March 28, 2003 CODE OF FEDERAL REGULATIONS 26 Part 1 (§§ 1.0-1 to 1.60) Revised as of April 1, 2003 Internal Revenue Containing a codification of documents of general applicability and future effect As of April 1, 2003 With Ancillaries

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 Table of Contents Page Explanation v Title 26: Chapter I—Internal Revenue Service, Department of the Treasury 3 Findings Aids: Table of CFR Titles and Chapters 557 Alphabetical List of Agencies Appearing in the CFR 575 Table of OMB Control Numbers 585 List of CFR Sections Affected 603

Cite this Code:CFR

To cite the regulations in this volume use title, part and section number. Thus, 26 CFR 1.0-1 refers to title 26, part 1, section 0-1. 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

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 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 dates and effective dates are usually not the same and care must be exercised by the user in determining the actual effective date. In instances where the effective date is beyond the cut-off date for the Code a note has been inserted to reflect the future effective date. In those instances where a regulation published in the Federal Register states a date certain for expiration, an appropriate note will be inserted following the text.

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 OBSOLETE PROVISIONS

Provisions that become obsolete before the revision date stated on the cover of each volume are not carried. Code users may find the text of provisions in effect on a given date in the past by using the appropriate numerical list of sections affected. For the period before January 1, 2001, consult either the List of CFR Sections Affected, 1949-1963, 1964-1972, 1973-1985, or 1986-2000, published in 11 separate volumes. For the period beginning January 1, 2001, a “List of CFR Sections Affected” is published at the end of each CFR volume.

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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 Statutory Authorities and Agency Rules (Table I). A list of CFR titles, chapters, and parts and an alphabetical list of agencies publishing in the CFR are also included in this volume.

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 Raymond A. Mosley, Director, Office of the Federal Register. April 1, 2003. THIS TITLE

Title 26—Internal Revenue is composed of twenty volumes. The contents of these volumes represent all current regulations issued by the Internal Revenue Service, Department of the Treasury, as of April 1, 2003. The first thirteen volumes comprise part 1 (Subchapter A—Income Tax) and are arranged by sections as follows: §§ 1.0-1-1.60; §§ 1.61-1.169; §§ 1.170-1.300; §§ 1.301-1.400; §§ 1.401-1.440; §§ 1.441-1.500; §§ 1.501-1.640; §§ 1.641-1.850; §§ 1.851-1.907; §§ 1.908-1.1000; §§ 1.1001-1.1400;§§ 1.1401—1.1503-2A; and§ 1.1551-1 to end. The fourteenth 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 § 602.101 of this chapter. For the convenience of the user, § 602.101 appears in the Finding Aids section of the volumes containing parts 1 to 599.

CFRORDR.FRM <LRH>26 CFR Ch. I (4-1-03 Edition)</LRH> <RRH>Internal Revenue Service, Treasury</RRH> <CFRTITLE> <TITLEHD> <PRTPAGE P="1"/> <HD SOURCE="HED">Title 26—Internal Revenue</HD> <P>(This book contains Part 1, §§ 1.0-1 to 1.60)</P> </TITLEHD> <CFRTOC> <PTHD>Part</PTHD> <CHAPTI> <SUBJECT> <E T="04">chapter i</E>—Internal Revenue Service, Department of the Treasury</SUBJECT> <PG>1</PG> </CHAPTI> </CFRTOC> </CFRTITLE> <CHAPTER> <TOC> <TOCHD> <PRTPAGE P="3"/> <HD SOURCE="HED">CHAPTER I—INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY</HD> <P>(Part 1, §§ 1.0-1 to 1.60)</P> </TOCHD> <EDNOTE> <HD SOURCE="HED">Editorial Note:</HD> <P>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, March 31, 1980.</P> </EDNOTE> <SUBCHAP> <HD SOURCE="HED">SUBCHAPTER A—INCOME TAX</HD> </SUBCHAP> <PTHD>Part</PTHD> <PGHD>Page</PGHD> <CHAPTI> <PT>1</PT> <SUBJECT>Income taxes</SUBJECT> <PG>5</PG> </CHAPTI> <SUPPLPUB> <HD SOURCE="HED">Supplementary Publications:</HD> <P> <E T="03">Internal Revenue Service Looseleaf Regulations System, Alcohol and Tobacco Tax Regulations,</E> and <E T="03">Regulations Under Tax Conventions.</E> </P> <P> <E T="04">Editorial Note:</E> Treasury Decision 6091, 19 FR 5167, Aug. 17, 1954, provides in part as follows:</P> <P> <E T="05">Paragraph 1.</E> All regulations (including all Treasury decisions) prescribed by, or under authority duly delegated by, the Secretary of the Treasury, or jointly by the Secretary and the Commissioner of Internal Revenue, or by the Commissioner of Internal Revenue with the approval of the Secretary of the Treasury, or jointly by the Commissioner of Internal Revenue and the Commissioner of Customs or the Commissioner of Narcotics with the approval of the Secretary of the Treasury, applicable under any provision of law in effect on the date of enactment of the Code, to the extent such provision of law is repealed by the Code, are hereby prescribed under and made applicable to the provisions of the Code corresponding to the provision of law so repealed insofar as any such regulation is not inconsistent with the Code. Such regulations shall become effective as regulations under the various provisions of the Code as of the dates the corresponding provisions of law are repealed by the Code, until superseded by regulations issued under the Code.</P> <P> <E T="05">Par. 2.</E> With respect to any provision of the Code which depends for its application upon the promulgation of regulations or which is to be applied in such manner as may be prescribed by regulations, all instructions or rules in effect immediately prior to the enactment of the Code, to the extent such instructions or rules could be prescribed as regulations under authority of such provision of the Code, shall be applied as regulations under such provision insofar as such instructions or rules are not inconsistent with the Code. Such instructions or rules shall be applied as regulations under the applicable provision of the Code as of the date such provision takes effect.</P> <P> <E T="05">Par. 3.</E> If any election made or other act done pursuant to any provision of the Internal Revenue Code of 1939 or prior internal revenue laws would (except for the enactment of the Code) be effective for any period subsequent to such enactment, and if corresponding provisions are contained in the Code, such election or other act shall be given the same effect under the corresponding provisions of the Code to the extent not inconsistent therewith. The term “act” includes, but is not limited to, an allocation, identification, declaration, agreement, option, waiver, relinquishment, or renunciation.</P> <P> <E T="05">Par. 4.</E> The limits of the various internal revenue districts have not been changed by the enactment of the Code. Furthermore, delegations of authority made pursuant to the provisions of Reorganization Plan No. 26 of 1950 and Reorganization Plan No. 1 of 1952 (as well as redelegations thereunder), including those governing the authority of the Commissioner of <PRTPAGE P="4"/>Internal Revenue, the Regional Commissioners of Internal Revenue, or the District Directors of Internal Revenue, are applicable to the provisions of the Code to the extent consistent therewith.</P> </SUPPLPUB> </TOC> <SUBCHAP TYPE="N"> <PRTPAGE P="5"/> <HD SOURCE="HED">SUBCHAPTER A—INCOME TAX</HD> <PART> <EAR>Pt. 1</EAR> <HD SOURCE="HED">PART 1—INCOME TAXES</HD> <CONTENTS> <SECHD>Sec.</SECHD> <SECTNO>1.0-1</SECTNO> <SUBJECT>Internal Revenue Code of 1954 and regulations.</SUBJECT> <SUBJGRP> <HD SOURCE="HED">Normal Taxes and Surtaxes</HD> <HD SOURCE="HD1">DETERMINATION OF TAX LIABILITY</HD> <HD SOURCE="HD3">Tax on Individuals</HD> <SECTNO>1.1-1</SECTNO> <SUBJECT>Income tax on individuals.</SUBJECT> <SECTNO>1.1-2</SECTNO> <SUBJECT>Limitation on tax.</SUBJECT> <SECTNO>1.1-3</SECTNO> <SUBJECT>Change in rates applicable to taxable year.</SUBJECT> <SECTNO>1.1(h)-1</SECTNO> <SUBJECT>Capital gains look-through rule for sales or exchanges of interests in a partnership, S corporation, or trust.</SUBJECT> <SECTNO>1.1(i)-1T</SECTNO> <SUBJECT>Questions and answers relating to the tax on unearned income certain minor children (Temporary).</SUBJECT> <SECTNO>1.2-1</SECTNO> <SUBJECT>Tax in case of joint return of husband and wife or the return of a surviving spouse.</SUBJECT> <SECTNO>1.2-2</SECTNO> <SUBJECT>Definitions and special rules.</SUBJECT> <SECTNO>1.3-1</SECTNO> <SUBJECT>Application of optional tax.</SUBJECT> <SECTNO>1.4-1</SECTNO> <SUBJECT>Number of exemptions.</SUBJECT> <SECTNO>1.4-2</SECTNO> <SUBJECT>Elections.</SUBJECT> <SECTNO>1.4-3</SECTNO> <SUBJECT>Husband and wife filing separate returns.</SUBJECT> <SECTNO>1.4-4</SECTNO> <SUBJECT>Short taxable year caused by death.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Tax on Corporations</HD> <SECTNO>1.11-1</SECTNO> <SUBJECT>Tax on corporations.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Changes in Rates During a Taxable Year</HD> <SECTNO>1.21-1</SECTNO> <SUBJECT>Changes in rate during a taxable year.</SUBJECT> <SECTNO>1.23-1</SECTNO> <SUBJECT>Residential energy credit.</SUBJECT> <SECTNO>1.23-2</SECTNO> <SUBJECT>Definitions.</SUBJECT> <SECTNO>1.23-3</SECTNO> <SUBJECT>Special rules.</SUBJECT> <SECTNO>1.23-4</SECTNO> <SUBJECT>Performance and quality standards. [Reserved]</SUBJECT> <SECTNO>1.23-5</SECTNO> <SUBJECT>Certification procedures.</SUBJECT> <SECTNO>1.23-6</SECTNO> <SUBJECT>Procedure and criteria for additions to the approved list of energy-conserving components or renewable energy sources.</SUBJECT> <SECTNO>1.25-1T</SECTNO> <SUBJECT>Credit for interest paid on certain home mortgages (Temporary).</SUBJECT> <SECTNO>1.25-2T</SECTNO> <SUBJECT>Amount of credit (Temporary).</SUBJECT> <SECTNO>1.25-3</SECTNO> <SUBJECT>Qualified mortgage credit certificate.</SUBJECT> <SECTNO>1.25-3T</SECTNO> <SUBJECT>Qualified mortgage credit certificate (Temporary).</SUBJECT> <SECTNO>1.25-4T</SECTNO> <SUBJECT>Qualified mortgage credit certificate program (Temporary).</SUBJECT> <SECTNO>1.25-5T</SECTNO> <SUBJECT>Limitation on aggregate amount of mortgage credit certificates (Temporary).</SUBJECT> <SECTNO>1.25-6T</SECTNO> <SUBJECT>Form of qualified mortgage credit certificate (Temporary).</SUBJECT> <SECTNO>1.25-7T</SECTNO> <SUBJECT>Public notice (Temporary).</SUBJECT> <SECTNO>1.25-8T</SECTNO> <SUBJECT>Reporting requirements (Temporary).</SUBJECT> <SECTNO>1.25A-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <SECTNO>1.25A-1</SECTNO> <SUBJECT>Calculation of education tax credit and general eligibility requirements.</SUBJECT> <SECTNO>1.25A-2</SECTNO> <SUBJECT>Definitions.</SUBJECT> <SECTNO>1.25A-3</SECTNO> <SUBJECT>Hope Scholarship Credit.</SUBJECT> <SECTNO>1.25A-4</SECTNO> <SUBJECT>Lifetime Learning Credit.</SUBJECT> <SECTNO>1.25A-5</SECTNO> <SUBJECT>Special rules relating to characterization and timing of payments.</SUBJECT> <SECTNO>1.28-0</SECTNO> <SUBJECT>Credit for clinical testing expenses for certain drugs for rare diseases or conditions; table of contents.</SUBJECT> <SECTNO>1.28-1</SECTNO> <SUBJECT>Credit for clinical testing expenses for certain drugs for rare diseases or conditions.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Credits Against Tax</HD> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">credits allowable under sections 30 through 45D</HD> <SECTNO>1.30-1</SECTNO> <SUBJECT>Definition of qualified electric vehicle and recapture of credit for qualified electric vehicle.</SUBJECT> <SECTNO>1.31-1</SECTNO> <SUBJECT>Credit for tax withheld on wages.</SUBJECT> <SECTNO>1.31-2</SECTNO> <SUBJECT>Credit for “special refunds” of employee social security tax.</SUBJECT> <SECTNO>1.32-2</SECTNO> <SUBJECT>Earned income credit for taxable years beginning after December 31, 1978.</SUBJECT> <SECTNO>1.32-3</SECTNO> <SUBJECT>Eligibility requirements after denial of the earned income credit.</SUBJECT> <SECTNO>1.34-1</SECTNO> <SUBJECT>Credit against tax and exclusion from gross income in case of dividends received by individuals.</SUBJECT> <SECTNO>1.34-2</SECTNO> <SUBJECT>Limitations on amount of credit.</SUBJECT> <SECTNO>1.34-3</SECTNO> <SUBJECT>Dividends to which the credit and exclusion apply.</SUBJECT> <SECTNO>1.34-4</SECTNO> <SUBJECT>Taxpayers not entitled to credit and exclusion.</SUBJECT> <SECTNO>1.34-5</SECTNO> <SUBJECT>Effective date; taxable years ending after July 31, 1954, subject to the Internal Revenue Code of 1939.</SUBJECT> <SECTNO>1.34-6</SECTNO> <SUBJECT>Dividends received after December 31, 1964.</SUBJECT> <SECTNO>1.35-1</SECTNO> <SUBJECT>Partially tax-exempt interest received by individuals.</SUBJECT> <SECTNO>1.35-2</SECTNO> <SUBJECT>Taxpayers not entitled to credit.</SUBJECT> <SECTNO>1.37-1</SECTNO> <SUBJECT>General rules for the credit for the elderly.</SUBJECT> <SECTNO>1.37-2</SECTNO> <SUBJECT>Credit for individuals age 65 or over.</SUBJECT> <SECTNO>1.37-3</SECTNO> <SUBJECT>Credit for individuals under age 65 who have public retirement system income.</SUBJECT> <SECTNO>1.38-1</SECTNO> <SUBJECT>Investment in certain depreciable property.</SUBJECT> <SECTNO>1.40-1</SECTNO> <SUBJECT>Questions and answers relating to the meaning of the term “qualified mixture” in section 40(b)(1).</SUBJECT> <SECTNO>1.41-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <SECTNO>1.41-1</SECTNO> <SUBJECT>Credit for increasing research activities.</SUBJECT> <SECTNO>1.41-2</SECTNO> <SUBJECT>Qualified Research Expenses.<PRTPAGE P="6"/> </SUBJECT> <SECTNO>1.41-3</SECTNO> <SUBJECT>Base amount for taxable years beginning on or after January 3, 2001.</SUBJECT> <SECTNO>1.41-4</SECTNO> <SUBJECT>Qualified research for expenditures paid or incurred on or after January 3, 2001.</SUBJECT> <SECTNO>1.41-4A</SECTNO> <SUBJECT>Qualified research for taxable years beginning before January 1, 1986.</SUBJECT> <SECTNO>1.41-5</SECTNO> <SUBJECT>Basic research for taxable years beginning after December 31, 1986. [Reserved]</SUBJECT> <SECTNO>1.41-5A</SECTNO> <SUBJECT>Basic research for taxable years beginning before January 1, 1987.</SUBJECT> <SECTNO>1.41-6</SECTNO> <SUBJECT>Aggregation of expenditures.</SUBJECT> <SECTNO>1.41-7</SECTNO> <SUBJECT>Special rules.</SUBJECT> <SECTNO>1.41-8</SECTNO> <SUBJECT>Special rules for taxable years ending on or after January 3, 2001.</SUBJECT> <SECTNO>1.42-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <SECTNO>1.42-1</SECTNO> <SUBJECT>[Reserved]</SUBJECT> <SECTNO>1.42-1T</SECTNO> <SUBJECT>Limitation on low-income housing credit allowed with respect to qualified low-income buildings receiving housing credit allocations from a State or local housing credit agency (temporary).</SUBJECT> <SECTNO>1.42-2</SECTNO> <SUBJECT>Waiver of requirement that an existing building eligible for the low-income housing credit was last placed in service more than 10 years prior to acquisition by the taxpayer.</SUBJECT> <SECTNO>1.42-3</SECTNO> <SUBJECT>Treatment of buildings financed with proceeds from a loan under an Affordable Housing Program established pursuant to section 721 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).</SUBJECT> <SECTNO>1.42-4</SECTNO> <SUBJECT>Application of not-for-profit rules of section 183 to low-income housing credit activities.</SUBJECT> <SECTNO>1.42-5</SECTNO> <SUBJECT>Monitoring compliance with low-income housing credit requirements.</SUBJECT> <SECTNO>1.42-6</SECTNO> <SUBJECT>Buildings qualifying for carryover allocations.</SUBJECT> <SECTNO>1.42-7</SECTNO> <SUBJECT>Substantially bond-financed buildings. [Reserved]</SUBJECT> <SECTNO>1.42-8</SECTNO> <SUBJECT>Election of appropriate percentage month.</SUBJECT> <SECTNO>1.42-9</SECTNO> <SUBJECT>For use by the general public.</SUBJECT> <SECTNO>1.42-10</SECTNO> <SUBJECT>Utility allowances.</SUBJECT> <SECTNO>1.42-11</SECTNO> <SUBJECT>Provision of services.</SUBJECT> <SECTNO>1.42-12</SECTNO> <SUBJECT>Effective dates and transitional rules.</SUBJECT> <SECTNO>1.42-13</SECTNO> <SUBJECT>Rules necessary and appropriate; housing credit agencies’ correction of administrative errors and omissions.</SUBJECT> <SECTNO>1.42-14</SECTNO> <SUBJECT>Allocation rules for post-1989 State housing credit ceiling amounts.</SUBJECT> <SECTNO>1.42-15</SECTNO> <SUBJECT>Available unit rule.</SUBJECT> <SECTNO>1.42-16</SECTNO> <SUBJECT>Eligible basis reduced by federal grants.</SUBJECT> <SECTNO>1.42-17</SECTNO> <SUBJECT>Qualified allocation plan.</SUBJECT> <SECTNO>1.42A-1</SECTNO> <SUBJECT>General tax credit for taxable years ending after December 31, 1975, and before January 1, 1979.</SUBJECT> <SECTNO>1.43-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <SECTNO>1.43-1</SECTNO> <SUBJECT>The enhanced oil recovery credit—general rules.</SUBJECT> <SECTNO>1.43-2</SECTNO> <SUBJECT>Qualified enhanced oil recovery project.</SUBJECT> <SECTNO>1.43-3</SECTNO> <SUBJECT>Certification.</SUBJECT> <SECTNO>1.43-4</SECTNO> <SUBJECT>Qualified enhanced oil recovery costs.</SUBJECT> <SECTNO>1.43-5</SECTNO> <SUBJECT>At-risk limitation. [Reserved]</SUBJECT> <SECTNO>1.43-6</SECTNO> <SUBJECT>Election out of section 43.</SUBJECT> <SECTNO>1.43-7</SECTNO> <SUBJECT>Effective date of regulations.</SUBJECT> <SECTNO>1.44-1</SECTNO> <SUBJECT>Allowance of credit for purchase of new principal residence after March 12, 1975, and before January 1, 1977.</SUBJECT> <SECTNO>1.44-2</SECTNO> <SUBJECT>Property to which credit for purchase of new principal residence applies.</SUBJECT> <SECTNO>1.44-3</SECTNO> <SUBJECT>Certificate by seller.</SUBJECT> <SECTNO>1.44-4</SECTNO> <SUBJECT>Recapture for certain dispositions.</SUBJECT> <SECTNO>1.44-5</SECTNO> <SUBJECT>Definitions.</SUBJECT> <SECTNO>1.44A-1</SECTNO> <SUBJECT>Expenses for household and dependent care services necessary for gainful employment.</SUBJECT> <SECTNO>1.44A-2</SECTNO> <SUBJECT>Limitations on amount creditable.</SUBJECT> <SECTNO>1.44A-3</SECTNO> <SUBJECT>Special rules applicable to married individuals.</SUBJECT> <SECTNO>1.44A-4</SECTNO> <SUBJECT>Other special rules relating to employment-related expenses.</SUBJECT> <SECTNO>1.44B-1</SECTNO> <SUBJECT>Credit for employment of certain new employees.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Research Credit—For Taxable Years Beginning Before January 1, 1990</HD> <SECTNO>1.41-0A</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <SECTNO>1.41-3A</SECTNO> <SUBJECT>Base period research expense.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">rules for computing credit for investment in certain depreciable property</HD> <SECTNO>1.45D-1T</SECTNO> <SUBJECT>New markets tax credit.</SUBJECT> <SECTNO>1.46-1</SECTNO> <SUBJECT>Determination of amount.</SUBJECT> <SECTNO>1.46-2</SECTNO> <SUBJECT>Carryback and carryover of unused credit.</SUBJECT> <SECTNO>1.46-3</SECTNO> <SUBJECT>Qualified investment.</SUBJECT> <SECTNO>1.46-4</SECTNO> <SUBJECT>Limitations with respect to certain persons.</SUBJECT> <SECTNO>1.46-5</SECTNO> <SUBJECT>Qualified progress expenditures.</SUBJECT> <SECTNO>1.46-6</SECTNO> <SUBJECT>Limitation in case of certain regulated companies.</SUBJECT> <SECTNO>1.46-7</SECTNO> <SUBJECT>Statutory provisions; plan requirements for taxpayers electing additional investment credit, etc.</SUBJECT> <SECTNO>1.46-8</SECTNO> <SUBJECT>Requirements for taxpayers electing additional one-percent investment credit (TRASOP's).</SUBJECT> <SECTNO>1.46-9</SECTNO> <SUBJECT>Requirements for taxpayers electing an extra one-half percent additional investment credit.</SUBJECT> <SECTNO>1.46-10</SECTNO> <SUBJECT>[Reserved]</SUBJECT> <SECTNO>1.46-11</SECTNO> <SUBJECT>Commuter highway vehicles.</SUBJECT> <SECTNO>1.47-1</SECTNO> <SUBJECT>Recomputation of credit allowed by section 38.</SUBJECT> <SECTNO>1.47-2</SECTNO> <SUBJECT>“Disposition” and “cessation”.</SUBJECT> <SECTNO>1.47-3</SECTNO> <SUBJECT>Exceptions to the application of § 1.47-1.</SUBJECT> <SECTNO>1.47-4</SECTNO> <SUBJECT>Electing small business corporation.</SUBJECT> <SECTNO>1.47-5</SECTNO> <SUBJECT>Estates and trusts.</SUBJECT> <SECTNO>1.47-6</SECTNO> <SUBJECT>Partnerships.</SUBJECT> <SECTNO>1.48-1</SECTNO> <SUBJECT>Definition of section 38 property.</SUBJECT> <SECTNO>1.48-2</SECTNO> <SUBJECT>New section 38 property.</SUBJECT> <SECTNO>1.48-3</SECTNO> <SUBJECT>Used section 38 property.</SUBJECT> <SECTNO>1.48-4</SECTNO> <SUBJECT>Election of lessor of new section 38 property to treat lessee as purchaser.</SUBJECT> <SECTNO>1.48-5</SECTNO> <SUBJECT>Electing small business corporations.<PRTPAGE P="7"/> </SUBJECT> <SECTNO>1.48-6</SECTNO> <SUBJECT>Estates and trusts.</SUBJECT> <SECTNO>1.48-9</SECTNO> <SUBJECT>Definition of energy property.</SUBJECT> <SECTNO>1.48-10</SECTNO> <SUBJECT>Single purpose agricultural or horticultural structures.</SUBJECT> <SECTNO>1.48-11</SECTNO> <SUBJECT>Qualified rehabilitated building; expenditures incurred before January 1, 1982.</SUBJECT> <SECTNO>1.48-12</SECTNO> <SUBJECT>Qualified rehabilitated building; expenditures incurred after December 31, 1981.</SUBJECT> <SECTNO>1.50-1</SECTNO> <SUBJECT>Restoration of credit.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">rules for computing credit for expenses of work incentive programs</HD> <SECTNO>1.50A-1</SECTNO> <SUBJECT>Determination of amount.</SUBJECT> <SECTNO>1.50A-2</SECTNO> <SUBJECT>Carryback and carryover of unused credit.</SUBJECT> <SECTNO>1.50A-3</SECTNO> <SUBJECT>Recomputation of credit allowed by section 40.</SUBJECT> <SECTNO>1.50A-4</SECTNO> <SUBJECT>Exceptions to the application of § 1.50A-3.</SUBJECT> <SECTNO>1.50A-5</SECTNO> <SUBJECT>Electing small business corporations.</SUBJECT> <SECTNO>1.50A-6</SECTNO> <SUBJECT>Estates and trusts.</SUBJECT> <SECTNO>1.50A-7</SECTNO> <SUBJECT>Partnerships.</SUBJECT> <SECTNO>1.50B-1</SECTNO> <SUBJECT>Definitions of WIN expenses and WIN employees.</SUBJECT> <SECTNO>1.50B-2</SECTNO> <SUBJECT>Electing small business corporations.</SUBJECT> <SECTNO>1.50B-3</SECTNO> <SUBJECT>Estates and trusts.</SUBJECT> <SECTNO>1.50B-4</SECTNO> <SUBJECT>Partnerships.</SUBJECT> <SECTNO>1.50B-5</SECTNO> <SUBJECT>Limitations with respect to certain persons.</SUBJECT> <SECTNO>1.51-1</SECTNO> <SUBJECT>Amount of credit.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Tax Surcharge</HD> <SECTNO>1.52-1</SECTNO> <SUBJECT>Trades or businesses that are under common control.</SUBJECT> <SECTNO>1.52-2</SECTNO> <SUBJECT>Adjustments for acquisitions and dispositions.</SUBJECT> <SECTNO>1.52-3</SECTNO> <SUBJECT>Limitations with respect to certain persons.</SUBJECT> <SECTNO>1.53-1</SECTNO> <SUBJECT>Limitation based on amount of tax.</SUBJECT> <SECTNO>1.53-2</SECTNO> <SUBJECT>Carryback and carryover of unused credit.</SUBJECT> <SECTNO>1.53-3</SECTNO> <SUBJECT>Separate rule for pass-through of jobs credit.</SUBJECT> <SECTNO>1.55-1</SECTNO> <SUBJECT>Alternative minimum taxable income.</SUBJECT> <SECTNO>1.56-0</SECTNO> <SUBJECT>Table of contents to § 1.56-1, adjustment for book income of corporations.</SUBJECT> <SECTNO>1.56-1</SECTNO> <SUBJECT>Adjustment for the book income of corporations.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Regulations Applicable to Taxable Years Beginning in 1969 and Ending in 1970</HD> <SECTNO>1.56A-1</SECTNO> <SUBJECT>Imposition of tax.</SUBJECT> <SECTNO>1.56A-2</SECTNO> <SUBJECT>Deferral of tax liability in case of certain net operating losses.</SUBJECT> <SECTNO>1.56A-3</SECTNO> <SUBJECT>Effective date.</SUBJECT> <SECTNO>1.56A-4</SECTNO> <SUBJECT>Certain taxpayers.</SUBJECT> <SECTNO>1.56A-5</SECTNO> <SUBJECT>Tax carryovers.</SUBJECT> <SECTNO>1.56(g)-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <SECTNO>1.56(g)-1</SECTNO> <SUBJECT>Adjusted current earnings.</SUBJECT> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Tax Preference Regulations</HD> <SECTNO>1.57-0</SECTNO> <SUBJECT>Scope.</SUBJECT> <SECTNO>1.57-1</SECTNO> <SUBJECT>Items of tax preference defined.</SUBJECT> <SECTNO>1.57-2—1.57-3</SECTNO> <SUBJECT>[Reserved]</SUBJECT> <SECTNO>1.57-4</SECTNO> <SUBJECT>Limitation on amounts treated as items of tax preference for taxable years beginning before January 1, 1976.</SUBJECT> <SECTNO>1.57-5</SECTNO> <SUBJECT>Records to be kept.</SUBJECT> <SECTNO>1.58-1</SECTNO> <SUBJECT>Minimum tax exemption.</SUBJECT> <SECTNO>1.58-2</SECTNO> <SUBJECT>General rules for conduit entities; partnerships and partners.</SUBJECT> <SECTNO>1.58-3</SECTNO> <SUBJECT>Estates and trusts.</SUBJECT> <SECTNO>1.58-3T</SECTNO> <SUBJECT>Treatment of non-alternative tax itemized deductions by trusts and estates and their beneficiaries in taxable years beginning after December 31, 1982 (temporary).</SUBJECT> <SECTNO>1.58-4</SECTNO> <SUBJECT>Electing small business corporations.</SUBJECT> <SECTNO>1.58-5</SECTNO> <SUBJECT>Common trust funds.</SUBJECT> <SECTNO>1.58-6</SECTNO> <SUBJECT>Regulated investment companies; real estate investment trusts.</SUBJECT> <SECTNO>1.58-7</SECTNO> <SUBJECT>Tax preferences attributable to foreign sources; preferences other than capital gains and stock options.</SUBJECT> <SECTNO>1.58-8</SECTNO> <SUBJECT>Capital gains and stock options.</SUBJECT> <SECTNO>1.58-9</SECTNO> <SUBJECT>Application of the tax benefit rule to the minimum tax for taxable years beginning prior to 1987.</SUBJECT> <SECTNO>1.59—1.60</SECTNO> <SUBJECT>[Reserved]</SUBJECT> </SUBJGRP> </CONTENTS> <AUTH> <HD SOURCE="HED">Authority:</HD> <P>26 U.S.C 7805, unless otherwise noted.</P> <P>Section 1.1(h)-1 also issued under 26 U.S.C. 1(h).</P> <P>Sections 1.23-1—1.23-6 also issued under 26 U.S.C. 23;</P> <P>Section 1.25-1T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-2T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-3 also issued under 26 U.S.C. 25.</P> <P>Section 1.25-3T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-4T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-5T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-6T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-7T also issued under 26 U.S.C. 25.</P> <P>Section 1.25-8T also issued under 26 U.S.C. 25.</P> <P>Section 1.25A-1 also issued under section 26 U.S.C. 25A(i).</P> <P>Section 1.25A-2 also issued under section 26 U.S.C. 25A(i).</P> <P>Section 1.25A-3 also issued under section 26 U.S.C. 25A(i).</P> <P>Section 1.25A-4 also issued under section 26 U.S.C. 25A(i).</P> <P>Section 1.25A-5 also issued under section 26 U.S.C. 25A(i).</P> <P>Section 1.28-0 also issued under 26 U.S.C. 28(d)(5);<PRTPAGE P="8"/> </P> <P>Section 1.28-1 also issued under 26 U.S.C. 28(d)(5);</P> <P>Section 1.30-1 also issued under 26 U.S.C. 30(d)(2).</P> <P>Sections 1.42-1T and 1.42-2T also issued under 26 U.S.C. 42(m);</P> <P>Section 1.42-2 also issued under 26 U.S.C. 42(m);</P> <P>Section 1.42-3 also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-4 also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-5 also issued under 26 U.S.C. 42(n);</P> <P>Sections 1.42-6, 1.42-8, 1.42-9, 1.42-10, 1.42-11, and 1.42-12, also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-13 also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-14 also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-15 also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-16 also issued under 26 U.S.C. 42(n);</P> <P>Section 1.42-17 also issued under 26 U.S.C. 42(n);</P> <P>Sections 1.43-0—1.43-7 also issued under section 26 U.S.C. 43;</P> <P>Section 1.45D-1T also issued under 26 U.S.C. 45D(i);</P> <P>Section 1.46-5 also issued under 26 U.S.C. 46(d)(6) and 26 U.S.C. 47(a)(3)(C);</P> <P>Section 1.46-6 also issued under 26 U.S.C. 46(f)(7);</P> <P>Section 1.47-1 also issued under 26 U.S.C. 47(a);</P> <P>Section 1.48-9 also issued under 26 U.S.C. 38(b) (as in effect before the amendments made by subtitle F of the Tax Reform Act of 1984);</P> <P>Sections 1.50A—1.50B also issued under 85 Stat. 553 (26 U.S.C. 40(b));</P> <P>Section 1.52-1 also issued under 26 U.S.C. 52(b);</P> <P>Section 1.56-1 also issued under 26 U.S.C. 56(f)(2)(H);</P> <P>Section 1.56(g)-1 also issued under section 7611(g)(3) of the Omnibus Budget Reconciliation Act of 1989 (Pub. L. 101-239, 103 Stat. 2373); and</P> <P>Section 1.58-9 also issued under 26 U.S.C. 58(h).</P> </AUTH> <SOURCE> <HD SOURCE="HED">Source:</HD> <P>T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 1960, unless otherwise noted.</P> </SOURCE> <SECTION> <SECTNO>§ 1.0-1</SECTNO> <SUBJECT>Internal Revenue Code of 1954 and regulations.</SUBJECT> <P>(a) <E T="03">Enactment of law.</E> The Internal Revenue Code of 1954 which became law upon enactment of Public Law 591, 83d Congress, approved August 16, 1954, provides in part as follows: </P> <EXTRACT> <P> <E T="03">Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,</E> That</P> <P>(a) <E T="03">Citation.</E> (1) The provisions of this Act set forth under the heading “Internal Revenue Title” may be cited as the “Internal Revenue Code of 1954”</P> <P>(2) The Internal Revenue Code enacted on February 10, 1939, as amended, may be cited as the “Internal Revenue Code of 1939”.</P> <P>(b) <E T="03">Publication.</E> This Act shall be published as volume 68A of the United States Statutes at Large, with a comprehensive table of contents and an appendix; but without an index or marginal references. The date of enactment, bill number, public law number, and chapter number, shall be printed as a headnote.</P> <P>(c) <E T="03">Cross reference.</E> For saving provisions, effective date provisions, and other related provisions, see chapter 80 (sec. 7801 and following) of the Internal Revenue Code of 1954.</P> <P>(d) <E T="03">Enactment of Internal Revenue Title into law.</E> The Internal Revenue Title referred to in subsection (a)(1) is as follows:</P> <STARS/> <FP>In general, the provisions of the Internal Revenue Code of 1954 are applicable with respect to taxable years beginning after December 31, 1953, and ending after August 16, 1954. Certain provisions of that Code are deemed to be included in the Internal Revenue Code of 1939. See section 7851.</FP> <P>(b) <E T="03">Scope of regulations.</E> The regulations in this part deal with (1) the income taxes imposed under subtitle A of the Internal Revenue Code of 1954, and (2) certain administrative provisions contained in subtitle F of such Code relating to such taxes. In general, the applicability of such regulations is commensurate with the applicability of the respective provisions of the Internal Revenue Code of 1954 except that with respect to the provisions of the Internal Revenue Code of 1954 which are deemed to be included in the Internal Revenue Code of 1939, the regulations relating to such provisions are applicable to certain fiscal years and short taxable years which are subject to the Internal Revenue Code of 1939. Those provisions of the regulations which are applicable to taxable years subject to the Internal Revenue Code of 1939 and the specific taxable years to which such provisions are so applicable are identified in each instance. The regulations in 26 CFR (1939) part 39 (Regulations 118) are continued in effect until superseded by the regulations in this part. See Treasury Decision 6091, approved August 16, 1954 (19 FR 5167, C.B. 1954-2, 47).</P> </EXTRACT> </SECTION> <SUBJGRP> <PRTPAGE P="9"/> <HD SOURCE="HED">Normal Taxes and Surtaxes</HD> <HD SOURCE="HD2">DETERMINATION OF TAX LIABILITY</HD> <HD SOURCE="HD3">Tax on Individuals</HD> <SECTION> <SECTNO>§ 1.1-1</SECTNO> <SUBJECT>Income tax on individuals.</SUBJECT> <P>(a) <E T="03">General rule.</E> (1) Section 1 of the Code imposes an income tax on the income of every individual who is a citizen or resident of the United States and, to the extent provided by section 871(b) or 877(b), on the income of a nonresident alien individual. For optional tax in the case of taxpayers with adjusted gross income of less than $10,000 (less than $5,000 for taxable years beginning before January 1, 1970) see section 3. The tax imposed is upon taxable income (determined by subtracting the allowable deductions from gross income). The tax is determined in accordance with the table contained in section 1. See subparagraph (2) of this paragraph for reference guides to the appropriate table for taxable years beginning on or after January 1, 1964, and before January 1, 1965, taxable years beginning after December 31, 1964, and before January 1, 1971, and taxable years beginning after December 31, 1970. In certain cases credits are allowed against the amount of the tax. See part IV (section 31 and following), subchapter A, chapter 1 of the Code. In general, the tax is payable upon the basis of returns rendered by persons liable therefor (subchapter A (sections 6001 and following), chapter 61 of the Code) or at the source of the income by withholding. For the computation of tax in the case of a joint return of a husband and wife, or a return of a surviving spouse, for taxable years beginning before January 1, 1971, see section 2. The computation of tax in such a case for taxable years beginning after December 31, 1970, is determined in accordance with the table contained in section 1(a) as amended by the Tax Reform Act of 1969. For other rates of tax on individuals, see section 5(a). For the imposition of an additional tax for the calendar years 1968, 1969, and 1970, see section 51(a).</P> <P>(2)(i) For taxable years beginning on or after January 1, 1964, the tax imposed upon a single individual, a head of a household, a married individual filing a separate return, and estates and trusts is the tax imposed by section 1 determined in accordance with the appropriate table contained in the following subsection of section 1:</P> <GPOTABLE CDEF="s50,r48,r48,r78" COLS="4" OPTS="L2"> <BOXHD> <CHED H="1"/> <CHED H="1">Taxable years beginning in 1964</CHED> <CHED H="1">Taxable years beginning after 1964 but before 1971</CHED> <CHED H="1">Taxable years beginning after Dec. 31, 1970 (references in this column are to the Code as amended by the Tax Reform Act of 1969)</CHED> </BOXHD> <ROW> <ENT I="01">Single individual</ENT> <ENT>Sec. 1(a)(1)</ENT> <ENT>Sec. 1(a)(2)</ENT> <ENT>Sec. 1(c).</ENT> </ROW> <ROW> <ENT I="01">Head of a household</ENT> <ENT>Sec. 1(b)(1)</ENT> <ENT>Sec. 1(b)(2)</ENT> <ENT>Sec. 1(b).</ENT> </ROW> <ROW> <ENT I="01">Married individual filing a separate return</ENT> <ENT>Sec. 1(a)(1)</ENT> <ENT>Sec. 1(a)(2)</ENT> <ENT>Sec. 1(d).</ENT> </ROW> <ROW> <ENT I="01">Estates and trusts</ENT> <ENT>Sec. 1(a)(1)</ENT> <ENT>Sec. 1(a)(2)</ENT> <ENT>Sec. 1(d).</ENT> </ROW> </GPOTABLE> <P>(ii) For taxable years beginning after December 31, 1970, the tax imposed by section 1(d), as amended by the Tax Reform Act of 1969, shall apply to the income effectively connected with the conduct of a trade or business in the United States by a married alien individual who is a nonresident of the United States for all or part of the taxable year or by a foreign estate or trust. For such years the tax imposed by section 1(c), as amended by such Act, shall apply to the income effectively connected with the conduct of a trade or business in the United States by an unmarried alien individual (other than a surviving spouse) who is a nonresident of the United States for all or part of the taxable year. See paragraph (b)(2) of § 1.871-8.</P> <P>(3) The income tax imposed by section 1 upon any amount of taxable income is computed by adding to the income tax for the bracket in which that amount falls in the appropriate table in section 1 the income tax upon the excess of that amount over the bottom of the bracket at the rate indicated in such table.</P> <P>(4) The provisions of section 1 of the Code, as amended by the Tax Reform Act of 1969, and of this paragraph may <PRTPAGE P="10"/>be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A, an unmarried individual, had taxable income for the calendar year 1964 of $15,750. Accordingly, the tax upon such taxable income would be $4,507.50, computed as follows from the table in section 1(a)(1):</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">Tax on $14,000 (from table)</ENT> <ENT>$3,790.00</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Tax on $1,750 (at 41 percent as determined from the table)</ENT> <ENT>717.50</ENT> </ROW> <ROW> <ENT I="03">Total tax on $15,750</ENT> <ENT>4,507.50</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Assume the same facts as in example (1), except the figures are for the calendar year 1965. The tax upon such taxable income would be $4,232.50, computed as follows from the table in section 1(a)(2):</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">Tax on $14,000 (from table)</ENT> <ENT>$3,550.00</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Tax on $1,750 (at 39 percent as determined from the table)</ENT> <ENT>682.50</ENT> </ROW> <ROW> <ENT I="03">Total tax on $15,750</ENT> <ENT>4,232.50</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>Assume the same facts as in example (1), except the figures are for the calendar year 1971. The tax upon such taxable income would be $3,752.50, computed as follows from the table in section 1(c), as amended:</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">Tax on $14,000 (from table)</ENT> <ENT>$3,210.00</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Tax on $1,750 (at 31 percent as determined from the table)</ENT> <ENT>542.50</ENT> </ROW> <ROW> <ENT I="03">Total tax on $15,750</ENT> <ENT>3,752.50</ENT> </ROW> </GPOTABLE> </EXAMPLE> <P>(b) <E T="03">Citizens or residents of the United States liable to tax.</E> In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States. Pursuant to section 876, a nonresident alien individual who is a bona fide resident of Puerto Rico during the entire taxable year is, except as provided in section 933 with respect to Puerto Rican source income, subject to taxation in the same manner as a resident alien individual. As to tax on nonresident alien individuals, see sections 871 and 877.</P> <P>(c) <E T="03">Who is a citizen.</E> Every person born or naturalized in the United States and subject to its jurisdiction is a citizen. For other rules governing the acquisition of citizenship, see chapters 1 and 2 of title III of the Immigration and Nationality Act (8 U.S.C. 1401-1459). For rules governing loss of citizenship, see sections 349 to 357, inclusive, of such Act (8 U.S.C. 1481-1489), Schneider v. Rusk, (1964) 377 U.S. 163, and Rev. Rul. 70-506, C.B. 1970-2, 1. For rules pertaining to persons who are nationals but not citizens at birth, e.g., a person born in American Samoa, see section 308 of such Act (8 U.S.C. 1408). For special rules applicable to certain expatriates who have lost citizenship with a principal purpose of avoiding certain taxes, see section 877. A foreigner who has filed his declaration of intention of becoming a citizen but who has not yet been admitted to citizenship by a final order of a naturalization court is an alien.</P> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 44216, Dec. 23, 1974]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.1-2</SECTNO> <SUBJECT>Limitation on tax.</SUBJECT> <P>(a) <E T="03">Taxable years ending before January 1, 1971.</E> For taxable years ending before January 1, 1971, the tax imposed by section 1 (whether by subsection (a) or subsection (b) thereof) shall not exceed 87 percent of the taxable income for the taxable year. For purposes of determining this limitation the tax under section 1 (a) or (b) and the tax at the 87-percent rate shall each be computed before the allowance of any credits against the tax. Where the alternative tax on capital gains is imposed under section 1201(b), the 87-percent limitation shall apply only to the partial tax computed on the taxable income reduced by 50 percent of the excess of net long-term capital gains over net short-term capital losses. Where, for purposes of computations under the income averaging provisions, section 1201(b) is treated as imposing the alternative tax on capital gains computed under section 1304(e)(2), the 87-percent limitation shall apply only to the tax equal to the tax imposed by section 1, reduced by the amount of the tax imposed by section 1 which is attributable to capital gain net income for the computation year.</P> <P>(b) <E T="03">Taxable years beginning after December 31, 1970.</E> If, for any taxable year beginning after December 31, 1970, an individual has earned taxable income which exceeds his taxable income as defined by section 1348, the tax imposed by section 1, as amended by the Tax Reform Act of 1969, shall not exceed the sum computed under the provisions <PRTPAGE P="11"/>of section 1348. For imposition of minimum tax for tax preferences see sections 56 through 58.</P> <CITA>[T.D. 7117, 36 FR 9397, May 25, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.1-3</SECTNO> <SUBJECT>Change in rates applicable to taxable year.</SUBJECT> <P>For computation of the tax for a taxable year during which a change in the tax rates occurs, see section 21 and the regulations thereunder.</P> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated by T.D. 7117, 36 FR 9397, May 25, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.1(h)-1</SECTNO> <SUBJECT>Capital gains look-through rule for sales or exchanges of interests in a partnership, S corporation, or trust.</SUBJECT> <P>(a) <E T="03">In general.</E> When an interest in a partnership held for more than one year is sold or exchanged, the transferor may recognize ordinary income (<E T="03">e.g.,</E> under section 751(a)), collectibles gain, section 1250 capital gain, and residual long-term capital gain or loss. When stock in an S corporation held for more than one year is sold or exchanged, the transferor may recognize ordinary income (<E T="03">e.g.,</E> under sections 304, 306, 341, 1254), collectibles gain, and residual long-term capital gain or loss. When an interest in a trust held for more than one year is sold or exchanged, a transferor who is not treated as the owner of the portion of the trust attributable to the interest sold or exchanged (sections 673 through 679) (a non-grantor transferor) may recognize collectibles gain and residual long-term capital gain or loss.</P> <P>(b) <E T="03">Look-through capital gain</E>—(1) <E T="03">In general.</E> Look-through capital gain is the share of collectibles gain allocable to an interest in a partnership, S corporation, or trust, plus the share of section 1250 capital gain allocable to an interest in a partnership, determined under paragraphs (b)(2) and (3) of this section.</P> <P>(2) <E T="03">Collectibles gain</E>—(i) <E T="03">Definition.</E> For purposes of this section, <E T="03">collectibles gain</E> shall be treated as gain from the sale or exchange of a collectible (as defined in section 408(m) without regard to section 408(m)(3)) that is a capital asset held for more than 1 year.</P> <P>(ii) <E T="03">Share of collectibles gain allocable to an interest in a partnership, S corporation, or a trust.</E> When an interest in a partnership, S corporation, or trust held for more than one year is sold or exchanged in a transaction in which all realized gain is recognized, the transferor shall recognize as collectibles gain the amount of net gain (but not net loss) that would be allocated to that partner (taking into account any remedial allocation under § 1.704-3(d)), shareholder, or beneficiary (to the extent attributable to the portion of the partnership interest, S corporation stock, or trust interest transferred that was held for more than one year) if the partnership, S corporation, or trust transferred all of its collectibles for cash equal to the fair market value of the assets in a fully taxable transaction immediately before the transfer of the interest in the partnership, S corporation, or trust. If less than all of the realized gain is recognized upon the sale or exchange of an interest in a partnership, S corporation, or trust, the same methodology shall apply to determine the collectibles gain recognized by the transferor, except that the partnership, S corporation, or trust shall be treated as transferring only a proportionate amount of each of its collectibles determined as a fraction that is the amount of gain recognized in the sale or exchange over the amount of gain realized in the sale or exchange. With respect to the transfer of an interest in a trust, this paragraph (b)(2) applies only to transfers by non-grantor transferors (as defined in paragraph (a) of this section). This paragraph (b)(2) does not apply to a transaction that is treated, for Federal income tax purposes, as a redemption of an interest in a partnership, S corporation, or trust.</P> <P>(3) <E T="03">Section 1250 capital gain</E>—(i) <E T="03">Definition.</E> For purposes of this section, <E T="03">section 1250 capital gain</E> means the capital gain (not otherwise treated as ordinary income) that would be treated as ordinary income if section 1250(b)(1) included all depreciation and the applicable percentage under section 1250(a) were 100 percent.</P> <P>(ii) <E T="03">Share of section 1250 capital gain allocable to interest in partnership.</E> When an interest in a partnership held for more than one year is sold or exchanged in a transaction in which all realized gain is recognized, there shall <PRTPAGE P="12"/>be taken into account under section 1(h)(7)(A)(i) in determining the partner's unrecaptured section 1250 gain the amount of section 1250 capital gain that would be allocated (taking into account any remedial allocation under § 1.704-3(d)) to that partner (to the extent attributable to the portion of the partnership interest transferred that was held for more than one year) if the partnership transferred all of its section 1250 property in a fully taxable transaction for cash equal to the fair market value of the assets immediately before the transfer of the interest in the partnership. If less than all of the realized gain is recognized upon the sale or exchange of an interest in a partnership, the same methodology shall apply to determine the section 1250 capital gain recognized by the transferor, except that the partnership shall be treated as transferring only a proportionate amount of each section 1250 property determined as a fraction that is the amount of gain recognized in the sale or exchange over the amount of gain realized in the sale or exchange. This paragraph (b)(3) does not apply to a transaction that is treated, for Federal income tax purposes, as a redemption of a partnership interest.</P> <P>(iii) <E T="03">Limitation with respect to net section 1231 gain.</E> In determining a transferor partner's net section 1231 gain (as defined in section 1231(c)(3)) for purposes of section 1(h)(7)(B), the transferor partner's allocable share of section 1250 capital gain in partnership property shall not be treated as section 1231 gain, regardless of whether the partnership property is used in the trade or business (as defined in section 1231(b)).</P> <P>(c) <E T="03">Residual long-term capital gain or loss.</E> The amount of residual long-term capital gain or loss recognized by a partner, shareholder of an S corporation, or beneficiary of a trust on account of the sale or exchange of an interest in a partnership, S corporation, or trust shall equal the amount of long-term capital gain or loss that the partner would recognize under section 741, that the shareholder would recognize upon the sale or exchange of stock of an S corporation, or that the beneficiary would recognize upon the sale or exchange of an interest in a trust (pre-look-through long-term capital gain or loss) minus the amount of look-through capital gain determined under paragraph (b) of this section.</P> <P>(d) <E T="03">Special rule for tiered entities.</E> In determining whether a partnership, S corporation, or trust has gain from collectibles, such partnership, S corporation, or trust shall be treated as owning its proportionate share of the collectibles of any partnership, S corporation, or trust in which it owns an interest either directly or indirectly through a chain of such entities. In determining whether a partnership has section 1250 capital gain, such partnership shall be treated as owning its proportionate share of the section 1250 property of any partnership in which it owns an interest, either directly or indirectly through a chain of partnerships.</P> <P>(e) <E T="03">Notification requirements.</E> Reporting rules similar to those that apply to the partners and the partnership under section 751(a) shall apply in the case of sales or exchanges of interests in a partnership, S corporation, or trust that cause holders of such interests to recognize collectibles gain and in the case of sales or exchanges of interests in a partnership that cause holders of such interests to recognize section 1250 capital gain. See § 1.751-1(a)(3).</P> <P>(f) <E T="03">Examples.</E> The following examples illustrate the requirements of this section: </P> <EXAMPLE> <HD SOURCE="HED">Example 1. Collectibles gain.</HD> <P>(i) <E T="03">A</E> and <E T="03">B</E> are equal partners in a personal service partnership <E T="03">(PRS).</E> <E T="03">B</E> transfers <E T="03">B</E>'s interest in <E T="03">PRS</E> to <E T="03">T</E> for $15,000 when <E T="03">PRS</E>'s balance sheet (reflecting a cash receipts and disbursements method of accounting) is as follows:</P> <GPOTABLE CDEF="s25,7,7" COLS="3" OPTS="L2,tp0,i1"> <BOXHD> <CHED H="1"/> <CHED H="1">ASSETS</CHED> <CHED H="2">Adjusted basis</CHED> <CHED H="2">Market value</CHED> </BOXHD> <ROW> <ENT I="01">Cash</ENT> <ENT>$3,000</ENT> <ENT>$3,000</ENT> </ROW> <ROW> <ENT I="01">Loans Owed to Partnership</ENT> <ENT>10,000</ENT> <ENT>10,000</ENT> </ROW> <ROW> <ENT I="02">Collectibles</ENT> <ENT>1,000</ENT> <ENT>3,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">Other Capital Assets</ENT> <ENT>6,000</ENT> <ENT>2,000</ENT> </ROW> <ROW> <ENT I="01">Capital Assets</ENT> <ENT>7,000</ENT> <ENT>5,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Unrealized Receivables</ENT> <ENT>0</ENT> <ENT>14,000</ENT> </ROW> <ROW> <ENT I="03">Total</ENT> <ENT>20,000</ENT> <ENT>32,000</ENT> </ROW> </GPOTABLE> <PRTPAGE P="13"/> <GPOTABLE CDEF="s25,7,7" COLS="3" OPTS="L2,tp0,i1"> <BOXHD> <CHED H="1"/> <CHED H="1">LIABILITIES AND CAPITAL</CHED> <CHED H="2">Adjusted basis</CHED> <CHED H="2">Market value</CHED> </BOXHD> <ROW> <ENT I="01">Liabilities</ENT> <ENT>2,000</ENT> <ENT>2,000</ENT> </ROW> <ROW> <ENT I="11">Capital:</ENT> </ROW> <ROW> <ENT I="02">A</ENT> <ENT>9,000</ENT> <ENT>15,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">B</ENT> <ENT>9,000</ENT> <ENT>15,000</ENT> </ROW> <ROW> <ENT I="03">Total</ENT> <ENT>20,000</ENT> <ENT>32,000</ENT> </ROW> </GPOTABLE> <P>(ii) At the time of the transfer, <E T="03">B</E> has held the interest in <E T="03">PRS</E> for more than one year, and <E T="03">B</E>'s basis for the partnership interest is $10,000 ($9,000 plus $1,000, <E T="03">B</E>'s share of partnership liabilities). None of the property owned by <E T="03">PRS</E> is section 704(c) property. The total amount realized by <E T="03">B</E> is $16,000, consisting of the cash received, $15,000, plus $1,000, <E T="03">B</E>'s share of the partnership liabilities assumed by <E T="03">T.</E> See section 752. <E T="03">B</E>'s undivided one-half interest in <E T="03">PRS</E> includes a one-half interest in the partnership's unrealized receivables and a one-half interest in the partnership's collectibles.</P> <P>(iii) If <E T="03">PRS</E> were to sell all of its section 751 property in a fully taxable transaction for cash equal to the fair market value of the assets immediately prior to the transfer of <E T="03">B's</E> partnership interest to <E T="03">T</E>, <E T="03">B</E> would be allocated $7,000 of ordinary income from the sale of <E T="03">PRS</E>'s unrealized receivables. Therefore, <E T="03">B</E> will recognize $7,000 of ordinary income with respect to the unrealized receivables. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 ($6,000) and the amount of ordinary income or loss determined under § 1.751-1(a)(2) ($7,000) is the partner's capital gain or loss on the sale of the partnership interest under section 741. In this case, the transferor has a $1,000 pre-look-through long-term capital loss.</P> <P>(iv) If <E T="03">PRS</E> were to sell all of its collectibles in a fully taxable transaction for cash equal to the fair market value of the assets immediately prior to the transfer of <E T="03">B's</E> partnership interest to <E T="03">T</E>, <E T="03">B</E> would be allocated $1,000 of gain from the sale of the collectibles. Therefore, <E T="03">B</E> will recognize $1,000 of collectibles gain on account of the collectibles held by <E T="03">PRS.</E> </P> <P>(v) The difference between the transferor's pre-look-through long-term capital gain or loss (−$1,000) and the look-through capital gain determined under this section ($1,000) is the transferor's residual long-term capital gain or loss on the sale of the partnership interest. Under these facts, <E T="03">B</E> will recognize a $2,000 residual long-term capital loss on account of the sale or exchange of the interest in <E T="03">PRS</E>.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2. Special allocations.</HD> <P>Assume the same facts as in <E T="03">Example 1</E>, except that under the partnership agreement, all gain from the sale of the collectibles is specially allocated to <E T="03">B</E>, and <E T="03">B</E> transfers <E T="03">B</E>'s interest to <E T="03">T</E> for $16,000. All items of income, gain, loss, or deduction of <E T="03">PRS</E>, other than the gain from the collectibles, are divided equally between <E T="03">A</E> and <E T="03">B.</E> Under these facts, <E T="03">B</E>'s amount realized is $17,000, consisting of the cash received, $16,000, plus $1,000, <E T="03">B's</E> share of the partnership liabilities assumed by <E T="03">T.</E> See section 752. <E T="03">B</E> will recognize $7,000 of ordinary income with respect to the unrealized receivables (determined under § 1.751-1(a)(2)). Accordingly, <E T="03">B</E>'s pre-look-through long-term capital gain would be $0. If <E T="03">PRS</E> were to sell all of its collectibles in a fully taxable transaction for cash equal to the fair market value of the assets immediately prior to the transfer of <E T="03">B's</E> partnership interest to <E T="03">T</E>, <E T="03">B</E> would be allocated $2,000 of gain from the sale of the collectibles. Therefore, <E T="03">B</E> will recognize $2,000 of collectibles gain on account of the collectibles held by <E T="03">PRS.</E> <E T="03">B</E> will recognize a $2,000 residual long-term capital loss on account of the sale of <E T="03">B's</E> interest in <E T="03">PRS</E>.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3. Net collectibles loss ignored.</HD> <P>Assume the same facts as in <E T="03">Example 1</E>, except that the collectibles held by <E T="03">PRS</E> have an adjusted basis of $3,000 and a fair market value of $1,000, and the other capital assets have an adjusted basis of $4,000 and a fair market value of $4,000. (The total adjusted basis and fair market value of the partnership's capital assets are the same as in <E T="03">Example 1</E>.) If <E T="03">PRS</E> were to sell all of its collectibles in a fully taxable transaction for cash equal to the fair market value of the assets immediately prior to the transfer of <E T="03">B</E>'s partnership interest to <E T="03">T</E>, <E T="03">B</E> would be allocated $1,000 of loss from the sale of the collectibles. Because none of the gain from the sale of the interest in <E T="03">PRS</E> is attributable to unrealized appreciation in the value of collectibles held by <E T="03">PRS</E>, the net loss in collectibles held by <E T="03">PRS</E> is not recognized at the time <E T="03">B</E> transfers the interest in <E T="03">PRS.</E> <E T="03">B</E> will recognize $7,000 of ordinary income (determined under § 1.751-1(a)(2)) and a $1,000 long-term capital loss on account of the sale of B's interest in <E T="03">PRS</E>.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4. Collectibles gain in an S corporation.</HD> <P>(i) A corporation (<E T="03">X</E>) has always been an S corporation and is owned by individuals <E T="03">A</E>, <E T="03">B</E>, and <E T="03">C.</E> In 1996, <E T="03">X</E> invested in antiques. Subsequent to their purchase, the antiques appreciated in value by $300. <E T="03">A</E> owns one-third of the shares of <E T="03">X</E> stock and has held that stock for more than one year. <E T="03">A</E>'s adjusted basis in the <E T="03">X</E> stock is $100. If <E T="03">A</E> were to sell all of <E T="03">A</E>'s <E T="03">X</E> stock to <E T="03">T</E> for $150, <E T="03">A</E> would realize $50 of pre-look-through long-term capital gain.</P> <P>(ii) If <E T="03">X</E> were to sell its antiques in a fully taxable transaction for cash equal to the fair market value of the assets immediately before the transfer to <E T="03">T</E>, <E T="03">A</E> would be allocated $100 of gain on account of the sale. Therefore, <E T="03">A</E> will recognize $100 of collectibles gain (look-through capital gain) on account of the collectibles held by <E T="03">X.</E> <PRTPAGE P="14"/> </P> <P>(iii) The difference between the transferor's pre-look-through long-term capital gain or loss ($50) and the look-through capital gain determined under this section ($100) is the transferor's residual long-term capital gain or loss on the sale of the S corporation stock. Under these facts, <E T="03">A</E> will recognize $100 of collectibles gain and a $50 residual long-term capital loss on account of the sale of <E T="03">A</E>'s interest in <E T="03">X</E>.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5. Sale or exchange of partnership interest where part of the interest has a short-term holding period.</HD> <P>(i) <E T="03">A</E>, <E T="03">B</E>, and <E T="03">C</E> form an equal partnership (<E T="03">PRS</E>). In connection with the formation, <E T="03">A</E> contributes $5,000 in cash and a capital asset with a fair market value of $5,000 and a basis of $2,000; <E T="03">B</E> contributes $7,000 in cash and a collectible with a fair market value of $3,000 and a basis of $3,000; and <E T="03">C</E> contributes $10,000 in cash. At the time of the contribution, <E T="03">A</E> had held the contributed property for two years. Six months later, when <E T="03">A</E>'s basis in <E T="03">PRS</E> is $7,000, <E T="03">A</E> transfers <E T="03">A</E>'s interest in <E T="03">PRS</E> to <E T="03">T</E> for $14,000 at a time when <E T="03">PRS</E>'s balance sheet (reflecting a cash receipts and disbursements method of accounting) is as follows:</P> <GPOTABLE CDEF="s25,7,7" COLS="3" OPTS="L2,tp0,i1"> <BOXHD> <CHED H="1"/> <CHED H="1">ASSETS</CHED> <CHED H="2">Adjusted basis</CHED> <CHED H="2">Market value</CHED> </BOXHD> <ROW> <ENT I="01">Cash </ENT> <ENT>$22,000 </ENT> <ENT>$22,000</ENT> </ROW> <ROW> <ENT I="01">Unrealized Receivables </ENT> <ENT>0 </ENT> <ENT>6,000</ENT> </ROW> <ROW> <ENT I="02">Capital Asset </ENT> <ENT>2,000 </ENT> <ENT>5,000</ENT> </ROW> <ROW> <ENT I="02">Collectible </ENT> <ENT>3,000 </ENT> <ENT>9,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Capital Assets </ENT> <ENT>5,000 </ENT> <ENT>14,000</ENT> </ROW> <ROW> <ENT I="03">Total </ENT> <ENT>27,000 </ENT> <ENT>42,000</ENT> </ROW> </GPOTABLE> <P>(ii) Although at the time of the transfer <E T="03">A</E> has not held <E T="03">A</E>'s interest in <E T="03">PRS</E> for more than one year, 50 percent of the fair market value of <E T="03">A</E>'s interest in <E T="03">PRS</E> was received in exchange for a capital asset with a long-term holding period. Therefore, 50 percent of <E T="03">A</E>'s interest in <E T="03">PRS</E> has a long-term holding period. See § 1.1223-3(b)(1).</P> <P>(iii) If <E T="03">PRS</E> were to sell all of its section 751 property in a fully taxable transaction immediately before <E T="03">A</E>'s transfer of the partnership interest, <E T="03">A</E> would be allocated $2,000 of ordinary income. Accordingly, <E T="03">A</E> will recognize $2,000 ordinary income and $5,000 ($7,000-$2,000) of capital gain on account of the transfer to <E T="03">T</E> of <E T="03">A</E>'s interest in <E T="03">PRS.</E> Fifty percent ($2,500) of that gain is long-term capital gain and 50 percent ($2,500) is short-term capital gain. See § 1.1223-3(c)(1).</P> <P>(iv) If the collectible were sold or exchanged in a fully taxable transaction immediately before <E T="03">A</E>'s transfer of the partnership interest, <E T="03">A</E> would be allocated $2,000 of gain attributable to the collectible. The gain attributable to the collectible that is allocable to the portion of the transferred interest in <E T="03">PRS</E> with a long-term holding period is $1,000 (50 percent of $2,000). Accordingly, <E T="03">A</E> will recognize $1,000 of collectibles gain on account of the transfer of <E T="03">A</E>'s interest in <E T="03">PRS.</E> </P> <P>(v) The difference between the amount of pre-look-through long-term capital gain or loss ($2,500) and the look-through capital gain ($1,000) is the amount of residual long-term capital gain or loss that <E T="03">A</E> will recognize on account of the transfer of <E T="03">A</E>'s interest in <E T="03">PRS.</E> Under these facts, <E T="03">A</E> will recognize a residual long-term capital gain of $1,500 and a short-term capital gain of $2,500.</P> </EXAMPLE> <P>(g) <E T="03">Effective date.</E> This section applies to transfers of interests in partnerships, S corporations, and trusts that occur on or after September 21, 2000.</P> <CITA>[T.D. 8902, 65 FR 57096, Sept. 21, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.1(i)-1T</SECTNO> <SUBJECT>Questions and answers relating to the tax on unearned income certain minor children (Temporary).</SUBJECT> <HD SOURCE="HD1">In General</HD> <P> <E T="03">Q-1. To whom does section 1(i) apply?</E> </P> <P>A-1. Section 1(i) applies to any child who is under 14 years of age at the close of the taxable year, who has at least one living parent at the close of the taxable year, and who recognizes over $1,000 of unearned income during the taxable year.</P> <P> <E T="03">Q-2. What is the effective date of section 1(i)?</E> </P> <P>A-2. Section 1(i) applies to taxable years of the child beginning after December 31, 1986.</P> <HD SOURCE="HD1">Computation of Tax</HD> <P> <E T="03">Q-3. What is the amount of tax imposed by section 1 on a child to whom section 1(i) applies?</E> </P> <P>A-3. In the case of a child to whom section 1(i) applies, the amount of tax imposed by section 1 equals the greater of (A) the tax imposed by section 1 without regard to section 1(i) or (B) the sum of the tax that would be imposed by section 1 if the child's taxable income was reduced by the child's net unearned income, plus the child's share of the allocable parental tax.</P> <P> <E T="03">Q-4. What is the allocable parental tax?</E> </P> <P>A-4. The allocable parental tax is the excess of (A) the tax that would be imposed by section 1 on the sum of the parent's taxable income plus the net unearned income of all children of such parent to whom section 1(i) applies, over (B) the tax imposed by section 1 on the parent's taxable income. Thus, <PRTPAGE P="15"/>the allocable parental tax is not computed with reference to unearned income of a child over 14 or a child under 14 with less than $1,000 of unearned income. <E T="03">See</E> A-10 through A-13 for rules regarding the determination of the parent(s) whose taxable income is taken into account under section 1(i). <E T="03">See</E> A-14 for rules regarding the determination of children of the parent whose net unearned income is taken into account under section 1(i).</P> <P> <E T="03">Q-5. What is the child's share of the allocable parental tax?</E> </P> <P>A-5. The child's share of the allocable parental tax is an amount that bears the same ratio to the total allocable parental tax as the child's net unearned income bears to the total net unearned income of all children of such parent to whom section 1(i) applies. See A-14. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>During 1988, D, and a 12 year old, receives $5,000 of unearned income and no earned income. D has no itemized deductions and is not eligible for a personal exemption. D's parents have two other children, E, a 15 year old, and F, a 10 year old. E has $10,000 of unearned income and F has $100 of unearned income. D's parents file a joint return for 1988 and report taxable income of $70,000. Neither D's nor his parent's taxable income is attributable to net capital gain. D's tax liability for 1988, determined without regard to section 1(i), is $675 on $4,500 of taxable income ($5,000 less $500 allowable standard deduction). In applying section 1(i), D's tax would be equal to the sum of (A) the tax that would be imposed on D's taxable income if it were reduced by any net unearned income, plus (B) D's share of the allocable parental tax. Only D's unearned income is taken into account in determining the allocable parental tax because E is over 14 and F has less than $1,000 of unearned income. <E T="03">See</E> A-4. D's net unearned income is $4,000 ($4,500 taxable unearned income less $500). The tax imposed on D's taxable income as reduced by D's net unearned income is $75 ($500×15%). The allocable parental tax is $1,225, the excess of $16,957.50 (the tax on $74,000, the parent's taxable income plus D's net unearned income) over $15,732.50 (the tax on $70,000, the parent's taxable income). <E T="03">See</E> A-4. Thus, D's tax under section 1(i)(1)(B) is $1,300 ($1,225+$75). Since this amount is greater than the amount of D's tax liability as determined without regard to section 1(i), the amount of tax imposed on D for 1988 is $1,300. <E T="03">See A-3.</E> </P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>H and W have 3 children, A, B, and C, who are all under 14 years of age. For the taxable year 1988, H and W file a joint return and report taxable income of $129,750. The tax imposed by section 1 on H and W is $35,355. A has $5,000 of net unearned income and B and C each have $2,500 of net unearned income during 1988. The allocable parental tax imposed on A, B, and C's combined net unearned income of $10,000 is $3,300. This tax is the excess of $38,655, which is the tax imposed by section 1 on $139,750 ($129,750+10,000), over $35,355 (the tax imposed by section 1 on H and W's taxable income of $129,750). <E T="03">See</E> A-4. Each child's share of the allocable parental tax is an amount that bears the same ratio to the total allocable parental tax as the child's net unearned income bears to the total net unearned income of A, B, and C. Thus, A's share of the allocable parental tax is $1,650 (5,000÷10,000×3,300) and B and C's share of the tax is $825 (2,500÷10,000×3,300) each. <E T="03">See</E> A-5.</P> </EXAMPLE> <HD SOURCE="HD1">Definition of Net Unearned Income</HD> <P> <E T="03">Q-6. What is net unearned income?</E> </P> <P>A-6. Net unearned income is the excess of the portion of adjusted gross income for the taxable year that is not “earned income” as defined in section 911(d)(2) (income that is not attributable to wages, salaries, or other amounts received as compensation for personal services), over the sum of the standard deduction amount provided for under section 63 (c)(5)(A) ($500 for 1987 and 1988; adjusted for inflation thereafter), plus the greater of (A) $500 (adjusted for inflation after 1988) or (B) the amount of allowable itemized deductions that are directly connected with the production of unearned income. A child's net unearned income for any taxable year shall not exceed the child's taxable income for such year. </P> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>A is a child who is under 14 years of age at the end of the taxable year 1987. Both of A's parents are alive at this time. During 1987, A receives $3,000 of interest from a bank savings account and earns $1,000 from a paper route and performing odd jobs. A has no itemized deductions for 1987. A's standard deduction is $1,000, which is an amount equal to A's earned income for 1987. Of this amount, $500 is applied against A's unearned income and the remaining $500 is applied against A's earned income. Thus, A's $500 of taxable earned income ($1,000 less the remaining $500 of the standard deduction) is taxed without regard to section 1 (i); A has $2,500 of taxable unearned income ($3,000 gross unearned income less $500 of the standard deduction) of which $500 is taxed without regard to section 1(i). The remaining $2,000 of taxable unearned income is A's net unearned income and is taxed under section 1(i).</P> </EXAMPLE> <EXAMPLE> <PRTPAGE P="16"/> <HD SOURCE="HED">Example 4.</HD> <P>B is a child who is subject to tax under section 1(i). B has $400 of earned income and $2,000 of unearned income. B has itemized deductions of $800 (net of the 2 percent of adjusted gross income (AGI) floor on miscellaneous itemized deductions under section 67) of which $200 are directly connected with the production of unearned income. The amount of itemized deductions that B may apply against unearned income is equal to the greater of $500 or the deductions directly connected with the production of unearned income. <E T="03">See</E> A-6. Thus, $500 of B's itemized deductions are applied against the $2,000 of unearned income and the remaining $300 of deductions are applied against earned income. As a result, B has taxable earned income of $100 and taxable unearned income of $1,500. Of these amounts, all of the earned income and $500 of the unearned income are taxed without regard to section 1(i). The remaining $1,000 of unearned income is net unearned income and is taxed under section 1(i).</P> </EXAMPLE> <HD SOURCE="HD1">Unearned Income Subject to tax Under Section 1(i)</HD> <P> <E T="03">Q-7. Will a child be subject to tax under section 1(i) on net unearned income (as defined in section 1(i) (4) and A-6 of this section) that is attributable to property transferred to the child prior to 1987?</E> </P> <P>A-7. Yes. The tax imposed by section 1(i) on a child's net unearned income applies to any net unearned income of the child for taxable years beginning after December 31, 1986, regardless of when the underlying assets were transferred to the child.</P> <P> <E T="03">Q-8. Will a child be subject to tax under section 1(i) on net unearned income that is attributable to gifts from persons other than the child's parents or attributable to assets resulting from the child's earned income?</E> </P> <P>A-8. Yes. The tax imposed by section 1(i) applies to all net unearned income of the child, regardless of the source of the assets that produced such income. Thus, the rules of section 1(i) apply to income attributable to gifts not only from the parents but also from any other source, such as the child's grandparents. Section 1(i) also applies to unearned income derived with respect to assets resulting from earned income of the child, such as interest earned on bank deposits. </P> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>A is a child who is under 14 years of age at the end of the taxable year beginning on January 1, 1987. Both of A's parents are alive at the end of the taxable year. During 1987, A receives $2,000 in interest from his bank account and $1,500 from a paper route. Some of the interest earned by A from the bank account is attributable to A's paper route earnings that were deposited in the account. The balance of the account is attributable to cash gifts from A's parents and grandparents and interest earned prior to 1987. Some cash gifts were received by A prior to 1987. A has no itemized deductions and is eligible to be claimed as a dependent on his parent's return. Therefore, for the taxable year 1987, A's standard deduction is $1,500, the amount of A's earned income. Of this standard deduction amount, $500 is allocated against unearned income and $1,000 is allocated against earned income. A's taxable unearned income is $1,500 of which $500 is taxed without regard to section 1(i). The remaining taxable unearned income of $1,000 is net unearned income and is taxed under section 1(i). The fact that some of A's unearned income is attributable to interest on principal created by earned income and gifts from persons other than A's parents or that some of the unearned income is attributable to property transferred to A prior to 1987, will not affect the tax treatment of this income under section 1(i). <E T="03">See</E> A-8.</P> </EXAMPLE> <P> <E T="03">Q-9. For purposes of section 1(i), does income which is not earned income (as defined in section 911(d)(2)) include social security benefits or pension benefits that are paid to the child?</E> </P> <P>A-9. Yes. For purposes of section 1(i), earned income (as defined in section 911(d)(2)) does not include any social security or pension benefits paid to the child. Thus, such amounts are included in unearned income to the extent they are includible in the child's gross income.</P> <HD SOURCE="HD1">Determination of the Parent's Taxable Income</HD> <P> <E T="03">Q-10. If a child's parents file a joint return, what is the taxable income that must be taken into account by the child in determining tax liability under section 1(i)?</E> </P> <P>A-10. In the case of parents who file a joint return, the parental taxable income to be taken into account in determining the tax liability of a child is the total taxable income shown on the joint return.</P> <P> <E T="03">Q-11. If a child's parents are married and file separate tax returns, which parent's taxable income must be taken into account by the child in determining tax liability under section 1(i)?</E> <PRTPAGE P="17"/> </P> <P>A-11. For purposes of determining the tax liability of a child under section 1(i), where such child's parents are married and file separate tax returns, the parent whose taxable income is the greater of the two for the taxable year shall be taken into account.</P> <P> <E T="03">Q-12. If the parents of a child are divorced, legally separated, or treated as not married under section 7703(b), which parent's taxable income is taken into account in computing the child's tax liability?</E> </P> <P>A-12. If the child's parents are divorced, legally separated, or treated as not married under section 7703(b), the taxable income of the custodial parent (within the meaning of section 152(e)) of the child is taken into account under section 1(i) in determining the child's tax liability.</P> <P> <E T="03">Q-13. If a parent whose taxable income must be taken into account in determining a child's tax liability under section 1(i) files a joint return with a spouse who is not a parent of the child, what taxable income must the child take into account?</E> </P> <P>A-13. The amount of a parent's taxable income that a child must take into account for purposes of section 1(i) where the parent files a joint return with a spouse who is not a parent of the child is the total taxable income shown on such joint return.</P> <HD SOURCE="HD1">Children of the Parent</HD> <P> <E T="03">Q-14. In determining a child's share of the allocable parental tax, is the net unearned income of legally adopted children, children related to such child by half-blood, or children from a prior marriage of the spouse of such child's parent taken into account in addition to the natural children of such child's parent?</E> </P> <P>A-14. Yes. In determining a child's share of the allocable parental tax, the net unearned income of all children subject to tax under section 1(i) and who use the same parent's taxable income as such child to determine their tax liability under section 1(i) must be taken into account. Such children are taken into account regardless of whether they are adopted by the parent, related to such child by half-blood, or are children from a prior marriage of the spouse of such child's parent.</P> <HD SOURCE="HD1">Rules Regarding Income From a Trust or Similar Instrument</HD> <P> <E T="03">Q-15. Will the unearned income of a child who is subject to section 1(i) that is attributable to gifts given to the child under the Uniform Gift to Minors Act (UGMA) be subject to tax under section 1(i)?</E> </P> <P>A-15. Yes. A gift under the UGMA vests legal title to the property in the child although an adult custodian is given certain rights to deal with the property until the child attains majority. Any unearned income attributable to such a gift is the child's unearned income and is subject to tax under section 1(i), whether distributed to the child or not.</P> <P> <E T="03">Q-16. Will a child who is a beneficiary of a trust be required to take into account the income of a trust in determining the child's tax liability under section 1(i)?</E> </P> <P>A-16. The income of a trust must be taken into account for purposes of determining the tax liability of a beneficiary who is subject to section 1(i) only to the extent it is included in the child's gross income for the taxable year under sections 652(a) or 662(a). Thus, income from a trust for the fiscal taxable year of a trust ending during 1987, that is included in the gross income of a child who is subject to section 1(i) and who has a calendar taxable year, will be subject to tax under section 1(i) for the child's 1987 taxable year.</P> <HD SOURCE="HD1">Subsequent Adjustments</HD> <P> <E T="03">Q-17. What effect will a subsequent adjustment to a parent's taxable income have on the child's tax liability if such parent's taxable income was used to determine the child's tax liability under section 1(i) for the same taxable year?</E> </P> <P>A-17. If the parent's taxable income is adjusted and if, for the same taxable year as the adjustment, the child paid tax determined under section 1(i) with reference to that parent's taxable income, then the child's tax liability under section 1(i) must be recomputed using the parent's taxable income as adjusted.</P> <P> <E T="03">Q-18. In the case where more than one child who is subject to section 1(i) uses the same parent's taxable income to determine their allocable parental tax, what effect <PRTPAGE P="18"/>will a subsequent adjustment to the net unearned income of one child have on the other child's share of the allocable parental tax?</E> </P> <P>A-18. If, for the same taxable year, more than one child uses the same parent's taxable income to determine their share of the allocable parental tax and a subsequent adjustment is made to one or more of such children's net unearned income, each child's share of the allocable parental tax must be recomputed using the combined net unearned income of all such children as adjusted.</P> <P> <E T="03">Q-19. If a recomputation of a child's tax under section 1(i), as a result of an adjustment to the taxable income of the child's parents or another child's net unearned income, results in additional tax being imposed by section 1(i) on the child, is the child subject to interest and penalties on such additional tax?</E> </P> <P>A-19. Any additional tax resulting from an adjustment to the taxable income of the child's parents or the net unearned income of another child shall be treated as an underpayment of tax and interest shall be imposed on such underpayment as provided in section 6601. However, the child shall not be liable for any penalties on the underpayment resulting from additional tax being imposed under section 1(i) due to such an adjustment. </P> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>D and M are the parents of C, a child under the age of 14. D and M file a joint return for 1988 and report taxable income of $69,900. C has unearned income of $3,000 and no itemized deductions for 1988. C properly reports a total tax liability of $635 for 1988. This amount is the sum of the allocable parental tax of $560 on C's net unearned income of $2,000 (the excess of $3,000 over the sum of $500 standard deduction and the first $500 of taxable unearned income) plus $75 (the tax imposed on C's first $500 of taxable unearned income). <E T="03">See</E> A-3. One year later, D and M's 1988 tax return is adjusted on audit by adding an additional $1,000 of taxable income. No adjustment is made to the amount reported as C's net unearned income for 1988. However, the adjustment to D and M's taxable income causes C's tax liability under section 1(i) for 1988 to be increased by $50 as a result of the phase-out of the 15 percent rate bracket. <E T="03">See</E> A-20. In addition to this further tax liability, C will be liable for interest on the $50. However, C will not have to pay any penalty on the delinquent amount.</P> </EXAMPLE> <HD SOURCE="HD1">Miscellaneous Rules</HD> <P> <E T="03">Q-20. Does the phase-out of the parent's 15 percent rate bracket and personal exemptions under section 1(g), if applicable, have any effect on the calculation of the allocable parental tax imposed on a child's net unearned income under section 1(i)?</E> </P> <P>A-20. Yes. Any phase-out of the parent's 15 percent rate bracket or personal exemptions under section 1(g) is given full effect in determining the tax that would be imposed on the sum of the parent's taxable income and the total net unearned income of all children of the parent. Thus, any additional tax on a child's net unearned income resulting from the phase-out of the 15 percent rate bracket and the personal exemptions is reflected in the tax liability of the child.</P> <P> <E T="03">Q-21. For purposes of calculating a parent's tax liability or the allocable parental tax imposed on a child, are other phase-outs, limitations, or floors on deductions or credits, such as the phase-out of the $25,000 passive loss allowance for rental real estate activities under section 469(i)(3) or the 2 percent of AGI floor on miscellaneous itemized deductions under section 67, affected by the addition of a child's net unearned income to the parent's taxable income?</E> </P> <P>A-21. No. A child's net unearned income is not taken into account in computing any deduction or credit for purposes of determining the parent's tax liability or the child's allocable parental tax. Thus, for example, although the amounts allowable to the parent as a charitable contribution deduction, medical expense deduction, section 212 deduction, or a miscellaneous itemized deduction are affected by the amount of the parent's adjusted gross income, the amount of these deductions that is allowed does not change as a result of the application of section 1(i) because the amount of the parent's adjusted gross income does not include the child's net unearned income. Similarly, the amount of itemized deductions that is allowed to a child does not change as a result of section 1(i) because section 1(i) only affects the amount of tax liability and not the child's adjusted gross income.</P> <P> <E T="03">Q-22. If a child is unable to obtain information concerning the tax return of the <PRTPAGE P="19"/>child's parents directly from such parents, how may the child obtain information from the parent's tax return which is necessary to determine the child's tax liability under section 1(i)?</E> </P> <P>A-22. Under section 6103(e)(1)(A)(iv), a return of a parent shall, upon written request, be open to inspection or disclosure to a child of that individual (or the child's legal representative) to the extent necessary to comply with section 1(i). Thus, a child may request the Internal Revenue Service to disclose sufficient tax information about the parent to the child so that the child can properly file his or her return.</P> <CITA>[T.D. 8158, 52 FR 33579, Sept. 4, 1987; 52 FR 36133, Sept. 25, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.2-1</SECTNO> <SUBJECT>Tax in case of joint return of husband and wife or the return of a surviving spouse.</SUBJECT> <P>(a) <E T="03">Taxable year ending before January 1, 1971.</E> (1) For taxable years ending before January 1, 1971, in the case of a joint return of husband and wife, or the return of a surviving spouse as defined in section 2(b), the tax imposed by section 1 shall be twice the tax that would be imposed if the taxable income were reduced by one-half. For rules relating to the filing of joint returns of husband and wife, see section 6013 and the regulations thereunder.</P> <P>(2) The method of computing, under section 2(a), the tax of husband and wife in the case of a joint return, or the tax of a surviving spouse, is as follows:</P> <P>(i) First, the taxable income is reduced by one-half. Second, the tax is determined as provided by section 1 by using the taxable income so reduced. Third, the tax so determined, which is the tax that would be determined if the taxable income were reduced by one-half, is then multiplied by two to produce the tax imposed in the case of the joint return or the return of a surviving spouse, subject, however, to the allowance of any credits against the tax under the provisions of sections 31 through 38 and the regulations thereunder.</P> <P>(ii) The limitation under section 1(c) of the tax to an amount not in excess of a specified percent of the taxable income for the taxable year is to be applied before the third step above, that is, the limitation to be applied upon the tax is determined as the applicable specified percent of one-half of the taxable income for the taxable year (such one-half of the taxable income being the actual aggregate taxable income of the spouses, or the total taxable income of the surviving spouse, as the case may be, reduced by one-half). For the percent applicable in determining the limitation of the tax under section 1(c), see § 1.1-2(a). After such limitation is applied, then the tax so limited is multiplied by two as provided in section 2(a) (the third step above).</P> <P>(iii) The following computation illustrates the method of application of section 2(a) in the determination of the tax of a husband and wife filing a joint return for the calendar year 1965. If the combined gross income is $8,200, and the only deductions are the two exemptions of the taxpayers under section 151(b) and the standard deduction under section 141, the tax on the joint return for 1965, without regard to any credits against the tax, is $1,034.20 determined as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,6/7"> <ROW> <ENT I="01">1. Gross income</ENT> <ENT>$8,200.00</ENT> </ROW> <ROW> <ENT I="11">2. Less:</ENT> </ROW> <ROW> <ENT I="03">Standard deduction, section 141</ENT> <ENT>$820</ENT> <ENT/> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Deduction for personal exemption, section 151</ENT> <ENT>1,200</ENT> <ENT>2,020.00</ENT> </ROW> <ROW> <ENT I="01">3. Taxable income</ENT> <ENT>6,180.00</ENT> </ROW> <ROW> <ENT I="01">4. Taxable income reduced by one-half</ENT> <ENT>3,090.00</ENT> </ROW> <ROW> <ENT I="01">5. Tax computed by the tax table provided under section 1(a)(2) ($310 plus 19 percent of excess over $2,000)</ENT> <ENT>517.10</ENT> </ROW> <ROW> <ENT I="01">6. Twice the tax in item 5</ENT> <ENT>1,034.20</ENT> </ROW> </GPOTABLE> <P>(b) <E T="03">Taxable years beginning after December 31, 1970.</E> (1) For taxable years beginning after December 31, 1970, in the case of a joint return of husband and wife, or the return of a surviving spouse as defined in section 2(a) of the Code as amended by the Tax Reform Act of 1969, the tax shall be determined in accordance with the table contained in section 1(a) of the Code as so amended. For rules relating to the filing of joint returns of husband and wife see section 6013 as amended and the regulations thereunder.</P> <P>(2) The following computation illustrates the method of computing the tax of a husband and wife filing a joint return for calendar year 1971. If the combined gross income is $8,200, and the <PRTPAGE P="20"/>only deductions are the two exemptions of the taxpayers under section 151(b), as amended, and the standard deduction under section 141, as amended, the tax on the joint return for 1971, without regard to any credits against the tax, is $968.46, determined as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,6/7"> <ROW> <ENT I="01">1. Gross income</ENT> <ENT>$8,200.00</ENT> </ROW> <ROW> <ENT I="11">2. Less:</ENT> </ROW> <ROW> <ENT I="02">Standard deduction, section 141</ENT> <ENT>$1,066.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="02">Deduction for personal exemption, section 151</ENT> <ENT>1,300.00</ENT> <ENT>2,366.00</ENT> </ROW> <ROW> <ENT I="01">3. Taxable income</ENT> <ENT>5,834.00</ENT> </ROW> <ROW> <ENT I="01">4. Tax computed by the tax table provided under section 1(a) ($620 plus 19 percent of excess over $4,000)</ENT> <ENT>968.46</ENT> </ROW> </GPOTABLE> <P>(3) The limitation under section 1348 with respect to the maximum rate of tax on earned income shall apply to a married individual only if such individual and his spouse file a joint return for the taxable year.</P> <P>(c) <E T="03">Death of a spouse.</E> If a joint return of a husband and wife is filed under the provisions of section 6013 and if the husband and wife have different taxable years solely because of the death of either spouse, the taxable year of the deceased spouse covered by the joint return shall, for the purpose of the computation of the tax in respect of such joint return, be deemed to have ended on the date of the closing of the surviving spouse's taxable year.</P> <P>(d) <E T="03">Computation of optional tax.</E> For computation of optional tax in the case of a joint return or the return of a surviving spouse, see section 3 and the regulations thereunder.</P> <P>(e) <E T="03">Change in rates.</E> For treatment of taxable years during which a change in the tax rates occurs see section 21 and the regulations thereunder.</P> <CITA>[T.D. 7117, 36 FR 9398, May 25, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.2-2</SECTNO> <SUBJECT>Definitions and special rules.</SUBJECT> <P>(a) <E T="03">Surviving spouse.</E> (1) If a taxpayer is eligible to file a joint return under the Internal Revenue Code of 1954 without regard to section 6013(a) (3) thereof for the taxable year in which his spouse dies, his return for each of the next 2 taxable years following the year of the death of the spouse shall be treated as a joint return for all purposes if all three of the following requirements are satisfied:</P> <P>(i) He has not remarried before the close of the taxable year the return for which is sought to be treated as a joint return, and</P> <P>(ii) He maintains as his home a household which constitutes for the taxable year the principal place of abode as a member of such household of a person who is (whether by blood or adoption) a son, stepson, daughter, or stepdaughter of the taxpayer, and</P> <P>(iii) He is entitled for the taxable year to a deduction under section 151 (relating to deductions for dependents) with respect to such son, stepson, daughter, or stepdaughter.</P> <P>(2) See paragraphs (c)(1) and (d) of this section for rules for the determination of when the taxpayer maintains as his home a household which constitutes for the taxable year the principal place of abode, as a member of such household, of another person.</P> <P>(3) If the taxpayer does not qualify as a surviving spouse he may nevertheless qualify as a head of a household if he meets the requirements of § 1.2-2(b).</P> <P>(4) The following example illustrates the provisions relating to a surviving spouse: </P> <EXAMPLE> <HD SOURCE="HED">Example:</HD> <P>Assume that the taxpayer meets the requirements of this paragraph for the years 1967 through 1971, and that the taxpayer, whose wife died during 1966 while married to him, remarried in 1968. In 1969, the taxpayer's second wife died while married to him, and he remained single thereafter. For 1967 the taxpayer will qualify as a surviving spouse, provided that neither the taxpayer nor the first wife was a nonresident alien at any time during 1966 and that she (immediately prior to her death) did not have a taxable year different from that of the taxpayer. For 1968 the taxpayer does not qualify as a surviving spouse because he remarried before the close of the taxable year. The taxpayer will qualify as a surviving spouse for 1970 and 1971, provided that neither the taxpayer nor the second wife was a nonresident alien at any time during 1969 and that she (immediately prior to her death) did not have a taxable year different from that of the taxpayer. On the other hand, if the taxpayer, in 1969, was divorced or legally separated from his second wife, the taxpayer will not qualify as a surviving spouse for 1970 or 1971, since he could not have filed a joint return for 1969 (the year in which his second wife died).</P> </EXAMPLE> <PRTPAGE P="21"/> <P>(b) <E T="03">Head of household.</E> (1) A taxpayer shall be considered the head of a household if, and only if, he is not married at the close of his taxable year, is not a surviving spouse (as defined in paragraph (a) of this section, and (i) maintains as his home a household which constitutes for such taxable year the principal place of abode, as a member of such household, of at least one of the individuals described in subparagraph (3), or (ii) maintains (whether or not as his home) a household which constitutes for such taxable year the principal place of abode of one of the individuals described in subparagraph (4).</P> <P>(2) Under no circumstances shall the same person be used to qualify more than one taxpayer as the head of a household for the same taxable year.</P> <P>(3) Any of the following persons may qualify the taxpayer as a head of a household:</P> <P>(i) A son, stepson, daughter, or stepdaughter of the taxpayer, or a descendant of a son or daughter of the taxpayer. For the purpose of determining whether any of the stated relationships exist, a legally adopted child of a person is considered a child of such person by blood. If any such person is not married at the close of the taxable year of the taxpayer, the taxpayer may qualify as the head of a household by reason of such person even though the taxpayer may not claim a deduction for such person under section 151, for example, because the taxpayer does not furnish more than half of the support of such person. However, if any such person is married at the close of the taxable year of the taxpayer, the taxpayer may qualify as the head of a household by reason of such person only if the taxpayer is entitled to a deduction for such person under section 151 and the regulations thereunder. In applying the preceding sentence there shall be disregarded any such person for whom a deduction is allowed under section 151 only by reason of section 152(c) (relating to persons covered by a multiple support agreement).</P> <P>(ii) Any other person who is a dependent of the taxpayer, if the taxpayer is entitled to a deduction for the taxable year for such person under section 151 and paragraphs (3) through (8) of section 152(a) and the regulations thereunder. Under section 151 the taxpayer may be entitled to a deduction for any of the following persons:</P> <P> <E T="03">(a)</E> His brother, sister, stepbrother, or stepsister;</P> <P> <E T="03">(b)</E> His father or mother, or an ancestor of either;</P> <P> <E T="03">(c)</E> His stepfather or stepmother;</P> <P> <E T="03">(d)</E> A son or a daughter of his brother or sister;</P> <P> <E T="03">(e)</E> A brother or sister of his father or mother; or</P> <P> <E T="03">(f)</E> His son-in-law, daughter-in-law, father-in-law, mother-in-law, brother- in-law, or sister-in-law;</P> <FP>if such person has a gross income of less than the amount determined pursuant to § 1.151-2 applicable to the calendar year in which the taxable year of the taxpayer begins, if the taxpayer supplies more than one-half of the support of such person for such calendar year and if such person does not make a joint return with his spouse for the taxable year beginning in such calendar year. The taxpayer may not be considered to be a head of a household by reason of any person for whom a deduction is allowed under section 151 only by reason of sections 152 (a)(9), 152 (a)(10), or 152(c) (relating to persons not related to the taxpayer, persons receiving institutional care, and persons covered by multiple support agreements).</FP> <P>(4) The father or mother of the taxpayer may qualify the taxpayer as a head of a household, but only if the taxpayer is entitled to a deduction for the taxable year for such father or mother under section 151 (determined without regard to section 152(c)). For example, an unmarried taxpayer who maintains a home for his widowed mother may not qualify as the head of a household by reason of his maintenance of a home for his mother if his mother has gross income equal to or in excess of the amount determined pursuant to § 1.151-2 applicable to the calendar year in which the taxable year of the taxpayer begins, or if he does not furnish more than one-half of the support of his mother for such calendar year. For this purpose, a person who legally adopted the taxpayer is considered the father or mother of the taxpayer.<PRTPAGE P="22"/> </P> <P>(5) For the purpose of this paragraph, the status of the taxpayer shall be determined as of the close of the taxpayer's taxable year. A taxpayer shall be considered as not married if at the close of his taxable year he is legally separated from his spouse under a decree of divorce or separate maintenance, or if at any time during the taxable year the spouse to whom the taxpayer is married at the close of his taxable year was a nonresident alien. A taxpayer shall be considered married at the close of his taxable year if his spouse (other than a spouse who is a nonresident alien) dies during such year.</P> <P>(6) If the taxpayer is a nonresident alien during any part of the taxable year he may not qualify as a head of a household even though he may comply with the other provisions of this paragraph. See the regulations prescribed under section 871 for a definition of nonresident alien.</P> <P>(c) <E T="03">Household.</E> (1) In order for a taxpayer to be considered as maintaining a household by reason of any individual described in paragraph (a)(1) or (b)(3) of this section, the household must actually constitute the home of the taxpayer for his taxable year. A physical change in the location of such home will not prevent a taxpayer from qualifying as a head of a household. Such home must also constitute the principal place of abode of at least one of the persons specified in such paragraph (a)(1) or (b)(3) of this section. It is not sufficient that the taxpayer maintain the household without being its occupant. The taxpayer and such other person must occupy the household for the entire taxable year of the taxpayer. However, the fact that such other person is born or dies within the taxable year will not prevent the taxpayer from qualifying as a head of household if the household constitutes the principal place of abode of such other person for the remaining or preceding part of such taxable year. The taxpayer and such other person will be considered as occupying the household for such entire taxable year notwithstanding temporary absences from the household due to special circumstances. A nonpermanent failure to occupy the common abode by reason of illness, education, business, vacation, military service, or a custody agreement under which a child or stepchild is absent for less than 6 months in the taxable year of the taxpayer, shall be considered temporary absence due to special circumstances. Such absence will not prevent the taxpayer from being considered as maintaining a household if (i) it is reasonable to assume that the taxpayer or such other person will return to the household, and (ii) the taxpayer continues to maintain such household or a substantially equivalent household in anticipation of such return.</P> <P>(2) In order for a taxpayer to be considered as maintaining a household by reason of any individual described in paragraph (b)(4) of this section, the household must actually constitute the principal place of abode of the taxpayer's dependent father or mother, or both of them. It is not, however, necessary for the purposes of such subparagraph for the taxpayer also to reside in such place of abode. A physical change in the location of such home will not prevent a taxpayer from qualifying as a head of a household. The father or mother of the taxpayer, however, must occupy the household for the entire taxable year of the taxpayer. They will be considered as occupying the household for such entire year notwithstanding temporary absences from the household due to special circumstances. For example, a nonpermanent failure to occupy the household by reason of illness or vacation shall be considered temporary absence due to special circumstances. Such absence will not prevent the taxpayer from qualifying as the head of a household if (i) it is reasonable to assume that such person will return to the household, and (ii) the taxpayer continues to maintain such household or a substantially equivalent household in anticipation of such return. However, the fact that the father or mother of the taxpayer dies within the year will not prevent the taxpayer from qualifying as a head of a household if the household constitutes the principal place of abode of the father or mother for the preceding part of such taxable year.</P> <P>(d) <E T="03">Cost of maintaining a household.</E> A taxpayer shall be considered as maintaining a household only if he pays <PRTPAGE P="23"/>more than one-half the cost thereof for his taxable year. The cost of maintaining a household shall be the expenses incurred for the mutual benefit of the occupants thereof by reason of its operation as the principal place of abode of such occupants for such taxable year. The cost of maintaining a household shall not include expenses otherwise incurred. The expenses of maintaining a household include property taxes, mortgage interest, rent, utility charges, upkeep and repairs, property insurance, and food consumed on the premises. Such expenses do not include the cost of clothing, education, medical treatment, vacations, life insurance, and transportation. In addition, the cost of maintaining a household shall not include any amount which represents the value of services rendered in the household by the taxpayer or by a person qualifying the taxpayer as a head of a household or as a surviving spouse.</P> <P>(e) <E T="03">Certain married individuals living apart.</E> For taxable years beginning after December 31, 1969, an individual who is considered as not married under section 143(b) shall be considered as not married for purposes of determining whether he or she qualifies as a single individual, a married individual, a head of household or a surviving spouse under sections 1 and 2 of the Code.</P> <CITA>[T.D. 7117, 36 FR 9398, May 25, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.3-1</SECTNO> <SUBJECT>Application of optional tax.</SUBJECT> <P>(a) <E T="03">General rules.</E> (1) For taxable years ending before January 1, 1970, an individual whose adjusted gross income is less than $5,000 (or a husband and wife filing a joint return whose combined adjusted gross income is less than $5,000) may elect to pay the tax imposed by section 3 in place of the tax imposed by section 1 (a) or (b). For taxable years beginning after December 31, 1969 and before January 1, 1971 an individual whose adjusted gross income is less than $10,000 (or a husband and wife filing a joint return whose combined adjusted gross income is less than $10,000) may elect to pay the tax imposed by section 3 as amended by the Tax Reform Act of 1969 in place of the tax imposed by section 1 (a) or (b). For taxable years beginning after December 31, 1970 an individual whose adjusted gross income is less than $10,000 (or a husband and wife filing a joint return whose combined adjusted gross income is less than $10,000) may elect to pay the tax imposed by section 3 as amended in place of the tax imposed by section 1 as amended. See § 1.4-2 for the manner of making such election. A taxpayer may make such election regardless of the sources from which his income is derived and regardless of whether his income is computed by the cash method or the accrual method. See section 62 and the regulations thereunder for the determination of adjusted gross income. For the purpose of determining whether a taxpayer may elect to pay the tax under section 3, the amount of the adjusted gross income is controlling, without reference to the number of exemptions to which the taxpayer may be entitled. See section 4 and the regulations thereunder for additional rules applicable to section 3.</P> <P>(2) The following examples illustrate the rule that section 3 applies only if the adjusted gross income is less than $10,000 ($5,000 for taxable years ending before January 1, 1970). </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A is employed at a salary of $9,200 for the calendar year 1970. In the course of such employment, he incurred travel expenses of $1,500 for which he was reimbursed during the year. Such items constitute his sole income for 1970. In such case the gross income is $10,700 but the amount of $1,500 is deducted from gross income in the determination of adjusted gross income and thus A's adjusted gross income for 1970 is $9,200. Hence, the adjusted gross income being less than $10,000, he may elect to pay his tax for 1970 under section 3. Similarly, in the case of an individual engaged in trade or business (excluding from the term “engaged in trade or business” the performance of personal services as an employee), there may be deducted from gross income in ascertaining adjusted gross income those expenses directly relating to the carrying on of such trade or business.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>If B has, as his only income for 1970, a salary of $11,600 and his spouse has no gross income, then B's adjusted gross income is $11,600 (not $11,600 reduced by exemptions of $1,250) and he is not for such year, entitled to pay his tax under section 3. If, however, B has for 1970 a salary of $13,000 and incident to his employment he incurs expenses in the amount of $3,400 for travel, meals, and lodging while away from home, for which he is not reimbursed, the adjusted gross income is <PRTPAGE P="24"/>$13,000 minus $3,400 or $9,600. In such case his adjusted gross income being less than $10,000, B may elect to pay the tax under section 3. However, if B's wife has adjusted gross income of $400, the total adjusted gross income is $10,000. In such case, if B and his wife file a joint return, they may not elect to pay the optional tax since the combined adjusted gross income is not less than $10,000. B may nevertheless elect to pay the optional tax, but if he makes this election he must file a separate return and, since his wife has gross income, he may not claim an exemption for her in computing the optional tax.</P> </EXAMPLE> <P>(b) <E T="03">Surviving spouse.</E> The return of a surviving spouse is treated as a joint return for purposes of section 3. See section 2, and the regulations thereunder, with respect to the qualifications of a taxpayer as a surviving spouse. Accordingly, if the taxpayer qualifies as a surviving spouse and elects to pay the optional tax, he shall use the column in the tax table, appropriate to his number of exemptions, provided for cases in which a joint return is filed.</P> <P>(c) <E T="03">Use of tax table.</E> (1) To determine the amount of the tax, the individual ascertains the amount of his adjusted gross income, refers to the appropriate table set forth in section 3 or the regulations thereunder, ascertains the income bracket into which such income falls, and, using the number of exemptions applicable to his case, finds the tax in the vertical column having at the top thereof a number corresponding to the number of exemptions to which the taxpayer is entitled.</P> <P>(2) Section 3(b) (relating to taxable years beginning after Dec. 31, 1964 and ending before Jan. 1, 1970) contains 5 tables for use in computing the tax. Table I is to be used by a single person who is not a head of household. Table II is to be used by a head of household. Table III is to be used by married persons filing joint returns and by a surviving spouse. Table IV is to be used by married persons filing separate returns using the 10 percent standard deduction. Table V is to be used by married persons filing separate returns using the minimum standard deduction. For an explanation of the standard deduction see section 141 and the regulations thereunder.</P> <P>(3) 30 tables are provided for use in computing the tax under the Tax Reform Act of 1969. Tables I through XV apply for taxable years beginning after December 31, 1969 and ending before January 1, 1971. Tables XVI through XXX apply for taxable years beginning after December 31, 1970. The standard deduction for Tables I through XV, applicable to taxable years beginning in 1970, is 10 percent. The standard deduction for Tables XVI through XXX, applicable to taxable years beginning in 1971, is 13 percent. For an explanation of the standard deduction and the low income allowance see section 141 as amended by the Tax Reform Act of 1969.</P> <P>(4) In the case of married persons filing separate returns who qualify to use the optional tax imposed by section 3, such persons shall use the tax imposed by the table for the applicable year in accordance with the rules prescribed by sections 4(c) and 141 and the regulations thereunder governing the use and application of the standard deduction and the low income allowance.</P> <P>(5) The tax shown in the tax tables set forth in section 3 or the regulations thereunder reflects full income splitting in the case of a joint return (including the return of a surviving spouse) and lesser income splitting in the case of a head of household. Therefore, it is possible for the tax shown in the tables relating to joint returns, or relating to a return of a head of a household, to be lower than that shown in the table for separate returns even though the amounts of adjusted gross income and the number of exemptions are the same.</P> <CITA>[T.D. 7117, 36 FR 9420, May 25, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.4-1</SECTNO> <SUBJECT>Number of exemptions.</SUBJECT> <P>(a) For the purpose of determining the optional tax imposed under section 3, the taxpayer shall use the number of exemptions allowable to him as deductions under section 151. See sections 151, 152, and 153, and the regulations thereunder. In general, one exemption is allowed for the taxpayer; one exemption for his spouse if a joint return is made, or if a separate return is made by the taxpayer and his spouse has no gross income for the calendar year in which the taxable year of the taxpayer begins and is not the dependent of another taxpayer for such calendar year; <PRTPAGE P="25"/>and one exemption for each dependent whose gross income for the calendar year in which the taxable year of the taxpayer begins is less than the applicable amount determined pursuant to § 1.151-2. No exemption is allowed for any dependent who has made a joint return with his spouse for the taxable year beginning in the calendar year in which the taxable year of the taxpayer begins. The taxpayer may, in certain cases, be allowed an exemption for a dependent child of the taxpayer notwithstanding the fact that such child has gross income equal to or in excess of the amount determined pursuant to § 1.151-2 applicable to the calendar year in which the taxable year of the taxpayer begins. The requirements for the allowance of such an exemption are set forth in paragraph (c) of § 1.152-1. See paragraphs (c) and (d) of § 1.151-1 with respect to additional exemptions for a taxpayer or spouse who has attained the age 65 years and for a blind taxpayer or blind spouse</P> <P>(b) The application of this section may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A, a married man whose duties as an employee require traveling away from his home, has as his sole gross income a salary of $5,600 for the calendar year 1954. His traveling expenses, including cost of meals and lodging, amount in such year to $750, and hence, his adjusted gross income is $4,850. His wife, B, has as her sole income interest in the amount of $85, and thus the aggregate adjusted gross income of A and B is $4,935. A has two dependent children neither of whom has any income. A and B file a joint return for 1954 on Form 1040. In such case four exemptions are allowable. The adjusted gross income falls within the tax bracket $4,900-4,950. By referring to such tax bracket in the tax table in section 3 and to the column headed “4” therein, the tax is found to be $407.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>C, a married man, has as his sole income in 1954 wages of $4,600, and has two dependent children neither of whom has any income. His wife, D, has adjusted gross income of $400. C files a separate return for 1954 and is entitled to claim three exemptions. C's income falls within the tax bracket $4,600-4,650 and hence, with three exemptions his tax is $480. No exemption is allowed with respect to since D has gross income and a joint return was not filed.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>D, a married man with no dependents, attains the age of 65 on September 1, 1954. The aggregate adjusted gross income of D and his wife for 1954 is $4,840. D and his wife file a joint return for 1954 and are entitled to three exemptions, one for each taxpayer and one additional exemption for D because of his age. Since the adjusted gross income of D and his wife falls within the tax bracket $4,800-4,850, the tax on a joint return is $509.</P> </EXAMPLE> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7114, 36 FR 9018, May 18, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.4-2</SECTNO> <SUBJECT>Elections.</SUBJECT> <P>(a) <E T="03">Making of election.</E> The election to pay the optional tax imposed under section 3 shall be made by (1) filing a return on Form 1040A, or (2) filing a return on Form 1040 and electing in such return, in accordance with the provisions of section 144 and the regulations thereunder, to take the standard deduction provided by section 141.</P> <P>(b) <E T="03">Election under section 3 and election of standard deduction.</E> Section 144 (a) and the regulations thereunder provide rules for treating an election to pay the tax under section 3 as an election to take the standard deduction, and for treating an election to take the standard deduction as an election to pay the tax under section 3. For example, if the taxpayer's return shows $5,000 or more of adjusted gross income and he elects to take the standard deduction, he will be deemed to have elected to pay the tax under section 3 if it is subsequently determined that his correct adjusted gross income is less than $5,000.</P> <P>(c) [Reserved]</P> <P>(d) <E T="03">Change of election.</E> For rules relating to a change of election to pay, or not to pay, the optional tax imposed under section 3, see section 144 (b) and the regulations thereunder.</P> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6581, 26 FR 11677, Dec. 6, 1961; T.D. 7269, 38 FR 9295, April 13, 1973]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.4-3</SECTNO> <SUBJECT>Husband and wife filing separate returns.</SUBJECT> <P>(a) <E T="03">In general.