[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2003 Edition]
[From the U.S. Government Printing Office]



[[Page i]]



                    26


          Part 1 (Secs. 1.1001 to 1.1400)

                         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
          Published by
          the Office of the Federal Register
          National Archives and Records
          Administration

A Special Edition of the Federal Register



[[Page ii]]

                                      




                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003



  For sale by the Superintendent of Documents, U.S. Government Printing 
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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     817
      Alphabetical List of Agencies Appearing in the CFR......     835
      Table of OMB Control Numbers............................     845
      List of CFR Sections Affected...........................     863



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

                     Cite this Code:  CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus,  26 CFR 1.1001-1 
                       refers to title 26, part 
                       1, section 1001-1.

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

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2003), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
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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.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
requirements.

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.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of 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.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.
    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

    There are no restrictions on the republication of material appearing 
in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, Washington, DC 20408 or e-mail 
info@fedreg.nara.gov.

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ELECTRONIC SERVICES

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CFR Sections Affected), The United States Government Manual, the Federal 
Register, Public Laws, Public Papers, Weekly Compilation of Presidential 
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free). E-mail, gpoaccess@gpo.gov.

[[Page vii]]

    The Office of the Federal Register also offers a free service on the 
National Archives and Records Administration's (NARA) World Wide Web 
site for public law numbers, Federal Register finding aids, and related 
information. Connect to NARA's web site at www.archives.gov/federal--
register. The NARA site also contains links to GPO Access.

                              Raymond A. Mosley,
                                    Director,
                          Office of the Federal Register.

April 1, 2003.



[[Page ix]]



                               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: Secs. 1.0-1-1.60; 
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850; 
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400; 
Secs. 1.1401--1.1503-2A; and Sec. 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 Sec. 602.101 of this 
chapter. For the convenience of the user, Sec. 602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

[[Page x]]





[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




           (This book contains part 1, Secs. 1.1001 to 1.1400)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




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


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, March 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes................................           5

Supplementary Publication: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations, and Regulations Under Tax Conventions.

[[Page 5]]



                  SUBCHAPTER A--INCOME TAX (CONTINUED)





PART 1--INCOME TAXES--Table of Contents




                  Normal Taxes and Surtaxes (Continued)

                 Gain or Loss on Disposition of Property

       Determination of Amount of and Recognition of Gain or Loss

Sec.
1.1001-1  Computation of gain or loss.
1.1001-2  Discharge of liabilities.
1.1001-3  Modifications of debt instruments.
1.1001-4  Modifications of certain notional principal contracts.
1.1001-5  European Monetary Union (conversion to the euro).
1.1002-1  Sales or exchanges.

                   Basis Rules of General Application

1.1011-1  Adjusted basis.
1.1011-2  Bargain sale to a charitable organization.
1.1012-1  Basis of property.
1.1012-2  Transfers in part a sale and in part a gift.
1.1013-1  Property included in inventory.
1.1014-1  Basis of property acquired from a decedent.
1.1014-2  Property acquired from a decedent.
1.1014-3  Other basis rules.
1.1014-4  Uniformity of basis; adjustment to basis.
1.1014-5  Gain or loss.
1.1014-6  Special rule for adjustments to basis where property is 
          acquired from a decedent prior to his death.
1.1014-7  Example applying rules of Secs. 1.1014-4 through 1.1014-6 to 
          case involving multiple interests.
1.1014-8  Bequest, devise, or inheritance of a remainder interest.
1.1014-9  Special rule with respect to DISC stock.
1.1015-1  Basis of property acquired by gift after December 31, 1920.
1.1015-2  Transfer of property in trust after December 31, 1920.
1.1015-3  Gift or transfer in trust before January 1, 1921.
1.1015-4  Transfers in part a gift and in part a sale.
1.1015-5  Increased basis for gift tax paid.
1.1016-1  Adjustments to basis; scope of section.
1.1016-2  Items properly chargeable to capital account.
1.1016-3  Exhaustion, wear and tear, obsolescence, amortization, and 
          depletion for periods since February 28, 1913.
1.1016-4  Exhaustion, wear and tear, obsolescence, amortization, and 
          depletion; periods during which income was not subject to tax.
1.1016-5  Miscellaneous adjustments to basis.
1.1016-6  Other applicable rules.
1.1016-10  Substituted basis.
1.1017-1  Basis reductions following a discharge of indebtedness.
1.1018-1  Adjusted basis; exception to section 270 of the Bankruptcy 
          Act, as amended.
1.1019-1  Property on which lessee has made improvements.
1.1020-1  Election as to amounts allowed in respect of depreciation, 
          etc., before 1952.
1.1021-1  Sale of annuities.

                       Common Nontaxable Exchanges

1.1031-0  Table of contents.
1.1031(a)-1  Property held for productive use in trade or business or 
          for investment.
1.1031(a)-2  Additional rules for exchanges of personal property.
1.1031(b)-1  Receipt of other property or money in tax-free exchange.
1.1031(b)-2  Safe harbor for qualified intermediaries.
1.1031(c)-1  Nonrecognition of loss.
1.1031(d)-1  Property acquired upon a tax-free exchange.
1.1031(d)-1T  Coordination of section 1060 with section 1031 
          (temporary).
1.1031(d)-2  Treatment of assumption of liabilities.
1.1031(e)-1  Exchange of livestock of different sexes.
1.1031(j)-1  Exchanges of multiple properties.
1.1031(k)-1  Treatment of deferred exchanges.
1.1032-1  Disposition by a corporation of its own capital stock.
1.1032-2  Disposition by a corporation of stock of a controlling 
          corporation in certain triangular reorganizations.
1.1032-3  Disposition of stock or stock options in certain transactions 
          not qualifying under any other nonrecognition provision.
1.1033(a)-1  Involuntary conversions; nonrecognition of gain.
1.1033(a)-2  Involuntary conversion into similar property, into money or 
          into dissimilar property.
1.1033(a)-3  Involuntary conversion of principal residence.
1.1033(b)-1  Basis of property acquired as a result of an involuntary 
          conversion.
1.1033(c)-1  Disposition of excess property within irrigation project 
          deemed to be involuntary conversion.
1.1033(d)-1  Destruction or disposition of livestock because of disease.
1.1033(e)-1  Sale or exchange of livestock solely on account of drought.

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1.1033(g)-1  Condemnation of real property held for productive use in 
          trade or business or for investment.
1.1033(h)-1  Effective date.
1.1034-1  Sale or exchange of residence.
1.1035-1  Certain exchanges of insurance policies.
1.1036-1  Stock for stock of the same corporation.
1.1037-1  Certain exchanges of United States obligations.
1.1038-1  Reacquisitions of real property in satisfaction of 
          indebtedness.
1.1038-2  Reacquisition and resale of property used as a principal 
          residence.
1.1038-3  Election to have section 1038 apply for taxable years 
          beginning after December 31, 1957.
1.1039-1  Certain sales of low-income housing projects.
1.1041-1T  Treatment of transfer of property between spouses or incident 
          to divorce (temporary).
1.1041-2  Redemptions of stock.
1.1042-1T  Questions and answers relating to the sales of stock to 
          employee stock ownership plans or certain cooperatives 
          (temporary).
1.1044(a)-1  Time and manner for making election under the Omnibus 
          Budget Reconciliation Act of 1993.

                              Special Rules

1.1051-1  Basis of property acquired during affiliation.
1.1052-1  Basis of property established by Revenue Act of 1932.
1.1052-2  Basis of property established by Revenue Act of 1934.
1.1052-3  Basis of property established by the Internal Revenue Code of 
          1939.
1.1053-1  Property acquired before March 1, 1913.
1.1054-1  Certain stock of Federal National Mortgage Association.
1.1055-1  General rule with respect to redeemable ground rents.
1.1055-2  Determination of amount realized on the transfer of the right 
          to hold real property subject to liabilities under a 
          redeemable ground rent.
1.1055-3  Basis of real property held subject to liabilities under a 
          redeemable ground rent.
1.1055-4  Basis of redeemable ground rent reserved or created in 
          connection with transfers of real property before April 11, 
          1963.
1.1059(e)-1  Non-pro rata redemptions.
1.1059A-1  Limitation on taxpayer's basis or inventory cost in property 
          imported from related persons.
Sec. 1.1060-1   Special allocation rules for certain asset acquitions.

                   Changes To Effectuate F.C.C. Policy

1.1071-1  Gain from sale or exchange to effectuate policies of Federal 
          Communications Commission.
1.1071-2  Nature and effect of election.
1.1071-3  Reduction of basis of property pursuant to election under 
          section 1071.
1.1071-4  Manner of election.

                 Exchanges in Obedience to S.E.C. Orders

1.1081-1  Terms used.
1.1081-2  Purpose and scope of exception.
1.1081-3  Exchanges of stock or securities solely for stock or 
          securities.
1.1081-4  Exchanges of property for property by corporations.
1.1081-5  Distribution solely of stock or securities.
1.1081-6  Transfers within system group.
1.1081-7  Sale of stock or securities received upon exchange by members 
          of system group.
1.1081-8  Exchanges in which money or other nonexempt property is 
          received.
1.1081-9  Requirements with respect to order of Securities and Exchange 
          Commission.
1.1081-10  Nonapplication of other provisions of the Internal Revenue 
          Code of 1954.
1.1081-11  Records to be kept and information to be filed with returns.
1.1082-1  Basis for determining gain or loss.
1.1082-2  Basis of property acquired upon exchanges under section 1081 
          (a) or (e).
1.1082-3  Reduction of basis of property by reason of gain not 
          recognized under section 1081(b).
1.1082-4  Basis of property acquired by corporation under section 
          1081(a), 1081(b), or 1081(e) as contribution of capital or 
          surplus, or in consideration for its own stock or securities.
1.1082-5  Basis of property acquired by shareholder upon tax-free 
          distribution under section 1081(c) (1) or (2).
1.1082-6  Basis of property acquired under section 1081(d) in 
          transactions between corporations of the same system group.
1.1083-1  Definitions.

                    Wash Sales of Stock or Securities

1.1091-1  Losses from wash sales of stock or securities.
1.1091-2  Basis of stock or securities acquired in ``wash sales''.
1.1092(b)-1T  Coordination of loss deferral rules and wash sale rules 
          (temporary).
1.1092(b)-2T  Treatment of holding periods and losses with respect to 
          straddle positions (temporary).
1.1092(b)-3T  Mixed straddles; straddle-by-straddle identification under 
          section 1092(b)(2)(A)(i)(I) (temporary).
1.1092(b)-4T  Mixed straddles; mixed straddle account (temporary).
1.1092(b)-5T  Definitions (temporary).
1.1092(c)-1  Qualified covered calls.

[[Page 7]]

1.1092(c)-2  Equity options with flexible terms.
1.1092(c)-3  Qualifying over-the-counter options.
1.1092(c)-4  Definitions.
1.1092(d)-1  Definitions and special rules.
1.1092(d)-2  Personal property.

                        CAPITAL GAINS AND LOSSES

                       Treatment of Capital Gains

1.1201-1  Alternative tax.
1.1202-0  Table of contents.
1.1202-1  Deduction for capital gains.
1.1202-2  Qualified small business stock; effect of redemptions.

                       Treatment of Capital Losses

1.1211-1  Limitation on capital losses.
1.1212-1  Capital loss carryovers and carrybacks.

         General Rules for Determining Capital Gains and Losses

1.1221-1  Meaning of terms.
1.1221-2  Hedging transactions.
1.1222-1  Other terms relating to capital gains and losses.
1.1223-1  Determination of period for which capital assets are held.
1.1223-3  Rules relating to the holding periods of partnership 
          interests.

         Special Rules for Determining Capital Gains and Losses

1.1231-1  Gains and losses from the sale or exchange of certain property 
          used in the trade or business.
1.1231-2  Livestock held for draft, breeding, dairy, or sporting 
          purposes.
1.1232-1  Bonds and other evidences of indebtedness; scope of section.
1.1232-2  Retirement.
1.1232-3  Gain upon sale or exchange of obligations issued at a discount 
          after December 31, 1954.
1.1232-3A  Inclusion as interest of original issue discount on certain 
          obligations issued after May 27, 1969.
1.1232-4  Obligations with excess coupons detached.
1.1233-1  Gains and losses from short sales.
1.1233-2  Hedging transactions.
1.1234-1  Options to buy or sell.
1.1234-2  Special rule for grantors of straddles applicable to certain 
          options granted on or before September 1, 1976.
1.1234-3  Special rules for the treatment of grantors of certain options 
          granted after September 1, 1976.
1.1234-4  Hedging transactions.
1.1235-1  Sale or exchange of patents.
1.1235-2  Definition of terms.
1.1236-1  Dealers in securities.
1.1237-1  Real property subdivided for sale.
1.1238-1  Amortization in excess of depreciation.
1.1239-1  Gain from sale or exchange of depreciable property between 
          certain related taxpayers after October 4, 1976.
1.1239-2  Gain from sale or exchange of depreciable property between 
          certain related taxpayers on or before October 4, 1976.
1.1240-1  Capital gains treatment of certain termination payments.
1.1241-1  Cancellation of lease or distributor's agreement.
1.1242-1  Losses on small business investment company stock.
1.1243-1  Loss of small business investment company.
1.1244(a)-1  Loss on small business stock treated as ordinary loss.
1.1244(b)-1  Annual limitation.
1.1244(c)-1  Section 1244 stock defined.
1.1244(c)-2  Small business corporation defined.
1.1244(d)-1  Contributions of property having basis in excess of value.
1.1244(d)-2  Increases in basis of section 1244 stock.
1.1244(d)-3  Stock dividend, recapitalizations, changes in name, etc.
1.1244(d)-4  Net operating loss deduction.
1.1244(e)-1  Records to be kept.
1.1245-1  General rule for treatment of gain from dispositions of 
          certain depreciable property.
1.1245-2  Definition of recomputed basis.
1.1245-3  Definition of section 1245 property.
1.1245-4  Exceptions and limitations.
1.1245-5  Adjustments to basis.
1.1245-6  Relation of section 1245 to other sections.
1.1247-1  Election by foreign investment companies to distribute income 
          currently.
1.1247-2  Computation and distribution of taxable income.
1.1247-3  Treatment of capital gains.
1.1247-4  Election by foreign investment company with respect to foreign 
          tax credit.
1.1247-5  Information and recordkeeping requirements.
1.1248-1  Treatment of gain from certain sales or exchanges of stock in 
          certain foreign corporations.
1.1248-2  Earnings and profits attributable to a block of stock in 
          simple cases.
1.1248-3  Earnings and profits attributable to stock in complex cases.
1.1248-4  Limitation on tax applicable to individuals.
1.1248-5  Stock ownership requirements for less developed country 
          corporations.
1.1248-6  Sale or exchange of stock in certain domestic corporations.
1.1248-7  Taxpayer to establish earnings and profits and foreign taxes.

[[Page 8]]

1.1249-1  Gain from certain sales or exchanges of patents, etc., to 
          foreign corporations.
1.1250-1  Gain from dispositions of certain depreciable realty.
1.1250-2  Additional depreciation defined.
1.1250-3  Exceptions and limitations.
1.1250-4  Holding period.
1.1250-5  Property with two or more elements.
1.1251-1  General rule for treatment of gain from disposition of 
          property used in farming where farm losses offset nonfarm 
          income.
1.1251-2  Excess deductions account.
1.1251-3  Definitions relating to section 1251.
1.1251-4  Exceptions and limitations.
1.1252-1  General rule for treatment of gain from disposition of farm 
          land.
1.1252-2  Special rules.
1.1254-0  Table of contents for section 1254 recapture rules.
1.1254-1  Treatment of gain from disposition of natural resource 
          recapture property.
1.1254-2  Exceptions and limitations.
1.1254-3  Section 1254 costs immediately after certain acquisitions.
1.1254-4  Special rules for S corporations and their shareholders.
1.1254-5  Special rules for partnerships and their partners.
1.1254-6  Effective date of regulations.
1.1256(e)-1  Identification of hedging transactions.
1.1258-1  Netting rule for certain conversion transactions.
1.1271-0  Original issue discount; effective date; table of contents.
1.1271-1  Special rules appplicable to amounts received on retirement, 
          sale, or exchange of debt instruments.
1.1272-1  Current inclusion of OID in income.
1.1272-2  Treatment of debt instruments purchased at a premium.
1.1272-3  Election by a holder to treat all interest on a debt 
          instrument as OID.
1.1273-1  Definition of OID.
1.1273-2  Determination of issue price and issue date.
1.1274-1  Debt instruments to which section 1274 applies.
1.1274-2  Issue price of debt instruments to which section 1274 applies.
1.1274-3  Potentially abusive situations defined.
1.1274-4  Test rate.
1.1274-5  Assumptions.
1.1274A-1  Special rules for certain transactions where stated principal 
          amount does not exceed $2,800,000.
1.1275-1  Definitions.
1.1275-2  Special rules relating to debt instruments.
1.1275-3  OID information reporting requirements.
1.1275-4  Contingent payment debt instruments.
1.1275-5  Variable rate debt instruments.
1.1275-6  Integration of qualifying debt instruments.
1.1275-7  Inflation-indexed debt instruments.
1.1286-1  Tax treatment of certain stripped bonds and stripped coupons.
1.1286-2  Stripped inflation-indexed debt instruments.
1.1287-1  Denial of capital gains treatment for gains on registration-
          required obligations not in registered form.
1.1291-0  Treatment of shareholders of certain passive foreign 
          investment companies; table of contents.
1.1291-1  Taxation of U.S. persons that are shareholders of PFICs that 
          are not pedigreed QEFs.
1.1291-9  Deemed dividend election.
1.1291-10  Deemed sale election.
1.1293-0  Table of contents.
1.1293-1  Current taxation of income from qualified electing funds.
1.1294-0  Table of contents.
1.1294-1T  Election to extend the time for payment of tax on 
          undistributed earnings of a qualified electing fund 
          (temporary).
1.1295-0  Table of contents.
1.1295-1  Qualified electing funds.
1.1295-3  Retroactive elections.
1.1296(e)-1  Definition of marketable stock.
1.1297-0  Table of contents.
1.1297-3T  Deemed sale election by a United States person that is a 
          shareholder of a passive foreign investment company 
          (temporary).

                            Income Averaging

1.1301-1  Averaging of farm income.

        READJUSTMENT OF TAX BETWEEN YEARS AND SPECIAL LIMITATIONS

        Mitigation of Effect of Limitations and Other Provisions

1.1311(a)-1  Introduction.
1.1311(a)-2  Purpose and scope of section 1311.
1.1311(b)-1  Maintenance of an inconsistent position.
1.1311(b)-2  Correction not barred at time of erroneous action.
1.1311(b)-3  Existence of relationship in case of adjustment by way of 
          deficiency assessment.
1.1312-1  Double inclusion of an item of gross income.
1.1312-2  Double allowance of a deduction or credit.
1.1312-3  Double exclusion of an item of gross income.
1.1312-4  Double disallowance of a deduction or credit.
1.1312-5  Correlative deductions and inclusions for trusts or estates 
          and legatees, beneficiaries, or heirs.

[[Page 9]]

1.1312-6  Correlative deductions and credits for certain related 
          corporations.
1.1312-7  Basis of property after erroneous treatment of a prior 
          transaction.
1.1312-8  Law applicable in determination of error.
1.1313(a)-1  Decision by Tax Court or other court as a determination.
1.1313(a)-2  Closing agreement as a determination.
1.1313(a)-3  Final disposition of claim for refund as a determination.
1.1313(a)-4  Agreement pursuant to section 1313(a)(4) as a 
          determination.
1.1313(c)-1  Related taxpayer.
1.1314(a)-1  Ascertainment of amount of adjustment in year of error.
1.1314(a)-2  Adjustment to other barred taxable years.
1.1314(b)-1  Method of adjustment.
1.1314(c)-1  Adjustment unaffected by other items.

       Involuntary Liquidation and Replacement of Lifo Inventories

1.1321-1  Involuntary liquidation of lifo inventories.
1.1321-2  Liquidation and replacement of lifo inventories by acquiring 
          corporations.

                           War Loss Recoveries

1.1331-1  Recoveries in respect of war losses.
1.1332-1  Inclusion in gross income of war loss recoveries.
1.1333-1  Tax adjustment measured by prior benefits.
1.1334-1  Restoration of value of investments.
1.1335-1  Elective method; time and manner of making election and effect 
          thereof.
1.1336-1  Basis of recovered property.
1.1337-1  Determination of tax benefits from allowable deductions.

                             Claim of Right

1.1341-1  Restoration of amounts received or accrued under claim of 
          right.
1.1342-1  Computation of tax where taxpayer recovers substantial amount 
          held by another under claim of right; effective date.

                            Other Limitations

1.1346-1  Recovery of unconstitutional taxes.
1.1347-1  Tax on certain amounts received from the United States.
1.1348-1  Fifty-percent maximum tax on earned income.
1.1348-2  Computation of the fifty-percent maximum tax on earned income.
1.1348-3  Definitions.

           Small Business Corporations and Their Shareholders

1.1361-0  Table of contents.
1.1361-1  S corporation defined.
1.1361-2  Definitions relating to S corporation subsidiaries.
1.1361-3  QSub election.
1.1361-4  Effect of QSub election.
1.1361-5  Termination of QSub election.
1.1361-6  Effective date.
1.1362-0  Table of contents.
1.1362-1  Election to be an S corporation.
1.1362-2  Termination of election.
1.1362-3  Treatment of S termination year.
1.1362-4  Inadvertent terminations.
1.1362-5  Election after termination.
1.1362-6  Elections and consents.
1.1362-7  Effective dates.
1.1362-8  Dividends received from affiliated subsidiaries.
1.1363-1  Effect of election on corporation.
1.1363-2  Recapture of LIFO benefits.
1.1366-0  Table of contents.
1.1366-1  Shareholder's share of items of an S corporation.
1.1366-2  Limitations on deduction of passthrough items of an S 
          corporation to its shareholders.
1.1366-3  Treatment of family groups.
1.1366-4  Special rules limiting the passthrough of certain items of an 
          S corporation to its shareholders.
1.1366-5  Effective date.
1.1367-0  Table of contents.
1.1367-1  Adjustments to basis of shareholder's stock in an S 
          corporation.
1.1367-2  Adjustments to basis of indebtedness to shareholder.
1.1367-3  Effective date and transition rule.
1.1368-0  Table of contents.
1.1368-1  Distributions by S corporations.
1.1368-2  Accumulated adjustments account (AAA).
1.1368-3  Examples.
1.1368-4  Effective date and transition rule.
1.1374-0  Table of contents.
1.1374-1  General rules and definitions.
1.1374-2  Net recognized built-in gain.
1.1374-3  Net unrealized built-in gain.
1.1374-4  Recognized built-in gain or loss.
1.1374-5  Loss carryforwards.
1.1374-6  Credits and credit carryforwards.
1.1374-7  Inventory.
1.1374-8  Section 1374(d)(8) transactions.
1.1374-9  Anti-stuffing rule.
1.1374-10  Effective date and additional rules.
1.1375-1  Tax imposed when passive investment income of corporation 
          having subchapter C earnings and profits exceed 25 percent of 
          gross receipts.
1.1377-0  Table of contents.
1.1377-1  Pro rata share.
1.1377-2  Post-termination transition period.
1.1377-3  Effective dates.
1.1378-1  Taxable year of S corporation.

             Section 1374 Before the Tax Reform Act of 1986

1.1374-1A  Tax imposed on certain capital gains.

[[Page 10]]

                     COOPERATIVES AND THEIR PATRONS

                      Tax Treatment of Cooperatives

1.1381-1  Organizations to which part applies.
1.1381-2  Tax on certain farmers' cooperatives.
1.1382-1  Taxable income of cooperatives; gross income.
1.1382-2  Taxable income of cooperatives; treatment of patronage 
          dividends.
1.1382-3  Taxable income of cooperatives; special deductions for exempt 
          farmers' cooperatives.
1.1382-4  Taxable income of cooperatives; payment period for each 
          taxable year.
1.1382-5  Taxable income of cooperatives; products marketed under 
          pooling arrangements.
1.1382-6  Taxable income of cooperatives; treatment of earnings received 
          after patronage occurred.
1.1382-7  Special rules applicable to cooperative associations exempt 
          from tax before January 1, 1952.
1.1383-1  Computation of tax where cooperative redeems nonqualified 
          written notices of allocation.

             Tax Treatment by Patrons of Patronage Dividends

1.1385-1  Amounts includible in patron's gross income.

                       Definitions; Special Rules

1.1388-1  Definitions and special rules.
1.1394-0  Table of contents.
1.1394-1  Enterprise zone facility bonds.

                   Empowerment Zone Employment Credit

1.1396-1  Qualified zone employees.
1.1397E-1  Qualified zone academy bonds.

              Rules Relating to Individuals' Title 11 Cases

1.1398-1  Treatment of passive activity losses and passive activity 
          credits in individuals' title 11 cases.
1.1398[dash]2  Treatment of section 465 losses in individuals' title 11 
          cases.
1.1398-3  Treatment of section 121 exclusion in individuals' title 11 
          cases.

    Authority: 26 U.S.C. 7805, unless otherwise noted.
    Section 1.1036-1 also issued under 26 U.S.C. 351(g)(4).
    Section 1.1059(e)-1 also issued under 26 U.S.C. 1059 (e)(1) and 
(e)(2).
    Section 1.1060-1 also issued under 26 U.S.C. 1060.
    Sections 1.1092(b)-1T and 1.1092(b)-2T also issued under 26 U.S.C. 
1092 (b)(1).
    Section 1.1092(b)-4T also issued under 26 U.S.C. 1092(b)(2).
    Section 1.1092(c)-1 also issued under 26 U.S.C. 1092(c)(4)(H).
    Section 1.1092(c)-2 also issued under 26 U.S.C. 1092(c)(4)(H).
    Section 1.1092(c)-3 also issued under 26 U.S.C. 1092(c)(4)(H).
    Section 1.1092(c)-4 also issued under 26 U.S.C. 1092(c)(4)(H).
    Section 1.1092(d)-2 also issued under 26 U.S.C. 1092(d)(3)(B).
    Section 1.1202-2 is also issued under 26 U.S.C. 1202(k).
    Section 1.1221-2 also issued under 26 U.S.C. 1221(b)(2)(A)(iii), 
(b)(2)(B), and (b)(3); 1502 and 6001.
    Section 1.1244(e)-1 also issued under 26 U.S.C. 1244(e).
    Section 1.1254-1 also issued under 26 U.S.C. 1254(b).
    Section 1.1254-2 also issued under 26 U.S.C. 1254(b).
    Section 1.1254-3 also issued under 26 U.S.C. 1254(b).
    Section 1.1254-4 also issued under 26 U.S.C. 1254(b).
    Section 1.1254-5 also issued under 26 U.S.C. 1254(b).
    Section 1.1254-6 also issued under 26 U.S.C. 1254(b).
    Section 1.1271-1 also issued under 26 U.S.C. 1275(d).
    Section 1.1272-1 also issued under 26 U.S.C. 1275(d).
    Section 1.1272-2 also issued under 26 U.S.C. 1275(d).
    Section 1.1272-3 also issued under 26 U.S.C. 1275(d).
    Section 1.1273-1 also issued under 26 U.S.C. 1275(d).
    Section 1.1273-2 also issued under 26 U.S.C. 1275(d).
    Section 1.1274-1 also issued under 26 U.S.C. 1275(d).
    Section 1.1274-2 also issued under 26 U.S.C. 1275(d).
    Section 1.1274-3 also issued under 26 U.S.C. 1275(d).
    Section 1.1274-4 also issued under 26 U.S.C. 1275(d).
    Section 1.1274-5 also issued under 26 U.S.C. 1275(d).
    Section 1.1274A-1 also issued under 26 U.S.C. 1274A(e) and 26 U.S.C. 
1275(d).
    Section 1.1275-1 also issued under 26 U.S.C. 1275(d).
    Section 1.1275-2 also issued under 26 U.S.C. 1275(d).
    Section 1.1275-3 also issued under 26 U.S.C. 1275(d).
    Section 1.1275-4 also issued under 26 U.S.C. 1275(d).
    Section 1.1275-5 also issued under 26 U.S.C. 1275(d).
    Section 1.1275-6 also issued under 26 U.S.C. 1275(d).
    Section 1.1275-7 also issued under 26 U.S.C. 1275(d).
    Section 1.1286-1 also issued under 26 U.S.C. 1275(D) and 1286(f).

[[Page 11]]

    Section 1.1286-2 also issued under 26 U.S.C. 1286(f).
    Section 1.1287-1 also issued under 26 U.S.C. 165 (j)(3).
    Section 1.1291-1 also issued under 26 U.S.C. 1291.
    Section 1.1291-9 also issued under 26 U.S.C. 1291(d)(2).
    Section 1.1291-10 also issued under 26 U.S.C. 1291(d)(2).
    Section 1.1293-1 also issued under 26 U.S.C. 1293.
    Section 1.1294-1T also issued under 26 U.S.C. 1294.
    Section 1.1295-1 also issued under 26 U.S.C. 1295.
    Section 1.1295-3 also issued under 26 U.S.C. 1295.
    Section 1.1296(e)-1 also issued under 26 U.S.C. 1296(e).
    Section 1.1297-3T also issued under 26 U.S.C. 1297(b)(1).
    Section 1.1301-1 also issued under 26 U.S.C. 1301(c).
    Section 1.1361-1(j) (6), (10) and (11) also issued under 26 U.S.C. 
1361(d)(2)(B)(iii).
    Section 1.1361-1(l) also issued under 26 U.S.C. 1361(c)(5)(C).
    Sections 1.1362-1, 1.1362-2, 1.1362-3, 1.1362-4, 1.1362-5, 1.1362-6, 
1.1362-7, and 1.1363-1 also issued under 26 U.S.C. 1377.
    Section 1.1368-1(f) and (g) also issued under 26 U.S.C. 1377(c).
    Section 1.1368-2(b) also issued under 26 U.S.C. 1368(c).
    Section 1.1374-1 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-2 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-3 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-4 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-5 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-6 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-7 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-8 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-9 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1374-10 also issued under 26 U.S.C. 1374(e) and 337(d).
    Section 1.1377-1 also issued under 26 U.S.C. 1377(a)(2) and (c).
    Section 1.1394-1 also issued under 26 U.S.C. 1397D.
    Section 1.1396-1 also issued under 26 U.S.C. 1397D.
    Section 1.1397E-1 also issued under 26 U.S.C. 1397E(b) and (d).

    Source: T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 
1960, unless otherwise noted.

                 GAIN OR LOSS ON DISPOSITION OF PROPERTY

       Determination of Amount of and Recognition of Gain or Loss



Sec. 1.1001-1  Computation of gain or loss.

    (a) General rule. Except as otherwise provided in subtitle A of the 
Code, the gain or loss realized from the conversion of property into 
cash, or from the exchange of property for other property differing 
materially either in kind or in extent, is treated as income or as loss 
sustained. The amount realized from a sale or other disposition of 
property is the sum of any money received plus the fair market value of 
any property (other than money) received. The fair market value of 
property is a question of fact, but only in rare and extraordinary cases 
will property be considered to have no fair market value. The general 
method of computing such gain or loss is prescribed by section 1001 (a) 
through (d) which contemplates that from the amount realized upon the 
sale or exchange there shall be withdrawn a sum sufficient to restore 
the adjusted basis prescribed by section 1011 and the regulations 
thereunder (i.e., the cost or other basis adjusted for receipts, 
expenditures, losses, allowances, and other items chargeable against and 
applicable to such cost or other basis). The amount which remains after 
the adjusted basis has been restored to the taxpayer constitutes the 
realized gain. If the amount realized upon the sale or exchange is 
insufficient to restore to the taxpayer the adjusted basis of the 
property, a loss is sustained to the extent of the difference between 
such adjusted basis and the amount realized. The basis may be different 
depending upon whether gain or loss is being computed. For example, see 
section 1015(a) and the regulations thereunder. Section 1001(e) and 
paragraph (f) of this section prescribe the method of computing gain or 
loss upon the sale or other disposition of a term interest in property 
the adjusted basis (or a portion) of which is determined pursuant, or by 
reference, to section 1014 (relating to the basis of property acquired 
from a decedent) or section 1015 (relating to

[[Page 12]]

the basis of property acquired by gift or by a transfer in trust).
    (b) Real estate taxes as amounts received. (1) Section 1001(b) and 
section 1012 state rules applicable in making an adjustment upon a sale 
of real property with respect to the real property taxes apportioned 
between seller and purchaser under section 164(d). Thus, if the seller 
pays (or agrees to pay) real property taxes attributable to the real 
property tax year in which the sale occurs, he shall not take into 
account, in determining the amount realized from the sale under section 
1001(b), any amount received as reimbursement for taxes which are 
treated under section 164(d) as imposed upon the purchaser. Similarly, 
in computing the cost of the property under section 1012, the purchaser 
shall not take into account any amount paid to the seller as 
reimbursement for real property taxes which are treated under section 
164(d) as imposed upon the purchaser. These rules apply whether or not 
the contract of sale calls for the purchaser to reimburse the seller for 
such real property taxes paid or to be paid by the seller.
    (2) On the other hand, if the purchaser pays (or is to pay) an 
amount representing real property taxes which are treated under section 
164(d) as imposed upon the seller, that amount shall be taken into 
account both in determining the amount realized from the sale under 
section 1001(b) and in computing the cost of the property under section 
1012. It is immaterial whether or not the contract of sale specifies 
that the sale price has been reduced by, or is in any way intended to 
reflect, the taxes allocable to the seller. See also paragraph (b) of 
Sec. 1.1012-1.
    (3) Subparagraph (1) of this paragraph shall not apply to a seller 
who, in a taxable year prior to the taxable year of sale, pays an amount 
representing real property taxes which are treated under section 164(d) 
as imposed on the purchaser, if such seller has elected to capitalize 
such amount in accordance with section 266 and the regulations 
thereunder (relating to election to capitalize certain carrying charges 
and taxes).
    (4) The application of this paragraph may be illustrated by the 
following examples:

    Example 1. Assume that the contract price on the sale of a parcel of 
real estate is $50,000 and that real property taxes thereon in the 
amount of $1,000 for the real property tax year in which occurred the 
date of sale were previously paid by the seller. Assume further that 
$750 of the taxes are treated under section 164(d) as imposed upon the 
purchaser and that he reimburses the seller in that amount in addition 
to the contract price. The amount realized by the seller is $50,000. 
Similarly, $50,000 is the purchaser's cost. If, in this example, the 
purchaser made no payment other than the contract price of $50,000, the 
amount realized by the seller would be $49,250, since the sales price 
would be deemed to include $750 paid to the seller in reimbursement for 
real property taxes imposed upon the purchaser. Similarly, $49,250 would 
be the purchaser's cost.
    Example 2. Assume that the purchaser in example (1), above, paid all 
of the real property taxes. Assume further that $250 of the taxes are 
treated under section 164(d) as imposed upon the seller. The amount 
realized by the seller is $50,250. Similarly, $50,250 is the purchaser's 
cost, regardless of the taxable year in which the purchaser makes actual 
payment of the taxes.
    Example 3. Assume that the seller described in the first part of 
example (1), above, paid the real property taxes of $1,000 in the 
taxable year prior to the taxable year of sale and elected under section 
266 to capitalize the $1,000 of taxes. In such a case, the amount 
realized is $50,750. Moreover, regardless of whether the seller elected 
to capitalize the real property taxes, the purchaser in that case could 
elect under section 266 to capitalize the $750 of taxes treated under 
section 164(d) as imposed upon him, in which case his adjusted basis 
would be $50,750 (cost of $50,000 plus capitalized taxes of $570).

    (c) Other rules. (1) Even though property is not sold or otherwise 
disposed of, gain is realized if the sum of all the amounts received 
which are required by section 1016 and other applicable provisions of 
subtitle A of the Code to be applied against the basis of the property 
exceeds such basis. Except as otherwise provided in section 301(c)(3)(B) 
with respect to distributions out of increase in value of property 
accrued prior to March 1, 1913, such gain is includible in gross income 
under section 61 as ``income from whatever source derived''. On the 
other hand, a loss is not ordinarily sustained prior to the sale or 
other disposition of

[[Page 13]]

the property, for the reason that until such sale or other disposition 
occurs there remains the possibility that the taxpayer may recover or 
recoup the adjusted basis of the property. Until some identifiable event 
fixes the actual sustaining of a loss and the amount thereof, it is not 
taken into account.
    (2) The provisions of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example: A, an individual on a calendar year basis, purchased 
certain shares of stock subsequent to February 28, 1913, for $10,000. On 
January 1, 1954, A's adjusted basis for the stock had been reduced to 
$1,000 by reason of receipts and distributions described in sections 
1016(a)(1) and 1016(a)(4). He received in 1954 a further distribution of 
$5,000, being a distribution covered by section 1016(a)(4), other than a 
distribution out of increase of value of property accrued prior to March 
1, 1913. This distribution applied against the adjusted basis as 
required by section 1016(a)(4) exceeds that basis by $4,000. The $4,000 
excess is a gain realized by A in 1954 and is includible in gross income 
in his return for that calendar year. In computing gain from the stock, 
as in adjusting basis, no distinction is made between items of receipts 
or distributions described in section 1016. If A sells the stock in 1955 
for $5,000, he realizes in 1955 a gain of $5,000, since the adjusted 
basis of the stock for the purpose of computing gain or loss from the 
sale is zero.

    (d) Installment sales. In the case of property sold on the 
installment plan, special rules for the taxation of the gain are 
prescribed in section 453.
    (e) Transfers in part a sale and in part a gift. (1) Where a 
transfer of property is in part a sale and in part a gift, the 
transferor has a gain to the extent that the amount realized by him 
exceeds his adjusted basis in the property. However, no loss is 
sustained on such a transfer if the amount realized is less than the 
adjusted basis. For the determination of basis of property in the hands 
of the transferee, see Sec. 1.1015-4. For the allocation of the adjusted 
basis of property in the case of a bargain sale to a charitable 
organization, see Sec. 1.1011-2.
    (2) Examples. The provisions of subparagraph (1) may be illustrated 
by the following examples:

    Example 1. A transfers property to his son for $60,000. Such 
property in the hands of A has an adjusted basis of $30,000 (and a fair 
market value of $90,000). A's gain is $30,000, the excess of $60,000, 
the amount realized, over the adjusted basis, $30,000. He has made a 
gift of $30,000, the excess of $90,000, the fair market value, over the 
amount realized, $60,000.
    Example 2. A transfers property to his son for $30,000. Such 
property in the hands of A has an adjusted basis of $60,000 (and a fair 
market value of $90,000). A has no gain or loss, and has made a gift of 
$60,000, the excess of $90,000, the fair market value, over the amount 
realized, $30,000.
    Example 3. A transfers property to his son for $30,000. Such 
property in A's hands has an adjusted basis of $30,000 (and a fair 
market value of $60,000). A has no gain and has made a gift of $30,000, 
the excess of $60,000, the fair market value, over the amount realized, 
$30,000.
    Example 4. A transfers property to his son for $30,000. Such 
property in A's hands has an adjusted basis of $90,000 (and a fair 
market value of $60,000). A has sustained no loss, and has made a gift 
of $30,000, the excess of $60,000, the fair market value, over the 
amount realized, $30,000.

    (f) Sale or other disposition of a term interest in property--(1) 
General rule. Except as otherwise provided in subparagraph (3) of this 
paragraph, for purposes of determining gain or loss from the sale or 
other disposition after October 9, 1969, of a term interest in property 
(as defined in subparagraph (2) of this paragraph) a taxpayer shall not 
take into account that portion of the adjusted basis of such interest 
which is determined pursuant, or by reference, to section 1014 (relating 
to the basis of property acquired from a decedent) or section 1015 
(relating to the basis of property acquired by gift or by a transfer in 
trust) to the extent that such adjusted basis is a portion of the 
adjusted uniform basis of the entire property (as defined in 
Sec. 1.1014-5). Where a term interest in property is transferred to a 
corporation in connection with a transaction to which section 351 
applies and the adjusted basis of the term interest (i) is determined 
pursuant to section 1014 or 1015 and (ii) is also a portion of the 
adjusted uniform basis of the entire property, a subsequent sale or 
other disposition of such term interest by the corporation will be 
subject to the provisions of section 1001(e) and this paragraph to the 
extent that the basis of the term interest so sold or otherwise disposed 
of is determined by reference to its basis in the hands of the 
transferor as provided by section 362(a). See

[[Page 14]]

subparagraph (2) of this paragraph for rules relating to the 
characterization of stock received by the transferor of a term interest 
in property in connection with a transaction to which section 351 
applies. That portion of the adjusted uniform basis of the entire 
property which is assignable to such interest at the time of its sale or 
other disposition shall be determined under the rules provided in 
Sec. 1.1014-5. Thus, gain or loss realized from a sale or other 
disposition of a term interest in property shall be determined by 
comparing the amount of the proceeds of such sale with that part of the 
adjusted basis of such interest which is not a portion of the adjusted 
uniform basis of the entire property.
    (2) Term interest defined. For purposes of section 1001(e) and this 
paragraph, a term interest in property means--
    (i) A life interest in property,
    (ii) An interest in property for a term of years, or
    (iii) An income interest in a trust.

Generally, subdivisions (i), (ii), and (iii) refer to an interest, 
present or future, in the income from property or the right to use 
property which will terminate or fail on the lapse of time, on the 
occurrence of an event or contingency, or on the failure of an event or 
contingency to occur. Such divisions do not refer to remainder or 
reversionary interests in the property itself or other interests in the 
property which will ripen into ownership of the entire property upon 
termination or failure of a preceding term interest. A term interest in 
property also includes any property received upon a sale or other 
disposition of a life interest in property, an interest in property for 
a term of years, or an income interest in a trust by the original holder 
of such interest, but only to the extent that the adjusted basis of the 
property received is determined by reference to the adjusted basis of 
the term interest so transferred.
    (3) Exception. Paragraph (1) of section 1001(e) and subparagraph (1) 
of this paragraph shall not apply to a sale or other disposition of a 
term interest in property as a part of a single transaction in which the 
entire interest in the property is transferred to a third person or to 
two or more other persons, including persons who acquire such entire 
interest as joint tenants, tenants by the entirety, or tenants in 
common. See Sec. 1.1014-5 for computation of gain or loss upon such a 
sale or other disposition where the property has been acquired from a 
decedent or by gift or transfer in trust.
    (4) Illustrations. For examples illustrating the application of this 
paragraph, see paragraph (c) of Sec. 1.1014-5.
    (g) Debt instruments issued in exchange for property--(1) In 
general. If a debt instrument is issued in exchange for property, the 
amount realized attributable to the debt instrument is the issue price 
of the debt instrument as determined under Sec. 1.1273-2 or Sec. 1.1274-
2, whichever is applicable. If, however, the issue price of the debt 
instrument is determined under section 1273(b)(4), the amount realized 
attributable to the debt instrument is its stated principal amount 
reduced by any unstated interest (as determined under section 483).
    (2) Certain debt instruments that provide for contingent payments--
(i) In general. Paragraph (g)(1) of this section does not apply to a 
debt instrument subject to either Sec. 1.483-4 or Sec. 1.1275-4(c) 
(certain contingent payment debt instruments issued for nonpublicly 
traded property).
    (ii) Special rule to determine amount realized. If a debt instrument 
subject to Sec. 1.1275-4(c) is issued in exchange for property, and the 
income from the exchange is not reported under the installment method of 
section 453, the amount realized attributable to the debt instrument is 
the issue price of the debt instrument as determined under Sec. 1.1274-
2(g), increased by the fair market value of the contingent payments 
payable on the debt instrument. If a debt instrument subject to 
Sec. 1.483-4 is issued in exchange for property, and the income from the 
exchange is not reported under the installment method of section 453, 
the amount realized attributable to the debt instrument is its stated 
principal amount, reduced by any unstated interest (as determined under 
section 483), and increased by the fair market value of the contingent 
payments payable on the debt instrument. This paragraph (g)(2)(ii), 
however, does not apply to a debt instrument if the fair market

[[Page 15]]

value of the contingent payments is not reasonably ascertainable. Only 
in rare and extraordinary cases will the fair market value of the 
contingent payments be treated as not reasonably ascertainable.
    (3) Coordination with section 453. If a debt instrument is issued in 
exchange for property, and the income from the exchange is not reported 
under the installment method of section 453, this paragraph (g) applies 
rather than Sec. 15a.453-1(d)(2) to determine the taxpayer's amount 
realized attributable to the debt instrument.
    (4) Effective date. This paragraph (g) applies to sales or exchanges 
that occur on or after August 13, 1996.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7142, 36 FR 
18950, Sept. 24, 1971; T.D. 7207, 37 FR 20797, Oct. 5, 1972; T.D. 7213, 
37 FR 21992, Oct. 18, 1972; T.D. 8517, 59 FR 4807, Feb. 2, 1994; T.D. 
8674, 61 FR 30139, June 14, 1996]



Sec. 1.1001-2  Discharge of liabilities.

    (a) Inclusion in amount realized--(1) In general. Except as provided 
in paragraph (a) (2) and (3) of this section, the amount realized from a 
sale or other disposition of property includes the amount of liabilities 
from which the transferor is discharged as a result of the sale or 
disposition.
    (2) Discharge of indebtedness. The amount realized on a sale or 
other disposition of property that secures a recourse liability does not 
include amounts that are (or would be if realized and recognized) income 
from the discharge of indebtedness under section 61(a)(12). For 
situations where amounts arising from the discharge of indebtedness are 
not realized and recognized, see section 108 and Sec. 1.61-12(b)(1).
    (3) Liability incurred on acquisition. In the case of a liability 
incurred by reason of the acquisition of the property, this section does 
not apply to the extent that such liability was not taken into account 
in determining the transferor's basis for such property.
    (4) Special rules. For purposes of this section--
    (i) The sale or other disposition of property that secures a 
nonrecourse liability discharges the transferor from the liability;
    (ii) The sale or other disposition of property that secures a 
recourse liability discharges the transferor from the liability if 
another person agrees to pay the liability (whether or not the 
transferor is in fact released from liability);
    (iii) A disposition of property includes a gift of the property or a 
transfer of the property in satisfaction of liabilities to which it is 
subject;
    (iv) Contributions and distributions of property between a partner 
and a partnership are not sales or other dispositions of property; and
    (v) The liabilities from which a transferor is discharged as a 
result of the sale or disposition of a partnership interest include the 
transferor's share of the liabilities of the partnership.
    (b) Effect of fair market value of security. The fair market value 
of the security at the time of sale or disposition is not relevant for 
purposes of determining under paragraph (a) of this section the amount 
of liabilities from which the taxpayer is discharged or treated as 
discharged. Thus, the fact that the fair market value of the property is 
less than the amount of the liabilities it secures does not prevent the 
full amount of those liabilities from being treated as money received 
from the sale or other disposition of the property. However, see 
paragraph (a)(2) of this section for a rule relating to certain income 
from discharge of indebtedness.
    (c) Examples. The provisions of this section may be illustrated by 
the following examples. In each example assume the taxpayer uses the 
cash receipts and disbursements method of accounting, makes a return on 
the basis of the calendar year, and sells or disposes of all property 
which is security for a given liability.

    Example 1. In 1976 A purchases an asset for $10,000. A pays the 
seller $1,000 in cash and signs a note payable to the seller for $9,000. 
A is personally liable for repayment with the seller having full 
recourse in the event of default. In addition, the asset which was 
purchased is pledged as security. During the years 1976 and 1977, A 
takes depreciation deductions on the asset in the amount of $3,100. 
During this same time period A reduces the outstanding principal on the 
note to $7,600. At the beginning of 1978 A sells the asset. The buyer 
pays A $1,600 in cash and assumes

[[Page 16]]

personal liability for the $7,600 outstanding liability. A becomes 
secondarily liable for repayment of the liability. A's amount realized 
is $9,200 ($1,600 + $7,600). Since A's adjusted basis in the asset is 
$6,900 ($10,000 - $3,100) A realizes a gain of $2,300 ($9,200 - $6,900).
    Example 2. Assume the same facts as in example (1) except that A is 
not personally liable on the $9,000 note given to the seller and in the 
event of default the seller's only recourse is to the asset. In 
addition, on the sale of the asset by A, the purchaser takes the asset 
subject to the liability. Nevertheless, A's amount realized is $9,200 
and A's gain realized is $2,300 on the sale.
    Example 3. In 1975 L becomes a limited partner in partnership GL. L 
contributes $10,000 in cash to GL and L's distributive share of 
partnership income and loss is 10 percent. L is not entitled to receive 
any guaranteed payments. In 1978 M purchases L's entire interest in 
partnership GL. At the time of the sale L's adjusted basis in the 
partnership interest is $20,000. At that time L's proportionate share of 
liabilities, of which no partner has assumed personal liability, is 
$15,000. M pays $10,000 in cash for L's interest in the partnership. 
Under section 752(d) and this section, L's share of partnership 
liabilities, $15,000, is treated as money received. Accordingly, L's 
amount realized on the sale of the partnership interest is $25,000 
($10,000 + $15,000). L's gain realized on the sale is $5,000 ($25,000 - 
$20,000).
    Example 4. In 1976 B becomes a limited partner in partnership BG. In 
1978 B contributes B's entire interest in BG to a charitable 
organization described in section 170(c). At the time of the 
contribution all of the partnership liabilities are liabilities for 
which neither B nor G has assumed any personal liability and B's 
proportionate share of which is $9,000. The charitable organization does 
not pay any cash or other property to B, but takes the partnership 
interest subject to the $9,000 of liabilities. Assume that the 
contribution is treated as a bargain sale to a charitable organization 
and that under section 1011(b) $3,000 is determined to be the portion of 
B's basis in the partnership interest allocable to the sale. Under 
section 752(d) and this section, the $9,000 of liabilities is treated by 
B as money received, thereby making B's amount realized $9,000. B's gain 
realized is $6,000 ($9,000 - $3,000).
    Example 5. In 1975 C, an individual, creates T, an irrevocable 
trust. Due to certain powers expressly retained by C, T is a ``grantor 
trust'' for purposes of subpart E of part 1 of subchapter J of the code 
and therefore C is treated as the owner of the entire trust. T purchases 
an interest in P, a partnership. C, as owner of T, deducts the 
distributive share of partnership losses attributable to the partnership 
interest held by T. In 1978, when the adjusted basis of the partnership 
interest held by T is $1,200, C renounces the powers previously and 
expressly retained that initially resulted in T being classified as a 
grantor trust. Consequently, T ceases to be a grantor trust and C is no 
longer considered to be the owner of the trust. At the time of the 
renunciation all of P's liabilities are liabilities on which none of the 
partners have assumed any personal liability and the proportionate share 
of which of the interest held by T is $11,000. Since prior to the 
renunciation C was the owner of the entire trust, C was considered the 
owner of all the trust property for Federal income tax purposes, 
including the partnership interest. Since C was considered to be the 
owner of the partnership interest, C not T, was considered to be the 
partner in P during the time T was a ``grantor trust''. However, at the 
time C renounced the powers that gave rise to T's classification as a 
grantor trust, T no longer qualified as a grantor trust with the result 
that C was no longer considered to be the owner of the trust and trust 
property for Federal income tax purposes. Consequently, at that time, C 
is considered to have transferred ownership of the interest in P to T, 
now a separate taxable entity, independent of its grantor C. On the 
transfer, C's share of partnership liabilities ($11,000) is treated as 
money received. Accordingly, C's amount realized is $11,000 and C's gain 
realized is $9,800 ($11,000 - $1,200).
    Example 6. In 1977 D purchases an asset for $7,500. D pays the 
seller $1,500 in cash and signs a note payable to the seller for $6,000. 
D is not personally liable for repayment but pledges as security the 
newly purchased asset. In the event of default, the seller's only 
recourse is to the asset. During the years 1977 and 1978 D takes 
depreciation deductions on the asset totaling $4,200 thereby reducing 
D's basis in the asset to $3,300 ($7,500 - $4,200). In 1979 D transfers 
the asset to a trust which is not a ``grantor trust'' for purposes of 
subpart E of part 1 of subchapter J of the Code. Therefore D is not 
treated as the owner of the trust. The trust takes the asset subject to 
the liability and in addition pays D $750 in cash. Prior to the transfer 
D had reduced the amount outstanding on the liability to $4,700. D's 
amount realized on the transfer is $5,450 ($4,700 + $750). Since D's 
adjusted basis is $3,300, D's gain realized is $2,150 ($5,450 - $3,300).
    Example 7. In 1974 E purchases a herd of cattle for breeding 
purposes. The purchase price is $20,000 consisting of $1,000 cash and a 
$19,000 note. E is not personally liable for repayment of the liability 
and the seller's only recourse in the event of default is to the herd of 
cattle. In 1977 E transfers the herd back to the original seller thereby 
satisfying the indebtedness pursuant to a provision in the original 
sales agreement. At the time of the transfer the fair market value of 
the herd is $15,000 and the remaining principal balance

[[Page 17]]

on the note is $19,000. At that time E's adjusted basis in the herd is 
$16,500 due to a deductible loss incurred when a portion of the herd 
died as a result of disease. As a result of the indebtedness being 
satisfied, E's amount realized is $19,000 notwithstanding the fact that 
the fair market value of the herd was less than $19,000. E's realized 
gain is $2,500 ($19,000 - $16,500).
    Example 8. In 1980, F transfers to a creditor an asset with a fair 
market value of $6,000 and the creditor discharges $7,500 of 
indebtedness for which F is personally liable. The amount realized on 
the disposition of the asset is its fair market value ($6,000). In 
addition, F has income from the discharge of indebtedness of $1,500 
($7,500 - $6,000).

[T.D. 7741, 45 FR 81744, Dec. 12, 1980]



Sec. 1.1001-3  Modifications of debt instruments.

    (a) Scope--(1) In general. This section provides rules for 
determining whether a modification of the terms of a debt instrument 
results in an exchange for purposes of Sec. 1.1001-1(a). This section 
applies to any modification of a debt instrument, regardless of the form 
of the modification. For example, this section applies to an exchange of 
a new instrument for an existing debt instrument, or to an amendment of 
an existing debt instrument. This section also applies to a modification 
of a debt instrument that the issuer and holder accomplish indirectly 
through one or more transactions with third parties. This section, 
however, does not apply to exchanges of debt instruments between 
holders.
    (2) Qualified tender bonds. This section does not apply for purposes 
of determining whether tax-exempt bonds that are qualified tender bonds 
are reissued for purposes of sections 103 and 141 through 150.
    (b) General rule. For purposes of Sec. 1.1001-1(a), a significant 
modification of a debt instrument, within the meaning of this section, 
results in an exchange of the original debt instrument for a modified 
instrument that differs materially either in kind or in extent. A 
modification that is not a significant modification is not an exchange 
for purposes of Sec. 1.1001-1(a). Paragraphs (c) and (d) of this section 
define the term modification and contain examples illustrating the 
application of the rule. Paragraphs (e) and (f) of this section provide 
rules for determining when a modification is a significant modification. 
Paragraph (g) of this section contains examples illustrating the 
application of the rules in paragraphs (e) and (f) of this section.
    (c) Modification defined--(1) In general--(i) Alteration of terms. A 
modification means any alteration, including any deletion or addition, 
in whole or in part, of a legal right or obligation of the issuer or a 
holder of a debt instrument, whether the alteration is evidenced by an 
express agreement (oral or written), conduct of the parties, or 
otherwise.
    (ii) Alterations occurring by operation of the terms of a debt 
instrument. Except as provided in paragraph (c)(2) of this section, an 
alteration of a legal right or obligation that occurs by operation of 
the terms of a debt instrument is not a modification. An alteration that 
occurs by operation of the terms may occur automatically (for example, 
an annual resetting of the interest rate based on the value of an index 
or a specified increase in the interest rate if the value of the 
collateral declines from a specified level) or may occur as a result of 
the exercise of an option provided to an issuer or a holder to change a 
term of a debt instrument.
    (2) Exceptions. The alterations described in this paragraph (c)(2) 
are modifications, even if the alterations occur by operation of the 
terms of a debt instrument.
    (i) Change in obligor or nature of instrument. An alteration that 
results in the substitution of a new obligor, the addition or deletion 
of a co-obligor, or a change (in whole or in part) in the recourse 
nature of the instrument (from recourse to nonrecourse or from 
nonrecourse to recourse) is a modification.
    (ii) Property that is not debt. An alteration that results in an 
instrument or property right that is not debt for Federal income tax 
purposes is a modification unless the alteration occurs pursuant to a 
holder's option under the terms of the instrument to convert the 
instrument into equity of the issuer (notwithstanding paragraph 
(c)(2)(iii) of this section).
    (iii) Certain alterations resulting from the exercise of an option. 
An alteration that results from the exercise of an option provided to an 
issuer or a holder

[[Page 18]]

to change a term of a debt instrument is a modification unless--
    (A) The option is unilateral (as defined in paragraph (c)(3) of this 
section); and
    (B) In the case of an option exercisable by a holder, the exercise 
of the option does not result in (or, in the case of a variable or 
contingent payment, is not reasonably expected to result in) a deferral 
of, or a reduction in, any scheduled payment of interest or principal.
    (3) Unilateral option. For purposes of this section, an option is 
unilateral only if, under the terms of an instrument or under applicable 
law--
    (i) There does not exist at the time the option is exercised, or as 
a result of the exercise, a right of the other party to alter or 
terminate the instrument or put the instrument to a person who is 
related (within the meaning of section 267(b) or section 707(b)(1)) to 
the issuer;
    (ii) The exercise of the option does not require the consent or 
approval of--
    (A) The other party;
    (B) A person who is related to that party (within the meaning of 
section 267(b) or section 707(b)(1)), whether or not that person is a 
party to the instrument; or
    (C) A court or arbitrator; and
    (iii) The exercise of the option does not require consideration 
(other than incidental costs and expenses relating to the exercise of 
the option), unless, on the issue date of the instrument, the 
consideration is a de minimis amount, a specified amount, or an amount 
that is based on a formula that uses objective financial information (as 
defined in Sec. 1.446-3(c)(4)(ii)).
    (4) Failure to perform--(i) In general. The failure of an issuer to 
perform its obligations under a debt instrument is not itself an 
alteration of a legal right or obligation and is not a modification.
    (ii) Holder's temporary forbearance. Notwithstanding paragraph 
(c)(1) of this section, absent a written or oral agreement to alter 
other terms of the debt instrument, an agreement by the holder to stay 
collection or temporarily waive an acceleration clause or similar 
default right (including such a waiver following the exercise of a right 
to demand payment in full) is not a modification unless and until the 
forbearance remains in effect for a period that exceeds--
    (A) Two years following the issuer's initial failure to perform; and
    (B) Any additional period during which the parties conduct good 
faith negotiations or during which the issuer is in a title 11 or 
similar case (as defined in section 368(a)(3)(A)).
    (5) Failure to exercise an option. If a party to a debt instrument 
has an option to change a term of an instrument, the failure of the 
party to exercise that option is not a modification.
    (6) Time of modification--(i) In general. Except as provided in this 
paragraph (c)(6), an agreement to change a term of a debt instrument is 
a modification at the time the issuer and holder enter into the 
agreement, even if the change in the term is not immediately effective.
    (ii) Closing conditions. If the parties condition a change in a term 
of a debt instrument on reasonable closing conditions (for example, 
shareholder, regulatory, or senior creditor approval, or additional 
financing), a modification occurs on the closing date of the agreement. 
Thus, if the reasonable closing conditions do not occur so that the 
change in the term does not become effective, a modification does not 
occur.
    (iii) Bankruptcy proceedings. If a change in a term of a debt 
instrument occurs pursuant to a plan of reorganization in a title 11 or 
similar case (within the meaning of section 368(a)(3)(A)), a 
modification occurs upon the effective date of the plan. Thus, unless 
the plan becomes effective, a modification does not occur.
    (d) Examples. The following examples illustrate the provisions of 
paragraph (c) of this section:

    Example 1. Reset bond. A bond provides for the interest rate to be 
reset every 49 days through an auction by a remarketing agent. The reset 
of the interest rate occurs by operation of the terms of the bond and is 
not an alteration described in paragraph (c)(2) of this section. Thus, 
the reset of the interest rate is not a modification.
    Example 2. Obligation to maintain collateral. The original terms of 
a bond provide that the bond must be secured by a certain type of 
collateral having a specified value. The terms also require the issuer 
to substitute

[[Page 19]]

collateral if the value of the original collateral decreases. Any 
substitution of collateral that is required to maintain the value of the 
collateral occurs by operation of the terms of the bond and is not an 
alteration described in paragraph (c)(2) of this section. Thus, such a 
substitution of collateral is not a modification.
    Example 3. Alteration contingent on an act of a party. The original 
terms of a bond provide that the interest rate is 9 percent. The terms 
also provide that, if the issuer files an effective registration 
statement covering the bonds with the Securities and Exchange 
Commission, the interest rate will decrease to 8 percent. If the issuer 
registers the bond, the resulting decrease in the interest rate occurs 
by operation of the terms of the bond and is not an alteration described 
in paragraph (c)(2) of this section. Thus, such a decrease in the 
interest rate is not a modification.
    Example 4. Substitution of a new obligor occurring by operation of 
the terms of the debt instrument. Under the original terms of a bond 
issued by a corporation, an acquirer of substantially all of the 
corporation's assets may assume the corporation's obligations under the 
bond. Substantially all of the corporation's assets are acquired by 
another corporation and the acquiring corporation becomes the new 
obligor on the bond. Under paragraph (c)(2)(i) of this section, the 
substitution of a new obligor, even though it occurs by operation of the 
terms of the bond, is a modification.
    Example 5. Defeasance with release of covenants. (i) A corporation 
issues a 30-year, recourse bond. Under the terms of the bond, the 
corporation may secure a release of the financial and restrictive 
covenants by placing in trust government securities as collateral that 
will provide interest and principal payments sufficient to satisfy all 
scheduled payments on the bond. The corporation remains obligated for 
all payments, including the contribution of additional securities to the 
trust if necessary to provide sufficient amounts to satisfy the payment 
obligations. Under paragraph (c)(3) of this section, the option to 
defease the bond is a unilateral option.
    (ii) The alterations occur by operation of the terms of the debt 
instrument and are not described in paragraph (c)(2) of this section. 
Thus, such a release of the covenants is not a modification.
    Example 6. Legal defeasance. Under the terms of a recourse bond, the 
issuer may secure a release of the financial and restrictive covenants 
by placing in trust government securities that will provide interest and 
principal payments sufficient to satisfy all scheduled payments on the 
bond. Upon the creation of the trust, the issuer is released from any 
recourse liability on the bond and has no obligation to contribute 
additional securities to the trust if the trust funds are not sufficient 
to satisfy the scheduled payments on the bond. The release of the issuer 
is an alteration described in paragraph (c)(2)(i) of this section, and 
thus is a modification.
    Example 7. Exercise of an option by a holder that reduces amounts 
payable. (i) A financial institution holds a residential mortgage. Under 
the original terms of the mortgage, the financial institution has an 
option to decrease the interest rate. The financial institution 
anticipates that, if market interest rates decline, it may exercise this 
option in lieu of the mortgagor refinancing with another lender.
    (ii) The financial institution exercises the option to reduce the 
interest rate. The exercise of the option results in a reduction in 
scheduled payments and is an alteration described in paragraph 
(c)(2)(iii) of this section. Thus, the change in interest rate is a 
modification.
    Example 8. Conversion of adjustable rate to fixed rate mortgage. (i) 
The original terms of a mortgage provide for a variable interest rate, 
reset annually based on the value of an objective index. Under the terms 
of the mortgage, the mortgagor may, upon the payment of a fee equal to a 
specified percentage of the outstanding principal amount of the 
mortgage, convert to a fixed rate of interest as determined based on the 
value of a second objective index. The exercise of the option does not 
require the consent or approval of any person or create a right of the 
holder to alter the terms of, or to put, the instrument.
    (ii) Because the required consideration to exercise the option is a 
specified amount fixed on the issue date, the exercise of the option is 
unilateral as defined in paragraph (c)(3) of this section. The 
conversion to a fixed rate of interest is not an alteration described in 
paragraph (c)(2) of this section. Thus, the change in the type of 
interest rate occurs by operation of the terms of the instrument and is 
not a modification.
    Example 9. Holder's option to increase interest rate. (i) A 
corporation issues an 8-year note to a bank in exchange for cash. Under 
the terms of the note, the bank has the option to increase the rate of 
interest by a specified amount upon a certain decline in the 
corporation's credit rating. The bank's right to increase the interest 
rate is a unilateral option as described in paragraph (c)(3) of this 
section.
    (ii) The credit rating of the corporation declines below the 
specified level. The bank exercises its option to increase the rate of 
interest. The increase in the rate of interest occurs by operation of 
the terms of the note and does not result in a deferral or a reduction 
in the scheduled payments or any other alteration described in paragraph 
(c)(2) of this section. Thus, the change in interest rate is not a 
modification.

[[Page 20]]

    Example 10. Issuer's right to defer payment of interest. A 
corporation issues a 5-year note. Under the terms of the note, interest 
is payable annually at the rate of 10 percent. The corporation, however, 
has an option to defer any payment of interest until maturity. For any 
payments that are deferred, interest will compound at a rate of 12 
percent. The exercise of the option, which results in the deferral of 
payments, does not result from the exercise of an option by the holder. 
The exercise of the option occurs by operation of the terms of the debt 
instrument and is not a modification.
    Example 11. Holder's option to grant deferral of payment. (i) A 
corporation issues a 10-year note to a bank in exchange for cash. 
Interest on the note is payable semi-annually. Under the terms of the 
note, the bank may grant the corporation the right to defer all or part 
of the interest payments. For any payments that are deferred, interest 
will compound at a rate 150 basis points greater than the stated rate of 
interest.
    (ii) The corporation encounters financial difficulty and is unable 
to satisfy its obligations under the note. The bank exercises its option 
under the note and grants the corporation the right to defer payments. 
The exercise of the option results in a right of the corporation to 
defer scheduled payments and, under paragraph (c)(3)(i) of this section, 
is not a unilateral option. Thus, the alteration is described in 
paragraph (c)(2)(iii) of this section and is a modification.
    Example 12. Alteration requiring consent. The original terms of a 
bond include a provision that the issuer may extend the maturity of the 
bond with the consent of the holder. Because any extension pursuant to 
this term requires the consent of both parties, such an extension does 
not occur by the exercise of a unilateral option (as defined in 
paragraph (c)(3) of this section) and is a modification.
    Example 13. Waiver of an acceleration clause. Under the terms of a 
bond, if the issuer fails to make a scheduled payment, the full 
principal amount of the bond is due and payable immediately. Following 
the issuer's failure to make a scheduled payment, the holder temporarily 
waives its right to receive the full principal for a period ending one 
year from the date of the issuer's default to allow the issuer to obtain 
additional financial resources. Under paragraph (c)(4)(ii) of this 
section, the temporary waiver in this situation is not a modification. 
The result would be the same if the terms provided the holder with the 
right to demand the full principal amount upon the failure of the issuer 
to make a scheduled payment and, upon such a failure, the holder 
exercised that right and then waived the right to receive the payment 
for one year.

    (e) Significant modifications. Whether the modification of a debt 
instrument is a significant modification is determined under the rules 
of this paragraph (e). Paragraph (e)(1) of this section provides a 
general rule for determining the significance of modifications not 
otherwise addressed in this paragraph (e). Paragraphs (e) (2) through 
(6) of this section provide specific rules for determining the 
significance of certain types of modifications. Paragraph (f) of this 
section provides rules of application, including rules for modifications 
that are effective on a deferred basis or upon the occurrence of a 
contingency.
    (1) General rule. Except as otherwise provided in paragraphs (e)(2) 
through (e)(6) of this section, a modification is a significant 
modification only if, based on all facts and circumstances, the legal 
rights or obligations that are altered and the degree to which they are 
altered are economically significant. In making a determination under 
this paragraph (e)(1), all modifications to the debt instrument (other 
than modifications subject to paragraphs (e) (2) through (6) of this 
section) are considered collectively, so that a series of such 
modifications may be significant when considered together although each 
modification, if considered alone, would not be significant.
    (2) Change in yield--(i) Scope of rule. This paragraph (e)(2) 
applies to debt instruments that provide for only fixed payments, debt 
instruments with alternative payment schedules subject to Sec. 1.1272-
1(c), debt instruments that provide for a fixed yield subject to 
Sec. 1.1272-1(d) (such as certain demand loans), and variable rate debt 
instruments. Whether a change in the yield of other debt instruments 
(for example, a contingent payment debt instrument) is a significant 
modification is determined under paragraph (e)(1) of this section.
    (ii) In general. A change in the yield of a debt instrument is a 
significant modification if the yield computed under paragraph 
(e)(2)(iii) of this section varies from the annual yield on the 
unmodified instrument (determined as of the date of the modification) by 
more than the greater of--
    (A) \1/4\ of one percent (25 basis points); or

[[Page 21]]

    (B) 5 percent of the annual yield of the unmodified instrument (.05 
x annual yield).
    (iii) Yield of the modified instrument--(A) In general. The yield 
computed under this paragraph (e)(2)(iii) is the annual yield of a debt 
instrument with--
    (1) An issue price equal to the adjusted issue price of the 
unmodified instrument on the date of the modification (increased by any 
accrued but unpaid interest and decreased by any accrued bond issuance 
premium not yet taken into account, and increased or decreased, 
respectively, to reflect payments made to the issuer or to the holder as 
consideration for the modification); and
    (2) Payments equal to the payments on the modified debt instrument 
from the date of the modification.
    (B) Prepayment penalty. For purposes of this paragraph (e)(2)(iii), 
a commercially reasonable prepayment penalty for a pro rata prepayment 
(as defined in Sec. 1.1275-2(f)) is not consideration for a modification 
of a debt instrument and is not taken into account in determining the 
yield of the modified instrument.
    (iv) Variable rate debt instruments. For purposes of this paragraph 
(e)(2), the annual yield of a variable rate debt instrument is the 
annual yield of the equivalent fixed rate debt instrument (as defined in 
Sec. 1.1275-5(e)) which is constructed based on the terms of the 
instrument (either modified or unmodified, whichever is applicable) as 
of the date of the modification.
    (3) Changes in timing of payments--(i) In general. A modification 
that changes the timing of payments (including any resulting change in 
the amount of payments) due under a debt instrument is a significant 
modification if it results in the material deferral of scheduled 
payments. The deferral may occur either through an extension of the 
final maturity date of an instrument or through a deferral of payments 
due prior to maturity. The materiality of the deferral depends on all 
the facts and circumstances, including the length of the deferral, the 
original term of the instrument, the amounts of the payments that are 
deferred, and the time period between the modification and the actual 
deferral of payments.
    (ii) Safe-harbor period. The deferral of one or more scheduled 
payments within the safe-harbor period is not a material deferral if the 
deferred payments are unconditionally payable no later than at the end 
of the safe-harbor period. The safe-harbor period begins on the original 
due date of the first scheduled payment that is deferred and extends for 
a period equal to the lesser of five years or 50 percent of the original 
term of the instrument. For purposes of this paragraph (e)(3)(ii), the 
term of an instrument is determined without regard to any option to 
extend the original maturity and deferrals of de minimis payments are 
ignored. If the period during which payments are deferred is less than 
the full safe-harbor period, the unused portion of the period remains a 
safe-harbor period for any subsequent deferral of payments on the 
instrument.
    (4) Change in obligor or security--(i) Substitution of a new obligor 
on recourse debt instruments--(A) In general. Except as provided in 
paragraph (e)(4)(i) (B), (C), or (D) of this section, the substitution 
of a new obligor on a recourse debt instrument is a significant 
modification.
    (B) Section 381(a) transaction. The substitution of a new obligor is 
not a significant modification if the acquiring corporation (within the 
meaning of section 381) becomes the new obligor pursuant to a 
transaction to which section 381(a) applies, the transaction does not 
result in a change in payment expectations, and the transaction (other 
than a reorganization within the meaning of section 368(a)(1)(F)) does 
not result in a significant alteration.
    (C) Certain asset acquisitions. The substitution of a new obligor is 
not a significant modification if the new obligor acquires substantially 
all of the assets of the original obligor, the transaction does not 
result in a change in payment expectations, and the transaction does not 
result in a significant alteration.
    (D) Tax-exempt bonds. The substitution of a new obligor on a tax-
exempt bond is not a significant modification if the new obligor is a 
related entity to

[[Page 22]]

the original obligor as defined in section 168(h)(4)(A) and the 
collateral securing the instrument continues to include the original 
collateral.
    (E) Significant alteration. For purposes of this paragraph (e)(4), a 
significant alteration is an alteration that would be a significant 
modification but for the fact that the alteration occurs by operation of 
the terms of the instrument.
    (F) Section 338 election. For purposes of this section, an election 
under section 338 following a qualified stock purchase of an issuer's 
stock does not result in the substitution of a new obligor.
    (G) Bankruptcy proceedings. For purposes of this section, the filing 
of a petition in a title 11 or similar case (as defined in section 
368(a)(3)(A)) by itself does not result in the substitution of a new 
obligor.
    (ii) Substitution of a new obligor on nonrecourse debt instruments. 
The substitution of a new obligor on a nonrecourse debt instrument is 
not a significant modification.
    (iii) Addition or deletion of co-obligor. The addition or deletion 
of a co-obligor on a debt instrument is a significant modification if 
the addition or deletion of the co-obligor results in a change in 
payment expectations. If the addition or deletion of a co-obligor is 
part of a transaction or series of related transactions that results in 
the substitution of a new obligor, however, the transaction is treated 
as a substitution of a new obligor (and is tested under paragraph 
(e)(4)(i)) of this section rather than as an addition or deletion of a 
co-obligor.
    (iv) Change in security or credit enhancement--(A) Recourse debt 
instruments. A modification that releases, substitutes, adds or 
otherwise alters the collateral for, a guarantee on, or other form of 
credit enhancement for a recourse debt instrument is a significant 
modification if the modification results in a change in payment 
expectations.
    (B) Nonrecourse debt instruments. A modification that releases, 
substitutes, adds or otherwise alters a substantial amount of the 
collateral for, a guarantee on, or other form of credit enhancement for 
a nonrecourse debt instrument is a significant modification. A 
substitution of collateral is not a significant modification, however, 
if the collateral is fungible or otherwise of a type where the 
particular units pledged are unimportant (for example, government 
securities or financial instruments of a particular type and rating). In 
addition, the substitution of a similar commercially available credit 
enhancement contract is not a significant modification, and an 
improvement to the property securing a nonrecourse debt instrument does 
not result in a significant modification.
    (v) Change in priority of debt. A change in the priority of a debt 
instrument relative to other debt of the issuer is a significant 
modification if it results in a change in payment expectations.
    (vi) Change in payment expectations--(A) In general. For purposes of 
this section, a change in payment expectations occurs if, as a result of 
a transaction--
    (1) There is a substantial enhancement of the obligor's capacity to 
meet the payment obligations under a debt instrument and that capacity 
was primarily speculative prior to the modification and is adequate 
after the modification; or
    (2) There is a substantial impairment of the obligor's capacity to 
meet the payment obligations under a debt instrument and that capacity 
was adequate prior to the modification and is primarily speculative 
after the modification.
    (B) Obligor's capacity. The obligor's capacity includes any source 
for payment, including collateral, guarantees, or other credit 
enhancement.
    (5) Changes in the nature of a debt instrument--(i) Property that is 
not debt. A modification of a debt instrument that results in an 
instrument or property right that is not debt for Federal income tax 
purposes is a significant modification. For purposes of this paragraph 
(e)(5)(i), any deterioration in the financial condition of the obligor 
between the issue date of the unmodified instrument and the date of 
modification (as it relates to the obligor's ability to repay the debt) 
is not taken into account unless, in connection with

[[Page 23]]

the modification, there is a substitution of a new obligor or the 
addition or deletion of a co-obligor.
    (ii) Change in recourse nature--(A) In general. Except as provided 
in paragraph (e)(5)(ii)(B) of this section, a change in the nature of a 
debt instrument from recourse (or substantially all recourse) to 
nonrecourse (or substantially all nonrecourse) is a significant 
modification. Thus, for example, a legal defeasance of a debt instrument 
in which the issuer is released from all liability to make payments on 
the debt instrument (including an obligation to contribute additional 
securities to a trust if necessary to provide sufficient funds to meet 
all scheduled payments on the instrument) is a significant modification. 
Similarly, a change in the nature of the debt instrument from 
nonrecourse (or substantially all nonrecourse) to recourse (or 
substantially all recourse) is a significant modification. If an 
instrument is not substantially all recourse or not substantially all 
nonrecourse either before or after a modification, the significance of 
the modification is determined under paragraph (e)(1) of this section.
    (B) Exceptions--(1) Defeasance of tax-exempt bonds. A defeasance of 
a tax-exempt bond is not a significant modification even if the issuer 
is released from any liability to make payments under the instrument if 
the defeasance occurs by operation of the terms of the original bond and 
the issuer places in trust government securities or tax-exempt 
government bonds that are reasonably expected to provide interest and 
principal payments sufficient to satisfy the payment obligations under 
the bond.
    (2) Original collateral. A modification that changes a recourse debt 
instrument to a nonrecourse debt instrument is not a significant 
modification if the instrument continues to be secured only by the 
original collateral and the modification does not result in a change in 
payment expectations. For this purpose, if the original collateral is 
fungible or otherwise of a type where the particular units pledged are 
unimportant (for example, government securities or financial instruments 
of a particular type and rating), replacement of some or all units of 
the original collateral with other units of the same or similar type and 
aggregate value is not considered a change in the original collateral.
    (6) Accounting or financial covenants. A modification that adds, 
deletes, or alters customary accounting or financial covenants is not a 
significant modification.
    (f) Rules of application--(1) Testing for significance--(i) In 
general. Whether a modification of any term is a significant 
modification is determined under each applicable rule in paragraphs (e) 
(2) through (6) of this section and, if not specifically addressed in 
those rules, under the general rule in paragraph (e)(1) of this section. 
For example, a deferral of payments that changes the yield of a fixed 
rate debt instrument must be tested under both paragraphs (e) (2) and 
(3) of this section.
    (ii) Contingent modifications. If a modification described in 
paragraphs (e) (2) through (5) of this section is effective only upon 
the occurrence of a substantial contingency, whether or not the change 
is a significant modification is determined under paragraph (e)(1) of 
this section rather than under paragraphs (e) (2) through (5) of this 
section.
    (iii) Deferred modifications. If a modification described in 
paragraphs (e) (4) and (5) of this section is effective on a 
substantially deferred basis, whether or not the change is a significant 
modification is determined under paragraph (e)(1) of this section rather 
than under paragraphs (e) (4) and (5) of this section.
    (2) Modifications that are not significant. If a rule in paragraphs 
(e) (2) through (4) of this section prescribes a degree of change in a 
term of a debt instrument that is a significant modification, a change 
of the same type but of a lesser degree is not a significant 
modification under that rule. For example, a 20 basis point change in 
the yield of a fixed rate debt instrument is not a significant 
modification under paragraph (e)(2) of this section. Likewise, if a rule 
in paragraph (e)(4) of this section requires a change in payment 
expectations for a modification to be significant, a modification of the 
same type that does not result in a change in

[[Page 24]]

payment expectations is not a significant modification under that rule.
    (3) Cumulative effect of modifications. Two or more modifications of 
a debt instrument over any period of time constitute a significant 
modification if, had they been done as a single change, the change would 
have resulted in a significant modification under paragraph (e) of this 
section. Thus, for example, a series of changes in the maturity of a 
debt instrument constitutes a significant modification if, combined as a 
single change, the change would have resulted in a significant 
modification. The significant modification occurs at the time that the 
cumulative modification would be significant under paragraph (e) of this 
section. In testing for a change of yield under paragraph (e)(2) of this 
section, however, any prior modification occurring more than 5 years 
before the date of the modification being tested is disregarded.
    (4) Modifications of different terms. Modifications of different 
terms of a debt instrument, none of which separately would be a 
significant modification under paragraphs (e) (2) through (6) of this 
section, do not collectively constitute a significant modification. For 
example, a change in yield that is not a significant modification under 
paragraph (e)(2) of this section and a substitution of collateral that 
is not a significant modification under paragraph (e)(4)(iv) of this 
section do not together result in a significant modification. Although 
the significance of each modification is determined independently, in 
testing a particular modification it is assumed that all other 
simultaneous modifications have already occurred.
    (5) Definitions. For purposes of this section:
    (i) Issuer and obligor are used interchangeably and mean the issuer 
of a debt instrument or a successor obligor.
    (ii) Variable rate debt instrument and contingent payment debt 
instrument have the meanings given those terms in section 1275 and the 
regulations thereunder.
    (iii) Tax-exempt bond means a state or local bond that satisfies the 
requirements of section 103(a).
    (iv) Conduit loan and conduit borrower have the same meanings as in 
Sec. 1.150-1(b).
    (6) Certain rules for tax-exempt bonds--(i) Conduit loans. For 
purposes of this section, the obligor of a tax-exempt bond is the entity 
that actually issues the bond and not a conduit borrower of bond 
proceeds. In determining whether there is a significant modification of 
a tax-exempt bond, however, transactions between holders of the tax-
exempt bond and a borrower of a conduit loan may be an indirect 
modification under paragraph (a)(1) of this section. For example, a 
payment by the holder of a tax-exempt bond to a conduit borrower to 
waive a call right may result in an indirect modification of the tax-
exempt bond by changing the yield on that bond.
    (ii) Recourse nature--(A) In general. For purposes of this section, 
a tax-exempt bond that does not finance a conduit loan is a recourse 
debt instrument.
    (B) Proceeds used for conduit loans. For purposes of this section, a 
tax-exempt bond that finances a conduit loan is a recourse debt 
instrument unless both the bond and the conduit loan are nonrecourse 
instruments.
    (C) Government securities as collateral. Notwithstanding paragraphs 
(f)(6)(ii) (A) and (B) of this section, for purposes of this section a 
tax-exempt bond that is secured only by a trust holding government 
securities or tax-exempt government bonds that are reasonably expected 
to provide interest and principal payments sufficient to satisfy the 
payment obligations under the bond is a nonrecourse instrument.
    (g) Examples. The following examples illustrate the provisions of 
paragraphs (e) and (f) of this section:

    Example 1. Modification of call right. (i) Under the terms of a 30-
year, fixed-rate bond, the issuer can call the bond for 102 percent of 
par at the end of ten years or for 101 percent of par at the end of 20 
years. At the end of the eighth year, the holder of the bond pays the 
issuer to waive the issuer's right to call the bond at the end of the 
tenth year. On the date of the modification, the issuer's credit rating 
is approximately the same as when the bond was issued, but market rates 
of interest have declined from that date.
    (ii) The holder's payment to the issuer changes the yield on the 
bond. Whether the

[[Page 25]]

change in yield is a significant modification depends on whether the 
yield on the modified bond varies from the yield on the original bond by 
more than the change in yield as described in paragraph (e)(2)(ii) of 
this section.
    (iii) If the change in yield is not a significant modification, the 
elimination of the issuer's call right must also be tested for 
significance. Because the specific rules of paragraphs (e)(2) through 
(e)(6) of this section do not address this modification, the 
significance of the modification must be determined under the general 
rule of paragraph (e)(1) of this section.
    Example 2. Extension of maturity and change in yield. (i) A zero-
coupon bond has an original maturity of ten years. At the end of the 
fifth year, the parties agree to extend the maturity for a period of two 
years without increasing the stated redemption price at maturity (i.e., 
there are no additional payments due between the original and extended 
maturity dates, and the amount due at the extended maturity date is 
equal to the amount due at the original maturity date).
    (ii) The deferral of the scheduled payment at maturity is tested 
under paragraph (e)(3) of this section. The safe-harbor period under 
paragraph (e)(3)(ii) of this section starts with the date the payment 
that is being deferred is due. For this modification, the safe-harbor 
period starts on the original maturity date, and ends five years from 
this date. All payments deferred within this period are unconditionally 
payable before the end of the safe-harbor period. Thus, the deferral of 
the payment at maturity for a period of two years is not a material 
deferral under the safe-harbor rule of paragraph (e)(3)(ii) of this 
section and thus is not a significant modification.
    (iii) Even though the extension of maturity is not a significant 
modification under paragraph (e)(3)(ii) of this section, the 
modification also decreases the yield of the bond. The change in yield 
must be tested under paragraph (e)(2) of this section.
    Example 3. Change in yield resulting from reduction of principal. 
(i) A debt instrument issued at par has an original maturity of ten 
years and provides for the payment of $100,000 at maturity with interest 
payments at the rate of 10 percent payable at the end of each year. At 
the end of the fifth year, and after the annual payment of interest, the 
issuer and holder agree to reduce the amount payable at maturity to 
$80,000. The annual interest rate remains at 10 percent but is payable 
on the reduced principal.
    (ii) In applying the change in yield rule of paragraph (e)(2) of 
this section, the yield of the instrument after the modification 
(measured from the date that the parties agree to the modification to 
its final maturity date) is computed using the adjusted issue price of 
$100,000. With four annual payments of $8,000, and a payment of $88,000 
at maturity, the yield on the instrument after the modification for 
purposes of determining if there has been a significant modification 
under paragraph (e)(2)(i) of this section is 4.332 percent. Thus, the 
reduction in principal is a significant modification.
    Example 4. Deferral of scheduled interest payments. (i) A 20-year 
debt instrument issued at par provides for the payment of $100,000 at 
maturity with annual interest payments at the rate of 10 percent. At the 
beginning of the eleventh year, the issuer and holder agree to defer all 
remaining interest payments until maturity with compounding. The yield 
of the modified instrument remains at 10 percent.
    (ii) The safe-harbor period of paragraph (e)(3)(ii) of this section 
begins at the end of the eleventh year, when the interest payment for 
that year is deferred, and ends at the end of the sixteenth year. 
However, the payments deferred during this period are not 
unconditionally payable by the end of that 5-year period. Thus, the 
deferral of the interest payments is not within the safe-harbor period.
    (iii) This modification materially defers the payments due under the 
instrument and is a significant modification under paragraph (e)(3)(i) 
of this section.
    Example 5. Assumption of mortgage with increase in interest rate. 
(i) A recourse debt instrument with a 9 percent annual yield is secured 
by an office building. Under the terms of the instrument, a purchaser of 
the building may assume the debt and be substituted for the original 
obligor if the purchaser has a specified credit rating and if the 
interest rate on the instrument is increased by one-half percent (50 
basis points). The building is sold, the purchaser assumes the debt, and 
the interest rate increases by 50 basis points.
    (ii) If the purchaser's acquisition of the building does not satisfy 
the requirements of paragraphs (e)(4)(i) (B) or (C) of this section, the 
substitution of the purchaser as the obligor is a significant 
modification under paragraph (e)(4)(i)(A) of this section.
    (iii) If the purchaser acquires substantially all of the assets of 
the original obligor, the assumption of the debt instrument will not 
result in a significant modification if there is not a change in payment 
expectations and the assumption does not result in a significant 
alteration.
    (iv) The change in the interest rate, if tested under the rules of 
paragraph (e)(2) of this section, would result in a significant 
modification. The change in interest rate that results from the 
transaction is a significant alteration. Thus, the transaction does not 
meet the requirements of paragraph (e)(4)(i)(C) of this section and is a 
significant modification under paragraph (e)(4)(i)(A) of this section.

[[Page 26]]

    Example 6. Assumption of mortgage. (i) A recourse debt instrument is 
secured by a building. In connection with the sale of the building, the 
purchaser of the building assumes the debt and is substituted as the new 
obligor on the debt instrument. The purchaser does not acquire 
substantially all of the assets of the original obligor.
    (ii) The transaction does not satisfy any of the exceptions set 
forth in paragraph (e)(4)(i) (B) or (C) of this section. Thus, the 
substitution of the purchaser as the obligor is a significant 
modification under paragraph (e)(4)(i)(A) of this section.
    (iii) Section 1274(c)(4), however, provides that if a debt 
instrument is assumed in connection with the sale or exchange of 
property, the assumption is not taken into account in determining if 
section 1274 applies to the debt instrument unless the terms and 
conditions of the debt instrument are modified in connection with the 
sale or exchange. Because the purchaser assumed the debt instrument in 
connection with the sale of property and the debt instrument was not 
otherwise modified, the debt instrument is not retested to determine 
whether it provides for adequate stated interest.
    Example 7. Substitution of a new obligor in section 381(a) 
transaction. (i) The interest rate on a 30-year debt instrument issued 
by a corporation provides for a variable rate of interest that is reset 
annually on June 1st based on an objective index.
    (ii) In the tenth year, the issuer merges (in a transaction to which 
section 381(a) applies) into another corporation that becomes the new 
obligor on the debt instrument. The merger occurs on June 1st, at which 
time the interest rate is also reset by operation of the terms of the 
instrument. The new interest rate varies from the previous interest rate 
by more than the greater of 25 basis points and 5 percent of the annual 
yield of the unmodified instrument. The substitution of a new obligor 
does not result in a change in payment expectations.
    (iii) The substitution of the new obligor occurs in a section 381(a) 
transaction and does not result in a change in payment expectations. 
Although the interest rate changed by more than the greater of 25 basis 
points and 5 percent of the annual yield of the unmodified instrument, 
this alteration did not occur as a result of the transaction and is not 
a significant alteration under paragraph (e)(4)(i)(E) of this section. 
Thus, the substitution meets the requirements of paragraph (e)(4)(i)(B) 
of this section and is not a significant modification.
    Example 8. Substitution of credit enhancement contract. (i) Under 
the terms of a recourse debt instrument, the issuer's obligations are 
secured by a letter of credit from a specified bank. The debt instrument 
does not contain any provision allowing a substitution of a letter of 
credit from a different bank. The specified bank, however, encounters 
financial difficulty and rating agencies lower its credit rating. The 
issuer and holder agree that the issuer will substitute a letter of 
credit from another bank with a higher credit rating.
    (ii) Under paragraph (e)(4)(iv)(A) of this section, the substitution 
of a different credit enhancement contract is not a significant 
modification of a recourse debt instrument unless the substitution 
results in a change in payment expectations. While the substitution of a 
new letter of credit by a bank with a higher credit rating does not 
itself result in a change in payment expectations, such a substitution 
may result in a change in payment expectations under certain 
circumstances (for example, if the obligor's capacity to meet payment 
obligations is dependent on the letter of credit and the substitution 
substantially enhances that capacity from primarily speculative to 
adequate).
    Example 9. Improvement to collateral securing nonrecourse debt. A 
parcel of land and its improvements, a shopping center, secure a 
nonrecourse debt instrument. The obligor expands the shopping center 
with the construction of an additional building on the same parcel of 
land. After the construction, the improvements that secure the 
nonrecourse debt include the new building. The building is an 
improvement to the property securing the nonrecourse debt instrument and 
its inclusion in the collateral securing the debt is not a significant 
modification under paragraph (e)(4)(iv)(B) of this section.

    (h) Effective date. This section applies to alterations of the terms 
of a debt instrument on or after September 24, 1996. Taxpayers, however, 
may rely on this section for alterations of the terms of a debt 
instrument after December 2, 1992, and before September 24, 1996.

[T.D. 8675, 61 FR 32930, June 26, 1996; 61 FR 47822, Sept. 11, 1996]



Sec. 1.1001-4  Modifications of certain notional principal contracts.

    (a) Dealer assignments. For purposes of Sec. 1.1001-1(a), the 
substitution of a new party on an interest rate or commodity swap, or 
other notional principal contract (as defined in Sec. 1.446-3(c)(1)), is 
not treated as a deemed exchange by the nonassigning party of the 
original contract for a modified contract that differs materially either 
in kind or in extent if--
    (1) The party assigning its rights and obligations under the 
contract and the

[[Page 27]]

party to which the rights and obligations are assigned are both dealers 
in notional principal contracts, as defined in Sec. 1.446-3(c)(4)(iii); 
and
    (2) The terms of the contract permit the substitution.
    (b) Effective date. This section applies to assignments of interest 
rate swaps, commodity swaps, and other notional principal contracts 
occurring on or after September 23, 1996.

[T.D. 8763, 63 FR 4396, Jan. 29, 1998]



Sec. 1.1001-5  European Monetary Union (conversion to the euro).

    (a) Conversion of currencies. For purposes of Sec. 1.1001-1(a), the 
conversion to the euro of legacy currencies (as defined in Sec. 1.985-
8(a)(1)) is not the exchange of property for other property differing 
materially in kind or extent.
    (b) Effect of currency conversion on other rights and obligations. 
For purposes of Sec. 1.1001-1(a), if, solely as the result of the 
conversion of legacy currencies to the euro, rights or obligations 
denominated in a legacy currency become rights or obligations 
denominated in the euro, that event is not the exchange of property for 
other property differing materially in kind or extent. Thus, for 
example, when a debt instrument that requires payments of amounts 
denominated in a legacy currency becomes a debt instrument requiring 
payments of euros, that alteration is not a modification within the 
meaning of Sec. 1.1001-3(c).
    (c) Effective date. This section applies to tax years ending after 
July 29, 1998.

[T.D. 8927, 66 FR 2218, Jan. 11, 2001]



Sec. 1.1002-1  Sales or exchanges.

    (a) General rule. The general rule with respect to gain or loss 
realized upon the sale or exchange of property as determined under 
section 1001 is that the entire amount of such gain or loss is 
recognized except in cases where specific provisions of subtitle A of 
the code provide otherwise.
    (b) Strict construction of exceptions from general rule. The 
exceptions from the general rule requiring the recognition of all gains 
and losses, like other exceptions from a rule of taxation of general and 
uniform application, are strictly construed and do not extend either 
beyond the words or the underlying assumptions and purposes of the 
exception. Nonrecognition is accorded by the Code only if the exchange 
is one which satisfies both (1) the specific description in the Code of 
an excepted exchange, and (2) the underlying purpose for which such 
exchange is excepted from the general rule. The exchange must be germane 
to, and a necessary incident of, the investment or enterprise in hand. 
The relationship of the exchange to the venture or enterprise is always 
material, and the surrounding facts and circumstances must be shown. As 
elsewhere, the taxpayer claiming the benefit of the exception must show 
himself within the exception.
    (c) Certain exceptions to general rule. Exceptions to the general 
rule are made, for example, by sections 351(a), 354, 361(a), 371(a)(1), 
371(b)(1), 721, 1031, 1035 and 1036. These sections describe certain 
specific exchanges of property in which at the time of the exchange 
particular differences exist between the property parted with and the 
property acquired, but such differences are more formal than 
substantial. As to these, the Code provides that such differences shall 
not be deemed controlling, and that gain or loss shall not be recognized 
at the time of the exchange. The underlying assumption of these 
exceptions is that the new property is substantially a continuation of 
the old investment still unliquidated; and, in the case of 
reorganizations, that the new enterprise, the new corporate structure, 
and the new property are substantially continuations of the old still 
unliquidated.
    (d) Exchange. Ordinarily, to constitute an exchange, the transaction 
must be a reciprocal transfer of property, as distinguished from a 
transfer of property for a money consideration only.

                   Basis Rules of General Application



Sec. 1.1011-1  Adjusted basis.

    The adjusted basis for determining the gain or loss from the sale or 
other disposition of property is the cost or other basis prescribed in 
section 1012 or other applicable provisions of subtitle A of the code, 
adjusted to the extent

[[Page 28]]

provided in sections 1016, 1017, and 1018 or as otherwise specifically 
provided for under applicable provisions of internal revenue laws.



Sec. 1.1011-2  Bargain sale to a charitable organization.

    (a) In general. (1) If for the taxable year a charitable 
contributions deduction is allowable under section 170 by reason of a 
sale or exchange of property, the taxpayer's adjusted basis of such 
property for purposes of determining gain from such sale or exchange 
must be computed as provided in section 1011(b) and paragraph (b) of 
this section. If after applying the provisions of section 170 for the 
taxable year, including the percentage limitations of section 170(b), no 
deduction is allowable under that section by reason of the sale or 
exchange of the property, section 1011(b) does not apply and the 
adjusted basis of the property is not required to be apportioned 
pursuant to paragraph (b) of this section. In such case the entire 
adjusted basis of the property is to be taken into account in 
determining gain from the sale or exchange, as provided in Sec. 1.1011-
1(e). In ascertaining whether or not a charitable contributions 
deduction is allowable under section 170 for the taxable year for such 
purposes, that section is to be applied without regard to this section 
and the amount by which the contributed portion of the property must be 
reduced under section 170(e)(1) is the amount determined by taking into 
account the amount of gain which would have been ordinary income or 
long-term capital gain if the contributed portion of the property had 
been sold by the donor at its fair market value at the time of the sale 
or exchange.
    (2) If in the taxable year there is a sale or exchange of property 
which gives rise to a charitable contribution which is carried over 
under section 170(b)(1)(D)(ii) or section 170(d) to a subsequent taxable 
year or is postponed under section 170(a)(3) to a subsequent taxable 
year, section 1011(b) and paragraph (b) of this section must be applied 
for purposes of apportioning the adjusted basis of the property for the 
year of the sale or exchange, whether or not such contribution is 
allowable as a deduction under section 170 in such subsequent year.
    (3) If property is transferred subject to an indebtedness, the 
amount of the indebtedness must be treated as an amount realized for 
purposes of determining whether there is a sale or exchange to which 
section 1011(b) and this section apply, even though the transferee does 
not agree to assume or pay the indebtedness.
    (4)(i) Section 1011(b) and this section apply where property is sold 
or exchanged in return for an obligation to pay an annuity and a 
charitable contributions deduction is allowable under section 170 by 
reason of such sale or exchange.
    (ii) If in such case the annuity received in exchange for the 
property is nonassignable, or is assignable but only to the charitable 
organization to which the property is sold or exchanged, and if the 
transferor is the only annuitant or the transferor and a designated 
survivor annuitant or annuitants are the only annuitants, any gain on 
such exchange is to be reported as provided in example (8) in paragraph 
(c) of this section. In determining the period over which gain may be 
reported as provided in such example, the life expectancy of the 
survivor annuitant may not be taken into account. The fact that the 
transferor may retain the right to revoke the survivor's annuity or 
relinquish his own right to the annuity will not be considered, for 
purposes of this subdivision, to make the annuity assignable to someone 
other than the charitable organization. Gain on an exchange of the type 
described in this subdivision pursuant to an agreement which is entered 
into after December 19, 1969, and before May 3, 1971, may be reported as 
provided in example (8) in paragraph (c) of this section, even though 
the annuity is assignable.
    (iii) In the case of an annuity to which subdivision (ii) of this 
subparagraph applies, the gain unreported by the transferor with respect 
to annuity payments not yet due when the following events occur is not 
required to be included in gross income of any person where--
    (a) The transferor dies before the entire amount of gain has been 
reported and there is no surviving annuitant, or

[[Page 29]]

    (b) The transferor relinquishes the annuity to the charitable 
organization.

