and 80 percent, respectively, the additional
depreciation for the replacement housing project would be $50,000, that
is, $100,000 minus $50,000, the amount of additional depreciation
necessary to produce $40,000 of recognized gain where the applicable
percentage is 80 percent.
(ii) If the property acquired in the transaction consists of more
than one element of section 1250 property by reason of section
1250(d)(8)(E), the additional depreciation under subdivision (i) of this
subparagraph shall be allocated solely to the reinvestment element.
(5) Additional limitation. If, in a transaction to which section
1039(a) applies, gain is recognized by the taxpayer, the amount of gain
recognized which is attributable to section 1250 property disposed of
is, under section 1250(d)(8)(F)(i), limited to an amount equal to the
net amount realized attributable to the section 1250 property disposed
of reduced by the greater of (i) the adjusted basis of the section 1250
property disposed of, or (ii) the cost of the section 1250 property
acquired. The limitation of section 1250(d)(8)(F)(i) may be illustrated
by the following example:
Example: Taxpayer D owns property constituting a qualified housing
project under section 1039(b)(1). In an approved disposition, the
project is sold for $225,000. The net amount realized on the disposition
is $225,000 of which $175,000 is attributable to the section 1250
property disposed of. The adjusted basis of such property is $150,000
and thus the gain realized upon the disposition of the section 1250
property is $25,000. Assume that the total gain realized upon
disposition of the project is $45,000. Within the reinvestment period, D
purchases another qualified housing project at a cost of $200,000, of
which $160,000 is attributable to section 1250 property. D elects, in
accordance with section 1039(a) and the regulations thereunder, to limit
the recognition of gain to $25,000, that is, the net amount realized
($225,000), minus the cost of the replacement housing project
($200,000). Under this subparagraph, $15,000 of the $25,000 gain
recognized is attributable to the section 1250 property disposed of,
that is, the net amount realized attributable to the
[[Page 471]]
section 1250 property disposed of ($175,000), reduced by $160,000, the
greater of the adjusted basis of the section 1250 property disposed of
($150,000) or the cost of the section 1250 property acquired ($160,000).
(6) Allocation rule. (i) If, in a transaction to which paragraph
(h)(1) of this section applies, the section 1250 property disposed of is
treated as consisting of more than one element by reason of the
application of section 1250(d)(8)(E) with respect to a prior
transaction, then the amount of gain recognized, the net amount
realized, and the additional depreciation with respect to each such
element shall be allocated to the elements of the replacement section
1250 property in accordance with the provisions of this subparagraph.
(ii) The portion of the net amount realized upon such a disposition
which shall be allocated to each element of the section 1250 property
disposed of is that amount which bears the same ratio to the net amount
realized attributable to all the section 1250 property disposed of in
the transaction as the additional depreciation for that element bears to
the total additional depreciation for all elements disposed of. If any
gain is recognized upon disposition of the section 1250 property, such
gain shall be allocated to each element in the same proportion as the
gain realized for that element bears to the gain realized for all
elements disposed of. The additional depreciation for each reinvestment
element of the replacement section 1250 property shall be the same as
for the corresponding element of the property disposed of, decreased by
the amount of additional depreciation necessary to produce the amount of
gain recognized for such element. The additional depreciation for any
additional cost element shall be zero.
(iii) The principles of this subparagraph may be illustrated by the
following example:
Example: Taxpayer E disposes of a qualified housing project in an
approved disposition. The net amount realized is $1,090,000 of which
$900,000 is attributable to section 1250 property. The section 1250
property consists of (1) a reinvestment element with an adjusted basis
of $300,000, additional depreciation of $100,000, and an applicable
percentage of 50 percent, and (2) an additional cost element with an
adjusted basis of $200,000, additional depreciation of $50,000, and an
applicable percentage of 80 percent. Gain of $400,000 is realized on the
disposition of the section 1250 property, that is, amount realized
($900,000) minus adjusted basis ($500,000). Within the reinvestment
period, E purchases another qualified housing project at a cost of
$1,000,000 of which $840,000 is attributable to section 1250 property. E
elects, in accordance with section 1039 and the regulations thereunder,
to limit recognition of gain (determined without regard to section 1250)
to $90,000, that is, the excess of the net amount realized ($1,090,000)
over the cost of the replacement project ($1,000,000). Under section
1250(d)(8)(A), the amount of gain recognized under section 1250(a) is
limited to $90,000 (see subparagraph (1) of this paragraph). Under
section 1250(d)(8)(F)(ii) and this subparagraph, $600,000 of the
$900,000 net amount realized attributable to the section 1250 property
is allocated to the reinvestment element, that is, additional
depreciation for the element ($100,000) over total additional
depreciation ($150,000) times the net amount realized ($900,000). The
remaining $300,000 is allocated to the additional cost element. Thus,
the gain realized attributable to the reinvestment element is $300,000,
that is, net amount realized ($600,000) minus adjusted basis ($300,000).
The gain realized attributable to the additional cost element is
$100,000, that is, net amount realized ($300,000) minus adjusted basis
($200,000). Under subparagraph (5) of this paragraph, the gain
recognized attributable to the section 1250 property is limited to
$60,000, that is, the net amount realized attributable to the section
1250 property disposed of ($900,000) minus the greater of the adjusted
basis of such property ($500,000) or the cost of the section 1250
property acquired in the transaction ($840,000). Under section
1250(d)(8)(F)(ii) and this subparagraph, $45,000 of the $60,000 gain
recognized is attributable to the reinvestment element, that is, $60,000
multiplied by a fraction whose numerator is the gain realized
attributable to the reinvestment element ($300,000) and whose
denominator is the total gain realized attributable to all the section
1250 property ($400,000). The remaining $15,000 of the gain recognized
is attributable to the additional cost element. The new property
acquired has no additional cost element. The reinvestment element of the
new property acquired consists of 2 subelements corresponding to the
reinvestment element and additional cost element of the property
disposed of. The subelement corresponding to the reinvestment element
has additional depreciation of $10,000, that is, its additional
depreciation immediately before the disposition ($100,000), minus
$90,000, the amount of additional depreciation necessary to produce
$45,000 of section 1250(a) gain where the applicable percentage is 50
percent. The subelement corresponding to the additional cost element
[[Page 472]]
has additional depreciation of $31,250, that is, its additional
depreciation immediately before the disposition ($50,000), minus
$18,750, the amount of additional depreciation necessary to produce
$15,000 of section 1250(a) gain where the applicable percentage is 80
percent.
[T.D. 7084, 36 FR 275, Jan. 8, 1971, as amended by T.D. 7193, 37 FR
12957, June 30, 1972; T.D. 7400, 41 FR 5101, Feb. 4, 1976; 41 FR 7095,
Feb. 17, 1976]
Sec. 1.1250-4 Holding period.
(a) General. In general, for purposes only of determining the
applicable percentage (as defined in section 1250 (1)(C) and (2)(B)) of
section 1250 property, the holding period of the property shall be
determined under the rules of section 1250(e) and this section and not
under the rules of section 1223. If the property is treated as
consisting of two or more elements (within the meaning of paragraph
(c)(1) of Sec. 1.1250-5), see paragraph (a)(2)(ii) of Sec. 1.1250-5
for application of this section to determination of holding period of
each element. Section 1250(e) does not affect the determination of the
amount of additional depreciation in respect of section 1250 property.
(b) Beginning of holding period. (1) For the purpose of determining
the applicable percentage, in the case of property acquired by the
taxpayer (other than by means of a transaction referred to in paragraph
(c) or (d) of this section), the holding period of the property shall
begin on the day after the date of its acquisition. See section
1250(e)(1)(A). Thus, for example, if a taxpayer purchases section 1250
property on January 1, 1965, the holding period of the property begins
on January 2, 1965. If he sells the property on October 1, 1966, the
holding period on the day of the sale is 21 full months, and,
accordingly, the applicable percentage is 99 percent. This result would
not be changed even if the property initially had been used solely as
the taxpayer's residence for a portion of the 21-month period. If,
however, the property were sold on September 30, 1966, the holding
period would be only 20 full months.
(2) For the purpose of determining the applicable percentage in the
case of property constructed, reconstructed, or erected by the taxpayer,
the holding period of the property shall begin on the first day of the
month during which the property is placed in service. See section
1250(e)(1)(B). Thus, for example, if a taxpayer constructs section 1250
property and places it in service on January 15, 1965, its holding
period begins on January 1, 1965. If the taxpayer sells the property on
December 31, 1966, its holding period on the day of sale is 24 full
months, and, accordingly, the applicable percentage is 96 percent. For
purposes of this subparagraph, property is placed in service on the date
on which it is first used, whether in a trade or business, in the
production of income, or in a personal activity. Thus, for example, a
residence constructed by a taxpayer for his personal use is placed in
service on the date it is occupied as a residence. For purposes of
determining the date property is placed in service, it is immaterial
when the period begins for depreciation with respect to the property
under any depreciation practice under which depreciation begins in any
month other than the month in which the property is placed in service.
If one or more units of a single property are placed in service on
different dates before the completion of the property, see paragraph
(c)(3) of Sec. 1.1250-5 (relating to treatment of each such unit as an
element).
(c) Property with transferred basis. Under section 1250(e)(2), if
the basis of property acquired in a transaction described in this
subparagraph is determined by reference to its basis in the hands of the
transferor, then the holding period of the property in the hands of the
transferee shall include the holding period of the property in the hands
of the transferor. The transactions described in this subparagraph are:
(1) A gift described in section 1250(d)(1).
(2) Certain transfers at death to the extent provided in paragraph
(b)(2)(ii) of Sec. 1.1250-3.
(3) Certain tax-free transactions to which section 1250(d)(3)
applies. For application of section 1250 (d)(3) and (e)(2) to a
distribution by a partnership to a partner, see paragraph (f)(1) of
Sec. 1.1250-3.
(4) A transfer described in paragraph (e)(4) of Sec. 1.1250-3
(relating to transaction under section 1081(d)(1)(A)).
[[Page 473]]
(5) A transfer at death where the basis of the property in the hands
of the transferee is determined under section 1022.
(d) Principal residence acquired in certain transactions. The
holding period of a principal residence acquired in a transaction to
which section 1034 and paragraph (g)(6) of Sec. 1.1250-3 apply includes
the holding period of the principal residence disposed of in such
transaction. See section 1250(e)(3). The holding period of a principal
residence acquired does not include the period beginning on the day
after the date of the disposition and ending on the date of the
acquisition.
(e) Application of transferred basis and principal residence rules.
The determination of holding period under this section shall be made
without regard to whether a transaction occurred prior to the effective
date of section 1250 and without regard to whether there was any gain
upon the transaction. Thus, for example, under paragraph (c) of this
section a donee's holding period for property includes his donor's
holding period notwithstanding that the gift occurred on or before
December 31, 1963, or that there was no additional depreciation in
respect of the property at the time of the gift.
(f) Qualified low-income housing project acquired in certain
transactions. The holding period of a reinvestment element (and of
subelements thereof) of section 1250 property (as defined in paragraph
(h) (2) of Sec. 1.1250-3) acquired in a transaction to which sections
1039(a) and 1250(d)(8)(A) apply includes the holding period of the
corresponding element of the section 1250 property disposed of. See
section 1250(e)(4). The holding period of the additional cost element
(as defined in paragraph (h)(2) of Sec. 1.1250-3) begins on the date
the replacement project is acquired. The holding period of a
reinvestment element of section 1250 property does not include the
period beginning on the day after the date of the disposition and ending
(1) on the date of the acquisition of the replacement housing project,
or (2) on the date the replacement housing project constructed or
reconstructed by the taxpayer is placed in service.
(g) Cross reference. If the adjusted basis of the property in the
hands of the transferee immediately after a transaction to which
paragraph (c) or (d) of this section applies exceeds its adjusted basis
in the hands of the transferor immediately before the transaction, the
excess is an addition to capital account under paragraph (d)(2)(ii) of
Sec. 1.1250-5 (relating to property with two or more elements).
(h) Effective/applicability date. This section applies on and after
January 19, 2017. For rules before January 19, 2017, see Sec. 1.1250-4
as contained in 26 CFR part 1 revised as of April 1, 2016.
[T.D. 7084, 36 FR 281, Jan. 8, 1971, as amended by T.D. 7400, 41 FR
5103, Feb. 4, 1976; T.D. 9811, 82 FR 6241, Jan. 19, 2017]
Sec. 1.1250-5 Property with two or more elements.
(a) Dispositions before January 1, 1970--(1) Amount treated as
ordinary income. If section 1250 property consisting of two or more
elements (described in paragraph (c) of this section) is disposed of
before January 1, 1970, the amount of gain taken into account under
section 1250(a)(2) shall be the sum, determined in three steps under
subparagraphs (2), (3), and (4) of this paragraph, of the amounts of
gain for each element.
(2) Step 1. The first step is to make the following computations:
(i) In respect of the property as a whole, compute the additional
depreciation (as defined in section 1250(b)), and the gain realized. For
purposes of this paragraph, in the case of a transaction other than a
sale, exchange or involuntary conversion, the gain realized shall be
considered to be the excess of the fair market value of the property
over its adjusted basis.
(ii) In respect of each element as if it were a separate property,
compute the additional depreciation for the element, and the applicable
percentage (as defined in section 1250(a)(2)) for the element. For
additional depreciation in respect of an element of property acquired in
certain transactions, see paragraph (e) of this section. For purposes of
determining additional depreciation, the holding period of an element
shall be determined under section 1223, applied by treating the element
as a separate property. However, for the
[[Page 474]]
purpose of determining applicable percentage, the holding period for an
element shall, except to the extent provided in paragraphs (c)(5), (e),
and (f) of this section, be determined in accordance with the rules
prescribed in Sec. 1.1250-4.
(3) Step 2. The second step is to determine the amount of gain for
each element in the following manner:
(i) If the amount of additional depreciation in respect of the
property as a whole is equal to the sum of the additional depreciation
in respect of each element having additional depreciation, and if such
amount is not more than the gain realized, then the amount of gain to be
taken into account for an element is the product of the additional
depreciation for the element, multiplied by the applicable percentage
for the element.
(ii) If subdivision (i) of this subparagraph does not apply, the
amount of gain to be taken into account for an element is the product
of:
(a) The additional depreciation for the element, multiplied by
(b) The applicable percentage for the element, and multiplied by
(c) A ratio, computed by dividing (1) the lower of the additional
depreciation in respect of the property as a whole or the gain realized,
by (2) the sum of the additional depreciation in respect of each element
having additional depreciation.
(4) Step 3. The third step is to compute the sum of the amounts of
gain for each element, as determined in step 2.
(5) Examples. The provisions of this subparagraph may be illustrated
by the following examples:
Example 1. Gain of $35,000 is realized upon a sale, before January
1, 1970, of section 1250 property which consists of four elements (W, X,
Y, and Z). Since on the date of the sale the amount of additional
depreciation in respect of the property as a whole ($24,000) is equal to
the sum of the additional depreciation in respect of each element having
additional depreciation and is less than the gain realized, the
additional depreciation for each element is determined under
subparagraph (3)(i) of this paragraph. The amount of gain taken into
account under section. 1250(a)(2) is $7,500, as determined in the
following table in accordance with the additional facts assumed.
------------------------------------------------------------------------
Additional Applicable Gain for
Element depreciation x percentage= element
------------------------------------------------------------------------
W............................ $12,000 x 0= 0
X............................ 6,000 x 50= $3,000
Y............................ 0 x 63= 0
Z............................ 6,000 x 75= 4,500
------------------------------------------
Totals..................... 24,000 ............ 7,500
------------------------------------------------------------------------
Example 2. Assume the same facts as in example (1), except that in
respect of the property as a whole the additional depreciation is
$20,000 because with respect to element Y additional depreciation
allowed was $4,000 less than straight line. Accordingly, the sum of the
additional depreciation for each element having additional depreciation
is $24,000, that is, $4,000 greater than the additional depreciation in
respect of the property as a whole. Thus, the additional depreciation
for each element is determined under subparagraph (3)(ii) of this
paragraph. The ratio referred to in subparagraph (3)(ii)(c) of this
paragraph is twenty twenty-fourths, that is, the lower of additional
depreciation in respect of the property as a whole ($20,000) or the gain
realized ($35,000), divided by the sum of the additional depreciation in
respect of each element having additional depreciation ($24,000). The
amount of gain taken into account under section 1250(a)(2) is $6,250, as
determined in the following table:
----------------------------------------------------------------------------------------------------------------
Additional Applicable
Element depreciation percentage Ratio= Gain for
x x element
----------------------------------------------------------------------------------------------------------------
W................................................................. $12,000 x 0 x 20:24= 0
X................................................................. 6,000 x 50 x 20:24= $2,500
Y................................................................. 0 x 63 x 20:24= 0
Z................................................................. 6,000 x 75 x 20:24= 3,750
---------------------------------------------
Totals.......................................................... 24,000 ........... ....... 6,250
----------------------------------------------------------------------------------------------------------------
(b) Dispositions after December 31, 1969--(1) Amount treated as
ordinary income. If section 1250 property consisting of two or more
elements (described in paragraph (c) of this section) is disposed of
after December 31, 1969, the amount of gain taken into account under
section 1250(a) shall be the sum, determined in 5 steps under
subparagraphs (2), (3), (4), (5), and (6) of this paragraph, of the
amount of gain for each element. Steps 3 and 4 are used only if the gain
realized exceeds the additional depreciation attributable to periods
after December 31, 1969, in respect of the property as a whole.
(2) Step 1. The first step is to make the following computations:
(i) In respect of the property as a whole, compute the additional
depreciation (as defined in section 1250(b)) attributable to periods
after December
[[Page 475]]
31, 1969, and the gain realized. For purposes of this paragraph, in the
case of a transaction other than a sale, exchange, or involuntary
conversion, the gain realized shall be considered to be the excess of
the fair market value of the property over its adjusted basis.
(ii) In respect of each element as if it were a separate property,
compute the additional depreciation for the element attributable to
periods after December 31, 1969, and the applicable percentage (as
defined in section 1250(a)(1)) for the element. For additional
depreciation in respect of an element of property acquired in certain
transactions, see paragraph (e) of this section. For purposes of
determining additional depreciation, the holding period of an element
shall be determined under section 1223, applied by treating the element
as a separate property. However, for the purpose of determining
applicable percentage, the holding period for an element shall, except
to the extent provided in paragraphs (c)(5), (e), and (f) of this
section, be determined in accordance with the rules prescribed in Sec.
1.1250-4.
(3) Step 2. The second step is to determine the amount of gain
recognized for each element under section 1250(a) (1) in the following
manner:
(i) If the amount of additional depreciation in respect of the
property as a whole attributable to periods after December 31, 1969, is
equal to the sum of the additional depreciation in respect of each
element having such additional depreciation, and if such amount is not
more than the gain realized, then the amount of gain to be taken into
account for an element under section 1250(a)(1) is the product of the
additional depreciation attributable to periods after December 31, 1960,
for the element, multiplied by the applicable percentage for the element
determined under section 1250(a)(1).
(ii) If subdivision (i) of this subparagraph does not apply, the
amount of gain to be taken into account under section 1250(a)(1) for an
element is the product of:
(a) The additional depreciation attributable to periods after
December 31, 1969, for the element multiplied by
(b) The applicable percentage for the element determined under
section 1250(a)(1) for the element, and multiplied by
(c) A ratio, computed by dividing (1) the lower of the additional
depreciation in respect of the property as a whole which is attributable
to periods after December 31, 1969, or the gain realized, by (2) the sum
of the additional depreciation attributable to periods after December
31, 1969, in respect of each element having such additional
depreciation.
(4) Step (3). If the gain realized exceeds the additional
depreciation in respect of the property as a whole attributable to
periods after December 31, 1969.
(i) Compute the additional depreciation attributable to periods
before January 1, 1970, and the remaining gain (or remaining potential
gain in the case of a transaction other than a sale, exchange, or
involuntary conversion), in respect of the property as a whole.
(ii) Compute the additional depreciation attributable to periods
before January 1, 1970, and the applicable percentage determined under
section 1250(a)(2) in respect of each element as if it were a separate
property. For additional depreciation in respect of an element of
property acquired in certain transactions, see paragraph (e) of this
section. For purposes of determining additional depreciation, the
holding period of an element shall be determined under section 1223,
applied by treating the element as a separate property. However, for the
purpose of determining applicable percentage, the holding period of an
element shall, except to the extent provided in paragraphs (c)(5), (e),
and (f) of this section, be determined in accordance with the rules
prescribed in Sec. 1.1250-4.
(5) Step (4). The fourth step is to compute the gain recognized
under section 1250(a)(2) for each element (if computation was required
under step (3)) in the following manner:
(i) If the amount of additional depreciation in respect of the
property as a whole attributable to periods before January 1, 1970, is
equal to the sum of the additional depreciation in respect of each
element having such additional depreciation, and if such amount is not
more than the remaining gain (or remaining potential gain), then the
[[Page 476]]
amount of gain to be taken into account for an element under section
1250(a)(2) is the product of the additional depreciation attributable to
periods before January 1, 1970, for the element, multiplied by the
applicable percentage determined under section 1250(a)(2) for the
element.
(ii) If subdivision (i) of this subparagraph does not apply, the
amount of gain to be taken into account for an element under section
1250(a)(2) is the product of:
(a) The additional depreciation attributable to periods before
January 1, 1970, for the element, multiplied by,
(b) The applicable percentage for the element determined under
section 1250(a)(2), and multiplied by,
(c) A ratio, computed by dividing (1) the lower of the additional
depreciation in respect of the property as a whole which is attributable
to periods before January 1, 1970,
or the remaining gain (or remaining potential gain), by (2) the sum of
the additional depreciation attributable to periods before January 1,
1970, in respect of each element having additional depreciation.
(6) Step (5). The fifth step is to compute the sum of the amount of
gain for each element, as determined in steps (2) and (4).
(7) Examples. The provisions of this subparagraph may be illustrated
by the following examples:
Example 1. Gain of $60,000 is realized upon a sale, after the
December 31, 1969, of section 1250 property which was constructed by the
taxpayer after such date. The property consists of four elements (W, X,
Y, and Z). Since on the date of sale the amount of additional
depreciation attributable to periods after December 31, 1969, in respect
of the property as a whole ($32,000), is equal to the sum of the
additional depreciation in respect of each element having such
additional depreciation and is less than the gain realized, the gain
recognized for each element is determined under subparagraph (3)(i) of
this paragraph. The amount of gain taken into account under section
1250(a)(1) is $28,500, as determined in the following table in
accordance with the additional facts assumed:
------------------------------------------------------------------------
Additional
depreciation Applicable Gain for
Element after Dec. 31, percentage= element
1969 x (1250(a)(1))
------------------------------------------------------------------------
W............................ $14,000 x 80= $11,200
X............................ 6,000 x 90= 5,400
Y............................ 2,000 x 95= 1,900
Z............................ 10,000 x 100= 10,000
------------------------------------------
Total...................... 32,000 ............ 28,500
------------------------------------------------------------------------
Example 2. Assume the same facts as in example (1), except that the
property was acquired by the taxpayer before January 1, 1970. Since the
gain realized ($60,000) exceeds the additional depreciation attributable
to periods after December 31, 1969 ($32,000), section 1250(a)(2) applies
to the remaining gain of $28,000. Since the additional depreciation in
respect of the property as a whole attributable to periods before
January 1, 1970 ($21,000), is equal to the sum of the additional
depreciation in respect of each element having such additional
depreciation and is less than the remaining gain ($28,000), the amount
of gain recognized for each element under section 1250(a)(2) is
determined under subparagraph (5)(i) of this paragraph. The amount of
gain taken into account under section 1250(a)(1) is $28,500 the same as
in example (1). The amount of gain taken into account under section
1250(a)(2) is $3,900, as determined in the following table in accordance
with the additional facts assumed:
----------------------------------------------------------------------------------------------------------------
Additional
depreciation Applicable Gain for
Element before Jan. 1, percentage= element
1970 x (1250(a)(2)) (1250)(a)(2))
----------------------------------------------------------------------------------------------------------------
W.............................................................. $8,000 x 0= $0
X.............................................................. 6,000 x 10= 600
Y.............................................................. 2,000 x 15= 300
Z.............................................................. 5,000 x 60= 3,000
------------------------------------------------
Total........................................................ 21,000 ............ 3,900
----------------------------------------------------------------------------------------------------------------
Example 3. (i) The facts are the same as in example (2) except that
element Y has a deficit in additional depreciation attributable to
periods after December 31, 1969, of $6,000 and thus the additional
depreciation attributable to periods after December 31, 1969, in respect
of the property as a whole is $24,000. The sum of the additional
depreciation for each element having additional depreciation is $30,000,
or $6,000 more than the additional depreciation in respect of the
property as a whole. Thus, the gain recognized for each element under
section 1250(a)(1) is determined under subparagraph (3)(ii) of this
paragraph. The ratio referred to in subparagraph (3)(ii) (c) of this
paragraph is 24:30, that is, the lower of the additional depreciation in
respect of the property as a whole attributable to periods after
December 31, 1969 ($24,000), or the gain realized ($60,000), divided by
the sum of the additional depreciation in respect of each element having
such additional depreciation ($30,000). The amount of gain taken into
account under section 1250(a)(1) is $21,280, as determined in the
following table:
[[Page 477]]
----------------------------------------------------------------------------------------------------------------
Additional Applicable
Element depreciation percentage x Ratio= Gain for
x (1250(a)(1)) element
----------------------------------------------------------------------------------------------------------------
W................................................................ $14,000 x 80 x 24:30= $8,960
X................................................................ 6,000 x 90 x 24:30= 4,320
Y................................................................ (6,000) x 95 x 24:30= 0
Z................................................................ 10,000 x 100 x 24:30= 8,000
--------------------------------------
Total.......................................................... 24,000 ............ ....... 21,280
----------------------------------------------------------------------------------------------------------------
(ii) In addition, gain is recognized under section 1250(a)(2) since
there is a remaining potential gain of $36,000, that is, gain realized
($60,000) minus the additional depreciation attributable to periods
after December 31, 1969 ($24,000). The gain recognized in respect of
each element and the gain recognized under section 1250(a)(2) ($3,900)
are the same as in example (2), since the additional depreciation
attributable to periods before January 1, 1970 ($21,000) is less than
the remaining gain ($36,000).
(c) Element--(1) General. For purposes of this section, in the case
of section 1250 property there shall be treated as separate elements the
separate improvements, units, remaining property, special elements, and
low-income housing elements which are respectively referred to in
paragraphs (c) (2), (3), (4), (5), and (6) of this section.
(2) Separate improvements. There shall be treated as an element each
separate improvement (as defined in paragraph (d)(1) of this section) to
the property.
(3) Units. If before completion of section 1250 property one or more
units thereof are placed in service, each such unit of the section 1250
property shall be treated as an element.
(4) Remaining property. The remaining property which is not taken
into account under subparagraph (2) or (3) of this paragraph shall be
treated as an element.
(5) Special elements. (i) If the basis of section 1250 property is
reduced in the manner described in paragraph (b)(2)(ii) of Sec. 1.1250-
3 (relating to property acquired from a decedent prior to his death) or
in paragraph (e)(3)(iii) of Sec. 1.1250-3 (relating to basis reduction
under section 1071 or 1082(a)(2)), then such property shall be
considered as having a special element with additional depreciation
equal to the amount of additional depreciation included in the
depreciation adjustments (referred to in paragraph (d)(1) of Sec.
1.1250-2) to which the basis reduction is attributable. For purposes of
computing applicable percentage, the holding period of a special element
under this subdivision shall be determined under paragraph (b)(2)(ii) or
(e)(3)(iii) (whichever is applicable) of Sec. 1.1250-3.
(ii) If a disposition described in section 1250(d)(4)(A) (relating
to like kind exchanges and involuntary conversions) of a portion of an
item of property gives rise to an addition to capital account (described
in the last sentence of paragraph (d)(2)(i) of this section) which is
not a separate improvement, then such property shall be considered as
having a special element with additional depreciation and, for purposes
of computing applicable percentage, a holding period determined under
paragraph (d)(7) of Sec. 1.1250-3.
(6) Low-income housing elements. If, in an approved disposition of a
qualified housing project, a replacement qualified housing project is
treated as consisting of more than one element of section 1250 property
by reason of section 1250(d)(8)(E) (see paragraph (h)(2) of Sec.
1.1250-3), the elements determined under such section shall be treated
as elements for purposes of this section. For definition of the terms
qualified housing project and approved disposition, see section 1039(b)
and the regulations thereunder.
(7) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. A taxpayer constructs an apartment house which he places
in service in three stages. The total cost is $1 million, of which
$350,000 is allocable to the first stage, $500,000 to the second stage,
and $150,000 to the third stage. The first stage, which is placed in
service on January 1, 1965, consists of 300 apartments and certain
facilities including a central heating system and a common lobby. The
second stage, which is placed in service on July 15, 1965, consists of
550 apartments and certain facilities including the motor for a central
air-conditioning system. The third stage, which is placed in service on
January 19, 1966, consists of the residue of the apartment house. On
December 31, 1968, the taxpayer disposes of the apartment house. On such
date, the apartment house has three elements which are described in the
table below:
[[Page 478]]
------------------------------------------------------------------------
Full months
Stage Kind of element Cost in holding Applicable
period percentage
------------------------------------------------------------------------
1 Unit.................. $350,000 48 72
2 Unit.................. 500,000 42 78
3 Remaining property.... 150,000 36 84
------------------------------------------------------------------------
Example 2. Assume the same facts as in example (1) except that on
January 1, 1969, two new floors, which were added after the apartment
house was completed, are placed in service and that on July 1, 1972, the
taxpayer disposes of the building. Assume further that the two new
floors are one separate improvement (within the meaning of paragraph (d)
of this section). On the date disposed of, the property consists of four
elements, that is, the three elements described in example (1) and the
separate improvement.
(d) Separate improvement--(1) Definition. For purposes of this
section, with respect to any section 1250 property, the term separate
improvement means an addition to capital account described in
subparagraph (2) of this paragraph which qualifies as an improvement
under the 1-year test prescribed in subparagraph (3) of this paragraph
and which satisfies the 36-month test prescribed in subparagraph (4) of
this paragraph.
(2) Addition to capital account. (i) In the case of any section 1250
property, an addition to capital account described in this subparagraph
is any addition to capital account in respect of such property after its
initial acquisition or completion by the taxpayer or by any person who
held the property during a period included in the taxpayer's holding
period (see Sec. 1.1250-4) for the property. An addition to the capital
account of section 1250 property may arise, for example, if there is an
expenditure for section 1250 property which is an improvement,
replacement, addition, or alteration to such property (regardless of
whether the cost thereof is capitalized or charged against the
depreciation reserve). In such a case, the addition to capital account
is the gross addition, unreduced by amounts attributable to replaced
property, to the net capital account and not the net addition to such
account. Thus, if a roof has an adjusted basis of $20,000, and is
replaced by constructing a new roof at a cost of $50,000, the gross
addition of $50,000 is an addition to capital account. (The adjusted
basis of the old roof is no longer included in the capital account for
the property.) For purposes of this section, the status of an addition
to capital account is not affected by whether or not it is treated as a
separate property for purposes of determining depreciation adjustments.
In case of an addition to the capital account of property arising after
December 31, 1963, upon a disposition referred to in section 1250(d)(4)
(relating to like kind exchanges and involuntary conversions) of a
portion of an item of such property, the amount of such addition (and
its basis for all purposes of the Code) shall be the basis thereof
determined under paragraph (d) (2), (3), or (4) (whichever is
applicable) of Sec. 1.1250-3, applied by treating such portion and such
addition as separate properties.
(ii) An addition to capital account may be attributable to an excess
of the adjusted basis of section 1250 property in the hands of a
transferee immediately after a transaction referred to in section
1250(e)(2) (relating to holding period of property with transferred
basis) over its adjusted basis in the hands of the transferor
immediately before the transaction. Thus, for example, such excess may
arise from a gift which is in part a sale or exchange (see paragraph
(a)(2) of Sec. 1.1250-3), from an increase in basis due to gift tax
paid (see section 1015(d)), from a transfer referred to in paragraph
(c)(2) of Sec. 1.1250-3 (relating to certain tax-free transactions) in
which gain is partially recognized, or from a distribution by a
partnership to a partner in which no gain is recognized by reason of the
application of section 731. Similarly, an addition to capital account
may be attributable to an excess of the adjusted basis of a principal
residence acquired in a transaction referred to in section 1250(e)(3)
over the adjusted basis of the principal residence disposed of, as well
as to any increase in the adjusted basis of section 1250 property of a
partnership by reason of an optional basis adjustment under section
734(b) or 743(b).
(iii) Whether or not an expenditure shall be treated as an addition
to capital account described in this subparagraph, as distinguished from
a separate item of property, may depend on how the property or
properties are disposed of. Thus, for example, if a taxpayer, who owns a
motel consisting of 10
[[Page 479]]
buildings with common heating and plumbing systems, adds to the motel
three new buildings which are connected to the common systems, and if
the taxpayer sells the motel to one person in one transaction, then for
purposes of this subparagraph the cost of the three new buildings shall
be treated as an addition to the capital account of the motel and, if
the 1-year and 36-month tests of subparagraphs (3) and (4) of this
paragraph are satisfied, the motel consists of at least two elements.
If, however, the 10-building group and the three-building group were
individually sold in separate transactions to two different people each
of whom would operate his group as a separate business, the motel would
consist of two items of property.
(3) One-year test for improvement. (i) An addition to capital
account of section 1250 property for any taxable year (including a short
taxable year and the entire taxable year in which the disposition
occurs) shall be treated as an improvement only if the sum of all
additions to the capital account of such property for such taxable year
exceeds the greater of:
(a) $2,000, or
(b) One percent of the unadjusted basis of the property, determined
as of the beginning (1) of such taxable year, or (2) of the holding
period (within the meaning of Sec. 1.1250-4) of the property, whichever
is the later.
(ii) For purposes of this section, the term unadjusted basis means
the adjusted basis of the property, determined without regard to the
adjustments provided in section 1016(a) (2) and (3) (relating to
adjustments for depreciation, amortization, and depletion). For purposes
of this paragraph, as of any particular date the unadjusted basis of
section 1250 property (a) includes the cost of any addition to capital
account for the property which arises prior to such date (regardless of
whether such addition qualified under this subparagraph as an
improvement), and (b) does not include the cost of a component retired
before such date.
(iii) In respect of a particular disposition of section 1250
property by a person:
(a) There shall not be taken into account under the 1-year test for
improvements in this subparagraph any addition to capital account which
arises by reason of (or after) such disposition or which arises before
the beginning of the holding period under Sec. 1.1250-4 of such person
for the property, and
(b) Such test shall be made in respect of each taxable year of such
person (and of any prior transferor) any day of which is included under
Sec. 1.1250-4 in such person's holding period for the property, except
that (1) such test shall be made for a taxable year of such person only
if such person actually owned the property on at least 1 day of such
taxable year, and (2) such test shall be made for a taxable year of such
prior transferor only if such prior transferor actually owned the
property on at least 1 day of such taxable year.
(iv) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. The unadjusted basis of section 1250 property as of the
beginning of January 1, 1960, is $300,000. During the taxable year
ending on December 31, 1960, the only additions to the capital account
for the property are addition A on January 1, 1960, costing $1,000, and
addition B on July 1, 1960, costing $600. Since the sum of the amounts
added to capital account for such taxable year is less than $2,000, A
and B are not treated as improvements. This result would not be changed
if addition C, costing $600, were added on December 15, 1960, since
although the sum of the additions ($1,000 plus $600 plus $600, or
$2,200) exceeds $2,000, such sum is less than 1 percent of the
unadjusted basis of the property as of the beginning of 1960 ($3,000,
that is, 1 percent of $300,000). If however, C cost $1,500, then A, B,
and C would each be considered an improvement since the sum of the
amounts added to capital account $3,100) would exceed $3,000.
Example 2. Green and his son both use the calendar year as the
taxable year. On February 1, 1965, Green makes addition A to a piece of
section 1250 property. On June 15, 1965, Green transfers such property
to his son as a gift which is in part a sale (see paragraph (a) of Sec.
1.1250-3). Addition B arises by reason of the transfer. On August 1,
1965, the son makes addition C to the property. For purposes of
determining the amount of gain recognized under section 1250(a) to Green
upon the transfer, the determination of whether addition A is an
improvement is made without taking into account additions B and C. For
purposes of determining the
[[Page 480]]
amount of gain recognized under section 1250(a) upon a subsequent
disposition of the property by the son, additions B and C would be taken
into account in the determination of whether A is an improvement, and A
would be taken into account in the determination of whether B and C are
improvements.
Example 3. Assume the same facts as in example (2). Assume further
that on September 15, 1965, the son transfers the property to a
corporation in exchange for cash and stock in the corporation in a
transaction qualifying under section 351 (see paragraph (c) of Sec.
1.1250-3), and that the corporation uses a fiscal year ending November
30. For purposes of determining the amount of gain recognized under
section 1250(a) upon a subsequent disposition by the corporation, the
one-year test under subdivision (i) of this subparagraph is made for the
entire taxable year of Green and of the son ending on December 31, 1965,
and in respect of the corporation's taxable year ending November 30,
1965. Accordingly, if on December 7, 1965, addition D is made by the
corporation, then, upon a subsequent disposition by the corporation, D
is taken into account for purposes of the determination in respect of
the entire taxable year of Green and of the son ending on December 31,
1965, and for the corporation's taxable year ending November 30, 1966,
but not for purposes of the corporation's taxable year ending November
30, 1965. If D were made on January 3, 1966, D would still be taken into
account for purposes of the determination in respect of the
corporation's taxable year ending November 30, 1966. However, since
neither Green nor his son actually owned the property on any day of the
taxable year ending December 31, 1966, no determination is made in
respect of such taxable year of Green or of the son.
(4) 36-month test for separate improvement. (i) If, during the 36-
month period ending on the last day of any taxable year (including a
short taxable year and the entire taxable year in which the disposition
occurs), the sum of the amounts treated under subparagraph (3) of this
paragraph as improvements for such period exceeds the greatest of:
(a) 25 percent of the adjusted basis of the property,
(b) 10 percent of the unadjusted basis (determined under
subparagraph (3)(ii) of this paragraph) of the property, or
(c) $5,000,
Then each such improvement during such period shall be treated as a
separate improvement, and thus as an element. For purposes of (a) and
(b) of this subdivision, the adjusted basis (or unadjusted basis) of
section 1250 property shall be determined as of the beginning of the 36-
month period, or as of the beginning of the holding period of the
property (within the meaning of Sec. 1.1250-4), whichever is the later.
(ii) In respect of a particular disposition of section 1250 property
by a person:
(a) There shall not be taken into account under the 36-month test
for separate improvements in this subparagraph any amount treated under
subparagraph (3) of this paragraph as an improvement which arises by
reason of (or after) the disposition or which arises before the
beginning of the holding period under Sec. 1.1250-4 of such person for
the property, and
(b) Such test shall be made in respect of each 36-month period
ending on the last day of each taxable year of such person (and of any
prior transferor) if at least 1 day of such period is included under
Sec. 1.1250-4 in such person's holding period for the property, except
that (1) such test shall be made for a 36-month period ending on the
last day of a taxable year of such person only if such person actually
owned the property on at least 1 day of such period, and (2) such test
shall be made for a 36-month period ending on the last day of a taxable
year of such prior transferor only if such prior transferor actually
owned the property on at least 1 day of such period.
(iii) For illustration of the principles of subdivision (ii) of this
subparagraph, see examples (2) and (3) in subparagraph (3)(iv) of this
paragraph.
(5) Example. The application of this paragraph may be illustrated by
the following example:
Example: (i) On December 31, 1967, X, a calendar year taxpayer,
purchases an item of section 1250 property at a cost of $100,000. In the
table below, the adjusted basis and unadjusted basis of the property are
shown for the beginning of January 1 of each taxable year and it is
assumed that each addition to capital was added on January 1 of the year
shown.
----------------------------------------------------------------------------------------------------------------
1 percent
Adjusted Unadjusted of
Year basis basis unadjusted Addition
basis
----------------------------------------------------------------------------------------------------------------
1969............................................................. $94,000 $100,000 $1,000 A-$10,000
1970............................................................. 97,030 110,000 1,100 B-4,000
1971............................................................. 94,041 114,000 1,140 C-6,000
1972............................................................. 92,799 120,000 1,200 ..........
[[Page 481]]
1973............................................................. 86,158 120,000 1,200 D-18,000
----------------------------------------------------------------------------------------------------------------
(ii) Since each addition to capital account for the property exceeds
the greater of $2,000 or one percent of unadjusted basis, determined as
of the beginning of the taxable year in which made, each addition to
capital account qualifies as an improvement under subparagraph (2) of
this paragraph.
(iii) Since the beginning of the holding period of the property
under Sec. 1.1250-4 (Jan. 1, 1968) is later than the beginning of the
36-month period ending on December 31, 1969, the determination as to
whether there are any separate improvements on the property as of
December 31, 1969, is made by examining the adjusted basis (or
unadjusted basis) of the property as of the beginning of January 1,
1968. As of December 31, 1969, there were no separate improvements on
the property since the only amount treated as an improvement for the
period beginning on January 1, 1968, and ending on December 31, 1969, in
addition A (costing $10,000), which is less than $25,000, that is, 25
percent of the adjusted basis ($100,000) of the property as of the
beginning of January 1, 1968.
(iv) As of December 31, 1970, there were no separate improvements on
the property since the sum of the amounts treated as improvements for
the 36-month period ending on December 31, 1970, is $14,000 (that is,
$10,000 for A, plus $4,000 for B), and this sum is less than $25,000,
that is, 25 percent of the adjusted basis ($100,000) of the property as
of the beginning of January 1, 1968.
(v) As of December 31, 1971, there were no separate improvements on
the property since the sum of the amounts treated as improvements for
the 36-month period ending on December 31, 1971, is $20,000 (that is,
$10,000 for A, plus $4,000 for B, plus $6,000 for C), and this sum is
less than $23,500, that is, 25 percent of the adjusted basis ($94,000)
of the property as of the beginning of January 1, 1969.
(vi) As of December 31, 1972, there were no separate improvements on
the property since the sum of the amounts treated as improvements for
the 36-month period ending on December 31, 1972, is $10,000 (that is,
$4,000 for B plus $6,000 for C), and this sum is less than $24,258 that
is, 25 percent of the adjusted basis ($97,030) of the property as of the
beginning of January 1, 1970.
(vii) As of December 31, 1973, C and D are separate improvements
(notwithstanding that as of December 31, 1971 and 1972, C was not a
separate improvement) since the sum of the amounts added for the 36-
month period ending December 31, 1973, is $24,000 (that is, $6,000 for C
plus $18,000 for D), and this sum exceeds the greatest of:
(a) $23,510, that is, 25 percent of the adjusted basis ($94,041) of
the section 1250 property as of the beginning of January 1, 1971,
(b) $11,400, that is, 10 percent of the unadjusted basis ($114,000)
of the property as of the beginning of such first day, or
(c) $5,000.
(e) Additional depreciation and holding period of property acquired
in certain transactions--(1) Transferred basis. If property consisting
of two or more elements is disposed of, and if the holding period of the
property in the hands of the transferee for purposes of computing
applicable percentage includes the holding period of the transferor by
reason of the application of paragraph (c) (other than subparagraph (2)
thereof) of Sec. 1.1250-4, then the additional depreciation for each
element of the property in the hands of the transferee immediately after
the transfer shall be computed in the manner set forth in this
subparagraph. First, any element having a deficit in additional
depreciation in the hands of the transferor immediately before such
transfer shall be considered to have the same deficit in the hands of
the transferee. Second, elements having additional depreciation in the
hands of the transferor immediately before the transfer shall be
considered to have additional depreciation in the hands of the
transferee. The sum of the transferee's additional depreciation for all
elements of the property having additional depreciation in the hands of
the transferor shall be an amount equal to the additional depreciation
in respect of the property as a whole immediately after the transfer
increased by the sum of the deficits in addition depreciation for all
elements having such deficits. In case there is more than one element
having additional depreciation, the additional depreciation for any such
element in the hands of the transferee shall be computed by multiplying
(i) the amount computed under the preceding sentence by (ii) the
additional depreciation for such element in the hands of the transferor
divided by the sum of the additional depreciation for all such elements
having additional depreciation in the hands of the transferor. For
purposes of computing applicable percentage, the holding period for an
element of such property in the hands of the
[[Page 482]]
transferee shall include the holding period of such element in the hands
of the transferor.
(2) Example. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following example:
Example: Section 1250 property has additional depreciation of
$16,000 of which $12,000 is additional depreciation for element X and
$4,000 for element Y. The property is transferred to a corporation in
exchange for cash of $6,000 and for stock in the corporation. Assume
that recognition of gain under section 1250(a) is limited to $6,000 (the
amount of cash received) by reason of the application of section 351(b)
(relating to transfer to corporation controlled by transferor) and
section 1250(d)(3) (relating to limitation on application of section
1250 in certain tax-free transactions). Under paragraph (c)(3)(i) of
Sec. 1.1250-3, the additional depreciation for the property in the
hands of the corporation immediately after the transfer is $10,000, that
is, the additional depreciation for the property in the hands of the
transferor immediately before the transfer ($16,000) minus the gain
under section 1250(a) recognized upon the transfer ($6,000). Under
subparagraph (1) of this paragraph, in the hands of the corporation
immediately after the transfer element X has additional depreciation of
$7,500 (\12/16\ of $10,000) and element Y as additional depreciation of
$2,500 (\4/16\ of $10,000). Under paragraph (d)(2)(ii) of this section
there is an addition of $6,000 to the capital account for the property.
(3) Principal residence. If a principal residence consisting of two
or more elements is disposed of, and if for purposes of computing
applicable percentage the holding period of the principal residence
acquired includes the holding period of the principal residence disposed
of by reason of the application of paragraph (d) of Sec. 1.1250-4, then
the additional depreciation (or a deficit in additional depreciation)
for an element of the principal residence acquired immediately after the
transaction shall be determined in a manner consistent with the
principles of subparagraph (1) of this paragraph. For purposes of
computing applicable percentage, the holding period for an element of
the principal residence acquired includes the holding period of such
element of the principal residence disposed of, but not the period
beginning on the day after the date of the disposition and ending on the
date of the acquisition.
(f) Holding period for small separate improvements--(1) General.
This paragraph prescribes a special holding period solely for the
purpose of computing the applicable percentage of a separate improvement
(as defined in paragraph (d) of this section) which is treated as an
element. See paragraph (a)(2)(ii) of this section for determination of
holding period under section 1223 for purposes of computing additional
depreciation. In respect of section 1250 property, if the amount of a
separate improvement does not exceed the greater of:
(i) $2,000, or
(ii) One percent of the unadjusted basis (within the meaning of
paragraph (d)(3)(ii) of this section) of such property, determined as of
the beginning of the taxable year in which such separate improvement was
made,
Then such separate improvement shall be treated for purposes of
computing applicable percentage as placed in service on the first day,
of a calendar month, which is the closest such first day to the middle
of the taxable year. See the last sentence of section 1250(f)(4)(B). If
two such first days are equally close to the middle of the taxable year,
the earliest of such days is the applicable day.
(2) Example. The application of this paragraph may be illustrated by
the following example:
Example: (i) The unadjusted basis of section 1250 property as of the
beginning of January 1, 1960, is $100,000. During the taxable year
ending on December 31, 1960, the only additions to the capital account
for the property are addition A on March 10, 1960, costing $1,200 and
addition B on September 16, 1960, costing $1,400. Since the sum of the
additions ($2,600) exceeds the greater of $2,000 and 1 percent of
unadjusted basis ($1,000, that is, 1 percent of $100,000), each addition
is an improvement under the 1-year test of paragraph (d)(3) of this
section. Assume that the 36-month test of paragraph (d)(4) of this
section is satisfied and, therefore, each addition is a separate
improvement treated as an element.
(ii) Since each element is less than $2,000, the provisions of this
paragraph apply. Since there are 366 days in 1960, the middle of the
year is at the end of 183 days, or July 1. Thus, that first day of a
calendar month in 1960, which is the closest first day (of a calendar
month) to the middle of the taxable year, is July 1, 1960. Accordingly,
for purposes of computing applicable percentage,
[[Page 483]]
elements A and B are each treated as placed in service on July 1, 1960.
[T.D. 7084, 36 FR 275, Jan. 8, 1971, as amended by T.D. 7193, 37 FR
12957, June 30, 1972; T.D. 7400, 41 FR 5103, Feb. 4, 1976]
Sec. 1.1251-1 General rule for treatment of gain from disposition
of property used in farming where farm losses offset nonfarm income.
(a) Applicability. The provisions of section 1251, this section, and
Sec. Sec. 1.1251-2 through 1.1251-4 shall apply with respect to any
taxable year beginning after December 31, 1969, but only if (1) there is
a farm net loss (as defined in section 1251(e)(2) and paragraph (b) of
Sec. 1.1251-3) for the taxable year, or (2) there is a balance in the
excess deductions account (as described in Sec. 1251-2) as of the close
of the taxable year before subtracting any amount under paragraph
(c)(1)(i) of Sec. 1251-2. See section 1251(a). In general, a taxpayer
who has a farm net loss and certain other taxpayers are required to
establish and maintain an excess deductions account as provided in
section 1251(b). Certain additions and subtractions are made to the
excess deductions account, and upon the disposition of farm recapture
property any gain to the extent of the balance in the excess deductions
account is recognized as ordinary income under section 1251(c)(1). See
paragraph (b)(1) of this section. Farm recapture property is, in
general, certain farming property (other than section 1250 property)
described in paragraph (1), (3), or (4) of section 1231(b). See
paragraph (a) of Sec. 1.1251-3.
(b) Ordinary income--(1) General rule. In general, subject to the
provisions of subparagraphs (2), (3), (4), and (5) of this paragraph,
upon a disposition of an item of farm recapture property during a
taxable year beginning after December 31, 1969, the amount of which:
(i) In the case of a sale, exchange, or involuntary conversion, the
amount realized, or
(ii) In the case of any other disposition, the fair market value of
such property
exceeds the adjusted basis of such property shall be recognized under
section 1251(c)(1) as gain from the sale or exchange of property which
is neither a capital asset nor property described in section 1231 (that
is, shall be recognized as ordinary income). The amount of gain
recognized as ordinary income under section 1251(c)(1) shall be
determined separately for each item of farm recapture property in a
manner consistent with the principles of subparagraphs (4) and (5) of
Sec. 1.1245-1(a) (relating to gain from dispositions of certain
depreciable property). Generally, such ordinary income treatment applies
even though in the absence of section 1251(c)(1) no gain would be
recognized under the Code. For example, if a corporation distributes
farm recapture property as a dividend gain may be recognized as ordinary
income to the corporation even though, in the absence of section
1251(c)(1), section 311(a) would preclude any recognition of gain to the
corporation. For purposes of section 1251, the term disposition shall
have the same meaning as in paragraph (a)(3) of Sec. 1.1245-1. For the
relation of section 1251 to other provisions of the Code, see paragraph
(e) of this section.
(2) Limitation as to dispositions of land--(i) In general. In the
case of a disposition of land, gain shall be recognized as ordinary
income under section 1251(c)(1) only to the extent of the land's
potential gain. See section 1251(c)(2)(C).
(ii) Potential gain. For purposes of section 1251, the term
potential gain means in respect of land an amount equal to the excess of
its fair market value over its adjusted basis, but limited to the extent
of the deductions allowable in respect to such land pursuant to an
election (if any) under sections 175 (relating to soil and water
conservation expenditures) and 182 (relating to expenditures by farmers
for clearing land) for the taxable year of disposition and the four
immediately preceding taxable years regardless of whether any such
preceding taxable year begins before December 31, 1969. See section
(e)(5).
(iii) Cross reference. For additional recapture of certain
deductions allowed under sections 175 and 182 in respect of farm land,
see section 1252.
(3) Exceptions and special rules. The amount of gain to be
recognized as ordinary income under section 1251(c)(1) after applying
subparagraph (2) of this
[[Page 484]]
paragraph, if applicable, shall be subject to the exceptions and special
rules of section 1251(d) and Sec. 1.1251-4.
(4) Limitation as to amount in excess deductions account--(i) In
general. The aggregate of the amount of gain recognized as ordinary
income under section 1251(c)(1) (after applying subparagraphs (2) and
(3) of this paragraph, if applicable) shall not exceed the amount in the
excess deductions account at the close of the taxable year after
subtracting from the account the amount specified in section
1251(b)(3)(A) and paragraph (c)(1)(i) of Sec. 1.1251-2. See section
1251(c)(2)(A). For transfer of amount in an excess deductions account,
see section 1251(b)(5).
(ii) Dispositions taken into account. If the aggregate of the amount
to which section 1251(c)(1) applies is limited for any taxable year by
the application of subdivision (i) of this subparagraph, section
1251(c)(1) shall apply in respect of dispositions of items of farm
recapture property in the order made. See section 1251(c)(2)(B).
(5) Relationship to section 1245. If property is disposed of which
qualifies as both section 1245 property (as defined in section
1245(a)(3)) as well as farm recapture property, then gain shall be
recognized as ordinary income under section 1251(c)(1) only to the
extent that the amount of any gain realized (in the case of a sale,
exchange, or involuntary conversion), or to the extent that the excess
of the fair market value of the property over its adjusted basis (in the
case of any other disposition), was not recognized as ordinary income
under section 1245(a)(1). The amount of gain recognized as ordinary
income under section 1245(a)(1) upon a disposition of farm recapture
property (i) is taken into account under paragraph (b)(2) of Sec.
1.1251-3 for purposes of computing farm net loss (or farm net income)
and (ii) is not under paragraph (c)(1)(ii) of Sec. 1.1251-2 subtracted
from the excess deductions account.
(6) Examples. The principles of this paragraph may be illustrated by
the following examples:
Example 1. A, an unmarried individual who uses the calendar year as
his taxable year, makes one disposition of farm recapture property
during 1970. On June 30, 1970, he sells for $75,000 farm recapture
property (other than land) with an adjusted basis of $43,000 for a
realized gain of $32,000 none of which is recognized under section 1245.
The balance in A's excess deductions account is $39,000 at the close of
1970 (after making the applicable additions and subtractions under
section 1251(b) (2) and (3)(A)). Hence, the entire gain of $32,000 is
recognized as ordinary income under section 1251(c)(1), and the balance
remaining in A's excess deductions account is $7,000. If, however, the
original balance in the excess deductions account were only $15,000,
then only $15,000 would be recognized as ordinary income under section
1251(c)(1) and A's excess deductions account balance would be reduced to
zero. The remaining gain of $17,000 may be treated as gain from the sale
or exchange of property described in section 1231.
Example 2. M, a calendar year corporation makes one disposition of
farm recapture property during 1975. On January 15, 1975, M distributes
as a dividend to its shareholders land which it had acquired on March 3,
1970. On that date, the excess of the fair market value ($67,500) over
the adjusted basis of land ($45,000) is $22,500 and the sum of the
deductions allowable in respect of such land under sections 175 and 182
is $5,000 for 1970 and $13,000 for the taxable year of disposition and
the four immediately preceding taxable years. Thus, the potential gain
(as defined in subparagraph (2)(ii) of this paragraph) is limited to
$13,000. At the end of M's taxable year (after making the applicable
additions and subtractions under section 1251(b) (2) and (3)(A) there is
a balance of $25,000 in the excess deductions account of M. Since such
balance exceeds the potential gain, M recognizes $13,000 as ordinary
income under section 1251(c)(1) even though, in the absence of that
provision, section 311(a) would preclude recognition of gain to M. The
balance in M's excess deductions account is reduced by $13,000, from
$25,000 to $12,000. With respect to the treatment of the remaining gain
($9,500) from the disposition of the land, see section 1252 and example
(2) of paragraph (e) Sec. 1.1252-1.
Example 3. Assume the same facts as in example (2), except that M
makes a second disposition of farm recapture property during 1975. On
June 5, 1975. M sells for $55,000 a breeding herd of cattle having an
adjusted basis of $35,000 for a realized gain of $20,000. M had acquired
the herd on April 1, 1971. Assume further that $6,000 of the $20,000
gain realized is treated as ordinary income under section 1245(a)(1).
Thus, the amount of gain M would recognize as ordinary income under
section 1251(c)(1), computed before applying the excess deductions
account limitation, is $14,000. In accordance with the computation in
example (1) of paragraph (c)(2) of Sec. 1.1251-2, the excess deductions
account limitations limit the maximum amount of gain which can be
recognized as ordinary income under
[[Page 485]]
section 1251(c)(1) upon the disposition of the land and the breeding
herd to $25,000. Under subparagraph (4)(ii) of this paragraph, the
amount of such limitation, $25,000, is assigned to each property in the
order of disposition. Thus, the amount of gain recognized as ordinary
income under section 1251 is $13,000 (as in example (1) of this
subparagraph) on the disposition of the land and $12,000 on the
disposition of the breeding herd. The remaining gain of $2,000 (i.e.,
$14,000 minus $12,000) on the disposition of the breeding herd may be
treated as gain from the sale or exchange of property described in
section 1231.
(c) Instances of nonapplication--(1) In general. Section 1251 does
not apply with respect to dispositions of farm recapture property by a
taxpayer during a taxable year if at the close of such year after making
the necessary additions and subtractions under section 1251(b) (2) and
(3)(A), there is no balance in the taxpayer's excess deductions account.
(2) Losses. Section 1251(c)(1) does not apply to losses. Thus,
section 1251(c)(1) does not apply if a loss is realized upon a sale,
exchange or involuntary conversion of property, all of which is farm
recapture property, nor does the section apply to a disposition of such
property other than by way of sale, exchange, or involuntary conversion
if at the time of the disposition the fair market value of such property
is not greater than its adjusted basis.
(3) Certain dispositions of interests in land. Section 1251(c)(1)
does not apply to dispositions of interests in land with respect to
which no deductions were allowable pursuant to an election under section
175 (relating to soil and water conservation expenditures) and 182
(relating to expenditures by farmers for clearing land) for the taxable
year of disposition and the four immediately preceding taxable years.
For possible application of section 1252 in such a case, see example (1)
of paragraph (e) of Sec. 1.1252-1.
(d) Partnerships. [Reserved]
(e) Relation of section 1251 to other provisions--(1) General. The
provisions of section 1251 apply (after applying paragraph (b)(5) of
this section, relating to section 1245 property) notwithstanding any
other provision of subtitle A of the Code. Thus, unless an exception or
special rule under section 1251(d) and Sec. 1.1251-4 applies, gain
under section 1251(c)(1) is recognized notwithstanding any contrary
nonrecognition provision or income characterizing provision. For
example, section 1251 overrides section 1231 (relating to property used
in a trade or business). Accordingly, gain recognized under section
1251(c)(1) upon a disposition of farm recapture property will be treated
as ordinary income to the extent of the balance in the taxpayer's excess
deductions account, and only the remaining gain, if any, from the
disposition may be considered as gain from the sale or exchange of a
capital asset if section 1231 is applicable. See example (3) of
paragraph (d)(6) of this section.
(2) Nonrecognition sections overridden. The nonrecognition of gain
provisions of subtitle A of the Code which section 1251 overrides
include, but are not limited to, sections 267(d), 311(a), 336, 337, and
512(b)(5). See section 1251(d) and Sec. 1.1251-4 for the extent to
which 1251(c)(1) overrides sections 332, 351, 361, 371(a), 374(a), 721,
1031, and 1033.
(3) Treatment of gain not recognized under section 1251(c)(1). For
treatment of gain not recognized under section 1251(c)(1), the
principles of paragraph (f) Sec. 1.1251-6 shall be applicable. Thus
section 1251 does not prevent gain which is not recognized under section
1251 from being considered as gain under another provision of the Code,
such as for example, section 1252(a)(1) (relating to treatment of gain
from disposition of farm land). See example (1) of paragraph (e) of
Sec. 1.1252-1.
(4) Exempt income. With regard to exempt income, the principles of
paragraph (e) of Sec. 1.1245-6 shall be applicable.
(5) Normal retirement of asset in multiple asset account. Section
1251(c)(1) does not require recognition of gain upon normal retirements
of farm recapture property in a multiple asset account as long as the
taxpayer's method of accounting, as described in paragraph (e)(2) of
Sec. 1.167(a)-8 (relating to accounting treatment of asset
retirements), does not require recognition of such gain.
(6) Installment method--(i) In general. Gain from a disposition to
which section 1251(c)(1) applies may be reported under the installment
method if such
[[Page 486]]
method is otherwise available under section 453 of the Code. In such
case, the income (other than interest) on each installment payment shall
be deemed to consist of gain to which section 1251(c)(1) applies until
all such gain has been reported, and the remaining portion (if any) of
such income shall be deemed to consist of gain to which section
1251(c)(1) does not apply. For treatment of amounts as interest on
certain deferred payments, see section 483. For adjustments in the
excess deductions account, see paragraph (c)(1)(ii) of Sec. 1.1251-2.
(ii) Special rule. If a taxpayer disposes of property used in the
trade or business of farming which qualifies as both section 1245
property as well as farm recapture property and elects to report the
gain from such disposition under the installment method, then the income
(other than interest) on each installment payment shall (a) first be
deemed to consist of gain to which section 1245(a)(1) applies until all
such gain has been reported, (b) The remaining portion (if any) of such
income shall be deemed to consist of gain to which section 1251(e)(1)
applies until all such gain has been reported, and (c) finally the
remaining portion (if any) of such income shall be deemed to consist of
gain to which neither section 1245(a)(1) nor 1251 (c)(1) applies. See
paragraph (d)(3) of Sec. 1.1252-1 with respect to the installment
method in regard to the disposition of property which is both farm
recapture property as well as farm land (as defined in section
1252(a)(2) and paragraph (a)(3)(i) of Sec. 1.1252-1).
[T.D. 7418, 41 FR 18814, May 7, 1976; 41 FR 23669, June 11, 1976]
Sec. 1.1251-2 Excess deductions account.
(a) Establishment and maintenance of account--(1) General rule. With
respect to any taxable year beginning after December 31, 1969, any
taxpayer who:
(i) Has a farm net loss (as defined in section 1251(e)(2) and in
paragraph (b) of Sec. 1.1251-3) for such a taxable year, or
(ii) Has an excess deductions account balance as of the close of
such a taxable year
shall establish (if not previously established) and maintain for
purposes of section 1251 an excess deductions account. See section
1251(b)(1). Once an excess deductions account is established (or
succeeded to under paragraph (e) of this section in the case of certain
corporate transactions and gifts) all entries (including the entries
prescribed by paragraph (f) of this section with respect to married
taxpayers who file joint returns) with respect to the account must be
part of the taxpayer's permanent records for all taxable years for which
the account must be maintained. For purposes of applying section 1251
and this section, the term taxpayer in the case of a partnership means
each partner of such partnership and in the case of an estate or trust
means the estate or trust regardless of whether it is taxable under
subpart A or E, subchapter J, chapter 1 of the Code.
(2) Distributions from estate or trust. If farm recapture property
is distributed from an estate or trust in a transaction to which section
1251(d) (1) or (2) (relating to exceptions for gifts and transfers at
death) applies, then the excess deductions account balance of the estate
or trust shall be succeeded to by the distributee in the amount, if any,
and manner prescribed in paragraph (e)(2) of this section. For purposes
of the preceding sentence only, the rules of paragraph (e)(2) of this
section shall be applied by treating each distribution as a gift at the
time made. Thus; for example, if all of the farm recapture property of
an estate or trust is distributed to a distributee on the date the
estate or trust terminates, the distributee will succeed on that date to
the excess deductions account balance of the estate or trust.
(3) Exception. A taxpayer is not required to maintain an excess
deductions account under subparagraph (1) of this paragraph for a
taxable year if:
(i) For such taxable year there would be no additions to the
taxpayer's excess deductions account, and
(ii) For the immediately preceding taxable year the balance in the
taxpayer's excess deductions account was reduced to zero by reason of
section 1251 (b)(3) (relating to subtractions from the account) or
section 1251(b)(5) (relating to transfer of account).
(b) Additions to account--(1) General rule. For each taxable year,
there shall
[[Page 487]]
be added to the excess deductions account an amount equal to the
taxpayer's farm net loss. See section 1251(b)(2)(A).
(2) Exceptions. In the case of an individual and, in the case of an
electing small business corporation (as defined in section 1371(b)),
subparagraph (1) of this paragraph shall apply for a taxable year:
(i) Only if the taxpayer's nonfarm adjusted gross income (as defined
in paragraph (d) of Sec. 1.1251-3) for such year exceeds $50,000, and
(ii) Only to the extent the taxpayer's farm net loss for such year
exceeds $25,000.
The limitations of this subparagraph apply to a person (other than a
trust) to whom the tax rates set forth in section 1 are applicable and
as prescribed in subparagraph (3) of this paragraph in respect of an
electing small business corporation.
(3) Electing small business corporation--(i) Taxable years ending
before December 11, 1971. For taxable years ending before December 11,
1971, in the case of an electing small business corporation (as defined
in section 1371(b):
(a) For purposes of subparagraph (2) of this paragraph, the term the
taxpayer means such corporation or any one of its shareholders, and the
term such year, in the case of a shareholder, means his taxable year
with which or within which the taxable year of the corporation ends (see
paragraph (d)(2) of Sec. 1.1251-3 for special rules relating to the
computation of nonfarm adjusted gross income of a shareholder of an
electing small business corporation), and
(b) The limitations in subparagraph (2) of this paragraph shall not
apply to the corporation for a taxable year if on any day of such year
there is a taxpayer who is a shareholder having, for his taxable year
with which or within which the taxable year of such corporation ends, a
farm net loss (as defined in paragraph (b) of Sec. 1.1251-3).
For purposes of determining whether a shareholder of such corporation
has a farm net loss, there shall not be taken into account his pro rata
share of farm net income or loss of any other electing small business
corporation for such corporation's taxable year ending with or within
his taxable year.
(c) The provisions of this subdivision (i) do not apply for purposes
of determining whether the shareholder must make an addition to his
excess deductions account and the amount of such addition.
(ii) Taxable years ending after December 10, 1971. [Reserved]
(4) Married individuals--(i) Lower limitations for separate returns.
If married taxpayers file separate returns, then for purposes of this
paragraph each spouse shall be treated as a separate individual.
However, in such case, (a) the amount specified in subparagraph (2)(i)
of this paragraph shall be $25,000 in lieu of $50,000, and (b) the
amount specified in subparagraph (2)(ii) of this paragraph shall be
$12,500 in lieu of $25,000. The lower limitations in the preceding
sentence shall not apply if the spouse of the taxpayer does not have any
nonfarm adjusted gross income for the taxable year. See section
1251(b)(2)(C).
(ii) Joint return. If married taxpayers for a taxable year file a
joint return under section 6013, then for purposes of this paragraph
they shall for such taxable year be treated as a single taxpayer. For
rules applicable to establishing, maintaining, and allocating a joint
excess deductions account, see paragraph (f) of this section.
(5) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. For 1971, the M Corporation which uses the claendar year
as its taxable year and which is not an electing small business
corporation has a farm net loss of $40,000 and nonfarm taxable income of
$45,000. Since subparagraph (2) of this paragraph does not apply to M,
it is required to make a $40,000 addition to its excess deductions
account.
Example 2. For 1971, A, an unmarried individual who uses the
calendar year as his taxable year, has a farm net loss of $33,000 and
nonfarm adjusted gross income of $65,000. Under subparagraph (2) of this
paragraph, A is required to make an addition of $8,000 to his excess
deductions account (that is, the excess of the farm net loss, $33,000,
over the $25,000 amount referred to in subparagraph (2)(ii) of this
paragraph). If, however, A were a trust, the limitation in subparagraph
(2) of this paragraph would not apply and such trust would be required
to add $33,000 (the
[[Page 488]]
amount of the entire farm net loss) to its excess deductions account.
Example 3. H and W each use the calendar year as the taxable year.
For 1971, H, a married taxpayer who files a separate return, has a farm
net loss of $45,000 and nonfarm adjusted gross income of $60,000. H's
spouse W does not have any nonfarm adjusted gross income for 1971. Thus,
the lower limitations in subparagraph (4)(i) of this paragraph do not
apply. Accordingly, H is required to make an addition of $20,000 to his
excess deductions account (that is, the excess of the farm net loss,
$45,000, over the $25,000 amount referred to in subparagraph (2)(ii) of
this paragraph).
Example 4. Assume the same facts as in example (3), except that for
1971 W has a farm net loss of $10,000 and nonfarm adjusted gross income
of $30,000. Thus, the lower limitations in subparagraph (4)(i) of this
paragraph do apply and H is required to make an addition of $32,500 to
his excess deductions account (that is, the excess of his farm net loss,
$45,000, over the $12,500 amount referred to in subparagraph (4)(i)(b)
of this paragraph). Since, however, W did not have a farm net loss in
excess of $12,500, she would not be required to make an addition to her
excess deductions account. For the result if H and W were to file a
joint return, see example (1) of paragraph (f)(6) of this section.
Example 5. For 1970, the M Corporation, which uses the calendar year
as its taxable year and which is an electing small business corporation,
has a farm net loss of $35,000 and nonfarm adjusted gross income of
$60,000. A, B, and C, the sole equal shareholders of M, are cash method
taxpayers and each uses a fiscal year ending on March 31. For the
taxable year ending March 31, 1971, A has a farm net loss of $5,000.
Thus, as M's taxable year ends within the taxable year of A during which
A has a farm net loss, the limitations in subparagraph (2) of this
paragraph do not apply with respect to M for 1970. See subparagraph (1)
of this paragraph, to add $35,000 to its excess deductions account.
Example 6. Assume the same facts as in example (5), except that A's
farm net loss occurred in his fiscal year ending March 31, 1970, and no
shareholder of M has a farm net loss for the fiscal year ending March
31, 1971. Thus, the limitations in subparagraph (2) of this paragraph do
apply with respect to M for 1970, and accordingly M is required to add
$10,000 to its excess deductions account for 1970 (that is, the excess
of M's farm net loss $35,000, over the $25,000 amount referred to in
subparagraph (2)(ii) of this paragraph).
Example 7. Assume the same facts as in example (6), except that M
has $45,000 of nonfarm adjusted gross income for 1970 and A, for his
taxable year ending March 31, 1971, has $40,000 of nonfarm adjusted
gross income, computed without regard to his interest in M. Assume the M
paid no dividends. Since, under paragraph (d)(2) of Sec. 1.1251-3, A's
income from M under section 1373(b) is computed on the basis of M's
nonfarm adjusted gross income, A's gross income from M is $15,000 (\1/3\
of $45,000), and A's total nonfarm adjusted gross income is $55,000.
Accordingly, M would be required to add $10,000 to its excess deductions
account for 1970 for the reasons stated in example (6).
Example 8. Assume the same facts as in example (7). Assume further
that A is one of two equal shareholders in N, another electing small
business corporation with a taxable year ending on January 31, and that
N for its taxable year ending on January 31, 1971, has a $42,000 nonfarm
loss and farm net income of $23,000. Assume that N paid no dividends.
Thus, A for purposes of subparagraph (2)(i) of this paragraph, would
only have a total of $34,000 of nonfarm adjusted gross income ($55,000)
computed per example (7) minus $21,000 (A's share of N's nonfarm net
operating loss (\1/2\ of $42,000) computed in accordance with paragraph
(d)(2) of Sec. 1.1251-3)). Assuming that no other shareholder of M has
nonfarm adjusted gross income in excess of $50,000, by reason of the
$50,000 limitation in subparagraph (2)(i) of this paragraph, M makes no
addition for 1971 to its excess deductions account. (N would make no
addition to its excess deductions account as it does not have a farm net
loss.) If, however, N were to have a nonfarm loss of only $8,000, A for
purposes of subparagraph (2)(i) of this paragraph would have a total of
$51,000 of nonfarm adjusted gross income ($51,000 of nonfarm adjusted
gross income ($55,000, minus \1/2\ of N's nonfarm loss of $8,000)).
Hence, with respect to M the result would be the same as in example (7)
(and N would make no addition to its excess deductions account since it
does not have a farm net loss).
Example 9. D and E are equal individual shareholders in corporations
X, Y, and Z, the stock of each corporation having recently been
purchased from a different unrelated person. X, Y, and Z are electing
small business corporations. D, E, and the corporations all use the
calendar year as the taxable year. For 1970, the farm net income of D
and E (determined without regard to their respective pro rata shares of
the farm net income or loss of X, Y, and Z) are $100,000 and zero,
respectively. For 1970, the farm net income or loss of the corporations
are losses of $80,000 and $20,000 for X and Z, respectively, and income
of $60,000 for Y. For 1970, the determinations under subparagraph
(3)(ii) of this paragraph as to whether a shareholder of corporation X
or Z (no determination is necessary with respect to Y since Y does not
have a farm net loss) has a farm net loss are made as follows:
[[Page 489]]
Determinations as to whether D or E has a farm net loss
----------------------------------------------------------------------------------------------------------------
As to X As to Z
---------------------------------------------------
D E D E
----------------------------------------------------------------------------------------------------------------
Farm net income (determined without regard to X, Y, and Z).. $100,000 $0 $100,000 $0
Pro rata (\1/2\) share of corporation's farm net income (or
loss):
Of X...................................................... ........... ........... (40,000) (40,000)
Of Y...................................................... 30,000 30,000 30,000 30,000
Of Z...................................................... (10,000) (10,000) ........... ...........
---------------------------------------------------
Farm net income (or loss) for purposes of determination. $120,000 $20,000 $90,000 ($10,000)
----------------------------------------------------------------------------------------------------------------
Accordingly, since the determination as to X indicates that neither D
nor E has a farm net loss, the limitations of subparagraph (2) of this
paragraph apply to X. Thus, assuming that X, D, or E has nonfarm
adjusted gross income in excess of $50,000, X will add $55,000 to its
excess deductions account, i.e., the excess of the farm net loss,
$80,000, over the $25,000 amount referred to in subparagraph (2)(ii) of
this paragraph. Since, however, the determination as to Z indicates that
E has a farm net loss, such limitations do not apply to Z. Thus, the
addition for 1970 to Z's excess deductions account is the entire amount
of its farm net loss, $20,000.
(c) Subtractions from account--(1) General rule. Under section
1251(b)(3), if there is any amount in the excess deductions account at
the close of a taxable year (determined after making any addition
required under paragraph (b) of this section for such year but before
making any reduction under this paragraph for such year), then the
excess deductions account shall be reduced (but not below zero) by
subtracting:
(i) An amount equal to (a) the farm net income (as defined in
section 1251 (e)(3) and in paragraph (c) of Sec. 1.1251-3) for such
year, plus (b) the amount (as determined in subparagraph (3) of this
paragraph) necessary to adjust the account for deductions for any
taxable year which did not result in a reduction of the taxpayer's tax
under subtitle A of the Code for such taxable year or any preceding
taxable year, and
(ii) After making any addition to the excess deductions account
under paragraph (b) of this section and any reduction under subdivision
(i) of this subparagraph for the taxable year, an amount equal to the
sum of the amounts recognized as ordinary income solely by reason of the
application of section 1251(c)(1). See section 1251(b)(3)(B). Thus, no
amount shall be subtracted under this subdivision for gain recognized by
reason of the application of section 1245(a)(1) or 1252(a)(1). For
effect on computation of farm net loss or income of gain recognized
under section 1245(a)(1) upon a disposition of farm recapture property,
see paragraph (b)(2) of Sec. 1.1251-3. In the case of an installment
sale of farm recapture property, the taxpayer's excess deductions
account shall be reduced under this subdivision in the year of such sale
by an amount equal to the gain (computed in the year of sale) to be
recognized as ordinary income under section 1251(c)(1).
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples in which it is assumed that
there is no subtraction for lack of tax benefit under subparagraph (3)
of this paragraph:
Example 1. Assume the same facts as in example (3) of paragraph
(b)(6) of Sec. 1.1251-1. M's excess deductions account balance as of
the close of 1975 is computed, in accordance with the additional facts
assumed, in the table below:
M's Excess Deductions Account
(1) Balance January 1, 1975............................ $26,000
(2) Additions for 1975.................................. 0
-----------------
(3) Subtotal............................................ 26,000
(4) Subtractions for 1975 (farm net income \1\)......... 1,000
-----------------
[[Page 490]]
(5) Excess deductions account limitation on gain 25,000
recognized as ordinary income under section 1251(c)(1)
for 1975...............................................
(6) Subtraction for disposition of farm recapture
property:..............................................
(a) Gain from disposition of land to $13,000
which section 1251(c)(1) applies
(computed before applying
limitation.........................
(b) Gain from disposition of 14,000
breeding herd to which section
1251(c)(1) applies (computed before
applying limitation)...............
----------------
(c) Sum of lines (a) and (b)........ 27,000
(d) Excess deductions account 25,000
limitation (amount in line (5))....
================
(e) Gain recognized as ordinary income .............. 25,000
under section 1251(c)(1) (lower of line
(6)(c) or line (6)(d)..................
---------------
(7) Balance December 31, 1975........... .............. 0
------------------------------------------------------------------------
\1\ Computed by treating the section 1245 gain of $6,000 under paragraph
(b)(1)(ii) of Sec. 1.1251-3 as gross income derived from the trade
or business of farming.
For allocation of the $25,000 of gain recognized as ordinary income to
the land and herd, and for treatment of the gain recognized in excess of
$25,000 see example (3) of paragraph (b)(6) of Sec. 1.1251-1.
Example 2. A is an unmarried individual who uses the calendar year
as his taxable year. In 1971, A makes a single disposition of farm
recapture property (other than land) realizing a gain of $46,000 of
which $15,000 is recognized as ordinary income under section 1245(a)(1).
The gain to which section 1251(c)(1) applies (computed before applying
the excess deductions account limitation in section 1251(c)(2)(A) and
paragraph (b)(4)(i) of Sec. 1.1251-1) is $31,000 (i.e., $46,000 minus
$15,000). The treatment of the gain realized on the disposition in
excess of the $15,000 recognized as ordinary income under section
1245(a)(1) and the balance in A's excess deductions account as of the
close of 1971 is computed, in accordance with the facts assumed, in the
table below:
A's Excess Deductions Account
(1) Balance January 1, 1971............................ $50,000
(2) Additions for 1971:
(a) Farm net loss for 1971 \1\...... $5,000
(b) Less amount in paragraph 25,000
(b)(2)(ii) of this section.........
(c) Total additions for 1971........ .............. 0
---------------
(3) Subtotal............................ .............. 50,000
(4) Subtractions for 1971............... .............. 0
---------------
(5) Excess deductions account limitation on gain 50,000
recognized as ordinary income under section 1251(c)(1)
for 1971...............................................
(6) Subtraction for dispositions of farm
recapture property:
(a) Gain to which section 1251(c)(1) 31,000
applies (computed before applying
limitation)........................
(b) Limitation (amount in line (5).. 50,000
================
(c) Gain recognized as ordinary .............. 31,000
income under section 1251(c)(1)
lower of line 6(a) or line 6(b)....
---------------
(7) Balance December 31, 1971........... 19,000
------------------------------------------------------------------------
\1\ Computed by treating the section 1245 gain of $15,000 under
paragraph (b)(1)(ii) of Sec. 1.1251-3 as gross income derived from
the trade or business of farming.
(3) Amount necessary to adjust the excess deductions account with
respect to deductions which did not result in a reduction of the
taxpayer's tax--(i) In general. Under section 1251(b)(3)(A), a
subtraction is made from the excess deductions account to adjust the
account for deductions that did not result in a reduction of the
taxpayer's tax for the taxable year or any preceding taxable year. The
amounts to be subtracted are determined under subdivisions (ii) and
(iii) of this subparagraph in accordance with the rules in subdivision
(iv) of this subparagraph. This subtraction shall be made before
determining the amount of gain to which section 1251(c) applies. The
amount subtracted under subdivision (ii) of this subparagraph is a
temporary subtraction made solely
[[Page 491]]
to determine the amount in the excess deductions account for purposes of
the limitation in section 1251(c)(2).
(ii) Temporary subtraction. The amount temporarily subtracted from
the excess deductions account for a taxable year is the sum of the farm
portion of (a) any net operating loss for such taxable year which does
not reduce taxable income (computed without regard to the deduction
under section 172(a)) in a prior year, and (b) any net operating loss
from a prior taxable year which is carried to such taxable year but
which does not reduce taxable income (computed without regard to the
deduction under section 172(a)) in such taxable year.
(iii) Permanent subtraction. The amount permanently subtracted from
the excess deductions account for a taxable year is the excess of the
farm portion of any net operating loss which may be carried to the
preceding year (reducing by the portion of such loss which reduced
taxable income (computed without regard to the deduction under section
172(a)) for such preceding year) over the amount of such loss which may
be carried to the taxable year, but the subtraction shall not be made
earlier than the taxable year in which the excess deductions account is
increased by reason of such loss.
(iv) Rules of application. For purposes of this subparagraph, the
following rules shall apply:
(a) The farm portion of a net operating loss is that portion of such
loss attributable to the trade or business of farming. Such portion and
the remaining portion (hereinafter referred to as the nonfarm loss)
shall be absorbed pro rata. If a farm net loss is not added to the
excess deductions account in the year in which such loss occurs, the net
operating loss (if any) for such year shall be treated as a nonfarm
loss.
(b) In the case of an individual (other than a trust), the farm
portion of a net operating loss shall be decreased by an amount, if any,
equal to the excess of $25,000 (or the amount determined under paragraph
(b)(2)(ii) of this section) over the nonfarm adjusted gross income. Such
amount shall be added to the nonfarm portion of such net operating loss.
(c) The amounts considered as reducing taxable income under
subdivision (ii) of this subparagraph in the taxable year shall be
determined on the basis of a tentative computation of taxable income for
such year in which the gain realized from the disposition of property to
which section 1251(c)(1) applied shall be computed without regard to the
excess deductions account limitation.
(v) Example. The provisions of this subparagraph may be illustrated
by the following example:
Example: A is an unmarried individual who uses the calendar year as
his taxable year. For the years 1970 through 1974, A's items of income
and deductions are as shown in the table below. A's personal deductions
are disregarded. A had no income or loss for any year prior to 1970.
Based upon such amounts and the computations shown below, A must
recognize as ordinary income under section 1251(c)(1), $35,325 for 1971,
$10,000 for 1972, $3,925 for 1973, and $150,000 for 1974.
----------------------------------------------------------------------------------------------------------------
Amounts assumed 1970 1971 1972 1973 1974
----------------------------------------------------------------------------------------------------------------
(a) Farm net income............. ($250,000) $20,000 $5,000 ($75,000) ($10,000)
(b) Nonfarm income.............. 55,000 (82,000) 30,000 10,000 200,000
(c) Gain which would be .............. 88,000 10,000 2,000 150,000
recognized as ordinary income
under 1251(c) (computed without
regard to the EDA limitation)
(hereinafter referred to as
farm property disposition).....
(d) Personal exemption.......... 625 675 750 750 750
(e) Net operating loss (NOL) (195,000) .............. .............. (45,000) ..............
(computed per section 172(c))..
----------------------------------------------------------------------------------------------------------------
I. COMPUTATIONS FOR 1971
1. Excess Deductions Account (EDA) Limitation for 1971:
a. EDA on December 31, 1970:
1970 Farm net loss.......................................................... 250,000
Less...................................................................... (25,000)
----------------
[[Page 492]]
225,000 225,000
b. Less farm net income for 1971.............................................. .............. (20,000)
-----------------
c. EDA before temporary subtraction........................................... .............. 205,000
d. Less temporary subtraction per subdivision (ii)(b):
Aggregate farm NOL carryover to 1971........................................ 195,000
Less tentative farm NOL deduction for 1971:
Farm net income......................................... 20,000
Nonfarm income.......................................... (82,000)
Farm property disposition............................... 88,000
Exemption............................................... (675)
----------------
Tentative taxable income................................ 25,325
Tentative NOL reducing taxable income................... 25,325 (25,325)
--------------------------------
.............. 169,675 (169,675)
-----------------
e. EDA limitation for 1971.................................................................... 35,325
=================
2. 1971 Taxable Income:
a. Farm net income............................................................................ 20,000
b. Nonfarm income............................................................................. ($82,000)
c. Farm property disposition.................................................................. 88,000
d. Exemption.................................................................................. (675)
e. Section 1202 deduction:
Farm property disposition................................................... $88,000
Less amount treated as ordinary income under section 1251(c) (lesser of 35,325
amount of gain on line 1(e))...............................................
----------------
Capital gain................................................................ 52,675
Less 50 percent deduction................................................... 26,337 (26,338)
---------------------------------
f. 1971 Taxable income........................................................ .............. (1,013)
=================
II. COMPUTATIONS FOR 1972
1. Excess Deductions Account Limitation for 1972:
a. EDA (line 1(c) above)...................................................................... 205,000
b. Less recapture in 1971..................................................................... (35,325)
c. Less farm net income for 1972.............................................................. (5,000)
d. Less permanent subtraction per subdivision (iii):
1970 Farm NOL carryover to 1971............................................. 195,000 ..............
Less 1970 farm NOL carryover to 1972 (computed per section 172(b)(2)):
Farm NOL to 1971........................................ $195,000 .............. ..............
Less 1971 taxable income computed per
section 172(b)(2):
Farm net income....................... $20,000
Nonfarm income........................ (82,000)
Farm property disposition............. 88,000
----------------
26,000 (26,000)
----------------
Farm NOL carryover to 1972.............. 169,000 ($169,000)
--------------------------------
.............. 26,000 ($26,000)
-------------------------------------------------------------------------------
e. EDA before making temporary subtractions................................................... 138,675
f. Less temporary subtraction per subdivision (ii)(b):
Farm NOL carryover to 1972.................................................. 169,000
Farm net income........................................... 5,000
Nonfarm income............................................ 30,000
Farm recapture disposition................................ 10,000
Exemption................................................. (750)
----------------
Tentative taxable income.................................. 44,250
Tentative NOL reducing taxable income..................... 44,250 (44,250)
--------------------------------
.............. 124,750 (124,750)
-------------------------------------------------------------------------------
g. EDA limitation for 1972.................................................................... 13,925
=================
2. Taxable Income for 1972:
a. Farm net income............................................................................ 5,000
b. Nonfarm income............................................................................. 30,000
c. Farm property disposition.................................................................. 10,000
[[Page 493]]
d. Exemption.................................................................................. (750)
e. Section 1202 deduction:
Farm property disposition................................................... 10,000
Less amount treated as ordinary income under section 1251(c) (lesser of 10,000 0
amount of gain on line 1(g))...............................................
---------------------------------
f. Taxable income before NOL deduction........................................................ 44,250
g. Net operating loss deduction............................................................... (44,250)
h. Taxable income for 1972.................................................................... 0
=================
III. COMPUTATIONS FOR 1973
1. Excess Deductions Account Limitation for 1973:
a. Line 1(e) above............................................................................ 138,675
b. Less recapture in 1972..................................................................... (10,000)
c. Less permanent subtraction per subdivision (iii):
1970 Farm NOL carryover to 1972............................. 169,000
Less 1970 Farm NOL reducing taxable income in 1972.......... (44,250)
-----------------
124,750 124,750
Less 1970 Farm NOL carryover to 1973 computed per section
172(b)(2):
Farm NOL to 1972.......................................... 169,000
1972 Taxable income computed per section 172(b)(2):
Farm net income $5,000
Nonfarm income 30,000
Farm recapture disposition 10,000
-----------------
45,000 ($45,000)
-----------------
Farm NOL carryover to 1973................................ 124,000 ($124,000)
-----------------
.............. 750 ($750)
-----------------
d. EDA before making temporary subtractions................................................... $127,925
e. Less temporary subtraction per subdivision .............. .............. .............. 0
(ii)(a)-zero (since 1973 farm loss treated as
nonfarm addition to NOL per subdivision
(iv)(a)).....................................
f. Less temporary subtraction per subdivision .............. .............. $124,000
(ii)(b): Aggregate farm NOL carryover to 1973
Less tentative farm NOL deduction for 1973:
Farm net income........................................... ($75,000)
Nonfarm income............................................ 10,000
Farm property disposition................................. 30,000
Exemption................................................. (750)
----------------
Tentative taxable income.................................. (44,250)
Tentative NOL reducing taxable income..................... 0 0
-----------------
124,000 (124,000)
-----------------
g. EDA limitation for 1973.................................................................... 3,925
=================
2. Taxable Income 1973:
a. Farm net income............................................................................ (75,000)
b. Nonfarm income............................................................................. 10,000
c. Farm property disposition.................................................................. 20,000
d. Exemption.................................................................................. (750)
e. Section 1202 deduction:
Farm property disposition................................................... 20,000
Less amount treated as ordinary income under section 1251(c) (lesser of 3,925
amount of gain on line 1(g))...............................................
-----------------
Capital gain................................................................ 16,075
Less 50 percent deduction................................................... 8,038 (8,037)
---------------------------------
f. Taxable income for 1973.................................................................... (53,787)
=================
IV. COMPUTATIONS FOR 1974
1. Excess Deductions Account Limitation for 1974:
a. Line 1(d) above............................................................................ 127,925
b. Less recapture in 1973..................................................................... (13,925)
c. Farm loss for 1974......................................... 10,000
[[Page 494]]
Plus farm NOL deduction (see Sec. 1.1251-3(b)(3))......... 45,000
----------------
55,000 55,000
Less............................................................................ 25,000
----------------
30,000 30,000
d. Less permanent subtraction per subdivision (iii):
1970 Farm NOL carryover to 1973............................................. 124,000
Less 1970 farm NOL carryover to 1974 per section 172(b)(2).................. 124,000
----------------
0 0
-----------------
e. EDA before making temporary subtractions................................................... 154,000
f. Less temporary subtraction per subdivision (ii)(b):
Aggregrate farm NOL carryover to 1974....................................... 124,000
Less tentative farm NOL deduction in 1974:
Farm net income........................................... (10,000)
Nonfarm income............................................ 200,000
Farm property disposition................................. 150,000
Exemption................................................. (750)
----------------
Tentative taxable income.................................. 339,250
Tentative NOL deduction................................... 169,000
Farm portion of tentative NOL deduction..................................... 124,000
----------------
0 0
-----------------
g. EDA limitation for 1974.................................................................... $154,000
=================
2. Taxable Income 1974:
a. Farm net income............................................................................ (10,000)
b. Nonfarm income............................................................................. 200,000
c. Farm property disposition.................................................................. 150,000
d. Exemption.................................................................................. (750)
e. Section 1202 deduction:
Farm property disposition................................................. $150,000
Less amount treated as ordinary income under section 1251(c) (lesser of 150,000 0
amount of gain on line 1(g)).............................................
---------------------------------
f. Taxable income before NOL deduction........................................................ 339,250
g. Net operating loss deduction............................................................... (169,000)
-----------------
h. Taxable income............................................................................. 170,250
----------------------------------------------------------------------------------------------------------------
(vi) Electing small business corporation. (a) In the case of an
electing small business corporation, the amounts to be subtracted under
subdivisions (ii) and (iii) of this subparagraph, shall be the sum of
the amounts under such subdivisions computed with respect to each
shareholder of the corporation for the taxable year of the shareholder
with which or within which the taxable year of the corporation ends, by
applying (b) of this subdivision (vi), in lieu of subdivision (iv)(a) of
this subparagraph.
(b) For purposes of (a) of this subdivision, the farm portion of a
shareholder's net operating loss is that portion of the net operating
loss of such shareholder attributable to the corporation's farm net
loss, and such portion and the remaining portion shall be considered to
be absorbed pro rata. If a corporation's farm net loss is not added to
its excess deduction account in the year in which such loss occurs, no
portion of a shareholder's net operating loss for the taxable year of
the shareholder with which or within which such taxable year of the
corporation ends shall be attributable to such corporation's farm net
loss.
(d) Exception for taxpayers using certain accounting methods--(1)
General rule. Under section 1251(b)(4), except to the extent that a
taxpayer has succeeded to an excess deductions account as provided in
paragraph (e) of this section (relating to receipt of farm recapture
property in certain corporate and gift transactions), additions to the
account shall not be required by a taxpayer who elects to compute
taxable income from the trade or business of
[[Page 495]]
farming (as defined in paragraph (e)(1) of Sec. 1.1251-3:
(i) By using inventories for all property which may be inventoried
except as to property to which subdivision (ii) of this subparagraph
applies, and
(ii) In accordance with subparagraph (3) of this paragraph, by
charging to capital account all expenditures paid or incurred which are
properly chargeable to capital account including such expenditures which
the taxpayer may, under chapter 1 of the Code or regulations prescribed
thereunder, otherwise treat or elect to treat as expenditures which are
not chargeable to capital account.
For rules as to procedure of making the election, effect of a change in
method of accounting upon making the election, and conditions for
revoking the election, see subparagraphs (4), (5), and (6),
respectively, of this paragraph.
(2) Inventories. The absence of property which may be inventories
shall not preclude a taxpayer from making an election under section
3251(b)(4). Any acceptable inventory method will satisfy the requirement
of subparagraph (1)(i) of this paragraph.