</E> If the separate adjusted gross income of a husband is less than $5,000 and the separate adjusted gross income of his wife is less than $5,000, and if each is required to file a return, the husband and the wife must each elect to pay the optional tax imposed under section 3 or neither may so elect. If the separate adjusted gross income of each spouse is $5,000 or more, then <PRTPAGE P="26"/>neither spouse can elect to pay the optional tax imposed under section 3. If the adjusted gross income of one spouse is $5,000 or more and that of the other spouse is less than $5,000, the election to pay the optional tax imposed under section 3 may be exercised by the spouse having adjusted gross income of less than $5,000 only if the spouse having adjusted gross income of $5,000 or more, in computing taxable income, uses the standard deduction provided by section 141. If the spouse having adjusted gross income of $5,000 or more does not use the standard deduction, then the spouse having adjusted gross income of less than $5,000 may not elect to pay the optional tax and must compute taxable income without regard to the standard deduction. Accordingly, if the spouse having adjusted gross income of $5,000 or more itemizes the deductions allowed by sections 161 and 211 in computing taxable income, the spouse having adjusted gross income of less than $5,000 must also compute taxable income by itemizing the deductions allowed by sections 161 and 211, and must pay the tax imposed by section 1. For rules relative to the election to take the standard deduction by husband and wife, see part IV (section 141 and following), subchapter B, chapter 1 of the Code, and the regulations thereunder.</P> <P>(b) <E T="03">Taxable years beginning after December 31, 1963, and before January 1, 1970.</E> (1) In the case of a husband and wife filing a separate return for a taxable year beginning after December 31, 1963, and before January 1, 1970, the optional tax imposed by section 3 shall be—</P> <P>(i) For taxable years beginning in 1964, the lesser of the tax shown in Table IV (relating to the 10-percent standard deduction for married persons filing separate returns) or Table V (relating to the minimum standard deduction for married persons filing separate returns) of section 3(a), and</P> <P>(ii) For a taxable year beginning after December 31, 1964, and before January 1, 1970, the lesser of the tax shown in Table IV (relating to the 10-percent standard deduction for married persons filing separate returns) or Table V (relating to minimum standard deduction for married persons filing separate returns) of section 3(b).</P> <P>(2) If the tax of one spouse is determined with regard to the 10-percent standard deduction provided for in Table IV of section 3(a) or 3(b) or if such spouse in computing taxable income uses the 10-percent standard deduction provided for in section 141(b), then the minimum standard deduction provided for in Table V of section 3(a) or 3(b) shall not apply in the case of the other spouse, if such spouse elects to pay the optional tax imposed under section (3). Thus, if a husband and wife compute their tax with reference to the standard deduction, one cannot elect to use the 10-percent standard deduction and the other elect to use the minimum standard deduction. However, an individual described in section 141(d)(2) may elect pursuant to such section and the regulations thereunder to pay the tax shown in Table V of section 3(a) or 3(b) in lieu of the tax shown in Table IV of section 3(a) or 3(b). See section 141(d) and the regulations thereunder for rules relating to the standard deduction in the case of married individuals filing separate returns.</P> <P>(c) <E T="03">Taxable years beginning after December 31, 1969.</E> (1) In the case of a husband and wife filing a separate return for a taxable year beginning after December 31, 1969, the optional tax imposed by section 3 shall be the lesser of the tax shown in—</P> <P>(i) The table prescribed under section 3 applicable to such taxable year in the case of married persons filing separate returns which applies the percentage standard deduction, or</P> <P>(ii) The table prescribed under section 3 applicable to such taxable year in the case of married persons filing separate returns which applies the low income allowance.</P> <P>(2) If the tax of one spouse is determined by the table described in subparagraph (1)(i) of this paragraph or if such spouse in computing taxable income uses the percentage standard deduction provided for in section 141(b), then the table described in subparagraph (1)(ii) of this paragraph shall not apply in the case of the other spouse, if such other spouse elects to pay the optional tax imposed under section 3. Thus, if a husband and wife compute <PRTPAGE P="27"/>the tax with reference to the standard deduction, one cannot elect to use the percentage standard deduction and the other elect to use the low income allowance. A married individual described in section 141(d)(2) may elect pursuant to such section and the regulations thereunder to pay the tax shown in the table described by subparagraph (1)(ii) of this paragraph in lieu of the tax shown in the table described by subparagraph (1)(i) of this paragraph. See section 141(d) and the regulations thereunder for rules relating to the standard deduction in the case of married individuals filing separate returns.</P> <P>(d) <E T="03">Determination of marital status.</E> For the purpose of applying the restrictions upon the right of a married person to elect to pay the tax under section 3, (1) the determination of marital status is made as of the close of the taxpayer's taxable year or, if his spouse died during such year, as of the date of death; (2) a person legally separated from his spouse under a decree of divorce or separate maintenance on the last day of his taxable year (or the date of death of his spouse, whichever is applicable) is not considered as married; and (3) with respect to taxable years beginning after December 31, 1969, a person, although considered as married within the meaning of section 143(a), is considered as not married if he lives apart from his spouse and satisfies the requirements set forth in section 143(b). See section 143 and the regulations thereunder.</P> <CITA>[T.D. 6792, 30 FR 529, Jan. 15, 1965, as amended by T.D. 7123, 36 FR 11084, June 9, 1971]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.4-4</SECTNO> <SUBJECT>Short taxable year caused by death.</SUBJECT> <P>An individual making a return for a period of less than 12 months on account of a change in his accounting period may not elect to pay the optional tax under section 3. However, the fact that the taxable year is less than 12 months does not prevent the determination of the tax for the taxable year under section 3 if the short taxable year results from the death of the taxpayer.</P> </SECTION> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Tax on Corporations</HD> <SECTION> <SECTNO>§ 1.11-1</SECTNO> <SUBJECT>Tax on corporations.</SUBJECT> <P>(a) Every corporation, foreign or domestic, is liable to the tax imposed under section 11 except (1) corporations specifically excepted under such section from such tax; (2) corporations expressly exempt from all taxation under subtitle A of the Code (see section 501); and (3) corporations subject to tax under section 511(a). For taxable years beginning after December 31, 1966, foreign corporations engaged in trade or business in the United States shall be taxable under section 11 only on their taxable income which is effectively connected with the conduct of a trade or business in the United States (see section 882(a)(1)). For definition of the terms “corporations,” “domestic,” and “foreign,” see section 7701(a) (3), (4), and (5), respectively. It is immaterial that a domestic corporation, and for taxable years beginning after December 31, 1966, a foreign corporation engaged in trade or business in the United States, which is subject to the tax imposed by section 11 may derive no income from sources within the United States. The tax imposed by section 11 is payable upon the basis of the returns rendered by the corporations liable thereto, except that in some cases a tax is to be paid at the source of the income. See subchapter A (sections 6001 and following), chapter 61 of the Code, and section 1442.</P> <P>(b) The tax imposed by section 11 consists of a normal tax and a surtax. The normal tax and the surtax are both computed upon the taxable income of the corporation for the taxable year, that is, upon the gross income of the corporation minus the deductions allowed by chapter 1 of the Code. However, the deduction provided in section 242 for partially tax-exempt interest is not allowed in computing the taxable income subject to the surtax.</P> <P>(c) The normal tax is at the rate of 22 percent and is applied to the taxable income for the taxable year. However, in the case of a taxable year ending after December 31, 1974, and before January 1, 1976, the normal tax is at the rate of 20 percent of so much of the taxable income as does not exceed $25,000 and at the rate of 22 percent of <PRTPAGE P="28"/>so much of the taxable income as does exceed $25,000 and is applied to the taxable income for the taxable year.</P> <P>(d) The surtax is at the rate of 26 percent and is upon the taxable income (computed without regard to the deduction, if any, provided in section 242 for partially tax-exempt interest) in excess of $25,000. However, in the case of a taxable year ending after December 31, 1974, and before January 1, 1976, the surtax is upon the taxable income (computed as provided in the preceding sentence) in excess of $50,000. In certain circumstances the exemption from surtax may be disallowed in whole or in part. See sections 269, 1551, 1561, and 1564 and the regulations thereunder. For purposes of sections 244, 247, 804, 907, 922 and §§ 1.51-1 and 1.815-4, when the phrase “the sum of the normal tax rate and the surtax rate for the taxable year” is used in any such section, the normal tax rate for all taxable years beginning after December 31, 1963, and ending before January 1, 1976, shall be considered to be 22 percent.</P> <P>(e) The computation of the tax on corporations imposed under section 11 may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>The X Corporation, a domestic corporation, has gross income of $86,000 for the calendar year 1964. The gross income includes interest of $5,000 on United States obligations for which a deduction under section 242 is allowable in determining taxable income subject to the normal tax. It has other deductions of $11,000. The tax of the X Corporation under section 11 for the calendar year is $28,400 ($15,400 normal tax and $13,000 surtax) computed as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,6/7"> <ROW> <ENT I="28"> <E T="04">Computation of Normal Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Gross income</ENT> <ENT>$86,000</ENT> </ROW> <ROW> <ENT I="11">Deductions:</ENT> </ROW> <ROW> <ENT I="02">Partially tax-exempt interest</ENT> <ENT>$5,000</ENT> <ENT/> </ROW> <ROW RUL="n,s,s"> <ENT I="02">Other</ENT> <ENT>11,000</ENT> <ENT>16,000</ENT> </ROW> <ROW> <ENT I="01">Taxable income</ENT> <ENT>70,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax (22 percent of $70,000)</ENT> <ENT>15,400 </ENT> </ROW> <ROW> <ENT I="28"> <E T="04">Computation of Surtax</E> </ENT> </ROW> <ROW> <ENT I="01">Taxable income</ENT> <ENT>70,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Add: Amount of partially tax-exempt interest deducted in computing taxable income</ENT> <ENT>5,000</ENT> </ROW> <ROW> <ENT I="01">Taxable income subject to surtax</ENT> <ENT>75,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Less: Exemption from surtax</ENT> <ENT>25,000</ENT> </ROW> <ROW> <ENT I="01">Excess of taxable income subject to surtax over exemption</ENT> <ENT>50,000</ENT> </ROW> <ROW> <ENT I="01">Surtax (26 percent of $50,000)</ENT> <ENT>13,000</ENT> </ROW> </GPOTABLE> </EXAMPLE> <P>(f) For special rules applicable to foreign corporations engaged in trade or business within the United States, see section 882 and the regulations thereunder. For additional tax on personal holding companies, see part II (section 541 and following), subchapter G, chapter 1 of the Code, and the regulations thereunder. For additional tax on corporations improperly accumulating surplus, see part I (section 531 and following), subchapter G, chapter 1 of the Code, and the regulations thereunder. For treatment of China Trade Act corporations, see sections 941 and 942 and the regulations thereunder. For treatment of Western Hemisphere trade corporations, see sections 921 and 922 and the regulations thereunder. For treatment of capital gains and losses, see subchapter P (section 1201 and following), chapter 1 of the Code. For computation of the tax for a taxable year during which a change in the tax rates occurs, see section 21 and the regulations thereunder.</P> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7293, 38 FR 32792, Nov. 28, 1973; T.D. 74-13, 41 FR 12639, Mar. 26, 1976]</CITA> </SECTION> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Changes in Rates During a Taxable Year</HD> <SECTION> <SECTNO>§ 1.21-1</SECTNO> <SUBJECT>Changes in rate during a taxable year.</SUBJECT> <P>(a) Section 21 applies to all taxpayers, including individuals and corporations. It provides a general rule applicable in any case where (1) any rate of tax imposed by chapter 1 of the Code upon the taxpayer is increased or decreased, or any such tax is repealed, and (2) the taxable year includes the effective date of the change, except where that date is the first day of the taxable year. For example, the normal tax on corporations under section 11(b) was decreased from 30 percent to 22 percent in the case of a taxable year beginning after December 31, 1963. Accordingly, the tax for a taxable year of a corporation beginning on January 1, 1964, would be computed under section 11(b) at the new rate without regard to section 21. However, for any taxable year beginning before January 1, 1964, and ending on or after that date, the tax would be computed under section 21. For additional circumstances under which section 21 is not applicable, see paragraph (k) of this section.<PRTPAGE P="29"/> </P> <P>(b) In any case in which section 21 is applicable, a tentative tax shall be computed by applying to the taxable income for the entire taxable year the rate for the period within the taxable year before the effective date of change, and another tentative tax shall be computed by applying to the taxable income for the entire taxable year the rate for the period within the taxable year on or after such effective date. The tax imposed on the taxpayer is the sum of—</P> <P>(1) An amount which bears the same ratio to the tentative tax computed at the rate applicable to the period within the taxable year before the effective date of the change that the number of days in such period bears to the number of days in the taxable year, and</P> <P>(2) An amount which bears the same ratio to the tentative tax computed at the rate applicable to the period within the taxable year on and after the effective date of the change that the number of days in such period bears to the number of days in the taxable year.</P> <P>(c) If the rate of tax is changed for taxable years “beginning after” or “ending after” a certain date, the following day is considered the effective date of the change for purposes of section 21. If the rate is changed for taxable years “beginning on or after” a certain date, that date is considered the effective date of the change for purposes of section 21. This rule may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Assume that the law provides that a change in a certain rate of tax shall be effective only with respect to taxable years beginning after December 31, 1969. The effective date of change for purposes of section 21 is January 1, 1970, and section 21 must be applied to any taxable year which begins before and ends on or after January 1, 1970.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Assume that the law provides that a change in a certain rate of tax shall be applicable only with respect to taxable years ending after December 31, 1970. For purposes of section 21, the effective date of change is January 1, 1971, and section 21 must be applied to any taxable year which begins before and ends on or after January 1, 1971.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>Assume that the law provides that a change in a certain rate of tax shall be effective only with respect to taxable years beginning on or after January 1, 1971. The effective date of change for purposes of section 21 is January 1, 1971, and section 21 must be applied to any taxable year which begins before and ends on or after January 1, 1971.</P> </EXAMPLE> <P>(d) If a tax is repealed, the repeal will be treated as a change of rate for purposes of section 21, and the rate for the period after the repeal (for purposes of computing the tentative tax with respect to that period) will be considered zero. For example, the Tax Reform Act of 1969 repealed section 1562, which imposed a 6 percent additional tax on controlled corporations electing multiple surtax exemptions, effective for taxable years beginning after December 31, 1974. For such controlled corporations having taxable years beginning in 1974 and ending in 1975, the rate for the period ending before January 1, 1975, would be 6 percent; the rate for the period beginning after December 31, 1974, would be zero. However, subject to the rules stated in this section, section 21 does not apply to the imposition of a new tax. For example, if a new tax is imposed for taxable years beginning on or after July 1, 1972, a computation under section 21 would not be required with respect to such new tax in the case of taxable years beginning before July 1, 1972, and ending on or after that date. If the effective date of the imposition of a new tax and the effective date of a change in rate of such tax fall in the same taxable year, section 21 is not applicable in computing the taxpayer's liability for such tax for such year unless the new tax is expressly imposed upon the taxpayer for a portion of his taxable year prior to the change in rate.</P> <P>(e) If a husband and wife have different taxable years because of the death of either spouse, and if a joint return is filed with respect to the taxable year of each, then, for purposes of section 21, the joint return shall be treated as if the taxable years of both spouses ended on the date of the closing of the surviving spouse's taxable year. See section 6013 (c), relating to treatment of joint return after death of either spouse. Accordingly, if a change in the rate of tax is effective during the taxable year of the surviving spouse, the tentative taxes with respect to the joint return shall be computed on the basis of the number of days during which each rate of tax was in effect for <PRTPAGE P="30"/>the taxable year of the surviving spouse.</P> <P>(f) Section 21 applies whether or not the taxpayer has a taxable year of less than 12 months. Moreover, section 21 applies whether or not the taxable income for a taxable year of less than 12 months is required to be placed on an annual basis under section 443. If the taxable income is required to be computed under section 443(b) then the tentative taxes under section 21 are computed as provided in paragraph (1) or (2) of section 443(b) and are reduced as provided in those paragraphs. The tentative taxes so computed and reduced are then apportioned as provided in section 21(a)(2) to determine the tax for such taxable year as computed under section 21.</P> <P>(g) If a taxpayer has made the election under section 441(f) (relating to computation of taxable income on the basis of an annual accounting period varying from 52 to 53 weeks), the rules provided in section 441(f)(2) shall be applicable for purposes of determining whether section 21 applies to the taxable year of the taxpayer. Where a taxpayer has made the election under section 441(f) and where section 21 applies to the taxable year of the taxpayer the computation under section 21(a)(2) shall be made upon the basis of the actual number of days in the taxable year and in each period thereof.</P> <P>(h)(1) Section 21 is applicable only if the rate of tax imposed by chapter 1 changes. Sections in which rates of tax are specified or incorporated by reference include the following: 1, 2, 3, 11, 511, 531, 541, 821, 831, 871, 881, 1201, and 1348 (for taxable years beginning after December 31, 1970). Except as provided in subparagraph (3) of this paragraph, section 21 is not applicable with respect to changes in the law relating to deductions from gross income, exclusions from or inclusions in gross income, or other items taken into account in determining the amount or character of income subject to tax. Moreover, section 21 is not applicable with respect to changes in the law relating to credits against the tax or with respect to changes in the law relating to limitations on the amount of tax. Section 21 is applicable, however, to all those computations specified in the section providing the rate of tax which are implicit in determining the rate. For example, if one of the tax brackets in the tax tables under section 3 were to be changed, section 21 would be applicable to that change. Thus, if the bracket relating to “at least $4,200 but not less than $4,250” for heads of households should be changed to increase or decrease the last sum specified, with corresponding changes being made in subsequent brackets, section 21 would be applicable. The enactment of sections 1561 and 1562 is considered a change in section 11(d) which constitutes a change in rate for the period ending after December 31, 1963. The amendment of section 1561 and the repeal of section 1562 by the Tax Reform Act of 1969 is considered a change in section 11(d) which constitutes a change in rate for the period ending after December 31, 1974. The repeal of the 2 percent additional tax imposed under section 1503 on corporations filing consolidated returns constitutes a change in rate for the period ending after December 31, 1963. The addition to the Code of section 1348 (relating to 50 percent maximum rate on earned income) is a change in rate to which section 21(a) is applicable. The amendment of section 11(d) by the Tax Reduction Act of 1975 which increases to $50,000 the surtax exemption for a taxable year ending during 1975 constitutes a change in rate for such portion of the taxable year (if less than the entire taxable year) as follows December 31, 1974. Similarly, the return of the surtax exemption to $25,000 for a taxable year ending during 1976 constitutes a change in rate for such portion of the taxable year (if less than the entire taxable year) as follows December 31, 1975.</P> <P>(2) Ordinarily, both the old and the new rates are applied to the same amount of taxable income. However, where the rate of tax is itself taken into account in determining taxable income (for example, the special deduction for Western Hemisphere trade corporations under section 922), the taxable income used in determining the tentative tax employing the rate before the effective date of change shall be determined by reference to that rate of tax, and the taxable income for the <PRTPAGE P="31"/>purpose of determining the tentative tax employing the rate for the period on and after the effective date of the change shall be determined by reference to the new tax rate.</P> <P>(3) Section 21 is applicable with respect to changes in the law relating to the standard deduction for individuals provided in part IV of subchapter B and to the deduction for personal exemptions for individuals provided in part V of subchapter B.</P> <P>(i) If the rate of tax changes more than once during the taxable year, section 21 is applicable to each change in rate. For example, if the rate of normal tax changed for taxable years beginning on or after March 1, 1954, and changed again for taxable years beginning on or after June 1, 1954, section 21 requires computation of 3 tentative taxes for any taxable year which began before March 1, 1954, and ended on or after June 1, 1954: One tentative tax at the rate in effect before the March 1 change; another tentative tax at the rate in effect from March 1 to May 31; and a third tentative tax at the rate in effect from June 1 to the end of the taxable year. The proportion of each such tentative tax taken into account in determining the tax imposed on the taxpayer is computed by reference to the portion of the taxable year before March 1, 1954, by reference to the portion of the taxable year from March 1, 1954, through May 31, 1954, and by reference to the portion of the taxable year from June 1, 1954, to the end of the taxable year, respectively.</P> <P>(j)(1) If a change in the rate of one tax imposed by chapter 1 of the Code does not affect the amount of other taxes imposed by chapter 1 of the Code the other taxes may be determined without regard to section 21 and section 21 will be applied only to the tax for which a change in rate is made. However, if the change of rate of one tax does affect the amount of other taxes imposed under chapter 1 of the Code, then the computation of the taxes under chapter 1 of the Code so affected shall be made by applying section 21. For example, if section 1201 applies to an individual taxpayer for a taxable year containing the effective date of a change in a rate of tax provided in section 1, then under section 21 the taxpayer must compute a tentative tax for each period for which a different rate of tax is effective under section 1. The tentative tax for each such period as computed under section 1201 will reflect the rate of tax provided by section 1 for such period.</P> <P>(2) In certain cases chapter 1 of the Code provides that the particular tax to be imposed upon the taxpayer shall be one of several taxes, the basis of selection being the tax that is greater or lesser. See, for example, sections 821 and 1201. If in any such case the rate of any one of these taxes changes, then the tentative taxes computed as provided by section 21 for each period shall be computed employing the tax selected in accordance with the general rule of selection for such a case, at the rate of tax in effect for such period. Thus, if a change in the rate of the alternative tax under section 1201 is such that the alternative tax under section 1201 is applicable if the old rate is used and is not applicable if the new rate is used, one tentative tax will consist of the alternative tax under section 1201 and the other tentative tax will consist of the tax imposed by the other applicable sections of chapter 1 of the Code. The two tentative taxes so computed are then prorated in accordance with section 21(a)(2) and the sum of the proportionate amounts is the tax imposed for the taxable year under chapter 1 of the Code. See the examples in paragraph (n) of this section.</P> <P>(k) Section 21 does not apply in the following situations:</P> <P>(1) The provisions of section 21 do not apply to the imposition of the tax surcharge by section 51. The proration rules of section 51(a) apply in the case of a taxable year ending on or after the effective date of the surcharge and beginning before July 1, 1970.</P> <P>(2) The provisions of section 21 do not apply to the imposition of the minimum tax for tax preferences by section 56. The proration rules of section 301(c) of the Tax Reform Act of 1969 (83 Stat. 586) apply in the case of a taxable year beginning in 1969 and ending in 1970.</P> <P>(l) In computing the number of days each rate of tax is in effect during the taxable year for purposes of section 21(a)(2), the effective date of the <PRTPAGE P="32"/>change in rate shall be counted in the period for which the new rate is in effect.</P> <P>(m) Any credits against tax, and any limitation in any credit against tax, shall be based upon the tax computed under section 21. For credits against tax, see part IV (section 31 and following), subchapter A, chapter 1 of the Code.</P> <P>(n) The application of section 21 may be illustrated by the following examples: (See also the examples in § 1.1561-2A(a)(3).) </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A, a married taxpayer filing a joint return, reports his income on the basis of a fiscal year ending June 30. For his fiscal year ending June 30, 1970, A reports taxable income (exclusive of capital gains and losses) of $50,000 and net long-term capital gain (section 1201 gain (net capital gain for taxable years beginning after December 31, 1976)) of $75,000. The rate of tax on capital gains under section 1201(b) relating to the alternative tax has been increased from 25 percent to a maximum rate of 29<FR>1/2</FR> percent with respect to gain in excess of $50,000 and the effective date of the change in rate is January 1, 1970. The income tax for the taxable year ended June 30, 1970, would be computed under section 21 as follows:</P> <GPOTABLE CDEF="s25,9,9,9" COLS="4" OPTS="L0,p1,6/7"> <ROW EXPSTB="02"> <ENT I="28"> <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW EXPSTB="00"> <ENT I="01">Taxable income exclusive of capital gains and losses</ENT> <ENT>$50,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Long-term capital gain</ENT> <ENT>75,000</ENT> </ROW> <ROW> <ENT I="22"/> <ENT>125,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Deduct 50% of long-term capital gain</ENT> <ENT>37,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Taxable income</ENT> <ENT>87,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tax under section 1 (1969 and 1970 rates)</ENT> <ENT>37,690</ENT> </ROW> <ROW EXPSTB="02"> <ENT I="28"> <E T="04">Alternative Tax Under Section</E> 1201(b) (1969 R<E T="04">ates</E>)</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="01">Taxable income ($50,000+50% of $75,000)</ENT> <ENT>$87,500</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Less 50% of long-term capital gain</ENT> <ENT>37,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income exclusive of capital gains</ENT> <ENT>50,000</ENT> </ROW> <ROW> <ENT I="01">Partial tax (tax on $50,000)</ENT> <ENT>17,060</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Plus 25% of $75,000</ENT> <ENT>18,750</ENT> </ROW> <ROW> <ENT I="01">Alternative tax under section 1201(b) at 1969 rates</ENT> <ENT>35,810</ENT> </ROW> <ROW> <ENT I="28"> <E T="04">Alternative Tax Under Section</E> 1201(b) (1970 <E T="04">Rates</E>)</ENT> </ROW> <ROW> <ENT I="28"> <E T="04">step i</E> </ENT> </ROW> <ROW> <ENT I="01">Taxable income ($50,000 + 50% of $75,000)</ENT> <ENT>$87,500</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">Deduct 50% of net section 1201 gain (net capital gain for taxable years beginning after December 31, 1976)</ENT> <ENT>37,500</ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="11"/> <ENT>50,000</ENT> </ROW> <ROW> <ENT I="01">Tax on $50,000 (taxable income exclusive of capital gains)</ENT> <ENT/> <ENT>$17,060</ENT> </ROW> <ROW> <ENT I="28"> <E T="04">step ii</E> </ENT> </ROW> <ROW> <ENT I="01">(a) Net section 1201 gain (net capital gain for taxable years beginning after December 31, 1976)</ENT> <ENT>75,000</ENT> </ROW> <ROW> <ENT I="01">(b) Subsection (d) gain</ENT> <ENT>50,000</ENT> </ROW> <ROW> <ENT I="01">25% of $50,000 (lesser of (a) or (b))</ENT> <ENT/> <ENT>12,500</ENT> </ROW> <ROW> <ENT I="28"> <E T="04">step iii</E> </ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="01">(c) 29<FR>1/2</FR>% of $25,000 (excess of (a) over (b))</ENT> <ENT>7,375</ENT> </ROW> <ROW> <ENT I="01">(d) Ordinary income</ENT> <ENT>$50,000</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">50% of net section 1201 gain (net capital gain for taxable years beginning after December 31, 1976)</ENT> <ENT>37,500</ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="11"/> <ENT>87,500</ENT> </ROW> <ROW> <ENT I="01">Tax on $87,500</ENT> <ENT>$37,690</ENT> </ROW> <ROW> <ENT I="01">Ordinary income</ENT> <ENT>$50,000</ENT> </ROW> <ROW RUL="n,s,n,n"> <ENT I="01">50% of subsection (d) gain</ENT> <ENT>25,000</ENT> </ROW> <ROW RUL="n,d,n,n"> <ENT I="11"/> <ENT>75,000</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">Tax on $75,000</ENT> <ENT>30,470</ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="01">Difference</ENT> <ENT>7,220</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Lesser of (c) or (d)</ENT> <ENT>$7,220</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Alternative tax (total of 3 steps) at rates effective on and after January 1, 1970</ENT> <ENT>36,780</ENT> </ROW> </GPOTABLE> <FP>Since the alternative tax is less than the tax imposed under section 1 for both the period in 1969 and the period in 1970, the alternative tax applies for both periods. Thus, since the effective date of the change in the rate of tax on capital gains is January 1, 1970, the old rate of alternative tax is effective for 184 days of the taxable year and the new rate of alternative tax is effective for 181 days of the <PRTPAGE P="33"/>taxable year. The alternative taxes are apportioned as follows:</FP> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">1969—184/365 of $35,810</ENT> <ENT>$18,052.16</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">1970—181/365 of $36,780</ENT> <ENT>18,238.85</ENT> </ROW> <ROW> <ENT I="11"/> <ENT>36,291.01</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Tax surcharge (See § 1.51-1(d)(1)(i))</ENT> <ENT>2,729.28</ENT> </ROW> <ROW> <ENT I="04">Total tax for the taxable year</ENT> <ENT>39,020.29</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>B, a single individual not a head of a household, has a taxable year ending March 31. For the taxable year ending March 31, 1971, B has adjusted gross income of $18,500. His computation of the tax imposed is as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,6/7"> <ROW> <ENT I="28">1970 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Adjusted gross income</ENT> <ENT>$18,500.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Standard deduction</ENT> <ENT>$1,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Personal exemption</ENT> <ENT>625.00</ENT> <ENT>1,625.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income under 1970 deduction provisions</ENT> <ENT>16,875.00</ENT> </ROW> <ROW> <ENT I="11">Tax on $16,875 (1970 rates):</ENT> </ROW> <ROW> <ENT I="02">Tax on first $16,000</ENT> <ENT>4,330.00</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">42 percent of $875</ENT> <ENT>367.50</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tentative tax at rates and deduction provisions effective on or after January 1, 1970</ENT> <ENT>4,697.50 </ENT> </ROW> <ROW> <ENT I="28">1971 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Adjusted gross income</ENT> <ENT>$18,500.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Standard deduction</ENT> <ENT>$1,500</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Personal exemption</ENT> <ENT>650</ENT> <ENT>2,150.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income under 1971 deduction provisions</ENT> <ENT>16,350.00</ENT> </ROW> <ROW> <ENT I="11">Tax on $16,350 (1971 rates):</ENT> </ROW> <ROW> <ENT I="02">Tax on first $16,000</ENT> <ENT>3,830</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">34 percent of $350</ENT> <ENT>119</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tentative tax at rates and deduction provisions effective on or after Januray 1, 1971</ENT> <ENT>3,949.00</ENT> </ROW> <ROW> <ENT I="11">The 1970 and 1971 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1970—275/365 of $4,697.50</ENT> <ENT>3,539.21</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">1971—90/365 of $3,949.00</ENT> <ENT>973.73</ENT> </ROW> <ROW> <ENT I="11"/> <ENT>4,512.94</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Tax surcharge (see § 1.51-1(d)(1)(i))</ENT> <ENT>56.26</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Total tax for the taxable year</ENT> <ENT>4,569.20</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>H and W, husband and wife, have a foster child, C, who qualifies as a dependent under section 152(b)(2) for the period beginning after December 31, 1969. H and W file a joint return on the basis of a taxable year ending August 31. For the taxable year ending August 31, 1970, H and W have adjusted gross income of $12,500. Their computation of the tax imposed is as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,6/7"> <ROW> <ENT I="28">1969 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Adjusted gross income</ENT> <ENT>$12,500.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="01">Standard deduction</ENT> <ENT>$1,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="01">Personal exemption (2)</ENT> <ENT>1,200.00</ENT> <ENT>2,200.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income under 1969 deduction provisions</ENT> <ENT>10,300.00</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="01">Taxable income reduced by one-half</ENT> <ENT/> <ENT>5,150.00</ENT> </ROW> <ROW> <ENT I="11">Tax on $5,150 (1969 rates):</ENT> </ROW> <ROW> <ENT I="02">Tax on first $4,000</ENT> <ENT>$690.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="02">22 percent of $1,150</ENT> <ENT>253.00</ENT> <ENT>943.00</ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="01">Twice the tax on $5,150</ENT> <ENT>$1,886.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tentative tax at rates and deduction provisions effective on or after January 1, 1969</ENT> <ENT>1,886.00</ENT> </ROW> <ROW> <ENT I="28">1970 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Adjusted gross income</ENT> <ENT>$12,500.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Standard deduction</ENT> <ENT>$1,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Personal exemption (3)</ENT> <ENT>1,875.00</ENT> <ENT>2,875.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income under 1970 deduction provisions</ENT> <ENT>$9,625.00</ENT> </ROW> <ROW> <ENT I="11">Tax on $9,625 (1970 rates):</ENT> </ROW> <ROW> <ENT I="02">Tax on first $8,000</ENT> <ENT>$1,380.00</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">22 percent of $1,625</ENT> <ENT>357.50</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tentative tax at rates and deduction provisions effective on or after January 1, 1970</ENT> <ENT>1,737.50</ENT> </ROW> <ROW> <ENT I="11">The 1969 and 1970 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1969—122/365 of $1,886</ENT> <ENT>$630.39</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">1970—243/365 of $1,737.50</ENT> <ENT>1,156.75</ENT> </ROW> <ROW> <ENT I="11"/> <ENT>1,787.14</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Tax surcharge (see § 1.51-1(d)(1)(i))</ENT> <ENT>104.05</ENT> </ROW> <ROW RUL="n,d"> <ENT I="02">Total tax for the taxable year</ENT> <ENT>1,891.19</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>B, a single individual with one exemption, reports his income on the basis of a fiscal year ending June 30. For fiscal year ending June 30, 1971, B reports adjusted gross income of $250,000, consisting of earned net income of $240,000 and investment income of $10,000. In addition, on April 24, 1971, stock was transferred to B pursuant to his exercise of a qualified stock option, and the fair market value of such stock at that time exceeded the option price by $175,000. This $175,000 constitutes an item of tax preference described in section 57(a)(6). B claims itemized deductions in the amount of $34,000. By reason of section 1348, the maximum rate of tax on earned taxable income for a taxable year beginning after 1970 but before 1972 is 60 percent. The income tax for the taxable year ending June 30, 1971, would be computed under section 21 as follows:</P> <GPOTABLE CDEF="s25,12,12" COLS="3" OPTS="L0,p1,6/7"> <ROW> <ENT I="28">1970 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Adjusted gross income</ENT> <ENT>$250,000.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Itemized deductions</ENT> <ENT>$34,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <PRTPAGE P="34"/> <ENT I="03">Personal exemption</ENT> <ENT>625.00</ENT> <ENT>34,625.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income under 1970 deduction provisions</ENT> <ENT>215,375.00</ENT> </ROW> <ROW> <ENT I="11">Tax on $215,375 (1970 rates)</ENT> </ROW> <ROW> <ENT I="01">Tax on first $100,000</ENT> <ENT>$55,490.00</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">70 percent of $115,375</ENT> <ENT>80,762.50</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tentative tax at rates and deduction provisions effective on or after January 1, 1970</ENT> <ENT>136,252.50</ENT> </ROW> <ROW> <ENT I="11">Minimum tax:</ENT> </ROW> <ROW> <ENT I="02">Total tax preference items</ENT> <ENT>175,000.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Exemption</ENT> <ENT>$30,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Income tax</ENT> <ENT>136,252.50</ENT> <ENT>166,252.50</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Subject to 10 percent tax</ENT> <ENT>8,747.50</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">10 percent tax</ENT> <ENT>874.75</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax ($136,252.50 + $874.75)</ENT> <ENT>137,127.25</ENT> </ROW> <ROW> <ENT I="28">1971 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW> <ENT I="01">Adjusted gross income</ENT> <ENT>$250,000.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Itemized deductions</ENT> <ENT>$34,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Personal exemption</ENT> <ENT>650.00</ENT> <ENT>34,650.00</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income under 1971 deduction provisions</ENT> <ENT>215,350.00</ENT> </ROW> <ROW> <ENT I="01">(a) Tax on highest amount of taxable income on which rate does not exceed 60 percent ($50,000) (1971 rates)</ENT> <ENT>20,190.00</ENT> </ROW> <ROW> <ENT I="11">(b) Earned taxable</ENT> </ROW> <ROW> <ENT I="11">income:</ENT> </ROW> <ROW> <ENT I="12">($215,350×</ENT> </ROW> <ROW> <ENT I="12">$240,000/</ENT> </ROW> <ROW> <ENT I="02">$250,000)</ENT> <ENT>$206,736.00</ENT> <ENT/> </ROW> <ROW> <ENT I="11">Less: Tax</ENT> </ROW> <ROW> <ENT I="11">preference offset:</ENT> </ROW> <ROW> <ENT I="11">($175,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">−$30,000)</ENT> <ENT>145,000.00</ENT> <ENT/> </ROW> <ROW RUL="n,d,n"> <ENT I="11"/> <ENT>61,736.00</ENT> <ENT/> </ROW> <ROW> <ENT I="01">(c) 60% of the amount by which $61,736 exceeds $50,000</ENT> <ENT>7,041.60</ENT> </ROW> <ROW> <ENT I="11">(d) Tax on $215,350 (1971 rates)</ENT> </ROW> <ROW> <ENT I="02">Tax on first $100,000</ENT> <ENT>53,090.00</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">70% of $115,350</ENT> <ENT>80,745.00</ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="04">Total</ENT> <ENT>133,835.00</ENT> </ROW> <ROW> <ENT I="11">(e) Tax on $61,736 (1971 rates)</ENT> </ROW> <ROW> <ENT I="02">Tax on first $60,000</ENT> <ENT>26,390.00</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">64% of $1,736</ENT> <ENT>1,111.04</ENT> </ROW> <ROW RUL="n,d,n"> <ENT I="04">Total</ENT> <ENT>27,501.04</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">(f) Excess of $133,835 over $27,501.04</ENT> <ENT>106,333.96</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Tentative tax (total of Steps (a), (c), and (f)) at rates and deduction provisions effective on or after January 1, 1971</ENT> <ENT>133,565.56</ENT> </ROW> <ROW> <ENT I="11">Minimum tax:</ENT> </ROW> <ROW> <ENT I="02">Total tax preference items</ENT> <ENT>175,000.00</ENT> </ROW> <ROW> <ENT I="12">Less:</ENT> </ROW> <ROW> <ENT I="03">Exemption</ENT> <ENT>$30,000.00</ENT> </ROW> <ROW RUL="n,s,s"> <ENT I="03">Income tax</ENT> <ENT>133,565.56</ENT> <ENT>163,565.56</ENT> </ROW> <ROW RUL="n,d"> <ENT I="02">Subject to 10 percent tax</ENT> <ENT>$11,434.44</ENT> </ROW> <ROW RUL="n,d"> <ENT I="02">10 percent tax</ENT> <ENT>1,143.44</ENT> </ROW> <ROW RUL="n,d"> <ENT I="03">Total tentative tax ($133,565.56 + $1,143.44)</ENT> <ENT>134,709.00</ENT> </ROW> <ROW> <ENT I="11">The 1970 and 1971 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1970—184/365 of $137,127.25</ENT> <ENT>69,127.16</ENT> </ROW> <ROW RUL="n,d"> <ENT I="02">1971—181/365 of $134,709</ENT> <ENT>66,800.90</ENT> </ROW> <ROW RUL="n,d"> <ENT I="03">Total tax for the taxable year</ENT> <ENT>135,928.06</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>The surtax exemption of corporation M (one of 4 subsidiary corporations of W corporation), which files its income tax returns on the basis of a fiscal year ending March 31, 1964, is less than $25,000, by reason of section 1561 of the Code applicable to taxable years ending after December 31, 1963, and beginning before January 1, 1975. The taxable income of corporation M is $100,000, and the amount of the surtax exemption determined under the new rule for the 1964 taxable year is $5,000 ($25,000÷5). M's income tax liability for the taxable year ending March 31, 1964, is computed as follows:</P> <GPOTABLE CDEF="s25,12,12" COLS="3" OPTS="L0,p1,6/7"> <ROW> <ENT I="28">1963 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax on $100,000 (1963 rates) 30 percent of $100,000</ENT> <ENT>$30,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Surtax on $75,000 (1963 rates and $25,000 surtax exemption) 22 percent of $75,000</ENT> <ENT>16,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at rates and surtax exemption effective before January 1, 1964</ENT> <ENT>46,500</ENT> </ROW> <ROW> <ENT I="28">1964 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax on $100,000 (1964 rates) 22 percent of $100,000</ENT> <ENT>$22,000</ENT> </ROW> <ROW RUL="n,s,n"> <PRTPAGE P="35"/> <ENT I="01">Surtax on $95,000 (1964 rates and a $5,000 surtax exemption) 28 percent of $95,000</ENT> <ENT>26,600</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at rates and surtax exemption effective after January 1, 1964</ENT> <ENT>48,600</ENT> </ROW> <ROW> <ENT I="11">The 1963 and 1964 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1963—275/366 of $46,500</ENT> <ENT>34,938.52</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">1964—91/366 of $48,600</ENT> <ENT>12,083.61</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tax for the taxable year</ENT> <ENT>47,022.13</ENT> </ROW> <ROW> <ENT I="28">M has the same amount of taxable income in 1965. Its income tax liability for the fiscal year ending March 31, 1965, is computed as follows:</ENT> </ROW> <ROW> <ENT I="28">1964 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax on $100,000 (1964 rates) 22 percent of $100,000</ENT> <ENT>$22,000</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Surtax on $95,000 (1964 rates and a $5,000 surtax exemption) 28 percent of $95,000</ENT> <ENT>26,600</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at the 1964 rates</ENT> <ENT>48,600</ENT> </ROW> <ROW> <ENT I="28">1965 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax on $100,000 (1965 rates) 22 percent of $100,000</ENT> <ENT>$22,000</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">Surtax on $95,000 (1965 rates and a $5,000 surtax exemption) 26 percent of $95,000</ENT> <ENT>24,700</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at the 1965 rates</ENT> <ENT>46,700</ENT> </ROW> <ROW> <ENT I="11">The 1964 and 1965 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1964—275/365 of $48,600</ENT> <ENT>$36,616.44</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">1965—90/365 of $46,700</ENT> <ENT>11,515.07</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tax for the taxable year</ENT> <ENT>48,131.51</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>Assume the same facts as in example (5), except that M elected the additional tax under section 1562 for its fiscal year ending March 31, 1964. M's tax liability is completed as follows:</P> <GPOTABLE CDEF="s25,12,12" COLS="3" OPTS="L0,p1,6/7"> <ROW> <ENT I="28">1963 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax on $100,000 (1963 rates) 30 percent of $100,000</ENT> <ENT>$30,000</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">Surtax on $75,000 (1963 rates and $25,000 surtax exemption) 22 percent of $75,000</ENT> <ENT>16,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at rates and surtax exemption effective before January 1, 1964</ENT> <ENT>46,500</ENT> </ROW> <ROW> <ENT I="28">1964 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="01">Normal tax on $100,000 (1964 rates) 22 percent of $100,000</ENT> <ENT>$22,000</ENT> </ROW> <ROW> <ENT I="01">Surtax on $75,000 (1964 rates and $25,000 surtax exemption) 28 percent of $75,000</ENT> <ENT>21,000</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="01">Additional tax on $25,000 6 percent of $25,000</ENT> <ENT>1,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at rates and surtax exemption effective on and after January 1, 1964</ENT> <ENT>44,500</ENT> </ROW> <ROW> <ENT I="11">The 1963 and 1964 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1963—275/366 of $46,500</ENT> <ENT>$34,938.52</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">1964—91/366 of $44,500</ENT> <ENT>11,064.21</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tax for the taxable year</ENT> <ENT>46,002.73</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 7.</HD> <P>Corporation N files its income tax returns on the basis of a fiscal year ending June 30. For its taxable year ending in 1976, the taxable income of N is $100,000. N's income tax liability is determined for the period July 1, 1975, through December 31, 1975, by taking into account two rates of normal tax under section 11(b)(2) (A) and (B) and the increase to $50,000 in the surtax exemption under section 11(d). For the period January 1, 1976, through June 30, 1976, N's income tax liability is determined by taking into account the single normal tax rate under section 11(b)(1) and the $25,000 surtax exemption under section 11(d). N's tax liability for the taxable year ending June 30, 1976, is computed as follows:</P> <GPOTABLE CDEF="s25,12,12" COLS="3" OPTS="L0,p1,6/7"> <ROW> <ENT I="28">1975 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="02">Normal tax on $100,000 (1975 rates) 20 percent of $25,000</ENT> <ENT>$5,000</ENT> </ROW> <ROW> <ENT I="02">22 percent of $75,000</ENT> <ENT>16,500</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">Surtax on $50,000 (1975 rates and $50,000 surtax exemption) 26 percent of $50,000</ENT> <ENT>13,000</ENT> </ROW> <ROW RUL="n,d"> <PRTPAGE P="36"/> <ENT I="04">Total tentative tax at rates and surtax exemption effective on and after January 1, 1975</ENT> <ENT>34,500</ENT> </ROW> <ROW> <ENT I="28">1976 <E T="04">Tentative Tax</E> </ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Taxable income</ENT> <ENT>$100,000</ENT> </ROW> <ROW> <ENT I="02">Normal tax on $100,000 (1976 rates) 22 percent of $100,000</ENT> <ENT>$22,000</ENT> </ROW> <ROW RUL="n,s,n"> <ENT I="02">Surtax on $75,000 (1976 rates and $25,000 surtax exemption) 26 percent of $75,000</ENT> <ENT>19,500</ENT> </ROW> <ROW RUL="n,d"> <ENT I="04">Total tentative tax at rates and surtax exemption effective on and after January 1, 1976</ENT> <ENT>41,500</ENT> </ROW> <ROW> <ENT I="11">The 1975 and 1976 tentative taxes are apportioned as follows:</ENT> </ROW> <ROW> <ENT I="02">1975—184/366 of $34,500</ENT> <ENT>$17,344</ENT> </ROW> <ROW RUL="n,s"> <ENT I="02">1976—182/366 of $41,500</ENT> <ENT>20,637</ENT> </ROW> <ROW> <ENT I="04">Total tax for the taxable year</ENT> <ENT>37,981</ENT> </ROW> </GPOTABLE> </EXAMPLE> <SECAUTH>(Secs. 1561(a) (83 Stat. 599; 26 U.S.C. 1561(a)) of the Internal Revenue Code)</SECAUTH> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as amended by T.D. 7164, 37 FR 4190, Feb. 29, 1972; T.D. 74-13, 41 FR 12639, Mar. 26, 1976; T.D. 7528, 42 FR 64694, Dec. 28, 1977; T.D. 7728, 45 FR 72651, Nov. 3, 1980]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.23-1</SECTNO> <SUBJECT>Residential energy credit.</SUBJECT> <P>(a) <E T="03">General rule.</E> Section 23 or former section 44C provides a residential energy credit against the tax imposed by chapter 1 of the Internal Revenue Code. The credit is an amount equal to the individual's qualified energy conservation expenditures (set out in paragraph (b)) plus the individual's qualified renewable energy source expenditures (set out in paragraph (c)) for the taxable year. However, the credit is subject to the limitations described in paragraph (d) and the special rules contained in § 1.23-3. The credit is nonrefundable (that is, the credit may not exceed an individual's tax liability for the taxable year). However, any unused credit may be carried over to succeeding years to the extent permitted under paragraph (e). Renters as well as owners of a dwelling unit may qualify for the credit. See § 1.23-3(h) for the rules relating to the allocation of the credit in the case of joint occupants of a dwelling unit.</P> <P>(b) <E T="03">Qualified energy conservation expenditures.</E> In the case of any dwelling unit, the qualified energy conservation expenditures are 15 percent of the energy conservation expenditures made by the taxpayer with respect to the dwelling unit during the taxable year, but not in excess of $2,000 of such expenditures. See § 1.23-2(a) for the definition of energy conservation expenditures.</P> <P>(c) <E T="03">Qualified renewable energy source expenditures.</E> In the case of taxable years beginning after December 31, 1979, the qualified renewable energy source expenditures are 40 percent of the renewable energy source expenditures made by the taxpayer during the taxable year (and before January 1, 1986) with respect to the dwelling units that do not exceed $10,000. In the case of taxable years beginning before January 1, 1980, the qualified renewable energy source expenditures are the renewable energy source expenditures made by the taxpayer with respect to the dwelling unit during the taxable year, but not in excess of—</P> <P>(1) 30 percent of the expenditures up to $2,000, plus</P> <P>(2) 20 percent of the expenditures over $2,000, but not more than $10,000.</P> <FP>See § 1.23-2(b) for the definition of renewable energy source expenditures.</FP> <P>(d) <E T="03">Limitations—</E>(1) <E T="03">Minimum dollar amount.</E> No residential energy credit shall be allowed with respect to any return (whether joint or separate) for any taxable year if the amount of the credit otherwise allowable (determined without regard to the tax liability limitation imposed by paragraph (d)(3) of this section) is less than $10.</P> <P>(2) <E T="03">Prior expenditures taken into account—</E>(i) <E T="03">In general.</E> For purposes of determining the credit for expenditures made during a taxable year, the taxpayer must reduce the maximum amount of allowable expenditures with respect to the dwelling until in computing qualified energy conservation expenditures (under paragraph (b)) or qualified renewable energy conservation expenditures (under paragraph (c)) by prior expenditures which were made by the taxpayer or by joint occupants (see § 1.23-3(h)) with respect to the <PRTPAGE P="37"/>same dwelling unit, and which were taken into account in computing the credit for prior taxable years. In the case of expenditures made during taxable years beginning before January 1, 1980, the reduction of the maximum amount under paragraph (c) must first be made with respect to the first $2,000 of expenditures (to which a 30 percent rate applies) and then with respect to the next $8,000 of expenditures (to which a 20 percent rate applies). This reduction must be made if all or any part of the credit was allowed in or was carried over from a prior taxable year.</P> <P>(ii) <E T="03">Change of principal residence.</E> A taxpayer is eligible for the maximum credit for qualifying expenditures made with respect to a new principal residence notwithstanding the allowance of a credit for qualifying expenditures made with respect to the taxpayer's previous principal residence. Furthermore, except in certain cases involving joint occupancy (see § 1.23-3(h)), a taxpayer is eligible for the maximum credit notwithstanding the allowance of a credit to a prior owner of the taxpayer's new principal residence.</P> <P>(iii) <E T="03">Example.</E> The rules with respect to the reduction for prior expenditures are illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>In 1978, A has $1,000 of energy conservation expenditures and $5,000 of renewable energy source expenditures in connection with A's principal residence. A's residential energy credit for 1978 is $1,350, made up of $150 of qualified energy conservation expenditures (15 percent of $1,000) plus $1,200 of qualified renewable energy source expenditures (30 percent of the first $2,000 plus 20 percent of the next $3,000). In 1979 A has an additional $2,000 of energy conservation expenditures and $3,000 of renewable energy source expenditures in connection with the same principal residence. A's residential energy credit for 1979 is $750, made up of $150 of qualified energy conservation expenditures (15 percent of the new maximum $1,000, which was reduced from $2,000 by $1,000 of energy conservation expenditures taken into account in 1978) plus $600 of qualified renewable energy source expenditures (20 percent of $3,000, which reflects the reduction of the maximum allowable expenditures by the $5,000 of renewable energy source expenditures taken into account in 1978). The maximum residential energy credit allowable to A with respect to the same principal residence in subsequent years in which the credit is allowable is $400 (20 percent of the new maximum of $2,000 for renewable energy source expenditures and none for energy conservation expenditures).</P> </EXAMPLE> <P>(3) <E T="03">Effects of grants and subsidized energy financing</E>—(i) <E T="03">In general.</E> Qualified expenditures financed with Federal, State, or local grants shall be taken into account for purposes of computing the residential energy credit only if the amount of such grants is taxable as gross income to the taxpayer under section 61 (relating to the definition of gross income) and the regulations thereunder. In the case of taxable years beginning after December 31, 1980, qualified expenditures made from subsidized energy financing (as defined in § 1.23-2(i)) shall not be taken into account (except as provided in the following sentence) for purposes of computing the residential energy credit. In addition, the taxpayer must reduce the maximum amount allowable expenditures (reduced as provided in paragraph (d)(2) of this section) with respect to the dwelling unit in computing qualified energy conservation expenditures (under paragraph (b) of this section) or qualified renewable energy source expenditures (under paragraph (c) of this section), whichever is appropriate, by an amount equal to the sum of—</P> <P>(A) The amount of expenditures from subsidized energy financing (as defined in § 1.23-2(i)) that were made by the taxpayer during the taxable year or any prior taxable year beginning after December 31, 1980, with respect to the same dwelling unit, and</P> <P>(B) The amount of any funds received by the taxpayer during the taxable year or any prior taxable year beginning after December 31, 1980, as a Federal, State, or local government grant made in taxable years beginning after December 31, 1980, that were used to make qualified expenditures with respect to the same dwelling unit and that were not included in the gross income of the taxpayer.</P> <P>(ii) <E T="03">Example.</E> The provisions of this paragraph (d)(3) may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>A had in 1979 made a renewable energy source expenditure of $2,000 in connection with A's residence for which he took the then allowed credit of $600. In 1981 A made additional renewable energy source expenditures of $9,000 with respect to which he <PRTPAGE P="38"/>received a loan of $5,000 from the Federal Solar-Energy and Energy Conservation Bank. Assume that the loan is subsidized energy financing. A computes the credit as follows: The initial maximum allowable dollar limit is $10,000 which is reduced by the sum of the prior year expenditures of $2,000 and the subsidized energy financing loan of $5,000 leaving a dollar limit of $3,000 ($10,000−($2,000+$5,000)). The $5,000 portion of the $9,000 funded by the subsidized energy financing loan is not allowed as a renewable energy source expenditure. The remaining expenditures in 1981 are $4,000 ($9,000−$5,000). However, this amount exceeds the allowed maximum dollar limit of $3,000. Therefore, A's creditable expenses for 1981 are only $3,000 on which the credit is $1,200 (40 percent of $3,000).</P> </EXAMPLE> <P>(4) <E T="03">Tax liability limitation</E>—(i) <E T="03">For taxable years beginning after December 31, 1983.</E> For taxable years beginning after December 31, 1983, the credit allowed by this section shall not exceed the amount of tax imposed by chapter 1 of the Internal Revenue Code of 1954 for the taxable year, reduced by the sum of credits allowable under—</P> <P>(A) Section 21 (relating to expenses for household and dependent care services necessary for gainful employment),</P> <P>(B) Section 22 (relating to credit for the elderly and the permanently and totally disabled), and</P> <P>(C) Section 24 (relating to contributions to candidates for public office).</P> <FP>See section 26 (b) and (c) for certain taxes that are not treated as imposed by chapter 1.</FP> <P>(ii) <E T="03">For taxable years beginning before January 1, 1984.</E> For taxable years beginning before January 1, 1984, the credit allowed by this section shall not exceed the amount of the tax imposed by chapter 1 of the Internal Revenue Code of 1954 for the taxable year, reduced by the sum of the credits allowable under—</P> <P>(A) Section 32 (relating to tax withheld at source on nonresident aliens and foreign corporations and on tax-free covenant bonds),</P> <P>(B) Section 33 (relating to the taxes of foreign countries and possessions of the United States),</P> <P>(C) Section 37 (relating to retirement income),</P> <P>(D) Section 38 (relating to investment in certain depreciable property),</P> <P>(E) Section 40 (relating to expenses of work incentive programs),</P> <P>(F) Section 41 (relating to contributions to candidates for public office),</P> <P>(G) Section 42 (relating to the general tax credit),</P> <P>(H) Section 44 (relating to purchase of new personal residence),</P> <P>(I) Section 44A (relating to expenses for household and dependent care services), and</P> <P>(J) Section 44B (relating to employment of certain new employees).</P> <P>(e) <E T="03">Carryforward of unused credit.</E> If the credit allowable by this section exceeds the tax liability limitation imposed by section 23(b)(5) (or former section 44C(b)(5)) and paragraph (d)(4) of this section, the excess credit shall be carried forward to the succeeding taxable year and added to the credit allowable under this section for the succeeding taxable year. A carryforward that is not used in the succeeding year because it exceeds the tax liability limitation shall be carried forward to later taxable years until used, except that no excess credit may be carried forward to any taxable year beginning after December 31, 1987.</P> <CITA>[T.D. 7717, 45 FR 57715, Aug. 29, 1980. Redesignated and amended by T.D. 8146, 52 FR 26669, July 16, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.23-2</SECTNO> <SUBJECT>Definitions.</SUBJECT> <P>For purposes of section 23 or former section 44C and regulations thereunder—</P> <P>(a) <E T="03">Energy conservation expenditures—</E>(1) <E T="03">In general.</E> The term “energy conservation expenditure” means an expenditure made on or after April 20, 1977, and before January 1, 1986, by a taxpayer for insulation or any other energy-conserving component, or for labor costs allocable to the original installation of such insulation or other component, if all of the following conditions are satisfied:</P> <P>(i) The insulation (as defined in paragraph (c)) or other energy-conserving component (as defined in paragraph (d)) is installed in or on a dwelling unit that is used as the taxpayer's principal residence when the installation is completed. See § 1.23-3(e) for the definition of principal residence.<PRTPAGE P="39"/> </P> <P>(ii) The dwelling unit is located in the United States (as defined in section 7701(a)(9)).</P> <P>(iii) The construction of the dwelling unit was substantially completed before April 20, 1977. See § 1.23-3(f) for the definition of the terms “construction” and “substantially completed”. In the case of expenditures made with respect to the enlargement of a dwelling unit, the construction of the enlargement must have been substantially completed before April 20, 1977.</P> <P>(2) <E T="03">Examples.</E> The application of this paragraph may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>In 1978, A spent $500 for the purchase and installation of new storm windows to replace old storm windows, $100 to reinstall old storm windows, and $150 to transfer a A's house insulation which had been installed in A's garage. Only the $500 spent for new storm windows qualifies as an energy conservation expenditure. The $100 spent to reinstall storm windows and the $150 spent to transfer insulation to A's house do not qualify since the only installation costs that qualify are those for the original installation of energy conservation property the original use of which commences with the taxpayer.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>In June 1977, B purchased for B's principal residence a new house that was substantially completed before April 20, 1977. Pursuant to B's request the builder installed storm windows on May 1, 1977, the cost of this option being included in the purchase price of the house. The portion of the purchase price of the residence allocable to the storm windows constitutes an energy conservation expenditure. However, no other part of the purchase price may be allocated to energy conservation property (insulation and other energy conserving components) installed before April 20, 1977. To qualify as an energy conservation expenditure, an expenditure must be made (<E T="03">i.e.,</E> installation of the energy conservation property must be completed) on or after April 20, 1977.</P> </EXAMPLE> <P>(b) <E T="03">Renewable energy source expenditures.</E> The term “renewable energy source expenditures” means an expenditure made on or after April 20, 1977, and before January 1, 1986, by a taxpayer for renewable energy source property (as defined in paragraph (e)), or for labor costs properly allocable to the on-site preparation, assembly, or original installation such property, if both of the following conditions are satisfied:</P> <P>(1) The renewable energy source property is installed in connection with a dwelling unit that is used as the taxpayer's principal residence when the installation is completed. See § 1.23-3(e).</P> <P>(2) The dwelling unit is located in the United States (as defined in section 7701(a)(9)).</P> <FP>Additionally, the term “renewable energy source expenditures” includes expenditures made after December 31, 1979, and before January 1, 1986, for an onsite well drilled for any geothermal deposit (as defined in paragraph (h)), or for labor costs properly allocable to onsite preparation, assembly, or original installation of such well, but only if the requirements of paragraphs (b) (1) and (2) of this section are met and the taxpayer has not elected under section 263(c) to deduct any portion of such expenditures or allocable labor costs.</FP> <FP>Eligibility as a renewable energy source expenditure does not depend on the date of construction of the dwelling unit. Thus, such an expenditure may be made in connection with either a new or an existing dwelling unit. Renewable energy source expenditures need only be made in connection with a dwelling, rather than in or on a dwelling unit. For example, a solar collector that otherwise constitutes renewable energy source property is not ineligible merely because it is installed separately from the dwelling unit. The term “renewable energy source expenditure” does not include any expenditure allocable to a swimming pool even when used as an energy storage medium or to any other energy storage medium whose primary function is other than the storage of energy. It also does not include the cost of maintenance of an installed system or the cost of leasing renewable energy source property.</FP> <P>(c) <E T="03">Insulation.</E> The term “insulation” means any item that satisfies all of the following conditions:</P> <P>(1) The item is specifically and primarily designed to reduce, when installed in or on a dwelling or on a water heater, the heat loss or gain of such dwelling or water heater. To qualify as insulation the item must be installed between a conditioned area and a nonconditioned area (except when installed on a water heater, water pipe, <PRTPAGE P="40"/>or heating/cooling duct). Thus for example, awnings do not qualify as insulation. For purposes of this section the term “conditioned area” means an area that has been heated or cooled by conventional or renewable energy source means. Insulation includes materials made of fiberglass, rock wool, cellulose, urea based foam, urethane, vermiculite, perlite, polystyrene, and extruded polystyrene foam.</P> <P>(2) The original use of the item begins with the taxpayer.</P> <P>(3) The item can reasonably be expected to remain in operation at least 3 years.</P> <P>(4) The item meets the applicable performance and quality standards prescribed in § 1.23-4 (if any) that are in effect at the time the taxpayer acquires the item. The term “insulation” shall not include items whose primary purpose is not insulation (e.g., whose function is primarily structural, decorative, or safety-related). For example, carpeting, drapes (including linings), shades, wood paneling, fireplace screens (including those made of glass), new or replacement walls (except for qualifying insulation therein) and exterior siding do not qualify although they may have been designed in part to have an insulating effect.</P> <P>(d) <E T="03">Other energy-conserving components.</E> The term “other energy-conserving component” means any item (other than insulation) that satisfies all of the following conditions:</P> <P>(1) The original use of the item begins with the taxpayer.</P> <P>(2) The item can reasonably be expected to remain in operation for at least 3 years.</P> <P>(3) The item meets the applicable performance and quality standards prescribed in § 1.23-4 (if any) that are in effect at the time of the taxpayer's acquisition of the item.</P> <P>(4) The item is one of the following items:</P> <P>(i) <E T="03">A furnace replacement burner.</E> The term “furnace replacement burner” means a device (for oil and gas-fired furnaces or boilers) that is designed to achieve a reduction in the amount of fuel consumed as a result of increased combustion efficiency. The burner must replace an existing burner. It does not qualify if it is acquired as a component of, or for use in, a new furnace or boiler.</P> <P>(ii) <E T="03">A device for modifying flue openings.</E> The term “device for modifying flue openings” means an automatically operated damper that—</P> <P>(A) Is designed for installation in the flue, between the barometric damper or draft hood and the chimney, of a furnace; and</P> <P>(B) Conserves energy by substantially reducing the flow of conditioned air through the chimney when the furnace is not in operation. Conditioned air is air that has been heated or cooled by conventional or renewable energy source means.</P> <P>(iii) <E T="03">A furnace ignition system.</E> The term “furnace ignition system” means an electrical or mechanical device, designed for installation in a gas-fired furnace or boiler that automatically ignites the gas burner. In order to qualify, the device must replace a gas pilot light. Furthermore, it does not qualify if it is acquired as a component of, or for use in, a new furnace or boiler.</P> <P>(iv) <E T="03">A storm or thermal window or door.</E> The terms “storm or thermal window” and “storm or thermal door” mean the following:</P> <P>(A)(<E T="03">1</E>) A window placed outside or inside an ordinary or prime window, creating an insulating air space.</P> <P>(<E T="03">2</E>) A window with enhanced resistance to heat flow through the glazed area by multi-glazing.</P> <P>(<E T="03">3</E>) A window that consists of glass or other glazing materials that have exceptional heat-absorbing or heat-reflecting properties. For purposes of this subdivision (iv), the term “glazing material” does not include films and coatings applied on the surface of a window.</P> <P>(B)(<E T="03">1</E>) A second door, installed outside or inside a prime exterior door, creating an insulating air space.</P> <P>(<E T="03">2</E>) A door with enhanced resistance to heat flow through the glazed area by multi-glazing.</P> <P>(<E T="03">3</E>) A prime exterior door that has an R-value (a measurement of the ability of insulation to resist the flow of heat) of at least 2 throughout.</P> <FP>For purposes of this subdivision, “multi-glazing” is an arrangement in which two or more sheets of glazing material are affixed in a window or <PRTPAGE P="41"/>door frame to create one or more insulating air spaces. Multi-glazing can be achieved by installing a preassembled, sealed insulating glass unit or by affixing one or more additional sheets of glazing onto an existing window (or sash) or door. For purposes of this subdivision, a storm or thermal window or door does not include any film applied on or over the surface of a window or door.</FP> <P>(v) <E T="03">Automatic energy-saving setback thermostat.</E> The term “automatic energy-saving setback thermostat” means a device that is designed to reduce energy consumption by regulating the demand on the heating or cooling system in which it is installed, and uses—</P> <P>(A) A temperature control device for interior spaces incorporating more than one temperature control level, and</P> <P>(B) A clock or other automatic mechanism for switching from one control level to another.</P> <P>(vi) <E T="03">Caulking and weatherstripping.</E> The term “caulking” means pliable materials used to fill small gaps at fixed joints on buildings to reduce the passage of air and moisture. Caulking includes, but is not limited to, materials commonly known as “sealants”, “putty”, and “glazing compounds”. The term “weatherstripping” means narrow strips of material placed over or in movable joints of windows and doors to reduce the passage of air and moisture.</P> <P>(vii) <E T="03">Energy usage display meter.</E> The term “energy usage display meter” means a device the sole purpose of which is to display the cost (in money) of energy usage in the dwelling. It may show cost information for electricity usage, gas usage, oil usage, or any combination thereof. The device may measure energy usage of the whole dwelling, or individual appliances or systems on an instantaneous or cumulative basis.</P> <P>(viii) <E T="03">Components specified by the Secretary.</E> The Secretary (or his delegate) may, in his discretion, after consultation with the Secretary of Energy and the Secretary of Housing and Urban Development (or their delegates), and any other appropriate Federal officers, specify by regulation other energy-conserving components for addition to the list of qualified items. See § 1.23-6 for the procedures and criteria to be used in determining whether an item will be considered for addition to the list of qualified items by the Secretary.</P> <FP>The term “other energy-conserving component” is limited to items in a category specifically listed in section 44(c)(4)(A) (i) through (vii) or added by the Secretary.</FP> <P>(e) <E T="03">Renewable energy source property</E>—(1) <E T="03">In general.</E> The term “renewable energy source property” includes any solar energy property, wind energy property, geothermal energy property, or property referred to in subparagraph (2), which meets the following conditions:</P> <P>(i) The original use of the property begins with the taxpayer.</P> <P>(ii) The property can reasonably be expected to remain in operation for at least 5 years.</P> <P>(iii) The property meets the applicable performance and quality standards prescribed in § 1.23-4 (if any) that are in effect at the time of the taxpayer's acquisition of the property.</P> <FP>Renewable energy source property does not include heating or cooling systems, nor systems to provide hot water or electricity, which serve to supplement renewable energy source equipment in heating, cooling, or providing hot water or electricity to a dwelling unit, and which employ a form of energy (such as oil or gas) other than solar, wind, or geothermal energy (or other forms of renewable energy provided in paragraph (e)(2) of this section. Thus, heat pumps or oil or gas furnaces, used in connection with renewable energy source property, are not eligible for the credit. In order to be eligible for the credit for renewable energy source property, the property (as well as labor costs properly allocable to onsite preparation, assembly or installation of equipment) must be clearly identifiable. See § 1.23-3(l) for recordkeeping rules.</FP> <P>(2) <E T="03">Renewable energy source specified by the Secretary.</E> In addition to solar, wind, and geothermal energy property, renewable energy source property includes property that transmits or uses another renewable energy source that the Secretary (or his delegate) specifies by regulations, after consultation with <PRTPAGE P="42"/>the Secretary of Energy and the Secretary of Housing and Urban Development (or their delegates), and any other appropriate Federal officers, to be of a kind that is appropriate for the purpose of heating or cooling the dwelling or providing hot water or (in the case of expenditures made after December 31, 1979) electricity for use within the dwelling. For purposes of this section, references to the transmission or use of energy include its collection and storage. See § 1.23-6 for the procedures and criteria to be used in determining when another energy source will be considered for addition to the list of qualified renewable energy sources.</P> <P>(f) <E T="03">Solar energy property—</E>(1) <E T="03">In general.</E> The term “solar energy property” means equipment and materials of a solar energy system as defined in this paragraph (and parts solely related to the functioning of such equipment) which, when installed in connection with a dwelling, transmits or uses solar energy to heat or cool the dwelling or to provide hot water or (in the case of expenditures made after December 31, 1979) electricity for use within the dwelling. For this purpose, solar energy is energy derived directly from sunlight (solar radiation). Property which uses, as an energy source, fuel or energy which is indirectly derived from sunlight (solar radiation), such as fossil fuel or wood or heat in underground water, is not considered solar energy property. Materials and components of “passive solar systems” as well as “active solar systems”, or a combination of both types of systems may qualify as solar energy property.</P> <P>(2) <E T="03">Active solar system.</E> An active solar system is based on the use of mechanically forced energy transfer, such as the use of fans or pumps to circulate solar generated energy, or thermal energy transfer, such as systems utilizing thermal siphon principles. Generally, this is accomplished through the use of equipment such as collectors (to absorb sunlight and create hot liquids or air), storage tanks (to store hot liquids), rockbeds (to store hot air), thermostats (to activate pumps or fans which circulate the hot liquids or air), and heat exchangers (to utilize hot liquids or air to heat air or water).</P> <P>(3) <E T="03">Passive solar system.</E> A passive solar system is based on the use of conductive, convective, or radiant energy transfer. In order to qualify as a passive solar system, a solar system used for heating purposes must contain all of the following: a solar collection area, an absorber, a storage mass, a heat distribution method, and heat regulation devices. The term “solar collection area” means an expanse of transparent or translucent material, such as glass which is positioned in such a manner that the rays of the sun directly strike an absorber. The term “absorber” means a surface, such as a floor, that is exposed to the rays of the sun admitted through the solar collection area, which converts solar radiation into heat, and then transfers the heat to a storage mass. The term “storage mass” means material, such as masonry, that receives and holds heat from the absorber and later releases the heat to the interior of the dwelling. The storage mass must be of sufficient volume, depth, and thermal energy capacity to store and deliver adequate amounts of solar heat for the relative size of the dwelling. In addition, the storage mass must be located so that it is capable of distributing the stored heat directly to the habitable areas of the dwelling through a heat distribution method. The term “heat distribution method” means the release of radiant heating from the storage mass within the habitable areas of the dwelling, or convective heating from the storage mass through airflow paths provided by openings or by ducts in the storage mass, to habitable areas of the dwelling. The term “heat regulations devices” means shading or venting mechanisms (such as awnings or insulated drapes) to control the amount of solar heat admitted through the solar collection areas and nighttime insulation or its equivalent to control the amount of heat permitted to escape from the interior of the dwelling.</P> <P>(4) <E T="03">Components with dual function.</E> To the extent that a passive or active solar system utilizes portions of the structure of a residence, only the materials and components whose sole purpose is to transmit or use solar radiation (and labor costs associated with <PRTPAGE P="43"/>installing such materials and components) are included within the term “solar energy property”. Accordingly, materials and components that serve a dual purpose, <E T="03">e.g.,</E> they have a significant structural function or are structural components of the dwelling (and labor costs associated with installing such materials and components) are not included within the term “solar energy property”. For example, roof ponds that form part of a roof (including additional structural components to support the roof), windows (including clerestories and skylights), and greenhouses do not qualify as solar energy property. However, with respect to expenditures made after December 31, 1979, a solar collector panel installed as a roof or portion thereof (including additional structural components to support the roof attributable to the collector) does not fail to qualify as solar energy property solely because it constitutes a structural component of the dwelling on which it is installed. For this purpose, the term “solar collector panel” does not include a skylight or other type of window. In the case of a trombe wall (a south facing wall composed of a mass wall and exterior glazing), the mass wall (and labor costs associated with installing the mass wall) will not qualify. However, the exterior (non-window) glazing will qualify. Any shading, venting and heat distribution mechanisms or storage systems that do not have a dual function will also qualify.</P> <P>(g) <E T="03">Wind energy property.</E> The term “wind energy property” means equipment (and parts solely related to the functioning of such equipment) which, when installed in connection with a dwelling, transmits or uses wind energy to produce energy in a useful form for personal residential purposes. Examples of equipment using wind energy to produce energy in a useful form are windmills, wind-driven generators, power conditioning and storage devices that use wind to generate electricity or mechanical forms of energy. Devices that use wind merely to ventilate do not qualify as wind energy property.</P> <P>(h) <E T="03">Geothermal energy property.</E> The term “geothermal energy property” means equipment (and parts solely related to the functioning of such equipment) necessary to transmit or use energy from a geothermal deposit to heat or cool a dwelling or provide hot water for use within the dwelling. With respect to expenditures made after December 31, 1979, the term “geothermal energy property” also means equipment (and parts solely related to the functioning of such equipment) necessary to transmit or use energy from a geothermal deposit to produce electricity for use within the dwelling. Equipment such as a pipe that serves both a geothermal function (by transmitting hot geothermal water within a dwelling) and a non-geothermal function (by transmitting hot water from a water heater within a dwelling) does not qualify as geothermal property. A geothermal deposit is a geothermal reservoir consisting of natural heat which is from an underground source and is stored in rocks or in an aqueous liquid or vapor (whether or not under pressure), having a temperature exceeding 50 degrees Celsius as measured at the wellhead or, in the case of a natural hot spring (where no well is drilled), at the intake to the distribution system.</P> <P>(i) <E T="03">Subsidized energy financing—</E>(1) <E T="03">In general.</E> The term “subsidized energy financing” means financing (<E T="03">e.g.,</E> a loan) made directly or indirectly (such as in association with, or through the facilities of, a bank or other lender) during a taxable year beginning after December 31, 1980, under a Federal, State, or local program, a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy. For purposes of this paragraph (i), financing is made when funds that constitute subsidized energy financing are disbursed. Subsidized energy financing includes financing under a Federal, State, or local program having two or more principal purposes (provided that at least one of the principal purposes is to provide subsidized financing for projects designed to conserve or produce energy), but only to the extent that the financing—</P> <P>(i) Is to be used for energy production or conservation purposes, or</P> <P>(ii) Is provided out of funds designated specifically for energy production or conservation.<PRTPAGE P="44"/> </P> <FP>Loan proceeds meet the use test of paragraph (i)(l)(i) of this section only to the extent that the loan application, the loan instrument, or any other loan-related documents indicate that the funds are intended for such use. However, loan proceeds designated for the purchase either of property that contains “insulation” or any “other energy-conserving component” or of “renewable energy source property” as defined in paragraphs (c), (d), and (e), respectively, of this section meet the test of paragraph (i)(l)(i) of this section. Financing is subsidized if the interest rate or other terms of the financing (including any special tax treatment) provided to the taxpayer in connection with the program or used to raise funds for the program are more favorable than the terms generally available commercially. In addition, financing is subsidized if the principal obligation of the financing provided to the taxpayer is reduced by funds provided under the program. The source from which the funds for the program are derived is not a factor to be taken into account in determining whether the financing is subsidized. If a public utility disburses funds for the financing of energy conservation or renewable energy source property under a program that obtains the funds through sales to the utility's ratepayers, the program is not considered to be a Federal, State or local program even though the utility is a governmental agency, and, thus, the funds are not subsidized energy financing. Subsidized energy financing does not include a grant includible in gross income under section 61, nontaxable grants, a credit against State or local taxes made directly to the taxpayer claiming the credit provided for in section 23, or a loan guarantee made directly to the taxpayer claiming the credit provided for in section 23.</FP> <P>(2) <E T="03">Examples.</E> The provisions of this paragraph (i) may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>State A has a farm and home loan program. The program is used to provide low interest mortgage loans. In 1984 State A's legislature enacted statutory amendments to its farm and home loan program in an effort to encourage energy conservation-type measures. Low interest loans for such improvements were made available to qualified purchasers and owners under the farm and home loan program. The energy conservation measures subsidized by the program include energy conserving components and renewable energy source devices. State A's tax exempt bonds are the source of funds for loans under the program. Although the 1984 legislation authorizing loans for energy conserving components and renewable energy source improvements did not diminish the original purpose of the farm and home loan program, the 1984 legislation added another principal purpose to the program. Therefore, State A's program which has two principal purposes, one of which is the conservation or production of energy, is considered as providing subsidized energy financing for purposes of section 23 (c)(10) of the Code, to the extent that financing is provided by State A out of funds designated specifically for energy production or conservation. State A's program will also be considered as providing subsidized energy financing to the extent that the loan proceeds are to be used for energy production or conservation purposes. Loan proceeds meet the use test of the preceding sentence only to the extent that loan application, the loan instruments, or any other loan-related documents indicate that the funds are intended for such use.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The United States Department of Energy disburses funds to State B that the Department received from settlements from alleged petroleum pricing and allocation violations. State B establishes a program under which B will use the funds to make loans at below market interest rates directly to qualified applicants for the purchase of renewable energy source property. B's loans are subsidized energy financing.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>State C establishes a program under which C will make loans at below market interest rates directly to qualified applicants for the purchases of renewable energy source property. The program is funded with money that State C was able to borrow after it obtained a loan guarantee from a Federal agency. C's loans provided under the program are subsidized energy financing.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>Company D is an electric utility that is a Federal agency. D purchases its electricity from another federal agency, transmits the electricity over its own distribution system, and sells the electricity to numerous local public utilities that in turn sell the electricity to their customers. D wishes to start a program under which D will make loans at below market interest rates directly to customers of the local utilities for the purchase of renewable energy source property from D. The local public utility will act as the collection agent for repayment of the loans. The loans will be repayable over a period of time not in excess of 15 years. Under law, D must cover its full costs through its own revenues derived from the sale of power and other services. While D may borrow by sale of bonds to the United <PRTPAGE P="45"/>States Treasury, D must borrow at rates comparable to the rates prevailing in the market for similar bonds. Thus, the subsidized loans made under D's program will be financed by the profits from the sale of electricity to consumers and not by the federal government. D's program, which is substantially the same as that carried out by private (investor-owned) utilities, is not considered to be a Federal, State or local governmental program. Therefore, D's loans are not subsidized energy financing.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>The Solar Energy and Energy Conservation Bank (Bank) disburses funds to State E. E disburses a portion of the funds to Financial Institution F. Both the Bank and State E make these disbursements under a program the principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy. F uses the funds to reduce a portion of the principal obligation on loans it issues to finance energy conservation or solar energy expenditures. Taxpayer G borrows $3,000 from F in order to purchase a solar water heating system. F uses $500 of the funds it received from the Bank to reduce the principal obligation of the loan to G to $2,500. The amount of subsidized energy financing to G is $3,000.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>State H allows a tax credit to Financial Institution J under a program the principal purpose of which is to provide loans at below market interest rates directly to qualified applicants for the purchase of renewable energy source property. J receives a credit each year in the amount of the excess of the interest that would have been paid at private market rates over the actual interest paid on such loans. The State H tax credit arrangement is an interest subsidy. Thus, any low-interest loans made pursuant to this credit arrangement are subsidized energy financing.</P> </EXAMPLE> <CITA>[T.D. 7717, 45 FR 57716, Aug. 29, 1980. Redesignated and amended by T.D. 8146, 52 FR 26670, July 16, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.23-3</SECTNO> <SUBJECT>Special rules.</SUBJECT> <P>(a) <E T="03">When expenditures are treated as made—</E>(1) <E T="03">Timeliness of an expenditure for the energy credit.</E> In general, for the purpose of determining whether an expenditure qualifies as being timely for the residential energy credit under section 23 or former section 44C (<E T="03">i.e.,</E> is made after April 19, 1977, and before January 1, 1986), the expenditure is treated as made when original installation of the item is completed. Thus, solely for that purpose, the time of payment or accrual is irrelevant.</P> <P>(2) <E T="03">Special rule for renewable energy source expenditures in the case of construction or reconstruction of a dwelling.</E> In the case of renewable energy source expenditures in connection with the construction or reconstruction of a dwelling that becomes the taxpayer's new principal residence, the expenditures are to be treated as made (for the purpose of determining the timeliness of an expenditure for the residential energy credit) when the taxpayer commences use of the dwelling as his or her principal residence following its construction or reconstruction. The term “reconstruction” means the replacement of most of a dwelling's major structural components such as floors, walls, and ceiling. When a taxpayer reoccupies a reconstructed dwelling that was the taxpayer's principal residence prior to reconstruction, a renewable energy source expenditure is considered made when the original installation of the renewable energy source property is completed.</P> <P>(3) <E T="03">Taxable year in which credit is allowable.</E> For the purpose of determining the taxable year in which the credit for an expenditure is allowable (once it has qualified as timely under subparagraph (1) or (2)), an expenditure is treated as made on the later of (i) the date on which it qualifies as timely; or (ii) the date on which it is paid or incurred by the taxpayer.</P> <P>(b) <E T="03">Expenditures in 1977.</E> No credit under section 23 or former section 44C shall be allowed for any taxable year beginning before 1978. However, the amount of any credit under section 23 or former section 44C for the taxpayer's first taxable year beginning after December 31, 1977, shall take into account qualified energy conservation expenditures and qualified renewable energy source expenditures made during the period beginning April 20, 1977, and ending on the last day of such first taxable year.</P> <P>(c) <E T="03">Cross reference.</E> For rules relating to expenditures financed with Federal, State, or local government grants or subsidized financing see paragraph (d)(3) of § 1.23-1 and paragraph (i) of § 1.23-2.</P> <P>(d) <E T="03">Expenditures qualifying both as energy conservation expenditures and renewable source expenditures.</E> In the case of an expenditure which meets both the definition of an energy conservation expenditure (as defined in § 1.23-2(a)) <PRTPAGE P="46"/>and a renewable energy source expenditure (as defined in § 1.23-2(b)), the taxpayer may claim either a credit under § 1.23-1(b) (relating to qualified energy conservation expenditures) or § 1.23-1(c) (relating to qualified renewable energy source expenditures) but may not claim both credits with respect to the same expenditure.</P> <P>(e) <E T="03">Principal residence.</E> For purposes of section 23 or former section 44C the determination of whether a dwelling unit is the taxpayer's principal residence shall be made under principles similar to those applicable to section 1034 and the regulations thereunder (relating to sale or exchange of a principal residence) except that ownership of the dwelling unit is not required. In making this determination, the period for which a dwelling is treated as a taxpayer's principal residence includes the 30-day period ending on the first day on which the dwelling unit would (but for this sentence) be treated as being used as the taxpayer's principal residence under principles similar to those applicable to section 1034. Thus, installation that are completed within that 30-day period may be eligible for the credit although, in the absence of the 30-day rule, the date of habitation of the dwelling unit by the taxpayer would mark the beginning of the taxpayer's use of the unit as a principal residence.</P> <P>(f) <E T="03">Construction substantially completed.</E> Construction of a dwelling unit is substantially completed when construction has progressed to the point where the unit could be put to use as a personal residence, even though comparatively minor items remain to be finished or performed in order to conform to the plans or specifications of the completed building. For this purpose, construction includes reconstruction as defined in paragraph (a)(2). This rule may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>On January 1, 1979, A purchases a dwelling that is to become A's principal residence. The dwelling unit was originally constructed in 1950. A spends $50,000 to reconstruct the dwelling by replacing most of the dwelling's major structural components such as floors, walls, and ceilings. Included in the cost is $3,000 attributable to energy-conserving components. Reconstruction is substantially completed on April 1, 1979, and A moves into the reconstructed residence on May 1, 1979. Since construction includes reconstruction, A's reconstructed residence is not considered substantially completed before April 20, 1977. Thus, amounts spent with respect to A's reconstructed residence for energy-conserving components do not qualify as energy conservation expenditures.</P> </EXAMPLE> <P>(g) <E T="03">Residential use of property.</E> To be eligible for the residential energy credit, expenditures must be made for personal residential purposes. If at least 80 percent of the use of a component or item of property is for personal residential purposes, the entire amount of the energy conservation expenditure or the renewable energy source expenditure is taken into account in computing the credit under this section. If less than 80 percent of the use of a component or item of property is for personal residential purposes, the amount of an expenditure taken into account is the amount that bears the same ratio to the amount of the expenditure as the amount of personal residential use of the component or item bears to its total use. For purposes of this paragraph, use of a component or an item of property with respect to a swimming pool is not a use for a personal residential purpose. The rules with respect to residential use of property are illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>In 1978 A makes an expenditure of $3,000 for the installation of storm windows of which 50 percent is on the portion of A's dwelling used as the principal family residence and 50 percent is on the portion of the dwelling used as an office. A has made no other energy conservation expenditures for the residence. The allowable energy conservation expenditure is $1,500 (50 percent of $3,000), the portion attributable to residential use. Therefore, the residential energy credit is $225 (the qualified conservation expenditure of 15 percent of $1.500).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>During 1979, B makes $10,000 of renewable energy source expenditures on solar energy property for B's principal residence. Approximately 60 percent of the use of the solar energy property will be for heating B's swimming pool; the other 40 percent will be for heating the dwelling unit. B had not previously made renewable energy source expenditures with respect to the residence. Since use for a swimming pool is not considered a residential use, less than 80 percent of the use of B's solar energy property is considered used for personal residential purposes. Therefore, only $4,000 (40 percent of <PRTPAGE P="47"/>$10,000), the proportionate part of B's expenditures representing personal residential use, is treated as a renewable energy source expenditure. B is allowed a $1,000 residential energy credit (30 percent of $2,000 plus 20 percent of $2,000) for 1979.</P> </EXAMPLE> <P>(h) <E T="03">Joint occupancy—</E>(1) <E T="03">In general.</E> If two or more individuals jointly occupied and used a dwelling unit as their principal residence during any portion of a calendar year—</P> <P>(i) The amount of the credit allowable under section 23 or former section 44C by reason of energy conservation expenditures or by reason of renewable energy source expenditures shall be determined by treating all of the joint occupants as one taxpayer whose taxable year is such calendar year; and</P> <P>(ii) The credit under section 23 or former section 44C allowable to each joint occupant for the taxable year with which or in which such calendar year ends shall be an amount which bears the same ratio to the amount determined under paragraph (h)(1)(i) of this section as the amount of energy conservation expenditures or renewable energy source expenditures made by that occupant bears to the total amount of each type of such expenditures made by all joint occupants during such calendar year.</P> <FP>The provisions of this subparagraph may be illustrated by the following example:</FP> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>A, a calendar year taxpayer, and B, a June 1 fiscal year taxpayer, make energy conservation exenditures of $2,000 (A making expenditures of $500 and B making expenditures of $1,500) on their principal and jointly occupied residence in 1978. A and B have not previously make energy conservation expenditures with respect to this residence. Of the $300 credit (15 percent of $2,000), $75 will be allocated to A ($500/$2,000 × $300) and $225 to B ($1,500/$2,000 × 300). A will claim the allocable share of the credit on A's 1978 tax return and B will claim the allocable share of the credit on B's tax return for the fiscal year ending May 31, 1979.</P> </EXAMPLE> <P>(2) <E T="03">Minimum credit.</E> The fact that one joint occupant may be unable to claim all or part of the credit under section 23 of former section 44C because of insufficient tax liability or because that occupant's allowable credit does not exceed the $10 minimum credit (as set forth in paragraph (d)(1) of § 1.23-1) shall have no effect upon the computation of the amount of the allowable credits for the other joint occupants.</P> <P>(3) <E T="03">Prior expenditures.</E> Because joint occupants are treated as one taxpayer for purposes of determining the residential energy credit, the maximum amount of energy conservation expenditures or renewable energy source expenditures must be reduced by the total amount of such expenditures made in connection with the dwelling unit during prior calendar years in which any one of the residents of the unit during the current calendar year was a resident (whether made by the current resident or by an individual previously occupying the dwelling with the current resident). However, the preceding sentence shall not apply to prior expenditures no part of which was taken into account in computing the credits under section 23 of former section 44C for such years. Prior years’ expenditures are not to be allocated among joint occupants to take into account the specific expenditures of each of the occupants in prior years.</P> <P>(4) The rules of this paragraph may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Assume A and B have together made prior years’ energy conservation expenditures of $1,600 (A having made $1,200 of expenditures and B having made $400) on their principal and jointly occupied residence. In the current year, each makes energy conservation expenditures of $300 with respect to the same residence. The maximum qualified expenditure with respect to the residence is reduced by the $1,600 of prior expenditures made by A and B. Therefore, only $400 of the $600 current expenditures are eligible as energy conservation expenditures. The resulting residential energy credit is $60 (15 percent of $400) of which $30 apiece will be allocated to A and B ($300/$600 × $60). The fact that A had previously computed the credit in prior years with respect to $1,200 of the total $1,600 of expenditures is irrelevant to the apportionment of the credit in the current year.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>In 1978, spouses C and D make $10,000 of renewable energy source expenditures with respect to their principal residence, half of which is paid by each spouse. No prior renewable energy source expenditures have been taken into account with respect to that residence by either C or D. C and D file separate returns for the calendar year. Under the joint occupancy rule, the maximum allowable renewable energy source credit with respect to C and D's principal <PRTPAGE P="48"/>residence is $2,200 (30 percent of the first $2,000, and 20 percent of the next $8,000 of expenditures). Half of this amount or $1,100, will be allowed to each spouse. If either spouse makes renewable energy source expenditures with respect to the same principal residence in future years, none of those expenditures would be qualified renewable energy source expenditures for which a credit can be claimed. That is, not more than $2,200 may be taken in the aggregate by C and D as a renewable energy source credit with respect to their principal residence.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>In 1978, E and F make energy conservation expenditures of $1,500 on their principal and jointly occupied residence. In 1979, E moves away and G becomes the other joint occupant of the residence. F and G make energy conservation expenditures of $1,000 in 1979. In 1980 F moves away and H moves in with G. G and H make energy conservation expenditures of $500. The maximum qualified expenditure made by F and G with respect to the residence is reduced by the $1,500 of prior expenditures made in 1978 by E and F. The maximum qualified expenditures made by G and H with respect to the residence is reduced only by the expenditures in prior years in connection with the residence during which either G or H was a joint occupant. Accordingly, the maximum qualified expenditures made by G and H with respect to the residence is reduced only by the $1,000 of prior expenditures made in 1979 by F and G.</P> </EXAMPLE> <P>(i) <E T="03">Condominiums and cooperative housing corporations.</E> An individual who is a tenant stockholder in a cooperative housing corporation (as defined in section 216) or who is a member of a condominium management association with respect to a condominium which he or she owns shall be treated as having made a proportionate share of the energy conservation expenditures or renewable energy source expenditures of such corporation or association. The cooperative stockholder's allocable share of the expenditures is to be the same as his or her proportionate share of the cooperative's total outstanding stock (including any stock held by the corporation). However, in the case where only certain cooperative stockholders are assessed for the expenditures made by the cooperative housing corporation, only those cooperative stockholders that are assessed shall be treated as having made a share of the expenditures of such corporation. In such case, the cooperative stockholder's share of the expenditures is the amount that the stockholder is assessed. The allocable share of a condominium management association member's energy conservation of renewable energy source expenditures is the amount that the member is assessed (or would be assessed in the case where expenditures are from general funds) by the association as a result of such expenditures. The residential energy credit for a qualified expenditure is allowable for the year in which the association or corporation has completed original installation of the item (or has paid or incurred the expenditure, if later). For purposes of this paragraph, the term “condominium management association” means an organization meeting the requirements of section 528(c)(1) of the Code (other than subparagraph (E) of that section), with respect to a condominium project substantially all the units of which are used as residences.</P> <P>(j) <E T="03">Joint ownership of energy conservation property or renewable energy source property—</E>(1) <E T="03">In general.</E> Energy conservation property renewable energy source property include property which is jointly owned by the taxpayer and another person (or persons) and installed in connection with two or more dwelling units. For example, the fact that a windmill, solar collector, or geothermal well and distribution system is owned by two or more individuals does not preclude its qualification as renewable energy source property. The amount of the credit allowable under section 23 shall be computed separately with respect to the amount of the expenditures made by each individual, subject to the limitations of $2,000 imposed by section 23(b)(1) and $10,000 imposed by section 23(b)(2), per dwelling units of jointly owned property. For example, in 1982, A, B, and C purchased as joint owners renewable energy source property that serviced two houses. One of the houses is jointly owned and occupied by A and B and the other is owned and occupied by C alone. The renewable energy source property cost $30,000 of which A paid $9,000, B paid $6,000, and C paid $15,000. A and B must share the $4,000 credit (40% of $10,000 maximum) with respect to the expenditures for the jointly owned house. Therefore, A is allowed a $2,400 credit ($4,000 times $9,000 divided <PRTPAGE P="49"/>by $9,000 plus $6,000) and B is allowed a $1,600 credit ($4,000 times $6,000 divided by $9,000 plus $6,000) with respect to the expenditures attributable to the jointly owned house. C is entitled to a credit of $4,000 with respect to the expenditures attributable to the other house.</P> <P>(2) <E T="03">Example.</E> The application of this subparagraph may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>A, B, and C each has a separate principal residence. They agree to finance jointly the construction of a solar collector, each providing one-third of the costs and taking one-third of the output of the collector. Each will separately pay for the costs of connecting the solar collector with his or her principal residence. Provided the solar collector and connection equipment otherwise qualify as renewable energy source property, A, B, and C will each be considered to have made renewable energy source expenditures equal to one-third of the cost of the collector plus his or her separate connection costs. Such expenditures will be subject to the limitations and other rules separately applicable to A, B, and C with respect to each principal residence, such as those with respect to the $10 minimum (§ 1.23-1(d)(1)), prior expenditures (§ 1.23-1(d)(2)), residential use (paragraph (g) of this section), and joint occupancy (paragraph (h) of this section).</P> </EXAMPLE> <P>(k) <E T="03">Basic adjustments.</E> If a credit is allowed under section 23 or former section 44C for any expenditure with respect to any property, the increase in the basis of that property which would (but for this paragraph) result from such expenditure shall be reduced by the amount of the credit allowed.</P> <P>(l) <E T="03">Recordkeeping—</E>(1) <E T="03">In general.</E> No residential energy credit is allowable unless the taxpayer maintains the rec-ords described in paragraph (l)(2) of this section. The records shall be retained so long as the contents thereof may become material in the administration of any internal revenue law.</P> <P>(2) <E T="03">Records.</E> The taxpayer must maintain records that clearly identify the energy-conserving components and renewable energy source property with respect to which a residential energy credit is claimed, and substantiate their cost to the taxpayer, any labor costs properly allocable to them paid for by the taxpayer, and the method used for allocating such labor costs.</P> <CITA>[T.D. 7717, 45 FR 57719, Aug. 29, 1980. Redesignated and amended by T.D. 8146, 52 FR 26672, July 16, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.23-4</SECTNO> <RESERVED>Performance and quality standards. [Reserved]</RESERVED> <CITA>[T.D. 7717, 45 FR 57721, Aug. 29, 1980. Redesignated by T.D. 8146, 52 FR 26672, July 16, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.23-5</SECTNO> <SUBJECT>Certification procedures.</SUBJECT> <P>(a) <E T="03">Certification that an item meets the definition of an energy-conserving component or renewable energy source property.</E> Upon the request of a manufacturer of an item pursuant to paragraph (b) of this section which is supported by proof that the item is entitled to be certified, the Assistant Commissioner (Technical) shall certify (or shall notify the manufacturer that the request is denied) that:</P> <P>(1) The item meets the definition of insulation (see § 1.23-2(c)(1)).</P> <P>(2) The item meets the definition of an other energy-conserving component specified in section 23(c)(4) or former section 44C(c)(4) see (§ 1.23-2(d)(4)).</P> <P>(3) The item meets the definition of solar energy property (see § 1.23-2(f)), wind energy property (see § 1.23-2(g)), or geothermal energy property (see § 1.23-2(h)).</P> <P>(4) The item meets the definition of a category of energy-conserving component that has been added to the list of approved items pursuant to paragraph (d)(4)(viii) of § 1.23-2.</P> <P>(5) The item meets the definition of renewable energy source property that transmits or uses a renewable energy source that has been added to the list of approved renewable energy sources pursuant to paragraph (e)(2) of § 1.23-2.</P> <P>(b) <E T="03">Procedure—</E>(1) <E T="03">In general.