If the transferor dies before the entire amount of gain on a two-life 
annuity has been reported, the unreported gain is required to be 
reported by the surviving annuitant or annuitants with respect to the 
annuity payments received by them.
    (b) Apportionment of adjusted basis. For purposes of determining 
gain on a sale or exchange to which this paragraph applies, the adjusted 
basis of the property which is sold or exchanged shall be that portion 
of the adjusted basis of the entire property which bears the same ratio 
to the adjusted basis as the amount realized bears to the fair market 
value of the entire property. The amount of such gain which shall be 
treated as ordinary income (or long-term capital gain) shall be that 
amount which bears the same ratio to the ordinary income (or long-term 
capital gain) which would have been recognized if the entire property 
had been sold by the donor at its fair market value at the time of the 
sale or exchange as the amount realized on the sale or exchange bears to 
the fair market value of the entire property at such time. The terms 
ordinary income and long-term capital gain, as used in this section, 
have the same meaning as they have in paragraph (a) of Sec. 1.170A-4. 
For determining the portion of the adjusted basis, ordinary income, and 
long- term capital gain allocated to the contributed portion of the 
property for purposes of applying section 170(e)(1) and paragraph (a) of 
Sec. 1.170A-4 to the contributed portion of the property, and for 
determining the donee's basis in such contributed portion, see paragraph 
(c) (2) and (4) of Sec. 1.170A-4. For determining the holding period of 
such contributed portion, see section 1223(2) and the regulations 
thereunder.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples, which are supplemented by other 
examples in paragraph (d) of Sec. 1.170A-4:

    Example 1. In 1970, A, a calendar-year individual taxpayer, sells to 
a church for $4,000 stock held for more than 6 months which has an 
adjusted basis of $4,000 and a fair market value of $10,000. A's 
contribution base for 1970, as defined in section 170(b)(1)(F), is 
$100,000, and during that year he makes no other charitable 
contributions. Thus, A makes a charitable contribution to the church of 
$6,000 ($10,000 value -$4,000 amount realized). Without regard to this 
section, A is allowed a deduction under section 170 of $6,000 for his 
charitable contribution to the church, since there is no reduction under 
section 170(e)(1) with respect to the long-term capital gain. 
Accordingly, under paragraph (b) of this section the adjusted basis for 
determining gain on the bargain sale is $1,600 ($4,000 adjusted basis x 
$4,000 amount realized / $10,000 value of property). A has recognized 
long-term capital gain of $2,400 ($4,000 amount realized - $1,600 
adjusted basis) on the bargain sale.
    Example 2. The facts are the same as in example (1) except that A 
also makes a charitable contribution in 1970 of $50,000 cash to the 
church. By reason of section 170(b)(1)(A), the deduction allowed under 
section 170 for 1970 is $50,000 for the amount of cash contributed to 
the church; however, the $6,000 contribution of property is carried over 
to 1971 under section 170(d). Under paragraphs (a)(2) and (b) of this 
section the adjusted basis for determining gain for 1970 on the bargain 
sale in that year is $1,600 ($4,000 x $4,000 / $10,000). A has a 
recognized long-term capital gain for 1970 of $2,400 ($4,000 - $1,600) 
on the sale.
    Example 3. In 1970, C, a calendar-year individual taxpayer, makes a 
charitable contribution of $50,000 cash to a church. In addition, he 
sells for $4,000 to a private foundation not described in section 
170(b)(1)(E) stock held for more than 6 months which has an adjusted 
basis of $4,000 and a fair market value of $10,000. Thus, C makes a 
charitable contribution of $6,000 of such property to the private 
foundation ($10,000 value - $4,000 amount realized). C's contribution 
base for 1970, as defined in section 170(b)(1)(F), is $100,000, and 
during that year he makes no other charitable contributions. By reason 
of section 170(b)(1)(A), the deduction allowed under section 170 for 
1970 is $50,000 for the amount of cash contributed to the church. Under 
section 170(e)(1)(B)(ii) and paragraphs (a)(1) and (c)(2)(i) of 
Sec. 1.170A-4, the $6,000 contribution of stock is reduced to $4,800 
($6,000 - [50% x ($6,000 value of contributed portion of stock - $3,600 
adjusted basis)]). However, by reason of section 170(b)(1)(B)(ii), 
applied without regard to section 1011(b), no deduction is allowed under 
section 170 for 1970 or any other year for the reduced contribution of 
$4,800 to the private foundation. Accordingly, paragraph (b) of this 
section does not apply for purposes of apportioning the adjusted basis 
of the stock sold to the private foundation, and under section 1.1011-
1(e) the recognized gain on the bargain sale is $0 ($4,000 amount 
realized - $4,000 adjusted basis).
    Example 4. In 1970, B, a calendar-year individual taxpayer, sells to 
a church for $2,000

[[Page 30]]

stock held for not more than 6 months which has an adjusted basis of 
$4,000 and a fair market value of $10,000. B's contribution base for 
1970, as defined in section 170(b)(1)(F), is $20,000 and during such 
year B makes no other charitable contributions. Thus, he makes a 
charitable contribution to the church of $8,000 ($10,000 value - $2,000 
amount realized). Under paragraph (b) of this section the adjusted basis 
for determining gain on the bargain sale is $800 ($4,000 adjusted basis 
x $2,000 amount realized / $10,000 value of stock). Accordingly, B, has 
a recognized short-term capital gain of $1,200 ($2,000 amount realized - 
$800 adjusted basis) on the bargain sale. After applying section 1011(b) 
and paragraphs (a)(1) and (c)(2)(i) of Sec. 1.170A-4, B is allowed a 
charitable contributions deduction for 1970 of $3,200 ($8,000 value of 
gift - [$8,000 - ($4,000 adjusted basis of property x $8,000 value of 
gift / $10,000 value of property)]).
    Example 5. The facts are the same as in Example 4 except that B 
sells the property to the church for $4,000. Thus, B makes a charitable 
contribution to the church of $6,000 ($10,000 value -$4,000 amount 
realized). Under paragraph (b) of this section the adjusted basis for 
determining gain on the bargain sale is $1,600 ($4,000 adjusted basis x 
$4,000 amount realized / $10,000 value of stock). Accordingly, B has a 
recognized short-term capital gain of $2,400 ($4,000 amount realized - 
$1,600 adjusted basis) on the bargain sale. After applying section 
1011(b) and paragraphs (a)(1) and (c)(2)(i) of Sec. 1.170A-4, B is 
allowed a charitable contributions deduction for 1970 of $2,400 ($6,000 
value of gift - [$6,000 - ($4,000 adjusted basis of property x $6,000 
value of gifts / $10,000 value of property)]).
    Example 6. The facts are the same as in Example 4 except that B 
sells the property to the church for $6,000. Thus, B makes a charitable 
contribution to the church of $4,000 ($10,000 value -$6,000 amount 
realized). Under paragraph (b) of this section the adjusted basis for 
determining gain on the bargain sale is $2,400 ($4,000 adjusted basis 
x$6,000 amount realized/$10,000 value of stock). Accordingly, B has a 
recognized short-term capital gain of $3,600 ($6,000 amount realized -
$2,400 adjusted basis) on the bargain sale. After applying section 
1011(b) and paragraphs (a)(1) and (c)(2)(i) of Sec. 1.170A-4, B is 
allowed a charitable contributions deduction for 1970 of $1,600 ($4,000 
value of gift -[$4,000 -($4,000 adjusted basis of property x$4,000 value 
of gift/$10,000 value of property]).
    Example 7. In 1970, C, a calendar-year individual taxpayer, sells to 
a church for $4,000 tangible personal property used in his business for 
more than 6 months which has an adjusted basis of $4,000 and a fair 
market value of $10,000. Thus, C makes a charitable contribution to the 
church of $6,000 ($10,000 value -$4,000 adjusted basis). C's 
contribution base for 1970, as defined in section 170(b)(1)(F) is 
$100,000 and during such year he makes no other charitable 
contributions. If C had sold the property at its fair market value at 
the time of its contribution, it is assumed that under section 1245 
$4,000 of the gain of $6,000 ($10,000 value -$4,000 adjusted basis) 
would have been treated as ordinary icome. Thus, there would have been 
long-term capital gain of $2,000. It is also assumed that the church 
does not put the property to an unrelated use, as defined in paragraph 
(b)(3) of Sec. 1.170A-4. Under paragraph (b) of this section the 
adjusted basis for determining gain on the bargain sale is $1,600 
($4,000 adjusted basis x$4,000 amount realized/$10,000 value of 
property). Accordingly, C has a recognized gain of $2,400 ($4,000 amount 
realized -$1,600 adjusted basis) on the bargain sale, consisting of 
ordinary income of $1,600 ($4,000 ordinary income x$4,000 amount 
realized/$10,000 value of property) and of long-term capital gain of 
$800 ($2,000 long-term gain x$4,000 amount realized/$10,000 value of 
property). After applying section 1011(b) and paragraphs (a) and 
(c)(2)(i) of Sec. 1.170A-4, C is allowed a charitable contributions 
deduction for 1970 of $3,600 ($6,000 gift -[$4,000 ordinary income 
x$6,000 value of gift/$10,000 value of property]).
    Example 8. (a) On January 1, 1970, A, a male of age 65, transfers 
capital assets consisting of securities held for more than 6 months to a 
church in exchange for a promise by the church to pay A a nonassignable 
annuity of $5,000 per year for life. The annuity is payable monthly with 
the first payment to be made on February 1, 1970. A's contribution base 
for 1970, as defined in section 170(b)(1)(F), is $200,000, and during 
that year he makes no other charitable contributions. On the date of 
transfer the securities have a fair market value of $100,000 and an 
adjusted basis to A of $20,000.
    (b) The present value of the right of a male age 65 to receive a 
life annuity of $5,000 per annum, payable in equal installments at the 
end of each monthly period, is $59,755 ($5,000 x [11.469 + 0.482]), 
determined in accordance with section 101(b) of the Code, paragraph 
(e)(1)(iii)(b)(2) of Sec. 1.101-2, and section 3 of Rev. Rul. 62-216, 
C.B. 1962-2, 30. Thus, A makes a charitable contribution to the church 
of $40,245 ($100,000 -$59,755). See Rev. Rul. 84-162, 1984-2 C.B. 200, 
for transfers for which the valuation date falls after November 23, 
1984. (See Sec. 601.601(d)(2)(ii)(b) of this chapter). For the 
applicable valuation tables in connection therewith, see Sec. 20.2031-
7(d)(6) of this chapter. See, however, Sec. 1.7520-3(b) (relating to 
exceptions to the use of standard actuarial factors in certain 
circumstances).
    (c) Under paragraph (b) of this section, the adjusted basis for 
determining gain on the bargain sale is $11,951 ($20,000 x $59,755 / 
$100,000). Accordingly, A has a recognized

[[Page 31]]

long-term capital gain of $47,804 ($59,755 - $11,951) on the bargain 
sale. Such gain is to be reported by A ratably over the period of years 
measured by the expected return multiple under the contract, but only 
from that portion of the annual payments which is a return of his 
investment in the contract under section 72 of the Code. For such 
purposes, the investment in the contract is $59,755, that is, the 
present value of the annuity.
    (d) The computation and application of the exclusion ratio, the 
gain, and the ordinary annuity income are as follows, determined by 
using the expected return multiple of 15.0 applicable under table I of 
Sec. 1.72-9:

A's expected return (annual payments of $5,000 x 15)........  $75,000.00
Exclusion ratio ($59,755 investment in contract divided by         79.7%
 expected return of $75,000)................................
Annual exclusion (annual payments of $5,000 x 79.7%)........   $3,985.00
Ordinary annuity income ($5,000-$3,985).....................   $1,015.00
Long-term capital gain per year ($47,804/15) with respect to   $3,186.93
 the annual exclusion.......................................
 

    (e) The exclusion ratio of 79.7 percent applies throughout the life 
of the contract. During the first 15 years of the annuity, A is required 
to report ordinary income of $1,015 and long-term capital gain of 
$3,186.93 with respect to the annuity payments he receives. After the 
total long-term capital gain of $47,804 has been reported by A, he is 
required to report only ordinary income of $1,015.00 per annum with 
respect to the annuity payments he receives.

    (d) Effective date. This section applies only to sales and exchanges 
made after December 19, 1969.
    (e) Cross reference. For rules relating to the treatment of 
liabilities on the sale or other disposition or encumbered property, see 
Sec. 1.1001-2.

[T.D. 7207, 37 FR 20798, Oct. 5, 1972, as amended by T.D. 7741, 45 FR 
81745, Dec. 12, 1980; T.D. 8176, 53 FR 5570, Feb. 25, 1988; 53 FR 11002, 
Apr. 4, 1988; T.D. 8540, 59 FR 30148, June 10, 1994]



Sec. 1.1012-1  Basis of property.

    (a) General rule. In general, the basis of property is the cost 
thereof. The cost is the amount paid for such property in cash or other 
property. This general rule is subject to exceptions stated in 
subchapter O (relating to gain or loss on the disposition of property), 
subchapter C (relating to corporate distributions and adjustments), 
subchapter K (relating to partners and partnerships), and subchapter P 
(relating to capital gains and losses), chapter 1 of the code.
    (b) Real estate taxes as part of cost. In computing the cost of real 
property, the purchaser shall not take into account any amount paid to 
the seller as reimbursement for real property taxes which are treated 
under section 164(d) as imposed upon the purchaser. This rule applies 
whether or not the contract of sale calls for the purchaser to reimburse 
the seller for such real estate taxes paid or to be paid by the seller. 
On the other hand, where the purchaser pays (or assumes liability for) 
real estate taxes which are treated under section 164(d) as imposed upon 
the seller, such taxes shall be considered part of the cost of the 
property. It is immaterial whether or not the contract of sale specifies 
that the sale price has been reduced by, or is in any way intended to 
reflect, real estate taxes allocable to the seller under section 164(d). 
For illustrations of the application of this paragraph, see paragraph 
(b) of Sec. 1.1001-1.
    (c) Sale of stock--(1) In general. If shares of stock in a 
corporation are sold or transferred by a taxpayer who purchased or 
acquired lots of stock on different dates or at different prices, and 
the lot from which the stock was sold or transferred cannot be 
adequately identified, the stock sold or transferred shall be charged 
against the earliest of such lots purchased or acquired in order to 
determine the cost or other basis of such stock and in order to 
determine the holding period of such stock for purposes of subchapter P, 
chapter 1 of the code. If, on the other hand, the lot from which the 
stock is sold or transferred can be adequately identified, the rule 
stated in the preceding sentence is not applicable. As to what 
constitutes ``adequate identification'', see subparagraphs (2), (3), and 
(4) of this paragraph.
    (2) Identification of stock. An adequate identification is made if 
it is shown that certificates representing shares of stock from a lot 
which was purchased or acquired on a certain date or for a certain price 
were delivered to the taxpayer's transferee. Except as otherwise 
provided in subparagraph (3) or (4) of this paragraph, such stock 
certificates delivered to the transferee constitute the stock sold or 
transferred by the

[[Page 32]]

taxpayer. Thus, unless the requirements of subparagraph (3) or (4) of 
this paragraph are met, the stock sold or transferred is charged to the 
lot to which the certificates delivered to the transferee belong, 
whether or not the taxpayer intends, or instructs his broker or other 
agent, to sell or transfer stock from a lot purchased or acquired on a 
different date or for a different price.
    (3) Identification on confirmation document. (i) Where the stock is 
left in the custody of a broker or other agent, an adequate 
identification is made if--
    (a) At the time of the sale or transfer, the taxpayer specifies to 
such broker or other agent having custody of the stock the particular 
stock to be sold or transferred, and
    (b) Within a reasonable time thereafter, confirmation of such 
specification is set forth in a written document from such broker or 
other agent.

Stock identified pursuant to this subdivision is the stock sold or 
transferred by the taxpayer, even though stock certificates from a 
different lot are delivered to the taxpayer's transferee.
    (ii) Where a single stock certificate represents stock from 
different lots, where such certificate is held by the taxpayer rather 
than his broker or other agent, and where the taxpayer sells a part of 
the stock represented by such certificate through a broker or other 
agent, an adequate identification is made if--
    (a) At the time of the delivery of the certificate to the broker or 
other agent, the taxpayer specifies to such broker or other agent the 
particular stock to be sold or transferred, and
    (b) Within a reasonable time thereafter, confirmation of such 
specification is set forth in a written document from such broker or 
agent.

Where part of the stock represented by a single certificate is sold or 
transferred directly by the taxpayer to the purchaser or transferee 
instead of through a broker or other agent, an adequate identification 
is made if the taxpayer maintains a written record of the particular 
stock which he intended to sell or transfer.
    (4) Stock held by a trustee, executor, or administrator. Where stock 
is held by a trustee or by an executor or administrator of an estate 
(and not left in the custody of a broker or other agent), an adequate 
identification is made if at the time of a sale, transfer, or 
distribution, the trustee, executor, or administrator--
    (i) Specifies in writing in the books and records of the trust or 
estate the particular stock to be sold, transferred, or distributed, and
    (ii) In the case of a distribution, also furnishes the distributee 
with a written document setting forth the particular stock distributed 
to him.

Stock identified pursuant to this subparagraph is the stock sold, 
transferred, or distributed by the trust or estate, even though stock 
certificates from a different lot are delivered to the purchaser, 
transferee, or distributee.
    (5) Subsequent sales. If stock identified under subparagraph (3) or 
(4) of this paragraph as belonging to a particular lot is sold, 
transferred, or distributed, the stock so identified shall be deemed to 
have been sold, transferred, or distributed, and such sale, transfer, or 
distribution will be taken into consideration in identifying the 
taxpayer's remaining stock for purposes of subsequent sales, transfers, 
or distributions.
    (6) Bonds. The provisions of subparagraphs (1) through (5) of this 
paragraph shall apply to the sale or transfer of bonds after July 13, 
1965.
    (7) Book-entry securities. (i) In applying the provisions of 
subparagraph (3)(i)(a) of this paragraph in the case of a sale or 
transfer of a book-entry security (as defined in subdivision (iii) (a) 
of this subparagraph) which is made after December 31, 1970, pursuant to 
a written instruction by the taxpayer, a specification by the taxpayer 
of the unique lot number which he has assigned to the lot which contains 
the securities being sold or transferred shall constitute specification 
as required by such subparagraph. The specification of the lot number 
shall be made either--
    (a) In such written instruction, or
    (b) In the case of a taxpayer in whose name the book entry by the 
Reserve Bank is made, in a list of lot numbers with respect to all book-
entry securities on the books of the Reserve Bank sold or transferred on 
that date by the taxpayer, provided such list is mailed

[[Page 33]]

to or received by the Reserve Bank on or before the Reserve Bank's next 
business day.

This subdivision shall apply only if the taxpayer assigns lot numbers in 
numerical sequence to successive purchases of securities of the same 
loan title (series) and maturity date, except that securities of the 
same loan title (series) and maturity date which are purchased at the 
same price on the same date may be included within the same lot.
    (ii) In applying the provisions of subparagraph (3)(i)(b) of this 
paragraph in the case of a sale or transfer of a book-entry security 
which is made pursuant to a written instruction by the taxpayer, a 
confirmation as required by such subparagraph shall be deemed made by--
    (a) In the case of a sale or transfer made after December 31, 1970, 
the furnishing to the taxpayer of a written advice of transaction, by 
the Reserve Bank or the person through whom the taxpayer sells or 
transfers the securities, which specifies the amount and description of 
the securities sold or transferred and the date of the transaction, or
    (b) In the case of a sale or transfer made before January 1, 1971, 
the furnishing of a serially-numbered advice of transaction by a Reserve 
Bank.
    (iii) For purposes of this subparagraph:
    (a) The term book-entry security means--
    (1) In the case of a sale or transfer made after December 31, 1970, 
a transferable Treasury bond, note, certificate of indebtedness, or bill 
issued under the Second Liberty Bond Act (31 U.S.C. 774 (2)), as 
amended, or other security of the United States (as defined in (b) of 
this subdivision (iii)) in the form of an entry made as prescribed in 31 
CFR part 306, or other comparable Federal regulations, on the records of 
a Reserve Bank, or
    (2) In the case of a sale or transfer made before January 1, 1971, a 
transferable Treasury bond, note, certificate of indebtedness, or bill 
issued under the Second Liberty Bond Act, as amended, in the form of an 
entry made as prescribed in 31 CFR part 306, subpart O, on the records 
of a Reserve Bank which is deposited in an account with a Reserve Bank 
(i) as collateral pledged to a Reserve Bank (in its individual capacity) 
for advances by it, (ii) as collateral pledged to the United States 
under Treasury Department Circular No. 92 or 176, both as revised and 
amended, (iii) by a member bank of the Federal Reserve System for its 
sole account for safekeeping by a Reserve Bank in its individual 
capacity, (iv) in lieu of a surety or sureties upon the bond required by 
section 61 of the Bankruptcy Act, as amended (11 U.S.C. 101), of a 
banking institution designated by a judge of one of the several courts 
of bankruptcy under such section as a depository for the moneys of a 
bankrupt's estate, (v) pursuant to 6 U.S.C. 15, in lieu of a surety or 
sureties required in connection with any recognizance, stipulation, 
bond, guaranty, or undertaking which must be furnished under any law of 
the United States or regulations made pursuant thereto, (vi) by a 
banking institution, pursuant to a State or local law, to secure the 
deposit in such banking institution of public funds by a State, 
municipality, or other political subdivision, (vii) by a State bank or 
trust company or a national bank, pursuant to a State or local law, to 
secure the faithful performance of trust or other fiduciary obligations 
by such State bank or trust company or national bank, or (viii) to 
secure funds which are deposited or held in trust by a State bank or 
trust company or a national bank and are awaiting investment, but which 
are used by such State bank or trust company or national bank in the 
conduct of its business;
    (b) The term other security of the United States means a bond, note, 
certificate of indebtedness, bill, debenture, or similar obligation 
which is subject to the provisions of 31 CFR part 306 or other 
comparable Federal regulations and which is issued by (1) any department 
or agency of the Government of the United States, or (2) the Federal 
National Mortgage Association, the Federal Home Loan Banks, the Federal 
Home Loan Mortgage Corporation, the Federal Land Banks, the Federal 
Intermediate Credit Banks, the Banks for Cooperatives, or the Tennessee 
Valley Authority;

[[Page 34]]

    (c) The term serially-numbered advice of transaction means the 
confirmation (prescribed in 31 CFR 306.116) issued by the Reserve Bank 
which is identifiable by a unique number and indicates that a particular 
written instruction to the Reserve Bank with respect to the deposit or 
withdrawal of a specified book-entry security (or securities) has been 
executed; and
    (d) The term Reserve Bank means a Federal Reserve Bank and its 
branches acting as Fiscal Agent of the United States.
    (d) Obligations issued as part of an investment unit. For purposes 
of determining the basis of the individual elements of an investment 
unit (as defined in paragraph (b)(2)(ii)(a) of Sec. 1.1232-3) consisting 
of an obligation and an option (which is not an excluded option under 
paragraph (b)(1)(iii)(c) of Sec. 1.1232-3), security, or other property, 
the cost of such investment unit shall be allocated to such individual 
elements on the basis of their respective fair market values. In the 
case of the initial issuance of an investment unit consisting of an 
obligation and an option, security, or other property, where neither the 
obligation nor the option, security, or other property has a readily 
ascertainable fair market value, the portion of the cost of the unit 
which is allocable to the obligation shall be an amount equal to the 
issue price of the obligation as determined under paragraph 
(b)(2)(ii)(a) of Sec. 1.1232-3.
    (e) Election as to certain regulated investment company stock--(1) 
General rule--(i) In general. Notwithstanding paragraph (c) of this 
section, and except as provided in subdivision (ii) of this 
subparagraph, if--
    (a) Shares of stock of a regulated investment company (as defined in 
subparagraph (5) of this paragraph) are left by a taxpayer in the 
custody of a custodian or agent in an account maintained for the 
acquisition or redemption of shares of such company, and
    (b) The taxpayer purchased or acquired shares of stock held in the 
account at different prices or bases, the taxpayer may elect to 
determine the cost or other basis of shares of stock he sells or 
transfers from such account by using one of the methods described in 
subparagraphs (3) and (4) of this paragraph. The cost or other basis 
determined in accordance with either of such methods shall be known as 
the average basis. For purposes of this paragraph, securities issued by 
unit investment trusts shall be treated as shares of stock and the term 
share or shares shall include fractions of a share.
    (ii) Certain gift shares. (a) Except as provided in subdivision (b) 
of this subdivision (ii), this paragraph shall not apply to any account 
which contains shares which were acquired by the taxpayer by gift after 
December 31, 1920, if the basis of such shares (adjusted for the period 
before the date of the gift as provided in section 1016) in the hands of 
the donor or the last preceding owner by whom it was not acquired by 
gift was greater than the fair market value of such shares at the time 
of the gift. However, shares acquired by a taxpayer as a result of a 
taxable dividend or a capital gain distribution from such an account may 
be included in an account to which this paragraph applies.
    (b) Notwithstanding the provisions of subdivision (a) of this 
subdivision (ii), this paragraph shall apply with respect to accounts 
containing gift shares described in such subdivision (a) if, at the time 
the election described in this paragraph is made in the manner 
prescribed in subparagraph (6) of this paragraph, the taxpayer includes 
a statement, in writing, indicating that the basis of such gift shares 
shall be the fair market value of such gift shares at the time they were 
acquired by the taxpayer by gift and that such basis shall be used in 
computing average basis in the manner described in subparagraph (3) or 
(4) of this paragraph. Such statement shall be effective with respect to 
gift shares acquired prior to making such election and with respect to 
gift shares acquired after such time and shall remain in effect so long 
as such election remains in effect.
    (2) Determination of average basis. Average basis shall be 
determined using either the method described in subparagraph (3) of this 
paragraph (the double-category method) or the method described in 
subparagraph (4) of this paragraph (the single-category method). The 
taxpayer shall specify, in the manner described in subparagraph (6)

[[Page 35]]

of this paragraph, the method used. Such method shall be used with 
respect to an account until such time as the election is revoked with 
the consent of the Commissioner. Although a taxpayer may specify 
different methods with respect to accounts in different regulated 
investment companies, the same method shall be used with respect to all 
of the taxpayer's accounts in the same regulated investment company.
    (3) Double-category method--(i) In general. In determining average 
basis using the double category method, all shares in an account at the 
time of each sale or transfer shall be divided into two categories. The 
first category shall include all shares in such account having, at the 
time of the sale or transfer, a holding period of more than 1-year (6-
months for taxable years beginning before 1977; 9-months for taxable 
years beginning in 1977) (the ``more-than 1-year (6-months for taxable 
years beginning before 1977; 9-months for taxable years beginning in 
1977)'' category), and the second category shall include all shares in 
such account having, at such time, a holding period of 1-year (6-months 
for taxable years beginning before 1977; 9-months for taxable years 
beginning in 1977) or less (the ``1-year (6-months for taxable years 
beginning before 1977; 9-months for taxable years beginning in 1977)-or-
less'' category). The cost or other basis of each share in a category 
shall be an amount equal to the remaining aggregate cost or other basis 
of all shares in that category at the time of the sale or transfer 
divided by the aggregate number of shares in that category at such time.
    (ii) Order of disposition of shares old or transferred. Prior to a 
sale or transfer of shares from such an account, the taxpayer may 
specify, to the custodian or agent having custody of the account, from 
which category (described in subdivision (i) of this subparagraph) the 
shares are to be sold or transferred. Shares shall be deemed sold or 
transferred from the category specified without regard to the stock 
certificates, if any, actually delivered if, within a reasonable time 
thereafter, confirmation of such specification is set forth in a written 
document from the custodian or agent having custody of the account. In 
the absence of such specification or confirmation, shares sold or 
transferred shall be charged against the more-than-1-year (6-months for 
taxable years beginning before 1977; 9-months for taxable years 
beginning in 1977) category. However, if the number of shares sold or 
transferred exceeds the number in such category, the additional shares 
sold or transferred shall be charged against the shares in the 1-year 
(6-months for taxable years beginning before 1977; 9-months for taxable 
years beginning in 1977)-or-less category. Any gain or loss attributable 
to a sale or transfer which is charged against shares in the more-than-
1-year (6-months for taxable years beginning before 1977; 9-months for 
taxable years beginning in 1977) category shall constitute long-term 
gain or loss, and any gain or loss attributable to a sale or transfer 
which is charged against shares in the 1-year (6-months for taxable 
years beginning before 1977; 9-months for taxable years beginning in 
1977)-or-less category shall constitute short-term gain or loss. As to 
adjustments from wash sales, see section 1091(d) and subdivisions (iii) 
(c) and (d) of this subparagraph.
    (iii) Special rules with respect to shares from the 1 year-or-less 
category. (a) After the taxpayer's holding period with respect to a 
share is more than 1-year (6-months for taxable years beginning before 
1977; 9-months for taxable years beginning in 1977), such share shall be 
changed from the 1-year (6-months for taxable years beginning before 
1977; 9-months for taxable years beginning in 1977)-or-less category to 
the more-than 1-year (6-months for taxable years beginning before 1977; 
9-months for taxable years beginning in 1977) category. For purposes of 
such change, the basis of a changed share shall be its actual cost or 
other basis to the taxpayer or its basis determined in accordance with 
the rules contained in subdivision (b)(2) of this subdivision (iii) if 
the rules of such subdivision (b)(2) are applicable.
    (b) If, during the period that shares are in the 1-year (6-months 
for taxable years beginning before 1977; 9-months for taxable years 
beginning in 1977)-or-less category some but not all of the shares in 
such category are sold or transferred, then--

[[Page 36]]

    (1) The shares sold or transferred (the basis of which was 
determined in the manner prescribed by subdivision (i) of this 
subparagraph) shall be assumed to be those shares in such category which 
were earliest purchased or acquired, and
    (2) The basis of those shares which are not sold or transferred and 
which are changed from the 1-year (6-months for taxable years beginning 
before 1977; 9-months for taxable years beginning in 1977)-or-less 
category to the more-than-1-year (6-months for taxable years beginning 
before 1977; 9-months for taxable years beginning in 1977) category 
shall be the average basis of the shares in the 1-year (6-months for 
taxable years beginning before 1977; 9-months for taxable years 
beginning in 1977)-or-less category at the time of the most recent sale 
or transfer of shares from such category. For such purposes, the average 
basis shall be determined in the manner prescribed in subdivision (i) of 
this subparagraph.
    (c) Paragraph (a) of Sec. 1.1091-2 contains examples which 
illustrate the general application of section 1091(d), relating to 
unadjusted basis in the case of a wash sale of stock. However, in the 
case of certain wash sales of stock from the 1-year (6-months for 
taxable years beginning before 1977; 9-months for taxable years 
beginning in 1977)-or-less category, the provisions of section 1091(d) 
shall be applied in the manner described in subdivision (d) of this 
subdivision (iii).
    (d) In the case of a wash sale of stock (determined in accordance 
with the provisions of section 1091) from the 1-year (6-months for 
taxable years beginning before 1977; 9-months for taxable years 
beginning in 1977)-or-less category which occurs after the acquisition 
of shares of stock into such category, the aggregate cost or other basis 
of all shares remaining in the 1-year (6-months for taxable years 
beginning before 1977; 9-months for taxable years beginning in 1977)-or-
less category after such sale shall be increased by the amount of the 
loss which is not deductible because of the provisions of section 1091 
and the regulations thereunder. The provisions of this subdivision may 
be illustrated by the following example:

    Example: Assume the following acquisitions to, and sale from, the 1-
year (6-months for taxable years beginning before 1977; 9-months for 
taxable years beginning in 1977)-or-less category:

 1-Year (6-Months for Taxable Years Beginning Before 1977; 9-Months for Taxable Years Beginning in 1977)-or-Less
                                                    Category
----------------------------------------------------------------------------------------------------------------
                                                                                      Number   Price/
                      Date                                     Action                 shares   share   Aggregate
----------------------------------------------------------------------------------------------------------------
1-5-71.........................................  Purchase..........................       10     $110    $1,100
2-5-71.........................................  ......do..........................       10      100     1,000
3-5-71.........................................  ......do..........................       10       90       900
                                                                                    ----------------------------
Average........................................  ..................................       30      100     3,000
3-15-71........................................  Sale..............................       10       90       900
                                                                                    ----------------------------
                                                 Loss..............................       10       10       100
----------------------------------------------------------------------------------------------------------------

    In this example, the unadjusted basis of the shares remaining in the 
account after the sale is $2,000 (aggregate basis of $3,000 before the 
sale, less $1,000, the aggregate basis of the shares sold after the 
averaging of costs). The adjusted basis of the shares remaining in the 
1-year (6-months for taxable years beginning before 1977; 9-months for 
taxable years beginning in 1977)-or-less category after the sale and 
after adjustment is $2,100 (the unadjusted basis of $2,000, plus the 
$100 loss resulting from the sale).

    (4) Single-category method--(i) In general. In determining average 
basis using the single-category method, the cost or other basis of all 
shares in an account at the time of each sale or transfer (whether such 
shares have a holding period of more than 1 year (6 months for taxable 
years beginning before 1977; 9 months for taxable years beginning in 
1977) or 1 year (6 months for taxable years beginning before 1977; 9 
months for taxable years beginning in 1977)-or-less) shall be used in 
making the computation. The cost or other basis of each share in such 
account shall be an amount equal to the remaining aggregate cost or 
other basis of all shares in such account at the time of the sale or 
transfer divided by the aggregate number of shares in such account at 
such time.
    (ii) Order of disposition of shares sold or transferred. In the case 
of the sale or transfer of shares from an account to which the election 
provided by this paragraph applies, and with respect to which the 
taxpayer has specified that he uses the single-category method of

[[Page 37]]

determining average basis, shares sold or transferred shall be deemed to 
be those shares first acquired. Thus, when shares are sold or 
transferred from an account such shares will be those with a holding 
period of more than 1 year (6 months for taxable years beginning before 
1977; 9 months for taxable years beginning in 1977) to the extent that 
such account contains shares with a holding period of more than 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977). If the number of shares sold or transferred 
exceeds the number of shares in the account with a holding period of 
more than 1 year (6 months for taxable years beginning before 1977; 9 
months for taxable years beginning in 1977), any such excess shares sold 
or transferred will be deemed to be shares with a holding period of 1 
year (6 months for taxable years beginning before 1977; 9 months for 
taxable years beginning in 1977) or less. Any gain or loss attributable 
to shares held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) 
shall constitute long-term gain or loss, and any gain or loss 
attributable to shares held for 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) or 
less shall constitute short-term gain or loss. For example, if a 
taxpayer sells or transfers 50 shares from an account containing 100 
shares with a holding period of more than 1 year (6 months for taxable 
years beginning before 1977; 9 months for taxable years beginning in 
1977) and 100 shares with a holding period of 6 months or less, all of 
the shares sold or transferred will be deemed to be shares with a 
holding period of more than 1 year (6 months for taxable years beginning 
before 1977; 9 months for taxable years beginning in 1977). If, however, 
the account contains 40 shares with a holding period of more than 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) and 100 shares with a holding period of 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) or less, the taxpayer will be deemed to have 
sold or transferred 40 shares with a holding period of more than 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) and 10 shares with a holding period of 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) or less.
    (iii) Restriction on use of single-category method. The single-
category method of determining average basis shall not be used where it 
appears from the facts and circumstances that a purpose of using such 
single-category method is to convert long-term capital gains or losses 
to short-term capital gains or losses or to convert short-term capital 
gains or losses to long-term capital gains or losses.
    (iv) Wash sales. The provisions of section 1091(d) (relating to 
unadjusted basis in the case of a wash sale of stock) and the 
regulations thereunder shall apply in the case of wash sales of stock 
from an account with respect to which the single-category method of 
determining average basis is being used.
    (5) Definition. (i) For purposes of this paragraph, a regulated 
investment company means any domestic corporation (other than a personal 
holding company as defined in section 542) which meets the limitations 
of section 851(b) and Sec. 1.851-2, and which is registered at all times 
during the taxable year under the Investment Company Act of 1940, as 
amended (15 U.S.C. 80a-1 to 80b-2), either as a management company, or 
as a unit investment trust.
    (ii) Notwithstanding subdivision (i), this paragraph shall not apply 
in the case of a unit investment trust unless it is one--
    (a) Substantially all of the assets of which consist (1) of 
securities issued by a single management company (as defined in such 
Act) and securities acquired pursuant to subdivision (b) of this 
subdivision (ii), or (2) securities issued by a single other 
corporation, and
    (b) Which has no power to invest in any other securities except 
securities issued by a single other management company, when permitted 
by such Act or the rules and regulations of the Securities and Exchange 
Commission.

[[Page 38]]

    (6) Election. (i) An election to adopt one of the methods described 
in this paragraph shall be made in an income tax return for the first 
taxable year ending on or after December 31, 1970, for which the 
taxpayer desires the election to apply. If the taxpayer does not file a 
timely return (taking into account extensions of the time for filing) 
for such taxable year, the election shall be filed at the time the 
taxpayer files his first return for such year. The election may be made 
with an amended return only if such amended return is filed no later 
than the time prescribed by law (including extensions thereof) for 
filing the return for such taxable year. If the election is made, the 
taxpayer shall clearly indicate on his income tax return for each year 
to which the election is applicable that an average basis has been used 
in reporting gain or loss from the sale or transfer of shares sold or 
transferred. In addition, the taxpayer shall specify on such return the 
method (either the single-category method or the double-category method) 
used in determining average basis. The taxpayer shall also indicate in a 
statement described in subparagraph (1)(ii)(b) of this paragraph if the 
election is to apply to accounts described in subparagraph (1)(ii) of 
this paragraph. Such statement shall be attached to, or incorporated in, 
such return. A taxpayer making the election shall maintain such records 
as are necessary to substantiate the average basis (or bases) used on 
his income tax return.
    (ii) An election made with respect to some of the shares of a 
regulated investment company sold or transferred from an account 
described in subparagraph (1)(i) of this paragraph applies to all such 
shares in the account. Such election also applies to all shares of that 
regulated investment company held in other such accounts (i.e., those 
described in subparagraph (1)(i) of this paragraph) by the electing 
taxpayer for his own benefit. Thus, the election shall apply to all 
shares of the regulated investment company held by the electing taxpayer 
(for his own benefit) in such accounts on or after the first day of the 
first taxable year for which the election is made. Such election does 
not apply to shares held in accounts described in subparagraph (1)(ii) 
of this paragraph unless the taxpayer indicates, in the manner described 
in subdivision (i) of this subparagraph, that the election is to apply 
to shares held in such accounts. An election made pursuant to the 
provisions of this paragraph may not be revoked without the prior 
written permission of the Commissioner.
    (7) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. (i) On January 11, 1971, taxpayer A, who files his income 
tax return on a calendar year basis, enters into an agreement with the W 
Bank establishing an account for the periodic acquisition of shares of 
the Y Company, an open-end mutual fund. The agreement provides (1) that 
the bank is to purchase, for A, shares of Y stock as A may from time to 
time direct, (2) that all shares in the account are to be left in the 
custody of the bank, and (3) that the bank is to reinvest any dividends 
paid by Y (including capital gain dividends) in additional shares of Y 
stock. Pursuant to the agreement, on January 11, 1971, February 1, 1971, 
and March 1, 1971, respectively, the bank purchases, at A's direction, 
100 shares of Y stock for a total of $1,880, 20 shares of Y stock for a 
total of $400, and 20 shares of Y stock for a total of $410. On March 
15, 1971, the bank reinvests a $1-per-share capital gain dividend (that 
is, a total of $140) in seven additional shares of Y stock. The 
acquisitions to A's account, are, therefore, as follows:

------------------------------------------------------------------------
                                                    Number of
                       Date                           shares     Basis
------------------------------------------------------------------------
January 11, 1971..................................        100     $1,880
February 1, 1971..................................         20        400
March 1, 1971.....................................         20        410
March 15, 1971....................................          7        140
------------------------------------------------------------------------

    On August 20, 1971, at A's direction, the bank redeems (i.e., sells) 
40 shares of Y stock, and on September 20, 1971, 30 shares. A elects to 
determine the gain or loss from the sales of the stock by reference to 
its average basis using the double-category method of determining 
average basis. A did not specify from which category the sales were to 
take place, and therefore, each sale is deemed to have been made from 
the more-than-6-months category.
    (ii) The average basis for the shares sold on August 20, 1971, is 
$19, and the total average basis for the 40 shares which are sold is 
$760, computed as follows:

------------------------------------------------------------------------
 Number of shares in the more-than-6-months category at the
                        time of sale                             Basis
------------------------------------------------------------------------
100.........................................................      $1,880

[[Page 39]]

 
20..........................................................         400
------------------------------------------------------------------------
    Total 120...............................................       2,280
------------------------------------------------------------------------


Average cost or other basis: $2,280 / 120 = $19.40 shares x $19 each = 
$760, total average basis. Therefore, after the sale on August 20, 1971, 
80 shares remain in the more-than-6-months category, and their remaining 
aggregate cost is $1,520.
    (iii) The average basis for the shares sold on September 20, 1971, 
must reflect the sale which was made on August 20, 1971. Accordingly, 
such average basis would be $19.35 and may be computed as follows:

------------------------------------------------------------------------
 Number of shares in the more-than-6-months category at the
                        time of sale                             Basis
------------------------------------------------------------------------
80..........................................................      $1,520
20..........................................................         410
7...........................................................         140
------------------------------------------------------------------------
    Total 107...............................................       2,070
------------------------------------------------------------------------

Average cost or other basis: $2,070 / 107 shares = $19.35 (to the 
nearest cent).
    Example 2. Taxpayer B, who files his income tax returns on a 
calendar year basis, enters into an agreement with the X Bank 
establishing an account for the periodic acquisition of shares of the Z 
Company, an open-end mutual fund. X acquired for B's account shares of Z 
on the following dates in the designated amounts:

January 15, 1971..........................  50 shares.
February 16, 1971.........................  30 shares.
March 15, 1971............................  25 shares.
 


Pursuant to B's direction, the Bank redeemed (i.e., sold) 25 shares from 
the account on February 1, 1971, and 20 shares on April 1, 1971, for a 
total of 45 shares. All of such shares had been held for less than 6 
months. B elects to determine the gain or loss from the sales of the 
stock by reference to its average basis using the double-category method 
of determining average basis. Thus, the 45 shares which were sold are 
assumed to be from the 50 shares which were purchased on January 15, 
1971. Accordingly, on July 16, 1971, only five shares from those shares 
which had been purchased on January 15, 1971, remain to be transferred 
from the 6-months-or-less category to the more- than-6-months category. 
The basis of such five shares for purposes of the change to the more-
than-6-months category would be the average basis of the shares in the 
6-months- or-less category at the time of the sale on April 1, 1971.
    Example 3. Assume the same facts as in example (2), except that an 
additional sale of 18 shares was made on May 3, 1971. There were, 
therefore, a total of 63 shares sold during the 6-month period beginning 
on January 15, 1971, the date of the earliest purchase. Fifty of the 
shares which were sold during such period shall be assumed to be the 
shares purchased on January 15, 1971, and the remaining 13 shares shall 
be assumed to be from the shares which were purchased on February 16, 
1971. Thus, none of the shares which were purchased on January 15, 1971, 
remain to be changed from the 6-months-or-less category to the more-
than-6-months category. In the absence of further dispositions of shares 
during the 6-month holding period for the shares purchased on February 
16, 1971, there would be 17 of such shares to be changed over after the 
expiration of that period since 13 of the shares sold on May 3, 1971, 
were assumed to be from the shares purchased on February 16, 1971. The 
basis of the 17 shares for purposes of the change to the more-than-6-
months category would be the average basis of the shares in the 6-
months-or-less category at the time of the sale on May 3, 1971.
    Example 4. Taxpayer C, who files his income tax returns on a 
calendar year basis, enters into an agreement with Y Bank establishing 
an account for the periodic acquisition of XYZ Company, a closed-end 
mutual fund. Y acquired for B's account shares of XYZ on the following 
dates in the designated amounts:

------------------------------------------------------------------------
                                                      Number of
                        Date                            shares     Cost
------------------------------------------------------------------------
January 8, 1971.....................................         25     $200
February 8, 1971....................................         24      200
March 8, 1971.......................................         23      200
April 8, 1971.......................................         23      200
------------------------------------------------------------------------


Pursuant to C's direction, the bank redeemed (i.e., sold) 40 shares from 
the account on July 15, 1971, for $10 per share or a total of $400. C 
elects to determine the gain or loss from the sale of the stock by 
reference to its average basis using the single-category method of 
determining average basis. The average basis for the shares sold on July 
15, 1971 (determined by dividing the total number of shares in the 
account at such time (95) into the aggregate cost of such shares ($800)) 
is $8.42 (to the nearest cent). Under the rules of subparagraph (4) of 
this paragraph the shares sold would be deemed to be those first 
acquired. Thus, C would realize a $39.50 ($1.58 x 25) long-term capital 
gain with respect to the 25 shares acquired on January 8, 1971, and he 
would realize a $23.70 ($1.58 x 15 short-term capital gain with respect 
to 15 of the shares acquired on February 8, 1971. The next sale occurred 
on August 16, 1971. At that time, absent further intervening 
acquisitions or dispositions, the account contained nine shares (the 24 
shares acquired on February 8, 1971, less 15 of such shares which were 
sold on July 15, 1971) with a holding period of more than 6 months, and 
46 shares with a holding period of 6 months or less.

[[Page 40]]

    Example 5. Taxpayer D owns four separate accounts (D-1, D-2, D-3, 
and D-4) for the periodic acquisition of shares of the Y Company, an 
open-end mutual fund. Account D-4 contains shares which D acquired by 
gift on April 15, 1970. These shares had an adjusted basis in the hands 
of the donor which was greater than the fair market value of the donated 
shares on such date. For his taxable year ending on December 31, 1971, D 
elects to use an average basis for shares sold from account D-1 during 
such year using the single-category method of determining average basis. 
Under the provisions of subparagraph (1)(ii) of this paragraph, D may 
use an average basis for shares sold or transferred from account D-4 if 
he includes with his statement of election a statement, in writing, 
indicating that the basis of such gift shares in account D-4 shall be 
the fair market value of such shares at the time he acquired such shares 
and that such basis shall be used in computing the average basis of 
shares in account D-4. In addition, since D elected to use an average 
basis for shares sold from account D-1, he must also use an average 
basis for all shares sold or transferred from accounts D-2 and D-3 (as 
well as account D-1) for his taxable year ending on December 31, 1971, 
and for all subsequent years until he revokes (with the consent of the 
Commissioner) his election to use an average basis for such accounts. 
Further, D must use the single-category method of determining average 
basis with respect to accounts D-2, D-3 (and D-4 if the above-mentioned 
statement is filed).

    (f) Special rules. For special rules for determining the basis for 
gain or loss in the case of certain vessels acquired through the 
Maritime Commission (or its successors) or pursuant to an agreement with 
the Secretary of Commerce, see sections 510, 511, and 607 of the 
Merchant Marine Act, 1936, as amended (46 U.S.C. 1160, 1161) and parts 2 
and 3 of this chapter. For special rules for determining the unadjusted 
basis of property recovered in respect of war losses, see section 1336. 
For special rules with respect to taxable years beginning before January 
1, 1964, for determining the basis for gain or loss in the case of a 
disposition of a share of stock acquired pursuant to the timely exercise 
of a restricted stock option where the option price was between 85 
percent and 95 percent of the fair market value of the stock at the time 
the option was granted, see paragraph (b) of Sec. 1.421-5. See section 
423(c)(1) or 424(c)(1), whichever is applicable, for special rules with 
respect to taxable years ending after December 31, 1963, for determining 
the basis for gain or loss in the case of the disposition of a share of 
stock acquired pursuant to the timely exercise of a stock option 
described in such sections. See section 422(c)(1) for special rules with 
respect to taxable years ending after December 31, 1963, for determining 
the basis for gain or loss in the case of an exercise of a qualified 
stock option.
    (g) Debt instruments issued in exchange for property--(1) In 
general. For purposes of paragraph (a) of this section, if a debt 
instrument is issued in exchange for property, the cost of the property 
that is attributable to the debt instrument is the issue price of the 
debt instrument as determined under Sec. 1.1273-2 or Sec. 1.1274-2, 
whichever is applicable. If, however, the issue price of the debt 
instrument is determined under section 1273(b)(4), the cost of the 
property attributable to the debt instrument is its stated principal 
amount reduced by any unstated interest (as determined under section 
483).
    (2) Certain tax-exempt obligations. This paragraph (g)(2) applies to 
a tax-exempt obligation (as defined in section 1275(a)(3)) that is 
issued in exchange for property and that has an issue price determined 
under Sec. 1.1274-2(j) (concerning tax-exempt contingent payment 
obligations and certain tax-exempt variable rate debt instruments 
subject to section 1274). Notwithstanding paragraph (g)(1) of this 
section, if this paragraph (g)(2) applies to a tax-exempt obligation, 
for purposes of paragraph (a) of this section, the cost of the property 
that is attributable to the obligation is the sum of the present values 
of the noncontingent payments (as determined under Sec. 1.1274-2(c)).
    (3) Effective date. This paragraph (g) applies to sales or exchanges 
that occur on or after August 13, 1996.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting 
Sec. 1.1012-1, see the List of CFR Sections Affected in the printed 
volume, 26 CFR part 600-end, and on GPO Access.



Sec. 1.1012-2  Transfers in part a sale and in part a gift.

    For rules relating to basis of property acquired in a transfer which 
is in

[[Page 41]]

part a gift and in part a sale, see Secs. 1.170A-4(c), 1.1011-2(b), and 
Sec. 1.105-4.

[T.D. 7207, 37 FR 20799, Oct. 5, 1972]



Sec. 1.1013-1  Property included in inventory.

    The basis of property required to be included in inventory is the 
last inventory value of such property in the hands of the taxpayer. The 
requirements with respect to the valuation of an inventory are stated in 
subpart D (section 471 and following), part II, subchapter E, chapter 1 
of the Code, and the regulations thereunder.



Sec. 1.1014-1  Basis of property acquired from a decedent.

    (a) General rule. The purpose of section 1014 is, in general, to 
provide a basis for property acquired from a decedent which is equal to 
the value placed upon such property for purposes of the Federal estate 
tax. Accordingly, the general rule is that the basis of property 
acquired from a decedent is the fair market value of such property at 
the date of the decedent's death, or, if the decedent's executor so 
elects, at the alternate valuation date prescribed in section 2032, or 
in section 811(j) of the Internal Revenue Code of 1939. Property 
acquired from a decedent includes, principally, property acquired by 
bequest, devise, or inheritance, and, in the case of decedents dying 
after December 31, 1953, property required to be included in determining 
the value of the decedent's gross estate under any provision of the 
Internal Revenue Code of 1954 or the Internal Revenue Code of 1939. The 
general rule governing basis of property acquired from a decedent, as 
well as other rules prescribed elsewhere in this section, shall have no 
application if the property is sold, exchanged, or otherwise disposed of 
before the decedent's death by the person who acquired the property from 
the decedent. For general rules on the applicable valuation date where 
the executor of a decedent's estate elects under section 2032, or under 
section 811(j) of the Internal Revenue Code of 1939, to value the 
decedent's gross estate at the alternate valuation date prescribed in 
such sections, see paragraph (e) of Sec. 1.1014-3.
    (b) Scope and application. With certain limitations, the general 
rule described in paragraph (a) of this section is applicable to the 
classes of property described in paragraphs (a) and (b) of Sec. 1.1014-
2, including stock in a DISC or former DISC. In the case of stock in a 
DISC or former DISC, the provisions of this section and Secs. 1.1014-2 
through 1.1014-8 are applicable, except as provided in Sec. 1.1014-9. 
Special basis rules with respect to the basis of certain other property 
acquired from a decedent are set forth in paragraph (c) of Sec. 1.1014-
2. These special rules concern certain stock or securities of a foreign 
personal holding company and the surviving spouse's one-half share of 
community property held with a decedent dying after October 21, 1942, 
and on or before December 31, 1947. In this section and Secs. 1.1014-2 
to 1.1014-6, inclusive, whenever the words property acquired from a 
decedent are used, they shall also mean property passed from a decedent, 
and the phrase person who acquired it from the decedent shall include 
the person to whom it passed from the decedent.
    (c) Property to which section 1014 does not apply. Section 1014 
shall have no application to the following classes of property:
    (1) Property which constitutes a right to receive an item of income 
in respect of a decedent under section 691; and
    (2) Restricted stock options described in section 421 which the 
employee has not exercised at death if the employee died before January 
1, 1957. In the case of employees dying after December 31, 1956, see 
paragraph (d)(4) of Sec. 1.421-5. In the case of employees dying in a 
taxable year ending after December 31, 1963, see paragraph (c)(4) of 
Sec. 1.421-8 with respect to an option described in part II of 
subchapter D.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6527, 26 FR 
413, Jan. 19, 1961; T.D. 6887, 31 FR 8812, June 24, 1966; T.D. 7283, 38 
FR 20825, Aug. 3, 1973]



Sec. 1.1014-2  Property acquired from a decedent.

    (a) In general. The following property, except where otherwise 
indicated, is considered to have been acquired from

[[Page 42]]

a decedent and the basis thereof is determined in accordance with the 
general rule in Sec. 1.1014-1:
    (1) Without regard to the date of the decedent's death, property 
acquired by bequest, devise, or inheritance, or by the decedent's estate 
from the decedent, whether the property was acquired under the 
decedent's will or under the law governing the descent and distribution 
of the property of decedents. However, see paragraph (c)(1) of this 
section if the property was acquired by bequest or inheritance from a 
decedent dying after August 26, 1937, and if such property consists of 
stock or securities of a foreign personal holding company.
    (2) Without regard to the date of the decedent's death, property 
transferred by the decedent during his lifetime in trust to pay the 
income for life to or on the order or direction of the decedent, with 
the right reserved to the decedent at all times before his death to 
revoke the trust.
    (3) In the case of decedents dying after December 31, 1951, property 
transferred by the decedent during his lifetime in trust to pay the 
income for life to or on the order or direction of the decedent with the 
right reserved to the decedent at all times before his death to make any 
change in the enjoyment thereof through the exercise of a power to 
alter, amend, or terminate the trust.
    (4) Without regard to the date of the decedent's death, property 
passing without full and adequate consideration under a general power of 
appointment exercised by the decedent by will. (See section 2041(b) for 
definition of general power of appointment.)
    (5) In the case of decedents dying after December 31, 1947, property 
which represents the surviving spouse's one-half share of community 
property held by the decedent and the surviving spouse under the 
community property laws of any State, Territory, or possession of the 
United States or any foreign country, if at least one-half of the whole 
of the community interest in that property was includible in determining 
the value of the decedent's gross estate under part III, chapter 11 of 
the Internal Revenue Code of 1954 (relating to the estate tax) or 
section 811 of the Internal Revenue Code of 1939. It is not necessary 
for the application of this subparagraph that an estate tax return be 
required to be filed for the estate of the decedent or that an estate 
tax be payable.
    (6) In the case of decedents dying after December 31, 1950, and 
before January 1, 1954, property which represents the survivor's 
interest in a joint and survivor's annuity if the value of any part of 
that interest was required to be included in determining the value of 
the decedent's gross estate under section 811 of the Internal Revenue 
Code of 1939. It is necessary only that the value of a part of the 
survivor's interest in the annuity be includible in the gross estate 
under section 811. It is not necessary for the application of this 
subparagraph that an estate tax return be required to be filed for the 
estate of the decedent or that an estate tax be payable.
    (b) Property acquired from a decedent dying after December 31, 1953-
-(1) In general. In addition to the property described in paragraph (a) 
of this section, and except as otherwise provided in subparagraph (3) of 
this paragraph, in the case of a decedent dying after December 31, 1953, 
property shall also be considered to have been acquired from the 
decedent to the extent that both of the following conditions are met: 
(i) The property was acquired from the decedent by reason of death, form 
of ownership, or other conditions (including property acquired through 
the exercise or non-exercise of a power of appointment), and (ii) the 
property is includible in the decedent's gross estate under the 
provisions of the Internal Revenue Code of 1954, or the Internal Revenue 
Code of 1939, because of such acquisition. The basis of such property in 
the hands of the person who acquired it from the decedent shall be 
determined in accordance with the general rule in Sec. 1.1014-1. See, 
however, Sec. 1.1014-6 for special adjustments if such property is 
acquired before the death of the decedent. See also subparagraph (3) of 
this paragraph for a description of property not within the scope of 
this paragraph.
    (2) Rules for the application of subparagraph (1) of this paragraph. 
Except as provided in subparagraph (3) of this

[[Page 43]]

paragraph, this paragraph generally includes all property acquired from 
a decedent, which is includible in the gross estate of the decedent if 
the decedent died after December 31, 1953. It is not necessary for the 
application of this paragraph that an estate tax return be required to 
be filed for the estate of the decedent or that an estate tax be 
payable. Property acquired prior to the death of a decedent which is 
includible in the decedent's gross estate, such as property transferred 
by a decedent in contemplation of death, and property held by a taxpayer 
and the decedent as joint tenants or as tenants by the entireties is 
within the scope of this paragraph. Also, this paragraph includes 
property acquired through the exercise or nonexercise of a power of 
appointment where such property is includible in the decedent's gross 
estate. It does not include property not includible in the decedent's 
gross estate such as property not situated in the United States acquired 
from a nonresident who is not a citizen of the United States.
    (3) Exceptions to application of this paragraph. The rules in this 
paragraph are not applicable to the following property:
    (i) Annuities described in section 72;
    (ii) Stock or securities of a foreign personal holding company as 
described in section 1014(b)(5) (see paragraph (c)(1) of this section);
    (iii) Property described in any paragraph other than paragraph (9) 
of section 1014(b). See paragraphs (a) and (c) of this section.

In illustration of subdivision (ii), assume that A acquired by gift 
stock of a character described in paragraph (c)(1) of this section from 
a donor and upon the death of the donor the stock was includible in the 
donor's estate as being a gift in contemplation of death. A's basis in 
the stock would not be determined by reference to its fair market value 
at the donor's death under the general rule in section 1014(a). 
Furthermore, the special basis rules prescribed in paragraph (c)(1) of 
this section are not applicable to such property acquired by gift in 
contemplation of death. It will be necessary to refer to the rules in 
section 1015(a) to determine the basis.
    (c) Special basis rules with respect to certain property acquired 
from a decedent--(1) Stock or securities of a foreign personal holding 
company. The basis of certain stock or securities of a foreign 
corporation which was a foreign personal holding company with respect to 
its taxable year next preceding the date of the decedent's death is 
governed by a special rule. If such stock was acquired from a decedent 
dying after August 26, 1937, by bequest or inheritance, or by the 
decedent's estate from the decedent, the basis of the property in the 
hands of the person who so acquired it (notwithstanding any other 
provision of section 1014) shall be the fair market value of such 
property at the date of the decedent's death or the adjusted basis of 
the stock in the hands of the decedent, whichever is lower.
    (2) Spouse's interest in community property of decedent dying after 
October 21, 1942, and on or before December 31, 1947. In the case of a 
decedent dying after October 21, 1942, and on or before December 31, 
1947, a special rule is provided for determining the basis of such part 
of any property, representing the surviving spouse's one-half share of 
property held by the decedent and the surviving spouse under the 
community property laws of any State, Territory, or possession of the 
United States or any foreign country, as was included in determining the 
value of the decedent's gross estate, if a tax under chapter 3 of the 
Internal Revenue Code of 1939 was payable upon the decedent's net 
estate. In such case the basis shall be the fair market value of such 
part of the property at the date of death (or the optional valuation 
elected under section 811(j) of the Internal Revenue Code of 1939) or 
the adjusted basis of the property determined without regard to this 
subparagraph, whichever is the higher.



Sec. 1.1014-3  Other basis rules.

    (a) Fair market value. For purposes of this section and Sec. 1.1014-
1, the value of property as of the date of the decedent's death as 
appraised for the purpose of the Federal estate tax or the alternate 
value as appraised for such purpose, whichever is applicable, shall be 
deemed to be its fair market value. If no estate tax return is required 
to be

[[Page 44]]

filed under section 6018 (or under section 821 or 864 of the Internal 
Revenue Code of 1939), the value of the property appraised as of the 
date of the decedent's death for the purpose of State inheritance or 
transmission taxes shall be deemed to be its fair market value and no 
alternate valuation date shall be applicable.
    (b) Property acquired from a decedent dying before March 1, 1913. If 
the decedent died before March 1, 1913, the fair market value on that 
date is taken in lieu of the fair market value on the date of death, but 
only to the same extent and for the same purposes as the fair market 
value on March 1, 1913, is taken under section 1053.
    (c) Reinvestments by a fiduciary. The basis of property acquired 
after the death of the decedent by a fiduciary as an investment is the 
cost or other basis of such property to the fiduciary, and not the fair 
market value of such property at the death of the decedent. For example, 
the executor of an estate purchases stock of X company at a price of 
$100 per share with the proceeds of the sale of property acquired from a 
decedent. At the date of the decedent's death the fair market value of 
such stock was $98 per share. The basis of such stock to the executor or 
to a legatee, assuming the stock is distributed, is $100 per share.
    (d) Reinvestments of property transferred during life. Where 
property is transferred by a decedent during life and the property is 
sold, exchanged, or otherwise disposed of before the decedent's death by 
the person who acquired the property from the decedent, the general rule 
stated in paragraph (a) of Sec. 1.1014-1 shall not apply to such 
property. However, in such a case, the basis of any property acquired by 
such donee in exchange for the original property, or of any property 
acquired by the donee through reinvesting the proceeds of the sale of 
the original property, shall be the fair market value of the property 
thus acquired at the date of the decedent's death (or applicable 
alternate valuation date) if the property thus acquired is properly 
included in the decedent's gross estate for Federal estate tax purposes. 
These rules also apply to property acquired by the donee in any further 
exchanges or in further reinvestments. For example, on January 1, 1956, 
the decedent made a gift of real property to a trust for the benefit of 
his children, reserving to himself the power to revoke the trust at 
will. Prior to the decedent's death, the trustee sold the real property 
and invested the proceeds in stock of the Y company at $50 per share. At 
the time of the decedent's death, the value of such stock was $75 per 
share. The corpus of the trust was required to be included in the 
decedent's gross estate owing to his reservation of the power of 
revocation. The basis of the Y company stock following the decedent's 
death is $75 per share. Moreover, if the trustee sold the Y Company 
stock before the decedent's death for $65 a share and reinvested the 
proceeds in Z company stock which increased in value to $85 per share at 
the time of the decedent's death, the basis of the Z company stock 
following the decedent's death would be $85 per share.
    (e) Alternate valuation dates. Section 1014(a) provides a special 
rule applicable in determining the basis of property described in 
Sec. 1.1014-2 where--
    (1) The property is includible in the gross estate of a decedent who 
died after October 21, 1942, and
    (2) The executor elects for estate tax purposes under section 2032, 
or section 811(j) of the Internal Revenue Code of 1939, to value the 
decedent's gross estate at the alternate valuation date prescribed in 
such sections.

In those cases, the value applicable in determining the basis of the 
property is not the value at the date of the decedent's death but (with 
certain limitations) the value at the date one year after his death if 
not distributed, sold, exchanged, or otherwise disposed of in the 
meantime. If such property was distributed, sold, exchanged, or 
otherwise disposed of within one year after the date of the decedent's 
death by the person who acquired it from the decedent, the value 
applicable in determining the basis is its value as of the date of such 
distribution, sale, exchange, or other disposition. For illustrations of 
the operation of this paragraph, see the estate tax regulations under 
section 2032.

[[Page 45]]



Sec. 1.1014-4  Uniformity of basis; adjustment to basis.

    (a) In general. (1) The basis of property acquired from a decedent, 
as determined under section 1014(a), is uniform in the hands of every 
person having possession or enjoyment of the property at any time under 
the will or other instrument or under the laws of descent and 
distribution. The principle of uniform basis means that the basis of the 
property (to which proper adjustments must, of course, be made) will be 
the same, or uniform, whether the property is possessed or enjoyed by 
the executor or administrator, the heir, the legatee or devisee, or the 
trustee or beneficiary of a trust created by a will or an inter vivos 
trust. In determining the amount allowed or allowable to a taxpayer in 
computing taxable income as deductions for depreciation or depletion 
under section 1016(a)(2), the uniform basis of the property shall at all 
times be used and adjusted. The sale, exchange, or other disposition by 
a life tenant or remainderman of his interest in property will, for 
purposes of this section, have no effect upon the uniform basis of the 
property in the hands of those who acquired it from the decedent. Thus, 
gain or loss on sale of trust assets by the trustee will be determined 
without regard to the prior sale of any interest in the property. 
Moreover, any adjustment for depreciation shall be made to the uniform 
basis of the property without regard to such prior sale, exchange, or 
other disposition.
    (2) Under the law governing wills and the distribution of the 
property of decedents, all titles to property acquired by bequest, 
devise, or inheritance relate back to the death of the decedent, even 
though the interest of the person taking the title was, at the date of 
death of the decedent, legal, equitable, vested, contingent, general, 
specific, residual, conditional, executory, or otherwise. Accordingly, 
there is a common acquisition date for all titles to property acquired 
from a decedent within the meaning of section 1014, and, for this 
reason, a common or uniform basis for all such interests. For example, 
if distribution of personal property left by a decedent is not made 
until one year after his death, the basis of such property in the hands 
of the legatee is its fair market value at the time when the decedent 
died, and not when the legatee actually received the property. If the 
bequest is of the residue to trustees in trust, and the executors do not 
distribute the residue to such trustees until five years after the death 
of the decedent, the basis of each piece of property left by the 
decedent and thus received, in the hands of the trustees, is its fair 
market value at the time when the decedent dies. If the bequest is to 
trustees in trust to pay to A during his lifetime the income of the 
property bequeathed, and after his death to distribute such property to 
the survivors of a class, and upon A's death the property is distributed 
to the taxpayer as the sole survivor, the basis of such property, in the 
hands of the taxpayer, is its fair market value at the time when the 
decedent died. The purpose of the Code in prescribing a general uniform 
basis rule for property acquired from a decedent is, on the one hand, to 
tax the gain, in respect of such property, to him who realizes it 
(without regard to the circumstances that at the death of the decedent 
it may have been quite uncertain whether the taxpayer would take or gain 
anything); and, on the other hand, not to recognize as gain any element 
of value resulting solely from the circumstance that the possession or 
enjoyment of the taxpayer was postponed. Such postponement may be, for 
example, until the administration of the decedent's estate is completed, 
until the period of the possession or enjoyment of another has 
terminated, or until an uncertain event has happened. It is the increase 
or decrease in the value of property reflected in a sale or other 
disposition which is recognized as the measure of gain or loss.
    (3) The principles stated in subparagraphs (1) and (2) of this 
paragraph do not apply to property transferred by an executor, 
administrator or trustee, to an heir, legatee, devisee or beneficiary 
under circumstances such that the transfer constitutes a sale or 
exchange. In such a case, gain or loss must be recognized by the 
transferor to the extent required by the revenue laws, and the 
transferee acquires a basis equal to the fair market value of the 
property on

[[Page 46]]

the date of the transfer. Thus, for example, if the trustee of a trust 
created by will transfers to a beneficiary, in satisfaction of a 
specific bequest of $10,000, securities which had a fair market value of 
$9,000 on the date of the decedent's death (the applicable valuation 
date) and $10,000 on the date of the transfer, the trust realizes a 
taxable gain of $1,000 and the basis of the securities in the hands of 
the beneficiary would be $10,000. As a further example, if the executor 
of an estate transfers to a trust property worth $200,000, which had a 
fair market value of $175,000 on the date of the decedent's death (the 
applicable valuation date), in satisfaction of the decedent's bequest in 
trust for the benefit of his wife of cash or securities to be selected 
by the executor in an amount sufficient to utilize the marital deduction 
to the maximum extent authorized by law (after taking into consideration 
any other property qualifying for the marital deduction), capital gain 
in the amount of $25,000 would be realized by the estate and the basis 
of the property in the hands of the trustees would be $200,000. If, on 
the other hand, the decedent bequeathed a fraction of his residuary 
estate to a trust for the benefit of his wife, which fraction will not 
change regardless of any fluctuations in value of property in the 
decedent's estate after his death, no gain or loss would be realized by 
the estate upon transfer of property to the trust, and the basis of the 
property in the hands of the trustee would be its fair market value on 
the date of the decedent's death or on the alternate valuation date.
    (b) Multiple interests. Where more than one person has an interest 
in property acquired from a decedent, the basis of such property shall 
be determined and adjusted without regard to the multiple interests. The 
basis of computing gain or loss on the sale of any one of such multiple 
interests shall be determined under Sec. 1.1014-5. Thus, the deductions 
for depreciation and for depletion allowed or allowable, under sections 
167 and 611, to a legal life tenant as if the life tenant were the 
absolute owner of the property, constitute an adjustment to the basis of 
the property not only in the hands of the life tenant, but also in the 
hands of the remainderman and every other person to whom the same 
uniform basis is applicable. Similarly, the deductions allowed or 
allowable under sections 167 and 611, both to the trustee and to the 
trust beneficiaries, constitute an adjustment to the basis of the 
property not only in the hands of the trustee, but also in the hands of 
the trust beneficiaries and every other person to whom the uniform basis 
is applicable. See, however, section 262. Similarly, adjustments in 
respect of capital expenditures or losses, tax-free distributions, or 
other distributions applicable in reduction of basis, or other items for 
which the basis is adjustable are made without regard to which one of 
the persons to whom the same uniform basis is applicable makes the 
capital expenditures or sustains the capital losses, or to whom the tax-
free or other distributions are made, or to whom the deductions are 
allowed or allowable. See Sec. 1.1014-6 for adjustments in respect of 
property acquired from a decedent prior to his death.
    (c) Records. The executor or other legal representative of the 
decedent, the fiduciary of a trust under a will, the life tenant and 
every other person to whom a uniform basis under this section is 
applicable, shall maintain records showing in detail all deductions, 
distributions, or other items for which adjustment to basis is required 
to be made by sections 1016 and 1017, and shall furnish to the district 
director such information with respect to those adjustments as he may 
require.



Sec. 1.1014-5  Gain or loss.

    (a) Sale or other disposition of a life interest, remainder 
interest, or other interest in property acquired from a decedent. (1) 
Except as provided in paragraph (b) of this section with respect to the 
sale or other disposition after October 9, 1969, of a term interest in 
property, gain or loss from a sale or other disposition of a life 
interest, remainder interest, or other interest in property acquired 
from a decedent is determined by comparing the amount of the proceeds 
with the amount of that part of the adjusted uniform basis which is 
assignable to the interest so transferred. The adjusted uniform basis is 
the uniform basis of the entire property adjusted to

[[Page 47]]

the date of sale or other disposition of any such interest as required 
by sections 1016 and 1017. The uniform basis is the unadjusted basis of 
the entire property determined immediately after the decedent's death 
under the applicable sections of part II of subchapter O of chapter 1 of 
the Code.
    (2) Except as provided in paragraph (b) of this section, the proper 
measure of gain or loss resulting from a sale or other disposition of an 
interest in property acquired from a decedent is so much of the increase 
or decrease in the value of the entire property as is reflected in such 
sale or other disposition. Hence, in ascertaining the basis of a life 
interest, remainder interest, or other interest which has been so 
transferred, the uniform basis rule contemplates that proper adjustments 
will be made to reflect the change in relative value of the interests on 
account of the passage of time.
    (3) The factors set forth in the tables contained in Sec. 20.2031-7 
or, for certain prior periods, Sec. 20.2031-7A, of part 20 of this 
chapter (Estate Tax Regulations) shall be used in the manner provided 
therein in determining the basis of the life interest, the remainder 
interest, or the term certain interest in the property on the date such 
interest is sold. The basis of the life interest, the remainder 
interest, or the term certain interest is computed by multiplying the 
uniform basis (adjusted to the time of the sale) by the appropriate 
factor. In the case of the sale of a life interest or a remainder 
interest, the factor used is the factor (adjusted where appropriate) 
which appears in the life interest or the remainder interest column of 
the table opposite the age (on the date of the sale) of the person at 
whose death the life interest will terminate. In the case of the sale of 
a term certain interest, the factor used is the factor (adjusted where 
appropriate) which appears in the term certain column of the table 
opposite the number of years remaining (on the date of sale) before the 
term certain interest will terminate.
    (b) Sale or other disposition of certain term interests. In 
determining gain or loss from the sale or other disposition after 
October 9, 1969, of a term interest in property (as defined in paragraph 
(f)(2) of Sec. 1.1001-1) the adjusted basis of which is determined 
pursuant, or by reference, to section 1014 (relating to the basis of 
property acquired from a decedent) or section 1015 (relating to the 
basis of property acquired by gift or by a transfer in trust), that part 
of the adjusted uniform basis assignable under the rules of paragraph 
(a) of this section to the interest sold or otherwise disposed of shall 
be disregarded to the extent and in the manner provided by section 
1001(e) and paragraph (f) of Sec. 1.1001-1.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples, in which references are made to 
the actuarial tables contained in part 20 of this chapter (Estate Tax 
Regulations):

    Example 1. Securities worth $500,000 at the date of decedent's death 
on January 1, 1971, are bequeathed to his wife, W, for life, with 
remainder over to his son, S. W is 48 years of age when the life 
interest is acquired. The estate does not elect the alternate valuation 
allowed by section 2032. By reference to Sec. 20.2031-7A(c), the life 
estate factor for age 48, female, is found to be 0.77488 and the 
remainder factor for such age is found to be 0.22512. Therefore, the 
present value of the portion of the uniform basis assigned to W's life 
interest is $387,440 ($500,000 x 0.77488), and the present value of the 
portion of the uniform basis assigned to S's remainder interest is 
$112,560 ($500,000 x 0.22512). W sells her life interest to her nephew, 
A, on February 1, 1971, for $370,000, at which time W is still 48 years 
of age. Pursuant to section 1001(e), W realizes no loss; her gain is 
$370,000, the amount realized from the sale. A has a basis of $370,000 
which he can recover by amortization deductions over W's life 
expectancy.
    Example 2. The facts are the same as in example (1) except that W 
retains the life interest for 12 years, until she is 60 years of age, 
and then sells it to A on February 1, 1983, when the fair market value 
of the securities has increased to $650,000. By reference to 
Sec. 20.2031-7A(c), the life estate factor for age 60, female, is found 
to be 0.63226 and the remainder factor for such age is found to be 
0.36774. Therefore, the present value on February 1, 1983, of the 
portion of the uniform basis assigned to W's life interest is $316,130 
($500,000 x 0.63226) and the present value on that date of the portion 
of the uniform basis assigned to S's remainder interest is $183,870 
($500,000 x 0.36774). W sells her life interest for $410,969, that being 
the commuted value of her remaining life interest in the securities as 
appreciated ($650,000 x 0.63226). Pursuant to section 1001(e), W's gain 
is $410,969, the amount realized. A has a basis of $410,969

[[Page 48]]

which he can recover by amortization deductions over W's life 
expectancy.
    Example 3. Unimproved land having a fair market value of $18,800 at 
the date of the decedent's death on January 1, 1970, is devised to A, a 
male, for life, with remainder over to B, a female. The estate does not 
elect the alternate valuation allowed by section 2032. On January 1, 
1971, A sells his life interest to S for $12,500. S is not related to A 
or B. At the time of the sale, A is 39 years of age. By reference to 
Sec. 20.2031-7A(c), the life estate factor for age 39, male, is found to 
be 0.79854. Therefore, the present value of the portion of the uniform 
basis assigned to A's life interest is $15,012.55 ($18,800 x 0.79854). 
This portion is disregarded under section 1001(e). A realizes no loss; 
his gain is $12,500, the amount realized. S has a basis of $12,500 which 
he can recover by amortization deductions over A's life expectancy.
    Example 4. The facts are the same as in example (3) except that on 
January 1, 1971, A and B jointly sell the entire property to S for 
$25,000 and divide the proceeds equally between them. A and B are not 
related, and there is no element of gift or compensation in the 
transaction. By reference to Sec. 20.2031-7A(c), the remainder factor 
for age 39, male, is found to be 0.20146. Therefore, the present value 
of the uniform basis assigned to B's remainder interest is $3,787.45 
($18,800 x 0.20146). On the sale A realizes a loss of $2,512.55 
($15,012.55 less $12,500), the portion of the uniform basis assigned to 
his life interest not being disregarded by reason of section 1001(e)(3). 
B's gain on the sale is $8,712.55 ($12,500 less $3,787.45). S has a 
basis in the entire property of $25,000, no part of which, however, can 
be recovered by amortization deductions over A's life expectancy.
    Example 5. (a) Nondepreciable property having a fair market value of 
$54,000 at the date of decedent's death on January 1, 1971, is devised 
to her husband, H, for life and, after his death, to her daughter, D, 
for life, with remainder over to her grandson, G. The estate does not 
elect the alternate valuation allowed by section 2032. On January 1, 
1973, H sells his life interest to D for $32,000. At the date of the 
sale, H is 62 years of age, and D is 45 years of age. By reference to 
Sec. 20.2031-7A(c), the life estate factor for age 62, male, is found to 
be 0.52321. Therefore, the present value on January 1, 1973, of the 
portion of the adjusted uniform basis assigned to H's life interest is 
$28,253 ($54,000 x 0.52321). Pursuant to section 1001(e), H realizes no 
loss; his gain is $32,000, the amount realized from the sale. D has a 
basis of $32,000 which she can recover by amortization deductions over 
H's life expectancy.
    (b) On January 1, 1976, D sells both life estates to G for $40,000. 
During each of the years 1973 through 1975, D is allowed a deduction for 
the amortization of H's life interest. At the date of the sale H is 65 
years of age, and D is 48 years of age. For purposes of determining gain 
or loss on the sale by D, the portion of the adjusted uniform basis 
assigned to H's life interest and the portion assigned to D's life 
interest are not taken into account under section 1001(e). However, 
pursuant to Sec. 1.1001-1(f)(1), D's cost basis in H's life interest, 
minus deductions for the amortization of such interest, is taken into 
account. On the sale, D realizes gain of $40,000 minus an amount which 
is equal to the $32,000 cost basis (for H's life estate) reduced by 
amortization deductions. G is entitled to amortize over H's life 
expectancy that part of the $40,000 cost which is attributable to H's 
life interest. That part of the $40,000 cost which is attributable to 
D's life interest is not amortizable by G until H dies.
    Example 6. Securities worth $1,000,000 at the date of decedent's 
death on January 1, 1971, are bequeathed to his wife, W, for life, with 
remainder over to his son, S. W is 48 years of age when the life 
interest is acquired. The estate does not elect the alternate valuation 
allowed by section 2032. By reference to Sec. 20.2031-7A(c), the life 
estate factor for age 48, female, is found to be 0.77488, and the 
remainder factor for such age is found to be 0.22512. Therefore, the 
present value of the portion of the uniform basis assigned to W's life 
interest is $774,880 ($1,000,000 x 0.77488), and the present value of 
the portion of the uniform basis assigned to S's remainder interest is 
$225,120 ($1,000,000 x 0.22512). On February 1, 1971, W transfers her 
life interest to corporation X in exchange for all of the stock of X 
pursuant to a transaction in which no gain or loss is recognized by 
reason of section 351. On February 1, 1972, W sells all of her stock in 
X to S for $800,000. Pursuant to section 1001(e) and Sec. 1.1001-
1(f)(2), W realizes no loss; her gain is $800,000, the amount realized 
from the sale. On February 1, 1972, X sells to N for $900,000 the life 
interest transferred to it by W. Pursuant to section 1001(e) and 
Sec. 1.1001-1(f)(1), X realizes no loss; its gain is $900,000, the 
amount realized from the sale. N has a basis of $900,000 which he can 
recover by amortization deductions over W's life expectancy.

[T.D. 7142, 36 FR 18951, Sept. 24, 1971, as amended by T.D. 8540, 59 FR 
30102, June 10, 1994]



Sec. 1.1014-6  Special rule for adjustments to basis where property is acquired from a decedent prior to his death.

    (a) In general. (1) The basis of property described in section 
1014(b)(9) which is acquired from a decedent prior to his death shall be 
adjusted for depreciation, obsolescence, amortization, and depletion 
allowed the taxpayer on such property for the period prior to the 
decedent's death. Thus, in general,

[[Page 49]]

the adjusted basis of such property will be its fair market value at the 
decedent's death, or the applicable alternate valuation date, less the 
amount allowed (determined with regard to section 1016(a)(2)(B)) to the 
taxpayer as deductions for exhaustion, wear and tear, obsolescence, 
amortization, and depletion for the period held by the taxpayer prior to 
the decedent's death. The deduction allowed for a taxable year in which 
the decedent dies shall be an amount properly allocable to that part of 
the year prior to his death. For a discussion of the basis adjustment 
required by section 1014(b)(9) where property is held in trust, see 
paragraph (c) of this section.
    (2) Where property coming within the purview of subparagraph (1) of 
this paragraph was held by the decedent and his surviving spouse as 
tenants by the entirety or as joint tenants with right of survivorship, 
and joint income tax returns were filed by the decedent and the 
surviving spouse in which the deductions referred to in subparagraph (1) 
were taken, there shall be allocated to the surviving spouse's interest 
in the property that proportion of the deductions allowed for each 
period for which the joint returns were filed which her income from the 
property bears to the total income from the property. Each spouse's 
income from the property shall be determined in accordance with local 
law.
    (3) The application of this paragraph may be illustrated by the 
following examples:

    Example 1. The taxpayer acquired income-producing property by gift 
on January 1, 1954. The property had a fair market value of $50,000 on 
the date of the donor's death, January 1, 1956, and was included in his 
gross estate at that amount for estate tax purposes as a transfer in 
contemplation of death. Depreciation in the amount of $750 per year was 
allowable for each of the taxable years 1954 and 1955. However, the 
taxpayer claimed depreciation in the amount of $500 for each of these 
years (resulting in a reduction in his taxes) and his income tax returns 
were accepted as filed. The adjusted basis of the property as of the 
date of the decedent's death is $49,000 ($50,000, the fair market value 
at the decedent's death, less $1,000, the total of the amounts actually 
allowed as deductions).
    Example 2. On July 1, 1952, H purchased for $30,000 income-producing 
property which he conveyed to himself and W, his wife, as tenants by the 
entirety. Under local law each spouse was entitled to one-half of the 
income therefrom. H died on January 1, 1955, at which time the fair 
market value of the property was $40,000. The entire value of the 
property was included in H's gross estate. H and W filed joint income 
tax returns for the years 1952, 1953, and 1954. The total depreciation 
allowance for the year 1952 was $500 and for each of the other years 
1953 and 1954 was $1,000. One-half of the $2,500 depreciation will be 
allocated to W. The adjusted basis of the property in W's hands of 
January 1, 1955, was $38,750 ($40,000, value on the date of H's death, 
less $1,250, depreciation allocated to W for periods before H's death). 
However, if, under local law, all of the income from the property was 
allocable to H, no adjustment under this paragraph would be required and 
W's basis for the property as of the date of H's death would be $40,000.

    (b) Multiple interests in property described in section 1014(b)(9) 
and acquired from a decedent prior to his death. (1) Where more than one 
person has an interest in property described in section 1014(b)(9) which 
was acquired from a decedent before his death, the basis of such 
property and of each of the several interests therein shall, in general, 
be determined and adjusted in accordance with the principles contained 
in Secs. 1.1014-4 and 1.1014-5, relating to the uniformity of basis 
rule. Application of these principles to the determination of basis 
under section 1014(b)(9) is shown in the remaining subparagraphs of this 
paragraph in connection with certain commonly encountered situations 
involving multiple interests in property acquired from a decedent before 
his death.
    (2) Where property is acquired from a decedent before his death, and 
the entire property is subsequently included in the decedent's gross 
estate for estate tax purposes, the uniform basis of the property, as 
well as the basis of each of the several interests in the property, 
shall be determined by taking into account the basis adjustments 
required by section 1014(a) owing to such inclusion of the entire 
property in the decedent's gross estate. For example, suppose that the 
decedent transfers property in trust, with a life estate to A, and the 
remainder to B or his estate. The transferred property consists of 100 
shares of the common stock of X Corporation, with a basis of $10,000 at 
the

[[Page 50]]

time of the transfer. At the time of the decedent's death the value of 
the stock is $20,000. The transfer is held to have been made in 
contemplation of death and the entire value of the trust is included in 
the decedent's gross estate. Under section 1014(a), the uniform basis of 
the property in the hands of the trustee, the life tenant, and the 
remainderman, is $20,000. If immediately prior to the decedent's death, 
A's share of the uniform basis of $10,000 was $6,000, and B's share was 
$4,000, then, immediately after the decedent's death, A's share of the 
uniform basis of $20,000 is $12,000, and B's share is $8,000.
    (3)(i) In cases where, due to the operation of the estate tax, only 
a portion of property acquired from a decedent before his death is 
included in the decedent's gross estate, as in cases where the decedent 
retained a reversion to take effect upon the expiration of a life estate 
in another, the uniform basis of the entire property shall be determined 
by taking into account any basis adjustments required by section 1014(a) 
owing to such inclusion of a portion of the property in the decedent's 
gross estate. In such cases the uniform basis is the adjusted basis of 
the entire property immediately prior to the decedent's death increased 
(or decreased) by an amount which bears the same relation to the total 
appreciation (or diminution) in value of the entire property (over the 
adjusted basis of the entire property immediately prior to the 
decedent's death) as the value of the property included in the 
decedent's gross estate bears to the value of the entire property. For 
example, assume that the decedent creates a trust to pay the income to A 
for life, remainder to B or his estate. The trust instrument further 
provides that if the decedent should survive A, the income shall be paid 
to the decedent for life. Assume that the decedent predeceases A, so 
that, due to the operation of the estate tax, only the present value of 
the remainder interest is included in the decedent's gross estate. The 
trust consists of 100 shares of the common stock of X Corporation with 
an adjusted basis immediately prior to the decedent's death of $10,000 
(as determined under section 1015). At the time of the decedent's death, 
the value of the stock is $20,000, and the value of the remainder 
interest in the hands of B is $8,000. The uniform basis of the entire 
property following the decedent's death is $14,000, computed as follows:

Uniform basis prior to decedent's death.......................   $10,000
                             plus
Increase in uniform basis (determined by the following             4,000
 formula).....................................................
[Increase in uniform basis (to be determined)/$10,000 (total
 appreciation)]=
[$8,000 (value of property included in gross estate)/$20,000
 (value of entire property)]
                                                               ---------
Uniform basis under section 1014(a)...........................    14,000
 

    (ii) In cases of the type described in subdivision (i) of this 
subparagraph, the basis of any interest which is included in the 
decedent's gross estate may be ascertained by adding to (or subtracting 
from) the basis of such interest determined immediately prior to the 
decedent's death the increase (or decrease) in the uniform basis of the 
property attributable to the inclusion of the interest in the decedent's 
gross estate. Where the interest is sold or otherwise disposed of at any 
time after the decedent's death, proper adjustment must be made in order 
to reflect the change in value of the interest on account of the passage 
of time, as provided in Sec. 1.1014-5. For an illustration of the 
operation of this subdivision, see step 6 of the example in Sec. 1.1014-
7.
    (iii) In cases of the type described in subdivision (i) of this 
subparagraph (cases where, due to the operation of the estate tax, only 
a portion of the property is included in the decedent's gross estate), 
the basis for computing the depreciation, amortization, or depletion 
allowance shall be the uniform basis of the property determined under 
section 1014(a). However, the manner of taking into account such 
allowance computed with respect to such uniform basis is subject to the 
following limitations:
    (a) In cases where the value of the life interest is not included in 
the decedent's gross estate, the amount of such allowance to the life 
tenant under section 167(h) (or section 611(b)) shall not exceed (or be 
less than) the amount which would have been allowable to the life tenant 
if no portion of the basis of the property was determined under section 
1014(a). Proper adjustment shall be made for the amount allowable to the 
life tenant, as required by section 1016.

[[Page 51]]

Thus, an appropriate adjustment shall be made to the uniform basis of 
the property in the hands of the trustee, to the basis of the life 
interest in the hands of the life tenant, and to the basis of the 
remainder in the hands of the remainderman.
    (b) Any remaining allowance (that is, the increase in the amount of 
depreciation, amortization, or depletion allowable resulting from any 
increase in the uniform basis of the property under section 1014(a)) 
shall not be allowed to the life tenant. The remaining allowance shall, 
instead, be allowed to the trustee to the extent that the trustee both 
(1) is required or permitted, by the governing trust instrument (or 
under local law), to maintain a reserve for depreciation, amortization, 
or depletion, and (2) actually maintains such a reserve. If, in 
accordance with the preceding sentence, the trustee does maintain such a 
reserve, the remaining allowance shall be taken into account, under 
section 1016, in adjusting the uniform basis of the property in the 
hands of the trustee and in adjusting the basis of the remainder 
interest in the hands of the remainderman, but shall not be taken into 
account, under section 1016, in determining the basis of the life 
interest in the hands of the life tenant. For an example of the 
operation of this subdivision, see paragraph (b) of Sec. 1.1014-7.
    (4) In cases where the basis of any interest in property is not 
determined under section 1014(a), as where such interest (i) is not 
included in the decedent's gross estate, or (ii) is sold, exchanged or 
otherwise disposed of before the decedent's death, the basis of such 
interest shall be determined under other applicable provisions of the 
Code. To illustrate, in the example shown in subparagraph (3)(i) of this 
paragraph the basis of the life estate in the hands of A shall be 
determined under section 1015, relating to the basis of property 
acquired by gift. If, on the other hand, A had sold his life interest 
prior to the decedent's death, the basis of the life estate in the hands 
of A's transferee would be determined under section 1012.
    (c) Adjustments for deductions allowed prior to the decedent's 
death. (1) As stated in paragraph (a) of this section, section 
1014(b)(9) requires a reduction in the uniform basis of property 
acquired from a decedent before his death for certain deductions allowed 
in respect of such property during the decedent's lifetime. In general, 
the amount of the reduction in basis required by section 1014(b)(9) 
shall be the aggregate of the deductions allowed in respect of the 
property, but shall not include deductions allowed in respect of the 
property to the decedent himself. In cases where, owing to the operation 
of the estate tax, only a part of the value of the entire property is 
included in the decedent's gross estate, the amount of the reduction 
required by section 1014(b)(9) shall be an amount which bears the same 
relation to the total of all deductions (described in paragraph (a) of 
this section) allowed in respect of the property as the value of the 
property included in the decedent's gross estate bears to the value of 
the entire property.
    (2) The application of this paragraph may be illustrated by the 
following examples:

    Example 1. The decedent creates a trust to pay the income to A for 
life, remainder to B or his estate. The property transferred in trust 
consists of an apartment building with a basis of $50,000 at the time of 
the transfer. The decedent dies 2 years after the transfer is made and 
the gift is held to have been made in contemplation of death. 
Depreciation on the property was allowed in the amount of $1,000 
annually. At the time of the decedent's death the value of the property 
is $58,000. The uniform basis of the property in the hands of the 
trustee, the life tenant, and the remainderman, immediately after the 
decedent's death is $56,000 ($58,000, fair market value of the property 
immediately after the decedent's death, reduced by $2,000, deductions 
for depreciation allowed prior to the decedent's death).
    Example 2. The decedent creates a trust to pay the income to A for 
life, remainder to B or his estate. The trust instrument provides that 
if the decedent should survive A, the income shall be paid to the 
decedent for life. The decedent predeceases A and the present value of 
the remainder interest is included in the decedent's gross estate for 
estate tax purposes. The property transferred consists of an apartment 
building with a basis of $110,000 at the time of the transfer. Following 
the creation of the trust and during the balance of the decedent's life, 
deductions for depreciation were allowed on the property in the amount 
of $10,000. At the time of

[[Page 52]]

decedent's death the value of the entire property is $150,000, and the 
value of the remainder interest is $100,000. Accordingly, the uniform 
basis of the property in the hands of the trustee, the life tenant, and 
the remainderman, as adjusted under section 1014(b)(9), is $126,666, 
computed as follows:

Uniform basis prior to decedent's death......................   $100,000
                             plus
Increase in uniform basis--before reduction (determined by        33,333
 the following formula)......................................
[Increase in uniform basis (to be determined)/$50,000 (total
 appreciation of property since time of transfer)]=
[$100,000 (value of property included in gross estate)/
 $150,000 (value of entire property)]
                                                              ----------
                             less                                133,333
Deductions allowed prior to decedent's death--taken into           6,667
 account under section 1014(b)(9) (determined by the
 following formula)..........................................
[Prior deductions taken into account (to be determined)
 $10,000 (total deductions allowed prior to decedent's
 death)]=
[$100,000 (value of property included in gross estate)
 $150,000 (value of entire property)]
                                                              ----------
Uniform basis under section 1014.............................    126,666
 


[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6712, 29 FR 
3656, Mar. 24, 1964; T.D. 7142, 36 FR 18952, Sept. 24, 1971]



Sec. 1.1014-7  Example applying rules of Secs. 1.1014-4 through 1.1014-6 to case involving multiple interests.

    (a) On January 1, 1950, the decedent creates a trust to pay the 
income to A for life, remainder to B or his estate. The trust instrument 
provides that if the decedent should survive A, the income shall be paid 
to the decedent for life. The decedent, who died on January 1, 1955, 
predeceases A, so that, due to the operation of the estate tax, only the 
present value of the remainder interest is included in the decedent's 
gross estate. The trust consists of an apartment building with a basis 
of $30,000 at the time of transfer. Under the trust instrument the 
trustee is required to maintain a reserve for depreciation. During the 
decedent's lifetime depreciation is allowed in the amount of $800 
annually. At the time of the decedent's death the value of the apartment 
building is $45,000. A, the life tenant, is 43 years of age at the time 
of the decedent's death. Immediately after the decedent's death, the 
uniform basis of the entire property under section 1014(a) is $32,027; 
A's basis for the life interest is $15,553; and B's basis for the 
remainder interest is $16,474, computed as follows:

Step 1. Uniform basis (adjusted) immediately prior to
 decedent's death:
  Basis at time of transfer...................................   $30,000
                             less
  Depreciation allowed under section 1016 before decedent's        4,000
   death ($800 x 5)...........................................
                                                     -----------
                                                                  26,000
Step 2. Value of property included in decedent's gross estate:
  0.40180 (remainder factor, age 43) x$45,000 (value of entire   $18,081
   property)..................................................
Step 3. Uniform basis of property under section 1014(a),
 before reduction required by section 1014(b)(9):
  Uniform basis (adjusted) prior to decedent's death..........    26,000
  Increase in uniform basis (determined by the following           7,634
   formula)...................................................
Increase in uniform basis (to be determined) $19,000 (total
 appreciation, $45,000-$26,000)]=
$18,081 (value of property included in gross estate) $45,000
 (value of entire property)]
                                                     -----------
                                                                  33,634
Step 4. Uniform basis reduced as required by section
 1014(b)(9) for deductions allowed prior to death:
  Uniform basis before reduction..............................   $33,634
                             less
  Deductions allowed prior to decedent's death--taken into         1,607
   account under section 1014(b)(9) (determined by the
   following formula).........................................
Prior deductions taken into account (to be determined) $4,000
 (total deductions allowed prior to decedent's death)]=
$18,081 (value of property included in gross estate) $45,000
 (value of entire property)
                                                     -----------
                                                                  32,027
Step 5. A's basis for the life interest at the time of the        15,553
 decedent's death, determined under section 1015: 0.59820
 (life factor, age 43) x $26,000
Step 6. B's basis for the remainder interest, determined under
 section 1014(a): Basis prior to the decedent's death:
  0.40180 (remainder factor, age 43) x $26,000................    10,447
                             plus
  Increase in uniform basis owing to decedent's death:
    Increase in uniform basis.......................    $7,634
                        plus
    Reduction required by section 1014(b)(9)........     1,607
                                                     ----------
                                                                   6,027
                                                               ---------
                                                                  16,474
 

    (b) Assume the same facts as in paragraph (a) of this section. 
Assume further, that following the decedent's death depreciation is 
allowed in the amount of $1,000 annually. As of January 1, 1964, when 
A's age is 52, the adjusted uniform basis of the entire property is 
$23,027; A's basis for the life interest is $9,323; and B's basis for 
the remainder interest is $13,704, computed as follows:

[[Page 53]]



Step 7. Uniform basis (adjusted) as of January 1, 1964:
  Uniform basis determined under section 1014(a), reduced as     $32,027
   required by section 1014(b)(9).............................
                             less
  Depreciation allowed since decedent's death ($1,000 x 9)....     9,000
                                                               ---------
                                                                  23,027
Step 8. Allocable share of adjustment for depreciation
 allowable in the nine years since the decedent's death:
                         A's interest
  0.49587 (life factor, age 52) x$7,200 ($800, depreciation        3,570
   attributable to uniform basis before increase under section
   1014(a), x9)...............................................
                         B's interest
  0.50413 (remainder factor, age 52) x$7,200 ($800,                3,630
   depreciation attributable to uniform basis before increase
   under section 1014(a), x9).................................
                             plus
  $200 (annual depreciation attributable to increase in            1,800
   uniform basis under section 1014(a)) x9....................
                                                               ---------
                                                                   5,430
Step 9. Tentative bases of A's and B's interests as of January
 1, 1964 (before adjustment for depreciation).
                         A's interest
  0.49587 (life factor, age 52) x$26,000 (adjusted uniform        12,893
   basis immediately before decedent's death).................
                         B's interest
  0.50413 (remainder factor, age 52) x$26,000 (adjusted           13,107
   uniform basis immediately before decedent's death).........
                             plus
  Increase in uniform basis owing to inclusion of remainder in     6,027
   decedent's gross estate....................................
                                                               ---------
                                                                  19,134
Step 10. Bases of A's and B's interests as of January 1, 1964.
                               A
  Tentative basis (Step 9)....................................    12,893
                             less
  Allocable depreciation (Step 8).............................     3,570
                                                               ---------
                                                                   9,323
                               B
  Tentative basis (Step 9)....................................    19,134
                             less
  Allocable depreciation (Step 8).............................     5,430
                                                               ---------
                                                                  13,704
 



Sec. 1.1014-8  Bequest, devise, or inheritance of a remainder interest.

    (a)(1) Where property is transferred for life, with remainder in 
fee, and the remainderman dies before the life tenant, no adjustment is 
made to the uniform basis of the property on the death of the 
remainderman (see paragraph (a) of Sec. 1.1014-4). However, the basis of 
the remainderman's heir, legatee, or devisee for the remainder interest 
is determined by adding to (or subtracting from) the part of the 
adjusted uniform basis assigned to the remainder interest (determined in 
accordance with the principles set forth in Secs. 1.1014-4 through 
1.1014-6) the difference between--
    (i) The value of the remainder interest included in the 
remainderman's estate, and
    (ii) The basis of the remainder interest immediately prior to the 
remainderman's death.
    (2) The basis of any property distributed to the heir, legatee, or 
devisee upon termination of a trust (or legal life estate) or at any 
other time (unless included in the gross income of the legatee or 
devisee) shall be determined by adding to (or subtracting from) the 
adjusted uniform basis of the property thus distributed the difference 
between--
    (i) The value of the remainder interest in the property included in 
the remainderman's estate, and
    (ii) The basis of the remainder interest in the property immediately 
prior to the remainderman's death.
    (b) The provisions of paragraph (a) of this section are illustrated 
by the following examples:

    Example 1. Assume that, under the will of a decedent, property 
consisting of common stock with a value of $1,000 at the time of the 
decedent's death is transferred in trust, to pay the income to A for 
life, remainder to B or to B's estate. B predeceases A and bequeaths the 
remainder interest to C. Assume that B dies on January 1, 1956, and that 
the value of the stock originally transferred is $1,600 at B's death. 
A's age at that time is 37. The value of the remainder interest included 
in B's estate is $547 (0.34185, remainder factor age 37, x$1,600), and 
hence $547 is C's basis for the remainder interest immediately after B's 
death. Assume that C sells the remainder interest on January 1, 1961, 
when A's age is 42. C's basis for the remainder interest at the time of 
such sale is $596, computed as follows:

Basis of remainder interest computed with respect to uniform        $391
 basis of entire property (0.39131, remainder factor age 42,
 x$1,000, uniform basis of entire property)...................
                        plus
Value of remainder interest included in B's estate..      $547
                        less
Basis of remainder interest immediately prior to B's       342
 death (0.34185, remainder factor age 37, x$1,000)..
                                                        ------       205
                                                               ---------
Basis of C's remainder interest at the time of sale...........       596
 


[[Page 54]]

    Example 2. Assume the same facts as in example (1), except that C 
does not sell the remainder interest. Upon A's death terminating the 
trust, C's basis for the stock distributed to him is computed as 
follows:

Uniform basis of the property, adjusted to date of termination    $1,000
 of the trust.................................................
                        plus
Value of remainder interests in the property at the       $547
 time of B's death..................................
                        less
B's share of uniform basis of the property at the          342
 time of his death..................................
                                                        ------       205
                                                               ---------
C's basis for the stock distributed to him upon the                1,205
 termination of the trust.....................................
 

    Example 3. Assume the same facts as in example (2), except that the 
property transferred is depreciable. Assume further that $100 of 
depreciation was allowed prior to B's death and that $50 of depreciation 
is allowed between the time of B's death and the termination of the 
trust. Upon A's death terminating the trust, C's basis for the property 
distributed to him is computed as follows:

Uniform basis of the property, adjusted to date of
 termination of the trust:
  Uniform basis immediately after decedent's death..    $1,000
  Depreciation allowed following decedent's death...       150
                                                     ----------
                                                                    $350
                        plus
Value of remainder interest in the property at the         547
 time of B's death..................................
                        less
B's share of uniform basis of the property at the          308
 time of his death (0.34185x$900, uniform basis at
 B's death).........................................
                                                     ----------
                                                        ------       239
                                                               ---------
C's basis for the property distributed to him upon the             1,089
 termination of the trust.....................................
 

    (c) The rules stated in paragraph (a) of this section do not apply 
where the basis of the remainder interest in the hands of the 
remainderman's transferee is determined by reference to its cost to such 
transferee. See also paragraph (a) of Sec. 1.1014-4. Thus, if, in 
example (1) of paragraph (b) of this section B sold his remainder 
interest to C for $547 in cash, C's basis for the stock distributed to 
him upon the death of A terminating the trust is $547.



Sec. 1.1014-9  Special rule with respect to DISC stock.

    (a) In general. If property consisting of stock of a DISC or former 
DISC (as defined in section 992(a) (1) or (3) as the case may be) is 
considered to have been acquired from a decedent (within the meaning of 
paragraph (a) or (b) of Sec. 1.1014-2), the uniform basis of such stock 
under section 1014, as determined pursuant to Secs. 1.1014-1 through 
1.1014-8 shall be reduced as provided in this section. Such uniform 
basis shall be reduced by the amount (hereinafter referred to in this 
section as the amount of reduction), if any, which the decedent would 
have included in his gross income under section 995(c) as a dividend if 
the decedent had lived and sold such stock at its fair market value on 
the estate tax valuation date. If the alternate valuation date for 
Federal estate tax purposes is elected under section 2032, in computing 
the gain which the decedent would have had if he had lived and sold the 
stock on the alternate valuation date, the decedent's basis shall be 
determined with reduction for any distributions with respect to the 
stock which may have been made, after the date of the decedent's death 
and on or before the alternate valuation date, from the DISC's 
previously taxed income (as defined in section 996(f)(2)). For this 
purpose, the last sentence of section 996(e)(2) (relating to reductions 
of basis of DISC stock) shall not apply. For purposes of this section, 
if the corporation is not a DISC or former DISC at the date of the 
decedent's death but is a DISC for a taxable year which begins after 
such date and on or before the alternate valuation date, the corporation 
will be considered to be a DISC or former DISC only if the alternate 
valuation date is elected. The provisions of this paragraph apply with 
respect to stock of a DISC or former DISC which is included in the gross 
estate of the decedent, including but not limited to property which--
    (1) Is acquired from the decedent before his death, and the entire 
property is subsequently included in the decedent's gross estate for 
estate tax purposes, or
    (2) Is acquired property described in paragraph (d) of Sec. 1.1014-
3.
    (b) Portion of property acquired from decedent before his death 
included in decedent's gross estate--(1) In general. In cases where, due 
to the operation of the estate tax, only a portion of property which 
consists of stock of a DISC or former DISC and which is acquired

[[Page 55]]

from a decedent before his death is included in the decedent's gross 
estate, the uniform basis of such stock under section 1014, as 
determined pursuant to Secs. 1.1014-1 through 1.1014-8, shall be reduced 
by an amount which bears the same ratio to the amount of reduction which 
would have been determined under paragraph (a) of this section if the 
entire property consisting of such stock were included in the decedent's 
gross estate as the value of such property included in the decedent's 
gross estate bears to the value of the entire property.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example: The decedent creates a trust during his lifetime to pay the 
income to A for life, remainder to B or his estate. The trust instrument 
further provides that if the decedent shall survive A, the income shall 
be paid to the decedent for life. The decedent predeceases A, so that, 
due to the operation of the estate tax, only the present value of the 
remainder interest is included in the decedent's gross estate. The trust 
consists of 100 shares of the stock of X corporation (which is a DISC at 
the time the shares are transferred to the trust and at the time of the 
decedent's death) with an adjusted basis immediately prior to the 
decedent's death of $10,000 (as determined under section 1015). At the 
time of the decedent's death the value of the stock is $20,000, and the 
value of the remainder interest in the hands of B is $8,000. Applying 
the principles of paragraph (b)(3)(i) of Sec. 1.1014-6, the uniform 
basis of the entire property following the decedent's death, prior to 
reduction pursuant to this paragraph, is $14,000. The amount of 
reduction which would have been determined under paragraph (a) of this 
section if the entire property consisting of such stock of X corporation 
were included in the decedent's gross estate is $5,000. The uniform 
basis of the entire property following the decedent's death, as reduced 
pursuant to this paragraph, is $12,000, computed as follows:

Uniform basis under section 1014(a), prior to                    $14,000
 reduction pursuant to this paragraph..............
Less decrease in uniform basis (determined by the                  2,000
 following formula)................................
                                                    --------------------
[Reduction in uniform basis (to be determined)/
 $5,000 (amount of reduction if paragraph (a)
 applied)] =
[$8,000 (value of property included in gross estate/
 $20,000 (value of entire property)]
Uniform basis under section 1014(a) reduced                       12,000
 pursuant to this paragraph........................
 

    (c) Estate tax valuation date. For purposes of section 1014(d) and 
this section, the estate tax valuation date is the date of the 
decedent's death or, in the case of an election under section 2032, the 
applicable valuation date prescribed by that section.
    (d) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. At the date of A's death, his DISC stock has a fair 
market value of $100. The estate does not elect the alternate valuation 
allowed by section 2032, and A's basis in such stock is $60 at the date 
of his death. The person who acquires such stock from the decedent will 
take as a basis for such stock its fair market value at A's death 
($100), reduced by the amount which would have been included in A's 
gross income under section 995(c) as a dividend if A had sold stock on 
the date he died. Thus, if the amount that would have been treated as a 
dividend under section 995(c) were $30, such person will take a basis of 
$70 for such stock ($100, reduced by $30). If such person were 
immediately to sell the DISC stock so received for $100, $30 of the 
proceeds from the sale would be treated as a dividend by such person 
under section 995(c).
    Example 2. Assume the same facts as in example (1) except that the 
estate elects the alternate valuation allowed by section 2032, the DISC 
stock has a fair market value of $140 on the alternate valuation date, 
the amount that would have been treated as a dividend under section 
995(c) in the event of a sale on such date is $50 and the DISC has $20 
of previously taxed income which accrued after the date of the 
decedent's death and before the alternate valuation date. The basis of 
the person who acquires such stock will be $90 determined as follows:

(1) Fair market value of DISC stock at alternate                    $140
 valuation date.......................................
(2) Less: Amount which would have been treated as a                   50
 dividend under section 995(c)........................
                                                       -----------------
(3) Basis of person who acquires DISC stock...........                90
 

    If a distribution of $20 attributable to such previously taxed 
income had been made by the DISC on or before the alternate valuation 
date (with the DISC stock having a fair market value of $120 after such 
distribution), the basis of the person who acquires such stock will be 
$70 determined as follows:

(1) Fair market value of DISC stock at alternate                    $120
 valuation date.......................................
(2) Less: Amount which would have been treated as a                   50
 dividend under section 995(c)........................
                                                       -----------------
(3) Basis of person who acquires DISC stock...........                70
 


[[Page 56]]


[T.D. 7283, 38 FR 20825, Aug. 3, 1973]



Sec. 1.1015-1  Basis of property acquired by gift after December 31, 1920.

    (a) General rule. (1) In the case of property acquired by gift after 
December 31, 1920 (whether by a transfer in trust or otherwise), the 
basis of the property for the purpose of determining gain is the same as 
it would be in the hands of the donor or the last preceding owner by 
whom it was not acquired by gift. The same rule applies in determining 
loss unless the basis (adjusted for the period prior to the date of gift 
in accordance with sections 1016 and 1017) is greater than the fair 
market value of the property at the time of the gift. In such case, the 
basis for determining loss is the fair market value at the time of the 
gift.
    (2) The provisions of subparagraph (1) of this paragraph may be 
illustrated by the following example.

    Example: A acquires by gift income-producing property which has an 
adjusted basis of $100,000 at the date of gift. The fair market value of 
the property at the date of gift is $90,000. A later sells the property 
for $95,000. In such case there is neither gain nor loss. The basis for 
determining loss is $90,000; therefore, there is no loss. Furthermore, 
there is no gain, since the basis for determining gain is $100,000.