(3) Property chargeable to capital account--(i) In general. Property
subject to the capitalization requirement prescribed in subparagraph
(1)(ii) of this paragraph includes all property described in section
1231(b) (1) and (3), without regard to any holding period therein
provided, which is used in the trade or business of farming. Thus, for
example, property subject to the capitalization requirement includes
property used in the trade or business of farming of a character subject
to the allowance for depreciation and real property so used regardless
of the period held, and livestock used in the trade or business of
farming which is held for draft, breeding, dairy, or sporting purposes
regardless of the period held.
(ii) Expenditures which must be capitalized. Expenditures subject to
the requirement of subparagraph (1)(ii) of this paragraph are all
expenditures, whether direct or indirect, paid or incurred, which are
properly chargeable to capital account. For examples of the meaning of
the term properly chargeable to capital account, see Sec. Sec. 1.61-4,
1.162-12, 1.263(a)-1, and 1.263(a)-2, and paragraph (a)(4) (ii) and
(iii) of Sec. 1.446-1. Other examples of expenditures referred to in
subparagraph (1)(ii) of this paragraph are expenditures under sections
175 (relating to soil and water conservation), 180 (relating to
fertilizer, etc.), 182 (relating to land clearing), and 266 (relating to
certain carrying charges) which (without regard to section 1251) a
taxpayer may treat or elect to treat as expenditures which are not
chargeable to capital account. Thus, for example, with respect to
developing a farm, ranch, orchard, or grove, amounts properly chargeable
to capital account include amounts paid or incurred for upkeep, taxes,
interest, and other carrying charges, water for irrigation, fertilizing,
controlling undergrowth, and the cultivating and spraying of trees. For
a further example, with respect to a produced animal, amounts properly
chargeable to capital account for the animal include all expenditures
paid or incurred for producing the animal, such as for stud, breeding,
and veterinary services, as well as all amounts paid or incurred with
respect to the brood animal during the gestation period of the produced
animal including all amounts paid or incurred for feed, maintenance,
utilities, indirect overhead, depreciation, insurance, and carrying
charges. Direct and indirect expenditures properly chargeable to capital
account with respect to raising an animal may include, in addition to
expenditures for feed, maintenance, etc., expenditures for training.
Direct and indirect expenditures with respect to feed may include, in
the case of a grazing operation, fees for the rental of grazing land,
and the portion of all labor, taxes, interest, fencing costs, and
carrying charges paid or incurred by the taxpayer allocable to grazing.
For purposes of this subparagraph, reasonable allocations shall be made
by the taxpayer of items between animals held for different purposes and
as to each animal held. However, all amounts allocated to a brood animal
during the period of gestation are, for purposes of this subparagraph,
entirely chargeable to the capital of the produced animal.
(iii) Unharvested crops. With respect to unharvested crops to which
section
[[Page 496]]
1231(b)(4) applies, see section 268 and paragraph (g) of Sec. 1.1016-5
(relating, respectively, to disallowance of certain deductions and to
adjustments to basis).
(iv) Changes in character of property. If, in a taxable year
subsequent to the first taxable year to which an election under section
1251(b)(4) applies, property which was not subject to the requirements
of subparagraph (1)(ii) of this paragraph becomes subject to such
requirements, then the following rules shall apply:
(a) The adjusted basis of such property at the beginning of the
taxable year in which it becomes subject to the requirements of
subparagraph (1)(ii) of this paragraph shall be equal to the amount its
adjusted basis would have been on such date had it been accounted for in
accordance with such requirements (taking into account, if applicable,
the depreciation which would have been allowed as determined by the
taxpayer using a period, salvage value, and methods that would have been
proper).
(b) At the beginning of the taxable year in which such property
becomes subject to the requirements of subparagraph (1)(ii) of this
paragraph:
(1) If such property was not included in the opening inventory, the
amount equal to the excess of its adjusted basis as computed in (a) of
this subdivision over its adjusted basis as of the close of the
preceding taxable year, or
(2) If such property was included in the opening inventory, such
opening inventory shall be reduced by the inventory value of such
property included therein and the amount of the difference between the
adjusted basis for the property computed in (a) of this subdivision and
such inventory value,
Shall be added to gross income for such taxable year and shall be
treated as gross income derived from the trade or business of farming
under paragraph (b)(1)(ii) of Sec. 1.1251-3, except that if the
difference in (b)(2) of this subdivision represents an excess of such
inventory value over the adjusted basis for the property computed in (a)
of this subdivision then such excess shall be subtracted from gross
income for such taxable year and shall be treated as a deduction allowed
which is directly connected with carrying on the trade or business of
farming under paragraph (b)(1)(i) of Sec. 1.1251-3.
(c) If any deductions for depreciation are treated as amounts which
would have been allowed in a prior taxable year or years for purposes of
(a) of this subdivision, such deduction shall be treated as having been
allowed for purposes of applying sections 1245 and 1250 in the same
taxable year or years and thus included in the amount of adjustments
reflected in adjusted basis within the meaning of paragraph (a)(1)(ii)
of Sec. 1.1245-2 or depreciation adjustments within the meaning of
paragraph (d)(1) of Sec. 1.1250-2 (as the case may be).
(d) For purposes of this subparagraph (3), if during a taxable year
property becomes subject to the requirements of subparagraph (1)(ii) of
this paragraph, it shall be considered subject to such requirements on
each day it is held during such year.
(e) The adjusted basis under (a) of this subdivision of property of
a character subject to the allowance for depreciation shall be its basis
for which deductions may be computed under section 167.
(v) Example. The provisions of subdivision (iv) of this subparagraph
may be illustrated by the following example:
Example: On January 1, 1974, A, an individual taxpayer who in a
previous year had elected under section 1251(b)(4) to compute income
from the trade or business of farming by using inventories and by
charging to capital account all items properly chargeable to capital
under the rules of subdivision (ii) of this subparagraph, purchases a
herd of six-month-old feeder calves for $13,000. During 1974, in
connection with such herd, A incurred raising costs of $4,000 and
carrying charges of $1,600 which would have been properly chargeable to
capital account within the meaning of subparagraph (1)(ii) of this
paragraph if the herd had not been included in inventory. A determines
under his unit-livestock method that on December 31, 1974, the inventory
value of the herd is $17,000. On March 1, 1975, A decides to use one-
half of the herd for breeding purposes with such part of the herd
becoming subject to the capitalization requirements. On January 1, 1975,
the adjusted basis for the animals held for breeding purposes, computed
under the provisions of subdivision (iv)(a) of this subparagraph, is
$9,300 (that is, the aggregate of one-half of the purchase price of
$13,000 for the entire herd of feeder calves, $6,500, one-half
[[Page 497]]
of the carrying charges of $1,600 incurred during 1974 in connection
with the entire herd, $800, and one-half of the $4,000 of raising costs
incurred during 1974 for the entire herd, $2,000). There is no
adjustment for the depreciation which would have been allowed since no
animal in the herd had reached an acceptable breeding age. Therefore, A
as of January 1, 1975, must under the provisions of subdivision
(iv)(b)(2) of this subparagraph subtract $8,500 from his opening
inventory value of $17,000. However, A has not changed his method of
accounting with respect to such animals. Under the provisions of
subdivision (iv)(b)(2) of this subparagraph, A for 1975 will add $800 to
his gross income (that is, the difference between the adjusted basis for
the calves to be used for breeding purposes, $9,300, over the inventory
value of such animals, $8,500). Such amount under the provisions of
subdivision (iv)(b) shall be treated as gross income derived from the
trade or business of farming under paragraph (b)(1) of Sec. 1.1251-3.
(4) Time and manner of making election--(i) In general. The election
under section 1251(b)(4) for any taxable year beginning after December
31, 1969, shall be filed within the time prescribed by law (including
extensions thereof) for filing the return for such taxable year. Such
election shall be made and filed by attaching a statement of such
election signed by the taxpayer to the return for the first taxable year
for which the election is made. The statement shall contain a
declaration that the taxpayer is making an election under section
1251(b)(4) of the Code and that taxable income from the trade or
business of farming is computed by using inventories for all property,
which may be inventoried and by charging to capital account all
expenditures paid or incurred which are properly chargeable to capital
account (including such expenditures which the taxpayer may, under
chapter 1 of the Code or regulations prescribed thereunder, otherwise
treat or elect to treat as expenditures which are not properly
chargeable to capital account). Additionally, the statement must contain
the information prescribed by subparagraph (5) of this paragraph, if
applicable.
(ii) Joint return. If for a taxable year taxpayers file a joint
return under section 6013, the election referred to in subparagraph (1)
of this paragraph must be made by both such taxpayers in accordance with
the provisions of subdivision (i) of this subparagraph. If, however, in
such case either of such taxpayers has for a previous taxable year made
such an election, then only the taxpayer who has not made such election
is required to comply with the provisions of subdivision (i) of this
subparagraph. The taxpayer who previously made such an election shall
attach a statement to the return specifying the taxable year for which
the election was made and with whom the election was filed.
(5) Change in method of accounting, etc.--(i) In general. If, in
order to comply with an election made under section 1251(b)(4), a
taxpayer must change his method of accounting (in computing taxable
income from the trade or business of farming) by placing in inventory a
class of items not previously treated as in an inventory or by charging
to capital account a class of items which had been consistently treated
as an expense or as part of inventory (see paragraph (e)(2)(ii)(b) of
Sec. 1.446-1), the taxpayer will be deemed to have obtained the consent
of the Commissioner as to such change in method of accounting solely as
to such items and there shall be taken into account in accordance with
section 481 of the Code and the regulations thereunder those adjustments
which are determined to be necessary by reason of such change solely as
to such items in order to prevent amounts from being duplicated or
omitted. For purposes of section 481(a)(2), such change in method of
accounting with respect to only such items shall be treated as a change
not initiated by the taxpayer and, thus, under paragraph (a)(2) of Sec.
1.481-1, no part of the adjustments required under section 481 with
respect to such items shall be based on amounts which are taken into
account in computing income (or which should have been taken into
account had the new method of accounting been used) for taxable years
beginning before January 1, 1954, or ending before August 17, 1954.
(ii) Additional information. If, in order to comply with an election
made under subparagraph (1) of this paragraph a taxpayer (or in the case
of a joint return one or both taxpayers) changes
[[Page 498]]
his method of accounting, then in addition to the information required
to be filed under subparagraph (4) of this paragraph the taxpayer must
file on Form 3115 as part of such election all the information described
in paragraph (e)(3) of Sec. 1.446-1 (relating to change in method of
accounting), but the time prescribed in paragraph (e)(3) of Sec. 1.446-
1 for filing Form 3115 shall not apply.
(iii) Election made before May 7, 1976. If an election referred to
in subparagraph (1) of this paragraph was made before May 7, 1976, the
taxpayer shall file not later than August 5, 1976, such information
referred to in subparagraph (4) of this paragraph not previously
required by applicable regulations to be filed in order to make such
election, and, in addition, if subdivision (ii) of this subparagraph
applies, the taxpayer shall file not later than August 5, 1976, on Form
3115 the information referred to in subdivision (ii) of this
subparagraph with the district director, or the director of the internal
revenue service center, with whom the election was filed. For this
purpose, Form 3115 shall be attached to a statement clearly identifying
the election referred to in subparagraph (1) of this paragraph and the
first taxable year to which it applied.
(6) Revocability of election--(i) In general. An election referred
to in subparagraph (1) of this paragraph is binding on the taxpayer or
in the case of a joint return both taxpayers) for the taxable year of
such election and for all subsequent taxable years (regardless of
whether they continue to file a joint return) and may not be revoked
except with the consent of the Commissioner. Since revocation would
constitute a change in method of accounting, in order to secure the
Commissioner's consent to the revocation of such an election and to a
change of the taxpayer's method of accounting, all the provisions of
paragraph (e)(3) of Sec. 1.446-1 must be met including the requirement
that Form 3115 must be filed within 180 days after the beginning of the
taxable year in which it is desired to make the change. See section 481
and the regulations thereunder (relating to certain adjustments required
by such changes).
(ii) Revocation of elections made prior to May 7, 1976. If on or
before May 7, 1976, an election under section 1251(b)(4) has been made,
such election may be revoked without permission of the Commissioner by
filing on or before August 5, 1976, with the district director or the
director of the internal revenue service center with whom the election
was filed a statement of revocation of an election under section
1251(b)(4). If such election to revoke is for a period which falls
within one or more taxable years for which an income tax returns shall
be filed for any such taxable years for which the computation of taxable
income is affected by reason of such revocation.
(e) Transfer of excess deductions account--(1) Certain corporate
transactions--(i) In general. Under section 1251(b)(5)(A), in the case
of a transfer described in section 1251(d)(3) and paragraph (c)(2) of
Sec. 1.1251-4 to which section 371(a) (relating to exchanges pursuant
to certain receivership and bankruptcy proceedings), 374(a) (relating to
exchanges pursuant to certain railroad reorganizations), or 381
(relating to carryovers in certain corporate acquisitions) applies, the
acquiring corporation shall succeed to and take into account as of the
close of the day of distribution or transfer the excess deductions
account of the transferor. Determinations under this subdivision shall
be made under subdivisions (ii), (iii), and (iv) of this subparagraph
regardless of whether section 381 applies. For treatment as farm
recapture property of stock or securities received in certain transfers
to controlled corporations to which section 1251(d)(3) (but not section
1251(b)(5)(A)) applies, see section 1251(d)(6) and paragraph (f) of
Sec. 1.1251-4.
(ii) Acquiring corporation. For purposes of subdivision (i) of this
subparagraph, determinations as to which corporation is the acquiring
corporation shall be made under paragraph (b)(2) of Sec. 1.381(a)-1.
(iii) Certain operating rules. For purposes of subdivision (i) of
this subparagraph, the operating rules of section 381(b) and Sec.
1.381(b)-1 shall apply. Thus, for example, except in the case of a
reorganization qualifying under section
[[Page 499]]
368(a)(1)(F) (whether or not such reorganization also qualifies under
any other provision of section 368(a)(1)), the amount of the excess
deductions account of the transferor shall be computed, as of the close
of the date of distribution or transfer (as determined under paragraph
(b) of Sec. 1.381(b)-1), as if the taxable year of the transferor
closed on such date (regardless of whether the taxable year actually
closed). In the case of a reorganization qualifying under section
368(a)(1)(F) (whether or not such reorganization also qualifies under
any other provision of section 368(a)(1)), the acquiring corporation's
excess deductions account shall be treated for purposes of section 1251
just as the transferor corporation's excess deductions account would
have been treated if there had been no reorganization.
(iv) Excess deductions account balance. For purposes of subdivision
(i) of this subparagraph, the amount in the transferor's excess
deductions account as of the close of the date of distribution or
transfer referred to in subdivision (iii) of this subparagraph shall be
the amount in such account determined after making all the applicable
additions and subtractions under section 1251(b) (other than
subtractions under paragraph (5)(A) of section 1251(b) and this
subparagraph) for the taxable year ending (or considered ending) on such
date including a subtraction by reason of gain (if any) recognized under
section 1251(c)(1) by reason of a disposition which is in part a sale or
exchange and in part a gift transaction to which section 1251(d)(1) and
paragraph (a)(2) of Sec. 1.1251-4 apply.
(2) Certain gifts--(i) In general. If farm recapture property is
disposed of by gift (including for purposes of this paragraph in a
transaction which is in part a sale or exchange and in part a gift or a
transaction treated under paragraph (a)(2) of this section as a gift),
and if such gift is made during any 1-year period (described in
subdivision (ii) of this subparagraph) for which the potential gain
limitation percentage (as computed in subdivision (iii) of this
subparagraph) exceeds 25 percent, then the provisions of subdivision
(iv) of this subparagraph shall apply in respect of such gift.
(ii) One-year period. For purposes of this subparagraph, a 1-year
period is a period of 365 days beginning on the date a gift is made by
the donor.
(iii) Potential gain limitation percentage. Under this subdivision,
the potential gain limitation percentage for any such 1-year period is a
percentage equal to (a) the sum of the potential gains (determined as of
the first day of such period) on each item of farm recapture property
held by such taxpayer on such first day disposed of by gift by the
taxpayer during such period, divided by (b) the sum of the potential
gains (determined as of the first day of such period) on all farm
recapture property held by such taxpayer on such first day.
(iv) Allocation ratio. With respect to each gift of property (to
which the provisions of this subdivision apply) made during a taxable
year, each donee shall succeed (at the time the first of such gifts is
made during such taxable year) to the same proportion of (a) the donor's
excess deductions account determined, as of the close of such taxable
year of the donor, after making all the applicable additions and
subtractions under section 1251(b) (other than subtractions under
section 1251(b)(5) and this paragraph), as (b) the potential gain
(determined immediately prior to the time the first of such gifts is
made during such taxable year) on the property (held by the donor
immediately prior to such time) received by such donee bears to (c) The
aggregate potential gain (determined immediately prior to such time) on
all farm recapture property held by the donor immediately prior to such
time.
(v) Definitions and certain special rules. For purposes of this
subparagraph:
(a) The term potential gain means an amount equal to the excess of
the fair market value of property over its adjusted basis, but, in the
case of land, limited under paragraph (b)(2)(ii) of Sec. 1.1251-1 to
the extent of the deductions allowable in respect of such land pursuant
to an election (if any) under sections 175 (relating to soil and water
conservation expenditures) and 182 (relating to expenditures by farmers
for clearing land) for the taxable year of disposition and the four
immediately preceding taxable years regardless of
[[Page 500]]
whether any such preceding taxable year begins before December 31, 1969.
See section 1251(e)(5).
(b) Property held on the first day of a one-year period shall
include property received by gift during such one-year period and the
potential gain with respect to such property, for purposes of making the
computations under this subparagraph, shall be the potential gain in the
hands of the donor reduced by the amount of gain (in the case of an
exchange which is part a sale and part a gift) taken into account by the
donor.
(c) Property held by a taxpayer on the first day of a one-year
period which property becomes farm recapture property in the hands of
such taxpayer during such one-year period shall be considered to be farm
recapture property on each day of such one-year period.
(vi) Part-sale-part-gift transaction. If property is disposed of in
a transaction which is in part a sale or exchange and in part a gift,
then for purposes of subdivisions (iii)(a) and (iv)(b) of this
subparagraph the potential gain with respect to the property transferred
shall be reduced by the amount of gain taken into account by the
transferor.
(vii) Joint return. For application of the provisions of this
subparagraph with respect to a taxable year for which a joint return is
filed, see paragraph (f)(4) of this section.
(3) Examples. The provisions of subparagraph (2) of this paragraph
may be illustrated by the following examples in which it is assumed that
all taxpayers are unmarried individuals.
Example 1. The only farm recapture property A owns is a farm,
consisting of farm land and certain farm equipment which is farm
recapture property. During the period involved, there was no deduction
allowable under section 175 or 182 to any person owning an interest in
the farm. A, who uses the calendar year as his taxable year, makes a
series of gifts of undivided interests in the farm. In these
circumstances, computations may be made by reference to percentages of
undivided interests in the farm. The potential gain limitation
percentages for each applicable 1-year period are computed, in
accordance with the additional facts assumed, in the table below:
------------------------------------------------------------------------
9/1/70 8/1/71 3/1/72 5/1/73
Date Gift to donee ------------------------------------------
C D E F
------------------------------------------------------------------------
(1) Percent of undivided 20% 10% 10% 60%
interest in entire farm
given as gift by A on date
indicated...................
(2) Percent of undivided 100% 80% 70% 60%
interest in entire farm held
by A immediately before gift
(3) Potential gain:..........
(a) On all property held $100,000 $96,000 $140,000 $125,000
by A on date of gift....
(b) Limitation percentage 30% 25% 14.28% 100%
(sum of amounts in line
(1) during 1-year period
beginning on date of
gift divided by line
(2))....................
------------------------------------------------------------------------
(ii) Under subparagraph (2)(iv) of this paragraph, C, D, and F each
succeed to the proportion of A's excess deductions account at each
applicable time as computed in accordance with the additional facts
assumed, in the table below:
----------------------------------------------------------------------------------------------------------------
Taxable year ending--
---------------------------------------------------------------
Dec. 31, 1970 Dec. 31, 1971 Dec. 32, 1972 Dec. 31, 1973
----------------------------------------------------------------------------------------------------------------
Gift to donee to which subparagraph (2)(iv) of C D E F
this paragraph applies during taxable year.....
(4) Potential gain (determined immediately prior
to time first gift to which subparagraph
(2)(iv) of this paragraph applies is made):
(a) On property received by donee to which $20,000 $12,000 .............. $125,000
such subparagraph (2)(iv) applies (line
(3)(a) multiplied by line (1) divided by
line (2))..................................
(b) Aggregate potential gain on all farm $100,000 $96,000 .............. $125,000
recapture property held by donor (line
(3)(a))....................................
(5) Allocation ratio (line (4)(a), divided by 20% 12.5% .............. 100%
line (4)(b))...................................
(6) Excess deductions account of A:.............
(a) At end of previous taxable year......... 0 $160,000 $210,000 $200,000
(b) Net increase (decrease) for taxable year $200,000 $80,000 ($10,000) $36,000
(determined before making any subtractions
under section 1251(b)(5) and this paragraph)...
(c) At 12/31 (so determined)................ $200,000 $240,000 $200,000 $236,000
[[Page 501]]
(d) Less: Portion to which donee succeeds $40,000 $30,000 $0 $236,000
(line (5), multiplied by line (6)(c))......
(e) At 12/31 (to line (6)(a) following $160,000 $210,000 $200,000 $0
taxable year)..............................
----------------------------------------------------------------------------------------------------------------
Since the potential gain limitation percentage for the 1-year period
beginning on September 1, 1970, exceeds 25 percent, a portion of A's
excess deductions account, under the provisions of subparagraph (2)(iv)
of this paragraph, is succeeded to by C and D. Similarly, since such
percentage for the 1-year period beginning May 1, 1973, exceeds 25
percent, such provisions apply to the gift made to F. Since, however,
such percentage is 25 percent or less for all 1-year periods in which
the gift to E falls (i.e., 25 percent and 14.28 percent for the 1-year
periods beginning, respectively, on August 1, 1971, and March 1, 1972)
such provisions do not apply to the gift to E.
Example: 2. (i) G uses the calendar year as his taxable year and H
uses a taxable year ending June 30. As of the close of 1972, G has
$100,000 in his excess deductions account, determined before any
subtractions under section 1251(b)(5) and this paragraph. G owns only
three items of farm recapture property, none of which is land. On May 1,
1972, G makes a gift of farm recapture property No. 1 to his son and on
September 1, 1972, G sells to H for $80,000 farm recapture property No.
2 in a transaction which is in part a sale and in part a gift. G owns
throughout all relevant periods farm recapture property No. 3. The
potential gain limitation percentage for G's one-year period beginning
May 1, 1972, is computed in accordance with the additional facts assumed
in the table below:
------------------------------------------------------------------------
Farm Recapture Property
--------------------------------------------------------------- Total
No. 1 No. 2 No. 3
------------------------------------------------------------------------
(1) Fair market value 5/1/72.. $25,000 $100,000 $800,000
(2) Adjusted basis 5/1/72..... $10,000 $60,000 $795,000
-----------------------------------------
(3) Potential gain (line (1), $15,000 $40,000 $5,000 $60,000
minus line (2))..............
=========================================
(4) Sum of potential gains on $15,000 $20,000 ......... $35,000
properties disposed of by
gift during period less gain
taken into account by
transferor on part-sale-part-
gift.........................
(5) Potential gain limitation ........ ......... ......... 58\1/3\%
percentage (total line (4),
divided by total line (3))...
------------------------------------------------------------------------
Since the potential gain limitation percentage for the one-year period
beginning on May 1, 1972, exceeds 25 percent, the provisions of
subparagraph (2)(iv) of this paragraph apply to the gift to the son and
that portion of the disposition to H which is a gift.
(ii) The portion of G's excess deductions account determined, as of
the close of 1972, before any subtraction under section 1251(b)(5) and
this paragraph, allocated to the son and to H as of May 1, 1972, is
computed in the table below:
------------------------------------------------------------------------
Property
----------------------------- Total
No. 1 No. 2 No. 3
------------------------------------------------------------------------
(1) Potential gain under part (i) $15,000 $40,000 $5,000 $60,000
of this example (since the first
day of the one-year period is
the same as the time as of which
the first gift was made during
the taxable year)...............
(2) Potential gain less amount 15,000 20,000 ....... ........
taken into account by transfer
on part-sale-part-gift..........
(3) Allocation percentage (line 25% 33\1/3\% ....... ........
(2), divided by $60,000)........
(4) Excess deductions account at ........ ........ ....... 100,000
close of taxable year (determine
before making any subtractions
under section 1251(b)(5) and
this paragraph).................
(5) Portion to which donee 25,000 33,333 ....... 58,333
succeeds on 5/1/72..............
(6) G's excess deductions account ........ ........ ....... $41,667
12/31/72........................
------------------------------------------------------------------------
Accordingly, the amount of G's excess deduction account succeeded to as
of May 1, 1972, is $25,000 by the son and $33,333 by H.
(f) Joint return--(1) Joint excess deductions account. If for a
taxable year a taxpayer and his spouse file a joint return under section
6013, then for such
[[Page 502]]
taxable year each taxpayer shall (if necessary) establish and maintain a
joint excess deductions account. Such joint excess deductions account
shall consist of the aggregate of the separately maintained excess
deductions account of each spouse. A separately maintained excess
deductions account shall be computed under the rules of paragraphs (b)
and (c) of this section, except that for each taxable year a joint
return is filed:
(i) The $50,000 amount in the nonfarm adjusted gross income
limitation in paragraph (b)(2)(i) of this section shall be considered
satisfied if the combined nonfarm adjusted gross income of both spouses
exceeds $50,000,
(ii) The $25,000 amount in the farm net loss exclusion in paragraph
(b)(2)(ii) of this section shall be allocated between the two spouses in
proportion to the farm net loss of each spouse having a farm net loss,
and
(iii) The separately maintained excess deductions account of each
spouse shall be reduced, if necessary, below zero, by the amount of such
spouse's farm net income (computed as if a separate return were filed)
plus the amount of gain (computed under subparagraph (3) of this
paragraph) which is recognized as ordinary income under section
1251(c)(1) in respect of a disposition of farm recapture property owned
by the taxpayer.
(2) Surviving spouse. For purposes of this paragraph, a joint return
does not include a return of a surviving spouse (as defined in section 2
relating to a spouse who died during either of his two taxable years
immediate preceding the taxable year) which is treated as a joint return
of a husband and wife under section 6013.
(3) Application of excess deductions account limitation in joint
return year. In the case of a taxable year for which a joint return is
filed, the aggregate of the amount of gain recognized as ordinary income
under section 1251(c)(1) (after applying paragraph (b) (2)(o) and (3) of
Sec. 1.125-1, if applicable) shall not exceed the amount in the joint
excess deductions account (that is, the aggregate of the separately
maintained excess deductions account of each spouse) at the close of the
taxable year after subtracting from each such separately maintained
account the amount specified in section 1251(b) (3) (A) and paragraph
(c) (1) (i) of this section as modified by the rules of this paragraph.
For the amount of limitation for a taxable year for which a separate
return is filed, see paragraph (b)(4) of this section. For
determinations as to which dispositions are taken into account for any
taxable year, see paragraph (b)(4) of Sec. 1.1251-1.
(4) Certain gifts--(i) In general. If farm recapture property is
transferred as a gift by a spouse to a person other than a spouse during
a taxable year for which a joint return is filed, the spouses shall for
purposes of applying the provisions of section 1251(b) (5) (B) and
paragraph (e)(2) of this section be treated as a single taxpayer. Thus,
under paragraph (e)(2) of Sec. 1.1251-2, the potential gain limitation
percentage and the proportion for allocating the amount in the joint
excess deductions account to one or more donees shall be determined by
treating the spouses as a single taxpayer. However, with respect to each
gift by a spouse, such spouse's separately maintained excess deductions
account shall be reduced (below zero, if necessary) by the amount of the
joint excess deductions account balance to which the donee of such gift
succeeded under paragraph (e)(2)(iv) of this section.
(ii) Gift between spouses. If farm recapture property is transferred
by gift by one spouse to another spouse during a taxable year for which
a joint return is filed, such gift shall not affect the balance in the
joint excess deductions account but its effect on the separately
maintained excess deductions account of each spouse shall be determined
as if separate returns were filed, but only after applying subdivision
(i) of this subparagraph.
(5) Allocation of joint excess deductions account upon filing
separate returns--(i) In general. If for any reason a taxpayer and his
spouse cease to file a joint return, then except as provided in this
subparagraph the amount of the separately maintained excess deductions
account of each spouse as of the close of the last taxable year for
which a joint return was filed shall be the amount of such spouse's
excess deductions account as of the beginning of the
[[Page 503]]
first taxable year for which they cease filing a joint return.
(ii) Deficit. If under subparagraph (4)(i) of this paragraph one of
the spouses has a deficit in his separately maintained excess deductions
account as of the close of the last taxable year for which a joint
return was filed, then as of the beginning of the first taxable year for
which they cease filing a joint return:
(a) The spouse who had such deficit shall have an excess deductions
account of zero, and
(b) The other spouse shall have an excess deductions account equal
to the amount prescribed in subdivision (i) of this subparagraph minus
the amount of such deficit.
(6) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 3. Assume the same facts as in example (4) of paragraph
(b)(5) of this section, except that H and W file a joint return under
section 6013 and that H has a farm net loss of only $40,000. Thus, since
the nonfarm adjusted gross income for calendar year 1971 was $60,000 for
H and $30,000 for W, their combined nonfarm adjusted gross income
exceeds $50,000, thereby satisfying under subparagraph (1)(i) of this
paragraph the $50,000 limitation of paragraph (b)(2)(i) of this section.
Assume further that for 1971 only W makes a dispostion of farm recapture
property (other than land and section 1245 property). As a result of
such disposition, W realizes a gain of $14,000. Accordingly, for 1971,
the separately maintained excess deductions accounts of H and W, their
joint excess deductions account, and the treatment of the gain realized
by W on the disposition of the farm recapture property are computed, in
accordance with the facts assumed in the table below:
Excess Deductions Accounts
----------------------------------------------------------------------------------------------------------------
H's W's Joint
----------------------------------------------------------------------------------------------------------------
(1) Balance Jan. 1, 1971............................ ........ $10,000 ........ $5,000 ........ $15,000
(2) Additions for 1971:
(a) Farm net loss for 1971........................ $40,000 ........ $10,000 ........ $50,000 ........
(b) Less amount in paragraph (b)(2)(ii) of this 20,000 ........ 5,000 ........ 25,000 ........
section as allocated under subparagraph (1)(ii)
of this paragraph................................
---------- ---------- ----------
(c) Total additions for 1971...................... ........ 20,000 ........ 5,000 ........ 25,000
---------- ---------- ---------
(3) Subtotal........................................ ........ 30,000 ........ 10,000 ........ 40,000
(4) Subtractions for 1971........................... ........ 0 ........ 0 ........
---------- ---------- ---------
(5) Excess deductions account limitation on gain ........ 30,000 ........ 10,000 ........ 40,000
recognized as ordinary income under section
1251(e)(1) for 1971................................
(6) Subtraction for dispositions of farm recapture
property:
(a) Gain to which section 1251(c)(1) applies 0 ........ 14,000 ........ 14,000 ........
(computed before applying limitation)............
(b) Limitation (amount in line (5))............... 30,000 ........ 10,000 ........ 40,000 ........
========== ========== ==========
(c) Gain recognized as ordinary income under ........ ........ ........ 14,000 ........ 14,000
section 1251(c)(1), computed for joint account
(lower of line 6(a) or line 6(b) subject to
provisions as to separately maintained accounts
of subparagraph (1)(iii).........................
---------- ---------- ---------
(7) Balance Dec. 31, 1971........................... ........ 30,000 ........ (4,000) ........ 26,000
----------------------------------------------------------------------------------------------------------------
If for 1972, H and W were to file separate returns, then the separately
maintained excess deductions account balances as of January 1, 1972,
would be $26,000 and zero respectively. See subparagraph (5)(ii) of this
paragraph.
[T.D. 7418, 41 FR 18816, May 7, 1976; 41 FR 23669, June 11, 1976]
Sec. 1.1251-3 Definitions relating to section 1251.
(a) Farm recapture property--(1) In general. (i) The term farm
recapture property means any property (other than section 1250 property
as defined in section 1250(c)) which, in the hands of the taxpayer is or
was property:
(a) Which is described in section 1231(b)(1) (relating to business
property held for more than 1 year (6 months for taxable years beginning
before 1977; 9 months for taxable years beginning in 1977), section
1231(b)(3) (relating to livestock), or section 1231(b)(4) (relating to
an unharvested crop), and
[[Page 504]]
(b) Which, at the time the property qualifies under (a) of this
subdivision, is used in the trade or business of farming (as defined in
paragraph (e) of this section).
(ii) The term farm recapture property also includes:
(a) Property acquired by gift and property acquired in a transaction
to which section 1251(b)(5)(A) applies, if such property was farm
recapture property within the meaning of subdivision (i) of this
subparagraph in the hands of the transferor, and
(b) Property the basis of which in the hands of the taxpayer holding
such property is determined by reference to the basis of other property
which in the hands of such taxpayer was farm recapture property within
the meaning of subdivision (i) of this paragraph. For purposes of (b) of
this subdivison (ii) property whose basis is determined in accordance
with the last sentence of section 1033(c) shall be considered as having
as basis determined by reference to the property whose conversion gave
rise to the application of such section.
(iii) Leasehold of farm recapture property. If property is farm
recapture property under this subparagraph, a leasehold of such property
is also farm recapture property is also farm recapture property to the
same extent as described in, and in accordance with the principles of
paragraph (a)(2) of Sec. 1.1245-3.
(iv) If property described in subdivision (ii) of this subparagraph
is stock or securities received in certain corporate transactions
described in section 1251(d)(6), see paragraph (f) of Sec. 1.1251-4 for
determination as to extent such stock or securities is farm recapture
property.
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following example:
Example: On December 15, 1971, A, an individual calendar year
taxpayer engaged in the trade or business of farming (as defined in
paragraph (e) of this section) exchanges in a transaction which
qualifies under section 1031(a) (relating to an exchange of property
held for productive use or investment) tractor No. 1 which A acquired on
March 1, 1971, for tractor No. 2. Under subparagraph (1)(i) of this
paragraph, tractor No. 1 is farm recapture property as the tractor was
used in the trade or business of farming and was held for a period in
excess of 6 months. Under subparagraph (1)(ii) of this paragraph,
tractor No. 2 is farm recapture property as the basis of tractor No. 2
in the hands of A is determined with reference to the adjusted basis of
tractor No. 1.
(b) Farm net loss--(1) In general. The term farm net loss means the
amount by which:
(i) The deductions allowed or allowable for the taxable year by
chapter 1 of subtitle A of the Code which are directly connected with
the carrying on of the trade or business of farming, exceed
(ii) The gross income derived from such trade or business.
(2) Disposition of farm recapture property. For purposes of
subparagraph (1) of this paragraph, no gain or loss (regardless of how
treated) resulting from the disposition of farm recapture property shall
be taken into account, except that under subparagraph (1)(ii) of this
paragraph gain upon disposition of such property which is recognized as
ordinary income by reason of section 1245(a)(1) shall be taken into
account. Thus, for example, if land used in the trade or business of
farming were disposed of and gain of $3,000 was realized, then none of
such gain would be taken into account in computing farm net loss and
farm net income even if all or a portion of such gain is recognized as
ordinary income by reason of section 1251(c)(1), section 1252(a)(1), or
both. If such land were disposed of at a loss, the result would be the
same. See paragraph (d)(1)(ii) of this section with respect to the
exclusion of gain or loss from the disposition of farm recapture
property from the computation of nonfarm adjusted gross income.
(3) Amount of deduction under section 172(a) attributable to farm
net loss. (i) If all or a portion of a net operating loss (within the
meaning of section 172(c)) for a taxable year is absorbed in another
taxable year as a carryover or carry back, then for purposes of
determining the amount of deductions referred to in subparagraph (1)(i)
of this paragraph for such other taxable year the portion of the amount
absorbed in such other taxable year which is attributable to amounts
directly connected with the carrying on of the trade or business of
farming shall be an
[[Page 505]]
amount equal to the amount absorbed, multiplied by a fraction the
numerator of which is the amount of the farm net loss for the taxable
year the net operating loss arose (but not in excess of the net
operating loss for such year) and the denominator of which is the amount
of the net operating loss for such year.
(ii) No portion of a farm net loss added to the excess deductions
account in the year a net operating loss arose (or which would have been
added to such account but for the application of the $25,000 or $12,500
farm net loss exclusion under paragraph (b) (2)(ii) or (4)(i)(b) of
Sec. 1.1251-2) shall be taken into account under subparagraph (1)(i) of
this paragraph in any other taxable year. Accordingly the same farm net
loss shall not be added to the excess deductions account more than once
and a farm net loss for any taxable year shall not be subject to the
$25,000 or $12,500 exclusion more than once.
(iii) If a net operating loss for a current taxable year
attributable in whole or part to a farm net loss is carried back and
absorbed in a preceding taxable year no redetermination shall be made
with respect to (a) the amount of gain recognized as ordinary income
under section 1251(c)(1) and paragraph (b) of Sec. 1.1251-1 in any
taxable year preceding the current taxable year, and (b) the amount of
the taxpayer's excess deductions account allocated under paragraph
(e)(2) of Sec. 1.1251-2 to a donee as of the close of any taxable year
preceding the current taxable year.
(4) Special rules as to estates and trusts. In the case of an estate
or trust, computations of amounts under this paragraph shall be made
without regard to any deductions under section 651 or 661. If on the
termination of an estate or trust the beneficiaries succeeding to its
property are allowed a deduction under section 642(h) (relating to
unused loss carryovers and excess deductions on termination available to
beneficiaries), to the extent the carryover or excess deduction is
attributable to a farm loss it shall have the same character in the
hands of the beneficiary as in the hands of the estate or trust. The
amount of a carryover or of excess deductions from a particular taxable
year of an estate or trust succeeded to under section 642(h) shall be
allocated between amounts attributable to a farm net loss and other
amounts in the same proportion as the farm net loss for such year bears
to the amount of such carryover or of excess deductions. If there is
more than one beneficiary, the total farm net loss succeeded to by all
the beneficiaries shall be allocated to each beneficiary in proportion
to the deduction of each under section 642(h).
(c) Farm net income. The term farm net income means the amount by
which the amount referred to in paragraph (b)(1)(ii) of this section
exceeds the amount referred to in paragraph (b)(1)(i) of this section.
(d) Nonfarm adjusted gross income--(1) In general. The term nonfarm
adjusted gross income means adjusted gross income (taxable income in the
case of a taxpayer other than an individual) computed without regard to:
(i) Income or deductions taken into account in computing farm net
loss and farm net income,
(ii) Gains and losses (regardless of how treated) resulting from the
disposition of farm recapture property, and
(iii) In the case of an estate or trust, the principles of paragraph
(b)(4) of this section, to the extent applicable, shall apply.
(2) Special rules. The following rules in addition to the rules of
subparagraph (1) of this paragraph, shall apply in computing the
adjusted gross income of a shareholder of an electing small business
corporation:
(i) The amount of any distribution described in section 1373 (c)(2)
made by the corporation shall be disregarded,
(ii) For purposes of computing the amount includible in the gross
income of a shareholder under section 1373(b), the corporation's
undistributable taxable income shall equal the corporation's nonfarm
adjusted gross income (as defined in subparagraph (1) of this paragraph)
minus the amount described in section 1373(c)(1), and
(iii) For purposes of computing a shareholder's deduction under
section 1374, the corporation's net operating loss shall be computed
without regard to the items referred to in subparagraph (1) (i) and (ii)
of this paragraph.
[[Page 506]]
(e) Trade or business of farming--(1) In general. For purposes of
section 1251, the term trade or business of farming includes any trade
or business with respect to which the taxpayer may compute gross income
under Sec. 1.61-4, expenses under Sec. 1.162-12, make an election
under section 175, 180, or 182, or use an inventory method referred to
in Sec. 1.471-6. Such term does not include any activity not engaged in
for profit within the meaning of section 183 and section 183-2.
(2) Horse racing. If a taxpayer is engaged in the raising of horses,
including horses which are bred or purchased, then for purposes of
section 1251 the term trade or business of farming also includes the
racing of such horses by the taxpayer. Thus, for example, if a taxpayer
purchases a yearling and develops it to the racing stage, the term trade
or business of farming includes the racing of such horse.
(3) Several businesses of farming. If a taxpayer is engaged in more
than one trade or business of farming, all such trades and businesses
shall be treated as one trade or business.
[T.D. 7418, 41 FR 18826, May 7, 1976, as amended by T.D. 7728, 45 FR
72650, Nov. 3, 1980]
Sec. 1.1251-4 Exceptions and limitations.
(a) Exception for gifts--(1) General rule. Section 1251(d)(1)
provides that no gain shall be recognized under section 1251(c)(1) upon
a disposition by gift. For purposes of this paragraph, the term gift
shall have the same meaning as in paragraph (a) of Sec. 1.1245-4 and,
with respect to the application of this paragraph, principles
illustrated by the examples of paragraph (a)(2) of Sec. 1245-4 shall
apply. For reduction in amount of charitable contribution in case of a
gift of farm recapture property, see section 170(e) and Sec. 1.170A-4.
(2) Disposition in part a sale or exchange and in part a gift. Where
a disposition of farm recpature property is in part a sale or exchange
and in part a gift, the amount of gain recognized as ordinary income
under section 1251(c)(1) shall not exceed:
(i) In the case of farm recapture property other than land, the
excess of the amount realized over adjusted basis, and
(ii) In the case of land, the lower of the amount in subdivision (i)
of this subparagraph or the potential gain (as defined in paragraph
(b)(2)(ii) of Sec. 1.1251-1.
(3) Treatment of land in hand of transferee. See paragraph (g) of
this section for treatment of transferee in the case of a disposition of
land to which this paragraph applies.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. A, a calendar year taxpayer, makes one disposition of
farm recapture property during 1976. On March 2, 1976, A makes a gift to
B (also a calendar year taxpayer) of a parcel of land which he had on
January 15, 1971. On the date of such disposition, the excess of the
fair market value ($65,000) over the adjusted basis of the land
($40,000) is $25,000 and the sum of the deductions allowable in respect
of such land under sections 175 and 182 is $21,000 for 1971 and $3,000
(attributable to 1975) for the taxable year of disposition and the four
immediately preceding taxable years. Thus, the potential gain (as
defined in paragraph (b)(2)(ii) of Sec. 1.1251-1) is limited to $3,000.
At the end of 1976 (after making the applicable additions and
subtractions under section 1251(b) (2) and (3)(A)), there is a balance
in A's excess deductions account of $25,000. However, upon making the
gift, A recognizes no gain under section 1251(c)(1) or section
1252(a)(1). See subparagraph (a)(1) of this paragraph and paragraph
(a)(1) of Sec. 1.1252-2. For treatment of the land in the hands of B,
see example (1) of paragraph (g)(3) of this section. For effect of the
gift on the excess deductions accounts of A and B, see paragraph (e)(2)
of Sec. 1.1251-2.
Example 2. Assume the same facts as in example (1), except that A
transfers the land to B for $50,000. Thus, the gain realized is $10,000
(amount realized, $50,000, minus adjusted basis $40,000), and A has made
a gift of $15,000 (fair market value, $65,000, minus amount realized,
$50,000). Since under subparagraph (2)(ii) of this paragraph, the
potential gain ($3,000) is lower than the gain realized ($10,000), the
gain to which section 1251(c)(1) could apply is limited by subparagraph
(2)(ii) of this paragraph to $3,000. Thus, as A has $25,000 in his
excess deductions account, $3,000 is recognized as ordinary income under
section 1251(c)(1). See example (2) of paragraph (a)(4) of Sec. 1.1252-
2 for computation of gain of $7,000 which is recognized as ordinary
income by A under section 1252(a)(1). For treatment of the land in the
hands of B, see example (2) of paragraph (g)(3) of this section.
(b) Exception for transfers at death--(1) General rule. Section
1251(d)(2) provides
[[Page 507]]
that, except as provided in section 691 (relating to income in respect
of a decedent), no gain shall be recognized under section 1251(c)(1)
upon a transfer at death. For purposes of this paragraph, the term
transfer at death shall have the same meaning as in paragraph (b) of
Sec. 1.1245-4 and, with respect to the application of this paragraph,
principles illustrated by the examples of paragraph (b)(2) of Sec.
1.1245-4 shall apply.
(2) Treatment of land in hands of transferee. If as of the date a
person acquires land which is farm recapture property from a decedent
such person's basis is determined, by reason of the application of
section 1014(a), solely by reference to the fair market value of the
property on the date of the decedent's death or on the applicable date
provided in section 2032 (relating to alternate valuation date), then on
such date the potential gain in respect to such land is zero.
(c) Certain corporate transactions--(1) Limitation on amount of
gain. Under section 1251(d)(3), upon a transfer of property described in
subparagraph (2) of this paragraph, the amount of gain recognized as
ordinary income by the transferor under section 1251(c)(1) shall not
exceed an amount equal to the excess (if any) of (i) the amount of gain
recognized to the transferor on the transfer (determined without regard
to section 1251) over (ii) the amount (if any) of gain recognized as
ordinary income under section 1245(a)(1). For purposes of this
subparagraph, the principles of paragraph (c)(1) of Sec. 1.1245-4 shall
apply. Thus, in case of a transfer of both farm recapture property and
property other than farm recapture property in a single transaction, the
amount realized from the disposition of the farm recapture property (as
determined in a manner consistent with the principles of paragraph
(a)(5) of Sec. 1.1245-1) shall be deemed to consist of that portion of
the fair market value of each property acquired which bears the same
ratio to the fair market value of such acquired property as the amount
realized from the disposition of farm recapture property bears to the
total amount realized. The preceding sentence shall be applied solely
for purposes of computing the portion of the total gain (determined
without regard to section 1251) which is eligible to be recognized as
ordinary income under section 1251(c)(1). Section 1251(d)(3) does not
apply to a disposition of property to an organization (other than a
cooperative described in section 521) which is exempt from the tax
imposed by chapter 1 of the Code.
(2) Transfers covered. The transfers referred to in subparagraphs
(1) of this paragraph are transfers of farm recapture property in which
the basis of such property in the hands of the transferee is determined
by reference to its basis in the hands of the transferor by reason of
the application of any of the following provisions:
(i) Section 332 (relating to distributions in complete liquidation
of an 80-percent-or-more controlled subsidiary corporation). For the
application of section 1251(d)(3) to such a complete liquidation, the
principles of paragraph (c)(3) of Sec. 1.1245-4 shall apply. Thus, for
example, the provisions of subparagraph (1) of this paragraph do not
apply to a liquidating distribution of farm recapture property by an 80-
percent-or-more controlled subsidiary to its parent if the parent's
basis for the property is determined, under section 334(b)(2), by
reference to its basis for the stock of the subsidiary.
(ii) Section 351 (relating to transfer to corporation controlled by
transferor).
(iii) Section 351 (relating to exchanges pursuant to certain
corporate reorganizations).
(iv) Section 371(a) (relating to exchanges pursuant to certain
receivership and bankruptcy proceedings).
(v) Section 374(a) (relating to exchanges pursuant to certain
railroad reorganizations).
(3) Partnerships. For the application of section 1251 to
partnerships, see paragraph (e) of this section.
(4) Treatment of land in hands of transferee. See paragraph (g) of
this section for treatment of transferee in the case of a disposition of
land to which this paragraph applies.
(5) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. (i) A, an individual calendar year taxpayer, makes one
disposition of farm recapture property during 1971. On January
[[Page 508]]
20, 1971. A transfers farm recapture property (other than land and
section 1245 property), having an adjusted basis of $22,000, to
corporation M in exchange for stock in M worth $35,000 plus $15,000 in
cash in a transaction qualifying under section 351. Thus, the amount
realized is $50,000, and the gain realized is the excess of the amount
realized, $50,000, over the adjusted basis, $22,000, or $28,000. Without
regard to section 1251, A would recognize gain of $15,000 under section
351(b), and M's basis for the farm recapture property would be
determined under section 362(a) by reference to its basis in the hands
of A. Assume further that the balance in A's excess deductions account
(after making the applicable additions and subtractions under section
1251(b) (2) and (3)(A)) at the close of 1971 is $20,000. Thus, since
such balance in the excess deductions account ($20,000) is lower than
the gain realized ($28,000), is subparagraph (1) of this paragraph did
not apply, gain of $20,000 would be recognized as ordinary income under
section 1251(c)(1). However, subparagraph (1) of this paragraph limits
the amount of gain to be recognized as ordinary income under section
1251(c)(1) to $15,000.
(ii) If, however, A transferred the farm recapture property to M
solely in exchange for stock worth $50,000, then, because of the
application of subparagraph (1) of this paragraph he would not recognize
any gain under section 1251(c)(1). If, instead, A transferred the farm
recapture property to M in exchange for stock worth $25,000 and $25,000
cash, only $20,000 (the amount of such balance in the excess deductions
account) of the gain of $25,000 recognized under section 351(b) would be
recognized as ordinary income under section 1251(c)(1). The remaining
$5,000 of gain recognized under section 351(b) may be treated as gain
from the sale or exchange of property described in section 1231. In the
hands of M, the property received from A is farm recapture property
under the provisions of paragraph (a)(11)(ii) of Sec. 1.1251-3. For
treatment of the property received by A in such transaction; see section
1251(d)(6) and paragraph (f) of this section.
Example 2. Assume the same facts as in subdivision (i) of example
(1), except that the farm recapture property is section 1245 property.
Assume further than $5,000 is recognized as ordinary income under
section 1245(a)(1), and that as of the close of 1971, A has a balance of
$15,000 in his excess deductions account (after making the applicable
additions and subtractions under section 1251(b) (2) and (3)(A) which,
under paragraph (b) of Sec. 1.1251-3, is computed by treating the
$5,000 of gain to which section 1245 applies as gross income derived
from the trade or business of farming). The amount of gain recognized as
ordinary income under section 1251(c)(1) is $10,000, computed as
follows:
(1) Amount of gain under section 1251(c)(1) (determined
without regard to subparagraph (1) of this paragraph):......
(a) Portion of gain realized ($28,000) in excess of $23,000
amount recognized as ordinary income under section
1245(a)(1) ($5,000).....................................
(b) Excess deductions account balance.................... 15,000
(c) Lower of (a) or (b).................................. 15,000
==========
(2) Limitation in subparagraph (1) of this paragraph:
(a) Gain recognized (determined without regard to section 15,000
1251)...................................................
(b) Minus: Gain recognized as ordinary income under 5,000
section 1245(a)(1)......................................
----------
(c) Difference........................................... 10,000
==========
(3) Lower of line (1)(c) or line (2)(c).................. 10,000
==========
(d) Limitation for like kind exchanges and involuntary conversions--
(1) General rule. Under section 1251(d)(4), if farm recapture property
is disposed of and gain (determined without regard to section 1251) is
not recognized in whole or in part under section 1031 (relating to like
kind exchanges) or section 1033 (relating to involuntary conversions),
then the amount of gain recognized as ordinary income by the transferor
under section 1251(c)(1) shall not exceed an amount equal to the excess
(if any) of (i) the amount of gain recognized on such disposition
(determined without regard to section 1251) or (ii) the amount (if any)
of gain recognized as ordinary income under section 1245(a)(1).
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples:
Example 1. (i) A, an individual calendar year taxpayer, owns a herd
of breeding cattle having an adjusted basis of $75,000 which he acquired
on March 30, 1970, A receives insurance proceeds of $90,000. Thus, the
gain realized is $15,000 (that is, the excess of the amount realized,
$75,000), A makes no other disposition of farm recapture property during
1970. Assume that had the herd been sold at its fair market value on
March 15, 1970, no gain would have been recognized as ordinary income
under section 1245(a)(1). As of the close of 1970, A has a balance of
$12,000 in his excess deductions account (after making the applicable
additions and subtractions under section 1251(b) (2) and (3)(A)). Thus,
since the balance in the excess deductions account, $12,000, is lower
than the gain realized, $15,000, the amount of gain which would be
recognized under section 1251(c)(1) (determined without regard to
subparagraph (1) of this paragraph) would be $12,000.
[[Page 509]]
(ii) Assume further that A spends $72,000 of the insurance proceeds
to purchase another breeding herd, $10,000 to purchase stock in the
acquisition of control of a corporation which owns property similar or
related in service or use to the destroyed breeding herd, and retains
cash of $8,000. Both of the acquisitions by A qualify under section
1033(a)(3)(A), and A properly elects under section 1033(a)(3)(A) and the
regulations thereunder to limit recognition of gain to $8,000 (that is,
the amount by which the amount realized from the conversion, $90,000
exceeds the cost of the stock and other property acquired to replace the
converted property, $72,000 plus $10,000). Thus, since $8,000 is the
amount of gain which would be recognized under section 1033(a)(3)
(determined without regard to section 1251), and since that amount is
lower than the gain of $12,000 which would be recognized under section
1251(c)(1) (determined without regard to subparagraph (1) of this
paragraph), under subparagraph (1) of this paragraph the amount of gain
recognized under section 1251(c)(1) is limited to $8,000. The stock
purchased for $10,000 qualifies under paragraph (a)(1)(ii)(b) of Sec.
1.1251-3 as farm recapture property.
Example 2. (i) A, an individual calendar year taxpayer, owns land
which he had acquired on March 7, 1970, having an adjusted basis of
$48,000, and a fair market value of $67,500. On January 15, 1975, A, as
a result of a condemnation action, receives $67,500 (its fair market
value) for the land. The aggregate of the deductions allowable in
respect of such land under sections 175 and 182 is $18,000, with $5,000
of such aggregate attributable to 1970 and $13,000 of such aggregate
attributable to 1970 and $13,000 of such aggregate attributable to 1975
and the four preceding taxable years. Thus, the potential gain (as
defined in paragraph (b)(2)(ii) of Sec. 1.1251-1) is limited to
$13,000, since that amount is lower than $19,500 (the excess of the fair
market value of the land, $67,500, over its adjusted basis, $48,000).
The gain realized by A is also $19,500. At the end of A's taxable year
(after making the applicable additions and subtractions under section
1251(b) (2) and (3)(A)) there is a balance of $21,000 in the excess
deductions account of A. Since the potential gain, $13,000, is lower
than both the excess deductions account balance, $21,000, and the gain
realized, $19,500, A would recognize $13,000 as ordinary income under
section 1251(c)(1) (determined without regard to subparagraph (1) of
this paragraph).
(ii) Assume further that A spends the entire amount received,
$67,500, to purchase stock in the acquisition of control of a
corporation which owns property similar or related in service or use to
A's condemned land which qualifies under section 1033(a)(3)(A), and A
properly elects under section 1033(a)(3)(A) and the regulations
thereunder to limit recognition of gain to zero (that is, the amount by
which the amount realized from the conversion, $67,500, exceeds the cost
of the stock acquired to replace the converted land, $67,500). Thus,
since no gain would be recognized under section 1033(a)(3) (determined
without regard to section 1251), under subparagraph (1) of this
paragraph, no gain is recognized under section 1251(c)(1). The stock
purchased for $67,500 qualifies under paragraph (a)(1)(ii)(b) of Sec.
1.1251-3 as farm recapture property. See example (1) of paragraph (d)(2)
of Sec. 1.1252-2 for a computation of gain recognized as ordinary
income under section 1252(a)(1).
Example 3. B, an individual calendar year taxpayer, owns a herd of
breeding cattle having an adjusted basis of $25,000 which he acquired on
March 30, 1970. On March 15, 1976, the entire herd is destroyed by a
blizzard and on March 20, 1976, B receives insurance proceeds of
$90,000. Thus, the gain realized is $65,000 (that is, the excess of the
amount realized, $90,000, over the adjusted basis, $25,000). B makes no
other disposition of farm recapture property during 1976. B spends
$60,000 of the insurance proceeds to purchase another breeding herd and
retains cash of $30,000. The acquisition by B qualifies under section
1033(a)(3)(A), and B properly elects under section 1033(a)(3)(A) and the
regulations thereunder to limit recognition of gain to $30,000 (that is,
the amount by which the amount realized from the conversion, $90,000,
exceeds the cost of the property acquired to replace the converted
property, $60,000). Assume that the amount of gain recognized under
section 1245(a)(1) is $20,000, and that as of the close of 1976 B has a
balance of $100,000 in his excess deductions account (after making the
applicable additions and subtractions under section 1251(b) (2) and
(3)(A) which, under paragraph (b) of Sec. 1.1251-3, is computed by
treating the $20,000 of gain to which section 1245 applies as gross
income derived from the trade or business of farming). The amount of
gain recognized as ordinary income under section 1251(c)(1) is $10,000,
computed as follows:
(1) Amount of gain under section 1251(c)(1) (determined
without regard to subparagraph (1) of this paragraph):
(a) Portion of gain realized ($65,000) in excess of $45,000
amount recognized as ordinary income under section
1245(a)(1) ($20,000)....................................
(b) Excess deductions account balance.................... 100,000
(c) Lower of (a) or (b).................................. 45,000
==========
(2) Limitation in subparagraph (1) of this paragraph:
(a) Gain recognized (determined without regard to section 30,000
1251)...................................................
(b) Minus: Gain recognized as ordinary income under $20,000
section 1245(a)(1)......................................
----------
(c) Difference........................................... 10,000
==========
[[Page 510]]
(3) Lower of line (1)(c) or line (2)(c)...................... 10,000
==========
(3) Application to single disposition of farm recapture property of
one class and property of different class. (i) If upon a sale of farm
recapture property of one class gain would be recognized under section
1251(c)(1), and if such farm recapture property together with property
of a different class or classes is disposed of in a single transaction
in which gain is not recognized in whole or in part under section 1031
(without regard to section 1251(c)(1), then rules consistent with the
principles of paragraph (d)(6) of Sec. 1.1250-3 (relating to gain from
disposition of certain depreciable realty) shall apply for purposes of
allocating the amount realized to each of the classes of property
disposed of and for purposes of determining what property the amount
realized for each class consists of.
(ii) For purposes of this subparagraph, the classes of property
other than farm recapture property are (a) section 1245 property, (b)
section 1250 property, and (c) other property.
(iii) For purposes of this subparagraph, the classes of farm
recapture property are (a) hand, (b) farm recapture property other than
land which is section 1245 property and (c) farm recapture property
other than land which is not section 1245 property.
(4) Treatment of land received in like kind exchange or involuntary
conversion. The aggregate of the deductions allowed under sections 175
and 182 in respect of land acquired in a transaction described in
subparagraph (1) of this paragraph shall include the aggregate of the
deductions allowable under sections 175 and 182 in respect of the land
transferred or converted (as the case may be) in such transaction minus
the amount of gain taken into account under sections 1251(c) and 1252(a)
with respect to the land transferred or converted. Upon a subsequent
disposition of such land, such deductions shall be treated as having
been allowable in the same taxable year as they were allowable with
respect to the land transferred or converted.
(e) Partnerships. [Reserved]
(f) Property transferred to controlled corporation. [Reserved]
(g) Treatment of land received by a transferee in a disposition by
gift and certain tax-free transactions--(1) General rule. If farm
recapture property which is land is disposed of in a transaction which
is either a gift to which paragraph (a)(1) of this section applies or a
completely tax-free transfer to which section 1251(b)(5)(A) applies,
then for purposes of section 1251:
(i) The aggregate of the deductions allowable under sections 175 and
182 in respect of the land in the hands of the transferee immediately
after the disposition shall be an amount equal to the aggregate of such
deductions for the taxable year and the four preceding taxable years in
the hands of the transferor immediately before the disposition,
(ii) Upon a subsequent disposition by the transferee (including a
computation of potential gain as defined in paragraph (b)(2)(ii) of
Sec. 1.1251-1), such deductions in the hands of the transferee shall be
treated as having been allowable with respect to the transferee in the
same taxable year they were allowable to the transferor, and
(iii) If the taxable years of the transferor and transferee
regularly end on different dates, then the aggregate of such deductions
allowable for taxable year with respect to the transferor shall be
treated in the hands of the transferee as allowable in the transferee's
taxable year in which the taxable year of the transferor regularly ends.
(2) Certain partially tax-free transfers. If farm recapture property
which is land is disposed of in a transaction which either is in part a
sale or exchange and in part a gift to which paragraph (a)(2) of this
section applies, or is a partially tax-free transfer to which section
1251(b)(5)(A) applies, then for purposes of section 1251:
(i) The amount determined under subparagraph (1)(i) of this
paragraph shall be reduced by the amount of gain taken into account
under sections 1251(c) and 1252(a) to the extent such gain is
attributable to the sections 175 and 182 deductions for the taxable year
and the preceding four taxable years (determined by attributing gain
under section 1252(a) to the oldest years first)
[[Page 511]]
by the transferor upon the disposition, and
(ii) For purposes of subparagraph (1)(ii) of this paragraph, the
amount of such gain recognized under sections 1251(c) and 1252(a) shall
reduce the aggregate of deductions allowable under sections 175 and 182
for the taxable year and each of the preceding four taxable years on a
pro rata basis.
(3) Examples. The provisions of subparagraphs (1) and (2) of this
paragraph may be illustrated by the following examples:
Example 1. Assume the same facts as in example (1) of paragraph
(a)(4) of this section. Therefore, on the date B receives the land in
the gift transaction, under subparagraph (1) (i) and (ii) of this
paragraph, the aggregate of the deductions allowable under sections 175
and 182 in respect of the land in the hands of B is the amount in the
hands of A, $24,000, and for purposes of applying section 1251 upon a
subsequent disposition by B (including the computation of potential
gain) such deductions in the hands of B shall be treated as allowable in
the same year as they were allowable to A. Thus, in respect to the land
in the hands of B, the allowable section 175 and 182 deductions of
$3,000 shall be treated as allowable in 1975.
Example 2. Assume the same facts as in example (2) of Paragraph
(a)(4) of this section. Under paragraph (2) of this paragraph, the
aggregate of the allowable sections 175 and 182 deductions with respect
to the land which pass over to B for purposes of section 1251 is zero
($3,000 deduction allowable under sections 175 and 182 for the taxable
year and the four preceding taxable years minus $3,000 gain taken into
account by A in accordance with example (2) of paragraph (a)(4) of this
section).
[T.D. 7818, 41 FR 18828, May 7, 1976; 41 FR 23669, June 11, 1976]
Sec. 1.1252-1 General rule for treatment of gain from disposition
of farm land.
(a) Ordinary income--(1) General rule. (i) Except as otherwise
provided in this section and Sec. 1.1252-2, if farm land is disposed of
during a taxable year beginning after December 31, 1969, then under
section 1252(a)(1) there shall be treated as gain from the sale or
exchange of property which is neither a capital asset nor property
described in section 1231 (that is, shall be recognized as ordinary
income) the lower of:
(a) The applicable percentage of the amount computed in subdivision
(ii) of this subparagraph, or
(b) The amount computed in subdivision (iii) of this subparagraph.
(ii) The amount computed in this subdivision is an amount equal to:
(a) The aggregate of the deductions allowed, in any taxable year any
day of which falls within the period the taxpayer held (or is considered
to have held) the farm land, under sections 175 (relating to soil and
water conservation expenditures) and 182 (relating to expenditures by
farmers for clearing land) for expenditures paid or incurred after
December 31, 1969, with respect to the farm land disposed of, minus
(b) The amount of gain recognized as ordinary income under section
1251(c)(1) (relating to gain from disposition of property used in
farming where farm losses offset nonfarm income) upon such disposition
of such land.
(iii) The amount computed in this subdivision is an amount equal to:
(a) The gain realized, that is, the excess of the amount realized
(in the case of a sale, exchange, or involuntary conversion) or the fair
market value of the farm land (in the case of any other disposition),
over the adjusted basis of the farm land, minus
(b) The amount of gain recognized as ordinary income under section
1251(c)(1) upon such disposition of such land.
(iv) If a deduction under section 175 is allowed in respect of the
farm land disposed of for a taxable year every day of which falls within
the period after the taxpayer held (or is considered to have held) the
farm land, and if the deduction is attributable to expenditures paid or
incurred after December 31, 1969, with respect to such land during the
period the taxpayer held (or is considered to have held) the land, then
the amount of such deduction shall be applied to increase the amount
computed (without regard to this subdivision) under subdivision (ii)(a)
of this subparagraph.
(2) Application of section. Any gain treated as ordinary income
under section 1252(a)(1) shall be recognized as ordinary income
notwithstanding any other provision of subtitle A of the Code. For
special rules with respect to
[[Page 512]]
the application of section 1252, see Sec. 1.1252-2. For the relation of
section 1252 to other provisions see paragraph (d) of this section.
(3) Meaning of terms. For purposes of section 1252:
(i) The term farm land means any land with respect to which
deductions have been allowed under section 175 or 182. See section
1252(a)(2).
(ii) The period for which farm land shall be considered to be held
shall be determined under section 1223.
(iii) The term disposition shall have the same meaning as in
paragraph (a)(3) of Sec. 1.1245-1.
(iv) The applicable percentage shall be determined as follows:
If the farm land is disposed of-- The applicable
percentage is--
Within 5 years after the date it was 100 percent.
acquired
Within the sixth year after it was 80 percent.
acquired
Within the seventh year after it was 60 percent.
acquired
Within the eighth year after it was 40 percent.
acquired.
Within the ninth year after it was 20 percent.
acquired.
Within the 10th year after it was acquired 0 percent.
and thereafter.
(4) Portion of parcel. The amount of gain to be recognized as
ordinary income under section 1252(a)(1) shall be determined separately
for each parcel of farm land in a manner consistent with the principles
of subparagraphs (4) and (5) of Sec. 1.1245-1(a) (relating to gain from
disposition of certain depreciable property). If (i) only a portion of a
parcel of farm land is disposed of in a transaction, or if two or more
portions of a single parcel are disposed of in one transaction, and (ii)
the aggregate of the deductions allowed under sections 175 and 182 with
respect to any such portion cannot be established to the satisfaction of
the Commissioner or his delegate, then the aggregate of the deductions
in respect of the entire parcel shall be allocated to each portion in
proportion to the fair market value of each at the time of the
disposition.
(b) Instances of non-application--(1) In general. Section 1252 does
not apply if a taxpayer disposes of farm land for which the holding
period is in excess of 9 years or with respect to which no deductions
have been allowed under sections 175 and 182.
(2) Losses. Section 1252(a)(1) does not apply to losses. Thus,
section 1252(a)(1) does not apply if a loss is realized upon a sale,
exchange, or involuntary conversion of property, all of which is farm
land, nor does the section apply to a disposition of such property other
than by way of sale, exchange, or involuntary conversion if at the time
of the disposition the fair market value of such property is not greater
than its adjusted basis.
(c) Treatment of partnerships and partners. [Reserved]
(d) Relation of section 1252 to other provisions--(1) General. The
provisions of section 1252 apply notwithstanding any other provisions of
subtitle A of the Code. Thus, unless an exception or limitation under
Sec. 1.1252-2 applies, gain under section 1252(a)(1) is recognized
notwithstanding any contrary nonrecognition provision or income
characterizing provision. For example, since section 1252 overrides
section 1231 (relating to property used in the trade or business), the
gain recognized under section 1252(a)(1) upon a disposition of farm land
will be treated as ordinary income and only the remaining gain, if any,
from the disposition may be considered as gain from the sale or exchange
of a capital asset if section 1231 is applicable. See example (1) of
paragraph (e) of this section.
(2) Nonrecognition sections overridden. The nonrecognition of gain
provisions of subtitle A of the Code which section 1252 overrides
include, but are not limited to, sections 267(d), 311(a), 336, 337, and
512(b)(5). See Sec. 1.1252-2 for the extent to which section 1252(a)(1)
overrides sections 332, 351, 361, 371(a), 374(a), 721, 731, 1031, and
1033.
(3) Installment method. Gain from a disposition to which section
1252(a)(1) applies may be reported under the installment method if such
method is otherwise available under section 453 of the Code. In such
case, the income (other than interest) on each installment payment shall
(i) first be deemed to consist of gain to which section 1251(c)(1)
applies (if applicable) until all such gain has been reported, (ii) the
next portion (if any) of such income shall be deemed to consist of gain
to which section 1252(a)(1) applies until all such gain has been
reported, and (iii) finally the remaining portion (if any) of such
income shall be deemed to consist of gain to which neither section
1251(c)(1) nor 1252(a)(1) applies. For
[[Page 513]]
treatment of amounts as interest on certain deferred payments, see
section 483.
(4) Exempt income. With regard to exempt income, the principles of
paragraph (e) of Sec. 1.1245-6 shall be applicable.
(5) Treatment of gain not recognized under section 1252(a)(1). For
treatment of gain not recognized under this section, the principles of
paragraph (f) of Sec. 1.1245-6 shall be applicable.
(e) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. Individual A uses the calendar year as his taxable year.
On April 10, 1975, he sells for $75,000 a parcel of farm land which he
had acquired on January 5, 1970, with an adjusted basis of $52,500 for a
realized gain of $22,500. The aggregate of the deductions allowed under
sections 175 and 182 with respect to such land is $18,000 and all of
such amount was allowed for 1970. Under the stated facts, none of the
$22,500 gain realized is recognized as ordinary income under section
1251(c)(1) as there is no potential gain (as defined in section
1251(e)(5)) with respect to the farm land. Since no gain is recognized
as ordinary income under section 1251(c)(1), and since the applicable
percentage, 80 percent, of the aggregate of the deductions allowed under
sections 175 and 182, $18,000, or $14,400, is lower than the gain
realized, $22,500, the amount of gain recognized as ordinary income
under section 1252(a)(1) is $14,400. The remaining $8,100 of the gain
may be treated as gain from the sale or exchange of property described
in section 1231.
Example 2. Assume the same facts as in example (2) of paragraph
(b)(6) of Sec. 1.1251-1. Assume further that the aggregate of the
amount of sections 175 and 182 deductions allowable to the M corporation
is equal to the amount allowed. Under paragraph (a)(1) of the section,
$5,000 is recognized as ordinary income under section 1252(a)(1) upon
the disposition of the land as a dividend, computed as follows:
(1) Aggregate of deductions allowed under sections 175 and $18,000
182.........................................................
(2) Minus: Gain recognized as ordinary income under section $13,000
1251(c)(1)..................................................
----------
(3) Difference............................................... $5,000
(4) Multiply: Applicable percentage for property disposed of 100%
within the fifth year after it was acquired.................
----------
(5) Amount in paragraph (a)(1)(i)(a) of this section......... $5,000
----------
(6) Gain realized (fair market value $67,500, less adjusted $22,500
basis, $45,000).............................................
(7) Minus: Amount in line (2)................................ $13,000
----------
(8) Amount in paragraph (a)(1)(i)(b) of this section......... $9,500
==========
(9) Lower of line (5) or line (8)............................ $5,000
==========
The gain realized, $22,500, minus the sum of the gain recognized as
ordinary income under section 1251(c)(1), $13,000, and under section
1252(a)(1), $5,000, equals $4,500. Assuming section 311(d) (relating to
certain distributions of appreciated property to redeem stock) does not
apply, under section 311(a) the corporation does not recognize gain on
account of the $4,500.
Example 3. Assume the same facts as in example (2) of this
paragraph, except that M contracted to sell the land for $67,500 which
would be paid in 10 equal payments of $6,750 each, plus a sufficient
amount of interest so that section 483 does not apply. Assume further
that the remaining gain of $4,500 is treated as gain from the sale or
exchange of property described in section 1231. M properly elects under
section 453 to report under the installment method gain of $13,000 to
which section 1251(c)(1) applies, gain of $5,000 to which section
1252(a)(1) applies, and gain of $4,500 to which section 1231 applies.
Since the total gain realized on the sale was $22,500, the gross profit
realized on each installment payment is $2,250, i.e., $6,750 x
($67,500). Accordingly, the treatment of the income to be reported on
each installment payment is as follows:
------------------------------------------------------------------------
Applicable sections
Payment No. --------------------------------
1251 1252 1231
------------------------------------------------------------------------
1...................................... $2,250 ......... .........
2...................................... 2,250 ......... .........
3...................................... 2,250 ......... .........
4...................................... 2,250 ......... .........
5...................................... 2,250 ......... .........
6...................................... 1,750 $500 .........
7...................................... ......... 2,250 .........
8...................................... ......... 2,250 .........
9...................................... ......... ......... $2,250
10..................................... ......... ......... 2,250
--------------------------------
Totals............................... 13,000 5,000 4,500
------------------------------------------------------------------------
[T.D. 7418, 41 FR 18831, May 7, 1976; 41 FR 23669, June 11, 1976]
Sec. 1.1252-2 Special rules.
(a) Exception for gifts--(1) General rule. In general, no gain shall
be recognized under section 1252(a)(1) upon a disposition of farm land
by gift. For purposes of section 1252 and this paragraph, the term gift
shall have the same meaning as in paragraph (a) of Sec. 1.1245-4 and,
with respect to the application of this paragraph, principles
illustrated by the examples of paragraph (a)(2) of Sec. 1.1245-4 shall
apply. For reduction in amount
[[Page 514]]
of charitable contribution in case of a gift of farm land, see section
170(e) and Sec. 1.170A-4.
(2) Disposition in part a sale or exchange and in part a gift. Where
a disposition of farm land is in part a sale or exchange and in part a
gift, the amount of gain which shall be recognized as ordinary income
under section 1252(a)(1) shall be computed under paragraph (a)(1) of
Sec. 1.1252-1, applied by treating the gain realized (for purposes of
paragraph (a)(1)(iii)(a) of Sec. 1.1252-1) as the excess of the amount
realized over the adjusted basis of the farm land.
(3) Treatment of farm land in hands of transferee. See paragraph (f)
of this section for treatment of the transferee in the case of a
disposition to which this paragraph applies.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. On March 2, 1976, A, a calendar year taxpayer, makes a
gift to B of a parcel of land having an adjusted basis of $40,000, a
fair market value of $65,000, and a holding period of 6 years (A, having
purchased the land on January 15, 1971). On the date of such gift, the
aggregate of the deductions allowed to A under sections 175 and 182 with
respect to the land is $24,000 with $21,000 of such amount attributable
to 1971. Upon making the gift, A recognizes no gain under section
1251(c)(1) or section 1252(a)(1). See paragraph (a)(1) of Sec. 1.1251-4
and subparagraph 1 of this paragraph. For treatment of the farm land in
the hands of B, see example (1) of paragraph (f)(3) of this section. For
effect of the gift on the excess deductions accounts of A and of B, see
paragraph (e)(2) of Sec. 1.1251-2.
Example 2. (i) Assume the same facts as in example (1), except that
A transfers the land to B for $50,000. Thus, the gain realized is
$10,000 (amount realized, $50,000, minus adjusted basis, $40,000), and A
has made a gift of $15,000 (fair market value, $65,000, minus amount
realized, $50,000).
(ii) Upon the transfer of the land to B, A recognizes $3,000 of gain
under section 1251(c)(1). See example (2) of paragraph (a)(4) of Sec.
1.1251-4. Thus, A recognizes $7,000 as ordinary income under section
1252(a)(1), computed under subparagraph (2) of this paragraph as
follows:
(1) Aggregate of deductions allowed under sections 175 and $24,000
182.........................................................
(2) Minus: Gain recognized as ordinary income under section $3,000
1251(c)(1)..................................................
----------
(3) Difference............................................... $21,000
(4) Multiply: Applicable percentage for land disposed of 80%
within sixth year after it was acquired.....................
----------
(5) Amount in paragraph (a)(1)(i)(a) of Sec. 1.1252-1...... $16,800
==========
(6) Gain realized (see subdivision (i) of this example)...... $10,000
(7) Minus: Amount in line (2)................................ $3,000
----------
(8) Amount in paragraph (a)(1)(i)(b) of Sec. 1.1252-1, $7,000
applied in accordance with subparagraph (2) of this
paragraph...................................................
==========
(9) Lower of line (5) or line (8)............................ $7,000
==========
Thus, the entire gain realized on the transfer, $10,000, is recognized
as ordinary income since that amount is equal to the sum of the gain
recognized as ordinary income under section 1251(c)(1), $3,000, and
under section 1252(a)(1), $7,000. For treatment of the farm land in the
hands of B, see example (2) of paragraph (f)(3) of this section.
(b) Exception for transfers at death--(1) In general. Except as
provided in section 691 (relating to income in respect of a decedent),
no gain shall be recognized under section 1252(a)(1) upon a transfer at
death. For purposes of section 1252 and this paragraph, the term
transfer at death shall have the same meaning as in paragraph (b) of
Sec. 1.1245-4 and, with respect to the application of this paragraph,
principles illustrated by the examples of paragraph (b)(2) of Sec.
1.1245-4 shall apply.
(2) Treatment of farm land in hands of transferee. If as of the date
a person acquires farm land from a decedent such person's basis is
determined, by reason of the application of section 1014(a), solely by
reference to the fair market value of the property on the date of the
decedent's death or on the applicable date provided in section 2032
(relating to alternative valuation date), then on such date the
aggregate of the sections 175 and 182 deductions allowed with respect to
the farm land in the hands of such transferee is zero.
(c) Limitation for certain tax-free transactions--(1) Limitation on
amount of gain. Upon a transfer of farm land described in subparagraph
(2) of this paragraph, the amount of gain recognized as ordinary income
under section 1252(a)(1) shall not exceed an amount equal to the excess
(if any) of (i) the amount of gain recognized to the transferor on the
transfer (determined without regard to section 1252) over (ii) the
amount (if any) of gain recognized as ordinary income under section
[[Page 515]]
1251(c)(1). For purposes of this subparagraph, the principles of
paragraph (c)(1) of Sec. 1.1245-4 shall apply. Thus, in the case of a
transfer of farm land and property other than farm land in one
transaction, the amount realized from the disposition of the farm land
(as determined in a manner consistent with the principles of paragraph
(a)(5) of Sec. 1.1245-1) shall be deemed to consist of that portion of
the fair market value of each property acquired which bears the same
ratio to the fair market value of such acquired property as the amount
realized from the disposition of the farm land bears to the total amount
realized. The preceding sentence shall be applied solely for purposes of
computing the portion of the total gain (determined without regard to
section 1252) which is eligible to be recognized as ordinary income
under section 1252(a)(1). The provisions of this paragraph do not apply
to a disposition of property to an organization (other than a
cooperative described in section 521) which is exempt from the tax
imposed by Chapter 1 of the Code.
(2) Transfers covered. The transfers referred to in subparagraph (1)
of this paragraph are transfers of farm land in which the basis of such
property in the hands of the transferee is determined by reference to
its basis in the hands of the transferor by reason of the application of
any of the following provisions:
(i) Section 332 (relating to distributions in complete liquidation
of an 80-percent-or-more controlled subsidiary corporation). For
application of subparagraph (1) of this paragraph to such a complete
liquidation, the principles of paragraph (c)(3) of Sec. 1.1245-4 shall
apply. Thus, for example, the provisions of subparagraph (1) of this
paragraph do not apply to a liquidating distribution of farm land by an
80-percent-or-more controlled subsidiary to its parent if the parent's
basis for the property is determined, under section 334(b)(2), by
reference to its basis for the stock of the subsidiary.
(ii) Section 351 (relating to transfer to a corporation controlled
by transferor).
(iii) Section 361 (relating to exchanges pursuant to certain
corporate reorganizations).
(iv) Section 371(a) (relating to exchanges pursuant to certain
receivership and bankruptcy proceedings).
(v) Section 374(a) (relating to exchanges pursuant to certain
railroad reorganizations).
(vi) Section 721 (relating to transfers to a partnership in exchange
for a partnership interest). See paragraph (e) of this section.
(vii) Section 731 (relating to distributions by a partnership to a
partner). For special carryover of basis rule, see paragraph (e) of this
section.
(3) Treatment of farm land in the hands of tranferee. See paragraph
(f) of this section for treatment of the transferee in the case of a
disposition to which this paragraph applies.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. On January 4, 1975, A, an individual calendar year
taxpayer, owns a parcel of farm land, which he acquired on March 25,
1970, having an adjusted basis of $15,000 and a fair market value of
$40,000. On that date he transfers the parcel to corporation M in
exchange for stock in the corporation worth $40,000 in a transaction
qualifying under section 351. On the date of such transfer, the
aggregate of the deductions allowed under sections 175 and 182 with
respect to the land is $18,000. Without regard to section 1252, A would
recognize no gain under section 351 upon the transfer and M's basis for
the land would be determined under section 362(a) by reference to its
basis in the hands of A. Thus, as a result of the disposition, no gain
is recognized as ordinary income under section 1251(c)(1) or section
1252(a)(1) by A since the amount of gain recognized under such sections
is limited to the amount of gain which is recognized under section 351
(determined without regard to sections 1251 and 1252). See paragraph
(c)(1) of Sec. 1.1251-4 and subparagraph (1) of this paragraph. For
treatment of the farm land in the hands of B, see paragraph (f)(1) of
this section. For effect of the transfer on the excess deductions
account of A and of B, see paragraph (e)(1) of Sec. 1.1251-2.
Example 2. Assume the same facts in example (1), except that A
transferred the land to M for stock in the corporation worth $32,000 and
$8,000 cash. The gain realized is $25,000 (amount realized, $40,000,
minus adjusted basis, $15,000). Without regard to section 1252, A would
recognize $8,000 of gain under section 351(b). Assume further that no
gain is recognized as ordinary income under section 1251(c)(1).
Therefore, since the applicable percentage, 100 percent, of the
aggregate of the deductions allowed under sections 175 and
[[Page 516]]
182, $18,000, is lower than the gain realized, $25,000, the amount of
gain to be recognized as ordinary income under section 1252(a)(1) would
be $18,000 if the provisions of subparagraph (1) of this paragraph do
not apply. Since under section 351(b) gain in the amount of $8,000 would
be recognized to the transferor without regard to section 1252, the
limitation provided in subparagraph (1) of this paragraph limits the
gain taken into account by A under section 1252(a)(1) to $8,000.
Example 3. Assume the same facts as in example (2), except that
$5,000 of gain is recognized as ordinary income under section
1251(c)(1). The amount of gain recognized as ordinary income under
section 1252(a)(1) is $3,000 computed as follows:
(1) Amount of gain under section 1252(a)(1) (determined
without regard to subparagraph (1) of this paragraph):
(a) Aggregate of deductions allowed under sections 175 $18,000
and 182.................................................
(b) Minus: Gain recognized as ordinary income under $5,000
section 1251(c)(1)......................................
----------
(c) Difference........................................... $13,000
(d) Multiply: Applicable percentage for property disposed 100%
of within the fifth year after it was acquired..........
----------
(e) Amount in paragraph (a)(1)(i)(a) of Sec. 1.1252-1.. $13,000
(f) Gain realized (amount realized $40,000, less adjusted $25,000
basis, $15,000).........................................
(g) Minus: Amount in line (b)............................ $5,000
----------
(h) Amount in paragraph (a)(1)(i)(b) of Sec. 1.1252-1.. $20,000
----------
(i) Lower of line (e) or (h)............................. $13,000
==========
(2) Limitation in subparagraph (1) of this paragraph:
(a) Gain recognized (determined without regard to section $8,000
1252)...................................................
(b) Minus: Gain recognized as ordinary income under $5,000
section 1251(c)(1)......................................
----------
(c) Difference........................................... $3,000
==========
(3) Lower of line (1)(i) or line (2)(c)...................... $3,000
==========
Thus, the entire gain recognized under section 351(b) (determined
without regard to sections 1251 and 1252), $8,000, is recognized as
ordinary income since that amount is equal to the sum of the gain
recognized as ordinary income under section 1251(c)(1), $5,000, and
under section 1252(a)(1), $3,000.
(d) Limitation for like kind exchanges and involuntary conversions--
(1) General rule. If farm land is disposed of and gain (determined
without regard to section 1252) is not recognized in whole or in part
under section 1031 (relating to like kind exchanges) or section 1033
(relating to involuntary conversions), then the amount of gain
recognized as ordinary income by the transferor under section 1252(a)(1)
shall not exceed the sum of:
(i) The excess (if any) of (a) the amount of gain recognized on such
disposition (determined without regard to section 1252) over (b) the
amount (if any) of gain recognized as ordinary income under section
1251(c)(1), plus
(ii) The fair market value of property acquired which is not farm
land and which is not taken into account under subdivision (i) of this
subparagraph (that is, the fair market value of property other than farm
land acquired which is qualifying property under section 1031 or 1033,
as the case may be).
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples:
Example 1. (i) Assume the same facts as in example (2)(ii) of
paragraph (d)(3) of Sec. 1.1251-4. Assume further that the aggregate of
the amount of sections 175 and 182 deductions allowable is equal to the
amount allowed. Under paragraph (a)(1) of Sec. 1.1252-1, $18,000 would
be recognized as ordinary income under section 1252(a)(1) (determined
without regard to subparagraph (1) of this paragraph), computed as
follows:
(1) Aggregate of deductions allowed under sections 175 and $18,000
182.........................................................
(2) Minus: Gain recognized as ordinary income under section 0
1251(c)(1)..................................................
----------
(3) Difference............................................... $18,000
(4) Multiply: Applicable percentage for property disposed of 100%
within the fifth year after it was acquired.................
(5) Amount in paragraph (a)(1)(i)(a) of Sec. 1.1252-1...... $18,000
==========
(6) Gain realized (amount realized, $67,500, less adjusted $19,500
basis, $48,000).............................................
(7) Minus: Amount in line (2)................................ 0
----------
(8) Amount in paragraph (a)(1)(i)(b) of Sec. 1.1252-1...... $19,500
==========
(9) Lower of line (5) or line (8)............................ $18,000
==========
(ii) Although no gain was recognized under section 1251(c)(1) and
the stock purchased by A for $67,500 is farm recapture property for
purposes of section 1251, it is not farm land for purposes of section
1252. Nevertheless, although no gain would be recognized under sections
1033(a)(3) and 1251(c)(1) (determined without regard to section 1252),
the limitation under subparagraph (1) of this paragraph is $67,500 (that
is, the fair market value of property other than farm land acquired
which is qualifying property under section 1033). Since the amount of
gain which would be recognized as ordinary income under section
1252(a)(1) (determined without regard to subparagraph (1) of this
paragraph), $18,000 (as computed in subdivision (i) of this example), is
lower than the amount of
[[Page 517]]
such limitation, $67,500, accordingly, only $18,000 is recognized as
ordinary income under section 1252(a)(1). For determination of basis of
the stock acquired, see subparagraph (5) of this paragraph.
Example 2. (i) Assume the same facts as in example (1) of this
subparagraph, except that the cost of the stock was $62,500 (its fair
market value). Thus, the amount of gain recognized on the disposition
under section 1033(a)(3) (determined without regard to sections 1251 and
1252) is $5,000, that is, $67,500 minus $62,500. Assume further that
$5,000 (the amount of gain recognized under section 1033(a)(3) (so
determined)) was recognized as ordinary income under section 1251(c)(1).
The amount of gain recognized as ordinary income under section
1252(a)(1) is $13,000, computed as follows:
(1) Amount of gain under section 1252(a)(1) (determined
without regard to subparagraph (1) of this paragraph):
(a) Aggregate of deductions allowed under sections 175 $18,000
and 182.................................................
(b) Minus: Gain recognized as ordinary income under $5,000
section 1251(c)(1)......................................
----------
(c) Difference........................................... $13,000
(d) Multiply: Applicable percentage for property disposed 100%
of within the fifth year after it was acquired..........
----------
(e) Amount in paragraph (a)(1)(i)(a) of Sec. 1.1252-1.. $13,000
----------
(f) Gain realized (amount realized, $67,500 (less $19,500
adjusted basis, $48,000))...............................
(g) Minus: Amount in line (b)............................ $5,000
----------
(h) Amount in paragraph (a)(1)(i)(b) of Sec. 1.1252-1.. $14,500
==========
(i) Lower of line (e) or (h)............................. $13,000
==========
(2) Limitation in subparagraph (1) of this paragraph:
(a) Gain recognized (determined without regard to section $5,000
1252)...................................................
(b) Minus: Gain recognized as ordinary income under $5,000
section 1251(c)(1)......................................
----------
(c) Difference........................................... 0
(d) Plus; The fair market value of property other than $62,500
farm land acquired which is qualifying property under
section 1033............................................
----------
(e) Sum of lines (c) and (d)............................. $62,500
==========
(3) Lower of line (1)(i) or line (2)(e)...................... $13,000
==========
(3) Application to single disposition of farm land and property of
different class. (i) If upon a sale of farm land gain would be
recognized under section 1252(a)(1), and if such land together with
property of a different class or classes is disposed of in one
transaction in which gain is not recognized in whole or in part under
section 1031 or 1033 (without regard to section 1252(a)(1)), then rules
consistent with the principles of paragraph (d)(6) of Sec. 1.1250-3
(relating to gain from disposition of certain depreciable realty) shall
apply for purposes of allocating the amount realized to each of the
classes of property disposed of and for purposes of determining what
property the amount realized for each class consists of.
(ii) For purposes of this subparagraph, the classes of property
other than farm recapture property (as defined in section 1251(e) and
paragraph (a)(1) of Sec. 1.1251-3) are (a) section 1245 property, (b)
section 1250 property, and (c) other property.
(iii) For purposes of this subparagraph, the classes of farm
recapture property are (a) land, (b) section 1245 property, and (c)
other property.
(4) Treatment of farm land received in like kind exchange or
involuntary conversion. The aggregate of the deductions allowed under
sections 175 and 182 in respect of land acquired in a transaction
described in subparagraph (1) of this paragraph shall include the
aggregate of the deductions allowed under sections 175 and 182 in
respect of the land transferred or converted (as the cr sections 175 and
182 in respect of land acquired in a transaction described in
subparagraph (1) of this paragraph shall include the aggregate of the
deductions allowed under sections 175 and 182 in respect of the land
transferred or converted (as the case may be) in such transaction minus
the amount of gain taken into account under sections 1251(c) and 1252(a)
with respect to the land transferred or converted. Upon a subsequent
disposition of such land, the holding period shall include the holding
period with respect to the land transferred or converted.
(5) Basis adjustment. In order to reflect gain recognized under
section 1252(a)(1) if property is acquired in a transaction to which
subparagraph (1) of this paragraph applies, its basis shall be
determined under the rules of section 1031(d) or 1033(c).
(e) Partnerships. [Reserved]
(f) Treatment of farm land received by a transferee in a disposition
by gift and certain tax-free transactions--(1) General rule. If farm
land is disposed of in a
[[Page 518]]
transaction which is either a gift to which paragraph (a)(1) of this
section applies, or a completely tax-free transfer to which paragraph
(c)(1) of this section applies, then for purposes of section 1252:
(i) The aggregate of the deductions allowed under sections 175 and
182 in respect of the land in the hands of the tranferee immediately
after the disposition shall be an amount equal to the amount of such
aggregate in the hands of the transferor immediately before the
disposition, and
(ii) For purposes of applying section 1252 upon a subsequent
disposition by the transferee (including a computation of the applicable
percentage), the holding period of the transferee shall include the
holding period of the transferor.
(2) Certain partially tax-free transfers. If farm land is disposed
of in a transaction which either is in part a sale or exchange and in
part a gift to which paragraph (a)(2)of this section applies, or is a
partially tax-free transfer to which paragraph (c)(1) of this section
applies, then for purposes of section 1252 the amount determined under
subparagraph (1)(i) of this paragraph shallbe reduced by the amount of
gain taken into account under sections 1251(c) and 1252(a) by the
transferor upon the disposition. Upon a subsequent disposition by the
transferee, the holding period for purposes of computing the amount
under section 1252(a)(1)(A), with respect to the 175 and 182 deductions
taken by the transferor, shall include the holding period of the
transferor. With respect to the 1975 and 182 deductions taken by the
transferee, the holding period shall not include the holding period of
the transferor.
(3) Examples. The provisions of subparagraphs (1) and (2) of this
paragraph may be illustrated by the following examples:
Example 1. Assume the same facts as in example (1) of paragraph
(a)(4) of this section. Therefore, on the date B receives the farm land
in the gift transaction, under subparagraph (1) of this paragraph the
aggregate of the deductions allowed under sections 175 and 182 in
respect of the farm land in the hands of B is the amount in the hands of
A, $24,000, and for purposes of applying section 1252 upon a subsequent
disposition by B (including a computation of the applicable percentage)
the holding period of B includes the holding period of A.
Example 2. Assume the same facts as in example (2) of paragraph
(a)(4) of this section. Under subparagraph (2) of this paragraph, the
aggregate of the sections 175 and 182 deductions which pass over to B
for purposes of section 1252 is $14,000 ($24,000 deductions allowable
under sections 175 and 182 minus $3,000 gain recognized under section
1251(c) in accordance with example (2) of paragraph (a)(4) of Sec.
1.1251-4, minus $7,000 gain recognized under section 1252(a) in
acordance with example (2) of paragraph (a)(4) of this section), B's
holding period includes the holding period of A (i.e., the period back
to January 15, 1971) with respect to A's deductions.
(g) Disposition of farm land not specifically covered. If farm land
is disposed of in a transaction not specifically covered under Sec.
1.1252-1 and this section, then the principles of section 1245 shall
apply.
[T.D. 7418, 41 FR 18832, May 7, 1976; 41 FR 23669, June 11, 1976]
Sec. 1.1254-0 Table of contents for section 1254 recapture rules.
This section lists the major captions contained in Sec. Sec.
1.1254-1 through 1.1254-6.