</E> A manufacturer of an item desiring to apply under paragraph (a) shall submit the application to the Commissioner of Internal Revenue, Attention: Associate Chief Counsel (Technical), CC:C:E, 1111 Constitution Avenue NW., Washington, DC 20224. Upon being advised by the National Office, orally or in writing, that an adverse decision is contemplated a manufacturer may request a conference. The conference must be <PRTPAGE P="50"/>held within 21 calendar days from the date of that advice. Procedures for requesting an extension of the 21-day period and notifying the manufacturer of the Service's decision on that request are the same as those applicable to conferences on ruling requests by taxpayers (see section 9.05 of Rev. Proc. 80-20).</P> <P>(2) <E T="03">Contents of application.</E> The application shall include a description of the item (including appropriate design drawings and specifications) and an explanation of the purpose and function of the item. There shall accompany the application a declaration in the following form: “Under penalties of perjury, I declare that I have examined this application, including accompanying documents and, to the best of my knowledge and belief, the facts presented in support of the application are true, correct, and complete.” The statement must be signed by the person or persons making the application.</P> <P>(c) <E T="03">Effect of certification under paragraph (a).</E> Certifications granted under paragraph (a)(1), (2), or (3) will be applied retroactively to April 20, 1977. However, certifications granted under paragraph (a) (4) or (5) will be applied retroactively only to the date the applicable energy-conserving component or renewable energy source was added by Treasury decision to the list of qualifying components or sources. Certification of an item under this section means that the applicable definitional requirement of § 1.23-2 is considered satisfied in the case of any person claiming a residential energy credit with respect to such item. However, it does not relieve manufacturers of the need to establish that their items conform to performance and quality standards (if any) provided under § 1.23-4 and that their items can reasonably be expected to remain in operation at least 3 years, in the case of insulation and other energy-conserving components, or at least 5 years, in the case of renewable energy source property.</P> <CITA>[T.D. 7717, 45 FR 57721, Aug. 29, 1980. Redesignated and amended by T.D. 8146, 52 FR 26672, July 16, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.23-6</SECTNO> <SUBJECT>Procedure and criteria for additions to the approved list of energy-conserving components or renewable energy sources.</SUBJECT> <P>(a) <E T="03">Procedures for additions to the list of energy-conserving components or renewable energy sources</E>—(1) <E T="03">In general.</E> A manufacturer of an item (or a group of manufacturers) desiring to apply for addition to the approved list of energy-conserving components or renewable energy sources pursuant to paragraph (d)(4)(viii) or (e)(2) of § 1.23-2 shall submit an application to the Internal Revenue Service, Attention: Associate Chief Counsel (Technical), CC:C:E, 1111 Constitution Avenue, NW., Washington, DC 20224. The term “manufacturer” includes a person who assembles an item or a system from components manufactured by other persons. The application shall provide the information required under paragraph (b) of this section. An application may request that more than one item be added to the approved list. It will be the responsibility of the Office of the Associate Chief Counsel (Technical) upon receipt of the application to determine whether all the information required under paragraph (b) of this section has been furnished with the application. If an application lacks essential information, the applicant will be advised of the additional information required. If the information (or a reasonable explanation of the reason why the information cannot be made available) is not forthcoming within 30 days of the date of that advice, the application will be closed and the applicant will be so informed. Any resubmission of information beyond the 30-day period will be treated as a new application. If the Office of the Associate Chief Counsel (Technical) already is considering an application with respect to the same or a similar item, it may consolidate applications. The Office of the Associate Chief Counsel will make a report and recommendation to the ad hoc advisory board as to whether each item that is the subject to an application should be added in accordance with the manufacturer's request to the approved list of energy-conserving components or renewable energy <PRTPAGE P="51"/>sources in light of the applicable criteria provided in paragraph (c) and the standards for Secretarial determination provided in paragraph (d) of this section. In making this recommendation, the Office of the Associate Chief Counsel shall consult with the Secretary of Energy and the Secretary of Housing and Urban Development (or their delegates) and any other appropriate Federal officers to obtain their views concerning the item in question. In addition, the Office of the Associate Chief Counsel may request from the manufacturer clarification of information submitted with the application. The Office of the Associate Chief Counsel shall report its recommendation and forward the application to the ad hoc advisory board for further consideration.</P> <P>(2) <E T="03">Ad hoc advisory board.</E> The Commissioner of Internal Revenue and the Assistant Secretary (Tax Policy) shall establish an ad hoc advisory board to consider applications and recommendations forwarded by the Office of the Associate Chief Counsel (Technical). If a finding in favor of addition of any item is made, the board shall report its recommendation and forward the application to the Commissioner for further consideration. If the item is approved by the Commissioner, the application will be forwarded to the Secretary (or his delegate) for further consideration. The application will be closed with respect to an item if the board, the Commissioner, or the Secretary (or his delegate) determines that, under the applicable criteria or the standards for Secretarial determination, the item should not be added to the list of energy-conserving components or renewable energy sources.</P> <P>(3) <E T="03">Action on application.</E> (i) A final decision to grant or deny any application filed under paragraph (a)(1) shall be made within 1 year after the application and all information required to be filed with such request under paragraph (b) have been received by the Office of the Associate Chief Counsel (Technical). The applicant manufacturer shall be notified in writing of the final decision. In the event of a favorable determination, a regulation will be issued in accordance with the procedures contained in § 601.601 to include the item as an energy-conserving component or as a renewable energy source. A final decision to grant approval of an application is made when a Treasury decision adding the item (that is subject of the application) as an energy-conserving component or as a renewable energy source is published in the <E T="04">Federal Register</E>.</P> <P>(ii) The applicant manufacturer shall be entitled to a conference and be so notified anytime an adverse action is contemplated by the Office of the Associate Chief Counsel, the ad hoc advisory board, the Commissioner of Internal Revenue, or the Secretary (or his delegate) and no conference was previously conducted. Upon being advised in writing that an adverse recommendation or decision as to any item that is the subject of an application is contemplated, a manufacturer may request a conference. The conference must be held within 21 calendar days from the mailing of that advice. Procedures for requesting an extension of the 21-day period and notifying the manufacturer of the recommendation or decision with respect to that request are the same as those applicable to conferences on ruling requests by taxpayers. The applicant is entitled to only one conference. There is no right to another conference when a favorable recommendation or decision is reversed at a higher level.</P> <P>(iii) A report of any application which has been denied during the preceding month and the reasons for the denial shall be published each month.</P> <P>(b) <E T="03">Contents of application.</E> The application by the manufacturer shall include the following information:</P> <P>(1) A description of the item and the generic class to which it belongs, including any features relating to safe installation and use of the item. This description shall include appropriate design drawings and technical specifications (or representative drawings and specifications when application by a group of manufacturers).</P> <P>(2) An explanation of the purpose, function, and each recommended use of the item.</P> <P>(3) An estimate (and explanation of the estimation methods employed and the assumptions made) of the total number of units that would be sold for <PRTPAGE P="52"/>each recommended use during the first 4 years following the addition of the item to the approved list and of the total number that would be sold for each recommended use during that period in the absence of addition. If the item is sold in more than one size, the estimate shall indicate the projected sales for each size. This estimate shall reflect total industry sales of the item. Past industry sales information for each recommended use for the previous two years shall also be provided.</P> <P>(4) Whether sufficient capacity is available to increase production to meet any increase in demand for the item, or for associated fuels and materials, caused by such addition. This determination shall be based on industry-wide data and not just the manufacturing capability of the applicant. If the applicant has the exclusive right to manufacture the item, this information shall also be provided in the application.</P> <P>(5) An estimate (including estimation methods and assumptions) of the energy in Btu's of oil and natural gas used directly or indirectly per unit by the applicant in the manufacture of the item and other items necessary for its use, the type of energy source (<E T="03">e.g.</E>, oil, natural gas, coal, electricity), and the extent of its use in the manufacturing process of the item. The applicant must also provide a list of the major components of the item and their composition and weight.</P> <P>(6) Test data and experience data (where experience data is available) to substantiate for each recommended use the energy savings in Btu's that are claimed will be achieved by one unit during a period of one year. The data shall be obtained by controlled tests in which, if possible, the addition of the item is the only variable. If the item may be sold in various configurations, data shall be provided with respect to energy savings from each configuration with significantly different energy use characteristics. Test methods are to conform to recognized industry or government standards. This determination shall take into account the seasonal use of the item. If the energy savings of the item varies with climatic conditions, data shall be provided with respect to each climate zone. The applicant may use the Department of Energy's climatic zones for heating and cooling (see § 450.35 of 10 CFR part 450 (1980)).</P> <P>(7) The impact of increased demand on the price of the item and the energy source used by the item.</P> <P>(8) The energy source which will be replaced or conserved by the item, and, in the case of a request for addition to the approved list of renewable energy sources, data establishing that the energy source is inexhaustible.</P> <P>(9) Data to show the total estimated savings of energy in Btu's attributable to reduced consumption of oil or natural gas whether directly or indirectly from use of the item, including assumptions underlying this estimate. If the consumption of both oil and natural gas will be reduced, data to show the energy savings in Btu's attributable to each shall be provided. The estimate is to be based on energy savings in Btu's per unit determined under paragraph (b)(6) of this section for the first four years of the useful life of the item and is to take into account only the additional units of the item estimated to be placed in service as a result of the addition using data obtained under paragraph (b)(3) of this section. If the item will result in reduction of oil or natural gas consumption by replacing an item which uses such an energy source, the application shall indicate the item replaced and the extent to which this reduction will occur.</P> <P>(10) Geographical information if required under paragraph (b)(6) of this section to show the climatic zones of the country where the item is expected to be used, including an estimate of the total number of additional units to be placed in service during the first 4 years following the addition of the item in the area as a result of the addition of the item to the list of qualifying items.</P> <P>(11) The retail cost of the item (or items if the item is sold in more than one size) including all installation costs necessary for safe and effective use.</P> <P>(12) Whether the item is designed for residential use.</P> <P>(13) The estimated useful life of the item and associated equipment necessary for its use.<PRTPAGE P="53"/> </P> <P>(14) The type and amount of waste and emissions in weight per unit of energy saved resulting from use of the item.</P> <P>(15) If the item might reasonably be suspected of presenting any health or safety hazard, test data to show that the item does not present such hazard.</P> <FP>With respect to applications for addition to the approved list of renewable energy sources, the term “item” as used in this paragraph refers to the property which uses the energy source and not the energy source itself. The application should clearly indicate whether the request is for addition to the approved list of energy-conserving components or renewable energy sources, identify the provisions for which data is being submitted, and present the data in the order requested. The tests required under this paragraph may be conducted by independent laboratories but the underlying data must be submitted along with the test results. There shall accompany the request a declaration in the following form: “Under penalties of perjury, I declare that I have examined this application, including accompanying documents, and, to the best of my knowledge and belief, the facts presented in support of the application are true, correct and complete.” The statement must be signed by the person or persons making the application. The declaration shall not be made by the taxpayer's representative.</FP> <P>(c) <E T="03">Criteria for additions—</E>(1) <E T="03">Additions to the approved list of energy-conserving components.</E> For an item to be considered for addition to the approved list of energy-conserving components, the manufacturer must show that the item increases the energy efficiency of a dwelling. For an item to be considered as increasing the energy efficiency of a dwelling, all of the following criteria must be met:</P> <P>(i) The use of the item must improve the energy efficiency of the dwelling structure, structural components of the dwelling, hot water heating, or heating or cooling systems.</P> <P>(ii) The use of the item must result, directly or indirectly, in a significant reduction in the consumption of oil or natural gas.</P> <P>(iii) The increase in energy efficiency must be established by test data and in accordance with accepted testing standards.</P> <P>(iv) The item must not present a safety, fire, environmental, or health hazard when properly installed.</P> <P>(2) <E T="03">Additions to the approved list of renewable energy sources.</E> For an energy source to be considered for addition to the approved list of renewable energy sources, the manufacturer must show that the following criteria are met:</P> <P>(i) As in the case of solar, wind, and geothermal energy, the energy source must be an inexhaustible energy supply. Accordingly, wood and agricultural products and by-products are not considered renewable energy sources. Similarly, no exhaustible or depletable energy source (such as sources that are depletable under 611) will be considered.</P> <P>(ii) The energy source must be capable of being used for heating or cooling a residential dwelling or providing hot water or electricity for use in such a dwelling.</P> <P>(iii) A practical working device, machine, or mechanism, etc., must exist and be commercially available to use such renewable energy source.</P> <P>(iv) The use of the renewable energy source must not present a significant safety, fire, environmental, or health hazard.</P> <P>(d) <E T="03">Standards for Secretarial determination—</E>(1) <E T="03">In general.</E> The Secretary will not make any addition to the approved list of energy-conserving components or renewable energy sources unless the Secretary determines that—</P> <P>(i) There will be a reduction in the total consumption of oil or natural gas as a result of the addition, and that reduction is sufficient to justify any resulting decrease in Federal revenues.</P> <P>(ii) The addition will not result in an increased use of any item which is known to be, or reasonably suspected to be, environmentally hazardous or a threat to public health or safety, and</P> <P>(iii) Available Federal subsidies do not make the addition unnecessary or inappropriate (in the light of the most advantageous allocation of economic resources).<PRTPAGE P="54"/> </P> <P>(2) <E T="03">Factors taken into account.</E> In making any determination under paragraph (d)(1)(i) of this section, the Secretary will—</P> <P>(i) Make an estimate of the amount by which the addition will reduce oil and natural gas consumption, and</P> <P>(ii) Determine whether the addition compares favorably, on the basis of the reduction in oil and natural gas consumption per dollar of cost to the Federal Government (including revenue loss), with other Federal programs in existence or being proposed.</P> <P>(3) <E T="03">Factors taken into account in making estimates.</E> In making any estimate under subparagraph (2)(i), the Secretary will take into account (among other factors)—</P> <P>(i) The extent to which the use of any item will be increased as a result of the addition,</P> <P>(ii) Whether sufficient capacity is available to increase production to meet any increase in demand for the item or associated fuels and materials caused by the addition,</P> <P>(iii) The amount of oil and natural gas used directly or indirectly in the manufacture of the item and other items necessary for its use,</P> <P>(iv) The estimated useful life of the item, and</P> <P>(v) The extent additional use of the item leads, directly or indirectly, to the reduced use of oil or natural gas. Indirect uses of oil or natural gas include use of electricity derived from oil or natural gas.</P> <P>(e) <E T="03">Effective date of addition to approved lists.</E> In the case of additions to the approved list of energy-conserving components or renewable energy sources, the credit allowable by § 1.23-1 shall apply with respect to expenditures which are made on or after the date a Treasury decision amending the regulations pursuant to the application is published in the <E T="04">Federal Register.</E> However, the Secretary may prescribe by regulations that expenditures for additions made on or after the date referred to in the preceding sentence and before the close of the taxable year in which such date occurs shall be taken into account in the following taxable year. Additions to the list will be subject to the performance and quality standards (if any) provided under § 1.23-4 which are in effect at the time of the addition. Furthermore, any addition made to the approved list will be subject to reevaluation by the Secretary for the purpose of determining whether the item still meets the requisite criteria and standards for addition to the list. If it is determined by the Secretary that an item no longer meets the requisite criteria, the Secretary will amend the regulations to delete the item from the approved list. Removal of an item from the list will be prospective from the date a Treasury decision amending the regulations is published in the <E T="04">Federal Register</E>.</P> <SECAUTH>(Secs. 44C and 7805 of the Internal Revenue Code of 1954 (92 Stat. 3175, 26 U.S.C. 44C; 68A Stat. 917, 26 U.S.C. 7805). The amendments to the Statement of Procedural Rules are issued under the authority contained in 5 U.S.C. 301 and 552)</SECAUTH> <CITA>[T.D. 7861, 47 FR 56331, Dec. 16, 1982. Redesignated and amended by T.D. 8146, 52 FR 26673, July 16, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-1T</SECTNO> <SUBJECT>Credit for interest paid on certain home mortgages (Temporary).</SUBJECT> <P>(a) <E T="03">In general.</E> Section 25 permits States and political subdivisions to elect to issue mortgage credit certificates in lieu of qualified mortgage bonds. An individual who holds a qualified mortgage credit certificate (as defined in § 1.25-3T) is entitled to a credit against his Federal income taxes. The amount of the credit depends upon (1) the amount of mortgage interest paid or accrued during the year and (2) the applicable certificate credit rate. See §1.25-2T. The amount of the deduction under section 163 for interest paid or accrued during any taxable year is reduced by the amount of the credit allowable under section 25 for such year. See § 1.163-6T. The holder of a qualified mortgage credit certificate may be entitled to additional withholding allowances. See section 3402 (m) and the regulations thereunder.</P> <P>(b) <E T="03">Definitions.</E> For purposes of §§ 1.25-2T through 1.25-8T and this section, the following definitions apply:</P> <P>(1) <E T="03">Mortgage.</E> The term “mortgage” includes deeds of trust, conditional sales contracts, pledges, agreements to hold title in escrow, and any other form of owner financing.<PRTPAGE P="55"/> </P> <P>(2) <E T="03">State.</E> (i) The term “State” includes a possession of the United States and the District of Columbia.</P> <P>(ii) Mortgage credit certificates issued by or on behalf of any State or political subdivision (“governmental unit”) by constituted authorities empowered to issue such certificates are the certificates of such governmental unit.</P> <P>(3) <E T="03">Qualified home improvement loan.</E> The term “qualified home improvement loan” has the meaning given that term under section 103A (1)(6) and the regulations thereunder.</P> <P>(4) <E T="03">Qualified rehabilitation loan.</E> The term “qualified rehabilitation loan” has the meaning given that term under section 103A (1)(7)(A) and the regulations thereunder.</P> <P>(5) <E T="03">Single-family and owner-occupied residences.</E> The terms “single-family” and “owner-occupied” have the meaning given those terms under section 103A (1)(9) and the regulations thereunder.</P> <P>(6) <E T="03">Constitutional home rule city.</E> The term “constitutional home rule city” means, with respect to any calendar year, any political subdivision of a State which, under a State constitution which was adopted in 1970 and effective on July 1, 1971, had home rule powers on the 1st day of the calendar year.</P> <P>(7) <E T="03">Targeted area residence.</E> The term “targeted area residence” has the meaning given that term under section 103A (k) and the regulations thereunder.</P> <P>(8) <E T="03">Acquisition cost.</E> The term “acquisition cost” has the meaning given that term under section 103A (1)(5) and the regulations thereunder.</P> <P>(9) <E T="03">Average area purchase price.</E> The term “average area purchase price” has the meaning given that term under subparagraphs (2), (3), and (4) of section 103A (f) and the regulations thereunder. For purposes of this paragraph (b)(9), all determinations of average area purchase price shall be made with respect to residences as that term is defined in section 103A and the regulations thereunder.</P> <P>(10) <E T="03">Total proceeds.</E> The “total proceeds” of an issue is the sum of the products determined by multiplying—</P> <P>(i) The certified indebtedness amount of each mortgage credit certificate issued pursuant to such issue, by</P> <P>(ii) The certificate credit rate specified in such certificate.</P> <FP>Each qualified mortgage credit certificate program shall be treated as a separate issue of mortgage credit certificates.</FP> <P>(11) <E T="03">Residence.</E> The term “residence” includes stock held by a tenant-stockholder in a cooperative housing corporation (as those terms are defined in section 216(b) (1) and (2)). It does not include property such as an appliance, a piece of furniture, a radio, <E T="03">etc.,</E> which, under applicable local law, is not a fixture. The term also includes any manufactured home which has a minimum of 400 square feet of living space and a minimum width in excess of 102 inches and which is of a kind customarily used at a fixed location. The preceding sentence shall not apply for purposes of determining the average area purchase price for single-family residences, nor shall it apply for purposes of determining the State ceiling amount. The term “residence” does not, however, include recreational vehicles, campers, and other similar vehicles.</P> <P>(12) <E T="03">Related person.</E> The term “related person” has the meaning given that term under section 103(b)(6)(C)(i) and § 1.103-10(e)(1).</P> <P>(13) <E T="03">Date of issue.</E> A mortgage credit certificate is considered issued on the date on which a closing agreement is signed with respect to the certified indebtedness amount.</P> <P>(c) <E T="03">Affidavits.</E> For purposes of §§ 1.25-1T through 1.25-8T, an affidavit filed in connection with the requirements of §§ 1.25-1T through 1.25-8T shall be made under penalties of perjury. Applicants for mortgage credit certificates who are required by a lender or the issuer to sign affidavits must be informed that any fraudulent statement will result in (1) the revocation of the individual's mortgage credit certificate, and (2) a $10,000 penalty under section 6709. Other persons required by a lender or an issuer to provide affidavits must receive similar notice. A person may not rely on an affidavit where that person knows or has reason to know that the <PRTPAGE P="56"/>information contained in the affidavit is false.</P> <CITA>[T.D. 8023, 50 FR 19346, May 8, 1985]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-2T</SECTNO> <SUBJECT>Amount of credit (Temporary).</SUBJECT> <P>(a) <E T="03">In general.</E> Except as otherwise provided, the amount of the credit allowable for any taxable year to an individual who holds a qualified mortgage credit certificate is equal to the product of the certificate credit rate (as defined in paragraph (b)) and the amount of the interest paid or accrued by the taxpayer during the taxable year on the certified indebtedness amount (as defined in paragraph (c)).</P> <P>(b) <E T="03">Certificate credit rate</E>—(1) <E T="03">In general.</E> For purposes of §§ 1.25-1T through 1.25-8T, the term “certificate credit rate” means the rate specified by the issuer on the mortgage credit certificate. The certificate credit rate shall not be less than 10 percent nor more than 50 percent.</P> <P>(2) <E T="03">Limitation in certain States.</E> (i) In the case of a State which—</P> <P>(A) Has a State ceiling for the calendar year in which an election is made that exceeds 20 percent of the average annual aggregate principal amount of mortgages executed during the immediately preceding 3 calendar years for single-family owner-occupied residences located within the jurisdiction of such State, or</P> <P>(B) Issued qualified mortgage bonds in an aggregate amount less than $150 million for calendar year 1983.</P> <FP>the certificate credit rate for any mortgage credit certificate issued under such program shall not exceed 20 percent unless the issuing authority submits a plan to the Commissioner to ensure that the weighted average of the certificate credit rates in such mortgage credit certificate program does not exceed 20 percent and the Commissioner approves such plan. For purposes of determining the average annual aggregate principal amount of mortgages executed during the immediately preceding 3 calendar years for single-family owner-occupied residences located within the jurisdiction of such State, an issuer may rely upon the amount published by the Treasury Department for such calendar years. An issuer may rely on a different amount from that safe-harbor limitation where the issuer has made a more accurate and comprehensive determination of that amount. The weighted average of the certificate credit rates in a mortgage credit certificate program is determined by dividing the sum of the products obtained by multiplying the certificate credit rate of each certificate by the certified indebtedness amount with respect to that certificate by the sum of the certified indebtedness amounts of the certificates issued. See section 103A(g) and the regulations thereunder for the definition of the term “State ceiling”.</FP> <P>(ii) The following example illustrates the application of this paragraph (b)(2): </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>City Z issues four qualified mortgage credit certificates pursuant to its qualified mortgage credit certificate program. H receives a certificate with a certificate credit rate of 30 percent and a certified indebtedness amount of $50,000. I receives a certificate with a certificate credit rate of 25 percent and a certified indebtedness amount of $100,000. J and K each receive certificates with certificate credit rates of 10 percent; their certified indebtedness amounts are $50,000 and $100,000, respectively. The weighted average of the certificate credit rates is determined by dividing the sum of the products obtained by multiplying the certificate credit rate of each certificate by the certified indebtedness amount with respect to that certificate ((.3×$50,000) + (.25×$100,000) + (.1×$50,000) + (.1×$100,000)) by the sum of the certified indebtedness amounts of the certificates issued ($50,000+$100,000+$50,000+$100,000). Thus, the weighted average of the certificate credit rates is 18.33 percent ($55,000/$300,000).</P> </EXAMPLE> <P>(c) <E T="03">Certified indebtedness amount</E>—(1) <E T="03">In general.</E> The term “certified indebtedness amount” means the amount of indebtedness which is—</P> <P>(i) Incurred by the taxpayer—</P> <P>(A) To acquire his principal residence, § 1.25-2T(c)(1)(i),</P> <P>(B) As a qualified home improvement loan, or</P> <P>(C) As a qualified rehabilitation loan, and</P> <P>(ii) Specified in the mortgage credit certificate.</P> <P>(2) <E T="03">Example.</E> The following example illustrates the application of this paragraph: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>On March 1, 1986, State X, pursuant to its qualified mortgage credit certificate program, provides a mortgage credit <PRTPAGE P="57"/>certificate to B. State X specifies that the maximum amount of the mortgage loan for which B may claim a credit is $65,000. On March 15, B purchases for $67,000 a single-family dwelling for use as his principal residence. B obtains from Bank M a mortgage loan for $60,000. State X, or Bank M acting on behalf of State X, indicates on B's mortgage credit certificate that the certified indebtedness amount of B's loan is $60,000. B may claim a credit under section 25 (e) based on this amount.</P> </EXAMPLE> <P>(d) <E T="03">Limitation on credit</E>—(1) <E T="03">Limitation where certificate credit rate exceeds 20 percent.</E> (i) If the certificate credit rate of any mortgage credit certificate exceeds 20 percent, the amount of the credit allowed to the taxpayer by section 25(a)(1) for any year shall not exceed $2,000. Any amount denied under this paragraph (d)(1) may not be carried forward under section 25(e)(1) and paragraph (d)(2) of this section.</P> <P>(ii) If two or more persons hold interests in any residence, the limitation of paragraph (d)(1)(i) shall be allocated among such persons in proporation to their respective interests in the residence.</P> <P>(2) <E T="03">Carryforward of unused credit.</E> (i) If the credit allowable under section 25 (a) and § 1.25-2T for any taxable year exceeds the applicable tax limit for that year, the excess (the “unused credit”) will be a carryover to each of the 3 succeeding taxable years and, subject to the limitations of paragraph (d)(2)(ii), will be added to the credit allowable by section 25 (a) and § 1.25-2T for that succeeding year.</P> <P>(ii) The amount of the unused credit for any taxable year (the “unused credit year”) which may be taken into account under this paragraph (d)(2) for any subsequent taxable year may not exceed the amount by which the applicable tax limit for that subsequent taxable year exceeds the sum of (A) the amount of the credit allowable under section 25 (a) and § 1.25-1T for the current taxable year, and (B) the sum of the unused credits which, by reason of this paragraph (d)(2), are carried to that subsequent taxable year and are attributable to taxable years before the unused credit year. Thus, if by reason of this paragraph (d)(2), unused credits from 2 prior taxable years are carried forward to a subsequent taxable year, the unused credit from the earlier of those 2 prior years must be taken into account before the unused credit from the later of those 2 years is taken into account.</P> <P>(iii) For purposes of this paragraph (d)(2) the term “applicable tax limit” means the limitation imposed by section 26 (a) for the taxable year reduced by the sum of the credits allowable for that year under section 21, relating to expenses for household and dependent care services necessary for gainful employment, section 22, relating to the credit for the elderly and the permanently disabled, section 23, relating to the residential energy credit, and section 24, relating to contributions to candidates for public office. The limitation imposed by section 26 (a) for any taxable year is equal to the taxpayer's tax liability (as defined in section 26 (b)) for that year.</P> <P>(iv) The following examples illustrate the application of this paragraph (d)(2): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) B, a calendar year taxpayer, holds a qualified mortgage credit certificate. For 1986 B's applicable tax limit (<E T="03">i.e.,</E> tax liability) is $1,100. The amount of the credit under section 25 (a) and § 1.25-2T for 1986 is $1,700. For 1986 B is not entitled to any of the credits described in sections 21 through 24. Under § 1.25-2T (d)(2), B's unused credit for 1986 is $600, and B is entitled to carry forward that amount to the 3 succeeding years.</P> <P>(ii) For 1987 B's applicable tax limit is $1,500, the amount of the credit under section 25 (a) and § 1.25-2T is $1,700, and the unused credit is $200. For 1988 B's applicable tax limit is $2,000, the amount of the credit under section 25 (a) and § 1.25-2T is $1,300, and there is no unused credit. For 1987 and 1988 B is not entitled to any of the credits described in sections 21 through 24. No portion of the unused credit for 1986 my be used in 1987. For 1988 B is entitled to claim a credit of $2,000 under section 25 (a) and § 1.25-2T, consisting of a $1,300 credit for 1988, the $600 unused credit for 1986, and $100 of the $200 unused credit for 1987. In addition, B may carry forward the remaining unused credit for 1987 ($100) to 1989 and 1990.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in Example (1) except that for 1988 B is entitled to a credit of $400 under section 23. B's applicable tax limit for 1988 is $1,600 ($2,000 less $400). For 1988 B is entitled to claim a credit of $1,600 under section 25 (a) and § 1.25-2T, consisting of a $1,300 credit for 1988 and $300 of the unused credit for 1986. In addition, B may carry forward the remaining unused credits of $300 for 1986 to 1989 and of $200 for 1987 to 1989 and 1990.</P> </EXAMPLE> <CITA>[T.D. 8023, 50 FR 19346, May 8, 1985]</CITA> </SECTION> <SECTION> <PRTPAGE P="58"/> <SECTNO>§ 1.25-3</SECTNO> <SUBJECT>Qualified mortgage credit certificate.</SUBJECT> <P>(a) through (g)(1)(ii) [Reserved] For further guidance, see § 1.25-3T(a) through (g)(1)(ii).</P> <P>(g)(1)(iii) <E T="03">Reissued certificate exception.</E> See paragraph (p) of this section for rules regarding the exception in the case of refinancing existing mortgages.</P> <P>(g)(2) through (o) [Reserved] For further guidance, see § 1.25-3T(g)(2) through (o).</P> <P>(p) <E T="03">Reissued certificates for certain refinancings—</E>(1) <E T="03">In general.</E> If the issuer of a qualified mortgage credit certificate reissues a certificate in place of an existing mortgage credit certificate to the holder of that existing certificate, the reissued certificate is treated as satisfying the requirements of this section. The period for which the reissued certificate is in effect begins with the date of the refinancing (that is, the date on which interest begins accruing on the refinancing loan).</P> <P>(2) <E T="03">Meaning of existing certificate.</E> For purposes of this paragraph (p), a mortgage credit certificate is an existing certificate only if it satisfies the requirements of this section. An existing certificate may be the original certificate, a certificate issued to a transferee under § 1.25-3T(h)(2)(ii), or a certificate previously reissued under this paragraph (p).</P> <P>(3) <E T="03">Limitations on reissued certificate.</E> An issuer may reissue a mortgage credit certificate only if all of the following requirements are satisfied:</P> <P>(i) The reissued certificate is issued to the holder of an existing certificate with respect to the same property to which the existing certificate relates.</P> <P>(ii) The reissued certificate entirely replaces the existing certificate (that is, the holder cannot retain the existing certificate with respect to any portion of the outstanding balance of the certified mortgage indebtedness specified on the existing certificate).</P> <P>(iii) The certified mortgage indebtedness specified on the reissued certificate does not exceed the remaining outstanding balance of the certified mortgage indebtedness specified on the existing certificate.</P> <P>(iv) The reissued certificate does not increase the certificate credit rate specified in the existing certificate.</P> <P>(v) The reissued certificate does not result in an increase in the tax credit that would otherwise have been allowable to the holder under the existing certificate for any taxable year. The holder of a reissued certificate determines the amount of tax credit that would otherwise have been allowable by multiplying the interest that was scheduled to have been paid on the refinanced loan by the certificate rate of the existing certificate. In the case of a series of refinancings, the tax credit that would otherwise have been allowable is determined from the amount of interest that was scheduled to have been paid on the original loan and the certificate rate of the original certificate.</P> <P>(A) In the case of a refinanced loan that is a fixed interest rate loan, the interest that was scheduled to be paid on the refinanced loan is determined using the scheduled interest method described in paragraph (p)(3)(v)(C) of this section.</P> <P>(B) In the case of a refinanced loan that is not a fixed interest rate loan, the interest that was scheduled to be paid on the refinanced loan is determined using either the scheduled interest method described in paragraph (p)(3)(v)(C) of this section or the hypothetical interest method described in paragraph (p)(3)(v)(D) of this section.</P> <P>(C) The scheduled interest method determines the amount of interest for each taxable year that was scheduled to have been paid in the taxable year based on the terms of the refinanced loan including any changes in the interest rate that would have been required by the terms of the refinanced loan and any payments of principal that would have been required by the terms of the refinanced loan (other than repayments required as a result of any refinancing of the loan).</P> <P>(D) The hypothetical interest method (which is available only for refinanced loans that are not fixed interest rate loans) determines the amount of interest treated as having been scheduled to be paid for a taxable year by constructing an amortization schedule for a hypothetical self-amortizing loan with level payments. The hypothetical loan must have a principal amount equal to the remaining outstanding <PRTPAGE P="59"/>balance of the certified mortgage indebtedness specified on the existing certificate, a maturity equal to that of the refinanced loan, and interest equal to the annual percentage rate (APR) of the refinancing loan that is required to be calculated for the Federal Truth in Lending Act.</P> <P>(E) A holder must consistently apply the scheduled interest method or the hypothetical interest method for all taxable years beginning with the first taxable year the tax credit is claimed by the holder based upon the reissued certificate.</P> <P>(4) <E T="03">Examples.</E> The following examples illustrate the application of paragraph (p)(3)(v) of this section: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A holder of an existing certificate that meets the requirements of this section seeks to refinance the mortgage on the property to which the existing certificate relates. The final payment on the holder's existing mortgage is due on December 31, 2000; the final payment on the new mortgage would not be due until January 31, 2004. The holder requests that the issuer provide to the holder a reissued mortgage credit certificate in place of the existing certificate. The requested certificate would have the same certificate credit rate as the existing certificate. For each calendar year through the year 2000, the credit that would be allowable to the holder with respect to the new mortgage under the requested certificate would not exceed the credit allowable for that year under the existing certificate. The requested certificate, however, would allow the holder credits for the years 2001 through 2004, years for which, due to the earlier scheduled retirement of the existing mortgage, no credit would be allowable under the existing certificate. Under paragraph (p)(3)(v) of this section, the issuer may not reissue the certificate as requested because, under the existing certificate, no credit would be allowable for the years 2001 through 2004. The issuer may, however, provide a reissued certificate that limits the amount of the credit allowable in each year to the amount allowable under the existing certificate. Because the existing certificate would allow no credit after December 31, 2000, the reissued certificate could expire on December 31, 2000.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>(a) The facts are the same as <E T="03">Example 1</E> except that the existing mortgage loan has a variable rate of interest and the refinancing loan will have a fixed rate of interest. To determine whether the limit under paragraph (p)(3)(v) of this section is met for any taxable year, the holder must calculate the amount of credit that otherwise would have been allowable absent the refinancing. This requires a determination of the amount of interest that would have been payable on the refinanced loan for the taxable year. The holder may determine this amount by—</P> <P>(1) Applying the terms of the refinanced loan, including the variable interest rate or rates, for the taxable year as though the refinanced loan continued to exist; or</P> <P>(2) Obtaining the amount of interest, and calculating the amount of credit that would have been available, from the schedule of equal payments that fully amortize a hypothetical loan with the principal amount equal to the remaining outstanding balance of the certified mortgage indebtedness specified on the existing certificate, the interest equal to the annual percentage rate (APR) of the refinancing loan, and the maturity equal to that of the refinanced loan.</P> <P>(b) The holder must apply the same method for each taxable year the tax credit is claimed based upon the reissued mortgage credit certificate.</P> </EXAMPLE> <P>(5) <E T="03">Coordination with Section 143(m)(3).</E> A refinancing loan underlying a reissued mortgage credit certificate that replaces a mortgage credit certificate issued on or before December 31, 1990, is not a federally subsidized indebtedness for the purposes of section 143(m)(3) of the Internal Revenue Code.</P> <CITA>[T.D. 8692, 61 FR 66214, Dec. 17, 1996]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-3T</SECTNO> <SUBJECT>Qualified mortgage credit certificate (Temporary).</SUBJECT> <P>(a) <E T="03">Definition of qualified mortgage credit certificate.</E> For purposes of §§ 1.25-1T through 1.25-8T, the term “qualified mortgage credit certificate” means a certificate that meets all of the requirements of this section.</P> <P>(b) <E T="03">Qualified mortgage credit certificate program.</E> A certificate meets the requirements of this paragraph if it is issued under a qualified mortgage credit certificate program (as defined in § 1.25-4T).</P> <P>(c) <E T="03">Required form and information.</E> A certificate meets the requirements of this paragraph if it is in the form specified in § 1.25-6T and if all the information required by the form is specified on the form.</P> <P>(d) <E T="03">Residence requirement—</E>(1) <E T="03">In general.</E> A certificate meets the requirements of this paragraph only if it is provided in connection with the acquisition, qualified rehabilitation, or qualified home improvement of a residence, that is—</P> <P>(i) A single-family residence (as defined in § 1.25-1T(b)(5)) which, at the <PRTPAGE P="60"/>time the financing on the residence is executed or assumed, can reasonably be expected by the issuer to become (or, in the case of a qualified home improvement loan, to continue to be) the principal residence (as defined in section 1034 and the regulations thereunder) of the holder of the certificate within a reasonable time after the financing is executed or assumed, and</P> <P>(ii) Located within the jurisdiction of the governmental unit issuing the certificate.</P> <FP>See section 103a(d) and the regulations thereunder for further definitions and requirements.</FP> <P>(2) <E T="03">Certification procedure.</E> The requirements of this paragraph will be met if the issuer or its agent obtains from the holder of the certificate an affidavit stating his intent to use (or, in the case of a qualified home improvement loan, that he is currently using and intends to continue to use) the residence as his principal residence within a reasonable time (<E T="03">e.g.,</E> 60 days) after the mortgage credit certificate is issued and stating that the holder will notify the issuer of the mortgage credit certificate if the residence ceases to be his principal residence. The affidavit must also state facts that are sufficient for the issuer or his agent to determine whether the residence is located within the jurisdiction of the issuer that issued the mortgage credit certificate.</P> <P>(e) <E T="03">3-year requirement</E>—(1) <E T="03">In general.</E> A certificate meets the requirements of this paragraph only if the holder of the certificate had no present ownership interest in a principal residence at any time during the 3-year period prior to the date on which the mortgage on the residence in connection with which the certificate is provided is executed. For purposes of the preceding sentence, the holder's interest in the residence with respect to which the certificate is being provided shall not be taken into account. See section 103A(e) and the regulations thereunder for further definitions and requirements.</P> <P>(2) <E T="03">Exceptions.</E> Paragraph (e)(1) shall not apply with respect to—</P> <P>(i) Any certificate provided with respect to a targeted area residence (as defined in § 1.25-1T(b)(7)),</P> <P>(ii) Any qualified home improvement loan (as defined in § 1.25-1T(b)(3)), and</P> <P>(iii) Any qualified rehabilitation loan (as defined in § 1.25-1T(b)(4)).</P> <P>(3) <E T="03">Certification procedure.</E> The requirements of paragraph (e)(1) will be met if the issuer or its agent obtains from the holder of the certificate an affidavit stating that he had no present ownership interest in a principal residence at any time during the 3-year period prior to the date of which the certificate is issued and the issuer or its agent obtains from the applicant copies of the applicant's Federal tax returns for the preceding 3 years and examines each statement to determine whether the applicant has claimed a deduction for taxes on property which was the applicant's principal residence pursuant to section 164(a)(1) or a deduction pursuant to section 163 for interest paid on a mortgage secured by property which was the applicant's principal residence. Where the mortgage is executed during the period between January 1 and February 15 and the applicant has not yet filed has Federal income tax return with the Internal Revenue Service, the issuer may, with respect to such year, rely on an affidavit of the applicant that the applicant is not entitled to claim deductions for taxes or interest on indebtedness with respect to property constituting his principal residence for the preceding calendar year. In the alternative, when applicable, the holder may provide an affidavit stating that one of the exceptions provided in paragraph (e)(2) applies.</P> <P>(4) <E T="03">Special rule.</E> An issuer may submit a plan to the Commissioner for distributing certificates, in an amount not to exceed 10 percent of the proceeds of the issue, to individuals who do not meet the requirements of this paragraph. Such plan must describe a procedure for ensuring that no more than 10 percent of the proceeds of a such issue will be used to provide certificates to such individuals. If the Commissioner approves the issuer's plan, certificates issued in accordance with the terms of the plan to holders who do not meet the 3-year requirement do not fail to satisfy the requirements of this paragraph.<PRTPAGE P="61"/> </P> <P>(f) <E T="03">Purchase price requirement</E>—(1) <E T="03">In general.</E> A certificate meets the requirements of this paragraph only if the acquisition cost (as defined in § 1.25-1T(b)(8)) of the residence, other than a targeted area residence, in connection with which the certificate is provided does not exceed 110 percent of the average area purchase price (as defined in § 1.25-1T(b)(9)) applicable to that residence. In the case of a targeted area residence (as defined in § 1.251T(b)(7)) the acquisition cost may not exceed 120 percent of the average area purchase price applicable to such residence. See section 1093A(f) and the regulations thereunder for further definitions and requirements.</P> <P>(2) <E T="03">Certification procedure.</E> The requirements of paragraph (f)(1) will be met if the issuer or its agent obtains affidavits executed by the seller and the buyer that state these requirements have been met. Such affidavits must include an itemized list of—</P> <P>(i) Any payments made by the buyer (or a related person) or for the benefit of the buyer,</P> <P>(ii) If the residence is incomplete, an estimate of the reasonable cost of completing the residence, and</P> <P>(iii) If the residence is purchased subject to a ground rent, the capitalized value of the ground rent.</P> <FP>The issuer or his agent must examine such affidavits and determine whether, on the basis of information contained therein, the purchase price requirement is met.</FP> <P>(g) <E T="03">New mortgage requirement—</E>(1) <E T="03">In general.</E> (i) A certificate meets the requirements of this paragraph only if the certificate is not issued in connection with the acquisition or replacement of an existing mortgage. Except in the case of a qualified home improvement loan, the certificate must be issued to an individual who did not have a mortgage (whether or not paid off) on the residence with respect to which the certificate is issued at any time prior to the execution of the mortgage.</P> <P>(ii) <E T="03">Exceptions.</E> For purposes of this paragraph, a certificate used in connection with the replacement of—</P> <P>(A) Construction period loans,</P> <P>(B) Bridge loans or similar temporary initial financing, and</P> <P>(C) In the case of a qualified rehabilitation loan, an existing mortgage,</P> <FP>shall not be treated as being used to acquire or replace an existing mortgage. Generally, temporary initial financing is any financing which has a term of 24 months or less. See section 103A(j)(1) and the regulations thereunder for examples illustrating the application of these requirements.</FP> <P>(2) <E T="03">Certification procedure.</E> The requirements of paragraph (g)(1) will be met if the issuer or its agent obtains from the holder of the certificate an affidavit stating that the mortage being acquired in connection with the certificate will not be used to acquire or replace an existing mortgage (other than one that falls within the exceptions described in paragraph (g)(1)(ii)).</P> <P>(h) <E T="03">Transfer of mortgage credit certificates—</E>(1) <E T="03">In general.</E> A certificate meets the requirements of this paragraph only if it is (i) not transferable or (ii) transferable only with the approval of the issuer.</P> <P>(2) <E T="03">Transfer procedure.</E> A certificate that is transferred with the approval of the issuer is a qualified mortgage credit certificate in the hands of the transferee only if each of the following requirements is met:</P> <P>(i) The transferee assumed liability for the remaining balance of the certified indebtedness amount in connection with the acquisition of the residence from the transferor,</P> <P>(ii) The issuer issues a new certificate to the transferee, and</P> <P>(iii) The new certificate meets each of the requirements of paragraphs (d), (e), (f), and (i) of this section based on the facts as they exist at the time of the transfer as if the mortgage credit certificate were being issued for the first time. For example, the purchase price requirement is to be determined by reference to the average area purchase price at the time of the assumption and not when the mortgage credit certificate was originally issued.</P> <P>(3) <E T="03">Statement on certificate.</E> The requirements of paragraph (h)(1) will be met if the mortgage credit certificate states that the certificate may not be transferred or states that the certificate may not be transferred unless the issuer issues a new certificate in place of the original certificate.<PRTPAGE P="62"/> </P> <P>(i) <E T="03">Prohibited mortgages—</E>(1) <E T="03">In general.</E> A certificate meets the requirements of this paragraph only if it is issued in connection with the acquisition of a residence none of the financing of which is provided from the proceeds of—</P> <P>(i) A qualified mortgage bond (as defined under section 103A(c)(1) and the regulations thereunder), or</P> <P>(ii) A qualified veterans’ mortgage bond (as defined under section 103A(c)(3) and the regulations thereunder).</P> <FP>Thus, for example, if a mortgagor has a mortgage on his principal residence that was obtained from the proceeds of a qualified mortgage bond, a mortgage credit certificate issued to such mortgagor in connection with a qualified home improvement loan with respect to such residence is not a qualified mortgage credit certificate. If, however, the financing provided from the proceeds of the qualified mortgage bond had been paid off in full, the certificate would be a qualified mortgage credit certificate (assuming all the requirements of this paragraph are met).</FP> <P>(2) <E T="03">Certification procedure.</E> The requirements of paragraph (i)(1) will be met if the issuer or its agent obtains from the holder of the certificate an affidavit stating that no portion of the financing of the residence in connection with which the certificate is issued is provided from the proceeds of a qualified mortgage bond or a qualified veterans’ mortgage bond.</P> <P>(j) <E T="03">Particular lenders—</E>(1) <E T="03">In general.</E> Except as otherwise provided in paragraph (j)(2), a certificate meets the requirements of this paragraph only if the certificate is not limited to indebtedness incurred from particular lenders. A certificate is limited to indebtedness from particular lenders if the issuer, directly or indirectly, prohibits the holder of a certificate from obtaining financing from one or more lenders or requires the holder of a certificate to obtain financing from one or more lenders. For purposes of this paragraph, a lender is any person, including an issuer of mortgage credit certificates, that provides financing for the acquisition, qualified rehabilitation, or qualified home improvement of a residence.</P> <P>(2) <E T="03">Exception.</E> A mortgage credit certificate that is limited to indebtedness incurred from particular lenders will not cease to meet the requirements of this paragraph if the Commissioner approves the basis for such limitation. The Commissioner may approve the basis for such limitation if the issuer establishes to the satisfaction of the Commissioner that it will result in a significant economic benefit to the holders of mortgage credit certificates (<E T="03">e.g</E>., substantially lower financing costs) compared to the result without such limitation.</P> <P>(3) <E T="03">Taxable bonds.</E> The requirements of this paragraph do not prevent an issuer of mortgage credit certificates from issuing mortgage subsidy bonds (other than obligations described in section 103 (a)) the proceeds of which are to be used to provide mortgages to holders of mortgage credit certificates provided that the holders of such certificates are not required to obtain financing from the proceeds of the bond issue. See § 1.25-4T (h) with respect to permissible fees.</P> <P>(4) <E T="03">Lists of participating lenders.</E> The requirements of this paragraph do not prohibit an issuer from maintaining a list of lenders that have stated that they will make loans to qualified holders of mortgage credit certificates, provided that (i) the issuer solicits such statements in a public notice similar to the notice described in § 1.25-7T, (ii) lenders are provided a reasonable period of time in which to express their interest in being included in such a list, and (iii) holders of mortgage credit certificates are not required to obtain financing from the lenders on the list. If an issuer maintains such a list, it must update the list at least annually.</P> <P>(5) <E T="03">Certification procedure.</E> The requirements of this paragraph will be met if (i) the issuer or its agent obtains from the holder of the certificate an affidavit stating that the certificate was not limited to indebtedness incurred from particular lenders or (ii) the issuer obtains a ruling from the Commissioner under paragraph (j)(2).</P> <P>(6) <E T="03">Examples.</E> The following examples illustrate the application of this paragraph: </P> <EXAMPLE> <PRTPAGE P="63"/> <HD SOURCE="HED">Example 1.</HD> <P>Under its mortgage credit certificate program, County Z distributes all the certificates to be issued to a group of 60 participating lenders. Residents of County Z may obtain mortgage credit certificates only from the participating lenders and only in connection with the acquisition of mortgage financing from that lender or one of the other participating lenders. Certificates issued under this program do not meet the requirements of this paragraph since the certificates are limited to indebtedness incurred from particular lenders. The certificates, therefore, are not qualified mortgage credit certificates.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>In connection with its mortgage credit certificate program, County Y arranges with Bank P for a line of credit to be used to provide mortgage financing to holders of mortgage credit certificates. County Y, pursuant to paragraph (j)(4), maintains a list of lenders participating in the mortgage credit certificate program. County Y distributes the certificates directly to applicants. Holders of the certificates are not required to obtain mortgage financing through the line of credit or through a lender on the list of participating lenders. Certificates issued pursuant to County Y's program satisfy the requirements of this paragraph.</P> </EXAMPLE> <P>(k) <E T="03">Developer certification</E>—(1) <E T="03">In general.</E> A mortgage credit certificate that is allocated by the issuer to any particular development meets the requirements of this paragraph only if the developer provides a certification to the purchaser of the residence and the issuer stating that the purchase price of that residence is not higher than the price would be if the issuer had not allocated mortgage credit certificates to the development. The certification must be made by the developer if a natural person or, if not, by a duly authorized official of the developer.</P> <P>(2) <E T="03">Certification procedure.</E> The requirements of this paragraph will be met if the issuer or its agent obtains from the holder of the certificate an affidavit stating that he has received from the developer the certification described in this paragraph.</P> <P>(l) <E T="03">Expiration</E>—(1) <E T="03">In general.</E> A certificate meets the requirements of this paragraph if the certified indebtedness amount is incurred prior to the close of the second calender year following the calendar year for which the issuer elected not to issue qualified mortgage bonds under § 1.25-4T with respect to that issue of mortgage credit certificates. Thus, for example, if on October 1, 1984, an issuing authority elects under § 1.25-4T not to issue qualified mortgage bonds, a mortgage credit certificate provided under that program does not meet the requirements of this paragraph unless the indebtedness is incurred on or before December 31, 1986.</P> <P>(2) <E T="03">Issuer-imposed expiration dates.</E> An issuer of mortgage credit certificates may provide that a certificate shall expire if the holder of the certificate does not incure certified indebtedness by a date that is prior to the expiration date provided in paragraph (l)(1). A certificate that expires prior to the date provided in paragraph (l)(1) may be reissued provided that the requirements of this paragraph are met.</P> <P>(m) <E T="03">Revocation.</E> A certificate meets the requirements of this paragraph only if it has not been revoked. Thus, the credit provided by section 25 and § 1.25-1T does not apply to interest paid or accrued following the revocation of a certificate. A certificate is treated as revoked when the residence to which the certificate relates ceases to be the holder's principal residence. An issuer may revoke a mortgage credit certificate if the certificate does not meet all the requirements of § 1.25-3T (d), (e), (f), (g), (h), (i), (j), (k), and (n). The certificate is revoked by the issure's notifying the holder of the certificate and the Internal Revenue Service that the certificate is revoked. The notice to the Internal Revenue Service shall be made as part of the report requred by § 1.25-8T (b)(2).</P> <P>(n) <E T="03">Interest paid to related person</E>—(1) <E T="03">In general.</E> A certificate does not meet the requirements of this paragraph if interest on the certified indebtedness amount is paid to a person who is a related person to the holder of the certificate.</P> <P>(2) <E T="03">Certification procedure.</E> The requirements of this paragraph will be met if the issuer or its agent obtains from the holder of the certificate an affidavit stating that a related person does not have, and is not expected to have, an interest as a creditor in the certified indebtedness amount.</P> <P>(o) <E T="03">Fraud.</E> Notwithstanding any other provision of this section, a mortgage credit certificate does not meet the requirements of this section and, therefore, the certificate is not a qualified <PRTPAGE P="64"/>mortgage credit certificate for any calendar year, if the holder of the certificate provides a certification or any other information to the lender providing the mortgage or to the issuer of the certificate containing a material misstatement and such misstatement is due to fraud. In determining whether any misstatement is due to fraud, the rules generally applicable to underpayments of tax due to fraud (including rules relating to the statute of limitations) shall apply. See § 1.6709-1T with respect to the penalty for filing negligent or fraudulent statements.</P> <CITA>[T.D. 8023, 50 FR 19348, May 8, 1985, as amended at T.D. 8502, 58 FR 67689, Dec. 22, 1993; T.D. 8692, 61 FR 66215, Dec. 17, 1996]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-4T</SECTNO> <SUBJECT>Qualified mortgage credit certificate program (Temporary).</SUBJECT> <P>(a) <E T="03">In general</E>—(1) <E T="03">Definition of qualified mortgage credit certificate program.</E> For purposes of §§ 1.25-1T through 1.25-8T, the term “qualified mortgage credit certificate program” means a program to issue qualified mortgage credit certificates which meets all of the requirements of paragraphs (b) through (i) of this section.</P> <P>(2) <E T="03">Requirements are a minimum.</E> Except as otherwise provided in this section, the requirements of this section are minimum requirements. Issuers may establish more stringent criteria for participation in a qualified mortgage credit certificate program. Thus, for example, an issuer may target 30 percent of the proceeds of an issue of mortgage credit certificates to targeted areas. Further, issuers may establish additional eligibility criteria for participation in a qualified mortgage credit certificate program. Thus, for example, issuers may impose an income limitation designed to ensure that only those individuals who could not otherwise purchase a residence will benefit from the credit.</P> <P>(3) Except as otherwise provided in this section and § 1.25-3T, issuers may use mortgage credit certificates in connection with other Federal, State, and local programs provided that such use complies with the requirements of § 1.25-3T(j). Thus, for example, a mortgage credit certificate may be issued in connection with the qualified rehabilitation of a residence part of the cost of which will be paid from the proceeds of a State grant.</P> <P>(b) <E T="03">Establishment of program.</E> A program meets the requirements of this paragraph only if it is established by a State or political subdivision thereof for any calendar year for which it has the authority to issue qualified mortgage bonds.</P> <P>(c) <E T="03">Election not to issue qualified mortgage bonds—</E>(1) <E T="03">In general.</E> A program meets the requirements of this paragraph only if the issuer elects, in the time and manner specified in this paragraph, not to issue an amount of qualified mortgage bonds that it may otherwise issue during the calendar year under section 103A and the regulations thereunder.</P> <P>(2) <E T="03">Manner of making election.</E> On or before the earlier of the date of distribution of mortgage credit certificates under a program or December 31, 1987, the issuer must file an election not to issue an amount of qualified mortgage bonds. The election (and the certification (or affidavit) described in paragraph (d)) shall be filed with the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255. The election should be titled “Mortgage Credit Certificate Election” and must include—</P> <P>(i) The name, address, and TIN of the issuer,</P> <P>(ii) The issuer's applicable limit, as defined in section 103A (g) and the regulations thereunder,</P> <P>(iii) The aggregate amount of qualified mortgage bonds issued by the issuing authority during the calendar year,</P> <P>(iv) The amount of the issuer's applicable limit that it has surrendered to other issuers during the calendar year,</P> <P>(v) The date and amount of any previous elections under this paragraph for the calendar year, and</P> <P>(vi) The amount of qualfied mortgage bonds that the issuer elects not to issue.</P> <P>(3) <E T="03">Revocation of election.</E> Any election made under this paragraph may be revoked, in whole or in part, at any time during the calendar year in which the election was made. The revocation, however, may not be made with respect to any part of the nonissued bond amount that has been used to issue <PRTPAGE P="65"/>mortgage credit certificates pursuant to the election. The revocation shall be filed with the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255. The revocation should be titled “Revocation of Mortgage Credit Certificate Election” and must include—</P> <P>(i) The name, address, and TIN of the issuer,</P> <P>(ii) The nonissued bond amount as originally elected, and</P> <P>(iii) The portion of the nonissued bond amount with respect to which the election is being revoked.</P> <P>(4) <E T="03">Special rule.</E> If at the time that an issuer makes an election under this paragraph it does not know its applicable limit, the issuer may elect not to use all of its remaining authority to issue qualified mortgage bonds; this form of election will be treated as meeting the requirements of paragraph (c)(2) if, prior to the later of the end of the calendar year and December 31, 1985, the issuer amends its election so as to indicate the exact amount of qualified mortgage bond authority that it elected not to issue.</P> <P>(5) <E T="03">Limitation on nonissued bond amount.</E> The amount of qualified mortgage bonds which an issuer elects not to issue may not exceed the issuer's applicable limit (as determined under section 103A (g) and the regulations thereunder). For example, a governmental unit that, pursuant to section 103A (g)(3), may issue $10 million of qualified mortgage bonds that elects to trade in $11 million in qualified mortgage bond authority has not met the requirements of this paragraph, and mortgage credit certificates issued pursuant to such election are not qualified mortgage credit certificates.</P> <P>(d) <E T="03">State certification requirement</E>—(1) <E T="03">In general.</E> A program meets the requirements of this paragraph only if the State official designated by law (or, where there is no State official, the Governor) certifies, based on facts and circumstances as of the date on which the certification is requested, following a request for such certification, that the issue meets the requirements of section 103A(g) (relating to volume limitation) and the regulations thereunder. A copy of the State certification must be attached to the issuer's election not to issue qualified mortgage bonds, except that, in the case of elections made during calendar year 1984, the certification may be filed with the Service prior to July 8, 1985 provided that mortgage credit certificates may not be distributed until the certification is filed. In the case of any constitutional home rule city, the certification shall be made by the chief executive officer of the city.</P> <P>(2) <E T="03">Certification procedure.</E> The official making the certification described in this paragraph (d) need not perform an independent investigation to determine whether the issuer has met the requirements of section 103A(g). In determining the aggregate amount of qualified mortgage bonds previously issued by that issuer during the calendar year the official may rely on copies of prior elections under paragraph (c) of this section made by the issuer for that year, together with an affidavit executed by an official of the issuer who is responsible for issuing bonds stating that the issuer has not, to date, issued any other issues of qualified mortgage bonds during the calendar year and stating the amount, if any, of the issuer's applicable limit that it has surrendered to other issuers during the calendar year; for any calendar year prior to 1985, the official may rely on an affidavit executed by a duly authorized official of the issuer who states the aggregate amount of qualified mortgage bonds issued by the issuer during the year. In determining the aggregate amount of qualified mortgage bonds that the issuer has previously elected not to issue during that calendar year, the official may rely on copies of any elections not to issue qualified mortgage bonds filed by the issuer for that calendar year, together with an affidavit executed by an official of the issuer responsible for issuing mortgage credit certificates stating that the issuer has not, to date, made any other elections not to issue qualified mortgage bonds. If, based on such information, the certifying official determines that the issuer has not, as of the date on which the certification is provided, exceeded its applicable limit for the year, the official may certify that the issue meets the requirements of section 103A(g). The fact that the <PRTPAGE P="66"/>certification described in this paragraph (d) is provided does not ensure that the issuer has met the requirements of section 103A(g) and the regulations thereunder, nor does it preclude the application of the penalty for over-issuance of mortgage credit certificates if such over-issuance actually occurs. See § 1.25-5T.</P> <P>(3) <E T="03">Special rule.</E> If within 30 days after the issuer files a proper request for the certification described in this paragraph (d) the issuer has not received from the State official designated by law (or, if there is no State official, the Governor) certification that the issue meets the requirements of section 103A(g) or, in the alternative, a statement that the issue does not meet such requirements, the issuer may submit, in lieu of the certification required by this paragraph (d), an affidavit executed by an officer of the issuer responsible for issuing mortgage credit certificates stating that—</P> <P>(i) The issue meets the requirements of section 103A(g) and the regulations thereunder,</P> <P>(ii) At least 30 days before the execution of the affidavit the issuer filed a proper request for the certification described in this paragraph (d), and</P> <P>(iii) The State official designated by law (or, if there is no State official, the Governor) has not provided the certification described in this paragraph (d) or a statement that the issue does not meet such requirements.</P> <FP>For purposes of this paragraph, a request for certification is proper if the request includes the reports and affidavits described in paragraph (d)(2).</FP> <P>(e) <E T="03">Information reporting requirement—</E>(1) <E T="03">Reports.</E> With respect to mortgage credit certificates issued after September 30, 1985, a program meets the requirements of this paragraph only if the issuer submits a report containing the information concerning the holders of certificates issued during the preceding reporting period required by this paragraph. The report must be filed for each reporting period in which certificates (other than transferred certificates) are issued under the program. The issuer is not responsible for false information provided by a holder if the issuer did not know or have reason to know that the information was false. The report must be filed on the form prescribed by the Internal Revenue Service. If no form is prescribed, or if the form prescribed is not readily available, the issuer may use its own form provided that such form is in the format set forth in this paragraph and contains the information required by this paragraph. The report must be titled “Mortgage Credit Certificate Information Report” and must include the name, address, and TIN of the issuer, the reporting period for which the information is provided, and the following tables containing information concerning the holders of certificates issued during the reporting period for which the report is filed:</P> <P>(i) A table titled “Number of Mortgage Credit Certificates by Income and Acquisition Cost” showing the number of mortgage credit certificates issued (other than those issued in connection with qualified home improvement and rehabilitation loans) according to the annualized gross income of the holders (categorized in the following intervals of income: </P> <EXTRACT> <FP>$0-$9,999;</FP> <FP>$10,000-$19,999;</FP> <FP>$20,000-$29,999;</FP> <FP>$30,000-$39,999;</FP> <FP>$40,000-$49,999;</FP> <FP>$50,000-$74,999; and</FP> <FP>$75,000 or more)</FP> </EXTRACT> <FP>and according to the acquisition cost of the residences acquired in connection with the mortgage credit certificates (categorized in the following intervals of acquisition cost:</FP> <EXTRACT> <FP>$0-$19,999;</FP> <FP>$20,000-$39,999;</FP> <FP>$40,000-$59,999;</FP> <FP>$60,000-$79,999;</FP> <FP>$80,000-$99,999;</FP> <FP>$100,000-$119,999;</FP> <FP>$120,000-$149,999;</FP> <FP>$150,000-$199,999; and</FP> <FP>$200,000 or more).</FP> </EXTRACT> <FP>For each interval of income and acquisition cost the table must also be categorized according to—</FP> <P>(A) The aggregate amount of fees charged to holders to cover any administrative costs incurred by the issuer in issuing mortgage credit certificates, and</P> <P>(B) The number of holders that—<PRTPAGE P="67"/> </P> <P>(<E T="03">1</E>) Did not have a present ownership interest in a principal residence at any time during the 3-year period ending on the date the mortgage credit certificate is executed (<E T="03">i.e.</E>, satisfied the 3-year requirement) and purchased residences in targeted areas,</P> <P>(<E T="03">2</E>) Satisfied the 3-year requirement and purchased residences not located in targeted areas,</P> <P>(<E T="03">3</E>) Did have a present ownership interest in a principal residence at any time during the 3-year period ending on the date the mortgage credit certificate is executed (<E T="03">i.e.,</E> did not satisfy the 3-year requirement) and purchased residences in targeted areas, and</P> <P>(<E T="03">4</E>) Did not satisfy the 3-year requirement and purchased residences not located in targeted areas.</P> <P>(ii) A table titled “Volume of Mortgage Credit Certificates by Income and Acquisition Cost” containing data on—</P> <P>(A) The total of the certified indebtedness amounts of the certificates issued (other than those issued in connection with qualified home improvement and rehabilitation loans);</P> <P>(B) The sum of the products of the certified indebtedness amount and the certificate credit rate for each certificate (other than those issued in connection with qualified home improvement and rehabilitation loans) according to annualized gross income (categorized in the same intervals of income as the preceding table) and according to the acquisition cost of the residences acquired in connection with mortgage credit certificates (categorized in the same intervals of acquisition cost as the preceding table); and</P> <P>(C) For each interval of income and acquisition cost, the information described in paragraph (e)(1)(ii) (A) and (B) categorized according to the holders that—</P> <P>(<E T="03">1</E>) Satisfied the 3-year requirement and purchased residences in targeted areas,</P> <P>(<E T="03">2</E>) Satisfied the 3-year requirement and purchased residences not located in targeted areas,</P> <P>(<E T="03">3</E>) Did not satisfy the 3-year requirement and purchased residences in targeted areas, and</P> <P>(<E T="03">4</E>) Did not satisfy the 3-year requirement and purchased residences not located in targeted areas.</P> <P>(iii) A table titled “Mortgage Credit Certificates for Qualified Home Improvement and Rehabilitation Loans” showing the number of mortgage credit certificates issued in connection with qualified home improvement loans and qualified rehabilitation loans, the total of the certified indebtedness amount with respect to such certificates, and the sum of the products of the certified indebtedness amount and the certificate credit rate for each certificate; the information contained in the table must also be categorized according to whether the residences with respect to which the certificates were provided are located in targeted areas.</P> <P>(2) <E T="03">Format.</E> If no form is prescribed by the Internal Revenue Service, or if the prescribed form is not readily available, the issuer must submit the report in the format specified in this paragraph (e)(2). The specified format of the report is the following:</P> <EXTRACT> <HD SOURCE="HD1">Mortgage Credit Certificate Information Report</HD> <FP>Name of issuer:</FP> <FP>Address of issuer:</FP> <FP>TIN of issuer:</FP> <FP>Reporting period:</FP> </EXTRACT> <GPOTABLE CDEF="s50,15,15,15,15,15" COLS="6" OPTS="L2,i1"> <TTITLE>Number of Mortgage Credit Certificates by Income and Acquisition Cost</TTITLE> <BOXHD> <CHED H="1">3-year requirement: Annualized gross monthly income of borrowers</CHED> <CHED H="1">Satisfied</CHED> <CHED H="2">Nontargeted area</CHED> <CHED H="2">Targeted area</CHED> <CHED H="1">Not satisfied</CHED> <CHED H="2">Nontargeted area</CHED> <CHED H="2">Targeted area</CHED> <CHED H="1">Totals fees</CHED> </BOXHD> <ROW> <ENT I="01">$0 to $9,999</ENT> </ROW> <ROW> <ENT I="01">$10,000 to $19,999</ENT> </ROW> <ROW> <ENT I="01">$20,000 to $29,999</ENT> </ROW> <ROW> <ENT I="01">$30,000 to $39,999</ENT> </ROW> <ROW> <ENT I="01">$40,000 to $49,999</ENT> </ROW> <ROW> <ENT I="01">$50,000 to $74,999</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">$75,000 or more</ENT> </ROW> <ROW> <ENT I="03">Total </ENT> </ROW> <ROW> <PRTPAGE P="68"/> <ENT I="21">Acquisition Cost </ENT> </ROW> <ROW> <ENT I="01">0 to $19,999</ENT> </ROW> <ROW> <ENT I="01">$20,000 to $39,999</ENT> </ROW> <ROW> <ENT I="01">$40,000 to $59,999</ENT> </ROW> <ROW> <ENT I="01">$60,000 to $79,999</ENT> </ROW> <ROW> <ENT I="01">$80,000 to $99,999</ENT> </ROW> <ROW> <ENT I="01">$100,000 to $119,999</ENT> </ROW> <ROW> <ENT I="01">$120,000 to $149,999</ENT> </ROW> <ROW> <ENT I="01">$150,000 to $199,999</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">$200,000 or more</ENT> </ROW> <ROW> <ENT I="03">Total</ENT> </ROW> </GPOTABLE> <PRTPAGE P="69"/> <GPOTABLE CDEF="s50,10,10,10,10,10,10,10,10,10,10" COLS="11" OPTS="L2,i1"> <TTITLE>Volume of Mortgage Credit Certificates by Income and Acouisition Cost</TTITLE> <BOXHD> <CHED H="1">Annualized gross monthly income of holders</CHED> <CHED H="1">Holders satisfying the 3-year requirement</CHED> <CHED H="2">Nontargeted area</CHED> <CHED H="3">Total of the certified indebtedness amounts</CHED> <CHED H="3">Sum of products of certified indebtedness amounts and credit rates</CHED> <CHED H="2">Targeted area</CHED> <CHED H="3">Total of the certified indebtedness amounts</CHED> <CHED H="3">Sum of products of certified indebtedness amounts and credit rates</CHED> <CHED H="1">3-year requirement not satisfied</CHED> <CHED H="2">Nontargeted area</CHED> <CHED H="3">Total of the certified indebtedness amounts</CHED> <CHED H="3">Sum of products of certified indebtedness amounts and credit rates</CHED> <CHED H="2">Targeted area</CHED> <CHED H="3">Total of the certified indebtedness amounts</CHED> <CHED H="3">Sum of products of certified indebtedness amounts and credit rates</CHED> <CHED H="1">Totals</CHED> <CHED H="2">Total of the certified indebtedness amounts</CHED> <CHED H="2">Total sum of products of certified indebtedness amounts and credit rates</CHED> </BOXHD> <ROW> <ENT I="01">$0 to $9,999</ENT> </ROW> <ROW> <ENT I="01">$10,000 to $19,999</ENT> </ROW> <ROW> <ENT I="01">$20,000 to $29,999</ENT> </ROW> <ROW> <ENT I="01">$30,000 to $39,999</ENT> </ROW> <ROW> <ENT I="01">$40,000 to $49,999</ENT> </ROW> <ROW> <ENT I="01">$50,000 to $74,999</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">$75,000 to more</ENT> </ROW> <ROW> <ENT I="03">Total </ENT> </ROW> <ROW> <ENT I="21">Acquisition Cost </ENT> </ROW> <ROW> <ENT I="01">$0 to $19,999</ENT> </ROW> <ROW> <ENT I="01">$20,000 to $39,999</ENT> </ROW> <ROW> <ENT I="01">$40,000 to $59,999</ENT> </ROW> <ROW> <ENT I="01">$60,000 to $79,999</ENT> </ROW> <ROW> <ENT I="01">$80,000 to $99,999</ENT> </ROW> <ROW> <ENT I="01">$100,000 to $119,999</ENT> </ROW> <ROW> <ENT I="01">$120,000 to $149,999</ENT> </ROW> <ROW> <ENT I="01">$150,000 to $199,999</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">$200,000 or more</ENT> </ROW> <ROW> <ENT I="03">Total</ENT> </ROW> </GPOTABLE> <PRTPAGE P="70"/> <GPOTABLE CDEF="s50,6,6,6" COLS="4" OPTS="L2,i1"> <TTITLE>Mortgage Credit Certificates for Qualified Home Improvement and Rehabilitation Loans</TTITLE> <BOXHD> <CHED H="1"/> <CHED H="1">Nontargeted area</CHED> <CHED H="1">Targeted area</CHED> <CHED H="1">Totals</CHED> </BOXHD> <ROW> <ENT I="21">Home Improvement Loans </ENT> </ROW> <ROW> <ENT I="01">Number of mortgage credit certificates</ENT> </ROW> <ROW> <ENT I="01">Total of the certified indebtedness amounts</ENT> </ROW> <ROW> <ENT I="01">Product of certified indebtedness amounts and credit rates </ENT> </ROW> <ROW> <ENT I="21">Rehabilitation Loans </ENT> </ROW> <ROW> <ENT I="01">Number of mortgage credit certificates</ENT> </ROW> <ROW> <ENT I="01">Total of the certified indebtedness amounts</ENT> </ROW> <ROW> <ENT I="01">Product of certified indebtedness amounts and credit rates</ENT> </ROW> </GPOTABLE> <P>(3) <E T="03">Definitions and special rules.</E> (i) For purposes of this paragraph the term “annualized gross income” means the borrower's gross monthly income multiplied by 12. Gross monthly income is the sum of monthly gross pay, any additional income from investments, pensions, Veterans Administration (VA) compensation, part-time employment, bonuses, dividends, interest, current overtime pay, net rental income, etc., and other income (such as alimony and child support, if the borrower chooses to disclose such income). Information with respect to gross monthly income may be obtained from available loan documents, <E T="03">e.g.,</E> the sum of lines 23D and 23E on the Application for VA or FmHA Home Loan Guaranty or for HUD/FHA Insured Mortgage (VA Form 26-1802a, HUD 92900, Jan. 1982), or the total line from the Gross Monthly Income section of FHLMC Residential Loan Application form (FHLMC 65 Rev. 8/78).</P> <P>(ii) For purposes of this paragraph, the term “reporting period” means each one year period beginning July 1 and ending June 30, except that issuers need not provide data with respect to the period prior to October 1, 1985.</P> <P>(iii) For purposes of this paragraph, verification of information concerning a holder's gross monthly income by utilizing other available information concerning the holder's income (<E T="03">e.g.,</E> Federal income tax returns) is not required. In determining whether the holder of a mortgage credit certificate acquiring a residence in a targeted area satisfies the 3-year requirement, the issuer may rely on a statement signed by the holder.</P> <P>(4) <E T="03">Time for filing.</E> The report required by this paragraph shall be filed not later than the 15th day of the second calendar month after the close of the reporting period. The Commissioner may grant an extension of time for the filing of a report required by this paragraph if there is reasonable cause for the failure to file such report in a timely fashion. The report may be filed at any time before such date but must be complete based on facts and reasonable expectations as of the date the report is filed. The report need not be amended to reflect information learned subsequent to the date of filing, or to reflect changed circumstances with respect to any holder.</P> <P>(5) <E T="03">Place for filing.</E> The report required by this paragraph is to be filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 19255.</P> <P>(f) <E T="03">Policy statement.</E> A program established pursuant to an election under paragraph (c) made after 1984 meets the requirements of this paragraph only if the applicable elected representative of the governmental unit—</P> <P>(1) Which is the issuer, or</P> <P>(2) On whose behalf the certificates were issued,</P> <FP>has published (after a public hearing following reasonable public notice) a policy statement described in § 1.103A-2(1) by the last day of the year preceding the year in which the election under paragraph (c) is made, and a copy of such report has been submitted to the Commissioner on or before such last day. See § 1.103A-2(1) for further definitions and requirements.</FP> <P>(g) <E T="03">Targeted areas requirement</E>—(1) <E T="03">In general.</E> A program meets the requirements of this paragraph only if—</P> <P>(i) The portion of the total proceeds of the issue specified in paragraph (g)(2) is made available to provide mortgage credit certificates in connection with owner financing of targeted area residents for at least 1 year after the date on which mortgage credit certificates are first made available with respect to targeted area residences, and<PRTPAGE P="71"/> </P> <P>(ii) The issuer attempts with reasonable diligence to place such proceeds with qualified persons. </P> <FP>Mortgage credit certificates are considered first made available with respect to targeted area residences on the date on which the issuer first begins to accept applications for mortgage credit certificates provided under that issue.</FP> <P>(2) <E T="03">Specified portion.</E> (i) The specified portion of the total proceeds of an issue is the lesser of—</P> <P>(A) 20 percent of the total proceeds, or</P> <P>(B) 8 percent of the average annual aggregate principal amount of mortgages executed during the immediately preceding 3 calendar years for single-family, owner-occupied residences in targeted areas within the jurisdiction of the issuing authority.</P> <FP>For purposes of computing the required portion of the total proceeds specified in paragraph (g)(2)(i)(B) where such provision is applicable, an issuer may rely upon the safe-harbor formula provided in the regulations under section 103A(h).</FP> <P>(ii) See § 1.25-1T(b)(10)(ii) for the definition of “total proceeds”.</P> <P>(h) <E T="03">Fees</E>—(1) <E T="03">In general.</E> A program meets the requirements of this paragraph only if each applicant is required to pay, directly or indirectly, no fee other than those fees permitted under this paragraph.</P> <P>(2) <E T="03">Permissible fees.</E> Applicants may be required to pay the following fees provided that they are reasonable:</P> <P>(i) Points, origination fees, servicing fees, and other fees in amounts that are customarily charged with respect to mortgages not provided in connection with mortgage credit certificates,</P> <P>(ii) Application fees, survey fees, credit report fees, insurance fees, or similar settlement or financing costs to the extent such amounts do not exceed the amounts charged in the area in cases where mortgages are not provided in connection with mortgage credit certificates. For example, amounts charged for FHA, VA, or similar private mortgage insurance on an individual's mortgage are permissible so long as such amounts do not exceed the amounts charged in the area with respect to a similar mortgage that is not provided in connection with a mortgage credit certificate, and</P> <P>(iii) Other fees that, taking into account all the facts and circumstances, are reasonably necessary to cover any administrative costs incurred by the issuer or its agent in issuing mortgage credit certificates.</P> <P>(i) <E T="03">Qualified mortgage credit certificate.</E> A program meets the requirements of this paragraph only if each mortgage credit certificate issued under the program meets each of the requirements of paragraphs (c) through (o) of § 1.25-3T.</P> <P>(j) <E T="03">Good faith compliance efforts</E>—(1) <E T="03">Eligibility requirements.</E> (i) A program under which each of the mortgage credit certificates issued does not meet each of the requirements of paragraphs (c) through (o) of § 1.25-3T shall be treated as meeting the requirements of paragraph (i) of this section if each of the requirements of this paragraph (j)(1) is satisfied. A mortgage credit certificate program meets the requirements of this paragraph (j)(1) only if each of the following provisions is met:</P> <P>(A) The issuer in good faith attempted to issue mortgage credit certificates only to individuals meeting each of the requirements of paragraphs (c) through (o) of § 1.25-3T. Good faith requires that agreements with lenders and agents and other relevant instruments contain restrictions that permit the approval of mortgage credit certificates only in accordance with the requirements of paragraphs (c) through (o) of § 1.25-3T. In addition, the issuer must establish reasonable procedures to ensure compliance with those requirements. Reasonable procedures include reasonable investigations by the issuer to determine whether individuals satisfy the requirements of paragraphs (c) through (o) of § 1.25-3T.</P> <P>(B) 95 percent or more of the total proceeds of the issue were devoted to individuals with respect to whom, at the time that the certificate was issued, all the requirements of paragraphs (c) through (o) of § 1.25-3T were met. If a holder of a mortgage credit certificate fails to meet more than one of these requirements, the amount of the certificate (<E T="03">i.e.,</E> the certificate credit rate multiplied by the certified <PRTPAGE P="72"/>indebtedness amount) issued to that individual will be taken into account only once in determining whether the 95-percent requirement is met. However, all of the defects in that individual's certificate must be corrected pursuant to paragraph (j)(1)(i)(C).</P> <P>(C) Any failure to meet the requirements of paragraphs (c) through (o) of § 1.25-3T is corrected within a reasonable period after that failure is discovered. For example, if an individual fails to meet one or more of such requirements those failures can be corrected by revoking that individual's certificate.</P> <P>(ii) <E T="03">Examples.</E> The following examples illustrate the application of this paragraph (j)(1): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>County X only distributes mortgage credit certificates to individuals who have contracted to purchase a principal residence. County X requires that applicants for mortgage credit certificates present the following information:</P> <P>(i) An affidavit stating that the applicant intends to use the residence in connection with which the mortgage credit certificate is issued as his principal residence within a reasonable time after the certificate is issued by County X, that the applicant will notify the County if the residence ceases to be his principal residence, and facts that are sufficient for County X to determine whether the residence is located within the jurisdiction of County X,</P> <P>(ii) An affidavit stating that the applicant had no present ownership interest in a principal residence at any time during the 3-year period prior to the date on which the certificate is issued,</P> <P>(iii) Copies of the applicant's Federal tax returns for the preceding 3 years,</P> <P>(iv) Affidavits from the seller of the residence with respect to which the certificate is issued and the applicant stating the purchase price of the residence, including an itemized list of (A) payments made by or for the benefit of the applicant, (B) if the residence is incomplete, an estimate of the reasonable cost of completing the residence, and (C) if the residence is subject to a ground rent, the capitalized value of the ground rent,</P> <P>(v) An affidavit executed by the applicant stating that the mortgage being acquired in connection with the certificate will not be used to acquire or replace an existing mortgage,</P> <P>(vi) An affidavit executed by the applicant stating that no portion of the financing for the residence in connection with which the certificate is issued is provided from the proceeds of a qualified mortgage bond or qualified veterans’ mortgage bond and that no portion of the mortgage for the residence is provided by a person related to the applicant (as defined in § 1.25-3T(n)),</P> <P>(vii) An affidavit executed by the applicant stating that the certificate was not limited to indebtedness incurred from particular lenders, and</P> <P>(viii) In the case of a mortgate credit certificate allocated for use in connection with a particular development, and affidavit executed by the applicant stating that the applicant received from the developer a certification stating that the price of the residence with respect to which the certificate was issued is no higher than it would be without the use of a mortgage credit certificate.</P> <FP>County X examines the information submitted by the applicant to determine whether the requirements of paragraphs (c), (d), (e), (f), (g), (i), (j), (k), and (n) of § 1.25-3T are met. County X determines that the certificate has not expired. The mortgage credit certificates issued by County X are in the form prescribed by § 1.25-6T and County X provides all the required information and statements. After determining that the applicant meets all these requirements County X issues a mortgage credit certificate to the applicant. This procedure for issuing mortgage credit certificates is sufficient evidence of the good faith of County X to meet the requirements of § 1.25-4T(j)(1)(i)(A).</FP> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>County W distributes preliminary mortgage credit certificates to individuals who have not entered into contracts to purchase a principal residence. County W issues preliminary certificates in the form prescribed by § 1.25-6T to those applicants that have submitted statements that they (i) intend to purchase a single-family residence located within the jurisdiction of County W which they will occupy as a principal residence, (ii) have had no present ownership interest in a principal residence within the preceding 3-year period, and (iii) will not use the certificate in connection with the acquisition or replacement of an existing mortgage. The certificates contain a maximum purchase price, the certificate credit rate, and a statement that the certificate will expire if the applicant does not enter into a closing agreement with respect to a loan within 6 months from the date of preliminary issuance. Holders of these certificates may apply for a mortgage loan from any lender. When the holder of the certificate applies for a loan the lender requires that he submit the following:</P> <P>(i) An affidavit stating that the applicant intends to use the residence in connection with which the mortgage credit certificate is issued as his principal residence within a reasonable time after the certificate is issued by County W, that the applicant will notify the County if the residence ceases to be his principal residence, and facts that are <PRTPAGE P="73"/>sufficient for County W to determine whether the residence is located within the jurisdication of County W,</P> <P>(ii) An affidavit stating that the applicant had no present ownership interest in a principal residence at any time during the 3-year period prior to the date on which the certificate is issued,</P> <P>(iii) Copies of the applicant's Federal tax returns for the preceding 3 years,</P> <P>(iv) Affidavits from the seller of the residence with respect to which the certificate is issued and the applicant stating the purchase price of the residence, including an itemized list of (A) payments made by or for the benefit of the applicant, (B) if the residence is incomplete, an estimate of the reasonable cost of completing the residence, and (C) if the residence is subject to a ground rent, the capitalized value of the ground rent,</P> <P>(v) An affidavit executed by the applicant stating that the mortgage being acquired in connection with the certificate will not be used to acquire or replace an existing mortgage,</P> <P>(vi) An affidavit executed by the applicant stating that no portion of the financing for the residence in connection with which the certificate is issued in provided from the proceeds of a qualified mortgage bond or qualified veterans’ mortgage bond and that no portion of the mortgage for the residence is provided by a person related to the applicant (as defined in § 1.25-3T(n)),</P> <P>(vii) An affidavit executed by the applicant stating that the certificate was not limited to indebtedness incurred from particular lenders, and</P> <P>(viii) In the case of a mortgage credit certificate allocated for use in connection with a particular development, an affidavit executed by the applicant stating that the applicant received from the developer a certification stating that the price of the residence with respect to which the certificate was issued is no higher than it would be without the use of a mortgage credit certificate.</P> <FP>The lender then submits those affidavits, together with its statement as to the amount of the indebtedness incurred, to County W. After determining that the requirements of paragraphs (c), (d), (e), (f), (g), (i), (j), (k) and (n) of § 1.25-3T are met and determining that the certificate has not expired, County W completes the mortgage credit certificate. This procedure for issuing mortgage credit certificates is sufficient evidence of the good faith of County W to meet the requirements of § 1.25-4T(j)(1)(i)(A).</FP> </EXAMPLE> <P>(2) <E T="03">Program requirements.</E> (i) A mortgage credit certificate program which fails to meet one or more of the requirements of paragraphs (b) through (h) of this section shall be treated as meeting such requirements if the requirements of this paragraph (j)(2) are satisfied. A mortgage credit certificate program meets the requirements of this paragraph (j)(2) only if each of the following provisions is met:</P> <P>(A) The issuer in good faith attempted to meet all of the requirements of paragraphs (b) through (h) of this section. This good faith requirement will be met if all reasonable steps are taken by the issuer to ensure that the program complies with these requirements.</P> <P>(B) Any failure to meet such requirements is due to inadvertent error, <E T="03">e.g.,</E> mathematical error, after taking reasonable steps to comply with such requirements.</P> <P>(ii) The following example illustrate the application of this paragraph (j)(2): </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>City X issues an issue of mortgage credit certificates. However, despite taking all reasonable steps to determine accurately the size of the applicable limit, as provided in section 103A (g)(3) and the regulations thereunder, the limit is exceeded because the amount of the mortgages, originated in the area during the past 3 years is incorrectly computed as a result of mathematical error. Such facts are sufficient evidence of the good faith of the issuer to meet the requirements of paragraph (j)(2).</P> </EXAMPLE> <CITA>[T.D. 8023, 50 FR 19350, May 8, 1985, as amended by T.D. 8048, 50 FR 35538, Sept. 3, 1985]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-5T</SECTNO> <SUBJECT>Limitation on aggregate amount of mortgage credit certificates (Temporary).</SUBJECT> <P>(a) <E T="03">In general.</E> If the aggregate amount of qualified mortgage credit certificates (as defined in paragraph (b)) issued by an issuer under a qualified mortgage credit certificate program exceeds 20 percent of the nonissued bond amount (as defined in paragraph (c)), the provisions of paragraph (d) shall apply.</P> <P>(b) <E T="03">Aggregate amount of mortgage credit certificates</E>—(1) <E T="03">In general.</E> The aggregate amount of qualified mortgage credit certificates issued under a qualified mortgage credit certificate program is the sum of the products determined by multiplying—</P> <P>(i) The certified indebtedness amount of each qualified mortgage credit certificate issued under that program, by</P> <P>(ii) The certificate credit rate with respect to such certificate.<PRTPAGE P="74"/> </P> <P>(2) <E T="03">Examples.</E> The following examples illustrate the application of this paragraph (b): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>For 1986 City Q has a nonissued bond amount of $100 million. After making a proper election, Q issues 2,000 qualified mortgage credit certificates each with a certificate credit rate of 20 percent and a certified indebtedness amount of $50,000. The aggregate amount of qualified mortgage credit certificates is $20 million (2,000×(.2×$50,000)). Since this amount does not exceed 20 percent of the nonissued bond amount (.2×$100 million = $20 million), Q has complied with the limitation on the aggregate amount of mortgage credit certificates, provided that it does not issue any additional certificates.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in example (1) except that instead of issuing all its certificates at the 20 percent rate, Q issues (i) qualified mortgage credit certificates with a certificate credit rate of 10 percent and an aggregate principal amount of $25 million, (ii) qualified mortgage credit certificates with a certificate credit rate of 40 percent and an aggregate principal amount of $25 million, and (iii) qualified mortgage credit certificates with a certificate credit rate of 30 percent and an aggregate principal amount of $25 million. The aggregate amount of qualified mortgage credit certificates is $20 million ((10 percent of $25 million) plus (40 percent of $25 million) plus (30 percent of $25 million)). Q has complied with the limitation on the aggregate amount of qualified mortgage credit certificates, provided that it does not issue any additional certificates pursuant to the same program.</P> </EXAMPLE> <P>(c) <E T="03">Nonissued bond amount.</E> The term “nonissued bond amount” means, with respect to any qualified mortgage credit certificate program, the amount of qualified mortgage bonds (as defined in section 103A(c)(1) and the regulations thereunder) which the issuer is otherwise authorized to issue and elects not to issue under section 25(c)(2) and § 1.25-4T(b). The amount of qualified mortgage bonds which an issuing authority is authorized to issue is determined under section 103A(g) and the regulations thereunder; such determination shall take into account any prior elections by the issuer not to issue qualified mortgage bonds, the amount of any reduction in the State ceiling under paragraph (d) of this section, and the aggregate amount of qualified mortgage bonds issued by the issuer prior to its election not to issue qualified mortgage bonds.</P> <P>(d) <E T="03">Noncompliance with limitation on aggregate amount of mortgage credit certificates</E>—(1) <E T="03">In general.</E> If the provisions of this paragraph apply, the State ceiling under section 103A(g)(4) and the regulations thereunder for the calendar year following the calendar year in which the Commissioner determines the correction amount for the State in which the issuer which exceeded the limitation on the aggregate amount of mortgage credit certificates is located shall be reduced by 1.25 times the correction amount with respect to such failure.</P> <P>(2) <E T="03">Correction amount.</E> (i) The term “correction amount” means an amount equal to the excess credit amount divided by .20.</P> <P>(ii) The term “excess credit amount” means the excess of—</P> <P>(A) The credit amount for any mortgage credit certificate program, over</P> <P>(B) The amount which would have been the credit amount for such program had such program met the requirements of section 25(d)(2) and paragraph (a) of this section.</P> <P>(iii) The term “credit amount” means the sum of the products determined by multiplying—</P> <P>(A) The certified indebtedness amount of each qualified mortgage credit certificate issued under the program, by</P> <P>(B) The certificate credit rate with respect to such certificate.</P> <P>(3) <E T="03">Example.</E> The following example illustrates the application of this paragraph: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>For 1987 City R has a nonissued bond amount of $100 million. City R issues all of its mortgage credit certificates with a certificate credit rate of 20 percent. City R issues certificates with an aggregate certified indebtedness amount of $120 million. The aggregate amount of mortgage credit certificates issued by City R is $24 million, which exceeds 20 percent of the nonissued bond amount. The State ceiling for the calendar year following the calendar year in which the Commissioner determines the correction amount is reduced by $25 million (the correction amount multiplied by 1.25). The correction amount is determined as follows: The credit amount is $24 million -(.2×$120 million); the amount which would have been the credit amount for the program had it met the requirements of section 25(d)(2) is $20 million (.2×$100 million); the excess credit <PRTPAGE P="75"/>amount is $4 million ($24 million—$20 million); therefore, the correction amount is $20 million ($4 million/.2).</P> </EXAMPLE> <P>(4) <E T="03">Cross-references.</E> See section 103A(g)(4) and the regulations thereunder with respect to the reduction of the applicable State ceiling.</P> <CITA>[T.D. 8023, 50 FR 19353, May 8, 1985]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-6T</SECTNO> <SUBJECT>Form of qualified mortgage credit certificate (Temporary).</SUBJECT> <P>(a) <E T="03">In general.</E> Qualified mortgage credit certificates are to be issued on the form prescribed by the Internal Revenue Service. If no form is prescribed by the Internal Revenue Service, or if the form prescribed by the Internal Revenue Service is not readily available, the issuer may use its own form provided that such form contains the information required by this section. Each mortgage credit certificate must be issued in a form such that there are at least three copies of the form. One copy of the certificate shall be retained by the issuer; one copy shall be retained by the lender; and one copy shall be forwarded to the State official who issued the certification required by § 1.25-4T(d), unless that State official has stated in writing that he does not want to receive such copies.</P> <P>(b) <E T="03">Required information.</E> Each qualified mortgage credit certificate must include the following information:</P> <P>(1) The name, address, and TIN of the issuer,</P> <P>(2) The date of the issuer's election not to issue qualified mortgage bonds pursuant to which the certificate is being issued,</P> <P>(3) The number assigned to the certificate,</P> <P>(4) The name, address, and TIN of the holder of the certificate,</P> <P>(5) The certificate credit rate,</P> <P>(6) The certified indebtness amount,</P> <P>(7) The acquisition cost of the residence being acquired in connection with the certificate,</P> <P>(8) The average area purchase price applicable to the residence,</P> <P>(9) Whether the certificate meets the requirements of § 1.25-3T(d), relating to residence requirement,</P> <P>(10) Whether the certificate meets the requirements of § 1.25-3T(e), relating to 3-year requirement,</P> <P>(11) Whether the certificate meets the requirements of § 1.25-3T(g), relating to new mortgage requirement,</P> <P>(12) Whether the certificate meets the requirements of § 1.25-3T(i), relating to prohibited mortgages,</P> <P>(13) Whether the certificate meets the requirements of § 1.25-3T(j), relating to particular lenders,</P> <P>(14) Whether the certificate meets the requirements of § 1.25-3T(k), relating to allocations to particular developments,</P> <P>(15) Whether the certificate meets the requirements of § 1.25-3T(n), relating to interest paid to related persons,</P> <P>(16) Whether the residence in connection with which the certificate is issued is a targeted area residence,</P> <P>(17) The date on which a closing agreement is signed with respect to the certified indebtness amount,</P> <P>(18) The expiration date of the certificate,</P> <P>(19) A statement that the certificate is not transferable or a statement that the certificate may be transferred only if the issuer issues a new certificate, and</P> <P>(20) A statement, signed under penalties of perjury by an authorized official of the issuer or its agent, that such person has made the determinations specified in paragraph (b) (9) through (16).</P> <CITA>[T.D. 8023, 50 FR 19354, May 8, 1985]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-7T</SECTNO> <SUBJECT>Public notice (Temporary).</SUBJECT> <P>(a) <E T="03">In general.</E> At least 90 days prior to the issuance of any mortgage credit certificate under a qualified mortgage credit certificate program, the issuer shall provide reasonable public notice of—</P> <P>(1) The eligibility requirements for such certificate,</P> <P>(2) The methods by which such certificates are to be issued, and</P> <P>(3) The other information required by this section.</P> <P>(b) <E T="03">Reasonable public notice</E>—(1) <E T="03">In general.</E> Reasonable public notice means published notice which is reasonably designed to inform individuals who would be eligible to receive mortgage credit certificates of the proposed issuance. Reasonable public notice may be provided through newspapers of general circulation.<PRTPAGE P="76"/> </P> <P>(2) <E T="03">Contents of notice.</E> The public notice required by paragraph (a) must include a brief description of the principal residence requirement, 3-year requirement, purchase price requirement, and new mortgage requirement. The notice must also provide a brief description of the methods by which the certificates are to be issued and the address and telephone number for obtaining further information.</P> <CITA>[T.D. 8023, 50 FR 19354, May 8, 1985]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25-8T</SECTNO> <SUBJECT>Reporting requirements (Temporary).</SUBJECT> <P>(a) <E T="03">Lender</E>—(1) <E T="03">In general.</E> Each person who makes a loan that is a certified indebtedness amount with respect to any mortgage credit certificate must file the report described in paragraph (a)(2) and must retain on its books and records the information described in paragraph (a)(3). The report described in paragraph (a)(2) is an annual report and must be filed on or before January 31 of the year following the calendar year to which the report relates. See section 6709(c) and the regulations thereunder for the applicable penalties with respect to failure to file reports.</P> <P>(2) <E T="03">Information required.</E> The report shall be submitted on Form 8329 and shall contain the information required therein. A separate Form 8329 shall be filed for each issue of mortgage credit certificates with respect to which the lender made mortgage loans during the preceding calendar year. Thus, for example, if during 1986 Bank M makes three mortgage loans which are certified indebtedness amounts with respect to State Z's January 15, 1986, issue of mortgage credit certificates, and two mortgage loans which are certified indebtedness amounts with respect to State Z's April 15, 1986, issue of mortgage credit certificates, and fifty mortgage loans which are certified indebtedness amounts with respect to County X's December 31, 1985, issue of mortgage credit certificates, Bank M must file three separate reports for calendar year 1986. The lender must submit the Form 8329 with the information required therein, including—</P> <P>(i) The name, address, and TIN of the issuer of the mortgage credit certificates,</P> <P>(ii) The date on which the election not to issue qualified mortgage bonds with respect to that mortgage credit certificate was made,</P> <P>(iii) The name, address, and TIN of the lender, and</P> <P>(iv) The sum of the products determined by multiplying—</P> <P>(A) The certified indebtedness amount of each mortgage credit certificate issued under such program, by</P> <P>(B) The certificate credit rate with respect to such certificate.