[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2011 Edition]
[From the U.S. Government Printing Office]



[[Page i]]

          

          26


          Part 1 (Sec. Sec.  1.0 to 1.60)

                         Revised as of April 1, 2009


          Internal Revenue
          



________________________

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2009
          With Ancillaries
                    Published by
                    Office of the Federal Register
                    National Archives and Records
                    Administration
                    A Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



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

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury                                               3
  Findings Aids:
      Table of CFR Titles and Chapters........................     587
      Alphabetical List of Agencies Appearing in the CFR......     607
      Table of OMB Control Numbers............................     617
      List of CFR Sections Affected...........................     635

[[Page iv]]





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

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

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

[[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, 2009), 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 
exercised by the user in determining the actual effective date. In 
instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

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 eleven separate 
volumes. For the period beginning January 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

INCORPORATION BY REFERENCE

    What is incorporation by reference? Incorporation by reference was 
established by statute and allows Federal agencies to meet the 
requirement to publish regulations in the Federal Register by referring 
to materials already published elsewhere. For an incorporation to be 
valid, the Director of the Federal Register must approve it. The legal 
effect of incorporation by reference is that the material is treated as 
if it were published in full in the Federal Register (5 U.S.C. 552(a)). 
This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
publication in accordance with 1 CFR part 51.
    What if the material incorporated by reference cannot be found? If 
you have any problem locating or obtaining a copy of material listed as 
an approved incorporation by reference, please contact the agency that 
issued the regulation containing that incorporation. If, after 
contacting the agency, you find the material is not available, please 
notify the Director of the Federal Register, National Archives and 
Records Administration, Washington DC 20408, or call 202-741-6010.

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.




[[Page vii]]



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.
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or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, Washington, DC 20408 or e-mail 
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SALES

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ELECTRONIC SERVICES

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CFR Sections Affected), The United States Government Manual, the Federal 
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    The Office of the Federal Register also offers a free service on the 
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register. The NARA site also contains links to GPO Access.

    Raymond A. Mosley,
    Director,
    Office of the Federal Register.
    April 1, 2009.







[[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, 
2009. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Sec. Sec.  1.0-1.60; 
Sec. Sec.  1.61-1.169; Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; 
Sec. Sec.  1.401-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end of part 1. The 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.

    For this volume, Cheryl E. Sirofchuck was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of 
Michael L. White, assisted by Ann Worley.


[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




           (This book contains part 1, Sec. Sec. 1.0 to 1.60)

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

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

[[Page 3]]



     CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY




                    (Part 1, Sec. Sec. 1.0 to 1.60)


  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
Part                                                                Page
1               Income taxes................................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System, Alcohol and Tobacco Tax Regulations, and 
  Regulations Under Tax Conventions.

  Editorial Note: Treasury Decision 6091, 19 FR 5167, Aug. 17, 1954, 
provides in part as follows:

  Paragraph 1. All regulations (including all Treasury decisions) 
prescribed by, or under authority duly delegated by, the Secretary of 
the Treasury, or jointly by the Secretary and the Commissioner of 
Internal Revenue, or by the Commissioner of Internal Revenue with the 
approval of the Secretary of the Treasury, or jointly by the 
Commissioner of Internal Revenue and the Commissioner of Customs or the 
Commissioner of Narcotics with the approval of the Secretary of the 
Treasury, applicable under any provision of law in effect on the date of 
enactment of the Code, to the extent such provision of law is repealed 
by the Code, are hereby prescribed under and made applicable to the 
provisions of the Code corresponding to the provision of law so repealed 
insofar as any such regulation is not inconsistent with the Code. Such 
regulations shall become effective as regulations under the various 
provisions of the Code as of the dates the corresponding provisions of 
law are repealed by the Code, until superseded by regulations issued 
under the Code.

  Par. 2. With respect to any provision of the Code which depends for 
its application upon the promulgation of regulations or which is to be 
applied in such manner as may be prescribed by regulations, all 
instructions or rules in effect immediately prior to the enactment of 
the Code, to the extent such instructions or rules could be prescribed 
as regulations under authority of such provision of the Code, shall be 
applied as regulations under such provision insofar as such instructions 
or rules are not inconsistent with the Code. Such instructions or rules 
shall be applied as regulations under the applicable provision of the 
Code as of the date such provision takes effect.

  Par. 3. If any election made or other act done pursuant to any 
provision of the Internal Revenue Code of 1939 or prior internal revenue 
laws would (except for the enactment of the Code) be effective for any 
period subsequent to such enactment, and if corresponding provisions are 
contained in the Code, such election or other act shall be given the 
same effect under the corresponding provisions of the Code to the extent 
not inconsistent therewith. The term ``act'' includes, but is not 
limited to, an allocation, identification, declaration, agreement, 
option, waiver, relinquishment, or renunciation.

  Par. 4. The limits of the various internal revenue districts have not 
been changed by the enactment of the Code. Furthermore, delegations of 
authority made pursuant to the provisions of Reorganization Plan No. 26 
of 1950 and Reorganization Plan No. 1 of 1952 (as well as redelegations 
thereunder), including those governing the authority of the Commissioner 
of

[[Page 4]]

Internal Revenue, the Regional Commissioners of Internal Revenue, or the 
District Directors of Internal Revenue, are applicable to the provisions 
of the Code to the extent consistent therewith.

[[Page 5]]



                         SUBCHAPTER A_INCOME TAX



PART 1_INCOME TAXES--Table of Contents




Sec.
1.0-1 Internal Revenue Code of 1954 and regulations.

                        Normal Taxes and Surtaxes

                     DETERMINATION OF TAX LIABILITY

                           Tax on Individuals

1.1-1 Income tax on individuals.
1.1-2 Limitation on tax.
1.1-3 Change in rates applicable to taxable year.
1.1(h)-1 Capital gains look-through rule for sales or exchanges of 
          interests in a partnership, S corporation, or trust.
1.1(i)-1T Questions and answers relating to the tax on unearned income 
          certain minor children (Temporary).
1.2-1 Tax in case of joint return of husband and wife or the return of a 
          surviving spouse.
1.2-2 Definitions and special rules.
1.3-1 Application of optional tax.
1.4-1 Number of exemptions.
1.4-2 Elections.
1.4-3 Husband and wife filing separate returns.
1.4-4 Short taxable year caused by death.

                           Tax on Corporations

1.11-1 Tax on corporations.

                 Changes in Rates During a Taxable Year

1.15-1 Changes in rate during a taxable year.
1.21-1 Expenses for household and dependent care services necessary for 
          gainful employment.
1.21-2 Limitations on amount creditable.
1.21-3 Special rules applicable to married taxpayers.
1.21-4 Payments to certain related individuals.
1.23-1 Residential energy credit.
1.23-2 Definitions.
1.23-3 Special rules.
1.23-4 Performance and quality standards. [Reserved]
1.23-5 Certification procedures.
1.23-6 Procedure and criteria for additions to the approved list of 
          energy-conserving components or renewable energy sources.
1.25-1T Credit for interest paid on certain home mortgages (Temporary).
1.25-2T Amount of credit (Temporary).
1.25-3 Qualified mortgage credit certificate.
1.25-3T Qualified mortgage credit certificate (Temporary).
1.25-4T Qualified mortgage credit certificate program (Temporary).
1.25-5T Limitation on aggregate amount of mortgage credit certificates 
          (Temporary).
1.25-6T Form of qualified mortgage credit certificate (Temporary).
1.25-7T Public notice (Temporary).
1.25-8T Reporting requirements (Temporary).
1.25A-0 Table of contents.
1.25A-1 Calculation of education tax credit and general eligibility 
          requirements.
1.25A-2 Definitions.
1.25A-3 Hope Scholarship Credit.
1.25A-4 Lifetime Learning Credit.
1.25A-5 Special rules relating to characterization and timing of 
          payments.
1.28-0 Credit for clinical testing expenses for certain drugs for rare 
          diseases or conditions; table of contents.
1.28-1 Credit for clinical testing expenses for certain drugs for rare 
          diseases or conditions.

                           Credits Against Tax

             credits allowable under sections 30 through 45D

1.30-1 Definition of qualified electric vehicle and recapture of credit 
          for qualified electric vehicle.
1.31-1 Credit for tax withheld on wages.
1.31-2 Credit for ``special refunds'' of employee social security tax.
1.32-2 Earned income credit for taxable years beginning after December 
          31, 1978.
1.32-3 Eligibility requirements after denial of the earned income 
          credit.
1.34-1 Special rule for owners of certain business entities.
1.35-1 Partially tax-exempt interest received by individuals.
1.35-2 Taxpayers not entitled to credit.
1.37-1 General rules for the credit for the elderly.
1.37-2 Credit for individuals age 65 or over.
1.37-3 Credit for individuals under age 65 who have public retirement 
          system income.
1.38-1 Investment in certain depreciable property.
1.40-1 Questions and answers relating to the meaning of the term 
          ``qualified mixture'' in section 40(b)(1).
1.41-0 Table of contents.
1.41-0T Table of contents (temporary).
1.41-1 Credit for increasing research activities.
1.41-2 Qualified research expenses.
1.41-3 Base amount for taxable years beginning on or after January 3, 
          2001.

[[Page 6]]

1.41-4 Qualified research for expenditures paid or incurred in taxable 
          years ending on or after December 31, 2003.
1.41-4A Qualified research for taxable years beginning before January 1, 
          1986.
1.41-5 Basic research for taxable years beginning after December 31, 
          1986. [Reserved]
1.41-5A Basic research for taxable years beginning before January 1, 
          1987.
1.41-6 Aggregation of expenditures.
1.41-6T Aggregation of expenditures (temporary).
1.41-7 Special rules.
1.41-8 Alternative incremental credit.
1.41-8T Alternative incremental credit (temporary).
1.41-9 Alternative simplified credit.
1.41-9T Alternative simplified credit (temporary).
1.42-0 Table of contents.
1.42-1 Limitation on low-income housing credit allowed with respect to 
          qualified low-income buildings receiving housing credit 
          allocations from a State or local housing credit agency.
1.42-1T Limitation on low-income housing credit allowed with respect to 
          qualified low-income buildings receiving housing credit 
          allocations from a State or local housing credit agency 
          (temporary).
1.42-2 Waiver of requirement that an existing building eligible for the 
          low-income housing credit was last placed in service more than 
          10 years prior to acquisition by the taxpayer.
1.42-3 Treatment of buildings financed with proceeds from a loan under 
          an Affordable Housing Program established pursuant to section 
          721 of the Financial Institutions Reform, Recovery, and 
          Enforcement Act of 1989 (FIRREA).
1.42-4 Application of not-for-profit rules of section 183 to low-income 
          housing credit activities.
1.42-5 Monitoring compliance with low-income housing credit 
          requirements.
1.42-6 Buildings qualifying for carryover allocations.
1.42-7 Substantially bond-financed buildings. [Reserved]
1.42-8 Election of appropriate percentage month.
1.42-9 For use by the general public.
1.42-10 Utility allowances.
1.42-11 Provision of services.
1.42-12 Effective dates and transitional rules.
1.42-13 Rules necessary and appropriate; housing credit agencies' 
          correction of administrative errors and omissions.
1.42-14 Allocation rules for post-2000 State housing credit ceiling 
          amount.
1.42-15 Available unit rule.
1.42-16 Eligible basis reduced by federal grants.
1.42-17 Qualified allocation plan.
1.42A-1 General tax credit for taxable years ending after December 31, 
          1975, and before January 1, 1979.
1.43-0 Table of contents.
1.43-1 The enhanced oil recovery credit--general rules.
1.43-2 Qualified enhanced oil recovery project.
1.43-3 Certification.
1.43-4 Qualified enhanced oil recovery costs.
1.43-5 At-risk limitation. [Reserved]
1.43-6 Election out of section 43.
1.43-7 Effective date of regulations.
1.44-1 Allowance of credit for purchase of new principal residence after 
          March 12, 1975, and before January 1, 1977.
1.44-2 Property to which credit for purchase of new principal residence 
          applies.
1.44-3 Certificate by seller.
1.44-4 Recapture for certain dispositions.
1.44-5 Definitions.
1.44B-1 Credit for employment of certain new employees.

   Research Credit--For Taxable Years Beginning Before January 1, 1990

1.41-0A Table of contents.
1.41-3A Base period research expense.

    rules for computing credit for investment in certain depreciable 
                                property

1.45D-1 New markets tax credit.
1.45G-0 Table of contents for the railroad track maintenance credit 
          rules.
1.45G-1 Railroad track maintenance credit.
1.46-1 Determination of amount.
1.46-2 Carryback and carryover of unused credit.
1.46-3 Qualified investment.
1.46-4 Limitations with respect to certain persons.
1.46-5 Qualified progress expenditures.
1.46-6 Limitation in case of certain regulated companies.
1.46-7 Statutory provisions; plan requirements for taxpayers electing 
          additional investment credit, etc.
1.46-8 Requirements for taxpayers electing additional one-percent 
          investment credit (TRASOP's).
1.46-9 Requirements for taxpayers electing an extra one-half percent 
          additional investment credit.
1.46-10 [Reserved]
1.46-11 Commuter highway vehicles.
1.47-1 Recomputation of credit allowed by section 38.
1.47-2 ``Disposition'' and ``cessation''.
1.47-3 Exceptions to the application of Sec. 1.47-1.
1.47-4 Electing small business corporation.
1.47-5 Estates and trusts.
1.47-6 Partnerships.
1.48-1 Definition of section 38 property.
1.48-2 New section 38 property.
1.48-3 Used section 38 property.

[[Page 7]]

1.48-4 Election of lessor of new section 38 property to treat lessee as 
          purchaser.
1.48-5 Electing small business corporations.
1.48-6 Estates and trusts.
1.48-9 Definition of energy property.
1.48-10 Single purpose agricultural or horticultural structures.
1.48-11 Qualified rehabilitated building; expenditures incurred before 
          January 1, 1982.
1.48-12 Qualified rehabilitated building; expenditures incurred after 
          December 31, 1981.
1.50-1 Restoration of credit.

   rules for computing credit for expenses of work incentive programs

1.50A-1 Determination of amount.
1.50A-2 Carryback and carryover of unused credit.
1.50A-3 Recomputation of credit allowed by section 40.
1.50A-4 Exceptions to the application of Sec. 1.50A-3.
1.50A-5 Electing small business corporations.
1.50A-6 Estates and trusts.
1.50A-7 Partnerships.
1.50B-1 Definitions of WIN expenses and WIN employees.
1.50B-2 Electing small business corporations.
1.50B-3 Estates and trusts.
1.50B-4 Partnerships.
1.50B-5 Limitations with respect to certain persons.
1.51-1 Amount of credit.

                              Tax Surcharge

1.52-1 Trades or businesses that are under common control.
1.52-2 Adjustments for acquisitions and dispositions.
1.52-3 Limitations with respect to certain persons.
1.53-1 Limitation based on amount of tax.
1.53-2 Carryback and carryover of unused credit.
1.53-3 Separate rule for pass-through of jobs credit.
1.55-1 Alternative minimum taxable income.
1.56-0 Table of contents to Sec. 1.56-1, adjustment for book income of 
          corporations.
1.56-1 Adjustment for the book income of corporations.

Regulations Applicable to Taxable Years Beginning in 1969 and Ending in 
                                  1970

1.56A-1 Imposition of tax.
1.56A-2 Deferral of tax liability in case of certain net operating 
          losses.
1.56A-3 Effective date.
1.56A-4 Certain taxpayers.
1.56A-5 Tax carryovers.
1.56(g)-0 Table of contents.
1.56(g)-1 Adjusted current earnings.

                       Tax Preference Regulations

1.57-0 Scope.
1.57-1 Items of tax preference defined.
1.57-2--1.57-3 [Reserved]
1.57-4 Limitation on amounts treated as items of tax preference for 
          taxable years beginning before January 1, 1976.
1.57-5 Records to be kept.
1.58-1 Minimum tax exemption.
1.58-2 General rules for conduit entities; partnerships and partners.
1.58-3 Estates and trusts.
1.58-3T Treatment of non-alternative tax itemized deductions by trusts 
          and estates and their beneficiaries in taxable years beginning 
          after December 31, 1982 (temporary).
1.58-4 Electing small business corporations.
1.58-5 Common trust funds.
1.58-6 Regulated investment companies; real estate investment trusts.
1.58-7 Tax preferences attributable to foreign sources; preferences 
          other than capital gains and stock options.
1.58-8 Capital gains and stock options.
1.58-9 Application of the tax benefit rule to the minimum tax for 
          taxable years beginning prior to 1987.
1.59-1 Optional 10-year writeoff of certain tax preferences.
1.60 [Reserved]

    Authority: 26 U.S.C 7805, unless otherwise noted.
    Section 1.1(h)-1 also issued under 26 U.S.C. 1(h).
    Section 1.21-1 also issued under 26 U.S.C. 21(f).
    Section 1.21-2 also issued under 26 U.S.C. 21(f).
    Section 1.21-3 also issued under 26 U.S.C. 21(f).
    Section 1.21-4 also issued under 26 U.S.C. 21(f).
    Sections 1.23-1--1.23-6 also issued under 26 U.S.C. 23;
    Section 1.25-1T also issued under 26 U.S.C. 25.
    Section 1.25-2T also issued under 26 U.S.C. 25.
    Section 1.25-3 also issued under 26 U.S.C. 25.
    Section 1.25-3T also issued under 26 U.S.C. 25.
    Section 1.25-4T also issued under 26 U.S.C. 25.
    Section 1.25-5T also issued under 26 U.S.C. 25.
    Section 1.25-6T also issued under 26 U.S.C. 25.
    Section 1.25-7T also issued under 26 U.S.C. 25.
    Section 1.25-8T also issued under 26 U.S.C. 25.

[[Page 8]]

    Section 1.25A-1 also issued under section 26 U.S.C. 25A(i).
    Section 1.25A-2 also issued under section 26 U.S.C. 25A(i).
    Section 1.25A-3 also issued under section 26 U.S.C. 25A(i).
    Section 1.25A-4 also issued under section 26 U.S.C. 25A(i).
    Section 1.25A-5 also issued under section 26 U.S.C. 25A(i).
    Section 1.28-0 also issued under 26 U.S.C. 28(d)(5);
    Section 1.28-1 also issued under 26 U.S.C. 28(d)(5);
    Section 1.30-1 also issued under 26 U.S.C. 30(d)(2);
    Section 1.41-6 also issued under 26 U.S.C. 1502;
    Section 1.41-8T also issued under 26 U.S.C. 41(c)(4)(B);
    Section 1.41-9T also issued under 26 U.S.C. 41(c)(5)(C);
    Section 1.42-1 also issued under 26 U.S.C. 42(n);
    Sections 1.42-1T and 1.42-2T also issued under 26 U.S.C. 42(m);
    Section 1.42-2 also issued under 26 U.S.C. 42(m);
    Section 1.42-3 also issued under 26 U.S.C. 42(n);
    Section 1.42-4 also issued under 26 U.S.C. 42(n);
    Section 1.42-5 also issued under 26 U.S.C. 42(n);
    Sections 1.42-6, 1.42-8, 1.42-9, 1.42-10, 1.42-11, and 1.42-12, also 
issued under 26 U.S.C. 42(n);
    Section 1.42-13 also issued under 26 U.S.C. 42(n);
    Section 1.42-14 also issued under 26 U.S.C. 42(n);
    Section 1.42-15 also issued under 26 U.S.C. 42(n);
    Section 1.42-16 also issued under 26 U.S.C. 42(n);
    Section 1.42-17 also issued under 26 U.S.C. 42(n);
    Sections 1.43-0--1.43-7 also issued under section 26 U.S.C. 43;
    Section 1.45D-1 also issued under 26 U.S.C. 45D(i);
    Section 1.46-5 also issued under 26 U.S.C. 46(d)(6) and 26 U.S.C. 
47(a)(3)(C);
    Section 1.46-6 also issued under 26 U.S.C. 46(f)(7);
    Section 1.47-1 also issued under 26 U.S.C. 47(a);
    Section 1.48-9 also issued under 26 U.S.C. 38(b) (as in effect 
before the amendments made by subtitle F of the Tax Reform Act of 1984);
    Sections 1.50A--1.50B also issued under 85 Stat. 553 (26 U.S.C. 
40(b));
    Section 1.52-1 also issued under 26 U.S.C. 52(b);
    Section 1.56-1 also issued under 26 U.S.C. 56(f)(2)(H);
    Section 1.56(g)-1 also issued under section 7611(g)(3) of the 
Omnibus Budget Reconciliation Act of 1989 (Pub. L. 101-239, 103 Stat. 
2373); and
    Section 1.58-9 also issued under 26 U.S.C. 58(h).

    Source: T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 
1960, unless otherwise noted.



Sec. 1.0-1  Internal Revenue Code of 1954 and regulations.

    (a) Enactment of law. The Internal Revenue Code of 1954 which became 
law upon enactment of Public Law 591, 83d Congress, approved August 16, 
1954, provides in part as follows:

    Be it enacted by the Senate and House of Representatives of the 
United States of America in Congress assembled, That
    (a) Citation. (1) The provisions of this Act set forth under the 
heading ``Internal Revenue Title'' may be cited as the ``Internal 
Revenue Code of 1954''
    (2) The Internal Revenue Code enacted on February 10, 1939, as 
amended, may be cited as the ``Internal Revenue Code of 1939''.
    (b) Publication. This Act shall be published as volume 68A of the 
United States Statutes at Large, with a comprehensive table of contents 
and an appendix; but without an index or marginal references. The date 
of enactment, bill number, public law number, and chapter number, shall 
be printed as a headnote.
    (c) Cross reference. For saving provisions, effective date 
provisions, and other related provisions, see chapter 80 (sec. 7801 and 
following) of the Internal Revenue Code of 1954.
    (d) Enactment of Internal Revenue Title into law. The Internal 
Revenue Title referred to in subsection (a)(1) is as follows:

                                * * * * *

In general, the provisions of the Internal Revenue Code of 1954 are 
applicable with respect to taxable years beginning after December 31, 
1953, and ending after August 16, 1954. Certain provisions of that Code 
are deemed to be included in the Internal Revenue Code of 1939. See 
section 7851.
    (b) Scope of regulations. The regulations in this part deal with (1) 
the income taxes imposed under subtitle A of the Internal Revenue Code 
of 1954, and (2) certain administrative provisions contained in subtitle 
F of such Code relating to such taxes. In general, the applicability of 
such regulations is commensurate with the applicability of the 
respective provisions of the Internal Revenue Code of 1954 except that 
with respect to the provisions of the Internal Revenue Code of 1954 
which are deemed to be included in the

[[Page 9]]

Internal Revenue Code of 1939, the regulations relating to such 
provisions are applicable to certain fiscal years and short taxable 
years which are subject to the Internal Revenue Code of 1939. Those 
provisions of the regulations which are applicable to taxable years 
subject to the Internal Revenue Code of 1939 and the specific taxable 
years to which such provisions are so applicable are identified in each 
instance. The regulations in 26 CFR (1939) part 39 (Regulations 118) are 
continued in effect until superseded by the regulations in this part. 
See Treasury Decision 6091, approved August 16, 1954 (19 FR 5167, C.B. 
1954-2, 47).

                        Normal Taxes and Surtaxes

                     DETERMINATION OF TAX LIABILITY

                           Tax on Individuals



Sec. 1.1-1  Income tax on individuals.

    (a) General rule. (1) Section 1 of the Code imposes an income tax on 
the income of every individual who is a citizen or resident of the 
United States and, to the extent provided by section 871(b) or 877(b), 
on the income of a nonresident alien individual. For optional tax in the 
case of taxpayers with adjusted gross income of less than $10,000 (less 
than $5,000 for taxable years beginning before January 1, 1970) see 
section 3. The tax imposed is upon taxable income (determined by 
subtracting the allowable deductions from gross income). The tax is 
determined in accordance with the table contained in section 1. See 
subparagraph (2) of this paragraph for reference guides to the 
appropriate table for taxable years beginning on or after January 1, 
1964, and before January 1, 1965, taxable years beginning after December 
31, 1964, and before January 1, 1971, and taxable years beginning after 
December 31, 1970. In certain cases credits are allowed against the 
amount of the tax. See part IV (section 31 and following), subchapter A, 
chapter 1 of the Code. In general, the tax is payable upon the basis of 
returns rendered by persons liable therefor (subchapter A (sections 6001 
and following), chapter 61 of the Code) or at the source of the income 
by withholding. For the computation of tax in the case of a joint return 
of a husband and wife, or a return of a surviving spouse, for taxable 
years beginning before January 1, 1971, see section 2. The computation 
of tax in such a case for taxable years beginning after December 31, 
1970, is determined in accordance with the table contained in section 
1(a) as amended by the Tax Reform Act of 1969. For other rates of tax on 
individuals, see section 5(a). For the imposition of an additional tax 
for the calendar years 1968, 1969, and 1970, see section 51(a).
    (2)(i) For taxable years beginning on or after January 1, 1964, the 
tax imposed upon a single individual, a head of a household, a married 
individual filing a separate return, and estates and trusts is the tax 
imposed by section 1 determined in accordance with the appropriate table 
contained in the following subsection of section 1:

----------------------------------------------------------------------------------------------------------------
                                                                                         Taxable years beginning
                                                                                           after Dec. 31, 1970
                                       Taxable years beginning  Taxable years beginning    (references in this
                                               in 1964           after 1964 but before    column are to the Code
                                                                          1971            as amended by the Tax
                                                                                           Reform Act of 1969)
----------------------------------------------------------------------------------------------------------------
Single individual....................  Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(c).
Head of a household..................  Sec. 1(b)(1)...........  Sec. 1(b)(2)...........  Sec. 1(b).
Married individual filing a separate   Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(d).
 return.
Estates and trusts...................  Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(d).
----------------------------------------------------------------------------------------------------------------

    (ii) For taxable years beginning after December 31, 1970, the tax 
imposed by section 1(d), as amended by the Tax Reform Act of 1969, shall 
apply to the income effectively connected with the conduct of a trade or 
business in the United States by a married alien individual who is a 
nonresident of the United States for all or part of the taxable year or 
by a foreign estate or trust. For such years the tax imposed by section 
1(c), as amended by such Act, shall apply to the income effectively 
connected with the conduct of a trade or business in the United States 
by an unmarried alien individual (other than a surviving spouse) who is 
a nonresident of the United States for all or

[[Page 10]]

part of the taxable year. See paragraph (b)(2) of Sec. 1.871-8.
    (3) The income tax imposed by section 1 upon any amount of taxable 
income is computed by adding to the income tax for the bracket in which 
that amount falls in the appropriate table in section 1 the income tax 
upon the excess of that amount over the bottom of the bracket at the 
rate indicated in such table.
    (4) The provisions of section 1 of the Code, as amended by the Tax 
Reform Act of 1969, and of this paragraph may be illustrated by the 
following examples:

    Example 1. A, an unmarried individual, had taxable income for the 
calendar year 1964 of $15,750. Accordingly, the tax upon such taxable 
income would be $4,507.50, computed as follows from the table in section 
1(a)(1):

Tax on $14,000 (from table).................................   $3,790.00
Tax on $1,750 (at 41 percent as determined from the table)..      717.50
                                                             -----------
    Total tax on $15,750....................................    4,507.50
 

    Example 2. Assume the same facts as in example (1), except the 
figures are for the calendar year 1965. The tax upon such taxable income 
would be $4,232.50, computed as follows from the table in section 
1(a)(2):

Tax on $14,000 (from table).................................   $3,550.00
Tax on $1,750 (at 39 percent as determined from the table)..      682.50
                                                             -----------
    Total tax on $15,750....................................    4,232.50
 

    Example 3. Assume the same facts as in example (1), except the 
figures are for the calendar year 1971. The tax upon such taxable income 
would be $3,752.50, computed as follows from the table in section 1(c), 
as amended:

Tax on $14,000 (from table).................................   $3,210.00
Tax on $1,750 (at 31 percent as determined from the table)..      542.50
                                                             -----------
    Total tax on $15,750....................................    3,752.50
 

    (b) Citizens or residents of the United States liable to tax. In 
general, all citizens of the United States, wherever resident, and all 
resident alien individuals are liable to the income taxes imposed by the 
Code whether the income is received from sources within or without the 
United States. Pursuant to section 876, a nonresident alien individual 
who is a bona fide resident of a section 931 possession (as defined in 
Sec. 1.931-1(c)(1) of this chapter) or Puerto Rico during the entire 
taxable year is, except as provided in section 931 or 933 with respect 
to income from sources within such possessions, subject to taxation in 
the same manner as a resident alien individual. As to tax on nonresident 
alien individuals, see sections 871 and 877.
    (c) Who is a citizen. Every person born or naturalized in the United 
States and subject to its jurisdiction is a citizen. For other rules 
governing the acquisition of citizenship, see chapters 1 and 2 of title 
III of the Immigration and Nationality Act (8 U.S.C. 1401-1459). For 
rules governing loss of citizenship, see sections 349 to 357, inclusive, 
of such Act (8 U.S.C. 1481-1489), Schneider v. Rusk, (1964) 377 U.S. 
163, and Rev. Rul. 70-506, C.B. 1970-2, 1. For rules pertaining to 
persons who are nationals but not citizens at birth, e.g., a person born 
in American Samoa, see section 308 of such Act (8 U.S.C. 1408). For 
special rules applicable to certain expatriates who have lost 
citizenship with a principal purpose of avoiding certain taxes, see 
section 877. A foreigner who has filed his declaration of intention of 
becoming a citizen but who has not yet been admitted to citizenship by a 
final order of a naturalization court is an alien.
    (d) Effective/applicability date. The second sentence of paragraph 
(b) of this section applies to taxable years ending after April 9, 2008.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 
44216, Dec. 23, 1974; T.D. 9391, 73 FR 19358, Apr. 9, 2008]



Sec. 1.1-2  Limitation on tax.

    (a) Taxable years ending before January 1, 1971. For taxable years 
ending before January 1, 1971, the tax imposed by section 1 (whether by 
subsection (a) or subsection (b) thereof) shall not exceed 87 percent of 
the taxable income for the taxable year. For purposes of determining 
this limitation the tax under section 1 (a) or (b) and the tax at the 
87-percent rate shall each be computed before the allowance of any 
credits against the tax. Where the alternative tax on capital gains is 
imposed under section 1201(b), the 87-percent limitation shall apply 
only to the partial tax computed on the taxable income reduced by 50 
percent of the excess of net long-term capital gains over net short-

[[Page 11]]

term capital losses. Where, for purposes of computations under the 
income averaging provisions, section 1201(b) is treated as imposing the 
alternative tax on capital gains computed under section 1304(e)(2), the 
87-percent limitation shall apply only to the tax equal to the tax 
imposed by section 1, reduced by the amount of the tax imposed by 
section 1 which is attributable to capital gain net income for the 
computation year.
    (b) Taxable years beginning after December 31, 1970. If, for any 
taxable year beginning after December 31, 1970, an individual has earned 
taxable income which exceeds his taxable income as defined by section 
1348, the tax imposed by section 1, as amended by the Tax Reform Act of 
1969, shall not exceed the sum computed under the provisions of section 
1348. For imposition of minimum tax for tax preferences see sections 56 
through 58.

[T.D. 7117, 36 FR 9397, May 25, 1971]



Sec. 1.1-3  Change in rates applicable to taxable year.

    For computation of the tax for a taxable year during which a change 
in the tax rates occurs, see section 21 and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated by T.D. 7117, 36 FR 
9397, May 25, 1971]



Sec. 1.1(h)-1  Capital gains look-through rule for sales or exchanges of 

interests in a partnership, S corporation, or trust.

    (a) In general. When an interest in a partnership held for more than 
one year is sold or exchanged, the transferor may recognize ordinary 
income (e.g., under section 751(a)), collectibles gain, section 1250 
capital gain, and residual long-term capital gain or loss. When stock in 
an S corporation held for more than one year is sold or exchanged, the 
transferor may recognize ordinary income (e.g., under sections 304, 306, 
341, 1254), collectibles gain, and residual long-term capital gain or 
loss. When an interest in a trust held for more than one year is sold or 
exchanged, a transferor who is not treated as the owner of the portion 
of the trust attributable to the interest sold or exchanged (sections 
673 through 679) (a non-grantor transferor) may recognize collectibles 
gain and residual long-term capital gain or loss.
    (b) Look-through capital gain--(1) In general. Look-through capital 
gain is the share of collectibles gain allocable to an interest in a 
partnership, S corporation, or trust, plus the share of section 1250 
capital gain allocable to an interest in a partnership, determined under 
paragraphs (b)(2) and (3) of this section.
    (2) Collectibles gain--(i) Definition. For purposes of this section, 
collectibles gain shall be treated as gain from the sale or exchange of 
a collectible (as defined in section 408(m) without regard to section 
408(m)(3)) that is a capital asset held for more than 1 year.
    (ii) Share of collectibles gain allocable to an interest in a 
partnership, S corporation, or a trust. When an interest in a 
partnership, S corporation, or trust held for more than one year is sold 
or exchanged in a transaction in which all realized gain is recognized, 
the transferor shall recognize as collectibles gain the amount of net 
gain (but not net loss) that would be allocated to that partner (taking 
into account any remedial allocation under Sec. 1.704-3(d)), 
shareholder, or beneficiary (to the extent attributable to the portion 
of the partnership interest, S corporation stock, or trust interest 
transferred that was held for more than one year) if the partnership, S 
corporation, or trust transferred all of its collectibles for cash equal 
to the fair market value of the assets in a fully taxable transaction 
immediately before the transfer of the interest in the partnership, S 
corporation, or trust. If less than all of the realized gain is 
recognized upon the sale or exchange of an interest in a partnership, S 
corporation, or trust, the same methodology shall apply to determine the 
collectibles gain recognized by the transferor, except that the 
partnership, S corporation, or trust shall be treated as transferring 
only a proportionate amount of each of its collectibles determined as a 
fraction that is the amount of gain recognized in the sale or exchange 
over the amount of gain realized in the sale or exchange. With respect 
to the transfer of an interest in a trust, this paragraph (b)(2) applies 
only to transfers by non-

[[Page 12]]

grantor transferors (as defined in paragraph (a) of this section). This 
paragraph (b)(2) does not apply to a transaction that is treated, for 
Federal income tax purposes, as a redemption of an interest in a 
partnership, S corporation, or trust.
    (3) Section 1250 capital gain--(i) Definition. For purposes of this 
section, section 1250 capital gain means the capital gain (not otherwise 
treated as ordinary income) that would be treated as ordinary income if 
section 1250(b)(1) included all depreciation and the applicable 
percentage under section 1250(a) were 100 percent.
    (ii) Share of section 1250 capital gain allocable to interest in 
partnership. When an interest in a partnership held for more than one 
year is sold or exchanged in a transaction in which all realized gain is 
recognized, there shall be taken into account under section 
1(h)(7)(A)(i) in determining the partner's unrecaptured section 1250 
gain the amount of section 1250 capital gain that would be allocated 
(taking into account any remedial allocation under Sec. 1.704-3(d)) to 
that partner (to the extent attributable to the portion of the 
partnership interest transferred that was held for more than one year) 
if the partnership transferred all of its section 1250 property in a 
fully taxable transaction for cash equal to the fair market value of the 
assets immediately before the transfer of the interest in the 
partnership. If less than all of the realized gain is recognized upon 
the sale or exchange of an interest in a partnership, the same 
methodology shall apply to determine the section 1250 capital gain 
recognized by the transferor, except that the partnership shall be 
treated as transferring only a proportionate amount of each section 1250 
property determined as a fraction that is the amount of gain recognized 
in the sale or exchange over the amount of gain realized in the sale or 
exchange. This paragraph (b)(3) does not apply to a transaction that is 
treated, for Federal income tax purposes, as a redemption of a 
partnership interest.
    (iii) Limitation with respect to net section 1231 gain. In 
determining a transferor partner's net section 1231 gain (as defined in 
section 1231(c)(3)) for purposes of section 1(h)(7)(B), the transferor 
partner's allocable share of section 1250 capital gain in partnership 
property shall not be treated as section 1231 gain, regardless of 
whether the partnership property is used in the trade or business (as 
defined in section 1231(b)).
    (c) Residual long-term capital gain or loss. The amount of residual 
long-term capital gain or loss recognized by a partner, shareholder of 
an S corporation, or beneficiary of a trust on account of the sale or 
exchange of an interest in a partnership, S corporation, or trust shall 
equal the amount of long-term capital gain or loss that the partner 
would recognize under section 741, that the shareholder would recognize 
upon the sale or exchange of stock of an S corporation, or that the 
beneficiary would recognize upon the sale or exchange of an interest in 
a trust (pre-look-through long-term capital gain or loss) minus the 
amount of look-through capital gain determined under paragraph (b) of 
this section.
    (d) Special rule for tiered entities. In determining whether a 
partnership, S corporation, or trust has gain from collectibles, such 
partnership, S corporation, or trust shall be treated as owning its 
proportionate share of the collectibles of any partnership, S 
corporation, or trust in which it owns an interest either directly or 
indirectly through a chain of such entities. In determining whether a 
partnership has section 1250 capital gain, such partnership shall be 
treated as owning its proportionate share of the section 1250 property 
of any partnership in which it owns an interest, either directly or 
indirectly through a chain of partnerships.
    (e) Notification requirements. Reporting rules similar to those that 
apply to the partners and the partnership under section 751(a) shall 
apply in the case of sales or exchanges of interests in a partnership, S 
corporation, or trust that cause holders of such interests to recognize 
collectibles gain and in the case of sales or exchanges of interests in 
a partnership that cause holders of such interests to recognize section 
1250 capital gain. See Sec. 1.751-1(a)(3).

[[Page 13]]

    (f) Examples. The following examples illustrate the requirements of 
this section:

    Example 1. Collectibles gain. (i) A and B are equal partners in a 
personal service partnership (PRS). B transfers B's interest in PRS to T 
for $15,000 when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................    $3,000    $3,000
Loans Owed to Partnership...........................    10,000    10,000
  Collectibles......................................     1,000     3,000
  Other Capital Assets..............................     6,000     2,000
                                                     -------------------
Capital Assets......................................     7,000     5,000
Unrealized Receivables..............................         0    14,000
                                                     -------------------
    Total...........................................    20,000    32,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                        LIABILITIES AND
                                                            CAPITAL
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Liabilities.........................................     2,000     2,000
Capital:
  A.................................................     9,000    15,000
  B.................................................     9,000    15,000
                                                     -------------------
    Total...........................................    20,000    32,000
------------------------------------------------------------------------

    (ii) At the time of the transfer, B has held the interest in PRS for 
more than one year, and B's basis for the partnership interest is 
$10,000 ($9,000 plus $1,000, B's share of partnership liabilities). None 
of the property owned by PRS is section 704(c) property. The total 
amount realized by B is $16,000, consisting of the cash received, 
$15,000, plus $1,000, B's share of the partnership liabilities assumed 
by T. See section 752. B's undivided one-half interest in PRS includes a 
one-half interest in the partnership's unrealized receivables and a one-
half interest in the partnership's collectibles.
    (iii) If PRS were to sell all of its section 751 property in a fully 
taxable transaction for cash equal to the fair market value of the 
assets immediately prior to the transfer of B's partnership interest to 
T, B would be allocated $7,000 of ordinary income from the sale of PRS's 
unrealized receivables. Therefore, B will recognize $7,000 of ordinary 
income with respect to the unrealized receivables. The difference 
between the amount of capital gain or loss that the partner would 
realize in the absence of section 751 ($6,000) and the amount of 
ordinary income or loss determined under Sec. 1.751-1(a)(2) ($7,000) is 
the partner's capital gain or loss on the sale of the partnership 
interest under section 741. In this case, the transferor has a $1,000 
pre-look-through long-term capital loss.
    (iv) If PRS were to sell all of its collectibles in a fully taxable 
transaction for cash equal to the fair market value of the assets 
immediately prior to the transfer of B's partnership interest to T, B 
would be allocated $1,000 of gain from the sale of the collectibles. 
Therefore, B will recognize $1,000 of collectibles gain on account of 
the collectibles held by PRS.
    (v) The difference between the transferor's pre-look-through long-
term capital gain or loss (-$1,000) and the look-through capital gain 
determined under this section ($1,000) is the transferor's residual 
long-term capital gain or loss on the sale of the partnership interest. 
Under these facts, B will recognize a $2,000 residual long-term capital 
loss on account of the sale or exchange of the interest in PRS.
    Example 2. Special allocations. Assume the same facts as in Example 
1, except that under the partnership agreement, all gain from the sale 
of the collectibles is specially allocated to B, and B transfers B's 
interest to T for $16,000. All items of income, gain, loss, or deduction 
of PRS, other than the gain from the collectibles, are divided equally 
between A and B. Under these facts, B's amount realized is $17,000, 
consisting of the cash received, $16,000, plus $1,000, B's share of the 
partnership liabilities assumed by T. See section 752. B will recognize 
$7,000 of ordinary income with respect to the unrealized receivables 
(determined under Sec. 1.751-1(a)(2)). Accordingly, B's pre-look-
through long-term capital gain would be $0. If PRS were to sell all of 
its collectibles in a fully taxable transaction for cash equal to the 
fair market value of the assets immediately prior to the transfer of B's 
partnership interest to T, B would be allocated $2,000 of gain from the 
sale of the collectibles. Therefore, B will recognize $2,000 of 
collectibles gain on account of the collectibles held by PRS. B will 
recognize a $2,000 residual long-term capital loss on account of the 
sale of B's interest in PRS.
    Example 3. Net collectibles loss ignored. Assume the same facts as 
in Example 1, except that the collectibles held by PRS have an adjusted 
basis of $3,000 and a fair market value of $1,000, and the other capital 
assets have an adjusted basis of $4,000 and a fair market value of 
$4,000. (The total adjusted basis and fair market value of the 
partnership's capital assets are the same as in Example 1.) If PRS were 
to sell all of its collectibles in a fully taxable transaction for cash 
equal to the fair market value of the assets immediately prior to the 
transfer of B's partnership interest to T, B would be allocated $1,000 
of loss from the sale of the collectibles. Because none of the gain from 
the sale of the interest in PRS is attributable to unrealized 
appreciation in the value of collectibles held by PRS, the net loss in 
collectibles held by PRS is not recognized at the time B transfers the 
interest in PRS. B will recognize $7,000 of

[[Page 14]]

ordinary income (determined under Sec. 1.751-1(a)(2)) and a $1,000 
long-term capital loss on account of the sale of B's interest in PRS.
    Example 4. Collectibles gain in an S corporation. (i) A corporation 
(X) has always been an S corporation and is owned by individuals A, B, 
and C. In 1996, X invested in antiques. Subsequent to their purchase, 
the antiques appreciated in value by $300. A owns one-third of the 
shares of X stock and has held that stock for more than one year. A's 
adjusted basis in the X stock is $100. If A were to sell all of A's X 
stock to T for $150, A would realize $50 of pre-look-through long-term 
capital gain.
    (ii) If X were to sell its antiques in a fully taxable transaction 
for cash equal to the fair market value of the assets immediately before 
the transfer to T, A would be allocated $100 of gain on account of the 
sale. Therefore, A will recognize $100 of collectibles gain (look-
through capital gain) on account of the collectibles held by X.
    (iii) The difference between the transferor's pre-look-through long-
term capital gain or loss ($50) and the look-through capital gain 
determined under this section ($100) is the transferor's residual long-
term capital gain or loss on the sale of the S corporation stock. Under 
these facts, A will recognize $100 of collectibles gain and a $50 
residual long-term capital loss on account of the sale of A's interest 
in X.
    Example 5. Sale or exchange of partnership interest where part of 
the interest has a short-term holding period. (i) A, B, and C form an 
equal partnership (PRS). In connection with the formation, A contributes 
$5,000 in cash and a capital asset with a fair market value of $5,000 
and a basis of $2,000; B contributes $7,000 in cash and a collectible 
with a fair market value of $3,000 and a basis of $3,000; and C 
contributes $10,000 in cash. At the time of the contribution, A had held 
the contributed property for two years. Six months later, when A's basis 
in PRS is $7,000, A transfers A's interest in PRS to T for $14,000 at a 
time when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................   $22,000   $22,000
Unrealized Receivables..............................         0     6,000
  Capital Asset.....................................     2,000     5,000
  Collectible.......................................     3,000     9,000
Capital Assets......................................     5,000    14,000
                                                     -------------------
    Total...........................................    27,000    42,000
------------------------------------------------------------------------

    (ii) Although at the time of the transfer A has not held A's 
interest in PRS for more than one year, 50 percent of the fair market 
value of A's interest in PRS was received in exchange for a capital 
asset with a long-term holding period. Therefore, 50 percent of A's 
interest in PRS has a long-term holding period. See Sec. 1.1223-
3(b)(1).
    (iii) If PRS were to sell all of its section 751 property in a fully 
taxable transaction immediately before A's transfer of the partnership 
interest, A would be allocated $2,000 of ordinary income. Accordingly, A 
will recognize $2,000 ordinary income and $5,000 ($7,000-$2,000) of 
capital gain on account of the transfer to T of A's interest in PRS. 
Fifty percent ($2,500) of that gain is long-term capital gain and 50 
percent ($2,500) is short-term capital gain. See Sec. 1.1223-3(c)(1).
    (iv) If the collectible were sold or exchanged in a fully taxable 
transaction immediately before A's transfer of the partnership interest, 
A would be allocated $2,000 of gain attributable to the collectible. The 
gain attributable to the collectible that is allocable to the portion of 
the transferred interest in PRS with a long-term holding period is 
$1,000 (50 percent of $2,000). Accordingly, A will recognize $1,000 of 
collectibles gain on account of the transfer of A's interest in PRS.
    (v) The difference between the amount of pre-look-through long-term 
capital gain or loss ($2,500) and the look-through capital gain ($1,000) 
is the amount of residual long-term capital gain or loss that A will 
recognize on account of the transfer of A's interest in PRS. Under these 
facts, A will recognize a residual long-term capital gain of $1,500 and 
a short-term capital gain of $2,500.

    (g) Effective date. This section applies to transfers of interests 
in partnerships, S corporations, and trusts that occur on or after 
September 21, 2000.

[T.D. 8902, 65 FR 57096, Sept. 21, 2000]



Sec. 1.1(i)-1T  Questions and answers relating to the tax on unearned income 

certain minor children (Temporary).

                               In General

    Q-1. To whom does section 1(i) apply?
    A-1. Section 1(i) applies to any child who is under 14 years of age 
at the close of the taxable year, who has at least one living parent at 
the close of the taxable year, and who recognizes over $1,000 of 
unearned income during the taxable year.
    Q-2. What is the effective date of section 1(i)?
    A-2. Section 1(i) applies to taxable years of the child beginning 
after December 31, 1986.

[[Page 15]]

                           Computation of Tax

    Q-3. What is the amount of tax imposed by section 1 on a child to 
whom section 1(i) applies?
    A-3. In the case of a child to whom section 1(i) applies, the amount 
of tax imposed by section 1 equals the greater of (A) the tax imposed by 
section 1 without regard to section 1(i) or (B) the sum of the tax that 
would be imposed by section 1 if the child's taxable income was reduced 
by the child's net unearned income, plus the child's share of the 
allocable parental tax.
    Q-4. What is the allocable parental tax?
    A-4. The allocable parental tax is the excess of (A) the tax that 
would be imposed by section 1 on the sum of the parent's taxable income 
plus the net unearned income of all children of such parent to whom 
section 1(i) applies, over (B) the tax imposed by section 1 on the 
parent's taxable income. Thus, the allocable parental tax is not 
computed with reference to unearned income of a child over 14 or a child 
under 14 with less than $1,000 of unearned income. See A-10 through A-13 
for rules regarding the determination of the parent(s) whose taxable 
income is taken into account under section 1(i). See A-14 for rules 
regarding the determination of children of the parent whose net unearned 
income is taken into account under section 1(i).
    Q-5. What is the child's share of the allocable parental tax?
    A-5. The child's share of the allocable parental tax is an amount 
that bears the same ratio to the total allocable parental tax as the 
child's net unearned income bears to the total net unearned income of 
all children of such parent to whom section 1(i) applies. See A-14.

    Example 1. During 1988, D, and a 12 year old, receives $5,000 of 
unearned income and no earned income. D has no itemized deductions and 
is not eligible for a personal exemption. D's parents have two other 
children, E, a 15 year old, and F, a 10 year old. E has $10,000 of 
unearned income and F has $100 of unearned income. D's parents file a 
joint return for 1988 and report taxable income of $70,000. Neither D's 
nor his parent's taxable income is attributable to net capital gain. D's 
tax liability for 1988, determined without regard to section 1(i), is 
$675 on $4,500 of taxable income ($5,000 less $500 allowable standard 
deduction). In applying section 1(i), D's tax would be equal to the sum 
of (A) the tax that would be imposed on D's taxable income if it were 
reduced by any net unearned income, plus (B) D's share of the allocable 
parental tax. Only D's unearned income is taken into account in 
determining the allocable parental tax because E is over 14 and F has 
less than $1,000 of unearned income. See A-4. D's net unearned income is 
$4,000 ($4,500 taxable unearned income less $500). The tax imposed on 
D's taxable income as reduced by D's net unearned income is $75 
($500x15%). The allocable parental tax is $1,225, the excess of 
$16,957.50 (the tax on $74,000, the parent's taxable income plus D's net 
unearned income) over $15,732.50 (the tax on $70,000, the parent's 
taxable income). See A-4. Thus, D's tax under section 1(i)(1)(B) is 
$1,300 ($1,225+$75). Since this amount is greater than the amount of D's 
tax liability as determined without regard to section 1(i), the amount 
of tax imposed on D for 1988 is $1,300. See A-3.
    Example 2. H and W have 3 children, A, B, and C, who are all under 
14 years of age. For the taxable year 1988, H and W file a joint return 
and report taxable income of $129,750. The tax imposed by section 1 on H 
and W is $35,355. A has $5,000 of net unearned income and B and C each 
have $2,500 of net unearned income during 1988. The allocable parental 
tax imposed on A, B, and C's combined net unearned income of $10,000 is 
$3,300. This tax is the excess of $38,655, which is the tax imposed by 
section 1 on $139,750 ($129,750+10,000), over $35,355 (the tax imposed 
by section 1 on H and W's taxable income of $129,750). See A-4. Each 
child's share of the allocable parental tax is an amount that bears the 
same ratio to the total allocable parental tax as the child's net 
unearned income bears to the total net unearned income of A, B, and C. 
Thus, A's share of the allocable parental tax is $1,650 (5,000/
10,000x3,300) and B and C's share of the tax is $825 (2,500/
10,000x3,300) each. See A-5.

                    Definition of Net Unearned Income

    Q-6. What is net unearned income?
    A-6. Net unearned income is the excess of the portion of adjusted 
gross income for the taxable year that is not ``earned income'' as 
defined in section 911(d)(2) (income that is not attributable to wages, 
salaries, or other amounts received as compensation for personal 
services), over the sum of the standard deduction amount provided for 
under section 63 (c)(5)(A) ($500 for 1987 and 1988; adjusted for 
inflation thereafter), plus the greater of (A) $500 (adjusted for 
inflation after 1988) or (B) the amount of allowable itemized deductions 
that are directly connected

[[Page 16]]

with the production of unearned income. A child's net unearned income 
for any taxable year shall not exceed the child's taxable income for 
such year.

    Example 3. A is a child who is under 14 years of age at the end of 
the taxable year 1987. Both of A's parents are alive at this time. 
During 1987, A receives $3,000 of interest from a bank savings account 
and earns $1,000 from a paper route and performing odd jobs. A has no 
itemized deductions for 1987. A's standard deduction is $1,000, which is 
an amount equal to A's earned income for 1987. Of this amount, $500 is 
applied against A's unearned income and the remaining $500 is applied 
against A's earned income. Thus, A's $500 of taxable earned income 
($1,000 less the remaining $500 of the standard deduction) is taxed 
without regard to section 1 (i); A has $2,500 of taxable unearned income 
($3,000 gross unearned income less $500 of the standard deduction) of 
which $500 is taxed without regard to section 1(i). The remaining $2,000 
of taxable unearned income is A's net unearned income and is taxed under 
section 1(i).
    Example 4. B is a child who is subject to tax under section 1(i). B 
has $400 of earned income and $2,000 of unearned income. B has itemized 
deductions of $800 (net of the 2 percent of adjusted gross income (AGI) 
floor on miscellaneous itemized deductions under section 67) of which 
$200 are directly connected with the production of unearned income. The 
amount of itemized deductions that B may apply against unearned income 
is equal to the greater of $500 or the deductions directly connected 
with the production of unearned income. See A-6. Thus, $500 of B's 
itemized deductions are applied against the $2,000 of unearned income 
and the remaining $300 of deductions are applied against earned income. 
As a result, B has taxable earned income of $100 and taxable unearned 
income of $1,500. Of these amounts, all of the earned income and $500 of 
the unearned income are taxed without regard to section 1(i). The 
remaining $1,000 of unearned income is net unearned income and is taxed 
under section 1(i).

            Unearned Income Subject to tax Under Section 1(i)

    Q-7. Will a child be subject to tax under section 1(i) on net 
unearned income (as defined in section 1(i) (4) and A-6 of this section) 
that is attributable to property transferred to the child prior to 1987?
    A-7. Yes. The tax imposed by section 1(i) on a child's net unearned 
income applies to any net unearned income of the child for taxable years 
beginning after December 31, 1986, regardless of when the underlying 
assets were transferred to the child.
    Q-8. Will a child be subject to tax under section 1(i) on net 
unearned income that is attributable to gifts from persons other than 
the child's parents or attributable to assets resulting from the child's 
earned income?
    A-8. Yes. The tax imposed by section 1(i) applies to all net 
unearned income of the child, regardless of the source of the assets 
that produced such income. Thus, the rules of section 1(i) apply to 
income attributable to gifts not only from the parents but also from any 
other source, such as the child's grandparents. Section 1(i) also 
applies to unearned income derived with respect to assets resulting from 
earned income of the child, such as interest earned on bank deposits.

    Example 5. A is a child who is under 14 years of age at the end of 
the taxable year beginning on January 1, 1987. Both of A's parents are 
alive at the end of the taxable year. During 1987, A receives $2,000 in 
interest from his bank account and $1,500 from a paper route. Some of 
the interest earned by A from the bank account is attributable to A's 
paper route earnings that were deposited in the account. The balance of 
the account is attributable to cash gifts from A's parents and 
grandparents and interest earned prior to 1987. Some cash gifts were 
received by A prior to 1987. A has no itemized deductions and is 
eligible to be claimed as a dependent on his parent's return. Therefore, 
for the taxable year 1987, A's standard deduction is $1,500, the amount 
of A's earned income. Of this standard deduction amount, $500 is 
allocated against unearned income and $1,000 is allocated against earned 
income. A's taxable unearned income is $1,500 of which $500 is taxed 
without regard to section 1(i). The remaining taxable unearned income of 
$1,000 is net unearned income and is taxed under section 1(i). The fact 
that some of A's unearned income is attributable to interest on 
principal created by earned income and gifts from persons other than A's 
parents or that some of the unearned income is attributable to property 
transferred to A prior to 1987, will not affect the tax treatment of 
this income under section 1(i). See A-8.

    Q-9. For purposes of section 1(i), does income which is not earned 
income (as defined in section 911(d)(2)) include social security 
benefits or pension benefits that are paid to the child?
    A-9. Yes. For purposes of section 1(i), earned income (as defined in 
section 911(d)(2)) does not include any social

[[Page 17]]

security or pension benefits paid to the child. Thus, such amounts are 
included in unearned income to the extent they are includible in the 
child's gross income.

              Determination of the Parent's Taxable Income

    Q-10. If a child's parents file a joint return, what is the taxable 
income that must be taken into account by the child in determining tax 
liability under section 1(i)?
    A-10. In the case of parents who file a joint return, the parental 
taxable income to be taken into account in determining the tax liability 
of a child is the total taxable income shown on the joint return.
    Q-11. If a child's parents are married and file separate tax 
returns, which parent's taxable income must be taken into account by the 
child in determining tax liability under section 1(i)?
    A-11. For purposes of determining the tax liability of a child under 
section 1(i), where such child's parents are married and file separate 
tax returns, the parent whose taxable income is the greater of the two 
for the taxable year shall be taken into account.
    Q-12. If the parents of a child are divorced, legally separated, or 
treated as not married under section 7703(b), which parent's taxable 
income is taken into account in computing the child's tax liability?
    A-12. If the child's parents are divorced, legally separated, or 
treated as not married under section 7703(b), the taxable income of the 
custodial parent (within the meaning of section 152(e)) of the child is 
taken into account under section 1(i) in determining the child's tax 
liability.
    Q-13. If a parent whose taxable income must be taken into account in 
determining a child's tax liability under section 1(i) files a joint 
return with a spouse who is not a parent of the child, what taxable 
income must the child take into account?
    A-13. The amount of a parent's taxable income that a child must take 
into account for purposes of section 1(i) where the parent files a joint 
return with a spouse who is not a parent of the child is the total 
taxable income shown on such joint return.

                         Children of the Parent

    Q-14. In determining a child's share of the allocable parental tax, 
is the net unearned income of legally adopted children, children related 
to such child by half-blood, or children from a prior marriage of the 
spouse of such child's parent taken into account in addition to the 
natural children of such child's parent?
    A-14. Yes. In determining a child's share of the allocable parental 
tax, the net unearned income of all children subject to tax under 
section 1(i) and who use the same parent's taxable income as such child 
to determine their tax liability under section 1(i) must be taken into 
account. Such children are taken into account regardless of whether they 
are adopted by the parent, related to such child by half-blood, or are 
children from a prior marriage of the spouse of such child's parent.

        Rules Regarding Income From a Trust or Similar Instrument

    Q-15. Will the unearned income of a child who is subject to section 
1(i) that is attributable to gifts given to the child under the Uniform 
Gift to Minors Act (UGMA) be subject to tax under section 1(i)?
    A-15. Yes. A gift under the UGMA vests legal title to the property 
in the child although an adult custodian is given certain rights to deal 
with the property until the child attains majority. Any unearned income 
attributable to such a gift is the child's unearned income and is 
subject to tax under section 1(i), whether distributed to the child or 
not.
    Q-16. Will a child who is a beneficiary of a trust be required to 
take into account the income of a trust in determining the child's tax 
liability under section 1(i)?
    A-16. The income of a trust must be taken into account for purposes 
of determining the tax liability of a beneficiary who is subject to 
section 1(i) only to the extent it is included in the child's gross 
income for the taxable year under sections 652(a) or 662(a). Thus, 
income from a trust for the fiscal taxable year of a trust ending during 
1987, that is included in the gross income of a child who is subject to 
section 1(i) and who has a calendar taxable year, will be subject to tax 
under

[[Page 18]]

section 1(i) for the child's 1987 taxable year.

                         Subsequent Adjustments

    Q-17. What effect will a subsequent adjustment to a parent's taxable 
income have on the child's tax liability if such parent's taxable income 
was used to determine the child's tax liability under section 1(i) for 
the same taxable year?
    A-17. If the parent's taxable income is adjusted and if, for the 
same taxable year as the adjustment, the child paid tax determined under 
section 1(i) with reference to that parent's taxable income, then the 
child's tax liability under section 1(i) must be recomputed using the 
parent's taxable income as adjusted.
    Q-18. In the case where more than one child who is subject to 
section 1(i) uses the same parent's taxable income to determine their 
allocable parental tax, what effect will a subsequent adjustment to the 
net unearned income of one child have on the other child's share of the 
allocable parental tax?
    A-18. If, for the same taxable year, more than one child uses the 
same parent's taxable income to determine their share of the allocable 
parental tax and a subsequent adjustment is made to one or more of such 
children's net unearned income, each child's share of the allocable 
parental tax must be recomputed using the combined net unearned income 
of all such children as adjusted.
    Q-19. If a recomputation of a child's tax under section 1(i), as a 
result of an adjustment to the taxable income of the child's parents or 
another child's net unearned income, results in additional tax being 
imposed by section 1(i) on the child, is the child subject to interest 
and penalties on such additional tax?
    A-19. Any additional tax resulting from an adjustment to the taxable 
income of the child's parents or the net unearned income of another 
child shall be treated as an underpayment of tax and interest shall be 
imposed on such underpayment as provided in section 6601. However, the 
child shall not be liable for any penalties on the underpayment 
resulting from additional tax being imposed under section 1(i) due to 
such an adjustment.

    Example 6. D and M are the parents of C, a child under the age of 
14. D and M file a joint return for 1988 and report taxable income of 
$69,900. C has unearned income of $3,000 and no itemized deductions for 
1988. C properly reports a total tax liability of $635 for 1988. This 
amount is the sum of the allocable parental tax of $560 on C's net 
unearned income of $2,000 (the excess of $3,000 over the sum of $500 
standard deduction and the first $500 of taxable unearned income) plus 
$75 (the tax imposed on C's first $500 of taxable unearned income). See 
A-3. One year later, D and M's 1988 tax return is adjusted on audit by 
adding an additional $1,000 of taxable income. No adjustment is made to 
the amount reported as C's net unearned income for 1988. However, the 
adjustment to D and M's taxable income causes C's tax liability under 
section 1(i) for 1988 to be increased by $50 as a result of the phase-
out of the 15 percent rate bracket. See A-20. In addition to this 
further tax liability, C will be liable for interest on the $50. 
However, C will not have to pay any penalty on the delinquent amount.

                           Miscellaneous Rules

    Q-20. Does the phase-out of the parent's 15 percent rate bracket and 
personal exemptions under section 1(g), if applicable, have any effect 
on the calculation of the allocable parental tax imposed on a child's 
net unearned income under section 1(i)?
    A-20. Yes. Any phase-out of the parent's 15 percent rate bracket or 
personal exemptions under section 1(g) is given full effect in 
determining the tax that would be imposed on the sum of the parent's 
taxable income and the total net unearned income of all children of the 
parent. Thus, any additional tax on a child's net unearned income 
resulting from the phase-out of the 15 percent rate bracket and the 
personal exemptions is reflected in the tax liability of the child.
    Q-21. For purposes of calculating a parent's tax liability or the 
allocable parental tax imposed on a child, are other phase-outs, 
limitations, or floors on deductions or credits, such as the phase-out 
of the $25,000 passive loss allowance for rental real estate activities 
under section 469(i)(3) or the 2 percent of AGI floor on miscellaneous 
itemized deductions under section 67, affected by the addition of a 
child's net unearned income to the parent's taxable income?

[[Page 19]]

    A-21. No. A child's net unearned income is not taken into account in 
computing any deduction or credit for purposes of determining the 
parent's tax liability or the child's allocable parental tax. Thus, for 
example, although the amounts allowable to the parent as a charitable 
contribution deduction, medical expense deduction, section 212 
deduction, or a miscellaneous itemized deduction are affected by the 
amount of the parent's adjusted gross income, the amount of these 
deductions that is allowed does not change as a result of the 
application of section 1(i) because the amount of the parent's adjusted 
gross income does not include the child's net unearned income. 
Similarly, the amount of itemized deductions that is allowed to a child 
does not change as a result of section 1(i) because section 1(i) only 
affects the amount of tax liability and not the child's adjusted gross 
income.
    Q-22. If a child is unable to obtain information concerning the tax 
return of the child's parents directly from such parents, how may the 
child obtain information from the parent's tax return which is necessary 
to determine the child's tax liability under section 1(i)?
    A-22. Under section 6103(e)(1)(A)(iv), a return of a parent shall, 
upon written request, be open to inspection or disclosure to a child of 
that individual (or the child's legal representative) to the extent 
necessary to comply with section 1(i). Thus, a child may request the 
Internal Revenue Service to disclose sufficient tax information about 
the parent to the child so that the child can properly file his or her 
return.

[T.D. 8158, 52 FR 33579, Sept. 4, 1987; 52 FR 36133, Sept. 25, 1987]



Sec. 1.2-1  Tax in case of joint return of husband and wife or the return of a 

surviving spouse.

    (a) Taxable year ending before January 1, 1971. (1) For taxable 
years ending before January 1, 1971, in the case of a joint return of 
husband and wife, or the return of a surviving spouse as defined in 
section 2(b), the tax imposed by section 1 shall be twice the tax that 
would be imposed if the taxable income were reduced by one-half. For 
rules relating to the filing of joint returns of husband and wife, see 
section 6013 and the regulations thereunder.
    (2) The method of computing, under section 2(a), the tax of husband 
and wife in the case of a joint return, or the tax of a surviving 
spouse, is as follows:
    (i) First, the taxable income is reduced by one-half. Second, the 
tax is determined as provided by section 1 by using the taxable income 
so reduced. Third, the tax so determined, which is the tax that would be 
determined if the taxable income were reduced by one-half, is then 
multiplied by two to produce the tax imposed in the case of the joint 
return or the return of a surviving spouse, subject, however, to the 
allowance of any credits against the tax under the provisions of 
sections 31 through 38 and the regulations thereunder.
    (ii) The limitation under section 1(c) of the tax to an amount not 
in excess of a specified percent of the taxable income for the taxable 
year is to be applied before the third step above, that is, the 
limitation to be applied upon the tax is determined as the applicable 
specified percent of one-half of the taxable income for the taxable year 
(such one-half of the taxable income being the actual aggregate taxable 
income of the spouses, or the total taxable income of the surviving 
spouse, as the case may be, reduced by one-half). For the percent 
applicable in determining the limitation of the tax under section 1(c), 
see Sec. 1.1-2(a). After such limitation is applied, then the tax so 
limited is multiplied by two as provided in section 2(a) (the third step 
above).
    (iii) The following computation illustrates the method of 
application of section 2(a) in the determination of the tax of a husband 
and wife filing a joint return for the calendar year 1965. If the 
combined gross income is $8,200, and the only deductions are the two 
exemptions of the taxpayers under section 151(b) and the standard 
deduction under section 141, the tax on the joint return for 1965, 
without regard to any credits against the tax, is $1,034.20 determined 
as follows:

1. Gross income.................................   $8,200.00
2. Less:
    Standard deduction, section 141.............        $820
    Deduction for personal exemption, section          1,200    2,020.00
     151........................................
                                                 -----------------------

[[Page 20]]

 
3. Taxable income...............................    6,180.00
4. Taxable income reduced by one-half...........    3,090.00
5. Tax computed by the tax table provided under       517.10
 section 1(a)(2) ($310 plus 19 percent of excess
 over $2,000)...................................
6. Twice the tax in item 5......................    1,034.20
 

    (b) Taxable years beginning after December 31, 1970. (1) For taxable 
years beginning after December 31, 1970, in the case of a joint return 
of husband and wife, or the return of a surviving spouse as defined in 
section 2(a) of the Code as amended by the Tax Reform Act of 1969, the 
tax shall be determined in accordance with the table contained in 
section 1(a) of the Code as so amended. For rules relating to the filing 
of joint returns of husband and wife see section 6013 as amended and the 
regulations thereunder.
    (2) The following computation illustrates the method of computing 
the tax of a husband and wife filing a joint return for calendar year 
1971. If the combined gross income is $8,200, and the only deductions 
are the two exemptions of the taxpayers under section 151(b), as 
amended, and the standard deduction under section 141, as amended, the 
tax on the joint return for 1971, without regard to any credits against 
the tax, is $968.46, determined as follows:

1. Gross income.................................   $8,200.00
2. Less:
  Standard deduction, section 141...............   $1,066.00
  Deduction for personal exemption, section 151.    1,300.00    2,366.00
                                                 -----------------------
3. Taxable income...............................    5,834.00
4. Tax computed by the tax table provided under       968.46
 section 1(a) ($620 plus 19 percent of excess
 over $4,000)...................................
 

    (3) The limitation under section 1348 with respect to the maximum 
rate of tax on earned income shall apply to a married individual only if 
such individual and his spouse file a joint return for the taxable year.
    (c) Death of a spouse. If a joint return of a husband and wife is 
filed under the provisions of section 6013 and if the husband and wife 
have different taxable years solely because of the death of either 
spouse, the taxable year of the deceased spouse covered by the joint 
return shall, for the purpose of the computation of the tax in respect 
of such joint return, be deemed to have ended on the date of the closing 
of the surviving spouse's taxable year.
    (d) Computation of optional tax. For computation of optional tax in 
the case of a joint return or the return of a surviving spouse, see 
section 3 and the regulations thereunder.
    (e) Change in rates. For treatment of taxable years during which a 
change in the tax rates occurs see section 21 and the regulations 
thereunder.

[T.D. 7117, 36 FR 9398, May 25, 1971]



Sec. 1.2-2  Definitions and special rules.

    (a) Surviving spouse. (1) If a taxpayer is eligible to file a joint 
return under the Internal Revenue Code of 1954 without regard to section 
6013(a) (3) thereof for the taxable year in which his spouse dies, his 
return for each of the next 2 taxable years following the year of the 
death of the spouse shall be treated as a joint return for all purposes 
if all three of the following requirements are satisfied:
    (i) He has not remarried before the close of the taxable year the 
return for which is sought to be treated as a joint return, and
    (ii) He maintains as his home a household which constitutes for the 
taxable year the principal place of abode as a member of such household 
of a person who is (whether by blood or adoption) a son, stepson, 
daughter, or stepdaughter of the taxpayer, and
    (iii) He is entitled for the taxable year to a deduction under 
section 151 (relating to deductions for dependents) with respect to such 
son, stepson, daughter, or stepdaughter.
    (2) See paragraphs (c)(1) and (d) of this section for rules for the 
determination of when the taxpayer maintains as his home a household 
which constitutes for the taxable year the principal place of abode, as 
a member of such household, of another person.
    (3) If the taxpayer does not qualify as a surviving spouse he may 
nevertheless qualify as a head of a household if he meets the 
requirements of Sec. 1.2-2(b).
    (4) The following example illustrates the provisions relating to a 
surviving spouse:

    Example: Assume that the taxpayer meets the requirements of this 
paragraph for the

[[Page 21]]

years 1967 through 1971, and that the taxpayer, whose wife died during 
1966 while married to him, remarried in 1968. In 1969, the taxpayer's 
second wife died while married to him, and he remained single 
thereafter. For 1967 the taxpayer will qualify as a surviving spouse, 
provided that neither the taxpayer nor the first wife was a nonresident 
alien at any time during 1966 and that she (immediately prior to her 
death) did not have a taxable year different from that of the taxpayer. 
For 1968 the taxpayer does not qualify as a surviving spouse because he 
remarried before the close of the taxable year. The taxpayer will 
qualify as a surviving spouse for 1970 and 1971, provided that neither 
the taxpayer nor the second wife was a nonresident alien at any time 
during 1969 and that she (immediately prior to her death) did not have a 
taxable year different from that of the taxpayer. On the other hand, if 
the taxpayer, in 1969, was divorced or legally separated from his second 
wife, the taxpayer will not qualify as a surviving spouse for 1970 or 
1971, since he could not have filed a joint return for 1969 (the year in 
which his second wife died).

    (b) Head of household. (1) A taxpayer shall be considered the head 
of a household if, and only if, he is not married at the close of his 
taxable year, is not a surviving spouse (as defined in paragraph (a) of 
this section, and (i) maintains as his home a household which 
constitutes for such taxable year the principal place of abode, as a 
member of such household, of at least one of the individuals described 
in subparagraph (3), or (ii) maintains (whether or not as his home) a 
household which constitutes for such taxable year the principal place of 
abode of one of the individuals described in subparagraph (4).
    (2) Under no circumstances shall the same person be used to qualify 
more than one taxpayer as the head of a household for the same taxable 
year.
    (3) Any of the following persons may qualify the taxpayer as a head 
of a household:
    (i) A son, stepson, daughter, or stepdaughter of the taxpayer, or a 
descendant of a son or daughter of the taxpayer. For the purpose of 
determining whether any of the stated relationships exist, a legally 
adopted child of a person is considered a child of such person by blood. 
If any such person is not married at the close of the taxable year of 
the taxpayer, the taxpayer may qualify as the head of a household by 
reason of such person even though the taxpayer may not claim a deduction 
for such person under section 151, for example, because the taxpayer 
does not furnish more than half of the support of such person. However, 
if any such person is married at the close of the taxable year of the 
taxpayer, the taxpayer may qualify as the head of a household by reason 
of such person only if the taxpayer is entitled to a deduction for such 
person under section 151 and the regulations thereunder. In applying the 
preceding sentence there shall be disregarded any such person for whom a 
deduction is allowed under section 151 only by reason of section 152(c) 
(relating to persons covered by a multiple support agreement).
    (ii) Any other person who is a dependent of the taxpayer, if the 
taxpayer is entitled to a deduction for the taxable year for such person 
under section 151 and paragraphs (3) through (8) of section 152(a) and 
the regulations thereunder. Under section 151 the taxpayer may be 
entitled to a deduction for any of the following persons:
    (a) His brother, sister, stepbrother, or stepsister;
    (b) His father or mother, or an ancestor of either;
    (c) His stepfather or stepmother;
    (d) A son or a daughter of his brother or sister;
    (e) A brother or sister of his father or mother; or
    (f) His son-in-law, daughter-in-law, father-in-law, mother-in-law, 
brother- in-law, or sister-in-law;


if such person has a gross income of less than the amount determined 
pursuant to Sec. 1.151-2 applicable to the calendar year in which the 
taxable year of the taxpayer begins, if the taxpayer supplies more than 
one-half of the support of such person for such calendar year and if 
such person does not make a joint return with his spouse for the taxable 
year beginning in such calendar year. The taxpayer may not be considered 
to be a head of a household by reason of any person for whom a deduction 
is allowed under section 151 only by reason of sections 152 (a)(9), 152 
(a)(10), or 152(c) (relating to persons not related to the taxpayer, 
persons receiving institutional care, and persons covered by multiple 
support agreements).