Sec. 1.1254-1 Treatment of gain from disposition of natural resource
recapture property.
(a) In general.
(b) Definitions.
(1) Section 1254 costs.
(2) Natural resource recapture property.
(3) Disposition.
(c) Disposition of a portion of natural resource recapture property.
(1) Disposition of a portion (other than an undivided interest) of
natural resource recapture property.
(2) Disposition of an undivided interest.
(3) Alternative allocation rule.
(d) Installment method.
Sec. 1.1254-2 Exceptions and limitations.
(a) Exception for gifts and section 1041 transfers.
(1) General rule.
(2) Part gift transactions.
(b) Exception for transfers at death.
(c) Limitation for certain tax-free transactions.
(1) General rule.
(2) Special rule for dispositions to certain tax exempt
organizations.
(3) Transfers described.
(4) Special rules for section 332 transfers.
(d) Limitation for like kind exchanges and involuntary conversions.
(1) General rule.
[[Page 519]]
(2) Disposition and acquisition of both natural resource recapture
property and other property.
Sec. 1.1254-3 Section 1254 costs immediately after certain
acquisitions.
(a) Transactions in which basis is determined by reference to cost
or fair market value of property transferred.
(1) Basis determined under section 1012.
(2) Basis determined under section 301(d), 334(a), or 358(a)(2).
(3) Basis determined solely under former section 334(b)(2) or former
section 334(c).
(4) Basis determined by reason of the application of section
1014(a).
(b) Gifts and certain tax-free transactions.
(1) General rule.
(2) Transactions covered.
(c) Certain transfers at death.
(d) Property received in a like kind exchange or involuntary
conversion.
(1) General rule.
(2) Allocation of section 1254 costs among multiple natural resource
recapture property acquired.
(e) Property transferred in cases to which section 1071 or 1081(b)
applies.
Sec. 1.1254-4 Special rules for S corporations and their shareholders.
(a) In general.
(b) Determination of gain treated as ordinary income under section
1254 upon a disposition of natural resource recapture property by an S
corporation.
(1) General rule.
(2) Examples.
(c) Character of gain recognized by a shareholder upon a sale or
exchange of S corporation stock.
(1) General rule.
(2) Exceptions.
(3) Examples.
(d) Section 1254 costs of a shareholder.
(e) Section 1254 costs of an acquiring shareholder after certain
acquisitions.
(1) Basis determined under section 1012.
(2) Basis determined under section 1014(a).
(3) Basis determined under section 1014(b)(9).
(4) Gifts and section 1041 transfers.
(f) Special rules for a corporation that was formerly an S
corporation or formerly a C corporation.
(1) Section 1254 costs of an S corporation that was formerly a C
corporation.
(2) Examples.
(3) Section 1254 costs of a C corporation that was formerly an S
corporation.
(g) Determination of a shareholder's section 1254 costs upon certain
stock transactions
(1) Issuance of stock.
(2) Natural resource recapture property acquired in exchange for
stock.
(3) Treatment of nonvested stock.
(4) Exception.
(5) Aggregate of S corporation shareholders' section 1254 costs with
respect to natural resource recapture property held by the S corporation
(6) Examples.
Sec. 1.1254-5 Special rules for partnerships and their partners.
(a) In general.
(b) Determination of gain treated as ordinary income under section
1254 upon the disposition of natural resource recapture property by a
partnership.
(1) General rule.
(2) Exception to partner level recapture in the case of abusive
allocations.
(3) Examples.
(c) Section 1254 costs of a partner.
(1) General rule.
(2) Section 1254 costs of a transferee partner after certain
acquisitions.
(d) Property distributed to a partner.
(1) In general.
(2) Aggregate of partners' section 1254 costs with respect to
natural resource recapture property held by a partnership.
Sec. 1.1254-6 Effective date of regulations.
[T.D. 8586, 60 FR 2501, Jan. 10, 1995, as amended by T.D. 8684, 61 FR
53063, Oct. 10, 1996]
Sec. 1.1254-1 Treatment of gain from disposition of natural resource
recapture property.
(a) In general. Upon any disposition of section 1254 property or any
disposition after December 31, 1975 of oil, gas, or geothermal property,
gain is treated as ordinary income in an amount equal to the lesser of
the amount of the section 1254 costs (as defined in paragraph (b)(1) of
this section) with respect to the property, or the amount, if any, by
which the amount realized on the sale, exchange, or involuntary
conversion, or the fair market value of the property on any other
disposition, exceeds the adjusted basis of the property. However, any
amount treated as ordinary income under the preceding sentence is not
included in the taxpayer's gross income from the property for purposes
of section 613. Generally, the lesser of the amounts described in this
paragraph (a) is treated as ordinary income even though, in the absence
of section 1254(a), no gain would be recognized upon the disposition
under any other provision of the Internal Revenue Code. For the
definition of the term
[[Page 520]]
section 1254 costs, see paragraph (b)(1) of this section. For the
definition of the terms section 1254 property, oil, gas, or geothermal
property, and natural resource recapture property, see paragraph (b)(2)
of this section. For rules relating to the disposition of natural
resource recapture property, see paragraphs (b)(3), (c), and (d) of this
section. For exceptions and limitations to the application of section
1254(a), see Sec. 1.1254-2.
(b) Definitions--(1) Section 1254 costs--(i) Property placed in
service after December 31, 1986. With respect to any property placed in
service by the taxpayer after December 31, 1986, the term section 1254
costs means--
(A) The aggregate amount of expenditures that have been deducted by
the taxpayer or any person under section 263, 616, or 617 with respect
to such property and that, but for the deduction, would have been
included in the adjusted basis of the property or in the adjusted basis
of certain depreciable property associated with the property; and
(B) The deductions for depletion under section 611 that reduced the
adjusted basis of the property.
(ii) Property placed in service before January 1, 1987. With respect
to any property placed in service by the taxpayer before January 1,
1987, the term section 1254 costs means--
(A) The aggregate amount of costs paid or incurred after December
31, 1975, with respect to such property, that have been deducted as
intangible drilling and development costs under section 263(c) by the
taxpayer or any other person (except that section 1254 costs do not
include costs incurred with respect to geothermal wells commenced before
October 1, 1978) and that, but for the deduction, would be reflected in
the adjusted basis of the property or in the adjusted basis of certain
depreciable property associated with the property; reduced by
(B) The amount (if any) by which the deduction for depletion allowed
under section 611 that was computed either under section 612 or sections
613 and 613A, with respect to the property, would have been increased if
the costs (paid or incurred after December 31, 1975) had been charged to
capital account rather than deducted.
(iii) Deductions under section 59 and section 291. Amounts
capitalized pursuant to an election under section 59(e) or pursuant to
section 291(b) are treated as section 1254 costs in the year in which an
amortization deduction is claimed under section 59(e)(1) or section
291(b)(2).
(iv) Suspended deductions. If a deduction of a section 1254 cost has
been suspended as of the date of disposition of section 1254 property,
the deduction is not treated as a section 1254 cost if it is included in
basis for determining gain or loss on the disposition. On the other
hand, if the deduction will eventually be claimed, it is a section 1254
cost as of the date of disposition. For example, a deduction suspended
pursuant to the 65 percent of taxable income limitation of section
613A(d)(1) may either be included in basis upon disposition of the
property or may be deducted in a year after the year of disposition. See
Sec. 1.613A-4(a)(1). If it is included in the basis then it is not a
section 1254 cost, but if it is deductible in a later year it is a
section 1254 cost as of the date of the disposition.
(v) Previously recaptured amounts. If an amount has been previously
treated as ordinary income pursuant to section 1254, it is not a section
1254 cost.
(vi) Nonproductive wells. The aggregate amount of section 1254 costs
paid or incurred on any property includes the amount of intangible
drilling and development costs incurred on nonproductive wells, but only
to the extent that the taxpayer recognizes income on the foreclosure of
a nonrecourse debt the proceeds from which were used to finance the
section 1254 costs with respect to the property. For this purpose, the
term nonproductive well means a well that does not produce oil or gas in
commercial quantities, including a well that is drilled for the purpose
of ascertaining the existence, location, or extent of an oil or gas
reservoir (e.g., a delineation well). The term nonproductive well does
not include an injection well (other than an injection well drilled as
part of a project that does not result in production in commercial
quantities).
[[Page 521]]
(vii) Calculation of amount described in paragraph (b)(1)(ii)(B) of
this section (hypothetical depletion offset)--(A) In general. In
calculating the amount described in paragraph (b)(1)(ii)(B) of this
section, the taxpayer shall apply the following rules. The taxpayer may
use the 65-percent-of-taxable-income limitation of section 613A(d)(1).
If the taxpayer uses that limitation, the taxpayer is not required to
recalculate the effect of such limitation with respect to any property
not disposed of. That is, the taxpayer may assume that the hypothetical
capitalization of intangible drilling and development costs with respect
to any property disposed of does not affect the allowable depletion with
respect to property retained by the taxpayer. Any intangible drilling
and development costs that, if they had not been treated as expenses
under section 263(c), would have properly been capitalized under Sec.
1.612-4(b)(2) (relating to items recoverable through depreciation under
section 167 or cost recovery under section 168) are treated as costs
described in Sec. 1.612-4(b)(1) (relating to items recoverable through
depletion). The increase in depletion attributable to the capitalization
of intangible drilling and development costs is computed by subtracting
the amount of cost or percentage depletion actually claimed from the
amount of cost or percentage depletion that would have been allowable if
intangible drilling and development costs had been capitalized. If the
remainder is zero or less than zero, the entire amount of intangible
drilling and development costs attributable to the property is
recapturable.
(B) Example. The following example illustrates the principles of
paragraph (b)(1)(vii)(A).
Example: Hypothetical depletion offset. In 1976, A purchased
undeveloped property for $10,000. During 1977, A incurred $200,000 of
productive well intangible drilling and development costs with respect
to the property. A deducted the intangible drilling and development
costs as expenses under section 263(c). Estimated reserves of 150,000
barrels of recoverable oil were discovered in 1977 and production began
in 1978. In 1978, A produced and sold 30,000 barrels of oil at $8 per
barrel, resulting in $240,000 of gross income. A had no other oil or gas
production in 1978. A claimed a percentage depletion deduction of
$52,800 (i.e., 22% of $240,000 gross income from the property). If A had
capitalized the intangible drilling and development costs, assume that
$200,000 of the costs would have been allocated to the depletable
property and none to depreciable property. A's cost depletion deduction
if the intangible drilling and development costs had been capitalized
would have been $42,000 (i.e., (($200,000 intangible drilling and
development costs + $10,000 acquisition costs) x 30,000 barrels of
production)/ 150,000 barrels of estimated recoverable reserves). Since
this amount is less than A's depletion deduction of $52,800 (percentage
depletion), no reduction is made to the amount of intangible drilling
and development costs ($200,000). On January 1, 1979, A sold the oil
property to B for $360,000 and calculated section 1254 recapture without
reference to the 65-percent-of-taxable-income limitation. A's gain on
the sale is the entire $360,000, because A's basis in the property at
the beginning of 1979 is zero (i.e., $10,000 cost less $52,800 depletion
deduction for 1978). Since the section 1254 costs ($200,000) are less
than A's gain on the sale, $200,000 is treated as ordinary income under
section 1254(a). The remaining amount of A's gain ($160,000) is not
subject to section 1254(a).
(2) Natural resource recapture property--(i) In general. The term
natural resource recapture property means section 1254 property or oil,
gas, or geothermal property as those terms are defined in this section.
(ii) Section 1254 property. The term section 1254 property means any
property (within the meaning of section 614) that is placed in service
by the taxpayer after December 31, 1986, if any expenditures described
in paragraph (b)(1)(i)(A) of this section (relating to costs under
section 263, 616, or 617) are properly chargeable to such property, or
if the adjusted basis of such property includes adjustments for
deductions for depletion under section 611.
(iii) Oil, gas, or geothermal property. The term oil, gas, or
geothermal property means any property (within the meaning of section
614) that was placed in service by the taxpayer before January 1, 1987,
if any expenditures described in paragraph (b)(1)(ii)(A) of this section
are properly chargeable to such property.
(iv) Property to which section 1254 costs are properly chargeable.
(A) An expenditure is properly chargeable to property if--
[[Page 522]]
(1) The property is an operating mineral interest with respect to
which the expenditure has been deducted;
(2) The property is a nonoperating mineral interest (e.g., a net
profits interest or an overriding royalty interest) burdening an
operating mineral interest if the nonoperating mineral interest is
carved out of an operating mineral interest described in paragraph
(b)(2)(iv)(A)(1) of this section;
(3) The property is a nonoperating mineral interest retained by a
lessor or sublessor if such lessor or sublessor held, prior to the lease
or sublease, an operating mineral interest described in paragraph
(b)(2)(iv)(A)(1) of this section; or
(4) The property is an operating or a nonoperating mineral interest
held by a taxpayer if a party related to the taxpayer (within the
meaning of section 267(b) or section 707(b)) held an operating mineral
interest (described in paragraph (b)(2)(iv)(A)(1) of this section) in
the same tract or parcel of land that terminated (in whole or in part)
without being disposed of (e.g., a working interest which terminated
after a specified period of time or a given amount of production), but
only if there exists between the related parties an arrangement or plan
to avoid recapture under section 1254. In such a case, the taxpayer's
section 1254 costs with respect to the property include those of the
related party.
(B) Example. The following example illustrates the provisions of
paragraph (2)(iv)(A)(4) of this section:
Example: Arrangement or plan to avoid recapture. C, an individual,
owns 100% of the stock of both X Co. and Y Co. On January 1, 1998, X Co.
enters into a standard oil and gas lease. X Co. immediately assigns to Y
Co. 1% of the working interest for one year, and 99% of the working
interest thereafter. In 1998, X Co. and Y Co. expend $300 in intangible
drilling and development costs developing the tract, of which $297 are
deducted by X Co. under section 263(c). On January 1, 1999, Y Co. sells
its 99% share of the working interest to an unrelated person. Based on
all the facts and circumstances, the arrangement between X Co. and Y Co.
is part of a plan or arrangement to avoid recapture under section 1254.
Therefore, Y Co. must include in its section 1254 costs the $297 of
intangible drilling and development costs deducted by X Co.
(v) Property the basis of which includes adjustments for depletion
deductions. The adjusted basis of property includes adjustments for
depletion under section 611 if--
(A) The basis of the property has been reduced by reason of
depletion deductions; or
(B) The property has been carved out of or is a portion of property
the basis of which has been reduced by reason of depletion deductions.
(vi) Property held by a transferee. Property held by a transferee is
natural resource recapture property if the property was natural resource
recapture property in the hands of the transferor and the transferee's
basis in the property is determined with reference to the transferor's
basis in the property (e.g., a gift) or is determined under section 732.
(vii) Property held by a transferor. Property held by a transferor
of natural resource recapture property is natural resource recapture
property if the transferor's basis in the property received is
determined with reference to the transferor's basis in the property
transferred by the transferor (e.g., a like kind exchange). For purposes
of this paragraph (b)(2), property described in this paragraph
(b)(2)(vii) is treated as placed in service at the time the property
transferred by the transferor was placed in service by the transferor.
(3) Disposition--(i) General rule. The term disposition has the same
meaning as in section 1245, relating to gain from dispositions of
certain depreciable property.
(ii) Exceptions. The term disposition does not include--
(A) Any transaction that is merely a financing device, such as a
mortgage or a production payment that is treated as a loan under section
636 and the regulations thereunder;
(B) Any abandonment (except that an abandonment is a disposition to
the extent the taxpayer recognizes income on the foreclosure of a
nonrecourse debt);
(C) Any creation of a lease or sublease of natural resource
recapture property;
(D) Any termination or election of the status of an S corporation;
[[Page 523]]
(E) Any unitization or pooling arrangement;
(F) Any expiration or reversion of an operating mineral interest
that expires or reverts by its own terms, in whole or in part; or
(G) Any conversion of an overriding royalty interest that, at the
option of the grantor or successor in interest, converts to an operating
mineral interest after a certain amount of production.
(iii) Special rule for carrying arrangements. In a carrying
arrangement, liability for section 1254 costs attributable to the entire
operating mineral interest held by the carrying party prior to reversion
or conversion remains attributable to the reduced operating mineral
interest retained by the carrying party after a portion of the operating
mineral interest has reverted to the carried party or after the
conversion of an overriding royalty interest that, at the option of the
grantor or successor in interest, converts to an operating mineral
interest after a certain amount of production.
(c) Disposition of a portion of natural resource recapture
property--(1) Disposition of a portion (other than an undivided
interest) of natural resource recapture property--(i) Natural resource
recapture property subject to the general rules of Sec. 1.1254-1. For
purposes of section 1254(a)(1) and paragraph (a) of this section, except
as provided in paragraphs (c) (1)(ii) and (3) of this section, in the
case of the disposition of a portion (that is not an undivided interest)
of natural resource recapture property, the entire amount of the section
1254 costs with respect to the natural resource recapture property is
treated as allocable to that portion of the property to the extent of
the amount of gain to which section 1254(a)(1) applies. If the amount of
the gain to which section 1254(a)(1) applies is less than the amount of
the section 1254 costs with respect to the natural resource recapture
property, the balance of the section 1254 costs remaining after
allocation to the portion of the property that was disposed of remains
subject to recapture by the taxpayer under section 1254(a)(1) upon
disposition of the remaining portion of the property. For example,
assume that A owns an 80-acre tract of land with respect to which A has
deducted intangible drilling and development costs under section 263(c).
If A sells the north 40 acres, the entire amount of the section 1254
costs with respect to the 80-acre tract is treated as allocable to the
40-acre portion sold (to the extent of the amount of gain to which
section 1254(a)(1) applies).
(ii) Natural resource recapture property subject to the exceptions
and limitations of Sec. 1.1254-2. For purposes of section 1254(a)(1)
and paragraph (a) of this section, except as provided in paragraph
(b)(3) of this section, in the case of the disposition of a portion
(that is not an undivided interest) of natural resource recapture
property to which section 1254(a)(1) does not apply by reason of the
application of Sec. 1.1254-2 (certain nonrecognition transactions), the
following rule for allocation of costs applies. An amount of the section
1254 costs that bears the same ratio to the entire amount of such costs
with respect to the entire natural resource recapture property as the
value of the property transferred bears to the value of the entire
natural resource recapture property is treated as allocable to the
portion of the natural resource recapture property transferred. The
balance of the section 1254 costs remaining after allocation to that
portion of the transferred property remains subject to recapture by the
taxpayer under section 1254(a)(1) upon disposition of the remaining
portion of the property. For example, assume that A owns an 80-acre
tract of land with respect to which A has deducted intangible drilling
and development costs under section 263(c). If A gives away the north 40
acres, and if 60 percent of the value of the 80-acre tract were
attributable to the north 40 acres given away, 60 percent of the section
1254 costs with respect to the 80-acre tract is allocable to the north
40 acres given away.
(2) Disposition of an undivided interest--(i) Natural resource
recapture property subject to the general rules of Sec. 1.1254-1. For
purposes of section 1254(a)(1), except as provided in paragraphs
(b)(2)(ii) and (b)(3) of this section, in the case of the disposition of
an undivided interest in natural resource recapture property (or a
portion thereof), a proportionate part of the
[[Page 524]]
section 1254 costs with respect to the natural resource recapture
property is treated as allocable to the transferred undivided interest
to the extent of the amount of gain to which section 1254(a)(1) applies.
For example, assume that A owns an 80-acre tract of land with respect to
which A has deducted intangible drilling and development costs under
section 263(c). If A sells an undivided 40 percent interest in the 80-
acre tract, 40 percent of the section 1254 costs with respect to the 80-
acre tract is allocable to the transferred 40 percent interest in the
80-acre tract. However, if the amount of gain recognized on the sale of
the 40 percent undivided interest were equal to only 35 percent of the
amount of section 1254 costs attributable to the 80-acre tract, only 35
percent of the section 1254 costs would be treated as attributable to
the undivided 40 percent interest. See paragraph (c)(3) of this section
for an alternative allocation rule.
(ii) Natural resource recapture property subject to the exceptions
and limitations of Sec. 1.1254-2. For purposes of section 1254(a)(1)
and paragraph (a) of this section, except as provided in paragraph
(b)(3) of this section, in the case of a disposition of an undivided
interest in natural resource recapture property (or a portion thereof)
to which section 1254 (a)(1) does not apply by reason of Sec. 1.1254-2,
a proportionate part of the section 1254 costs with respect to the
natural resource recapture property is treated as allocable to the
transferred undivided interest. See paragraph (c)(3) of this section for
an alternative allocation rule.
(3) Alternative allocation rule--(i) In general. The rules for the
allocation of costs set forth in section 1254(a)(2) and paragraphs (c)
(1) and (2) of this section do not apply with respect to section 1254
costs that the taxpayer establishes to the satisfaction of the
Commissioner do not relate to the transferred property. Except as
provided in paragraphs (c)(3) (ii) and (iii) of this section, a taxpayer
may satisfy this requirement only by receiving a private letter ruling
from the Internal Revenue Service that the section 1254 costs do not
relate to the transferred property.
(ii) Portion of property. Upon the transfer of a portion of a
natural resource recapture property (other than an undivided interest)
with respect to which section 1254 costs have been incurred, a taxpayer
may treat section 1254 costs as not relating to the transferred portion
if the transferred portion does not include any part of any deposit with
respect to which the costs were incurred.
(iii) Undivided interest. Upon the transfer of an undivided interest
in a natural resource recapture property with respect to which section
1254 costs have been incurred, a taxpayer may treat costs as not
relating to the transferred interest if the undivided interest is an
undivided interest in a portion of the natural resource recapture
property, and the portion would be eligible for the alternative
allocation rule under paragraph (c)(3)(ii) of this section.
(iv) Substantiation. If a taxpayer treats section 1254 costs
incurred with respect to a natural resource recapture property as not
relating to a transferred interest in a portion of the property, the
taxpayer must indicate on his or her tax return that the costs do not
relate to the transferred portion and maintain the records and
supporting evidence that substantiate this position.
(d) Installment method. Gain from a disposition to which section
1254(a)(1) applies is reported on the installment method if that method
otherwise applies under section 453 or 453A of the Internal Revenue Code
and the regulations thereunder. The portion of each installment payment
as reported that represents income (other than interest) is treated as
gain to which section 1254(a)(1) applies until all of the gain (to which
section 1254(a)(1) applies) has been reported, and the remaining portion
(if any) of the income is then treated as gain to which section
1254(a)(1) does not apply. For treatment of amounts as interest on
certain deferred payments, see sections 483, 1274, and the regulations
thereunder.
[T.D. 8586, 60 FR 2502, Jan. 10, 1995]
Sec. 1.1254-2 Exceptions and limitations.
(a) Exception for gifts and section 1041 transfers--(1) General
rule. No gain is recognized under section 1254(a)(1) upon
[[Page 525]]
a disposition of natural resource recapture property by a gift or by a
transfer in which no gain or loss is recognized pursuant to section 1041
(relating to transfers between spouses). For purposes of this paragraph
(a), the term gift means, except to the extent that paragraph (a)(2) of
this section applies, a transfer of natural resource recapture property
that, in the hands of the transferee, has a basis determined under the
provisions of section 1015(a) or 1015(d) (relating to basis of property
acquired by gift) or section 1022 (relating to the basis of property
acquired from certain decedents who died in 2010). For rules concerning
the potential reduction in the amount of the charitable contribution in
the case of natural resource recapture property, see section 170(e) and
Sec. 1.170A-4. See Sec. 1.1254-3(b)(1) for determination of potential
recapture of section 1254 costs on property acquired by gift. See Sec.
1.1254-1 (c)(1)(ii) and (c)(2)(ii) for apportionment of section 1254
costs on a gift of a portion of natural resource recapture property.
(2) Part gift transactions. If a disposition of natural resource
recapture property is in part a sale or exchange and in part a gift, the
gain that is treated as ordinary income pursuant to section 1254(a)(1)
is the lower of the section 1254 costs with respect to the property or
the excess of the amount realized upon the disposition of the property
over the adjusted basis of the property. In the case of a transfer
subject to section 1011(b) (relating to bargain sales to charitable
organizations), the adjusted basis for purposes of the preceding
sentence is the adjusted basis for determining gain or loss under
section 1011(b).
(b) Exception for transfers at death. Except as provided in section
691 (relating to income in respect of a decedent), no gain is recognized
under section 1254(a)(1) upon a transfer at death. For purposes of this
paragraph, the term transfer at death means a transfer of natural
resource recapture property that, in the hands of the transferee, has a
basis determined under the provisions of section 1014(a) (relating to
basis of property acquired from a decedent) because of the death of the
transferor. See Sec. 1.1254-3 (a)(4) and (c) for the determination of
potential recapture of section 1254 costs on property acquired in a
transfer at death.
(c) Limitation for certain tax-free transactions--(1) General rule.
Upon a transfer of property described in paragraph (c)(3) of this
section, the amount of gain treated as ordinary income by the transferor
under section 1254(a)(1) may not exceed the amount of gain recognized to
the transferor on the transfer (determined without regard to section
1254). In the case of a transfer of both natural resource recapture
property and property that is not natural resource recapture property in
one transaction, the amount realized from the disposition of the natural
resource recapture property is deemed to be equal to the amount that
bears the same ratio to the total amount realized as the fair market
value of the natural resource recapture property bears to the aggregate
fair market value of all the property transferred. The preceding
sentence is applied solely for purposes of computing the portion of the
total gain (determined without regard to section 1254) that may be
recognized as ordinary income under section 1254(a)(1).
(2) Special rule for dispositions to certain tax-exempt
organizations. Paragraph (c)(1) of this section does not apply to a
disposition of natural resource recapture property to an organization
(other than a cooperative described in section 521) that is exempt from
the tax imposed by chapter I of the Internal Revenue Code. The preceding
sentence does not apply to a disposition of natural resource recapture
property to an organization described in section 511 (a)(2) or (b)(2)
(relating to imposition of tax on unrelated business income of
charitable, etc., organizations) if, immediately after the disposition,
the organization uses the property in an unrelated trade or business as
defined in section 513. If any property with respect to which gain is
not recognized by reason of the exception of this paragraph (c)(2)
ceases to be used in an unrelated trade or business of the organization
acquiring the property, that organization is, for purposes of section
1254, treated as having disposed of the property on the date of the
cessation.
[[Page 526]]
(3) Transfers described. The transfers referred to in paragraph
(c)(1) of this section are transfers of natural resource recapture
property in which the basis of the natural resource recapture property
in the hands of the transferee is determined by reference to its basis
in the hands of the transferor by reason of the application of any of
the following provisions:
(i) Section 332 (relating to certain liquidations of subsidiaries).
See paragraph (c)(4) of this section.
(ii) Section 351 (relating to transfer to a corporation controlled
by transferor).
(iii) Section 361 (relating to exchanges pursuant to certain
corporate reorganizations).
(iv) Section 721 (relating to transfers to a partnership in exchange
for a partnership interest).
(v) Section 731 (relating to distributions by a partnership to a
partner). For purposes of this paragraph, the basis of natural resource
recapture property distributed by a partnership to a partner is deemed
to be determined by reference to the adjusted basis of such property to
the partnership.
(4) Special rules for section 332 transfers. In the case of a
distribution in complete liquidation of a subsidiary to which section
332 applies, the limitation provided in this paragraph (c) is confined
to instances in which the basis of the natural resource recapture
property in the hands of the transferee is determined, under section
334(b)(1), by reference to its basis in the hands of the transferor.
Thus, for example, the limitation may apply in respect of a liquidating
distribution of natural resource recapture property by a subsidiary
corporation to the parent corporation, but does not apply in respect of
a liquidating distribution of natural resource recapture property to a
minority shareholder. This paragraph (c) does not apply to a liquidating
distribution of natural resource recapture property by a subsidiary to
its parent if the parent's basis for the property is determined under
section 334(b)(2) (as in effect before enactment of the Tax Reform Act
of 1986), by reference to its basis for the stock of the subsidiary.
This paragraph (c) does not apply to a liquidating distribution under
section 332 of natural resource recapture property by a subsidiary to
its parent if gain is recognized and there is a corresponding increase
in the parent's basis in the property (e.g., certain distributions to a
tax-exempt or foreign corporation).
(d) Limitation for like kind exchanges and involuntary conversions--
(1) General rule. If natural resource recapture property is disposed of
and gain (determined without regard to section 1254) is not recognized
in whole or in part under section 1031 (relating to like kind exchanges)
or section 1033 (relating to involuntary conversions), the amount of
gain taken into account by the transferor under section 1254(a)(1) may
not exceed the sum of--
(i) The amount of gain recognized on the disposition (determined
without regard to section 1254); plus
(ii) The fair market value of property acquired that is not natural
resource recapture property (determined without regard to Sec. 1.1254-
1(b)(2)(vii)) and is not taken into account under paragraph (d)(1)(i) of
this section (that is, qualifying property under section 1031 or 1033
that is not natural resource recapture property).
(2) Disposition and acquisition of both natural resource recapture
property and other property. For purposes of this paragraph (d), if both
natural resource recapture property and property that is not natural
resource recapture property are acquired as the result of one
disposition in which both natural resource recapture property and
property that is not natural resource recapture property are disposed
of--
(i) The total amount realized upon the disposition is allocated
between the natural resource recapture property and the property that is
not natural resource recapture property disposed of in proportion to
their respective fair market values;
(ii) The amount realized upon the disposition of the natural
resource recapture property is deemed to consist of so much of the fair
market value of the natural resource recapture property acquired as is
not in excess of the amount realized from the natural resource recapture
property disposed of, and the remaining portion (if any) of the
[[Page 527]]
amount realized upon the disposition of such property is deemed to
consist of so much of the fair market value of the property that is not
natural resource recapture property acquired as is not in excess of the
remaining portion; and
(iii) The amount realized upon the disposition of the property that
is not natural resource recapture property is deemed to consist of so
much of the fair market value of all the property acquired which was not
taken into account under paragraph (d)(2)(ii) of this section. Except as
provided in section 1060 and the regulations thereunder, if a buyer and
seller have adverse interests as to such allocation of the amount
realized, any arm's-length agreement between the buyer and seller is
used to establish the allocation. In the absence of such an agreement,
the allocation is made by taking into account the appropriate facts and
circumstances.
[T.D. 8586, 60 FR 2505, Jan. 10, 1995, as amended by T.D. 8684, 61 FR
53063, Oct. 10, 1996; T.D. 9811, 82 FR 6241, Jan. 19, 2017]
Sec. 1.1254-3 Section 1254 costs immediately after certain
acquisitions.
(a) Transactions in which basis is determined by reference to cost
or fair market value of property transferred--(1) Basis determined under
section 1012. If, on the date a person acquires natural resource
recapture property, the person's basis for the property is determined
solely by reference to its cost (within the meaning of section 1012),
the amount of section 1254 costs with respect to the natural resource
recapture property in the person's hands is zero on the acquisition
date.
(2) Basis determined under section 301(d), 334(a), or 358(a)(2). If,
on the date a person acquires natural resource recapture property, the
person's basis for the property is determined solely by reason of the
application of section 301(d) (relating to basis of property received in
a corporate distribution), section 334(a) (relating to basis of property
received in a liquidation in which gain or loss is recognized), or
section 358(a)(2) (relating to basis of other property received in
certain exchanges), the amount of the section 1254 costs with respect to
the natural resource recapture property in the person's hands is zero on
the acquisition date.
(3) Basis determined solely under former section 334(b)(2) or former
section 334(c). If, on the date a person acquires natural resource
recapture property, the person's basis for the property is determined
solely under the provisions of section 334(b)(2) (prior to amendment of
that section by the Tax Equity and Fiscal Responsibility Act of 1982) or
(c) (prior to repeal of that section by the Tax Reform Act of 1986)
(relating to basis of property received in certain corporate
liquidations), the amount of section 1254 costs with respect to the
natural resource recapture property in the person's hands is zero on the
acquisition date.
(4) Basis determined by reason of the application of section
1014(a). If, on the date a person acquires natural resource recapture
property from a decedent, the person's basis is determined, by reason of
the application of section 1014(a), solely by reference to the fair
market value of the property on the date of the decedent's death or on
the applicable date provided in section 2032 (relating to alternate
valuation date), the amount of section 1254 costs with respect to the
natural resource recapture property in the person's hands is zero on the
acquisition date. See paragraph (c) of this section for the treatment of
certain transfers at death.
(b) Gifts and certain tax-free transactions--(1) General rule. If
natural resource recapture property is transferred in a transaction
described in paragraph (b)(2) of this section, the amount of section
1254 costs with respect to the natural resource recapture property in
the hands of the transferee immediately after the disposition is an
amount equal to--
(i) The amount of section 1254 costs with respect to the natural
resource recapture property in the hands of the transferor immediately
before the disposition (and in the case of an S corporation or
partnership transferor, the section 1254 costs of the shareholders or
partners with respect to the natural resource recapture property); minus
(ii) The amount of any gain taken into account as ordinary income
under section 1254(a)(1) by the transferor upon the disposition (and in
the case of
[[Page 528]]
an S corporation or partnership transferor, any such gain taken into
account as ordinary income by the shareholders or partners).
(2) Transactions covered. The transactions to which paragraph (b)(1)
of this section apply are--
(i) A disposition that is a gift or in part a sale or exchange and
in part a gift;
(ii) A transaction described in section 1041(a);
(iii) A disposition described in Sec. 1.1254-2(c)(3) (relating to
certain tax-free transactions); or
(iv) A transfer at death where basis of property in the hands of the
transferee is determined under section 1022.
(c) Certain transfers at death. If natural resource recapture
property is acquired in a transfer at death, the amount of section 1254
costs with respect to the natural resource recapture property in the
hands of the transferee immediately after the transfer includes the
amount, if any, of the section 1254 costs deducted by the transferee
before the decedent's death, to the extent that the basis of the natural
resource recapture property (determined under section 1014(a)) is
required to be reduced under the second sentence of section 1014(b)(9)
(relating to adjustments to basis where the property is acquired from a
decedent prior to death).
(d) Property received in a like kind exchange or involuntary
conversion--(1) General rule. If natural resource recapture property is
disposed of in a like kind exchange under section 1031 or involuntary
conversion under section 1033, then immediately after the disposition
the amount of section 1254 costs with respect to any natural resource
recapture property acquired for the property transferred is an amount
equal to--
(i) The amount of section 1254 costs with respect to the natural
resource recapture property disposed of (including the section 1254
costs of the shareholders of an S corporation or of the partners of a
partnership with respect to the natural resource recapture property);
minus
(ii) The amount of any gain taken into account as ordinary income
under section 1254(a)(1) by the transferor upon the disposition (and in
the case of an S corporation or partnership transferor, any such gain
taken into account as ordinary income by the shareholders or partners).
(2) Allocation of section 1254 costs among multiple natural resource
recapture properties acquired. If more than one parcel of natural
resource recapture property is acquired at the same time from the same
person in a transaction referred to in paragraph (d)(1) of this section,
the total amount of section 1254 costs with respect to the parcels is
allocated to the parcels in proportion to their respective adjusted
bases.
(e) Property transferred in cases to which section 1071 or 1081(b)
applies. Rules similar to the rules of section 1245(b)(5) shall apply
under section 1254.
[T.D. 8586, 60 FR 2506, Jan. 10, 1995, as amended by T.D. 8684, 61 FR
53063, Oct. 10, 1996; T.D. 9811, 82 FR 6242, Jan. 19, 2017]
Sec. 1.1254-4 Special rules for S corporations and their shareholders.
(a) In general. This section provides rules for applying the
provisions of section 1254 to S corporations and their shareholders upon
the disposition by an S corporation (and a corporation that was formerly
an S corporation) of natural resource recapture property and upon the
disposition by a shareholder of stock of an S corporation that holds
natural resource recapture property.
(b) Determination of gain treated as ordinary income under section
1254 upon a disposition of natural resource recapture property by an S
corporation--(1) General rule. Upon a disposition of natural resource
recapture property by an S corporation, the amount of gain treated as
ordinary income under section 1254 is determined at the shareholder
level. Each shareholder must recognize as ordinary income under section
1254 the lesser of--
(i) The shareholder's section 1254 costs with respect to the
property disposed of; or
(ii) The shareholder's share of the amount, if any, by which the
amount realized on the sale, exchange, or involuntary conversion, or the
fair market value of the property upon any other disposition (including
a distribution),
[[Page 529]]
exceeds the adjusted basis of the property.
(2) Examples. The following examples illustrate the provisions of
paragraph (b)(1) of this section:
Example 1. Disposition of natural resource recapture property other
than oil and gas property. A and B are equal shareholders in X, an S
corporation. On January 1, 1997, X acquires for $90,000 an undeveloped
mineral property, its sole property. During 1997, X expends and deducts
$100,000 in developing the property. On January 15, 1998, X sells the
property for $250,000 when X's basis in the property is $90,000. Thus, X
recognizes gain of $160,000 on the sale. A and B's share of the $160,000
gain recognized is $80,000 each. Each shareholder has $50,000 of section
1254 costs with respect to the property. Under these circumstances, A
and B each are required to recognize $50,000 of the $80,000 of gain on
the sale of the property as ordinary income under section 1254.
Example 2. Disposition of oil and gas property the adjusted basis of
which is allocated to the shareholders under section 613A(c)(11). C and
D are equal shareholders in Y, an S corporation. On January 1, 1997, Y
acquires for $150,000 an undeveloped oil and gas property, its sole
property. During 1997, Y expends in developing the property $40,000 in
intangible drilling costs which it elects to expense under section
263(c). On January 15, 1998, Y sells the property for $200,000. C and
D's share of the $200,000 amount realized on the sale is $100,000 each.
C and D each have a basis of $75,000 in the property and $20,000 of
section 1254 costs with respect to the property. Under these
circumstances, C and D each are required to recognize $20,000 of the
$25,000 gain on the sale of the property as ordinary income under
section 1254.
(c) Character of gain recognized by a shareholder upon a sale or
exchange of S corporation stock--(1) General rule. Except as provided in
paragraph (c)(2) of this section, if an S corporation shareholder
recognizes gain upon a sale or exchange of stock in the S corporation
(determined without regard to section 1254), the gain is treated as
ordinary income under section 1254 to the extent of the shareholder's
section 1254 costs (with respect to the shares sold or exchanged).
(2) Exceptions--(i) Gain not attributable to section 1254 costs--(A)
General rule. Paragraph (c)(1) of this section does not apply to any
portion of the gain recognized on the sale or exchange of the stock that
the taxpayer establishes is not attributable to section 1254 costs. The
portion of the gain recognized that is not attributable to section 1254
costs is that portion of the gain recognized that exceeds the amount of
ordinary income that the shareholder would have recognized under section
1254 (with respect to the shares sold or exchanged) if, immediately
prior to the sale or exchange of the stock, the corporation had sold at
fair market value all of the corporation's property the disposition of
which would result in the recognition by the shareholder of ordinary
income under section 1254.
(B) Substantiation. To establish that a portion of the gain
recognized is not attributable to a shareholder's section 1254 costs so
as to qualify for the exception contained in paragraph (c)(2)(i)(A) of
this section, the shareholder must attach to the shareholder's tax
return a statement detailing the shareholder's share of the fair market
value and basis, and the shareholder's section 1254 costs, for each of
the S corporation's natural resource recapture properties held
immediately before the sale or exchange of stock.
(ii) Transactions entered into as part of a plan to avoid
recognition of ordinary income under section 1254. In the case of a
contribution of property prior to a sale or exchange of stock pursuant
to a plan a principal purpose of which is to avoid recognition of
ordinary income under section 1254, paragraph (c)(1) of this section
does not apply. Instead, the amount recognized as ordinary income under
section 1254 is the amount of ordinary income the selling or exchanging
shareholder would have recognized under section 1254 (with respect to
the shares sold or exchanged) had the S corporation sold its natural
resource recapture property the disposition of which would have resulted
in the recognition of ordinary income under section 1254. The amount
recognized as ordinary income under the preceding sentence reduces the
amount realized on the sale or exchange of the stock.
This reduced amount realized is used in determining any gain or loss
on the sale or exchange.
(3) Examples. The following examples illustrate the provisions of
this paragraph (c):
[[Page 530]]
Example 1. Application of general rule upon a sale of S corporation
stock. C and D are equal shareholders in Y, an S corporation. As of
January 1, 1997, Y holds two mining properties: Blackacre, with an
adjusted basis of $5,000 and a fair market value of $35,000, and
Whiteacre, with an adjusted basis of $20,000 and a fair market value of
$15,000. Y also holds securities with a basis of $5,000 and a fair
market value of $10,000. On January 1, 1997, D sells 50 percent of D's Y
stock to E for $15,000. As of the date of the sale, D's adjusted basis
in the Y stock sold is $7,500, and D has $18,000 of section 1254 costs
with respect to Blackacre and $12,000 of section 1254 costs with respect
to Whiteacre. Under this paragraph (c), the gain recognized by D upon
the sale of Y stock is treated as ordinary income to the extent of D's
section 1254 costs with respect to the stock sold, unless D establishes
that a portion of such excess is not attributable to D's section 1254
costs. However, because D would recognize $7,500 in ordinary income
under section 1254 with respect to the stock sold if Y sold Blackacre
(the only asset the disposition of which would result in ordinary income
to D under section 1254), the $7,500 of gain recognized by D upon the
sale of D's Y stock is attributable to D's section 1254 costs.
Therefore, upon the sale of stock to E, D recognizes $7,500 of ordinary
income under this paragraph (c).
Example 2. Sale of S corporation stock where gain is not entirely
attributable to section 1254 costs. Assume the same facts as in Example
1, except that Blackacre has a fair market value of $25,000, and the
securities have a fair market value of $20,000. Immediately prior to the
sale of stock to E, if Y had sold Blackacre (its only asset the
disposition of which would result in the recognition of ordinary income
to D under section 1254), D would recognize $5,000 in ordinary income
with respect to the stock sold under section 1254. D attaches a
statement to D's tax return for 1997 detailing D's share of the fair
market values and bases, and D's section 1254 costs with respect to
Blackacre and Whiteacre. Therefore, upon the sale of stock to E, of the
$7,500 gain recognized by D, $5,000 is ordinary income under this
paragraph (c).
Example 3. Contribution of property prior to sale of S corporation
stock as part of a plan to avoid recognition of ordinary income under
section 1254. H owns all of the stock of Z, an S corporation. As of
January 1, 1997, H has $3,000 of section 1254 costs with respect to
property P, which is natural resource recapture property and Z's only
asset. Property P has an adjusted basis of $5,000 and a fair market
value of $8,000. H has a basis of $5,000 in Z stock, which has a fair
market value of $8,000. On January 1, 1997, H contributes securities to
Z which have a basis of $7,000 and a fair market value of $4,000. On
April 15, 1997, H sells all of the Z stock to J for $12,000. On that
date, H's adjusted basis in the Z stock is also $12,000. Based on all
the facts and circumstances, the sale of stock is part of a plan (along
with the contribution by H of the securities to Z) that has a principal
purpose to avoid recognition of ordinary income under section 1254.
Consequently, under paragraph (c)(2)(ii) of this section, H must
recognize $3,000 as ordinary income under section 1254, the amount of
ordinary income that H would recognize as ordinary income under section
1254 if property P were sold at fair market value. In addition, H
reduces the amount realized on the sale of the stock ($12,000) by
$3,000. As a result, H also recognizes a $3,000 capital loss on the sale
of the stock ($9,000 amount realized less $12,000 adjusted basis).
(d) Section 1254 costs of a shareholder. An S corporation
shareholder's section 1254 costs with respect to any natural resource
recapture property held by the corporation include all of the
shareholder's section 1254 costs with respect to the property in the
hands of the S corporation. See Sec. 1.1254-1(b)(1) for the definition
of section 1254 costs.
(e) Section 1254 costs of an acquiring shareholder after certain
acquisitions--(1) Basis determined under section 1012. If stock in an S
corporation that holds natural resource recapture property is acquired
and the acquiring shareholder's basis for the stock is determined solely
by reference to its cost (within the meaning of section 1012), the
amount of section 1254 costs with respect to the property held by the
corporation in the acquiring shareholder's hands is zero on the
acquisition date.
(2) Basis determined under section 1014(a). If stock in an S
corporation that holds natural resource recapture property is acquired
from a decedent and the acquiring shareholder's basis is determined, by
reason of the application of section 1014(a), solely by reference to the
fair market value of the stock on the date of the decedent's death or on
the applicable date provided in section 2032 (relating to alternate
valuation date), the amount of section 1254 costs with respect to the
property held by the corporation in the acquiring shareholder's hands is
zero on the acquisition date.
(3) Basis determined under section 1014(b)(9). If stock in an S
corporation that holds natural resource recapture property is acquired
before the death of the decedent, the amount of section 1254 costs with
respect to the property
[[Page 531]]
held by the corporation in the acquiring shareholder's hands includes
the amount, if any, of the section 1254 costs deducted by the acquiring
shareholder before the decedent's death, to the extent that the basis of
the stock (determined under section 1014(a)) is required to be reduced
under section 1014(b)(9) (relating to adjustments to basis when the
property is acquired before the death of the decedent).
(4) Gifts and section 1041 transfers. If stock is acquired in a
transfer that is a gift, in a transfer that is a part sale or exchange
and part gift, in a transfer that is described in section 1041(a), or in
a transfer at death where the basis of property in the hands of the
transferee is determined under section 1022, the amount of section 1254
costs with respect to the property held by the corporation in the
acquiring shareholder's hands immediately after the transfer is an
amount equal to--
(i) The amount of section 1254 costs with respect to the property
held by the corporation in the hands of the transferor immediately
before the transfer; minus
(ii) The amount of any gain recognized as ordinary income under
section 1254 by the transferor upon the transfer.
(f) Special rules for a corporation that was formerly an S
corporation or formerly a C corporation--(1) Section 1254 costs of an S
corporation that was formerly a C corporation. In the case of a C
corporation that holds natural resource recapture property and that
elects to be an S corporation, each shareholder's section 1254 costs as
of the beginning of the corporation's first taxable year as an S
corporation include a pro rata share of the section 1254 costs of the
corporation as of the close of the last taxable year that the
corporation was a C corporation.
(2) Examples. The following examples illustrate the application of
the provisions of paragraph (f)(1) of this section:
Example 1. Sale of natural resource recapture property held by an S
corporation that was formerly a C corporation. (i) Y is a C corporation
that elects to be an S corporation effective January 1, 1997. On that
date, Y owns Oil Well, which is natural resource recapture property and
a capital asset. Y has section 1254 costs of $20,000 as of the close of
the last taxable year that it was a C corporation. On January 1, 1997,
Oil Well has a value of $200,000 and a basis of $100,000. Thus, under
section 1374, Y's net unrealized built-in gain is $100,000. Also on that
date, Y's basis in Oil Well is allocated to A, Y's sole shareholder,
under section 613A(c)(11) and the section 1254 costs are allocated to A
under paragraph (f)(1) of this section. In addition, A has a basis in
A's Y stock of $100,000.
(ii) On November 1, 1997, Y sells Oil Well for $250,000. During
1997, Y has taxable income greater than $100,000, and no other
transactions or items treated as recognized built-in gain or loss. Under
section 1374, Y has net recognized built-in gain of $100,000. Assuming a
tax rate of 35 percent on capital gain, Y has a tax of $35,000 under
section 1374. The tax of $35,000 is treated as a capital loss under
section 1366(f)(2). A has a realized gain on the sale of $150,000
($250,000 minus $100,000) of which $20,000 is recognized as ordinary
income under section 1254, and $130,000 is recognized as capital gain.
Consequently, A recognizes ordinary income of $20,000 and net capital
gain of $95,000 ($130,000 minus $35,000) on the sale.
Example 2. Sale of stock followed by sale of natural resource
recapture property held by an S corporation that was formerly a C
corporation. (i) Assume the same facts as in Example 1(i). On November
1, 1997, A sells all of A's Y stock to P for $250,000. A has a realized
gain on the sale of $150,000 ($250,000 minus $100,000) of which $20,000
is recognized as ordinary income under section 1254, and $130,000 is
recognized as capital gain.
(ii) On November 2, 1997, Y sells Oil Well for $250,000. During
1997, Y has taxable income greater than $100,000, and no other
transactions or items treated as recognized built-in gain or loss. Under
section 1374, Y has net recognized built-in gain of $100,000. Assuming a
tax rate of 35 percent on capital gain, Y has a tax of $35,000 under
section 1374. The tax of $35,000 is treated as a capital loss under
section 1366(f)(2). P has a realized gain on the sale of $150,000
($250,000 minus $100,000), which is recognized as capital gain.
Consequently, P recognizes net capital gain of $115,000 ($150,000 minus
$35,000) on the sale.
(3) Section 1254 costs of a C corporation that was formerly an S
corporation. In the case of an S corporation that becomes a C
corporation, the C corporation's section 1254 costs with respect to any
natural resource recapture property held by the corporation as of the
beginning of the corporation's first taxable year as a C corporation
include the sum of its shareholders' section 1254 costs with respect to
the property as of the close of the last taxable year that the
corporation was an S corporation. In the case of an S termination
[[Page 532]]
year as defined in section 1362(e)(4), the shareholders' section 1254
costs are determined as of the close of the S short year as defined in
section 1362(e)(1)(A). See paragraph (g)(5) of this section for rules on
determining the aggregate amount of the shareholders' section 1254
costs.
(g) Determination of a shareholder's section 1254 costs upon certain
stock transactions--(1) Issuance of stock. Upon an issuance of stock
(whether such stock is newly-issued or had been held as treasury stock)
by an S corporation in a reorganization described in section 368 or
otherwise--
(i) Each recipient of shares must be allocated a pro rata share
(determined solely with respect to the shares issued in the transaction)
of the aggregate of the S corporation shareholders' section 1254 costs
with respect to natural resource recapture property held by the S
corporation immediately before the issuance (as determined pursuant to
paragraph (g)(5) of this section); and
(ii) Each pre-existing shareholder must reduce his or her section
1254 costs with respect to natural resource recapture property held by
the S corporation immediately before the issuance by an amount equal to
the pre-existing shareholder's section 1254 costs immediately before the
issuance multiplied by the percentage of stock of the corporation issued
in the transaction.
(2) Natural resource recapture property acquired in exchange for
stock. If natural resource recapture property is transferred to an S
corporation in exchange for stock of the S corporation (for example, in
a section 351 transaction, or in a reorganization described in section
368), the S corporation must allocate to its shareholders a pro rata
share of the S corporation's section 1254 costs with respect to the
property immediately after the transaction (as determined under Sec.
1.1254-3(b)(1)).
(3) Treatment of nonvested stock. Stock issued in connection with
the performance of services that is substantially nonvested (within the
meaning of Sec. 1.83-3(b)) is treated as issued for purposes of this
section at the first time it is treated as outstanding stock of the S
corporation for purposes of section 1361.
(4) Exception. Paragraph (g)(1) of this section does not apply to
stock issued in exchange for stock of the same S corporation (as for
example, in a recapitalization described in section 368(a)(1)(E)).
(5) Aggregate of S corporation shareholders' section 1254 costs with
respect to natural resource recapture property held by the S
corporation--(i) In general. The aggregate of S corporation
shareholders' section 1254 costs is equal to the sum of each
shareholder's section 1254 costs. The S corporation must determine each
shareholder's section 1254 costs under either paragraph (g)(5)(ii)
(written data) or paragraph (g)(5)(iii) (assumptions) of this section.
The S corporation may determine the section 1254 costs of some
shareholders under paragraph (g)(5)(ii) of this section and of others
under paragraph (g)(5)(iii) of this section.
(ii) Written data. An S corporation may determine a shareholder's
section 1254 costs by using written data provided by a shareholder
showing the shareholder's section 1254 costs with respect to natural
resource recapture property held by the S corporation unless the S
corporation knows or has reason to know that the written data is
inaccurate. If an S corporation does not receive written data upon which
it may rely, the S corporation must use the assumptions provided in
paragraph (g)(5)(iii) of this section in determining a shareholder's
section 1254 costs.
(iii) Assumptions. An S corporation that does not use written data
pursuant to paragraph (g)(5)(ii) of this section to determine a
shareholder's section 1254 costs must use the following assumptions to
determine the shareholder's section 1254 costs--
(A) The shareholder deducted his or her share of the amount of
deductions under sections 263(c), 616, and 617 in the first year in
which the shareholder could claim a deduction for such amounts, unless
in the case of expenditures under sections 263(c) or 616 the S
corporation elected to capitalize such amounts;
(B) The shareholder was not subject to the following limitations
with respect to the shareholder's depletion allowance under section 611,
except to the extent a limitation applied at the
[[Page 533]]
corporate level: the taxable income limitation of section 613(a); the
depletable quantity limitations of section 613A(c); or the limitations
of sections 613A(d)(2), (3), and (4) (exclusion of retailers and
refiners).
(6) Examples. The following examples illustrate the provisions of
this paragraph (g):
Example 1. Transfer of natural resource recapture property to an S
corporation in a section 351 transaction. As of January 1, 1997, A owns
all the stock (20 shares) in X, an S corporation. X holds property that
is not natural resource recapture property that has a fair market value
of $2,000 and an adjusted basis of $2,000. On January 1, 1997, B
transfers natural resource recapture property, Property P, to X in
exchange for 80 shares of X stock in a transaction that qualifies under
section 351. Property P has a fair market value of $8,000 and an
adjusted basis of $5,000. Pursuant to section 351, B does not recognize
gain on the transaction. Immediately prior to the transaction, B's
section 1254 costs with respect to Property P equaled $6,000. Under
Sec. 1.1254-2(c)(1), B does not recognize any gain under section 1254
on the section 351 transaction and, under Sec. 1.1254-3(b)(1), X's
section 1254 costs with respect to Property P immediately after the
contribution equal $6,000. Under paragraph (g)(2) of this section, each
shareholder is allocated a pro rata share of X's section 1254 costs. The
pro rata share of X's section 1254 costs that is allocated to A equals
$1,200 (20 percent interest in X multiplied by X's $6,000 of section
1254 costs). The pro rata share of X's section 1254 costs that is
allocated to B equals $4,800 (80 percent interest in X multiplied by X's
$6,000 of section 1254 costs).
Example 2. Contribution of money in exchange for stock of an S
corporation holding natural resource recapture property. As of January
1, 1997, A and B each own 50 percent of the stock (50 shares each) in X,
an S corporation. X holds natural resource recapture property, Property
P, which has a fair market value of $20,000 and an adjusted basis of
$14,000. A's and B's section 1254 costs with respect to Property P are
$4,000 and $1,500, respectively. On January 1, 1997, C contributes
$20,000 to X in exchange for 100 shares of X's stock. Under paragraph
(g)(1)(i) of this section, X must allocate to C a pro rata share of its
shareholders' section 1254 costs. Using the assumptions set forth in
paragraph (g)(5)(iii) of this section, X determines that A's section
1254 costs with respect to natural resource recapture property held by X
equal $4,500. Using written data provided by B, X determines that B's
section 1254 costs with respect to Property P equal $1,500. Thus, the
aggregate of X's shareholders' section 1254 costs equals $6,000. C's pro
rata share of the $6,000 of section 1254 costs equals $3,000 (C's 50
percent interest in X multiplied by $6,000). Under paragraph (g)(1)(ii)
of this section, A's section 1254 costs are reduced by $2,000 (A's
actual section 1254 costs ($4,000) multiplied by 50 percent). B's
section 1254 costs are reduced by $750 (B's actual section 1254 costs
($1,500) multiplied by 50 percent).
Example 3. Merger involving an S corporation that holds natural
resource recapture property. X, an S corporation with one shareholder,
A, holds as its sole asset natural resource recapture property that has
a fair market value of $120,000 and an adjusted basis of $40,000. A has
section 1254 costs with respect to the property of $60,000. For valid
business reasons, X merges into Y, an S corporation with one
shareholder, B, in a reorganization described in section 368(a)(1)(A). Y
holds property that is not natural resource recapture property that has
a fair market value of $120,000 and basis of $120,000. Under paragraph
(c) of this section, A does not recognize ordinary income under section
1254 upon the exchange of stock in the merger because A did not
otherwise recognize gain on the merger. Under paragraph (g)(2) of this
section, Y must allocate to A and B a pro rata share of its $60,000 of
section 1254 costs. Thus, A and B are each allocated $30,000 of section
1254 costs (50 percent interest in X, each, multiplied by $60,000).
[T.D. 8684, 61 FR 53063, Oct. 10, 1996, as amended by T.D. 9811, 82 FR
6242, Jan. 19, 2017]
Sec. 1.1254-5 Special rules for partnerships and their partners.
(a) In general. This section provides rules for applying the
provisions of section 1254 to partnerships and their partners upon the
disposition of natural resource recapture property by the partnership
and certain distributions of property by a partnership. See section 751
and the regulations thereunder for rules concerning the treatment of
gain upon the transfer of a partnership interest.
(b) Determination of gain treated as ordinary income under section
1254 upon the disposition of natural resource recapture property by a
partnership--(1) General rule. Upon a disposition of natural resource
recapture property by a partnership, the amount treated as ordinary
income under section 1254 is determined at the partner level. Each
partner must recognize as ordinary income under section 1254 the lesser
of--
(i) The partner's section 1254 costs with respect to the property
disposed of; or
[[Page 534]]
(ii) The partner's share of the amount, if any, by which the amount
realized upon the sale, exchange, or involuntary conversion, or the fair
market value of the property upon any other disposition, exceeds the
adjusted basis of the property.
(2) Exception to partner level recapture in the case of abusive
allocations. Paragraph (b)(1) of this section does not apply in
determining the amount treated as ordinary income under section 1254
upon a disposition of section 1254 property by a partnership if the
partnership has allocated the amount realized or gain recognized from
the disposition with a principal purpose of avoiding the recognition of
ordinary income under section 1254. In such case, the amount of gain on
the disposition recaptured as ordinary income under section 1254 is
determined at the partnership level.
(3) Examples. The provisions of paragraphs (a) and (b) of this
section are illustrated by the following examples which assume that
capital accounts are maintained in accordance with section 704(b) and
the regulations thereunder:
Example 1. Partner level recapture--In general. A, B, and C, have
equal interests in capital in Partnership ABC that was formed on January
1, 1985. The partnership acquired an undeveloped domestic oil property
on January 1, 1985, for $120,000. The partnership allocated the
property's basis to each partner in proportion to the partner's interest
in partnership capital, so each partner was allocated $40,000 of basis.
In 1985, the partnership incurred $60,000 of productive well intangible
drilling and development costs with respect to the property. The
partnership elected to deduct the intangible drilling and development
costs as expenses under section 263(c). Each partner deducted $20,000 of
the intangible drilling and development costs. Assume that depletion
allowable under section 613A(c)(7)(D) for each partner for 1985 was
$10,000. On January 1, 1986, the partnership sold the oil property to an
unrelated third party for $210,000. Each partner's allocable share of
the amount realized is $70,000. Each partner's basis in the oil property
at the end of 1985 is $30,000 ($40,000 cost--$10,000 depletion
deductions claimed). Each partner has a gain of $40,000 on the sale of
the oil property ($70,000 amount realized--$30,000 adjusted basis in the
oil property). Assume that each partner's depletion allowance would not
have been increased if the intangible drilling and development costs had
been capitalized. Each partner's section 1254 costs with respect to the
property are $20,000. Thus, A, B, and C each must treat $20,000 of gain
recognized as ordinary income under section 1254(a).
Example 2. Special allocation of intangible drilling and development
costs. K and L form a partnership on January 1, 1997, to acquire and
develop a geothermal property as defined under section 613(e)(2). The
partnership agreement provides that all intangible drilling and
development costs will be allocated to partner K, and that all other
items of income, gain, or loss will be allocated equally between the two
partners. Assume these allocations have substantial economic effect
under section 704(b) and the regulations thereunder. The partnership
acquires a lease covering undeveloped acreage located in the United
States for $50,000. In 1997, the partnership incurs $50,000 of
intangible drilling and development costs that are allocated to partner
K. The partnership also has $30,000 of depletion deductions, which are
allocated equally between K and L. On January 1, 1998, the partnership
sells the geothermal property to an unrelated third party for $160,000
and recognizes a gain of $140,000 ($160,000 amount realized less $20,000
adjusted basis ($50,000 unadjusted basis less $30,000 depletion
deductions)). This gain is allocated equally between K and L. Because
K's section 1254 costs are $65,000 and L's section 1254 costs are
$15,000, K recognizes $65,000 as ordinary income under section 1254(a)
and L recognizes $15,000 as ordinary income under section 1254(a). The
remaining $5,000 of gain allocated to K and $55,000 of gain allocated to
L is characterized without regard to section 1254.
Example 3. Section 59(e) election to capitalize intangible drilling
and development costs. Partnership DK has 50 equal partners. On January
1, 1995, the partnership purchases an undeveloped oil and gas property
for $100,000. The partnership allocates the property's basis equally
among the partners, so each partner is allocated $2,000 of basis. In
January 1995, the partnership incurs $240,000 of intangible drilling and
development costs with respect to the property. The partnership elects
to deduct the intangible drilling and development costs as expenses
under section 263(c). Each partner is allocated $4,800 of intangible
drilling and development costs. One of the partners, H, elects under
section 59(e) to capitalize his $4,800 share of intangible drilling and
development costs. Therefore, H is permitted to amortize his $4,800
share of intangible drilling and development costs over 60 months. H
takes a $960 amortization deduction in 1995. Each of the remaining 49
partners deducts his $4,800 share of intangible drilling and development
costs in 1995. Assume that depletion allowable for each partner under
section 613A(c)(7)(D) for 1995 is $1,000. On December 31, 1995, the
partnership sells the property for $300,000. Each partner
[[Page 535]]
is allocated $6,000 of amount realized. Each partner that deducted the
intangible drilling and development costs has a basis in the oil
property at the end of 1995 of $1,000 ($2,000 cost - $1,000 depletion
deductions claimed). Each of these partners has a gain of $5,000 on the
sale of the oil property ($6,000 amount realized - $1,000 adjusted basis
in the property). The section 1254 costs of each partner that deducted
intangible drilling and development costs are $5,800 ($4,800 intangible
drilling and development costs deducted + $1,000 depletion deductions
claimed). Because each partner's section 1254 costs ($5,800) exceed each
partner's share of amount realized less each partner's adjusted basis
($5,000), each partner must treat his $5,000 gain recognized on the sale
of the oil property as ordinary income under section 1254(a). Because H
elected under section 59(e) to capitalize the $4,800 of intangible
drilling and development costs and amortized only $960 of the costs in
1995, the $3,840 of unamortized intangible drilling and development
costs are included in H's basis in the oil property. Therefore, at the
end of 1995 H's basis in the oil property is $4,840 (($2,000 cost +
$4,800 capitalized intangible drilling and development costs) - ($960
intangible drilling and development costs amortized + $1,000 depletion
deduction claimed)). H's gain on the sale of the oil property is $1,160
($6,000 amount realized - $4,840 adjusted basis). H's section 1254 costs
are $1,960 ($960 intangible drilling and development costs amortized +
$1,000 depletion deductions claimed). Because H's section 1254 costs
($1,960) exceed H's share of amount realized less H's adjusted basis
($1,160), H must treat the $1,160 of gain recognized as ordinary income
under section 1254(a).
(c) Section 1254 costs of a partner--(1) General rule. A partner's
section 1254 costs with respect to property held by a partnership
include all of the partner's section 1254 costs with respect to the
property in the hands of the partnership. In the case of property
contributed to a partnership in a transaction described in section 721,
a partner's section 1254 costs include all of the partner's section 1254
costs with respect to the property prior to contribution. Section
1.1254-1(b)(1)(iv), which provides rules concerning the treatment of
suspended deductions, applies to amounts not deductible pursuant to
section 704(d).
(2) Section 1254 costs of a transferee partner after certain
acquisitions--(i) Basis determined under section 1012. If a person
acquires an interest in a partnership that holds natural resource
recapture property (transferee partner) and the transferee partner's
basis for the interest is determined by reference to its cost (within
the meaning of section 1012), the amount of the transferee partner's
section 1254 costs with respect to the property held by the partnership
is zero on the acquisition date.
(ii) Basis determined by reason of the application of section
1014(a). If a transferee partner acquires an interest in a partnership
that holds natural resource recapture property from a decedent and the
transferee partner's basis is determined, by reason of the application
of section 1014(a), solely by reference to the fair market value of the
partnership interest on the date of the decedent's death or on the
applicable date provided in section 2032 (relating to alternate
valuation date), the amount of the transferee partner's section 1254
costs with respect to property held by the partnership is zero on the
acquisition date.
(iii) Basis determined by reason of the application of section
1014(b)(9). If an interest in a partnership that holds natural resource
recapture property is acquired before the death of the decedent, the
amount of the transferee partner's section 1254 costs with respect to
property held by the partnership shall include the amount, if any, of
the section 1254 costs deducted by the transferee partner before the
decedent's death, to the extent that the basis of the partner's interest
(determined under section 1014(a)) is required to be reduced under
section 1014(b)(9) (relating to adjustments to basis when the property
is acquired before the death of the decedent).
(iv) Gifts and section 1041 transfers. If an interest in a
partnership is transferred in a transfer that is a gift, in a transfer
that is a part sale or exchange and part gift, in a transfer that is
described in section 1041(a), or in a transfer at death where the basis
of property in the hands of the transferee is determined under section
1022, the amount of the transferee partner's section 1254 costs with
respect to property held by the partnership immediately after the
transfer is an amount equal to--
(A) The amount of the transferor partner's section 1254 costs with
respect to the property immediately before the transfer; minus
[[Page 536]]
(B) The amount of any gain recognized as ordinary income under
section 1254 by the transferor partner upon the transfer.
(d) Property distributed to a partner--(1) In general. The section
1254 costs for any natural resource recapture property received by a
partner in a distribution with respect to part or all of an interest in
a partnership include--
(i) The aggregate of the partners' section 1254 costs with respect
to the natural resource recapture property immediately prior to the
distribution; reduced by
(ii) The amount of any gain taken into account as ordinary income
under section 751 by the partnership or the partners (as constituted
after the distribution) on the distribution of the natural resource
recapture property.
(2) Aggregate of partners' section 1254 costs with respect to
natural resource recapture property held by a partnership--(i) In
general. The aggregate of partners' section 1254 costs is equal to the
sum of each partner's section 1254 costs. The partnership must determine
each partner's section 1254 costs under either paragraph (d)(2)(i)(A)
(written data) or paragraph (d)(2)(i)(B) (assumptions) of this section.
The partnership may determine the section 1254 costs of some of the
partners under paragraph (d)(2)(i)(A) of this section and of others
under paragraph (d)(2)(i)(B) of this section.
(A) Written data. A partnership may determine a partner's section
1254 costs by using written data provided by a partner showing the
partner's section 1254 costs with respect to natural resource recapture
property held by the partnership unless the partnership knows or has
reason to know that the written data is inaccurate. If a partnership
does not receive written data upon which it may rely, the partnership
must use the assumptions provided in paragraph (d)(2)(i)(B) of this
section in determining a partner's section 1254 costs.
(B) Assumptions. A partnership that does not use written data
pursuant to paragraph (d)(2)(i)(A) of this section to determine a
partner's section 1254 costs must use the following assumptions to
determine the partner's section 1254 costs:
(1) The partner deducted his or her share of deductions under
section 263(c), 616, or 617 for the first year in which the partner
could claim a deduction for such amounts, unless in the case of
expenditures under section 263(c) or 616, the partnership elected to
capitalize such amounts;
(2) The partner was not subject to the following limitations with
respect to the partner's depletion allowance under section 611, except
to the extent a limitation applied at the partnership level: the taxable
income limitation of section 613(a); the depletable quantity limitations
of section 613A(c); or the limitations of section 613A(d)(2), (3), and
(4) (exclusion of retailers and refiners).
[T.D. 8586, 60 FR 2507, Jan. 10, 1995, as amended by T.D. 9811, 82 FR
6242, Jan. 19, 2017]
Sec. 1.1254-6 Effective/applicability date.
(a) Sections 1.1254-1 through 1.1254-3 and 1.1254-5 are effective
with respect to any disposition of natural resource recapture property
occurring after March 13, 1995. The rule in Sec. 1.1254-
1(b)(2)(iv)(A)(2), relating to a nonoperating mineral interest carved
out of an operating mineral interest with respect to which an
expenditure has been deducted, is effective with respect to any
disposition occurring after March 13, 1995, of property (within the
meaning of section 614) that is placed in service by the taxpayer after
December 31, 1986. Section 1.1254-4 applies to dispositions of natural
resource recapture property by an S corporation (and a corporation that
was formerly an S corporation) and dispositions of S corporation stock
occurring on or after October 10, 1996. Sections 1.1254-2(d)(1)(ii) and
1.1254-3(b)(1)(i), (b)(1)(ii), (d)(1)(i), and (d)(1)(ii) are effective
for dispositions of property occurring on or after October 10, 1996.
(b) The provisions of Sec. Sec. 1.1254-2(a)(1), 1.1254-3(b)(2),
1.1254-4(e)(4), and 1.1254-5(c)(2)(iv) that relate to section 1022 are
effective on and after January 19, 2017.
[T.D. 9811, 82 FR 6242, Jan. 19, 2017]
Sec. 1.1256(e)-1 Identification of hedging transactions.
(a) Identification and recordkeeping requirements. Under section
1256(e)(2), a
[[Page 537]]
taxpayer that enters into a hedging transaction must identify the
transaction as a hedging transaction before the close of the day on
which the taxpayer enters into the transaction.
(b) Requirements for identification. The identification of a hedging
transaction for purposes of section 1256(e)(2) must satisfy the
requirements of Sec. 1.1221-2(f)(1). Solely for purposes of section
1256(f)(1), however, an identification that does not satisfy all of the
requirements of Sec. 1.1221-2(f)(1) is nevertheless treated as an
identification under section 1256(e)(2).
(c) Consistency with Sec. 1.1221-2. Any identification for purposes
of Sec. 1.1221-2(f)(1) is also an identification for purposes of this
section. If a taxpayer satisfies the requirements of Sec. 1.1221-
2(g)(1)(ii), the transaction is treated as if it were not identified as
a hedging transaction for purposes of section 1256(e)(2).
(d) Effective date. The rules of this section apply to transactions
entered into on or after March 20, 2002.
[T.D. 8985, 67 FR 12870, Mar. 20, 2002; 67 FR 31955, May 13, 2002]
Sec. 1.1258-1 Netting rule for certain conversion transactions.
(a) Purpose. The purpose of this section is to provide taxpayers
with a method to net certain gains and losses from positions of the same
conversion transaction before determining the amount of gain treated as
ordinary income under section 1258(a).
(b) Netting of gain and loss for identified transactions--(1) In
general. If a taxpayer disposes of or terminates all the positions of an
identified netting transaction (as defined in paragraph (b)(2) of this
section) within a 14-day period in a single taxable year, all gains and
losses on those positions taken into account for Federal tax purposes
within that period (other than built-in losses as defined in paragraph
(c) of this section) are netted solely for purposes of determining the
amount of gain treated as ordinary income under section 1258(a). For
purposes of the preceding sentence, a taxpayer is treated as disposing
of any position that is treated as sold under any provision of the Code
or regulations thereunder (for example, under section 1256(a)(1)).
(2) Identified netting transaction. For purposes of this section, an
identified netting transaction is a conversion transaction (as defined
in section 1258(c)) that the taxpayer identifies as an identified
netting transaction on its books and records. Identification of each
position of the conversion transaction must be made before the close of
the day on which the position becomes part of the conversion
transaction. No particular form of identification is necessary, but all
the positions of a single conversion transaction must be identified as
part of the same transaction and must be distinguished from all other
positions.
(c) Definition of built-in loss. For purposes of this section,
built-in loss means--
(1) Built-in loss as defined in section 1258(d)(3)(B); and
(2) If a taxpayer realizes gain or loss on any one position of a
conversion transaction (for example, under section 1256), as of the date
that gain or loss is realized, any unrecognized loss in any other
position of the conversion transaction that is not disposed of,
terminated, or treated as sold under any provision of the Code or
regulations thereunder within 14 days of and within the same taxable
year as the realization event.
(d) Examples. These examples illustrate this section:
Example 1. Identified netting transaction with simultaneous actual
dispositions. (i) On December 1, 1995, A purchases 1,000 shares of XYZ
stock for $100,000 and enters into a forward contract to sell 1,000
shares of XYZ stock on November 30, 1997, for $110,000. The XYZ stock is
actively traded as defined in Sec. 1.1092(d)-1(a) and is a capital
asset in A's hands. A maintains books and records on which, on December
1, 1995, it identifies the two positions as all the positions of a
single conversion transaction. A owns no other XYZ stock. On December 1,
1996, when the applicable imputed income amount for the transaction is
$7,000, A sells the 1,000 shares of XYZ stock for $95,000. On the same
day, A terminates its forward contract with its counterparty, receiving
$10,200. No dividends were received on the stock during the time it was
part of the conversion transaction.
(ii) The XYZ stock and forward contract are positions of a
conversion transaction. Under section 1258(c)(1), substantially all of
A's expected return from the overall transaction is attributable to the
time value of the net investment in the transaction. Under
[[Page 538]]
section 1258(c)(2)(B), the transaction is an applicable straddle as
defined in section 1258(d)(1).
(iii) A disposed of or terminated all the positions of the
conversion transaction within 14 days and within the same taxable year
as required by paragraph (b)(1) of this section. The transaction is an
identified netting transaction because it meets the identification
requirement of paragraph (b)(2) of this section. Solely for purposes of
section 1258(a), the $5,000 loss realized ($100,000 basis less $95,000
amount realized) on the disposition of the XYZ stock is netted against
the $10,200 gain recognized on the disposition of the forward contract.
Thus, the net gain from the conversion transaction for purposes of
section 1258(a) is $5,200 ($10,200 gain less $5,000 loss). Only the
$5,200 net gain is recharacterized as ordinary income under section
1258(a) even though the applicable imputed income amount is $7,000. For
Federal tax purposes other than section 1258(a), A has recognized a
$10,200 gain on the disposition of the forward contract ($5,200 of which
is treated as ordinary income) and realized a separate $5,000 loss on
the sale of the XYZ stock.
Example 2. Identified netting transaction with built-in loss. (i)
The facts are the same as in Example 1, except that A had purchased the
XYZ stock for $104,000 on May 15, 1995. The XYZ stock had a fair market
value of $100,000 on December 1, 1995, the date it became part of a
conversion transaction.
(ii) The results are the same as in Example 1, except that A has
built-in loss (in addition to the $5,000 loss that arose economically
during the period of the conversion transaction), as defined in section
1258(d)(3)(B), of $4,000 on the XYZ stock. That $4,000 built-in loss is
not netted against the $10,200 gain on the forward contract for purposes
of section 1258(a). Thus, the net gain from the conversion transaction
for purposes of section 1258(a) is $5,200, the same as in Example 1. The
$4,000 built-in loss is recognized and has a character determined
without regard to section 1258.
(e) Effective date and transition rule--(1) In general. These
regulations are effective for conversion transactions that are
outstanding on or after December 21, 1995.
(2) Transition rule for identification requirements. In the case of
a conversion transaction entered into before February 20, 1996,
paragraph (b)(2) of this section is treated as satisfied if the
identification is made before the close of business on February 20,
1996.
[T.D. 8649, 60 FR 66084, Dec. 21, 1995]
Sec. 1.1271-0 Original issue discount; effective date;
table of contents.
(a) Effective date. Except as otherwise provided, Sec. Sec. 1.1271-
1 through 1.1275-5 apply to debt instruments issued on or after April 4,
1994. Taxpayers, however, may rely on these sections (as contained in 26
CFR part 1 revised April 1, 1996) for debt instruments issued after
December 21, 1992, and before April 4, 1994.
(b) Table of contents. This section lists captioned paragraphs
contained in Sec. Sec. 1.1271-1 through 1.1275-7.
Sec. 1.1271-1 Special rules applicable to amounts received on
retirement, sale, or exchange of debt instruments.
(a) Intention to call before maturity.
(1) In general.
(2) Exceptions.
(b) Short-term obligations.
(1) In general.
(2) Method of making elections.
(3) Counting conventions.
Sec. 1.1272-1 Current inclusion of OID in income.
(a) Overview.
(1) In general.
(2) Debt instruments not subject to OID inclusion rules.
(b) Accrual of OID.
(1) Constant yield method.
(2) Exceptions.
(3) Modifications.
(4) Special rules for determining the OID allocable to an accrual
period.
(c) Yield and maturity of certain debt instruments subject to
contingencies.
(1) Applicability.
(2) Payment schedule that is significantly more likely than not to
occur.
(3) Mandatory sinking fund provision.
(4) Consistency rule. [Reserved]
(5) Treatment of certain options.
(6) Subsequent adjustments.
(7) Effective date.
(d) Certain debt instruments that provide for a fixed yield.
(e) Convertible debt instruments.
(f) Special rules to determine whether a debt instrument is a short-
term obligation.
(1) Counting of either the issue date or maturity date.
(2) Coordination with paragraph (c) of this section for certain
sections of the Internal Revenue Code.
(g) Basis adjustment.
(h) Debt instruments denominated in a currency other than the U.S.
dollar.
(i) [Reserved]
(j) Examples.
[[Page 539]]
Sec. 1.1272-2 Treatment of debt instruments purchased at a premium.
(a) In general.
(b) Definitions and special rules.
(1) Purchase.
(2) Premium.
(3) Acquisition premium.
(4) Acquisition premium fraction.
(5) Election to accrue discount on a constant yield basis.
(6) Special rules for determining basis.
(c) Examples.
Sec. 1.1272-3 Election by a holder to treat all interest on a debt
instrument as OID.
(a) Election.
(b) Scope of election.
(1) In general.
(2) Exceptions, limitations, and special rules.
(c) Mechanics of the constant yield method.
(1) In general.
(2) Special rules to determine adjusted basis.
(d) Time and manner of making the election.
(e) Revocation of election.
(f) Effective date.
Sec. 1.1273-1 Definition of OID.
(a) In general.
(b) Stated redemption price at maturity.
(c) Qualified stated interest.
(1) Definition.
(2) Debt instruments subject to contingencies.
(3) Variable rate debt instrument.
(4) Stated interest in excess of qualified stated interest.
(5) Short-term obligations.
(6) Business day convention.
(d) De minimis OID.
(1) In general.
(2) De minimis amount.
(3) Installment obligations.
(4) Special rule for interest holidays, teaser rates, and other
interest shortfalls.
(5) Treatment of de minimis OID by holders.
(e) Definitions.
(1) Installment obligation.
(2) Self-amortizing installment obligation.
(3) Weighted average maturity.
(f) Examples.
Sec. 1.1273-2 Determination of issue price and issue date.
(a) Debt instruments issued for money.
(1) Issue price.
(2) Issue date.
(b) Publicly traded debt instruments issued for property.
(1) Issue price.
(2) Issue date.
(c) Debt instruments issued for publicly traded property.
(1) Issue price.
(2) Issue date.
(d) Other debt instruments.
(1) Issue price.
(2) Issue date.
(e) Special rule for certain sales to bond houses, brokers, or
similar persons.
(f) Traded on an established market (publicly traded).
(1) In general.
(2) Sales price.
(3) Firm quote.
(4) Indicative quote.
(5) Presumption that price or quote is equal to fair market value.
(6) Exception for small debt issues.
(7) Anti-abuse rules.
(8) Convertible debt instruments.
(9) Issuer-holder consistency requirement.
(10) Effective/applicability dates.
(g) Treatment of certain cash payments incident to lending
transactions.
(1) Applicability.
(2) Payments from borrower to lender.
(3) Payments from lender to borrower.
(4) Payments between lender and third party.
(5) Examples.
(h) Investment units.
(1) In general.
(2) Consistent allocation by holders and issuer.
(i) [Reserved]
(j) Convertible debt instruments.
(k) Below-market loans subject to section 7872(b).
(l) [Reserved]
(m) Treatment of amounts representing pre-issuance accrued interest.
(1) Applicability.
(2) Exclusion of pre-issuance accrued interest from issue price.
(3) Example.
Sec. 1.1274-1 Debt instruments to which section 1274 applies.
(a) In general.
(b) Exceptions.
(1) Debt instrument with adequate stated interest and no OID .
(2) Exceptions under sections 1274(c)(1)(B), 1274(c)(3), 1274A(c),
and 1275(b)(1).
(3) Other exceptions to section 1274.
(c) Examples.
Sec. 1.1274-2 Issue price of debt instruments to which section 1274
applies.
(a) In general.
(b) Issue price.
(1) Debt instruments that provide for adequate stated interest;
stated principal amount.
(2) Debt instruments that do not provide for adequate stated
interest; imputed principal amount.
[[Page 540]]
(3) Debt instruments issued in a potentially abusive situation; fair
market value.
(c) Determination of whether a debt instrument provides for adequate
stated interest.
(1) In general.
(2) Determination of present value.
(d) Treatment of certain options.
(e) Mandatory sinking funds.
(f) Treatment of variable rate debt instruments.
(1) Stated interest at a qualified floating rate.
(2) Stated interest at a single objective rate.
(g) Treatment of contingent payment debt instruments.
(h) Examples.
(i) [Reserved]
(j) Special rules for tax-exempt obligations.
(1) Certain variable rate debt instruments.
(2) Contingent payment debt instruments.
(3) Effective date.
Sec. 1.1274-3 Potentially abusive situations defined.
(a) In general.
(b) Operating rules.
(1) Debt instrument exchanged for nonrecourse financing.
(2) Nonrecourse debt with substantial down payment.
(3) Clearly excessive interest.
(4) Debt-for-debt exchange.
(c) Other situations to be specified by Commissioner.
(d) Consistency rule.
Sec. 1.1274-4 Test rate.
(a) Determination of test rate of interest.
(1) In general.
(2) Test rate for certain debt instruments.
(b) Applicable Federal rate.
(c) Special rules to determine the term of a debt instrument for
purposes of determining the applicable Federal rate.
(1) Installment obligations.
(2) Certain variable rate debt instruments.
(3) Counting of either the issue date or the maturity date.
(4) Certain debt instruments that provide for principal payments
uncertain as to time.
(d) Foreign currency loans.
(e) Examples.
Sec. 1.1274-5 Assumptions.
(a) In general.
(b) Modifications of debt instruments.
(1) In general.
(2) Election to treat buyer as modifying the debt instrument.
(c) Wraparound indebtedness.
(d) Consideration attributable to assumed debt.
Sec. 1.1274A-1 Special rules for certain transactions where stated
principal amount does not exceed $2,800,000.
(a) In general.
(b) Rules for both qualified and cash method debt instruments.
(1) Sale-leaseback transactions.
(2) Debt instruments calling for contingent payments.
(3) Aggregation of transactions.
(4) Inflation adjustment of dollar amounts.
(c) Rules for cash method debt instruments.
(1) Time and manner of making cash method election.
(2) Successors of electing parties.
(3) Modified debt instrument.
(4) Debt incurred or continued to purchase or carry a cash method
debt instrument.
Sec. 1.1275-1 Definitions.
(a) Applicability.
(b) Adjusted issue price.
(1) In general.
(2) Adjusted issue price for subsequent holders.
(c) OID.
(d) Debt instrument.
(e) Tax-exempt obligations.
(f) Issue.
(1) Debt instruments issued on or after March 13, 2001.
(2) Debt instruments issued before March 13, 2001.
(3) Transition rule.
(4) Cross-references for reopening and aggregation rules.
(g) Debt instruments issued by a natural person.
(h) Publicly offered debt instrument.
(i) [Reserved]
(j) Life annuity exception under section 1275(a)(1)(B)(i).
(k) Exception under section 1275(a)(1)(B)(ii) for annuities issued
by an insurance company subject to tax under subchapter L of the
Internal Revenue Code.
(1) Rule.
(2) Examples.
(3) Effective date.
(1) Purpose.
(2) General rule.
(3) Availability of a cash surrender option.
(4) Availability of a loan secured by the contract.
(5) Minimum payout provision.
(6) Maximum payout provision.
(7) Decreasing payout provision.
(8) Effective dates.
Sec. 1.1275-2 Special rules relating to debt instruments.
(a) Payment ordering rule.
(1) In general.
(2) Exceptions.
[[Page 541]]
(b) Debt instruments distributed by corporations with respect to
stock.
(1) Treatment of distribution.
(2) Issue date.
(c) Aggregation of debt instruments.
(1) General rule.
(2) Exception if separate issue price established.
(3) Special rule for debt instruments that provide for the issuance
of additional debt instruments.
(4) Examples.
(d) Special rules for Treasury securities.
(1) Issue price and issue date.
(2) Reopenings of Treasury securities.
(e) Disclosure of certain information to holders.
(f) Treatment of pro rata prepayments.
(1) Treatment as retirement of separate debt instrument.
(2) Definition of pro rata prepayment.
(g) Anti-abuse rule.
(1) In general.
(2) Unreasonable result.
(3) Examples.
(4) Effective date.
(h) Remote and incidental contingencies.
(1) In general.
(2) Remote contingencies.
(3) Incidental contingencies.
(4) Aggregation rule.
(5) Consistency rule.
(6) Subsequent adjustments.
(7) Effective date.
(i) [Reserved]
(j) Treatment of certain modifications.
(k) Reopenings.
(1) In general.
(2) Definitions.
(3) Qualified reopening.
(4) Issuer's treatment of a qualified reopening.
(5) Effective/applicability dates.
Sec. 1.1275-3 OID information reporting requirements.
(a) In general.
(b) Information required to be set forth on face of debt instruments
that are not publicly offered.
(1) In general.
(2) Time for legending.
(3) Legend must survive reissuance upon transfer.
(4) Exceptions.
(c) Information required to be reported to Secretary upon issuance
of publicly offered debt instruments.
(1) In general.
(2) Time for filing information return.
(3) Exceptions.
(4) Subsequent registration.
(d) Application to foreign issuers and U.S. issuers of
foreigntargeted debt instruments.
(e) Penalties.
(f) Effective date.
Sec. 1.1275-4 Contingent payment debt instruments.
(a) Applicability.
(1) In general.
(2) Exceptions.
(3) Insolvency and default.
(4) Convertible debt instruments.
(5) Remote and incidental contingencies.
(b) Noncontingent bond method.
(1) Applicability.
(2) In general.
(3) Description of method.
(4) Comparable yield and projected payment schedule.
(5) Qualified stated interest.
(6) Adjustments.
(7) Adjusted issue price, adjusted basis, and retirement.
(8) Character on sale, exchange, or retirement.
(9) Operating rules.
(c) Method for debt instruments not subject to the noncontingent
bond method.
(1) Applicability.
(2) Separation into components.
(3) Treatment of noncontingent payments.
(4) Treatment of contingent payments.
(5) Basis different from adjusted issue price.
(6) Treatment of a holder on sale, exchange, or retirement.
(7) Examples.
(d) Rules for tax-exempt obligations.
(1) In general.
(2) Certain tax-exempt obligations with interest-based or revenue-
based payments
(3) All other tax-exempt obligations.
(4) Basis different from adjusted issue price.
(e) Amounts treated as interest under this section.
(f) Effective date.
Sec. 1.1275-5 Variable rate debt instruments.
(a) Applicability.
(1) In general.
(2) Principal payments.
(3) Stated interest.
(4) Current value.
(5) No contingent principal payments.
(6) Special rule for debt instruments issued for nonpublicly traded
property.
(b) Qualified floating rate.
(1) In general.
(2) Certain rates based on a qualified floating rate.
(3) Restrictions on the stated rate of interest.
(c) Objective rate.
(1) Definition.
(2) Other objective rates to be specified by Commissioner.
(3) Qualified inverse floating rate.
(4) Significant front-loading or back-loading of interest.
(5) Tax-exempt obligations.
(d) Examples.
[[Page 542]]
(e) Qualified stated interest and OID with respect to a variable
rate debt instrument.
(1) In general.
(2) Variable rate debt instrument that provides for annual payments
of interest at a single variable rate.
(3) All other variable rate debt instruments except for those that
provide for a fixed rate.
(4) Variable rate debt instrument that provides for a single fixed
rate.
(f) Special rule for certain reset bonds.
Sec. 1.1275-6 Integration of qualifying debt instruments.
(a) In general.
(b) Definitions.
(1) Qualifying debt instrument.
(2) Section 1.1275-6 hedge.
(3) Financial instrument.
(4) Synthetic debt instrument.
(c) Integrated transaction.
(1) Integration by taxpayer.
(2) Integration by Commissioner.
(d) Special rules for legging into and legging out of an integrated
transaction.
(1) Legging into.
(2) Legging out.
(e) Identification requirements.
(f) Taxation of integrated transactions.
(1) General rule.
(2) Issue date.
(3) Term.
(4) Issue price.
(5) Adjusted issue price.
(6) Qualified stated interest.
(7) Stated redemption price at maturity.
(8) Source of interest income and allocation of expense.
(9) Effectively connected income.
(10) Not a short-term obligation.
(11) Special rules in the event of integration by the Commissioner.
(12) Retention of separate transaction rules for certain purposes.
(13) Coordination with consolidated return rules.
(g) Predecessors and successors.
(h) Examples.
(i) [Reserved]
(j) Effective date.
Sec. 1.1275-7 Inflation-indexed debt instruments.
(a) Overview.
(b) Applicability.
(1) In general.
(2) Exceptions.
(c) Definitions.
(1) Inflation-indexed debt instrument.
(2) Reference index.
(3) Qualified inflation index.
(4) Inflation-adjusted principal amount.
(5) Minimum guarantee payment.
(d) Coupon bond method.
(1) In general.
(2) Applicability.
(3) Qualified stated interest.
(4) Inflation adjustments.
(5) Example.
(e) Discount bond method.
(1) In general.
(2) No qualified stated interest.
(3) OID.
(4) Example.
(f) Special rules.
(1) Deflation adjustments.
(2) Adjusted basis.
(3) Subsequent holders.
(4) Minimum guarantee.
(5) Temporary unavailability of a qualified inflation index.
(g) TIPS.
(1) Reopenings.
(2) TIPS issued with more than a de minimis amount of premium.
(h) Effective/applicability dates.
(1) In general.
(2) TIPS issued with more than a de minimis amount of premium.
[T.D. 8517, 59 FR 4808, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30139, June 14, 1996; T.D. 8709, 62 FR 617, Jan. 6, 1997; T.D. 8754, 63
FR 1057, Jan. 8, 1998; T.D. 8838, 64 FR 48547, Sept. 7, 1999; T.D. 8840,
64 FR 60343, Nov. 5, 1999; T.D. 8934, 66 FR 2815, Jan. 12, 2001; T.D.
8993, 67 FR 30548, May 7, 2002; T.D. 9599, 77 FR 56536, Sept. 13, 2012;
T.D. 9609, 78 FR 668, Jan. 4, 2013; T.D. 9616, 78 FR 23126, Apr. 18,
2013]
Sec. 1.1271-1 Special rules applicable to amounts received on
retirement, sale, or exchange of debt instruments.
(a) Intention to call before maturity--(1) In general. For purposes
of section 1271(a)(2), all or a portion of gain realized on a sale or
exchange of a debt instrument to which section 1271 applies is treated
as interest income if there was an intention to call the debt instrument
before maturity. An intention to call a debt instrument before maturity
means a written or oral agreement or understanding not provided for in
the debt instrument between the issuer and the original holder of the
debt instrument that the issuer will redeem the debt instrument before
maturity. In the case of debt instruments that are part of an issue, the
agreement or understanding must be between the issuer and the original
holders of a substantial amount of the debt instruments in the issue. An
intention to call before maturity can exist even if the intention is
conditional (e.g., the issuer's decision to call depends on the
financial condition of the issuer on the potential call date) or is not
legally binding. For purposes of
[[Page 543]]
this section, original holder means the first holder (other than an
underwriter or dealer that purchased the debt instrument for resale in
the ordinary course of its trade or business).
(2) Exceptions. In addition to the exceptions provided in sections
1271(a)(2)(B) and 1271(b), section 1271(a)(2) does not apply to--
(i) A debt instrument that is publicly offered (as defined in Sec.
1.1275-1(h));
(ii) A debt instrument to which section 1272(a)(6) applies (relating
to certain interests in or mortgages held by a REMIC, and certain other
debt instruments with payments subject to acceleration); or
(iii) A debt instrument sold pursuant to a private placement
memorandum that is distributed to more than ten offerees and that is
subject to the sanctions of section 12(2) of the Securities Act of 1933
(15 U.S.C. 77l) or the prohibitions of section 10(b) of the Securities
Exchange Act of 1934 (15 U.S.C. 78j).
(b) Short-term obligations--(1) In general. Under sections 1271
(a)(3) and (a)(4), all or a portion of the gain realized on the sale or
exchange of a short-term government or nongovernment obligation is
treated as interest income. Sections 1271 (a)(3) and (a)(4), however, do
not apply to any short-term obligation subject to section 1281. See
Sec. 1.1272-1(f) for rules to determine if an obligation is a short-
term obligation.
(2) Method of making elections. Elections to accrue on a constant
yield basis under sections 1271 (a)(3)(E) and (a)(4)(D) are made on an
obligation-by-obligation basis by reporting the transaction on the basis
of daily compounding on the taxpayer's timely filed Federal income tax
return for the year of the sale or exchange. These elections are
irrevocable.