    (3) If the facts necessary to determine the basis of property in the 
hands of the donor or the last preceding owner by whom it was not 
acquired by gift are unknown to the donee, the district director shall, 
if possible, obtain such facts from such donor or last preceding owner, 
or any other person cognizant thereof. If the district director finds it 
impossible to obtain such facts, the basis in the hands of such donor or 
last preceding owner shall be the fair market value of such property as 
found by the district director as of the date or approximate date at 
which, according to the best information the district director is able 
to obtain, such property was acquired by such donor or last preceding 
owner. See paragraph (e) of this section for rules relating to fair 
market value.
    (b) Uniform basis; proportionate parts of. Property acquired by gift 
has a single or uniform basis although more than one person may acquire 
an interest in such property. The uniform basis of the property remains 
fixed subject to proper adjustment for items under sections 1016 and 
1017. However, the value of the proportionate parts of the uniform basis 
represented, for instance, by the respective interests of the life 
tenant and remainderman are adjustable to reflect the change in the 
relative values of such interest on account of the lapse of time. The 
portion of the basis attributable to an interest at the time of its sale 
or other disposition shall be determined under the rules provided in 
Sec. 1.1014-5. In determining gain or loss from the sale or other 
disposition after October 9, 1969, of a term interest in property (as 
defined in Sec. 1.1001-1(f)(2)) the adjusted basis of which is 
determined pursuant, or by reference, to section 1015, that part of the 
adjusted uniform basis assignable under the rules of Sec. 1.1014- 5(a) 
to the interest sold or otherwise disposed of shall be disregarded to 
the extent and in the manner provided by section 1001(e) and 
Sec. 1.1001-1(f).
    (c) Time of acquisition. The date that the donee acquires an 
interest in property by gift is when the donor relinquishes dominion 
over the property and not necessarily when title to the property is 
acquired by the donee. Thus, the date that the donee acquires an 
interest in property by gift where he is a successor in interest, such 
as in the case of a remainderman of a life estate or a beneficiary of 
the distribution of the corpus of a trust, is the date such interests 
are created by the donor and not the date the property is actually 
acquired.
    (d) Property acquired by gift from a decedent dying after December 
31, 1953. If an interest in property was acquired by the taxpayer by 
gift from a donor dying after December 31, 1953, under conditions which 
required the inclusion of the property in the donor's gross estate for 
estate tax purposes, and the property had not been sold, exchanged, or 
otherwise disposed of by the taxpayer before the donor's death, see the 
rules prescribed in section 1014 and the regulations thereunder.
    (e) Fair market value. For the purposes of this section, the value 
of property as appraised for the purpose of the Federal gift tax, or, if 
the gift is not

[[Page 57]]

subject to such tax, its value as appraised for the purpose of a State 
gift tax, shall be deemed to be the fair market value of the property at 
the time of the gift.
    (f) Reinvestments by fiduciary. If the property is an investment by 
the fiduciary under the terms of the gift (as, for example, in the case 
of a sale by the fiduciary of property transferred under the terms of 
the gift, and the reinvestment of the proceeds), the cost or other basis 
to the fiduciary is taken in lieu of the basis specified in paragraph 
(a) of this section.
    (g) Records. To insure a fair and adequate determination of the 
proper basis under section 1015, persons making or receiving gifts of 
property should preserve and keep accessible a record of the facts 
necessary to determine the cost of the property and, if pertinent, its 
fair market value as of March 1, 1913, or its fair market value as of 
the date of the gift.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6693, 28 FR 
12818, Dec. 3, 1963; T.D. 7142, 36 FR 18952, Sept. 24, 1971]



Sec. 1.1015-2  Transfer of property in trust after December 31, 1920.

    (a) General rule. (1) In the case of property acquired after 
December 31, 1920, by transfer in trust (other than by a transfer in 
trust by a gift, bequest, or devise) the basis of property so acquired 
is the same as it would be in the hands of the grantor increased in the 
amount of gain or decreased in the amount of loss recognized to the 
grantor upon such transfer under the law applicable to the year in which 
the transfer was made. If the taxpayer acquired the property by a 
transfer in trust, this basis applies whether the property be in the 
hands of the trustee, or the beneficiary, and whether acquired prior to 
the termination of the trust and distribution of the property, or 
thereafter.
    (2) The principles stated in paragraph (b) of Sec. 1.1015-1 
concerning the uniform basis are applicable in determining the basis of 
property where more than one person acquires an interest in property by 
transfer in trust after December 31, 1920.
    (b) Reinvestment by fiduciary. If the property is an investment made 
by the fiduciary (as, for example, in the case of a sale by the 
fiduciary of property transferred by the grantor, and the reinvestment 
of the proceeds), the cost or other basis to the fiduciary is taken in 
lieu of the basis specified in paragraph (a) of this section.



Sec. 1.1015-3  Gift or transfer in trust before January 1, 1921.

    (a) In the case of property acquired by gift or transfer in trust 
before January 1, 1921, the basis of such property is the fair market 
value thereof at the time of the gift or at the time of the transfer in 
trust.
    (b) The principles stated in paragraph (b) of Sec. 1.1015-1 
concerning the uniform basis are applicable in determining the basis of 
property where more than one person acquires an interest in property by 
gift or transfer in trust before January 1, 1921. In addition, if an 
interest in such property was acquired from a decedent and the property 
had not been sold, exchanged, or otherwise disposed of before the death 
of the donor, the rules prescribed in section 1014 and the regulations 
thereunder are applicable in determining the basis of such property in 
the hands of the taxpayer.



Sec. 1.1015-4  Transfers in part a gift and in part a sale.

    (a) General rule. Where a transfer of property is in part a sale and 
in part a gift, the unadjusted basis of the property in the hands of the 
transferee is the sum of--
    (1) Whichever of the following is the greater:
    (i) The amount paid by the transferee for the property, or
    (ii) The transferor's adjusted basis for the property at the time of 
the transfer, and
    (2) The amount of increase, if any, in basis authorized by section 
1015(d) for gift tax paid (see Sec. 1.1015-5).

For determining loss, the unadjusted basis of the property in the hands 
of the transferee shall not be greater than the fair market value of the 
property at the time of such transfer. For determination of gain or loss 
of the transferor, see Sec. 1.1001-1(e) and Sec. 1.1011-2. For special 
rule where there has been a charitable contribution of less than a 
taxpayer's entire interest in property, see section 170(e)(2) and 
Sec. 1.170A-4(c).

[[Page 58]]

    (b) Examples. The rule of paragraph (a) of this section is 
illustrated by the following examples:

    Example 1. If A transfers property to his son for $30,000, and such 
property at the time of the transfer has an adjusted basis of $30,000 in 
A's hands (and a fair market value of $60,000), the unadjusted basis of 
the property in the hands of the son is $30,000.
    Example 2. If A transfers property to his son for $60,000, and such 
property at the time of transfer has an adjusted basis of $30,000 in A's 
hands (and a fair market value of $90,000), the unadjusted basis of such 
property in the hands of the son is $60,000.
    Example 3. If A transfers property to his son for $30,000, and such 
property at the time of transfer has an adjusted basis in A's hands of 
$60,000 (and a fair market value of $90,000), the unadjusted basis of 
such property in the hands of the son is $60,000.
    Example 4. If A transfers property to his son for $30,000 and such 
property at the time of transfer has an adjusted basis of $90,000 in A's 
hands (and a fair market value of $60,000), the unadjusted basis of the 
property in the hands of the son ins $90,000. However, since the 
adjusted basis of the property in A's hands at the time of the transfer 
was greater than the fair market value at that time, for the purpose of 
determining any loss on a later sale or other disposition of the 
property by the son its unadjusted basis in his hands is $60,000.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6693, 28 FR 
12818, Dec. 3, 1963; T.D. 7207, 37 FR 20799, Oct. 5, 1972]



Sec. 1.1015-5  Increased basis for gift tax paid.

    (a) General rule in the case of gifts made on or before December 31, 
1976. (1)(i) Subject to the conditions and limitations provided in 
section 1015(d), as added by the Technical Amendments Act of 1958, the 
basis (as determined under section 1015(a) and paragraph (a) of 
Sec. 1.1015-1) of property acquired by gift is increased by the amount 
of gift tax paid with respect to the gift of such property. Under 
section 1015(d)(1)(A), such increase in basis applies to property 
acquired by gift on or after September 2, 1958 (the date of enactment of 
the Technical Amendments Act of 1958). Under section 1015(d)(1)(B), such 
increase in basis applies to property acquired by gift before September 
2, 1958, and not sold, exchanged, or otherwise disposed of before such 
date. If section 1015(d)(1)(A) applies, the basis of the property is 
increased as of the date of the gift regardless of the date of payment 
of the gift tax. For example, if the property was acquired by gift on 
September 8, 1958, and sold by the donee on October 15, 1958, the basis 
of the property would be increased (subject to the limitation of section 
1015(d)) as of September 8, 1958 (the date of the gift), by the amount 
of gift tax applicable to such gift even though such tax was not paid 
until March 1, 1959. If section 1015(d)(1)(B) applies, any increase in 
the basis of the property due to gift tax paid (regardless of date of 
payment) with respect to the gift is made as of September 2, 1958. Any 
increase in basis under section 1015(d) can be no greater than the 
amount by which the fair market value of the property at the time of the 
gift exceeds the basis of such property in the hands of the donor at the 
time of the gift. See paragraph (b) of this section for rules for 
determining the amount of gift tax paid in respect of property 
transferred by gift.
    (ii) With respect to property acquired by gift before September 2, 
1958, the provisions of section 1015(d) and this section do not apply 
if, before such date, the donee has sold, exchanged, or otherwise 
disposed of such property. The phrase sold, exchanged, or otherwise 
disposed of includes the surrender of a stock certificate for corporate 
assets in complete or partial liquidation of a corporation pursuant to 
section 331. It also includes the exchange of property for property of a 
like kind such as the exchange of one apartment house for another. The 
phrase does not, however, extend to transactions which are mere changes 
in form. Thus, it does not include a transfer of assets to a corporation 
in exchange for its stock in a transaction with respect to which no gain 
or loss would be recognizable for income tax purposes under section 351. 
Nor does it include an exchange of stock or securities in a corporation 
for stock or securities in the same corporation or another corporation 
in a transaction such as a merger, recapitalization, reorganization, or 
other transaction described in section 368(a) or 355, with respect to 
which no gain or loss is recognizable for income tax purposes under 
section 354 or 355. If a binding contract for the sale, exchange, or 
other disposition of property is entered

[[Page 59]]

into, the property is considered as sold, exchanged, or otherwise 
disposed of on the effective date of the contract, unless the contract 
is not subsequently carried out substantially in accordance with its 
terms. The effective date of a contract is normally the date it is 
entered into (and not the date it is consummated, or the date legal 
title to the property passes) unless the contract specifies a different 
effective date. For purposes of this subdivision, in determining whether 
a transaction comes within the phrase sold, exchanged, or otherwise 
disposed of, if a transaction would be treated as a mere change in the 
form of the property if it occurred in a taxable year subject to the 
Internal Revenue Code of 1954, it will be so treated if the transaction 
occurred in a taxable year subject to the Internal Revenue Code of 1939 
or prior revenue law.
    (2) Application of the provisions of subparagraph (1) of this 
paragraph may be illustrated by the following examples:

    Example 1. In 1938, A purchased a business building at a cost of 
$120,000. On September 2, 1958, at which time the property had an 
adjusted basis in A's hands of $60,000, he gave the property to his 
nephew, B. At the time of the gift to B, the property had a fair market 
value of $65,000 with respect to which A paid a gift tax in the amount 
of $7,545. The basis of the property in B's hands at the time of the 
gift, as determined under section 1015(a) and Sec. 1.1015-1, would be 
the same as the adjusted basis in A's hands at the time of the gift, or 
$60,000. Under section 1015(d) and this section, the basis of the 
building in B's hands as of the date of the gift would be increased by 
the amount of the gift tax paid with respect to such gift, limited to an 
amount by which the fair market value of the property at the time of the 
gift exceeded the basis of the property in the hands of A at the time of 
gift, or $5,000. Therefore, the basis of the property in B's hands 
immediately after the gift, both for determining gain or loss on the 
sale of the property, would be $65,000.
    Example 2. C purchased property in 1938 at a cost of $100,000. On 
October 1, 1952, at which time the property had an adjusted basis of 
$72,000 in C's hands, he gave the property to his daughter, D. At the 
date of the gift to D, the property had a fair market value of $85,000 
with respect to which C paid a gift tax in the amount of $11,745. On 
September 2, 1958, D still held the property which then had an adjusted 
basis in her hands of $65,000. Since the excess of the fair market value 
of the property at the time of the gift to D over the adjusted basis of 
the property in C's hands at such time is greater than the amount of 
gift tax paid, the basis of the property in D's hands would be increased 
as of September 2, 1958, by the amount of the gift tax paid, or $11,745. 
The adjusted basis of the property in D's hands, both for determining 
gain or loss on the sale of the property, would then be $76,745 ($65,000 
plus $11,745).
    Example 3. On December 31, 1951, E gave to his son, F, 500 shares of 
common stock of the X Corporation which shares had been purchased 
earlier by E at a cost of $100 per share, or a total cost of $50,000. 
The basis in E's hands was still $50,000 on the date of the gift to F. 
On the date of the gift, the fair market value of the 500 shares was 
$80,000 with respect to which E paid a gift tax in the amount of 
$10,695. In 1956, the 500 shares of X Corporation stock were exchanged 
for 500 shares of common stock of the Y Corporation in a reorganization 
with respect to which no gain or loss was recognized for income tax 
purposes under section 354. F still held the 500 shares of Y Corporation 
stock on September 2, 1958. Under such circumstances, the 500 shares of 
X Corporation stock would not, for purposes of section 1015(d) and this 
section, be considered as having been sold, exchanged, or otherwise 
disposed of by F before September 2, 1958. Therefore, the basis of the 
500 shares of Y Corporation stock held by F as of such date would, by 
reason of section 1015(d) and this section, be increased by $10,695, the 
amount of gift tax paid with respect to the gift to F of the X 
Corporation stock.
    Example 4. On November 15, 1953, G gave H property which had a fair 
market value of $53,000 and a basis in the hands of G of $20,000. G paid 
gift tax of $5,250 on the transfer. On November 16, 1956, H gave the 
property to J who still held it on September 2, 1958. The value of the 
property on the date of the gift to J was $63,000 and H paid gift tax of 
$7,125 on the transfer. Since the property was not sold, exchanged, or 
otherwise disposed of by J before September 2, 1958, and the gift tax 
paid on the transfer to J did not exceed $43,000 ($63,000, fair market 
value of property at time of gift to J, less $20,000, basis of property 
in H's hands at that time), the basis of property in his hands is 
increased on September 2, 1958, by $7,125, the amount of gift tax paid 
by H on the transfer. No increase in basis is allowed for the $5,250 
gift tax paid by G on the transfer to H, since H had sold, exchanged, or 
otherwise disposed of the property before September 2, 1958.

    (b) Amount of gift tax paid with respect to gifts made on or before 
December 31, 1976. (1)(i) If only one gift was made during a certain 
calendar period (as defined in Sec. 25.2502-1(c)(1)), the entire

[[Page 60]]

amount of the gift tax paid under chapter 12 or the corresponding 
provisions of prior revenue laws for that calendar period is the amount 
of the gift tax paid with respect to the gift.
    (ii) If more than one gift was made during a certain calendar 
period, the amount of the gift tax paid under chapter 12 or the 
corresponding provisions of prior revenue laws with respect to any 
specified gift made during that calendar period is an amount, A, which 
bears the same ratio to B (the total gift tax paid for that calendar 
period) as C (the amount of the gift, computed as described in this 
paragraph (b)(1)(ii)) bears to D (the total taxable gifts for the 
calendar period computed without deduction for the gift tax specific 
exemption under section 2521 (as in effect prior to its repeal by the 
Tax Reform Act of 1976) or the corresponding provisions of prior revenue 
laws). Stated algebraically, the amount of the gift tax paid with 
respect to a gift equals:

 [Amount of the gift (C) / Total taxable gifts, plus specific exemption 
                 allowed (D)] x Total gift tax paid (B)

For purposes of the ratio stated in the preceding sentence, the amount 
of the gift referred to as factor ``C'' is the value of the gift reduced 
by any portion excluded or deducted under section 2503(b) (annual 
exclusion), 2522 (charitable deduction), or 2523 (marital deduction) of 
the Code or the corresponding provisions of prior revenue laws. In 
making the computations described in this paragraph, the values to be 
used are those finally determined for purposes of the gift tax.
    (iii) If a gift consists of more than one item of property, the gift 
tax paid with respect to each item shall be computed by allocating to 
each item a proportionate part of the gift tax paid with respect to the 
gift, computed in accordance with the provisions of this paragraph.
    (2) For purposes of this paragraph, it is immaterial whether the 
gift tax is paid by the donor or the donee. Where more than one gift of 
a present interest in property is made to the same donee during a 
calendar period (as defined in Sec. 25.2502-1(c)(1)), the annual 
exclusion shall apply to the earliest of such gifts in point of time.
    (3) Where the donor and his spouse elect under section 2513 or the 
corresponding provisions of prior law to have any gifts made by either 
of them considered as made one-half by each, the amount of gift tax paid 
with respect to such a gift is the sum of the amounts of tax (computed 
separately) paid with respect to each half of the gift by the donor and 
his spouse.
    (4) The method described in section 1015(d)(2) and this paragraph 
for computing the amount of gift tax paid in respect of a gift may be 
illustrated by the following examples:

    Example 1. Prior to 1959 H made no taxable gifts. On July 1, 1959, 
he made a gift to his wife, W, of land having a value for gift purposes 
of $60,000 and gave to his son, S, certain securities valued at $60,000. 
During the year 1959, H also contributed $5,000 in cash to a charitable 
organization described in section 2522. H filed a timely gift tax return 
for 1959 with respect to which he paid gift tax in the amount of $6,000, 
computed as follows:

Value of land given to W..................  ........   $60,000  ........
Less: Annual exclusion....................    $3,000  ........  ........
Marital deduction.........................    30,000    33,000  ........
                                           --------------------
Included amount of gift...................  ........  ........   $27,000
                                                               =========
Value of securities given to S............  ........    60,000  ........
Less: Annual exclusion....................  ........     3,000  ........
                                                     ----------
Included amount of gift...................  ........  ........    57,000
Gift to charitable organization...........  ........     5,000  ........
Less: Annual exclusion....................     3,000  ........  ........
Charitable deduction......................     2,000     5,000  ........
                                           --------------------
Included amount of gift...................  ........  ........         0
Total included gifts......................  ........  ........    84,000
Less: Specific exemption allowed..........  ........  ........    30,000
                                                               ---------
Taxable gifts for 1959....................  ........  ........    54,000
                                                               =========
Gift tax on $54,000.......................  ........  ........     6,000
 


In determining the gift tax paid with respect to the land given to W, 
amount C of the ratio set forth in subparagraph (1)(ii) of this 
paragraph is $60,000, value of property given to W, less $33,000 (the 
sum of $3,000, the amount excluded under section 2503(b), and $30,000, 
the amount deducted under section 2523), or $27,000. Amount D of the 
ratio is $84,000 (the amount of taxable gifts, $54,000, plus the gift 
tax specific exemption, $30,000). The gift tax paid with respect to the 
land given to W is $1,928.57, computed as follows:

$27,000(C) / $84,000(D) x $6,000(B)

    Example 2. The facts are the same as in example (1) except that H 
made his gifts to W and S on July 1, 1971, and that prior to 1971, H 
made no taxable gifts. Furthermore, H

[[Page 61]]

made his charitable contribution on August 12, 1971. These were the only 
gifts made by H during 1971. H filed his gift tax return for the third 
quarter of 1971 on November 15, 1971, as required by section 6075(b). 
With respect to the above gifts H paid a gift tax in the amount of 
$6,000 on total taxable gifts of $54,000 for the third quarter of 1971. 
The gift tax paid with respect to the land given to W is $1,928.57. The 
computations for these figures are identical to those used in example 
(1).
    Example 3. On January 15, 1956, A made a gift to his nephew, N, of 
land valued at $86,000, and on June 30, 1956, gave N securities valued 
at $40,000. On July 1, 1956, A gave to his sister, S, $46,000 in cash. A 
and his wife, B, were married during the entire calendar year 1956. The 
amount of A's taxable gifts for prior years was zero although in 
arriving at that amount A had used in full the specific exemption 
authorized by section 2521. B did not make any gifts before 1956. A and 
B elected under section 2513 to have all gifts made by either during 
1956 treated as made one-half by A and one-half by B. Pursuant to that 
election, A and B each filed a gift tax return for 1956. A paid gift tax 
of $11,325 and B paid gift tax of $5,250, computed as follows:

------------------------------------------------------------------------
                                                          A         B
------------------------------------------------------------------------
Value of land given to N............................   $43,000   $43,000
Less: exclusion.....................................     3,000     3,000
                                                     -------------------
    Included amount of gift.........................    40,000    40,000
                                                     ===================
Value of securities given to N......................    20,000    20,000
Less: exclusion.....................................      None      None
                                                     -------------------
    Included amount of gift.........................    20,000    20,000
                                                     ===================
Cash gift to S......................................    23,000    23,000
Less: exclusion.....................................     3,000     3,000
                                                     -------------------
    Included amount of gift.........................    20,000    20,000
                                                     ===================
    Total included gifts............................    80,000    80,000
Less: specific exemption............................      None    30,000
                                                     -------------------
    Taxable gifts for 1956..........................    80,000    50,000
                                                     ===================
Gift tax for 1956...................................    11,325     5,250
------------------------------------------------------------------------


The amount of the gift tax paid by A with respect to the land given to N 
is computed as follows:

$40,000(C) / $80,000(D) x $11,325(B) = $5,662.50

The amount of the gift tax paid by B with respect to the land given to N 
is computed as follows:

$40,000(C) / $80,000(D) x $5,250(B) = $2,625

The amount of the gift tax paid with respect to the land is $5,662.50 
plus $2,625, or $8,287.50. Computed in a similar manner, the amount of 
gift tax paid by A with respect to the securities given to N is 
$2,831.25, and the amount of gift tax paid by B with respect thereto is 
$1,312.50, or a total of $4,143.75.
    Example 4. The facts are the same as in example (3) except that A 
gave the land to N on January 15, 1972, the securities to N on February 
3, 1972, and the cash to S on March 7, 1972. As in example (3), the 
amount of A's taxable gifts for taxable years prior to 1972 was zero, 
although in arriving at that amount A had used in full the specific 
exemption authorized by section 2521. B did not make any gifts before 
1972. Pursuant to the election under section 2513, A and B treated all 
gifts made by either during 1972 as made one-half by A and one-half by 
B. A and B each filed a gift tax return for the first quarter of 1972 on 
May 15, 1972, as required by section 6075(b). A paid gift tax of $11,325 
on taxable gifts of $80,000 and B paid gift tax of $5,250 on taxable 
gifts of $50,000. The amount of the gift tax paid by A and B with 
respect to the land given to N is $5,662.50 and $2,625, respectively. 
The computations for these figures are identical to those used in 
example (3).

    (c) Special rule for increased basis for gift tax paid in the case 
of gifts made after December 31, 1976--(1) In general. With respect to 
gifts made after December 31, 1976 (other than gifts between spouses 
described in section 1015(e)), the increase in basis for gift tax paid 
is determined under section 1015(d)(6). Under section 1015(d)(6)(A), the 
increase in basis with respect to gift tax paid is limited to the amount 
(not in excess of the amount of gift tax paid) that bears the same ratio 
to the amount of gift tax paid as the net appreciation in value of the 
gift bears to the amount of the gift.
    (2) Amount of gift. In general, for purposes of section 
1015(d)(6)(A)(ii), the amount of the gift is determined in conformance 
with the provisions of paragraph (b) of this section. Thus, the amount 
of the gift is the amount included with respect to the gift in 
determining (for purposes of section 2503(a)) the total amount of gifts 
made during the calendar year (or calendar quarter in the case of a gift 
made on or before December 31, 1981), reduced by the amount of any 
annual exclusion allowable with respect to the gift under section 
2503(b), and any deductions allowed with respect to the gift under 
section 2522 (relating to the charitable deduction) and section 2523 
(relating to the marital deduction). Where more than one gift of a 
present interest in property is made to the same donee

[[Page 62]]

during a calendar year, the annual exclusion shall apply to the earliest 
of such gifts in point of time.
    (3) Amount of gift tax paid with respect to the gift. In general, 
for purposes of section 1015(d)(6), the amount of gift tax paid with 
respect to the gift is determined in conformance with the provisions of 
paragraph (b) of this section. Where more than one gift is made by the 
donor in a calendar year (or quarter in the case of gifts made on or 
before December 31, 1981), the amount of gift tax paid with respect to 
any specific gift made during that period is the amount which bears the 
same ratio to the total gift tax paid for that period (determined after 
reduction for any gift tax unified credit available under section 2505) 
as the amount of the gift (computed as described in paragraph (c)(2) of 
this section) bears to the total taxable gifts for the period.
    (4) Qualified domestic trusts. For purposes of section 1015(d)(6), 
in the case of a qualified domestic trust (QDOT) described in section 
2056A(a), any distribution during the noncitizen surviving spouse's 
lifetime with respect to which a tax is imposed under section 
2056A(b)(1)(A) is treated as a transfer by gift, and any estate tax paid 
on the distribution under section 2056A(b)(1)(A) is treated as a gift 
tax. The rules under this paragraph apply in determining the extent to 
which the basis in the assets distributed is increased by the tax 
imposed under section 2056A(b)(1)(A).
    (5) Examples. Application of the provisions of this paragraph (c) 
may be illustrated by the following examples:

    Example 1. (i) Prior to 1995, X exhausts X's gift tax unified credit 
available under section 2505. In 1995, X makes a gift to X's child Y, of 
a parcel of real estate having a fair market value of $100,000. X's 
adjusted basis in the real estate immediately before making the gift was 
$70,000. Also in 1995, X makes a gift to X's child Z, of a painting 
having a fair market value of $70,000. X timely files a gift tax return 
for 1995 and pays gift tax in the amount of $55,500, computed as 
follows:

------------------------------------------------------------------------
 
Value of real estate transferred to Y...........    $100,000  ..........
Less: Annual exclusion..........................      10,000  ..........
                                                 ------------
Included amount of gift (C).....................  ..........     $90,000
Value of painting transferred to Z..............     $70,000  ..........
Less: annual exclusion..........................      10,000  ..........
                                                 ------------
Included amount of gift.........................  ..........      60,000
                                                             -----------
    Total included gifts (D)....................  ..........    $150,000
    Total gift tax liability for 1995 gifts (B).  ..........     $55,500
------------------------------------------------------------------------

    (ii) The gift tax paid with respect to the real estate transferred 
to Y, is determined as follows:
[GRAPHIC] [TIFF OMITTED] TR22AU95.005

    (iii)(A) The amount by which Y's basis in the real property is 
increased is determined as follows:
[GRAPHIC] [TIFF OMITTED] TR22AU95.006

    (B) Y's basis in the real property is $70,000 plus $11,100, or 
$81,100. If X had not exhausted any of X's unified credit, no gift tax 
would have been paid and, as a result, Y's basis would not be increased.
    Example 2. (i) X dies in 1995. X's spouse, Y, is not a United States 
citizen. In order to obtain the marital deduction for property passing 
to X's spouse, X established a QDOT in X's will. In 1996, the trustee of 
the QDOT makes a distribution of principal from the QDOT in the form of 
shares of stock having a fair market value of $70,000 on the date of 
distribution. The trustee's basis in the stock (determined under section 
1014) is $50,000. An estate tax is imposed on the distribution under 
section 2056A(b)(1)(A) in the amount $38,500, and is paid. Y's basis in 
the shares of stock is increased by a portion of the section 2056A 
estate tax paid determined as follows:

[[Page 63]]

[GRAPHIC] [TIFF OMITTED] TR22AU95.007

    (ii) Y's basis in the stock is $50,000 plus $11,000, or $61,000.

    (6) Effective date. The provisions of this paragraph (c) are 
effective for gifts made after August 22, 1995.
    (d) Treatment as adjustment to basis. Any increase in basis under 
section 1015(d) and this section shall, for purposes of section 1016(b) 
(relating to adjustments to a substituted basis), be treated as an 
adjustment under section 1016(a) to the basis of the donee's property to 
which such increase applies. See paragraph (p) of Sec. 1.1016-5.

[T.D. 6693, 28 FR 12818, Dec. 3, 1963, as amended by T.D. 7238, 37 FR 
28715, Dec. 29, 1972; T.D. 7910, 48 FR 40372, Sept. 7, 1983; T.D. 8612, 
60 FR 43537, Aug. 22, 1995]



Sec. 1.1016-1  Adjustments to basis; scope of section.

    Section 1016 and Secs. 1.1016-2 to 1.1016-10, inclusive, contain the 
rules relating to the adjustments to be made to the basis of property to 
determine the adjusted basis as defined in section 1011. However, if the 
property was acquired from a decedent before his death, see Sec. 1.1014-
6 for adjustments on account of certain deductions allowed the taxpayer 
for the period between the date of acquisition of the property and the 
date of death of the decedent. If an election has been made under the 
Retirement-Straight Line Adjustment Act of 1958 (26 U.S.C. 1016 note), 
see Sec. 1.9001-1 for special rules for determining adjusted basis in 
the case of a taxpayer who has changed from the retirement to the 
straight-line method of computing depreciation allowances.



Sec. 1.1016-2  Items properly chargeable to capital account.

    (a) The cost or other basis shall be properly adjusted for any 
expenditure, receipt, loss, or other item, properly chargeable to 
capital account, including the cost of improvements and betterments made 
to the property. No adjustment shall be made in respect of any item 
which, under any applicable provision of law or regulation, is treated 
as an item not properly chargeable to capital account but is allowable 
as a deduction in computing net or taxable income for the taxable year. 
For example, in the case of oil and gas wells no adjustment may be made 
in respect of any intangible drilling and development expense allowable 
as a deduction in computing net or taxable income. See the regulations 
under section 263(c).
    (b) The application of the foregoing provisions may be illustrated 
by the following example:

    Example: A, who makes his returns on the calendar year basis, 
purchased property in 1941 for $10,000. He subsequently expended $6,000 
for improvements. Disregarding, for the purpose of this example, the 
adjustments required for depreciation, the adjusted basis of the 
property is $16,000. If A sells the property in 1954 for $20,000, the 
amount of his gain will be $4,000.

    (c) Adjustments to basis shall be made for carrying charges such as 
taxes and interest, with respect to property (whether real or personal, 
improved or unimproved, and whether productive or unproductive), which 
the taxpayer elects to treat as chargeable to capital account under 
section 266, rather than as an allowable deduction. The term taxes for 
this purpose includes duties and excise taxes but does not include 
income taxes.
    (d) Expenditures described in section 173 to establish, maintain, or 
increase the circulation of a newspaper, magazine, or other periodical 
are chargeable to capital account only in accordance with and in the 
manner provided in the regulations under section 173.



Sec. 1.1016-3  Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 28, 1913.

    (a) In general--(1) Adjustment where deduction is claimed. (i) For 
taxable periods beginning on or after January 1, 1952, the cost or other 
basis of property shall be decreased for exhaustion, wear and tear, 
obsolescence, amortization,

[[Page 64]]

and depletion by the greater of the following two amounts:
    (a) The amount allowed as deductions in computing taxable income, to 
the extent resulting in a reduction of the taxpayer's income taxes, or
    (b) The amount allowable for the years involved.

See paragraph (b) of this section. Where the taxpayer makes an 
appropriate election the above rule is applicable for periods since 
February 28, 1913, and before January 1, 1952. See paragraph (d) of this 
section. For rule for such periods where no election is made, see 
paragraph (c) of this section.
    (ii) The determination of the amount properly allowable for 
exhaustion, wear and tear, obsolescence, amortization, and depletion 
shall be made on the basis of facts reasonably known to exist at the end 
of the taxable year. A taxpayer is not permitted to take advantage in a 
later year of his prior failure to take any such allowance or his taking 
an allowance plainly inadequate under the known facts in prior years. In 
the case of depreciation, if in prior years the taxpayer has 
consistently taken proper deductions under one method, the amount 
allowable for such prior years shall not be increased even though a 
greater amount would have been allowable under another proper method. 
For rules governing losses on retirement of depreciable property, 
including rules for determining basis, see Sec. 1.167(a)-8. This 
subdivision may be illustrated by the following example:

    Example: An asset was purchased January 1, 1950, at a cost of 
$10,000. The useful life of the asset is 10 years. It has no salvage 
value. Depreciation was deducted and allowed for 1950 to 1954 as 
follows:

1950..........................................................      $500
1951..........................................................  ........
1952..........................................................     1,000
1953..........................................................     1,000
1954..........................................................     1,000
                                                               ---------
    Total amount allowed......................................     3,500
 


The correct reserve as of December 31, 1954, is computed as follows:

December 31:
  1950 ($10,000/10)................................               $1,000
  1951 ($9,000/9)..................................                1,000
  1952 ($8,000/8)..................................                1,000
  1953 ($7,000/7)..................................                1,000
  1954 ($6,000/6)..................................                1,000
                                                    --------------------
    Reserve December 31, 1954......................                5,000
Depreciation for 1955 is computed as follows:
  Cost.............................................               10,000
  Reserve as of December 31, 1954..................                5,000
                                                    --------------------
    Unrecovered cost...............................                5,000
  Depreciation allowable for 1955 ($5,000/5).......                1,000
 


    (2) Adjustment for amount allowable where no depreciation deduction 
claimed. (i) If the taxpayer has not taken a depreciation deduction 
either in the taxable year or for any prior taxable year, adjustments to 
basis of the property for depreciation allowable shall be determined by 
using the straight-line method of depreciation. (See Sec. 1.1016-4 for 
adjustments in the case of persons exempt from income taxation.)
    (ii) For taxable years beginning after December 31, 1953, and ending 
after August 16, 1954, if the taxpayer with respect to any property has 
taken a deduction for depreciation properly under one of the methods 
provided in section 167(b) for one or more years but has omitted the 
deduction in other years, the adjustment to basis for the depreciation 
allowable in such a case will be the deduction under the method which 
was used by the taxpayer with respect to that property. Thus, if A 
acquired property in 1954 on which he properly computed his depreciation 
deduction under the method described in section 167(b)(2) (the 
declining-balance method) for the first year of its useful life but did 
not take a deduction in the second and third year of the asset's life, 
the adjustment to basis for depreciation allowable for the second and 
third year will be likewise computed under the declining-balance method.
    (3) Adjustment for depletion deductions with respect to taxable 
years before 1932. Where for any taxable year before the taxable year 
1932 the depletion allowance was based on discovery value or a 
percentage of income, then the adjustment for depletion for such year 
shall not exceed a depletion deduction which would have been allowable 
for such year if computed without reference to discovery value or a 
percentage of income.
    (b) Adjustment for periods beginning on or after January 1, 1952. 
The decrease required by paragraph (a) of this section for deductions in 
respect of any period

[[Page 65]]

beginning on or after January 1, 1952, shall be whichever is the greater 
of the following amounts:
    (1) The amount allowed as deductions in computing taxable income 
under subtitle A of the Code or prior income tax laws and resulting (by 
reason of the deductions so allowed) in a reduction for any taxable year 
of the taxpayer's taxes under subtitle A of the Code (other than chapter 
2, relating to tax on self-employment income) or prior income, war-
profits, or excess-profits tax laws; or
    (2) The amount properly allowable as deductions in computing taxable 
income under subtitle A of the Code or prior income tax laws (whether or 
not the amount properly allowable would have caused a reduction for any 
taxable year of the taxpayer's taxes).
    (c) Adjustment for periods since February 28, 1913, and before 
January 1, 1952, where no election made. If no election has been 
properly made under section 1020, or under section 113(d) of the 
Internal Revenue Code of 1939 (see paragraph (d) of this section), the 
decrease required by paragraph (a) of this section for deductions in 
respect of any period since February 28, 1913, and before January 1, 
1952, shall be whichever of the following amounts is the greater:
    (1) The amount allowed as deductions in computing net income under 
chapter 1 of the Internal Revenue Code of 1939 or prior income tax laws;
    (2) The amount properly allowable in computing net income under 
chapter 1 of the Internal Revenue Code of 1939 or prior income tax laws.

For the purpose of determining the decrease required by this paragraph, 
it is immaterial whether or not the amount under subparagraph (1) of 
this paragraph or the amount under subparagraph (2) of this paragraph 
would have resulted in a reduction for any taxable year of the 
taxpayer's taxes.
    (d) Adjustment for periods since February 28, 1913, and before 
January 1, 1952, where election made. If an election has been properly 
made under section 1020, or under section 113(d) of the Internal Revenue 
Code of 1939, the decrease required by paragraph (a) of this section for 
deductions in respect of any period since February 28, 1913, and before 
January 1, 1952, shall be whichever is the greater of the following 
amounts:
    (1) The amount allowed as deductions in computing net income under 
chapter 1 of the Internal Revenue Code of 1939 or prior income tax laws 
and resulting (by reason of the deductions so allowed) in a reduction 
for any taxable year of the taxpayer's taxes under such chapter 1 (other 
than subchapter E, relating to tax on self-employment income), 
subchapter E, chapter 2, of the Internal Revenue Code of 1939, or prior 
income, war-profits, or excess-profits tax laws;
    (2) The amount properly allowable as deductions in computing net 
income under chapter 1 of the Internal Revenue Code of 1939 or prior 
income tax laws (whether or not the amount properly allowable would have 
caused a reduction for any taxable year of the taxpayer's taxes).
    (e) Determination of amount allowed which reduced taxpayer's taxes. 
(1) As indicated in paragraphs (b) and (d) of this section, there are 
situations in which it is necessary to determine (for the purpose of 
ascertaining the basis adjustment required by paragraph (a) of this 
section) the extent to which the amount allowed as deductions resulted 
in a reduction for any taxable year of the taxpayer's taxes under 
subtitle A (other than chapter 2 relating to tax on self-employment 
income) of the Code, or prior income, war-profits, or excess-profits tax 
laws. This amount (amount allowed which resulted in a reduction of the 
taxpayer's taxes) is hereinafter referred to as the tax-benefit amount 
allowed. For the purpose of determining whether the tax-benefit amount 
allowed exceeded the amount allowable, a determination must be made of 
that portion of the excess of the amount allowed over the amount 
allowable which, if disallowed, would not have resulted in an increase 
in any such tax previously determined. If the entire excess of the 
amount allowed over the amount allowable could be disallowed without any 
such increase in tax, the tax-benefit amount allowed shall not be 
considered to have exceeded the amount allowable. In such a case (if 
paragraph (b) or (d) of this section is applicable) the reduction in 
basis required by paragraph (a) of this section

[[Page 66]]

would be the amount properly allowable as a deduction. If only part of 
such excess could be disallowed without any such increase in tax, the 
tax-benefit amount allowed shall be considered to exceed the amount 
allowable to the extent of the remainder of such excess. In such a case 
(if paragraph (b) or (d) of this section is applicable), the reduction 
in basis required by paragraph (a) of this section would be the amount 
of the tax-benefit amount allowed.
    (2) For the purpose of determining the tax-benefit amount allowed 
the tax previously determined shall be determined under the principles 
of section 1314. The only adjustments made in determining whether there 
would be an increase in tax shall be those resulting from the 
disallowance of the amount allowed. The taxable years for which the 
determination is made shall be the taxable year for which the deduction 
was allowed and any other taxable year which would be affected by the 
disallowance of such deduction. Examples of such other taxable years are 
taxable years to which there was a carryover or carryback of a net 
operating loss from the taxable year for which the deduction was 
allowed, and taxable years for which a computation under section 111 or 
section 1333 was made by reference to the taxable year for which the 
deduction was allowed. In determining whether the disallowance of any 
part of the deduction would not have resulted in an increase in any tax 
previously determined, proper adjustment must be made for previous 
determinations under section 1311, or section 3801 of the Internal 
Revenue Code of 1939, and for any previous application of section 
1016(a)(2)(B), or section 113(b) (1)(B)(ii) of the Internal Revenue Code 
of 1939.
    (3) If a determination under section 1016(a)(2)(B) must be made with 
respect to several properties for each of which the amount allowed for 
the taxable year exceeded the amount allowable, the tax-benefit amount 
allowed with respect to each of such properties shall be an allocated 
portion of the tax-benefit amount allowed determined by reference to the 
sum of the amounts allowed and the sum of the amounts allowable with 
respect to such several properties.
    (4) In the case of property held by a partnership or trust, the 
computation of the tax-benefit amount allowed shall take into account 
the tax benefit of the partners or beneficiaries, as the case may be, 
from the deduction by the partnership or trust of the amount allowed to 
the partnership or the trust. For this purpose, the determination of the 
amount allowed which resulted in a tax benefit to the partners or 
beneficiaries shall be made in the same manner as that provided above 
with respect to the taxes of the person holding the property.
    (5) A taxpayer seeking to limit the adjustment to basis to the tax-
benefit amount allowed for any period, in lieu of the amount allowed, 
must establish the tax-benefit amount allowed. A failure of adequate 
proof as to the tax-benefit amount allowed with respect to one period 
does not preclude the taxpayer from limiting the adjustment to basis to 
the tax-benefit amount allowed with respect to another period for which 
adequate proof is available. For example, a corporate transferee may 
have available adequate records with respect to the tax effect of the 
deduction of erroneous depreciation for certain taxable years, but may 
not have available adequate records with respect to the deduction of 
excessive depreciation for other taxable years during which the property 
was held by its transferor. In such case the corporate transferee shall 
not be denied the right to apply this section with respect to the 
erroneous depreciation for the period for which adequate proof is 
available.
    (f) Determination of amount allowable in prior taxable years. (1) 
One of the factors in determining the adjustment to basis as of any date 
is the amount of depreciation, depletion, etc., allowable for periods 
prior to such date. The amount allowable for such prior periods is 
determined under the law applicable to such prior periods; all 
adjustments required by the law applicable to such periods are made in 
determining the adjusted basis of the property for the purpose of 
determining the amount allowable. Provisions corresponding to the rules 
in section 1016(a)(2)(B) described in paragraphs (d) and (e) of this 
section, which limit adjustments to the

[[Page 67]]

tax-benefit amount allowed where an election is properly exercised, were 
first enacted by the Act of July 14, 1952 (66 Stat. 629). That law 
provided that corresponding rules are deemed to be includible in all 
revenue laws applicable to taxable years ending after December 31, 1931. 
Accordingly, those rules shall be taken into account in determining the 
amount of depreciation, etc., allowable for any taxable year ending 
after December 31, 1931. For example, if the adjusted basis of property 
held by the taxpayer since January 1, 1930, is determined as of January 
1, 1955, and if an election was properly made under section 1020, or 
section 113(d) of the Internal Revenue Code of 1939, then the amount 
allowable which is taken into account in computing the adjusted basis as 
of January 1, 1955, shall be determined by taking those rules into 
account for all taxable years ending after December 31, 1931. The Act of 
July 14, 1952, made no change in the law applicable in determining the 
amount allowable for taxable years ending before January 1, 1932. If 
there was a final decision of a court prior to the enactment of the Act 
of July 14, 1952, determining the amount allowable for a particular 
taxable year, such determination shall be adjusted. In such case the 
adjustment shall be made only for the purpose of taking the provision of 
that law into account and only to the extent made necessary by such 
provisions.
    (2) Although the Act of July 14, 1952, amended the law applicable to 
all taxable years ending after December 31, 1931, the amendment does not 
permit refund, credit, or assessment of a deficiency for any taxable 
year for which such refund, credit, or assessment was barred by any law 
or rule of law.
    (g) Property with transferred basis. The following rules apply in 
the determination of the adjustments to basis of property in the hands 
of a transferee, donee, or grantee which are required by section 
1016(b), or section 113(b)(2) of the Internal Revenue Code of 1939, with 
respect to the period the property was held by the transferor, donor, or 
grantor:
    (1) An election or a revocation of an election under section 1020, 
or section 113(d) of the Internal Revenue Code of 1939, by a transferor, 
donor, or grantor, which is made after the date of the transfer, gift, 
or grant of the property shall not affect the basis of such property in 
the hands of the transferee, donee, or grantee. An election or a 
revocation of an election made before the date of the transfer, gift, or 
grant of the property shall be taken into account in determining under 
section 1016(b) the adjustments to basis of such property as of the date 
of the transfer, gift, or grant, whether or not an election or a 
revocation of an election under section 1020, or section 113(d) of the 
Internal Revenue Code of 1939, was made by the transferee, donee, or 
grantee.
    (2) An election by the transferee, donee, or grantee or a revocation 
of such an election shall be applicable in determining the adjustments 
to basis for the period during which the property was held by the 
transferor, donor, or grantor, whether or not the transferor, donor, or 
grantor had made an election or a revocation of an election, provided 
that the property was held by the transferee, donee, or grantee at any 
time on or before the date on which the election or revocation was made.
    (h) Examples. The application of section 1016(a) (1) and (2) may be 
illustrated by the following examples:

    Example 1. The case of Corporation A discloses the following facts:

The cost or other basis is to be adjusted by $16,500 with respect to the 
years 1952-54, that is, by the amount allowable but not less than the 
amount allowed which reduced the taxpayer's taxes. An adjustment must 
also be made with respect to the years 1949-1951, the amount of such 
adjustment depending upon whether an election was properly made under 
section 1020, or section 113(d) of the Internal Revenue Code of 1939. If 
no such election was made, the amount of the adjustment with respect to 
the years 1949-1951 is $19,500, that is, the amount allowed but not less 
than the amount allowable. If an election was properly made, the amount 
of the adjustment with respect to the years 1949-1951 is $19,000, that 
is, the amount allowable but not less than the amount allowed which 
reduced the taxpayer's taxes.

[[Page 68]]


----------------------------------------------------------------------------------------------------------------
                                                                                                         (6)--
                                                                                                        Amount
                                                                       (3)--                 (5)--     allowable
                                                                      Amount                 Amount     but not
                                                            (2)--     allowed     (4)--    allowable   less than
                        (1)--Year                           Amount     which      Amount    but not     amount
                                                           allowed    reduced   allowable  less than    allowed
                                                                    taxpayer's               amount      which
                                                                       taxes                allowed     reduced
                                                                                                      taxpayer's
                                                                                                         taxes
----------------------------------------------------------------------------------------------------------------
1949.....................................................   $6,000     $5,500     $5,000     $6,000      $5,500
1950.....................................................    7,000      7,000      6,500      7,000       7,000
1951.....................................................    5,000      4,000      6,500      6,500       6,500
                                                          ------------------------------------------------------
  Total, 1949-1951.......................................  .......  ..........  .........    19,500      19,000
                                                          ======================================================
1952.....................................................    6,500      6,500      6,000   .........      6,500
1953.....................................................    5,000      4,000      4,000   .........      4,000
1954.....................................................    4,500      4,500      6,000   .........      6,000
                                                          ------------------------------------------------------
  Total, 1952-1954.......................................  .......  ..........  .........  .........     16,500
----------------------------------------------------------------------------------------------------------------

    Example 2. Corporation A, which files its returns on the basis of a 
calendar year, purchased a building on January 1, 1950, at a cost of 
$100,000. On the basis of the facts reasonably known to exist at the end 
of 1950, a period of 50 years should have been used as the correct 
useful life of the building; nevertheless, depreciation was computed by 
Corporation A on the basis of a useful life of 25 years, and was allowed 
for 1950 through 1953 as a deduction in an annual amount of $4,000. The 
building was sold on January 1, 1954. Corporation A did not make an 
election under section 1020, or section 113(d) of the Internal Revenue 
Code of 1939. No part of the amount allowed Corporation A for any of the 
years 1950 through 1953 resulted in a reduction of Corporation A's 
taxes. The adjusted basis of the building as of January 1, 1954, is 
$88,166, computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                  Adjustments
                                                  to basis as
                                                       of       Adjusted   Remaining  Depreciation  Depreciation
                  Taxable year                     beginning    basis on    life on     allowable      allowed
                                                   of taxable   January 1  January 1
                                                      year
----------------------------------------------------------------------------------------------------------------
1950............................................  ...........    $100,000         50      $2,000        $4,000
1951............................................      $4,000       96,000         49       1,959         4,000
1952............................................       8,000       92,000         48       1,917         4,000
1953............................................       9,917       90,083         47       1,917         4,000
1954............................................      11,834       88,166  .........  ............  ............
----------------------------------------------------------------------------------------------------------------

    Example 3. The facts are the same as in example (2), except that 
Corporation A made a proper election under section 1020. In such case, 
the adjusted basis of the building as of January 1, 1954, is $92,000 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                  Adjustments
                                                  to basis as
                                                       of       Adjusted   Remaining  Depreciation  Depreciation
                  Taxable year                     beginning    basis on    life on     allowable      allowed
                                                   of taxable   January 1  January 1
                                                      year
----------------------------------------------------------------------------------------------------------------
1950............................................  ...........    $100,000         50      $2,000        $4,000
1951............................................      $2,000       98,000         49       2,000         4,000
1952............................................       4,000       96,000         48       2,000         4,000
1953............................................       6,000       94,000         47       2,000         4,000

[[Page 69]]

 
1954............................................       8,000       92,000
----------------------------------------------------------------------------------------------------------------

    Example 4. If it is assumed that in example (2), or in example (3), 
all of the deduction allowed Corporation A for 1953 had resulted in a 
reduction of A's taxes, the adjustment to the basis of the building for 
depreciation for 1953 would reflect the entire $4,000 deduction. In such 
case, the adjusted basis of the building as of January 1, 1954, would be 
$86,083 in example (2), and $90,000 in example (3).
    Example 5. The facts are the same as in example (2), except that for 
the year 1950 all of the $4,000 amount allowed Corporation A as a 
deduction for depreciation for that year resulted in a reduction of A's 
taxes. In such case, the adjustments to the basis of the building remain 
the same as those set forth in example (2).
    Example 6. The facts are the same as in example (3), except that for 
the year 1950 all of the $4,000 amount allowed Corporation A as a 
deduction for depreciation resulted in a reduction of A's taxes. In such 
case, the adjusted basis of the building as of January 1, 1954, is 
$90,123, computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                  Adjustments
                                                  to basis as
                                                       of       Adjusted   Remaining  Depreciation  Depreciation
                  Taxable year                     beginning    basis on    life on     allowable      allowed
                                                   of taxable   January 1  January 1
                                                      year
----------------------------------------------------------------------------------------------------------------
1950............................................  ...........    $100,000         50      $2,000        $4,000
1951............................................      $4,000       96,000         49       1,959         4,000
1952............................................       5,959       94,041         48       1,959         4,000
1953............................................       7,918       92,082         47       1,959         4,000
1954............................................       9,877       90,123
----------------------------------------------------------------------------------------------------------------



Sec. 1.1016-4  Exhaustion, wear and tear, obsolescence, amortization, and depletion; periods during which income was not subject to tax.

    (a) Adjustments to basis must be made for exhaustion, wear and tear, 
obsolescence, amortization, and depletion to the extent actually 
sustained in respect of:
    (1) Any period before March 1, 1913,
    (2) Any period since February 28, 1913, during which the property 
was held by a person or organization not subject to income taxation 
under chapter 1 of the Code or prior income tax laws,
    (3) Any period since February 28, 1913, and before January 1, 1958, 
during which the property was held by a person subject to tax under part 
I, subchapter L, chapter 1 of the Code, or prior income tax law, to the 
extent that section 1016(a)(2) does not apply, and
    (4) Any period since February 28, 1913, during which such property 
was held by a person subject to tax under part II of subchapter L, 
chapter 1 of the Code, or prior income tax law, to the extent that 
section 1016(a)(2) does not apply.
    (b) The amount of the adjustments described in paragraph (a) of this 
section actually sustained is that amount charged off on the books of 
the taxpayer where such amount is considered by the Commissioner to be 
reasonable. Otherwise, the amount actually sustained will be the amount 
that would have been allowable as a deduction:
    (1) During the period described in paragraph (a) (1) or (2) of this 
section, had the taxpayer been subject to income tax during those 
periods, or
    (2) During the period described in paragraph (a) (3) or (4) of this 
section, with respect to property held by a taxpayer described in that 
paragraph, to the extent that section 1016(a)(2) was

[[Page 70]]

inapplicable to such property during that period.

In the case of a taxpayer subject to the adjustment required by 
subparagraph (1) or (2) of this paragraph, depreciation shall be 
determined by using the straight line method.

[T.D. 6681, 28 FR 11131, Oct. 17, 1963]



Sec. 1.1016-5  Miscellaneous adjustments to basis.

    (a) Certain stock distributions. (1) In the case of stock, the cost 
or other basis must be diminished by the amount of distributions 
previously made which, under the law applicable to the year in which the 
distribution was made, either were tax free or were applicable in 
reduction of basis (not including distributions made by a corporation 
which was classified as a personal service corporation under the 
provisions of the Revenue Act of 1918 (40 Stat. 1057) or the Revenue Act 
of 1921 (42 Stat. 227), out of its earnings or profits which were 
taxable in accordance with the provisions of section 218 of the Revenue 
Act of 1918 or the Revenue Act of 1921). For adjustments to basis in the 
case of certain corporate distributions, see section 301 and the 
regulations thereunder.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example: A, who makes his returns upon the calendar year basis, 
purchased stock in 1923 for $5,000. He received in 1924 a distribution 
of $2,000 paid out of earnings and profits of the corporation 
accumulated before March 1, 1913. The adjusted basis for determining the 
gain or loss from the sale or other disposition of the stock in 1954 is 
$5,000 less $2,000, or $3,000, and the amount of the gain or loss from 
the sale or other disposition of the stock is the difference between 
$3,000 and the amount realized from the sale or other disposition.

    (b) Amortizable bond premium--(1) In general. A holder's basis in a 
bond is reduced by the amount of bond premium used to offset qualified 
stated interest income under Sec. 1.171-2. This reduction occurs when 
the holder takes the qualified stated interest into account under the 
holder's regular method of accounting.
    (2) Special rules for taxable bonds. A holder's basis in a taxable 
bond is reduced by the amount of bond premium allowed as a deduction 
under Sec. 1.171-3(c)(5)(ii) (relating to the issuer's call of a taxable 
bond) or under Sec. 1.171-2(a)(4)(i)(A) (relating to excess bond 
premium).
    (3) Special rule for tax-exempt obligations. A holder's basis in a 
tax-exempt obligation is reduced by the amount of excess bond premium 
that is treated as a nondeductible loss under Sec. 1.171-2(a)(4)(ii).
    (c) Municipal bonds. In the case of a municipal bond (as defined in 
section 75(b)), basis shall be adjusted to the extent provided in 
section 75 or as provided in section 22(o) of the Internal Revenue Code 
of 1939, and the regulations thereunder.
    (d) Sale or exchange of residence. Where the acquisition of a new 
residence results in the nonrecognition of any part of the gain on the 
sale, or exchange, or involuntary conversion of the old residence, the 
basis of the new residence shall be reduced by the amount of the gain 
not so recognized pursuant to section 1034(a), or section 112(n) of the 
Internal Revenue Code of 1939, and the regulations thereunder. See 
section 1034(e) and the regulations thereunder.
    (e) Loans from Commodity Credit Corporation. In the case of property 
pledged to the Commodity Credit Corporation, the basis of such property 
shall be increased by the amount received as a loan from such 
corporation and treated by the taxpayer as income for the year in which 
received under section 77, or under section 123 of the Internal Revenue 
Code of 1939. The basis of such property shall be reduced to the extent 
of any deficiency on such loan with respect to which the taxpayer has 
been relieved from liability.
    (f) Deferred development and exploration expenses. Expenditures for 
development and exploration of mines or mineral deposits treated as 
deferred expenses under sections 615 and 616, or under the corresponding 
provisions of prior income tax laws, are chargeable to capital account 
and shall be an adjustment to the basis of the property to which they 
relate. The basis so adjusted shall be reduced by the amount of such 
expenditures allowed as deductions which results in a reduction for

[[Page 71]]

any taxable year of the taxpayer's taxes under subtitle A (other than 
chapter 2 relating to tax on self-employment income) of the Code, or 
prior income, war-profits, or excess-profits tax laws, but not less than 
the amounts allowable under such provisions for the taxable year and 
prior years. This amount is considered as the tax-benefit amount allowed 
and shall be determined in accordance with paragraph (e) of Sec. 1.1016-
3. For example, if a taxpayer purchases unexplored and undeveloped 
mining property for $1,000,000 and at the close of the development stage 
has incurred exploration and development costs of $9,000,000 treated as 
deferred expenses, the basis of such property at such time for computing 
gain or loss will be $10,000,000. Assuming that the taxpayer in this 
example has operated the mine for several years and has deducted 
allowable percentage depletion in the amount of $2,000,000 and has 
deducted allowable deferred exploration and development expenditures of 
$2,000,000, the basis of the property in the taxpayer's hands for 
purposes of determining gain or loss from a sale will be $6,000,000.
    (g) Sale of land with unharvested crop. In the case of an 
unharvested crop which is sold, exchanged, or involuntarily converted 
with the land and which is considered as property used in the trade or 
business under section 1231, the basis of such crop shall be increased 
by the amount of the items which are attributable to the production of 
such crop and which are disallowed, under section 268, as deductions in 
computing taxable income. The basis of any other property shall be 
decreased by the amount of any such items which are attributable to such 
other property, notwithstanding any provisions of section 1016 or of 
this section to the contrary. For example, if the items attributable to 
the production of an unharvested crop consist only of fertilizer costing 
$100 and $50 depreciation on a tractor used only to cultivate such crop, 
and such items are disallowed under section 268, the adjustments to the 
basis of such crop shall include an increase of $150 for such items and 
the adjustments to the basis of the tractor shall incude a reduction of 
$50 for depreciation.
    (h) Consent dividends. (1) In the case of amounts specified in a 
shareholder's consent to which section 28 of the Internal Revenue Code 
of 1939 applies, the basis of the consent stock shall be increased to 
the extent provided in subsection (h) of such section.
    (2) In the case of amounts specified in a shareholder's consent to 
be treated as a consent dividend to which section 565 applies, the basis 
of the consent stock shall be increased by the amount which, under 
section 565(c)(2), is treated as contributed to the capital of the 
corporation.
    (i) Stock in foreign personal holding company. In the case of the 
stock of a United States shareholder in a foreign personal holding 
company, basis shall be adjusted to the extent provided in section 
551(f) or corresponding provisions of prior income tax laws.
    (j) Research and experimental expenditures. Research and 
experimental expenditures treated as deferred expenses under section 
174(b) are chargeable to capital account and shall be an adjustment to 
the basis of the property to which they relate. The basis so adjusted 
shall be reduced by the amount of such expenditures allowed as 
deductions which results in a reduction for any taxable year of the 
taxpayer's taxes under subtitle A (other than chapter 2 relating to tax 
on self-employment income) of the Code, or prior income, war-profits, or 
excess-profits tax laws, but not less than the amounts allowable under 
such provisions for the taxable year and prior years. This amount is 
considered as the tax-benefit amount allowed and shall be determined in 
accordance with paragraph (e) of Sec. 1.1016-3.
    (k) Deductions disallowed in connection with disposal of coal or 
domestic iron ore. Basis shall be adjusted by the amount of the 
deductions disallowed under section 272 with respect to the disposal of 
coal or domestic iron ore covered by section 631.
    (l) Expenditures attributable to grants or loans covered by section 
621. In the case of expenditures attributable to a grant or loan made to 
a taxpayer by the United States for the encouragement of exploration 
for, or development or mining of, critical and strategic minerals or 
metals, basis shall be

[[Page 72]]

adjusted to the extent provided in section 621, or in section 22(b)(15) 
of the Internal Revenue Code of 1939.
    (m) Trademark and trade name expenditures. Trademark and trade name 
expenditures treated as deferred expenses under section 177 are 
chargeable to capital account and shall be an adjustment to the basis of 
the property to which they relate. The basis so adjusted shall be 
reduced by the amount of such expenditures allowed as deductions which 
results in a reduction for any taxable year of the taxpayer's taxes 
under subtitle A (other than chapter 2, relating to tax on self-
employment income) of the Code, but not less than the amounts allowable 
under such section for the taxable year and prior years. This amount is 
considered as the tax-benefit amount allowed and shall be determined in 
accordance with paragraph (e) of Sec. 1.1016-3.
    (n) Life insurance companies. In the case of any evidence of 
indebtedness referred to in section 818(b), the basis shall be adjusted 
to the extent of the adjustments required under section 818(b) (or the 
corresponding provisions of prior income tax laws) for the taxable year 
and all prior taxable years. The basis of any such evidence of 
indebtedness shall be reduced by the amount of the adjustment required 
under section 818(b) (or the corresponding provision of prior income tax 
laws) on account of amortizable premium and shall be increased by the 
amount of the adjustment required under section 818(b) on account of 
accruable discounts.
    (o) Stock and indebtedness of electing small business corporation. 
In the case of a shareholder of an electing small business corporation, 
as defined in section 1371(b), the basis of the shareholder's stock in 
such corporation, and the basis of any indebtedness of such corporation 
owing to the shareholder, shall be adjusted to the extent provided in 
Secs. 1.1375-4, 1.1376-1, and 1.1376-2.
    (p) Gift tax paid on certain property acquired by gift. Basis shall 
be adjusted by that amount of the gift tax paid in respect of property 
acquired by gift which, under section 1015(d), is an increase in the 
basis of such property.
    (q) Section 38 property. In the case of property which is or has 
been section 38 property (as defined in section 48(a)), the basis shall 
be adjusted to the extent provided in section 48(g) and in section 
203(a)(2) of the Revenue Act of 1964.
    (r) Stock in controlled foreign corporations and other property. In 
the case of stock in controlled foreign corporations (or foreign 
corporations which were controlled foreign corporations) and of property 
by reason of which a person is considered as owning such stock, the 
basis shall be adjusted to the extent provided in section 961.
    (s) Original issue discount. In the case of certain corporate 
obligations issued at a discount after May 27, 1969, the basis shall be 
increased under section 1232(a)(3)(E) by the amount of original issue 
discount included in the holder's gross income pursuant to section 
1232(a)(3).
    (t) Section 23 credit. In the case of property with respect to which 
a credit has been allowed under section 23 or former section 44C 
(relating to residential energy credit), basis shall be adjusted as 
provided in paragraph (k) of Sec. 1.23-3.
    (u) Gas guzzler tax. In the case of an automobile upon which the gas 
guzzler tax was imposed, the basis shall be reduced as provided in 
section 1016 (d).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting 
Sec. 1.1016-5, see the List of CFR Sections Affected in the printed 
volume, 26 CFR 600a-end, and on GPO Access.



Sec. 1.1016-6  Other applicable rules.

    (a) Adjustments must always be made to eliminate double deductions 
or their equivalent. Thus, in the case of the stock of a subsidiary 
company, the basis thereof must be properly adjusted for the amount of 
the subsidiary company's losses for the years in which consolidated 
returns were made.
    (b) In determining basis, and adjustments to basis, the principles 
of estoppel apply, as elsewhere under the Code, and prior internal 
revenue laws.



Sec. 1.1016-10  Substituted basis.

    (a) Whenever it appears that the basis of property in the hands of 
the taxpayer is a substituted basis, as defined in section 1016(b), the 
adjustments indicated in Secs. 1.1016-1 to 1.1016-

[[Page 73]]

6, inclusive, shall be made after first making in respect of such 
substituted basis proper adjustments of a similar nature in respect of 
the period during which the property was held by the transferor, donor, 
or grantor, or during which the other property was held by the person 
for whom the basis is to be determined. In addition, whenever it appears 
that the basis of property in the hands of the taxpayer is a substituted 
basis, as defined in section 1016(b)(1), the adjustments indicated in 
Secs. 1.1016-7 to 1.1016-9, inclusive, and in section 1017 shall also be 
made, whenever necessary, after first making in respect of such 
substituted basis a proper adjustment of a similar nature in respect of 
the period during which the property was held by the transferor, donor, 
or grantor. Similar rules shall also be applied in the case of a series 
of substituted bases.
    (b)cation of this section may be illustrated by the following 
example:

    Example: A, who makes his returns upon the calendar year basis, in 
1935 purchased the X Building and subsequently gave it to his son B. B 
exchanged the X Building for the Y Building in a tax-free exchange, and 
then gave the Y Building to his wife C. C, in determining the gain from 
the sale or disposition of the Y Building in 1954, is required to reduce 
the basis of the building by deductions for depreciation which were 
successively allowed (but not less than the amount allowable) to A and B 
upon the X Building and to B upon the Y Building, in addition to the 
deductions for depreciation allowed (but not less than the amount 
allowable) to herself during her ownership of the Y Building.



Sec. 1.1017-1  Basis reductions following a discharge of indebtedness.

    (a) General rule for section 108(b)(2)(E). This paragraph (a) 
applies to basis reductions under section 108(b)(2)(E) that are required 
by section 108(a)(1) (A) or (B) because the taxpayer excluded discharge 
of indebtedness (COD income) from gross income. A taxpayer must reduce 
in the following order, to the extent of the excluded COD income (but 
not below zero), the adjusted bases of property held on the first day of 
the taxable year following the taxable year that the taxpayer excluded 
COD income from gross income (in proportion to adjusted basis):--
    (1) Real property used in a trade or business or held for 
investment, other than real property described in section 1221(1), that 
secured the discharged indebtedness immediately before the discharge;
    (2) Personal property used in a trade or business or held for 
investment, other than inventory, accounts receivable, and notes 
receivable, that secured the discharged indebtedness immediately before 
the discharge;
    (3) Remaining property used in a trade or business or held for 
investment, other than inventory, accounts receivable, notes receivable, 
and real property described in section 1221(1);
    (4) Inventory, accounts receivable, notes receivable, and real 
property described in section 1221(1); and
    (5) Property not used in a trade or business nor held for 
investment.
    (b) Operating rules--(1) Prior tax-attribute reduction. The amount 
of excluded COD income applied to reduce basis does not include any COD 
income applied to reduce tax attributes under sections 108(b)(2) (A) 
through (D) and, if applicable, section 108(b)(5). For example, if a 
taxpayer excludes $100 of COD income from gross income under section 
108(a) and reduces tax attributes by $40 under sections 108(b)(2) (A) 
through (D), the taxpayer is required to reduce the adjusted bases of 
property by $60 ($100-$40) under section 108(b)(2)(E).
    (2) Multiple discharged indebtednesses. If a taxpayer has COD income 
attributable to more than one discharged indebtedness resulting in the 
reduction of tax attributes under sections 108(b)(2) (A) through (D) 
and, if applicable, section 108(b)(5), paragraph (b)(1) of this section 
must be applied by allocating the tax-attribute reductions among the 
indebtednesses in proportion to the amount of COD income attributable to 
each discharged indebtedness. For example, if a taxpayer excludes $20 of 
COD income attributable to secured indebtedness A and excludes $80 of 
COD income attributable to unsecured indebtedness B (a total exclusion 
of $100), and if the taxpayer reduces tax attributes by $40 under 
sections 108(b)(2) (A) through (D), the taxpayer must reduce the amount 
of COD

[[Page 74]]

income attributable to secured indebtedness A to $12 ($20 - ($20 / $100 
x $40)) and must reduce the amount of COD income attributable to 
unsecured indebtedness B to $48 ($80 - ($80 / $100 x $40)).
    (3) Limitation on basis reductions under section 108(b)(2)(E) in 
bankruptcy or insolvency. If COD income arises from a discharge of 
indebtedness in a title 11 case or while the taxpayer is insolvent, the 
amount of any basis reduction under section 108(b)(2)(E) shall not 
exceed the excess of--
    (i) The aggregate of the adjusted bases of property and the amount 
of money held by the taxpayer immediately after the discharge; over
    (ii) The aggregate of the liabilities of the taxpayer immediately 
after the discharge.
    (c) Modification of ordering rules for basis reductions under 
sections 108(b)(5) and 108(c)--(1) In general. The ordering rules 
prescribed in paragraph (a) of this section apply, with appropriate 
modifications, to basis reductions under sections 108(b)(5) and (c). 
Thus, a taxpayer that elects to reduce basis under section 108(b)(5) 
may, to the extent that the election applies, reduce only the adjusted 
basis of property described in paragraphs (a) (1), (2), and (3) of this 
section and, if an election is made under paragraph (f) of this section, 
paragraph (a) (4) of this section. Within paragraphs (a) (1), (2), (3) 
and (4) of this section, such a taxpayer may reduce only the adjusted 
bases of depreciable property. A taxpayer that elects to apply section 
108(c) may reduce only the adjusted basis of property described in 
paragraphs (a) (1) and (3) of this section and, within paragraphs (a)(1) 
and (3) of this section, may reduce only the adjusted bases of 
depreciable real property. Furthermore, for basis reductions under 
section 108(c), a taxpayer must reduce the adjusted basis of the 
qualifying real property to the extent of the discharged qualified real 
property business indebtedness before reducing the adjusted bases of 
other depreciable real property. The term qualifying real property means 
real property with respect to which the indebtedness is qualified real 
property business indebtedness within the meaning of section 108(c)(3). 
See paragraphs (f) and (g) of this section for elections relating to 
section 1221(1) property and partnership interests.
    (2) Partial basis reductions under section 108(b)(5). If the amount 
of basis reductions under section 108(b)(5) is less than the amount of 
the COD income excluded from gross income under section 108(a), the 
taxpayer must reduce the balance of its tax attributes, including any 
remaining adjusted bases of depreciable and other property, by following 
the ordering rules under section 108(b)(2). For example, if a taxpayer 
excludes $100 of COD income from gross income under section 108(a) and 
elects to reduce the adjusted bases of depreciable property by $10 under 
section 108(b)(5), the taxpayer must reduce its remaining tax attributes 
by $90, starting with net operating losses under section 108(b)(2).
    (3) Modification of fresh start rule for prior basis reductions 
under section 108(b)(5). After reducing the adjusted bases of 
depreciable property under section 108(b)(5), a taxpayer must compute 
the limitation on basis reductions under section 1017(b)(2) using the 
aggregate of the remaining adjusted bases of property. For example, if, 
immediately after the discharge of indebtedness in a title 11 case, a 
taxpayer's adjusted bases of property is $100 and its undischarged 
indebtedness is $70, and if the taxpayer elects to reduce the adjusted 
bases of depreciable property by $10 under section 108(b)(5), section 
1017(b)(2) limits any further basis reductions under section 
108(b)(2)(E) to $20 (($100 - $10) - $70).
    (d) Changes in security. If any property is added or eliminated as 
security for an indebtedness during the one-year period preceding the 
discharge of that indebtedness, such addition or elimination shall be 
disregarded where a principal purpose of the change is to affect the 
taxpayer's basis reductions under section 1017.
    (e) Depreciable property. For purposes of this section, the term 
depreciable property means any property of a character subject to the 
allowance for depreciation or amortization, but only if the basis 
reduction would reduce the

[[Page 75]]

amount of depreciation or amortization which otherwise would be 
allowable for the period immediately following such reduction. Thus, for 
example, a lessor cannot reduce the basis of leased property where the 
lessee's obligation in respect of the property will restore to the 
lessor the loss due to depreciation during the term of the lease, since 
the lessor cannot take depreciation in respect of such property.
    (f) Election to treat section 1221(1) real property as depreciable--
(1) In general. For basis reductions under section 108(b)(5) and basis 
reductions relating to qualified farm indebtedness, a taxpayer may elect 
under sections 1017(b) (3)(E) and (4)(C), respectively, to treat real 
property described in section 1221(1) as depreciable property. This 
election is not available, however, for basis reductions under section 
108(c).
    (2) Time and manner. To make an election under section 1017(b) 
(3)(E) or (4)(C), a taxpayer must enter the appropriate information on 
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness 
(and Section 1082 Basis Adjustment), and attach the form to a timely 
filed (including extensions) Federal income tax return for the taxable 
year in which the taxpayer has COD income that is excluded from gross 
income under section 108(a). An election under this paragraph (f) may be 
revoked only with the consent of the Commissioner.
    (g) Partnerships--(1) Partnership COD income. For purposes of 
paragraph (a) of this section, a taxpayer must treat a distributive 
share of a partnership's COD income as attributable to a discharged 
indebtedness secured by the taxpayer's interest in that partnership.
    (2) Partnership interest treated as depreciable property--(i) In 
general. For purposes of making basis reductions, if a taxpayer makes an 
election under section 108(b)(5) (or 108(c)), the taxpayer must treat a 
partnership interest as depreciable property (or depreciable real 
property) to the extent of the partner's proportionate share of the 
partnership's basis in depreciable property (or depreciable real 
property), provided that the partnership consents to a corresponding 
reduction in the partnership's basis (inside basis) in depreciable 
property (or depreciable real property) with respect to such partner.
    (ii) Request by partner and consent of partnership--(A) In general. 
Except as otherwise provided in this paragraph (g)(2)(ii), a taxpayer 
may choose whether or not to request that a partnership reduce the 
inside basis of its depreciable property (or depreciable real property) 
with respect to the taxpayer, and the partnership may grant or withhold 
such consent, in its sole discretion. A request by the taxpayer must be 
made before the due date (including extensions) for filing the 
taxpayer's Federal income tax return for the taxable year in which the 
taxpayer has COD income that is excluded from gross income under section 
108(a).
    (B) Request for consent required. A taxpayer must request a 
partnership's consent to reduce inside basis if, at the time of the 
discharge, the taxpayer owns (directly or indirectly) a greater than 50 
percent interest in the capital and profits of the partnership, or if 
reductions to the basis of the taxpayer's depreciable property (or 
depreciable real property) are being made with respect to the taxpayer's 
distributive share of COD income of the partnership.
    (C) Granting of request required. A partnership must consent to 
reduce its partners' shares of inside basis with respect to a discharged 
indebtedness if consent is requested with respect to that indebtedness 
by partners owning (directly or indirectly) an aggregate of more than 80 
percent of the capital and profits interests of the partnership or five 
or fewer partners owning (directly or indirectly) an aggregate of more 
than 50 percent of the capital and profits interests of the partnership. 
For example, if there is a cancellation of partnership indebtedness that 
is secured by real property used in a partnership's trade or business, 
and if partners owning (in the aggregate) 90 percent of the capital and 
profits interests of the partnership elect to exclude the COD income 
under section 108(c), the partnership must make the appropriate 
reductions in those partners' shares of inside basis.
    (iii) Partnership consent statement--(A) Partnership requirement. A 
consenting partnership must include with the

[[Page 76]]

Form 1065, U.S. Partnership Return of Income, for the taxable year 
following the year that ends with or within the taxable year the 
taxpayer excludes COD income from gross income under section 108(a), and 
must provide to the taxpayer on or before the due date of the taxpayer's 
return (including extensions) for the taxable year in which the taxpayer 
excludes COD income from gross income, a statement that--
    (1) Contains the name, address, and taxpayer identification number 
of the partnership; and
    (2) States the amount of the reduction of the partner's 
proportionate interest in the adjusted bases of the partnership's 
depreciable property or depreciable real property, whichever is 
applicable.
    (B) Taxpayer's requirement. Statements described in paragraph 
(g)(2)(iii)(A) of this section must be attached to a taxpayer's timely 
filed (including extensions) Federal income tax return for the taxable 
year in which the taxpayer has COD income that is excluded from gross 
income under section 108(a).
    (iv) Partner's share of partnership basis--(A) In general. For 
purposes of this paragraph (g), a partner's proportionate share of the 
partnership's basis in depreciable property (or depreciable real 
property) is equal to the sum of--
    (1) The partner's section 743(b) basis adjustments to items of 
partnership depreciable property (or depreciable real property); and
    (2) The common basis depreciation deductions (but not including 
remedial allocations of depreciation deductions under Sec. 1.704-3(d)) 
that, under the terms of the partnership agreement effective for the 
taxable year in which the discharge of indebtedness occurs, are 
reasonably expected to be allocated to the partner over the property's 
remaining useful life. The assumptions made by a partnership in 
determining the reasonably expected allocation of depreciation 
deductions must be consistent for each partner. For example, a 
partnership may not treat the same depreciation deductions as being 
reasonably expected by more than one partner.
    (B) Effective date. This paragraph (g)(2)(iv) applies to elections 
made under sections 108(b)(5) and 108(c) on or after December 15, 1999.
    (v) Treatment of basis reduction--(A) Basis adjustment. The amount 
of the reduction to the basis of depreciable partnership property 
constitutes an adjustment to the basis of partnership property with 
respect to the partner only. No adjustment is made to the common basis 
of partnership property. Thus, for purposes of income, deduction, gain, 
loss, and distribution, the partner will have a special basis for those 
partnership properties the bases of which are adjusted under section 
1017 and this section.
    (B) Recovery of adjustments to basis of partnership property. 
Adjustments to the basis of partnership property under this section are 
recovered in the manner described in Sec. 1.743-1.
    (C) Effect of basis reduction. Adjustments to the basis of 
partnership property under this section are treated in the same manner 
and have the same effect as an adjustment to the basis of partnership 
property under section 743(b). The following example illustrates this 
paragraph (g)(2)(v):

    Example. (i) A, B, and C are equal partners in partnership PRS, 
which owns (among other things) Asset 1, an item of depreciable property 
with a basis of $30,000. A's basis in its partnership interest is 
$20,000. Under the terms of the partnership agreement, A's share of the 
depreciation deductions from Asset 1 over its remaining useful life will 
be $10,000. Under section 1017, A requests, and PRS agrees, to decrease 
the basis of Asset 1 with respect to A by $10,000.
    (ii) In the year following the reduction of basis under section 
1017, PRS amends its partnership agreement to provide that items of 
depreciation and loss from Asset 1 will be allocated equally between B 
and C. In that year, A's distributive share of the partnership's common 
basis depreciation deductions from Asset 1 is now $0. Under Sec. 1.743-
1(j)(4)(ii)(B), the amount of the section 1017 basis adjustment that A 
recovers during the year is $1,000. A will report $1,000 of ordinary 
income because A's distributive share of the partnership's common basis 
depreciation deductions from Asset 1 ($0) is insufficient to offset the 
amount of the section 1017 basis adjustment recovered by A during the 
year ($1,000).
    (iii) In the following year, PRS sells Asset 1 for $15,000 and 
recognizes a $12,000 loss. This loss is allocated equally between B and 
C, and A's share of the loss is $0. Upon the sale of Asset 1, A recovers 
its entire remaining

[[Page 77]]

section 1017 basis adjustment ($9,000). A will report $9,000 of ordinary 
income.

    (D) Effective date. This paragraph (g)(2)(v) applies to elections 
made under sections 108(b)(5) and 108(c) on or after December 15, 1999.
    (3) Partnership basis reduction. The rules of this section 
(including this paragraph (g)) apply in determining the properties to 
which the partnership's basis reductions must be made.
    (h) Special allocation rule for cases to which section 1398 applies. 
If a bankruptcy estate and a taxpayer to whom section 1398 applies 
(concerning only individuals under Chapter 7 or 11 of title 11 of the 
United States Code) hold property subject to basis reduction under 
section 108(b) (2)(E) or (5) on the first day of the taxable year 
following the taxable year of discharge, the bankruptcy estate must 
reduce all of the adjusted bases of its property before the taxpayer is 
required to reduce any adjusted bases of property.
    (i) Effective date. This section applies to discharges of 
indebtedness occurring on or after October 22, 1998.

[T.D. 8787, 63 FR 56563, Oct. 22, 1998, as amended by T.D. 8847, 64 FR 
69921, Dec. 15, 1999]



Sec. 1.1018-1  Adjusted basis; exception to section 270 of the Bankruptcy Act, as amended.

    The adjustment to basis provided by section 270 of the Bankruptcy 
Act, as amended (11 U.S.C. 670), and by Secs. 1.1016-7 and 1.1016-8 
shall not be made if, in a proceeding under section 77B of such Act, as 
amended (11 U.S.C. 207; 48 Stat. 912), indebtedness was canceled in 
pursuance of a plan of reorganization which was consummated by 
adjustment of the capital or debt structure of the insolvent 
corporation, and the final judgment or decree in such proceeding was 
entered before September 22, 1938. Section 1018 and this section do not 
apply if the plan of reorganization under such section 77B was 
consummated by the transfer of assets of the insolvent corporation to 
another corporation.



Sec. 1.1019-1  Property on which lessee has made improvements.

    In any case in which a lessee of real property has erected buildings 
or made other improvements upon the leased property and the lease is 
terminated by forfeiture or otherwise resulting in the realization by 
such lessor of income which, were it not for the provisions of section 
109, would be includible in gross income of the lessor, the amount so 
excluded from gross income shall not be taken into account in 
determining the basis or the adjusted basis of such property or any 
portion thereof in the hands of the lessor. If, however, in any taxable 
year beginning before January 1, 1942, there has been included in the 
gross income of the lessor an amount representing any part of the value 
of such property attributable to such buildings or improvements, the 
basis of each portion of such property shall be properly adjusted for 
the amount so included in gross income. For example, A leased in 1930 to 
B for a period of 25 years unimproved real property and in accordance 
with the terms of the lease B erected a building on the property. It was 
estimated that upon expiration of the lease the building would have a 
depreciated value of $50,000, which value the lessor elected to report 
(beginning in 1931) as income over the term of the lease. This method of 
reporting was used until 1942. In 1952 B forfeits the lease. The amount 
of $22,000 reported as income by A during the years 1931 to 1941, 
inclusive, shall be added to the basis of the property represented by 
the improvements in the hands of A. If in such case A did not report 
during the period of the lease any income attributable to the value of 
the building erected by the lessee and the lease was forfeited in 1940 
when the building was worth $75,000, such amount, having been included 
in gross income under the law applicable to that year, is added to the 
basis of the property represented by the improvements in the hands of A. 
As to treatment of such property for the purposes of capital gains and 
losses, see subchapter P (section 1201 and following), chapter 1 of the 
Code.



Sec. 1.1020-1  Election as to amounts allowed in respect of depreciation, etc., before 1952.

    (a) In general. (1) Any person may elect to have the adjustments to 
the cost or other basis of property under

[[Page 78]]

section 1016(a)(2) determined in accordance with subparagraph (B) of 
such section by filing a statement of election in accordance with the 
requirements set forth in paragraph (b) of this section. Any election 
made after 1952 shall be irrevocable when made. Any election made after 
1952 shall apply with respect to all property held by the person making 
the election at any time on or before December 31, 1952, and shall apply 
to all periods since February 28, 1913, and before January 1, 1952, 
during which such person held such property or for which adjustments 
must be made under section 1016(b). For rules with respect to an 
election made on or before December 31, 1952, see paragraph (c) of this 
section.
    (2) An election by a partner on his own behalf is not an election 
for the partnership of which he is a member. A separate election must be 
made on behalf of the partnership. (See section 703(b) (relating to 
elections of the partnership).) An election on behalf of the partnership 
applies only with respect to the partnership, and does not apply to the 
separate property of the partners. A similar rule applies with respect 
to elections by trusts and beneficiaries of trusts. These rules also 
apply with respect to a revocation of an election where such election 
was made on or before December 31, 1952.
    (b) Rules applicable to making of election. The following rules are 
applicable to the making of an election under section 1020:
    (1) Form of election. The election shall be in the form of a 
statement in writing, shall state the name and address of the taxpayer 
making the election, and shall contain a statement that such taxpayer 
elects to have the provisions of section 1016(a)(2)(B) apply in respect 
of all periods since February 28, 1913, and before January 1, 1952.
    (2) Signature. The statement shall be signed by the taxpayer making 
the election, if an individual, or, if the taxpayer making the election 
is not an individual, the statement shall be signed by the person or 
persons required to sign the income return of such taxpayer.
    (3) Filing. The statement must be filed on or before December 31, 
1954, in the office of the district director for the internal revenue 
district in which the income tax return for the year of the election is 
required to be filed. For rules as to when timely mailing will be 
treated as timely filing of the statement see section 7502.
    (4) Filing of duplicate. A copy of the statement of election must be 
filed with the first return, amended return, or claim for refund filed 
on or after the date on which the election is made.
    (c) Election made on or before December 31, 1952. An election made 
on or before December 31, 1952, in accordance with the provisions of 
section 113(d) of the Internal Revenue Code of 1939, may be revoked by 
filing on or before December 31, 1954, in the same office in which the 
election was filed, a statement of revocation signed in the same manner 
as the election. Such statement made by any person is irrevocable when 
made with respect to such person, and no new election may thereafter be 
made by such person. A copy of the revocation must be filed with the 
first return, amended return, or claim for refund, filed after the date 
of the revocation. For additional rules with respect to election made on 
or before December 31, 1952, see 26 CFR (1939) 39.113(b)(1)-1 
(Regulations 118).
    (d) Validity of elections or revocation of elections. An election or 
revocation of an election which conforms in substance to the provisions 
of this section will not be deemed invalid solely because it was filed 
before the date on which the regulations in this section were 
promulgated.
    (e) Effect of election. For rules relating to the effect of an 
election under this section, see section 1016(a)(2) and the regulations 
thereunder.



Sec. 1.1021-1  Sale of annuities.

    In the case of a transfer for value of an annuity contract to which 
section 72(g) and paragraph (a) of Sec. 1.72-10 apply, the transferor 
shall adjust his basis in such contract as of the time immediately prior 
to such transfer by subtracting from the premiums or other consideration 
he has paid or is deemed to have paid for such contract all amounts he 
has received or is deemed to have received under such annuity contract 
to the extent that such amounts were not includible in the

[[Page 79]]

gross income of the transferor or other recipient under the applicable 
income tax law. In any case where the amounts which were not includible 
in the gross income of the recipient were received or deemed to have 
been received by such transferor exceed the amounts paid or deemed paid 
by him, the adjusted basis of the contract shall be zero. The income 
realized by the transferor on such a transfer shall not exceed the total 
of the amounts received as consideration for the transfer.

                       Common Nontaxable Exchanges



Sec. 1.1031-0  Table of contents.

    This section lists the captions that appear in the regulations under 
section 1031.

Sec. 1.1031(a)-1 Property held for productive use in a trade or business 
                           or for investment.

    (a) In general.
    (b) Definition of ``like kind.''
    (c) Examples of exchanges of property of a ``like kind.''
    (d) Examples of exchanges not solely in kind.
    (e) Effective date.

  Sec. 1.1031(a)-2 Additional rules for exchanges of personal property.

    (a) Introduction.
    (b) Depreciable tangible personal property.
    (c) Intangible personal property and nondepreciable personal 
property.

    Sec. 1.1031(b)-1 Receipt of other property or money in tax-free 
                                exchange.

Sec. 1.1031(b)-2 Safe harbor for qualified intermediaries.

                Sec. 1.1031(c)-1 Nonrecognition of loss.

      Sec. 1.1031(d)-1 Property acquired upon a tax-free exchange.

    Sec. 1.1031(d)-1T Coordination of section 1060 with section 1031 
                              (temporary).

        Sec. 1.1031(d)-2 Treatment of assumption of liabilities.

       Sec. 1.1031(e)-1 Exchanges of livestock of different sexes.

           Sec. 1.1031(j)-1 Exchanges of multiple properties.

    (a) Introduction.
    (b) Computation of gain recognized.
    (c) Computation of basis of properties received.
    (d) Examples.
    (e) Effective date.

            Sec. 1.1031(K)-1 Treatment of deferred exchanges.

    (a) Overview.
    (b) Identification and receipt requirements.
    (c) Identification of replacement property before the end of the 
identification period.
    (d) Receipt of identified replacement property.
    (e) Special rules for identification and receipt of replacement 
property to be produced.
    (f) Receipt of money or other property.
    (g) Safe harbors.
    (h) Interest and growth factors.
    (i) [Reserved]
    (j) Determination of gain or loss recognized and the basis of 
property received in a deferred exchange.
    (k) Definition of disqualified person.
    (l) [Reserved]
    (m) Definition of fair market value.
    (n) No inference with respect to actual or constructive receipt 
rules outside of section 1031.
    (o) Effective date.

[T.D. 8346, 56 FR 19937, May 1, 1991]



Sec. 1.1031(a)-1  Property held for productive use in trade or business or for investment.

    (a) In general--(1) Exchanges of property solely for property of a 
like kind. Section 1031(a)(1) provides an exception from the general 
rule requiring the recognition of gain or loss upon the sale or exchange 
of property. Under section 1031(a)(1), no gain or loss is recognized if 
property held for productive use in a trade or business or for 
investment is exchanged solely for property of a like kind to be held 
either for productive use in a trade or business or for investment. 
Under section 1031(a)(1), property held for productive use in a trade or 
business may be exchanged for property held for investment. Similarly, 
under section 1031(a)(1), property held for investment may be exchanged 
for property held for productive use in a trade or business. However, 
section 1031(a)(2) provides that section 1031(a)(1) does not apply to 
any exchange of--
    (i) Stock in trade or other property held primarily for sale;
    (ii) Stocks, bonds, or notes;
    (iii) Other securities or evidences of indebtedness or interest;
    (iv) Interests in a partnership;
    (v) Certificates of trust or beneficial interests; or
    (vi) Choses in action.

[[Page 80]]


Section 1031(a)(1) does not apply to any exchange of interests in a 
partnership regardless of whether the interests exchanged are general or 
limited partnership interests or are interests in the same partnership 
or in different partnerships. An interest in a partnership that has in 
effect a valid election under section 761(a) to be excluded from the 
application of all of subchapter K is treated as an interest in each of 
the assets of the partnership and not as an interest in a partnership 
for purposes of section 1031(a)(2)(D) and paragraph (a)(1)(iv) of this 
section. An exchange of an interest in such a partnership does not 
qualify for nonrecognition of gain or loss under section 1031 with 
respect to any asset of the partnership that is described in section 
1031(a)(2) or to the extent the exchange of assets of the partnership 
does not otherwise satisfy the requirements of section 1031(a).
    (2) Exchanges of property not solely for property of a like kind. A 
transfer is not within the provisions of section 1031(a) if, as part of 
the consideration, the taxpayer receives money or property which does 
not meet the requirements of section 1031(a), but the transfer, if 
otherwise qualified, will be within the provisions of either section 
1031 (b) or (c). Similarly, a transfer is not within the provisions of 
section 1031(a) if, as part of the consideration, the other party to the 
exchange assumes a liability of the taxpayer (or acquires property from 
the taxpayer that is subject to a liability), but the transfer, if 
otherwise qualified, will be within the provisions of either section 
1031 (b) or (c). A transfer of property meeting the requirements of 
section 1031(a) may be within the provisions of section 1031(a) even 
though the taxpayer transfers in addition property not meeting the 
requirements of section 1031(a) or money. However, the nonrecognition 
treatment provided by section 1031(a) does not apply to the property 
transferred which does not meet the requirements of section 1031(a).
    (b) Definition of ``like kind.'' As used in section 1031(a), the 
words like kind have reference to the nature or character of the 
property and not to its grade or quality. One kind or class of property 
may not, under that section, be exchanged for property of a different 
kind or class. The fact that any real estate involved is improved or 
unimproved is not material, for that fact relates only to the grade or 
quality of the property and not to its kind or class. Unproductive real 
estate held by one other than a dealer for future use or future 
realization of the increment in value is held for investment and not 
primarily for sale. For additional rules for exchanges of personal 
property, see Sec. 1.1031 (a)-2.
    (c) Examples of exchanges of property of a ``like kind.'' No gain or 
loss is recognized if (1) a taxpayer exchanges property held for 
productive use in his trade or business, together with cash, for other 
property of like kind for the same use, such as a truck for a new truck 
or a passenger automobile for a new passenger automobile to be used for 
a like purpose; or (2) a taxpayer who is not a dealer in real estate 
exchanges city real estate for a ranch or farm, or exchanges a leasehold 
of a fee with 30 years or more to run for real estate, or exchanges 
improved real estate for unimproved real estate; or (3) a taxpayer 
exchanges investment property and cash for investment property of a like 
kind.
    (d) Examples of exchanges not solely in kind. Gain or loss is 
recognized if, for instance, a taxpayer exchanges (1) Treasury bonds 
maturing March 15, 1958, for Treasury bonds maturing December 15, 1968, 
unless section 1037(a) (or so much of section 1031 as relates to section 
1037(a)) applies to such exchange, or (2) a real estate mortgage for 
consolidated farm loan bonds.
    (e) Effective date relating to exchanges of partnership interests. 
The provisions of paragraph (a)(1) of this section relating to exchanges 
of partnership interests apply to transfers of property made by 
taxpayers on or after April 25, 1991.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6935, 32 FR 
15822, Nov. 17, 1967; T.D. 8343, 56 FR 14854, Apr. 12, 1991; T.D. 8346, 
56 FR 19937, May 1, 1991]



Sec. 1.1031(a)-2  Additional rules for exchanges of personal property.

    (a) Introduction. Section 1.1031(a)-1(b) provides that the 
nonrecognition rules of section 1031 do not apply to an exchange of one 
kind or class of property

[[Page 81]]

for property of a different kind or class. This section contains 
additional rules for determining whether personal property has been 
exchanged for property of a like kind or like class. Personal properties 
of a like class are considered to be of a ``like kind'' for purposes of 
section 1031. In addition, an exchange of properties of a like kind may 
qualify under section 1031 regardless of whether the properties are also 
of a like class. In determining whether exchanged properties are of a 
like kind, no inference is to be drawn from the fact that the properties 
are not of a like class. Under paragraph (b) of this section, 
depreciable tangible personal properties are of a like class if they are 
either within the same General Asset Class (as defined in paragraph 
(b)(2) of this section) or within the same Product Class (as defined in 
paragraph (b)(3) of this section). Paragraph (c) of this section 
provides rules for exchanges of intangible personal property and 
nondepreciable personal property.
    (b) Depreciable tangible personal property--(1) General rule. 
Depreciable tangible personal property is exchanged for property of a 
``like kind'' under section 1031 if the property is exchanged for 
property of a like kind or like class. Depreciable tangible personal 
property is of a like class to other depreciable tangible personal 
property if the exchanged properties are either within the same General 
Asset Class or within the same Product Class. A single property may not 
be classified within more than one General Asset Class or within more 
than one Product Class. In addition, property classified within any 
General Asset Class may not be classified within a Product Class. A 
property's General Asset Class or Product Class is determined as of the 
date of the exchange.
    (2) General Asset Classes. Except as provided in paragraphs (b)(4) 
and (b)(5) of this section, property within a General Asset Class 
consists of depreciable tangible personal property described in one of 
asset classes 00.11 through 00.28 and 00.4 of Rev. Proc. 87-56, 1987-2 
C.B. 674. These General Asset Classes describe types of depreciable 
tangible personal property that frequently are used in many businesses. 
The General Asset Classes are as follows:
    (i) Office furniture, fixtures, and equipment (asset class 00.11),
    (ii) Information systems (computers and peripheral equipment) (asset 
class 00.12),
    (iii) Data handling equipment, except computers (asset class 00.13),
    (iv) Airplanes (airframes and engines), except those used in 
commercial or contract carrying of passengers or freight, and all 
helicopters (airframes and engines) (asset class 00.21),
    (v) Automobiles, taxis (asset class 00.22),
    (vi) Buses (asset class 00.23),
    (vii) Light general purpose trucks (asset class 00.241),
    (viii) Heavy general purpose trucks (asset class 00.242),
    (ix) Railroad cars and locomotives, except those owned by railroad 
transportation companies (asset class 00.25),
    (x) Tractor units for use over-the-road (asset class 00.26),
    (xi) Trailers and trailer-mounted containers (asset class 00.27),
    (xii) Vessels, barges, tugs, and similar water-transportation 
equipment, except those used in marine construction (asset class 00.28), 
and
    (xiii) Industrial steam and electric generation and/or distribution 
systems (asset class 00.4).
    (3) Product Classes. Except as provided in paragraphs (b)(4) and 
(b)(5) of this section, property within a Product Class consists of 
depreciable tangible personal property that is listed in a 4-digit 
product class within Division D of the Standard Industrial 
Classification codes, set forth in Executive Office of the President, 
Office of Management and Budget, Standard Industrial Classification 
Manual (1987) (SIC Manual). Copies of the SIC Manual may be obtained 
from the National Technical Information Service, an agency of the U.S. 
Department of Commerce. Division D of the SIC Manual contains a listing 
of manufactured products and equipment. For this purpose, any 4-digit 
product class ending in a ``9'' (i.e., a miscellaneous category) will 
not be considered a Product Class. If a property is listed in more than 
one product class, the property is treated as listed in any one of those 
product classes. A

[[Page 82]]

property's 4-digit product classification is referred to as the 
property's ``SIC Code.''
    (4) Modifications of Rev. Proc. 87-56 and SIC Manual. The asset 
classes of Rev. Proc. 87-56 and the product classes of the SIC Manual 
may be updated or otherwise modified from time to time. In the event 
Rev. Proc. 87-56 is modified, the General Asset Classes will follow the 
modification, and the modification will be effective for exchanges 
occurring on or after the date the modification is published in the 
Internal Revenue Bulletin, unless otherwise provided. Similarly, in the 
event the SIC Manual is modified, the Product Classes will follow the 
modification, and the modification will be effective for exchanges 
occurring on or after the effective date of the modification. However, 
taxpayers may rely on the unmodified SIC Manual for exchanges occurring 
during the one-year period following the effective date of the 
modification. The SIC Manual generally is modified every five years, in 
years ending in a 2 or 7 (e.g., 1987 and 1992). The effective date of 
the modified SIC Manual is announced in the Federal Register and 
generally is January 1 of the year the SIC Manual is modified.
    (5) Modified classification through published guidance. The 
Commissioner may, by guidance published in the Internal Revenue 
Bulletin, supplement the guidance provided in this section relating to 
classification of properties. For example, the Commissioner may 
determine not to follow, in whole or in part, any modification of Rev. 
Proc. 87-56 or the SIC Manual. The Commissioner may also determine that 
two types of property that are listed in separate product classes each 
ending in a ``9'' are of a like class, or that a type of property that 
has a SIC Code is of a like class to a type of property that does not 
have a SIC Code.
    (6) No inference outside of section 1031. The rules provided in this 
section concerning the use of Rev. Proc. 87-56 and the SIC Manual are 
limited to exchanges under section 1031. No inference is intended with 
respect to the classification of property for other purposes, such as 
depreciation.
    (7) Examples. The application of this paragraph (b) may be 
illustrated by the following examples:

    Example 1. Taxpayer A transfers a personal computer (asset class 
00.12) to B in exchange for a printer (asset class 00.12). With respect 
to A, the properties exchanged are within the same General Asset Class 
and therefore are of a like class.
    Example 2. Taxpayer C transfers an airplane (asset class 00.21) to D 
in exchange for a heavy general purpose truck (asset class 00.242). The 
properties exchanged are not of a like class because they are within 
different General Asset Classes. Because each of the properties is 
within a General Asset Class, the properties may not be classified 
within a Product Class. The airplane and heavy general purpose truck are 
also not of a like kind. Therefore, the exchange does not qualify for 
nonrecognition of gain or loss under section 1031.
    Example 3. Taxpayer E transfers a grader to F in exchange for a 
scraper. Neither property is within any of the General Asset Classes, 
and both properties are within the same Product Class (SIC Code 3533). 
With respect to E, therefore, the properties exchanged are of a like 
class.
    Example 4. Taxpayer G transfers a personal computer (asset class 
00.12), an airplane (asset class 00.21) and a sanding machine (SIC Code 
3553), to H in exchange for a printer (asset class 00.12), a heavy 
general purpose truck (asset class 00.242) and a lathe (SIC Code 3553). 
The personal computer and the printer are of a like class because they 
are within the same General Asset Class; the sanding machine and the 
lathe are of a like class because neither property is within any of the 
General Asset Classes and they are within the same Product Class. The 
airplane and the heavy general purpose truck are neither within the same 
General Asset Class nor within the same Product Class, and are not of a 
like kind.

    (c) Intangible personal property and nondepreciable personal 
property--(1) General rule. An exchange of intangible personal property 
of nondepreciable personal property qualifies for nonrecognition of gain 
or loss under section 1031 only if the exchanged properties are of a 
like kind. No like classes are provided for these properties. Whether 
intangible personal property is of a like kind to other intangible 
personal property generally depends on the nature or character of the 
rights involved (e.g., a patent or a copyright) and also on the nature 
or character of the underlying property to which the intangible personal 
property relates.

[[Page 83]]

    (2) Goodwill and going concern value. The goodwill or going concern 
value of a business is not of a like kind to the goodwill or going 
concern value of another business.
    (3) Examples. The application of this paragraph (c) may be 
illustrated by the following examples:

    Example 1. Taxpayer K exchanges a copyright on a novel for a 
copyright on a different novel. The properties exchanged are of a like 
kind.
    Example 2. Taxpayer J exchanges a copyright on a novel for a 
copyright on a song. The properties exchanged are not of a like kind.

    (d) Effective date. Section 1.1031(a)-2 is effective for exchanges 
occurring on or after April 11, 1991.

[T.D. 8343, 56 FR 14854, Apr. 12, 1991]



Sec. 1.1031(b)-1  Receipt of other property or money in tax-free exchange.

    (a) If the taxpayer receives other property (in addition to property 
permitted to be received without recognition of gain) or money--
    (1) In an exchange described in section 1031(a) of property held for 
investment or productive use in trade or business for property of like 
kind to be held either for productive use or for investment,
    (2) In an exchange described in section 1035(a) of insurance 
policies or annuity contracts,
    (3) In an exchange described in section 1036(a) of common stock for 
common stock, or preferred stock for preferred stock, in the same 
corporation and not in connection with a corporate reorganization, or
    (4) In an exchange described in section 1037(a) of obligations of 
the United States, issued under the Second Liberty Bond Act (31 U.S.C. 
774 (2)), solely for other obligations issued under such Act, the gain, 
if any, to the taxpayer will be recognized under section 1031(b) in an 
amount not in excess of the sum of the money and the fair market value 
of the other property, but the loss, if any, to the taxpayer from such 
an exchange will not be recognized under section 1031(c) to any extent.
    (b) The application of this section may be illustrated by the 
following examples:

    Example 1. A, who is not a dealer in real estate, in 1954 exchanges 
real estate held for investment, which he purchased in 1940 for $5,000, 
for other real estate (to be held for productive use in trade or 
business) which has a fair market value of $6,000, and $2,000 in cash. 
The gain from the transaction is $3,000, but is recognized only to the 
extent of the cash received of $2,000.
    Example 2. (a) B, who uses the cash receipts and disbursements 
method of accounting and the calendar year as his taxable year, has 
never elected under section 454(a) to include in gross income currently 
the annual increase in the redemption price of non-interest-bearing 
obligations issued at a discount. In 1943, for $750 each, B purchased 
four $1,000 series E U.S. savings bonds bearing an issue date of March 
1, 1943.
    (b) On October 1, 1963, the redemption value of each such bond was 
$1,396, and the total redemption value of the four bonds was $5,584. On 
that date B submitted the four $1,000 series E bonds to the United 
States in a transaction in which one of such $1,000 bonds was reissued 
by issuing four $100 series E U.S. savings bonds bearing an issue date 
of March 1, 1943, and by considering six $100 series E bonds bearing an 
issue date of March 1, 1943, to have been issued. The redemption value 
of each such $100 series E bond was $139.60 on October 1, 1963. Then, as 
part of the transaction, the six $100 series E bonds so considered to 
have been issued and the three $1,000 series E bonds were exchanged, in 
an exchange qualifying under section 1037(a), for five $1,000 series H 
U.S. savings bonds plus $25.60 in cash.
    (c) The gain realized on the exchange qualifying under section 
1037(a) is $2,325.60, determined as follows:

Amount realized:
  Par value of five series H bonds...........................  $5,000.00
  Cash received..............................................      25.60
                                                   ------------
    Total realized...........................................   5,025.60
Less: Adjusted basis of series E bonds surrendered in the
 exchange:
    Three $1,000 series E bonds...................  $2,250.00
    Six $100 series E bonds at $75 each...........     450.00
                                                   -----------
                                                                2,700.00
                                                              ----------
    Gain realized.................................  .........   2,325.60
 

    (d) Pursuant to section 1031(b), only $25.60 (the money received) of 
the total gain of $2,325.60 realized on the exchange is recognized at 
the time of exchange and must be included in B's gross income for 1963. 
The $2,300 balance of the gain ($2,325.60 less $25.60) must be included 
in B's gross income for the taxable year in which the series H bonds are 
redeemed or disposed of, or reach final maturity, whichever is earlier, 
as provided in paragraph (c) of Sec. 1.454-1.
    (e) The gain on the four $100 series E bonds, determined by using 
$75 as a basis for each

[[Page 84]]

such bond, must be included in B's gross income for the taxable year in 
which such bonds are redeemed or disposed of, or reach final maturity, 
whichever is earlier.
    Example 3. (a) The facts are the same as in example (2), except 
that, as part of the transaction, the $1,000 series E bond is reissued 
by considering ten $100 series E bonds bearing an issue date of March 1, 
1943, to have been issued. Six of the $100 series E bonds so considered 
to have been issued are surrendered to the United States as part of the 
exchange qualifying under section 1037(a) and the other four are 
immediately redeemed.
    (b) Pursuant to section 1031(b), only $25.60 (the money received) of 
the total gain of $2,325.60 realized on the exchange qualifying under 
section 1037(a) is recognized at the time of the exchange and must be 
included in B's gross income for 1963. The $2,300 balance of the gain 
($2,325.60 less $25.60) realized on such exchange must be included in 
B's gross income for the taxable year in which the series H bonds are 
redeemed or disposed of, or reach final maturity, whichever is earlier, 
as provided in paragraph (c) of Sec. 1.454-1.
    (c) The redemption on October 1, 1963, of the four $100 series E 
bonds considered to have been issued at such time results in gain of 
$258.40, which is then recognized and must be included in B's gross 
income for 1963. This gain of $258.40 is the difference between the 
$558.40 redemption value of such bonds on the date of the exchange and 
the $300 (4x$75) paid for such series E bonds in 1943.
    Example 4. On November 1, 1963, C purchased for $91 a marketable 
U.S. bond which was originally issued at its par value of $100 under the 
Second Liberty Bond Act. On February 1, 1964, in an exchange qualifying 
under section 1037(a), C surrendered the bond to the United States for 
another marketable U.S. bond, which then had a fair market value of $92, 
and $1.85 in cash, $0.85 of which was interest. The $0.85 interest 
received is includible in gross income for the taxable year of the 
exchange, but the $2 gain ($93 less $91) realized on the exchange is 
recognized for such year under section 1031(b) to the extent of $1 (the 
money received). Under section 1031(d), C's basis in the bond received 
in exchange is $91 (his basis of $91 in the bond surrendered, reduced by 
the $1 money received and increased by the $1 gain recognized).