[[Page 22]]

    (4) The father or mother of the taxpayer may qualify the taxpayer as 
a head of a household, but only if the taxpayer is entitled to a 
deduction for the taxable year for such father or mother under section 
151 (determined without regard to section 152(c)). For example, an 
unmarried taxpayer who maintains a home for his widowed mother may not 
qualify as the head of a household by reason of his maintenance of a 
home for his mother if his mother has gross income equal to or in excess 
of the amount determined pursuant to Sec. 1.151-2 applicable to the 
calendar year in which the taxable year of the taxpayer begins, or if he 
does not furnish more than one-half of the support of his mother for 
such calendar year. For this purpose, a person who legally adopted the 
taxpayer is considered the father or mother of the taxpayer.
    (5) For the purpose of this paragraph, the status of the taxpayer 
shall be determined as of the close of the taxpayer's taxable year. A 
taxpayer shall be considered as not married if at the close of his 
taxable year he is legally separated from his spouse under a decree of 
divorce or separate maintenance, or if at any time during the taxable 
year the spouse to whom the taxpayer is married at the close of his 
taxable year was a nonresident alien. A taxpayer shall be considered 
married at the close of his taxable year if his spouse (other than a 
spouse who is a nonresident alien) dies during such year.
    (6) If the taxpayer is a nonresident alien during any part of the 
taxable year he may not qualify as a head of a household even though he 
may comply with the other provisions of this paragraph. See the 
regulations prescribed under section 871 for a definition of nonresident 
alien.
    (c) Household. (1) In order for a taxpayer to be considered as 
maintaining a household by reason of any individual described in 
paragraph (a)(1) or (b)(3) of this section, the household must actually 
constitute the home of the taxpayer for his taxable year. A physical 
change in the location of such home will not prevent a taxpayer from 
qualifying as a head of a household. Such home must also constitute the 
principal place of abode of at least one of the persons specified in 
such paragraph (a)(1) or (b)(3) of this section. It is not sufficient 
that the taxpayer maintain the household without being its occupant. The 
taxpayer and such other person must occupy the household for the entire 
taxable year of the taxpayer. However, the fact that such other person 
is born or dies within the taxable year will not prevent the taxpayer 
from qualifying as a head of household if the household constitutes the 
principal place of abode of such other person for the remaining or 
preceding part of such taxable year. The taxpayer and such other person 
will be considered as occupying the household for such entire taxable 
year notwithstanding temporary absences from the household due to 
special circumstances. A nonpermanent failure to occupy the common abode 
by reason of illness, education, business, vacation, military service, 
or a custody agreement under which a child or stepchild is absent for 
less than 6 months in the taxable year of the taxpayer, shall be 
considered temporary absence due to special circumstances. Such absence 
will not prevent the taxpayer from being considered as maintaining a 
household if (i) it is reasonable to assume that the taxpayer or such 
other person will return to the household, and (ii) the taxpayer 
continues to maintain such household or a substantially equivalent 
household in anticipation of such return.
    (2) In order for a taxpayer to be considered as maintaining a 
household by reason of any individual described in paragraph (b)(4) of 
this section, the household must actually constitute the principal place 
of abode of the taxpayer's dependent father or mother, or both of them. 
It is not, however, necessary for the purposes of such subparagraph for 
the taxpayer also to reside in such place of abode. A physical change in 
the location of such home will not prevent a taxpayer from qualifying as 
a head of a household. The father or mother of the taxpayer, however, 
must occupy the household for the entire taxable year of the taxpayer. 
They will be considered as occupying the household for such entire year 
notwithstanding temporary absences from

[[Page 23]]

the household due to special circumstances. For example, a nonpermanent 
failure to occupy the household by reason of illness or vacation shall 
be considered temporary absence due to special circumstances. Such 
absence will not prevent the taxpayer from qualifying as the head of a 
household if (i) it is reasonable to assume that such person will return 
to the household, and (ii) the taxpayer continues to maintain such 
household or a substantially equivalent household in anticipation of 
such return. However, the fact that the father or mother of the taxpayer 
dies within the year will not prevent the taxpayer from qualifying as a 
head of a household if the household constitutes the principal place of 
abode of the father or mother for the preceding part of such taxable 
year.
    (d) Cost of maintaining a household. A taxpayer shall be considered 
as maintaining a household only if he pays more than one-half the cost 
thereof for his taxable year. The cost of maintaining a household shall 
be the expenses incurred for the mutual benefit of the occupants thereof 
by reason of its operation as the principal place of abode of such 
occupants for such taxable year. The cost of maintaining a household 
shall not include expenses otherwise incurred. The expenses of 
maintaining a household include property taxes, mortgage interest, rent, 
utility charges, upkeep and repairs, property insurance, and food 
consumed on the premises. Such expenses do not include the cost of 
clothing, education, medical treatment, vacations, life insurance, and 
transportation. In addition, the cost of maintaining a household shall 
not include any amount which represents the value of services rendered 
in the household by the taxpayer or by a person qualifying the taxpayer 
as a head of a household or as a surviving spouse.
    (e) Certain married individuals living apart. For taxable years 
beginning after December 31, 1969, an individual who is considered as 
not married under section 143(b) shall be considered as not married for 
purposes of determining whether he or she qualifies as a single 
individual, a married individual, a head of household or a surviving 
spouse under sections 1 and 2 of the Code.

[T.D. 7117, 36 FR 9398, May 25, 1971]



Sec. 1.3-1  Application of optional tax.

    (a) General rules. (1) For taxable years ending before January 1, 
1970, an individual whose adjusted gross income is less than $5,000 (or 
a husband and wife filing a joint return whose combined adjusted gross 
income is less than $5,000) may elect to pay the tax imposed by section 
3 in place of the tax imposed by section 1 (a) or (b). For taxable years 
beginning after December 31, 1969 and before January 1, 1971 an 
individual whose adjusted gross income is less than $10,000 (or a 
husband and wife filing a joint return whose combined adjusted gross 
income is less than $10,000) may elect to pay the tax imposed by section 
3 as amended by the Tax Reform Act of 1969 in place of the tax imposed 
by section 1 (a) or (b). For taxable years beginning after December 31, 
1970 an individual whose adjusted gross income is less than $10,000 (or 
a husband and wife filing a joint return whose combined adjusted gross 
income is less than $10,000) may elect to pay the tax imposed by section 
3 as amended in place of the tax imposed by section 1 as amended. See 
Sec. 1.4-2 for the manner of making such election. A taxpayer may make 
such election regardless of the sources from which his income is derived 
and regardless of whether his income is computed by the cash method or 
the accrual method. See section 62 and the regulations thereunder for 
the determination of adjusted gross income. For the purpose of 
determining whether a taxpayer may elect to pay the tax under section 3, 
the amount of the adjusted gross income is controlling, without 
reference to the number of exemptions to which the taxpayer may be 
entitled. See section 4 and the regulations thereunder for additional 
rules applicable to section 3.
    (2) The following examples illustrate the rule that section 3 
applies only if the adjusted gross income is less than $10,000 ($5,000 
for taxable years ending before January 1, 1970).

    Example 1. A is employed at a salary of $9,200 for the calendar year 
1970. In the

[[Page 24]]

course of such employment, he incurred travel expenses of $1,500 for 
which he was reimbursed during the year. Such items constitute his sole 
income for 1970. In such case the gross income is $10,700 but the amount 
of $1,500 is deducted from gross income in the determination of adjusted 
gross income and thus A's adjusted gross income for 1970 is $9,200. 
Hence, the adjusted gross income being less than $10,000, he may elect 
to pay his tax for 1970 under section 3. Similarly, in the case of an 
individual engaged in trade or business (excluding from the term 
``engaged in trade or business'' the performance of personal services as 
an employee), there may be deducted from gross income in ascertaining 
adjusted gross income those expenses directly relating to the carrying 
on of such trade or business.
    Example 2. If B has, as his only income for 1970, a salary of 
$11,600 and his spouse has no gross income, then B's adjusted gross 
income is $11,600 (not $11,600 reduced by exemptions of $1,250) and he 
is not for such year, entitled to pay his tax under section 3. If, 
however, B has for 1970 a salary of $13,000 and incident to his 
employment he incurs expenses in the amount of $3,400 for travel, meals, 
and lodging while away from home, for which he is not reimbursed, the 
adjusted gross income is $13,000 minus $3,400 or $9,600. In such case 
his adjusted gross income being less than $10,000, B may elect to pay 
the tax under section 3. However, if B's wife has adjusted gross income 
of $400, the total adjusted gross income is $10,000. In such case, if B 
and his wife file a joint return, they may not elect to pay the optional 
tax since the combined adjusted gross income is not less than $10,000. B 
may nevertheless elect to pay the optional tax, but if he makes this 
election he must file a separate return and, since his wife has gross 
income, he may not claim an exemption for her in computing the optional 
tax.

    (b) Surviving spouse. The return of a surviving spouse is treated as 
a joint return for purposes of section 3. See section 2, and the 
regulations thereunder, with respect to the qualifications of a taxpayer 
as a surviving spouse. Accordingly, if the taxpayer qualifies as a 
surviving spouse and elects to pay the optional tax, he shall use the 
column in the tax table, appropriate to his number of exemptions, 
provided for cases in which a joint return is filed.
    (c) Use of tax table. (1) To determine the amount of the tax, the 
individual ascertains the amount of his adjusted gross income, refers to 
the appropriate table set forth in section 3 or the regulations 
thereunder, ascertains the income bracket into which such income falls, 
and, using the number of exemptions applicable to his case, finds the 
tax in the vertical column having at the top thereof a number 
corresponding to the number of exemptions to which the taxpayer is 
entitled.
    (2) Section 3(b) (relating to taxable years beginning after Dec. 31, 
1964 and ending before Jan. 1, 1970) contains 5 tables for use in 
computing the tax. Table I is to be used by a single person who is not a 
head of household. Table II is to be used by a head of household. Table 
III is to be used by married persons filing joint returns and by a 
surviving spouse. Table IV is to be used by married persons filing 
separate returns using the 10 percent standard deduction. Table V is to 
be used by married persons filing separate returns using the minimum 
standard deduction. For an explanation of the standard deduction see 
section 141 and the regulations thereunder.
    (3) 30 tables are provided for use in computing the tax under the 
Tax Reform Act of 1969. Tables I through XV apply for taxable years 
beginning after December 31, 1969 and ending before January 1, 1971. 
Tables XVI through XXX apply for taxable years beginning after December 
31, 1970. The standard deduction for Tables I through XV, applicable to 
taxable years beginning in 1970, is 10 percent. The standard deduction 
for Tables XVI through XXX, applicable to taxable years beginning in 
1971, is 13 percent. For an explanation of the standard deduction and 
the low income allowance see section 141 as amended by the Tax Reform 
Act of 1969.
    (4) In the case of married persons filing separate returns who 
qualify to use the optional tax imposed by section 3, such persons shall 
use the tax imposed by the table for the applicable year in accordance 
with the rules prescribed by sections 4(c) and 141 and the regulations 
thereunder governing the use and application of the standard deduction 
and the low income allowance.
    (5) The tax shown in the tax tables set forth in section 3 or the 
regulations thereunder reflects full income splitting in the case of a 
joint return (including the return of a surviving spouse) and lesser 
income splitting in

[[Page 25]]

the case of a head of household. Therefore, it is possible for the tax 
shown in the tables relating to joint returns, or relating to a return 
of a head of a household, to be lower than that shown in the table for 
separate returns even though the amounts of adjusted gross income and 
the number of exemptions are the same.

[T.D. 7117, 36 FR 9420, May 25, 1971]



Sec. 1.4-1  Number of exemptions.

    (a) For the purpose of determining the optional tax imposed under 
section 3, the taxpayer shall use the number of exemptions allowable to 
him as deductions under section 151. See sections 151, 152, and 153, and 
the regulations thereunder. In general, one exemption is allowed for the 
taxpayer; one exemption for his spouse if a joint return is made, or if 
a separate return is made by the taxpayer and his spouse has no gross 
income for the calendar year in which the taxable year of the taxpayer 
begins and is not the dependent of another taxpayer for such calendar 
year; and one exemption for each dependent whose gross income for the 
calendar year in which the taxable year of the taxpayer begins is less 
than the applicable amount determined pursuant to Sec. 1.151-2. No 
exemption is allowed for any dependent who has made a joint return with 
his spouse for the taxable year beginning in the calendar year in which 
the taxable year of the taxpayer begins. The taxpayer may, in certain 
cases, be allowed an exemption for a dependent child of the taxpayer 
notwithstanding the fact that such child has gross income equal to or in 
excess of the amount determined pursuant to Sec. 1.151-2 applicable to 
the calendar year in which the taxable year of the taxpayer begins. The 
requirements for the allowance of such an exemption are set forth in 
paragraph (c) of Sec. 1.152-1. See paragraphs (c) and (d) of Sec. 
1.151-1 with respect to additional exemptions for a taxpayer or spouse 
who has attained the age 65 years and for a blind taxpayer or blind 
spouse
    (b) The application of this section may be illustrated by the 
following examples:

    Example 1. A, a married man whose duties as an employee require 
traveling away from his home, has as his sole gross income a salary of 
$5,600 for the calendar year 1954. His traveling expenses, including 
cost of meals and lodging, amount in such year to $750, and hence, his 
adjusted gross income is $4,850. His wife, B, has as her sole income 
interest in the amount of $85, and thus the aggregate adjusted gross 
income of A and B is $4,935. A has two dependent children neither of 
whom has any income. A and B file a joint return for 1954 on Form 1040. 
In such case four exemptions are allowable. The adjusted gross income 
falls within the tax bracket $4,900-4,950. By referring to such tax 
bracket in the tax table in section 3 and to the column headed ``4'' 
therein, the tax is found to be $407.
    Example 2. C, a married man, has as his sole income in 1954 wages of 
$4,600, and has two dependent children neither of whom has any income. 
His wife, D, has adjusted gross income of $400. C files a separate 
return for 1954 and is entitled to claim three exemptions. C's income 
falls within the tax bracket $4,600-4,650 and hence, with three 
exemptions his tax is $480. No exemption is allowed with respect to 
since D has gross income and a joint return was not filed.
    Example 3. D, a married man with no dependents, attains the age of 
65 on September 1, 1954. The aggregate adjusted gross income of D and 
his wife for 1954 is $4,840. D and his wife file a joint return for 1954 
and are entitled to three exemptions, one for each taxpayer and one 
additional exemption for D because of his age. Since the adjusted gross 
income of D and his wife falls within the tax bracket $4,800-4,850, the 
tax on a joint return is $509.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7114, 36 FR 
9018, May 18, 1971]



Sec. 1.4-2  Elections.

    (a) Making of election. The election to pay the optional tax imposed 
under section 3 shall be made by (1) filing a return on Form 1040A, or 
(2) filing a return on Form 1040 and electing in such return, in 
accordance with the provisions of section 144 and the regulations 
thereunder, to take the standard deduction provided by section 141.
    (b) Election under section 3 and election of standard deduction. 
Section 144 (a) and the regulations thereunder provide rules for 
treating an election to pay the tax under section 3 as an election to 
take the standard deduction, and for treating an election to take the 
standard deduction as an election to pay the tax under section 3. For 
example, if the taxpayer's return shows $5,000 or more

[[Page 26]]

of adjusted gross income and he elects to take the standard deduction, 
he will be deemed to have elected to pay the tax under section 3 if it 
is subsequently determined that his correct adjusted gross income is 
less than $5,000.
    (c) [Reserved]
    (d) Change of election. For rules relating to a change of election 
to pay, or not to pay, the optional tax imposed under section 3, see 
section 144 (b) and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6581, 26 FR 
11677, Dec. 6, 1961; T.D. 7269, 38 FR 9295, April 13, 1973]



Sec. 1.4-3  Husband and wife filing separate returns.

    (a) In general. If the separate adjusted gross income of a husband 
is less than $5,000 and the separate adjusted gross income of his wife 
is less than $5,000, and if each is required to file a return, the 
husband and the wife must each elect to pay the optional tax imposed 
under section 3 or neither may so elect. If the separate adjusted gross 
income of each spouse is $5,000 or more, then neither spouse can elect 
to pay the optional tax imposed under section 3. If the adjusted gross 
income of one spouse is $5,000 or more and that of the other spouse is 
less than $5,000, the election to pay the optional tax imposed under 
section 3 may be exercised by the spouse having adjusted gross income of 
less than $5,000 only if the spouse having adjusted gross income of 
$5,000 or more, in computing taxable income, uses the standard deduction 
provided by section 141. If the spouse having adjusted gross income of 
$5,000 or more does not use the standard deduction, then the spouse 
having adjusted gross income of less than $5,000 may not elect to pay 
the optional tax and must compute taxable income without regard to the 
standard deduction. Accordingly, if the spouse having adjusted gross 
income of $5,000 or more itemizes the deductions allowed by sections 161 
and 211 in computing taxable income, the spouse having adjusted gross 
income of less than $5,000 must also compute taxable income by itemizing 
the deductions allowed by sections 161 and 211, and must pay the tax 
imposed by section 1. For rules relative to the election to take the 
standard deduction by husband and wife, see part IV (section 141 and 
following), subchapter B, chapter 1 of the Code, and the regulations 
thereunder.
    (b) Taxable years beginning after December 31, 1963, and before 
January 1, 1970. (1) In the case of a husband and wife filing a separate 
return for a taxable year beginning after December 31, 1963, and before 
January 1, 1970, the optional tax imposed by section 3 shall be--
    (i) For taxable years beginning in 1964, the lesser of the tax shown 
in Table IV (relating to the 10-percent standard deduction for married 
persons filing separate returns) or Table V (relating to the minimum 
standard deduction for married persons filing separate returns) of 
section 3(a), and
    (ii) For a taxable year beginning after December 31, 1964, and 
before January 1, 1970, the lesser of the tax shown in Table IV 
(relating to the 10-percent standard deduction for married persons 
filing separate returns) or Table V (relating to minimum standard 
deduction for married persons filing separate returns) of section 3(b).
    (2) If the tax of one spouse is determined with regard to the 10-
percent standard deduction provided for in Table IV of section 3(a) or 
3(b) or if such spouse in computing taxable income uses the 10-percent 
standard deduction provided for in section 141(b), then the minimum 
standard deduction provided for in Table V of section 3(a) or 3(b) shall 
not apply in the case of the other spouse, if such spouse elects to pay 
the optional tax imposed under section (3). Thus, if a husband and wife 
compute their tax with reference to the standard deduction, one cannot 
elect to use the 10-percent standard deduction and the other elect to 
use the minimum standard deduction. However, an individual described in 
section 141(d)(2) may elect pursuant to such section and the regulations 
thereunder to pay the tax shown in Table V of section 3(a) or 3(b) in 
lieu of the tax shown in Table IV of section 3(a) or 3(b). See section 
141(d) and the regulations thereunder for rules relating to the standard 
deduction in the case of married individuals filing separate returns.

[[Page 27]]

    (c) Taxable years beginning after December 31, 1969. (1) In the case 
of a husband and wife filing a separate return for a taxable year 
beginning after December 31, 1969, the optional tax imposed by section 3 
shall be the lesser of the tax shown in--
    (i) The table prescribed under section 3 applicable to such taxable 
year in the case of married persons filing separate returns which 
applies the percentage standard deduction, or
    (ii) The table prescribed under section 3 applicable to such taxable 
year in the case of married persons filing separate returns which 
applies the low income allowance.
    (2) If the tax of one spouse is determined by the table described in 
subparagraph (1)(i) of this paragraph or if such spouse in computing 
taxable income uses the percentage standard deduction provided for in 
section 141(b), then the table described in subparagraph (1)(ii) of this 
paragraph shall not apply in the case of the other spouse, if such other 
spouse elects to pay the optional tax imposed under section 3. Thus, if 
a husband and wife compute the tax with reference to the standard 
deduction, one cannot elect to use the percentage standard deduction and 
the other elect to use the low income allowance. A married individual 
described in section 141(d)(2) may elect pursuant to such section and 
the regulations thereunder to pay the tax shown in the table described 
by subparagraph (1)(ii) of this paragraph in lieu of the tax shown in 
the table described by subparagraph (1)(i) of this paragraph. See 
section 141(d) and the regulations thereunder for rules relating to the 
standard deduction in the case of married individuals filing separate 
returns.
    (d) Determination of marital status. For the purpose of applying the 
restrictions upon the right of a married person to elect to pay the tax 
under section 3, (1) the determination of marital status is made as of 
the close of the taxpayer's taxable year or, if his spouse died during 
such year, as of the date of death; (2) a person legally separated from 
his spouse under a decree of divorce or separate maintenance on the last 
day of his taxable year (or the date of death of his spouse, whichever 
is applicable) is not considered as married; and (3) with respect to 
taxable years beginning after December 31, 1969, a person, although 
considered as married within the meaning of section 143(a), is 
considered as not married if he lives apart from his spouse and 
satisfies the requirements set forth in section 143(b). See section 143 
and the regulations thereunder.

[T.D. 6792, 30 FR 529, Jan. 15, 1965, as amended by T.D. 7123, 36 FR 
11084, June 9, 1971]



Sec. 1.4-4  Short taxable year caused by death.

    An individual making a return for a period of less than 12 months on 
account of a change in his accounting period may not elect to pay the 
optional tax under section 3. However, the fact that the taxable year is 
less than 12 months does not prevent the determination of the tax for 
the taxable year under section 3 if the short taxable year results from 
the death of the taxpayer.

                           Tax on Corporations



Sec. 1.11-1  Tax on corporations.

    (a) Every corporation, foreign or domestic, is liable to the tax 
imposed under section 11 except (1) corporations specifically excepted 
under such section from such tax; (2) corporations expressly exempt from 
all taxation under subtitle A of the Code (see section 501); and (3) 
corporations subject to tax under section 511(a). For taxable years 
beginning after December 31, 1966, foreign corporations engaged in trade 
or business in the United States shall be taxable under section 11 only 
on their taxable income which is effectively connected with the conduct 
of a trade or business in the United States (see section 882(a)(1)). For 
definition of the terms ``corporations,'' ``domestic,'' and ``foreign,'' 
see section 7701(a) (3), (4), and (5), respectively. It is immaterial 
that a domestic corporation, and for taxable years beginning after 
December 31, 1966, a foreign corporation engaged in trade or business in 
the United States, which is subject to the tax imposed by section 11 may 
derive no income from sources within the United States. The tax imposed 
by section 11 is payable upon the basis of the

[[Page 28]]

returns rendered by the corporations liable thereto, except that in some 
cases a tax is to be paid at the source of the income. See subchapter A 
(sections 6001 and following), chapter 61 of the Code, and section 1442.
    (b) The tax imposed by section 11 consists of a normal tax and a 
surtax. The normal tax and the surtax are both computed upon the taxable 
income of the corporation for the taxable year, that is, upon the gross 
income of the corporation minus the deductions allowed by chapter 1 of 
the Code. However, the deduction provided in section 242 for partially 
tax-exempt interest is not allowed in computing the taxable income 
subject to the surtax.
    (c) The normal tax is at the rate of 22 percent and is applied to 
the taxable income for the taxable year. However, in the case of a 
taxable year ending after December 31, 1974, and before January 1, 1976, 
the normal tax is at the rate of 20 percent of so much of the taxable 
income as does not exceed $25,000 and at the rate of 22 percent of so 
much of the taxable income as does exceed $25,000 and is applied to the 
taxable income for the taxable year.
    (d) The surtax is at the rate of 26 percent and is upon the taxable 
income (computed without regard to the deduction, if any, provided in 
section 242 for partially tax-exempt interest) in excess of $25,000. 
However, in the case of a taxable year ending after December 31, 1974, 
and before January 1, 1976, the surtax is upon the taxable income 
(computed as provided in the preceding sentence) in excess of $50,000. 
In certain circumstances the exemption from surtax may be disallowed in 
whole or in part. See sections 269, 1551, 1561, and 1564 and the 
regulations thereunder. For purposes of sections 244, 247, 804, 907, 922 
and Sec. Sec. 1.51-1 and 1.815-4, when the phrase ``the sum of the 
normal tax rate and the surtax rate for the taxable year'' is used in 
any such section, the normal tax rate for all taxable years beginning 
after December 31, 1963, and ending before January 1, 1976, shall be 
considered to be 22 percent.
    (e) The computation of the tax on corporations imposed under section 
11 may be illustrated by the following example:

    Example. The X Corporation, a domestic corporation, has gross income 
of $86,000 for the calendar year 1964. The gross income includes 
interest of $5,000 on United States obligations for which a deduction 
under section 242 is allowable in determining taxable income subject to 
the normal tax. It has other deductions of $11,000. The tax of the X 
Corporation under section 11 for the calendar year is $28,400 ($15,400 
normal tax and $13,000 surtax) computed as follows:

                        Computation of Normal Tax
Gross income....................................     $86,000
Deductions:
  Partially tax-exempt interest.................      $5,000
  Other.........................................      11,000      16,000
                                                 -----------------------
Taxable income..................................      70,000
Normal tax (22 percent of $70,000)..............      15,400
 
                          Computation of Surtax
Taxable income..................................      70,000
Add: Amount of partially tax-exempt interest           5,000
 deducted in computing taxable income...........
                                                 -------------
Taxable income subject to surtax................      75,000
Less: Exemption from surtax.....................      25,000
                                                 -------------
Excess of taxable income subject to surtax over       50,000
 exemption......................................
Surtax (26 percent of $50,000)..................      13,000
 

    (f) For special rules applicable to foreign corporations engaged in 
trade or business within the United States, see section 882 and the 
regulations thereunder. For additional tax on personal holding 
companies, see part II (section 541 and following), subchapter G, 
chapter 1 of the Code, and the regulations thereunder. For additional 
tax on corporations improperly accumulating surplus, see part I (section 
531 and following), subchapter G, chapter 1 of the Code, and the 
regulations thereunder. For treatment of China Trade Act corporations, 
see sections 941 and 942 and the regulations thereunder. For treatment 
of Western Hemisphere trade corporations, see sections 921 and 922 and 
the regulations thereunder. For treatment of capital gains and losses, 
see subchapter P (section 1201 and following), chapter 1 of the Code. 
For computation of the tax for a taxable year during which a change in 
the tax rates occurs, see section 21 and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7293, 38 FR 
32792, Nov. 28, 1973; T.D. 74-13, 41 FR 12639, Mar. 26, 1976]

[[Page 29]]

                 Changes in Rates During a Taxable Year



Sec. 1.15-1  Changes in rate during a taxable year.

    (a) Section 21 applies to all taxpayers, including individuals and 
corporations. It provides a general rule applicable in any case where 
(1) any rate of tax imposed by chapter 1 of the Code upon the taxpayer 
is increased or decreased, or any such tax is repealed, and (2) the 
taxable year includes the effective date of the change, except where 
that date is the first day of the taxable year. For example, the normal 
tax on corporations under section 11(b) was decreased from 30 percent to 
22 percent in the case of a taxable year beginning after December 31, 
1963. Accordingly, the tax for a taxable year of a corporation beginning 
on January 1, 1964, would be computed under section 11(b) at the new 
rate without regard to section 21. However, for any taxable year 
beginning before January 1, 1964, and ending on or after that date, the 
tax would be computed under section 21. For additional circumstances 
under which section 21 is not applicable, see paragraph (k) of this 
section.
    (b) In any case in which section 21 is applicable, a tentative tax 
shall be computed by applying to the taxable income for the entire 
taxable year the rate for the period within the taxable year before the 
effective date of change, and another tentative tax shall be computed by 
applying to the taxable income for the entire taxable year the rate for 
the period within the taxable year on or after such effective date. The 
tax imposed on the taxpayer is the sum of--
    (1) An amount which bears the same ratio to the tentative tax 
computed at the rate applicable to the period within the taxable year 
before the effective date of the change that the number of days in such 
period bears to the number of days in the taxable year, and
    (2) An amount which bears the same ratio to the tentative tax 
computed at the rate applicable to the period within the taxable year on 
and after the effective date of the change that the number of days in 
such period bears to the number of days in the taxable year.
    (c) If the rate of tax is changed for taxable years ``beginning 
after'' or ``ending after'' a certain date, the following day is 
considered the effective date of the change for purposes of section 21. 
If the rate is changed for taxable years ``beginning on or after'' a 
certain date, that date is considered the effective date of the change 
for purposes of section 21. This rule may be illustrated by the 
following examples:

    Example 1. Assume that the law provides that a change in a certain 
rate of tax shall be effective only with respect to taxable years 
beginning after December 31, 1969. The effective date of change for 
purposes of section 21 is January 1, 1970, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1970.
    Example 2. Assume that the law provides that a change in a certain 
rate of tax shall be applicable only with respect to taxable years 
ending after December 31, 1970. For purposes of section 21, the 
effective date of change is January 1, 1971, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1971.
    Example 3. Assume that the law provides that a change in a certain 
rate of tax shall be effective only with respect to taxable years 
beginning on or after January 1, 1971. The effective date of change for 
purposes of section 21 is January 1, 1971, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1971.

    (d) If a tax is repealed, the repeal will be treated as a change of 
rate for purposes of section 21, and the rate for the period after the 
repeal (for purposes of computing the tentative tax with respect to that 
period) will be considered zero. For example, the Tax Reform Act of 1969 
repealed section 1562, which imposed a 6 percent additional tax on 
controlled corporations electing multiple surtax exemptions, effective 
for taxable years beginning after December 31, 1974. For such controlled 
corporations having taxable years beginning in 1974 and ending in 1975, 
the rate for the period ending before January 1, 1975, would be 6 
percent; the rate for the period beginning after December 31, 1974, 
would be zero. However, subject to the rules stated in this section, 
section 21 does not apply to the imposition of a new tax. For example, 
if a new tax is imposed for taxable years beginning on or after July 1, 
1972, a computation

[[Page 30]]

under section 21 would not be required with respect to such new tax in 
the case of taxable years beginning before July 1, 1972, and ending on 
or after that date. If the effective date of the imposition of a new tax 
and the effective date of a change in rate of such tax fall in the same 
taxable year, section 21 is not applicable in computing the taxpayer's 
liability for such tax for such year unless the new tax is expressly 
imposed upon the taxpayer for a portion of his taxable year prior to the 
change in rate.
    (e) If a husband and wife have different taxable years because of 
the death of either spouse, and if a joint return is filed with respect 
to the taxable year of each, then, for purposes of section 21, the joint 
return shall be treated as if the taxable years of both spouses ended on 
the date of the closing of the surviving spouse's taxable year. See 
section 6013 (c), relating to treatment of joint return after death of 
either spouse. Accordingly, if a change in the rate of tax is effective 
during the taxable year of the surviving spouse, the tentative taxes 
with respect to the joint return shall be computed on the basis of the 
number of days during which each rate of tax was in effect for the 
taxable year of the surviving spouse.
    (f) Section 21 applies whether or not the taxpayer has a taxable 
year of less than 12 months. Moreover, section 21 applies whether or not 
the taxable income for a taxable year of less than 12 months is required 
to be placed on an annual basis under section 443. If the taxable income 
is required to be computed under section 443(b) then the tentative taxes 
under section 21 are computed as provided in paragraph (1) or (2) of 
section 443(b) and are reduced as provided in those paragraphs. The 
tentative taxes so computed and reduced are then apportioned as provided 
in section 21(a)(2) to determine the tax for such taxable year as 
computed under section 21.
    (g) If a taxpayer has made the election under section 441(f) 
(relating to computation of taxable income on the basis of an annual 
accounting period varying from 52 to 53 weeks), the rules provided in 
section 441(f)(2) shall be applicable for purposes of determining 
whether section 21 applies to the taxable year of the taxpayer. Where a 
taxpayer has made the election under section 441(f) and where section 21 
applies to the taxable year of the taxpayer the computation under 
section 21(a)(2) shall be made upon the basis of the actual number of 
days in the taxable year and in each period thereof.
    (h)(1) Section 21 is applicable only if the rate of tax imposed by 
chapter 1 changes. Sections in which rates of tax are specified or 
incorporated by reference include the following: 1, 2, 3, 11, 511, 531, 
541, 821, 831, 871, 881, 1201, and 1348 (for taxable years beginning 
after December 31, 1970). Except as provided in subparagraph (3) of this 
paragraph, section 21 is not applicable with respect to changes in the 
law relating to deductions from gross income, exclusions from or 
inclusions in gross income, or other items taken into account in 
determining the amount or character of income subject to tax. Moreover, 
section 21 is not applicable with respect to changes in the law relating 
to credits against the tax or with respect to changes in the law 
relating to limitations on the amount of tax. Section 21 is applicable, 
however, to all those computations specified in the section providing 
the rate of tax which are implicit in determining the rate. For example, 
if one of the tax brackets in the tax tables under section 3 were to be 
changed, section 21 would be applicable to that change. Thus, if the 
bracket relating to ``at least $4,200 but not less than $4,250'' for 
heads of households should be changed to increase or decrease the last 
sum specified, with corresponding changes being made in subsequent 
brackets, section 21 would be applicable. The enactment of sections 1561 
and 1562 is considered a change in section 11(d) which constitutes a 
change in rate for the period ending after December 31, 1963. The 
amendment of section 1561 and the repeal of section 1562 by the Tax 
Reform Act of 1969 is considered a change in section 11(d) which 
constitutes a change in rate for the period ending after December 31, 
1974. The repeal of the 2 percent additional tax imposed under section 
1503 on corporations filing consolidated returns constitutes a change in 
rate for the period

[[Page 31]]

ending after December 31, 1963. The addition to the Code of section 1348 
(relating to 50 percent maximum rate on earned income) is a change in 
rate to which section 21(a) is applicable. The amendment of section 
11(d) by the Tax Reduction Act of 1975 which increases to $50,000 the 
surtax exemption for a taxable year ending during 1975 constitutes a 
change in rate for such portion of the taxable year (if less than the 
entire taxable year) as follows December 31, 1974. Similarly, the return 
of the surtax exemption to $25,000 for a taxable year ending during 1976 
constitutes a change in rate for such portion of the taxable year (if 
less than the entire taxable year) as follows December 31, 1975.
    (2) Ordinarily, both the old and the new rates are applied to the 
same amount of taxable income. However, where the rate of tax is itself 
taken into account in determining taxable income (for example, the 
special deduction for Western Hemisphere trade corporations under 
section 922), the taxable income used in determining the tentative tax 
employing the rate before the effective date of change shall be 
determined by reference to that rate of tax, and the taxable income for 
the purpose of determining the tentative tax employing the rate for the 
period on and after the effective date of the change shall be determined 
by reference to the new tax rate.
    (3) Section 21 is applicable with respect to changes in the law 
relating to the standard deduction for individuals provided in part IV 
of subchapter B and to the deduction for personal exemptions for 
individuals provided in part V of subchapter B.
    (i) If the rate of tax changes more than once during the taxable 
year, section 21 is applicable to each change in rate. For example, if 
the rate of normal tax changed for taxable years beginning on or after 
March 1, 1954, and changed again for taxable years beginning on or after 
June 1, 1954, section 21 requires computation of 3 tentative taxes for 
any taxable year which began before March 1, 1954, and ended on or after 
June 1, 1954: One tentative tax at the rate in effect before the March 1 
change; another tentative tax at the rate in effect from March 1 to May 
31; and a third tentative tax at the rate in effect from June 1 to the 
end of the taxable year. The proportion of each such tentative tax taken 
into account in determining the tax imposed on the taxpayer is computed 
by reference to the portion of the taxable year before March 1, 1954, by 
reference to the portion of the taxable year from March 1, 1954, through 
May 31, 1954, and by reference to the portion of the taxable year from 
June 1, 1954, to the end of the taxable year, respectively.
    (j)(1) If a change in the rate of one tax imposed by chapter 1 of 
the Code does not affect the amount of other taxes imposed by chapter 1 
of the Code the other taxes may be determined without regard to section 
21 and section 21 will be applied only to the tax for which a change in 
rate is made. However, if the change of rate of one tax does affect the 
amount of other taxes imposed under chapter 1 of the Code, then the 
computation of the taxes under chapter 1 of the Code so affected shall 
be made by applying section 21. For example, if section 1201 applies to 
an individual taxpayer for a taxable year containing the effective date 
of a change in a rate of tax provided in section 1, then under section 
21 the taxpayer must compute a tentative tax for each period for which a 
different rate of tax is effective under section 1. The tentative tax 
for each such period as computed under section 1201 will reflect the 
rate of tax provided by section 1 for such period.
    (2) In certain cases chapter 1 of the Code provides that the 
particular tax to be imposed upon the taxpayer shall be one of several 
taxes, the basis of selection being the tax that is greater or lesser. 
See, for example, sections 821 and 1201. If in any such case the rate of 
any one of these taxes changes, then the tentative taxes computed as 
provided by section 21 for each period shall be computed employing the 
tax selected in accordance with the general rule of selection for such a 
case, at the rate of tax in effect for such period. Thus, if a change in 
the rate of the alternative tax under section 1201 is such that the 
alternative tax under section 1201 is applicable if the old rate is used 
and is not applicable if the new rate is used, one tentative tax will 
consist of

[[Page 32]]

the alternative tax under section 1201 and the other tentative tax will 
consist of the tax imposed by the other applicable sections of chapter 1 
of the Code. The two tentative taxes so computed are then prorated in 
accordance with section 21(a)(2) and the sum of the proportionate 
amounts is the tax imposed for the taxable year under chapter 1 of the 
Code. See the examples in paragraph (n) of this section.
    (k) Section 21 does not apply in the following situations:
    (1) The provisions of section 21 do not apply to the imposition of 
the tax surcharge by section 51. The proration rules of section 51(a) 
apply in the case of a taxable year ending on or after the effective 
date of the surcharge and beginning before July 1, 1970.
    (2) The provisions of section 21 do not apply to the imposition of 
the minimum tax for tax preferences by section 56. The proration rules 
of section 301(c) of the Tax Reform Act of 1969 (83 Stat. 586) apply in 
the case of a taxable year beginning in 1969 and ending in 1970.
    (l) In computing the number of days each rate of tax is in effect 
during the taxable year for purposes of section 21(a)(2), the effective 
date of the change in rate shall be counted in the period for which the 
new rate is in effect.
    (m) Any credits against tax, and any limitation in any credit 
against tax, shall be based upon the tax computed under section 21. For 
credits against tax, see part IV (section 31 and following), subchapter 
A, chapter 1 of the Code.
    (n) The application of section 21 may be illustrated by the 
following examples: (See also the examples in Sec. 1.1561-2A(a)(3).)

    Example 1. A, a married taxpayer filing a joint return, reports his 
income on the basis of a fiscal year ending June 30. For his fiscal year 
ending June 30, 1970, A reports taxable income (exclusive of capital 
gains and losses) of $50,000 and net long-term capital gain (section 
1201 gain (net capital gain for taxable years beginning after December 
31, 1976)) of $75,000. The rate of tax on capital gains under section 
1201(b) relating to the alternative tax has been increased from 25 
percent to a maximum rate of 29\1/2\ percent with respect to gain in 
excess of $50,000 and the effective date of the change in rate is 
January 1, 1970. The income tax for the taxable year ended June 30, 
1970, would be computed under section 21 as follows:

                              Tentative Tax
Taxable income exclusive of capital      $50,000
 gains and losses...................
Long-term capital gain..............      75,000
                                     -------------
                                         125,000
Deduct 50% of long-term capital gain      37,500
                                     -------------
      Taxable income................      87,500
                                     =============
Tax under section 1 (1969 and 1970        37,690
 rates).............................
                                     =============
           Alternative Tax Under Section 1201(b) (1969 Rates)
Taxable income ($50,000+50% of           $87,500
 $75,000)...........................
Less 50% of long-term capital gain..      37,500
                                     -------------
Taxable income exclusive of capital       50,000
 gains..............................
                                     =============
Partial tax (tax on $50,000)........      17,060
Plus 25% of $75,000.................      18,750
                                     -------------
Alternative tax under section             35,810
 1201(b) at 1969 rates..............
           Alternative Tax Under Section 1201(b) (1970 Rates)
                                 step i
Taxable income ($50,000 + 50% of         $87,500
 $75,000)...........................
Deduct 50% of net section 1201 gain       37,500
 (net capital gain for taxable years
 beginning after December 31, 1976).
                                     ------------
                                          50,000
                                     ============
Tax on $50,000 (taxable income        ..........     $17,060
 exclusive of capital gains)........
                                 step ii
(a) Net section 1201 gain (net            75,000
 capital gain for taxable years
 beginning after December 31, 1976).
(b) Subsection (d) gain.............      50,000
25% of $50,000 (lesser of (a) or      ..........      12,500
 (b))...............................
                                step iii
(c) 29\1/2\% of $25,000 (excess of         7,375
 (a) over (b))......................
                                     ============
(d) Ordinary income.................     $50,000

[[Page 33]]

 
50% of net section 1201 gain (net         37,500
 capital gain for taxable years
 beginning after December 31, 1976).
                                     ------------
                                          87,500
                                     ============
Tax on $87,500......................     $37,690
Ordinary income.....................     $50,000
50% of subsection (d) gain..........      25,000
                                     ------------
                                          75,000
                                     ============
Tax on $75,000......................      30,470
                                     ------------
Difference..........................       7,220
                                     ============
Lesser of (c) or (d)................      $7,220
                                     -------------
Alternative tax (total of 3 steps)        36,780
 at rates effective on and after
 January 1, 1970....................
                                     =============
 


Since the alternative tax is less than the tax imposed under section 1 
for both the period in 1969 and the period in 1970, the alternative tax 
applies for both periods. Thus, since the effective date of the change 
in the rate of tax on capital gains is January 1, 1970, the old rate of 
alternative tax is effective for 184 days of the taxable year and the 
new rate of alternative tax is effective for 181 days of the taxable 
year. The alternative taxes are apportioned as follows:

1969--184/365 of $35,810....................................  $18,052.16
1970--181/365 of $36,780....................................   18,238.85
                                                             -----------
                                                               36,291.01
Tax surcharge (See Sec.  1.51-1(d)(1)(i))..................    2,729.28
                                                             -----------
      Total tax for the taxable year........................   39,020.29
 

    Example 2. B, a single individual not a head of a household, has a 
taxable year ending March 31. For the taxable year ending March 31, 
1971, B has adjusted gross income of $18,500. His computation of the tax 
imposed is as follows:

                           1970 Tentative Tax
Adjusted gross income...........................  $18,500.00
  Less:
    Standard deduction..........................   $1,000.00
    Personal exemption..........................      625.00    1,625.00
                                                 -----------------------
Taxable income under 1970 deduction provisions..   16,875.00
                                                 =============
Tax on $16,875 (1970 rates):
  Tax on first $16,000..........................    4,330.00
  42 percent of $875............................      367.50
                                                 ------------
Tentative tax at rates and deduction provisions     4,697.50
 effective on or after January 1, 1970..........
                                                 =============
 
                           1971 Tentative Tax
Adjusted gross income...........................  $18,500.00
  Less:
    Standard deduction..........................      $1,500
    Personal exemption..........................         650    2,150.00
                                                 -----------------------
Taxable income under 1971 deduction provisions..   16,350.00
                                                 =============
Tax on $16,350 (1971 rates):
  Tax on first $16,000..........................       3,830
  34 percent of $350............................         119
                                                 ------------
Tentative tax at rates and deduction provisions     3,949.00
 effective on or after Januray 1, 1971..........
                                                 =============
The 1970 and 1971 tentative taxes are
 apportioned as follows:
  1970--275/365 of $4,697.50....................    3,539.21
  1971--90/365 of $3,949.00.....................      973.73
                                                 -------------
                                                    4,512.94
Tax surcharge (see Sec.  1.51-1(d)(1)(i))......       56.26
                                                 -------------
 Total tax for the taxable year.................    4,569.20
                                                 =============
 

    Example 3. H and W, husband and wife, have a foster child, C, who 
qualifies as a dependent under section 152(b)(2) for the period 
beginning after December 31, 1969. H and W file a joint return on the 
basis of a taxable year ending August 31. For the taxable year ending 
August 31, 1970, H and W have adjusted gross income of $12,500. Their 
computation of the tax imposed is as follows:

                           1969 Tentative Tax
Adjusted gross income...........................  $12,500.00
  Less:
 Standard deduction.............................   $1,000.00
 Personal exemption (2).........................    1,200.00    2,200.00
                                                 -----------------------
Taxable income under 1969 deduction provisions..   10,300.00
                                                 =============
Taxable income reduced by one-half..............  ..........    5,150.00
                                                             ===========
Tax on $5,150 (1969 rates):
  Tax on first $4,000...........................     $690.00
  22 percent of $1,150..........................      253.00      943.00
                                                 -----------------------
Twice the tax on $5,150.........................   $1,886.00
                                                 ============
Tentative tax at rates and deduction provisions     1,886.00
 effective on or after January 1, 1969..........
                                                 =============
                           1970 Tentative Tax
Adjusted gross income...........................  $12,500.00
  Less:
    Standard deduction..........................   $1,000.00
    Personal exemption (3)......................    1,875.00    2,875.00
                                                 -----------------------
Taxable income under 1970 deduction provisions..   $9,625.00
                                                 =============
Tax on $9,625 (1970 rates):
  Tax on first $8,000...........................   $1,380.00
  22 percent of $1,625..........................      357.50
                                                 ------------
Tentative tax at rates and deduction provisions     1,737.50
 effective on or after January 1, 1970..........
                                                 =============

[[Page 34]]

 
The 1969 and 1970 tentative taxes are
 apportioned as follows:
  1969--122/365 of $1,886.......................     $630.39
  1970--243/365 of $1,737.50....................    1,156.75
                                                 -------------
                                                    1,787.14
Tax surcharge (see Sec.  1.51-1(d)(1)(i))......      104.05
                                                 -------------
  Total tax for the taxable year................    1,891.19
                                                 =============
 

    Example 4. B, a single individual with one exemption, reports his 
income on the basis of a fiscal year ending June 30. For fiscal year 
ending June 30, 1971, B reports adjusted gross income of $250,000, 
consisting of earned net income of $240,000 and investment income of 
$10,000. In addition, on April 24, 1971, stock was transferred to B 
pursuant to his exercise of a qualified stock option, and the fair 
market value of such stock at that time exceeded the option price by 
$175,000. This $175,000 constitutes an item of tax preference described 
in section 57(a)(6). B claims itemized deductions in the amount of 
$34,000. By reason of section 1348, the maximum rate of tax on earned 
taxable income for a taxable year beginning after 1970 but before 1972 
is 60 percent. The income tax for the taxable year ending June 30, 1971, 
would be computed under section 21 as follows:

                           1970 Tentative Tax
Adjusted gross income...................     $250,000.00
  Less:
    Itemized deductions.................      $34,000.00
    Personal exemption..................          625.00       34,625.00
                                         -------------------------------
Taxable income under 1970 deduction           215,375.00
 provisions.............................
                                         =================
Tax on $215,375 (1970 rates)
Tax on first $100,000...................      $55,490.00
70 percent of $115,375..................       80,762.50
                                         ----------------
Tentative tax at rates and deduction          136,252.50
 provisions effective on or after
 January 1, 1970........................
                                         =================
Minimum tax:
  Total tax preference items............      175,000.00
  Less:
    Exemption...........................      $30,000.00
    Income tax..........................      136,252.50      166,252.50
                                         -------------------------------
Subject to 10 percent tax...............        8,747.50
                                         =================
10 percent tax..........................          874.75
                                         =================
      Total tentative tax ($136,252.50 +      137,127.25
       $874.75).........................
                                         =================
                           1971 Tentative Tax
Adjusted gross income...................     $250,000.00
  Less:
    Itemized deductions.................      $34,000.00
    Personal exemption..................          650.00       34,650.00
                                         -------------------------------
Taxable income under 1971 deduction           215,350.00
 provisions.............................
                                         =================
(a) Tax on highest amount of taxable           20,190.00
 income on which rate does not exceed 60
 percent ($50,000) (1971 rates).........
(b) Earned taxable
 income:
  ($215,350x
  $240,000/
  $250,000).............................     $206,736.00
Less: Tax
 preference offset:
 ($175,000
-$30,000)...............................      145,000.00
                                         -----------------
                                               61,736.00
                                         ================
(c) 60% of the amount by which $61,736          7,041.60
 exceeds $50,000........................
(d) Tax on $215,350 (1971 rates)
  Tax on first $100,000.................       53,090.00
  70% of $115,350.......................       80,745.00
                                         ----------------
      Total.............................      133,835.00
                                         ================
(e) Tax on $61,736 (1971 rates)
  Tax on first $60,000..................       26,390.00
  64% of $1,736.........................        1,111.04
                                         ----------------
      Total.............................       27,501.04
                                         ================
(f) Excess of $133,835 over $27,501.04..      106,333.96
                                         -----------------
Tentative tax (total of Steps (a), (c),       133,565.56
 and (f)) at rates and deduction
 provisions effective on or after
 January 1, 1971........................
                                         =================
Minimum tax:
  Total tax preference items............      175,000.00
  Less:
    Exemption...........................      $30,000.00
    Income tax..........................      133,565.56      163,565.56
                                         -------------------------------
  Subject to 10 percent tax.............      $11,434.44
                                         =================
  10 percent tax........................        1,143.44
                                         =================
    Total tentative tax ($133,565.56 +        134,709.00
     $1,143.44).........................
                                         =================
The 1970 and 1971 tentative taxes are
 apportioned as follows:
  1970--184/365 of $137,127.25..........       69,127.16
  1971--181/365 of $134,709.............       66,800.90
                                         =================
    Total tax for the taxable year......      135,928.06
                                         =================
 

    Example 5. The surtax exemption of corporation M (one of 4 
subsidiary corporations of W corporation), which files its income tax

[[Page 35]]

returns on the basis of a fiscal year ending March 31, 1964, is less 
than $25,000, by reason of section 1561 of the Code applicable to 
taxable years ending after December 31, 1963, and beginning before 
January 1, 1975. The taxable income of corporation M is $100,000, and 
the amount of the surtax exemption determined under the new rule for the 
1964 taxable year is $5,000 ($25,000/5). M's income tax liability for 
the taxable year ending March 31, 1964, is computed as follows:

                           1963 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1963 rates) 30           $30,000
 percent of $100,000....................
Surtax on $75,000 (1963 rates and                 16,500
 $25,000 surtax exemption) 22 percent of
 $75,000................................
                                         -----------------
      Total tentative tax at rates and            46,500
       surtax exemption effective before
       January 1, 1964..................
                                         =================
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1964 rates and a               26,600
 $5,000 surtax exemption) 28 percent of
 $95,000................................
                                         ----------------
      Total tentative tax at rates and            48,600
       surtax exemption effective after
       January 1, 1964..................
                                         =================
The 1963 and 1964 tentative taxes are
 apportioned as follows:
  1963--275/366 of $46,500..............       34,938.52
  1964--91/366 of $48,600...............       12,083.61
                                         -----------------
      Total tax for the taxable year....       47,022.13
                                         =================
     M has the same amount of taxable income in 1965. Its income tax
   liability for the fiscal year ending March 31, 1965, is computed as
                                follows:
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1964 rates and a               26,600
 $5,000 surtax exemption) 28 percent of
 $95,000................................
                                         -----------------
      Total tentative tax at the 1964             48,600
       rates............................
                                         =================
                           1965 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1965 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1965 rates and a               24,700
 $5,000 surtax exemption) 26 percent of
 $95,000................................
                                         ----------------
      Total tentative tax at the 1965             46,700
       rates............................
                                         =================
The 1964 and 1965 tentative taxes are
 apportioned as follows:
  1964--275/365 of $48,600..............      $36,616.44
  1965--90/365 of $46,700...............       11,515.07
                                         -----------------
      Total tax for the taxable year....       48,131.51
                                         =================
 

    Example 6. Assume the same facts as in example (5), except that M 
elected the additional tax under section 1562 for its fiscal year ending 
March 31, 1964. M's tax liability is completed as follows:

                           1963 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1963 rates) 30           $30,000
 percent of $100,000....................
Surtax on $75,000 (1963 rates and                 16,500
 $25,000 surtax exemption) 22 percent of
 $75,000................................
                                         ----------------
      Total tentative tax at rates and            46,500
       surtax exemption effective before
       January 1, 1964..................
                                         =================
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $75,000 (1964 rates and                 21,000
 $25,000 surtax exemption) 28 percent of
 $75,000................................
Additional tax on $25,000 6 percent of             1,500
 $25,000................................
                                         ----------------
      Total tentative tax at rates and            44,500
       surtax exemption effective on and
       after January 1, 1964............
                                         =================
The 1963 and 1964 tentative taxes are
 apportioned as follows:
  1963--275/366 of $46,500..............      $34,938.52
  1964--91/366 of $44,500...............       11,064.21
                                         -----------------
      Total tax for the taxable year....       46,002.73
                                         =================
 


[[Page 36]]

    Example 7. Corporation N files its income tax returns on the basis 
of a fiscal year ending June 30. For its taxable year ending in 1976, 
the taxable income of N is $100,000. N's income tax liability is 
determined for the period July 1, 1975, through December 31, 1975, by 
taking into account two rates of normal tax under section 11(b)(2) (A) 
and (B) and the increase to $50,000 in the surtax exemption under 
section 11(d). For the period January 1, 1976, through June 30, 1976, 
N's income tax liability is determined by taking into account the single 
normal tax rate under section 11(b)(1) and the $25,000 surtax exemption 
under section 11(d). N's tax liability for the taxable year ending June 
30, 1976, is computed as follows:

                           1975 Tentative Tax
Taxable income..........................        $100,000
                                         =================
  Normal tax on $100,000 (1975 rates) 20          $5,000
   percent of $25,000...................
  22 percent of $75,000.................          16,500
  Surtax on $50,000 (1975 rates and               13,000
   $50,000 surtax exemption) 26 percent
   of $50,000...........................
                                         ----------------
      Total tentative tax at rates and            34,500
       surtax exemption effective on and
       after January 1, 1975............
                                         =================
                           1976 Tentative Tax
Taxable income..........................        $100,000
                                         =================
  Normal tax on $100,000 (1976 rates) 22         $22,000
   percent of $100,000..................
  Surtax on $75,000 (1976 rates and               19,500
   $25,000 surtax exemption) 26 percent
   of $75,000...........................
                                         ----------------
      Total tentative tax at rates and            41,500
       surtax exemption effective on and
       after January 1, 1976............
                                         =================
The 1975 and 1976 tentative taxes are
 apportioned as follows:
  1975--184/366 of $34,500..............         $17,344
  1976--182/366 of $41,500..............          20,637
                                         -----------------
      Total tax for the taxable year....          37,981
 


(Secs. 1561(a) (83 Stat. 599; 26 U.S.C. 1561(a)) of the Internal Revenue 
Code)

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7164, 37 FR 4190, Feb. 29, 1972; T.D. 74-13, 41 FR 
12639, Mar. 26, 1976; T.D. 7528, 42 FR 64694, Dec. 28, 1977; T.D. 7728, 
45 FR 72651, Nov. 3, 1980. Redesignated by T.D. 9354, 72 FR 45341, Aug. 
14, 2007]



Sec. 1.21-1  Expenses for household and dependent care services necessary for 

gainful employment.

    (a) In general. (1) Section 21 allows a credit to a taxpayer against 
the tax imposed by chapter 1 for employment-related expenses for 
household services and care (as defined in paragraph (d) of this 
section) of a qualifying individual (as defined in paragraph (b) of this 
section). The purpose of the expenses must be to enable the taxpayer to 
be gainfully employed (as defined in paragraph (c) of this section). For 
taxable years beginning after December 31, 2004, a qualifying individual 
must have the same principal place of abode (as defined in paragraph (g) 
of this section) as the taxpayer for more than one-half of the taxable 
year. For taxable years beginning before January 1, 2005, the taxpayer 
must maintain a household (as defined in paragraph (h) of this section) 
that includes one or more qualifying individuals.
    (2) The amount of the credit is equal to the applicable percentage 
of the employment-related expenses that may be taken into account by the 
taxpayer during the taxable year (but subject to the limits prescribed 
in Sec. 1.21-2). Applicable percentage means 35 percent reduced by 1 
percentage point for each $2,000 (or fraction thereof) by which the 
taxpayer's adjusted gross income for the taxable year exceeds $15,000, 
but not less than 20 percent. For example, if a taxpayer's adjusted 
gross income is $31,850, the applicable percentage is 26 percent.
    (3) Expenses may be taken as a credit under section 21, regardless 
of the taxpayer's method of accounting, only in the taxable year the 
services are performed or the taxable year the expenses are paid, 
whichever is later.
    (4) The requirements of section 21 and Sec. Sec. 1.21-1 through 
1.21-4 are applied at the time the services are performed, regardless of 
when the expenses are paid.
    (5) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples.

    Example 1. In December 2007, B pays for the care of her child for 
January 2008. Under paragraph (a)(3) of this section, B may claim the 
credit in 2008, the later of the years in

[[Page 37]]

which the expenses are paid and the services are performed.
    Example 2. The facts are the same as in Example 1, except that B's 
child turns 13 on February 1, 2008, and B pays for the care provided in 
January 2008 on February 3, 2008. Under paragraph (a)(4) of this 
section, the determination of whether the expenses are employment-
related expenses is made when the services are performed. Assuming other 
requirements are met, the amount B pays will be an employment-related 
expense under section 21, because B's child is a qualifying individual 
when the services are performed, even though the child is not a 
qualifying individual when B pays the expenses.

    (b) Qualifying individual--(1) In general. For taxable years 
beginning after December 31, 2004, a qualifying individual is--
    (i) The taxpayer's dependent (who is a qualifying child within the 
meaning of section 152) who has not attained age 13;
    (ii) The taxpayer's dependent (as defined in section 152, determined 
without regard to subsections (b)(1), (b)(2), and (d)(1)(B)) who is 
physically or mentally incapable of self-care and who has the same 
principal place of abode as the taxpayer for more than one-half of the 
taxable year; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care and who has the same principal place of abode as the 
taxpayer for more than one-half of the taxable year.
    (2) Taxable years beginning before January 1, 2005. For taxable 
years beginning before January 1, 2005, a qualifying individual is--
    (i) The taxpayer's dependent for whom the taxpayer is entitled to a 
deduction for a personal exemption under section 151(c) and who is under 
age 13;
    (ii) The taxpayer's dependent who is physically or mentally 
incapable of self-care; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care.
    (3) Qualification on a daily basis. The status of an individual as a 
qualifying individual is determined on a daily basis. An individual is 
not a qualifying individual on the day the status terminates.
    (4) Physical or mental incapacity. An individual is physically or 
mentally incapable of self-care if, as a result of a physical or mental 
defect, the individual is incapable of caring for the individual's 
hygiene or nutritional needs, or requires full-time attention of another 
person for the individual's own safety or the safety of others. The 
inability of an individual to engage in any substantial gainful activity 
or to perform the normal household functions of a homemaker or care for 
minor children by reason of a physical or mental condition does not of 
itself establish that the individual is physically or mentally incapable 
of self-care.
    (5) Special test for divorced or separated parents or parents living 
apart--(i) Scope. This paragraph (b)(5) applies to a child (as defined 
in section 152(f)(1) for taxable years beginning after December 31, 
2004, and in section 151(c)(3) for taxable years beginning before 
January 1, 2005) who--
    (A) Is under age 13 or is physically or mentally incapable of self-
care;
    (B) Receives over one-half of his or her support during the calendar 
year from one or both parents who are divorced or legally separated 
under a decree of divorce or separate maintenance, are separated under a 
written separation agreement, or live apart at all times during the last 
6 months of the calendar year; and
    (C) Is in the custody of one or both parents for more than one-half 
of the calendar year.
    (ii) Custodial parent allowed the credit. A child to whom this 
paragraph (b)(5) applies is the qualifying individual of only one parent 
in any taxable year and is the qualifying child of the custodial parent 
even if the noncustodial parent may claim the dependency exemption for 
that child for that taxable year. See section 21(e)(5). The custodial 
parent is the parent having custody for the greater portion of the 
calendar year. See section 152(e)(4)(A).
    (6) Example. The provisions of this paragraph (b) are illustrated by 
the following examples.

    Example. C pays $420 for the care of her child, a qualifying 
individual, to be provided from January 2 through January 31, 2008 (21 
days of care). On January 20, 2008, C's child turns 13 years old. Under 
paragraph (b)(3) of this section, C's child is a qualifying individual 
from January 2 through January 19, 2008 (13 days of care). C may take 
into account $260, the pro rata amount C pays for

[[Page 38]]

the care of her child for 13 days, under section 21. See Sec. 1.21-
2(a)(4).

    (c) Gainful employment--(1) In general. Expenses are employment-
related expenses only if they are for the purpose of enabling the 
taxpayer to be gainfully employed. The expenses must be for the care of 
a qualifying individual or household services performed during periods 
in which the taxpayer is gainfully employed or is in active search of 
gainful employment. Employment may consist of service within or outside 
the taxpayer's home and includes self-employment. An expense is not 
employment-related merely because it is paid or incurred while the 
taxpayer is gainfully employed. The purpose of the expense must be to 
enable the taxpayer to be gainfully employed. Whether the purpose of an 
expense is to enable the taxpayer to be gainfully employed depends on 
the facts and circumstances of the particular case. Work as a volunteer 
or for a nominal consideration is not gainful employment.
    (2) Determination of period of employment on a daily basis--(i) In 
general. Expenses paid for a period during only part of which the 
taxpayer is gainfully employed or in active search of gainful employment 
must be allocated on a daily basis.
    (ii) Exception for short, temporary absences. A taxpayer who is 
gainfully employed is not required to allocate expenses during a short, 
temporary absence from work, such as for vacation or minor illness, 
provided that the care-giving arrangement requires the taxpayer to pay 
for care during the absence. An absence of 2 consecutive calendar weeks 
is a short, temporary absence. Whether an absence longer than 2 
consecutive calendar weeks is a short, temporary absence is determined 
based on all the facts and circumstances.
    (iii) Part-time employment. A taxpayer who is employed part-time 
generally must allocate expenses for dependent care between days worked 
and days not worked. However, if a taxpayer employed part-time is 
required to pay for dependent care on a periodic basis (such as weekly 
or monthly) that includes both days worked and days not worked, the 
taxpayer is not required to allocate the expenses. A day on which the 
taxpayer works at least 1 hour is a day of work.
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. D works during the day and her husband, E, works at night 
and sleeps during the day. D and E pay for care for a qualifying 
individual during the hours when D is working and E is sleeping. Under 
paragraph (c)(1) of this section, the amount paid by D and E for care 
may be for the purpose of allowing D and E to be gainfully employed and 
may be an employment-related expense under section 21.
    Example 2. F works at night and pays for care for a qualifying 
individual during the hours when F is working. Under paragraph (c)(1) of 
this section, the amount paid by F for care may be for the purpose of 
allowing F to be gainfully employed and may be an employment-related 
expense under section 21.
    Example 3. G, the custodial parent of two children who are 
qualifying individuals, hires a housekeeper for a monthly salary to care 
for the children while G is gainfully employed. G becomes ill and as a 
result is absent from work for 4 months. G continues to pay the 
housekeeper to care for the children while G is absent from work. During 
this 4-month period, G performs no employment services, but receives 
payments under her employer's wage continuation plan. Although G may be 
considered to be gainfully employed during her absence from work, the 
absence is not a short, temporary absence within the meaning of 
paragraph (c)(2)(ii) of this section, and her payments for household and 
dependent care services during the period of illness are not for the 
purpose of enabling her to be gainfully employed. G's expenses are not 
employment-related expenses, and she may not take the expenses into 
account under section 21.
    Example 4. To be gainfully employed, H sends his child to a 
dependent care center that complies with all state and local 
requirements. The dependent care center requires payment for days when a 
child is absent from the center. H takes 8 days off from work as 
vacation days. Because the absence is less than 2 consecutive calendar 
weeks, under paragraph (c)(2)(ii) of this section, H's absence is a 
short, temporary absence. H is not required to allocate expenses between 
days worked and days not worked. The entire fee for the period that 
includes the 8 vacation days may be an employment-related expense under 
section 21.
    Example 5. J works 3 days per week and her child attends a dependent 
care center (that complies with all state and local requirements) to 
enable her to be gainfully employed. The dependent care center allows 
payment for any 3 days per week for $150 or

[[Page 39]]

5 days per week for $250. J enrolls her child for 5 days per week, and 
her child attends the care center for 5 days per week. Under paragraph 
(c)(2)(iii) of this section, J must allocate her expenses for dependent 
care between days worked and days not worked. Three-fifths of the $250, 
or $150 per week, may be an employment-related expense under section 21.
    Example 6. The facts are the same as in Example 5, except that the 
dependent care center does not offer a 3-day option. The entire $250 
weekly fee may be an employment-related expense under section 21.

    (d) Care of qualifying individual and household services--(1) In 
general. To qualify for the dependent care credit, expenses must be for 
the care of a qualifying individual. Expenses are for the care of a 
qualifying individual if the primary function is to assure the 
individual's well-being and protection. Not all expenses relating to a 
qualifying individual are for the individual's care. Amounts paid for 
food, lodging, clothing, or education are not for the care of a 
qualifying individual. If, however, the care is provided in such a 
manner that the expenses cover other goods or services that are 
incidental to and inseparably a part of the care, the full amount is for 
care.
    (2) Allocation of expenses. If an expense is partly for household 
services or for the care of a qualifying individual and partly for other 
goods or services, a reasonable allocation must be made. Only so much of 
the expense that is allocable to the household services or care of a 
qualifying individual is an employment-related expense. An allocation 
must be made if a housekeeper or other domestic employee performs 
household duties and cares for the qualifying children of the taxpayer 
and also performs other services for the taxpayer. No allocation is 
required, however, if the expense for the other purpose is minimal or 
insignificant or if an expense is partly attributable to the care of a 
qualifying individual and partly to household services.
    (3) Household services. Expenses for household services may be 
employment-related expenses if the services are performed in connection 
with the care of a qualifying individual. The household services must be 
the performance in and about the taxpayer's home of ordinary and usual 
services necessary to the maintenance of the household and attributable 
to the care of the qualifying individual. Services of a housekeeper are 
household services within the meaning of this paragraph (d)(3) if the 
services are provided, at least in part, to the qualifying individual. 
Such services as are performed by chauffeurs, bartenders, or gardeners 
are not household services.
    (4) Manner of providing care. The manner of providing care need not 
be the least expensive alternative available to the taxpayer. The cost 
of a paid caregiver may be an expense for the care of a qualifying 
individual even if another caregiver is available at no cost.
    (5) School or similar program. Expenses for a child in nursery 
school, pre-school, or similar programs for children below the level of 
kindergarten are for the care of a qualifying individual and may be 
employment-related expenses. Expenses for a child in kindergarten or a 
higher grade are not for the care of a qualifying individual. However, 
expenses for before- or after-school care of a child in kindergarten or 
a higher grade may be for the care of a qualifying individual.
    (6) Overnight camps. Expenses for overnight camps are not 
employment-related expenses.
    (7) Day camps. (i) The cost of a day camp or similar program may be 
for the care of a qualifying individual and an employment-related 
expense, without allocation under paragraph (d)(2) of this section, even 
if the day camp specializes in a particular activity. Summer school and 
tutoring programs are not for the care of a qualifying individual and 
the costs are not employment-related expenses.
    (ii) A day camp that meets the definition of dependent care center 
in section 21(b)(2)(D) and paragraph (e)(2) of this section must comply 
with the requirements of section 21(b)(2)(C) and paragraph (e)(2) of 
this section.
    (8) Transportation. The cost of transportation by a dependent care 
provider of a qualifying individual to or from a place where care of 
that qualifying individual is provided may be for the care of the 
qualifying individual. The cost of transportation not provided by a 
dependent care provider is not for the care of the qualifying 
individual.

[[Page 40]]

    (9) Employment taxes. Taxes under sections 3111 (relating to the 
Federal Insurance Contributions Act) and 3301 (relating to the Federal 
Unemployment Tax Act) and similar state payroll taxes are employment-
related expenses if paid in respect of wages that are employment-related 
expenses.
    (10) Room and board. The additional cost of providing room and board 
for a caregiver over usual household expenditures may be an employment-
related expense.
    (11) Indirect expenses. Expenses that relate to, but are not 
directly for, the care of a qualifying individual, such as application 
fees, agency fees, and deposits, may be for the care of a qualifying 
individual and may be employment-related expenses if the taxpayer is 
required to pay the expenses to obtain the related care. However, 
forfeited deposits and other payments are not for the care of a 
qualifying individual if care is not provided.
    (12) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. To be gainfully employed, K sends his 3-year old child to 
a pre-school. The pre-school provides lunch and snacks. Under paragraph 
(d)(1) of this section, K is not required to allocate expenses between 
care and the lunch and snacks, because the lunch and snacks are 
incidental to and inseparably a part of the care. Therefore, K may treat 
the full amount paid to the pre-school as for the care of his child.
    Example 2. L, a member of the armed forces, is ordered to a combat 
zone. To be able to comply with the orders, L places her 10-year old 
child in boarding school. The school provides education, meals, and 
housing to L's child in addition to care. Under paragraph (d)(2) of this 
section, L must allocate the cost of the boarding school between 
expenses for care and expenses for education and other services not 
constituting care. Only the part of the cost of the boarding school that 
is for the care of L's child is an employment-related expense under 
section 21.
    Example 3. To be gainfully employed, M employs a full-time 
housekeeper to care for M's two children, aged 9 and 13 years. The 
housekeeper regularly performs household services of cleaning and 
cooking and drives M to and from M's place of employment, a trip of 15 
minutes each way. Under paragraph (d)(3) of this section, the chauffeur 
services are not household services. M is not required to allocate a 
portion of the expense of the housekeeper to the chauffeur services 
under paragraph (d)(2) of this section, however, because the chauffeur 
services are minimal and insignificant. Further, no allocation under 
paragraph (d)(2) of this section is required to determine the portion of 
the expenses attributable to the care of the 13-year old child (not a 
qualifying individual) because the household expenses are in part 
attributable to the care of the 9-year-old child. Accordingly, the 
entire expense of employing the housekeeper is an employment-related 
expense. The amount that M may take into account as an employment-
related expense under section 21, however, is limited to the amount 
allowable for one qualifying individual.
    Example 4. To be gainfully employed, N sends her 9-year-old child to 
a summer day camp that offers computer activities and recreational 
activities such as swimming and arts and crafts. Under paragraph 
(d)(7)(i) of this section, the full cost of the summer day camp may be 
for care.
    Example 5. To be gainfully employed, O sends her 9-year-old child to 
a math tutoring program for two hours per day during the summer. Under 
paragraph (d)(7)(i) of this section, the cost of the tutoring program is 
not for care.
    Example 6. To be gainfully employed, P hires a full-time housekeeper 
to care for her 8-year old child. In order to accommodate the 
housekeeper, P moves from a 2-bedroom apartment to a 3-bedroom apartment 
that otherwise is comparable to the 2-bedroom apartment. Under paragraph 
(d)(10) of this section, the additional cost to rent the 3-bedroom 
apartment over the cost of the 2-bedroom apartment and any additional 
utilities attributable to the housekeeper's residence in the household 
may be employment-related expenses under section 21.
    Example 7. Q pays a fee to an agency to obtain the services of an au 
pair to care for Q's children, qualifying individuals, to enable Q to be 
gainfully employed. An au pair from the agency subsequently provides 
care for Q's children. Under paragraph (d)(11) of this section, the fee 
may be an employment-related expense.
    Example 8. R places a deposit with a pre-school to reserve a place 
for her child. R sends the child to a different pre-school and forfeits 
the deposit. Under paragraph (d)(11) of this section, the forfeited 
deposit is not an employment-related expense.