</P> <P>(3) <E T="03">Recordkeeping requirements.</E> Each person who makes a loan that is a certified indebtedness amount with respect to any mortgage credit certificate must retain the information specified in this paragraph (a)(3) on its books and records for 6 years following the year in which the loan was made. With respect to each loan the lender must retain the following information:</P> <P>(i) The name, address, and TIN of each holder of a qualified mortgage credit certificate with respect to which a loan is made,</P> <P>(ii) The name, address, and TIN of the issuer of such certificate, and</P> <P>(iii) The date the loan for the certified indebtedness amount is closed, the certified indebtedness amount, and the certificate credit rate of such certificate.</P> <P>(b) <E T="03">Issuers</E>—(1) <E T="03">In general.</E> Each issuer of mortgage credit certificates shall file the report described in paragraph (b)(2) of this section.</P> <P>(2) <E T="03">Quarterly reports.</E> (i) Each issuer which elects to issue mortgage credit certificates shall file reports on Form 8330. These reports shall be filed on a quarterly basis, beginning with the quarter in which the election is made, and are due on the following dates: April 30 (for the quarter ending March 31), July 31 (for the quarter ending June 30), October 31 (for the quarter ending September 30), and January 31 (for the quarter ending December 31). For elections made prior to May 8, 1985, the first report need not be filed until July 31, 1985. An issuer shall file a separate report for each issue of mortgage credit certificates. In the quarter in which the last qualified mortgage credit certificate that may be issued under a program is issued, the issuer must state that fact on the report to be filed <PRTPAGE P="77"/>for that quarter; the issuer is not required to file any subsequent reports with respect to that program. See section 6709(c) for the penalties with respect to failure to file a report.</P> <P>(ii) The report shall be submitted on Form 8330 and shall contain the information required therein, including—</P> <P>(A) The name, address, and TIN of the issuer of the mortgage credit certificates,</P> <P>(B) The date of the issuer's election not to issue qualified mortgage bonds with respect to the mortgage credit certificate program and the nonissued bond amount of the program,</P> <P>(C) The sum of the products determined by multiplying—</P> <P>(<E T="03">1</E>) The certified indebtedness amount of each qualified mortgage credit certificate issued under that program during the calendar quarter, by</P> <P>(<E T="03">2</E>) The certificate credit rate with respect to such certificate, and</P> <P>(D) A listing of the name, address, and TIN of each holder of a qualified mortgage credit certificate which has been revoked during the calendar quarter.</P> <P>(c) <E T="03">Extensions of time for filing reports.</E> The Commissioner may grant an extension of time for the filing of a report required by this section if there is reasonable cause for the failure to file such report in a timely fashion.</P> <P>(d) <E T="03">Place for filing.</E> The reports required by this section are to be filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 19225.</P> <P>(e) <E T="03">Cross reference.</E> See section 6709 and the regulations thereunder with respect to the penalty for failure to file a report required by this section.</P> <CITA>[T.D. 8023, 50 FR 19354, May 8, 1985]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25A-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <P>This section lists captions contained in §§ 1.25A-1, 1.25A-2, 1.25A-3, 1.25A-4, and 1.25A-5.</P> <EXTRACT> <FP SOURCE="FP-2"> <E T="03">§ 1.25A-1Calculation of education tax credit and general eligibility requirements</E> </FP> <FP SOURCE="FP1-2">(a) Amount of education tax credit.</FP> <FP SOURCE="FP1-2">(b) Coordination of Hope Scholarship Credit and Lifetime Learning Credit.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Hope Scholarship Credit.</FP> <FP SOURCE="FP1-2">(3) Lifetime Learning Credit.</FP> <FP SOURCE="FP1-2">(4) Examples.</FP> <FP SOURCE="FP1-2">(c) Limitation based on modified adjusted gross income.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Modified adjusted gross income defined.</FP> <FP SOURCE="FP1-2">(3) Inflation adjustment.</FP> <FP SOURCE="FP1-2">(d) Election.</FP> <FP SOURCE="FP1-2">(e) Identification requirement.</FP> <FP SOURCE="FP1-2">(f) Claiming the credit in the case of a dependent.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Examples.</FP> <FP SOURCE="FP1-2">(g) Married taxpayers.</FP> <FP SOURCE="FP1-2">(h) Nonresident alien taxpayers and dependents.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.25A-2Definitions</E> </FP> <FP SOURCE="FP1-2">(a) Claimed dependent.</FP> <FP SOURCE="FP1-2">(b) Eligible educational institution.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Rules on Federal financial aid programs.</FP> <FP SOURCE="FP1-2">(c) Academic period.</FP> <FP SOURCE="FP1-2">(d) Qualified tuition and related expenses.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Required fees.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Books, supplies, and equipment.</FP> <FP SOURCE="FP1-2">(iii) Nonacademic fees.</FP> <FP SOURCE="FP1-2">(3) Personal expenses.</FP> <FP SOURCE="FP1-2">(4) Treatment of a comprehensive or bundled fee.</FP> <FP SOURCE="FP1-2">(5) Hobby courses.</FP> <FP SOURCE="FP1-2">(6) Examples.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.25A-3Hope Scholarship Credit</E> </FP> <FP SOURCE="FP1-2">(a) Amount of the credit.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Maximum credit.</FP> <FP SOURCE="FP1-2">(b) Per student credit.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Example.</FP> <FP SOURCE="FP1-2">(c) Credit allowed for only two taxable years.</FP> <FP SOURCE="FP1-2">(d) Eligible student.</FP> <FP SOURCE="FP1-2">(1) Eligible student defined.</FP> <FP SOURCE="FP1-2">(i) Degree requirement.</FP> <FP SOURCE="FP1-2">(ii) Work load requirement.</FP> <FP SOURCE="FP1-2">(iii) Year of study requirement.</FP> <FP SOURCE="FP1-2">(iv) No felony drug conviction.</FP> <FP SOURCE="FP1-2">(2) Examples.</FP> <FP SOURCE="FP1-2">(e) Academic period for prepayments.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Example.</FP> <FP SOURCE="FP1-2">(f) Effective date.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.25A-4Lifetime Learning Credit</E> </FP> <FP SOURCE="FP1-2">(a) Amount of the credit.</FP> <FP SOURCE="FP1-2">(1) Taxable years beginning before January 1, 2003.</FP> <FP SOURCE="FP1-2">(2) Taxable years beginning after December 31, 2002.</FP> <FP SOURCE="FP1-2">(3) Coordination with the Hope Scholarship Credit.</FP> <FP SOURCE="FP1-2">(4) Examples.</FP> <FP SOURCE="FP1-2">(b) Credit allowed for unlimited number of taxable years.</FP> <FP SOURCE="FP1-2">(c) Both degree and nondegree courses are eligible for the credit.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Examples.</FP> <FP SOURCE="FP1-2">(d) Effective date.<PRTPAGE P="78"/> </FP> <FP SOURCE="FP-2"> <E T="03">§ 1.25A-5Special Rules Relating to Characterization and Timing of Payments</E> </FP> <FP SOURCE="FP1-2">(a) Educational expenses paid by claimed dependent.</FP> <FP SOURCE="FP1-2">(b) Educational expenses paid by a third party.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Special rule for tuition reduction included in gross income of employee.</FP> <FP SOURCE="FP1-2">(3) Examples.</FP> <FP SOURCE="FP1-2">(c) Adjustment to qualified tuition and related expenses for certain excludable educational assistance.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) No adjustment for excludable educational assistance attributable to expenses paid in a prior year.</FP> <FP SOURCE="FP1-2">(3) Scholarships and fellowship grants.</FP> <FP SOURCE="FP1-2">(4) Examples.</FP> <FP SOURCE="FP1-2">(d) No double benefit.</FP> <FP SOURCE="FP1-2">(e) Timing rules.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Prepayment rule.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Example.</FP> <FP SOURCE="FP1-2">(3) Expenses paid with loan proceeds.</FP> <FP SOURCE="FP1-2">(4) Expenses paid through third party installment payment plans.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Example.</FP> <FP SOURCE="FP1-2">(f) Refund of qualified tuition and related expenses.</FP> <FP SOURCE="FP1-2">(1) Payment and refund of qualified tuition and related expenses in the same taxable year.</FP> <FP SOURCE="FP1-2">(2) Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year before return filed for prior taxable year.</FP> <FP SOURCE="FP1-2">(3) Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Recapture amount.</FP> <FP SOURCE="FP1-2">(4) Refund of loan proceeds treated as refund of qualified tuition and related expenses.</FP> <FP SOURCE="FP1-2">(5) Excludable educational assistance received in a subsequent taxable year treated as a refund.</FP> <FP SOURCE="FP1-2">(6) Examples. </FP> </EXTRACT> <CITA>[T.D. 9034, 67 FR 78691, Dec. 26, 2002]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25A-1</SECTNO> <SUBJECT>Calculation of education tax credit and general eligibility requirements.</SUBJECT> <P>(a) <E T="03">Amount of education tax credit.</E> An individual taxpayer is allowed a nonrefundable education tax credit against income tax imposed by chapter 1 of the Internal Revenue Code for the taxable year. The amount of the education tax credit is the total of the Hope Scholarship Credit (as described in § 1.25A-3) plus the Lifetime Learning Credit (as described in § 1.25A-4). For limitations on the credits allowed by subpart A of part IV of subchapter A of chapter 1 of the Internal Revenue Code, see section 26.</P> <P>(b) <E T="03">Coordination of Hope Scholarship Credit and Lifetime Learning Credit—</E>(1) <E T="03">In general.</E> In the same taxable year, a taxpayer may claim a Hope Scholarship Credit for each eligible student's qualified tuition and related expenses (as defined in § 1.25A-2(d)) and a Lifetime Learning Credit for one or more other students' qualified tuition and related expenses. However, a taxpayer may not claim both a Hope Scholarship Credit and a Lifetime Learning Credit with respect to the same student in the same taxable year.</P> <P>(2) <E T="03">Hope Scholarship Credit.</E> Subject to certain limitations, a Hope Scholarship Credit may be claimed for the qualified tuition and related expenses paid during a taxable year with respect to each eligible student (as defined in § 1.25A-3(d)). Qualified tuition and related expenses paid during a taxable year with respect to one student may not be taken into account in computing the amount of the Hope Scholarship Credit with respect to any other student. In addition, qualified tuition and related expenses paid during a taxable year with respect to any student for whom a Hope Scholarship Credit is claimed may not be taken into account in computing the amount of the Lifetime Learning Credit.</P> <P>(3) <E T="03">Lifetime Learning Credit.</E> Subject to certain limitations, a Lifetime Learning Credit may be claimed for the aggregate amount of qualified tuition and related expenses paid during a taxable year with respect to students for whom no Hope Scholarship Credit is claimed.</P> <P>(4) <E T="03">Examples.</E> The following examples illustrate the rules of this paragraph (b): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>In 1999, Taxpayer A pays qualified tuition and related expenses for his dependent, B, to attend College Y during 1999. Assuming all other relevant requirements are met, Taxpayer A may claim either a Hope Scholarship Credit or a Lifetime Learning Credit with respect to dependent B, but not both. See § 1.25A-3(a) and § 1.25A-4(a).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>In 1999, Taxpayer C pays $2,000 in qualified tuition and related expenses for her dependent, D, to attend College Z during 1999. In 1999, Taxpayer C also pays $500 in <PRTPAGE P="79"/>qualified tuition and related expenses to attend a computer course during 1999 to improve Taxpayer C's job skills. Assuming all other relevant requirements are met, Taxpayer C may claim a Hope Scholarship Credit for the $2,000 of qualified tuition and related expenses attributable to dependent D (see § 1.25A-3(a)) and a Lifetime Learning Credit (see § 1.25A-4(a)) for the $500 of qualified tuition and related expenses incurred to improve her job skills.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>The facts are the same as in <E T="03">Example 2,</E> except that Taxpayer C pays $3,000 in qualified tuition and related expenses for her dependent, D, to attend College Z during 1999. Although a Hope Scholarship Credit is available only with respect to the first $2,000 of qualified tuition and related expenses paid with respect to D (see § 1.25A-3(a)), Taxpayer C may not add the $1,000 of excess expenses to her $500 of qualified tuition and related expenses in computing the amount of the Lifetime Learning Credit.</P> </EXAMPLE> <P>(c) <E T="03">Limitation based on modified adjusted gross income—</E>(1) <E T="03">In general.</E> The education tax credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified adjusted gross income between $40,000 and $50,000 ($80,000 and $100,000 for married individuals who file a joint return). Thus, taxpayers with modified adjusted gross income above $50,000 (or $100,000 for joint filers) may not claim an education tax credit.</P> <P>(2) <E T="03">Modified adjusted gross income defined.</E> The term <E T="03">modified adjusted gross income</E> means the adjusted gross income (as defined in section 62) of the taxpayer for the taxable year increased by any amount excluded from gross income under section 911, 931, or 933 (relating to income earned abroad or from certain U.S. possessions or Puerto Rico).</P> <P>(3) <E T="03">Inflation adjustment.</E> For taxable years beginning after 2001, the amounts in paragraph (c)(1) of this section will be increased for inflation occurring after 2000 in accordance with section 1(f)(3). If any amount adjusted under this paragraph (c)(3) is not a multiple of $1,000, the amount will be rounded to the next lowest multiple of $1,000.</P> <P>(d) <E T="03">Election.</E> No education tax credit is allowed unless a taxpayer elects to claim the credit on the taxpayer's federal income tax return for the taxable year in which the credit is claimed. The election is made by attaching Form 8863, “Education Credits (Hope and Lifetime Learning Credits),” to the federal income tax return.</P> <P>(e) <E T="03">Identification requirement.</E> No education tax credit is allowed unless a taxpayer includes on the federal income tax return claiming the credit the name and the taxpayer identification number of the student for whom the credit is claimed. For rules relating to assessment for an omission of a correct taxpayer identification number, see section 6213(b) and (g)(2)(J).</P> <P>(f) <E T="03">Claiming the credit in the case of a dependent—</E>(1) <E T="03">In general.</E> If a student is a claimed dependent of another taxpayer, only that taxpayer may claim the education tax credit for the student's qualified tuition and related expenses. However, if another taxpayer is eligible to, but does not, claim the student as a dependent, only the student may claim the education tax credit for the student's qualified tuition and related expenses.</P> <P>(2) <E T="03">Examples.</E> The following examples illustrate the rules of this paragraph (f): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>In 1999, Taxpayer A pays qualified tuition and related expenses for his dependent, B, to attend University Y during 1999. Taxpayer A claims B as a dependent on his federal income tax return. Therefore, assuming all other relevant requirements are met, Taxpayer A is allowed an education tax credit on his federal income tax return, and B is not allowed an education tax credit on B's federal income tax return. The result would be the same if B paid the qualified tuition and related expenses. See § 1.25A-5(a).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>In 1999, Taxpayer C has one dependent, D. In 1999, D pays qualified tuition and related expenses to attend University Z during 1999. Although Taxpayer C is eligible to claim D as a dependent on her federal income tax return, she does not do so. Therefore, assuming all other relevant requirements are met, D is allowed an education tax credit on D's federal income tax return, and Taxpayer C is not allowed an education tax credit on her federal income tax return, with respect to D's education expenses. The result would be the same if C paid the qualified tuition and related expenses on behalf of D. See § 1.25A-5(b).</P> </EXAMPLE> <P>(g) <E T="03">Married taxpayers.</E> If a taxpayer is married (within the meaning of section 7703), no education tax credit is allowed to the taxpayer unless the taxpayer and the taxpayer's spouse file a joint Federal income tax return for the taxable year.<PRTPAGE P="80"/> </P> <P>(h) <E T="03">Nonresident alien taxpayers and dependents.</E> If a taxpayer or the taxpayer's spouse is a nonresident alien for any portion of the taxable year, no education tax credit is allowed unless the nonresident alien is treated as a resident alien by reason of an election under section 6013(g) or (h). In addition, if a student is a nonresident alien, a taxpayer may not claim an education tax credit with respect to the qualified tuition and related expenses of the student unless the student is a claimed dependent (as defined in § 1.25A-2(a)).</P> <CITA>[T.D. 9034, 67 FR 78691, Dec. 26, 2002]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25A-2</SECTNO> <SUBJECT>Definitions.</SUBJECT> <P>(a) <E T="03">Claimed dependent.</E> A <E T="03">claimed dependent</E> means a dependent (as defined in section 152) for whom a deduction under section 151 is allowed on a taxpayer's federal income tax return for the taxable year. Among other requirements under section 152, a nonresident alien student must be a resident of a country contiguous to the United States in order to be treated as a dependent.</P> <P>(b) <E T="03">Eligible educational institution—</E>(1) <E T="03">In general.</E> In general, an <E T="03">eligible educational institution</E> means a college, university, vocational school, or other postsecondary educational institution that is—</P> <P>(i) Described in section 481 of the Higher Education Act of 1965 (20 U.S.C. 1088) as in effect on August 5, 1997, (generally all accredited public, nonprofit, and proprietary postsecondary institutions); and</P> <P>(ii) Participating in a Federal financial aid program under title IV of the Higher Education Act of 1965 or is certified by the Department of Education as eligible to participate in such a program but chooses not to participate.</P> <P>(2) <E T="03">Rules on Federal financial aid programs.</E> For rules governing an educational institution's eligibility to participate in Federal financial aid programs, see 20 U.S.C. 1070; 20 U.S.C. 1094; and 34 CFR 600 and 668.</P> <P>(c) <E T="03">Academic period. Academic period</E> means a quarter, semester, trimester, or other period of study as reasonably determined by an eligible educational institution. In the case of an eligible educational institution that uses credit hours or clock hours, and does not have academic terms, each payment period (as defined in 34 CFR 668.4, revised as of July 1, 2002) may be treated as an academic period.</P> <P>(d) <E T="03">Qualified tuition and related expenses—</E>(1) <E T="03">In general. Qualified tuition and related expenses</E> means tuition and fees required for the enrollment or attendance of a student for courses of instruction at an eligible educational institution.</P> <P>(2) <E T="03">Required fees</E>—(i) <E T="03">In general.</E> Except as provided in paragraph (d)(3) of this section, the test for determining whether any fee is a qualified tuition and related expense is whether the fee is required to be paid to the eligible educational institution as a condition of the student's enrollment or attendance at the institution.</P> <P>(ii) <E T="03">Books, supplies, and equipment.</E> Qualified tuition and related expenses include fees for books, supplies, and equipment used in a course of study only if the fees must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.</P> <P>(iii) <E T="03">Nonacademic fees.</E> Except as provided in paragraph (d)(3) of this section, qualified tuition and related expenses include fees charged by an eligible educational institution that are not used directly for, or allocated to, an academic course of instruction only if the fee must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.</P> <P>(3) <E T="03">Personal expenses.</E> Qualified tuition and related expenses do not include the costs of room and board, insurance, medical expenses (including student health fees), transportation, and similar personal, living, or family expenses, regardless of whether the fee must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.</P> <P>(4) <E T="03">Treatment of a comprehensive or bundled fee.</E> If a student is required to pay a fee (such as a comprehensive fee or a bundled fee) to an eligible educational institution that combines charges for qualified tuition and related expenses with charges for personal expenses described in paragraph (d)(3) of this section, the portion of the <PRTPAGE P="81"/>fee that is allocable to personal expenses is not included in qualified tuition and related expenses. The determination of what portion of the fee relates to qualified tuition and related expenses and what portion relates to personal expenses must be made by the institution using a reasonable method of allocation.</P> <P>(5) <E T="03">Hobby courses.</E> Qualified tuition and related expenses do not include expenses that relate to any course of instruction or other education that involves sports, games, or hobbies, or any noncredit course, unless the course or other education is part of the student's degree program, or in the case of the Lifetime Learning Credit, the student takes the course to acquire or improve job skills.</P> <P>(6) <E T="03">Examples.</E> The following examples illustrate the rules of this paragraph (d). In each example, assume that the institution is an eligible educational institution and that all other relevant requirements to claim an education tax credit are met. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>University V offers a degree program in dentistry. In addition to tuition, all students enrolled in the program are required to pay a fee to University V for the rental of dental equipment. Because the equipment rental fee must be paid to University V for enrollment and attendance, the tuition and the equipment rental fee are qualified tuition and related expenses.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>First-year students at College W are required to obtain books and other reading materials used in its mandatory first-year curriculum. The books and other reading materials are not required to be purchased from College W and may be borrowed from other students or purchased from off-campus bookstores, as well as from College W's bookstore. College W bills students for any books and materials purchased from College W's bookstore. The fee that College W charges for the first-year books and materials purchased at its bookstore is not a qualified tuition and related expense because the books and materials are not required to be purchased from College W for enrollment or attendance at the institution.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>All students who attend College X are required to pay a separate student activity fee in addition to their tuition. The student activity fee is used solely to fund on-campus organizations and activities run by students, such as the student newspaper and the student government (no portion of the fee covers personal expenses). Although labeled as a student activity fee, the fee is required for enrollment or attendance at College X. Therefore, the fee is a qualified tuition and related expense.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>The facts are the same as in <E T="03">Example 3</E>, except that College X offers an optional athletic fee that students may pay to receive discounted tickets to sports events. The athletic fee is not required for enrollment or attendance at College X. Therefore, the fee is not a qualified tuition and related expense.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>College Y requires all students to live on campus. It charges a single comprehensive fee to cover tuition, required fees, and room and board. Based on College Y's reasonable allocation, sixty percent of the comprehensive fee is allocable to tuition and other required fees not allocable to personal expenses, and the remaining forty percent of the comprehensive fee is allocable to charges for room and board and other personal expenses. Therefore, only sixty percent of College Y's comprehensive fee is a qualified tuition and related expense.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>As a degree student at College Z, Student A is required to take a certain number of courses outside of her chosen major in Economics. To fulfill this requirement, Student A enrolls in a square dancing class offered by the Physical Education Department. Because Student A receives credit toward her degree program for the square dancing class, the tuition for the square dancing class is included in qualified tuition and related expenses.</P> </EXAMPLE> <CITA>[T.D. 9034, 67 FR 78691, Dec. 26, 2002]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25A-3</SECTNO> <SUBJECT>Hope Scholarship Credit.</SUBJECT> <P>(a) <E T="03">Amount of the credit</E>—(1) <E T="03">In general.</E> Subject to the phaseout of the education tax credit described in § 1.25A-1(c), the Hope Scholarship Credit amount is the total of—</P> <P>(i) 100 percent of the first $1,000 of qualified tuition and related expenses paid during the taxable year for education furnished to an eligible student (as defined in paragraph (d) of this section) who is the taxpayer, the taxpayer's spouse, or any claimed dependent during any academic period beginning in the taxable year (or treated as beginning in the taxable year, see § 1.25A-5(e)(2)); plus</P> <P>(ii) 50 percent of the next $1,000 of such expenses paid with respect to that student.</P> <P>(2) <E T="03">Maximum credit.</E> For taxable years beginning before 2002, the maximum Hope Scholarship Credit allowed for each eligible student is $1,500. For taxable years beginning after 2001, the amounts used in paragraph (a)(1) of <PRTPAGE P="82"/>this section to determine the maximum credit will be increased for inflation occurring after 2000 in accordance with section 1(f)(3). If any amount adjusted under this paragraph (a)(2) is not a multiple of $100, the amount will be rounded to the next lowest multiple of $100.</P> <P>(b) <E T="03">Per student credit—</E>(1) <E T="03">In general.</E> A Hope Scholarship Credit may be claimed for the qualified tuition and related expenses of each eligible student (as defined in paragraph (d) of this section).</P> <P>(2) <E T="03">Example.</E> The following example illustrates the rule of this paragraph (b). In the example, assume that all the requirements to claim an education tax credit are met. The example is as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>In 1999, Taxpayer A has two dependents, B and C, both of whom are eligible students. Taxpayer A pays $1,600 in qualified tuition and related expenses for dependent B to attend a community college. Taxpayer A pays $5,000 in qualified tuition and related expenses for dependent C to attend University X. Taxpayer A may claim a Hope Scholarship Credit of $1,300 ($1,000 + (.50 × $600)) for dependent B, and the maximum $1,500 Hope Scholarship Credit for dependent C, for a total Hope Scholarship Credit of $2,800.</P> </EXAMPLE> <P>(c) <E T="03">Credit allowed for only two taxable years.</E> For each eligible student, the Hope Scholarship Credit may be claimed for no more than two taxable years.</P> <P>(d) <E T="03">Eligible student</E>—(1) <E T="03">Eligible student defined.</E> For purposes of the Hope Scholarship Credit, the term <E T="03">eligible student</E> means a student who satisfies all of the following requirements—</P> <P>(i) <E T="03">Degree requirement.</E> For at least one academic period that begins during the taxable year, the student enrolls at an eligible educational institution in a program leading toward a postsecondary degree, certificate, or other recognized postsecondary educational credential;</P> <P>(ii) <E T="03">Work load requirement.</E> For at least one academic period that begins during the taxable year, the student enrolls for at least one-half of the normal full-time work load for the course of study the student is pursuing. The standard for what is half of the normal full-time work load is determined by each eligible educational institution. However, the standard for half-time may not be lower than the applicable standard for half-time established by the Department of Education under the Higher Education Act of 1965 and set forth in 34 CFR 674.2(b) (revised as of July 1, 2002) for a half-time undergraduate student;</P> <P>(iii) <E T="03">Year of study requirement.</E> As of the beginning of the taxable year, the student has not completed the first two years of postsecondary education at an eligible educational institution. Whether a student has completed the first two years of postsecondary education at an eligible educational institution as of the beginning of a taxable year is determined based on whether the institution in which the student is enrolled in a degree program (as described in paragraph (d)(1)(i) of this section) awards the student two years of academic credit at that institution for postsecondary course work completed by the student prior to the beginning of the taxable year. Any academic credit awarded by the eligible educational institution solely on the basis of the student's performance on proficiency examinations is disregarded in determining whether the student has completed two years of postsecondary education; and</P> <P>(iv) <E T="03">No felony drug conviction.</E> The student has not been convicted of a Federal or State felony offense for possession or distribution of a controlled substance as of the end of the taxable year for which the credit is claimed.</P> <P>(2) <E T="03">Examples.</E> The following examples illustrate the rules of this paragraph (d). In each example, assume that the student has not been convicted of a felony drug offense, that the institution is an eligible educational institution unless otherwise stated, that the qualified tuition and related expenses are paid during the same taxable year that the academic period begins, and that a Hope Scholarship Credit has not previously been claimed for the student (see paragraph (c) of this section). The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Student A graduates from high school in June 1998 and is enrolled in an undergraduate degree program at College U for the 1998 Fall semester on a full-time basis. For the 1999 Spring semester, Student A again is enrolled at College U on a full-time basis. For the 1999 Fall semester, Student A is enrolled in less than half the normal full-<PRTPAGE P="83"/>time course work for her degree program. Because Student A is enrolled in an undergraduate degree program on at least a half-time basis for at least one academic period that begins during 1998 and at least one academic period that begins during 1999, Student A is an eligible student for taxable years 1998 and 1999 (including the 1999 Fall semester when Student A enrolls at College U on less than a half-time basis).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Prior to 1998, Student B attended college for several years on a full-time basis. Student B transfers to College V for the 1998 Spring semester. College V awards Student B credit for some (but not all) of the courses he previously completed, and College V classifies Student B as a first-semester sophomore. During both the Spring and Fall semesters of 1998, Student B is enrolled in at least one-half the normal full-time work load for his degree program at College V. Because College V does not classify Student B as having completed the first two years of postsecondary education as of the beginning of 1998, Student B is an eligible student for taxable year 1998.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>The facts are the same as in <E T="03">Example 2.</E> After taking classes on a half-time basis for the 1998 Spring and Fall semesters, Student B is enrolled at College V for the 1999 Spring semester on a full-time basis. College V classifies Student B as a second-semester sophomore for the 1999 Spring semester and as a first-semester junior for the 1999 Fall semester. Because College V does not classify Student B as having completed the first two years of postsecondary education as of the beginning of 1999, Student B is an eligible student for taxable year 1999. Therefore, the qualified expenses and required fees paid for the 1999 Spring semester and the 1999 Fall semester are taken into account in calculating any Hope Scholarship Credit.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>Prior to 1998, Student C was not enrolled at another eligible educational institution. At the time that Student C enrolls in a degree program at College W for the 1998 Fall semester, Student C takes examinations to demonstrate her proficiency in several subjects. On the basis of Student C's performance on these examinations, College W classifies Student C as a second-semester sophomore as of the beginning of the 1998 Fall semester. Student C is enrolled at College W during the 1998 Fall semester and during the 1999 Spring and Fall semesters on a full-time basis and is classified as a first-semester junior as of the beginning of the 1999 Spring semester. Because Student C was not enrolled in a college or other eligible educational institution prior to 1998 (but rather was awarded three semesters of academic credit solely because of proficiency examinations), Student C is not treated as having completed the first two years of postsecondary education at an eligible educational institution as of the beginning of 1998 or as of the beginning of 1999. Therefore, Student C is an eligible student for both taxable years 1998 and 1999.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>During the 1998 Fall semester, Student D is a high school student who takes classes on a half-time basis at College X. Student D is not enrolled as part of a degree program at College X because College X does not admit students to a degree program unless the student has a high school diploma or equivalent. Because Student D is not enrolled in a degree program at College X during 1998, Student D is not an eligible student for taxable year 1998.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>The facts are the same as in <E T="03">Example 5.</E> In addition, during the 1999 Spring semester, Student D again attends College X but not as part of a degree program. Student D graduates from high school in June 1999. For the 1999 Fall semester, Student D enrolls in College X as part of a degree program, and College X awards Student D credit for her prior course work at College X. During the 1999 Fall semester, Student D is enrolled in more than one-half the normal full-time work load of courses for her degree program at College X. Because Student D is enrolled in a degree program at College X for the 1999 Fall term on at least a half-time basis, Student D is an eligible student for all of taxable year 1999. Therefore, the qualified tuition and required fees paid for classes taken at College X during both the 1999 Spring semester (during which Student D was not enrolled in a degree program) and the 1999 Fall semester are taken into account in computing any Hope Scholarship Credit.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 7.</HD> <P>Student E completed two years of undergraduate study at College S. College S is not an eligible educational institution for purposes of the education tax credit. At the end of 1998, Student E enrolls in an undergraduate degree program at College Z, an eligible educational institution, for the 1999 Spring semester on a full-time basis. College Z awards Student E two years of academic credit for his previous course work at College S and classifies Student E as a first-semester junior for the 1999 Spring semester. Student E is treated as having completed the first two years of postsecondary education at an eligible educational institution as of the beginning of 1999. Therefore, Student E is not an eligible student for taxable year 1999.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 8.</HD> <P>Student F received a degree in 1998 from College R. College R is not an eligible educational institution for purposes of the education tax credit. During 1999, Student F is enrolled in a graduate-degree program at College Y, an eligible educational institution, for the 1999 Fall semester on a full-time basis. By admitting Student F to its graduate degree program, College Y treats Student F as having completed the first two years of postsecondary education as of the beginning of 1999. Therefore, Student <PRTPAGE P="84"/>F is not an eligible student for taxable year 1999.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 9.</HD> <P>Student G graduates from high school in June 2001. In January 2002, Student G is enrolled in a one-year postsecondary certificate program on a full-time basis to obtain a certificate as a travel agent. Student G completes the program in December 2002 and is awarded a certificate. In January 2003, Student G enrolls in a one-year postsecondary certificate program on a full-time basis to obtain a certificate as a computer programer. Student G meets the degree requirement, the work load requirement, and the year of study requirement for the taxable years 2002 and 2003. Therefore, Student G is an eligible student for both taxable years 2002 and 2003.</P> </EXAMPLE> <P>(e) <E T="03">Academic period for prepayments—</E>(1) <E T="03">In general.</E> For purposes of determining whether a student meets the requirements in paragraph (d) of this section for a taxable year, if qualified tuition and related expenses are paid during one taxable year for an academic period that begins during January, February or March of the next taxable year (for taxpayers on a fiscal taxable year, use the first three months of the next taxable year), the academic period is treated as beginning during the taxable year in which the payment is made.</P> <P>(2) <E T="03">Example.</E> The following example illustrates the rule of this paragraph (e). In the example, assume that all the requirements to claim a Hope Scholarship Credit are met. The example is as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>Student G graduates from high school in June 1998. After graduation, Student G works full-time for several months to earn money for college. Student G is enrolled on a full-time basis in an undergraduate degree program at University W, an eligible educational institution, for the 1999 Spring semester, which begins in January 1999. Student G pays tuition to University W for the 1999 Spring semester in December 1998. Because the tuition paid by Student G in 1998 relates to an academic period that begins during the first three months of 1999, Student G's eligibility to claim a Hope Scholarship Credit in 1998 is determined as if the 1999 Spring semester began in 1998. Thus, assuming Student G has not been convicted of a felony drug offense as of December 31, 1998, Student G is an eligible student for 1998.</P> </EXAMPLE> <P>(f) <E T="03">Effective date</E>. The Hope Scholarship Credit is applicable for qualified tuition and related expenses paid after December 31, 1997, for education furnished in academic periods beginning after December 31, 1997.</P> <CITA>[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25A-4</SECTNO> <SUBJECT>Lifetime Learning Credit.</SUBJECT> <P>(a) <E T="03">Amount of the credit</E>—(1) <E T="03">Taxable years beginning before January 1, 2003</E>. Subject to the phaseout of the education tax credit described in § 1.25A-1(c), for taxable years beginning before 2003, the Lifetime Learning Credit amount is 20 percent of up to $5,000 of qualified tuition and related expenses paid during the taxable year for education furnished to the taxpayer, the taxpayer's spouse, and any claimed dependent during any academic period beginning in the taxable year (or treated as beginning in the taxable year, see § 1.25A-5(e)(2)).</P> <P>(2) <E T="03">Taxable years beginning after December 31, 2002.</E> Subject to the phaseout of the education tax credit described in § 1.25A-1(c), for taxable years beginning after 2002, the Lifetime Learning Credit amount is 20 percent of up to $10,000 of qualified tuition and related expenses paid during the taxable year for education furnished to the taxpayer, the taxpayer's spouse, and any claimed dependent during any academic period beginning in the taxable year (or treated as beginning in the taxable year, see § 1.25A-5(e)(2)).</P> <P>(3) <E T="03">Coordination with the Hope Scholarship Credit</E>. Expenses paid with respect to a student for whom the Hope Scholarship Credit is claimed are not eligible for the Lifetime Learning Credit.</P> <P>(4) <E T="03">Examples</E>. The following examples illustrate the rules of this paragraph (a). In each example, assume that all the requirements to claim a Lifetime Learning Credit or a Hope Scholarship Credit, as applicable, are met. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>In 1999, Taxpayer A pays qualified tuition and related expenses of $3,000 for dependent B to attend an eligible educational institution, and Taxpayer A pays qualified tuition and related expenses of $4,000 for dependent C to attend an eligible educational institution. Taxpayer A does not claim a Hope Scholarship Credit with respect to either B or C. Although Taxpayer A paid $7,000 of qualified tuition and related expenses during the taxable year, Taxpayer A may claim the Lifetime Learning Credit with respect to only $5,000 of such expenses. <PRTPAGE P="85"/>Therefore, the maximum Lifetime Learning Credit Taxpayer A may claim for 1999 is $1,000 (.20 × $5,000).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>In 1999, Taxpayer D pays $6,000 of qualified tuition and related expenses for dependent E, and $2,000 of qualified tuition and related expenses for dependent F, to attend eligible educational institutions. Dependent F has already completed the first two years of postsecondary education. For 1999, Taxpayer D claims the maximum $1,500 Hope Scholarship Credit with respect to dependent E. In computing the amount of the Lifetime Learning Credit, Taxpayer D may not include any of the $6,000 of qualified tuition and related expenses paid on behalf of dependent E but may include the $2,000 of qualified tuition and related expenses of dependent F.</P> </EXAMPLE> <P>(b) <E T="03">Credit allowed for unlimited number of taxable years</E>. There is no limit to the number of taxable years that a taxpayer may claim a Lifetime Learning Credit with respect to any student.</P> <P>(c) <E T="03">Both degree and nondegree courses are eligible for the credit</E>—(1) <E T="03">In general</E>. For purposes of the Lifetime Learning Credit, amounts paid for a course at an eligible educational institution are qualified tuition and related expenses if the course is either part of a postsecondary degree program or is not part of a postsecondary degree program but is taken by the student to acquire or improve job skills.</P> <P>(2) <E T="03">Examples</E>. The following examples illustrate the rule of this paragraph (c). In each example, assume that all the requirements to claim a Lifetime Learning Credit are met. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Taxpayer A, a professional photographer, enrolls in an advanced photography course at a local community college. Although the course is not part of a degree program, Taxpayer A enrolls in the course to improve her job skills. The course fee paid by Taxpayer A is a qualified tuition and related expense for purposes of the Lifetime Learning Credit.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Taxpayer B, a stockbroker, plans to travel abroad on a “photo-safari” for his next vacation. In preparation for the trip, Taxpayer B enrolls in a noncredit photography class at a local community college. Because Taxpayer B is not taking the photography course as part of a degree program or to acquire or improve his job skills, amounts paid by Taxpayer B for the course are not qualified tuition and related expenses for purposes of the Lifetime Learning Credit.</P> </EXAMPLE> <P>(d) <E T="03">Effective date</E>. The Lifetime Learning Credit is applicable for qualified tuition and related expenses paid after June 30, 1998, for education furnished in academic periods beginning after June 30, 1998.</P> <CITA>[T.D. 9034, 67 FR 78691, Dec. 26, 2002]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.25A-5</SECTNO> <SUBJECT>Special rules relating to characterization and timing of payments.</SUBJECT> <P>(a) <E T="03">Educational expenses paid by claimed dependent</E>. For any taxable year for which the student is a claimed dependent of another taxpayer, qualified tuition and related expenses paid by the student are treated as paid by the taxpayer to whom the deduction under section 151 is allowed.</P> <P>(b) <E T="03">Educational expenses paid by a third party</E>—(1) <E T="03">In general</E>. Solely for purposes of section 25A, if a third party (someone other than the taxpayer, the taxpayer's spouse if the taxpayer is treated as married within the meaning of section 7703, or a claimed dependent) makes a payment directly to an eligible educational institution to pay for a student's qualified tuition and related expenses, the student is treated as receiving the payment from the third party and, in turn, paying the qualified tuition and related expenses to the institution.</P> <P>(2) <E T="03">Special rule for tuition reduction included in gross income of employee</E>. Solely for purposes of section 25A, if an eligible educational institution provides a reduction in tuition to an employee of the institution (or to the spouse or dependent child of an employee, as described in section 132(h)(2)) and the amount of the tuition reduction is included in the employee's gross income, the employee is treated as receiving payment of an amount equal to the tuition reduction and, in turn, paying such amount to the institution.</P> <P>(3) <E T="03">Examples</E>. The following examples illustrate the rules of this paragraph (b). In each example, assume that all the requirements to claim an education tax credit are met. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Grandparent D makes a direct payment to an eligible educational institution for Student E's qualified tuition and related expenses. Student E is not a claimed dependent in 1999. For purposes of claiming <PRTPAGE P="86"/>an education tax credit, Student E is treated as receiving the money from her grandparent and, in turn, paying her qualified tuition and related expenses.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Under a court-approved divorce decree, Parent A is required to pay Student C's college tuition. Parent A makes a direct payment to an eligible educational institution for Student C's 1999 tuition. Under paragraph (b)(1) of this section, Student C is treated as receiving the money from Parent A and, in turn, paying the qualified tuition and related expenses. Under the divorce decree, Parent B has custody of Student C for 1999. Parent B properly claims Student C as a dependent on Parent B's 1999 federal income tax return. Under paragraph (a) of this section, expenses paid by Student C are treated as paid by Parent B. Thus, Parent B may claim an education tax credit for the qualified tuition and related expenses paid directly to the institution by Parent A.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>University A, an eligible educational institution, offers reduced tuition charges to its employees and their dependent children. F is an employee of University A. F's dependent child, G, enrolls in a graduate-level course at University A. Section 117(d) does not apply, because it is limited to tuition reductions provided for education below the graduate level. Therefore, the amount of the tuition reduction received by G is treated as additional compensation from University A to F and is included in F's gross income. For purposes of claiming a Lifetime Learning Credit, F is treated as receiving payment of an amount equal to the tuition reduction from University A and, in turn, paying such amount to University A on behalf of F's child, G.</P> </EXAMPLE> <P>(c) <E T="03">Adjustment to qualified tuition and related expenses for certain excludable educational assistance</E>—(1) <E T="03">In general</E>. In determining the amount of an education tax credit, qualified tuition and related expenses for any academic period must be reduced by the amount of any tax-free educational assistance allocable to such period. For this purpose, <E T="03">tax-free educational assistance</E> means—</P> <P>(i) A qualified scholarship that is excludable from income under section 117;</P> <P>(ii) A veterans' or member of the armed forces' educational assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38, United States Code, or under chapter 1606 of title 10, United States Code;</P> <P>(iii) Employer-provided educational assistance that is excludable from income under section 127; or</P> <P>(iv) Any other educational assistance that is excludable from gross income (other than as a gift, bequest, devise, or inheritance within the meaning of section 102(a)).</P> <P>(2) <E T="03">No adjustment for excludable educational assistance attributable to expenses paid in a prior year</E>. A reduction is not required under paragraph (c)(1) of this section if the amount of excludable educational assistance received during the taxable year is treated as a refund of qualified tuition and related expenses paid in a prior taxable year. See paragraph (f)(5) of this section.</P> <P>(3) <E T="03">Scholarships and fellowship grants</E>. For purposes of paragraph (c)(1)(i) of this section, a scholarship or fellowship grant is treated as a qualified scholarship excludable under section 117 except to the extent—</P> <P>(i) The scholarship or fellowship grant (or any portion thereof) may be applied, by its terms, to expenses other than qualified tuition and related expenses within the meaning of section 117(b)(2) (such as room and board) and the student reports the grant (or the appropriate portion thereof) as income on the student's federal income tax return if the student is required to file a return; or</P> <P>(ii) The scholarship or fellowship grant (or any portion thereof) must be applied, by its terms, to expenses other than qualified tuition and related expenses within the meaning of section 117(b)(2) (such as room and board) and the student reports the grant (or the appropriate portion thereof) as income on the student's federal income tax return if the student is required to file a return.</P> <P>(4) <E T="03">Examples</E>. The following examples illustrate the rules of this paragraph (c). In each example, assume that all the requirements to claim an education tax credit are met. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>University X charges Student A, who lives on University X's campus, $3,000 for tuition and $5,000 for room and board. University X awards Student A a $2,000 scholarship. The terms of the scholarship permit it to be used to pay any of a student's costs of attendance at University X, including tuition, room and board, and other incidental expenses. University X applies the $2,000 scholarship against Student A's $8,000 <PRTPAGE P="87"/>total bill, and Student A pays the $6,000 balance of her bill from University X with a combination of savings and amounts she earns from a summer job. University X does not require A to pay any additional fees beyond the $3,000 in tuition in order to enroll in or attend classes. Student A does not report any portion of the scholarship as income on her federal income tax return. Since Student A does not report the scholarship as income, the scholarship is treated under paragraph (c)(3) of this section as a qualified scholarship that is excludable under section 117. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid only $1,000 ($3,000 tuition−$2,000 scholarship) in qualified tuition and related expenses to University X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in <E T="03">Example 1</E>, except that Student A reports the entire scholarship as income on the student's federal income tax return. Since the full amount of the scholarship may be applied to expenses other than qualified expenses (room and board) and Student A reports the scholarship as income, the exception in paragraph (c)(3) of this section applies and the scholarship is not treated as a qualified scholarship excludable under section 117. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid $3,000 of qualified tuition and related expenses to University X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>The facts are the same as in <E T="03">Example 1</E>, except that the terms of the scholarship require it to be used to pay tuition. Under paragraph (c)(3) of this section, the scholarship is treated as a qualified scholarship excludable under section 117. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid only $1,000 ($3,000 tuition−$2,000 scholarship) in qualified tuition and related expenses to University X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>The facts are the same as in <E T="03">Example 1</E>, except that the terms of the scholarship require it to be used to pay tuition or room and board charged by University X, and the scholarship amount is $6,000. Under the terms of the scholarship, Student A may allocate the scholarship between tuition and room and board in any manner. However, because room and board totals $5,000, that is the maximum amount that can be applied under the terms of the scholarship to expenses other than qualified expenses and at least $1,000 of the scholarship must be applied to tuition. Therefore, the maximum amount of the exception under paragraph (c)(3) of this section is $5,000 and at least $1,000 is treated as a qualified scholarship excludable under section 117 ($6,000 scholarship−$5,000 room and board). If Student A reports $5,000 of the scholarship as income on the student's federal income tax return, then Student A will be treated as having paid $2,000 ($3,000 tuition−$1,000 qualified scholarship excludable under section 117) in qualified tuition and related expenses to University X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>The facts are the same as in <E T="03">Example 1</E>, except that in addition to the scholarship that University X awards to Student A, University X also provides Student A with an education loan and pays Student A for working in a work/study job in the campus dining hall. The loan is not excludable educational assistance within the meaning of paragraph (c) of this section. In addition, wages paid to a student who is performing services for the payor are neither a qualified scholarship nor otherwise excludable from gross income. Therefore, Student A is not required to reduce her qualified tuition and related expenses by the amounts she receives from the student loan or as wages from her work/study job.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>In 1999, Student B pays University Y $1,000 in tuition for the 1999 Spring semester. University Y does not require Student B to pay any additional fees beyond the $1,000 in tuition in order to enroll in classes. Student B is an employee of Company Z. At the end of the academic period and during the same taxable year that Student B paid tuition to University Y, Student B provides Company Z with proof that he has satisfactorily completed his courses at University Y. Pursuant to an educational assistance program described in section 127(b), Company Z reimburses Student B for all of the tuition paid to University Y. Because the reimbursement from Company Z is employer-provided educational assistance that is excludable from Student B's gross income under section 127, the reimbursement reduces Student B's qualified tuition and related expenses. Therefore, for purposes of calculating an education tax credit, Student B is treated as having paid no qualified tuition and related expenses to University Y during 1999.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 7.</HD> <P>The facts are the same as in <E T="03">Example 6</E> except that the reimbursement from Company Z is not pursuant to an educational assistance program described in section 127(b), is not otherwise excludable from Student B's gross income, and is taxed as additional compensation to Student B. Because the reimbursement is not excludable educational assistance within the meaning of paragraph (c)(1) of this section, Student B is not required to reduce his qualified tuition and related expenses by the $1,000 reimbursement he received from his employer. Therefore, for purposes of calculating an education tax credit, Student B is treated as paying $1,000 in qualified tuition and related expenses to University Y during 1999.</P> </EXAMPLE> <P>(d) <E T="03">No double benefit</E>. Qualified tuition and related expenses do not include any expense for which a deduction is allowed under section 162, section 222, <PRTPAGE P="88"/>or any other provision of chapter 1 of the Internal Revenue Code.</P> <P>(e) <E T="03">Timing rules</E>—(1) <E T="03">In general</E>. Except as provided in paragraph (e)(2) of this section, an education tax credit is allowed only for payments of qualified tuition and related expenses for an academic period beginning in the same taxable year as the year the payment is made. Except for certain individuals who do not use the cash receipts and disbursements method of accounting, qualified tuition and related expenses are treated as paid in the year in which the expenses are actually paid. See § 1.461-1(a)(1).</P> <P>(2) <E T="03">Prepayment rule</E>—(i) <E T="03">In general</E>. If qualified tuition and related expenses are paid during one taxable year for an academic period that begins during the first three months of the taxpayer's next taxable year (<E T="03">i.e.</E>, in January, February, or March of the next taxable year for calendar year taxpayers), an education tax credit is allowed with respect to the qualified tuition and related expenses only in the taxable year in which the expenses are paid.</P> <P>(ii) <E T="03">Example</E>. The following example illustrates the rule of this paragraph (e)(2). In the example, assume that all the requirements to claim an education tax credit are met. The example is as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>In December 1998, Taxpayer A, a calendar year taxpayer, pays College Z $1,000 in qualified tuition and related expenses to attend classes during the 1999 Spring semester, which begins in January 1999. Taxpayer A may claim an education tax credit only in 1998 for payments made in 1998 for the 1999 Spring semester.</P> </EXAMPLE> <P>(3) <E T="03">Expenses paid with loan proceeds</E>. An education tax credit may be claimed for qualified tuition and related expenses paid with the proceeds of a loan only in the taxable year in which the expenses are paid, and may not be claimed in the taxable year in which the loan is repaid. Loan proceeds disbursed directly to an eligible educational institution will be treated as paid on the date the institution credits the proceeds to the student's account. For example, in the case of any loan issued or guaranteed as part of a Federal student loan program under title IV of the Higher Education Act of 1965, loan proceeds will be treated as paid on the date of disbursement (as defined in 34 CFR 668.164(a), revised as of July 1, 2002) by the eligible educational institution. If a taxpayer does not know the date the institution credits the student's account, the taxpayer must treat the qualified tuition and related expenses as paid on the last date for payment prescribed by the institution.</P> <P>(4) <E T="03">Expenses paid through third party installment payment plans</E>—(i) <E T="03">In general</E>. A taxpayer, an eligible educational institution, and a third party installment payment company may enter into an agreement in which the company agrees to collect installment payments of qualified tuition and related expenses from the taxpayer and to remit the installment payments to the institution. If the third party installment payment company is the taxpayer's agent for purposes of paying qualified tuition and related expenses to the eligible educational institution, the taxpayer is treated as paying the qualified expenses on the date the company pays the institution. However, if the third party installment payment company is the eligible educational institution's agent for purposes of collecting payments of qualified tuition and related expenses from the taxpayer, the taxpayer is treated as paying the qualified expenses on the date the taxpayer pays the company.</P> <P>(ii) <E T="03">Example</E>. The following example illustrates the rule of this paragraph (e)(4). The example is as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>Student A, Company B, and College C enter into a written agreement in which Student A agrees to pay the tuition required to attend College C in 10 equal monthly installments to Company B. Under the written agreement, Student A is not relieved of her obligation to pay College C until Company B remits the payments to College C. Under the written agreement, Company B agrees to disburse the monthly installment payments to College C within 30 days of receipt. Because Company B acts as Student A's agent for purposes of paying qualified expenses to College C, Student A is treated as paying qualified expenses on the date Company B disburses payments to College C.</P> </EXAMPLE> <P>(f) <E T="03">Refund of qualified tuition and related expenses—(1) Payment and refund of qualified tuition and related expenses in the same taxable year</E>. With respect to any student, the amount of qualified <PRTPAGE P="89"/>tuition and related expenses for a taxable year is calculated by adding all qualified tuition and related expenses paid for the taxable year, and subtracting any refund of such expenses received from the eligible educational institution during the same taxable year (including refunds of loan proceeds described in paragraph (f)(4) of this section).</P> <P>(2) <E T="03">Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year before return filed for prior taxable year</E>. If, in a taxable year, a taxpayer or someone other than the taxpayer receives a refund (including refunds of loan proceeds described in paragraph (f)(4) of this section) of qualified tuition and related expenses paid on behalf of a student in a prior taxable year and the refund is received before the taxpayer files a federal income tax return for the prior taxable year, the amount of the qualified tuition and related expenses for the prior taxable year is reduced by the amount of the refund.</P> <P>(3) <E T="03">Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year</E>—(i) <E T="03">In general</E>. If, in a taxable year (refund year), a taxpayer or someone other than the taxpayer receives a refund (including refunds of loan proceeds described in paragraph (f)(4) of this section) of qualified tuition and related expenses paid on behalf of a student for which the taxpayer claimed an education tax credit in a prior taxable year, the tax imposed by chapter 1 of the Internal Revenue Code for the refund year is increased by the recapture amount.</P> <P>(ii) <E T="03">Recapture amount</E>. The recapture amount is the difference in tax liability for the prior taxable year (taking into account any redetermination of such tax liability by audit or amended return) that results when the tax liability for the prior year is calculated using the taxpayer's redetermined credit. The redetermined credit is computed by reducing the amount of the qualified tuition and related expenses taken into account in determining any credit claimed in the prior taxable year by the amount of the refund of the qualified tuition and related expenses (redetermined qualified expenses), and computing the allowable credit using the redetermined qualified expenses and the relevant facts and circumstances of the prior taxable year, such as modified adjusted gross income (redetermined credit).</P> <P>(4) <E T="03">Refund of loan proceeds treated as refund of qualified tuition and related expenses</E>. If loan proceeds used to pay qualified tuition and related expenses (as described in paragraph (e)(3) of this section) during a taxable year are refunded by an eligible educational institution to a lender on behalf of the borrower, the refund is treated as a refund of qualified tuition and related expenses for purposes of paragraphs (f)(1), (2), and (3) of this section.</P> <P>(5) <E T="03">Excludable educational assistance received in a subsequent taxable year treated as a refund</E>. If, in a taxable year, a taxpayer or someone other than the taxpayer receives any excludable educational assistance (described in paragraph (c)(1) of this section) for the qualified tuition and related expenses paid on behalf of a student during a prior taxable year (or attributable to enrollment at an eligible educational institution during a prior taxable year), the educational assistance is treated as a refund of qualified tuition and related expenses for purposes of paragraphs (f)(2) and (3) of this section. If the excludable educational assistance is received before the taxpayer files a federal income tax return for the prior taxable year, the amount of the qualified tuition and related expenses for the prior taxable year is reduced by the amount of the excludable educational assistance as provided in paragraph (f)(2) of this section. If the excludable educational assistance is received after the taxpayer has filed a federal income tax return for the prior taxable year, any education tax credit claimed for the prior taxable year is subject to recapture as provided in paragraph (f)(3) of this section.</P> <P>(6) <E T="03">Examples</E>. The following examples illustrate the rules of this paragraph (f). In each example, assume that all the requirements to claim an education tax credit are met. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>In January 1998, Student A, a full-time freshman at University X, pays <PRTPAGE P="90"/>$2,000 for qualified tuition and related expenses for a 16-hour work load for the 1998 Spring semester. Prior to beginning classes, Student A withdraws from 6 course hours. On February 15, 1998, Student A receives a $750 refund from University X. In September 1998, Student A pays University X $1,000 to enroll half-time for the 1998 Fall semester. Prior to beginning classes, Student A withdraws from a 2-hour course, and she receives a $250 refund in October 1998. Student A computes the amount of qualified tuition and related expenses she may claim for 1998 by:</P> <P>(i) Adding all qualified expenses paid during the taxable year ($2,000 + 1,000 = $3,000);</P> <P>(ii) Adding all refunds of qualified tuition and related expenses received during the taxable year ($750 + $250 = $1,000); and, then</P> <P>(iii) Subtracting paragraph (ii) of this <E T="03">Example 1</E> from paragraph (i) of this <E T="03">Example 1</E> ($3,000 −$1,000 = $2,000). Therefore, Student A's qualified tuition and related expenses for 1998 are $2,000.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>(i) In December 1998, Student B, a senior at College Y, pays $2,000 for qualified tuition and related expenses for a 16-hour work load for the 1999 Spring semester. Prior to beginning classes, Student B withdraws from a 4-hour course. On January 15, 1999, Student B files her 1998 income tax return and claims a $400 Lifetime Learning Credit for the $2,000 qualified expenses paid in 1998, which reduces her tax liability for 1998 by $400. On February 15, 1999, Student B receives a $500 refund from College Y.</P> <P>(ii) Student B calculates the increase in tax for 1999 by—</P> <P>(A) Calculating the redetermined qualified expenses for 1998 ($2,000 − $500 = $1,500);</P> <P>(B) Calculating the redetermined credit for the redetermined qualified expenses ($1,500 × .20 = $300); and</P> <P>(C) Calculating the difference in tax liability for 1998 resulting from the redetermined credit. Because Student B's tax liability for 1998 was reduced by the full amount of the $400 education tax credit claimed on her 1998 income tax return, the difference in tax liability can be determined by subtracting the redetermined credit from the credit claimed in 1998 ($400−$300 = $100).</P> <P>(iii) Therefore, Student B must increase the tax on her 1999 federal income tax return by $100.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>In September 1998, Student C pays College Z $1,200 in qualified tuition and related expenses to attend evening classes during the 1998 Fall semester. Student C is an employee of Company R. On January 15, 1999, Student C files a federal income tax return for 1998 claiming a Lifetime Learning Credit of $240 (.20 x $1,200), which reduces Student C's tax liability for 1998 by $240. Pursuant to an educational assistance program described in section 127(b), Company R reimburses Student C in February 1999 for the $1,200 of qualified tuition and related expenses paid by Student C in 1998. The $240 education tax credit claimed by Student C for 1998 is subject to recapture. Because Student C paid no net qualified tuition and related expenses for 1998, the redetermined credit for 1998 is zero. Student C must increase the amount of Student C's 1999 tax by the recapture amount, which is $240 (the difference in tax liability for 1998 resulting from the redetermined credit for 1998 ($0)). Because the $1,200 reimbursement relates to expenses for which the taxpayer claimed an education tax credit in a prior year, the reimbursement does not reduce the amount of any qualified tuition and related expenses that Student C paid in 1999.</P> </EXAMPLE> <CITA>[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.28-0</SECTNO> <SUBJECT>Credit for clinical testing expenses for certain drugs for rare diseases or conditions; table of contents.</SUBJECT> <P>In order to facilitate use of § 1.28-1, this section lists the paragraphs, subparagraphs, and subdivisions contained in § 1.28-1. </P> <EXTRACT> <P>(a) General rule.</P> <P>(b) Qualified clinical testing expenses.</P> <P>(1) In general.</P> <P>(2) Modification of section 41(b).</P> <P>(3) Exclusion for amounts funded by another person.</P> <P>(i) In general.</P> <P>(ii) Clinical testing in which taxpayer retains no rights.</P> <P>(iii) Clinical testing in which taxpayer retains substantial rights.</P> <P>(A) In general.</P> <P>(B) Drug by drug determination.</P> <P>(iv) Funding for qualified clinical testing expenses determinable only in subsequent taxable years.</P> <P>(4) Special rule governing the application of section 41(b) beyond its expiration date.</P> <P>(c) Clinical testing.</P> <P>(1) In general.</P> <P>(2) Definition of “human clinical testing”.</P> <P>(3) Definition of “carried out under” section 505(i).</P> <P>(d) Definition and special rules.</P> <P>(1) Definition of “rare disease or condition”.</P> <P>(i) In general.</P> <P>(ii) Cost of developing and making available the designated drug.</P> <P>(A) In general.</P> <P>(B) Exclusion of costs funded by another person.</P> <P>(C) Computation of cost.</P> <P>(D) Allocation of common costs. Costs for developing and making available the designated drug for both the disease or condition for which it is designated and one or more other diseases or conditions.<PRTPAGE P="91"/> </P> <P>(iii) Recovery from sales.</P> <P>(iv) Recordkeeping requirements.</P> <P>(2) Tax liability limitation.</P> <P>(i) Taxable years beginning after December 31, 1986.</P> <P>(ii) Taxable years beginning before January 1, 1987, and after December 31, 1983.</P> <P>(iii) Taxable years beginning before January 1, 1984.</P> <P>(3) Special limitations on foreign testing.</P> <P>(i) Clinical testing conducted outside the United States—In general.</P> <P>(ii) Insufficient testing population in the United States.</P> <P>(A) In general.</P> <P>(B) “Insufficient testing population”.</P> <P>(C) “Unrelated to the taxpayer”.</P> <P>(4) Special limitations for certain corporations.</P> <P>(i) Corporations to which section 936 applies.</P> <P>(ii) Corporations to which section 934(b) applies.</P> <P>(5) Aggregation of expenditures.</P> <P>(i) Controlled group of corporations: organizations under common control.</P> <P>(A) In general.</P> <P>(B) Definition of controlled group of corporations.</P> <P>(C) Definition of organization.</P> <P>(D) Determination of common control.</P> <P>(ii) Tax accounting periods used.</P> <P>(A) In general.</P> <P>(B) Special rule where the timing of clinical testing is manipulated.</P> <P>(iii) Membership during taxable year in more than one group.</P> <P>(iv) Intra-group transactions.</P> <P>(A) In general.</P> <P>(B) In-house research expenses.</P> <P>(C) Contract research expenses.</P> <P>(D) Lease payments.</P> <P>(E) Payments for supplies.</P> <P>(6) Allocations.</P> <P>(i) Pass-through in the case of an S corporation</P> <P>(ii) Pass-through in the case of an estate or a trust.</P> <P>(iii) Pass-through in the case of a partnership.</P> <P>(A) In general.</P> <P>(B) Certain partnership non-business expenditures.</P> <P>(C) Apportionment.</P> <P>(iv) Year in which taken into account.</P> <P>(v) Credit allowed subject to limitation.</P> <P>(7) Manner of making an election.</P> </EXTRACT> <CITA>[T.D. 8232, 53 FR 38710, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.28-1</SECTNO> <SUBJECT>Credit for clinical testing expenses for certain drugs for rare diseases or conditions.</SUBJECT> <P>(a) <E T="03">General rule.</E> Section 28 provides a credit against the tax imposed by chapter 1 of the Internal Revenue Code. The amount of the credit is equal to 50 percent of the qualified clinical testing expenses (as defined in paragraph (b) of this section) for the taxable year. The credit applies to qualified clinical testing expenses paid or incurred by the taxpayer after December 31, 1982, and before January 1, 1991. The credit may not exceed the taxpayer's tax liability for the taxable year (as determined under paragraph (d)(2) of this section).</P> <P>(b) <E T="03">Qualified clinical testing expenses</E>—(1) <E T="03">In general.</E> Except as otherwise provided in paragraph (b)(3) of this section, the term “qualified clinical testing expenses” means the amounts which are paid or incurred during the taxable year which would constitute “qualified research expenses” within the meaning of section 41(b) (relating to the credit for increasing research activities) as modified by section 28(b)(1)(B) and paragraph (b)(2) of this section. For example, amounts paid or incurred for the acquisition of depreciable property used in the conduct of clinical testing (as defined in paragraph (c) of this section) are not qualified clinical testing expenses.</P> <P>(2) <E T="03">Modification of section 41(b).</E> For purposes of paragraph (b)(1) of this section, section 41(b) is modified by substituting “clinical testing” for “qualified research” each place it appears in paragraph (2) of section 41(b) (relating to in-house research expenses) and paragraph (3) of section 41(b) (relating to contract research expenses). In addition, “100 percent” is substituted for “65 percent” in paragraph (3)(A) of section 41(b).</P> <P>(3) <E T="03">Exclusion for amounts funded by another person—</E>(i) <E T="03">In general.</E> The term “qualified clinical testing expenses” shall not include any amount which would otherwise constitute qualified clinical testing expenses, to the extent such amount is funded by a grant, contract, or otherwise by another person (or any governmental entity). The determination of the extent to which an amount is funded shall be made in light of all the facts and circumstances. For a special rule regarding funding between commonly controlled businesses, see paragraph (d)(5)(iv) of § 1.28-1.</P> <P>(ii) <E T="03">Clinical testing in which taxpayer retains no rights.</E> If a taxpayer conducting clinical testing with respect to <PRTPAGE P="92"/>the designated drug for another person retains no substantial rights in the clinical testing under the agreement providing for the clinical testing the taxpayer's clinical testing expenses are treated as fully funded for purposes of section 28(b)(1)(C). Thus, for example, if the taxpayer incurs clinical testing expenses under an agreement that confers on another person the exclusive right to exploit the results of the clinical testing, those expenses do not constitute qualified clinical testing expenses because they are fully funded under this paragraph (b)(3)(ii). Incidental benefits to the taxpayer from the conduct of the clinical testing (for example, increased experience in the field of human clinical testing) do not constitute substantial rights in the clinical testing.</P> <P>(iii) <E T="03">Clinical testing in which taxpayer retains substantial rights—</E>(A) <E T="03">In general.</E> If a taxpayer conducting clinical testing with respect to the designated drug for another person retains substantial rights in the clinical testing under the agreement providing for the clinical testing, the clinical testing expenses are funded to the extent of the payments (and fair market value of any property at the time of transfer) to which the taxpayer becomes entitled by conducting the clinical testing. The taxpayer shall reduce the amount paid or incurred by the taxpayer for the clinical testing expenses that would, but for section 28(b)(1)(C) constitute qualified clinical testing expenses of the taxpayer by the amount of the funding determined under the preceding sentence. Rights retained in the clinical testing are not treated as property for purposes of this paragraph (b)(3)(iii)(A). If the property that is transferred to the taxpayer is to be consumed in the clinical testing (for example, supplies), the taxpayer should exclude the value of that property from both the payments received and the expenses paid or incurred for the clinical testing.</P> <P>(B) <E T="03">Drug by drug determination.</E> The provisions of this paragraph (b)(3) shall be applied separately to each designated drug tested by the taxpayer.</P> <P>(iv) <E T="03">Funding for qualified clinical testing expenses determinable only in subsequent taxable years.</E> If, at the time the taxpayer files its return for a taxable year, it is impossible to determine to what extent some or all of the qualified clinical testing expenses may be funded, the taxpayer shall treat the clinical testing expenses as fully funded for purposes of that return. When the amount of funding for qualified clinical testing expenses is finally determined, the taxpayer should amend the return and any interim returns to reflect the amount of funding for qualified clinical testing expenses.</P> <P>(4) <E T="03">Special rule governing the application of section 41(b) beyond its expiration date.</E> For purposes of section 28 and this section, section 41(b), as amended, and the regulations thereunder shall be deemed to remain in effect after December 31, 1988.</P> <P>(c) <E T="03">Clinical testing—</E>(1) <E T="03">In general.</E> The term “clinical testing” means any human clinical testing which—</P> <P>(i) Is carried out under an exemption under section 505(i) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(i)) and the regulations relating thereto (21 CFR part 312) for the purpose of testing a drug for a rare disease or condition as defined in paragraph (d)(1) of this section,</P> <P>(ii) Occurs after the date the drug is designated as a drug for a rare disease or condition under section 526 of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 360bb),</P> <P>(iii) Occurs before the date on which an application for the designated drug is approved under section 505(b) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(b)) or, if the drug is a biological product (other than a radioactive biological product intended for human use), before the date on which a license for such drug is issued under section 351 of the Public Health Services Act (42 U.S.C. 262), and</P> <P>(iv) Is conducted by or on behalf of the taxpayer to whom the designation under section 526 of the Federal Food, Drug, and Cosmetic Act applies.</P> <FP>Human clinical testing shall be taken into account under this paragraph (c)(1) only to the extent that the testing relates to the use of a drug for the rare disease or condition for which the drug was designated under section 526 of the Federal Food, Drug, and Cosmetic Act. For purposes of paragraph <PRTPAGE P="93"/>(c)(1)(i) of this section the testing under section 505(i) exemption procedures (21 CFR part 312) of a biological product (other than a radioactive biological product intended for human use) pursuant to 21 CFR § 601.21 is deemed to be carried out under an exemption under section 505(i) of the Federal Food, Drug, and Cosmetic Act.</FP> <P>(2) <E T="03">Definition of “human clinical testing.”</E> Testing is considered to be human clinical testing only to the extent that it uses human subjects to determine the effect of the designated drug on humans and is necessary for the designated drug either to be approved under section 505(b) of the Federal Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 314), or if the designated drug is a biological product (other than a radioactive biological product intended for human use), to be licensed under section 351 of the Public Health Services Act and the regulations thereunder (21 CFR part 601). For purposes of this paragraph (c)(2), a human subject is an individual who is a participant in research, either as a recipient of the drug or as a control. A subject may be either a healthy individual or a patient.</P> <P>(3) <E T="03">Definition of “carried out under” section 505(i).</E> Human clinical testing is not carried out under section 505(i) of the Federal Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 312) unless the primary purpose of the human clinical testing is to ascertain the data necessary to qualify the designated drug for sale in the United States, and not to ascertain data unrelated or only incidentally related to that needed to qualify the designated drug. Whether or not this primary purpose test is met shall be determined in light of all of the facts and circumstances.</P> <P>(d) <E T="03">Definition and special rules—</E>(1) <E T="03">Definition of “rare disease or condition”—</E>(i) <E T="03">In general.</E> The term “rare disease or condition” means any disease or condition which—</P> <P>(A) Afflicts 200,000 or fewer persons in the United States, or</P> <P>(B) Afflicts more than 200,000 persons in the United States but for which there is no reasonable expectation that the cost of developing and making available in the United States (as defined in section 7701(a)(9)) a drug for such disease or condition will be recovered from sales in the United States (as so defined) of such drug.</P> <FP>Determinations under paragraph (d)(1)(i)(B) of this section with respect to any drug shall be made on the basis of the facts and circumstances as of the date such drug is designated under section 526 of the Federal Food, Drug, and Cosmetic Act. Examples of diseases or conditions which in 1987 afflicted 200,000 or fewer persons in the United States are Duchenne dystrophy, one of the muscular dystrophies; Huntington's disease, a hereditary chorea; myoclonus; Tourette's syndrome; and amyotrophic lateral sclerosis (ALS or Lou Gehrig's disease).</FP> <P>(ii) <E T="03">Cost of developing and making available the designated drug—</E>(A) <E T="03">In general.</E> Except as otherwise provided in this paragraph (d)(1)(ii), the taxpayer's computation of the cost of developing and making available in the United States the designated drug shall include only the costs that the taxpayer (or any person whose right to make sales of the drug is directly or indirectly derived from the taxpayer, e.g., a licensee or transferee) has incurred or reasonably expects to incur in developing and making available in the United States the designated drug for the disease or condition for which it is designated. For example, if, prior to designation under section 526, the taxpayer incurred costs of $125,000 to test the drug for the rare disease or condition for which it is subsequently designated and incurred $500,000 to test the same drug for other diseases, and if, on the date of designation, the taxpayer expects to incur costs of $1.2 million to test the drug for the rare disease or condition for which it is designated, the taxpayer shall include in its cost computation both the $125,000 incurred prior to designation and the $1.2 million expected to be incurred after designation to test the drug for the rare disease or condition for which it is designated. The taxpayer shall not include the $500,000 incurred to test the drug for other diseases.</P> <P>(B) <E T="03">Exclusion of costs funded by another person.</E> In computing the cost of developing and making available in the United States the designated drug, the <PRTPAGE P="94"/>taxpayer shall not include any cost incurred or expected to be incurred by the taxpayer to the extent that the cost is funded or is reasonably expected to be funded (determined under the principles of paragraph (b)(3)) by a grant, contract, or otherwise by another person (or any governmental entity).</P> <P>(C) <E T="03">Computation of cost.</E> The cost computation shall use only reasonable costs incurred after the first indication of an orphan application for the designated drug. Such costs shall include the costs of obtaining data needed, and of meetings to be held, in connection with a request for FDA assistance under section 525 of the Federal, Food, Drug, and Cosmetic Act (21 U.S.C. 360aa) or a request for orphan designation under section 526 of that Act; costs of determining patentability of the drug; costs of screening, animal and clinical studies; costs associated with preparation of a Notice of Claimed Investigational Exemption for a New Drug (IND) and a New Drug Application (NDA); costs of possible distribution of drug under a “treatment” protocol; costs of development of a dosage form; manufacturing costs; distribution costs; promotion costs; costs to maintain required records and reports; and costs of the taxpayer in acquiring the right to market a drug from the owner of that right prior to designation. The taxpayer shall also include general overhead, depreciation costs and premiums for insurance against liability losses to the extent that the taxpayer can demonstrate that these costs are properly allocable to the designated drug under the established standards of financial accounting and reporting of research and development costs.</P> <P>(D) <E T="03">Allocation of common costs. Costs for developing and making available the designated drug for both the disease or condition for which it is designated and one or more other diseases or conditions.</E> In the case where the costs incurred or expected to be incurred in developing and making available the designated drug for the disease or condition for which it is designated are also incurred or expected to be incurred in developing and making available in the United States the same drug for one or more other diseases or conditions (whether or not they are also designated or expected to be designated), the costs shall be allocated between the cost of developing and making available the designated drug for the disease or condition for which the drug is designated and the cost of developing and making available the designated drug for the other diseases or conditions. The amount of the common costs to be allocated to the cost of developing and making available the designated drug for the disease or condition for which it is designated is determined by multiplying the common costs by a fraction the numerator of which is the sum of the expected amount of sales in the United States of the designated drug for the disease or condition for which the drug is designated and the denominator of which is the total expected amount of sales in the United States of the designated drug. For example, if prior to designation, the taxpayer incurs (among other costs) costs of $100,000 in testing the designated drug for its toxic effect on animals (without reference to any disease or condition), and if the taxpayer expects to recover $500,000 from sales in the United States of the designated drug for disease X, the disease for which the drug is designated, and further expects to recover another $1.5 million from the sales in the United States of the designated drug for disease Y, the taxpayer must allocate a proportionate amount of the common costs of $100,000 to the cost of developing and making available the designated drug for both disease X and disease Y. Since the ratio of the expected amount of sales in the United States of the designated drug for disease X to the total of both the expected amount of sales in the United States of the designated drug for disease X and the expected amount of sales in the United States of the designated drug for disease Y is $500,000/$2,000,000, 25% of the common costs of $100,000 (<E T="03">i.e.,</E> $25,000) is allocated to the cost of developing and making available the designated drug for disease X.</P> <P>(iii) <E T="03">Recovery from sales.</E> In determining whether the taxpayer's cost described in paragraph (d)(1)(ii) of this section will be recovered from sales in <PRTPAGE P="95"/>the United States of the designated drug for the disease or condition for which the drug is designated, the taxpayer shall include anticipated sales by the taxpayer or any person whose right to make such sales is directly or indirectly derived from the taxpayer (such as a licensee or transferee). The anticipated sales shall be based upon the size of the anticipated patient population for which the designated drug would be useful, including the following factors: the degree of effectiveness and safety of the designated drug, if known: the projected fraction of the anticipated patient population expected to be given the designated drug and to continue to take it; other available agents and other types of therapy; the likelihood that superior agents will become available within a few years; and the number of years during which the designated drug would be exclusively available, <E T="03">e.g.,</E> under a patent.</P> <P>(iv) <E T="03">Recordkeeping requirements.</E> The taxpayer shall keep records sufficient to substantiate the cost and sales estimates made pursuant to this paragraph (d)(1). The records required by this paragraph (d)(1)(iv) shall be retained so long as the contents thereof may become material in the administration of section 28.</P> <P>(2) <E T="03">Tax liability limitation</E>—(i) <E T="03">Taxable years beginning after December 31, 1986.</E> The credit allowed by section 28 shall not exceed the excess (if any) of—</P> <P>(A) The taxpayer's regular tax liability for the taxable year (as defined in section 26(b)), reduced by the sum of the credits allowable under—</P> <P>(<E T="03">1</E>) Section 21 (relating to expenses for household and dependent care services necessary for gainful employment),</P> <P>(<E T="03">2</E>) Section 22 (relating to the elderly and permanently and totally disabled),</P> <P>(<E T="03">3</E>) Section 23 (relating to residential energy),</P> <P>(<E T="03">4</E>) Section 25 (relating to interest on certain home mortgages), and</P> <P>(<E T="03">5</E>) Section 27 (relating to taxes on foreign countries and possessions of the United States), over</P> <P>(B) The tentative minimum tax for the taxable year (as determined under section 55(b)(1)).</P> <P>(ii) <E T="03">Taxable years beginning before January 1, 1987, and after December 31, 1983.</E> The credit allowed by section 28 shall not exceed the taxpayer's tax liability for the taxable year (as defined in section 26 (b) prior to its amendment by the Tax Reform Act of 1986 (Pub. L. 99-514)), reduced by the sum of the credits allowable under—</P> <P>(A) Section 21 (relating to expenses for household dependent care services necessary for gainful employment),</P> <P>(B) Section 22 (relating to the elderly and permanently and totally disabled),</P> <P>(C) Section 23 (relating to residential energy),</P> <P>(D) Section 24 (relating to contributions to candidates for public office),</P> <P>(E) Section 25 (relating to interest on certain home mortgages), and</P> <P>(F) Section 27 (relating to the taxes on foreign countries and possessions of the United States).</P> <P>(iii) <E T="03">Taxable years beginning before January 1, 1984.</E> The credit allowed by section 28 shall not exceed the amount of the tax imposed by chapter 1 of the Internal Revenue Code for the taxable year, reduced by the sum of the credits allowable under the following sections as designated prior to the enactment of the Tax Reform Act of 1984 (Pub. Law 98-369):</P> <P>(A) Section 32 (relating to tax withheld at source on nonresident aliens and foreign corporations and on tax-free convenant bonds),</P> <P>(B) Sections 33 (relating to taxes of foreign countries and possessions of the United States),</P> <P>(C) Section 37 (relating to the retirement income),</P> <P>(D) Section 38 (relating to investment in certain depreciable property),</P> <P>(E) Section 40 (relating to expenses of work incentive programs).</P> <P>(F) Section 41 (relating to contributions to candidates for public office).</P> <P>(G) Section 44 (relating to purchase of new principal residence).</P> <P>(H) Section 44A (relating to expenses for household and dependent care services necessary for gainful employment).</P> <P>(I) Section 44B (relating to employment of certain new employees).</P> <P>(J) Section 44C (relating to residential energy).</P> <P>(K) Section 44D (relating to producing fuel from a nonconventional source).<PRTPAGE P="96"/> </P> <P>(L) Section 44E (relating to alcohol used as fuel).</P> <P>(M) Section 44F (relating to increasing research activities), and</P> <P>(N) Section 44G (relating to employee stock ownership).</P> <FP>The term “tax imposed by chapter 1” as used in this paragraph (d)(2)(iii) does not include any tax treated as not imposed by chapter 1 of the Internal Revenue Code under the last sentence of section 53(a).</FP> <P>(3) <E T="03">Special limitations on foreign testing—</E>(i) <E T="03">Clinical testing conducted outside of the United States—In general.</E> Except as otherwise provided in this paragraph (d)(3), expenses paid or incurred with respect to clinical testing conducted outside the United States (as defined in section 7701(a)(9)) are not eligible for credit under this section. Thus, for example, wages paid an employee clinical investigator for clinical testing conducted in medical facilities in the United States and Mexico generally must be apportioned between the clinical testing conducted within the United States and the clinical testing conducted outside the United States, and only the wages apportioned to the clinical testing conducted within the United States are qualified clinical testing expenses.</P> <P>(ii) <E T="03">Insufficient testing population in the United States</E>—(A) <E T="03">In general.</E> If clinical testing is conducted outside of the United States because there is an insufficient testing population in the United States, and if the clinical testing is conducted by a United States person (as defined in section 7701(a)(30)) or is conducted by any other person unrelated to the taxpayer to whom the designation under section 526 of the Federal Food, Drug, and Cosmetic Act applies, then the expenses paid or incurred for clinical testing conducted outside of the United States are eligible for the credit provided by section 28.</P> <P>(B) “<E T="03">Insufficient testing population.</E>” The testing population in the United States is insufficient if there are not within the United States the number of available and appropriate human subjects needed to produce reliable data from the clinical investigation.</P> <P>(C) “<E T="03">Unrelated to the taxpayer.</E>” For the purpose of determining whether a person is unrelated to the taxpayer to whom the designation under section 526 of the Federal Food, Drug, and Cosmetic Act and the regulations thereunder applies, the rules of section 613A(d)(3) shall apply except that the number “5” in section 613A(d)(3) (A), (B), and (C) shall be deleted and the number “10” inserted in lieu thereof.</P> <P>(4) <E T="03">Special limitations for certain corporations—</E>(i) <E T="03">Corporations to which section 936 applies.</E> Expenses paid or incurred for clinical testing conducted either inside or outside the United States by a corporation to which section 936 (relating to Puerto Rico and possessions tax credit) applies are not eligible for the credit under section 28.</P> <P>(ii) <E T="03">Corporations to which section 934(b) applies.</E> For taxable years beginning before January 1, 1987, expenses paid or incurred for clinical testing conducted either inside or outside the United States by a corporation to which section 934(b) (relating to the limitation on reduction in income tax liability incurred to the Virgin Islands), as in effect prior to its amendment by the Tax Reform Act of 1986, applies are not eligible for the credit under section 28. For taxable years beginning after December 31, 1986, see section 1277(c)(1) of the Tax Reform Act of 1986 (100 Stat. 2600) which makes the rule set forth in the preceding sentence inapplicable with respect to corporations created or organized in the Virgin Islands only if (and so long as) an implementing agreement described in that section is in effect between the United States and the Virgin Islands.</P> <P>(5) <E T="03">Aggregation of expenditures—</E>(i) <E T="03">Controlled group of corporations; organizations under common control—</E>(A) <E T="03">In general.</E> In determining the amount of the credit allowable with respect to an organization that at the end of its taxable year is a member of a controlled group of corporations or a member of a group of organizations under common control, all members of the group are treated as a single taxpayer and the credit (if any) allowable to the member is determined on the basis of its proportionate share of the qualified clinical testing expenses of the aggregated group.<PRTPAGE P="97"/> </P> <P>(B) <E T="03">Definition of controlled group of corporations.</E> For purposes of this section, the term “controlled group of corporations” shall have the meaning given to the term by section 41(f)(5).</P> <P>(C) <E T="03">Definition of organization.</E> For purposes of this section, an organization is a sole proprietorship, a partnership, a trust, an estate, or a corporation, that is carrying on a trade or business (within the meaning of section 162). For purposes of this section, any corporation that is a member of a commonly controlled group shall be deemed to be carrying on a trade or business if any other member of that group is carrying on any trade or business.</P> <P>(D) <E T="03">Determination of common control.</E> Whether organizations are under common control shall be determined under the principles set forth in paragraphs (b) through (g) of 26 CFR 1.52-1.</P> <P>(ii) <E T="03">Tax accounting periods used—</E>(A) <E T="03">In general.</E> The credit allowable to a member of a controlled group of corporations or a group of organizations under common control is that member's share of the aggregate credit computed as of the end of such member's taxable year.</P> <P>(B) <E T="03">Special rule where the timing of clinical testing is manipulated.</E> If the timing of clinical testing by members using different tax accounting periods is manipulated to generate a credit in excess of the amount that would be allowable if all members of the group used the same tax accounting period, the district director may require all members of the group to calculate the credit in the current taxable year and all future years by using the “conformed years” method. Each member computing a credit under the “conformed years” method shall compute the credit as if all members of the group had the same taxable year as the computing member.</P> <P>(iii) <E T="03">Membership during taxable year in more than one group.</E> An organization may be a member of only one group for a taxable year. If, without application of this paragraph (d)(5)(iii), an organization would be a member of more than one group at the end of its taxable year, the organization shall be treated as a member of the group in which it was included for its preceding taxable year. If the organization was not included for its preceding taxable year in any group in which it could be included as of the end of its taxable year, the organization shall designate in its timely filed return the group in which it is being included. If the return for a taxable year is due before May 1, 1985, the organization may designate its group membership through an amended return for that year filed on or before April 30, 1985. If the organization does not so designate, then the district director with audit jurisdiction of the return will determine the group in which the business is to be included.</P> <P>(iv) <E T="03">Intra-group transactions—</E> (A) <E T="03">In general.</E> Because all members of a group under common control are treated as a single taxpayer for purposes of determining the credit, transactions between members of the group are generally disregarded.</P> <P>(B) <E T="03">In-house research expenses.</E> If one member of a group conducts clinical testing on behalf of another member, the member conducting the clinical testing shall include in its qualified clinical testing expenses any in-house research expenses for that work and shall not treat any amount received or accrued from the other member as funding the clinical testing. Conversely, the member for whom the clinical testing is conducted shall not treat any part of any amount paid or incurred as a contract research expense. For purposes of determining whether the in-house research for that work is clinical testing, the member performing the clinical testing shall be treated as carrying on any trade or business carried on by the member on whose behalf the clinical testing is performed.</P> <P>(C) <E T="03">Contract research expenses.</E> If a member of a group pays or incurs contract research expenses to a person outside the group in carrying on the member's trade or business, that member shall include those expenses as qualified clinical testing expenses. However, if the expenses are not paid or incurred in carrying on any trade or business of that member, those expenses may be taken into account as contract research expenses by another member of the group provided that the other member—<PRTPAGE P="98"/> </P> <P>(<E T="03">1</E>) Reimburses the member paying or incurring the expenses, and</P> <P>(<E T="03">2</E>) Carries on a trade or business to which the clinical testing relates.</P> <P>(D) <E T="03">Lease payments.</E> Amounts paid or incurred to another member of the group for the lease of personal property owned by a person outside the group shall be taken into account as in-house research expenses for purposes of section 28 only to the extent of the lesser of—</P> <P>(<E T="03">1</E>) The amount paid or incurred to the other member, or</P> <P>(<E T="03">2</E>) The amount of the lease expense paid to a person outside the group.</P> <P>The amount paid or incurred to another member of the group for the lease of personal property owned by a member of the group is not taken into account for purposes of section 28.</P> <P>(E) <E T="03">Payment for supplies.</E> Amounts paid or incurred to another member of the group for supplies shall be taken into account as in-house research expenses for purposes of section 28 only to the extent of the lesser of—</P> <P>(<E T="03">1</E>) The amount paid or incurred to the other member, or</P> <P>(<E T="03">2</E>) The amount of the other member's basis in the supplies.</P> <P>(6) <E T="03">Allocations</E>—(i) <E T="03">Pass-through in the case of an S corporation.</E> In the case of an S corporation (as defined in section 1361), the amount of the credit for qualified clinical testing expenses computed for the corporation for any taxable year shall be allocated among the persons who are shareholders of the corporation during the taxable year according to the provisions of section 1366 and section 1377.</P> <P>(ii) <E T="03">Pass-through in the case of an estate or a trust.</E> In the case of an estate or a trust, the amount of the credit for qualified clinical testing expenses computed for the estate or trust for any taxable year shall be apportioned between the estate or trust and the beneficiaries on the basis of the income of the estate or trust allocable to each.</P> <P>(iii) <E T="03">Pass-through in the case of a partnership—</E>(A) <E T="03">In general.</E> In the case of a partnership, the credit for qualified clinical testing expenses computed for the partnership for any taxable year shall be apportioned among the persons who are partners during the taxable year in accordance with section 704 and the regulations thereunder.</P> <P>(B) <E T="03">Certain partnership non-business expenditures.</E> A partner's share of an in-house research expense or contract research expense paid or incurred by a partnership other than in carrying on a trade or business of the partnership constitutes a qualified clinical testing expense of the partner if—</P> <P>(<E T="03">1</E>) The partner is entitled to make independent use of the result of the clinical testing, and</P> <P>(<E T="03">2</E>) The clinical testing expense paid or incurred in carrying on the clinical testing would have been paid or incurred by the partner in carrying on a trade or business of the partner if the partner had carried on the clinical testing that was in fact carried on by the partnership.</P> <P>(C) <E T="03">Apportionment.</E> Qualified clinical testing expenses to which paragraph (d)(6)(iii)(B) of this section applies shall be apportioned among the persons who are partners during the taxable year in accordance with section 704 and the regulations thereunder. For purposes of section 28, these expenses shall be treated as paid or incurred directly by the partners rather than by the partnership. Thus, the partnership shall disregard these expenses in computing the credit to be apportioned under paragraph (d)(6)(iii)(A) of this section, and each partner shall aggregate the portion of these expenses allocated to the partner with other qualified clinical testing expenses of the partner in making the computations under section 28.</P> <P>(iv) <E T="03">Year in which taken into account.</E> An amount apportioned to a person under paragraph (d)(6) of this section shall be taken into account by the person in the taxable year of such person in which or with which the taxable year of the corporation, estate, trust, or partnership (as the case may be) ends.</P> <P>(v) <E T="03">Credit allowed subject to limitation.</E> Any person to whom any amount has been apportioned under paragraph (d)(6)(i), (ii), or (iii) of this section is allowed, subject to the limitation provided in section 28(d)(2), a credit for that amount.</P> <P>(7) <E T="03">Manner of making an election.</E> To make an election to have section 28 <PRTPAGE P="99"/>apply for its taxable year, the taxpayer shall file Form 6765 (Credit for Increasing Research Activities (or for claiming the orphan drugs credit)) containing all the information required by that form.</P> <CITA>[T.D. 8232, 53 FR 38711, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988; 53 FR 41013, Oct. 19, 1988]</CITA> </SECTION> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">Credits Against Tax</HD> </SUBJGRP> <SUBJGRP> <HD SOURCE="HED">credits allowable under sections 30 through 45D</HD> <SECTION> <SECTNO>§ 1.30-1</SECTNO> <SUBJECT>Definition of qualified electric vehicle and recapture of credit for qualified electric vehicle.</SUBJECT> <P>(a) <E T="03">Definition of qualified electric vehicle.</E> A qualified electric vehicle is a motor vehicle that meets the requirements of section 30(c). Accordingly, a qualified electric vehicle does not include any motor vehicle that has ever been used (for either personal or business use) as a non-electric vehicle.</P> <P>(b) <E T="03">Recapture of credit for qualified electric vehicle—</E>(1) <E T="03">In general</E>—(i) <E T="03">Addition to tax.</E> If a recapture event occurs with respect to a taxpayer's qualified electric vehicle, the taxpayer must add the recapture amount to the amount of tax due in the taxable year in which the recapture event occurs. The recapture amount is not treated as income tax imposed on the taxpayer by chapter 1 of the Internal Revenue Code for purposes of computing the alternative minimum tax or determining the amount of any other allowable credits for the taxable year in which the recapture event occurs.</P> <P>(ii) <E T="03">Reduction of carryover.</E> If a recapture event occurs with respect to a taxpayer's qualified electric vehicle, and if a portion of the section 30 credit for the cost of that vehicle was disallowed under section 30(b)(3)(B) and consequently added to the taxpayer's minimum tax credit pursuant to section 53(d)(1)(B)(iii), the taxpayer must reduce its minimum tax credit carryover by an amount equal to the portion of any minimum tax credit carryover attributable to the disallowed section 30 credit, multiplied by the recapture percentage for the taxable year of recapture. Similarly, the taxpayer must reduce any other credit carryover amounts (such as under section 469) by the portion of the carryover attributable to section 30, multiplied by the recapture percentage.</P> <P>(2) <E T="03">Recapture event</E>—(i) <E T="03">In general.</E> A recapture event occurs if, within 3 full years from the date a qualified electric vehicle is placed in service, the vehicle ceases to be a qualified electric vehicle. A vehicle ceases to be a qualified electric vehicle if—</P> <P>(A) The vehicle is modified so that it is no longer primarily powered by electricity;</P> <P>(B) The vehicle is used in a manner described in section 50(b); or</P> <P>(C) The taxpayer receiving the credit under section 30 sells or disposes of the vehicle and knows or has reason to know that the vehicle will be used in a manner described in paragraph (b)(2)(i)(A) or (B) of this section.</P> <P>(ii) <E T="03">Exception for disposition.</E> Except as provided in paragraph (b)(2)(i)(C) of this section, a sale or other disposition (including a disposition by reason of an accident or other casualty) of a qualified electric vehicle is not a recapture event.</P> <P>(3) <E T="03">Recapture amount.</E> The recapture amount is equal to the recapture percentage times the decrease in the credits allowed under section 30 for all prior taxable years that would have resulted solely from reducing to zero the cost taken into account under section 30 with respect to such vehicle, including any credits allowed attributable to section 30 (such as under sections 53 and 469).</P> <P>(4) <E T="03">Recapture date.</E> The recapture date is the actual date of the recapture event unless a recapture event described in paragraph (b)(2)(i)(B) of this section occurs, in which case the recapture date is the first day of the recapture year.</P> <P>(5) <E T="03">Recapture percentage.</E> For purposes of this section, the recapture percentage is—</P> <P>(i) 100, if the recapture date is within the first full year after the date the vehicle is placed in service;</P> <P>(ii) 66 <FR>2/3</FR>, if the recapture date is within the second full year after the date the vehicle is placed in service; or</P> <P>(iii) 33 <FR>1/3</FR>, if the recapture date is within the third full year after the date the vehicle is placed in service.<PRTPAGE P="100"/> </P> <P>(6) <E T="03">Basis adjustment.</E> As of the first day of the taxable year in which the recapture event occurs, the basis of the qualified electric vehicle is increased by the recapture amount and the carryover reductions taken into account under paragraphs (b)(1)(i) and (ii) of this section, respectively. For a vehicle that is of a character that is subject to an allowance for depreciation, this increase in basis is recoverable over the remaining recovery period for the vehicle beginning as of the first day of the taxable year of recapture.</P> <P>(7) <E T="03">Application of section 1245 for sales and other dispositions.</E> For purposes of section 1245, the amount of the credit allowable under section 30(a) with respect to any qualified electric vehicle that is (or has been) of a character subject to an allowance for depreciation is treated as a deduction allowed for depreciation under section 167. Therefore, upon a sale or other disposition of a depreciable qualified electric vehicle, section 1245 will apply to any gain recognized to the extent the basis of the depreciable vehicle was reduced under section 30(d)(1) net of any basis increase described in paragraph (b)(6) of this section.</P> <P>(8) <E T="03">Examples.</E> The following examples illustrate the provisions of this section: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A, a calendar-year taxpayer, purchases and places in service for personal use on January 1, 1995, a qualified electric vehicle costing $25,000. On A's 1995 federal income tax return, A claims a credit of $2,500. On January 2, 1996, A sells the vehicle to an unrelated third party who subsequently converts the vehicle into a non-electric vehicle on October 15, 1996. There is no recapture upon the sale of the vehicle by A provided A did not know or have reason to know that the purchaser intended to convert the vehicle to non-electric use.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>B, a calendar-year taxpayer, purchases and places in service for personal use on October 11, 1994, a qualified electric vehicle costing $20,000. On B's 1994 federal income tax return, B claims a credit of $2,000, which reduces B's tax by $2,000. The basis of the vehicle is reduced to $18,000 ($20,000−$2,000). On March 8, 1996, B sells the vehicle to a tax-exempt entity. Because B knowingly sold the vehicle to a tax-exempt entity described in section 50(b) in the second full year from the date the vehicle was placed in service, B must recapture $1,333 ($2,000×66 <FR>2/3</FR> percent). This recapture amount increases B's tax by $1,333 on B's 1996 federal income tax return and is added to the basis of the vehicle as of January 1, 1996, the beginning of the taxable year in which the recapture event occurred.