    (c) Consideration received in the form of an assumption of 
liabilities (or a transfer subject to a liability) is to be treated as 
other property or money for the purposes of section 1031(b). Where, on 
an exchange described in section 1031(b), each party to the exchange 
either assumes a liability of the other party or acquires property 
subject to a liability, then, in determining the amount of other 
property or money for purposes of section 1031(b), consideration given 
in the form of an assumption of liabilities (or a receipt of property 
subject to a liability) shall be offset against consideration received 
in the form of an assumption of liabilities (or a transfer subject to a 
liability). See Sec. 1.1031(d)-2, examples (1) and (2).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6935, 32 FR 
15822, Nov. 17, 1967]



Sec. 1.1031(b)-2  Safe harbor for qualified intermediaries.

    (a) In the case of simultaneous transfers of like-kind properties 
involving a qualified intermediary (as defined in Sec. 1.1031(k)-
1(g)(4)(iii)), the qualified intermediary is not considered the agent of 
the taxpayer for purposes of section 1031(a). In such a case, the 
transfer and receipt of property by the taxpayer is treated as an 
exchange.
    (b) In the case of simultaneous exchanges of like-kind properties 
involving a qualified intermediary (as defined in Sec. 1.1031(k)-
1(g)(4)(iii)), the receipt by the taxpayer of an evidence of 
indebtedness of the transferee of the qualified intermediary is treated 
as the receipt of an evidence of indebtedness of the person acquiring 
property from the taxpayer for purposes of section 453 and Sec. 15a.453-
1(b)(3)(i) of this chapter.
    (c) Paragraph (a) of this section applies to transfers of property 
made by taxpayers on or after June 10, 1991.
    (d) Paragraph (b) of this section applies to transfers of property 
made by taxpayers on or after April 20, 1994. A taxpayer may choose to 
apply paragraph (b) of this section to transfers of property made on or 
after June 10, 1991.

[T.D. 8346, 56 FR 19937, May 1, 1991, as amended by T.D. 8535, 59 FR 
18749, Apr. 20, 1994]



Sec. 1.1031(c)-1  Nonrecognition of loss.

    Section 1031(c) provides that a loss shall not be recognized from an 
exchange of property described in section 1031(a), 1035(a), 1036(a), or 
1037(a) where there is received in the exchange other property or money 
in addition to property permitted to be received without recognition of 
gain or loss. See example (4) of paragraph (a)(3) of Sec. 1.1037-1 for 
an illustration of the application of this section in the case of an 
exchange

[[Page 85]]

of U.S. obligations described in section 1037(a).

[T.D. 6935, 32 FR 15822, Nov. 17, 1967]



Sec. 1.1031(d)-1  Property acquired upon a tax-free exchange.

    (a)If, in an exchange of property solely of the type described in 
section 1031, section 1035(a), section 1036(a), or section 1037(a), no 
part of the gain or loss was recognized under the law applicable to the 
year in which the exchange was made, the basis of the property acquired 
is the same as the basis of the property transferred by the taxpayer 
with proper adjustments to the date of the exchange. If additional 
consideration is given by the taxpayer in the exchange, the basis of the 
property acquired shall be the same as the property transferred 
increased by the amount of additional consideration given (see section 
1016 and the regulations thereunder).
    (b) If, in an exchange of properties of the type indicated in 
section 1031, section 1035(a), section 1036(a), or section 1037(a), gain 
to the taxpayer was recognized under the provisions of section 1031(b) 
or a similar provision of a prior revenue law, on account of the receipt 
of money in the transaction, the basis of the property acquired is the 
basis of the property transferred (adjusted to the date of the 
exchange), decreased by the amount of money received and increased by 
the amount of gain recognized on the exchange. The application of this 
paragaph may be illustrated by the following example:

    Example: A, an individual in the moving and storage business, in 
1954 transfers one of his moving trucks with an adjusted basis in his 
hands of $2,500 to B in exchange for a truck (to be used in A's 
business) with a fair market value of $2,400 and $200 in cash. A 
realizes a gain of $100 upon the exchange, all of which is recognized 
under section 1031(b). The basis of the truck acquired by A is 
determined as follows:

Adjusted basis of A's former truck......................          $2,500
Less: Amount of money received..........................             200
                                                         ---------------
    Difference..........................................           2,300
Plus: Amount of gain recognized.........................             100
                                                         ---------------
    Basis of truck acquired by A........................           2,400
 

    (c) If, upon an exchange of properties of the type described in 
section 1031, section 1035(a), section 1036(a), or section 1037(a), the 
taxpayer received other property (not permitted to be received without 
the recognition of gain) and gain from the transaction was recognized as 
required under section 1031(b), or a similar provision of a prior 
revenue law, the basis (adjusted to the date of the exchange) of the 
property transferred by the taxpayer, decreased by the amount of any 
money received and increased by the amount of gain recognized, must be 
allocated to and is the basis of the properties (other than money) 
received on the exchange. For the purpose of the allocation of the basis 
of the properties received, there must be assigned to such other 
property an amount equivalent to its fair market value at the date of 
the exchange. The application of this paragraph may be illustrated by 
the following example:

    Example: A, who is not a dealer in real estate, in 1954 transfers 
real estate held for investment which he purchased in 1940 for $10,000 
in exchange for other real estate (to be held for investment) which has 
a fair market value of $9,000, an automobile which has a fair market 
value of $2,000, and $1,500 in cash. A realizes a gain of $2,500, all of 
which is recognized under section 1031(b). The basis of the property 
received in exchange is the basis of the real estate A transfers 
($10,000) decreased by the amount of money received ($1,500) and 
increased in the amount of gain that was recognized ($2,500), which 
results in a basis for the property received of $11,000. This basis of 
$11,000 is allocated between the automobile and the real estate received 
by A, the basis of the automobile being its fair market value at the 
date of the exchange, $2,000, and the basis of the real estate received 
being the remainder, $9,000.

    (d) Section 1031(c) and, with respect to section 1031 and section 
1036(a), similar provisions of prior revenue laws provide that no loss 
may be recognized on an exchange of properties of a type described in 
section 1031, section 1035(a), section 1036(a), or section 1037(a), 
although the taxpayer receives other property or money from the 
transaction. However, the basis of the property or properties (other 
than money) received by the taxpayer is the basis (adjusted to the date 
of the exchange) of the property transferred, decreased by the amount of 
money received. This basis must be allocated to the properties received, 
and for this purpose there must be allocated to

[[Page 86]]

such other property an amount of such basis equivalent to its fair 
market value at the date of the exchange.
    (e) If, upon an exchange of properties of the type described in 
section 1031, section 1035(a), section 1036(a), or section 1037(a), the 
taxpayer also exchanged other property (not permitted to be transferred 
without the recognition of gain or loss) and gain or loss from the 
transaction is recognized under section 1002 or a similar provision of a 
prior revenue law, the basis of the property acquired is the total basis 
of the properties transferred (adjusted to the date of the exchange) 
increased by the amount of gain and decreased by the amount of loss 
recognized on the other property. For purposes of this rule, the 
taxpayer is deemed to have received in exchange for such other property 
an amount equal to its fair market value on the date of the exchange. 
The application of this paragraph may be illustrated by the following 
example:

    Example: A exchanges real estate held for investment plus stock for 
real estate to be held for investment. The real estate transferred has 
an adjusted basis of $10,000 and a fair market value of $11,000. The 
stock transferred has an adjusted basis of $4,000 and a fair market 
value of $2,000. The real estate acquired has a fair market value of 
$13,000. A is deemed to have received a $2,000 portion of the acquired 
real estate in exchange for the stock, since $2,000 is the fair market 
value of the stock at the time of the exchange. A $2,000 loss is 
recognized under section 1002 on the exchange of the stock for real 
estate. No gain or loss is recognized on the exchange of the real estate 
since the property received is of the type permitted to be received 
without recognition of gain or loss. The basis of the real estate 
acquired by A is determined as follows:

Adjusted basis of real estate transferred..........              $10,000
Adjusted basis of stock transferred................                4,000
                                                    --------------------
                                                                  14,000
Less: Loss recognized on transfer of stock.........                2,000
                                                    --------------------
    Basis of real estate acquired upon the exchange               12,000
 


[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6935, 32 FR 
15823, Nov. 17, 1967]



Sec. 1.1031(d)-1T  Coordination of section 1060 with section 1031 (temporary).

    If the properties exchanged under section 1031 are part of a group 
of assets which constitute a trade or business under section 1060, the 
like-kind property and other property or money which are treated as 
transferred in exchange for the like-kind property shall be excluded 
from the allocation rules of section 1060. However, section 1060 shall 
apply to property which is not like-kind property or other property or 
money which is treated as transferred in exchange for the like-kind 
property. For application of the section 1060 allocation rules to 
property which is not part of the like-kind exchange, see Sec. 1.1060-
1(b), (c), and (d) Example 1 in Sec. 1.338-6(b), to which reference is 
made by Sec. 1.1060-1(c)(2).

[T.D. 8215, 53 FR 27044, July 18, 1988, as amended by T.D. 8858, 65 FR 
1237, Jan. 7, 2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.1031(d)-2  Treatment of assumption of liabilities.

    For the purposes of section 1031(d), the amount of any liabilities 
of the taxpayer assumed by the other party to the exchange (or of any 
liabilities to which the property exchanged by the taxpayer is subject) 
is to be treated as money received by the taxpayer upon the exchange, 
whether or not the assumption resulted in a recognition of gain or loss 
to the taxpayer under the law applicable to the year in which the 
exchange was made. The application of this section may be illustrated by 
the following examples:

    Example 1. B, an individual, owns an apartment house which has an 
adjusted basis in his hands of $500,000, but which is subject to a 
mortgage of $150,000. On September 1, 1954, he transfers the apartment 
house to C, receiving in exchange therefor $50,000 in cash and another 
apartment house with a fair market value on that date of $600,000. The 
transfer to C is made subject to the $150,000 mortgage. B realizes a 
gain of $300,000 on the exchange, computed as follows:

Value of property received.................................     $600,000
Cash.......................................................       50,000
Liabilities subject to which old property was transferred..      150,000
                                               --------------
    Total consideration received...........................      800,000
Less: Adjusted basis of property transferred...............      500,000
                                               --------------

[[Page 87]]

 
    Gain realized..........................................      300,000
                                               ==============
Under section 1031(b), $200,000 of the $300,000 gain is          500,000
 recognized. The basis of the apartment house acquired by B
 upon the exchange is $500,000, computed as follows:
 Adjusted basis of property transferred....................
Less: Amount of money received:
  Cash........................................      $50,000
  Amount of liabilities subject to which            150,000
   property was transferred...................
                                                     ------      200,000
                                                            ------------
    Difference................................  ...........      300,000
Plus: Amount of gain recognized upon the exchange..........      200,000
                                               --------------
    Basis of property acquired upon the exchange...........      500,000
 

    Example 2. (a) D, an individual, owns an apartment house. On 
December 1, 1955, the apartment house owned by D has an adjusted basis 
in his hands of $100,000, a fair market value of $220,000, but is 
subject to a mortgage of $80,000. E, an individual, also owns an 
apartment house. On December 1, 1955, the apartment house owned by E has 
an adjusted basis of $175,000, a fair market value of $250,000, but is 
subject to a mortgage of $150,000. On December 1, 1955, D transfers his 
apartment house to E, receiving in exchange therefore $40,000 in cash 
and the apartment house owned by E. Each apartment house is transferred 
subject to the mortgage on it.
    (b) D realizes a gain of $120,000 on the exchange, computed as 
follows:

Value of property received......................  ..........    $250,000
Cash........................................................      40,000
Liabilities subject to which old property was transferred...      80,000
                                                 -------------
    Total consideration received............................     370,000
Less:
  Adjusted basis of property transferred........    $100,000
  Liabilities to which new property is subject..     150,000
                                                    --------     250,000
                                                             -----------
    Gain realized...............................  ..........     120,000
 


For purposes of section 1031(b), the amount of other property or money 
received by D is $40,000. (Consideration received by D in the form of a 
transfer subject to a liability of $80,000 is offset by consideration 
given in the form of a receipt of property subject to a $150,000 
liability. Thus, only the consideration received in the form of cash, 
$40,000, is treated as other property or money for purposes of section 
1031(b).) Accordingly, under section 1031(b), $40,000 of the $120,000 
gain is recognized. The basis of the apartment house acquired by D is 
$170,000, computed as follows:

Adjusted basis of property transferred............              $100,000
Liabilities to which new property is subject......               150,000
                             -----------------------
    Total.........................................               250,000
Less: Amount of money                      $40,000
 received: Cash.............
Amount of liabilities                       80,000
 subject to which property
 was transferred............
                                          --------               120,000
                                                   ---------------------
    Difference....................................               130,000
Plus: Amount of gain recognized upon the exchange.                40,000
                             -----------------------
    Basis of property acquired upon the exchange..               170,000
 

    (c) E realizes a gain of $75,000 on the exchange, computed as 
follows:

Value of property received........................              $220,000
Liabilities subject to which old property was                    150,000
 transferred......................................
                             -----------------------
    Total consideration received..................               370,000
Less:
  Adjusted basis of property              $175,000
   transferred..............
  Cash......................                40,000
  Liabilities to which new                  80,000
   property is subject......
                                          --------               295,000
                                                   ---------------------
    Gain realized.................................                75,000
 

For purposes of section 1031(b), the amount of other property or money 
received by E is $30,000. (Consideration received by E in the form of a 
transfer subject to a liability of $150,000 is offset by consideration 
given in the form of a receipt of property subject to an $80,000 
liability and by the $40,000 cash paid by E. Although consideration 
received in the form of cash or other property is not offset by 
consideration given in the form of an assumption of liabilities or a 
receipt of property subject to a liability, consideration given in the 
form of cash or other property is offset against consideration received 
in the form of an assumption of liabilities or a transfer of property 
subject to a liability.) Accordingly, under section 1031(b), $30,000 of 
the $75,000 gain is recognized. The basis of the apartment house 
acquired by E is $175,000, computed as follows:

Adjusted basis of property transferred............              $175,000
Cash..............................................                40,000

[[Page 88]]

 
Liabilities to which new property is subject......                80,000
                             -----------------------
    Total.........................................               295,000
Less: Amount of money                     $150,000
 received: Amount of
 liabilities subject to
 which property was
 transferred................
                                          --------               150,000
                                                   ---------------------
    Difference....................................               145,000
Plus: Amount of gain recognized upon the exchange.                30,000
                             -----------------------
    Basis of property acquired upon the exchange..               175,000
 



Sec. 1.1031(e)-1  Exchange of livestock of different sexes.

    Section 1031(e) provides that livestock of different sexes are not 
property of like kind. Section 1031(e) and this section are applicable 
to taxable years to which the Internal Revenue Code of 1954 applies.

[T.D. 7141, 36 FR 18792, Sept. 22, 1971]



Sec. 1.1031(j)-1  Exchanges of multiple properties.

    (a) Introduction--(1) Overview. As a general rule, the application 
of section 1031 requires a property-by-property comparison for computing 
the gain recognized and basis of property received in a like-kind 
exchange. This section provides an exception to this general rule in the 
case of an exchange of multiple properties. An exchange is an exchange 
of multiple properties if, under paragraph (b)(2) of this section, more 
than one exchange group is created. In addition, an exchange is an 
exchange of multiple properties if only one exchange group is created 
but there is more than one property being transferred or received within 
that exchange group. Paragraph (b) of this section provides rules for 
computing the amount of gain recognized in an exchange of multiple 
properties qualifying for nonrecognition of gain or loss under section 
1031. Paragraph (c) of this section provides rules for computing the 
basis of properties received in an exchange of multiple properties 
qualifying for nonrecognition of gain or loss under section 1031.
    (2) General approach. (i) In general, the amount of gain recognized 
in an exchange of multiple properties is computed by first separating 
the properties transferred and the properties received by the taxpayer 
in the exchange into exchange groups in the manner described in 
paragraph (b)(2) of this section. The separation of the properties 
transferred and the properties received in the exchange into exchange 
groups involves matching up properties of a like kind of like class to 
the extent possible. Next, all liabilities assumed by the taxpayer as 
part of the transaction are offset by all liabilities of which the 
taxpayer is relieved as part of the transaction, with the excess 
liabilities assumed or relieved allocated in accordance with paragraph 
(b)(2)(ii) of this section. Then, the rules of section 1031 and the 
regulations thereunder are applied separately to each exchange group to 
determine the amount of gain recognized in the exchange. See 
Secs. 1.1031(b)-1 and 1.1031(c)-1. Finally, the rules of section 1031 
and the regulations thereunder are applied separately to each exchange 
group to determine the basis of the properties received in the exchange. 
See Secs. 1.1031(d)-1 and 1.1031(d)-2.
    (ii) For purposes of this section, the exchanges are assumed to be 
made at arms' length, so that the aggregate fair market value of the 
property received in the exchange equals the aggregate fair market value 
of the property transferred. Thus, the amount realized with respect to 
the properties transferred in each exchange group is assumed to equal 
their aggregate fair market value.
    (b) Computation of gain recognized--(1) In general. In computing the 
amount of gain recognized in an exchange of multiple properties, the 
fair market value must be determined for each property transferred and 
for each property received by the taxpayer in the exchange. In addition, 
the adjusted basis must be determined for each property transferred by 
the taxpayer in the exchange.
    (2) Exchange groups and residual group. The properties transferred 
and the properties received by the taxpayer in the exchange are 
separated into exchange groups and a residual group to

[[Page 89]]

the extent provided in this paragraph (b)(2).
    (i) Exchange groups. Each exchange group consists of the properties 
transferred and received in the exchange, all of which are of a like 
kind or like class. If a property could be included in more than one 
exchange group, the taxpayer may include the property in any of those 
exchange groups. Property eligible for inclusion within an exchange 
group does not include money or property described in section 1031(a)(2) 
(i.e., stock in trade or other property held primarily for sale, stocks, 
bonds, notes, other securities or evidences of indebtedness or interest, 
interests in a partnership, certificates of trust or beneficial 
interests, or choses in action). For example, an exchange group may 
consist of all exchanged properties that are within the same General 
Asset Class or within the same Product Class (as defined in 
Sec. 1.1031(a)-2(b)). Each exchange group must consist of at least one 
property transferred and at least one property received in the exchange.
    (ii) Treatment of liabilities. (A) All liabilities assumed by the 
taxpayer as part of the exchange are offset against all liabilities of 
which the taxpayer is relieved as part of the exchange, regardless of 
whether the liabilities are recourse or nonrecourse and regardless of 
whether the liabilities are secured by or otherwise relate to specific 
property transferred or received as part of the exchange. See 
Secs. 1.1031 (b)-1(c) and 1.1031(d)-2. For purposes of this section, 
liabilities assumed by the taxpayer as part of the exchange consist of 
liabilities of the other party to the exchange assumed by the taxpayer 
and liabilities subject to which the other party's property is 
transferred in the exchange. Similarly, liabilities of which the 
taxpayer is relieved as part of the exchange consist of liabilities of 
the taxpayer assumed by the other party to the exchange and liabilities 
subject to which the taxpayer's property is transferred.
    (B) If there are excess liabilities assumed by the taxpayer as part 
of the exchange (i.e., the amount of liabilities assumed by the taxpayer 
exceeds the amount of liabilities of which the taxpayer is relieved), 
the excess is allocated among the exchange groups (but not to the 
residual group) in proportion to the aggregate fair market value of the 
properties received by the taxpayer in the exchange groups. The amount 
of excess liabilities assumed by the taxpayer that are allocated to each 
exchange group may not exceed the aggregate fair market value of the 
properties received in the exchange group.
    (C) If there are excess liabilities of which the taxpayer is 
relieved as part of the exchange (i.e., the amount of liabilities of 
which the taxpayer is relieved exceeds the amount of liabilities assumed 
by the taxpayer), the excess is treated as a Class I asset for purposes 
of making allocations to the residual group under paragraph (b)(2)(iii) 
of this section.
    (D) Paragraphs (b)(2)(ii) (A), (B), and (C) of this section are 
applied in the same manner even if section 1031 and this section apply 
to only a portion of a larger transaction (such as a transaction 
described in section 1060(c) and Sec. 1.1060-1T(b)). In that event, the 
amount of excess liabilities assumed by the taxpayer or the amount of 
excess liabilities of which the taxpayer is relieved is determined based 
on all liabilities assumed by the taxpayer and all liabilities of which 
the taxpayer is relieve as part of the larger transaction.
    (iii) Residual group. If the aggregate fair market value of the 
properties transferred in all of the exchange groups differs from the 
aggregate fair market value of the properties received in all of the 
exchange groups (taking liabilities into account in the manner described 
in paragraph (b)(2)(ii) of this section), a residual group is created. 
The residual group consists of an amount of money or other property 
having an aggregate fair market value equal to that difference. The 
residual group consists of either money or other property transferred in 
the exchange or money or other property received in the exchange, but 
not both. For this purpose, other property includes property described 
in section 1031(a)(2) (i.e., stock in trade or other property held 
primarily for sale, stocks, bonds, notes, other securities or evidences 
of indebtedness or interest, interests in a partnership, certificates of 
trust or beneficial interests, or choses in action), property 
transferred that is not of a

[[Page 90]]

like kind or like class with any property received, and property 
received that is not of a like kind or like class with any property 
transferred. The money and properties that are allocated to the residual 
group are considered to come from the following assets in the following 
order: first from Class I assets, then from Class II assets, then from 
Class III assets, and then from Class IV assets. The terms Class I 
assets, Class II assets, Class III assets, and Class IV assets have the 
same meanings as in Sec. 1.338-6(b), to which reference is made by 
Sec. 1.1060-1(c)(2). Within each Class, taxpayers may choose which 
properties are allocated to the residual group.
    (iv) Exchange group surplus and deficiency. For each of the exchange 
groups described in this section, an ``exchange group surplus'' or 
``exchange group deficiency,'' if any, must be determined. An exchange 
group surplus is the excess of the aggregate fair market value of the 
properties received (less the amount of any excess liabilities assumed 
by the taxpayer that are allocated to that exchange group), in an 
exchange group over the aggregate fair market value of the properties 
transferred in that exchange group. An exchange group deficiency is the 
excess of the aggregate fair market value of the properties transferred 
in an exchange group over the aggregate fair market value of the 
properties received (less the amount of any excess liabilities assumed 
by the taxpayer that are allocated to that exchange group) in that 
exchange group.
    (3) Amount of gain recognized. (i) For purposes of this section, the 
amount of gain or loss realized with respect to each exchange group and 
the residual group is the difference between the aggregate fair market 
value of the properties transferred in that exchange group or residual 
group and the properties' aggregate adjusted basis. The gain realized 
with respect to each exchange group is recognized to the extent of the 
lesser of the gain realized and the amount of the exchange group 
deficiency, if any. Losses realized with respect to an exchange group 
are not recognized. See section 1031 (a) and (c). The total amount of 
gain recognized under section 1031 in the exchange is the sum of the 
amount of gain recognized with respect to each exchange group. With 
respect to the residual group, the gain or loss realized (as determined 
under this section) is recognized as provided in section 1001 or other 
applicable provision of the Code.
    (ii) The amount of gain or loss realized and recognized with respect 
to properties transferred by the taxpayer that are not within any 
exchange group or the residual group is determined under section 1001 
and other applicable provisions of the Code, with proper adjustments 
made for all liabilities not allocated to the exchange groups or the 
residual group.
    (c) Computation of basis of properties received. In an exchange of 
multiple properties qualifying for nonrecognition of gain or loss under 
section 1031 and this section, the aggregate basis of properties 
received in each of the exchange groups is the aggregate adjusted basis 
of the properties transferred by the taxpayer within that exchange 
group, increased by the amount of gain recognized by the taxpayer with 
respect to that exchange group, increased by the amount of the exchange 
group surplus or decreased by the amount of the exchange group 
deficiency, and increased by the amount, if any, of excess liabilities 
assumed by the taxpayer that are allocated to that exchange group. The 
resulting aggregate basis of each exchange group is allocated 
proportionately to each property received in the exchange group in 
accordance with its fair market value. The basis of each property 
received within the residual group (other than money) is equal to its 
fair market value.
    (d) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. (i) K exchanges computer A (asset class 00.12) and 
automobile A (asset class 00.22), both of which were held by K for 
productive use in its business, with W for printer B (asset class 00.12) 
and automobile B (asset class 00.22), both of which will be held by K 
for productive use in its business. K's adjusted basis and the fair 
market value of the exchanged properties are as follows:

------------------------------------------------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Computer A..............................            $375          $1,000

[[Page 91]]

 
Automobile A............................           1,500           4,000
Printer B...............................                           2,050
Automobile B............................                           2,950
------------------------------------------------------------------------

    (ii) Under paragraph (b)(2) of this section, the properties 
exchanged are separated into exchange groups as follows:
    (A) The first exchange group consists of computer A and printer B 
(both are within the same General Asset Class) and, as to K, has an 
exchange group surplus of $1050 because the fair market value of printer 
B ($2050) exceeds the fair market value of computer A ($1000) by that 
amount.
    (B) The second exchange group consists of automobile A and 
automobile B (both are within the same General Asset Class) and, as to 
K, has an exchange group deficiency of $1050 because the fair market 
value of automobile A ($4000) exceeds the fair market value of 
automobile B ($2950) by that amount.
    (iii) K recognizes gain on the exchange as follows:
    (A) With respect to the first exchange group, the amount of gain 
realized is the excess of the fair market value of computer A ($1000) 
over its adjusted basis ($375), or $625. The amount of gain recognized 
is the lesser of the gain realized ($625) and the exchange group 
deficiency ($0), or $0.
    (B) With respect to the second exchange group, the amount of gain 
realized is the excess of the fair market value of automobile A ($4000) 
over its adjusted basis ($1500), or $2500. The amount of gain recognized 
is the lesser of the gain realized ($2500) and the exchange group 
deficiency ($1050), or $1050.
    (iv) The total amount of gain recognized by K in the exchange is the 
sum of the gains recognized with respect to both exchange groups ($0 + 
$1050), or $1050.
    (v) The bases of the property received by K in the exchange, printer 
B and automobile B, are determined in the following manner:
    (A) The basis of the property received in the first exchange group 
is the adjusted basis of the property transferred within the exchange 
group ($375), increased by the amount of gain recognized with respect to 
that exchange group ($0), increased by the amount of the exchange group 
surplus ($1050), and increased by the amount of excess liabilities 
assumed allocated to that exchange group ($0), or $1425. Because printer 
B was the only property received within the first exchange group, the 
entire basis of $1425 is allocated to printer B.
    (B) The basis of the property received in the second exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($1500), increased by the amount of gain recognized with respect 
to that exchange group ($1050), decreased by the amount of the exchange 
group deficiency ($1050), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($0), or $1500. 
Because automobile B was the only property received within the second 
exchange group, the entire basis of $1500 is allocated to automobile B.
    Example 2. (i) F exchanges computer A (asset class 00.12) and 
automobile A (asset class 00.22), both of which were held by F for 
productive use in its business, with G for printer B (asset class 00.12) 
and automobile B (asset class 00.22), both of which will be held by F 
for productive use in its business, and corporate stock and $500 cash. 
The adjusted basis and fair market value of the properties are as 
follows:

------------------------------------------------------------------------
                                                            Fair market
                                          Adjusted basis       value
------------------------------------------------------------------------
Computer A..............................            $375          $1,000
Automobile A............................           3,500           4,000
Printer B...............................  ..............             800
Automobile B............................  ..............           2,950
Corporate stock.........................  ..............             750
Cash....................................  ..............             500
------------------------------------------------------------------------

    (ii) Under paragraph (b)(2) of this section, the properties 
exchanged are separated into exchange groups as follows:
    (A) The first exchange group consists of computer A and printer B 
(both are within the same General Asset Class) and, as to F, has an 
exchange group deficiency of $200 because the fair market value of 
computer A ($1000) exceeds the fair market value of printer B ($800) by 
that amount.
    (B) The second exchange group consists of automobile A and 
automobile B (both are within the same General Asset Class) and, as to 
F, has an exchange group deficiency of $1050 because the fair market 
value of automobile A ($4000) exceeds the fair market value of 
automobile B ($2950) by that amount.
    (C) Because the aggregate fair market value of the properties 
transferred by F in the exchange groups ($5,000) exceeds the aggregate 
fair market value of the properties received by F in the exchange groups 
($3750) by $1250, there is a residual group in that amount consisting of 
the $500 cash and the $750 worth of corporate stock.
    (iii) F recognizes gain on the exchange as follows:
    (A) With respect to the first exchange group, the amount of gain 
realized is the excess of the fair market value of computer A ($1000) 
over its adjusted basis ($375), or $625. The amount of gain recognized 
is the lesser of the gain realized ($625) and the exchange group 
deficiency ($200), or $200.
    (B) With respect to the second exchange group, the amount of gain 
realized is the excess of the fair market value of automobile A ($4000) 
over its adjusted basis ($3500), or $500. The amount of gain recognized 
is the lesser

[[Page 92]]

of the gain realized ($500) and the exchange group deficiency ($1050), 
or $500.
    (C) No property transferred by F was allocated to the residual 
group. Therefore, F does not recognize gain or loss with respect to the 
residual group.
    (iv) The total amount of gain recognized by F in the exchange is the 
sum of the gains recognized with respect to both exchange groups ($200 + 
$500), or $700.
    (v) The bases of the properties received by F in the exchange 
(printer B, automobile B, and the corporate stock) are determined in the 
following manner:
    (A) The basis of the property received in the first exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($375), increased by the amount of gain recognized with respect to 
that exchange group ($200), decreased by the amount of the exchange 
group deficiency ($200), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($0), or $375. 
Because printer B was the only property received within the first 
exchange group, the entire basis of $375 is allocated to printer B.
    (B) The basis of the property received in the second exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($3500), increased by the amount of gain recognized with respect 
to that exchange group ($500), decreased by the amount of the exchange 
group deficiency ($1050), and increased by the amount of excess 
liabilites assumed allocated to that exchange group ($0), or $2950. 
Because automobile B was the only property received within the second 
exchange group, the entire basis of $2950 is allocated to automobile B.
    (C) The basis of the property received within the residual group 
(the corporate stock) is equal to its fair market value or $750. Cash of 
$500 is also received within the residual group.
    Example 3. (i) J and H enter into an exchange of the following 
properties. All of the property (except for the inventory) transferred 
by J was held for productive use in J's business. All of the property 
received by J will be held by J for productive use in its business.

----------------------------------------------------------------------------------------------------------------
                      J Transfers:                                             H Transfers:
----------------------------------------------------------------------------------------------------------------
                                              Adjusted   Fair market                                 Fair market
                 Property                      basis        value                Property               value
----------------------------------------------------------------------------------------------------------------
Computer A................................       $1,500       $5,000  Computer Z...................       $4,500
Computer B................................          500        3,000  Printer Y....................        2,500
Printer C.................................        2,000        1,500  Real Estate X................        1,000
Real Estate D.............................        1,200        2,000  Real Estate W................        4,000
Real Estate E.............................            0        1,800  Grader V.....................        2,000
Scraper F.................................        3,300        2,500  Truck T......................        1,700
Inventory.................................        1,000        1,700  Cash.........................        1,800
                                           --------------------------                               ------------
      Total...............................        9,500       17,500    ...........................       17,500
----------------------------------------------------------------------------------------------------------------

    (ii) Under paragraph (b)(2) of this section, the properties 
exchanged are separated into exchange groups as follows:
    (A) The first exchange group consists of computer A, computer B, 
printer C, computer Z, and printer Y (all are within the same General 
Asset Class) and, as to J, has an exchange group deficiency of $2500 
(($5000 + $3000 + $1500) - ($4500 + $2500)).
    (B) The second exchange group consists of real estate D, E, X and W 
(all are of a like kind) and, as to J, has an exchange group surplus of 
$1200 (($1000 + $4000) - ($2000 + $1800)).
    (C) The third exchange group consists of scraper F and grader V 
(both are within the same Product Class (SIC Code 3531)) and, as to J, 
has an exchange group deficiency of $500 ($2500 - $2000).
    (D) Because the aggregate fair market value of the properties 
transferred by J in the exchange groups ($15,800) exceeds the aggregate 
fair market value of the properties received by J in the exchange groups 
($14,000) by $1800, there is a residual group in that amount consisting 
of the $1800 cash (a Class I asset).
    (E) The transaction also includes a taxable exchange of inventory 
(which is property described in section 1031 (a)(2)) for truck T (which 
is not of a like kind or like class to any property transferred in the 
exchange).
    (iii) J recognizes gain on the transaction as follows:
    (A) With respect to the first exchange group, the amount of gain 
realized is the excess of the aggregate fair market value of the 
properties transferred in the exchange group ($9500) over the aggregate 
adjusted basis ($4000), or $5500. The amount of gain recognized is the 
lesser of the gain realized ($5500) and the exchange group deficiency 
($2500), or $2500.
    (B) With respect to the second exchange group, the amount of gain 
realized is the excess of the aggregate fair market value of the 
properties transferred in the exchange group ($3800) over the aggregate 
adjusted

[[Page 93]]

basis ($1200), or $2600. The amount of gain recognized is the lesser of 
the gain realized ($2600) and the exchange group deficiency ($0), or $0.
    (C) With respect to the third exchange group, a loss is realized in 
the amount of $800 because the fair market value of the property 
transferred in the exchange group ($2500) is less than its adjusted 
basis ($3300). Although a loss of $800 was realized, under section 1031 
(a) and (c) losses are not recognized.
    (D) No property transferred by J was allocated to the residual 
group. Therefore, J does not recognize gain or loss with respect to the 
residual group.
    (E) With respect to the taxable exchange of inventory for truck T, 
gain of $700 is realized and recognized by J (amount realized of $1700 
(the fair market value of truck T) less the adjusted basis of the 
inventory ($1000)).
    (iv) The total amount of gain recognized by J in the transaction is 
the sum of the gains recognized under section 1031 with respect to each 
exchange group ($2500 + $0 + $0) and any gain recognized outside of 
section 1031 ($700), or $3200.
    (v) The bases of the property received by J in the exchange are 
determined in the following manner:
    (A) The aggregate basis of the properties received in the first 
exchange group is the adjusted basis of the properties transferred 
within that exchange group ($4000), increased by the amount of gain 
recognized with respect to that exchange group ($2500), decreased by the 
amount of the exchange group deficiency ($2500), and increased by the 
amount of excess liabilities assumed allocated to that exchange group 
($0), or $4000. This $4000 of basis is allocated proportionately among 
the assets received within the first exchange group in accordance with 
their fair market values: Computer Z's basis is $2571 ($4000 x $4500/
$7000); printer Y's basis is $1429 ($4000 x $2500/$7000).
    (B) The aggregate basis of the properties received in the second 
exchange group is the adjusted basis of the properties transferred 
within that exchange group ($1200), increased by the amount of gain 
recognized with respect to that exchange group ($0), increased by the 
amount of the exchange group surplus ($1200), and increased by the 
amount of excess liabilities assumed allocated to that exchange group 
($0), or $2400. This $2400 of basis is allocated proportionately among 
the assets received within the second exchange group in accordance with 
their fair market values: Real estate X's basis is $480 ($2400 x $1000/
$5000); real estate W's basis is $1920 ($2400 x $4000/$5000).
    (c) The basis of the property received in the third exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($3300), increased by the amount of gain recognized with respect 
to that exchange group ($0), decreased by the amount of the exchange 
group deficiency ($500), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($0), or $2800. 
Because grader V was the only property received within the third 
exchange group, the entire basis of $2800 is allocated to grader V.
    (D) Cash of $1800 is received within the residual group.
    (E) The basis of the property received in the taxable exchange 
(truck T) is equal to its cost of $1700.
    Example 4. (i) B exchanges computer A (asset class 00.12), 
automobile A (asset class 00.22) and truck A (asset class 00.241), with 
C for computer R (asset class 00.12), automobile R (asset class 00.22), 
truck R (asset class 00.241) and $400 cash. All properties transferred 
by either B or C were held for productive use in the respective 
transferor's business. Similarly, all properties to be received by 
either B or C will be held for productive use in the respective 
recipient's business. Automobile A, automobile R and truck R are each 
secured by a nonrecourse liability and are transferred subject to such 
liability. The adjusted basis, fair market value, and liability secured 
by each property, if any, are as follows:

------------------------------------------------------------------------
                                                       Fair
                                          Adjusted    market   Liability
                                           basis      value
------------------------------------------------------------------------
B transfers:
  Computer A...........................       $800     $1,500         $0
  Automobile A.........................        900      2,500        500
  Truck A..............................        700      2,000          0
C transfers:
  Computer R...........................      1,100      1,600          0
  Automobile R.........................      2,100      3,100        750
  Truck R..............................        600      1,400        250
  Cash.................................  .........        400  .........
------------------------------------------------------------------------

    (ii) The tax treatment to B is as follows:
    (A)(1) The first exchange group consists of computers A and R (both 
are within the same General Asset Class).
    (2) The second exchange group consists of automobiles A and R (both 
are within the same General Asset Class).
    (3) The third exchange group consists of trucks A and R (both are in 
the same General Asset Class).
    (B) Under paragraph (b)(2)(ii) of this section, all liabilities 
assumed by B ($1000) are offset by all liabilities of which B is 
relieved ($500), resulting in excess liabilities assumed of $500. The 
excess liabilities assumed of $500 is allocated among the exchange 
groups in proportion to the fair market value of the properties received 
by B in the exchange groups as follows:
    (1) $131 of excess liabilities assumed ($500 x $1600/$6100) is 
allocated to the first exchange group. The first exchange group has an 
exchange group deficiency of $31 because the fair market value of 
computer A ($1500) exceeds the fair market value of computer R

[[Page 94]]

less the excess liabilities assumed allocated to the exchange group 
($1600-$131) by that amount.
    (2) $254 of excess liabilities assumed ($500 x $3100/$6100) is 
allocated to the second exchange group. The second exchange group has an 
exchange group surplus of $346 because the fair market value of 
automobile R less the excess liabilities assumed allocated to the 
exchange group ($3100-$254) exceeds the fair market value of automobile 
A ($2500) by that amount.
    (3) $115 of excess liabilities assumed ($500 x $1400/$6100) is 
allocated to the third exchange group. The third exchange group has an 
exchange group deficiency of $715 because the fair market value of truck 
A ($2000) exceeds the fair market value of truck R less the excess 
liabilities assumed allocated to the exchange group ($1400-$115) by that 
amount.
    (4) The difference between the aggregate fair market value of the 
properties transferred in all of the exchange groups, $6000, and the 
aggregate fair market value of the properties received in all of the 
exchange groups (taking excess liabilities assumed into account), $5600, 
is $400. Therefore there is a residual group in that amount consisting 
of $400 cash received.
    (C) B recognizes gain on the exchange as follows:
    (1) With respect to the first exchange group, the amount of gain 
realized is the excess of the fair market value of computer A ($1500) 
over its adjusted basis ($800), or $700. The amount of gain recognized 
is the lesser of the gain realized ($700) and the exchange group 
deficiency ($31), or $31.
    (2) With respect to the second exchange group, the amount of gain 
realized is the excess of the fair market value of automobile A ($2500) 
over its adjusted basis ($900), or $1600.
    The amount of gain recognized is the lesser of the gain realized 
($1600) and the exchange group deficiency ($0), or $0.
    (3) With respect to the third exchange group, the amount of gain 
realized is the excess of the fair market value of truck A ($2000) over 
its adjusted basis ($700), or $1300. The amount of gain recognized is 
the lesser of gain realized ($1300) and the exchange group deficiency 
($715), or $715.
    (4) No property transferred by B was allocated to the residual 
group. Therefore, B does not recognize gain or loss with respect to the 
residual group.
    (D) The total amount of gain recognized by B in the exchange is the 
sum of the gains recognized under section 1031 with respect to each 
exchange group ($31 + $0 +$715), or $746.
    (E) the bases of the property received by B in the exchange 
(computer R, automobile R, and truck R) are determined in the following 
manner:
    (1) The basis of the property received in the first exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($800), increased by the amount of gain recognized with respect to 
that exchange group ($31), decreased by the amount of the exchange group 
deficiency ($31), and increased by the amount of excess liabilities 
assumed allocated to that exchange group ($131), or $931. Because 
computer R was the only property received within the first exchange 
group, the entire basis of $931 is allocated to computer R.
    (2) The basis of the property received in the second exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($900), increased by the amount of gain recognized with respect to 
that exchange group ($0), increased by the amount of the exchange group 
surplus ($346), and increased by the amount of excess liabilities 
assumed allocated to that exchange group ($254), or $1500. Because 
automobile R was the only property received within the second exchange 
group, the entire basis of $1500 is allocated to automobile R.
    (3) The basis of the property received in the third exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($700), increased by the amount of gain recognized with respect to 
that exchange group ($715), decreased by the amount of the exchange 
group deficiency ($715), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($115), or $815. 
Because truck R was the only property received within the third exchange 
group, the entire basis of $815 is allocated to truck R.
    (F) Cash of $400 is also received by B.
    (iii) The tax treatment to C is as follows:
    (A) (1) The first exchange group consists of computers R and A (both 
are within the same General Asset Class).
    (2) The second exchange group consists of automobiles R and A (both 
are within the same General Asset Class).
    (3) The third exchange group consists of trucks R and A (both are in 
the same General Asset Class).
    (B) Under paragraph (b)(2)(ii) of this section, all liabilities of 
which C is relieved ($1000) are offset by all liabilities assumed by C 
($500), resulting in excess liabilities relieved of $500. This excess 
liabilities relieved is treated as cash received by C.
    (1) The first exchange group has an exchange group deficiency of 
$100 because the fair market value of computer R ($1600) exceeds the 
fair market value of computer A ($1500) by that amount.
    (2) The second exchange group has an exchange group deficiency of 
$600 because the fair market value of automobile R ($3100) exceeds the 
fair market value of automobile A ($2500) by that amount.
    (3) The third exchange group has an exchange group surplus of $600 
because the fair market value of truck A ($2000) exceeds the

[[Page 95]]

fair market value of truck R ($1400) by that amount.
    (4) The difference between the aggregate fair market value of the 
properties transferred by C in all of the exchange groups, $6100, and 
the aggregate fair market value of the properties received by C in all 
of the exchange groups, $6000, is $100. Therefore, there is a residual 
group in that amount, consisting of excess liabilities relieved of $100, 
which is treated as cash received by C.
    (5) The $400 cash paid by C and $400 of the excess liabilities 
relieved which is treated as cash received by C are not within the 
exchange groups of the residual group.
    (C) C recognizes gain on the exchange as follows:
    (1) With respect to the first exchange group, the amount of gain 
realized is the excess of the fair market value of computer R ($1600) 
over its adjusted basis ($1100), or $500. The amount of gain recognized 
is the lesser of the gain realized ($500) and the exchange group 
deficiency ($100), or $100.
    (2) With respect to the second exchange group, the amount of gain 
realized is the excess of the fair market value of automobile R ($3100) 
over its adjusted basis ($2100), or $1000. The amount of gain recognized 
is the lesser of the gain realized ($1000) and the exchange group 
deficiency ($600), or $600.
    (3) With respect to the third exchange group, the amount of gain 
realized is the excess of the fair market value of truck R ($1400) over 
its adjusted basis ($600), or $800. The amount of gain recognized is the 
lesser of gain realized ($800) and the exchange group deficiency ($0), 
or $0.
    (4) No property transferred by C was allocated to the residual 
group. Therefore, C does not recognize any gain with respect to the 
residual group.
    (D) The total amount of gain recognized by C in the exchange is the 
sum of the gains recognized under section 1031 with respect to each 
exchange group ($100+$600+$0), or $700.
    (E) The bases of the properties received by C in the exchange 
(computer A, automobile A, and truck A) are determined in the following 
manner:
    (1) The basis of the property received in the first exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($1100), increased by the amount of gain recognized with respect 
to that exchange group ($100), decreased by the amount of the exchange 
group deficiency ($100), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($0), or $1100. 
Because computer A was the only property received within the first 
exchange group, the entire basis of $1100 is allocated to computer A.
    (2) The basis of the property received in the second exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($2100), increased by the amount of gain recognized with respect 
to that exchange group ($600), decreased by the amount of the exchange 
group deficiency ($600), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($0), or $2100. 
Because automobile A was the only property received within the second 
exchange group, the entire basis of $2100 is allocated to automobile A.
    (3) The basis of the property received in the third exchange group 
is the adjusted basis of the property transferred within that exchange 
group ($600), increased by the amount of gain recognized with respect to 
that exchange group ($0), increased by the amount of the exchange group 
surplus ($600), and increased by the amount of excess liabilities 
assumed allocated to that exchange group ($0), or $1200. Because truck A 
was the only property received within the third exchange group, the 
entire basis of $1200 is allocated to truck A.
    Example 5. (i) U exchanges real estate A, real estate B, and grader 
A (SIC Code 3531) with V for real estate R and railroad car R (General 
Asset Class 00.25). All properties transferred by either U or V were 
held for productive use in the respective transferor's business. 
Similarly, all properties to be received by either U or V will be held 
for productive use in the respective recipient's business. Real estate R 
is secured by a recourse liability and is transferred subject to that 
liability. The adjusted basis, fair market value, and liability secured 
by each property, if any, are as follows:

------------------------------------------------------------------------
                                     Adjusted   Fair market
                                      basis        value      Liability
------------------------------------------------------------------------
U Transfers:
  Real Estate A..................        $2000        $5000  ...........
  Real Estate B..................         8000       13,500  ...........
  Grader A.......................          500         2000  ...........
V Transfers:
  Real Estate R..................      $20,000      $26,500        $7000
  Railroad car R.................         1200         1000
------------------------------------------------------------------------

    (ii) The tax treatment to U is as follows:
    (A) The exchange group consists of real estate A, real estate B, and 
real estate R.
    (B) Under paragraph (b)(2)(ii) of this section, all liabilities 
assumed by U ($7000) are excess liabilities assumed. The excess 
liabilities assumed of $7000 is allocated to the exchange group.
    (1) The exchange group has an exchange group surplus of $1000 
because the fair market value of real estate R less the excess 
liabilities assumed allocated to the exchange group ($26,500-$7000) 
exceeds the aggregate fair market value of real estate A and B ($18,500) 
by that amount.
    (2) The difference between the aggregate fair market value of the 
properties received in the exchange group (taking excess liabilities 
assumed into account), $19,500, and the aggregate fair market value of 
the properties

[[Page 96]]

transferred in the exchange group, $18,500, is $1000. Therefore, there 
is a residual group in that amount consisting of $1000 (or 50 percent of 
the fair market value) of grader A.
    (3) The transaction also includes a taxable exchange of the 50 
percent portion of grader A not allocated to the residual group (which 
is not of a like kind or like class to any property received by U in the 
exchange) for railroad car R (which is not of a like kind or like class 
to any property transferred by U in the exchange).
    (C) U recognizes gain on the exchange as follows:
    (1) With respect to the exchange group, the amount of the gain 
realized is the excess of the aggregate fair market value of real estate 
A and B ($18,500) over the aggregate adjusted basis ($10,000), or $8500. 
The amount of the gain recognized is the lesser of the gain realized 
($8500) and the exchange group deficiency ($0), or $0.
    (2) With respect to the residual group, the amount of gain realized 
and recognized is the excess of the fair market value of the 50 percent 
portion of grader A that is allocated to the residual group ($1000) over 
its adjusted basis ($250), or $750.
    (3) With respect to the taxable exchange of the 50 percent portion 
of grader A not allocated to the residual group for railroad car R, gain 
of $750 is realized and recognized by U (amount realized of $1000 (the 
fair market value of railroad car R) less the adjusted basis of the 50 
percent portion of grader A not allocated to the residual group ($250)).
    (D) The total amount of gain recognized by U in the transaction is 
the sum of the gain recognized under section 1031 with respect to the 
exchange group ($0), any gain recognized with respect to the residual 
group ($750), and any gain recognized with respect to property 
transferred that is not in the exchange group or the residual group 
($750), or $1500.
    (E) The bases of the property received by U in the exchange (real 
estate R and railroad car R) are determined in the following manner:
    (1) The basis of the property received in the exchange group is the 
aggregate adjusted basis of the property transferred within that 
exchange group ($10,000), increased by the amount of gain recognized 
with respect to that exchange group ($0), increased by the amount of the 
exchange group surplus ($1000), and increased by the amount of excess 
liabilities assumed allocated to that exchange group ($7000), or 
$18,000. Because real estate R is the only property received within the 
exchange group, the entire basis of $18,000 is allocated to real estate 
R.
    (2) The basis of railroad car R is equal to its cost of $1000.
    (iii) The tax treatment to V is as follows:
    (A) The exchange group consists of real estate R, real estate A, and 
real estate B.
    (B) Under paragraph (b)(2)(ii) of this section, the liabilities of 
which V is relieved ($7000) results in excess liabilities relieved of 
$7000 and is treated as cash received by V.
    (1) The exchange group has an exchange group deficiency of $8000 
because the fair market value of real estate R ($26,500) exceeds the 
aggregate fair market value of real estate A and B ($18,500) by that 
amount.
    (2) The difference between the aggregate fair market value of the 
properties transferred by V in the exchange group, $26,500, and the 
aggregate fair market value of the properties received by V in the 
exchange group, $18,500, is $8000. Therefore, there is a residual group 
in that amount, consisting of the excess liabilities relieved of $7000, 
which is treated as cash received by V, and $1000 (or 50 percent of the 
fair market value) of grader A.
    (3) The transaction also includes a taxable exchange of railroad car 
R (which is not of a like kind or like class to any property received by 
V in the exchange) for the 50 percent portion of grader A (which is not 
of a like kind or like class to any property transferred by V in the 
exchange) not allocated to the residual group.
    (C) V recognizes gain on the exchange as follows:
    (1) With respect to the exchange group, the amount of the gain 
realized is the excess of the fair market value of real estate R 
($26,500) over its adjusted basis ($20,000), or $6500. The amount of the 
gain recognized is the lesser of the gain realized ($6500) and the 
exchange group deficiency ($8000), or $6500.
    (2) No property transferred by V was allocated to the residual 
group. Therefore, V does not recognize gain or loss with respect to the 
residual group.
    (3) With respect to the taxable exchange of railroad car R for the 
50 percent portion of grader A not allocated to the exchange group or 
the residual group, a loss is realized and recognized in the amount of 
$200 (the excess of the $1200 adjusted basis of railroad car R over the 
amount realized of $1000 (fair market value of the 50 percent portion of 
grader A)).
    (D) The basis of the property received by V in the exchange (real 
estate A, real estate B, and grader A) are determined in the following 
manner:
    (1) The basis of the property received in the exchange group is the 
adjusted basis of the property transferred within that exchange group 
($20,000), increased by the amount of gain recognized with respect to 
that exchange group ($6500), and decreased by the amount of the exchange 
group deficiency ($8000), or $18,500. This $18,500 of basis is allocated 
proportionately among the assets received within the exchange group in 
accordance with their fair market values: real estate A's basis is $5000 
($18,500 x $5000/

[[Page 97]]

$18,500); real estate B's basis is $13,500 ($18,500 x $13,500/$18,500).
    (2) The basis of grader A is $2000.

    (e) Effective date. Section 1.1031 (j)-1 is effective for exchanges 
occurring on or after April 11, 1991.

[T.D. 8343, 56 FR 14855, Apr. 12, 1991, as amended by T.D. 8858, 65 FR 
1237, Jan. 7, 2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.1031(k)-1  Treatment of deferred exchanges.

    (a) Overview. This section provides rules for the application of 
section 1031 and the regulations thereunder in the case of a ``deferred 
exchange.'' For purposes of section 1031 and this section, a deferred 
exchange is defined as an exchange in which, pursuant to an agreement, 
the taxpayer transfers property held for productive use in a trade or 
business or for investment (the ``relinquished property'') and 
subsequently receives property to be held either for productive use in a 
trade or business or for investment (the ``replacement property''). In 
the case of a deferred exchange, if the requirements set forth in 
paragraphs (b), (c), and (d) of this section (relating to identification 
and receipt of replacement property) are not satisfied, the replacement 
property received by the taxpayer will be treated as property which is 
not of a like kind to the relinquished property. In order to constitute 
a deferred exchange, the transaction must be an exchange (i.e., a 
transfer of property for property, as distinguished from a transfer of 
property for money). For example, a sale of property followed by a 
purchase of property of a like kind does not qualify for nonrecognition 
of gain or loss under section 1031 regardless of whether the 
identification and receipt requirements of section 1031(a)(3) and 
paragraphs (b), (c), and (d) of this section are satisfied. The transfer 
of relinquished property in a deferred exchange is not within the 
provisions of section 1031(a) if, as part of the consideration, the 
taxpayer receives money or property which does not meet the requirements 
of section 1031(a), but the transfer, if otherwise qualified, will be 
within the provisions of either section 1031 (b) or (c). See 
Sec. 1.1031(a)-1(a)(2). In addition, in the case of a transfer of 
relinquished property in a deferred exchange, gain or loss may be 
recognized if the taxpayer actually or constructively receives money or 
property which does not meet the requirements of section 1031(a) before 
the taxpayer actually receives like-kind replacement property. If the 
taxpayer actually or constructively receives money or property which 
does not meet the requirements of section 1031(a) in the full amount of 
the consideration for the relinquished property, the transaction will 
constitute a sale, and not a deferred exchange, even though the taxpayer 
may ultimately receive like-kind replacement property. For purposes of 
this section, property which does not meet the requirements of section 
1031(a) (whether by being described in section 1031(a)(2) or otherwise) 
is referred to as ``other property.'' For rules regarding actual and 
constructive receipt, and safe harbors therefrom, see paragraphs (f) and 
(g), respectively, of this section. For rules regarding the 
determination of gain or loss recognized and the basis of property 
received in a deferred exchange, see paragraph (j) of this section.
    (b) Identification and receipt requirements--(1) In general. In the 
case of a deferred exchange, any replacement property received by the 
taxpayer will be treated as property which is not of a like kind to the 
relinquished property if--
    (i) The replacement property is not ``identified'' before the end of 
the ``identification period,'' or
    (ii) The identified replacement property is not received before the 
end of the ``exchange period.''
    (2) Identification period and exchange period. (i) The 
identification period begins on the date the taxpayer transfers the 
relinquished property and ends at midnight on the 45th day thereafter.
    (ii) The exchange period begins on the date the taxpayer transfers 
the relinquished property and ends at midnight on the earlier of the 
180th day thereafter or the due date (including extensions) for the 
taxpayer's return of the tax imposed by chapter 1 of subtitle A of the 
Code for the taxable year in which the transfer of the relinquished 
property occurs.
    (iii) If, as part of the same deferred exchange, the taxpayer 
transfers more

[[Page 98]]

than one relinquished property and the relinquished properties are 
transferred on different dates, the identification period and the 
exchange period are determined by reference to the earliest date on 
which any of the properties are transferred.
    (iv) For purposes of this paragraph (b)(2), property is transferred 
when the property is disposed of within the meaning of section 1001(a).
    (3) Example. This paragraph (b) may be illustrated by the following 
example.

    Example: (i) M is a corporation that files its Federal income tax 
return on a calendar year basis. M and C enter into an agreement for an 
exchange of property that requires M to transfer property X to C. Under 
the agreement, M is to identify like-kind replacement property which C 
is required to purchase and to transfer to M. M transfers property X to 
C on November 16, 1992.
    (ii) The identification period ends at midnight on December 31, 
1992, the day which is 45 days after the date of transfer of property X. 
The exchange period ends at midnight on March 15, 1993, the due date for 
M's Federal income tax return for the taxable year in which M 
transferred property X. However, if M is allowed the automatic six-month 
extension for filing its tax return, the exchange period ends at 
midnight on May 15, 1993, the day which is 180 days after the date of 
transfer of property X.

    (c) Identification of replacement property before the end of the 
identification period--(1) In general. For purposes of paragraph 
(b)(1)(i) of this section (relating to the identification requirement), 
replacement property is identified before the end of the identification 
period only if the requirements of this paragraph (c) are satisfied with 
respect to the replacement property. However, any replacement property 
that is received by the taxpayer before the end of the identification 
period will in all events be treated as identified before the end of the 
identification period.
    (2) Manner of identifying replacement property. Replacement property 
is identified only if it is designated as replacement property in a 
written document signed by the taxpayer and hand delivered, mailed, 
telecopied, or otherwise sent before the end of the identification 
period to either--
    (i) The person obligated to transfer the replacement property to the 
taxpayer (regardless of whether that person is a disqualified person as 
defined in paragraph (k) of this section); or
    (ii) Any other person involved in the exchange other than the 
taxpayer or a disqualified person (as defined in paragraph (k) of this 
section).

Examples of persons involved in the exchange include any of the parties 
to the exchange, an intermediary, an escrow agent, and a title company. 
An identification of replacement property made in a written agreement 
for the exchange of properties signed by all parties thereto before the 
end of the identification period will be treated as satisfying the 
requirements of this paragraph (c)(2).
    (3) Description of replacement property. Replacement property is 
identified only if it is unambiguously described in the written document 
or agreement. Real property generally is unambiguously described if it 
is described by a legal description, street address, or distinguishable 
name (e.g., the Mayfair Apartment Building). Personal property generally 
is unambiguously described if it is described by a specific description 
of the particular type of property. For example, a truck generally is 
unambigously described if it is described by a specific make, model, and 
year.
    (4) Alternative and multiple properties. (i) The taxpayer may 
identify more than one replacement property. Regardless of the number of 
relinguished properties transferred by the taxpayer as part of the same 
deferred exchange, the maximum number of replacement properties that the 
taxpayer may identify is--
    (A) Three properties without regard to the fair market values of the 
properties (the ``3-property rule''), or
    (B) Any number of properties as long as their aggregate fair market 
value as of the end of the identification period does not exceed 200 
percent of the aggregate fair market value of all the relinguished 
properties as of the date the relinguished properties were transferred 
by the taxpayer (the ``200-percent rule'').
    (ii) If, as of the end of the identification period, the taxpayer 
has identified more properties as replacement properties than permitted 
by paragraph (c)(4)(i) of this section, the taxpayer is

[[Page 99]]

treated as if no replacement property had been identified. The preceding 
sentence will not apply, however, and an identification satisfying the 
requirements of paragraph (c)(4)(i) of this section will be considered 
made, with respect to--
    (A) Any replacement property received by the taxpayer before the end 
of the identification period, and
    (B) Any replacement property identified before the end of the 
identification period and received before the end of the exchange 
period, but only if the taxpayer receives before the end of the exchange 
period identified replacement property the fair market vlaue of which is 
at least 95 percent of the aggregate fair market value of all identified 
replacement properties (the ``95-percent rule'').

For this purpose, the fair market value of each identified replacement 
property is determined as of the earlier of the date the property is 
received by the taxpayer or the last day of the exchange period.
    (iii) For purposes of applying the 3-property rule, the 200-percent 
rule, and the 95-percent rule, all identifications of replacement 
property, other than identifications of replacement property that have 
been revoked in the manner provided in paragraph (c)(6) of this section, 
are taken into account. For example, if, in a deferred exchange, B 
transfers property X with a fair market value of $100,000 to C and B 
receives like-kind property Y with a fair market value of $50,000 before 
the end of the identification period, under paragraph (c)(1) of this 
section, property Y is treated as identified by reason of being received 
before the end of the identification period. Thus, under paragraph 
(c)(4)(i) of this section, B may identify either two additional 
replacement properties of any fair market value or any number of 
additional replacement properties as long as the aggregate fair market 
value of the additional replacement properties does not exceed $150,000.
    (5) Incidental property disregarded. (i) Solely for purposes of 
applying this paragraph (c), property that is incidental to a larger 
item of property is not treated as property that is separate from the 
larger item of property. Property is incidental to a larger item of 
property if--
    (A) In standard commercial transactions, the property is typically 
transferred together with the larger item of property, and
    (B) The aggregate fair market value of all of the incidental 
property does not exceed 15 percent of the aggregate fair market value 
of the larger item of property.
    (ii) This paragraph (c)(5) may be illustrated by the following 
examples.

    Example 1. For purposes of paragraph (c) of this section, a spare 
tire and tool kit will not be treated as separate property from a truck 
with a fair market value of $10,000, if the aggregate fair market value 
of the spare tire and tool kit does not exceed $1,500. For purposes of 
the 3-property rule, the truck, spare tire, and tool kit are treated as 
1 property. Moreover, for purposes of paragraph (c)(3) of this section 
(relating to the description of replacement property), the truck, spare 
tire, and tool kit are all considered to be unambiguously described if 
the make, model, and year of the truck are specified, even if no 
reference is made to the spare tire and tool kit.
    Example 2. For purposes of paragraph (c) of this section, furniture, 
laundry machines, and other miscellaneous items of personal property 
will not be treated as separate property from an apartment building with 
a fair market value of $1,000,000, if the aggregate fair market value of 
the furniture, laundry machines, and other personal property does not 
exceed $150,000. For purposes of the 3-property rule, the apartment 
building, furniture, laundry machines, and other personal property are 
treated as 1 property. Moreover, for purposes of paragraph (c)(3) of 
this section (relating to the description of replacement property), the 
apartment building, furniture, laundry machines, and other personal 
property are all considered to be unambiguously described if the legal 
description, street address, or distinguishable name of the apartment 
building is specified, even if no reference is made to the furniture, 
laundry machines, and other personal property.

    (6) Revocation of identification. An identification of replacement 
property may be revoked at any time before the end of the identification 
period. An identification of replacement property is revoked only if the 
revocation is made in a written document signed by the taxpayer and hand 
delivered, mailed, telecopied, or othewise sent before the end of the 
identification period to the person to whom the identification of the 
replacement property was

[[Page 100]]

sent. An identification of replacement property that is made in a 
written agreement for the exchange of properties is treated as revoked 
only if the revocation is made in a written amendment to the agreement 
or in a written document signed by the taxpayer and hand delivered, 
mailed, telecopied, or othewise sent before the end of the 
identification period to all of the parties to the agreement.
    (7) Examples. This paragraph (c) may be illustrated by the following 
examples. Unless otherwise provided in an example, the following facts 
are assumed: B, a calendar year taxpayer, and C agree to enter into a 
deferred exchange. Pursuant to their agreement, B transfers real 
property X to C on May 17, 1991. Real property X, which has been held by 
B for investment, is unencumbered and has a fair market value on May 17, 
1991, of $100,000. On or before July 1, 1991 (the end of the 
identification period), B is to identify replacement property that is of 
a like kind to real property X. On or before November 13, 1991 (the end 
of the exchange period), C is required to purchase the property 
identified by B and to transfer that property to B. To the extent the 
fair market value of the replacement property transferred to B is 
greater or less than the fair market value of real property X, either B 
or C, as applicable, will make up the difference by paying cash to the 
other party after the date the replacement property is received by B. No 
replacement property is identified in the agreement. When subsequently 
identified, the replacement property is described by legal description 
and is of a like kind to real property X (determined without regard to 
section 1031(a)(3) and this section). B intends to hold the replacement 
property received for investment.

    Example 1. (i) On July 2, 1991, B identifies real property E as 
replacement property by designating real property E as replacement 
property in a written document signed by B and personally delivered to 
C.
    (ii) Because the identification was made after the end of the 
identification period, pursuant to paragraph (b)(1)(i) of this section 
(relating to the identification requirement), real property E is treated 
as property which is not of a like kind to real property X.
    Example 2. (i) C is a corporation of which 20 percent of the 
outstanding stock is owned by B. On July 1, 1991, B identifies real 
property F as replacement property by designating real property F as 
replacement property in a written document signed by B and mailed to C.
    (ii) Because C is the person obligated to transfer the replacement 
property to B, real property F is identified before the end of the 
identification period. The fact that C is a ``disqualified person'' as 
defined in paragraph (k) of this section does not change this result.
    (iii) Real property F would also have been treated as identified 
before the end of the identification period if, instead of sending the 
identification to C, B had designated real property F as replacement 
property in a written agreement for the exchange of properties signed by 
all parties thereto on or before July 1, 1991.
    Example 3. (i) On June 3, 1991, B identifies the replacement 
property as ``unimproved land located in Hood County with a fair market 
value not to exceed $100,000.'' The designation is made in a written 
document signed by B and personally delivered to C. On July 8, 1991, B 
and C agree that real property G is the property described in the June 
3, 1991 document.
    (ii) Because real property G was not unambiguously described before 
the end of the identification period, no replacement property is 
identified before the end of the identification period.
    Example 4. (i) On June 28, 1991, B identifies real properties H, J, 
and K as replacement properties by designating these properties as 
replacement properties in a written document signed by B and personally 
delivered to C. The written document provides that by August 1, 1991, B 
will orally inform C which of the identified properties C is to transfer 
to B. As of July 1, 1991, the fair market values of real properties H, 
J, and K are $75,000, $100,000, and $125,000, respectively.
    (ii) Because B did not identify more than three properties as 
replacement properties, the requirements of the 3-property rule are 
satisfied, and real properties H, J, and K are all identified before the 
end of the identification period.
    Example 5. (i) On May 17, 1991, B identifies real properties L, M, 
N, and P as replacement properties by designating these properties as 
replacement properties in a written document signed by B and personally 
delivered to C. The written document provides that by July 2, 1991, B 
will orally inform C which of the identified properties C is to transfer 
to B. As of July 1, 1991, the fair market values of real properties L, 
M, N, and P are $30,000, $40,000, $50,000, and $60,000, respectively.

[[Page 101]]

    (ii) Although B identified more than three properties as replacement 
properties, the aggregate fair market value of the identified properties 
as of the end of the identification period ($180,000) did not exceed 200 
percent of the aggregate fair market value of real property X (200% x 
$100,000 = $200,000). Therefore, the requirements of the 200-percent 
rule are satisfied, and real properties L, M, N, and P are all 
identified before the end of the identification period.
    Example 6. (i) On June 21, 1991, B identifies real properties Q, R, 
and S as replacement properties by designating these properties as 
replacement properties in a written document signed by B and mailed to 
C. On June 24, 1991, B identifies real properties T and U as replacement 
properties in a written document signed by B and mailed to C. On June 
28, 1991, B revokes the identification of real properties Q and R in a 
written document signed by B and personally delivered to C.
    (ii) B has revoked the identification of real properties Q and R in 
the manner provided by paragraph (c)(6) of this section. Identifications 
of replacement property that have been revoked in the manner provided by 
paragraph (c)(6) of this section are not taken into account for purposes 
of applying the 3-property rule. Thus, as of June 28, 1991, B has 
identified only replacement properties S, T, and U for purposes of the 
3-property rule. Because B did not identify more than three properties 
as replacement properties for purposes of the 3-property rule, the 
requirements of that rule are satisfied, and real properties S, T, and U 
are all identified before the end of the identification period.
    Example 7. (i) On May 20, 1991, B identifies real properties V and W 
as replacement properties by designating these properties as replacement 
properties in a written document signed by B and personally delivered to 
C. On June 4, 1991, B identifies real properties Y and Z as replacement 
properties in the same manner. On June 5, 1991, B telephones C and 
orally revokes the identification of real properties V and W. As of July 
1, 1991, the fair market values of real properties V, W, Y, and Z are 
$50,000, $70,000, $90,000, and $100,000, respectively. On July 31, 1991, 
C purchases real property Y and Z and transfers them to B.
    (ii) Pursuant to paragraph (c)(6) of this section (relating to 
revocation of identification), the oral revocation of the identification 
of real properties V and W is invalid. Thus, the identification of real 
properties V and W is taken into account for purposes of determining 
whether the requirements of paragraph (c)(4) of this section (relating 
to the identification of alternative and multiple properties) are 
satisfied. Because B identified more than three properties and the 
aggregate fair market value of the identified properties as of the end 
of the identification period ($310,000) exceeds 200 percent of the fair 
market value of real property X (200% x $100,000 = $200,000), the 
requirements of paragraph (c)(4) of this section are not satisfied, and 
B is treated as if B did not identify any replacement property.

    (d) Receipt of identified replacement property--(1) In general. For 
purposes of paragraph (b)(1)(ii) of this section (relating to the 
receipt requirement), the identified replacement property is received 
before the end of the exchange period only if the requriements of this 
paragraph (d) are satisfied with respect to the replacement property. In 
the case of a deferred exchange, the identified replacement property is 
received before the end of the exchange period if--
    (i) The taxpayer receives the replacement property before the end of 
the exchange period, and
    (ii) The replacement property received is substantially the same 
property as identified.

If the taxpayer has identified more than one replacement property, 
section 1031(a)(3)(B) and this paragraph (d) are applied separately to 
each replacement property.
    (2) Examples. This paragraph (d) may be illustrated by the following 
examples. The following facts are assumed: B, a calendar year taxpayer, 
and C agree to enter into a deferred exchange. Pursuant to their 
agreement, B transfers real property X to C on May 17, 1991. Real 
property X, which has been held by B for investment, is unencumbered and 
has a fair market value on May 17, 1991, of $100,000. On or before July 
1, 1991 (the end of the identification period), B is to identify 
replacement property that is of a like kind to real property X. On or 
before November 13, 1991 (the end of the exchange period), C is required 
to purchase the property identified by B and to transfer that property 
to B. To the extent the fair market value of the replacement property 
transferred to B is greater or less than the fair market value of real 
property X, either B or C, as applicable, will make up the difference by 
paying cash to the other party after the date the replacement property 
is received by B. The replacement property is identified in a manner

[[Page 102]]

that satisfies paragraph (c) of this section (relating to identification 
of replacement property) and is of a like kind to real property X 
(determined without regard to section 1031(a)(3) and this section). B 
intends to hold any replacement property received for investment.

    Example 1. (i) In the agreement, B identifies real properties J, K, 
and L as replacement properties. The agreement provides that by July 26, 
1991, B will orally inform C which of the properties C is to transfer to 
B.
    (ii) As of July 1, 1991, the fair market values of real properties 
J, K, and L are $75,000, $100,000, and $125,000, respectively. On July 
26, 1991, B instructs C to acquire real property K. On October 31, 1991, 
C purchases real property K for $100,000 and transfers the property to 
B.
    (iii) Because real property K was identified before the end of the 
identification period and was received before the end of the exchange 
period, the identification and receipt requirements of section 
1031(a)(3) and this section are satisfied with respect to real property 
K.
    Example 2. (i) In the agreement, B identifies real property P as 
replacement property. Real property P consists of two acres of 
unimproved land. On October 15, 1991, the owner of real property P 
erects a fence on the property. On November 1, 1991, C purchases real 
property P and transfers it to B.
    (ii) The erection of the fence on real property P subsequent to its 
identification did not alter the basic nature or character of real 
property P as unimproved land. B is considered to have received 
substantially the same property as identified.
    Example 3. (i) In the agreement, B identifies real property Q as 
replacement property. Real property Q consists of a barn on two acres of 
land and has a fair market value of $250,000 ($187,500 for the barn and 
underlying land and $87,500 for the remaining land). As of July 26, 
1991, real property Q remains unchanged and has a fair market value of 
$250,000. On that date, at B's direction, C purchases the barn and 
underlying land for $187,500 and transfers it to B, and B pays $87,500 
to C.
    (ii) The barn and underlying land differ in basic nature or 
character from real property Q as a whole, B is not considered to have 
received substantially the same property as identified.
    Example 4. (i) In the agreement, B identifies real property R as 
replacement property. Real property R consists of two acres of 
unimproved land and has a fair market value of $250,000. As of October 
3, 1991, real property R remains unimproved and has a fair market value 
of $250,000. On that date, at B's direction, C purchases 1\1/2\ acres of 
real property R for $187,500 and transfers it to B, and B pays $87,500 
to C.
    (ii) The portion of real property R that B received does not differ 
from the basic nature or character of real property R as a whole. 
Moreover, the fair market value of the portion of real property R that B 
received ($187,500) is 75 percent of the fair market value of real 
property R as of the date of receipt. Accordingly, B is considered to 
have received substantially the same property as identified.

    (e) Special rules for identification and receipt of replacement 
property to be produced--(1) In general. A transfer of relinquished 
property in a deferred exchange will not fail to qualify for 
nonrecognition of gain or loss under section 1031 merely because the 
replacement property is not in existence or is being produced at the 
time the property is identified as replacement property. For purposes of 
this paragraph (e), the terms ``produced'' and ``production'' have the 
same meanings as provided in section 263A(g)(1) and the regulations 
thereunder.
    (2) Identification of replacement property to be produced. (i) In 
the case of replacement property that is to be produced, the replacement 
property must be identified as provided in paragraph (c) of this section 
(relating to identification of replacement property). For example, if 
the identified replacement property consists of improved real property 
where the improvements are to be constructed, the description of the 
replacement property satisfies the requirements of paragraph (c)(3) of 
this section (relating to description of replacement property) if a 
legal description is provided for the underlying land and as much detail 
is provided regarding construction of the improvements as is practicable 
at the time the identification is made.
    (ii) For purposes of paragraphs (c)(4)(i)(B) and (c)(5) of this 
section (relating to the 200-percent rule and incidental property), the 
fair market value of replacement property that is to be produced is its 
estimated fair market value as of the date it is expected to be received 
by the taxpayer.
    (3) Receipt of replacement property to be produced. (i) For purposes 
of paragraph (d)(1)(ii) of this section (relating to receipt of the 
identified replacement property), in determining whether the

[[Page 103]]

replacement property received by the taxpayer is substantially the same 
property as identified where the identified replacement property is 
property to be produced, variations due to usual or typical production 
changes are not taken into account. However, if substantial changes are 
made in the property to be produced, the replacement property received 
will not be considered to be substantially the same property as 
identified.
    (ii) If the identified replacement property is personal property to 
be produced, the replacement property received will not be considered to 
be substantially the same property as identified unless production of 
the replacement property received is completed on or before the date the 
property is received by the taxpayer.
    (iii) If the identified replacement property is real property to be 
produced and the production of the property is not completed on or 
before the date the taxpayer receives the property, the property 
received will be considered to be substantially the same property as 
identified only if, had production been completed on or before the date 
the taxpayer receives the replacement property, the property received 
would have been considered to be substantially the same property as 
identified. Even so, the property received is considered to be 
substantially the same property as identified only to the extent the 
property received constitutes real property under local law.
    (4) Additional rules. The transfer of relinquished property is not 
within the provisions of section 1031(a) if the relinquished property is 
transferred in exchange for services (including production services). 
Thus, any additional production occurring with respect to the 
replacement property after the property is received by the taxpayer will 
not be treated as the receipt of property of a like kind.
    (5) Example. This paragraph (e) may be illustrated by the following 
example.

    Example: (i) B, a calendar year taxpayer, and C agree to enter into 
a deferred exchange. Pursuant to their agreement, B transfers improved 
real property X and personal property Y to C on May 17, 1991. On or 
before November 13, 1991 (the end of the exchange period), C is required 
to transfer to B real property M, on which C is constructing 
improvements, and personal property N, which C is producing. C is 
obligated to complete the improvements and production regardless of when 
properties M and N are transferred to B. Properties M and N are 
identified in a manner that satisfies paragraphs (c) (relating to 
identification of replacement property) and (e)(2) of this section. In 
addition, properties M and N are of a like kind, respectively, to real 
property X and personal property Y (determined without regard to section 
1031(a)(3) and this section). On November 13, 1991, when construction of 
the improvements to property M is 20 percent completed and the 
production of property N is 90 percent completed, C transfers to B 
property M and property N. If construction of the improvements had been 
completed, property M would have been considered to be substantially the 
same property as identified. Under local law, property M constitutes 
real property to the extent of the underlying land and the 20 percent of 
the construction that is completed.
    (ii) Because property N is personal property to be produced and 
production of property N is not completed before the date the property 
is received by B, property N is not considered to be substantially the 
same property as identified and is treated as property which is not of a 
like kind to property Y.
    (iii) Property M is considered to be substantially the same property 
as identified to the extent of the underlying land and the 20 percent of 
the construction that is completed when property M is received by B. 
However, any additional construction performed by C with respect to 
property M after November 13, 1991, is not treated as the receipt of 
property of a like kind.

    (f) Receipt of money or other property--(1) In general. A transfer 
of relinquished property in a deferred exchange is not within the 
provisions of section 1031(a) if, as part of the consideration, the 
taxpayer receives money or other property. However, such a transfer, if 
otherwise qualified, will be within the provisions of either section 
1031 (b) or (c). See Sec. 1.1031(a)-1(a)(2). In addition, in the case of 
a transfer of relinquished property in a deferred exchange, gain or loss 
may be recognized if the taxpayer actually or constructively receives 
money or other property before the taxpayer actually receives like-kind 
replacement property. If the taxpayer actually or constructively 
receives money or other property in the full amount of the consideration 
for the relinquished property before the

[[Page 104]]

taxpayer actually receives like-kind replacement property, the 
transaction will constitute a sale and not a deferred exchange, even 
though the taxpayer may ultimately receive like-kind replacement 
property.
    (2) Actual and constructive receipt. Except as provided in paragraph 
(g) of this section (relating to safe harbors), for purposes of section 
1031 and this section, the determination of whether (or the extent to 
which) the taxpayer is in actual or constructive receipt of money or 
other property before the taxpayer actually receives like-kind 
replacement property is made under the general rules concerning actual 
and constructive receipt and without regard to the taxpayer's method of 
accounting. The taxpayer is in actual receipt of money or property at 
the time the taxpayer actually receives the money or property or 
receives the economic benefit of the money or property. The taxpayer is 
in constructive receipt of money or property at the time the money or 
property is credited to the taxpayer's account, set apart for the 
taxpayer, or otherwise made available so that the taxpayer may draw upon 
it at any time or so that the taxpayer can draw upon it if notice of 
intention to draw is given. Although the taxpayer is not in constructive 
receipt of money or property if the taxpayer's control of its receipt is 
subject to substantial limitations or restrictions, the taxpayer is in 
constructive receipt of the money or property at the time the 
limitations or restrictions lapse, expire, or are waived. In addition, 
actual or constructive receipt of money or property by an agent of the 
taxpayer (determined without regard to paragraph (k) of this section) is 
actual or constructive receipt by the taxpayer.
    (3) Example. This paragraph (f) may be illustrated by the following 
example.

    Example: (i) B, a calendar year taxpayer, and C agree to enter into 
a deferred exchange. Pursuant to the agreement, on May 17, 1991, B 
transfers real property X to C. Real property X, which has been held by 
B for investment, is unencumbered and has a fair market value on May 17, 
1991, of $100,000. On or before July 1, 1991 (the end of the 
identification period), B is to identify replacement property that is of 
a like kind to real property X. On or before November 13, 1991 (the end 
of the exchange period), C is required to purchase the property 
identified by B and to transfer that property to B. At any time after 
May 17, 1991, and before C has purchased the replacement property, B has 
the right, upon notice, to demand that C pay $100,000 in lieu of 
acquiring and transferring the replacement property. Pursuant to the 
agreement, B identifies replacement property, and C purchases the 
replacement property and transfers it to B.
    (ii) Under the agreement, B has the unrestricted right to demand the 
payment of $100,000 as of May 17, 1991. B is therefore in constructive 
receipt of $100,000 on that date. Because B is in constructive receipt 
of money in the full amount of the consideration for the relinquished 
property before B actually receives the like-kind replacement property, 
the transaction constitutes a sale, and the transfer of real property X 
does not qualify for nonrecognition of gain or loss under section 1031. 
B is treated as if B received the $100,000 in consideration for the sale 
of real property X and then purchased the like-kind replacement 
property.
    (iii) If B's right to demand payment of the $100,000 were subject to 
a substantial limitation or restriction (e.g., the agreement provided 
that B had no right to demand payment before November 14, 1991 (the end 
of the exchange period)), then, for purposes of this section, B would 
not be in actual or constructive receipt of the money unless (or until) 
the limitation or restriction lapsed, expired, or was waived.

    (g) Safe harbors--(1) In general. Paragraphs (g)(2) through (g)(5) 
of this section set forth four safe harbors the use of which will result 
in a determination that the taxpayer is not in actual or constructive 
receipt of money or other property for purposes of section 1031 and this 
section. More than one safe harbor can be used in the same deferred 
exchange, but the terms and conditions of each must be separately 
satisfied. For purposes of the safe harbor rules, the term ``taxpayer'' 
does not include a person or entity utilized in a safe harbor (e.g., a 
qualified intermediary). See paragraph (g)(8), Example 3(v), of this 
section.
    (2) Security or guarantee arrangements. (i) In the case of a 
deferred exchange, the determination of whether the taxpayer is in 
actual or constructive receipt of money or other property before the 
taxpayer actually receives like-kind replacement property will be made 
without regard to the fact that

[[Page 105]]

the obligation of the taxpayer's transferee to transfer the replacement 
property to the taxpayer is or may be secured or guaranteed by one or 
more of the following--
    (A) A mortgage, deed of trust, or other security interest in 
property (other than cash or a cash equivalent),
    (B) A standby letter of credit which satisfies all of the 
requirements of Sec. 15A.453-1 (b)(3)(iii) and which may not be drawn 
upon in the absence of a default of the transferee's obligation to 
transfer like-kind replacement property to the taxpayer, or
    (C) A guarantee of a third party.
    (ii) Paragraph (g)(2)(i) of this section ceases to apply at the time 
the taxpayer has an immediate ability or unrestricted right to receive 
money or other property pursuant to the security or guarantee 
arrangement.
    (3) Qualified escrow accounts and qualified trusts. (i) In the case 
of a deferred exchange, the determination of whether the taxpayer is in 
actual or constructive receipt of money or other property before the 
taxpayer actually receives like-kind replacement property will be made 
without regard to the fact that the obligation of the taxpayer's 
transferee to transfer the replacement property to the taxpayer is or 
may be secured by cash or a cash equivalent if the cash or cash 
equivalent is held in a qualified escrow account or in a qualified 
trust.
    (ii) A qualified escrow account is an escrow account wherein--
    (A) The escrow holder is not the taxpayer or a disqualified person 
(as defined in paragraph (k) of this section), and
    (B) The escrow agreement expressly limits the taxpayer's rights to 
receive, pledge, borrow, or otherwise obtain the benefits of the cash or 
cash equivalent held in the escrow account as provided in paragraph 
(g)(6) of this section.
    (iii) A qualified trust is a trust wherein--
    (A) The trustee is not the taxpayer or a disqualified person (as 
defined in paragraph (k) of this section, except that for this purpose 
the relationship between the taxpayer and the trustee created by the 
qualified trust will not be considered a relationship under section 
267(b)), and
    (B) The trust agreement expressly limits the taxpayer's rights to 
receive, pledge, borrow, or otherwise obtain the benefits of the cash or 
cash equivalent held by the trustee as provided in paragraph (g)(6) of 
this section.
    (iv) Paragraph (g)(3)(i) of this section ceases to apply at the time 
the taxpayer has an immediate ability or unrestricted right to receive, 
pledge, borrow, or otherwise obtain the benefits of the cash or cash 
equivalent held in the qualified escrow account or qualified trust. 
Rights conferred upon the taxpayer under state law to terminate or 
dismiss the escrow holder of a qualified escrow account or the trustee 
of a qualified trust are disregarded for this purpose.
    (v) A taxpayer may receive money or other property directly from a 
party to the exchange, but not from a qualified escrow account or a 
qualified trust, without affecting the application of paragraph 
(g)(3)(i) of this section.
    (4) Qualified intermediaries. (i) In the case of a taxpayer's 
transfer of relinquished property involving a qualified intermediary, 
the qualified intermediary is not considered the agent of the taxpayer 
for purposes of section 1031(a). In such a case, the taxpayer's transfer 
of relinquished property and subsequent receipt of like-kind replacement 
property is treated as an exchange, and the determination of whether the 
taxpayer is in actual or constructive receipt of money or other property 
before the taxpayer actually receives like-kind replacement property is 
made as if the qualified intermediary is not the agent of the taxpayer.
    (ii) Paragraph (g)(4)(i) of this section applies only if the 
agreement between the taxpayer and the qualified intermediary expressly 
limits the taxpayer's rights to receive, pledge, borrow, or otherwise 
obtain the benefits of money or other property held by the qualified 
intermediary as provided in paragraph (g)(6) of this section.
    (iii) A qualified intermediary is a person who--
    (A) Is not the taxpayer or a disqualified person (as defined in 
paragraph (k) of this section), and
    (B) Enters into a written agreement with the taxpayer (the 
``exchange

[[Page 106]]

agreement'') and, as required by the exchange agreement, acquires the 
relinquished property from the taxpayer, transfers the relinquished 
property, acquires the replacement property, and transfers the 
replacement property to the taxpayer.
    (iv) Regardless of whether an intermediary acquires and transfers 
property under general tax principals, solely for purposes of paragraph 
(g)(4)(iii)(B) of this section--
    (A) An intermediary is treated as acquiring and transferring 
property if the intermediary acquires and transfers legal title to that 
property,
    (B) An intermediary is treated as acquiring and transferring the 
relinquished property if the intermediary (either on its own behalf or 
as the agent of any party to the transaction) enters into an agreement 
with a person other than the taxpayer for the transfer of the 
relinquished property to that person and, pursuant to that agreement, 
the relinquished property is transferred to that person, and
    (C) An intermediary is treated as acquiring and transferring 
replacement property if the intermediary (either on its own behalf or as 
the agent of any party to the transaction) enters into an agreement with 
the owner of the replacement property for the transfer of that property 
and, pursuant to that agreement, the replacement property is transferred 
to the taxpayer.
    (v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of 
this section, an intermediary is treated as entering into an agreement 
if the rights of a party to the agreement are assigned to the 
intermediary and all parties to that agreement are notified in writing 
of the assignment on or before the date of the relevent transfer of 
property. For example, if a taxpayer enters into an agreement for the 
transfer of relinquished property and thereafter assigns its rights in 
that agreement to an intermediary and all parties to that agreement are 
notified in writing of the assignment on or before the date of the 
transfer of the relinquished property, the intermediary is treated as 
entering into that agreement. If the relinquished property is 
transferred pursuant to that agreement, the intermediary is treated as 
having acquired and transferred the relinquished property.
    (vi) Paragraph (g)(4)(i) of this section ceases to apply at the time 
the taxpayer has an immediate ability or unrestricted right to receive, 
pledge, borrow, or otherwise obtain the benefits of money or other 
property held by the qualified intermediary. Rights conferred upon the 
taxpayer under state law to terminate or dismiss the qualified 
intermediary are disregarded for this purpose.
    (vii) A taxpayer may receive money or other property directly from a 
party to the transaction other than the qualified intermediary without 
affecting the application of paragraph (g)(4)(i) of this section.
    (5) Interest and growth factors. In the case of a deferred exchange, 
the determination of whether the taxpayer is in actual or constructive 
receipt of money or other property before the taxpayer actually receives 
the like-kind replacement property will be made without regard to the 
fact that the taxpayer is or may be entitled to receive any interest or 
growth factor with respect to the deferred exchange. The preceding 
sentence applies only if the agreement pursuant to which the taxpayer is 
or may be entitled to the interest or growth factor expressly limits the 
taxpayer's rights to receive the interest or growth factor as provided 
in paragragh (g)(6) of this section. For additional rules concerning 
interest or growth factors, see paragraph (h) of this section.
    (6) Additional restrictions on safe harbors under paragraphs (g)(3) 
through (g)(5). (i) An agreement limits a taxpayer's rights as provided 
in this paragraph (g)(6) only if the agreement provides that the 
taxpayer has no rights, except as provided in paragraph (g)(6)(ii) and 
(g)(6)(iii) of this section, to receive, pledge, borrow, or otherwise 
obtain the benefits of money or other property before the end of the 
exchange period.
    (ii) The agreement may provide that if the taxpayer has not 
identified replacement property by the end of the identification period, 
the taxpayer may have rights to receive, pledge, borrow, or othewise 
obtain the benefits of money or other property at any time

[[Page 107]]

after the end of the identification period.
    (iii) The agreement may provide that if the taxpayer has identified 
replacement property, the taxpayer may have rights to receive, pledge, 
borrow, or otherwise obtain the benefits of money or other property upon 
or after--
    (A) The receipt by the taxpayer of all of the replacement property 
to which the taxpayer is entitled under the exchange agreement, or
    (B) The occurrence after the end of the identification period of a 
material and substantial contingency that--
    (1) Relates to the deferred exchange,
    (2) Is provided for in writing, and
    (3) Is beyond the control of the taxpayer and of any disqualified 
person (as defined in paragraph (k) of this section), other than the 
person obligated to transfer the replacement property to the taxpayer.
    (7) Items disregarded in applying safe harbors under paragraphs 
(g)(3) through (g)(5). In determining whether a safe harbor under 
paragraphs (g)(3) through (g)(5) of this section ceases to apply and 
whether the taxpayer's rights to receive, pledge, borrow, or otherwise 
obtain the benefits of money or other property are expressly limited as 
provided in paragraph (g)(6) of this section, the taxpayer's receipt of 
or right to receive any of the following items will be disregarded--
    (i) Items that a seller may receive as a consequence of the 
disposition of property and that are not included in the amount realized 
from the disposition of property (e.g., prorated rents), and
    (ii) Transactional items that relate to the disposition of the 
relinquished property or to the acquisition of the replacement property 
and appear under local standards in the typical closing statements as 
the responsibility of a buyer or seller (e.g., commissions, prorated 
taxes, recording or transfer taxes, and title company fees).
    (8) Examples. This paragraph (g) may be illustrated by the following 
examples. Unless otherwise provided in an example, the following facts 
are assumed: B, a calendar year taxpayer, and C agree to enter into a 
deferred exchange. Pursuant to their agreement, B is to transfer real 
property X to C on May 17, 1991. Real property X, which has been held by 
B for investment, is unencumbered and has a fair market value on May 17, 
1991, of $100,000. On or before July 1, 1991 (the end of the 
identification period), B is to identify replacement property that is of 
a like kind to real property X. On or before November 13, 1991 (the end 
of the exchange period), C is required to purchase the property 
identified by B and to transfer that property to B. To the extent the 
fair market value of the replacement property transferred to B is 
greater or less than the fair market value property X, either B or C, as 
applicable, will make up the difference by paying cash to the other 
party after the date the replacement property is received by B. The 
replacement property is identified as provided in paragraph (c) of this 
section (relating to identification of replacement property) and is of a 
like kind to real property X (determined without regard to section 
1031(a)(3) and this section). B intends to hold any replacement property 
received for investment.

    Example 1. (i) On May 17, 1991, B transfers real property X to C. On 
the same day, C pays $10,000 to B and deposits $90,000 in escrow as 
security for C's obligation to perform under the agreement. The escrow 
agreement provides that B has no rights to receive, pledge, borrow, or 
otherwise obtain the benefits of the money in escrow before November 14, 
1991, except that:
    (A) if B fails to identify replacement property on or before July 1, 
1991, B may demand the funds in escrow at any time after July 1, 1991; 
and
    (B) if B identifies and receives replacement property, then B may 
demand the balance of the remaining funds in escrow at any time after B 
has received the replacement property.
    The funds in escrow may be used to purchase the replacement 
property. The escrow holder is not a disqualified person as defined in 
paragraph (k) of this section. Pursuant to the terms of the agreement, B 
identifies replacement property, and C purchases the replacement 
property using the funds in escrow and tranfers the replacement property 
to B.
    (ii) C's obligation to transfer the replacement property to B was 
secured by cash held in a qualified escrow account because the escrow 
holder was not a disqualified person and the escrow agreement expressly 
limited B's rights to receive, pledge, borrow, or otherwise obtain the 
benefits of the money in escrow as provided in paragraph (g)(6) of this

[[Page 108]]

section. In addition, B did not have the immediate ability or 
unrestricted right to receive money or other property in escrow before B 
actually received the like-kind replacement property. Therefore, for 
purposes of section 1031 and this section, B is determined not to be in 
actual or constructive receipt of the $90,000 held in escrow before B 
received the like-kind replacement property. The transfer of real 
property X by B and B's acquisition of the replacement property qualify 
as an exchange under section 1031. See paragraph (j) of this section for 
determining the amount of gain or loss recognized.
    Example 2. (i) On May 17, 1991, B transfers real property X to C, 
and C deposits $100,000 in escrow as security for C's obligation to 
perform under the agreement. Also on May 17, B identifies real property 
J as replacement property. The escrow agreement provides that no funds 
may be paid out without prior written approval of both B and C. The 
escrow agreement also provides that B has no rights to receive, pledge, 
borrow, or otherwise obtain the benefits of the money in escrow before 
November 14, 1991, except that:
    (A) B may demand the funds in escrow at any time after the later of 
July 1, 1991, and the occurrence of any of the following events--
    (1) real property J is destroyed, seized, requisitioned, or 
condemned, or
    (2) a determination is made that the regulatory approval necessary 
for the transfer of real property J cannot be obtained in time for real 
property J to be transferred to B before the end of the exchange period;
    (B) B may demand the funds in escrow at any time after August 14, 
1991, if real property J has not been rezoned from residential to 
commercial use by that date; and
    (C) B may demand the funds in escrow at the time B receives real 
property J or any time thereafter.
    Otherwise, B is entitled to all funds in escrow after November 13, 
1991. The funds in escrow may be used to purchase the replacement 
property. The escrow holder is not a disqualified person as described in 
paragraph (k) of this section. Real property J is not rezoned from 
residential to commercial use on or before August 14, 1991.
    (ii) C's obligation to transfer the replacement property to B was 
secured by cash held in a qualified escrow account because the escrow 
holder was not a disqualified person and the escrow agreement expressly 
limited B's rights to receive, pledge, borrow, or otherwise obtain the 
benefits of the money in escrow as provided in paragraph (g)(6) of this 
section. From May 17, 1991, until August 15, 1991, B did not have the 
immediate ability or unrestricted right to receive money or other 
property before B actually received the like-kind replacement property. 
Therefore, for purposes of section 1031 and this section, B is 
determined not to be in actual or constructive receipt of the $100,000 
in escrow from May 17, 1991, until August 15, 1991. However, on August 
15, 1991, B had the unrestricted right, upon notice, to draw upon the 
$100,000 held in escrow. Thus, the safe harbor ceased to apply and B was 
in constructive receipt of the funds held in escrow. Because B 
constructively received the full amount of the consideration ($100,000) 
before B actually received the like-kind replacement property, the 
transaction is treated as a sale and not as a deferred exchange. The 
result does not change even if B chose not to demand the funds in escrow 
and continued to attempt to have real property J rezoned and to receive 
the property on or before November 13, 1991.
    (iii) If real property J had been rezoned on or before August 14, 
1991, and C had purchased real property J and transferred it to B on or 
before November 13, 1991, the transaction would have qualified for 
nonrecognition of gain or loss under section 1031(a).
    Example 3. (i) On May 1, 1991, D offers to purchase real property X 
for $100,000. However, D is unwilling to participate in a like-kind 
exchange. B thus enters into an exchange agreement with C whereby B 
retains C to facilitate an exchange with respect to real property X. C 
is not a disqualified person as described in paragraph (k) of this 
section. The exchange agreement between B and C provides that B is to 
execute and deliver a deed conveying real property X to C who, in turn, 
is to execute and deliver a deed conveying real property X to D. The 
exchange agreement expressly limits B's rights to receive, pledge, 
borrow, or otherwise obtain the benefits of money or other property held 
by C as provided in paragraph (g)(6) of this section. On May 3, 1991, C 
enters into an agreement with D to transfer real property X to D for 
$100,000. On May 17, 1991, B executes and delivers to C a deed conveying 
real property X to C. On the same date, C executes and delivers to D a 
deed conveying real property X to D, and D deposits $100,000 in escrow. 
The escrow holder is not a disqualified person as defined in paragraph 
(k) of this section and the escrow agreement expressly limits B's rights 
to receive, pledge, borrow, or otherwise obtain the benefits of money or 
other property in escrow as provided in paragraph (g)(6) of this 
section. However, the escrow agreement provides that the money in escrow 
may be used to purchase replacement property. On June 3, 1991, B 
identifies real property K as replacement property. On August 9, 1991, E 
executes and delivers to C a deed conveying real property K to C and 
$80,000 is released from the escrow and paid to E. On the same date, C 
executes and delivers to B a deed conveying real property K to B, and 
the escrow holder pays B $20,000, the balance of the $100,000 sale price 
of real property X remaining after the purchase of real property K for 
$80,000.

[[Page 109]]

    (ii) B and C entered into an exchange agreement that satisfied the 
requirements of paragraph (g)(4)(iii)(B) of this section. Regardless of 
whether C may have acquired and transferred real property X under 
general tax principles, C is treated as having acquired and transferred 
real property X because C acquired and transferred legal title to real 
property X. Similarly, C is treated as having acquired and transferred 
real property K because C acquired and transferred legal title to real 
property K. Thus, C was a qualified intermediary. This result is reached 
for purposes of this section regardless of whether C was B's agent under 
state law.
    (iii) Because the escrow holder was not a disqualified person and 
the escrow agreement expressly limited B's rights to receive, pledge, 
borrow, or otherwise obtain the benefits of money or other property in 
escrow as provided in paragraph (g)(6) of this section, the escrow 
account was a qualified escrow account. For purposes of section 1031 and 
this section, therefore, B is determined not to be in actual or 
constructive receipt of the funds in escrow before B received real 
property K.
    (iv) The exchange agreement between B and C expressly limited B's 
rights to receive, pledge, borrow, or otherwise obtain the benefits of 
any money held by C as provided in paragraph (g)(6) of this section. 
Because C was a qualified intermediary, for purposes of section 1031 and 
this section B is determined not to be in actual or constructive receipt 
of any funds held by C before B received real property K. In addition, 
B's transfer of real property X and acquisition of real property K 
qualify as an exchange under section 1031. See paragraph (j) of this 
section for determining the amount of gain or loss recognized.
    (v) If the escrow agreement had expressly limited C's rights to 
receive, pledge, borrow, or otherwise obtain the benefits of money or 
other property in escrow as provided in paragraph (g)(6) of this 
section, but had not expressly limited B's rights to receive, pledge, 
borrow, or otherwise obtain the benefits of that money or other 
property, the escrow account would not have been a qualified escrow 
account. Consequently, paragraph (g)(3)(i) of this section would not 
have been applicable in determining whether B was in actual or 
constructive receipt of that money or other property before B received 
real property K.
    Example 4. (i) On May 1, 1991, B enters into an agreement to sell 
real property X to D for $100,000 on May 17, 1991. However, D is 
unwilling to participate in a like-kind exchange. B thus enters into an 
exchange agreement with C whereby B retains C to facilitate an exchange 
with respect to real property X. C is not a disqualified person as 
described in paragraph (k) of this section. In the exchange agreement 
between B and C, B assigns to C all of B's rights in the agreement with 
D. The exchange agreement expressly limits B's rights to receive, 
pledge, borrow, or otherwise obtain the benefits of money or other 
property held by C as provided in paragraph (g)(6) of this section. On 
May 17, 1991, B notifies D in writing of the assignment. On the same 
date, B executes and delivers to D a deed conveying real property X to 
D. D pays $10,000 to B and $90,000 to C. On June 1, 1991, B identifies 
real property L as replacement property. On July 5, 1991, B enters into 
an agreement to purchase real property L from E for $90,000, assigns its 
rights in that agreement to C, and notifies E in writing of the 
assignment. On August 9, 1991, C pays $90,000 to E, and E executes and 
delivers to B a deed conveying real property L to B.
    (ii) The exchange agreement entered into by B and C satisfied the 
requirements of paragraph (g)(4)(iii)(B) of this section. Because B's 
rights in its agreements with D and E were assigned to C, and D and E 
were notified in writing of the assignment on or before the transfer of 
real properties X and L, respectively, C is treated as entering into 
those agreements. Because C is treated as entering into an agreement 
with D for the transfer of real property X and, pursuant to that 
agreement, real property X was transferred to D, C is treated as 
acquiring and transferring real property X. Similarly, because C is 
treated as entering into an agreement with E for the transfer of real 
property K and, pursuant to that agreement, real property K was 
transferred to B, C is treated as acquiring and transferring real 
property K. This result is reached for purposes of this section 
regardless of whether C was B's agent under state law and regardless of 
whether C is considered, under general tax principles, to have acquired 
title or beneficial ownership of the properties. Thus, C was a qualified 
intermediary.
    (iii) The exchange agreement between B and C expressly limited B's 
rights to receive, pledge, borrow, or otherwise obtain the benefits of 
the money held by C as provided in paragraph (g)(6) of this section. 
Thus, B did not have the immediate ability or unrestricted right to 
receive money or other property held by C before B received real 
property L. For purposes of section 1031 and this section, therefore, B 
is determined not to be in actual or constructive receipt of the $90,000 
held by C before B received real property L. In addition, the transfer 
of real property X by B and B's acquisition of real property L qualify 
as an exchange under section 1031. See paragraph (j) of this section for 
determining the amount of gain or loss recognized.
    Example 5. (i) On May 1, 1991, B enters into an agreement to sell 
real property X to D for $100,000. However, D is unwilling to 
participate in a like-kind exchange. B thus enters

[[Page 110]]

into an agreement with C whereby B retains C to facilitate an exchange 
with respect to real property X. C is not a disqualified person as 
described in paragraph (k) of this section. The agreement between B and 
C expressly limits B's rights to receive, pledge, borrow, or otherwise 
obtain the benefits of money or other property held by C as provided in 
paragraph (g)(6) of this section. C neither enters into an agreement 
with D to transfer real property X to D nor is assigned B's rights in 
B's agreement to sell real property X to D. On May 17, 1991, B transfers 
real property X to D and instructs D to transfer the $100,000 to C. On 
June 1, 1991, B identifies real property M as replacement property. On 
August 9, 1991, C purchases real property L from E for $100,000, and E 
executes and delivers to C a deed conveying real property M to C. On the 
same date, C executes and delivers to B a deed conveying real property M 
to B.
    (ii) Because B transferred real property X directly to D under B's 
agreement with D, C did not acquire real property X from B and transfer 
real property X to D. Moreover, because C did not acquire legal title to 
real property X, did not enter into an agreement with D to transfer real 
property X to D, and was not assigned B's rights in B's agreement to 
sell real property X to D, C is not treated as acquiring and 
transferring real property X. Thus, C was not a qualified intermediary 
and paragraph (g)(4))(i) of this section does not apply.
    (iii) B did not exchange real property X for real property M. 
Rather, B sold real property X to D and purchased, through C, real 
property M. Therefore, the transfer of real property X does not qualify 
for nonrecognition of gain or loss under section 1031.