    (e) Services outside the taxpayer's household--(1) In general. The 
credit is allowable for expenses for services performed outside the 
taxpayer's household only if the care is for one or more qualifying 
individuals who are described in this section at--
    (i) Paragraph (b)(1)(i) or (b)(2)(i); or

[[Page 41]]

    (ii) Paragraph (b)(1)(ii), (b)(2)(ii), (b)(1)(iii), or (b)(2)(iii) 
and regularly spend at least 8 hours each day in the taxpayer's 
household.
    (2) Dependent care centers--(i) In general. The credit is allowable 
for services performed by a dependent care center only if--
    (A) The center complies with all applicable laws and regulations, if 
any, of a state or local government, such as state or local licensing 
requirements and building and fire code regulations; and
    (B) The requirements provided in this paragraph (e) are met.
    (ii) Definition. The term dependent care center means any facility 
that provides full-time or part-time care for more than six individuals 
(other than individuals who reside at the facility) on a regular basis 
during the taxpayer's taxable year, and receives a fee, payment, or 
grant for providing services for the individuals (regardless of whether 
the facility is operated for profit). For purposes of the preceding 
sentence, a facility is presumed to provide full-time or part-time care 
for six or fewer individuals on a regular basis during the taxpayer's 
taxable year if the facility has six or fewer individuals (including the 
taxpayer's qualifying individual) enrolled for full-time or part-time 
care on the day the qualifying individual is enrolled in the facility 
(or on the first day of the taxable year the qualifying individual 
attends the facility if the qualifying individual was enrolled in the 
facility in the preceding taxable year) unless the Internal Revenue 
Service demonstrates that the facility provides full-time or part-time 
care for more than six individuals on a regular basis during the 
taxpayer's taxable year.
    (f) Reimbursed expenses. Employment-related expenses for which the 
taxpayer is reimbursed (for example, under a dependent care assistance 
program) may not be taken into account for purposes of the credit.
    (g) Principal place of abode. For purposes of this section, the term 
principal place of abode has the same meaning as in section 152.
    (h) Maintenance of a household--(1) In general. For taxable years 
beginning before January 1, 2005, the credit is available only to a 
taxpayer who maintains a household that includes one or more qualifying 
individuals. A taxpayer maintains a household for the taxable year (or 
lesser period) only if the taxpayer (and spouse, if applicable) occupies 
the household and furnishes over one-half of the cost for the taxable 
year (or lesser period) of maintaining the household. The household must 
be the principal place of abode for the taxable year of the taxpayer and 
the qualifying individual or individuals.
    (2) Cost of maintaining a household. (i) Except as provided in 
paragraph (h)(2)(ii) of this section, for purposes of this section, the 
term cost of maintaining a household has the same meaning as in Sec. 
1.2-2(d) without regard to the last sentence thereof.
    (ii) The cost of maintaining a household does not include the value 
of services performed in the household by the taxpayer or by a 
qualifying individual described in paragraph (b) of this section or any 
expense paid or reimbursed by another person.
    (3) Monthly proration of annual costs. In determining the cost of 
maintaining a household for a period of less than a taxable year, the 
cost for the entire taxable year must be prorated on the basis of the 
number of calendar months within that period. A period of less than a 
calendar month is treated as a full calendar month.
    (4) Two or more families. If two or more families occupy living 
quarters in common, each of the families is treated as maintaining a 
separate household. A taxpayer is maintaining a household if the 
taxpayer provides more than one-half of the cost of maintaining the 
separate household. For example, if two unrelated taxpayers with their 
respective children occupy living quarters in common and each taxpayer 
pays more than one-half of the household costs for each respective 
family, each taxpayer is treated as maintaining a household.
    (i) Reserved.
    (j) Expenses qualifying as medical expenses--(1) In general. A 
taxpayer may not take an amount into account as both an employment-
related expense under section 21 and an expense for medical care under 
section 213.

[[Page 42]]

    (2) Examples. The provisions of this paragraph (j) are illustrated 
by the following examples:

    Example 1. S has $6,500 of employment-related expenses for the care 
of his child who is physically incapable of self-care. The expenses are 
for services performed in S's household that also qualify as expenses 
for medical care under section 213. Of the total expenses, S may take 
into account $3,000 under section 21. S may deduct the balance of the 
expenses, or $3,500, as expenses for medical care under section 213 to 
the extent the expenses exceed 7.5 percent of S's adjusted gross income.
    Example 2. The facts are the same as in Example 1, however, S first 
takes into account the $6,500 of expenses under section 213. S deducts 
$500 as an expense for medical care, which is the amount by which the 
expenses exceed 7.5 percent of his adjusted gross income. S may not take 
into account the $6,000 balance as employment-related expenses under 
section 21, because he has taken the full amount of the expenses into 
account in computing the amount deductible under section 213.

    (k) Substantiation. A taxpayer claiming a credit for employment-
related expenses must maintain adequate records or other sufficient 
evidence to substantiate the expenses in accordance with section 6001 
and the regulations thereunder.
    (l) Effective/applicability date. This section and Sec. Sec. 1.21-2 
through 1.21-4 apply to taxable years ending after August 14, 2007.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.21-2  Limitations on amount creditable.

    (a) Annual dollar limitation. (1) The amount of employment-related 
expenses that may be taken into account under Sec. 1.21-1(a) for any 
taxable year cannot exceed--
    (i) $2,400 ($3,000 for taxable years beginning after December 31, 
2002, and before January 1, 2011) if there is one qualifying individual 
with respect to the taxpayer at any time during the taxable year; or
    (ii) $4,800 ($6,000 for taxable years beginning after December 31, 
2002, and before January 1, 2011) if there are two or more qualifying 
individuals with respect to the taxpayer at any time during the taxable 
year.
    (2) The amount determined under paragraph (a)(1) of this section is 
reduced by the aggregate amount excludable from gross income under 
section 129 for the taxable year.
    (3) A taxpayer may take into account the total amount of employment-
related expenses that do not exceed the annual dollar limitation 
although the amount of employment-related expenses attributable to one 
qualifying individual is disproportionate to the total employment-
related expenses. For example, a taxpayer with expenses in 2007 of 
$4,000 for one qualifying individual and $1,500 for a second qualifying 
individual may take into account the full $5,500.
    (4) A taxpayer is not required to prorate the annual dollar 
limitation if a qualifying individual ceases to qualify (for example, by 
turning age 13) during the taxable year. However, the taxpayer may take 
into account only amounts that qualify as employment-related expenses 
before the disqualifying event. See also Sec. 1.21-1(b)(6).
    (b) Earned income limitation--(1) In general. The amount of 
employment-related expenses that may be taken into account under section 
21 for any taxable year cannot exceed--
    (i) For a taxpayer who is not married at the close of the taxable 
year, the taxpayer's earned income for the taxable year; or
    (ii) For a taxpayer who is married at the close of the taxable year, 
the lesser of the taxpayer's earned income or the earned income of the 
taxpayer's spouse for the taxable year.
    (2) Determination of spouse. For purposes of this paragraph (b), a 
taxpayer must take into account only the earned income of a spouse to 
whom the taxpayer is married at the close of the taxable year. The 
spouse's earned income for the entire taxable year is taken into 
account, however, even though the taxpayer and the spouse were married 
for only part of the taxable year. The taxpayer is not required to take 
into account the earned income of a spouse who died or was divorced or 
separated from the taxpayer during the taxable year. See Sec. 1.21-3(b) 
for rules providing that certain married taxpayers legally separated or 
living apart are treated as not married.

[[Page 43]]

    (3) Definition of earned income. For purposes of this section, the 
term earned income has the same meaning as in section 32(c)(2) and the 
regulations thereunder.
    (4) Attribution of earned income to student or incapacitated spouse. 
(i) For purposes of this section, a spouse is deemed, for each month 
during which the spouse is a full-time student or is a qualifying 
individual described in Sec. 1.21-1(b)(1)(iii) or (b)(2)(iii), to be 
gainfully employed and to have earned income of not less than--
    (A) $200 ($250 for taxable years beginning after December 31, 2002, 
and before January 1, 2011) if there is one qualifying individual with 
respect to the taxpayer at any time during the taxable year; or
    (B) $400 ($500 for taxable years beginning after December 31, 2002, 
and before January 1, 2011) if there are two or more qualifying 
individuals with respect to the taxpayer at any time during the taxable 
year.
    (ii) For purposes of this paragraph (b)(4), a full-time student is 
an individual who, during each of 5 calendar months of the taxpayer's 
taxable year, is enrolled as a student for the number of course hours 
considered to be a full-time course of study at an educational 
organization as defined in section 170(b)(1)(A)(ii). The enrollment for 
5 calendar months need not be consecutive.
    (iii) Earned income may be attributed under this paragraph (b)(4), 
in the case of any husband and wife, to only one spouse in any month.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. In 2007, T, who is married to U, pays employment-related 
expenses of $5,000 for the care of one qualifying individual. T's earned 
income for the taxable year is $40,000 and her husband's earned income 
is $2,000. T did not exclude any dependent care assistance under section 
129. Under paragraph (b)(1) of this section, T may take into account 
under section 21 only the amount of employment-related expenses that 
does not exceed the lesser of her earned income or the earned income of 
U, or $2,000.
    Example 2. The facts are the same as in Example 1 except that U is a 
full-time student at an educational organization within the meaning of 
section 170(b)(1)(A)(ii) for 9 months of the taxable year and has no 
earned income. Under paragraph (b)(4) of this section, U is deemed to 
have earned income of $2,250. T may take into account $2,250 of 
employment-related expenses under section 21.
    Example 3. For all of 2007, V is a full-time student and W, V's 
husband, is an individual who is incapable of self-care (as defined in 
Sec. 1.21-1(b)(1)(iii)). V and W have no earned income and pay expenses 
of $5,000 for W's care. Under paragraph (b)(4) of this section, either V 
or W may be deemed to have $3,000 of earned income. However, earned 
income may be attributed to only one spouse under paragraph (b)(4)(iii) 
of this section. Under the limitation in paragraph (b)(1)(ii) of this 
section, the lesser of V's and W's earned income is zero. V and W may 
not take the expenses into account under section 21.

    (d) Cross-reference. For an additional limitation on the credit 
under section 21, see section 26.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.21-3  Special rules applicable to married taxpayers.

    (a) Joint return requirement. No credit is allowed under section 21 
for taxpayers who are married (within the meaning of section 7703 and 
the regulations thereunder) at the close of the taxable year unless the 
taxpayer and spouse file a joint return for the taxable year. See 
section 6013 and the regulations thereunder relating to joint returns of 
income tax by husband and wife.
    (b) Taxpayers treated as not married. The requirements of paragraph 
(a) of this section do not apply to a taxpayer who is legally separated 
under a decree of divorce or separate maintenance or who is treated as 
not married under section 7703(b) and the regulations thereunder 
(relating to certain married taxpayers living apart). A taxpayer who is 
treated as not married under this paragraph (b) is not required to take 
into account the earned income of the taxpayer's spouse for purposes of 
applying the earned income limitation on the amount of employment-
related expenses under Sec. 1.21-2(b).
    (c) Death of married taxpayer. If a married taxpayer dies during the 
taxable year and the survivor may make a joint return with respect to 
the deceased spouse under section 6013(a)(3), the credit is allowed for 
the year only if a joint return is made. If, however,

[[Page 44]]

the surviving spouse remarries before the end of the taxable year in 
which the deceased spouse dies, a credit may be allowed on the decedent 
spouse(s separate return.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.21-4  Payments to certain related individuals.

    (a) In general. A credit is not allowed under section 21 for any 
amount paid by the taxpayer to an individual--
    (1) For whom a deduction under section 151(c) (relating to 
deductions for personal exemptions for dependents) is allowable either 
to the taxpayer or the taxpayer's spouse for the taxable year;
    (2) Who is a child of the taxpayer (within the meaning of section 
152(f)(1) for taxable years beginning after December 31, 2004, and 
section 151(c)(3) for taxable years beginning before January 1, 2005) 
and is under age 19 at the close of the taxable year;
    (3) Who is the spouse of the taxpayer at any time during the taxable 
year; or
    (4) Who is the parent of the taxpayer's child who is a qualifying 
individual described in Sec. 1.21-1(b)(1)(i) or (b)(2)(i).
    (b) Payments to partnerships or other entities. In general, 
paragraph (a) of this section does not apply to services performed by 
partnerships or other entities. If, however, the partnership or other 
entity is established or maintained primarily to avoid the application 
of paragraph (a) of this section to permit the taxpayer to claim the 
credit, for purposes of section 21, the payments of employment-related 
expenses are treated as made directly to each partner or owner in 
proportion to that partner's or owner's ownership interest. Whether a 
partnership or other entity is established or maintained to avoid the 
application of paragraph (a) of this section is determined based on the 
facts and circumstances, including whether the partnership or other 
entity is established for the primary purpose of caring for the 
taxpayer's qualifying individual or providing household services to the 
taxpayer.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. During 2007, X pays $5,000 to her mother for the care of 
X's 5-year old child who is a qualifying individual. The expenses 
otherwise qualify as employment-related expenses. X's mother is not her 
dependent. X may take into account under section 21 the amounts paid to 
her mother for the care of X's child.
    Example 2. Y is divorced and has custody of his 5-year old child, 
who is a qualifying individual. Y pays $6,000 during 2007 to Z, who is 
his ex-wife and the child's mother, for the care of the child. The 
expenses otherwise qualify as employment-related expenses. Under 
paragraph (a)(4) of this section, Y may not take into account under 
section 21 the amounts paid to Z because Z is the child's mother.
    Example 3. The facts are the same as in Example 2, except that Z is 
not the mother of Y's child. Y may take into account under section 21 
the amounts paid to Z.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.23-1  Residential energy credit.

    (a) General rule. Section 23 or former section 44C provides a 
residential energy credit against the tax imposed by chapter 1 of the 
Internal Revenue Code. The credit is an amount equal to the individual's 
qualified energy conservation expenditures (set out in paragraph (b)) 
plus the individual's qualified renewable energy source expenditures 
(set out in paragraph (c)) for the taxable year. However, the credit is 
subject to the limitations described in paragraph (d) and the special 
rules contained in Sec. 1.23-3. The credit is nonrefundable (that is, 
the credit may not exceed an individual's tax liability for the taxable 
year). However, any unused credit may be carried over to succeeding 
years to the extent permitted under paragraph (e). Renters as well as 
owners of a dwelling unit may qualify for the credit. See Sec. 1.23-
3(h) for the rules relating to the allocation of the credit in the case 
of joint occupants of a dwelling unit.
    (b) Qualified energy conservation expenditures. In the case of any 
dwelling unit, the qualified energy conservation expenditures are 15 
percent of the energy conservation expenditures made by the taxpayer 
with respect to the dwelling unit during the taxable year, but not in 
excess of $2,000 of such expenditures. See Sec. 1.23-2(a) for the 
definition of energy conservation expenditures.

[[Page 45]]

    (c) Qualified renewable energy source expenditures. In the case of 
taxable years beginning after December 31, 1979, the qualified renewable 
energy source expenditures are 40 percent of the renewable energy source 
expenditures made by the taxpayer during the taxable year (and before 
January 1, 1986) with respect to the dwelling units that do not exceed 
$10,000. In the case of taxable years beginning before January 1, 1980, 
the qualified renewable energy source expenditures are the renewable 
energy source expenditures made by the taxpayer with respect to the 
dwelling unit during the taxable year, but not in excess of--
    (1) 30 percent of the expenditures up to $2,000, plus
    (2) 20 percent of the expenditures over $2,000, but not more than 
$10,000.

See Sec. 1.23-2(b) for the definition of renewable energy source 
expenditures.
    (d) Limitations--(1) Minimum dollar amount. No residential energy 
credit shall be allowed with respect to any return (whether joint or 
separate) for any taxable year if the amount of the credit otherwise 
allowable (determined without regard to the tax liability limitation 
imposed by paragraph (d)(3) of this section) is less than $10.
    (2) Prior expenditures taken into account--(i) In general. For 
purposes of determining the credit for expenditures made during a 
taxable year, the taxpayer must reduce the maximum amount of allowable 
expenditures with respect to the dwelling until in computing qualified 
energy conservation expenditures (under paragraph (b)) or qualified 
renewable energy conservation expenditures (under paragraph (c)) by 
prior expenditures which were made by the taxpayer or by joint occupants 
(see Sec. 1.23-3(h)) with respect to the same dwelling unit, and which 
were taken into account in computing the credit for prior taxable years. 
In the case of expenditures made during taxable years beginning before 
January 1, 1980, the reduction of the maximum amount under paragraph (c) 
must first be made with respect to the first $2,000 of expenditures (to 
which a 30 percent rate applies) and then with respect to the next 
$8,000 of expenditures (to which a 20 percent rate applies). This 
reduction must be made if all or any part of the credit was allowed in 
or was carried over from a prior taxable year.
    (ii) Change of principal residence. A taxpayer is eligible for the 
maximum credit for qualifying expenditures made with respect to a new 
principal residence notwithstanding the allowance of a credit for 
qualifying expenditures made with respect to the taxpayer's previous 
principal residence. Furthermore, except in certain cases involving 
joint occupancy (see Sec. 1.23-3(h)), a taxpayer is eligible for the 
maximum credit notwithstanding the allowance of a credit to a prior 
owner of the taxpayer's new principal residence.
    (iii) Example. The rules with respect to the reduction for prior 
expenditures are illustrated by the following example:

    Example. In 1978, A has $1,000 of energy conservation expenditures 
and $5,000 of renewable energy source expenditures in connection with 
A's principal residence. A's residential energy credit for 1978 is 
$1,350, made up of $150 of qualified energy conservation expenditures 
(15 percent of $1,000) plus $1,200 of qualified renewable energy source 
expenditures (30 percent of the first $2,000 plus 20 percent of the next 
$3,000). In 1979 A has an additional $2,000 of energy conservation 
expenditures and $3,000 of renewable energy source expenditures in 
connection with the same principal residence. A's residential energy 
credit for 1979 is $750, made up of $150 of qualified energy 
conservation expenditures (15 percent of the new maximum $1,000, which 
was reduced from $2,000 by $1,000 of energy conservation expenditures 
taken into account in 1978) plus $600 of qualified renewable energy 
source expenditures (20 percent of $3,000, which reflects the reduction 
of the maximum allowable expenditures by the $5,000 of renewable energy 
source expenditures taken into account in 1978). The maximum residential 
energy credit allowable to A with respect to the same principal 
residence in subsequent years in which the credit is allowable is $400 
(20 percent of the new maximum of $2,000 for renewable energy source 
expenditures and none for energy conservation expenditures).

    (3) Effects of grants and subsidized energy financing--(i) In 
general. Qualified expenditures financed with Federal, State, or local 
grants shall be taken into account for purposes of computing the 
residential energy credit only if the amount of such grants is taxable 
as gross income to the taxpayer under section 61 (relating to the 
definition of gross income) and the regulations

[[Page 46]]

thereunder. In the case of taxable years beginning after December 31, 
1980, qualified expenditures made from subsidized energy financing (as 
defined in Sec. 1.23-2(i)) shall not be taken into account (except as 
provided in the following sentence) for purposes of computing the 
residential energy credit. In addition, the taxpayer must reduce the 
maximum amount allowable expenditures (reduced as provided in paragraph 
(d)(2) of this section) with respect to the dwelling unit in computing 
qualified energy conservation expenditures (under paragraph (b) of this 
section) or qualified renewable energy source expenditures (under 
paragraph (c) of this section), whichever is appropriate, by an amount 
equal to the sum of--
    (A) The amount of expenditures from subsidized energy financing (as 
defined in Sec. 1.23-2(i)) that were made by the taxpayer during the 
taxable year or any prior taxable year beginning after December 31, 
1980, with respect to the same dwelling unit, and
    (B) The amount of any funds received by the taxpayer during the 
taxable year or any prior taxable year beginning after December 31, 
1980, as a Federal, State, or local government grant made in taxable 
years beginning after December 31, 1980, that were used to make 
qualified expenditures with respect to the same dwelling unit and that 
were not included in the gross income of the taxpayer.
    (ii) Example. The provisions of this paragraph (d)(3) may be 
illustrated by the following example:

    Example. A had in 1979 made a renewable energy source expenditure of 
$2,000 in connection with A's residence for which he took the then 
allowed credit of $600. In 1981 A made additional renewable energy 
source expenditures of $9,000 with respect to which he received a loan 
of $5,000 from the Federal Solar-Energy and Energy Conservation Bank. 
Assume that the loan is subsidized energy financing. A computes the 
credit as follows: The initial maximum allowable dollar limit is $10,000 
which is reduced by the sum of the prior year expenditures of $2,000 and 
the subsidized energy financing loan of $5,000 leaving a dollar limit of 
$3,000 ($10,000-($2,000+$5,000)). The $5,000 portion of the $9,000 
funded by the subsidized energy financing loan is not allowed as a 
renewable energy source expenditure. The remaining expenditures in 1981 
are $4,000 ($9,000-$5,000). However, this amount exceeds the allowed 
maximum dollar limit of $3,000. Therefore, A's creditable expenses for 
1981 are only $3,000 on which the credit is $1,200 (40 percent of 
$3,000).

    (4) Tax liability limitation--(i) For taxable years beginning after 
December 31, 1983. For taxable years beginning after December 31, 1983, 
the credit allowed by this section shall not exceed the amount of tax 
imposed by chapter 1 of the Internal Revenue Code of 1954 for the 
taxable year, reduced by the sum of credits allowable under--
    (A) Section 21 (relating to expenses for household and dependent 
care services necessary for gainful employment),
    (B) Section 22 (relating to credit for the elderly and the 
permanently and totally disabled), and
    (C) Section 24 (relating to contributions to candidates for public 
office).

See section 26 (b) and (c) for certain taxes that are not treated as 
imposed by chapter 1.
    (ii) For taxable years beginning before January 1, 1984. For taxable 
years beginning before January 1, 1984, the credit allowed by this 
section shall not exceed the amount of the tax imposed by chapter 1 of 
the Internal Revenue Code of 1954 for the taxable year, reduced by the 
sum of the credits allowable under--
    (A) Section 32 (relating to tax withheld at source on nonresident 
aliens and foreign corporations and on tax-free covenant bonds),
    (B) Section 33 (relating to the taxes of foreign countries and 
possessions of the United States),
    (C) Section 37 (relating to retirement income),
    (D) Section 38 (relating to investment in certain depreciable 
property),
    (E) Section 40 (relating to expenses of work incentive programs),
    (F) Section 41 (relating to contributions to candidates for public 
office),
    (G) Section 42 (relating to the general tax credit),
    (H) Section 44 (relating to purchase of new personal residence),
    (I) Section 44A (relating to expenses for household and dependent 
care services), and
    (J) Section 44B (relating to employment of certain new employees).

[[Page 47]]

    (e) Carryforward of unused credit. If the credit allowable by this 
section exceeds the tax liability limitation imposed by section 23(b)(5) 
(or former section 44C(b)(5)) and paragraph (d)(4) of this section, the 
excess credit shall be carried forward to the succeeding taxable year 
and added to the credit allowable under this section for the succeeding 
taxable year. A carryforward that is not used in the succeeding year 
because it exceeds the tax liability limitation shall be carried forward 
to later taxable years until used, except that no excess credit may be 
carried forward to any taxable year beginning after December 31, 1987.

[T.D. 7717, 45 FR 57715, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26669, July 16, 1987]



Sec. 1.23-2  Definitions.

    For purposes of section 23 or former section 44C and regulations 
thereunder--
    (a) Energy conservation expenditures--(1) In general. The term 
``energy conservation expenditure'' means an expenditure made on or 
after April 20, 1977, and before January 1, 1986, by a taxpayer for 
insulation or any other energy-conserving component, or for labor costs 
allocable to the original installation of such insulation or other 
component, if all of the following conditions are satisfied:
    (i) The insulation (as defined in paragraph (c)) or other energy-
conserving component (as defined in paragraph (d)) is installed in or on 
a dwelling unit that is used as the taxpayer's principal residence when 
the installation is completed. See Sec. 1.23-3(e) for the definition of 
principal residence.
    (ii) The dwelling unit is located in the United States (as defined 
in section 7701(a)(9)).
    (iii) The construction of the dwelling unit was substantially 
completed before April 20, 1977. See Sec. 1.23-3(f) for the definition 
of the terms ``construction'' and ``substantially completed''. In the 
case of expenditures made with respect to the enlargement of a dwelling 
unit, the construction of the enlargement must have been substantially 
completed before April 20, 1977.
    (2) Examples. The application of this paragraph may be illustrated 
by the following examples:

    Example 1. In 1978, A spent $500 for the purchase and installation 
of new storm windows to replace old storm windows, $100 to reinstall old 
storm windows, and $150 to transfer a A's house insulation which had 
been installed in A's garage. Only the $500 spent for new storm windows 
qualifies as an energy conservation expenditure. The $100 spent to 
reinstall storm windows and the $150 spent to transfer insulation to A's 
house do not qualify since the only installation costs that qualify are 
those for the original installation of energy conservation property the 
original use of which commences with the taxpayer.
    Example 2. In June 1977, B purchased for B's principal residence a 
new house that was substantially completed before April 20, 1977. 
Pursuant to B's request the builder installed storm windows on May 1, 
1977, the cost of this option being included in the purchase price of 
the house. The portion of the purchase price of the residence allocable 
to the storm windows constitutes an energy conservation expenditure. 
However, no other part of the purchase price may be allocated to energy 
conservation property (insulation and other energy conserving 
components) installed before April 20, 1977. To qualify as an energy 
conservation expenditure, an expenditure must be made (i.e., 
installation of the energy conservation property must be completed) on 
or after April 20, 1977.

    (b) Renewable energy source expenditures. The term ``renewable 
energy source expenditures'' means an expenditure made on or after April 
20, 1977, and before January 1, 1986, by a taxpayer for renewable energy 
source property (as defined in paragraph (e)), or for labor costs 
properly allocable to the on-site preparation, assembly, or original 
installation such property, if both of the following conditions are 
satisfied:
    (1) The renewable energy source property is installed in connection 
with a dwelling unit that is used as the taxpayer's principal residence 
when the installation is completed. See Sec. 1.23-3(e).
    (2) The dwelling unit is located in the United States (as defined in 
section 7701(a)(9)).

Additionally, the term ``renewable energy source expenditures'' includes 
expenditures made after December 31, 1979, and before January 1, 1986, 
for an onsite well drilled for any geothermal deposit (as defined in 
paragraph (h)), or

[[Page 48]]

for labor costs properly allocable to onsite preparation, assembly, or 
original installation of such well, but only if the requirements of 
paragraphs (b) (1) and (2) of this section are met and the taxpayer has 
not elected under section 263(c) to deduct any portion of such 
expenditures or allocable labor costs.

Eligibility as a renewable energy source expenditure does not depend on 
the date of construction of the dwelling unit. Thus, such an expenditure 
may be made in connection with either a new or an existing dwelling 
unit. Renewable energy source expenditures need only be made in 
connection with a dwelling, rather than in or on a dwelling unit. For 
example, a solar collector that otherwise constitutes renewable energy 
source property is not ineligible merely because it is installed 
separately from the dwelling unit. The term ``renewable energy source 
expenditure'' does not include any expenditure allocable to a swimming 
pool even when used as an energy storage medium or to any other energy 
storage medium whose primary function is other than the storage of 
energy. It also does not include the cost of maintenance of an installed 
system or the cost of leasing renewable energy source property.
    (c) Insulation. The term ``insulation'' means any item that 
satisfies all of the following conditions:
    (1) The item is specifically and primarily designed to reduce, when 
installed in or on a dwelling or on a water heater, the heat loss or 
gain of such dwelling or water heater. To qualify as insulation the item 
must be installed between a conditioned area and a nonconditioned area 
(except when installed on a water heater, water pipe, or heating/cooling 
duct). Thus for example, awnings do not qualify as insulation. For 
purposes of this section the term ``conditioned area'' means an area 
that has been heated or cooled by conventional or renewable energy 
source means. Insulation includes materials made of fiberglass, rock 
wool, cellulose, urea based foam, urethane, vermiculite, perlite, 
polystyrene, and extruded polystyrene foam.
    (2) The original use of the item begins with the taxpayer.
    (3) The item can reasonably be expected to remain in operation at 
least 3 years.
    (4) The item meets the applicable performance and quality standards 
prescribed in Sec. 1.23-4 (if any) that are in effect at the time the 
taxpayer acquires the item. The term ``insulation'' shall not include 
items whose primary purpose is not insulation (e.g., whose function is 
primarily structural, decorative, or safety-related). For example, 
carpeting, drapes (including linings), shades, wood paneling, fireplace 
screens (including those made of glass), new or replacement walls 
(except for qualifying insulation therein) and exterior siding do not 
qualify although they may have been designed in part to have an 
insulating effect.
    (d) Other energy-conserving components. The term ``other energy-
conserving component'' means any item (other than insulation) that 
satisfies all of the following conditions:
    (1) The original use of the item begins with the taxpayer.
    (2) The item can reasonably be expected to remain in operation for 
at least 3 years.
    (3) The item meets the applicable performance and quality standards 
prescribed in Sec. 1.23-4 (if any) that are in effect at the time of 
the taxpayer's acquisition of the item.
    (4) The item is one of the following items:
    (i) A furnace replacement burner. The term ``furnace replacement 
burner'' means a device (for oil and gas-fired furnaces or boilers) that 
is designed to achieve a reduction in the amount of fuel consumed as a 
result of increased combustion efficiency. The burner must replace an 
existing burner. It does not qualify if it is acquired as a component 
of, or for use in, a new furnace or boiler.
    (ii) A device for modifying flue openings. The term ``device for 
modifying flue openings'' means an automatically operated damper that--
    (A) Is designed for installation in the flue, between the barometric 
damper or draft hood and the chimney, of a furnace; and
    (B) Conserves energy by substantially reducing the flow of 
conditioned

[[Page 49]]

air through the chimney when the furnace is not in operation. 
Conditioned air is air that has been heated or cooled by conventional or 
renewable energy source means.
    (iii) A furnace ignition system. The term ``furnace ignition 
system'' means an electrical or mechanical device, designed for 
installation in a gas-fired furnace or boiler that automatically ignites 
the gas burner. In order to qualify, the device must replace a gas pilot 
light. Furthermore, it does not qualify if it is acquired as a component 
of, or for use in, a new furnace or boiler.
    (iv) A storm or thermal window or door. The terms ``storm or thermal 
window'' and ``storm or thermal door'' mean the following:
    (A)(1) A window placed outside or inside an ordinary or prime 
window, creating an insulating air space.
    (2) A window with enhanced resistance to heat flow through the 
glazed area by multi-glazing.
    (3) A window that consists of glass or other glazing materials that 
have exceptional heat-absorbing or heat-reflecting properties. For 
purposes of this subdivision (iv), the term ``glazing material'' does 
not include films and coatings applied on the surface of a window.
    (B)(1) A second door, installed outside or inside a prime exterior 
door, creating an insulating air space.
    (2) A door with enhanced resistance to heat flow through the glazed 
area by multi-glazing.
    (3) A prime exterior door that has an R-value (a measurement of the 
ability of insulation to resist the flow of heat) of at least 2 
throughout.

For purposes of this subdivision, ``multi-glazing'' is an arrangement in 
which two or more sheets of glazing material are affixed in a window or 
door frame to create one or more insulating air spaces. Multi-glazing 
can be achieved by installing a preassembled, sealed insulating glass 
unit or by affixing one or more additional sheets of glazing onto an 
existing window (or sash) or door. For purposes of this subdivision, a 
storm or thermal window or door does not include any film applied on or 
over the surface of a window or door.
    (v) Automatic energy-saving setback thermostat. The term ``automatic 
energy-saving setback thermostat'' means a device that is designed to 
reduce energy consumption by regulating the demand on the heating or 
cooling system in which it is installed, and uses--
    (A) A temperature control device for interior spaces incorporating 
more than one temperature control level, and
    (B) A clock or other automatic mechanism for switching from one 
control level to another.
    (vi) Caulking and weatherstripping. The term ``caulking'' means 
pliable materials used to fill small gaps at fixed joints on buildings 
to reduce the passage of air and moisture. Caulking includes, but is not 
limited to, materials commonly known as ``sealants'', ``putty'', and 
``glazing compounds''. The term ``weatherstripping'' means narrow strips 
of material placed over or in movable joints of windows and doors to 
reduce the passage of air and moisture.
    (vii) Energy usage display meter. The term ``energy usage display 
meter'' means a device the sole purpose of which is to display the cost 
(in money) of energy usage in the dwelling. It may show cost information 
for electricity usage, gas usage, oil usage, or any combination thereof. 
The device may measure energy usage of the whole dwelling, or individual 
appliances or systems on an instantaneous or cumulative basis.
    (viii) Components specified by the Secretary. The Secretary (or his 
delegate) may, in his discretion, after consultation with the Secretary 
of Energy and the Secretary of Housing and Urban Development (or their 
delegates), and any other appropriate Federal officers, specify by 
regulation other energy-conserving components for addition to the list 
of qualified items. See Sec. 1.23-6 for the procedures and criteria to 
be used in determining whether an item will be considered for addition 
to the list of qualified items by the Secretary.

The term ``other energy-conserving component'' is limited to items in a 
category specifically listed in section 44(c)(4)(A) (i) through (vii) or 
added by the Secretary.

[[Page 50]]

    (e) Renewable energy source property--(1) In general. The term 
``renewable energy source property'' includes any solar energy property, 
wind energy property, geothermal energy property, or property referred 
to in subparagraph (2), which meets the following conditions:
    (i) The original use of the property begins with the taxpayer.
    (ii) The property can reasonably be expected to remain in operation 
for at least 5 years.
    (iii) The property meets the applicable performance and quality 
standards prescribed in Sec. 1.23-4 (if any) that are in effect at the 
time of the taxpayer's acquisition of the property.

Renewable energy source property does not include heating or cooling 
systems, nor systems to provide hot water or electricity, which serve to 
supplement renewable energy source equipment in heating, cooling, or 
providing hot water or electricity to a dwelling unit, and which employ 
a form of energy (such as oil or gas) other than solar, wind, or 
geothermal energy (or other forms of renewable energy provided in 
paragraph (e)(2) of this section. Thus, heat pumps or oil or gas 
furnaces, used in connection with renewable energy source property, are 
not eligible for the credit. In order to be eligible for the credit for 
renewable energy source property, the property (as well as labor costs 
properly allocable to onsite preparation, assembly or installation of 
equipment) must be clearly identifiable. See Sec. 1.23-3(l) for 
recordkeeping rules.
    (2) Renewable energy source specified by the Secretary. In addition 
to solar, wind, and geothermal energy property, renewable energy source 
property includes property that transmits or uses another renewable 
energy source that the Secretary (or his delegate) specifies by 
regulations, after consultation with the Secretary of Energy and the 
Secretary of Housing and Urban Development (or their delegates), and any 
other appropriate Federal officers, to be of a kind that is appropriate 
for the purpose of heating or cooling the dwelling or providing hot 
water or (in the case of expenditures made after December 31, 1979) 
electricity for use within the dwelling. For purposes of this section, 
references to the transmission or use of energy include its collection 
and storage. See Sec. 1.23-6 for the procedures and criteria to be used 
in determining when another energy source will be considered for 
addition to the list of qualified renewable energy sources.
    (f) Solar energy property--(1) In general. The term ``solar energy 
property'' means equipment and materials of a solar energy system as 
defined in this paragraph (and parts solely related to the functioning 
of such equipment) which, when installed in connection with a dwelling, 
transmits or uses solar energy to heat or cool the dwelling or to 
provide hot water or (in the case of expenditures made after December 
31, 1979) electricity for use within the dwelling. For this purpose, 
solar energy is energy derived directly from sunlight (solar radiation). 
Property which uses, as an energy source, fuel or energy which is 
indirectly derived from sunlight (solar radiation), such as fossil fuel 
or wood or heat in underground water, is not considered solar energy 
property. Materials and components of ``passive solar systems'' as well 
as ``active solar systems'', or a combination of both types of systems 
may qualify as solar energy property.
    (2) Active solar system. An active solar system is based on the use 
of mechanically forced energy transfer, such as the use of fans or pumps 
to circulate solar generated energy, or thermal energy transfer, such as 
systems utilizing thermal siphon principles. Generally, this is 
accomplished through the use of equipment such as collectors (to absorb 
sunlight and create hot liquids or air), storage tanks (to store hot 
liquids), rockbeds (to store hot air), thermostats (to activate pumps or 
fans which circulate the hot liquids or air), and heat exchangers (to 
utilize hot liquids or air to heat air or water).
    (3) Passive solar system. A passive solar system is based on the use 
of conductive, convective, or radiant energy transfer. In order to 
qualify as a passive solar system, a solar system used for heating 
purposes must contain all of the following: a solar collection area, an 
absorber, a storage mass, a heat distribution method, and heat 
regulation devices. The term ``solar collection area'' means an expanse 
of

[[Page 51]]

transparent or translucent material, such as glass which is positioned 
in such a manner that the rays of the sun directly strike an absorber. 
The term ``absorber'' means a surface, such as a floor, that is exposed 
to the rays of the sun admitted through the solar collection area, which 
converts solar radiation into heat, and then transfers the heat to a 
storage mass. The term ``storage mass'' means material, such as masonry, 
that receives and holds heat from the absorber and later releases the 
heat to the interior of the dwelling. The storage mass must be of 
sufficient volume, depth, and thermal energy capacity to store and 
deliver adequate amounts of solar heat for the relative size of the 
dwelling. In addition, the storage mass must be located so that it is 
capable of distributing the stored heat directly to the habitable areas 
of the dwelling through a heat distribution method. The term ``heat 
distribution method'' means the release of radiant heating from the 
storage mass within the habitable areas of the dwelling, or convective 
heating from the storage mass through airflow paths provided by openings 
or by ducts in the storage mass, to habitable areas of the dwelling. The 
term ``heat regulations devices'' means shading or venting mechanisms 
(such as awnings or insulated drapes) to control the amount of solar 
heat admitted through the solar collection areas and nighttime 
insulation or its equivalent to control the amount of heat permitted to 
escape from the interior of the dwelling.
    (4) Components with dual function. To the extent that a passive or 
active solar system utilizes portions of the structure of a residence, 
only the materials and components whose sole purpose is to transmit or 
use solar radiation (and labor costs associated with installing such 
materials and components) are included within the term ``solar energy 
property''. Accordingly, materials and components that serve a dual 
purpose, e.g., they have a significant structural function or are 
structural components of the dwelling (and labor costs associated with 
installing such materials and components) are not included within the 
term ``solar energy property''. For example, roof ponds that form part 
of a roof (including additional structural components to support the 
roof), windows (including clerestories and skylights), and greenhouses 
do not qualify as solar energy property. However, with respect to 
expenditures made after December 31, 1979, a solar collector panel 
installed as a roof or portion thereof (including additional structural 
components to support the roof attributable to the collector) does not 
fail to qualify as solar energy property solely because it constitutes a 
structural component of the dwelling on which it is installed. For this 
purpose, the term ``solar collector panel'' does not include a skylight 
or other type of window. In the case of a trombe wall (a south facing 
wall composed of a mass wall and exterior glazing), the mass wall (and 
labor costs associated with installing the mass wall) will not qualify. 
However, the exterior (non-window) glazing will qualify. Any shading, 
venting and heat distribution mechanisms or storage systems that do not 
have a dual function will also qualify.
    (g) Wind energy property. The term ``wind energy property'' means 
equipment (and parts solely related to the functioning of such 
equipment) which, when installed in connection with a dwelling, 
transmits or uses wind energy to produce energy in a useful form for 
personal residential purposes. Examples of equipment using wind energy 
to produce energy in a useful form are windmills, wind-driven 
generators, power conditioning and storage devices that use wind to 
generate electricity or mechanical forms of energy. Devices that use 
wind merely to ventilate do not qualify as wind energy property.
    (h) Geothermal energy property. The term ``geothermal energy 
property'' means equipment (and parts solely related to the functioning 
of such equipment) necessary to transmit or use energy from a geothermal 
deposit to heat or cool a dwelling or provide hot water for use within 
the dwelling. With respect to expenditures made after December 31, 1979, 
the term ``geothermal energy property'' also means equipment (and parts 
solely related to the functioning of such equipment) necessary to 
transmit or use energy from a geothermal deposit to produce electricity 
for use within the dwelling.

[[Page 52]]

Equipment such as a pipe that serves both a geothermal function (by 
transmitting hot geothermal water within a dwelling) and a non-
geothermal function (by transmitting hot water from a water heater 
within a dwelling) does not qualify as geothermal property. A geothermal 
deposit is a geothermal reservoir consisting of natural heat which is 
from an underground source and is stored in rocks or in an aqueous 
liquid or vapor (whether or not under pressure), having a temperature 
exceeding 50 degrees Celsius as measured at the wellhead or, in the case 
of a natural hot spring (where no well is drilled), at the intake to the 
distribution system.
    (i) Subsidized energy financing--(1) In general. The term 
``subsidized energy financing'' means financing (e.g., a loan) made 
directly or indirectly (such as in association with, or through the 
facilities of, a bank or other lender) during a taxable year beginning 
after December 31, 1980, under a Federal, State, or local program, a 
principal purpose of which is to provide subsidized financing for 
projects designed to conserve or produce energy. For purposes of this 
paragraph (i), financing is made when funds that constitute subsidized 
energy financing are disbursed. Subsidized energy financing includes 
financing under a Federal, State, or local program having two or more 
principal purposes (provided that at least one of the principal purposes 
is to provide subsidized financing for projects designed to conserve or 
produce energy), but only to the extent that the financing--
    (i) Is to be used for energy production or conservation purposes, or
    (ii) Is provided out of funds designated specifically for energy 
production or conservation.

Loan proceeds meet the use test of paragraph (i)(l)(i) of this section 
only to the extent that the loan application, the loan instrument, or 
any other loan-related documents indicate that the funds are intended 
for such use. However, loan proceeds designated for the purchase either 
of property that contains ``insulation'' or any ``other energy-
conserving component'' or of ``renewable energy source property'' as 
defined in paragraphs (c), (d), and (e), respectively, of this section 
meet the test of paragraph (i)(l)(i) of this section. Financing is 
subsidized if the interest rate or other terms of the financing 
(including any special tax treatment) provided to the taxpayer in 
connection with the program or used to raise funds for the program are 
more favorable than the terms generally available commercially. In 
addition, financing is subsidized if the principal obligation of the 
financing provided to the taxpayer is reduced by funds provided under 
the program. The source from which the funds for the program are derived 
is not a factor to be taken into account in determining whether the 
financing is subsidized. If a public utility disburses funds for the 
financing of energy conservation or renewable energy source property 
under a program that obtains the funds through sales to the utility's 
ratepayers, the program is not considered to be a Federal, State or 
local program even though the utility is a governmental agency, and, 
thus, the funds are not subsidized energy financing. Subsidized energy 
financing does not include a grant includible in gross income under 
section 61, nontaxable grants, a credit against State or local taxes 
made directly to the taxpayer claiming the credit provided for in 
section 23, or a loan guarantee made directly to the taxpayer claiming 
the credit provided for in section 23.
    (2) Examples. The provisions of this paragraph (i) may be 
illustrated by the following examples:

    Example 1. State A has a farm and home loan program. The program is 
used to provide low interest mortgage loans. In 1984 State A's 
legislature enacted statutory amendments to its farm and home loan 
program in an effort to encourage energy conservation-type measures. Low 
interest loans for such improvements were made available to qualified 
purchasers and owners under the farm and home loan program. The energy 
conservation measures subsidized by the program include energy 
conserving components and renewable energy source devices. State A's tax 
exempt bonds are the source of funds for loans under the program. 
Although the 1984 legislation authorizing loans for energy conserving 
components and renewable energy source improvements did not diminish the 
original purpose of the farm and home loan program, the 1984 legislation 
added another principal purpose to the program. Therefore, State A's 
program which has two

[[Page 53]]

principal purposes, one of which is the conservation or production of 
energy, is considered as providing subsidized energy financing for 
purposes of section 23 (c)(10) of the Code, to the extent that financing 
is provided by State A out of funds designated specifically for energy 
production or conservation. State A's program will also be considered as 
providing subsidized energy financing to the extent that the loan 
proceeds are to be used for energy production or conservation purposes. 
Loan proceeds meet the use test of the preceding sentence only to the 
extent that loan application, the loan instruments, or any other loan-
related documents indicate that the funds are intended for such use.
    Example 2. The United States Department of Energy disburses funds to 
State B that the Department received from settlements from alleged 
petroleum pricing and allocation violations. State B establishes a 
program under which B will use the funds to make loans at below market 
interest rates directly to qualified applicants for the purchase of 
renewable energy source property. B's loans are subsidized energy 
financing.
    Example 3. State C establishes a program under which C will make 
loans at below market interest rates directly to qualified applicants 
for the purchases of renewable energy source property. The program is 
funded with money that State C was able to borrow after it obtained a 
loan guarantee from a Federal agency. C's loans provided under the 
program are subsidized energy financing.
    Example 4. Company D is an electric utility that is a Federal 
agency. D purchases its electricity from another federal agency, 
transmits the electricity over its own distribution system, and sells 
the electricity to numerous local public utilities that in turn sell the 
electricity to their customers. D wishes to start a program under which 
D will make loans at below market interest rates directly to customers 
of the local utilities for the purchase of renewable energy source 
property from D. The local public utility will act as the collection 
agent for repayment of the loans. The loans will be repayable over a 
period of time not in excess of 15 years. Under law, D must cover its 
full costs through its own revenues derived from the sale of power and 
other services. While D may borrow by sale of bonds to the United States 
Treasury, D must borrow at rates comparable to the rates prevailing in 
the market for similar bonds. Thus, the subsidized loans made under D's 
program will be financed by the profits from the sale of electricity to 
consumers and not by the federal government. D's program, which is 
substantially the same as that carried out by private (investor-owned) 
utilities, is not considered to be a Federal, State or local 
governmental program. Therefore, D's loans are not subsidized energy 
financing.
    Example 5. The Solar Energy and Energy Conservation Bank (Bank) 
disburses funds to State E. E disburses a portion of the funds to 
Financial Institution F. Both the Bank and State E make these 
disbursements under a program the principal purpose of which is to 
provide subsidized financing for projects designed to conserve or 
produce energy. F uses the funds to reduce a portion of the principal 
obligation on loans it issues to finance energy conservation or solar 
energy expenditures. Taxpayer G borrows $3,000 from F in order to 
purchase a solar water heating system. F uses $500 of the funds it 
received from the Bank to reduce the principal obligation of the loan to 
G to $2,500. The amount of subsidized energy financing to G is $3,000.
    Example 6. State H allows a tax credit to Financial Institution J 
under a program the principal purpose of which is to provide loans at 
below market interest rates directly to qualified applicants for the 
purchase of renewable energy source property. J receives a credit each 
year in the amount of the excess of the interest that would have been 
paid at private market rates over the actual interest paid on such 
loans. The State H tax credit arrangement is an interest subsidy. Thus, 
any low-interest loans made pursuant to this credit arrangement are 
subsidized energy financing.

[T.D. 7717, 45 FR 57716, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26670, July 16, 1987]



Sec. 1.23-3  Special rules.

    (a) When expenditures are treated as made--(1) Timeliness of an 
expenditure for the energy credit. In general, for the purpose of 
determining whether an expenditure qualifies as being timely for the 
residential energy credit under section 23 or former section 44C (i.e., 
is made after April 19, 1977, and before January 1, 1986), the 
expenditure is treated as made when original installation of the item is 
completed. Thus, solely for that purpose, the time of payment or accrual 
is irrelevant.
    (2) Special rule for renewable energy source expenditures in the 
case of construction or reconstruction of a dwelling. In the case of 
renewable energy source expenditures in connection with the construction 
or reconstruction of a dwelling that becomes the taxpayer's new 
principal residence, the expenditures are to be treated as made (for the 
purpose of determining the timeliness of an expenditure for the 
residential energy credit) when the taxpayer commences use of the 
dwelling as his or her

[[Page 54]]

principal residence following its construction or reconstruction. The 
term ``reconstruction'' means the replacement of most of a dwelling's 
major structural components such as floors, walls, and ceiling. When a 
taxpayer reoccupies a reconstructed dwelling that was the taxpayer's 
principal residence prior to reconstruction, a renewable energy source 
expenditure is considered made when the original installation of the 
renewable energy source property is completed.
    (3) Taxable year in which credit is allowable. For the purpose of 
determining the taxable year in which the credit for an expenditure is 
allowable (once it has qualified as timely under subparagraph (1) or 
(2)), an expenditure is treated as made on the later of (i) the date on 
which it qualifies as timely; or (ii) the date on which it is paid or 
incurred by the taxpayer.
    (b) Expenditures in 1977. No credit under section 23 or former 
section 44C shall be allowed for any taxable year beginning before 1978. 
However, the amount of any credit under section 23 or former section 44C 
for the taxpayer's first taxable year beginning after December 31, 1977, 
shall take into account qualified energy conservation expenditures and 
qualified renewable energy source expenditures made during the period 
beginning April 20, 1977, and ending on the last day of such first 
taxable year.
    (c) Cross reference. For rules relating to expenditures financed 
with Federal, State, or local government grants or subsidized financing 
see paragraph (d)(3) of Sec. 1.23-1 and paragraph (i) of Sec. 1.23-2.
    (d) Expenditures qualifying both as energy conservation expenditures 
and renewable source expenditures. In the case of an expenditure which 
meets both the definition of an energy conservation expenditure (as 
defined in Sec. 1.23-2(a)) and a renewable energy source expenditure 
(as defined in Sec. 1.23-2(b)), the taxpayer may claim either a credit 
under Sec. 1.23-1(b) (relating to qualified energy conservation 
expenditures) or Sec. 1.23-1(c) (relating to qualified renewable energy 
source expenditures) but may not claim both credits with respect to the 
same expenditure.
    (e) Principal residence. For purposes of section 23 or former 
section 44C the determination of whether a dwelling unit is the 
taxpayer's principal residence shall be made under principles similar to 
those applicable to section 1034 and the regulations thereunder 
(relating to sale or exchange of a principal residence) except that 
ownership of the dwelling unit is not required. In making this 
determination, the period for which a dwelling is treated as a 
taxpayer's principal residence includes the 30-day period ending on the 
first day on which the dwelling unit would (but for this sentence) be 
treated as being used as the taxpayer's principal residence under 
principles similar to those applicable to section 1034. Thus, 
installation that are completed within that 30-day period may be 
eligible for the credit although, in the absence of the 30-day rule, the 
date of habitation of the dwelling unit by the taxpayer would mark the 
beginning of the taxpayer's use of the unit as a principal residence.
    (f) Construction substantially completed. Construction of a dwelling 
unit is substantially completed when construction has progressed to the 
point where the unit could be put to use as a personal residence, even 
though comparatively minor items remain to be finished or performed in 
order to conform to the plans or specifications of the completed 
building. For this purpose, construction includes reconstruction as 
defined in paragraph (a)(2). This rule may be illustrated by the 
following example:

    Example. On January 1, 1979, A purchases a dwelling that is to 
become A's principal residence. The dwelling unit was originally 
constructed in 1950. A spends $50,000 to reconstruct the dwelling by 
replacing most of the dwelling's major structural components such as 
floors, walls, and ceilings. Included in the cost is $3,000 attributable 
to energy-conserving components. Reconstruction is substantially 
completed on April 1, 1979, and A moves into the reconstructed residence 
on May 1, 1979. Since construction includes reconstruction, A's 
reconstructed residence is not considered substantially completed before 
April 20, 1977. Thus, amounts spent with respect to A's reconstructed 
residence for energy-conserving components do not qualify as energy 
conservation expenditures.


[[Page 55]]


    (g) Residential use of property. To be eligible for the residential 
energy credit, expenditures must be made for personal residential 
purposes. If at least 80 percent of the use of a component or item of 
property is for personal residential purposes, the entire amount of the 
energy conservation expenditure or the renewable energy source 
expenditure is taken into account in computing the credit under this 
section. If less than 80 percent of the use of a component or item of 
property is for personal residential purposes, the amount of an 
expenditure taken into account is the amount that bears the same ratio 
to the amount of the expenditure as the amount of personal residential 
use of the component or item bears to its total use. For purposes of 
this paragraph, use of a component or an item of property with respect 
to a swimming pool is not a use for a personal residential purpose. The 
rules with respect to residential use of property are illustrated by the 
following examples:

    Example 1. In 1978 A makes an expenditure of $3,000 for the 
installation of storm windows of which 50 percent is on the portion of 
A's dwelling used as the principal family residence and 50 percent is on 
the portion of the dwelling used as an office. A has made no other 
energy conservation expenditures for the residence. The allowable energy 
conservation expenditure is $1,500 (50 percent of $3,000), the portion 
attributable to residential use. Therefore, the residential energy 
credit is $225 (the qualified conservation expenditure of 15 percent of 
$1.500).
    Example 2. During 1979, B makes $10,000 of renewable energy source 
expenditures on solar energy property for B's principal residence. 
Approximately 60 percent of the use of the solar energy property will be 
for heating B's swimming pool; the other 40 percent will be for heating 
the dwelling unit. B had not previously made renewable energy source 
expenditures with respect to the residence. Since use for a swimming 
pool is not considered a residential use, less than 80 percent of the 
use of B's solar energy property is considered used for personal 
residential purposes. Therefore, only $4,000 (40 percent of $10,000), 
the proportionate part of B's expenditures representing personal 
residential use, is treated as a renewable energy source expenditure. B 
is allowed a $1,000 residential energy credit (30 percent of $2,000 plus 
20 percent of $2,000) for 1979.

    (h) Joint occupancy--(1) In general. If two or more individuals 
jointly occupied and used a dwelling unit as their principal residence 
during any portion of a calendar year--
    (i) The amount of the credit allowable under section 23 or former 
section 44C by reason of energy conservation expenditures or by reason 
of renewable energy source expenditures shall be determined by treating 
all of the joint occupants as one taxpayer whose taxable year is such 
calendar year; and
    (ii) The credit under section 23 or former section 44C allowable to 
each joint occupant for the taxable year with which or in which such 
calendar year ends shall be an amount which bears the same ratio to the 
amount determined under paragraph (h)(1)(i) of this section as the 
amount of energy conservation expenditures or renewable energy source 
expenditures made by that occupant bears to the total amount of each 
type of such expenditures made by all joint occupants during such 
calendar year.

The provisions of this subparagraph may be illustrated by the following 
example:

    Example. A, a calendar year taxpayer, and B, a June 1 fiscal year 
taxpayer, make energy conservation exenditures of $2,000 (A making 
expenditures of $500 and B making expenditures of $1,500) on their 
principal and jointly occupied residence in 1978. A and B have not 
previously make energy conservation expenditures with respect to this 
residence. Of the $300 credit (15 percent of $2,000), $75 will be 
allocated to A ($500/$2,000 x $300) and $225 to B ($1,500/$2,000 x 300). 
A will claim the allocable share of the credit on A's 1978 tax return 
and B will claim the allocable share of the credit on B's tax return for 
the fiscal year ending May 31, 1979.

    (2) Minimum credit. The fact that one joint occupant may be unable 
to claim all or part of the credit under section 23 of former section 
44C because of insufficient tax liability or because that occupant's 
allowable credit does not exceed the $10 minimum credit (as set forth in 
paragraph (d)(1) of Sec. 1.23-1) shall have no effect upon the 
computation of the amount of the allowable credits for the other joint 
occupants.
    (3) Prior expenditures. Because joint occupants are treated as one 
taxpayer for purposes of determining the residential energy credit, the 
maximum

[[Page 56]]

amount of energy conservation expenditures or renewable energy source 
expenditures must be reduced by the total amount of such expenditures 
made in connection with the dwelling unit during prior calendar years in 
which any one of the residents of the unit during the current calendar 
year was a resident (whether made by the current resident or by an 
individual previously occupying the dwelling with the current resident). 
However, the preceding sentence shall not apply to prior expenditures no 
part of which was taken into account in computing the credits under 
section 23 of former section 44C for such years. Prior years' 
expenditures are not to be allocated among joint occupants to take into 
account the specific expenditures of each of the occupants in prior 
years.
    (4) The rules of this paragraph may be illustrated by the following 
examples:

    Example 1. Assume A and B have together made prior years' energy 
conservation expenditures of $1,600 (A having made $1,200 of 
expenditures and B having made $400) on their principal and jointly 
occupied residence. In the current year, each makes energy conservation 
expenditures of $300 with respect to the same residence. The maximum 
qualified expenditure with respect to the residence is reduced by the 
$1,600 of prior expenditures made by A and B. Therefore, only $400 of 
the $600 current expenditures are eligible as energy conservation 
expenditures. The resulting residential energy credit is $60 (15 percent 
of $400) of which $30 apiece will be allocated to A and B ($300/$600 x 
$60). The fact that A had previously computed the credit in prior years 
with respect to $1,200 of the total $1,600 of expenditures is irrelevant 
to the apportionment of the credit in the current year.
    Example 2. In 1978, spouses C and D make $10,000 of renewable energy 
source expenditures with respect to their principal residence, half of 
which is paid by each spouse. No prior renewable energy source 
expenditures have been taken into account with respect to that residence 
by either C or D. C and D file separate returns for the calendar year. 
Under the joint occupancy rule, the maximum allowable renewable energy 
source credit with respect to C and D's principal residence is $2,200 
(30 percent of the first $2,000, and 20 percent of the next $8,000 of 
expenditures). Half of this amount or $1,100, will be allowed to each 
spouse. If either spouse makes renewable energy source expenditures with 
respect to the same principal residence in future years, none of those 
expenditures would be qualified renewable energy source expenditures for 
which a credit can be claimed. That is, not more than $2,200 may be 
taken in the aggregate by C and D as a renewable energy source credit 
with respect to their principal residence.
    Example 3. In 1978, E and F make energy conservation expenditures of 
$1,500 on their principal and jointly occupied residence. In 1979, E 
moves away and G becomes the other joint occupant of the residence. F 
and G make energy conservation expenditures of $1,000 in 1979. In 1980 F 
moves away and H moves in with G. G and H make energy conservation 
expenditures of $500. The maximum qualified expenditure made by F and G 
with respect to the residence is reduced by the $1,500 of prior 
expenditures made in 1978 by E and F. The maximum qualified expenditures 
made by G and H with respect to the residence is reduced only by the 
expenditures in prior years in connection with the residence during 
which either G or H was a joint occupant. Accordingly, the maximum 
qualified expenditures made by G and H with respect to the residence is 
reduced only by the $1,000 of prior expenditures made in 1979 by F and 
G.

    (i) Condominiums and cooperative housing corporations. An individual 
who is a tenant stockholder in a cooperative housing corporation (as 
defined in section 216) or who is a member of a condominium management 
association with respect to a condominium which he or she owns shall be 
treated as having made a proportionate share of the energy conservation 
expenditures or renewable energy source expenditures of such corporation 
or association. The cooperative stockholder's allocable share of the 
expenditures is to be the same as his or her proportionate share of the 
cooperative's total outstanding stock (including any stock held by the 
corporation). However, in the case where only certain cooperative 
stockholders are assessed for the expenditures made by the cooperative 
housing corporation, only those cooperative stockholders that are 
assessed shall be treated as having made a share of the expenditures of 
such corporation. In such case, the cooperative stockholder's share of 
the expenditures is the amount that the stockholder is assessed. The 
allocable share of a condominium management association member's energy 
conservation of renewable energy source expenditures is the amount that 
the member is assessed (or would be assessed in the case where

[[Page 57]]

expenditures are from general funds) by the association as a result of 
such expenditures. The residential energy credit for a qualified 
expenditure is allowable for the year in which the association or 
corporation has completed original installation of the item (or has paid 
or incurred the expenditure, if later). For purposes of this paragraph, 
the term ``condominium management association'' means an organization 
meeting the requirements of section 528(c)(1) of the Code (other than 
subparagraph (E) of that section), with respect to a condominium project 
substantially all the units of which are used as residences.
    (j) Joint ownership of energy conservation property or renewable 
energy source property--(1) In general. Energy conservation property 
renewable energy source property include property which is jointly owned 
by the taxpayer and another person (or persons) and installed in 
connection with two or more dwelling units. For example, the fact that a 
windmill, solar collector, or geothermal well and distribution system is 
owned by two or more individuals does not preclude its qualification as 
renewable energy source property. The amount of the credit allowable 
under section 23 shall be computed separately with respect to the amount 
of the expenditures made by each individual, subject to the limitations 
of $2,000 imposed by section 23(b)(1) and $10,000 imposed by section 
23(b)(2), per dwelling units of jointly owned property. For example, in 
1982, A, B, and C purchased as joint owners renewable energy source 
property that serviced two houses. One of the houses is jointly owned 
and occupied by A and B and the other is owned and occupied by C alone. 
The renewable energy source property cost $30,000 of which A paid 
$9,000, B paid $6,000, and C paid $15,000. A and B must share the $4,000 
credit (40% of $10,000 maximum) with respect to the expenditures for the 
jointly owned house. Therefore, A is allowed a $2,400 credit ($4,000 
times $9,000 divided by $9,000 plus $6,000) and B is allowed a $1,600 
credit ($4,000 times $6,000 divided by $9,000 plus $6,000) with respect 
to the expenditures attributable to the jointly owned house. C is 
entitled to a credit of $4,000 with respect to the expenditures 
attributable to the other house.
    (2) Example. The application of this subparagraph may be illustrated 
by the following example:

    Example. A, B, and C each has a separate principal residence. They 
agree to finance jointly the construction of a solar collector, each 
providing one-third of the costs and taking one-third of the output of 
the collector. Each will separately pay for the costs of connecting the 
solar collector with his or her principal residence. Provided the solar 
collector and connection equipment otherwise qualify as renewable energy 
source property, A, B, and C will each be considered to have made 
renewable energy source expenditures equal to one-third of the cost of 
the collector plus his or her separate connection costs. Such 
expenditures will be subject to the limitations and other rules 
separately applicable to A, B, and C with respect to each principal 
residence, such as those with respect to the $10 minimum (Sec. 1.23-
1(d)(1)), prior expenditures (Sec. 1.23-1(d)(2)), residential use 
(paragraph (g) of this section), and joint occupancy (paragraph (h) of 
this section).

    (k) Basic adjustments. If a credit is allowed under section 23 or 
former section 44C for any expenditure with respect to any property, the 
increase in the basis of that property which would (but for this 
paragraph) result from such expenditure shall be reduced by the amount 
of the credit allowed.
    (l) Recordkeeping--(1) In general. No residential energy credit is 
allowable unless the taxpayer maintains the records described in 
paragraph (l)(2) of this section. The records shall be retained so long 
as the contents thereof may become material in the administration of any 
internal revenue law.
    (2) Records. The taxpayer must maintain records that clearly 
identify the energy-conserving components and renewable energy source 
property with respect to which a residential energy credit is claimed, 
and substantiate their cost to the taxpayer, any labor costs properly 
allocable to them paid for by the taxpayer, and the method used for 
allocating such labor costs.

[T.D. 7717, 45 FR 57719, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26672, July 16, 1987]

[[Page 58]]



Sec. 1.23-4  Performance and quality standards. [Reserved]

[T.D. 7717, 45 FR 57721, Aug. 29, 1980. Redesignated by T.D. 8146, 52 FR 
26672, July 16, 1987]



Sec. 1.23-5  Certification procedures.

    (a) Certification that an item meets the definition of an energy-
conserving component or renewable energy source property. Upon the 
request of a manufacturer of an item pursuant to paragraph (b) of this 
section which is supported by proof that the item is entitled to be 
certified, the Assistant Commissioner (Technical) shall certify (or 
shall notify the manufacturer that the request is denied) that:
    (1) The item meets the definition of insulation (see Sec. 1.23-
2(c)(1)).
    (2) The item meets the definition of an other energy-conserving 
component specified in section 23(c)(4) or former section 44C(c)(4) see 
(Sec. 1.23-2(d)(4)).
    (3) The item meets the definition of solar energy property (see 
Sec. 1.23-2(f)), wind energy property (see Sec. 1.23-2(g)), or 
geothermal energy property (see Sec. 1.23-2(h)).
    (4) The item meets the definition of a category of energy-conserving 
component that has been added to the list of approved items pursuant to 
paragraph (d)(4)(viii) of Sec. 1.23-2.
    (5) The item meets the definition of renewable energy source 
property that transmits or uses a renewable energy source that has been 
added to the list of approved renewable energy sources pursuant to 
paragraph (e)(2) of Sec. 1.23-2.
    (b) Procedure--(1) In general. A manufacturer of an item desiring to 
apply under paragraph (a) shall submit the application to the 
Commissioner of Internal Revenue, Attention: Associate Chief Counsel 
(Technical), CC:C:E, 1111 Constitution Avenue NW., Washington, DC 20224. 
Upon being advised by the National Office, orally or in writing, that an 
adverse decision is contemplated a manufacturer may request a 
conference. The conference must be held within 21 calendar days from the 
date of that advice. Procedures for requesting an extension of the 21-
day period and notifying the manufacturer of the Service's decision on 
that request are the same as those applicable to conferences on ruling 
requests by taxpayers (see section 9.05 of Rev. Proc. 80-20).
    (2) Contents of application. The application shall include a 
description of the item (including appropriate design drawings and 
specifications) and an explanation of the purpose and function of the 
item. There shall accompany the application a declaration in the 
following form: ``Under penalties of perjury, I declare that I have 
examined this application, including accompanying documents and, to the 
best of my knowledge and belief, the facts presented in support of the 
application are true, correct, and complete.'' The statement must be 
signed by the person or persons making the application.
    (c) Effect of certification under paragraph (a). Certifications 
granted under paragraph (a)(1), (2), or (3) will be applied 
retroactively to April 20, 1977. However, certifications granted under 
paragraph (a) (4) or (5) will be applied retroactively only to the date 
the applicable energy-conserving component or renewable energy source 
was added by Treasury decision to the list of qualifying components or 
sources. Certification of an item under this section means that the 
applicable definitional requirement of Sec. 1.23-2 is considered 
satisfied in the case of any person claiming a residential energy credit 
with respect to such item. However, it does not relieve manufacturers of 
the need to establish that their items conform to performance and 
quality standards (if any) provided under Sec. 1.23-4 and that their 
items can reasonably be expected to remain in operation at least 3 
years, in the case of insulation and other energy-conserving components, 
or at least 5 years, in the case of renewable energy source property.

[T.D. 7717, 45 FR 57721, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26672, July 16, 1987]



Sec. 1.23-6  Procedure and criteria for additions to the approved list of 

energy-conserving components or renewable energy sources.

    (a) Procedures for additions to the list of energy-conserving 
components or renewable energy sources--(1) In general. A manufacturer 
of an item (or a group of manufacturers) desiring to apply for addition 
to the approved list of energy-

[[Page 59]]

conserving components or renewable energy sources pursuant to paragraph 
(d)(4)(viii) or (e)(2) of Sec. 1.23-2 shall submit an application to 
the Internal Revenue Service, Attention: Associate Chief Counsel 
(Technical), CC:C:E, 1111 Constitution Avenue, NW., Washington, DC 
20224. The term ``manufacturer'' includes a person who assembles an item 
or a system from components manufactured by other persons. The 
application shall provide the information required under paragraph (b) 
of this section. An application may request that more than one item be 
added to the approved list. It will be the responsibility of the Office 
of the Associate Chief Counsel (Technical) upon receipt of the 
application to determine whether all the information required under 
paragraph (b) of this section has been furnished with the application. 
If an application lacks essential information, the applicant will be 
advised of the additional information required. If the information (or a 
reasonable explanation of the reason why the information cannot be made 
available) is not forthcoming within 30 days of the date of that advice, 
the application will be closed and the applicant will be so informed. 
Any resubmission of information beyond the 30-day period will be treated 
as a new application. If the Office of the Associate Chief Counsel 
(Technical) already is considering an application with respect to the 
same or a similar item, it may consolidate applications. The Office of 
the Associate Chief Counsel will make a report and recommendation to the 
ad hoc advisory board as to whether each item that is the subject to an 
application should be added in accordance with the manufacturer's 
request to the approved list of energy-conserving components or 
renewable energy sources in light of the applicable criteria provided in 
paragraph (c) and the standards for Secretarial determination provided 
in paragraph (d) of this section. In making this recommendation, the 
Office of the Associate Chief Counsel shall consult with the Secretary 
of Energy and the Secretary of Housing and Urban Development (or their 
delegates) and any other appropriate Federal officers to obtain their 
views concerning the item in question. In addition, the Office of the 
Associate Chief Counsel may request from the manufacturer clarification 
of information submitted with the application. The Office of the 
Associate Chief Counsel shall report its recommendation and forward the 
application to the ad hoc advisory board for further consideration.
    (2) Ad hoc advisory board. The Commissioner of Internal Revenue and 
the Assistant Secretary (Tax Policy) shall establish an ad hoc advisory 
board to consider applications and recommendations forwarded by the 
Office of the Associate Chief Counsel (Technical). If a finding in favor 
of addition of any item is made, the board shall report its 
recommendation and forward the application to the Commissioner for 
further consideration. If the item is approved by the Commissioner, the 
application will be forwarded to the Secretary (or his delegate) for 
further consideration. The application will be closed with respect to an 
item if the board, the Commissioner, or the Secretary (or his delegate) 
determines that, under the applicable criteria or the standards for 
Secretarial determination, the item should not be added to the list of 
energy-conserving components or renewable energy sources.
    (3) Action on application. (i) A final decision to grant or deny any 
application filed under paragraph (a)(1) shall be made within 1 year 
after the application and all information required to be filed with such 
request under paragraph (b) have been received by the Office of the 
Associate Chief Counsel (Technical). The applicant manufacturer shall be 
notified in writing of the final decision. In the event of a favorable 
determination, a regulation will be issued in accordance with the 
procedures contained in Sec. 601.601 to include the item as an energy-
conserving component or as a renewable energy source. A final decision 
to grant approval of an application is made when a Treasury decision 
adding the item (that is subject of the application) as an energy-
conserving component or as a renewable energy source is published in the 
Federal Register.
    (ii) The applicant manufacturer shall be entitled to a conference 
and be so notified anytime an adverse action is

[[Page 60]]

contemplated by the Office of the Associate Chief Counsel, the ad hoc 
advisory board, the Commissioner of Internal Revenue, or the Secretary 
(or his delegate) and no conference was previously conducted. Upon being 
advised in writing that an adverse recommendation or decision as to any 
item that is the subject of an application is contemplated, a 
manufacturer may request a conference. The conference must be held 
within 21 calendar days from the mailing of that advice. Procedures for 
requesting an extension of the 21-day period and notifying the 
manufacturer of the recommendation or decision with respect to that 
request are the same as those applicable to conferences on ruling 
requests by taxpayers. The applicant is entitled to only one conference. 
There is no right to another conference when a favorable recommendation 
or decision is reversed at a higher level.
    (iii) A report of any application which has been denied during the 
preceding month and the reasons for the denial shall be published each 
month.
    (b) Contents of application. The application by the manufacturer 
shall include the following information:
    (1) A description of the item and the generic class to which it 
belongs, including any features relating to safe installation and use of 
the item. This description shall include appropriate design drawings and 
technical specifications (or representative drawings and specifications 
when application by a group of manufacturers).
    (2) An explanation of the purpose, function, and each recommended 
use of the item.
    (3) An estimate (and explanation of the estimation methods employed 
and the assumptions made) of the total number of units that would be 
sold for each recommended use during the first 4 years following the 
addition of the item to the approved list and of the total number that 
would be sold for each recommended use during that period in the absence 
of addition. If the item is sold in more than one size, the estimate 
shall indicate the projected sales for each size. This estimate shall 
reflect total industry sales of the item. Past industry sales 
information for each recommended use for the previous two years shall 
also be provided.
    (4) Whether sufficient capacity is available to increase production 
to meet any increase in demand for the item, or for associated fuels and 
materials, caused by such addition. This determination shall be based on 
industry-wide data and not just the manufacturing capability of the 
applicant. If the applicant has the exclusive right to manufacture the 
item, this information shall also be provided in the application.
    (5) An estimate (including estimation methods and assumptions) of 
the energy in Btu's of oil and natural gas used directly or indirectly 
per unit by the applicant in the manufacture of the item and other items 
necessary for its use, the type of energy source (e.g., oil, natural 
gas, coal, electricity), and the extent of its use in the manufacturing 
process of the item. The applicant must also provide a list of the major 
components of the item and their composition and weight.
    (6) Test data and experience data (where experience data is 
available) to substantiate for each recommended use the energy savings 
in Btu's that are claimed will be achieved by one unit during a period 
of one year. The data shall be obtained by controlled tests in which, if 
possible, the addition of the item is the only variable. If the item may 
be sold in various configurations, data shall be provided with respect 
to energy savings from each configuration with significantly different 
energy use characteristics. Test methods are to conform to recognized 
industry or government standards. This determination shall take into 
account the seasonal use of the item. If the energy savings of the item 
varies with climatic conditions, data shall be provided with respect to 
each climate zone. The applicant may use the Department of Energy's 
climatic zones for heating and cooling (see Sec. 450.35 of 10 CFR part 
450 (1980)).
    (7) The impact of increased demand on the price of the item and the 
energy source used by the item.
    (8) The energy source which will be replaced or conserved by the 
item, and, in the case of a request for addition to the approved list of 
renewable energy

[[Page 61]]

sources, data establishing that the energy source is inexhaustible.
    (9) Data to show the total estimated savings of energy in Btu's 
attributable to reduced consumption of oil or natural gas whether 
directly or indirectly from use of the item, including assumptions 
underlying this estimate. If the consumption of both oil and natural gas 
will be reduced, data to show the energy savings in Btu's attributable 
to each shall be provided. The estimate is to be based on energy savings 
in Btu's per unit determined under paragraph (b)(6) of this section for 
the first four years of the useful life of the item and is to take into 
account only the additional units of the item estimated to be placed in 
service as a result of the addition using data obtained under paragraph 
(b)(3) of this section. If the item will result in reduction of oil or 
natural gas consumption by replacing an item which uses such an energy 
source, the application shall indicate the item replaced and the extent 
to which this reduction will occur.
    (10) Geographical information if required under paragraph (b)(6) of 
this section to show the climatic zones of the country where the item is 
expected to be used, including an estimate of the total number of 
additional units to be placed in service during the first 4 years 
following the addition of the item in the area as a result of the 
addition of the item to the list of qualifying items.
    (11) The retail cost of the item (or items if the item is sold in 
more than one size) including all installation costs necessary for safe 
and effective use.
    (12) Whether the item is designed for residential use.
    (13) The estimated useful life of the item and associated equipment 
necessary for its use.
    (14) The type and amount of waste and emissions in weight per unit 
of energy saved resulting from use of the item.
    (15) If the item might reasonably be suspected of presenting any 
health or safety hazard, test data to show that the item does not 
present such hazard.