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>X, a calendar-year taxpayer, purchases and places in service for business use on January 1, 1994, a qualified electric vehicle costing $30,000. On X's 1994 federal income tax return, X claims a credit of $3,000, which reduces X's tax by $3,000. The basis of the vehicle is reduced to $27,000 ($30,000−$3,000) prior to any adjustments for depreciation. On March 8, 1995, X converts the qualified electric vehicle into a gasoline-propelled vehicle. Because X modified the vehicle so that it is no longer primarily powered by electricity in the second full year from the date the vehicle was placed in service, X must recapture $2,000 ($3,000 × 66<FR>2/3</FR> percent). This recapture amount increases X's tax by $2,000 on X's 1995 federal income tax return. The recapture amount of $2,000 is added to the basis of the vehicle as of January 1, 1995, the beginning of the taxable year of recapture, and to the extent the property remains depreciable, the adjusted basis is recoverable over the remaining recovery period.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>The facts are the same as in <E T="03">Example 3.</E> In 1996, X sells the vehicle for $31,000, recognizing a gain from this sale. Under paragraph (b)(7) of this section, section 1245 will apply to any gain recognized on the sale of a depreciable vehicle to the extent the basis of the vehicle was reduced by the section 30 credit net of any basis increase from recapture of the section 30 credit. Accordingly, the gain from the sale of the vehicle is subject to section 1245 to the extent of the depreciation allowance for the vehicle plus the credit allowed under section 30 ($3,000), less the previous recapture amount ($2,000). Any remaining amount of gain may be subject to other applicable provisions of the Internal Revenue Code.</P> </EXAMPLE> <P>(c) <E T="03">Effective date.</E> This section is effective on October 14, 1994. If the recapture date is before the effective date of this section, a taxpayer may use any reasonable method to recapture the benefit of any credit allowable under section 30(a) consistent with section 30 and its legislative history. For this purpose, the recapture date is defined in paragraph (b)(4) of this section.</P> <CITA>[60 FR 39649, Aug. 3, 1995]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.31-1</SECTNO> <SUBJECT>Credit for tax withheld on wages.</SUBJECT> <P>(a) The tax deducted and withheld at the source upon wages under chapter 24 of the Internal Revenue Code of 1954 (or in the case of amounts withheld in 1954, <PRTPAGE P="101"/>under subchapter D, chapter 9 of the Internal Revenue Code of 1939) is allowable as a credit against the tax imposed by Subtitle A of the Internal Revenue Code of 1954, upon the recipient of the income. If the tax has actually been withheld at the source, credit or refund shall be made to the recipient of the income even though such tax has not been paid over to the Government by the employer. For the purpose of the credit, the recipient of the income is the person subject to tax imposed under Subtitle A upon the wages from which the tax was withheld. For instance, if a husband and wife domiciled in a State recognized as a community property State for Federal tax purposes make separate returns, each reporting for income tax purposes one- half of the wages received by the husband, each spouse is entitled to one-half of the credit allowable for the tax withheld at source with respect to such wages.</P> <P>(b) The tax withheld during any calendar year shall be allowed as a credit against the tax imposed by Subtitle A for the taxable year of the recipient of the income which begins in that calendar year. If such recipient has more than one taxable year beginning in that calendar year, the credit shall be allowed against the tax for the last taxable year so beginning.</P> </SECTION> <SECTION> <SECTNO>§ 1.31-2</SECTNO> <SUBJECT>Credit for “special refunds” of employee social security tax.</SUBJECT> <P>(a) <E T="03">In general.</E> (1) In the case of an employee receiving wages from more than one employer during the calendar year, amounts may be deducted and withheld as employee social security tax with respect to more than $3,600 of wages received during the calendar year 1954, and with respect to more than $4,200 of wages received during a calendar year after 1954. For example, employee social security tax may be deducted and withheld on $5,000 of wages received by an employee during a particular calendar year if the employee is paid wages in such year in the amount of $3,000 by one employer and in the amount of $2,000 by another employer. Section 6413(c) (as amended by section 202 of the Social Security Amendments of 1954 (68 Stat. 1089)), permits, under certain conditions, a so-called “special refund” of the amount of employee social security tax deducted and withheld with respect to wages paid to an employee in a calendar year after 1954 in excess of $4,200 ($3,600 for the calendar year 1954) by reason of the employee receiving wages from more than one employer during the calendar year. For provisions relating to the imposition of the employee tax and the limitation on wages, see with respect to the calendar year 1954, sections 1400 and 1426(a)(1) of the Internal Revenue Code of 1939 and, with respect to calendar years after 1954, sections 3101 and 3121(a)(1) of the Internal Revenue Code of 1954, as amended by sections 208(b) and 204(a), respectively, of the Social Security Amendments of 1954 (68 Stat. 1094, 1091).</P> <P>(2) An employee who is entitled to a special refund of employee tax with respect to wages received during a calendar year and who is also required to file an income tax return for such calendar year (or for his last taxable year beginning in such calendar year) may obtain the benefits of such special refund only by claiming credit for such special refund in the same manner as if such special refund were an amount deducted and withheld as income tax at the source. For provisions for claiming special refunds for 1955 and subsequent years in the case of employees not required to file income tax returns, see section 6413(c) and the regulations thereunder. For provisions relating to such refunds for 1954, see 26 CFR (1939) 408.802 (regulations 128).</P> <P>(3) The amount of the special refund allowed as a credit shall be considered as an amount deducted and withheld as income tax at the source under chapter 24 of the Internal Revenue Code of 1954 (or, in the case of a special refund for 1954, subchapter D, chapter 9 of the Internal Revenue Code of 1939). If the amount of such special refund when added to amounts deducted and withheld as income tax exceeds the taxes imposed by subtitle A of the Internal Revenue Code of 1954, the amount of the excess constitutes an overpayment of income tax under Subtitle A, and interest on such overpayment is allowed to the extent provided under section 6611 upon an overpayment of income tax resulting from a credit for income <PRTPAGE P="102"/>tax withheld at source. See section 6401(b).</P> <P>(b) <E T="03">Federal and State employees and employees of certain foreign corporations.</E> The provisions of this section shall apply to the amount of a special refund allowable to an employee of a Federal agency or a wholly owned instrumentality of the United States, to the amount of a special refund allowable to an employee of any State or political subdivision thereof (or any instrumentality of any one or more of the foregoing), and to the amount of a special refund allowable to employees of certain foreign corporations. See, with respect to such special refunds for 1954, section 1401(d)(4) of the Internal Revenue Code of 1939, and with respect to such special refunds for 1955 and subsequent years, section 6413(c)(2) of the Internal Revenue Code of 1954, as amended by section 202 of the Social Security amendments of 1954.</P> </SECTION> <SECTION> <SECTNO>§ 1.32-2</SECTNO> <SUBJECT>Earned income credit for taxable years beginning after December 31, 1978.</SUBJECT> <P>(a) [Reserved]</P> <P>(b) <E T="03">Limitations.</E> (1) [Reserved]</P> <P>(2) <E T="03">Married individuals.</E> No credit is allowed by section 32 in the case of an eligible individual who is married (within the meaning of section 7703 and the regulations thereunder) unless the individual and spouse file a single return jointly (a joint return) for the taxable year (see section 6013 and the regulations thereunder relating to joint returns of income tax by husband and wife). The requirements of the preceding sentence do not apply to an eligible individual who is not considered as married under section 7703(b) and the regulations thereunder (relating to certain married individuals living apart).</P> <P>(3) <E T="03">Length of taxable year.</E> No credit is allowed by section 32 in the case of a taxable year covering a period of less than 12 months. However, the rule of the preceding sentence does not apply to a taxable year closed by reason of the death of the eligible individual.</P> <P>(c) <E T="03">Definitions.</E> (1) [Reserved]</P> <P>(2) <E T="03">Earned income.</E> For purposes of this section, earned income is computed without regard to any community property laws which may otherwise be applicable. Earned income is reduced by any net loss in earnings from self-employment. Earned income does not include amounts received as a pension, an annuity, unemployment compensation, or workmen's compensation, or an amount to which section 871(a) and the regulations thereunder apply (relating to income of nonresident alien individuals not connected with United States business).</P> <P>(d) [Reserved]</P> <P>(e) <E T="03">Coordination of credit with advance payments</E>—(1) <E T="03">Recapture of excess advance payments.</E> If any advance payment of earned income credit under section 3507 is made to an individual by an employer during any calendar year, then the total amount of these advance payments to the individual in that calendar year is treated as an additional amount of tax imposed (by chapter 1 of the Code) upon the individual on the tax return for the individual's last taxable year beginning in that calendar year.</P> <P>(2) <E T="03">Reconciliation of payments advanced and credit allowed.</E> Any additional amount of tax under paragraph (e)(1) of this section is not treated as a tax imposed by chapter 1 of the Internal Revenue Code for purposes of determining the amount of any credit (other than the earned income credit) allowable under part IV, subchapter A, chapter 1 of the Internal Revenue Code.</P> <CITA>[T.D. 7683, 45 FR 16175, Mar. 13, 1980. Redesignated by T.D. 8448, 57 FR 54923, Nov. 23, 1992; T.D. 9045, 68 FR 10656, Mar. 6, 2003]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.32-3</SECTNO> <SUBJECT>Eligibility requirements after denial of the earned income credit.</SUBJECT> <P>(a) <E T="03">In general.</E> A taxpayer who has been denied the earned income credit (EIC), in whole or in part, as a result of the deficiency procedures under subchapter B of chapter 63 (deficiency procedures) is ineligible to file a return claiming the EIC subsequent to the denial until the taxpayer demonstrates eligibility for the EIC in accordance with paragraph (c) of this section. If a taxpayer demonstrates eligibility for a taxable year in accordance with paragraph (c) of this section, the taxpayer need not comply with those requirements for any subsequent taxable year unless the Service again denies the EIC as a result of the deficiency procedures.<PRTPAGE P="103"/> </P> <P>(b) <E T="03">Denial of the EIC as a result of the deficiency procedures.</E> For purposes of this section, denial of the EIC as a result of the deficiency procedures occurs when a tax on account of the EIC is assessed as a deficiency (other than as a mathematical or clerical error under section 6213(b)(1)).</P> <P>(c) <E T="03">Demonstration of eligibility.</E> In the case of a taxpayer to whom paragraph (a) of this section applies, and except as otherwise provided by the Commissioner in the instructions for Form 8862, “Information To Claim Earned Income Credit After Disallowance,” no claim for the EIC filed subsequent to the denial is allowed unless the taxpayer properly completes Form 8862, demonstrating eligibility for the EIC, and otherwise is eligible for the EIC. If any item of information on Form 8862 is incorrect or inconsistent with any item on the return, the taxpayer will be treated as not demonstrating eligibility for the EIC. The taxpayer must follow the instructions for Form 8862 to determine the income tax return to which Form 8862 must be attached. If the taxpayer attaches Form 8862 to an incorrect tax return, the taxpayer will not be relieved of the requirement that the taxpayer attach Form 8862 to the correct tax return and will, therefore, not be treated as meeting the taxpayer's obligation under paragraph (a) of this section.</P> <P>(d) <E T="03">Failure to demonstrate eligibility.</E> If a taxpayer to whom paragraph (a) of this section applies fails to satisfy the requirements of paragraph (c) of this section with respect to a particular taxable year, the IRS can deny the EIC as a mathematical or clerical error under section 6213(g)(2)(K).</P> <P>(e) <E T="03">Special rule where one spouse denied EIC.</E> The eligibility requirements set forth in this section apply to taxpayers filing a joint return where one spouse was denied the EIC for a taxable year prior to marriage and has not established eligibility as either an unmarried or married taxpayer for a subsequent taxable year.</P> <P>(f) <E T="03">Effective date.</E> This section applies to returns claiming the EIC for taxable years beginning after December 31, 1997, where the EIC was denied for a taxable year beginning after December 31, 1996.</P> <CITA>[T.D. 8953, 66 FR 33637, June 25, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.34-1</SECTNO> <SUBJECT>Credit against tax and exclusion from gross income in case of dividends received by individuals.</SUBJECT> <P>(a) <E T="03">In general.</E> (1) Section 34 provides a credit against the income tax of an individual for certain dividends received after July 31, 1954, and on or before December 31, 1964. The credit, subject to the limitations provided in section 34(b), is equal to 4 percent of the dividends received before January 1, 1964, and 2 percent of the dividends received during the calendar year 1964. The credit is allowable with respect to dividends received in any taxable year ending after July 31, 1954, but applies only to dividends received on or before December 31, 1964. The credit applies only to dividends which are received from domestic corporations and which are included in the gross income of the taxpayer. Section 116 provides for the exclusion from gross income of the first $100 ($50 for dividends received in taxable years beginning before January 1, 1964) of certain dividends received by an individual. See § 1.116-1. In determining which dividends are entitled to the credit against income tax provided by section 34, the exclusion from gross income provided in section 116 is applied to the first dividends received in the taxable year. Since the exclusion applies to dividends received at any time during a taxable year ending after July 31, 1954, dividends received before August 1, 1954, may be taken into account in determining the exclusion from gross income under section 116 but do not constitute dividends for which a credit is allowed.</P> <P>(2) The application of section 34 (without regard to the limitations provided in section 34(b)) may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>A, an individual who makes his return on the basis of the calendar year, receives in the year 1954 the following dividends: $100 on March 1, $100 on June 1, $100 on September 1, and $100 on December 1. $50 of the dividends received by A on March 1, 1954, is excluded from gross income under section 116. The balance of the dividends received in 1954, amounting to $350, is includible in the gross income of A. Subject to the limitation in section 34(b) a credit of $8 is allowed under <PRTPAGE P="104"/>section 34 (4 percent of $200, the amount of the dividends received after July 31, 1954, that is, $100 received on September 1, 1954, and $100 received on December 1, 1954).</P> </EXAMPLE> <P>(b) <E T="03">Tax credit.</E> The credit is used to reduce the tax imposed by Subtitle A of the Code, including the alternative tax under section 1201 in the case of capital gains and the self-employment tax under chapter 2 of the Code; however, it may not be used by the taxpayer as a credit against penalties, additions to the tax, or interest on delinquent taxes.</P> <P>(c) <E T="03">Joint return of husband and wife.</E> (1) In the case of a joint return the credit is determined on the basis of the dividends received by both the husband and wife after taking into account the exclusion allowed by section 116. See § 1.116-1. The credit is allowable in the case of a joint return on account of the dividends received by each spouse without regard to whether the spouse would be liable for the tax imposed by Subtitle A if the joint return had not been filed. However, the limitations on amount of credit in section 34(b) are determined by reference to the tax and the credit under section 33 required to be shown on the joint return and to the combined taxable income of husband and wife. For this purpose, it makes no difference whether the tax, the credit, or the taxable income is attributable to one or the other spouse. If both the husband and wife are entitled to the credit, their combined credit shall not exceed the amount so computed.</P> <P>(2) The application of subparagraph (1) of this paragraph may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>H and W, husband and wife, make a joint return for the calendar year 1954. The only dividend received by either of them during the year is a dividend received by H on September 1 in the amount of $400. Subject to the limitations of section 34(b), the credit amounts to $14 (4 percent of $350, the dividends included in gross income after allowance of the exclusion of $50 under section 116).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in example (1) except that W also received a dividend on September 1 of $30. Since this dividend (being less than the maximum amount allowable as an exclusion under section 116(a)) is excluded from W's gross income, it does not affect the computation of the tax credit and the tax credit is the same as in example (1).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>H and W, husband and wife, make a joint return for the calendar year 1954. H and W each received a $400 dividend on September 1, 1954, and these were the only dividends received by them in 1954. Since H and W may each exclude $50 of the dividends received by them, $700 of dividend income is included in gross income. Subject to the limitations in section 34(b), the credit against the tax of H and W amounts to $28 (4 percent of $700).</P> </EXAMPLE> <P>(d) <E T="03">Individuals receiving dividends.</E> Where two or more persons hold stock as tenants in common, as joint tenants, or as tenants by the entirety, the dividends received with respect to such stock shall be considered as being received by each tenant to the extent that he is entitled under local law to a share of such dividends. Where dividends constitute community property under local law each spouse shall be considered as receiving one-half of such dividends.</P> <P>(e) <E T="03">Time dividends are received.</E> In cases where it is necessary to determine the time of receipt of dividends, the rules established to determine in which taxable year dividends must be included in gross income apply, including the rules relating to constructive receipt. See section 451 and regulations thereunder.</P> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6777, 29 FR 17806, Dec. 16, 1964]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.34-2</SECTNO> <SUBJECT>Limitations on amount of credit.</SUBJECT> <P>(a) Under section 34(b) the credit may not exceed the lesser of either—</P> <P>(1) The amount of the tax imposed by chapter 1 of the Code for the taxable year reduced by the foreign tax credit allowable under section 33, or</P> <P>(2) Whichever of the following is applicable:</P> <P>(i) In the case of a taxable year ending before January 1, 1955, or beginning after December 31, 1963, 2 percent of the taxable income for such taxable year;</P> <P>(ii) In the case of a taxable year ending after December 31, 1954, and beginning before January 1, 1964, 4 percent of the taxable income for such taxable year. In the case of a taxpayer who computes his tax under section 3 or <PRTPAGE P="105"/>who uses the standard deduction provided by section 141, the taxable income for the taxable year is the adjusted gross income for the taxable year reduced by the standard deduction prescribed in section 141 and the deductions for personal exemptions provided in section 151. Where the alternative tax on capital gains is imposed under section 1201(b), the taxable income for such taxable year is the taxable income as defined in section 63, which includes 50 percent of the excess of net long-term capital gain over net short-term capital loss.</P> <P>(b) The application of the limitations in paragraph (a) of this section may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>Assume the following facts in the case of an individual whose taxable year is the calendar year:</P> <HD SOURCE="HD2">1954</HD> <P>Computation of tax liability without regard to the dividend received credit:</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">(1) Gross income</ENT> <ENT>$7,500</ENT> </ROW> <ROW> <ENT I="01">(2) Deductions</ENT> <ENT>2,900</ENT> </ROW> <ROW> <ENT I="01">(3) Taxable income</ENT> <ENT>4,600</ENT> </ROW> <ROW> <ENT I="01">(4) Income tax liability</ENT> <ENT>996</ENT> </ROW> <ROW> <ENT I="01">(5) Foreign tax credit</ENT> <ENT>16</ENT> </ROW> <ROW> <ENT I="01">(6) Income tax liability minus foreign tax credit</ENT> <ENT>980</ENT> </ROW> </GPOTABLE> <P>Computation of limitation under section 34(b)(1):</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">(7) Dividends for which credit is allowable</ENT> <ENT>$2,500</ENT> </ROW> <ROW> <ENT I="01">(8) Dividends received credit under section 34(a); (2,500×0.04)</ENT> <ENT>100</ENT> </ROW> <ROW> <ENT I="01">(9) Dividends received credit, as limited by section 34(b)(1); (item (6) or item (8) whichever is lesser)</ENT> <ENT>100</ENT> </ROW> </GPOTABLE> <P>Computation of limitation under section 34(b)(2):</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">(10) Taxable income</ENT> <ENT>$4,600</ENT> </ROW> <ROW> <ENT I="01">(11) Dividends received credit under section 34(b)(2); (4,600×0.02)</ENT> <ENT>92</ENT> </ROW> </GPOTABLE> <P>Dividends received credit allowable:</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">Item (6), item (9), or item (11), whichever is lesser</ENT> <ENT>$92</ENT> </ROW> </GPOTABLE> <HD SOURCE="HD2">1955</HD> <P>Computation of tax liability without regard to the dividend received credit:</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,6/7"> <ROW> <ENT I="01">(12) Gross income</ENT> <ENT>$7,500</ENT> </ROW> <ROW> <ENT I="01">(13) Deductions</ENT> <ENT>2,900</ENT> </ROW> <ROW> <ENT I="01">(14) Taxable income</ENT> <ENT>4,600</ENT> </ROW> <ROW> <ENT I="01">(15) Income tax liability</ENT> <ENT>996</ENT> </ROW> <ROW> <ENT I="01">(16) Foreign tax credit</ENT> <ENT>816</ENT> </ROW> <ROW> <ENT I="01">(17) Income tax liability minus foreign tax credit</ENT> <ENT>180</ENT> </ROW> </GPOTABLE> <P>Computation of limitation under section 34(b)(1):</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,p1,6/7"> <BOXHD> <CHED H="1"/> <CHED H="1"/> </BOXHD> <ROW> <ENT I="01">(18) Dividends for which credit is allowable</ENT> <ENT>$2,500</ENT> </ROW> <ROW> <ENT I="01">(19) Dividends received credit under section 34(a); (2,500×0.04)</ENT> <ENT>100</ENT> </ROW> <ROW> <ENT I="01">(20) Dividends received credit as limited by section 34(b)(1); (item (17) or item (19) whichever is lesser)</ENT> <ENT>100</ENT> </ROW> </GPOTABLE> <P>Computation of limitation under section 34(b)(2):</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,p1,6/7"> <BOXHD> <CHED H="1"/> <CHED H="1"/> </BOXHD> <ROW> <ENT I="01">(21) Taxable income</ENT> <ENT>$4,600</ENT> </ROW> <ROW> <ENT I="01">(22) Dividends received credit under section 34(b)(2); (4,600×0.04)</ENT> <ENT>184</ENT> </ROW> </GPOTABLE> <P>Dividends received credit allowable:</P> <GPOTABLE CDEF="s25,9" COLS="2" OPTS="L0,p1,6/7"> <BOXHD> <CHED H="1"/> <CHED H="1"/> </BOXHD> <ROW> <ENT I="01">Item (17), item (19), or item (22), whichever is lesser</ENT> <ENT>$100</ENT> </ROW> </GPOTABLE> </EXAMPLE> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6777, 29 FR 17807, Dec. 16, 1964]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.34-3</SECTNO> <SUBJECT>Dividends to which the credit and exclusion apply.</SUBJECT> <P>(a) <E T="03">General rule.</E> The credit under section 34 and the exclusion under section 116 apply only to distributions of property defined as dividends by section 316. Thus, the credit and the exclusion are not allowed with respect to patronage dividends paid by either exempt or taxable farm cooperatives. Nor are they allowed for distributions to nonstockholding policyholders by an insurance company having shares of stock or for any distribution by a mutual insurance company. See paragraph (b) of this section for an additional restriction with respect to stock life insurance companies. The credit and the exclusion are, however, allowed with respect to dividends paid on capital stock by nonexempt cooperatives and with respect to dividends paid on capital stock by building and loan associations. However, see paragraph (b) of this section with respect to so-called dividends paid by building and loan associations ineligible for the credit and the exclusion. The credit and the exclusion are allowed with respect to distributions from any organization taxed as a corporation if the distribution falls within the definition of a dividend in section 316.</P> <P>(b) <E T="03">Dividends from certain corporations.</E> (1) Section 34 (c) and (d) contains further restrictions on the type of distributions which are treated as dividends for purposes of the credit and exclusion. Thus, no credit or exclusion is applicable with respect to dividends received from a corporation organized under the China Trade Act, 1922; from stock life insurance companies before <PRTPAGE P="106"/>January 1, 1959, in taxable years ending before such date; from corporations which during their taxable year of the distribution or their preceding taxable year were corporations to which section 931 applies (relating to income from sources within possessions of the United States); from corporations which during the taxable year of the distribution or the preceding taxable year are corporations exempt from tax either under section 501, relating to charitable, etc., organizations, or under section 521, relating to farmers’ cooperative associations.</P> <P>(2) So-called dividends paid by mutual savings banks, cooperative banks, and building and loan associations which are allowed as a deduction under section 591 are ineligible for the credit and exclusion.</P> <P>(3) For special rules as to the limitation on the amount of dividends for which a credit and exclusion are allowable in the case of dividends paid by a regulated investment company, see section 854 and the regulations thereunder.</P> <P>(4) See section 857(c) and paragraph (d) of § 1.857-4 for special rules which deny a credit under section 34 and exclusion under section 116 in the case of dividends received from a real estate investment trust with respect to a taxable year for which such trust is taxable under part II, subchapter M, chapter 1 of the Code.</P> <CITA>[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 4092, Apr. 28, 1962; T.D. 6625, 27 FR 12541, Dec. 19, 1962]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.34-4</SECTNO> <SUBJECT>Taxpayers not entitled to credit and exclusion.</SUBJECT> <P>(a) The credit or exclusion is not available to nonresident aliens with respect to whom a tax is imposed for the taxable year under section 871(a). If the taxpayer elects under section 6014 to have the Government compute his tax, the credit is not taken into account in such computation although the taxpayer is allowed the exclusion under section 116.</P> <P>(b) For treatment of dividends received by estates or trusts, and the allocation of such dividends between an estate or trust and the beneficiary thereof, see sections 642, 652, and 662 and the regulations thereunder. 3</P> <P>(c) For treatment of dividends received by a partnership see section 702 and the regulations thereunder.</P> <P>(d) For treatment of dividends received by a common trust fund, see section 584 and the regulations thereunder.</P> </SECTION> <SECTION> <SECTNO>§ 1.34-5</SECTNO> <SUBJECT>Effective date; taxable years ending after July 31, 1954, subject to the Internal Revenue Code of 1939.</SUBJECT> <P>Pursuant to section 7851(a)(1)(C), the regulations prescribed in §§ 1.34-1 to 1.34-4, inclusive, shall also apply to taxable years beginning before January 1, 1954, and ending after July 31, 1954, and to taxable years beginning after December 31, 1953, and ending after July 31, 1954, but before August 17, 1954, though such years are subject to the Internal Revenue Code of 1939.</P> </SECTION> <SECTION> <SECTNO>§ 1.34-6</SECTNO> <SUBJECT>Dividends received after December 31, 1964.</SUBJECT> <P>In the case of dividends received after December 31, 1964, section 34 and the regulations issued thereunder do not apply.</P> <CITA>[T.D. 6777, 29 FR 17807, Dec. 16, 1964]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.35-1</SECTNO> <SUBJECT>Partially tax-exempt interest received by individuals.</SUBJECT> <P>(a) The credit against tax under section 35 shall be allowed only to individuals and if the requirements of both paragraphs (1) and (2) of section 35(a) are met. Where the alternative tax on capital gains is imposed under section 1201(b), the taxable income for such taxable year is the taxable income as defined in section 63, which includes 50 percent of the excess of net long-term capital gain over net short-term capital loss.</P> <P>(b) For the treatment of partially tax-exempt interest in the case of amounts not allocable to any beneficiary of an estate or trust, see section 642(a)(1), and for treatment of amounts allocable to a beneficiary, see sections 652 and 662. For treatment of partially tax-exempt interest received by a partnership, see section 702(a)(7). For treatment of such interest received by a common trust fund, see section 584(c)(2).<PRTPAGE P="107"/> </P> <P>(c) The application of section 35 may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>In his taxable year, 1955, A received $4,500 of partially tax-exempt interest. A's taxable income is $4,000 upon which the tax prior to any credits against tax is $840. His foreign tax credit under section 33 is $610, and his dividends received credit under section 34 is $120. A's credit under section 35 for partially tax-exempt interest is $110, determined as follows:</P> <GPOTABLE CDEF="s25,8,8" COLS="3" OPTS="L0,6/7"> <ROW> <ENT I="28"> <E T="03">Section 35(a)</E> </ENT> </ROW> <ROW EXPSTB="01"> <ENT I="01">Partially tax-exempt interest</ENT> <ENT>$4,500</ENT> </ROW> <ROW> <ENT I="01">Credit computed under section 35(a); 3 percent of $4,500</ENT> <ENT>135</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="28"> <E T="03">Section 35(b)(1)</E> </ENT> </ROW> <ROW EXPSTB="01"> <ENT I="01">Tax imposed by chapter 1</ENT> <ENT>840</ENT> </ROW> <ROW> <ENT I="11">Less:</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="02">Credit allowed under section 33</ENT> <ENT>$610</ENT> </ROW> <ROW> <ENT I="02">Credit allowed under section 34</ENT> <ENT>120</ENT> </ROW> <ROW RUL="n,n,s"> <ENT I="11"/> <ENT>————</ENT> <ENT>$730</ENT> </ROW> <ROW EXPSTB="01"> <ENT I="01">Limitation on credit under section 35(b)(1)</ENT> <ENT>110 </ENT> </ROW> <ROW EXPSTB="00"> <ENT I="28"> <E T="03">Section 35(b)(2)</E> </ENT> </ROW> <ROW EXPSTB="01"> <ENT I="01">Taxable income</ENT> <ENT>4,000</ENT> </ROW> <ROW> <ENT I="01">Limitation on credit under section 35(b)(2); 3 percent of $4,000</ENT> <ENT>120</ENT> </ROW> </GPOTABLE> <FP>Since of the three figures ($135, $110, and $120), the lesser is $110, A's credit under section 35 is limited to $110.</FP> </EXAMPLE> </SECTION> <SECTION> <SECTNO>§ 1.35-2</SECTNO> <SUBJECT>Taxpayers not entitled to credit.</SUBJECT> <P>For taxable years beginning after December 31, 1957, no credit shall be allowed under section 35 to a nonresident alien individual with respect to whom a tax is imposed for such taxable year under section 871(a).</P> </SECTION> <SECTION> <SECTNO>§ 1.37-1</SECTNO> <SUBJECT>General rules for the credit for the elderly.</SUBJECT> <P>(a) <E T="03">In general.</E> In the case of an individual, section 37 provides a credit against the tax imposed by chapter 1 of the Internal Revenue Code of 1954. This section and §§ 1.37-2 and 1.37-3 provide guidance in the computation of the credit for the elderly provided under section 37 for taxable years beginning after 1975. For rules relating to the computation of the retirement income credit provided under section 37 for taxable years beginning before 1976, see 26 CFR 1.37-1 through 1.37-5 (Rev. as of April 1, 1980). Note that section 403 of the Tax Reduction and Simplification Act of 1977 provides that a taxpayer may elect to compute the credit under section 37 for the taxpayer's first taxable year beginning in 1976 in accordance with the rules applicable to taxable years beginning before 1976.</P> <P>(b) <E T="03">Limitation on the amount of the credit.</E> The credit allowed by section 37 for a taxable year shall not exceed the tax imposed by chapter 1 of the Code for the taxable year (reduced, in the case of a taxable year beginning before 1979, by the general tax credit allowed by section 42).</P> <P>(c) <E T="03">Married couples must file joint returns.</E> If the taxpayer is married at the close of the taxable year, the credit provided by section 37 shall be allowed only if the taxpayer and the taxpayer's spouse file a joint return for the taxable year. The preceding sentence shall not apply in the case of a husband and wife who are not members of the same household at any time during the taxable year. For the determination of marital status, see §§ 143 and 1.143-1.</P> <P>(d) <E T="03">Nonresident aliens ineligible.</E> No credit is allowed under section 37 to any individual for any taxable year during which that individual is at any time a nonresident alien unless the individual is treated, by reason of an election under section 6013 (g) or (h), as a resident of the United States for that taxable year.</P> <CITA>[T.D. 7743, 45 FR 84049, Dec. 22, 1980]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.37-2</SECTNO> <SUBJECT>Credit for individuals age 65 or over.</SUBJECT> <P>(a) <E T="03">In general.</E> This section illustrates the computation of the credit for the elderly in the case of an individual who has attained the age of 65 before the close of the taxable year. This section shall not apply to an individual for any taxable year for which the individual makes the election described in section 37(e)(2) and paragraph (b) of § 1.37-3.</P> <P>(b) <E T="03">Computation of credit.</E> The credit for the elderly for an individual to whom this section applies equals 15 percent of the individual's “section 37 amount” for the taxable year. An individual's “section 37 amount” for a taxable year is the initial amount determined under section 37(b)(2), reduced as provided in section 37(b)(3) and (c)(1).</P> <P>(c) <E T="03">Examples.</E> The computation of the credit for the elderly for individuals to whom this section applies may be illustrated by the following examples: </P> <EXAMPLE> <PRTPAGE P="108"/> <HD SOURCE="HED">Example 1.</HD> <P>A, a single individual who is 67 years old, has adjusted gross income of $8,000 for the calendar year 1977. A also receives social security payments of $1,450 during 1977. A does not itemize deductions. A's credit for the elderly is $120, computed as follows:</P> <GPOTABLE CDEF="s20,7,7" COLS="3" OPTS="L0,6/7"> <ROW EXPSTB="01"> <ENT I="01">Initial amount under section 37(b)(2)</ENT> <ENT>$2,500</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="11">Reductions required by section 37 (b)(3) and (c)(1):</ENT> </ROW> <ROW> <ENT I="03">Social security payments</ENT> <ENT>$1,450</ENT> <ENT/> </ROW> <ROW RUL="n,s,n"> <ENT I="03">One-half the excess of adjusted gross income over $7,500</ENT> <ENT>250</ENT> <ENT>1,700</ENT> </ROW> <ROW EXPSTB="01" RUL="n,n,d"> <ENT I="01">Section 37 amount</ENT> <ENT>800</ENT> </ROW> <ROW> <ENT I="01">15 pct. of $800</ENT> <ENT>$120</ENT> </ROW> </GPOTABLE> <FP>A's tax from the tax tables, which reflect the allowance of the general tax credit, is $662. Accordingly, the limitation of section 37(c)(2) and paragraph (b) of § 1.37-1 does not reduce A's credit for the elderly.</FP> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>H and W, who have both attained the age of 65, file a joint return for calendar year 1977. For that year H and W have adjusted gross income of $8,120; H also receives a railroad retirement pension of $1,550, and W receives social security payments of $1,200. H and W do not itemize deductions. The credit for the elderly allowed to H and W for 1977 is $139, computed as follows:</P> <GPOTABLE CDEF="s20,7,7" COLS="3" OPTS="L0,6/7"> <ROW EXPSTB="01"> <ENT I="01">Initial amount under section 37(b)(2)</ENT> <ENT>$3,750</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="11">Reductions required by section 37 (b)(3):</ENT> </ROW> <ROW> <ENT I="03">Railroad retirement pension</ENT> <ENT>$1,550</ENT> <ENT/> </ROW> <ROW RUL="n,s,n"> <ENT I="03">Social Security payments</ENT> <ENT>1,200</ENT> <ENT>2,750</ENT> </ROW> <ROW EXPSTB="01" RUL="n,n,d"> <ENT I="01">Section 37 amount</ENT> <ENT>1,000</ENT> </ROW> <ROW> <ENT I="01">15 pct. of $1,000</ENT> <ENT>150</ENT> </ROW> <ROW> <ENT I="01">Limitation based upon amount of tax (derived from table reflecting allowance of general tax credit)</ENT> <ENT>$139</ENT> </ROW> </GPOTABLE> <FP>Since the adjusted gross income of H and W is not greater than $10,000, no reduction of the initial amount is required under section 37 (c)(1).</FP> </EXAMPLE> <CITA>[T.D. 7743, 45 FR 84050, Dec. 22, 1980]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.37-3</SECTNO> <SUBJECT>Credit for individuals under age 65 who have public retirement system income.</SUBJECT> <P>(a) <E T="03">In general.</E> This section provides rules for the computation of the credit for the elderly under section 37(e) in the case of an individual who has not attained the age of 65 before the close of the taxable year and whose gross income for the taxable year includes retirement income within the meaning of paragraph (d)(1)(ii) of this section (<E T="03">i.e.,</E> under a public retirement system). If such an individual is married within the meaning of section 143 at the close of the taxable year and the spouse of the individual has attained the age of 65 before the close of the taxable year, this section shall apply to the individual for the taxable year only if both spouses make the election described in paragraph (b) of this section. If both spouses make the election described in paragraph (b) of this section for the taxable year, the credit of each spouse shall be determined under the rules of this section. See paragraph (f)(2) of this section for a limitation on the effects of community property laws in making determinations and computations under section 37(e) and this section.</P> <P>(b) <E T="03">Election by certain married taxpayers.</E> If a married individual under age 65 at the close of the taxable year has retirement income and the spouse of that individual has attained the age of 65 before the close of the taxable year, both spouses may elect to compute the credit provided by section 37 under the rules of section 37(e) and this section. The spouses shall signify the election on the return (or amended return) for the taxable year in the manner prescribed in the instructions accompanying the return. The election may be made at any time before the expiration of the period of limitation for filing claim for credit or return for the taxable year. The election may be revoked without the consent of the Commissioner at any time before the expiration of that period by filing an amended return.</P> <P>(c) <E T="03">Computation of credit.</E> The credit of an individual under section 37(e) and this section equals 15 percent of the individual's credit base for the taxable year. The credit base of an individual for a taxable year is the lesser of—</P> <P>(1) The retirement income of the individual for the taxable year, or</P> <P>(2) The amount determined under section 37(e)(5), as modified by section 37(e) (6) and (7).</P> <P>(d) <E T="03">Retirement income</E>—(1) <E T="03">General rule—</E>(i) <E T="03">For individuals 65 or over.</E> Section 37(e)(4)(A) enumerates the kinds of income which may be treated as the retirement income of an individual who has attained the age of 65 before the close of the taxable year. They include income from pensions and annuities, interest, rents, dividends, certain bonds received under a qualified bond <PRTPAGE P="109"/>purchase plan, and certain individual retirement accounts or annuities.</P> <P>(ii) <E T="03">For individuals under 65.</E> In the case of an individual who has not attained the age of 65 before the close of the taxable year, retirement income consists only of income from pensions and annuities (including disability annuity payments) under a public retirement system which arises from services performed by that individual or by a present or former spouse of that individual. The term “public retirement system” means a pension, annuity, or retirement, or similar fund or system established by the United States, a State, a possession of the United States, any political subdivision of any of the foregoing, or the District of Columbia.</P> <P>(2) <E T="03">Rents.</E> For purposes of section 37(e)(4)(A)(iii), income from rents shall be the gross amount received, not reduced by depreciation or other expenses, except that beneficiaries of a trust or estate shall treat as retirement income only their proportionate shares, of the taxable rents of the trust or estate. In the case of an amount received for board and lodging, only the portion of the amount received for lodging is income from rents.</P> <P>(3) <E T="03">Disability annuity payments received by individual under age 65.</E> Disability annuity payments received under a public retirement system by an individual under age 65 at the close of the taxable year shall not be treated as retirement income unless the payments are for periods after the date on which the individual reached minimum retirement age, that is, the age at which the individual would be eligible to receive a pension or annuity without regard to disability, and any of the following conditions is satisfied—</P> <P>(i) The individual is precluded from seeking the benefits of section 105(d) (relating to certain disability payments) for that taxable year by reason of an irrevocable election;</P> <P>(ii) The individual was not permanently and totally disabled at the time of retirement (and was not permanently and totally disabled either on January 1, 1976, or on January 1, 1977, if the individual retired before the later date on disability or under circumstances which entitled the individual to retire on disability); or</P> <P>(iii) The payments are for periods after the individual reached mandatory retirement age.</P> <FP>For purposes of this paragraph, disability annuity payments include payments to an individual who retired on partial or temporary disability.</FP> <P>(4) <E T="03">Compensation of personal services rendered during taxable year.</E> Retirement income does not include any amount representing compensation for personal services rendered during the taxable year. For this purpose, amounts received as a pension shall not be treated as representing compensation for personal services rendered during the taxable year if the period of service during the taxable year is not substantial when compared with the total years of service. For example, an individual on the calendar year basis retires on November 30 after 5 years of service and receives a pension during the remainder of his taxable year. The pension is not treated as representing compensation for personal services rendered during such taxable year merely because it is paid by reason of the services of the individual for a period of 5 years which includes a portion of the taxable year.</P> <P>(5) <E T="03">Amounts not includible in gross income.</E> Retirement income does not include any amount not includible in the gross income of the individual for the taxable year. For example, if a portion of an annuity is excluded from gross income under section 72, relating to annuities, that portion of the annuity is not retirement income; similarly, the portion of dividend income excluded from gross income under section 116, relating to the partial exclusion of dividends received by individuals is not retirement income.</P> <P>(e) <E T="03">Earned income—</E>(1) <E T="03">In general.</E> The term “earned income” in section 37(e)(5)(B) generally has the same meaning as in section 911(b), except that earned income does not include any amount received as a pension or annuity. See section 911(b) and the regulations thereunder. Section 911(b) provides, in general, that earned income includes wages, salaries, professional fees, and other amounts received as <PRTPAGE P="110"/>compensation for personal services rendered.</P> <P>(2) <E T="03">Earned income from self-employment.</E> For purposes of section 37(e)(5)(B), the earned income of a taxpayer from self-employment in a trade or business shall not exceed—</P> <P>(i) The taxpayer's share of the net profits from the trade or business if capital is not a material income-producing factor in that trade or business; or</P> <P>(ii) Thirty percent of the taxpayer's share of the net profits from the trade or business if capital is a material income-producing factor in that trade or business.</P> <FP>For other rules relating to the determination of earned income from self-employment in a trade or business, see section 911(b) and the regulations thereunder.</FP> <P>(3) <E T="03">Disability annuity payments received by individuals under age 65.</E> Disability annuity payments received under a public retirement system by an individual under age 65 at the close of the taxable year shall be treated as earned income for purposes of section 37(e)(5)(B) unless the payments are treated as retirement income under paragraph (d)(3) of this section.</P> <P>(f) <E T="03">Computation of credit under section 37(e) in the case of joint returns—</E>(1) <E T="03">In general.</E> In the case of a joint return of husband and wife, the credit base of each spouse under section 37(e) is computed separately. The spouses then combine their credit bases and compute a single credit. The limitation in section 37(c)(2) and paragraph (b) of § 1.37-1 on the amount of the credit is determined by reference to the joint tax liability of the spouses. Thus, regardless of whether a spouse would be liable for the tax imposed by chapter 1 of the Code if the joint return had not been filed, the credit base of that spouse is taken into account in computing the credit.</P> <P>(2) <E T="03">Community property laws.</E> For taxable years beginning after 1977, married individuals filing joint returns shall disregard community property laws in making any determination or computation required under section 37(e) or this section. Each item of income is attributed in full to the spouse whose income it would have been in the absence of community property laws. Thus, if a 67-year old individual files a joint return with a 62-year old spouse for 1979 and the only income of the couple is from a public pension of the older spouse, that public pension is attributed in full to the older spouse for purposes of section 37(e) even though the applicable community property law may treat one-half of the pension as the income of the 62-year old spouse. Since the younger spouse consequently has no retirement income within the meaning of paragraph (d) of this section, the couple may not make the election described in paragraph (b) of this section.</P> <P>(g) <E T="03">Examples.</E> The computation of the credit for the elderly under section 37(e) and this section is illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>B, who is 62 years old and single, receives a fully taxable pension of $2,400 from a public retirement system during 1977. B performed the services giving rise to the pension. During that year, B also earns $2,650 from a part-time job. B receives no tax-exempt pension or annuity in 1977. Subject to the limitation of section 37(c)(2) and paragraph (b) of § 1.37-1, B's credit for the elderly for 1977 under section 37(e) is $195, computed as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,6/7"> <ROW EXPSTB="01"> <ENT I="01">Maximum retirement income level under section 37(e)(5)</ENT> <ENT>$2,500</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="11">Earned income offset under section 37(e)(5)(B)(ii):</ENT> </ROW> <ROW> <ENT I="03">Earned income in excess of $1,700</ENT> <ENT>$950</ENT> <ENT/> </ROW> <ROW RUL="n,s,n"> <ENT I="03">One-half of earned income in excess of $1,200, but not in excess of $1,700</ENT> <ENT>250</ENT> <ENT>1,200</ENT> </ROW> <ROW EXPSTB="01" RUL="n,n,d"> <ENT I="01">Amount determined under section 37(e)(5)</ENT> <ENT>1,300</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="01">Retirement income</ENT> <ENT>2,400</ENT> </ROW> <ROW> <ENT I="01">Credit for the elderly (15 pct. of $1,300)</ENT> <ENT>195</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>During 1978 H, who is 67 years old, has earnings of $1,300 and retirement income (rents, interest, etc.) of $6,000. H also receives social security payments totalling $1,400. During 1978 W, who is 63 years old, earns $1,600 and receives a fully taxable pension of $1,400 from a public retirement system that constitutes retirement income. W performed the services giving rise to the pension. H and W file a joint return for 1978 and elect to compute the credit for the elderly under section 37(e). Under the applicable law these items of income are community income, and both spouses share equally in each item. Because H and W are filing a joint return, they disregard community property laws in computing their credit under section <PRTPAGE P="111"/>37(e). The couple allocates $1,600 of the $3,750 referred to in section 37(e)(6) to W and $2,150 to H. Subject to the limitation of section 37(c)(2) and paragraph (b) of § 1.37-1, their credit for the elderly is $315, computed as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,p1,6/7"> <ROW EXPSTB="01"> <ENT I="11">Credit base of H:</ENT> </ROW> <ROW> <ENT I="02">Amount allocated to H under section 37(e)(6)</ENT> <ENT>$2,150</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="12">Reductions required by section 37(e)(5):</ENT> </ROW> <ROW> <ENT I="04">Social Security payments</ENT> <ENT>$1,400</ENT> <ENT/> </ROW> <ROW RUL="n,s,n"> <ENT I="04">One-half of excess of earnings over $1,200</ENT> <ENT>50</ENT> <ENT>1,450</ENT> </ROW> <ROW EXPSTB="01" RUL="n,n,d"> <ENT I="02">Amount determined under section 37(e)(5)</ENT> <ENT>700</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="02">Retirement income</ENT> <ENT>6,000</ENT> </ROW> <ROW> <ENT I="02">Credit base of H</ENT> <ENT>700</ENT> </ROW> <ROW> <ENT I="11">Credit base of W:</ENT> </ROW> <ROW> <ENT I="02">Amount allocated to W under section 37(e)(6)</ENT> <ENT>$1,600</ENT> </ROW> <ROW> <ENT I="12">Reduction required by section 37(e)(5)(B):</ENT> </ROW> <ROW RUL="n,n,s"> <ENT I="04">One-half of excess of earnings over $1,200</ENT> <ENT>$200</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="04">Amount determined under section 37(e)(5)</ENT> <ENT>1,400</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="02">Retirement income</ENT> <ENT>1,400</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="02">Credit base of W</ENT> <ENT>1,400</ENT> </ROW> <ROW> <ENT I="12">Computation of credit:</ENT> </ROW> <ROW> <ENT I="04">Credit base of H</ENT> <ENT>700</ENT> </ROW> <ROW RUL="n,n,s"> <ENT I="04">Credit base of W</ENT> <ENT>1,400</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="04">Combined credit base</ENT> <ENT>2,100</ENT> </ROW> <ROW> <ENT I="02">Credit for the elderly (15 pct. of $2,100)</ENT> <ENT>315</ENT> </ROW> </GPOTABLE> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>(a) Assume the same facts as in example (2) of this paragraph, except that H and W live apart at all times during 1978 and file separate returns. Under these circumstances, H and W must give effect to the applicable community property law in determining their credits under section 37(e). Thus, each spouse must take into account one-half of each item of income.</P> <P>(b) Subject to the limitation of section 37(c)(2) and paragraph (b) of § 1.37-1, H's credit for the elderly is $157.50, computed as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,p0,6/7"> <ROW EXPSTB="01"> <ENT I="01">Maximum retirement income level under section 37(e)(7)</ENT> <ENT>$1,875</ENT> </ROW> <ROW EXPSTB="00"> <ENT I="11">Reductions required by section 37(e)(5):</ENT> </ROW> <ROW> <ENT I="03">Social security payments</ENT> <ENT>$700</ENT> <ENT/> </ROW> <ROW RUL="n,s,n"> <ENT I="03">One-half of excess of earnings over $1,200 (taking into account one-half of combined earnings of $2,900)</ENT> <ENT>125</ENT> <ENT>825</ENT> </ROW> <ROW EXPSTB="01" RUL="n,n,d"> <ENT I="01">Amount determined under section 37(e)(5)</ENT> <ENT>1,050</ENT> </ROW> <ROW RUL="n,n,d"> <ENT I="01">Retirement income</ENT> <ENT>3,700</ENT> </ROW> <ROW> <ENT I="01">Credit of H (15 pct. of $1,050)</ENT> <ENT>157.50</ENT> </ROW> </GPOTABLE> <P>(c) Subject to the limitation of section 37(c)(2) and paragraph (b) of § 1.37-1, W's credit for the elderly is computed as follows:</P> <GPOTABLE CDEF="s25,9,9" COLS="3" OPTS="L0,p1,6/7"> <ROW> <ENT I="01">Maximum retirement income level under section 37(e)(7)</ENT> <ENT>$1,875</ENT> </ROW> <ROW> <ENT I="11">Reductions required by section 37(e)(5):</ENT> </ROW> <ROW> <ENT I="03">Social security payments</ENT> <ENT>$700</ENT> <ENT/> </ROW> <ROW RUL="n,s,n"> <ENT I="03">One-half of excess of earnings over $1,200</ENT> <ENT>125</ENT> <ENT>825</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Amount determined under section 37(e)(5)</ENT> <ENT>1,050</ENT> </ROW> <ROW RUL="n,d"> <ENT I="01">Retirement income (limited to W's share of public pension)</ENT> <ENT>700</ENT> </ROW> <ROW> <ENT I="01">Credit of W (15 pct. of $700)</ENT> <ENT>105</ENT> </ROW> </GPOTABLE> </EXAMPLE> <CITA>[T.D. 7743, 45 FR 84050, Dec. 22, 1980]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.38-1</SECTNO> <SUBJECT>Investment in certain depreciable property.</SUBJECT> <P>Regulations under sections 46 through 50 are prescribed under the authority granted the Secretary by section 38(b) to prescribe regulations as may be necessary to carry out the purposes of section 38 and subpart B, part IV, subchapter A, chapter 1 of the Code.</P> <CITA>[44 FR 20417, Apr. 5, 1979]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.40-1</SECTNO> <SUBJECT>Questions and answers relating to the meaning of the term “qualified mixture” in section 40(b)(1).</SUBJECT> <P> <E T="03">Q-1.</E> What is a “qualified mixture” within the meaning of section 40(b)(1)?</P> <P> <E T="03">A-1.</E> A “qualified mixture” is a mixture of alcohol and gasoline or of alcohol and special fuel which (1) is sold by the taxpayer producing such mixture to any person for use as a fuel, or (2) is used as a fuel by the taxpayer producing such mixture.</P> <P> <E T="03">Q-2.</E> Must alcohol be present in a product in order for that product to be considered a mixture of alcohol and either gasoline or a special fuel?</P> <P> <E T="03">A-2.</E> No. A product is considered to be a mixture of alcohol and gasoline or of alcohol and a special fuel if the product is derived from alcohol and either gasoline or a special fuel even if the alcohol is chemically transformed in producing the product so that the alcohol is no longer present as a separate chemical in the final product, provided that there is no significant loss in the energy content of the alcohol. Thus, a <PRTPAGE P="112"/>product may be considered to be “mixture of alcohol and gasoline or of alcohol and a special fuel” within the meaning of section 40(b)(1)(B) if such product is produced in a chemical reaction between alcohol and either gasoline or a special fuel. Similarly a product may be considered to be a “mixture of alcohol and gasoline or of alcohol and a special fuel” if such product is produced by blending a chemical compound derived from alcohol with either gasoline or a special fuel.</P> <P>Thus, for example, a blend of gasoline and ethyl tertiary butyl ether (ETBE), a compound derived from ethanol (a qualified alcohol), in a chemical reaction in which there is no significant loss in the energy content of the ethanol, is considered for purposes of section 40(b)(1)(B) to be a mixture of gasoline and the ethanol used to produce the ETBE, even though the ethanol is chemically transformed in the production of ETBE and is not present in the final product.</P> <CITA>[T.D. 8291, 55 FR 8948, Mar. 9, 1990]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <P>This section lists the paragraphs contained in §§ 1.41-1 through 1.41-8 as follows: </P> <EXTRACT> <FP SOURCE="FP-2"> <E T="03">§ 1.41-1Credit for increasing research activities.</E> </FP> <FP SOURCE="FP1-2">(a) Amount of credit.</FP> <FP SOURCE="FP1-2">(b) Introduction to regulations under section 41.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-2Qualified research expenses.</E> </FP> <FP SOURCE="FP1-2">(a) Trade or business requirement.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) New business.</FP> <FP SOURCE="FP1-2">(3) Research performed for others.</FP> <FP SOURCE="FP1-2">(i) Taxpayer not entitled to results.</FP> <FP SOURCE="FP1-2">(ii) Taxpayer entitled to results.</FP> <FP SOURCE="FP1-2">(4) Partnerships.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Special rule for certain partnerships and joint ventures.</FP> <FP SOURCE="FP1-2">(b) Supplies and personal property used in the conduct of qualified research.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Certain utility charges.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Extraordinary expenditures.</FP> <FP SOURCE="FP1-2">(3) Right to use personal property.</FP> <FP SOURCE="FP1-2">(4) Use of personal property in taxable years beginning after December 31, 1985.</FP> <FP SOURCE="FP1-2">(c) Qualified services.</FP> <FP SOURCE="FP1-2">(1) Engaging in qualified research.</FP> <FP SOURCE="FP1-2">(2) Direct supervision.</FP> <FP SOURCE="FP1-2">(3) Direct support.</FP> <FP SOURCE="FP1-2">(d) Wages paid for qualified services.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) “Substantially all.”</FP> <FP SOURCE="FP1-2">(e) Contract research expenses.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Performance of qualified research.</FP> <FP SOURCE="FP1-2">(3) “On behalf of.”</FP> <FP SOURCE="FP1-2">(4) Prepaid amounts.</FP> <FP SOURCE="FP1-2">(5) Examples.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-3Base amount for taxable years beginning on or after January 3, 2001.</E> </FP> <FP SOURCE="FP1-2">(a) New taxpayers.</FP> <FP SOURCE="FP1-2">(b) Special rules for short taxable years.</FP> <FP SOURCE="FP1-2">(1) Short credit year.</FP> <FP SOURCE="FP1-2">(2) Short taxable year preceding credit year.</FP> <FP SOURCE="FP1-2">(3) Short taxable year in determining fixed-base percentage.</FP> <FP SOURCE="FP1-2">(c) Definition of gross receipts.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Amounts excluded.</FP> <FP SOURCE="FP1-2">(3) Foreign corporations.</FP> <FP SOURCE="FP1-2">(d) Consistency requirement.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Illustrations.</FP> <FP SOURCE="FP1-2">(e) Effective date.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-4Qualified research for expenditures paid or incurred on or after January 3, 2001.</E> </FP> <FP SOURCE="FP1-2">(a) Qualified research.</FP> <FP SOURCE="FP1-2">(1) General rule.</FP> <FP SOURCE="FP1-2">(2) Requirements of section 41(d)(1).</FP> <FP SOURCE="FP1-2">(3) Undertaken for the purpose of discovering information.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Common knowledge.</FP> <FP SOURCE="FP1-2">(iii) Means of discovery.</FP> <FP SOURCE="FP1-2">(iv) Patent safe harbor.</FP> <FP SOURCE="FP1-2">(v) Rebuttable presumption.</FP> <FP SOURCE="FP1-2">(4) Technological in nature.</FP> <FP SOURCE="FP1-2">(5) Process of experimentation.</FP> <FP SOURCE="FP1-2">(6) Substantially all requirement.</FP> <FP SOURCE="FP1-2">(7) Use of computers and information technology.</FP> <FP SOURCE="FP1-2">(8) Illustrations.</FP> <FP SOURCE="FP1-2">(b) Application of requirements for qualified research.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Shrinking-back rule.</FP> <FP SOURCE="FP1-2">(3) Illustration.</FP> <FP SOURCE="FP1-2">(c) Excluded activities.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Research after commercial production.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Certain additional activities related to the business component.</FP> <FP SOURCE="FP1-2">(iii) Activities related to production process or technique.</FP> <FP SOURCE="FP1-2">(iv) Clinical testing.</FP> <FP SOURCE="FP1-2">(3) Adaptation of existing business components.</FP> <FP SOURCE="FP1-2">(4) Duplication of existing business component.</FP> <FP SOURCE="FP1-2">(5) Surveys, studies, research relating to management functions, etc.</FP> <FP SOURCE="FP1-2">(6) Internal-use computer software.</FP> <FP SOURCE="FP1-2">(i) General rule.</FP> <FP SOURCE="FP1-2">(ii) Requirements.</FP> <FP SOURCE="FP1-2">(iii) Primarily for internal use.<PRTPAGE P="113"/> </FP> <FP SOURCE="FP1-2">(iv) Software used in the provision of services.</FP> <FP SOURCE="FP1-2">(A) Computer services.</FP> <FP SOURCE="FP1-2">(B) Noncomputer services.</FP> <FP SOURCE="FP1-2">(v) Exception for certain software used in providing noncomputer services.</FP> <FP SOURCE="FP1-2">(vi) High threshold of innovation test.</FP> <FP SOURCE="FP1-2">(vii) Application of high threshold of innovation test.</FP> <FP SOURCE="FP1-2">(viii) Illustrations.</FP> <FP SOURCE="FP1-2">(ix) Effective dates.</FP> <FP SOURCE="FP1-2">(7) Activities outside the United States, Puerto Rico, and other possessions.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Apportionment of in-house research expenses.</FP> <FP SOURCE="FP1-2">(iii) Apportionment of contract research expenses.</FP> <FP SOURCE="FP1-2">(8) Research in the social sciences, etc.</FP> <FP SOURCE="FP1-2">(9) Research funded by any grant, contract, or otherwise.</FP> <FP SOURCE="FP1-2">(10) Illustrations.</FP> <FP SOURCE="FP1-2">(d) Documentation.</FP> <FP SOURCE="FP1-2">(e) Effective dates.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-5Basic research for taxable years beginning after December 31, 1986.</E> [Reserved]</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-6Aggregation of expenditures.</E> </FP> <FP SOURCE="FP1-2">(a) Controlled group of corporations; trades or businesses under common control.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Definition of trade or business.</FP> <FP SOURCE="FP1-2">(3) Determination of common control.</FP> <FP SOURCE="FP1-2">(4) Examples.</FP> <FP SOURCE="FP1-2">(b) Minimum base period research expenses.</FP> <FP SOURCE="FP1-2">(c) Tax accounting periods used.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Special rule where timing of research is manipulated.</FP> <FP SOURCE="FP1-2">(d) Membership during taxable year in more than one group.</FP> <FP SOURCE="FP1-2">(e) Intra-group transactions.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) In-house research expenses.</FP> <FP SOURCE="FP1-2">(3) Contract research expenses.</FP> <FP SOURCE="FP1-2">(4) Lease payments.</FP> <FP SOURCE="FP1-2">(5) Payment for supplies.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-7Special rules.</E> </FP> <FP SOURCE="FP1-2">(a) Allocations.</FP> <FP SOURCE="FP1-2">(1) Corporation making an election under subchapter S.</FP> <FP SOURCE="FP1-2">(i) Pass-through, for taxable years beginning after December 31, 1982, in the case of an S corporation.</FP> <FP SOURCE="FP1-2">(ii) Pass-through, for taxable years beginning before January 1, 1983, in the case of a subchapter S corporation.</FP> <FP SOURCE="FP1-2">(2) Pass-through in the case of an estate or trust.</FP> <FP SOURCE="FP1-2">(3) Pass-through in the case of a partnership.</FP> <FP SOURCE="FP1-2">(i) In general.</FP> <FP SOURCE="FP1-2">(ii) Certain expenditures by joint ventures.</FP> <FP SOURCE="FP1-2">(4) Year in which taken into account.</FP> <FP SOURCE="FP1-2">(5) Credit allowed subject to limitation.</FP> <FP SOURCE="FP1-2">(b) Adjustments for certain acquisitions and dispositions—Meaning of terms.</FP> <FP SOURCE="FP1-2">(c) Special rule for pass-through of credit.</FP> <FP SOURCE="FP1-2">(d) Carryback and carryover of unused credits.</FP> <FP SOURCE="FP-2"> <E T="03">§ 1.41-8Special rules for taxable years ending on or after January 3, 2001.</E> </FP> <FP SOURCE="FP1-2">(a) Alternative incremental credit.</FP> <FP SOURCE="FP1-2">(b) Election.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Time and manner of election.</FP> <FP SOURCE="FP1-2">(3) Revocation.</FP> <FP SOURCE="FP1-2">(4) Effective date.</FP> </EXTRACT> <CITA>[T.D. 8930, 65 FR 287, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-1</SECTNO> <SUBJECT>Credit for increasing research activities.</SUBJECT> <P>(a) <E T="03">Amount of credit.</E> The amount of a taxpayer's credit is determined under section 41(a). For taxable years beginning after June 30, 1996, and at the election of the taxpayer, the portion of the credit determined under section 41(a)(1) may be calculated using the alternative incremental credit set forth in section 41(c)(4).</P> <P>(b) <E T="03">Introduction to regulations under section 41.</E> (1) Sections 1.41-2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain provisions of section 41. The following table identifies the provisions of section 41 that are addressed, and lists each provision with the section of the regulations in which it is covered.</P> <GPOTABLE CDEF="s60,r60" COLS="2" OPTS="L2,tp0,i1"> <BOXHD> <CHED H="1">Section of the regulation</CHED> <CHED H="1">Section of the Internal Revenue Code</CHED> </BOXHD> <ROW> <ENT I="01">§ 1.41-2</ENT> <ENT>41(b).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-3</ENT> <ENT>41(c).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-4</ENT> <ENT>41(d).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-5</ENT> <ENT>41(e).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-6</ENT> <ENT>41(f).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-7</ENT> <ENT>41(f).<LI>41(g).</LI> </ENT> </ROW> <ROW> <ENT I="01">§ 1.41-8</ENT> <ENT>41(c).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-3A</ENT> <ENT>41(c) (taxable years beginning before January 1, 1990).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-4A</ENT> <ENT>41(d) (taxable years beginning before January 1, 1986).</ENT> </ROW> <ROW> <ENT I="01">§ 1.41-5A</ENT> <ENT>41(e) (taxable years beginning before January 1, 1987).</ENT> </ROW> </GPOTABLE> <P>(2) Section 1.41-3A also addresses the special rule in section 221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable years overlapping the effective dates of section 41. Section 41 was formerly designated as sections 30 and 44F. Sections 1.41-0 through 1.41-8 and 1.41-0A through 1.41-5A refer to these sections as section 41 for conformity purposes. Whether section 41, <PRTPAGE P="114"/>former section 30, or former section 44F applies to a particular expenditure depends upon when the expenditure was paid or incurred.</P> <CITA>[T.D. 8930, 65 FR 288, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-2</SECTNO> <SUBJECT>Qualified Research Expenses.</SUBJECT> <P>(a) <E T="03">Trade or business requirement—</E>(1) <E T="03">In general.</E> An in-house research expense of the taxpayer or a contract research expense of the taxpayer is a qualified research expense only if the expense is paid or incurred by the taxpayer in carrying on a trade or business of the taxpayer. The phrase “in carrying on a trade or business” has the same meaning for purposes of section 41(b)(1) as it has for purposes of section 162; thus, expenses paid or incurred in connection with a trade or business within the meaning of section 174(a) (relating to the deduction for research and experimental expenses) are not necessarily paid or incurred in carrying on a trade or business for purposes of section 41. A research expense must relate to a particular trade or business being carried on by the taxpayer at the time the expense is paid or incurred in order to be a qualified research expense. For purposes of section 41, a contract research expense of the taxpayer is not a qualified research expense if the product or result of the research is intended to be transferred to another in return for license or royalty payments and the taxpayer does not use the product of the research in the taxpayer's trade or business.</P> <P>(2) <E T="03">New business.</E> Expenses paid or incurred prior to commencing a new business (as distinguished from expanding an existing business) may be paid or incurred in connection with a trade or business but are not paid or incurred in carrying on a trade or business. Thus, research expenses paid or incurred by a taxpayer in developing a product the sale of which would constitute a new trade or business for the taxpayer are not paid or incurred in carrying on a trade or business.</P> <P>(3) <E T="03">Research performed for others—</E>(i) <E T="03">Taxpayer not entitled to results.</E> If the taxpayer performs research on behalf of another person and retains no substantial rights in the research, that research shall not be taken into account by the taxpayer for purposes of section 41. See § 1.41-4A(d)(2).</P> <P>(ii) <E T="03">Taxpayer entitled to results.</E> If the taxpayer in carrying on a trade or business performs research on behalf of other persons but retains substantial rights in the research, the taxpayer shall take otherwise qualified expenses for that research into account for purposes of section 41 to the extent provided in § 1.41-4A(d)(3).</P> <P>(4) <E T="03">Partnerships</E>—(i) <E T="03">In general.</E> An in-house research expense or a contract research expense paid or incurred by a partnership is a qualified research expense of the partnership if the expense is paid or incurred by the partnership in carrying on a trade or business of the partnership, determined at the partnership level without regard to the trade or business of any partner.</P> <P>(ii) <E T="03">Special rule for certain partnerships and joint ventures.</E> (A) If a partnership or a joint venture (taxable as a partnership) is not carrying on the trade or business to which the research relates, then the general rule in paragraph (a)(4)(i) of this section would not allow any of such expenditures to qualify as qualified research expenses.</P> <P>(B) Notwithstanding paragraph (a)(4)(ii)(A) of this section, if all the partners or venturers are entitled to make independent use of the results of the research, this paragraph (a)(4)(ii) may allow a portion of such expenditures to be treated as qualified research expenditures by certain partners or venturers.</P> <P>(C) First, in order to determine the amount of credit that may be claimed by certain partners or venturers, the amount of qualified research expenditures of the partnership or joint venture is determined (assuming for this purpose that the partnership or joint venture is carrying on the trade or business to which the research relates).</P> <P>(D) Second, this amount is reduced by the proportionate share of such expenses allocable to those partners or venturers who would not be able to claim such expenses as qualified research expenditures if they had paid or incurred such expenses directly. For this purpose such partners’ or venturers’ proportionate share of such expenses shall be determined on the basis of such partners’ or venturers’ share of <PRTPAGE P="115"/>partnership items of income or gain (excluding gain allocated under section 704(c)) which results in the largest proportionate share. Where a partner's or venturer's share of partnership items of income or gain (excluding gain allocated under section 704(c)) may vary during the period such partner or venturer is a partner or venturer in such partnership or joint venture, such share shall be the highest share such partner or venturer may receive.</P> <P>(E) Third, the remaining amount of qualified research expenses is allocated among those partners or venturers who would have been entitled to claim a credit for such expenses if they had paid or incurred the research expenses in their own trade or business, in the relative proportions that such partners or venturers share deductions for expenses under section 174 for the taxable year that such expenses are paid or incurred.</P> <P>(F) For purposes of section 41, research expenditures to which this paragraph (a)(4)(ii) applies shall be treated as paid or incurred directly by such partners or venturers. See § 1.41-7(a)(3)(ii) for special rules regarding these expenses.</P> <P>(iii) The following examples illustrate the application of the principles contained in paragraph (a)(4)(ii) of this section. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A joint venture (taxable as a partnership) is formed by corporations A, B, and C to develop and market a supercomputer. A and B are in the business of developing computers, and each has a 30 percent distributive share of each item of income, gain, loss, deduction, credit and basis of the joint venture. C, which is an investment banking firm, has a 40 percent distributive share of each item of income, gain, loss, deduction, credit and basis of the joint venture. The joint venture agreement provides that A's, B's and C's distributive shares will not vary during the life of the joint venture, liquidation proceeds are to be distributed in accordance with the partners’ capital account balances, and any partner with a deficit in its capital account following the distribution of liquidation proceeds is required to restore the amount of such deficit to the joint venture. Assume in Year 1 that the joint venture incurs $100x of “qualified research expenses.” Assume further that the joint venture cannot claim the research credit for such expenses because it is not carrying on the trade or business to which the research relates. In addition A, B, and C are all entitled to make independent use of the results of the research. First, the amount of qualified research expenses of the joint venture is $l00x. Second, this amount is reduced by the proportionate share of such expenses allocable to C, the venturer which would not have been able to claim such expenses as qualified research expenditures if it had paid or incurred them directly, C's proportionate share of such expenses is $40x (40% of $100x). The reduced amount is $60x. Third, the remaining $60x of qualified research expenses is allocated between A and B in the relative proportions that A and B share deductions for expenses under section 174. A is entitled to treat $30x ((30%/(30%+30%)) $60x) as a qualified research expense. B is also entitled to treat $30x ((30%/(30%+30%)) $60x) as a qualified research expense.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Assume the same facts as in example (1) except that the joint venture agreement provides that during the first 2 years of the joint venture, A and B are each allocated 10 percent of each item of income, gain, loss, deduction, credit and basis, and C is allocated 80 percent of each item of income, gain, loss, deduction, credit and basis. Thereafter the allocations are the same as in example (1). Assume for purposes of this example that such allocations have substantial economic effect for purposes of section 704 (b). C's highest share of such items during the life of the joint venture is 80 percent. Therefore C's proportionate share of the joint venture's qualified research expenses is $80x (80% of $100x). The reduced amount of qualified research expenses is $20x ($100x−$80x). A is entitled to treat $10x ((10%/(10%+10%)) $20x) as a qualified research expense in Year 1. B is also entitled to treat $10x ((10%/(10%+10%)) $20x) as a qualified research expense in Year 1.</P> </EXAMPLE> <P>(b) <E T="03">Supplies and personal property used in the conduct of qualified research</E>—(1) <E T="03">In general.</E> Supplies and personal property (except to the extent provided in paragraph (b)(4) of this section) are used in the conduct of qualified research if they are used in the performance of qualified services (as defined in section 41(b)(2)(B), but without regard to the last sentence thereof) by an employee of the taxpayer (or by a person acting in a capacity similar to that of an employee of the taxpayer; see example (6) of § 1.41-2(e)(5)). Expenditures for supplies or for the use of personal property that are indirect research expenditures or general and administrative expenses do not qualify as inhouse research expenses.<PRTPAGE P="116"/> </P> <P>(2) <E T="03">Certain utility charges</E>—(i) <E T="03">In general.</E> In general, amounts paid or incurred for utilities such as water, electricity, and natural gas used in the building in which qualified research is performed are treated as expenditures for general and administrative expenses.</P> <P>(ii) <E T="03">Extraordinary expenditures.</E> To the extent the taxpayer can establish that the special character of the qualified research required additional extraordinary expenditures for utilities, the additional expenditures shall be treated as amounts paid or incurred for supplies used in the conduct of qualified research. For example, amounts paid for electricity used for general laboratory lighting are treated as general and administrative expenses, but amounts paid for electricity used in operating high energy equipment for qualified research (such as laser or nuclear research) may be treated as expenditures for supplies used in the conduct of qualified research to the extent the taxpayer can establish that the special character of the research required an extraordinary additional expenditure for electricity.</P> <P>(3) <E T="03">Right to use personal property.</E> The determination of whether an amount is paid to or incurred for another person for the right to use personal property in the conduct of qualified research shall be made without regard to the characterization of the transaction as a lease under section 168(f)(8) (as that section read before it was repealed by the Tax Reform Act of 1986). See § 5c.168(f)(8)-1(b).</P> <P>(4) <E T="03">Use of personal property in taxable years beginning after December 31, 1985.</E> For taxable years beginning after December 31, 1985, amounts paid or incurred for the use of personal property are not qualified research expenses, except for any amount paid or incurred to another person for the right to use (time-sharing) computers in the conduct of qualified research. The computer must be owned and operated by someone other than the taxpayer, located off the taxpayer's premises, and the taxpayer must not be the primary user of the computer.</P> <P>(c) <E T="03">Qualified services</E>—(1) <E T="03">Engaging in qualified research.</E> The term “engaging in qualified research” as used in section 41(b)(2)(B) means the actual conduct of qualified research (as in the case of a scientist conducting laboratory experiments).</P> <P>(2) <E T="03">Direct supervision.</E> The term “direct supervision” as used in section 41(b)(2)(B) means the immediate supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). “Direct supervision” does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.</P> <P>(3) <E T="03">Direct support.</E> The term “direct support” as used in section 41(b)(2)(B) means services in the direct support of either—</P> <P>(i) Persons engaging in actual conduct of qualified research, or</P> <P>(ii) Persons who are directly supervising persons engaging in the actual conduct of qualified research. For example, direct support of research includes the services of a secretary for typing reports describing laboratory results derived from qualified research, of a laboratory worker for cleaning equipment used in qualified research, of a clerk for compiling research data, and of a machinist for machining a part of an experimental model used in qualified research. Direct support of research activities does not include general administrative services, or other services only indirectly of benefit to research activities. For example, services of payroll personnel in preparing salary checks of laboratory scientists, of an accountant for accounting for research expenses, of a janitor for general cleaning of a research laboratory, or of officers engaged in supervising financial or personnel matters do not qualify as direct support of research. This is true whether general administrative personnel are part of the research department or in a separate department. Direct support does not include supervision. Supervisory services constitute “qualified services” only to the extent provided in paragraph (c)(2) of this section.</P> <P>(d) <E T="03">Wages paid for qualified services—</E>(1) <E T="03">In general.</E> Wages paid to or incurred <PRTPAGE P="117"/>for an employee constitute in-house research expenses only to the extent the wages were paid or incurred for qualified services performed by the employee. If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense. In the absence of another method of allocation that the taxpayer can demonstrate to be more appropriate, the amount of in-house research expense shall be determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the taxpayer to the total time spent by the employee in the performance of all services for the taxpayer during the taxable year.</P> <P>(2) “<E T="03">Substantially all</E>.” Notwithstanding paragraph (d)(1) of this section, if substantially all of the services performed by an employee for the taxpayer during the taxable year consist of services meeting the requirements of section 41(b)(2)(B) (i) or (ii), then the term “qualified services” means all of the services performed by the employee for the taxpayer during the taxable year. Services meeting the requirements of section 41(b)(2)(B) (i) or (ii) constitute substantially all of the services performed by the employee during a taxable year only if the wages allocated (on the basis used for purposes of paragraph (d)(1) of this section) to services meeting the requirements of section 41(b)(2)(B) (i) or (ii) constitute at least 80 percent of the wages paid to or incurred by the taxpayer for the employee during the taxable year.</P> <P>(e) <E T="03">Contract research expenses—</E>(1) <E T="03">In general.</E> A contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person other than an employee of the taxpayer for the performance on behalf of the taxpayer of—</P> <P>(i) Qualified research as defined in § 1.41-4 or 1.41-4A, whichever is applicable, or</P> <P>(ii) Services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B).</P> <FP>Where the contract calls for services other than services described in this paragraph (e)(1), only 65 percent of the portion of the amount paid or incurred that is attributable to the services described in this paragraph (e)(1) is a contract research expense.</FP> <P>(2) <E T="03">Performance of qualified research.</E> An expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement that—</P> <P>(i) Is entered into prior to the performance of the qualified research,</P> <P>(ii) Provides that research be performed on behalf of the taxpayer, and</P> <P>(iii) Requires the taxpayer to bear the expense even if the research is not successful.</P> <FP>If an expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result rather than the performance of the research, and the payment is not a contract research expense. The previous sentence applies only to that portion of a payment which is contingent on the success of the research.</FP> <P>(3) “<E T="03">On behalf of.”</E> Qualified research is performed on behalf of the taxpayer if the taxpayer has a right to the research results. Qualified research can be performed on behalf of the taxpayer notwithstanding the fact that the taxpayer does not have exclusive rights to the results.</P> <P>(4) <E T="03">Prepaid amounts.</E> Notwithstanding paragraph (e)(1) of this section, if any contract research expense paid or incurred during any taxable year is attributable to qualified research to be conducted after the close of such taxable year, the expense so attributable shall be treated for purposes of section 41(b)(1)(B) as paid or incurred during the period during which the qualified research is conducted.</P> <P>(5) <E T="03">Examples.</E> The following examples illustrate provisions contained in paragraphs (e) (1) through (4) of this section. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A, a cash-method taxpayer using the calendar year as the taxable year, enters into a contract with B Corporation under which B is to perform qualified research on behalf of A. The contract requires A to pay B $300x, regardless of the success of <PRTPAGE P="118"/>the research. In 1982, B performs all of the research, and A makes full payment of $300x under the contract. Accordingly, during the taxable year 1982, $195x (65 percent of the payment of $300x) constitutes a contract research expense of A.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in example (1), except that B performs 50 percent of the research in 1983. Of the $195x of contract research expense paid in 1982, paragraph (e)(4) of this section provides that $97.5x (50 percent of $195x) is a contract research expense for 1982 and the remaining $97.5x is contract research expense for 1983.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>The facts are the same as in example (1), except that instead of calling for a flat payment of $300x, the contract requires A to reimburse B for all expenses plus pay B $l00x. B incurs expenses attributable to the research as follows:</P> <GPOTABLE CDEF="s25,6" COLS="2" OPTS="L0,7/8,g1,t1,i1"> <ROW> <ENT I="01">Labor</ENT> <ENT>$90x</ENT> </ROW> <ROW> <ENT I="01">Supplies</ENT> <ENT>20x</ENT> </ROW> <ROW> <ENT I="01">Depreciation on equipment</ENT> <ENT>50x</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Overhead</ENT> <ENT>40x </ENT> </ROW> <ROW> <ENT I="04">Total</ENT> <ENT>200x</ENT> </ROW> </GPOTABLE> <FP>Under this agreement A pays B $300x during 1982. Accordingly, during taxable year 1982, $195x (65 percent of $300x) of the payment constitutes a contract research expense of A.</FP> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>The facts are the same as in example (3), except that A agrees to reimburse B for all expenses and agrees to pay B an additional amount of $100x, but the additional $100x is payable only if the research is successful. The research is successful and A pays B $300x during 1982. Paragraph (e)(2) of this section provides that the contingent portion of the payment is not an expense incurred for the performance of qualified research. Thus, for taxable year 1982, $130x (65 percent of the payment of $200x) constitutes a contract research expense of A.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>C conducts in-house qualified research in carrying on a trade or business. In addition, C pays D Corporation, a provider of computer services, $100x to develop software to be used in analyzing the results C derives from its research. Because the software services, if performed by an employee of C, would constitute qualified services, $65x of the $100x constitutes a contract research expense of C.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>C conducts in-house qualified research in carrying on C's trade or business. In addition, C contracts with E Corporation, a provider of temporary secretarial services, for the services of a secretary for a week. The secretary spends the entire week typing reports describing laboratory results derived from C's qualified research. C pays E $400 for the secretarial service, none of which constitutes wages within the meaning of section 41(b)(2)(D). These services, if performed by employees of C, would constitute qualified services within the meaning of section 41(b)(2)(B). Thus, pursuant to paragraph (e)(1) of this section, $260 (65 percent of $400) constitutes a contract research expense of C.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 7.</HD> <P>C conducts in-house qualified research in carrying on C's trade or business. In addition, C pays F, an outside accountant, $100x to keep C's books and records pertaining to the research project. The activity carried on by the accountant does not constitute qualified research as defined in section 41(d). The services performed by the accountant, if performed by an employee of C, would not constitute qualified services (as defined in section 41(b)(2)(B)). Thus, under paragraph (e)(1) of this section, no portion of the $100x constitutes a contract research expense.</P> </EXAMPLE> <CITA>[T.D. 8251, 54 FR 21204, May 17, 1989, as amended by T.D. 8930, 65 FR 287, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-3</SECTNO> <SUBJECT>Base amount for taxable years beginning on or after January 3, 2001.</SUBJECT> <P>(a) <E T="03">New taxpayers.</E> If, with respect to any credit year, the taxpayer has not been in existence for any previous taxable year, the average annual gross receipts of the taxpayer for the four taxable years preceding the credit year shall be zero. If, with respect to any credit year, the taxpayer has been in existence for at least one previous taxable year, but has not been in existence for four taxable years preceding the taxable year, then the average annual gross receipts of the taxpayer for the four taxable years preceding the credit year shall be the average annual gross receipts for the number of taxable years preceding the credit year for which the taxpayer has been in existence.</P> <P>(b) <E T="03">Special rules for short taxable years</E>—(1) <E T="03">Short credit year.</E> If a credit year is a short taxable year, then the base amount determined under section 41(c)(1) (but not section 41(c)(2)) shall be modified by multiplying that amount by the number of months in the short taxable year and dividing the result by 12.</P> <P>(2) <E T="03">Short taxable year preceding credit year.</E> If one or more of the four taxable years preceding the credit year is a short taxable year, then the gross receipts for such year are deemed to be equal to the gross receipts actually derived in that year multiplied by 12 and divided by the number of months in that year.<PRTPAGE P="119"/> </P> <P>(3) <E T="03">Short taxable year in determining fixed-base percentage.</E> No adjustment shall be made on account of a short taxable year to the computation of a taxpayer's fixed-base percentage.</P> <P>(c) <E T="03">Definition of gross receipts</E>—(1) <E T="03">In general.</E> For purposes of section 41, gross receipts means the total amount, as determined under the taxpayer's method of accounting, derived by the taxpayer from all its activities and from all sources (<E T="03">e.g.,</E> revenues derived from the sale of inventory before reduction for cost of goods sold).</P> <P>(2) <E T="03">Amounts excluded.</E> For purposes of this paragraph (c), gross receipts do not include amounts representing—</P> <P>(i) Returns or allowances;</P> <P>(ii) Receipts from the sale or exchange of capital assets, as defined in section 1221;</P> <P>(iii) Repayments of loans or similar instruments (<E T="03">e.g.,</E> a repayment of the principal amount of a loan held by a commercial lender);</P> <P>(iv) Receipts from a sale or exchange not in the ordinary course of business, such as the sale of an entire trade or business or the sale of property used in a trade or business as defined under section 1221(2);</P> <P>(v) Amounts received with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority; and</P> <P>(vi) Amounts received by a taxpayer in a taxable year that precedes the first taxable year in which the taxpayer derives more than $25,000 in gross receipts other than investment income. For purposes of this paragraph (c)(2)(vi), investment income is interest or distributions with respect to stock (other than the stock of a 20-percent owned corporation as defined in section 243(c)(2).</P> <P>(3) <E T="03">Foreign corporations.</E> For purposes of section 41, in the case of a foreign corporation, gross receipts include only gross receipts that are effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico, or other possessions of the United States. See section 864(c) and applicable regulations thereunder for the definition of effectively connected income.</P> <P>(d) <E T="03">Consistency requirement</E>—(1) <E T="03">In general.</E> In computing the credit for increasing research activities for taxable years beginning after December 31, 1989, qualified research expenses and gross receipts taken into account in computing a taxpayer's fixed-base percentage and a taxpayer's base amount must be determined on a basis consistent with the definition of qualified research expenses and gross receipts for the credit year, without regard to the law in effect for the taxable years taken into account in computing the fixed-base percentage or the base amount. This consistency requirement applies even if the period for filing a claim for credit or refund has expired for any taxable year taken into account in computing the fixed-base percentage or the base amount.</P> <P>(2) <E T="03">Illustrations.</E> The following examples illustrate the application of the consistency rule of paragraph (d)(1) of this section: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) X, an accrual method taxpayer using the calendar year as its taxable year, incurs qualified research expenses in 2001. X wants to compute its research credit under section 41 for the tax year ending December 31, 2001. As part of the computation, X must determine its fixed-base percentage, which depends in part on X's qualified research expenses incurred during the fixed-base period, the taxable years beginning after December 31, 1983, and before January 1, 1989.</P> <P>(ii) During the fixed-base period, X reported the following amounts as qualified research expenses on its Form 6765:</P> <GPOTABLE CDEF="s50,6" COLS="2" OPTS="L0,tp0,p0,7/8,g1,t1"> <ROW> <ENT I="01">1984</ENT> <ENT>$100x</ENT> </ROW> <ROW> <ENT I="01">1985</ENT> <ENT> 120x</ENT> </ROW> <ROW> <ENT I="01">1986</ENT> <ENT> 150x</ENT> </ROW> <ROW> <ENT I="01">1987</ENT> <ENT> 180x</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">1988</ENT> <ENT> 170x</ENT> </ROW> <ROW> <ENT I="03">Total</ENT> <ENT> 720x</ENT> </ROW> </GPOTABLE> <P>(iii) For the taxable years ending December 31, 1984, and December 31, 1985, X based the amounts reported as qualified research expenses on the definition of qualified research in effect for those taxable years. The definition of qualified research changed for taxable years beginning after December 31, 1985. If X used the definition of qualified research applicable to its taxable year ending December 31, 2001, the credit year, its qualified research expenses for the taxable years ending December 31, 1984, and December 31, <PRTPAGE P="120"/>1985, would be reduced to $ 80x and $ 100x, respectively. Under the consistency rule in section 41(c)(5) and paragraph (d)(1) of this section, to compute the research credit for the tax year ending December 31, 2001, X must reduce its qualified research expenses for 1984 and 1985 to reflect the change in the definition of qualified research for taxable years beginning after December 31, 1985. Thus, X's total qualified research expenses for the fixed-base period (1984-1988) to be used in computing the fixed-base percentage is $80 + 100 + 150 + 180 + 170 = $680x.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in <E T="03">Example 1,</E> except that, in computing its qualified research expenses for the taxable year ending December 31, 2001, X claimed that a certain type of expenditure incurred in 2001 was a qualified research expense. X's claim reflected a change in X's position, because X had not previously claimed that similar expenditures were qualified research expenses. The consistency rule requires X to adjust its qualified research expenses in computing the fixed-base percentage to include any similar expenditures not treated as qualified research expenses during the fixed-base period, regardless of whether the period for filing a claim for credit or refund has expired for any year taken into account in computing the fixed-base percentage.</P> </EXAMPLE> <P>(e) <E T="03">Effective date.</E> The rules in paragraphs (c) and (d) of this section are applicable for taxable years beginning on or after the date final regulations are published in the <E T="04">Federal Register</E>.</P> <CITA>[T.D. 8930, 66 FR 289, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-4</SECTNO> <SUBJECT>Qualified research for expenditures paid or incurred on or after January 3, 2001.</SUBJECT> <P>(a) <E T="03">Qualified research</E>—(1) <E T="03">General rule.</E> Research activities related to the development or improvement of a business component constitute qualified research only if the research activities meet all of the requirements of section 41(d)(1) and this section, and are not otherwise excluded under section 41(d)(3)(B) or (d)(4), or this section.</P> <P>(2) <E T="03">Requirements of section 41(d)(1).</E> Research constitutes qualified research only if it is research—</P> <P>(i) With respect to which expenditures may be treated as expenses under section 174, see § 1.174-2;</P> <P>(ii) That is undertaken for the purpose of discovering information that is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and</P> <P>(iii) Substantially all of the activities of which constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality. </P> <FP>For certain recordkeeping requirements, see paragraph (d) of this section.</FP> <P>(3) <E T="03">Undertaken for the purpose of discovering information</E>—(i) <E T="03">In general.</E> For purposes of section 41(d) and this section, research is undertaken for the purpose of discovering information only if it is undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. A determination that research is undertaken for the purpose of discovering information does not require that the taxpayer succeed in obtaining the knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering, nor does it require that the advance sought be more than evolutionary. However, research is not undertaken for the purpose of discovering information merely because an expenditure may be treated as an expense under section 174.</P> <P>(ii) <E T="03">Common knowledge.</E> Common knowledge of skilled professionals in a particular field of science or engineering means information that should be known to skilled professionals had they performed, before the research in question is undertaken, a reasonable investigation of the existing level of information in the particular field of science or engineering. Thus, knowledge may, in certain circumstances, exceed, expand, or refine the common knowledge of skilled professionals in a particular field of science or engineering even though such knowledge has previously been obtained by other persons. For example, trade secrets generally are not within the common knowledge of skilled professionals in a particular field of science or engineering because they are not reasonably available to skilled professionals not employed, hired, or licensed by the owner of such trade secrets.<PRTPAGE P="121"/> </P> <P>(iii) <E T="03">Means of discovery.</E> In seeking to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering, a taxpayer may employ existing technologies in a particular field and may rely on existing principles of science or engineering.</P> <P>(iv) <E T="03">Patent safe harbor.</E> For purposes of section 41(d) and paragraph (a)(3)(i) of this section, the issuance of a patent by the Patent and Trademark Office under the provisions of section 151 of title 35, United States Code (other than a patent for design issued under the provisions of section 171 of title 35, United States Code) is conclusive evidence that a taxpayer has obtained knowledge that exceeds, expands, or refines the common knowledge of skilled professionals. However, the issuance of such a patent is not a precondition for credit availability.</P> <P>(v) <E T="03">Rebuttable presumption.</E> If a taxpayer demonstrates with credible evidence that research activities were undertaken to obtain the information described in the taxpayer's contemporaneous documentation required under paragraph (d)(1) of this section, and if that documentation also sets forth the basis for the taxpayer's belief that obtaining this information would exceed, expand, or refine the common knowledge of skilled professionals in the particular field of science or engineering, the research activities are presumed to satisfy the requirements of this paragraph (a)(3). However, the presumption applies only if the taxpayer cooperates with reasonable requests by the Commissioner for witnesses, information, documents, meetings, and interviews. Furthermore, the Commissioner may overcome the presumption in this paragraph if the Commissioner demonstrates that the information described in the taxpayer's documentation was within the common knowledge of skilled professionals (as described in paragraph (a)(3)(ii) of this section), or that the research activities were not undertaken to obtain the information described in the taxpayer's documentation.</P> <P>(4) <E T="03">Technological in nature.</E> For purposes of section 41(d) and this section, information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.</P> <P>(5) <E T="03">Process of experimentation.</E> For purposes of section 41(d) and this section, a process of experimentation is a process to evaluate more than one alternative designed to achieve a result where the capability or method of achieving that result is uncertain at the outset. A process of experimentation does not include the evaluation of alternatives to establish the appropriate design of a business component, if the capability and method for developing or improving the business component are not uncertain. A process of experimentation in the physical or biological sciences, engineering, or computer science may involve—</P> <P>(i) Developing one or more hypotheses designed to achieve the intended result;</P> <P>(ii) Designing an experiment (that, where appropriate to the particular field of research, is intended to be replicable with an established experimental control) to test and analyze those hypotheses (through, for example, modeling, simulation, or a systematic trial and error methodology);</P> <P>(iii) Conducting the experiment; and</P> <P>(iv) Refining or discarding the hypotheses as part of a sequential design process to develop or improve the business component.</P> <P>(6) <E T="03">Substantially all requirement.</E> The substantially all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is satisfied only if 80 percent or more of the research activities, measured on a cost or other consistently applied reasonable basis (and without regard to § 1.41-2(d)(2)), constitute elements of a process of experimentation for a purpose described in section 41(d)(3). The substantially all requirement is applied separately to each business component.</P> <P>(7) <E T="03">Use of computers and information technology.</E> The employment of computers or information technology, or the reliance on principles of computer science or information technology to store, collect, manipulate, translate, disseminate, produce, distribute, or <PRTPAGE P="122"/>process data or information, and similar uses of computers and information technology does not itself establish that qualified research has been undertaken.</P> <P>(8) <E T="03">Illustrations.</E> The following examples illustrate the application of this paragraph (a): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) <E T="03">Facts.</E> X and other manufacturing companies have previously designed and manufactured a particular kind of machine using Material S. Material T is less expensive than Material S. X wishes to design a new machine that appears and functions exactly the same as its existing machines, but that is made of Material T instead of Material S. The capability and method necessary to achieve this objective should not have been known to skilled professionals had they conducted a reasonable investigation of the existing information in the relevant field of science or engineering at the time the research was undertaken.</P> <P>(ii) <E T="03">Conclusion.</E> X's activities to design the new machine using Material T may be qualified research within the meaning of section 41(d)(1) and this paragraph (a). In seeking to design the machine, X undertook to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>(i) <E T="03">Facts.</E> X is engaged in the business of developing and manufacturing widgets. X wants to manufacture an improved widget made out of a material that X has not previously used. Although X is uncertain how to use the material to manufacture an improved widget, the capability and method of using the material to manufacture such widgets should have been known to skilled professionals had they conducted a reasonable investigation of the existing level of information in the particular field of science or engineering at the time the research was undertaken.</P> <P>(ii) <E T="03">Conclusion.</E> Even though X's expenditures for the activities to resolve the uncertainty in manufacturing the improved widget may be treated as expenses for research activities under section 174 and § 1.174-2, X's activities to resolve the uncertainty in manufacturing the improved widget are not qualified research within the meaning of section 41(d) and this paragraph (a). Although X's activities were intended to eliminate uncertainty, the activities were not undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>(i) <E T="03">Facts.</E> X desires to build a bridge that can sustain greater traffic flow without deterioration than can existing bridges. The capability and method used to build such a bridge should not have been known to skilled professionals had they conducted a reasonable investigation of the existing level of information in the particular field of science or engineering at the time the research was undertaken. X eventually abandons the project after attempts to develop the technology prove unsuccessful.</P> <P>(ii) <E T="03">Conclusion.</E> X's activities to develop the technology to build the bridge may be qualified research within the meaning of section 41(d)(1) and this paragraph (a), regardless of the fact that X did not actually succeed in developing that technology. In seeking to develop the technology, X undertook to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>(i) <E T="03">Facts.</E> The facts are the same as in <E T="03">Example 3</E>, except that Y successfully builds a bridge that can sustain the greater traffic flow. Thereafter, Z seeks to build a bridge that can also sustain such greater traffic flow. The method Y used to build its bridge is a closely guarded trade secret that is not known to Z and should not have been known to skilled professionals had they conducted a reasonable investigation of the existing level of information in the particular field of science or engineering at the time the research was undertaken.</P> <P>(ii) <E T="03">Conclusion.</E> Z's activities to develop the technology to build the bridge may be qualified research within the meaning of section 41(d)(1) and this paragraph (a), even if it so happens that the technology Z used to build its bridge is similar or identical to the technology Y used. In developing the technology, Z undertook to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>(i) <E T="03">Facts.</E> X, a widget manufacturer, seeks to develop a new widget and initiates Project A. Before or during the early stages of Project A, X's employees prepare contemporaneous documentation that describes the principal questions to be answered by Project A and the information that X seeks to obtain to exceed, expand, or refine the common knowledge of skilled professionals in the relevant field of science or engineering. The documentation includes a statement from one of X's skilled professionals setting forth the basis for that professional's belief that the information is beyond the common knowledge of skilled professionals in the relevant field. Upon examination by the Commissioner, X presents credible evidence that the research activities were undertaken to obtain the information described in the contemporaneous documentation. X cooperates with all requests by the IRS for witnesses, information, documents, meetings, and interviews.<PRTPAGE P="123"/> </P> <P>(ii) <E T="03">Conclusion.</E> X's research activities with respect to Project A are presumed to be undertaken for the purpose of obtaining knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering. The Commissioner may overcome this presumption by demonstrating that the information X sought to obtain was within the common knowledge of skilled professionals in the relevant field of science or engineering (<E T="03">i.e.,</E> by demonstrating that, at the time Project A began, the information should have been known to skilled professionals had they performed a reasonable investigation of the existing level of knowledge in the relevant field).</P> </EXAMPLE> <P>(b) <E T="03">Application of requirements for qualified research</E>—(1) <E T="03">In general.</E> The requirements for qualified research in section 41(d)(1) and paragraph (a) of this section, must be applied separately to each business component, as defined in section 41(d)(2)(B). In cases involving development of both a product and a manufacturing or other commercial production process for the product, research activities relating to development of the process are not qualified research unless the requirements of section 41(d) and this section are met for the research activities relating to the process without taking into account the research activities relating to development of the product. Similarly, research activities relating to development of the product are not qualified research unless the requirements of section 41(d) and this section are met for the research activities relating to the product without taking into account the research activities relating to development of the manufacturing or other commercial production process.</P> <P>(2) <E T="03">Shrinking-back rule.</E> The requirements of section 41(d) and paragraph (a) of this section are to be applied first at the level of the discrete business component, that is, the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer. If the requirements for credit eligibility are met at that first level, then some or all of the taxpayer's research expenses are eligible for the credit. A special shrinking-back rule </P> applies in the case where a taxpayer incurs some research expenses with respect to that discrete business component that would constitute qualified research expenses with respect to that business component but for the fact that less than substantially all of the research activities with respect to that component constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality. In such a case, the requirements for the credit are to be applied at the next most significant subset of elements of the business component. The shrinking-back of the applicable business component continues until a subset or series of subsets of elements of the business component satisfies substantially all requirements of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section (treating that subset of elements as a business component) or the most basic element fails to satisfy the requirements. This shrinking-back rule is applied only if a taxpayer does not satisfy the requirements of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section with respect to the overall business component. The shrinking-back rule is not itself applied as a reason to exclude research activities from credit eligibility.<P>(3) <E T="03">Illustration.</E> The following example illustrates the application of this paragraph (b):</P> <EXTRACT> <P>(i) <E T="03">Facts.</E> X, a widget manufacturer, develops a widget that is improved in several respects. Among the various improvements to the widget is an improvement to the widget's cooling mechanism. Although the capability and method of making the other improvements to the widget would have been known to skilled professionals had they conducted a reasonable investigation of the existing level of information in the particular field of science or engineering, the method of developing the improved cooling mechanism and of incorporating the improved mechanism into the widget would not have been known to skilled professionals had they conducted a reasonable investigation of the existing level of information in the particular field of science or engineering. Substantially all of X's research activities in improving the widget constitute elements of a process of experimentation <PRTPAGE P="124"/>for purposes of improving the performance of the widget. None of X's research activities in improving the widget are described in section 41(d)(4) or paragraph (c) of this section.</P> <P>(ii) <E T="03">Conclusion.</E> Some, but not all, of X's research activities in developing the improved widget are qualified research within the meaning of section 41(d)(1) and paragraph (a) of this section. In seeking to improve the widget, some of X's activities (related to improving the cooling mechanism and incorporating the improved cooling mechanism into the widget) were undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering. However, other activities (related to the other improvements) were not undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering, and thus are not qualified research and are not eligible for the credit. Not all of X's research activities relating to the widget are eligible for the credit because some of the activities are not qualified research as defined in section 41(d) and paragraph (a) of this section, even though the widget qualifies as a business component with respect to which qualified research that satisfies the requirements of section 41(d) and paragraph (a) of this section is undertaken.