(3) Counting conventions. In computing the ratable share of
acquisition discount under section 1271(a)(3) or OID under section
1271(a)(4), any reasonable counting convention may be used (e.g., 30
days per month/360 days per year).
[T.D. 8517, 59 FR 4809, Feb. 2, 1994]
Sec. 1.1272-1 Current inclusion of OID in income.
(a) Overview--(1) In general. Under section 1272(a)(1), a holder of
a debt instrument includes accrued OID in gross income (as interest),
regardless of the holder's regular method of accounting. A holder
includes qualified stated interest (as defined in Sec. 1.1273-1(c)) in
income under the holder's regular method of accounting. See Sec. Sec.
1.446-2 and 1.451-1.
(2) Debt instruments not subject to OID inclusion rules. Sections
1272(a)(2) and 1272(c) list exceptions to the general inclusion rule of
section 1272(a)(1). For purposes of section 1272(a)(2)(E) (relating to
certain loans between natural persons), a loan does not include a
stripped bond or stripped coupon within the meaning of section 1286(e),
and the rule in section 1272(a)(2)(E)(iii), which treats a husband and
wife as 1 person, does not apply to loans made between a husband and
wife.
(b) Accrual of OID--(1) Constant yield method. Except as provided in
paragraphs (b)(2) and (b)(3) of this section, the amount of OID
includible in the income of a holder of a debt instrument for any
taxable year is determined using the constant yield method as described
under this paragraph (b)(1).
(i) Step one: Determine the debt instrument's yield to maturity. The
yield to maturity or yield of a debt instrument is the discount rate
that, when used in computing the present value of all principal and
interest payments to be made under the debt instrument, produces an
amount equal to the issue price of the debt instrument. The yield must
be constant over the term of the debt instrument and, when expressed as
a percentage, must be calculated to at least two decimal places. See
paragraph (c) of this section for rules relating to the yield of certain
debt instruments subject to contingencies.
(ii) Step two: Determine the accrual periods. An accrual period is
an interval of time over which the accrual of OID is measured. Accrual
periods may be of any length and may vary in length over the term of the
debt instrument, provided that each accrual period is no longer than 1
year and each scheduled payment of principal or interest occurs either
on the final day of an accrual period or on the first day of an accrual
period. In general, the computation of
[[Page 544]]
OID is simplest if accrual periods correspond to the intervals between
payment dates provided by the terms of the debt instrument. In computing
the length of accrual periods, any reasonable counting convention may be
used (e.g., 30 days per month/360 days per year).
(iii) Step three: Determine the OID allocable to each accrual
period. Except as provided in paragraph (b)(4) of this section, the OID
allocable to an accrual period equals the product of the adjusted issue
price of the debt instrument (as defined in Sec. 1.1275-1(b)) at the
beginning of the accrual period and the yield of the debt instrument,
less the amount of any qualified stated interest allocable to the
accrual period. In performing this calculation, the yield must be stated
appropriately taking into account the length of the particular accrual
period. Example 1 in paragraph (j) of this section provides a formula
for converting a yield based upon an accrual period of one length to an
equivalent yield based upon an accrual period of a different length.
(iv) Step four: Determine the daily portions of OID. The daily
portions of OID are determined by allocating to each day in an accrual
period the ratable portion of the OID allocable to the accrual period.
The holder of the debt instrument includes in income the daily portions
of OID for each day during the taxable year on which the holder held the
debt instrument.
(2) Exceptions. Paragraph (b)(1) of this section does not apply to--
(i) A debt instrument to which section 1272(a)(6) applies (certain
interests in or mortgages held by a REMIC, and certain other debt
instruments with payments subject to acceleration);
(ii) A debt instrument that provides for contingent payments, other
than a debt instrument described in paragraph (c) or (d) of this section
or except as provided in Sec. 1.1275-4; or
(iii) A variable rate debt instrument to which Sec. 1.1275-5
applies, except as provided in Sec. 1.1275-5.
(3) Modifications. The amount of OID includible in income by a
holder under paragraph (b)(1) of this section is adjusted if--
(i) The holder purchased the debt instrument at a premium or an
acquisition premium (within the meaning of Sec. 1.1272-2); or
(ii) The holder made an election for the debt instrument under Sec.
1.1272-3 to treat all interest as OID.
(4) Special rules for determining the OID allocable to an accrual
period. The following rules apply to determine the OID allocable to an
accrual period under paragraph (b)(1)(iii) of this section.
(i) Unpaid qualified stated interest allocable to an accrual period.
In determining the OID allocable to an accrual period, if an interval
between payments of qualified stated interest contains more than 1
accrual period--
(A) The amount of qualified stated interest payable at the end of
the interval (including any qualified stated interest that is payable on
the first day of the accrual period immediately following the interval)
is allocated on a pro rata basis to each accrual period in the interval;
and
(B) The adjusted issue price at the beginning of each accrual period
in the interval must be increased by the amount of any qualified stated
interest that has accrued prior to the first day of the accrual period
but that is not payable until the end of the interval. See Example 2 of
paragraph (j) of this section for an example illustrating the rules in
this paragraph (b)(4)(i).
(ii) Final accrual period. The OID allocable to the final accrual
period is the difference between the amount payable at maturity (other
than a payment of qualified stated interest) and the adjusted issue
price at the beginning of the final accrual period.
(iii) Initial short accrual period. If all accrual periods are of
equal length, except for either an initial shorter accrual period or an
initial and a final shorter accrual period, the amount of OID allocable
to the initial accrual period may be computed using any reasonable
method. See Example 3 in paragraph (j) of this section.
(iv) Payment on first day of an accrual period. The adjusted issue
price at the beginning of an accrual period is reduced by the amount of
any payment (other than a payment of qualified stated interest) that is
made on the first day of the accrual period.
[[Page 545]]
(c) Yield and maturity of certain debt instruments subject to
contingencies--(1) Applicability. This paragraph (c) provides rules to
determine the yield and maturity of certain debt instruments that
provide for an alternative payment schedule (or schedules) applicable
upon the occurrence of a contingency (or contingencies). This paragraph
(c) applies, however, only if the timing and amounts of the payments
that comprise each payment schedule are known as of the issue date and
the debt instrument is subject to paragraph (c)(2), (3), or (5) of this
section. A debt instrument does not provide for an alternative payment
schedule merely because there is a possibility of impairment of a
payment (or payments) by insolvency, default, or similar circumstances.
See Sec. 1.1275-4 for the treatment of a debt instrument that provides
for a contingency that is not described in this paragraph (c). See Sec.
1.1273-1(c) to determine whether stated interest on a debt instrument
subject to this paragraph (c) is qualified stated interest.
(2) Payment schedule that is significantly more likely than not to
occur. If, based on all the facts and circumstances as of the issue
date, a single payment schedule for a debt instrument, including the
stated payment schedule, is significantly more likely than not to occur,
the yield and maturity of the debt instrument are computed based on this
payment schedule.
(3) Mandatory sinking fund provision. Notwithstanding paragraph
(c)(2) of this section, if a debt instrument is subject to a mandatory
sinking fund provision, the provision is ignored for purposes of
computing the yield and maturity of the debt instrument if the use and
terms of the provision meet reasonable commercial standards. For
purposes of the preceding sentence, a mandatory sinking fund provision
is a provision that meets the following requirements:
(i) The provision requires the issuer to redeem a certain amount of
debt instruments in an issue prior to maturity.
(ii) The debt instruments actually redeemed are chosen by lot or
purchased by the issuer either in the open market or pursuant to an
offer made to all holders (with any proration determined by lot).
(iii) On the issue date, the specific debt instruments that will be
redeemed on any date prior to maturity cannot be identified.
(4) Consistency rule. [Reserved]
(5) Treatment of certain options. Notwithstanding paragraphs (c) (2)
and (3) of this section, the rules of this paragraph (c)(5) determine
the yield and maturity of a debt instrument that provides the holder or
issuer with an unconditional option or options, exercisable on one or
more dates during the term of the debt instrument, that, if exercised,
require payments to be made on the debt instrument under an alternative
payment schedule or schedules (e.g., an option to extend or an option to
call a debt instrument at a fixed premium). Under this paragraph (c)(5),
an issuer is deemed to exercise or not exercise an option or combination
of options in a manner that minimizes the yield on the debt instrument,
and a holder is deemed to exercise or not exercise an option or
combination of options in a manner that maximizes the yield on the debt
instrument. If both the issuer and the holder have options, the rules of
this paragraph (c)(5) are applied to the options in the order that they
may be exercised. See paragraph (j) Example 5 through Example 8 of this
section.
(6) Subsequent adjustments. If a contingency described in this
paragraph (c) (including the exercise of an option described in
paragraph (c)(5) of this section) actually occurs or does not occur,
contrary to the assumption made pursuant to this paragraph (c) (a change
in circumstances), then, solely for purposes of sections 1272 and 1273,
the debt instrument is treated as retired and then reissued on the date
of the change in circumstances for an amount equal to its adjusted issue
price on that date. See paragraph (j) Example 5 and Example 7 of this
section. If, however, the change in circumstances results in a
substantially contemporaneous pro-rata prepayment as defined in Sec.
1.1275-2(f)(2), the pro-rata prepayment is treated as a payment in
retirement of a portion of the debt instrument, which may result in gain
or
[[Page 546]]
loss to the holder. See paragraph (j) Example 6 and Example 8 of this
section.
(7) Effective date. This paragraph (c) applies to debt instruments
issued on or after August 13, 1996.
(d) Certain debt instruments that provide for a fixed yield. If a
debt instrument provides for one or more contingent payments but all
possible payment schedules under the terms of the instrument result in
the same fixed yield, the yield of the debt instrument is the fixed
yield. For example, the yield of a debt instrument with principal
payments that are fixed in total amount but that are uncertain as to
time (such as a demand loan) is the stated interest rate if the issue
price of the instrument is equal to the stated principal amount and
interest is paid or compounded at a fixed rate over the entire term of
the instrument. This paragraph (d) applies to debt instruments issued on
or after August 13, 1996.
(e) Convertible debt instruments. For purposes of section 1272, an
option is ignored if it is an option to convert a debt instrument into
the stock of the issuer, into the stock or debt of a related party
(within the meaning of section 267(b) or 707(b)(1)), or into cash or
other property in an amount equal to the approximate value of such stock
or debt. For debt instruments issued on or after February 5, 2013, the
term stock in the preceding sentence means an equity interest in any
entity that is classified, for Federal tax purposes, as either a
partnership or a corporation.
(f) Special rules to determine whether a debt instrument is a short-
term obligation--(1) Counting of either the issue date or maturity date.
For purposes of determining whether a debt instrument is a short-term
obligation (i.e., a debt instrument with a fixed maturity date that is
not more than 1 year from the date of issue), the term of the debt
instrument includes either the issue date or the maturity date, but not
both dates.
(2) Coordination with paragraph (c) of this section for certain
sections of the Internal Revenue Code. Notwithstanding paragraph (c) of
this section, solely for purposes of determining whether a debt
instrument is a short-term obligation under sections 871(g)(1)(B)(i),
881, 1271(a)(3), 1271(a)(4), 1272(a)(2)(C), and 1283(a)(1), the maturity
date of a debt instrument is the last possible date that the instrument
could be outstanding under the terms of the instrument. For purposes of
the preceding sentence, the last possible date that the debt instrument
could be outstanding is determined without regard to Sec. 1.1275-2(h)
(relating to payments subject to remote or incidental contingencies).
(g) Basis adjustment. The basis of a debt instrument in the hands of
the holder is increased by the amount of OID included in the holder's
gross income and decreased by the amount of any payment from the issuer
to the holder under the debt instrument other than a payment of
qualified stated interest. See, however, Sec. 1.1275-2(f) for rules
regarding basis adjustments on a pro rata prepayment.
(h) Debt instruments denominated in a currency other than the U.S.
dollar. Section 1272 and this section apply to a debt instrument that
provides for all payments denominated in, or determined by reference to,
the functional currency of the taxpayer or qualified business unit of
the taxpayer (even if that currency is other than the U.S. dollar). See
Sec. 1.988-2(b) to determine interest income or expense for debt
instruments that provide for payments denominated in, or determined by
reference to, a nonfunctional currency.
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section. Each example assumes that all taxpayers use the calendar year
as the taxable year. In addition, each example assumes a 30-day month,
360-day year, and that the initial accrual period begins on the issue
date and the final accrual period ends on the day before the stated
maturity date. Although, for purposes of simplicity, the yield as stated
is rounded to two decimal places, the computations do not reflect any
such rounding convention.
Example 1. Accrual of OID on zero coupon debt instrument; choice of
accrual periods. (i) Facts. On July 1, 1994, A purchases at original
issue, for $675,564.17, a debt instrument that matures on July 1, 1999,
and provides for a single payment of $1,000,000 at maturity.
(ii) Determination of yield. Under paragraph (b)(1)(i) of this
section, the yield of the debt
[[Page 547]]
instrument is 8 percent, compounded semiannually.
(iii) Determination of accrual period. Under paragraph (b)(1)(ii) of
this section, accrual periods may be of any length, provided that each
accrual period is no longer than 1 year and each scheduled payment of
principal or interest occurs either on the first or final day of an
accrual period. The yield to maturity to be used in computing OID
accruals in any accrual period, however, must reflect the length of the
accrual period chosen. A yield based on compounding b times per year is
equivalent to a yield based on compounding c times per year as indicated
by the following formula:
r = c{(1 + i/b)b/c-1{time}
In which:
i = The yield based on compounding b times per year expressed as a
decimal
r = The equivalent yield based on compounding c times per year expressed
as a decimal
b = The number of compounding periods in a year on which i is based (for
example, 12, if i is based on monthly compounding)
c = The number of compounding periods in a year on which r is based
(iv) Determination of OID allocable to each accrual period. Assume
that A decides to compute OID on the debt instrument using semiannual
accrual periods. Under paragraph (b)(1)(iii) of this section, the OID
allocable to the first semiannual accrual period is $27,022.56: the
product of the issue price ($675,564.17) and the yield properly adjusted
for the length of the accrual period (8 percent/2), less qualified
stated interest allocable to the accrual period ($0). The daily portion
of OID for the first semiannual accrual period is $150.13 ($27,022.56/
180).
(v) Determination of OID if monthly accrual periods are used.
Alternatively, assume that A decides to compute OID on the debt
instrument using monthly accrual periods. Using the above formula, the
yield on the debt instrument reflecting monthly compounding is 7.87
percent, compounded monthly (12{(1 + .08/2)\2/12\-1{time} ). Under
paragraph (b)(1)(iii) of this section, the OID allocable to the first
monthly accrual period is $4,430.48: the product of the issue price
($675,564.17) and the yield properly adjusted for the length of the
accrual period (7.87 percent/12), less qualified stated interest
allocable to the accrual period ($0). The daily portion of OID for the
first monthly accrual period is $147.68 ($4,430.48/30).
Example 2. Accrual of OID on debt instrument with qualified stated
interest. (i) Facts. On September 1, 1994, A purchases at original
issue, for $90,000, B corporation's debt instrument that matures on
September 1, 2004, and has a stated principal amount of $100,000,
payable on that date. The debt instrument provides for semiannual
payments of interest of $3,000, payable on September 1 and March 1 of
each year, beginning on March 1, 1995.
(ii) Determination of yield. The debt instrument is a 10-year debt
instrument with an issue price of $90,000 and a stated redemption price
at maturity of $100,000. The semiannual payments of $3,000 are qualified
stated interest payments. Under paragraph (b)(1)(i) of this section, the
yield is 7.44 percent, compounded semiannually.
(iii) Accrual of OID if semiannual accrual periods are used. Assume
that A decides to compute OID on the debt instrument using semiannual
accrual periods. Under paragraph (b)(1)(iii) of this section, the OID
allocable to the first semiannual accrual period equals the product of
the issue price ($90,000) and the yield properly adjusted for the length
of the accrual period (7.44 percent/2), less qualified stated interest
allocable to the accrual period ($3,000). Therefore, the amount of OID
for the first semiannual accrual period is $345.78 ($3,345.78-$3,000).
(iv) Adjustment for accrued but unpaid qualified stated interest if
monthly accrual periods are used. Assume, alternatively, that A decides
to compute OID on the debt instrument using monthly accrual periods. The
yield, compounded monthly, is 7.32 percent. Under paragraph (b)(1)(iii)
of this section, the OID allocable to the first monthly accrual period
is the product of the issue price ($90,000) and the yield properly
adjusted for the length of the accrual period (7.32 percent/12), less
qualified stated interest allocable to the accrual period. Under
paragraph (b)(4)(i)(A) of this section, the qualified stated interest
allocable to the first monthly accrual period is the pro rata amount of
qualified stated interest allocable to the interval between payment
dates ($3,000 x \1/6\, or $500). Therefore, the amount of OID for the
first monthly accrual period is $49.18 ($549.18-$500). Under paragraph
(b)(4)(i)(B) of this section, the adjusted issue price of the debt
instrument for purposes of determining the amount of OID for the second
monthly accrual period is $90,549.18 ($90,000 + $49.18 + $500). Although
the adjusted issue price of the debt instrument for this purpose
includes the amount of qualified stated interest allocable to the first
monthly accrual period, A includes the qualified stated interest in
income based on A's regular method of accounting (e.g., an accrual
method or the cash receipts and disbursements method).
Example 3. Accrual of OID for debt instrument with initial short
accrual period. (i) Facts. On May 1, 1994, G purchases at original
issue, for $80,000, H corporation's debt instrument maturing on July 1,
2004. The debt instrument provides for a single payment at maturity of
$250,000. G computes its OID using 6-month accrual periods ending on
January 1 and July 1 of each year and an initial short
[[Page 548]]
2-month accrual period from May 1, 1994, through June 30, 1994.
(ii) Determination of yield. The yield on the debt instrument is
11.53 percent, compounded semiannually.
(iii) Determination of OID allocable to initial short accrual
period. Under paragraph (b)(4)(iii) of this section, G may use any
reasonable method to compute OID for the initial short accrual period.
One reasonable method is to calculate the amount of OID pursuant to the
following formula:
OIDshort = IP x (i/k) x f
In which:
OIDshort = The amount of OID allocable to the initial short
accrual period
IP = The issue price of the debt instrument
i = The yield to maturity expressed as a decimal
k = The number of accrual periods in a year
f = A fraction whose numerator is the number of days in the initial
short accrual period, and whose denominator is the number of
days in a full accrual period
(iv) Amount of OID for the initial short accrual period. Under this
method, the amount of OID for the initial short accrual period is $1,537
($80,000 x (11.53 percent/2) x (60/180)).
(v) Alternative method. Another reasonable method is to calculate
the amount of OID for the initial short accrual period using the yield
based on bi-monthly compounding, computed pursuant to the formula set
forth in Example 1 of paragraph (j) of this section. Under this method,
the amount of OID for the initial short accrual period is $1,508.38
($80,000 x (11.31 percent/6)).
Example 4. Impermissible accrual of OID using a method other than
constant yield method. (i) Facts. On July 1, 1994, B purchases at
original issue, for $100,000, C corporation's debt instrument that
matures on July 1, 1999, and has a stated principal amount of $100,000.
The debt instrument provides for a single payment at maturity of
$148,024.43. The yield of the debt instrument is 8 percent, compounded
semiannually.
(ii) Determination of yield. Assume that C uses 6 monthly accrual
periods to compute its OID for 1994. The yield must reflect monthly
compounding (as determined using the formula described in Example 1 of
paragraph (j) of this section). As a result, the monthly yield of the
debt instrument is 7.87 percent, divided by 12. C may not compute its
monthly yield for the last 6 months in 1994 by dividing 8 percent by 12.
Example 5. Debt instrument subject to put option. (i) Facts. On
January 1, 1995, G purchases at original issue, for $70,000, H
corporation's debt instrument maturing on January 1, 2010, with a stated
principal amount of $100,000, payable at maturity. The debt instrument
provides for semiannual payments of interest of $4,000, payable on
January 1 and July 1 of each year, beginning on July 1, 1995. The debt
instrument gives G an unconditional right to put the bond back to H,
exercisable on January 1, 2005, in return for $85,000 (exclusive of the
$4,000 of stated interest payable on that date).
(ii) Determination of yield and maturity. Yield determined without
regard to the put option is 12.47 percent, compounded semiannually.
Yield determined by assuming that the put option is exercised (i.e., by
using January 1, 2005, as the maturity date and $85,000 as the stated
principal amount payable on that date) is 12.56 percent, compounded
semiannually. Thus, under paragraph (c)(5) of this section, it is
assumed that G will exercise the put option, because exercise of the
option would increase the yield of the debt instrument. Thus, for
purposes of calculating OID, the debt instrument is assumed to be a 10-
year debt instrument with an issue price of $70,000, a stated redemption
price at maturity of $85,000, and a yield of 12.56 percent, compounded
semiannually.
(iii) Consequences if put option is, in fact, not exercised. If the
put option is, in fact, not exercised, then, under paragraph (c)(6) of
this section, the debt instrument is treated, solely for purposes of
sections 1272 and 1273, as if it were reissued on January 1, 2005, for
an amount equal to its adjusted issue price on that date, $85,000. The
new debt instrument matures on January 1, 2010, with a stated principal
amount of $100,000 payable on that date and provides for semiannual
payments of interest of $4,000. The yield of the new debt instrument is
12.08 percent, compounded semiannually.
Example 6. Debt instrument subject to partial call option. (i)
Facts. On January 1, 1995, H purchases at original issue, for $95,000, J
corporation's debt instrument that matures on January 1, 2000, and has a
stated principal amount of $100,000, payable on that date. The debt
instrument provides for semiannual payments of interest of $4,000,
payable on January 1 and July 1 of each year, beginning on July 1, 1995.
On January 1, 1998, J has an unconditional right to call 50 percent of
the principal amount of the debt instrument for $55,000 (exclusive of
the $4,000 of stated interest payable on that date). If the call is
exercised, the semiannual payments of interest made after the call date
will be reduced to $2,000.
(ii) Determination of yield and maturity. Yield determined without
regard to the call option is 9.27 percent, compounded semiannually.
Yield determined by assuming J exercises its call option is 10.75
percent, compounded semiannually. Thus, under paragraph (c)(5) of this
section, it is assumed that J will not exercise the call option because
exercise of the option would increase the yield of the debt instrument.
Thus, for
[[Page 549]]
purposes of calculating OID, the debt instrument is assumed to be a 5-
year debt instrument with a single principal payment at maturity of
$100,000, and a yield of 9.27 percent, compounded semiannually.
(iii) Consequences if the call option is, in fact, exercised. If the
call option is, in fact, exercised, then under paragraph (c)(6) of this
section, the debt instrument is treated as if the issuer made a pro rata
prepayment of $55,000 that is subject to Sec. 1.1275-2(f).
Consequently, under Sec. 1.1275-2(f)(1), the instrument is treated as
consisting of two debt instruments, one that is retired on the call date
and one that remains outstanding after the call date. The adjusted issue
price, adjusted basis in the hands of the holder, and accrued OID of the
original debt instrument is allocated between the two instruments based
on the portion of the original instrument treated as retired. Since each
payment remaining to be made after the call date is reduced by one-half,
one-half of the adjusted issue price, adjusted basis, and accrued OID is
allocated to the debt instrument that is treated as retired. The
adjusted issue price of the original debt instrument immediately prior
to the call date is $97,725.12, which equals the issue price of the
original debt instrument ($95,000) increased by the OID previously
includible in gross income ($2,725.12). One-half of this adjusted issue
price is allocated to the debt instrument treated as retired, and the
other half is allocated to the debt instrument that is treated as
remaining outstanding. Thus, the debt instrument treated as remaining
outstanding has an adjusted issue price immediately after the call date
of $97,725.12/2, or $48,862.56. The yield of this debt instrument
continues to be 9.27 percent, compounded semiannually. In addition, the
portion of H's adjusted basis allocated to the debt instrument treated
as retired is $97,725.12/2 or $48,862.56. Accordingly, under section
1271, H realizes a gain on the deemed retirement equal to $6,137.44
($55,000 - $48,862.56).
Example 7. Debt instrument issued at par that provides for payment
of interest in kind. (i) Facts. On January 1, 1995, A purchases at
original issue, for $100,000, X corporation's debt instrument maturing
on January 1, 2000, at a stated principal amount of $100,000, payable on
that date. The debt instrument provides for annual payments of interest
of $6,000 on January 1 of each year, beginning on January 1, 1996. The
debt instrument gives X the unconditional right to issue, in lieu of the
first interest payment, a second debt instrument (PIK instrument)
maturing on January 1, 2000, with a stated principal amount of $6,000.
The PIK instrument, if issued, would provide for annual payments of
interest of $360 on January 1 of each year, beginning on January 1,
1997.
(ii) Aggregation of PIK instrument with original debt instrument.
Under Sec. 1.1275-2(c)(3), the issuance of the PIK instrument is not
considered a payment made on the original debt instrument, and the PIK
instrument is aggregated with the original debt instrument. The issue
date of the PIK instrument is the same as the original debt instrument.
(iii) Determination of yield and maturity. The right to issue the
PIK instrument is treated as an option to defer the initial interest
payment until maturity. Yield determined without regard to the option is
6 percent, compounded annually, Yield determined by assuming X exercises
the option is 6 percent, compounded annually. Thus, under paragraph
(c)(5) of this section, it is assumed that X will not exercise the
option by issuing the PIK instrument because exercise of the option
would not decrease the yield of the debt instrument. For purposes of
calculating OID, the debt instrument is assumed to be a 5-year debt
instrument with a single principal payment at maturity of $100,000 and
ten semiannual interest payments of $6,000, beginning on January 1,
1996. As a result, the debt instrument's yield is 6 percent, compounded
annually.
(iv) Determination of OID. Under the payment schedule that would
result if the option was exercised, none of the interest on the debt
instrument would be qualified stated interest. Accordingly, under Sec.
1.1273-1(c)(2), no payments on the debt instrument are qualified stated
interest payments. Thus, $6,000 of OID accrues during the first annual
accrual period. If the PIK instrument is not issued, $6,000 of OID
accrues during each annual accrual period.
(v) Consequences if the PIK instrument is issued. Under paragraph
(c)(6) of this section, if X issues the PIK instrument on January 1,
1996, the issuance of the PIK instrument is not a payment on the debt
instrument. Solely for purposes of sections 1272 and 1273, the debt
instrument is deemed reissued on January 1, 1996, for an issue price of
$106,000. The recomputed yield is 6 percent, compounded annually. The
OID for the first annual accrual period after the deemed reissuance is
$6,360. The adjusted issue price of the debt instrument at the beginning
of the next annual accrual period is $106,000 ($106,000 + $6,360 -
$6,360). The OID for each of the four remaining annual accrual periods
is $6,360.
Example 8. Debt instrument issued at a discount that provides for
payment of interest in kind. (i) Facts. On January 1, 1995, T purchases
at original issue, for $75,500, U corporation's debt instrument maturing
on January 1, 2000, at a stated principal amount of $100,000, payable on
that date. The debt instrument provides for annual payments of interest
of $4,000 on January 1 of each year, beginning on January 1, 1996. The
debt instrument gives U the unconditional right to issue, in lieu of the
first interest payment, a second debt instrument (PIK instrument)
maturing on January 1, 2000, with a stated
[[Page 550]]
principal amount of $4,000. The PIK instrument, if issued, would provide
for annual payments of interest of $160 on January 1 of each year,
beginning on January 1, 1997.
(ii) Aggregation of PIK instrument with original debt instrument.
Under Sec. 1.1275-2(c)(3), the issuance of the PIK instrument is not
considered a payment made on the original debt instrument, and the PIK
instrument is aggregated with the original debt instrument. The issue
date of the PIK instrument is the same as the original debt instrument.
(iii) Determination of yield and maturity. The right to issue the
PIK instrument is treated as an option to defer the initial interest
payment until maturity. Yield determined without regard to the option is
10.55 percent, compounded annually. Yield determined by assuming U
exercises the option is 10.32 percent, compounded annually. Thus, under
paragraph (c)(5) of this section, it is assumed that U will exercise the
option by issuing the PIK instrument because exercise of the option
would decrease the yield of the debt instrument. For purposes of
calculating OID, the debt instrument is assumed to be a 5-year debt
instrument with a single principal payment at maturity of $104,000 and
four annual interest payments of $4,160, beginning on January 1, 1997.
As a result, the yield is 10.32 percent, compounded annually.
(iv) Consequences if the PIK instrument is not issued. Assume that T
chooses to compute OID accruals on the basis of an annual accrual
period. On January 1, 1996, the adjusted issue price of the debt
instrument, and T's adjusted basis in the instrument, is $83,295.15.
Under paragraph (c)(6) of this section, if U actually makes the $4,000
interest payment on January 1, 1996, the debt instrument is treated as
if U made a pro rata prepayment (within the meaning of Sec. 1.1275-
2(f)(2)) of $4,000, which reduces the amount of each payment remaining
on the instrument by a factor of 4/104, or 1/26. Thus, under Sec.
1.1275-2(f)(1) and section 1271, T realizes a gain of $796.34 ($4,000 -
($83,295.15/26)). The adjusted issue price of the debt instrument and
T's adjusted basis immediately after the payment is $80,091.49
($83,295.15 x 25/26) and the yield continues to be 10.32 percent,
compounded annually.
Example 9. Debt instrument with stepped interest rate. (i) Facts. On
July 1, 1994, G purchases at original issue, for $85,000, H
corporation's debt instrument maturing on July 1, 2004. The debt
instrument has a stated principal amount of $100,000, payable on the
maturity date and provides for semiannual interest payments on January 1
and July 1 of each year, beginning on January 1, 1995. The amount of
each payment is $2,000 for the first 5 years and $5,000 for the final 5
years.
(ii) Determination of OID. Assume that G computes its OID using 6-
month accrual periods ending on January 1 and July 1 of each year. The
yield of the debt instrument, determined under paragraph (b)(1)(i) of
this section, is 8.65 percent, compounded semiannually. Interest is
unconditionally payable at a fixed rate of at least 4 percent,
compounded semiannually, for the entire term of the debt instrument.
Consequently, under Sec. 1.1273-1(c)(1), the semiannual payments are
qualified stated interest payments to the extent of $2,000. The amount
of OID for the first 6-month accrual period is $1,674.34 (the issue
price of the debt instrument ($85,000) times the yield of the debt
instrument for that accrual period (.0865/2) less the amount of any
qualified stated interest allocable to that accrual period ($2,000)).
Example 10. Debt instrument payable on demand that provides for
interest at a constant rate. (i) Facts. On January 1, 1995, V purchases
at original issue, for $100,000, W corporation's debt instrument. The
debt instrument calls for interest to accrue at a rate of 9 percent,
compounded annually. The debt instrument is redeemable at any time at
the option of V for an amount equal to $100,000, plus accrued interest.
V uses annual accrual periods to accrue OID on the debt instrument.
(ii) Amount of OID. Pursuant to paragraph (d) of this section, the
yield of the debt instrument is 9 percent, compounded annually. If the
debt instrument is not redeemed during 1995, the amount of OID allocable
to the year is $9,000.
[T.D. 8517, 59 FR 4810, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30140, June 14, 1996; T.D. 9612, 78 FR 8015, Feb. 5, 2013]
Sec. 1.1272-2 Treatment of debt instruments purchased at a premium.
(a) In general. Under section 1272(c)(1), if a holder purchases a
debt instrument at a premium, the holder does not include any OID in
gross income. Under section 1272(a)(7), if a holder purchases a debt
instrument at an acquisition premium, the holder reduces the amount of
OID includible in gross income by the fraction determined under
paragraph (b)(4) of this section.
(b) Definitions and special rules--(1) Purchase. For purposes of
section 1272 and this section, purchase means any acquisition of a debt
instrument, including the acquisition of a newly issued debt instrument
in a debt-for-debt exchange or the acquisition of a debt instrument from
a donor.
(2) Premium. A debt instrument is purchased at a premium if its
adjusted basis, immediately after its purchase by the holder (including
a purchase at original issue), exceeds the sum of all
[[Page 551]]
amounts payable on the instrument after the purchase date other than
payments of qualified stated interest (as defined in Sec. 1.1273-1(c)).
(3) Acquisition premium. A debt instrument is purchased at an
acquisition premium if its adjusted basis, immediately after its
purchase (including a purchase at original issue), is--
(i) Less than or equal to the sum of all amounts payable on the
instrument after the purchase date other than payments of qualified
stated interest (as defined in Sec. 1.1273-1(c)); and
(ii) Greater than the instrument's adjusted issue price (as defined
in Sec. 1.1275-1(b)).
(4) Acquisition premium fraction. In applying section 1272(a)(7),
the cost of a debt instrument is its adjusted basis immediately after
its acquisition by the purchaser. Thus, the numerator of the fraction
determined under section 1272(a)(7)(B) is the excess of the adjusted
basis of the debt instrument immediately after its acquisition by the
purchaser over the adjusted issue price of the debt instrument. The
denominator of the fraction determined under section 1272(a)(7)(B) is
the excess of the sum of all amounts payable on the debt instrument
after the purchase date, other than payments of qualified stated
interest, over the instrument's adjusted issue price.
(5) Election to accrue discount on a constant yield basis. Rather
than applying the acquisition premium fraction, a holder of a debt
instrument purchased at an acquisition premium may elect under Sec.
1.1272-3 to compute OID accruals by treating the purchase as a purchase
at original issuance and applying the mechanics of the constant yield
method.
(6) Special rules for determining basis--(i) Debt instruments
acquired in exchange for other property. For purposes of section
1272(a)(7), section 1272(c)(1), and this section, if a debt instrument
is acquired in an exchange for other property (other than in a
reorganization defined in section 368) and the basis of the debt
instrument is determined, in whole or in part, by reference to the basis
of the other property, the basis of the debt instrument may not exceed
its fair market value immediately after the exchange. For example, if a
debt instrument is distributed by a partnership to a partner in a
liquidating distribution and the partner's basis in the debt instrument
would otherwise be determined under section 732, the partner's basis in
the debt instrument may not exceed its fair market value for purposes of
this section.
(ii) Acquisition by gift. For purposes of this section, a donee's
adjusted basis in a debt instrument is the donee's basis for determining
gain under section 1015(a).
(c) Examples. The following examples illustrate the rules of this
section.
Example 1. Debt instrument purchased at an acquisition premium. (i)
Facts. On July 1, 1994, A purchased at original issue, for $500, a debt
instrument issued by Corporation X. The debt instrument matures on July
1, 1999, and calls for a single payment at maturity of $1,000. Under
section 1273(a), the debt instrument has a stated redemption price at
maturity of $1,000 and, thus, OID of $500. On July 1, 1996, when the
debt instrument's adjusted issue price is $659.75, A sells the debt
instrument to B for $750 in cash.
(ii) Acquisition premium fraction. Because the cost to B of the debt
instrument is less than the amount payable on the debt instrument after
the purchase date, but is greater than the debt instrument's adjusted
issue price, B has paid an acquisition premium for the debt instrument.
Accordingly, the daily portion of OID for any day that B holds the debt
instrument is reduced by a fraction, the numerator of which is $90.25
(the excess of the cost of the debt instrument over its adjusted issue
price) and the denominator of which is $340.25 (the excess of the sum of
all payments after the purchase date over its adjusted issue price).
Example 2. Debt-for-debt exchange where holder is considered to
purchase new debt instrument at a premium. (i) Facts. On January 1,
1995, H purchases at original issue, for $1,000, a debt instrument
issued by Corporation X. On July 1, 1997, when H's adjusted basis in the
debt instrument is $1,000, Corporation X issues a new debt instrument
with a stated redemption price at maturity of $750 to H in exchange for
the old debt instrument. Assume that the issue price of the new debt
instrument is $600. Thus, under section 1273(a), the debt instrument has
OID of $150. The exchange qualifies as a recapitalization under section
368(a)(1)(E), with the consequence that, under sections 354 and 358, H
recognizes no loss on the exchange and has an adjusted basis in the new
debt instrument of $1,000.
(ii) Application of section 1272(c)(1). Under paragraphs (b)(1) and
(b)(2) of this section, H
[[Page 552]]
purchases the new debt instrument at a premium of $250. Accordingly,
under section 1272(c)(1), H is not required to include OID in income
with respect to the new debt instrument.
Example 3. Debt-for-debt exchange where holder is considered to
purchase new debt instrument at an acquisition premium. (i) Facts. The
facts are the same as in Example 2 of paragraph (c) of this section,
except that H purchases the old debt instrument from another holder on
July 1, 1995, and on July 1, 1997, H's adjusted basis in the old debt
instrument is $700. Under section 1273(a), the new debt instrument is
issued with OID of $150.
(ii) Application of section 1272(a)(7). Under paragraphs (b)(1) and
(b)(3) of this section, H purchases the new debt instrument at an
acquisition premium of $100. Accordingly, the daily portion of OID that
is includible in H's income is reduced by the fraction determined under
section 1272(a)(7).
Example 4. Treatment of acquisition premium for debt instrument
acquired by gift. (i) Facts. On July 1, 1994, D receives as a gift a
debt instrument with a stated redemption price at maturity of $1,000 and
an adjusted issue price of $800. On that date, the fair market value of
the debt instrument is $900 and the donor's adjusted basis in the debt
instrument is $950.
(ii) Application of section 1272(a)(7). Under paragraphs (b)(1),
(b)(3), and (b)(6)(ii) of this section, D is considered to have
purchased the debt instrument at an acquisition premium of $150.
Accordingly, the daily portion of OID that is includible in D's income
is reduced by the fraction determined under section 1272(a)(7).
[T.D. 8517, 59 FR 4814, Feb. 2, 1994]
Sec. 1.1272-3 Election by a holder to treat all interest on a debt
instrument as OID.
(a) Election. A holder of a debt instrument may elect to include in
gross income all interest that accrues on the instrument by using the
constant yield method described in paragraph (c) of this section. For
purposes of this election, interest includes stated interest,
acquisition discount, OID, de minimis OID, market discount, de minimis
market discount, and unstated interest, as adjusted by any amortizable
bond premium or acquisition premium.
(b) Scope of election--(1) In general. Except as provided in
paragraph (b)(2) of this section, a holder may make the election for any
debt instrument.
(2) Exceptions, limitations, and special rules--(i) Debt instrument
with amortizable bond premium (as determined under section 171). (A) A
holder may make the election for a debt instrument with amortizable bond
premium only if the instrument qualifies as a bond under section 171(d).
(B) If a holder makes the election under this section for a debt
instrument with amortizable bond premium, the holder is deemed to have
made the election under section 171(c)(2) for the taxable year in which
the instrument was acquired. If the holder has previously made the
election under section 171(c)(2), the requirements of that election with
respect to any debt instrument are satisfied by electing to amortize the
bond premium under the rules provided by this section.
(ii) Debt instrument with market discount. (A) A holder may make the
election under this section for a debt instrument with market discount
only if the holder is eligible to make an election under section
1278(b).
(B) If a holder makes the election under this section for a debt
instrument with market discount, the holder is deemed to have made both
the election under section 1276(b)(2) for that instrument and the
election under section 1278(b) for the taxable year in which the
instrument was acquired. If the holder has previously made the election
under section 1278(b), the requirements of that election with respect to
any debt instrument are satisfied by electing to include the market
discount in income in accordance with the rules provided by this
section.
(iii) Tax-exempt debt instrument. A holder may not make the election
for a tax-exempt obligation as defined in section 1275(a)(3).
(c) Mechanics of the constant yield method--(1) In general. For
purposes of this section, the amount of interest that accrues during an
accrual period is determined under rules similar to those under section
1272 (the constant yield method). In applying the constant yield method,
however, a debt instrument subject to the election is treated as if--
(i) The instrument is issued for the holder's adjusted basis
immediately after its acquisition by the holder;
(ii) The instrument is issued on the holder's acquisition date; and
[[Page 553]]
(iii) None of the interest payments provided for in the instrument
are qualified stated interest payments.
(2) Special rules to determine adjusted basis. For purposes of
paragraph (c)(1)(i) of this section--
(i) If the debt instrument is acquired in an exchange for other
property (other than in a reorganization defined in section 368) and the
basis of the debt instrument is determined, in whole or in part, by
reference to the basis of the other property, the adjusted basis of the
debt instrument may not exceed its fair market value immediately after
the exchange; and
(ii) If the debt instrument was acquired with amortizable bond
premium (as determined under section 171), the adjusted basis of the
debt instrument is reduced by an amount equal to the value attributable
to any conversion feature.
(d) Time and manner of making the election. The election must be
made for the taxable year in which the holder acquires the debt
instrument. A holder makes the election by attaching to the holder's
timely filed Federal income tax return a statement that the holder is
making an election under this section and that identifies the debt
instruments subject to the election. A holder may make the election for
a class or group of debt instruments by attaching a statement describing
the type or types of debt instruments being designated for the election.
(e) Revocation of election. The election may not be revoked unless
approved by the Commissioner.
(f) Effective date. This section applies to debt instruments
acquired on or after April 4, 1994.
[T.D. 8517, 59 FR 4815, Feb. 2, 1994]
Sec. 1.1273-1 Definition of OID.
(a) In general. Section 1273(a)(1) defines OID as the excess of a
debt instrument's stated redemption price at maturity over its issue
price. Section 1.1273-2 defines issue price, and paragraph (b) of this
section defines stated redemption price at maturity. Paragraph (d) of
this section provides rules for de minimis amounts of OID. Although the
total amount of OID for a debt instrument may be indeterminate, Sec.
1.1272-1(d) provides a rule to determine OID accruals on certain debt
instruments that provide for a fixed yield. See Example 10 in Sec.
1.1272-1(j).
(b) Stated redemption price at maturity. A debt instrument's stated
redemption price at maturity is the sum of all payments provided by the
debt instrument other than qualified stated interest payments. If the
payment schedule of a debt instrument is determined under Sec. 1.1272-
1(c) (relating to certain debt instruments subject to contingencies),
that payment schedule is used to determine the instrument's stated
redemption price at maturity.
(c) Qualified stated interest--(1) Definition--(i) In general.
Qualified stated interest is stated interest that is unconditionally
payable in cash or in property (other than debt instruments of the
issuer), or that will be constructively received under section 451, at
least annually at a single fixed rate (within the meaning of paragraph
(c)(1)(iii) of this section).
(ii) Unconditionally payable. Interest is unconditionally payable
only if reasonable legal remedies exist to compel timely payment or the
debt instrument otherwise provides terms and conditions that make the
likelihood of late payment (other than a late payment that occurs within
a reasonable grace period) or nonpayment a remote contingency (within
the meaning of Sec. 1.1275-2(h)). For purposes of the preceding
sentence, remedies or other terms and conditions are not taken into
account if the lending transaction does not reflect arm's length dealing
and the holder does not intend to enforce the remedies or other terms
and conditions. For purposes of determining whether interest is
unconditionally payable, the possibility of nonpayment due to default,
insolvency, or similar circumstances, or due to the exercise of a
conversion option described in Sec. 1.1272-1(e) is ignored. This
paragraph (c)(1)(ii) applies to debt instruments issued on or after
August 13, 1996.
(iii) Single fixed rate--(A) In general. Interest is payable at a
single fixed rate only if the rate appropriately takes into account the
length of the interval between payments. Thus, if the interval between
payments varies during the term of the debt instrument,
[[Page 554]]
the value of the fixed rate on which a payment is based generally must
be adjusted to reflect a compounding assumption that is consistent with
the length of the interval preceding the payment. See Example 1 in
paragraph (f) of this section.
(B) Special rule for certain first and final payment intervals.
Notwithstanding paragraph (c)(1)(iii)(A) of this section, if a debt
instrument provides for payment intervals that are equal in length
throughout the term of the instrument, except that the first or final
payment interval differs in length from the other payment intervals, the
first or final interest payment is considered to be made at a fixed rate
if the value of the rate on which the payment is based is adjusted in
any reasonable manner to take into account the length of the interval.
See Example 2 of paragraph (f) of this section. The rule in this
paragraph (c)(1)(iii)(B) also applies if the lengths of both the first
and final payment intervals differ from the length of the other payment
intervals.
(2) Debt instruments subject to contingencies. The determination of
whether a debt instrument described in Sec. 1.1272-1(c) (a debt
instrument providing for an alternative payment schedule (or schedules)
upon the occurrence of one or more contingencies) provides for qualified
stated interest is made by analyzing each alternative payment schedule
(including the stated payment schedule) as if it were the debt
instrument's sole payment schedule. Under this analysis, the debt
instrument provides for qualified stated interest to the extent of the
lowest fixed rate at which qualified stated interest would be payable
under any payment schedule. See Example (4) of paragraph (f) of this
section.
(3) Variable rate debt instrument. In the case of a variable rate
debt instrument, qualified stated interest is determined under Sec.
1.1275-5(e).
(4) Stated interest in excess of qualified stated interest. To the
extent that stated interest payable under a debt instrument exceeds
qualified stated interest, the excess is included in the debt
instrument's stated redemption price at maturity.
(5) Short-term obligations. In the case of a debt instrument with a
term that is not more than 1 year from the date of issue, no payments of
interest are treated as qualified stated interest payments.
(6) Business day convention--(i) Rule. For purposes of this
paragraph (c), if a scheduled payment date for stated interest falls on
a Saturday, Sunday, or Federal holiday (within the meaning of 5 U.S.C.
6103) but, under the terms of the debt instrument, the stated interest
is payable on the first business day that immediately follows the
scheduled payment date, the stated interest is treated as payable on the
scheduled payment date, provided no additional interest is payable as a
result of the deferral.
(ii) Effective/applicability date. Paragraph (c)(6)(i) of this
section applies to a debt instrument issued on or after September 13,
2012. A taxpayer, however, may rely on paragraph (c)(6)(i) of this
section for a debt instrument issued before that date.
(d) De minimis OID--(1) In general. If the amount of OID with
respect to a debt instrument is less than the de minimis amount, the
amount of OID is treated as zero, and all stated interest (including
stated interest that would otherwise be characterized as OID) is treated
as qualified stated interest.
(2) De minimis amount. The de minimis amount is an amount equal to
0.0025 multiplied by the product of the stated redemption price at
maturity and the number of complete years to maturity from the issue
date.
(3) Installment obligations. In the case of an installment
obligation (as defined in paragraph (e)(1) of this section), paragraph
(d)(2) of this section is applied by substituting for the number of
complete years to maturity the weighted average maturity (as defined in
paragraph (e)(3) of this section). Alternatively, in the case of a debt
instrument that provides for payments of principal no more rapidly than
a self-amortizing installment obligation (as defined in paragraph (e)(2)
of this section), the de minimis amount defined in paragraph (d)(2) of
this section may be calculated by substituting 0.00167 for 0.0025.
(4) Special rule for interest holidays, teaser rates, and other
interest shortfalls--(i) In general. This paragraph
[[Page 555]]
(d)(4) provides a special rule to determine whether a debt instrument
with a teaser rate (or rates), an interest holiday, or any other
interest shortfall has de minimis OID. This rule applies if--
(A) The amount of OID on the debt instrument is more than the de
minimis amount as otherwise determined under paragraph (d) of this
section; and
(B) All stated interest provided for in the debt instrument would be
qualified stated interest under paragraph (c) of this section except
that for 1 or more accrual periods the interest rate is below the rate
applicable for the remainder of the instrument's term (e.g., if as a
result of an interest holiday, none of the stated interest is qualified
stated interest).
(ii) Redetermination of OID for purposes of the de minimis test. For
purposes of determining whether a debt instrument described in paragraph
(d)(4)(i) of this section has de minimis OID, the instrument's stated
redemption price at maturity is treated as equal to the instrument's
issue price plus the greater of the amount of foregone interest or the
excess (if any) of the instrument's stated principal amount over its
issue price. The amount of foregone interest is the amount of additional
stated interest that would be required to be payable on the debt
instrument during the period of the teaser rate, holiday, or shortfall
so that all stated interest would be qualified stated interest under
paragraph (c) of this section. See Example 5 and Example 6 of paragraph
(f) of this section. In addition, for purposes of computing the de
minimis amount of OID, the weighted average maturity of the debt
instrument is determined by treating all stated interest payments as
qualified stated interest payments.
(5) Treatment of de minimis OID by holders--(i) Allocation of de
minimis OID to principal payments. The holder of a debt instrument
includes any de minimis OID (other than de minimis OID treated as
qualified stated interest under paragraph (d)(1) of this section, such
as de minimis OID attributable to a teaser rate or interest holiday) in
income as stated principal payments are made. The amount includible in
income with respect to each principal payment equals the product of the
total amount of de minimis OID on the debt instrument and a fraction,
the numerator of which is the amount of the principal payment made and
the denominator of which is the stated principal amount of the
instrument.
(ii) Character of de minimis OID--(A) De minimis OID treated as gain
recognized on retirement. Any amount of de minimis OID includible in
income under this paragraph (d)(5) is treated as gain recognized on
retirement of the debt instrument. See section 1271 to determine whether
a retirement is treated as an exchange of the debt instrument.
(B) Treatment of de minimis OID on sale or exchange. Any gain
attributable to de minimis OID that is recognized on the sale or
exchange of a debt instrument is capital gain if the debt instrument is
a capital asset in the hands of the seller.
(iii) Treatment of subsequent holders. If a subsequent holder
purchases a debt instrument issued with de minimis OID at a premium (as
defined in Sec. 1.1272-2(b)(2)), the subsequent holder does not include
the de minimis OID in income. Otherwise, a subsequent holder includes
any discount in income under the market discount rules (sections 1276
through 1278) rather than under the rules of this paragraph (d)(5).
(iv) Cross-reference. See Sec. 1.1272-3 for an election by a holder
to treat de minimis OID as OID.
(e) Definitions--(1) Installment obligation. An installment
obligation is a debt instrument that provides for the payment of any
amount other than qualified stated interest before maturity.
(2) Self-amortizing installment obligation. A self-amortizing
installment obligation is an obligation that provides for equal payments
composed of principal and qualified stated interest that are
unconditionally payable at least annually during the entire term of the
debt instrument with no significant additional payment required at
maturity.
(3) Weighted average maturity. The weighted average maturity of a
debt instrument is the sum of the following amounts determined for each
payment under the instrument (other than a payment of qualified stated
interest)--
[[Page 556]]
(i) The number of complete years from the issue date until the
payment is made; multiplied by
(ii) A fraction, the numerator of which is the amount of the payment
and the denominator of which is the debt instrument's stated redemption
price at maturity.
(f) Examples. The following examples illustrate the rules of this
section.
Example 1. Qualified stated interest. (i) Facts. On January 1, 1995,
A purchases at original issue, for $100,000, a debt instrument that
matures on January 1, 1999, and has a stated principal amount of
$100,000, payable at maturity. The debt instrument provides for interest
payments of $8,000 on January 1, 1996, and January 1, 1997, and
quarterly interest payments of $1,942.65, beginning on April 1, 1997.
(ii) Amount of qualified stated interest. The annual payments of
$8,000 and the quarterly payments of $1,942.65 are payable at a single
fixed rate because 8 percent, compounded annually, is equivalent to 7.77
percent, compounded quarterly. Consequently, all stated interest
payments under the debt instrument are qualified stated interest
payments.
Example 2. Qualified stated interest with short initial payment
interval. On October 1, 1994, A purchases at original issue, for
$100,000, a debt instrument that matures on January 1, 1998, and has a
stated principal amount of $100,000, payable at maturity. The debt
instrument provides for an interest payment of $2,000 on January 1,
1995, and interest payments of $8,000 on January 1, 1996, January 1,
1997, and January 1, 1998. Under paragraph (c)(1)(iii)(B) of this
section, all stated interest payments on the debt instrument are
computed at a single fixed rate and are qualified stated interest
payments.
Example 3. Stated interest in excess of qualified stated interest.
(i) Facts. On January 1, 1995, B purchases at original issue, for
$100,000, C corporation's 5-year debt instrument. The debt instrument
provides for a principal payment of $100,000, payable at maturity, and
calls for annual interest payments of $10,000 for the first 3 years and
annual interest payments of $10,600 for the last 2 years.
(ii) Payments in excess of qualified stated interest. All of the
first three interest payments and $10,000 of each of the last two
interest payments are qualified stated interest payments within the
meaning of paragraph (c)(1) of this section. Under paragraph (c)(4) of
this section, the remaining $600 of each of the last two interest
payments is included in the stated redemption price at maturity, so that
the stated redemption price at maturity is $101,200. Pursuant to
paragraph (e)(3) of this section, the weighted average maturity of the
debt instrument is 4.994 years [(4 years x $600/$101,200) + (5 years x
$100,600/$101,200)]. The de minimis amount, or one-fourth of 1 percent
of the stated redemption price at maturity multiplied by the weighted
average maturity, is $1,263.50. Because the actual amount of discount,
$1,200, is less than the de minimis amount, the instrument is treated as
having no OID, and, under paragraph (d)(1) of this section, all of the
interest payments are treated as qualified stated interest payments.
Example 4. Qualified stated interest on a debt instrument that is
subject to an option. (i) Facts. On January 1, 1997, A issues, for
$100,000, a 10-year debt instrument that provides for a $100,000
principal payment at maturity and for annual interest payments of
$10,000. Under the terms of the debt instrument, A has the option,
exercisable on January 1, 2002, to lower the annual interest payments to
$8,000. In addition, the debt instrument gives the holder an
unconditional right to put the debt instrument back to A, exercisable on
January 1, 2002, in return for $100,000.
(ii) Amount of qualified stated interest. Under paragraph (c)(2) of
this section, the debt instrument provides for qualified stated interest
to the extent of the lowest fixed rate at which qualified stated
interest would be payable under any payment schedule. If the payment
schedule determined by assuming that the issuer's option will be
exercised and the put option will not be exercised were treated as the
debt instrument's sole payment schedule, only $8,000 of each annual
interest payment would be qualified stated interest. Under any other
payment schedule, the debt instrument would provide for annual qualified
stated interest payments of $10,000. Accordingly, only $8,000 of each
annual interest payment is qualified stated interest. Any excess of each
annual interest payment over $8,000 is included in the debt instrument's
stated redemption price at maturity.
Example 5. De minimis OID; interest holiday. (i) Facts. On January
1, 1995, C purchases at original issue, for $97,561, a debt instrument
that matures on January 1, 2007, and has a stated principal amount of
$100,000, payable at maturity. The debt instrument provides for an
initial interest holiday of 1 quarter and quarterly interest payments of
$2,500 thereafter (beginning on July 1, 1995). The issue price of the
debt instrument is $97,561. C chooses to accrue OID based on quarterly
accrual periods.
(ii) De minimis amount of OID. But for the interest holiday, all
stated interest on the debt instrument would be qualified stated
interest. Under paragraph (d)(4) of this section, for purposes of
determining whether the debt instrument has de minimis OID, the stated
redemption price at maturity of the instrument is $100,061 ($97,561
(issue price) plus $2,500 (the greater of the amount of foregone
interest ($2,500) and the amount equal to the
[[Page 557]]
excess of the instrument's stated principal amount over its issue price
($2,439)). Thus, the debt instrument is treated as having OID of $2,500
($100,061 minus $97,561). Because this amount is less than the de
minimis amount of $3,001.83 (0.0025 multiplied by $100,061 multiplied by
12 complete years to maturity), the debt instrument is treated as having
no OID, and all stated interest is treated as qualified stated interest.
Example 6. De minimis OID; teaser rate. (i) Facts. The facts are the
same as in Example 5 of this paragraph (f) except that C uses an initial
semiannual accrual period rather than an initial quarterly accrual
period.
(ii) De minimis amount of OID. The debt instrument provides for an
initial teaser rate because the interest rate for the semiannual accrual
period is less than the interest rate applicable to the subsequent
quarterly accrual periods. But for the initial teaser rate, all stated
interest on the debt instrument would be qualified stated interest.
Under paragraph (d)(4) of this section, for purposes of determining
whether the debt instrument has de minimis OID, the stated redemption
price at maturity of the instrument is $100,123.50 ($97,561 (issue
price) plus $2,562.50 (the greater of the amount of foregone interest
($2,562.50) and the amount equal to the excess of the instrument's
stated principal amount over its issue price ($2,439)). Thus, the debt
instrument is treated as having OID of $2,562.50 ($100,123.50 minus
$97,561). Because this amount is less than the de minimis amount of
$3,003.71 (0.0025 multiplied by $100,123.50 multiplied by 12 complete
years to maturity), the debt instrument is treated as having no OID, and
all stated interest is treated as qualified stated interest.
[T.D. 8517, 59 FR 4815, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30141, June 14, 1996; T.D. 9599, 77 FR 56536, Sept. 13, 2012]
Sec. 1.1273-2 Determination of issue price and issue date.
(a) Debt instruments issued for money--(1) Issue price. If a
substantial amount of the debt instruments in an issue is issued for
money, the issue price of each debt instrument in the issue is the first
price at which a substantial amount of the debt instruments is sold for
money. Thus, if an issue consists of a single debt instrument that is
issued for money, the issue price of the debt instrument is the amount
paid for the instrument. For example, in the case of a debt instrument
evidencing a loan to a natural person, the issue price of the instrument
is the amount loaned. See Sec. 1.1275-2(d) for rules regarding Treasury
securities. For purposes of this paragraph (a), money includes
functional currency and, in certain circumstances, nonfunctional
currency. See Sec. 1.988-2(b)(2) for circumstances when nonfunctional
currency is treated as money rather than as property.
(2) Issue date. The issue date of an issue described in paragraph
(a)(1) of this section is the first settlement date or closing date,
whichever is applicable, on which a substantial amount of the debt
instruments in the issue is sold for money.
(b) Publicly traded debt instruments issued for property--(1) Issue
price. If a substantial amount of the debt instruments in an issue is
traded on an established market (within the meaning of paragraph (f) of
this section) and the issue is not described in paragraph (a)(1) of this
section, the issue price of each debt instrument in the issue is the
fair market value of the debt instrument, determined as of the issue
date (as defined in paragraph (b)(2) of this section). See paragraph (f)
of this section for rules to determine the fair market value of a debt
instrument for purposes of this section.
(2) Issue date. The issue date of an issue described in paragraph
(b)(1) of this section is the first date on which a substantial amount
of the traded debt instruments in the issue is issued.
(c) Debt instruments issued for publicly traded property--(1) Issue
price. If a substantial amount of the debt instruments in an issue is
issued for property that is traded on an established market (within the
meaning of paragraph (f) of this section) and the issue is not described
in paragraph (a)(1) or (b)(1) of this section, the issue price of each
debt instrument in the issue is the fair market value of the property,
determined as of the issue date (as defined in paragraph (c)(2) of this
section). For purposes of the preceding sentence, property means a debt
instrument, stock, security, contract, commodity, or nonfunctional
currency. But see Sec. 1.988-2(b)(2) for circumstances when
nonfunctional currency is treated as money rather than as property. See
paragraph (f) of this section for rules to determine the fair market
value of property for purposes of this section.
(2) Issue date. The issue date of an issue described in paragraph
(c)(1) of this section is the first date on which a
[[Page 558]]
substantial amount of the debt instruments in the issue is issued for
traded property.
(d) Other debt instruments--(1) Issue price. If an issue of debt
instruments is not described in paragraph (a)(1), (b)(1), or (c)(1) of
this section, the issue price of each debt instrument in the issue is
determined as if the debt instrument were a separate issue. If the issue
price of a debt instrument that is treated as a separate issue under the
preceding sentence is not determined under paragraph (a)(1), (b)(1), or
(c)(1) of this section, and if section 1274 applies to the debt
instrument, the issue price of the instrument is determined under
section 1274. Otherwise, the issue price of the debt instrument is its
stated redemption price at maturity under section 1273(b)(4). See
section 1274(c) and Sec. 1.1274-1 to determine if section 1274 applies
to a debt instrument.
(2) Issue date. The issue date of an issue described in paragraph
(d)(1) of this section is the date on which the debt instrument is
issued for money or in a sale or exchange.
(e) Special rule for certain sales to bond houses, brokers, or
similar persons. For purposes of determining the issue price and issue
date of a debt instrument under this section, sales to bond houses,
brokers, or similar persons or organizations acting in the capacity of
underwriters, placement agents, or wholesalers are ignored.
(f) Traded on an established market (publicly traded)--(1) In
general. Except as provided in paragraph (f)(6) of this section,
property (including a debt instrument described in paragraph (b)(1) of
this section) is traded on an established market for purposes of this
section if, at any time during the 31-day period ending 15 days after
the issue date--
(i) There is a sales price for the property as described in
paragraph (f)(2) of this section;
(ii) There are one or more firm quotes for the property as described
in paragraph (f)(3) of this section; or
(iii) There are one or more indicative quotes for the property as
described in paragraph (f)(4) of this section.
(2) Sales price--(i) In general. A sales price exists if the price
for an executed purchase or sale of the property within the 31-day
period described in paragraph (f)(1) of this section is reasonably
available within a reasonable period of time after the sale.
(ii) Pricing information for a debt instrument. For purposes of
paragraph (f)(2)(i) of this section, the price of a debt instrument is
considered reasonably available if the sales price (or information
sufficient to calculate the sales price) appears in a medium that is
made available to issuers of debt instruments, persons that regularly
purchase or sell debt instruments (including a price provided only to
certain customers or to subscribers), or persons that broker purchases
or sales of debt instruments.
(3) Firm quote. A firm quote is considered to exist when a price
quote is available from at least one broker, dealer, or pricing service
(including a price provided only to certain customers or to subscribers)
for property and the quoted price is substantially the same as the price
for which the person receiving the quoted price could purchase or sell
the property. A price quote is considered to be available whether the
quote is initiated by a person providing the quote or provided at the
request of the person receiving the quote. The identity of the person
providing the quote must be reasonably ascertainable for a quote to be
considered a firm quote for purposes of this paragraph (f)(3). A quote
will be considered a firm quote if the quote is designated as a firm
quote by the person providing the quote or if market participants
typically purchase or sell, as the case may be, at the quoted price,
even if the party providing the quote is not legally obligated to
purchase or sell at that price.
(4) Indicative quote. An indicative quote is considered to exist
when a price quote is available from at least one broker, dealer, or
pricing service (including a price provided only to certain customers or
to subscribers) for property and the price quote is not a firm quote
described in paragraph (f)(3) of this section.
(5) Presumption that price or quote is equal to fair market value--
(i) In general. For purposes of this section, the fair market value of
property will be presumed to be equal to its sales price or
[[Page 559]]
quoted price determined under paragraphs (f)(2) through (f)(4) of this
section. If there is more than one sales price under paragraph (f)(2) of
this section, more than one quoted price under paragraph (f)(3) or
(f)(4) of this section, or both one or more sales prices under paragraph
(f)(2) of this section and quoted prices under paragraph (f)(3) or
(f)(4) of this section, a taxpayer may use any reasonable method,
consistently applied to the same or substantially similar facts, to
determine the fair market value. For example, to determine the fair
market value under a reasonable method, a taxpayer may consider factors
such as (but not necessarily limited to) the timing of each relevant
sale or quote in relation to the issue date; whether the price is
derived from a sale, a firm quote, or an indicative quote; the size of
each relevant sale or quote; or whether the sales price or quote
corresponds to pricing information provided by an independent bond or
loan pricing service.
(ii) Special rule for property for which there is only an indicative
quote. If property is described only in paragraph (f)(4) of this
section, and the taxpayer determines that the quote (or an average of
the quotes) materially misrepresents the fair market value of the
property, the taxpayer can use any method that provides a reasonable
basis to determine the fair market value of the property. A taxpayer
must establish that the method chosen more accurately reflects the value
of the property than the quote or quotes for the property to use the
method provided in this paragraph (f)(5)(ii). For an equity or debt
instrument, a volume discount or control premium will not be considered
to create a material misrepresentation of value for purposes of this
paragraph (f)(5)(ii).
(6) Exception for small debt issues. Notwithstanding any other
provision in paragraph (f) of this section, a debt instrument will not
be treated as traded on an established market if at the time the
determination is made the outstanding stated principal amount of the
issue that includes the debt instrument does not exceed US$100 million
(or, for a debt instrument denominated in a currency other than the U.S.
dollar, the equivalent amount in the currency in which the debt
instrument is denominated).
(7) Anti-abuse rules--(i) Effect of certain temporary restrictions
on trading. If there is any temporary restriction on trading a purpose
of which is to avoid the characterization of the property as one that is
traded on an established market for Federal income tax purposes, then
the property is treated as traded on an established market. For purposes
of the preceding sentence, a temporary restriction on trading need not
be imposed by the issuer.
(ii) Artificial pricing information. If a principal purpose for the
existence of any sale or price quotation is to cause the property to be
traded on an established market or to materially misrepresent the value
of property, that sale or price quotation is disregarded.
(8) Convertible debt instruments. A debt instrument is not treated
as traded on an established market solely because the debt instrument is
convertible into property that is so traded.
(9) Issuer-holder consistency requirement--(i) General rule. For
purposes of this section, an issuer must determine whether property is
traded on an established market and, if so, the fair market value of the
property. An issuer is required to exercise reasonable diligence to
determine whether purchases or sales have taken place, the quantity of
purchases and sales, the price at which purchases or sales occurred, the
existence of firm or indicative quotes, and any other relevant
information using the rules provided in paragraph (f) of this section to
determine the fair market value of the property. If an issuer determines
that property is traded on an established market, the issuer is required
to make that determination as well as the fair market value of the
property (which can be stated as the issue price of the debt instrument)
available to holders in a commercially reasonable fashion, including by
electronic publication, within 90 days of the date that the debt
instrument is issued. Each determination by an issuer is binding on a
holder of the debt instrument unless the holder explicitly discloses
that its determination is different from the issuer's determination (for
example, the holder
[[Page 560]]
determines a different fair market value for the property or determines
that the property is not traded on an established market). A holder must
describe in the disclosure the reasons for its different determination
and, if applicable, how the holder determined the fair market value. A
holder's disclosure must be filed on a timely filed Federal income tax
return for the taxable year that includes the acquisition date of the
debt instrument. If an issuer for any reason does not make the fair
market value or issue price of a debt instrument reasonably available to
a holder, the holder must determine the fair market value of the
property and issue price of the debt instrument using the rules provided
in paragraph (f) of this section.
(ii) Co-obligors. If a debt instrument has more than one obligor,
the obligors must designate one obligor (issuer) to determine whether
property is traded on an established market and, if so, the fair market
value of the property and issue price of the debt instrument and make
the price available to holders using the rules provided in paragraph
(f)(9)(i) of this section.
(10) Effective/applicability dates--(i) This paragraph (f) applies
to a debt instrument issued on or after November 13, 2012.
(ii) For rules applying to a debt instrument issued before November
13, 2012, see paragraph (f) of this section as contained in 26 CFR part
1, revised April 1, 2011.
(g) Treatment of certain cash payments incident to lending
transactions--(1) Applicability. The provisions of this paragraph (g)
apply to cash payments made incident to private lending transactions
(including seller financing).
(2) Payments from borrower to lender--(i) Money lending transaction.
In a lending transaction to which section 1273(b)(2) applies, a payment
from the borrower to the lender (other than a payment for property or
for services provided by the lender, such as commitment fees or loan
processing costs) reduces the issue price of the debt instrument
evidencing the loan. However, solely for purposes of determining the tax
consequences to the borrower, the issue price is not reduced if the
payment is deductible under section 461(g)(2).
(ii) Section 1274 transaction. In a lending transaction to which
section 1274 applies, a payment from the buyer-borrower to the seller-
lender that is designated as interest or points reduces the stated
principal amount of the debt instrument evidencing the loan, but is
included in the purchase price of the property. If the payment is
deductible under section 461(g)(2), however, the issue price of the debt
instrument (as otherwise determined under section 1274 and the rule in
the preceding sentence) is increased by the amount of the payment to
compute the buyer-borrower's interest deductions under section 163.
(3) Payments from lender to borrower. A payment from the lender to
the borrower in a lending transaction is treated as an amount loaned.
(4) Payments between lender and third party. If, as part of a
lending transaction, a party other than the borrower (the third party)
makes a payment to the lender, that payment is treated in appropriate
circumstances as made from the third party to the borrower followed by a
payment in the same amount from the borrower to the lender and governed
by the provisions of paragraph (g)(2) of this section. If, as part of a
lending transaction, the lender makes a payment to a third party, that
payment is treated in appropriate circumstances as an additional amount
loaned to the borrower and then paid by the borrower to the third party.
The character of the deemed payment between the borrower and the third
party depends on the substance of the transaction.
(5) Examples. The following examples illustrate the rules of this
paragraph (g).
Example 1. Payments from borrower to lender in a cash transaction.
(i) Facts. A lends $100,000 to B for a term of 10 years. At the time the
loan is made, B pays $4,000 in points to A. Assume that the points are
not deductible by B under section 461(g)(2) and that the stated
redemption price at maturity of the debt instrument is $100,000.
(ii) Payment results in OID. Under paragraph (g)(2)(i) of this
section, the issue price of B's debt instrument evidencing the loan is
$96,000. Because the amount of OID on the debt instrument ($4,000) is
more than a de
[[Page 561]]
minimis amount of OID, A accounts for the OID under Sec. 1.1272-1. B
accounts for the OID under Sec. 1.163-7.
Example 2. Payments from borrower to lender in a section 1274
transaction. (i) Facts. A sells property to B for $1,000,000 in a
transaction that is not a potentially abusive situation (within the
meaning of Sec. 1.1274-3). In consideration for the property, B gives A
$300,000 and issues a 5-year debt instrument that has a stated principal
amount of $700,000, payable at maturity, and that calls for semiannual
payments of interest at a rate of 8.5 percent. In addition to the cash
downpayment, B pays A $14,000 designated as points on the loan. Assume
that the points are not deductible under section 461(g)(2).
(ii) Issue price. Under paragraph (g)(2)(ii) of this section, the
stated principal amount of B's debt instrument is -$686,000 ($700,000
minus $14,000). Assuming a test rate of 9 percent, compounded
semiannually, the imputed principal amount of B's debt instrument under
Sec. 1.1274-2(c)(1) is $686,153. Under Sec. 1.1274-2(b)(1), the issue
price of B's debt instrument is the stated principal amount of $686,000.
Because the amount of OID on the debt instrument ($700,000-$686,000, or
$14,000) is more than a de minimis amount of OID, A accounts for the OID
under Sec. 1.1272-1 and B accounts for the OID under Sec. 1.163-7. B's
basis in the property purchased is $1,000,000 ($686,000 debt instrument
plus $314,000 cash payments).
Example 3. Payments between lender and third party (seller-paid
points). (i) Facts. A sells real property to B for $500,000 in a
transaction that is not a potentially abusive situation (within the
meaning of Sec. 1.1274-3). B makes a cash down payment of $100,000 and
borrows $400,000 of the purchase price from a lender, L, repayable in
annual installments over a term of 15 years calling for interest at a
rate of 9 percent, compounded annually. As part of the transaction, A
makes a payment of $8,000 to L to facilitate the loan to B.
(ii) Payment results in a de minimis amount of OID. Under the
provisions of paragraphs (g)(2)(i) and (g)(4) of this section, B is
treated as having made an $8,000 payment directly to L and a payment of
only $492,000 to A for the property. Thus, B's basis in the property is
$492,000. The payment to L reduces the issue price of B's debt
instrument to $392,000, resulting in $8,000 of OID ($400,000-$392,000).
Because the amount of OID is de minimis under Sec. 1.1273-1(d), L
accounts for the de minimis OID under Sec. 1.1273-1(d)(5). But see
Sec. 1.1272-3 (election to treat de minimis OID as OID). B accounts for
the de minimis OID under Sec. 1.163-7.
(h) Investment units--(1) In general. Under section 1273(c)(2), an
investment unit is treated as if the investment unit were a debt
instrument. The issue price of the investment unit is determined under
paragraph (a)(1), (b)(1), or (c)(1) of this section, if applicable. The
issue price of the investment unit is then allocated between the debt
instrument and the property right (or rights) that comprise the unit
based on their relative fair market values. If paragraphs (a)(1),
(b)(1), and (c)(1) of this section are not applicable, however, the
issue price of the debt instrument that is part of the investment unit
is determined under section 1273(b)(4) or 1274, whichever is applicable.
(2) Consistent allocation by holders and issuer. The issuer's
allocation of the issue price of the investment unit is binding on all
holders of the investment unit. However, the issuer's determination is
not binding on a holder that explicitly discloses that its allocation is
different from the issuer's allocation. Unless otherwise provided by the
Commissioner, the disclosure must be made on a statement attached to the
holder's timely filed Federal income tax return for the taxable year
that includes the acquisition date of the investment unit. See Sec.
1.1275-2(e) for rules relating to the issuer's obligation to disclose
certain information to holders.
(i) [Reserved]
(j) Convertible debt instruments. The issue price of a debt
instrument includes any amount paid for an option to convert the
instrument into stock (or another debt instrument) of either the issuer
or a related party (within the meaning of section 267(b) or 707(b)(1))
or into cash or other property in an amount equal to the approximate
value of such stock (or debt instrument). For debt instruments issued on
or after February 5, 2013, the term stock in the preceding sentence
means an equity interest in any entity that is classified, for Federal
tax purposes, as either a partnership or a corporation.
(k) Below-market loans subject to section 7872(b). The issue price
of a below-market loan subject to section 7872(b) (a term loan other
than a gift loan) is the issue price determined under this section,
reduced by the excess amount determined under section 7872(b)(1).
(l) [Reserved]
[[Page 562]]
(m) Treatment of amounts representing pre-issuance accrued
interest--(1) Applicability. Paragraph (m)(2) of this section provides
an alternative to the general rule of this section for determining the
issue price of a debt instrument if--
(i) A portion of the initial purchase price of the instrument is
allocable to interest that has accrued prior to the issue date (pre-
issuance accrued interest); and
(ii) The instrument provides for a payment of stated interest on the
first payment date within 1 year of the issue date that equals or
exceeds the amount of the pre-issuance accrued interest.
(2) Exclusion of pre-issuance accrued interest from issue price. If
a debt instrument meets the requirements of paragraph (m)(1) of this
section, the instrument's issue price may be computed by subtracting
from the issue price (as otherwise computed under this section) the
amount of pre-issuance accrued interest. If the issue price of the debt
instrument is computed in this manner, a portion of the stated interest
payable on the first payment date must be treated as a return of the
excluded pre-issuance accrued interest, rather than as an amount payable
on the instrument.
(3) Example. The following example illustrates the rule of paragraph
(m) of this section.
Example: (i) Facts. On January 15, 1995, A purchases at original
issue, for $1,005, B corporation's debt instrument. The debt instrument
provides for a payment of principal of $1,000 on January 1, 2005, and
provides for semiannual interest payments of $60 on January 1 and July 1
of each year, beginning on July 1, 1995.
(ii) Determination of pre-issuance accrued interest. Under
paragraphs (m)(1) and (m)(2) of this section, $5 of the $1,005 initial
purchase price of the debt instrument is allocable to pre-issuance
accrued interest. Accordingly, the debt instrument's issue price may be
computed by subtracting the amount of pre-issuance accrued interest ($5)
from the issue price otherwise computed under this section ($1,005),
resulting in an issue price of $1,000. If the issue price is computed in
this manner, $5 of the $60 payment made on July 1, 1995, must be treated
as a repayment by B of the pre-issuance accrued interest.
[T.D. 8517, 59 FR 4817, Feb. 2, 1994, as amended by T.D. 9599, 77 FR
56536, Sept. 13, 2012; T.D. 9612, 78 FR 8016, Feb. 5, 2013]
Sec. 1.1274-1 Debt instruments to which section 1274 applies.
(a) In general. Subject to the exceptions and limitations in
paragraph (b) of this section, section 1274 and this section apply to
any debt instrument issued in consideration for the sale or exchange of
property. For purposes of section 1274, property includes debt
instruments and investment units, but does not include money, services,
or the right to use property. For the treatment of certain obligations
given in exchange for services or the use of property, see sections 404
and 467. For purposes of this paragraph (a), money includes functional
currency and, in certain circumstances, nonfunctional currency. See
Sec. 1.988-2(b)(2) for circumstances when nonfunctional currency is
treated as money rather than as property.
(b) Exceptions--(1) Debt instrument with adequate stated interest
and no OID. Section 1274 does not apply to a debt instrument if--
(i) All interest payable on the instrument is qualified stated
interest;
(ii) The stated rate of interest is at least equal to the test rate
of interest (as defined in Sec. 1.1274-4);
(iii) The debt instrument is not issued in a potentially abusive
situation (as defined in Sec. 1.1274-3); and
(iv) No payment from the buyer-borrower to the seller-lender
designated as points or interest is made at the time of issuance of the
debt instrument.
(2) Exceptions under sections 1274(c)(1)(B), 1274(c)(3), 1274A(c),
and 1275(b)(1)--(i) In general. Sections 1274(c)(1)(B), 1274(c)(3),
1274A(c), and 1275(b)(1) describe certain transactions to which section
1274 does not apply. This paragraph (b)(2) provides certain rules to be
used in applying those exceptions.
(ii) Special rules for certain exceptions under section 1274(c)(3)--
(A) Determination of sales price for certain sales of farms. For
purposes of section 1274(c)(3)(A), the determination as to whether the
sales price cannot exceed $1,000,000 is made without regard to any other
exception to, or limitation on, the applicability of section 1274 (e.g.,
without regard to the special rules regarding sales of principal
residences
[[Page 563]]
and land transfers between related persons). In addition, the sales
price is determined without regard to section 1274 and without regard to
any stated interest. The sales price includes the amount of any
liability included in the amount realized from the sale or exchange. See
Sec. 1.1001-2.
(B) Sales involving total payments of $250,000 or less. Under
section 1274(c)(3)(C), the determination of the amount of payments due
under all debt instruments and the amount of other consideration to be
received is made as of the date of the sale or exchange or, if earlier,
the contract date. If the precise amount due under any debt instrument
or the precise amount of any other consideration to be received cannot
be determined as of that date, section 1274(c)(3)(C) applies only if it
can be determined that the maximum of the aggregate amount of payments
due under the debt instruments and other consideration to be received
cannot exceed $250,000. For purposes of section 1274(c)(3)(C), if a
liability is assumed or property is taken subject to a liability, the
aggregate amount of payments due includes the outstanding principal
balance or adjusted issue price (in the case of an obligation originally
issued at a discount) of the obligation.
(C) Coordination with section 1273 and Sec. 1.1273-2. In accordance
with section 1274(c)(3)(D), section 1274 and this section do not apply
if the issue price of a debt instrument issued in consideration for the
sale or exchange of property is determined under paragraph (a)(1),
(b)(1), or (c)(1) of Sec. 1.1273-2.
(3) Other exceptions to section 1274--(i) Holders of certain below-
market instruments. Section 1274 does not apply to any holder of a debt
instrument that is issued in consideration for the sale or exchange of
personal use property (within the meaning of section 1275(b)(3)) in the
hands of the issuer and that evidences a below-market loan described in
section 7872(c)(1).
(ii) Transactions involving certain demand loans. Section 1274 does
not apply to any debt instrument that evidences a demand loan that is a
below-market loan described in section 7872(c)(1).
(iii) Certain transfers subject to section 1041. Section 1274 does
not apply to any debt instrument issued in consideration for a transfer
of property subject to section 1041 (relating to transfers of property
between spouses or incident to divorce).
(c) Examples. The following examples illustrate the rules of this
section.
Example 1. Single stated rate paid semiannually. A debt instrument
issued in consideration for the sale of nonpublicly traded property in a
transaction that is not a potentially abusive situation calls for the
payment of a principal amount of $1,000,000 at the end of a 10-year term
and 20 semiannual interest payments of $60,000. Assume that the test
rate of interest is 12 percent, compounded semiannually. The debt
instrument is not subject to section 1274 because it provides for
interest equal to the test rate and all interest payable on the
instrument is qualified stated interest.
Example 2. Sale of farm for debt instrument with contingent
interest. (i) Facts. On July 1, 1995, A, an individual, sells to B land
used as a farm within the meaning of section 6420(c)(2). As partial
consideration for the sale, B issues a debt instrument calling for a
single $500,000 payment due in 10 years unless profits from the land in
each of the 10 years preceding maturity of the debt instrument exceed a
specified amount, in which case B is to make a payment of $1,200,000.
The debt instrument does not provide for interest.
(ii) Total payments may exceed $1,000,000. Even though the total
payments ultimately payable under the contract may be less than
$1,000,000, at the time of the sale or exchange it cannot be determined
that the sales price cannot exceed $1,000,000. Thus, the sale of the
land used as a farm is not an excepted transaction described in section
1274(c)(3)(A).
Example 3. Sale between related parties subject to section 483(e).
(i) Facts. On July 1, 1995, A, an individual, sells land (not used as a
farm within the meaning of section 6420(c)(2)) to A's child B for
$650,000. In consideration for the sale, B issues a 10-year debt
instrument to A that calls for a payment of $650,000. No other
consideration is given. The debt instrument does not provide for
interest.
(ii) Treatment of debt instrument. For purposes of section 483(e),
the $650,000 debt instrument is treated as two separate debt
instruments: a $500,000 debt instrument and a $150,000 debt instrument.
The $500,000 debt instrument is subject to section 483(e), and
accordingly is covered by the exception from section 1274 described in
section 1274(c)(3)(F). Because the amount of the payments due as
consideration for the sale exceeds $250,000, however, the $150,000 debt
instrument is subject to section 1274.
[T.D. 8517, 59 FR 4820, Feb. 2, 1994]
[[Page 564]]
Sec. 1.1274-2 Issue price of debt instruments to which section
1274 applies.
(a) In general. If section 1274 applies to a debt instrument,
section 1274 and this section determine the issue price of the debt
instrument. For rules relating to the determination of the amount and
timing of OID to be included in income, see section 1272 and the
regulations thereunder.
(b) Issue price--(1) Debt instruments that provide for adequate
stated interest; stated principal amount. The issue price of a debt
instrument that provides for adequate stated interest is the stated
principal amount of the debt instrument. For purposes of section 1274,
the stated principal amount of a debt instrument is the aggregate amount
of all payments due under the debt instrument, excluding any amount of
stated interest. Under Sec. 1.1273-2(g)(2)(ii), however, the stated
principal amount of a debt instrument is reduced by any payment from the
buyer- borrower to the seller-lender that is designated as interest or
points. See Example 2 of Sec. 1.1273-2(g)(5).
(2) Debt instruments that do not provide for adequate stated
interest; imputed principal amount. The issue price of a debt instrument
that does not provide for adequate stated interest is the imputed
principal amount of the debt instrument.
(3) Debt instruments issued in a potentially abusive situation; fair
market value. Notwithstanding paragraphs (b)(1) and (b)(2) of this
section, in the case of a debt instrument issued in a potentially
abusive situation (as defined in Sec. 1.1274-3), the issue price of the
debt instrument is the fair market value of the property received in
exchange for the debt instrument, reduced by the fair market value of
any consideration other than the debt instrument issued in consideration
for the sale or exchange.
(c) Determination of whether a debt instrument provides for adequate
stated interest--(1) In general. A debt instrument provides for adequate
stated interest if its stated principal amount is less than or equal to
its imputed principal amount. Imputed principal amount means the sum of
the present values, as of the issue date, of all payments, including
payments of stated interest, due under the debt instrument (determined
by using a discount rate equal to the test rate of interest as
determined under Sec. 1.1274-4). If a debt instrument has a single
fixed rate of interest that is paid or compounded at least annually, and
that rate is equal to or greater than the test rate, the debt instrument
has adequate stated interest.
(2) Determination of present value. The present value of a payment
is determined by discounting the payment from the date it becomes due to
the date of the sale or exchange at the test rate of interest. To
determine present value, a compounding period must be selected, and the
test rate must be based on the same compounding period.
(d) Treatment of certain options. This paragraph (d) provides rules
for determining the issue price of a debt instrument to which section
1274 applies (other than a debt instrument issued in a potentially
abusive situation) that is subject to one or more options described in
both paragraphs (c)(1) and (c)(5) of Sec. 1.1272-1. Under this
paragraph (d), an issuer will be deemed to exercise or not exercise an
option or combination of options in a manner that minimizes the
instrument's imputed principal amount, and a holder will be deemed to
exercise or not exercise an option or combination of options in a manner
that maximizes the instrument's imputed principal amount. If both the
issuer and the holder have options, the rules of this paragraph (d) are
applied to the options in the order that they may be exercised. Thus,
the deemed exercise of one option may eliminate other options that are
later in time. See Sec. 1.1272-1(c)(5) to determine the debt
instrument's yield and maturity for purposes of determining the accrual
of OID with respect to the instrument.
(e) Mandatory sinking funds. In determining the issue price of a
debt instrument to which section 1274 applies (other than a debt
instrument issued in a potentially abusive situation) and that is
subject to a mandatory sinking fund provision described in Sec. 1.1272-
1(c)(3), the mandatory sinking fund provision is ignored.
[[Page 565]]
(f) Treatment of variable rate debt instruments--(1) Stated interest
at a qualified floating rate--(i) In general. For purposes of paragraph
(c) of this section, the imputed principal amount of a variable rate
debt instrument (within the meaning of Sec. 1.1275-5(a)) that provides
for stated interest at a qualified floating rate (or rates) is
determined by assuming that the instrument provides for a fixed rate of
interest for each accrual period to which a qualified floating rate
applies. For purposes of the preceding sentence, the assumed fixed rate
in each accrual period is the greater of--
(A) The value of the applicable qualified floating rate as of the
first date on which there is a binding written contract that
substantially sets forth the terms under which the sale or exchange is
ultimately consummated; or
(B) The value of the applicable qualified floating rate as of the
date on which the sale or exchange occurs.
(ii) Interest rate restrictions. Notwithstanding paragraph (f)(1)(i)
of this section, if, as a result of interest rate restrictions (such as
an interest rate cap), the expected yield of the debt instrument taking
the restrictions into account is significantly less than the expected
yield of the debt instrument without regard to the restrictions, the
interest payments on the debt instrument (other than any fixed interest
payments) are treated as contingent payments. Reasonably symmetric
interest rate caps and floors, or reasonably symmetric governors, that
are fixed throughout the term of the debt instrument do not result in
the debt instrument being subject to this rule.
(2) Stated interest at a single objective rate. For purposes of
paragraph (c) of this section, the imputed principal amount of a
variable rate debt instrument (within the meaning of Sec. 1.1275-5(a))
that provides for stated interest at a single objective rate is
determined by treating the interest payments as contingent payments.
(g) Treatment of contingent payment debt instruments.
Notwithstanding paragraph (b) of this section, if a debt instrument
subject to section 1274 provides for one or more contingent payments,
the issue price of the debt instrument is the lesser of the instrument's
noncontingent principal payments and the sum of the present values of
the noncontingent payments (as determined under paragraph (c) of this
section). However, if the debt instrument is issued in a potentially
abusive situation, the issue price of the debt instrument is the fair
market value of the noncontingent payments. For additional rules
relating to a debt instrument that provides for one or more contingent
payments, see Sec. 1.1275-4. This paragraph (g) applies to debt
instruments issued on or after August 13, 1996.
(h) Examples. The following examples illustrate the rules of this
section. Each example assumes a 30-day month, 360-day year. In addition,
each example assumes that the debt instrument is not a qualified debt
instrument (as defined in section 1274A(b)) and is not issued in a
potentially abusive situation.
Example 1. Debt instrument without a fixed rate over its entire
term. (i) Facts. On January 1, 1995, A sells nonpublicly traded property
to B for a stated purchase price of $3,500,000. In consideration for the
sale, B makes a down payment of $500,000 and issues a 10-year debt
instrument with a stated principal amount of $3,000,000, payable at
maturity. The debt instrument calls for no interest in the first 2 years
and interest at a rate of 15 percent payable annually over the remaining
8 years of the debt instrument. The first interest payment of $450,000
is due on December 31, 1997, and the last interest payment is due on
December 31, 2004, together with the $3,000,000 payment of principal.
Assume that the test rate of interest applicable to the debt instrument
is 10.5 percent, compounded annually.
(ii) Applicability of section 1274. Because the debt instrument does
not provide for any interest during the first 2 years, none of the
interest on the debt instrument is qualified stated interest. Therefore,
the issue price of the debt instrument is determined under section 1274.
See Sec. 1.1274-1(b)(1). If the debt instrument has adequate stated
interest, the issue price of the instrument is its stated principal
amount. Otherwise, the issue price of the debt instrument is its imputed
principal amount. The debt instrument has adequate stated interest only
if the stated principal amount is less than or equal to the imputed
principal amount.
(iii) Determination of imputed principal amount. To compute the
imputed principal amount of the debt instrument, all payments
[[Page 566]]
due under the debt instrument are discounted back to the issue date at
10.5 percent, compounded annually, as follows:
(A) The present value of the $3,000,000 principal payment payable on
December 31, 2004, is $1,105,346.59, determined as follows:
[GRAPHIC] [TIFF OMITTED] TR02FE94.000
(B) The present value of the eight interest payments of $450,000 as
of January 1, 1997, is $2,357,634.55, determined as follows:
[GRAPHIC] [TIFF OMITTED] TR02FE94.001
(C) The present value of this interim amount as of January 1, 1995,
is $1,930,865.09, determined as follows:
[GRAPHIC] [TIFF OMITTED] TR02FE94.002
(iv) Determination of issue price. The debt instrument's imputed
principal amount (that is, the present value of all payments due under
the debt instrument) is $3,036,211.68 ($1,105,346.59 + $1,930,865.09).
Because the stated principal amount ($3,000,000) is less than the
imputed principal amount, the debt instrument provides for adequate
stated interest. Therefore, the issue price of the debt instrument is
its stated principal amount ($3,000,000).
Example 2. Debt instrument subject to issuer call option. (i) Facts.
On January 1, 1995, in partial consideration for the sale of nonpublicly
traded property, H corporation issues to G a 10-year debt instrument,
maturing on January 1, 2005, with a stated principal amount of
$10,000,000, payable on that date. The debt instrument provides for
annual payments of interest of 8 percent for the first 5 years and 14
percent for the final 5 years, payable on January 1 of each year,
beginning on January 1, 1996. In addition the debt instrument provides H
with the unconditional option to call (prepay) the debt instrument at
the end of 5 years for its stated principal amount of $10,000,000.
Assume that the Federal mid-term and long-term rates applicable to the
sale based on annual compounding are 9 percent and 10 percent,
respectively.
(ii) Option presumed exercised. Assuming exercise of the call
option, the imputed principal amount as determined under paragraph (d)
of this section is $9,611,034.87 (the present value of all of the
payments due within a 5-year term discounted at a test rate of 9
percent, compounded annually). Assuming nonexercise of the call option,
the imputed principal amount is $10,183,354.78 (the present value of all
of the payments due within a 10-year term discounted at a test rate of
10 percent, compounded annually). For purposes of determining the
imputed principal amount, the option is presumed exercised because the
imputed principal amount, assuming exercise of the option, is less than
the imputed principal amount, assuming the option is not exercised.
Because the option is presumed exercised, the debt instrument fails to
provide for adequate stated interest because the imputed principal
amount ($9,611,034.87) is less than the stated principal amount
($10,000,000). Thus, the issue price of the debt instrument is
$9,611,034.87.
Example 3. Variable rate debt instrument with a single rate over its
entire term. (i) Facts. On January 1, 1995, A sells B nonpublicly traded
property. In partial consideration for the sale, B issues a debt
instrument in the principal amount of $1,000,000, payable in 5 years.
The debt instrument calls for interest payable monthly at a rate of 1
percentage point above the average prime lending rate of a major bank
for the month preceding the month of the interest payment. Assume that
the test rate of interest applicable to the debt instrument is 10.5
percent, compounded monthly. Assume also that 1 percentage point above
the prime lending rate of the designated bank on the date of the sale is
12.5 percent, compounded monthly, which is greater than 1 percentage
point above the prime lending rate of the designated bank on the first
date on which there is a binding written contract that substantially
sets forth the terms under which the sale is consummated.
(ii) Debt instrument has adequate stated interest. The debt
instrument is a variable rate debt instrument (within the meaning of
Sec. 1.1275-5) that provides for stated interest at a qualified
floating rate. Under paragraph (f)(1)(i) of this section, the debt
instrument is treated as if it provided for a fixed rate of interest
equal to 12.5 percent, compounded monthly. Because the test rate of
interest is 10.5 percent, compounded monthly, the debt instrument
provides for adequate stated interest.
Example 4. Debt instrument with a capped variable rate. On July 1,
1995, A sells nonpublicly traded property to B in return for a debt
instrument with a stated principal amount of $10,000,000, payable on
July 1, 2005. Interest is payable on July 1 of each year, beginning on
July 1, 1996, at the Federal short-term rate for June of the same year.
The debt instrument provides, however, that the interest rate cannot
rise above 8.5 percent, compounded annually. Assume that, as of the date
the test rate of interest for the debt instrument is determined, the
Federal short-term rate is 8 percent, compounded annually. Assume
further that, as a result of the interest rate cap of 8.5 percent,
compounded annually, the expected yield of the debt instrument is
significantly less than the expected yield of the debt instrument if
[[Page 567]]
it did not include the interest rate cap. Under paragraph (f)(1)(ii) of
this section, the variable payments are treated as contingent payments
for purposes of this section.
(i) [Reserved]
(j) Special rules for tax-exempt obligations--(1) Certain variable
rate debt instruments. Notwithstanding paragraph (b) of this section, if
a tax-exempt obligation (as defined in section 1275(a)(3)) is a variable
rate debt instrument (within the meaning of Sec. 1.1275-5) that pays
interest at an objective rate and is subject to section 1274, the issue
price of the obligation is the greater of the obligation's fair market
value and its stated principal amount.