With respect to applications for addition to the approved list of 
renewable energy sources, the term ``item'' as used in this paragraph 
refers to the property which uses the energy source and not the energy 
source itself. The application should clearly indicate whether the 
request is for addition to the approved list of energy-conserving 
components or renewable energy sources, identify the provisions for 
which data is being submitted, and present the data in the order 
requested. The tests required under this paragraph may be conducted by 
independent laboratories but the underlying data must be submitted along 
with the test results. There shall accompany the request a declaration 
in the following form: ``Under penalties of perjury, I declare that I 
have examined this application, including accompanying documents, and, 
to the best of my knowledge and belief, the facts presented in support 
of the application are true, correct and complete.'' The statement must 
be signed by the person or persons making the application. The 
declaration shall not be made by the taxpayer's representative.
    (c) Criteria for additions--(1) Additions to the approved list of 
energy-conserving components. For an item to be considered for addition 
to the approved list of energy-conserving components, the manufacturer 
must show that the item increases the energy efficiency of a dwelling. 
For an item to be considered as increasing the energy efficiency of a 
dwelling, all of the following criteria must be met:
    (i) The use of the item must improve the energy efficiency of the 
dwelling structure, structural components of the dwelling, hot water 
heating, or heating or cooling systems.
    (ii) The use of the item must result, directly or indirectly, in a 
significant reduction in the consumption of oil or natural gas.
    (iii) The increase in energy efficiency must be established by test 
data and in accordance with accepted testing standards.
    (iv) The item must not present a safety, fire, environmental, or 
health hazard when properly installed.
    (2) Additions to the approved list of renewable energy sources. For 
an energy source to be considered for addition to the approved list of 
renewable energy

[[Page 62]]

sources, the manufacturer must show that the following criteria are met:
    (i) As in the case of solar, wind, and geothermal energy, the energy 
source must be an inexhaustible energy supply. Accordingly, wood and 
agricultural products and by-products are not considered renewable 
energy sources. Similarly, no exhaustible or depletable energy source 
(such as sources that are depletable under 611) will be considered.
    (ii) The energy source must be capable of being used for heating or 
cooling a residential dwelling or providing hot water or electricity for 
use in such a dwelling.
    (iii) A practical working device, machine, or mechanism, etc., must 
exist and be commercially available to use such renewable energy source.
    (iv) The use of the renewable energy source must not present a 
significant safety, fire, environmental, or health hazard.
    (d) Standards for Secretarial determination--(1) In general. The 
Secretary will not make any addition to the approved list of energy-
conserving components or renewable energy sources unless the Secretary 
determines that--
    (i) There will be a reduction in the total consumption of oil or 
natural gas as a result of the addition, and that reduction is 
sufficient to justify any resulting decrease in Federal revenues.
    (ii) The addition will not result in an increased use of any item 
which is known to be, or reasonably suspected to be, environmentally 
hazardous or a threat to public health or safety, and
    (iii) Available Federal subsidies do not make the addition 
unnecessary or inappropriate (in the light of the most advantageous 
allocation of economic resources).
    (2) Factors taken into account. In making any determination under 
paragraph (d)(1)(i) of this section, the Secretary will--
    (i) Make an estimate of the amount by which the addition will reduce 
oil and natural gas consumption, and
    (ii) Determine whether the addition compares favorably, on the basis 
of the reduction in oil and natural gas consumption per dollar of cost 
to the Federal Government (including revenue loss), with other Federal 
programs in existence or being proposed.
    (3) Factors taken into account in making estimates. In making any 
estimate under subparagraph (2)(i), the Secretary will take into account 
(among other factors)--
    (i) The extent to which the use of any item will be increased as a 
result of the addition,
    (ii) Whether sufficient capacity is available to increase production 
to meet any increase in demand for the item or associated fuels and 
materials caused by the addition,
    (iii) The amount of oil and natural gas used directly or indirectly 
in the manufacture of the item and other items necessary for its use,
    (iv) The estimated useful life of the item, and
    (v) The extent additional use of the item leads, directly or 
indirectly, to the reduced use of oil or natural gas. Indirect uses of 
oil or natural gas include use of electricity derived from oil or 
natural gas.
    (e) Effective date of addition to approved lists. In the case of 
additions to the approved list of energy-conserving components or 
renewable energy sources, the credit allowable by Sec. 1.23-1 shall 
apply with respect to expenditures which are made on or after the date a 
Treasury decision amending the regulations pursuant to the application 
is published in the Federal Register. However, the Secretary may 
prescribe by regulations that expenditures for additions made on or 
after the date referred to in the preceding sentence and before the 
close of the taxable year in which such date occurs shall be taken into 
account in the following taxable year. Additions to the list will be 
subject to the performance and quality standards (if any) provided under 
Sec. 1.23-4 which are in effect at the time of the addition. 
Furthermore, any addition made to the approved list will be subject to 
reevaluation by the Secretary for the purpose of determining whether the 
item still meets the requisite criteria and standards for addition to 
the list. If it is determined by the Secretary that an item no longer 
meets the requisite criteria, the Secretary will amend the regulations 
to delete

[[Page 63]]

the item from the approved list. Removal of an item from the list will 
be prospective from the date a Treasury decision amending the 
regulations is published in the Federal Register.

(Secs. 44C and 7805 of the Internal Revenue Code of 1954 (92 Stat. 3175, 
26 U.S.C. 44C; 68A Stat. 917, 26 U.S.C. 7805). The amendments to the 
Statement of Procedural Rules are issued under the authority contained 
in 5 U.S.C. 301 and 552)

[T.D. 7861, 47 FR 56331, Dec. 16, 1982. Redesignated and amended by T.D. 
8146, 52 FR 26673, July 16, 1987]



Sec. 1.25-1T  Credit for interest paid on certain home mortgages (Temporary).

    (a) In general. Section 25 permits States and political subdivisions 
to elect to issue mortgage credit certificates in lieu of qualified 
mortgage bonds. An individual who holds a qualified mortgage credit 
certificate (as defined in Sec. 1.25-3T) is entitled to a credit 
against his Federal income taxes. The amount of the credit depends upon 
(1) the amount of mortgage interest paid or accrued during the year and 
(2) the applicable certificate credit rate. See Sec. 1.25-2T. The 
amount of the deduction under section 163 for interest paid or accrued 
during any taxable year is reduced by the amount of the credit allowable 
under section 25 for such year. See Sec. 1.163-6T. The holder of a 
qualified mortgage credit certificate may be entitled to additional 
withholding allowances. See section 3402 (m) and the regulations 
thereunder.
    (b) Definitions. For purposes of Sec. Sec. 1.25-2T through 1.25-8T 
and this section, the following definitions apply:
    (1) Mortgage. The term ``mortgage'' includes deeds of trust, 
conditional sales contracts, pledges, agreements to hold title in 
escrow, and any other form of owner financing.
    (2) State. (i) The term ``State'' includes a possession of the 
United States and the District of Columbia.
    (ii) Mortgage credit certificates issued by or on behalf of any 
State or political subdivision (``governmental unit'') by constituted 
authorities empowered to issue such certificates are the certificates of 
such governmental unit.
    (3) Qualified home improvement loan. The term ``qualified home 
improvement loan'' has the meaning given that term under section 103A 
(1)(6) and the regulations thereunder.
    (4) Qualified rehabilitation loan. The term ``qualified 
rehabilitation loan'' has the meaning given that term under section 103A 
(1)(7)(A) and the regulations thereunder.
    (5) Single-family and owner-occupied residences. The terms ``single-
family'' and ``owner-occupied'' have the meaning given those terms under 
section 103A (1)(9) and the regulations thereunder.
    (6) Constitutional home rule city. The term ``constitutional home 
rule city'' means, with respect to any calendar year, any political 
subdivision of a State which, under a State constitution which was 
adopted in 1970 and effective on July 1, 1971, had home rule powers on 
the 1st day of the calendar year.
    (7) Targeted area residence. The term ``targeted area residence'' 
has the meaning given that term under section 103A (k) and the 
regulations thereunder.
    (8) Acquisition cost. The term ``acquisition cost'' has the meaning 
given that term under section 103A (1)(5) and the regulations 
thereunder.
    (9) Average area purchase price. The term ``average area purchase 
price'' has the meaning given that term under subparagraphs (2), (3), 
and (4) of section 103A (f) and the regulations thereunder. For purposes 
of this paragraph (b)(9), all determinations of average area purchase 
price shall be made with respect to residences as that term is defined 
in section 103A and the regulations thereunder.
    (10) Total proceeds. The ``total proceeds'' of an issue is the sum 
of the products determined by multiplying--
    (i) The certified indebtedness amount of each mortgage credit 
certificate issued pursuant to such issue, by
    (ii) The certificate credit rate specified in such certificate.

Each qualified mortgage credit certificate program shall be treated as a 
separate issue of mortgage credit certificates.

[[Page 64]]

    (11) Residence. The term ``residence'' includes stock held by a 
tenant-stockholder in a cooperative housing corporation (as those terms 
are defined in section 216(b) (1) and (2)). It does not include property 
such as an appliance, a piece of furniture, a radio, etc., which, under 
applicable local law, is not a fixture. The term also includes any 
manufactured home which has a minimum of 400 square feet of living space 
and a minimum width in excess of 102 inches and which is of a kind 
customarily used at a fixed location. The preceding sentence shall not 
apply for purposes of determining the average area purchase price for 
single-family residences, nor shall it apply for purposes of determining 
the State ceiling amount. The term ``residence'' does not, however, 
include recreational vehicles, campers, and other similar vehicles.
    (12) Related person. The term ``related person'' has the meaning 
given that term under section 103(b)(6)(C)(i) and Sec. 1.103-10(e)(1).
    (13) Date of issue. A mortgage credit certificate is considered 
issued on the date on which a closing agreement is signed with respect 
to the certified indebtedness amount.
    (c) Affidavits. For purposes of Sec. Sec. 1.25-1T through 1.25-8T, 
an affidavit filed in connection with the requirements of Sec. Sec. 
1.25-1T through 1.25-8T shall be made under penalties of perjury. 
Applicants for mortgage credit certificates who are required by a lender 
or the issuer to sign affidavits must be informed that any fraudulent 
statement will result in (1) the revocation of the individual's mortgage 
credit certificate, and (2) a $10,000 penalty under section 6709. Other 
persons required by a lender or an issuer to provide affidavits must 
receive similar notice. A person may not rely on an affidavit where that 
person knows or has reason to know that the information contained in the 
affidavit is false.

[T.D. 8023, 50 FR 19346, May 8, 1985]



Sec. 1.25-2T  Amount of credit (Temporary).

    (a) In general. Except as otherwise provided, the amount of the 
credit allowable for any taxable year to an individual who holds a 
qualified mortgage credit certificate is equal to the product of the 
certificate credit rate (as defined in paragraph (b)) and the amount of 
the interest paid or accrued by the taxpayer during the taxable year on 
the certified indebtedness amount (as defined in paragraph (c)).
    (b) Certificate credit rate--(1) In general. For purposes of 
Sec. Sec. 1.25-1T through 1.25-8T, the term ``certificate credit rate'' 
means the rate specified by the issuer on the mortgage credit 
certificate. The certificate credit rate shall not be less than 10 
percent nor more than 50 percent.
    (2) Limitation in certain States. (i) In the case of a State which--
    (A) Has a State ceiling for the calendar year in which an election 
is made that exceeds 20 percent of the average annual aggregate 
principal amount of mortgages executed during the immediately preceding 
3 calendar years for single-family owner-occupied residences located 
within the jurisdiction of such State, or
    (B) Issued qualified mortgage bonds in an aggregate amount less than 
$150 million for calendar year 1983.

the certificate credit rate for any mortgage credit certificate issued 
under such program shall not exceed 20 percent unless the issuing 
authority submits a plan to the Commissioner to ensure that the weighted 
average of the certificate credit rates in such mortgage credit 
certificate program does not exceed 20 percent and the Commissioner 
approves such plan. For purposes of determining the average annual 
aggregate principal amount of mortgages executed during the immediately 
preceding 3 calendar years for single-family owner-occupied residences 
located within the jurisdiction of such State, an issuer may rely upon 
the amount published by the Treasury Department for such calendar years. 
An issuer may rely on a different amount from that safe-harbor 
limitation where the issuer has made a more accurate and comprehensive 
determination of that amount. The weighted average of the certificate 
credit rates in a mortgage credit certificate program is determined by 
dividing the sum of the products obtained by multiplying the certificate 
credit rate of

[[Page 65]]

each certificate by the certified indebtedness amount with respect to 
that certificate by the sum of the certified indebtedness amounts of the 
certificates issued. See section 103A(g) and the regulations thereunder 
for the definition of the term ``State ceiling''.
    (ii) The following example illustrates the application of this 
paragraph (b)(2):

    Example. City Z issues four qualified mortgage credit certificates 
pursuant to its qualified mortgage credit certificate program. H 
receives a certificate with a certificate credit rate of 30 percent and 
a certified indebtedness amount of $50,000. I receives a certificate 
with a certificate credit rate of 25 percent and a certified 
indebtedness amount of $100,000. J and K each receive certificates with 
certificate credit rates of 10 percent; their certified indebtedness 
amounts are $50,000 and $100,000, respectively. The weighted average of 
the certificate credit rates is determined by dividing the sum of the 
products obtained by multiplying the certificate credit rate of each 
certificate by the certified indebtedness amount with respect to that 
certificate ((.3x$50,000) + (.25x$100,000) + (.1x$50,000) + 
(.1x$100,000)) by the sum of the certified indebtedness amounts of the 
certificates issued ($50,000+$100,000+$50,000+$100,000). Thus, the 
weighted average of the certificate credit rates is 18.33 percent 
($55,000/$300,000).

    (c) Certified indebtedness amount--(1) In general. The term 
``certified indebtedness amount'' means the amount of indebtedness which 
is--
    (i) Incurred by the taxpayer--
    (A) To acquire his principal residence, Sec. 1.25-2T(c)(1)(i),
    (B) As a qualified home improvement loan, or
    (C) As a qualified rehabilitation loan, and
    (ii) Specified in the mortgage credit certificate.
    (2) Example. The following example illustrates the application of 
this paragraph:

    Example. On March 1, 1986, State X, pursuant to its qualified 
mortgage credit certificate program, provides a mortgage credit 
certificate to B. State X specifies that the maximum amount of the 
mortgage loan for which B may claim a credit is $65,000. On March 15, B 
purchases for $67,000 a single-family dwelling for use as his principal 
residence. B obtains from Bank M a mortgage loan for $60,000. State X, 
or Bank M acting on behalf of State X, indicates on B's mortgage credit 
certificate that the certified indebtedness amount of B's loan is 
$60,000. B may claim a credit under section 25 (e) based on this amount.

    (d) Limitation on credit--(1) Limitation where certificate credit 
rate exceeds 20 percent. (i) If the certificate credit rate of any 
mortgage credit certificate exceeds 20 percent, the amount of the credit 
allowed to the taxpayer by section 25(a)(1) for any year shall not 
exceed $2,000. Any amount denied under this paragraph (d)(1) may not be 
carried forward under section 25(e)(1) and paragraph (d)(2) of this 
section.
    (ii) If two or more persons hold interests in any residence, the 
limitation of paragraph (d)(1)(i) shall be allocated among such persons 
in proporation to their respective interests in the residence.
    (2) Carryforward of unused credit. (i) If the credit allowable under 
section 25 (a) and Sec. 1.25-2T for any taxable year exceeds the 
applicable tax limit for that year, the excess (the ``unused credit'') 
will be a carryover to each of the 3 succeeding taxable years and, 
subject to the limitations of paragraph (d)(2)(ii), will be added to the 
credit allowable by section 25 (a) and Sec. 1.25-2T for that succeeding 
year.
    (ii) The amount of the unused credit for any taxable year (the 
``unused credit year'') which may be taken into account under this 
paragraph (d)(2) for any subsequent taxable year may not exceed the 
amount by which the applicable tax limit for that subsequent taxable 
year exceeds the sum of (A) the amount of the credit allowable under 
section 25 (a) and Sec. 1.25-1T for the current taxable year, and (B) 
the sum of the unused credits which, by reason of this paragraph (d)(2), 
are carried to that subsequent taxable year and are attributable to 
taxable years before the unused credit year. Thus, if by reason of this 
paragraph (d)(2), unused credits from 2 prior taxable years are carried 
forward to a subsequent taxable year, the unused credit from the earlier 
of those 2 prior years must be taken into account before the unused 
credit from the later of those 2 years is taken into account.
    (iii) For purposes of this paragraph (d)(2) the term ``applicable 
tax limit'' means the limitation imposed by section 26 (a) for the 
taxable year reduced by the sum of the credits allowable for

[[Page 66]]

that year under section 21, relating to expenses for household and 
dependent care services necessary for gainful employment, section 22, 
relating to the credit for the elderly and the permanently disabled, 
section 23, relating to the residential energy credit, and section 24, 
relating to contributions to candidates for public office. The 
limitation imposed by section 26 (a) for any taxable year is equal to 
the taxpayer's tax liability (as defined in section 26 (b)) for that 
year.
    (iv) The following examples illustrate the application of this 
paragraph (d)(2):

    Example 1. (i) B, a calendar year taxpayer, holds a qualified 
mortgage credit certificate. For 1986 B's applicable tax limit (i.e., 
tax liability) is $1,100. The amount of the credit under section 25 (a) 
and Sec. 1.25-2T for 1986 is $1,700. For 1986 B is not entitled to any 
of the credits described in sections 21 through 24. Under Sec. 1.25-2T 
(d)(2), B's unused credit for 1986 is $600, and B is entitled to carry 
forward that amount to the 3 succeeding years.
    (ii) For 1987 B's applicable tax limit is $1,500, the amount of the 
credit under section 25 (a) and Sec. 1.25-2T is $1,700, and the unused 
credit is $200. For 1988 B's applicable tax limit is $2,000, the amount 
of the credit under section 25 (a) and Sec. 1.25-2T is $1,300, and 
there is no unused credit. For 1987 and 1988 B is not entitled to any of 
the credits described in sections 21 through 24. No portion of the 
unused credit for 1986 my be used in 1987. For 1988 B is entitled to 
claim a credit of $2,000 under section 25 (a) and Sec. 1.25-2T, 
consisting of a $1,300 credit for 1988, the $600 unused credit for 1986, 
and $100 of the $200 unused credit for 1987. In addition, B may carry 
forward the remaining unused credit for 1987 ($100) to 1989 and 1990.
    Example 2. The facts are the same as in Example (1) except that for 
1988 B is entitled to a credit of $400 under section 23. B's applicable 
tax limit for 1988 is $1,600 ($2,000 less $400). For 1988 B is entitled 
to claim a credit of $1,600 under section 25 (a) and Sec. 1.25-2T, 
consisting of a $1,300 credit for 1988 and $300 of the unused credit for 
1986. In addition, B may carry forward the remaining unused credits of 
$300 for 1986 to 1989 and of $200 for 1987 to 1989 and 1990.

[T.D. 8023, 50 FR 19346, May 8, 1985]



Sec. 1.25-3  Qualified mortgage credit certificate.

    (a)-(g)(1)(ii) [Reserved]. For further guidance, see Sec. 1.25-
3T(a) through (g)(1)(ii).
    (g)(1)(iii) Reissued certificate exception. See paragraph (p) of 
this section for rules regarding the exception in the case of 
refinancing existing mortgages.
    (g)(2)-(o) [Reserved]. For further guidance, see Sec. 1.25-3T(g)(2) 
through (o).
    (p) Reissued certificates for certain refinancings--(1) In general. 
If the issuer of a qualified mortgage credit certificate reissues a 
certificate in place of an existing mortgage credit certificate to the 
holder of that existing certificate, the reissued certificate is treated 
as satisfying the requirements of this section. The period for which the 
reissued certificate is in effect begins with the date of the 
refinancing (that is, the date on which interest begins accruing on the 
refinancing loan).
    (2) Meaning of existing certificate. For purposes of this paragraph 
(p), a mortgage credit certificate is an existing certificate only if it 
satisfies the requirements of this section. An existing certificate may 
be the original certificate, a certificate issued to a transferee under 
Sec. 1.25-3T(h)(2)(ii), or a certificate previously reissued under this 
paragraph (p).
    (3) Limitations on reissued certificate. An issuer may reissue a 
mortgage credit certificate only if all of the following requirements 
are satisfied:
    (i) The reissued certificate is issued to the holder of an existing 
certificate with respect to the same property to which the existing 
certificate relates.
    (ii) The reissued certificate entirely replaces the existing 
certificate (that is, the holder cannot retain the existing certificate 
with respect to any portion of the outstanding balance of the certified 
mortgage indebtedness specified on the existing certificate).
    (iii) The certified mortgage indebtedness specified on the reissued 
certificate does not exceed the remaining outstanding balance of the 
certified mortgage indebtedness specified on the existing certificate.
    (iv) The reissued certificate does not increase the certificate 
credit rate specified in the existing certificate.
    (v) The reissued certificate does not result in an increase in the 
tax credit that would otherwise have been allowable to the holder under 
the existing certificate for any taxable year. The holder of a reissued 
certificate determines the amount of tax credit that would otherwise 
have been allowable

[[Page 67]]

by multiplying the interest that was scheduled to have been paid on the 
refinanced loan by the certificate rate of the existing certificate. In 
the case of a series of refinancings, the tax credit that would 
otherwise have been allowable is determined from the amount of interest 
that was scheduled to have been paid on the original loan and the 
certificate rate of the original certificate.
    (A) In the case of a refinanced loan that is a fixed interest rate 
loan, the interest that was scheduled to be paid on the refinanced loan 
is determined using the scheduled interest method described in paragraph 
(p)(3)(v)(C) of this section.
    (B) In the case of a refinanced loan that is not a fixed interest 
rate loan, the interest that was scheduled to be paid on the refinanced 
loan is determined using either the scheduled interest method described 
in paragraph (p)(3)(v)(C) of this section or the hypothetical interest 
method described in paragraph (p)(3)(v)(D) of this section.
    (C) The scheduled interest method determines the amount of interest 
for each taxable year that was scheduled to have been paid in the 
taxable year based on the terms of the refinanced loan including any 
changes in the interest rate that would have been required by the terms 
of the refinanced loan and any payments of principal that would have 
been required by the terms of the refinanced loan (other than repayments 
required as a result of any refinancing of the loan).
    (D) The hypothetical interest method (which is available only for 
refinanced loans that are not fixed interest rate loans) determines the 
amount of interest treated as having been scheduled to be paid for a 
taxable year by constructing an amortization schedule for a hypothetical 
self-amortizing loan with level payments. The hypothetical loan must 
have a principal amount equal to the remaining outstanding balance of 
the certified mortgage indebtedness specified on the existing 
certificate, a maturity equal to that of the refinanced loan, and 
interest equal to the annual percentage rate (APR) of the refinancing 
loan that is required to be calculated for the Federal Truth in Lending 
Act.
    (E) A holder must consistently apply the scheduled interest method 
or the hypothetical interest method for all taxable years beginning with 
the first taxable year the tax credit is claimed by the holder based 
upon the reissued certificate.
    (4) Examples. The following examples illustrate the application of 
paragraph (p)(3)(v) of this section:

    Example 1. A holder of an existing certificate that meets the 
requirements of this section seeks to refinance the mortgage on the 
property to which the existing certificate relates. The final payment on 
the holder's existing mortgage is due on December 31, 2000; the final 
payment on the new mortgage would not be due until January 31, 2004. The 
holder requests that the issuer provide to the holder a reissued 
mortgage credit certificate in place of the existing certificate. The 
requested certificate would have the same certificate credit rate as the 
existing certificate. For each calendar year through the year 2000, the 
credit that would be allowable to the holder with respect to the new 
mortgage under the requested certificate would not exceed the credit 
allowable for that year under the existing certificate. The requested 
certificate, however, would allow the holder credits for the years 2001 
through 2004, years for which, due to the earlier scheduled retirement 
of the existing mortgage, no credit would be allowable under the 
existing certificate. Under paragraph (p)(3)(v) of this section, the 
issuer may not reissue the certificate as requested because, under the 
existing certificate, no credit would be allowable for the years 2001 
through 2004. The issuer may, however, provide a reissued certificate 
that limits the amount of the credit allowable in each year to the 
amount allowable under the existing certificate. Because the existing 
certificate would allow no credit after December 31, 2000, the reissued 
certificate could expire on December 31, 2000.
    Example 2. (a) The facts are the same as Example 1 except that the 
existing mortgage loan has a variable rate of interest and the 
refinancing loan will have a fixed rate of interest. To determine 
whether the limit under paragraph (p)(3)(v) of this section is met for 
any taxable year, the holder must calculate the amount of credit that 
otherwise would have been allowable absent the refinancing. This 
requires a determination of the amount of interest that would have been 
payable on the refinanced loan for the taxable year. The holder may 
determine this amount by--
    (1) Applying the terms of the refinanced loan, including the 
variable interest rate or rates, for the taxable year as though the 
refinanced loan continued to exist; or
    (2) Obtaining the amount of interest, and calculating the amount of 
credit that would

[[Page 68]]

have been available, from the schedule of equal payments that fully 
amortize a hypothetical loan with the principal amount equal to the 
remaining outstanding balance of the certified mortgage indebtedness 
specified on the existing certificate, the interest equal to the annual 
percentage rate (APR) of the refinancing loan, and the maturity equal to 
that of the refinanced loan.
    (b) The holder must apply the same method for each taxable year the 
tax credit is claimed based upon the reissued mortgage credit 
certificate.

    (5) Coordination with Section 143(m)(3). A refinancing loan 
underlying a reissued mortgage credit certificate that replaces a 
mortgage credit certificate issued on or before December 31, 1990, is 
not a federally subsidized indebtedness for the purposes of section 
143(m)(3) of the Internal Revenue Code.

[T.D. 8692, 61 FR 66214, Dec. 17, 1996]



Sec. 1.25-3T  Qualified mortgage credit certificate (Temporary).

    (a) Definition of qualified mortgage credit certificate. For 
purposes of Sec. Sec. 1.25-1T through 1.25-8T, the term ``qualified 
mortgage credit certificate'' means a certificate that meets all of the 
requirements of this section.
    (b) Qualified mortgage credit certificate program. A certificate 
meets the requirements of this paragraph if it is issued under a 
qualified mortgage credit certificate program (as defined in Sec. 1.25-
4T).
    (c) Required form and information. A certificate meets the 
requirements of this paragraph if it is in the form specified in Sec. 
1.25-6T and if all the information required by the form is specified on 
the form.
    (d) Residence requirement--(1) In general. A certificate meets the 
requirements of this paragraph only if it is provided in connection with 
the acquisition, qualified rehabilitation, or qualified home improvement 
of a residence, that is--
    (i) A single-family residence (as defined in Sec. 1.25-1T(b)(5)) 
which, at the time the financing on the residence is executed or 
assumed, can reasonably be expected by the issuer to become (or, in the 
case of a qualified home improvement loan, to continue to be) the 
principal residence (as defined in section 1034 and the regulations 
thereunder) of the holder of the certificate within a reasonable time 
after the financing is executed or assumed, and
    (ii) Located within the jurisdiction of the governmental unit 
issuing the certificate.

See section 103a(d) and the regulations thereunder for further 
definitions and requirements.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating his intent to use (or, in the case of a 
qualified home improvement loan, that he is currently using and intends 
to continue to use) the residence as his principal residence within a 
reasonable time (e.g., 60 days) after the mortgage credit certificate is 
issued and stating that the holder will notify the issuer of the 
mortgage credit certificate if the residence ceases to be his principal 
residence. The affidavit must also state facts that are sufficient for 
the issuer or his agent to determine whether the residence is located 
within the jurisdiction of the issuer that issued the mortgage credit 
certificate.
    (e) 3-year requirement--(1) In general. A certificate meets the 
requirements of this paragraph only if the holder of the certificate had 
no present ownership interest in a principal residence at any time 
during the 3-year period prior to the date on which the mortgage on the 
residence in connection with which the certificate is provided is 
executed. For purposes of the preceding sentence, the holder's interest 
in the residence with respect to which the certificate is being provided 
shall not be taken into account. See section 103A(e) and the regulations 
thereunder for further definitions and requirements.
    (2) Exceptions. Paragraph (e)(1) shall not apply with respect to--
    (i) Any certificate provided with respect to a targeted area 
residence (as defined in Sec. 1.25-1T(b)(7)),
    (ii) Any qualified home improvement loan (as defined in Sec. 1.25-
1T(b)(3)), and
    (iii) Any qualified rehabilitation loan (as defined in Sec. 1.25-
1T(b)(4)).
    (3) Certification procedure. The requirements of paragraph (e)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that he had no present

[[Page 69]]

ownership interest in a principal residence at any time during the 3-
year period prior to the date of which the certificate is issued and the 
issuer or its agent obtains from the applicant copies of the applicant's 
Federal tax returns for the preceding 3 years and examines each 
statement to determine whether the applicant has claimed a deduction for 
taxes on property which was the applicant's principal residence pursuant 
to section 164(a)(1) or a deduction pursuant to section 163 for interest 
paid on a mortgage secured by property which was the applicant's 
principal residence. Where the mortgage is executed during the period 
between January 1 and February 15 and the applicant has not yet filed 
has Federal income tax return with the Internal Revenue Service, the 
issuer may, with respect to such year, rely on an affidavit of the 
applicant that the applicant is not entitled to claim deductions for 
taxes or interest on indebtedness with respect to property constituting 
his principal residence for the preceding calendar year. In the 
alternative, when applicable, the holder may provide an affidavit 
stating that one of the exceptions provided in paragraph (e)(2) applies.
    (4) Special rule. An issuer may submit a plan to the Commissioner 
for distributing certificates, in an amount not to exceed 10 percent of 
the proceeds of the issue, to individuals who do not meet the 
requirements of this paragraph. Such plan must describe a procedure for 
ensuring that no more than 10 percent of the proceeds of a such issue 
will be used to provide certificates to such individuals. If the 
Commissioner approves the issuer's plan, certificates issued in 
accordance with the terms of the plan to holders who do not meet the 3-
year requirement do not fail to satisfy the requirements of this 
paragraph.
    (f) Purchase price requirement--(1) In general. A certificate meets 
the requirements of this paragraph only if the acquisition cost (as 
defined in Sec. 1.25-1T(b)(8)) of the residence, other than a targeted 
area residence, in connection with which the certificate is provided 
does not exceed 110 percent of the average area purchase price (as 
defined in Sec. 1.25-1T(b)(9)) applicable to that residence. In the 
case of a targeted area residence (as defined in Sec. 1.251T(b)(7)) the 
acquisition cost may not exceed 120 percent of the average area purchase 
price applicable to such residence. See section 1093A(f) and the 
regulations thereunder for further definitions and requirements.
    (2) Certification procedure. The requirements of paragraph (f)(1) 
will be met if the issuer or its agent obtains affidavits executed by 
the seller and the buyer that state these requirements have been met. 
Such affidavits must include an itemized list of--
    (i) Any payments made by the buyer (or a related person) or for the 
benefit of the buyer,
    (ii) If the residence is incomplete, an estimate of the reasonable 
cost of completing the residence, and
    (iii) If the residence is purchased subject to a ground rent, the 
capitalized value of the ground rent.

The issuer or his agent must examine such affidavits and determine 
whether, on the basis of information contained therein, the purchase 
price requirement is met.
    (g) New mortgage requirement--(1) In general. (i) A certificate 
meets the requirements of this paragraph only if the certificate is not 
issued in connection with the acquisition or replacement of an existing 
mortgage. Except in the case of a qualified home improvement loan, the 
certificate must be issued to an individual who did not have a mortgage 
(whether or not paid off) on the residence with respect to which the 
certificate is issued at any time prior to the execution of the 
mortgage.
    (ii) Exceptions. For purposes of this paragraph, a certificate used 
in connection with the replacement of--
    (A) Construction period loans,
    (B) Bridge loans or similar temporary initial financing, and
    (C) In the case of a qualified rehabilitation loan, an existing 
mortgage,

shall not be treated as being used to acquire or replace an existing 
mortgage. Generally, temporary initial financing is any financing which 
has a term of 24 months or less. See section 103A(j)(1) and the 
regulations thereunder for examples illustrating the application of 
these requirements.

[[Page 70]]

    (2) Certification procedure. The requirements of paragraph (g)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that the mortage being acquired in 
connection with the certificate will not be used to acquire or replace 
an existing mortgage (other than one that falls within the exceptions 
described in paragraph (g)(1)(ii)).
    (h) Transfer of mortgage credit certificates--(1) In general. A 
certificate meets the requirements of this paragraph only if it is (i) 
not transferable or (ii) transferable only with the approval of the 
issuer.
    (2) Transfer procedure. A certificate that is transferred with the 
approval of the issuer is a qualified mortgage credit certificate in the 
hands of the transferee only if each of the following requirements is 
met:
    (i) The transferee assumed liability for the remaining balance of 
the certified indebtedness amount in connection with the acquisition of 
the residence from the transferor,
    (ii) The issuer issues a new certificate to the transferee, and
    (iii) The new certificate meets each of the requirements of 
paragraphs (d), (e), (f), and (i) of this section based on the facts as 
they exist at the time of the transfer as if the mortgage credit 
certificate were being issued for the first time. For example, the 
purchase price requirement is to be determined by reference to the 
average area purchase price at the time of the assumption and not when 
the mortgage credit certificate was originally issued.
    (3) Statement on certificate. The requirements of paragraph (h)(1) 
will be met if the mortgage credit certificate states that the 
certificate may not be transferred or states that the certificate may 
not be transferred unless the issuer issues a new certificate in place 
of the original certificate.
    (i) Prohibited mortgages--(1) In general. A certificate meets the 
requirements of this paragraph only if it is issued in connection with 
the acquisition of a residence none of the financing of which is 
provided from the proceeds of--
    (i) A qualified mortgage bond (as defined under section 103A(c)(1) 
and the regulations thereunder), or
    (ii) A qualified veterans' mortgage bond (as defined under section 
103A(c)(3) and the regulations thereunder).

Thus, for example, if a mortgagor has a mortgage on his principal 
residence that was obtained from the proceeds of a qualified mortgage 
bond, a mortgage credit certificate issued to such mortgagor in 
connection with a qualified home improvement loan with respect to such 
residence is not a qualified mortgage credit certificate. If, however, 
the financing provided from the proceeds of the qualified mortgage bond 
had been paid off in full, the certificate would be a qualified mortgage 
credit certificate (assuming all the requirements of this paragraph are 
met).
    (2) Certification procedure. The requirements of paragraph (i)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that no portion of the financing of the 
residence in connection with which the certificate is issued is provided 
from the proceeds of a qualified mortgage bond or a qualified veterans' 
mortgage bond.
    (j) Particular lenders--(1) In general. Except as otherwise provided 
in paragraph (j)(2), a certificate meets the requirements of this 
paragraph only if the certificate is not limited to indebtedness 
incurred from particular lenders. A certificate is limited to 
indebtedness from particular lenders if the issuer, directly or 
indirectly, prohibits the holder of a certificate from obtaining 
financing from one or more lenders or requires the holder of a 
certificate to obtain financing from one or more lenders. For purposes 
of this paragraph, a lender is any person, including an issuer of 
mortgage credit certificates, that provides financing for the 
acquisition, qualified rehabilitation, or qualified home improvement of 
a residence.
    (2) Exception. A mortgage credit certificate that is limited to 
indebtedness incurred from particular lenders will not cease to meet the 
requirements of this paragraph if the Commissioner approves the basis 
for such limitation. The Commissioner may approve the basis for such 
limitation if the issuer establishes to the satisfaction of the 
Commissioner that it will result in a

[[Page 71]]

significant economic benefit to the holders of mortgage credit 
certificates (e.g., substantially lower financing costs) compared to the 
result without such limitation.
    (3) Taxable bonds. The requirements of this paragraph do not prevent 
an issuer of mortgage credit certificates from issuing mortgage subsidy 
bonds (other than obligations described in section 103 (a)) the proceeds 
of which are to be used to provide mortgages to holders of mortgage 
credit certificates provided that the holders of such certificates are 
not required to obtain financing from the proceeds of the bond issue. 
See Sec. 1.25-4T (h) with respect to permissible fees.
    (4) Lists of participating lenders. The requirements of this 
paragraph do not prohibit an issuer from maintaining a list of lenders 
that have stated that they will make loans to qualified holders of 
mortgage credit certificates, provided that (i) the issuer solicits such 
statements in a public notice similar to the notice described in Sec. 
1.25-7T, (ii) lenders are provided a reasonable period of time in which 
to express their interest in being included in such a list, and (iii) 
holders of mortgage credit certificates are not required to obtain 
financing from the lenders on the list. If an issuer maintains such a 
list, it must update the list at least annually.
    (5) Certification procedure. The requirements of this paragraph will 
be met if (i) the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that the certificate was not limited to 
indebtedness incurred from particular lenders or (ii) the issuer obtains 
a ruling from the Commissioner under paragraph (j)(2).
    (6) Examples. The following examples illustrate the application of 
this paragraph:

    Example 1. Under its mortgage credit certificate program, County Z 
distributes all the certificates to be issued to a group of 60 
participating lenders. Residents of County Z may obtain mortgage credit 
certificates only from the participating lenders and only in connection 
with the acquisition of mortgage financing from that lender or one of 
the other participating lenders. Certificates issued under this program 
do not meet the requirements of this paragraph since the certificates 
are limited to indebtedness incurred from particular lenders. The 
certificates, therefore, are not qualified mortgage credit certificates.
    Example 2. In connection with its mortgage credit certificate 
program, County Y arranges with Bank P for a line of credit to be used 
to provide mortgage financing to holders of mortgage credit 
certificates. County Y, pursuant to paragraph (j)(4), maintains a list 
of lenders participating in the mortgage credit certificate program. 
County Y distributes the certificates directly to applicants. Holders of 
the certificates are not required to obtain mortgage financing through 
the line of credit or through a lender on the list of participating 
lenders. Certificates issued pursuant to County Y's program satisfy the 
requirements of this paragraph.

    (k) Developer certification--(1) In general. A mortgage credit 
certificate that is allocated by the issuer to any particular 
development meets the requirements of this paragraph only if the 
developer provides a certification to the purchaser of the residence and 
the issuer stating that the purchase price of that residence is not 
higher than the price would be if the issuer had not allocated mortgage 
credit certificates to the development. The certification must be made 
by the developer if a natural person or, if not, by a duly authorized 
official of the developer.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that he has received from the developer 
the certification described in this paragraph.
    (l) Expiration--(1) In general. A certificate meets the requirements 
of this paragraph if the certified indebtedness amount is incurred prior 
to the close of the second calender year following the calendar year for 
which the issuer elected not to issue qualified mortgage bonds under 
Sec. 1.25-4T with respect to that issue of mortgage credit 
certificates. Thus, for example, if on October 1, 1984, an issuing 
authority elects under Sec. 1.25-4T not to issue qualified mortgage 
bonds, a mortgage credit certificate provided under that program does 
not meet the requirements of this paragraph unless the indebtedness is 
incurred on or before December 31, 1986.
    (2) Issuer-imposed expiration dates. An issuer of mortgage credit 
certificates may provide that a certificate shall expire if the holder 
of the certificate does

[[Page 72]]

not incure certified indebtedness by a date that is prior to the 
expiration date provided in paragraph (l)(1). A certificate that expires 
prior to the date provided in paragraph (l)(1) may be reissued provided 
that the requirements of this paragraph are met.
    (m) Revocation. A certificate meets the requirements of this 
paragraph only if it has not been revoked. Thus, the credit provided by 
section 25 and Sec. 1.25-1T does not apply to interest paid or accrued 
following the revocation of a certificate. A certificate is treated as 
revoked when the residence to which the certificate relates ceases to be 
the holder's principal residence. An issuer may revoke a mortgage credit 
certificate if the certificate does not meet all the requirements of 
Sec. 1.25-3T (d), (e), (f), (g), (h), (i), (j), (k), and (n). The 
certificate is revoked by the issure's notifying the holder of the 
certificate and the Internal Revenue Service that the certificate is 
revoked. The notice to the Internal Revenue Service shall be made as 
part of the report requred by Sec. 1.25-8T (b)(2).
    (n) Interest paid to related person--(1) In general. A certificate 
does not meet the requirements of this paragraph if interest on the 
certified indebtedness amount is paid to a person who is a related 
person to the holder of the certificate.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that a related person does not have, 
and is not expected to have, an interest as a creditor in the certified 
indebtedness amount.
    (o) Fraud. Notwithstanding any other provision of this section, a 
mortgage credit certificate does not meet the requirements of this 
section and, therefore, the certificate is not a qualified mortgage 
credit certificate for any calendar year, if the holder of the 
certificate provides a certification or any other information to the 
lender providing the mortgage or to the issuer of the certificate 
containing a material misstatement and such misstatement is due to 
fraud. In determining whether any misstatement is due to fraud, the 
rules generally applicable to underpayments of tax due to fraud 
(including rules relating to the statute of limitations) shall apply. 
See Sec. 1.6709-1T with respect to the penalty for filing negligent or 
fraudulent statements.

[T.D. 8023, 50 FR 19348, May 8, 1985, as amended at T.D. 8502, 58 FR 
67689, Dec. 22, 1993; T.D. 8692, 61 FR 66215, Dec. 17, 1996]



Sec. 1.25-4T  Qualified mortgage credit certificate program (Temporary).

    (a) In general--(1) Definition of qualified mortgage credit 
certificate program. For purposes of Sec. Sec. 1.25-1T through 1.25-8T, 
the term ``qualified mortgage credit certificate program'' means a 
program to issue qualified mortgage credit certificates which meets all 
of the requirements of paragraphs (b) through (i) of this section.
    (2) Requirements are a minimum. Except as otherwise provided in this 
section, the requirements of this section are minimum requirements. 
Issuers may establish more stringent criteria for participation in a 
qualified mortgage credit certificate program. Thus, for example, an 
issuer may target 30 percent of the proceeds of an issue of mortgage 
credit certificates to targeted areas. Further, issuers may establish 
additional eligibility criteria for participation in a qualified 
mortgage credit certificate program. Thus, for example, issuers may 
impose an income limitation designed to ensure that only those 
individuals who could not otherwise purchase a residence will benefit 
from the credit.
    (3) Except as otherwise provided in this section and Sec. 1.25-3T, 
issuers may use mortgage credit certificates in connection with other 
Federal, State, and local programs provided that such use complies with 
the requirements of Sec. 1.25-3T(j). Thus, for example, a mortgage 
credit certificate may be issued in connection with the qualified 
rehabilitation of a residence part of the cost of which will be paid 
from the proceeds of a State grant.
    (b) Establishment of program. A program meets the requirements of 
this paragraph only if it is established by a State or political 
subdivision thereof for any calendar year for which it has the authority 
to issue qualified mortgage bonds.
    (c) Election not to issue qualified mortgage bonds--(1) In general. 
A program

[[Page 73]]

meets the requirements of this paragraph only if the issuer elects, in 
the time and manner specified in this paragraph, not to issue an amount 
of qualified mortgage bonds that it may otherwise issue during the 
calendar year under section 103A and the regulations thereunder.
    (2) Manner of making election. On or before the earlier of the date 
of distribution of mortgage credit certificates under a program or 
December 31, 1987, the issuer must file an election not to issue an 
amount of qualified mortgage bonds. The election (and the certification 
(or affidavit) described in paragraph (d)) shall be filed with the 
Internal Revenue Service Center, Philadelphia, Pennsylvania 19255. The 
election should be titled ``Mortgage Credit Certificate Election'' and 
must include--
    (i) The name, address, and TIN of the issuer,
    (ii) The issuer's applicable limit, as defined in section 103A (g) 
and the regulations thereunder,
    (iii) The aggregate amount of qualified mortgage bonds issued by the 
issuing authority during the calendar year,
    (iv) The amount of the issuer's applicable limit that it has 
surrendered to other issuers during the calendar year,
    (v) The date and amount of any previous elections under this 
paragraph for the calendar year, and
    (vi) The amount of qualfied mortgage bonds that the issuer elects 
not to issue.
    (3) Revocation of election. Any election made under this paragraph 
may be revoked, in whole or in part, at any time during the calendar 
year in which the election was made. The revocation, however, may not be 
made with respect to any part of the nonissued bond amount that has been 
used to issue mortgage credit certificates pursuant to the election. The 
revocation shall be filed with the Internal Revenue Service Center, 
Philadelphia, Pennsylvania 19255. The revocation should be titled 
``Revocation of Mortgage Credit Certificate Election'' and must 
include--
    (i) The name, address, and TIN of the issuer,
    (ii) The nonissued bond amount as originally elected, and
    (iii) The portion of the nonissued bond amount with respect to which 
the election is being revoked.
    (4) Special rule. If at the time that an issuer makes an election 
under this paragraph it does not know its applicable limit, the issuer 
may elect not to use all of its remaining authority to issue qualified 
mortgage bonds; this form of election will be treated as meeting the 
requirements of paragraph (c)(2) if, prior to the later of the end of 
the calendar year and December 31, 1985, the issuer amends its election 
so as to indicate the exact amount of qualified mortgage bond authority 
that it elected not to issue.
    (5) Limitation on nonissued bond amount. The amount of qualified 
mortgage bonds which an issuer elects not to issue may not exceed the 
issuer's applicable limit (as determined under section 103A (g) and the 
regulations thereunder). For example, a governmental unit that, pursuant 
to section 103A (g)(3), may issue $10 million of qualified mortgage 
bonds that elects to trade in $11 million in qualified mortgage bond 
authority has not met the requirements of this paragraph, and mortgage 
credit certificates issued pursuant to such election are not qualified 
mortgage credit certificates.
    (d) State certification requirement--(1) In general. A program meets 
the requirements of this paragraph only if the State official designated 
by law (or, where there is no State official, the Governor) certifies, 
based on facts and circumstances as of the date on which the 
certification is requested, following a request for such certification, 
that the issue meets the requirements of section 103A(g) (relating to 
volume limitation) and the regulations thereunder. A copy of the State 
certification must be attached to the issuer's election not to issue 
qualified mortgage bonds, except that, in the case of elections made 
during calendar year 1984, the certification may be filed with the 
Service prior to July 8, 1985 provided that mortgage credit certificates 
may not be distributed until the certification is filed. In the case of 
any constitutional home rule city, the certification shall be made by 
the chief executive officer of the city.

[[Page 74]]

    (2) Certification procedure. The official making the certification 
described in this paragraph (d) need not perform an independent 
investigation to determine whether the issuer has met the requirements 
of section 103A(g). In determining the aggregate amount of qualified 
mortgage bonds previously issued by that issuer during the calendar year 
the official may rely on copies of prior elections under paragraph (c) 
of this section made by the issuer for that year, together with an 
affidavit executed by an official of the issuer who is responsible for 
issuing bonds stating that the issuer has not, to date, issued any other 
issues of qualified mortgage bonds during the calendar year and stating 
the amount, if any, of the issuer's applicable limit that it has 
surrendered to other issuers during the calendar year; for any calendar 
year prior to 1985, the official may rely on an affidavit executed by a 
duly authorized official of the issuer who states the aggregate amount 
of qualified mortgage bonds issued by the issuer during the year. In 
determining the aggregate amount of qualified mortgage bonds that the 
issuer has previously elected not to issue during that calendar year, 
the official may rely on copies of any elections not to issue qualified 
mortgage bonds filed by the issuer for that calendar year, together with 
an affidavit executed by an official of the issuer responsible for 
issuing mortgage credit certificates stating that the issuer has not, to 
date, made any other elections not to issue qualified mortgage bonds. 
If, based on such information, the certifying official determines that 
the issuer has not, as of the date on which the certification is 
provided, exceeded its applicable limit for the year, the official may 
certify that the issue meets the requirements of section 103A(g). The 
fact that the certification described in this paragraph (d) is provided 
does not ensure that the issuer has met the requirements of section 
103A(g) and the regulations thereunder, nor does it preclude the 
application of the penalty for over-issuance of mortgage credit 
certificates if such over-issuance actually occurs. See Sec. 1.25-5T.
    (3) Special rule. If within 30 days after the issuer files a proper 
request for the certification described in this paragraph (d) the issuer 
has not received from the State official designated by law (or, if there 
is no State official, the Governor) certification that the issue meets 
the requirements of section 103A(g) or, in the alternative, a statement 
that the issue does not meet such requirements, the issuer may submit, 
in lieu of the certification required by this paragraph (d), an 
affidavit executed by an officer of the issuer responsible for issuing 
mortgage credit certificates stating that--
    (i) The issue meets the requirements of section 103A(g) and the 
regulations thereunder,
    (ii) At least 30 days before the execution of the affidavit the 
issuer filed a proper request for the certification described in this 
paragraph (d), and
    (iii) The State official designated by law (or, if there is no State 
official, the Governor) has not provided the certification described in 
this paragraph (d) or a statement that the issue does not meet such 
requirements.

For purposes of this paragraph, a request for certification is proper if 
the request includes the reports and affidavits described in paragraph 
(d)(2).
    (e) Information reporting requirement--(1) Reports. With respect to 
mortgage credit certificates issued after September 30, 1985, a program 
meets the requirements of this paragraph only if the issuer submits a 
report containing the information concerning the holders of certificates 
issued during the preceding reporting period required by this paragraph. 
The report must be filed for each reporting period in which certificates 
(other than transferred certificates) are issued under the program. The 
issuer is not responsible for false information provided by a holder if 
the issuer did not know or have reason to know that the information was 
false. The report must be filed on the form prescribed by the Internal 
Revenue Service. If no form is prescribed, or if the form prescribed is 
not readily available, the issuer may use its own form provided that 
such form is in the format set forth in this paragraph and contains the 
information required by this paragraph. The report must be titled 
``Mortgage Credit Certificate Information Report'' and must include

[[Page 75]]

the name, address, and TIN of the issuer, the reporting period for which 
the information is provided, and the following tables containing 
information concerning the holders of certificates issued during the 
reporting period for which the report is filed:
    (i) A table titled ``Number of Mortgage Credit Certificates by 
Income and Acquisition Cost'' showing the number of mortgage credit 
certificates issued (other than those issued in connection with 
qualified home improvement and rehabilitation loans) according to the 
annualized gross income of the holders (categorized in the following 
intervals of income:

$0-$9,999;
$10,000-$19,999;
$20,000-$29,999;
$30,000-$39,999;
$40,000-$49,999;
$50,000-$74,999; and
$75,000 or more)


and according to the acquisition cost of the residences acquired in 
connection with the mortgage credit certificates (categorized in the 
following intervals of acquisition cost:

$0-$19,999;
$20,000-$39,999;
$40,000-$59,999;
$60,000-$79,999;
$80,000-$99,999;
$100,000-$119,999;
$120,000-$149,999;
$150,000-$199,999; and
$200,000 or more).


For each interval of income and acquisition cost the table must also be 
categorized according to--
    (A) The aggregate amount of fees charged to holders to cover any 
administrative costs incurred by the issuer in issuing mortgage credit 
certificates, and
    (B) The number of holders that--
    (1) Did not have a present ownership interest in a principal 
residence at any time during the 3-year period ending on the date the 
mortgage credit certificate is executed (i.e., satisfied the 3-year 
requirement) and purchased residences in targeted areas,
    (2) Satisfied the 3-year requirement and purchased residences not 
located in targeted areas,
    (3) Did have a present ownership interest in a principal residence 
at any time during the 3-year period ending on the date the mortgage 
credit certificate is executed (i.e., did not satisfy the 3-year 
requirement) and purchased residences in targeted areas, and
    (4) Did not satisfy the 3-year requirement and purchased residences 
not located in targeted areas.
    (ii) A table titled ``Volume of Mortgage Credit Certificates by 
Income and Acquisition Cost'' containing data on--
    (A) The total of the certified indebtedness amounts of the 
certificates issued (other than those issued in connection with 
qualified home improvement and rehabilitation loans);
    (B) The sum of the products of the certified indebtedness amount and 
the certificate credit rate for each certificate (other than those 
issued in connection with qualified home improvement and rehabilitation 
loans) according to annualized gross income (categorized in the same 
intervals of income as the preceding table) and according to the 
acquisition cost of the residences acquired in connection with mortgage 
credit certificates (categorized in the same intervals of acquisition 
cost as the preceding table); and
    (C) For each interval of income and acquisition cost, the 
information described in paragraph (e)(1)(ii) (A) and (B) categorized 
according to the holders that--
    (1) Satisfied the 3-year requirement and purchased residences in 
targeted areas,
    (2) Satisfied the 3-year requirement and purchased residences not 
located in targeted areas,
    (3) Did not satisfy the 3-year requirement and purchased residences 
in targeted areas, and
    (4) Did not satisfy the 3-year requirement and purchased residences 
not located in targeted areas.
    (iii) A table titled ``Mortgage Credit Certificates for Qualified 
Home Improvement and Rehabilitation Loans'' showing the number of 
mortgage credit certificates issued in connection with qualified home 
improvement loans and qualified rehabilitation loans, the total of the 
certified indebtedness amount with respect to such certificates, and the 
sum of the products of the certified indebtedness amount and the 
certificate credit rate for each certificate;

[[Page 76]]

the information contained in the table must also be categorized 
according to whether the residences with respect to which the 
certificates were provided are located in targeted areas.
    (2) Format. If no form is prescribed by the Internal Revenue 
Service, or if the prescribed form is not readily available, the issuer 
must submit the report in the format specified in this paragraph (e)(2). 
The specified format of the report is the following:

             Mortgage Credit Certificate Information Report

Name of issuer:
Address of issuer:
TIN of issuer:
Reporting period:

                                          Number of Mortgage Credit Certificates by Income and Acquisition Cost
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         Satisfied                           Not satisfied
  3-year requirement: Annualized gross monthly income of  ----------------------------------------------------------------------------    Totals fees
                        borrowers                           Nontargeted area    Targeted area     Nontargeted area    Targeted area
--------------------------------------------------------------------------------------------------------------------------------------------------------
$0 to $9,999.............................................
$10,000 to $19,999.......................................
$20,000 to $29,999.......................................
$30,000 to $39,999.......................................
$40,000 to $49,999.......................................
$50,000 to $74,999.......................................
$75,000 or more..........................................
                                                          ----------------------------------------------------------------------------------------------
  Total..................................................
 
                     Acquisition Cost
 
0 to $19,999.............................................
$20,000 to $39,999.......................................
$40,000 to $59,999.......................................
$60,000 to $79,999.......................................
$80,000 to $99,999.......................................
$100,000 to $119,999.....................................
$120,000 to $149,999.....................................
$150,000 to $199,999.....................................
$200,000 or more.........................................
                                                          ----------------------------------------------------------------------------------------------
    Total................................................
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 77]]


                                                              Volume of Mortgage Credit Certificates by Income and Acouisition Cost
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             Holders satisfying the 3-year requirement                   3-year requirement not satisfied                       Totals
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
                                                           Nontargeted area              Targeted area             Nontargeted area              Targeted area
                                                     ----------------------------------------------------------------------------------------------------------------               Total sum of
                                                                       Sum of                      Sum of                      Sum of                      Sum of     Total of the   products of
     Annualized gross monthly income of holders       Total of the   products of  Total of the   products of  Total of the   products of  Total of the   products of    certified     certified
                                                        certified     certified     certified     certified     certified     certified     certified     certified   indebtedness  indebtedness
                                                      indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness     amounts     amounts and
                                                         amounts     amounts and     amounts     amounts and     amounts     amounts and     amounts     amounts and                credit rates
                                                                    credit rates                credit rates                credit rates                credit rates
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
$0 to $9,999........................................
$10,000 to $19,999..................................
$20,000 to $29,999..................................
$30,000 to $39,999..................................
$40,000 to $49,999..................................
$50,000 to $74,999..................................
$75,000 to more.....................................
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
    Total...........................................
 
                  Acquisition Cost
 
$0 to $19,999.......................................
$20,000 to $39,999..................................
$40,000 to $59,999..................................
$60,000 to $79,999..................................
$80,000 to $99,999..................................
$100,000 to $119,999................................
$120,000 to $149,999................................
$150,000 to $199,999................................
$200,000 or more....................................
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
    Total...........................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 78]]


     Mortgage Credit Certificates for Qualified Home Improvement and
                          Rehabilitation Loans
------------------------------------------------------------------------
                                          Nontargeted  Targeted
                                              area       area     Totals
------------------------------------------------------------------------
         Home Improvement Loans
 
Number of mortgage credit certificates..
Total of the certified indebtedness
 amounts................................
Product of certified indebtedness
 amounts and credit rates...............
 
          Rehabilitation Loans
 
Number of mortgage credit certificates..
Total of the certified indebtedness
 amounts................................
Product of certified indebtedness
 amounts and credit rates...............
------------------------------------------------------------------------

    (3) Definitions and special rules. (i) For purposes of this 
paragraph the term ``annualized gross income'' means the borrower's 
gross monthly income multiplied by 12. Gross monthly income is the sum 
of monthly gross pay, any additional income from investments, pensions, 
Veterans Administration (VA) compensation, part-time employment, 
bonuses, dividends, interest, current overtime pay, net rental income, 
etc., and other income (such as alimony and child support, if the 
borrower chooses to disclose such income). Information with respect to 
gross monthly income may be obtained from available loan documents, 
e.g., the sum of lines 23D and 23E on the Application for VA or FmHA 
Home Loan Guaranty or for HUD/FHA Insured Mortgage (VA Form 26-1802a, 
HUD 92900, Jan. 1982), or the total line from the Gross Monthly Income 
section of FHLMC Residential Loan Application form (FHLMC 65 Rev. 8/78).
    (ii) For purposes of this paragraph, the term ``reporting period'' 
means each one year period beginning July 1 and ending June 30, except 
that issuers need not provide data with respect to the period prior to 
October 1, 1985.
    (iii) For purposes of this paragraph, verification of information 
concerning a holder's gross monthly income by utilizing other available 
information concerning the holder's income (e.g., Federal income tax 
returns) is not required. In determining whether the holder of a 
mortgage credit certificate acquiring a residence in a targeted area 
satisfies the 3-year requirement, the issuer may rely on a statement 
signed by the holder.
    (4) Time for filing. The report required by this paragraph shall be 
filed not later than the 15th day of the second calendar month after the 
close of the reporting period. The Commissioner may grant an extension 
of time for the filing of a report required by this paragraph if there 
is reasonable cause for the failure to file such report in a timely 
fashion. The report may be filed at any time before such date but must 
be complete based on facts and reasonable expectations as of the date 
the report is filed. The report need not be amended to reflect 
information learned subsequent to the date of filing, or to reflect 
changed circumstances with respect to any holder.
    (5) Place for filing. The report required by this paragraph is to be 
filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 
19255.
    (f) Policy statement. A program established pursuant to an election 
under paragraph (c) made after 1984 meets the requirements of this 
paragraph only if the applicable elected representative of the 
governmental unit--
    (1) Which is the issuer, or
    (2) On whose behalf the certificates were issued,

has published (after a public hearing following reasonable public 
notice) a policy statement described in Sec. 1.103A-2(1) by the last 
day of the year preceding the year in which the election under paragraph 
(c) is made, and a copy of such report has been submitted to the 
Commissioner on or before such last day. See Sec. 1.103A-2(1) for 
further definitions and requirements.
    (g) Targeted areas requirement--(1) In general. A program meets the 
requirements of this paragraph only if--
    (i) The portion of the total proceeds of the issue specified in 
paragraph (g)(2) is made available to provide mortgage credit 
certificates in connection with owner financing of targeted area 
residents for at least 1 year after the date on which mortgage credit 
certificates are first made available with respect to targeted area 
residences, and

[[Page 79]]

    (ii) The issuer attempts with reasonable diligence to place such 
proceeds with qualified persons.


Mortgage credit certificates are considered first made available with 
respect to targeted area residences on the date on which the issuer 
first begins to accept applications for mortgage credit certificates 
provided under that issue.
    (2) Specified portion. (i) The specified portion of the total 
proceeds of an issue is the lesser of--
    (A) 20 percent of the total proceeds, or
    (B) 8 percent of the average annual aggregate principal amount of 
mortgages executed during the immediately preceding 3 calendar years for 
single-family, owner-occupied residences in targeted areas within the 
jurisdiction of the issuing authority.

For purposes of computing the required portion of the total proceeds 
specified in paragraph (g)(2)(i)(B) where such provision is applicable, 
an issuer may rely upon the safe-harbor formula provided in the 
regulations under section 103A(h).
    (ii) See Sec. 1.25-1T(b)(10)(ii) for the definition of ``total 
proceeds''.
    (h) Fees--(1) In general. A program meets the requirements of this 
paragraph only if each applicant is required to pay, directly or 
indirectly, no fee other than those fees permitted under this paragraph.
    (2) Permissible fees. Applicants may be required to pay the 
following fees provided that they are reasonable:
    (i) Points, origination fees, servicing fees, and other fees in 
amounts that are customarily charged with respect to mortgages not 
provided in connection with mortgage credit certificates,
    (ii) Application fees, survey fees, credit report fees, insurance 
fees, or similar settlement or financing costs to the extent such 
amounts do not exceed the amounts charged in the area in cases where 
mortgages are not provided in connection with mortgage credit 
certificates. For example, amounts charged for FHA, VA, or similar 
private mortgage insurance on an individual's mortgage are permissible 
so long as such amounts do not exceed the amounts charged in the area 
with respect to a similar mortgage that is not provided in connection 
with a mortgage credit certificate, and
    (iii) Other fees that, taking into account all the facts and 
circumstances, are reasonably necessary to cover any administrative 
costs incurred by the issuer or its agent in issuing mortgage credit 
certificates.
    (i) Qualified mortgage credit certificate. A program meets the 
requirements of this paragraph only if each mortgage credit certificate 
issued under the program meets each of the requirements of paragraphs 
(c) through (o) of Sec. 1.25-3T.
    (j) Good faith compliance efforts--(1) Eligibility requirements. (i) 
A program under which each of the mortgage credit certificates issued 
does not meet each of the requirements of paragraphs (c) through (o) of 
Sec. 1.25-3T shall be treated as meeting the requirements of paragraph 
(i) of this section if each of the requirements of this paragraph (j)(1) 
is satisfied. A mortgage credit certificate program meets the 
requirements of this paragraph (j)(1) only if each of the following 
provisions is met:
    (A) The issuer in good faith attempted to issue mortgage credit 
certificates only to individuals meeting each of the requirements of 
paragraphs (c) through (o) of Sec. 1.25-3T. Good faith requires that 
agreements with lenders and agents and other relevant instruments 
contain restrictions that permit the approval of mortgage credit 
certificates only in accordance with the requirements of paragraphs (c) 
through (o) of Sec. 1.25-3T. In addition, the issuer must establish 
reasonable procedures to ensure compliance with those requirements. 
Reasonable procedures include reasonable investigations by the issuer to 
determine whether individuals satisfy the requirements of paragraphs (c) 
through (o) of Sec. 1.25-3T.
    (B) 95 percent or more of the total proceeds of the issue were 
devoted to individuals with respect to whom, at the time that the 
certificate was issued, all the requirements of paragraphs (c) through 
(o) of Sec. 1.25-3T were met. If a holder of a mortgage credit 
certificate fails to meet more than one of these requirements, the 
amount of the certificate (i.e., the certificate credit rate multiplied 
by the certified

[[Page 80]]

indebtedness amount) issued to that individual will be taken into 
account only once in determining whether the 95-percent requirement is 
met. However, all of the defects in that individual's certificate must 
be corrected pursuant to paragraph (j)(1)(i)(C).
    (C) Any failure to meet the requirements of paragraphs (c) through 
(o) of Sec. 1.25-3T is corrected within a reasonable period after that 
failure is discovered. For example, if an individual fails to meet one 
or more of such requirements those failures can be corrected by revoking 
that individual's certificate.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (j)(1):

    Example 1. County X only distributes mortgage credit certificates to 
individuals who have contracted to purchase a principal residence. 
County X requires that applicants for mortgage credit certificates 
present the following information:
    (i) An affidavit stating that the applicant intends to use the 
residence in connection with which the mortgage credit certificate is 
issued as his principal residence within a reasonable time after the 
certificate is issued by County X, that the applicant will notify the 
County if the residence ceases to be his principal residence, and facts 
that are sufficient for County X to determine whether the residence is 
located within the jurisdiction of County X,
    (ii) An affidavit stating that the applicant had no present 
ownership interest in a principal residence at any time during the 3-
year period prior to the date on which the certificate is issued,
    (iii) Copies of the applicant's Federal tax returns for the 
preceding 3 years,
    (iv) Affidavits from the seller of the residence with respect to 
which the certificate is issued and the applicant stating the purchase 
price of the residence, including an itemized list of (A) payments made 
by or for the benefit of the applicant, (B) if the residence is 
incomplete, an estimate of the reasonable cost of completing the 
residence, and (C) if the residence is subject to a ground rent, the 
capitalized value of the ground rent,
    (v) An affidavit executed by the applicant stating that the mortgage 
being acquired in connection with the certificate will not be used to 
acquire or replace an existing mortgage,
    (vi) An affidavit executed by the applicant stating that no portion 
of the financing for the residence in connection with which the 
certificate is issued is provided from the proceeds of a qualified 
mortgage bond or qualified veterans' mortgage bond and that no portion 
of the mortgage for the residence is provided by a person related to the 
applicant (as defined in Sec. 1.25-3T(n)),
    (vii) An affidavit executed by the applicant stating that the 
certificate was not limited to indebtedness incurred from particular 
lenders, and
    (viii) In the case of a mortgate credit certificate allocated for 
use in connection with a particular development, and affidavit executed 
by the applicant stating that the applicant received from the developer 
a certification stating that the price of the residence with respect to 
which the certificate was issued is no higher than it would be without 
the use of a mortgage credit certificate.

County X examines the information submitted by the applicant to 
determine whether the requirements of paragraphs (c), (d), (e), (f), 
(g), (i), (j), (k), and (n) of Sec. 1.25-3T are met. County X 
determines that the certificate has not expired. The mortgage credit 
certificates issued by County X are in the form prescribed by Sec. 
1.25-6T and County X provides all the required information and 
statements. After determining that the applicant meets all these 
requirements County X issues a mortgage credit certificate to the 
applicant. This procedure for issuing mortgage credit certificates is 
sufficient evidence of the good faith of County X to meet the 
requirements of Sec. 1.25-4T(j)(1)(i)(A).
    Example 2. County W distributes preliminary mortgage credit 
certificates to individuals who have not entered into contracts to 
purchase a principal residence. County W issues preliminary certificates 
in the form prescribed by Sec. 1.25-6T to those applicants that have 
submitted statements that they (i) intend to purchase a single-family 
residence located within the jurisdiction of County W which they will 
occupy as a principal residence, (ii) have had no present ownership 
interest in a principal residence within the preceding 3-year period, 
and (iii) will not use the certificate in connection with the 
acquisition or replacement of an existing mortgage. The certificates 
contain a maximum purchase price, the certificate credit rate, and a 
statement that the certificate will expire if the applicant does not 
enter into a closing agreement with respect to a loan within 6 months 
from the date of preliminary issuance. Holders of these certificates may 
apply for a mortgage loan from any lender. When the holder of the 
certificate applies for a loan the lender requires that he submit the 
following:
    (i) An affidavit stating that the applicant intends to use the 
residence in connection with which the mortgage credit certificate is 
issued as his principal residence within a reasonable time after the 
certificate is issued by County W, that the applicant will notify the 
County if the residence ceases to be his principal residence, and facts 
that are

[[Page 81]]

sufficient for County W to determine whether the residence is located 
within the jurisdication of County W,
    (ii) An affidavit stating that the applicant had no present 
ownership interest in a principal residence at any time during the 3-
year period prior to the date on which the certificate is issued,
    (iii) Copies of the applicant's Federal tax returns for the 
preceding 3 years,
    (iv) Affidavits from the seller of the residence with respect to 
which the certificate is issued and the applicant stating the purchase 
price of the residence, including an itemized list of (A) payments made 
by or for the benefit of the applicant, (B) if the residence is 
incomplete, an estimate of the reasonable cost of completing the 
residence, and (C) if the residence is subject to a ground rent, the 
capitalized value of the ground rent,
    (v) An affidavit executed by the applicant stating that the mortgage 
being acquired in connection with the certificate will not be used to 
acquire or replace an existing mortgage,
    (vi) An affidavit executed by the applicant stating that no portion 
of the financing for the residence in connection with which the 
certificate is issued in provided from the proceeds of a qualified 
mortgage bond or qualified veterans' mortgage bond and that no portion 
of the mortgage for the residence is provided by a person related to the 
applicant (as defined in Sec. 1.25-3T(n)),
    (vii) An affidavit executed by the applicant stating that the 
certificate was not limited to indebtedness incurred from particular 
lenders, and
    (viii) In the case of a mortgage credit certificate allocated for 
use in connection with a particular development, an affidavit executed 
by the applicant stating that the applicant received from the developer 
a certification stating that the price of the residence with respect to 
which the certificate was issued is no higher than it would be without 
the use of a mortgage credit certificate.

The lender then submits those affidavits, together with its statement as 
to the amount of the indebtedness incurred, to County W. After 
determining that the requirements of paragraphs (c), (d), (e), (f), (g), 
(i), (j), (k) and (n) of Sec. 1.25-3T are met and determining that the 
certificate has not expired, County W completes the mortgage credit 
certificate. This procedure for issuing mortgage credit certificates is 
sufficient evidence of the good faith of County W to meet the 
requirements of Sec. 1.25-4T(j)(1)(i)(A).

    (2) Program requirements. (i) A mortgage credit certificate program 
which fails to meet one or more of the requirements of paragraphs (b) 
through (h) of this section shall be treated as meeting such 
requirements if the requirements of this paragraph (j)(2) are satisfied. 
A mortgage credit certificate program meets the requirements of this 
paragraph (j)(2) only if each of the following provisions is met:
    (A) The issuer in good faith attempted to meet all of the 
requirements of paragraphs (b) through (h) of this section. This good 
faith requirement will be met if all reasonable steps are taken by the 
issuer to ensure that the program complies with these requirements.
    (B) Any failure to meet such requirements is due to inadvertent 
error, e.g., mathematical error, after taking reasonable steps to comply 
with such requirements.
    (ii) The following example illustrate the application of this 
paragraph (j)(2):

    Example. City X issues an issue of mortgage credit certificates. 
However, despite taking all reasonable steps to determine accurately the 
size of the applicable limit, as provided in section 103A (g)(3) and the 
regulations thereunder, the limit is exceeded because the amount of the 
mortgages, originated in the area during the past 3 years is incorrectly 
computed as a result of mathematical error. Such facts are sufficient 
evidence of the good faith of the issuer to meet the requirements of 
paragraph (j)(2).