</P> </EXTRACT> <P>(c) <E T="03">Excluded activities</E>—(1) <E T="03">In general.</E> Qualified research does not include any activity described in section 41(d)(4) and paragraph (c) of this section.</P> <P>(2) <E T="03">Research after commercial production</E>—(i) <E T="03">In general.</E> Activities conducted after the beginning of commercial production of a business component are not qualified research. Activities are conducted after the beginning of commercial production of a business component if such activities are conducted after the component is developed to the point where it is ready for commercial sale or use, or meets the basic functional and economic requirements of the taxpayer for the component's sale or use.</P> <P>(ii) <E T="03">Certain additional activities related to the business component.</E> The following activities are deemed to occur after the beginning of commercial production of a business component—</P> <P>(A) Preproduction planning for a finished business component;</P> <P>(B) Tooling-up for production;</P> <P>(C) Trial production runs;</P> <P>(D) Trouble shooting involving detecting faults in production equipment or processes;</P> <P>(E) Accumulating data relating to production processes; and</P> <P>(F) Debugging flaws in a business component.</P> <P>(iii) <E T="03">Activities related to production process or technique.</E> In cases involving development of both a product and a manufacturing or other commercial production process for the product, the exclusion described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of this section applies separately for the activities relating to the development of the product and the activities relating to the development of the process. For example, even after a product meets the taxpayer's basic functional and economic requirements, activities relating to the development of the manufacturing process still may constitute qualified research, provided that the development of the process itself separately satisfies the requirements of section 41(d) and this section, and the activities are conducted before the process meets the taxpayer's basic functional and economic requirements or is ready for commercial use.</P> <P>(iv) <E T="03">Clinical testing.</E> Clinical testing of a pharmaceutical product prior to its commercial production in the United States is not treated as occurring after the beginning of commercial production even if the product is commercially available in other countries. Additional clinical testing of a pharmaceutical product after a product has been approved for a specific therapeutic use by the Food and Drug Administration and is ready for commercial production and sale are not treated as occurring after the beginning of commercial production if such clinical tests are undertaken to establish new functional uses, characteristics, indications, combinations, dosages, or delivery forms for the product. A functional use, characteristic, indication, combination, dosage or delivery form shall <PRTPAGE P="125"/>be considered new only if such functional use, characteristic, indication, combination, dosage or delivery form must be approved by the Food and Drug Administration.</P> <P>(3) <E T="03">Adaptation of existing business components.</E> Activities relating to adapting an existing business component to a particular customer's requirement or need are not qualified research. This exclusion does not apply merely because a business component is intended for a specific customer.</P> <P>(4) <E T="03">Duplication of existing business component.</E> Activities relating to reproducing an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information about the business component are not qualified research. This exclusion does not apply merely because the taxpayer inspects an existing business component in the course of developing its own business component.</P> <P>(5) <E T="03">Surveys, studies, research relating to management functions, etc.</E> Qualified research does not include activities relating to—</P> <P>(i) Efficiency surveys;</P> <P>(ii) Management functions or techniques, including such items as preparation of financial data and analysis, development of employee training programs and management organization plans, and management-based changes in production processes (such as rearranging work stations on an assembly line);</P> <P>(iii) Market research, testing, or development (including advertising or promotions);</P> <P>(iv) Routine data collections; or</P> <P>(v) Routine or ordinary testing or inspections for quality control.</P> <P>(6) <E T="03">Internal-use computer software</E>—(i) <E T="03">General rule.</E> Research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use is eligible for the research credit only if the software satisfies the requirements of paragraph (c)(6)(ii) of this section.</P> <P>(ii) <E T="03">Requirements.</E> The requirements of this paragraph (c)(6)(ii) are—</P> <P>(A) The research satisfies the requirements of section 41(d)(1);</P> <P>(B) The research is not otherwise excluded under section 41(d)(4) (other than section 41(d)(4)(E)); and (C) One of the following conditions is met—</P> <P>(<E T="03">1</E>) The taxpayer develops the software for use in an activity that constitutes qualified research (other than the development of the internal-use software itself);</P> <P>(<E T="03">2</E>) The taxpayer develops the software for use in a production process that meets the requirements of section 41(d)(1);</P> <P>(<E T="03">3</E>) The taxpayer develops a new or improved package of computer software and hardware together as a single product, of which the software is an integral part, that is used directly by the taxpayer in providing technological services in its trade or business to customers. In these cases, eligibility for the research credit is to be determined by examining the combined hardware-software product as a single product;</P> <P>(<E T="03">4</E>) The taxpayer develops the software for use in providing computer services to customers; or</P> <P>(<E T="03">5</E>) The software satisfies the high threshold of innovation test of paragraph (c)(6)(vi) of this section.</P> <P>(iii) <E T="03">Primarily for internal use.</E> Software is developed primarily for the taxpayer's internal use if the software is to be used internally, for example, in general administrative functions of the taxpayer (such as payroll, bookkeeping, or personnel management) or in providing noncomputer services (such as accounting, consulting or banking services). If computer software is developed primarily for the taxpayer's internal use, the requirements of paragraph (c)(6) apply even though the taxpayer intends to, or subsequently does, sell, lease, or license the computer software.</P> <P>(iv) <E T="03">Software used in the provision of services</E>—(A) <E T="03">Computer services.</E> For purposes of this section, a computer service is a service offered by a taxpayer to customers who conduct business with the taxpayer primarily for the use of the taxpayer's computer or software technology. A taxpayer does not provide a computer service merely because customers interact with the taxpayer's software.<PRTPAGE P="126"/> </P> <P>(B)<E T="03"> Noncomputer services.</E> For purposes of this section, a noncomputer service is a service offered by a taxpayer to customers who conduct business with the taxpayer primarily to obtain a service other than a computer service, even if such other service is enabled, supported, or facilitated by computer or software technology.</P> <P>(v) <E T="03">Exception for certain software used in providing noncomputer services.</E> The requirements of paragraph (c)(6)(ii)(C) of this section are deemed satisfied for research with respect to computer software if, at the time the research was undertaken—</P> <P>(A) The software is designed to provide customers a new feature with respect to a noncomputer service;</P> <P>(B) The taxpayer reasonably anticipated that customers would choose to obtain the noncomputer service from the taxpayer (rather than from the taxpayer's competitors) because of those new features provided by the software; and (C) Those new features were not available from any of the taxpayer's competitors.</P> <P>(vi) <E T="03">High threshold of innovation test.</E> Computer software satisfies the high threshold of innovation test of this paragraph (c)(6)(vi) only if the taxpayer can establish that—</P> <P>(A) The software is innovative in that the software is intended to result in a reduction in cost, improvement in speed, or other improvement, that is substantial and economically significant;</P> <P>(B) The software development involves significant economic risk in that the taxpayer commits substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period; and</P> <P>(C) The software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the requirements of paragraphs (c)(6)(vi)(A) and (B) of this section.</P> <P>(vii) <E T="03">Application of high threshold of innovation test.</E> In determining if the high threshold of innovation test of paragraph (c)(6)(vi) of this section is satisfied, all of the facts and circumstances are considered. The determination of whether the software is intended to result in an improvement or cost reduction that is substantial and economically significant is based on a comparison of the intended result with software that is within the common knowledge of skilled professionals in the relevant field of science or engineering, see § 1.41-4(a)(3)(ii). Similarly, the extent of uncertainty and technical risk is determined with respect to the common knowledge of skilled professionals in the relevant field of science or engineering. Further, in determining if the high threshold of innovation test of paragraph (c)(6)(vi) of this section is satisfied, the activities to develop the new or improved software are considered independent of the effect of any modifications to related hardware or other software.</P> <P>(viii) <E T="03">Illustrations.</E> The following examples illustrate the application of this paragraph (c)(6): </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) <E T="03">Facts.</E> X is engaged in the business of manufacturing and selling widgets to wholesalers. X has experienced strong growth and at the same time has expanded its product offerings. X also has increased significantly the size of its business by expanding into new territories. The increase in the size and scope of its business has strained X's existing financial management systems such that management can no longer obtain timely comprehensive financial data. Accordingly, X undertakes the development of a financial management computer software system that is more appropriate to its newly expanded operations.</P> <P>(ii) <E T="03">Conclusion.</E> X's new computer software system is developed by X primarily for X's internal use. X's activities to develop the new computer software system may be eligible for the research credit only if the computer software development activities satisfy the requirements of paragraph (c)(6)(ii) of this section.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>(i) <E T="03">Facts.</E> X is engaged in the business of designing, manufacturing, and selling widgets. X delivers its widgets in the same manner and time as its competitors. In keeping with X's corporate commitment to provide customers with top quality service, X undertakes a project to develop for X's internal use a computer software system to facilitate the tracking of the manufacturing and delivery of widgets which will enable X's customers to monitor the progress of their orders and know precisely when their widgets will be delivered. X's computer software activities include research activities that <PRTPAGE P="127"/>satisfy the discovery requirement in section 41(d)(1) and paragraph (a)(3) of this section. At the time the research is undertaken, X reasonably anticipates that if it is successful, X will increase its market share as compared to X's competitors, none of which has such a tracking feature for its delivery system.</P> <P>(ii) <E T="03">Conclusion.</E> Although X's computer software system is developed primarily for X's internal use, X's activities are excepted from the high threshold of innovation test of paragraph (c)(6)(vi) of this section because, at the time the research is undertaken, X's software is designed to provide improved tracking features, X reasonably anticipates that customers will purchase widgets from X because these improved tracking features, and because comparable tracking features are not available from any of X's competitors.</P> </EXAMPLE> <P>(ix) <E T="03">Effective dates.</E> This paragraph (c)(6) is applicable for taxable years beginning after December 31, 1985, except paragraphs (c)(6)(ii)(C)(<E T="03">4</E>), (c)(6)(iv)(A) and (B), (c)(6)(v), the second and third sentences of paragraph (c)(6)(vii), and paragraph (c)(6)(viii) <E T="03">Example 2</E> of this section apply to expenditures paid or incurred on or after January 3, 2001.</P> <P>(7) <E T="03">Activities outside the United States, Puerto Rico, and other possessions</E>—(i) <E T="03">In general.</E> Research conducted outside the United States, as defined in section 7701(a)(9), the Commonwealth of Puerto Rico and other possessions of the United States does not constitute qualified research.</P> <P>(ii) <E T="03">Apportionment of in-house research expenses.</E> In-house research expenses paid or incurred for qualified services performed both (A) in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and (B) outside the United States, the Commonwealth of Puerto Rico and other possessions of the United States must be apportioned between the services performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and the services performed outside the United States, the Commonwealth of Puerto Rico and other possessions of the United States. Only those in-house research expenses apportioned to the services performed within the United States, the Commonwealth of Puerto Rico and other possessions of the United States are eligible to be treated as qualified research expenses, unless the in-house research expenses are wages and the 80 percent rule of § 1.41-2(d)(2) applies.</P> <P>(iii) <E T="03">Apportionment of contract research expenses.</E> If contract research is performed partly in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and partly outside the United States, the Commonwealth of Puerto Rico and other possessions of the United States, only 65 percent (or 75 percent in the case of amounts paid to qualified research consortia) of the portion of the contract amount that is attributable to the research activity performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States may qualify as a contract research expense (even if 80 percent or more of the contract amount is for research performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States).</P> <P>(8) <E T="03">Research in the social sciences, etc.</E> Qualified research does not include research in the social sciences (including economics, business management, and behavioral sciences), arts, or humanities.</P> <P>(9) <E T="03">Research funded by any grant, contract, or otherwise.</E> Qualified research does not include any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity). To determine the extent to which research is so funded, § 1.41-4A(d) applies.</P> <P>(10) <E T="03">Illustrations.</E> The following examples illustrate provisions contained in paragraphs (c)(1) through (9) of this section. No inference should be drawn from these examples concerning the application of section 41(d)(1) and paragraph (a) of this section to these facts. The examples are as follows: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) <E T="03">Facts.</E> X, a tire manufacturer, seeks to build a tire that will not deteriorate as rapidly under certain conditions of high speed and temperature as do existing tires. X commences laboratory research on January 1. On April 1, X determines in the laboratory that a certain combination of materials and additives can withstand higher rotational speeds and temperatures than the combination of materials and additives used in existing tires. On the basis of this determination, X undertakes further research activities to determine how to design a tire using those <PRTPAGE P="128"/>materials and additives, and to determine whether such a tire functions outside the laboratory as intended under various actual road conditions. By September 1, X's research has progressed to the point where the new tire meets X's basic functional and economic requirements.</P> <P>(ii) <E T="03">Conclusion.</E> Any research activities conducted by X after September 1 with respect to the design of the tire are not qualified research within the meaning of section 41(d)(1) and paragraph (a) of this section because they are undertaken after the beginning of commercial production of the tire. Whether any activities X engaged in to develop a process for manufacturing the new tire constitute qualified research depends on if the development of the process itself separately satisfies the requirements of section 41(d) and paragraph (c)(2) of this section, and also depends on if the activities occur before the point in time when the process meets the taxpayer's basic functional and economic requirements or is ready for commercial use.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>(i) <E T="03">Facts.</E> For several years, X has manufactured and sold a particular kind of widget. X initiates a new research project to develop an improved widget.</P> <P>(ii) <E T="03">Conclusion.</E> X's activities to develop an improved widget are not excluded from the definition of qualified research under section 41(d)(4)(A) and paragraph (c)(2) of this section until the beginning of commercial production of the improved widget. The fact that X's activities relating to the improved widget are undertaken after the beginning of commercial production of the unimproved widget does not bar the activities from credit eligibility because those activities constitute a new research project to develop a new business component, an improved widget.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>(i) <E T="03">Facts.</E> X, a computer software development firm, owns all substantial rights in a general ledger accounting software core program that X markets and licenses to customers. X incurs expenditures in adapting the core software program to the requirements of C, one of X's customers.</P> <P>(ii) <E T="03">Conclusion.</E> Because X's activities represent activities to adapt an existing software program to a particular customer's requirement, X's activities are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>(i) <E T="03">Facts.</E> The facts are the same as in <E T="03">Example 3,</E> except that C pays X to adapt the core software program to C's requirements.</P> <P>(ii) <E T="03">Conclusion.</E> Because X's activities are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section, C's payments to X do not constitute contract research expenses under section 41(b)(3)(A).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>(i) <E T="03">Facts.</E> The facts are the same as in Example 3, except that C's own employees adapt the core software program to C's requirements.</P> <P>(ii) <E T="03">Conclusion.</E> Because C's employees' activities are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section, the wages C paid to its employees do not constitute in-house research expenses under section 41(b)(2)(A).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>(i) <E T="03">Facts.</E> An existing gasoline additive is manufactured by Y using three ingredients, A, B, and C. X seeks to develop and manufacture its own gasoline additive that appears and functions in a manner similar to Y's additive. To develop its own additive, X first inspects the composition of Y's additive, and uses knowledge gained from the inspection to reproduce A and B in the laboratory. Any differences between ingredients A and B that are used in Y's additive and those reproduced by X are insignificant and are not material to the viability, effectiveness, or cost of A and B. X desires to use with A and B an ingredient that has a materially lower cost than ingredient C. Accordingly, X engages in a process of experimentation to discover potential alternative formulations of the additive (<E T="03">i.e.</E>, the development and use of various ingredients other than C to use with A and B).</P> <P>(ii) <E T="03">Conclusion.</E> X's activities in analyzing and reproducing ingredients A and B involve duplication of existing business components and are excluded from qualified research under section 41(d)(4)(C) and paragraph (c)(4) of this section. X's experimentation activities to discover potential alternative formulations of the additive do not involve duplication of an existing business component and are not excluded from qualified research under section 41(d)(4)(C) and paragraph (c)(4) of this section.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 7.</HD> <P>(i) <E T="03">Facts.</E> X, an insurance company, develops a new life insurance product. In the course of developing the product, X engages in research with respect to the effect of pricing and tax consequences on demand for the product, the expected volatility of interest rates, and the expected mortality rates (based on published data and prior insurance claims).</P> <P>(ii) <E T="03">Conclusion.</E> X's activities related to the new product represent research in the social sciences, and are thus excluded from qualified research under section 41(d)(4)(G) and paragraph (c)(8) of this section.</P> </EXAMPLE> <P>(d) <E T="03">Documentation.</E> No credit shall be allowed under section 41 with regard to an expenditure relating to a research project unless the taxpayer—</P> <P>(1) Prepares documentation before or during the early stages of the research project, that describes the principal <PRTPAGE P="129"/>questions to be answered and the information the taxpayer seeks to obtain to satisfy the requirements of paragraph (a)(3) of this section, and retains that documentation on paper or electronically in the manner prescribed in applicable regulations, revenue rulings, revenue procedures, or other appropriate guidance until such time as taxes may no longer be assessed (except under section 6501(c)(1), (2), or (3)) for any year in which the taxpayer claims to have qualified research expenditures in connection with the research project; and</P> <P>(2) Satisfies section 6001 and the regulations thereunder.</P> <P>(e) <E T="03">Effective dates.</E> In general, the rules of this section are applicable for expenditures paid or incurred on or after January 3, 2001. The rules of paragraph (d), however, apply to research projects that begin on or after March 5, 2001.</P> <CITA>[T.D. 8930, 66 FR 290, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-4A</SECTNO> <SUBJECT>Qualified research for taxable years beginning before January 1, 1986.</SUBJECT> <P>(a) <E T="03">General rule.</E> Except as otherwise provided in section 30(d) (as that section read before amendment by the Tax Reform Act of 1986) and in this section, the term “qualified research” means research, expenditures for which would be research and experimental expenditures within the meaning of section 174. Expenditures that are ineligible for the section 174 deduction elections are not expenditures for qualified research. For example, expenditures for the acquisition of land or depreciable property used in research, and mineral exploration costs described in section 174(d), are not expenditures for qualified research.</P> <P>(b) <E T="03">Activities outside the United States</E>—(1) <E T="03">In-house research.</E> In-house research conducted outside the United States (as defined in section 7701(a)(9)) cannot constitute qualified research. Thus, wages paid to an employee scientist for services performed in a laboratory in the United States and in a test station in Antarctica must be apportioned between the services performed within the United States and the services performed outside the United States, and only the wages apportioned to the services conducted within the United States are qualified research expenses unless the 80 percent rule of § 1.41-2(d)(2) applies.</P> <P>(2) <E T="03">Contract research.</E> If contract research is performed partly within the United States and partly without, only 65 percent of the portion of the contract amount that is attributable to the research performed within the United States can qualify as contract research expense (even if 80 percent or more of the contract amount was for research performed in the United States).</P> <P>(c) <E T="03">Social sciences or humanities.</E> Qualified research does not include research in the social sciences or humanities. For purposes of section 30(d)(2) (as that section read before amendment by the Tax Reform Act of 1986) and of this section, the phrase “research in the social sciences or humanities” encompasses all areas of research other than research in a field of laboratory science (such as physics or biochemistry), engineering or technology. Examples of research in the social sciences or humanities include the development of a new life insurance contract, a new economic model or theory, a new accounting procedure or a new cookbook.</P> <P>(d) <E T="03">Research funded by any grant, contract, or otherwise</E>—(1) <E T="03">In general.</E> Research does not constitute qualified research to the extent it is funded by any grant, contract, or otherwise by another person (including any governmental entity). All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded. Amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research (see § 1.41-2(e)(2)) are not treated as funding. For special rules regarding funding between commonly controlled businesses, see § 1.41-6(e).</P> <P>(2) <E T="03">Research in which taxpayer retains no rights.</E> If a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research, the research is treated as fully funded for purposes of section <PRTPAGE P="130"/>41(d)(4)(H), and no expenses paid or incurred by the taxpayer in performing the research are qualified research expenses. For example, if the taxpayer performs research under an agreement that confers on another person the exclusive right to exploit the results of the research, the taxpayer is not performing qualified research because the research is treated as fully funded under this paragraph (d)(2). Incidental benefits to the taxpayer from performance of the research (for example, increased experience in a field of research) do not constitute substantial rights in the research. If a taxpayer performing research for another person retains no substantial rights in the research and if the payments to the researcher are contingent upon the success of the research, neither the performer nor the person paying for the research is entitled to treat any portion of the expenditures as qualified research expenditures.</P> <P>(3) <E T="03">Research in which the taxpayer retains substantial rights</E>—(i) <E T="03">In general.</E> If a taxpayer performing research for another person retains substantial rights in the research under the agreement providing for the research, the research is funded to the extent of the payments (and fair market value of any property) to which the taxpayer becomes entitled by performing the research. A taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research. Except as otherwise provided in paragraph (d)(3)(ii) of this section, the taxpayer shall reduce the amount paid or incurred by the taxpayer for the research that would, but for section 41(d)(4)(H), constitute qualified research expenses of the taxpayer by the amount of funding determined under the preceding sentence.</P> <P>(ii) <E T="03">Pro rata allocation.</E> If the taxpayer can establish to the satisfaction of the district director—</P> <P>(A) The total amount of research expenses,</P> <P>(B) That the total amount of research expenses exceed the funding, and</P> <P>(C) That the otherwise qualified research expenses (that is, the expenses which would be qualified research expenses if there were no funding) exceed 65 percent of the funding, then the taxpayer may allocate the funding pro rata to nonqualified and otherwise qualified research expenses, rather than allocating it 100 percent to otherwise qualified research expenses (as provided in paragraph (d)(3)(i) of this section). In no event, however, shall less than 65 percent of the funding be applied against the otherwise qualified research expenses.</P> <P>(iii) <E T="03">Project-by-project determination.</E> The provisions of this paragraph (d)(3) shall be applied separately to each research project undertaken by the taxpayer.</P> <P>(4) <E T="03">Independent research and development under the Federal Acquisition Regulations System and similar provisions.</E> The Federal Acquisition Regulations System and similar rules and regulations relating to contracts (fixed price, cost plus, etc.) with government entities provide for allocation of certain “independent research and development costs” and “bid and proposal costs” of a contractor to contracts entered into with that contractor. In general, any “independent research and development costs” and “bid and proposal costs” paid to a taxpayer by reason of such a contract shall not be treated as funding the underlying research activities except to the extent the “independent research and development costs” and “bid and proposal costs” are properly severable from the contract. See § 1.451-3(e); see also section 804(d)(2) of the Tax Reform Act of 1986.</P> <P>(5) <E T="03">Funding determinable only in subsequent taxable year.</E> If at the time the taxpayer files its return for a taxable year, it is impossible to determine to what extent particular research performed by the taxpayer during that year may be funded, then the taxpayer shall treat the research as completely funded for purposes of completing that return. When the amount of funding is finally determined, the taxpayer should amend the return and any interim returns to reflect the proper amount of funding.</P> <P>(6) <E T="03">Examples.</E> The following examples illustrate the application of the principles contained in this paragraph. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>A enters into a contract with B Corporation, a cash-method taxpayer using the calendar year as its taxable year, under <PRTPAGE P="131"/>which B is to perform research that would, but for section 41(d)(3)(H), be qualified research of B. The agreement calls for A to pay B $120x, regardless of the outcome of the research. In 1982, A makes full payment of $120x under the contract, B performs all the research, and B pays all the expenses connected with the research, as follows:</P> <GPOTABLE CDEF="s30,6" COLS="2" OPTS="L0,7/8,g1,t1,i1"> <ROW> <ENT I="01">In-house research expenses </ENT> <ENT>$100x</ENT> </ROW> <ROW> <ENT I="11">Outside research:</ENT> </ROW> <ROW> <ENT I="02">(Amount B paid to third parties for research, 65 percent of which ($26x) is treated as a contract research expense of B) </ENT> <ENT>40x</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">Overhead and other expenses</ENT> <ENT>10x</ENT> </ROW> <ROW> <ENT I="03">Total</ENT> <ENT>150x</ENT> </ROW> </GPOTABLE> <P>If B has no rights to the research, B is fully funded. Alternatively, assume that B retains the right to use the results of the research in carrying on B's business. Of B's otherwise qualified research expenses of $126x + $26x), $120x is treated as funded by A. Thus $6x ($126x − $120x) is treated as a qualified research expense of B. However, if B establishes the facts required under paragraph (d)(3) of this section, B can allocate the funding pro rata to nonqualified and otherwise qualified research expenses. Thus $100.8x ($120x ($126x/$150x)) would be allocated to otherwise qualified research expenses. B's qualified research expenses would be $25.2x ($126x − $100.8x). For purposes of the following examples (2), (3) and (4) assume that B retains substantial rights to use the results of the research in carrying on B's business.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in example (1) (assuming that B retains the right to use the results of the research in carrying on B's business) except that, although A makes full payment of $120x during 1982, B does not perform the research or pay the associated expenses until 1983. The computations are unchanged. However, B's qualified research expenses determined in example (1) are qualified research expenses during 1983.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>The facts are the same as in example (1) (assuming that B retains the right to use the results of the research in carrying on B's business) except that, although B performs the research and pays the associated expenses during 1982, A does not pay the $120x until 1983. The computations are unchanged and the amount determined in example (1) is a qualified research expense of B during 1982.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>The facts are the same as in example (1) (assuming that B retains the right to use the results of the research in carrying on B's business) except that, instead of agreeing to pay B $120x, A agrees to pay $100x regardless of the outcome and an additional $20x only if B's research produces a useful product. B's research produces a useful product and A pays B $120x during 1982. The $20x payment that is conditional on the success of the research is not treated as funding. Assuming that B establishes to the satisfaction of the district director the actual research expenses, B can allocate the funding to nonqualified and otherwise qualified research expenses. Thus $84x ($100x ($126x/$150x)) would be allocated to otherwise qualified research expenses. B's qualified research expenses would be $42x ($126x − $84x).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>C enters into a contract with D, a cash-method taxpayer using the calendar year as its taxable year, under which D is to perform research in which both C and D will have substantial rights. C agrees to reimburse D for 80 percent of D's expenses for the research. D performs part of the research in 1982 and the rest in 1983. At the time that D files its return for 1982, D is unable to determine the extent to which the research is funded under the provisions of this paragraph. Under these circumstances, D may not treat any of the expenses paid by D for this research during 1982 as qualified research expenses on its 1982 return. When the project is complete and D can determine the extent of funding, D should file an amended return for 1982 to take into account any qualified research expense for 1982.</P> </EXAMPLE> <CITA>[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 8930, 66 FR 295, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-5</SECTNO> <SUBJECT>Basic research for taxable years beginning after December 31, 1986. [Reserved]</SUBJECT> </SECTION> <SECTION> <SECTNO>§ 1.41-5A</SECTNO> <SUBJECT>Basic research for taxable years beginning before January 1, 1987.</SUBJECT> <P>(a) <E T="03">In general.</E> The amount expended for basic research within the meaning of section 30(e) (before amended by the Tax Reform Act of 1986) equals the sum of money plus the taxpayer's basis in tangible property (other than land) transferred for use in the performance of basic research.</P> <P>(b) <E T="03">Trade or business requirement.</E> Any amount treated as a contract research expense under section 30(e) (before amendment by the Tax Reform Act of 1986) shall be deemed to have been paid or incurred in carrying on a trade or business, if the corporation that paid or incurred the expenses is actually engaged in carrying on some trade or business.</P> <P>(c) <E T="03">Prepaid amounts—</E>(1) <E T="03">In general.</E> If any basic research expense paid or incurred during any taxable year is attributable to research to be conducted after the close of such taxable year, the <PRTPAGE P="132"/>expense so attributable shall be treated for purposes of section 30(b)(1)(B) (before amendment by the Tax Reform Act of 1986) as paid or incurred during the period in which the basic research is conducted.</P> <P>(2) <E T="03">Transfers of property.</E> In the case of transfers of property to be used in the performance of basic research, the research in which that property is to be used shall be considered to be conducted ratably over a period beginning on the day the property is first so used and continuing for the number of years provided with respect to property of that class under section 168(c)(2) (before amendment by the Tax Reform Act of 1986). For example, if an item of property which is 3-year property under section 168(c) is transferred to a university for basic research on January 12, 1983, and is first so used by the university on March 1, 1983, then the research in which that property is used is considered to be conducted ratably from March 1, 1983, through February 28, 1986.</P> <P>(d) <E T="03">Written research agreement—</E>(1) <E T="03">In general.</E> A written research agreement must be entered into prior to the performance of the basic research.</P> <P>(2) <E T="03">Agreement between a corporation and a qualified organization after June 30, 1983—</E>(i) <E T="03">In general.</E> A written research agreement between a corporation and a qualified organization (including a qualified fund) entered into after June 30, 1983, shall provide that the organization shall inform the corporation within 60 days after the close of each taxable year of the corporation what amount of funds provided by the corporation pursuant to the agreement was expended on basic research during the taxable year of the corporation. In determining amounts expended on basic research, the qualified organization shall take into account the exclusions specified in section 30(e)(3) (before amendment by the Tax Reform Act of 1986) and in paragraph (e) of this section.</P> <P>(ii) <E T="03">Transfers of property.</E> In the case of transfers of property to be used in basic research, the agreement shall provide that substantially all use of the property is to be for basic research, as defined in section 30(e)(3) (before amendment by the Tax Reform Act of 1986).</P> <P>(3) <E T="03">Agreement between a qualified fund and a qualified educational organization after June 30, 1983.</E> A written research agreement between a qualified fund and a qualified educational organization (see section 30(e)(4)(B)(iii) (before amendment by the Tax Reform Act of 1986)) entered into after June 30, 1983, shall provide that the qualified educational organization shall furnish sufficient information to the qualified fund to enable the qualified fund to comply with the written research agreements it has entered into with grantor corporations, including the requirement set forth in paragraph (d)(2) of this section.</P> <P>(e) <E T="03">Exclusions—</E>(1) <E T="03">Research conducted outside the United States.</E> If a taxpayer pays or incurs an amount for basic research to be performed partly within the United States and partly without, only 65 percent of the portion of the amount attributable to research performed within the United States can be treated as a contract research expense (even if 80 percent or more of the contract amount was for basic research performed in the United States).</P> <P>(2) <E T="03">Research in the social sciences or humanities.</E> Basic research does not include research in the social sciences or humanities, within the meaning of § 1.41-4A(c).</P> <P>(f) <E T="03">Procedure for making an election to be treated as a qualified fund.</E> In order to make an election to be treated as a qualified fund within the meaning of section 30(e)(4)(B)(iii) (before amendment by the Tax Reform Act of 1986) or as an organization described in section 41(e)(6)(D), the organization shall file with the Internal Revenue Service center with which it files its annual return a statement that—</P> <P>(1) Sets out the name, address, and taxpayer identification number of the electing organization (the “taxpayer”) and of the organization that established and maintains the electing organization (the “controlling organization”),</P> <P>(2) Identifies the election as an election under section 41(e)(6)(D) of the Code,<PRTPAGE P="133"/> </P> <P>(3) Affirms that the controlling organization and the taxpayer are section 501(c)(3) organizations,</P> <P>(4) Provides that the taxpayer elects to be treated as a private foundation for all Code purposes other than section 4940,</P> <P>(5) Affirms that the taxpayer satisfies the requirement of section 41(e)(6)(D)(iii), and</P> <P>(6) Specifies the date on which the election is to become effective.</P> <FP>If an election to be treated as a qualified fund is filed before February 1, 1982, the election may be made effective as of any date after June 30, 1981, and before January 1, 1986. If an election is filed on or after February 1, 1982, the election may be made effective as of any date on or after the date on which the election is filed.</FP> <CITA>[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 8930, 66 FR 295, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-6</SECTNO> <SUBJECT>Aggregation of expenditures.</SUBJECT> <P>(a) <E T="03">Controlled group of corporations; trades or businesses under common control—</E>(1) <E T="03">In general.</E> In determining the amount of research credit allowed with respect to a trade or business that at the end of its taxable year is a member of a controlled group of corporations or a member of a group of trades or businesses under common control, all members of the group are treated as a single taxpayer and the credit (if any) allowed to the member is determined on the basis of its proportionate share (if any) of the increase in qualified research expenses of the aggregated group.</P> <P>(2) <E T="03">Definition of trade or business.</E> For purposes of this section, a trade or business is a sole proprietorship, a partnership, a trust, an estate, or a corporation that is carrying on a trade or business (within the meaning of section 162). For purposes of this section, any corporation that is a member of a commonly controlled group shall be deemed to be carrying on a trade or business if any other member of that group is carrying on any trade or business.</P> <P>(3) <E T="03">Determination of common control.</E> For rules for determining whether trades or businesses are under common control, see paragraphs (b) through (g) of § 1.52-1 except that the words “singly or” in § 1.52-1(d)(1)(i) shall be treated as deleted.</P> <P>(4) <E T="03">Examples.</E> The following examples illustrate provisions of this paragraph. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) <E T="03">Facts.</E> A controlled group of four corporations (all of which are calendar-year taxpayers) had qualified research expenses (“research expenses”) during the base period and taxable year as follows:</P> <GPOTABLE CDEF="s25,10,8,7" COLS="4" OPTS="L2"> <BOXHD> <CHED H="1">Corporation</CHED> <CHED H="1">Base period (average)</CHED> <CHED H="1">Taxable year</CHED> <CHED H="1">Change</CHED> </BOXHD> <ROW> <ENT I="01">A</ENT> <ENT>$60</ENT> <ENT>$40</ENT> <ENT>($20)</ENT> </ROW> <ROW> <ENT I="01">B</ENT> <ENT>10</ENT> <ENT>15</ENT> <ENT>5</ENT> </ROW> <ROW> <ENT I="01">C</ENT> <ENT>30</ENT> <ENT>70</ENT> <ENT>40</ENT> </ROW> <ROW> <ENT I="01">D</ENT> <ENT>15</ENT> <ENT>25</ENT> <ENT>10</ENT> </ROW> </GPOTABLE> <P>(ii) <E T="03">Total credit.</E> Because the research expenses of the four corporations are treated as if made by one taxpayer, the total amount of incremental expenses eligible for the credit is $35 ($55 increase attributable to B, C, and D less $20 decrease attributable to A). The total amount of credit allowable to members of the group is 20% of the incremental amount or $7.00.</P> <P>(iii) <E T="03">Allocation of credit.</E> No amount of credit is allocated to A since A's research expenses did not increase in the taxable year. The $7.00 credit is allocated to B, C, and D, the members of the group that increased their research expenses. This allocation is made on the basis of the ratio of each corporation's increase in its research expenses to the sum of increases in those expenses. Inasmuch as the total increase made by those members of the group whose research expenses rose (B, C, and D) was $55, B's share of the $7.00 credit is 5/55; C's share is 40/55; and D's share is 10/55.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in example (1) except that A had zero research expenses in the taxable year. Thus, the controlled group had a decrease rather than an increase in aggregate research expenses. Accordingly, no amount of credit is allowable to any member of the group even though B, C, and D actually increased their research expenses in comparison with their own base period expenses.</P> </EXAMPLE> <P>(b) <E T="03">Minimum base period research expenses.</E> For purposes of this section, the rule in section 41(c)(3) (pertaining to minimum base period research expenses) shall be applied only to the aggregate amount of base period research expenses. See the treatment of corporation C in example (1) of paragraph (a)(4) of this section.<PRTPAGE P="134"/> </P> <P>(c) <E T="03">Tax accounting periods used</E>—(1) <E T="03">In general.</E> The credit allowable to a member of a controlled group of corporations or of a group of trades or businesses under common control is that member's share of the aggregate credit computed as of the end of such member's taxable year. In computing the aggregate credit in the case of a group whose members have different taxable years, a member shall generally treat the taxable year of another member that ends with or within the determination year of the computing member as the determination year of that other member. The base period research expenses taken into account with respect to a determination year of another member shall be the base period research expenses determined for that year under § 1.41-3A, except that § 1.41-3A(c)(2) shall be applied only at the aggregate level.</P> <P>(2) <E T="03">Special rule where timing of research is manipulated.</E> If the timing of research by members using different tax accounting periods is manipulated to generate a credit in excess of the amount that would be allowable if all members of the group used the same tax accounting period, the district director may require each member of the group to calculate the credit in the current taxable year and all future years as if all members of the group had the same taxable year and base period as the computing member.</P> <P>(d) <E T="03">Membership during taxable year in more than one group.</E> A trade or business may be a member of only one group for a taxable year. If, without application of this paragraph, a business would be a member of more than one group at the end of its taxable year, the business shall be treated as a member of the group in which it was included for its preceding taxable year. If the business was not included for its preceding taxable year in any group in which it could be included as of the end of its taxable year, the business shall designate in its timely filed (including extensions) return the group in which it is being included. If the return for a taxable year is due before July 1, 1983, the business may designate its group membership through an amended return for that year filed on or before June 30, 1983. If the business does not so designate, then the district director with audit jurisdiction of the return will determine the group in which the business is to be included.</P> <P>(e) <E T="03">Intra-group transactions</E>—(1) <E T="03">In general.</E> Because all members of a group under common control are treated as a single taxpayer for purposes of determining the research credit, transfers between members of the group are generally disregarded.</P> <P>(2) <E T="03">In-house research expenses.</E> If one member of a group performs qualified research on behalf of another member, the member performing the research shall include in its qualified research expenses any in-house research expenses for that work and shall not treat any amount received or accrued as funding the research. Conversely, the member for whom the research is performed shall not treat any part of any amount paid or incurred as a contract research expense. For purposes of determining whether the in-house research for that work is qualified research, the member performing the research shall be treated as carrying on any trade or business carried on by the member on whose behalf the research is performed.</P> <P>(3) <E T="03">Contract research expenses.</E> If a member of a group pays or incurs contract research expenses to a person outside the group in carrying on the member's trade or business, that member shall include those expenses as qualified research expenses. However, if the expenses are not paid or incurred in carrying on any trade or business of that member, those expenses may be taken into account as contract research expenses by another member of the group provided that the other member—</P> <P>(i) Reimburses the member paying or incurring the expenses, and</P> <P>(ii) Carries on a trade or business to which the research relates.</P> <P>(4) <E T="03">Lease Payments.</E> The amount paid or incurred to another member of the group for the lease of personal property owned by a member of the group is not taken into account for purposes of section 41. Amounts paid or incurred to another member of the group for the lease of personal property owned by a person outside the group shall be taken <PRTPAGE P="135"/>into account as in-house research expenses for purposes of section 41 only to the extent of the lesser of—</P> <P>(i) The amount paid or incurred to the other member, or</P> <P>(ii) The amount of the lease expenses paid to the person outside the group.</P> <P>(5) <E T="03">Payment for supplies.</E> Amounts paid or incurred to another member of the group for supplies shall be taken into account as in-house research expenses for purposes of section 41 only to the extent of the lesser of—</P> <P>(i) The amount paid or incurred to the other member, or</P> <P>(ii) The amount of the other member's basis in the supplies.</P> <CITA>[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 8930, 66 FR 295, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-7</SECTNO> <SUBJECT>Special rules.</SUBJECT> <P>(a) <E T="03">Allocations</E>—(1) <E T="03">Corporation making an election under subchapter S</E>—(i) <E T="03">Pass-through, for taxable years beginning after December 31, 1982, in the case of an S corporation.</E> In the case of an S corporation (as defined in section 1361) the amount of research credit computed for the corporation shall be allocated to the shareholders according to the provisions of section 1366 and section 1377.</P> <P>(ii) <E T="03">Pass-through, for taxable years beginning before January 1, 1983, in the case of a subchapter S corporation.</E> In the case of an electing small business corporation (as defined in section 1371 as that section read before the amendments made by the subchapter S Revision Act of 1982), the amount of the research credit computed for the corporation for any taxable year shall be apportioned pro rata among the persons who are shareholders of the corporation on the last day of the corporation's taxable year.</P> <P>(2) <E T="03">Pass-through in the case of an estate or trust.</E> In the case of an estate or trust, the amount of the research credit computed for the estate or trust for any taxable year shall be apportioned among the estate or trust and the beneficiaries on the basis of the income of the estate or trust allocable to each.</P> <P>(3) <E T="03">Pass-through in the case of a partnership—</E>(i) <E T="03">In general.</E> In the case of a partnership, the research credit computed for the partnership for any taxable year shall be apportioned among the persons who are partners during the taxable year in accordance with section 704 and the regulations thereunder. See, for example, § 1.704-1(b)(4)(ii). Because the research credit is an expenditure-based credit, the credit is to be allocated among the partners in the same proportion as section 174 expenditures are allocated for the year.</P> <P>(ii) <E T="03">Certain expenditures by joint ventures.</E> Research expenses to which § 1.41-2(a)(4)(ii) applies shall be apportioned among the persons who are partners during the taxable year in accordance with the provisions of that section. For purposes of section 41, these expenses shall be treated as paid or incurred directly by the partners rather than by the partnership. Thus, the partnership shall disregard these expenses in computing the credit to be apportioned under paragraph (a)(3)(i) of this section, and in making the computations under section 41 each partner shall aggregate its distributive share of these expenses with other research expenses of the partner. The limitation on the amount of the credit set out in section 41(g) and in paragraph (c) of this section shall not apply because the credit is computed by the partner, not the partnership.</P> <P>(4) <E T="03">Year in which taken into account.</E> An amount apportioned to a person under this paragraph shall be taken into account by the person in the taxable year of such person which or within which the taxable year of the corporation, estate, trust, or partnership (as the case may be) ends.</P> <P>(5) <E T="03">Credit allowed subject to limitation.</E> The credit allowable to any person to whom any amount has been apportioned under paragraph (a)(1), (2) or (3)(i) of this section is subject to section 41(g) and sections 38 and 39 of the Code, if applicable.</P> <P>(b) <E T="03">Adjustments for certain acquisitions and dispositions—Meaning of terms.</E> For the meaning of “acquisition,” “separate unit,” and “major portion,” see paragraph (b) of § 1.52-2. An “acquisition” includes an incorporation or a liquidation.</P> <P>(c) <E T="03">Special rule for pass-through of credit.</E> The special rule contained in section 41(g) for the pass-through of the credit in the case of an individual <PRTPAGE P="136"/>who owns an interest in an unincorporated trade or business, is a partner in a partnership, is a beneficiary of an estate or trust, or is a shareholder in an S corporation shall be applied in accordance with the principles set forth in § 1.53-3.</P> <P>(d) <E T="03">Carryback and carryover of unused credits.</E> The taxpayer to whom the credit is passed through under paragraph (c) of this section shall not be prevented from applying the unused portion in a carryback or carryover year merely because the entity that earned the credit changes its form of conducting business.</P> <CITA>[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated by T.D. 8930, 66 FR 295, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.41-8</SECTNO> <SUBJECT>Special rules for taxable years ending on or after January 3, 2001.</SUBJECT> <P>(a) <E T="03">Alternative incremental credit.</E> At the election of the taxpayer, the credit determined under section 41(a)(1) equals the amount determined under section 41(c)(4).</P> <P>(b) <E T="03">Election—</E>(1) <E T="03">In general.</E> A taxpayer may elect to apply the provisions of the alternative incremental credit in section 41(c)(4) for any taxable year of the taxpayer beginning after June 30, 1996. If a taxpayer makes an election under section 41(c)(4), the election applies to the taxable year for which made and all subsequent taxable years.</P> <P>(2) <E T="03">Time and manner of election.</E> An election under section 41(c)(4) is made by completing the portion of Form 6765, “Credit for Increasing Research Activities,” relating to the election of the alternative incremental credit, and attaching the completed form to the taxpayer's timely filed original return (including extensions) for the taxable year to which the election applies.</P> <P>(3) <E T="03">Revocation.</E> An election under this section may not be revoked except with the consent of the Commissioner. A taxpayer must attach the Commissioner's consent to revoke an election under section 41(c)(4) to the taxpayer's timely filed original return (including extensions) for the taxable year of the revocation.</P> <P>(4) <E T="03">Effective date.</E> Paragraphs (b)(2) and (3) of this section are applicable for taxable years ending on or after January 3, 2001.</P> <CITA>[T.D. 8930, 66 FR 295, Jan. 3, 2001]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <P>This section lists the paragraphs contained in §§ 1.42-1 and 1.42-2.</P> <EXTRACT> <HD SOURCE="HD2">§ 1.42-1 [Reserved]</HD> <HD SOURCE="HD2">§ 1.42-2Waiver of requirement that an existing building eligible for the low-income housing credit was last placed in service more than 10 years prior to acquisition by the taxpayer.</HD> <P>(a) Low-income housing credit for existing building</P> <P>(b) Waiver of 10-year holding period requirement</P> <P>(c) Waiver requirements</P> <P>(1) Federally-assisted building</P> <P>(2) Federal mortgage funds at risk</P> <P>(3) Statement by the Department of Housing and Urban Development or the Farmers’ Home Administration</P> <P>(4) No prior credit allowed</P> <P>(d) Application for waiver</P> <P>(1) Time and manner</P> <P>(2) Information required</P> <P>(3) Other rules</P> <P>(4) Effective date of waiver</P> <P>(5) Attachment to return</P> <P>(e) Effective date of regulations</P> </EXTRACT> <CITA>[T.D. 8302, 55 FR 21189, May 23, 1990]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-1</SECTNO> <RESERVED>[Reserved]</RESERVED> </SECTION> <SECTION> <SECTNO>§ 1.42-1T</SECTNO> <SUBJECT>Limitation on low-income housing credit allowed with respect to qualified low-income buildings receiving housing credit allocations from a State or local housing credit agency (temporary).</SUBJECT> <P>(a) <E T="03">In general</E>—(1) <E T="03">Determination of amount of low-income housing credit.</E> Section 42 provides that, for purposes of section 38, a low-income housing credit is determined for a building in an amount equal to the applicable percentage of the qualified basis of the qualified low-income building. In general, the credit may be claimed annually for a 10-year credit period, beginning with the taxable year in which the building is placed in service or, at the election of the taxpayer, the succeeding taxable year. If, after the first year of the credit period, the qualified basis of a building is increased in excess of the qualified basis upon which the credit was initially determined, the allowable credit with respect to such additional qualified basis is determined <PRTPAGE P="137"/>using a credit percentage equal to two-thirds of the applicable percentage for the initial qualified basis. The credit for additions to qualified basis is generally allowable for the remaining years in the 15-year compliance period which begins with the first taxable year of the credit period for the building. In general, the low-income housing credit is available with respect to buildings placed in service after December 31, 1986, in taxable years ending after that date. <E T="03">See</E> section 42 for the definitions of “qualified low-income building”, “applicable percentage”, “qualified basis”, “credit period”, “compliance period”, and for other rules relating to determination of the amount of the low-income housing credit.</P> <P>(2) <E T="03">Limitation on low-income housing credit allowed.</E> Generally, the low-income housing credit determined under section 42 is allowed and may be claimed for any taxable year if, and to the extent that, the owner of a qualified low-income building receives a housing credit allocation from a State or local housing credit agency. The aggregate amount of housing credit allocations that may be made in any calendar year by all housing credit agencies within a State is limited by a State housing credit ceiling, or volume cap, described in paragraph (b) of this section. The authority to make housing credit allocations within the State housing credit ceiling may be apportioned among the State and local housing credit agencies, under the rules prescribed in paragraph (c) of this section. Upon apportionment of the State housing credit volume cap, each State or local housing credit agency receives an aggregate housing credit dollar amount that may be used to make housing credit allocations among qualified low-income buildings located within an agency's geographic jurisdiction. The rules governing the making of housing credit allocations by any state or local housing credit agency are provided in paragraph (d) of this section. Housing credit allocations are required to be taken into account by owners of qualified low-income buildings under the rules prescribed in paragraph (e) of this section. Exceptions to the requirement that a qualified low-income building receive a housing credit allocation from a State or local housing credit agency are provided in paragraph (f) of this section. Rules regarding termination of the authority of State and local housing credit agencies to make housing credit allocations after December 31, 1989, are specified in paragraph (g) of this section. Rules concerning information reporting by State and local housing credit agencies and owners of qualified low-income buildings are provided in paragraph (h) of this section. Special statutory transitional rules are incorporated into this section of the regulations as described in paragraph (i) of this section.</P> <P>(b) <E T="03">The State housing credit ceiling.</E> The aggregate amount of housing credit allocations that may be made in any calendar year by all State and local housing credit agencies within a State may not exceed the State's housing credit ceiling for such calendar year. The State housing credit ceiling for each State for any calendar year is equal to $1.25 multiplied by the State's population. A State's population for any calendar year is determined by reference to the most recent census estimate (whether final or provisional) of the resident population of the State released by the Bureau of the Census before the beginning of the calendar year for which the State's housing credit ceiling is set. Unless otherwise prescribed by applicable revenue procedure, determinations of population are based on the most recent estimates of population contained in the Bureau of the Census publication, “Current Population Reports, Series P-25: Population Estimates and Projections, Estimates of the Population of States”. For purposes of this section, the District of Columbia and United States possessions are treated as States.</P> <P>(c) <E T="03">Apportionment of State housing credit ceiling among State and local housing credit agencies</E>—(1) <E T="03">In general.</E> A State's housing credit ceiling for any calendar year is apportioned among the State and local housing credit agencies within such State under the rules prescribed in this paragraph. A “State housing credit agency” is any State agency specifically authorized by gubernatorial act or State statute to <PRTPAGE P="138"/>make housing credit allocations on behalf of the State and to carry out the provisions of section 42(h). A “local housing credit agency” is any agency of a political subdivision of the State that is specifically authorized by a State enabling act to make housing credit allocations on behalf of the State or political subdivision and to carry out the provisions of section 42(h). A “State enabling act” is any gubernatorial act, State statute, or State housing credit agency regulation (if authorized by gubernatorial act or State statute). A State enabling act enacted on or before October 22, 1986, the date of enactment of the Tax Reform Act of 1986, shall be given effect for purposes of this paragraph if such State enabling act expressly carries out the provisions of section 42(h).</P> <P>(2) <E T="03">Primary apportionment.</E> Except as otherwise provided in paragraphs (c) (3) and (4) of this section, a State's housing credit ceiling is apportioned in its entirety to the State housing credit agency. Such an apportionment is the “primary apportionment” of a State's housing credit ceiling. There shall be no primary apportionment of the State housing credit ceiling and no grants of housing credit allocations in such State until a State housing credit agency is authorized by gubernatorial act or State statute. If a State has more than one State housing credit agency, such agencies shall be treated as a single agency for purposes of the primary apportionment. In such a case, the State housing credit ceiling may be divided among the multiple State housing credit agencies pursuant to gubernatorial act or State statute.</P> <P>(3) <E T="03">States with 1 or more constitutional home rule cities</E>—(i) <E T="03">In general.</E> Notwithstanding paragraph (c)(2) of this section, in any State with 1 or more constitutional home rule cities, a portion of the State housing credit ceiling is apportioned to each constitutional home rule city. In such a State, except as provided in paragraph (c)(4) of this section, the remainder of the State housing credit ceiling is apportioned to the State housing credit agency under paragraph (c)(2) of this section. <E T="03">See</E> paragraph (c)(3)(iii) of this section. The term “constitutional home rule city” means, with respect to any calendar year, any political subdivision of a State that, under a State constitution that was adopted in 1970 and effective on July 1, 1971, had home rule powers on the first day of the calendar year.</P> <P>(ii) <E T="03">Amount of apportionment to a constitutional home rule city.</E> The amount of the State housing credit ceiling apportioned to a constitutional home rule city for any calendar year is an amount that bears the same ratio to the State housing credit ceiling for that year as the population of the constitutional home rule city bears to the population of the entire State. The population of any constitutional home rule city for any calendar year is determined by reference to the most recent census estimate (whether final or provisional) of the resident population of the constitutional home rule city released by the Bureau of the Census before the beginning of the calendar year for which the State housing credit ceiling is apportioned. However, determinations of the population of a constitutional home rule city may not be based on Bureau of the Census estimates that do not contain estimates for all of the constitutional home rule cities within the State. If no Bureau of the Census estimate is available for all such constitutional home rule cities, the most recent decennial census of population shall be relied on. Unless otherwise prescribed by applicable revenue procedure, determinations of population for constitutional home rule cities are based on estimates of population contained in the Bureau of the Census publication, “Current Population Reports, Series P-26: Local Population Estimates”.</P> <P>(iii) <E T="03">Effect of apportionments to constitutional home rule cities on apportionments to other housing credit agencies.</E> The aggregate amounts of the State housing credit ceiling apportioned to constitutional home rule cities under this paragraph (c)(3) reduce the State housing credit ceiling available for apportionment under paragraph (c) (2) or (4) of this section. Unless otherwise provided in a State constitutional amendment or by law changing the home rule provisions adopted in a manner provided by the State constitution, the power of the governor or State legislature to apportion the State housing <PRTPAGE P="139"/>credit ceiling among local housing credit agencies under paragraph (c)(4) of this section shall not be construed as allowing any reduction of the portion of the State housing credit ceiling apportioned to a constitutional home rule city under this paragraph (c)(3). However, any constitutional home rule city may agree to a reduction in its apportionment of the State housing credit ceiling under this paragraph (c)(3), in which case the amount of the State housing credit ceiling not apportioned to the constitutional home rule city shall be available for apportionment under paragraph (c) (2) or (4) of this section.</P> <P>(iv) <E T="03">Treatment of governmental authority within constitutional home rule city.</E> For purposes of determining which agency within a constitutional home rule city receives the apportionment of the State housing credit ceiling under this paragraph (c)(3), the rules of this paragraph (c) shall be applied by treating the constitutional home rule city as a “State”, the chief executive officer of a constitutional home rule city as a “governor”, and a city council as a “State legislature”. A constitutional home rule city is also treated as a “State” for purposes of the set-aside requirement for housing credit allocations to projects involving a qualified nonprofit organization. <E T="03">See</E> paragraph (c)(5) of this section for rules governing set-aside requirements. In this connection, a constitutional home rule city may agree with the State housing credit agency to exchange an apportionment set aside for projects involving a qualified nonprofit organization for an apportionment that is not so restricted. In such a case, the authorizing gubernatorial act, State statute, or State housing credit agency regulation (if authorized by gubernatorial act or State statute) must ensure that the set-aside apportionment transferred to the State housing credit agency be used for the purposes described in paragraph (c)(5) of this section.</P> <P>(4) <E T="03">Apportionment to local housing credit agencies</E>—(i) <E T="03">In general.</E> In lieu of the primary apportionment under paragraph (c)(2) of this section, all or a portion of the State housing credit ceiling may be apportioned among housing credit agencies of governmental subdivisions. Apportionments of the State housing credit ceiling to local housing credit agencies must be made pursuant to a State enabling act as defined in paragraph (c)(1) of this section. Apportionments of the State housing credit ceiling may be made to housing credit agencies of constitutional home rule cities under this paragraph (c)(4), in addition to apportionments made under paragraph (c)(3) of this section. Apportionments of the State housing credit ceiling under this paragraph (c)(4) need not be based on the population of political subdivisions and may, but are not required to, give balanced consideration to the low-income housing needs of the entire State.</P> <P>(ii) <E T="03">Change in apportionments during a calendar year.</E> The apportionment of the State housing credit ceiling among State and local housing credit agencies under this paragraph (c)(4) may be changed after the beginning of a calendar year, pursuant to a State enabling act. No change in apportionments shall retroactively reduce the housing credit allocations made by any agency during such year. Any change in the apportionment of the State housing credit ceiling under this paragraph (c)(4) that occurs during a calendar year is effective only to the extent housing credit agencies have not previously made housing credit allocations during such year from their original apportionments of the State housing credit ceiling for such year. To the extent apportionments of the State housing credit ceiling to local housing credit agencies made pursuant to this paragraph (c)(4) for any calendar year are not used by such local agencies before a certain date (<E T="03">e.g.,</E> November 1) to make housing credit allocations in such year, the amount of unused apportionments may revert back to the State housing credit agency for reapportionment. Such reversion must be specifically authorized by the State enabling act.</P> <P>(iii) <E T="03">Exchanges of apportionments.</E> Any State or local housing credit agency that receives an apportionment of the State housing credit ceiling for any calendar year under this paragraph (c)(4) may exchange part or all of such apportionment with another State or <PRTPAGE P="140"/>local housing credit agency to the extent no housing credit allocations have been made in such year from the exchanged portions. Such exchanges must be made with another housing credit agency in the same State and must be consistent with the State enabling act. If an apportionment set aside for projects involving a qualified nonprofit organization is transferred or exchanged, the transferee housing credit agency shall be required to use the set-aside apportionment for the purposes described in paragraph (c)(5) of this section.</P> <P>(iv) <E T="03">Written records of apportionments.</E> All apportionments, exchanges of apportionments, and reapportionments of the State housing credit ceiling which are authorized by this paragraph (c)(4) must be evidenced in the written records maintained by each State and local housing credit agency.</P> <P>(5) <E T="03">Set-aside apportionments for projects involving a qualified nonprofit organization</E>—(i) <E T="03">In general.</E> Ten percent of the State housing credit ceiling for a calendar year must be set aside exclusively for projects involving a qualified nonprofit organization (as defined in paragraph (c)(5)(ii) of this section). Thus, at least 10 percent of apportionments of the State housing credit ceiling under paragraphs (c) (2) and (3) of this section must be used only to make housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization. In the case of apportionments of the State housing credit ceiling under paragraph (c)(4) of this section, the State enabling act must ensure that the apportionment of at least 10 percent of the State housing credit ceiling be used exclusively to make housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization. The State enabling act shall prescribe which housing credit agencies in the State receive apportionments that must be set aside for making housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization. These set-aside apportionments may be distributed disproportionately among the State or local housing credit agencies receiving apportionments under paragraph (c)(4) of this section. The 10-percent set-aside requirement of this paragraph (c)(4) is a minimum requirement, and the State enabling act may set aside more than 10 percent of the State housing credit ceiling for apportionment to housing credit agencies for exclusive use in making housing credit allocations to buildings that are part of projects involving a qualified nonprofit organization.</P> <P>(ii) <E T="03">Projects involving a qualified nonprofit organization.</E> The term “projects involving a qualified nonprofit organization” means projects with respect to which a qualified nonprofit organization is to materially participate (within the meaning of section 469(h)) in the development and continuing operation of the project throughout the 15-year compliance period. The term “qualified nonprofit organization” means any organization that is described in section 501(c) (3) or (4), is exempt from tax under section 501(a), and includes as one of its exempt purposes the fostering of low-income housing.</P> <P>(6) <E T="03">Expiration of unused apportionments.</E> Apportionments of the State housing credit ceiling under this paragraph (c) for any calendar year may be used by housing credit agencies to make housing credit allocations only in such calendar year. Any part of an apportionment of the State housing credit ceiling for any calendar year that is not used for housing credit allocations in such year expires as of the end of such year and does not carry over to any other year. However, any part of an apportionment for 1989 that is not used to make a housing credit allocation in 1989 may be carried over to 1990 and used to make a housing credit allocation to a qualified low-income building described in section 42(n)(2)(B). <E T="03">See</E> paragraph (g)(2) of this section.</P> <P>(d) <E T="03">Housing credit allocations made by State and local housing credit agencies</E>—(1) <E T="03">In general.</E> This paragraph governs State and local housing credit agencies in making housing credit allocations to qualified low-income buildings. The amount of the apportionment of the State housing credit ceiling for any calendar year received by any State or local housing credit agency under paragraph (c) of this section constitutes the <PRTPAGE P="141"/>agency's aggregate housing credit dollar amount for such year. The aggregate amount of housing credit allocations made in any calendar year by a State or local housing credit agency may not exceed such agency's aggregate housing credit dollar amount for such year. A State or local housing credit agency may make housing credit allocations only to qualified low-income buildings located within the agency's geographic jurisdiction.</P> <P>(2) <E T="03">Amount of a housing credit allocation.</E> In making a housing credit allocation, a State or local housing credit agency must specify a credit percentage, not to exceed the building's applicable percentage determined under section 42(b), and a qualified basis amount. The amount of the housing credit allocation for any building is the product of the specified credit percentage and the specified qualified basis amount. In specifying the credit percentage and qualified basis amount, the State or local housing credit agency shall not take account of the first-year conventions described in section 42(f) (2)(A) and (3)(B). A State or local housing credit agency may adopt rules or regulations governing conditions for specification of less than the maximum credit percentage and qualified basis amount allowable under section 42 (b) and (c), respectively. For example, an agency may specify a credit percentage and a qualified basis amount of less than the maximum credit percentage and qualified basis amount allowable under section 42 (b) and (c), respectively, when the financing and rental assistance from all sources for the project of which the building is a part is sufficient to provide the continuing operation of the building without the maximum credit amount allowable under section 42.</P> <P>(3) <E T="03">Counting housing credit allocations against an agency's aggregate housing credit dollar amount.</E> The aggregate amount of housing credit allocations made in any calendar year by a State or local housing credit agency may not exceed such agency's aggregate housing credit dollar amount (<E T="03">i.e.,</E> the agency's apportionment of the State housing credit ceiling for such year). This limitation on the aggregate dollar amount of housing credit allocations shall be computed separately for set-aside apportionments received pursuant to paragraph (c)(5) of this section. Housing credit allocations count against an agency's aggregate housing credit dollar amount without regard to the amount of credit allowable to or claimed by an owner of a building in the taxable year in which the allocation is made or in any subsequent year. Thus, housing credit allocations (which are computed without regard to the first-year conventions as provided in paragraph (d)(2) of this section) count in full against an agency's aggregate housing credit dollar amount, even though the first-year conventions described in section 42(f) (2)(A) and (3)(B) may reduce the amount of credit claimed by a taxpayer in the first year in which a credit is allowable. <E T="03">See also</E> paragraph (e)(2) of this section. Housing credit allocations count against an agency's aggregate housing credit dollar amount only in the calendar year in which made and not in subsequent taxable years in the credit period or compliance period during which a taxpayer may claim a credit based on the original housing credit allocation. Since the aggregate amount of housing credit allocations made in any calendar year by a State or local housing credit agency may not exceed such agency's aggregate housing credit dollar amount, an agency shall at all times during a calendar year maintain a record of its cumulative allocations made during such year and its remaining unused aggregate housing credit dollar amount.</P> <P>(4) <E T="03">Rules for when applications for housing credit allocations exceed an agency's aggregate housing credit dollar amount.</E> A State or local housing credit agency may adopt rules or regulations governing the awarding of housing credit allocations when an agency expects that applicants during a calendar year will seek aggregate allocations in excess of the agency's aggregate housing credit dollar amount. The State enabling act may provide uniform standards for the awarding of housing credit allocations when there is actual or anticipated excess demand from applicants in any calendar year.</P> <P>(5) <E T="03">Reduced or additional housing credit allocations</E>—(i) <E T="03">In general.</E> A State or local housing credit agency may not <PRTPAGE P="142"/>reduce or rescind a housing credit allocation made to a qualified low-income building in the manner prescribed in paragraph (d)(8) of this section. Thus, a housing credit agency may not reduce or rescind a housing credit allocation made to a qualified low-income building which is acquired by a new owner who is entitled to a carryover of the allowable credit for such building under section 42(d)(7). A housing credit agency may make additional housing credit allocations to a building in any year in the building's compliance period, whether or not there are additions to qualified basis for which an increased credit is allowable under section 42(f)(3). Each additional housing credit allocation made to a building is treated as a separate allocation and is subject to the rules and requirements of this section. However, in the case of an additional housing credit allocation made with respect to additions to qualified basis for which an increased credit is allowable under section 42(f)(3), the amount of the allocation that counts against the agency's aggregate housing credit dollar amount shall be computed as if the specified credit percentage were unreduced in the manner prescribed in section 42(f)(3)(A) and the specified qualified basis amount were unreduced by the first-year convention prescribed in section 42(f)(3)(B).</P> <P>(ii) <E T="03">Examples.</E> The rules of paragraph (d)(5)(i) of this section may be illustrated by the following examples: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>For 1987, the County L Housing Credit Agency has an aggregate housing credit dollar amount of $2 million. D, an individual, places in service on July 1, 1987, a new qualified low-income building. As of the close of each month in 1987 in which the building is in service, the building consists of 100 residential rental units, of which 20 units are both rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income. The total floor space of the residential rental units is 120,000 square feet, and the total floor space of the low-income units is 20,000 square feet. Tne building is not Federally subsidized within the meaning of section 42(i)(2). As of the end of 1987, the building has eligible basis under section 42(d) of $1 million. Thus, the qualified basis of the building determined without regard to the first-year convention provided in section 42(f) is $166,666.67 (<E T="03">i.e.,</E> $1 million eligible basis times <FR>1/6</FR>, the floor space fraction which is required to be used instead of the larger unit fraction). However, the amount of the low-income housing credit determined for 1987 under section 42 reflects the first-year convention provided in section 42(f)(2). Since the building has the same floor space and unit fractions as of the close of each of the six months in 1987 during which it is in service, upon applying the first-year convention in section 42(f)(2), the qualified basis of the building in 1987 is $83,333.33 (<E T="03">i.e.,</E> $1 million eligible basis times <FR>1/12</FR>, the fraction determined under section 42(f)(2)(A)). Under paragraph (d)(2) of this section, the County L Housing Credit Agency may make a housing credit allocation by specifying a credit percentage, not to exceed 9 percent, and a qualified basis amount, which may be greater or less than the qualified basis of the building in 1987 as determined under section 42(c), without regard to the first-year convention provided in section 42(f)(2). If the County L Housing Credit Agency specifies a credit percentage of 8 percent and a qualified basis amount of $100,000, the amount of the housing credit allocation is $8,000. Under paragraph (d)(3) of this section, the County L Housing Credit Agency's aggregate housing credit dollar amount for 1987 is reduced by $8,000, notwithstanding that D is entitled to claim less than $8,000 of the credit in 1987 under the rules in paragraph (e) of this section. Under paragraph (e)(2) of this section, in 1987 D is entitled to claim only $4,000 of the credit, determined by applying the first-year convention of <FR>6/12</FR> to the specified qualified basis amount contained in the housing credit allocation (<E T="03">i.e.,</E> .08×$100,000×(<FR>6/12</FR>)).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>The facts are the same as in <E T="03">Example 1</E> except that on July 1, 1988, the number of occupied low-income units increases to 50 units and the floor space of the occupied low-income units increases to 48,000 square feet. These occupancy fractions remain unchanged as of the close of each month remaining in 1988. Under section 42(c), the qualified basis of the building in 1988, without regard to the first-year convention in section 42(f)(3)(B), is $400,000 (<E T="03">i.e.,</E> $1 million eligible basis times .4, the floor space fraction which is required to be used instead of the larger unit fraction). D's 1987 housing credit allocation from the County L Housing Credit Agency remains effective in 1988 and entitles D to a credit of $8,000 (<E T="03">i.e.,</E> .08, the specified credit percentage, times $100,000, the specified qualified basis amount). With respect to the additional $300,000 of qualified basis which the 1987 housing credit allocation does not cover, D must apply to the County L Housing Credit Agency for an additional housing credit allocation. Assume that the County L Housing Credit Agency has a sufficient aggregate housing credit dollar amount for 1988 to make a housing credit allocation to D in 1988 by specifying a credit percentage of 9 percent and a qualified basis <PRTPAGE P="143"/>amount of $300,000. The amount of the housing credit allocation that counts against the County L Housing Credit Agency's aggregate housing credit dollar amount is $27,000 (<E T="03">i.e.,</E> the amount counted (.09 times $300,000) is unreduced in the manner prescribed in section 42(f)(3) (A) and (B)). Since D's qualified basis in 1987 was $166,666.67, D is entitled to claim a credit in 1988 with respect to such basis of $14,000 (<E T="03">i.e.,</E> .08×$100,000, the 1987 credit alllocation, +.09×$66,666.67, the 1988 credit allocation). In addition, D is entitled to claim a credit in 1988 and subsequent years in the 15-year compliance period with respect to the additional $233,333.33 of qualified basis covered by the 1988 housing credit allocation. However, the allowable credit for 1988 with respect to this amount of additional qualified basis is subject to reductions prescribed in section 42(f)(3) (A) and (B). Thus, D is entitled in 1988 to a credit at a 6-percent rate applied to $116,666.67 of additional qualified basis, which is reduced to reflect the first-year convention. D's total allowable low-income housing credit in 1988 is $21,000 (<E T="03">i.e.,</E> $14,000 with respect to original qualified basis + $7,000 with respect to 1988 additions to qualified basis). If the County L Housing Credit Agency had specified an 8-percent credit percentage in 1988 with respect to the qualified basis not covered by the 1987 housing credit allocation to D, D's allowable credit with respect to the $233,333.33 of additions to qualified basis would not exceed, in 1988 and subsequent years, an amount determined by applying a specified credit percentage of 5.33 percent (<E T="03">i.e.,</E> two-thirds of 8 percent). In 1988, D's specified qualified basis amount would be adjusted for the first-year convention.</P> </EXAMPLE> <P>(6) <E T="03">No carryover of unused aggregate housing credit dollar amount.</E> Any portion of a State or local housing credit agency's aggregate housing credit dollar amount for any calendar year that is not used to make a housing credit allocation in such year may not be carried over to any other year, except as provided in paragraph (g) of this section. An agency may not permit owners of qualified low-income buildings to transfer housing credit allocations to other buildings. However, an agency may provide a procedure whereby owners may return to the agency, prior to the end of the calendar year in which housing credit allocations are made, unusable portions of such allocations. In such a case, an owner's housing credit allocation is deemed reduced by the amount of the allocation returned to the agency, and the agency may reallocate such amount to other qualified low-income buildings prior to the end of the year.</P> <P>(7) <E T="03">Effect of housing credit allocations in excess of an agency's aggregate housing credit dollar amount.</E> In the event that a State or local housing credit agency makes housing credit allocations in excess of its aggregate housing credit dollar amount for any calendar year, the allocations shall be deemed reduced (to the extent of such excess) for buildings in the reverse order in which such allocations were made during such year.</P> <P>(8) <E T="03">Time and manner for making housing credit allocations—</E>(i) <E T="03">Time.</E> Housing credit allocations are effective for the calendar year in which made in the manner prescribed in paragraph (d)(8)(ii) of this section. A State or local housing credit agency may not make a housing credit allocation to a qualified low-income building prior to the calendar year in which such building is placed in service. An agency may adopt its own procedures for receiving applications for housing credit allocations from owners of qualified low-income buildings. An agency may provide a procedure for making, in advance of a building's being placed in service, a binding commitment (<E T="03">e.g.,</E> by contract, inducement, resolution, or other means) to make a housing credit allocation in the calendar year in which a qualified low-income building is placed in service or in a subsequent calendar year. Any advance commitment shall not constitute a housing credit allocation for purposes of this section.</P> <P>(ii) <E T="03">Manner.</E> Housing credit allocations are deemed made when part I of IRS Form 8609, Low-Income Housing Credit Allocation Certification, is completed and signed by an authorized official of the housing credit agency and mailed to the owner of the qualified low-income building. A copy of all completed (as to part I) Form 8609 allocations along with a single completed Form 8610, Annual Low-Income Housing Credit Agencies Report, must also be mailed to the Internal Revenue Service not later than the 28th day of the second calendar month after the close of the calendar year in which the housing credit was allocated to the qualified low-income building. Housing <PRTPAGE P="144"/>credit allocations to a qualified low-income building must be made on Form 8609 and must include—</P> <P>(A) The address of the building;</P> <P>(B) The name, address, and taxpayer identification number of the housing credit agency making the housing credit allocation;</P> <P>(C) The name, address, and taxpayer identification number of the owner of the qualified low-income building;</P> <P>(D) The date of the allocation of housing credit;</P> <P>(E) The housing credit dollar amount allocated to the building on such date;</P> <P>(F) The specified maximum applicable credit percentage allocated to the building on such date;</P> <P>(G) The specified maximum qualified basis amount;</P> <P>(H) The percentage of the aggregate basis financed by tax-exempt bonds taken into account for purposes of the volume cap under section 146;</P> <P>(I) A certification under penalties of perjury by an authorized State or local housing credit agency official that the allocation is made in compliance with the requirements of section 42(h); and</P> <P>(J) Any additional information that may be required by Form 8609 or by an applicable revenue procedure.</P> <FP> <E T="03">See</E> paragraph (h) of this section for additional rules concerning filing of forms.</FP> <P>(iii) <E T="03">Certification.</E> The certifying official for the State or local housing credit agency need not perform an independent investigation of the qualified low-income building in order to certify on part I of Form 8609 that the housing credit allocation meets the requirements of section 42(h). For example, the certifying official may rely on information contained in an application for a low-income housing credit allocation submitted by the building owner which sets forth facts necessary to determine that the building is eligible for the low-income housing credit under section 42.</P> <P>(iv) <E T="03">Fee.</E> A State or local housing credit agency may charge building owners applying for housing credit allocations a reasonable fee to cover the agency's administrative expenses for processing applications.</P> <P>(v) <E T="03">No continuing agency responsibility.</E> The State or local housing credit agency need not monitor or investigate the continued compliance of a qualified low-income building with the requirements of section 42 throughout the applicable compliance period.</P> <P>(e) <E T="03">Housing credit allocation taken into account by owner of a qualified low-income building</E>—(1) <E T="03">Time and manner for taking housing credit allocation into account.</E> An owner of a qualified low-income building may not claim a low-income housing credit determined under section 42 in any year in excess of an effective housing credit allocation received from a State or local housing credit agency. A housing credit allocation made to a qualified low-income building is effective with respect to any owner of the building beginning with the owner's taxable year in which the housing credit allocation is received. A housing credit allocation is deemed received in a taxable year, except as modified in the succeeding sentence, if that allocation is made (in the manner described in paragraph (d)(8) of this section) not later than the earlier of (i) the 60th day after the close of the taxable year, or (ii) the close of the calendar year in which such taxable year ends. A housing credit allocation is deemed received in a taxable year ending in 1987, if such allocation is made (in the manner described in paragraph (d)(8) of this section) on or before December 31, 1987. A housing credit allocation is not effective for any taxable year if received in a calendar year which ends prior to when the qualified low-income building is placed in service. A housing credit allocation made to a qualified low-income building remains effective for all taxable years in the compliance period. A taxpayer is required to complete the Form 8609 on which a housing credit agency made the applicable housing credit allocation and submit a copy of such Form 8609 with its Federal income tax return for each year in the compliance period. Failure to comply with the requirement of the preceding sentence with respect to any taxable year after the first taxable year in the credit period shall be treated as a mathematical or clerical error for purposes of the provisions of section 6213 (b)(1) and (g)(2).<PRTPAGE P="145"/> </P> <P>(2) <E T="03">First-year convention limitation on housing credit allocation taken into account.</E> For purposes of the limitation that the allowable low-income housing credit may not exceed the effective housing credit allocation received from a State or local housing credit agency, as provided in paragraph (e)(1) of this section, the amount of the effective housing credit allocation shall be adjusted by applying the first-year convention provided in section 42(f)(2)(A) and (3)(B) and the percentage credit reduction provided in section 42(f)(3)(A). Under paragraphs (d) (2) and (5) of this section, the State or local housing credit agency must specify the credit percentage and qualified basis amount, the product of which is the amount of the housing credit allocation, without taking account of the first-year convention described in section 42(f)(2)(A) and (3)(B) or the percentage credit reduction prescribed in section 42(f)(3)(A). However, for purposes of the limitation on the amount of the allowable low-income housing credit, as provided in paragraph (e)(1) of this section, in a taxable year in which the first-year convention applies to the amount of credit determined under section 42(a), the specified qualified basis amount shall be adjusted by the first-year convention fraction which is equal to the number of full months (during the first taxable year) in which the building was in service divided by 12. In addition, for purposes of the limitation on the amount of the allowable low-income housing credit, as provided in paragraph (e)(1) of this section, in a taxable year in which the reduction in credit percentage applies to additions to qualified basis, as prescribed in section 42(f)(3), the specified credit percentage shall be reduced by one-third. <E T="03">See</E> examples in paragraphs (d)(5)(ii) and (e)(3)(ii) of this section.</P> <P>(3) <E T="03">Use of excess housing credit allocation for increases in qualified basis</E>—(i) <E T="03">In general.</E> If the housing credit allocation made to a qualified low-income building exceeds the amount of credit allowable with respect to such building in any taxable year (without regard to the first-year conventions under section 42(f)), such excess is not transferable to another qualified low-income building. However, if in a subsequent year there are increases in the qualified basis for which an increased credit is allowable under section 42(f)(3) at a reduced credit percentage, the original housing credit allocation (including the specified credit percentage and qualified basis amount) would be effective with respect to such increased credit.</P> <P>(ii) <E T="03">Example.</E> The provisions of this paragraph (e)(3) may be illustrated by the following example: </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>In 1987, a newly-constructed qualified low-income building receives a housing credit allocation of $90,000 based on a specified credit percentage of 9 percent and a specified qualified basis amount of $1,000,000. The building is placed in service in 1987, but the qualified basis in such year is only $800,000, resulting in an allowable credit in 1987 (determined without regard to the first-year conventions) of $72,000. In 1988, the qualified basis is increased to $1,100,000, resulting in an additional credit allowable under section 42(f)(3) (without regard to the first-year conventions) of $18,000 (<E T="03">i.e.,</E> $300,000 × .06, or <FR>2/3</FR> of .09). The unused portion of the 1987 housing credit allocation ($18,000) is effective in 1988 and in each subsequent year in the compliance period only with respect to the specified qualified basis for the 1987 housing credit allocation ($1,000,000). Thus, the owner is allowed to claim a credit in 1988 and in each subsequent year (without regard to the first-year conventions), based on the effective housing credit allocation from 1987, of $84,000 (<E T="03">i.e.,</E> $72,000 + ($200,000 × .06)). The owner of the qualified low-income building must obtain a new housing credit allocation in 1988 with respect to the additional $100,000 of qualified basis in order to claim a credit on such basis in 1988 and in each subsequent year. If the applicable first-year convention under section 42(f)(3)(B) entitled the owner in 1988 to only <FR>1/2</FR> of the otherwise applicable credit for the additions to qualified basis, under paragraph (e)(2) of this section the owner is allowed to claim a credit in 1988, based on the effective housing credit allocation from 1987, of $78,000 (<E T="03">i.e.,</E> $72,000 + ($200,000 × .06 × .5)).</P> </EXAMPLE> <P>(4) <E T="03">Separate housing credit allocations for new buildings and increases in qualified basis.</E> Separate housing credit allocations must be received for each building with respect to which a housing credit may be claimed. Rehabilitation expenditures with respect to a qualified low-income building are treated as a separate new building under section 42(e) and must receive a separate housing credit allocation. Increases in qualified basis in a qualified <PRTPAGE P="146"/>low-income building are not generally treated as a new building for purposes of section 42. To the extent that a prior housing credit allocation received with respect to a qualified low-income building does not allow an increased credit with respect to an increase in the qualified basis of such building, an additional housing credit allocation must be received in order to claim a credit with respect to that portion of increase in qualified basis. <E T="03">See</E> paragraph (e)(3) of this section. The amount of credit allowable with respect to an increase in qualified basis is subject to the credit percentage limitation of section 42(f)(3)(A) and the first-year convention of section 42(f)(3)(B). <E T="03">See</E> paragraph (d)(5) of this section for a rule requiring that the State or local housing credit agency count a housing credit allocation made with respect to an increase in qualified basis as if the specified credit percentage were unreduced in the manner prescribed in section 42(f)(3) and the specified basis amount were unreduced by the first-year convention prescribed in section 42(f)(3)(B).</P> <P>(5) <E T="03">Acquisition of building for which a prior housing credit allocation has been made.</E> If a carryover credit would be allowable to an acquirer of a qualified low-income building under section 42(d)(7), such acquirer need not obtain a new housing credit allocation with respect to such building. Under section 42(d)(7), the acquirer would be entitled to claim only such credits as would have been allowable to the prior owner of the building.</P> <P>(6) <E T="03">Multiple housing credit allocations.</E> A qualified low-income building may receive multiple housing credit allocations from different housing credit agencies having overlapping jurisdictions. A qualified low-income building that receives a housing credit allocation set aside exclusively for projects involving a qualified nonprofit organization may also receive a housing credit allocation from a housing credit agency's aggregate housing credit dollar amount that is not so set aside.</P> <P>(f) <E T="03">Exception to housing credit allocation requirement</E>—(1) <E T="03">Tax-exempt bond financing</E>—(i) <E T="03">In general.</E> No housing credit allocation is required in order to claim a credit under section 42 with respect to that portion of the eligible basis (as defined in section 42(d)) of a qualified low-income building that is financed with the proceeds of an obligation described in section 103(a) (“tax-exempt bond”) which is taken into account for purposes of the volume cap under section 146. In addition, no housing credit allocation is required in order to claim a credit under section 42 with respect to the entire qualified basis (as defined in section 42(c)) of a qualified low-income building if 70 percent or more of the aggregate basis of the building and the land on which the building is located is financed with the proceeds of tax-exempt bonds which are taken into account for purposes of the volume cap under section 146. For purposes of this paragraph, “land on which the building is located” includes only land that is functionally related and subordinate to the qualified low-income building. <E T="03">See</E> § 1.103-8(b)(4)(iii) for the meaning of the term “functionally related and subordinate”. For purposes of this paragraph, the basis of the land shall be determined using principles that are consistent with the rules contained in section 42(d).</P> <P>(ii) <E T="03">Determining use of bond proceeds.</E> For purposes of determining the portion of proceeds of an issue of tax-exempt bonds used to finance (A) the eligible basis of a qualified low-income building, and (B) the aggregate basis of the building and the land on which the building is located, the proceeds of the issue must be allocated in the bond indenture or a related document (as defined in § 1.103-13(b)(8)) in a manner consistent with the method used to allocate the net proceeds of the issue for purposes of determining whether 95 percent or more of the net proceeds of the issue are to be used for the exempt purpose of the issue. If the issuer is not consistent in making this allocation throughout the bond indenture and related documents, or if neither the bond indenture nor a related document provides an allocation, the proceeds of the issue will be allocated on a pro rata basis to all of the property financed by the issue, based on the relative cost of the property.</P> <P>(iii) <E T="03">Example.</E> The provisions of this paragraph may be illustrated by the following example: </P> <EXAMPLE> <PRTPAGE P="147"/> <HD SOURCE="HED">Example.</HD> <P>In 1987, County K assigns $500,000 of its volume cap for private activity bonds under section 146 to a $500,000 issue of exempt facility bonds to provide a qualified residential rental project to be owned by A, an individual. The aggregate basis of the building and the land on which the building is located is $700,000. Under the terms of the bond indenture, the net proceeds of the issue are to be used to finance $490,000 of the eligible basis of the building. More than 70 percent of the aggregate basis of the qualified low-income building and the land on which the building is located is financed with the proceeds of tax-exempt bonds to which a portion of the volume cap under section 146 was allocated. Accordingly, A may claim a credit under section 42 without regard to whether any housing credit dollar amount was allocated to that building. If, instead, the aggregate basis of the building and land were $800,000, A would be able to claim the credit under section 42 without receiving a housing credit allocation for the building only to the extent that the credit was attributable to eligible basis of the building financed with tax-exempt bonds.</P> </EXAMPLE> <P>(g) <E T="03">Termination of authority to make housing credit allocation</E>—(1) <E T="03">In general.</E> No State or local housing credit agency shall receive an apportionment of a State housing credit ceiling for calendar years after 1989. Consequently, no housing credit allocations may be made after 1989, except as provided in paragraph (g)(2) of this section. Housing credit allocations made prior to January 1, 1990, remain effective after such date.</P> <P>(2) <E T="03">Carryover of unused 1989 apportionment.</E> Any State or local housing credit agency that has an unused portion of its apportionment of the State housing credit ceiling for 1989 from which housing credit allocations have not been made in 1989 may carry over such unused portion into 1990. Such carryover portion of the 1989 apportionment shall be treated as the agency's apportionment for 1990. From this 1990 apportionment, the State or local housing credit agency may make housing credit allocations only to a qualified low-income building meeting the following requirements:</P> <P>(i) The building must be constructed, reconstructed, or rehabilitated by the taxpayer seeking the allocation;</P> <P>(ii) More than 10 percent of the reasonably anticipated cost of such construction, reconstruction, or rehabilitation must have been incurred as of January 1, 1989; and</P> <P>(iii) The building must be placed in service before January 1, 1991.</P> <P>(3) <E T="03">Expiration of exception for tax-exempt bond financed projects.</E> The exception to the requirement that a housing credit allocation be received with respect to any portion of the eligible basis of a qualified low-income building, as provided in paragraph (f) of this section, shall not apply to any building placed in service after 1989, unless such building is described in paragraphs (g)(2) (i), (ii), and (iii) of this section.</P> <P>(h) <E T="03">Filing of forms and special rules</E>—(1) <E T="03">Completed form.</E> For purposes of this section, a form shall be treated as completed if the State or local housing credit agency or the building owner has made a good faith effort to complete the form in accordance with the form and the instructions for the form.</P> <P>(2) <E T="03">Manner of filing.</E> A completed Form 8586, Low-Income Housing Credit, shall be filed with the owner's Federal income tax return for each taxable year the owner of a qualified low-income building is claiming the low-income housing credit during the 10-year credit period. A completed Form 8609 (or copy thereof) shall be filed with the owner's Federal income tax return for each of the 15 taxable years in the compliance period. If a housing credit allocation is not required to be received by an owner under paragraph (f) of this section, the owner shall obtain a blank copy of Form 8609 and fill in the address of the building and the name and address of the owner in part I. Part II of Form 8609 shall be completed by the owner of the qualified low-income building only for the first year the low-income housing credit is claimed by the building owner. Part III of Form 8609 (Statement of Qualification) shall be completed by the owner of the qualified low-income building for each year of the 15-year compliance period.</P> <P>(3) <E T="03">Revised or renumbered forms.</E> If any form is revised or renumbered, any reference in this section to the form shall be treated as a reference to the revised or renumbered form.</P> <P>(i) <E T="03">Transitional rules.</E> The transitional rules contained in section 252(f)(1) of <PRTPAGE P="148"/>the Tax Reform Act of 1986 are incorporated into this section of the regulations for purposes of determining whether a qualified low-income building is entitled to receive a housing credit allocation or is excepted from the requirement that a housing credit allocation be received. Housing credit allocations made to qualified low-income buildings described in section 252(f)(1) shall not count against the State or local housing credit agency's aggregate housing credit dollar amount. The transitional rules contained in section 252(f)(2) of the Tax Reform Act of 1986 are incorporated into this section of the regulations for purposes of determining amounts available to certain State or local housing credit agencies for the making of housing credit allocations to certain qualified low-income housing projects. Amounts available to housing credit agencies under section 252(f)(2) shall be treated as special apportionments unavailable for housing credit allocations to qualified low-income buildings not described in section 252(f)(2). Housing credit allocations made from the special apportionments shall not count against the State or local credit agency's aggregate housing credit dollar amount. The set-aside requirements shall not apply to these special apportionments. The transitional rules contained in section 252(f)(3) of the Tax Reform Act 1986 are incorporated in this section of the regulations for purposes of determining the amount of housing credit allocations received by certain qualified low-income buildings. Housing credit allocations deemed received under section 252(f)(3) shall not count against the State or local housing credit agency's aggregate housing credit dollar amount.</P> <CITA>[T.D. 8144, 52 FR 23433, June 22, 1987; 52 FR 24583, July 1, 1987]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-2</SECTNO> <SUBJECT>Waiver of requirement that an existing building eligible for the low-income housing credit was last placed in service more than 10 years prior to acquisition by the taxpayer.</SUBJECT> <P>(a) <E T="03">Low-income housing credit for existing building.</E> Section 42 provides that, for purposes of section 38, new and existing qualified low-income buildings are eligible for a low-income housing credit. The eligibility rules for new and existing buildings differ. Under section 42(d)(2), an existing building may be eligible for the low-income housing credit based upon the acquisition cost and amounts chargeable to capital account (to the extent properly included in eligible basis) if—</P> <P>(1) The taxpayer acquires the building by purchase (as defined in section 179(d)(2), as applicable under section 42(d)(2)(D)(iii)(I)),</P> <P>(2) There is a period of at least 10 years between the date of the building's acquisition by the taxpayer and the later of—(i) The date the building was last placed in service, or</P> <P>(ii) The date of the most recent nonqualified substantial improvement of the building, and</P> <P>(3) The building was not previously placed in service by the taxpayer, or by a person who was a related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the building was last previously placed in service.</P> <P>(b) <E T="03">Waiver of 10-year holding period requirement.</E> Section 42(d)(6) provides that a taxpayer may apply for a waiver of the 10-year holding period requirement specified in paragraph (a)(2) of this section. The Internal Revenue Service will grant a waiver only if—</P> <P>(1) The existing building satisfies all of the requirements in paragraph (c) of this section, and</P> <P>(2) The taxpayer makes an application in conformity with the requirements in paragraph (d) of this section.</P> <P>(c) <E T="03">Waiver requirements</E>—(1) <E T="03">Federally-assisted building.</E> To satisfy the requirement of this paragraph, a building must be a Federally-assisted building. The term “Federally assisted building” means any building which is substantially assisted, financed, or operated under section 8 of the United States Housing Act of 1937, section 221(d)(3) or 236 of the National Housing Act, or section 515 of the Housing Act of 1949, as such acts were in effect on October 22, 1986.</P> <P>(2) <E T="03">Federal mortgage funds at risk.