(2) Contingent payment debt instruments. Notwithstanding paragraphs
(b) and (g) of this section, if a tax-exempt obligation (as defined in
section 1275(a)(3)) is subject to section 1274 and Sec. 1.1275-4, the
issue price of the obligation is the fair market value of the
obligation. However, in the case of a tax-exempt obligation that is
subject to Sec. 1.1275-4(d)(2) (an obligation that provides for
interest-based or revenue-based payments), the issue price of the
obligation is the greater of the obligation's fair market value and its
stated principal amount.
(3) Effective date. This paragraph (j) applies to debt instruments
issued on or after August 13, 1996.
[T.D. 8517, 59 FR 4821, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30141, June 14, 1996]
Sec. 1.1274-3 Potentially abusive situations defined.
(a) In general. For purposes of section 1274, a potentially abusive
situation means---
(1) A tax shelter (as defined in section 6662(d)(2)(C)(ii)); or
(2) Any other situation involving--
(i) A recent sales transaction;
(ii) Nonrecourse financing;
(iii) Financing with a term in excess of the useful life of the
property; or
(iv) A debt instrument with clearly excessive interest.
(b) Operating rules--(1) Debt instrument exchanged for nonrecourse
financing. Nonrecourse financing does not include an exchange of a
nonrecourse debt instrument for an outstanding recourse or nonrecourse
debt instrument.
(2) Nonrecourse debt with substantial down payment. Nonrecourse
financing does not include a sale or exchange of a real property
interest financed by a nonrecourse debt instrument if, in addition to
the nonrecourse debt instrument, the purchaser makes a down payment in
money that equals or exceeds 20 percent of the total stated purchase
price of the real property interest. For purposes of the preceding
sentence, a real property interest means any interest, other than an
interest solely as a creditor, in real property.
(3) Clearly excessive interest. Interest on a debt instrument is
clearly excessive if the interest, in light of the terms of the debt
instrument and the creditworthiness of the borrower, is clearly greater
than the arm's length amount of interest that would have been charged in
a cash lending transaction between the same two parties.
(4) Debt-for-debt exchange--(i) Rule. A debt instrument issued in a
debt-for-debt exchange, including a deemed exchange under Sec. 1.1001-
3, will not be treated as the subject of a recent sales transaction for
purposes of section 1274(b)(3)(B)(ii)(I) even if the debt instrument
exchanged for the newly issued debt instrument was recently acquired
prior to the exchange. Therefore, the issue price of the debt instrument
will not be determined under section 1274(b)(3). However, if the debt
instrument or the property for which the debt instrument is issued is
publicly traded within the meaning of Sec. 1.1273-2(f), the rules of
Sec. 1.1273-2 will apply to determine the issue price of the debt
instrument.
(ii) Effective/applicability date. Paragraph (b)(4)(i) of this
section applies to a debt instrument issued on or after November 13,
2012.
(c) Other situations to be specified by Commissioner. The
Commissioner may designate in the Internal Revenue Bulletin situations
that, although described in paragraph (a)(2) of this section, will not
be treated as potentially abusive because they do not have the effect of
significantly misstating basis or amount realized (see Sec.
601.601(d)(2)(ii) of this chapter).
(d) Consistency rule. The issuer's determination that the debt
instrument
[[Page 568]]
is or is not issued in a potentially abusive situation is binding on all
holders of the debt instrument. However, the issuer's determination is
not binding on a holder who explicitly discloses a position that is
inconsistent with the issuer's determination. Unless otherwise
prescribed by the Commissioner, the disclosure must be made on a
statement attached to the holder's timely filed Federal income tax
return for the taxable year that includes the acquisition date of the
debt instrument. See Sec. 1.1275-2(e) for rules relating to the
issuer's obligation to disclose certain information to holders.
[T.D. 8517, 59 FR 4822, Feb. 2, 1994, as amended by T.D. 9599, 77 FR
56538, Sept. 13, 2012]
Sec. 1.1274-4 Test rate.
(a) Determination of test rate of interest--(1) In general--(i) Test
rate is the 3-month rate. Except as provided in paragraph (a)(2) of this
section, the test rate of interest for a debt instrument issued in
consideration for the sale or exchange of property is the 3-month rate.
(ii) The 3-month rate. Except as provided in paragraph (a)(1)(iii)
of this section, the 3-month rate is the lower of--
(A) The lowest applicable Federal rate (based on the appropriate
compounding period) in effect during the 3-month period ending with the
first month in which there is a binding written contract that
substantially sets forth the terms under which the sale or exchange is
ultimately consummated; or
(B) The lowest applicable Federal rate (based on the appropriate
compounding period) in effect during the 3-month period ending with the
month in which the sale or exchange occurs.
(iii) Special rule if there is no binding written contract. If there
is no binding written contract that substantially sets forth the terms
under which the sale or exchange is ultimately consummated, the 3-month
rate is the lowest applicable Federal rate (based on the appropriate
compounding period) in effect during the 3-month period ending with the
month in which the sale or exchange occurs.
(2) Test rate for certain debt instruments--(i) Sale-leaseback
transactions. Under section 1274(e) (relating to certain sale-leaseback
transactions), the test rate is 110 percent of the 3-month rate
determined under paragraph (a)(1) of this section. For purposes of
section 1274(e)(3), related party means a person related to the
transferor within the meaning of section 267(b) or 707(b)(1).
(ii) Qualified debt instrument. Under section 1274A(a), the test
rate for a qualified debt instrument is no greater than 9 percent,
compounded semiannually, or an equivalent rate based on an appropriate
compounding period.
(iii) Alternative test rate for short-term obligations--(A)
Requirements. This paragraph (a)(2)(iii)(A) provides an alternative test
rate under section 1274(d)(1)(D) for a debt instrument with a maturity
of 1 year or less. This alternative test rate applies, however, only if
the debt instrument provides for adequate stated interest using the
alternative test rate, the issuer provides on the face of the debt
instrument that the instrument qualifies as having adequate stated
interest under section 1274(d)(1)(D), and the issuer and holder treat or
agree to treat the instrument as having adequate stated interest.
(B) Alternative test rate. For purposes of paragraph (a)(2)(iii)(A),
the alternative test rate is the market yield on U.S. Treasury bills
with the same maturity date as the debt instrument. If the same maturity
date is not available, the market yield on U.S. Treasury bills that
mature in the same week or month as the debt instrument is used. The
alternative test rate is determined as of the date on which there is a
binding written contract that substantially sets forth the terms under
which the sale or exchange is ultimately consummated or as of the date
of the sale or exchange, whichever date results in a lower rate. If
there is no binding written contract, however, the alternative test rate
is determined as of the date of the sale or exchange.
(b) Applicable Federal rate. Except as otherwise provided in this
section, the applicable Federal rate for a debt instrument is based on
the term of the instrument (i.e., short-term, mid-term, or long-term).
See section 1274(d)(1). The Internal Revenue Service publishes the
applicable Federal rates for each
[[Page 569]]
month in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of
this chapter). The applicable Federal rates are based on the yield to
maturity of outstanding marketable obligations of the United States of
similar maturities during the one month period ending on the 14th day of
the month preceding the month for which the rates are applicable.
(c) Special rules to determine the term of a debt instrument for
purposes of determining the applicable Federal rate--(1) Installment
obligation. If a debt instrument is an installment obligation (as
defined in Sec. 1.1273-1(e)(1)), the term of the instrument is the
instrument's weighted average maturity (as defined in Sec. 1.1273-
1(e)(3)).
(2) Certain variable rate debt instruments--(i) In general. Except
as otherwise provided in paragraph (c)(2)(ii) of this section, if a
variable rate debt instrument (as defined in Sec. 1.1275-5(a)) provides
for stated interest at a qualified floating rate (or rates), the term of
the instrument is determined by reference to the longest interval
between interest adjustment dates, or, if the variable rate debt
instrument provides for a fixed rate, the interval between the issue
date and the last day on which the fixed rate applies, if this interval
is longer.
(ii) Restrictions on adjustments. If, due to significant
restrictions on variations in a qualified floating rate or the use of
certain formulae pursuant to Sec. 1.1275-5(b)(2) (e.g., 15 percent of
1-year LIBOR, plus 800 basis points), the rate in substance resembles a
fixed rate, the applicable Federal rate is determined by reference to
the term of the debt instrument.
(3) Counting of either the issue date or the maturity date. The term
of a debt instrument includes either the issue date or the maturity
date, but not both dates.
(4) Certain debt instruments that provide for principal payments
uncertain as to time. If a debt instrument provides for principal
payments that are fixed in total amount but uncertain as to time, the
term of the instrument is determined by reference to the latest possible
date on which a principal payment can be made or, in the case of an
installment obligation, by reference to the longest weighted average
maturity under any possible payment schedule.
(d) Foreign currency loans. If all of the payments of a debt
instrument are denominated in, or determined by reference to, a currency
other than the U.S. dollar, the applicable Federal rate for the debt
instrument is a foreign currency rate of interest that is analogous to
the applicable Federal rate described in this section. For this purpose,
an analogous rate of interest is a rate based on yields (with the
appropriate compounding period) of the highest grade of outstanding
marketable obligations denominated in such currency (excluding any
obligations that benefit from special tax exemptions or preferential tax
rates not available to debt instruments generally) with due
consideration given to the maturities of the obligations.
(e) Examples. The following examples illustrate the rules of this
section.
Example 1. Variable rate debt instrument that limits the amount of
increase and decrease in the rate. (i) Facts. On July 1, 1996, A sells
nonpublicly traded property to B in return for a 5-year debt instrument
that provides for interest to be paid on July 1 of each year, beginning
on July 1, 1997, based on the prime rate of a local bank on that date.
However, the interest rate cannot increase or decrease from one year to
the next by more than .25 percentage points (25 basis points).
(ii) Significant restriction. The debt instrument is a variable rate
debt instrument (as defined in Sec. 1.1275-5) that provides for stated
interest at a qualified floating rate. Assume that based on all the
facts and circumstances, the restriction is a significant restriction on
the variations in the rate of interest. Under paragraph (c)(2)(ii) of
this section, the applicable Federal rate is determined by reference to
the term of the debt instrument, and the applicable Federal rate is the
Federal mid-term rate.
Example 2. Installment obligation. (i) Facts. On January 1, 1996, A
sells nonpublicly traded property to B in exchange for a debt instrument
that calls for a payment of $500,000 on January 1, 2001, and a payment
of $1,000,000 on January 1, 2006. The debt instrument does not provide
for any stated interest.
(ii) Determination of term. The debt instrument is an installment
obligation. Under paragraph (c)(1) of this section, the term of the debt
instrument is its weighted average maturity (as defined in Sec. 1.1273-
1(e)(3)). The debt instrument's weighted average maturity is 8.33 years,
which is the sum of (A) the ratio of the first payment to total payments
[[Page 570]]
(500,000/1,500,000), multiplied by the number of complete years from the
issue date until the payment is due (5 years), and (B) the ratio of the
second payment to total payments (1,000,000/1,500,000), multiplied by
the number of complete years from the issue date until the second
payment is due (10 years).
(iii) Applicable Federal rate. Based on the calculation in paragraph
(ii) of this example, the term of the debt instrument is treated as 8.33
years. Consequently, the applicable Federal rate is the Federal mid-term
rate.
[T.D. 8517, 59 FR 4823, Feb. 2, 1994]
Sec. 1.1274-5 Assumptions.
(a) In general. Section 1274 does not apply to a debt instrument if
the debt instrument is assumed, or property is taken subject to the debt
instrument, in connection with a sale or exchange of property, unless
the terms of the debt instrument, as part of the sale or exchange, are
modified in a manner that would constitute an exchange under section
1001.
(b) Modifications of debt instruments--(1) In general. Except as
provided in paragraph (b)(2) of this section, if a debt instrument is
assumed, or property is taken subject to a debt instrument, in
connection with a sale or exchange of property, the terms of the debt
instrument are modified as part of the sale or exchange, and the
modification triggers an exchange under section 1001, the modification
is treated as a separate transaction taking place immediately before the
sale or exchange and is attributed to the seller of the property. For
purposes of this paragraph (b), a debt instrument is not considered to
be modified as part of the sale or exchange unless the seller knew or
had reason to know about the modification.
(2) Election to treat buyer as modifying the debt instrument--(i) In
general. Rather than having the rules in paragraph (b)(1) of this
section apply, the seller and buyer may jointly elect to treat the
transaction as one in which the buyer first assumed the original
(unmodified) debt instrument and then subsequently modified the debt
instrument. For this purpose, the modification is treated as a separate
transaction taking place immediately after the sale or exchange.
(ii) Time and manner of making the election. The buyer and seller
make the election under paragraph (b)(2)(i) of this section by jointly
signing a statement that includes the names, addresses, and taxpayer
identification numbers of the seller and buyer, and a clear indication
that the election is being made under paragraph (b)(2)(i) of this
section. Both the buyer and the seller must sign this statement not
later than the earlier of the last day (including extensions) for filing
the Federal income tax return of the buyer or seller for the taxable
year in which the sale or exchange of the property occurs. The buyer and
seller should attach this signed statement (or a copy thereof) to their
timely filed Federal income tax returns.
(c) Wraparound indebtedness. For purposes of paragraph (a) of this
section, the issuance of wraparound indebtedness is not considered an
assumption.
(d) Consideration attributable to assumed debt. If, as part of the
consideration for the sale or exchange of property, the buyer assumes,
or takes the property subject to, an indebtedness that was issued with
OID (including a debt instrument issued in a prior sale or exchange to
which section 1274 applied), the portion of the buyer's basis in the
property and the seller's amount realized attributable to the debt
instrument equals the adjusted issue price of the debt instrument as of
the date of the sale or exchange.
[T.D. 8517, 59 FR 4824, Feb. 2, 1994]
Sec. 1.1274A-1 Special rules for certain transactions where stated
principal amount does not exceed $2,800,000.
(a) In general. Section 1274A allows the use of a lower test rate
for purposes of sections 483 and 1274 in the case of a qualified debt
instrument (as defined in section 1274A(b)) and, if elected by the
borrower and the lender, the use of the cash receipts and disbursements
method of accounting for interest on a cash method debt instrument (as
defined in section 1274A(c)(2)). This section provides special rules for
qualified debt instruments and cash method debt instruments.
(b) Rules for both qualified and cash method debt instruments--(1)
Sale-leaseback transactions. A debt instrument
[[Page 571]]
issued in a sale-leaseback transaction (within the meaning of section
1274(e)) cannot be either a qualified debt instrument or a cash method
debt instrument.
(2) Debt instruments calling for contingent payments. A debt
instrument that provides for contingent payments cannot be a qualified
debt instrument unless it can be determined at the time of the sale or
exchange that the maximum stated principal amount due under the debt
instrument cannot exceed the amount specified in section 1274A(b).
Similarly, a debt instrument that provides for contingent payments
cannot be a cash method debt instrument unless it can be determined at
the time of the sale or exchange that the maximum stated principal
amount due under the debt instrument cannot exceed the amount specified
in section 1274A(c)(2)(A).
(3) Aggregation of transactions--(i) General rule. The aggregation
rules of section 1274A(d)(1) are applied using a facts and circumstances
test.
(ii) Examples. The following examples illustrate the application of
section 1274A(d)(1) and paragraph (b)(3)(i) of this section.
Example 1. Aggregation of two sales to a single person. In two
transactions evidenced by separate sales agreements, A sells undivided
half interests in Blackacre to B. The sales are pursuant to a plan for
the sale of a 100 percent interest in Blackacre to B. These sales or
exchanges are part of a series of related transactions and, thus, are
treated as a single sale for purposes of section 1274A.
Example 2. Aggregation of two purchases by unrelated individuals.
Pursuant to a plan, unrelated individuals X and Y purchase undivided
half interests in Blackacre from A and subsequently contribute these
interests to a partnership in exchange for equal interests in the
partnership. These purchases are treated as part of the same transaction
and, thus, are treated as a single sale for purposes of section 1274A.
Example 3. Aggregation of sales made pursuant to a tender offer.
Fifteen unrelated individuals own all of the stock of X Corporation. Y
Corporation makes a tender offer to these 15 shareholders. The terms
offered to each shareholder are identical. Shareholders holding a
majority of the shares of X Corporation elect to tender their shares
pursuant to Y Corporation's offer. These sales are part of the same
transaction and, thus, are treated as a single sale for purposes of
section 1274A.
Example 4. No aggregation for separate sales of similar property to
unrelated persons. Pursuant to a newspaper advertisement, X Corporation
offers for sale similar condominiums in a single building. The prices of
the units vary due to a variety of factors, but the financing terms
offered by X Corporation to all buyers are identical. The units are
purchased by unrelated buyers who decided whether to purchase units in
the building at the price and on the terms offered by X Corporation,
without regard to the actions of other buyers. Because each buyer acts
individually, the sales are not part of the same transaction or a series
of related transactions and, thus, are treated as separate sales.
(4) Inflation adjustment of dollar amounts. Under section
1274A(d)(2), the dollar amounts specified in sections 1274A(b) and
1274A(c)(2)(A) are adjusted for inflation. The dollar amounts, adjusted
for inflation, are published in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii) of this chapter).
(c) Rules for cash method debt instruments--(1) Time and manner of
making cash method election. The borrower and lender make the election
described in section 1274A(c)(2)(D) by jointly signing a statement that
includes the names, addresses, and taxpayer identification numbers of
the borrower and lender, a clear indication that an election is being
made under section 1274A(c)(2), and a declaration that the debt
instrument with respect to which the election is being made fulfills the
requirements of a cash method debt instrument. Both the borrower and the
lender must sign this statement not later than the earlier of the last
day (including extensions) for filing the Federal income tax return of
the borrower or lender for the taxable year in which the debt instrument
is issued. The borrower and lender should attach this signed statement
(or a copy thereof) to their timely filed Federal income tax returns.
(2) Successors of electing parties. Except as otherwise provided in
this paragraph (c)(2), the cash method election under section 1274A(c)
applies to any successor of the electing lender or borrower. Thus, for
any period after the transfer of a cash method debt instrument, the
successor takes into account the interest (including unstated interest)
on the instrument under the cash receipts and disbursements method of
[[Page 572]]
accounting. Nevertheless, if the lender (or any successor thereof)
transfers the cash method debt instrument to a taxpayer who uses an
accrual method of accounting, section 1272 rather than section 1274A(c)
applies to the successor of the lender with respect to the debt
instrument for any period after the date of the transfer. The borrower
(or any successor thereof), however, remains on the cash receipts and
disbursements method of accounting with respect to the cash method debt
instrument.
(3) Modified debt instrument. In the case of a debt instrument
issued in a debt-for-debt exchange that qualifies as an exchange under
section 1001, the debt instrument is eligible for the election to be a
cash method debt instrument if the other prerequisites to making the
election in section 1274A(c) are met. However, if a principal purpose of
the modification is to defer interest income or deductions through the
use of the election, then the debt instrument is not eligible for the
election.
(4) Debt incurred or continued to purchase or carry a cash method
debt instrument. If a debt instrument is incurred or continued to
purchase or carry a cash method debt instrument, rules similar to those
under section 1277 apply to determine the timing of the interest
deductions for the debt instrument. For purposes of the preceding
sentence, rules similar to those under section 265(a)(2) apply to
determine whether a debt instrument is incurred or continued to purchase
or carry a cash method debt instrument.
[T.D. 8517, 59 FR 4824, Feb. 2, 1994]
Sec. 1.1275-1 Definitions.
(a) Applicability. The definitions contained in this section apply
for purposes of sections 163(e) and 1271 through 1275 and the
regulations thereunder.
(b) Adjusted issue price--(1) In general. The adjusted issue price
of a debt instrument at the beginning of the first accrual period is the
issue price. Thereafter, the adjusted issue price of the debt instrument
is the issue price of the debt instrument--
(i) Increased by the amount of OID previously includible in the
gross income of any holder (determined without regard to section
1272(a)(7) and section 1272(c)(1)); and
(ii) Decreased by the amount of any payment previously made on the
debt instrument other than a payment of qualified stated interest. See
Sec. 1.1275-2(f) for rules regarding adjustments to adjusted issue
price on a pro rata prepayment.
(2) Bond issuance premium. If a debt instrument is issued with bond
issuance premium (as defined in Sec. 1.163-13(c)), for purposes of
determining the issuer's adjusted issue price, the adjusted issue price
determined under paragraph (b)(1) of this section is also decreased by
the amount of bond issuance premium previously allocable under Sec.
1.163-13(d)(3).
(3) Adjusted issue price for subsequent holders. For purposes of
calculating OID accruals, acquisition premium, or market discount, a
holder (other than a purchaser at original issuance) determines adjusted
issue price in any manner consistent with the regulations under sections
1271 through 1275.
(c) OID. OID means original issue discount (as defined in section
1273(a) and Sec. 1.1273-1).
(d) Debt instrument. Except as provided in section 1275(a)(1)(B)
(relating to certain annuity contracts; see paragraph (j) of this
section), debt instrument means any instrument or contractual
arrangement that constitutes indebtedness under general principles of
Federal income tax law (including, for example, a certificate of deposit
or a loan). Nothing in the regulations under sections 163(e), 483, and
1271 through 1275, however, shall influence whether an instrument
constitutes indebtedness for Federal income tax purposes. See Sec.
1.385-3 for rules that treat certain instruments that otherwise would be
treated as indebtedness as stock for Federal tax purposes.
(e) Tax-exempt obligations. For purposes of section 1275(a)(3)(B),
exempt from tax means exempt from Federal income tax.
(f) Issue. (1) Debt instruments issued on or after March 13, 2001.
(2) Debt instruments issued before March 13, 2001.
(3) Transition rule.
(4) Cross-references for reopening and aggregation rules.
[[Page 573]]
(g) Debt instruments issued by a natural person. If an entity is a
primary obligor under a debt instrument, the debt instrument is
considered to be issued by the entity and not by a natural person even
if a natural person is a co-maker and is jointly liable for the debt
instrument's repayment. A debt instrument issued by a partnership is
considered to be issued by the partnership as an entity even if the
partnership is composed entirely of natural persons.
(h) Publicly offered debt instrument. A debt instrument is publicly
offered if it is part of an issue of debt instruments the initial
offering of which--
(1) Is registered with the Securities and Exchange Commission; or
(2) Would be required to be registered under the Securities Act of
1933 (15 U.S.C. 77a et seq.) but for an exemption from registration--
(i) Under section 3 of the Securities Act of 1933 (relating to
exempted securities);
(ii) Under any law (other than the Securities Act of 1933) because
of the identity of the issuer or the nature of the security; or
(iii) Because the issue is intended for distribution to persons who
are not United States persons.
(i) [Reserved]
(j) Life annuity exception under section 1275(a)(1)(B)(i)--(1)
Purpose. Section 1275(a)(1)(B)(i) excepts an annuity contract from the
definition of debt instrument if section 72 applies to the contract and
the contract depends (in whole or in substantial part) on the life
expectancy of one or more individuals. This paragraph (j) provides rules
to ensure that an annuity contract qualifies for the exception in
section 1275(a)(1)(B)(i) only in cases where the life contingency under
the contract is real and significant.
(2) General rule--(i) Rule. For purposes of section
1275(a)(1)(B)(i), an annuity contract depends (in whole or in
substantial part) on the life expectancy of one or more individuals only
if--
(A) The contract provides for periodic distributions made not less
frequently than annually for the life (or joint lives) of an individual
(or a reasonable number of individuals); and
(B) The contract does not contain any terms or provisions that can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants).
(ii) Terminology. For purposes of this paragraph (j):
(A) Contract. The term contract includes all written or unwritten
understandings among the parties as well as any person or persons acting
in concert with one or more of the parties.
(B) Annuitant. The term annuitant refers to the individual (or
reasonable number of individuals) referred to in paragraph (j)(2)(i)(A)
of this section.
(C) Terminating death. The phrase terminating death refers to the
annuitant death that can terminate periodic distributions under the
contract. (See paragraph (j)(2)(i)(A) of this section.) For example, if
a contract provides for periodic distributions until the later of the
death of the last-surviving annuitant or the end of a term certain, the
terminating death is the death of the last-surviving annuitant.
(iii) Coordination with specific rules. Paragraphs (j) (3) through
(7) of this section describe certain terms and conditions that can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). If a term or provision is not specifically
described in paragraphs (j) (3) through (7) of this section, the annuity
contract must be tested under the general rule of paragraph (j)(2)(i) of
this section to determine whether it depends (in whole or in substantial
part) on the life expectancy of one or more individuals.
(3) Availability of a cash surrender option--(i) Impact on life
contingency. The availability of a cash surrender option can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). Thus, the availability of any cash surrender
option causes the contract to fail to be described in section
1275(a)(1)(B)(i). A cash surrender option is available if there is
reason to believe that the issuer (or a person acting in concert
[[Page 574]]
with the issuer) will be willing to terminate or purchase all or a part
of the annuity contract by making one or more payments of cash or
property (other than an annuity contract described in this paragraph
(j)).
(ii) Examples. The following examples illustrate the rules of this
paragraph (j)(3):
Example 1. (i) Facts. On March 1, 1998, X issues a contract to A for
cash. The contract provides that, effective on any date chosen by A (the
annuity starting date), X will begin equal monthly distributions for A's
life. The amount of each monthly distribution will be no less than an
amount based on the contract's account value as of the annuity starting
date, A's age on that date, and permanent purchase rate guarantees
contained in the contract. The contract also provides that, at any time
before the annuity starting date, A may surrender the contract to X for
the account value less a surrender charge equal to a declining
percentage of the account value. For this purpose, the initial account
value is equal to the cash invested. Thereafter, the account value
increases annually by at least a minimum guaranteed rate.
(ii) Analysis. The ability to obtain the account value less the
surrender charge, if any, is a cash surrender option. This ability can
significantly reduce the probability that total distributions under the
contract will increase commensurately with A's longevity. Thus, the
contract fails to be described in section 1275(a)(1)(B)(i).
Example 2. (i) Facts. On March 1, 1998, X issues a contract to B for
cash. The contract provides that beginning on March 1, 1999, X will
distribute to B a fixed amount of cash each month for B's life. Based on
X's advertisements, marketing literature, or illustrations or on oral
representations by X's sales personnel, there is reason to believe that
an affiliate of X stands ready to purchase B's contract for its commuted
value.
(ii) Analysis. Because there is reason to believe that an affiliate
of X stands ready to purchase B's contract for its commuted value, a
cash surrender option is available within the meaning of paragraph
(j)(3)(i) of this section. This availability can significantly reduce
the probability that total distributions under the contract will
increase commensurately with B's longevity. Thus, the contract fails to
be described in section 1275(a)(1)(B)(i).
(4) Availability of a loan secured by the contract--(i) Impact on
life contingency. The availability of a loan secured by the contract can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). Thus, the availability of any such loan
causes the contract to fail to be described in section 1275(a)(1)(B)(i).
A loan secured by the contract is available if there is reason to
believe that the issuer (or a person acting in concert with the issuer)
will be willing to make a loan that is directly or indirectly secured by
the annuity contract.
(ii) Example. The following example illustrates the rules of this
paragraph (j)(4):
Example: (i) Facts. On March 1, 1998, X issues a contract to C for
$100,000. The contract provides that, effective on any date chosen by C
(the annuity starting date), X will begin equal monthly distributions
for C's life. The amount of each monthly distribution will be no less
than an amount based on the contract's account value as of the annuity
starting date, C's age on that date, and permanent purchase rate
guarantees contained in the contract. From marketing literature
circulated by Y, there is reason to believe that, at any time before the
annuity starting date, C may pledge the contract to borrow up to $75,000
from Y. Y is acting in concert with X.
(ii) Analysis. Because there is reason to believe that Y, a person
acting in concert with X, is willing to lend money against C's contract,
a loan secured by the contract is available within the meaning of
paragraph (j)(4)(i) of this section. This availability can significantly
reduce the probability that total distributions under the contract will
increase commensurately with C's longevity. Thus, the contract fails to
be described in section 1275(a)(1)(B)(i).
(5) Minimum payout provision--(i) Impact on life contingency. The
existence of a minimum payout provision can significantly reduce the
probability that total distributions under the contract will increase
commensurately with the longevity of the annuitant (or annuitants).
Thus, the existence of any minimum payout provision causes the contract
to fail to be described in section 1275(a)(1)(B)(i).
(ii) Definition of minimum payout provision. A minimum payout
provision is a contractual provision (for example, an agreement to make
distributions over a term certain) that provides for one or more
distributions made--
(A) After the terminating death under the contract; or
[[Page 575]]
(B) By reason of the death of any individual (including
distributions triggered by or increased by terminal or chronic illness,
as defined in section 101(g)(1) (A) and (B)).
(iii) Exceptions for certain minimum payouts--(A) Recovery of
consideration paid for the contract. Notwithstanding paragraphs
(j)(2)(i)(A) and (j)(5)(i) of this section, a contract does not fail to
be described in section 1275(a)(1)(B)(i) merely because it provides
that, after the terminating death, there will be one or more
distributions that, in the aggregate, do not exceed the consideration
paid for the contract less total distributions previously made under the
contract.
(B) Payout for one-half of life expectancy. Notwithstanding
paragraphs (j)(2)(i)(A) and (j)(5)(i) of this section, a contract does
not fail to be described in section 1275(a)(1)(B)(i) merely because it
provides that, if the terminating death occurs after the annuity
starting date, distributions under the contract will continue to be made
after the terminating death until a date that is no later than the
halfway date. This exception does not apply unless the amounts
distributed in each contract year will not exceed the amounts that would
have been distributed in that year if the terminating death had not
occurred until the expected date of the terminating death, determined
under paragraph (j)(5)(iii)(C) of this section.
(C) Definition of halfway date. For purposes of this paragraph
(j)(5)(iii), the halfway date is the date halfway between the annuity
starting date and the expected date of the terminating death, determined
as of the annuity starting date, with respect to all then-surviving
annuitants. The expected date of the terminating death must be
determined by reference to the applicable mortality table prescribed
under section 417(e)(3)(A)(ii)(I).
(iv) Examples. The following examples illustrate the rules of this
paragraph (j)(5):
Example 1. (i) Facts. On March 1, 1998, X issues a contract to D for
cash. The contract provides that, effective on any date D chooses (the
annuity starting date), X will begin equal monthly distributions for the
greater of D's life or 10 years, regardless of D's age as of the annuity
starting date. The amount of each monthly distribution will be no less
than an amount based on the contract's account value as of the annuity
starting date, D's age on that date, and permanent purchase rate
guarantees contained in the contract.
(ii) Analysis. A minimum payout provision exists because, if D dies
within 10 years of the annuity starting date, one or more distributions
will be made after D's death. The minimum payout provision does not
qualify for the exception in paragraph (j)(5)(iii)(B) of this section
because D may defer the annuity starting date until his remaining life
expectancy is less than 20 years. If, on the annuity starting date, D's
life expectancy is less than 20 years, the minimum payout period (10
years) will last beyond the halfway date. The minimum payout provision,
therefore, can significantly reduce the probability that total
distributions under the contract will increase commensurately with D's
longevity. Thus, the contract fails to be described in section
1275(a)(1)(B)(i).
Example 2. (i) Facts. The facts are the same as in Example 1 of this
paragraph (j)(5)(iv) except that the monthly distributions will last for
the greater of D's life or a term certain. D may choose the length of
the term certain subject to the restriction that, on the annuity
starting date, the term certain must not exceed one-half of D's life
expectancy as of the annuity starting date. The contract also does not
provide for any adjustment in the amount of distributions by reason of
the death of D or any other individual, except for a refund of D's
aggregate premium payments less the sum of all prior distributions under
the contract.
(ii) Analysis. The minimum payout provision qualifies for the
exception in paragraph (j)(5)(iii)(B) of this section because
distributions under the minimum payout provision will not continue past
the halfway date and the contract does not provide for any adjustments
in the amount of distributions by reason of the death of D or any other
individual, other than a guaranteed death benefit described in paragraph
(j)(5)(iii)(A) of this section. Accordingly, the existence of this
minimum payout provision does not prevent the contract from being
described in section 1275(a)(1)(B)(i).
(6) Maximum payout provision--(i) Impact on life contingency. The
existence of a maximum payout provision can significantly reduce the
probability that total distributions under the contract will increase
commensurately with the longevity of the annuitant (or annuitants).
Thus, the existence of any maximum payout provision causes the contract
to fail to be described in section 1275(a)(1)(B)(i).
(ii) Definition of maximum payout provision. A maximum payout
provision is
[[Page 576]]
a contractual provision that provides that no distributions under the
contract may be made after some date (the termination date), even if the
terminating death has not yet occurred.
(iii) Exception. Notwithstanding paragraphs (j)(2)(i)(A) and
(j)(6)(i) of this section, an annuity contract does not fail to be
described in section 1275(a)(1)(B)(i) merely because the contract
contains a maximum payout provision, provided that the period of time
from the annuity starting date to the termination date is at least twice
as long as the period of time from the annuity starting date to the
expected date of the terminating death, determined as of the annuity
starting date, with respect to all then-surviving annuitants. The
expected date of the terminating death must be determined by reference
to the applicable mortality table prescribed under section
417(e)(3)(A)(ii)(I).
(iv) Example. The following example illustrates the rules of this
paragraph (j)(6):
Example: (i) Facts. On March 1, 1998, X issues a contract to E for
cash. The contract provides that beginning on April 1, 1998, X will
distribute to E a fixed amount of cash each month for E's life but that
no distributions will be made after April 1, 2018. On April 1, 1998, E's
life expectancy is 9 years.
(ii) Analysis. A maximum payout provision exists because if E
survives beyond April 1, 2018, E will receive no further distributions
under the contract. The period of time from the annuity starting date
(April 1, 1998) to the termination date (April 1, 2018) is 20 years.
Because this 20-year period is more than twice as long as E's life
expectancy on April 1, 1998, the maximum payout provision qualifies for
the exception in paragraph (j)(6)(iii) of this section. Accordingly, the
existence of this maximum payout provision does not prevent the contract
from being described in section 1275(a)(1)(B)(i).
(7) Decreasing payout provision--(i) General rule. If the amount of
distributions during any contract year (other than the last year during
which distributions are made) may be less than the amount of
distributions during the preceding year, this possibility can
significantly reduce the probability that total distributions under the
contract will increase commensurately with the longevity of the
annuitant (or annuitants). Thus, the existence of this possibility
causes the contract to fail to be described in section 1275(a)(1)(B)(i).
(ii) Exception for certain variable distributions. Notwithstanding
paragraph (j)(7)(i) of this section, if an annuity contract provides
that the amount of each distribution must increase and decrease in
accordance with investment experience, cost of living indices, or
similar fluctuating criteria, then the possibility that the amount of a
distribution may decrease for this reason does not significantly reduce
the probability that the distributions under the contract will increase
commensurately with the longevity of the annuitant (or annuitants).
(iii) Examples. The following examples illustrate the rules of this
paragraph (j)(7):
Example 1. (i) Facts. On March 1, 1998, X issues a contract to F for
$100,000. The contract provides that beginning on March 1, 1999, X will
make distributions to F each year until F's death. Prior to March 1,
2009, distributions are to be made at a rate of $12,000 per year.
Beginning on March 1, 2009, distributions are to be made at a rate of
$3,000 per year.
(ii) Analysis. If F is alive in 2009, the amount distributed in 2009
($3,000) will be less than the amount distributed in 2008 ($12,000). The
exception in paragraph (j)(7)(ii) of this section does not apply. The
decrease in the amount of any distributions made on or after March 1,
2009, can significantly reduce the probability that total distributions
under the contract will increase commensurately with F's longevity.
Thus, the contract fails to be described in section 1275(a)(1)(B)(i).
Example 2. (i) Facts. On March 1, 1998, X issues a contract to G for
cash. The contract provides that, effective on any date G chooses (the
annuity starting date), X will begin monthly distributions to G for G's
life. Prior to the annuity starting date, the account value of the
contract reflects the investment return, including changes in the market
value, of an identifiable pool of assets. When G chooses the annuity
starting date, G must also choose whether the distributions are to be
fixed or variable. If fixed, the amount of each monthly distribution
will remain constant at an amount that is no less than an amount based
on the contract's account value as of the annuity starting date, G's age
on that date, and permanent purchase rate guarantees contained in the
contract. If variable, the monthly distributions will fluctuate to
reflect the investment return, including changes in the market value, of
the pool of assets. The monthly distributions
[[Page 577]]
under the contract will not otherwise decline from year to year.
(ii) Analysis. Because the only possible year-to-year declines in
annuity distributions are described in paragraph (j)(7)(ii) of this
section, the possibility that the amount of distributions may decline
from the previous year does not reduce the probability that total
distributions under the contract will increase commensurately with G's
longevity. Thus, the potential fluctuation in the annuity distributions
does not cause the contract to fail to be described in section
1275(a)(1)(B)(i).
(8) Effective dates--(i) In general. Except as provided in paragraph
(j)(8) (ii) and (iii) of this section, this paragraph (j) is applicable
for interest accruals on or after February 9, 1998 on annuity contracts
held on or after February 9, 1998.
(ii) Grandfathered contracts. This paragraph (j) does not apply to
an annuity contract that was purchased before April 7, 1995. For
purposes of this paragraph (j)(8), if any additional investment in such
a contract is made on or after April 7, 1995, and the additional
investment is not required to be made under a binding contractual
obligation that was entered into before April 7, 1995, then the
additional investment is treated as the purchase of a contract after
April 7, 1995.
(iii) Contracts consistent with the provisions of FI-33-94,
published at 1995-1 C.B. 920. See Sec. 601.601(d)(2)(ii)(b) of this
chapter. This paragraph (j) does not apply to a contract purchased on or
after April 7, 1995, and before February 9, 1998, if all payments under
the contract are periodic payments that are made at least annually for
the life (or lives) of one or more individuals, do not increase at any
time during the term of the contract, and are part of a series of
distributions that begins within one year of the date of the initial
investment in the contract. An annuity contract that is otherwise
described in the preceding sentence does not fail to be described
therein merely because it also provides for a payment (or payments) made
by reason of the death of one or more individuals.
(k) Exception under section 1275(a)(1)(B)(ii) for annuities issued
by an insurance company subject to tax under subchapter L of the
Internal Revenue Code--(1) Rule. For purposes of section
1275(a)(1)(B)(ii), an annuity contract issued by a foreign insurance
company is considered as issued by an insurance company subject to tax
under subchapter L if the insurance company is subject to tax under
subchapter L with respect to income earned on the annuity contract.
(2) Examples. The following examples illustrate the rule of
paragraph (k)(1) of this section. Each example assumes that the annuity
contract is a contract to which section 72 applies and was issued in a
transaction where there is no consideration other than cash or another
qualifying annuity contract, pursuant to the exercise of an election
under an insurance contract by a beneficiary thereof on the death of the
insured party, or in a transaction involving a qualified pension or
employee benefit plan. The examples are as follows:
Example 1. Company X is an insurance company that is organized,
licensed and doing business in Country Y. Company X does not have a U.S.
trade or business and is not, under section 842, subject to U.S. income
tax under subchapter L with respect to income earned on annuity
contracts. A, a U.S. taxpayer, purchases an annuity contract from
Company X in Country Y. The annuity contract is not excepted from the
definition of a debt instrument by section 1275(a)(1)(B)(ii).
Example 2. The facts are the same as in Example 1, except that
Company X has a U.S. trade or business. A purchased the annuity from
Company X's U.S. trade or business. Under section 842(a), Company X is
subject to tax under subchapter L with respect to income earned on the
annuity contract. Under these facts, the annuity contract is excepted
from the definition of a debt instrument by section 1275(a)(1)(B)(ii).
Example 3. The facts are the same as in Example 2, except that there
is a tax treaty between Country Y and the United States. Company X is a
resident of Country Y for purposes of the U.S.-Country Y tax treaty.
Company X's activities in the U.S. do not constitute a permanent
establishment under the U.S.-Country Y tax treaty. Because Company X
does not have a U.S. permanent establishment, Company X is not subject
to tax under subchapter L with respect to income earned on the annuity
contract. Thus, the annuity contract is not excepted from the definition
of a debt instrument by section 1275(a)(1)(B)(ii).
Example 4. The facts are the same as in Example 1, except that
Company X is a foreign insurance corporation controlled by a U.S.
shareholder. Company X does not make an
[[Page 578]]
election 1 under section 953(d) to be treated as a domestic corporation.
The controlling U.S. shareholder is required under sections 953 and 954
to include income earned on the annuity contract in its taxable income
under subpart F. However, Company X is not subject to tax under
subchapter L with respect to income earned on the annuity contract.
Thus, the annuity contract is not excepted from the definition of a debt
instrument by section 1275(a)(1)(B)(ii).
Example 5. The facts are the same as in Example 4, except that
Company X properly elects under section 953(d) to be treated as a
domestic corporation. By reason of its election, Company X is subject to
tax under subchapter L with respect to income earned on the annuity
contract. Thus, the annuity contract is excepted from the definition of
a debt instrument by section 1275(a)(1)(B)(ii).
(3) Effective date. This paragraph (k) is applicable for interest
accruals on or after June 6, 2002. This paragraph (k) does not apply to
an annuity contract that was purchased before January 12, 2001. For
purposes of this paragraph (k), if any additional investment in a
contract purchased before January 12, 2001, is made on or after January
12, 2001, and the additional investment is not required to be made under
a binding written contractual obligation that was entered into before
that date, then the additional investment is treated as the purchase of
a contract after January 12, 2001.
[T.D. 8517, 59 FR 4825, Feb. 2, 1994, as amended by T.D. 8746, 62 FR
68183, Dec. 31, 1997; T.D. 8754, 63 FR 1057, Jan. 8, 1998; T.D. 8934, 66
FR 2815, Jan. 12, 2001; T.D. 8993, 67 FR 30548, May 7, 2002; T.D. 9790,
81 FR 72984, Oct. 21, 2016: T.D. 9880, 84 FR 59302, Nov. 4, 2019]
Sec. 1.1275-2 Special rules relating to debt instruments.
(a) Payment ordering rule--(1) In general. Except as provided in
paragraph (a)(2) of this section, each payment under a debt instrument
is treated first as a payment of OID to the extent of the OID that has
accrued as of the date the payment is due and has not been allocated to
prior payments, and second as a payment of principal. Thus, no portion
of any payment is treated as prepaid interest.
(2) Exceptions. The rule in paragraph (a)(1) of this section does
not apply to--
(i) A payment of qualified stated interest;
(ii) A payment of points deductible under section 461(g)(2), in the
case of the issuer;
(iii) A pro rata prepayment described in paragraph (f)(2) of this
section; or
(iv) A payment of additional interest or a similar charge provided
with respect to amounts that are not paid when due.
(b) Debt instruments distributed by corporations with respect to
stock--(1) Treatment of distribution. For purposes of determining the
issue price of a debt instrument distributed by a corporation with
respect to its stock, the instrument is treated as issued by the
corporation for property. See section 1275(a)(4). Thus, under section
1273(b)(3), the issue price of a distributed debt instrument that is
traded on an established market is its fair market value. The issue
price of a distributed debt instrument that is not traded on an
established market is determined under section 1274 or section
1273(b)(4).
(2) Issue date. The issue date of a debt instrument distributed by a
corporation with respect to its stock is the date of the distribution.
(c) Aggregation of debt instruments--(1) General rule. Except as
provided in paragraph (c)(2) of this section, debt instruments issued in
connection with the same transaction or related transactions (determined
based on all the facts and circumstances) are treated as a single debt
instrument for purposes of sections 1271 through 1275 and the
regulations thereunder. This rule ordinarily applies only to debt
instruments of a single issuer that are issued to a single holder. The
Commissioner may, however, aggregate debt instruments that are issued by
more than one issuer or that are issued to more than one holder if the
debt instruments are issued in an arrangement that is designed to avoid
the aggregation rule (e.g., debt instruments issued by or to related
parties or debt instruments originally issued to different holders with
the understanding that the debt instruments will be transferred to a
single holder).
(2) Exception if separate issue price established. Paragraph (c)(1)
of this section does not apply to a debt instrument if--
[[Page 579]]
(i) The debt instrument is part of an issue a substantial portion of
which is traded on an established market within the meaning of Sec.
1.1273-2(f); or
(ii) The debt instrument is part of an issue a substantial portion
of which is issued for money (or for property traded on an established
market within the meaning of Sec. 1.1273-2(f)) to parties who are not
related to the issuer or holder and who do not purchase other debt
instruments of the same issuer in connection with the same transaction
or related transactions.
(3) Special rule for debt instruments that provide for the issuance
of additional debt instruments. If, under the terms of a debt instrument
(the original debt instrument), the holder may receive one or more
additional debt instruments of the issuer, the additional debt
instrument or instruments are aggregated with the original debt
instrument. Thus, the payments made pursuant to an additional debt
instrument are treated as made on the original debt instrument, and the
distribution by the issuer of the additional debt instrument is not
considered to be a payment made on the original debt instrument. This
paragraph (c)(3) applies regardless of whether the right to receive an
additional debt instrument is fixed as of the issue date or is
contingent upon subsequent events. See Sec. 1.1272-1(c) for the
treatment of certain rights to issue additional debt instruments in lieu
of cash payments.
(4) Examples. The following examples illustrate the rules set forth
in paragraphs (c)(1) and (c)(2) of this section.
Example 1. Exception for debt instruments issued separately to other
purchasers. On January 1, 1995, Corporation M issues two series of
bonds, Series A and Series B. The two series are sold for cash and have
different terms. Although some holders purchase bonds from both series,
a substantial portion of the bonds is issued to different holders. H
purchases bonds from both series. Under the exception in paragraph
(c)(2)(ii) of this section, the Series A and Series B bonds purchased by
H are not aggregated.
Example 2. Tiered REMICs. Z forms a dual tier real estate mortgage
investment conduit (REMIC). In the dual tier structure, Z forms REMIC A
to acquire a pool of real estate mortgages and to issue a residual
interest and several classes of regular interests. Contemporaneously, Z
forms REMIC B to acquire as qualified mortgages all of the regular
interests in REMIC A. REMIC B issues several classes of regular
interests and a residual interest, and Z sells all of those interests to
unrelated parties in a public offering. Under the general rule set out
in paragraph (c)(1) of this section, all of the regular interests issued
by REMIC A and held by REMIC B are treated as a single debt instrument
for purposes of sections 1271 through 1275.
(d) Special rules for Treasury securities--(1) Issue price and issue
date. The issue price of an issue of Treasury securities is the average
price of the securities sold. The issue date of an issue of Treasury
securities is the first settlement date on which a substantial amount of
the securities in the issue is sold. For an issue of Treasury securities
sold from November 1, 1998, to March 13, 2001, the issue price of the
issue is the price of the securities sold at auction.
(2) Reopenings of Treasury securities--(i) Treatment of additional
Treasury securities. Notwithstanding Sec. 1.1275-1(f), additional
Treasury securities issued in a qualified reopening are part of the same
issue as the original Treasury securities. As a result, the additional
Treasury securities have the same issue price, issue date, and (with
respect to holders) the same adjusted issue price as the original
Treasury securities. This paragraph (d)(2) applies to qualified
reopenings that occur on or after March 25, 1992.
(ii) Definitions--(A) Additional Treasury securities. Additional
Treasury securities are Treasury securities with terms that are in all
respects identical to the terms of the original Treasury securities.
(B) Original Treasury securities. Original Treasury securities are
securities comprising any issue of outstanding Treasury securities.
(C) Qualified reopening--reopenings on or after March 13, 2001. For
a reopening of Treasury securities that occurs on or after March 13,
2001, a qualified reopening is a reopening that occurs not more than one
year after the original Treasury securities were first issued to the
public or, under paragraph (k)(3)(iii) of this section, a reopening in
which the additional Treasury securities are issued with no more than a
de minimis amount of OID. For a reopening of Treasury securities that
occurs
[[Page 580]]
on or after September 13, 2012, a qualified reopening also is a
reopening of Treasury securities that is described in paragraph
(k)(3)(v) of this section.
(D) Qualified reopening--reopenings before March 13, 2001. For a
reopening of Treasury securities that occurs before March 13, 2001, a
qualified reopening is a reopening that occurs not more than one year
after the original Treasury securities were first issued to the public.
However, for a reopening of Treasury securities (other than Treasury
Inflation-Indexed Securities) that occurred prior to November 5, 1999, a
qualified reopening is a reopening of Treasury securities that satisfied
the preceding sentence and that was intended to alleviate an acute,
protracted shortage of the original Treasury securities.
(e) Disclosure of certain information to holders. Certain provisions
of the regulations under section 163(e) and sections 1271 through 1275
provide that the issuer's determination of an item controls the holder's
treatment of the item. In such a case, the issuer must provide the
relevant information to the holder in a reasonable manner. For example,
the issuer may provide the name or title and either the address or
telephone number of a representative of the issuer who will make
available to holders upon request the information required for holders
to comply with these provisions of the regulations.
(f) Treatment of pro rata prepayments--(1) Treatment as retirement
of separate debt instrument. A pro rata prepayment is treated as a
payment in retirement of a portion of a debt instrument, which may
result in a gain or loss to the holder. Generally, the gain or loss is
calculated by assuming that the original debt instrument consists of two
instruments, one that is retired and one that remains outstanding. The
adjusted issue price, holder's adjusted basis, and accrued but unpaid
OID of the original debt instrument, determined immediately before the
pro rata prepayment, are allocated between these two instruments based
on the portion of the instrument that is treated as retired by the pro
rata prepayment.
(2) Definition of pro rata prepayment. For purposes of paragraph
(f)(1) of this section, a pro rata prepayment is a payment on a debt
instrument made prior to maturity that--
(i) Is not made pursuant to the instrument's payment schedule
(including a payment schedule determined under Sec. 1.1272-1(c)); and
(ii) Results in a substantially pro rata reduction of each payment
remaining to be paid on the instrument.
(g) Anti-abuse rule--(1) In general. If a principal purpose in
structuring a debt instrument or engaging in a transaction is to achieve
a result that is unreasonable in light of the purposes of section
163(e), sections 1271 through 1275, or any related section of the Code,
the Commissioner can apply or depart from the regulations under the
applicable sections as necessary or appropriate to achieve a reasonable
result. For example, if this paragraph (g) applies to a debt instrument
that provides for a contingent payment, the Commissioner can treat the
contingency as if it were a separate position. See also Sec. 1.988-
2(b)(18) for debt instruments with payments denominated in (or
determined by reference to) a currency other than the taxpayer's
functional currency.
(2) Unreasonable result. Whether a result is unreasonable is
determined based on all the facts and circumstances. In making this
determination, a significant fact is whether the treatment of the debt
instrument is expected to have a substantial effect on the issuer's or a
holder's U.S. tax liability. In the case of a contingent payment debt
instrument, another significant fact is whether the result is obtainable
without the application of Sec. 1.1275-4 and any related provisions
(e.g., if the debt instrument and the contingency were entered into
separately). A result will not be considered unreasonable, however, in
the absence of an expected substantial effect on the present value of a
taxpayer's tax liability.
(3) Examples. The following examples illustrate the provisions of
this paragraph (g):
Example 1. A issues a current-pay, increasing-rate note that
provides for an early call option. Although the option is deemed
exercised on the call date under Sec. 1.1272-1(c)(5), the option is not
expected to be exercised by
[[Page 581]]
A. In addition, a principal purpose of including the option in the terms
of the note is to limit the amount of interest income includible by the
holder in the period prior to the call date by virtue of the option
rules in Sec. 1.1272-1(c)(5). Moreover, the application of the option
rules is expected to substantially reduce the present value of the
holder's tax liability. Based on these facts, the application of Sec.
1.1272-1(c)(5) produces an unreasonable result. Therefore, under this
paragraph (g), the Commissioner can apply the regulations (in whole or
in part) to the note without regard to Sec. 1.1272-1(c)(5).
Example 2. C, a foreign corporation not subject to U.S. taxation,
issues to a U.S. holder a debt instrument that provides for a contingent
payment. The debt instrument is issued for cash and is subject to the
noncontingent bond method in Sec. 1.1275-4(b). Six months after
issuance, C and the holder modify the debt instrument so that there is a
deemed reissuance of the instrument under section 1001. The new debt
instrument is subject to the rules of Sec. 1.1275-4(c) rather than
Sec. 1.1275-4(b). The application of Sec. 1.1275-4(c) is expected to
substantially reduce the present value of the holder's tax liability as
compared to the application of Sec. 1.1275-4(b). In addition, a
principal purpose of the modification is to substantially reduce the
present value of the holder's tax liability through the application of
Sec. 1.1275-4(c). Based on these facts, the application of Sec.
1.1275-4(c) produces an unreasonable result. Therefore, under this
paragraph (g), the Commissioner can apply the noncontingent bond method
to the modified debt instrument.
Example 3. D issues a convertible debt instrument rather than an
economically equivalent investment unit consisting of a debt instrument
and a warrant. The convertible debt instrument is issued at par and
provides for annual payments of interest. D issues the convertible debt
instrument rather than the investment unit so that the debt instrument
would not have OID. See Sec. 1.1273-2(j). In general, this is a
reasonable result in light of the purposes of the applicable statutes.
Therefore, the Commissioner generally will not use the authority under
this paragraph (g) to depart from the application of Sec. 1.1273-2(j)
in this case.
(4) Effective date. This paragraph (g) applies to debt instruments
issued on or after August 13, 1996.
(h) Remote and incidental contingencies--(1) In general. This
paragraph (h) applies to a debt instrument if one or more payments on
the instrument are subject to either a remote or incidental contingency.
Whether a contingency is remote or incidental is determined as of the
issue date of the debt instrument, including any date there is a deemed
reissuance of the debt instrument under paragraph (h)(6) (ii) or (j) of
this section or Sec. 1.1272-1(c)(6). Except as otherwise provided, the
treatment of the contingency under this paragraph (h) applies for all
purposes of sections 163(e) (other than sections 163(e)(5)) and 1271
through 1275 and the regulations thereunder. For purposes of this
paragraph (h), the possibility of impairment of a payment by insolvency,
default, or similar circumstances is not a contingency.
(2) Remote contingencies. A contingency is remote if there is a
remote likelihood either that the contingency will occur or that the
contingency will not occur. If there is a remote likelihood that the
contingency will occur, it is assumed that the contingency will not
occur. If there is a remote likelihood that the contingency will not
occur, it is assumed that the contingency will occur.
(3) Incidental contingencies--(i) Contingency relating to amount. A
contingency relating to the amount of a payment is incidental if, under
all reasonably expected market conditions, the potential amount of the
payment is insignificant relative to the total expected amount of the
remaining payments on the debt instrument. If a payment on a debt
instrument is subject to an incidental contingency described in this
paragraph (h)(3)(i), the payment is ignored until the payment is made.
However, see paragraph (h)(6)(i)(B) of this section for the treatment of
the debt instrument if a change in circumstances occurs prior to the
date the payment is made.
(ii) Contingency relating to time. A contingency relating to the
timing of a payment is incidental if, under all reasonably expected
market conditions, the potential difference in the timing of the payment
(from the earliest date to the latest date) is insignificant. If a
payment on a debt instrument is subject to an incidental contingency
described in this paragraph (h)(3)(ii), the payment is treated as made
on the earliest date that the payment could be made pursuant to the
contingency. If the payment is not made on this date, a taxpayer makes
appropriate adjustments to take into account the delay in payment.
However, see paragraph
[[Page 582]]
(h)(6)(i)(C) of this section for the treatment of the debt instrument if
the delay is not insignificant.
(4) Aggregation rule. For purposes of paragraph (h)(2) of this
section, if a debt instrument provides for multiple contingencies each
of which has a remote likelihood of occurring but, when all of the
contingencies are considered together, there is a greater than remote
likelihood that at least one of the contingencies will occur, none of
the contingencies is treated as a remote contingency. For purposes of
paragraph (h)(3)(i) of this section, if a debt instrument provides for
multiple contingencies each of which is incidental but the potential
total amount of all of the payments subject to the contingencies is not,
under reasonably expected market conditions, insignificant relative to
the total expected amount of the remaining payments on the debt
instrument, none of the contingencies is treated as incidental.
(5) Consistency rule. For purposes of paragraphs (h) (2) and (3) of
this section, the issuer's determination that a contingency is either
remote or incidental is binding on all holders. However, the issuer's
determination is not binding on a holder that explicitly discloses that
its determination is different from the issuer's determination. Unless
otherwise prescribed by the Commissioner, the disclosure must be made on
a statement attached to the holder's timely filed Federal income tax
return for the taxable year that includes the acquisition date of the
debt instrument. See Sec. 1.1275-2(e) for rules relating to the
issuer's obligation to disclose certain information to holders.
(6) Subsequent adjustments--(i) Applicability. This paragraph (h)(6)
applies to a debt instrument when there is a change in circumstances.
For purposes of the preceding sentence, there is a change in
circumstances if--
(A) A remote contingency actually occurs or does not occur, contrary
to the assumption made in paragraph (h)(2) of this section;
(B) A payment subject to an incidental contingency described in
paragraph (h)(3)(i) of this section becomes fixed in an amount that is
not insignificant relative to the total expected amount of the remaining
payments on the debt instrument; or
(C) A payment subject to an incidental contingency described in
paragraph (h)(3)(ii) of this section becomes fixed such that the
difference between the assumed payment date and the due date of the
payment is not insignificant.
(ii) In general. If a change in circumstances occurs, solely for
purposes of sections 1272 and 1273, the debt instrument is treated as
retired and then reissued on the date of the change in circumstances for
an amount equal to the instrument's adjusted issue price on that date.
(iii) Contingent payment debt instruments. Notwithstanding paragraph
(h)(6)(ii) of this section, in the case of a contingent payment debt
instrument subject to Sec. 1.1275-4, if a change in circumstances
occurs, no retirement or reissuance is treated as occurring, but any
payment that is fixed as a result of the change in circumstances is
governed by the rules in Sec. 1.1275-4 that apply when the amount of a
contingent payment becomes fixed.
(7) Effective date. This paragraph (h) applies to debt instruments
issued on or after August 13, 1996.
(i) [Reserved]
(j) Treatment of certain modifications. If the terms of a debt
instrument are modified to defer one or more payments, and the
modification does not cause an exchange under section 1001, then, solely
for purposes of sections 1272 and 1273, the debt instrument is treated
as retired and then reissued on the date of the modification for an
amount equal to the instrument's adjusted issue price on that date. This
paragraph (j) applies to debt instruments issued on or after August 13,
1996.
(k) Reopenings--(1) In general. Notwithstanding Sec. 1.1275-1(f),
additional debt instruments issued in a qualified reopening are part of
the same issue as the original debt instruments. As a result, the
additional debt instruments have the same issue date, the same issue
price, and (with respect to holders) the same adjusted issue price as
the original debt instruments.
(2) Definitions--(i) Original debt instruments. Original debt
instruments are
[[Page 583]]
debt instruments comprising any single issue of outstanding debt
instruments. For purposes of determining whether a particular reopening
is a qualified reopening, debt instruments issued in prior qualified
reopenings are treated as original debt instruments and debt instruments
issued in the particular reopening are not so treated.
(ii) Additional debt instruments. Additional debt instruments are
debt instruments that, without the application of this paragraph (k)--
(A) Are part of a single issue of debt instruments;
(B) Are not part of the same issue as the original debt instruments;
and
(C) Have terms that are in all respects identical to the terms of
the original debt instruments as of the reopening date.
(iii) Reopening date. The reopening date is the issue date of the
additional debt instruments (determined without the application of this
paragraph (k)).
(iv) Announcement date. The announcement date is the later of seven
days before the date on which the price of the additional debt
instruments is established or the date on which the issuer's intent to
reopen a security is publicly announced through one or more media,
including an announcement reported on the standard electronic news
services used by security broker-dealers (for example, Reuters,
Telerate, or Bloomberg).
(3) Qualified reopening--(i) Definition. A qualified reopening is a
reopening of original debt instruments that is described in paragraph
(k)(3)(ii), (k)(3)(iii), (k)(3)(iv), or (k)(3)(v) of this section. In
addition, see paragraph (d)(2) of this section to determine if a
reopening of Treasury securities is a qualified reopening.
(ii) Reopening within six months. A reopening is described in this
paragraph (k)(3)(ii) if--
(A) The original debt instruments are publicly traded (within the
meaning of Sec. 1.1273-2(f)) as of the date on which the price of the
additional debt instruments is established (or, if earlier, the
announcement date);
(B) The reopening date of the additional debt instruments is not
more than six months after the issue date of the original debt
instruments; and
(C) On the date on which the price of the additional debt
instruments is established (or, if earlier, the announcement date), the
yield of the original debt instruments (based on their fair market
value) is not more than 110 percent of the yield of the original debt
instruments on their issue date (or, if the original debt instruments
were issued with no more than a de minimis amount of OID, the coupon
rate).
(iii) Reopening with de minimis OID. A reopening (including a
reopening of Treasury securities) is described in this paragraph
(k)(3)(iii) if--
(A) The original debt instruments are publicly traded (within the
meaning of Sec. 1.1273-2(f)) as of the date on which the price of the
additional debt instruments is established (or, if earlier, the
announcement date); and
(B) The additional debt instruments are issued with no more than a
de minimis amount of OID (determined without the application of this
paragraph (k)).
(iv) Non-publicly traded debt issued for cash. A reopening is
described in this paragraph (k)(3)(iv) if the additional debt
instruments are issued for cash to persons unrelated to the issuer (as
determined under section 267(b) or 707(b)) for an arm's length price and
either the requirements in paragraphs (k)(3)(ii)(B) and (k)(3)(ii)(C) of
this section for a reopening within six months are satisfied or the
requirements in paragraph (k)(3)(iii)(B) of this section for a reopening
with de minimis OID are satisfied. For purposes of paragraph
(k)(3)(ii)(C) of this section, the yield test is satisfied if, on the
date on which the price of the additional debt instruments is
established (or, if earlier, the announcement date), the yield of the
additional debt instruments (based on their cash purchase price) is not
more than 110 percent of the yield of the original debt instruments on
their issue date (or, if the original debt instruments were issued with
no more than a de minimis amount of OID, the coupon rate).
(v) 100 Percent yield test for reopening after six months. A
reopening is described in this paragraph (k)(3)(v) if the additional
debt instruments are issued more than six months after the issue date of
the original debt instruments
[[Page 584]]
and either the requirements in paragraphs (k)(3)(ii)(A) and
(k)(3)(ii)(C) of this section are satisfied or the additional debt
instruments are issued for cash to persons unrelated to the issuer (as
determined under section 267(b) or 707(b)) for an arm's length price and
the requirements in paragraph (k)(3)(ii)(C) of this section are
satisfied. For purposes of the preceding sentence, the yield test in
paragraph (k)(3)(ii)(C) of this section is satisfied if, on the date on
which the price of the additional debt instruments is established (or,
if earlier, the announcement date), the yield of the additional debt
instruments (based on their fair market value or cash purchase price,
whichever is applicable) is not more than 100 percent of the yield of
the original debt instruments on their issue date (or, if the original
debt instruments were issued with no more than a de minimis amount of
OID, the coupon rate).
(vi) Exceptions. This paragraph (k)(3) does not apply to a reopening
of tax-exempt obligations (as defined in section 1275(a)(3)) or
contingent payment debt instruments (within the meaning of Sec. 1.1275-
4).
(4) Issuer's treatment of a qualified reopening. See Sec. 1.163-
7(e) for the issuer's treatment of the debt instruments that are part of
a qualified reopening.
(5) Effective/applicability dates--(i) Except as provided in
paragraph (k)(5)(ii) of this section, this paragraph (k) applies to debt
instruments that are part of a reopening if the reopening date is on or
after March 13, 2001.
(ii) Paragraphs (k)(3)(ii)(A), (k)(3)(iii)(A), (k)(3)(iv) and
(k)(3)(v) of this section apply to debt instruments that are part of a
reopening if the reopening date is on or after September 13, 2012.
[T.D. 8517, 59 FR 4826, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30142, June 14, 1996; T.D. 8840, 64 FR 60343, Nov. 5, 1999; T.D. 8934,
66 FR 2816, Jan. 12, 2001; T.D. 9157, 69 FR 52829, Aug. 30, 2004; T.D.
9599, 77 FR 56538, Sept. 13, 2012]
Sec. 1.1275-3 OID information reporting requirements.
(a) In general. This section provides legending and information
reporting requirements intended to facilitate the reporting of OID.
(b) Information required to be set forth on face of debt instruments
that are not publicly offered--(1) In general. Except as provided in
paragraph (b)(4) or paragraph (d) of this section, this paragraph (b)
applies to any debt instrument that is not publicly offered (within the
meaning of Sec. 1.1275-1(h)), is issued in physical form, and has OID.
The issuer of any such debt instrument must legend the instrument by
stating on the face of the instrument that the debt instrument was
issued with OID. In addition, the issuer must either--
(i) Set forth on the face of the debt instrument the issue price,
the amount of OID, the issue date, the yield to maturity, and, in the
case of a debt instrument subject to the rules of Sec. 1.1275-4(b), the
comparable yield and projected payment schedule; or
(ii) Provide the name or title and either the address or telephone
number of a representative of the issuer who will, beginning no later
than 10 days after the issue date, promptly make available to holders
upon request the information described in paragraph (b)(1)(i) of this
section.
(2) Time for legending. An issuer may satisfy the requirements of
this paragraph (b) by legending the debt instrument when it is first
issued in physical form. Legending is not required, however, before the
first holder of the debt instrument disposes of the instrument.
(3) Legend must survive reissuance upon transfer. Any new physical
security that is issued (for example, upon registration of transfer of
ownership) must contain any required legend.
(4) Exceptions. Paragraph (b)(1) of this section does not apply to
debt instruments described in section 1272(a)(2) (relating to debt
instruments not subject to the periodic OID inclusion rules), debt
instruments issued by natural persons (as defined in Sec. 1.6049-
4(f)(2)), REMIC regular interests or other debt instruments subject to
section 1272(a)(6), or stripped bonds and coupons within the meaning of
section 1286.
(c) Information required to be reported to Secretary upon issuance
of publicly offered debt instruments--(1) In general. Except as provided
in paragraph (c)(3) or paragraph (d) of this section, the information
reporting requirements of
[[Page 585]]
this paragraph (c) apply to any debt instrument that is publicly offered
and has original issue discount. The issuer of any such debt instrument
must make an information return on the form prescribed by the
Commissioner (Form 8281, as of September 2, 1992). The prescribed form
must be filed with the Internal Revenue Service in the manner specified
on the form. The taxpayer must use the prescribed form even if other
information returns are filed using other methods (e.g., electronic
media), unless the Commissioner announces otherwise in a revenue
procedure.
(2) Time for filing information return. The prescribed form must be
filed for each issue of publicly offered debt instruments within 30 days
after the issue date of the issue.
(3) Exceptions. The rules of paragraph (c)(1) of this section do not
apply to debt instruments described in section 1272(a)(2), debt
instruments issued by natural persons (as defined in Sec. 1.6049-
4(f)(2)), certificates of deposit, REMIC regular interests or other debt
instruments subject to section 1272(a)(6), or (unless otherwise required
by the Commissioner pursuant to a revenue ruling or revenue procedure)
stripped bonds and coupons (within the meaning of section 1286).
(4) Subsequent registration. Except as provided in paragraph (c)(3)
or (d) of this section, the information reporting requirements of
paragraph (c)(1) of this section apply to any debt instrument that has
original issue discount if the instrument is part of an issue the
offering of which is registered with the Securities and Exchange
Commission (SEC) after the issue date of the debt instrument. For
example, this paragraph (c)(4) applies to a newly issued debt instrument
(B bond) exchanged for an otherwise identical non-SEC-registered debt
instrument (A bond) if the B bond is part of an issue the offering of
which is registered with the SEC and the B bond has an issue date that
is the same as the issue date of the A bond for federal tax purposes
because the exchange is not a realization event under Sec. 1.1001-3. If
a debt instrument is subject to this paragraph (c)(4), the prescribed
form (Form 8281 or any successor) must be filed with the Internal
Revenue Service within 30 days after the date the offering is registered
with the SEC. This paragraph (c)(4) applies to a debt instrument that is
part of an issue the offering of which is registered with the SEC on or
after January 1, 2014.
(d) Application to foreign issuers and U.S. issuers of foreign-
targeted debt instruments. A foreign or domestic issuer is subject to
the rules of this section with respect to an issue of debt instruments
unless the issue is not offered for sale or resale in the United States
in connection with its original issuance.
(e) Penalties. See section 6706 for rules relating to the penalty
imposed for failure to meet the information reporting requirements
imposed by this section.
(f) Effective date. Paragraphs (c), (d), and (e) of this section are
effective for an issue of debt instruments issued after September 2,
1992.
[T.D. 8431, 57 FR 40322, Sept. 3, 1992; 57 FR 46243, Oct. 7, 1992, as
amended by T.D. 8517, 59 FR 4827, Feb. 2, 1994; T.D. 8674, 61 FR 30143,
June 14, 1996; T.D. 9616, 78 FR 23126, Apr. 18, 2013]
Sec. 1.1275-4 Contingent payment debt instruments.
(a) Applicability--(1) In general. Except as provided in paragraph
(a)(2) of this section, this section applies to any debt instrument that
provides for one or more contingent payments. In general, paragraph (b)
of this section applies to a contingent payment debt instrument that is
issued for money or publicly traded property and paragraph (c) of this
section applies to a contingent payment debt instrument that is issued
for nonpublicly traded property. Paragraph (d) of this section provides
special rules for tax-exempt obligations. See Sec. 1.1275-6 for a
taxpayer's treatment of a contingent payment debt instrument and a
hedge.
(2) Exceptions. This section does not apply to--
(i) A debt instrument that has an issue price determined under
section 1273(b)(4) (e.g., a debt instrument subject to section 483);
(ii) A variable rate debt instrument (as defined in Sec. 1.1275-5);
[[Page 586]]
(iii) A debt instrument subject to Sec. 1.1272-1(c) (a debt
instrument that provides for certain contingencies) or Sec. 1.1272-1(d)
(a debt instrument that provides for a fixed yield);
(iv) A debt instrument subject to section 988 (except as provided in
Sec. 1.988-6);
(v) A debt instrument to which section 1272(a)(6) applies (certain
interests in or mortgages held by a REMIC, and certain other debt
instruments with payments subject to acceleration);
(vi) A debt instrument (other than a tax-exempt obligation)
described in section 1272(a)(2) (e.g., U.S. savings bonds, certain loans
between natural persons, and short-term taxable obligations);
(vii) An inflation-indexed debt instrument (as defined in Sec.
1.1275-7); or
(viii) A debt instrument issued pursuant to a plan or arrangement
if--
(A) The plan or arrangement is created by a state statute;
(B) A primary objective of the plan or arrangement is to enable the
participants to pay for the costs of post-secondary education for
themselves or their designated beneficiaries; and
(C) Contingent payments on the debt instrument are related to such
objective.
(3) Insolvency and default. A payment is not contingent merely
because of the possibility of impairment by insolvency, default, or
similar circumstances.
(4) Convertible debt instruments. A debt instrument does not provide
for contingent payments merely because it provides for an option to
convert the debt instrument into the stock of the issuer, into the stock
or debt of a related party (within the meaning of section 267(b) or
707(b)(1)), or into cash or other property in an amount equal to the
approximate value of such stock or debt. For debt instruments issued on
or after February 5, 2013, the term stock in the preceding sentence
means an equity interest in any entity that is classified, for Federal
tax purposes, as either a partnership or a corporation.
(5) Remote and incidental contingencies. A payment is not a
contingent payment merely because of a contingency that, as of the issue
date, is either remote or incidental. See Sec. 1.1275-2(h) for the
treatment of remote and incidental contingencies.
(b) Noncontingent bond method--(1) Applicability. The noncontingent
bond method described in this paragraph (b) applies to a contingent
payment debt instrument that has an issue price determined under Sec.
1.1273-2 (e.g., a contingent payment debt instrument that is issued for
money or publicly traded property).
(2) In general. Under the noncontingent bond method, interest on a
debt instrument must be taken into account whether or not the amount of
any payment is fixed or determinable in the taxable year. The amount of
interest that is taken into account for each accrual period is
determined by constructing a projected payment schedule for the debt
instrument and applying rules similar to those for accruing OID on a
noncontingent debt instrument. If the actual amount of a contingent
payment is not equal to the projected amount, appropriate adjustments
are made to reflect the difference.
(3) Description of method. The following steps describe how to
compute the amount of income, deductions, gain, and loss under the
noncontingent bond method:
(i) Step one: Determine the comparable yield. Determine the
comparable yield for the debt instrument under the rules of paragraph
(b)(4) of this section. The comparable yield is determined as of the
debt instrument's issue date.
(ii) Step two: Determine the projected payment schedule. Determine
the projected payment schedule for the debt instrument under the rules
of paragraph (b)(4) of this section. The projected payment schedule is
determined as of the issue date and remains fixed throughout the term of
the debt instrument (except under paragraph (b)(9)(ii) of this section,
which applies to a payment that is fixed more than 6 months before it is
due).
(iii) Step three: Determine the daily portions of interest.
Determine the daily portions of interest on the debt instrument for a
taxable year as follows. The amount of interest that accrues in each
accrual period is the product of the comparable yield of the debt
instrument (properly adjusted for the length
[[Page 587]]
of the accrual period) and the debt instrument's adjusted issue price at
the beginning of the accrual period. See paragraph (b)(7)(ii) of this
section to determine the adjusted issue price of the debt instrument.
The daily portions of interest are determined by allocating to each day
in the accrual period the ratable portion of the interest that accrues
in the accrual period. Except as modified by paragraph (b)(3)(iv) of
this section, the daily portions of interest are includible in income by
a holder for each day in the holder's taxable year on which the holder
held the debt instrument and are deductible by the issuer for each day
during the issuer's taxable year on which the issuer was primarily
liable on the debt instrument.
(iv) Step four: Adjust the amount of income or deductions for
differences between projected and actual contingent payments. Make
appropriate adjustments to the amount of income or deductions
attributable to the debt instrument in a taxable year for any
differences between projected and actual contingent payments. See
paragraph (b)(6) of this section to determine the amount of an
adjustment and the treatment of the adjustment.
(4) Comparable yield and projected payment schedule. This paragraph
(b)(4) provides rules for determining the comparable yield and projected
payment schedule for a debt instrument. The comparable yield and
projected payment schedule must be supported by contemporaneous
documentation showing that both are reasonable, are based on reliable,
complete, and accurate data, and are made in good faith.
(i) Comparable yield--(A) In general. Except as provided in
paragraph (b)(4)(i)(B) of this section, the comparable yield for a debt
instrument is the yield at which the issuer would issue a fixed rate
debt instrument with terms and conditions similar to those of the
contingent payment debt instrument (the comparable fixed rate debt
instrument), including the level of subordination, term, timing of
payments, and general market conditions. For example, if a Sec. 1.1275-
6 hedge (or the substantial equivalent) is available, the comparable
yield is the yield on the synthetic fixed rate debt instrument that
would result if the issuer entered into the Sec. 1.1275-6 hedge. If a
Sec. 1.1275-6 hedge (or the substantial equivalent) is not available,
but similar fixed rate debt instruments of the issuer trade at a price
that reflects a spread above a benchmark rate, the comparable yield is
the sum of the value of the benchmark rate on the issue date and the
spread. In determining the comparable yield, no adjustments are made for
the riskiness of the contingencies or the liquidity of the debt
instrument. The comparable yield must be a reasonable yield for the
issuer and must not be less than the applicable Federal rate (based on
the overall maturity of the debt instrument).
(B) Presumption for certain debt instruments. This paragraph
(b)(4)(i)(B) applies to a debt instrument if the instrument provides for
one or more contingent payments not based on market information and the
instrument is part of an issue that is marketed or sold in substantial
part to persons for whom the inclusion of interest under this paragraph
(b) is not expected to have a substantial effect on their U.S. tax
liability. If this paragraph (b)(4)(i)(B) applies to a debt instrument,
the instrument's comparable yield is presumed to be the applicable
Federal rate (based on the overall maturity of the debt instrument). A
taxpayer may overcome this presumption only with clear and convincing
evidence that the comparable yield for the debt instrument should be a
specific yield (determined using the principles in paragraph
(b)(4)(i)(A) of this section) that is higher than the applicable Federal
rate. The presumption may not be overcome with appraisals or other
valuations of nonpublicly traded property. Evidence used to overcome the
presumption must be specific to the issuer and must not be based on
comparable issuers or general market conditions.
(ii) Projected payment schedule. The projected payment schedule for
a debt instrument includes each noncontingent payment and an amount for
each contingent payment determined as follows:
(A) Market-based payments. If a contingent payment is based on
market information (a market-based payment), the amount of the projected
payment is
[[Page 588]]
the forward price of the contingent payment. The forward price of a
contingent payment is the amount one party would agree, as of the issue
date, to pay an unrelated party for the right to the contingent payment
on the settlement date (e.g., the date the contingent payment is made).
For example, if the right to a contingent payment is substantially
similar to an exchange-traded option, the forward price is the spot
price of the option (the option premium) compounded at the applicable
Federal rate from the issue date to the date the contingent payment is
due.
(B) Other payments. If a contingent payment is not based on market
information (a non-market-based payment), the amount of the projected
payment is the expected value of the contingent payment as of the issue
date.
(C) Adjustments to the projected payment schedule. The projected
payment schedule must produce the comparable yield. If the projected
payment schedule does not produce the comparable yield, the schedule
must be adjusted consistent with the principles of this paragraph (b)(4)
to produce the comparable yield. For example, the adjusted amounts of
non-market-based payments must reasonably reflect the relative expected
values of the payments and must not be set to accelerate or defer income
or deductions. If the debt instrument contains both market-based and
non-market-based payments, adjustments are generally made first to the
non-market-based payments because more objective information is
available for the market-based payments.
(iii) Market information. For purposes of this paragraph (b), market
information is any information on which an objective rate can be based
under Sec. 1.1275-5(c) (1) or (2).
(iv) Issuer/holder consistency. The issuer's projected payment
schedule is used to determine the holder's interest accruals and
adjustments. The issuer must provide the projected payment schedule to
the holder in a manner consistent with the issuer disclosure rules of
Sec. 1.1275-2(e). If the issuer does not create a projected payment
schedule for a debt instrument or the issuer's projected payment
schedule is unreasonable, the holder of the debt instrument must
determine the comparable yield and projected payment schedule for the
debt instrument under the rules of this paragraph (b)(4). A holder that
determines its own projected payment schedule must explicitly disclose
this fact and the reason why the holder set its own schedule (e.g., why
the issuer's projected payment schedule is unreasonable). Unless
otherwise prescribed by the Commissioner, the disclosure must be made on
a statement attached to the holder's timely filed Federal income tax
return for the taxable year that includes the acquisition date of the
debt instrument.
(v) Issuer's determination respected--(A) In general. If the issuer
maintains the contemporaneous documentation required by this paragraph
(b)(4), the issuer's determination of the comparable yield and projected
payment schedule will be respected unless either is unreasonable.
(B) Unreasonable determination. For purposes of paragraph
(b)(4)(v)(A) of this section, a comparable yield or projected payment
schedule generally will be considered unreasonable if it is set with a
purpose to overstate, understate, accelerate, or defer interest accruals
on the debt instrument. In a determination of whether a comparable yield
or projected payment schedule is unreasonable, consideration will be
given to whether the treatment of the debt instrument under this section
is expected to have a substantial effect on the issuer's or holder's
U.S. tax liability. For example, if a taxable issuer markets a debt
instrument to a holder not subject to U.S. taxation, the comparable
yield will be given close scrutiny and will not be respected unless
contemporaneous documentation shows that the yield is not too high.
(C) Exception. Paragraph (b)(4)(v)(A) of this section does not apply
to a debt instrument subject to paragraph (b)(4)(i)(B) of this section
(concerning a yield presumption for certain debt instruments that
provide for non-market-based payments).
(vi) Examples. The following examples illustrate the provisions of
this paragraph (b)(4). In each example, assume that the instrument
described is a debt
[[Page 589]]
instrument for Federal income tax purposes. No inference is intended,
however, as to whether the instrument is a debt instrument for Federal
income tax purposes.
Example 1. Market-based payment. (i) Facts. On December 31, 1996, X
corporation issues for $1,000,000 a debt instrument that matures on
December 31, 2006. The debt instrument provides for annual payments of
interest, beginning in 1997, at the rate of 6 percent and for a payment
at maturity equal to $1,000,000 plus the excess, if any, of the price of
10,000 shares of publicly traded stock in an unrelated corporation on
the maturity date over $350,000, or less the excess, if any, of $350,000
over the price of 10,000 shares of the stock on the maturity date. On
the issue date, the forward price to purchase 10,000 shares of the stock
on December 31, 2006, is $350,000.
(ii) Comparable yield. Under paragraph (b)(4)(i) of this section,
the debt instrument's comparable yield is the yield on the synthetic
debt instrument that would result if X corporation entered into a Sec.
1.1275-6 hedge. A Sec. 1.1275-6 hedge in this case is a forward
contract to purchase 10,000 shares of the stock on December 31, 2006. If
X corporation entered into this hedge, the resulting synthetic debt
instrument would yield 6 percent, compounded annually. Thus, the
comparable yield on the debt instrument is 6 percent, compounded
annually.
(iii) Projected payment schedule. Under paragraph (b)(4)(ii) of this
section, the projected payment schedule for the debt instrument consists
of 10 annual payments of $60,000 and a projected amount for the
contingent payment at maturity. Because the right to the contingent
payment is based on market information, the projected amount of the
contingent payment is the forward price of the payment. The right to the
contingent payment is substantially similar to a right to a payment of
$1,000,000 combined with a cash-settled forward contract for the
purchase of 10,000 shares of the stock for $350,000 on December 31,
2006. Because the forward price to purchase 10,000 shares of the stock
on December 31, 2006, is $350,000, the amount to be received or paid
under the forward contract is projected to be zero. As a result, the
projected amount of the contingent payment at maturity is $1,000,000,
consisting of the $1,000,000 base amount and no additional amount to be
received or paid under the forward contract.
(A) Assume, alternatively, that on the issue date the forward price
to purchase 10,000 shares of the stock on December 31, 2006, is
$370,000. If X corporation entered into a Sec. 1.1275-6 hedge (a
forward contract to purchase the shares for $370,000), the resulting
synthetic debt instrument would yield 6.15 percent, compounded annually.
Thus, the comparable yield on the debt instrument is 6.15 percent,
compounded annually. The projected payment schedule for the debt
instrument consists of 10 annual payments of $60,000 and a projected
amount for the contingent payment at maturity. The projected amount of
the contingent payment is $1,020,000, consisting of the $1,000,000 base
amount plus the excess $20,000 of the forward price of the stock over
the purchase price of the stock under the forward contract.
(B) Assume, alternatively, that on the issue date the forward price
to purchase 10,000 shares of the stock on December 31, 2006, is
$330,000. If X corporation entered into a Sec. 1.1275-6 hedge, the
resulting synthetic debt instrument would yield 5.85 percent, compounded
annually. Thus, the comparable yield on the debt instrument is 5.85
percent, compounded annually. The projected payment schedule for the
debt instrument consists of 10 annual payments of $60,000 and a
projected amount for the contingent payment at maturity. The projected
amount of the contingent payment is $980,000, consisting of the
$1,000,000 base amount minus the excess $20,000 of the purchase price of
the stock under the forward contract over the forward price of the
stock.
Example 2. Non-market-based payments. (i) Facts. On December 31,
1996, Y issues to Z for $1,000,000 a debt instrument that matures on
December 31, 2000. The debt instrument has a stated principal amount of
$1,000,000, payable at maturity, and provides for payments on December
31 of each year, beginning in 1997, of $20,000 plus 1 percent of Y's
gross receipts, if any, for the year. On the issue date, Y has
outstanding fixed rate debt instruments with maturities of 2 to 10 years
that trade at a price that reflects an average of 100 basis points over
Treasury bonds. These debt instruments have terms and conditions similar
to those of the debt instrument. Assume that on December 31, 1996, 4-
year Treasury bonds have a yield of 6.5 percent, compounded annually,
and that no Sec. 1.1275-6 hedge is available for the debt instrument.
In addition, assume that the interest inclusions attributable to the
debt instrument are expected to have a substantial effect on Z's U.S.
tax liability.
(ii) Comparable yield. The comparable yield for the debt instrument
is equal to the value of the benchmark rate (i.e., the yield on 4-year
Treasury bonds) on the issue date plus the spread. Thus, the debt
instrument's comparable yield is 7.5 percent, compounded annually.
(iii) Projected payment schedule. Y anticipates that it will have no
gross receipts in 1997, but that it will have gross receipts in later
years, and those gross receipts will grow each year for the next three
years. Based on its business projections, Y believes that it is not
unreasonable to expect that its
[[Page 590]]
gross receipts in 1999 and each year thereafter will grow by between 6
percent and 13 percent over the prior year. Thus, Y must take these
expectations into account in establishing a projected payment schedule
for the debt instrument that results in a yield of 7.5 percent,
compounded annually. Accordingly, Y could reasonably set the following
projected payment schedule for the debt instrument:
------------------------------------------------------------------------
Noncontingent Contingent
Date payment payment
------------------------------------------------------------------------
12/31/1997............................... $20,000 $0
12/31/1998............................... 20,000 70,000
12/31/1999............................... 20,000 75,600
12/31/2000............................... 1,020,000 83,850
------------------------------------------------------------------------
(5) Qualified stated interest. No amounts payable on a debt
instrument to which this paragraph (b) applies are qualified stated
interest within the meaning of Sec. 1.1273-1(c).
(6) Adjustments. This paragraph (b)(6) provides rules for the
treatment of positive and negative adjustments under the noncontingent
bond method. A taxpayer takes into account only those adjustments that
occur during a taxable year while the debt instrument is held by the
taxpayer or while the taxpayer is primarily liable on the debt
instrument.
(i) Determination of positive and negative adjustments. If the
amount of a contingent payment is more than the projected amount of the
contingent payment, the difference is a positive adjustment on the date
of the payment. If the amount of a contingent payment is less than the
projected amount of the contingent payment, the difference is a negative
adjustment on the date of the payment (or on the scheduled date of the
payment if the amount of the payment is zero).
(ii) Treatment of net positive adjustments. The amount, if any, by
which total positive adjustments on a debt instrument in a taxable year
exceed the total negative adjustments on the debt instrument in the
taxable year is a net positive adjustment. A net positive adjustment is
treated as additional interest for the taxable year.
(iii) Treatment of net negative adjustments. The amount, if any, by
which total negative adjustments on a debt instrument in a taxable year
exceed the total positive adjustments on the debt instrument in the
taxable year is a net negative adjustment. A taxpayer's net negative
adjustment on a debt instrument for a taxable year is treated as
follows:
(A) Reduction of interest accruals. A net negative adjustment first
reduces interest for the taxable year that the taxpayer would otherwise
account for on the debt instrument under paragraph (b)(3)(iii) of this
section.
(B) Ordinary income or loss. If the net negative adjustment exceeds
the interest for the taxable year that the taxpayer would otherwise
account for on the debt instrument under paragraph (b)(3)(iii) of this
section, the excess is treated as ordinary loss by a holder and ordinary
income by an issuer. However, the amount treated as ordinary loss by a
holder is limited to the amount by which the holder's total interest
inclusions on the debt instrument exceed the total amount of the
holder's net negative adjustments treated as ordinary loss on the debt
instrument in prior taxable years. The amount treated as ordinary income
by an issuer is limited to the amount by which the issuer's total
interest deductions on the debt instrument exceed the total amount of
the issuer's net negative adjustments treated as ordinary income on the
debt instrument in prior taxable years.
(C) Carryforward. If the net negative adjustment exceeds the sum of
the amounts treated by the taxpayer as a reduction of interest and as
ordinary income or loss (as the case may be) on the debt instrument for
the taxable year, the excess is a negative adjustment carryforward for
the taxable year. In general, a taxpayer treats a negative adjustment
carryforward for a taxable year as a negative adjustment on the debt
instrument on the first day of the succeeding taxable year. However, if
a holder of a debt instrument has a negative adjustment carryforward on
the debt instrument in a taxable year in which the debt instrument is
sold, exchanged, or retired, the negative adjustment carryforward
reduces the holder's amount realized on the sale, exchange, or
retirement. If an issuer of a debt instrument has a negative adjustment
carryforward on the debt instrument for a taxable year
[[Page 591]]
in which the debt instrument is retired, the issuer takes the negative
adjustment carryforward into account as ordinary income.
(D) Treatment under section 67. A net negative adjustment is not
subject to section 67 (the 2-percent floor on miscellaneous itemized
deductions).
(iv) Cross-references. If a holder has a basis in a debt instrument
that is different from the debt instrument's adjusted issue price, the
holder may have additional positive or negative adjustments under
paragraph (b)(9)(i) of this section. If the amount of a contingent
payment is fixed more than 6 months before the date it is due, the
amount and timing of the adjustment are determined under paragraph
(b)(9)(ii) of this section.
(7) Adjusted issue price, adjusted basis, and retirement--(i) In
general. If a debt instrument is subject to the noncontingent bond
method, this paragraph (b)(7) provides rules to determine the adjusted
issue price of the debt instrument, the holder's basis in the debt
instrument, and the treatment of any scheduled or unscheduled
retirements. In general, because any difference between the actual
amount of a contingent payment and the projected amount of the payment
is taken into account as an adjustment to income or deduction, the
projected payments are treated as the actual payments for purposes of
making adjustments to issue price and basis and determining the amount
of any contingent payment made on a scheduled retirement.
(ii) Definition of adjusted issue price. The adjusted issue price of
a debt instrument is equal to the debt instrument's issue price,
increased by the interest previously accrued on the debt instrument
under paragraph (b)(3)(iii) of this section (determined without regard
to any adjustments taken into account under paragraph (b)(3)(iv) of this
section), and decreased by the amount of any noncontingent payment and
the projected amount of any contingent payment previously made on the
debt instrument. See paragraph (b)(9)(ii) of this section for special
rules that apply when a contingent payment is fixed more than 6 months
before it is due.
(iii) Adjustments to basis. A holder's basis in a debt instrument is
increased by the interest previously accrued by the holder on the debt
instrument under paragraph (b)(3)(iii) of this section (determined
without regard to any adjustments taken into account under paragraph
(b)(3)(iv) of this section), and decreased by the amount of any
noncontingent payment and the projected amount of any contingent payment
previously made on the debt instrument to the holder. See paragraph
(b)(9)(i) of this section for special rules that apply when basis is
different from adjusted issue price and paragraph (b)(9)(ii) of this
section for special rules that apply when a contingent payment is fixed
more than 6 months before it is due.
(iv) Scheduled retirements. For purposes of determining the amount
realized by a holder and the repurchase price paid by the issuer on the
scheduled retirement of a debt instrument, a holder is treated as
receiving, and the issuer is treated as paying, the projected amount of
any contingent payment due at maturity. If the amount paid or received
is different from the projected amount, see paragraph (b)(6) of this
section for the treatment of the difference by the taxpayer. Under
paragraph (b)(6)(iii)(C) of this section, the amount realized by a
holder on the retirement of a debt instrument is reduced by any negative
adjustment carryforward determined in the taxable year of the
retirement.
(v) Unscheduled retirements. An unscheduled retirement of a debt
instrument (or the receipt of a pro-rata prepayment that is treated as a
retirement of a portion of a debt instrument under Sec. 1.1275-2(f)) is
treated as a repurchase of the debt instrument (or a pro-rata portion of
the debt instrument) by the issuer from the holder for the amount paid
by the issuer to the holder.
(vi) Examples. The following examples illustrate the provisions of
paragraphs (b) (6) and (7) of this section. In each example, assume that
the instrument described is a debt instrument for Federal income tax
purposes. No inference is intended, however, as to whether the
instrument is a debt instrument for Federal income tax purposes.
Example 1. Treatment of positive and negative adjustments. (i)
Facts. On December 31, 1996,
[[Page 592]]
Z, a calendar year taxpayer, purchases a debt instrument subject to this
paragraph (b) at original issue for $1,000. The debt instrument's
comparable yield is 10 percent, compounded annually, and the projected
payment schedule provides for payments of $500 on December 31, 1997
(consisting of a noncontingent payment of $375 and a projected amount of
$125) and $660 on December 31, 1998 (consisting of a noncontingent
payment of $600 and a projected amount of $60). The debt instrument is a
capital asset in the hands of Z.
(ii) Adjustment in 1997. Based on the projected payment schedule,
Z's total daily portions of interest on the debt instrument are $100 for
1997 (issue price of $1,000 x 10 percent). Assume that the payment
actually made on December 31, 1997, is $375, rather than the projected
$500. Under paragraph (b)(6)(i) of this section, Z has a negative
adjustment of $125 on December 31, 1997, attributable to the difference
between the amount of the actual payment and the amount of the projected
payment. Because Z has no positive adjustments for 1997, Z has a net
negative adjustment of $125 on the debt instrument for 1997. This net
negative adjustment reduces to zero the $100 total daily portions of
interest Z would otherwise include in income in 1997. Accordingly, Z has
no interest income on the debt instrument for 1997. Because Z had no
interest inclusions on the debt instrument for prior taxable years, the
remaining $25 of the net negative adjustment is a negative adjustment
carryforward for 1997 that results in a negative adjustment of $25 on
January 1, 1998.