[T.D. 8023, 50 FR 19350, May 8, 1985, as amended by T.D. 8048, 50 FR 
35538, Sept. 3, 1985]



Sec. 1.25-5T  Limitation on aggregate amount of mortgage credit certificates 

(Temporary).

    (a) In general. If the aggregate amount of qualified mortgage credit 
certificates (as defined in paragraph (b)) issued by an issuer under a 
qualified mortgage credit certificate program exceeds 20 percent of the 
nonissued bond amount (as defined in paragraph (c)), the provisions of 
paragraph (d) shall apply.
    (b) Aggregate amount of mortgage credit certificates--(1) In 
general. The aggregate amount of qualified mortgage credit certificates 
issued under a qualified mortgage credit certificate program is the sum 
of the products determined by multiplying--
    (i) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under that program, by
    (ii) The certificate credit rate with respect to such certificate.

[[Page 82]]

    (2) Examples. The following examples illustrate the application of 
this paragraph (b):

    Example 1. For 1986 City Q has a nonissued bond amount of $100 
million. After making a proper election, Q issues 2,000 qualified 
mortgage credit certificates each with a certificate credit rate of 20 
percent and a certified indebtedness amount of $50,000. The aggregate 
amount of qualified mortgage credit certificates is $20 million 
(2,000x(.2x$50,000)). Since this amount does not exceed 20 percent of 
the nonissued bond amount (.2x$100 million = $20 million), Q has 
complied with the limitation on the aggregate amount of mortgage credit 
certificates, provided that it does not issue any additional 
certificates.
    Example 2. The facts are the same as in example (1) except that 
instead of issuing all its certificates at the 20 percent rate, Q issues 
(i) qualified mortgage credit certificates with a certificate credit 
rate of 10 percent and an aggregate principal amount of $25 million, 
(ii) qualified mortgage credit certificates with a certificate credit 
rate of 40 percent and an aggregate principal amount of $25 million, and 
(iii) qualified mortgage credit certificates with a certificate credit 
rate of 30 percent and an aggregate principal amount of $25 million. The 
aggregate amount of qualified mortgage credit certificates is $20 
million ((10 percent of $25 million) plus (40 percent of $25 million) 
plus (30 percent of $25 million)). Q has complied with the limitation on 
the aggregate amount of qualified mortgage credit certificates, provided 
that it does not issue any additional certificates pursuant to the same 
program.

    (c) Nonissued bond amount. The term ``nonissued bond amount'' means, 
with respect to any qualified mortgage credit certificate program, the 
amount of qualified mortgage bonds (as defined in section 103A(c)(1) and 
the regulations thereunder) which the issuer is otherwise authorized to 
issue and elects not to issue under section 25(c)(2) and Sec. 1.25-
4T(b). The amount of qualified mortgage bonds which an issuing authority 
is authorized to issue is determined under section 103A(g) and the 
regulations thereunder; such determination shall take into account any 
prior elections by the issuer not to issue qualified mortgage bonds, the 
amount of any reduction in the State ceiling under paragraph (d) of this 
section, and the aggregate amount of qualified mortgage bonds issued by 
the issuer prior to its election not to issue qualified mortgage bonds.
    (d) Noncompliance with limitation on aggregate amount of mortgage 
credit certificates--(1) In general. If the provisions of this paragraph 
apply, the State ceiling under section 103A(g)(4) and the regulations 
thereunder for the calendar year following the calendar year in which 
the Commissioner determines the correction amount for the State in which 
the issuer which exceeded the limitation on the aggregate amount of 
mortgage credit certificates is located shall be reduced by 1.25 times 
the correction amount with respect to such failure.
    (2) Correction amount. (i) The term ``correction amount'' means an 
amount equal to the excess credit amount divided by .20.
    (ii) The term ``excess credit amount'' means the excess of--
    (A) The credit amount for any mortgage credit certificate program, 
over
    (B) The amount which would have been the credit amount for such 
program had such program met the requirements of section 25(d)(2) and 
paragraph (a) of this section.
    (iii) The term ``credit amount'' means the sum of the products 
determined by multiplying--
    (A) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under the program, by
    (B) The certificate credit rate with respect to such certificate.
    (3) Example. The following example illustrates the application of 
this paragraph:

    Example. For 1987 City R has a nonissued bond amount of $100 
million. City R issues all of its mortgage credit certificates with a 
certificate credit rate of 20 percent. City R issues certificates with 
an aggregate certified indebtedness amount of $120 million. The 
aggregate amount of mortgage credit certificates issued by City R is $24 
million, which exceeds 20 percent of the nonissued bond amount. The 
State ceiling for the calendar year following the calendar year in which 
the Commissioner determines the correction amount is reduced by $25 
million (the correction amount multiplied by 1.25). The correction 
amount is determined as follows: The credit amount is $24 million (.2 x 
$120 million); the amount which would have been the credit amount for 
the program had it met the requirements of section 25(d)(2) is $20 
million (.2x$100 million); the excess credit

[[Page 83]]

amount is $4 million ($24 million--$20 million); therefore, the 
correction amount is $20 million ($4 million/.2).

    (4) Cross-references. See section 103A(g)(4) and the regulations 
thereunder with respect to the reduction of the applicable State 
ceiling.

[T.D. 8023, 50 FR 19353, May 8, 1985]



Sec. 1.25-6T  Form of qualified mortgage credit certificate (Temporary).

    (a) In general. Qualified mortgage credit certificates are to be 
issued on the form prescribed by the Internal Revenue Service. If no 
form is prescribed by the Internal Revenue Service, or if the form 
prescribed by the Internal Revenue Service is not readily available, the 
issuer may use its own form provided that such form contains the 
information required by this section. Each mortgage credit certificate 
must be issued in a form such that there are at least three copies of 
the form. One copy of the certificate shall be retained by the issuer; 
one copy shall be retained by the lender; and one copy shall be 
forwarded to the State official who issued the certification required by 
Sec. 1.25-4T(d), unless that State official has stated in writing that 
he does not want to receive such copies.
    (b) Required information. Each qualified mortgage credit certificate 
must include the following information:
    (1) The name, address, and TIN of the issuer,
    (2) The date of the issuer's election not to issue qualified 
mortgage bonds pursuant to which the certificate is being issued,
    (3) The number assigned to the certificate,
    (4) The name, address, and TIN of the holder of the certificate,
    (5) The certificate credit rate,
    (6) The certified indebtness amount,
    (7) The acquisition cost of the residence being acquired in 
connection with the certificate,
    (8) The average area purchase price applicable to the residence,
    (9) Whether the certificate meets the requirements of Sec. 1.25-
3T(d), relating to residence requirement,
    (10) Whether the certificate meets the requirements of Sec. 1.25-
3T(e), relating to 3-year requirement,
    (11) Whether the certificate meets the requirements of Sec. 1.25-
3T(g), relating to new mortgage requirement,
    (12) Whether the certificate meets the requirements of Sec. 1.25-
3T(i), relating to prohibited mortgages,
    (13) Whether the certificate meets the requirements of Sec. 1.25-
3T(j), relating to particular lenders,
    (14) Whether the certificate meets the requirements of Sec. 1.25-
3T(k), relating to allocations to particular developments,
    (15) Whether the certificate meets the requirements of Sec. 1.25-
3T(n), relating to interest paid to related persons,
    (16) Whether the residence in connection with which the certificate 
is issued is a targeted area residence,
    (17) The date on which a closing agreement is signed with respect to 
the certified indebtness amount,
    (18) The expiration date of the certificate,
    (19) A statement that the certificate is not transferable or a 
statement that the certificate may be transferred only if the issuer 
issues a new certificate, and
    (20) A statement, signed under penalties of perjury by an authorized 
official of the issuer or its agent, that such person has made the 
determinations specified in paragraph (b) (9) through (16).

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec. 1.25-7T  Public notice (Temporary).

    (a) In general. At least 90 days prior to the issuance of any 
mortgage credit certificate under a qualified mortgage credit 
certificate program, the issuer shall provide reasonable public notice 
of--
    (1) The eligibility requirements for such certificate,
    (2) The methods by which such certificates are to be issued, and
    (3) The other information required by this section.
    (b) Reasonable public notice--(1) In general. Reasonable public 
notice means published notice which is reasonably designed to inform 
individuals who would be eligible to receive mortgage credit 
certificates of the proposed issuance. Reasonable public notice may be 
provided through newspapers of general circulation.

[[Page 84]]

    (2) Contents of notice. The public notice required by paragraph (a) 
must include a brief description of the principal residence requirement, 
3-year requirement, purchase price requirement, and new mortgage 
requirement. The notice must also provide a brief description of the 
methods by which the certificates are to be issued and the address and 
telephone number for obtaining further information.

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec. 1.25-8T  Reporting requirements (Temporary).

    (a) Lender--(1) In general. Each person who makes a loan that is a 
certified indebtedness amount with respect to any mortgage credit 
certificate must file the report described in paragraph (a)(2) and must 
retain on its books and records the information described in paragraph 
(a)(3). The report described in paragraph (a)(2) is an annual report and 
must be filed on or before January 31 of the year following the calendar 
year to which the report relates. See section 6709(c) and the 
regulations thereunder for the applicable penalties with respect to 
failure to file reports.
    (2) Information required. The report shall be submitted on Form 8329 
and shall contain the information required therein. A separate Form 8329 
shall be filed for each issue of mortgage credit certificates with 
respect to which the lender made mortgage loans during the preceding 
calendar year. Thus, for example, if during 1986 Bank M makes three 
mortgage loans which are certified indebtedness amounts with respect to 
State Z's January 15, 1986, issue of mortgage credit certificates, and 
two mortgage loans which are certified indebtedness amounts with respect 
to State Z's April 15, 1986, issue of mortgage credit certificates, and 
fifty mortgage loans which are certified indebtedness amounts with 
respect to County X's December 31, 1985, issue of mortgage credit 
certificates, Bank M must file three separate reports for calendar year 
1986. The lender must submit the Form 8329 with the information required 
therein, including--
    (i) The name, address, and TIN of the issuer of the mortgage credit 
certificates,
    (ii) The date on which the election not to issue qualified mortgage 
bonds with respect to that mortgage credit certificate was made,
    (iii) The name, address, and TIN of the lender, and
    (iv) The sum of the products determined by multiplying--
    (A) The certified indebtedness amount of each mortgage credit 
certificate issued under such program, by
    (B) The certificate credit rate with respect to such certificate.
    (3) Recordkeeping requirements. Each person who makes a loan that is 
a certified indebtedness amount with respect to any mortgage credit 
certificate must retain the information specified in this paragraph 
(a)(3) on its books and records for 6 years following the year in which 
the loan was made. With respect to each loan the lender must retain the 
following information:
    (i) The name, address, and TIN of each holder of a qualified 
mortgage credit certificate with respect to which a loan is made,
    (ii) The name, address, and TIN of the issuer of such certificate, 
and
    (iii) The date the loan for the certified indebtedness amount is 
closed, the certified indebtedness amount, and the certificate credit 
rate of such certificate.
    (b) Issuers--(1) In general. Each issuer of mortgage credit 
certificates shall file the report described in paragraph (b)(2) of this 
section.
    (2) Quarterly reports. (i) Each issuer which elects to issue 
mortgage credit certificates shall file reports on Form 8330. These 
reports shall be filed on a quarterly basis, beginning with the quarter 
in which the election is made, and are due on the following dates: April 
30 (for the quarter ending March 31), July 31 (for the quarter ending 
June 30), October 31 (for the quarter ending September 30), and January 
31 (for the quarter ending December 31). For elections made prior to May 
8, 1985, the first report need not be filed until July 31, 1985. An 
issuer shall file a separate report for each issue of mortgage credit 
certificates. In the quarter in which the last qualified mortgage credit 
certificate that may be issued under a program is issued, the issuer 
must state that fact on the report to be filed

[[Page 85]]

for that quarter; the issuer is not required to file any subsequent 
reports with respect to that program. See section 6709(c) for the 
penalties with respect to failure to file a report.
    (ii) The report shall be submitted on Form 8330 and shall contain 
the information required therein, including--
    (A) The name, address, and TIN of the issuer of the mortgage credit 
certificates,
    (B) The date of the issuer's election not to issue qualified 
mortgage bonds with respect to the mortgage credit certificate program 
and the nonissued bond amount of the program,
    (C) The sum of the products determined by multiplying--
    (1) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under that program during the calendar 
quarter, by
    (2) The certificate credit rate with respect to such certificate, 
and
    (D) A listing of the name, address, and TIN of each holder of a 
qualified mortgage credit certificate which has been revoked during the 
calendar quarter.
    (c) Extensions of time for filing reports. The Commissioner may 
grant an extension of time for the filing of a report required by this 
section if there is reasonable cause for the failure to file such report 
in a timely fashion.
    (d) Place for filing. The reports required by this section are to be 
filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 
19225.
    (e) Cross reference. See section 6709 and the regulations thereunder 
with respect to the penalty for failure to file a report required by 
this section.

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec. 1.25A-0  Table of contents.

    This section lists captions contained in Sec. Sec. 1.25A-1, 1.25A-
2, 1.25A-3, 1.25A-4, and 1.25A-5.
Sec. 1.25A-1 Calculation of Education Tax Credit and General 
          Eligibility Requirements
    (a) Amount of education tax credit.
    (b) Coordination of Hope Scholarship Credit and Lifetime Learning 
Credit.
    (1) In general.
    (2) Hope Scholarship Credit.
    (3) Lifetime Learning Credit.
    (4) Examples.
    (c) Limitation based on modified adjusted gross income.
    (1) In general.
    (2) Modified adjusted gross income defined.
    (3) Inflation adjustment.
    (d) Election.
    (e) Identification requirement.
    (f) Claiming the credit in the case of a dependent.
    (1) In general.
    (2) Examples.
    (g) Married taxpayers.
    (h) Nonresident alien taxpayers and dependents.
Sec. 1.25A-2 Definitions
    (a) Claimed dependent.
    (b) Eligible educational institution.
    (1) In general.
    (2) Rules on Federal financial aid programs.
    (c) Academic period.
    (d) Qualified tuition and related expenses.
    (1) In general.
    (2) Required fees.
    (i) In general.
    (ii) Books, supplies, and equipment.
    (iii) Nonacademic fees.
    (3) Personal expenses.
    (4) Treatment of a comprehensive or bundled fee.
    (5) Hobby courses.
    (6) Examples.
Sec. 1.25A-3 Hope Scholarship Credit
    (a) Amount of the credit.
    (1) In general.
    (2) Maximum credit.
    (b) Per student credit.
    (1) In general.
    (2) Example.
    (c) Credit allowed for only two taxable years.
    (d) Eligible student.
    (1) Eligible student defined.
    (i) Degree requirement.
    (ii) Work load requirement.
    (iii) Year of study requirement.
    (iv) No felony drug conviction.
    (2) Examples.
    (e) Academic period for prepayments.
    (1) In general.
    (2) Example.
    (f) Effective date.
Sec. 1.25A-4 Lifetime Learning Credit
    (a) Amount of the credit.
    (1) Taxable years beginning before January 1, 2003.
    (2) Taxable years beginning after December 31, 2002.
    (3) Coordination with the Hope Scholarship Credit.
    (4) Examples.
    (b) Credit allowed for unlimited number of taxable years.
    (c) Both degree and nondegree courses are eligible for the credit.
    (1) In general.
    (2) Examples.
    (d) Effective date.

[[Page 86]]

Sec. 1.25A-5 Special Rules Relating to Characterization and Timing of 
          Payments
    (a) Educational expenses paid by claimed dependent.
    (b) Educational expenses paid by a third party.
    (1) In general.
    (2) Special rule for tuition reduction included in gross income of 
employee.
    (3) Examples.
    (c) Adjustment to qualified tuition and related expenses for certain 
excludable educational assistance.
    (1) In general.
    (2) No adjustment for excludable educational assistance attributable 
to expenses paid in a prior year.
    (3) Scholarships and fellowship grants.
    (4) Examples.
    (d) No double benefit.
    (e) Timing rules.
    (1) In general.
    (2) Prepayment rule.
    (i) In general.
    (ii) Example.
    (3) Expenses paid with loan proceeds.
    (4) Expenses paid through third party installment payment plans.
    (i) In general.
    (ii) Example.
    (f) Refund of qualified tuition and related expenses.
    (1) Payment and refund of qualified tuition and related expenses in 
the same taxable year.
    (2) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year before return filed for prior 
taxable year.
    (3) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year.
    (i) In general.
    (ii) Recapture amount.
    (4) Refund of loan proceeds treated as refund of qualified tuition 
and related expenses.
    (5) Excludable educational assistance received in a subsequent 
taxable year treated as a refund.
    (6) Examples.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-1  Calculation of education tax credit and general eligibility 

requirements.

    (a) Amount of education tax credit. An individual taxpayer is 
allowed a nonrefundable education tax credit against income tax imposed 
by chapter 1 of the Internal Revenue Code for the taxable year. The 
amount of the education tax credit is the total of the Hope Scholarship 
Credit (as described in Sec. 1.25A-3) plus the Lifetime Learning Credit 
(as described in Sec. 1.25A-4). For limitations on the credits allowed 
by subpart A of part IV of subchapter A of chapter 1 of the Internal 
Revenue Code, see section 26.
    (b) Coordination of Hope Scholarship Credit and Lifetime Learning 
Credit--(1) In general. In the same taxable year, a taxpayer may claim a 
Hope Scholarship Credit for each eligible student's qualified tuition 
and related expenses (as defined in Sec. 1.25A-2(d)) and a Lifetime 
Learning Credit for one or more other students' qualified tuition and 
related expenses. However, a taxpayer may not claim both a Hope 
Scholarship Credit and a Lifetime Learning Credit with respect to the 
same student in the same taxable year.
    (2) Hope Scholarship Credit. Subject to certain limitations, a Hope 
Scholarship Credit may be claimed for the qualified tuition and related 
expenses paid during a taxable year with respect to each eligible 
student (as defined in Sec. 1.25A-3(d)). Qualified tuition and related 
expenses paid during a taxable year with respect to one student may not 
be taken into account in computing the amount of the Hope Scholarship 
Credit with respect to any other student. In addition, qualified tuition 
and related expenses paid during a taxable year with respect to any 
student for whom a Hope Scholarship Credit is claimed may not be taken 
into account in computing the amount of the Lifetime Learning Credit.
    (3) Lifetime Learning Credit. Subject to certain limitations, a 
Lifetime Learning Credit may be claimed for the aggregate amount of 
qualified tuition and related expenses paid during a taxable year with 
respect to students for whom no Hope Scholarship Credit is claimed.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses for his dependent, B, to attend College Y during 1999. Assuming 
all other relevant requirements are met, Taxpayer A may claim either a 
Hope Scholarship Credit or a Lifetime Learning Credit with respect to 
dependent B, but not both. See Sec. 1.25A-3(a) and Sec. 1.25A-4(a).
    Example 2. In 1999, Taxpayer C pays $2,000 in qualified tuition and 
related expenses for her dependent, D, to attend College Z during 1999. 
In 1999, Taxpayer C also pays $500 in

[[Page 87]]

qualified tuition and related expenses to attend a computer course 
during 1999 to improve Taxpayer C's job skills. Assuming all other 
relevant requirements are met, Taxpayer C may claim a Hope Scholarship 
Credit for the $2,000 of qualified tuition and related expenses 
attributable to dependent D (see Sec. 1.25A-3(a)) and a Lifetime 
Learning Credit (see Sec. 1.25A-4(a)) for the $500 of qualified tuition 
and related expenses incurred to improve her job skills.
    Example 3. The facts are the same as in Example 2, except that 
Taxpayer C pays $3,000 in qualified tuition and related expenses for her 
dependent, D, to attend College Z during 1999. Although a Hope 
Scholarship Credit is available only with respect to the first $2,000 of 
qualified tuition and related expenses paid with respect to D (see Sec. 
1.25A-3(a)), Taxpayer C may not add the $1,000 of excess expenses to her 
$500 of qualified tuition and related expenses in computing the amount 
of the Lifetime Learning Credit.

    (c) Limitation based on modified adjusted gross income--(1) In 
general. The education tax credit that a taxpayer may otherwise claim is 
phased out ratably for taxpayers with modified adjusted gross income 
between $40,000 and $50,000 ($80,000 and $100,000 for married 
individuals who file a joint return). Thus, taxpayers with modified 
adjusted gross income above $50,000 (or $100,000 for joint filers) may 
not claim an education tax credit.
    (2) Modified adjusted gross income defined. The term modified 
adjusted gross income means the adjusted gross income (as defined in 
section 62) of the taxpayer for the taxable year increased by any amount 
excluded from gross income under section 911, 931, or 933 (relating to 
income earned abroad or from certain U.S. possessions or Puerto Rico).
    (3) Inflation adjustment. For taxable years beginning after 2001, 
the amounts in paragraph (c)(1) of this section will be increased for 
inflation occurring after 2000 in accordance with section 1(f)(3). If 
any amount adjusted under this paragraph (c)(3) is not a multiple of 
$1,000, the amount will be rounded to the next lowest multiple of 
$1,000.
    (d) Election. No education tax credit is allowed unless a taxpayer 
elects to claim the credit on the taxpayer's federal income tax return 
for the taxable year in which the credit is claimed. The election is 
made by attaching Form 8863, ``Education Credits (Hope and Lifetime 
Learning Credits),'' to the federal income tax return.
    (e) Identification requirement. No education tax credit is allowed 
unless a taxpayer includes on the federal income tax return claiming the 
credit the name and the taxpayer identification number of the student 
for whom the credit is claimed. For rules relating to assessment for an 
omission of a correct taxpayer identification number, see section 
6213(b) and (g)(2)(J).
    (f) Claiming the credit in the case of a dependent--(1) In general. 
If a student is a claimed dependent of another taxpayer, only that 
taxpayer may claim the education tax credit for the student's qualified 
tuition and related expenses. However, if another taxpayer is eligible 
to, but does not, claim the student as a dependent, only the student may 
claim the education tax credit for the student's qualified tuition and 
related expenses.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (f):

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses for his dependent, B, to attend University Y during 1999. 
Taxpayer A claims B as a dependent on his federal income tax return. 
Therefore, assuming all other relevant requirements are met, Taxpayer A 
is allowed an education tax credit on his federal income tax return, and 
B is not allowed an education tax credit on B's federal income tax 
return. The result would be the same if B paid the qualified tuition and 
related expenses. See Sec. 1.25A-5(a).
    Example 2. In 1999, Taxpayer C has one dependent, D. In 1999, D pays 
qualified tuition and related expenses to attend University Z during 
1999. Although Taxpayer C is eligible to claim D as a dependent on her 
federal income tax return, she does not do so. Therefore, assuming all 
other relevant requirements are met, D is allowed an education tax 
credit on D's federal income tax return, and Taxpayer C is not allowed 
an education tax credit on her federal income tax return, with respect 
to D's education expenses. The result would be the same if C paid the 
qualified tuition and related expenses on behalf of D. See Sec. 1.25A-
5(b).

    (g) Married taxpayers. If a taxpayer is married (within the meaning 
of section 7703), no education tax credit is allowed to the taxpayer 
unless the taxpayer and the taxpayer's spouse file a joint Federal 
income tax return for the taxable year.

[[Page 88]]

    (h) Nonresident alien taxpayers and dependents. If a taxpayer or the 
taxpayer's spouse is a nonresident alien for any portion of the taxable 
year, no education tax credit is allowed unless the nonresident alien is 
treated as a resident alien by reason of an election under section 
6013(g) or (h). In addition, if a student is a nonresident alien, a 
taxpayer may not claim an education tax credit with respect to the 
qualified tuition and related expenses of the student unless the student 
is a claimed dependent (as defined in Sec. 1.25A-2(a)).

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-2  Definitions.

    (a) Claimed dependent. A claimed dependent means a dependent (as 
defined in section 152) for whom a deduction under section 151 is 
allowed on a taxpayer's federal income tax return for the taxable year. 
Among other requirements under section 152, a nonresident alien student 
must be a resident of a country contiguous to the United States in order 
to be treated as a dependent.
    (b) Eligible educational institution--(1) In general. In general, an 
eligible educational institution means a college, university, vocational 
school, or other postsecondary educational institution that is--
    (i) Described in section 481 of the Higher Education Act of 1965 (20 
U.S.C. 1088) as in effect on August 5, 1997, (generally all accredited 
public, nonprofit, and proprietary postsecondary institutions); and
    (ii) Participating in a Federal financial aid program under title IV 
of the Higher Education Act of 1965 or is certified by the Department of 
Education as eligible to participate in such a program but chooses not 
to participate.
    (2) Rules on Federal financial aid programs. For rules governing an 
educational institution's eligibility to participate in Federal 
financial aid programs, see 20 U.S.C. 1070; 20 U.S.C. 1094; and 34 CFR 
600 and 668.
    (c) Academic period. Academic period means a quarter, semester, 
trimester, or other period of study as reasonably determined by an 
eligible educational institution. In the case of an eligible educational 
institution that uses credit hours or clock hours, and does not have 
academic terms, each payment period (as defined in 34 CFR 668.4, revised 
as of July 1, 2002) may be treated as an academic period.
    (d) Qualified tuition and related expenses--(1) In general. 
Qualified tuition and related expenses means tuition and fees required 
for the enrollment or attendance of a student for courses of instruction 
at an eligible educational institution.
    (2) Required fees--(i) In general. Except as provided in paragraph 
(d)(3) of this section, the test for determining whether any fee is a 
qualified tuition and related expense is whether the fee is required to 
be paid to the eligible educational institution as a condition of the 
student's enrollment or attendance at the institution.
    (ii) Books, supplies, and equipment. Qualified tuition and related 
expenses include fees for books, supplies, and equipment used in a 
course of study only if the fees must be paid to the eligible 
educational institution for the enrollment or attendance of the student 
at the institution.
    (iii) Nonacademic fees. Except as provided in paragraph (d)(3) of 
this section, qualified tuition and related expenses include fees 
charged by an eligible educational institution that are not used 
directly for, or allocated to, an academic course of instruction only if 
the fee must be paid to the eligible educational institution for the 
enrollment or attendance of the student at the institution.
    (3) Personal expenses. Qualified tuition and related expenses do not 
include the costs of room and board, insurance, medical expenses 
(including student health fees), transportation, and similar personal, 
living, or family expenses, regardless of whether the fee must be paid 
to the eligible educational institution for the enrollment or attendance 
of the student at the institution.
    (4) Treatment of a comprehensive or bundled fee. If a student is 
required to pay a fee (such as a comprehensive fee or a bundled fee) to 
an eligible educational institution that combines charges for qualified 
tuition and related expenses with charges for personal expenses 
described in paragraph (d)(3) of this section, the portion of the

[[Page 89]]

fee that is allocable to personal expenses is not included in qualified 
tuition and related expenses. The determination of what portion of the 
fee relates to qualified tuition and related expenses and what portion 
relates to personal expenses must be made by the institution using a 
reasonable method of allocation.
    (5) Hobby courses. Qualified tuition and related expenses do not 
include expenses that relate to any course of instruction or other 
education that involves sports, games, or hobbies, or any noncredit 
course, unless the course or other education is part of the student's 
degree program, or in the case of the Lifetime Learning Credit, the 
student takes the course to acquire or improve job skills.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (d). In each example, assume that the institution is an 
eligible educational institution and that all other relevant 
requirements to claim an education tax credit are met. The examples are 
as follows:

    Example 1. University V offers a degree program in dentistry. In 
addition to tuition, all students enrolled in the program are required 
to pay a fee to University V for the rental of dental equipment. Because 
the equipment rental fee must be paid to University V for enrollment and 
attendance, the tuition and the equipment rental fee are qualified 
tuition and related expenses.
    Example 2. First-year students at College W are required to obtain 
books and other reading materials used in its mandatory first-year 
curriculum. The books and other reading materials are not required to be 
purchased from College W and may be borrowed from other students or 
purchased from off-campus bookstores, as well as from College W's 
bookstore. College W bills students for any books and materials 
purchased from College W's bookstore. The fee that College W charges for 
the first-year books and materials purchased at its bookstore is not a 
qualified tuition and related expense because the books and materials 
are not required to be purchased from College W for enrollment or 
attendance at the institution.
    Example 3. All students who attend College X are required to pay a 
separate student activity fee in addition to their tuition. The student 
activity fee is used solely to fund on-campus organizations and 
activities run by students, such as the student newspaper and the 
student government (no portion of the fee covers personal expenses). 
Although labeled as a student activity fee, the fee is required for 
enrollment or attendance at College X. Therefore, the fee is a qualified 
tuition and related expense.
    Example 4. The facts are the same as in Example 3, except that 
College X offers an optional athletic fee that students may pay to 
receive discounted tickets to sports events. The athletic fee is not 
required for enrollment or attendance at College X. Therefore, the fee 
is not a qualified tuition and related expense.
    Example 5. College Y requires all students to live on campus. It 
charges a single comprehensive fee to cover tuition, required fees, and 
room and board. Based on College Y's reasonable allocation, sixty 
percent of the comprehensive fee is allocable to tuition and other 
required fees not allocable to personal expenses, and the remaining 
forty percent of the comprehensive fee is allocable to charges for room 
and board and other personal expenses. Therefore, only sixty percent of 
College Y's comprehensive fee is a qualified tuition and related 
expense.
    Example 6. As a degree student at College Z, Student A is required 
to take a certain number of courses outside of her chosen major in 
Economics. To fulfill this requirement, Student A enrolls in a square 
dancing class offered by the Physical Education Department. Because 
Student A receives credit toward her degree program for the square 
dancing class, the tuition for the square dancing class is included in 
qualified tuition and related expenses.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-3  Hope Scholarship Credit.

    (a) Amount of the credit--(1) In general. Subject to the phaseout of 
the education tax credit described in Sec. 1.25A-1(c), the Hope 
Scholarship Credit amount is the total of--
    (i) 100 percent of the first $1,000 of qualified tuition and related 
expenses paid during the taxable year for education furnished to an 
eligible student (as defined in paragraph (d) of this section) who is 
the taxpayer, the taxpayer's spouse, or any claimed dependent during any 
academic period beginning in the taxable year (or treated as beginning 
in the taxable year, see Sec. 1.25A-5(e)(2)); plus
    (ii) 50 percent of the next $1,000 of such expenses paid with 
respect to that student.
    (2) Maximum credit. For taxable years beginning before 2002, the 
maximum Hope Scholarship Credit allowed for each eligible student is 
$1,500. For taxable years beginning after 2001, the amounts used in 
paragraph (a)(1) of

[[Page 90]]

this section to determine the maximum credit will be increased for 
inflation occurring after 2000 in accordance with section 1(f)(3). If 
any amount adjusted under this paragraph (a)(2) is not a multiple of 
$100, the amount will be rounded to the next lowest multiple of $100.
    (b) Per student credit--(1) In general. A Hope Scholarship Credit 
may be claimed for the qualified tuition and related expenses of each 
eligible student (as defined in paragraph (d) of this section).
    (2) Example. The following example illustrates the rule of this 
paragraph (b). In the example, assume that all the requirements to claim 
an education tax credit are met. The example is as follows:

    Example. In 1999, Taxpayer A has two dependents, B and C, both of 
whom are eligible students. Taxpayer A pays $1,600 in qualified tuition 
and related expenses for dependent B to attend a community college. 
Taxpayer A pays $5,000 in qualified tuition and related expenses for 
dependent C to attend University X. Taxpayer A may claim a Hope 
Scholarship Credit of $1,300 ($1,000 + (.50 x $600)) for dependent B, 
and the maximum $1,500 Hope Scholarship Credit for dependent C, for a 
total Hope Scholarship Credit of $2,800.

    (c) Credit allowed for only two taxable years. For each eligible 
student, the Hope Scholarship Credit may be claimed for no more than two 
taxable years.
    (d) Eligible student--(1) Eligible student defined. For purposes of 
the Hope Scholarship Credit, the term eligible student means a student 
who satisfies all of the following requirements--
    (i) Degree requirement. For at least one academic period that begins 
during the taxable year, the student enrolls at an eligible educational 
institution in a program leading toward a postsecondary degree, 
certificate, or other recognized postsecondary educational credential;
    (ii) Work load requirement. For at least one academic period that 
begins during the taxable year, the student enrolls for at least one-
half of the normal full-time work load for the course of study the 
student is pursuing. The standard for what is half of the normal full-
time work load is determined by each eligible educational institution. 
However, the standard for half-time may not be lower than the applicable 
standard for half-time established by the Department of Education under 
the Higher Education Act of 1965 and set forth in 34 CFR 674.2(b) 
(revised as of July 1, 2002) for a half-time undergraduate student;
    (iii) Year of study requirement. As of the beginning of the taxable 
year, the student has not completed the first two years of postsecondary 
education at an eligible educational institution. Whether a student has 
completed the first two years of postsecondary education at an eligible 
educational institution as of the beginning of a taxable year is 
determined based on whether the institution in which the student is 
enrolled in a degree program (as described in paragraph (d)(1)(i) of 
this section) awards the student two years of academic credit at that 
institution for postsecondary course work completed by the student prior 
to the beginning of the taxable year. Any academic credit awarded by the 
eligible educational institution solely on the basis of the student's 
performance on proficiency examinations is disregarded in determining 
whether the student has completed two years of postsecondary education; 
and
    (iv) No felony drug conviction. The student has not been convicted 
of a Federal or State felony offense for possession or distribution of a 
controlled substance as of the end of the taxable year for which the 
credit is claimed.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (d). In each example, assume that the student has not been 
convicted of a felony drug offense, that the institution is an eligible 
educational institution unless otherwise stated, that the qualified 
tuition and related expenses are paid during the same taxable year that 
the academic period begins, and that a Hope Scholarship Credit has not 
previously been claimed for the student (see paragraph (c) of this 
section). The examples are as follows:

    Example 1. Student A graduates from high school in June 1998 and is 
enrolled in an undergraduate degree program at College U for the 1998 
Fall semester on a full-time basis. For the 1999 Spring semester, 
Student A again is enrolled at College U on a full-time basis. For the 
1999 Fall semester, Student A is enrolled in less than half the normal 
full-

[[Page 91]]

time course work for her degree program. Because Student A is enrolled 
in an undergraduate degree program on at least a half-time basis for at 
least one academic period that begins during 1998 and at least one 
academic period that begins during 1999, Student A is an eligible 
student for taxable years 1998 and 1999 (including the 1999 Fall 
semester when Student A enrolls at College U on less than a half-time 
basis).
    Example 2. Prior to 1998, Student B attended college for several 
years on a full-time basis. Student B transfers to College V for the 
1998 Spring semester. College V awards Student B credit for some (but 
not all) of the courses he previously completed, and College V 
classifies Student B as a first-semester sophomore. During both the 
Spring and Fall semesters of 1998, Student B is enrolled in at least 
one-half the normal full-time work load for his degree program at 
College V. Because College V does not classify Student B as having 
completed the first two years of postsecondary education as of the 
beginning of 1998, Student B is an eligible student for taxable year 
1998.
    Example 3. The facts are the same as in Example 2. After taking 
classes on a half-time basis for the 1998 Spring and Fall semesters, 
Student B is enrolled at College V for the 1999 Spring semester on a 
full-time basis. College V classifies Student B as a second-semester 
sophomore for the 1999 Spring semester and as a first-semester junior 
for the 1999 Fall semester. Because College V does not classify Student 
B as having completed the first two years of postsecondary education as 
of the beginning of 1999, Student B is an eligible student for taxable 
year 1999. Therefore, the qualified expenses and required fees paid for 
the 1999 Spring semester and the 1999 Fall semester are taken into 
account in calculating any Hope Scholarship Credit.
    Example 4. Prior to 1998, Student C was not enrolled at another 
eligible educational institution. At the time that Student C enrolls in 
a degree program at College W for the 1998 Fall semester, Student C 
takes examinations to demonstrate her proficiency in several subjects. 
On the basis of Student C's performance on these examinations, College W 
classifies Student C as a second-semester sophomore as of the beginning 
of the 1998 Fall semester. Student C is enrolled at College W during the 
1998 Fall semester and during the 1999 Spring and Fall semesters on a 
full-time basis and is classified as a first-semester junior as of the 
beginning of the 1999 Spring semester. Because Student C was not 
enrolled in a college or other eligible educational institution prior to 
1998 (but rather was awarded three semesters of academic credit solely 
because of proficiency examinations), Student C is not treated as having 
completed the first two years of postsecondary education at an eligible 
educational institution as of the beginning of 1998 or as of the 
beginning of 1999. Therefore, Student C is an eligible student for both 
taxable years 1998 and 1999.
    Example 5. During the 1998 Fall semester, Student D is a high school 
student who takes classes on a half-time basis at College X. Student D 
is not enrolled as part of a degree program at College X because College 
X does not admit students to a degree program unless the student has a 
high school diploma or equivalent. Because Student D is not enrolled in 
a degree program at College X during 1998, Student D is not an eligible 
student for taxable year 1998.
    Example 6. The facts are the same as in Example 5. In addition, 
during the 1999 Spring semester, Student D again attends College X but 
not as part of a degree program. Student D graduates from high school in 
June 1999. For the 1999 Fall semester, Student D enrolls in College X as 
part of a degree program, and College X awards Student D credit for her 
prior course work at College X. During the 1999 Fall semester, Student D 
is enrolled in more than one-half the normal full-time work load of 
courses for her degree program at College X. Because Student D is 
enrolled in a degree program at College X for the 1999 Fall term on at 
least a half-time basis, Student D is an eligible student for all of 
taxable year 1999. Therefore, the qualified tuition and required fees 
paid for classes taken at College X during both the 1999 Spring semester 
(during which Student D was not enrolled in a degree program) and the 
1999 Fall semester are taken into account in computing any Hope 
Scholarship Credit.
    Example 7. Student E completed two years of undergraduate study at 
College S. College S is not an eligible educational institution for 
purposes of the education tax credit. At the end of 1998, Student E 
enrolls in an undergraduate degree program at College Z, an eligible 
educational institution, for the 1999 Spring semester on a full-time 
basis. College Z awards Student E two years of academic credit for his 
previous course work at College S and classifies Student E as a first-
semester junior for the 1999 Spring semester. Student E is treated as 
having completed the first two years of postsecondary education at an 
eligible educational institution as of the beginning of 1999. Therefore, 
Student E is not an eligible student for taxable year 1999.
    Example 8. Student F received a degree in 1998 from College R. 
College R is not an eligible educational institution for purposes of the 
education tax credit. During 1999, Student F is enrolled in a graduate-
degree program at College Y, an eligible educational institution, for 
the 1999 Fall semester on a full-time basis. By admitting Student F to 
its graduate degree program, College Y treats Student F as having 
completed the first two years of postsecondary education as of the 
beginning of 1999. Therefore, Student

[[Page 92]]

F is not an eligible student for taxable year 1999.
    Example 9. Student G graduates from high school in June 2001. In 
January 2002, Student G is enrolled in a one-year postsecondary 
certificate program on a full-time basis to obtain a certificate as a 
travel agent. Student G completes the program in December 2002 and is 
awarded a certificate. In January 2003, Student G enrolls in a one-year 
postsecondary certificate program on a full-time basis to obtain a 
certificate as a computer programer. Student G meets the degree 
requirement, the work load requirement, and the year of study 
requirement for the taxable years 2002 and 2003. Therefore, Student G is 
an eligible student for both taxable years 2002 and 2003.

    (e) Academic period for prepayments--(1) In general. For purposes of 
determining whether a student meets the requirements in paragraph (d) of 
this section for a taxable year, if qualified tuition and related 
expenses are paid during one taxable year for an academic period that 
begins during January, February or March of the next taxable year (for 
taxpayers on a fiscal taxable year, use the first three months of the 
next taxable year), the academic period is treated as beginning during 
the taxable year in which the payment is made.
    (2) Example. The following example illustrates the rule of this 
paragraph (e). In the example, assume that all the requirements to claim 
a Hope Scholarship Credit are met. The example is as follows:

    Example. Student G graduates from high school in June 1998. After 
graduation, Student G works full-time for several months to earn money 
for college. Student G is enrolled on a full-time basis in an 
undergraduate degree program at University W, an eligible educational 
institution, for the 1999 Spring semester, which begins in January 1999. 
Student G pays tuition to University W for the 1999 Spring semester in 
December 1998. Because the tuition paid by Student G in 1998 relates to 
an academic period that begins during the first three months of 1999, 
Student G's eligibility to claim a Hope Scholarship Credit in 1998 is 
determined as if the 1999 Spring semester began in 1998. Thus, assuming 
Student G has not been convicted of a felony drug offense as of December 
31, 1998, Student G is an eligible student for 1998.

    (f) Effective date. The Hope Scholarship Credit is applicable for 
qualified tuition and related expenses paid after December 31, 1997, for 
education furnished in academic periods beginning after December 31, 
1997.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]



Sec. 1.25A-4  Lifetime Learning Credit.

    (a) Amount of the credit--(1) Taxable years beginning before January 
1, 2003. Subject to the phaseout of the education tax credit described 
in Sec. 1.25A-1(c), for taxable years beginning before 2003, the 
Lifetime Learning Credit amount is 20 percent of up to $5,000 of 
qualified tuition and related expenses paid during the taxable year for 
education furnished to the taxpayer, the taxpayer's spouse, and any 
claimed dependent during any academic period beginning in the taxable 
year (or treated as beginning in the taxable year, see Sec. 1.25A-
5(e)(2)).
    (2) Taxable years beginning after December 31, 2002. Subject to the 
phaseout of the education tax credit described in Sec. 1.25A-1(c), for 
taxable years beginning after 2002, the Lifetime Learning Credit amount 
is 20 percent of up to $10,000 of qualified tuition and related expenses 
paid during the taxable year for education furnished to the taxpayer, 
the taxpayer's spouse, and any claimed dependent during any academic 
period beginning in the taxable year (or treated as beginning in the 
taxable year, see Sec. 1.25A-5(e)(2)).
    (3) Coordination with the Hope Scholarship Credit. Expenses paid 
with respect to a student for whom the Hope Scholarship Credit is 
claimed are not eligible for the Lifetime Learning Credit.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (a). In each example, assume that all the requirements to 
claim a Lifetime Learning Credit or a Hope Scholarship Credit, as 
applicable, are met. The examples are as follows:

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses of $3,000 for dependent B to attend an eligible educational 
institution, and Taxpayer A pays qualified tuition and related expenses 
of $4,000 for dependent C to attend an eligible educational institution. 
Taxpayer A does not claim a Hope Scholarship Credit with respect to 
either B or C. Although Taxpayer A paid $7,000 of qualified tuition and 
related expenses during the taxable year, Taxpayer A may claim the 
Lifetime Learning Credit with respect to only $5,000 of such expenses.

[[Page 93]]

Therefore, the maximum Lifetime Learning Credit Taxpayer A may claim for 
1999 is $1,000 (.20 x $5,000).
    Example 2. In 1999, Taxpayer D pays $6,000 of qualified tuition and 
related expenses for dependent E, and $2,000 of qualified tuition and 
related expenses for dependent F, to attend eligible educational 
institutions. Dependent F has already completed the first two years of 
postsecondary education. For 1999, Taxpayer D claims the maximum $1,500 
Hope Scholarship Credit with respect to dependent E. In computing the 
amount of the Lifetime Learning Credit, Taxpayer D may not include any 
of the $6,000 of qualified tuition and related expenses paid on behalf 
of dependent E but may include the $2,000 of qualified tuition and 
related expenses of dependent F.

    (b) Credit allowed for unlimited number of taxable years. There is 
no limit to the number of taxable years that a taxpayer may claim a 
Lifetime Learning Credit with respect to any student.
    (c) Both degree and nondegree courses are eligible for the credit--
(1) In general. For purposes of the Lifetime Learning Credit, amounts 
paid for a course at an eligible educational institution are qualified 
tuition and related expenses if the course is either part of a 
postsecondary degree program or is not part of a postsecondary degree 
program but is taken by the student to acquire or improve job skills.
    (2) Examples. The following examples illustrate the rule of this 
paragraph (c). In each example, assume that all the requirements to 
claim a Lifetime Learning Credit are met. The examples are as follows:

    Example 1. Taxpayer A, a professional photographer, enrolls in an 
advanced photography course at a local community college. Although the 
course is not part of a degree program, Taxpayer A enrolls in the course 
to improve her job skills. The course fee paid by Taxpayer A is a 
qualified tuition and related expense for purposes of the Lifetime 
Learning Credit.
    Example 2. Taxpayer B, a stockbroker, plans to travel abroad on a 
``photo-safari'' for his next vacation. In preparation for the trip, 
Taxpayer B enrolls in a noncredit photography class at a local community 
college. Because Taxpayer B is not taking the photography course as part 
of a degree program or to acquire or improve his job skills, amounts 
paid by Taxpayer B for the course are not qualified tuition and related 
expenses for purposes of the Lifetime Learning Credit.

    (d) Effective date. The Lifetime Learning Credit is applicable for 
qualified tuition and related expenses paid after June 30, 1998, for 
education furnished in academic periods beginning after June 30, 1998.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-5  Special rules relating to characterization and timing of 

payments.

    (a) Educational expenses paid by claimed dependent. For any taxable 
year for which the student is a claimed dependent of another taxpayer, 
qualified tuition and related expenses paid by the student are treated 
as paid by the taxpayer to whom the deduction under section 151 is 
allowed.
    (b) Educational expenses paid by a third party--(1) In general. 
Solely for purposes of section 25A, if a third party (someone other than 
the taxpayer, the taxpayer's spouse if the taxpayer is treated as 
married within the meaning of section 7703, or a claimed dependent) 
makes a payment directly to an eligible educational institution to pay 
for a student's qualified tuition and related expenses, the student is 
treated as receiving the payment from the third party and, in turn, 
paying the qualified tuition and related expenses to the institution.
    (2) Special rule for tuition reduction included in gross income of 
employee. Solely for purposes of section 25A, if an eligible educational 
institution provides a reduction in tuition to an employee of the 
institution (or to the spouse or dependent child of an employee, as 
described in section 132(h)(2)) and the amount of the tuition reduction 
is included in the employee's gross income, the employee is treated as 
receiving payment of an amount equal to the tuition reduction and, in 
turn, paying such amount to the institution.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. Grandparent D makes a direct payment to an eligible 
educational institution for Student E's qualified tuition and related 
expenses. Student E is not a claimed dependent in 1999. For purposes of 
claiming

[[Page 94]]

an education tax credit, Student E is treated as receiving the money 
from her grandparent and, in turn, paying her qualified tuition and 
related expenses.
    Example 2. Under a court-approved divorce decree, Parent A is 
required to pay Student C's college tuition. Parent A makes a direct 
payment to an eligible educational institution for Student C's 1999 
tuition. Under paragraph (b)(1) of this section, Student C is treated as 
receiving the money from Parent A and, in turn, paying the qualified 
tuition and related expenses. Under the divorce decree, Parent B has 
custody of Student C for 1999. Parent B properly claims Student C as a 
dependent on Parent B's 1999 federal income tax return. Under paragraph 
(a) of this section, expenses paid by Student C are treated as paid by 
Parent B. Thus, Parent B may claim an education tax credit for the 
qualified tuition and related expenses paid directly to the institution 
by Parent A.
    Example 3. University A, an eligible educational institution, offers 
reduced tuition charges to its employees and their dependent children. F 
is an employee of University A. F's dependent child, G, enrolls in a 
graduate-level course at University A. Section 117(d) does not apply, 
because it is limited to tuition reductions provided for education below 
the graduate level. Therefore, the amount of the tuition reduction 
received by G is treated as additional compensation from University A to 
F and is included in F's gross income. For purposes of claiming a 
Lifetime Learning Credit, F is treated as receiving payment of an amount 
equal to the tuition reduction from University A and, in turn, paying 
such amount to University A on behalf of F's child, G.

    (c) Adjustment to qualified tuition and related expenses for certain 
excludable educational assistance--(1) In general. In determining the 
amount of an education tax credit, qualified tuition and related 
expenses for any academic period must be reduced by the amount of any 
tax-free educational assistance allocable to such period. For this 
purpose, tax-free educational assistance means--
    (i) A qualified scholarship that is excludable from income under 
section 117;
    (ii) A veterans' or member of the armed forces' educational 
assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38, 
United States Code, or under chapter 1606 of title 10, United States 
Code;
    (iii) Employer-provided educational assistance that is excludable 
from income under section 127; or
    (iv) Any other educational assistance that is excludable from gross 
income (other than as a gift, bequest, devise, or inheritance within the 
meaning of section 102(a)).
    (2) No adjustment for excludable educational assistance attributable 
to expenses paid in a prior year. A reduction is not required under 
paragraph (c)(1) of this section if the amount of excludable educational 
assistance received during the taxable year is treated as a refund of 
qualified tuition and related expenses paid in a prior taxable year. See 
paragraph (f)(5) of this section.
    (3) Scholarships and fellowship grants. For purposes of paragraph 
(c)(1)(i) of this section, a scholarship or fellowship grant is treated 
as a qualified scholarship excludable under section 117 except to the 
extent--
    (i) The scholarship or fellowship grant (or any portion thereof) may 
be applied, by its terms, to expenses other than qualified tuition and 
related expenses within the meaning of section 117(b)(2) (such as room 
and board) and the student reports the grant (or the appropriate portion 
thereof) as income on the student's federal income tax return if the 
student is required to file a return; or
    (ii) The scholarship or fellowship grant (or any portion thereof) 
must be applied, by its terms, to expenses other than qualified tuition 
and related expenses within the meaning of section 117(b)(2) (such as 
room and board) and the student reports the grant (or the appropriate 
portion thereof) as income on the student's federal income tax return if 
the student is required to file a return.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. University X charges Student A, who lives on University 
X's campus, $3,000 for tuition and $5,000 for room and board. University 
X awards Student A a $2,000 scholarship. The terms of the scholarship 
permit it to be used to pay any of a student's costs of attendance at 
University X, including tuition, room and board, and other incidental 
expenses. University X applies the $2,000 scholarship against Student 
A's $8,000

[[Page 95]]

total bill, and Student A pays the $6,000 balance of her bill from 
University X with a combination of savings and amounts she earns from a 
summer job. University X does not require A to pay any additional fees 
beyond the $3,000 in tuition in order to enroll in or attend classes. 
Student A does not report any portion of the scholarship as income on 
her federal income tax return. Since Student A does not report the 
scholarship as income, the scholarship is treated under paragraph (c)(3) 
of this section as a qualified scholarship that is excludable under 
section 117. Therefore, for purposes of calculating an education tax 
credit, Student A is treated as having paid only $1,000 ($3,000 tuition-
$2,000 scholarship) in qualified tuition and related expenses to 
University X.
    Example 2. The facts are the same as in Example 1, except that 
Student A reports the entire scholarship as income on the student's 
federal income tax return. Since the full amount of the scholarship may 
be applied to expenses other than qualified expenses (room and board) 
and Student A reports the scholarship as income, the exception in 
paragraph (c)(3) of this section applies and the scholarship is not 
treated as a qualified scholarship excludable under section 117. 
Therefore, for purposes of calculating an education tax credit, Student 
A is treated as having paid $3,000 of qualified tuition and related 
expenses to University X.
    Example 3. The facts are the same as in Example 1, except that the 
terms of the scholarship require it to be used to pay tuition. Under 
paragraph (c)(3) of this section, the scholarship is treated as a 
qualified scholarship excludable under section 117. Therefore, for 
purposes of calculating an education tax credit, Student A is treated as 
having paid only $1,000 ($3,000 tuition-$2,000 scholarship) in qualified 
tuition and related expenses to University X.
    Example 4. The facts are the same as in Example 1, except that the 
terms of the scholarship require it to be used to pay tuition or room 
and board charged by University X, and the scholarship amount is $6,000. 
Under the terms of the scholarship, Student A may allocate the 
scholarship between tuition and room and board in any manner. However, 
because room and board totals $5,000, that is the maximum amount that 
can be applied under the terms of the scholarship to expenses other than 
qualified expenses and at least $1,000 of the scholarship must be 
applied to tuition. Therefore, the maximum amount of the exception under 
paragraph (c)(3) of this section is $5,000 and at least $1,000 is 
treated as a qualified scholarship excludable under section 117 ($6,000 
scholarship-$5,000 room and board). If Student A reports $5,000 of the 
scholarship as income on the student's federal income tax return, then 
Student A will be treated as having paid $2,000 ($3,000 tuition-$1,000 
qualified scholarship excludable under section 117) in qualified tuition 
and related expenses to University X.
    Example 5. The facts are the same as in Example 1, except that in 
addition to the scholarship that University X awards to Student A, 
University X also provides Student A with an education loan and pays 
Student A for working in a work/study job in the campus dining hall. The 
loan is not excludable educational assistance within the meaning of 
paragraph (c) of this section. In addition, wages paid to a student who 
is performing services for the payor are neither a qualified scholarship 
nor otherwise excludable from gross income. Therefore, Student A is not 
required to reduce her qualified tuition and related expenses by the 
amounts she receives from the student loan or as wages from her work/
study job.
    Example 6. In 1999, Student B pays University Y $1,000 in tuition 
for the 1999 Spring semester. University Y does not require Student B to 
pay any additional fees beyond the $1,000 in tuition in order to enroll 
in classes. Student B is an employee of Company Z. At the end of the 
academic period and during the same taxable year that Student B paid 
tuition to University Y, Student B provides Company Z with proof that he 
has satisfactorily completed his courses at University Y. Pursuant to an 
educational assistance program described in section 127(b), Company Z 
reimburses Student B for all of the tuition paid to University Y. 
Because the reimbursement from Company Z is employer-provided 
educational assistance that is excludable from Student B's gross income 
under section 127, the reimbursement reduces Student B's qualified 
tuition and related expenses. Therefore, for purposes of calculating an 
education tax credit, Student B is treated as having paid no qualified 
tuition and related expenses to University Y during 1999.

    Example 7. The facts are the same as in Example 6 except that the 
reimbursement from Company Z is not pursuant to an educational 
assistance program described in section 127(b), is not otherwise 
excludable from Student B's gross income, and is taxed as additional 
compensation to Student B. Because the reimbursement is not excludable 
educational assistance within the meaning of paragraph (c)(1) of this 
section, Student B is not required to reduce his qualified tuition and 
related expenses by the $1,000 reimbursement he received from his 
employer. Therefore, for purposes of calculating an education tax 
credit, Student B is treated as paying $1,000 in qualified tuition and 
related expenses to University Y during 1999.

    (d) No double benefit. Qualified tuition and related expenses do not 
include any expense for which a deduction is allowed under section 162, 
section 222,

[[Page 96]]

or any other provision of chapter 1 of the Internal Revenue Code.
    (e) Timing rules--(1) In general. Except as provided in paragraph 
(e)(2) of this section, an education tax credit is allowed only for 
payments of qualified tuition and related expenses for an academic 
period beginning in the same taxable year as the year the payment is 
made. Except for certain individuals who do not use the cash receipts 
and disbursements method of accounting, qualified tuition and related 
expenses are treated as paid in the year in which the expenses are 
actually paid. See Sec. 1.461-1(a)(1).
    (2) Prepayment rule--(i) In general. If qualified tuition and 
related expenses are paid during one taxable year for an academic period 
that begins during the first three months of the taxpayer's next taxable 
year (i.e., in January, February, or March of the next taxable year for 
calendar year taxpayers), an education tax credit is allowed with 
respect to the qualified tuition and related expenses only in the 
taxable year in which the expenses are paid.
    (ii) Example. The following example illustrates the rule of this 
paragraph (e)(2). In the example, assume that all the requirements to 
claim an education tax credit are met. The example is as follows:

    Example. In December 1998, Taxpayer A, a calendar year taxpayer, 
pays College Z $1,000 in qualified tuition and related expenses to 
attend classes during the 1999 Spring semester, which begins in January 
1999. Taxpayer A may claim an education tax credit only in 1998 for 
payments made in 1998 for the 1999 Spring semester.

    (3) Expenses paid with loan proceeds. An education tax credit may be 
claimed for qualified tuition and related expenses paid with the 
proceeds of a loan only in the taxable year in which the expenses are 
paid, and may not be claimed in the taxable year in which the loan is 
repaid. Loan proceeds disbursed directly to an eligible educational 
institution will be treated as paid on the date the institution credits 
the proceeds to the student's account. For example, in the case of any 
loan issued or guaranteed as part of a Federal student loan program 
under title IV of the Higher Education Act of 1965, loan proceeds will 
be treated as paid on the date of disbursement (as defined in 34 CFR 
668.164(a), revised as of July 1, 2002) by the eligible educational 
institution. If a taxpayer does not know the date the institution 
credits the student's account, the taxpayer must treat the qualified 
tuition and related expenses as paid on the last date for payment 
prescribed by the institution.
    (4) Expenses paid through third party installment payment plans--(i) 
In general. A taxpayer, an eligible educational institution, and a third 
party installment payment company may enter into an agreement in which 
the company agrees to collect installment payments of qualified tuition 
and related expenses from the taxpayer and to remit the installment 
payments to the institution. If the third party installment payment 
company is the taxpayer's agent for purposes of paying qualified tuition 
and related expenses to the eligible educational institution, the 
taxpayer is treated as paying the qualified expenses on the date the 
company pays the institution. However, if the third party installment 
payment company is the eligible educational institution's agent for 
purposes of collecting payments of qualified tuition and related 
expenses from the taxpayer, the taxpayer is treated as paying the 
qualified expenses on the date the taxpayer pays the company.
    (ii) Example. The following example illustrates the rule of this 
paragraph (e)(4). The example is as follows:

    Example. Student A, Company B, and College C enter into a written 
agreement in which Student A agrees to pay the tuition required to 
attend College C in 10 equal monthly installments to Company B. Under 
the written agreement, Student A is not relieved of her obligation to 
pay College C until Company B remits the payments to College C. Under 
the written agreement, Company B agrees to disburse the monthly 
installment payments to College C within 30 days of receipt. Because 
Company B acts as Student A's agent for purposes of paying qualified 
expenses to College C, Student A is treated as paying qualified expenses 
on the date Company B disburses payments to College C.

    (f) Refund of qualified tuition and related expenses--(1) Payment 
and refund of qualified tuition and related expenses in the same taxable 
year. With respect to any student, the amount of qualified

[[Page 97]]

tuition and related expenses for a taxable year is calculated by adding 
all qualified tuition and related expenses paid for the taxable year, 
and subtracting any refund of such expenses received from the eligible 
educational institution during the same taxable year (including refunds 
of loan proceeds described in paragraph (f)(4) of this section).
    (2) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year before return filed for prior 
taxable year. If, in a taxable year, a taxpayer or someone other than 
the taxpayer receives a refund (including refunds of loan proceeds 
described in paragraph (f)(4) of this section) of qualified tuition and 
related expenses paid on behalf of a student in a prior taxable year and 
the refund is received before the taxpayer files a federal income tax 
return for the prior taxable year, the amount of the qualified tuition 
and related expenses for the prior taxable year is reduced by the amount 
of the refund.
    (3) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year--(i) In general. If, in a 
taxable year (refund year), a taxpayer or someone other than the 
taxpayer receives a refund (including refunds of loan proceeds described 
in paragraph (f)(4) of this section) of qualified tuition and related 
expenses paid on behalf of a student for which the taxpayer claimed an 
education tax credit in a prior taxable year, the tax imposed by chapter 
1 of the Internal Revenue Code for the refund year is increased by the 
recapture amount.
    (ii) Recapture amount. The recapture amount is the difference in tax 
liability for the prior taxable year (taking into account any 
redetermination of such tax liability by audit or amended return) that 
results when the tax liability for the prior year is calculated using 
the taxpayer's redetermined credit. The redetermined credit is computed 
by reducing the amount of the qualified tuition and related expenses 
taken into account in determining any credit claimed in the prior 
taxable year by the amount of the refund of the qualified tuition and 
related expenses (redetermined qualified expenses), and computing the 
allowable credit using the redetermined qualified expenses and the 
relevant facts and circumstances of the prior taxable year, such as 
modified adjusted gross income (redetermined credit).
    (4) Refund of loan proceeds treated as refund of qualified tuition 
and related expenses. If loan proceeds used to pay qualified tuition and 
related expenses (as described in paragraph (e)(3) of this section) 
during a taxable year are refunded by an eligible educational 
institution to a lender on behalf of the borrower, the refund is treated 
as a refund of qualified tuition and related expenses for purposes of 
paragraphs (f)(1), (2), and (3) of this section.
    (5) Excludable educational assistance received in a subsequent 
taxable year treated as a refund. If, in a taxable year, a taxpayer or 
someone other than the taxpayer receives any excludable educational 
assistance (described in paragraph (c)(1) of this section) for the 
qualified tuition and related expenses paid on behalf of a student 
during a prior taxable year (or attributable to enrollment at an 
eligible educational institution during a prior taxable year), the 
educational assistance is treated as a refund of qualified tuition and 
related expenses for purposes of paragraphs (f)(2) and (3) of this 
section. If the excludable educational assistance is received before the 
taxpayer files a federal income tax return for the prior taxable year, 
the amount of the qualified tuition and related expenses for the prior 
taxable year is reduced by the amount of the excludable educational 
assistance as provided in paragraph (f)(2) of this section. If the 
excludable educational assistance is received after the taxpayer has 
filed a federal income tax return for the prior taxable year, any 
education tax credit claimed for the prior taxable year is subject to 
recapture as provided in paragraph (f)(3) of this section.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (f). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. In January 1998, Student A, a full-time freshman at 
University X, pays

[[Page 98]]

$2,000 for qualified tuition and related expenses for a 16-hour work 
load for the 1998 Spring semester. Prior to beginning classes, Student A 
withdraws from 6 course hours. On February 15, 1998, Student A receives 
a $750 refund from University X. In September 1998, Student A pays 
University X $1,000 to enroll half-time for the 1998 Fall semester. 
Prior to beginning classes, Student A withdraws from a 2-hour course, 
and she receives a $250 refund in October 1998. Student A computes the 
amount of qualified tuition and related expenses she may claim for 1998 
by:
    (i) Adding all qualified expenses paid during the taxable year 
($2,000 + 1,000 = $3,000);
    (ii) Adding all refunds of qualified tuition and related expenses 
received during the taxable year ($750 + $250 = $1,000); and, then
    (iii) Subtracting paragraph (ii) of this Example 1 from paragraph 
(i) of this Example 1 ($3,000 -$1,000 = $2,000). Therefore, Student A's 
qualified tuition and related expenses for 1998 are $2,000.
    Example 2. (i) In December 1998, Student B, a senior at College Y, 
pays $2,000 for qualified tuition and related expenses for a 16-hour 
work load for the 1999 Spring semester. Prior to beginning classes, 
Student B withdraws from a 4-hour course. On January 15, 1999, Student B 
files her 1998 income tax return and claims a $400 Lifetime Learning 
Credit for the $2,000 qualified expenses paid in 1998, which reduces her 
tax liability for 1998 by $400. On February 15, 1999, Student B receives 
a $500 refund from College Y.
    (ii) Student B calculates the increase in tax for 1999 by--
    (A) Calculating the redetermined qualified expenses for 1998 ($2,000 
- $500 = $1,500);
    (B) Calculating the redetermined credit for the redetermined 
qualified expenses ($1,500 x .20 = $300); and
    (C) Calculating the difference in tax liability for 1998 resulting 
from the redetermined credit. Because Student B's tax liability for 1998 
was reduced by the full amount of the $400 education tax credit claimed 
on her 1998 income tax return, the difference in tax liability can be 
determined by subtracting the redetermined credit from the credit 
claimed in 1998 ($400-$300 = $100).
    (iii) Therefore, Student B must increase the tax on her 1999 federal 
income tax return by $100.
    Example 3. In September 1998, Student C pays College Z $1,200 in 
qualified tuition and related expenses to attend evening classes during 
the 1998 Fall semester. Student C is an employee of Company R. On 
January 15, 1999, Student C files a federal income tax return for 1998 
claiming a Lifetime Learning Credit of $240 (.20 x $1,200), which 
reduces Student C's tax liability for 1998 by $240. Pursuant to an 
educational assistance program described in section 127(b), Company R 
reimburses Student C in February 1999 for the $1,200 of qualified 
tuition and related expenses paid by Student C in 1998. The $240 
education tax credit claimed by Student C for 1998 is subject to 
recapture. Because Student C paid no net qualified tuition and related 
expenses for 1998, the redetermined credit for 1998 is zero. Student C 
must increase the amount of Student C's 1999 tax by the recapture 
amount, which is $240 (the difference in tax liability for 1998 
resulting from the redetermined credit for 1998 ($0)). Because the 
$1,200 reimbursement relates to expenses for which the taxpayer claimed 
an education tax credit in a prior year, the reimbursement does not 
reduce the amount of any qualified tuition and related expenses that 
Student C paid in 1999.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]



Sec. 1.28-0  Credit for clinical testing expenses for certain drugs for rare 

diseases or conditions; table of contents.

    In order to facilitate use of Sec. 1.28-1, this section lists the 
paragraphs, subparagraphs, and subdivisions contained in Sec. 1.28-1.

    (a) General rule.
    (b) Qualified clinical testing expenses.
    (1) In general.
    (2) Modification of section 41(b).
    (3) Exclusion for amounts funded by another person.
    (i) In general.
    (ii) Clinical testing in which taxpayer retains no rights.
    (iii) Clinical testing in which taxpayer retains substantial rights.
    (A) In general.
    (B) Drug by drug determination.
    (iv) Funding for qualified clinical testing expenses determinable 
only in subsequent taxable years.
    (4) Special rule governing the application of section 41(b) beyond 
its expiration date.
    (c) Clinical testing.
    (1) In general.
    (2) Definition of ``human clinical testing''.
    (3) Definition of ``carried out under'' section 505(i).
    (d) Definition and special rules.
    (1) Definition of ``rare disease or condition''.
    (i) In general.
    (ii) Cost of developing and making available the designated drug.
    (A) In general.
    (B) Exclusion of costs funded by another person.
    (C) Computation of cost.
    (D) Allocation of common costs. Costs for developing and making 
available the designated drug for both the disease or condition for 
which it is designated and one or more other diseases or conditions.

[[Page 99]]

    (iii) Recovery from sales.
    (iv) Recordkeeping requirements.
    (2) Tax liability limitation.
    (i) Taxable years beginning after December 31, 1986.
    (ii) Taxable years beginning before January 1, 1987, and after 
December 31, 1983.
    (iii) Taxable years beginning before January 1, 1984.
    (3) Special limitations on foreign testing.
    (i) Clinical testing conducted outside the United States--In 
general.
    (ii) Insufficient testing population in the United States.
    (A) In general.
    (B) ``Insufficient testing population''.
    (C) ``Unrelated to the taxpayer''.
    (4) Special limitations for certain corporations.
    (i) Corporations to which section 936 applies.
    (ii) Corporations to which section 934(b) applies.
    (5) Aggregation of expenditures.
    (i) Controlled group of corporations: organizations under common 
control.
    (A) In general.
    (B) Definition of controlled group of corporations.
    (C) Definition of organization.
    (D) Determination of common control.
    (ii) Tax accounting periods used.
    (A) In general.
    (B) Special rule where the timing of clinical testing is 
manipulated.
    (iii) Membership during taxable year in more than one group.
    (iv) Intra-group transactions.
    (A) In general.
    (B) In-house research expenses.
    (C) Contract research expenses.
    (D) Lease payments.
    (E) Payments for supplies.
    (6) Allocations.
    (i) Pass-through in the case of an S corporation
    (ii) Pass-through in the case of an estate or a trust.
    (iii) Pass-through in the case of a partnership.
    (A) In general.
    (B) Certain partnership non-business expenditures.
    (C) Apportionment.
    (iv) Year in which taken into account.
    (v) Credit allowed subject to limitation.
    (7) Manner of making an election.

[T.D. 8232, 53 FR 38710, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988]



Sec. 1.28-1  Credit for clinical testing expenses for certain drugs for rare 

diseases or conditions.

    (a) General rule. Section 28 provides a credit against the tax 
imposed by chapter 1 of the Internal Revenue Code. The amount of the 
credit is equal to 50 percent of the qualified clinical testing expenses 
(as defined in paragraph (b) of this section) for the taxable year. The 
credit applies to qualified clinical testing expenses paid or incurred 
by the taxpayer after December 31, 1982, and before January 1, 1991. The 
credit may not exceed the taxpayer's tax liability for the taxable year 
(as determined under paragraph (d)(2) of this section).
    (b) Qualified clinical testing expenses--(1) In general. Except as 
otherwise provided in paragraph (b)(3) of this section, the term 
``qualified clinical testing expenses'' means the amounts which are paid 
or incurred during the taxable year which would constitute ``qualified 
research expenses'' within the meaning of section 41(b) (relating to the 
credit for increasing research activities) as modified by section 
28(b)(1)(B) and paragraph (b)(2) of this section. For example, amounts 
paid or incurred for the acquisition of depreciable property used in the 
conduct of clinical testing (as defined in paragraph (c) of this 
section) are not qualified clinical testing expenses.
    (2) Modification of section 41(b). For purposes of paragraph (b)(1) 
of this section, section 41(b) is modified by substituting ``clinical 
testing'' for ``qualified research'' each place it appears in paragraph 
(2) of section 41(b) (relating to in-house research expenses) and 
paragraph (3) of section 41(b) (relating to contract research expenses). 
In addition, ``100 percent'' is substituted for ``65 percent'' in 
paragraph (3)(A) of section 41(b).
    (3) Exclusion for amounts funded by another person--(i) In general. 
The term ``qualified clinical testing expenses'' shall not include any 
amount which would otherwise constitute qualified clinical testing 
expenses, to the extent such amount is funded by a grant, contract, or 
otherwise by another person (or any governmental entity). The 
determination of the extent to which an amount is funded shall be made 
in light of all the facts and circumstances. For a special rule 
regarding funding between commonly controlled businesses, see paragraph 
(d)(5)(iv) of Sec. 1.28-1.
    (ii) Clinical testing in which taxpayer retains no rights. If a 
taxpayer conducting clinical testing with respect to

[[Page 100]]

the designated drug for another person retains no substantial rights in 
the clinical testing under the agreement providing for the clinical 
testing the taxpayer's clinical testing expenses are treated as fully 
funded for purposes of section 28(b)(1)(C). Thus, for example, if the 
taxpayer incurs clinical testing expenses under an agreement that 
confers on another person the exclusive right to exploit the results of 
the clinical testing, those expenses do not constitute qualified 
clinical testing expenses because they are fully funded under this 
paragraph (b)(3)(ii). Incidental benefits to the taxpayer from the 
conduct of the clinical testing (for example, increased experience in 
the field of human clinical testing) do not constitute substantial 
rights in the clinical testing.
    (iii) Clinical testing in which taxpayer retains substantial 
rights--(A) In general. If a taxpayer conducting clinical testing with 
respect to the designated drug for another person retains substantial 
rights in the clinical testing under the agreement providing for the 
clinical testing, the clinical testing expenses are funded to the extent 
of the payments (and fair market value of any property at the time of 
transfer) to which the taxpayer becomes entitled by conducting the 
clinical testing. The taxpayer shall reduce the amount paid or incurred 
by the taxpayer for the clinical testing expenses that would, but for 
section 28(b)(1)(C) constitute qualified clinical testing expenses of 
the taxpayer by the amount of the funding determined under the preceding 
sentence. Rights retained in the clinical testing are not treated as 
property for purposes of this paragraph (b)(3)(iii)(A). If the property 
that is transferred to the taxpayer is to be consumed in the clinical 
testing (for example, supplies), the taxpayer should exclude the value 
of that property from both the payments received and the expenses paid 
or incurred for the clinical testing.
    (B) Drug by drug determination. The provisions of this paragraph 
(b)(3) shall be applied separately to each designated drug tested by the 
taxpayer.
    (iv) Funding for qualified clinical testing expenses determinable 
only in subsequent taxable years. If, at the time the taxpayer files its 
return for a taxable year, it is impossible to determine to what extent 
some or all of the qualified clinical testing expenses may be funded, 
the taxpayer shall treat the clinical testing expenses as fully funded 
for purposes of that return. When the amount of funding for qualified 
clinical testing expenses is finally determined, the taxpayer should 
amend the return and any interim returns to reflect the amount of 
funding for qualified clinical testing expenses.
    (4) Special rule governing the application of section 41(b) beyond 
its expiration date. For purposes of section 28 and this section, 
section 41(b), as amended, and the regulations thereunder shall be 
deemed to remain in effect after December 31, 1988.
    (c) Clinical testing--(1) In general. The term ``clinical testing'' 
means any human clinical testing which--
    (i) Is carried out under an exemption under section 505(i) of the 
Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(i)) and the 
regulations relating thereto (21 CFR part 312) for the purpose of 
testing a drug for a rare disease or condition as defined in paragraph 
(d)(1) of this section,
    (ii) Occurs after the date the drug is designated as a drug for a 
rare disease or condition under section 526 of the Federal Food, Drug, 
and Cosmetic Act (21 U.S.C. 360bb),
    (iii) Occurs before the date on which an application for the 
designated drug is approved under section 505(b) of the Federal Food, 
Drug, and Cosmetic Act (21 U.S.C. 355(b)) or, if the drug is a 
biological product (other than a radioactive biological product intended 
for human use), before the date on which a license for such drug is 
issued under section 351 of the Public Health Services Act (42 U.S.C. 
262), and
    (iv) Is conducted by or on behalf of the taxpayer to whom the 
designation under section 526 of the Federal Food, Drug, and Cosmetic 
Act applies.