    (h) Interest and growth factors--(1) In general. For purposes of 
this section, the taxpayer is treated as being entitled to receive 
interest or a growth factor with respect to a deferred exchange if the 
amount of money or property the taxpayer is entitled to receive depends 
upon the length of time elapsed between transfer of the relinquished 
property and receipt of the replacement property.
    (2) Treatment as interest. If, as part of a deferred exchange, the 
taxpayer receives interest or a growth factor, the interest or growth 
factor will be treated as interest, regardless of whether it is paid to 
the taxpayer in cash or in property (including property of a like kind). 
The taxpayer must include the interest or growth factor in income 
according to the taxpayer's method of accounting.
    (i) [Reserved]
    (j) Determination of gain or loss recognized and the basis of 
property received in a deferred exchange--(1) In general. Except as 
otherwise provided, the amount of gain or loss recognized and the basis 
of property received in a deferred exchange is determined by applying 
the rules of section 1031 and the regulations thereunder. See 
Secs. 1.1031(b)-1, 1.1031(c)-1, 1.1031(d)-1, 1.1031(d)-1T, 1.1031(d)-2, 
and 1.1031(j)-1.
    (2) Coordination with section 453--(i) Qualified escrow accounts and 
qualified trusts. Subject to the limitations of paragraphs (j)(2) (iv) 
and (v) of this section, in the case of a taxpayer's transfer of 
relinquished property in which the obligation of the taxpayer's 
transferee to transfer replacement property to the taxpayer is or may be 
secured by cash or a cash equivalent, the determination of whether the 
taxpayer has received a payment for purposes of section 453 and 
Sec. 15a.453-1(b)(3)(i) of this chapter will be made without regard to 
the fact that the obligation is or may be so secured if the cash or cash 
equivalent is held in a qualified escrow account or a qualified trust. 
This paragraph (j)(2)(i) ceases to apply at the earlier of--
    (A) The time described in paragraph (g)(3)(iv) of this section; or
    (B) The end of the exchange period.
    (ii) Qualified intermediaries. Subject to the limitations of 
paragraphs (j)(2) (iv) and (v) of this section, in the case of a 
taxpayer's transfer of relinquished property involving a qualified 
intermediary, the determination of whether the taxpayer has received a 
payment for purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this 
chapter is made as if the qualified intermediary is not the agent of the 
taxpayer. For purposes of this paragraph (j)(2)(ii), a person who 
otherwise satisfies the definition of a qualified intermediary is 
treated as a qualified intermediary even though that person ultimately 
fails to acquire identified replacement property and transfer it to the 
taxpayer. This paragraph (j)(2)(ii) ceases to apply at the earlier of--
    (A) The time described in paragraph (g)(4)(vi) of this section; or
    (B) The end of the exchange period.

[[Page 111]]

    (iii) Transferee indebtedness. In the case of a transaction 
described in paragraph (j)(2)(ii) of this section, the receipt by the 
taxpayer of an evidence of indebtedness of the transferee of the 
qualified intermediary is treated as the receipt of an evidence of 
indebtedness of the person acquiring property from the taxpayer for 
purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter.
    (iv) Bona fide intent requirement. The provisions of paragraphs 
(j)(2) (i) and (ii) of this section do not apply unless the taxpayer has 
a bona fide intent to enter into a deferred exchange at the beginning of 
the exchange period. A taxpayer will be treated as having a bona fide 
intent only if it is reasonable to believe, based on all the facts and 
circumstances as of the beginning of the exchange period, that like-kind 
replacement property will be acquired before the end of the exchange 
period.
    (v) Disqualified property. The provisions of paragraphs (j)(2) (i) 
and (ii) of this section do not apply if the relinquished property is 
disqualified property. For purposes of this paragraph (j)(2), 
disqualified property means property that is not held for productive use 
in a trade or business or for investment or is property described in 
section 1031(a)(2).
    (vi) Examples. This paragraph (j)(2) may be illustrated by the 
following examples. Unless otherwise provided in an example, the 
following facts are assumed: B is a calendar year taxpayer who agrees to 
enter into a deferred exchange. Pursuant to the agreement, B is to 
transfer real property X. Real property X, which has been held by B for 
investment, is unencumbered and has a fair market value of $100,000 at 
the time of transfer. B's adjusted basis in real property X at that time 
is $60,000. B identifies a single like-kind replacement property before 
the end of the identification period, and B receives the replacement 
property before the end of the exchange period. The transaction 
qualifies as a like-kind exchange under section 1031.

    Example 1. (i) On September 22, 1994, B transfers real property X to 
C and C agrees to acquire like-kind property and deliver it to B. On 
that date B has a bona fide intent to enter into a deferred exchange. 
C's obligation, which is not payable on demand or readily tradable, is 
secured by $100,000 in cash. The $100,000 is deposited by C in an escrow 
account that is a qualified escrow account under paragraph (g)(3) of 
this section. The escrow agreement provides that B has no rights to 
receive, pledge, borrow, or otherwise obtain the benefits of the cash 
deposited in the escrow account until the earlier of the date the 
replacement property is delivered to B or the end of the exchange 
period. On March 11, 1995, C acquires replacement property having a fair 
market value of $80,000 and delivers the replacement property to B. The 
$20,000 in cash remaining in the qualified escrow account is distributed 
to B at that time.
    (ii) Under section 1031(b), B recognizes gain to the extent of the 
$20,000 in cash that B receives in the exchange. Under paragraph 
(j)(2)(i) of this section, the qualified escrow account is disregarded 
for purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter 
in determining whether B is in receipt of payment. Accordingly, B's 
receipt of C's obligation on September 22, 1994, does not constitute a 
payment. Instead, B is treated as receiving payment on March 11, 1995, 
on receipt of the $20,000 in cash from the qualified escrow account. 
Subject to the other requirements of sections 453 and 453A, B may report 
the $20,000 gain in 1995 under the installment method. See section 
453(f)(6) for special rules for determining total contract price and 
gross profit in the case of an exchange described in section 1031(b).
    Example 2. (i) D offers to purchase real property X but is unwilling 
to participate in a like-kind exchange. B thus enters into an exchange 
agreement with C whereby B retains C to facilitate an exchange with 
respect to real property X. On September 22, 1994, pursuant to the 
agreement, B transfers real property X to C who transfers it to D for 
$100,000 in cash. On that date B has a bona fide intent to enter into a 
deferred exchange. C is a qualified intermediary under paragraph (g)(4) 
of this section. The exchange agreement provides that B has no rights to 
receive, pledge, borrow, or otherwise obtain the benefits of the money 
held by C until the earlier of the date the replacement property is 
delivered to B or the end of the exchange period. On March 11, 1995, C 
acquires replacement property having a fair market value of $80,000 and 
delivers it, along with the remaining $20,000 from the transfer of real 
property X to B.
    (ii) Under section 1031(b), B recognizes gain to the extent of the 
$20,000 cash B receives in the exchange. Under paragraph (j)(2)(ii) of 
this section, any agency relationship between B and C is disregarded for 
purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter in 
determining whether B is in receipt of payment. Accordingly, B is not 
treated as having received payment on September 22, 1994, on C's receipt 
of payment

[[Page 112]]

from D for the relinquished property. Instead, B is treated as receiving 
payment on March 11, 1995, on receipt of the $20,000 in cash from C. 
Subject to the other requirements of sections 453 and 453A, B may report 
the $20,000 gain in 1995 under the installment method.
    Example 3. (i) D offers to purchase real property X but is unwilling 
to participate in a like-kind exchange. B enters into an exchange 
agreement with C whereby B retains C as a qualified intermediary to 
facilitate an exchange with respect to real property X. On December 1, 
1994, pursuant to the agreement, B transfers real property X to C who 
transfers it to D for $100,000 in cash. On that date B has a bona fide 
intent to enter into a deferred exchange. The exchange agreement 
provides that B has no rights to receive, pledge, borrow, or otherwise 
obtain the benefits of the cash held by C until the earliest of the end 
of the identification period if B has not identified replacement 
property, the date the replacement property is delivered to B, or the 
end of the exchange period. Although B has a bona fide intent to enter 
into a deferred exchange at the beginning of the exchange period, B does 
not identify or acquire any replacement property. In 1995, at the end of 
the identification period, C delivers the entire $100,000 from the sale 
of real property X to B.
    (ii) Under section 1001, B realizes gain to the extent of the amount 
realized ($100,000) over the adjusted basis in real property X 
($60,000), or $40,000. Because B has a bona fide intent at the beginning 
of the exchange period to enter into a deferred exchange, paragraph 
(j)(2)(iv) of this section does not make paragraph (j)(2)(ii) of this 
section inapplicable even though B fails to acquire replacement 
property. Further, under paragraph (j)(2)(ii) of this section, C is a 
qualified intermediary even though C does not acquire and transfer 
replacement property to B. Thus, any agency relationship between B and C 
is disregarded for purposes of section 453 and Sec. 15a.453-1(b)(3)(i) 
of this chapter in determining whether B is in receipt of payment. 
Accordingly, B is not treated as having received payment on December 1, 
1994, on C's receipt of payment from D for the relinquished property. 
Instead, B is treated as receiving payment at the end of the 
identification period in 1995 on receipt of the $100,000 in cash from C. 
Subject to the other requirements of sections 453 and 453A, B may report 
the $40,000 gain in 1995 under the installment method.
    Example 4. (i) D offers to purchase real property X but is unwilling 
to participate in a like-kind exchange. B thus enters into an exchange 
agreement with C whereby B retains C to facilitate an exchange with 
respect to real property X. C is a qualified intermediary under 
paragraph (g)(4) of this section. On September 22, 1994, pursuant to the 
agreement, B transfers real property X to C who then transfers it to D 
for $80,000 in cash and D's 10-year installment obligation for $20,000. 
On that date B has a bona fide intent to enter into a deferred exchange. 
The exchange agreement provides that B has no rights to receive, pledge, 
borrow, or otherwise obtain the benefits of the money or other property 
held by C until the earlier of the date the replacement property is 
delivered to B or the end of the exchange period. D's obligation bears 
adequate stated interest and is not payable on demand or readily 
tradable. On March 11, 1995, C acquires replacement property having a 
fair market value of $80,000 and delivers it, along with the $20,000 
installment obligation, to B.
    (ii) Under section 1031(b), $20,000 of B's gain (i.e., the amount of 
the installment obligation B receives in the exchange) does not qualify 
for nonrecognition under section 1031(a). Under paragraphs (j)(2) (ii) 
and (iii) of this section, B's receipt of D's obligation is treated as 
the receipt of an obligation of the person acquiring the property for 
purposes of section 453 and Sec. 15a.453-1(b)(3)(i) of this chapter in 
determining whether B is in receipt of payment. Accordingly, B's receipt 
of the obligation is not treated as a payment. Subject to the other 
requirements of sections 453 and 453A, B may report the $20,000 gain 
under the installment method on receiving payments from D on the 
obligation.
    Example 5. (i) B is a corporation that has held real property X to 
expand its manufacturing operations. However, at a meeting in November 
1994, B's directors decide that real property X is not suitable for the 
planned expansion, and authorize a like-kind exchange of this property 
for property that would be suitable for the planned expansion. B enters 
into an exchange agreement with C whereby B retains C as a qualified 
intermediary to facilitate an exchange with respect to real property X. 
On November 28, 1994, pursuant to the agreement, B transfers real 
property X to C, who then transfers it to D for $100,000 in cash. The 
exchange agreement does not include any limitations or conditions that 
make it unreasonable to believe that like-kind replacement property will 
be acquired before the end of the exchange period. The exchange 
agreement provides that B has no rights to receive, pledge, borrow, or 
otherwise obtain the benefits of the cash held by C until the earliest 
of the end of the identification period, if B has not identified 
replacement property, the date the replacement property is delivered to 
B, or the end of the exchange period. In early January 1995, B's 
directors meet and decide that it is not feasible to proceed with the 
planned expansion due to a business downturn reflected in B's 
preliminary financial reports for the last quarter of 1994. Thus, B's 
directors instruct C

[[Page 113]]

to stop seeking replacement property. C delivers the $100,000 cash to B 
on January 12, 1995, at the end of the identification period. Both the 
decision to exchange real property X for other property and the decision 
to cease seeking replacement property because of B's business downturn 
are recorded in the minutes of the directors' meetings. There are no 
other facts or circumstances that would indicate whether, on November 
28, 1994, B had a bona fide intent to enter into a deferred like-kind 
exchange.
    (ii) Under section 1001, B realizes gain to the extent of the amount 
realized ($100,000) over the adjusted basis of real property X 
($60,000), or $40,000. The directors' authorization of a like-kind 
exchange, the terms of the exchange agreement with C, and the absence of 
other relevant facts, indicate that B had a bona fide intent at the 
beginning of the exchange period to enter into a deferred like-kind 
exchange. Thus, paragraph (j)(2)(iv) of this section does not make 
paragraph (j)(2)(ii) of this section inapplicable, even though B fails 
to acquire replacement property. Further, under paragraph (j)(2)(ii) of 
this section, C is a qualified intermediary, even though C does not 
transfer replacement property to B. Thus, any agency relationship 
between B and C is disregarded for purposes of section 453 and 
Sec. 15a.453-1(b)(3)(i) of this chapter in determining whether B is in 
receipt of payment. Accordingly, B is not treated as having received 
payment until January 12, 1995, on receipt of the $100,000 cash from C. 
Subject to the other requirements of sections 453 and 453A, B may report 
the $40,000 gain in 1995 under the installment method.
    Example 6. (i) B has held real property X for use in its trade or 
business, but decides to transfer that property because it is no longer 
suitable for B's planned expansion of its commercial enterprise. B and D 
agree to enter into a deferred exchange. Pursuant to their agreement, B 
transfers real property X to D on September 22, 1994, and D deposits 
$100,000 cash in a qualified escrow account as security for D's 
obligation under the agreement to transfer replacement property to B 
before the end of the exchange period. D's obligation is not payable on 
demand or readily tradable. The agreement provides that B is not 
required to accept any property that is not zoned for commercial use. 
Before the end of the identification period, B identifies real 
properties J, K, and L, all zoned for residential use, as replacement 
properties. Any one of these properties, rezoned for commercial use, 
would be suitable for B's planned expansion. In recent years, the zoning 
board with jurisdiction over properties J, K, and L has rezoned similar 
properties for commercial use. The escrow agreement provides that B has 
no rights to receive, pledge, borrow, or otherwise obtain the benefits 
of the money in the escrow account until the earlier of the time that 
the zoning board determines, after the end of the identification period, 
that it will not rezone the properties for commercial use or the end of 
the exchange period. On January 5, 1995, the zoning board decides that 
none of the properties will be rezoned for commercial use. Pursuant to 
the exchange agreement, B receives the $100,000 cash from the escrow on 
January 5, 1995. There are no other facts or circumstances that would 
indicate whether, on September 22, 1994, B had a bona fide intent to 
enter into a deferred like-kind exchange.
    (ii) Under section 1001, B realizes gain to the extent of the amount 
realized ($100,000) over the adjusted basis of real property X 
($60,000), or $40,000. The terms of the exchange agreement with D, the 
identification of properties J, K, and L, the efforts to have those 
properties rezoned for commercial purposes, and the absence of other 
relevant facts, indicate that B had a bona fide intent at the beginning 
of the exchange period to enter into a deferred exchange. Moreover, the 
limitations imposed in the exchange agreement on acceptable replacement 
property do not make it unreasonable to believe that like-kind 
replacement property would be acquired before the end of the exchange 
period. Therefore, paragraph (j)(2)(iv) of this section does not make 
paragraph (j)(2)(i) of this section inapplicable even though B fails to 
acquire replacement property. Thus, for purposes of section 453 and 
Sec. 15a.453-1(b)(3)(i) of this chapter, the qualified escrow account is 
disregarded in determining whether B is in receipt of payment. 
Accordingly, B is not treated as having received payment on September 
22, 1994, on D's deposit of the $100,000 cash into the qualified escrow 
account. Instead, B is treated as receiving payment on January 5, 1995. 
Subject to the other requirements of sections 453 and 453A, B may report 
the $40,000 gain in 1995 under the installment method.

    (vii) Effective date. This paragraph (j)(2) is effective for 
transfers of property occurring on or after April 20, 1994. Taxpayers 
may apply this paragraph (j)(2) to transfers of property occurring 
before April 20, 1994, but on or after June 10, 1991, if those transfers 
otherwise meet the requirements of Sec. 1.1031(k)-1. In addition, 
taxpayers may apply this paragraph (j)(2) to transfers of property 
occurring before June 10, 1991, but on or after May 16, 1990, if those 
transfers otherwise meet the requirements of Sec. 1.1031(k)-1 or follow 
the guidance of IA-237-84 published in 1990-1, C.B. See 
Sec. 601.601(d)(2)(ii)(b) of this chapter.

[[Page 114]]

    (3) Examples. This paragraph (j) may be illustrated by the following 
examples. Unless otherwise provided in an example, the following facts 
are assumed: B, a calendar year taxpayer, and C agree to enter into a 
deferred exchange. Pursuant to their agreement, B is to transfer real 
property X to C on May 17, 1991. Real property X, which has been held by 
B for investment, is unencumbered and has a fair market value on May 17, 
1991, of $100,000. B's adjusted basis in real property X is $40,000. On 
or before July 1, 1991 (the end of the identification period), B is to 
identify replacement property that is of a like kind to real property X. 
On or before November 13, 1991 (the end of the exchange period), C is 
required to purchase the property identified by B and to transfer that 
property to B. To the extent the fair market value of the replacement 
property transferred to B is greater or less than the fair market value 
of real property X, either B or C, as applicable, will make up the 
difference by paying cash to the other party after the date the 
replacement property is received. The replacement property is identified 
as provided in paragraph (c) of this section and is of a like kind to 
real property X (determined without regard to section 1031(a)(3) and 
this section). B intends to hold any replacement property received for 
investment.

    Example 1. (i) On May 17, 1991, B transfers real property X to C and 
identifies real property R as replacement property. On June 3, 1991, C 
transfers $10,000 to B. On September 4, 1991, C purchases real property 
R for $90,000 and transfers real property R to B.
    (ii) The $10,000 received by B is ``money or other property'' for 
purposes of section 1031 and the regulations thereunder. Under section 
1031(b), B recognizes gain in the amount of $10,000. Under section 
1031(d), B's basis in real property R is $40,000 (i.e., B's basis in 
real property X ($40,000), decreased in the amount of money received 
($10,000), and increased in the amount of gain recognized ($10,000) in 
the deferred exchange).
    Example 2. (i) On May 17, 1991, B transfers real property X to C and 
identifies real property S as replacement property, and C transfers 
$10,000 to B. On September 4, 1991, C purchases real property S for 
$100,000 and transfers real property S to B. On the same day, B 
transfers $10,000 to C.
    (ii) The $10,000 received by B is ``money or other property'' for 
purposes of section 1031 and the regulations thereunder. Under section 
1031(b), B recognizes gain in the amount of $10,000. Under section 
1031(d), B's basis in real property S is $50,000 (i.e., B's basis in 
real property X ($40,000), decreased in the amount of money received 
($10,000), increased in the amount of gain recognized ($10,000), and 
increased in the amount of the additional consideration paid by B 
($10,000) in the deferred exchange).
    Example 3. (i) Under the exchange agreement, B has the right at all 
times to demand $100,000 in cash in lieu of replacement property. On May 
17, 1991, B transfers real property X to C and identifies real property 
T as replacement property. On September 4, 1991, C purchases real 
property T for $100,000 and transfers real property T to B.
    (ii) Because B has the right on May 17, 1991, to demand $100,000 in 
cash in lieu of replacement property, B is in constructive receipt of 
the $100,000 on that date. Thus, the transaction is a sale and not an 
exchange, and the $60,000 gain realized by B in the transaction (i.e., 
$100,000 amount realized less $40,000 adjusted basis) is recognized. 
Under section 1031(d), B's basis in real property T is $100,000.
    Example 4. (i) Under the exchange agreement, B has the right at all 
times to demand up to $30,000 in cash and the balance in replacement 
propertry instead of receiving replacement property in the amount of 
$100,000. On May 17, 1991, B transfers real property X to C and 
identifies real property U as replacement property. On September 4, 
1991, C purchases real property U for $100,000 and transfers real 
property U to B.
    (ii) The transaction qualifies as a deferred exchange under section 
1031 and this section. However, because B had the right on May 17, 1991, 
to demand up to $30,000 in cash, B is in constructive receipt of $30,000 
on that date. Under section 1031(b), B recognizes gain in the amount of 
$30,000. Under section 1031(d), B's basis in real property U is $70,000 
(i.e., B's basis in real property X ($40,000), decreased in the amount 
of money that B received ($30,000), increased in the amount of gain 
recognized ($30,000), and increased in the amount of additional 
consideration paid by B ($30,000) in the deferred exchange).
    Example 5. (i) Assume real property X is encumbered by a mortgage of 
$30,000. On May 17, 1991, B transfers real property X to C and 
identifies real property V as replacement property, and C assumes the 
$30,000 mortgage on real property X. Real property V is encumbered by a 
$20,000 mortgage. On July 5, 1991, C purchases real property V for 
$90,000 by paying $70,000 and assuming the mortgage and transfers real 
property V to B with B assuming the mortgage.
    (ii) The consideration received by B in the form of the liability 
assumed by C ($30,000) is offset by the consideration given by B in the 
form of the liability assumed by B ($20,000). The excess of the 
liability assumed by C over

[[Page 115]]

the liability assumed by B, $10,000, is treated as ``money or other 
property.'' See Sec. 1.1031(b)-1(c). Thus, B recognizes gain under 
section 1031(b) in the amount of $10,000. Under section 1031(d), B's 
basis in real property V is $40,000 (i.e., B's basis in real property X 
($40,000), decreased in the amount of money that B is treated as 
receiving in the form of the liability assumed by C ($30,000), increased 
in the amount of money that B is treated as paying in the form of the 
liability assumed by B ($20,000), and increased in the amount of the 
gain recognized ($10,000) in the deferred exchange).

    (k) Definition of disqualified person. (1) For purposes of this 
section, a disqualified person is a person described in paragraph 
(k)(2), (k)(3), or (k)(4) of this section.
    (2) The person is the agent of the taxpayer at the time of the 
transaction. For this purpose, a person who has acted as the taxpayer's 
employee, attorney, accountant, investment banker or broker, or real 
estate agent or broker within the 2-year period ending on the date of 
the transfer of the first of the relinquished properties is treated as 
an agent of the taxpayer at the time of the transaction. Solely for 
purposes of this paragraph (k)(2), performance of the following services 
will not be taken into account--
    (i) Services for the taxpayer with respect to exchanges of property 
intended to qualify for nonrecognition of gain or loss under section 
1031; and
    (ii) Routine financial, title insurance, escrow, or trust services 
for the taxpayer by a financial institution, title insurance company, or 
escrow company.
    (3) The person and the taxpayer bear a relationship described in 
either section 267(b) or section 707(b) (determined by substituting in 
each section ``10 percent'' for ``50 percent'' each place it appears).
    (4)(i) Except as provided in paragraph (k)(4)(ii) of this section, 
the person and a person described in paragraph (k)(2) of this section 
bear a relationship described in either section 267(b) or 707(b) 
(determined by substituting in each section ``10 percent'' for ``50 
percent'' each place it appears).
    (ii) In the case of a transfer of relinquished property made by a 
taxpayer on or after January 17, 2001, paragraph (k)(4)(i) of this 
section does not apply to a bank (as defined in section 581) or a bank 
affiliate if, but for this paragraph (k)(4)(ii), the bank or bank 
affiliate would be a disqualified person under paragraph (k)(4)(i) of 
this section solely because it is a member of the same controlled group 
(as determined under section 267(f)(1), substituting ``10 percent'' for 
``50 percent' where it appears) as a person that has provided investment 
banking or brokerage services to the taxpayer within the 2-year period 
described in paragraph (k)(2) of this section. For purposes of this 
paragraph (k)(4)(ii), a bank affiliate is a corporation whose principal 
activity is rendering services to facilitate exchanges of property 
intended to qualify for nonrecognition of gain under section 1031 and 
all of whose stock is owned by either a bank or a bank holding company 
(within the meaning of section 2(a) of the Bank Holding Company Act of 
1956 (12 U.S.C. 1841(a)).
    (5) This paragraph (k) may be illustrated by the following examples. 
Unless otherwise provided, the following facts are assumed: On May 1, 
1991, B enters into an exchange agreement (as defined in paragraph 
(g)(4)(iii)(B) of this section) with C whereby B retains C to facilitate 
an exchange with respect to real property X. On May 17, 1991, pursuant 
to the agreement, B executes and delivers to C a deed conveying real 
property X to C. C has no relationship to B described in paragraph 
(k)(2), (k)(3), or (k)(4) of this section.

    Example 1. (i) C is B's accountant and has rendered accounting 
services to B within the 2-year period ending on May 17, 1991, other 
than with respect to exchanges of property intended to qualify for 
nonrecognition of gain or loss under section 1031.
    (ii) C is a disqualified person because C has acted as B's 
accountant within the 2-year period ending on May 17, 1991.
    (iii) If C had not acted as B's accountant within the 2-year period 
ending on May 17, 1991, or if C had acted as B's accountant within that 
period only with respect to exchanges intended to qualify for 
nonrecognition of gain or loss under section 1031, C would not have been 
a disqualified person.
    Example 2. (i) C, which is engaged in the trade or business of 
acting as an intermediary to facilitate deferred exchanges, is a wholly 
owned subsidiary of an escrow company that has performed routine escrow 
services for B in the past. C has previously

[[Page 116]]

been retained by B to act as an intermediary in prior section 1031 
exchanges.
    (ii) C is not a disqualified person notwithstanding the intermediary 
services previously provided by C to B (see paragraph (k)(2)(i) of this 
section) and notwithstanding the combination of C's relationship to the 
escrow company and the escrow services previously provided by the escrow 
company to B (see paragraph (k)(2)(ii) of this section).
    Example 3. (i) C is a corporation that is only engaged in the trade 
or business of acting as an intermediary to facilitate deferred 
exchanges. Each of 10 law firms owns 10 percent of the outstanding stock 
of C. One of the 10 law firms that owns 10 percent of C is M. J is the 
managing partner of M and is the president of C. J, in his capacity as a 
partner in M, has also rendered legal advice to B within the 2-year 
period ending on May 17, 1991, on matters other than exchanges intended 
to qualify for nonrecognition of gain or loss under section 1031.
    (ii) J and M are disqualified persons. C, however, is not a 
disqualified person because neither J nor M own, directly or indirectly, 
more than 10 percent of the stock of C. Similarly, J's participation in 
the management of C does not make C a disqualified person.

    (l) [Reserved]
    (m) Definition of fair market value. For purposes of this section, 
the fair market value of property means the fair market value of the 
property without regard to any liabilities secured by the property.
    (n) No inference with respect to actual or constructive receipt 
rules outside of section 1031. The rules provided in this section 
relating to actual or constructive receipt are intended to be rules for 
determining whether there is actual or constructive receipt in the case 
of a deferred exchange. No inference is intended regarding the 
application of these rules for purposes of determining whether actual or 
constructive receipt exists for any other purpose.
    (o) Effective date. This section applies to transfers of property 
made by a taxpayer on or after June 10, 1991. However, a transfer of 
property made by a taxpayer on or after May 16, 1990, but before June 
10, 1991, will be treated as complying with section 1031 (a)(3) and this 
section if the deferred exchange satisfies either the provision of this 
section or the provisions of the notice of proposed rulemaking published 
in the Federal Register on May 16, 1990 (55 FR 20278).

[T.D. 8346, 56 FR 19938, May 1, 1991, as amended by T.D. 8535, 59 FR 
18749, Apr. 20, 1994; T.D. 8982, 67 FR 4909, Feb. 1, 2002]



Sec. 1.1032-1  Disposition by a corporation of its own capital stock.

    (a) The disposition by a corporation of shares of its own stock 
(including treasury stock) for money or other property does not give 
rise to taxable gain or deductible loss to the corporation regardless of 
the nature of the transaction or the facts and circumstances involved. 
For example, the receipt by a corporation of the subscription price of 
shares of its stock upon their original issuance gives rise to neither 
taxable gain nor deductible loss, whether the subscription or issue 
price be equal to, in excess of, or less than, the par or stated value 
of such stock. Also, the exchange or sale by a corporation of its own 
shares for money or other property does not result in taxable gain or 
deductible loss, even though the corporation deals in such shares as it 
might in the shares of another corporation. A transfer by a corporation 
of shares of its own stock (including treasury stock) as compensation 
for services is considered, for purposes of section 1032(a), as a 
disposition by the corporation of such shares for money or other 
property.
    (b) Section 1032(a) does not apply to the acquisition by a 
corporation of shares of its own stock except where the corporation 
acquires such shares in exchange for shares of its own stock (including 
treasury stock). See paragraph (e) of Sec. 1.311-1, relating to 
treatment of acquisitions of a corporation's own stock. Section 1032(a) 
also does not relate to the tax treatment of the recipient of a 
corporation's stock.
    (c) Where a corporation acquires shares of its own stock in exchange 
for shares of its own stock (including treasury stock) the transaction 
may qualify not only under section 1032(a), but also under section 
368(a)(1)(E) (recapitalization) or section 305(a) (distribution of stock 
and stock rights).
    (d) For basis of property acquired by a corporation in connection 
with a

[[Page 117]]

transaction to which section 351 applies or in connection with a 
reorganization, see section 362. For basis of property acquired by a 
corporation in a transaction to which section 1032 applies but which 
does not qualify under any other nonrecognition provision, see section 
1012.



Sec. 1.1032-2  Disposition by a corporation of stock of a controlling corporation in certain triangular reorganizations.

    (a) Scope. This section provides rules for certain triangular 
reorganizations described in Sec. 1.358-6(b) when the acquiring 
corporation (S) acquires property or stock of another corporation (T) in 
exchange for stock of the corporation (P) in control of S.
    (b) General nonrecognition of gain or loss. For purposes of 
Sec. 1.1032-1(a), in the case of a forward triangular merger, a 
triangular C reorganization, or a triangular B reorganization (as 
described in Sec. 1.358-6(b)), P stock provided by P to S, or directly 
to T or T's shareholders on behalf of S, pursuant to the plan of 
reorganization is treated as a disposition by P of shares of its own 
stock for T's assets or stock, as applicable. For rules governing the 
use of P stock in a reverse triangular merger, see section 361.
    (c) Treatment of S. S must recognize gain or loss on its exchange of 
P stock as consideration in a forward triangular merger, a triangular C 
reorganization, or a triangular B reorganization (as described in 
Sec. 1.358-6(b)), if S did not receive the P stock from P pursuant to 
the plan of reorganization. See Sec. 1.358-6(d) for the effect on P's 
basis in its S or T stock, as applicable. For rules governing S's use of 
P stock in a reverse triangular merger, see section 361.
    (d) Examples. The rules of this section are illustrated by the 
following examples. For purposes of these examples, P, S, and T are 
domestic corporations, P and S do not file consolidated returns, P owns 
all of the only class of S stock, the P stock exchanged in the 
transaction satisfies the requirements of the applicable reorganization 
provisions, and the facts set forth the only corporate activity.

    Example 1. Forward triangular merger solely for P stock. (a) Facts. 
T has assets with an aggregate basis of $60 and fair market value of 
$100 and no liabilities. Pursuant to a plan, P forms S by transferring 
$100 of P stock to S and T merges into S. In the merger, the T 
shareholders receive, in exchange for their T stock, the P stock that P 
transferred to S. The transaction is a reorganization to which sections 
368(a)(1)(A) and (a)(2)(D) apply.
    (b) No gain or loss recognized on the use of P stock. Under 
paragraph (b) of this section, the P stock provided by P pursuant to the 
plan of reorganization is treated for purposes of Sec. 1.1032-1(a) as 
disposed of by P for the T assets acquired by S in the merger. 
Consequently, neither P nor S has taxable gain or deductible loss on the 
exchange.
    Example 2. Forward triangular merger solely for P stock provided in 
part by S. (a) Facts. T has assets with an aggregate basis of $60 and 
fair market value of $100 and no liabilities. S is an operating company 
with substantial assets that has been in existence for several years. S 
also owns P stock with a $20 adjusted basis and $30 fair market value. S 
acquired the P stock in an unrelated transaction several years before 
the reorganization. Pursuant to a plan, P transfers additional P stock 
worth $70 to S and T merges into S. In the merger, the T shareholders 
receive $100 of P stock ($70 of P stock provided by P to S as part of 
the plan and $30 of P stock held by S previously). The transaction is a 
reorganization to which sections 368(a)(1)(A) and (a)(2)(D) apply.
    (b) Gain or loss recognized by S on the use of its P stock. Under 
paragraph (b) of this section, the $70 of P stock provided by P pursuant 
to the plan of reorganization is treated as disposed of by P for the T 
assets acquired by S in the merger. Consequently, neither P nor S has 
taxable gain or deductible loss on the exchange of those shares. Under 
paragraph (c) of this section, however, S recognizes $10 of gain on the 
exchange of its P stock in the reorganization because S did not receive 
the P stock from P pursuant to the plan of reorganization. See 
Sec. 1.358-6(d) for the effect on P's basis in its S stock.

    (e) Stock options. The rules of this section shall apply to an 
option to buy or sell P stock issued by P in the same manner as the 
rules of this section apply to P stock.
    (f) Effective dates. This section applies to triangular 
reorganizations occurring on or after December 23, 1994, except for 
paragraph (e) of this section, which applies to transfers of stock 
options occurring on or after May 16, 2000.

[T.D. 8648, 60 FR 66081, Dec. 21, 1995, as amended by T.D. 8883, 65 FR 
31076, May 16, 2000]

[[Page 118]]



Sec. 1.1032-3  Disposition of stock or stock options in certain transactions not qualifying under any other nonrecognition provision.

    (a) Scope. This section provides rules for certain transactions in 
which a corporation or a partnership (the acquiring entity) acquires 
money or other property (as defined in Sec. 1.1032-1) in exchange, in 
whole or in part, for stock of a corporation (the issuing corporation).
    (b) Nonrecognition of gain or loss--(1) General rule. In a 
transaction to which this section applies, no gain or loss is recognized 
on the disposition of the issuing corporation's stock by the acquiring 
entity. The transaction is treated as if, immediately before the 
acquiring entity disposes of the stock of the issuing corporation, the 
acquiring entity purchased the issuing corporation's stock from the 
issuing corporation for fair market value with cash contributed to the 
acquiring entity by the issuing corporation (or, if necessary, through 
intermediate corporations or partnerships). For rules that may apply in 
determining the issuing corporation's adjustment to basis in the 
acquiring entity (or, if necessary, in determining the adjustment to 
basis in intermediate entities), see sections 358, 722, and the 
regulations thereunder.
    (2) Special rule for actual payment for stock of the issuing 
corporation. If the issuing corporation receives money or other property 
in payment for its stock, the amount of cash deemed contributed under 
paragraph (b)(1) of this section is the difference between the fair 
market value of the issuing corporation stock and the amount of money or 
the fair market value of other property that the issuing corporation 
receives as payment.
    (c) Applicability. The rules of this section apply only if, pursuant 
to a plan to acquire money or other property--
    (1) The acquiring entity acquires stock of the issuing corporation 
directly or indirectly from the issuing corporation in a transaction in 
which, but for this section, the basis of the stock of the issuing 
corporation in the hands of the acquiring entity would be determined, in 
whole or in part, with respect to the issuing corporation's basis in the 
issuing corporation's stock under section 362(a) or 723 (provided that, 
in the case of an indirect acquisition by the acquiring entity, the 
transfers of issuing corporation stock through intermediate entities 
occur immediately after one another);
    (2) The acquiring entity immediately transfers the stock of the 
issuing corporation to acquire money or other property (from a person 
other than an entity from which the stock was directly or indirectly 
acquired);
    (3) The party receiving stock of the issuing corporation in the 
exchange specified in paragraph (c)(2) of this section from the 
acquiring entity does not receive a substituted basis in the stock of 
the issuing corporation within the meaning of section 7701(a)(42); and
    (4) The issuing corporation stock is not exchanged for stock of the 
issuing corporation.
    (d) Stock options. The rules of this section shall apply to an 
option issued by a corporation to buy or sell its own stock in the same 
manner as the rules of this section apply to the stock of an issuing 
corporation.
    (e) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) X, a corporation, owns all of the stock of Y 
corporation. Y reaches an agreement with C, an individual, to acquire a 
truck from C in exchange for 10 shares of X stock with a fair market 
value of $100. To effectuate Y's agreement with C,X transfers to Y the X 
stock in a transaction in which, but for this section, the basis of the 
X stock in the hands of Y would be determined with respect to X's basis 
in the X stock under section 362(a). Y immediately transfers the X stock 
to C to acquire the truck.
    (ii) In this Example 1, no gain or loss is recognized on the 
disposition of the X stock by Y. Immediately before Y's disposition of 
the X stock, Y is treated as purchasing the X stock from X for $100 of 
cash contributed to Y by X. Under section 358, X's basis in its Y stock 
is increased by $100.
    Example 2. (i) Assume the same facts as Example 1, except that, 
rather than X stock, X transfers an option with a fair market value of 
$100 to purchase X stock.
    (ii) In this Example 2, no gain or loss is recognized on the 
disposition of the X stock option by Y. Immediately before Y's 
disposition of the X stock option, Y is treated as purchasing the X 
stock option from X for $100 of cash contributed to Y by X. Under 
section 358, X's basis in its Y stock is increased by $100.

[[Page 119]]

    Example 3. (i) X, a corporation, owns all of the outstanding stock 
of Y corporation. Y is a partner in partnership Z. Z reaches an 
agreement with C, an individual, to acquire a truck from C in exchange 
for 10 shares of X stock with a fair market value of $100. To effectuate 
Z's agreement with C, X transfers to Y the X stock in a transaction in 
which, but for this section, the basis of the X stock in the hands of Y 
would be determined with respect to X's basis in the X stock under 
section 362(a). Y immediately transfers the X stock to Z in a 
transaction in which, but for this section, the basis of the X stock in 
the hands of Z would be determined under section 723. Z immediately 
transfers the X stock to C to acquire the truck.
    (ii) In this Example 3, no gain or loss is recognized on the 
disposition of the X stock by Z. Immediately before Z's disposition of 
the X stock, Z is treated as purchasing the X stock from X for $100 of 
cash indirectly contributed to Z by X through an intermediate 
corporation, Y. Under section 722, Y's basis in its Z partnership 
interest is increased by $100, and, under section 358, X's basis in its 
Y stock is increased by $100.
    Example 4. (i) X, a corporation, owns all of the outstanding stock 
of Y corporation. B, an individual, is an employee of Y. Pursuant to an 
agreement between X and Y to compensate B for services provided to Y, X 
transfers to B 10 shares of X stock with a fair market value of $100. 
Under Sec. 1.83-6(d), but for this section, the transfer of X stock by X 
to B would be treated as a contribution of the X stock by X to the 
capital of Y, and immediately thereafter, a transfer of the X stock by Y 
to B. But for this section, the basis of the X stock in the hands of Y 
would be determined with respect to X's basis in the X stock under 
section 362(a).
    (ii) In this Example 4, no gain or loss is recognized on the deemed 
disposition of the X stock by Y. Immediately before Y's deemed 
disposition of the X stock, Y is treated as purchasing the X stock from 
X for $100 of cash contributed to Y by X. Under section 358, X's basis 
in its Y stock is increased by $100.
    Example 5. (i) X, a corporation, owns all of the outstanding stock 
of Y corporation. B, an individual, is an employee of Y. To compensate B 
for services provided to Y, B is offered the opportunity to purchase 10 
shares of X stock with a fair market value of $100 at a reduced price of 
$80. B transfers $80 and Y transfers $10 to X as partial payment for the 
X stock.
    (ii) In this Example 5, no gain or loss is recognized on the deemed 
disposition of the X stock by Y. Immediately before Y's deemed 
disposition of the X stock, Y is treated as purchasing the X stock from 
X for $100, $80 of which Y is deemed to have received from B, $10 of 
which originated with Y, and $10 of which is deemed to have been 
contributed to Y by X. Under section 358, X's basis in its Y stock is 
increased by $10.
    Example 6. (i) X, a corporation, owns stock of Y. To compensate Y's 
employee, B, for services provided to Y, X issues 10 shares of X stock 
to B, subject to a substantial risk of forfeiture. B does not have an 
election under section 83(b) in effect with respect to the X stock. X 
retains the only reversionary interest in the X stock in the event that 
B forfeits the right to the stock. Several years after X's transfer of 
the X shares, the stock vests. At the time the stock vests, the 10 
shares of X stock have a fair market value of $100. Under Sec. 1.83-
6(d), but for this section, the transfer of the X stock by X to B would 
be treated, at the time the stock vests, as a contribution of the X 
stock by X to the capital of Y, and immediately thereafter, a 
disposition of the X stock by Y to B. The basis of the X stock in the 
hands of Y, but for this section, would be determined with respect to 
X's basis in the X stock under section 362(a).
    (ii) In this Example 6, no gain or loss is recognized on the deemed 
disposition of X stock by Y when the stock vests. Immediately before Y's 
deemed disposition of the X stock, Y is treated as purchasing X's stock 
from X for $100 of cash contributed to Y by X. Under section 358, X's 
basis in its Y stock is increased by $100.
    Example 7. (i) Assume the same facts as in Example 6, except that Y 
(rather than X) retains a reversionary interest in the X stock in the 
event that B forfeits the right to the stock. Several years after X's 
transfer of the X shares, the stock vests.
    (ii) In this Example 7, this section does not apply to Y's deemed 
disposition of the X shares because Y is not deemed to have transferred 
the X stock to B immediately after receiving the stock from X. For the 
tax consequences to Y on the deemed disposition of the X stock, see 
Sec. 1.83-6(b).
    Example 8. (i) X, a corporation, owns all of the outstanding stock 
of Y corporation. In Year 1, X issues to Y's employee, B, a nonstatutory 
stock option to purchase 10 shares of X stock as compensation for 
services provided to Y. The option is exercisable against X and does not 
have a readily ascertainable fair market value (determined under 
Sec. 1.83-7(b)) at the time the option is granted. In Year 2, B 
exercises the option by paying X the strike price of $80 for the X 
stock, which then has a fair market value of $100.
    (ii) In this Example 8, because, under section 83(e)(3), section 
83(a) does not apply to the grant of the option, paragraph (d) of this 
section also does not apply to the grant of the option. Section 83 and 
Sec. 1.1032-3 apply in Year 2 when the option is exercised; thus, no 
gain or loss is recognized on the deemed disposition of X stock by Y in 
Year 2. Immediately before Y's deemed disposition of the X stock in Year 
2, Y is treated as purchasing the X stock from X for $100, $80 of which 
Y

[[Page 120]]

is deemed to have received from B and the remaining $20 of which is 
deemed to have been contributed to Y by X. Under section 358, X's basis 
in its Y stock is increased by $20.
    Example 9. (i) A, an individual, owns a majority of the stock of X. 
X owns stock of Y constituting control of Y within the meaning of 
section 368(c). A transfers 10 shares of its X stock to B, a key 
employee of Y. The fair market value of the 10 shares on the date of 
transfer was $100.
    (ii) In this Example 9, A is treated as making a nondeductible 
contribution of the 10 shares of X to the capital of X, and no gain or 
loss is recognized by A as a result of this transfer. See Commissioner 
v. Fink, 483 U.S. 89 (1987). A must allocate his basis in the 
transferred shares to his remaining shares of X stock. No gain or loss 
is recognized on the deemed disposition of the X stock by Y. Immediately 
before Y's disposition of the X stock, Y is treated as purchasing the X 
stock from X for $100 of cash contributed to Y by X. Under section 358, 
X's basis in its Y stock is increased by $100.
    Example 10. (i) In Year 1, X, a corporation, forms a trust which 
will be used to satisfy deferred compensation obligations owed by Y, X's 
wholly owned subsidiary, to Y's employees. X funds the trust with X 
stock, which would revert to X upon termination of the trust, subject to 
the employees' rights to be paid the deferred compensation due to them. 
The creditors of X can reach all the trust assets upon the insolvency of 
X. Similarly, Y's creditors can reach all the trust assets upon the 
insolvency of Y. In Year 5, the trust transfers X stock to the employees 
of Y in satisfaction of the deferred compensation obligation.
    (ii) In this Example 10, X is considered to be the grantor of the 
trust, and, under section 677, X is also the owner of the trust. Any 
income earned by the trust would be reflected on X's income tax return. 
Y is not considered a grantor or owner of the trust corpus at the time X 
transfers X stock to the trust. In Year 5, when employees of Y receive X 
stock in satisfaction of the deferred compensation obligation, no gain 
or loss is recognized on the deemed disposition of the X stock by Y. 
Immediately before Y's deemed disposition of the X stock, Y is treated 
as purchasing the X stock from X for fair market value using cash 
contributed to Y by X. Under section 358, X's basis in its Y stock 
increases by the amount of cash deemed contributed.

    (f) Effective date. This section applies to transfers of stock or 
stock options of the issuing corporation occurring on or after May 16, 
2000.

[T.D. 8883, 65 FR 31076, May 16, 2000; 65 FR 37482, June 15, 2000]



Sec. 1.1033(a)-1  Involuntary conversions; nonrecognition of gain.

    (a) In general. Section 1033 applies to cases where property is 
compulsorily or involuntarily converted. An involuntary conversion may 
be the result of the destruction of property in whole or in part, the 
theft of property, the seizure of property, the requisition or 
condemnation of property, or the threat or imminence of requisition or 
condemnation of property. An involuntary conversion may be a conversion 
into similar property or into money or into dissimilar property. Section 
1033 provides that, under certain specified circumstances, any gain 
which is realized from an involuntary conversion shall not be 
recognized. In cases where property is converted into other property 
similar or related in service or use to the converted property, no gain 
shall be recognized regardless of when the disposition of the converted 
property occurred and regardless of whether or not the taxpayer elects 
to have the gain not recognized. In other types of involuntary 
conversion cases, however, the proceeds arising from the disposition of 
the converted property must (within the time limits specified) be 
reinvested in similar property in order to avoid recognition of any gain 
realized. Section 1033 applies only with respect to gains; losses from 
involuntary conversions are recognized or not recognized without regard 
to this section.
    (b) Special rules. For rules relating to the application of section 
1033 to involuntary conversions of a principal residence with respect to 
which an election has been made under section 121 (relating to gain from 
sale or exchange of residence of individual who has attained age 65), 
see paragraph (g) of Sec. 1.121-5. For rules applicable to involuntary 
conversions of a principal residence occurring before January 1, 1951, 
see Sec. 1.1033(a)-3. For rules applicable to involuntary conversions of 
a principal residence occurring after December 31, 1950, and before 
January 1, 1954, see paragraph (h)(1) of Sec. 1.1034-1. For rules 
applicable to involuntary conversions of a personal residence occurring 
after December 31, 1953, see Sec. 1.1033(a)-3. For special rules 
relating to the election to have section 1034 apply to certain 
involuntary conversions of a principal

[[Page 121]]

reisdence occurring after December 31, 1957, see paragraph (h)(2) of 
Sec. 1.1034-1. For special rules relating to certain involuntary 
conversions of real property held either for productive use in trade or 
business or for investment and occurring after December 31, 1957, see 
Sec. 1.1033(g)-1. See also special rules applicable to involuntary 
conversions of property sold pursuant to reclamation laws, livestock 
destroyed by disease, and livestock sold on account of drought provided 
in Secs. 1.1033(c)-1, 1.1033(d)-1, and 1.1033(e)-1, respectively. For 
rules relating to basis of property acquired through involuntary 
conversions, see Sec. 1.1033(b)-1. For determination of the period for 
which the taxpayer has held property acquired as a result of certain 
involuntary conversions, see section 1223 and regulations issued 
thereunder. For treatment of gains from involuntary conversions as 
capital gains in certain cases, see section 1231(a) and regulations 
issued thereunder. For portion of war loss recoveries treated as gain on 
involuntary conversion, see section 1332(b)(3) and regulations issued 
thereunder.

(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26 
U.S.C. 7805))

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6856, 30 FR 
13318, Oct. 20, 1965; T.D. 7625, 44 FR 31013, May 30, 1979; T.D. 7758, 
46 FR 6925, Jan. 22, 1981]



Sec. 1.1033(a)-2  Involuntary conversion into similiar property, into money or into dissimilar property.

    (a) In general. The term disposition of the converted property means 
the destruction, theft, seizure, requisition, or condemnation of the 
converted property, or the sale or exchange of such property under 
threat or imminence of requisition or condemnation.
    (b) Conversion into similar property. If property (as a result of 
its destruction in whole or in part, theft, seizure, or requisition or 
condemnation or threat or imminence thereof) is compulsorily or 
involuntarily converted only into property similar or related in service 
or use to the property so converted, no gain shall be recognized. Such 
nonrecognition of gain is mandatory.
    (c) Conversion into money or into dissimilar property. (1) If 
property (as a result of its destruction in whole or in part, theft, 
seizure, or requisition or condemnation or threat or imminence thereof) 
is compulsorily or involuntarily converted into money or into property 
not similar or related in service or use to the converted property, the 
gain, if any, shall be recognized, at the election of the taxpayer, only 
to the extent that the amount realized upon such conversion exceeds the 
cost of other property purchased by the taxpayer which is similar or 
related in service or use to the property so converted, or the cost of 
stock of a corporation owning such other property which is purchased by 
the taxpayer in the acquisition of control of such corporation, if the 
taxpayer purchased such other property, or such stock, for the purpose 
of replacing the property so converted and during the period specified 
in subparagraph (3) of this paragraph. For the purposes of section 1033, 
the term control means the ownership of stock possessing at least 80 
percent of the total combined voting power of all classes of stock 
entitled to vote and at least 80 percent of the total number of shares 
of all other classes of stock of the corporation.
    (2) All of the details in connection with an involuntary conversion 
of property at a gain (including those relating to the replacement of 
the converted property, or a decision not to replace, or the expiration 
of the period for replacement) shall be reported in the return for the 
taxable year or years in which any of such gain is realized. An election 
to have such gain recognized only to the extent provided in subparagraph 
(1) of this paragraph shall be made by including such gain in gross 
income for such year or years only to such extent. If, at the time of 
filing such a return, the period within which the converted property 
must be replaced has expired, or if such an election is not desired, the 
gain should be included in gross income for such year or years in the 
regular manner. A failure to so include such gain in gross income in the 
regular manner shall be deemed to be an election by the taxpayer to have 
such gain recognized only to the extent provided in subparagraph (1) of 
this paragraph even though the details in connection with the conversion 
are not reported in such return.

[[Page 122]]

If, after having made an election under section 1033(a)(2), the 
converted property is not replaced within the required period of time, 
or replacement is made at a cost lower than was anticipated at the time 
of the election, or a decision is made not to replace, the tax liability 
for the year or years for which the election was made shall be 
recomputed. Such recomputation should be in the form of an amended 
return. If a decision is made to make an election under section 
1033(a)(2) after the filing of the return and the payment of the tax for 
the year or years in which any of the gain on an involuntary conversion 
is realized and before the expiration of the period within which the 
converted property must be replaced, a claim for credit or refund for 
such year or years should be filed. If the replacement of the converted 
property occurs in a year or years in which none of the gain on the 
conversion is realized, all of the details in connection with such 
replacement shall be reported in the return for such year or years.
    (3) The period referred to in subparagraphs (1) and (2) of this 
paragraph is the period of time commencing with the date of the 
disposition of the converted property, or the date of the beginning of 
the threat or imminence of requisition or condemnation of the converted 
property, whichever is earlier, and ending 2 years (or, in the case of a 
disposition occurring before December 31, 1969, 1 year) after the close 
of the first taxable year in which any part of the gain upon the 
conversion is realized, or at the close of such later date as may be 
designated pursuant to an application of the taxpayer. Such application 
shall be made prior to the expiration of 2 years (or, in the case of a 
disposition occurring before December 31, 1969, 1 year) after the close 
of the first taxable year in which any part of the gain from the 
conversion is realized, unless the taxpayer can show to the satisfaction 
of the district director--
    (i) Reasonable cause for not having filed the application within the 
required period of time, and
    (ii) The filing of such application was made within a reasonable 
time after the expiration of the required period of time. The 
application shall contain all of the details in connection with the 
involuntary conversion. Such application shall be made to the district 
director for the internal revenue district in which the return is filed 
for the first taxable year in which any of the gain from the involuntary 
conversion is realized. No extension of time shall be granted pursuant 
to such application unless the taxpayer can show reasonable cause for 
not being able to replace the converted property within the required 
period of time.

See section 1033(g)(4) and Sec. 1.1033(g)-1 for the circumstances under 
which, in the case of the conversion of real property held either for 
productive use in trade or business or for investment, the 2-year period 
referred to in this paragraph (c)(3) shall be extended to 3 years.
    (4) Property or stock purchased before the disposition of the 
converted property shall be considered to have been purchased for the 
purpose of replacing the converted property only if such property or 
stock is held by the taxpayer on the date of the disposition of the 
converted property. Property or stock shall be considered to have been 
purchased only if, but for the provisions of section 1033(b), the 
unadjusted basis of such property or stock would be its cost to the 
taxpayer within the meaning of section 1012. If the taxpayers unadjusted 
basis of the replacement property would be determined, in the absence of 
section 1033(b), under any of the exceptions referred to in section 
1012, the unadjusted basis of the property would not be its cost within 
the meaning of section 1012. For example, if property similar or related 
in service or use to the converted property is acquired by gift and its 
basis is determined under section 1015, such property will not qualify 
as a replacement for the converted property.
    (5) If a taxpayer makes an election under section 1033(a)(2), any 
deficiency, for any taxable year in which any part of the gain upon the 
conversion is realized, which is attributable to such gain may be 
assessed at any time before the expiration of three years from the date 
the district director with whom the return for such year has been filed 
is notified by the taxpayer of the replacement of the converted property 
or of an

[[Page 123]]

intention not to replace, or of a failure to replace, within the 
required period, notwithstanding the provisions of section 6212(c) or 
the provisions of any other law or rule of law which would otherwise 
prevent such assessment. If replacement has been made, such notification 
shall contain all of the details in connection with such replacement. 
Such notification should be made in the return for the taxable year or 
years in which the replacement occurs, or the intention not to replace 
is formed, or the period for replacement expires, if this return is 
filed with such district director. If this return is not filed with such 
district director, then such notification shall be made to such district 
director at the time of filing this return. If the taxpayer so desires, 
he may, in either event, also notify such district director before the 
filing of such return.
    (6) If a taxpayer makes an election under section 1033(a)(2) and the 
replacement property or stock was purchased before the beginning of the 
last taxable year in which any part of the gain upon the conversion is 
realized, any deficiency, for any taxable year ending before such last 
taxable year, which is attributable to such election may be assessed at 
any time before the expiration of the period within which a deficiency 
for such last taxable year may be assessed, notwithstanding the 
provisions of section 6212(c) or 6501 or the provisions of any law or 
rule of law which would otherwise prevent such assessment.
    (7) If the taxpayer makes an election under section 1033(a)(2), the 
gain upon the conversion shall be recognized to the extent that the 
amount realized upon such conversion exceeds the cost of the replacement 
property or stock, regardless of whether such amount is realized in one 
or more taxable years.
    (8) The proceeds of a use and occupancy insurance contract, which by 
its terms insured against actual loss sustained of net profits in the 
business, are not proceeds of an involuntary conversion but are income 
in the same manner that the profits for which they are substituted would 
have been.
    (9) There is no investment in property similar in character and 
devoted to a similar use if--
    (i) The proceeds of unimproved real estate, taken upon condemnation 
proceedings, are invested in improved real estate.
    (ii) The proceeds of conversion of real property are applied in 
reduction of indebtedness previously incurred in the purchase or a 
leasehold.
    (iii) The owner of a requisitioned tug uses the proceeds to buy 
barges.
    (10) If, in a condemnation proceeding, the Government retains out of 
the award sufficient funds to satisfy special assessments levied against 
the remaining portion of the plot or parcel of real estate affected for 
benefits accruing in connection with the condemnation, the amount so 
retained shall be deducted from the gross award in determining the 
amount of the net award.
    (11) If, in a condemnation proceeding, the Government retains out of 
the award sufficient funds to satisfy liens (other than liens due to 
special assessments levied against the remaining portion of the plot or 
parcel of real estate affected for benefits accruing in connection with 
the condemnation) and mortgages against the property, and itself pays 
the same, the amount so retained shall not be deducted from the gross 
award in determining the amount of the net award. If, in a condemnation 
proceeding, the Government makes an award to a mortgagee to satisfy a 
mortgage on the condemned property, the amount of such award shall be 
considered as a part of the amount realized upon the conversion 
regardless of whether or not the taxpayer was personally liable for the 
mortgage debt. Thus, if a taxpayer has acquired property worth $100,000 
subject to a $50,000 mortgage (regardless of whether or not he was 
personally liable for the mortgage debt) and, in a condemnation 
proceeding, the Government awards the taxpayer $60,000 and awards the 
mortgagee $50,000 in satisfaction of the mortgage, the entire $110,000 
is considered to be the amount realized by the taxpayer.

[[Page 124]]

    (12) An amount expended for replacement of an asset, in excess of 
the recovery for loss, represents a capital expenditure and is not a 
deductible loss for income tax purposes.

(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26 
U.S.C. 7805)

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6679, 28 FR 
10515, Oct. 1, 1963; T.D. 7075, 35 FR 17996, Nov. 24, 1970; T.D. 7625, 
44 FR 31013, May 30, 1979; T.D. 7758, 46 FR 6925, Jan. 22, 1981]



Sec. 1.1033(a)-3  Involuntary conversion of principal residence.

    Section 1033 shall apply in the case of property used by the 
taxpayer as his principal residence if the destruction, theft, seizure, 
requisition, or condemnation of such residence, or the sale or exchange 
of such residence under threat or imminence thereof, occurs before 
January 1, 1951, or after December 31, 1953. However, section 1033 shall 
not apply to the seizure, requisition, or condemnation (but not 
destruction), or the sale or exchange under threat or imminence thereof, 
of such residence property if the seizure, requisition, condemnation, 
sale, or exchange occurs after December 31, 1957, and if the taxpayer 
properly elects under section 1034(i) to treat the transaction as a sale 
(see paragraph (h)(2)(ii) of Sec. 1.1034-1). See section 121 and 
paragraphs (d) and (g) of Sec. 1.121-5 for special rules relating to the 
involuntary conversion of a principal residence of individuals who have 
attained age 65.

[T.D. 6856, 30 FR 13319, Oct. 20, 1965. Redesignated and amended by T.D. 
7625, 44 FR 31013, May 30, 1979]



Sec. 1.1033(b)-1  Basis of property acquired as a result of an involuntary conversion.

    (a) The provisions of the first sentence of section 1033(b) may be 
illustrated by the following example:

    Example: A's vessel which has an adjusted basis of $100,000 is 
destroyed in 1950 and A receives in 1951 insurance in the amount of 
$200,000. If A invests $150,000 in a new vessel, taxable gain to the 
extent of $50,000 would be recognized. The basis of the new vessel is 
$100,000; that is, the adjusted basis of the old vessel ($100,000) minus 
the money received by the taxpayer which was not expended in the 
acquisition of the new vessel ($50,000) plus the amount of gain 
recognized upon the conversion ($50,000). If any amount in excess of the 
proceeds of the conversion is expended in the acquisition of the new 
property, such amount may be added to the basis otherwise determined.

    (b) The provisions of the last sentence of section 1033(b) may be 
illustrated by the following example:

    Example: A taxpayer realizes $22,000 from the involuntary conversion 
of his barn in 1955; the adjusted basis of the barn to him was $10,000, 
and he spent in the same year $20,000 for a new barn which resulted in 
the nonrecognition of $10,000 of the $12,000 gain on the conversion. The 
basis of the new barn to the taxpayer would be $10,000--the cost of the 
new barn ($20,000) less the amount of the gain not recognized on the 
conversion ($10,000). The basis of the new barn would not be a 
substituted basis in the hands of the taxpayer within the meaning of 
section 1016(b)(2). If the replacement of the converted barn had been 
made by the purchase of two smaller barns which, together, were similar 
or related in service or use to the converted barn and which cost $8,000 
and $12,000, respectively, then the basis of the two barns would be 
$4,000 and $6,000, respectively, the total basis of the purchased 
property ($10,000) allocated in proportion to their respective costs 
(8,000/ 20,000 of $10,000 or $4,000; and 12,000/20,000 of $10,000, or 
$6,000).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960. 
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979]



Sec. 1.1033(c)-1  Disposition of excess property within irrigation project deemed to be involuntary conversion.

    (a) The sale, exchange, or other disposition occurring in a taxable 
year to which the Internal Revenue Code of 1954 applies, of excess lands 
lying within an irrigation project or division in order to conform to 
acreage limitations of the Federal reclamation laws effective with 
respect to such project or division shall be treated as an involuntary 
conversion to which the provisions of section 1033 and the regulations 
thereunder shall be applicable. The term excess lands means irrigable 
lands within an irrigation project or division held by one owner in 
excess of the amount of irrigable land held by such owner entitled to 
receive water under the Federal reclamation laws applicable to such 
owner in such project or division. Such excess lands may be either (1) 
lands receiving no water from

[[Page 125]]

the project or division, or (2) lands receiving water only because the 
owner thereof has executed a valid recordable contract agreeing to sell 
such lands under terms and conditions satisfactory to the Secretary of 
the Interior.
    (b) If a disposition in order to conform to the acreage limitation 
provisions of Federal reclamation laws includes property other than 
excess lands (as, for example, where the excess lands alone do not 
constitute a marketable parcel) the provisions of section 1033(d) shall 
apply only to the part of the disposition that relates to excess lands.
    (c) The provisions of Sec. 1.1033(a)-2 shall be applicable in the 
case of dispositions treated as involuntary conversions under this 
section. The details in connection with such a disposition required to 
be reported under paragraph (c)(2) of Sec. 1.1033(a)-2 shall include the 
authority whereby the lands disposed of are considered excess lands, as 
defined in this section, and a statement that such disposition is not 
part of a plan contemplating the disposition of all or any nonexcess 
land within the irrigation project or division.
    (d) The term involuntary conversion, where it appears in subtitle A 
of the Code or the regulations thereunder, includes dispositions of 
excess property within irrigation projects described in this section. 
(See, e.g., section 1231 and the regulations thereunder.)

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960. 
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979]



Sec. 1.1033(d)-1  Destruction or disposition of livestock because of disease.

    (a) The destruction occurring in a taxable year to which the 
Internal Revenue Code of 1954 applies, of livestock by, or on account 
of, disease, or the sale or exchange, in such a year, of livestock 
because of disease, shall be treated as an involuntary conversion to 
which the provisions of section 1033 and the regulations thereunder 
shall be applicable. Livestock which are killed either because they are 
diseased or because of exposure to disease shall be considered destroyed 
on account of disease. Livestock which are sold or exchanged because 
they are diseased or have been exposed to disease, and would not 
otherwise have been sold or exchanged at that particular time shall be 
considered sold or exchanged because of disease.
    (b) The provisions of Sec. 1.1033(a)-2 shall be applicable in the 
case of a disposition treated as an involuntary conversion under this 
section. The details in connection with such a disposition required to 
be reported under paragraph (c)(2) of Sec. 1.1033(a)-2 shall include a 
recital of the evidence that the livestock were destroyed by or on 
account of disease, or sold or exchanged because of disease.
    (c) The term involuntary conversion, where it appears in subtitle A 
of the Code or the regulations thereunder, includes disposition of 
livestock described in this section. (See, e.g., section 1231 and the 
regulations thereunder.)

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960. 
Redesignated by T.D. 7625, 44 FR 31013, May 30, 1979]



Sec. 1.1033(e)-1  Sale or exchange of livestock solely on account of drought.

    (a) The sale or exchange of livestock (other than poultry) held for 
draft, breeding, or dairy purposes in excess of the number the taxpayer 
would sell or exchange during the taxable year if he followed his usual 
business practices shall be treated as an involuntary conversion to 
which section 1033 and the regulations thereunder are applicable if the 
sale or exchange of such livestock by the taxpayer is solely on account 
of drought. Section 1033(e) and this section shall apply only to sales 
and exchanges occurring after December 31, 1955.
    (b) To qualify under section 1033(e) and this section, the sale or 
exchange of the livestock need not take place in a drought area. While 
it is not necessary that the livestock be held in a drought area, the 
sale or exchange of the livestock must be solely on account of drought 
conditions the existence of which affected the water, grazing, or other 
requirements of the livestock so as to necessitate their sale or 
exchange.
    (c) The total sales or exchanges of livestock held for draft, 
breeding, or dairy purposes occurring in any taxable year which may 
qualify as an involuntary conversion under section

[[Page 126]]

1033(e) and this section is limited to the excess of the total number of 
such livestock sold or exchanged during the taxable year over the number 
that the taxpayer would have sold or exchanged if he had followed his 
usual business practices, that is, the number he would have been 
expected to sell or exchange under ordinary circumstances if there had 
been no drought. For example, if in the past it has been a taxpayer's 
practice to sell or exchange annually one-half of his herd of dairy 
cows, only the number sold or exchanged solely on account of drought 
conditions which is in excess of one-half of his herd, may qualify as an 
involuntary conversion under section 1033(e) and this section.
    (d) The replacement requirements of section 1033 will be satisfied 
only if the livestock sold or exchanged is replaced within the 
prescribed period with livestock which is similar or related in service 
or use to the livestock sold or exchanged because of drought, that is, 
the new livestock must be functionally the same as the livestock 
involuntarily converted. This means that the new livestock must be held 
for the same useful purpose as the old was held. Thus, although dairy 
cows could be replaced by dairy cows, a taxpayer could not replace draft 
animals with breeding or dairy animals.
    (e) The provisions of Sec. 1.1033(a)-2 shall be applicable in the 
case of a sale or exchange treated as an involuntary conversion under 
this section. The details in connection with such a disposition required 
to be reported under paragraph (c)(2) of Sec. 1.1033(a)-2 shall include:
    (1) Evidence of the existence of the drought conditions which forced 
the sale or exchange of the livestock;
    (2) A computation of the amount of gain realized on the sale or 
exchange;
    (3) The number and kind of livestock sold or exchanged; and
    (4) The number of livestocks of each kind that would have been sold 
or exchanged under the usual business practice in the absence of the 
drought.
    (f) The term involuntary conversion, where it appears in subtitle A 
of the Code or the regulations thereunder, includes the sale or exchange 
of livestock described in this section.
    (g) The provisions of section 1033(e) and this section apply to 
taxable years ending after December 31, 1955, but only in the case of 
sales or exchange of livestock after December 31, 1955.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960. 
Redesignated by T.D. 7625, 44 FR 31013, May 30, 1979]



Sec. 1.1033(g)-1  Condemnation of real property held for productive use in trade or business or for investment.

    (a) Special rule in general. This section provides special rules for 
applying section 1033 with respect to certain dispositions, occurring 
after December 31, 1957, of real property held either for productive use 
in trade or business or for investment (not including stock in trade or 
other property held primarily for sale). For this purpose, disposition 
means the seizure, requisition, or condemnation (but not destruction) of 
the converted property, or the sale or exchange of such property under 
threat or imminence of seizure, requisition, or condemnation. In such 
cases, for purposes of applying section 1033, the replacement of such 
property with property of like kind to be held either for productive use 
in trade or business or for investment shall be treated as property 
similar or related in service or use to the property so converted. For 
principles in determining whether the replacement property is property 
of like kind, see paragraph (b) of Sec. 1.1031(a)-1.
    (b) Election to treat outdoor advertising displays as real property-
-(1) In general. Under section 1033(g)(3) of the Code, a taxpayer may 
elect to treat property which constitutes an outdoor advertising display 
as real property for purposes of chapter 1 of the Code. The election is 
available for taxable years beginning after December 31, 1970. In the 
case of an election made on or before July 21, 1981, the election is 
available whether or not the period for filing a claim for credit or 
refund under section 6511 has expired. No election may be made with 
respect to any property for which (i) the investment credit under 
section 38 has been claimed, or (ii) an election to expense certain 
depreciable business assets under section 179(a) is in effect. The 
election once made applies to all outdoor advertising displays of the 
taxpayer which may be made the subject of an election under this 
paragraph, including all outdoor

[[Page 127]]

advertising displays acquired or constructed by the taxpayer in a 
taxable year after the taxable year for which the election is made. The 
election applies with respect to dispositions during the taxable year 
for which made and all subsequent taxable years (unless an effective 
revocation is made pursuant to paragraph (b)(2) (ii) or (iii)).
    (2) Election--(i) Time and manner of making election--(A) In 
general. Unless otherwise provided in the return or in the instructions 
for a return for a taxable year, any election made under section 
1033(g)(3) shall be made by attaching a statement to the return (or 
amended return if filed on or before July 21, 1981) for the first 
taxable year to which the election is to apply. Any election made under 
this paragraph must be made not later than the time, including 
extensions thereof, prescribed by law for filing the income tax return 
for such taxable year or July 21, 1981, whichever occurs last. If a 
taxpayer makes an election (or revokes an election under subdivision 
(ii) or (iii) of this subparagraph (b) (2)) for a taxable year for which 
he or she has previously filed a return, the return for that taxable 
year and all other taxable years affected by the election (or 
revocation) must be amended to reflect any tax consequences of the 
election (or revocation). However, no return for a taxable year for 
which the period for filing a claim for credit or refund under section 
6511 has expired may be amended to make any changes other than those 
resulting from the election (or revocation). In order for the election 
(or revocation) to be effective, the taxpayer must remit with the 
amended return any additional tax due resulting from the election (or 
revocation), notwithstanding the provisions of section 6212(c) or 6501 
or the provisions of any other law which would prevent assessment or 
collection of such tax.
    (B) Statement required when making election. The statement required 
when making the election must clearly indicate that the election to 
treat outdoor advertising displays as real property is being made.
    (ii) Revocation of election by Commissioner's consent. Except as 
otherwise provided in paragraph (b)(2)(iii) of this section, an election 
under section 1033(g)(3) shall be irrevocable unless consent to revoke 
is obtained from the Commissioner. In order to secure the Commissioner's 
consent to revoke an election, the taxpayer must file a request for 
revocation of election with the Commissioner of Internal Revenue, 
Washington, DC 20224. The request for revocation shall include--
    (A) The taxpayer's name, address, and taxpayer identification 
number,
    (B) The date on which and taxable year for which the election was 
made and the Internal Revenue Service office with which it was filed,
    (C) Identification of all outdoor advertising displays of the 
taxpayer to which the revocation would apply (including the location, 
date of purchase, and adjusted basis in such property),
    (D) The effective date desired for the revocation, and
    (E) The reasons for requesting the revocation.

The Commissioner may require such other information as may be necessary 
in order to determine whether the requested revocation will be 
permitted. The Commissioner may prescribe administrative procedures 
(subject to such limitations, terms and conditions as he deems 
necessary) to obtain his consent to permit the taxpayer to revoke the 
election. The taxpayer may submit a request for revocation for any 
taxable year for which the period of limitations for filing a claim for 
credit or refund or overpayment of tax has not expired.
    (iii) Revocation where election was made on or before December 11, 
1979. In the case of an election made on or before December 11, 1979, 
the taxpayer may revoke such election provided such revocation is made 
not later than March 23, 1981. The request for revocation shall be made 
in conformity with the requirements of paragraph (b)(2)(ii), except 
that, in lieu of the information required by paragraph (b)(2)(ii)(E), 
the taxpayer shall state that the revocation is being made pursuant to 
this paragraph. In addition, the taxpayer must forward, with the 
statement of revocation, copies of his or her tax returns, including 
both the original return and any amended returns, for the taxable year 
in which the

[[Page 128]]

original election was made and for all subsequent years and must remit 
any additional tax due as a result of the revocation.
    (3) Definition of outdoor advertising display. The term outdoor 
advertising display means a rigidly assembled sign, display, or device 
that constitutes, or is used to display, a commercial or other 
advertisement to the public and is permanently affixed to the ground or 
permanently atttached to a building or other inherently permanent 
structure. The term includes highway billboards affixed to the ground 
with wood or metal poles, pipes, or beams, with or without concrete 
footings.
    (4) Character of replacement property. For purposes of section 
1033(g), an interest in real property purchased as replacement property 
for a compulsorily or involuntarily converted outdoor advertising 
display (with respect to which an election under this section is in 
effect) shall be considered property of a like kind as the property 
converted even though a taxpayer's interest in the replacement property 
is different from the interest held in the property converted. Thus, for 
example, a fee simple interest in real estate acquired to replace a 
converted billboard and a 5-year leasehold interest in the real property 
on which the billboard was located qualifies as property of a like kind 
under this section.
    (c) Special rule for period within which property must be replaced. 
In the case of a disposition described in paragraph (a) of this section, 
section 1033(a)(2)(B) and Sec. 1.1033(a)-2(c)(3) (relating to the period 
within which the property must be replaced) shall be applied by 
substituting 3 years for 2 years. This paragraph shall apply to any 
disposition described in section 1033(f)(1) and paragraph (a) of this 
section occurring after December 31, 1974, unless a condemnation 
proceeding with respect to the property was begun before October 4, 
1976. Thus, regardless of when the property is disposed of, the taxpayer 
will not be eligible for the 3-year replacement period if a condemnation 
proceeding was begun before October 4, 1976. However, if the property is 
disposed of after December 31, 1974, and the condemnation proceeding was 
begun (if at all) after October 4, 1976, then the taxpayer is eligible 
for the 3-year replacement period. For the purposes of this paragraph, 
whether a condemnation proceeding is considered as having begun is 
determined under the applicable State or Federal procedural law.
    (d) Limitation on application of special rule. This section shall 
not apply to the purchase of stock in the acquisition of control of a 
corporation described in section 1033(a)(2)(A).

(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26 
U.S.C. 7805))

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960. 
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979; 44 FR 
38458, July 2, 1979. Further redesignated and amended by T.D. 7758, 46 
FR 6925, Jan. 22, 1981; T.D. 7758, 46 FR 23235, Apr. 24, 1981; T.D. 
8121, 52 FR 414, Jan. 6, 1987]



Sec. 1.1033(h)-1  Effective date.

    Except as provided otherwise in Sec. 1.1033(e)-1 and Sec. 1.1033(g)-
1, the provisions of section 1033 and the regulations thereunder are 
effective for taxable years beginning after December 31, 1953, and 
ending after August 16, 1954.

(Secs. 1033 (90 Stat. 1920, 26 U.S.C. 1033), and 7805 (68A Stat. 917, 26 
U.S.C. 7805))

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960. 
Redesignated and amended by T.D. 7625, 44 FR 31013, May 30, 1979. 
Further redesignated and amended by T.D. 7758, 46 FR 6925, Jan. 22, 
1981]



Sec. 1.1034-1  Sale or exchange of residence.

    (a) Nonrecognition of gain; general statement. Section 1034 provides 
rules for the nonrecognition of gain in certain cases where a taxpayer 
sells one residence after December 31, 1953, and buys or builds, and 
uses as his principal residence, another residence within specified time 
limits before or after such sale. In general, if the taxpayer invests in 
a new residence an amount at least as large as the adjusted sales price 
of his old residence, no gain is recognized on the sale of the old 
residence (see paragraph (b) of this section for definitions of adjusted 
sales price, new residence, and old residence). On the other hand, if 
the new residence costs the taxpayer less than the adjusted sales price 
of the old residence, gain is recognized to the extent of the 
difference. Thus, if an amount equal to or

[[Page 129]]

greater than the adjusted sales price of an old residence is invested in 
a new residence, according to the rules stated in section 1034, none of 
the gain (if any) realized from the sale shall be recognized. If an 
amount less than such adjusted sales price is so invested, gain shall be 
recognized, but only to the extent provided in section 1034. If there is 
no investment in a new residence, section 1034 is inapplicable and all 
of the gain shall be recognized. Whenever, as a result of the 
application of section 1034, any or all of the gain realized on the sale 
of an old residence is not recognized, a corresponding reduction must be 
made in the basis of the new residence. The provisions of section 1034 
are mandatory, so that the taxpayer cannot elect to have gain recognized 
under circumstances where this section is applicable. Section 1034 
applies only to gains; losses are recognized or not recognized without 
regard to the provisions of this section. Section 1034 affects only the 
amount of gain recognized, and not the amount of gain realized (see also 
section 1001 and the regulations issued thereunder). Any gain realized 
upon disposition of other property in exchange for the new residence is 
not affected by section 1034. For special rules relating to the sale or 
exchange of a principal residence by a taxpayer who has attained age 65, 
see section 121 and paragraph (g) of Sec. 1.121-5. For special rules 
relating to a case where real property with respect to the sale of which 
gain is not recognized under this section is reacquired by the seller in 
partial or full satisfaction of the indebtedness arising from such sale 
and resold by him within 1 year after the date of such reacquisition, 
see Sec. 1.1038-2.
    (b) Definitions. The following definitions of frequently used terms 
are applicable for purposes of section 1034 (other definitions and 
detailed explanations appear in subsequent paragraphs of this 
regulation):
    (1) Old residence means property used by the taxpayer as his 
principal residence which is the subject of a sale by him after December 
31, 1953 (section 1034(a); for detailed explanation see paragraph (c)(3) 
of this section).
    (2) New residence means property used by the taxpayer as his 
principal residence which is the subject of a purchase by him (section 
1034(a); for detailed explanation and limitations see paragraphs (c)(3) 
and (d)(1) of this section).
    (3) Adjusted sales price means the amount realized reduced by the 
fixing-up expenses (section 1034(b)(1); for special rule applicable in 
some cases to husband and wife, see paragraph (f) of this section).
    (4) Amount realized is to be computed by subtracting,
    (i) The amount of the items which, in determining the gain from the 
sale of the old residence, are properly an offset against the 
consideration received upon the sale (such as commissions and expenses 
of advertising the property for sale, of preparing the deed, and of 
other legal services in connection with the sale); from
    (ii) The amount of the consideration so received, determined (in 
accordance with section 1001(b) and regulations issued thereunder) by 
adding to the sum of any money so received, the fair market value of the 
property (other than money) so received. If, as part of the 
consideration for the sale, the purchaser either assumes a liability of 
the taxpayer or acquires the old residence subject to a liability 
(whether or not the taxpayer is personally liable on the debt), such 
assumption or acquisition, in the amount of the liability, shall be 
treated as money received by the taxpayer in computing the amount 
realized.
    (5) Gain realized is the excess (if any) of the amount realized over 
the adjusted basis of the old residence (see also section 1001(a) and 
regulations issued thereunder).
    (6) Fixing-up expenses means the aggregate of the expenses for work 
performed (in any taxable year, whether beginning before, on, or after 
January 1, 1954) on the old residence in order to assist in its sale, 
provided that such expenses (i) are incurred for work performed during 
the 90-day period ending on the day on which the contract to sell the 
old residence is entered into; and (ii) are paid on or before the 30th 
day after the date of the sale of the old residence; and (iii) are 
neither (a) allowable as deductions in computing taxable income under 
section 63(a), nor (b) taken into account in computing

[[Page 130]]

the amount realized from the sale of the old residence (section 1034(b) 
(2) and (3)). Fixing-up expenses does not include expenditures which are 
properly chargeable to capital account and which would, therefore, 
constitute adjustments to the basis of the old residence (see section 
1016 and regulations issued thereunder).
    (7) Cost of purchasing the new residence means the total of all 
amounts which are attributable to the acquisition, construction, 
reconstruction, and improvements constituting capital expenditures, made 
during the period beginning 18 months (one year in the case of a sale of 
an old residence prior to January 1, 1975) before the date of sale of 
the old residence and ending either (i) 18 months (one year in the case 
of a sale of an old residence prior to January 1, 1975) after such date 
in the case of a new residence purchased but not constructed by the 
taxpayer, or (ii) two years (18 months in the case of a sale of an old 
residence prior to January 1, 1975) after such date in the case of a new 
residence the construction of which was commenced by the taxpayer before 
the expiration of 18 months (one year in the case of a sale of an old 
residence prior to January 1, 1975) after such date (section 1034(a), 
(c)(2) and (c)(5); for detailed explanation, see paragraph (c)(4) of 
this section; for special rule applicable in some cases to husband and 
wife, see paragraph (f) of this section; see also paragraph (b)(9) of 
this section for definition of purchase).
    (8) Sale (of a residence) means a sale or an exchange (of a 
residence) for other property which occurs after December 31, 1953, an 
involuntary conversion (of a residence) which occurs after December 31, 
1950, and before January 1, 1954, or certain involuntary conversions 
where the disposition of the property occurs after December 31, 1957, in 
respect of which a proper election is made under section 1034(i)(2) (see 
sections 1034(c)(1), 1034(i)(1)(A), and 1034(i)(2); for detailed 
explanation concerning involuntary conversions, see paragraph (h) of 
this section).
    (9) Purchase (of a residence) means a purchase or an acquisition (of 
a residence) on the exchange of property or the partial or total 
construction or reconstruction (of a residence) by the taxpayer (section 
1034(c) (1) and (2)). However, the mere improvement of a residence, not 
amounting to reconstruction, does not constitute purchase of a 
residence.
    (c) Rules for application of section 1034--(1) General rule; 
limitations on applicability. Gain realized from the sale (after 
December 31, 1953) of an old residence will be recognized only to the 
extent that the taxpayer's adjusted sales price of the old residence 
exceeds the taxpayer's cost of purchasing the new residence, provided 
that the taxpayer either (i) within a period beginning 18 months (one 
year in the case of a sale of an old residence prior to January 1, 1975) 
before the date of such sale and ending 18 months (one year in the case 
of a sale of an old residence prior to January 1, 1975) after such date 
purchases property and uses it as his principal residence, or (ii) 
within a period beginning 18 months (one year in the case of a sale of 
an old residence prior to January 1, 1975) before the date of such sale 
and ending two years (18 months in the case of a sale of an old 
residence prior to January 1, 1975) after such date uses as his 
principal residence a new residence the construction of which was 
commenced by him at any time before the expiration of 18 months (one 
year in the case of a sale of an old residence prior to January 1, 1975) 
after the date of the sale of the old residence (section 1034 (a) and 
(c)(5); for detailed explanation of use as principal residence see 
subparagraph (3) of this paragraph). The rule stated in the preceding 
sentence applies to a new residence purchased by the taxpayer before the 
date of sale of the old residence provided the new residence is still 
owned by him on such date (section 1034(c)(3)). Whether the construction 
of a new residence was commenced by the taxpayer before the expiration 
of 18 months (one year in the case of a sale of an old residence prior 
to January 1, 1975) after the date of the sale of the old residence will 
depend upon the facts and circumstances of each case. Section 1034 is 
not applicable to the sale of a residence if within the previous 18 
months (previous year in the case of a sale of an old residence prior to 
January 1, 1975) the taxpayer made another sale of residential property 
on which gain was realized

[[Page 131]]

but not recognized (section 1034(d)). For further details concerning 
limitations on the application of section 1034, see paragraph (d) of 
this section.
    (2) Computation and examples. In applying the general rule stated in 
subparagraph (1) of this paragraph, the taxpayer should first subtract 
the commissions and other selling expenses from the selling price of his 
old residence, to determine the amount realized. A comparison of the 
amount realized with the cost or other basis of the old residence will 
then indicate whether there is any gain realized on the sale. Unless the 
amount realized is greater than the cost or other basis, no gain is 
realized and section 1034 does not apply. If the amount realized exceeds 
the cost or other basis, the amount of such excess constitutes the gain 
realized. The amount realized should then be reduced by the fixing-up 
expenses (if any), to determined the adjusted sales price. A comparison 
of the adjusted sales price of the old residence with the cost of 
purchasing the new residence will indicate how much (if any) of the 
realized gain is to be recognized. If the cost of purchasing the new 
residence is the same as, or greater than, the adjusted sales price of 
the old residence, then none of the realized gain is to be recognized. 
On the other hand, if the cost of purchasing the new residence is 
smaller than the adjusted sales price of the old residence, the gain 
realized, all of the gain realized is to be recognized to the extent of 
the difference. It should be noted that any amount of gain realized but 
not recognized is to be applied as a downward adjustment to the basis of 
the new residence (for details see paragraph (e) of this section).) The 
application of the general rule stated above may be illustrated by the 
following examples:

    Example 1. A taxpayer decides to sell his residence, which has a 
basis of $17,500. To make it more attractive to buyers, he paints the 
outside at a cost of $300 in April, 1954. He pays for the painting when 
the work is finished. In May, 1954, he sells the house for $20,000. 
Brokers' commissions and other selling expenses are $1,000. In October, 
1954, the taxpayer buys a new residence for $18,000. The amount 
realized, the gain realized, the adjusted sales price, and the gain to 
be recognized are computed as follows:

Selling price.................................................   $20,000
Less: Commissions and other selling expenses..................     1,000
                                                               ---------
Amount realized...............................................    19,000
Less: Basis...................................................    17,500
                                                               ---------
Gain realized.................................................     1,500
                                                               =========
Amount realized...............................................    19,000
Less: Fixing-up expenses......................................       300
                                                               ---------
Adjusted sales price..........................................    18,700
Cost of purchasing new residence..............................    18,000
                                                               ---------
Gain recognized...............................................       700
Gain realized but not recognized..............................       800
Adjusted basis of new residence (see paragraph (e) of this        17,200
 section).....................................................
 

    Example 2. The facts are the same as in example (1), except that the 
selling price of the old residence is $18,500. The computations are as 
follows:

Selling price.................................................   $18,500
Less: Commissions and other selling expenses..................     1,000
                                                               ---------
Amount realized...............................................    17,500
Less: Basis...................................................    17,500
                                                               ---------
Gain realized.................................................         0
 

    Note: Since no gain is realized, section 1034 is inapplicable; it 
is, therefore, unnecessary to compute the adjusted sales price of the 
old residence and compare it with the cost of purchasing the new 
residence. No adjustment to the basis of the new residence is to be 
made.
    Example 3. The facts are the same as in example (1), except that the 
cost of purchasing the new residence is $17,000. The computations are as 
follows:

Selling price.................................................   $20,000
Less: Commissions and other selling expenses..................     1,000
                                                               ---------
Amount realized...............................................    19,000
Less: Basis...................................................    17,500
                                                               ---------
Gain realized.................................................     1,500
                                                               =========
Amount realized...............................................    19,000
Less: Fixing-up expenses......................................       300
                                                               ---------
Adjusted sales price..........................................    18,700
Cost of purchasing the new residence..........................    17,000
                                                               ---------
Gain recognized...............................................     1,500
 

    Note: Since the adjusted sales price of the old residence exceeds 
the cost of purchasing the new residence by $1,700, which is more than 
the gain realized, all of the gain realized is recognized. No adjustment 
to the basis of the new residence is to be made.

Gain realized but not recognized.................................     $0
 

    Example 4. The facts are the same as in example (1), except that the 
fixing-up expenses are $1,100. The computations are as follows:

Selling price.................................................   $20,000
Less: Commissions and other selling expenses..................     1,000
                                                               ---------
Amount realized...............................................    19,000
Less: Basis...................................................    17,500
                                                               ---------

[[Page 132]]

 
Gain realized.................................................     1,500
                                                               =========
Amount realized...............................................    19,000
Less: Fixing-up expenses......................................     1,100
                                                               ---------
Adjusted sales price..........................................    17,900
Cost of purchasing the new residence..........................    18,000
                                                               ---------
Gain recognized...............................................         0
 

    Note: Since the cost of purchasing the new residence exceeds the 
adjusted sales price, none of the gain realized is recognized.

Gain realized but not recognized....................              $1,500
                                                     -------------------
Adjusted basis of new residence (see paragraph (e)                16,500
 of this section)...................................
 

    (3) Property used by the taxpayer as his principal residence. (i) 
Whether or not property is used by the taxpayer as his residence, and 
whether or not property is used by the taxpayer as his principal 
residence (in the case of a taxpayer using more than one property as a 
residence), depends upon all the facts and circumstances in each case, 
including the good faith of the taxpayer. The mere fact that property 
is, or has been, rented is not determinative that such property is not 
used by the taxpayer as his principal residence. For example, if the 
taxpayer purchases his new residence before he sells his old residence, 
the fact that he temporarily rents out the new residence during the 
period before he vacates the old residence may not, in the light of all 
the facts and circumstances in the case, prevent the new residence from 
being considered as property used by the taxpayer as his principal 
residence. Property used by the taxpayer as his principal residence may 
include a houseboat, a house trailer, or stock held by a tenant-
stockholder in a cooperative housing corporation (as those terms are 
defined in section 216(b) (1) and (2)), if the dwelling which the 
taxpayer is entitled to occupy as such stockholder is used by him as his 
principal residence (section 1034(f)). Property used by the taxpayer as 
his principal residence does not include personal property such as a 
piece of furniture, a radio, etc., which, in accordance with the 
applicable local law, is not a fixture.
    (ii) Where part of a property is used by the taxpayer as his 
principal residence and part is used for other purposes, an allocation 
must be made to determine the application of this section. If the old 
residence is used only partially for residential purposes, only that 
part of the gain allocable to the residential portion is not to be 
recognized under this section and only an amount allocable to the 
selling price of such portion need be invested in the new residence in 
order to have the gain allocable to such portion not recognized under 
this section. If the new residence is used only partially for 
residential purposes only so much of its cost as is allocable to the 
residential portion may be counted as the cost of purchasing the new 
residence.
    (4) Cost of purchasing new residence. (i) The taxpayer's cost of 
purchasing the new residence includes not only cash but also any 
indebtedness to which the property purchased is subject at the time of 
purchase whether or not assumed by the taxpayer (including purchase-
money mortgages, etc.) and the face amount of any liabilities of the 
taxpayer which are part of the consideration for the purchase. 
Commissions and other purchasing expenses paid or incurred by the 
taxpayer on the purchase of the new residence are to be included in 
determining such cost. In the case of an acquisition of a residence upon 
an exchange which is considered as a purchase under this section, the 
fair market value of the new residence on the date of the exchange shall 
be considered as the taxpayer's cost of purchasing the new residence. 
Where any part of the new residence is acquired by the taxpayer other 
than by purchase, the value of such part is not to be included in 
determining the taxpayer's cost of the new residence (see paragraph 
(b)(9) of this section for definition of purchase). For example, if the 
taxpayer acquires a residence by gift or inheritance, and spends $20,000 
in reconstructing such residence, only such $20,000 may be treated as 
his cost of purchasing the new residence.
    (ii) The taxpayer's cost of purchasing the new residence includes 
only so much of such cost as is attributable to acquisition, 
construction, reconstruction, or improvements made within the period of 
three years or 42 months (two years or 30 months in the case of a sale 
of an old residence prior to January 1, 1975), as the case may be, in 
which the purchase and use of the new residence must be made in order to 
have gain on

[[Page 133]]

the sale of the old residence not recognized under this section. Thus, 
if the construction of the new residence is begun three years before the 
date of sale of the old residence and completed on the date of sale of 
the old residence, only that portion of the cost which is attributable 
to the last 18 months (last year in the case of a sale of an old 
residence prior to January 1, 1975) of such construction constitutes the 
taxpayer's cost of purchasing the new residence, for purposes of section 
1034. Furthermore, the taxpayer's cost of purchasing the new residence 
includes only such amounts as are properly chargeable to capital account 
rather than to current expense. As to what constitutes capital 
expenditures, see section 263.
    (iii) The provisions of this subparagraph may be illustrated by the 
following example:

    Example: M began the construction of a new residence on January 15, 
1974, and completed it on October 14, 1974. The cost of $45,000 was 
incurred ratably over the 9-month period of construction. On December 
14, 1975, M sold his old residence and realized a gain. In determining 
the extent to which the realized gain is not to be recognized under 
section 1034, M's cost of constructing the new residence shall include 
only the $20,000 which was attributable to the June 15--October 14, 
1974, period (4 months at $5,000). The $25,000 balance of the cost of 
constructing the new residence was not attributable to the period 
beginning 18 months before the date of the sale of the old residence and 
ending two years after such date and, under section 1034, is not 
properly a part of M's cost of constructing the new residence.

    (d) Limitations on application of section 1034. (1) If a residence 
is purchased by the taxpayer prior to the date of the sale of the old 
residence, the purchased residence shall, in no event, be treated as a 
new residence if such purchased residence is sold or otherwise disposed 
of by him prior to the date of the sale of the old residence (section 
1034(c)(3)). And, if the taxpayer, during the period within which the 
purchase and use of the new residence must be made in order to have any 
gain on the sale of the old residence not recognized under this section, 
purchases more than one property which is used by him as his principal 
residence during the 18 months (or two years in the case of the 
construction of the new residence) succeeding the date of the sale of 
the old residence, only the last of such properties shall be considered 
a new residence (section 1034(c)(4)). In the case of a sale of an old 
residence prior to January 1, 1975, the period of 18 months (or two 
years) referred to in the preceding sentence shall be one year (or 18 
months). If within 18 months (one year in the case of a sale of an old 
residence prior to January 1, 1975) before the date of the sale of the 
old residence, the taxpayer sold other property used by him as his 
principal residence at a gain, and any part of such gain was not 
recognized under this section or section 112(n) of the Internal Revenue 
Code of 1939, this section shall not apply with respect to the sale of 
the old residence (section 1034(d)).
    (2) The following example will illustrate the rules of subparagraph 
(1) of this paragraph:

    Example: A taxpayer sells his old residence on January 15, 1954, and 
purchases another residence on February 15, 1954. On March 15, 1954, he 
sells the residence which he bought on February 15, 1954, and purchases 
another residence on April 15, 1954. The gain on the sale of the old 
residence on January 15, 1954, will not be recognized except to the 
extent to which the taxpayer's adjusted sales price of the old residence 
exceeds the cost of purchasing the residence which he purchased on April 
15, 1954. Gain on the sale of the residence which was bought on February 
15, 1954, and sold on March 15, 1954, will be recognized.

    (e) Basis of new residence. (1) Where the purchase of a new 
residence results, under this section, in the nonrecognition of any part 
of the gain realized upon the sale of an old residence, then, in 
determining the adjusted basis of the new residence as of any time 
following the sale of the old residence, the adjustments to basis shall 
include a reduction by an amount equal to the amount of the gain which 
was not recognized upon the sale of the old residence (section 1034(e); 
for special rule applicable in some cases to husband and wife, see 
paragraph (f) of this section). Such a reduction is not to be made for 
the purpose of determining the adjusted basis of the new residence as of 
any time preceding the sale of the old residence. For the purpose of 
this determination, the amount of the gain not recognized under this 
section upon

[[Page 134]]

the sale of the old residence includes only so much of the gain as is 
not recognized because of the taxpayer's cost, up to the date of the 
determination of the adjusted basis, of purchasing the new residence.
    (2) The following example will illustrate the rule of subparagraph 
(1) of this paragraph:

    Example: On January 1, 1954, the taxpayer buys a new residence for 
$10,000. On March 1, 1954, he sells for an adjusted sales price of 
$15,000 his old residence, which has an adjusted basis to him of $5,000 
(no fixing-up expenses are involved, so that $15,000 is the amount 
realized as well as the adjusted sales price). Between April 1 and April 
15 a wing is constructed on the new house at a cost of $5,000. Between 
May 1 and May 15 a garage is constructed at a cost of $2,000. The 
adjusted basis of the new residence is $10,000 during January and 
February, $5,000 during March, $5,000 following the completion of the 
construction in April, and $7,000 following the completion of the 
construction in May. Since the old residence was not sold until March 1, 
no adjustment to the basis of the new residence is made during January 
and February. Computations for March, April, and May are as follows:

Amount realized on sale of old residence............             $15,000
Less: Adjusted basis of old residence...............               5,000
                                                     -------------------
Gain realized on sale of old residence..............              10,000
                    March 1, 1954
Adjusted sales price of old residence...............              15,000
Less: Cost of purchasing new residence..............              10,000
                                                     -------------------
Gain recognized.....................................               5,000
                                                     -------------------
Gain realized but not recognized....................               5,000
                                                     ===================
Cost of purchasing new residence....................              10,000
Less: Gain realized but not recognized..............               5,000
                                                     -------------------
Adjusted basis of new residence.....................               5,000
                   April 15, 1954
Gain realized on sale of old residence..............              10,000
Adjusted sales price of old residence...............              15,000
Less: Cost of purchasing new residence..............              15,000
                                                     -------------------
Gain recognized.....................................                   0
                                                     -------------------
Gain realized but not recognized....................              10,000
                                                     ===================
Cost of purchasing new residence....................              15,000
Less: Gain realized but not recognized..............              10,000
                                                     -------------------
Adjusted basis of new residence.....................               5,000
                                                     ===================
                    May 15, 1954
Gain realized on sale of old residence..............              10,000
Adjusted sales price of old residence...............              15,000
Less: Cost of purchasing new residence..............              17,000
                                                     -------------------
Gain recognized.....................................                   0
                                                     -------------------
Gain realized but not recognized....................              10,000
                                                     ===================
Cost of purchasing new residence....................              17,000
Less: Gain realized but not recognized..............              10,000
                                                     -------------------
Adjusted basis of new residence.....................               7,000
 

    (f) Husband and wife. (1) If the taxpayer and his spouse file the 
consent referred to in this paragraph, then the taxpayer's adjusted 
sales price of the old residence shall mean the taxpayer's, or the 
taxpayer's and his spouse's, adjusted sales price of the old residence, 
and the taxpayer's cost of purchasing the new residence shall mean the 
cost to the taxpayer, or to his spouse, or to both of them, of 
purchasing the new residence, whether such new residence is held by the 
taxpayer, or his spouse, or both (section 1034(g)). Such consent may be 
filed only if the old residence and the new residence are each used by 
the taxpayer and his same spouse as their principal residence. If the 
taxpayer and his spouse do not file such a consent, the recognition of 
gain upon sale of the old residence shall be determined under this 
section without regard to the foregoing.
    (2) The consent referred to in subparagraph (1) of this paragraph is 
a consent by the taxpayer and his spouse to have the basis of the 
interest of either of them in the new residence reduced from what it 
would have been but for the filing of such consent by an amount by which 
the gain of either of them on the sale of his interest in the old 
residence is not recognized solely by reason of the filing of such 
consent. Such reduction in basis is applicable to the basis of the new 
residence, whether such basis is that of the husband, of the wife, or 
divided between them. If the basis is divided between the husband and 
wife, the reduction in basis shall be divided between them in the same 
proportion as the basis (determined without regard to such reduction) is 
divided. Such consent shall be filed with the district director with 
whom the taxpayer filed the return for the taxable year or years in 
which the gain from the sale of the old residence was realized.
    (3) The following examples will illustrate the application of this 
rule:

    Example 1. A taxpayer, in 1954, sells for an adjusted sales price of 
$10,000 the principal residence of himself and his wife, which he

[[Page 135]]

owns individually and which has an adjusted basis to him of $5,000 (no 
fixing-up expenses are involved, so that $10,000 is the amount realized 
as well as the adjusted sales price). Within a year after such sale he 
and his wife contribute $5,000 each from their separate funds for the 
purchase of their new principal residence which they hold as tenants in 
common, each owning an undivided one-half interest therein. If the 
taxpayer and his wife file the required consent, the gain of $5,000 upon 
the sale of the old residence will not be recognized to the taxpayer, 
and the adjusted basis of the taxpayer's interest in the new residence 
will be $2,500 and the adjusted basis of his wife's interest in such 
property will be $2,500.
    Example 2. A taxpayer and his wife, in 1954, sell for an adjusted 
sales price of $10,000 their principal residence, which they own as 
joint tenants and which has an adjusted basis of $2,500 to each of them 
($5,000 together) (no fixing-up expenses are involved, so that $10,000 
is the amount realized as well as the adjusted sales price). Within a 
year after such sale, the wife spends $10,000 of her own funds in the 
purchase of a principal residence for herself and the taxpayer and takes 
title in her name only. If the taxpayer and his wife file the required 
consent, the adjusted basis to the wife of the new residence will be 
$5,000, and the gain of the taxpayer will be $2,500 upon the sale of the 
old residence will not be recognized. The wife, as a taxpayer herself, 
will have her gain of $2,500 on the sale of the old residence not 
recognized under the general rule.

    (g) Members of Armed Forces. (1) Section 1034(h) provides a special 
rule for members of the Armed Forces with respect to the period after 
the sale of the old residence within which the acquisition of a new 
residence may result in a non-recognition of gain on such sale. The 
running of the period of 18 months (one year in the case of a sale of an 
old residence prior to January 1, 1975) after the sale of the old 
residence in the case of the purchase of a new residence, or the period 
of two years (18 months in the case of a sale of an old residence prior 
to January 12, 1975) after such sale in the case of the construction of 
a new residence, is suspended during any time that the taxpayer serves 
on extended active duty with the Armed Forces of the United States. 
(This paragraph applies to time served on extended active duty prior to 
July 1, 1973, only if such extended active duty occurred during an 
induction period as defined in section 112(c)(5) as in effect prior to 
July 1, 1973.) However, in no event may such suspension extend for more 
than four years after the date of the sale of the old residence the 
period within which the purchase or construction of a new residence may 
result in a nonrecognition of gain. For example, if the taxpayer is on 
extended active duty with the Army from January 1, 1975, to June 30, 
1976, and if he sold his old residence on January 10, 1975, the latest 
date on which the taxpayer may use a new residence constructed by him 
and have any part of the gain on the sale of his old residence not 
recognized under this section is June 30, 1978 (the date two years 
following the taxpayer's termination of active duty). However, if this 
taxpayer were on extended active duty with the Army from January 1, 
1975, to December 31, 1978, the latest date on which he might use a new 
residence constructed by him and have any part of the gain on the sale 
of his old residence not recognized under this section would be January 
10, 1979 (the date four years following the date of the sale of the old 
residence).
    (2) This suspension covers not only the Armed Forces service of the 
taxpayer but if the taxpayer and his same spouse used both the old and 
the new residences as their principal residence, then the extension 
applies in like manner to the time the taxpayer's spouse is on extended 
active duty with the Armed Forces of the United States.
    (3) The time during which the running of the period is suspended is 
part of such period. Thus, construction costs during such time are 
includible in the cost of purchasing the new residence under paragraph 
(c)(4) of this section.
    (4) The running of the period of 18 months (or two years) after the 
date of sale of the old residence referred to in section 1034(c)(4) and 
in paragraph (d) of this section is not suspended. The running of the 
18-month period prior to the date of the sale of the old residence 
within which the new residence may be purchased in order to have gain on 
the sale of the old residence not recognized under this section is also 
not suspended. In the case of a sale of an old residence prior to 
January 1, 1975, the periods of 18 months (or two years) referred to in 
each of the two preceding

[[Page 136]]

sentences shall be one year (or 18 months).
    (5) The term extended active duty means any period of active duty 
which is served pursuant to a call or order to such duty for a period in 
excess of 90 days or for an indefinite period. If the call or order is 
for a period of more than 90 days, it is immaterial that the time served 
pursuant to such call or order is less than 90 days, if the reason for 
such shorter period of service occurs after the beginning of such duty. 
As to what constitutes active service as a member of the Armed Forces of 
the United States, see paragraph (i) of Sec. 1.112-1. As to who are 
members of the Armed Forces of the United States, see section 
7701(a)(15), and the regulations in part 301 of this chapter 
(Regulations on Procedure and Administration).
    (h) Special rules for involuntary conversions--(1) In general. 
Except as provided in subparagraph (2) of this paragraph, section 1034 
is inapplicable to involuntary conversions of personal residences 
occurring after December 31, 1953 (section 1034(i)(1)(B)). For purposes 
of section 1034, an involuntary conversion of a personal residence 
occurring after December 31, 1950, and before January 1, 1954, is 
treated as a sale of such residence (section 1034(i)(1)(A); see 
paragraph (b)(8) of this section). For purposes of this paragraph, an 
involuntary conversion is defined, as the destruction in whole or in 
part, theft, seizure, requisition, or condemnation of property, or the 
sale or exchange of property under threat or imminence thereof. See 
section 1033 and Sec. 1.1033(a)-3 for treatment of residences 
involuntarily converted after December 31, 1953.
    (2) Election to treat condemnation of personal residence as sale. 
(i) Section 1034(i)(2) provides a special rule which permits a taxpayer 
to elect to treat the seizure, requisition, or condemnation of his 
principal residence, or the sale or exchange of such residence under 
threat or imminence thereof, if occurring after December 31, 1957, as 
the sale of such residence for purposes of section 1034 (relating to 
sale or exchange of residence). A taxpayer may thus elect to have 
section 1034 apply, rather than section 1033 (relating to involuntary 
conversions), in determining the amount of gain realized on the 
disposition of his old residence that will not be recognized and the 
extent to which the basis of his new residence acquired in lieu thereof 
shall be reduced. Once made, the election shall be irrevocable.
    (ii) If the taxpayer elects to be governed by the provisions of 
section 1034, section 1033 will have no application. Thus, a taxpayer 
who elects under section 1034(i)(2) to treat the seizure, requisition, 
or condemnation of his principal residence (but not the destruction), or 
the sale or exchange of such residence under threat or imminence 
thereof, as a sale for the purpose of section 1034 must satisfy the 
requirements of section 1034 and this section. For example, under 
section 1034 a taxpayer generally must replace his old residence with a 
new residence which he uses as his principal residence, within a period 
beginning 18 months (one year in the case of a sale of an old residence 
prior to January 1, 1975) before the date of disposition of his old 
residence, and ending 18 months (one year in the case of a sale of an 
old residence prior to January 1, 1975) after such date. However, in the 
case of a new residence the construction of which was commenced by the 
taxpayer within such period, the replacement period shall not expire 
until 2 years (18 months in the case of a sale of an old residence prior 
to January 1, 1975) after the date of disposition of the old residence.
    (iii) Time and manner of making election. The election under section 
1034(i)(2) shall be made in a statement attached to the taxpayer's 
income tax return, when filed, for the taxable year during which the 
disposition of his old residence occurs. The statement shall indicate 
that the taxpayer elects under section 1034(i)(2) to treat the 
disposition of his old residence as a sale for purposes of section 1034, 
and shall also show--
    (a) The basis of the old residence;
    (b) The date of its disposition;
    (c) The adjusted sales price of the old residence, if known; and
    (d) The purchase price, date of purchase, and date of occupancy of 
the new residence if it has been acquired prior to the time of making 
the election.