(iii) Adjustment to issue price and basis. Z's total daily portions
of interest on the debt instrument are $100 for 1997. The adjusted issue
price of the debt instrument and Z's adjusted basis in the debt
instrument are increased by this amount, despite the fact that Z does
not include this amount in income because of the net negative adjustment
for 1997. In addition, the adjusted issue price of the debt instrument
and Z's adjusted basis in the debt instrument are decreased on December
31, 1997, by the projected amount of the payment on that date ($500).
Thus, on January 1, 1998, Z's adjusted basis in the debt instrument and
the adjusted issue price of the debt instrument are $600.
(iv) Adjustments in 1998. Based on the projected payment schedule,
Z's total daily portions of interest are $60 for 1998 (adjusted issue
price of $600 x 10 percent). Assume that the payment actually made on
December 31, 1998, is $700, rather than the projected $660. Under
paragraph (b)(6)(i) of this section, Z has a positive adjustment of $40
on December 31, 1998, attributable to the difference between the amount
of the actual payment and the amount of the projected payment. Because Z
also has a negative adjustment of $25 on January 1, 1998, Z has a net
positive adjustment of $15 on the debt instrument for 1998 (the excess
of the $40 positive adjustment over the $25 negative adjustment). As a
result, Z has $75 of interest income on the debt instrument for 1998
(the $15 net positive adjustment plus the $60 total daily portions of
interest that are taken into account by Z in that year).
(v) Retirement. Based on the projected payment schedule, Z's
adjusted basis in the debt instrument immediately before the payment at
maturity is $660 ($600 plus $60 total daily portions of interest for
1998). Even though Z receives $700 at maturity, for purposes of
determining the amount realized by Z on retirement of the debt
instrument, Z is treated as receiving the projected amount of the
contingent payment on December 31, 1998. Therefore, Z is treated as
receiving $660 on December 31, 1998. Because Z's adjusted basis in the
debt instrument immediately before its retirement is $660, Z recognizes
no gain or loss on the retirement.
Example 2. Negative adjustment carryforward for year of sale. (i)
Facts. Assume the same facts as in Example 1 of this paragraph
(b)(7)(vi), except that Z sells the debt instrument on January 1, 1998,
for $630.
(ii) Gain on sale. On the date the debt instrument is sold, Z's
adjusted basis in the debt instrument is $600. Because Z has a negative
adjustment of $25 on the debt instrument on January 1, 1998, and has no
positive adjustments on the debt instrument in 1998, Z has a net
negative adjustment for 1998 of $25. Because Z has not included in
income any interest on the debt instrument, the entire $25 net negative
adjustment is a negative adjustment carryforward for the taxable year of
the sale. Under paragraph (b)(6)(iii)(C) of this section, the $25
negative adjustment carryforward reduces the amount realized by Z on the
sale of the debt instrument from $630 to $605. Thus, Z has a gain on the
sale of $5 ($605-$600). Under paragraph (b)(8)(i) of this section, the
gain is treated as interest income.
Example 3. Negative adjustment carryforward for year of retirement.
(i) Facts. Assume the same facts as in Example 1 of this paragraph
(b)(7)(vi), except that the payment actually made on December 31, 1998,
is $615, rather than the projected $660.
(ii) Adjustments in 1998. Under paragraph (b)(6)(i) of this section,
Z has a negative adjustment of $45 on December 31, 1998, attributable to
the difference between the amount of the actual payment and the amount
of the projected payment. In addition, Z has a negative adjustment of
$25 on January 1, 1998. See Example 1(ii) of this paragraph (b)(7)(vi).
Because Z has no positive adjustments in 1998, Z has a net negative
adjustment of $70 for 1998. This net negative adjustment reduces to zero
the $60 total daily portions of interest Z would otherwise include in
income for 1998. Therefore, Z has no interest income
[[Page 593]]
on the debt instrument for 1998. Because Z had no interest inclusions on
the debt instrument for 1997, the remaining $10 of the net negative
adjustment is a negative adjustment carryforward for 1998 that reduces
the amount realized by Z on retirement of the debt instrument.
(iii) Loss on retirement. Immediately before the payment at
maturity, Z's adjusted basis in the debt instrument is $660. Under
paragraph (b)(7)(iv) of this section, Z is treated as receiving the
projected amount of the contingent payment, or $660, as the payment at
maturity. Under paragraph (b)(6)(iii)(C) of this section, however, this
amount is reduced by any negative adjustment carryforward determined for
the taxable year of retirement to calculate the amount Z realizes on
retirement of the debt instrument. Thus, Z has a loss of $10 on the
retirement of the debt instrument, equal to the amount by which Z's
adjusted basis in the debt instrument ($660) exceeds the amount Z
realizes on the retirement of the debt instrument ($660 minus the $10
negative adjustment carryforward). Under paragraph (b)(8)(ii) of this
section, the loss is a capital loss.
(8) Character on sale, exchange, or retirement--(i) Gain. Any gain
recognized by a holder on the sale, exchange, or retirement of a debt
instrument subject to this paragraph (b) is interest income.
(ii) Loss. Any loss recognized by a holder on the sale, exchange, or
retirement of a debt instrument subject to this paragraph (b) is
ordinary loss to the extent that the holder's total interest inclusions
on the debt instrument exceed the total net negative adjustments on the
debt instrument the holder took into account as ordinary loss. Any
additional loss is treated as loss from the sale, exchange, or
retirement of the debt instrument. However, any loss that would
otherwise be ordinary under this paragraph (b)(8)(ii) and that is
attributable to the holder's basis that could not be amortized under
section 171(b)(4) is loss from the sale, exchange, or retirement of the
debt instrument.
(iii) Special rule if there are no remaining contingent payments on
the debt instrument--(A) In general. Notwithstanding paragraphs (b)(8)
(i) and (ii) of this section, if, at the time of the sale, exchange, or
retirement of the debt instrument, there are no remaining contingent
payments due on the debt instrument under the projected payment
schedule, any gain or loss recognized by the holder is gain or loss from
the sale, exchange, or retirement of the debt instrument. See paragraph
(b)(9)(ii) of this section to determine whether there are no remaining
contingent payments on a debt instrument that provides for fixed but
deferred contingent payments.
(B) Exception for certain positive adjustments. Notwithstanding
paragraph (b)(8)(iii)(A) of this section, if a positive adjustment on a
debt instrument is spread under paragraph (b)(9)(ii) (F) or (G) of this
section, any gain recognized by the holder on the sale, exchange, or
retirement of the instrument is treated as interest income to the extent
of the positive adjustment that has not yet been accrued and included in
income by the holder.
(iv) Examples. The following examples illustrate the provisions of
this paragraph (b)(8). In each example, assume that the instrument
described is a debt instrument for Federal income tax purposes. No
inference is intended, however, as to whether the instrument is a debt
instrument for Federal income tax purposes.
Example 1. Gain on sale. (i) Facts. On January 1, 1998, D, a
calendar year taxpayer, sells a debt instrument that is subject to
paragraph (b) of this section for $1,350. The projected payment schedule
for the debt instrument provides for contingent payments after January
1, 1998. On January 1, 1998, D has an adjusted basis in the debt
instrument of $1,200. In addition, D has a negative adjustment
carryforward of $50 for 1997 that, under paragraph (b)(6)(iii)(C) of
this section, results in a negative adjustment of $50 on January 1,
1998. D has no positive adjustments on the debt instrument on January 1,
1998.
(ii) Character of gain. Under paragraph (b)(6) of this section, the
$50 negative adjustment on January 1, 1998, results in a negative
adjustment carryforward for 1998, the taxable year of the sale of the
debt instrument. Under paragraph (b)(6)(iii)(C) of this section, the
negative adjustment carryforward reduces the amount realized by D on the
sale of the debt instrument from $1,350 to $1,300. As a result, D
realizes a $100 gain on the sale of the debt instrument, equal to the
$1,300 amount realized minus D's $1,200 adjusted basis in the debt
instrument. Under paragraph (b)(8)(i) of this section, the gain is
interest income to D.
Example 2. Loss on sale. (i) Facts. On December 31, 1996, E, a
calendar year taxpayer, purchases a debt instrument at original issue
for $1,000. The debt instrument is a capital
[[Page 594]]
asset in the hands of E. The debt instrument provides for a single
payment on December 31, 1998 (the maturity date of the instrument), of
$1,000 plus an amount based on the increase, if any, in the price of a
specified commodity over the term of the instrument. The comparable
yield for the debt instrument is 9.54 percent, compounded annually, and
the projected payment schedule provides for a payment of $1,200 on
December 31, 1998. Based on the projected payment schedule, the total
daily portions of interest are $95 for 1997 and $105 for 1998.
(ii) Ordinary loss. Assume that E sells the debt instrument for
$1,050 on December 31, 1997. On that date, E has an adjusted basis in
the debt instrument of $1,095 ($1,000 original basis, plus total daily
portions of $95 for 1997). Therefore, E realizes a $45 loss on the sale
of the debt instrument ($1,050-$1,095). The loss is ordinary to the
extent E's total interest inclusions on the debt instrument ($95) exceed
the total net negative adjustments on the instrument that E took into
account as an ordinary loss. Because E has not had any net negative
adjustments on the debt instrument, the $45 loss is an ordinary loss.
(iii) Capital loss. Alternatively, assume that E sells the debt
instrument for $990 on December 31, 1997. E realizes a $105 loss on the
sale of the debt instrument ($990 - $1,095). The loss is ordinary to the
extent E's total interest inclusions on the debt instrument ($95) exceed
the total net negative adjustments on the instrument that E took into
account as an ordinary loss. Because E has not had any net negative
adjustments on the debt instrument, $95 of the $105 loss is an ordinary
loss. The remaining $10 of the $105 loss is a capital loss.
(9) Operating rules. The rules of this paragraph (b)(9) apply to a
debt instrument subject to the noncontingent bond method notwithstanding
any other rule of this paragraph (b).
(i) Basis different from adjusted issue price. This paragraph
(b)(9)(i) provides rules for a holder whose basis in a debt instrument
is different from the adjusted issue price of the debt instrument (e.g.,
a subsequent holder that purchases the debt instrument for more or less
than the instrument's adjusted issue price).
(A) General rule. The holder accrues interest under paragraph
(b)(3)(iii) of this section and makes adjustments under paragraph
(b)(3)(iv) of this section based on the projected payment schedule
determined as of the issue date of the debt instrument. However, upon
acquiring the debt instrument, the holder must reasonably allocate any
difference between the adjusted issue price and the basis to daily
portions of interest or projected payments over the remaining term of
the debt instrument. Allocations are taken into account under paragraphs
(b)(9)(i) (B) and (C) of this section.
(B) Basis greater than adjusted issue price. If the holder's basis
in the debt instrument exceeds the debt instrument's adjusted issue
price, the amount of the difference allocated to a daily portion of
interest or to a projected payment is treated as a negative adjustment
on the date the daily portion accrues or the payment is made. On the
date of the adjustment, the holder's adjusted basis in the debt
instrument is reduced by the amount the holder treats as a negative
adjustment under this paragraph (b)(9)(i)(B). See paragraph
(b)(9)(ii)(E) of this section for a special rule that applies when a
contingent payment is fixed more than 6 months before it is due.
(C) Basis less than adjusted issue price. If the holder's basis in
the debt instrument is less than the debt instrument's adjusted issue
price, the amount of the difference allocated to a daily portion of
interest or to a projected payment is treated as a positive adjustment
on the date the daily portion accrues or the payment is made. On the
date of the adjustment, the holder's adjusted basis in the debt
instrument is increased by the amount the holder treats as a positive
adjustment under this paragraph (b)(9)(i)(C). See paragraph
(b)(9)(ii)(E) of this section for a special rule that applies when a
contingent payment is fixed more than 6 months before it is due.
(D) Premium and discount rules do not apply. The rules for accruing
premium and discount in sections 171, 1272(a)(7), 1276, and 1281 do not
apply. Other rules of those sections, such as section 171(b)(4),
continue to apply to the extent relevant.
(E) Safe harbor for exchange listed debt instruments. If the debt
instrument is exchange listed property (within the meaning of Sec.
1.1273-2(f)(2) as contained in 26 CFR part 1, revised April 1, 2011), it
is reasonable for the holder to allocate any difference between the
holder's basis and the adjusted issue price
[[Page 595]]
of the debt instrument pro-rata to daily portions of interest (as
determined under paragraph (b)(3)(iii) of this section) over the
remaining term of the debt instrument. A pro-rata allocation is not
reasonable, however, to the extent the holder's yield on the debt
instrument, determined after taking into account the amounts allocated
under this paragraph (b)(9)(i)(E), is less than the applicable Federal
rate for the instrument. For purposes of the preceding sentence, the
applicable Federal rate for the debt instrument is determined as if the
purchase date were the issue date and the remaining term of the
instrument were the term of the instrument.
(F) Examples. The following examples illustrate the provisions of
this paragraph (b)(9)(i). In each example, assume that the instrument
described is a debt instrument for Federal income tax purposes. No
inference is intended, however, as to whether the instrument is a debt
instrument for Federal income tax purposes. In addition, assume that
each instrument is not exchange listed property.
Example 1. Basis greater than adjusted issue price. (i) Facts. On
July 1, 1998, Z purchases for $1,405 a debt instrument that matures on
December 31, 1999, and promises to pay on the maturity date $1,000 plus
the increase, if any, in the price of a specified amount of a commodity
from the issue date to the maturity date. The debt instrument was
originally issued on December 31, 1996, for an issue price of $1,000.
The comparable yield for the debt instrument is 10.25 percent,
compounded semiannually, and the projected payment schedule for the debt
instrument (determined as of the issue date) provides for a single
payment at maturity of $1,350. At the time of the purchase, the debt
instrument has an adjusted issue price of $1,162, assuming semiannual
accrual periods ending on December 31 and June 30 of each year. The
increase in the value of the debt instrument over its adjusted issue
price is due to an increase in the expected amount of the contingent
payment and not to a decrease in market interest rates. The debt
instrument is a capital asset in the hands of Z. Z is a calendar year
taxpayer.
(ii) Allocation of the difference between basis and adjusted issue
price. Z's basis in the debt instrument on July 1, 1998, is $1,405.
Under paragraph (b)(9)(i)(A) of this section, Z allocates the $243
difference between basis ($1,405) and adjusted issue price ($1,162) to
the contingent payment at maturity. Z's allocation of the difference
between basis and adjusted issue price is reasonable because the
increase in the value of the debt instrument over its adjusted issue
price is due to an increase in the expected amount of the contingent
payment.
(iii) Treatment of debt instrument for 1998. Based on the projected
payment schedule, $60 of interest accrues on the debt instrument from
July 1, 1998 to December 31, 1998 (the product of the debt instrument's
adjusted issue price on July 1, 1998 ($1,162) and the comparable yield
properly adjusted for the length of the accrual period (10.25 percent/
2)). Z has no net negative or positive adjustments for 1998. Thus, Z
includes in income $60 of total daily portions of interest for 1998. On
December 31, 1998, Z's adjusted basis in the debt instrument is $1,465
($1,405 original basis, plus total daily portions of $60 for 1998).
(iv) Effect of allocation to contingent payment at maturity. Assume
that the payment actually made on December 31, 1999, is $1,400, rather
than the projected $1,350. Thus, under paragraph (b)(6)(i) of this
section, Z has a positive adjustment of $50 on December 31, 1999. In
addition, under paragraph (b)(9)(i)(B) of this section, Z has a negative
adjustment of $243 on December 31, 1999, which is attributable to the
difference between Z's basis in the debt instrument on July 1, 1998, and
the instrument's adjusted issue price on that date. As a result, Z has a
net negative adjustment of $193 for 1999. This net negative adjustment
reduces to zero the $128 total daily portions of interest Z would
otherwise include in income in 1999. Accordingly, Z has no interest
income on the debt instrument for 1999. Because Z had $60 of interest
inclusions for 1998, $60 of the remaining $65 net negative adjustment is
treated by Z as an ordinary loss for 1999. The remaining $5 of the net
negative adjustment is a negative adjustment carryforward for 1999 that
reduces the amount realized by Z on the retirement of the debt
instrument from $1,350 to $1,345.
(v) Loss at maturity. On December 31, 1999, Z's basis in the debt
instrument is $1,350 ($1,405 original basis, plus total daily portions
of $60 for 1998 and $128 for 1999, minus the negative adjustment of
$243). As a result, Z realizes a loss of $5 on the retirement of the
debt instrument (the difference between the amount realized on the
retirement ($1,345) and Z's adjusted basis in the debt instrument
($1,350)). Under paragraph (b)(8)(ii) of this section, the $5 loss is
treated as loss from the retirement of the debt instrument.
Consequently, Z realizes a total loss of $65 on the debt instrument for
1999 (a $60 ordinary loss and a $5 capital loss).
Example 2. Basis less than adjusted issue price. (i) Facts. On
January 1, 1999, Y purchases for $910 a debt instrument that pays 7
percent interest semiannually on June 30 and December 31 of each year,
and that
[[Page 596]]
promises to pay on December 31, 2001, $1,000 plus or minus $10 times the
positive or negative difference, if any, between a specified amount and
the value of an index on December 31, 2001. However, the payment on
December 31, 2001, may not be less than $650. The debt instrument was
originally issued on December 31, 1996, for an issue price of $1,000.
The comparable yield for the debt instrument is 9.80 percent, compounded
semiannually, and the projected payment schedule for the debt instrument
(determined as of the issue date) provides for semiannual payments of
$35 and a contingent payment at maturity of $1,175. On January 1, 1999,
the debt instrument has an adjusted issue price of $1,060, assuming
semiannual accrual periods ending on December 31 and June 30 of each
year. Y is a calendar year taxpayer.
(ii) Allocation of the difference between basis and adjusted issue
price. Y's basis in the debt instrument on January 1, 1999, is $910.
Under paragraph (b)(9)(i)(A) of this section, Y must allocate the $150
difference between basis ($910) and adjusted issue price ($1,060) to
daily portions of interest or to projected payments. These amounts will
be positive adjustments taken into account at the time the daily
portions accrue or the payments are made.
(A) Assume that, because of a decrease in the relevant index, the
expected value of the payment at maturity has declined by about 9
percent. Based on forward prices on January 1, 1999, Y determines that
approximately $105 of the difference between basis and adjusted issue
price is allocable to the contingent payment. Y allocates the remaining
$45 to daily portions of interest on a pro-rata basis (i.e., the amount
allocated to an accrual period equals the product of $45 and a fraction,
the numerator of which is the total daily portions for the accrual
period and the denominator of which is the total daily portions
remaining on the debt instrument on January 1, 1999). This allocation is
reasonable.
(B) Assume alternatively that, based on yields of comparable debt
instruments and its purchase price for the debt instrument, Y determines
that an appropriate yield for the debt instrument is 13 percent,
compounded semiannually. Based on this determination, Y allocates $55.75
of the difference between basis and adjusted issue price to daily
portions of interest as follows: $15.19 to the daily portions of
interest for the taxable year ending December 31, 1999; $18.40 to the
daily portions of interest for the taxable year ending December 31,
2000; and $22.16 to the daily portions of interest for the taxable year
ending December 31, 2001. Y allocates the remaining $94.25 to the
contingent payment at maturity. This allocation is reasonable.
(ii) Fixed but deferred contingent payments. This paragraph
(b)(9)(ii) provides rules that apply when the amount of a contingent
payment becomes fixed before the payment is due. For purposes of
paragraph (b) of this section, if a contingent payment becomes fixed
within the 6-month period ending on the due date of the payment, the
payment is treated as a contingent payment even after the payment is
fixed. If a contingent payment becomes fixed more than 6 months before
the payment is due, the following rules apply to the debt instrument.
(A) Determining adjustments. The amount of the adjustment
attributable to the contingent payment is equal to the difference
between the present value of the amount that is fixed and the present
value of the projected amount of the contingent payment. The present
value of each amount is determined by discounting the amount from the
date the payment is due to the date the payment becomes fixed, using a
discount rate equal to the comparable yield on the debt instrument. The
adjustment is treated as a positive or negative adjustment, as
appropriate, on the date the contingent payment becomes fixed. See
paragraph (b)(9)(ii)(G) of this section to determine the timing of the
adjustment if all remaining contingent payments on the debt instrument
become fixed substantially contemporaneously.
(B) Payment schedule. The contingent payment is no longer treated as
a contingent payment after the date the amount of the payment becomes
fixed. On the date the contingent payment becomes fixed, the projected
payment schedule for the debt instrument is modified prospectively to
reflect the fixed amount of the payment. Therefore, no adjustment is
made under paragraph (b)(3)(iv) of this section when the contingent
payment is actually made.
(C) Accrual period. Notwithstanding the determination under Sec.
1.1272-1(b)(1)(ii) of accrual periods for the debt instrument, an
accrual period ends on the day the contingent payment becomes fixed, and
a new accrual period begins on the day after the day the contingent
payment becomes fixed.
[[Page 597]]
(D) Adjustments to basis and adjusted issue price. The amount of any
positive adjustment on a debt instrument determined under paragraph
(b)(9)(ii)(A) of this section increases the adjusted issue price of the
instrument and the holder's adjusted basis in the instrument. Similarly,
the amount of any negative adjustment on a debt instrument determined
under paragraph (b)(9)(ii)(A) of this section decreases the adjusted
issue price of the instrument and the holder's adjusted basis in the
instrument.
(E) Basis different from adjusted issue price. If a holder's basis
in a debt instrument exceeds the debt instrument's adjusted issue price,
the amount allocated to a projected payment under paragraph (b)(9)(i) of
this section is treated as a negative adjustment on the date the payment
becomes fixed. If a holder's basis in a debt instrument is less than the
debt instrument's adjusted issue price, the amount allocated to a
projected payment under paragraph (b)(9)(i) of this section is treated
as a positive adjustment on the date the payment becomes fixed.
(F) Special rule for certain contingent interest payments.
Notwithstanding paragraph (b)(9)(ii)(A) of this section, this paragraph
(b)(9)(ii)(F) applies to contingent stated interest payments that are
adjusted to compensate for contingencies regarding the reasonableness of
the debt instrument's stated rate of interest. For example, this
paragraph (b)(9)(ii)(F) applies to a debt instrument that provides for
an increase in the stated rate of interest if the credit quality of the
issuer or liquidity of the debt instrument deteriorates. Contingent
stated interest payments of this type are recognized over the period to
which they relate in a reasonable manner.
(G) Special rule when all contingent payments become fixed.
Notwithstanding paragraph (b)(9)(ii)(A) of this section, if all the
remaining contingent payments on a debt instrument become fixed
substantially contemporaneously, any positive or negative adjustments on
the instrument are taken into account in a reasonable manner over the
period to which they relate. For purposes of the preceding sentence, a
payment is treated as a fixed payment if all remaining contingencies
with respect to the payment are remote or incidental (within the meaning
of Sec. 1.1275-2(h)).
(H) Example. The following example illustrates the provisions of
this paragraph (b)(9)(ii). In this example, assume that the instrument
described is a debt instrument for Federal income tax purposes. No
inference is intended, however, as to whether the instrument is a debt
instrument for Federal income tax purposes.
Example: Fixed but deferred payments. (i) Facts. On December 31,
1996, B, a calendar year taxpayer, purchases a debt instrument at
original issue for $1,000. The debt instrument matures on December 31,
2002, and provides for a payment of $1,000 at maturity. In addition, on
December 31, 1999, and December 31, 2002, the debt instrument provides
for payments equal to the excess of the average daily value of an index
for the 6-month period ending on September 30 of the preceding year over
a specified amount. The debt instrument's comparable yield is 10
percent, compounded annually, and the instrument's projected payment
schedule consists of a payment of $250 on December 31, 1999, and a
payment of $1,439 on December 31, 2002. B uses annual accrual periods.
(ii) Interest accrual for 1997. Based on the projected payment
schedule, B includes a total of $100 of daily portions of interest in
income in 1997. B's adjusted basis in the debt instrument and the debt
instrument's adjusted issue price on December 31, 1997, is $1,100.
(iii) Interest accrual for 1998--(A) Adjustment. Based on the
projected payment schedule, B would include $110 of total daily portions
of interest in income in 1998. However, assume that on September 30,
1998, the payment due on December 31, 1999, fixes at $300, rather than
the projected $250. Thus, on September 30, 1998, B has an adjustment
equal to the difference between the present value of the $300 fixed
amount and the present value of the $250 projected amount of the
contingent payment. The present values of the two payments are
determined by discounting each payment from the date the payment is due
(December 31, 1999) to the date the payment becomes fixed (September 30,
1998), using a discount rate equal to 10 percent, compounded annually.
The present value of the fixed payment is $266.30 and the present value
of the projected amount of the contingent payment is $221.91. Thus, on
September 30, 1998, B has a positive adjustment of $44.39 ($266.30-
$221.91).
(B) Effect of adjustment. Under paragraph (b)(9)(ii)(C) of this
section, B's accrual period
[[Page 598]]
ends on September 30, 1998. The daily portions of interest on the debt
instrument for the period from January 1, 1998 to September 30, 1998
total $81.51. The adjusted issue price of the debt instrument and B's
adjusted basis in the debt instrument are thus increased over this
period by $125.90 (the sum of the daily portions of interest of $81.51
and the positive adjustment of $44.39 made at the end of the period) to
$1,225.90. For purposes of all future accrual periods, including the new
accrual period from October 1, 1998, to December 31, 1998, the debt
instrument's projected payment schedule is modified to reflect a fixed
payment of $300 on December 31, 1999. Based on the new adjusted issue
price of the debt instrument and the new projected payment schedule, the
yield on the debt instrument does not change.
(C) Interest accrual for 1998. Based on the modified projected
payment schedule, $29.56 of interest accrues during the accrual period
that ends on December 31, 1998. Because B has no other adjustments
during 1998, the $44.39 positive adjustment on September 30, 1998,
results in a net positive adjustment for 1998, which is additional
interest for that year. Thus, B includes $155.46 ($81.51 + $29.56 +
$44.39) of interest in income in 1998. B's adjusted basis in the debt
instrument and the debt instrument's adjusted issue price on December
31, 1998, is $1,255.46 ($1,225.90 from the end of the prior accrual
period plus $29.56 total daily portions for the current accrual period).
(iii) Timing contingencies. This paragraph (b)(9)(iii) provides
rules for debt instruments that have payments that are contingent as to
time.
(A) Treatment of certain options. If a taxpayer has an unconditional
option to put or call the debt instrument, to exchange the debt
instrument for other property, or to extend the maturity date of the
debt instrument, the projected payment schedule is determined by using
the principles of Sec. 1.1272-1(c)(5).
(B) Other timing contingencies. [Reserved]
(iv) Cross-border transactions--(A) Allocation of deductions. For
purposes of Sec. 1.861-8, the holder of a debt instrument shall treat
any deduction or loss treated as an ordinary loss under paragraph
(b)(6)(iii)(B) or (b)(8)(ii) of this section as a deduction that is
definitely related to the class of gross income to which income from
such debt instrument belongs. Accordingly, if a U.S. person holds a debt
instrument issued by a related controlled foreign corporation and,
pursuant to section 904(d)(3) and the regulations thereunder, any
interest accrued by such U.S. person with respect to such debt
instrument would be treated as foreign source general limitation income,
any deductions relating to a net negative adjustment will reduce the
U.S. person's foreign source general limitation income. The holder shall
apply the general rules relating to allocation and apportionment of
deductions to any other deduction or loss realized by the holder with
respect to the debt instrument.
(B) Investments in United States real property. Notwithstanding
paragraph (b)(8)(i) of this section, gain on the sale, exchange, or
retirement of a debt instrument that is a United States real property
interest is treated as gain for purposes of sections 897, 1445, and
6039C.
(v) Coordination with subchapter M and related provisions. For
purposes of sections 852(c)(2) and 4982 and Sec. 1.852-11, any positive
adjustment, negative adjustment, income, or loss on a debt instrument
that occurs after October 31 of a taxable year is treated in the same
manner as foreign currency gain or loss that is attributable to a
section 988 transaction.
(vi) Coordination with section 1092. A holder treats a negative
adjustment and an issuer treats a positive adjustment as a loss with
respect to a position in a straddle if the debt instrument is a position
in a straddle and the contingency (or any portion of the contingency) to
which the adjustment relates would be part of the straddle if entered
into as a separate position.
(c) Method for debt instruments not subject to the noncontingent
bond method--(1) Applicability. This paragraph (c) applies to a
contingent payment debt instrument (other than a tax-exempt obligation)
that has an issue price determined under Sec. 1.1274-2. For example,
this paragraph (c) generally applies to a contingent payment debt
instrument that is issued for nonpublicly traded property.
(2) Separation into components. If paragraph (c) of this section
applies to a debt instrument (the overall debt instrument), the
noncontingent payments are subject to the rules in paragraph (c)(3) of
this section, and the contingent payments are accounted for
[[Page 599]]
separately under the rules in paragraph (c)(4) of this section.
(3) Treatment of noncontingent payments. The noncontingent payments
are treated as a separate debt instrument. The issue price of the
separate debt instrument is the issue price of the overall debt
instrument, determined under Sec. 1.1274-2(g). No interest payments on
the separate debt instrument are qualified stated interest payments
(within the meaning of Sec. 1.1273-1(c)) and the de minimis rules of
section 1273(a)(3) and Sec. 1.1273-1(d) do not apply to the separate
debt instrument.
(4) Treatment of contingent payments--(i) In general. Except as
provided in paragraph (c)(4)(iii) of this section, the portion of a
contingent payment treated as interest under paragraph (c)(4)(ii) of
this section is includible in gross income by the holder and deductible
from gross income by the issuer in their respective taxable years in
which the payment is made.
(ii) Characterization of contingent payments as principal and
interest--(A) General rule. A contingent payment is treated as a payment
of principal in an amount equal to the present value of the payment,
determined by discounting the payment at the test rate from the date the
payment is made to the issue date. The amount of the payment in excess
of the amount treated as principal under the preceding sentence is
treated as a payment of interest.
(B) Test rate. The test rate used for purposes of paragraph
(c)(4)(ii)(A) of this section is the rate that would be the test rate
for the overall debt instrument under Sec. 1.1274-4 if the term of the
overall debt instrument began on the issue date of the overall debt
instrument and ended on the date the contingent payment is made.
However, in the case of a contingent payment that consists of a payment
of stated principal accompanied by a payment of stated interest at a
rate that exceeds the test rate determined under the preceding sentence,
the test rate is the stated interest rate.
(iii) Certain delayed contingent payments--(A) General rule.
Notwithstanding paragraph (c)(4)(ii) of this section, if a contingent
payment becomes fixed more than 6 months before the payment is due, the
issuer and holder are treated as if the issuer had issued a separate
debt instrument on the date the payment becomes fixed, maturing on the
date the payment is due. This separate debt instrument is treated as a
debt instrument to which section 1274 applies. The stated principal
amount of this separate debt instrument is the amount of the payment
that becomes fixed. An amount equal to the issue price of this debt
instrument is characterized as interest or principal under the rules of
paragraph (c)(4)(ii) of this section and accounted for as if this amount
had been paid by the issuer to the holder on the date that the amount of
the payment becomes fixed. To determine the issue price of the separate
debt instrument, the payment is discounted at the test rate from the
maturity date of the separate debt instrument to the date that the
amount of the payment becomes fixed.
(B) Test rate. The test rate used for purposes of paragraph
(c)(4)(iii)(A) of this section is determined in the same manner as the
test rate under paragraph (c)(4)(ii)(B) of this section is determined
except that the date the contingent payment is due is used rather than
the date the contingent payment is made.
(5) Basis different from adjusted issue price. This paragraph (c)(5)
provides rules for a holder whose basis in a debt instrument is
different from the instrument's adjusted issue price (e.g., a subsequent
holder). This paragraph (c)(5), however, does not apply if the holder is
reporting income under the installment method of section 453.
(i) Allocation of basis. The holder must allocate basis to the
noncontingent component (i.e., the right to the noncontingent payments)
and to any separate debt instruments described in paragraph (c)(4)(iii)
of this section in an amount up to the total of the adjusted issue price
of the noncontingent component and the adjusted issue prices of the
separate debt instruments. The holder must allocate the remaining basis,
if any, to the contingent component (i.e., the right to the contingent
payments).
(ii) Noncontingent component. Any difference between the holder's
basis in the noncontingent component and the
[[Page 600]]
adjusted issue price of the noncontingent component, and any difference
between the holder's basis in a separate debt instrument and the
adjusted issue price of the separate debt instrument, is taken into
account under the rules for market discount, premium, and acquisition
premium that apply to a noncontingent debt instrument.
(iii) Contingent component. Amounts received by the holder that are
treated as principal payments under paragraph (c)(4)(ii) of this section
reduce the holder's basis in the contingent component. If the holder's
basis in the contingent component is reduced to zero, any additional
principal payments on the contingent component are treated as gain from
the sale or exchange of the debt instrument. Any basis remaining on the
contingent component on the date the final contingent payment is made
increases the holder's adjusted basis in the noncontingent component
(or, if there are no remaining noncontingent payments, is treated as
loss from the sale or exchange of the debt instrument).
(6) Treatment of a holder on sale, exchange, or retirement. This
paragraph (c)(6) provides rules for the treatment of a holder on the
sale, exchange, or retirement of a debt instrument subject to this
paragraph (c). Under this paragraph (c)(6), the holder must allocate the
amount received from the sale, exchange, or retirement of a debt
instrument first to the noncontingent component and to any separate debt
instruments described in paragraph (c)(4)(iii) of this section in an
amount up to the total of the adjusted issue price of the noncontingent
component and the adjusted issue prices of the separate debt
instruments. The holder must allocate the remaining amount received, if
any, to the contingent component.
(i) Amount allocated to the noncontingent component. The amount
allocated to the noncontingent component and any separate debt
instruments is treated as an amount realized from the sale, exchange, or
retirement of the noncontingent component or separate debt instrument.
(ii) Amount allocated to the contingent component. The amount
allocated to the contingent component is treated as a contingent payment
that is made on the date of the sale, exchange, or retirement and is
characterized as interest and principal under the rules of paragraph
(c)(4)(ii) of this section.
(7) Examples. The following examples illustrate the provisions of
this paragraph (c). In each example, assume that the instrument
described is a debt instrument for Federal income tax purposes. No
inference is intended, however, as to whether the instrument is a debt
instrument for Federal income tax purposes.
Example 1. Contingent interest payments. (i) Facts. A owns
Blackacre, unencumbered depreciable real estate. On January 1, 1997, A
sells Blackacre to B. As consideration for the sale, B makes a
downpayment of $1,000,000 and issues to A a debt instrument that matures
on December 31, 2001. The debt instrument provides for a payment of
principal at maturity of $5,000,000 and a contingent payment of interest
on December 31 of each year equal to a fixed percentage of the gross
rents B receives from Blackacre in that year. Assume that the debt
instrument is not issued in a potentially abusive situation. Assume also
that on January 1, 1997, the short-term applicable Federal rate is 5
percent, compounded annually, and the mid-term applicable Federal rate
is 6 percent, compounded annually.
(ii) Determination of issue price. Under Sec. 1.1274-2(g), the
issue price of the debt instrument is $3,736,291, which is the present
value, as of the issue date, of the $5,000,000 noncontingent payment due
at maturity, calculated using a discount rate equal to the mid-term
applicable Federal rate. Under Sec. 1.1012-1(g)(1), B's basis in
Blackacre on January 1, 1997, is $4,736,291 ($1,000,000 down payment
plus the $3,736,291 issue price of the debt instrument).
(iii) Noncontingent payment treated as separate debt instrument.
Under paragraph (c)(3) of this section, the right to the noncontingent
payment of principal at maturity is treated as a separate debt
instrument. The issue price of this separate debt instrument is
$3,736,291 (the issue price of the overall debt instrument). The
separate debt instrument has a stated redemption price at maturity of
$5,000,000 and, therefore, OID of $1,263,709.
(iv) Treatment of contingent payments. Assume that the amount of
contingent interest that is fixed and paid on December 31, 1997, is
$200,000. Under paragraph (c)(4)(ii) of this section, this payment is
treated as consisting of a payment of principal of $190,476, which is
the present value of the payment, determined by discounting the payment
at the test rate of 5 percent, compounded annually, from the date the
payment is made to the
[[Page 601]]
issue date. The remainder of the $200,000 payment ($9,524) is treated as
interest. The additional amount treated as principal gives B additional
basis in Blackacre on December 31, 1997. The portion of the payment
treated as interest is includible in gross income by A and deductible by
B in their respective taxable years in which December 31, 1997 occurs.
The remaining contingent payments on the debt instrument are accounted
for similarly, using a test rate of 5 percent, compounded annually, for
the contingent payments due on December 31, 1998, and December 31, 1999,
and a test rate of 6 percent, compounded annually, for the contingent
payments due on December 31, 2000, and December 31, 2001.
Example 2. Fixed but deferred payment. (i) Facts. The facts are the
same as in paragraph (c)(7) Example 1 of this section, except that the
contingent payment of interest that is fixed on December 31, 1997, is
not payable until December 31, 2001, the maturity date.
(ii) Treatment of deferred contingent payment. Assume that the
amount of the payment that becomes fixed on December 31, 1997, is
$200,000. Because this amount is not payable until December 31, 2001,
under paragraph (c)(4)(iii) of this section, a separate debt instrument
to which section 1274 applies is treated as issued by B on December 31,
1997 (the date the payment is fixed). The maturity date of this separate
debt instrument is December 31, 2001 (the date on which the payment is
due). The stated principal amount of this separate debt instrument is
$200,000, the amount of the payment that becomes fixed. The imputed
principal amount of the separate debt instrument is $158,419, which is
the present value, as of December 31, 1997, of the $200,000 payment,
computed using a discount rate equal to the test rate of the overall
debt instrument (6 percent, compounded annually). An amount equal to the
issue price of the separate debt instrument is treated as an amount paid
on December 31, 1997, and characterized as interest and principal under
the rules of paragraph (c)(4)(ii) of this section. The amount of the
deemed payment characterized as principal is equal to $150,875, which is
the present value, as of January 1, 1997 (the issue date of the overall
debt instrument), of the deemed payment, computed using a discount rate
of 5 percent, compounded annually. The amount of the deemed payment
characterized as interest is $7,544 ($158,419 -$150,875), which is
includible in gross income by A and deductible by B in their respective
taxable years in which December 31, 1997 occurs.
(d) Rules for tax-exempt obligations--(1) In general. Except as
modified by this paragraph (d), the noncontingent bond method described
in paragraph (b) of this section applies to a tax-exempt obligation (as
defined in section 1275(a)(3)) to which this section applies. Paragraph
(d)(2) of this section applies to certain tax-exempt obligations that
provide for interest-based payments or revenue-based payments and
paragraph (d)(3) of this section applies to all other obligations.
Paragraph (d)(4) of this section provides rules for a holder whose basis
in a tax-exempt obligation is different from the adjusted issue price of
the obligation.
(2) Certain tax-exempt obligations with interest-based or revenue-
based payments--(i) Applicability. This paragraph (d)(2) applies to a
tax-exempt obligation that provides for interest-based payments or
revenue-based payments.
(ii) Interest-based payments. A tax-exempt obligation provides for
interest-based payments if the obligation would otherwise qualify as a
variable rate debt instrument under Sec. 1.1275-5 except that--
(A) The obligation provides for more than one fixed rate;
(B) The obligation provides for one or more caps, floors, or
governors (or similar restrictions) that are fixed as of the issue date;
(C) The interest on the obligation is not compounded or paid at
least annually; or
(D) The obligation provides for interest at one or more rates equal
to the product of a qualified floating rate and a fixed multiple greater
than zero and less than .65, or at one or more rates equal to the
product of a qualified floating rate and a fixed multiple greater than
zero and less than .65, increased or decreased by a fixed rate.
(iii) Revenue-based payments. A tax-exempt obligation provides for
revenue-based payments if the obligation--
(A) Is issued to refinance (including a series of refinancings) an
obligation (in a series of refinancings, the original obligation), the
proceeds of which were used to finance a project or enterprise; and
(B) Would otherwise qualify as a variable rate debt instrument under
Sec. 1.1275-5 except that it provides for stated interest payments at
least annually based on a single fixed percentage of the revenue, value,
change in value,
[[Page 602]]
or other similar measure of the performance of the refinanced project or
enterprise.
(iv) Modifications to the noncontingent bond method. If a tax-exempt
obligation is subject to this paragraph (d)(2), the following
modifications to the noncontingent bond method described in paragraph
(b) of this section apply to the obligation.
(A) Daily portions and net positive adjustments. The daily portions
of interest determined under paragraph (b)(3)(iii) of this section and
any net positive adjustment on the obligation are interest for purposes
of section 103.
(B) Net negative adjustments. A net negative adjustment for a
taxable year reduces the amount of tax-exempt interest the holder would
otherwise account for on the obligation for the taxable year under
paragraph (b)(3)(iii) of this section. If the net negative adjustment
exceeds this amount, the excess is a nondeductible, noncapitalizable
loss. If a regulated investment company (RIC) within the meaning of
section 851 has a net negative adjustment in a taxable year that would
be a nondeductible, noncapitalizable loss under the prior sentence, the
RIC must use this loss to reduce its tax-exempt interest income on other
tax-exempt obligations held during the taxable year.
(C) Gains. Any gain recognized on the sale, exchange, or retirement
of the obligation is gain from the sale or exchange of the obligation.
(D) Losses. Any loss recognized on the sale, exchange, or retirement
of the obligation is treated the same as a net negative adjustment under
paragraph (d)(2)(iv)(B) of this section.
(E) Special rule for losses and net negative adjustments.
Notwithstanding paragraphs (d)(2)(iv) (B) and (D) of this section, on
the sale, exchange, or retirement of the obligation, the holder may
claim a loss from the sale or exchange of the obligation to the extent
the holder has not received in cash or property the sum of its original
investment in the obligation and any amounts included in income under
paragraph (d)(4)(ii) of this section.
(3) All other tax-exempt obligations--(i) Applicability. This
paragraph (d)(3) applies to a tax-exempt obligation that is not subject
to paragraph (d)(2) of this section.
(ii) Modifications to the noncontingent bond method. If a tax-exempt
obligation is subject to this paragraph (d)(3), the following
modifications to the noncontingent bond method described in paragraph
(b) of this section apply to the obligation.
(A) Modification to projected payment schedule. The comparable yield
for the obligation is the greater of the obligation's yield, determined
without regard to the contingent payments, and the tax-exempt applicable
Federal rate that applies to the obligation. The Internal Revenue
Service publishes the tax-exempt applicable Federal rate for each month
in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this
chapter).
(B) Daily portions. The daily portions of interest determined under
paragraph (b)(3)(iii) of this section are interest for purposes of
section 103.
(C) Adjustments. A net positive adjustment on the obligation is
treated as gain to the holder from the sale or exchange of the
obligation in the taxable year of the adjustment. A net negative
adjustment on the obligation is treated as a loss to the holder from the
sale or exchange of the obligation in the taxable year of the
adjustment.
(D) Gains and losses. Any gain or loss recognized on the sale,
exchange, or retirement of the obligation is gain or loss from the sale
or exchange of the obligation.
(4) Basis different from adjusted issue price. This paragraph (d)(4)
provides rules for a holder whose basis in a tax-exempt obligation is
different from the adjusted issue price of the obligation. The rules of
paragraph (b)(9)(i) of this section do not apply to tax-exempt
obligations.
(i) Basis greater than adjusted issue price. If the holder's basis
in the obligation exceeds the obligation's adjusted issue price, the
holder, upon acquiring the obligation, must allocate this difference to
daily portions of interest on a yield to maturity basis over the
remaining term of the obligation. The amount allocated to a daily
portion of interest is not deductible by the holder. However, the
holder's basis in the
[[Page 603]]
obligation is reduced by the amount allocated to a daily portion of
interest on the date the daily portion accrues.
(ii) Basis less than adjusted issue price. If the holder's basis in
the obligation is less than the obligation's adjusted issue price, the
holder, upon acquiring the obligation, must allocate this difference to
daily portions of interest on a yield to maturity basis over the
remaining term of the obligation. The amount allocated to a daily
portion of interest is includible in income by the holder as ordinary
income on the date the daily portion accrues. The holder's adjusted
basis in the obligation is increased by the amount includible in income
by the holder under this paragraph (d)(4)(ii) on the date the daily
portion accrues.
(iii) Premium and discount rules do not apply. The rules for
accruing premium and discount in sections 171, 1276, and 1288 do not
apply. Other rules of those sections continue to apply to the extent
relevant.
(e) Amounts treated as interest under this section. Amounts treated
as interest under this section are treated as OID for all purposes of
the Internal Revenue Code.
(f) Effective date. This section applies to debt instruments issued
on or after August 13, 1996.
[T.D. 8674, 61 FR 30143, June 14, 1996, as amended by T.D. 8709, 62 FR
618, Jan. 6, 1997; T.D. 8838, 64 FR 48547, Sept. 7, 1999; T.D. 9157, 69
FR 52829, Aug. 30, 2004; T.D. 9599, 77 FR 56538, Sept. 13, 2012; T.D.
9612, 78 FR 8016, Feb. 5, 2013]
Sec. 1.1275-5 Variable rate debt instruments.
(a) Applicability--(1) In general. This section provides rules for
variable rate debt instruments. Except as provided in paragraph (a)(6)
of this section, a variable rate debt instrument is a debt instrument
that meets the conditions described in paragraphs (a)(2), (3), (4), and
(5) of this section. If a debt instrument that provides for a variable
rate of interest does not qualify as a variable rate debt instrument,
the debt instrument is a contingent payment debt instrument. See Sec.
1.1275-4 for the treatment of a contingent payment debt instrument. See
Sec. 1.1275-6 for a taxpayer's treatment of a variable rate debt
instrument and a hedge.
(2) Principal payments. The issue price of the debt instrument must
not exceed the total noncontingent principal payments by more than an
amount equal to the lesser of--
(i) .015 multiplied by the product of the total noncontingent
principal payments and the number of complete years to maturity from the
issue date (or, in the case of an installment obligation, the weighted
average maturity as defined in Sec. 1.1273-1(e)(3)); or
(ii) 15 percent of the total noncontingent principal payments.
(3) Stated interest--(i) General rule. The debt instrument must not
provide for any stated interest other than stated interest (compounded
or paid at least annually) at--
(A) One or more qualified floating rates;
(B) A single fixed rate and one or more qualified floating rates;
(C) A single objective rate; or
(D) A single fixed rate and a single objective rate that is a
qualified inverse floating rate.
(ii) Certain debt instruments bearing interest at a fixed rate for
an initial period. If interest on a debt instrument is stated at a fixed
rate for an initial period of 1 year or less followed by a variable rate
that is either a qualified floating rate or an objective rate for a
subsequent period, and the value of the variable rate on the issue date
is intended to approximate the fixed rate, the fixed rate and the
variable rate together constitute a single qualified floating rate or
objective rate. A fixed rate and a variable rate will be conclusively
presumed to meet the requirements of the preceding sentence if the value
of the variable rate on the issue date does not differ from the value of
the fixed rate by more than .25 percentage points (25 basis points).
(4) Current value. The debt instrument must provide that a qualified
floating rate or objective rate in effect at any time during the term of
the instrument is set at a current value of that rate. A current value
is the value of the rate on any day that is no earlier than 3 months
prior to the first day on which that value is in effect and no
[[Page 604]]
later than 1 year following that first day.
(5) No contingent principal payments. Except as provided in
paragraph (a)(2) of this section, the debt instrument must not provide
for any principal payments that are contingent (within the meaning of
Sec. 1.1275-4(a)).
(6) Special rule for debt instruments issued for nonpublicly traded
property. A debt instrument (other than a tax-exempt obligation) that
would otherwise qualify as a variable rate debt instrument under this
section is not a variable rate debt instrument if section 1274 applies
to the instrument and any stated interest payments on the instrument are
treated as contingent payments under Sec. 1.1274-2. This paragraph
(a)(6) applies to debt instruments issued on or after August 13, 1996.
(b) Qualified floating rate--(1) In general. A variable rate is a
qualified floating rate if variations in the value of the rate can
reasonably be expected to measure contemporaneous variations in the cost
of newly borrowed funds in the currency in which the debt instrument is
denominated. The rate may measure contemporaneous variations in
borrowing costs for the issuer of the debt instrument or for issuers in
general. Except as provided in paragraph (b)(2) of this section, a
multiple of a qualified floating rate is not a qualified floating rate.
If a debt instrument provides for two or more qualified floating rates
that can reasonably be expected to have approximately the same values
throughout the term of the instrument, the qualified floating rates
together constitute a single qualified floating rate. Two or more
qualified floating rates will be conclusively presumed to meet the
requirements of the preceding sentence if the values of all rates on the
issue date are within .25 percentage points (25 basis points) of each
other.
(2) Certain rates based on a qualified floating rate. For a debt
instrument issued on or after August 13, 1996, a variable rate is a
qualified floating rate if it is equal to either--
(i) The product of a qualified floating rate described in paragraph
(b)(1) of this section and a fixed multiple that is greater than .65 but
not more than 1.35; or
(ii) The product of a qualified floating rate described in paragraph
(b)(1) of this section and a fixed multiple that is greater than .65 but
not more than 1.35, increased or decreased by a fixed rate.
(3) Restrictions on the stated rate of interest. A variable rate is
not a qualified floating rate if it is subject to a restriction or
restrictions on the maximum stated interest rate (cap), a restriction or
restrictions on the minimum stated interest rate (floor), a restriction
or restrictions on the amount of increase or decrease in the stated
interest rate (governor), or other similar restrictions. Notwithstanding
the preceding sentence, the following restrictions will not cause a
variable rate to fail to be a qualified floating rate--
(i) A cap, floor, or governor that is fixed throughout the term of
the debt instrument;
(ii) A cap or similar restriction that is not reasonably expected as
of the issue date to cause the yield on the debt instrument to be
significantly less than the expected yield determined without the cap;
(iii) A floor or similar restriction that is not reasonably expected
as of the issue date to cause the yield on the debt instrument to be
significantly more than the expected yield determined without the floor;
or
(iv) A governor or similar restriction that is not reasonably
expected as of the issue date to cause the yield on the debt instrument
to be significantly more or significantly less than the expected yield
determined without the governor.
(c) Objective rate--(1) Definition--(i) In general. For debt
instruments issued on or after August 13, 1996, an objective rate is a
rate (other than a qualified floating rate) that is determined using a
single fixed formula and that is based on objective financial or
economic information. For example, an objective rate generally includes
a rate that is based on one or more qualified floating rates or on the
yield of actively traded personal property (within the meaning of
section 1092(d)(1)).
(ii) Exception. For purposes of paragraph (c)(1)(i) of this section,
an objective rate does not include a rate based on information that is
within the control of the issuer (or a related party
[[Page 605]]
within the meaning of section 267(b) or 707(b)(1)) or that is unique to
the circumstances of the issuer (or a related party within the meaning
of section 267(b) or 707(b)(1)), such as dividends, profits, or the
value of the issuer's stock. However, a rate does not fail to be an
objective rate merely because it is based on the credit quality of the
issuer.
(2) Other objective rates to be specified by Commissioner. The
Commissioner may designate in the Internal Revenue Bulletin variable
rates other than those described in paragraph (c)(1) of this section
that will be treated as objective rates (see Sec. 601.601(d)(2)(ii) of
this chapter).
(3) Qualified inverse floating rate. An objective rate described in
paragraph (c)(1) of this section is a qualified inverse floating rate
if--
(i) The rate is equal to a fixed rate minus a qualified floating
rate; and
(ii) The variations in the rate can reasonably be expected to
inversely reflect contemporaneous variations in the qualified floating
rate (disregarding any restrictions on the rate that are described in
paragraphs (b)(3)(i), (b)(3)(ii), (b)(3)(iii), and (b)(3)(iv) of this
section).
(4) Significant front-loading or back-loading of interest.
Notwithstanding paragraph (c)(1) of this section, a variable rate of
interest on a debt instrument is not an objective rate if it is
reasonably expected that the average value of the rate during the first
half of the instrument's term will be either significantly less than or
significantly greater than the average value of the rate during the
final half of the instrument's term.
(5) Tax-exempt obligations. Notwithstanding paragraph (c)(1) of this
section, in the case of a tax-exempt obligation (within the meaning of
section 1275(a)(3)), a variable rate is an objective rate only if it is
a qualified inverse floating rate or a qualified inflation rate. A rate
is a qualified inflation rate if the rate measures contemporaneous
changes in inflation based on a general inflation index.
(d) Examples. The following examples illustrate the rules of
paragraphs (b) and (c) of this section. For purposes of these examples,
assume that the debt instrument is not a tax-exempt obligation. In
addition, unless otherwise provided, assume that the rate is not
reasonably expected to result in a significant front-loading or back-
loading of interest and that the rate is not based on objective
financial or economic information that is within the control of the
issuer (or a related party) or that is unique to the circumstances of
the issuer (or a related party).
Example 1. Rate based on LIBOR. X issues a debt instrument that
provides for annual payments of interest at a rate equal to the value of
the 1-year London Interbank Offered Rate (LIBOR) at the end of each
year. Variations in the value of 1-year LIBOR over the term of the debt
instrument can reasonably be expected to measure contemporaneous
variations in the cost of newly borrowed funds over that term.
Accordingly, the rate is a qualified floating rate.
Example 2. Rate increased by a fixed amount. X issues a debt
instrument that provides for annual payments of interest at a rate equal
to 200 basis points (2 percent) plus the current value, at the end of
each year, of the average yield on 1-year Treasury securities as
published in Federal Reserve bulletins. Variations in the value of this
interest rate can reasonably be expected to measure contemporaneous
variations in the cost of newly borrowed funds. Accordingly, the rate is
a qualified floating rate.
Example 3. Rate based on commercial paper rate. X issues a debt
instrument that provides for a rate of interest that is periodically
adjusted to equal the current interest rate of Bank's commercial paper.
Variations in the value of this interest rate can reasonably be expected
to measure contemporaneous variations in the cost of newly borrowed
funds. Accordingly, the rate is a qualified floating rate.
Example 4. Rate based on changes in the value of a commodity index.
On January 1, 1997, X issues a debt instrument that provides for annual
interest payments at the end of each year at a rate equal to the
percentage increase, if any, in the value of an index for the year
immediately preceding the payment. The index is based on the prices of
several actively traded commodities. Variations in the value of this
interest rate cannot reasonably be expected to measure contemporaneous
variations in the cost of newly borrowed funds. Accordingly, the rate is
not a qualified floating rate. However, because the rate is based on
objective financial information using a single fixed formula, the rate
is an objective rate.
Example 5. Rate based on a percentage of S&P 500 Index. On January
1, 1997, X issues a debt instrument that provides for annual interest
payments at the end of each year based on a
[[Page 606]]
fixed percentage of the value of the S&P 500 Index. Variations in the
value of this interest rate cannot reasonably be expected to measure
contemporaneous variations in the cost of newly borrowed funds and,
therefore, the rate is not a qualified floating rate. Although the rate
is described in paragraph (c)(1)(i) of this section, the rate is not an
objective rate because, based on historical data, it is reasonably
expected that the average value of the rate during the first half of the
instrument's term will be significantly less than the average value of
the rate during the final half of the instrument's term.
Example 6. Rate based on issuer's profits. On January 1, 1997, Z
issues a debt instrument that provides for annual interest payments
equal to 1 percent of Z's gross profits earned during the year
immediately preceding the payment. Variations in the value of this
interest rate cannot reasonably be expected to measure contemporaneous
variations in the cost of newly borrowed funds. Accordingly, the rate is
not a qualified floating rate. In addition, because the rate is based on
information that is unique to the issuer's circumstances, the rate is
not an objective rate.
Example 7. Rate based on a multiple of an interest index. On January
1, 1997, Z issues a debt instrument with annual interest payments at a
rate equal to two times the value of 1-year LIBOR as of the payment
date. Because the rate is a multiple greater than 1.35 times a qualified
floating rate, the rate is not a qualified floating rate. However,
because the rate is based on objective financial information using a
single fixed formula, the rate is an objective rate.
Example 8. Variable rate based on the cost of borrowed funds in a
foreign currency. On January 1, 1997, Y issues a 5-year dollar
denominated debt instrument that provides for annual interest payments
at a rate equal to the value of 1-year French franc LIBOR as of the
payment date. Variations in the value of French franc LIBOR do not
measure contemporaneous changes in the cost of newly borrowed funds in
dollars. As a result, the rate is not a qualified floating rate for an
instrument denominated in dollars. However, because the rate is based on
objective financial information using a single fixed formula, the rate
is an objective rate.
Example 9. Qualified inverse floating rate. On January 1, 1997, X
issues a debt instrument that provides for annual interest payments at
the end of each year at a rate equal to 12 percent minus the value of 1-
year LIBOR as of the payment date. On the issue date, the value of 1-
year LIBOR is 6 percent. Because the rate can reasonably be expected to
inversely reflect contemporaneous variations in 1-year LIBOR, it is a
qualified inverse floating rate. However, if the value of 1-year LIBOR
on the issue date were 11 percent rather than 6 percent, the rate would
not be a qualified inverse floating rate because the rate could not
reasonably be expected to inversely reflect contemporaneous variations
in 1-year LIBOR.
Example 10. Rate based on an inflation index. On January 1, 1997, X
issues a debt instrument that provides for annual interest payments at
the end of each year at a rate equal to 400 basis points (4 percent)
plus the annual percentage change in a general inflation index (e.g.,
the Consumer Price Index, U.S. City Average, All Items, for all Urban
Consumers, seasonally unadjusted). The rate, however, may not be less
than zero. Variations in the value of this interest rate cannot
reasonably be expected to measure contemporaneous variations in the cost
of newly borrowed funds. Accordingly, the rate is not a qualified
floating rate. However, because the rate is based on objective economic
information using a single fixed formula, the rate is an objective rate.
(e) Qualified stated interest and OID with respect to a variable
rate debt instrument--(1) In general. This paragraph (e) provides rules
to determine the amount and accrual of OID and qualified stated interest
on a variable rate debt instrument. In general, the rules convert the
debt instrument into a fixed rate debt instrument and then apply the
general OID rules to the debt instrument. The issue price of a variable
rate debt instrument, however, is not determined under this paragraph
(e). See Sec. Sec. 1.1273-2 and 1.1274-2 to determine the issue price
of a variable rate debt instrument.
(2) Variable rate debt instrument that provides for annual payments
of interest at a single variable rate. If a variable rate debt
instrument provides for stated interest at a single qualified floating
rate or objective rate and the interest is unconditionally payable in
cash or in property (other than debt instruments of the issuer), or will
be constructively received under section 451, at least annually, the
following rules apply to the instrument:
(i) All stated interest with respect to the debt instrument is
qualified stated interest.
(ii) The amount of qualified stated interest and the amount of OID,
if any, that accrues during an accrual period is determined under the
rules applicable to fixed rate debt instruments by assuming that the
variable rate is a fixed rate equal to--
(A) In the case of a qualified floating rate or qualified inverse
floating rate,
[[Page 607]]
the value, as of the issue date, of the qualified floating rate or
qualified inverse floating rate; or
(B) In the case of an objective rate (other than a qualified inverse
floating rate), a fixed rate that reflects the yield that is reasonably
expected for the debt instrument.
(iii) The qualified stated interest allocable to an accrual period
is increased (or decreased) if the interest actually paid during an
accrual period exceeds (or is less than) the interest assumed to be paid
during the accrual period under paragraph (e)(2)(ii) of this section.
(3) All other variable rate debt instruments except for those that
provide for a fixed rate. If a variable rate debt instrument is not
described in paragraph (e)(2) of this section and does not provide for
interest payable at a fixed rate (other than an initial fixed rate
described in paragraph (a)(3)(ii) of this section), the amount of
interest and OID accruals for the instrument are determined under this
paragraph (e)(3).
(i) Step one: Determine the fixed rate substitute for each variable
rate provided under the debt instrument--(A) Qualified floating rate.
The fixed rate substitute for each qualified floating rate provided for
in the debt instrument is the value of each rate as of the issue date.
If, however, a variable rate debt instrument provides for two or more
qualified floating rates with different intervals between interest
adjustment dates, the fixed rate substitutes for the rates must be based
on intervals that are equal in length. For example, if a 4-year debt
instrument provides for 24 monthly interest payments based on the value
of the 30-day commercial paper rate on each payment date followed by 8
quarterly interest payments based on the value of quarterly LIBOR on
each payment date, the fixed rate substitutes may be based on the
values, as of the issue date, of the 90-day commercial paper rate and
quarterly LIBOR. Alternatively, the fixed rate substitutes may be based
on the values, as of the issue date, of the 30-day commercial paper rate
and monthly LIBOR.
(B) Qualified inverse floating rate. The fixed rate substitute for a
qualified inverse floating rate is the value of the qualified inverse
floating rate as of the issue date.
(C) Objective rate. The fixed rate substitute for an objective rate
(other than a qualified inverse floating rate) is a fixed rate that
reflects the yield that is reasonably expected for the debt instrument.
(ii) Step two: Construct the equivalent fixed rate debt instrument.
The equivalent fixed rate debt instrument has terms that are identical
to those provided under the variable rate debt instrument, except that
the equivalent fixed rate debt instrument provides for the fixed rate
substitutes (determined in paragraph (e)(3)(i) of this section) in lieu
of the qualified floating rates or objective rate provided under the
variable rate debt instrument.
(iii) Step three: Determine the amount of qualified stated interest
and OID with respect to the equivalent fixed rate debt instrument. The
amount of qualified stated interest and OID, if any, are determined for
the equivalent fixed rate debt instrument under the rules applicable to
fixed rate debt instruments and are taken into account as if the holder
held the equivalent fixed rate debt instrument.
(iv) Step four: Make appropriate adjustments for actual variable
rates. Qualified stated interest or OID allocable to an accrual period
must be increased (or decreased) if the interest actually accrued or
paid during an accrual period exceeds (or is less than) the interest
assumed to be accrued or paid during the accrual period under the
equivalent fixed rate debt instrument. This increase or decrease is an
adjustment to qualified stated interest for the accrual period if the
equivalent fixed rate debt instrument (as determined under paragraph
(e)(3)(ii) of this section) provides for qualified stated interest and
the increase or decrease is reflected in the amount actually paid during
the accrual period. Otherwise, this increase or decrease is an
adjustment to OID for the accrual period.
(v) Examples. The following examples illustrate the rules in
paragraphs (e) (2) and (3) of this section:
Example 1. Equivalent fixed rate debt instrument. (i) Facts. X
purchases at original issue a 6-year variable rate debt instrument that
[[Page 608]]
provides for semiannual payments of interest. For the first 3 years, the
rate of interest is the value of 6-month LIBOR on the payment date. For
the final 3 years, the rate is the value of the 6-month T-bill rate on
the payment date. On the issue date, the value of 6-month LIBOR is 3
percent, compounded semiannually, and the 6-month T-bill rate is 2
percent, compounded semiannually.
(ii) Determination of equivalent fixed rate debt instrument. Under
paragraph (e)(3)(i) of this section, the fixed rate substitute for 6-
month LIBOR is 3 percent, compounded semiannually, and the fixed rate
substitute for the 6-month T-bill rate is 2 percent, compounded
semiannually. Under paragraph (e)(3)(ii) of this section, the equivalent
fixed rate debt instrument is a 6-year debt instrument that provides for
semiannual payments of interest at 3 percent, compounded semiannually,
for the first 3 years followed by 2 percent, compounded semiannually,
for the final 3 years.
Example 2. Equivalent fixed rate debt instrument with de minimis
OID. (i) Facts. Y purchases at original issue, for $100,000, a 4-year
variable rate debt instrument that has a stated principal amount of
$100,000, payable at maturity. The debt instrument provides for monthly
payments of interest at the end of each month. For the first year, the
interest rate is the monthly commercial paper rate and for the last 3
years, the interest rate is the monthly commercial paper rate plus 100
basis points. On the issue date, the monthly commercial paper rate is 3
percent, compounded monthly.
(ii) Equivalent fixed rate debt instrument. Under paragraph
(e)(3)(ii) of this section, the equivalent fixed rate debt instrument
for the variable rate debt instrument is a 4-year debt instrument that
has an issue price and stated principal amount of $100,000. The
equivalent fixed rate debt instrument provides for monthly payments of
interest at 3 percent, compounded monthly, for the first year ($250 per
month) and monthly payments of interest at 4 percent, compounded
monthly, for the last 3 years ($333.33 per month).
(iii) De minimis OID. Under Sec. 1.1273-1(a), because a portion
(100 basis points) of each interest payment in the final 3 years is not
a qualified stated interest payment, the equivalent fixed rate debt
instrument has OID of $2,999.88 ($102,999.88 -$100,000). However, under
Sec. 1.1273-1(d)(4) (the de minimis rule relating to teaser rates and
interest holidays), the stated redemption price at maturity of the
equivalent fixed rate debt instrument is $100,999.96 ($100,000 (issue
price) plus $999.96 (the greater of the amount of foregone interest
($999.96) and the amount equal to the excess of the instrument's stated
principal amount over its issue price ($0)). Thus, the equivalent fixed
rate debt instrument is treated as having OID of $999.96 ($100,999.96 -
$100,000). Because this amount is less than the de minimis amount of
$1,010 (0.0025 multiplied by $100,999.96 multiplied by 4 complete years
to maturity), the equivalent fixed rate debt instrument has de minimis
OID. Therefore, the variable rate debt instrument has zero OID and all
stated interest payments are qualified stated interest payments.
Example 3. Adjustment to qualified stated interest for actual
payment of interest. (i) Facts. On January 1, 1995, Z purchases at
original issue, for $90,000, a variable rate debt instrument that
matures on January 1, 1997, and has a stated principal amount of
$100,000, payable at maturity. The debt instrument provides for annual
payments of interest on January 1 of each year, beginning on January 1,
1996. The amount of interest payable is the value of annual LIBOR on the
payment date. The value of annual LIBOR on January 1, 1995, and January
1, 1996, is 5 percent, compounded annually. The value of annual LIBOR on
January 1, 1997, is 7 percent, compounded annually.
(ii) Accrual of OID and qualified stated interest. Under paragraph
(e)(2) of this section, the variable rate debt instrument is treated as
a 2-year debt instrument that has an issue price of $90,000, a stated
principal amount of $100,000, and interest payments of $5,000 at the end
of each year. The debt instrument has $10,000 of OID and the annual
interest payments of $5,000 are qualified stated interest payments.
Under Sec. 1.1272-1, the debt instrument has a yield of 10.82 percent,
compounded annually. The amount of OID allocable to the first annual
accrual period (assuming Z uses annual accrual periods) is $4,743.25
(($90,000 x .1082)- $5,000), and the amount of OID allocable to the
second annual accrual period is $5,256.75 ($100,000-$94,743.25). Under
paragraph (e)(2)(iii) of this section, the $2,000 difference between the
$7,000 interest payment actually made at maturity and the $5,000
interest payment assumed to be made at maturity under the equivalent
fixed rate debt instrument is treated as additional qualified stated
interest for the period.
(4) Variable rate debt instrument that provides for a single fixed
rate--(i) General rule. If a variable rate debt instrument provides for
stated interest either at one or more qualified floating rates or at a
qualified inverse floating rate and in addition provides for stated
interest at a single fixed rate (other than an initial fixed rate
described in paragraph (a)(3)(ii) of this section), the amount of
interest and OID are determined using the method of paragraph (e)(3) of
this section, as modified by this paragraph (e)(4). For purposes of
paragraphs (e)(3)(i) through (e)(3)(iii) of
[[Page 609]]
this section, the variable rate debt instrument is treated as if it
provided for a qualified floating rate (or a qualified inverse floating
rate, if the debt instrument provides for a qualified inverse floating
rate), rather than the fixed rate. The qualified floating rate (or
qualified inverse floating rate) replacing the fixed rate must be such
that the fair market value of the variable rate debt instrument as of
the issue date would be approximately the same as the fair market value
of an otherwise identical debt instrument that provides for the
qualified floating rate (or qualified inverse floating rate) rather than
the fixed rate.
(ii) Example. The following example illustrates the rule in
paragraph (e)(4)(i) of this section.
Example: Variable rate debt instrument that provides for a single
fixed rate. (i) Facts. On January 1, 1995, X purchases at original
issue, for $100,000, a variable rate debt instrument that matures on
January 1, 2001, and that has a stated principal amount of $100,000. The
debt instrument provides for payments of interest on January 1 of each
year, beginning on January 1, 1996. For the first 4 years, the interest
rate is 4 percent, compounded annually, and for the last 2 years the
interest rate is the value of 1-year LIBOR, as of the payment date, plus
200 basis points. On January 1, 1995, the value of 1-year LIBOR is 2
percent, compounded annually. In addition, assume that on January 1,
1995, the variable rate debt instrument has approximately the same fair
market value as an otherwise identical debt instrument that provides for
an interest rate equal to the value of 1-year LIBOR, as of the payment
date, for the first 4 years.
(ii) Equivalent fixed rate debt instrument. Under paragraph
(e)(4)(i) of this section, for purposes of paragraphs (e)(3)(i) through
(e)(3)(iii) of this section, the variable rate debt instrument is
treated as if it provided for an interest rate equal to the value of 1-
year LIBOR, as of the payment date, for the first 4 years. Under
paragraph (e)(3)(ii) of this section, the equivalent fixed rate debt
instrument for the variable rate debt instrument is a 6-year debt
instrument that has an issue price and stated principal amount of
$100,000. The equivalent fixed rate debt instrument provides for
interest payments of $2,000 for the first 4 years and $4,000 for the
last 2 years.
(iii) Accrual of OID and qualified stated interest. Under Sec.
1.1273-1, the equivalent fixed rate debt instrument has OID of $4,000
because a portion (200 basis points) of each interest payment in the
last 2 years is not a qualified stated interest payment. The $4,000 of
OID is allocable over the 6-year term of the debt instrument under Sec.
1.1272-1. Under paragraph (e)(3)(iv) of this section, the difference
between the $4,000 payment made in the first 4 years and the $2,000
payment assumed to be made on the equivalent fixed rate debt instrument
in those years is an adjustment to qualified stated interest. In
addition, any difference between the amount actually paid in each of the
last 2 years and the $4,000 payment assumed to be made on the equivalent
fixed rate debt instrument is an adjustment to qualified stated
interest.
(f) Special rule for certain reset bonds. Notwithstanding paragraph
(e) of this section, this paragraph (f) provides a special rule for a
variable rate debt instrument that provides for stated interest at a
fixed rate for an initial interval, and provides that on the date
immediately following the end of the initial interval (the effective
date) the stated interest rate will be a rate determined under a
procedure (such as an auction procedure) so that the fair market value
of the instrument on the effective date will be a fixed amount (the
reset value). Solely for purposes of calculating the accrual of OID, the
variable rate debt instrument is treated as--
(1) Maturing on the date immediately preceding the effective date
for an amount equal to the reset value; and
(2) Reissued on the effective date for an amount equal to the reset
value.
[T.D. 8517, 59 FR 4827, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30153, June 14, 1996]
Sec. 1.1275-6 Integration of qualifying debt instruments.
(a) In general. This section generally provides for the integration
of a qualifying debt instrument with a hedge or combination of hedges if
the combined cash flows of the components are substantially equivalent
to the cash flows on a fixed or variable rate debt instrument. The
integrated transaction is generally subject to the rules of this section
rather than the rules to which each component of the transaction would
be subject on a separate basis. The purpose of this section is to permit
a more appropriate determination of the character and timing of income,
deductions, gains, or losses than would be permitted by separate
treatment of the components. The rules of this section affect only the
taxpayer who holds (or
[[Page 610]]
issues) the qualifying debt instrument and enters into the hedge.
(b) Definitions--(1) Qualifying debt instrument. A qualifying debt
instrument is any debt instrument (including an integrated transaction
as defined in paragraph (c) of this section) other than--
(i) A tax-exempt obligation as defined in section 1275(a)(3);
(ii) A debt instrument to which section 1272(a)(6) applies (certain
interests in or mortgages held by a REMIC, and certain other debt
instruments with payments subject to acceleration); or
(iii) A debt instrument that is subject to Sec. 1.483-4 or Sec.
1.1275-4(c) (certain contingent payment debt instruments issued for
nonpublicly traded property).
(2) Section 1.1275-6 hedge--(i) In general. A Sec. 1.1275-6 hedge
is any financial instrument (as defined in paragraph (b)(3) of this
section) if the combined cash flows of the financial instrument and the
qualifying debt instrument permit the calculation of a yield to maturity
(under the principles of section 1272), or the right to the combined
cash flows would qualify under Sec. 1.1275-5 as a variable rate debt
instrument that pays interest at a qualified floating rate or rates
(except for the requirement that the interest payments be stated as
interest). A financial instrument is not a Sec. 1.1275-6 hedge,
however, if the resulting synthetic debt instrument does not have the
same term as the remaining term of the qualifying debt instrument. A
financial instrument that hedges currency risk is not a Sec. 1.1275-6
hedge.
(ii) Limitations--(A) A debt instrument issued by a taxpayer and a
debt instrument held by the taxpayer cannot be part of the same
integrated transaction.
(B) A debt instrument can be a Sec. 1.1275-6 hedge only if it is
issued substantially contemporaneously with, and has the same maturity
(including rights to accelerate or delay payments) as, the qualifying
debt instrument.
(3) Financial instrument. For purposes of this section, a financial
instrument is a spot, forward, or futures contract, an option, a
notional principal contract, a debt instrument, or a similar instrument,
or combination or series of financial instruments. Stock is not a
financial instrument for purposes of this section.
(4) Synthetic debt instrument. The synthetic debt instrument is the
hypothetical debt instrument with the same cash flows as the combined
cash flows of the qualifying debt instrument and the Sec. 1.1275-6
hedge.
(c) Integrated transaction--(1) Integration by taxpayer. Except as
otherwise provided in this section, a qualifying debt instrument and a
Sec. 1.1275-6 hedge are an integrated transaction if all of the
following requirements are satisfied:
(i) The taxpayer satisfies the identification requirements of
paragraph (e) of this section on or before the date the taxpayer enters
into the Sec. 1.1275-6 hedge.
(ii) None of the parties to the Sec. 1.1275-6 hedge are related
within the meaning of section 267(b) or 707(b)(1), or, if the parties
are related, the party providing the hedge uses, for Federal income tax
purposes, a mark-to-market method of accounting for the hedge and all
similar or related transactions.
(iii) Both the qualifying debt instrument and the Sec. 1.1275-6
hedge are entered into by the same individual, partnership, trust,
estate, or corporation (regardless of whether the corporation is a
member of an affiliated group of corporations that files a consolidated
return).
(iv) If the taxpayer is a foreign person engaged in a U.S. trade or
business and the taxpayer issues or acquires a qualifying debt
instrument, or enters into a Sec. 1.1275-6 hedge, through the trade or
business, all items of income and expense associated with the qualifying
debt instrument and the Sec. 1.1275-6 hedge (other than interest
expense that is subject to Sec. 1.882-5) would have been effectively
connected with the U.S. trade or business throughout the term of the
qualifying debt instrument had this section not applied.
(v) Neither the qualifying debt instrument, nor any other debt
instrument that is part of the same issue as the qualifying debt
instrument, nor the Sec. 1.1275-6 hedge was, with respect to the
taxpayer, part of an integrated transaction that was terminated or
otherwise legged out of within the 30 days
[[Page 611]]
immediately preceding the date that would be the issue date of the
synthetic debt instrument.
(vi) The qualifying debt instrument is issued or acquired by the
taxpayer on or before the date of the first payment on the Sec. 1.1275-
6 hedge, whether made or received by the taxpayer (including a payment
made to purchase the hedge). If the qualifying debt instrument is issued
or acquired by the taxpayer after, but substantially contemporaneously
with, the date of the first payment on the Sec. 1.1275-6 hedge, the
qualifying debt instrument is treated, solely for purposes of this
paragraph (c)(1)(vi), as meeting the requirements of the preceding
sentence.
(vii) Neither the Sec. 1.1275-6 hedge nor the qualifying debt
instrument was, with respect to the taxpayer, part of a straddle (as
defined in section 1092(c)) prior to the issue date of the synthetic
debt instrument.
(2) Integration by Commissioner. The Commissioner may treat a
qualifying debt instrument and a financial instrument (whether entered
into by the taxpayer or by a related party) as an integrated transaction
if the combined cash flows on the qualifying debt instrument and
financial instrument are substantially the same as the combined cash
flows required for the financial instrument to be a Sec. 1.1275-6
hedge. The Commissioner, however, may not integrate a transaction unless
the qualifying debt instrument either is subject to Sec. 1.1275-4 or is
subject to Sec. 1.1275-5 and pays interest at an objective rate. The
circumstances under which the Commissioner may require integration
include, but are not limited to, the following:
(i) A taxpayer fails to identify a qualifying debt instrument and
the Sec. 1.1275-6 hedge under paragraph (e) of this section.
(ii) A taxpayer issues or acquires a qualifying debt instrument and
a related party (within the meaning of section 267(b) or 707(b)(1))
enters into the Sec. 1.1275-6 hedge.
(iii) A taxpayer issues or acquires a qualifying debt instrument and
enters into the Sec. 1.1275-6 hedge with a related party (within the
meaning of section 267(b) or 707(b)(1)).
(iv) The taxpayer legs out of an integrated transaction and within
30 days enters into a new Sec. 1.1275-6 hedge with respect to the same
qualifying debt instrument or another debt instrument that is part of
the same issue.
(d) Special rules for legging into and legging out of an integrated
transaction--(1) Legging into--(i) Definition. Legging into an
integrated transaction under this section means that a Sec. 1.1275-6
hedge is entered into after the date the qualifying debt instrument is
issued or acquired by the taxpayer, and the requirements of paragraph
(c)(1) of this section are satisfied on the date the Sec. 1.1275-6
hedge is entered into (the leg-in date).
(ii) Treatment. If a taxpayer legs into an integrated transaction,
the taxpayer treats the qualifying debt instrument under the applicable
rules for taking interest and OID into account up to the leg-in date,
except that the day before the leg-in date is treated as the end of an
accrual period. As of the leg-in date, the qualifying debt instrument is
subject to the rules of paragraph (f) of this section.
(iii) Anti-abuse rule. If a taxpayer legs into an integrated
transaction with a principal purpose of deferring or accelerating income
or deductions on the qualifying debt instrument, the Commissioner may--
(A) Treat the qualifying debt instrument as sold for its fair market
value on the leg-in date; or
(B) Refuse to allow the taxpayer to integrate the qualifying debt
instrument and the Sec. 1.1275-6 hedge.
(2) Legging out--(i) Definition--(A) Legging out if the taxpayer has
integrated. If a taxpayer has integrated a qualifying debt instrument
and a Sec. 1.1275-6 hedge under paragraph (c)(1) of this section,
legging out means that, prior to the maturity of the synthetic debt
instrument, the Sec. 1.1275-6 hedge ceases to meet the requirements for
a Sec. 1.1275-6 hedge, the taxpayer fails to meet any requirement of
paragraph (c)(1) of this section, or the taxpayer disposes of or
otherwise terminates all or a part of the qualifying debt instrument or
Sec. 1.1275-6 hedge. If the taxpayer fails to meet the requirements of
paragraph (c)(1) of this section but meets the requirements of paragraph
(c)(2) of
[[Page 612]]
this section, the Commissioner may treat the taxpayer as not legging
out.
(B) Legging out if the Commissioner has integrated. If the
Commissioner has integrated a qualifying debt instrument and a financial
instrument under paragraph (c)(2) of this section, legging out means
that, prior to the maturity of the synthetic debt instrument, the
requirements for Commissioner integration under paragraph (c)(2) of this
section are not met or the taxpayer fails to meet the requirements for
taxpayer integration under paragraph (c)(1) of this section and the
Commissioner agrees to allow the taxpayer to be treated as legging out.
(C) Exception for certain nonrecognition transactions. If, in a
single nonrecognition transaction, a taxpayer disposes of, or ceases to
be primarily liable on, the qualifying debt instrument and the Sec.
1.1275-6 hedge, the taxpayer is not treated as legging out. Instead, the
integrated transaction is treated under the rules governing the
nonrecognition transaction. For example, if a holder of an integrated
transaction is acquired in a reorganization under section 368(a)(1)(A),
the holder is treated as disposing of the synthetic debt instrument in
the reorganization rather than legging out. If the successor holder is
not eligible for integrated treatment, the successor is treated as
legging out.
(ii) Operating rules. If a taxpayer legs out (or is treated as
legging out) of an integrated transaction, the following rules apply:
(A) The transaction is treated as an integrated transaction during
the time the requirements of paragraph (c) (1) or (2) of this section,
as appropriate, are satisfied.
(B) Immediately before the taxpayer legs out, the taxpayer is
treated as selling or otherwise terminating the synthetic debt
instrument for its fair market value and, except as provided in
paragraph (d)(2)(ii)(D) of this section, any income, deduction, gain, or
loss is realized and recognized at that time.
(C) If, immediately after the taxpayer legs out, the taxpayer holds
or remains primarily liable on the qualifying debt instrument,
adjustments are made to reflect any difference between the fair market
value of the qualifying debt instrument and the adjusted issue price of
the qualifying debt instrument. If, immediately after the taxpayer legs
out, the taxpayer is a party to a Sec. 1.1275-6 hedge, the Sec.
1.1275-6 hedge is treated as entered into at its fair market value.
(D) If a taxpayer legs out of an integrated transaction by disposing
of or otherwise terminating a Sec. 1.1275-6 hedge within 30 days of
legging into the integrated transaction, then any loss or deduction
determined under paragraph (d)(2)(ii)(B) of this section is not allowed.
Appropriate adjustments are made to the qualifying debt instrument for
any disallowed loss. The adjustments are taken into account on a yield
to maturity basis over the remaining term of the qualifying debt
instrument.
(E) If a holder of a debt instrument subject to Sec. 1.1275-4 legs
into an integrated transaction with respect to the instrument and
subsequently legs out of the integrated transaction, any gain recognized
under paragraph (d)(2)(ii) (B) or (C) of this section is treated as
interest income to the extent determined under the principles of Sec.
1.1275-4(b)(8)(iii)(B) (rules for determining the character of gain on
the sale of a debt instrument all of the payments on which have been
fixed). If the synthetic debt instrument would qualify as a variable
rate debt instrument, the equivalent fixed rate debt instrument
determined under Sec. 1.1275-5(e) is used for this purpose.
(e) Identification requirements. For each integrated transaction, a
taxpayer must enter and retain as part of its books and records the
following information--
(1) The date the qualifying debt instrument was issued or acquired
(or is expected to be issued or acquired) by the taxpayer and the date
the Sec. 1.1275-6 hedge was entered into by the taxpayer;
(2) A description of the qualifying debt instrument and the Sec.
1.1275-6 hedge; and
(3) A summary of the cash flows and accruals resulting from treating
the qualifying debt instrument and the Sec. 1.1275-6 hedge as an
integrated transaction (i.e., the cash flows and accruals on the
synthetic debt instrument).
[[Page 613]]
(f) Taxation of integrated transactions--(1) General rule. An
integrated transaction is generally treated as a single transaction by
the taxpayer during the period that the transaction qualifies as an
integrated transaction. Except as provided in paragraph (f)(12) of this
section, while a qualifying debt instrument and a Sec. 1.1275-6 hedge
are part of an integrated transaction, neither the qualifying debt
instrument nor the Sec. 1.1275-6 hedge is subject to the rules that
would apply on a separate basis to the debt instrument and the Sec.
1.1275-6 hedge, including section 1092 or Sec. 1.446-4. The rules that
would govern the treatment of the synthetic debt instrument generally
govern the treatment of the integrated transaction. For example, the
integrated transaction may be subject to section 263(g) or, if the
synthetic debt instrument would be part of a straddle, section 1092.
Generally, the synthetic debt instrument is subject to sections 163(e)
and 1271 through 1275, with terms as set forth in paragraphs (f) (2)
through (13) of this section.
(2) Issue date. The issue date of the synthetic debt instrument is
the first date on which the taxpayer entered into all of the components
of the synthetic debt instrument.
(3) Term. The term of the synthetic debt instrument is the period
beginning on the issue date of the synthetic debt instrument and ending
on the maturity date of the qualifying debt instrument.
(4) Issue price. The issue price of the synthetic debt instrument is
the adjusted issue price of the qualifying debt instrument on the issue
date of the synthetic debt instrument. If, as a result of entering into
the Sec. 1.1275-6 hedge, the taxpayer pays or receives one or more
payments that are substantially contemporaneous with the issue date of
the synthetic debt instrument, the payments reduce or increase the issue
price as appropriate.
(5) Adjusted issue price. In general, the adjusted issue price of
the synthetic debt instrument is determined under the principles of
Sec. 1.1275-1(b).
(6) Qualified stated interest. No amounts payable on the synthetic
debt instrument are qualified stated interest within the meaning of
Sec. 1.1273-1(c).
(7) Stated redemption price at maturity--(i) Synthetic debt
instruments that are borrowings. In general, if the synthetic debt
instrument is a borrowing, the instrument's stated redemption price at
maturity is the sum of all amounts paid or to be paid on the qualifying
debt instrument and the Sec. 1.1275-6 hedge, reduced by any amounts
received or to be received on the Sec. 1.1275-6 hedge.
(ii) Synthetic debt instruments that are held by the taxpayer. In
general, if the synthetic debt instrument is held by the taxpayer, the
instrument's stated redemption price at maturity is the sum of all
amounts received or to be received by the taxpayer on the qualifying
debt instrument and the Sec. 1.1275-6 hedge, reduced by any amounts
paid or to be paid by the taxpayer on the Sec. 1.1275-6 hedge.
(iii) Certain amounts ignored. For purposes of this paragraph
(f)(7), if an amount paid or received on the Sec. 1.1275-6 hedge is
taken into account under paragraph (f)(4) of this section to determine
the issue price of the synthetic debt instrument, the amount is not
taken into account to determine the synthetic debt instrument's stated
redemption price at maturity.
(8) Source of interest income and allocation of expense. The source
of interest income from the synthetic debt instrument is determined by
reference to the source of income of the qualifying debt instrument
under sections 861(a)(1) and 862(a)(1). For purposes of section 904, the
character of interest from the synthetic debt instrument is determined
by reference to the character of the interest income from the qualifying
debt instrument. Interest expense is allocated and apportioned under
regulations under section 861 or under Sec. 1.882-5.
(9) Effectively connected income. If the requirements of paragraph
(c)(1)(iv) of this section are satisfied, any interest income resulting
from the synthetic debt instrument entered into by the foreign person is
treated as effectively connected with a U.S. trade or business, and any
interest expense resulting from the synthetic debt instrument entered
into by the foreign person is allocated and apportioned under Sec.
1.882-5.
[[Page 614]]
(10) Not a short-term obligation. For purposes of section
1272(a)(2)(C), a synthetic debt instrument is not treated as a short-
term obligation.
(11) Special rules in the event of integration by the Commissioner.
If the Commissioner requires integration, appropriate adjustments are
made to the treatment of the synthetic debt instrument, and, if
necessary, the qualifying debt instrument and financial instrument. For
example, the Commissioner may treat a financial instrument that is not a
Sec. 1.1275-6 hedge as a Sec. 1.1275-6 hedge when applying the rules
of this section. The issue date of the synthetic debt instrument is the
date determined appropriate by the Commissioner to require integration.
(12) Retention of separate transaction rules for certain purposes.
This paragraph (f)(12) provides for the retention of separate
transaction rules for certain purposes. In addition, by publication in
the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this
chapter), the Commissioner may require use of separate transaction rules
for any aspect of an integrated transaction.
(i) Foreign persons that enter into integrated transactions giving
rise to U.S. source income not effectively connected with a U.S. trade
or business. If a foreign person enters into an integrated transaction
that gives rise to U.S. source interest income (determined under the
source rules for the synthetic debt instrument) not effectively
connected with a U.S. trade or business of the foreign person, paragraph
(f) of this section does not apply for purposes of sections 871(a), 881,
1441, 1442, and 6049. These sections of the Internal Revenue Code are
applied to the qualifying debt instrument and the Sec. 1.1275-6 hedge
on a separate basis.
(ii) Relationship between taxpayer and other persons. Because the
rules of this section affect only the taxpayer that enters into an
integrated transaction (i.e., either the issuer or a particular holder
of a qualifying debt instrument), any provisions of the Internal Revenue
Code or regulations that govern the relationship between the taxpayer
and any other person are applied on a separate basis. For example,
taxpayers must comply with any reporting or disclosure requirements on
any qualifying debt instrument as if it were not part of an integrated
transaction. Thus, if required under Sec. 1.1275-4(b)(4), an issuer of
a contingent payment debt instrument subject to integrated treatment
must provide the projected payment schedule to holders. Similarly, if a
U.S. corporation enters into an integrated transaction that includes a
notional principal contract, the source of any payment received by the
counterparty on the notional principal contract is determined under
Sec. 1.863-7 as if the contract were not part of an integrated
transaction, and, if received by a foreign person who is not engaged in
a U.S. trade or business, the payment is non-U.S. source income that is
not subject to U.S. withholding tax.
(13) Coordination with consolidated return rules. If a taxpayer
enters into a Sec. 1.1275-6 hedge with a member of the same
consolidated group (the counterparty) and the Sec. 1.1275-6 hedge is
part of an integrated transaction for the taxpayer, the Sec. 1.1275-6
hedge is not treated as an intercompany transaction for purposes of
Sec. 1.1502-13. If the taxpayer legs out of integrated treatment, the
taxpayer and the counterparty are each treated as disposing of its
position in the Sec. 1.1275-6 hedge under the principles of paragraph
(d)(2) of this section. If the Sec. 1.1275-6 hedge remains in existence
after the leg-out date, the Sec. 1.1275-6 hedge is treated under the
rules that would otherwise apply to the transaction (including Sec.
1.1502-13 if the transaction is between members).
(g) Predecessors and successors. For purposes of this section, any
reference to a taxpayer, holder, issuer, or person includes, where
appropriate, a reference to a predecessor or successor. For purposes of
the preceding sentence, a predecessor is a transferor of an asset or
liability (including an integrated transaction) to a transferee (the
successor) in a nonrecognition transaction. Appropriate adjustments, if
necessary, are made in the application of this section to predecessors
and successors.
(h) Examples. The following examples illustrate the provisions of
this section. In each example, assume that the
[[Page 615]]
qualifying debt instrument is a debt instrument for Federal income tax
purposes. No inference is intended, however, as to whether the debt
instrument is a debt instrument for Federal income tax purposes.
Example 1. Issuer hedge. (i) Facts. On January 1, 1997, V, a
domestic corporation, issues a 5-year debt instrument for $1,000. The
debt instrument provides for annual payments of interest at a rate equal
to the value of 1-year LIBOR and a principal payment of $1,000 at
maturity. On the same day, V enters into a 5-year interest rate swap
agreement with an unrelated party. Under the swap, V pays 6 percent and
receives 1-year LIBOR on a notional principal amount of $1,000. The
payments on the swap are fixed and made on the same days as the payments
on the debt instrument. On January 1, 1997, V identifies the debt
instrument and the swap as an integrated transaction in accordance with
the requirements of paragraph (e) of this section.
(ii) Eligibility for integration. The debt instrument is a
qualifying debt instrument. The swap is a Sec. 1.1275-6 hedge because
it is a financial instrument and a yield to maturity on the combined
cash flows of the swap and the debt instrument can be calculated. V has
met the identification requirements, and the other requirements of
paragraph (c)(1) of this section are satisfied. Therefore, the
transaction is an integrated transaction under this section.
(iii) Treatment of the synthetic debt instrument. The synthetic debt
instrument is a 5-year debt instrument that has an issue price of $1,000
and provides for annual interest payments of $60 and a principal payment
of $1,000 at maturity. Under paragraph (f)(6) of this section, no
amounts payable on the synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(i) of this section, the synthetic
debt instrument has a stated redemption price at maturity of $1,300 (the
sum of all amounts to be paid on the qualifying debt instrument and the
swap, reduced by amounts to be received on the swap). The synthetic debt
instrument, therefore, has $300 of OID.
Example 2. Issuer hedge with an option. (i) Facts. On December 31,
1996, W, a domestic corporation, issues for $1,000 a debt instrument
that matures on December 31, 1999. The debt instrument has a stated
principal amount of $1,000 payable at maturity. The debt instrument also
provides for a payment at maturity equal to $10 times the increase, if
any, in the value of a nationally known composite index of stocks from
December 31, 1996, to the maturity date. On December 31, 1996, W
purchases from an unrelated party an option that pays $10 times the
increase, if any, in the stock index from December 31, 1996, to December
31, 1999. W pays $250 for the option. On December 31, 1996, W identifies
the debt instrument and option as an integrated transaction in
accordance with the requirements of paragraph (e) of this section.
(ii) Eligibility for integration. The debt instrument is a
qualifying debt instrument. The option is a Sec. 1.1275-6 hedge because
it is a financial instrument and a yield to maturity on the combined
cash flows of the option and the debt instrument can be calculated. W
has met the identification requirements, and the other requirements of
paragraph (c)(1) of this section are satisfied. Therefore, the
transaction is an integrated transaction under this section.