Human clinical testing shall be taken into account under this paragraph 
(c)(1) only to the extent that the testing relates to the use of a drug 
for the rare disease or condition for which the drug was designated 
under section 526 of the Federal Food, Drug, and Cosmetic Act. For 
purposes of paragraph

[[Page 101]]

(c)(1)(i) of this section the testing under section 505(i) exemption 
procedures (21 CFR part 312) of a biological product (other than a 
radioactive biological product intended for human use) pursuant to 21 
CFR Sec. 601.21 is deemed to be carried out under an exemption under 
section 505(i) of the Federal Food, Drug, and Cosmetic Act.
    (2) Definition of ``human clinical testing.'' Testing is considered 
to be human clinical testing only to the extent that it uses human 
subjects to determine the effect of the designated drug on humans and is 
necessary for the designated drug either to be approved under section 
505(b) of the Federal Food, Drug, and Cosmetic Act and the regulations 
thereunder (21 CFR part 314), or if the designated drug is a biological 
product (other than a radioactive biological product intended for human 
use), to be licensed under section 351 of the Public Health Services Act 
and the regulations thereunder (21 CFR part 601). For purposes of this 
paragraph (c)(2), a human subject is an individual who is a participant 
in research, either as a recipient of the drug or as a control. A 
subject may be either a healthy individual or a patient.
    (3) Definition of ``carried out under'' section 505(i). Human 
clinical testing is not carried out under section 505(i) of the Federal 
Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 
312) unless the primary purpose of the human clinical testing is to 
ascertain the data necessary to qualify the designated drug for sale in 
the United States, and not to ascertain data unrelated or only 
incidentally related to that needed to qualify the designated drug. 
Whether or not this primary purpose test is met shall be determined in 
light of all of the facts and circumstances.
    (d) Definition and special rules--(1) Definition of ``rare disease 
or condition''--(i) In general. The term ``rare disease or condition'' 
means any disease or condition which--
    (A) Afflicts 200,000 or fewer persons in the United States, or
    (B) Afflicts more than 200,000 persons in the United States but for 
which there is no reasonable expectation that the cost of developing and 
making available in the United States (as defined in section 7701(a)(9)) 
a drug for such disease or condition will be recovered from sales in the 
United States (as so defined) of such drug.

Determinations under paragraph (d)(1)(i)(B) of this section with respect 
to any drug shall be made on the basis of the facts and circumstances as 
of the date such drug is designated under section 526 of the Federal 
Food, Drug, and Cosmetic Act. Examples of diseases or conditions which 
in 1987 afflicted 200,000 or fewer persons in the United States are 
Duchenne dystrophy, one of the muscular dystrophies; Huntington's 
disease, a hereditary chorea; myoclonus; Tourette's syndrome; and 
amyotrophic lateral sclerosis (ALS or Lou Gehrig's disease).
    (ii) Cost of developing and making available the designated drug--
(A) In general. Except as otherwise provided in this paragraph 
(d)(1)(ii), the taxpayer's computation of the cost of developing and 
making available in the United States the designated drug shall include 
only the costs that the taxpayer (or any person whose right to make 
sales of the drug is directly or indirectly derived from the taxpayer, 
e.g., a licensee or transferee) has incurred or reasonably expects to 
incur in developing and making available in the United States the 
designated drug for the disease or condition for which it is designated. 
For example, if, prior to designation under section 526, the taxpayer 
incurred costs of $125,000 to test the drug for the rare disease or 
condition for which it is subsequently designated and incurred $500,000 
to test the same drug for other diseases, and if, on the date of 
designation, the taxpayer expects to incur costs of $1.2 million to test 
the drug for the rare disease or condition for which it is designated, 
the taxpayer shall include in its cost computation both the $125,000 
incurred prior to designation and the $1.2 million expected to be 
incurred after designation to test the drug for the rare disease or 
condition for which it is designated. The taxpayer shall not include the 
$500,000 incurred to test the drug for other diseases.
    (B) Exclusion of costs funded by another person. In computing the 
cost of developing and making available in the United States the 
designated drug, the

[[Page 102]]

taxpayer shall not include any cost incurred or expected to be incurred 
by the taxpayer to the extent that the cost is funded or is reasonably 
expected to be funded (determined under the principles of paragraph 
(b)(3)) by a grant, contract, or otherwise by another person (or any 
governmental entity).
    (C) Computation of cost. The cost computation shall use only 
reasonable costs incurred after the first indication of an orphan 
application for the designated drug. Such costs shall include the costs 
of obtaining data needed, and of meetings to be held, in connection with 
a request for FDA assistance under section 525 of the Federal, Food, 
Drug, and Cosmetic Act (21 U.S.C. 360aa) or a request for orphan 
designation under section 526 of that Act; costs of determining 
patentability of the drug; costs of screening, animal and clinical 
studies; costs associated with preparation of a Notice of Claimed 
Investigational Exemption for a New Drug (IND) and a New Drug 
Application (NDA); costs of possible distribution of drug under a 
``treatment'' protocol; costs of development of a dosage form; 
manufacturing costs; distribution costs; promotion costs; costs to 
maintain required records and reports; and costs of the taxpayer in 
acquiring the right to market a drug from the owner of that right prior 
to designation. The taxpayer shall also include general overhead, 
depreciation costs and premiums for insurance against liability losses 
to the extent that the taxpayer can demonstrate that these costs are 
properly allocable to the designated drug under the established 
standards of financial accounting and reporting of research and 
development costs.
    (D) Allocation of common costs. Costs for developing and making 
available the designated drug for both the disease or condition for 
which it is designated and one or more other diseases or conditions. In 
the case where the costs incurred or expected to be incurred in 
developing and making available the designated drug for the disease or 
condition for which it is designated are also incurred or expected to be 
incurred in developing and making available in the United States the 
same drug for one or more other diseases or conditions (whether or not 
they are also designated or expected to be designated), the costs shall 
be allocated between the cost of developing and making available the 
designated drug for the disease or condition for which the drug is 
designated and the cost of developing and making available the 
designated drug for the other diseases or conditions. The amount of the 
common costs to be allocated to the cost of developing and making 
available the designated drug for the disease or condition for which it 
is designated is determined by multiplying the common costs by a 
fraction the numerator of which is the sum of the expected amount of 
sales in the United States of the designated drug for the disease or 
condition for which the drug is designated and the denominator of which 
is the total expected amount of sales in the United States of the 
designated drug. For example, if prior to designation, the taxpayer 
incurs (among other costs) costs of $100,000 in testing the designated 
drug for its toxic effect on animals (without reference to any disease 
or condition), and if the taxpayer expects to recover $500,000 from 
sales in the United States of the designated drug for disease X, the 
disease for which the drug is designated, and further expects to recover 
another $1.5 million from the sales in the United States of the 
designated drug for disease Y, the taxpayer must allocate a 
proportionate amount of the common costs of $100,000 to the cost of 
developing and making available the designated drug for both disease X 
and disease Y. Since the ratio of the expected amount of sales in the 
United States of the designated drug for disease X to the total of both 
the expected amount of sales in the United States of the designated drug 
for disease X and the expected amount of sales in the United States of 
the designated drug for disease Y is $500,000/$2,000,000, 25% of the 
common costs of $100,000 (i.e., $25,000) is allocated to the cost of 
developing and making available the designated drug for disease X.
    (iii) Recovery from sales. In determining whether the taxpayer's 
cost described in paragraph (d)(1)(ii) of this section will be recovered 
from sales in

[[Page 103]]

the United States of the designated drug for the disease or condition 
for which the drug is designated, the taxpayer shall include anticipated 
sales by the taxpayer or any person whose right to make such sales is 
directly or indirectly derived from the taxpayer (such as a licensee or 
transferee). The anticipated sales shall be based upon the size of the 
anticipated patient population for which the designated drug would be 
useful, including the following factors: the degree of effectiveness and 
safety of the designated drug, if known: the projected fraction of the 
anticipated patient population expected to be given the designated drug 
and to continue to take it; other available agents and other types of 
therapy; the likelihood that superior agents will become available 
within a few years; and the number of years during which the designated 
drug would be exclusively available, e.g., under a patent.
    (iv) Recordkeeping requirements. The taxpayer shall keep records 
sufficient to substantiate the cost and sales estimates made pursuant to 
this paragraph (d)(1). The records required by this paragraph (d)(1)(iv) 
shall be retained so long as the contents thereof may become material in 
the administration of section 28.
    (2) Tax liability limitation--(i) Taxable years beginning after 
December 31, 1986. The credit allowed by section 28 shall not exceed the 
excess (if any) of--
    (A) The taxpayer's regular tax liability for the taxable year (as 
defined in section 26(b)), reduced by the sum of the credits allowable 
under--
    (1) Section 21 (relating to expenses for household and dependent 
care services necessary for gainful employment),
    (2) Section 22 (relating to the elderly and permanently and totally 
disabled),
    (3) Section 23 (relating to residential energy),
    (4) Section 25 (relating to interest on certain home mortgages), and
    (5) Section 27 (relating to taxes on foreign countries and 
possessions of the United States), over
    (B) The tentative minimum tax for the taxable year (as determined 
under section 55(b)(1)).
    (ii) Taxable years beginning before January 1, 1987, and after 
December 31, 1983. The credit allowed by section 28 shall not exceed the 
taxpayer's tax liability for the taxable year (as defined in section 26 
(b) prior to its amendment by the Tax Reform Act of 1986 (Pub. L. 99-
514)), reduced by the sum of the credits allowable under--
    (A) Section 21 (relating to expenses for household dependent care 
services necessary for gainful employment),
    (B) Section 22 (relating to the elderly and permanently and totally 
disabled),
    (C) Section 23 (relating to residential energy),
    (D) Section 24 (relating to contributions to candidates for public 
office),
    (E) Section 25 (relating to interest on certain home mortgages), and
    (F) Section 27 (relating to the taxes on foreign countries and 
possessions of the United States).
    (iii) Taxable years beginning before January 1, 1984. The credit 
allowed by section 28 shall not exceed the amount of the tax imposed by 
chapter 1 of the Internal Revenue Code for the taxable year, reduced by 
the sum of the credits allowable under the following sections as 
designated prior to the enactment of the Tax Reform Act of 1984 (Pub. 
Law 98-369):
    (A) Section 32 (relating to tax withheld at source on nonresident 
aliens and foreign corporations and on tax-free convenant bonds),
    (B) Sections 33 (relating to taxes of foreign countries and 
possessions of the United States),
    (C) Section 37 (relating to the retirement income),
    (D) Section 38 (relating to investment in certain depreciable 
property),
    (E) Section 40 (relating to expenses of work incentive programs).
    (F) Section 41 (relating to contributions to candidates for public 
office).
    (G) Section 44 (relating to purchase of new principal residence).
    (H) Section 44A (relating to expenses for household and dependent 
care services necessary for gainful employment).
    (I) Section 44B (relating to employment of certain new employees).
    (J) Section 44C (relating to residential energy).
    (K) Section 44D (relating to producing fuel from a nonconventional 
source).

[[Page 104]]

    (L) Section 44E (relating to alcohol used as fuel).
    (M) Section 44F (relating to increasing research activities), and
    (N) Section 44G (relating to employee stock ownership).

The term ``tax imposed by chapter 1'' as used in this paragraph 
(d)(2)(iii) does not include any tax treated as not imposed by chapter 1 
of the Internal Revenue Code under the last sentence of section 53(a).
    (3) Special limitations on foreign testing--(i) Clinical testing 
conducted outside of the United States--In general. Except as otherwise 
provided in this paragraph (d)(3), expenses paid or incurred with 
respect to clinical testing conducted outside the United States (as 
defined in section 7701(a)(9)) are not eligible for credit under this 
section. Thus, for example, wages paid an employee clinical investigator 
for clinical testing conducted in medical facilities in the United 
States and Mexico generally must be apportioned between the clinical 
testing conducted within the United States and the clinical testing 
conducted outside the United States, and only the wages apportioned to 
the clinical testing conducted within the United States are qualified 
clinical testing expenses.
    (ii) Insufficient testing population in the United States--(A) In 
general. If clinical testing is conducted outside of the United States 
because there is an insufficient testing population in the United 
States, and if the clinical testing is conducted by a United States 
person (as defined in section 7701(a)(30)) or is conducted by any other 
person unrelated to the taxpayer to whom the designation under section 
526 of the Federal Food, Drug, and Cosmetic Act applies, then the 
expenses paid or incurred for clinical testing conducted outside of the 
United States are eligible for the credit provided by section 28.
    (B) ``Insufficient testing population.'' The testing population in 
the United States is insufficient if there are not within the United 
States the number of available and appropriate human subjects needed to 
produce reliable data from the clinical investigation.
    (C) ``Unrelated to the taxpayer.'' For the purpose of determining 
whether a person is unrelated to the taxpayer to whom the designation 
under section 526 of the Federal Food, Drug, and Cosmetic Act and the 
regulations thereunder applies, the rules of section 613A(d)(3) shall 
apply except that the number ``5'' in section 613A(d)(3) (A), (B), and 
(C) shall be deleted and the number ``10'' inserted in lieu thereof.
    (4) Special limitations for certain corporations--(i) Corporations 
to which section 936 applies. Expenses paid or incurred for clinical 
testing conducted either inside or outside the United States by a 
corporation to which section 936 (relating to Puerto Rico and 
possessions tax credit) applies are not eligible for the credit under 
section 28.
    (ii) Corporations to which section 934(b) applies. For taxable years 
beginning before January 1, 1987, expenses paid or incurred for clinical 
testing conducted either inside or outside the United States by a 
corporation to which section 934(b) (relating to the limitation on 
reduction in income tax liability incurred to the Virgin Islands), as in 
effect prior to its amendment by the Tax Reform Act of 1986, applies are 
not eligible for the credit under section 28. For taxable years 
beginning after December 31, 1986, see section 1277(c)(1) of the Tax 
Reform Act of 1986 (100 Stat. 2600) which makes the rule set forth in 
the preceding sentence inapplicable with respect to corporations created 
or organized in the Virgin Islands only if (and so long as) an 
implementing agreement described in that section is in effect between 
the United States and the Virgin Islands.
    (5) Aggregation of expenditures--(i) Controlled group of 
corporations; organizations under common control--(A) In general. In 
determining the amount of the credit allowable with respect to an 
organization that at the end of its taxable year is a member of a 
controlled group of corporations or a member of a group of organizations 
under common control, all members of the group are treated as a single 
taxpayer and the credit (if any) allowable to the member is determined 
on the basis of its proportionate share of the qualified clinical 
testing expenses of the aggregated group.

[[Page 105]]

    (B) Definition of controlled group of corporations. For purposes of 
this section, the term ``controlled group of corporations'' shall have 
the meaning given to the term by section 41(f)(5).
    (C) Definition of organization. For purposes of this section, an 
organization is a sole proprietorship, a partnership, a trust, an 
estate, or a corporation, that is carrying on a trade or business 
(within the meaning of section 162). For purposes of this section, any 
corporation that is a member of a commonly controlled group shall be 
deemed to be carrying on a trade or business if any other member of that 
group is carrying on any trade or business.
    (D) Determination of common control. Whether organizations are under 
common control shall be determined under the principles set forth in 
paragraphs (b) through (g) of 26 CFR 1.52-1.
    (ii) Tax accounting periods used--(A) In general. The credit 
allowable to a member of a controlled group of corporations or a group 
of organizations under common control is that member's share of the 
aggregate credit computed as of the end of such member's taxable year.
    (B) Special rule where the timing of clinical testing is 
manipulated. If the timing of clinical testing by members using 
different tax accounting periods is manipulated to generate a credit in 
excess of the amount that would be allowable if all members of the group 
used the same tax accounting period, the district director may require 
all members of the group to calculate the credit in the current taxable 
year and all future years by using the ``conformed years'' method. Each 
member computing a credit under the ``conformed years'' method shall 
compute the credit as if all members of the group had the same taxable 
year as the computing member.
    (iii) Membership during taxable year in more than one group. An 
organization may be a member of only one group for a taxable year. If, 
without application of this paragraph (d)(5)(iii), an organization would 
be a member of more than one group at the end of its taxable year, the 
organization shall be treated as a member of the group in which it was 
included for its preceding taxable year. If the organization was not 
included for its preceding taxable year in any group in which it could 
be included as of the end of its taxable year, the organization shall 
designate in its timely filed return the group in which it is being 
included. If the return for a taxable year is due before May 1, 1985, 
the organization may designate its group membership through an amended 
return for that year filed on or before April 30, 1985. If the 
organization does not so designate, then the district director with 
audit jurisdiction of the return will determine the group in which the 
business is to be included.
    (iv) Intra-group transactions--(A) In general. Because all members 
of a group under common control are treated as a single taxpayer for 
purposes of determining the credit, transactions between members of the 
group are generally disregarded.
    (B) In-house research expenses. If one member of a group conducts 
clinical testing on behalf of another member, the member conducting the 
clinical testing shall include in its qualified clinical testing 
expenses any in-house research expenses for that work and shall not 
treat any amount received or accrued from the other member as funding 
the clinical testing. Conversely, the member for whom the clinical 
testing is conducted shall not treat any part of any amount paid or 
incurred as a contract research expense. For purposes of determining 
whether the in-house research for that work is clinical testing, the 
member performing the clinical testing shall be treated as carrying on 
any trade or business carried on by the member on whose behalf the 
clinical testing is performed.
    (C) Contract research expenses. If a member of a group pays or 
incurs contract research expenses to a person outside the group in 
carrying on the member's trade or business, that member shall include 
those expenses as qualified clinical testing expenses. However, if the 
expenses are not paid or incurred in carrying on any trade or business 
of that member, those expenses may be taken into account as contract 
research expenses by another member of the group provided that the other 
member--

[[Page 106]]

    (1) Reimburses the member paying or incurring the expenses, and
    (2) Carries on a trade or business to which the clinical testing 
relates.
    (D) Lease payments. Amounts paid or incurred to another member of 
the group for the lease of personal property owned by a person outside 
the group shall be taken into account as in-house research expenses for 
purposes of section 28 only to the extent of the lesser of--
    (1) The amount paid or incurred to the other member, or
    (2) The amount of the lease expense paid to a person outside the 
group.
    The amount paid or incurred to another member of the group for the 
lease of personal property owned by a member of the group is not taken 
into account for purposes of section 28.
    (E) Payment for supplies. Amounts paid or incurred to another member 
of the group for supplies shall be taken into account as in-house 
research expenses for purposes of section 28 only to the extent of the 
lesser of--
    (1) The amount paid or incurred to the other member, or
    (2) The amount of the other member's basis in the supplies.
    (6) Allocations--(i) Pass-through in the case of an S corporation. 
In the case of an S corporation (as defined in section 1361), the amount 
of the credit for qualified clinical testing expenses computed for the 
corporation for any taxable year shall be allocated among the persons 
who are shareholders of the corporation during the taxable year 
according to the provisions of section 1366 and section 1377.
    (ii) Pass-through in the case of an estate or a trust. In the case 
of an estate or a trust, the amount of the credit for qualified clinical 
testing expenses computed for the estate or trust for any taxable year 
shall be apportioned between the estate or trust and the beneficiaries 
on the basis of the income of the estate or trust allocable to each.
    (iii) Pass-through in the case of a partnership--(A) In general. In 
the case of a partnership, the credit for qualified clinical testing 
expenses computed for the partnership for any taxable year shall be 
apportioned among the persons who are partners during the taxable year 
in accordance with section 704 and the regulations thereunder.
    (B) Certain partnership non-business expenditures. A partner's share 
of an in-house research expense or contract research expense paid or 
incurred by a partnership other than in carrying on a trade or business 
of the partnership constitutes a qualified clinical testing expense of 
the partner if--
    (1) The partner is entitled to make independent use of the result of 
the clinical testing, and
    (2) The clinical testing expense paid or incurred in carrying on the 
clinical testing would have been paid or incurred by the partner in 
carrying on a trade or business of the partner if the partner had 
carried on the clinical testing that was in fact carried on by the 
partnership.
    (C) Apportionment. Qualified clinical testing expenses to which 
paragraph (d)(6)(iii)(B) of this section applies shall be apportioned 
among the persons who are partners during the taxable year in accordance 
with section 704 and the regulations thereunder. For purposes of section 
28, these expenses shall be treated as paid or incurred directly by the 
partners rather than by the partnership. Thus, the partnership shall 
disregard these expenses in computing the credit to be apportioned under 
paragraph (d)(6)(iii)(A) of this section, and each partner shall 
aggregate the portion of these expenses allocated to the partner with 
other qualified clinical testing expenses of the partner in making the 
computations under section 28.
    (iv) Year in which taken into account. An amount apportioned to a 
person under paragraph (d)(6) of this section shall be taken into 
account by the person in the taxable year of such person in which or 
with which the taxable year of the corporation, estate, trust, or 
partnership (as the case may be) ends.
    (v) Credit allowed subject to limitation. Any person to whom any 
amount has been apportioned under paragraph (d)(6)(i), (ii), or (iii) of 
this section is allowed, subject to the limitation provided in section 
28(d)(2), a credit for that amount.
    (7) Manner of making an election. To make an election to have 
section 28

[[Page 107]]

apply for its taxable year, the taxpayer shall file Form 6765 (Credit 
for Increasing Research Activities (or for claiming the orphan drugs 
credit)) containing all the information required by that form.

[T.D. 8232, 53 FR 38711, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988; 53 FR 
41013, Oct. 19, 1988]

                           Credits Against Tax

             credits allowable under sections 30 through 45D



Sec. 1.30-1  Definition of qualified electric vehicle and recapture of credit 

for qualified electric vehicle.

    (a) Definition of qualified electric vehicle. A qualified electric 
vehicle is a motor vehicle that meets the requirements of section 30(c). 
Accordingly, a qualified electric vehicle does not include any motor 
vehicle that has ever been used (for either personal or business use) as 
a non-electric vehicle.
    (b) Recapture of credit for qualified electric vehicle--(1) In 
general--(i) Addition to tax. If a recapture event occurs with respect 
to a taxpayer's qualified electric vehicle, the taxpayer must add the 
recapture amount to the amount of tax due in the taxable year in which 
the recapture event occurs. The recapture amount is not treated as 
income tax imposed on the taxpayer by chapter 1 of the Internal Revenue 
Code for purposes of computing the alternative minimum tax or 
determining the amount of any other allowable credits for the taxable 
year in which the recapture event occurs.
    (ii) Reduction of carryover. If a recapture event occurs with 
respect to a taxpayer's qualified electric vehicle, and if a portion of 
the section 30 credit for the cost of that vehicle was disallowed under 
section 30(b)(3)(B) and consequently added to the taxpayer's minimum tax 
credit pursuant to section 53(d)(1)(B)(iii), the taxpayer must reduce 
its minimum tax credit carryover by an amount equal to the portion of 
any minimum tax credit carryover attributable to the disallowed section 
30 credit, multiplied by the recapture percentage for the taxable year 
of recapture. Similarly, the taxpayer must reduce any other credit 
carryover amounts (such as under section 469) by the portion of the 
carryover attributable to section 30, multiplied by the recapture 
percentage.
    (2) Recapture event--(i) In general. A recapture event occurs if, 
within 3 full years from the date a qualified electric vehicle is placed 
in service, the vehicle ceases to be a qualified electric vehicle. A 
vehicle ceases to be a qualified electric vehicle if--
    (A) The vehicle is modified so that it is no longer primarily 
powered by electricity;
    (B) The vehicle is used in a manner described in section 50(b); or
    (C) The taxpayer receiving the credit under section 30 sells or 
disposes of the vehicle and knows or has reason to know that the vehicle 
will be used in a manner described in paragraph (b)(2)(i)(A) or (B) of 
this section.
    (ii) Exception for disposition. Except as provided in paragraph 
(b)(2)(i)(C) of this section, a sale or other disposition (including a 
disposition by reason of an accident or other casualty) of a qualified 
electric vehicle is not a recapture event.
    (3) Recapture amount. The recapture amount is equal to the recapture 
percentage times the decrease in the credits allowed under section 30 
for all prior taxable years that would have resulted solely from 
reducing to zero the cost taken into account under section 30 with 
respect to such vehicle, including any credits allowed attributable to 
section 30 (such as under sections 53 and 469).
    (4) Recapture date. The recapture date is the actual date of the 
recapture event unless a recapture event described in paragraph 
(b)(2)(i)(B) of this section occurs, in which case the recapture date is 
the first day of the recapture year.
    (5) Recapture percentage. For purposes of this section, the 
recapture percentage is--
    (i) 100, if the recapture date is within the first full year after 
the date the vehicle is placed in service;
    (ii) 66 \2/3\, if the recapture date is within the second full year 
after the date the vehicle is placed in service; or
    (iii) 33 \1/3\, if the recapture date is within the third full year 
after the date the vehicle is placed in service.

[[Page 108]]

    (6) Basis adjustment. As of the first day of the taxable year in 
which the recapture event occurs, the basis of the qualified electric 
vehicle is increased by the recapture amount and the carryover 
reductions taken into account under paragraphs (b)(1)(i) and (ii) of 
this section, respectively. For a vehicle that is of a character that is 
subject to an allowance for depreciation, this increase in basis is 
recoverable over the remaining recovery period for the vehicle beginning 
as of the first day of the taxable year of recapture.
    (7) Application of section 1245 for sales and other dispositions. 
For purposes of section 1245, the amount of the credit allowable under 
section 30(a) with respect to any qualified electric vehicle that is (or 
has been) of a character subject to an allowance for depreciation is 
treated as a deduction allowed for depreciation under section 167. 
Therefore, upon a sale or other disposition of a depreciable qualified 
electric vehicle, section 1245 will apply to any gain recognized to the 
extent the basis of the depreciable vehicle was reduced under section 
30(d)(1) net of any basis increase described in paragraph (b)(6) of this 
section.
    (8) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. A, a calendar-year taxpayer, purchases and places in 
service for personal use on January 1, 1995, a qualified electric 
vehicle costing $25,000. On A's 1995 federal income tax return, A claims 
a credit of $2,500. On January 2, 1996, A sells the vehicle to an 
unrelated third party who subsequently converts the vehicle into a non-
electric vehicle on October 15, 1996. There is no recapture upon the 
sale of the vehicle by A provided A did not know or have reason to know 
that the purchaser intended to convert the vehicle to non-electric use.
    Example 2. B, a calendar-year taxpayer, purchases and places in 
service for personal use on October 11, 1994, a qualified electric 
vehicle costing $20,000. On B's 1994 federal income tax return, B claims 
a credit of $2,000, which reduces B's tax by $2,000. The basis of the 
vehicle is reduced to $18,000 ($20,000-$2,000). On March 8, 1996, B 
sells the vehicle to a tax-exempt entity. Because B knowingly sold the 
vehicle to a tax-exempt entity described in section 50(b) in the second 
full year from the date the vehicle was placed in service, B must 
recapture $1,333 ($2,000x66 \2/3\ percent). This recapture amount 
increases B's tax by $1,333 on B's 1996 federal income tax return and is 
added to the basis of the vehicle as of January 1, 1996, the beginning 
of the taxable year in which the recapture event occurred.
    Example 3. X, a calendar-year taxpayer, purchases and places in 
service for business use on January 1, 1994, a qualified electric 
vehicle costing $30,000. On X's 1994 federal income tax return, X claims 
a credit of $3,000, which reduces X's tax by $3,000. The basis of the 
vehicle is reduced to $27,000 ($30,000-$3,000) prior to any adjustments 
for depreciation. On March 8, 1995, X converts the qualified electric 
vehicle into a gasoline-propelled vehicle. Because X modified the 
vehicle so that it is no longer primarily powered by electricity in the 
second full year from the date the vehicle was placed in service, X must 
recapture $2,000 ($3,000 x 66\2/3\ percent). This recapture amount 
increases X's tax by $2,000 on X's 1995 federal income tax return. The 
recapture amount of $2,000 is added to the basis of the vehicle as of 
January 1, 1995, the beginning of the taxable year of recapture, and to 
the extent the property remains depreciable, the adjusted basis is 
recoverable over the remaining recovery period.
    Example 4. The facts are the same as in Example 3. In 1996, X sells 
the vehicle for $31,000, recognizing a gain from this sale. Under 
paragraph (b)(7) of this section, section 1245 will apply to any gain 
recognized on the sale of a depreciable vehicle to the extent the basis 
of the vehicle was reduced by the section 30 credit net of any basis 
increase from recapture of the section 30 credit. Accordingly, the gain 
from the sale of the vehicle is subject to section 1245 to the extent of 
the depreciation allowance for the vehicle plus the credit allowed under 
section 30 ($3,000), less the previous recapture amount ($2,000). Any 
remaining amount of gain may be subject to other applicable provisions 
of the Internal Revenue Code.

    (c) Effective date. This section is effective on October 14, 1994. 
If the recapture date is before the effective date of this section, a 
taxpayer may use any reasonable method to recapture the benefit of any 
credit allowable under section 30(a) consistent with section 30 and its 
legislative history. For this purpose, the recapture date is defined in 
paragraph (b)(4) of this section.

[60 FR 39649, Aug. 3, 1995]



Sec. 1.31-1  Credit for tax withheld on wages.

    (a) The tax deducted and withheld at the source upon wages under 
chapter 24 of the Internal Revenue Code of 1954 (or in the case of 
amounts withheld in 1954,

[[Page 109]]

under subchapter D, chapter 9 of the Internal Revenue Code of 1939) is 
allowable as a credit against the tax imposed by Subtitle A of the 
Internal Revenue Code of 1954, upon the recipient of the income. If the 
tax has actually been withheld at the source, credit or refund shall be 
made to the recipient of the income even though such tax has not been 
paid over to the Government by the employer. For the purpose of the 
credit, the recipient of the income is the person subject to tax imposed 
under Subtitle A upon the wages from which the tax was withheld. For 
instance, if a husband and wife domiciled in a State recognized as a 
community property State for Federal tax purposes make separate returns, 
each reporting for income tax purposes one- half of the wages received 
by the husband, each spouse is entitled to one-half of the credit 
allowable for the tax withheld at source with respect to such wages.
    (b) The tax withheld during any calendar year shall be allowed as a 
credit against the tax imposed by Subtitle A for the taxable year of the 
recipient of the income which begins in that calendar year. If such 
recipient has more than one taxable year beginning in that calendar 
year, the credit shall be allowed against the tax for the last taxable 
year so beginning.



Sec. 1.31-2  Credit for ``special refunds'' of employee social security tax.

    (a) In general. (1) In the case of an employee receiving wages from 
more than one employer during the calendar year, amounts may be deducted 
and withheld as employee social security tax with respect to more than 
$3,600 of wages received during the calendar year 1954, and with respect 
to more than $4,200 of wages received during a calendar year after 1954. 
For example, employee social security tax may be deducted and withheld 
on $5,000 of wages received by an employee during a particular calendar 
year if the employee is paid wages in such year in the amount of $3,000 
by one employer and in the amount of $2,000 by another employer. Section 
6413(c) (as amended by section 202 of the Social Security Amendments of 
1954 (68 Stat. 1089)), permits, under certain conditions, a so-called 
``special refund'' of the amount of employee social security tax 
deducted and withheld with respect to wages paid to an employee in a 
calendar year after 1954 in excess of $4,200 ($3,600 for the calendar 
year 1954) by reason of the employee receiving wages from more than one 
employer during the calendar year. For provisions relating to the 
imposition of the employee tax and the limitation on wages, see with 
respect to the calendar year 1954, sections 1400 and 1426(a)(1) of the 
Internal Revenue Code of 1939 and, with respect to calendar years after 
1954, sections 3101 and 3121(a)(1) of the Internal Revenue Code of 1954, 
as amended by sections 208(b) and 204(a), respectively, of the Social 
Security Amendments of 1954 (68 Stat. 1094, 1091).
    (2) An employee who is entitled to a special refund of employee tax 
with respect to wages received during a calendar year and who is also 
required to file an income tax return for such calendar year (or for his 
last taxable year beginning in such calendar year) may obtain the 
benefits of such special refund only by claiming credit for such special 
refund in the same manner as if such special refund were an amount 
deducted and withheld as income tax at the source. For provisions for 
claiming special refunds for 1955 and subsequent years in the case of 
employees not required to file income tax returns, see section 6413(c) 
and the regulations thereunder. For provisions relating to such refunds 
for 1954, see 26 CFR (1939) 408.802 (regulations 128).
    (3) The amount of the special refund allowed as a credit shall be 
considered as an amount deducted and withheld as income tax at the 
source under chapter 24 of the Internal Revenue Code of 1954 (or, in the 
case of a special refund for 1954, subchapter D, chapter 9 of the 
Internal Revenue Code of 1939). If the amount of such special refund 
when added to amounts deducted and withheld as income tax exceeds the 
taxes imposed by subtitle A of the Internal Revenue Code of 1954, the 
amount of the excess constitutes an overpayment of income tax under 
Subtitle A, and interest on such overpayment is allowed to the extent 
provided under section 6611 upon an overpayment of income tax resulting 
from a credit for income

[[Page 110]]

tax withheld at source. See section 6401(b).
    (b) Federal and State employees and employees of certain foreign 
corporations. The provisions of this section shall apply to the amount 
of a special refund allowable to an employee of a Federal agency or a 
wholly owned instrumentality of the United States, to the amount of a 
special refund allowable to an employee of any State or political 
subdivision thereof (or any instrumentality of any one or more of the 
foregoing), and to the amount of a special refund allowable to employees 
of certain foreign corporations. See, with respect to such special 
refunds for 1954, section 1401(d)(4) of the Internal Revenue Code of 
1939, and with respect to such special refunds for 1955 and subsequent 
years, section 6413(c)(2) of the Internal Revenue Code of 1954, as 
amended by section 202 of the Social Security amendments of 1954.



Sec. 1.32-2  Earned income credit for taxable years beginning after December 

31, 1978.

    (a) [Reserved]
    (b) Limitations. (1) [Reserved]
    (2) Married individuals. No credit is allowed by section 32 in the 
case of an eligible individual who is married (within the meaning of 
section 7703 and the regulations thereunder) unless the individual and 
spouse file a single return jointly (a joint return) for the taxable 
year (see section 6013 and the regulations thereunder relating to joint 
returns of income tax by husband and wife). The requirements of the 
preceding sentence do not apply to an eligible individual who is not 
considered as married under section 7703(b) and the regulations 
thereunder (relating to certain married individuals living apart).
    (3) Length of taxable year. No credit is allowed by section 32 in 
the case of a taxable year covering a period of less than 12 months. 
However, the rule of the preceding sentence does not apply to a taxable 
year closed by reason of the death of the eligible individual.
    (c) Definitions. (1) [Reserved]
    (2) Earned income. For purposes of this section, earned income is 
computed without regard to any community property laws which may 
otherwise be applicable. Earned income is reduced by any net loss in 
earnings from self-employment. Earned income does not include amounts 
received as a pension, an annuity, unemployment compensation, or 
workmen's compensation, or an amount to which section 871(a) and the 
regulations thereunder apply (relating to income of nonresident alien 
individuals not connected with United States business).
    (d) [Reserved]
    (e) Coordination of credit with advance payments--(1) Recapture of 
excess advance payments. If any advance payment of earned income credit 
under section 3507 is made to an individual by an employer during any 
calendar year, then the total amount of these advance payments to the 
individual in that calendar year is treated as an additional amount of 
tax imposed (by chapter 1 of the Code) upon the individual on the tax 
return for the individual's last taxable year beginning in that calendar 
year.
    (2) Reconciliation of payments advanced and credit allowed. Any 
additional amount of tax under paragraph (e)(1) of this section is not 
treated as a tax imposed by chapter 1 of the Internal Revenue Code for 
purposes of determining the amount of any credit (other than the earned 
income credit) allowable under part IV, subchapter A, chapter 1 of the 
Internal Revenue Code.

[T.D. 7683, 45 FR 16175, Mar. 13, 1980. Redesignated by T.D. 8448, 57 FR 
54923, Nov. 23, 1992; T.D. 9045, 68 FR 10656, Mar. 6, 2003]



Sec. 1.32-3  Eligibility requirements after denial of the earned income 

credit.

    (a) In general. A taxpayer who has been denied the earned income 
credit (EIC), in whole or in part, as a result of the deficiency 
procedures under subchapter B of chapter 63 (deficiency procedures) is 
ineligible to file a return claiming the EIC subsequent to the denial 
until the taxpayer demonstrates eligibility for the EIC in accordance 
with paragraph (c) of this section. If a taxpayer demonstrates 
eligibility for a taxable year in accordance with paragraph (c) of this 
section, the taxpayer need not comply with those requirements for any 
subsequent taxable year unless the Service again denies the EIC as a 
result of the deficiency procedures.

[[Page 111]]

    (b) Denial of the EIC as a result of the deficiency procedures. For 
purposes of this section, denial of the EIC as a result of the 
deficiency procedures occurs when a tax on account of the EIC is 
assessed as a deficiency (other than as a mathematical or clerical error 
under section 6213(b)(1)).
    (c) Demonstration of eligibility. In the case of a taxpayer to whom 
paragraph (a) of this section applies, and except as otherwise provided 
by the Commissioner in the instructions for Form 8862, ``Information To 
Claim Earned Income Credit After Disallowance,'' no claim for the EIC 
filed subsequent to the denial is allowed unless the taxpayer properly 
completes Form 8862, demonstrating eligibility for the EIC, and 
otherwise is eligible for the EIC. If any item of information on Form 
8862 is incorrect or inconsistent with any item on the return, the 
taxpayer will be treated as not demonstrating eligibility for the EIC. 
The taxpayer must follow the instructions for Form 8862 to determine the 
income tax return to which Form 8862 must be attached. If the taxpayer 
attaches Form 8862 to an incorrect tax return, the taxpayer will not be 
relieved of the requirement that the taxpayer attach Form 8862 to the 
correct tax return and will, therefore, not be treated as meeting the 
taxpayer's obligation under paragraph (a) of this section.
    (d) Failure to demonstrate eligibility. If a taxpayer to whom 
paragraph (a) of this section applies fails to satisfy the requirements 
of paragraph (c) of this section with respect to a particular taxable 
year, the IRS can deny the EIC as a mathematical or clerical error under 
section 6213(g)(2)(K).
    (e) Special rule where one spouse denied EIC. The eligibility 
requirements set forth in this section apply to taxpayers filing a joint 
return where one spouse was denied the EIC for a taxable year prior to 
marriage and has not established eligibility as either an unmarried or 
married taxpayer for a subsequent taxable year.
    (f) Effective date. This section applies to returns claiming the EIC 
for taxable years beginning after December 31, 1997, where the EIC was 
denied for a taxable year beginning after December 31, 1996.

[T.D. 8953, 66 FR 33637, June 25, 2001]



Sec. 1.34-1  Special rule for owners of certain business entities.

    Amounts payable under sections 6420, 6421, and 6427 to a business 
entity that is treated as separate from its owner under Sec. 1.1361-
4(a)(8) (relating to certain qualified subchapter S subsidiaries) or 
Sec. 301.7701-2(c)(2)(v) of this chapter (relating to certain wholly-
owned entities) are, for purposes of section 34, treated as payable to 
the owner of that entity.

[T.D. 9356, 72 FR 45893, Aug. 16, 2007]



Sec. 1.35-1  Partially tax-exempt interest received by individuals.

    (a) The credit against tax under section 35 shall be allowed only to 
individuals and if the requirements of both paragraphs (1) and (2) of 
section 35(a) are met. Where the alternative tax on capital gains is 
imposed under section 1201(b), the taxable income for such taxable year 
is the taxable income as defined in section 63, which includes 50 
percent of the excess of net long-term capital gain over net short-term 
capital loss.
    (b) For the treatment of partially tax-exempt interest in the case 
of amounts not allocable to any beneficiary of an estate or trust, see 
section 642(a)(1), and for treatment of amounts allocable to a 
beneficiary, see sections 652 and 662. For treatment of partially tax-
exempt interest received by a partnership, see section 702(a)(7). For 
treatment of such interest received by a common trust fund, see section 
584(c)(2).
    (c) The application of section 35 may be illustrated by the 
following example:

    Example. In his taxable year, 1955, A received $4,500 of partially 
tax-exempt interest. A's taxable income is $4,000 upon which the tax 
prior to any credits against tax is $840. His foreign tax credit under 
section 33 is $610, and his dividends received credit under section 34 
is $120. A's credit under section 35 for partially tax-exempt interest 
is $110, determined as follows:

                              Section 35(a)
 
Partially tax-exempt interest................................     $4,500

[[Page 112]]

 
Credit computed under section 35(a); 3 percent of $4,500.....        135
                            Section 35(b)(1)
Tax imposed by chapter 1.....................................        840
Less:
  Credit allowed under section 33.................       $610
  Credit allowed under section 34.................        120
                                                     --------       $730
                                                              ----------
Limitation on credit under section 35(b)(1)..................        110
 
                            Section 35(b)(2)
 
Taxable income...............................................      4,000
Limitation on credit under section 35(b)(2); 3 percent of            120
 $4,000......................................................
 


Since of the three figures ($135, $110, and $120), the lesser is $110, 
A's credit under section 35 is limited to $110.



Sec. 1.35-2  Taxpayers not entitled to credit.

    For taxable years beginning after December 31, 1957, no credit shall 
be allowed under section 35 to a nonresident alien individual with 
respect to whom a tax is imposed for such taxable year under section 
871(a).



Sec. 1.37-1  General rules for the credit for the elderly.

    (a) In general. In the case of an individual, section 37 provides a 
credit against the tax imposed by chapter 1 of the Internal Revenue Code 
of 1954. This section and Sec. Sec. 1.37-2 and 1.37-3 provide guidance 
in the computation of the credit for the elderly provided under section 
37 for taxable years beginning after 1975. For rules relating to the 
computation of the retirement income credit provided under section 37 
for taxable years beginning before 1976, see 26 CFR 1.37-1 through 1.37-
5 (Rev. as of April 1, 1980). Note that section 403 of the Tax Reduction 
and Simplification Act of 1977 provides that a taxpayer may elect to 
compute the credit under section 37 for the taxpayer's first taxable 
year beginning in 1976 in accordance with the rules applicable to 
taxable years beginning before 1976.
    (b) Limitation on the amount of the credit. The credit allowed by 
section 37 for a taxable year shall not exceed the tax imposed by 
chapter 1 of the Code for the taxable year (reduced, in the case of a 
taxable year beginning before 1979, by the general tax credit allowed by 
section 42).
    (c) Married couples must file joint returns. If the taxpayer is 
married at the close of the taxable year, the credit provided by section 
37 shall be allowed only if the taxpayer and the taxpayer's spouse file 
a joint return for the taxable year. The preceding sentence shall not 
apply in the case of a husband and wife who are not members of the same 
household at any time during the taxable year. For the determination of 
marital status, see Sec. Sec. 143 and 1.143-1.
    (d) Nonresident aliens ineligible. No credit is allowed under 
section 37 to any individual for any taxable year during which that 
individual is at any time a nonresident alien unless the individual is 
treated, by reason of an election under section 6013 (g) or (h), as a 
resident of the United States for that taxable year.

[T.D. 7743, 45 FR 84049, Dec. 22, 1980]



Sec. 1.37-2  Credit for individuals age 65 or over.

    (a) In general. This section illustrates the computation of the 
credit for the elderly in the case of an individual who has attained the 
age of 65 before the close of the taxable year. This section shall not 
apply to an individual for any taxable year for which the individual 
makes the election described in section 37(e)(2) and paragraph (b) of 
Sec. 1.37-3.
    (b) Computation of credit. The credit for the elderly for an 
individual to whom this section applies equals 15 percent of the 
individual's ``section 37 amount'' for the taxable year. An individual's 
``section 37 amount'' for a taxable year is the initial amount 
determined under section 37(b)(2), reduced as provided in section 
37(b)(3) and (c)(1).
    (c) Examples. The computation of the credit for the elderly for 
individuals to whom this section applies may be illustrated by the 
following examples:

    Example 1. A, a single individual who is 67 years old, has adjusted 
gross income of $8,000 for the calendar year 1977. A also receives 
social security payments of $1,450 during 1977. A does not itemize 
deductions. A's credit for the elderly is $120, computed as follows:

Initial amount under section 37(b)(2).........................    $2,500
Reductions required by section 37 (b)(3) and (c)(1):
    Social security payments........................    $1,450
    One-half the excess of adjusted gross income           250     1,700
     over $7,500....................................
                                                     ----------
Section 37 amount.............................................       800
                                                               =========
15 pct. of $800...............................................      $120
 


[[Page 113]]


A's tax from the tax tables, which reflect the allowance of the general 
tax credit, is $662. Accordingly, the limitation of section 37(c)(2) and 
paragraph (b) of Sec. 1.37-1 does not reduce A's credit for the 
elderly.
    Example 2. H and W, who have both attained the age of 65, file a 
joint return for calendar year 1977. For that year H and W have adjusted 
gross income of $8,120; H also receives a railroad retirement pension of 
$1,550, and W receives social security payments of $1,200. H and W do 
not itemize deductions. The credit for the elderly allowed to H and W 
for 1977 is $139, computed as follows:

Initial amount under section 37(b)(2).........................    $3,750
Reductions required by section 37 (b)(3):
    Railroad retirement pension.....................    $1,550
    Social Security payments........................     1,200     2,750
                                                     ----------
Section 37 amount.............................................     1,000
                                                               =========
15 pct. of $1,000.............................................       150
Limitation based upon amount of tax (derived from table             $139
 reflecting allowance of general tax credit)..................
 


Since the adjusted gross income of H and W is not greater than $10,000, 
no reduction of the initial amount is required under section 37 (c)(1).

[T.D. 7743, 45 FR 84050, Dec. 22, 1980]



Sec. 1.37-3  Credit for individuals under age 65 who have public retirement 

system income.

    (a) In general. This section provides rules for the computation of 
the credit for the elderly under section 37(e) in the case of an 
individual who has not attained the age of 65 before the close of the 
taxable year and whose gross income for the taxable year includes 
retirement income within the meaning of paragraph (d)(1)(ii) of this 
section (i.e., under a public retirement system). If such an individual 
is married within the meaning of section 143 at the close of the taxable 
year and the spouse of the individual has attained the age of 65 before 
the close of the taxable year, this section shall apply to the 
individual for the taxable year only if both spouses make the election 
described in paragraph (b) of this section. If both spouses make the 
election described in paragraph (b) of this section for the taxable 
year, the credit of each spouse shall be determined under the rules of 
this section. See paragraph (f)(2) of this section for a limitation on 
the effects of community property laws in making determinations and 
computations under section 37(e) and this section.
    (b) Election by certain married taxpayers. If a married individual 
under age 65 at the close of the taxable year has retirement income and 
the spouse of that individual has attained the age of 65 before the 
close of the taxable year, both spouses may elect to compute the credit 
provided by section 37 under the rules of section 37(e) and this 
section. The spouses shall signify the election on the return (or 
amended return) for the taxable year in the manner prescribed in the 
instructions accompanying the return. The election may be made at any 
time before the expiration of the period of limitation for filing claim 
for credit or return for the taxable year. The election may be revoked 
without the consent of the Commissioner at any time before the 
expiration of that period by filing an amended return.
    (c) Computation of credit. The credit of an individual under section 
37(e) and this section equals 15 percent of the individual's credit base 
for the taxable year. The credit base of an individual for a taxable 
year is the lesser of--
    (1) The retirement income of the individual for the taxable year, or
    (2) The amount determined under section 37(e)(5), as modified by 
section 37(e) (6) and (7).
    (d) Retirement income--(1) General rule--(i) For individuals 65 or 
over. Section 37(e)(4)(A) enumerates the kinds of income which may be 
treated as the retirement income of an individual who has attained the 
age of 65 before the close of the taxable year. They include income from 
pensions and annuities, interest, rents, dividends, certain bonds 
received under a qualified bond purchase plan, and certain individual 
retirement accounts or annuities.
    (ii) For individuals under 65. In the case of an individual who has 
not attained the age of 65 before the close of the taxable year, 
retirement income consists only of income from pensions and annuities 
(including disability annuity payments) under a public retirement system 
which arises from services performed by that individual or by a present 
or former spouse of that individual. The term ``public retirement 
system'' means a pension, annuity, or retirement, or similar fund or 
system established by the United States, a

[[Page 114]]

State, a possession of the United States, any political subdivision of 
any of the foregoing, or the District of Columbia.
    (2) Rents. For purposes of section 37(e)(4)(A)(iii), income from 
rents shall be the gross amount received, not reduced by depreciation or 
other expenses, except that beneficiaries of a trust or estate shall 
treat as retirement income only their proportionate shares, of the 
taxable rents of the trust or estate. In the case of an amount received 
for board and lodging, only the portion of the amount received for 
lodging is income from rents.
    (3) Disability annuity payments received by individual under age 65. 
Disability annuity payments received under a public retirement system by 
an individual under age 65 at the close of the taxable year shall not be 
treated as retirement income unless the payments are for periods after 
the date on which the individual reached minimum retirement age, that 
is, the age at which the individual would be eligible to receive a 
pension or annuity without regard to disability, and any of the 
following conditions is satisfied--
    (i) The individual is precluded from seeking the benefits of section 
105(d) (relating to certain disability payments) for that taxable year 
by reason of an irrevocable election;
    (ii) The individual was not permanently and totally disabled at the 
time of retirement (and was not permanently and totally disabled either 
on January 1, 1976, or on January 1, 1977, if the individual retired 
before the later date on disability or under circumstances which 
entitled the individual to retire on disability); or
    (iii) The payments are for periods after the individual reached 
mandatory retirement age.

For purposes of this paragraph, disability annuity payments include 
payments to an individual who retired on partial or temporary 
disability.
    (4) Compensation of personal services rendered during taxable year. 
Retirement income does not include any amount representing compensation 
for personal services rendered during the taxable year. For this 
purpose, amounts received as a pension shall not be treated as 
representing compensation for personal services rendered during the 
taxable year if the period of service during the taxable year is not 
substantial when compared with the total years of service. For example, 
an individual on the calendar year basis retires on November 30 after 5 
years of service and receives a pension during the remainder of his 
taxable year. The pension is not treated as representing compensation 
for personal services rendered during such taxable year merely because 
it is paid by reason of the services of the individual for a period of 5 
years which includes a portion of the taxable year.
    (5) Amounts not includible in gross income. Retirement income does 
not include any amount not includible in the gross income of the 
individual for the taxable year. For example, if a portion of an annuity 
is excluded from gross income under section 72, relating to annuities, 
that portion of the annuity is not retirement income; similarly, the 
portion of dividend income excluded from gross income under section 116, 
relating to the partial exclusion of dividends received by individuals 
is not retirement income.
    (e) Earned income--(1) In general. The term ``earned income'' in 
section 37(e)(5)(B) generally has the same meaning as in section 911(b), 
except that earned income does not include any amount received as a 
pension or annuity. See section 911(b) and the regulations thereunder. 
Section 911(b) provides, in general, that earned income includes wages, 
salaries, professional fees, and other amounts received as compensation 
for personal services rendered.
    (2) Earned income from self-employment. For purposes of section 
37(e)(5)(B), the earned income of a taxpayer from self-employment in a 
trade or business shall not exceed--
    (i) The taxpayer's share of the net profits from the trade or 
business if capital is not a material income-producing factor in that 
trade or business; or
    (ii) Thirty percent of the taxpayer's share of the net profits from 
the trade or business if capital is a material income-producing factor 
in that trade or business.

[[Page 115]]


For other rules relating to the determination of earned income from 
self-employment in a trade or business, see section 911(b) and the 
regulations thereunder.
    (3) Disability annuity payments received by individuals under age 
65. Disability annuity payments received under a public retirement 
system by an individual under age 65 at the close of the taxable year 
shall be treated as earned income for purposes of section 37(e)(5)(B) 
unless the payments are treated as retirement income under paragraph 
(d)(3) of this section.
    (f) Computation of credit under section 37(e) in the case of joint 
returns--(1) In general. In the case of a joint return of husband and 
wife, the credit base of each spouse under section 37(e) is computed 
separately. The spouses then combine their credit bases and compute a 
single credit. The limitation in section 37(c)(2) and paragraph (b) of 
Sec. 1.37-1 on the amount of the credit is determined by reference to 
the joint tax liability of the spouses. Thus, regardless of whether a 
spouse would be liable for the tax imposed by chapter 1 of the Code if 
the joint return had not been filed, the credit base of that spouse is 
taken into account in computing the credit.
    (2) Community property laws. For taxable years beginning after 1977, 
married individuals filing joint returns shall disregard community 
property laws in making any determination or computation required under 
section 37(e) or this section. Each item of income is attributed in full 
to the spouse whose income it would have been in the absence of 
community property laws. Thus, if a 67-year old individual files a joint 
return with a 62-year old spouse for 1979 and the only income of the 
couple is from a public pension of the older spouse, that public pension 
is attributed in full to the older spouse for purposes of section 37(e) 
even though the applicable community property law may treat one-half of 
the pension as the income of the 62-year old spouse. Since the younger 
spouse consequently has no retirement income within the meaning of 
paragraph (d) of this section, the couple may not make the election 
described in paragraph (b) of this section.
    (g) Examples. The computation of the credit for the elderly under 
section 37(e) and this section is illustrated by the following examples:

    Example 1. B, who is 62 years old and single, receives a fully 
taxable pension of $2,400 from a public retirement system during 1977. B 
performed the services giving rise to the pension. During that year, B 
also earns $2,650 from a part-time job. B receives no tax-exempt pension 
or annuity in 1977. Subject to the limitation of section 37(c)(2) and 
paragraph (b) of Sec. 1.37-1, B's credit for the elderly for 1977 under 
section 37(e) is $195, computed as follows:

Maximum retirement income level under section 37(e)(5)......      $2,500
Earned income offset under section
 37(e)(5)(B)(ii):
    Earned income in excess of $1,700...........        $950
    One-half of earned income in excess of               250       1,200
     $1,200, but not in excess of $1,700........
                                                 ------------
Amount determined under section 37(e)(5)....................       1,300
                                                             ===========
Retirement income...........................................       2,400
                                                             ===========
Credit for the elderly (15 pct. of $1,300)..................         195
 

    Example 2. During 1978 H, who is 67 years old, has earnings of 
$1,300 and retirement income (rents, interest, etc.) of $6,000. H also 
receives social security payments totalling $1,400. During 1978 W, who 
is 63 years old, earns $1,600 and receives a fully taxable pension of 
$1,400 from a public retirement system that constitutes retirement 
income. W performed the services giving rise to the pension. H and W 
file a joint return for 1978 and elect to compute the credit for the 
elderly under section 37(e). Under the applicable law these items of 
income are community income, and both spouses share equally in each 
item. Because H and W are filing a joint return, they disregard 
community property laws in computing their credit under section 37(e). 
The couple allocates $1,600 of the $3,750 referred to in section 
37(e)(6) to W and $2,150 to H. Subject to the limitation of section 
37(c)(2) and paragraph (b) of Sec. 1.37-1, their credit for the elderly 
is $315, computed as follows:

Credit base of H:
  Amount allocated to H under section 37(e)(6)..............      $2,150
  Reductions required by section 37(e)(5):
      Social Security payments..................      $1,400
      One-half of excess of earnings over $1,200          50       1,450
                                                 ------------
  Amount determined under section 37(e)(5)..................         700
                                                             ===========
  Retirement income.........................................       6,000
                                                             ===========

[[Page 116]]

 
  Credit base of H..........................................         700
Credit base of W:
  Amount allocated to W under section 37(e)(6)..............      $1,600
  Reduction required by section 37(e)(5)(B):
      One-half of excess of earnings over $1,200............        $200
                                                             -----------
      Amount determined under section 37(e)(5)..............       1,400
                                                             ===========
  Retirement income.........................................       1,400
                                                             ===========
  Credit base of W..........................................       1,400
                                                             ===========
  Computation of credit:
      Credit base of H......................................         700
      Credit base of W......................................       1,400
                                                             -----------
      Combined credit base..................................       2,100
                                                             ===========
  Credit for the elderly (15 pct. of $2,100)................         315
 

    Example 3. (a) Assume the same facts as in example (2) of this 
paragraph, except that H and W live apart at all times during 1978 and 
file separate returns. Under these circumstances, H and W must give 
effect to the applicable community property law in determining their 
credits under section 37(e). Thus, each spouse must take into account 
one-half of each item of income.
    (b) Subject to the limitation of section 37(c)(2) and paragraph (b) 
of Sec. 1.37-1, H's credit for the elderly is $157.50, computed as 
follows:

Maximum retirement income level under section 37(e)(7)......      $1,875
Reductions required by section 37(e)(5):
    Social security payments....................        $700
    One-half of excess of earnings over $1,200           125         825
     (taking into account one-half of combined
     earnings of $2,900)........................
                                                 ------------
Amount determined under section 37(e)(5)....................       1,050
                                                             ===========
Retirement income...........................................       3,700
                                                             ===========
Credit of H (15 pct. of $1,050).............................      157.50
 

    (c) Subject to the limitation of section 37(c)(2) and paragraph (b) 
of Sec. 1.37-1, W's credit for the elderly is computed as follows:

Maximum retirement income level under section         $1,875
 37(e)(7).......................................
Reductions required by section 37(e)(5):
    Social security payments....................        $700
    One-half of excess of earnings over $1,200..         125         825
                                                 ------------
Amount determined under section 37(e)(5)........       1,050
                                                 =============
Retirement income (limited to W's share of               700
 public pension)................................
                                                 =============
Credit of W (15 pct. of $700)...................         105
 


[T.D. 7743, 45 FR 84050, Dec. 22, 1980]



Sec. 1.38-1  Investment in certain depreciable property.

    Regulations under sections 46 through 50 are prescribed under the 
authority granted the Secretary by section 38(b) to prescribe 
regulations as may be necessary to carry out the purposes of section 38 
and subpart B, part IV, subchapter A, chapter 1 of the Code.

[44 FR 20417, Apr. 5, 1979]



Sec. 1.40-1  Questions and answers relating to the meaning of the term 

``qualified mixture'' in section 40(b)(1).

    Q-1. What is a ``qualified mixture'' within the meaning of section 
40(b)(1)?
    A-1. A ``qualified mixture'' is a mixture of alcohol and gasoline or 
of alcohol and special fuel which (1) is sold by the taxpayer producing 
such mixture to any person for use as a fuel, or (2) is used as a fuel 
by the taxpayer producing such mixture.
    Q-2. Must alcohol be present in a product in order for that product 
to be considered a mixture of alcohol and either gasoline or a special 
fuel?
    A-2. No. A product is considered to be a mixture of alcohol and 
gasoline or of alcohol and a special fuel if the product is derived from 
alcohol and either gasoline or a special fuel even if the alcohol is 
chemically transformed in producing the product so that the alcohol is 
no longer present as a separate chemical in the final product, provided 
that there is no significant loss in the energy content of the alcohol. 
Thus, a product may be considered to be ``mixture of alcohol and 
gasoline or of alcohol and a special fuel'' within the meaning of 
section 40(b)(1)(B) if such product is produced in a chemical reaction 
between alcohol and either gasoline or a special fuel. Similarly a 
product may be considered to be a ``mixture of alcohol and gasoline or 
of alcohol and a special fuel'' if such product is produced by blending 
a chemical compound derived from alcohol with either gasoline or a 
special fuel.
    Thus, for example, a blend of gasoline and ethyl tertiary butyl 
ether (ETBE), a compound derived from ethanol (a qualified alcohol), in 
a chemical reaction in which there is no significant

[[Page 117]]

loss in the energy content of the ethanol, is considered for purposes of 
section 40(b)(1)(B) to be a mixture of gasoline and the ethanol used to 
produce the ETBE, even though the ethanol is chemically transformed in 
the production of ETBE and is not present in the final product.

[T.D. 8291, 55 FR 8948, Mar. 9, 1990]



Sec. 1.41-0  Table of contents.

    This section lists the table of contents for Sec. Sec. 1.41-1 
through 1.41-9.

         Sec. 1.41-1 Credit for increasing research activities.

    (a) Amount of credit.
    (b) Introduction to regulations under section 41.

                Sec. 1.41-2 Qualified research expenses.

    (a) Trade or business requirement.
    (1) In general.
    (2) New business.
    (3) Research performed for others.
    (i) Taxpayer not entitled to results.
    (ii) Taxpayer entitled to results.
    (4) Partnerships.
    (i) In general.
    (ii) Special rule for certain partnerships and joint ventures.
    (b) Supplies and personal property used in the conduct of qualified 
research.
    (1) In general.
    (2) Certain utility charges.
    (i) In general.
    (ii) Extraordinary expenditures.
    (3) Right to use personal property.
    (4) Use of personal property in taxable years beginning after 
December 31, 1985.
    (c) Qualified services.
    (1) Engaging in qualified research.
    (2) Direct supervision.
    (3) Direct support.
    (d) Wages paid for qualified services.
    (1) In general.
    (2) ``Substantially all.''
    (e) Contract research expenses.
    (1) In general.
    (2) Performance of qualified research.
    (3) ``On behalf of.''
    (4) Prepaid amounts.
    (5) Examples.

Sec. 1.41-3 Base amount for taxable years beginning on or after January 
                                3, 2001.

    (a) New taxpayers.
    (b) Special rules for short taxable years.
    (1) Short credit year.
    (2) Short taxable year preceding credit year.
    (3) Short taxable year in determining fixed-base percentage.
    (c) Definition of gross receipts.
    (1) In general.
    (2) Amounts excluded.
    (3) Foreign corporations.
    (d) Consistency requirement.
    (1) In general.
    (2) Illustrations.
    (e) Effective date.

  Sec. 1.41-4 Qualified research for expenditures paid or incurred in 
           taxable years ending on or after December 31, 2003.

    (a) Qualified research.
    (1) General rule.
    (2) Requirements of section 41(d)(1).
    (3) Undertaken for the purpose of discovering information.
    (i) In general.
    (ii) Application of the discovering information requirement.
    (iii) Patent safe harbor.
    (4) Technological in nature.
    (5) Process of experimentation.
    (i) In general.
    (ii) Qualified purpose.
    (6) Substantially all requirement.
    (7) Use of computers and information technology.
    (8) Illustrations.
    (b) Application of requirements for qualified research.
    (1) In general.
    (2) Shrinking-back rule.
    (3) Illustration.
    (c) Excluded activities.
    (1) In general.
    (2) Research after commercial production.
    (i) In general.
    (ii) Certain additional activities related to the business 
component.
    (iii) Activities related to production process or technique.
    (iv) Clinical testing.
    (3) Adaptation of existing business components.
    (4) Duplication of existing business component.
    (5) Surveys, studies, research relating to management functions, 
etc.
    (6) Internal use software for taxable years beginning on or after 
December 31, 1985. [Reserved].
    (7) Activities outside the United States, Puerto Rico, and other 
possessions.
    (i) In general.
    (ii) Apportionment of in-house research expenses.
    (iii) Apportionment of contract research expenses.
    (8) Research in the social sciences, etc.
    (9) Research funded by any grant, contract, or otherwise.
    (10) Illustrations.
    (d) Recordkeeping for the research credit.
    (e) Effective dates.

[[Page 118]]

 Sec. 1.41-5 Basic research for taxable years beginning after December 
                          31, 1986. [Reserved]

                Sec. 1.41-6 Aggregation of expenditures.

    (a) Controlled groups of corporations; trades or businesses under 
common control.
    (1) In general.
    (2) Consolidated groups.
    (3) Definitions.
    (b) Computation of the group credit.
    (1) In general.
    (2) Start-up companies.
    (c) Allocation of the group credit.
    (1) In general.
    (2) Stand-alone entity credit.
    (d) Special rules for consolidated groups.
    (1) In general.
    (2) Start-up company status.
    (3) Special rule for allocation of group credit among consolidated 
group members.
    (e) Examples.
    (f) For taxable years beginning before January 1, 1990.
    (g) Tax accounting periods used.
    (1) In general.
    (2) Special rule when timing of research is manipulated.
    (h) Membership during taxable year in more than one group.
    (i) Intra-group transactions.
    (1) In general.
    (2) In-house research expenses.
    (3) Contract research expenses.
    (4) Lease payments.
    (5) Payment for supplies.
    (j) Effective/applicability date.
    (1) In general.
    (2) Consolidated group rule.
    (3) Taxable years ending on or before December 31, 2006.

                       Sec. 1.41-7 Special rules.

    (a) Allocations.
    (1) Corporation making an election under subchapter S.
    (i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation.
    (2) Pass-through in the case of an estate or trust.
    (3) Pass-through in the case of a partnership.
    (i) In general.
    (ii) Certain expenditures by joint ventures.
    (4) Year in which taken into account.
    (5) Credit allowed subject to limitation.
    (b) Adjustments for certain acquisitions and dispositions--Meaning 
of terms.
    (c) Special rule for pass-through of credit.
    (d) Carryback and carryover of unused credits.

              Sec. 1.41-8 Alternative incremental credit.

    (a) Determination of credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (5) Effective/applicability dates.

               Sec. 1.41-9 Alternative simplified credit.

    [Reserved] For further guidance, see the entries for Sec. 1.41-9T 
in Sec. 1.41-0T.

[T.D. 8930, 65 FR 287, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, 
Jan. 2, 2004; T.D. 9205, 70 FR 29601, May 24, 2005; T.D. 9296, 71 FR 
65725, Nov. 9, 2006; T.D. 9401, 73 FR 34187, June 17, 2008]



Sec. 1.41-0T  Table of contents (temporary).

    This section lists the table of contents for Sec. Sec. 1.41-6T, 
1.41-8T, and 1.41-9T.

         Sec. 1.41-6T Aggregation of expenditures (temporary).

    (a) [Reserved] For further guidance, see the entry for Sec. 1.41-
6(a) in Sec. 1.41-0.
    (b) Computation of the group credit.
    (1) In general.
    (2) [Reserved] For further guidance, see the entry for Sec. 1.41-
6(b)(2) in Sec. 1.41-0.
    (c) Allocation of the group credit.
    (1) [Reserved] For further guidance, see the entry for Sec. 1.41-
6(c)(1) in Sec. 1.41-0.
    (2) Stand-alone entity credit.
    (d) [Reserved] For further guidance, see the entry for Sec. 1.41-
6(d) in Sec. 1.41-0.
    (e) Example.
    (f) through (i) [Reserved] For further guidance, see the entries for 
Sec. 1.41-6(f) through (i) in Sec. 1.41-0.
    (j) Effective/applicability dates.

        Sec. 1.41-8T Alternative incremental credit (temporary).

    (a) [Reserved] For further guidance, see the entry for Sec. 1.41-
8(a) in Sec. 1.41-0.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (i) In general.
    (ii) Designated member.
    (5) Effective/applicability dates.

        Sec. 1.41-9T Alternative simplified credit (temporary).

    (a) Determination of credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (i) In general.
    (ii) Designated member.
    (c) Special rules.

[[Page 119]]

    (d) Effective/applicability dates.
    (e) Expiration date.

[T.D. 9401, 73 FR 34187, June 17, 2008]



Sec. 1.41-1  Credit for increasing research activities.

    (a) Amount of credit. The amount of a taxpayer's credit is 
determined under section 41(a). For taxable years beginning after June 
30, 1996, and at the election of the taxpayer, the portion of the credit 
determined under section 41(a)(1) may be calculated using the 
alternative incremental credit set forth in section 41(c)(4). For 
taxable years ending after December 31, 2006, and at the election of the 
taxpayer, the portion of the credit determined under section 41(a)(1) 
may be calculated using either the alternative incremental credit set 
forth in section 41(c)(4), or the alternative simplified credit set 
forth in section 41(c)(5).
    (b) Introduction to regulations under section 41. (1) Sections 1.41-
2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain 
provisions of section 41. The following table identifies the provisions 
of section 41 that are addressed, and lists each provision with the 
section of the regulations in which it is covered.

------------------------------------------------------------------------
                                               Section of the Internal
         Section of the regulation                  Revenue Code
------------------------------------------------------------------------
Sec.  1.41-2.............................  41(b).
Sec.  1.41-3.............................  41(c).
Sec.  1.41-4.............................  41(d).
Sec.  1.41-5.............................  41(e).
Sec.  1.41-6.............................  41(f).
Sec.  1.41-7.............................  41(f).
                                            41(g).
Sec.  1.41-8.............................  41(c).
Sec.  1.41-3A............................  41(c) (taxable years
                                             beginning before January 1,
                                             1990).
Sec.  1.41-4A............................  41(d) (taxable years
                                             beginning before January 1,
                                             1986).
Sec.  1.41-5A............................  41(e) (taxable years
                                             beginning before January 1,
                                             1987).
------------------------------------------------------------------------

    (2) Section 1.41-3A also addresses the special rule in section 
221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable 
years overlapping the effective dates of section 41. Section 41 was 
formerly designated as sections 30 and 44F. Sections 1.41-0 through 
1.41-8 and 1.41-0A through 1.41-5A refer to these sections as section 41 
for conformity purposes. Whether section 41, former section 30, or 
former section 44F applies to a particular expenditure depends upon when 
the expenditure was paid or incurred.

[T.D. 8930, 65 FR 288, Jan. 3, 2001, as amended by T.D. 9401, 73 FR 
34187, June 17, 2008]



Sec. 1.41-2  Qualified research expenses.