[[Page 137]]

    (i) Statute of limitations. (1) Whenever a taxpayer sells property 
used as his principal residence at a gain, the statutory period 
prescribed in section 6501(a) for the assessment of a deficiency 
attributable to any part of such gain shall not expire prior to the 
expiration of three years from the date of receipt, by the district 
director with whom the return was filed for the taxable year or years in 
which the gain from the sale of the old residence was realized (section 
1034(j)), of a written notice from the taxpayer of--
    (i) The taxpayer's cost of purchasing the new residence which the 
taxpayer claims result in nonrecognition of any part of such gain.
    (ii) The taxpayer's intention not to purchase a new residence within 
the period when such a purchase will result in nonrecognition of any 
part of such gain, or
    (iii) The taxpayer's failure to make such a purchase within such 
period.

Any gain from the sale of the old residence which is required to be 
recognized shall be included in gross income for the taxable year or 
years in which such gain was realized. Any deficiency attributable to 
any portion of such gain may be assessed before the expiration of the 3-
year period described in this paragraph, notwithstanding the provisions 
of any law or rule of law which might otherwise bar such assessment.
    (2) The notification required by the preceding subparagraph shall 
contain all pertinent details in connection with the sale of the old 
residence and, where applicable, the purchase price of the new 
residence. The notification shall be in the form of a written statement 
and shall be accompanied, where appropriate, by an amended return for 
the year in which the gain from the sale of the old residence was 
realized, in order to reflect the inclusion in gross income for that 
year of gain required to be recognized in connection with such sale.
    (j) Effective date. Pursuant to section 7851(a)(1)(C), paragraphs 
(a), (b), (c), (d), (f), (g), and (i) of this section apply in the case 
of any sale (as defined in paragraph (b)(8) of this section) made after 
December 31, 1953, although such sale may occur in a taxable year 
subject to the Internal Revenue Code of 1939. Similarly, the rule in 
paragraph (h) of this section that involuntary conversions of personal 
residences are not to be treated as sales for purposes of section 1034 
but are governed by section 1033 applies to any such involuntary 
conversion made after December 31, 1953, although such involuntary 
conversion may occur in a taxable year subject to the Internal Revenue 
Code of 1939. The rule in paragraph (e) of this section requiring an 
adjustment to the basis of a new residence, the purchase of which 
results (under section 1034, or section 112(n) of the Internal Revenue 
Code of 1939) in the nonrecognition of gain on the sale of an old 
residence, applies in determining the adjusted basis of the new 
residence at any time following such sale, although such sale may occur 
in a taxable year subject to the Internal Revenue Code of 1939.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6916, 32 FR 
5924, Apr. 13, 1967; 32 FR 6971, May 6, 1967; T.D. 7404, 41 FR 6758, 
Feb. 13, 1976; T.D. 7625, 44 FR 31013, May 30, 1979]



Sec. 1.1035-1  Certain exchanges of insurance policies.

    Under the provisions of section 1035 no gain or loss is recognized 
on the exchange of:
    (a) A contract of life insurance for another contract of life 
insurance or for an endowment or annuity contract (section 1035(a)(1));
    (b) A contract of endowment insurance for another contract of 
endowment insurance providing for regular payments beginning at a date 
not later than the date payments would have begun under the contract 
exchanged, or an annuity contract (section 1035(a)(2)); or
    (c) An annuity contract for another annuity contract (section 
1035(a)(3)), but section 1035 does not apply to such exchanges if the 
policies exchanged to not relate to the same insured. The exchange, 
without recognition of gain or loss, of an annuity contract for another 
annuity contract under section 1035(a)(3) is limited to cases where the 
same person or persons are the obligee or obligees under the contract 
received in exchange as under the original contract. This section and 
section 1035 do not apply to transactions involving the

[[Page 138]]

exchange of an endowment contract or annuity contract for a life 
insurance contract, nor an annuity contract for an endowment contract. 
In the case of such exchanges, any gain or loss shall be recognized. In 
the case of exchanges which would be governed by section 1035 except for 
the fact that the property received in exchange consists not only of 
property which could otherwise be received without the recognition of 
gain or loss, but also of other property or money, see section 1031 (b) 
and (c) and the regulations thereunder. Such an exchange does not come 
within the provisions of section 1035. Determination of the basis of 
property acquired in an exchange under section 1035(a) shall be governed 
by section 1031(d) and the regulations thereunder.



Sec. 1.1036-1  Stock for stock of the same corporation.

    (a) Section 1036 permits the exchange, without the recognition of 
gain or loss, of common stock for common stock, or of preferred stock 
for preferred stock, in the same corporation. Section 1036 applies even 
though voting stock is exchanged for nonvoting stock or nonvoting stock 
is exchanged for voting stock. It is not limited to an exchange between 
two individual stockholders; it includes a transaction between a 
stockholder and the corporation. However, a transaction between a 
stockholder and the corporation may qualify not only under section 
1036(a), but also under section 368(a)(1)(E) (recapitalization) or 
section 305(a) (distribution of stock and stock rights). The provisions 
of section 1036(a) do not apply if stock is exchanged for bonds, or 
preferred stock is exchanged for common stock, or common stock is 
exchanged for preferred stock, or common stock in one corporation is 
exchanged for common stock in another corporation. See paragraph (l) of 
section 1301-1 for certain transactions treated as distributions under 
section 301. See paragraph (e)(5) of Sec. 1.368-2 for certain 
transactions which result in deemed distributions under section 305(c) 
to which sections 305(b)(4) and 301 apply.
    (b) For rules relating to recognition of gain or loss where an 
exchange is not wholly in kind, see subsections (b) and (c) of section 
1031. For rules relating to the basis of property acquired in an 
exchange described in paragraph (a) of this section, see subsection (d) 
of section 1031.
    (c) A transfer is not within the provisions of section 1036(a) if as 
part of the consideration the other party to the exchange assumes a 
liability of the taxpayer (or if the property transferred is subject to 
a liability), but the transfer, if otherwise qualified, will be within 
the provisions of section 1031(b).
    (d) Nonqualified preferred stock. See Sec. 1.356-7(a) for the 
applicability of the definition of nonqualified preferred stock in 
section 351(g)(2) for stock issued prior to June 9, 1997, and for stock 
issued in transactions occurring after June 8, 1997, that are described 
in section 1014(f)(2) of the Taxpayer Relief Act of 1997, Public Law 
105-34 (111 Stat. 788, 921).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7281, 38 FR 
18540, July 12, 1973; T.D. 8904, 65 FR 58652, Oct. 2, 2000]



Sec. 1.1037-1  Certain exchanges of United States obligations.

    (a) Nonrecognition of gain or loss--(1) In general. Section 1037(a) 
provides for the nonrecognition of gain or loss on the surrender to the 
United States of obligations of the United States issued under the 
Second Liberty Bond Act (31 U.S.C. 774(2)) when such obligations are 
exchanged solely for other obligations issued under that Act and the 
Secretary provides by regulations promulgated in connection with the 
issue of such other obligations that gain or loss is not to be 
recognized on such exchange. It is not necessary that at the time of the 
exchange the obligation which is surrendered to the United States be a 
capital asset in the hands of the taxpayer. For purposes of section 
1037(a) and this subparagraph, a circular of the Treasury Department 
which offers to exchange obligations of the United States issued under 
the Second Liberty Bond Act for other obligations issued under that Act 
shall constitute regulations promulgated by the Secretary in connection 
with the issue of the obligations offered to be exchanged if such 
circular contains a declaration by the Secretary that no gain or loss 
shall be recognized for Federal

[[Page 139]]

income tax purposes on the exchange or grants the privilege of 
continuing to defer the reporting of the income of the bonds exchanged 
until such time as the bonds received in the exchange are redeemed or 
disposed of, or have reached final maturity, whichever is earlier. See, 
for example, regulations of the Bureau of the Public Debt, 31 CFR part 
339, or Treasury Department Circular 1066, 26 FR 8647. The application 
of section 1037(a) and this subparagraph will not be precluded merely 
because the taxpayer is required to pay money on the exchange. See 
section 1031 and the regulations thereunder if the taxpayer receives 
money on the exchange.
    (2) Recognition of gain or loss postponed. Gain or loss which has 
been realized but not recognized on the exchange of a U.S. obligation 
for another such obligation because of the provisions of section 1037(a) 
(or so much of section 1031 (b) or (c) as related to section 1037(a)) 
shall be recognized at such time as the obligation received in the 
exchange is disposed of, or redeemed, in a transaction other than an 
exchange described in section 1037(a) (or so much of section 1031 (b) or 
(c) as relates to section 1037(a)) or reaches final maturity, whichever 
is earlier, to the extent gain or loss is realized on such later 
transaction.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples, in which it is assumed that the 
taxpayer uses the cash receipts and disbursements method of accounting 
and has never elected under section 454(a) to include in gross income 
currently the annual increase in the redemption price of non-interest-
bearing obligations issued at a discount. In addition, it is assumed 
that the old obligations exchanged are capital assets transferred in an 
exchange in respect of which regulations are promulgated pursuant to 
section 1037(a):

    Example 1. A, the owner of a $1,000 series E U.S. savings bond 
purchased for $750 and bearing an issue date of May 1, 1945, surrenders 
the bond to the United States in exchange solely for series H U.S. 
savings bonds on February 1, 1964, when the series E bond has a 
redemption value of $1,304.80. In the exchange A pays an additional 
$195.20 and obtains three $500 series H bonds. None of the $554.80 gain 
($1,304.80 less $750) realized by A on the series E bond is recognized 
at the time of the exchange.
    Example 2. In 1963, B purchased for $97 a marketable U.S. bond which 
was originally issued at its par value of $100. In 1964 he surrenders 
the bond to the United States in exchange solely for another marketable 
U.S. bond which then has a fair market value of $95. B's loss of $2 on 
the old bond is not recognized at the time of the exchange, and his 
basis for the new bond is $97 under section 1031(d). If it has been 
necessary for B to pay $1 additional consideration in the exchange, his 
basis in the new bond would be $98.
    Example 3. The facts are the same as in example (2) except that B 
also receives $1 interest on the old bond for the period which has 
elapsed since the last interest payment date and that B does not pay any 
additional consideration on the exchange. As in example (2), B has a 
loss of $2 which is not recognized at the time of the exchange and his 
basis in the new bond is $97. In addition, the $1 of interest received 
on the old bond is includible in gross income. B holds the new bond 1 
year and sells it in the market for $99 plus interest. At this time he 
has a gain of $2, the difference between his basis of $97 in the new 
bond and the sales price of such bond. In addition, the interest 
received on the new bond is includible in gross income.
    Example 4. The facts are the same as in example (2), except that in 
addition to the new bond B also receives $1.85 in cash, $0.85 of which 
is interest. The $0.85 interest received is includible in gross income. 
B's loss of $1 ($97 less $96) on the old bond is not recognized at the 
time of the exchange by reason of section 1031(c). Under section 1031(d) 
B's basis in the new bond is $96 (his basis of $97 in the old bond, 
reduced by the $1 cash received in the exchange).
    Example 5. (a) For $975 D subscribes to a marketable U.S. obligation 
which has a face value of $1,000. Thereafter, he surrenders this 
obligation to the United States in exchange solely for a 10-year 
marketable $1,000 obligation which at the time of exchange has a fair 
market value of $930, at which price such obligation is initially 
offered to the public. At the time of issue of the new obligation there 
was no intention to call it before maturity. Five years after the 
exchange D sells the new obligation for $960.
    (b) On the exchange of the old obligation for the new obligation D 
sustains a loss of $45 ($975 less $930), none of which is recognized 
pursuant to section 1037(a).
    (c) The basis of the new obligation in D's hands, determined under 
section 1031(d), is $975 (the same basis as that of the old obligation).
    (d) On the sale of the new obligation D sustains a loss of $15 ($975 
less $960), all of which is recognized by reason of section 1002.
    Example 6. (a) The facts are the same as in example (5), except that 
five years after the

[[Page 140]]

exchange D sells the new obligation for $1,020.
    (b) On the exchange of the old obligation for the new obligation D 
sustains a loss of $45 ($975 less $930), none of which is recognized 
pursuant to section 1037(a).
    (c) The basis of the new obligation in D's hands, determined under 
section 1031(d), is $975 (the same basis as that of the old obligation). 
The issue price of the new obligation under section 1232(b)(2) is $930.
    (d) On the sale of the new obligation D realizes a gain of $45 
($1,020 less $975), all of which is recognized by reason of section 
1002. Of this gain of $45, the amount of $35 is treated as ordinary 
income and $10 is treated as long-term capital gain, determined as 
follows:

(1) Ordinary income under first sentence of section
 1232(a)(2)(B) on sale of new obligation:
  Stated redemption price of new obligation at maturity........   $1,000
  Less: Issue price of new obligation under section 1232(b)(2).      930
                                                                --------
  Original issue discount on new obligation....................       70
                                                                ========
  Proration under section 1232(a)(2)(B)(ii): ($70x60 months/120       35
   months).....................................................
(2) Long-term capital gain ($45 less $35)......................       10
 

    Example 7. (a) The facts are the same as in example (5), except that 
D retains the new obligation and redeems it at maturity for $1,000.
    (b) On the exchange of the old obligation for the new obligation D 
sustains a loss of $45 ($975 less $930), none of which is recognized 
pursuant to section 1037(a).
    (c) The basis of the new obligation in D's hands, determined under 
section 1031(d), is $975 (the same basis as that of the old obligation). 
The issue price of the new obligation is $930 under section 1232(b)(2).
    (d) On the redemption of the new obligation D realizes a gain of $25 
($1,000 less $975), all of which is recognized by reason of section 
1002. Of this gain of $25, the entire amount is treated as ordinary 
income, determined as follows:

Ordinary income under first sentence of section 1232(a)(2)(B)
 on redemption of new obligation:
  Stated redemption price of new obligation at maturity........   $1,000
  Less: Issue price of new obligation under section 1232(b)(2).      930
                                                                --------
  Original issue discount on new obligation....................       70
                                                                ========
  Proration under section 1232(a)(2)(B)(ii): ($70x120 months/         25
   120 months), but such amount not to exceed the $25 gain
   recognized on redemption....................................
 

    (b) Application of section 1232 upon disposition or redemption of 
new obligation--(1) Exchanges involving nonrecognition of gain on 
obligations issued at a discount. If an obligation, the gain on which is 
subject to the first sentence of section 1232(a)(2)(B), because the 
obligation was originally issued at a discount, is surrendered to the 
United States in exchange for another obligation and any part of the 
gain realized on the exchange is not then recognized because of the 
provisions of section 1037(a) (or because of so much of section 1031(b) 
as relates to section 1037(a)), the first sentence of section 
1232(a)(2)(B) shall apply to so much of such unrecognized gain as is 
later recognized upon the disposition or redemption of the obligation 
which is received in the exchange as though the obligation so disposed 
of or redeemed were the obligation surrendered, rather than the 
obligation received, in such exchange. See the first sentence of section 
1037(b)(1). Thus, in effect that portion of the gain which is 
unrecognized on the exchange but is recognized upon the later 
disposition or redemption of the obligation received from the United 
States in the exchange shall be considered as ordinary income in an 
amount which is equal to the gain which, by applying the first sentence 
of section 1232(a)(2)(B) upon the earlier surrender of the old 
obligation to the United States, would have been considered as ordinary 
income if the gain had been recognized upon such earlier exchange. Any 
portion of the gain which is recognized under section 1031(b) upon the 
earlier exchange and is treated at such time as ordinary income shall be 
deducted from the gain which is treated as ordinary income by applying 
the first sentence of section 1232(a)(2)(B) pursuant to this 
subparagraph upon the disposition or redemption of the obligation which 
is received in the earlier exchange. This subparagraph shall apply only 
in a case where on the exchange of United States obligations there was 
some gain not recognized by reason of section 1037(a) (or so much of 
section 1031(b) as relates to section 1037(a)); it shall not apply 
where, only loss was unrecognized by reason of section 1037(a).
    (2) Rules to apply when a nontransferable obligation is surrendered 
in the exchange. For purposes of applying both section 1232(a)(2)(B) and 
subparagraph (1) of this paragraph to the total gain realized on the 
obligation which is

[[Page 141]]

later disposed of or redeemed, if the obligation surrendered to the 
United States in the earlier exchange is a nontransferable obligation 
described in section 454 (a) or (c)--
    (i) The aggregate amount considered, with respect to the obligation 
so surrendered in the earlier exchange, as ordinary income shall not 
exceed the difference between the issue price of the surrendered 
obligation and the stated redemption price of the surrendered obligation 
which applied at the time of the earlier exchange, and
    (ii) The issue price of the obligation which is received from the 
United States in the earlier exchange shall be considered to be the 
stated redemption price of the surrendered obligation which applied at 
the time of the earlier exchange, increased by the amount of other 
consideration (if any) paid to the United States as part of the earlier 
exchange.


If the obligation received in the earlier exchange is a nontransferable 
obligation described in section 454(c) and such obligation is partially 
redeemed before final maturity or partially disposed of by being 
partially reissued to another owner, the amount determined by applying 
subdivision (i) of this subparagraph shall be determined on a basis 
proportional to the total denomination of obligations redeemed or 
disposed of. See paragraph (c) of Sec. 1.454-1.
    (3) Long-term capital gain. If, in a case where both subparagraphs 
(1) and (2) of this paragraph are applied, the total gain realized on 
the redemption or disposition of the obligation which is received from 
the United States in the exchange to which section 1037(a) (or so much 
of section 1031(b) as related to section 1037(a)) applies exceeds the 
amount of gain which, by applying such subparagraphs, is treated as 
ordinary income, the gain in excess of such amount shall be treated as 
long-term capital gain.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples, in which it is assumed that the 
taxpayer uses the cash receipts and disbursements method of accounting 
and has never elected under section 454(a) to include in gross income 
currently the annual increase in the redemption price of non-interest-
bearing obligations issued at a discount. In addition, it is assumed 
that the old obligations exchanged are capital assets transferred in an 
exchange in respect of which regulations are promulgated pursuant to 
section 1037(a):

    Example 1. (a) A purchased a noninterest-bearing nontransferable 
U.S. bond for $74 which was issued after December 31, 1954, and 
redeemable in 10 years for $100. Several years later, when the stated 
redemption value of such bond is $94.50, A surrenders it to the United 
States in exchange for $1 in cash and a 10-year marketable bond having a 
face value of $100. On the date of exchange the bond received in the 
exchange has a fair market value of $96. Less than one month after the 
exchange, A sells the new bond for $96.
    (b) On the exchange of the old bond for the new bond A realizes a 
gain of $23, determined as follows:

Amount realized (a new bond worth $96 plus $1 cash)..............    $97
Less: Adjusted basis of old bond.................................     74
                                                                  ------
    Gain realized................................................     23
 

    Pursuant to so much of section 1031(b) as applies to section 
1037(a), the amount of such gain which is recognized is $1 (the money 
received). Such recognized gain of $1 is treated as ordinary income. On 
the exchange of the old bond a gain of $22 ($23 less $1) is not 
recognized.
    (c) The basis of the new bond in A's hands, determined under section 
1031(d) is $74 (the basis of the old bond, decreased by the $1 received 
in cash and increased by the $1 gain recognized on the exchange).
    (d) On the sale of the new bond A realizes a gain of $22 ($96 less 
$74), all of which is recognized by reason of section 1002. Of this gain 
of $22, the amount of $19.50 is treated as ordinary income and $2.50 is 
treated as long-term capital gain, determined as follows:

(1) Ordinary income, treating sale of new bond as though
 a sale of old bond and applying section 1037(b)(1)(A):
  Stated redemption price of old bond...................          $94.50
  Less: Issue price of old bond.........................           74.00
                                         -----------------
    Aggregate gain under section 1037(b)(1)(A) (not to             20.50
     exceed $22 not recognized at time of exchange).....
    Less: Amount of such gain recognized at time of                 1.00
     exchange...........................................
                                         -----------------
  Ordinary income.......................................           19.50
                                         =================
(2) Ordinary income under first sentence of section
 1232(a)(2)(B), applying section 1037(b)(1)(B) to sale
 of new bond:
  Stated redemption price of new bond at         $100.00
   maturity.............................

[[Page 142]]

 
  Less: Issue price of new bond under              94.50
   section 1037(b)(1)(B) ($94.50 plus $0
   additional consideration paid on
   exchange)............................
                                         ----------------
  Original issue discount on new bond...            5.50
                                         ================
  Proration under section                                              0
   1232(a)(2)(B)(ii): ($5.50x0 months/
   120 months)..........................
                                                         ---------------
(3) Total ordinary income (sum of subparagraphs (1) and            19.50
 (2))...................................................
(4) Long-term capital gain ($22 less $19.50)............            2.50
 

    Example 2. (a) The facts are the same as in example (1), except 
that, less than one month after the exchange of the old bond, the new 
bond is sold for $92.
    (b) On the sale of the new bond A realizes a gain of $18 ($92 less 
$74), all of which is recognized by reason of section 1002. Of this 
gain, the entire amount of $18 is treated as ordinary income. This 
amount is determined as provided in paragraph (d)(1) of example (1) 
except that the ordinary income of $19.50 is limited to the $18 
recognized on the sale of the new bond.
    Example 3. (a) The facts are the same as in example (1), except that 
2 years after the exchange of the old bond A sells the new bond for $98.
    (b) On the sale of the new bond A realizes a gain of $24 ($98 less 
$74), all of which is recognized by reason of section 1002. Of this gain 
of $24, the amount of $20.60 is treated as ordinary income and $3.40 is 
treated as long-term capital gain, determined as follows:

(1) Ordinary income applicable to old bond (determined as         $19.50
 provided in paragraph (d)(1) of example (1)).................
(2) Ordinary income applicable to new bond (determined as           1.10
 provided in paragraph (d)(2) of example (1), except that the
 proration of the original issue discount under section
 1232(a)(2)(B)(ii) amounts to $1.10 ($5.50x24 months/120
 months)......................................................
                                                               ---------
(3) Total ordinary income (sum of subparagraphs (1) and (2))..     20.60
(4) Long-term capital gain ($24 less $20.60)..................      3.40
 

    Example 4. (a) The facts are the same as in example (1), except that 
A retains the new bond and redeems it at maturity for $100.
    (b) On the redemption of the new bond A realizes a gain of $26 ($100 
less $74), all of which is recognized by reason of section 1002. Of this 
gain of $26, the amount of $25 is treated as ordinary income and $1 is 
treated as long-term capital gain, determined as follows:

(1) Ordinary income applicable to old bond (determined as         $19.50
 provided in paragraph (d)(1) of example (1)).................
(2) Ordinary income applicable to new bond (determined as           5.50
 provided in paragraph (d)(2) of example (1), except that the
 proration of the original issue discount under section
 1232(a)(2)(B)(ii) amounts to $5.50 ($5.50x120 months/120
 months)).....................................................
                                                               ---------
(3) Total ordinary income (sum of subparagraphs (1) and (2))..     25.00
(4) Long-term capital gain ($26 less $25).....................      1.00
 

    Example 5. (a) In 1958 B purchased for $7,500 a series E United 
States savings bond having a face value of $10,000. In 1965 when the 
stated redemption value of the series E bond is $9,760, B surrenders it 
to the United States in exchange solely for a $10,000 series H U.S. 
savings bond, after paying $240 additional consideration. B retains the 
series H bond and redeems it at maturity in 1975 for $10,000, after 
receiving all the semiannual interest payments thereon.
    (b) On the exchange of the series E bond for the series H bond, B 
realizes a gain of $2,260 ($9,760 less $7,500), none of which is 
recognized at such time by reason of section 1037(a).
    (c) The basis of the series H bond in B's hands, determined under 
section 1031(d), is $7,740 (the $7,500 basis of the series E bond, plus 
$240 additional consideration paid for the series H bond).
    (d) On the redemption of the series H bond, B realizes a gain of 
$2,260 ($10,000 less $7,740), all of which is recognized by reason of 
section 1002. This entire gain is treated as ordinary income by treating 
the redemption of the series H bond as though it were a redemption of 
the series E bond and by applying section 1037(b)(1)(A).
    (e) Under section 1037(b)(1)(B) the issue price of the series H 
bonds is $10,000 ($9,760 stated redemption price of the series E bond at 
time of exchange, plus $240 additional consideration paid). Thus, with 
respect to the series H bond, there is no original issue discount to 
which section 1232(a)(2)(B) might apply.
    Example 6. (a) The facts are the same as in example (5), except that 
in 1970 B submits the $10,000 series H bond to the United States for 
partial redemption in the amount of $3,000 and for reissuance of the 
remainder in $1,000 series H savings bonds registered in his name. On 
this transaction B receives $3,000 cash and seven $1,000 series H bonds, 
bearing the original issue date of the $10,000 bond which is partially 
redeemed. The $1,000, series H bonds are redeemed at maturity in 1975 
for $7,000.
    (b) On the partial redemption of the $10,000 series H bond in 1970 B 
realizes a gain of $678 ($3,000 less $2,322 [$7,740x$3,000/$10,000]), 
all of which is recognized at such time by reason of section 1002 and 
paragraph (c) of Sec. 1.454-1. This entire gain is treated as ordinary 
income, by treating the partial redemption of the series H bond as 
though it were a redemption of the relevant denominational

[[Page 143]]

portion of the series E bond and by applying section 1037(b)(1)(A).
    (c) On the redemption at maturity in 1975 of the seven $1,000 series 
H bonds B realizes a gain of $1,582 ($7,000 less $5,418 [$7,740x$7,000/
$10,000]), all of which is recognized at such time by reason of section 
1002 and paragraph (c) of Sec. 1.454-1. This entire gain is treated as 
ordinary income, determined in the manner described in paragraph (b) of 
this example.
    Example 7. (a) The facts are the same as in example (5), except that 
in 1970 B requests the United States to reissue the $10,000 series H 
bond by issuing two $5,000 series H bonds bearing the original issue 
date of such $10,000 bond. One of such $5,000 bonds is registered in B's 
name, and the other is registered in the name of C, who is B's son. Each 
$5,000 series H bond is redeemed at maturity in 1975 for $5,000.
    (b) On the issuing in 1970 of the $5,000 series H bond to C, B 
realizes a gain of $1,130 ($5,000 less $3,870 [$7,740x$5,000/$10,000]), 
all of which is recognized at such time by reason of section 1002 and 
paragraph (c) of Sec. 1.454-1. This entire gain is treated as ordinary 
income by treating the transaction as though it were a redemption of the 
relevant denominational portion of the series E bond and by applying 
section 1037(b)(1)(A).
    (c) On the redemption at maturity in 1975 of the $5,000 series H 
bond registered in his name B realizes a gain of $1,130 ($5,000 less 
$3,870 [$7,740x$5,000/$10,000]), all of which is recognized at such time 
by reason of section 1002 and paragraph (c) of Sec. 1.454-1. This entire 
gain is treated as ordinary income, determined in the manner described 
in paragraph (b) of this example.
    (d) On the redemption at maturity in 1975 of the $5,000 series H 
bond registered in his name C does not realize any gain, since the 
amount realized on redemption does not exceed his basis in the property, 
determined as provided in section 1015.

    (5) Exchanges involving nonrecognition of gain or loss on 
transferable obligations issued at not less than par--(i) In general. If 
a transferable obligation of the United States which was originally 
issued at not less than par is surrendered to the United States for 
another transferable obligation in an exchange to which the provisions 
of section 1037(a) (or so much of section 1031 (b) or (c) as relates to 
section 1037(a)) apply, the issue price of the obligation received from 
the United States in the exchange shall be considered for purposes of 
applying section 1232 to gain realized on the disposition or redemption 
of the obligation so received, to be the same as the issue price of the 
obligation which is surrendered to the United States in the exchange, 
increased by the amount of other consideration, if any, paid to the 
United States as part of the exchange. This subparagraph shall apply 
irrespective of whether there is gain or loss unrecognized on the 
exchange and irrespective of the fair market value, at the time of the 
exchange, of either the obligation surrendered to, or the obligation 
received from, the United States in the exchange.
    (ii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples, in which it is assumed that the 
taxpayer uses the cash receipts and disbursements method of accounting 
and that the old obligations exchanged are capital assets transferred in 
an exchange in respect of which regulations are promulgated pursuant to 
section 1037(a):

    Example 1. (a) A purchases in the market for $85 a marketable U.S. 
bond which was originally issued at its par value of $100. Three months 
later, A surrenders this bond to the United States in exchange solely 
for another $100 marketable U.S. bond which then has a fair market value 
of $88. He holds the new bond for 5 months and then sells it on the 
market for $92.
    (b) On the exchange of the old bond for the new bond A realizes a 
gain of $3 ($88 less $85), none of which is recognized by reason of 
section 1037(a).
    (c) The basis of the new bond in A's hands, determined under section 
1031(d), is $85 (the same as that of the old bond). The issue price of 
the new bond for purposes of section 1232(a)(2)(B) is considered under 
section 1037(b)(2) to be $100 (the same issue price as that of the old 
bond).
    (d) On the sale of the new bond A realizes a gain of $7 ($92 less 
$85), all of which is recognized by reason of section 1002. Of this gain 
of $7, the entire amount is treated as long-term capital gain, 
determined as follows:

(1) Ordinary income under first sentence of
 section 1232(a)(2)(B), applicable to old bond:
  Stated redemption price of old bond at maturity.       $100
  Less: Issue price of old bond...................        100
                                                   -----------
  Original issue discount on old bond........................          0
(2) Ordinary income under first sentence of section
 1232(a)(2)(B), applying section 1037(b)(2) to sale of new
 bond:
  Stated redemption price of new bond at maturity.        100
  Less: Issue price of new bond under section             100
   1037(b)(2).....................................
                                                   -----------
  Original issue discount on new bond........................          0

[[Page 144]]

 
(3) Long-term capital gain ($7 less sum of subparagraphs (1)          $7
 and (2))....................................................
 

    Example 2. The facts are the same as in example (1), except that A 
retains the new bond and redeems it at maturity for $100. On the 
redemption of the new bond, A realizes a gain of $15 ($100 less $85), 
all of which is recognized under section 1002. This entire gain is 
treated as long-term capital gain, determined in the same manner as 
provided in paragraph (d) of example (1).
    Example 3. (a) For $1,000 B subscribes to a marketable U.S. bond 
which has a face value of $1,000. Thereafter, he surrenders this bond to 
the United States in exchange solely for a 10-year marketable $1,000 
bond which at the time of exchange has a fair market value of $930, at 
which price such bond is initially offered to the public. Five years 
after the exchange, B sells the new bond for $950.
    (b) On the exchange of the old bond for the new bond, B sustains a 
loss of $70 ($1,000 less $930), none of which is recognized pursuant to 
section 1037(a).
    (c) The basis of the new bond in A's hands, determined under section 
1031(d), is $1,000 (the same basis as that of the old bond).
    (d) On the sale of the new bond B sustains a loss of $50 ($1,000 
less $950), all of which is recognized by reason of section 1002.
    Example 4. (a) The facts are the same as in example (3), except that 
5 years after the exchange B sells the new bond for $1,020.
    (b) On the exchange of the old bond for the new bond B sustains a 
loss of $70 ($1,000 less $930), none of which is recognized pursuant to 
section 1037(a).
    (c) The basis of the new bond in B's hands, determined under section 
1031(d), is $1,000 (the same basis as that of the old bond). The issue 
price of the new bond for purposes of section 1232(a)(2)(B) is 
considered under section 1037(b)(2) to be $1,000 (the same issue price 
as that of the old bond).
    (d) On the sale of the new bond B realizes a gain of $20 ($1,020 
less $1,000), all of which is recognized by reason of section 1002. This 
entire gain is treated as long-term capital gain, determined in the same 
manner as provided in paragraph (d) of example (1).

    (6) Other rules for applying section 1232. To the extent not 
specifically affected by the provisions of section 1037(b) and 
subparagraphs (1) through (5) of this paragraph, any gain realized on 
the disposition or redemption of any obligation received from the United 
States in an exchange to which section 1037(a) (or so much of section 
1031 (b) or (c) as relates to section 1037(a)) applies shall be treated 
in the manner provided by section 1232 if the facts and circumstances 
relating to the acquisition and disposition or redemption of such 
obligation require the application of section 1232.
    (c) Holding period of obligation received in the exchange. The 
holding period of an obligation received from the United States in an 
exchange to which the provisions of section 1037(a) (or so much of 
section 1031 (b) or (c) as relates to section 1037(a)) apply shall 
include the period for which the obligation which was surrendered to the 
United States in the exchange was held by the taxpayer, but only if the 
obligation so surrendered was at the time of the exchange a capital 
asset in the hands of the taxpayer. See section 1223 and the regulations 
thereunder.
    (d) Basis. The basis of an obligation received from the United 
States in an exchange to which the provisions of section 1037(a) (or so 
much of section 1031 (b) or (c) as relates to section 1037(a)) apply 
shall be determined as provided in section 1031(d) and the regulations 
thereunder.
    (e) Effective date. Section 1.1037 and this section shall apply only 
for taxable years ending after September 22, 1959.

[T.D. 6935, 32 FR 15824, Nov. 17, 1967, as amended by T.D. 7154, 36 FR 
24998, Dec. 28, 1971]



Sec. 1.1038-1  Reacquisitions of real property in satisfaction of indebtedness.

    (a) Scope of section 1038--(1) General rule on gain or loss. If a 
sale of real property gives rise to indebtedness to the seller which is 
secured by the real property which is sold, and the seller of such 
property reacquires such property in a taxable year beginning after 
September 2, 1964, in partial or full satisfaction of such indebtedness, 
then, except as provided in paragraphs (b) and (f) of this section, no 
gain or loss shall result to the seller from such reacquisition. The 
treatment so provided is mandatory; however, see Sec. 1.1038-3 for an 
election to apply the provisions of this section to certain taxable 
years beginning after December 31, 1957. It is immaterial, for purposes 
of applying this subparagraph, whether the seller realized a gain or 
sustained a loss on the sale of the real property, or whether it can be 
ascertained at the time of the sale whether gain or loss occurs as

[[Page 145]]

a result of the sale. It is also immaterial what method of accounting 
the seller used in reporting gain or loss from the sale of the real 
property or whether at the time of reacquisition such property has 
depreciated or appreciated in value since the time of the original sale. 
Moreover, the character of the gain realized on the original sale of the 
property is immaterial for purposes of applying this subparagraph. The 
provisions of this section shall apply, except as provided in 
Sec. 1.1038-2, to the reacquisition of real property which was used by 
the seller as his principal residence and with respect to the sale of 
which an election under section 121 is in effect or with respect to the 
sale of which gain was not recognized under section 1034.
    (2) Sales giving rise to indebtedness--(i) Sale defined. For 
purposes of this section, it is not necessary for title to the property 
to have passed to the purchaser in order to have a sale. Ordinarily, a 
sale of property has occurred in a transaction in which title to the 
property has not passed to the purchaser, if the purchaser has a 
contractual right to retain possession of the property so long as he 
performs his obligations under the contract and to obtain title to the 
property upon the completion of the contract. However, a sale may have 
occurred even if the purchaser does not have the right to possession 
until he partially or fully satisfies the terms of the contract. For 
example, if S contracts to sell real property to P, and if S promises to 
convey title to P upon the completion of all of the payments due under 
the contract and to allow P to obtain possession of the property after 
10 percent of the purchase price has been paid, there has been a sale on 
the date of the contract for purposes of this section. This section 
shall not apply to a disposition of real property which constituted an 
exchange of property or was treated as a sale under section 121(d)(4) or 
section 1034(i); nor shall it apply to a sale of stock in a cooperative 
housing corporation described in section 121(d)(3) or section 1034(f).
    (ii) Secured indebtedness defined. An indebtedness to the seller is 
secured by the real property for purposes of this section whenever the 
seller has the right to take title or possession of the property or both 
if there is a default with respect to such indebtedness. A sale of real 
property may give rise to an indebtedness to the seller although the 
seller is limited in his recourse to the property for payment of the 
indebtedness in the case of a default.
    (3) Reacquisitions in partial or full satisfaction of indebtedness--
(i) Purpose of reacquisition. This section applies only where the seller 
reacquires the real property in partial or full satisfaction of the 
indebtedness to him that arose from the sale of the real property and 
was secured by the property. That is, the reacquisition must be in 
furtherance of the seller's security rights in the property with respect 
to indebtedness to him that arose at the time of the sale. Accordingly, 
if the seller in reacquiring the real property does not pay 
consideration in addition to discharging the purchaser's indebtedness to 
him that arose from the sale and was secured by such property, this 
section shall apply to the reacquisition even though the purchaser has 
not defaulted in his obligations under the contract or such a default is 
not imminent. If in addition to discharging the purchaser's indebtedness 
to him that arose from the sale the seller pays consideration in 
reacquiring the real property, this section shall generally apply to the 
reacquisition if the reacquisition and the payment of additional 
consideration is provided for in the original contract for the sale of 
the property. This section generally shall apply to a reacquisition of 
real property if the seller reacquires the property either when the 
purchaser has defaulted in his obligations under the contract or when 
such a default is imminent. This section generally shall not apply to a 
reacquisition of real property where the seller pays consideration in 
addition to discharging the purchaser's indebtedness to him that arose 
from the sale if the reacquisition and payment of additional 
consideration was not provided for in the original contract for the sale 
of the property and if the purchaser has not defaulted in his 
obligations under the contract or such a default is not imminent. Thus, 
for example, if the purchaser is in arrears on the payment of interest 
or principal or has in any

[[Page 146]]

other way defaulted on his contract for the purchase of the property, or 
if the facts of the case indicate that the purchaser is unable 
satisfactorily to perform his obligations under the contract, and the 
seller reacquires the property from the purchaser in a transaction in 
which the seller pays consideration in addition to discharging the 
purchaser's indebtedness to him that arose from the sale and was secured 
by the property, this section shall apply to the reacquisition. 
Additional consideration paid by the seller includes money and other 
property paid or transferred by the seller. Also, the reacquisition by 
the seller of real property subject to an indebtedness (or the 
assumption, upon the reacquisition, of indebtedness) which arose 
subsequent to the original sale shall be considered as a payment by the 
seller of additional consideration. However, the reacquisition by the 
seller of real property subject to an indebtedness (or the assumption, 
upon the reacquisition, of an indebtedness) which arose prior to or 
arose out of the original sale shall not be considered as a payment by 
the seller of additional consideration.
    (ii) Manner of reacquisition. For purposes of applying section 1038 
and this section there must be a reacquisition by the seller of the real 
property itself, but the manner in which the seller so reduces the 
property to ownership or possession, as the case may be, shall generally 
be immaterial. Thus, the seller may reduce the real property to 
ownership or possession or both, as the case may require, by agreement 
or by process of law. The reduction of the real property to ownership or 
possession by agreement includes, where valid under local law, such 
methods as voluntary conveyance from the purchaser and abandonment to 
the seller. The reduction of the real property to ownership or 
possession by process of law includes foreclosure proceedings in which a 
competitive bid is entered, such as foreclosure by judicial sale or by 
power of sale contained in the loan agreement without recourse to the 
courts, as well as those types of foreclosure proceedings in which a 
competitive bid is not entered, such as strict foreclosure and 
foreclosure by entry and possession, by writ of entry, or by publication 
or notice.
    (4) Persons from whom real property may be reacquired. The real 
property reacquired in satisfaction of the indebtedness need not be 
reacquired from the purchaser but may be reacquired from the purchaser's 
transferee or assignee, or from a trustee holding title to such property 
pending the purchaser's satisfaction of the terms of the contract, so 
long as the indebtedness that is partially or completely satisfied in 
the reacquisition of such property arose in the original sale of the 
property and was secured by the property so reacquired. In such a case, 
a reference in this section to the purchaser shall, where appropriate, 
include the purchaser's transferee or assignee. Thus, for example, this 
section will apply if the seller reacquires the property from a 
purchaser from the original purchaser and either the property is subject 
to, or the subsequent purchaser assumes, the liability to the seller on 
the indebtedness.
    (5) Reacquisitions not included. This section shall not apply to 
reacquisitions of real property by mutual savings banks, domestic 
building and loan associations, and cooperative banks, described in 
section 593(a). However, for rules respecting the reacquisition of real 
property by such organizations, see Sec. 1.595-1.
    (b) Amount of gain resulting from a reacquisition--(1) Determination 
of amount--(i) In general. As a result of a reacquisition to which 
paragraph (a) of this section applies gain shall be derived by the 
seller to the extent that the amount of money and the fair market value 
of other property (other than obligations of the purchaser arising with 
respect to the sale) which are received by the seller, prior to such 
reacquisition, with respect to the sale of the property exceed the 
amount of the gain derived by the seller on the sale of such property 
which is returned as income for periods prior to the reacquisition. 
However, the amount of gain so determined shall in no case exceed the 
amount determined under paragraph (c) of this section with respect to 
such reacquisition.
    (ii) Amount of gain returned as income for prior periods. For 
purposes of this

[[Page 147]]

subparagraph and paragraph (c)(1) of this section, the amount of gain on 
the sale of the property which is returned as income for periods prior 
to the reacquisition of the real property does not include any amount of 
income determined under paragraph (f)(2) of this section which is 
considered to be received at the time of the reacquisition of the 
property. However, the amount of gain on the sale of the property which 
is returned as income for such periods does include gain on the sale 
resulting from payments received in the taxable year in which the date 
of reacquisition occurs if such payments are received prior to such 
reacquisition. The application of this subdivision may be illustrated by 
the following example:

    Example: In 1965 S, who uses the calendar year as the taxable year, 
sells to P for $10,000 real property which has an adjusted basis of 
$3,000. S properly elects under section 453 to report the income from 
the sale on the installment method. In 1965 and 1966, S receives a total 
of $4,000 on the contract. On May 15, 1967, S receives $1,000 on the 
contract. Because of P's default, S reacquires the property on August 
31, 1967. The gain on the sale which is returned as income for periods 
prior to the reacquisition is $3,500 ($5,000x$7,000/$10,000).

    (2) Amount of money and other property received with respect to the 
sale--(i) In general. Amounts of money and other property received by 
the seller with respect to the sale of the property include payments 
made by the purchaser for the seller's benefit, as well as payments made 
and other property transferred directly to the seller. If the purchaser 
of the real property makes payments on a mortgage or other indebtedness 
to which the property is subject at the time of the sale of such 
property to him, or on which the seller was personally liable at the 
time of such sale, such payments are considered amounts received by the 
seller with respect to the sale. However, if after the sale the 
purchaser borrows money and uses the property as security for the loan, 
payments by the purchaser in satisfaction of the indebtedness are not 
considered as amounts received by the seller with respect to the sale, 
although the seller does in fact receive some indirect benefit when the 
purchaser makes such payments.
    (ii) Payments by purchaser at time of reacquisition. All payments 
made by the purchaser at the time of the reacquisition of the real 
property that are with respect to the original sale of the property 
shall be treated, for purposes of subparagraph (1) of this paragraph, by 
the seller as having been received prior to the reacquisition with 
respect to such sale. For example, if the purchaser, at the time of the 
reacquisition by the seller, pays money or other property to the seller 
in partial or complete satisfaction of the purchaser's indebtedness on 
the original sale, the seller shall treat such amounts as having been 
received prior to the reacquisition with respect to the sale.
    (iii) Interest received. For purposes of this subparagraph and 
paragraph (c)(1) of this section any amounts received by the seller as 
interest, stated or unstated, are excluded from the computation of gain 
on the sale of the property and are not considered amounts of money or 
other property received with respect to the sale.
    (iv) Amounts received on sale of purchaser's indebtedness. Money or 
other property received by the seller on the sale of the purchaser's 
indebtedness that arose at the time of the sale of the real property are 
amounts received by the seller with respect to the sale of such real 
property, except that the amounts so received from the sale of such 
indebtedness shall be reduced by the amount of money and the fair market 
value of other property paid or transferred by the seller, before the 
reacquisition of the real property, to reacquire such indebtedness. For 
example, if S sells real property to P for $25,000, and under the 
contract receives $10,000 down and a note from P for $15,000, S would 
receive $22,000 with respect to the sale if he were to discount the note 
for $12,000. If before the reacquisition of the real property S were to 
reacquire the discounted note for $8,000, he would receive $14,000 with 
respect to the sale.
    (3) Obligations of the purchaser arising with respect to the sale. 
The term obligations of the purchaser arising with respect to the sale 
of the real property includes, for purposes of subparagraph (1) of this 
paragraph, only that indebtedness on

[[Page 148]]

which the purchaser is liable to the seller and which arises out of the 
sale of such property. Thus, the term does not include any indebtedness 
in respect of the property that the seller owes to a third person which 
the purchaser assumes, or to which the property is subject, at the time 
of the sale of the property to the purchaser. Nor does the term include 
any indebtedness on which the purchaser is liable to the seller if such 
indebtedness arises subsequent to the sale of such property.
    (c) Limitation upon amount of gain--(1) In general. Except as 
provided by subparagraph (2) of this paragraph, the amount of gain on a 
reacquisition of real property, as determined under paragraph (b) of 
this section, shall in no case exceed--
    (i) The amount by which the price at which the real property was 
sold exceeded its adjusted basis at the time of the sale, as determined 
under Sec. 1.1011-1, reduced by
    (ii) The amount of gain on the sale of such real property which is 
returned as income for periods prior to the reacquisition, and by
    (iii) The amount of money and the fair market value of other 
property (other than obligations of the purchaser to the seller which 
are secured by the real property) paid or transferred by the seller in 
connection with the reacquisition of such real property.
    (2) Cases where limitation does not apply. The limitation provided 
by subparagraph (1) of this paragraph shall not apply in a case where 
the selling price of property is indefinite in amount and cannot be 
ascertained at the time of the reacquisition of such property, as, for 
example, where the selling price is stated as a percentage of the 
profits to be realized from the development of the property which is 
sold. Moreover, the limitation so provided shall not apply to a 
reacquisition of real property occurring in a taxable year beginning 
before September 3, 1964, to which the provisions of this section are 
applied pursuant to an election under Sec. 1.1038-3.
    (3) Determination of sales price. The price at which the real 
property was sold shall be, for purposes of subparagraph (1) of this 
paragraph, the gross sales price reduced by the selling commissions, 
legal fees, and other expenses incident to the sale of such property 
which are properly taken into account in determining gain or loss on the 
sale. For example, the amount of selling commissions paid by a nondealer 
will be deducted from the gross sales price in determining the price at 
which the real property was sold; on the other hand, selling commissions 
paid by a real estate dealer will be deducted as a business expense. 
Examples of other expenses incident to the sale of the property are 
expenses for appraisal fees, advertising expense, cost of preparing 
maps, recording fees, and documentary stamp taxes. Payments on 
indebtedness to the seller which are for interest, stated or unstated, 
are not included in determining the price at which the property was 
sold. See paragraph (b)(2)(iii) of this section.
    (4) Determination of amounts paid or transferred in connection with 
a reacquisition--(i) In general. Amounts of money or property paid or 
transferred by the seller of the real property in connection with the 
reacquisition of such property include payments of money, or transfers 
of property, to persons from whom the real property is reacquired as 
well as to other persons. Payments or transfers in connection with the 
reacquisition of the property do not include money or property paid or 
transferred by the seller to reacquire obligations of the purchaser to 
the seller which were received by the seller with respect to the sale of 
the property or which arose subsequent to the sale. Amounts of money or 
property paid or transferred by the seller in connection with the 
reacquisition of the property include payments or transfers for such 
items as court costs and fees for services of an attorney, master, 
trustee, or auctioneer, or for publication, acquiring title, clearing 
liens, or filing and recording.
    (ii) Assumption of indebtedness. The assumption by the seller, upon 
reacquisition of the real property, of any indebtedness to another 
person which at such time is secured by such property will be considered 
a payment of money by the seller in connection with the reacquisition. 
Also, if at the time of reacquisition such property is subject to an

[[Page 149]]

indebtedness which is not an indebtedness of the purchaser to the 
seller, the seller shall be considered to have paid money, in an amount 
equal to such indebtedness, in connection with the reacquisition of the 
property. Thus, for example, if at the time of the sale the purchaser 
executes in connection with the sale a first mortgage to a bank and a 
second mortgage to the seller and at the time of reacquisition the 
seller reacquires the property subject to the first mortgage which he 
does not assume, the seller will be considered to have paid money, in an 
amount equal to the unpaid amount of the first mortgage, in connection 
with the reacquisition.
    (d) Character of gain resulting from a reacquisition. Paragraphs (b) 
and (c) of this section set forth the extent to which gain shall be 
derived from a reacquisition to which paragraph (a) of this section 
applies, but the rule provided by section 1038 and this section do not 
affect the character of the gain so derived. The character of the gain 
resulting from such a reacquisition is determined on the basis of 
whether the gain on the original sale was returned on the installment 
method or, if not, on the basis of whether title to the real property 
was transferred to the purchaser; and, if title was transferred to the 
purchaser in a deferred-payment sale, whether the reconveyance of the 
property to the seller was voluntary. For example, if the gain on the 
original sale of the reacquired property was returned on the installment 
method, the character of the gain on reacquisition by the seller shall 
be determined in accordance with the rules provided in paragraph (a) of 
Sec. 1.453-9. If the original sale was not on the installment method but 
was a deferred-payment sale, as described in Sec. 1.453-6(a), where 
title to the real property was transferred to the purchaser and the 
seller accepts a voluntary reconveyance of the property, the gain on the 
reacquisition shall be ordinary income; however, if the obligations 
satisfied are securities (as defined in section 165(g)(2)(C)), any gain 
resulting from the reacquisition is capital gain subject to the 
provisions of subchapter P of chapter 1 of the Code.
    (e) Recognition of gain. The entire amount of the gain determined 
under paragraphs (b) and (c) of this section with respect to a 
reacquisition to which paragraph (a) of this section applies shall be 
recognized notwithstanding any other provisions of subtitle A (relating 
to income taxes) of the Code.
    (f) Special rules applicable to worthless indebtedness--(1) 
Worthlessness resulting from reacquisition. No debt of the purchaser to 
the seller which was secured by the reacquired real property shall be 
considered as becoming worthless or partially worthless as a result of a 
reacquisition of such real property to which paragraph (a) of this 
section applies. Accordingly, no deduction for a bad debt and no charge 
against a reserve for bad debts shall be allowed, as a result of the 
reacquisition, in order to reflect the noncollectibility of any 
indebtedness of the purchaser to the seller which at the time of 
reacquisition was secured by such real property.
    (2) Indebtedness treated as worthless prior to reacquisition--(i) 
Prior taxable years. If for any taxable year ending before the taxable 
year in which occurs a reacquisition of real property to which paragraph 
(a) of this section applies the seller of such property has treated any 
indebtedness of the purchaser which is secured by such property as 
having become worthless or partially worthless by taking a bad debt 
deduction under section 166(a), he shall be considered as receiving, at 
the time of such reacquisition, income in an amount equal to the amount 
of such indebtedness previously treated by him as having become 
worthless. The amount so treated as income received shall be treated as 
a recovery of a bad debt previously deducted as worthless or partially 
worthless. Accordingly, the amount of such income shall be excluded from 
gross income, as provided in Sec. 1.111-1, to the extent of the recovery 
exclusion with respect to such item. For purposes of Sec. 1.111-1, if 
the indebtedness was treated as partially worthless in a prior taxable 
year, the amount treated under this subparagraph as a recovery shall be 
considered to be with respect to the part of the indebtedness that was 
previously deducted as worthless. The seller shall not be considered to 
have treated an indebtedness as worthless in any taxable year for which 
he

[[Page 150]]

took the standard deduction under section 141 or paid the tax imposed by 
section 3 if a deduction in respect of such indebtedness was not allowed 
in determining adjusted gross income for such year under section 62.
    (ii) Current taxable year. No deduction shall be allowed under 
section 166 (a), for the taxable year in which occurs a reacquisition of 
real property to which paragraph (a) of this section applies, in respect 
of any indebtedness of the purchaser secured by such property which has 
been treated by the seller as having become worthless or partially 
worthless in such taxable year but prior to the date of such 
reacquisition.
    (3) Basis adjustment. The basis of any indebtedness described in 
subparagraph (2)(i) of this paragraph shall be increased (as of the date 
of the reacquisition) by an amount equal to the amount which, under such 
subparagraph of this paragraph, is treated as income received by the 
seller with respect to such indebtedness, but only to the extent the 
amount so treated as received is not excluded from gross income by 
reason of the application of Sec. 1.111-1.
    (g) Rules for determining gain or loss on disposition of reacquired 
property--(1) Basis of reacquired real property. The basis of any real 
property acquired in a reacquisition to which paragraph (a) of this 
section applies shall be the sum of the following amounts, determined as 
of the date of such reacquisition:
    (i) The amount of the adjusted basis, determined under sections 453 
and 1011, and the regulations thereunder, of all indebtedness of the 
purchaser to the seller which at the time of reacquisition was secured 
by such property, including any increase by reason of paragraph (f)(3) 
of this section,
    (ii) The amount of gain determined under paragraphs (b) and (c) of 
this section with respect to such reacquisition, and
    (iii) The amount of money and the fair market value of other 
property (other than obligations of the purchaser to the seller which 
are secured by the real property) paid or transferred by the seller in 
connection with the reacquisition of such real property, determined as 
provided in paragraph (c) of this section even though such paragraph 
does not apply to the reacquisition.
    (2) Basis of undischarged indebtedness. The basis of any 
indebtedness of the purchaser to the seller which was secured by the 
reacquired real property described in subparagraph (1) of this 
paragraph, to the extent that such indebtedness is not discharged upon 
the reacquisition of such property, shall be zero. Therefore, to the 
extent not discharged upon the reacquisition of the real property, 
indebtedness on the original obligation of the purchaser, a substituted 
obligation of the purchaser, a deficiency judgment entered in a court of 
law into which the purchaser's obligation has merged, or any other 
obligation of the purchaser to the seller, shall be zero if such 
indebtedness constitutes an indebtedness to the seller which was secured 
by such property.
    (3) Holding period of reacquired property. Since the reacquisition 
described in subparagraph (1) of this paragraph is in a sense considered 
a nullification of the original sale of the real property, for purposes 
of determining gain or loss on a disposition of such property after its 
reacquisition the period for which the seller has held the real property 
at the time of such disposition shall include the period for which such 
property is held by him prior to the original sale. However, the holding 
period shall not include the period of time commencing with the date 
following the date on which the property is originally sold to the 
purchaser and ending with the date on which the property is reacquired 
by the seller. The period for which the property was held by the seller 
prior to the original sale shall be determined as provided in 
Sec. 1.1223-1. For example, if under paragraph (a) of Sec. 1.1223-1 real 
property, which was acquired as the result of an involuntary conversion, 
has been held for five months on January 1, 1965, the date of its sale, 
and such property is reacquired on July 2, 1965, and resold on July 3, 
1965, the seller will be considered to have held such property for five 
months and one day for purposes of this subparagraph.
    (h) Illustrations. The application of this section may be 
illustrated by the

[[Page 151]]

following examples in which it is assumed that the reacquisition is in 
satisfaction of secured indebtedness arising out of the sale of the real 
property:

    Example 1. (a) S purchases real property for $20 and sells it to P 
for $100, the property not being mortgaged at the time of sale. Under 
the contract P pays $10 down and executes a note for $90, with stated 
interest at 6 percent, to be paid in nine annual installments. S 
properly elects to report the gain on the installment method. After the 
second $10 annual payment P defaults and S accepts a voluntary 
reconveyance of the property in complete satisfaction of the 
indebtedness. S pays $5 in connection with the reacquisition of the 
property. The fair market value of the property at the time of the 
reacquisition is $110.
    (b) The gain derived by S on the reacquisition of the property is 
$6, determined as follows:

Gain before application of limitation:
  Money with respect to the sale received by S prior to the          $30
   reacquisition.............................................
  Less: Gain returned by S as income for periods prior to the         24
   reacquisition ($30x[ ($100-$20)/$100])....................
                                                   ------------
  Gain before application of limitation......................          6
                                                   ============
Limitation on amount of gain:
  Sales price of real property...............................        100
  Less:
    Adjusted basis of the property at the time of         $20
     sale.........................................
    Gain returned by S as income for periods prior         24
     to the reacquisition.........................
    Amount of money paid by S in connection with            5         49
     the reacquisition............................
                                                   ---------------------
  Limitation on amount of gain...............................         51
                                                   ============
Gain resulting from the reacquisition of the property........          6
 

    (c) The basis of the reacquired real property at the date of the 
reacquisition is $25, determined as follows:

Adjusted basis of P's indebtedness to S ($70-[$70x$80/$100]).        $14
Gain resulting from the reacquisition of the property........          6
Amount of money paid by S in connection with the                       5
 reacquisition...............................................
                                                              ----------
    Basis of reacquired property.............................         25
 

    Example 2. (a) The facts are the same as in example (1) except that 
S purchased the property for $80.
    (b) The gain derived by S on the reacquisition of the property is 
$9, determined as follows:

Gain before application of limitation:
  Money with respect to the sale received by S prior to the          $30
   reacquisition.............................................
  Less: Gain returned by S as income for periods prior to the         $6
   reacquisition ($30x[($100-$80)/$100]).....................
                                                   ------------
  Gain before application of limitation......................         24
                                                   ============
Limitation on amount of gain:
  Sales price of real property...............................        100
  Less:
    Adjusted basis of the property at the time of         $80
     sale.........................................
    Gain returned by S as income for periods prior          6
     to the reacquisition.........................
    Amount of money paid by S in connection with            5         91
     the reacquisition............................
                                                   ---------------------
  Limitation on amount of gain...............................          9
                                                   ============
  Gain resulting from the reacquisition of the property......          9
 

    (c) The basis of the reacquired real property at the date of the 
reacquisition is $70, determined as follows:

Adjusted basis of P's indebtedness to S ($70-[$70x$20/$100]).        $56
Gain resulting from the reacquisition of the property........          9
Amount of money paid by S in connection with the                       5
 reacquisition...............................................
                                                              ----------
    Basis of reacquired property.............................         70
                                                              ==========
 

    Example 3. (a) S purchases real property for $70 and sells it to P 
for $100, the property not being mortgaged at the time of sale. Under 
the contract P pays $10 down and executes a note for $90, with stated 
interest at 6 percent, to be paid in nine annual installments. S 
properly elects to report the gain on the installment method. After the 
first $10 annual payment P defaults and S accepts a voluntary 
reconveyance of the property in complete satisfaction of the 
indebtedness. S pays $5 in connection with the reacquisition of the 
property. The fair market value of the property at the time of the 
reacquisition is $50.
    (b) The gain derived by S on the reacquisition of the property is 
$14, determined as follows:

Gain before application of limitation:
  Money with respect to the sale received by S prior to the          $20
   reacquisition.............................................
  Less: Gain returned by S as income for periods prior to the          6
   reacquisition ($20x[($100-$70)/$100]).....................
                                                   ------------
  Gain before application of limitation......................         14
                                                   ============
Limitation on amount of gain:
  Sales price of real property...............................        100
  Less:
    Adjusted basis of the property at time of sale        $70
    Gain returned by S as income for periods prior          6
     to the reacquisition.........................

[[Page 152]]

 
    Amount paid by S in connection with the                 5         81
     reacquisition................................
                                                   ---------------------
  Limitation on amount of gain...............................         19
                                                   ============
  Gain resulting from the reacquisition of the property......         14
 

    (c) The basis of the reacquired real property at the date of the 
reacquisition is $75, determined as follows:

Adjusted basis of P's indebtedness to S ($80-[$80x$30/$100]).        $56
Gain resulting from the reacquisition of the property........         14
Amount of money paid by S in connection with the                       5
 reacquisition...............................................
                                                              ----------
    Basis of reacquired property.............................         75
 

    Example 4. (a) S purchases real property for $20 and sells it to P 
for $100, the property not being mortgaged at the time of sale. Under 
the contract P pays $10 down and executes a note for $90, with stated 
interest at 6 percent, to be paid in nine annual installments. S 
properly elects to report gain on the installment method. After the 
second $10 annual payment P defaults and S accepts from P in complete 
satisfaction of the indebtedness a voluntary reconveyance of the 
property plus cash in the amount of $20. S does not pay any amount in 
connection with the reacquisition of the property. The fair market value 
of the property at the time of the reacquisition is $30.
    (b) The gain derived by S on the reacquisition of the property is 
$10, determined as follows:

Gain before application of the limitation:
  Money with respect to the sale received by S prior to the          $50
   reacquisition ($30+$20)...................................
  Less: Gain returned by S as income for periods prior to the         40
   reacquisition ($50x[($100-$20)/$100]).....................
                                                   ------------
  Gain before application of limitation......................         10
                                                   ============
Limitation on amount of gain:
  Sales price of real property...............................        100
  Less:
    Adjusted basis of the property at time of sale        $20
    Gain returned by S as income for periods prior         40         60
     to the reacquisition.........................
                                                   ---------------------
  Limitation on amount of gain...............................         40
                                                   ============
Gain resulting from the reacquisition of the property........         10
 

    (c) The basis of the reacquired real property at the date of the 
reacquisition is $20, determined as follows:

Adjusted basis of P's indebtedness to S ($50-[$50x$80/$100]).        $10
Gain resulting from the reacquisition of the property........         10
                                                              ----------
    Basis of reacquired property.............................         20
 

    Example 5. (a) S purchases real property for $80 and sells it to P 
for $100, the property not being mortgaged at the time of sale. Under 
the contract P pays $10 down and executes a note for $90, with stated 
interest at 6 percent, to be paid in nine annual installments. At the 
time of sale P's note has a fair market value of $90. S does not elect 
to report the gain on the installment method but treats the transaction 
as a deferred-payment sale. After the third $10 annual payment P 
defaults and S forecloses. Under the foreclosure sale S bids in the 
property at $70, cancels P's obligation of $60, and pays $10 to P. There 
are no other amounts paid by S in connection with the reacquisition of 
the property. The fair market value of the property at the time of the 
reacquisition is $70.
    (b) The gain derived by S on the reacquisition of the property is 
$0, determined as follows:

Gain before application of the limitation:
  Money with respect to the sale received by S prior to the          $40
   reacquisition.............................................
  Less: Gain returned by S as income for periods prior to the         20
   reacquisition ([$10+$90]-$80).............................
                                                   ------------
  Gain before application of limitation......................         20
                                                   ============
Limitation on amount of gain:
  Sales price of real property....................                   100
  Less:
    Adjusted basis of the property at the time of         $80
     sale.........................................
    Gain returned by S as income for periods prior         20
     to the reacquisition.........................
    Amount of money paid by S in connection with           10        110
     the reacquisition............................
                                                   ---------------------
  Limitation on amount of gain (not to be less than zero)....          0
                                                   ============
Gain resulting from the reacquisition of the property........          0
 

    (c) The basis of the reacquired real property at the date of the 
reacquisition is $70, determined as follows:

Adjusted basis of P's indebtedness to S (face value at time          $60
 of reacquisition)...........................................
Gain resulting from the reacquisition of the property........          0
Amount of money paid by S in connection with the                      10
 reacquisition...............................................
                                                              ----------
    Basis of reacquired property.............................         70
 


[T.D. 6916, 32 FR 5925, Apr. 13, 1967; 32 FR 6971, May 6, 1967]



Sec. 1.1038-2  Reacquisition and resale of property used as a principal residence.

    (a) Application of special rules--(1) In general. If paragraph (a) 
of Sec. 1.1038-1 applies to the reacquisition of real property which was 
used by the seller as his

[[Page 153]]

principal residence and with respect to the sale of which an election 
under section 121 is in effect or with respect to the sale of which gain 
was not recognized under section 1034, the provisions of Sec. 1.1038-1 
(other than paragraph (a) thereof) shall not, and this section shall, 
apply to the reacquisition of such property if the property is resold by 
the seller within one year after the date of the reacquisition. For 
purposes of this section an election under section 121 shall be 
considered to be in effect with respect to the sale of the property if, 
at the close of the last day for making such an election under section 
121(c) with respect to such sale, an election under section 121 has been 
made and not revoked. Thus, a taxpayer who properly elects, subsequent 
to the reacquisition, to have section 121 apply to a sale of his 
residence may be eligible for the treatment provided in this section. 
The treatment provided by this section is mandatory; however, see 
Sec. 1.1038-3 for an election to apply the provisions of this section to 
certain taxable years beginning after December 31, 1957.
    (2) Sale and resale treated as one transaction. In the case of a 
reacquisition to which this section applies, the resale of the 
reacquired property shall be treated, for purposes of applying sections 
121 and 1034, as part of the transaction constituting the original sale 
of such property. In effect, the reacquisition is generally disregarded 
pursuant to this section and, for purposes of applying sections 121 and 
1034, the resale of the property is considered to constitute a sale of 
such property occurring on the date of the original sale of such 
property.
    (b) Transactions not included. (1) If with respect to the original 
sale of the property there was no nonrecognition of gain under section 
1034 and an election under section 121 is not in effect, the provisions 
of Sec. 1.1038-1, and not this section, shall apply to the 
reacquisition. Thus, for example, if in the case of a taxpayer not 
entitled to the benefit of section 121 there is no gain on the original 
sale of the property, the provisions of Sec. 1.1038-1, and not this 
section, shall apply even though a redetermination of gain under this 
section would result in the nonrecognition of gain on the sale under 
section 1034. Also, if in the case of such a taxpayer there was gain on 
the original sale of the property but after the application of section 
1034 all of such gain was recognized, the provisions of Sec. 1.1038-1, 
and not this section, shall apply to the reacquisition.
    (2) If the original sale of the property was not eligible for the 
treatment provided by section 121 and section 1034, the provisions of 
Sec. 1.1038-1, and not this section, shall apply to the reacquisition of 
the property even though the resale of such property is eligible for the 
treatment provided by either or both of sections 121 and 1034.
    (c) Redetermination of gain required--(1) Sale of old residence. The 
amount of gain excluded under section 121 on the sale of the property 
and the amount of gain recognized under section 1034 on the sale of the 
property shall be redetermined under this section by recomputing the 
adjusted sales price and the adjusted basis of the property, and any 
adjustments resulting from the redetermination of the gain on the sale 
of such property shall be reflected in the income of the seller for his 
taxable year in which the resale of the property occurs.
    (2) Sale of new residence. If gain was not recognized under section 
1034 on the original sale of the property, the adjusted basis of the new 
residence shall be redetermined under this section. If the new residence 
has been sold, the amount of gain returned on such sale of the new 
residence which is affected by the redetermination of the recognized 
gain on the sale of the old residence shall be redetermined under this 
section, and any adjustments resulting from the redetermination of the 
gain on the sale of the new residence shall be reflected in income of 
the seller for his taxable year in which the resale of the old residence 
occurs.
    (d) Redetermination of adjusted sales price. For purposes of 
applying sections 121 and 1034 pursuant to this section, the adjusted 
sales price of the reacquired real property shall be redetermined by 
taking into account both the sale and the resale of the property and 
shall be--
    (1) The amount realized, which for purposes of section 1001 shall 
be--

[[Page 154]]

    (i) The amount realized on the resale of the property, as determined 
under paragraph (b)(4) of Sec. 1.1034-1, plus
    (ii) The amount realized on the original sale of the property, 
determined as provided in paragraph (b)(4) of Sec. 1.1034-1, less that 
portion of any obligations of the purchaser arising with respect to such 
sale which at the time of reacquisition is secured by such property and 
is unpaid, less
    (iii) The amount of money and the fair market value of other 
property (other than obligations of the purchaser to the seller secured 
by the real property) paid or transferred by the seller in connection 
with the reacquisition of such real property,

reduced by

    (2) The total of the fixing-up expenses (as defined in par. (b)(6) 
of Sec. 1.1034-1) incurred for work performed on such real property to 
assist in both its original sale and its resale.

For purposes of applying paragraph (b)(6) of Sec. 1.1034-1, there shall 
be two 90-day periods, the first ending on the day on which the contract 
to sell is entered into in connection with the original sale of the 
property, and the second ending on the day on which the contract to sell 
is entered into in connection with the resale of the property. There 
shall also be two 30-day periods for such purposes, the first ending on 
the 30th day after the date of the original sale, and the second ending 
on the 30th day after the date of the resale. For determination of the 
obligations of the purchaser arising with respect to the original sale 
of the property, see paragraph (b)(3) of Sec. 1.1038-1. For 
determination of amounts paid or transferred by the seller in connection 
with the reacquisition of the property, see paragraph (c)(4) of 
Sec. 1.1038-1.
    (e) Determination of adjusted basis at time of resale. For purposes 
of applying sections 121 and 1034 pursuant to this section, the adjusted 
basis of the reacquired real property at the time of its resale shall 
be--
    (1) The sum of--
    (i) The adjusted basis of such property at the time of the original 
sale, with proper adjustment under section 1016(a) in respect of such 
property for the period occurring after the reacquisition of such 
property, and
    (ii) Any indebtedness of the purchaser to the seller which arose 
subsequent to the original sale of such property and which at the time 
of reacquisition was secured by such property,

reduced by

    (2) Any indebtedness of the purchaser to the seller which at the 
time of reacquisition was secured by the reacquired real property and 
which, for any taxable year ending before the taxable year in which 
occurs the reacquisition to the seller which was secured by the seller 
as having become worthless or partially worthless by taking a bad debt 
deduction under section 166(a).

The reduction under the preceding sentence by reason of having treated 
indebtedness as worthless or partially worthless shall not exceed the 
amount by which there would be an increase in the basis of such 
indebtedness under paragraph (f)(3) of Sec. 1.1038-1 if section 1038(d) 
had been applicable to the reacquisition of such property.
    (f) Treatment of indebtedness secured by the property--(1) Year of 
reacquisition. No debt of the purchaser to the seller which was secured 
by the reacquired real property shall be considered as becoming 
worthless or partially worthless as a result of a reacquisition of such 
real property to which this section applies. Accordingly, no deduction 
for a bad debt shall be allowed, as a result of the reacquisition, in 
order to reflect the noncollectibility of any indebtedness of the 
purchaser to the seller which at the time of reacquisition was secured 
by such real property. In addition, no deduction shall be allowed, for 
the taxable year in which occurs a reacquisition of real property to 
which this section applies, in respect of any indebtedness of the 
purchaser secured by such property which has been treated by the seller 
as having become worthless or partially worthless in such taxable year 
but prior to the date of such reacquisition.

[[Page 155]]

    (2) Prior taxable years. For reduction of the basis of the real 
property for indebtedness treated as worthless or partially worthless 
for taxable years ending before the taxable year in which occurs the 
reacquisition, see paragraph (e) of this section.
    (3) Basis of indebtedness. The basis of any indebtedness of the 
purchaser to the seller which was secured by the reacquired real 
property, to the extent that such indebtedness is not discharged upon 
the reacquisition of such property, shall be zero.
    (g) Date of sale. Since the resale of the property, by being treated 
as part of the transaction constituting the original sale of the 
property, is treated as having occurred on the date of the original 
sale, in determining whether any of the time requirements of section 121 
or section 1034 are satisfied for purposes of this section the date of 
the original sale is used, except to the extent provided in paragraph 
(d)(2) of this section.
    (h) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. (a) On June 30, 1964, S, a single individual over 65 
years of age, sells his principal residence to P for $25,000, the 
property not being mortgaged at the time of sale. S properly elects to 
apply the provisions of section 121 to the sale. Under the contract, P 
pays $5,000 down and executes a note for $20,000 with stated interest at 
6 percent, the principal being payable in installments of $5,000 each on 
January 1 of each year and the note being secured by the real property 
which is sold. At the time of sale P's note has a fair market value of 
$20,000. S does not elect to report the gain on the installment method 
but treats the transaction as a deferred-payment sale, title to the 
property being transferred to P at the time of sale. S uses the calendar 
year as the taxable year and the cash receipts and disbursements method 
of accounting. After making two annual payments of $5,000 each on the 
note, P defaults on the contract, and on March 1, 1967, S reacquires the 
real property in full satisfaction of P's indebtedness, title to the 
property being voluntarily reconveyed to S. On November 1, 1967, S sells 
the property to T for $35,000. The assumption is made that no fixing-up 
expenses are incurred for work performed on the principal residence in 
order to assist in the sale of the property in 1964 or in the resale of 
the property in 1967. At the time of sale in 1964 the property has an 
adjusted basis of $15,000. S does not treat any indebtedness with 
respect to the sale in 1964 as being worthless or partially worthless or 
make any capital expenditures with respect to the property after such 
sale. In his return for 1964, S includes in income $2,000 capital gain 
from the sale of his residence.
    (b) The results obtained before and after the reacquisition of the 
property are as follows:

------------------------------------------------------------------------
                                                Before         After
                                            reacquisition  reacquisition
------------------------------------------------------------------------
Adjusted sales price:
  $5,000+$20,000..........................      $25,000    .............
  $15,000+$35,000.........................  .............      $50,000
Less: Adjusted basis of property at time         15,000         15,000
 of sale..................................
                                           -----------------------------
Gain on sale..............................       10,000         35,000
                                           =============================
Gain excluded from income under section
 121:.....................................
  $10,000x$20,000/$25,000.................        8,000    .............
  $35,000x$20,000/$50,000.................  .............       14,000
Gain included in income after   applying
 section 121:
  $10,000-$8,000..........................        2,000    .............
  $35,000-$14,000.........................  .............       21,000
------------------------------------------------------------------------

    (c) S is required to show the additional inclusion of $19,000 
capital gain ($21,000 -$2,000) in income on his return for 1967.
    Example 2. (a) The facts are the same as in example (1) except that 
on April 1, 1965, S purchases a new residence at a cost of $30,000 and 
qualifies for the nonrecognition of gain under section 1034 in respect 
of the sale of his principal residence on June 30, 1964. In his return 
for 1964, S does not include any capital gain in income as a result of 
the sale of the old residence.
    (b) The results obtained before and after the reacquisition of the 
property are as follows:

------------------------------------------------------------------------
                                                Before         After
                                            reacquisition  reacquisition
------------------------------------------------------------------------
Application of section 121 (see example
 (1)):
  Adjusted sales price....................      $25,000        $50,000
  Less: Adjusted basis of property at time       15,000         15,000
   of sale................................
                                           -----------------------------
  Gain on sale............................       10,000         35,000
                                           =============================
  Gain excluded from income under section         8,000         14,000
   121....................................
  Gain not excluded from income under             2,000         21,000
   section 121............................
Application of section 1034: Adjusted
 sales price:
  $25,000-$8,000..........................       17,000    .............
  $50,000-$14,000.........................  .............       36,000
Less: Cost of new residence...............       30,000         30,000
                                           -----------------------------
Gain recognized under section 1034 on sale            0          6,000
 of old residence.........................
                                           =============================
Gain not recognized under section 1034 on
 sale of old residence:
  ($10,000-[$8,000+$0])...................        2,000    .............

[[Page 156]]

 
  ($35,000- [$14,000+$6,000]).............  .............       15,000
Adjusted basis of new residence on April
 1, 1965:
  $30,000-$2,000..........................       28,000    .............
  $30,000-$15,000.........................  .............       15,000
------------------------------------------------------------------------

    (c) The $6,000 of capital gain on the sale of the old residence is 
required to be included in income on the return for 1967. The adjusted 
basis on April 1, 1965, for determining gain on a sale or exchange of 
the new residence at any time on or after that date is $15,000, after 
taking into account the reacquisition and resale of the old residence.
    Example 3. The facts are the same as in example (2) except that S 
sells the new residence on June 20, 1965, for $40,000 and includes 
$12,000 of capital gain ($40,000- $28,000) on its sale in his income on 
the return for 1965. S is required to include the additional capital 
gain of $13,000 ([$40,000- $15,000]-$12,000) on the sale of the new 
residence in his income on the return for 1967. For this purpose, the 
assumption is also made that there are no additional adjustments to the 
basis of the new residence after April 1, 1965.

[T.D. 6916, 32 FR 5929, Apr. 13, 1967; 32 FR 6971, May 6, 1967]



Sec. 1.1038-3  Election to have section 1038 apply for taxable years beginning after December 31, 1957.

    (a) In general. If an election is made in the manner provided by 
paragraph (b) of this section, the applicable provisions of 
Secs. 1.1038-1 and 1.1038-2 shall apply to all reacquisitions of real 
property occurring in each and every taxable year beginning after 
December 31, 1957, and before September 3, 1964, for which the 
assessment of a deficiency, or the credit or refund of an overpayment, 
is not prevented on September 2, 1964, by the operation of any law or 
rule of law. The election so made shall apply to all taxable years 
beginning after December 31, 1957, and before September 3, 1964, for 
which the assessment of a deficiency, or the credit or refund of an 
overpayment, is not prevented on September 2, 1964, by the operation of 
any law or rule of law and shall apply to every reacquisition occurring 
in such taxable years. The fact that the assessment of a deficiency, or 
the credit or refund of an overpayment, is prevented for any other 
taxable year or years affected by the election will not prohibit the 
making of an election under this section. For example, if an individual 
who uses the calendar year as the taxable year were to sell in 1960 real 
property used as his principal residence in respect of the sale of which 
gain is not recognized under section 1034, and if such property were 
reacquired by the seller in 1962 and resold within 1 year, he would be 
permitted to make an election under this section with respect to such 
reacquisition even though on September 2, 1964, the period of 
limitations on assessment or refund has run for 1960. An election under 
this section shall be deemed a consent to the application of the 
provisions of this section.
    (b) Time and manner of making election--(1) In general. (i) An 
election to have the provisions of Sec. 1.1038-2 apply to reacquisitions 
of real property occurring in taxable years beginning after December 31, 
1957, and before September 3, 1964, shall be made by filing on or before 
September 3, 1965, a return, an amended return, or a claim for refund, 
whichever is proper, for each taxable year in which the resale of such 
real property occurs. If the return for any such year is not due on or 
before such date and has not been filed, the election with respect to 
such taxable year shall be made by filing on or before such date the 
statement described in subparagraph (2) of this paragraph.
    (ii) An election to have the provisions of Sec. 1.1038-1 apply to 
reacquisitions of real property occurring in taxable years beginning 
after December 31, 1957, and before September 3, 1964, shall be made by 
filing on or before September 3, 1965, a return, an amended return, or a 
claim for refund, whichever is proper, for each taxable year in which 
such reacquisitions occur. If the return for any such year is not due on 
or before such date and has not been filed, the election with respect to 
such taxable year shall be made by filing on or before such date the 
statement described in subparagraph (2) of this paragraph.
    (iii) If the facts are such that Sec. 1.1038-2 applies to a 
reacquisition of property except that the reacquisition occurs in a 
taxable year beginning after December 31, 1957, and before September 3,

[[Page 157]]

1964, an election may not be made under this paragraph to have the 
provisions of Sec. 1.1038-1 apply to such reacquisition.
    (iv) Once made, an election under this paragraph may not be revoked 
after September 3, 1965. To any return, amended return, or claim for 
refund filed under this subparagraph there shall be attached the 
statement described in subparagraph (2) of this paragraph.
    (2) Statement to be attached. The statement described in 
subparagraph (1) of this paragraph shall indicate--
    (i) The name, address and account number of the taxpayer, and the 
fact that the taxpayer is electing to have the provisions of section 
1038 apply to the reacquisitions of real property,
    (ii) The taxable years in which the reacquisitions of property occur 
and any other taxable year or years the tax for which is affected by the 
application of section 1038 to such reacquisitions,
    (iii) The office of the district director where the return or 
returns for such taxable year or years were or will be filed,
    (iv) The dates on which such return or returns were filed and on 
which the tax for such taxable year or years was paid,
    (v) The type of real property reacquired, the terms under which such 
property was sold and reacquired, and an indication of whether the 
taxpayer is applying the provisions of Sec. 1.1038-2 to the 
reacquisition of such property,
    (vi) If Sec. 1.1038-2 is being applied to the reacquisition, the 
terms under which the old residence was resold and, if applicable, the 
terms under which the new residence was sold, and
    (vii) The office where, and the date when, the election to apply 
section 121 in respect to any sale of such property was or will be made.
    (3) Place for filing. Any claim for refund, amended return, or 
statement, filed under this paragraph in respect of any taxable year, 
whether the taxable year in which occurs the reacquisition of property 
or the taxable year in which occurs the resale of the old residence, 
shall be filed in the office of the district director in which the 
return for such taxable year was or will be filed.
    (c) Extension of period of limitations on assessment or refund--(1) 
Assessment of tax. If an election is properly made under paragraph (b) 
of this section and the assessment of a deficiency for the taxable years 
to which such election applies is not prevented on September 2, 1964, by 
the operation of any law or rule of law, the period within which a 
deficiency for such taxable years may be assessed shall, to the extent 
such deficiency is attributable to the application of section 1038, not 
expire prior to one year after the date on which such election is made.
    (2) Refund of tax. If an election is properly made under paragraph 
(b) of this section and the credit or refund of any overpayment for the 
taxable years to which such election applies is not prevented on 
September 2, 1964, by the operation of any law or rule of law, the 
period within which a claim for credit or refund of an overpayment for 
such taxable years may be filed shall, to the extent such overpayment is 
attributable to the application of section 1038, not expire prior to one 
year after the date on which such election is made.
    (d) Payment of interest for period prior to September 2, 1964. No 
interest shall be payable with respect to any deficiency attributable to 
the application of the provisions of section 1038, and no interest shall 
be allowed with respect to any credit or refund of any overpayment 
attributable to the application of such section, for any period prior to 
September 2, 1964. See section 2(c)(3) of the Act of September 2, 1964 
(Pub. L. 88-750, 78 Stat. 856).

[T.D. 6916, 32 FR 5930, Apr. 13, 1967]



Sec. 1.1039-1  Certain sales of low-income housing projects.

    (a) Nonrecognition of gain. Section 1039 provides rules under which 
the taxpayer may elect not to recognize gain in certain cases where a 
qualified housing project is sold or disposed of after October 9, 1969, 
in an approved disposition and another such qualified housing project or 
projects (referred to as the replacement project) is acquired, 
constructed, or reconstructed within a specified reinvestment period. If 
the requirements of section 1039 are met, and if the taxpayer makes an 
election in

[[Page 158]]

accordance with the provisions of paragraph (b)(4) of this section, then 
the gain realized upon the sale or disposition is recognized only to the 
extent that the net amount realized on such sale or disposition exceeds 
the cost of the replacement project. However, notwithstanding section 
1039, gain may be recognized by reason of the application of section 
1245 or 1250 to the sale or disposition. (See Sec. 1.1245-6(b) and 
Sec. 1.1250-3(h). The terms qualified housing project, approved 
disposition, reinvestment period, and net amount realized are defined in 
paragraph (c) of this section.
    (b) Rules of application--(1) In general. The election under section 
1039(a) may be made only by the taxpayer owning the qualified housing 
project disposed of. Thus, if the qualified housing project disposed of 
is owned by a partnership, the partnership must make the election. (See 
section 703(b).) Similarly, if the qualified housing project disposed of 
is owned by a corporation or trust, the corporation or trust must make 
the election. In addition, the reinvestment of the taxpayer must be in 
such a manner that the taxpayer would be entitled to a deduction for 
depreciation on the replacement project. Thus, if the qualified housing 
project disposed of is owned by individual A, the purchase by A of stock 
in a corporation owning or constructing such a project or of an interest 
in a partnership owning or constructing such a project will not be 
considered as the purchase or construction by A of such a project.
    (2) Special rules. (i) The cost of a replacement project acquired 
before the approved disposition of a qualified housing project shall be 
taken into account under section 1039 only if such property is held by 
the taxpayer on the date of the approved disposition.
    (ii) Except as provided in section 1039 (d), no property acquired by 
the taxpayer shall be taken into account for purposes of section 
1039(a)(2) unless the unadjusted basis of such property is its cost 
within the meaning of section 1012. For example, if a qualified housing 
project is acquired in an exchange under section 1031, relating to 
exchange of property held for productive use or investment, such 
property will not be taken into account under section 1039(a)(2) because 
its basis is determined by reference to the basis of the property 
exchanged. (See section 1031(d).)
    (3) Cost of replacement project. The taxpayer's cost for the 
replacement project includes only amounts properly treated as capital 
expenditures by the taxpayer that are attributable to acquisition, 
construction, or reconstruction made within the reinvestment period (as 
defined in paragraph (c)(4) of this section). See section 263 for rules 
as to what constitutes capital expenditures. Thus, assume that a 
calendar year taxpayer realizes gain in 1970 upon the approved 
disposition of a qualified housing project occurring on January 1, 1970. 
If the taxpayer had begun construction of another qualified housing 
project on January 1, 1969, and completes such construction on June 1, 
1972, only that portion of the cost attributable to the period before 
January 1, 1972, constitutes the cost of the replacement project for 
purposes of section 1039. For purposes of determining the cost of a 
replacement project attributable to a particular period, the total cost 
of the project may be allocated to such period on the basis of the 
portion of the total project actually constructed during such period.
    (4) Election. (i) An election not to recognize the gain realized 
upon an approved disposition of a qualified housing project to the 
extent provided in section 1039(a) may be made by attaching a statement 
to the income tax return filed for the first taxable year in which any 
portion of the gain on such disposition is realized. Such a statement 
shall contain the information required by subdivision (iii) of this 
subparagraph. If the taxpayer does not file such a statement for the 
first taxable year in which any portion of the gain is realized, but 
fails to report a portion of the gain realized upon the approved 
disposition as income for such year or for any subsequent taxable year, 
then an election shall be deemed to be made under section 1039 (a) with 
respect to that portion of the gain not reported as income.
    (ii) An election may be made under section 1039(a) even though the 
replacement project has not been acquired or constructed at the time of 
election. However, if an election has been made

[[Page 159]]

and (a) a replacement project is not constructed, reconstructed, or 
acquired, (b) the cost of the replacement project is lower than the net 
amount realized from the approved disposition, or (c) a decision is made 
not to construct, reconstruct, or acquire a replacement project, then 
the tax liability for the year or years for which the election was made 
shall be recomputed and an amended return filed. An election may be made 
even though the taxpayer has filed his return and recognized gain upon 
the disposition provided that the period of limitation on filing claims 
for credit or refund prescribed by section 6511 has not expired. In such 
case, a statement containing the information required by subdivision 
(iii) of this subparagraph should be filed together with a claim for 
credit or refund for the taxable year or years in which gain was 
recognized.
    (iii) The statement referred to in subdivisions (i) and (ii) of this 
subparagraph shall contain the following information:
    (a) The date of the approved disposition;
    (b) If a replacement project has been acquired, the date of 
acquisition and cost of the project;
    (c) If a replacement project has been constructed or reconstructed 
by or for the taxpayer, the date construction was begun, the date 
construction was completed, and the percentage of construction completed 
within the reinvestment period;
    (d) If no replacement project has been constructed, reconstructed, 
or acquired prior to the time of filing of the statement, the estimated 
cost of such construction, reconstruction, or acquisition;
    (e) The adjusted basis of the project disposed of; and
    (f) The amount realized upon the approved disposition and a 
description of the expenses directly connected with the disposition and 
the taxes (other than income taxes) attributable to the disposition.
    (c) Definitions--(1) General. The definitions contained in 
subparagraphs (2) through (5) of this paragraph shall apply for purposes 
of this section.
    (2) Qualified housing project. The term qualified housing project 
means a rental or cooperative housing project for lower income families 
that has been constructed, reconstructed, or rehabilitated pursuant to a 
mortgage which is insured under section 221(d)(3) or 236 of the National 
Housing Act, provided that with respect to the housing project disposed 
of and the replacement project constructed, reconstructed, or acquired, 
the owner of the project at the time of the approved disposition and 
prior to the close of the reinvestment period is, under such sections or 
regulations issued thereunder,
    (i) Limited as to rate of return on his investment in the project, 
and
    (ii) Limited as to rentals or occupancy charges for units in the 
project.

If the owner of the project is organized and operated as a nonprofit 
cooperative or other nonprofit organization, then such owner shall be 
considered to meet the requirement of subdivision (i) of this 
subparagraph.
    (3) Approved disposition. The term approved disposition means a sale 
or other disposition of a qualified housing project to the tenants or 
occupants of units in such project, or to a nonprofit cooperative or 
other nonprofit organization formed and operated solely for the benefit 
of such tenants or occupants, provided that it is approved by the 
Secretary of Housing and Urban Development or his delegate under section 
221 (d)(3) or 236 of the National Housing Act or regulations issued 
under such sections. Evidence of such approval should be attached to the 
tax return or statement in which the election under section 1039 is 
made.
    (4) Reinvestment period. (i) The term reinvestment period means the 
period beginning 1 year before the date of the disposition and ending 1 
year after the close of the first taxable year in which any part of the 
gain from such disposition is realized, or at such later date as may be 
designated pursuant to an application made by the taxpayer. Such 
application shall be made before the expiration of one year after the 
close of the first taxable year in which any part of the gain from such 
disposition is realized, unless the taxpayer can show to the 
satisfaction of the district director that--

[[Page 160]]

    (a) Reasonable cause exists for not having filed the application 
within the required period, and
    (b) The filing of such application was made within a reasonable time 
after the expiration of the required period.

The application shall contain all the information required by paragraph 
(b)(4) of this section and shall be made to the district director for 
the internal revenue district in which the return is filed for the first 
taxable year in which any of the gain from the approved disposition is 
realized.
    (ii) Ordinarily, requests for extension of the reinvestment period 
will not be granted until near the end of such period and any extension 
will usually be limited to a period not exceeding one year. Although 
granting of an extension depends upon the facts and circumstances of a 
particular case, if a predominant portion of the construction of the 
replacement project has been completed or is reasonably expected to be 
completed within the reinvestment period (determined without regard to 
any extension thereof), an extension of the reinvestment period will 
ordinarily be granted. The fact that there is a scarcity of replacement 
property for acquisition will not be considered sufficient grounds for 
granting an extension.
    (5) Net amount realized. (i) The net amount realized from the 
approved disposition of a qualified housing project is the amount 
realized from such disposition, reduced by--
    (a) The expenses paid or incurred by the taxpayer which are directly 
connected with the approved disposition, and
    (b) The amount of taxes (other than income taxes) paid or incurred 
by the taxpayer which are attributable to the approved disposition.
    (ii) Examples of expenses directly connected with an approved 
disposition of a qualified housing project include amounts paid for 
sales or other commissions, advertising, and for the preparation of a 
deed or other legal services in connection with the disposition. An 
amount paid for a repair to the building will be considered as an 
expense directly connected with the approved disposition under 
subdivision (i)(a) of this subparagraph only if such repair is required 
as a condition of sale, or is required by the Secretary of Housing and 
Urban Development or his delegate as a condition of approval of the 
disposition.
    (iii) Examples of taxes that are attributable to the approved 
disposition include local property transfer taxes and stamp taxes. A 
local real property tax is not so attributable.
    (d) Basis and holding period of replacement project--(1) Basis. If 
the taxpayer makes an election under section 1039, the basis of the 
replacement housing project shall be its cost (including costs incurred 
subsequent to the reinvestment period) reduced by the amount of gain not 
recognized under section 1039 (a). If the replacement consists of more 
than one housing project, the basis determined under this subparagraph 
shall be allocated to the properties in proportion to their respective 
costs.
    (2) Holding period. The holding period of the replacement housing 
project shall begin on the date the taxpayer acquires such project, that 
is, on the date the taxpayer first acquires possession or control of 
such project and bears the burdens and enjoys the benefits of ownership 
of the replacement project. (For special rule regarding the holding 
period of property for purposes of section 1250, see section 
1250(e)(4).)
    (e) Assessment of deficiencies--(1) Deficiency attributable to gain. 
If a taxpayer makes an election under section 1039(a) with respect to an 
approved disposition, any deficiency attributable to the gain on such 
disposition, for any taxable year in which any part of such gain is 
realized, may be assessed at any time before the expiration of 3 years 
after the date the district director or director of the regional service 
center with whom the return for such year has been filed is notified by 
the taxpayer of the acquisition or the completion of construction or 
reconstruction of the replacement qualified housing project or of the 
failure to acquire, construct, or reconstruct a replacement qualified 
housing project, as the case may be. Such a deficiency may be assessed 
before the expiration of such 3-year period notwithstanding the 
provisions of section 6212(c) or the provisions of any other law or rule 
of law which would

[[Page 161]]

otherwise prevent such assessment. If replacement has been made, such 
notification shall contain the information required by paragraph 
(b)(4)(iii) of this section. Such notification shall be attached to the 
return filed for the taxable year or years in which the replacement 
occurs, or in which the period for the replacement expires, and a copy 
of such notification shall be filed with the district director or 
director of regional service center with whom the election under section 
1039(a) was required to be filed, if the return is not filed with such 
director.
    (2) Deficiency attributable to election. If gain upon an approved 
disposition is realized in two (or more) taxable years, and the 
replacement qualified housing project was acquired, constructed, or 
reconstructed before the beginning of the last such year, any 
deficiency, for any taxable year before such last year, which is 
attributable to an election by the taxpayer under section 1039(a) may be 
assessed at any time before the expiration of the period within which a 
deficiency for such last taxable year may be assessed, notwithstanding 
the provisions of section 6212(c) or 6501 or the provisions of any law 
or rule of law which would otherwise prevent such assessment. Thus, if 
gain upon an approved disposition is realized in 1971 and 1975, and if a 
replacement project is purchased in 1971, any deficiency for 1971 may be 
assessed within the period for assessing a deficiency for 1975.

[T.D. 7191, 37 FR 12951, June 30, 1972; 37 FR 14385, July 20, 1972, as 
amended by T.D. 7400, 41 FR 5101, Feb. 4, 1976]



Sec. 1.1041-1T  Treatment of transfer of property between spouses or incident to divorce (temporary).

    Q-1: How is the transfer of property between spouses treated under 
section 1041?
    A-1: Generally, no gain or loss is recognized on a transfer of 
property from an individual to (or in trust for the benefit of) a spouse 
or, if the transfer is incident to a divorce, a former spouse. The 
following questions and answers describe more fully the scope, tax 
consequences and other rules which apply to transfers of property under 
section 1041.
    (a) Scope of section 1041 in general.
    Q-2: Does section 1041 apply only to transfers of property incident 
to divorce?
    A-2: No. Section 1041 is not limited to transfers of property 
incident to divorce. Section 1041 applies to any transfer of property 
between spouses regardless of whether the transfer is a gift or is a 
sale or exchange between spouses acting at arm's length (including a 
transfer in exchange for the relinquishment of property or marital 
rights or an exchange otherwise governed by another nonrecognition 
provision of the Code). A divorce or legal separation need not be 
contemplated between the spouses at the time of the transfer nor must a 
divorce or legal separation ever occur.

    Example 1. A and B are married and file a joint return. A is the 
sole owner of a condominium unit. A sale or gift of the condominium from 
A to B is a transfer which is subject to the rules of section 1041.
    Example 2. A and B are married and file separate returns. A is the 
owner of an independent sole proprietorship, X Company. In the ordinary 
course of business, X Company makes a sale of property to B. This sale 
is a transfer of property between spouses and is subject to the rules of 
section 1041.
    Example 3. Assume the same facts as in example (2), except that X 
Company is a corporation wholly owned by A. This sale is not a sale 
between spouses subject to the rules of section 1041. However, in 
appropriate circumstances, general tax principles, including the step-
transaction doctrine, may be applicable in recharacterizing the 
transaction.

    Q-3: Do the rules of section 1041 apply to a transfer between 
spouses if the transferee spouse is a nonresident alien?
    A-3: No. Gain or loss (if any) is recognized (assuming no other 
nonrecognition provision applies) at the time of a transfer of property 
if the property is transferred to a spouse who is a nonresident alien.
    Q-4: What kinds of transfers are governed by section 1041?
    A-4: Only transfers of property (whether real or personal, tangible 
or intangible) are governed by section 1041. Transfers of services are 
not subject to the rules of section 1041.
    Q-5: Must the property transferred to a former spouse have been 
owned by the transferor spouse during the marriage?

[[Page 162]]

    A-5: No. A transfer of property acquired after the marriage ceases 
may be governed by section 1041.
    (b) Transfer incident to the divorce.
    Q-6: When is a transfer of property incident to the divorce?
    A-6: A transfer of property is incident to the divorce in either of 
the following 2 circumstances--
    (1) The transfer occurs not more than one year after the date on 
which the marriage ceases, or
    (2) The transfer is related to the cessation of the marriage.

Thus, a transfer of property occurring not more than one year after the 
date on which the marriage ceases need not be related to the cessation 
of the marriage to qualify for section 1041 treatment. (See A-7 for 
transfers occurring more than one year after the cessation of the 
marriage.)
    Q-7: When is a transfer of property related to the cessation of the 
marriage?
    A-7: A transfer of property is treated as related to the cessation 
of the marriage if the transfer is pursuant to a divorce or separation 
instrument, as defined in section 71(b)(2), and the transfer occurs not 
more than 6 years after the date on which the marriage ceases. A divorce 
or separation instrument includes a modification or amendment to such 
decree or instrument. Any transfer not pursuant to a divorce or 
separation instrument and any transfer occurring more than 6 years after 
the cessation of the marriage is presumed to be not related to the 
cessation of the marriage. This presumption may be rebutted only by 
showing that the transfer was made to effect the division of property 
owned by the former spouses at the time of the cessation of the 
marriage. For example, the presumption may be rebutted by showing that 
(a) the transfer was not made within the one- and six-year periods 
described above because of factors which hampered an earlier transfer of 
the property, such as legal or business impediments to transfer or 
disputes concerning the value of the property owned at the time of the 
cessation of the marriage, and (b) the transfer is effected promptly 
after the impediment to transfer is removed.
    Q-8: Do annulments and the cessations of marriages that are void ab 
initio due to violations of state law constitute divorces for purposes 
of section 1041?
    A-8: Yes.
    (c) Transfers on behalf of a spouse.
    Q-9: May transfers of property to third parties on behalf of a 
spouse (or former spouse) qualify under section 1041?
    A-9: Yes. There are three situations in which a transfer of property 
to a third party on behalf of a spouse (or former spouse) will qualify 
under section 1041, provided all other requirements of the section are 
satisfied. The first situation is where the transfer to the third party 
is required by a divorce or separation instrument. The second situation 
is where the transfer to the third party is pursuant to the written 
request of the other spouse (or former spouse). The third situation is 
where the transferor receives from the other spouse (or former spouse) a 
written consent or ratification of the transfer to the third party. Such 
consent or ratification must state that the parties intend the transfer 
to be treated as a transfer to the nontransferring spouse (or former 
spouse) subject to the rules of section 1041 and must be received by the 
transferor prior to the date of filing of the transferor's first return 
of tax for the taxable year in which the transfer was made. In the three 
situations described above, the transfer of property will be treated as 
made directly to the nontransferring spouse (or former spouse) and the 
nontransferring spouse will be treated as immediately transferring the 
property to the third party. The deemed transfer from the 
nontransferring spouse (or former spouse) to the third party is not a 
transaction that qualifies for nonrecognition of gain under section 
1041. This A-9 shall not apply to transfers to which Sec. 1.1041-2 
applies.
    (d) Tax consequences of transfers subject to section 1041.
    Q-10: How is the transferor of property under section 1041 treated 
for income tax purposes?
    A-10: The transferor of property under section 1041 recognizes no 
gain or loss on the transfer even if the transfer was in exchange for 
the release of marital rights or other consideration. This rule applies 
regardless of whether the

[[Page 163]]

transfer is of property separately owned by the transferor or is a 
division (equal or unequal) of community property. Thus, the result 
under section 1041 differs from the result in United States v. Davis, 
370 U.S. 65 (1962).
    Q-11: How is the transferee of property under section 1041 treated 
for income tax purposes?
    A-11: The transferee of property under section 1041 recognizes no 
gain or loss upon receipt of the transferred property. In all cases, the 
basis of the transferred property in the hands of the transferee is the 
adjusted basis of such property in the hands of the transferor 
immediately before the transfer. Even if the transfer is a bona fide 
sale, the transferee does not acquire a basis in the transferred 
property equal to the transferee's cost (the fair market value). This 
carryover basis rule applies whether the adjusted basis of the 
transferred property is less than, equal to, or greater than its fair 
market value at the time of transfer (or the value of any consideration 
provided by the transferee) and applies for purposes of determining loss 
as well as gain upon the subsequent disposition of the property by the 
transferee. Thus, this rule is different from the rule applied in 
section 1015(a) for determining the basis of property acquired by gift.
    Q-12: Do the rules described in A-10 and A-11 apply even if the 
transferred property is subject to liabilities which exceed the adjusted 
basis of the property?
    A-12: Yes. For example, assume A owns property having a fair market 
value of $10,000 and an adjusted basis of $1,000. In contemplation of 
making a transfer of this property incident to a divorce from B, A 
borrows $5,000 from a bank, using the property as security for the 
borrowing. A then transfers the property to B and B assumes, or takes 
the property subject to, the liability to pay the $5,000 debt. Under 
section 1041, A recognizes no gain or loss upon the transfer of the 
property, and the adjusted basis of the property in the hands of B is 
$1,000.
    Q-13: Will a transfer under section 1041 result in a recapture of 
investment tax credits with respect to the property transferred?
    A-13: In general, no. Property transferred under section 1041 will 
not be treated as being disposed of by, or ceasing to be section 38 
property with respect to, the transferor. However, the transferee will 
be subject to investment tax credit recapture if, upon or after the 
transfer, the property is disposed of by, or ceases to be section 38 
property with respect to, the transferee. For example, as part of a 
divorce property settlement, B receives a car from A that has been used 
in A's business for two years and for which an investment tax credit was 
taken by A. No part of A's business is transferred to B and B's use of 
the car is solely personal. B is subject to recapture of the investment 
tax credit previously taken by A.
    (e) Notice and recordkeeping requirement with respect to 
transactions under section 1041.
    Q-14: Does the trasnsferor of property in a transaction described in 
section 1041 have to supply, at the time of the transfer, the transferee 
with records sufficient to determine the adjusted basis and holding 
period of the property at the time of the transfer and (if applicable) 
with notice that the property transferred under section 1041 is 
potentially subject to recapture of the investment tax credit?
    A-14: Yes. A transferor of property under section 1041 must, at the 
time of the transfer, supply the transferee with records sufficient to 
determine the adjusted basis and holding period of the property as of 
the date of the transfer. In addition, in the case of a transfer of 
property which carries with it a potential liability for investment tax 
credit recapture, the transferor must, at the time of the transfer, 
supply the transferee with records sufficient to determine the amount 
and period of such potential liability. Such records must be preserved 
and kept accessible by the transferee.
    (f) Property settlements--effective dates, transitional periods and 
elections.
    Q-15: When does section 1041 become effective?
    A-15: Generally, section 1041 applies to all transfers after July 
18, 1984. However, it does not apply to transfers after July 18, 1984 
pursuant to instruments in effect on or before July 18,

[[Page 164]]

1984. (See A-16 with respect to exceptions to the general rule.)
    Q-16: Are there any exceptions to the general rule stated in A-15 
above?
    A-16: Yes. Two transitional rules provide exceptions to the general 
rule stated in A-15. First, section 1041 will apply to transfers after 
July 18, 1984 under instruments that were in effect on or before July 
18, 1984 if both spouses (or former spouses) elect to have section 1041 
apply to such transfers. Second, section 1041 will apply to all 
transfers after December 31, 1983 (including transfers under instruments 
in effect on or before July 18, 1984) if both spouses (or former 
spouses) elect to have section 1041 apply. (See A-18 relating to the 
time and manner of making the elections under the first or second 
transitional rule.)
    Q-17: Can an election be made to have section 1041 apply to some, 
but not all, transfers made after December 31, 1983, or some but not 
all, transfers made after July 18, 1984 under instruments in effect on 
or before July 18, 1984?
    A-17: No. Partial elections are not allowed. An election under 
either of the two elective transitional rules applies to all transfers 
governed by that election whether before or after the election is made, 
and is irrevocable.
    (g) Property settlements--time and manner of making the elections 
under section 1041.
    Q-18: How do spouses (or former spouses) elect to have section 1041 
apply to transfers after December 31, 1983, or to transfers after July 
18, 1984 under instruments in effect on or before July 18, 1984?
    A-18: In order to make an election under section 1041 for property 
transfers after December 31, 1983, or property transfers under 
instruments that were in effect on or before July 18, 1984, both spouses 
(or former spouses) must elect the application of the rules of section 
1041 by attaching to the transferor's first filed income tax return for 
the taxable year in which the first transfer occurs, a statement signed 
by both spouses (or former spouses) which includes each spouse's social 
security number and is in substantially the form set forth at the end of 
this answer.
    In addition, the transferor must attach a copy of such statement to 
his or her return for each subsequent taxable year in which a transfer 
is made that is governed by the transitional election. A copy of the 
signed statment must be kept by both parties.
    The election statements shall be in substantially the following 
form:
    In the case of an election regarding transfers after 1983:

                          Section 1041 Election

    The undersigned hereby elect to have the provisions of section 1041 
of the Internal Revenue Code apply to all qualifying transfers of 
property after December 31, 1983. The undersigned understand that 
section 1041 applies to all property transferred between spouses, or 
former spouses incident to divorce. The parties further understand that 
the effects for Federal income tax purposes of having section 1041 apply 
are that (1) no gain or loss is recognized by the transferor spouse or 
former spouse as a result of this transfer; and (2) the basis of the 
transferred property in the hands of the transferee is the adjusted 
basis of the property in the hands of the transferor immediately before 
the transfer, whether or not the adjusted basis of the transferred 
property is less than, equal to, or greater than its fair market value 
at the time of the transfer. The undersigned understand that if the 
transferee spouse or former spouse disposes of the property in a 
transaction in which gain is recognized, the amount of gain which is 
taxable may be larger than it would have been if this election had not 
been made.