(iii) Treatment of the synthetic debt instrument. Under paragraph
(f)(4) of this section, the issue price of the synthetic debt instrument
is equal to the issue price of the debt instrument ($1,000) reduced by
the payment for the option ($250). As a result, the synthetic debt
instrument is a 3-year debt instrument with an issue price of $750.
Under paragraph (f)(7) of this section, the synthetic debt instrument
has a stated redemption price at maturity of $1,000 (the $250 payment
for the option is not taken into account). The synthetic debt
instrument, therefore, has $250 of OID.
Example 3. Hedge with prepaid swap. (i) Facts. On January 1, 1997, H
purchases for [pound]1,000 a 5-year debt instrument that provides for
semiannual payments based on 6-month pound LIBOR and a payment of the
[pound]1,000 principal at maturity. On the same day, H enters into a
swap with an unrelated third party under which H receives semiannual
payments, in pounds, of 10 percent, compounded semiannually, and makes
semiannual payments, in pounds, of 6-month pound LIBOR on a notional
principal amount of [pound]1,000. Payments on the swap are fixed and
made on the same dates as the payments on the debt instrument. H also
makes a [pound]162 prepayment on the swap. On January 1, 1997, H
identifies the swap and the debt instrument as an integrated transaction
in accordance with the requirements of paragraph (e) of this section.
(ii) Eligibility for integration. The debt instrument is a
qualifying debt instrument. The swap is a Sec. 1.1275-6 hedge because
it is a financial instrument and a yield to maturity on the combined
cash flows of the swap and the debt instrument can be calculated.
Although the debt instrument is denominated in pounds, the swap hedges
only interest rate risk, not currency risk. Therefore, the transaction
is an integrated transaction under this section. See Sec. 1.988-5(a)
for the treatment of a debt instrument and a swap if the swap hedges
currency risk.
(iii) Treatment of the synthetic debt instrument. Under paragraph
(f)(4) of this section, the issue price of the synthetic debt instrument
is equal to the issue price of the debt
[[Page 616]]
instrument ([pound]1,000) increased by the prepayment on the swap
([pound]162). As a result, the synthetic debt instrument is a 5-year
debt instrument that has an issue price of [pound]1,162 and provides for
semiannual interest payments of [pound]50 and a principal payment of
[pound]1,000 at maturity. Under paragraph (f)(6) of this section, no
amounts payable on the synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(ii) of this section, the
synthetic debt instrument's stated redemption price at maturity is
[pound]1,500 (the sum of all amounts to be received on the qualifying
debt instrument and the Sec. 1.1275-6 hedge, reduced by all amounts to
be paid on the Sec. 1.1275-6 hedge other than the [pound]162 prepayment
for the swap). The synthetic debt instrument, therefore, has [pound]338
of OID.
Example 4. Legging into an integrated transaction by a holder. (i)
Facts. On December 31, 1996, X corporation purchases for $1,000,000 a
debt instrument that matures on December 31, 2006. The debt instrument
provides for annual payments of interest at the rate of 6 percent and
for a payment at maturity equal to $1,000,000, increased by the excess,
if any, of the price of 1,000 units of a commodity on December 31, 2006,
over $350,000, and decreased by the excess, if any, of $350,000 over the
price of 1,000 units of the commodity on that date. The projected amount
of the payment at maturity determined under Sec. 1.1275-4(b)(4) is
$1,020,000. On December 31, 1999, X enters into a cash-settled forward
contract with an unrelated party to sell 1,000 units of the commodity on
December 31, 2006, for $450,000. On December 31, 1999, X also identifies
the debt instrument and the forward contract as an integrated
transaction in accordance with the requirements of paragraph (e) of this
section.
(ii) Eligibility for integration. X meets the requirements for
integration as of December 31, 1999. Therefore, X legged into an
integrated transaction on that date. Prior to that date, X treats the
debt instrument under the applicable rules of Sec. 1.1275-4.
(iii) Treatment of the synthetic debt instrument. As of December 31,
1999, the debt instrument and the forward contract are treated as an
integrated transaction. The issue price of the synthetic debt instrument
is equal to the adjusted issue price of the qualifying debt instrument
on the leg-in date, $1,004,804 (assuming one year accrual periods). The
term of the synthetic debt instrument is from December 31, 1999, to
December 31, 2006. The synthetic debt instrument provides for annual
interest payments of $60,000 and a principal payment at maturity of
$1,100,000 ($1,000,000 + $450,000 - $350,000). Under paragraph (f)(6) of
this section, no amounts payable on the synthetic debt instrument are
qualified stated interest. Thus, under paragraph (f)(7)(ii) of this
section, the synthetic debt instrument's stated redemption price at
maturity is $1,520,000 (the sum of all amounts to be received by X on
the qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by
all amounts to be paid by X on the Sec. 1.1275-6 hedge). The synthetic
debt instrument, therefore, has $515,196 of OID.
Example 5. Abusive leg-in. (i) Facts. On January 1, 1997, Y
corporation purchases for $1,000,000 a debt instrument that matures on
December 31, 2001. The debt instrument provides for annual payments of
interest at the rate of 6 percent, a payment on December 31, 1999, of
the increase, if any, in the price of a commodity from January 1, 1997,
to December 31, 1999, and a payment at maturity of $1,000,000 and the
increase, if any, in the price of the commodity from December 31, 1999
to maturity. Because the debt instrument is a contingent payment debt
instrument subject to Sec. 1.1275-4, Y accrues interest based on the
projected payment schedule.
(ii) Leg-in. By late 1999, the price of the commodity has
substantially increased, and Y expects a positive adjustment on December
31, 1999. In late 1999, Y enters into an agreement to exchange the two
commodity based payments on the debt instrument for two payments on the
same dates of $100,000 each. Y identifies the transaction as an
integrated transaction in accordance with the requirements of paragraph
(e) of this section. Y disposes of the hedge in early 2000.
(iii) Treatment. The legging into an integrated transaction has the
effect of deferring the positive adjustment from 1999 to 2000. Because Y
legged into the integrated transaction with a principal purpose to defer
the positive adjustment, the Commissioner may treat the debt instrument
as sold for its fair market value on the leg-in date or refuse to allow
integration.
Example 6. Integration of offsetting debt instruments. (i) Facts. On
January 1, 1997, Z issues two 10-year debt instruments. The first, Issue
1, has an issue price of $1,000, pays interest annually at 6 percent,
and, at maturity, pays $1,000, increased by $1 times the increase, if
any, in the value of the S&P 100 Index over the term of the instrument
and reduced by $1 times the decrease, if any, in the value of the S&P
100 Index over the term of the instrument. However, the amount paid at
maturity may not be less than $500 or more than $1,500. The second,
Issue 2, has an issue price of $1,000, pays interest annually at 8
percent, and, at maturity, pays $1,000, reduced by $1 times the
increase, if any, in the value of the S&P 100 Index over the term of the
instrument and increased by $1 times the decrease, if any, in the value
of the S&P 100 Index over the term of the instrument. The amount paid at
maturity may not be less than $500 or more than $1,500. On January 1,
1997, Z identifies Issue 1 as the qualifying debt instrument, Issue 2 as
a Sec. 1.1275-6 hedge, and otherwise meets the identification
requirements of paragraph (e) of this section.
[[Page 617]]
(ii) Eligibility for integration. Both Issue 1 and Issue 2 are
qualifying debt instruments. Z has met the identification requirements
by identifying Issue 1 as the qualifying debt instrument and Issue 2 as
the Sec. 1.1275-6 hedge. The other requirements of paragraph (c)(1) of
this section are satisfied. Therefore, the transaction is an integrated
transaction under this section.
(iii) Treatment of the synthetic debt instrument. The synthetic debt
instrument has an issue price of $2,000, provides for a payment at
maturity of $2,000, and, in addition, provides for annual payments of
$140. Under paragraph (f)(6) of this section, no amounts payable on the
synthetic debt instrument are qualified stated interest. Thus, under
paragraph (f)(7)(i) of this section, the synthetic debt instrument's
stated redemption price at maturity is $3,400 (the sum of all amounts to
be paid on the qualifying debt instrument and the Sec. 1.1275-6 hedge,
reduced by amounts to be received on the Sec. 1.1275-6 hedge other than
the $1,000 payment received on the issue date). The synthetic debt
instrument, therefore, has $1,400 of OID.
Example 7. Integrated transaction entered into by a foreign person.
(i) Facts. X, a foreign person, enters into an integrated transaction by
purchasing a qualifying debt instrument that pays U.S. source interest
and entering into a notional principal contract with a U.S. corporation.
Neither the income from the qualifying debt instrument nor the income
from the notional principal contract is effectively connected with a
U.S. trade or business. The notional principal contract is a Sec.
1.1275-6 hedge.
(ii) Treatment of integrated transaction. Under paragraph (f)(8) of
this section, X will receive U.S. source income from the integrated
transaction. However, under paragraph (f)(12)(i) of this section, the
qualifying debt instrument and the notional principal contract are
treated as if they are not part of an integrated transaction for
purposes of determining whether tax is due and must be withheld on
income. Accordingly, because the Sec. 1.1275-6 hedge would produce
foreign source income under Sec. 1.863-7 to X if it were not part of an
integrated transaction, any income on the Sec. 1.1275-6 hedge generally
will not be subject to tax under sections 871(a) and 881, and the U.S.
corporation that is the counterparty will not be required to withhold
tax on payments under the Sec. 1.1275-6 hedge under sections 1441 and
1442.
(i) [Reserved]
(j) Effective date. This section applies to a qualifying debt
instrument issued on or after August 13, 1996. This section also applies
to a qualifying debt instrument acquired by the taxpayer on or after
August 13, 1996, if--
(1) The qualifying debt instrument is a fixed rate debt instrument
or a variable rate debt instrument; or
(2) The qualifying debt instrument and the Sec. 1.1275-6 hedge are
acquired by the taxpayer substantially contemporaneously.
[T.D. 8674, 61 FR 30155, June 14, 1996]
Sec. 1.1275-7 Inflation-indexed debt instruments.
(a) Overview. This section provides rules for the Federal income tax
treatment of an inflation-indexed debt instrument. If a debt instrument
is an inflation-indexed debt instrument, one of two methods will apply
to the instrument: the coupon bond method (as described in paragraph (d)
of this section) or the discount bond method (as described in paragraph
(e) of this section). Both methods determine the amount of OID that is
taken into account each year by a holder or an issuer of an inflation-
indexed debt instrument.
(b) Applicability--(1) In general. Except as provided in paragraph
(b)(2) of this section, this section applies to an inflation-indexed
debt instrument as defined in paragraph (c)(1) of this section. For
example, this section applies to Treasury Inflation-Protected Securities
(TIPS).
(2) Exceptions. This section does not apply to an inflation-indexed
debt instrument that is also--
(i) A debt instrument (other than a tax-exempt obligation) described
in section 1272(a)(2) (for example, U.S. savings bonds, certain loans
between natural persons, and short-term taxable obligations); or
(ii) A debt instrument subject to section 529 (certain debt
instruments issued by qualified state tuition programs).
(c) Definitions. The following definitions apply for purposes of
this section:
(1) Inflation-indexed debt instrument. An inflation-indexed debt
instrument is a debt instrument that satisfies the following conditions:
(i) Issued for cash. The debt instrument is issued for U.S. dollars
and all payments on the instrument are denominated in U.S. dollars.
[[Page 618]]
(ii) Indexed for inflation and deflation. Except for a minimum
guarantee payment (as defined in paragraph (c)(5) of this section), each
payment on the debt instrument is indexed for inflation and deflation. A
payment is indexed for inflation and deflation if the amount of the
payment is equal to--
(A) The amount that would be payable if there were no inflation or
deflation over the term of the debt instrument, multiplied by
(B) A ratio, the numerator of which is the value of the reference
index for the date of the payment and the denominator of which is the
value of the reference index for the issue date.
(iii) No other contingencies. No payment on the debt instrument is
subject to a contingency other than the inflation contingency or the
contingencies described in this paragraph (c)(1)(iii). A debt instrument
may provide for--
(A) A minimum guarantee payment as defined in paragraph (c)(5) of
this section; or
(B) Payments under one or more alternate payment schedules if the
payments under each payment schedule are indexed for inflation and
deflation and a payment schedule for the debt instrument can be
determined under Sec. 1.1272-1(c). (For purposes of this section, the
rules of Sec. 1.1272-1(c) are applied to the debt instrument by
assuming that no inflation or deflation will occur over the term of the
instrument.)
(2) Reference index. The reference index is an index used to measure
inflation and deflation over the term of a debt instrument. To qualify
as a reference index, an index must satisfy the following conditions:
(i) The value of the index is reset once a month to a current value
of a single qualified inflation index (as defined in paragraph (c)(3) of
this section). For this purpose, a value of a qualified inflation index
is current if the value has been updated and published within the
preceding six month period.
(ii) The reset occurs on the same day of each month (the reset
date).
(iii) The value of the index for any date between reset dates is
determined through straight-line interpolation.
(3) Qualified inflation index. A qualified inflation index is a
general price or wage index that is updated and published at least
monthly by an agency of the United States Government (for example, the
non-seasonally adjusted U.S. City Average All Items Consumer Price Index
for All Urban Consumers (CPI-U), which is published by the Bureau of
Labor Statistics of the Department of Labor).
(4) Inflation-adjusted principal amount. For any date, the
inflation-adjusted principal amount of an inflation-indexed debt
instrument is an amount equal to--
(i) The outstanding principal amount of the debt instrument
(determined as if there were no inflation or deflation over the term of
the instrument), multiplied by
(ii) A ratio, the numerator of which is the value of the reference
index for the date and the denominator of which is the value of the
reference index for the issue date.
(5) Minimum guarantee payment. In general, a minimum guarantee
payment is an additional payment made at maturity on a debt instrument
if the total amount of inflation-adjusted principal paid on the
instrument is less than the instrument's stated principal amount. The
amount of the additional payment must be no more than the excess, if
any, of the debt instrument's stated principal amount over the total
amount of inflation-adjusted principal paid on the instrument. An
additional payment is not a minimum guarantee payment unless the
qualified inflation index used to determine the reference index is
either the CPI-U or an index designated for this purpose by the
Commissioner in the Federal Register or the Internal Revenue Bulletin
(see Sec. 601.601(d)(2)(ii) of this chapter). See paragraph (f)(4) of
this section for the treatment of a minimum guarantee payment.
(d) Coupon bond method--(1) In general. This paragraph (d) describes
the method (coupon bond method) to be used to account for qualified
stated interest and inflation adjustments (OID) on an inflation-indexed
debt instrument described in paragraph (d)(2) of this section.
(2) Applicability. The coupon bond method applies to an inflation-
indexed
[[Page 619]]
debt instrument that satisfies the following conditions:
(i) Issued at par. The debt instrument is issued at par. A debt
instrument is issued at par if the difference between its issue price
and principal amount for the issue date is less than the de minimis
amount. For this purpose, the de minimis amount is determined using the
principles of Sec. 1.1273-1(d). See paragraph (g)(2) of this section,
however, for the treatment of TIPS issued with more than a de minimis
amount of premium.
(ii) All stated interest is qualified stated interest. All stated
interest on the debt instrument is qualified stated interest. For
purposes of this paragraph (d), stated interest is qualified stated
interest if the interest is unconditionally payable in cash, or is
constructively received under section 451, at least annually at a single
fixed rate. Stated interest is payable at a single fixed rate if the
amount of each interest payment is determined by multiplying the
inflation adjusted principal amount for the payment date by the single
fixed rate.
(3) Qualified stated interest. Under the coupon bond method,
qualified stated interest is taken into account under the taxpayer's
regular method of accounting. The amount of accrued but unpaid qualified
stated interest as of any date is determined by using the principles of
Sec. 1.446-3(e)(2)(ii) (relating to notional principal contracts). For
example, if the interval between interest payment dates spans two
taxable years, a taxpayer using an accrual method of accounting
determines the amount of accrued qualified stated interest for the first
taxable year by reference to the inflation-adjusted principal amount at
the end of the first taxable year.
(4) Inflation adjustments--(i) Current accrual. Under the coupon
bond method, an inflation adjustment is taken into account for each
taxable year in which the debt instrument is outstanding.
(ii) Amount of inflation adjustment. For any relevant period (such
as the taxable year or the portion of the taxable year during which a
taxpayer holds an inflation-indexed debt instrument), the amount of the
inflation adjustment is equal to--
(A) The sum of the inflation-adjusted principal amount at the end of
the period and the principal payments made during the period, minus
(B) The inflation-adjusted principal amount at the beginning of the
period.
(iii) Positive inflation adjustments. A positive inflation
adjustment is OID.
(iv) Negative inflation adjustments. A negative inflation adjustment
is a deflation adjustment that is taken into account under the rules of
paragraph (f)(1) of this section.
(5) Example. The following example illustrates the coupon bond
method:
Example: (i) Facts. On October 15, 1997, X purchases at original
issue, for $100,000, a debt instrument that is indexed for inflation and
deflation. The debt instrument matures on October 15, 1999, has a stated
principal amount of $100,000, and has a stated interest rate of 5
percent, compounded semiannually. The debt instrument provides that the
principal amount is indexed to the CPI-U. Interest is payable on April
15 and October 15 of each year. The amount of each interest payment is
determined by multiplying the inflation-adjusted principal amount for
each interest payment date by the stated interest rate, adjusted for the
length of the accrual period. The debt instrument provides for a single
payment of the inflation-adjusted principal amount at maturity. In
addition, the debt instrument provides for an additional payment at
maturity equal to the excess, if any, of $100,000 over the inflation-
adjusted principal amount at maturity. X uses the cash receipts and
disbursements method of accounting and the calendar year as its taxable
year.
(ii) Indexing methodology. The debt instrument provides that the
inflation-adjusted principal amount for any day is determined by
multiplying the principal amount of the instrument for the issue date by
a ratio, the numerator of which is the value of the reference index for
the day the inflation-adjusted principal amount is to be determined and
the denominator of which is the value of the reference index for the
issue date. The value of the reference index for the first day of a
month is the value of the CPI-U for the third preceding month. The value
of the reference index for any day other than the first day of a month
is determined based on a straight-line interpolation between the value
of the reference index for the first day of the month and the value of
the reference index for the first day of the next month.
(iii) Inflation-indexed debt instrument subject to the coupon bond
method. Under paragraph (c)(1) of this section, the debt instrument is
an inflation-indexed debt instrument. Because there is no difference
between the debt
[[Page 620]]
instrument's issue price ($100,000) and its principal amount for the
issue date ($100,000) and because all stated interest is qualified
stated interest, the coupon bond method applies to the instrument.
(iv) Reference index values. Assume the following table lists the
relevant reference index values for 1997 through 1999:
------------------------------------------------------------------------
Reference index
Date value
------------------------------------------------------------------------
Oct. 15, 1997..................................... 100
Jan. 1, 1998...................................... 101
Apr. 15, 1998..................................... 103
Oct. 15, 1998..................................... 105
Jan. 1, 1999...................................... 99
------------------------------------------------------------------------
(v) Treatment of X in 1997. X does not receive any payments of
interest on the debt instrument in 1997. Therefore, X has no qualified
stated interest income for 1997. X, however, must take into account the
inflation adjustment for 1997. The inflation-adjusted principal amount
for January 1, 1998, is $101,000 ($100,000 x 101/100). Therefore, the
inflation adjustment for 1997 is $1,000, the inflation-adjusted
principal amount for January 1, 1998 ($101,000) minus the principal
amount for the issue date ($100,000). X includes the $1,000 inflation
adjustment in income as OID in 1997.
(vi) Treatment of X in 1998. In 1998, X receives two payments of
interest: On April 15, 1998, X receives a payment of $2,575 ($100,000 x
103/100 x .05/2), and on October 15, 1998, X receives a payment of
$2,625 ($100,000 x 105/100 x .05/2). Therefore, X's qualified stated
interest income for 1998 is $5,200 ($2,575 + $2,625). X also must take
into account the inflation adjustment for 1998. The inflation-adjusted
principal amount for January 1, 1999, is $99,000 ($100,000 x 99/100).
Therefore, the inflation adjustment for 1998 is negative $2,000, the
inflation-adjusted principal amount for January 1, 1999 ($99,000) minus
the inflation-adjusted principal amount for January 1, 1998 ($101,000).
Because the amount of the inflation adjustment is negative, it is a
deflation adjustment. Under paragraph (f)(1)(i) of this section, X uses
this $2,000 deflation adjustment to reduce the interest otherwise
includible in income by X with respect to the debt instrument in 1998.
Therefore, X includes $3,200 in income for 1998, the qualified stated
interest income for 1998 ($5,200) minus the deflation adjustment
($2,000).
(e) Discount bond method--(1) In general. This paragraph (e)
describes the method (discount bond method) to be used to account for
OID on an inflation-indexed debt instrument that does not qualify for
the coupon bond method.
(2) No qualified stated interest. Under the discount bond method, no
interest on an inflation-indexed debt instrument is qualified stated
interest.
(3) OID. Under the discount bond method, the amount of OID that
accrues on an inflation-indexed debt instrument is determined as
follows:
(i) Step one: Determine the debt instrument's yield to maturity. The
yield of the debt instrument is determined under the rules of Sec.
1.1272-1(b)(1)(i). In calculating the yield under those rules for
purposes of this paragraph (e)(3)(i), the payment schedule of the debt
instrument is determined as if there were no inflation or deflation over
the term of the instrument.
(ii) Step two: Determine the accrual periods. The accrual periods
are determined under the rules of Sec. 1.1272-1(b)(1)(ii). However, no
accrual period can be longer than 1 month.
(iii) Step three: Determine the percentage change in the reference
index during the accrual period. The percentage change in the reference
index during the accrual period is equal to--
(A) The ratio of the value of the reference index at the end of the
period to the value of the reference index at the beginning of the
period,
(B) Minus one.
(iv) Step four: Determine the OID allocable to each accrual period.
The OID allocable to an accrual period (n) is determined by using the
following formula:
OID((n) = AIP(n) x [r + inf(n) + (r x
inf(n))]
in which,
r = yield of the debt instrument as determined under paragraph (e)(3)(i)
of this section (adjusted for the length of the accrual period);
inf(n) = percentage change in the value of the reference
index for period (n) as determined under paragraph (e)(3)(iii) of this
section; and
AIP(n) = adjusted issue price at the beginning of period (n).
(v) Step five: Determine the daily portions of OID. The daily
portions of OID are determined and taken into account under the rules of
Sec. 1.1272-1(b)(1)(iv). If the daily portions determined under this
paragraph (e)(3)(v) are negative
[[Page 621]]
amounts, however, these amounts (deflation adjustments) are taken into
account under the rules for deflation adjustments described in paragraph
(f)(1) of this section.
(4) Example. The following example illustrates the discount bond
method:
Example: (i) Facts. On November 15, 1997, X purchases at original
issue, for $91,403, a zero-coupon debt instrument that is indexed for
inflation and deflation. The principal amount of the debt instrument for
the issue date is $100,000. The debt instrument provides for a single
payment on November 15, 2000. The amount of the payment will be
determined by multiplying $100,000 by a fraction, the numerator of which
is the CPI-U for September 2000, and the denominator of which is the
CPI-U for September 1997. The debt instrument also provides that in no
event will the payment on November 15, 2000, be less than $100,000. X
uses the cash receipts and disbursements method of accounting and the
calendar year as its taxable year.
(ii) Inflation-indexed debt instrument. Under paragraph (c)(1) of
this section, the instrument is an inflation-indexed debt instrument.
The debt instrument's principal amount for the issue date ($100,000)
exceeds its issue price ($91,403) by $8,597, which is more than the de
minimis amount for the debt instrument ($750). Therefore, the coupon
bond method does not apply to the debt instrument. As a result, the
discount bond method applies to the debt instrument.
(iii) Yield and accrual period. Assume X chooses monthly accrual
periods ending on the 15th day of each month. The yield of the debt
instrument is determined as if there were no inflation or deflation over
the term of the instrument. Therefore, based on the issue price of
$91,403 and an assumed payment at maturity of $100,000, the yield of the
debt instrument is 3 percent, compounded monthly.
(iv) Percentage change in reference index. Assume that the CPI-U for
September 1997 is 160; for October 1997 is 161.2; and for November 1997
is 161.7. The value of the reference index for November 15, 1997, is
160, the value of the CPI-U for September 1997. Similarly, the value of
the reference index for December 15, 1997, is 161.2, and for January 15,
1998, is 161.7. The percentage change in the reference index from
November 15, 1997, to December 15, 1997, (inf1) is 0.0075
(161.2/160-1); the percentage change in the reference index from
December 15, 1997, to January 15, 1998, (inf2) is 0.0031
(161.7/161.2-1).
(v) Treatment of X in 1997. For the accrual period ending on
December 15, 1997, r is .0025 (.03/12), inf1 is .0075, and
the product of r and inf1 is .00001875. Under paragraph
(e)(3) of this section, the amount of OID allocable to the accrual
period ending on December 15, 1997, is $916. This amount is determined
by multiplying the issue price of the debt instrument ($91,403) by
.01001875 (the sum of r, inf1, and the product of r and
inf1). The adjusted issue price of the debt instrument on
December 15, 1997, is $92,319 ($91,403 + $916). For the accrual period
ending on January 15, 1998, r is .0025 (.03/12), inf2 is
.0031, and the product of r and inf2 is .00000775. Under
paragraph (e)(3) of this section, the amount of OID allocable to the
accrual period ending on January 15, 1998, is $518. This amount is
determined by multiplying the adjusted issue price of the debt
instrument ($92,319) by .00560775 (the sum of r, inf2, and
the product of r and inf2). Because the accrual period ending
on January 15, 1998, spans two taxable years, only $259 of this amount
($518/30 days x 15 days) is allocable to 1997. Therefore, X includes
$1,175 of OID in income for 1997 ($916 + $259).
(f) Special rules. The following rules apply to an inflation-indexed
debt instrument:
(1) Deflation adjustments--(i) Holder. A deflation adjustment
reduces the amount of interest otherwise includible in income by a
holder with respect to the debt instrument for the taxable year. For
purposes of this paragraph (f)(1)(i), interest includes OID, qualified
stated interest, and market discount. If the amount of the deflation
adjustment exceeds the interest otherwise includible in income by the
holder with respect to the debt instrument for the taxable year, the
excess is treated as an ordinary loss by the holder for the taxable
year. However, the amount treated as an ordinary loss is limited to the
amount by which the holder's total interest inclusions on the debt
instrument in prior taxable years exceed the total amount treated by the
holder as an ordinary loss on the debt instrument in prior taxable
years. If the deflation adjustment exceeds the interest otherwise
includible in income by the holder with respect to the debt instrument
for the taxable year and the amount treated as an ordinary loss for the
taxable year, this excess is carried forward to reduce the amount of
interest otherwise includible in income by the holder with respect to
the debt instrument for subsequent taxable years.
(ii) Issuer. A deflation adjustment reduces the interest otherwise
deductible by the issuer with respect to the debt instrument for the
taxable year. For
[[Page 622]]
purposes of this paragraph (f)(1)(ii), interest includes OID and
qualified stated interest. If the amount of the deflation adjustment
exceeds the interest otherwise deductible by the issuer with respect to
the debt instrument for the taxable year, the excess is treated as
ordinary income by the issuer for the taxable year. However, the amount
treated as ordinary income is limited to the amount by which the
issuer's total interest deductions on the debt instrument in prior
taxable years exceed the total amount treated by the issuer as ordinary
income on the debt instrument in prior taxable years. If the deflation
adjustment exceeds the interest otherwise deductible by the issuer with
respect to the debt instrument for the taxable year and the amount
treated as ordinary income for the taxable year, this excess is carried
forward to reduce the interest otherwise deductible by the issuer with
respect to the debt instrument for subsequent taxable years. If there is
any excess remaining upon the retirement of the debt instrument, the
issuer takes the excess amount into account as ordinary income.
(2) Adjusted basis. A holder's adjusted basis in an inflation-
indexed debt instrument is determined under Sec. 1.1272-1(g). However,
a holder's adjusted basis in the debt instrument is decreased by the
amount of any deflation adjustment the holder takes into account to
reduce the amount of interest otherwise includible in income or treats
as an ordinary loss with respect to the instrument during the taxable
year. The decrease occurs when the deflation adjustment is taken into
account under paragraph (f)(1) of this section.
(3) Subsequent holders. A holder determines the amount of
acquisition premium or market discount on an inflation-indexed debt
instrument by reference to the adjusted issue price of the instrument on
the date the holder acquires the instrument. A holder determines the
amount of bond premium on an inflation-indexed debt instrument by
assuming that the amount payable at maturity on the instrument is equal
to the instrument's inflation-adjusted principal amount for the day the
holder acquires the instrument. Any premium or market discount is taken
into account over the remaining term of the debt instrument as if there
were no further inflation or deflation. See section 171 for additional
rules relating to the amortization of bond premium and sections 1276
through 1278 for additional rules relating to market discount.
(4) Minimum guarantee. Under both the coupon bond method and the
discount bond method, a minimum guarantee payment is ignored until the
payment is made. If there is a minimum guarantee payment, the payment is
treated as interest on the date it is paid.
(5) Temporary unavailability of a qualified inflation index.
Notwithstanding any other rule of this section, an inflation-indexed
debt instrument may provide for a substitute value of the qualified
inflation index if and when the publication of the value of the
qualified inflation index is temporarily delayed. The substitute value
may be determined by the issuer under any reasonable method. For
example, if the CPI-U is not reported for a particular month, the debt
instrument may provide that a substitute value may be determined by
increasing the last reported value by the average monthly percentage
increase in the qualified inflation index over the preceding twelve
months. The use of a substitute value does not result in a reissuance of
the debt instrument.
(g) TIPS--(1) Reopenings. For rules concerning a reopening of TIPS,
see paragraphs (d)(2), (k)(3)(iii), and (k)(3)(v) of Sec. 1.1275-2.
(2) TIPS issued with more than a de minimis amount of premium--(i)
Coupon bond method. Notwithstanding paragraph (d)(2)(i) of this section,
the coupon bond method described in paragraph (d) of this section
applies to TIPS issued with more than a de minimis amount of premium.
For this purpose, the de minimis amount is determined using the
principles of Sec. 1.1273-1(d).
(ii) Example. The following example illustrates the application of
the bond premium rules to a TIPS issued with bond premium:
Example. (i) Facts. X, a calendar year taxpayer, purchases at
original issuance TIPS with a stated principal amount of $100,000
[[Page 623]]
and a stated interest rate of .125 percent, compounded semiannually. For
purposes of this example, assume that the TIPS are issued in Year 1 on
January 1, stated interest is payable on June 30 and December 31 of each
year, and that the TIPS mature on December 31, Year 5. X pays $102,000
for the TIPS, which is the issue price for the TIPS as determined under
Sec. 1.1275-2(d)(1). Assume that the inflation-adjusted principal
amount for the first coupon in Year 1 is $101,225 (resulting in an
interest payment of $63.27) and for the second coupon in Year 1 is
$102,500 (resulting in an interest payment of $64.06). X elects to
amortize bond premium under Sec. 1.171-4. (For simplicity, contrary to
actual practice, the TIPS in this example were issued on the date with
respect to which the calculation of the first coupon began.)
(ii) Bond premium. The stated interest on the TIPS is qualified
stated interest under Sec. 1.1273-1(c). X acquired the TIPS with bond
premium of $2,000 (basis of $102,000 minus the TIPS' stated principal
amount of $100,000). See Sec. Sec. 1.171-1(d), 1.171-3(b), and
paragraph (f)(3) of this section. The $2,000 is more than the de minimis
amount of premium for the TIPS of $1,250 (.0025 times the stated
principal amount of the TIPS ($100,000) times the number of complete
years to the TIPS' maturity (5 years)). Under paragraph (g)(2)(i) of
this section, X must use the coupon bond method to determine X's income
from the TIPS.
(iii) Allocation of bond premium. Under Sec. 1.171-3(b), the bond
premium of $2,000 is allocable to each semiannual accrual period by
assuming that there will be no inflation or deflation over the term of
the TIPS. Moreover, for purposes of Sec. 1.171-2, the yield of the
securities is determined by assuming that there will be no inflation or
deflation over their term. Based on this assumption, for purposes of
section 171, the TIPS provide for semiannual interest payments of $62.50
and a $100,000 payment at maturity. As a result, the yield of the
securities for purposes of section 171 is -0.2720 percent, compounded
semiannually. Under Sec. 1.171-2, the bond premium allocable to an
accrual period is the excess of the qualified stated interest allocable
to the accrual period ($62.50 for each accrual period) over the product
of the taxpayer's adjusted acquisition price at the beginning of the
accrual period (determined without regard to any inflation or deflation)
and the taxpayer's yield. Therefore, the $2,000 of bond premium is
allocable to each semiannual accrual period in Year 1 as follows:
$201.22 to the accrual period ending on June 30, Year 1 (the excess of
the stated interest of $62.50 over ($102,000 x -0.002720/2)); and
$200.95 to the accrual period ending on December 31, Year 1 (the excess
of the stated interest of $62.50 over ($101,798.78 x -0. 002720/2)). The
adjusted acquisition price at the beginning of the accrual period ending
on December 31, Year 1 is $101,798.78 (the adjusted acquisition price of
$102,000 at the beginning of the accrual period ending on June 30, Year
1 reduced by the $201.22 of premium allocable to that accrual period).
(iv) Income determined by applying the coupon bond method and the
bond premium rules. Under paragraph (d)(4) of this section, the
application of the coupon bond method to the TIPS results in a positive
inflation adjustment in Year 1 of $2,500, which is includible in X's
income for Year 1. However, because X acquired the TIPS at a premium and
elected to amortize the premium, the premium allocable to Year 1 will
offset the income on the TIPS as follows: The premium allocable to the
first accrual period of $201.22 first offsets the interest payable for
that period of $63.27. The remaining $137.95 of premium is treated as a
deflation adjustment that offsets the positive inflation adjustment. See
Sec. 1.171-3(b). The premium allocable to the second accrual period of
$200.95 first offsets the interest payable for that period of $64.06.
The remaining $136.89 of premium is treated as a deflation adjustment
that further offsets the positive inflation adjustment. As a result, X
does not include in income any of the stated interest received in Year 1
and includes in Year 1 income only $2,225.16 of the positive inflation
adjustment for Year 1 ($2,500 - $137.94 - $136.89).
(h) Effective/applicability dates--(1) In general. This section
applies to an inflation-indexed debt instrument issued on or after
January 6, 1997.
(2) TIPS issued with more than a de minimis amount of premium.
Notwithstanding paragraph (h)(1) of this section, paragraph (g)(2) of
this section applies to TIPS issued with more than a de minimis amount
of premium on or after April 8, 2011.
[T.D. 8709, 62 FR 618, Jan. 6, 1997. Redesignated by T.D. 8838, 64 FR
48547, Sept. 7, 1999, as amended by T.D. 8840, 64 FR 60343, Nov. 5,
1999; T.D. 8934, 66 FR 2817, Jan. 12, 2001; T.D. 9609, 78 FR 668, Jan.
4, 2013]
Sec. 1.1286-1 Tax treatment of certain stripped bonds and stripped
coupons.
(a) De minimis OID. If the original issue discount determined under
section 1286(a) with respect to the purchase of a stripped bond or
stripped coupon is less than the amount computed under subparagraphs (A)
and (B) of section 1273(a)(3) and the regulations thereunder, then the
amount of original issue discount with respect to that purchase (other
than any tax-exempt
[[Page 624]]
portion thereof, determined under section 1286(d)(2)) shall be
considered to be zero. For purposes of this computation, the number of
complete years to maturity is measured from the date the stripped bond
or stripped coupon is purchased.
(b) Treatment of certain stripped bonds as market discount bonds--
(1) In general. By publication in the Internal Revenue Bulletin (see
Sec. 601.601(d)(2)(ii)(b) of the Statement of Procedural Rules), the
Internal Revenue Service may (subject to the limitation of paragraph
(b)(2) of this section) provide that certain mortgage loans that are
stripped bonds are to be treated as market discount bonds under section
1278. Thus, any purchaser of such a bond is to account for any discount
on the bond as market discount rather than original issue discount.
(2) Limitation. This treatment may be provided for a stripped bond
only if, immediately after the most recent disposition referred to in
section 1286(b)--
(i) The amount of original issue discount with respect to the
stripped bond is determined under paragraph (a) of this section
(concerning de minimis OID); or
(ii) The annual stated rate of interest payable on the stripped bond
is no more than 100 basis points lower than the annual stated rate of
interest payable on the original bond from which it and any other
stripped bond or bonds and any stripped coupon or coupons were stripped.
(c) Effective date. This section is effective on and after August 8,
1991.
[T.D. 8463, 57 FR 61812, Dec. 29, 1992]
Sec. 1.1286-2 Stripped inflation-protected debt instruments.
Stripped inflation-protected debt instruments. If a Treasury
Inflation-Protected Security is stripped under the Department of the
Treasury's Separate Trading of Registered Interest and Principal of
Securities (STRIPS) program, the holders of the principal and coupon
components must use the discount bond method (as described in Sec.
1.1275-7(e)) to account for the original issue discount on the
components.
[T.D. 8709, 62 FR 621, Jan. 6, 1997. Redesignated by T.D. 8838, 64 FR
48547, Sept. 7, 1999; T.D. 9609, 78 FR 668, Jan. 4, 2013]
Sec. 1.1287-1 Denial of capital gains treatment for gains on
registration-required obligations not in registered form.
(a) In general. Except as provided in paragraph (c) of this section,
any gain on the sale or other disposition of a registration-required
obligation held after December 31, 1982, that is not in registered form
shall be treated as ordinary income unless the issuance of the
obligation was subject to tax under section 4701. The term registration-
required obligation has the meaning given to that term in section
163(f)(2), except that clause (iv) of subparagraph (A) thereof shall not
apply. Therefore, although an obligation that is not in registered form
is described in Sec. 1.163-5(c)(1), the holder of such an obligation
shall be required to treat the gain on the sale or other disposition of
such obligation as ordinary income. The term holder means the person
that would be denied a loss deduction under section 165(j)(1) or denied
capital gain treatment under section 1287(a).
(b) Registered form--(1) Obligations issued after September 21,
1984. With respect to any obligation originally issued after September
21, 1984, the term registered form has the meaning given that term in
section 103(j)(3) and the regulations thereunder. Therefore, an
obligation that would otherwise be in registered form is not considered
to be in registered form if it can be transferred at that time or at any
time until its maturity by any means not described in Sec. 5f.103-1(c).
An obligation that, as of a particular time, is not considered to be in
registered form because it can be transferred by any means not described
in Sec. 5f.103-1(c) is considered to be in registered form at all times
during the period beginning with a later time and ending with the
maturity of the obligation in which the obligation can be transferred
only by a means described in Sec. 5f.103-1(c).
(2) Obligations issued after December 31, 1982, and on or before
September 21, 1984. With respect to any obligation originally issued
after December 31, 1982, and on or before September 21, 1984, or an
obligation originally issued after September 21, 1984, pursuant to the
exercise of a warrant or the conversion of
[[Page 625]]
a convertible obligation, which warrant or obligation (including
conversion privilege) was issued after December 31, 1982, and on or
before September 21, 1984, that obligation will be considered to be in
registered form if it satisfied Sec. 5f.163-1 or the proposed
regulations provided in Sec. 1.163.-5(c) and published in the Federal
Register on September 2, 1983 (48 FR 39953).
(c) Registration-required obligations not in registered form which
are not subject to section 1287(c). Notwithstanding the fact than an
obligation is a registration-required obligation that is not in
registered form, the holder will not be subject to section 1287(a) if
the holder meets the conditions of Sec. 1.165-12(c).
(d) Effective date. These regulations apply generally to obligations
issued after January 20, 1987. However, a taxpayer may choose to apply
the rules of Sec. 1.1287-1 with respect to an obligation issued after
December 31, 1982, and on or before January 20, 1987, which obligation
is held after January 20, 1987.
[T.D. 8110, 51 FR 45461, Dec. 19, 1986]
Sec. 1.1288-1 Adjustment of applicable Federal rate for tax-exempt
obligations.
(a) In general. In applying section 483 or section 1274 to a tax-
exempt obligation, the applicable Federal rate is adjusted to take into
account the tax exemption for interest on the obligation. For each
applicable Federal rate determined under section 1274(d), the Secretary
computes a corresponding adjusted applicable Federal rate by multiplying
the applicable Federal rate by the adjustment factor described in
paragraph (b) of this section. The Internal Revenue Service publishes
the applicable Federal rates and the adjusted applicable Federal rates
for each month in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii) of this chapter).
(b) Adjustment factor. The adjustment factor is a percentage equal
to--
(1) The excess of 100 percent, over
(2) The product of--
(i) 59 percent, and
(ii) The sum of the maximum rate in effect under section 1
applicable to individuals and the maximum rate in effect under section
1411 applicable to individuals for the month to which the adjusted
applicable Federal rate applies.
(c) Effective/applicability date. The rules of this section apply to
the determination of adjusted applicable Federal rates beginning with
the rates determined during August 2016 that apply during September
2016.
[T.D. 9763, 81 FR 24484, Apr. 26, 2016]
Sec. 1.1291-0 Treatment of shareholders of certain passive foreign
investment companies; table of contents.
This section contains a listing of the headings for Sec. Sec.
1.1291-1, 1.1291-9, and 1.1291-10.
Sec. 1.1291-1 Taxation of U.S. persons that are shareholders of section
1291 funds.
(a) through (b)(2)(i) [Reserved]
(ii) Pedigreed QEF.
(b)(2)(iii) and (iv) [Reserved]
(v) Section 1291 fund.
(3) through (6) [Reserved]
(7) Shareholder.
(8) Indirect shareholder.
(i) In general.
(ii) Ownership through a corporation.
(A) Ownership through a non-PFIC foreign corporation.
(B) Ownership through a PFIC.
(C) Ownership through a domestic corporation.
(iii) Ownership through pass-through entities.
(A) Partnerships.
(B) S Corporations.
(C) Estates and nongrantor trusts.
(D) Grantor trusts.
(iv) Examples.
(c) Coordination with other PFIC rules.
(1) and (2) [Reserved]
(3) Coordination with section 1296: Distributions and dispositions.
(4) Coordination with mark to market rules under chapter 1 of the
Internal Revenue Code other than section 1296.
(i) In general.
(ii) Coordination rule.
(d) [Reserved]
(e) Exempt organization as shareholder.
(1) In general.
(2) Ownership through certain tax-exempt organizations and accounts.
(f) through (i) [Reserved]
(j) Applicability dates.
Sec. 1.1291-9 Deemed dividend election.
(a) Deemed dividend election.
(1) In general.
(2) Post-1986 earnings and profits defined.
(i) In general.
(ii) Pro rata share of post-1986 earnings and profits attributable
to shareholder's stock.
[[Page 626]]
(A) In general.
(B) Reduction for previously taxed amounts.
(b) Who may make the election.
(c) Time for making the election.
(d) Manner of making the election.
(1) In general.
(2) Attachment to Form 8621.
(e) Qualification date.
(1) In general.
(2) Elections made after March 31, 1995, and before January 27,
1997.
(i) In general.
(ii) Exception.
(3) Examples.
(f) Adjustment to basis.
(g) Treatment of holding period.
(h) Coordination with section 959(e).
(i) Election inapplicable to shareholder of former PFIC.
(1) [Reserved]
(2) Former PFIC.
(j) Definitions.
(1) Passive foreign investment company (PFIC).
(2) Types of PFICs.
(i) Qualified electing fund (QEF).
(ii) Pedigreed QEF.
(iii) Unpedigreed QEF.
(iv) Former PFIC.
(3) Shareholder.
(k) Effective/applicability dates.
Sec. 1.1291-10 Deemed sale election.
(a) Deemed sale election.
(b) Who may make the election.
(c) Time for making the election.
(d) Manner of making the election.
(e) Qualification date.
(1) In general.
(2) Elections made after March 31, 1995, and before January 27,
1997.
(i) In general.
(ii) Exception.
(f) Adjustments to basis.
(1) In general.
(2) Adjustment to basis for section 1293 inclusion with respect to
deemed sale election made after March 31, 1995, and before January 27,
1997.
(g) Treatment of holding period.
(h) Election inapplicable to shareholder of former PFIC.
(i) Effective date.
[T.D. 8701, 61 FR 68151, Dec. 27, 1996, as amended by T.D. 8750, 63 FR
13, Jan. 2, 1998; T.D. 9123, 69 FR 24073, May 3, 2004; T.D. 9806, 81 FR
95465, Dec. 28, 2016]
Sec. 1.1291-1 Taxation of U.S. persons that are shareholders
of section 1291 funds.
(a) through (b)(2)(i) [Reserved]
(ii) Pedigreed QEF. A PFIC is a pedigreed QEF with respect to a
shareholder if the PFIC has been a QEF with respect to the shareholder
for all taxable years during which the corporation was a PFIC that are
included wholly or partly in the shareholder's holding period of the
PFIC stock.
(b)(2)(iii) and (iv) [Reserved]
(v) Section 1291 fund. A PFIC is a section 1291 fund with respect to
a shareholder unless the PFIC is a pedigreed QEF with respect to the
shareholder or a section 1296 election is in effect with respect to the
shareholder.
(3) through (6) [Reserved]
(7) Shareholder. A shareholder is a United States person that
directly owns stock of a PFIC (a direct shareholder), or that is an
indirect shareholder (as defined in section 1298(a) and paragraph (b)(8)
of this section), except as provided in paragraph (e) of this section.
For purposes of sections 1291 and 1298, a domestic partnership or S
corporation (as defined in section 1361(a)(1)) is not treated as a
shareholder of a PFIC except for purposes of any information reporting
requirements, including the requirement to file an annual report under
section 1298(f). In addition, to the extent that a person is treated
under sections 671 through 678 as the owner of a portion of a domestic
trust, the trust is not treated as a shareholder of a PFIC with respect
to PFIC stock held by that portion of the trust, except for purposes of
the information reporting requirements of Sec. 1.1298-1(b)(3)(i)
(imposing an information reporting requirement on domestic liquidating
trusts and fixed investment trusts).
(8) Indirect shareholder--(i) In general. An indirect shareholder of
a PFIC is a United States person that indirectly owns stock of a PFIC. A
person indirectly owns stock when it is treated as owning stock of a
corporation owned by another person, including another United States
person, under this paragraph (b)(8). In applying this paragraph (b)(8),
the determination of a person's indirect ownership is made on the basis
of all the facts and circumstances in each case; the substance rather
than the form of ownership is controlling, taking into account the
purposes of sections 1291 through 1298.
[[Page 627]]
(ii) Ownership through a corporation--(A) Ownership through a non-
PFIC foreign corporation. A person that directly or indirectly owns 50
percent or more in value of the stock of a foreign corporation that is
not a PFIC is considered to own a proportionate amount (by value) of any
stock owned directly or indirectly by the foreign corporation.
(B) Ownership through a PFIC. A person that directly or indirectly
owns stock of a PFIC is considered to own a proportionate amount (by
value) of any stock owned directly or indirectly by the PFIC. Section
1297(d) does not apply in determining whether a corporation is a PFIC
for purposes of this paragraph (b)(8)(ii)(B).
(C) Ownership through a domestic corporation--(1) In general. Solely
for purposes of determining whether a person satisfies the ownership
threshold described in paragraph (b)(8)(ii)(A) of this section, a person
that directly or indirectly owns 50 percent or more in value of the
stock of a domestic corporation is considered to own a proportionate
amount (by value) of any stock owned directly or indirectly by the
domestic corporation.
(2) Non-duplication. Paragraph (b)(8)(ii)(C)(1) of this section does
not apply to treat a United States person as owning (other than for
purposes of applying the ownership threshold in paragraph (b)(8)(ii)(A)
of this section) stock of a PFIC that is directly owned or considered
owned indirectly within the meaning of this paragraph (b)(8) by another
United States person (determined without regard to paragraph
(b)(8)(ii)(C)(1)). See Example 1 of paragraph (b)(8)(iv) of this
section.
(3) S corporations. The 50 percent limitation in paragraph
(b)(8)(ii)(C)(1) of this section does not apply with respect to stock
owned directly or indirectly by an S corporation. See paragraph
(b)(8)(iii)(B) of this section for rules regarding stock owned directly
or indirectly by an S corporation.
(iii) Ownership through pass-through entities--(A) Partnerships. If
a foreign or domestic partnership directly or indirectly owns stock, the
partners of the partnership are considered to own such stock
proportionately in accordance with their ownership interests in the
partnership.
(B) S Corporations. If an S corporation directly or indirectly owns
stock, each S corporation shareholder is considered to own such stock
proportionately in accordance with the shareholder's ownership interest
in the S corporation.
(C) Estates and nongrantor trusts. If a foreign or domestic estate
or nongrantor trust (other than an employees' trust described in section
401(a) that is exempt from tax under section 501(a)) directly or
indirectly owns stock, each beneficiary of the estate or trust is
considered to own a proportionate amount of such stock. For purposes of
this paragraph (b)(8)(iii)(C), a nongrantor trust is any trust or
portion of a trust that is not treated as owned by one or more persons
under sections 671 through 679.
(D) Grantor trusts. If a foreign or domestic trust directly or
indirectly owns stock, a person that is treated under sections 671
through 679 as the owner of any portion of the trust that holds an
interest in the stock is considered to own the interest in the stock
held by that portion of the trust.
(iv) Examples. The rules of this paragraph (b)(8) are illustrated by
the following examples:
Example 1. A is a United States person who owns 49 percent of the
stock of FC1, a foreign corporation that is not a PFIC, and separately
all the stock of DC, a domestic corporation that is not an S
corporation. DC, in turn, owns the remaining 51 percent of the stock of
FC1, and FC1 owns 100 shares of stock in a PFIC that is not a controlled
foreign corporation (CFC) within the meaning of section 957(a). DC is an
indirect shareholder with respect to 51 percent of the PFIC stock held
by FC1 under paragraph (b)(8)(ii)(A) of this section. In determining
whether A owns 50 percent or more of the value of FC1 for purposes of
applying paragraph (b)(8)(ii)(A) of this section, A is considered under
paragraph (b)(8)(ii)(C)(1) of this section as indirectly owning all the
stock of FC1 that DC directly owns. However, because 51 shares of the
PFIC stock held by FC1 are indirectly owned by DC under paragraph
(b)(8)(ii)(A) of this section, pursuant to the limitation imposed by
paragraph (b)(8)(ii)(C)(2) of this section, only the remaining 49 shares
of the PFIC stock are considered as indirectly owned by A under
paragraph (b)(8) of this section.
(c) Coordination with other PFIC rules.
(1)-(2) [Reserved]
[[Page 628]]
(3) Coordination with section 1296: distributions and dispositions.
If PFIC stock is marked to market under section 1296 for any taxable
year, then, except as provided in Sec. 1.1296-1(i), section 1291 and
the regulations thereunder shall not apply to any distribution with
respect to section 1296 stock (as defined in Sec. 1.1296-1(a)(2)), or
to any disposition of such stock, for such taxable year.
(4) Coordination with mark to market rules under chapter 1 of the
Internal Revenue Code other than section 1296--(i) In general. If PFIC
stock is marked to market for any taxable year under section 475 or any
other provision of chapter 1 of the Internal Revenue Code, other than
section 1296, regardless of whether the application of such provision is
mandatory or results from an election by the taxpayer or another person,
then, except as provided in paragraph (c)(4)(ii) of this section,
section 1291 and the regulations thereunder shall not apply to any
distribution with respect to such PFIC stock or to any disposition of
such PFIC stock for such taxable year. See Sec. Sec. 1.1295-1(i)(3) and
1.1296-1(h)(3)(i) for rules regarding the automatic termination of an
existing election under section 1295 or section 1296 when a taxpayer
marks to market PFIC stock under section 475 or any other provision of
chapter 1 of the Internal Revenue Code.
(ii) Coordination rule--(A) Notwithstanding any provision in this
section to the contrary, the rule of paragraph (c)(4)(ii)(B) of this
section shall apply to the first taxable year in which a United States
person marks to market its PFIC stock under a provision of chapter 1 of
the Internal Revenue Code, other than section 1296, if such foreign
corporation was a PFIC for any taxable year, prior to such first taxable
year, during the United States person's holding period (as defined in
section 1291(a)(3)(A) and Sec. 1.1296-1(f)) in such stock, and for
which such corporation was not treated as a QEF with respect to such
United States person.
(B) For the first taxable year of a United States person that marks
to market its PFIC stock under any provision of chapter 1 of the
Internal Revenue Code, other than section 1296, such United States
person shall, in lieu of the rules under which the United States person
marks to market, apply the rules of Sec. 1.1296-1(i)(2) and (3) as if
the United States person had made an election under section 1296 for
such first taxable year.
(d) [Reserved]
(e) Exempt organization as shareholder--(1) In general. If the
shareholder of a PFIC is an organization exempt from tax under this
chapter, section 1291 and these regulations apply to such shareholder
only if a dividend from the PFIC would be taxable to the organization
under subchapter F.
(2) Ownership through certain tax-exempt organizations and accounts.
To the extent a United States person owns stock of a PFIC through an
organization or account described in Sec. 1.1298-1(c)(1), that person
is not treated as a shareholder with respect to the PFIC stock.
(f)-(i) [Reserved]
(j) Applicability dates. (1) Paragraphs (c)(3) and (4) of this
section apply for taxable years beginning on or after May 3, 2004.
(2) Paragraph (e)(1) of this section is applicable on and after
April 1, 1992.
(3) Paragraphs (b)(2)(ii), (b)(2)(v), (b)(7), (b)(8), and (e)(2) of
this section apply to taxable years of shareholders ending on or after
December 31, 2013.
[T.D. 8750, 63 FR 13, Jan. 2, 1998. Redesignated by T.D. 8870, 65 FR
5779, Feb. 7, 2000, as amended by T.D. 9123, 69 FR 24073, May 3, 2004;
T.D. 9806, 81 FR 95465, Dec. 28, 2016]
Sec. 1.1291-9 Deemed dividend election.
(a) Deemed dividend election--(1) In general. This section provides
rules for making the election under section 1291(d)(2)(B) (deemed
dividend election). Under that section, a shareholder (as defined in
paragraph (j)(3) of this section) of a PFIC that is an unpedigreed QEF
may elect to include in income as a dividend the shareholder's pro rata
share of the post-1986 earnings and profits of the PFIC attributable to
the stock held on the qualification date (as defined in paragraph (e) of
this section), provided the PFIC is a controlled foreign corporation
(CFC) within the meaning of section 957(a) for the taxable year for
which the shareholder elects under section 1295 to treat the PFIC as a
QEF (section 1295 election). If the shareholder
[[Page 629]]
makes the deemed dividend election, the PFIC will become a pedigreed QEF
with respect to the shareholder. The deemed dividend is taxed under
section 1291 as an excess distribution received on the qualification
date. The excess distribution determined under this paragraph (a) is
allocated under section 1291(a)(1)(A) only to those days in the
shareholder's holding period during which the foreign corporation
qualified as a PFIC. For purposes of the preceding sentence, the holding
period of the PFIC stock with respect to which the election is made ends
on the day before the qualification date. For the definitions of PFIC,
QEF, unpedigreed QEF, and pedigreed QEF, see paragraph (j) (1) and (2)
of this section.
(2) Post-1986 earnings and profits defined--(i) In general. For
purposes of this section, the term post-1986 earnings and profits means
the undistributed earnings and profits, within the meaning of section
902(c)(1), as of the day before the qualification date, that were
accumulated and not distributed in taxable years of the PFIC beginning
after 1986 and during which it was a PFIC, but without regard to whether
the earnings relate to a period during which the PFIC was a CFC.
(ii) Pro rata share of post-1986 earnings and profits attributable
to shareholder's stock--(A) In general. A shareholder's pro rata share
of the post-1986 earnings and profits of the PFIC attributable to the
stock held by the shareholder on the qualification date is the amount of
post-1986 earnings and profits of the PFIC accumulated during any
portion of the shareholder's holding period ending at the close of the
day before the qualification date and attributable, under the principles
of section 1248 and the regulations under that section, to the PFIC
stock held on the qualification date.
(B) Reduction for previously taxed amounts. A shareholder's pro rata
share of the post-1986 earnings and profits of the PFIC does not include
any amount that the shareholder demonstrates to the satisfaction of the
Commissioner (in the manner provided in paragraph (d)(2) of this
section) was, pursuant to another provision of the law, previously
included in the income of the shareholder, or of another U.S. person if
the shareholder's holding period of the PFIC stock includes the period
during which the stock was held by that other U.S. person.
(b) Who may make the election. A shareholder of an unpedigreed QEF
that is a CFC for the taxable year of the PFIC for which the shareholder
makes the section 1295 election may make the deemed dividend election
provided the shareholder held stock of that PFIC on the qualification
date. A shareholder is treated as holding stock of the PFIC on the
qualification date if its holding period with respect to that stock
under section 1223 includes the qualification date. A shareholder may
make the deemed dividend election without regard to whether the
shareholder is a United States shareholder within the meaning of section
951(b). A deemed dividend election may be made by a shareholder whose
pro rata share of the post-1986 earnings and profits of the PFIC
attributable to the PFIC stock held on the qualification date is zero.
(c) Time for making the election. The shareholder makes the deemed
dividend election in the shareholder's return for the taxable year that
includes the qualification date. If the shareholder and the PFIC have
the same taxable year, the shareholder makes the deemed dividend
election in either the original return for the taxable year for which
the shareholder makes the section 1295 election, or in an amended return
for that year. If the shareholder and the PFIC have different taxable
years, the deemed dividend election must be made in an amended return
for the taxable year that includes the qualification date. If the deemed
dividend election is made in an amended return, the amended return must
be filed by a date that is within three years of the due date, as
extended under section 6081, of the original return for the taxable year
that includes the qualification date.
(d) Manner of making the election--(1) In general. A shareholder
makes the deemed dividend election by filing Form 8621 and the
attachment to Form 8621 described in paragraph (d)(2) of this section
with the return for the taxable year of the shareholder that includes
the qualification date, reporting
[[Page 630]]
the deemed dividend as an excess distribution pursuant to section
1291(a)(1), and paying the tax and interest due on the excess
distribution. A shareholder that makes the deemed dividend election
after the due date of the return (determined without regard to
extensions) for the taxable year that includes the qualification date
must pay additional interest, pursuant to section 6601, on the amount of
the underpayment of tax for that year.
(2) Attachment to Form 8621. The shareholder must attach a schedule
to Form 8621 that demonstrates the calculation of the shareholder's pro
rata share of the post-1986 earnings and profits of the PFIC that is
treated as distributed to the shareholder on the qualification date
pursuant to this section. If the shareholder is claiming an exclusion
from its pro rata share of the post-1986 earnings and profits for an
amount previously included in its income or the income of another U.S.
person, the shareholder must include the following information:
(i) The name, address, and taxpayer identification number of each
U.S. person that previously included an amount in income, the amount
previously included in income by each such U.S. person, the provision of
the law pursuant to which the amount was previously included in income,
and the taxable year or years of inclusion of each amount; and
(ii) A description of the transaction pursuant to which the
shareholder acquired, directly or indirectly, the stock of the PFIC from
another U.S. person, and the provisions of law pursuant to which the
shareholder's holding period includes the period the other U.S. person
held the CFC stock.
(e) Qualification date--(1) In general. Except as otherwise provided
in this paragraph (e), the qualification date is the first day of the
PFIC's first taxable year as a QEF (first QEF year).
(2) Elections made after March 31, 1995, and before January 27,
1997--(i) In general. The qualification date for deemed dividend
elections made after March 31, 1995, and before January 27, 1997, is the
first day of the shareholder's election year. The shareholder's election
year is the taxable year of the shareholder for which it made the
section 1295 election.
(ii) Exception. A shareholder who made the deemed dividend election
after May 1, 1992, and before January 27, 1997, may elect to change its
qualification date to the first day of the first QEF year, provided the
periods of limitations on assessment for the taxable year that includes
that date and for the shareholder's election year have not expired. A
shareholder changes the qualification date by filing amended returns,
with revised Forms 8621 and the attachments described in paragraph
(d)(2) of this section, for the shareholder's election year and the
shareholder's taxable year that includes the first day of the first QEF
year, and making all appropriate adjustments and payments.
(3) Examples. The rules of this paragraph (e) are illustrated by the
following examples:
Example 1. (i) Eligibility to make deemed dividend election. A is a
U.S. person who files its income tax return on a calendar year basis. On
January 2, 1994, A purchased one percent of the stock of M, a PFIC with
a taxable year ending November 30. M was both a CFC and a PFIC, but not
a QEF, for all of its taxable years. On December 3, 1996, M made a
distribution to its shareholders. A received $100, all of which A
reported in its 1996 return as an excess distribution as provided in
section 1291(a)(1). A decides to make the section 1295 election in A's
1997 taxable year to treat M as a QEF effective for M's taxable year
beginning December 1, 1996. Because A did not make the section 1295
election in 1994, the first year in its holding period of M stock that M
qualified as a PFIC, M would be an unpedigreed QEF and A would be
subject to both sections 1291 and 1293. A, however, may elect under
section 1291(d)(2) to purge the years M was not a QEF from A's holding
period. If A makes the section 1291(d)(2) election, the December 3
distribution will not be taxable under section 1291(a). Because M is a
CFC, even though A is not a U.S. shareholder within the meaning of
section 951(b), A may make the deemed dividend election under section
1291(d)(2)(B).
(ii) Making the election. Under paragraph (e)(1) of this section,
the qualification date, and therefore the date of the deemed dividend,
is December 1, 1996. Accordingly, to make the deemed dividend election,
A must file an amended return for 1996, and include the deemed dividend
in income in that year. As a result, M will be a pedigreed QEF as of
December 1, 1996, and the December 3, 1996, distribution will not be
taxable as an excess
[[Page 631]]
distribution. Therefore, in its amended return, A may report the
December 3, 1996, distribution consistent with section 1293 and the
general rules applicable to corporate distributions.
Example 2. X, a U.S. person, owned a five percent interest in the
stock of FC, a PFIC with a taxable year ending June 30. X never made the
section 1295 election with respect to FC. X transferred her interest in
FC to her granddaughter, Y, a U.S. person, on February 14, 1996. The
transfer qualified as a gift for Federal income tax purposes, and no
gain was recognized on the transfer (see Regulation Project INTL-656-87,
published in 1992-1 C.B. 1124; see Sec. 601.601(d)(2)(ii)(b) of this
chapter). As provided in section 1223(2), Y's holding period includes
the period that X held the FC stock. Y decides to make the section 1295
election in her 1996 return to treat FC as a QEF for its taxable year
beginning July 1, 1995. However, because Y's holding period includes the
period that X held the FC stock, and FC was a PFIC but not a QEF during
that period, FC will be an unpedigreed QEF with respect to Y unless Y
makes a section 1291(d)(2) election. Although Y did not actually own the
stock of FC on the qualification date (July 1, 1995), Y's holding period
includes that date. Therefore, provided FC is a CFC for its taxable year
beginning July 1, 1995, Y may make a section 1291(d)(2)(B) election to
treat FC as a pedigreed QEF.
(f) Adjustment to basis. A shareholder that makes the deemed
dividend election increases its adjusted basis of the stock of the PFIC
owned directly by the shareholder by the amount of the deemed dividend.
If the shareholder makes the deemed dividend election with respect to a
PFIC of which it is an indirect shareholder, the shareholder's adjusted
basis of the stock or other property owned directly by the shareholder,
through which ownership of the PFIC is attributed to the shareholder, is
increased by the amount of the deemed dividend. In addition, solely for
purposes of determining the subsequent treatment under the Code and
regulations of a shareholder of the stock of the PFIC, the adjusted
basis of the direct owner of the stock of the PFIC is increased by the
amount of the deemed dividend.
(g) Treatment of holding period. For purposes of applying sections
1291 through 1297 to the shareholder after the deemed dividend, the
shareholder's holding period of the stock of the PFIC begins on the
qualification date. For other purposes of the Code and regulations, this
holding period rule does not apply.
(h) Coordination with section 959(e). For purposes of section
959(e), the entire deemed dividend is treated as included in gross
income under section 1248(a).
(i) Election inapplicable to shareholder of a former PFIC or of a
section 1297(e) PFIC. A shareholder may not make the section 1295 and
deemed dividend elections if the foreign corporation is a former PFIC
(as defined in paragraph (j)(2)(iv) of this section) or a section
1297(e) PFIC (as defined in paragraph (j)(2)(v) of this section) with
respect to the shareholder. For the rules regarding the election by a
shareholder of a former PFIC, see Sec. 1.1298-3. For the rules
regarding the election by a shareholder of a section 1297(e) PFIC, see
Sec. 1.1297-3.
(j) Definitions--(1) Passive foreign investment company (PFIC). A
passive foreign investment company (PFIC) is a foreign corporation that
satisfies either the income test of section 1296(a)(1) or the asset test
of section 1296(a)(2). A corporation will not be treated as a PFIC with
respect to a shareholder for those days included in the shareholder's
holding period when the shareholder, or a person whose holding period of
the stock is included in the shareholder's holding period, was not a
United States person within the meaning of section 7701(a)(30).
(2) Types of PFICs--(i) Qualified electing fund (QEF). A PFIC is a
qualified electing fund (QEF) with respect to a shareholder that has
elected, under section 1295, to be taxed currently on its share of the
PFIC's earnings and profits pursuant to section 1293.
(ii) Pedigreed QEF. A PFIC is a pedigreed QEF with respect to a
shareholder if the PFIC has been a QEF with respect to the shareholder
for all taxable years during which the corporation was a PFIC that are
included wholly or partly in the shareholder's holding period of the
PFIC stock.
(iii) Unpedigreed QEF. A PFIC is an unpedigreed QEF for a taxable
year if--
(A) An election under section 1295 is in effect for that year;
(B) The PFIC has been a QEF with respect to the shareholder for at
least one, but not all, of the taxable years
[[Page 632]]
during which the corporation was a PFIC that are included wholly or
partly in the shareholder's holding period of the PFIC stock; and
(C) The shareholder has not made an election under section
1291(d)(2) and this section or Sec. 1.1291-10 with respect to the PFIC
to purge the nonQEF years from the shareholder's holding period.
(iv) Former PFIC. A foreign corporation is a former PFIC with
respect to a shareholder if the corporation satisfies neither the income
test of section 1297(a)(1) nor the asset test of section 1297(a)(2), but
its stock, held by that shareholder, is treated as stock of a PFIC,
pursuant to section 1298(b)(1), because the corporation was a PFIC that
was not a QEF at some time during the shareholder's holding period of
the stock.
(v) Section 1297(e) PFIC. A foreign corporation is a section 1297(e)
PFIC with respect to a shareholder (as defined in paragraph (j)(3) of
this section) if--
(A) The foreign corporation qualifies as a PFIC under section
1297(a) on the first day on which the qualified portion of the
shareholder's holding period in the foreign corporation begins, as
determined under section 1297(e)(2); and
(B) The stock of the foreign corporation held by the shareholder is
treated as stock of a PFIC, pursuant to section 1298(b)(1), because, at
any time during the shareholder's holding period of the stock, other
than the qualified portion, the corporation was a PFIC that was not a
QEF.
(3) A shareholder is a United States person that is a shareholder as
defined in Sec. 1.1291-1(b)(7) or an indirect shareholder as defined in
Sec. 1.1291-1(b)(8), except as provided in Sec. 1.1291-1(e).
(k) Effective/applicability date. (1) The rules of this section,
except for paragraph (j)(2)(v) of this section, are applicable as of
April 1, 1995.
(2) The rules of paragraph (j)(2)(v) of this section are applicable
as of December 8, 2005.
(3) Paragraph (j)(3) of this section applies to taxable years of
shareholders ending on or after December 31, 2013.
[T.D. 8701, 61 FR 68151, Dec. 27, 1996; 62 FR 7155, Feb. 18, 1997, as
amended by T.D. 8750, 63 FR 13, Jan. 2, 1998; T.D. 9231, 70 FR 72915,
Dec. 8, 2005; T.D. 9360, 72 FR 54821, Sept. 27, 2007; T.D. 9650, 78 FR
79608, Dec. 31, 2013; T.D. 9806, 81 FR 95466, Dec. 28, 2016]
Sec. 1.1291-10 Deemed sale election.
(a) Deemed sale election. This section provides rules for making the
election under section 1291(d)(2)(A) (deemed sale election). Under that
section, a shareholder (as defined in Sec. 1.1291-9(j)(3)) of a PFIC
that is an unpedigreed QEF may elect to recognize gain with respect to
the stock of the unpedigreed QEF held on the qualification date (as
defined in paragraph (e) of this section). If the shareholder makes the
deemed sale election, the PFIC will become a pedigreed QEF with respect
to the shareholder. A shareholder that makes the deemed sale election is
treated as having sold, for its fair market value, the stock of the PFIC
that the shareholder held on the qualification date. The gain recognized
on the deemed sale is taxed under section 1291 as an excess distribution
received on the qualification date. In the case of an election made by
an indirect shareholder, the amount of gain to be recognized and taxed
as an excess distribution is the amount of gain that the direct owner of
the stock of the PFIC would have realized on an actual sale or other
disposition of the stock of the PFIC indirectly owned by the
shareholder. Any loss realized on the deemed sale is not recognized. For
the definitions of PFIC, QEF, unpedigreed QEF, and pedigreed QEF, see
Sec. 1.1291-9(j) (1) and (2).
(b) Who may make the election. A shareholder of an unpedigreed QEF
may make the deemed sale election provided the shareholder held stock of
that PFIC on the qualification date. A shareholder is treated as holding
stock of the PFIC on the qualification date if its holding period with
respect to that stock under section 1223 includes the qualification
date. A deemed sale election may be made by a shareholder that would
realize a loss on the deemed sale.
[[Page 633]]
(c) Time for making the election. The shareholder makes the deemed
sale election in the shareholder's return for the taxable year that
includes the qualification date. If the shareholder and the PFIC have
the same taxable year, the shareholder makes the deemed sale election in
either the original return for the taxable year for which the
shareholder makes the section 1295 election, or in an amended return for
that year. If the shareholder and the PFIC have different taxable years,
the deemed sale election must be made in an amended return for the
taxable year that includes the qualification date. If the deemed sale
election is made in an amended return, the amended return must be filed
by a date that is within three years of the due date, as extended under
section 6081, of the original return for the taxable year that includes
the qualification date.
(d) Manner of making the election. A shareholder makes the deemed
sale election by filing Form 8621 with the return for the taxable year
of the shareholder that includes the qualification date, reporting the
gain as an excess distribution pursuant to section 1291(a), and paying
the tax and interest due on the excess distribution. A shareholder that
makes the deemed sale election after the due date of the return
(determined without regard to extensions) for the taxable year that
includes the qualification date must pay additional interest, pursuant
to section 6601, on the amount of the underpayment of tax for that year.
A shareholder that realizes a loss on the deemed sale reports the loss
on Form 8621, but does not recognize the loss.
(e) Qualification date--(1) In general. Except as otherwise provided
in this paragraph (e), the qualification date is the first day of the
PFIC's first taxable year as a QEF (first QEF year).
(2) Elections made after March 31, 1995, and before January 27,
1997--(i) In general. The qualification date for deemed sale elections
made after March 31, 1995, and before January 27, 1997, is the first day
of the shareholder's election year. The shareholder's election year is
the taxable year of the shareholder for which it made the section 1295
election.
(ii) Exception. A shareholder who made the deemed sale election
after May 1, 1992, and before January 27, 1997, may elect to change its
qualification date to the first day of the first QEF year, provided the
periods of limitations on assessment for the taxable year that includes
that date and for the shareholder's election year have not expired. A
shareholder changes the qualification date by filing amended returns,
with revised Forms 8621, for the shareholder's election year and the
shareholder's taxable year that includes the first day of the first QEF
year, and making all appropriate adjustments and payments.
(f) Adjustments to basis--(1) In general. A shareholder that makes
the deemed sale election increases its adjusted basis of the PFIC stock
owned directly by the amount of gain recognized on the deemed sale. If
the shareholder makes the deemed sale election with respect to a PFIC of
which it is an indirect shareholder, the shareholder's adjusted basis of
the stock or other property owned directly by the shareholder, through
which ownership of the PFIC is attributed to the shareholder, is
increased by the amount of gain recognized by the shareholder. In
addition, solely for purposes of determining the subsequent treatment
under the Code and regulations of a shareholder of the stock of the
PFIC, the adjusted basis of the direct owner of the stock of the PFIC is
increased by the amount of gain recognized on the deemed sale. A
shareholder shall not adjust the basis of any stock with respect to
which the shareholder realized a loss on the deemed sale.
(2) Adjustment of basis for section 1293 inclusion with respect to
deemed sale election made after March 31, 1995, and before January 27,
1997. For purposes of determining the amount of gain recognized with
respect to a deemed sale election made after March 31, 1995, and before
January 27, 1997, by a shareholder that treats the first day of the
shareholder's election year as the qualification date, the adjusted
basis of the stock deemed sold includes the shareholder's section
1293(a) inclusion attributable to the period beginning with the first
day of the PFIC's first QEF year and ending on the day before the
qualification date.
(g) Treatment of holding period. For purposes of applying sections
1291
[[Page 634]]
through 1297 to the shareholder after the deemed sale, the shareholder's
holding period of the stock of the PFIC begins on the qualification
date, without regard to whether the shareholder recognized gain on the
deemed sale. For other purposes of the Code and regulations, this
holding period rule does not apply.
(h) Election inapplicable to shareholder of former PFIC. A
shareholder may not make the section 1295 and deemed sale elections if
the foreign corporation is a former PFIC (as defined in Sec. 1.1291-
9(j)(2)(iv)) with respect to the shareholder. For the rules regarding
the election by a shareholder of a former PFIC, see Sec. 1.1297-3T.
(i) Effective date. The rules of this section are applicable as of
April 1, 1995.
[T.D. 8701, 61 FR 68153, Dec. 27, 1996]
Sec. 1.1293-0 Table of contents.
This section contains a listing of the headings for Sec. 1.1293-1.
Sec. 1.1293-1 Current inclusion of income of qualified electing funds.
(a) In general. [Reserved]
(1) Other rules. [Reserved]
(2) Net capital gain defined.
(i) In general.
(ii) Effective date.
(b) Other rules. [Reserved]
(c) Application of rules of inclusion with respect to stock held by
a pass through entity.
(1) In general.
(2) QEF stock transferred to a pass through entity.
(i) Pass through entity makes a section 1295 election.
(ii) Pass through entity does not make a section 1295 election.
(3) Effective date.
[T.D. 8750, 63 FR 13, Jan. 2, 1998, as amended by T.D. 8870, 65 FR
16319, Mar. 28, 2000]
Sec. 1.1293-1 Current taxation of income from qualified electing funds.
(a) In general. [Reserved]
(1) Other rules. [Reserved]
(2) Net capital gain defined--(i) In general. This paragraph (a)(2)
defines the term net capital gain for purposes of sections 1293 and 1295
and the regulations under those sections. The QEF, as defined in Sec.
1.1291-9(j)(2)(i), in determining its net capital gain for a taxable
year, may either--
(A) Calculate and report the amount of each category of long-term
capital gain provided in section 1(h) that was recognized by the PFIC in
the taxable year;
(B) Calculate and report the amount of net capital gain recognized
by the PFIC in the taxable year, stating that that amount is subject to
the highest capital gain rate of tax applicable to the shareholder; or
(C) Calculate its earnings and profits for the taxable year and
report the entire amount as ordinary earnings.
(ii) Effective date. Paragraph (a)(2)(i) of this section is
applicable to sales by QEFs during their taxable years ending on or
after May 7, 1997.
(b) Other rules. [Reserved]
(c) Application of rules of inclusion with respect to stock held by
a pass through entity--(1) In general. If a domestic pass through entity
makes a section 1295 election, as provided in paragraph (d)(2) of this
section, with respect to the PFIC shares that it owns, directly or
indirectly, the domestic pass through entity takes into account its pro
rata share of the ordinary earnings and net capital gain attributable to
the QEF shares held by the pass through entity. A U.S. person that
indirectly owns QEF shares through the domestic pass through entity
accounts for its pro rata shares of ordinary earnings and net capital
gain attributable to the QEF shares according to the general rules
applicable to inclusions of income from the domestic pass through
entity. For the definition of pass through entity, see Sec. 1.1295-
1(j).
(2) QEF stock transferred to a pass through entity--(i) Pass through
entity makes a section 1295 election. If a shareholder transfers stock
subject to a section 1295 election to a domestic pass through entity of
which it is an interest holder and the pass through entity makes a
section 1295 election with respect to that stock, as provided in Sec.
1.1295-1(d)(2), the shareholder takes into account its pro rata shares
of the ordinary earnings and net capital gain attributable to the QEF
shares under the rules applicable to inclusions of income from the pass
through entity.
(ii) Pass through entity does not make a section 1295 election. If
the pass through entity does not make a section 1295
[[Page 635]]
election with respect to the PFIC, the shares of which were transferred
to the pass through entity subject to the 1295 election of the
shareholder, the shareholder continues to be subject, in its capacity as
an indirect shareholder, to the income inclusion rules of section 1293
and reporting rules required of shareholders of QEFs. Proper adjustments
to reflect an inclusion in income under section 1293 by the indirect
shareholder must be made, under the principles of Sec. 1.1291-9(f), to
the basis of the indirect shareholder's interest in the pass through
entity.
(3) Effective date. Paragraph (c) of this section is applicable to
taxable years of shareholders beginning after December 31, 1997.
[T.D. 8750, 63 FR 14, Jan. 2, 1998. Redesignated and amended by T.D.
8870, 65 FR 5779, 5781, Feb. 7, 2000]
Sec. 1.1294-0 Table of contents.
This section contains a listing of the headings for Sec. 1.1294-1T.
Sec. 1.1294-1T Election to extend the time for payment of tax on
undistributed earnings of a qualified electing fund.
(a) Purpose and scope.
(b) Election to extend time for payment of tax.
(1) In general.
(2) Exception.
(3) Undistributed earnings.
(i) In general.
(ii) Effect of loan, pledge or guarantee.
(c) Time for making the election.
(1) In general.
(2) Exception.
(d) Manner of making the election.
(1) In general.
(2) Information to be included in the election.
(e) Termination of the extension.
(f) Undistributed PFIC earnings tax liability.
(g) Authority to require a bond.
(h) Annual reporting requirement.
[T.D. 8750, 63 FR 13, Jan. 2, 1998]
Sec. 1.1294-1T Election to extend the time for payment of tax on
undistributed earnings of a qualified electing fund (temporary).
(a) Purpose and scope. This section provides rules for making the
annual election under section 1294. Under that section, a U.S. person
that is a shareholder in a qualified electing fund (QEF) may elect to
extend the time for payment of its tax liability which is attributable
to its share of the undistributed earnings of the QEF. In general, a QEF
is a passive foreign investment company (PFIC), as defined in section
1296, that makes the election under section 1295. Under section 1293, a
U.S. person that owns, or is treated as owning, stock of a QEF at any
time during the taxable year of the QEF shall include in gross income,
as ordinary income, its pro rata share of the ordinary earnings of the
QEF for the taxable year and, as long-term capital gain, its pro rata
share of the net capital gain of the QEF for the taxable year. The
shareholder's share of the earnings shall be included in the
shareholder's taxable year in which or with which the taxable year of
the QEF ends.
(b) Election to extend time for payment--(1) In general. A U.S.
person that is a shareholder of a QEF on the last day of the QEF's
taxable year may elect under section 1294 to extend the time for payment
of that portion of its tax liability which is attributable to the
inclusion in income pursuant to section 1293 of the shareholder's share
of the QEF's undistributed earnings. The election under section 1294 may
be made only with respect to undistributed earnings, and interest is
imposed under section 6601 on the amount of the tax liability which is
subject to the extension. This interest must be paid on the termination
of the election.
(2) Exception. An election under this Sec. 1.1294-1T cannot be made
for a taxable year of the shareholder if any portion of the QEF's
earning is includible in the gross income of the shareholder for such
year under either section 551 (relating to foreign personal holding
companies) or section 951 (relating to controlled foreign corporations).
(3) Undistributed earnings--(i) In general. For purposes of this
Sec. 1.1294-1T the term undistributed earnings means the excess, if
any, of the amount includible in gross income by reason of section
1293(a) for the shareholder's taxable year (the includible amount) over
the sum of (A) the amount of any distribution to the shareholder during
the QEF's taxable year and (B) the portion of the includible amount that
is attributable to stock in the QEF that the
[[Page 636]]
shareholder transferred or otherwise disposed of before the end of the
QEF's year. For purposes of this paragraph, a distribution will be
treated as made from the most recently accumulated earnings and profits.
(ii) Effect of a loan, pledge or guarantee. A loan, pledge, or
guarantee described in Sec. 1.1294-1T(e) (2) or (4) will be treated as
a distribution of earnings for purposes of paragraph (b)(3)(i)(A). If
earnings are treated as distributed in a taxable year by reason of a
loan, pledge or guarantee described in Sec. 1.1294-1T(e) (2) or (4),
but the amount of the deemed distribution resulting therefrom was less
than the amount of the actual loan by the QEF (or the amount of the loan
secured by the pledge or guarantee), earnings derived by the QEF in a
subsequent taxable year will be treated as distributed in such
subsequent year to the shareholder for purposes of paragraph
(b)(3)(i)(A) by virtue of such loan, but only to the extent of the
difference between the outstanding principal balance on the loan in such
subsequent year and the prior years' deemed distributions resulting from
the loan. For this purpose, the outstanding principal balance on a loan
in a taxable year shall be treated as equal to the greatest amount of
the outstanding balance at any time during such year.
Example 1. (i) Facts. FC is a PFIC that made the election under
section 1295 to be a QEF for its taxable year beginning January 1, 1987.
S owned 500 shares, or 50 percent, of FC throughout the first six months
of 1987, but on June 30, 1987 sold 10 percent, or 50 shares, of the FC
stock that it held. FC had $100,000x of ordinary earnings but no net
capital gain in 1987. No part of FC's earnings is includible in S's
income under either section 551 or 951. FC made no distributions to its
shareholders in 1987. S's pro rata share of income is determined by
attributing FC's income ratably to each day in FC's year. Accordingly,
FC's daily earnings are $274x ($100,000x/365). S's share of the earnings
of FC is $47,484x, determined as follows.
FC's daily earnings x number of days percentage held by S x percentage
of ownership in FC.
Accordingly, S's pro rata share of FC's earnings for the first six
months of FC's year deemed earned while S held 50 percent of FC's stock
is $24,797x ($274x x 181 days x 50%). S's pro rata share of FC's
earnings for remainder of FC's year deemed earned while S held 45
percent of FC's stock is $22,687x ($274x x 184 days x 45%). Therefore,
S's total share of FC's earnings to be included in income under section
1293 is $47,484x ($24,797x + $22,687x).
(ii) Election. S intends to make the election under section 1294 to
defer the payment of its tax liability that is attributable to the
undistributed earnings of FC. The amount of current year undistributed
earnings as defined in Sec. 1.1294-1T(b)(3) with respect to which S can
make the election is the excess of S's inclusion in gross income under
section 1293(a) for the taxable year over the sum of (1) the cash and
other property distributed to S during FC's tax year out of earnings
included in income pursuant to section 1293(a), and (2) the earnings
attributable to stock disposed of during FC's tax year. Because S sold
10 percent, or 50 shares, of the FC stock that it held during the first
six months of the year, 10 percent of its share of the earnings for that
part of the year, which is $2,480x ($24,797x x 10%), is attributable to
the shares sold. S therefore cannot make the election under section 1294
to extend the time for payment of its tax liability on that amount.
Accordingly, S can make the election under section 1294 with respect to
its tax on $45,004x ($47,484x less $2,480x), which is its pro rata share
of FC's earnings, reduced by the earnings attributable to the stock
disposed of during the year.
Example 2. (i) Facts. The facts are the same as in Example 1 with
the following exceptions. S did not sell any FC stock during 1987.
Therefore, because S held 50 percent of the FC stock throughout 1987,
S's pro rata share of FC's ordinary earnings was $50,000x, no part of
which was includible in S's income under either section 551 or 951.
There were no actual distributions of earnings to S in 1988. On December
31, 1987, S pledged the FC stock as security for a bank loan of
$75,000x. The pledge is treated as a disposition of the FC stock and
therefore a distribution of S's share of the undistributed earnings of
FC up to the amount of the loan principal. S's entire share of the
undistributed earnings of FC are deemed distributed as a result of the
pledge of the FC stock. S therefore cannot make the election under
section 1294 to extend the time for payment of its tax liability on its
share of FC's earnings for 1987.
(ii) Deemed distribution. In 1988, FC has ordinary earnings of
$100,000x but no net capital gain. S's pro rata share of FC's 1988
ordinary earnings was $50,000x. S's loan remained outstanding throughout
1988; the highest loan balance during 1988 was $74,000x. Of S's share of
the ordinary earnings of FC of $50,000x, $24,000x is deemed distributed
to S. This is the amount by which the highest loan balance for the year
($74,000x) exceeds the portion of the undistributed earnings of FC
deemed distributed to S in 1987 by reason of the pledge ($50,000x). S
may make the election under section 1294 to extend the time for
[[Page 637]]
payment of its tax liability on $26,000x, which is the amount by which
S's includible amount for 1988 exceeds the amount deemed distributed to
S during 1988.
(c) Time for making the election--(1) In general. An election under
this Sec. 1.1294-1T may be made for any taxable year in which a
shareholder reports income pursuant to section 1293. Except as provided
in paragraph (c)(2), the election shall be made by the due date, as
extended, of the tax return for the shareholder's taxable year for which
the election is made.
(2) Exception. An election under this section may be made within 60
days of receipt of notification from the QEF of the shareholder's pro
rata share of the ordinary earnings and net capital gain if notification
is received after the time for filing the election provided in paragraph
(c)(1) (and requires the filing of an amended return to report income
pursuant to section 1293). If the notification reports an increase in
the shareholder's pro rata share of the earnings previously reported to
the shareholder by the QEF, the shareholder may make the election under
this paragraph (c)(2) only with respect to the amount of such increase.
(d) Manner of making the election--(1) In general. A shareholder
shall make the election by (i) attaching to its return for the year of
the election Form 8621 or a statement containing the information and
representations required by this section and (ii) filing a copy of Form
8621 or the statement with the Internal Revenue Service Center, P.O. Box
21086, Philadelphia, Pennsylvania 19114.
(2) Information to be included in the election statement. If a
statement is used in lieu of Form 8621, the statement should be
identified, in a heading, as an election under section 1294 of the Code.
The statement must include the following information and
representations:
(i) The name, address, and taxpayer identification number of the
electing shareholder and the taxable year of the shareholder for which
the election is being made;
(ii) The name, address and taxpayer identification number of the QEF
if provided to the shareholder;
(iii) A statement that the shareholder is making the election under
section 1294 of the Code;
(iv) A schedule containing the following information:
(A) The ordinary earnings and net capital gain for the current year
included in the shareholder's income under section 1293;
(B) The amount of cash and other property distributed by the QEF
during its taxable year with respect to stock held directly or
indirectly by the shareholder during that year, identifying the amount
of such distributions that is paid out of current earnings and profits
and the amount paid out of each prior year's earnings and profits; and
(C) The undistributed PFIC earnings tax liability (as defined in
paragraph (f) of this section) for the taxable year, payment of which is
being deferred by reason of the election under section 1294;
(v) The number of shares of stock held in the QEF during the QEF's
taxable year which gave rise to the section 1293 inclusion and the
number of such shares transferred, deemed transferred or otherwise
disposed of by the electing shareholder before the end of the QEF's
taxable year, and the data of transfer; and
(vi) The representations of the electing shareholder that--
(A) No part of the QEF's earnings for the taxable year is includible
in the electing shareholder's gross income under either section 551 or
951 of the Code;
(B) The election is made only with respect to the shareholder's pro
rata share of the undistributed earnings of the QEF; and
(C) The electing shareholder, upon termination of the election to
extend the date for payment, shall pay the undistributed PFIC earnings
tax liability attributable to those earnings to which the termination
applies as well as interest on such tax liability pursuant to section
6601. Payment of this tax and interest must be made by the due date
(determined without extensions) of the tax return for the taxable year
in which the termination occurs.
(e) Termination of the extension. The election to extend the date
for payment of tax will be terminated in
[[Page 638]]
whole or in part upon the occurrence of any of the following events:
(1) The QEF's distribution of earnings to which the section 1294
extension to pay tax is attributable; the extension will terminate only
with respect to the tax attributable to the earnings that were
distributed.
(2) The electing shareholder's transfer of stock in the QEF (or use
thereof as security for a loan) with respect to which an election under
this Sec. 1.1294-1T was made. The election will be terminated with
respect to the undistributed earnings attributable to the shares of the
stock transferred. In the case of a pledge of the stock, the election
will be terminated with respect to undistributed earnings equal to the
amount of the loan for which the stock is pledged.
(3) Revocation of the QEF's election as a QEF or cessation of the
QEF's status as a PFIC. A revocation of the QEF election or cessation of
PFIC status will result in the complete termination of the extension.
(4) A loan of property by the QEF directly or indirectly to the
electing shareholder or related person, or a pledge or guarantee by the
QEF with respect to a loan made by another party to the electing
shareholder or related person. The election will be terminated with
respect to undistributed earnings in an amount equal to the amount of
the loan, pledge, or guarantee.
(5) A determination by the District Director pursuant to section
1294(c)(3) that collection of the tax is in jeopardy. The amount of
undistributed earnings with respect to which the extension is terminated
under this paragraph (d)(5) will be left to the discretion of the
District Director.
(f) Undistributed PFIC earnings tax liability. The electing
shareholder's tax liability attributable to the ordinary earnings and
net capital gain included in gross income under section 1293 shall be
the excess of the tax imposed under chapter 1 of the Code for the
taxable year over the tax that would be imposed for the taxable year
without regard to the inclusion in income under section 1293 of the
undistributed earnings as defined in paragraph (b)(3) of this section.
Example: The facts are the same as in Sec. 1.1294-1T (b)(3),
Example 1, with the following exceptions. S, a domestic corporation, did
not dispose of any FC stock in 1987. Therefore, because S held 50
percent of the FC stock throughout 1987, S's pro rata share of FC's
ordinary earnings was $50,000x. In addition to $50,000x of ordinary
earnings from FC, S had $12,500x of domestic source income and $6,000x
of expenses (other than interest expense) not definitely related to any
gross income. These expenses are apportioned, pursuant to Sec. 1.861-
8(c)(2), on a pro rata basis between the domestic and foreign source
income--$1,200x of expenses, or one-fifth, to domestic source income,
and $4,800x of expenses, or four-fifths, to the section 1293 inclusion.
FC paid foreign taxes of $25,000x in 1987. Accordingly, S is entitled to
claim as an indirect foreign tax credit pursuant to section 1293(f) a
proportionate amount of the foreign taxes paid by FC, which is $12,500x
($25,000x x $50,000x/$100,000x). S is taxed in the U.S. at the rate of
34 percent. The amount of tax liability for which S may extend the time
for payment is determined as follows:
1987 Tax Liability (With Section 1293 Inclusion)
------------------------------------------------------------------------
Source U.S. Foreign
------------------------------------------------------------------------
Income.................................. 12,500x 0
Section 1293............................ 0 50,000x
Expenses................................ -1,200x -4,800x
-------------------------------
Taxable income.......................... 11,300x 45,200x
===============================
Total taxable income.................. 56,500x
U.S. income tax rate.................. x34%
----------------
Pre-credit U.S. tax................... 19,210x
Foreign tax credit.................... -12,500x
----------------
1987 Tax Liability.................... 6,710x
------------------------------------------------------------------------
1987 Tax Liability (Without Section 1293 Inclusion)
------------------------------------------------------------------------
Source U.S. Foreign
------------------------------------------------------------------------
Income.................................. 12,500x 0
Expenses................................ -6,000x
----------------
Taxable income.......................... 6,500x
U.S. tax rate........................... x34%
----------------
U.S. Tax................................ 2,210x
Foreign tax credit...................... 0
----------------
Hypothetical 1987 Tax Liability......... 2,210x
------------------------------------------------------------------------
The amount of tax, payment of which S may defer pursuant to section
1294, is $4,500x ($6,710x less $2,210x).
(g) Authority to require a bond. Pursuant to the authority granted
in section
[[Page 639]]
6165 and in the manner provided therein, and subject to notification,
the District Director may require the electing shareholder to furnish a
bond to secure payment of the tax, the time for payment of which is
extended under this section. If the electing shareholder does not
furnish the bond within 60 days after receiving a request from the
District Director, the election will be revoked.
(h) Annual reporting requirement. The electing shareholder must
attach Form 8621 or a statement to its income tax return for each year
during which an election under this section is outstanding. The
statement must contain the following information:
(1) The total amount of undistributed earnings as of the end of the
taxable year to which the outstanding elections apply;
(2) The total amount of the undistributed PFIC earnings tax
liability and accrued interest charge as of the end of the year;
(3) The total amount of distributions received during the taxable
year; and
(4) A description of the occurrence of any other termination event
described in paragraph (e) of this section that occurred during the
taxable year.