    (a) Trade or business requirement--(1) In general. An in-house 
research expense of the taxpayer or a contract research expense of the 
taxpayer is a qualified research expense only if the expense is paid or 
incurred by the taxpayer in carrying on a trade or business of the 
taxpayer. The phrase ``in carrying on a trade or business'' has the same 
meaning for purposes of section 41(b)(1) as it has for purposes of 
section 162; thus, expenses paid or incurred in connection with a trade 
or business within the meaning of section 174(a) (relating to the 
deduction for research and experimental expenses) are not necessarily 
paid or incurred in carrying on a trade or business for purposes of 
section 41. A research expense must relate to a particular trade or 
business being carried on by the taxpayer at the time the expense is 
paid or incurred in order to be a qualified research expense. For 
purposes of section 41, a contract research expense of the taxpayer is 
not a qualified research expense if the product or result of the 
research is intended to be transferred to another in return for license 
or royalty payments and the taxpayer does not use the product of the 
research in the taxpayer's trade or business.
    (2) New business. Expenses paid or incurred prior to commencing a 
new business (as distinguished from expanding an existing business) may 
be paid or incurred in connection with a trade or business but are not 
paid or incurred in carrying on a trade or business. Thus, research 
expenses paid or incurred by a taxpayer in developing a product the sale 
of which would constitute a new trade or business for the taxpayer are 
not paid or incurred in carrying on a trade or business.
    (3) Research performed for others--(i) Taxpayer not entitled to 
results. If the taxpayer performs research on behalf of another person 
and retains no substantial rights in the research, that research shall 
not be taken into account

[[Page 120]]

by the taxpayer for purposes of section 41. See Sec. 1.41-4A(d)(2).
    (ii) Taxpayer entitled to results. If the taxpayer in carrying on a 
trade or business performs research on behalf of other persons but 
retains substantial rights in the research, the taxpayer shall take 
otherwise qualified expenses for that research into account for purposes 
of section 41 to the extent provided in Sec. 1.41-4A(d)(3).
    (4) Partnerships--(i) In general. An in-house research expense or a 
contract research expense paid or incurred by a partnership is a 
qualified research expense of the partnership if the expense is paid or 
incurred by the partnership in carrying on a trade or business of the 
partnership, determined at the partnership level without regard to the 
trade or business of any partner.
    (ii) Special rule for certain partnerships and joint ventures. (A) 
If a partnership or a joint venture (taxable as a partnership) is not 
carrying on the trade or business to which the research relates, then 
the general rule in paragraph (a)(4)(i) of this section would not allow 
any of such expenditures to qualify as qualified research expenses.
    (B) Notwithstanding paragraph (a)(4)(ii)(A) of this section, if all 
the partners or venturers are entitled to make independent use of the 
results of the research, this paragraph (a)(4)(ii) may allow a portion 
of such expenditures to be treated as qualified research expenditures by 
certain partners or venturers.
    (C) First, in order to determine the amount of credit that may be 
claimed by certain partners or venturers, the amount of qualified 
research expenditures of the partnership or joint venture is determined 
(assuming for this purpose that the partnership or joint venture is 
carrying on the trade or business to which the research relates).
    (D) Second, this amount is reduced by the proportionate share of 
such expenses allocable to those partners or venturers who would not be 
able to claim such expenses as qualified research expenditures if they 
had paid or incurred such expenses directly. For this purpose such 
partners' or venturers' proportionate share of such expenses shall be 
determined on the basis of such partners' or venturers' share of 
partnership items of income or gain (excluding gain allocated under 
section 704(c)) which results in the largest proportionate share. Where 
a partner's or venturer's share of partnership items of income or gain 
(excluding gain allocated under section 704(c)) may vary during the 
period such partner or venturer is a partner or venturer in such 
partnership or joint venture, such share shall be the highest share such 
partner or venturer may receive.
    (E) Third, the remaining amount of qualified research expenses is 
allocated among those partners or venturers who would have been entitled 
to claim a credit for such expenses if they had paid or incurred the 
research expenses in their own trade or business, in the relative 
proportions that such partners or venturers share deductions for 
expenses under section 174 for the taxable year that such expenses are 
paid or incurred.
    (F) For purposes of section 41, research expenditures to which this 
paragraph (a)(4)(ii) applies shall be treated as paid or incurred 
directly by such partners or venturers. See Sec. 1.41-7(a)(3)(ii) for 
special rules regarding these expenses.
    (iii) The following examples illustrate the application of the 
principles contained in paragraph (a)(4)(ii) of this section.

    Example 1. A joint venture (taxable as a partnership) is formed by 
corporations A, B, and C to develop and market a supercomputer. A and B 
are in the business of developing computers, and each has a 30 percent 
distributive share of each item of income, gain, loss, deduction, credit 
and basis of the joint venture. C, which is an investment banking firm, 
has a 40 percent distributive share of each item of income, gain, loss, 
deduction, credit and basis of the joint venture. The joint venture 
agreement provides that A's, B's and C's distributive shares will not 
vary during the life of the joint venture, liquidation proceeds are to 
be distributed in accordance with the partners' capital account 
balances, and any partner with a deficit in its capital account 
following the distribution of liquidation proceeds is required to 
restore the amount of such deficit to the joint venture. Assume in Year 
1 that the joint venture incurs $100x of ``qualified research 
expenses.'' Assume further that the joint venture cannot claim the 
research credit for such expenses because it is not carrying on the 
trade or business to which the research relates. In addition A, B, and C 
are

[[Page 121]]

all entitled to make independent use of the results of the research. 
First, the amount of qualified research expenses of the joint venture is 
$l00x. Second, this amount is reduced by the proportionate share of such 
expenses allocable to C, the venturer which would not have been able to 
claim such expenses as qualified research expenditures if it had paid or 
incurred them directly, C's proportionate share of such expenses is $40x 
(40% of $100x). The reduced amount is $60x. Third, the remaining $60x of 
qualified research expenses is allocated between A and B in the relative 
proportions that A and B share deductions for expenses under section 
174. A is entitled to treat $30x ((30%/(30%+30%)) $60x) as a qualified 
research expense. B is also entitled to treat $30x ((30%/(30%+30%)) 
$60x) as a qualified research expense.
    Example 2. Assume the same facts as in example (1) except that the 
joint venture agreement provides that during the first 2 years of the 
joint venture, A and B are each allocated 10 percent of each item of 
income, gain, loss, deduction, credit and basis, and C is allocated 80 
percent of each item of income, gain, loss, deduction, credit and basis. 
Thereafter the allocations are the same as in example (1). Assume for 
purposes of this example that such allocations have substantial economic 
effect for purposes of section 704 (b). C's highest share of such items 
during the life of the joint venture is 80 percent. Therefore C's 
proportionate share of the joint venture's qualified research expenses 
is $80x (80% of $100x). The reduced amount of qualified research 
expenses is $20x ($100x-$80x). A is entitled to treat $10x ((10%/
(10%+10%)) $20x) as a qualified research expense in Year 1. B is also 
entitled to treat $10x ((10%/(10%+10%)) $20x) as a qualified research 
expense in Year 1.

    (b) Supplies and personal property used in the conduct of qualified 
research--(1) In general. Supplies and personal property (except to the 
extent provided in paragraph (b)(4) of this section) are used in the 
conduct of qualified research if they are used in the performance of 
qualified services (as defined in section 41(b)(2)(B), but without 
regard to the last sentence thereof) by an employee of the taxpayer (or 
by a person acting in a capacity similar to that of an employee of the 
taxpayer; see example (6) of Sec. 1.41-2(e)(5)). Expenditures for 
supplies or for the use of personal property that are indirect research 
expenditures or general and administrative expenses do not qualify as 
inhouse research expenses.
    (2) Certain utility charges--(i) In general. In general, amounts 
paid or incurred for utilities such as water, electricity, and natural 
gas used in the building in which qualified research is performed are 
treated as expenditures for general and administrative expenses.
    (ii) Extraordinary expenditures. To the extent the taxpayer can 
establish that the special character of the qualified research required 
additional extraordinary expenditures for utilities, the additional 
expenditures shall be treated as amounts paid or incurred for supplies 
used in the conduct of qualified research. For example, amounts paid for 
electricity used for general laboratory lighting are treated as general 
and administrative expenses, but amounts paid for electricity used in 
operating high energy equipment for qualified research (such as laser or 
nuclear research) may be treated as expenditures for supplies used in 
the conduct of qualified research to the extent the taxpayer can 
establish that the special character of the research required an 
extraordinary additional expenditure for electricity.
    (3) Right to use personal property. The determination of whether an 
amount is paid to or incurred for another person for the right to use 
personal property in the conduct of qualified research shall be made 
without regard to the characterization of the transaction as a lease 
under section 168(f)(8) (as that section read before it was repealed by 
the Tax Reform Act of 1986). See Sec. 5c.168(f)(8)-1(b).
    (4) Use of personal property in taxable years beginning after 
December 31, 1985. For taxable years beginning after December 31, 1985, 
amounts paid or incurred for the use of personal property are not 
qualified research expenses, except for any amount paid or incurred to 
another person for the right to use (time-sharing) computers in the 
conduct of qualified research. The computer must be owned and operated 
by someone other than the taxpayer, located off the taxpayer's premises, 
and the taxpayer must not be the primary user of the computer.
    (c) Qualified services--(1) Engaging in qualified research. The term 
``engaging in qualified research'' as used in section 41(b)(2)(B) means 
the actual conduct of qualified research (as in the

[[Page 122]]

case of a scientist conducting laboratory experiments).
    (2) Direct supervision. The term ``direct supervision'' as used in 
section 41(b)(2)(B) means the immediate supervision (first-line 
management) of qualified research (as in the case of a research 
scientist who directly supervises laboratory experiments, but who may 
not actually perform experiments). ``Direct supervision'' does not 
include supervision by a higher-level manager to whom first-line 
managers report, even if that manager is a qualified research scientist.
    (3) Direct support. The term ``direct support'' as used in section 
41(b)(2)(B) means services in the direct support of either--
    (i) Persons engaging in actual conduct of qualified research, or
    (ii) Persons who are directly supervising persons engaging in the 
actual conduct of qualified research. For example, direct support of 
research includes the services of a secretary for typing reports 
describing laboratory results derived from qualified research, of a 
laboratory worker for cleaning equipment used in qualified research, of 
a clerk for compiling research data, and of a machinist for machining a 
part of an experimental model used in qualified research. Direct support 
of research activities does not include general administrative services, 
or other services only indirectly of benefit to research activities. For 
example, services of payroll personnel in preparing salary checks of 
laboratory scientists, of an accountant for accounting for research 
expenses, of a janitor for general cleaning of a research laboratory, or 
of officers engaged in supervising financial or personnel matters do not 
qualify as direct support of research. This is true whether general 
administrative personnel are part of the research department or in a 
separate department. Direct support does not include supervision. 
Supervisory services constitute ``qualified services'' only to the 
extent provided in paragraph (c)(2) of this section.
    (d) Wages paid for qualified services--(1) In general. Wages paid to 
or incurred for an employee constitute in-house research expenses only 
to the extent the wages were paid or incurred for qualified services 
performed by the employee. If an employee has performed both qualified 
services and nonqualified services, only the amount of wages allocated 
to the performance of qualified services constitutes an in-house 
research expense. In the absence of another method of allocation that 
the taxpayer can demonstrate to be more appropriate, the amount of in-
house research expense shall be determined by multiplying the total 
amount of wages paid to or incurred for the employee during the taxable 
year by the ratio of the total time actually spent by the employee in 
the performance of qualified services for the taxpayer to the total time 
spent by the employee in the performance of all services for the 
taxpayer during the taxable year.
    (2) ``Substantially all.'' Notwithstanding paragraph (d)(1) of this 
section, if substantially all of the services performed by an employee 
for the taxpayer during the taxable year consist of services meeting the 
requirements of section 41(b)(2)(B) (i) or (ii), then the term 
``qualified services'' means all of the services performed by the 
employee for the taxpayer during the taxable year. Services meeting the 
requirements of section 41(b)(2)(B) (i) or (ii) constitute substantially 
all of the services performed by the employee during a taxable year only 
if the wages allocated (on the basis used for purposes of paragraph 
(d)(1) of this section) to services meeting the requirements of section 
41(b)(2)(B) (i) or (ii) constitute at least 80 percent of the wages paid 
to or incurred by the taxpayer for the employee during the taxable year.
    (e) Contract research expenses--(1) In general. A contract research 
expense is 65 percent of any expense paid or incurred in carrying on a 
trade or business to any person other than an employee of the taxpayer 
for the performance on behalf of the taxpayer of--
    (i) Qualified research as defined in Sec. 1.41-4 or 1.41-4A, 
whichever is applicable, or
    (ii) Services which, if performed by employees of the taxpayer, 
would constitute qualified services within the meaning of section 
41(b)(2)(B).

Where the contract calls for services other than services described in 
this paragraph (e)(1), only 65 percent of the

[[Page 123]]

portion of the amount paid or incurred that is attributable to the 
services described in this paragraph (e)(1) is a contract research 
expense.
    (2) Performance of qualified research. An expense is paid or 
incurred for the performance of qualified research only to the extent 
that it is paid or incurred pursuant to an agreement that--
    (i) Is entered into prior to the performance of the qualified 
research,
    (ii) Provides that research be performed on behalf of the taxpayer, 
and
    (iii) Requires the taxpayer to bear the expense even if the research 
is not successful.

If an expense is paid or incurred pursuant to an agreement under which 
payment is contingent on the success of the research, then the expense 
is considered paid for the product or result rather than the performance 
of the research, and the payment is not a contract research expense. The 
previous sentence applies only to that portion of a payment which is 
contingent on the success of the research.
    (3) ``On behalf of.'' Qualified research is performed on behalf of 
the taxpayer if the taxpayer has a right to the research results. 
Qualified research can be performed on behalf of the taxpayer 
notwithstanding the fact that the taxpayer does not have exclusive 
rights to the results.
    (4) Prepaid amounts. Notwithstanding paragraph (e)(1) of this 
section, if any contract research expense paid or incurred during any 
taxable year is attributable to qualified research to be conducted after 
the close of such taxable year, the expense so attributable shall be 
treated for purposes of section 41(b)(1)(B) as paid or incurred during 
the period during which the qualified research is conducted.
    (5) Examples. The following examples illustrate provisions contained 
in paragraphs (e) (1) through (4) of this section.

    Example 1. A, a cash-method taxpayer using the calendar year as the 
taxable year, enters into a contract with B Corporation under which B is 
to perform qualified research on behalf of A. The contract requires A to 
pay B $300x, regardless of the success of the research. In 1982, B 
performs all of the research, and A makes full payment of $300x under 
the contract. Accordingly, during the taxable year 1982, $195x (65 
percent of the payment of $300x) constitutes a contract research expense 
of A.
    Example 2. The facts are the same as in example (1), except that B 
performs 50 percent of the research in 1983. Of the $195x of contract 
research expense paid in 1982, paragraph (e)(4) of this section provides 
that $97.5x (50 percent of $195x) is a contract research expense for 
1982 and the remaining $97.5x is contract research expense for 1983.
    Example 3. The facts are the same as in example (1), except that 
instead of calling for a flat payment of $300x, the contract requires A 
to reimburse B for all expenses plus pay B $l00x. B incurs expenses 
attributable to the research as follows:

Labor..........................................................     $90x
Supplies.......................................................      20x
Depreciation on equipment......................................      50x
Overhead.......................................................      40x
                                                                --------
 
      Total....................................................     200x
 


Under this agreement A pays B $300x during 1982. Accordingly, during 
taxable year 1982, $195x (65 percent of $300x) of the payment 
constitutes a contract research expense of A.
    Example 4. The facts are the same as in example (3), except that A 
agrees to reimburse B for all expenses and agrees to pay B an additional 
amount of $100x, but the additional $100x is payable only if the 
research is successful. The research is successful and A pays B $300x 
during 1982. Paragraph (e)(2) of this section provides that the 
contingent portion of the payment is not an expense incurred for the 
performance of qualified research. Thus, for taxable year 1982, $130x 
(65 percent of the payment of $200x) constitutes a contract research 
expense of A.
    Example 5. C conducts in-house qualified research in carrying on a 
trade or business. In addition, C pays D Corporation, a provider of 
computer services, $100x to develop software to be used in analyzing the 
results C derives from its research. Because the software services, if 
performed by an employee of C, would constitute qualified services, $65x 
of the $100x constitutes a contract research expense of C.
    Example 6. C conducts in-house qualified research in carrying on C's 
trade or business. In addition, C contracts with E Corporation, a 
provider of temporary secretarial services, for the services of a 
secretary for a week. The secretary spends the entire week typing 
reports describing laboratory results derived from C's qualified 
research. C pays E $400 for the secretarial service, none of which 
constitutes wages within the meaning of section 41(b)(2)(D). These 
services, if performed by employees of C, would constitute qualified 
services within the meaning of section 41(b)(2)(B). Thus, pursuant to 
paragraph (e)(1) of this section, $260 (65 percent of $400) constitutes 
a contract research expense of C.

[[Page 124]]

    Example 7. C conducts in-house qualified research in carrying on C's 
trade or business. In addition, C pays F, an outside accountant, $100x 
to keep C's books and records pertaining to the research project. The 
activity carried on by the accountant does not constitute qualified 
research as defined in section 41(d). The services performed by the 
accountant, if performed by an employee of C, would not constitute 
qualified services (as defined in section 41(b)(2)(B)). Thus, under 
paragraph (e)(1) of this section, no portion of the $100x constitutes a 
contract research expense.

[T.D. 8251, 54 FR 21204, May 17, 1989, as amended by T.D. 8930, 65 FR 
287, Jan. 3, 2001]



Sec. 1.41-3  Base amount for taxable years beginning on or after January 3, 

2001.

    (a) New taxpayers. If, with respect to any credit year, the taxpayer 
has not been in existence for any previous taxable year, the average 
annual gross receipts of the taxpayer for the four taxable years 
preceding the credit year shall be zero. If, with respect to any credit 
year, the taxpayer has been in existence for at least one previous 
taxable year, but has not been in existence for four taxable years 
preceding the taxable year, then the average annual gross receipts of 
the taxpayer for the four taxable years preceding the credit year shall 
be the average annual gross receipts for the number of taxable years 
preceding the credit year for which the taxpayer has been in existence.
    (b) Special rules for short taxable years--(1) Short credit year. If 
a credit year is a short taxable year, then the base amount determined 
under section 41(c)(1) (but not section 41(c)(2)) shall be modified by 
multiplying that amount by the number of months in the short taxable 
year and dividing the result by 12.
    (2) Short taxable year preceding credit year. If one or more of the 
four taxable years preceding the credit year is a short taxable year, 
then the gross receipts for such year are deemed to be equal to the 
gross receipts actually derived in that year multiplied by 12 and 
divided by the number of months in that year.
    (3) Short taxable year in determining fixed-base percentage. No 
adjustment shall be made on account of a short taxable year to the 
computation of a taxpayer's fixed-base percentage.
    (c) Definition of gross receipts--(1) In general. For purposes of 
section 41, gross receipts means the total amount, as determined under 
the taxpayer's method of accounting, derived by the taxpayer from all 
its activities and from all sources (e.g., revenues derived from the 
sale of inventory before reduction for cost of goods sold).
    (2) Amounts excluded. For purposes of this paragraph (c), gross 
receipts do not include amounts representing--
    (i) Returns or allowances;
    (ii) Receipts from the sale or exchange of capital assets, as 
defined in section 1221;
    (iii) Repayments of loans or similar instruments (e.g., a repayment 
of the principal amount of a loan held by a commercial lender);
    (iv) Receipts from a sale or exchange not in the ordinary course of 
business, such as the sale of an entire trade or business or the sale of 
property used in a trade or business as defined under section 1221(2);
    (v) Amounts received with respect to sales tax or other similar 
state and local taxes if, under the applicable state or local law, the 
tax is legally imposed on the purchaser of the good or service, and the 
taxpayer merely collects and remits the tax to the taxing authority; and
    (vi) Amounts received by a taxpayer in a taxable year that precedes 
the first taxable year in which the taxpayer derives more than $25,000 
in gross receipts other than investment income. For purposes of this 
paragraph (c)(2)(vi), investment income is interest or distributions 
with respect to stock (other than the stock of a 20-percent owned 
corporation as defined in section 243(c)(2).
    (3) Foreign corporations. For purposes of section 41, in the case of 
a foreign corporation, gross receipts include only gross receipts that 
are effectively connected with the conduct of a trade or business within 
the United States, the Commonwealth of Puerto Rico, or other possessions 
of the United States. See section 864(c) and applicable regulations 
thereunder for the definition of effectively connected income.

[[Page 125]]

    (d) Consistency requirement--(1) In general. In computing the credit 
for increasing research activities for taxable years beginning after 
December 31, 1989, qualified research expenses and gross receipts taken 
into account in computing a taxpayer's fixed-base percentage and a 
taxpayer's base amount must be determined on a basis consistent with the 
definition of qualified research expenses and gross receipts for the 
credit year, without regard to the law in effect for the taxable years 
taken into account in computing the fixed-base percentage or the base 
amount. This consistency requirement applies even if the period for 
filing a claim for credit or refund has expired for any taxable year 
taken into account in computing the fixed-base percentage or the base 
amount.
    (2) Illustrations. The following examples illustrate the application 
of the consistency rule of paragraph (d)(1) of this section:

    Example 1. (i) X, an accrual method taxpayer using the calendar year 
as its taxable year, incurs qualified research expenses in 2001. X wants 
to compute its research credit under section 41 for the tax year ending 
December 31, 2001. As part of the computation, X must determine its 
fixed-base percentage, which depends in part on X's qualified research 
expenses incurred during the fixed-base period, the taxable years 
beginning after December 31, 1983, and before January 1, 1989.
    (ii) During the fixed-base period, X reported the following amounts 
as qualified research expenses on its Form 6765:

1984...........................................................    $100x
1985...........................................................     120x
1986...........................................................     150x
1987...........................................................     180x
1988...........................................................     170x
                                                                --------
    Total......................................................     720x
 

    (iii) For the taxable years ending December 31, 1984, and December 
31, 1985, X based the amounts reported as qualified research expenses on 
the definition of qualified research in effect for those taxable years. 
The definition of qualified research changed for taxable years beginning 
after December 31, 1985. If X used the definition of qualified research 
applicable to its taxable year ending December 31, 2001, the credit 
year, its qualified research expenses for the taxable years ending 
December 31, 1984, and December 31, 1985, would be reduced to $ 80x and 
$ 100x, respectively. Under the consistency rule in section 41(c)(5) and 
paragraph (d)(1) of this section, to compute the research credit for the 
tax year ending December 31, 2001, X must reduce its qualified research 
expenses for 1984 and 1985 to reflect the change in the definition of 
qualified research for taxable years beginning after December 31, 1985. 
Thus, X's total qualified research expenses for the fixed-base period 
(1984-1988) to be used in computing the fixed-base percentage is $80 + 
100 + 150 + 180 + 170 = $680x.
    Example 2. The facts are the same as in Example 1, except that, in 
computing its qualified research expenses for the taxable year ending 
December 31, 2001, X claimed that a certain type of expenditure incurred 
in 2001 was a qualified research expense. X's claim reflected a change 
in X's position, because X had not previously claimed that similar 
expenditures were qualified research expenses. The consistency rule 
requires X to adjust its qualified research expenses in computing the 
fixed-base percentage to include any similar expenditures not treated as 
qualified research expenses during the fixed-base period, regardless of 
whether the period for filing a claim for credit or refund has expired 
for any year taken into account in computing the fixed-base percentage.

    (e) Effective date. The rules in paragraphs (c) and (d) of this 
section are applicable for taxable years beginning on or after the date 
final regulations are published in the Federal Register.

[T.D. 8930, 66 FR 289, Jan. 3, 2001]



Sec. 1.41-4  Qualified research for expenditures paid or incurred in taxable 

years ending on or after December 31, 2003.

    (a) Qualified research--(1) General rule. Research activities 
related to the development or improvement of a business component 
constitute qualified research only if the research activities meet all 
of the requirements of section 41(d)(1) and this section, and are not 
otherwise excluded under section 41(d)(3)(B) or (d)(4), or this section.
    (2) Requirements of section 41(d)(1). Research constitutes qualified 
research only if it is research--
    (i) With respect to which expenditures may be treated as expenses 
under section 174, see Sec. 1.174-2;
    (ii) That is undertaken for the purpose of discovering information 
that is technological in nature, and the application of which is 
intended to be useful in the development of a new or improved business 
component of the taxpayer; and

[[Page 126]]

    (iii) Substantially all of the activities of which constitute 
elements of a process of experimentation that relates to a qualified 
purpose.
    (3) Undertaken for the purpose of discovering information--(i) In 
general. For purposes of section 41(d) and this section, research must 
be undertaken for the purpose of discovering information that is 
technological in nature. Research is undertaken for the purpose of 
discovering information if it is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
Uncertainty exists if the information available to the taxpayer does not 
establish the capability or method for developing or improving the 
business component, or the appropriate design of the business component.
    (ii) Application of the discovering information requirement. A 
determination that research is undertaken for the purpose of discovering 
information that is technological in nature does not require the 
taxpayer be seeking to obtain information that exceeds, expands or 
refines the common knowledge of skilled professionals in the particular 
field of science or engineering in which the taxpayer is performing the 
research. In addition, a determination that research is undertaken for 
the purpose of discovering information that is technological in nature 
does not require that the taxpayer succeed in developing a new or 
improved business component.
    (iii) Patent safe harbor. For purposes of section 41(d) and 
paragraph (a)(3)(i) of this section, the issuance of a patent by the 
Patent and Trademark Office under the provisions of 35 U.S.C. 151 (other 
than a patent for design issued under the provisions of 35 U.S.C. 171) 
is conclusive evidence that a taxpayer has discovered information that 
is technological in nature that is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
However, the issuance of such a patent is not a precondition for credit 
availability.
    (4) Technological in nature. For purposes of section 41(d) and this 
section, information is technological in nature if the process of 
experimentation used to discover such information fundamentally relies 
on principles of the physical or biological sciences, engineering, or 
computer science. A taxpayer may employ existing technologies and may 
rely on existing principles of the physical or biological sciences, 
engineering, or computer science to satisfy this requirement.
    (5) Process of experimentation--(i) In general. For purposes of 
section 41(d) and this section, a process of experimentation is a 
process designed to evaluate one or more alternatives to achieve a 
result where the capability or the method of achieving that result, or 
the appropriate design of that result, is uncertain as of the beginning 
of the taxpayer's research activities. A process of experimentation must 
fundamentally rely on the principles of the physical or biological 
sciences, engineering, or computer science and involves the 
identification of uncertainty concerning the development or improvement 
of a business component, the identification of one or more alternatives 
intended to eliminate that uncertainty, and the identification and the 
conduct of a process of evaluating the alternatives (through, for 
example, modeling, simulation, or a systematic trial and error 
methodology). A process of experimentation must be an evaluative process 
and generally should be capable of evaluating more than one alternative. 
A taxpayer may undertake a process of experimentation if there is no 
uncertainty concerning the taxpayer's capability or method of achieving 
the desired result so long as the appropriate design of the desired 
result is uncertain as of the beginning of the taxpayer's research 
activities. Uncertainty concerning the development or improvement of the 
business component (e.g., its appropriate design) does not establish 
that all activities undertaken to achieve that new or improved business 
component constitute a process of experimentation.
    (ii) Qualified purpose. For purposes of section 41(d) and this 
section, a process of experimentation is undertaken for a qualified 
purpose if it relates to a new or improved function, performance, 
reliability or quality of the business component. Research will not be 
treated as conducted for a qualified purpose

[[Page 127]]

if it relates to style, taste, cosmetic, or seasonal design factors.
    (6) Substantially all requirement. In order for activities to 
constitute qualified research under section 41(d)(1), substantially all 
of the activities must constitute elements of a process of 
experimentation that relates to a qualified purpose. The substantially 
all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied only if 80 percent or more of a taxpayer's research 
activities, measured on a cost or other consistently applied reasonable 
basis (and without regard to section 1.41-2(d)(2)), constitute elements 
of a process of experimentation for a purpose described in section 
41(d)(3). Accordingly, if 80 percent (or more) of a taxpayer's research 
activities with respect to a business component constitute elements of a 
process of experimentation for a purpose described in section 41(d)(3), 
the substantially all requirement is satisfied even if the remaining 20 
percent (or less) of a taxpayer's research activities with respect to 
the business component do not constitute elements of a process of 
experimentation for a purpose described in section 41(d)(3), so long as 
these remaining research activities satisfy the requirements of section 
41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). The 
substantially all requirement is applied separately to each business 
component.
    (7) Use of computers and information technology. The employment of 
computers or information technology, or the reliance on principles of 
computer science or information technology to store, collect, 
manipulate, translate, disseminate, produce, distribute, or process data 
or information, and similar uses of computers and information technology 
does not itself establish that qualified research has been undertaken.
    (8) Illustrations. The following examples illustrate the application 
of paragraph (a)(5) of this section:

    Example 1. (i) Facts. X is engaged in the business of developing and 
manufacturing widgets. X wants to change the color of its blue widget to 
green. X obtains from various suppliers several different shades of 
green paint. X paints several sample widgets, and surveys X's customers 
to determine which shade of green X's customers prefer.
    (ii) Conclusion. X's activities to change the color of its blue 
widget to green are not qualified research under section 41(d)(1) and 
paragraph (a)(5) of this section because substantially all of X's 
activities are not undertaken for a qualified purpose. All of X's 
research activities are related to style, taste, cosmetic, or seasonal 
design factors.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that X chooses one of the green paints. X obtains samples of the green 
paint from a supplier and determines that X must modify its painting 
process to accommodate the green paint because the green paint has 
different characteristics from other paints X has used. X obtains 
detailed data on the green paint from X's paint supplier. X also 
consults with the manufacturer of X's paint spraying machines. The 
manufacturer informs X that X must acquire a new nozzle that operates 
with the green paint X wants to use. X tests the nozzles to ensure that 
they work as specified by the manufacturer of the paint spraying 
machines.
    (ii) Conclusion. X's activities to modify its painting process are a 
separate business component under section 41(d)(2)(A). X's activities to 
modify its painting process to change the color of its blue widget to 
green are not qualified research under section 41(d)(1) and paragraph 
(a)(5) of this section. X did not conduct a process of evaluating 
alternatives in order to eliminate uncertainty regarding the 
modification of its painting process. Rather, the manufacturer of the 
paint machines eliminated X's uncertainty regarding the modification of 
its painting process. X's activities to test the nozzles to determine if 
the nozzles work as specified by the manufacturer of the paint spraying 
machines are in the nature of routine or ordinary testing or inspection 
for quality control.
    Example 3. (i) Facts. X is engaged in the business of manufacturing 
food products and currently manufactures a large-shred version of a 
product. X seeks to modify its current production line to permit it to 
manufacture both a large-shred version and a fine-shred version of one 
of its food products. A smaller, thinner shredding blade capable of 
producing a fine-shred version of the food product, however, is not 
commercially available. Thus, X must develop a new shredding blade that 
can be fitted onto its current production line. X is uncertain 
concerning the design of the new shredding blade, because the material 
used in its existing blade breaks when machined into smaller, thinner 
blades. X engages in a systematic trial and error process of analyzing 
various blade designs and materials to determine whether the new 
shredding blade must be constructed of a different material from that of 
its existing shredding blade and, if so, what material will best meet 
X's functional requirements.

[[Page 128]]

    (ii) Conclusion. X's activities to modify its current production 
line by developing the new shredding blade meet the requirements of 
qualified research as set forth in paragraph (a)(2) of this section. 
Substantially all of X's activities constitute elements of a process of 
experimentation because X evaluated alternatives to achieve a result 
where the method of achieving that result, and the appropriate design of 
that result, were uncertain as of the beginning of the taxpayer's 
research activities. X identified uncertainties related to the 
development of a business component, and identified alternatives 
intended to eliminate these uncertainties. Furthermore, X's process of 
evaluating identified alternatives was technological in nature, and was 
undertaken to eliminate the uncertainties.
    Example 4. (i) Facts. X is in the business of designing, developing 
and manufacturing automobiles. In response to government-mandated fuel 
economy requirements, X seeks to update its current model vehicle and 
undertakes to improve aerodynamics by lowering the hood of its current 
model vehicle. X determines, however, that lowering the hood changes the 
air flow under the hood, which changes the rate at which air enters the 
engine through the air intake system, and which reduces the 
functionality of the cooling system. X's engineers are uncertain how to 
design a lower hood to obtain the increased fuel economy, while 
maintaining the necessary air flow under the hood. X designs, models, 
simulates, tests, refines, and re-tests several alternative designs for 
the hood and associated proposed modifications to both the air intake 
system and cooling system. This process enables X to eliminate the 
uncertainties related to the integrated design of the hood, air intake 
system, and cooling system, and such activities constitute eighty-five 
percent of X's total activities to update its current model vehicle. X 
then engages in additional activities that do not involve a process of 
evaluating alternatives in order to eliminate uncertainties. The 
additional activities constitute only fifteen percent of X's total 
activities to update its current model vehicle.
    (ii) Conclusion. In general, if eighty percent or more of a 
taxpayer's research activities measured on a cost or other consistently 
applied reasonable basis constitute elements of a process of 
experimentation for a qualified purpose under section 41(d)(3)(A) and 
paragraph (a)(5)(ii) of this section, then the substantially all 
requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied. Substantially all of X's activities constitute 
elements of a process of experimentation because X evaluated 
alternatives to achieve a result where the method of achieving that 
result, and the appropriate design of that result, were uncertain as of 
the beginning of X's research activities. X identified uncertainties 
related to the improvement of a business component and identified 
alternatives intended to eliminate these uncertainties. Furthermore, X's 
process of evaluating the identified alternatives was technological in 
nature and was undertaken to eliminate the uncertainties. Because 
substantially all (in this example, eighty-five percent) of X's 
activities to update its current model vehicle constitute elements of a 
process of experimentation for a qualified purpose described in section 
41(d)(3)(A), all of X's activities to update its current model vehicle 
meet the requirements of qualified research as set forth in paragraph 
(a)(2) of this section, provided that X's remaining activities (in this 
example, fifteen percent of X's total activities) satisfy the 
requirements of section 41(d)(1)(A) and are not otherwise excluded under 
section 41(d)(4).

    (b) Application of requirements for qualified research--(1) In 
general. The requirements for qualified research in section 41(d)(1) and 
paragraph (a) of this section, must be applied separately to each 
business component, as defined in section 41(d)(2)(B). In cases 
involving development of both a product and a manufacturing or other 
commercial production process for the product, research activities 
relating to development of the process are not qualified research unless 
the requirements of section 41(d) and this section are met for the 
research activities relating to the process without taking into account 
the research activities relating to development of the product. 
Similarly, research activities relating to development of the product 
are not qualified research unless the requirements of section 41(d) and 
this section are met for the research activities relating to the product 
without taking into account the research activities relating to 
development of the manufacturing or other commercial production process.
    (2) Shrinking-back rule. The requirements of section 41(d) and 
paragraph (a) of this section are to be applied first at the level of 
the discrete business component, that is, the product, process, computer 
software, technique, formula, or invention to be held for sale, lease, 
or license, or used by the taxpayer in a trade or business of the 
taxpayer. If these requirements are not met at that level, then they 
apply at the most significant subset of elements

[[Page 129]]

of the product, process, computer software, technique, formula, or 
invention to be held for sale, lease, or license. This shrinking back of 
the product is to continue until either a subset of elements of the 
product that satisfies the requirements is reached, or the most basic 
element of the product is reached and such element fails to satisfy the 
test. This shrinking-back rule is applied only if a taxpayer does not 
satisfy the requirements of section 41(d)(1) and paragraph (a)(2) of 
this section with respect to the overall business component. The 
shrinking-back rule is not itself applied as a reason to exclude 
research activities from credit eligibility.
    (3) Illustration. The following example illustrates the application 
of this paragraph (b):

    Example. X, a motorcycle engine builder, develops a new carburetor 
for use in a motorcycle engine. X also modifies an existing engine 
design for use with the new carburetor. Under the shrinking-back rule, 
the requirements of section 41(d)(1) and paragraph (a) of this section 
are applied first to the engine. If the modifications to the engine when 
viewed as a whole, including the development of the new carburetor, do 
not satisfy the requirements of section 41(d)(1) and paragraph (a) of 
this section, those requirements are applied to the next most 
significant subset of elements of the business component. Assuming that 
the next most significant subset of elements of the engine is the 
carburetor, the research activities in developing the new carburetor may 
constitute qualified research within the meaning of section 41(d)(1) and 
paragraph (a) of this section.

    (c) Excluded activities--(1) In general. Qualified research does not 
include any activity described in section 41(d)(4) and paragraph (c) of 
this section.
    (2) Research after commercial production--(i) In general. Activities 
conducted after the beginning of commercial production of a business 
component are not qualified research. Activities are conducted after the 
beginning of commercial production of a business component if such 
activities are conducted after the component is developed to the point 
where it is ready for commercial sale or use, or meets the basic 
functional and economic requirements of the taxpayer for the component's 
sale or use.
    (ii) Certain additional activities related to the business 
component. The following activities are deemed to occur after the 
beginning of commercial production of a business component--
    (A) Preproduction planning for a finished business component;
    (B) Tooling-up for production;
    (C) Trial production runs;
    (D) Trouble shooting involving detecting faults in production 
equipment or processes;
    (E) Accumulating data relating to production processes; and
    (F) Debugging flaws in a business component.
    (iii) Activities related to production process or technique. In 
cases involving development of both a product and a manufacturing or 
other commercial production process for the product, the exclusion 
described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of 
this section applies separately for the activities relating to the 
development of the product and the activities relating to the 
development of the process. For example, even after a product meets the 
taxpayer's basic functional and economic requirements, activities 
relating to the development of the manufacturing process still may 
constitute qualified research, provided that the development of the 
process itself separately satisfies the requirements of section 41(d) 
and this section, and the activities are conducted before the process 
meets the taxpayer's basic functional and economic requirements or is 
ready for commercial use.
    (iv) Clinical testing. Clinical testing of a pharmaceutical product 
prior to its commercial production in the United States is not treated 
as occurring after the beginning of commercial production even if the 
product is commercially available in other countries. Additional 
clinical testing of a pharmaceutical product after a product has been 
approved for a specific therapeutic use by the Food and Drug 
Administration and is ready for commercial production and sale is not 
treated as occurring after the beginning of commercial production if 
such clinical testing is undertaken to establish new functional uses, 
characteristics, indications, combinations, dosages, or delivery forms 
for the product. A functional

[[Page 130]]

use, characteristic, indication, combination, dosage, or delivery form 
shall be considered new only if such functional use, characteristic, 
indication, combination, dosage, or delivery form must be approved by 
the Food and Drug Administration.
    (3) Adaptation of existing business components. Activities relating 
to adapting an existing business component to a particular customer's 
requirement or need are not qualified research. This exclusion does not 
apply merely because a business component is intended for a specific 
customer.
    (4) Duplication of existing business component. Activities relating 
to reproducing an existing business component (in whole or in part) from 
a physical examination of the business component itself or from plans, 
blueprints, detailed specifications, or publicly available information 
about the business component are not qualified research. This exclusion 
does not apply merely because the taxpayer examines an existing business 
component in the course of developing its own business component.
    (5) Surveys, studies, research relating to management functions, 
etc. Qualified research does not include activities relating to--
    (i) Efficiency surveys;
    (ii) Management functions or techniques, including such items as 
preparation of financial data and analysis, development of employee 
training programs and management organization plans, and management-
based changes in production processes (such as rearranging work stations 
on an assembly line);
    (iii) Market research, testing, or development (including 
advertising or promotions);
    (iv) Routine data collections; or
    (v) Routine or ordinary testing or inspections for quality control.
    (6) Internal use software for taxable years beginning on or after 
December 31, 1985. [Reserved].
    (7) Activities outside the United States, Puerto Rico, and other 
possessions--(i) In general. Research conducted outside the United 
States, as defined in section 7701(a)(9), the Commonwealth of Puerto 
Rico and other possessions of the United States does not constitute 
qualified research.
    (ii) Apportionment of in-house research expenses. In-house research 
expenses paid or incurred for qualified services performed both in the 
United States, the Commonwealth of Puerto Rico and other possessions of 
the United States and outside the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States must be 
apportioned between the services performed in the United States, the 
Commonwealth of Puerto Rico and other possessions of the United States 
and the services performed outside the United States, the Commonwealth 
of Puerto Rico and other possessions of the United States. Only those 
in-house research expenses apportioned to the services performed within 
the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States are eligible to be treated as qualified research 
expenses, unless the in-house research expenses are wages and the 80 
percent rule of Sec. 1.41-2(d)(2) applies.
    (iii) Apportionment of contract research expenses. If contract 
research is performed partly in the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States and partly 
outside the United States, the Commonwealth of Puerto Rico and other 
possessions of the United States, only 65 percent (or 75 percent in the 
case of amounts paid to qualified research consortia) of the portion of 
the contract amount that is attributable to the research activity 
performed in the United States, the Commonwealth of Puerto Rico and 
other possessions of the United States may qualify as a contract 
research expense (even if 80 percent or more of the contract amount is 
for research performed in the United States, the Commonwealth of Puerto 
Rico and other possessions of the United States).
    (8) Research in the social sciences, etc. Qualified research does 
not include research in the social sciences (including economics, 
business management, and behavioral sciences), arts, or humanities.
    (9) Research funded by any grant, contract, or otherwise. Qualified 
research does not include any research to the

[[Page 131]]

extent funded by any grant, contract, or otherwise by another person (or 
governmental entity). To determine the extent to which research is so 
funded, Sec. 1.41-4A(d) applies.
    (10) Illustrations. The following examples illustrate provisions 
contained in paragraphs (c)(1) through (9) (excepting paragraphs (c)(6) 
of this section) of this section. No inference should be drawn from 
these examples concerning the application of section 41(d)(1) and 
paragraph (a) of this section to these facts. The examples are as 
follows:

    Example 1. (i) Facts. X, a tire manufacturer, develops a new 
material to use in its tires. X conducts research to determine the 
changes that will be necessary for X to modify its existing 
manufacturing processes to manufacture the new tire. X determines that 
the new tire material retains heat for a longer period of time than the 
materials X currently uses for tires, and, as a result, the new tire 
material adheres to the manufacturing equipment during tread cooling. X 
evaluates several alternatives for processing the treads at cooler 
temperatures to address this problem, including a new type of belt for 
its manufacturing equipment to be used in tread cooling. Such a belt is 
not commercially available. Because X is uncertain of the belt design, X 
develops and conducts sophisticated engineering tests on several 
alternative designs for a new type of belt to be used in tread cooling 
until X successfully achieves a design that meets X's requirements. X 
then manufactures a set of belts for its production equipment, installs 
the belts, and tests the belts to make sure they were manufactured 
correctly.
    (ii) Conclusion. X's research with respect to the design of the new 
belts to be used in its manufacturing of the new tire may be qualified 
research under section 41(d)(1) and paragraph (a) of this section. 
However, X's expenses to implement the new belts, including the costs to 
manufacture, install, and test the belts were incurred after the belts 
met the taxpayer's functional and economic requirements and are excluded 
as research after commercial production under section 41(d)(4)(A) and 
paragraph (c)(2) of this section.
    Example 2. (i) Facts. For several years, X has manufactured and sold 
a particular kind of widget. X initiates a new research project to 
develop a new or improved widget.
    (ii) Conclusion. X's activities to develop a new or improved widget 
are not excluded from the definition of qualified research under section 
41(d)(4)(A) and paragraph (c)(2) of this section. X's activities 
relating to the development of a new or improved widget constitute a new 
research project to develop a new business component. X's research 
activities relating to the development of the new or improved widget, a 
new business component, are not considered to be activities conducted 
after the beginning of commercial production under section 41(d)(4)(A) 
and paragraph (c)(2) of this section.
    Example 3. (i) Facts. X, a computer software development firm, owns 
all substantial rights in a general ledger accounting software core 
program that X markets and licenses to customers. X incurs expenditures 
in adapting the core software program to the requirements of C, one of 
X's customers.
    (ii) Conclusion. Because X's activities represent activities to 
adapt an existing software program to a particular customer's 
requirement or need, X's activities are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that C pays X to adapt the core software program to C's requirements.
    (ii) Conclusion. Because X's activities are excluded from the 
definition of qualified research under section 41(d)(4)(B) and paragraph 
(c)(3) of this section, C's payments to X are not for qualified research 
and are not considered to be contract research expenses under section 
41(b)(3)(A).
    Example 5. (i) Facts. The facts are the same as in Example 3, except 
that C's own employees adapt the core software program to C's 
requirements.
    (ii) Conclusion. Because C's employees' activities to adapt the core 
software program to C's requirements are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section, the wages C paid to its employees do not constitute in-
house research expenses under section 41(b)(2)(A).
    Example 6. (i) Facts. X manufacturers and sells rail cars. Because 
rail cars have numerous specifications related to performance, 
reliability and quality, rail car designs are subject to extensive, 
complex testing in the scientific or laboratory sense. B orders 
passenger rail cars from X. B's rail car requirements differ from those 
of X's other existing customers only in that B wants fewer seats in its 
passenger cars and a higher quality seating material and carpet that are 
commercially available. X manufactures rail cars meeting B's 
requirements.
    (ii) Conclusion. X's activities to manufacture rail cars for B are 
excluded from the definition of qualified research. The rail car sold to 
B was not a new business component, but merely an adaptation of an 
existing business component that did not require a process of 
experimentation. Thus, X's activities to manufacture rail cars for B are 
excluded from the definition of qualified research under section 
41(d)(4)(B) and paragraph (c)(3)

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of this section because X's activities represent activities to adapt an 
existing business component to a particular customer's requirement or 
need.
    Example 7. (i) Facts. X, a manufacturer, undertakes to create a 
manufacturing process for a new valve design. X determines that it 
requires a specialized type of robotic equipment to use in the 
manufacturing process for its new valves. Such robotic equipment is not 
commercially available, and X, therefore, purchases the existing robotic 
equipment for the purpose of modifying it to meet its needs. X's 
engineers identify uncertainty that is technological in nature 
concerning how to modify the existing robotic equipment to meet its 
needs. X's engineers develop several alternative designs, and conduct 
experiments using modeling and simulation in modifying the robotic 
equipment and conduct extensive scientific and laboratory testing of 
design alternatives. As a result of this process, X's engineers develop 
a design for the robotic equipment that meets X's needs. X constructs 
and installs the modified robotic equipment on its manufacturing 
process.
    (ii) Conclusion. X's research activities to determine how to modify 
X's robotic equipment for its manufacturing process are not excluded 
from the definition of qualified research under section 41(d)(4)(B) and 
paragraph (c)(3) of this section, provided that X's research activities 
satisfy the requirements of section 41(d)(1).
    Example 8. (i) Facts. An existing gasoline additive is manufactured 
by Y using three ingredients, A, B, and C. X seeks to develop and 
manufacture its own gasoline additive that appears and functions in a 
manner similar to Y's additive. To develop its own additive, X first 
inspects the composition of Y's additive, and uses knowledge gained from 
the inspection to reproduce A and B in the laboratory. Any differences 
between ingredients A and B that are used in Y's additive and those 
reproduced by X are insignificant and are not material to the viability, 
effectiveness, or cost of A and B. X desires to use with A and B an 
ingredient that has a materially lower cost than ingredient C. 
Accordingly, X engages in a process of experimentation to develop, 
analyze and test potential alternative formulations of the additive.
    (ii) Conclusion. X's activities in analyzing and reproducing 
ingredients A and B involve duplication of existing business components 
and are excluded from the definition of qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section. X's experimentation 
activities to develop potential alternative formulations of the additive 
do not involve duplication of an existing business component and are not 
excluded from the definition of qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section.
    Example 9. (i) Facts. X, a manufacturing corporation, undertakes to 
restructure its manufacturing organization. X organizes a team to design 
an organizational structure that will improve X's business operations. 
The team includes X's employees as well as outside management 
consultants. The team studies current operations, interviews X's 
employees, and studies the structure of other manufacturing facilities 
to determine appropriate modifications to X's current business 
operations. The team develops a recommendation of proposed modifications 
which it presents to X's management. X's management approves the team's 
recommendation and begins to implement the proposed modifications.
    (ii) Conclusion. X's activities in developing and implementing the 
new management structure are excluded from the definition of qualified 
research under section 41(d)(4)(D) and paragraph (c)(5) of this section. 
Qualified research does not include activities relating to management 
functions or techniques including management organization plans and 
management-based changes in production processes.
    Example 10. (i) Facts. X, an insurance company, develops a new life 
insurance product. In the course of developing the product, X engages in 
research with respect to the effect of pricing and tax consequences on 
demand for the product, the expected volatility of interest rates, and 
the expected mortality rates (based on published data and prior 
insurance claims).
    (ii) Conclusion. X's activities related to the new product represent 
research in the social sciences (including economics and business 
management) and are thus excluded from the definition of qualified 
research under section 41(d)(4)(G) and paragraph (c)(8) of this section.

    (d) Recordkeeping for the research credit. A taxpayer claiming a 
credit under section 41 must retain records in sufficiently usable form 
and detail to substantiate that the expenditures claimed are eligible 
for the credit. For the rules governing record retention, see Sec. 
1.6001-1. To facilitate compliance and administration, the IRS and 
taxpayers may agree to guidelines for the keeping of specific records 
for purposes of substantiating research credits.
    (e) Effective dates. This section is applicable for taxable years 
ending on or after December 31, 2003.

[T.D. 8930, 66 FR 290, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, 
Jan. 2, 2004]

[[Page 133]]



Sec. 1.41-4A  Qualified research for taxable years beginning before January 1, 

1986.

    (a) General rule. Except as otherwise provided in section 30(d) (as 
that section read before amendment by the Tax Reform Act of 1986) and in 
this section, the term ``qualified research'' means research, 
expenditures for which would be research and experimental expenditures 
within the meaning of section 174. Expenditures that are ineligible for 
the section 174 deduction elections are not expenditures for qualified 
research. For example, expenditures for the acquisition of land or 
depreciable property used in research, and mineral exploration costs 
described in section 174(d), are not expenditures for qualified 
research.
    (b) Activities outside the United States--(1) In-house research. In-
house research conducted outside the United States (as defined in 
section 7701(a)(9)) cannot constitute qualified research. Thus, wages 
paid to an employee scientist for services performed in a laboratory in 
the United States and in a test station in Antarctica must be 
apportioned between the services performed within the United States and 
the services performed outside the United States, and only the wages 
apportioned to the services conducted within the United States are 
qualified research expenses unless the 80 percent rule of Sec. 1.41-
2(d)(2) applies.
    (2) Contract research. If contract research is performed partly 
within the United States and partly without, only 65 percent of the 
portion of the contract amount that is attributable to the research 
performed within the United States can qualify as contract research 
expense (even if 80 percent or more of the contract amount was for 
research performed in the United States).
    (c) Social sciences or humanities. Qualified research does not 
include research in the social sciences or humanities. For purposes of 
section 30(d)(2) (as that section read before amendment by the Tax 
Reform Act of 1986) and of this section, the phrase ``research in the 
social sciences or humanities'' encompasses all areas of research other 
than research in a field of laboratory science (such as physics or 
biochemistry), engineering or technology. Examples of research in the 
social sciences or humanities include the development of a new life 
insurance contract, a new economic model or theory, a new accounting 
procedure or a new cookbook.
    (d) Research funded by any grant, contract, or otherwise--(1) In 
general. Research does not constitute qualified research to the extent 
it is funded by any grant, contract, or otherwise by another person 
(including any governmental entity). All agreements (not only research 
contracts) entered into between the taxpayer performing the research and 
other persons shall be considered in determining the extent to which the 
research is funded. Amounts payable under any agreement that are 
contingent on the success of the research and thus considered to be paid 
for the product or result of the research (see Sec. 1.41-2(e)(2)) are 
not treated as funding. For special rules regarding funding between 
commonly controlled businesses, see Sec. 1.41-6(e).
    (2) Research in which taxpayer retains no rights. If a taxpayer 
performing research for another person retains no substantial rights in 
research under the agreement providing for the research, the research is 
treated as fully funded for purposes of section 41(d)(4)(H), and no 
expenses paid or incurred by the taxpayer in performing the research are 
qualified research expenses. For example, if the taxpayer performs 
research under an agreement that confers on another person the exclusive 
right to exploit the results of the research, the taxpayer is not 
performing qualified research because the research is treated as fully 
funded under this paragraph (d)(2). Incidental benefits to the taxpayer 
from performance of the research (for example, increased experience in a 
field of research) do not constitute substantial rights in the research. 
If a taxpayer performing research for another person retains no 
substantial rights in the research and if the payments to the researcher 
are contingent upon the success of the research, neither the performer 
nor the person paying for the research is entitled to treat any portion 
of the expenditures as qualified research expenditures.

[[Page 134]]

    (3) Research in which the taxpayer retains substantial rights--(i) 
In general. If a taxpayer performing research for another person retains 
substantial rights in the research under the agreement providing for the 
research, the research is funded to the extent of the payments (and fair 
market value of any property) to which the taxpayer becomes entitled by 
performing the research. A taxpayer does not retain substantial rights 
in the research if the taxpayer must pay for the right to use the 
results of the research. Except as otherwise provided in paragraph 
(d)(3)(ii) of this section, the taxpayer shall reduce the amount paid or 
incurred by the taxpayer for the research that would, but for section 
41(d)(4)(H), constitute qualified research expenses of the taxpayer by 
the amount of funding determined under the preceding sentence.
    (ii) Pro rata allocation. If the taxpayer can establish to the 
satisfaction of the district director--
    (A) The total amount of research expenses,
    (B) That the total amount of research expenses exceed the funding, 
and
    (C) That the otherwise qualified research expenses (that is, the 
expenses which would be qualified research expenses if there were no 
funding) exceed 65 percent of the funding, then the taxpayer may 
allocate the funding pro rata to nonqualified and otherwise qualified 
research expenses, rather than allocating it 100 percent to otherwise 
qualified research expenses (as provided in paragraph (d)(3)(i) of this 
section). In no event, however, shall less than 65 percent of the 
funding be applied against the otherwise qualified research expenses.
    (iii) Project-by-project determination. The provisions of this 
paragraph (d)(3) shall be applied separately to each research project 
undertaken by the taxpayer.
    (4) Independent research and development under the Federal 
Acquisition Regulations System and similar provisions. The Federal 
Acquisition Regulations System and similar rules and regulations 
relating to contracts (fixed price, cost plus, etc.) with government 
entities provide for allocation of certain ``independent research and 
development costs'' and ``bid and proposal costs'' of a contractor to 
contracts entered into with that contractor. In general, any 
``independent research and development costs'' and ``bid and proposal 
costs'' paid to a taxpayer by reason of such a contract shall not be 
treated as funding the underlying research activities except to the 
extent the ``independent research and development costs'' and ``bid and 
proposal costs'' are properly severable from the contract. See Sec. 
1.451-3(e); see also section 804(d)(2) of the Tax Reform Act of 1986.
    (5) Funding determinable only in subsequent taxable year. If at the 
time the taxpayer files its return for a taxable year, it is impossible 
to determine to what extent particular research performed by the 
taxpayer during that year may be funded, then the taxpayer shall treat 
the research as completely funded for purposes of completing that 
return. When the amount of funding is finally determined, the taxpayer 
should amend the return and any interim returns to reflect the proper 
amount of funding.
    (6) Examples. The following examples illustrate the application of 
the principles contained in this paragraph.

    Example 1. A enters into a contract with B Corporation, a cash-
method taxpayer using the calendar year as its taxable year, under which 
B is to perform research that would, but for section 41(d)(3)(H), be 
qualified research of B. The agreement calls for A to pay B $120x, 
regardless of the outcome of the research. In 1982, A makes full payment 
of $120x under the contract, B performs all the research, and B pays all 
the expenses connected with the research, as follows:

In-house research expenses.....................................    $100x
Outside research:
  (Amount B paid to third parties for research, 65 percent of        40x
   which ($26x) is treated as a contract research expense of B)
Overhead and other expenses....................................      10x
                                                                --------
    Total......................................................     150x
 

    If B has no rights to the research, B is fully funded. 
Alternatively, assume that B retains the right to use the results of the 
research in carrying on B's business. Of B's otherwise qualified 
research expenses of $126x + $26x), $120x is treated as funded by A. 
Thus $6x ($126x - $120x) is treated as a qualified research expense of 
B. However, if B establishes the facts required under paragraph (d)(3) 
of this section, B can allocate the funding pro rata to nonqualified and 
otherwise

[[Page 135]]

qualified research expenses. Thus $100.8x ($120x ($126x/$150x)) would be 
allocated to otherwise qualified research expenses. B's qualified 
research expenses would be $25.2x ($126x - $100.8x). For purposes of the 
following examples (2), (3) and (4) assume that B retains substantial 
rights to use the results of the research in carrying on B's business.
    Example 2. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, although A makes full payment of $120x during 
1982, B does not perform the research or pay the associated expenses 
until 1983. The computations are unchanged. However, B's qualified 
research expenses determined in example (1) are qualified research 
expenses during 1983.
    Example 3. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, although B performs the research and pays the 
associated expenses during 1982, A does not pay the $120x until 1983. 
The computations are unchanged and the amount determined in example (1) 
is a qualified research expense of B during 1982.
    Example 4. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, instead of agreeing to pay B $120x, A agrees to 
pay $100x regardless of the outcome and an additional $20x only if B's 
research produces a useful product. B's research produces a useful 
product and A pays B $120x during 1982. The $20x payment that is 
conditional on the success of the research is not treated as funding. 
Assuming that B establishes to the satisfaction of the district director 
the actual research expenses, B can allocate the funding to nonqualified 
and otherwise qualified research expenses. Thus $84x ($100x ($126x/
$150x)) would be allocated to otherwise qualified research expenses. B's 
qualified research expenses would be $42x ($126x - $84x).
    Example 5. C enters into a contract with D, a cash-method taxpayer 
using the calendar year as its taxable year, under which D is to perform 
research in which both C and D will have substantial rights. C agrees to 
reimburse D for 80 percent of D's expenses for the research. D performs 
part of the research in 1982 and the rest in 1983. At the time that D 
files its return for 1982, D is unable to determine the extent to which 
the research is funded under the provisions of this paragraph. Under 
these circumstances, D may not treat any of the expenses paid by D for 
this research during 1982 as qualified research expenses on its 1982 
return. When the project is complete and D can determine the extent of 
funding, D should file an amended return for 1982 to take into account 
any qualified research expense for 1982.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 
8930, 66 FR 295, Jan. 3, 2001]



Sec. 1.41-5  Basic research for taxable years beginning after December 31, 

1986. [Reserved]



Sec. 1.41-5A  Basic research for taxable years beginning before January 1, 

1987.

    (a) In general. The amount expended for basic research within the 
meaning of section 30(e) (before amended by the Tax Reform Act of 1986) 
equals the sum of money plus the taxpayer's basis in tangible property 
(other than land) transferred for use in the performance of basic 
research.
    (b) Trade or business requirement. Any amount treated as a contract 
research expense under section 30(e) (before amendment by the Tax Reform 
Act of 1986) shall be deemed to have been paid or incurred in carrying 
on a trade or business, if the corporation that paid or incurred the 
expenses is actually engaged in carrying on some trade or business.
    (c) Prepaid amounts--(1) In general. If any basic research expense 
paid or incurred during any taxable year is attributable to research to 
be conducted after the close of such taxable year, the expense so 
attributable shall be treated for purposes of section 30(b)(1)(B) 
(before amendment by the Tax Reform Act of 1986) as paid or incurred 
during the period in which the basic research is conducted.
    (2) Transfers of property. In the case of transfers of property to 
be used in the performance of basic research, the research in which that 
property is to be used shall be considered to be conducted ratably over 
a period beginning on the day the property is first so used and 
continuing for the number of years provided with respect to property of 
that class under section 168(c)(2) (before amendment by the Tax Reform 
Act of 1986). For example, if an item of property which is 3-year 
property under section 168(c) is transferred to a university for basic 
research on January 12, 1983, and is first so used by the university on 
March 1, 1983, then the research in which that property is used

[[Page 136]]

is considered to be conducted ratably from March 1, 1983, through 
February 28, 1986.
    (d) Written research agreement--(1) In general. A written research 
agreement must be entered into prior to the performance of the basic 
research.
    (2) Agreement between a corporation and a qualified organization 
after June 30, 1983--(i) In general. A written research agreement 
between a corporation and a qualified organization (including a 
qualified fund) entered into after June 30, 1983, shall provide that the 
organization shall inform the corporation within 60 days after the close 
of each taxable year of the corporation what amount of funds provided by 
the corporation pursuant to the agreement was expended on basic research 
during the taxable year of the corporation. In determining amounts 
expended on basic research, the qualified organization shall take into 
account the exclusions specified in section 30(e)(3) (before amendment 
by the Tax Reform Act of 1986) and in paragraph (e) of this section.
    (ii) Transfers of property. In the case of transfers of property to 
be used in basic research, the agreement shall provide that 
substantially all use of the property is to be for basic research, as 
defined in section 30(e)(3) (before amendment by the Tax Reform Act of 
1986).
    (3) Agreement between a qualified fund and a qualified educational 
organization after June 30, 1983. A written research agreement between a 
qualified fund and a qualified educational organization (see section 
30(e)(4)(B)(iii) (before amendment by the Tax Reform Act of 1986)) 
entered into after June 30, 1983, shall provide that the qualified 
educational organization shall furnish sufficient information to the 
qualified fund to enable the qualified fund to comply with the written 
research agreements it has entered into with grantor corporations, 
including the requirement set forth in paragraph (d)(2) of this section.
    (e) Exclusions--(1) Research conducted outside the United States. If 
a taxpayer pays or incurs an amount for basic research to be performed 
partly within the United States and partly without, only 65 percent of 
the portion of the amount attributable to research performed within the 
United States can be treated as a contract research expense (even if 80 
percent or more of the contract amount was for basic research performed 
in the United States).
    (2) Research in the social sciences or humanities. Basic research 
does not include research in the social sciences or humanities, within 
the meaning of Sec. 1.41-4A(c).
    (f) Procedure for making an election to be treated as a qualified 
fund. In order to make an election to be treated as a qualified fund 
within the meaning of section 30(e)(4)(B)(iii) (before amendment by the 
Tax Reform Act of 1986) or as an organization described in section 
41(e)(6)(D), the organization shall file with the Internal Revenue 
Service center with which it files its annual return a statement that--
    (1) Sets out the name, address, and taxpayer identification number 
of the electing organization (the ``taxpayer'') and of the organization 
that established and maintains the electing organization (the 
``controlling organization''),
    (2) Identifies the election as an election under section 41(e)(6)(D) 
of the Code,
    (3) Affirms that the controlling organization and the taxpayer are 
section 501(c)(3) organizations,
    (4) Provides that the taxpayer elects to be treated as a private 
foundation for all Code purposes other than section 4940,
    (5) Affirms that the taxpayer satisfies the requirement of section 
41(e)(6)(D)(iii), and
    (6) Specifies the date on which the election is to become effective.

If an election to be treated as a qualified fund is filed before 
February 1, 1982, the election may be made effective as of any date 
after June 30, 1981, and before January 1, 1986. If an election is filed 
on or after February 1, 1982, the election may be made effective as of 
any date on or after the date on which the election is filed.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 
8930, 66 FR 295, Jan. 3, 2001]

[[Page 137]]



Sec. 1.41-6  Aggregation of expenditures.

    (a) Controlled group of corporations; trades or businesses under 
common control--(1) In general. To determine the amount of research 
credit (if any) allowable to a trade or business that at the end of its 
taxable year is a member of a controlled group, a taxpayer must--
    (i) Compute the group credit in the manner described in paragraph 
(b) of this section; and
    (ii) Allocate the group credit among the members of the group in the 
manner described in paragraph (c) of this section.
    (2) Consolidated groups. For special rules relating to consolidated 
groups, see paragraph (d) of this section.
    (3) Definitions. For purposes of this section--
    (i) Consolidated group has the meaning set forth in Sec. 1.1502-
1(h).
    (ii) Controlled group and group mean a controlled group of 
corporations, as defined in section 41(f)(5), or a group of trades or 
businesses under common control. For rules for determining whether 
trades or businesses are under common control, see Sec. 1.52-1 (b) 
through (g).
    (iii) Credit year means the taxable year for which the member is 
computing the credit.
    (iv) Group credit means the research credit (if any) allowable to a 
controlled group.
    (v) Trade or business means a sole proprietorship, a partnership, a 
trust, an estate, or a corporation that is carrying on a trade or 
business (within the meaning of section 162). Any corporation that is a 
member of a commonly controlled group shall be deemed to be carrying on 
a trade or business if any other member of that group is carrying on any 
trade or business.
    (b) Computation of the group credit--(1) In general. All members of 
a controlled group are treated as a single taxpayer for purposes of 
computing the research credit. The group credit is computed by applying 
all of the section 41 computational rules on an aggregate basis. All 
members of a controlled group must use the same method of computation, 
either the method described in section 41(a) or the alternative 
incremental research credit (AIRC) method described in section 41(c)(4), 
in computing the group credit for a credit year.
    (2) Start-up companies--(i) In general. For purposes of computing 
the group credit, a controlled group is treated as a start-up company 
for purposes of section 41(c)(3)(B)(i) if--
    (A) There was no taxable year beginning before January 1, 1984, in 
which a member of the group had gross receipts and either the same 
member or another member also had qualified research expenditures 
(QREs); or
    (B) There were fewer than three taxable years beginning after 
December 31, 1983, and before January 1, 1989, in which a member of the 
group had gross receipts and either the same member or another member 
also had QREs.
    (ii) Example. The following example illustrates the principles of 
paragraph (b)(2)(i) of this section:

    Example. A, B, and C, all of which are calendar year taxpayers, are 
members of a controlled group. During the 1983 taxable year, A had QREs, 
but no gross receipts; B had gross receipts, but no QREs; and C had no 
QREs or gross receipts. The 1984 taxable year was the first taxable year 
for which each of A, B, and C had both QREs and gross receipts. A, B, 
and C had both QREs and gross receipts in 1985, 1986, 1987, and 1988. 
Because the first taxable year for which each of A, B, and C had both 
QREs and gross receipts began after December 31, 1983, each of A, B, and 
C is a start-up company under section 41(c)(3)(B)(i) and each is a 
start-up company for purposes of computing the stand-alone entity 
credit. During the 1983 taxable year, at least one member of the group, 
A, had QREs and at least one member of the group, B, had gross receipts, 
thus, the group had both QREs and gross receipts in 1983. Therefore, the 
controlled group is not a start-up company because the first taxable 
year for which the group had both QREs and gross receipts did not begin 
after December 31, 1983, and there were not fewer than three taxable 
years beginning after December 31, 1983, and before January 1, 1989, in 
which a member of the group had gross receipts and QREs.

    (iii) First taxable year after December 31, 1993, for which the 
controlled group had QREs. In the case of a controlled group that is 
treated as a start-up company under section 41(c)(3)(B)(i) and paragraph 
(b)(2)(i) of this section, for purposes of determining the group's 
fixed-base percentage under section 41(c)(3)(B)(ii), the first taxable 
year after December 31, 1993, for which the

[[Page 138]]

group has QREs is the first taxable year in which at least one member of 
the group has QREs.
    (iv) Example. The following example illustrates the principles of 
paragraph (b)(2)(iii) of this section:

    Example. D, E, and F, all of which are calendar year taxpayers, are 
members of a controlled group. The group is treated as a start-up 
company under section 41(c)(3)(B)(i) and paragraph (b)(2)(i) of this 
section. The first taxable year after December 31, 1993, for which D had 
QREs was 1994. The first taxable year after December 31, 1993, for which 
E had QREs was 1995. The first taxable year after December 31, 1993, for 
which F had QREs was 1996. Because the 1994 taxable year was the first 
taxable year after December 31, 1993, for which at least one member of 
the group, D, had QREs, for purposes of determining the group's fixed-
based percentage under section 41(c)(3)(B)(ii), the 1994 taxable year 
was the first taxable year after December 31, 1993, for which the group 
had QREs.

    (c) Allocation of the group credit--(1) In general. (i) To the 
extent the group credit (if any) computed under paragraph (b) of this 
section does not exceed the sum of the stand-alone entity credits of all 
of the members of a controlled group, computed under paragraph (c)(2) of 
this section, such group credit shall be allocated among the members of 
the controlled group in proportion to the stand-alone entity credits of 
the members of the controlled group, computed under paragraph (c)(2) of 
this section:
[GRAPHIC] [TIFF OMITTED] TR09NO06.005

    (ii) To the extent that the group credit (if any) computed under 
paragraph (b) of this section exceeds the sum of the stand-alone entity 
credits of all of the members of the controlled group, computed under 
paragraph (c)(2) of this section, such excess shall be allocated among 
the members of a controlled group in proportion to the QREs of the 
members of the controlled group:
[GRAPHIC] [TIFF OMITTED] TR09NO06.006

    (2) Stand-alone entity credit. The term stand-alone entity credit 
means the research credit (if any) that would be allowable to a member 
of a controlled group if the credit were computed as if section 41(f)(1) 
did not apply, except that the member must apply the rules provided in 
paragraphs (d)(1) (relating to consolidated groups) and (i) (relating to 
intra-group transactions) of this section. Each member's stand-alone 
entity credit for any credit year must be computed under whichever 
method (the method described in section 41(a) or the method described in 
section 41(c)(4)) results in the greater stand-alone entity credit for 
that member, without regard to the method used to compute the group 
credit.
    (d) Special rules for consolidated groups--(1) In general. For 
purposes of applying paragraph (c) of this section, a consolidated group 
whose members are members of a controlled group is treated as a single 
member of the controlled group and a single stand-alone entity credit is 
computed for the consolidated group.
    (2) Start-up company status. A consolidated group's status as a 
start-up company and the first taxable year after December 31, 1993, for 
which a consolidated group has QREs are determined in accordance with 
the principles of paragraph (b)(2) of this section.
    (3) Special rule for allocation of group credit among consolidated 
group members. The portion of the group credit that is

[[Page 139]]

allocated to a consolidated group is allocated to the members of the 
consolidated group in accordance with the principles of paragraph (c) of 
this section. However, for this purpose, the stand-alone entity credit 
of a member of a consolidated group is computed without regard to 
section 41(f)(1), but with regard to paragraph (i) of this section.
    (e) Examples. The following examples illustrate the provisions of 
this section. Unless otherwise stated, no members of a controlled group 
are members of a consolidated group, no member of the group made any 
basic research payments or paid or incurred any amounts to an energy 
research consortium, and the group has not made an AIRC election (except 
as provided in Example 6) or an ASC election. For an example 
illustrating the calculation of the alternative simplified credit under 
section 41(c)(5), which is applicable for taxable years ending after 
December 31, 2006, see Sec. 1.41-6T(e).