    In the case of an election regarding preexisting decrees:

                          Section 1041 Election

    The undersigned hereby elect to have the provisions of section 1041 
of the Internal Revenue Code apply to all qualifying transfers of 
property after July 18, 1984 under any instrument in effect on or before 
July 18, 1984. The undersigned understand that section 1041 applies to 
all property transferred between spouses, or former spouses incident to 
the divorce. The parties further understand that the effects for Federal 
income tax purposes of having section 1041 apply are that (1) no gain or 
loss is recognized by the transferor spouse or former spouse as a result 
of this transfer; and (2) the basis of the transferred property in the 
hands of the transferee is the adjusted basis of the property in the 
hands of the transferor immediately before the transfer, whether or not 
the adjusted basis of the transferred property is less than, equal to, 
or greater than its fair market value at the time of the transfer.

[[Page 165]]

The undersigned understand that if the transferee spouse or former 
spouse disposes of the property in a transaction in which gain is 
recognized, the amount of gain which is taxable may be larger than it 
would have been if this election had not been made.

(Secs. 1041(d)(4), (98 Stat. 798, 26 U.S.C. 1041(d)(4)), 152(e)(2)(A) 
(98 Stat. 802, 26 U.S.C. 152(e)(2)(A)), 215(c) (98 Stat. 800, 26 U.S.C. 
215(c)) and 7805 (68A Stat. 917, 26 U.S.C. 7805) of the Internal Revenue 
Code of 1954))

[T.D. 7973, 49 FR 34452, Aug. 31, 1984; T.D. 9035, 68 FR 1536, Jan. 13, 
2003]



Sec. 1.1041-2  Redemptions of stock.

    (a) In general--(1) Redemptions of stock not resulting in 
constructive distributions. Notwithstanding Q&A-9 of Sec. 1.1041-1T(c), 
if a corporation redeems stock owned by a spouse or former spouse 
(transferor spouse), and the transferor spouse's receipt of property in 
respect of such redeemed stock is not treated, under applicable tax law, 
as resulting in a constructive distribution to the other spouse or 
former spouse (nontransferor spouse), then the form of the stock 
redemption shall be respected for Federal income tax purposes. 
Therefore, the transferor spouse will be treated as having received a 
distribution from the corporation in redemption of stock.
    (2) Redemptions of stock resulting in constructive distributions. 
Notwithstanding Q&A-9 of Sec. 1.1041-1T(c), if a corporation redeems 
stock owned by a transferor spouse, and the transferor spouse's receipt 
of property in respect of such redeemed stock is treated, under 
applicable tax law, as resulting in a constructive distribution to the 
nontransferor spouse, then the redeemed stock shall be deemed first to 
be transferred by the transferor spouse to the nontransferor spouse and 
then to be transferred by the nontransferor spouse to the redeeming 
corporation. Any property actually received by the transferor spouse 
from the redeeming corporation in respect of the redeemed stock shall be 
deemed first to be transferred by the corporation to the nontransferor 
spouse in redemption of such spouse's stock and then to be transferred 
by the nontransferor spouse to the transferor spouse.
    (b) Tax consequences--(1) Transfers described in paragraph (a)(1) of 
this section. Section 1041 will not apply to any of the transfers 
described in paragraph (a)(1) of this section. See section 302 for rules 
relating to the tax consequences of certain redemptions; redemptions 
characterized as distributions under section 302(d) will be subject to 
section 301 if received from a Subchapter C corporation or section 1368 
if received from a Subchapter S corporation.
    (2) Transfers described in paragraph (a)(2) of this section. The tax 
consequences of each deemed transfer described in paragraph (a)(2) of 
this section are determined under applicable provisions of the Internal 
Revenue Code as if the spouses had actually made such transfers. 
Accordingly, section 1041 applies to any deemed transfer of the stock 
and redemption proceeds between the transferor spouse and the 
nontransferor spouse, provided the requirements of section 1041 are 
otherwise satisfied with respect to such deemed transfer. Section 1041, 
however, will not apply to any deemed transfer of stock by the 
nontransferor spouse to the redeeming corporation in exchange for the 
redemption proceeds. See section 302 for rules relating to the tax 
consequences of certain redemptions; redemptions characterized as 
distributions under section 302(d) will be subject to section 301 if 
received from a Subchapter C corporation or section 1368 if received 
from a Subchapter S corporation.
    (c) Special rules in case of agreements between spouses or former 
spouses-- (1) Transferor spouse taxable. Notwithstanding applicable tax 
law, a transferor spouse's receipt of property in respect of the 
redeemed stock shall be treated as a distribution to the transferor 
spouse in redemption of such stock for purposes of paragraph (a)(1) of 
this section, and shall not be treated as resulting in a constructive 
distribution to the nontransferor spouse for purposes of paragraph 
(a)(2) of this section, if a divorce or separation instrument, or a 
valid written agreement between the transferor spouse and the 
nontransferor spouse, expressly provides that--
    (i) Both spouses or former spouses intend for the redemption to be 
treated, for Federal income tax purposes, as a redemption distribution 
to the transferor spouse; and

[[Page 166]]

    (ii) Such instrument or agreement supersedes any other instrument or 
agreement concerning the purchase, sale, redemption, or other 
disposition of the stock that is the subject of the redemption.
    (2) Nontransferor spouse taxable. Notwithstanding applicable tax 
law, a transferor spouse's receipt of property in respect of the 
redeemed stock shall be treated as resulting in a constructive 
distribution to the nontransferor spouse for purposes of paragraph 
(a)(2) of this section, and shall not be treated as a distribution to 
the transferor spouse in redemption of such stock for purposes of 
paragraph (a)(1) of this section, if a divorce or separation instrument, 
or a valid written agreement between the transferor spouse and the 
nontransferor spouse, expressly provides that--
    (i) Both spouses or former spouses intend for the redemption to be 
treated, for Federal income tax purposes, as resulting in a constructive 
distribution to the nontransferor spouse; and
    (ii) Such instrument or agreement supersedes any other instrument or 
agreement concerning the purchase, sale, redemption, or other 
disposition of the stock that is the subject of the redemption.
    (3) Execution of agreements. For purposes of this paragraph (c), a 
divorce or separation instrument must be effective, or a valid written 
agreement must be executed by both spouses or former spouses, prior to 
the date on which the transferor spouse (in the case of paragraph (c)(1) 
of this section) or the nontransferor spouse (in the case of paragraph 
(c)(2) of this section) files such spouse's first timely filed Federal 
income tax return for the year that includes the date of the stock 
redemption, but no later than the date such return is due (including 
extensions).
    (d) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. Corporation X has 100 shares outstanding. A and B each 
own 50 shares. A and B divorce. The divorce instrument requires B to 
purchase A's shares, and A to sell A's shares to B, in exchange for 
$100x. Corporation X redeems A's shares for $100x. Assume that, under 
applicable tax law, B has a primary and unconditional obligation to 
purchase A's stock, and therefore the stock redemption results in a 
constructive distribution to B. Also assume that the special rule of 
paragraph (c)(1) of this section does not apply. Accordingly, under 
paragraphs (a)(2) and (b)(2) of this section, A shall be treated as 
transferring A's stock of Corporation X to B in a transfer to which 
section 1041 applies (assuming the requirements of section 1041 are 
otherwise satisfied), B shall be treated as transferring the Corporation 
X stock B is deemed to have received from A to Corporation X in exchange 
for $100x in an exchange to which section 1041 does not apply and 
sections 302(d) and 301 apply, and B shall be treated as transferring 
the $100x to A in a transfer to which section 1041 applies.
    Example 2. Assume the same facts as Example 1, except that the 
divorce instrument provides as follows: ``A and B agree that the 
redemption will be treated for Federal income tax purposes as a 
redemption distribution to A.'' The divorce instrument further provides 
that it ``supersedes all other instruments or agreements concerning the 
purchase, sale, redemption, or other disposition of the stock that is 
the subject of the redemption.'' By virtue of the special rule of 
paragraph (c)(1) of this section and under paragraphs (a)(1) and (b)(1) 
of this section, the tax consequences of the redemption shall be 
determined in accordance with its form as a redemption of A's shares by 
Corporation X and shall not be treated as resulting in a constructive 
distribution to B. See section 302.
    Example 3. Assume the same facts as Example 1, except that the 
divorce instrument requires A to sell A's shares to Corporation X in 
exchange for a note. B guarantees Corporation X's payment of the note. 
Assume that, under applicable tax law, B does not have a primary and 
unconditional obligation to purchase A's stock, and therefore the stock 
redemption does not result in a constructive distribution to B. Also 
assume that the special rule of paragraph (c)(2) of this section does 
not apply. Accordingly, under paragraphs (a)(1) and (b)(1) of this 
section, the tax consequences of the redemption shall be determined in 
accordance with its form as a redemption of A's shares by Corporation X. 
See section 302.
    Example 4. Assume the same facts as Example 3, except that the 
divorce instrument provides as follows: ``A and B agree the redemption 
shall be treated, for Federal income tax purposes, as resulting in a 
constructive distribution to B.'' The divorce instrument further 
provides that it ``supersedes any other instrument or agreement 
concerning the purchase, sale, redemption, or other disposition of the 
stock that is the subject of the redemption.'' By virtue of the special 
rule of paragraph (c)(2) of this section, the redemption is treated as 
resulting in a constructive distribution to B for purposes of paragraph 
(a)(2) of this section. Accordingly, under paragraphs (a)(2) and (b)(2) 
of this section, A

[[Page 167]]

shall be treated as transferring A's stock of Corporation X to B in a 
transfer to which section 1041 applies (assuming the requirements of 
section 1041 are otherwise satisfied), B shall be treated as 
transferring the Corporation X stock B is deemed to have received from A 
to Corporation X in exchange for a note in an exchange to which section 
1041 does not apply and sections 302(d) and 301 apply, and B shall be 
treated as transferring the note to A in a transfer to which section 
1041 applies.

    (e) Effective date. Except as otherwise provided in this paragraph, 
this section is applicable to redemptions of stock on or after January 
13, 2003, except for redemptions of stock that are pursuant to 
instruments in effect before January 13, 2003. For redemptions of stock 
before January 13, 2003 and redemptions of stock that are pursuant to 
instruments in effect before January 13, 2003, see Sec. 1.1041-1T(c), A-
9. However, these regulations will be applicable to redemptions 
described in the preceding sentence of this paragraph (e) if the spouses 
or former spouses execute a written agreement on or after August 3, 2001 
that satisfies the requirements of one of the special rules in paragraph 
(c) of this section with respect to such redemption. A divorce or 
separation instrument or valid written agreement executed on or after 
August 3, 2001, and before May 13, 2003 that meets the requirements of 
the special rule in Regulations Project REG-107151-00 published in 2001-
2 C.B. 370 (see Sec. 601.601(d)(2) of this chapter) will be treated as 
also meeting the requirements of the special rule in paragraph (c)(2) of 
this section.

[T.D. 9035, 68 FR 1536, Jan. 13, 2003]



Sec. 1.1042-1T  Questions and answers relating to the sales of stock to employee stock ownership plans or certain cooperatives (temporary).

    Q-1: What does section 1042 provide?
    A-1: (a) Section 1042 provides rules under which a taxpayer may 
elect not to recognize gain in certain cases where qualified securities 
are sold to a qualifying employee stock ownership plan or worker-owned 
cooperative in taxable years of the seller beginning after July 18, 
1984, and qualified replacement property is purchased by the taxpayer 
within the replacement period. If the requirements of Q&A-2 of this 
section are met, and if the taxpayer makes an election under section 
1042(a) in accordance with Q&A-3 of this section, the gain realized by 
the taxpayer on the sale of the qualified securities is recognized only 
to the extent that the amount realized on such sale exceeds the cost to 
the taxpayer of the qualified replacement property.
    (b) Under section 1042, the term qualified securities means employer 
securities (as defined in section 409(l)) with respect to which each of 
the following requirements is satisfied: (1) The employer securities 
were issued by a domestic corporation; (2) for at least one year before 
and immediately after the sale, the domestic corporation that issued the 
employer securities (and each corporation that is a member of a 
controlled group of corporations with such corporation for purposes of 
section 409(l)) has no stock outstanding that is readily tradeable on an 
established market; (3) as of the time of the sale, the employer 
securities have been held by the taxpayer for more than 1 year; and (4) 
the employer securities were not received by the taxpayer in a 
distribution from a plan described in section 401(a) or in a transfer 
pursuant to an option or other right to acquire stock to which section 
83, 422, 422A, 423, or 424 applies.
    (c) The term replacement period means the period which begins 3 
months before the date on which the sale of qualified securities occurs 
and which ends 12 months after the date of such sale. A replacement 
period may include any period which occurs prior to July 19, 1984.
    (d) The term qualified replacement property means any securities (as 
defined in section 165(g)(2)) issued by a domestic corporation which 
does not, for the taxable year of such corporation in which the 
securities are purchased by the taxpayer, have passive investment income 
(as defined in section 1362(d)(3)(D)) that exceeds 25 percent of the 
gross receipts of such corporation for the taxable year preceding the 
taxable year of purchase. In addition, securities of the domestic 
corporation that issued the employer securities qualifying under section 
1042 (and of any corporation that is a member of a controlled group of 
corporations

[[Page 168]]

with such corporation for purposes of section 409(l)) will not qualify 
as qualified replacement property.
    (e) For purposes of section 1042(a), there is a purchase of 
qualified replacement property only if the basis of such property is 
determined by reference to its cost to the taxpayer. If the basis of the 
qualified replacement property is determined by reference to its basis 
in the hands of the transferor thereof or another person, or by 
reference to the basis of property (other than cash or its equivalent) 
exchanged for such property, then the basis of such property is not 
determined solely by reference to its cost to the taxpayer.
    Q-2: What is a sale of qualified securities for purposes of section 
1042(b)?
    A-2: (a) Under section 1042(b), a sale of qualified securities is 
one under which all of the following requirements are met:
    (1) The qualified securities are sold to an employee stock ownership 
plan (as defined in section 4975(e)(7)) maintained by the corporation 
that issued the qualified securities (or by a member of the controlled 
group of corporations with such corporation for purposes of section 
409(l)) or to an eligible worker-owned cooperative (as defined in 
section 1042(c)(2));
    (2) The employee stock ownership plan or eligible worker-owned 
cooperative owns, immediately after the sale, 30 percent or more of the 
total value of the employer securities (within the meaning of section 
409(l) outstanding as of such time;
    (3) No portion of the assets of the employee stock ownership plan or 
eligible worker-owned cooperative attributable to qualified securities 
that are sold to the plan or cooperative by the taxpayer or by any other 
person in a sale with respect to which an election under section 1042(a) 
is made accrue under the plan or are allocated by the cooperative, 
either directly or indirectly and either concurrently with or at any 
time thereafter, for the benefit of (i) the taxpayer; (ii) any person 
who is a member of the family of the taxpayer (within the meaning of 
section 267(c)(4)); or (iii) any person who owns (after the application 
of section 318(a)), at any time after July 18, 1984, and until 
immediately after the sale, more than 25 percent of in value of the 
outstanding portion of any class of stock of the corporation that issued 
the qualified securities (or of any member of the controlled group of 
corporations with such corporation for purposes of section 409(l)). For 
purposes of this calculation, stock that is owned, directly or 
indirectly, by or for a qualified plan shall not be treated as 
outstanding.
    (4) The taxpayer files with the Secretary (as part of the required 
election described in Q&A-3 of this section) a verified written 
statement of the domestic corporation (or corporations) whose employees 
are covered by the plan acquiring the qualified securities or of any 
authorized officer of the eligible workerowned cooperative, consenting 
to the application of section 4978(a) with respect to such corporation 
or cooperative.
    (b) For purposes of determining whether paragraph (a)(2) of this 
section is satisfied, sales of qualified securities by two or more 
taxpayers may be treated as a single sale if such sales are made as part 
of a single, integrated transaction under a prearranged agreement 
between the taxpayers.
    (c) For purposes of determining whether paragraph (a)(3) of this 
section is satisfied with respect to the prohibition against an accrual 
or allocation of qualified securities, the accrual or allocation of any 
benefits or contributions or other assets that are not attributable to 
qualified securities sold to the employee stock ownership plan or 
eligible worker-owned cooperative in a sale with respect to which an 
election under section 1042(a) is made (including any accrual or 
allocation under any other plan or arrangement maintained by the 
corporation or any member of the controlled group of corporations with 
such corporation for purposes of section 409(l)) must be made without 
regard to the allocation of such qualified securities. Paragraph (a)(3) 
of this section above may be illustrated in part by the following 
example: Individuals A, B, and C own 50, 25, and 25, respectively, of 
the 100 outstanding shares of common stock of Corporation X. Such shares 
constitute qualified securities as defined in Q&A-1 of this section. A 
and B, but not C, are employees of Corporation X. For the benefit of all 
its

[[Page 169]]

employees, Corporation X establishes an employee stock ownership plan 
that obtains a loan meeting the exemption requirements of section 
4975(d)(3). The loan proceeds are used by the plan to purchase the 100 
shares of qualified securities from A, B, and C, all of whom elect 
nonrecognition treatment under section 1042(a) with respect to the gain 
realized on their sale of such securities. Under the requirements of 
paragraph (a)(3) of this section, no part of the assets of the plan 
attributable to the 100 shares of qualified securities may accrue under 
the plan (or under any other plan or arrangement maintained by 
Corporation X) for the benefit of A or B or any person who is a member 
of the family of A or B (as determined under section 267(c)(4)). 
Furthermore, no other assets of the plan or assets of the employer may 
accrue for the benefit of such individuals in lieu of the receipt of 
assets attributable to such qualified securities.
    (d) A sale under section 1042(a) shall not include any sale of 
securities by a dealer or underwriter in the ordinary course of its 
trade or business as a dealer or underwriter, whether or not guaranteed.
    Q-3: What is the time and manner for making the election under 
section 1042(a)?
    A-3: (a) The election not to recognize the gain realized upon the 
sale of qualified securities to the extent provided under section 
1042(a) shall be made in a statement of election attached to the 
taxpayer's income tax return filed on or before the due date (including 
extensions of time) for the taxable year in which the sale occurs. If a 
taxpayer does not make a timely election under this section to obtain 
section 1042(a) nonrecognition treatment with respect to the sale of 
qualified securities, it may not subsequently make an election on an 
amended return or otherwise. Also, an election once made is irrevocable.
    (b) The statement of election shall provide that the taxpayer elects 
to treat the sale of securities as a sale of qualified securities under 
section 1042(a), and shall contain the following information:
    (1) A description of the qualified securities sold, including the 
type and number of shares;
    (2) The date of the sale of the qualified securities;
    (3) The adjusted basis of the qualified securities;
    (4) The amount realized upon the sale of the qualified securities;
    (5) The identity of the employee stock ownership plan or eligible 
worker-owned cooperative to which the qualified securities were sold; 
and
    (6) If the sale was part of a single, interrelated transaction under 
a prearranged agreement between taxpayers involving other sales of 
qualified securities, the names and taxpayer identification numbers of 
the other taxpayers under the agreement and the number of shares sold by 
the other taxpayers. See Q&A-2 of this section.

If the taxpayer has purchased qualified replacement property at the time 
of the election, the taxpayer must attach as part of the statement of 
election a statement of purchase describing the qualified replacement 
property, the date of the purchase, and the cost of the property, and 
declaring such property to be the qualified replacement property with 
respect to the sale of qualified securities. Such statement of purchase 
must be notarized by the later of thirty days after the purchase or 
March 6, 1986. In addition, the statement of election must be 
accompanied by the verified written statement of consent required under 
Q&A-2 of this section with respect to the qualified securities sold.
    (c) If the taxpayer has not purchased qualified replacement property 
at the time of the filing of the statement of election, a timely 
election under this Q&A shall not be considered to have been made unless 
the taxpayer attaches the notarized statement of purchase described 
above to the taxpayer's income tax return filed for the taxable year 
following the year for which the election under section 1042(a) was 
made. Such notarized statement of purchase shall be filed with the 
district director or the director of the regional service center with 
whom such election was originally filed, if the return is not filed with 
such director.

[[Page 170]]

    Q-4: What is the basis of qualified replacement property?
    A-4: If a taxpayer makes an election under section 1042(a), the 
basis of the qualified replacement property purchased by the taxpayer 
during the replacement period shall be reduced by an amount equal to the 
amount of gain which was not recognized. If more than one item of 
qualified replacement property is purchased, the basis of each of such 
items shall be reduced by an amount determined by multiplying the total 
gain not recognized by reason of the application of section 1042(a) by a 
fraction, the numerator of which is the cost of such item of property 
and the denominator of which is the total cost of all such items of 
property. For the rule regarding the holding period of qualified 
replacement property, see section 1223(13).
    Q-5: What is the statute of limitations for the assessment of a 
deficiency relating to the gain on the sale of qualified securities?
    A-5: (a) If any gain is realized by the taxpayer on the sale of any 
qualified securities and such gain has not been recognized under section 
1042(a) in accordance with the requirements of this section, the 
statutory period provided in section 6501(a) for the assessment of any 
deficiency with respect to such gain shall not expire prior to the 
expiration of 3 years from the date of receipt, by the district director 
or director of regional service center with whom the statement of 
election under 1042(a) was originally filed, of:
    (1) A notarized statement of purchase as described in Q&A-3;
    (2) A written statement of the taxpayer's intention not to purchase 
qualified replacement property within the replacement period; or
    (3) A written statement of the taxpayer's failure to purchase 
qualified replacement property within the replacement period.

In those situations when a taxpayer is providing a written statement of 
an intention not to purchase or of a failure to purchase qualified 
replacement property, the statement shall be accompanied, where 
appropriate, by an amended return for the taxable year in which the gain 
from the sale of the qualified securities was realized, in order to 
reflect the inclusion in gross income for that year of gain required to 
be recognized in connection with such sale.
    (b) Any gain from the sale of qualified securities which is required 
to be recognized due to a failure to meet the requirements under section 
1042 shall be included in the gross income for the taxable year in which 
the gain was realized. If any gain from the sale of qualified securities 
is not recognized under section 1042(a) in accordance with the 
requirements of this section, any deficiency attributable to any portion 
of such gain may be assessed at any time before the expiration of the 3-
year period described in this Q&A, notwithstanding the provision of any 
law or rule of law which would otherwise prevent such assessment.
    Q-6: When does section 1042 become effective?
    A-6: Section 1042 applies to sales of qualified securities in 
taxable years of sellers beginning after July 18, 1984.

[T.D. 8073, 51 FR 4333, Feb. 4, 1986]



Sec. 1.1044(a)-1  Time and manner for making election under the Omnibus Budget Reconciliation Act of 1993.

    (a) Description. Section 1044(a), as added by section 13114 of the 
Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66, 107 Stat. 
430), generally allows individuals and C corporations that sell publicly 
traded securities after August 9, 1993, to elect not to recognize 
certain gain from the sale if the taxpayer purchases common stock or a 
partnership interest in a specialized small business investment company 
(SSBIC) within the 60-day period beginning on the date the publicly 
traded securities are sold.
    (b) Time and manner for making the election. The election under 
section 1044(a) must be made on or before the due date (including 
extensions) for the income tax return for the year in which the publicly 
traded securities are sold. The election is to be made by reporting the 
entire gain from the sale of publicly traded securities on Schedule D of 
the income tax return in accordance with instructions for Schedule D, 
and by attaching a statement to Schedule D showing--

[[Page 171]]

    (1) How the nonrecognized gain was calculated;
    (2) The SSBIC in which common stock or a partnership interest was 
purchased;
    (3) The date the SSBIC stock or partnership interest was purchased; 
and
    (4) The basis of the SSBIC stock or partnership interest.
    (c) Revocability of election. The election described in this section 
is revocable with the consent of the Commissioner.
    (d) Effective date. The rules set forth in this section are 
effective December 12, 1996.

[T.D. 8688, 61 FR 65322, Dec. 12, 1996]

                              Special Rules



Sec. 1.1051-1  Basis of property acquired during affiliation.

    (a)(1) The basis of property acquired by a corporation during a 
period of affiliation from a corporation with which it was affiliated 
shall be the same as it would be in the hands of the corporation from 
which acquired. This rule is applicable if the basis of the property is 
material in determining tax liability for any year, whether a separate 
return or a consolidated return is made in respect of such year. For the 
purpose of this section, the term period of affiliation means the period 
during which such corporations were affiliated (determined in accordance 
with the law applicable thereto), but does not include any taxable year 
beginning on or after January 1, 1922, unless a consolidated return was 
made, nor any taxable year after the taxable year 1928.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example: The X Corporation, the Y Corporation, and the Z Corporation 
were affiliated for the taxable year 1920. During that year the X 
Corporation transferred assets to the Y Corporation for $120,000 cash, 
and the Y Corporation in turn transferred the assets during the same 
year to the Z Corporation for $130,000 cash. The assets were acquired by 
the X Corporation in 1916 at a cost of $100,000. The basis of the assets 
in the hands of the Z Corporation is $100,000.

    (b) The basis of property acquired by a corporation during any 
period, in the taxable year 1929 or any subsequent taxable year, in 
respect of which a consolidated return was made or was required under 
the regulations governing the making of consolidated returns, shall be 
determined in accordance with such regulations. The basis in the case of 
property held by a corporation during any period, in the taxable year 
1929 or any subsequent taxable year, in respect of which a consolidated 
return is made or is required under the regulations governing the making 
of consolidated returns, shall be adjusted in respect of any items 
relating to such period in accordance with such regulations.
    (c) Except as otherwise provided in the regulations promulgated 
under section 1502 of the Internal Revenue Code of 1954 or the 
regulations under section 141 of the Internal Revenue Code of 1939 or 
the Revenue Act of 1938 (52 Stat. 447), 1936 (49 Stat. 1652), 1934 (48 
Stat. 683), 1932 (47 Stat. 169), or 1928 (45 Stat. 791), the basis of 
property after a consolidated return period shall be the same as the 
basis immediately prior to the close of such period.



Sec. 1.1052-1  Basis of property established by Revenue Act of 1932.

    Section 1052(a) provides that if property was acquired after 
February 28, 1913, in any taxable year beginning before January 1, 1934, 
and the basis of the property, for the purposes of the Revenue Act of 
1932 (47 Stat. 169), was prescribed by section 113(a) (6), (7), or (9) 
of that act, then for purposes of subtitle A of the Code, the basis 
shall be the same as the basis prescribed in the Revenue Act of 1932. 
For the rules applicable in determining the basis of stocks or 
securities under section 113(a)(9) of the Revenue Act of 1932 in case of 
certain distributions after December 31, 1923, and in any taxable year 
beginning before January 1, 1934, see 26 CFR (1939) 39.113 (a)(12)-1 
(Regulations 118).



Sec. 1.1052-2  Basis of property established by Revenue Act of 1934.

    Section 1052(b) provides that if property was acquired after 
February 28, 1913, in any taxable year beginning before January 1, 1936, 
and the basis of the property for the purposes of the Revenue Act of 
1934 (48 Stat. 683) was

[[Page 172]]

prescribed by section 113(a) (6), (7), or (8) of that act, then for 
purposes of subtitle A of the Code, the basis shall be the same as the 
basis prescribed in the Revenue Act of 1934. For example, if after 
December 31, 1920, and in any taxable year beginning before January 1, 
1936, property was acquired by a corporation by the issuance of its 
stock or securities in connection with a transaction which is not 
described in section 112(b)(5) of the Internal Revenue Code of 1939 but 
which is described in section 112(b)(5) of the Revenue Act of 1934, the 
basis of the property so acquired shall be the same as it would be in 
the hands of the transferor, with proper adjustments to the date of the 
exchange.



Sec. 1.1052-3  Basis of property established by the Internal Revenue Code of 1939.

    Section 1052(c) provides that if property was acquired after 
February 28, 1913, in a transaction to which the Internal Revenue Code 
of 1939 applied and the basis thereof was prescribed by section 113(a) 
(6), (7), (8), (13), (15), (18), (19) or (23) of such Code, then for 
purposes of subtitle A of the Internal Revenue Code of 1954, the basis 
shall be the same as the basis prescribed in the Internal Revenue Code 
of 1939. In such cases, see section 113(a) of the Internal Revenue Code 
of 1939 and the regulations thereunder.



Sec. 1.1053-1  Property acquired before March 1, 1913.

    (a) Basis for determining gain. In the case of property acquired 
before March 1, 1913, the basis as of March 1, 1913, for determining 
gain is the cost or other basis, adjusted as provided in section 1016 
and other applicable provisions of chapter 1 of the Code, or its fair 
market value as of March 1, 1913, whichever is greater.
    (b) Basis for determining loss. In the case of property acquired 
before March 1, 1913, the basis as of March 1, 1913, for determining 
loss is the basis determined in accordance with part II (section 1011 
and following), subchapter O, chapter 1 of the Code, or other applicable 
provisions of chapter 1 of the Code, without reference to the fair 
market value as of March 1, 1913.
    (c) Example. The application of paragraphs (a) and (b) of this 
section may be illustrated by the following example:

    Example: (i) On March 1, 1908, a taxpayer purchased for $100,000, 
property having a useful life of 50 years. Assuming that there were no 
capital improvements to the property, the depreciation sustained on the 
property before March 1, 1913, was $10,000 (5 years @ $2,000), so that 
the original cost adjusted, as of March 1, 1913, for depreciation 
sustained prior to that date is $90,000. On that date the property had a 
fair market value of $94,500 with a remaining life of 45 years.
    (ii) For the purpose of determining gain from the sale or other 
disposition of the property on March 1, 1954, the basis of the property 
is the fair market value of $94,500 as of March 1, 1913, adjusted for 
depreciation allowed or allowable after February 28, 1913, computed on 
$94,500. Thus, the substituted basis, $94,500, is reduced by the 
depreciation adjustment from March 1, 1913, to February 28, 1954, in the 
aggregate of $86,100 (41 years @ $2,100), leaving an adjusted basis for 
determining gain of $8,400 ($94,500 less $86,100).
    (iii) For the purpose of determining loss from the sale or other 
disposition of such property on March 1, 1954, the basis of the property 
is its cost, adjusted for depreciation sustained before March 1, 1913, 
computed on cost, and the amount of depreciation allowed or allowable 
after February 28, 1913, computed on the fair market value of $94,500 as 
of March 1, 1913. In this example, the amount of depreciation sustained 
before March 1, 1913, is $10,000 and the amount of depreciation 
determined for the period after February 28, 1913, is $86,100. 
Therefore, the aggregate amount of depreciation for which the cost 
($100,000) should be adjusted is $96,100 ($10,000 plus $86,100), and the 
adjusted basis for determining loss on March 1, 1954, is $3,900 
($100,000 less $96,100).

    (d) Fair market value. The determination of the fair market value of 
property on March 1, 1913, is generally a question of fact and shall be 
established by competent evidence. In determining the fair market value 
of stock or other securities, due regard shall be given to the fair 
market value of the corporate assets as of such date, and other 
pertinent factors. In the case of property traded in on public 
exchanges, actual sales on or near the basic date afford evidence of 
value. In general, the fair market value of a block or aggregate of a 
particular kind of property is not to be determined by a forced-sale 
price, or by an estimate of what a whole block or aggregate would bring 
if

[[Page 173]]

placed upon the market at one and the same time. In such a case the 
value should be determined by ascertaining as the basis the fair market 
value of each unit of the property. All relevant facts and elements of 
value as of the basic date should be considered in each case.



Sec. 1.1054-1  Certain stock of Federal National Mortgage Association.

    (a) In general. The basis in the hands of the initial holder of a 
share of stock which is issued pursuant to section 303(c) of the Federal 
National Mortgage Association Charter Act (12 U.S.C., section 1718) in a 
taxable year beginning after December 31, 1959, shall be an amount equal 
to the issuance price of the stock reduced by the amount, if any, 
required by section 162(d) to be treated (with respect to such share) as 
an ordinary and necessary business expense. See section 162(d) and 
Sec. 1.162-19. For purposes of this section the initial holder is the 
original purchaser who is issued stock of the Federal National Mortgage 
Association (FNMA) pursuant to section 303(c) of the Act and who appears 
on the books of FNMA as the initial holder. See Sec. 1.162-19.
    (b) Example. The provisions of this section may be illustrated by 
the following example:

    Example: Pursuant to section 303(c) of the Federal National Mortgage 
Association Charter Act a certificate of FNMA stock is issued to A as of 
January 1, 1961. The issuance price of the stock was $100 and the fair 
market value of the stock on the date of issue was $69. A was required 
by section 162(d) to treat $31 as a business expense for the year 1961. 
The basis of the share of stock in the hands of A, the initial holder, 
shall be $69, the amount paid for the stock ($100) reduced by $31.

[T.D. 6690, 28 FR 12254, Nov. 19, 1963]



Sec. 1.1055-1  General rule with respect to redeemable ground rents.

    (a) Character of a redeemable ground rent. For purposes of subtitle 
A of the Code (1) a redeemable ground rent (as defined in section 
1055(c) and paragraph (b) of this section) shall be treated as being in 
the nature of a mortgage, and (2) real property held subject to 
liabilities under such a redeemable ground rent shall be treated as held 
subject to liabilities under a mortgage. Thus, under section 1055(a) and 
this paragraph, the transfer of property subject to a redeemable ground 
rent has the same effect as the transfer of property subject to a 
mortgage, the acquisition of property subject to a redeemable ground 
rent is to be treated the same as the acquisition of property subject to 
a mortgage, and the holding of property subject to a redeemable ground 
rent is to be treated in the same manner as the holding of property 
subject to a mortgage. See section 163(c) for the treatment of any 
annual or periodic rental payment under a redeemable ground rent as 
interest.
    (b) Definition of redeemable ground rent. For purposes of subtitle A 
of the Code, the term redeemable ground rent means only a ground rent 
with respect to which all the following conditions are met:
    (1) There is a lease of land which is assignable by the lessee 
without the consent of the lessor.
    (2) The term of the lease is for a period in excess of 15 years, 
taking into account all periods for which the lease may be renewed at 
the option of the lessee.
    (3) The lessee has a present or future right to terminate the lease 
and to acquire the lessor's interest in the land (i.e., to redeem the 
ground rent) by the payment of a determined or determinable amount, 
which amount is referred to in Secs. 1.1055-2, 1.1055-3, and 1.1055-4 as 
a redemption price. Such right must exist by virtue of State or local 
law. If the lessee's right to terminate the lease and to acquire the 
lessor's interest is not granted by State or local law but exists solely 
by virtue of a private agreement or privately created condition, the 
ground rent is not a redeemable ground rent.
    (4) The lessor's interest in the land subject to the lease is 
primarily a security interest to protect the payment to him of the 
annual or periodic rental payments due under the lease.
    (c) Effective date. In general, the provisions of section 1055 and 
paragraph (a) of this section take effect on April 11, 1963, and apply 
with respect to taxable years ending on or after such date. See 
Sec. 1.1055-3 for rules for determining the basis of real property 
acquired subject to liabilities under a redeemable

[[Page 174]]

ground rent regardless of when such property was acquired. See also 
Sec. 1.1055-4 for rules for determining the basis of a redeemable ground 
rent in the hands of a holder who reserved or created such ground rent 
in connection with a transfer, occurring before April 11, 1963, of the 
right to hold real property subject to liabilities under such ground 
rent.

[T.D. 6821, 30 FR 6216, May 4, 1965]



Sec. 1.1055-2  Determination of amount realized on the transfer of the right to hold real property subject to liabilities under a redeemable ground rent.

    In determining the amount realized from a transfer, occurring on or 
after April 11, 1963, of the right to hold real property subject to 
liabilities under a redeemable ground rent, such ground rent shall be 
accounted for in the same manner as a mortgage for an amount of money 
equal to the redemption price of the ground rent. The provisions of this 
section apply in respect of any such transfer even though such ground 
rent was created prior to April 11, 1963. For provisions relating to the 
determination of the amount of and recognition of gain or loss from the 
sale or other disposition of property, see section 1001 and the 
regulations thereunder.

[T.D. 6821, 30 FR 6217, May 4, 1965]



Sec. 1.1055-3  Basis of real property held subject to liabilities under a redeemable ground rent.

    (a) In general. The provisions of section 1055(a) and paragraph (a) 
of Sec. 1.1055-1 are applicable in determining the basis of real 
property held on or after April 11, 1963, in any case where the property 
at the time of acquisition was subject to liabilities under a redeemable 
ground rent. (See section 1055(b)(2).) Thus, if on or after April 11, 
1963, a taxpayer holds real property which was subject to liabilities 
under a redeemable ground rent at the time he acquired it, the basis of 
such property in the hands of such taxpayer, regardless of when the 
property was acquired, will include the redeemable ground rent in the 
same manner as if it were a mortgage in an amount equal to the 
redemption price of such ground rent. Likewise, if on or after April 11, 
1963, a taxpayer holds real property which was subject to liabilities 
under a redeemable ground rent at the time he acquired it and which has 
a substituted basis in his hands, the basis of the property in the hands 
of the taxpayer's predecessor in interest is to be determined by 
treating the redeemable ground rent in the same manner as a mortgage in 
an amount equal to the redemption price of such ground rent.
    (b) Illustrations. The provisions of this section may be illustrated 
by the following examples:

    Example 1. On April 11, 1963, taxpayer A held residential property 
which he acquired on January 15, 1963, for a purchase price of $10,000 
and which, at the time he acquired it, was subject to a ground rent 
redeemable for a redemption price of $1,600. A's basis for the property 
includes the purchase price ($10,000) plus the redeemable ground rent in 
the same manner as if it were a mortgage for $1,600.
    Example 2. In 1962, taxpayer X, a corporation, acquired real 
property subject to a redeemable ground rent in a transfer to which 
section 351 (relating to transfer of property to corporation controlled 
by transferor) applied and in which the basis of the property to X was 
the transferor's basis. X still held the property on April 11, 1963. The 
transferor's basis in the property is to be determined by treating the 
redeemable ground rent to which it was subject in the transferor's hands 
as if it were a mortgage.

[T.D. 6821, 30 FR 6217, May 4, 1965]



Sec. 1.1055-4  Basis of redeemable ground rent reserved or created in connection with transfers of real property before April 11, 1963.

    (a) In general. In the case of a redeemable ground rent created or 
reserved in connection with a transfer, occurring before April 11, 1963, 
of the right to hold real property subject to liabilities under such 
ground rent, the basis of such ground rent on or after April 11, 1963, 
in the hands of the person who reserved or created the ground rent is 
the amount which was taken into account in respect of such ground rent 
in computing the amount realized from the transfer of such real 
property. Thus, if no such amount was taken into account, such basis 
shall be determined without regard to section 1055. (See section 
1055(b)(3).)
    (b) The provisions of this section may be illustrated by the 
following examples:


[[Page 175]]


    Example 1. The taxpayer, who was in the business of building houses, 
purchased an undeveloped lot of land for $500 and built a house thereon 
at a cost of $10,000. Subsequently, he transferred the right to hold the 
lot improved by the house for a consideration of $12,000, and an annual 
ground rent for such property of $120 which was redeemable for a 
redemption price of $2,000. The taxpayer reported a $2,000 gain on the 
transfer, treating the amount realized as $12,000 and his cost allocable 
to the interest transferred as $10,000. Since the builder did not take 
the redeemable ground rent into account in computing gain on the 
transfer, his basis for such ground rent is $500 (the cost of the land 
not offset against the consideration received for the transfer). Thus, 
if he subsequently sells the redeemable ground rent (or if it is 
redeemed from him) for $2,000, he has no gain of $1,500 in the year of 
sale (or redemption).
    Example 2. Assume the same facts as in Example 1 except that the 
builder reported a gain of $3,500 on the transfer, treating the amount 
realized as $14,000 ($12,000 cash plus $2,000 for the redeemable ground 
rent) and his costs as $10,500 ($10,000 for the house and $500 for the 
lot). Since the taxpayer took the entire amount of the redeemable ground 
rent into account in computing his gain, his basis for such ground rent 
is $2,000. Thus, if he subsequently sells the redeemable ground rent (or 
if it is redeemed from him) for $2,000, he has no gain or loss on the 
transaction.
    Example 3. Assume the same facts as in Example 1 except that the 
builder reported a gain of $3,000 on the transfer. He computed this gain 
by treating the amount realized as $12,000 but treating his cost 
allocable to the interest transferred as $12,000/$14,000ths of his total 
$10,500 cost, or $9,000. Since the builder still has remaining $1,500 of 
unallocated cost, his basis for the redeemable ground rent is $1,500. 
Thus, if he subsequently sells the redeemable ground rent (or if it is 
redeemed from him) for $2,000, he has a gain of $500 in the year of sale 
(or redemption).

[T.D. 6821, 30 FR 6217, May 4, 1965]



Sec. 1.1059(e)-1  Non-pro rata redemptions.

    (a) In general. Section 1059(d)(6) (exception where stock held 
during entire existence of corporation) and section 1059(e)(2) 
(qualifying dividends) do not apply to any distribution treated as an 
extraordinary dividend under section 1059(e)(1). For example, if a 
redemption of stock is not pro rata as to all shareholders, any amount 
treated as a dividend under section 301 is treated as an extraordinary 
dividend regardless of whether the dividend is a qualifying dividend.
    (b) Reorganizations. For purposes of section 1059(e)(1), any 
exchange under section 356 is treated as a redemption and, to the extent 
any amount is treated as a dividend under section 356(a)(2), it is 
treated as a dividend under section 301.
    (c) Effective date. This section applies to distributions announced 
(within the meaning of section 1059(d)(5)) on or after June 17, 1996.

[T.D. 8724, 62 FR 38028, July 16, 1997]



Sec. 1.1059A-1  Limitation on taxpayer's basis or inventory cost in property imported from related persons.

    (a) General rule. In the case of property imported into the United 
States in a transaction (directly or indirectly) by a controlled 
taxpayer from another member of a controlled group of taxpayers, except 
for the adjustments permitted by paragraph (c) (2) of this section, the 
amount of any costs taken into account in computing the basis or 
inventory cost of the property by the purchasing U.S. taxpayer and which 
costs are also taken into account in computing the valuation of the 
property for customs purposes may not, for purposes of the basis or 
inventory cost, be greater than the amount of the costs used in 
computing the customs value. For purposes of this section, the terms 
controlled taxpayer and group of controlled taxpayers shall have the 
meaning set forth in Sec. 1.482-1(a).
    (b) Definitions--(1) Import. For purposes of section 1059A and this 
section only, the term import means the filing of the entry 
documentation required by the U.S. Customs Service to secure the release 
of imported merchandise from custody of the U.S. Customs Service.
    (2) Indirectly. For purposes of this section, indirectly refers to a 
transaction between a controlled taxpayer and another member of the 
controlled group whereby property is imported through a person acting as 
an agent of, or otherwise on behalf of, either or both related persons, 
or as a middleman or conduit for transfer of the property between a 
controlled taxpayer and another member of the controlled group. In the 
case of the importation of property indirectly, an adjustment

[[Page 176]]

shall be permitted under paragraph (c)(2) of this section for a 
commission or markup paid to the person acting as agent, middleman, or 
conduit, only to the extent that the commission or markup: is otherwise 
properly included in cost basis or inventory cost; was actually incurred 
by the taxpayer and not remitted, directly or indirectly, to the 
taxpayer or related party; and there is a substantial business reason 
for the use of a middleman, agent, or conduit.
    (c) Customs value--(1) Definition. For purposes of this section 
only, the term customs value means the value required to be taken into 
account for purposes of determining the amount of any customs duties or 
any other duties which may be imposed on the importation of any 
property. Where an item or a portion of an item is not subject to any 
customs duty or is subject to a free rate of duty, such item or portion 
of such item shall not be subject to the provisions of section 1059A or 
this section. Thus, for example, the portion of an item that is an 
American good returned and not subject to duty (items 806.20 and 806.30, 
Tariff Schedules of the United States, 19 U.S.C. 1202); imports on which 
no duty is imposed that are valued by customs for statistical purposes 
only; and items subject to a zero rate of duty (19 U.S.C. 1202, General 
Headnote 3) are not subject to section 1059A or this section. Also, 
items subject only to the user fee under 19 U.S.C. 58(c), or the harbor 
maintenance tax imposed by 26 U.S.C. 4461, or only to both, are not 
subject to section 1059A or this section. This section imposes no 
limitation on a claimed basis or inventory cost in property which is 
less than the value used to compute the customs duty with respect to the 
same property. Section 1059A and this section have no application to 
imported property not subject to any customs duty based on value, 
including property subject only to a per item duty or a duty based on 
volume, because there is no customs value, within the meaning of this 
paragraph, with respect to such property.
    (2) Adjustments to customs value. To the extent not otherwise 
included in customs value, a taxpayer, for purposes of determining the 
limitation on claimed basis or inventory cost of property under this 
section, may increase the customs value of imported property by the 
amounts incurred by it and properly included in inventory cost for--
    (i) Freight charges,
    (ii) Insurance charges,
    (iii) The construction, erection, assembly, or technical assistance 
provided with respect to, the property after its importation into the 
United States, and
    (iv) Any other amounts which are not taken into account in 
determining the customs value, which are not properly includible in 
customs value, and which are appropriately included in the cost basis or 
inventory cost for income tax purposes. See Sec. 1.471-11 and section 
263A.

Appropriate adjustments may also be made to customs values when the 
taxpayer has not allocated the value of assists to individual articles 
but rather has reported the value of assists on a periodic basis in 
accordance with 19 CFR 152.103(e). When 19 CFR 152.103(e) has been 
utilized for customs purposes, the taxpayer may adjust his customs 
values by allocating the value of the assists to all imported articles 
to which the assists relate. To the extent that an amount attributable 
to an adjustment permitted by this section is paid by a controlled 
taxpayer to another member of the group of controlled taxpayers, an 
adjustment is permitted under this section only to the extent that the 
amount incurred represents an arm's length charge within the meaning of 
Sec. 1.482-1(d)(3).
    (3) Offsets to adjustments. To the extent that a customs value is 
adjusted under paragraph (c)(2) of this section for purposes of 
calculating the limitation on claimed cost basis or inventory cost under 
this section, the amount of the adjustments must be offset (reduced) by 
amounts that properly reduce the cost basis of inventory and that are 
not taken into account in determining customs value, such as rebates and 
other reductions in the price actually incurred, effected between the 
purchaser and related seller after the date of importation of the 
property.

[[Page 177]]

    (4) Application of section 1059A to property having dutiable and 
nondutiable portions. When an item of imported property is subiect to a 
duty upon the full value of the imported article, less the cost or value 
of American goods returned, and the taxpayer claims a basis or inventory 
cost greater than the customs value reported for the item, the claimed 
tax basis or inventory cost in the dutiable portion of the item is 
limited under section 1059A and this section to the customs value of the 
dutiable portion under paragraph (c)(1). The claimed tax basis or 
inventory cost in the nondutiable portion of the item is determined by 
multiplying the customs value of the nondutiable portion by a fraction 
the numerator of which is the amount by which the claimed basis or 
inventory cost of the item exceeds the customs value of the item and the 
denominator of which is the customs value of the item and adding this 
amount to the customs value of the nondutiable portion of the item. The 
claimed tax basis or inventory cost in the dutiable portion is 
determined by multiplying the customs value of the dutiable portion by a 
fraction the numerator of which is the amount by which the claimed basis 
or inventory cost of the item exceeds the customs value of the item and 
the denominator of which is the customs value of the item and adding 
this amount to the customs value of the dutiable portion of the item. 
However, the taxpayer may not claim a tax basis or inventory cost in the 
dutiable portion greater than the customs value of this portion of the 
item.
    (5) Allocation of adjustments to property having dutiable and 
nondutiable portions. When an item of imported property is subject to a 
duty upon the full value of the imported article, less the cost or value 
of American goods returned, and the taxpayer establishes that the 
customs value may be increased by adjustments permitted under paragraph 
(c)(2) of this section for purposes of the section 1059A limitation, the 
taxpayer's basis or inventory cost of the dutiable portion of the item 
is determined by multiplying the customs value of the dutiable portion 
times the percentage that the adjustments represent of the total customs 
value of the item and adding this amount to the customs value of the 
dutiable portion of the item. The taxpayer's basis or inventory cost of 
the nondutiable portion of the item is determined in the same manner. 
The amount so determined for the dutiable portion of the item is the 
section 1059A limitation for this portion of the item.
    (6) Alternative method of demonstrating compliance. In lieu of 
calculating all adjustments and offsets to adjustments to customs value 
for an item of property pursuant to paragraph (c) (2) and (3) of this 
section, a taxpayer may demonstrate compliance with this section and 
section 1059A by comparing costs taken into account in computing basis 
or inventory costs of the property and the costs taken into account in 
computing customs value at any time after importation, provided that in 
any such comparison the same costs are included both in basis or 
inventory costs and in customs value. If, on the basis of such 
comparison, the basis or inventory cost is equal to or less than the 
customs value, the taxpayer shall be deemed to have met the requirements 
of this section and section 1059A.
    (7) Relationship of section 1059A to section 482. Neither this 
section nor section 1059A limits in any way the authority of the 
Commissioner to increase or decrease the claimed basis or inventory cost 
under section 482 or any other appropriate provision of law. Neither 
does this section or section 1059A permit a taxpayer to adjust upward 
its cost basis or inventory cost for property appropriately determined 
under section 482 because such basis or inventory cost is less than the 
customs value with respect to such property.
    (8) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Corporation X, a United States taxpayer, and Y 
Corporation are members of a group of controlled corporations. X pays 
$2,000 to Y for merchandise imported into the United States and an 
additional $150 for ocean freight and insurance. The customs value of 
the shipment is determined to be the amount actually paid by X ($2,000) 
and does not include the charges for ocean freight and insurance. For 
purposes of computing the limitation on its inventory cost for the 
merchandise under section 1059A and this section, X is permitted, under 
paragraph

[[Page 178]]

(c)(2) of this section, to increase the customs value ($2,000) by 
amounts it paid for ocean freight and insurance charges ($150). Thus, 
the inventory cost claimed by X in the merchandise may not exceed 
$2,150.
    Example 2. Assume the same facts as in Example 1 except that, 
subsequent to the date of importation of the merchandise, Y grants to X 
a rebate of $200 of the purchase price. At the time of sale, the rebate 
was contingent upon the volume of merchandise ultimately bought by X 
from Y. The value of the merchandise, for customs purposes, is not 
decreased by the rebate paid to X by Y. Therefore, the customs value, 
for customs purposes, of the merchandise remains the same ($2,000). For 
purposes of computing its inventory cost, X was permitted, under 
paragraph (c)(2) of this section, to increase the customs value for 
purposes of section 1059A of $2,000 by the amounts it paid for ocean 
freight and insurance charges ($150). However, under paragraph (c)(3) of 
this section, X is required to reduce the amount of the customs value by 
the lesser of the amount of the rebate or the amount of any positive 
adjustments to the original customs value. The inventory price claimed 
by X may not exceed $2,000 ($2,000 customs value, plus $150 
transportation adjustment, less $150 offsetting rebate adjustment). 
While X's limitation under section 1059A is $2,000, X may not claim a 
basis or inventory cost in the merchandise in excess of $1,950. See 
I.R.C. section 1012; and section 1.471-2.
    Example 3. Corporation X, a United States taxpayer, and Y 
Corporation are members of a group of controlled corporations. X pays 
$10,000 to Y for merchandise imported into the United States. The 
merchandise is composed, in part, of American goods returned. The 
customs value of the merchandise, on which a customs duty is imposed, is 
determined to be $8,000 ($10,000, the amount declared by X, less $2,000, 
the value of the American goods returned). For income tax purposes, X 
claims a cost basis in the merchandise of $11,000. None of the 
adjustments permitted by paragraph (c)(2) of this section is applicable. 
The portion of the merchandise constituting American goods returned 
represented 20 percent of the total customs value of the merchandise. 
Since the cost basis claimed by X for income tax purposes represents a 
10 percent increase over the customs valuation (before reduction for 
American goods returned), the claimed tax basis in the dutiable content 
is considered to be $8,800 and in the portion constituting American 
goods returned is $2,200. Since a customs duty was imposed only on the 
dutiable content of the merchandise, the limitation in section 1059A and 
this section is applicable only to the claimed tax basis in this portion 
of the merchandise. Accordingly, under paragraph (a) of this section, X 
is limited to a cost basis of $10,200 in the merchandise. This amount 
represents a cost basis of $8,000 in the dutiable content and of $2,200 
in the portion of the merchandise constituting American goods returned.
    Example 4. Assume the same facts as in Example 3 except that X 
establishes that it is entitled to increase its customs value by $1,000 
in adjustments permitted by paragraph (c)(2) of this section. Since the 
adjustments to customs value that X is entitled to under paragraph 
(c)(2) of this section are 10 percent of the customs value, for purposes 
of determining the limitation under section 1059A and this section, both 
the dutiable content and the portion of the merchandise constituting 
American goods returned shall be increased to an amount 10 percent 
greater than the respective values determined for customs purposes, or 
$8,800 for the dutiable content and $2,200 for the portion of the 
merchandise constituting American goods returned. Accordingly, under 
paragraph (a) of this section, X is limited to a cost basis of $11,000 
in the merchandise.
    Example 5. Corporation X, a United States taxpayer, and Y 
Corporation are members of a group of controlled corporations. X pays 
$10,000 to Y for merchandise imported into the United States. The 
customs value of the merchandise, on which a customs duty is imposed, is 
determined to be $10,000. Subsequent to the date of importation of the 
merchandise, Y grants to X a rebate of $1,000 of the purchase price. The 
value of the merchandise, for customs purposes, is not decreased by the 
rebate paid to X by Y. Notwithstanding the fact that X correctly 
reported and paid customs duty on a value of $10,000 and that its 
limitation on basis or inventory cost under this section is $10,000, X 
may not claim a basis or inventory cost in the merchandise in excess of 
$9,000. See I.R.C. section 1012; and section 1.471-2.
    Example 6. Corporation X, a United States taxpayer, and Y 
Corporation are members of a group of controlled corporations. X pays 
$5,000 to Y for merchandise imported into the United States. The 
merchandise is not subject to a customs duty or is subject to a free 
rate of duty and is valued by customs solely for statistical purposes. 
Accordingly, pursuant to paragraph (c)(1) of this section, the 
merchandise is not subject to the provisions of section 1059A or this 
section.
    Example 7. Assume the same facts as in Example 6, except that the 
merchandise is subject to a customs duty based on value and that the 
customs value (taking into account no costs other than the value of the 
goods) is determined to be $5,000. Assume further that the $5,000 
payment is only for the value of the goods, no other cost is reflected 
in that payment, and only the $5,000 payment to Y is reflected in X's 
inventory cost or basis prior to inclusion of any other amounts properly 
included in inventory or cost basis. Pursuant

[[Page 179]]

to paragraph (c)(6) of this section, X, by demonstrating these facts is 
deemed to meet the requirements of this section and section 1059A.
    Example 8. Corporation X, a United States taxpayer, and Y 
Corporation are members of a group of controlled corporations. X pays $9 
to Y for merchandise imported into the United States and an additional 
$1 for ocean freight. The customs value of the article does not include 
the $l paid for ocean freight. Furthermore, for customs purposes the 
value is calculated pursuant to computed value and is determined to be 
$8. For purposes of computing the limitation on its inventory cost for 
the article under section 1059A and this section, X is permitted, under 
paragraph (c)(2) of this section, to increase the customs value ($8) by 
the amount it paid for ocean freight ($1). Thus, the inventory cost 
claimed by X in the article may not exceed $9.

    (9) Averaged customs values. In cases of transactions in which (i) 
an appropriate transfer price is properly determined for tax purposes by 
reference to events occurring after importation, (ii) the value for 
customs purposes of one article is higher and of a second article is 
lower than the actual transaction values, (iii) the relevant articles 
have been appraised on the basis of a value estimated at the time of 
importation in accordance with customs regulations, and (iv) the entries 
have been liquidated upon importation, the section 1059A limitation on 
the undervalued article may be increased up to the amount of actual 
transaction value by the amount of the duty overpaid on the overvalued 
article times a fraction the numerator of which is ``1'' and the 
denominator of which is the rate of duty on the undervalued article. 
This paragraph (c)(9) applies exclusively to cases of property imported 
in transactions that are open for tax purposes in which the actual 
transaction value cannot be determined and the entry has been liquidated 
for customs purposes on the basis of a value estimated at the time of 
importation in accordance with customs regulations; in these cases, the 
property is appropriately valued for tax purposes by reference to a 
formula, in existence at the time of importation, based on subsequent 
events and valued for customs purposes by a different formula. This 
paragraph (c)(9) does not apply where customs value is correctly 
determined for purposes of liquidating the entry and where the customs 
value is subsequently adjusted for tax purposes, for example by a 
rebate, under paragraph (c)(2) of this section. The application of 
paragraph (c)(9) may be illustrated by the following example:

    Example: Corporation X, a United States taxpayer, and Y Corporation 
are members of a group of controlled corporations. X purchases Articles 
A and B from Y on consignment and imports the Articles into the United 
States. The purchase price paid by X will be determined as a percentage 
of the sale prices that X realizes. Rather than deferring liquidation, 
customs liquidates the entry on the basis of estimated values and the 
customs duties are paid by X. Ultimately, it is determined that Article 
A was undervalued and Article B was overvalued by X for customs 
purposes. The section 1059A limitation for Article A is computed as 
follows:

------------------------------------------------------------------------
                                                   Article A   Article B
------------------------------------------------------------------------
Finally-determined customs value................          $9          $9
Transaction value...............................         $10          $5
Duty rate.......................................         10%          5%
Customs duty paid...............................        $.90        $.45
Duty overpaid or (underpaid)....................      ($.10)        $.20
------------------------------------------------------------------------

    The section 1059A limitation on Article A may be increased by the 
amount of the duty over-paid on Article B, $.20, times 1/.10, up to the 
amount of the transaction value. Therefore, the section 1059A limitation 
on Article A is $9.00 plus $1.00, or a total of $10.00. The section 
1059A limitation on Article B is reduced (but never below transaction 
value) by $2.00 to $7.00.

    (d) Finality of customs value and of other determinations of the 
U.S. Customs Service. For purposes of section 1059A and this section, a 
taxpayer is bound by the finally-determined customs value and by every 
final determination made by the U.S. Customs Service, including, but not 
limited to, dutiable value, the value attributable to the cost or value 
of products of the United States, and classification of the product for 
purposes of imposing any duty. The customs value is considered to be 
finally determined, and all U.S. Customs Service determinations are 
considered final, when liquidation of the entry becomes final. For this 
purpose, the term liquidation means the ascertainment of the customs 
duties occurring on the entry of the property, and liquidation of the 
entry is considered to become final after 90 days following notice of 
liquidation to the importer,

[[Page 180]]

unless a protest is filed. If the importer files a protest, the customs 
value will be considered finally determined and all other U.S. Customs 
Service determinations will be considered final either when a decision 
by the Customs Service on the protest is not contested after expiration 
of the period allowed to contest the decision or when a judgment of the 
Court of International Trade becomes final. For purposes of this 
section, any adjustments to the customs value resulting from a petition 
under 19 U.S.C. section 1516 (requests by interested parties unrelated 
to the importer for redetermination of the appraised value, 
classification, or the rate of duty imposed on imported merchandise) or 
reliquidation under 19 U.S.C. section 1521 (reliquidation by the Customs 
Service upon a finding that fraud was involved in the original 
liquidation) will not be taken into account. However, reliquidation 
under 19 U.S.C. section 1501 (voluntary reliquidation by the Customs 
Service within 90 days of the original liquidation to correct errors in 
appraisement, classification, or any element entering into a liquidation 
or reliquidation) or reliquidation under 19 U.S.C. section 1520(c)(1) 
(to correct a clerical error, mistake of fact, or other inadvertance 
within one year of a liquidation or reliquidation) will be taken into 
account in the same manner as, and take the place of, the original 
liquidation in determining customs value.
    (e) Drawbacks. For purposes of this section, a drawback, that is, a 
refund or remission (in whole or in part) of a customs duty because of a 
particular use made (or to be made) of the property on which the duty 
was assessed or collected, shall not affect the determination of the 
customs value of the property.
    (f) Effective date. Property imported by a taxpayer is subject to 
section 1059A and this section if the entry documentation required to be 
filed to obtain the release of the property from the custody of the 
United States Customs Service was filed after March 18, 1986. Section 
1059A and this section will not apply to imported property where (1) the 
entry documentation is filed prior to September 3, 1987; and (2) the 
importation was liquidated under the circumstances described in 
paragraph (c)(9) of this section.

[T.D. 8260, 54 FR 37311, Sept. 8, 1989]



Sec. 1.1060-1  Special allocation rules for certain asset acquisitions.

    (a) Scope--(1) In general. This section prescribes rules relating to 
the requirements of section 1060, which, in the case of an applicable 
asset acquisition, requires the transferor (the seller) and the 
transferee (the purchaser) each to allocate the consideration paid or 
received in the transaction among the assets transferred in the same 
manner as amounts are allocated under section 338(b)(5) (relating to the 
allocation of adjusted grossed-up basis among the assets of the target 
corporation when a section 338 election is made). In the case of an 
applicable asset acquisition described in paragraph (b)(1) of this 
section, sellers and purchasers must allocate the consideration under 
the residual method as described in Secs. 1.338-6 and 1.338-7 in order 
to determine, respectively, the amount realized from, and the basis in, 
each of the transferred assets. For rules relating to distributions of 
partnership property or transfers of partnership interests which are 
subject to section 1060(d), see Sec. 1.755-2T.
    (2) Effective date. The provisions of this section apply to any 
asset acquisition occurring after March 15, 2001. For rules applicable 
to asset acquisitions on or before March 15, 2001, see Sec. 1.1060-1T in 
effect prior to March 16, 2001 (see 26 CFR part 1 revised April 1, 
2000).
    (3) Outline of topics. In order to facilitate the use of this 
section, this paragraph (a)(3) lists the major paragraphs in this 
section as follows:

(a) Scope.
(1) In general.
(2) Effective date.
(3) Outline of topics.
(b) Applicable asset acquisition.
(1) In general.
(2) Assets constituting a trade or business.
(i) In general.
(ii) Goodwill or going concern value.
(iii) Factors indicating goodwill or going concern value.
(3) Examples.
(4) Asymmetrical transfers of assets.
(5) Related transactions.
(6) More than a single trade or business.
(7) Covenant entered into by the seller.

[[Page 181]]

(8) Partial non-recognition exchanges.
(c) Allocation of consideration among assets under the residual method.
(1) Consideration.
(2) Allocation of consideration among assets.
(3) Certain costs.
(4) Effect of agreement between parties.
(d) Examples.
(e) Reporting requirements.
(1) Applicable asset acquisitions.
(i) In general.
(ii) Time and manner of reporting.
(A) In general.
(B) Additional reporting requirement.
(2) Transfers of interests in partnerships.

    (b) Applicable asset acquisition--(1) In general. An applicable 
asset acquisition is any transfer, whether direct or indirect, of a 
group of assets if the assets transferred constitute a trade or business 
in the hands of either the seller or the purchaser and, except as 
provided in paragraph (b)(8) of this section, the purchaser's basis in 
the transferred assets is determined wholly by reference to the 
purchaser's consideration.
    (2) Assets constituting a trade or business--(i) In general. For 
purposes of this section, a group of assets constitutes a trade or 
business if--
    (A) The use of such assets would constitute an active trade or 
business under section 355; or
    (B) Its character is such that goodwill or going concern value could 
under any circumstances attach to such group.
    (ii) Goodwill or going concern value. Goodwill is the value of a 
trade or business attributable to the expectancy of continued customer 
patronage. This expectancy may be due to the name or reputation of a 
trade or business or any other factor. Going concern value is the 
additional value that attaches to property because of its existence as 
an integral part of an ongoing business activity. Going concern value 
includes the value attributable to the ability of a trade or business 
(or a part of a trade or business) to continue functioning or generating 
income without interruption notwithstanding a change in ownership. It 
also includes the value that is attributable to the immediate use or 
availability of an acquired trade or business, such as, for example, the 
use of the revenues or net earnings that otherwise would not be received 
during any period if the acquired trade or business were not available 
or operational.
    (iii) Factors indicating goodwill or going concern value. In making 
the determination in this paragraph (b)(2), all the facts and 
circumstances surrounding the transaction are taken into account. 
Whether sufficient consideration is available to allocate to goodwill or 
going concern value after the residual method is applied is not relevant 
in determining whether goodwill or going concern value could attach to a 
group of assets. Factors to be considered include--
    (A) The presence of any intangible assets (whether or not those 
assets are section 197 intangibles), provided, however, that the 
transfer of such an asset in the absence of other assets will not be a 
trade or business for purposes of section 1060;
    (B) The existence of an excess of the total consideration over the 
aggregate book value of the tangible and intangible assets purchased 
(other than goodwill and going concern value) as shown in the financial 
accounting books and records of the purchaser; and
    (C) Related transactions, including lease agreements, licenses, or 
other similar agreements between the purchaser and seller (or managers, 
directors, owners, or employees of the seller) in connection with the 
transfer.
    (3) Examples. The following examples illustrate paragraphs (b)(1) 
and (2) of this section:

    Example 1. S is a high grade machine shop that manufactures 
microwave connectors in limited quantities. It is a successful company 
with a reputation within the industry and among its customers for 
manufacturing unique, high quality products. Its tangible assets consist 
primarily of ordinary machinery for working metal and plating. It has no 
secret formulas or patented drawings of value. P is a company that 
designs, manufactures, and markets electronic components. It wants to 
establish an immediate presence in the microwave industry, an area in 
which it previously has not been engaged. P is acquiring assets of a 
number of smaller companies and hopes that these assets will 
collectively allow it to offer a broad product mix. P acquires the 
assets of S in order to augment its product mix and to promote its 
presence in the microwave industry. P will not use the assets acquired 
from S to manufacture microwave connectors. The assets transferred are 
assets that constitute a trade or

[[Page 182]]

business in the hands of the seller. Thus, P's purchase of S's assets is 
an applicable asset acquisition. The fact that P will not use the assets 
acquired from S to continue the business of S does not affect this 
conclusion.
    Example 2. S, a sole proprietor who operates a car wash, both leases 
the building housing the car wash and sells all of the car wash 
equipment to P. S's use of the building and the car wash equipment 
constitute a trade or business. P begins operating a car wash in the 
building it leases from S. Because the assets transferred together with 
the asset leased are assets which constitute a trade or business, P's 
purchase of S's assets is an applicable asset acquisition.
    Example 3. S, a corporation, owns a retail store business in State X 
and conducts activities in connection with that business enterprise that 
meet the active trade or business requirement of section 355. P is a 
minority shareholder of S. S distributes to P all the assets of S used 
in S's retail business in State X in complete redemption of P's stock in 
S held by P. The distribution of S's assets in redemption of P's stock 
is treated as a sale or exchange under sections 302(a) and 302(b)(3), 
and P's basis in the assets distributed to it is determined wholly by 
reference to the consideration paid, the S stock. Thus, S's distribution 
of assets constituting a trade or business to P is an applicable asset 
acquisition.
    Example 4. S is a manufacturing company with an internal financial 
bookkeeping department. P is in the business of providing a financial 
bookkeeping service on a contract basis. As part of an agreement for P 
to begin providing financial bookkeeping services to S, P agrees to buy 
all of the assets associated with S's internal bookkeeping operations 
and provide employment to any of S's bookkeeping department employees 
who choose to accept a position with P. In addition to selling P the 
assets associated with its bookkeeping operation, S will enter into a 
long term contract with P for bookkeeping services. Because assets 
transferred from S to P, along with the related contract for bookkeeping 
services, are a trade or business in the hands of P, the sale of the 
bookkeeping assets from S to P is an applicable asset acquisition.

    (4) Asymmetrical transfers of assets. A purchaser is subject to 
section 1060 if--
    (i) Under general principles of tax law, the seller is not treated 
as transferring the same assets as the purchaser is treated as 
acquiring;
    (ii) The assets acquired by the purchaser constitute a trade or 
business; and
    (iii) Except as provided in paragraph (b)(8) of this section, the 
purchaser's basis in the transferred assets is determined wholly by 
reference to the purchaser's consideration.
    (5) Related transactions. Whether the assets transferred constitute 
a trade or business is determined by aggregating all transfers from the 
seller to the purchaser in a series of related transactions. Except as 
provided in paragraph (b)(8) of this section, all assets transferred 
from the seller to the purchaser in a series of related transactions are 
included in the group of assets among which the consideration paid or 
received in such series is allocated under the residual method. The 
principles of Sec. 1.338-1(c) are also applied in determining which 
assets are included in the group of assets among which the consideration 
paid or received is allocated under the residual method.
    (6) More than a single trade or business. If the assets transferred 
from a seller to a purchaser include more than one trade or business, 
then, in applying this section, all of the assets transferred (whether 
or not transferred in one transaction or a series of related 
transactions and whether or not part of a trade or business) are treated 
as a single trade or business.
    (7) Covenant entered into by the seller. If, in connection with an 
applicable asset acquisition, the seller enters into a covenant (e.g., a 
covenant not to compete) with the purchaser, that covenant is treated as 
an asset transferred as part of a trade or business.
    (8) Partial non-recognition exchanges. A transfer may constitute an 
applicable asset acquisition notwithstanding the fact that no gain or 
loss is recognized with respect to a portion of the group of assets 
transferred. All of the assets transferred, including the non-
recognition assets, are taken into account in determining whether the 
group of assets constitutes a trade or business. The allocation of 
consideration under paragraph (c) of this section is done without taking 
into account either the non-recognition assets or the amount of money or 
other property that is treated as transferred in exchange for the non-
recognition assets (together, the non-recognition exchange property). 
The basis in and gain or loss recognized with respect to the non-
recognition exchange property are

[[Page 183]]

determined under such rules as would otherwise apply to an exchange of 
such property. The amount of the money and other property treated as 
exchanged for non-recognition assets is the amount by which the fair 
market value of the non-recognition assets transferred by one party 
exceeds the fair market value of the non-recognition assets transferred 
by the other (to the extent of the money and the fair market value of 
property transferred in the exchange). The money and other property that 
are treated as transferred in exchange for the non-recognition assets 
(and which are not included among the assets to which section 1060 
applies) are considered to come from the following assets in the 
following order: first from Class I assets, then from Class II assets, 
then from Class III assets, then from Class IV assets, then from Class V 
assets, then from Class VI assets, and then from Class VII assets. For 
this purpose, liabilities assumed (or to which a non-recognition 
exchange property is subject) are treated as Class I assets. See Example 
1 in paragraph (d) of this section for an example of the application of 
section 1060 to a single transaction which is, in part, a non-
recognition exchange.
    (c) Allocation of consideration among assets under the residual 
method--(1) Consideration. The seller's consideration is the amount, in 
the aggregate, realized from selling the assets in the applicable asset 
acquisition under section 1001(b). The purchaser's consideration is the 
amount, in the aggregate, of its cost of purchasing the assets in the 
applicable asset acquisition that is properly taken into account in 
basis.
    (2) Allocation of consideration among assets. For purposes of 
determining the seller's amount realized for each of the assets sold in 
an applicable asset acquisition, the seller allocates consideration to 
all the assets sold by using the residual method under Secs. 1.338-6 and 
1.338-7, substituting consideration for ADSP. For purposes of 
determining the purchaser's basis in each of the assets purchased in an 
applicable asset acquisition, the purchaser allocates consideration to 
all the assets purchased by using the residual method under Secs. 1.338-
6 and 1.338-7, substituting consideration for AGUB. In allocating 
consideration, the rules set forth in paragraphs (c)(3) and (4) of this 
section apply in addition to the rules in Secs. 1.338-6 and 1.338-7.
    (3) Certain costs. The seller and purchaser each adjusts the amount 
allocated to an individual asset to take into account the specific 
identifiable costs incurred in transferring that asset in connection 
with the applicable asset acquisition (e.g., real estate transfer costs 
or security interest perfection costs). Costs so allocated increase, or 
decrease, as appropriate, the total consideration that is allocated 
under the residual method. No adjustment is made to the amount allocated 
to an individual asset for general costs associated with the applicable 
asset acquisition as a whole or with groups of assets included therein 
(e.g., non-specific appraisal fees or accounting fees). These latter 
amounts are taken into account only indirectly through their effect on 
the total consideration to be allocated.
    (4) Effect of agreement between parties. If, in connection with an 
applicable asset acquisition, the seller and purchaser agree in writing 
as to the allocation of any amount of consideration to, or as to the 
fair market value of, any of the assets, such agreement is binding on 
them to the extent provided in this paragraph (c)(4). Nothing in this 
paragraph (c)(4) restricts the Commissioner's authority to challenge the 
allocations or values arrived at in an allocation agreement. This 
paragraph (c)(4) does not apply if the parties are able to refute the 
allocation or valuation under the standards set forth in Commissioner v. 
Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967) (a 
party wishing to challenge the tax consequences of an agreement as 
construed by the Commissioner must offer proof that, in an action 
between the parties to the agreement, would be admissible to alter that 
construction or show its unenforceability because of mistake, undue 
influence, fraud, duress, etc.).
    (d) Examples. The following examples illustrate this section:

    Example 1. (i) On January 1, 2001, A transfers assets X, Y, and Z to 
B in exchange for assets D, E, and F plus $1,000 cash.

[[Page 184]]

    (ii) Assume the exchange of assets constitutes an exchange of like-
kind property to which section 1031 applies. Assume also that goodwill 
or going concern value could under any circumstances attach to each of 
the DEF and XYZ groups of assets and, therefore, each group constitutes 
a trade or business under section 1060.
    (iii) Assume the fair market values of the assets and the amount of 
money transferred are as follows:

------------------------------------------------------------------------
                                                                  Fair
                             Asset                               market
                                                                  value
------------------------------------------------------------------------
By A:
  X...........................................................     $ 400
  Y...........................................................       400
  Z...........................................................       200
                                                               ---------
    Total.....................................................     1,000
                                                               =========
By B:
  D...........................................................        40
  E...........................................................        30
  F...........................................................        30
  Cash (amount)...............................................     1,000
                                                               ---------
    Total.....................................................     1,100
------------------------------------------------------------------------

    (iv) Under paragraph (b)(8) of this section, for purposes of 
allocating consideration under paragraph (c) of this section, the like-
kind assets exchanged and any money or other property that are treated 
as transferred in exchange for the like-kind property are excluded from 
the application of section 1060.
    (v) Since assets X, Y, and Z are like-kind property, they are 
excluded from the application of the section 1060 allocation rules.
    (vi) Since assets D, E, and F are like-kind property, they are 
excluded from the application of the section 1060 allocation rules. 
Thus, the allocation rules of section 1060 do not apply in determining 
B's gain or loss with respect to the disposition of assets D, E, and F, 
and the allocation rules of section 1060 and paragraph (c) of this 
section are not applied to determine A's bases of assets D, E, and F. In 
addition, $900 of the $1,000 cash B gave to A for A's like-kind assets 
(X, Y, and Z) is treated as transferred in exchange for the like-kind 
property in order to equalize the fair market values of the like-kind 
assets. Therefore, $900 of the cash is excluded from the application of 
the section 1060 allocation rules.
    (vii) $100 of the cash is allocated under section 1060 and paragraph 
(c) of this section.
    (viii) A received $100 that must be allocated under section 1060 and 
paragraph (c) of this section. Since A transferred no Class I, II, III, 
IV, V, or VI assets to which section 1060 applies, in determining its 
amount realized for the part of the exchange to which section 1031 does 
not apply, the $100 is allocated to Class VII assets (goodwill and going 
concern value).
    (ix) B gave A $100 that must be allocated under section 1060 and 
paragraph (c) of this section. Since B received from A no Class I, II, 
III, IV, V, or VI assets to which section 1060 applies, the $100 
consideration is allocated by B to Class VII assets (goodwill and going 
concern value).
    Example 2. (i) On January 1, 2001, S, a sole proprietor, sells to P, 
a corporation, a group of assets that constitutes a trade or business 
under paragraph (b)(2) of this section. S, who plans to retire 
immediately, also executes in P's favor a covenant not to compete. P 
pays S $3,000 in cash and assumes $1,000 in liabilities. Thus, the total 
consideration is $4,000.
    (ii) On the purchase date, P and S also execute a separate agreement 
that states that the fair market values of the Class II, Class III, 
Class V, and Class VI assets S sold to P are as follows:

------------------------------------------------------------------------
                                                                  Fair
        Asset  class                       Asset                 market
                                                                  value
------------------------------------------------------------------------
II.........................  Actively traded securities.......      $500
                                                               ---------
                                Total Class II................       500
                                                               =========
III........................  Accounts receivable..............       200
                                                               ---------
                                Total Class III...............       200
                                                               =========
V..........................  Furniture and fixtures...........       800
                             Building.........................       800
                             Land.............................       200
                             Equipment........................       400
                                                               ---------
                                Total Class V.................     2,200
                                                               =========
VI.........................  Covenant not to compete..........       900
                                                               ---------
                                Total Class VI................       900
------------------------------------------------------------------------

    (iii) P and S each allocate the consideration in the transaction 
among the assets transferred under paragraph (c) of this section in 
accordance with the agreed upon fair market values of the assets, so 
that $500 is allocated to Class II assets, $200 is allocated to the 
Class III asset, $2,200 is allocated to Class V assets, $900 is 
allocated to Class VI assets, and $200 ($4,000 total consideration less 
$3,800 allocated to assets in Classes II, III, V, and VI) is allocated 
to the Class VII assets (goodwill and going concern value).
    (iv) In connection with the examination of P's return, the 
Commissioner, in determining the fair market values of the assets 
transferred, may disregard the parties' agreement. Assume that the 
Commissioner correctly determines that the fair market value of the 
covenant not to compete was $500. Since the allocation of consideration 
among Class II, III, V, and VI assets results in allocation up to the 
fair market value limitation, the $600 of unallocated consideration 
resulting from the Commissioner's redetermination of the value of the 
covenant

[[Page 185]]

not to compete is allocated to Class VII assets (goodwill and going 
concern value).

    (e) Reporting requirements--(1) Applicable asset acquisitions--(i) 
In general. Unless otherwise excluded from this requirement by the 
Commissioner, the seller and the purchaser in an applicable asset 
acquisition each must report information concerning the amount of 
consideration in the transaction and its allocation among the assets 
transferred. They also must report information concerning subsequent 
adjustments to consideration.
    (ii) Time and manner of reporting--(A) In general. The seller and 
the purchaser each must file asset acquisition statements on Form 8594, 
``Asset Allocation Statement,'' with their income tax returns or returns 
of income for the taxable year that includes the first date assets are 
sold pursuant to an applicable asset acquisition. This reporting 
requirement applies to all asset acquisitions described in this section. 
For reporting requirements relating to asset acquisitions occurring 
before March 16, 2001, as described in paragraph (a)(2) of this section, 
see the temporary regulations under section 1060 in effect prior to 
March 16, 2001 (see 26 CFR part 1 revised April 1, 2000).
    (B) Additional reporting requirement. When an increase or decrease 
in consideration is taken into account after the close of the first 
taxable year that includes the first date assets are sold in an 
applicable asset acquisition, the seller and the purchaser each must 
file a supplemental asset acquisition statement on Form 8594 with the 
income tax return or return of income for the taxable year in which the 
increase (or decrease) is properly taken into account.
    (2) Transfers of interests in partnerships. For reporting 
requirements relating to the transfer of a partnership interest, see 
Sec. 1.755-2T(c).

[T.D. 8940, 66 FR 9954, Feb. 13, 2001]

                   Changes To Effectuate F.C.C. Policy



Sec. 1.1071-1  Gain from sale or exchange to effectuate policies of Federal Communications Commission.

    (a)(1) At the election of the taxpayer, section 1071 postpones the 
recognition of the gain upon the sale or exchange of property if the 
Federal Communications Commission grants the taxpayer a certificate with 
respect to the ownership and control of radio broadcasting stations 
which is in accordance with subparagraph (2) of this paragraph. Any 
taxpayer desiring to obtain the benefits of section 1071 shall file such 
certificate with the Commissioner of Internal Revenue, or the district 
director for the internal revenue district in which the income tax 
return of the taxpayer is required to be filed.
    (2)(i) In the case of a sale or exchange before January 1, 1958, the 
certificate from the Federal Communications Commission must clearly 
identify the property and show that the sale or exchange is necessary or 
appropriate to effectuate the policies of such Commission with respect 
to the ownership and control of radio broadcasting stations.
    (ii) In the case of a sale or exchange after December 31, 1957, the 
certificate from the Federal Communications Commission must clearly 
identify the property and show that the sale or exchange is necessary or 
appropriate to effectuate a change in a policy of, or the adoption of a 
new policy by, such Commission with respect to the ownership and control 
of radio broadcasting stations.
    (3) The certificate shall be accompanied by a detailed statement 
showing the kind of property, the date of acquisition, the cost or other 
basis of the property, the date of sale or exchange, the name and 
address of the transferee, and the amount of money and the fair market 
value of the property other than money received upon such sale or 
exchange.
    (b) Section 1071 applies only in the case of a sale or exchange made 
necessary by reason of the Federal Communications Commission's policies 
as to ownership or control of radio facilities. Section 1071 does not 
apply in the case of a sale or exchange made necessary as a result of 
other matters, such as the operation of a broadcasting station in a 
manner determined by the Commission to be not in the public interest or 
in violation of Federal or State law.
    (c) An election to have the benefits of section 1071 shall be made 
in the manner prescribed in Sec. 1.1071-4.

[[Page 186]]

    (d) For purposes of section 1071, the term radio broadcasting 
includes telecasting.



Sec. 1.1071-2  Nature and effect of election.

    (a) Alternative elections. (1) A taxpayer entitled to the benefits 
of section 1071 in respect of a sale or exchange of property may elect--
    (i) To treat such sale or exchange as an involuntary conversion 
under the provisions of section 1033; or
    (ii) To treat such sale or exchange as an involuntary conversion 
under the provisions of section 1033, and in addition elect to reduce 
the basis of property, in accordance with the regulations prescribed in 
Sec. 1.1071-3, by all or part of the gain that would otherwise be 
recognized under section 1033; or
    (iii) To reduce the basis of property, in accordance with the 
regulations prescribed in Sec. 1.1071-3, by all or part of the gain 
realized upon the sale or exchange.
    (2) The effect of the provisions of subparagraph (1) of this 
paragraph is, in general, to grant the taxpayer an election to treat the 
proceeds of the sale or exchange as the proceeds of an involuntary 
conversion subject to the provisions of section 1033, and a further 
election to reduce the basis of certain property owned by the taxpayer 
by the amount of the gain realized upon the sale or exchange to the 
extent of that portion of the proceeds which is not treated as the 
proceeds of an involuntary conversion.
    (3) An election in respect to a sale or exchange under section 1071 
shall be irrevocable and binding for the taxable year in which the sale 
or exchange takes place and for all subsequent taxable years.
    (b) Application of section 1033. (1) If the taxpayer elects, under 
either paragraph (a)(1) (i) or (ii) of this section, to treat the sale 
or exchange as an involuntary conversion, the provisions of section 
1033, as modified by section 1071, together with the regulations 
prescribed under such sections, shall be applicable in determining the 
amount of recognized gain and the basis of property required as a result 
of such sale or exchange. For the purposes of section 1071 and the 
regulations thereunder, stock of a corporation operating a radio 
broadcasting station shall be treated as property similar or related in 
service or use to the property sold or exchanged. Securities of such a 
corporation other than stock, or securities of a corporation not 
operating a radio broadcasting station, do not constitute property 
similar or related in service or use to the property sold or exchanged. 
If the taxpayer exercises the election referred to in paragraph 
(a)(1)(i) of this section, the gain realized upon such sale or exchange 
shall be recognized to the extent of that part of the money received 
upon the sale or exchange which is not expended in the manner prescribed 
in section 1033 and the regulations thereunder. If, however, the 
taxpayer exercises the elections referred to in paragraph (a)(1)(ii) of 
this section, the amount of the gain which would be recognized, 
determined in the same manner as in the case of an election under 
paragraph (a)(1)(i) of this section, shall not be recognized but shall 
be applied to reduce the basis of property, remaining in the hands of 
the taxpayer after such sale or exchange or acquired by him during the 
same taxable year, which is of a character subject to the allowance for 
depreciation under section 167. Such reduction of basis shall be made in 
accordance with and under the conditions prescribed by Sec. 1.1071-3.
    (2) In the application of section 1033 to determine the recognized 
gain and the basis of property acquired as a result of a sale or 
exchange pursuant to an election under paragraph (a)(1) (i) or (ii) of 
this section, the entire amount of the proceeds of such sale or exchange 
shall be taken into account.
    (c) Example. The application of the provisions of section 1071 may 
be illustrated by the following example:

    Example: A, who makes his return on a calendar year basis, sold in 
1954, for $100,000 cash, stock of X Corporation, which operates a radio 
broadcasting station. A's basis of this stock was $75,000. The sale was 
certified by the Federal Communications Commission as provided in 
section 1071. Soon after, in the same taxable year, A used $50,000 of 
the proceeds of the sale to purchase stock in Y Corporation, which 
operates a radio broadcasting station. A elected in his 1954 return to 
treat such sale and purchase as an involuntary conversion subject to the 
provisions

[[Page 187]]

of section 1033. He also elected at the same time to reduce the basis of 
depreciable property by the amount of the gain that otherwise would be 
recognized under the provisions of section 1033, as made applicable by 
section 1071. The sale results in a recognized gain of $25,000 under 
section 1033. However, this gain is not recognized in this case because 
the taxpayer elected to reduce the basis of other property by the amount 
of the gain. This may be shown as follows:

(1) Sale price of X Corporation stock..............             $100,000
Basis for gain or loss.............................               75,000
                                                    --------------------
  Gain realized....................................               25,000
                                                    ====================
Proceeds of sale...................................              100,000
Amount expended to replace property sold...........               50,000
                                                    --------------------
  Amount not expended in manner prescribed in                     50,000
   section 1033....................................
                                                    ====================
Realized gain, recognized under section 1033 (not                 25,000
 to exceed the unexpended portion of proceeds of
 sale).............................................
Less: Amount applied as a reduction of basis of                   25,000
 depreciable property..............................
                                                    --------------------
  Recognized gain for tax purposes.................                 None
 

    (2) The basis of Y Corporation stock in the hands of A is $50,000, 
computed in accordance with section 1033 and the regulations prescribed 
under that section. The $50,000 basis is computed as follows:

Basis of property sold (converted).................              $75,000
Less: Amount of proceeds not expended..............               50,000
                                                    --------------------
  Balance..........................................               25,000
Plus amount of gain recognized under section 1033..               25,000
                                                    --------------------
  Basis of Y Corporation stock in A's hands........               50,000
 



Sec. 1.1071-3  Reduction of basis of property pursuant to election under section 1071.

    (a) General rule. (1) In addition to the adjustments provided in 
section 1016 and other applicable provisions of chapter 1 of the Code 
which adjustments are required to be made with respect to the cost or 
other basis of property, a further adjustment shall be made in the 
amount of the unrecognized gain under section 1071, if the taxpayer so 
elects. Such further adjustment shall be made only with respect to the 
cost or other basis of property which is of a character subject to the 
allowance for depreciation under section 167 (whether or not used in 
connection with a broadcasting business), and which remains in the hands 
of the taxpayer immediately after the sale or exchange in respect of 
which the election is made, or which is acquired by the taxpayer in the 
same taxable year in which such sale or exchange occurs. If the property 
is in the hands of the taxpayer immediately after the sale or exchange, 
the time of reduction of the basis is the date of the sale or exchange; 
in all other cases the time of reduction of the basis is the date of 
acquisition.
    (2) The reduction of basis under section 1071 in the amount of the 
unrecognized gain shall be made in respect of the cost or other basis, 
as of the time prescribed, of all units of property of the specified 
character. The cost or other basis of each unit shall be decreased in an 
amount equal to such proportion of the unrecognized gain as the adjusted 
basis (for determining gain, determined without regard to this section) 
of such unit bears to the aggregate of such adjusted bases of all units 
of such property, but the amount of the decrease shall not be more than 
the amount of such adjusted basis. If in the application of such rule 
the adjusted basis of any unit is reduced to zero, the process shall be 
repeated to reduce the adjusted basis of the remaining units of property 
by the portion of the unrecognized gain which is not absorbed in the 
first application of the rule. For such purpose the adjusted basis of 
the remaining units shall be the adjusted basis for determining gain 
reduced by the amount of the adjustment previously made under this 
section. The process shall be repeated until the entire amount of the 
unrecognized gain has been absorbed.
    (3) The application of the provisions of this section may be 
illustrated by the following example:

    Example: Using the facts given in the example set forth in 
Sec. 1.1071-2(c), except that the taxpayer elects to reduce the basis of 
depreciable property in accordance with paragraph (a)(1)(iii) of 
Sec. 1.1071-2, the computation may be illustrated as follows:

Sale price of X Corporation stock..................             $100,000
Basis for gain or loss.............................               75,000
                                                    --------------------
Realized gain (recognized except for the election                $25,000
 under Sec.  1.1071-1).............................
                                                    ====================
Adjusted basis of other depreciable property in
 hands of A immediately after sale:
    Building.......................................               80,000
    Transmitter....................................               16,000

[[Page 188]]

 
    Fixtures.......................................                4,000
                                                    --------------------
      Total........................................              100,000
                                                    ====================
Computation of reduction:
  Building (80,000/100,000)x$25,000 (gain).........               20,000
  Transmitter (16,000/100,000)x$25,000.............                4,000
  Fixtures (4,000/100,000)x$25,000.................                1,000
                                                    --------------------
    Total reduction................................               25,000
                                                    ====================
New basis of assets:
  Building ($80,000 minus $20,000).................               60,000
  Transmitter ($16,000 minus $4,000)...............               12,000
  Fixtures ($4,000 minus $1,000)...................                3,000
                                                    --------------------
    Total adjusted basis after reduction under                    75,000
     section 1071..................................
                                                    ====================
Realized gain upon sale of X Corporation stock.....               25,000
Less: Amount applied as a reduction to basis of                   25,000
 depreciable property..............................
                                                    --------------------
    Recognized gain for tax purposes...............                 None
 


    (b) Special cases. With the consent of the Commissioner, the 
taxpayer may, however, have the basis of the various units of property 
of the class specified in section 1071 and this section adjusted in a 
manner different from the general rule set forth in paragraph (a) of 
this section. Variations from such general rule may, for example, 
involve adjusting the basis of only certain units of such property. The 
request for variations from such general rule should be filed by the 
taxpayer with his return for the taxable year in which he elects to have 
the basis of property reduced under section 1071. Agreement between the 
taxpayer and the Commissioner as to any variations from such general 
rule shall be effective only if incorporated in a closing agreement 
entered into under the provisions of section 7121.



Sec. 1.1071-4  Manner of election.

    (a) An election under the provisions of section 1071 shall be in the 
form of a written statement and shall be executed and filed in 
duplicate. Such statement shall be signed by the taxpayer or his 
authorized representative. In the case of a corporation, the statement 
shall be signed with the corporate name, followed by the signature and 
title of an officer of the corporation empowered to sign for the 
corporation, and the corporate seal must be affixed. An election under 
section 1071 to reduce the basis of property and an election under such 
section to treat the sale or exchange as an involuntary conversion under 
section 1033 may be exercised independently of each other. An election 
under section 1071 must be filed with the return for the taxable year in 
which the sale or exchange occurs. Where practicable, the certificate of 
the Federal Communications Commission required by Sec. 1.1071-1 should 
be filed with the election.
    (b) If, in pursuance of an election to have the basis of its 
property adjusted under section 1071, the taxpayer desires to have such 
basis adjusted in any manner different from the general rule set forth 
in paragraph (a) of Sec. 1.1071-3, the precise method (including 
allocation of amounts) should be set forth in detail on separate sheets 
accompanying the election. Consent by the Commissioner to any departure 
from such general rule shall be effected only by a closing agreement 
entered into under the provisions of section 7121.

                 Exchanges In Obedience To S.E.C. Orders



Sec. 1.1081-1  Terms used.

    The following terms, when used in this section and Secs. 1.1081-2 to 
1.1083-1, inclusive, shall have the meanings assigned to them in section 
1083: Order of the Securities and Exchange Commission; registered 
holding company; holding company system; associate company; majority-
owned subsidiary company; system group; nonexempt property; and stock or 
securities. Any other term used in this section and Secs. 1.1081-2 to 
1.1083-1, inclusive, which is defined in the Internal Revenue Code of 
1954, shall be given the respective definition contained in such Code.



Sec. 1.1081-2  Purpose and scope of exception.

    (a) The general rule is that the entire amount of gain or loss from 
the sale or exchange of property is to be recognized (see section 1002) 
and that the entire amount received as a dividend is to be included in 
gross income. (See sections 61 and 301.) Exceptions to the general rule 
are provided elsewhere in subchapters C and O, chapter 1 of the Code, 
one of which is that made by section 1081 with respect to exchanges,

[[Page 189]]

sales, and distributions specifically described in section 1081. Section 
1081 provides the extent to which gain or loss is not to be recognized 
on (1) the receipt of a distribution described in section 1081(c)(2), or 
(2) an exchange or sale, or the receipt of a distribution, made in 
obedience to an order of the Securities and Exchange Commission, which 
is issued to effectuate the provisions of section 11 (b) of the Public 
Utility Holding Company Act of 1935 (15 U.S.C. 79k (b)). Section 331 
provides that a distribution in liquidation of a corporation shall be 
treated as an exchange. Such distribution is to be treated as an 
exchange under the provisions of sections 1081 to 1083, inclusive. The 
order of the Securities and Exchange Commission must be one requiring or 
approving action which the Commission finds to be necessary or 
appropriate to effect a simplification or geographical integration of a 
particular public utility holding company system. For specific 
requirements with respect to an order of the Securities and Exchange 
Commission, see section 1081 (f).
    (b) The requirements for nonrecognition of gain or loss as provided 
in section 1081 are precisely stated with respect to the following 
general types of transactions:
    (1) The exchange that is provided for in section 1081 (a), in which 
stock or securities in a registered holding company or a majority-owned 
subsidiary company are exchanged for stock or securities.
    (2) The exchange that is provided for in section 1081 (b), in which 
a registered holding company or an associate company of a registered 
holding company exchanges property for property.
    (3) The distribution that is provided for in section 1081 (c)(1), in 
which stock or securities are distributed to a shareholder in a 
corporation which is a registered holding company or a majority-owned 
subsidiary company, or the distribution that is provided for in section 
1081 (c)(2), in which a corporation distributes to a shareholder, rights 
to acquire common stock in a second corporation.
    (4) The transfer that is provided for in section 1081 (d), in which 
a corporation which is a member of a system group transfers property to 
another member of the same system group.

Certain rules with respect to the receipt of nonexempt property on an 
exchange described in section 1081 (a) are prescribed in section 1081 
(e).
    (c) These exceptions to the general rule are to be strictly 
construed. Unless both the purpose and the specific requirements of 
sections 1081 to 1083, inclusive, are clearly met, the recognition of 
gain or loss upon the exchange, sale, or distribution will not be 
postponed under those sections. Moreover, even though a taxable 
transaction occurs in connection or simultaneously with a realization of 
gain or loss to which nonrecognition is accorded, nevertheless, 
nonrecognition will not be accorded to such taxable transaction. In 
other words, the provisions of section 1081 do not extend in any case to 
gain or loss other than that realized from and directly attributable to 
a disposition of property as such, or the receipt of a corporate 
distribution as such, in an exchange, sale, or distribution specifically 
described in section 1081.
    (d) The application of the provisions of part VI (section 1081 and 
following), subchapter O, chapter 1 of the Code, is intended to result 
only in postponing the recognition of gain or loss until a disposition 
of property is made which is not covered by such provisions, and, in the 
case of an exchange or sale subject to the provisions of section 1081 
(b), in the reduction of basis of certain property. The provisions of 
section 1082 with respect to the continuation of basis and the reduction 
in basis are designed to effect these results. Although the time of 
recognition may be shifted, there must be a true reflection of income in 
all cases, and it is intended that the provisions of such part VI, shall 
not be construed or applied in such a way as to defeat this purpose.



Sec. 1.1081-3  Exchanges of stock or securities solely for stock or securities.

    The exchange, without the recognition of gain or loss, that is 
provided for in section 1081 (a) must be one in which stock or 
securities in a corporation which is a registered holding company

[[Page 190]]

or a majority-owned subsidiary company are exchanged solely for stock or 
securities other than stock or securities which constitute nonexempt 
property. An exchange is not within the provisions of section 1081 (a) 
unless the stock or securities transferred and those received are stock 
or securities as defined by section 1083 (f). The stock or securities 
which may be received without the recognition of gain or loss are not 
limited to stock or securities in the corporation from which they are 
received. An exchange within the provisions of section 1081 (a) may be a 
transaction between the holder of stock or securities and the 
corporation which issued the stock or securities. Also the exchange may 
be made by a holder of stock or securities with an associate company 
(i.e., a corporation in the same holding company system with the issuing 
corporation) which is a registered holding company or a majority-owned 
subsidiary company. In either case, the nonrecognition provisions of 
section 1081 (a) apply only to the holder of the stock or securities. 
However, the transferee corporation must be acting in obedience to an 
order of the Securities and Exchange Commission directed to such 
corporation, if no gain or loss is to be recognized to the holder of the 
stock or securities who makes the exchange with such corporation. See 
also section 1081(b), in case the holder of the stock or securities is a 
registered holding company or an associate company of a registered 
holding company. An exchange is not within the provisions of section 
1081(a) if it is within the provisions of section 1081(d), relating to 
transfers within a system group. For treatment when nonexempt property 
is received, see section 1081(e); for further limitations, see section 
1081(f).



Sec. 1.1081-4  Exchanges of property for property by corporations.