</E> To satisfy the requirement of this paragraph, Federal mortgage funds must be at risk with respect to a mortgage that is secured by the building or a project <PRTPAGE P="149"/>of which the building is a part. For purposes of this paragraph, Federal mortgage funds are at risk if, in the event of a default by the mortgagor on the mortgage secured by the building or the project of which the building is a part—</P> <P>(i) The mortgage could be assigned to the Department of Housing and Urban Development or the Farmers’ Home Administration, or</P> <P>(ii) There could arise a claim against a Federal mortgage insurance fund (or such Department or Administration).</P> <P>(3) <E T="03">Statement by the Department of Housing and Urban Development or the Farmers’ Home Administration.</E> (i) To satisfy the requirement of this paragraph, a letter or other written statement must be made or received and approved by the national office of the Department of Housing and Urban Development or the Farmers’ Home Administration (“the Federal agency”). This letter or statement shall include the following:</P> <P>(A) A statement that, as of the earlier of the time of the taxpayer's acquisition of the building or the taxpayer's application for a waiver, the building is a Federally-assisted building within the meaning of paragraph (c)(1) of this section and identifies the source of Federal assistance;</P> <P>(B) A statement that a waiver of the 10-year holding period requirement is necessary to avert Federal mortgage funds being at risk within the meaning of paragraph (c)(2) of this section; and</P> <P>(C) A statement that the Federal agency has taken a Federal agency action as described in paragraph (c)(3)(ii) of this section.</P> <P>(ii) The following specified Federal agency actions shall be the only means of satisfying the requirement of this paragraph:</P> <P>(A) The Federal agency intends to accept an assignment of a mortgage secured by the building or the project of which the building is a part, and such assignment requires payments by the agency or a mortgage insurance fund maintained by the agency to the prior mortgagee;</P> <P>(B) The Federal agency or a mortgage insurance fund maintained by the agency intends to accept, as a consequence of foreclosure proceedings or otherwise, conveyance of the building or the project of which the building is a part;</P> <P>(C) The Federal agency or a mortgage insurance fund maintained by the agency intends, as a consequence of default, to take possession of, hold title to, or otherwise assume ownership of the building or the project of which the building is a part; or</P> <P>(D) The Federal agency has designated the building or the project of which the building is a part as a troubled building or project. A designation of a troubled building or project must satisfy the following requirements:</P> <P>(<E T="03">1</E>) Designation of troubled status must be based on a review by the Federal agency of the financial condition of the building or project and on a determination by the Federal agency of a history of financial distress or mortgage defaults;</P> <P>(<E T="03">2</E>) Designation of troubled status must be made or received and approved by the national office of the Federal agency; and</P> <P>(<E T="03">3</E>) Federal agency regulations or procedures must provide that, in the event of transfer of the ownership of a designated troubled building or project, the building or project may be subject to continued review by the Federal agency. Each Federal agency may prescribe its own standards and procedures for designating a troubled building or project so long as such standards are consistent with the requirements of this paragraph (c)(3)(ii)(D).</P> <P>(4) <E T="03">No prior credit allowed.</E> The requirement of this paragraph is satisfied only if no prior owner was allowed a low-income housing credit under section 42 for the building.</P> <P>(d) <E T="03">Application for waiver</E>—(1) <E T="03">Time and manner.</E> In order to receive a waiver of the 10-year holding period requirement specified in paragraph (a)(2) of this section, a taxpayer must file an application (including the applicable user fee) that complies with the requirements of this paragraph (d) and Rev. Proc. 90-1, 1990-1 I.R.B. 8 (or any subsequent applicable revenue procedure). The application must be filed by a taxpayer who has acquired the building by purchase or who has a binding contract to purchase the building. <PRTPAGE P="150"/>Such binding contract may be conditioned upon the granting of a waiver under this section. The application may be filed at any time after a binding contract has been entered into, but no later than 12 months after the taxpayer's acquisition of the building. An application for a waiver of the 10-year holding period requirement must not contain a request for a ruling on any other issue arising under section 42 or other sections of the Internal Revenue Code. An application for a waiver of the 10-year holding period requirement must be mailed or delivered to the address listed in section 3.01 of Rev. Proc. 90-1 (or any subsequent applicable revenue procedure).</P> <P>(2) <E T="03">Information required.</E> An application for a waiver of the 10-year holding period requirement must contain the following information:</P> <P>(i) The taxpayer's name, address and taxpayer identification number;</P> <P>(ii) The name (if any) and address of the acquired building and the project (if any) of which it is a part;</P> <P>(iii) The date of acquisition or the date of the binding contract for acquisition of the building by the taxpayer and the expected date of acquisition, the amount of consideration paid or to be paid for the acquisition (including the value of any liabilities assumed by the taxpayer), and the taxpayer's certification that such acquisition is by purchase (as defined in section 179(d)(2), as applicable under section 42 (d)(2)(D)(iii)(I));</P> <P>(iv) The identity of the person from whom the building is acquired, and whether such person is a Federal agency, a mortgagee holding title to the building, or the mortgagor or prior owner;</P> <P>(v) The date the building was last placed in service and the date of the most recent (if any) nonqualified substantial improvement of the building (as defined in section 42 (d)(2)(D)(i));</P> <P>(vi) The taxpayer's certification that the building was not previously placed in service by the taxpayer, or by a person who was a related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the building was last placed in service;</P> <P>(vii) The amount and disposition (<E T="03">e.g.,</E> discharge, assignment, assumption, or refinance) of the outstanding mortgage at the time of acquisition and the identities of the mortgagee and mortgagor;</P> <P>(viii) The taxpayer's certification that no prior owner was allowed a low-income housing credit under section 42 for the building (made to the best of the taxpayer's knowledge, with no documentation from other persons needed to be submitted); and</P> <P>(ix) The statement from the Federal agency required by paragraph (c)(3)(i) of this section.</P> <P>(3) <E T="03">Other rules.</E> (i) In the event that an acquired building will be owned by more than one taxpayer, a single application for waiver may be filed by one taxpayer on behalf of the co-owners if the application contains the names, addresses and taxpayer identification numbers of the other owners. A general partner or a designated limited partner may file an application for waiver on behalf of a partnership.</P> <P>(ii) In the event that multiple Federally-assisted buildings in a project are being acquired by the taxpayer, a single application for waiver with respect to such buildings may be filed if the application contains the required information set out for the address of each Federally-assisted building involved.</P> <P>(iii) In the event that specific Federally-assisted buildings are being acquired by the taxpayer in a project consisting of multiple buildings that may or may not be Federally-assisted, a single application for waiver with respect to the Federally-assisted buildings being acquired may be filed if the application contains the required information set out for the address of each Federally-assisted building being acquired.</P> <P>(4) <E T="03">Effective date of waiver.</E> A waiver will be effective when granted in writing by the Internal Revenue Service after submission of a completed application for waiver filed under this paragraph (d).</P> <P>(5) <E T="03">Attachment to return.</E> A waiver letter granted by the Internal Revenue Service shall be filed with the taxpayer's Federal income tax return for the first taxable year the low-income housing credit is claimed by the taxpayer.<PRTPAGE P="151"/> </P> <P>(e) <E T="03">Effective date of regulations.</E> The provisions of § 1.42-2 are effective for buildings placed in service by the taxpayer after December 31, 1986.</P> <CITA>[T.D. 8302, 55 FR 21189, May 23, 1990; 55 FR 25973, June 26, 1990]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-3</SECTNO> <SUBJECT>Treatment of buildings financed with proceeds from a loan under an Affordable Housing Program established pursuant to section 721 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).</SUBJECT> <P>(a) <E T="03">Treatment under sections 42(i) and 42(b).</E> A below market loan funded in whole or in part with funds from an Affordable Housing Program established under section 721 of FIRREA is not, solely by reason of the Affordable Housing Program funds, a below market Federal loan as defined in section 42(i)(2)(D). Thus, any building with respect to which the proceeds of the loan are used during the tax year is not, solely by reason of the Affordable Housing Program funds, treated as a federally subsidized building for that tax year and subsequent tax years for purposes of determining the applicable percentage for the building under section 42(b).</P> <P>(b) <E T="03">Effective date.</E> The rules set forth in paragraph (a) of this section are effective for loans made after August 8, 1989.</P> <CITA>[56 FR 48734, Sept. 26, 1991]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-4</SECTNO> <SUBJECT>Application of not-for-profit rules of section 183 to low-income housing credit activities.</SUBJECT> <P>(a) <E T="03">Inapplicability to section 42.</E> In the case of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable, section 183 does not apply to disallow losses, deductions, or credits attributable to the ownership and operation of the building.</P> <P>(b) <E T="03">Limitation.</E> Notwithstanding paragraph (a) of this section, losses, deductions, or credits attributable to the ownership and operation of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable may be limited or disallowed under other provisions of the Code or principles of tax law. See, <E T="03">e.g.,</E> sections 38(c), 163(d), 465, 469; <E T="03">Knetsch</E> v. <E T="03">United States,</E> 364 U.S. 361 (1960), 1961-1 C.B. 34 (“sham” or “economic substance” analysis); and <E T="03">Frank Lyon Co.</E> v. <E T="03">Commissioner,</E> 435 U.S. 561 (1978), 1978-1 C.B. 46 (“ownership” analysis).</P> <P>(c) <E T="03">Effective date.</E> The rules set forth in paragraphs (a) and (b) of this section are effective with respect to buildings placed in service after December 31, 1986.</P> <CITA>[T.D. 8420, 57 FR 24729, June 11, 1992]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-5</SECTNO> <SUBJECT>Monitoring compliance with low-income housing credit requirements.</SUBJECT> <P>(a) <E T="03">Compliance monitoring requirement</E>—(1) <E T="03">In general.</E> Under section 42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains a procedure that the State or local housing credit agency (“Agency”) (or an agent of, or other private contractor hired by, the Agency) will follow in monitoring for noncompliance with the provisions of section 42 and in notifying the Internal Revenue Service of any noncompliance of which the Agency becomes aware. These regulations only address compliance monitoring procedures required of Agencies. The regulations do not address forms and other records that may be required by the Service on examination or audit. For example, if a building is sold or otherwise transferred by the owner, the transferee should obtain from the transferor information related to the first year of the credit period so that the transferee can substantiate credits claimed.</P> <P>(2) <E T="03">Requirements for a monitoring procedure</E>—(i) <E T="03">In general.</E> A procedure for monitoring for noncompliance under section 42(m)(1)(B)(iii) must include—</P> <P>(A) The recordkeeping and record retention provisions of paragraph (b) of this section;</P> <P>(B) The certification and review provisions of paragraph (c) of this section;</P> <P>(C) The inspection provision of paragraph (d) of this section; and</P> <P>(D) The notification-of-noncompliance provisions of paragraph (e) of this section.</P> <P>(ii) <E T="03">Order and form.</E> A monitoring procedure will meet the requirements of section 42 (m)(1)(B)(iii) if it contains <PRTPAGE P="152"/>the substance of these provisions. The particular order and form of the provisions in the allocation plan is not material. A monitoring procedure may contain additional provisions or requirements.</P> <P>(b) <E T="03">Recordkeeping and record retention provisions</E>—(1) <E T="03">Recordkeeping provision.</E> Under the recordkeeping provision, the owner of a low-income housing project must be required to keep records for each qualified low-income building in the project that show for each year in the compliance period—</P> <P>(i) The total number of residential rental units in the building (including the number of bedrooms and the size in square feet of each residential rental unit);</P> <P>(ii) The percentage of residential rental units in the building that are low-income units;</P> <P>(iii) The rent charged on each residential rental unit in the building (including any utility allowances);</P> <P>(iv) The number of occupants in each low-income unit, but only if rent is determined by the number of occupants in each unit under section 42(g)(2) (as in effect before the amendments made by the Omnibus Budget Reconciliation Act of 1989);</P> <P>(v) The low-income unit vacancies in the building and information that shows when, and to whom, the next available units were rented;</P> <P>(vi) The annual income certification of each low-income tenant per unit. For an exception to this requirement, see section 42(g)(8)(B) (which provides a special rule for a 100 percent low-income building);</P> <P>(vii) Documentation to support each low-income tenant's income certification (for example, a copy of the tenant's federal income tax return, Forms W-2, or verifications of income from third parties such as employers or state agencies paying unemployment compensation). For an exception to this requirement, see section 42(g)(8)(B) (which provides a special rule for a 100 percent low-income building). Tenant income is calculated in a manner consistent with the determination of annual income under section 8 of the United States Housing Act of 1937 (“Section 8”), not in accordance with the determination of gross income for federal income tax liability. In the case of a tenant receiving housing assistance payments under Section 8, the documentation requirement of this paragraph (b)(1)(vii) is satisfied if the public housing authority provides a statement to the building owner declaring that the tenant's income does not exceed the applicable income limit under section 42 (g);</P> <P>(viii) The eligible basis and qualified basis of the building at the end of the first year of the credit period; and</P> <P>(ix) The character and use of the nonresidential portion of the building included in the building's eligible basis under section 42 (d) (<E T="03">e.g.</E>, tenant facilities that are available on a comparable basis to all tenants and for which no separate fee is charged for use of the facilities, or facilities reasonably required by the project).</P> <P>(2) <E T="03">Record retention provision.</E> Under the record retention provision, the owner of a low-income housing project must be required to retain the records described in paragraph (b)(1) of this section for at least 6 years after the due date (with extensions) for filing the federal income tax return for that year. The records for the first year of the credit period, however, must be retained for at least 6 years beyond the due date (with extensions) for filing the federal income tax return for the last year of the compliance period of the building.</P> <P>(3) <E T="03">Inspection record retention provision.</E> Under the inspection record retention provision, the owner of a low-income housing project must be required to retain the original local health, safety, or building code violation reports or notices that were issued by the State or local government unit (as described in paragraph (c)(1)(vi) of this section) for the Agency's inspection under paragraph (d) of this section. Retention of the original violation reports or notices is not required once the Agency reviews the violation reports or notices and completes its inspection, unless the violation remains uncorrected.</P> <P>(c) <E T="03">Certification and review provisions</E>—(1) <E T="03">Certification.</E> Under the certification provision, the owner of a low-income housing project must be required to certify at least annually to the Agency <PRTPAGE P="153"/>that, for the preceding 12-month period—</P> <P>(i) The project met the requirements of:</P> <P>(A) The 20-50 test under section 42 (g)(1)(A), the 40-60 test under section 42 (g)(1)(B), or the 25-60 test under sections 42 (g)(4) and 142 (d)(6) for New York City, whichever minimum set-aside test was applicable to the project; and</P> <P>(B) If applicable to the project, the 15-40 test under sections 42(g)(4) and 142 (d)(4)(B) for “deep rent skewed” projects;</P> <P>(ii) There was no change in the applicable fraction (as defined in section 42(c)(1)(B)) of any building in the project, or that there was a change, and a description of the change;</P> <P>(iii) The owner has received an annual income certification from each low-income tenant, and documentation to support that certification; or, in the case of a tenant receiving Section 8 housing assistance payments, the statement from a public housing authority described in paragraph (b)(1)(vii) of this section. For an exception to this requirement, see section 42(g)(8)(B) (which provides a special rule for a 100 percent low-income building);</P> <P>(iv) Each low-income unit in the project was rent-restricted under section 42(g)(2);</P> <P>(v) All units in the project were for use by the general public (as defined in § 1.42-9), including the requirement that no finding of discrimination under the Fair Housing Act, 42 U.S.C. 3601-3619, occurred for the project. A finding of discrimination includes an adverse final decision by the Secretary of the Department of Housing and Urban Development (HUD), 24 CFR 180.680, an adverse final decision by a substantially equivalent state or local fair housing agency, 42 U.S.C. 3616a(a)(1), or an adverse judgment from a federal court;</P> <P>(vi) The buildings and low-income units in the project were suitable for occupancy, taking into account local health, safety, and building codes (or other habitability standards), and the State or local government unit responsible for making local health, safety, or building code inspections did not issue a violation report for any building or low-income unit in the project. If a violation report or notice was issued by the governmental unit, the owner must attach a statement summarizing the violation report or notice or a copy of the violation report or notice to the annual certification submitted to the Agency under paragraph (c)(1) of this section. In addition, the owner must state whether the violation has been corrected;</P> <P>(vii) There was no change in the eligible basis (as defined in section 42(d)) of any building in the project, or if there was a change, the nature of the change (<E T="03">e.g.</E>, a common area has become commercial space, or a fee is now charged for a tenant facility formerly provided without charge);</P> <P>(viii) All tenant facilities included in the eligible basis under section 42(d) of any building in the project, such as swimming pools, other recreational facilities, and parking areas, were provided on a comparable basis without charge to all tenants in the building;</P> <P>(ix) If a low-income unit in the project became vacant during the year, that reasonable attempts were or are being made to rent that unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project were or will be rented to tenants not having a qualifying income;</P> <P>(x) If the income of tenants of a low-income unit in the building increased above the limit allowed in section 42(g)(2)(D)(ii), the next available unit of comparable or smaller size in the building was or will be rented to tenants having a qualifying income;</P> <P>(xi) An extended low-income housing commitment as described in section 42(h)(6) was in effect (for buildings subject to section 7108(c)(1) of the Omnibus Budget Reconciliation Act of 1989, 103 Stat. 2106, 2308-2311), including the requirement under section 42(h)(6)(B)(iv) that an owner cannot refuse to lease a unit in the project to an applicant because the applicant holds a voucher or certificate of eligibility under section 8 of the United States Housing Act of 1937, 42 U.S.C. 1437f (for buildings subject to section 13142(b)(4) of the Omnibus Budget Reconciliation Act of 1993, 107 Stat. 312, 438-439); and<PRTPAGE P="154"/> </P> <P>(xii) All low-income units in the project were used on a nontransient basis (except for transitional housing for the homeless provided under section 42(i)(3)(B)(iii) or single-room-occupancy units rented on a month-by-month basis under section 42(i)(3)(B)(iv)).</P> <P>(2) <E T="03">Review.</E> The review provision must—</P> <P>(i) Require that the Agency review the certifications submitted under paragraph (c)(1) of this section for compliance with the requirements of section 42;</P> <P>(ii) Require that with respect to each low-income housing project—</P> <P>(A) The Agency must conduct on-site inspections of all buildings in the project by the end of the second calendar year following the year the last building in the project is placed in service and, for at least 20 percent of the project's low-income units, inspect the units and review the low-income certifications, the documentation supporting the certifications, and the rent records for the tenants in those units; and</P> <P>(B) At least once every 3 years, the Agency must conduct on-site inspections of all buildings in the project and, for at least 20 percent of the project's low-income units, inspect the units and review the low-income certifications, the documentation supporting the certifications, and the rent records for the tenants in those units; and</P> <P>(iii) Require that the Agency randomly select which low-income units and tenant records are to be inspected and reviewed by the Agency. The review of tenant records may be undertaken wherever the owner maintains or stores the records (either on-site or off-site). The units and tenant records to be inspected and reviewed must be chosen in a manner that will not give owners of low-income housing projects advance notice that a unit and tenant records for a particular year will or will not be inspected and reviewed. However, an Agency may give an owner reasonable notice that an inspection of the building and low-income units or tenant record review will occur so that the owner may notify tenants of the inspection or assemble tenant records for review (for example, 30 days notice of inspection or review).</P> <P>(3) <E T="03">Frequency and form of certification.</E> A monitoring procedure must require that the certifications and reviews of paragraph (c)(1) and (2) of this section be made at least annually covering each year of the 15-year compliance period under section 42(i)(1). The certifications must be made under penalty of perjury. A monitoring procedure may require certifications and reviews more frequently than on a 12-month basis, provided that all months within each 12-month period are subject to certification.</P> <P>(4) <E T="03">Exception for certain buildings</E>—(i) <E T="03">In general.</E> The review requirements under paragraph (c)(2)(ii) of this section may provide that owners are not required to submit, and the Agency is not required to review, the tenant income certifications, supporting documentation, and rent records for buildings financed by the Rural Housing Service (RHS), formerly known as Farmers Home Administration, under the section 515 program, or buildings of which 50 percent or more of the aggregate basis (taking into account the building and the land) is financed with the proceeds of obligations the interest on which is exempt from tax under section 103 (tax-exempt bonds). In order for a monitoring procedure to except these buildings, the Agency must meet the requirements of paragraph (c)(4)(ii) of this section.</P> <P>(ii) <E T="03">Agreement and review.</E> The Agency must enter into an agreement with the RHS or tax-exempt bond issuer. Under the agreement, the RHS or tax-exempt bond issuer must agree to provide information concerning the income and rent of the tenants in the building to the Agency. The Agency may assume the accuracy of the information provided by RHS or the tax-exempt bond issuer without verification. The Agency must review the information and determine that the income limitation and rent restriction of section 42 (g)(1) and (2) are met. However, if the information provided by the RHS or tax-exempt bond issuer is not sufficient for <PRTPAGE P="155"/>the Agency to make this determination, the Agency must request the necessary additional income or rent information from the owner of the buildings. For example, because RHS determines tenant eligibility based on its definition of “adjusted annual income,” rather than “annual income” as defined under Section 8, the Agency may have to calculate the tenant's income for section 42 purposes and may need to request additional income information from the owner.</P> <P>(iii) <E T="03">Example.</E> The exception permitted under paragraph (c)(4)(i) and (ii) of this section is illustrated by the following example. </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>An Agency selects for review buildings financed by the RHS. The Agency has entered into an agreement described in paragraph (c)(4)(ii) of this section with the RHS with respect to those buildings. In reviewing the RHS-financed buildings, the Agency obtains the tenant income and rent information from the RHS for 20 percent of the low-income units in each of those buildings. The Agency calculates the tenant income and rent to determine whether the tenants meet the income and rent limitation of section 42 (g)(1) and (2). In order to make this determination, the Agency may need to request additional income or rent information from the owners of the RHS buildings if the information provided by the RHS is not sufficient.</P> </EXAMPLE> <P>(5) <E T="03">Agency reports of compliance monitoring activities.</E> The Agency must report its compliance monitoring activities annually on Form 8610, “Annual Low-Income Housing Credit Agencies Report.”</P> <P>(d) <E T="03">Inspection provision</E>—(1) <E T="03">In general.</E> Under the inspection provision, the Agency must have the right to perform an on-site inspection of any low-income housing project at least through the end of the compliance period of the buildings in the project. The inspection provision of this paragraph (d) is a separate requirement from any tenant file review under paragraph (c)(2)(ii) of this section.</P> <P>(2) <E T="03">Inspection standard.</E> For the on-site inspections of buildings and low-income units required by paragraph (c)(2)(ii) of this section, the Agency must review any local health, safety, or building code violations reports or notices retained by the owner under paragraph (b)(3) of this section and must determine—</P> <P>(i) Whether the buildings and units are suitable for occupancy, taking into account local health, safety, and building codes (or other habitability standards); or</P> <P>(ii) Whether the buildings and units satisfy, as determined by the Agency, the uniform physical condition standards for public housing established by HUD (24 CFR 5.703). The HUD physical condition standards do not supersede or preempt local health, safety, and building codes. A low-income housing project under section 42 must continue to satisfy these codes and, if the Agency becomes aware of any violation of these codes, the Agency must report the violation to the Service. However, provided the Agency determines by inspection that the HUD standards are met, the Agency is not required under this paragraph (d)(2)(ii) to determine by inspection whether the project meets local health, safety, and building codes.</P> <P>(3) <E T="03">Exception from inspection provision.</E> An Agency is not required to inspect a building under this paragraph (d) if the building is financed by the RHS under the section 515 program, the RHS inspects the building (under 7 CFR part 1930), and the RHS and Agency enter into a memorandum of understanding, or other similar arrangement, under which the RHS agrees to notify the Agency of the inspection results.</P> <P>(4) <E T="03">Delegation.</E> An Agency may delegate inspection under this paragraph (d) to an Authorized Delegate retained under paragraph (f) of this section. Such Authorized Delegate, which may include HUD or a HUD-approved inspector, must notify the Agency of the inspection results.</P> <P>(e) <E T="03">Notification-of-noncompliance provision</E>—(1) <E T="03">In general.</E> Under the notification-of-noncompliance provisions, the Agency must be required to give the notice described in paragraph (e)(2) of this section to the owner of a low-income housing project and the notice described in paragraph (e)(3) of this section to the Service.</P> <P>(2) <E T="03">Notice to owner.</E> The Agency must be required to provide prompt written notice to the owner of a low-income housing project if the Agency does not <PRTPAGE P="156"/>receive the certification described in paragraph (c)(1) of this section, or does not receive or is not permitted to inspect the tenant income certifications, supporting documentation, and rent records described in paragraph (c)(2)(ii) of this section, or discovers by inspection, review, or in some other manner, that the project is not in compliance with the provisions of section 42.</P> <P>(3) <E T="03">Notice to Internal Revenue Service</E>—(i) <E T="03">In general.</E> The Agency must be required to file Form 8823, “Low-Income Housing Credit Agencies Report of Noncompliance,” with the Service no later than 45 days after the end of the correction period (as described in paragraph (e)(4) of this section, including extensions permitted under that paragraph) and no earlier than the end of the correction period, whether or not the noncompliance or failure to certify is corrected. The Agency must explain on Form 8823 the nature of the noncompliance or failure to certify and indicate whether the owner has corrected the noncompliance or failure to certify. Any change in either the applicable fraction or eligible basis under paragraph (c)(1)(ii) and (vii) of this section, respectively, that results in a decrease in the qualified basis of the project under section 42 (c)(1)(A) is noncompliance that must be reported to the Service under this paragraph (e)(3). If an Agency reports on Form 8823 that a building is entirely out of compliance and will not be in compliance at any time in the future, the Agency need not file Form 8823 in subsequent years to report that building's noncompliance. If the noncompliance or failure to certify is corrected within 3 years after the end of the correction period, the Agency is required to file Form 8823 with the Service reporting the correction of the noncompliance or failure to certify.</P> <P>(ii) <E T="03">Agency retention of records.</E> An Agency must retain records of noncompliance or failure to certify for 6 years beyond the Agency's filing of the respective Form 8823. In all other cases, the Agency must retain the certifications and records described in paragraph (c) of this section for 3 years from the end of the calendar year the Agency receives the certifications and records.</P> <P>(4) <E T="03">Correction period.</E> The correction period shall be that period specified in the monitoring procedure during which an owner must supply any missing certifications and bring the project into compliance with the provisions of section 42. The correction period is not to exceed 90 days from the date of the notice to the owner described in paragraph (e)(2) of this section. An Agency may extend the correction period for up to 6 months, but only if the Agency determines there is good cause for granting the extension.</P> <P>(f) <E T="03">Delegation of Authority</E>—(1) <E T="03">Agencies permitted to delegate compliance monitoring functions</E>—(i) <E T="03">In general.</E> An Agency may retain an agent or other private contractor (“Authorized Delegate”) to perform compliance monitoring. The Authorized Delegate must be unrelated to the owner of any building that the Authorized Delegate monitors. The Authorized Delegate may be delegated all of the functions of the Agency, except for the responsibility of notifying the Service under paragraphs (c)(5) and (e)(3) of this section. For example, the Authorized Delegate may be delegated the responsibility of reviewing tenant certifications and documentation under paragraph (c) (1) and (2) of this section, the right to inspect buildings and records as described in paragraph (d) of this section, and the responsibility of notifying building owners of lack of certification or noncompliance under paragraph (e)(2) of this section. The Authorized Delegate must notify the Agency of any noncompliance or failure to certify.</P> <P>(ii) <E T="03">Limitations.</E> An Agency that delegates compliance monitoring to an Authorized Delegate under paragraph (f)(1)(i) of this section must use reasonable diligence to ensure that the Authorized Delegate properly performs the delegated monitoring functions. Delegation by an Agency of compliance monitoring functions to an Authorized Delegate does not relieve the Agency of its obligation to notify the Service of any noncompliance of which the Agency becomes aware.</P> <P>(2) <E T="03">Agencies permitted to delegate compliance monitoring functions to another Agency.</E> An Agency may delegate all or some of its compliance monitoring responsibilities for a building to another <PRTPAGE P="157"/>Agency within the State. This delegation may include the responsibility of notifying the Service under paragraph (e)(3) of this section.</P> <P>(g) <E T="03">Liability.</E> Compliance with the requirements of section 42 is the responsibility of the owner of the building for which the credit is allowable. The Agency's obligation to monitor for compliance with the requirements of section 42 does not make the Agency liable for an owner's noncompliance.</P> <P>(h) <E T="03">Effective date.</E> Allocation plans must comply with these regulations by June 30, 1993. The requirement of section 42 (m)(1)(B)(iii) that allocation plans contain a procedure for monitoring for noncompliance becomes effective on January 1, 1992, and applies to buildings for which a low-income housing credit is, or has been, allowable at any time. Thus, allocation plans must comply with section 42(m)(1)(B)(iii) prior to June 30, 1993, the effective date of these regulations. An allocation plan that complies with these regulations, with the notice of proposed rulemaking published in the <E T="04">Federal Register</E> on December 27, 1991, or with a reasonable interpretation of section 42(m)(1)(B)(iii) will satisfy the requirements of section 42(m)(1)(B)(iii) for periods before June 30, 1993. Section 42(m)(1)(B)(iii) and these regulations do not require monitoring for whether a building or project is in compliance with the requirements of section 42 prior to January 1, 1992. However, if an Agency becomes aware of noncompliance that occurred prior to January 1, 1992, the Agency is required to notify the Service of that noncompliance. In addition, the requirements in paragraphs (b)(3) and (c)(1)(v), (vi), and (xi) of this section (involving recordkeeping and annual owner certifications) and paragraphs (c)(2)(ii)(B), (c)(2)(iii), and (d) of this section (involving tenant file reviews and physical inspections of existing projects, and the physical inspection standard) are applicable January 1, 2001. The requirement in paragraph (c)(2)(ii)(A) of this section (involving tenant file reviews and physical inspections of new projects) is applicable for buildings placed in service on or after January 1, 2001. The requirements in paragraph (c)(5) of this section (involving Agency reporting of compliance monitoring activities to the Service) and paragraph (e)(3)(i) of this section (involving Agency reporting of corrected noncompliance or failure to certify within 3 years after the end of the correction period) are applicable January 14, 2000.</P> <CITA>[T.D. 8430, 57 FR 40121, Sept. 2, 1992; 57 FR 57280, Dec. 3, 1992; 58 FR 7748, Feb. 9, 1993; T.D. 8563, 59 FR 50163, Oct. 3, 1994; T.D. 8859, 65 FR 2326, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-6</SECTNO> <SUBJECT>Buildings qualifying for carryover allocations.</SUBJECT> <P>(a) <E T="03">Carryover allocations.</E> A carryover allocation is an allocation that meets the requirements of section 42(h)(1) (E) or (F). If the requirements of section 42(h)(1) (E) or (F) that are required to be satisfied by the close of the calendar year are not satisfied, the allocation is treated as if it had not been made. For example, if the taxpayer's basis in the project as of the close of the calendar year of allocation is not more than 10 percent of the taxpayer's reasonably expected basis in the project as of the close of the second calendar year following the year of allocation, the carryover allocation is not valid and is treated as if it had not been made.</P> <P>(b) <E T="03">Carryover-allocation basis</E>—(1) <E T="03">In general.</E> Subject to the limitations of paragraph (b)(2) of this section, a taxpayer's basis in a project for purposes of section 42(h)(1) (E)(ii) or (F) (carryover-allocation basis) is the taxpayer's adjusted basis in land or depreciable property that is reasonably expected to be part of the project, whether or not these amounts are includible in eligible basis under section 42(d). Thus, for example, if the project is to include property that is not residential rental property, such as commercial space, the basis attributable to the commercial space, although not includible in eligible basis, is includible in carryover-allocation basis. The adjusted basis of land and depreciable property is determined under sections 1012 and 1016, and generally includes the direct and indirect costs of acquiring, constructing, and rehabilitating the property. Costs otherwise includible in carryover-allocation basis are not excluded by reason of having been incurred prior to the <PRTPAGE P="158"/>calendar year in which the carryover allocation is made.</P> <P>(2) <E T="03">Limitations</E>—For purposes of determining carryover-allocation basis under paragraph (b)(1) of this section, the following limitations apply.</P> <P>(i) <E T="03">Taxpayer must have basis in land or depreciable property related to the project.</E> A taxpayer has carryover-allocation basis to the extent that it has basis in land or depreciable property and the land or depreciable property is reasonably expected to be part of the project for which the carryover allocation is made. This basis includes all items that are properly capitalizable with respect to the land or depreciable property. For example, a nonrefundable downpayment for, or an amount paid to acquire an option to purchase, land or depreciable property may be included in carryover-allocation basis if properly capitalizable into the basis of land or depreciable property that is reasonably expected to be part of a project.</P> <P>(ii) <E T="03">High cost areas.</E> Any increase in eligible basis that may result under section 42(d)(5)(C) from a building's location in a qualified census tract or difficult development area is not taken into account in determining carryover-allocation basis or reasonably expected basis.</P> <P>(iii) <E T="03">Amounts not treated as paid or incurred.</E> An amount is not includible in carryover-allocation basis unless it is treated as paid or incurred under the method of accounting used by the taxpayer. For example, a cash method taxpayer cannot include construction costs in carryover-allocation basis unless the costs have been paid, and an accrual method taxpayer cannot include construction costs in carryover- allocation basis unless they have been properly accrued. See paragraph (b)(2)(iv) of this section for a special rule for fees.</P> <P>(iv) <E T="03">Fees.</E> A fee is includible in carryover-allocation basis only to the extent the requirements of paragraph (b)(2)(iii) of this section are met and—</P> <P>(A) The fee is reasonable;</P> <P>(B) The taxpayer is legally obligated to pay the fee;</P> <P>(C) The fee is capitalizable as part of the taxpayer's basis in land or depreciable property that is reasonably expected to be part of the project;</P> <P>(D) The fee is not paid (or to be paid) by the taxpayer to itself; and</P> <P>(E) If the fee is paid (or to be paid) by the taxpayer to a related person, and the taxpayer uses the cash method of accounting, the taxpayer could properly accrue the fee under the accrual method of accounting (considering, for example, the rules of section 461(h)). A person is a related person if the person bears a relationship to the taxpayer specified in sections 267(b) or 707(b)(1), or if the person and the taxpayer are engaged in trades or businesses under common control (within the meaning of subsections (a) and (b) of section 52).</P> <P>(3) <E T="03">Reasonably expected basis.</E> Rules similar to the rules of paragraphs (a) and (b) of this section apply in determining the taxpayer's reasonably expected basis in a project (land and depreciable basis) as of the close of the second calendar year following the calendar year of the allocation.</P> <P>(4) <E T="03">Examples.</E> The following examples illustrate the rules of paragraphs (a) and (b) of this section. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) <E T="03">Facts.</E> C, an accrual-method taxpayer, receives a carryover allocation from Agency, the state housing credit agency, in September of 1993. As of that date, C has not begun construction of the low-income housing building C plans to build. However, C has owned the land on which C plans to build the building since 1985. C's basis in the land is $100,000. C reasonably expects that by the end of 1995, C's basis in the project of which the building is to be a part will be $2,000,000. C also expects that because the project is located in a qualified census tract, C will be able to increase its basis in the project to $2,600,000. Before the close of 1993, C incurs $150,000 of costs for architects’ fees and site preparation. C properly accrues these costs under its method of accounting and capitalizes the costs.</P> <P>(ii) <E T="03">Determination of carryover-allocation basis.</E> C's $100,000 basis in the land is includible in carryover-allocation basis even though C has owned the land since 1985. The $150,000 of costs C has incurred for architects’ fees and site preparation are also includible in carryover-allocation basis. The expected increase in basis due to the project's location in a qualified census tract is not taken into account in determining C's carryover-allocation basis. Accordingly, C's carryover-allocation basis in the project of which the building is a part is $250,000.<PRTPAGE P="159"/> </P> <P>(iii) <E T="03">Determination of whether building is qualified.</E> C's reasonably expected basis in the project at the close of the second calendar year following the calendar year of allocation is $2,000,000. The expected increase in eligible basis due to the project's location in a qualified census tract is not taken into account in determining this amount. Because C's carryover-allocation basis is more than 10 percent of C's reasonably expected basis in the project of which the building is a part, the building for which C received the carryover allocation is a qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph (a) of this section.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2</HD> <P>. (i) <E T="03">Facts.</E> D, an accrual-method taxpayer, receives a carryover allocation from Agency, the state housing credit agency, on September 11, 1993. As of that date, D has not begun construction of the low-income housing building D plans to build and D does not have basis in the land on which D plans to build the building. In 1993, D incurs some costs related to the planned building, including architects’ fees. However, at the close of 1993, these costs do not exceed 10 percent of D's reasonably expected basis in the project.</P> <P>(ii) <E T="03">Determination of whether building is qualified.</E> Because D's carryover-allocation basis is not more than 10 percent of D's reasonably expected basis in the project of which the building is a part, the building for which D received a carryover allocation is not a qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph (a) of this section. The carryover allocation to D is not valid, and is treated as if it had not been made.</P> </EXAMPLE> <P>(c) <E T="03">Verification of basis by Agency</E>—(1) <E T="03">Verification requirement.</E> An Agency that makes a carryover allocation to a taxpayer must verify that, as of the close of the calendar year of allocation, the taxpayer has incurred more than 10 percent of the reasonably expected basis in the project (land and depreciable basis).</P> <P>(2) <E T="03">Manner of verification.</E> An Agency may verify that a taxpayer has incurred more than 10 percent of its reasonably expected basis in a project by obtaining a certification from the taxpayer, in writing and under penalty of perjury, that the taxpayer has incurred by the close of the calendar year of the allocation more than 10 percent of the reasonably expected basis in the project. The certification must be accompanied by supporting documentation that the Agency must review. Supporting documentation may include, for example, copies of checks or other records of payments. Alternatively, an Agency may verify that the taxpayer has incurred adequate basis by requiring that the taxpayer obtain from an attorney or certified public accountant a written certification to the Agency, that the attorney or accountant has examined all eligible costs incurred with respect to the project and that, based upon this examination, it is the attorney's or accountant's belief that the taxpayer has incurred more than 10 percent of its reasonably expected basis in the project by the close of the calendar year of the allocation.</P> <P>(3) <E T="03">Time of verification.</E> An Agency may require that the basis certification be submitted to or received by the Agency prior to the close of the calendar year of allocation or within a reasonable time after the close of the calendar year of allocation. The Agency will need to verify basis in order to accurately complete the Form 8610, ‘Annual Low-Income Housing Credit Agencies Report,’ for the calendar year. If certification is not timely made, or supporting documentation is lacking, inadequate, or does not actually support the certification, the Agency should notify the taxpayer and try to get adequate documentation. If the Agency cannot verify before the Form 8610 is filed that the taxpayer has satisfied the basis requirement for a carryover allocation, the allocation is treated as if it had not been made and the carryover allocation document should not be filed with the Form 8610.</P> <P>(d) <E T="03">Requirements for making carryover allocations</E>—(1) <E T="03">In general.</E> Generally, an allocation is made when an Agency issues the Form 8609, ‘Low-Income Housing Credit Allocation Certification,’ for a building. See § 1.42-1T(d)(8)(ii). An Agency does not issue the Form 8609 for a building until the building is placed in service. However, in cases where allocations of credit are made pursuant to section 42(h)(1)(E) (relating to carryover allocations for buildings) or section 42(h)(1)(F) (relating to carryover allocations for multiple-building projects), Form 8609 is not used as the allocating document because the buildings are not yet in service. When an allocation is made pursuant to section 42(h)(1) (E) or (F), <PRTPAGE P="160"/>the allocating document is the document meeting the requirements of paragraph (d)(2) of this section. In addition, when an allocation is made pursuant to section 42(h)(1)(F), the requirements of paragraph (d)(3) of this section must be met for the allocation to be valid. An allocation pursuant to section 42(h)(1) (E) or (F) reduces the state housing credit ceiling for the year in which the allocation is made, whether or not the Form 8609 is also issued in that year.</P> <P>(2) <E T="03">Requirements for allocation.</E> An allocation pursuant to section 42(h)(1) (E) or (F) is made when an allocation document containing the following information is completed, signed, and dated by an authorized official of the Agency—</P> <P>(i) The address of each building in the project, or if none exists, a specific description of the location of each building;</P> <P>(ii) The name, address, and taxpayer identification number of the taxpayer receiving the allocation;</P> <P>(iii) The name and address of the Agency;</P> <P>(iv) The taxpayer identification number of the Agency;</P> <P>(v) The date of the allocation;</P> <P>(vi) The housing credit dollar amount allocated to the building or project, as applicable;</P> <P>(vii) The taxpayer's reasonably expected basis in the project (land and depreciable basis) as of the close of the second calendar year following the calendar year in which the allocation is made;</P> <P>(viii) The taxpayer's basis in the project (land and depreciable basis) as of the close of the calendar year in which the allocation is made and the percentage that basis bears to the reasonably expected basis in the project (land and depreciable basis) as of the close of the second following calendar year;</P> <P>(ix) The date that each building in the project is expected to be placed in service; and</P> <P>(x) The Building Identification Number (B.I.N.) to be assigned to each building in the project. The B.I.N. must reflect the year an allocation is first made to the building, regardless of the year that the building is placed in service. This B.I.N. must be used for all allocations of credit for the building. For example, rehabilitation expenditures treated as a separate new building under section 42(e) should not have a separate B.I.N. if the building to which the rehabilitation expenditures are made has a B.I.N. In this case, the B.I.N. used for the rehabilitation expenditures shall be the B.I.N. previously assigned to the building, although the rehabilitation expenditures must have a separate Form 8609 for the allocation. Similarly, a newly constructed building that receives an allocation of credit in different calendar years must have a separate Form 8609 for each allocation. The B.I.N. assigned to the building for the first allocation must be used for the subsequent allocation.</P> <P>(3) <E T="03">Special rules for project-based allocations</E>—(i) <E T="03">In general.</E> An allocation pursuant to section 42(h)(1)(F) (a project-based allocation) must meet the requirements of this section as well as the requirements of section 42(h)(1)(F), including the minimum basis requirement of section 42(h)(1)(E)(ii).</P> <P>(ii) <E T="03">Requirement of section 42(h)(1)(F)(i)(III).</E> An allocation satisfies the requirement of section 42(h)(1)(F)(i)(III) if the Form 8609 that is issued for each building that is placed in service in the project states the portion of the project-based allocation that is applied to that building.</P> <P>(4) <E T="03">Recordkeeping requirements</E>—(i) <E T="03">Taxpayer.</E> When an allocation is made pursuant to section 42(h)(1) (E) or (F), the taxpayer must retain a copy of the allocation document and file an additional copy with the Form 8609 that is issued to the taxpayer for a building after the building is placed in service. The taxpayer need only file a copy of the allocation document with the Form 8609 for the building for the first year the credit is claimed. However, the Form 8609 must be filed for the first taxable year in which the credit is claimed and for each taxable year thereafter throughout the compliance period, whether or not a credit is claimed for the taxable year.</P> <P>(ii) <E T="03">Agency.</E> The Agency must retain the original carryover allocation document made under paragraph (d)(2) of <PRTPAGE P="161"/>this section and file Schedule A (Form 8610), “Carryover Allocation of the Low-Income Housing Credit,” with the Agency's Form 8610 for the year the allocation is made. The Agency must also retain a copy of the Form 8609 that is issued to the taxpayer and file the original with the Agency's Form 8610 that reflects the year the form is issued.</P> <P>(5) <E T="03">Separate procedure for election of appropriate percentage month.</E> If a taxpayer receives an allocation under section 42(h)(1) (E) or (F) and wishes to elect under section 42(b)(2)(A)(ii) to use the appropriate percentage for a month other than the month in which a building is placed in service, the requirements specified in § 1.42-8 must be met for the election to be effective.</P> <P>(e) <E T="03">Special rules.</E> The following rules apply for purposes of this section.</P> <P>(1) <E T="03">Treatment of partnerships and other flow-through entities.</E> With respect to taxpayers that own projects through partnerships or other flow-through entities (e.g., S corporations, estates, or trusts), carryover-allocation basis is determined at the entity level using the rules provided by this section. In addition, the entity is responsible for providing to the Agency the certification and documentation required under the basis verification requirement in paragraph (c) of this section.</P> <P>(2) <E T="03">Transferees.</E> If land or depreciable property that is expected to be part of a project is transferred after a carryover allocation has been made for a building that is reasonably expected to be part of the project, but before the close of the calendar year of the allocation, the transferee's carryover-allocation basis is determined under the principles of this section and section 42(d)(7). See also Rev. Rul. 91-38, 1991-2 C.B. 3 (see § 601.601(d)(2)(ii)(<E T="03">b</E>) of this chapter). In addition, the transferee is treated as the taxpayer for purposes of the basis verification requirement of this section, and therefore, is responsible for providing to the Agency the required certifications and documentation.</P> <CITA>[T.D. 8520, 59 FR 10069, Mar. 3, 1994, as amended by T.D. 8859, 65 FR 2328, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-7</SECTNO> <RESERVED>Substantially bond-financed buildings. [Reserved]</RESERVED> </SECTION> <SECTION> <SECTNO>§ 1.42-8</SECTNO> <SUBJECT>Election of appropriate percentage month.</SUBJECT> <P>(a) <E T="03">Election under section 42(b)(2)(A)(ii)(I) to use the appropriate percentage for the month of a binding agreement</E>—(1) <E T="03">In general.</E> For purposes of section 42(b)(2)(A)(ii)(I), an agreement between a taxpayer and an Agency as to the housing credit dollar amount to be allocated to a building is considered binding if it—</P> <P>(i) Is in writing;</P> <P>(ii) Is binding under state law on the Agency, the taxpayer, and all successors in interest;</P> <P>(iii) Specifies the type(s) of building(s) to which the housing credit dollar amount applies (i.e., a newly constructed or existing building, or substantial rehabilitation treated as a separate new building under section 42(e));</P> <P>(iv) Specifies the housing credit dollar amount to be allocated to the building(s); and</P> <P>(v) Is dated and signed by the taxpayer and the Agency during the month in which the requirements of paragraphs (a)(1) (i) through (iv) of this section are met.</P> <P>(2) <E T="03">Effect on state housing credit ceiling.</E> Generally, a binding agreement described in paragraph (a)(1) of this section is an agreement by the Agency to allocate credit to the taxpayer at a future date. The binding agreement may include a reservation of credit or a binding commitment (under section 42(h)(1)(C)) to allocate credit in a future taxable year. A reservation or a binding commitment to allocate credit in a future year has no effect on the state housing credit ceiling until the year the Agency actually makes an allocation. However, if the binding agreement is also a carryover allocation under section 42(h)(1) (E) or (F), the state housing credit ceiling is reduced by the amount allocated by the Agency to the taxpayer in the year the carryover allocation is made. For a binding agreement to be a valid carryover allocation, the requirements of paragraph (a)(1) of this section and § 1.42-6 must be met.</P> <P>(3) <E T="03">Time and manner of making election.</E> An election under section <PRTPAGE P="162"/>42(b)(2)(A)(ii)(I) may be made either as part of the binding agreement under paragraph (a)(1) of this section to allocate a specific housing credit dollar amount or in a separate document that references the binding agreement. In either case, the election must—</P> <P>(i) Be in writing;</P> <P>(ii) Reference section 42(b)(2)(A)(ii)(I);</P> <P>(iii) Be signed by the taxpayer;</P> <P>(iv) If it is in a separate document, reference the binding agreement that meets the requirements of paragraph (a)(1) of this section; and</P> <P>(v) Be notarized by the 5th day following the end of the month in which the binding agreement was made.</P> <P>(4) <E T="03">Multiple agreements—</E>(i) <E T="03">Rescinded agreements.</E> A taxpayer may not make an election under section 42(b)(2)(A)(ii)(I) for a building if an election has previously been made for the building for a different month. For example, assume a taxpayer entered into a binding agreement for allocation of a specific housing credit dollar amount to a building and made the election under section 42(b)(2)(A)(ii)(I) to apply the appropriate percentage for the month of the binding agreement. If the binding agreement subsequently is rescinded under state law, and the taxpayer enters into a new binding agreement for allocation of a specific housing credit dollar amount to the building, the taxpayer must apply to the building the appropriate percentage for the elected month of the rescinded binding agreement. However, if no prior election was made with respect to the rescinded binding agreement, the taxpayer may elect the appropriate percentage for the month of the new binding agreement.</P> <P>(ii) <E T="03">Increases in credit.</E> The election under section 42(b)(2)(A)(ii)(I), once made, applies to any increase in the credit amount allocated for a building, whether the increase occurs in the same or in a subsequent year. However, in the case of a binding agreement (or carryover allocation that is treated as a binding agreement) to allocate a credit amount under section 42(e)(1) for substantial rehabilitation treated as a separate new building, a taxpayer may make the election under section 42(b)(2)(A)(ii)(I) notwithstanding that a prior election under section 42(b)(2)(A)(ii)(I) is in effect for a prior allocation of credit for a substantial rehabilitation that was previously placed in service under section 42(e).</P> <P>(5) <E T="03">Amount allocated.</E> The housing credit dollar amount eventually allocated to a building may be more or less than the amount specified in the binding agreement. Depending on the Agency's determination pursuant to section 42(m)(2) as to the financial feasibility of the building (or project), the Agency may allocate a greater housing credit dollar amount to the building (provided that the Agency has additional housing credit dollar amounts available to allocate for the calendar year of the allocation) or the Agency may allocate a lesser housing credit dollar amount. Under section 42(h)(7)(D), in allocating a housing credit dollar amount, the Agency must specify the applicable percentage and maximum qualified basis of the building. The applicable percentage may be less, but not greater than, the appropriate percentage for the month the building is placed in service, or the month elected by the taxpayer under section 42(b)(2)(A)(ii)(I). Whether the appropriate percentage is the appropriate percentage for the 70-percent present value credit or the 30-percent present value credit is determined under section 42(i)(2) when the building is placed in service.</P> <P>(6) <E T="03">Procedures—</E>(i) <E T="03">Taxpayer.</E> The taxpayer must give the original notarized election statement to the Agency before the close of the 5th calendar day following the end of the month in which the binding agreement is made. The taxpayer must retain a copy of the binding agreement and the election statement and must file an additional copy of each with the taxpayer's Form 8609, Low-Income Housing Credit Allocation Certification, for the first taxable year in which credit is claimed for the building.</P> <P>(ii) <E T="03">Agency.</E> The Agency must file with the Internal Revenue Service the original of the binding agreement and the election statement with the Agency's Form 8610, Annual Low-Income Housing Credit Agencies Report, that accounts for the year the allocation is actually made. The Agency must also <PRTPAGE P="163"/>retain a copy of the binding agreement and the election statement.</P> <P>(7) <E T="03">Examples.</E> The following examples illustrate the provisions of this section. In each example, X is the taxpayer, Agency is the state housing credit agency, and the carryover allocations meet the requirements of § 1.42-6 and are otherwise valid. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>(i) In August 1993, X and Agency enter into an agreement that Agency will allocate $100,000 of housing credit dollar amount for the low-income housing building X is constructing. The agreement is binding and meets all the requirements of paragraph (a)(1) of this section. The agreement is a reservation of credit, not an allocation, and therefore, has no effect on the state housing credit ceiling. On or before September 5, 1993, X signs and has notarized a written election statement that meets the requirements of paragraph (a)(3) of this section. The applicable percentage for the building is the appropriate percentage for the month of August 1993.</P> <P>(ii) Agency makes a carryover allocation of $100,000 of housing credit dollar amount for the building on October 2, 1993. The carryover allocation reduces Agency's state housing credit ceiling for 1993. Due to unexpectedly high construction costs, when X places the building in service in July 1994, the product of the building's qualified basis and the applicable percentage for the building (the appropriate percentage for the month of August 1993) is $150,000, rather than $100,000. Notwithstanding that only $100,000 of credit was allocated for the building in 1993, Agency may allocate an additional $50,000 of housing credit dollar amount for the building from its state housing credit ceiling for 1994. The appropriate percentage for the month of August 1993 is the applicable percentage for the building for the entire $150,000 of credit allocated for the building, even though separate allocations were made in 1993 and 1994. Because allocations were made for the building in two separate calendar years, Agency must issue two Forms 8609 to X. One Form 8609 must reflect the $100,000 allocation made in 1993, and the other Form 8609 must reflect the $50,000 allocation made in 1994.</P> <P>(iii) X gives the original notarized statement to Agency on or before September 5, 1993, and retains a copy of the binding agreement, election statement, and carryover allocation document. X files a copy of the binding agreement, election statement, and carryover allocation document with X's Form 8609 for the first taxable year in which X claims credit for the building.</P> <P>(iv) Agency files the original of the binding agreement, election statement, and 1993 carryover allocation document with its 1993 Form 8610. Agency retains a copy of the binding agreement, election statement, and carryover allocation document. After the building is placed in service in 1994, Agency issues to X a copy of the Form 8609 reflecting the 1993 carryover allocation of $100,000 and files the original of that form with its 1994 Form 8610. Agency also files the original of the 1994 Form 8609 reflecting the $50,000 allocation with its 1994 Form 8610 and issues to X a copy of the 1994 Form 8609. Agency retains copies of the Forms 8609 that are issued to X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>(i) In September 1993, X and Agency enter into an agreement that Agency will allocate $70,000 of housing credit dollar amount for rehabilitation expenditures that X is incurring and that X will treat as a new low-income housing building under section 42(e)(1). The agreement is binding and meets all the requirements of paragraph (a)(1) of this section. The agreement is a reservation of credit, not an allocation, and therefore, has no effect on Agency's state housing credit ceiling. On or before October 5, 1993, X signs and has notarized a written election statement that meets the requirements of paragraph (a)(3) of this section. The applicable percentage for the building is the appropriate percentage for the month of September 1993. Agency makes a carryover allocation of $70,000 of housing credit dollar amount for the building on November 15, 1993. The carryover allocation reduces by $70,000 Agency's state housing credit ceiling for 1993.</P> <P>(ii) In October 1994, X and Agency enter into another binding agreement meeting the requirements of paragraph (a)(1) of this section. Under the agreement, Agency will allocate $50,000 of housing credit dollar amount for additional rehabilitation expenditures by X that qualify as a second separate new building under section 42(e)(1). On or before November 5, 1994, X signs and has notarized a written election statement meeting the requirements of paragraph (a)(3) of this section. On December 1, 1994, X receives a carryover allocation under section 42(h)(1)(E) for $50,000. The carryover allocation reduces by $50,000 Agency's state housing credit ceiling for 1994. The applicable percentage for the rehabilitation expenditures treated as the second separate new building is the appropriate percentage for the month of October 1994, not September 1993. The appropriate percentage for the month of September 1993 still applies to the allocation of $70,000 for the rehabilitation expenditures treated as the first separate new building. Because allocations were made for the building in two separate calendar years, Agency must issue two Forms 8609 to X. One Form 8609 must reflect the $70,000 allocation made in 1993, and the other Form 8609 must reflect the $50,000 allocation made in 1994.<PRTPAGE P="164"/> </P> <P>(iii) X gives the first original notarized statement to Agency on or before October 5, 1993, and retains a copy of the first binding agreement, election statement, and carryover allocation document issued in 1993. X gives the second original notarized statement to Agency on or before November 5, 1994, and retains a copy of the second binding agreement, election statement, and carryover allocation document issued in 1994. X files a copy of the binding agreements, election statements, and carryover allocation documents with X's Forms 8609 for the first taxable year in which X claims credit for the buildings.</P> <P>(iv) Agency retains a copy of the binding agreements, election statements, and carryover allocation documents. Agency files the original of the first binding agreement, election statement, and 1993 carryover allocation document with its 1993 Form 8610. Agency files the original of the second binding agreement, election statement, and 1994 carryover allocation document with its 1994 Form 8610. After X notifies Agency of the date each building is placed in service, the Agency will issue copies of the respective Forms 8609 to X, and file the originals of those forms with the Agency's Form 8610 that reflects the year each form is issued. The Agency also retains copies of the Forms 8609.</P> </EXAMPLE> <P>(b) <E T="03">Election under section 42(b)(2)(A)(ii)(II) to use the appropriate percentage for the month tax-exempt bonds are issued</E>—(1) <E T="03">Time and manner of making election.</E> In the case of any building to which section 42(h)(4)(B) applies, an election under section 42(b)(2)(A)(ii)(II) to use the appropriate percentage for the month tax-exempt bonds are issued must—</P> <P>(i) Be in writing;</P> <P>(ii) Reference section 42(b)(2)(A)(ii)(II);</P> <P>(iii) Specify the percentage of the aggregate basis of the building and the land on which the building is located that is financed with the proceeds of obligations described in section 42(h)(4)(A) (tax-exempt bonds);</P> <P>(iv) State the month in which the tax-exempt bonds are issued;</P> <P>(v) State that the month in which the tax-exempt bonds are issued is the month elected for the appropriate percentage to be used for the building;</P> <P>(vi) Be signed by the taxpayer; and</P> <P>(vii) Be notarized by the 5th day following the end of the month in which the bonds are issued.</P> <P>(2) <E T="03">Bonds issued in more than one month.</E> If a building described in section 42(h)(4)(B) (substantially bond-financed building) is financed with tax-exempt bonds issued in more than one month, the taxpayer may elect the appropriate percentage for any month in which the bonds are issued. Once the election is made, the appropriate percentage elected applies for the building even if all bonds are not issued in that month. The requirements of this paragraph (b), including the time limitation contained in paragraph (b)(1)(vii) of this section, must also be met.</P> <P>(3) <E T="03">Limitations on appropriate percentage.</E> Under section 42(m)(2)(D), the credit allowable for a substantially bond- financed building is limited to the amount necessary to assure the project's feasibility. Accordingly, in making the determination under section 42(m)(2), an Agency may use an applicable percentage that is less, but not greater than, the appropriate percentage for the month the building is placed in service, or the month elected by the taxpayer under section 42(b)(2)(A)(ii)(II).</P> <P>(4) <E T="03">Procedures</E>—(i) <E T="03">Taxpayer.</E> The taxpayer must provide the original notarized election statement to the Agency before the close of the 5th calendar day following the end of the month in which the bonds are issued. If an authority other than the Agency issues the tax-exempt bonds, the taxpayer must also give the Agency a signed statement from the issuing authority that certifies the information described in paragraphs (b)(1)(iii) and (iv) of this section. The taxpayer must file a copy of the election statement with the taxpayer's Form 8609 for the first taxable year in which credit is claimed for the building. The taxpayer must also retain a copy of the election statement.</P> <P>(ii) <E T="03">Agency.</E> The Agency must file with the Internal Revenue Service the original of the election statement and the corresponding Form 8609 for the building with the Agency's Form 8610 that reflects the year the Form 8609 is issued. The Agency must also retain a copy of the election statement and the Form 8609.</P> <CITA>[T.D. 8520, 59 FR 10071, Mar. 3, 1994]</CITA> </SECTION> <SECTION> <PRTPAGE P="165"/> <SECTNO>§ 1.42-9</SECTNO> <SUBJECT>For use by the general public.</SUBJECT> <P>(a) <E T="03">General rule.</E> If a residential rental unit in a building is not for use by the general public, the unit is not eligible for a section 42 credit. A residential rental unit is for use by the general public if the unit is rented in a manner consistent with housing policy governing non-discrimination, as evidenced by rules or regulations of the Department of Housing and Urban Development (HUD) (24 CFR subtitle A and chapters I through XX). See HUD Handbook 4350.3 (or its successor). A copy of HUD Handbook 4350.3 may be requested by writing to: HUD, Directives Distribution Section, room B-100, 451 7th Street, SW., Washington, DC 20410.</P> <P>(b) <E T="03">Limitations.</E> Notwithstanding paragraph (a) of this section, if a residential rental unit is provided only for a member of a social organization or provided by an employer for its employees, the unit is not for use by the general public and is not eligible for credit under section 42. In addition, any residential rental unit that is part of a hospital, nursing home, sanitarium, lifecare facility, trailer park, or intermediate care facility for the mentally and physically handicapped is not for use by the general public and is not eligible for credit under section 42.</P> <P>(c) <E T="03">Treatment of units not for use by the general public.</E> The costs attributable to a residential rental unit that is not for use by the general public are not excludable from eligible basis by reason of the unit's ineligibility for the credit under this section. However, in calculating the applicable fraction, the unit is treated as a residential rental unit that is not a low-income unit.</P> <CITA>[T.D. 8520, 59 FR 10073, Mar. 3, 1994]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-10</SECTNO> <SUBJECT>Utility allowances.</SUBJECT> <P>(a) <E T="03">Inclusion of utility allowances in gross rent.</E> If the cost of any utilities (other than telephone) for a residential rental unit are paid directly by the tenant(s), the gross rent for that unit includes the applicable utility allowance determined under this section. This section only applies for purposes of determining gross rent under section 42(g)(2)(B)(ii) as to rent-restricted units.</P> <P>(b) <E T="03">Applicable utility allowances</E>—(1) <E T="03">FmHA-assisted buildings.</E> If a building receives assistance from the Farmers Home Administration (FmHA-assisted building), the applicable utility allowance for all rent-restricted units in the building is the utility allowance determined under the method prescribed by the Farmers Home Administration (FmHA) for the building. For example, if a building receives assistance under FmHA's section 515 program (whether or not the building or its tenants also receive other state or federal assistance), the applicable utility allowance for all rent-restricted units in the building is determined using Exhibit A-6 of 7 CFR part 1944, subpart E (or a successor method of determining utility allowances).</P> <P>(2) <E T="03">Buildings with FmHA assisted tenants.</E> If any tenant in a building receives FmHA rental assistance payments (FmHA tenant assistance), the applicable utility allowance for all rent-restricted units in the building (including any units occupied by tenants receiving HUD rental assistance payments) is the applicable FmHA utility allowance.</P> <P>(3) <E T="03">HUD-regulated buildings.</E> If neither a building nor any tenant in the building receives FmHA housing assistance, and the rents and utility allowances of the building are reviewed by HUD on an annual basis (HUD-regulated building), the applicable utility allowance for all rent-restricted units in the building is the applicable HUD utility allowance.</P> <P>(4) <E T="03">Other buildings.</E> If a building is neither an FmHA-assisted nor a HUD-regulated building, and no tenant in the building receives FmHA tenant assistance, the applicable utility allowance for rent-restricted units in the building is determined under the following methods.</P> <P>(i) <E T="03">Tenants receiving HUD rental assistance.</E> The applicable utility allowance for any rent-restricted units occupied by tenants receiving HUD rental assistance payments (HUD tenant assistance) is the applicable Public Housing Authority (PHA) utility allowance established for the Section 8 Existing Housing Program.</P> <P>(ii) <E T="03">Other tenants—</E>(A) <E T="03">General rule.</E> If none of the rules of paragraphs (b)(1), <PRTPAGE P="166"/>(2), (3), and (4)(i) of this section apply to any rent-restricted units in a building, the appropriate utility allowance for the units is the applicable PHA utility allowance. However, if a local utility company estimate is obtained for any unit in the building in accordance with paragraph (b)(4)(ii)(B) of this section, that estimate becomes the appropriate utility allowance for all rent-restricted units of similar size and construction in the building. This local utility company estimate procedure is not available for and does not apply to units to which the rules of paragraphs (b) (1), (2), (3), or (4)(i) of this section apply.</P> <P>(B) <E T="03">Utility company estimate.</E> Any interested party (including a low-income tenant, a building owner, or an Agency) may obtain a local utility company estimate for a unit. The estimate is obtained when the interested party receives, in writing, information from a local utility company providing the estimated cost of that utility for a unit of similar size and construction for the geographic area in which the building containing the unit is located. The local utility company estimate may be obtained by an interested party at any time during the building's extended use period (see section 42(h)(6)(D)) or, if the building does not have an extended use period, during the building's compliance period (see section 42(i)(1)). Unless the parties agree otherwise, costs incurred in obtaining the estimate are borne by the initiating party. The interested party that obtains the local utility company estimate (the initiating party) must retain the original of the utility company estimate and must furnish a copy of the local utility company estimate to the owner of the building (where the initiating party is not the owner), and the Agency that allocated credit to the building (where the initiating party is not the Agency). The owner of the building must make available copies of the utility company estimate to the tenants in the building.</P> <P>(c) <E T="03">Changes in applicable utility allowance.</E> If at any time during the building's extended use period (or, if the building does not have an extended use period, the building's compliance period), the applicable utility allowance for a unit changes, the new utility allowance must be used to compute gross rents of rent-restricted units due 90 days after the change. For example, if rent must be lowered because a local utility company estimate is obtained that shows a higher utility cost than the otherwise applicable PHA utility allowance, the lower rent must be in effect for rent due more than 90 days after the date of the local utility company estimate.</P> <CITA>[T.D. 8520, 59 FR 10073, Mar. 3, 1994]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-11</SECTNO> <SUBJECT>Provision of services.</SUBJECT> <P>(a) <E T="03">General rule.</E> The furnishing to tenants of services other than housing (whether or not the services are significant) does not prevent the units occupied by the tenants from qualifying as residential rental property eligible for credit under section 42. However, any charges to low-income tenants for services that are not optional generally must be included in gross rent for purposes of section 42(g).</P> <P>(b) <E T="03">Services that are optional—</E>(1) <E T="03">General rule.</E> A service is optional if payment for the service is not required as a condition of occupancy. For example, for a qualified low-income building with a common dining facility, the cost of meals is not included in gross rent for purposes of section 42(g)(2)(A) if payment for the meals in the facility is not required as a condition of occupancy and a practical alternative exists for tenants to obtain meals other than from the dining facility.</P> <P>(2) <E T="03">Continual or frequent services.</E> If continual or frequent nursing, medical, or psychiatric services are provided, it is presumed that the services are not optional and the building is ineligible for the credit, as is the case with a hospital, nursing home, sanitarium, lifecare facility, or intermediate care facility for the mentally and physically handicapped. See also § 1.42-9(b).</P> <P>(3) <E T="03">Required services—</E>(i) <E T="03">General rule.</E> The cost of services that are required as a condition of occupancy must be included in gross rent even if federal or state law requires that the services be offered to tenants by building owners.</P> <P>(ii) <E T="03">Exceptions—</E>(A) <E T="03">Supportive services.</E> Section 42(g)(2)(B)(iii) provides an exception for certain fees paid for supportive services. For purposes of section 42(g)(2)(B)(iii), a supportive service <PRTPAGE P="167"/>is any service provided under a planned program of services designed to enable residents of a residential rental property to remain independent and avoid placement in a hospital, nursing home, or intermediate care facility for the mentally or physically handicapped. For a building described in section 42(i)(3)(B)(iii) (relating to transitional housing for the homeless) or section 42(i)(3)(B)(iv) (relating to single-room occupancy), a supportive service includes any service provided to assist tenants in locating and retaining permanent housing.</P> <P>(B) <E T="03">Specific project exception.</E> Gross rent does not include the cost of mandatory meals in any federally-assisted project for the elderly and handicapped (in existence on or before January 9, 1989) that is authorized by 24 CFR 278 to provide a mandatory meals program.</P> <CITA>[T.D. 8520, 59 FR 10074, Mar. 3, 1994, as amended by T.D. 8859, 65 FR 2328, Jan. 14, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-12</SECTNO> <SUBJECT>Effective dates and transitional rules.</SUBJECT> <P>(a) <E T="03">Effective date.</E> The rules set forth in §§ 1.42-6 and 1.42-8 through 1.42-12 are effective May 2, 1994. However, binding agreements, election statements, and carryover allocation documents entered into before May 2, 1994, that follow the guidance set forth in Notice 89-1, 1989-1 C.B. 620 (see § 601.601(d)(2)(ii)(<E T="03">b</E>) of this chapter) need not be changed to conform to the rules set forth in §§ 1.42-6 and 1.42-8 through 1.42-12.</P> <P>(b) <E T="03">Prior periods.</E> Notice 89-1, 1989-1 C.B. 620 and Notice 89-6, 1989-1 C.B. 625 (see § 601.601(d)(2)(ii)(<E T="03">b</E>) of this chapter) may be applied for periods prior to May 2, 1994.</P> <P>(c) <E T="03">Carryover allocations.</E> The rule set forth in § 1.42-6(d)(4)(ii) relating to the requirement that state and local housing agencies file Schedule A (Form 8610), “Carryover Allocation of the Low-Income Housing Credit,” is applicable for carryover allocations made after December 31, 1999.</P> <CITA>[T.D. 8520, 59 FR 10074, Mar. 3, 1994; 59 FR 15501, Apr. 1, 1994, as amended by T.D. 8859, 65 FR 2328, Jan. 14, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-13</SECTNO> <SUBJECT>Rules necessary and appropriate; housing credit agencies’ correction of administrative errors and omissions.</SUBJECT> <P>(a) <E T="03">Publication of guidance.</E> Under section 42(n), the Secretary has authority to prescribe regulations as may be necessary or appropriate to carry out the purposes of section 42. The Secretary may also provide guidance through various publications in the Internal Revenue Bulletin. (See § 601.601(d)(2)(ii)(<E T="03">b</E>) of this chapter.)</P> <P>(b) <E T="03">Correcting administrative errors and omissions—</E>(1) <E T="03">In general.</E> An Agency may correct an administrative error or omission with respect to allocations and recordkeeping, as described in paragraph (b)(2) of this section, within a reasonable period after the Agency discovers the administrative error or omission. Whether a correction is made within a reasonable period depends on the facts and circumstances of each situation. Except as provided in paragraph (b)(3)(iii) of this section, an Agency need not obtain the prior approval of the Secretary to correct an administrative error or omission, if the correction is made in accordance with paragraph (b)(3)(i) of this section. The administrative errors and omissions to which this paragraph (b) applies are strictly limited to those described in paragraph (b)(2) of this section, and, thus, do not include, for example, any misinterpretation of the applicable rules and regulations under section 42. Accordingly, an Agency's allocation of a particular calendar year's low-income housing credit dollar amount made after the close of that calendar year, or the use of an incorrect population amount in calculating a State's housing credit ceiling for a calendar year are not administrative errors that can be corrected under this paragraph (b).</P> <P>(2) <E T="03">Administrative errors and omissions described.</E> An administrative error or omission is a mistake that results in a document that inaccurately reflects the intent of the Agency at the time the document is originally completed or, if the mistake affects a taxpayer, a document that inaccurately reflects <PRTPAGE P="168"/>the intent of the Agency and the affected taxpayer at the time the document is originally completed. Administrative errors and omissions described in this paragraph (b)(2) include the following—</P> <P>(i) A mathematical error;</P> <P>(ii) An entry on a document that is inconsistent with another entry on the same or another document regarding the same property, or taxpayer;</P> <P>(iii) A failure in tracking the housing credit dollar amount an Agency has allocated (or that remains to be allocated) in the current calendar year (e.g., a failure to include in its State housing credit ceiling a previously allocated credit dollar amount that has been returned by a taxpayer);</P> <P>(iv) An omission of information that is required on a document; and</P> <P>(v) Any other type of error or omission identified by guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(<E T="03">b</E>) of this chapter) as an administrative error or omission covered by this paragraph (b).</P> <P>(3) <E T="03">Procedures for correcting administrative errors or omissions—</E>(i) <E T="03">In general.</E> An Agency's correction of an administrative error or omission, as described in paragraph (b)(2) of this section, must amend the document so that the corrected document reflects the original intent of the Agency, or the Agency and the affected taxpayer, and complies with applicable rules and regulations under section 42.</P> <P>(ii) <E T="03">Specific procedures.</E> If a document corrects a document containing an administrative error or omission that has not yet been filed with the Internal Revenue Service, the Agency, or the Agency and the affected taxpayer, should complete and file the corrected document as the original. When a document containing an administrative error or omission has already been filed with the Service, the Agency, or the Agency and the affected taxpayer, should refile a copy of the document containing the administrative error or omission, and prominently and clearly note the correction thereon or on an attached new document. The Agency should indicate at the top of the document(s) that the correction is being made under § 1.42-13 of the Income Tax Regulations.</P> <P>(iii) <E T="03">Secretary's prior approval required.</E> Except as provided in paragraph (b)(3)(vi) of this section, an Agency must obtain the Secretary's prior approval to correct an administrative error or omission, as described in paragraph (b)(2) of this section, if the correction is not made before the close of the calendar year of the error or omission and the correction—</P> <P>(A) Is a numerical change to the housing credit dollar amount allocated for the building or project;</P> <P>(B) Affects the determination of any component of the State's housing credit ceiling under section 42(h)(3)(C); or</P> <P>(C) Affects the State's unused housing credit carryover that is assigned to the Secretary under section 42(h)(3)(D).</P> <P>(iv) <E T="03">Requesting the Secretary's approval.</E> To obtain the Secretary's approval under paragraph (b)(3)(iii) of this section, an Agency must submit a request for the Secretary's approval within a reasonable period after discovering the administrative error or omission, and must agree to any conditions that may be required by the Secretary under paragraph (b)(3)(v) of this section. When requesting the Secretary's approval, the Agency, or the Agency and the affected taxpayer, must file an application that complies with the requirements of this paragraph (b)(3)(iv). For further information on the application procedure see Rev. Proc. 93-1, 1993-1 I.R.B. 10 (or any subsequent applicable revenue procedure). (See § 601.601(d)(2)(ii)(<E T="03">b</E>) of this chapter.) The application requesting the Secretary's approval must contain the following information—</P> <P>(A) The name, address, and identification number of each affected taxpayer;</P> <P>(B) The Building Identification Number (B.I.N.) and address of each building or project affected by the administrative error or omission;</P> <P>(C) A statement explaining the administrative error or omission and the intent of the Agency, or of the Agency and the affected taxpayer, when the document was originally completed;</P> <P>(D) Copies of any supporting documentation;</P> <P>(E) A statement explaining the effect, if any, that a correction of the administrative error or omission would <PRTPAGE P="169"/>have on the housing credit dollar amount allocated for any building or project; and</P> <P>(F) A statement explaining the effect, if any, that a correction of the administrative error or omission would have on the determination of the components of the State's housing credit ceiling under section 42(h)(3)(C) or on the State's unused housing credit carryover that is assigned to the Secretary under section 42(h)(3)(D).</P> <P>(v) <E T="03">Agreement to conditions.</E> To obtain the Secretary's approval under paragraph (b)(3)(iii) of this section, an Agency, or the Agency and the affected taxpayer, must agree to the conditions the Secretary considers appropriate.</P> <P>(vi) <E T="03">Secretary's automatic approval.</E> The Secretary grants automatic approval to correct an administrative error or omission described in paragraph (b)(2) of this section if—</P> <P>(A) The correction is not made before the close of the calendar year of the error or omission and the correction is a numerical change to the housing credit dollar amount allocated for the building or multiple-building project;</P> <P>(B) The administrative error or omission resulted in an allocation document (the Form 8609, “Low-Income Housing Credit Allocation Certification,” or the allocation document under the requirements of section 42(h)(1)(E) or (F), and § 1.42-6(d)(2)) that either did not accurately reflect the number of buildings in a project (for example, an allocation document for a 10-building project only references 8 buildings instead of 10 buildings), or the correct information (other than the amount of credit allocated on the allocation document);</P> <P>(C) The administrative error or omission does not affect the Agency's ranking of the building(s) or project and the total amount of credit the Agency allocated to the building(s) or project; and</P> <P>(D) The Agency corrects the administrative error or omission by following the procedures described in paragraph (b)(3)(vii) of this section.</P> <P>(vii) <E T="03">How Agency corrects errors or omissions subject to automatic approval.</E> An Agency corrects an administrative error or omission described in paragraph (b)(3)(vi) of this section by—</P> <P>(A) Amending the allocation document described in paragraph (b)(3)(vi)(B) of this section to correct the administrative error or omission. The Agency will indicate on the amended allocation document that it is making the “correction under § 1.42-13(b)(3)(vii).” If correcting the allocation document requires including any additional B.I.N.(s) in the document, the document must include any B.I.N.(s) already existing for buildings in the project. If possible, the additional B.I.N.(s) should be sequentially numbered from the existing B.I.N.(s);</P> <P>(B) Amending, if applicable, the Schedule A (Form 8610), “Carryover Allocation of the Low-Income Housing Credit,” and attaching a copy of this schedule to Form 8610, “Annual Low-Income Housing Credit Agencies Report,” for the year the correction is made. The Agency will indicate on the schedule that it is making the “correction under § 1.42-13(b)(3)(vii).” For a carryover allocation made before January 1, 2000, the Agency must complete Schedule A (Form 8610), and indicate on the schedule that it is making the “correction under § 1.42-13(b)(3)(vii)”;</P> <P>(C) Amending, if applicable, the Form 8609 and attaching the original of this amended form to Form 8610 for the year the correction is made. The Agency will indicate on the Form 8609 that it is making the “correction under § 1.42-13(b)(3)(vii)”; and</P> <P>(D) Mailing or otherwise delivering a copy of any amended allocation document and any amended Form 8609 to the affected taxpayer.</P> <P>(viii) <E T="03">Other approval procedures.</E> The Secretary may grant automatic approval to correct other administrative errors or omissions as designated in one or more documents published either in the <E T="04">Federal Register</E> or in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter).</P> <P>(c) <E T="03">Examples.</E> The following examples illustrate the scope of this section: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Individual B applied to Agency X for a reservation of a low-income housing credit dollar amount for a building that is part of a low-income housing project. When applying for the low-income housing credit dollar amount, B informed Agency X that B intended to form Partnership Y to finance the project. After receiving the reservation letter and prior to receiving an allocation, B <PRTPAGE P="170"/>formed Partnership Y and sold partnership interests to a number of limited partners. B contributed the low-income housing project to Partnership Y in exchange for a partnership interest. B and Partnership Y informed Agency X of the ownership change. When actually allocating the housing credit dollar amount, Agency X sent Partnership Y a document listing B, rather than Partnership Y, as the building's owner. Partnership Y promptly notified Agency X of the error. After reviewing related documents, Agency X determined that it had incorrectly listed B as the building's owner on the allocation document. Since the parties originally intended that Partnership Y would receive the allocation as the owner of the building, Agency X may correct the error without obtaining the Secretary's approval, and insert Partnership Y as the building's owner on the allocation document.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Agency Y allocated a lower low-income housing credit dollar amount for a low-income housing building than Agency Y originally intended. After the close of the calendar year of the allocation, B, the building's owner, discovered the error and promptly notified Agency Y. Agency Y reviewed relevant documents and agreed that an error had occurred. Agency Y and B must apply, as provided in paragraph (b)(3)(iv) of this section, for the Secretary's approval before Agency Y may correct the error.</P> </EXAMPLE> <P>(d) <E T="03">Effective date.</E> This section is effective February 24, 1994. However, an Agency may elect to apply these regulations to administrative errors or omissions that occurred before the publication of these regulations. Any reasonable method used by a State or local housing credit agency to correct an administrative error or omission prior to February 24, 1994, will be considered proper, provided that the method is consistent with the rules of section 42. Paragraphs (b)(3)(vi), (vii), and (viii) of this section are effective January 14, 2000.</P> <CITA>[T.D. 8521, 59 FR 8861, Feb. 24, 1994, as amended by T.D. 8859, 65 FR 2328, Jan. 14, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-14</SECTNO> <SUBJECT>Allocation rules for post-1989 State housing credit ceiling amounts.</SUBJECT> <P>(a) <E T="03">In general.</E> The State housing credit ceiling for a State for any calendar year after 1989 is comprised of four components. The four components are—</P> <P>(1) $1.25 multiplied by the State population (the population component);</P> <P>(2) The unused State housing credit ceiling, if any, of the State for the preceding calendar year (the unused carryforward component);</P> <P>(3) The amount of State housing credit ceiling returned in the calendar year (the returned credit component); plus</P> <P>(4) The amount, if any, allocated to the State by the Secretary under section 42(h)(3)(D) from a national pool of unused credit (the national pool component).</P> <P>(b) <E T="03">The population component.</E> The population component of the State housing credit ceiling of a State for any calendar year is determined pursuant to section 146(j). Thus, a State's population for any calendar year is determined by reference to the most recent census estimate, whether final or provisional, of the resident population of the State released by the Bureau of the Census before the beginning of the calendar year for which the State's housing credit ceiling is set. Unless otherwise prescribed by applicable revenue procedure, determinations of population are based on the most recent estimates of population contained in the Bureau of the Census publication, <E T="03">Current Population Report, Series P-25; Population Estimates and Projections, Estimates of the Population of States.</E> For convenience, the Internal Revenue Service publishes the population estimates annually in the Internal Revenue Bulletin. (See § 601.601(d)(2)(ii)(<E T="03">b</E>)).</P> <P>(c) <E T="03">The unused carryforward component.</E> The unused carryforward component of the State housing credit ceiling of a State for any calendar year is the excess, if any, of the sum of the population and returned credit components, over the aggregate housing credit dollar amount allocated for the year. Any credit amounts attributable to the national pool component of the State housing credit ceiling that remain unallocated at the close of a calendar year are not carried forward to the succeeding calendar year; instead, the credit expires and cannot be reallocated by any Agency.</P> <P>(d) <E T="03">The returned credit component—</E>(1) <E T="03">In general.</E> The returned credit component of the State housing credit ceiling of a State for any calendar year equals <PRTPAGE P="171"/>the housing credit dollar amount returned during the calendar year that was validly allocated within the State in a prior calendar year to any project that does not become a qualified low-income housing project within the period required by section 42, or as required by the terms of the allocation. The returned credit component also includes credit allocated in a prior calendar year that is returned as a result of the cancellation of an allocation by mutual consent or by an Agency's determination that the amount allocated is not necessary for the financial feasibility of the project. For purposes of this section, credit is allocated within a State if it is allocated from the State's housing credit ceiling by an Agency of the State or of a constitutional home rule city in the State.</P> <P>(2) <E T="03">Limitations and special rules.</E> The following limitations and special rules apply for purposes of this paragraph (d).</P> <P>(i) <E T="03">General limitations.</E> Notwithstanding any other provision of this paragraph (d), returned credit does not include any credit that was—</P> <P>(A) Allocated prior to calendar year 1990;</P> <P>(B) Allowable under section 42(h)(4) (relating to the portion of credit attributable to eligible basis financed by certain tax-exempt bonds under section 103); or</P> <P>(C) Allocated during the same calendar year that it is received back by the Agency.</P> <P>(ii) <E T="03">Credit period limitation.</E> Notwithstanding any other provision of this paragraph (d), an allocation of credit may not be returned any later than 180 days following the close of the first taxable year of the credit period for the building that received the allocation. After this date, credit that might otherwise be returned expires, and cannot be returned to or reallocated by any Agency.</P> <P>(iii) <E T="03">Three-month rule for returned credit.</E> An Agency may, in its discretion, treat any portion of credit that is returned from a project after September 30 of a calendar year and that is not reallocated by the close of the calendar year as returned on January 1 of the succeeding calendar year. In this case, the returned credit becomes part of the returned credit component of the State housing credit ceiling for the succeeding calendar year. Any portion of credit that is returned from a project after September 30 of a calendar year that is reallocated by the close of the calendar year is treated as part of the returned credit component of the State housing credit ceiling for the calendar year that the credit was returned.</P> <P>(iv) <E T="03">Returns of credit.</E> Subject to the limitations of paragraphs (d)(2) (i) and (ii) of this section, credit is returned to the Agency in the following instances in the manner described in paragraph (d)(3) of this section.</P> <P>(A) <E T="03">Building not qualified within required time period.</E> If a building is not a qualified building within the time period required by section 42, it loses its credit allocation and the credit is returned. For example, a building is not qualified within the required time period if it is not placed in service within the period required by section 42 or if the project of which the building is a part fails to meet the minimum set-aside requirements of section 42(g)(1) by the close of the first year of the credit period.</P> <P>(B) <E T="03">Noncompliance with terms of the allocation.</E> If a building does not comply with the terms of its allocation, it loses the credit allocation and the credit is returned. The terms of an allocation are the written conditions agreed to by the Agency and the allocation recipient in the allocation document.</P> <P>(C) <E T="03">Mutual consent.</E> If the Agency and the allocation recipient cancel an allocation of an amount of credit by mutual consent, that amount of credit is returned.</P> <P>(D) <E T="03">Amount not necessary for financial feasibility.</E> If an Agency determines under section 42(m)(2) that an amount of credit allocated to a project is not necessary for the financial feasibility of the project and its viability as a qualified low-income housing project throughout the credit period, that amount of credit is returned.</P> <P>(3) <E T="03">Manner of returning credit—(</E> i) <E T="03">Taxpayer notification.</E> After an Agency determines that a building or project no longer qualifies under paragraph (d)(2)(iv)(A), (B), or (D) of this section <PRTPAGE P="172"/>for all or part of the allocation it received, the Agency must provide written notification to the allocation recipient, or its successor in interest, that all or part of the allocation is no longer valid. The notification must also state the amount of the allocation that is no longer valid. The date of the notification is the date the credit is returned to the Agency. If an allocation is cancelled by mutual consent under paragraph (d)(2)(iv)(C) of this section, there must be a written agreement signed by the Agency, and the allocation recipient, or its successor in interest, indicating the amount of the allocation that is returned to the Agency. The effective date of the agreement is the date the credit is returned to the Agency.</P> <P>(ii) <E T="03">Internal Revenue Service notification.</E> If a credit is returned within 180 days following the close of the first taxable year of a building's credit period as provided in paragraph (d)(2)(ii) of this section, and a Form 8609, <E T="03">Low-Income Housing Credit Allocation Certification,</E> has been issued for the building, the Agency must notify the Internal Revenue Service that the credit has been returned. If only part of the credit has been returned, this notification requirement is satisfied when the Agency attaches to an amended Form 8610, <E T="03">Annual Low- Income Housing Credit Agencies Report,</E> the original of an amended Form 8609 reflecting the correct amount of credit attributed to the building together with an explanation for the filing of the amended Forms. The Agency must send a copy of the amended Form 8609 to the taxpayer that owns the building. If the building is not issued an amended Form 8609 because all of the credit allocated to the building is returned, notification to the Internal Revenue Service is satisfied by following the requirements prescribed in § 1.42-5(e)(3) for filing a Form 8823, <E T="03">Low-Income Housing Credit Agencies Report of Noncompliance.</E> </P> <P>(e) <E T="03">The national pool component.</E> The national pool component of the State housing credit ceiling of a State for any calendar year is the portion of the National Pool allocated to the State by the Secretary for the calendar year. The national pool component for any calendar year is zero unless a State is a <E T="03">qualified State.</E> (See paragraph (i) of this section for rules regarding the National Pool and the description of a qualified State.) Credit from the national pool component of a State housing credit ceiling must be allocated prior to the close of the calendar year or the credit expires and cannot be reallocated by any Agency. A national pool component credit that is allocated during a calendar year and returned after the close of the calendar year may qualify as part of the returned credit component of the State housing credit ceiling for the calendar year that the credit is returned.</P> <P>(f) <E T="03">When the State housing credit ceiling is determined.</E> For purposes of accounting for the State housing credit ceiling on Form 8610 and for purposes of determining the set-aside apportionment for projects involving qualified nonprofit organizations described in section 42(h)(5) and § 1.42-1T(c)(5), the State housing credit ceiling for any calendar year is determined at the close of the calendar year.</P> <P>(g) <E T="03">Stacking order.</E> Under section 42(h)(3)(C), credit is treated as allocated from the various components of the State housing credit ceiling in the following order. The first credit allocated for any calendar year is treated as credit from the sum of the population and returned credit components of the State housing credit ceiling. Once all of the credit in these components has been allocated, the next credit allocated is treated as credit from the unused carryforward component of the State housing credit ceiling. Finally, after all of the credit from the population component, returned credit component, and unused carryforward component has been allocated, any further credit allocated is treated as credit from the national pool component.</P> <P>(h) <E T="03">Nonprofit set-aside</E>—(1) <E T="03">Determination of set-aside.</E> Under section 42(h)(5) and § 1.42-1T(c)(5), at least 10 percent of a State housing credit ceiling in any calendar year must be set aside exclusively for projects involving qualified nonprofit organizations (the nonprofit set-aside). However, credit allocated from the nonprofit set-aside in a calendar year and returned in a subsequent calendar year does not retain its <PRTPAGE P="173"/>nonprofit set-aside character. The credit becomes part of the returned credit component of the State housing credit ceiling for the calendar year that the credit is returned and must be included in determining the nonprofit set-aside of the State housing credit ceiling for that calendar year. Similarly, credit amounts that are not allocated from the nonprofit set-aside in a calendar year and are returned in a subsequent calendar year become part of the returned credit component of the State housing credit ceiling for that year and are also included in determining the set-aside for that year.</P> <P>(2) <E T="03">Allocation rules.</E> An Agency may allocate credit from any component of the State housing credit ceiling as part of the nonprofit set-aside and need not reserve 10 percent of each component for the nonprofit set-aside. Thus, an Agency may satisfy the nonprofit set-aside requirement of section 42(h)(5) and § 1.42-1T(c)(5) in any calendar year by setting aside for allocation an amount equal to at least 10 percent of the total State housing credit ceiling for the calendar year.</P> <P>(i) <E T="03">National Pool</E>—(1) <E T="03">In general.</E> The unused housing credit carryover of a State for any calendar year is assigned to the Secretary for inclusion in a national pool of unused housing credit carryovers (National Pool) that is reallocated among qualified States the succeeding calendar year. The assignment to the Secretary is made on Form 8610.</P> <P>(2) <E T="03">Unused housing credit carryover.</E> The unused housing credit carryover of a State for any calendar year is the excess, if any, of the unused carryforward component of the State housing credit ceiling for the calendar year over the excess, if any, of—</P> <P>(i) The total housing credit dollar amount allocated for the year; over</P> <P>(ii) The sum of the population and returned credit components of the State housing credit ceiling for the year.</P> <P>(3) <E T="03">Qualified State</E>—(i) <E T="03">In general.</E> The term <E T="03">qualified State</E> means, with respect to any calendar year, any State that has allocated its entire State housing credit ceiling for the preceding calendar year and for which a request is made by the State, not later than May 1 of the calendar year, to receive an allocation of credit from the National Pool for that calendar year. Except as provided in paragraph (i)(3)(ii) of this section, a State is not a qualified State in a calendar year if there remains any unallocated credit in its State housing credit ceiling at the close of the preceding calendar year that was apportioned to any Agency within the State for the calendar year.</P> <P>(ii) <E T="03">Exceptions</E>—(A) <E T="03">De minimis amount.</E> If the amount remaining unallocated at the close of a calendar year is only a de minimis amount of credit, the State is a qualified State eligible to participate in the National Pool. For that purpose, a credit amount is de minimis if it does not exceed 1 percent of the aggregate State housing credit ceiling of the State for the calendar year.</P> <P>(B) <E T="03">Other circumstances.</E> Pursuant to the authority under section 42(n), the Internal Revenue Service may determine that a State is a qualified State eligible to participate in the National Pool even though the State's unallocated credit is in excess of the 1 percent safe harbor set forth in paragraph (A) of this section. The Internal Revenue Service will make this determination based on all the facts and circumstances, weighing heavily the interests of the States who would otherwise qualify for the National Pool. The Internal Revenue Service will generally grant relief under this paragraph only where a State's unallocated credit is not substantial.</P> <P>(iii) <E T="03">Time and manner for making request.</E> For further guidance as to the time and manner for making a request of housing credit dollar amounts from the National Pool by a qualified State, see Rev. Proc. 92-31, 1992-1 C.B. 775. (See 601.601(d)(2)(ii)(<E T="03">b</E>)).</P> <P>(4) <E T="03">Formula for determining the National Pool.</E> The amount allocated to a qualified State in any calendar year is an amount that bears the same ratio to the aggregate unused housing credit carryovers of all States for the preceding calendar year as that State's population for the calendar year bears to the population of all qualified States for the calendar year.</P> <P>(j) <E T="03">Coordination between Agencies.</E> The Agency responsible for filing Form 8610 on behalf of all Agencies within a State <PRTPAGE P="174"/>and making any request on behalf of the State for credit from the National Pool (the Filing Agency) must coordinate with each Agency within the State to ensure that the various requirements of this section are complied with. For example, the Filing Agency of a State must ensure that all Agencies within the State that were apportioned a credit amount for the calendar year have allocated all of their respective credit amounts for the calendar year before the Filing Agency can make a request on behalf of the State for a distribution of credit from the National Pool.</P> <P>(k) <E T="03">Examples.</E> (1) The operation of the rules of this section may be illustrated by the following examples. Unless otherwise stated in an example, Agency A is the sole Agency authorized to make allocations of housing credit dollar amounts in State M, all of Agency A's allocations are valid, and for calendar year 1994 Agency A has available for allocation a State housing credit ceiling consisting of the following housing credit dollar amounts:</P> <GPOTABLE CDEF="s25,6" COLS="2" OPTS="L0,7/8,g1,t1,i1"> <ROW> <ENT I="01">A. Population component </ENT> <ENT>$100</ENT> </ROW> <ROW> <ENT I="01">B. Unused carryforward component </ENT> <ENT>50</ENT> </ROW> <ROW> <ENT I="01">C. Returned credit component </ENT> <ENT>10</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">D. National pool component </ENT> <ENT>0</ENT> </ROW> <ROW> <ENT I="04">Total </ENT> <ENT>160</ENT> </ROW> </GPOTABLE> <P>(2) In addition, the $10 of returned credit component was returned before October 1, 1994. </P> <EXAMPLE> <HD SOURCE="HED">Example 1</HD> <P>(i) <E T="03">Additional facts.</E> By the close of 1994, Agency A had allocated $80 of the State M housing credit ceiling. Of the $80 allocated, $16 was allocated to projects involving qualified nonprofit organizations.</P> <P>(ii) <E T="03">Application of stacking rules.</E> The first credit allocated is treated as allocated from the population and returned credit components of the State housing credit ceiling, to the extent of those components. In this case, the $80 of credit allocated is less than the sum of the population and returned credit components. The excess of the sum of the population and returned credit components over the total amount allocated for the calendar year ($110−80=$30) becomes the unused carryforward component of State M's 1995 State housing credit ceiling. Because Agency A did not allocate credit in excess of the sum of the population and returned credit components, no credit is treated as allocated from State M's $50 unused carryforward component in 1994. Because none of this component may be carried forward, all $50 is assigned to the Secretary for inclusion in the National Pool. Under paragraph (i)(3) of this section, State M does not qualify for credit from the National Pool for the 1995 calendar year.