The electing shareholder also shall file by the due date, as extended,
for its return a copy of Form 8621 or the statement with the
Philadelphia Service Center, P.O. Box 21086, Philadelphia, Pennsylvania
19114.
[T.D. 8178, 53 FR 6773, Mar. 2, 1988; 53 FR 11731, Apr. 8, 1988]
Sec. 1.1295-0 Table of contents.
This section contains a listing of the headings for Sec. Sec.
1.1295-1 and 1.1295-3.
Sec. 1.1295-1 Qualified electing funds.
(a) In general. [Reserved]
(b) Application of section 1295 election. [Reserved]
(1) Election personal to shareholder. [Reserved]
(2) Election applicable to specific corporation only.
(i) In general. [Reserved]
(ii) Stock of QEF received in a nonrecognition transfer. [Reserved]
(iii) Exception for options.
(3) Application of general rules to stock held by a pass through
entity.
(i) Stock subject to a section 1295 election transferred to a pass
through entity.
(ii) Limitation on application of pass through entity's section 1295
election.
(iii) Effect of partnership termination on section 1295 election.
(iv) Characterization of stock held through a pass through entity.
(4) Application of general rules to a taxpayer filing a joint return
under section 6013.
(c) Effect of section 1295 election.
(1) In general.
(2) Years to which section 1295 election applies.
(i) In general.
(ii) Effect of PFIC status on election.
(iii) Effect on election of complete termination of a shareholder's
interest in the PFIC.
(iv) Effect on section 1295 election of transfer of stock to a
domestic pass through entity.
(v) Examples.
(d) Who may make a section 1295 election.
(1) General rule.
(2) Application of general rule to pass through entities.
(i) Partnerships.
(A) Domestic partnership.
(B) Foreign partnership.
(ii) S corporation.
(iii) Trust or estate.
(A) Domestic trust or estate.
(1) Nongrantor trust or estate.
(2) Grantor trust.
(B) Foreign trust or estate.
(1) Nongrantor trust or estate.
(2) Grantor trust.
(iv) Indirect ownership of the pass through entity or the PFIC.
(3) Indirect ownership of a PFIC through other PFICs.
(4) Member of consolidated return group as shareholder.
(5) Option holder.
(6) Exempt organization.
(e) Time for making a section 1295 election.
(1) General rule.
(2) Examples.
(f) Manner of making a section 1295 election and the annual election
requirements of the shareholder.
(1) Manner of making the election.
(2) Annual election requirements.
(i) In general.
(ii) Retention of documents.
(g) Annual election requirements of the PFIC or intermediary.
(1) PFIC Annual Information Statement.
(2) Alternative documentation.
(3) Annual Intermediary Statement.
(4) Combined statements.
(i) PFIC Annual Information Statement.
(ii) Annual Intermediary Statement.
(h) Transition rules.
(i) Invalidation, termination or revocation of section 1295
election.
[[Page 640]]
(1) Invalidation or termination of election at the discretion of the
Commissioner.
(i) In general.
(ii) Deferral of section 1293 inclusion.
(iii) When effective.
(2) Shareholder revocation.
(i) In general.
(ii) Time for and manner of requesting consent to revoke.
(A) Time.
(B) Manner of making request.
(iii) When effective.
(3) Automatic termination.
(4) Effect of invalidation, termination or revocation.
(5) Election after invalidation, termination or revocation.
(i) In general.
(ii) Special rule.
(j) Definitions.
(k) Effective dates.
Sec. 1.1295-3 Retroactive elections.
(a) In general.
(b) General rule.
(c) Protective Statement.
(1) In general.
(2) Reasonable belief statement.
(3) Who executes and files the Protective Statement.
(4) Waiver of the periods of limitations.
(i) Time for and manner of extending periods of limitations.
(A) In general.
(B) Application of general rule to domestic partnerships.
(1) In general
(2) Special rules.
(i) Addition of partner to non-TEFRA partnership.
(ii) Change in status from non-TEFRA partnership to TEFRA
partnership.
(C) Application of general rule to domestic nongrantor trusts and
domestic estates.
(D) Application of general rule to S corporations.
(E) Effect on waiver of complete termination of a pass through
entity or pass through entity's business.
(F) Application of general rule to foreign partnerships, foreign
trusts, domestic or foreign grantor trusts, and foreign estates.
(ii) Terms of waiver.
(A) Scope of waiver.
(B) Period of waiver.
(5) Time for and manner of filing a Protective Statement.
(i) In general.
(ii) Special rule for taxable years ended before January 2, 1998
(6) Applicability of the Protective Statement.
(i) In general.
(ii) Invalidity of the Protective Statement.
(7) Retention of Protective Statement and information demonstrating
reasonable belief.
(d) Reasonable belief.
(1) In general.
(2) Knowledge of law required.
(e) Special rules for qualified shareholders.
(1) In general.
(2) Qualified shareholder.
(3) Exceptions.
(f) Special consent.
(1) In general.
(2) Reasonable reliance on a qualified tax professional.
(i) In general.
(ii) Shareholder deemed to have not reasonably relied on a qualified
tax professional.
(3) Prejudice to the interests of the United States government.
(i) General rule.
(ii) Elimination of prejudice to the interests of the United States
government.
(4) Procedural requirements.
(i) Filing instructions.
(ii) Affidavit from shareholder.
(iii) Affidavits from other persons.
(iv) Other information.
(v) Notification of Internal Revenue Service.
(vi) Who requests special consent under this paragraph (f) and who
enters into a closing agreement.
(g) Time for and manner of making a retroactive election.
(1) Time for making a retroactive election.
(i) In general.
(ii) Transition rule.
(iii) Ownership not required at time retroactive election is made.
(2) Manner of making a retroactive election.
(3) Who makes the retroactive election.
(4) Other elections.
(i) Section 1291(d)(2) election.
(ii) Section 1294 election.
(h) Effective date.
[T.D. 8750, 63 FR 14, Jan. 2, 1998, as amended by T.D. 8870, 65 FR 5779,
Feb. 7, 2000; 65 FR 16319, Mar. 28, 2000; T.D. 9123, 69 FR 24073, May 3,
2004]
Sec. 1.1295-1 Qualified electing funds.
(a) In general. [Reserved]
(b) Application of section 1295 election. [Reserved]
(1) Election personal to shareholder. [Reserved]
(2) Election applicable to specific corporation only--
(i) In general. [Reserved]
(ii) Stock of QEF received in a nonrecognition transfer. [Reserved]
(iii) Exception for options. A shareholder's section 1295 election
does not apply to any option to buy stock of the PFIC.
[[Page 641]]
(3) Application of general rules to stock held by a pass through
entity--(i) Stock subject to a section 1295 election transferred to a
pass through entity. A shareholder's section 1295 election will not
apply to a domestic pass through entity to which the shareholder
transfers stock subject to section 1295 election, or to any other U.S.
person that is an interest holder or beneficiary of the domestic pass
through entity. However, as provided in paragraph (c)(2)(iv) of this
section (relating to a transfer to a domestic pass through entity of
stock subject to a section 1295 election), a shareholder that transfers
stock subject to a section 1295 election to a pass through entity will
continue to be subject to the section 1295 election with respect to the
stock indirectly owned through the pass through entity and any other
stock of that PFIC owned by the shareholder.
(ii) Limitation on application of pass through entity's section 1295
election. Except as provided in paragraph (c)(2)(iv) of this section, a
section 1295 election made by a domestic pass through entity does not
apply to other stock of the PFIC held directly or indirectly by the
interest holder or beneficiary.
(iii) Effect of partnership termination on section 1295 election.
Termination of a section 1295 election made by a domestic partnership by
reason of the termination of the partnership under section 708(b) will
not terminate the section 1295 election with respect to partners of the
terminated partnership that are partners of the new partnership. Except
as otherwise provided, the stock of the PFIC of which the new partners
are indirect shareholders will be treated as stock of a QEF only if the
new domestic partnership makes a section 1295 election with respect to
that stock.
(iv) Characterization of stock held through a pass through entity.
Stock of a PFIC held through a pass through entity will be treated as
stock of a pedigreed QEF with respect to an interest holder or
beneficiary only if--
(A) In the case of PFIC stock acquired (other than in a transaction
in which gain is not recognized pursuant to regulations under section
1291(f) with respect to that stock) and held by a domestic pass through
entity, the pass through entity makes the section 1295 election and the
PFIC has been a QEF with respect to the pass through entity for all
taxable years that are included wholly or partly in the pass through
entity's holding period of the PFIC stock and during which the foreign
corporation was a PFIC within the meaning of Sec. 1.1291-9(j)(1); or
(B) In the case of PFIC stock transferred by an interest holder or
beneficiary to a pass through entity in a transaction in which gain is
not fully recognized (including pursuant to regulations under section
1291(f)), the pass through entity makes the section 1295 election with
respect to the PFIC stock transferred for the taxable year in which the
transfer was made. The PFIC stock transferred will be treated as stock
of a pedigreed QEF by the pass through entity, however, only if that
stock was treated as stock of a pedigreed QEF with respect to the
interest holder or beneficiary at the time of the transfer, and the PFIC
has been a QEF with respect to the pass through entity for all taxable
years of the PFIC that are included wholly or partly in the pass through
entity's holding period of the PFIC stock during which the foreign
corporation was a PFIC within the meaning of Sec. 1.1291-9(j).
(v) Characterization of stock distributed by a partnership. In the
case of PFIC stock distributed by a partnership to a partner in a
transaction in which gain is not fully recognized, the PFIC stock will
be treated as stock of a pedigreed QEF by the partners only if that
stock was treated as stock of a pedigreed QEF with respect to the
partnership for all taxable years of the PFIC that are included wholly
or partly in the partnership's holding period of the PFIC stock during
which the foreign corporation was a PFIC within the meaning of Sec.
1.1291-9(j), and the partner has a section 1295 election in effect with
respect to the distributed PFIC stock for the partner's taxable year in
which the distribution was made. If the partner does not have a section
1295 election in effect, the stock shall be treated as stock in a
section 1291 fund. See paragraph (k) of this section for special
applicability date of paragraph (b)(3)(v) of this section.
[[Page 642]]
(4) Application of general rules to a taxpayer filing a joint return
under section 6013. A section 1295 election made by a taxpayer in a
joint return, within the meaning of section 6013, will be treated as
also made by the spouse that joins in the filing of that return. See
paragraph (k) of this section for special applicability date of
paragraph (b)(4) of this section.
(c) Effect of section 1295 election--(1) In general. Except as
otherwise provided in this paragraph (c), the effect of a shareholder's
section 1295 election is to treat the foreign corporation as a QEF with
respect to the shareholder for each taxable year of the foreign
corporation ending with or within a taxable year of the shareholder for
which the election is effective. A section 1295 election is effective
for the shareholder's election year and all subsequent taxable years of
the shareholder unless invalidated, terminated or revoked as provided in
paragraph (i) of this section. The terms shareholder and shareholder's
election year are defined in paragraph (j) of this section.
(2) Years to which section 1295 election applies--(i) In general.
Except as otherwise provided in this paragraph (c), a foreign
corporation with respect to which a section 1295 election is made will
be treated as a QEF for its taxable year ending with or within the
shareholder's election year and all subsequent taxable years of the
foreign corporation that are included wholly or partly in the
shareholder's holding period (or periods) of stock of the foreign
corporation.
(ii) Effect of PFIC status on election. A foreign corporation will
not be treated as a QEF for any taxable year of the foreign corporation
that the foreign corporation is not a PFIC under section 1297(a) and is
not treated as a PFIC under section 1298(b)(1). Therefore, a shareholder
shall not be required to include pursuant to section 1293 the
shareholder's pro rata share of ordinary earnings and net capital gain
for such year and shall not be required to satisfy the section 1295
annual reporting requirement of paragraph (f)(2) of this section for
such year. Cessation of a foreign corporation's status as a PFIC will
not, however, terminate a section 1295 election. Thus, if the foreign
corporation is a PFIC in any taxable year after a year in which it is
not treated as a PFIC, the shareholder's original election under section
1295 continues to apply and the shareholder must take into account its
pro rata share of ordinary earnings and net capital gain for such year
and comply with the section 1295 annual reporting requirement.
(iii) Effect on election of complete termination of a shareholder's
interest in the PFIC. Complete termination of a shareholder's direct and
indirect interest in stock of a foreign corporation will not terminate a
shareholder's section 1295 election with respect to the foreign
corporation. Therefore, if a shareholder reacquires a direct or indirect
interest in any stock of the foreign corporation, that stock is
considered to be stock for which an election under section 1295 has been
made and the shareholder is subject to the income inclusion and
reporting rules required of a shareholder of a QEF.
(iv) Effect on section 1295 election of transfer of stock to a
domestic pass through entity. The transfer of a shareholder's direct or
indirect interest in stock of a foreign corporation to a domestic pass
through entity (as defined in paragraph (j) of this section) will not
terminate the shareholder's section 1295 election with respect to the
foreign corporation, whether or not the pass through entity makes a
section 1295 election. For the rules concerning the application of
section 1293 to stock transferred to a domestic pass through entity, see
Sec. 1.1293-1(c).
(v) Examples. The following examples illustrate the rules of this
paragraph (c)(2).
Example 1. In 1998, C, a U.S. person, purchased stock of FC, a
foreign corporation that is a PFIC. Both FC and C are calendar year
taxpayers. C made a timely section 1295 election to treat FC as a QEF in
C's 1998 return, and FC was therefore a pedigreed QEF. C included its
shares of FC's 1998 ordinary earnings and net capital gain in C's 1998
Income and did not make a section 1294 election to defer the time for
payment of tax on that income. In 1999, 2000, and 2001, FC did not
satisfy either the income or asset test of section 1296(a), and
therefore was neither a PFIC nor a QEF. C therefore did not have to
include its pro rata shares of the ordinary earnings and net capital
gain of FC pursuant
[[Page 643]]
to section 1293, or satisfy the section 1295 annual reporting
requirements for any of those years. FC qualified as a PFIC again in
2002. Because C had made a section 1295 election in 1998, and the
election had not been invalidated, terminated, or revoked, within the
meaning of paragraph (i) of this section, C's section 1295 election
remains in effect for 2002. C therefore is subject in 2002 to the income
inclusion and reporting rules required of shareholders of QEFs.
Example 2. The facts are the same as in Example (1) except that FC
did not lose PFIC status in any year and C sold all the FC stock in 1999
and repurchased stock of FC in 2002. Because C had made a section 1295
election in 1998 with respect to stock of FC, and the election had not
been invalidated, terminated, or revoked, within the meaning of
paragraph (i) of this section, C's section 1295 election remained in
effect and therefore applies to the stock of FC purchased by C in 2002.
C therefore is subject in 2002 to the income inclusion and reporting
rules required of shareholders of QEFs.
Example 3. The facts are the same as in Example (2) except that C is
a partner in domestic partnership P and C transferred its FC stock to P
in 1999. Because C had made a section 1295 election in 1998 with respect
to stock of FC, and the election had not been invalidated, terminated,
or revoked, within the meaning of paragraph (i) of this section, C's
section 1295 election remains in effect with respect to its indirect
interest in the stock of FC. If P does not make the section 1295
election with respect to the FC stock, C will continue to be subject, in
C's capacity as an indirect shareholder of FC, to the income inclusion
and reporting rules required of shareholders of QEFs in 1999 and
subsequent years for that portion of the FC stock C is treated as owning
indirectly through the partnership. If P makes the section 1295
election, C will take into account its pro rata shares of the ordinary
earnings and net capital gain of the FC under the rules applicable to
inclusions of income from P.
(d) Who may make a section 1295 election--(1) General rule. Except
as otherwise provided in this paragraph (d), any U.S. person that is a
shareholder (as defined in paragraph (j) of this section) of a PFIC,
including a shareholder that holds stock of a PFIC in bearer form, may
make a section 1295 election with respect to that PFIC. The shareholder
need not own directly or indirectly any stock of the PFIC at the time
the shareholder makes the section 1295 election provided the shareholder
is a shareholder of the PFIC during the taxable year of the PFIC that
ends with or within the taxable year of the shareholder for which the
section 1295 election is made. Except in the case of a shareholder that
is an exempt organization that may not make a section 1295 election, as
provided in paragraph (d)(6) of this section, in a chain of ownership
only the first U.S. person that is a shareholder of the PFIC may make
the section 1295 election.
(2) Application of general rule to pass through entities--(i)
Partnerships--(A) Domestic partnership. A domestic partnership that
holds an interest in stock of a PFIC makes the section 1295 election
with request to that PFIC. The partnership election applies only to the
stock of the PFIC held directly or indirectly by the partnership and not
to any other stock held directly or indirectly by any partner. As
provided in Sec. 1.1293-1(c)(1), shareholders owning stock of a QEF by
reason of an interest in the partnership take into account the section
1293 inclusions with respect to the QEF shares owned by the partnership
under the rules applicable to inclusions of income from the partnership.
(B) Foreign partnership. A U.S. person that holds an interest in a
foreign partnership that, in turn, holds an interest in stock of a PFIC
makes the section 1295 election with respect to that PFIC. A partner's
election applies to the stock of the PFIC owned directly or indirectly
by the foreign partnership and to any other stock of the PFIC owned by
that partner. A section 1295 election by a partner applies only to that
partner.
(ii) S corporation. An S corporation that holds an interest in stock
of a PFIC makes the section 1295 election with respect to that PFIC. The
S corporation election applies only to the stock of the PFIC held
directly or indirectly by the S corporation and not to any other stock
held directly or indirectly by any S corporation shareholder. As
provided in Sec. 1.1293-1(c)(1), shareholders owning stock of a QEF by
reason of an interest in the S corporation take into account the section
1293 inclusions with respect to the QEF shares under the rules
applicable to inclusions of income from the S corporation.
(iii) Trust or estate--(A) Domestic trust or estate--(1) Nongrantor
trust or estate.
[[Page 644]]
A domestic nongrantor trust or a domestic estate that holds an interest
in stock of a PFIC makes the section 1295 election with respect to that
PFIC. The trust or estate's election applies only to the stock of the
PFIC held directly or indirectly by the trust or estate and not to any
other stock held directly or indirectly by any beneficiary. As provided
in Sec. 1.1293-1(c)(1), shareholders owning stock of a QEF by reason of
an interest in a domestic trust or estate take into account the section
1293 inclusions with respect to the QEF shares under the rules
applicable to inclusions of income from the trust or estate.
(2) Grantor trust. A U.S. person that is treated under sections 671
through 678 as the owner of the portion of a domestic trust that owns an
interest in stock of a PFIC makes the section 1295 election with respect
to that PFIC. If that person ceases to be treated as the owner of the
portion of the trust that owns an interest in the PFIC stock and is a
beneficiary of the trust, that person's section 1295 election will
continue to apply to the PFIC stock indirectly owned by that person
under the rules of paragraph (c)(2)(iv) of this section as if the person
had transferred its interest in the PFIC stock to the trust. However,
the stock will be treated as stock of a PFIC that is not a QEF with
respect to other beneficiaries of the trust, unless the trust makes the
section 1295 election as provided in paragraph (d)(2)(iii)(A)(1) of this
section.
(B) Foreign trust or estate--(1) Nongrantor trust or estate. A U.S.
person that is a beneficiary of a foreign nongrantor trust or estate
that holds an interest in stock of a PFIC makes the section 1295
election with respect to that PFIC. A beneficiary's section 1295
election applies to all the PFIC stock owned directly and indirectly by
the trust or estate and to the other PFIC stock owned directly or
indirectly by the beneficiary. A section 1295 election by a beneficiary
applies only to that beneficiary.
(2) Grantor trust. A U.S. person that is treated under sections 671
through 679 as the owner of the portion of a foreign trust that owns an
interest in stock of a PFIC stock makes the section 1295 election with
respect to that PFIC. If that person ceases to be treated as the owner
of the portion of the trust that owns an interest in the PFIC stock and
is a beneficiary of the trust, that person's section 1295 election will
continue to apply to the PFIC stock indirectly owned by that person
under the rules of paragraph (c)(2)(iv) of this section. However, as
provided in paragraph (d)(2)(iii)(B)(1) of this section, any other
shareholder that is a beneficiary of the trust and that wishes to treat
the PFIC as a QEF must make the section 1295 election.
(iv) Indirect ownership of the pass through entity or the PFIC. The
rules of this paragraph (d)(2) apply whether or not the shareholder
holds its interest in the pass through entity directly or indirectly and
whether or not the pass through entity holds its interest in the PFIC
directly or indirectly.
(3) Indirect ownership of a PFIC through other PFICs--(i) In
general. An election under section 1295 shall apply only to the foreign
corporation for which an election is made. Therefore, if a shareholder
makes an election under section 1295 to treat a PFIC as a QEF, that
election applies only to stock in that foreign corporation and not to
the stock in any other corporation which the shareholder is treated as
owning by virtue of its ownership of stock in the QEF.
(ii) Example. The following example illustrates the rules of
paragraph (d)(3)(i) of this section:
Example. In 1988, T, a U.S. person, purchased stock of FC, a foreign
corporation that is a PFIC. FC also owns the stock of SC, a foreign
corporation that is a PFIC. T makes an election under section 1295 to
treat FC as a QEF. T's section 1295 election applies only to the stock T
owns in FC, and does not apply to the stock T indirectly owns in SC.
(4) Member of consolidated return group as shareholder. Pursuant to
Sec. 1.1502-77(a), the common parent of an affiliated group of
corporations that join in filing a consolidated income tax return makes
a section 1295 election for all members of the affiliated group. An
election by a common parent will be effective for all members of the
affiliated group with respect to interests in PFIC stock held at the
time the election is
[[Page 645]]
made or at any time thereafter. A separate election must be made by the
common parent for each PFIC of which a member of the affiliated group is
a shareholder.
(5) Option holder. A holder of an option to acquire stock of a PFIC
may not make a section 1295 election that will apply to the option or to
the stock subject to the option.
(6) Exempt organization. A tax-exempt organization that is not
taxable under section 1291, pursuant to Sec. 1.1291-1(e), with respect
to a PFIC may not make a section 1295 election with respect to that
PFIC. In addition, such an exempt organization will not be subject to
any section 1295 election made by a domestic pass through entity.
(e) Time for making a section 1295 election--(1) In general. Except
as provided in Sec. 1.1295-3, a shareholder making the section 1295
election must make the election on or before the due date, as extended
under section 6081 (election due date), for filing the shareholder's
income tax return for the first taxable year to which the election will
apply. The section 1295 election must be made in the original return for
that year, or in an amended return, provided the amended return is filed
on or before the election due date.
(2) Examples. The following examples illustrate the rules of
paragraph (e)(1) of this section:
Example 1. In 1998, C, a domestic corporation, purchased stock of
FC, a foreign corporation that is a PFIC. Both C and FC are calendar
year taxpayers. C wishes to make the section 1295 election for its
taxable year ended December 31, 1998. The section 1295 election must be
made on or before March 15, 1999, the due date of C's 1998 income tax
return as provided by section 6072(b). On March 14, 1999, C files a
request for a three-month extension of time to file its 1998 income tax
return under section 6081(b). C's time to file its 1998 income tax
return and to make the section 1295 election is thereby extended to June
15, 1999.
Example 2. The facts are the same as in Example 1 except that on May
1, 1999, C filed its 1998 income tax return and failed to include the
section 1295 election. C may file an amended income tax return for 1998
to make the section 1295 election provided the amended return is filed
on or before the extended due date of June 15, 1999.
(f) Manner of making a section 1295 election and the annual election
requirements of the shareholder--(1) Manner of making the election. A
shareholder must make a section 1295 election by--
(i) Completing Form 8621 in the manner required by that form and
this section for making the section 1295 election;
(ii) Attaching Form 8621 to its Federal income tax return filed by
the election due date for the shareholder's election year; and
(iii) Receiving and reflecting in Form 8621 the information provided
in the PFIC Annual Information Statement described in paragraph (g)(1)
of this section, the Annual Intermediary Statement described in
paragraph (g)(3) of this section, or the applicable combined statement
described in paragraph (g)(4) of this section, for the taxable year of
the PFIC ending with or within the taxable year for which Form 8621 is
being filed. If the PFIC Annual Information Statement contains a
statement described in paragraph (g)(1)(ii)(C) of this section, the
shareholder must attach a statement to Form 8621 that indicates that the
shareholder rather than the PFIC calculated the PFIC's ordinary earnings
and net capital gain.
(2) Annual election requirements--(i) In general. A shareholder that
makes a section 1295 election with respect to a PFIC held directly or
indirectly, for each taxable year to which the section 1295 election
applies, must--
(A) Complete Form 8621 in the manner required by that form and this
section;
(B) Attach Form 8621 to its Federal income tax return filed by the
due date of the return, as extended; and
(C) Receive and reflect in Form 8621 the PFIC Annual Information
Statement described in paragraph (g)(1) of this section, the Annual
Intermediary Statement described in paragraph (g)(3) of this section, or
the applicable combined statement described in paragraph (g)(4) of this
section, for the MTtaxable year of the PFIC ending with or within the
taxable year for which Form 8621 is being filed. If the PFIC Annual
Information Statement contains a statement described in paragraph
(g)(1)(ii)(C) of this section, the shareholder must attach a statement
to its Form 8621 that the shareholder
[[Page 646]]
rather than the PFIC provided the calculations of the PFIC's ordinary
earnings and net capital gain.
(ii) Retention of documents. For all taxable years subject to the
section 1295 election, the shareholder must retain copies of all Forms
8621, with their attachments, and PFIC Annual Information Statements or
Annual Intermediary Statements. Failure to produce those documents at
the request of the Commissioner in connection with an examination may
result in invalidation or termination of the shareholder's section 1295
election.
(3) Effective date. See paragraph (k) of this section for special
applicability date of paragraph (f) of this section.
(g) Annual election requirements of the PFIC or intermediary--(1)
PFIC Annual Information Statement. For each year of the PFIC ending in a
taxable year of a shareholder to which the shareholder's section 1295
election applies, the PFIC must provide the shareholder with a PFIC
Annual Information Statement. The PFIC Annual Information Statement is a
statement of the PFIC, signed by the PFIC or an authorized
representative of the PFIC, that contains the following information and
representations--
(i) The first and last days of the taxable year of the PFIC to which
the PFIC Annual Information Statement applies;
(ii) Either--
(A) The shareholder's pro rata shares of the ordinary earnings and
net capital gain (as defined in Sec. 1.1295-1(a)(2)) of the PFIC for
the taxable year indicated in paragraph (g)(1)(i) of this section; or
(B) Sufficient information to enable the shareholder to calculate
its pro rata shares of the PFIC's ordinary earnings and net capital
gain, for that taxable year; or
(C) A statement that the foreign corporation has permitted the
shareholder to examine the books of account, records, and other
documents of the foreign corporation for the shareholder to calculate
the amounts of the PFIC's ordinary earnings and the net capital gain
according to Federal income tax accounting principles and to calculate
the shareholder's pro rata shares of the PFIC's ordinary earnings and
net capital gain;
(iii) The amount of cash and the fair market value of other property
distributed or deemed distributed to the shareholder during the taxable
year of the PFIC to which the PFIC Annual Information Statement
pertains; and
(iv) Either--
(A) A statement that the PFIC will permit the shareholder to inspect
and copy the PFIC's permanent books of account, records, and such other
documents as may be maintained by the PFIC to establish that the PFIC's
ordinary earnings and net capital gain are computed in accordance with
U.S. income tax principles, and to verify these amounts and the
shareholder's pro rata shares thereof; or
(B) In lieu of the statement required in paragraph (g)(1)(iv)(A) of
this section, a description of the alternative documentation
requirements approved by the Commissioner, with a copy of the private
letter ruling and the closing agreement entered into by the Commissioner
and the PFIC pursuant to paragraph (g)(2) of this section.
(2) Alternative documentation. In rare and unusual circumstances,
the Commissioner will consider alternative documentation requirements
necessary to verify the ordinary earnings and net capital gain of a PFIC
other than the documentation requirements described in paragraph
(g)(1)(iv)(A) of this section. Alternative documentation requirements
will be allowed only pursuant to a private letter ruling and a closing
agreement entered into by the Commissioner and the PFIC describing an
alternative method of verifying the PFIC's ordinary earnings and net
capital gain. If the PFIC has not obtained a private letter ruling from
the Commissioner approving an alternative method of verifying the PFIC's
ordinary earnings and net capital gain by the time a shareholder is
required to make a section 1295 election, the shareholder may not use an
alternative method for that taxable year.
(3) Annual Intermediary Statement. In the case of a U.S. person that
is an indirect shareholder of a PFIC that is owned through an
intermediary, as defined in paragraph (j) of this section, an Annual
Intermediary Statement
[[Page 647]]
issued by an intermediary containing the information described in
paragraph (g)(1) of this section and reporting the indirect
shareholder's pro rata share of the ordinary earnings and net capital
gain of the QEF as described in paragraph (g)(1)(ii)(A) of this section,
may be provided to the indirect shareholder in lieu of the PFIC Annual
Information Statement if the following conditions are satisfied--
(i) The intermediary receives a copy of the PFIC Annual Information
Statement or the intermediary receives an annual intermediary statement
from another intermediary which contains a statement that the other
intermediary has received a copy of the PFIC Annual Information
Statement and represents that the conditions of paragraphs (g)(3)(ii)
and (g)(3)(iii) of this section are met;
(ii) The representations and information contained in the Annual
Intermediary Statement reflect the representations and information
contained in the PFIC Annual Information Statement; and
(iii) The PFIC Annual Information Statement issued to the
intermediary contains either the representation set forth in paragraph
(g)(1)(iv)(A) of this section, or, if alternative documentation
requirements were approved by the Commissioner pursuant to paragraph
(g)(2) of this section, a copy of the private letter ruling and closing
agreement between the Commissioner and the PFIC, agreeing to an
alternative method of verifying PFIC ordinary earnings and net capital
gain as described in paragraph (g)(2) of this section;
(4) Combined statements--(i) PFIC Annual Information Statement. A
PFIC that owns directly or indirectly any stock of one or more PFICs
with respect to which a shareholder may make the section 1295 election
may prepare a PFIC Annual Information Statement that combines with its
own information and representations the information and representations
of all the PFICs. The PFIC may use any format for a combined PFIC Annual
Information Statement provided the required information and
representations are separately stated and identified with the respective
corporations.
(ii) Annual Intermediary Statement. An intermediary described in
paragraph (g)(3) of this section that owns directly or indirectly stock
of one or more PFICs with respect to which an indirect shareholder may
make the section 1295 election may prepare an Annual Intermediary
Statement that combines with its own information and representations the
information and representations with respect to all the PFICs. The
intermediary may use any format for a combined Annual Intermediary
Statement provided the required information and representations are
separately stated and identified with the intermediary and the
respective corporations.
(5) Effective date. See paragraph (k) of this section for special
applicability date of paragraph (g) of this section.
(h) Transition rules. Taxpayers may rely on Notice 88-125 (1988-2
C.B. 535) (see Sec. 601.601(d)(2) of this chapter), for rules on making
and maintaining elections for shareholder election years (as defined in
paragraph (j) of this section) beginning after December 31, 1986, and
before January 1, 1998. Elections made under Notice 88-125 must be
maintained as provided in Sec. 1.1295-1 for taxable years beginning
after December 31, 1997. A section 1295 election made prior to February
2, 1998 that was intended to be effective for the taxable year of the
PFIC that began during the shareholder's election year will be effective
for that taxable year of the foreign corporation provided that it is
clear from all the facts and circumstances that the shareholder intended
the election to be effective for that taxable year of the foreign
corporation.
(i) Invalidation, termination, or revocation of section 1295
election--(1) Invalidation or termination of election at the discretion
of the Commissioner--(i) In general. The Commissioner, in the
Commissioner's discretion, may invalidate or terminate a section 1295
election applicable to a shareholder if the shareholder, the PFIC, or
any intermediary fails to satisfy the requirements for making a section
1295 election or the annual election requirements of this section to
which the shareholder, PFIC, or intermediary is subject, including the
requirement to provide, on request, copies of the books and
[[Page 648]]
records of the PFIC or other documentation substantiating the ordinary
earnings and net capital gain of the PFIC.
(ii) Deferral of section 1293 inclusion. The Commissioner may
invalidate any pass through entity section 1295 election with respect to
an interest holder or beneficiary if the section 1293 inclusion with
respect to that interest holder or beneficiary is not included in the
gross income of either the pass through entity, an intermediate pass
through entity, or the interest holder or beneficiary within two years
of the end of the PFIC's taxable year due to nonconforming taxable years
of the interest holder and the pass through entity or any intermediate
pass through entity.
(iii) When effective. Termination of a shareholder's section 1295
election will be effective for the taxable year of the PFIC determined
by the Commissioner in the Commissioner's discretion. An invalidation of
a shareholder's section 1295 election will be effective for the first
taxable year to which the section 1295 election applied, and the
shareholder whose election is invalidated will be treated as if the
section 1295 election was never made.
(2) Shareholder revocation--(i) In general. In the Commissioner's
discretion, upon a finding of a substantial change in circumstances, the
Commissioner may consent to a shareholder's request to revoke a section
1295 election. Request for revocation must be made by the shareholder
that made the election and at the time and in the manner provided in
paragraph (i)(2)(ii) of this section.
(ii) Time for and manner of requesting consent to revoke--(A) Time.
The shareholder must request consent to revoke the section 1295 election
no later than 12 calendar months after the discovery of the substantial
change of circumstances that forms the basis for the shareholder's
request to revoke the section 1295 election.
(B) Manner of making request. A shareholder requests consent to
revoke a section 1295 election by filing a ruling request with the
Office of the Associate Chief Counsel (International). The ruling
request must satisfy the requirements, including payment of the user
fee, for filing ruling requests with that office.
(iii) When effective. Unless otherwise determined by the
Commissioner, revocation of a section 1295 election will be effective
for the first taxable year of the PFIC beginning after the date the
Commissioner consents to the revocation.
(3) Automatic termination. If a United States person, or the United
States shareholder on behalf of a controlled foreign corporation, makes
an election pursuant to section 1296 and the regulations thereunder with
respect to PFIC stock for which a QEF election is in effect, or marks to
market such stock under another provision of chapter 1 of the Internal
Revenue Code, the QEF election is automatically terminated with respect
to such stock that is marked to market under section 1296 or another
provision of chapter 1 of the Internal Revenue Code. Such termination
shall be effective on the last day of the shareholder's taxable year
preceding the first taxable year for which the section 1296 election is
in effect or such stock is marked to market under another provision of
chapter 1 of the Internal Revenue Code.
Example. Corp Y, a domestic corporation, owns directly 100 shares of
marketable stock in foreign corporation FX, a PFIC. Corp Y also owns a
50 percent interest in FP, a foreign partnership that owns 200 shares of
FX stock. Accordingly, under section 1298(a)(3) and Sec. 1.1296-
1(e)(1), Corp Y is treated as indirectly owning 100 shares of FX stock.
Corp Y also owns 100 percent of the stock of FZ, a foreign corporation
that is not a PFIC. FZ owns 100 shares of FX stock, and therefore under
section 1298(a)(2)(A), Corp Y is treated as owning the 100 shares of FX
stock owned by FZ. For taxable year 2005, Corp Y has a QEF election in
effect with respect to all 300 shares of FX stock that it owns directly
or indirectly. See generally Sec. 1.1295-1(c)(1). For taxable year
2006, Corp Y makes a timely election pursuant to section 1296 and the
regulations thereunder. For purposes of section 1296, Corp Y is treated
as owning stock held indirectly through a partnership, but not through a
foreign corporation. Section 1296(g); Sec. 1.1296-1(e)(1). Accordingly,
Corp Y's section 1296 election covers the 100 shares it owns directly
and the 100 shares it owns indirectly through FP, but not the 100 shares
owned by FZ. With respect to the first 200 shares, Corp Y's QEF election
is automatically terminated effective December 31, 2005. With respect to
the 100 shares Corp Y owns
[[Page 649]]
through foreign FZ, Corp Y's QEF election remains in effect unless
invalidated, terminated, or revoked pursuant to this paragraph (i).
(4) Effect of invalidation, termination, or revocation. An
invalidation, termination, or revocation of a section 1295 election--
(i) Terminates all section 1294 elections, as provided in Sec.
1.1294-1T(e), and the undistributed PFIC earnings tax liability and
interest thereon are due by the due date, without regard to extensions,
for the return for the last taxable year of the shareholder to which the
section 1295 election applies;
(ii) In the Commissioner's discretion, results in a deemed sale of
the QEF stock on the last day of the PFIC's last taxable year as a QEF,
in which gain, but not loss, will be recognized and with respect to
which appropriate basis and holding period adjustments will be made; and
(iii) Subjects the shareholder to any other terms and conditions
that the Commissioner determines are necessary to ensure the
shareholder's compliance with sections 1291 through 1298 or any other
provisions of the Code.
(5) Effect after invalidation, termination, or revocation--(i) In
general. Without the Commissioner's consent, a shareholder whose section
1295 election was invalidated, terminated, or revoked under this
paragraph (i) may not make the section 1295 election with respect to the
PFIC before the sixth taxable year in which the invalidation,
termination, or revocation became effective.
(ii) Special rule. Notwithstanding paragraph (i)(5)(i) of this
section, a shareholder whose section 1295 election was terminated
pursuant to paragraph (i)(3) of this section, and either whose section
1296 election has subsequently been terminated because its PFIC stock
ceased to be marketable or who no longer marks to market such stock
under another provision of chapter 1 of the Internal Revenue Code, may
make a section 1295 election with respect to its PFIC stock before the
sixth taxable year in which its prior section 1295 election was
terminated.
(j) Definitions. For purposes of this section--
Intermediary is a nominee or shareholder of record that holds stock
on behalf of the shareholder or on behalf of another person in a chain
of ownership between the shareholder and the PFIC, and any direct or
indirect beneficial owner of PFIC stock (including a beneficial owner
that is a pass through entity) in the chain of ownership between the
shareholder and the PFIC.
Pass through entity is a partnership, S corporation, trust, or
estate.
Shareholder has the same meaning as the term shareholder in Sec.
1.1291-9(j)(3), except that for purposes of this section, a partnership
and an S corporation also are treated as shareholders. Furthermore,
unless otherwise provided, an interest holder of a pass through entity,
which is treated as a shareholder of a PFIC, also will be treated as a
shareholder of the PFIC.
Shareholder's election year is the taxable year of the shareholder
for which it made the section 1295 election.
(k) Effective dates. Except as otherwise provided, paragraphs
(b)(2)(iii), (b)(3), (b)(4), and (c) through (j) of this section are
applicable to taxable years of shareholders beginning after December 31,
1997. However, taxpayers may apply the rules under paragraphs (b)(4),
(f) and (g) of this section to a taxable year beginning before January
1, 1998, provided the statute of limitations on the assessment of tax
has not expired as of April 27, 1998, and, in the case of paragraph
(b)(4) of this section, the taxpayers who filed the joint return have
consistently applied the rules of that section to all taxable years
following the year the election was made. Paragraph (b)(3)(v) of this
section is applicable as of February 7, 2000, however, a taxpayer may
apply the rules to a taxable year prior to the applicable date provided
the statute of limitations on the assessment of tax for that taxable
year has not expired. Paragraphs (i)(3) and (i)(5)(ii) of this section
are applicable for taxable years beginning on or after May 3, 2004.
[T.D. 8750, 63 FR 15, Jan. 2, 1998. Redesignated and amended by T.D.
8870, 65 FR 5779, 5781, Feb. 7, 2000; T.D. 9123, 69 FR 24073, May 3,
2004]
Sec. 1.1295-3 Retroactive elections.
(a) In general. This section prescribes the exclusive rules under
which a shareholder, as defined in Sec. 1.1295-1(j),
[[Page 650]]
may make a section 1295 election for a taxable year after the election
due date, as defined in Sec. 1.1295-1(e) (retroactive election).
Therefore, a shareholder may not seek such relief under any other
provision of the law, including Sec. 301.9100 of this chapter.
Paragraph (b) of this section describes the general rules for a
shareholder to preserve the ability to make a retroactive election.
These rules require that the shareholder possess reasonable belief as of
the election due date that the foreign corporation was not a PFIC for
its taxable year that ended in the shareholder's taxable year to which
the election due date pertains, and that the shareholder file a
Protective Statement to preserve its ability to make a retroactive
election. Paragraph (c) of this section establishes the terms,
conditions and other requirements with respect to a Protective Statement
required to be filed under the general rules. Paragraph (d) of this
section sets forth factors that establishes a shareholder's reasonable
belief that a foreign corporation was not a PFIC. Paragraph (e) of this
section prescribes special rules for certain shareholders that are
deemed to satisfy the reasonable belief requirement and therefore are
not required to file a Protective Statement. Paragraph (f) of this
section describes the limited circumstances under which the Commissioner
may permit a shareholder that lacked the requisite reasonable belief or
failed to satisfy the requirements of paragraph (b) or (e) of this
section to make a retroactive election. Paragraph (g) of this section
provides the time for and manner of making a retroactive election.
Paragraph (h) of this section provides the effective date of this
section.
(b) General rule. Except as provided in paragraphs (e) and (f) of
this section, a shareholder may make a retroactive election for a
taxable year of the shareholder (retroactive election year) only if the
shareholder--
(1) Reasonably believed, within the meaning of paragraph (d) of this
section, that as of the election due date, as defined in Sec. 1.1295-
1(e), the foreign corporation was not a PFIC for its taxable year that
ended during the retroactive election year;
(2) Filed a Protective Statement with respect to the foreign
corporation, applicable to the retroactive election year, in which the
shareholder described the basis for its reasonable belief and extended,
in the manner provided in paragraph (c)(4) of this section, the periods
of limitations on the assessment of taxes determined under sections 1291
and 1298 with respect to the foreign corporation (PFIC related taxes)
for all taxable years of the shareholder to which the Protective
Statement applies; and
(3) Complied with the other terms and conditions of the Protective
Statement.
(c) Protective Statement--(1) In general. A Protective Statement is
a statement executed under penalties of perjury by the shareholder, or a
person authorized to sign a Federal income tax return on behalf of the
shareholder, that preserves the shareholder's ability to make a
retroactive election. To file a Protective Statement that applies to a
taxable year of the shareholder, the shareholder must reasonably believe
as of the election due date that the foreign corporation was not a PFIC
for the foreign corporation's taxable year that ended during the
retroactive election year. The Protective Statement must contain--
(i) The shareholder's reasonable belief statement, as described in
paragraph (c)(2) of this section;
(ii) The shareholder's agreement extending the periods of
limitations on the assessment of PFIC related taxes for all taxable
years to which the Protective Statement applies, as provided in
paragraph (c)(4) of this section; and
(iii) The following information and representations--
(A) The shareholder's name, address, taxpayer identification number,
and the shareholder's first taxable year to which the Protective
Statement applies;
(B) The foreign corporation's name, address, and taxpayer
identification number, if any; and
(C) The highest percentage of shares of each class of stock of the
foreign corporation held directly or indirectly by the shareholder
during the shareholder's first taxable year to which the Protective
Statement applies.
[[Page 651]]
(2) Reasonable belief statement. The Protective Statement must
contain a reasonable belief statement, as described in paragraph (c)(1)
of this section. The reasonable belief statement is a description of the
shareholder's basis for its reasonable belief that the foreign
corporation was not a PFIC for its taxable year that ended with or
within the shareholder's first taxable year to which the Protective
Statement applies. If the Protective Statement applies to a taxable year
or years described in paragraph (c)(5)(ii) of this section, the
reasonable belief statement must describe the shareholder's basis for
its reasonable belief that the foreign corporation was not a PFIC for
the foreign corporation's taxable year or years that ended in such
taxable year or years of the shareholder. The reasonable belief
statement must discuss the application of the income and asset tests to
the foreign corporation and the factors, including those stated in
paragraph (d) of this section, that affect the results of those tests.
(3) Who executes and files the Protective Statement. The person that
executes and files and Protective Statement is the person that makes the
section 1295 election, as provided in Sec. 1.1295-1(d).
(4) Waiver of the periods of limitations--(i) Time for and manner of
extending periods of limitations. (A) In general. A shareholder that
files the Protective Statement with the Commissioner must extend the
periods of limitations on the assessment of all PFIC related taxes for
all of the shareholder's taxable years to which the Protective Statement
applies, as provided in this paragraph (c)(4). The shareholder is
required to execute the waiver on such form as the Commission may
prescribe for purposes of this paragraph (c)(4). Until that form is
published, the shareholder must execute a statement in which the
shareholder agrees to extend the periods of limitations on the
assessment of all PFIC related taxes for all the shareholder's taxable
years to which the Protective Statement applies, as provided in this
paragraph (c)(4), and agrees to the restrictions in paragraph
(c)(4)(ii)(A) of this section. The shareholder or a person authorized to
sign the shareholder's Federal income tax return must sign the form or
statement. A properly executed form or statement authorized by this
paragraph (c)(4) will be deemed consented to and signed by a Service
Center Director or the Assistant Commissioner (International) for
purposes of Sec. 301.6501(c)-1(d) of this chapter.
(B) Application of general rule to domestic partnerships-- (1) In
general. A domestic partnership that holds an interest in stock of a
PFIC satisfies the waiver requirement of paragraph (c)(4) of this
section pursuant to the rules of this paragraph (c)(4)(i)(B)(1). The
partnership must file one or more waivers obtained or arranged under
this paragraph (c)(4)(i)(B) as part of the Protective Statement, as
provided in paragraph (c)(1) of this section. The partnership must
either--
(i) Obtain from each partner the partner's waiver of the periods of
limitations;
(ii) Obtain from each partner a duly executed power of attorney
under Sec. 601.501 of this chapter authorizing the partnership to
extend that partner's periods of limitations, and execute a waiver on
behalf of the partners; or
(iii) In the case of a domestic partnership governed by the unified
audit and litigation procedures of sections 6221 through 6233 (TEFRA
partnership), arrange for the tax matters partner (or any other person
authorized to enter into an agreement to extend the periods of
limitations), as provided in section 6229(b), to execute a waiver on
behalf of all the partners.
(2) Special rules--(i) Addition of partner to non-TEFRA partnership.
In the case of any individual who becomes a partner in a domestic
partnership other than a TEFRA partnership (non-TEFRA partnership) in a
taxable year subsequent to the year in which the partnership filed a
Protective Statement, the partner and the partnership must comply with
the rules applicable to non-TEFRA partnerships, as provided in paragraph
(c)(4)(i)(B)(1) of this section, by the due date, as extended, for the
Federal income tax return of the partnership for the taxable year during
which the individual became a partner. Failure to so comply will render
the Protective Statement invalid with respect to the partnership and
partners.
[[Page 652]]
(ii) Change in status from non-TEFRA partnership to TEFRA
partnership. If a partnership is a non-TEFRA partnership in one taxable
year but becomes a TEFRA partnership in a subsequent taxable year, the
partnership must file one or more waivers obtained or arranged under
this paragraph (c)(4)(i)(B)(2)(ii), as part of the Protective Statement,
as provided in paragraph (c)(1) of this section. The partnership must
either--obtain from any new partner the partner's waiver described in
this paragraph (c)(4); obtain from the new partner a duly executed power
of attorney under Sec. 601.501 of this chapter authorizing the
partnership to extend the partner's periods of limitations, and execute
a waiver on behalf of the new partner; or arrange for the tax matters
partner (or any other person authorized to enter into an agreement to
extend the periods of limitations) to execute a waiver on behalf of all
the partners. In each case, the partnership must attach any new waiver
of a partner's periods of limitations, and a copy of the Protective
Statement to its Federal income tax return for that taxable year.
(C) Application of general rule to domestic nongrantor trusts and
domestic estates. A domestic nongrantor trust or a domestic estate that
holds an interest in stock of a PFIC satisfies the waiver requirement of
this paragraph (c)(4) at the entity level. For this purpose, such entity
must comply with rules similar to those applicable to non-TEFRA
partnerships, as provided in paragraph (c)(4)(i)(B)(1) of this section.
(D) Application of general rule to S corporations. An S corporation
that holds an interest in stock of a PFIC satisfies the waiver
requirement of this paragraph (c)(4) at the S corporation level. For
this purpose, the S corporation must comply with rules similar to those
applicable to non-TEFRA partnerships, as provided in paragraph
(c)(4)(i)(B)(1) of this section. However, in the case of an S
corporation that was governed by the unified audit corporate proceedings
of sections 6241 through 6245 for any taxable year to which a Protective
Statement applies (former TEFRA S corporation), the tax matters person
(or any other person authorized to enter into such an agreement), as was
provided in sections 6241 through 6245, may execute a waiver described
in this paragraph (c)(4) that applies to such taxable year; for any
other taxable year, the former TEFRA S corporation must comply with
rules similar to those applicable to non-TEFRA partnerships.
(E) Effect on waiver of complete termination of a pass through
entity or pass through entity's business. The complete termination of a
pass through entity described in paragraphs (c)(4)(i) (B) through (D) of
this section, or a pass through entity's trade or business, will not
terminate a waiver that applies to a partner, shareholder, or
beneficiary.
(F) Application of general rule to foreign partnerships, foreign
trusts, domestic or foreign grantor trusts, and foreign estates. A U.S.
person that is a partner or beneficiary of a foreign partnership,
foreign trust, or foreign estate that holds an interest in stock of a
PFIC satisfies the waiver requirement of this paragraph (c)(4) at the
partner or beneficiary level. A U.S. person that is treated under
sections 671 through 679 as the owner of the portion of a domestic or
foreign trust that owns an interest in PFIC stock also satisfies the
waiver requirement at the owner level. A waiver by a partner or
beneficiary applies only to that partner or beneficiary, and is not
affected by a complete termination of the entity or the entity's trade
or business.
(ii) Terms of waiver--(A) Scope of waiver. The waiver of the periods
of limitations is limited to the assessment of PFIC related taxes. If
the period of limitations for a taxable year affected by a retroactive
election has expired with respect to the assessment of other non-PFIC
related taxes, no adjustments, other than consequential changes, may be
made by the Internal Revenue Service or by the shareholder to any other
item of income, deduction, or credit for that year. If the period of
limitations for refunds or credits for a taxable year affected by a
retroactive election is open only by virtue of the assessment period
extension and section 6511(c), no refund or credit is allowable on
grounds other than adjustments to PFIC related taxes and consequential
changes.
[[Page 653]]
(B) Period of Waiver. The extension of the periods of limitations on
the assessment of PFIC related taxes will be effective for all of the
shareholder's taxable years to which the Protective Statement applies.
In addition, the waiver, to the extent it applies to the period of
limitations for a particular year, will terminate with respect to that
year no sooner than three years from the date on which the shareholder
files an amended return, as provided in paragraph (g) of this section,
for that year. For the suspension of the running of the period of
limitations for the collection of taxes for which a shareholder has
elected under section 1294 to extend the time for payment, as provided
in paragraph (g)(3)(ii) of this section, see sections 6503(i) and
6229(h).
(5) Time of and manner for filing a Protective Statement--(i) In
general. Except as provided in paragraph (c)(5)(ii) of this section, a
Protective Statement must be attached to the shareholder's federal
income tax return for the shareholder's first taxable year to which the
Protective Statement will apply. The shareholder must file its return
and the copy of the Protective Statement by the due date, as extended
under section 6081, for the return.
(ii) Special rule for taxable years ended before January 2, 1998. A
shareholder may file a Protective Statement that applies to the
shareholder's taxable year or years that ended before January 2, 1998,
provided the period of limitations on the assessment of taxes for any
such year has not expired (open year). The shareholder must file the
Protective Statement applicable to such open year or years, as provided
in paragraph (c)(5)(i) of this section, by the due date, as extended,
for the shareholder's return for the first taxable year ending after
January 2, 1998.
(6) Applicability of the Protective Statement--(i) In general.
Except as otherwise provided in this paragraph (c)(6), a Protective
Statement applies to the shareholder's first taxable year for which the
Protective Statement was filed and to each subsequent taxable year. The
Protective Statement will not apply to any taxable year of the
shareholder during which the shareholder does not own any stock of the
foreign corporation or to any taxable year thereafter. Accordingly, if
the shareholder has not made a retroactive election with respect to the
previously owned stock by the time the shareholder reacquires stock of
the foreign corporation, the shareholder must file another Protective
Statement to preserve its right to make a retroactive election with
respect to the later acquired stock. For the rule that provides that a
section 1295 election made with respect to a foreign corporation applies
to stock of that corporation acquired after a lapse in ownership, see
Sec. 1.1295-1(c)(2)(iii).
(ii) Invalidity of the Protective Statement. A shareholder will be
treated as if it never filed a Protective Statement if--
(A) The shareholder failed to make a retroactive election by the
date prescribed for making the retroactive election in paragraph (g)(1)
of this section; or
(B) The waiver of the periods of limitations terminates (by reason
of a court decision or other determination) with respect to any taxable
year before the expiration of three years from the date of filing of an
amended return for that year pursuant to paragraph (g) of this section.
(7) Retention of Protective Statement and information demonstrating
reasonable belief. A shareholder that files a Protective Statement must
retain a copy of the Protective Statement and its attachments and must,
for each taxable year of the shareholder to which the Protective
Statement applies, retain information sufficient to demonstrate the
shareholder's reasonable belief that the foreign corporation was not a
PFIC for the taxable year of the foreign corporation ending during each
such taxable year of the shareholder.
(d) Reasonable belief--(1) In general. A foreign corporation is a
PFIC for a taxable year if the foreign corporation satisfies either the
income or asset test of section 1297(a). To determine whether a
shareholder had reasonable belief that the foreign corporation is not a
PFIC under section 1297(a), the shareholder must consider all relevant
facts and circumstances. Reasonable belief may be based on a variety of
factors, including reasonable asset valuations as well
[[Page 654]]
as reasonable interpretations of the applicable provisions of the Code,
regulations, and administrative guidance regarding the direct and
indirect ownership of the income or assets of the foreign corporation,
the proper character of that income or those assets, and similar issues.
Reasonable belief may be based on reasonable predictions regarding
income to be earned and assets to be owned in subsequent years where
qualifications of the foreign corporation as a PFIC for the current
taxable year will depend on the qualification of the corporation as a
PFIC in a subsequent year. Reasonable belief may be based on an analysis
of generally available financial information of the foreign corporation.
To determine whether a shareholder had reasonable belief that the
foreign corporation was not a PFIC, the Commissioner may consider the
size of the shareholder's interest in the foreign corporation.
(2) Knowledge of law required. Reasonable belief must be based on a
good faith effort to apply the Code, regulations, and related
administrative guidance. Any person's failure to know or apply these
provisions will not form the basis of reasonable belief.
(e) Special rules for qualified shareholders--(1) In general. A
shareholder that is a qualified shareholder, as defined in paragraph
(e)(2) of this section, for a taxable year of the shareholder is not
required to satisfy the reasonable belief requirement of paragraph
(b)(1) of this section or file a Protective Statement to preserve its
ability to make a retroactive election with respect to such taxable
year. Accordingly, a qualified shareholder may make a retroactive
election for any open taxable year in the shareholder's holding period.
The retroactive election will be treated as made in the earliest taxable
year of the shareholder during which the foreign corporation qualified
as a PFIC (including a taxable year ending prior to January 2, 1998) and
the shareholder will be treated as a shareholder of a pedigreed QEF, as
defined in Sec. 1.1291-9(j)(2)(ii), provided the shareholder--
(i) Has been a qualified shareholder with respect to the foreign
corporation for all taxable years of the shareholder included in the
shareholder's holding period during which the foreign corporation was a
PFIC, or in the case of taxable years ending before January 2, 1998, the
shareholder satisfies the criteria of a qualified shareholder, for all
such years; or
(ii) Has been a qualified shareholder, or in the case of taxable
years ending before January 2, 1998 satisfies the criteria of a
qualified shareholder, for all taxable years in its holding period
before it filed a Protective Statement, which Protective Statement is
applicable to all subsequent years, beginning with the first taxable
year in which the shareholder is not a qualified shareholder.
(2) Qualified shareholder. A shareholder will be treated as a
qualified shareholder for a taxable year if the shareholder did not file
a Protective Statement applicable to an earlier taxable year included in
the shareholder's holding period of the stock of the foreign corporation
currently held and--
(i) At all times during the taxable year the shareholder owned,
within the meaning of section 958, directly, indirectly, or
constructively, less than two percent of the vote and value of each
class of stock of the foreign corporation; and
(ii) With respect to the taxable year of the foreign corporation
ending within the shareholder's taxable year, the foreign corporation or
U.S. counsel for the foreign corporation indicated in a public filing,
disclosure statement or other notice provided to U.S. persons that are
shareholders of the foreign corporation (corporate filing) that the
foreign corporation--
(A) Reasonably believes that it is not or should not constitute a
PFIC for the corporation's taxable year; or
(B) Is unable to conclude that it is not or should not be a PFIC
(due to certain asset valuation or interpretation issues, or because
PFIC status will depend on the income or assets of the foreign
corporation in the corporation's subsequent taxable years) but
reasonably believes that, more likely than not, it ultimately will not
be a PFIC.
(3) Exceptions. Notwithstanding paragraph (e)(2)(ii) of this
section, a shareholder will not be treated as a qualified shareholder
for a taxable year of the
[[Page 655]]
shareholder if the shareholder knew or had reason to know that a
corporate filing regarding the foreign corporation's PFIC status was
inaccurate, or knew that the foreign corporation was a PFIC for the
taxable year of the foreign corporation ending with or within such
taxable year of the shareholder. For purposes of this paragraph, a
shareholder will be treated as knowing that a foreign corporation was a
PFIC if the principal activity of the foreign corporation, directly or
indirectly, is owning or trading a diversified portfolio of stock,
securities, or other financial contracts.
(f) Special consent--(1) In general. A shareholder that has not
satisfied the requirements of paragraph (b) or (e) of this section may
request the consent of the Commissioner to make a retroactive election
for a taxable year of the shareholder provided the shareholder satisfies
the requirements set forth in this paragraph (f). The Commissioner will
grant relief under this paragraph (f) only if--
(i) The shareholder reasonably relied on a qualified tax
professional, within the meaning of paragraph (f)(2) of this section;
(ii) Granting consent will not prejudice the interests of the United
States government, as provided in paragraph (f)(3) of this section;
(iii) The shareholder requests consent under paragraph (f) of this
section before a representative of the Internal Revenue Service raises
upon audit the PFIC status of the corporation for any taxable year of
the shareholder; and
(iv) The shareholder satisfies the procedural requirements set forth
in paragraph (f)(4) of this section.
(2) Reasonable reliance on a qualified tax professional--(i) In
general. Except as provided in paragraph (f)(2)(ii) of this section, a
shareholder is deemed to have reasonably relied on a qualified tax
professional only if the shareholder reasonably relied on a qualified
tax professional (including a tax professional employed by the
shareholder) who failed to identify the foreign corporation as a PFIC or
failed to advise the shareholder of the consequences of making, or
failing to make, the section 1295 election. A shareholder will not be
considered to have reasonably relied on a qualified tax professional if
the shareholder knew, or reasonably should have known, that the foreign
corporation was a PFIC and of the availability of a section 1295
election, or knew or reasonably should have known that the qualified tax
professional--
(A) Was not competent to render tax advice with respect to the
ownership of shares of a foreign corporation; or
(B) Did not have access to all relevant facts and circumstances.
(ii) Shareholder deemed to have not reasonably relied on a qualified
tax professional. For purposes of this paragraph (f)(2), a shareholder
is deemed to have not reasonably relied on a qualified tax professional
if the shareholder was informed by the qualified tax professional that
the foreign corporation was a PFIC and of the availability of the
section 1295 election and related tax consequences, but either chose not
to make the section 1295 election or was unable to make a valid section
1295 election.
(3) Prejudice to the interests of the United States government--(1)
General rule. Except as otherwise provided in paragraph (f)(3)(ii) of
this section, the Commissioner will not grant consent under paragraph
(f) of this section if doing so would prejudice the interests of the
United States government. The interests of the United States government
are prejudiced if granting relief would result in the shareholder having
a lower tax liability, taking into account applicable interest charges,
in the aggregate for all years affected by the retroactive election
(other than by a de minimis amount) than the shareholder would have had
if the shareholder had made the section 1295 election by the election
due date. The time value of money is taken into account for purposes of
this computation.
(ii) Elimination of prejudice to the interests of the United States
government. Notwithstanding the general rule of paragraph (f)(3)(i) of
this section, if granting relief would prejudice the interests of the
United States government, the Commissioner may, in the Commissioner's
sole discretion, grant consent to make the election provided the
shareholder enters into a closing agreement with the Commissioner that
requires the shareholder to pay an
[[Page 656]]
amount sufficient to eliminate any prejudice to the United States
government as a consequence of the shareholder's inability to file
amended returns for closed taxable years.
(4) Procedural requirements--(i) Filing instructions. A shareholder
requests consent under paragraph (f) of this section to make a
retroactive election by filing with the Office of the Associate Chief
Counsel (International) a ruling request that includes the affidavits
required by this paragraph (f)(4). The ruling request must satisfy the
requirements, including payment of the user fee, for ruling requests
filed with that office.
(ii) Affidavit from shareholder. The shareholder, or a person
authorized to sign a Federal income tax return on behalf of the
shareholder, must submit a detailed affidavit describing the events that
led to the failure to make a section 1295 election by the election due
date, and to the discovery thereof. The shareholder's affidavit must
describe the engagement and responsibilities of the qualified tax
professional as well as the extent to which the shareholder relied on
the tax professional. The shareholder must sign the affidavit under
penalties of perjury. An individual who signs for an entity must have
personal knowledge of the facts and circumstances at issue.
(iii) Affidavits from other persons. The shareholder must submit
detailed affidavits from individuals having knowledge or information
about the events that led to the failure to make a section 1295 election
by the election due date, and to the discovery thereof. These
individuals must include the qualified tax professional upon whose
advice the shareholder relied, as well as any individual (including an
employee of the shareholder) who made a substantial contribution to the
return's preparation, and any accountant or attorney, knowledgeable in
tax matters, who advised the shareholder with regard to its ownership of
the stock of the foreign corporation. Each affidavit must describe the
individual's engagement and responsibilities as well as the advice
concerning the tax treatment of the foreign corporation that that
individual provided to the shareholder. Each affidavit also must include
the individual's name, address, and taxpayer identification number, and
must be signed by the individual under penalties of perjury.
(iv) Other information. In connection with a request for consent
under this paragraph (f), a shareholder must provide any additional
information requested by the Commissioner.
(v) Notification of Internal Revenue Service. The shareholder must
notify the branch of the Associate Chief Counsel (International)
considering the request for relief under this paragraph (f) if, while
the shareholder's request for consent is pending, the Internal Revenue
Service begins an examination of the shareholder's return for the
retroactive election year or for any subsequent taxable year during
which the shareholder holds stock of the foreign corporation.
(vi) Who requests special consent under this paragraph (f) and who
enters into a closing agreement. The person that requests consent under
this paragraph (f) is the person that makes the section 1295 election,
as provided in Sec. 1.1295-1(d). If a shareholder is required to enter
into a closing agreement with the Commissioner, as described in
paragraph (f)(3)(ii) of this section, rules similar to those under
paragraphs (c)(4)(i) (B) through (E) of this section apply for purposes
of determining the person that enters into the closing agreement.
(g) Time for and manner of making a retroactive election--(1) Time
for making a retroactive election--(i) In general. Except as otherwise
provided in paragraph (g)(1)(ii) of this section, a shareholder must
make a retroactive election, in the manner provided in paragraph (g)(2)
of this section, on or before the due date, as extended, for the
shareholder's return--
(A) In the case of a shareholder that makes a retroactive election
pursuant to paragraph (b) or (e) of this section, for the taxable year
in which the shareholder determines or reasonably should have determined
that the foreign corporation was a PFIC; or
(B) In the case of a shareholder that obtains the consent of the
Commissioner pursuant to paragraph (f) of this section for the taxable
year in which such consent is granted.
[[Page 657]]
(ii) Transition rule. A shareholder that files a Protective
Statement for a taxable year described in paragraph (c)(5)(ii) of this
section may make a retroactive election by the due date, as extended,
for the return for the first taxable year ended after January 2, 1998
even if the shareholder determined or should have determined that the
foreign corporation was a PFIC for a year described in paragraph
(c)(5)(ii) of this section at any time on or before January 2, 1998.
(iii) Ownership not required at time retroactive election is made.
The shareholder need not own shares of the foreign corporation at the
time the shareholder makes a retroactive election with respect to the
foreign corporation.
(2) Manner of making a retroactive election. A shareholder that has
satisfied the requirements of paragraph (b) or (e) of this section, or a
shareholder that has been granted consent under paragraph (f) of this
section, must make a retroactive election in the manner provided in Form
8621 for making a section 1295 election, and must attach Form 8621 to an
amended return for the later of the retroactive election year or the
earliest open taxable year of the shareholder. The shareholder also must
file an amended return for each of its subsequent taxable years affected
by the retroactive election. In each amended return the shareholder must
redetermine its income tax liability for that year to take into account
the assessment of PFIC related taxes. If the period of limitations for
the assessment of taxes for a taxable year affected by the retroactive
election has expired except to the extent the waiver of limitations,
described in paragraph (c)(4) of this section, has extended such period,
no adjustments, other than consequential changes, may be made to any
other items of income, deduction, or credit in that year. In addition,
the shareholder must pay all taxes and interest owing by reason of the
PFIC and QEF status of the foreign corporation in those years (except to
the extent a section 1294 election extends the time to pay the taxes and
interest). A shareholder that filed a Protective Statement must attach
to Form 8621 filed with each amended return a representation that the
shareholder, until the taxable year in which it determined or reasonably
should have determined that the foreign corporation was a PFIC,
reasonably believed, within the meaning of paragraph (d) of this
section, that the foreign corporation was not a PFIC in the taxable year
for which the amended return is filed, and in all other taxable years to
which the Protective Statement applies. A shareholder that entered into
a closing agreement must comply with the terms of that agreement, as
provided in paragraph (f)(3)(ii) of this section, to eliminate any
prejudice to the United States government's interests, as described in
paragraph (f)(3) of this section.
(3) Who makes the retroactive election. The person that makes the
retroactive election is the person that makes the section 1295 election,
as provided in Sec. 1.1295-1(d). A partner, shareholder, or beneficiary
for which a pass through entity, as described in paragraphs (c)(4)(i)
(B) through (D) of this section, filed a Protective Statement may make a
retroactive election, if the pass through entity completely terminates
its business or otherwise ceases to exist.
(4) Other elections--(i) Section 1291(d)(2) election. If the foreign
corporation for which the shareholder makes a retroactive election will
be treated as an unpedigreed QEF, as defined in Sec. 1.1291-
9(j)(2)(iii), with respect to the shareholder, the shareholder may make
an election under section 1291(d)(2) to purge its holding period of the
years or parts of years before the effective date of the retroactive
election. If the qualification date, within the meaning of Sec. 1.1291-
9(e) or 1.1291-10(e), falls in a taxable year for which the period of
limitations has expired, the shareholder may treat the first day of the
retroactive election year as the qualification date. The shareholder may
make a section 1291(d)(2) election at the time that it makes the
retroactive election, but no later than two years after the date that
the amended return in which the retroactive election is made is filed.
For the requirements for making a section 1291(d)(2) election, see
Sec. Sec. 1.1291-9 and 1.1291-10.
(ii) Section 1294 election. A shareholder may make an election under
section 1294 to extend the time for payment of
[[Page 658]]
tax on the shareholder's pro rata shares of the ordinary earnings and
net capital gain of the foreign corporation reported in the
shareholder's amended return, and section 6621 interest attributable to
such tax, but only to the extent the tax and interest are attributable
to earnings that have not been distributed to the shareholder. The
shareholder must make a section 1294 election for a taxable year at the
time that it files its amended return for that year, as provided in
paragraph (g)(1) of this section. For the requirements for making a
section 1294 election, see Sec. 1.1294-1T.
(h) Effective date. The rules of this section are effective as of
January 2, 1998.
[T.D. 8750, 63 FR 19, Jan. 2, 1998. Redesignated and amended by T.D.
8870, 65 FR 5781, Feb. 7, 2000]
Sec. 1.1296-1 Mark to market election for marketable stock.
(a) Definitions--(1) Eligible RIC. An eligible RIC is a regulated
investment company that offers for sale, or has outstanding, any stock
of which it is the issuer and which is redeemable at net asset value, or
that publishes net asset valuations at least annually.
(2) Section 1296 stock. The term section 1296 stock means marketable
stock in a passive foreign investment company (PFIC), including any PFIC
stock owned directly or indirectly by an eligible RIC, for which there
is a valid section 1296 election. Section 1296 stock does not include
stock of a foreign corporation that previously had been a PFIC, and for
which a section 1296 election remains in effect.
(3) Unreversed inclusions--(i) General rule. The term unreversed
inclusions means with respect to any section 1296 stock, the excess, if
any, of--
(A) The amount of mark to market gain included in gross income of
the United States person under paragraph (c)(1) of this section with
respect to such stock for prior taxable years; over
(B) The amount allowed as a deduction to the United States person
under paragraph (c)(3) of this section with respect to such stock for
prior taxable years.
(ii) Section 1291 adjustment. The amount referred to in paragraph
(a)(3)(i)(A) of this section shall include any amount subject to section
1291 under the coordination rule of paragraph (i)(2)(ii) of this
section.
(iii) Example. An example of the computation of unreversed
inclusions is as follows:
Example. A, a United States person, acquired stock in Corp X, a
foreign corporation, on January 1, 2005 for $150. At such time and at
all times thereafter, Corp X was a PFIC and A's stock in Corp X was
marketable. For taxable years 2005 and 2006, Corp X was a nonqualified
fund subject to taxation under section 1291. A made a timely section
1296 election with respect to the X stock, effective for taxable year
2007. The fair market value of the X stock was $200 as of December 31,
2006, and $240 as of December 31, 2007. Additionally, Corp X made no
distribution with respect to its stock for the taxable years at issue.
In 2007, pursuant to paragraph (i)(2)(ii) of this section, A must
include the $90 gain in the X stock in accordance with the rules of
section 1291 for purposes of determining the deferred tax amount and any
applicable interest. Nonetheless, for purposes of determining the amount
of the unreversed inclusions pursuant to paragraph (a)(3)(ii) of this
section, A will include the $90 of gain that was taxed under section
1291 and not the interest thereon.
(iv) Special rule for regulated investment companies. In the case of
a regulated investment company which had elected to mark to market the
PFIC stock held by such company as of the last day of the taxable year
preceding such company's first taxable year for which such company makes
a section 1296 election, the amount referred to in paragraph
(a)(3)(i)(A) of this section shall include amounts previously included
in gross income by the company pursuant to such mark to market election
with respect to such stock for prior taxable years. For further
guidance, see Notice 92-53 (1992-2 C.B. 384) (see also 601.601(d)(2) of
this chapter).
(b) Application of section 1296 election--(1) In general. Any United
States person and any controlled foreign corporation (CFC) that owns
directly, or is treated as owning under this section, marketable stock,
as defined in Sec. 1.1296-2, in a PFIC may make an election to mark to
market such stock in accordance with the provisions of section 1296 and
this section.
(2) Election applicable to specific United States person. A section
1296 election
[[Page 659]]
applies only to the United States person (or CFC that is treated as a
U.S. person under paragraph (g)(2) of this section) that makes the
election. Accordingly, a United States person's section 1296 election
will not apply to a transferee of section 1296 stock.
(3) Election applicable to specific corporation only. A section 1296
election is made with respect to a single foreign corporation, and thus
a separate section 1296 election must be made for each foreign
corporation that otherwise meets the requirements of this section. A
United States person's section 1296 election with respect to stock in a
foreign corporation applies to all marketable stock of the corporation
that the person owns directly, or is treated as owning under paragraph
(e) of this section, at the time of the election or that is subsequently
acquired.
(c) Effect of election--(1) Recognition of gain. If the fair market
value of section 1296 stock on the last day of the United States
person's taxable year exceeds its adjusted basis, the United States
person shall include in gross income for its taxable year the excess of
the fair market value of such stock over its adjusted basis (mark to
market gain).
(2) Character of gain. Mark to market gain, and any gain on the sale
or other disposition of section 1296 stock, shall be treated as ordinary
income.
(3) Recognition of loss. If the adjusted basis of section 1296 stock
exceeds its fair market value on the last day of the United States
person's taxable year, such person shall be allowed a deduction for such
taxable year equal to the lesser of the amount of such excess or the
unreversed inclusions with respect to such stock (mark to market loss).
(4) Character of loss--(i) Losses not in excess of unreversed
inclusions. Any mark to market loss allowed as a deduction under
paragraph (c)(3) of this section, and any loss on the sale or other
disposition of section 1296 stock, to the extent that such loss does not
exceed the unreversed inclusions attributable to such stock, shall be
treated as an ordinary loss, deductible in computing adjusted gross
income.
(ii) Losses in excess of unreversed inclusions. Any loss recognized
on the sale or other disposition of section 1296 stock in excess of any
prior unreversed inclusions will be subject to the rules generally
applicable to losses provided elsewhere in the Internal Revenue Code and
the regulations thereunder.
(5) Application of election to separate lots of stock. In the case
in which a United States person purchased or acquired shares of stock in
a PFIC at different prices, the rules of this section shall be applied
in a manner consistent with the rules of Sec. 1.1012-1.
(6) Source rules. The source of any amount included in gross income
under paragraph (c)(1) of this section, or the allocation and
apportionment of any amount allowed as a deduction under paragraph
(c)(3) of this section, shall be determined in the same manner as if
such amounts were gain or loss (as the case may be) from the sale of
stock in the PFIC.
(7) Examples. The following examples illustrate this paragraph (c):
Example 1. Treatment of gain as ordinary income. A, a United States
individual, purchases stock in FX, a foreign corporation that is not a
PFIC, in 1990 for $1,000. On January 1, 2005, when the fair market value
of the FX stock is $1,100, FX becomes a PFIC. A makes a timely section
1296 election for taxable year 2005. On December 31, 2005, the fair
market value of the FX stock is $1,200. For taxable year 2005, A
includes $200 of mark to market gain (the excess of the fair market
value of FX stock ($1,200) over A's adjusted basis ($1,000)) in gross
income as ordinary income and pursuant to paragraph (d)(1) of this
section increases his basis in the FX stock by that amount.
Example 2. Treatment of gain as capital gain. The facts are the same
as in Example 1. For taxable year 2006, FX does not satisfy either the
asset test or the income test of section 1297(a). A does not revoke the
section 1296 election it made with respect to the FX stock. On December
1, 2006, A sells the FX stock when the fair market value of the stock is
$1,500. For taxable year 2006, A includes $300 of gain (the excess of
the fair market value of FX stock ($1,500) over A's adjusted basis
($1,200)) in gross income as long-term capital gain because at the time
of sale of the FX stock by A, FX did not qualify as a PFIC, and,
therefore, the FX stock was not section 1296 stock at the time of the
disposition. Further, A's holding period for non-PFIC purposes was more
than one year.
Example 3. Treatment of losses as ordinary where they do not exceed
unreversed inclusions. The facts are the same as in Example 1. On
December 1, 2006, A sells the stock in FX for $1,100. At that time, A's
unreversed inclusions (the amount A included in income as
[[Page 660]]
mark to market gain) with respect to the stock in FX are $200.
Accordingly, for taxable year 2006, A recognizes a loss on the sale of
the FX stock of $100, (the fair market value of the FX stock ($1,100)
minus A's adjusted basis ($1,200) in the stock) that is treated as an
ordinary loss because the loss does not exceed the unreversed inclusions
attributable to the stock of FX.
Example 4. Treatment of losses as long-term capital losses. The
facts are the same as in Example 3, except that FX does not satisfy
either the asset test or the income test of section 1297(a) for taxable
year 2006. For taxable year 2006, A's $100 loss from the sale of the FX
stock is treated as long-term capital loss because at the time of the
sale of the FX stock by A FX did not qualify as a PFIC, and, therefore,
the FX stock was not section 1296 stock at the time of the disposition.
Further, A's holding period in the FX stock for non-PFIC purposes was
more than one year.
Example 5. Long-term capital loss treatment of losses in excess of
unreversed inclusions. The facts are the same as in Example 3, except
that A sells his FX stock for $900. At the time of A's sale of the FX
stock on December 1, 2006, A's unreversed inclusions with respect to the
FX stock are $200. Accordingly, the $300 loss recognized by A on the
disposition is treated as an ordinary loss to the extent of his
unreversed inclusions ($200). The amount of the loss in excess of A's
unreversed inclusions ($100) will be treated as a long-term capital loss
because A's holding period in the FC stock for non-PFIC purposes was
more than one year.
Example 6. Application of section 1296 election to separate lots of
stock. On January 1, 2005, Corp A, a domestic corporation, purchased 100
shares (first lot) of stock in FX, a PFIC, for $500 ($5 per share). On
June 1, 2005, Corp A purchased 100 shares (second lot) of FX stock for
$1,000 ($10 per share). Corp A made a timely section 1296 election with
respect to its FX stock for taxable year 2005. On December 31, 2005, the
fair market value of FX stock was $8 per share. For taxable year 2005,
Corp A includes $300 of gain in gross income as ordinary income under
paragraph (c)(1) of this section with respect to the first lot, and
adjusts its basis in that lot to $800 pursuant to paragraph (d)(1) of
this section. With respect to the second lot, Corp A is not permitted to
recognize a loss under paragraph (c)(3) of this section for taxable year
2005. Although Corp A's adjusted basis in that stock exceeds its fair
market value by $200, Corp A has no unreversed inclusions with respect
to that particular lot of stock. On July 1, 2006, Corp A sells 100
shares of FX stock for $900. Assuming that Corp A adequately identifies
(in accordance with the rules of Sec. 1.1012-1(c)) the shares of FX
stock sold as being from the second lot, Corp A recognizes $100 of long
term capital loss pursuant to paragraph (c)(4)(ii) of this section.
(d) Adjustment to basis--(1) Stock held directly. The adjusted basis
of the section 1296 stock shall be increased by the amount included in
the gross income of the United States person under paragraph (c)(1) of
this section with respect to such stock, and decreased by the amount
allowed as a deduction to the United States person under paragraph
(c)(3) of this section with respect to such stock.
(2) Stock owned through certain foreign entities. (i) In the case of
section 1296 stock that a United States person is treated as owning
through certain foreign entities pursuant to paragraph (e) of this
section, the basis adjustments under paragraph (d)(1) of this section
shall apply to such stock in the hands of the foreign entity actually
holding such stock, but only for purposes of determining the subsequent
treatment under chapter 1 of the Internal Revenue Code of the United
States person with respect to such stock. Such increase or decrease in
the adjusted basis of the section 1296 stock shall constitute an
adjustment to the basis of partnership property only with respect to the
partner making the section 1296 election. Corresponding adjustments
shall be made to the adjusted basis of the United States person's
interest in the foreign entity and in any intermediary entity described
in paragraph (e) of this section through which the United States person
holds the PFIC stock.
(ii) Example. The following example illustrates this paragraph
(d)(2):
Example. FP is a foreign partnership. Corp A, a domestic
corporation, owns a 20 percent interest in FP. Corp B, a domestic
corporation, owns a 30 percent interest in FP. Corp C, a foreign
corporation, with no direct or indirect shareholders that are U.S.
persons, owns a 50% interest in FP. Corp A, Corp B, and FP all use a
calendar year for their taxable year. In 2005, FP purchases stock in FX,
a foreign corporation and a PFIC, for $1,000. Corp A makes a timely
section 1296 election for taxable year 2005. On December 31, 2005, the
fair market value of the PFIC stock is $1,100. Corp A includes $20 of
ordinary income in taxable year 2005 under paragraphs (c)(1) and (2) of
this section. Corp A increases its basis in its FP partnership interest
by $20. FP increases its basis in the FX stock to $1,020 solely for
purposes of determining the
[[Page 661]]
subsequent treatment of Corp A, under chapter 1 of the Internal Revenue
Code, with respect to such stock. In 2006, FP sells the FX stock for
$1,200. For purposes of determining the amount of gain of Corp A, FP
will be treated as having $180 in gain of which $20 is allocated to Corp
A. Corp A's $20 of gain will be treated as ordinary income under
paragraph (c)(2) of this section. For purposes of determining the amount
of gain attributable to Corp B, FP will be treated as having $200 gain,
$60 of which will be allocated to Corp B.
(3) Stock owned indirectly by an eligible RIC. Paragraph (d)(2) of
this section shall also apply to an eligible RIC which is an indirect
shareholder under Sec. 1.1296-2(f) of stock in a PFIC and has a valid
section 1296 election in effect with respect to the PFIC stock.
(4) Stock acquired from a decedent. In the case of stock of a PFIC
that is acquired by bequest, devise, or inheritance (or by the
decedent's estate) and with respect to which a section 1296 election was
in effect as of the date of the decedent's death, notwithstanding
section 1014 or section 1022, the basis of such stock in the hands of
the person so acquiring it shall be the adjusted basis of such stock in
the hands of the decedent immediately before his death (or, if lesser,
the basis that would have been determined under section 1014 or section
1022 without regard to this paragraph (d)).
(5) Transition rule for individuals becoming subject to United
States income taxation--(i) In general. If any individual becomes a
United States person in a taxable year beginning after December 31,
1997, solely for purposes of this section, the adjusted basis, before
adjustments under this paragraph (d), of any section 1296 stock owned by
such individual on the first day of such taxable year shall be treated
as being the greater of its fair market value or its adjusted basis on
such first day.
(ii) An example of the transition rule for individuals becoming
subject to United States income taxation is as follows:
Example. A, a nonresident alien individual, purchases marketable
stock in FX, a PFIC, for $50 in 1995. On January 1, 2005, A becomes a
United States person and makes a timely section 1296 election with
respect to the stock in accordance with paragraph (h) of this section.
The fair market value of the FX stock on January 1, 2005, is $100. The
fair market value of the FX stock on December 31, 2005, is $110. Under
paragraph (d)(5)(i) of this section, A computes the amount of mark to
market gain or loss for the FX stock in 2005 by reference to an adjusted
basis of $100, and therefore A includes $10 in gross income as mark to
market gain under paragraph (c)(1) of this section. Additionally, under
paragraph (d)(1) of this section, A's adjusted basis in the FX stock for
purposes of this section is increased to $110 (and to $60 for all other
tax purposes). A sells the FX stock in 2006 for $120. For purposes of
applying section 1001, A must use its original basis of $50, with any
adjustments under paragraph (d)(1) of this section, $10 in this case,
and therefore A recognizes $60 of gain. Under paragraph (c)(2) of this
section (which is applied using an adjusted basis of $110), $10 of such
gain is treated as ordinary income. The remaining $50 of gain from the
sale of the FX stock is long term capital gain because A held such stock
for more than one year.
(e) Stock owned through certain foreign entities--(1) In general.
Except as provided in paragraph (e)(2) of this section, the following
rules shall apply in determining stock ownership for purposes of this
section. PFIC stock owned, directly or indirectly, by or for a foreign
partnership, foreign trust (other than a foreign trust described in
sections 671 through 679), or foreign estate shall be considered as
being owned proportionately by its partners or beneficiaries. PFIC stock
owned, directly or indirectly, by or for a foreign trust described in
sections 671 through 679 shall be considered as being owned
proportionately by its grantors or other persons treated as owners under
sections 671 through 679 of any portion of the trust that includes the
stock. The determination of a person's proportionate interest in a
foreign partnership, foreign trust or foreign estate will be made on the
basis of all the facts and circumstances. Stock considered owned by
reason of this paragraph shall, for purposes of applying the rules of
this section, be treated as actually owned by such person.
(2) Stock owned indirectly by eligible RICs. The rules for
attributing ownership of stock contained in Sec. 1.1296-2(f) will apply
to determine the indirect ownership of PFIC stock by an eligible RIC.
(f) Holding period. Solely for purposes of sections 1291 through
1298, if section 1296 applied to stock with respect to the taxpayer for
any prior taxable
[[Page 662]]
year, the taxpayer's holding period in such stock shall be treated as
beginning on the first day of the first taxable year beginning after the
last taxable year for which section 1296 so applied.
(g) Special rules--(1) Certain dispositions of stock. To the extent
a United States person is treated as actually owning stock in a PFIC
under paragraph (e) of this section, any disposition which results in
the United States person being treated as no longer owning such stock,
and any disposition by the person owning such stock, shall be treated as
a disposition by the United States person of the stock in the PFIC.
(2) Treatment of CFC as a United States person. In the case of a CFC
that owns, or is treated as owning under paragraph (e) of this section,
section 1296 stock:
(i) Other than with respect to the sourcing rules in paragraph
(c)(6) of this section, this section shall apply to the CFC in the same
manner as if such corporation were a United States person. The CFC will
be treated as a foreign person for purposes of applying the source rules
of paragraph (c)(6).
(ii) For purposes of subpart F of part III of subchapter N of the
Internal Revenue Code--
(A) Amounts included in the CFC's gross income under paragraph
(c)(1) or (i)(2)(ii) of this section shall be treated as foreign
personal holding company income under section 954(c)(1)(A); and
(B) Amounts allowed as a deduction under paragraph (c)(3) of this
section shall be treated as a deduction allocable to foreign personal
holding company income for purposes of computing net foreign base
company income under Sec. 1.954-1(c).
(iii) A United States shareholder, as defined in section 951(b), of
the CFC shall not be subject to section 1291 with respect to any stock
of the PFIC for the period during which the section 1296 election is in
effect for that stock, and the holding period rule of paragraph (f) of
this section shall apply to such United States shareholder.
(iv) The rules of this paragraph (g)(2) shall not apply to a United
States person that is a shareholder of the PFIC for purposes of section
1291, but is not a United States shareholder under section 951(b) with
respect to the CFC making a section 1296 election.
(3) Timing of inclusions for stock owned through certain foreign
entities. In the case of section 1296 stock that a United States person
is treated as owning through certain foreign entities pursuant to
paragraph (e) of this section, the mark to market gain or mark to market
loss is determined in accordance with paragraphs (c) and (i)(2)(ii) of
this section as of the last day of the taxable year of the foreign
partnership, foreign trust or foreign estate and then included in the
taxable year of such United States person that includes the last day of
the taxable year of the entity.
(h) Elections--(1) Timing and manner for making a section 1296
election--(i) United States persons. A United States person that owns
marketable stock in a PFIC, or is treated as owning marketable stock
under paragraph (e) of this section, on the last day of the taxable year
of such person, and that wants to make a section 1296 election, must
make a section 1296 election for such taxable year on or before the due
date (including extensions) of the United States person's income tax
return for that year. The section 1296 election must be made on the Form
8621, ``Return by a Shareholder of a Passive Foreign Investment Company
or Qualified Electing Fund'', included with the original tax return of
the United States person for that year, or on an amended return,
provided that the amended return is filed on or before the election due
date.
(ii) Controlled foreign corporations. A section 1296 election by a
CFC shall be made by its controlling United States shareholders, as
defined in Sec. 1.964-1(c)(5), and shall be included with the Form
5471, ``Information Return of U.S. Persons With Respect to Certain
Foreign Corporations'', for that CFC by the due date (including
extensions) of the original income tax returns of the controlling United
States shareholders for that year. A section 1296 election by a CFC
shall be binding on all United States shareholders of the CFC.
(iii) Retroactive elections for PFIC stock held in prior years. A
late section 1296 election may be permitted only in
[[Page 663]]
accordance with Sec. 301.9100 of this chapter.
(2) Effect of section 1296 election--(i) A section 1296 election
will apply to the taxable year for which such election is made and
remain in effect for each succeeding taxable year unless such election
is revoked or terminated pursuant to paragraph (h)(3) of this section.
(ii) Cessation of a foreign corporation as a PFIC. A United States
person will not include mark to market gain or loss pursuant to
paragraph (c) of this section with respect to any stock of a foreign
corporation for any taxable year that such foreign corporation is not a
PFIC under section 1297 or treated as a PFIC under section 1298(b)(1)
(taking into account the holding period rule of paragraph (f) of this
section). Cessation of a foreign corporation's status as a PFIC will
not, however, terminate a section 1296 election. Thus, if a foreign
corporation is a PFIC in a taxable year after a year in which it is not
treated as a PFIC, the United States person's original election (unless
revoked or terminated in accordance with paragraph (h)(3) of this
section) continues to apply and the shareholder must include any mark to
market gain or loss in such year.
(3) Revocation or termination of election--(i) In general. A United
States person's section 1296 election is terminated if the section 1296
stock ceases to be marketable; if the United States person elects, or is
required, to mark to market the section 1296 stock under another
provision of chapter 1 of the Internal Revenue Code; or if the
Commissioner, in the Commissioner's discretion, consents to the United
States person's request to revoke its section 1296 election upon a
finding of a substantial change in circumstances. A substantial change
in circumstances for this purpose may include a foreign corporation
ceasing to be a PFIC.
(ii) Timing of termination or revocation. Where a section 1296
election is terminated automatically (e.g., the stock ceases to be
marketable), section 1296 will cease to apply beginning with the taxable
year in which such termination occurs. Where a section 1296 election is
revoked with the consent of the Commissioner, section 1296 will cease to
apply beginning with the first taxable year of the United States person
after the revocation is granted unless otherwise provided by the
Commissioner.
(4) Examples. The operation of the rules of this paragraph (h) is
illustrated by the following examples:
Example 1. A, a United States person, owns stock in FX, a PFIC. A
makes a QEF election in 1996 with respect to the FX stock. For taxable
year 2005, A makes a timely section 1296 election with respect to its
stock, and thus its QEF election is automatically terminated pursuant to
Sec. 1.1295-1(i)(3). In 2006, A's stock in FX ceases to be marketable,
and therefore its section 1296 election is automatically terminated
under paragraph (h)(3) of this section. Beginning with taxable year
2006, A is subject to the rules of section 1291 with respect to its FX
stock unless it makes a new QEF election. See Sec. 1.1295-1(i)(5).
Example 2. The facts are the same as in Example 1, except that A's
stock in FX becomes marketable again in 2007. A may make a new section
1296 election with respect to the FX stock for its taxable year 2007, or
thereafter. A will be subject to the coordination rules under paragraph
(i) of this section unless it made a new QEF election in 2006.
(i) Coordination rules for first year of election--(1) In general.
Notwithstanding any provision in this section to the contrary, the rules
of this paragraph (i) shall apply to the first taxable year in which a
section 1296 election is effective with respect to marketable stock of a
PFIC if such foreign corporation was a PFIC for any taxable year, prior
to such first taxable year, during the United States person's holding
period (as defined in paragraph (f) of this section) in such stock, and
for which such corporation was not treated as a QEF with respect to such
United States person.
(2) Shareholders other than regulated investment companies. For the
first taxable year of a United States person (other than a regulated
investment company) for which a section 1296 election is in effect with
respect to the stock of a PFIC, such United States person shall, in lieu
of the rules of paragraphs (c) and (d) of this section--
(i) Apply the rules of section 1291 to any distributions with
respect to, or disposition of, section 1296 stock;
(ii) Apply section 1291 to the amount of the excess, if any, of the
fair market value of such section 1296 stock on the last day of the
United States person's taxable year over its adjusted basis, as
[[Page 664]]
if such amount were gain recognized from the disposition of stock on the
last day of the taxpayer's taxable year; and
(iii) Increase its adjusted basis in the section 1296 stock by the
amount of excess, if any, subject to section 1291 under paragraph
(i)(2)(ii) of this section.
(3) Shareholders that are regulated investment companies. For the
first taxable year of a regulated investment company for which a section
1296 election is in effect with respect to the stock of a PFIC, such
regulated investment company shall increase its tax under section 852 by
the amount of interest that would have been imposed under section
1291(c)(3) for such taxable year if such regulated investment company
were subject to the rules of paragraph (i)(2) of this section, and not
this paragraph (i)(3). No deduction or increase in basis shall be
allowed for the increase in tax imposed under this paragraph (i)(3).
(4) The operation of the rules of this paragraph (i) is illustrated
by the following examples:
Example (1). A, a United States person and a calendar year taxpayer,
owns marketable stock in FX, a PFIC that it acquired on January 1, 1992.
At all times, A's FX stock was a nonqualified fund subject to taxation
under section 1291. A made a timely section 1296 election effective for
taxable year 2005. At the close of taxable year 2005, the fair market
value of A's FX stock exceeded its adjusted basis by $10. Pursuant to
paragraph (i)(2)(ii) of this section, A must treat the $10 gain under
section 1291 as if the FX stock were disposed of on December 31, 2005.
Further, A increases its adjusted basis in the FX stock by the $10 in
accordance with paragraph (i)(2)(iii) of this section.
Example (2). Assume the same facts as in Example (1), except that A
is a RIC that had not made an election prior to 2005 to mark to market
the PFIC stock. In taxable year 2005, A includes $10 of ordinary income
under paragraph (c)(1) of this section, and such amount is not subject
to section 1291. A also increases its tax imposed under section 852 by
the amount of interest that would have been determined under section
1291(c)(3), and no deduction is permitted for such amount. Finally,
under paragraph (d)(1) of this section, A increases its adjusted basis
in the FX stock by $10.
(j) Effective/applicability date. The provisions in this section are
applicable for taxable years beginning on or after May 3, 2004. The
provisions of paragraph (d)(4) of this section relating to section 1022
are effective on and after January 19, 2017.
[T.D. 9123, 69 FR 24074, May 3, 2004, as amended by T.D. 9811, 82 FR
6242, Jan. 19, 2017]