    (a) Application of section 1081(b). Section 1081(b) applies only to 
the transfers specified therein with respect to which section 1081(d) is 
inapplicable, and deals only with such transfers if gain is realized 
upon the sale or other disposition effected by such transfers. If loss 
is realized section 1081(b) is inapplicable and the application of other 
provisions of subtitle A of the Code must be determined. See section 
1081(g). If section 1081(b) is applicable, the other provisions of 
subchapters C and O, chapter 1 of the Code, relating to the 
nonrecognition of gain are inapplicable, and the conditions under which, 
and the extent to which, the realized gain is not recognized are set 
forth in paragraphs (b), (c), (d), (e), and (f) of this section.
    (b) Nonrecognition of gain; no nonexempt proceeds. No gain is 
recognized to a transferor corporation upon the sale or other 
disposition of property transferred by such transferor corporation in 
exchange solely for property other than nonexempt property, as defined 
in section 1083(e), but only if all of the following requirements are 
satisfied:
    (1) The transferor corporation is, under the definition in section 
1083 (b), a registered holding company or an associate company of a 
registered holding company;
    (2) Such transfer is in obedience to an order of the Securities and 
Exchange Commission (as defined in section 1083 (a)) and such order 
satisfies the requirements of section 1081 (f);
    (3) The transferor corporation has filed the required consent to the 
regulations under section 1082(a)(2) (see paragraph (g) of this 
section); and
    (4) The entire amount of the gain, as determined under section 1001, 
can be applied in reduction of basis under section 1082(a)(2).
    (c) Nonrecognition of gain; nonexempt proceeds. If the transaction 
would be within the provisions of paragraph (b) of this section if it 
were not for the fact that the property received in exchange consists in 
whole or in part of nonexempt property (as defined in section 1083 (e)), 
then no gain is recognized if such nonexempt property, or an amount 
equal to the fair market value of such nonexempt property at the time of 
the transfer.
    (1) Is expended within the required 24-month period for property 
other than nonexempt property; or
    (2) Is invested within the required 24-month period as a 
contribution to the capital, or as paid-in surplus, of another 
corporation;

[[Page 191]]


but only if the expenditure or investment is made
    (3) In accordance with an order of the Securities and Exchange 
Commission (as defined in section 1083 (a)) which satisfies the 
requirements of section 1081 (f) and which recites that such expenditure 
or investment by the transferor corporation is necessary or appropriate 
to the integration or simplification of the holding company system of 
which the transferor corporation is a member; and
    (4) The required consent, waiver, and bond have been executed and 
filed. See paragraphs (g) and (h) of this section.
    (d) Recognition of gain in part; insufficient expenditure or 
investment in case of nonexempt proceeds. If the transaction would be 
within the provisions of paragraph (c) of this section if it were not 
for the fact that the amount expended or invested is less than the fair 
market value of the nonexempt property received in exchange, then the 
gain, if any, is recognized, but in an amount not in excess of the 
amount by which the fair market value of such nonexempt property at the 
time of the transfer exceeds the amount so expended and invested.
    (e) Items treated as expenditures for the purpose of paragraphs (c) 
and (d) of this section. For the purposes of paragraphs (c) and (d) of 
this section, the following are treated as expenditures for property 
other than nonexempt property:
    (1) A distribution in cancellation or redemption (except a 
distribution having the effect of a dividend) of the whole or a part of 
the transferor's own stock (not acquired on the transfer);
    (2) A payment in complete or partial retirement or cancellation of 
securities representing indebtedness of the transferor or a complete or 
partial retirement or cancellation of such securities which is a part of 
the consideration for the transfer; and
    (3) If, on the transfer, a liability of the transferor is assumed, 
or property of the transferor is transferred subject to a liability, the 
amount of such liability.
    (f) Recognition of gain in part; inability to reduce basis. If the 
transaction would be within the provisions of paragraph (b) or (c) of 
this section, if it were not for the fact that an amount of gain cannot 
be applied in reduction of basis under section 1082(a)(2), then the 
gain, if any, is recognized, but in an amount not in excess of the 
amount which cannot be so applied in reduction of basis. If the 
transaction would be within the provisions of paragraph (d) of this 
section, if it were not for the fact that an amount of gain cannot be 
applied in reduction of basis under section 1082(a)(2), then the gain, 
if any, is recognized, but in an amount not in excess of the aggregate 
of--
    (1) The amount of gain which would be recognized under paragraph (d) 
of this section if there were no inability to reduce basis under section 
1082(a)(2); and
    (2) The amount of gain which cannot be applied in reduction of basis 
under section 1082(a)(2).
    (g) Consent to regulations under section 1082(a)(2). To be entitled 
to the benefits of the provisions of section 1081(b), a corporation must 
file with its return for the taxable year in which the transfer occurs a 
consent to have the basis of its property adjusted under section 
1082(a)(2) (see Sec. 1.1082-3), in accordance with the provisions of the 
regulations in effect at the time of filing of the return for the 
taxable year in which the transfer occurs. Such consent shall be made on 
Form 982 in accordance with these regulations and instructions on the 
form or issued therewith.
    (h) Requirements with respect to expenditure or investment. If the 
full amount of the expenditure or investment required for the 
application of paragraph (c) of this section has not been made by the 
close of the taxable year in which such transfer occurred, the taxpayer 
shall file with the return for such year an application for the benefit 
of the 24-month period for expenditure and investment, reciting the 
nature and time of the proposed expenditure or investment. When 
requested by the district director, the taxpayer shall execute and file 
(at such time and in such form) such waiver of the statute of 
limitations with respect to the assessment of deficiencies (for the 
taxable year of the transfer and for all succeeding taxable years in any 
of which falls any part of the period beginning with the date of the 
transfer and ending 24 months thereafter) as the

[[Page 192]]

district director may specify, and such bond with such surety as the 
district director may require, in an amount not in excess of double the 
estimated maximum income tax which would be payable if the corporation 
does not make the required expenditure or investment within the required 
24-month period.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6751, 29 FR 
11356, Aug. 6, 1964; T.D. 7517, 42 FR 58935, Nov. 14, 1977]



Sec. 1.1081-5  Distribution solely of stock or securities.

    (a) In general. If, without any surrender of his stock or securities 
as defined in section 1083(f), a shareholder in a corporation which is a 
registered holding company or a majority-owned subsidiary company 
receives stock or securities in such corporation or owned by such 
corporation, no gain to the shareholder will be recognized with respect 
to the stock or securities received by such shareholder which do not 
constitute nonexempt property, if the distribution to such shareholder 
is made by the distributing corporation in obedience to an order of the 
Securities and Exchange Commission directed to such corporation. A 
distribution is not within the provisions of section 1081(c)(1) if it is 
within the provisions of section 1081(d), relating to transfers within a 
system group. A distribution is also not within the provisions of 
section 1081(c)(1) if it involves a surrender by the shareholder of 
stock or securities or a transfer by the shareholder of property in 
exchange for the stock or securities received by the shareholder. For 
further limitations, see section 1081(f).
    (b) Special rule. (1) If there is distributed to a shareholder in a 
corporation rights to acquire common stock in a second corporation, no 
gain to the shareholder from the receipt of the rights shall be 
recognized, but only if all the following requirements are met:
    (i) The rights are received by the shareholder without the surrender 
by the shareholder of any stock in the distributing corporation,
    (ii) Such distribution is in accordance with an arrangement forming 
a ground for an order of the Securities and Exchange Commission issued 
pursuant to section 3 of the Public Utility Holding Company Act of 1935 
(15 U. S. C. 79c) that the distributing corporation is exempt from any 
provision or provisions of such act, and
    (iii) Before January 1, 1958, the distributing corporation disposes 
of all the common stock in the second corporation which it owns.
    (2) The distributing corporation shall, as soon as practicable, 
notify the district director in whose district the corporation's income 
tax return and supporting data was filed (see paragraph (g) of 
Sec. 1.1081-11), as to whether or not the requirement of subparagraph 
(1)(iii) of this paragraph has been met. If such requirement has not 
been met, the periods of limitation (sections 6501 and 6502) with 
respect to any deficiency, including interest and additions to the tax, 
resulting solely from the receipt of such rights to acquire stock, shall 
include one year immediately following the date of such notification; 
and assessment and collection shall be made notwithstanding any 
provisions of law or rule of law which would otherwise prevent such 
assessment and collection.



Sec. 1.1081-6  Transfers within system group.

    (a) The nonrecognition of gain or loss provided for in section 
1081(d)(1) is applicable to an exchange of property for other property 
(including money and other nonexempt property) between corporations 
which are all members of the same system group. The term system group is 
defined in section 1083 (d).
    (b) Section 1081 (d)(1) also provides for nonrecognition of gain to 
a corporation which is a member of a system group if property (including 
money or other nonexempt property) is distributed to such corporation as 
a shareholder in a corporation which is a member of the same system 
group, without the surrender by such shareholder of stock or securities 
in the distributing corporation.
    (c) As stated in Sec. 1.1081-2, nonrecognition of gain or loss will 
not be accorded to a transaction not clearly provided for in part VI 
(section 1081 and following), subchapter O, chapter 1 of the Code, even 
though such transaction occurs simultaneously or in connection with an 
exchange, sale, or distribution

[[Page 193]]

to which nonrecognition is specifically accorded. Therefore, 
nonrecognition will not be accorded to any gain or loss realized from 
the discharge, or the removal of the burden, of the pecuniary 
obligations of a member of a system group, even though such obligations 
are acquired upon a transfer or distribution specifically described in 
section 1081 (d)(1); but the fact that the acquisition of such 
obligations was upon a transfer or distribution specifically described 
in section 1081 (d)(1) will, because of the basis provisions of section 
1082 (d), affect the cost to the member of such discharge or its 
equivalent. Thus, section 1081 (d)(1) does not provide for the 
nonrecognition of any gain or loss realized from the discharge of the 
indebtedness of a member of a system group as the result of the 
acquisition in exchange, sale, or distribution of its own bonds, notes, 
or other evidences of indebtedness which were acquired by another member 
of the same system group for a consideration less or more than the 
issuing price thereof (with proper adjustments for amortization of 
premiums or discounts).
    (d) The provisions of paragraph (c) of this section may be 
illustrated by the following example:

    Example: Suppose that the A Corporation and the B Corporation are 
both members of the same system group; that the A Corporation holds at a 
cost of $900 a bond issued by the B Corporation at par, $1,000; and that 
the A Corporation and the B Corporation enter into an exchange subject 
to the provisions of section 1081 (d)(1) in which the $1,000 bond of the 
B Corporation is transferred from the A Corporation to the B 
Corporation. The $900 basis reflecting the cost to the A Corporation 
which would have been the basis available to the B Corporation if the 
property transferred to it had been something other than its own 
securities (see Sec. 1.1082-6) will, in this type of transaction, 
reflect the cost to the B Corporation of effecting a retirement of its 
own $1,000 bond. The $100 gain of the B Corporation reflected in the 
retirement will therefore be recognized.

    (e) No exchange or distribution may be made without the recognition 
of gain or loss as provided for in section 1081 (d)(1), unless all the 
corporations which are parties to such exchange or distribution are 
acting in obedience to an order of the Securities and Exchange 
Commission. If an exchange or distribution is within the provisions of 
section 1081 (d)(1) and also may be considered to be within some other 
provisions of section 1081, it shall be considered that only the 
provisions of section 1081 (d)(1) apply and that the nonrecognition of 
gain or loss upon such exchange or distribution is by virtue of that 
section.



Sec. 1.1081-7  Sale of stock or securities received upon exchange by members of system group.

    (a) Section 1081(d)(2) provides that to the extent that property 
received upon an exchange by corporations which are members of the same 
system group consists of stock or securities issued by the corporation 
from which such property was received, such stock or securities may, 
under certain specifically described circumstances, be sold to a party 
not a member of the system group, without the recognition of gain or 
loss to the selling corporation. The nonrecognition of gain or loss is 
limited, in the case of stock, to a sale of stock which is preferred as 
to both dividends and assets. The stock or securities must have been 
received upon an exchange with respect to which section 1081(d)(1) 
operated to prevent recognition of gain or loss to any party to the 
exchange. Nonrecognition of gain or loss upon the sale of such stock or 
securities is permitted only if the proceeds derived from the sale are 
applied in retirement or cancellation of stock or securities of the 
selling corporation which were outstanding at the time the exchange was 
made. It is also essential to nonrecognition of gain or loss upon the 
sale that both the sale of the stock or securities and the application 
of the proceeds derived therefrom be made in obedience to an order of 
the Securities and Exchange Commission. If any part of the proceeds 
derived from the sale is not applied in making the required retirement 
or cancellation of stock or securities and if the sale is otherwise 
within the provisions of section 1081 (d)(2), the gain resulting from 
the sale shall be recognized, but in an amount not in excess of the 
proceeds which are not so applied. In any event, if the proceeds derived 
from the sale of the stock or securities exceed the fair market

[[Page 194]]

value of such stock or securities at the time of the exchange through 
which they were acquired by the selling corporation, the gain resulting 
from the sale is to be recognized to the extent of such excess. Section 
1081 (d)(2) does not provide for the nonrecognition of any gain 
resulting from the retirement of bonds, notes, or other evidences of 
indebtedness for a consideration less than the issuing price thereof. 
Also, that section does not provide for the nonrecognition of gain or 
loss upon the sale of any stock or securities received upon a 
distribution or otherwise than upon an exchange.
    (b) The application of paragraph (a) of this section may be 
illustrated by the following example:

    Example: The X Corporation and the Y Corporation, both of which make 
their income tax returns on a calendar year basis, are members of the 
same system group. As part of an exchange to which section 1081 (d)(1) 
is applicable the Y Corporation on June 1, 1954, issued to the X 
Corporation 1,000 shares of class A stock, preferred as to both 
dividends and assets. The fair market value of such stock at the time of 
issuance was $90,000 and its basis to the X Corporation was $75,000. On 
December 1, 1954, in obedience to an appropriate order of the Securities 
and Exchange Commission, the X Corporation sells all of such stock to 
the public for $100,000 and applies $95,000 of this amount to the 
retirement of its own bonds, which were outstanding on June 1, 1954. The 
remaining $5,000 is not used to retire any of the X Corporation's stock 
or securities. Of the total gain of $25,000 realized on the disposition 
of the Y Corporation stock, only $10,000 is recognized (the difference 
between the fair market value of the stock when acquired and the amount 
for which it was sold), since such amount is greater than the portion 
($5,000) of the proceeds not applied to the retirement of the X 
Corporation's stock or securities. If in this example the stock acquired 
by the X Corporation had not been stock of the Y Corporation issued to 
the X Corporation or if it had been stock not preferred as to both 
dividends and assets, the full amount of the gain ($25,000) realized 
upon its disposition would have been recognized, regardless of what was 
done with the proceeds.



Sec. 1.1081-8  Exchanges in which money or other nonexempt property is received.

    (a) Under section 1081(e)(1), if in any exchange (not within any of 
the provisions of section 1081(d)) in which stock or securities in a 
corporation which is a registered holding company or a majority-owned 
subsidiary are exchanged for stock or securities as provided for in 
section 1081 (a), there is received by the taxpayer money or other 
nonexempt property (in addition to property permitted to be received 
without recognition of gain), then--
    (1) The gain, if any, to the taxpayer is to be recognized in an 
amount not in excess of the sum of the money and the fair market value 
of the other nonexempt property, but
    (2) The loss, if any, to the taxpayer from such an exchange is not 
to be recognized to any extent.
    (b) If money or other nonexempt property is received from a 
corporation in an exchange described in paragraph (a) of this section 
and if the distribution of such money or other nonexempt property by or 
on behalf of such corporation has the effect of the distribution of a 
taxable dividend, then, as provided in section 1081 (e)(2), there shall 
be taxed to each distributee (1) as a dividend, such an amount of the 
gain recognized on the exchange as is not in excess of the distributee's 
ratable share of the undistributed earnings and profits of the 
corporation accumulated after February 28, 1913, and (2) the remainder 
of the gain so recognized shall be taxed as a gain from the exchange of 
property.



Sec. 1.1081-9  Requirements with respect to order of Securities and Exchange Commission.

    The term order of the Securities and Exchange Commission is defined 
in section 1083(a). In addition to the requirements specified in that 
definition, section 1081(f) provides that, except in the case of a 
distribution described in section 1081(c)(2), the provisions of section 
1081 shall not apply to an exchange, expenditure, investment, 
distribution, or sale unless each of the following requirements is met:
    (a) The order of the Securities and Exchange Commission must recite 
that the exchange, expenditure, investment, distribution, or sale is 
necessary or appropriate to effectuate the provisions of section 11(b) 
of the Public Utility Holding Company Act of 1935 (15 U. S. C. 79k (b)).

[[Page 195]]

    (b) The order shall specify and itemize the stocks and securities 
and other property (including money) which are ordered to be acquired, 
transferred, received, or sold upon such exchange, acquisition, 
expenditure, distribution, or sale and, in the case of an investment, 
the investment to be made, so as clearly to identify such property.
    (c) The exchange, acquisition, expenditure, investment, 
distribution, or sale shall be made in obedience to such order and shall 
be completed within the time prescribed in such order.

These requirements were not designed merely to simplify the 
administration of the provisions of section 1081, and they are not to be 
considered as pertaining only to administrative matters. Each one of the 
three requirements is essential and must be met if gain or loss is not 
to be recognized upon the transaction.



Sec. 1.1081-10  Nonapplication of other provisions of the Internal Revenue Code of 1954.

    The effect of section 1081(g) is that an exchange, sale, or 
distribution which is within section 1081 shall, with respect to the 
nonrecognition of gain or loss and the determination of basis, be 
governed only by the provisions of part VI (section 1081 and following), 
subchapter O, chapter 1 of the Code, the purpose being to prevent 
overlapping of those provisions and other provisions of subtitle A of 
the Code. In other words, if by virtue of section 1081 any portion of a 
person's gain or loss on any particular exchange, sale, or distribution 
is not to be recognized, then the gain or loss of such person shall be 
nonrecognized only to the extent provided in section 1081, regardless of 
what the result might have been if part VI (section 1081 and following), 
subchapter O, chapter 1 of the Code, had not been enacted; and 
similarly, the basis in the hands of such person of the property 
received by him in such transaction shall be the basis provided by 
section 1082, regardless of what the basis of such property might have 
been under section 1011 if such part VI had not been enacted. On the 
other hand, if section 1081 does not provide for the nonrecognition of 
any portion of a person's gain or loss (whether or not such person is 
another party to the same transaction referred to above), then the gain 
or loss of such person shall be recognized or nonrecognized to the 
extent provided for by other provisions of subtitle A of the Code as if 
such part VI had not been enacted; and similarly, the basis in his hands 
of the property received by him in such transaction shall be the basis 
provided by other provisions of subtitle A of the Code as if such part 
VI had not been enacted.



Sec. 1.1081-11  Records to be kept and information to be filed with returns.

    (a) Exchanges; holders of stock or securities. Every holder of stock 
or securities who receives stock or securities and other property 
(including money) upon an exchange shall, if the exchange is made with a 
corporation acting in obedience to an order of the Securities and 
Exchange Commission, file as a part of his income tax return for the 
taxable year in which the exchange takes place a complete statement of 
all facts pertinent to the nonrecognition of gain or loss upon such 
exchange, including--
    (1) A clear description of the stock or securities transferred in 
the exchange, together with a statement of the cost or other basis of 
such stock or securities.
    (2) The name and address of the corporation from which the stock or 
securities were received in the exchange.
    (3) A statement of the amount of stock or securities and other 
property (including money) received from the exchange. The amount of 
each kind of stock or securities and other property received shall be 
set forth upon the basis of the fair market value thereof at the date of 
the exchange.
    (b) Exchanges; corporations subject to S.E.C. orders. Each 
corporation which is a party to an exchange made in obedience to an 
order of the Securities and Exchange Commission directed to such 
corporation shall file as a part of its income tax return for its 
taxable year in which the exchange takes place a complete statement of 
all facts pertinent to the nonrecognition of gain or loss upon such 
exchange, including--

[[Page 196]]

    (1) A copy of the order of the Securities and Exchange Commission 
directed to such corporation, in obedience to which the exchange was 
made.
    (2) A certified copy of the corporate resolution authorizing the 
exchange.
    (3) A clear description of all property, including all stock or 
securities, transferred in the exchange, together with a complete 
statement of the cost or other basis of each class of property.
    (4) The date of acquisition of any stock or securities transferred 
in the exchange, and, if any of such stock or securities were acquired 
by the corporation in obedience to an order of the Securities and 
Exchange Commission, a copy of such order.
    (5) The name and address of all persons to whom any property was 
transferred in the exchange.
    (6) If any property transferred in the exchange was transferred to 
another corporation, a copy of any order of the Securities and Exchange 
Commission directed to the other corporation, in obedience to which the 
exchange was made by such other corporation.
    (7) If the corporation transfers any nonexempt property, the amount 
of the undistributed earnings and profits of the corporation accumulated 
after February 28, 1913, to the time of the exchange, computed in 
accordance with the last sentence in paragraph (b) of Sec. 1.316-2.
    (8) A statement of the amount of stock or securities and other 
property (including money) received upon the exchange, including a 
statement of all distributions or other dispositions made thereof. The 
amount of each kind of stock or securities and other property received 
shall be stated on the basis of the fair market value thereof at the 
date of the exchange.
    (9) A statement showing as to each class of its stock the number of 
shares and percentage owned by any other corporation, the voting rights 
and voting power, and the preference (if any) as to both dividends and 
assets.
    (10) The term exchange shall, whenever occurring in this paragraph, 
be read as exchange, expenditure, or investment.
    (c) Distributions; shareholders. Each shareholder who receives stock 
or securities or other property (including money) upon a distribution 
made by a corporation in obedience to an order of the Securities and 
Exchange Commission shall file as a part of his income tax return for 
the taxable year in which such distribution is received a complete 
statement of all facts pertinent to the nonrecognition of gain upon such 
distribution, including--
    (1) The name and address of the corporation from which the 
distribution is received.
    (2) A statement of the amount of stock or securities or other 
property received upon the distribution, including (in case the 
shareholder is a corporation) a statement of all distributions or other 
disposition made of such stock or securities or other property by the 
shareholder. The amount of each class of stock or securities and each 
kind of property shall be stated on the basis of the fair market value 
thereof at the date of the distribution.
    (3) If the shareholder is a corporation, a statement showing as to 
each class of its stock the number of shares and percentage owned by a 
registered holding company or a majority-owned subsidiary company of a 
registered holding company, the voting rights and voting power, and the 
preference (if any) as to both dividends and assets.
    (d) Distributions; distributing corporations subject to S.E.C. 
orders. Every corporation making a distribution in obedience to an order 
of the Securities and Exchange Commission shall file as a part of its 
income tax return for its taxable year in which the distribution is made 
a complete statement of all facts pertinent to the nonrecognition of 
gain to the distributee upon such distribution including--
    (1) A copy of the order of the Securities and Exchange Commission, 
in obedience to which the distribution was made.
    (2) A certified copy of the corporate resolution authorizing the 
distribution.
    (3) A statement of the amount of stock or securities or other 
property (including money) distributed to each shareholder. The amount 
of each kind of stock or securities or other property shall be stated on 
the basis of the fair market value thereof at the date of the 
distribution.

[[Page 197]]

    (4) The date of acquisition of the stock or securities distributed, 
and, if any of such stock or securities were acquired by the 
distributing corporation in obedience to an order of the Securities and 
Exchange Commission, a copy of such order.
    (5) The amount of the undistributed earnings and profits of the 
corporation accumulated after February 28, 1913, to the time of the 
distribution, computed in accordance with the last sentence in paragraph 
(b) of Sec. 1.316-2.
    (6) A statement showing as to each class of its stock the number of 
shares and percentage owned by any other corporation, the voting rights 
and voting power, and the preference (if any) as to both dividends and 
assets.
    (e) Sales by members of system groups. Each corporation which is a 
member of a system group and which in obedience to an order of the 
Securities and Exchange Commission sells stock or securities received 
upon an exchange (made in obedience to an order of the Securities and 
Exchange Commission) and applies the proceeds derived therefrom in 
retirement or cancellation of its own stock or securities shall file as 
a part of its income tax return for the taxable year in which the sale 
is made a complete statement of all facts pertaining to the 
nonrecognition of gain or loss upon such sale, including--
    (1) A copy of the order of the Securities and Exchange Commission in 
obedience to which the sale was made.
    (2) A copy of the order of the Securities and Exchange Commission in 
obedience to which the proceeds derived from the sale were applied in 
whole or in part in the retirement or cancellation of its stock or 
securities.
    (3) A certified copy of the corporate resolutions authorizing the 
sale of the stock or securities and the application of the proceeds 
derived therefrom.
    (4) A clear description of the stock or securities sold, including 
the name and address of the corporation by which they were issued.
    (5) The date of acquisition of the stock or securities sold, 
together with a statement of the fair market value of such stock or 
securities at the date of acquisition, and a copy of all orders of the 
Securities and Exchange Commission in obedience to which such stock or 
securities were acquired.
    (6) The amount of the proceeds derived from such sale.
    (7) The portion of the proceeds of such sale which was applied in 
retirement or cancellation of its stock or securities, together with a 
statement showing how long such stock or securities were outstanding 
prior to retirement or cancellation.
    (8) The issuing price of its stock or securities which were retired 
or canceled.
    (f) Section 1081 (c)(2) distributions; shareholders. Each 
shareholder who receives a distribution described in section 1081 (c)(2) 
(concerning rights to acquire common stock) shall file as a part of his 
income tax return for the taxable year in which such distribution is 
received a complete statement of all the facts pertinent to the 
nonrecognition of gain upon such distribution, including--
    (1) The name and address of the corporation from which the 
distribution is received.
    (2) A statement of the amount of the rights received upon the 
distribution, stated on the basis of their fair market value at the date 
of the distribution.
    (g) Section 1081 (c)(2) distributions; distributing corporations. 
Every corporation making a distribution described in section 1081(c)(2) 
(concerning rights to acquire common stock) shall file as a part of its 
income tax return for its taxable year in which the distribution is made 
a complete statement of all facts pertinent to the nonrecognition of 
gain to the distributees upon such distribution including--
    (1) A copy of the arrangement forming the basis for the issuance of 
the order by the Securities and Exchange Commission.
    (2) A copy of the order issued by the Securities and Exchange 
Commission pursuant to section 3 of the Public Utility Holding Company 
Act of 1935 (15 U.S.C. 79c).
    (3) A certified copy of the corporate resolution authorizing the 
arrangement and the distribution.
    (4) A statement of the amount of the rights distributed to each 
shareholder, stated on the basis of their fair market value at the date 
of the distribution.

[[Page 198]]

    (5) The date of acquisition of the stock with respect to which such 
rights are distributed, and if any were acquired by the distributing 
corporation in obedience to an order of the Securities and Exchange 
Commission, a copy of such order.
    (6) The amount of the undistributed earnings and profits of the 
distributing corporation accumulated after February 28, 1913, to the 
time of the distribution computed in accordance with the last sentence 
in paragraph (b) of Sec. 1.316-2.
    (h) General requirements. Permanent records in substantial form 
shall be kept by every taxpayer who participates in an exchange or 
distribution to which sections 1081 to 1083, inclusive, are applicable, 
showing the cost or other basis of the property transferred and the 
amount of stock or securities and other property (including money) 
received, in order to facilitate the determination of gain or loss from 
a subsequent disposition of such stock or securities and other property 
received on the exchange or distribution.



Sec. 1.1082-1  Basis for determining gain or loss.

    (a) For determining the basis of property acquired in a taxable year 
beginning before January 1, 1942, in any manner described in section 372 
of the Internal Revenue Code of 1939 prior to its amendment by the 
Revenue Act of 1942 (56 Stat. 798), see such section (before its 
amendment by such Act).
    (b) If the property was acquired in a taxable year beginning after 
December 31, 1941, in any manner described in section 1082 (other than 
subsection (a)(2)), or section 372 (other than subsection (a)(2)) of the 
Internal Revenue Code of 1939 after its amendments, the basis shall be 
that prescribed in section 1082 with respect to such property. However, 
in the case of property acquired in a transaction described in section 
1081(c)(2), this paragraph is applicable only if the property was 
acquired in a distribution made in a taxable year subject to the 
Internal Revenue Code of 1954.
    (c) Section 1082 makes provisions with respect to the basis of 
property acquired in a transfer in connection with which the recognition 
of gain or loss is prohibited by the provisions of section 1081 with 
respect to the whole or any part of the property received. In general, 
and except as provided in Sec. 1.1082-3, it is intended that the basis 
for determining gain or loss pertaining to the property prior to its 
transfer, as well as the basis for determining the amount of 
depreciation or depletion deductible and the amount of earnings or 
profits available for distribution, shall continue notwithstanding the 
nontaxable conversion of the asset in form or its change in ownership. 
The continuance of the basis may be reflected in a shift thereof from 
one asset to another in the hands of the same owner, or in its transfer 
with the property from one owner into the hands of another. See also 
Sec. 1.1081-2.



Sec. 1.1082-2  Basis of property acquired upon exchanges under section 1081 (a) or (e).

    (a) In the case of an exchange of stock or securities for stock or 
securities as described in section 1081 (a), if no part of the gain or 
loss upon such exchange was recognized under section 1081, the basis of 
the property acquired is the same as the basis of the property 
transferred by the taxpayer with proper adjustments to the date of the 
exchange.
    (b) If, in an exchange of stock or securities as described in 
section 1081 (a), gain to the taxpayer was recognized under section 1081 
(e) on account of the receipt of money, the basis of the property 
acquired is the basis of the property transferred (adjusted to the date 
of the exchange), decreased by the amount of money received and 
increased by the amount of gain recognized upon the exchange. If, upon 
such exchange, there were received by the taxpayer money and other 
nonexempt property (not permitted to be received without the recognition 
of gain), and gain from the transaction was recognized under section 
1081 (e), the basis (adjusted to the date of the exchange) of the 
property transferred by the taxpayer, decreased by the amount of money 
received and increased by the amount of gain recognized, must be 
apportioned to and is the basis of the properties (other than money) 
received on the exchange. For the purpose of the

[[Page 199]]

allocation of such basis to the properties received, there must be 
assigned to the nonexempt property (other than money) an amount 
equivalent to its fair market value at the date of the exchange.
    (c) Section 1081(e) provides that no loss may be recognized on an 
exchange of stock or securities for stock or securities as described in 
section 1081(a), although the taxpayer receives money or other nonexempt 
property from the transaction. However, the basis of the property (other 
than money) received by the taxpayer is the basis (adjusted to the date 
of the exchange) of the property transferred, decreased by the amount of 
money received. This basis must be apportioned to the properties 
received, and for this purpose there must be allocated to the nonexempt 
property (other than money) an amount of such basis equivalent to the 
fair market value of such nonexempt property at the date of the 
exchange.
    (d) Section 1082 (a) does not apply in ascertaining the basis of 
property acquired by a corporation by the issuance of its stock or 
securities as the consideration in whole or in part for the transfer of 
the property to it. For the rule in such cases, see section 1082 (b).
    (e) For purposes of this section, any reference to section 1081 
shall be deemed to include a reference to corresponding provisions of 
prior internal revenue laws.



Sec. 1.1082-3  Reduction of basis of property by reason of gain not recognized under section 1081(b).

    (a) Introductory. In addition to the adjustments provided in section 
1016 and other applicable provisions of chapter 1 of the Code, and the 
regulations relating thereto, which are required to be made with respect 
to the cost or other basis of property, section 1082(a)(2) provides that 
a further adjustment shall be made in any case in which there shall have 
been a nonrecognition of gain under section 1081(b). Such further 
adjustment shall be made with respect to the basis of the property in 
the hands of the transferor immediately after the transfer and of the 
property acquired within 24 months after such transfer by an expenditure 
or investment to which section 1081(b) relates, and on account of which 
expenditure or investment gain is not recognized. If the property is in 
the hands of the transferor immediately after the transfer, the time of 
reduction is the day of the transfer; in all other cases the time of 
reduction is the date of acquisition. The effect of applying an amount 
in reduction of basis of property under section 1081 (b) is to reduce by 
such amount the basis for determining gain upon sale or other 
disposition, the basis for determining loss upon sale or other 
disposition, the basis for depreciation and for depletion, and any other 
amount which the Code prescribes shall be the same as any of such bases. 
For the purposes of the application of an amount in reduction of basis 
under section 1081(b), property is not considered as having a basis 
capable of reduction if--
    (1) It is money, or
    (2) If its adjusted basis for determining gain at the time the 
reduction is to be made is zero, or becomes zero at any time in the 
application of section 1081 (b).
    (b) General rule. (1) Section 1082 (a)(2) sets forth seven 
categories of property, the basis of which for determining gain or loss 
shall be reduced in the order stated.
    (2) If any of the property in the first category has a basis capable 
of reduction, the reduction must first be made before applying an amount 
in reduction of the basis of any property in the second or in a 
succeeding category, to each of which in turn a similar rule is applied.
    (3) In the application of the rule to each category, the amount of 
the gain not recognized shall be applied to reduce the cost or other 
basis of all the property in the category as follows: The cost or other 
basis (at the time immediately after the transfer or, if the property is 
not then held but is thereafter acquired, at the time of such 
acquisition) of each unit of property in the first category shall be 
decreased (but the amount of the decrease shall not be more than the 
amount of the adjusted basis at such time for determining gain, 
determined without regard to this section) in an amount equal to such 
proportion of the unrecognized gain as the adjusted basis (for

[[Page 200]]

determining gain, determined without regard to this section) at such 
time of each unit of property of the taxpayer in that category bears to 
the aggregate of the adjusted basis (for determining gain, computed 
without regard to this section) at such time of all the property of the 
taxpayer in that category. When such adjusted basis of the property in 
the first category has been thus reduced to zero, a similar rule shall 
be applied, with respect to the portion of such gain which is unabsorbed 
in such reduction of the basis of the property in such category, in 
reducing the basis of the property in the second category. A similar 
rule with respect to the remaining unabsorbed gain shall be applied in 
reducing the basis of the property in the next succeeding category.
    (c) Special cases. (1) With the consent of the Commissioner, the 
taxpayer may, however, have the basis of the various units of property 
within a particular category specified in section 1082(a)(2) adjusted in 
a manner different from the general rule set forth in paragraph (b) of 
this section. Variations from such general rule may, for example, 
involve adjusting the basis of only certain units of the taxpayer's 
property within a given category. A request for variations from the 
general rule should be filed by the taxpayer with its income tax return 
for the taxable year in which the transfer of property has occurred.
    (2) Agreement between the taxpayer and the Commissioner as to any 
variations from such general rule shall be effective only if 
incorporated in a closing agreement entered into under the provisions of 
section 7121. If no such agreement is entered into by the taxpayer and 
the Commissioner, then the consent filed on Form 982 shall (except as 
otherwise provided in this subparagraph) be deemed to be a consent to 
the application of such general rule, and such general rule shall apply 
in the determination of the basis of the taxpayer's property. If, 
however, the taxpayer specifically states on such form that it does not 
consent to the application of the general rule, then, in the absence of 
a closing agreement, the document filed shall not be deemed a consent 
within the meaning of section 1081(b)(4).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7517, 42 FR 
58935, Nov. 14, 1977]



Sec. 1.1082-4  Basis of property acquired by corporation under section 1081(a), 1081(b), or 1081(e) as contribution of capital or surplus, or in consideration 
          for its own stock or securities.

    If, in connection with an exchange of stock or securities for stock 
or securities as described in section 1081(a), or an exchange of 
property for property as described in section 1081(b), or an exchange as 
described in section 1081(e), property is acquired by a corporation by 
the issuance of its stock or securities, the basis of such property 
shall be determined under section 1082(b). If the corporation issued its 
stock or securities as part or sole consideration for the property 
acquired, the basis of the property in the hands of the acquiring 
corporation is the basis (adjusted to the date of the exchange) which 
the property would have had in the hands of the transferor if the 
transfer had not been made, increased in the amount of gain or decreased 
in the amount of loss recognized under section 1081 to the transferor 
upon the transfer. If any property is acquired by a corporation from a 
shareholder as paid-in surplus, or from any person as a contribution to 
capital, the basis of the property to the corporation is the basis 
(adjusted to the date of acquisition) of the property in the hands of 
the transferor.



Sec. 1.1082-5  Basis of property acquired by shareholder upon tax-free distribution under section 1081(c) (1) or (2).

    (a) Stock or securities. If there was distributed to a shareholder 
in a corporation which is a registered holding company or a majority-
owned subsidiary company, stock or securities (other than stock or 
securities which are nonexempt property), and if by virtue of section 
1081 (c)(1) no gain was recognized to the shareholder upon such 
distribution, then the basis of the stock in respect of which the 
distribution was made must be apportioned between such stock and the 
stock or securities so distributed to the shareholder. The

[[Page 201]]

basis of the old shares and the stock or securities received upon the 
distribution shall be determined in accordance with the following rules:
    (1) If the stock or securities received upon the distribution 
consist solely of stock in the distributing corporation and the stock 
received is all of substantially the same character and preference as 
the stock in respect of which the distribution is made, the basis of 
each share will be the quotient of the cost or other basis of the old 
shares of stock divided by the total number of the old and the new 
shares.
    (2) If the stock or securities received upon the distribution are in 
whole or in part stock in a corporation other than the distributing 
corporation, or are in whole or in part stock of a character or 
preference materially different from the stock in respect of which the 
distribution is made, or if the distribution consists in whole or in 
part of securities other than stock, the cost or other basis of the 
stock in respect of which the distribution is made shall be apportioned 
between such stock and the stock or securities distributed in 
proportion, as nearly as may be, to the respective values of each class 
of stock or security, old and new, at the time of such distribution, and 
the basis of each share of stock or unit of security will be the 
quotient of the cost or other basis of the class of stock or security to 
which such share or unit belongs, divided by the number of shares or 
units in the class. Within the meaning of this subparagraph, stocks or 
securities in one corporation are different in class from stocks or 
securities in another corporation, and, in general, any material 
difference in character or preference or terms sufficient to distinguish 
one stock or security from another stock or security, so that different 
values may properly be assigned thereto, will constitute a difference in 
class.
    (b) Stock rights. If there was distributed to a shareholder in a 
corporation rights to acquire common stock in a second corporation, and 
if by virtue of section 1081 (c)(2) no gain was recognized to the 
shareholder upon such distribution, then the basis of the stock in 
respect of which the distribution was made must be apportioned between 
such stock and the stock rights so distributed to the shareholder. The 
basis of such stock and the stock rights received upon the distribution 
shall be determined in accordance with the following:
    (1) The cost or other basis of the stock in respect of which the 
distribution is made shall be apportioned between such stock and the 
stock rights distributed, in proportion to the respective values thereof 
at the time the rights are issued.
    (2) The basis for determining gain or loss from the sale of a right, 
or from the sale of a share of stock in respect of which the 
distribution is made, will be the quotient of the cost or other basis, 
properly adjusted, assigned to the rights or the stock, divided, as the 
case may be, by the number of rights acquired or by the number of shares 
of such stock held.
    (c) Cross reference. As to the basis of stock or securities 
distributed by one member of a system group to another member of the 
same system group, see Sec. 1.1082-6.



Sec. 1.1082-6  Basis of property acquired under section 1081(d) in transactions between corporations of the same system group.

    (a) If property was acquired by a corporation which is a member of a 
system group, from a corporation which is a member of the same system 
group, upon a transfer or distribution described in section 1081 (d)(1), 
then as a general rule the basis of such property in the hands of the 
acquiring corporation is the basis which such property would have had in 
the hands of the transferor if the transfer or distribution had not been 
made. Except as otherwise indicated in this section, this rule will 
apply equally to cases in which the consideration for the property 
acquired consists of stock or securities, money, and other property, or 
any of them, but it is contemplated that an ultimate true reflection of 
income will be obtained in all cases, notwithstanding any peculiarities 
in form which the various transactions may assume. See the example in 
Sec. 1.1081-6.
    (b) An exception to the general rule is provided for in case the 
property acquired consists of stock or securities

[[Page 202]]

issued by the corporation from which such stock or securities were 
received. If such stock or securities were the sole consideration for 
the property transferred to the corporation issuing such stock or 
securities, then the basis of the stock or securities shall be (1) the 
same as the basis (adjusted to the time of the transfer) of the property 
transferred for such stock or securities, or (2) the fair market value 
of such stock or securities at the time of their receipt, whichever is 
the lower. If such stock or securities constituted only part 
consideration for the property transferred to the corporation issuing 
such stock or securities, then the basis shall be an amount which bears 
the same ratio to the basis of the property transferred as the fair 
market value of such stock or securities on their receipt bears to the 
total fair market value of the entire consideration received, except 
that the fair market value of such stock or securities at the time of 
their receipt shall be the basis therefor, if such value is lower than 
such amount.
    (c) The application of paragraph (b) of this section may be 
illustrated by the following examples:

    Example 1. Suppose the A Corporation has property with an adjusted 
basis of $600,000 and, in an exchange in which section 1081 (d)(1) is 
applicable, transfers such property to the B Corporation in exchange for 
a total consideration of $1,000,000, consisting of (1) cash in the 
amount of $100,000, (2) tangible property having a fair market value of 
$400,000 and an adjusted basis in the hands of the B Corporation of 
$300,000, and (3) stock or securities issued by the B Corporation with a 
par value and a fair market value as of the date of their receipt in the 
amount of $500,000. The basis to the B Corporation of the property 
received by it is $600,000, which is the adjusted basis of such property 
in the hands of the A Corporation. The basis to the A Corporation of the 
assets (other than cash) received by it is as follows: Tangible 
property, $300,000, the adjusted basis of such property to the B 
Corporation, the former owner; stock or securities issued by the B 
Corporation, $300,000, an amount equal to 550,000/ 1,000,000ths of 
$600,000.
    Example 2. Suppose that in example (1) the property of the A 
Corporation transferred to the B Corporation had an adjusted basis of 
$1,100,000 instead of $600,000, and that all other factors in the 
example remain the same. In such case, the basis to the A Corporation of 
the stock or securities in the B Corporation is $500,000, which was the 
fair market value of such stock or securities at the time of their 
receipt by the A Corporation, because this amount is less than the 
amount established as 500,000/1,000,000ths of $1,100,000 or $550,000.



Sec. 1.1083-1  Definitions.

    (a) Order of the Securities and Exchange Commission. (1) An order of 
the Securities and Exchange Commission as defined in section 1083(a) 
must be issued after May 28, 1938 (the date of the enactment of the 
Revenue Act of 1938 (52 Stat. 447)), and must be issued under the 
authority of section 11(b) or 11(e) of the Public Utility Holding 
Company Act of 1935 (15 U.S.C. 79k (b), (e)), to effectuate the 
provisions of section 11(b) of such Act. In all cases the order must 
become or have become final in accordance with law; i.e., it must be 
valid, outstanding, and not subject to further appeal. See further 
sections 1083(a) and 1081(f).
    (2) Section 11 (b) of the Public Utility Holding Company Act of 1935 
provides:

    Sec. 11. Simplification of holding company systems.* * *
    (b) It shall be the duty of the Commission, as soon as practicable 
after January 1, 1938:
    (1) To require by order, after notice and opportunity for hearing, 
that each registered holding company, and each subsidiary company 
thereof, shall take such action as the Commission shall find necessary 
to limit the operations of the holding-company system of which such 
company is a part to a single integrated public-utility system, and to 
such other businesses as are reasonably incidental, or economically 
necessary or appropriate to the operations of such integrated public-
utility system: Provided, however, That the Commission shall permit a 
registered holding company to continue to control one or more additional 
integrated public-utility systems, if, after notice and opportunity for 
hearing, it finds that--
    (A) Each of such additional systems cannot be operated as an 
independent system without the loss of substantial economies which can 
be secured by the retention of control by such holding company of such 
system;
    (B) All of such additional systems are located in one State, or in 
adjoining States, or in a contiguous foreign country; and
    (C) The continued combination of such systems under the control of 
such holding company is not so large (considering the state of the art 
and the area or region affected) as to impair the advantages of 
localized management, efficient operation, or the effectiveness of 
regulation.


[[Page 203]]


The Commission may permit as reasonably incidental, or economically 
necessary or appropriate to the operations of one or more integrated 
public-utility systems the retention of an interest in any business 
(other than the business of a public-utility company as such) which the 
Commission shall find necessary or appropriate in the public interest or 
for the protection of investors or consumers and not detrimental to the 
proper functioning of such system or systems.
    (2) To require by order, after notice and opportunity for hearing, 
that each registered holding company, and each subsidiary company 
thereof, shall take such steps as the Commission shall find necessary to 
ensure that the corporate structure or continued existence of any 
company in the holding-company system does not unduly or unnecessarily 
complicate the structure, or unfairly or inequitably distribute voting 
power among security holders, of such holding-company system. In 
carrying out the provisions of this paragraph the Commission shall 
require each registered holding company (and any company in the same 
holding-company system with such holding company) to take such action as 
the Commission shall find necessary in order that such holding company 
shall cease to be a holding company with respect to each of its 
subsidiary companies which itself has a subsidiary company which is a 
holding company. Except for the purpose of fairly and equitably 
distributing voting power among the security holders of such company, 
nothing in this paragraph shall authorize the Commission to require any 
change in the corporate structure or existence of any company which is 
not a holding company, or of any company whose principal business is 
that of a public-utility company. The Commission may by order revoke or 
modify any order previously made under this subsection, if, after notice 
and opportunity for hearing, it finds that the conditions upon which the 
order was predicated do not exist. Any order made under this subsection 
shall be subject to judicial review as provided in section 24.

    (3) Section 11(e) of the Public Utility Holding Company Act of 1935 
provides:

    Sec. 11. Simplification of holding company systems. * * *
    (e) In accordance with such rules and regulations or order as the 
Commission may deem necessary or appropriate in the public interest or 
for the protection of investors or consumers, any registered holding 
company or any subsidiary company of a registered holding company may, 
at any time after January 1, 1936, submit a plan to the Commission for 
the divestment of control, securities, or other assets, or for other 
action by such company or any subsidiary company thereof for the purpose 
of enabling such company or any subsidiary company thereof to comply 
with the provisions of subsection (b). If, after notice and opportunity 
for hearing, the Commission shall find such plan, as submitted or as 
modified, necessary to effectuate the provisions of subsection (b) and 
fair and equitable to the persons affected by such plan, the Commission 
shall make an order approving such plan; and the Commission, at the 
request of the company, may apply to a court, in accordance with the 
provisions of subsection (f) of section 18, to enforce and carry out the 
terms and provisions of such plan. If, upon any such application, the 
court, after notice and opportunity for hearing, shall approve such plan 
as fair and equitable and as appropriate to effectuate the provisions of 
section 11, the court as a court of equity may, to such extent as it 
deems necessary for the purpose of carrying out the terms and provisions 
of such plan, take exclusive jurisdiction and possession of the company 
or companies and the assets thereof, wherever located; and the court 
shall have jurisdiction to appoint a trustee, and the court may 
constitute and appoint the Commission as sole trustee, to hold or 
administer, under the direction of the court and in accordance with the 
plan theretofore approved by the court and the Commission, the assets so 
possessed.

    (b) Registered holding company, holding-company system, and 
associate company. (1) Under section 5 of the Public Utility Holding 
Company Act of 1935 (15 U.S.C. 79e), any holding company may register by 
filing with the Securities and Exchange Commission a notification of 
registration, in such form as the Commission may by rules and 
regulations prescribe as necessary or appropriate in the public interest 
or for the protection of investors or consumers. A holding company shall 
be deemed to be registered upon receipt by the Securities and Exchange 
Commission of such notification of registration. As used in this part, 
the term registered holding company means a holding company whose 
notification of registration has been so received and whose registration 
is still in effect under section 5 of the Public Utility Holding Company 
Act of 1935. Under section 2 (a)(7) of the Public Utility Holding 
Company Act of 1935 (15 U.S.C. 79b (a)(7)), a corporation is a holding 
company (unless it is declared not to be such by the Securities and 
Exchange Commission), if such corporation directly or indirectly owns, 
controls, or holds with power to vote 10

[[Page 204]]

percent or more of the outstanding voting securities of a public-utility 
company (i.e., an electric utility company or a gas utility company as 
defined by such act) or of any other holding company. A corporation is 
also a holding company if the Securities and Exchange Commission 
determines, after notice and opportunity for hearing, that such 
corporation directly or indirectly exercises (either alone or pursuant 
to an arrangement or understanding with one or more other persons) such 
a controlling influence over the management or policies of any public-
utility company (i.e., an electric utility company or a gas utility 
company as defined by such act) or holding company as to make it 
necessary or appropriate in the public interest or for the protection of 
investors or consumers that such corporation be subject to the 
obligations, duties, and liabilities imposed upon holding companies by 
the Public Utility Holding Company Act of 1935 (15 U.S.C. ch. 2C). An 
electric utility company is defined by section 2 (a)(3) of the Public 
Utility Holding Company Act of 1935 (15 U.S.C. 79b (a)(3)) to mean a 
company which owns or operates facilities used for the generation, 
transmission, or distribution of electrical energy for sale, other than 
sale to tenants or employees of the company operating such facilities 
for their own use and not for resale; and a gas utility company is 
defined by section 2 (a)(4) of such act (15 U.S.C. 79b (a)(4)), to mean 
a company which owns or operates facilities used for the distribution at 
retail (other than distribution only in enclosed portable containers, or 
distribution to tenants or employees of the company operating such 
facilities for their own use and not for resale) of natural or 
manufactured gas for heat, light, or power. However, under certain 
conditions the Securities and Exchange Commission may declare a company 
not to be an electric utility company or a gas utility company, as the 
case may be, in which event the company shall not be considered an 
electric utility company or a gas utility company.
    (2) The term holding company system has the meaning assigned to it 
by section 2 (a)(9) of the Public Utility Holding Company Act of 1935 
(15 U.S.C. 79b (a)(9)), and hence means any holding company, together 
with all its subsidiary companies (i.e., subsidiary companies within the 
meaning of section 2(a)(8) of such act (15 U.S.C. 79b (a)(8)), which in 
general include all companies 10 percent of whose outstanding voting 
securities is owned directly or indirectly by such holding company) and 
all mutual service companies of which such holding company or any 
subsidiary company thereof is a member company. The term mutual service 
company means a company approved as a mutual service company under 
section 13 of the Public Utility Holding Company Act of 1935 (15 U.S.C. 
79m). The term member company is defined by action 2 (a)(14) of such act 
(15 U.S.C. 79b (a)(14)), to mean a company which is a member of an 
association or group of companies mutually served by a mutual service 
company.
    (3) The term associate company has the meaning assigned to it by 
section 2 (a)(10) of the Public Utility Holding Company Act of 1935 (15 
U.S.C. 79b (a)(10)), and hence an associate company of a company is any 
company in the same holding-company system with such company.
    (c) Majority-owned subsidiary company. The term majority-owned 
subsidiary company is defined in section 1083 (c). Direct ownership by a 
registered holding company of more than 50 percent of the specified 
stock of another corporation is not necessary to constitute such 
corporation a majority-owned subsidiary company. To illustrate, if the H 
Corporation, a registered holding company, owns 51 percent of the common 
stock of the A Corporation and 31 percent of the common stock of the B 
Corporation, and the A Corporation owns 20 percent of the common stock 
of the B Corporation (the common stock in each case being the only stock 
entitled to vote), both the A Corporation and the B Corporation are 
majority-owned subsidiary companies.
    (d) System group. The term system group is defined in section 1083 
(d) to mean one or more chains of corporations connected through stock 
ownership with a common parent corporation, if at least 90 percent of 
each class of stock (other than (1) stock which is

[[Page 205]]

preferred as to both dividends and assets, and (2) stock which is 
limited and preferred as to dividends but which is not preferred as to 
assets but only if the total value of such stock is less than 1 percent 
of the aggregate value of all classes of stock which are not preferred 
as to both dividends and assets) of each of the corporations (except the 
common parent corporation) is owned directly by one or more of the other 
corporations, and if the common parent corporation owns directly at 
least 90 percent of each class of stock (other than stock preferred as 
to both dividends and assets) of at least one of the other corporations; 
but no corporation is a member of a system group unless it is either a 
registered holding company or a majority-owned subsidiary company. While 
the type of stock which must, for the purpose of this definition, be at 
least 90 percent owned may be different from the voting stock which must 
be more than 50 percent owned for the purpose of the definition of a 
majority-owned subsidiary company under section 1083(c), as a general 
rule both types of ownership tests must be met under section 1083(d), 
since a corporation, in order to be a member of a system group, must 
also be a registered holding company or a majority-owned subsidiary 
company.
    (e) Nonexempt property. The term nonexempt property is defined by 
section 1083(e) to include--
    (1) The amount of any consideration in the form of a cancellation or 
assumption of debts or other liabilities of the transferor (including a 
continuance of encumbrances subject to which the property was 
transferred). To illustrate, if in obedience to an order of the 
Securities and Exchange Commission the X Corporation, a registered 
holding company, transfers property to the Y Corporation in exchange for 
property (not nonexempt property) with a fair market value of $500,000, 
the X Corporation receives $100,000 of nonexempt property, if for 
example--
    (i) The Y Corporation cancels $100,000 of indebtedness owed to it by 
the X Corporation;
    (ii) The Y Corporation assumes an indebtedness of $100,000 owed by 
the X Corporation to another company, the A Corporation; or
    (iii) The Y Corporation takes over the property conveyed to it by 
the X Corporation subject to a mortgage of $100,000.
    (2) Short-term obligations (including notes, drafts, bills of 
exchange, and bankers' acceptances) having a maturity at the time of 
issuance of not exceeding 24 months, exclusive of days of grace.
    (3) Securities issued or guaranteed as to principal or interest by a 
government or subdivision thereof (including those issued by a 
corporation which is an instrumentality of a government or subdivision 
thereof).
    (4) Stock or securities which were acquired from a registered 
holding company which acquired such stock or securities after February 
28, 1938, or an associate company of a registered holding company which 
acquired such stock or securities after February 28, 1938, unless such 
stock or securities were acquired in obedience to an order of the 
Securities and Exchange Commission (as defined in section 1083 (a)) or 
were acquired with the authorization or approval of the Securities and 
Exchange Commission under any section of the Public Utility Holding 
Company Act of 1935, and are not nonexempt property within the meaning 
of section 1083(e) (1), (2), or (3).
    (5) Money, and the right to receive money not evidenced by a 
security other than an obligation described as nonexempt property in 
section 1083 (e) (2) or (3). The term the right to receive money 
includes, among other items, accounts receivable, claims for damages, 
and rights to refunds of taxes.
    (f) Stock or securities. The term stock or securities is defined in 
section 1083(f) for the purposes of part VI (section 1081 and 
following), subchapter O, chapter 1 of the Code. As therein defined, the 
term includes voting trust certificates and stock rights or warrants.

                    Wash Sales of Stock or Securities



Sec. 1.1091-1  Losses from wash sales of stock or securities.

    (a) A taxpayer cannot deduct any loss claimed to have been sustained 
from the sale or other disposition of

[[Page 206]]

stock or securities if, within a period beginning 30 days before the 
date of such sale or disposition and ending 30 days after such date 
(referred to in this section as the 61-day period), he has acquired (by 
purchase or by an exchange upon which the entire amount of gain or loss 
was recognized by law), or has entered into a contract or option so to 
acquire, substantially identical stock or securities. However, this 
prohibition does not apply (1) in the case of a taxpayer, not a 
corporation, if the sale or other disposition of stock or securities is 
made in connection with the taxpayer's trade or business, or (2) in the 
case of a corporation, a dealer in stock or securities, if the sale or 
other disposition of stock or securities is made in the ordinary course 
of its business as such dealer.
    (b) Where more than one loss is claimed to have been sustained 
within the taxable year from the sale or other disposition of stock or 
securities, the provisions of this section shall be applied to the 
losses in the order in which the stock or securities the disposition of 
which resulted in the respective losses were disposed of (beginning with 
the earliest disposition). If the order of disposition of stock or 
securities disposed of at a loss on the same day cannot be determined, 
the stock or securities will be considered to have been disposed of in 
the order in which they were originally acquired (beginning with the 
earliest acquisition).
    (c) Where the amount of stock or securities acquired within the 61-
day period is less than the amount of stock or securities sold or 
otherwise disposed of, then the particular shares of stock or securities 
the loss from the sale or other disposition of which is not deductible 
shall be those with which the stock or securities acquired are matched 
in accordance with the following rule: The stock or securities acquired 
will be matched in accordance with the order of their acquisition 
(beginning with the earliest acquisition) with an equal number of the 
shares of stock or securities sold or otherwise disposed of.
    (d) Where the amount of stock or securities acquired within the 61-
day period is not less than the amount of stock or securities sold or 
otherwise disposed of, then the particular shares of stock or securities 
the acquisition of which resulted in the nondeductibility of the loss 
shall be those with which the stock or securities disposed of are 
matched in accordance with the following rule: The stock or securities 
sold or otherwise disposed of will be matched with an equal number of 
the shares of stock or securities acquired in accordance with the order 
of acquisition (beginning with the earliest acquisition) of the stock or 
securities acquired.
    (e) The acquisition of any share of stock or any security which 
results in the nondeductibility of a loss under the provisions of this 
section shall be disregarded in determining the deductibility of any 
other loss.
    (f) The word acquired as used in this section means acquired by 
purchase or by an exchange upon which the entire amount of gain or loss 
was recognized by law, and comprehends cases where the taxpayer has 
entered into a contract or option within the 61-day period to acquire by 
purchase or by such an exchange.
    (g) For purposes of determining under this section the 61-day period 
applicable to a short sale of stock or securities, the principles of 
paragraph (a) of Sec. 1.1233-1 for determining the consummation of a 
short sale shall generally apply except that the date of entering into 
the short sale shall be deemed to be the date of sale if, on the date of 
entering into the short sale, the taxpayer owns (or on or before such 
date has entered into a contract or option to acquire) stock or 
securities identical to those sold short and subsequently delivers such 
stock or securities to close the short sale.
    (h) The following examples illustrate the application of this 
section:

    Example 1. A, whose taxable year is the calendar year, on December 
1, 1954, purchased 100 shares of common stock in the M Company for 
$10,000 and on December 15, 1954, purchased 100 additional shares for 
$9,000. On January 3, 1955, he sold the 100 shares purchased on December 
1, 1954, for $9,000. Because of the provisions of section 1091, no loss 
from the sale is allowable as a deduction.
    Example 2. A, whose taxable year is the calendar year, on September 
21, 1954, purchased 100 shares of the common stock of the M

[[Page 207]]

Company for $5,000. On December 21, 1954, he purchased 50 shares of 
substantially identical stock for $2,750, and on December 27, 1954, he 
purchased 25 additional shares of such stock for $1,125. On January 3, 
1955, he sold for $4,000 the 100 shares purchased on September 21, 1954. 
There is an indicated loss of $1,000 on the sale of the 100 shares. 
Since, within the 61-day period, A purchased 75 shares of substantially 
identical stock, the loss on the sale of 75 of the shares ($3,750-
$3,000, or $750) is not allowable as a deduction because of the 
provisions of section 1091. The loss on the sale of the remaining 25 
shares ($1,250-$1,000, or $250) is deductible subject to the limitations 
provided in sections 267 and 1211. The basis of the 50 shares purchased 
December 21, 1954, the acquisition of which resulted in the 
nondeductibility of the loss ($500) sustained on 50 of the 100 shares 
sold on January 3, 1955, is $2,500 (the cost of 50 of the shares sold on 
January 3, 1955) + $750 (the difference between the purchase price 
($2,750) of the 50 shares acquired on December 21, 1954, and the selling 
price ($2,000) of 50 of the shares sold on January 3, 1955), or $3,250. 
Similarly, the basis of the 25 shares purchased on December 27, 1954, 
the acquisition of which resulted in the nondeductibility of the loss 
($250) sustained on 25 of the shares sold on January 3, 1955, is 
$1,250+$125, or $1,375. See Sec. 1.1091-2.
    Example 3. A, whose taxable year is the calendar year, on September 
15, 1954, purchased 100 shares of the stock of the M Company for $5,000. 
He sold these shares on February 1, 1956, for $4,000. On each of the 
four days from February 15, 1956, to February 18, 1956, inclusive, he 
purchased 50 shares of substantially identical stock for $2,000. There 
is an indicated loss of $1,000 from the sale of the 100 shares on 
February 1, 1956, but, since within the 61-day period A purchased not 
less than 100 shares of substantially identical stock, the loss is not 
deductible. The particular shares of stock the purchase of which 
resulted in the nondeductibility of the loss are the first 100 shares 
purchased within such period, that is, the 50 shares purchased on 
February 15, 1956, and the 50 shares purchased on February 16, 1956. In 
determining the period for which the 50 shares purchased on February 15, 
1956, and the 50 shares purchased on February 16, 1956, were held, there 
is to be included the period for which the 100 shares purchased on 
September 15, 1954, and sold on February 1, 1956, were held.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6926, 32 FR 
11468, Aug. 9, 1967]



Sec. 1.1091-2  Basis of stock or securities acquired in ``wash sales''.

    (a) In general. The application of section 1091(d) may be 
illustrated by the following examples:

    Example 1. A purchased a share of common stock of the X Corporation 
for $100 in 1935, which he sold January 15, 1955, for $80. On February 
1, 1955, he purchased a share of common stock of the same corporation 
for $90. No loss from the sale is recognized under section 1091. The 
basis of the new share is $110; that is, the basis of the old share 
($100) increased by $10, the excess of the price at which the new share 
was acquired ($90) over the price at which the old share was sold ($80).
    Example 2. A purchased a share of common stock of the Y Corporation 
for $100 in 1935, which he sold January 15, 1955, for $80. On February 
1, 1955, he purchased a share of common stock of the same corporation 
for $70. No loss from the sale is recognized under section 1091. The 
basis of the new share is $90; that is, the basis of the old share 
($100) decreased by $10, the excess of the price at which the old share 
was sold ($80) over the price at which the new share was acquired ($70).

    (b) Special rule. For a special rule as to the adjustment to basis 
required under section 1091(d) in the case of wash sales involving 
certain regulated investment company stock for which there is an average 
basis, see paragraph (e)(3)(iii) (c) and (d) of Sec. 1.1012-1.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7129, 36 FR 
12738, July 7, 1971]



Sec. 1.1092(b)-1T  Coordination of loss deferral rules and wash sale rules (temporary).

    (a) In general. Except as otherwise provided, in the case of the 
disposition of a position or positions of a straddle, the rules of 
paragraph (a)(1) of this section apply before the application of the 
rules of paragraph (a)(2) of this section.
    (1) Any loss sustained from the disposition of shares of stock or 
securities that constitute positions of a straddle shall not be taken 
into account for purposes of this subtitle if, within a period beginning 
30 days before the date of such disposition and ending 30 days after 
such date, the taxpayer has acquired (by purchase or by an exchange

[[Page 208]]

on which the entire amount of gain or loss was recognized by law), or 
has entered into a contract or option so to acquire, substantially 
identical stock or securities.
    (2) Except as otherwise provided, if a taxpayer disposes of less 
than all of the positions of a straddle, any loss sustained with respect 
to the disposition of that position or positions (hereinafter referred 
to as loss position) shall not be taken into account for purposes of 
this subtitle to the extent that the amount of unrecognized gain as of 
the close of the taxable year in one or more of the following positions-
-
    (i) Successor positions,
    (ii) Offsetting positions to the loss position, or
    (iii) Offsetting positions to any successor position,

exceeds the amount of loss disallowed under paragraph (a)(1) of this 
section. See Sec. 1.1092(b)-5T relating to definitions.
    (b) Carryover of disallowed loss. Any loss that is disallowed under 
paragraph (a) of this section shall, subject to any further application 
of paragraph (a)(1) of this section and the limitations under paragraph 
(a)(2) of this section, be treated as sustained in the succeeding 
taxable year. However, a loss disallowed in Year 1, for example, under 
paragraph (a)(1) of this section will not be allowed in Year 2 unless 
the substantially identical stock or securities, the acquisition of 
which caused the loss to be disallowed in Year 1, are disposed of during 
Year 2 and paragraphs (a)(1) and (a)(2) of this section do not apply in 
Year 2 to disallow the loss.
    (c) Treatment of disallowed loss--(1) Character. If the disposition 
of a loss position would (but for the application of this section) 
result in a capital loss, the loss allowed under paragraph (b) of this 
section with respect to the disposition of the loss position shall be 
treated as a capital loss. In any other case, a loss allowed under 
paragraph (b) of this section shall be treated as an ordinary loss. For 
example, if the disposition of a loss position would, but for the 
application of paragraph (a) of this section, give rise to a capital 
loss, that loss when allowed pursuant to paragraph (b) of this section 
will be treated as a capital loss on the date the loss is allowed 
regardless of whether any gain or loss with respect to one or more 
successor positions would be treated as ordinary income or loss.
    (2) Section 1256 contracts. If the disposition of a loss position 
would (but for the application of this section) result in 60 percent 
long-term capital loss and 40 percent short-term capital loss, the loss 
allowed under paragraph (b) of this section with respect to the 
disposition of the loss position shall be treated as 60 percent long-
term capital loss and 40 percent short-term capital loss regardless of 
whether any gain or loss with respect to one or more successor positions 
would be treated as 100 percent long-term or short-term capital gain or 
loss.
    (d) Exceptions. (1) This section shall not apply to losses 
sustained--
    (i) With respect to the disposition of one or more positions that 
constitute part of a hedging transaction;
    (ii) With respect to the disposition of a loss position included in 
a mixed straddle account (as defined in paragraph (b) of Sec. 1.1092(b)-
4T); and
    (iii) With respect to the disposition of a position that is part of 
a straddle consisting only of section 1256 contracts.
    (2) Paragraph (a)(1) of this section shall not apply to losses 
sustained by a dealer in stock or securities if such losses are 
sustained in a transaction made in the ordinary course of such business.
    (e) Coordination with section 1091. Section 1092(b) applies in lieu 
of section 1091 to losses sustained from the disposition of positions in 
a straddle. See example (18) of paragraph (g) of this section.
    (f) Effective date. The provisions of this section apply to 
dispositions of loss positions on or after January 24, 1985.
    (g) Examples. This section may be illustrated by the following 
examples. It is assumed in each example that the following positions are 
the only positions held directly or indirectly (through a related person 
or flowthrough entity) by an individual calendar year taxpayer during 
the taxable year and none of the exceptions

[[Page 209]]

contained in paragraph (d) of this section apply.

    Example 1. On December 1, 1985, A enters into offsetting long and 
short positions. On December 10, 1985, A disposes of the short position 
at an $11 loss, at which time there is $5 of unrealized gain in the 
offsetting long position. At year-end there is still $5 of unrecognized 
gain in the offsetting long position. Under these circumstances, $5 of 
the $11 loss will be disallowed for 1985 because there is $5 of 
unrecognized gain in the offsetting long position; the remaining $6 of 
loss, however, will be taken into account in 1985.
    Example 2. Assume the facts are the same as in example (1), except 
that at year-end there is $11 of unrecognized gain in the offsetting 
long position. Under these circumstances, the entire $11 loss will be 
disallowed for 1985 because there is $11 of unrecognized gain at year-
end in the offsetting long position.
    Example 3. Assume the facts are the same as in example (1), except 
that at year-end there is no unrecognized gain in the offsetting long 
position. Under these circumstances, the entire $11 loss will be allowed 
for 1985.
    Example 4. On November 1, 1985, A enters into offsetting long and 
short positions. On November 10, 1985, A disposes of the long position 
at a $10 loss, at which time there is $10 of unrealized gain in the 
short position. On November 11, 1985, A enters into a new long position 
(successor position) that is offsetting with respect to the retained 
short position but is not substantially identical to the long position 
disposed of on November 10, 1985. A holds both positions through year-
end, at which time there is $10 of unrecognized gain in the successor 
long position and no unrecognized gain in the offsetting short position. 
Under these circumstances, the entire $10 loss will be disallowed for 
1985 because there is $10 of unrecognized gain in the successor long 
position.
    Example 5. Assume the facts are the same as in example (4), except 
that at year-end there is $4 of unrecognized gain in the successor long 
position and $6 of unrecognized gain in the offsetting short position. 
Under these circumstances, the entire $10 loss will be disallowed for 
1985 because there is a total of $10 of unrecognized gain in both the 
successor long position and offsetting short position.
    Example 6. Assume the facts are the same as in example (4), except 
that at year-end A disposes of the offsetting short position at a $2 
loss. Under these circumstances, $10 of the total $12 loss will be 
disallowed because there is $10 of unrecognized gain in the successor 
long position.
    Example 7. Assume the facts are the same as in example (4), and on 
January 10, 1986, A disposes of the successor long position at no gain 
or loss. A holds the offsetting short position until year-end, at which 
time there is $10 of unrecognized gain. Under these circumstances, the 
$10 loss will be disallowed for 1986 because there is $10 of 
unrecognized gain in an offsetting position at year-end.
    Example 8. Assume the facts are the same as in example (4), except 
at year-end there is $8 of unrecognized gain in the successor long 
position and $8 of unrecognized loss in the offsetting short position. 
Under these circumstances, $8 of the total $10 realized loss will be 
disallowed because there is $8 of unrecognized gain in the successor 
long position.
    Example 9. On October 1, 1985, A enters into offsetting long and 
short positions. Neither the long nor the short position is stock or 
securities. On October 2, 1985, A disposes of the short position at a 
$10 loss and the long position at a $10 gain. On October 3, 1985, A 
enters into a long position identical to the original long position. At 
year-end there is $10 of unrecognized gain in the second long position. 
Under these circumstances, the $10 loss is allowed because the second 
long position is not a successor position or offsetting position to the 
short loss position.
    Example 10. On November 1, 1985, A enters into offsetting long and 
short positions. On November 10, 1985, there is $20 of unrealized gain 
in the long position and A disposes of the short position at a $20 loss. 
By November 15, 1985, the value of the long position has declined 
eliminating all unrealized gain in the position. On November 15, 1985, A 
establishes a second short position (successor position) that is 
offsetting with respect to the long position but is not substantially 
identical to the short position disposed of on November 10, 1985. At 
year-end there is no unrecognized gain in the offsetting long position 
or in the successor short position. Under these circumstances, the $20 
loss sustained with respect to the short loss position will be allowed 
for 1985 because at year-end there is no unrecognized gain in the 
successor short position or the offsetting long position.
    Example 11. Assume the facts are the same as in example (10), except 
that the second short position was established on November 8, 1985, and 
there is $20 of unrecognized gain in the second short position at year-
end. Since the second short position was entered into within 30 days 
before the disposition of the loss position, the second short position 
is considered a successor position to the loss position. Under these 
circumstances, the $20 loss will be disallowed because there is $20 of 
unrecognized gain in a successor position.
    Example 12. Assume the facts are the same as in example (10), except 
that at year-end there is $18 of unrecognized gain in the offsetting 
long position and $18 of unrecognized gain in the successor short 
position. Under these circumstances, the entire loss will be disallowed 
because there is more than $20 of

[[Page 210]]

unrecognized gain in both the successor short position and offsetting 
long position.
    Example 13. Assume the facts are the same as in example (10), except 
that there is $20 of unrecognized gain in the successor short position 
and no unrecognized gain in the offsetting long position at year-end. 
Under these circumstances, the entire $20 loss will be disallowed 
because there is $20 of unrecognized gain in the successor short 
position.
    Example 14. On January 2, 1986, A enters into offsetting long and 
short positions. Neither the long nor the short position is stock or 
securities. On March 3, 1986, A disposes of the long position at a $10 
gain. On March 10, 1986, A disposes of the short position at a $10 loss. 
On March 14, 1986, A enters into a new short position. On April 10, 
1986, A enters into an offsetting long position. A holds both positions 
to year-end, at which time there is $10 of unrecognized gain in the 
offsetting long position and no unrecognized gain or loss in the short 
position. Under these circumstances, the $10 loss will be allowed 
because (1) the rules of paragraph (a)(1) of this section are not 
applicable; and (2) the rules of paragraph (a)(2) of this section do not 
apply, since all positions of the straddle that contained the loss 
position were disposed of.
    Example 15. On December 1, 1985, A enters into offsetting long and 
short positions. On December 4, 1985, A disposes of the short position 
at a $10 loss. On December 5, 1985, A establishes a new short position 
that is offsetting to the long position, but is not substantially 
identical to the short position disposed of on December 4, 1985. On 
December 6, 1985, A disposes of the long position at a $10 gain. On 
December 7, 1985, A enters into a second long position that is 
offsetting to the new short position, but is not substantially identical 
to the long position disposed of on December 6, 1985. A holds both 
positions to year-end at which time there is no unrecognized gain in the 
second short position and $10 of unrecognized gain in the offsetting 
long position. Under these circumstances, the entire $10 loss will be 
disallowed for the 1985 taxable year because the second long position is 
an offsetting position with respect to the second short position which 
is a successor position.
    Example 16. On September 1, 1985, A enters into offsetting positions 
consisting of a long section 1256 contract and short non-section 1256 
position. No elections under sections 1256(d)(1) or 1092(b)(2)(A), 
relating to mixed straddles, are made. On November 1, 1985, at which 
time there is $20 of unrecognized gain in the short non-section 1256 
position, A disposes of the long section 1256 contract at a $20 loss and 
on the same day acquires a long non-section 1256 position (successor 
position) that is offsetting with respect to the short non-section 1256 
position. But for the application of this section, A's disposition of 
the section 1256 contract would give rise to a capital loss. At year-end 
there is a $20 of unrecognized gain in the offsetting short non-section 
1256 position and no unrecognized gain in the successor long position. 
Under these circumstances, the entire $20 loss will be disallowed for 
1985 because there is $20 unrecognized gain in the offsetting short 
position. In 1986, A disposes of the successor long non-section 1256 
position and there is no unrecognized gain at year-end in the offsetting 
short position. Under these circumstances, the $20 loss disallowed in 
1985 with respect to the section 1256 contract will be treated in 1986 
as 60 percent long-term capital loss and 40 percent short-term capital 
loss.
    Example 17. On January 2, 1986, A, not a dealer in stock or 
securities, acquires stock in X Corporation (X stock) and an offsetting 
put option. On March 3, 1986, A disposes of the X stock at a $10 loss. 
On March 10, 1986, A disposes of the put option at a $10 gain. On March 
14, 1986, A acquires new X stock that is substantially identical to the 
X stock disposed of on March 3, 1986. A holds the X stock to year-end. 
Under these circumstances, the $10 loss will be disallowed for 1986 
under paragraph (a)(1) of this section because A, within a period 
beginning 30 days before March 3, 1986 and ending 30 days after such 
date, acquired stock substantially identical to the X stock disposed of.
    Example 18. On June 2, 1986, A, not a dealer in stock or securities, 
acquires stock in X Corporation (X stock). On September 2, 1986, A 
disposes of the X stock at a $100 loss. On September 15, 1986, A 
acquires new X stock that is substantially identical to the X stock 
disposed of on September 2, 1986, and an offsetting put option. A holds 
these straddle positions to year-end. Under these circumstances, section 
1091, rather than section 1092(b), will apply to disallow the $100 loss 
for 1986 because the loss was not sustained from the disposition of a 
position that was part of a straddle. See paragraph (e) of this section.
    Example 19. On November 1, 1985, A, not a dealer in stock or 
securities, acquires stock in Y Corporation (Y stock) and an offsetting 
put option. On November 12, 1985, there is $20 of unrealized gain in the 
put option and A disposes of the Y stock at a $20 loss. By November 15, 
1985, the value of the put option has declined eliminating all 
unrealized gain in the position. On November 15, 1985, A acquires a 
second Y stock position that is substantially identical to the Y stock 
disposed of on November 12, 1985. At year-end there is no unrecognized 
gain in the put option or the Y stock. Under these circumstances, the 
$20 loss will be disallowed for 1985 under paragraph (a)(1) of this 
section because A, within a period beginning 30 days before November 12, 
1985 and ending 30 days after such date, acquired stock substantially 
identical to the Y stock disposed of.

[[Page 211]]

    Example 20. Assume the facts are the same as in Example 19 and that 
on December 31, 1986, A disposes of the put option at a $40 gain and 
there is $20 of unrecognized loss in the Y stock. Under these 
circumstances, the $20 loss which was disallowed in 1985 also will be 
disallowed for 1986 under the rules of paragraph (a)(1) of this section 
because A has not disposed of the stock substantially identical to the Y 
stock disposed of on November 12, 1985.
    Example 21. Assume the facts are the same as in example (19), except 
that on December 31, 1986, A disposes of the Y stock at a $20 loss and 
there is $40 of unrecognized gain in the put option. Under these 
circumstances, A will not recognize in 1986 either the $20 loss 
disallowed in 1985 or the $20 loss sustained with respect to the 
December 31, 1986 disposition of Y stock. Paragraph (a)(1) of this 
section does not apply to disallow the losses in 1986 since the 
substantially identical Y stock was disposed of during the year (and no 
substantially identical stock or securities was acquired by A within the 
61 day period). However, paragraph (a)(2) of this section applies to 
disallow for 1986 the $40 of losses sustained with respect to the 
dispositions of positions in the straddle because there is $40 of 
unrecognized gain in the put option, an offsetting position to the loss 
positions.
    Example 22. On January 2, 1986, A, not a dealer in stock or 
securities, acquires stock in X Corporation (X stock) and an offsetting 
put option. On March 3, 1986, A disposes of the X stock at a $10 loss. 
On March 17, 1986, A acquires new X stock that is substantially 
identical to the X stock disposed of on March 3, 1986. On December 31, 
1986, A disposes of the X stock at a $5 gain, at which time there is $5 
of unrecognized gain in the put option. Under these circumstances, the 
$10 loss sustained with respect to the March 3, 1986, disposition of X 
stock will be allowed under paragraph (a) (1) of this section since the 
substantially identical X stock acquired on March 17, 1986, was disposed 
of by year-end (and no substantially identical stock or securities were 
acquired by A within the 61 day period). However, $5 of the $10 loss 
will be disallowed under paragraph (a)(2) of this section because there 
is $5 of unrecognized gain in the put option, an offsetting position to 
the loss position.
    Example 23. Assume the facts are the same as in example (22), except 
that on December 31, 1986, A disposes of the offsetting put option at a 
$5 loss and there is $5 of unrecognized gain in the X stock acquired on 
March 17, 1986. Under these circumstances, the $10 loss sustained with 
respect to the X stock disposed of on March 3, 1986, will be disallowed 
for 1986 under paragraph (a)(1) of this section. The $5 loss sustained 
upon the disposition of the put option will be allowed because (1) the 
rules of paragraph (a)(1) of this section are not applicable; and (2) 
the rules of paragraph (a)(2) of this section allow the loss, since the 
unrecognized gain in the X stock ($5) is not in excess of the loss ($10) 
disallowed under paragraph (a)(1) of this section.
    Example 24. On January 2, 1986, A, not a dealer in stock or 
securities, acquires 200 shares of Z Corporation stock (Z stock) and 2 
put options on Z stock (giving A the right to sell 200 shares of Z 
stock). On September 2, 1986, there is $200 of unrealized gain in the 
put option positions and A disposes of the 200 shares of Z stock at a 
$200 loss. On September 10, 1986, A acquires 100 shares of Z stock 
(substantially identical to the Z stock disposed of on September 2, 
1986), and a call option that is offsetting to the put options on Z 
stock and that is not an option to acquire property substantially 
identical to the Z stock disposed of on September 2, 1986. At year-end, 
there is $80 of unrecognized gain in the Z stock position, $80 of 
unrecognized gain in the call option position, and no unrecognized gain 
or loss in the offsetting put option positions. Under these 
circumstances, $40 of the $200 loss sustained with respect to the 
September 2, 1986 disposition of Z stock will be recognized by A in 1986 
under paragraph (a) of this section, as set forth below. Paragraph 
(a)(1) of this section applies first to disallow $100 of the loss (\1/2\ 
of the loss), since 100 shares of substantially identical Z stock (\1/2\ 
of the stock) were acquired within the 61 day period. Paragraph (a)(2) 
of this section then applies to disallow that portion of the loss 
allowed under paragraph (a)(1) of this section ($200-$100=$100) equal to 
the excess of the total unrecognized gain in the Z stock and call option 
positions (successor positions to the loss position) ($80+$80=$160) over 
the $100 loss disallowed under paragraph (a)(1) of this section ($160-
$100=$60; $100-$60=$40).
    Example 25. Assume the facts are the same as in example (24), except 
that at year-end there is $110 of unrecognized gain in the Z stock 
position, $78 of unrecognized gain in the call option position, and $10 
of unrecognized gain in the offsetting put option positions. Under these 
circumstances, $2 of the $200 loss sustained with respect to the 
September 2, 1986 disposition of Z stock will be allowed in 1986 under 
paragraph (a) of this section, as set forth below. Paragraph (a)(1) of 
this section applies first to disallow $100 of the loss (\1/2\ of the 
loss) since 100 shares of substantially identical Z stock (\1/2\ of the 
stock) were acquired within the 61 day period. Paragraph (a)(2) of this 
section then applies to disallow that portion of the loss allowed under 
paragraph (a)(1) of this section ($200-$100=$100) equal to the excess of 
the total unrecognized gain in the Z stock and call option positions 
(successor positions to the loss position) and the put option positions 
(offsetting positions to the loss position) ($110+$78+$10=$198) over the 
$100 loss

[[Page 212]]

disallowed under paragraph (a)(1) of this section ($198-$100=$98; $100-
$98=$2).
    Example 26. Assume the facts are the same as in example (24), except 
that at year-end there is $120 of unrecognized gain in the Z stock 
position, $88 of unrecognized gain in the call option position, and $10 
of unrecognized loss in one of the offsetting put option positions. At 
year-end A disposes of the other put option position at a $10 loss. 
Under these circumstances, $2 of the $210 loss sustained with respect to 
the September 2, 1986 disposition of Z stock ($200) and the year-end 
disposition of a put option ($10) will be allowed in 1986 under 
paragraph (a) of this section, as set forth below. Paragraph (a)(1) of 
this section applies first to disallow $100 of the loss from the 
disposition of Z stock (\1/2\ of the loss), since 100 shares of 
substantially identical Z stock (\1/2\ of the stock) were acquired 
within the 61 day period. Paragraph (a)(2) of this section then applies 
to disallow that portion of the loss allowed under paragraph (a)(1) of 
this section ($210-$100=$110) equal to the excess of the total 
unrecognized gain in the Z stock and call option positions (successor 
positions to the Z stock loss position, and offsetting positions to the 
put option loss position) ($120+$88=$208) over the $100 loss disallowed 
under paragraph (a)(1) of this section ($208-$100=$108; $110-$108=$2).
    Example 27. On January 27, 1986, A enters into offsetting long (L1) 
and short (S1) positions. Neither L1 nor S1 nor any other positions 
entered into by A in 1986 are stock or securities. On February 3, 1986, 
A disposes of L1 at a $10 loss. On February 5, 1986, A enters into a new 
long position (L2) that is offsetting to S1. On October 15, 1986, A 
disposes of S1 at an $11 loss. On October 17, 1986, A enters into a new 
short position (S2) that is offsetting to L2. On December 30, 1986, A 
disposes of L2 at a $12 loss. On December 31, 1986, A enters into a new 
long position (L3) that is offsetting to S2. At year-end, S2 has an 
unrecognized gain of $33. Paragraph (a)(1) of this section does not 
apply since none of the positions were shares of stock or securities. 
However, all $33 ($10+$11+$12) of the losses sustained with respect to 
L1, S1 and L2 will be disallowed under paragraph (a)(2) because there is 
$33 of unrecognized gain in S2 at year-end. The $10 loss from the 
disposition of L1 is disallowed because S2 is or was an offsetting 
position to a successor long position (L2 or L3). The $11 loss from the 
disposition of S1 is disallowed because S2 is a successor position to 
S1. The $12 loss from the disposition of L2 is disallowed because S2 was 
an offsetting position to L2.

(Secs. 1092(b) and 7805 of the Internal Revenue Code of 1954 (68A Stat. 
917, 95 Stat. 324, 26 U.S.C. 1092(b), 7805) and sec. 102(h) of the Tax 
Reform Act of 1984 (98 Stat. 625))

[T.D. 8007, 50 FR 3319, Jan. 24, 1985, as amended by T.D. 8070, 51 FR 
1786, Jan. 15, 1986; 51 FR 3773, Jan. 30, 1986; 51 FR 5516, Feb. 14, 
1986]



Sec. 1.1092(b)-2T  Treatment of holding periods and losses with respect to straddle positions (temporary).

    (a) Holding period--(1) In general. Except as otherwise provided in 
this section, the holding period of any position that is part of a 
straddle shall not begin earlier than the date the taxpayer no longer 
holds directly or indirectly (through a related person or flowthrough 
entity) an offsetting position with respect to that position. See 
Sec. 1.1092(b)-5T relating to definitions.
    (2) Positions held for the long-term capital gain holding period (or 
longer) prior to establishment of the straddle. Paragraph (a)(1) of this 
section shall not apply to a position held by a taxpayer for the long-
term capital gain holding period (or longer) before a straddle that 
includes such position is established. The determination of whether a 
position has been held by a taxpayer for the long-term capital gain 
holding period (or longer) shall be made by taking into account the 
application of paragraph (a)(1) of this section. See section 1222(3) 
relating to the holding period for long-term capital gains.
    (b) Treatment of loss--(1) In general. Except as provided in 
paragraph (b)(2) of this section, loss on the disposition of one or more 
positions (loss position) of a straddle shall be treated as a long-term 
capital loss if--
    (i) On the date the taxpayer entered into the loss position the 
taxpayer held directly or indirectly (through a related person or 
flowthrough entity) one or more offsetting positions with respect to the 
loss position; and
    (ii) All gain or loss with respect to one or more positions in the 
straddle would be treated as long-term capital

[[Page 213]]

gain or loss if such positions were disposed of on the day the loss 
position was entered into.
    (2) Special rules for non-section 1256 positions in a mixed 
straddle. Loss on the disposition of one or more positions (loss 
position) that are part of a mixed straddle and that are non-section 
1256 positions shall be treated as 60 percent long-term capital loss and 
40 percent short-term capital loss if--
    (i) Gain or loss from the disposition of one or more of the 
positions of the straddle that are section 1256 contracts would be 
considered gain or loss from the sale or exchange of a capital asset;
    (ii) The disposition of no position in the straddle (other than a 
section 1256 contract) would result in a long-term capital gain or loss; 
and
    (iii) An election under section 1092(b)(2)(A)(i)(I) (relating to 
straddle-by-straddle identification) or 1092(b)(2)(A)(i)(II) (relating 
to mixed straddle accounts) has not been made.
    (c) Exceptions--(1) In general. This section shall not apply to 
positions that--
    (i) Constitute part of a hedging transaction;
    (ii) Are included in a straddle consisting only of section 1256 
contracts; or
    (iii) Are included in a mixed straddle account (as defined in 
paragraph (b) of Sec. 1.1092(b)-4T).
    (2) Straddle-by-straddle identification. Paragraphs (a)(2) and (b) 
of this section shall not apply to positions in a section 1092(b)(2) 
identified mixed straddle. See Sec. 1.1092(b)-3T.
    (d) Special rule for positions held by regulated investment 
companies. For purposes of section 851(b)(3) (relating to the definition 
of a regulated investment company), the holding period rule of paragraph 
(a) of this section shall not apply to positions of a straddle. However, 
if section 1233(b) (without regard to sections 1233(e)(2)(A) and 
1092(b)) would have applied to such positions, then for purposes of 
section 851(b)(3) the rules of section 1233(b) shall apply. Similarly, 
the effect of daily marking-to-market provided under Sec. 1.1092(b)-
4T(c) will be disregarded for purposes of section 851(b)(3).
    (e) Effective date--(1) In general. Except as provided in paragraph 
(e)(2) of this section, the provisions of this section apply to 
positions in a straddle established after June 23, 1981, in taxable 
years ending after such date.
    (2) Special effective date for mixed straddle positions. The 
provisions of paragraph (b)(2) of this section shall apply to positions 
in a mixed straddle established on or after January 1, 1984.
    (f) Examples. Paragraphs (a) through (e) may be illustrated by the 
following examples. It is assumed in each example that the following 
positions are the only positions held directly or indirectly (through a 
related person or flowthrough entity) by an individual calendar year 
taxpayer during the taxable year and none of the exceptions in paragraph 
(c) of this section apply.

    Example 1. On October 1, 1984, A acquires gold. On January 1, 1985, 
A enters into an offsetting short gold forward contract. On April 1, 
1985, A disposes of the short gold forward contract at no gain or loss. 
On April 10, 1985, A sells the gold at a gain. Since the gold had not 
been held for more than 6 months before the offsetting short position 
was entered into, the holding period for the gold begins no earlier than 
the time the straddle is terminated. Thus, the holding period of the 
original gold purchased on October 1, 1984, and sold on April 10, 1985, 
begins on April 1, 1985, the date the straddle was terminated. 
Consequently, gain recognized with respect to the gold will be treated 
as short-term capital gain.
    Example 2. On January 1, 1985, A enters into a long gold forward 
contract. On May 1, 1985, A enters into an offsetting short gold 
regulated futures contract. A does not make an election under section 
1256(d) or 1092(b)(2)(A). On August 1, 1985, A disposes of the gold 
forward contract at a gain. Since the forward contract had not been held 
by A for more than 6 months prior to the establishment of the straddle, 
the holding period for the forward contract begins no earlier than the 
time the straddle is terminated. Thus, the gain recognized on the 
closing of the gold forward contract will be treated as short-term 
capital gain.
    Example 3. Assume the facts are the same as in example (2), except 
that A disposes of the short gold regulated futures contract on July 1, 
1985, at no gain or loss and the forward contract on November 1, 1985. 
Since the forward contract had not been held for more than 6 months 
before the mixed straddle was established, the holding period for the 
forward contract begins July 1, 1985, the date

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the straddle terminated. Thus, the gain recognized on the closing of the 
forward contract will be treated as short-term capital gain.
    Example 4. On January 1, 1985, A enters into a long gold forward 
contract and on August 4, 1985, A enters into an offsetting short gold 
forward contract. On September 1, 1985, A disposes of the short position 
at a loss. Since an offsetting long position had been held by A for more 
than 6 months prior to the acquisition of the offsetting short position, 
the loss with respect to the closing of the short position will be 
treated as long-term capital loss.
    Example 5. On March 1, 1985, A enters into a long gold forward 
contract and on July 17, 1985, A enters into an offsetting short gold 
regulated futures contract. A does not make an election under section 
1256(d) or 1092(b)(2)(A). On August 10, 1985, A disposes of the long 
gold forward contract at a loss. Since the gold forward contract was 
part of a mixed straddle, and the disposition of no position in the 
straddle (other than the regulated futures contract) would give rise to 
a long-term capital loss, the loss recognized on the termination of the 
gold forward contract will be treated as 40 percent short-term capital 
loss and 60 percent long-term capital loss.
    Example 6. Assume the facts are the same as in example (5), except 
that on August 11, 1985, A disposes of the short gold regulated futures 
contract at a gain. Under these circumstances, the gain will be treated 
as 60 percent long-term capital gain and 40 percent short-term capital 
gain since the holding period rules of paragraph (a) of this section are 
not applicable to section 1256 contracts.
    Example 7. Assume the facts are the same as in example (5), except 
that A enters into the long gold forward contract on January 1, 1985, 
and does not dispose of the long gold forward contract but instead on 
August 10, 1985, disposes of the short gold regulated futures contract 
at a loss. Under these circumstances, the loss will be treated as a 
long-term capital loss since A held an offsetting non-section 1256 
position for more than 6 months prior to the establishment of the 
straddle. However, such loss may be subject to the rules of 
Sec. 1.1092(b)-1T.

(Secs. 1092(b) and 7805 of the Internal Revenue Code of 1954 (68A Stat. 
917, 95 Stat. 324, 26 U.S.C. 1092(b), 7805) and sec. 102(h) of the Tax 
Reform Act of 1984 (98 Stat. 625))

[T.D. 8007, 50 FR 3320, Jan. 24, 1985, as amended by T.D. 8070, 51 FR 
1788, Jan. 15, 1986]



Sec. 1.1092(b)-3T  Mixed straddles; straddle-by-straddle identification under section 1092(b)(2)(A)(i)(I) (temporary).

    (a) In general. Except as otherwise provided, a taxpayer shall treat 
in accordance with paragraph (b) of this section gains and losses on 
positions that are part of a mixed straddle for which the taxpayer has 
made an election under paragraph (d) of this section (hereinafter 
referred to as a section 1092(b)(2) identified mixed straddle). No 
election may be made under this section for any straddle composed of one 
or more positions that are includible in a mixed straddle account (as 
defined in paragraph (b) of Sec. 1.1092(b)-4T) or for any straddle for 
which an election under section 1256(d) has been made. See 
Sec. 1.1092(b)-5T relating to definitions.
    (b) Treatment of gains and losses from positions included in a 
section 1092(b)(2) identified mixed straddle--(1) In general. Gains and 
losses from positions that are part of a section 1092(b)(2) identified 
mixed straddle shall be determined and treated in accordance with the 
rules of paragraph (b) (2) through (7) of this section.
    (2) All positions of a section 1092(b)(2) identified mixed straddle 
are disposed of on the same day. If all positions of a section 
1092(b)(2) identified mixed straddle are disposed of (or deemed disposed 
of) on the same say, gains and losses from section 1256 contracts in the 
straddle shall be netted, and gains and losses from non-section 1256 
positions in the straddle shall be netted. Net gain or loss from the 
section 1256 contracts shall then be offset against net gain or loss 
from the non-section 1256 positions to determine the net gain or loss 
from the straddle. If net gain or loss from the straddle is attributable 
to the positions of the straddle that are section 1256 contracts, such 
gain or loss shall be treated as 60 percent long-term capital gain or 
loss and 40 percent short-term capital gain or loss. If net gain or loss 
from the straddle is attributable to the positions of the straddle that 
are non-section 1256 positions, such gain or loss shall be treated as 
short-term capital gain or

[[Page 215]]

loss. This paragraph (b)(2) may be illustrated by the following 
examples. It is assumed in each example that the positions are the only 
positions held directly or indirectly (through a related person or 
flowthrough entity) by an individual calendar year taxpayer during the 
taxable year.

    Example 1. On April 1, 1985, A enters into a non-section 1256 
position and an offsetting section 1256 contract and makes a valid 
election to treat such straddle as a section 1092(b)(2) identified mixed 
straddle. On April 10, 1985, A disposes of the non-section 1256 position 
at a $600 loss and the section 1256 contract at a $600 gain. Under these 
circumstances, the $600 loss on the non-section 1256 position will be 
offset against the $600 gain on the section 1256 contract and the net 
gain or loss from the straddle will be zero.
    Example 2. Assume the facts are the same as in example (1), except 
that the gain on the section 1256 contract is $800. Under these 
circumstances, the $600 loss on the non-section 1256 position will be 
offset against the $800 gain on the section 1256 contract. The net gain 
of $200 from the straddle will be treated as 60 percent long-term 
capital gain and 40 percent short-term capital gain because it is 
attributable to the section 1256 contract.
    Example 3. Assume the facts are the same as in example (1), except 
that the loss on the non-section 1256 position is $800. Under these 
circumstances, the $600 gain on the section 1256 contract will be offset 
against the $800 loss on the non-section 1256 position. The net loss of 
$200 from the straddle will be treated as short-term capital loss 
because it is attributable to the non-section 1256 position.
    Example 4. On May 1, 1985, A enters into a straddle consisting of 
two non-section 1256 positions and two section 1256 contracts and makes 
a valid election to treat the straddle as a section 1092(b)(2) 
identified mixed straddle. On May 10, 1985, A disposes of the non-
section 1256 positions, one at a $700 loss and the other at a $500 gain, 
and disposes of the section 1256 contracts, one at a $400 gain and the 
other at a $300 loss. Under these circumstances, the gain and losses 
from the section 1256 contracts and non-section 1256 positions will 
first be netted, resulting in a net gain of $100 ($400-$300) on the 
section 1256 contracts and a net loss of $200 ($700-$500) on the non-
section 1256 positions. The net gain of $100 from the section 1256 
contracts will then be offset against the $200 net loss on the non-
section 1256 positions. The net loss of $100 from the straddle will be 
treated as short-term capital loss because it is attributable to the 
non-section 1256 positions.
    Example 5. On December 30, 1985, A enters into a section 1256 
contract and an offsetting non-section 1256 position and makes a valid 
election to treat such straddle as a section 1092(b)(2) identified mixed 
straddle. On December 31, 1985, A disposes of the non-section 1256 
position at a $2,000 gain. A also realizes a $2,000 loss on the section 
1256 contract because it is deemed disposed of under section 1256(a)(1). 
Under these circumstances, the $2,000 gain on the non-section 1256 
position will be offset against the $2,000 loss on the section 1256 
contract, and the net gain or loss from the straddle will be zero.
    Example 6. Assume the facts are the same as in example (5), except 
that the section 1092(b)(2) identified mixed straddle was entered into 
on November 12, 1985, A realizes a $2,200 loss on the section 1256 
contract, and on December 15, 1985, A enters into a non-section 1256 
position that is offsetting to the non-section 1256 gain position of the 
section 1092(b)(2) identified mixed straddle. At year-end there is $200 
of unrecognized gain in the non-section 1256 position that was entered 
into on December 15. Under these circumstances, the $2,200 loss on the 
section 1256 contract will be offset against the $2,000 gain on the non-
section 1256 position. The net $200 loss from the straddle will be 
treated as 60 percent long-term capital loss and 40 percent short-term 
capital loss because it is attributable to the section 1256 contract. 
The net loss of $200 from the straddle will be disallowed in 1985 under 
the loss deferral rules of section 1092(a) because there is $200 of 
unrecognized gain in a successor position (as defined in paragraph (n) 
of Sec. 1.1092(b)-5T) at year-end. See paragraph (c) of this section.

    (3) All of the non-section 1256 positions of a section 1092(b)(2) 
identified mixed straddle disposed of on the same day. This paragraph 
(b)(3) applies if all of the non-section 1256 positions of a section 
1092(b)(2) identified mixed straddle are disposed of on the same day or 
if this paragraph (b)(3) is made applicable by paragraph (b)(5) of this 
section. In the case to which this paragraph (b)(3) applies, gain and 
loss realized from non-section 1256 positions shall be netted. Realized 
and unrealized gain and loss with respect to the section 1256 contracts 
of the straddle also shall be netted on that day. Realized net gain or 
loss from the non-section 1256 positions shall then be offset against 
net gain or loss from the section 1256 contracts to determine the net 
gain or loss from the straddle on that day. Net gain or loss from the 
straddle that is attributable to the non-section 1256 positions shall be 
realized and treated as short-term capital gain or loss on that day. Net 
gain or loss from the straddle that is attributable to realized gain or 
loss with respect to section 1256 contracts

[[Page 216]]

shall be realized and treated as 60 percent long-term capital gain or 
loss and 40 percent short-term capital gain or loss. Any gain or loss 
subsequently realized on the section 1256 contracts shall be adjusted 
(through an adjustment to basis or otherwise) to take into account the 
extent to which gain or loss was offset by unrealized gain or loss on 
the section 1256 contracts on that day. This paragraph (b)(3) may be 
illustrated by the following examples. It is assumed in each example 
that the positions are the only positions held directly or indirectly 
(through a related person or flowthrough entity) by an individual 
calendar year taxpayer during the taxable year.

    Example 1. On July 20, 1985, A enters into a section 1256 contract 
and an offsetting non-section 1256 position and makes a valid election 
to treat such straddle as a section 1092(b)(2) identified mixed 
straddle. On July 27, 1985, A disposes of the non-section 1256 position 
at a $1,500 loss, at which time there is $1,500 of unrealized gain in 
the section 1256 contract. A holds the section 1256 contract at year-end 
at which time there is $1,800 of gain. Under these circumstances, on 
July 27, 1985, A offsets the $1,500 loss on the non-section 1256 
position against the $1,500 gain on the section 1256 contract and 
realizes no gain or loss. On December 31, 1985, A realizes a $300 gain 
on the section 1256 contract because the position is deemed disposed of 
under section 1256(a)(1). The $300 gain is equal to $1,800 of gain less 
a $1,500 adjustment for unrealized gain offset against the loss realized 
on the non-section 1256 position on July 27, 1985, and the gain will be 
treated as 60 percent long-term capital gain and 40 percent short-term 
capital gain.
    Example 2. Assume the facts are the same as in example (1), except 
that on July 27, 1985, A realized a $1,700 loss on the non-section 1256 
position. Under these circumstances, on July 27, 1985, A offsets the 
$1,700 loss on the non-section 1256 position against the $1,500 gain on 
the section 1256 contract. A realizes a $200 loss from the straddle on 
July 27, 1985, which will be treated as short-term capital loss because 
it is attributable to the non-section 1256 position. On December 31, 
1985, A realizes a $300 gain on the section 1256 contract, computed as 
in example (1), which will be treated as 60 percent long-term capital 
gain and 40 percent short-term capital gain.
    Example 3. On March 1, 1985, A enters into a straddle consisting of 
two non-section 1256 positions and two section 1256 contracts and makes 
a valid election to treat such straddle as a section 1092(b)(2) 
identified mixed straddle. On March 11, 1985, A disposes of the non-
section 1256 positions, one at a $100 loss and the other at a $150 loss, 
and disposes of one section 1256 contract at a $100 loss. On that day 
there is $100 of unrealized gain on the section 1256 contract retained 
by A. A holds the remaining section 1256 contract at year-end, at which 
time there is $150 of gain. Under these circumstances, on March 11, 
1985, A will first net the gains and losses from the section 1256 
contracts and net the gains and losses from the non-section 1256 
positions resulting in no gain or loss on the section 1256 contracts and 
a net loss of $250 on the non-section 1256 positions. Since there is no 
gain or loss to offset against the non-section 1256 positions, the net 
loss of $250 will be treated as short-term capital loss because it is 
attributable to the non-section 1256 positions. On December 31, 1985, A 
realizes a $50 gain on the remaining section 1256 contract because the 
position is deemed disposed of under section 1256(a)(1). The $50 gain is 
equal to $150 gain less a $100 adjustment to take into account the $100 
unrealized gain that was offset against the $100 loss realized on the 
section 1256 contract on March 11, 1985.
    Example 4. Assume the facts are the same as in example (3), except 
that A disposes of the section 1256 contract at a $500 gain. As in 
example (3), A has a net loss of $250 on the non-section 1256 positions 
disposed of. In this example, however, A has net gain of $600 
($500+$100) on the section 1256 contracts on March 11, 1985. Therefore, 
of the net gain from the straddle of $350 ($600-$250), $250 ($500-$250) 
is treated as 60 percent long-term capital gain and 40 percent short-
term capital gain because only $250 is attributable to the realized gain 
from the section 1256 contract. In addition, because none of the $100 
unrealized gain from the remaining section 1256 contract was offset 
against gain or loss on the non-section 1256 positions, no adjustment is 
made under paragraph (b)(3) of this section and the entire $150 gain on 
December 31 with respect to that contract is realized on that date.

    (4) All of the section 1256 contracts of a section 1092(b)(2) 
identified mixed straddle disposed of on the same day. This paragraph 
(b)(4) applies if all of the section 1256 contracts of a section 
1092(b)(2) identified mixed straddle are disposed of (or deemed disposed 
of) on the same day or if this paragraph (b)(4) is made applicable by 
paragraph (b)(5) of this section. In the case to which this paragraph 
(b)(4) applies, gain and loss realized from section 1256 contracts shall 
be netted. Realized and unrealized gain and loss with respect to the 
non-section 1256 positions of the straddle also shall be netted on that 
day. Realized

[[Page 217]]

net gain or loss from the section 1256 contracts shall be treated as 
short-term capital gain or loss to the extent of net gain or loss on the 
non-section 1256 positions on that day. Net gain or loss with respect to 
the section 1256 contracts that exceeds the net gain or loss with 
respect to the non-section 1256 positions of the straddle shall be 
treated as 60 percent long-term capital gain or loss and 40 percent 
short-term capital gain or loss. See paragraph (b)(7) of this section 
relating to the gain or loss on such non-section 1256 positions. This 
paragraph (b)(4) may be illustrated by the following examples. It is 
assumed in each example that the positions are the only positions held 
directly or indirectly (through a related person or flowthrough entity) 
by an individual calendar year taxpayer during the taxable year.

    Example 1. On December 30, 1985, A enters into a section 1256 
contract and an offsetting non-section 1256 position and makes a valid 
election to treat such straddle as a section 1092(b)(2) identified mixed 
straddle. On December 31, 1985, A disposes of the section 1256 contract 
at a $1,000 gain, at which time there is $1,000 of unrealized loss in 
the non-section 1256 position. Under these circumstances, the $1,000 
gain realized on the section 1256 contract will be treated as short-term 
capital gain because there is a $1,000 loss on the non-section 1256 
position.
    Example 2. Assume the facts are the same as in example (1), except 
that A realized a $1,500 gain on the disposition of the section 1256 
contract. Under these circumstances, $1,000 of the gain realized on the 
section 1256 contract will be treated as short-term capital gain because 
there is a $1,000 loss on the non-section 1256 position. The net gain of 
$500 from the straddle will be treated as 60 percent long-term capital 
gain and 40 percent short-term capital gain because it is attributable 
to the section 1256 contract.
    Example 3. Assume the facts are the same as in example (1), except 
that A realized a $1,000 loss on the section 1256 contract and there is 
$1,000 of unrecognized gain on the non-section 1256 position. Under 
these circumstances, the $1,000 loss on the section 1256 contract will 
be treated as short-term capital loss because there is a $1,000 gain on 
the non-section 1256 position. Such loss, however, will be disallowed in 
1985 under the loss deferral rules of section 1092(a) because there is 
$1,000 of unrecognized gain in an offsetting position at year-end. See 
paragraph (c) of this section.
    Example 4. Assume the facts are the same as in example (1), except 
that the section 1256 contract and non-section 1256 position were 
entered into on December 1, 1985, and the section 1256 contract is 
disposed of on December 19, 1985, for a $1,000 gain, at which time there 
is $1,000 of unrealized loss on the non-section 1256 position. At year-
end there is only $800 of unrealized loss in the non-section 1256 
position. Under these circumstances, the result is the same as in 
example (1) because there was $1,000 of unrealized loss on the non-
section 1256 position at the time of the disposition of the section 1256 
contract.
    Example 5. On July 15, 1985, A enters into a straddle consisting of 
two non-secti