</P> <P>(iii) <E T="03">Nonprofit set-aside.</E> Agency A allocated exactly the amount of credit to projects involving qualified nonprofit organizations as necessary to meet the nonprofit set-aside requirement ($16, 10% of the $160 ceiling).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2</HD> <P>(i) <E T="03">Additional facts.</E> By the close of 1994, Agency A had allocated $130 of the State M housing credit ceiling. Of the $130 allocated, $20 was allocated to projects involving qualified nonprofit organizations.</P> <P>(ii) <E T="03">Application of stacking rules.</E> The first $110 of credit allocated is treated as allocated from the population and returned credit components. In this case, because all of the population and returned credit components are allocated, no amount is included in State M's 1995 State housing credit ceiling as an unused carryforward component. The next $20 of credit allocated is treated as allocated from the $50 unused carryforward component. The $30 remaining in the unused carryforward component is assigned to the Secretary for inclusion in the National Pool for the 1995 calendar year. Under paragraph (i)(3) of this section, State M does not qualify for credit from the National Pool for the 1995 calendar year.</P> <P>(iii) <E T="03">Nonprofit set-aside.</E> Agency A allocated $4 more credit to projects involving qualified nonprofit organizations than necessary to meet the nonprofit set-aside requirement. This does not reduce the application of the 10% nonprofit set-aside requirement to the State M housing credit ceiling for the succeeding year.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3</HD> <P>(i) <E T="03">Additional fact.</E> None of the applications for credit that Agency A received for 1994 are for projects involving qualified nonprofit organizations.</P> <P>(ii) <E T="03">Nonprofit set-aside.</E> Because at least 10% of the State housing credit ceiling must be set aside for projects involving a qualified nonprofit organization, Agency A can allocate only $144 of the $160 State housing credit ceiling for calendar year 1994 ($160−16=$144). If Agency A allocates $144 of credit, the credit is treated as allocated $110 from the population and returned credit components and $34 from the unused carryforward component. The $16 of unallocated credit that is set aside for projects involving qualified nonprofit organizations is treated as the balance of the unused carryforward component, and is assigned to the Secretary for inclusion in the National Pool. Under paragraph (i)(3) of this section, State M does not qualify for credit from the National Pool for the 1995 calendar year.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4</HD> <P>(i) <E T="03">Additional facts.</E> The $10 of returned credit component was returned prior to October 1, 1994. However, a $40 credit that had been allocated in calendar year 1993 to a <PRTPAGE P="175"/>project involving a qualified nonprofit organization was returned to the Agency by a mutual consent agreement dated November 15, 1994. By the close of 1994, Agency A had allocated $160 of the State M housing credit ceiling, including $16 of credit to projects involving qualified nonprofit organizations.</P> <P>(ii) <E T="03">Effect of three-month rule.</E> Under the three-month rule of paragraph (d)(2)(iii) of this section, Agency A may treat all or part of the $40 of previously allocated credit as returned on January 1, 1995. If Agency A treats all of the $40 amount as having been returned in calendar year 1995, the State M housing credit ceiling for 1994 is $160. This entire amount, including the $16 nonprofit set-aside, has been allocated in 1994. Under paragraph (i)(3) of this section, State M qualifies for the National Pool for the 1995 calendar year.</P> <P>(iii) <E T="03">If three-month rule not used.</E> If Agency A treats all of the $40 of previously allocated credit as returned in calendar year 1994, the State housing credit ceiling for the 1994 calendar year will be $200 of which $50 will be attributable to the returned credit component ($10+$40=$50). Because credit amounts allocated in a prior calendar year that are returned in a subsequent calendar year do not retain their nonprofit character, the nonprofit set-aside for calendar year 1994 is $20 (10% of $200). The $160 that Agency A allocated during 1994 is first treated as allocated from the population and returned credit components, which total $150. The next $10 of credit allocated is treated as allocated from the unused carryforward component. The $40 of unallocated credit from the unused carryforward component includes the $4 of unallocated nonprofit set-aside. The entire $40 of credit from the carryforward component is assigned to the Secretary for inclusion in the National Pool for the 1995 calendar year. State M does not qualify for credit from the National Pool for the 1995 calendar year.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5</HD> <P>(i) (A) <E T="03">Additional facts.</E> For calendar year 1994, Agency A has a State housing credit ceiling that consists of the following housing credit dollar amounts:</P> <GPOTABLE CDEF="s25,6" COLS="2" OPTS="L0,p1,7/8,g1,t1,i1"> <BOXHD> <CHED H="1"/> <CHED H="1"/> </BOXHD> <ROW> <ENT I="01">A. Population component </ENT> <ENT>$100</ENT> </ROW> <ROW> <ENT I="01">B. Unused carryforward component </ENT> <ENT>0</ENT> </ROW> <ROW> <ENT I="01">C. Returned credit component </ENT> <ENT>20</ENT> </ROW> <ROW RUL="n,s"> <ENT I="01">D. National pool component </ENT> <ENT>10</ENT> </ROW> <ROW> <ENT I="04">Total </ENT> <ENT>130</ENT> </ROW> <ROW> <ENT I="01">Minimum nonprofit set-aside </ENT> <ENT>13</ENT> </ROW> <ROW> <ENT I="01">Ceiling amount not set-aside </ENT> <ENT>117</ENT> </ROW> </GPOTABLE> <P>In addition, the $20 of returned credit component was returned before October 1, 1994. By the close of 1994, Agency A had allocated $100 of the State housing credit ceiling.</P> <P>(ii) <E T="03">Application of stacking rules.</E> The $20 excess of the sum of the population component and the returned credit component over the total amount allocated for the calendar year ($120−100=$20) becomes the unused carryforward component of the State housing credit ceiling for the 1995 calendar year. The $10 of unallocated credit from the national pool component expires and cannot be reallocated. This amount is neither carried over to 1995 by State M nor assigned to the Secretary for inclusion in the National Pool. Under paragraph (i)(3) of this section, State M does not qualify for credit from the National Pool for the 1995 calendar year.</P> </EXAMPLE> <P>(l) <E T="03">Effective date.</E> The rules set forth in § 1.42-14 are effective January 1, 1994.</P> <CITA>[T.D. 8563, 59 FR 50163, Oct. 3, 1994; 60 FR 3345, Jan. 17, 1995]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-15</SECTNO> <SUBJECT>Available unit rule.</SUBJECT> <P>(a) <E T="03">Definitions.</E> The following definitions apply to this section:</P> <P> <E T="03">Applicable income limitation</E> means the limitation applicable under section 42(g)(1) or, for deep rent skewed projects described in section 142(d)(4)(B), 40 percent of area median gross income.</P> <P> <E T="03">Available unit rule</E> means the rule in section 42(g)(2)(D)(ii).</P> <P> <E T="03">Comparable unit</E> means a residential unit in a low-income building that is comparably sized or smaller than an over-income unit or, for deep rent skewed projects described in section 142(d)(4)(B), any low-income unit. For purposes of determining whether a residential unit is comparably sized, a comparable unit must be measured by the same method used to determine qualified basis for the credit year in which the comparable unit became available.</P> <P> <E T="03">Current resident</E> means a person who is living in the low-income building.</P> <P> <E T="03">Low-income unit</E> is defined by section 42(i)(3)(A).</P> <P> <E T="03">Nonqualified resident</E> means a new occupant or occupants whose aggregate income exceeds the applicable income limitation.</P> <P> <E T="03">Over-income unit</E> means a low-income unit in which the aggregate income of the occupants of the unit increases above 140 percent of the applicable income limitation under section 42(g)(1), or above 170 percent of the applicable income limitation for deep rent skewed projects described in section 142(d)(4)(B).<PRTPAGE P="176"/> </P> <P> <E T="03">Qualified resident</E> means an occupant either whose aggregate income (combined with the income of all other occupants of the unit) does not exceed the applicable income limitation and who is otherwise a low-income resident under section 42, or who is a current resident.</P> <P>(b) <E T="03">General section 42(g)(2)(D)(i) rule.</E> Except as provided in paragraph (c) of this section, notwithstanding an increase in the income of the occupants of a low-income unit above the applicable income limitation, if the income of the occupants initially met the applicable income limitation, and the unit continues to be rent-restricted—</P> <P>(1) The unit continues to be treated as a low-income unit; and</P> <P>(2) The unit continues to be included in the numerator and the denominator of the ratio used to determine whether a project satisfies the applicable minimum set-aside requirement of section 42(g)(1).</P> <P>(c) <E T="03">Exception.</E> A unit ceases to be treated as a low-income unit if it becomes an over-income unit and a nonqualified resident occupies any comparable unit that is available or that subsequently becomes available in the same low-income building. In other words, the owner of a low-income building must rent to qualified residents all comparable units that are available or that subsequently become available in the same building to continue treating the over-income unit as a low-income unit. Once the percentage of low-income units in a building (excluding the over-income units) equals the percentage of low-income units on which the credit is based, failure to maintain the over-income units as low-income units has no immediate significance. The failure to maintain the over-income units as low-income units, however, may affect the decision of whether or not to rent a particular available unit at market rate at a later time. A unit is not available for purposes of the available unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law (for example, a unit is not available if it is subject to a preliminary reservation that is binding on the owner under local law prior to the date a lease is signed or the unit is occupied).</P> <P>(d) <E T="03">Effect of current resident moving within building.</E> When a current resident moves to a different unit within the building, the newly occupied unit adopts the status of the vacated unit. Thus, if a current resident, whose income exceeds the applicable income limitation, moves from an over-income unit to a vacant unit in the same building, the newly occupied unit is treated as an over-income unit. The vacated unit assumes the status the newly occupied unit had immediately before it was occupied by the current resident.</P> <P>(e) <E T="03">Available unit rule applies separately to each building in a project.</E> In a project containing more than one low-income building, the available unit rule applies separately to each building.</P> <P>(f) <E T="03">Result of noncompliance with available unit rule.</E> If any comparable unit that is available or that subsequently becomes available is rented to a nonqualified resident, all over-income units for which the available unit was a comparable unit within the same building lose their status as low-income units; thus, comparably sized or larger over-income units would lose their status as low-income units.</P> <P>(g) <E T="03">Relationship to tax-exempt bond provisions.</E> Financing arrangements that purport to be exempt-facility bonds under section 142 must meet the requirements of sections 103 and 141 through 150 for interest on the obligations to be excluded from gross income under section 103(a). This section is not intended as an interpretation under section 142.</P> <P>(h) <E T="03">Examples.</E> The following examples illustrate this section: </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>This example illustrates noncompliance with the available unit rule in a low-income building containing three over-income units. On January 1, 1998, a qualified low-income housing project, consisting of one building containing ten identically sized residential units, received a housing credit dollar amount allocation from a state housing credit agency for five low-income units. By the close of 1998, the first year of the credit period, the project satisfied the minimum set-aside requirement of section 42(g)(1)(B). Units 1, 2, 3, 4, and 5 were occupied by individuals whose incomes did not exceed the income limitation applicable <PRTPAGE P="177"/>under section 42(g)(1) and were otherwise low-income residents under section 42. Units 6, 7, 8, and 9 were occupied by market-rate tenants. Unit 10 was vacant. To avoid recapture of credit, the project owner must maintain five of the units as low-income units. On November 1, 1999, the certificates of annual income state that annual incomes of the individuals in Units 1, 2, and 3 increased above 140 percent of the income limitation applicable under section 42(g)(1), causing those units to become over-income units. On November 30, 1999, Units 8 and 9 became vacant. On December 1, 1999, the project owner rented Units 8 and 9 to qualified residents who were not current residents at rates meeting the rent restriction requirements of section 42(g)(2). On December 31, 1999, the project owner rented Unit 10 to a market-rate tenant. Because Unit 10, an available comparable unit, was leased to a market-rate tenant, Units 1, 2, and 3 ceased to be treated as low-income units. On that date, Units 4, 5, 8, and 9 were the only remaining low-income units. Because the project owner did not maintain five of the residential units as low-income units, the qualified basis in the building is reduced, and credit must be recaptured. If the project owner had rented Unit 10 to a qualified resident who was not a current resident, eight of the units would be low-income units. At that time, Units 1, 2, and 3, the over-income units, could be rented to market-rate tenants because the building would still contain five low-income units.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>This example illustrates the provisions of paragraph (d) of this section. A low-income project consists of one six-floor building. The residential units in the building are identically sized. The building contains two over-income units on the sixth floor and two vacant units on the first floor. The project owner, desiring to maintain the over-income units as low-income units, wants to rent the available units to qualified residents. J, a resident of one of the over-income units, wishes to occupy a unit on the first floor. J's income has recently increased above the applicable income limitation. The project owner permits J to move into one of the units on the first floor. Despite J's income exceeding the applicable income limitation, J is a qualified resident under the available unit rule because J is a current resident of the building. The unit newly occupied by J becomes an over-income unit under the available unit rule. The unit vacated by J assumes the status the newly occupied unit had immediately before J occupied the unit. The over-income units in the building continue to be treated as low-income units.</P> </EXAMPLE> <P>(i) <E T="03">Effective date.</E> This section applies to leases entered into or renewed on and after September 26, 1997.</P> <CITA>[T.D. 8732, 62 FR 50505, Sept. 26, 1997]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-16</SECTNO> <SUBJECT>Eligible basis reduced by federal grants.</SUBJECT> <P>(a) <E T="03">In general.</E> If, during any taxable year of the compliance period (described in section 42(i)(1)), a grant is made with respect to any building or the operation thereof and any portion of the grant is funded with federal funds (whether or not includible in gross income), the eligible basis of the building for the taxable year and all succeeding taxable years is reduced by the portion of the grant that is so funded.</P> <P>(b) <E T="03">Grants do not include certain rental assistance payments.</E> A federal rental assistance payment made to a building owner on behalf or in respect of a tenant is not a grant made with respect to a building or its operation if the payment is made pursuant to—</P> <P>(1) Section 8 of the United States Housing Act of 1937 (42 U.S.C. 1437f)</P> <P>(2) A qualifying program of rental assistance administered under section 9 of the United States Housing Act of 1937 (42 U.S.C. 1437g); or</P> <P>(3) A program or method of rental assistance as the Secretary may designate by publication in the <E T="04">Federal Register</E> or in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter).</P> <P>(c) <E T="03">Qualifying rental assistance program.</E> For purposes of paragraph (b)(2) of this section, payments are made pursuant to a qualifying rental assistance program administered under section 9 of the United States Housing Act of 1937 to the extent that the payments—</P> <P>(1) Are made to a building owner pursuant to a contract with a public housing authority with respect to units the owner has agreed to maintain as public housing units (PH-units) in the building;</P> <P>(2) Are made with respect to units occupied by public housing tenants, provided that, for this purpose, units may be considered occupied during periods of short term vacancy (not to exceed 60 days); and<PRTPAGE P="178"/> </P> <P>(3) Do not exceed the difference between the rents received from a building's PH-unit tenants and a pro rata portion of the building's actual operating costs that are reasonably allocable to the PH-units (based on square footage, number of bedrooms, or similar objective criteria), and provided that, for this purpose, operating costs do not include any development costs of a building (including developer's fees) or the principal or interest of any debt incurred with respect to any part of the building.</P> <P>(d) <E T="03">Effective date.</E> This section is effective September 26, 1997.</P> <CITA>[T.D. 8731, 62 FR 50503, Sept. 26, 1997]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42-17</SECTNO> <SUBJECT>Qualified allocation plan.</SUBJECT> <P>(a) <E T="03">Requirements</E>—(1) <E T="03">In general.</E> [Reserved]</P> <P>(2) <E T="03">Selection criteria.</E> [Reserved]</P> <P>(3) <E T="03">Agency evaluation.</E> Section 42(m)(2)(A) requires that the housing credit dollar amount allocated to a project is not to exceed the amount the Agency determines is necessary for the financial feasibility of the project and its viability as a qualified low-income housing project throughout the credit period. In making this determination, the Agency must consider—</P> <P>(i) The sources and uses of funds and the total financing planned for the project. The taxpayer must certify to the Agency the full extent of all federal, state, and local subsidies that apply (or which the taxpayer expects to apply) to the project. The taxpayer must also certify to the Agency all other sources of funds and all development costs for the project. The taxpayer's certification should be sufficiently detailed to enable the Agency to ascertain the nature of the costs that will make up the total financing package, including subsidies and the anticipated syndication or placement proceeds to be raised. Development cost information, whether or not includible in eligible basis under section 42(d), that should be provided to the Agency includes, but is not limited to, site acquisition costs, construction contingency, general contractor's overhead and profit, architect's and engineer's fees, permit and survey fees, insurance premiums, real estate taxes during construction, title and recording fees, construction period interest, financing fees, organizational costs, rent-up and marketing costs, accounting and auditing costs, working capital and operating deficit reserves, syndication and legal fees, and developer fees;</P> <P>(ii) Any proceeds or receipts expected to be generated by reason of tax benefits;</P> <P>(iii) The percentage of the housing credit dollar amount used for project costs other than the costs of intermediaries. This requirement should not be applied so as to impede the development of projects in hard-to-develop areas under section 42(d)(5)(C); and</P> <P>(iv) The reasonableness of the developmental and operational costs of the project.</P> <P>(4) <E T="03">Timing of Agency evaluation</E>—(i) <E T="03">In general.</E> The financial determinations and certifications required under paragraph (a)(3) of this section must be made as of the following times—</P> <P>(A) The time of the application for the housing credit dollar amount;</P> <P>(B) The time of the allocation of the housing credit dollar amount; and</P> <P>(C) The date the building is placed in service.</P> <P>(ii) <E T="03">Time limit for placed-in-service evaluation.</E> For purposes of paragraph (a)(4)(i)(C) of this section, the evaluation for when a building is placed in service must be made not later than the date the Agency issues the Form 8609, “Low-Income Housing Credit Allocation Certification.” The Agency must evaluate all sources and uses of funds under paragraph (a)(3)(i) of this section paid, incurred, or committed by the taxpayer for the project up until date the Agency issues the Form 8609.</P> <P>(5) <E T="03">Special rule for final determinations and certifications.</E> For the Agency's evaluation under paragraph (a)(4)(i)(C) of this section, the taxpayer must submit a schedule of project costs. Such schedule is to be prepared on the method of accounting used by the taxpayer for federal income tax purposes, and must detail the project's total costs as well as those costs that may qualify for inclusion in eligible basis under section 42(d). For projects with more than 10 units, the schedule of project costs must be accompanied by a Certified Public Accountant's audit report on the schedule (an Agency may require <PRTPAGE P="179"/>an audited schedule of project costs for projects with fewer than 11 units). The CPA's audit must be conducted in accordance with generally accepted auditing standards. The auditor's report must be unqualified.</P> <P>(6) <E T="03">Bond-financed projects.</E> A project qualifying under section 42(h)(4) is not entitled to any credit unless the governmental unit that issued the bonds (or on behalf of which the bonds were issued), or the Agency responsible for issuing the Form(s) 8609 to the project, makes determinations under rules similar to the rules in paragraphs (a) (3), (4), and (5) of this section.</P> <P>(b) <E T="03">Effective date.</E> This section is effective on January 1, 2001.</P> <CITA>[T.D. 8859, 65 FR 2329, Jan. 14, 2000]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.42A-1</SECTNO> <SUBJECT>General tax credit for taxable years ending after December 31, 1975, and before January 1, 1979.</SUBJECT> <P>(a)(1) <E T="03">Allowance of credit for taxable years ending after December 31, 1975, and beginning before January 1, 1977.</E> Subject to the special rules of paragraphs (b)(1), (c) and (d) and the limitation of paragraph (e)(1) of this section, an individual is allowed as a credit against the tax imposed by chapter 1 for the taxable year in the case of taxable years ending after December 31, 1975, and beginning before January 1, 1977, an amount equal to the greater of—</P> <P>(i) 2 percent of so much of the individual's taxable income as does not exceed $9,000, or</P> <P>(ii) $35 multiplied by the total number of deductions for personal exemptions to which the individual is entitled for the taxable year under section 151 (b) and (e) and the regulations thereunder (relating to allowance of deductions for personal exemptions with respect to the individual, the individual's spouse, and dependents).</P> <FP>For purposes of applying subdivision (ii) of this paragraph (a)(1), the total number of deductions for personal exemptions shall not include any additional exemptions to which the individual or his spouse may be entitled based upon age of 65 or more or blindness under section 151 (c) or (d) and the regulations thereunder.y</FP> <P>(2) <E T="03">Allowance of credit for taxable years beginning after December 31, 1976, and ending before January 1, 1979.</E> Subject to the special rules of paragraphs (b)(2), (c) and (d) and the limitation of paragraph (e)(2) of this section, an individual is allowed as a credit against the tax imposed by section 1, or against the tax imposed in lieu of the tax imposed by section 1, for the taxable year in the case of taxable years beginning after December 31, 1976, and ending before January 1, 1979, an amount equal to the greater of—</P> <P>(i) 2 percent of so much of the individual's taxable income for the taxable year, reduced by the zero bracket amount determined under section 63 (d), as does not exceed $9,000, or</P> <P>(ii) $35 multiplied by the total number of deductions for personal exemptions to which the individual is entitled for the taxable year under section 151 and the regulations thereunder (relating to allowance of deductions for personal exemptions).</P> <P>(b) <E T="03">Married individuals filing separate returns—</E>(1) <E T="03">For taxable years ending after December 31, 1975, and beginning before January 1, 1977.</E> In the case of taxable years ending after December 31, 1975, and beginning before January 1, 1977, a married individual who files a separate return for the taxable year is allowed as a credit for the taxable year an amount equal to either—</P> <P>(i) 2 percent of so much of the individual's taxable income as does not exceed $4,500, or</P> <P>(ii) $35 multiplied by the total number of deductions for personal exemptions to which the individual is entitled for the taxable year under section 151 (b) and (e) and the regulations thereunder, but only if both the individual and the individual's spouse elect to have the credit determined in the manner described in this subdivision (ii) for their corresponding taxable years. The elections shall be made by both married individuals separately calculating and claiming the credit in the manner and amount described in this subdivision (ii) on their separate returns for their corresponding taxable years. The rules of section 142 (a) and the regulations thereunder (relating to individuals not eligible for the standard deduction) in effect for taxable years beginning before January 1, 1977, apply to determine whether the taxable <PRTPAGE P="180"/>years of the individual and the individual's spouse correspond to each other. For purposes of applying this subdivision (ii), the total number of deductions for personal exemptions shall not include any additional exemptions to which the individual may be entitled based upon age of 65 or more or blindness under section 151 (c) or (d) and the regulations thereunder.</P> <P>(2) <E T="03">For taxable years beginning after December 31, 1976, and ending before January 1, 1979.</E> In the case of taxable years beginning after December 31, 1976, and ending before January 1, 1979, a married individual who files a separate return for the taxable year shall determine the amount of the credit for the taxable year under section 42(a)(2) and § 1.42A-1(a)(2)(ii).</P> <P>(3) <E T="03">Determination of marital status.</E> For purposes of this paragraph, the determination of marital status shall be made as provided by section 143 and the regulations thereunder (relating to the determination of marital status).</P> <P>(c) <E T="03">Return for short period on change of annual accounting period.</E> In computing the credit provided by section 42 and this section for a period of less than 12 months (hereinafter referred to as a “short period”), where income is to be annualized under section 443(b)(1) in order to determine the tax—</P> <P>(1) The credit allowed by paragraphs (a) (1)(i) and (2)(i) of this section shall be computed based upon the amount of the taxable income annualized under the rules of section 443(b)(1) and § 1.443-1(b)(1), or</P> <P>(2)(i) The credit allowed by paragraph (a)(1)(ii) of this section shall be computed based upon the total number of deductions for personal exemptions to which the individual is entitled for the short period under section 151 (b) and (e) and the regulations thereunder (relating to allowance of deductions for personal exemptions with respect to the individual, the individual's spouse, and dependents), and</P> <P>(ii) The credit allowed by paragraph (a)(2)(ii) of this section shall be computed based upon the total number of deductions for personal exemptions to which the individual is entitled for the short period under section 151 and the regulations thereunder (relating to allowance of deductions for personal exemptions).</P> <FP>As so computed, the credit allowed by section 42 and this section shall be allowed against the tax computed on the basis of the annualized taxable income. See § 1.443-1(b)(1)(vi).</FP> <P>(d) <E T="03">Certain persons not eligible—</E>(1) <E T="03">Estates and trusts.</E> The credit provided by section 42 and this section shall not be allowed in the case of any estate or trust. Thus, the credit shall not be allowed to an estate of an individual in bankruptcy or to an estate of a deceased individual. However, in the case of a deceased individual, the credit shall be allowed on the decedent's final return filed by his executor or other representative. Also, the credit provided by section 42 and this section shall be allowed in the case of a return filed by an estate of an infant, incompetent, or an individual under a disability.</P> <P>(2) <E T="03">Nonresident alien individuals.</E> The credit provided by section 42 and this section shall not be allowed in the case of any nonresident alien individual. As used in this subparagraph, the term “nonresident alien individual” has the meaning provided by § 1.871-2. See, however, section 6013(g) for election to treat nonresident alien individual as resident of the United States. The credit shall be allowed to an alien individual who is a resident of the United States for part of the taxable year. See § 1.871-2(b) for rules relating to the determination of residence of an alien individual. For purposes of paragraphs (a) (1)(i) and (2)(i) of this section, the credit allowed shall be computed by taking into account only that portion of the individual's taxable income which is attributable to the period of his residence in the United States. For purposes of paragraph (a)(1)(ii) of this section, the credit allowed shall be computed by taking into account only the total number of deductions for personal exemptions to which the individual is entitled under section 151 (b) and (e) for the period of his residence in the United States. For purposes of paragraph (a)(2)(ii) of this section, the credit allowed shall be computed by taking into account only the total <PRTPAGE P="181"/>number of deductions for personal exemptions to which the individual is entitled under section 151 for the period of his residence in the United States. See § 1.871-13 for rules relating to changes of residence status during a taxable year.</P> <P>(e) <E T="03">Limitation</E>—(1) <E T="03">For taxable years ending after December 31, 1975, and beginning before January 1, 1977.</E> For taxable years ending after December 31, 1975, and beginning before January 1, 1977, the credit allowed by section 42 and this section shall not exceed the amount of tax imposed by chapter 1 for the taxable year. In the case of an alien individual who is a resident of the United States for a part of the taxable year, the credit allowed by section 42 and this section shall not exceed the amount of tax imposed by chapter 1 for that portion of the taxable year during which the alien individual was a resident of the United States. See § 1.871-13.</P> <P>(2) <E T="03">For taxable years beginning after December 31, 1976, and ending before January 1, 1979.</E> For taxable years beginning after December 31, 1976, and ending before January 1, 1979, the credit allowed by section 42 and this section shall not exceed the amount of tax imposed by section 1, or the amount of tax imposed in lieu of the tax imposed by section 1, for the taxable year. In the case of an alien individual who is a resident of the United States for a part of the taxable year, the credit allowed by section 42 and this section shall not exceed the amount of tax imposed by section 1, or the amount of tax imposed in lieu of the tax imposed by section 1, for that portion of the taxable year during which the alien individual was a resident of the United States. See § 1.871-13.</P> <P>(f) <E T="03">Application with other credits.</E> In determining the credits allowed under—</P> <P>(1) Section 33 (relating to foreign tax credit),</P> <P>(2) Section 37 (relating to credit for the elderly),</P> <P>(3) Section 38 (relating to investment in certain depreciable property),</P> <P>(4) Section 40 (relating to expenses of work incentive programs), and</P> <P>(5) Section 41 (relating to contributions to candidates for public office),</P> <FP>the tax imposed for the taxable year shall first be reduced (before any other reduction) by the credit allowed by section 42 and this section for the taxable year.</FP> <P>(g) <E T="03">Income tax tables to reflect credit.</E> The tables prescribed under section 3 shall reflect the credit allowed by section 42 and this section.</P> <P>(h) <E T="03">Effective dates.</E> The credit allowed by section 42 and this section applies only for taxable years ending after December 31, 1975, and before January 1, 1979.</P> <CITA>[T.D. 7547, 43 FR 19653, May 8, 1978]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-0</SECTNO> <SUBJECT>Table of contents.</SUBJECT> <P>This section lists the captions contained in §§ 1.43-0 through 1.43-7.</P> <EXTRACT> <HD SOURCE="HD2">§ 1.43-1The enhanced oil recovery credit—general rules.</HD> <FP SOURCE="FP-1">(a) Claiming the credit.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Examples.</FP> <FP SOURCE="FP-1">(b) Amount of the credit.</FP> <FP SOURCE="FP-1">(c) Phase-out of the credit as crude oil prices increase.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Inflation adjustment.</FP> <FP SOURCE="FP1-2">(3) Examples.</FP> <FP SOURCE="FP-1">(d) Reduction of associated deductions.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Certain deductions by an integrated oil company.</FP> <FP SOURCE="FP-1">(e) Basis adjustment.</FP> <FP SOURCE="FP-1">(f) Passthrough entity basis adjustment.</FP> <FP SOURCE="FP1-2">(1) Partners’ interests in a partnership.</FP> <FP SOURCE="FP1-2">(2) Shareholders’ stock in an S corporation.</FP> <FP SOURCE="FP-1">(g) Examples.</FP> <HD SOURCE="HD2">§ 1.43-2Qualified enhanced oil recovery project.</HD> <FP SOURCE="FP-1">(a) Qualified enhanced oil recovery project.</FP> <FP SOURCE="FP-1">(b) More than insignificant increase.</FP> <FP SOURCE="FP-1">(c) First injection of liquids, gases, or other matter.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Example.</FP> <FP SOURCE="FP-1">(d) Significant expansion exception.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Substantially unaffected reservoir volume.</FP> <FP SOURCE="FP1-2">(3) Terminated projects.</FP> <FP SOURCE="FP1-2">(4) Change in tertiary recovery method.</FP> <FP SOURCE="FP1-2">(5) Examples.</FP> <FP SOURCE="FP-1">(e) Qualified tertiary recovery methods.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Tertiary recovery methods that qualify.</FP> <FP SOURCE="FP1-2">(3) Recovery methods that do not qualify.</FP> <FP SOURCE="FP1-2">(4) Examples.<PRTPAGE P="182"/> </FP> <HD SOURCE="HD2">§ 1.43-3Certification.</HD> <FP SOURCE="FP-1">(a) Petroleum engineer's certification of a project.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Timing of certification.</FP> <FP SOURCE="FP1-2">(3) Content of certification.</FP> <FP SOURCE="FP-1">(b) Operator's continued certification of a project.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Timing of certification.</FP> <FP SOURCE="FP1-2">(3) Content of certification.</FP> <FP SOURCE="FP-1">(c) Notice of project termination.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Timing of notice.</FP> <FP SOURCE="FP1-2">(3) Content of notice.</FP> <FP SOURCE="FP-1">(d) Failure to submit certification.</FP> <FP SOURCE="FP-1">(e) Effective date.</FP> <HD SOURCE="HD2">§ 1.43-4Qualified enhanced oil recovery costs.</HD> <FP SOURCE="FP-1">(a) Qualifying costs.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Costs paid or incurred for an asset which is used to implement more than one qualified enhanced oil recovery project or for other activities.</FP> <FP SOURCE="FP-1">(b) Costs defined.</FP> <FP SOURCE="FP1-2">(1) Qualified tertiary injectant expenses.</FP> <FP SOURCE="FP1-2">(2) Intangible drilling and development costs.</FP> <FP SOURCE="FP1-2">(3) Tangible property costs.</FP> <FP SOURCE="FP1-2">(4) Examples.</FP> <FP SOURCE="FP-1">(c) Primary purpose.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Tertiary injectant costs.</FP> <FP SOURCE="FP1-2">(3) Intangible drilling and development costs.</FP> <FP SOURCE="FP1-2">(4) Tangible property costs.</FP> <FP SOURCE="FP1-2">(5) Offshore drilling platforms.</FP> <FP SOURCE="FP1-2">(6) Examples.</FP> <FP SOURCE="FP-1">(d) Costs paid or incurred prior to first injection.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) First injection after filing of return for taxable year costs are allowable.</FP> <FP SOURCE="FP1-2">(3) First injection more than 36 months after close of taxable year costs are paid or incurred.</FP> <FP SOURCE="FP1-2">(4) Injections in volumes less than the volumes specified in the project plan.</FP> <FP SOURCE="FP1-2">(5) Examples.</FP> <FP SOURCE="FP-1">(e) Other rules.</FP> <FP SOURCE="FP1-2">(1) Anti-abuse rule.</FP> <FP SOURCE="FP1-2">(2) Costs paid or incurred to acquire a project.</FP> <FP SOURCE="FP1-2">(3) Examples.</FP> <HD SOURCE="HD2">§ 1.43-5At-risk limitation.</HD> <HD SOURCE="HD2">§ 1.43-6Election out of section 43.</HD> <FP SOURCE="FP-1">(a) Election to have the credit not apply.</FP> <FP SOURCE="FP1-2">(1) In general.</FP> <FP SOURCE="FP1-2">(2) Time for making the election.</FP> <FP SOURCE="FP1-2">(3) Manner of making the election.</FP> <FP SOURCE="FP-1">(b) Election by partnerships and S corporations.</FP> <HD SOURCE="HD2">§ 1.43-7Effective date of regulations.</HD> </EXTRACT> <CITA>[T.D. 8448, 57 FR 54923, Nov. 23, 1992]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-1</SECTNO> <SUBJECT>The enhanced oil recovery credit—general rules.</SUBJECT> <P>(a) <E T="03">Claiming the credit—</E>(1) <E T="03">In general.</E> The enhanced oil recovery credit (the “credit”) is a component of the section 38 general business credit. A taxpayer that owns an operating mineral interest (as defined in § 1.614-2(b)) in a property may claim the credit for qualified enhanced oil recovery costs (as described in § 1.43-4) paid or incurred by the taxpayer in connection with a qualified enhanced oil recovery project (as described in § 1.43-2) undertaken with respect to the property. A taxpayer that does not own an operating mineral interest in a property may not claim the credit. To the extent a credit included in the current year business credit under section 38(b) is unused under section 38, the credit is carried back or forward under the section 39 business credit carryback and carryforward rules.</P> <P>(2) <E T="03">Examples.</E> The following examples illustrate the principles of this paragraph (a). </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Credit for operating mineral interest owner. In 1992, A, the owner of an operating mineral interest in a property, begins a qualified enhanced oil recovery project using cyclic steam. B, who owns no interest in the property, purchases and places in service a steam generator. B sells A steam, which A uses as a tertiary injectant described in section 193. Because A owns an operating mineral interest in the property with respect to which the project is undertaken, A may claim a credit for the cost of the steam. Although B owns the steam generator used to produce steam for the project, B may not claim a credit for B's costs because B does not own an operating mineral interest in the property.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Credit for operating mineral interest owner. C and D are partners in CD, a partnership that owns an operating mineral interest in a property. In 1992, CD begins a qualified enhanced oil recovery project using cyclic steam. D purchases a steam generator and sells steam to CD. Because CD owns an operating mineral interest in the property with respect to which the project is undertaken, CD may claim a credit for the cost of the steam. Although D owns the steam generator used to produce steam for the project, D may not claim a credit for the costs of the steam generator because D paid these costs <PRTPAGE P="183"/>in a capacity other than that of an operating mineral interest owner.</P> </EXAMPLE> <P>(b) <E T="03">Amount of the credit.</E> A taxpayer's credit is an amount equal to 15 percent of the taxpayer's qualified enhanced oil recovery costs for the taxable year, reduced by the phase-out amount, if any, determined under paragraph (c) of this section.</P> <P>(c) <E T="03">Phase-out of the credit as crude oil prices increase—</E>(1) <E T="03">In general.</E> The amount of the credit (determined without regard to this paragraph (c)) for any taxable year is reduced by an amount which bears the same ratio to the amount of the credit (determined without regard to this paragraph (c)) as—</P> <P>(i) The amount by which the reference price determined under section 29(d)(2)(C) for the calendar year immediately preceding the calendar year in which the taxable year begins exceeds $28 (as adjusted under paragraph (c)(2) of this section); bears to</P> <P>(ii) $6.</P> <P>(2) <E T="03">Inflation adjustment</E>—(i) <E T="03">In general.</E> For any taxable year beginning in a calendar year after 1991, an amount equal to $28 multiplied by the inflation adjustment factor is substituted for the $28 amount under paragraph (c)(1)(i) of this section.</P> <P>(ii) <E T="03">Inflation adjustment factor.</E> For purposes of this paragraph (c), the inflation adjustment factor for any calendar year is a fraction, the numerator of which is the GNP implicit price deflator for the preceding calendar year and the denominator of which is the GNP implicit price deflator for 1990. The “GNP implicit price deflator” is the first revision of the implicit price deflator for the gross national product as computed and published by the Secretary of Commerce. As early as practicable, the inflation adjustment factor for each calendar year will be published by the Internal Revenue Service in the Internal Revenue Bulletin.</P> <P>(3) <E T="03">Examples.</E> The following examples illustrate the principles of this paragraph (c). </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Reference price exceeds $28. In 1992, E, the owner of an operating mineral interest in a property, incurs $100 of qualified enhanced oil recovery costs. The reference price for 1991 determined under section 29(d)(2)(C) is $30 and the inflation adjustment factor for 1992 is 1. E's credit for 1992 determined without regard to the phase-out for crude oil price increases is $15 ($100 × 15%). In determining E's credit, the credit is reduced by $5 ($15 × ($30 − ($28 × 1))/6). Accordingly, E's credit for 1992 is $10 ($15 − $5).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Inflation adjustment. In 1993, F, the owner of an operating mineral interest in a property, incurs $100 of qualified enhanced oil recovery costs. The 1992 reference price is $34, and the 1993 inflation adjustment factor is 1.10. F's credit for 1993 determined without regard to the phase-out for crude oil price increases is $15 ($100 × 15%). In determining F's credit, $30.80 (1.10 × $28) is substituted for $28, and the credit is reduced by $8 ($15 × ($34 − $30.80)/6). Accordingly, F's credit for 1993 is $7 ($15 − $8).</P> </EXAMPLE> <P>(d) <E T="03">Reduction of associated deductions—</E>(1) <E T="03">In general.</E> Any deduction allowable under chapter 1 for an expenditure taken into account in computing the amount of the credit determined under paragraph (b) of this section is reduced by the amount of the credit attributable to the expenditure.</P> <P>(2) <E T="03">Certain deductions by an integrated oil company.</E> For purposes of determining the intangible drilling and development costs that an integrated oil company must capitalize under section 291(b), the amount allowable as a deduction under section 263(c) is the deduction allowable after paragraph (d)(1) of this section is applied. See § 1.43-4(b)(2) (extent to which integrated oil company intangible drilling and development costs are qualified enhanced oil recovery costs).</P> <P>(e) <E T="03">Basis adjustment.</E> For purposes of subtitle A, the increase in the basis of property which would (but for this paragraph (e)) result from an expenditure with respect to the property is reduced by the amount of the credit determined under paragraph (b) of this section attributable to the expenditure.</P> <P>(f) <E T="03">Passthrough entity basis adjustment</E>—(1) <E T="03">Partners’ interests in a partnership.</E> To the extent a partnership expenditure is not deductible under paragraph (d)(1) of this section or does not increase the basis of property under paragraph (e) of this section, the expenditure is treated as an expenditure described in section 705(a)(2)(B) (concerning decreases to basis of partnership interests). Thus, <PRTPAGE P="184"/>the adjusted bases of the partners’ interests in the partnership are decreased (but not below zero).</P> <P>(2) <E T="03">Shareholders’ stock in an S corporation.</E> To the extent an S corporation expenditure is not deductible under paragraph (d)(1) of this section or does not increase the basis of property under paragraph (e) of this section, the expenditure is treated as an expenditure described in section 1367(a)(2)(D) (concerning decreases to basis of S corporation stock). Thus, the bases of the shareholders’ S corporation stock are decreased (but not below zero).</P> <P>(g) <E T="03">Examples.</E> The following examples illustrate the principles of paragraphs (d) through (f) of this section. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Deductions reduced for credit amount. In 1992, G, the owner of an operating mineral interest in a property, incurs $100 of intangible drilling and development costs in connection with a qualified enhanced oil recovery project undertaken with respect to the property. G elects under section 263(c) to deduct these intangible drilling and development costs. The amount of the credit determined under paragraph (b) of this section attributable to the $100 of intangible drilling and development costs is $15 ($100 × 15%). Therefore, G's otherwise allowable deduction of $100 for the intangible drilling and development costs is reduced by $15. Accordingly, in 1992, G may deduct under section 263(c) only $85 ($100 − $15) for these costs.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Integrated oil company deduction reduced. The facts are the same as in <E T="03">Example 1,</E> except that G is an integrated oil company. As in <E T="03">Example 1,</E> the amount of the credit determined under paragraph (b) of this section attributable to the $100 of intangible drilling and development costs is $15, and G's allowable deduction under section 263(c) is $85. Because G is an integrated oil company, G must capitalize 25.50 ($85 × 30%) under section 291(b). Therefore, in 1992, G may deduct under section 263(c) only $59.50 ($85 − $25.50) for these intangible drilling and development costs.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>Basis of property reduced. In 1992, H, the owner of an operating mineral interest in a property, pays $100 to purchase tangible property that is an integral part of a qualified enhanced oil recovery project undertaken with respect to the property. The amount of the credit determined under paragraph (b) of this section attributable to the $100 is $15 ($100 × 15%). Therefore, for purposes of subtitle A, H's basis in the tangible property is $85 ($100 − $15).</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>Basis of interest in passthrough entity reduced. In 1992, I is a $50% partner in IJ, a partnership that owns an operating mineral interest in a property. IJ pays $200 to purchase tangible property that is an integral part of a qualified enhanced oil recovery project undertaken with respect to the property. The amount of the credit determined under paragraph (b) of this section attributable to the $200 is $30 ($200 × 15%). Therefore, for purposes of subtitle A, IJ's basis in the tangible property is $170 ($200 − $30). Under paragraph (f) of this section, the amount of the purchase price that does not increase the basis of the property ($30) is treated as an expenditure described in section 705(a)(2)(B). Therefore, I's basis in the partnership interest is reduced by $15 (I's allocable share of the section 705(a)(2)(B) expenditure ($30 × 50%)).</P> </EXAMPLE> <CITA>[T.D. 8448, 57 FR 54923, Nov. 23, 1992; 58 FR 7987, Feb. 11, 1993]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-2</SECTNO> <SUBJECT>Qualified enhanced oil recovery project.</SUBJECT> <P>(a) <E T="03">Qualified enhanced oil recovery project.</E> A “qualified enhanced oil recovery project” is any project that meets all of the following requirements—</P> <P>(1) The project involves the application (in accordance with sound engineering principles) of one or more qualified tertiary recovery methods (as described in paragraph (e) of this section) that is reasonably expected to result in more than an insignificant increase in the amount of crude oil that ultimately will be recovered;</P> <P>(2) The project is located within the United States (within the meaning of section 638(1));</P> <P>(3) The first injection of liquids, gases, or other matter for the project (as described in paragraph (c) of this section) occurs after December 31, 1990; and</P> <P>(4) The project is certified under § 1.43-3.</P> <P>(b) <E T="03">More than insignificant increase.</E> For purposes of paragraph (a)(1) of this section, all the facts and circumstances determine whether the application of a tertiary recovery method can reasonably be expected to result in more than an insignificant increase in the amount of crude oil that ultimately will be recovered. Certain information submitted as part of a project certification is relevant to this determination. See § 1.43-3(a)(3)(i)(D). In no event is the application of a recovery method that merely accelerates the recovery of crude oil considered an application of one or more qualified tertiary recovery <PRTPAGE P="185"/>methods that can reasonably be expected to result in more than an insignificant increase in the amount of crude oil that ultimately will be recovered.</P> <P>(c) <E T="03">First injection of liquids, gases, or other matter</E>—(1) <E T="03">In general.</E> The “first injection of liquids, gases, or other matter” generally occurs on the date a tertiary injectant is first injected into the reservoir. The “first injection of liquids, gases, or other matter” does not include—</P> <P>(i) The injection into the reservoir of any liquids, gases, or other matter for the purpose of pretreating or preflushing the reservoir to enhance the efficiency of the tertiary recovery method; or</P> <P>(ii) Test or experimental injections.</P> <P>(2) <E T="03">Example.</E> The following example illustrates the principles of this paragraph (c). </P> <EXAMPLE> <HD SOURCE="HED">Example.</HD> <P>Injections to pretreat the reservoir. In 1989, A, the owner of an operating mineral interest in a property, began injecting water into the reservoir for the purpose of elevating reservoir pressure to obtain miscibility pressure to prepare for the injection of miscible gas in connection with an enhanced oil recovery project. In 1992, A obtains miscibility pressure in the reservoir and begins injecting miscible gas into the reservoir. The injection of miscible gas, rather than the injection of water, is the first injection of liquids, gases, or other matter into the reservoir for purposes of determining whether the first injection of liquids, gases, or other matter occurs after December 31, 1990.</P> </EXAMPLE> <P>(d) <E T="03">Significant expansion exception—</E>(1) <E T="03">In general.</E> If a project for which the first injection of liquids, gases, or other matter (within the meaning of paragraph (c)(1) of this section) occurred before January 1, 1991, is significantly expanded after December 31, 1990, the expansion is treated as a separate project for which the first injection of liquids, gases, or other matter occurs after December 31, 1990.</P> <P>(2) <E T="03">Substantially unaffected reservoir volume.</E> A project is considered significantly expanded if the injection of liquids, gases, or other matter after December 31, 1990, is reasonably expected to result in more than an insignificant increase in the amount of crude oil that ultimately will be recovered from reservoir volume that was substantially unaffected by the injection of liquids, gases, or other matter before January 1, 1991.</P> <P>(3) <E T="03">Terminated projects.</E> Except as otherwise provided in this paragraph (d)(3), a project is considered significantly expanded if each qualified tertiary recovery method implemented in the project prior to January 1, 1991, terminated more than 36 months before implementing an enhanced oil recovery project that commences after December 31, 1990. Notwithstanding the provisions of the preceding sentence, if a project implemented prior to January 1, 1991, is terminated for less than 36 months before implementing an enhanced oil recovery project that commences after December 31, 1990, a taxpayer may request permission to treat the project that commences after December 31, 1990, as a significant expansion. Permission will not be granted if the Internal Revenue Service determines that a project was terminated to make an otherwise nonqualifying project eligible for the credit. For purposes of section 43, a qualified tertiary recovery method terminates at the point in time when the method no longer results in more than an insignificant increase in the amount of crude oil that ultimately will be recovered. All the facts and circumstances determine whether a tertiary recovery method has terminated. Among the factors considered is the project plan, the unit plan of development, or other similar plan. A tertiary recovery method is not necessarily terminated merely because the injection of the tertiary injectant has ceased. For purposes of this paragraph (d)(1), a project is implemented when costs that will be taken into account in determining the credit with respect to the project are paid or incurred.</P> <P>(4) <E T="03">Change in tertiary recovery method.</E> If the application of a tertiary recovery method or methods with respect to an enhanced oil recovery project for which the first injection of liquids, gases, or other matter occurred before January 1, 1991, has not been terminated for more than 36 months, a taxpayer may request a private letter ruling from the Internal Revenue Service whether the <PRTPAGE P="186"/>application of a different tertiary recovery method or methods after December 31, 1990, that does not affect reservoir volume substantially unaffected by the previous tertiary recovery method or methods, is treated as a significant expansion. All the facts and circumstances determine whether a change in tertiary recovery method is treated as a significant expansion. Among the factors considered are whether the change in tertiary recovery method is in accordance with sound engineering principles and whether the change in method will result in more than an insignificant increase in the amount of crude oil that would be recovered using the previous method. A more intensive application of a tertiary recovery method after December 31, 1990, is not treated as a significant expansion.</P> <P>(5) <E T="03">Examples.</E> The following examples illustrate the principles of this paragraph (d). </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Substantially unaffected reservoir volume. In January 1988, B, the owner of an operating mineral interest in a property, began injecting steam into the reservoir in connection with a cyclic steam enhanced oil recovery project. The project affected only a portion of the reservoir volume. In 1992, B begins cyclic steam injections with respect to reservoir volume that was substantially unaffected by the previous cyclic steam project. Because the injection of steam into the reservoir in 1992 affects reservoir volume that was substantially unaffected by the previous cyclic steam injection, the cyclic steam injection in 1992 is treated as a separate project for which the first injection of liquids, gases, or other matter occurs after December 31, 1990.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Tertiary recovery method terminated more than 36 months. In 1982, C, the owner of an operating mineral interest in a property, implemented a tertiary recovery project using cyclic steam injection as a method for the recovery of crude oil. The project was certified as a tertiary recovery project for purposes of the windfall profit tax. In May 1988, the application of the cyclic steam tertiary recovery method terminated. In July 1992, C begins drilling injection wells as part of a project to apply the steam drive tertiary recovery method with respect to the same project area affected by the cyclic steam method. C begins steam injections in September 1992. Because C commences an enhanced oil recovery project more than 36 months after the previous tertiary recovery method was terminated, the project is treated as a separate project for which the first injection of liquids, gases, or other matter occurs after December 31, 1990.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>Change in tertiary recovery method affecting substantially unaffected reservoir volume. In 1984, D, the owner of an operating mineral interest in a property, implemented a tertiary recovery project using cyclic steam as a method for the recovery of crude oil. The project was certified as a tertiary recovery project for purposes of the windfall profit tax. D continued the cyclic steam injection until 1992, when the tertiary recovery method was changed from cyclic steam injection to steam drive. The steam drive affects reservoir volume that was substantially unaffected by the cyclic steam injection. Because the steam drive affects reservoir volume that was substantially unaffected by the cyclic steam injection, the steam drive is treated as a separate project for which the first injection of liquids, gases, or other matter occurs after December 31, 1990.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>Change in tertiary recovery method not affecting substantially unaffected reservoir volume. In 1988, E, the owner of an operating mineral interest in a property, undertook an immiscible nitrogen enhanced oil recovery project that resulted in more than an insignificant increase in the ultimate recovery of crude oil from the property. E continued the immiscible nitrogen project until 1992, when the project was converted from immiscible nitrogen displacement to miscible nitrogen displacement by increasing the injection of nitrogen to increase reservoir pressure. The miscible nitrogen displacement affects the same reservoir volume that was affected by the immiscible nitrogen displacement. Because the miscible nitrogen displacement does not affect reservoir volume that was substantially unaffected by the immiscible nitrogen displacement nor was the immiscible nitrogen displacement project terminated for more than 36 months before the miscible nitrogen displacement project was implemented, E must obtain a ruling whether the change from immiscible nitrogen displacement to miscible nitrogen displacement is treated as a separate project for which the first injection of liquids, gases, or other matter occurs after December 31, 1990. If E does not receive a ruling, the miscible nitrogen displacement project is not a qualified project.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>More intensive application of a tertiary recovery method. In 1989, F, the owner of an operating mineral interest in a property, undertook an immiscible carbon dioxide displacement enhanced oil recovery project. F began injecting carbon dioxide into the reservoir under immiscible conditions. The injection of carbon dioxide under immiscible conditions resulted in more than an insignificant increase in the ultimate recovery of crude oil from the property. F continues to inject the same amount of carbon <PRTPAGE P="187"/>dioxide into the reservoir until 1992, when new engineering studies indicate that an increase in the amount of carbon dioxide injected is reasonably expected to result in a more than insignificant increase in the amount of crude oil that would be recovered from the property as a result of the previous injection of carbon dioxide. The increase in the amount of carbon dioxide injected affects the same reservoir volume that was affected by the previous injection of carbon dioxide. Because the additional carbon dioxide injected in 1992 does not affect reservoir volume that was substantially unaffected by the previous injection of carbon dioxide and the previous immiscible carbon dioxide displacement method was not terminated for more than 36 months before additional carbon dioxide was injected, the increase in the amount of carbon dioxide injected into the reservoir is not a significant expansion. Therefore, it is not a separate project for which the first injection of liquids, gases, or other matter occurs after December 31, 1990.</P> </EXAMPLE> <P>(e) <E T="03">Qualified tertiary recovery methods—</E>(1) <E T="03">In general.</E> For purposes of paragraph (a)(1) of this section, a “qualified tertiary recovery method” is any one or any combination of the tertiary recovery methods described in paragraph (e)(2) of this section. To account for advances in enhanced oil recovery technology, the Internal Revenue Service may by revenue ruling prescribe that a method not described in paragraph (e)(2) of this section is a “qualified tertiary recovery method.” In addition, a taxpayer may request a private letter ruling that a method not described in paragraph (e)(2) of this section or in a revenue ruling is a qualified tertiary recovery method. Generally, the methods identified in revenue rulings or private letter rulings will be limited to those methods that involve the displacement of oil from the reservoir rock by means of modifying the properties of the fluids in the reservoir or providing the energy and drive mechanism to force the oil to flow to a production well. The recovery methods described in paragraph (e)(3) of this section are not “qualified tertiary recovery methods.”</P> <P>(2) <E T="03">Tertiary recovery methods that qualify—</E>(i) <E T="03">Thermal recovery methods—</E>(A) <E T="03">Steam drive injection.</E> The continuous injection of steam into one set of wells (injection wells) or other injection source to effect oil displacement toward and production from a second set of wells (production wells);</P> <P>(B) <E T="03">Cyclic steam injection—</E>The alternating injection of steam and production of oil with condensed steam from the same well or wells; and</P> <P>(C) <E T="03">In situ combustion.</E> The combustion of oil or fuel in the reservoir sustained by injection of air, oxygen-enriched air, oxygen, or supplemental fuel supplied from the surface to displace unburned oil toward producing wells. This process may include the concurrent, alternating, or subsequent injection of water.</P> <P>(ii) <E T="03">Gas Flood recovery methods—</E>(A) <E T="03">Miscible fluid displacement.</E> The injection of gas (<E T="03">e.g.,</E> natural gas, enriched natural gas, a liquified petroleum slug driven by natural gas, carbon dioxide, nitrogen, or flue gas) or alcohol into the reservoir at pressure levels such that the gas or alcohol and reservoir oil are miscible;</P> <P>(B) <E T="03">Carbon dioxide augmented waterflooding.</E> The injection of carbonated water, or water and carbon dioxide, to increase waterflood efficiency;</P> <P>(C) <E T="03">Immiscible carbon dioxide displacement.</E> The injection of carbon dioxide into an oil reservoir to effect oil displacement under conditions in which miscibility with reservoir oil is not obtained. This process may include the concurrent, alternating, or subsequent injection of water; and</P> <P>(D) <E T="03">Immiscible nonhydrocarbon gas displacement.</E> The injection of nonhydrocarbon gas (<E T="03">e.g.,</E> nitrogen) into an oil reservoir, under conditions in which miscibility with reservoir oil is not obtained, to obtain a chemical or physical reaction (other than pressure) between the oil and the injected gas or between the oil and other reservoir fluids. This process may include the concurrent, alternating, or subsequent injection of water.</P> <P>(iii) <E T="03">Chemical flood recovery methods</E>—(A) <E T="03">Microemulsion flooding.</E> The injection of a surfactant system <E T="03">(e.g.,</E> a surfactant, hydrocarbon, cosurfactant, electrolyte, and water) to enhance the displacement of oil toward producing wells; and</P> <P>(B) <E T="03">Caustic flooding</E>—The injection of water that has been made chemically basic by the addition of alkali metal <PRTPAGE P="188"/>hydroxides, silicates, or other chemicals.</P> <P>(iv) <E T="03">Mobility control recovery method—Polymer augmented waterflooding.</E> The injection of polymeric additives with water to improve the areal and vertical sweep efficiency of the reservoir by increasing the viscosity and decreasing the mobility of the water injected. Polymer augmented waterflooding does not include the injection of polymers for the purpose of modifying the injection profile of the wellbore or the relative permeability of various layers of the reservoir, rather than modifying the water-oil mobility ratio.</P> <P>(3) <E T="03">Recovery methods that do not qualify.</E> The term “qualified tertiary recovery method” does not include—</P> <P>(i) Waterflooding—The injection of water into an oil reservoir to displace oil from the reservoir rock and into the bore of the producing well;</P> <P>(ii) Cyclic gas injection—The increase or maintenance of pressure by injection of hydrocarbon gas into the reservoir from which it was originally produced;</P> <P>(iii) Horizontal drilling—The drilling of horizontal, rather than vertical, wells to penetrate hydrocarbon bearing formations;</P> <P>(iv) Gravity drainage—The production of oil by gravity flow from drainholes that are drilled from a shaft or tunnel dug within or below the oil bearing zones; and</P> <P>(v) Other methods—Any recovery method not specifically designated as a qualified tertiary recovery method in either paragraph (e)(2) of this section or in a revenue ruling or private letter ruling described in paragraph (e)(1) of this section.</P> <P>(4) <E T="03">Examples.</E> The following examples illustrate the principles of this paragraph (e). </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P> <E T="03">Polymer augmented waterflooding.</E> In 1992 G, the owner of an operating mineral interest in a property, begins a waterflood project with respect to the property. To reduce the relative permeability in certain areas of the reservoir and minimize water coning, G injects polymers to plug thief zones and improve the areal and vertical sweep efficiency of the reservoir. The injection of polymers into the reservoir does not modify the water-oil mobility ratio. Accordingly, the injection of polymers into the reservoir in connection with the waterflood project does not constitute polymer augmented waterflooding and the project is not a qualified enhanced oil recovery project.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P> <E T="03">Polymer augmented waterflooding.</E> In 1993 H, the owner of an operating mineral interest in a property, begins a caustic flooding project with respect to the property. Engineering studies indicate that the relative permeability of various layers of the reservoir may result in the loss of the injectant to thief zones, thereby reducing the areal and vertical sweep efficiency of the reservoir. As part of the caustic flooding project, H injects polymers to plug the thief zones and improve the areal and vertical sweep efficiency of the reservoir. Because the polymers are injected into the reservoir to improve the effectiveness of the caustic flooding project, the project is a qualified enhanced oil recovery project.</P> </EXAMPLE> <CITA>[T.D. 8448, 57 FR 54925, Nov. 23, 1992; 58 FR 6678, Feb. 1, 1993]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-3</SECTNO> <SUBJECT>Certification</SUBJECT> <P>(a) <E T="03">Petroleum engineer's certification of a project—</E>(1) <E T="03">In general.</E> A petroleum engineer must certify, under penalties of perjury, that an enhanced oil recovery project meets the requirements of section 43(c)(2)(A). A petroleum engineer's certification must be submitted for each project. The petroleum engineer certifying a project must be duly registered or certified in any State.</P> <P>(2) <E T="03">Timing of certification.</E> The operator of an enhanced oil recovery project or any other operating mineral interest owner designated by the operator (“designated owner”) must submit a petroleum engineer's certification to the Internal Revenue Service Center, Austin, Texas, or such other place as may be designated by revenue procedure or other published guidance, not later than the last date prescribed by law (including extensions) for filing the operator's or designated owner's federal income tax return for the first taxable year for which the enhanced oil recovery credit (the “credit”) is allowable. The operator may designate any other operating mineral interest owner (the “designated owner”) to file the petroleum engineer's certification.</P> <P>(3) <E T="03">Content of certification</E>—(i) <E T="03">In general.</E> A petroleum engineer's certification must contain the following information—</P> <P>(A) The name and taxpayer identification number of the operator or the <PRTPAGE P="189"/>designated owner submitting the certification;</P> <P>(B) A statement identifying the project, including its geographic location;</P> <P>(C) A statement that the project involves a tertiary recovery method (as defined in section 43(c)(2)(A)(i)) and a description of the process used, including—</P> <P>(<E T="03">1</E>) A description of the implementation and operation of the project sufficient to establish that it is implemented and operated in accordance with sound engineering practices;</P> <P>(<E T="03">2</E>) If the project involves the application of a tertiary recovery method approved in a private letter ruling described in paragraph (e)(1) of § 1.43-2, a copy of the private letter ruling, and</P> <P>(<E T="03">3</E>) The date on which the first injection of liquids, gases, or other matter occurred or is expected to occur.</P> <P>(D) A statement that the application of a qualified tertiary recovery method or methods is expected to result in more than an insignificant increase in the amount of crude oil that ultimately will be recovered, including—</P> <P>(<E T="03">1</E>) Data on crude oil reserve estimates covering the project area with and without the enhanced oil recovery process,</P> <P>(<E T="03">2</E>) Production history prior to implementation of the project and estimates of production after implementation of the project, and</P> <P>(<E T="03">3</E>) An adequate delineation of the reservoir, or portion of the reservoir, from which the ultimate recovery of crude oil is expected to be increased as a result of the implementation and operation of the project; and</P> <P>(E) A statement that the petroleum engineer believes that the project is a qualified enhanced oil recovery project within the meaning of section 43(c)(2)(A).</P> <P>(ii) <E T="03">Additional information for significantly expanded projects.</E> The petroleum engineer's certification for a project that is significantly expanded must in addition contain—</P> <P>(A) If the expansion affects reservoir volume that was substantially unaffected by a previously implemented project, an adequate delineation of the reservoir volume affected by the previously implemented project;</P> <P>(B) If the expansion involves the implementation of an enhanced oil recovery project more than 36 months after the termination of a qualified tertiary recovery method that was applied before January 1, 1991, the date on which the previous tertiary recovery method terminated and an explanation of the data or assumptions relied upon to determine the termination date;</P> <P>(C) If the expansion involves the implementation of an enhanced oil recovery project less than 36 months after the termination of a qualified tertiary recovery method that was applied before January 1, 1991, a copy of a private letter ruling from the Internal Revenue Service that the project implemented after December 31, 1990 is treated as a significant expansion; or</P> <P>(D) If the expansion involves the application after December 31, 1990, of a tertiary recovery method or methods that do not affect reservoir volume that was substantially unaffected by the application of a different tertiary recovery method or methods before January 1, 1991, a copy of a private letter ruling from the Internal Revenue Service that the change in tertiary recovery method is treated as a significant expansion.</P> <P>(b) <E T="03">Operator's continued certification of a project</E>—(1) <E T="03">In general.</E> For each taxable year following the taxable year for which the petroleum engineer's certification is submitted, the operator or designated owner must certify, under penalties of perjury, that an enhanced oil recovery project continues to be implemented substantially in accordance with the petroleum engineer's certification submitted for the project. An operator's certification must be submitted for each project.</P> <P>(2) <E T="03">Timing of certification.</E> The operator or designated owner of an enhanced oil recovery project must submit an operator's certification to the Internal Revenue Service Center, Austin, Texas, or such other place as may be designated by revenue procedure or other published guidance, not later than the last date prescribed by law (including extensions) for filing the operator's or designated owner's federal income tax return for any taxable year <PRTPAGE P="190"/>after the taxable year for which the petroleum engineer's certification is filed.</P> <P>(3) <E T="03">Content of certification.</E> An operator's certification must contain the following information—</P> <P>(i) The name and taxpayer identification number of the operator or the designated owner submitting the certification;</P> <P>(ii) A statement identifying the project including its geographic location and the date on which the petroleum engineer's certification was filed;</P> <P>(iii) A statement that the project continues to be implemented substantially in accordance with the petroleum engineer's certification (as described in paragraph (a) of this section) submitted for the project; and</P> <P>(iv) A description of any significant change or anticipated change in the information submitted under paragraph (a)(3) of this section, including a change in the date on which the first injection of liquids, gases, or other matter occurred or is expected to occur.</P> <P>(c) <E T="03">Notice of project termination</E>—(1) <E T="03">In general.</E> If the application of a tertiary recovery method is terminated, the operator or designated owner must submit a notice of project termination to the Internal Revenue Service.</P> <P>(2) <E T="03">Timing of notice.</E> The operator or designated owner of an enhanced oil recovery project must submit the notice of project termination to the Internal Revenue Service Center, Austin, Texas, or such other place as may be designated by revenue procedure or other published guidance, not later than the last date prescribed by law (including extensions) for filing the operator's or designated owner's federal income tax return for the taxable year in which the project terminates.</P> <P>(3) <E T="03">Content of notice.</E> A notice of project termination must contain the following information—</P> <P>(i) The name and taxpayer identification number of the operator or the designated owner submitting the notice;</P> <P>(ii) A statement identifying the project including its geographic location and the date on which the petroleum engineer's certification was filed; and</P> <P>(iii) The date on which the application of the tertiary recovery method was terminated.</P> <P>(d) <E T="03">Failure to submit certification.</E> If a petroleum engineer's certification (as described in paragraph (a) of this section) or an operator's certification (as described in paragraph (b) of this section) is not submitted in the time or manner prescribed by this section, the credit will be allowed only after the appropriate certifications are submitted.</P> <CITA>[T.D. 8384, 56 FR 67177, Dec. 30, 1991; 57 FR 6074, Feb. 20, 1992; 57 FR 6353, Feb. 24, 1992. Redesignated and amended by T.D. 8448, 57 FR 54927, Nov. 23, 1992]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-4</SECTNO> <SUBJECT>Qualified enhanced oil recovery costs.</SUBJECT> <P>(a) <E T="03">Qualifying costs</E>—(1) <E T="03">In general.</E> Except as provided in paragraph (e) of this section, amounts paid or incurred in any taxable year beginning after December 31, 1990, that are qualified tertiary injectant expenses (as described in paragraph (b)(1) of this section), intangible drilling and development costs (as described in paragraph (b)(2) of this section), and tangible property costs (as described in paragraph (b)(3) of this section) are “qualified enhanced oil recovery costs” if the amounts are paid or incurred with respect to an asset which is used for the primary purpose (as described in paragraph (c) of this section) of implementing an enhanced oil recovery project. Any amount paid or incurred in any taxable year beginning before January 1, 1991, in connection with an enhanced oil recovery project is not a qualified enhanced oil recovery cost.</P> <P>(2) <E T="03">Costs paid or incurred for an asset which is used to implement more than one qualified enhanced oil recovery project or for other activities.</E> Any cost paid or incurred during the taxable year for an asset which is used to implement more than one qualified enhanced oil recovery project is allocated among the projects in determining the qualified enhanced oil recovery costs for each qualified project for the taxable year. Similarly, any cost paid or incurred during the taxable year for an asset which is used to implement a qualified enhanced oil recovery project and which is also used for other activities (for example, an enhanced oil recovery <PRTPAGE P="191"/>project that is not a qualified enhanced oil recovery project) is allocated among the qualified enhanced oil recovery project and the other activities to determine the qualified enhanced oil recovery costs for the taxable year. See § 1.613-5(a). Any cost paid or incurred for an asset which is used to implement a qualified enhanced oil recovery project and which is also used for other activities is not required to be allocated under this paragraph (a)(2) if the use of the property for nonqualifying activities is <E T="03">de minimis</E> (<E T="03">e.g.,</E> not greater than 10%). Costs are allocated under this paragraph (a)(2) only if the asset with respect to which the costs are paid or incurred is used for the primary purpose of implementing an enhanced oil recovery project. <E T="03">See</E> paragraph (c) of this section. Any reasonable allocation method may be used. A method that allocates costs based on the anticipated use in a project or activity is a reasonable method.</P> <P>(b) <E T="03">Costs defined</E>—(1) <E T="03">Qualified tertiary injectant expenses.</E> For purposes of this section, “qualified tertiary injectant expenses” means any costs that are paid or incurred in connection with a qualified enhanced oil recovery project and that are deductible under section 193 for the taxable year. <E T="03">See</E> section 193 and § 1.193-1. Qualified tertiary injectant expenses are taken into account in determining the credit with respect to the taxable year in which the tertiary injectant expenses are deductible under section 193.</P> <P>(2) <E T="03">Intangible drilling and development costs.</E> For purposes of this section, “intangible drilling and development costs” means any intangible drilling and development costs that are paid or incurred in connection with a qualified enhanced oil recovery project and for which the taxpayer may make an election under section 263(c) for the taxable year. Intangible drilling and development costs are taken into account in determining the credit with respect to the taxable year in which the taxpayer may deduct the intangible drilling and development costs under section 263(c). For purposes of this paragraph (b)(2), the amount of the intangible drilling and development costs for which an integrated oil company may make an election under section 263(c) is determined without regard to section 291(b).</P> <P>(3) <E T="03">Tangible property costs—</E>(i) <E T="03">In general.</E> For purposes of this section, “tangible property costs” means an amount paid or incurred during a taxable year for tangible property that is an integral part of a qualified enhanced oil recovery project and that is depreciable or amortizable under chapter 1. An amount paid or incurred for tangible property is taken into account in determining the credit with respect to the taxable year in which the cost is paid or incurred.</P> <P>(ii) <E T="03">Integral part.</E> For purposes of this paragraph (b), tangible property is an integral part of a qualified enhanced oil recovery project if the property is used directly in the project and is essential to the completeness of the project. All the facts and circumstances determine whether tangible property is used directly in a qualified enhanced oil recovery project and is essential to the completeness of the project. Generally, property used to acquire or produce the tertiary injectant or property used to transport the tertiary injectant to a project site is property that is an integral part of the project.</P> <P>(4) <E T="03">Examples.</E> The following examples illustrate the principles of this paragraph (b). Assume for each of these examples that the qualified enhanced oil recovery costs are paid or incurred with respect to an asset which is used for the primary purpose of implementing an enhanced oil recovery project. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Qualified costs—in general. (i) In 1992, X, a corporation, acquires an operating mineral interest in a property and undertakes a cyclic steam enhanced oil recovery project with respect to the property. X pays a fee to acquire a permit to drill and hires a contractor to drill six wells. As part of the project implementation, X constructs a building to serve as an office on the property and purchases equipment, including downhole equipment (<E T="03">e.g.,</E> casing, tubing, packers, and sucker rods), pumping units, a steam generator, and equipment to remove gas and water from the oil after it is produced. X constructs roads to transport the equipment to the wellsites and incurs costs <PRTPAGE P="192"/>for clearing and draining the ground in preparation for the drilling of the wells. X purchases cars and trucks to provide transportation for monitoring the wellsites. In addition, X contracts with Y for the delivery of water to produce steam to be injected in connection with the cyclic steam project, and purchases storage tanks to store the water.</P> <P>(ii) The leasehold acquisition costs are not qualified enhanced oil recovery costs. However, the costs of the permit to drill are intangible drilling and development costs that are qualified costs. The costs associated with hiring the contractor to drill, constructing roads, and clearing and draining the ground are intangible drilling and development costs that are qualified enhanced oil recovery costs. The downhole equipment, the pumping units, the steam generator, and the equipment to remove the gas and water from the oil after it is produced are used directly in the project and are essential to the completeness of the project. Therefore, this equipment is an integral part of the project and the costs of the equipment are qualified enhanced oil recovery costs. Although the building that X constructs as an office and the cars and trucks X purchases to provide transportation for monitoring the wellsites are used directly in the project, they are not essential to the completeness of the project. Therefore, the building and the cars and trucks are not an integral part of the project and their costs are not qualified enhanced oil recovery costs. The cost of the water X purchases from Y is a tertiary injectant expense that is a qualified enhanced oil recovery cost. The storage tanks X acquires to store the water are required to provide a proximate source of water for the production of steam. Therefore, the water storage tank are an integral part of the project and the costs of the water storage tanks are qualified enhanced oil recovery costs.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Diluent storage tanks. In 1992, A, the owner of an operating mineral interest, undertakes a qualified enhanced oil recovery project with respect to the property. A acquires diluent to be used in connection with the project. A stores the diluent in a storage tank that A acquires for that purpose. The storage tank provides a proximate source of diluent to be used in the tertiary recovery method. Therefore, the storage tank is used directly in the project and is essential to the completeness of the project. Accordingly, the storage tanks is an integral part of the project and the cost of the storage tank is a qualified enhanced oil recovery cost.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>Oil storage tanks. In 1992, Z, a corporation and the owner of an operating mineral interest in a property, undertakes a qualified enhanced oil recovery project with respect to the property. Z acquires storage tanks that Z will use solely to store the crude oil that is produced from the enhanced oil recovery project. The storage tanks are not used directly in the project and are not essential to the completeness of the project. Therefore, the storage tanks are not an integral part of the enhanced oil recovery project and the costs of the storage tanks are not qualified enhanced oil recovery costs.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>Oil refinery. B, the owner of an operating mineral interest in a property, undertakes a qualified enhanced oil recovery project with respect to the property. Located on B's property is an oil refinery where B will refine the crude oil produced from the project. The refinery is not used directly in the project and is not essential to the completeness of the project. Therefore, the refinery is not an integral part of the enhanced oil recovery project.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>Gas processing plant. C, the owner of an operating mineral interest in a property, undertakes a qualified enhanced oil recovery project with respect to the property. A gas processing plant where C will process gas produced in the project is located on C's property. The gas processing plant is not used directly in the project and is not essential to the completeness of the project. Therefore, the gas processing plant is not an integral part of the enhanced oil recovery project.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 6.</HD> <P>Gas processing equipment. The facts are the same as in <E T="03">Example 5</E> except that C uses a portion of the gas processing plant to separate and recycle the tertiary injectant. The gas processing equipment used to separate and recycle the tertiary injectant is used directly in the project and is essential to the completeness of the project. Therefore, the gas processing equipment used to separate and recycle the tertiary injectant is an integral part of the enhanced oil recovery project and the costs of this equipment are qualified enhanced oil recovery costs.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 7.</HD> <P>Steam generator costs allocated. In 1988, D, the owner of an operating mineral interest in a property, undertook a steam drive project with respect to the property. In 1992, D decides to undertake a steam drive project with respect to reservoir volume that was substantially unaffected by the 1988 project. The 1992 project is a significant expansion that is a qualified enhanced oil recovery project. D purchases a new steam generator with sufficient capacity to provide steam for both the 1988 project and the 1992 project. The steam generator is used directly in the 1992 project and is essential to the completeness of the 1992 project. Accordingly, the steam generator is an integral part of the 1992 project. Because the steam generator is also used to provide steam for the 1988 project, D must allocate the cost of the steam generator to the 1988 project and the 1992 project. Only the portion of the cost of the steam generator that is allocable to <PRTPAGE P="193"/>the 1992 project is a qualified enhanced oil recovery cost.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 8.</HD> <P>Carbon dioxide pipeline. In 1992, E, the owner of an operating mineral interest in a property, undertakes an immiscible carbon dioxide displacement project with respect to the property. E constructs a pipeline to convey carbon dioxide to the project site. E contracts with F, a producer of carbon dioxide, to purchase carbon dioxide to be injected into injection wells in E's enhanced oil recovery project. The cost of the carbon dioxide is a tertiary injectant expense that is a qualified enhanced oil recovery cost. The pipeline is used by E to transport the tertiary injectant, that is, the carbon dioxide to the project site. Therefore, the pipeline is an integral part of the project. Accordingly, the cost of the pipeline is a qualified enhanced oil recovery cost.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 9.</HD> <P>Water source wells. In 1992, G the owner of an operating mineral interest in a property, undertakes a polymer augmented waterflood project with respect to the property. G drills water wells to provide water for injection in connection with the project. The costs of drilling the water wells are intangible drilling and development costs that are paid or incurred in connection with the project. Therefore, the costs of drilling the water wells are qualified enhanced oil recovery costs.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 10.</HD> <P>Leased equipment. In 1992, H, the owner of an operating mineral interest in a property undertakes a steam drive project with respect to the property. H contracts with I, a driller, to drill injection wells in connection with the project. H also leases a steam generator to provide steam for injection in connection with the project. The drilling costs are intangible drilling and development costs that are paid in connection with the project and are qualified enhanced oil recovery costs. The steam generator is used to produce the tertiary injectant. The steam generator is used directly in the project and is essential to the completeness of the project; therefore, it is an integral part of the project. The costs of leasing the steam generator are tangible property costs that are qualified enhanced oil recovery costs.</P> </EXAMPLE> <P>(c) <E T="03">Primary purpose—</E>(1) <E T="03">In general.</E> For purposes of this section, a cost is a qualified enhanced oil recovery cost only if the cost is paid or incurred with respect to an asset which is used for the primary purpose of implementing one or more enhanced oil recovery projects, at least one of which is a qualified enhanced oil recovery project. All the facts and circumstances determine whether an asset is used for the primary purpose of implementing an enhanced oil recovery project. For purposes of this paragraph (c), an enhanced oil recovery project is a project that satisfies the requirements of paragraphs (a) (1) and (2) of section 1.43-2.</P> <P>(2) <E T="03">Tertiary injectant costs.</E> Tertiary injectant costs generally satisfy the primary purpose test of this paragraph (c).</P> <P>(3) <E T="03">Intangible drilling and development costs.</E> Intangible drilling and development costs paid or incurred with respect to a well that is used in connection with the recovery of oil by primary or secondary methods are not qualified enhanced oil recovery costs. Except as provided in this paragraph (c)(3), a well used for primary or secondary recovery is not used for the primary purpose of implementing an enhanced oil recovery project. A well drilled for the primary purpose of implementing an enhanced oil recovery project is not considered to be used for primary or secondary recovery, notwithstanding that some primary or secondary production may result when the well is drilled, provided that such primary or secondary production is consistent with the unit plan of development or other similar plan. All the facts and circumstances determine whether primary or secondary recovery is consistent with the unit plan of development or other similar plan.</P> <P>(4) <E T="03">Tangible property costs.</E> Tangible property costs must be paid or incurred with respect to property which is used for the primary purpose of im-ple-ment-ing an enhanced oil recovery project.</P> <P>If tangible property is used partly in a qualified enhanced oil recovery project and partly in another activity, the property must be primarily used to implement the qualified enhanced oil recovery project.</P> <P>(5) <E T="03">Offshore drilling platforms.</E> Amounts paid or incurred in connection with the acquisition, construction, transportation, erection, or installation of an offshore drilling platform (regardless of whether the amounts are intangible drilling and development costs) that is used in connection with the recovery of oil by primary or secondary methods are not qualified enhanced oil recovery costs. An offshore drilling platform used for primary or secondary recovery is not used for the <PRTPAGE P="194"/>primary purpose of implementing an enhanced oil recovery project.</P> <P>(6) <E T="03">Examples.</E> The following examples illustrate the principles of this paragraph (c). </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Intangible drilling and development costs. In 1992, J incurs intangible drilling and development costs in drilling a well. J intends to use the well as an injection well in connection with an enhanced oil recovery project in 1994, but in the meantime will use the well in connection with a secondary recovery project. J may not take the intangible drilling and development costs into account in determining the credit because the primary purpose of a well used for secondary recovery is not to implement a qualified enhanced oil recovery project.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Offshore drilling platform. K, the owner of an operating mineral interest in an offshore oil field located within the United States, constructs an offshore drilling platform that is designed to accommodate the primary, secondary, and tertiary development of the field. Subsequent to primary and secondary development of the field, K commences an enhanced oil recovery project that involves the application of a qualified tertiary recovery method. As part of the enhanced oil recovery project, K drills injection wells from the offshore drilling platform K used in the primary and secondary development of the field and installs an additional separator on the platform.</P> <P>Because the offshore drilling platform was used in the primary and secondary development of the field and was not used for the primary purpose of implementing tertiary development of the field, costs incurred by K in connection with the acquisition, construction, transportation, erection, or installation of the offshore drilling platform are not qualified enhanced oil recovery costs. However, the costs K incurs for the additional separator are qualified enhanced oil recovery costs because the separator is used for the primary purpose of implementing tertiary development of the field. In addition, the intangible drilling and development costs K incurs in connection with drilling the injection wells are qualified enhanced oil recovery costs with respect to which K may claim the enhanced oil recovery credit.</P> </EXAMPLE> <P>(d) <E T="03">Costs paid or incurred prior to first injection—</E>(1) <E T="03">In general.</E> Qualified enhanced oil recovery costs may be paid or incurred prior to the date of the first injection of liquids, gases, or other matter (within the meaning of § 1.43-2(c)). If the first injection of liquids, gases, or other matter occurs on or before the date the taxpayer files the taxpayer's federal income tax return for the taxable year with respect to which the costs are allowable, the costs may be taken into account on that return. If the first injection of liquids, gases, or other matter is expected to occur after the date the taxpayer files that return, costs may be taken into account on that return if the Internal Revenue Service issues a private letter ruling to the taxpayer that so permits.</P> <P>(2) <E T="03">First injection after filing of return for taxable year costs are allowable.</E> Except as provided in paragraph (d)(3) of this section, if the first injection of liquids, gases, or other matter occurs or is expected to occur after the date the taxpayer files the taxpayer's federal income tax return for the taxable year with respect to which the costs are allowable, the costs may be taken into account on an amended return (or in the case of a Coordinated Examination Program taxpayer, on a written statement treated as a qualified return) after the earlier of—</P> <P>(i) The date the first injection of liquids, gases, or other matter occurs; or</P> <P>(ii) The date the Internal Revenue Service issues a private letter ruling that provides that the taxpayer may take costs into account prior to the first injection of liquids, gases, or other matter.</P> <P>(3) <E T="03">First injection more than 36 months after close of taxable year costs are paid or incurred.</E> If the first injection of liquids, gases, or other matter occurs more than 36 months after the close of the taxable year in which costs are paid or incurred, the taxpayer may take the costs into account in determining the credit only if the Internal Revenue Service issues a private letter ruling to the taxpayer that so provides.</P> <P>(4) <E T="03">Injections in volumes less than the volumes specified in the project plan.</E> For purposes of this paragraph (d), injections in volumes significantly less than the volumes specified in the project plan, the unit plan of development, or another similar plan do not constitute the first injection of liquids, gases, or other matter.</P> <P>(5) <E T="03">Examples.</E> The following examples illustrate the provisions of paragraph (d) of this section. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>First injection before return filed. In 1992, L, a calendar year taxpayer, undertakes a qualified enhanced oil recovery <PRTPAGE P="195"/>project on a property in which L owns an operating mineral interest. L incurs $1,000 of intangible drilling and development costs, which L may elect to deduct under section 263(c) for 1992. The first injection of liquids, gases, or other matter (within the meaning of § 1.43-2(c)) occurs in March 1993. L files a 1992 federal income tax return in April 1993. Because the first injection occurs before the filing of L's 1992 federal income tax return, L may take the $1,000 of intangible drilling and development costs into account in determining the credit for 1992 on that return.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>First injection after return filed. In 1993, M, a calendar year taxpayer, undertakes a qualified enhanced oil recovery project on a property in which M owns an operating mineral interest. M incurs $2,000 of intangible drilling and development costs, which M elects to deduct under section 263(c) for 1993. The first injection of liquids, gases, or other matter is expected to occur in 1995. M files a 1993 federal income tax return in April 1994. Because the first injection of liquids, gases, or other matter occurs after the date on which M's 1993 federal income tax return is filed in April 1994, M may take the $2,000 of intangible drilling and development costs into account on an amended return for 1993 after the earlier of the date the first injection of liquids, gases, or other matter occurs, or the date the Internal Revenue Service issues a private letter ruling that provides that M may take the $2,000 into account prior to first injection.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>First injection more than 36 months after taxable year. N, a calendar year taxpayer, owns an operating mineral interest in a property on which N undertakes an immiscible carbon dioxide displacement project. In 1994, N incurs $5,000 in connection with the construction of a pipeline to transport carbon dioxide to the project site. The first injection of liquids, gases, or other matter is expected to occur after the pipeline is completed in 1998. Because the first injection of liquids, gases, or other matter occurs more than 36 months after the close of the taxable year in which the $5,000 is incurred, N may take the $5,000 into account in determining the credit only if N receives a private letter ruling from the Internal Revenue Service that provides that N may take the $5,000 into account prior to first injection.</P> </EXAMPLE> <P>(e) <E T="03">Other rules—</E>(1) <E T="03">Anti-abuse rule.</E> Costs paid or incurred with respect to an asset that is acquired, used, or transferred in a manner designed to duplicate or otherwise unreasonably increase the amount of the credit are not qualified enhanced oil recovery costs, regardless of whether the costs would otherwise be creditable for a single taxpayer or more than one taxpayer.</P> <P>(2) <E T="03">Costs paid or incurred to acquire a project.</E> A purchaser of an existing qualified enhanced oil recovery project may claim the credit for any section 43 costs in excess of the acquisition cost. However, costs paid or incurred to acquire an existing qualified enhanced oil recovery project (or an interest in an existing qualified enhanced oil recovery project) are not eligible for the credit.</P> <P>(3) <E T="03">Examples.</E> The following examples illustrate the principles of paragraph (e) of this section. </P> <EXAMPLE> <HD SOURCE="HED">Example 1.</HD> <P>Duplicating or unreasonably increasing the credit. O owns an operating mineral interest in a property with respect to which a qualified enhanced oil recovery project is implemented. O acquires pumping units, rods, casing, and separators for use in connection with the project from an unrelated equipment dealer in an arm's length transaction. The equipment is used for the primary purpose of implementing the project. Some of the equipment acquired by O is used equipment. The costs paid by O for the used equipment are qualified enhanced oil recovery costs. O does not need to determine whether the equipment has been previously used in an enhanced oil recovery project.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 2.</HD> <P>Duplicating or unreasonably increasing the credit. P and Q are co-owners of an oil property with respect to which a qualified enhanced oil recovery project is implemented. In 1992, P and Q jointly purchase a nitrogen plant to supply the tertiary injectant used in the project. P and Q claim the credit for their respective costs for the plant. In 1994, X, a corporation unrelated to P or Q, purchases the nitrogen plant and enters into an agreement to sell nitrogen to P and Q. Because this transaction duplicates or otherwise unreasonably increases the credit, the credit is not allowable for the amounts incurred by P and Q for the nitrogen purchased from X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 3.</HD> <P>Duplicating or unreasonably increasing the credit. The facts are the same as in <E T="03">Example 2.</E> In addition, in 1995, P and Q reacquire the nitrogen plant from X. This constitutes the acquisition of property in a manner designed to duplicate or otherwise unreasonably increase the amount of the credit. Therefore, the credit is not allowable for amounts incurred by P and Q for the nitrogen plant purchased from X.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 4.</HD> <P>Duplicating or unreasonably increasing the credit. R owns an operating mineral interest in a property with respect to which a qualified enhanced oil recovery project is implemented. R acquires a pump that is installed at the site of the project. After the pump has been placed in service for <PRTPAGE P="196"/>6 months, R transfers the pump to a secondary recovery project and acquires a replacement pump for the tertiary project. The original pump is suited to the needs of the secondary recovery project and could have been installed there initially. The pumps have been acquired in a manner designed to duplicate or otherwise unreasonably increase the amount of the credit. Depending on the facts, the cost of one pump or the other may be a qualified enhanced oil recovery cost; however, R may not claim the credit with respect to the cost of both pumps.</P> </EXAMPLE> <EXAMPLE> <HD SOURCE="HED">Example 5.</HD> <P>Acquiring a project. In 1993, S purchases all of T's interest in a qualified enhanced oil recovery project, including all of T's interest in tangible property that is an integral part of the project and all of T's operating mineral interest. In 1994, S incurs costs for additional tangible property that is an integral part of the project and which is used for the primary purpose of implementing the project. S also incurs costs for tertiary injectants that are injected in connection with the project. In determining the credit for 1994, S may take into account costs S incurred for tangible property and tertiary injectants. However, S may not take into account any amount that S paid for T's interest in the project in determining S's credit for any taxable year.</P> </EXAMPLE> <CITA>[T.D. 8448, 57 FR 54927, Nov. 23, 1992; 58 FR 7987, Feb. 11, 1993]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-5</SECTNO> <SUBJECT>At-risk limitation. [Reserved]</SUBJECT> </SECTION> <SECTION> <SECTNO>§ 1.43-6</SECTNO> <SUBJECT>Election out of section 43.</SUBJECT> <P>(a) <E T="03">Election to have the credit not apply—</E>(1) <E T="03">In general.</E> A taxpayer may elect to have section 43 not apply for any taxable year. The taxpayer may revoke an election to have section 43 not apply for any taxable year. An election to have section 43 not apply (or a revocation of an election to have section 43 not apply) for any taxable year is effective only for the taxable year to which the election relates.</P> <P>(2) <E T="03">Time for making the election.</E> A taxpayer may make an election under paragraph (a) of this section to have section 43 not apply (or revoke an election to have section 43 not apply) for any taxable year at any time before the expiration of the 3-year period beginning on the last date prescribed by law (determined without regard to extensions) for filing the return for the taxable year. The time for making the election (or revoking the election) is prescribed by section 43(e)(2) and may not be extended under § 1.9100-1.</P> <P>(3) <E T="03">Manner of making the election.</E> An election (or revocation) under paragraph (a)(1) of this section is made by attaching a statement to the taxpayer's federal income tax return or an amended return (or, in the case of a Coordinated Examination Program taxpayer, on a written statement treated as a qualified amended return) for the taxable year for which the election (or revocation) applies. The taxpayer must indicate whether the taxpayer is electing to not have section 43 apply or is revoking such an election and designate the project or projects to which the election (or revocation) applies. For any taxable year, the last election (or revocation) made by a taxpayer within the period prescribed in paragraph (a)(2) of this section determines whether section 43 applies for that taxable year.</P> <P>(b) <E T="03">Election by partnerships and S corporations.</E> For partnerships and S corporations, an election to have section 43 not apply (or a revocation of an election to have section 43 not apply) for any taxable year is made, in accordance with the requirements of paragraph (a) of this section, by the partnership or S corporation with respect to the qualified enhanced oil recovery costs paid or incurred by the partnership or S corporation for the taxable year to which the election relates.</P> <CITA>[T.D. 8448, 57 FR 54930, Nov. 23, 1992]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.43-7</SECTNO> <SUBJECT>Effective date of regulations.</SUBJECT> <P>The provisions of §§ 1.43-1, 1.43-2 and 1.43-4 through 1.43-7 are effective with respect to costs paid or incurred after December 31, 1991, in connection with a qualified enhanced oil recovery project. The provisions of § 1.43-3 are effective for taxable years beginning after December 31, 1990. For costs paid or incurred after December 31, 1990, and before January 1, 1992, in connection with a qualified enhanced oil recovery project, taxpayers must take reasonable return positions taking into consideration the statute and its legislative history.</P> <CITA>[T.D. 8448, 57 FR 54931, Nov. 23, 1992]</CITA> </SECTION> <SECTION> <PRTPAGE P="197"/> <SECTNO>§ 1.44-1</SECTNO> <SUBJECT>Allowance of credit for purchase of new principal residence after March 12, 1975, and before January 1, 1977.</SUBJECT> <P>(a) <E T="03">General rule.</E> Section 44 provides a credit against the tax imposed by chapter 1 of the Internal Revenue Code of 1954 in the case of an individual who purchases a new principal residence (as defined in paragraph (a) of § 1.44-5) which is property to which section 44 applies (as provided in § 1.44-2). Subject to the limitations set forth in paragraph (b) of this section, the credit is in an amount equal to 5 percent of the purchase price (as defined in paragraph (b) of § 1.44-5).</P> <P>(b) <E T="03">Limitations—</E>(1) <E T="03">Maximum credit.</E> The credit allowed under section 44 and this section may not exceed $2,000.</P> <P>(2) <E T="03">Limitation to one residence.</E> Such credit shall be allowed with respect to only one residence of the taxpayer; the combined purchase prices of more than one new principal residence cannot be aggregated to increase the credit allowed.</P> <P>(3) <E T="03">Married individuals.</E> In the case of a husband and wife who file a joint return under section 6013, the maximum credit allowed on the joint return is $2,000. In the case of married individuals filing separate returns the maximum credit allowable to each spouse is $1,000. Where a husband and wife do not make equal contributions with respect to the purchase price of the new principal residence, allocation of the credit is to be made in proportion to their respective ownership interests in such residence. For this purpose, tenants by the entirety or joint tenants with right of survivorship are treated as equal owners.</P> <P>(4) <E T="03">Certain other taxpayers.</E> Where a new principal residence is purchased by two or more taxpayers (other than a husband and wife), the amount of the credit allowed will be allocated among the taxpayers in proportion to their respective ownership interests in such residence, with the limitation that the sum of the credits allowed to all such taxpayers shall not exceed $2,000. For this purpose, joint tenants with right of survivorship are treated as equal owners. For an example of the operation of this provision see <E T="03">Example (2)</E> of § 1.44-5(b)(2)(ii).</P> <P>(5) <E T="03">Application with other credits.</E> The credit allowed by this section shall not exceed the amount of the tax imposed by chapter 1 of the Code for the taxable year, reduced by the sum of the credits allowable under—</P> <P>(i) Section 33 (relating to taxes of foreign countries and possessions of the United States),</P> <P>(ii) Section 37 (relating to retirement income),</P> <P>(iii) Section 38 (relating to investment in certain depreciable property),</P> <P>(iv) Section 40 (relating to expenses of work incentive program),</P> <P>(v) Section 41 (relating to contributions to candidates for public office), and</P> <P>(vi) Section 42 (relating to personal exemptions).</P> <CITA>[T.D. 7391, 40 FR 55851, Dec. 2, 1975]</CITA> </SECTION> <SECTION> <SECTNO>§ 1.44-2</SECTNO> <SUBJECT>Property to which credit for purchase of new principal residence applies.</SUBJECT> <P>The provisions of section 44 and the regulations thereunder apply to a new principal residence which satisfies the following conditions:</P> <P>(a) <E T="03">Construction.</E> The construction of the residence must have begun before March 26, 1975. For this purpose construction is considered to have commenced in the following circumstances:</P> <P>(1)(i) Except as provided in subparagraph (2) of this paragraph, construction is considered to commence when actual physical work of a significant amount has occurred on the building site of the residence. A significant amount of construction requires more than drilling to determine soil conditions, preparation of an architect's sketches, securing of a building permit, or grading of the land. Land preparation and improvements such as the clearing and grading (excavation or filling), construction of roads and sidewalks, and installation of sewers and utilities are not considered commencement of construction of the residence even though they might involve a significant expenditure. However, driving pilings for the foundation, digging of the footings, excavation of the building foundation, pouring of floor slabs, or construction of compacted earthen pads when specifically prepared and designed for a particul