    Example 1. Group credit is less than sum of members' stand-alone 
entity credits--(i) Facts. A, B, and C, all of which are calendar-year 
taxpayers, are members of a controlled group. For purposes of computing 
the group credit for the 2004 taxable year (the credit year), A, B, and 
C had the following:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Group
                                                         A               B               C           aggregate
----------------------------------------------------------------------------------------------------------------
Credit Year QREs................................           $200x            $20x           $110x           $330x
1984-1988 QREs..................................            $40x            $10x           $100x           $150x
1984-1988 Gross Receipts........................         $1,000x           $350x           $150x         $1,500x
Average Annual Gross Receipts for 4 Years                $1,200x           $200x           $300x         $1,700x
 Preceding the Credit Year......................
----------------------------------------------------------------------------------------------------------------

    (ii) Computation of the group credit--(A) In general. The research 
credit allowable to the group is computed as if A, B, and C were one 
taxpayer. The group credit is equal to 20 percent of the excess of the 
group's aggregate credit year QREs ($330x) over the group's base amount 
($170x). The group credit is 0.20 x ($330x-$170x), which equals $32x.
    (B) Group's base amount--(1) Computation. The group's base amount 
equals the greater of: The group's fixed-base percentage (10 percent) 
multiplied by the group's aggregate average annual gross receipts for 
the 4 taxable years preceding the credit year ($1,700x), or the group's 
minimum base amount ($165x). The group's base amount, therefore, is 
$170x, which is the greater of: 0.10 x $1,700x, which equals $170x, or 
$165x.
    (2) Group's minimum base amount. The group's minimum base amount is 
50 percent of the group's aggregate credit year QREs. The group's 
minimum base amount is 0.50 x $330x, which equals $165x.
    (3) Group's fixed-base percentage. The group's fixed-base percentage 
is the lesser of: The ratio that the group's aggregate QREs for the 
taxable years beginning after December 31, 1983, and before January 1, 
1989, bear to the group's aggregate gross receipts for the same period, 
or 16 percent (the statutory maximum). The group's fixed-base 
percentage, therefore, is 10 percent, which is the lesser of: $150x/
$1,500x, which equals 10 percent, or 16 percent.
    (iii) Allocation of the group credit. Under paragraph (c)(2) of this 
section, each member's stand-alone entity credit must be computed using 
the method that results in the greater stand-alone entity credit for 
that member. The stand-alone entity credit for each of A, B, and C is 
greater using the method described in section 41(a). Therefore, the 
stand-alone entity credit for each of A, B, and C must be computed using 
the method described in section 41(a). A's stand-alone entity credit is 
$20x. B's stand-alone entity credit is $2x. C's stand-alone entity 
credit is $11x. The sum of the members' stand-alone entity credits is 
$33x. Because the group credit of $32x is less than the sum of the 
stand-alone entity credits of all the members of the group ($33x), the 
group credit is allocated among the members of the group based on the 
ratio that each member's stand-alone entity credit bears to the sum of 
the stand-alone entity credits of all the members of the group. The $32x 
group credit is allocated as follows:

----------------------------------------------------------------------------------------------------------------
                                                         A               B               C             Total
----------------------------------------------------------------------------------------------------------------
Stand-Alone Entity Credit.......................            $20x             $2x            $11x            $33x
Allocation Ratio (Stand-Alone Entity Credit/Sum            20/33            2/33           11/33  ..............
 of Stand-Alone Entity Credits).................
Multiplied by: Group Credit.....................            $32x            $32x            $32x  ..............
Equals: Credit Allocated to Member..............         $19.39x          $1.94x         $10.67x            $32x
----------------------------------------------------------------------------------------------------------------


[[Page 140]]

    Example 2. Group credit exceeds sum of members' stand-alone entity 
credits--(i) Facts. D, E, F, and G, all of which are calendar-year 
taxpayers, are members of a controlled group. For purposes of computing 
the group credit for the 2004 taxable year (the credit year), D, E, F, 
and G had the following:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Group
                                         D               E               F               G           aggregate
----------------------------------------------------------------------------------------------------------------
Credit Year QREs................           $580x            $10x            $70x            $15x           $675x
1984-1988 QREs..................           $500x            $25x           $100x            $25x           $650x
1984-1988 Gross Receipts........         $4,000x         $5,000x         $2,000x        $10,000x        $21,000x
Average Annual Gross Receipts            $5,000x         $5,000x         $2,000x         $5,000x        $17,000x
 for 4 Years Preceding the
 Credit Year....................
----------------------------------------------------------------------------------------------------------------

    (ii) Computation of the group credit--(A) In general. The research 
credit allowable to the group is computed as if D, E, F, and G were one 
taxpayer. The group credit is equal to 20 percent of the excess of the 
group's aggregate credit year QREs ($675x) over the group's base amount 
($527x). The group credit is 0.20 x ($675x-$527x), which equals $29.76x.
    (B) Group's base amount--(1) Computation. The group's base amount 
equals the greater of: The group's fixed-base percentage (3.10 percent) 
multiplied by the group's aggregate average annual gross receipts for 
the 4 taxable years preceding the credit year ($17,000x), or the group's 
minimum base amount ($337.50x). The group's base amount, therefore, is 
$527x, which is the greater of: 0.031 x $17,000x, which equals $527x, or 
$337.50x.
    (2) Group's minimum base amount. The group's minimum base amount is 
50 percent of the group's aggregate credit year QREs. The group's 
minimum base amount is 0.50 x $675x, which equals $337.50x.
    (3) Group's fixed-base percentage. The group's fixed-base percentage 
is the lesser of: The ratio that the group's aggregate QREs for the 
taxable years beginning after December 31, 1983, and before January 1, 
1989, bear to the group's aggregate gross receipts for the same period, 
or 16 percent (the statutory maximum). The group's fixed-base 
percentage, therefore, is 3.10 percent, which is the lesser of: $650x/
$21,000x, which equals 3.10 percent, or 16 percent.
    (iii) Allocation of the group credit. Under paragraph (c)(2) of this 
section, each member's stand-alone entity credit must be computed using 
the method that results in the greater stand-alone entity credit for 
that member. The stand-alone entity credits for D ($19.46x) and F 
($1.71x) are greater using the AIRC method. Therefore, the stand-alone 
entity credits for D and F must be computed using the AIRC method. The 
stand-alone entity credit for G ($0.50x) is greater using the method 
described in section 41(a). Therefore, the stand-alone entity credit for 
G must be computed using the method described in section 41(a). E's 
stand-alone entity credit computed under either method is zero. The sum 
of the members' stand-alone entity credits is $21.67x. Because the group 
credit of $29.76x is greater than the sum of the stand-alone entity 
credits of all the members of the group ($21.67x), each member of the 
group is allocated an amount of the group credit equal to that member's 
stand-alone entity credit. The excess of the group credit over the sum 
of the members' stand alone entity credits ($8.09x) is allocated among 
the members of the group based on the ratio that each member's QREs bear 
to the sum of the QREs of all the members of the group. The $29.76x 
group credit is allocated as follows:

----------------------------------------------------------------------------------------------------------------
                                         D               E               F               G             Total
----------------------------------------------------------------------------------------------------------------
Group Credit....................  ..............  ..............  ..............  ..............         $29.76x
Minus: Sum of Stand-Alone Entity         $19.46x          $0.00x          $1.71x          $0.50x         $21.67x
 Credits........................
Equals: Excess Group Credit.....  ..............  ..............  ..............  ..............          $8.09x
                                  ..............  ..............  ..............  ..............  ..............
Excess Group Credit.............          $8.09x          $8.09x          $8.09x          $8.09x  ..............
Multiplied By Allocation Ratio:          580/675          10/675          70/675          15/675  ..............
 QREs/Sum of QREs...............
Excess Group Credit Allocated...          $6.95x          $0.12x          $0.84x          $0.18x  ..............
Plus: Stand-Alone Entity Credit.         $19.46x          $0.00x          $1.71x          $0.50x  ..............
Equals: Credit Allocated to              $26.41x          $0.12x          $2.55x          $0.68x         $29.76x
 Member.........................
----------------------------------------------------------------------------------------------------------------

    Example 3. Consolidated group within a controlled group--(i) Facts. 
The facts are the same as in Example 2, except that D and E file a 
consolidated return.
    (ii) Allocation of the group credit--(A) In general. For purposes of 
allocating the controlled group's research credit of $29.76x among the 
members of the controlled group,

[[Page 141]]

D and E are treated as a single member of the controlled group.
    (B) Computation of stand-alone entity credits. The stand-alone 
entity credit for the consolidated group is computed by treating D and E 
as a single entity. Under paragraph (c)(2) of this section, the stand-
alone entity credit for each member must be computed using the method 
that results in the greater stand-alone entity credit for that member. 
The stand-alone entity credit for each of the DE consolidated group 
($17.55x) and F ($1.71x) is greater using the AIRC method. Therefore, 
the stand-alone entity credit for each of the DE consolidated group and 
F must be computed using the AIRC method. The stand-alone entity credit 
for G ($0.50x) is greater using the method described in section 41(a). 
Therefore, the stand-alone entity credit for G must be computed using 
the method described in section 41(a). The sum of the members' stand-
alone entity credits is $19.76x.
    (C) Allocation of controlled group credit. Because the group credit 
of $29.76x is greater than the sum of the stand-alone entity credits of 
all the members of the group ($19.76x), each member of the group is 
allocated an amount of the group credit equal to that member's stand-
alone entity credit. The excess of the group credit over the sum of the 
members' stand-alone entity credits ($10.00x) is allocated among the 
members of the group based on the ratio that each member's QREs bear to 
the sum of the QREs of all the members of the group. The group credit of 
$29.76x is allocated as follows:

----------------------------------------------------------------------------------------------------------------
                                                        DE               F               G             Total
----------------------------------------------------------------------------------------------------------------
Group Credit....................................  ..............  ..............  ..............         $29.76x
Minus: Sum of Stand-Alone Entity Credits........         $17.55x          $1.71x          $0.50x         $19.76x
Equals: Excess Group Credit.....................  ..............  ..............  ..............         $10.00x
                                                  ..............  ..............  ..............  ..............
Excess Group Credit.............................         $10.00x         $10.00x         $10.00x  ..............
Multiplied By Allocation Ratio: QREs/Sum of QREs         590/675          70/675          15/675  ..............
Excess Group Credit Allocated...................          $8.74x          $1.04x          $0.22x  ..............
Plus: Stand-Alone Entity Credit.................         $17.55x          $1.71x          $0.50x  ..............
Equals: Credit Allocated to Member..............         $26.29x          $2.75x          $0.72x         $29.76x
----------------------------------------------------------------------------------------------------------------

    (iii) Allocation of the group credit allocated to consolidated 
group--(A) In general. The group credit that is allocated to a 
consolidated group is allocated among the members of the consolidated 
group in accordance with the principles of paragraph (c) of this 
section.
    (B) Computation of stand-alone entity credits. Under paragraph 
(c)(2) of this section, the stand-alone entity credit for each member of 
the consolidated group must be computed using the method that results in 
the greater stand-alone entity credit for that member. The stand-alone 
entity credit for D ($19.46x) is greater using the AIRC method. 
Therefore, the stand-alone entity credit for D must be computed using 
the AIRC method. The stand-alone entity credit for E is zero under 
either method. The sum of the stand-alone entity credits of the members 
of the consolidated group is $19.46x.
    (C) Allocation among members of consolidated group. Because the 
amount of the group credit allocated to the consolidated group ($26.29x) 
is greater than $19.46x, the sum of the stand-alone entity credits of 
all the members of the consolidated group, each member of the 
consolidated group is allocated an amount of the group credit allocated 
to the consolidated group equal to that member's stand-alone entity 
credit The excess of the group credit allocated to the consolidated 
group over the sum of the consolidated group members' stand alone entity 
credits ($6.83x) is allocated among the members of the consolidated 
group based on the ratio that each member's QREs bear to the sum of the 
QREs of all the members of the consolidated group. The group credit of 
$26.29x allocated to the DE consolidated group is allocated between D 
and E as follows:

----------------------------------------------------------------------------------------------------------------
                                                                         D               E             Total
----------------------------------------------------------------------------------------------------------------
Group Credit....................................................  ..............  ..............         $26.29x
Minus: Sum of Stand-Alone Entity Credits........................         $19.46x          $0.00x         $19.46x
Excess Group Credit.............................................  ..............  ..............          $6.83x
                                                                  ..............  ..............  ..............
Excess Group Credit.............................................          $6.83x          $6.83x  ..............
Multiplied By Allocation Ratio: QREs/Sum of QREs................         580/590          10/590  ..............
Excess Group Credit Allocated...................................          $6.71x          $0.12x  ..............
Plus: Stand-Alone Entity Credit.................................         $19.46x          $0.00x  ..............
Equals: Credit Allocated to Member..............................         $26.17x          $0.12x         $26.29x
----------------------------------------------------------------------------------------------------------------


[[Page 142]]

    Example 4. Member is a start-up company--(i) Facts. H, I, and J, all 
of which are calendar-year taxpayers, are members of a controlled group. 
The first taxable year for which J has both QREs and gross receipts 
begins after December 31, 1983, therefore, J is a start-up company under 
section 41(c)(3)(B)(i). The first taxable year for which H and I had 
both QREs and gross receipts began before December 31, 1983, therefore, 
H and I are not start-up companies under section 41(c)(3)(B)(i). For 
purposes of computing the group credit for the 2004 taxable year (the 
credit year), H, I, and J had the following:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Group
                                                         H               I               J           aggregate
----------------------------------------------------------------------------------------------------------------
Credit Year QREs................................           $200x            $20x            $50x           $270x
1984-1988 QREs..................................            $55x            $15x             $0x            $70x
1984-1988 Gross Receipts........................         $1,000x           $400x             $0x         $1,400x
Average Annual Gross Receipts for 4 Years                $1,200x           $200x             $0x         $1,400x
 Preceding the Credit Year......................
----------------------------------------------------------------------------------------------------------------

    (ii) Computation of the group credit--(A) In general. The research 
credit allowable to the group is computed as if H, I, and J were one 
taxpayer. The group credit is equal to 20 percent of the excess of the 
group's aggregate credit year QREs ($270x) over the group's base amount 
($135x). The group credit is 0.20 x ($270x-$135x), which equals $27x.
    (B) Group's base amount--(1) Computation. The group's base amount 
equals the greater of: the group's fixed-base percentage (5 percent) 
multiplied by the group's aggregate average annual gross receipts for 
the 4 taxable years preceding the credit year ($1,400x), or the group's 
minimum base amount ($135x). The group's base amount, therefore, is 
$135x, which is the greater of: 0.05 x $1,400x, which equals $70x, or 
$135x.
    (2) Group's minimum base amount. The group's minimum base amount is 
50 percent of the group's aggregate credit year QREs. The group's 
minimum base amount is 0.50 x $270x, which equals $135x.
    (3) Group's fixed-base percentage. Because the first taxable year in 
which at least one member of the group has QREs and at least one member 
of the group has gross receipts does not begin after December 31, 1983, 
the group is not a start-up company. Therefore, the group's fixed-base 
percentage is the lesser of: the ratio that the group's aggregate QREs 
for the taxable years beginning after December 31, 1983, and before 
January 1, 1989, bear to the group's aggregate gross receipts for the 
same period, or 16 percent (the statutory maximum). The group's fixed-
base percentage, therefore, is 5 percent, which is the lesser of: $70x/
$1,400x, which equals 5 percent, or 16 percent.
    (iii) Allocation of the group credit. Under paragraph (c)(2) of this 
section, the stand-alone entity credit for each member of the group must 
be computed using the method that results in the greater stand-alone 
entity credit for that member. The stand-alone entity credits for H 
($20x), I ($2x), and J ($5x) are greater using the method described in 
section 41(a). Therefore, the stand-alone entity credits for each of H, 
I, and J must be computed using the method described in section 41(a). 
The sum of the stand-alone entity credits of the members of the group is 
$27x. Because the group credit of $27x is equal to the sum of the stand-
alone entity credits of all the members of the group ($27x), the group 
credit is allocated among the members of the group based on the ratio 
that each member's stand-alone entity credit bears to the sum of the 
stand-alone entity credits of all the members of the group. The group 
credit of $27x is allocated as follows:

----------------------------------------------------------------------------------------------------------------
                                                         H               I               J             Total
----------------------------------------------------------------------------------------------------------------
Stand-Alone Entity Credit.......................            $20x             $2x             $5x            $27x
Allocation Ratio (Stand-Alone Entity Credit/Sum            20/27            2/27            5/27  ..............
 of Stand-Alone Entity Credits).................
Multiplied by: Group Credit.....................            $27x            $27x            $27x  ..............
Equals: Credit Allocated to Member..............            $20x             $2x             $5x            $27x
----------------------------------------------------------------------------------------------------------------

    Example 5. Group is a start-up company--(i) Facts. K, L, and M, all 
of which are calendar-year taxpayers, are members of a controlled group. 
The taxable year ending on December 31, 1999, is the first taxable year 
in which a member of the group had QREs and either the same member or 
another member also had gross receipts. In that year, each of K, L, and 
M had both QREs and gross receipts. The 2004 taxable year is the fifth 
taxable year beginning after December 31, 1993, for which at least one 
member of the group had QREs For purposes of computing the group credit 
for the 2004 taxable year (the credit year), K, L, and M had the 
following:

[[Page 143]]



----------------------------------------------------------------------------------------------------------------
                                                                                                       Group
                                                         K               L               M           aggregate
----------------------------------------------------------------------------------------------------------------
Credit Year QREs................................           $255x            $25x           $100x           $380x
1984-1988 QREs..................................             $0x             $0x             $0x             $0x
1984-1988 Gross Receipts........................             $0x             $0x             $0x             $0x
Average Annual Gross Receipts for 4 Years                $1,600x           $340x           $300x         $2,240x
 Preceding the Credit Year......................
----------------------------------------------------------------------------------------------------------------

    (ii) Computation of the group credit--(A) In general. The research 
credit allowable to the group is computed as if K, L, and M were one 
taxpayer. The group credit is equal to 20 percent of the excess of the 
group's aggregate credit year QREs ($380x) over the group's base amount 
($190x). The group credit is 0.20x ($380x - $190x), which equals $38x.
    (B) Group's base amount--(1) Computation. The group's base amount 
equals the greater of: the group's fixed-base percentage (3 percent) 
multiplied by the group's aggregate average annual gross receipts for 
the 4 taxable years preceding the credit year ($2,240x), or the group's 
minimum base amount ($190x). The group's base amount, therefore, is 
$190x, which is the greater of: 0.03 x $2,240x, which equals $67.20x, or 
$190x.
    (2) Group's minimum base amount. The group's minimum base amount is 
50 percent of the group's aggregate credit year QREs. The group's 
minimum base amount is 0.50 x $380x, which equals $190x.
    (3) Group's fixed-base percentage. Because the first taxable year in 
which at least one member of the group has QREs and at least one member 
of the group has gross receipts begins after December 31, 1983, the 
group is treated as a start-up company under section 41(c)(3)(B)(i) and 
paragraph (b)(2)(i) of this section. Because the 2004 taxable year is 
the fifth taxable year beginning after December 31, 1993, for which at 
least one member of the group had QREs, under section 
41(c)(3)(B)(ii)(I), the group's fixed-base percentage is 3 percent.
    (iii) Allocation of the group credit. Under paragraph (c)(2) of this 
section, the stand-alone entity credit for each member of the group must 
be computed using the method that results in the greater stand-alone 
entity credit for that member. The stand-alone entity credit for each of 
K ($25.5x), L ($2.5x), and M ($10x) is greater using the method 
described in section 41(a). Therefore the stand-alone entity credits for 
each of K, L, and M must be computed using the method described in 
section 41(a). The sum of the stand-alone entity credits of all the 
members of the group is $38x. Because the group credit of $38x is equal 
to sum of the stand-alone entity credits of all the members of the group 
($38x), the group credit is allocated among the members of the group 
based on the ratio that each member's stand-alone entity credit bears to 
the sum of the stand-alone entity credits of all the members of the 
group. The $38x group credit is allocated as follows:

----------------------------------------------------------------------------------------------------------------
                                                         K               L               M             Total
----------------------------------------------------------------------------------------------------------------
Stand-Alone Entity Credit.......................          $25.5x           $2.5x            $10x            $38x
Allocation Ratio (Stand-Alone Entity Credit/Sum          25.5/38          2.5/38           10/38  ..............
 of Stand-Alone Entity Credits).................
Multiplied by: Group Credit.....................            $38x            $38x            $38x  ..............
Equals: Credit Allocated to Member..............          $25.5x           $2.5x            $10x            $38x
----------------------------------------------------------------------------------------------------------------

    Example 6. Group alternative incremental research credit--(i) Facts. 
N, O, and P, all of which are calendar-year taxpayers, are members of a 
controlled group. The research credit under section 41(a) is not 
allowable to the group for the 2004 taxable year because the group's 
aggregate QREs for the 2004 taxable year are less than the group's base 
amount. The group credit is computed using the AIRC rules of section 
41(c)(4). For purposes of computing the group credit for the 2004 
taxable year (the credit year), N, O, and P had the following:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Group
                                                         N               O               P           aggregate
----------------------------------------------------------------------------------------------------------------
Credit Year QREs................................             $0x            $20x           $110x           $130x
Average Annual Gross Receipts for 4 Years                $1,200x           $200x           $300x         $1,700x
 Preceding the Credit Year......................
----------------------------------------------------------------------------------------------------------------

    (ii) Computation of the group credit. The research credit allowable 
to the group is computed as if N, O, and P were one taxpayer. The group 
credit is equal to the sum of: 2.65

[[Page 144]]

percent of so much of the group's aggregate QREs for the taxable year as 
exceeds 1 percent of the group's aggregate average annual gross receipts 
for the 4 taxable years preceding the credit year, but does not exceed 
1.5 percent of such average; 3.2 percent of so much of the group's 
aggregate QREs as exceeds 1.5 percent of such average but does not 
exceed 2 percent of such average; and 3.75 percent of so much of such 
QREs as exceeds 2 percent of such average. The group credit is [0.0265 x 
[($1,700x x 0.015) - ($1,700x x 0.01)]] + [0.032 x [($1,700x x 0.02) - 
($1,700x x 0.015)]] + [0.0375 x [$130x - ($1,700x x 0.02)]], which 
equals $4.10x.
    (iii) Allocation of the group credit. Under paragraph (c)(2) of this 
section, the stand-alone entity credit for each member of the group must 
be computed using the method that results in the greater stand-alone 
entity credit for that member. The stand-alone entity credit for N is 
zero under either method. The stand-alone entity credit for each of O 
($0.66x) and P ($3.99x) is greater using the AIRC method. Therefore, the 
stand-alone entity credits for each of O and P must be computed using 
the AIRC method. The sum of the stand-alone entity credits of the 
members of the group is $4.65x. Because the group credit of $4.10x is 
less than the sum of the stand-alone entity credits of all the members 
of the group ($4.65x), the group credit is allocated among the members 
of the group based on the ratio that each member's stand-alone entity 
credit bears to the sum of the stand-alone entity credits of all the 
members of the group. The $4.10x group credit is allocated as follows:

----------------------------------------------------------------------------------------------------------------
                                                         N               O               P             Total
----------------------------------------------------------------------------------------------------------------
Stand-Alone Entity Credit.......................          $0.00x          $0.66x          $3.99x          $4.65x
Allocation Ratio (Stand-Alone Entity Credit/Sum           0/4.65       0.66/4.65       3.99/4.65  ..............
 of Stand-Alone Entity Credits).................
Multiplied by: Group Credit.....................          $4.10x          $4.10x          $4.10x  ..............
Equals: Credit Allocated to Member..............          $0.00x          $0.58x          $3.52x          $4.10x
----------------------------------------------------------------------------------------------------------------

    (f) For taxable years beginning before January 1, 1990. For taxable 
years beginning before January 1, 1990, see Sec. 1.41-6 as contained in 
26 CFR part 1, revised April 1, 2005.
    (g) Tax accounting periods used--(1) In general. The credit 
allowable to a member of a controlled group is that member's share of 
the group credit computed as of the end of that member's taxable year. 
In computing the group credit for a group whose members have different 
taxable years, a member generally should treat the taxable year of 
another member that ends with or within the credit year of the computing 
member as the credit year of that other member. For example, Q, R, and S 
are members of a controlled group of corporations. Both Q and R are 
calendar year taxpayers. S files a return using a fiscal year ending 
June 30. For purposes of computing the group credit at the end of Q's 
and R's taxable year on December 31, S's fiscal year ending June 30, 
which ends within Q's and R's taxable year, is treated as S's credit 
year.
    (2) Special rule when timing of research is manipulated. If the 
timing of research by members using different tax accounting periods is 
manipulated to generate a credit in excess of the amount that would be 
allowable if all members of the group used the same tax accounting 
period, then the appropriate Internal Revenue Service official in the 
operating division that has examination jurisdiction of the return may 
require each member of the group to calculate the credit in the current 
taxable year and all future years as if all members of the group had the 
same taxable year and base period as the computing member.
    (h) Membership during taxable year in more than one group. A trade 
or business may be a member of only one group for a taxable year. If, 
without application of this paragraph, a business would be a member of 
more than one group at the end of its taxable year, the business shall 
be treated as a member of the group in which it was included for its 
preceding taxable year. If the business was not included for its 
preceding taxable year in any group in which it could be included as of 
the end of its taxable year, the business shall designate in its timely 
filed (including extensions) return the group in which it is being 
included. If the return for a taxable year is due before July 1, 1983, 
the business may designate its group membership through an amended 
return for that year filed on or before

[[Page 145]]

June 30, 1983. If the business does not so designate, then the 
appropriate Internal Revenue Service official in the operating division 
that has examination jurisdiction of the return will determine the group 
in which the business is to be included.
    (i) Intra-group transactions--(1) In general. Because all members of 
a group under common control are treated as a single taxpayer for 
purposes of determining the research credit, transfers between members 
of the group are generally disregarded.
    (2) In-house research expenses. If one member of a group performs 
qualified research on behalf of another member, the member performing 
the research shall include in its QREs any in-house research expenses 
for that work and shall not treat any amount received or accrued as 
funding the research. Conversely, the member for whom the research is 
performed shall not treat any part of any amount paid or incurred as a 
contract research expense. For purposes of determining whether the in-
house research for that work is qualified research, the member 
performing the research shall be treated as carrying on any trade or 
business carried on by the member on whose behalf the research is 
performed.
    (3) Contract research expenses. If a member of a group pays or 
incurs contract research expenses to a person outside the group in 
carrying on the member's trade or business, that member shall include 
those expenses as QREs. However, if the expenses are not paid or 
incurred in carrying on any trade or business of that member, those 
expenses may be taken into account as contract research expenses by 
another member of the group provided that the other member--
    (i) Reimburses the member paying or incurring the expenses; and
    (ii) Carries on a trade or business to which the research relates.
    (4) Lease payments. The amount paid or incurred to another member of 
the group for the lease of personal property owned by a member of the 
group is not taken into account for purposes of section 41. Amounts paid 
or incurred to another member of the group for the lease of personal 
property owned by a person outside the group shall be taken into account 
as in-house research expenses for purposes of section 41 only to the 
extent of the lesser of--
    (i) The amount paid or incurred to the other member; or
    (ii) The amount of the lease expenses paid to the person outside the 
group.
    (5) Payment for supplies. Amounts paid or incurred to another member 
of the group for supplies shall be taken into account as in-house 
research expenses for purposes of section 41 only to the extent of the 
lesser of--
    (i) The amount paid or incurred to the other member; or
    (ii) The amount of the other member's basis in the supplies.
    (j) Effective/applicability dates--(1) In general. Except for 
paragraph (d) of this section, these regulations are applicable for 
taxable years ending on or after May 24, 2005. Generally, a taxpayer may 
use any reasonable method of computing and allocating the credit 
(including use of the consolidated group rule contained in paragraph (d) 
of this section) for taxable years ending before May 24, 2005. However, 
paragraph (b) of this section, relating to the computation of the group 
credit, and paragraph (c) of this section, relating to the allocation of 
the group credit, (applied without regard to paragraph (d) of this 
section) will apply to taxable years ending on or after December 29, 
1999, if the members of a controlled group, as a whole, claimed more 
than 100 percent of the amount that would be allowable under paragraph 
(b) of this section. In the case of a controlled group whose members 
have different taxable years and whose members use inconsistent methods 
of allocation, the members of the controlled group shall be deemed to 
have, as a whole, claimed more than 100 percent of the amount that would 
be allowable under paragraph (b) of this section.
    (2) Consolidated group rule. Paragraph (d) of this section is 
applicable for taxable years ending on or after November 9, 2006. For 
taxable years ending on or after May 24, 2005, and before November 9, 
2006, see Sec. 1.41-6T(d) as contained in 26 CFR part 1, revised April 
1, 2006.
    (3) Taxable years ending on or before December 31, 2006. Paragraphs 
(b)(1) and (c)(2) of this section are applicable for

[[Page 146]]

taxable years ending on or before December 31, 2006. For taxable years 
ending after December 31, 2006, see Sec. 1.41-6T.

[T.D. 9296, 71 FR 65725, Nov. 9, 2006; 71 FR 70875, Dec. 7, 2006; 71 FR 
75614, Dec. 15, 2006; T.D. 9401, 73 FR 34188, June 17, 2008]



Sec. 1.41-6T  Aggregation of expenditures (temporary).

    (a) [Reserved] For further guidance, see Sec. 1.41-6(a).
    (b) Computation of the group credit--(1) In general. All members of 
a controlled group are treated as a single taxpayer for purposes of 
computing the research credit. The group credit is computed by applying 
all of the section 41 computational rules on an aggregate basis. All 
members of a controlled group must use the same method of computation, 
either the method described in section 41(a)(1), the alternative 
incremental credit (AIRC) method described in section 41(c)(4), or the 
alternative simplified credit (ASC) method described in section 
41(c)(5), in computing the group credit for a credit year.
    (2) [Reserved] For further guidance, see Sec. 1.41-6(b)(2).
    (c) Allocation of the group credit. (1) [Reserved] For further 
guidance, see Sec. 1.41-6(c)(1).
    (2) Stand-alone entity credit. The term stand-alone entity credit 
means the research credit (if any) that would be allowable to a member 
of a controlled group if the credit were computed as if section 41(f)(1) 
did not apply, except that the member must apply the rules provided in 
Sec. 1.41-6(d)(1) (relating to consolidated groups) and Sec. 1.41-6(i) 
(relating to intra-group transactions). Each member's stand-alone entity 
credit for any credit year must be computed under whichever method (the 
method described in section 41(a), the method described in section 
41(c)(4), or the method described in section 41(c)(5)) results in the 
greatest stand-alone entity credit for that member, without regard to 
the method used to compute the group credit.
    (d) [Reserved] For further guidance see Sec. 1.41-6(d).
    (e) Example--Group alternative simplified credit. The following 
example illustrates a group computation in a year for which the ASC 
method under section 41(c)(5) is in effect. No members of the controlled 
group are members of a consolidated group and no member of the group 
made any basic research payments or paid or incurred any amounts to an 
energy research consortium.

    Example. (i) Facts. Q, R, and S, all of which are calendar-year 
taxpayers, are members of a controlled group. The research credit under 
section 41(a)(1) is not allowable to the group for the 2008 taxable year 
(the credit year) because the group's aggregate QREs for the credit year 
are less than the group's base amount. The group does not use the AIRC 
method of section 41(c)(4) because its aggregate QREs for the credit 
year do not exceed 1 percent of the average annual gross receipts for 
the four years preceding the credit year. The group credit is computed 
using the ASC rules of section 41(c)(5).

Assume that each member of the group had QREs in each of the three years 
preceding the credit year. For purposes of computing the group credit 
for the credit year, Q, R, and S had the following:

------------------------------------------------------------------------
                                                                 Group
                                  Q          R          S      aggregate
------------------------------------------------------------------------
Credit Year QREs............        $0x       $20x       $30x       $50x
Average QREs for 3 Years            10x        20x        10x        40x
 Preceding the Credit Year..
------------------------------------------------------------------------

    (ii) Computation of the group credit. The research credit allowable 
to the group is computed as if Q, R, and S are one taxpayer. The group 
credit is equal to 12 percent of so much of the QREs for the credit year 
as exceeds 50 percent of the average QREs for the three taxable years 
preceding the credit year. The group credit is 0.12 x ($50x-(0.5 x 
$40x)), which equals $3.6x.
    (iii) Allocation of the group credit. Under paragraph (c)(2) of this 
section, the stand-alone entity credit for each member of the group must 
be computed using the method that results in the greatest stand-alone 
entity credit for that member. The stand-alone entity credit for Q is 
zero under all three methods. Assume that the stand-alone entity credit 
for each of R ($1.2x) and S ($3x) is greatest using the ASC method. 
Therefore, the stand-alone entity credits for each of R and S must be 
computed using the ASC method. The sum of the stand-alone entity

[[Page 147]]

credits of the members of the group is $4.2x. Because the group credit 
of $3.6x is less than the sum of the stand-alone entity credits of all 
the members of the group ($4.2x), the group credit is allocated among 
the members of the group based on the ratio that each member's stand-
alone entity credit bears to the sum of the stand-alone entity credits 
of all the members of the group. The $3.6x group credit is allocated as 
follows:

------------------------------------------------------------------------
                                  Q          R          S        Total
------------------------------------------------------------------------
Stand-Alone Entity Credit...        $0x      $1.2x        $3x      $4.2x
Allocation Ratio (Stand-          0/4.2    1.2/4.2      3/4.2
 Alone Entity Credit/Sum of
 Stand-Alone Entity Credits)
Multiplied by: Group Credit.      $3.6x      $3.6x      $3.6x
Equals: Credit Allocated to         $0x     $1.03x     $2.57x      $3.6x
 Member.....................
------------------------------------------------------------------------


    (f) through (i) [Reserved] For further guidance see Sec. 1.41-6(f) 
through (i).
    (j) Effective/applicability dates. This section is applicable for 
taxable years ending after December 31, 2006. For taxable years ending 
on or before December 31, 2006, see Sec. 1.41-6.
    (k) Expiration date. The applicability of this section will expire 
on or before June 13, 2011.

[T.D. 9401, 73 FR 34188, June 17, 2008]



Sec. 1.41-7  Special rules.

    (a) Allocations--(1) Corporation making an election under subchapter 
S--(i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation. In the case of an S corporation 
(as defined in section 1361) the amount of research credit computed for 
the corporation shall be allocated to the shareholders according to the 
provisions of section 1366 and section 1377.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation. In the case of an 
electing small business corporation (as defined in section 1371 as that 
section read before the amendments made by the subchapter S Revision Act 
of 1982), the amount of the research credit computed for the corporation 
for any taxable year shall be apportioned pro rata among the persons who 
are shareholders of the corporation on the last day of the corporation's 
taxable year.
    (2) Pass-through in the case of an estate or trust. In the case of 
an estate or trust, the amount of the research credit computed for the 
estate or trust for any taxable year shall be apportioned among the 
estate or trust and the beneficiaries on the basis of the income of the 
estate or trust allocable to each.
    (3) Pass-through in the case of a partnership--(i) In general. In 
the case of a partnership, the research credit computed for the 
partnership for any taxable year shall be apportioned among the persons 
who are partners during the taxable year in accordance with section 704 
and the regulations thereunder. See, for example, Sec. 1.704-
1(b)(4)(ii). Because the research credit is an expenditure-based credit, 
the credit is to be allocated among the partners in the same proportion 
as section 174 expenditures are allocated for the year.
    (ii) Certain expenditures by joint ventures. Research expenses to 
which Sec. 1.41-2(a)(4)(ii) applies shall be apportioned among the 
persons who are partners during the taxable year in accordance with the 
provisions of that section. For purposes of section 41, these expenses 
shall be treated as paid or incurred directly by the partners rather 
than by the partnership. Thus, the partnership shall disregard these 
expenses in computing the credit to be apportioned under paragraph 
(a)(3)(i) of this section, and in making the computations under section 
41 each partner shall aggregate its distributive share of these expenses 
with other research expenses of the partner. The limitation on the 
amount of the credit set out in section 41(g) and in paragraph (c) of 
this section shall not apply because the credit is computed by the 
partner, not the partnership.
    (4) Year in which taken into account. An amount apportioned to a 
person under this paragraph shall be taken into account by the person in 
the taxable year of such person which or within which the taxable year 
of the corporation, estate, trust, or partnership (as the case may be) 
ends.

[[Page 148]]

    (5) Credit allowed subject to limitation. The credit allowable to 
any person to whom any amount has been apportioned under paragraph 
(a)(1), (2) or (3)(i) of this section is subject to section 41(g) and 
sections 38 and 39 of the Code, if applicable.
    (b) Adjustments for certain acquisitions and dispositions--Meaning 
of terms. For the meaning of ``acquisition,'' ``separate unit,'' and 
``major portion,'' see paragraph (b) of Sec. 1.52-2. An ``acquisition'' 
includes an incorporation or a liquidation.
    (c) Special rule for pass-through of credit. The special rule 
contained in section 41(g) for the pass-through of the credit in the 
case of an individual who owns an interest in an unincorporated trade or 
business, is a partner in a partnership, is a beneficiary of an estate 
or trust, or is a shareholder in an S corporation shall be applied in 
accordance with the principles set forth in Sec. 1.53-3.
    (d) Carryback and carryover of unused credits. The taxpayer to whom 
the credit is passed through under paragraph (c) of this section shall 
not be prevented from applying the unused portion in a carryback or 
carryover year merely because the entity that earned the credit changes 
its form of conducting business.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated by T.D. 8930, 66 FR 
295, Jan. 3, 2001]



Sec. 1.41-8  Alternative incremental credit.

    (a) Determination of credit. At the election of the taxpayer, the 
credit determined under section 41(a)(1) equals the amount determined 
under section 41(c)(4).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative incremental research credit (AIRC) in 
section 41(c)(4) for any taxable year of the taxpayer beginning after 
June 30, 1996. If a taxpayer makes an election under section 41(c)(4), 
the election applies to the taxable year for which made and all 
subsequent taxable years unless revoked in the manner prescribed in 
paragraph (b)(3) of this section.
    (2) Time and manner of election. An election under section 41(c)(4) 
is made by completing the portion of Form 6765, ``Credit for Increasing 
Research Activities,'' relating to the election of the AIRC, and 
attaching the completed form to the taxpayer's timely filed (including 
extensions) original return for the taxable year to which the election 
applies. An election under section 41(c)(4) may not be made on an 
amended return.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(4) if the 
taxpayer completes the portion of Form 6765 relating to the regular 
credit and attaches the completed form to the taxpayer's timely filed 
(including extensions) original return for the year to which the 
revocation applies. An election under section 41(c)(4) may not be 
revoked on an amended return.
    (4) Special rules for controlled groups--(i) In general. In the case 
of a controlled group of corporations, all the members of which are not 
included on a single consolidated return, an election (or revocation) 
must be made by the designated member by satisfying the requirements of 
paragraph (b)(2) or (b)(3) of this section (whichever applies), and such 
election (or revocation) by the designated member shall be binding on 
all the members of the group for the credit year to which the election 
(or revocation) relates. If the designated member fails to timely make 
(or revoke) an election, each member of the group must compute the group 
credit using the method used to compute the group credit for the 
immediately preceding credit year.
    (ii) Designated member. For purposes of this paragraph (b)(4) of 
this section, for any credit year, the term designated member means that 
member of the group that is allocated the greatest amount of the group 
credit under Sec. 1.41-6(c) based on the amount of credit reported on 
the original timely filed Federal income tax return (even if that member 
subsequently is determined not to be the designated member). If the 
members of a group compute the group credit using different methods 
(either the method described in section 41(a) or the AIRC method of 
section

[[Page 149]]

41(c)(4)) and at least two members of the group qualify as the 
designated member, then the term designated member means that member 
that computes the group credit using the method that yields the greater 
group credit. For example, A, B, C, and D are members of a controlled 
group but are not members of a consolidated group. For the 2005 taxable 
year, the group credit using the method described in section 41(a) is 
$10x. Under this method, A would be allocated $5x of the group credit, 
which would be the largest share of the group credit under this method. 
For the 2005 taxable year, the group credit using the AIRC method is 
$15x. Under the AIRC method, C would be allocated $5x of the group 
credit, which is the largest share of the group credit computed using 
the AIRC method. Because the group credit is greater using the AIRC 
method and C is allocated the greatest amount of credit under that 
method, C is the designated member. Therefore, C's section 41(c)(4) 
election is binding on all the members of the group for the 2005 taxable 
year.
    (5) Effective/applicability dates. These regulations are applicable 
for taxable years ending on or after November 9, 2006. For taxable years 
ending on or after May 24, 2005, and before November 9, 2006, see Sec. 
1.41-8T(b)(5) as contained in 26 CFR part 1, revised April 1, 2006. 
Paragraphs (b)(3) and (b)(4)(ii) of this section are applicable for 
taxable years ending on or before December 31, 2006. For taxable years 
ending after December 31, 2006, see Sec. 1.41-8T.

[T.D. 9296, 71 FR 65732, Nov. 9, 2006; 71 FR 70875, Dec. 7, 2006, as 
amended by T.D. 9401, 73 FR 34189, June 17, 2008]



Sec. 1.41-8T  Alternative incremental credit (temporary).

    (a) [Reserved] For further guidance, see Sec. 1.41-8(a).
    (b) Election--(1) [Reserved] For further guidance, see Sec. 1.41-
8(b)(1).
    (2) Time and manner of election. An election under section 41(c)(4) 
is made by completing the portion of Form 6765, ``Credit for Increasing 
Research Activities,'' (or successor form) relating to the election of 
the AIRC, and attaching the completed form to the taxpayer's timely 
filed (including extensions) original return for the taxable year to 
which the election applies. An election under section 41(c)(4) may not 
be made on an amended return. An extension of time to make an election 
under section 41(c)(4) will not be granted under Sec. 301.9100-3 of 
this chapter.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(4) if the 
taxpayer completes the portion of Form 6765, ``Credit For Increasing 
Research Activities,'' (or successor form) relating to the amount 
determined under section 41(a)(1) (the regular credit) or the 
alternative simplified credit (ASC) and attaches the completed form to 
the taxpayer's timely filed (including extensions) original return for 
the year to which the revocation applies. An election under section 
41(c)(4) may not be revoked on an amended return. An extension of time 
to revoke an election under section 41(c)(4) will not be granted under 
Sec. 301.9100-3 of this chapter.
    (4) Special rules for controlled groups--(i) [Reserved] For further 
guidance, see Sec. 1.41-8(b)(4)(i).
    (ii) Designated member. For purposes of this paragraph (b)(4), for 
any credit year, the term designated member means that member of the 
group that is allocated the greatest amount of the group credit under 
Sec. 1.41-6(c) based on the amount of credit reported on the original 
timely-filed Federal income tax return (even if that member subsequently 
is determined not to be the designated member). If the members of a 
group compute the group credit using different methods (the method 
described in section 41(a)(1), the AIRC method of section 41(c)(4), or 
the ASC method of section 41(c)(5)) and at least two members of the 
group qualify as the designated member, then the term designated member 
means that member that computes the group credit using the method that 
yields the greatest group credit. For example, A, B, C, and D are 
members of a controlled group but are not members of a consolidated 
group. For the 2008 taxable year (the credit year), the group credit 
using the method described in section 41(a)(1) is

[[Page 150]]

$10x. Under this method, A would be allocated $5x of the group credit, 
which would be the largest share of the group credit under this method. 
For the credit year, the group credit using the AIRC method is $15x. 
Under the AIRC method, B would be allocated $5x of the group credit, 
which is the largest share of the group credit computed using the AIRC 
method. For the credit year, the group credit using the ASC method is 
$10x. Under the ASC method, C would be allocated $5x of the group 
credit, which is the largest share of the group credit computed using 
the ASC method. Because the group credit is greatest using the AIRC 
method and B is allocated the greatest amount of credit under that 
method, B is the designated member. Therefore, if B makes a section 
41(c)(4) election on its original timely-filed return for the credit 
year, that election is binding on all members of the group for the 
credit year.
    (5) Effective/applicability dates. This section is applicable for 
taxable years ending after December 31, 2006. For taxable years ending 
on or before December 31, 2006, see Sec. 1.41-8.
    (6) Expiration date. This applicability of this section expires on 
or before June 13, 2011.

[T.D. 9401, 73 FR 34189, June 17, 2008]



Sec. 1.41-9  Alternative simplified credit.

    [Reserved] For further guidance, see Sec. 1.41-9T.

[T.D. 9401, 73 FR 34189, June 17, 2008]



Sec. 1.41-9T  Alternative simplified credit (temporary).

    (a) Determination of credit. At the election of the taxpayer, the 
credit determined under section 41(a)(1) equals the amount determined 
under section 41(c)(5).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative simplified credit (ASC) in section 
41(c)(5) for any taxable year of the taxpayer ending after December 31, 
2006. If a taxpayer makes an election under section 41(c)(5), the 
election applies to the taxable year for which made and all subsequent 
taxable years unless revoked in the manner prescribed in paragraph 
(b)(3) of this section.
    (2) Time and manner of election. An election under section 41(c)(5) 
is made by completing the portion of Form 6765, ``Credit for Increasing 
Research Activities,'' (or successor form) relating to the election of 
the ASC, and attaching the completed form to the taxpayer's timely filed 
(including extensions) original return for the taxable year to which the 
election applies. An election under section 41(c)(5) may not be made on 
an amended return. An extension of time to make an election under 
section 41(c)(5) will not be granted under Sec. 301.9100-3 of this 
chapter.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(5) if the 
taxpayer completes the portion of Form 6765 (or successor form) relating 
to the credit determined under section 41(a)(1) (the regular credit) or 
the alternative incremental credit (AIRC) and attaches the completed 
form to the taxpayer's timely filed (including extensions) original 
return for the year to which the revocation applies. An election under 
section 41(c)(5) may not be revoked on an amended return. An extension 
of time to revoke an election under section 41(c)(5) will not be granted 
under Sec. 301.9100-3 of this chapter.
    (4) Special rules for controlled groups--(i) In general. In the case 
of a controlled group of corporations, all the members of which are not 
included on a single consolidated return, an election (or revocation) 
must be made by the designated member by satisfying the requirements of 
paragraph (b)(2) or (b)(3) of this section (whichever applies), and such 
election (or revocation) by the designated member shall be binding on 
all the members of the group for the credit year to which the election 
(or revocation) relates. If the designated member fails to timely make 
(or revoke) an election, each member of the group must compute the group 
credit using the method used to compute the group credit for the 
immediately preceding credit year.
    (ii) Designated member. For purposes of this paragraph (b)(4), for 
any credit year, the term designated member means

[[Page 151]]

that member of the group that is allocated the greatest amount of the 
group credit under Sec. 1.41-6(c) based on the amount of credit 
reported on the original timely-filed Federal income tax return (even if 
that member subsequently is determined not to be the designated member). 
If the members of a group compute the group credit using different 
methods (the method described in section 41(a), the AIRC method of 
section 41(c)(4), or the ASC method of section 41(c)(5)) and at least 
two members of the group qualify as the designated member, then the term 
designated member means that member that computes the group credit using 
the method that yields the greatest group credit. For example, A, B, C, 
and D are members of a controlled group but are not members of a 
consolidated group. For the 2008 taxable year (the credit year), the 
group credit using the method described in section 41(a)(1) is $10x. 
Under this method, A would be allocated $5x of the group credit, which 
would be the largest share of the group credit under this method. For 
the credit year, the group credit using the AIRC method is $10x. Under 
the AIRC method, B would be allocated $5x of the group credit, which is 
the largest share of the group credit computed using the AIRC method. 
For the credit year, the group credit using the ASC method is $15x. 
Under the ASC method, C would be allocated $5x of the group credit, 
which is the largest share of the group credit computed using the ASC 
method. Because the group credit is greatest using the ASC method and C 
is allocated the greatest amount of credit under that method, C is the 
designated member. Therefore, if C makes a section 41(c)(5) election on 
its original timely-filed return for the credit year, that election is 
binding on all members of the group for the credit year.
    (c) Special rules--(1) Qualified research expenses (QREs) required 
in all years. Unless a taxpayer has QREs in each of the three taxable 
years preceding the taxable year for which the credit is being 
determined, the credit equals that percentage of the QREs for the 
taxable year provided by section 41(c)(5)(B)(ii).
    (2) Section 41(c)(6) applicability. QREs for the three taxable years 
preceding the credit year must be determined on a basis consistent with 
the definition of QREs for the credit year, without regard to the law in 
effect for the three taxable years preceding the credit year. This 
consistency requirement applies even if the period for filing a claim 
for credit or refund has expired for any of the three taxable years 
preceding the credit year.
    (3) Section 41(h)(2) applicability. Solely for purposes of the 
computation under section 41(h)(2), the average QREs for the three 
taxable years preceding the taxable year for which the credit is being 
determined shall be treated as the base amount.
    (4) Short taxable years. If one or more of the three taxable years 
preceding the credit year is a short taxable year, then the QREs for 
such year are deemed to be equal to the QREs actually paid or incurred 
in that year multiplied by 12 and divided by the number of months in 
that year. If a credit year is a short taxable year, then the average 
QREs for the three taxable years preceding the credit year are modified 
by multiplying that amount by the number of months in the short taxable 
year and dividing the result by 12.
    (5) Controlled groups. For purposes of computing the group credit 
under Sec. 1.41-6, a controlled group must apply the rules of this 
paragraph (c) on an aggregate basis. For example, if the controlled 
group has QREs in each of the three taxable years preceding the taxable 
year for which the credit is being determined, the controlled group 
applies the credit computation provided by section 41(c)(5)(A) rather 
than section 41(c)(5)(B)(ii).
    (d) Effective/applicability dates. This section is applicable for 
taxable years ending after December 31, 2006. For certain transitional 
rules, see Division A, section 104(b)(3), (c)(2), and (c)(4) of the Tax 
Relief and Health Care Act of 2006 (Pub. L. 109-432, 120 Stat. 2922).
    (e) Expiration date. The applicability of this section expires on or 
before June 13, 2011.

[T.D. 9401, 73 FR 34189, June 17, 2008]



Sec. 1.42-0  Table of contents.

    This section lists the paragraphs contained in Sec. Sec. 1.42-1 and 
1.42-2.

[[Page 152]]

                         Sec. 1.42-1 [Reserved]

 Sec. 1.42-2 Waiver of requirement that an existing building eligible 
 for the low-income housing credit was last placed in service more than 
             10 years prior to acquisition by the taxpayer.

    (a) Low-income housing credit for existing building
    (b) Waiver of 10-year holding period requirement
    (c) Waiver requirements
    (1) Federally-assisted building
    (2) Federal mortgage funds at risk
    (3) Statement by the Department of Housing and Urban Development or 
the Farmers' Home Administration
    (4) No prior credit allowed
    (d) Application for waiver
    (1) Time and manner
    (2) Information required
    (3) Other rules
    (4) Effective date of waiver
    (5) Attachment to return
    (e) Effective date of regulations

[T.D. 8302, 55 FR 21189, May 23, 1990]



Sec. 1.42-1  Limitation on low-income housing credit allowed with respect to 

qualified low-income buildings receiving housing credit allocations from a 

State or local housing credit agency.

    (a)-(g) [Reserved]. For further guidance, see Sec. 1.42-1T(a) 
through (g).
    (h) Filing of forms. Unless otherwise provided in forms or 
instructions, a completed Form 8586, ``Low-Income Housing Credit,'' (or 
any successor form) must be filed with the owner's Federal income tax 
return for each taxable year the owner of a qualified low-income 
building is claiming the low-income housing credit under section 42(a). 
Unless otherwise provided in forms or instructions, a completed Form 
8609, ``Low-Income Housing Credit Allocation and Certification,'' (or 
any successor form) must be filed by the building owner with the IRS. 
The requirements for completing and filing Forms 8586 and 8609 are 
addressed in the instructions to the forms.
    (i) [Reserved]. For further guidance, see Sec. 1.42-1T(i).
    (j) Effective dates. Section 1.42-1(h) applies to forms filed on or 
after November 7, 2005. The rules that apply for forms filed before 
November 7, 2005 are contained in Sec. 1.42-1T(h) and Sec. 1.42-1(h) 
(see 26 CFR part 1 revised as of April 1, 2003, and April 1, 2005).

[T.D. 9112, 69 FR 3827, Jan. 27, 2004, as amended by T.D. 9228, 70 FR 
67356, Nov. 7, 2005]



Sec. 1.42-1T  Limitation on low-income housing credit allowed with respect to 

qualified low-income buildings receiving housing credit allocations from a 

State or local housing credit agency (temporary).

    (a) In general--(1) Determination of amount of low-income housing 
credit. Section 42 provides that, for purposes of section 38, a low-
income housing credit is determined for a building in an amount equal to 
the applicable percentage of the qualified basis of the qualified low-
income building. In general, the credit may be claimed annually for a 
10-year credit period, beginning with the taxable year in which the 
building is placed in service or, at the election of the taxpayer, the 
succeeding taxable year. If, after the first year of the credit period, 
the qualified basis of a building is increased in excess of the 
qualified basis upon which the credit was initially determined, the 
allowable credit with respect to such additional qualified basis is 
determined using a credit percentage equal to two-thirds of the 
applicable percentage for the initial qualified basis. The credit for 
additions to qualified basis is generally allowable for the remaining 
years in the 15-year compliance period which begins with the first 
taxable year of the credit period for the building. In general, the low-
income housing credit is available with respect to buildings placed in 
service after December 31, 1986, in taxable years ending after that 
date. See section 42 for the definitions of ``qualified low-income 
building'', ``applicable percentage'', ``qualified basis'', ``credit 
period'', ``compliance period'', and for other rules relating to 
determination of the amount of the low-income housing credit.
    (2) Limitation on low-income housing credit allowed. Generally, the 
low-income housing credit determined under section 42 is allowed and may 
be claimed for any taxable year if, and to the extent that, the owner of 
a qualified low-income building receives a housing credit allocation 
from a State

[[Page 153]]

or local housing credit agency. The aggregate amount of housing credit 
allocations that may be made in any calendar year by all housing credit 
agencies within a State is limited by a State housing credit ceiling, or 
volume cap, described in paragraph (b) of this section. The authority to 
make housing credit allocations within the State housing credit ceiling 
may be apportioned among the State and local housing credit agencies, 
under the rules prescribed in paragraph (c) of this section. Upon 
apportionment of the State housing credit volume cap, each State or 
local housing credit agency receives an aggregate housing credit dollar 
amount that may be used to make housing credit allocations among 
qualified low-income buildings located within an agency's geographic 
jurisdiction. The rules governing the making of housing credit 
allocations by any state or local housing credit agency are provided in 
paragraph (d) of this section. Housing credit allocations are required 
to be taken into account by owners of qualified low-income buildings 
under the rules prescribed in paragraph (e) of this section. Exceptions 
to the requirement that a qualified low-income building receive a 
housing credit allocation from a State or local housing credit agency 
are provided in paragraph (f) of this section. Rules regarding 
termination of the authority of State and local housing credit agencies 
to make housing credit allocations after December 31, 1989, are 
specified in paragraph (g) of this section. Rules concerning information 
reporting by State and local housing credit agencies and owners of 
qualified low-income buildings are provided in paragraph (h) of this 
section. Special statutory transitional rules are incorporated into this 
section of the regulations as described in paragraph (i) of this 
section.
    (b) The State housing credit ceiling. The aggregate amount of 
housing credit allocations that may be made in any calendar year by all 
State and local housing credit agencies within a State may not exceed 
the State's housing credit ceiling for such calendar year. The State 
housing credit ceiling for each State for any calendar year is equal to 
$1.25 multiplied by the State's population. A State's population for any 
calendar year is determined by reference to the most recent census 
estimate (whether final or provisional) of the resident population of 
the State released by the Bureau of the Census before the beginning of 
the calendar year for which the State's housing credit ceiling is set. 
Unless otherwise prescribed by applicable revenue procedure, 
determinations of population are based on the most recent estimates of 
population contained in the Bureau of the Census publication, ``Current 
Population Reports, Series P-25: Population Estimates and Projections, 
Estimates of the Population of States''. For purposes of this section, 
the District of Columbia and United States possessions are treated as 
States.
    (c) Apportionment of State housing credit ceiling among State and 
local housing credit agencies--(1) In general. A State's housing credit 
ceiling for any calendar year is apportioned among the State and local 
housing credit agencies within such State under the rules prescribed in 
this paragraph. A ``State housing credit agency'' is any State agency 
specifically authorized by gubernatorial act or State statute to make 
housing credit allocations on behalf of the State and to carry out the 
provisions of section 42(h). A ``local housing credit agency'' is any 
agency of a political subdivision of the State that is specifically 
authorized by a State enabling act to make housing credit allocations on 
behalf of the State or political subdivision and to carry out the 
provisions of section 42(h). A ``State enabling act'' is any 
gubernatorial act, State statute, or State housing credit agency 
regulation (if authorized by gubernatorial act or State statute). A 
State enabling act enacted on or before October 22, 1986, the date of 
enactment of the Tax Reform Act of 1986, shall be given effect for 
purposes of this paragraph if such State enabling act expressly carries 
out the provisions of section 42(h).
    (2) Primary apportionment. Except as otherwise provided in 
paragraphs (c) (3) and (4) of this section, a State's housing credit 
ceiling is apportioned in its entirety to the State housing credit 
agency. Such an apportionment is the ``primary apportionment'' of a 
State's housing credit ceiling. There shall be

[[Page 154]]

no primary apportionment of the State housing credit ceiling and no 
grants of housing credit allocations in such State until a State housing 
credit agency is authorized by gubernatorial act or State statute. If a 
State has more than one State housing credit agency, such agencies shall 
be treated as a single agency for purposes of the primary apportionment. 
In such a case, the State housing credit ceiling may be divided among 
the multiple State housing credit agencies pursuant to gubernatorial act 
or State statute.
    (3) States with 1 or more constitutional home rule cities--(i) In 
general. Notwithstanding paragraph (c)(2) of this section, in any State 
with 1 or more constitutional home rule cities, a portion of the State 
housing credit ceiling is apportioned to each constitutional home rule 
city. In such a State, except as provided in paragraph (c)(4) of this 
section, the remainder of the State housing credit ceiling is 
apportioned to the State housing credit agency under paragraph (c)(2) of 
this section. See paragraph (c)(3)(iii) of this section. The term 
``constitutional home rule city'' means, with respect to any calendar 
year, any political subdivision of a State that, under a State 
constitution that was adopted in 1970 and effective on July 1, 1971, had 
home rule powers on the first day of the calendar year.
    (ii) Amount of apportionment to a constitutional home rule city. The 
amount of the State housing credit ceiling apportioned to a 
constitutional home rule city for any calendar year is an amount that 
bears the same ratio to the State housing credit ceiling for that year 
as the population of the constitutional home rule city bears to the 
population of the entire State. The population of any constitutional 
home rule city for any calendar year is determined by reference to the 
most recent census estimate (whether final or provisional) of the 
resident population of the constitutional home rule city released by the 
Bureau of the Census before the beginning of the calendar year for which 
the State housing credit ceiling is apportioned. However, determinations 
of the population of a constitutional home rule city may not be based on 
Bureau of the Census estimates that do not contain estimates for all of 
the constitutional home rule cities within the State. If no Bureau of 
the Census estimate is available for all such constitutional home rule 
cities, the most recent decennial census of population shall be relied 
on. Unless otherwise prescribed by applicable revenue procedure, 
determinations of population for constitutional home rule cities are 
based on estimates of population contained in the Bureau of the Census 
publication, ``Current Population Reports, Series P-26: Local Population 
Estimates''.
    (iii) Effect of apportionments to constitutional home rule cities on 
apportionments to other housing credit agencies. The aggregate amounts 
of the State housing credit ceiling apportioned to constitutional home 
rule cities under this paragraph (c)(3) reduce the State housing credit 
ceiling available for apportionment under paragraph (c) (2) or (4) of 
this section. Unless otherwise provided in a State constitutional 
amendment or by law changing the home rule provisions adopted in a 
manner provided by the State constitution, the power of the governor or 
State legislature to apportion the State housing credit ceiling among 
local housing credit agencies under paragraph (c)(4) of this section 
shall not be construed as allowing any reduction of the portion of the 
State housing credit ceiling apportioned to a constitutional home rule 
city under this paragraph (c)(3). However, any constitutional home rule 
city may agree to a reduction in its apportionment of the State housing 
credit ceiling under this paragraph (c)(3), in which case the amount of 
the State housing credit ceiling not apportioned to the constitutional 
home rule city shall be available for apportionment under paragraph (c) 
(2) or (4) of this section.
    (iv) Treatment of governmental authority within constitutional home 
rule city. For purposes of determining which agency within a 
constitutional home rule city receives the apportionment of the State 
housing credit ceiling under this paragraph (c)(3), the rules of this 
paragraph (c) shall be applied by treating the constitutional home rule 
city as a ``State'', the chief executive officer of a constitutional 
home rule city as a ``governor'', and a city council as

[[Page 155]]

a ``State legislature''. A constitutional home rule city is also treated 
as a ``State'' for purposes of the set-aside requirement for housing 
credit allocations to projects involving a qualified nonprofit 
organization. See paragraph (c)(5) of this section for rules governing 
set-aside requirements. In this connection, a constitutional home rule 
city may agree with the State housing credit agency to exchange an 
apportionment set aside for projects involving a qualified nonprofit 
organization for an apportionment that is not so restricted. In such a 
case, the authorizing gubernatorial act, State statute, or State housing 
credit agency regulation (if authorized by gubernatorial act or State 
statute) must ensure that the set-aside apportionment transferred to the 
State housing credit agency be used for the purposes described in 
paragraph (c)(5) of this section.
    (4) Apportionment to local housing credit agencies--(i) In general. 
In lieu of the primary apportionment under paragraph (c)(2) of this 
section, all or a portion of the State housing credit ceiling may be 
apportioned among housing credit agencies of governmental subdivisions. 
Apportionments of the State housing credit ceiling to local housing 
credit agencies must be made pursuant to a State enabling act as defined 
in paragraph (c)(1) of this section. Apportionments of the State housing 
credit ceiling may be made to housing credit agencies of constitutional 
home rule cities under this paragraph (c)(4), in addition to 
apportionments made under paragraph (c)(3) of this section. 
Apportionments of the State housing credit ceiling under this paragraph 
(c)(4) need not be based on the population of political subdivisions and 
may, but are not required to, give balanced consideration to the low-
income housing needs of the entire State.
    (ii) Change in apportionments during a calendar year. The 
apportionment of the State housing credit ceiling among State and local 
housing credit agencies under this paragraph (c)(4) may be changed after 
the beginning of a calendar year, pursuant to a State enabling act. No 
change in apportionments shall retroactively reduce the housing credit 
allocations made by any agency during such year. Any change in the 
apportionment of the State housing credit ceiling under this paragraph 
(c)(4) that occurs during a calendar year is effective only to the 
extent housing credit agencies have not previously made housing credit 
allocations during such year from their original apportionments of the 
State housing credit ceiling for such year. To the extent apportionments 
of the State housing credit ceiling to local housing credit agencies 
made pursuant to this paragraph (c)(4) for any calendar year are not 
used by such local agencies before a certain date (e.g., November 1) to 
make housing credit allocations in such year, the amount of unused 
apportionments may revert back to the State housing credit agency for 
reapportionment. Such reversion must be specifically authorized by the 
State enabling act.
    (iii) Exchanges of apportionments. Any State or local housing credit 
agency that receives an apportionment of the State housing credit 
ceiling for any calendar year under this paragraph (c)(4) may exchange 
part or all of such apportionment with another State or local housing 
credit agency to the extent no housing credit allocations have been made 
in such year from the exchanged portions. Such exchanges must be made 
with another housing credit agency in the same State and must be 
consistent with the State enabling act. If an apportionment set aside 
for projects involving a qualified nonprofit organization is transferred 
or exchanged, the transferee housing credit agency shall be required to 
use the set-aside apportionment for the purposes described in paragraph 
(c)(5) of this section.
    (iv) Written records of apportionments. All apportionments, 
exchanges of apportionments, and reapportionments of the State housing 
credit ceiling which are authorized by this paragraph (c)(4) must be 
evidenced in the written records maintained by each State and local 
housing credit agency.
    (5) Set-aside apportionments for projects involving a qualified 
nonprofit organization--(i) In general. Ten percent of the State housing 
credit ceiling for a calendar year must be set aside exclusively for 
projects involving a qualified nonprofit organization (as defined in

[[Page 156]]

paragraph (c)(5)(ii) of this section). Thus, at least 10 percent of 
apportionments of the State housing credit ceiling under paragraphs (c) 
(2) and (3) of this section must be used only to make housing credit 
allocations to buildings that are part of projects involving a qualified 
nonprofit organization. In the case of apportionments of the State 
housing credit ceiling under paragraph (c)(4) of this section, the State 
enabling act must ensure that the apportionment of at least 10 percent 
of the State housing credit ceiling be used exclusively to make housing 
credit allocations to buildings that are part of projects involving a 
qualified nonprofit organization. The State enabling act shall prescribe 
which housing credit agencies in the State receive apportionments that 
must be set aside for making housing credit allocations to buildings 
that are part of projects involving a qualified nonprofit organization. 
These set-aside apportionments may be distributed disproportionately 
among the State or local housing credit agencies receiving 
apportionments under paragraph (c)(4) of this section. The 10-percent 
set-aside requirement of this paragraph (c)(4) is a minimum requirement, 
and the State enabling act may set aside more than 10 percent of the 
State housing credit ceiling for apportionment to housing credit 
agencies for exclusive use in making housing credit allocations to 
buildings that are part of projects involving a qualified nonprofit 
organization.
    (ii) Projects involving a qualified nonprofit organization. The term 
``projects involving a qualified nonprofit organization'' means projects 
with respect to which a qualified nonprofit organization is to 
materially participate (within the meaning of section 469(h)) in the 
development and continuing operation of the project throughout the 15-
year compliance period. The term ``qualified nonprofit organization'' 
means any organization that is described in section 501(c) (3) or (4), 
is exempt from tax under section 501(a), and includes as one of its 
exempt purposes the fostering of low-income housing.
    (6) Expiration of unused apportionments. Apportionments of the State 
housing credit ceiling under this paragraph (c) for any calendar year 
may be used by housing credit agencies to make housing credit 
allocations only in such calendar year. Any part of an apportionment of 
the State housing credit ceiling for any calendar year that is not used 
for housing credit allocations in such year expires as of the end of 
such year and does not carry over to any other year. However, any part 
of an apportionment for 1989 that is not used to make a housing credit 
allocation in 1989 may be carried over to 1990 and used to make a 
housing credit allocation to a qualified low-income building described 
in section 42(n)(2)(B). See paragraph (g)(2) of this section.
    (d) Housing credit allocations made by State and local housing 
credit agencies--(1) In general. This paragraph governs State and local 
housing credit agencies in making housing credit allocations to 
qualified low-income buildings. The amount of the apportionment of the 
State housing credit ceiling for any calendar year received by any State 
or local housing credit agency under paragraph (c) of this section 
constitutes the agency's aggregate housing credit dollar amount for such 
year. The aggregate amount of housing credit allocations made in any 
calendar year by a State or local housing credit agency may not exceed 
such agency's aggregate housing credit dollar amount for such year. A 
State or local housing credit agency may make housing credit allocations 
only to qualified low-income buildings located within the agency's 
geographic jurisdiction.
    (2) Amount of a housing credit allocation. In making a housing 
credit allocation, a State or local housing credit agency must specify a 
credit percentage, not to exceed the building's applicable percentage 
determined under section 42(b), and a qualified basis amount. The amount 
of the housing credit allocation for any building is the product of the 
specified credit percentage and the specified qualified basis amount. In 
specifying the credit percentage and qualified basis amount, the State 
or local housing credit agency shall not take account of the first-year 
conventions described in section 42(f) (2)(A) and (3)(B). A State or 
local housing credit agency may adopt rules or regulations governing 
conditions for

[[Page 157]]

specification of less than the maximum credit percentage and qualified 
basis amount allowable under section 42 (b) and (c), respectively. For 
example, an agency may specify a credit percentage and a qualified basis 
amount of less than the maximum credit percentage and qualified basis 
amount allowable under section 42 (b) and (c), respectively, when the 
financing and rental assistance from all sources for the project of 
which the building is a part is sufficient to provide the continuing 
operation of the building without the maximum credit amount allowable 
under section 42.
    (3) Counting housing credit allocations against an agency's 
aggregate housing credit dollar amount. The aggregate amount of housing 
credit allocations made in any calendar year by a State or local housing 
credit agency may not exceed such agency's aggregate housing credit 
dollar amount (i.e., the agency's apportionment of the State housing 
credit ceiling for such year). This limitation on the aggregate dollar 
amount of housing credit allocations shall be computed separately for 
set-aside apportionments received pursuant to paragraph (c)(5) of this 
section. Housing credit allocations count against an agency's aggregate 
housing credit dollar amount without regard to the amount of credit 
allowable to or claimed by an owner of a building in the taxable year in 
which the allocation is made or in any subsequent year. Thus, housing 
credit allocations (which are computed without regard to the first-year 
conventions as provided in paragraph (d)(2) of this section) count in 
full against an agency's aggregate housing credit dollar amount, even 
though the first-year conventions described in section 42(f) (2)(A) and 
(3)(B) may reduce the amount of credit claimed by a taxpayer in the 
first year in which a credit is allowable. See also paragraph (e)(2) of 
this section. Housing credit allocations count against an agency's 
aggregate housing credit dollar amount only in the calendar year in 
which made and not in subsequent taxable years in the credit period or 
compliance period during which a taxpayer may claim a credit based on 
the original housing credit allocation. Since the aggregate amount of 
housing credit allocations made in any calendar year by a State or local 
housing credit agency may not exceed such agency's aggregate housing 
credit dollar amount, an agency shall at all times during a calendar 
year maintain a record of its cumulative allocations made during such 
year and its remaining unused aggregate housing credit dollar amount.
    (4) Rules for when applications for housing credit allocations 
exceed an agency's aggregate housing credit dollar amount. A State or 
local housing credit agency may adopt rules or regulations governing the 
awarding of housing credit allocations when an agency expects that 
applicants during a calendar year will seek aggregate allocations in 
excess of the agency's aggregate housing credit dollar amount. The State 
enabling act may provide uniform standards for the awarding of housing 
credit allocations when there is actual or anticipated excess demand 
from applicants in any calendar year.
    (5) Reduced or additional housing credit allocations--(i) In 
general. A State or local housing credit agency may not reduce or 
rescind a housing credit allocation made to a qualified low-income 
building in the manner prescribed in paragraph (d)(8) of this section. 
Thus, a housing credit agency may not reduce or rescind a housing credit 
allocation made to a qualified low-income building which is acquired by 
a new owner who is entitled to a carryover of the allowable credit for 
such building under section 42(d)(7). A housing credit agency may make 
additional housing credit allocations to a building in any year in the 
building's compliance period, whether or not there are additions to 
qualified basis for which an increased credit is allowable under section 
42(f)(3). Each additional housing credit allocation made to a building 
is treated as a separate allocation and is subject to the rules and 
requirements of this section. However, in the case of an additional 
housing credit allocation made with respect to additions to qualified 
basis for which an increased credit is allowable under section 42(f)(3), 
the amount of the allocation that counts against the agency's aggregate 
housing credit dollar amount shall be computed as if the specified 
credit

[[Page 158]]

percentage were unreduced in the manner prescribed in section 
42(f)(3)(A) and the specified qualified basis amount were unreduced by 
the first-year convention prescribed in section 42(f)(3)(B).
    (ii) Examples. The rules of paragraph (d)(5)(i) of this section may 
be illustrated by the following examples:

    Example 1. For 1987, the County L Housing Credit Agency has an 
aggregate housing credit dollar amount of $2 million. D, an individual, 
places in service on July 1, 1987, a new qualified low-income building. 
As of the close of each month in 1987 in which the building is in 
service, the building consists of 100 residential rental units, of which 
20 units are both rent-restricted and occupied by individuals whose 
income is 50 percent or less of area median gross income. The total 
floor space of the residential rental units is 120,000 square feet, and 
the total floor space of the low-income units is 20,000 square feet. The 
building is not Federally subsidized within the meaning of section 
42(i)(2). As of the end of 1987, the building has eligible basis under 
section 42(d) of $1 million. Thus, the qualified basis of the building 
determined without regard to the first-year convention provided in 
section 42(f) is $166,666.67 (i.e., $1 million eligible basis times \1/
6\, the floor space fraction which is required to be used instead of the 
larger unit fraction). However, the amount of the low-income housing 
credit determined for 1987 under section 42 reflects the first-year 
convention provided in section 42(f)(2). Since the building has the same 
floor space and unit fractions as of the close of each of the six months 
in 1987 during which it is in service, upon applying the first-year 
convention in section 42(f)(2), the qualified basis of the building in 
1987 is $83,333.33 (i.e., $1 million eligible basis times \1/12\, the 
fraction determined under section 42(f)(2)(A)). Under paragraph (d)(2) 
of this section, the County L Housing Credit Agency may make a housing 
credit allocation by specifying a credit percentage, not to exceed 9 
percent, and a qualified basis amount, which may be greater or less than 
the qualified basis of the building in 1987 as determined under section 
42(c), without regard to the first-year convention provided in section 
42(f)(2). If the County L Housing Credit Agency specifies a credit 
percentage of 8 percent and a qualified basis amount of $100,000, the 
amount of the housing credit allocation is $8,000. Under paragraph 
(d)(3) of this section, the County L Housing Credit Agency's aggregate 
housing credit dollar amount for 1987 is reduced by $8,000, 
notwithstanding that D is entitled to claim less than $8,000 of the 
credit in 1987 under the rules in paragraph (e) of this section. Under 
paragraph (e)(2) of this section, in 1987 D is entitled to claim only 
$4,000 of the credit, determined by applying the first-year convention 
of \6/12\ to the specified qualified basis amount contained in the 
housing credit allocation (i.e., .08x$100,000x(\6/12\)).
    Example 2. The facts are the same as in Example 1 except that on 
July 1, 1988, the number of occupied low-income units increases to 50 
units and the floor space of the occupied low-income units increases to 
48,000 square feet. These occupancy fractions remain unchanged as of the 
close of each month remaining in 1988. Under section 42(c), the 
qualified basis of the building in 1988, without regard to the first-
year convention in section 42(f)(3)(B), is $400,000 (i.e., $1 million 
eligible basis times .4, the floor space fraction which is required to 
be used instead of the larger unit fraction). D's 1987 housing credit 
allocation from the County L Housing Credit Agency remains effective in 
1988 and entitles D to a credit of $8,000 (i.e., .08, the specified 
credit percentage, times $100,000, the specified qualified basis 
amount). With respect to the additional $300,000 of qualified basis 
which the 1987 housing credit allocation does not cover, D must apply to 
the County L Housing Credit Agency for an additional housing credit 
allocation. Assume that the County L Housing Credit Agency has a 
sufficient aggregate housing credit dollar amount for 1988 to make a 
housing credit allocation to D in 1988 by specifying a credit percentage 
of 9 percent and a qualified basis amount of $300,000. The amount of the 
housing credit allocation that counts against the County L Housing 
Credit Agency's aggregate housing credit dollar amount is $27,000 (i.e., 
the amount counted (.09 times $300,000) is unreduced in the manner 
prescribed in section 42(f)(3) (A) and (B)). Since D's qualified basis 
in 1987 was $166,666.67, D is entitled to claim a credit in 1988 with 
respect to such basis of $14,000 (i.e., .08x$100,000, the 1987 credit 
alllocation, +.09x$66,666.67, the 1988 credit allocation). In addition, 
D is entitled to claim a credit in 1988 and subsequent years in the 15-
year compliance period with respect to the additional $233,333.33 of 
qualified basis covered by the 1988 housing credit allocation. However, 
the allowable credit for 1988 with respect to this amount of additional 
qualified basis is subject to reductions prescribed in section 42(f)(3) 
(A) and (B). Thus, D is entitled in 1988 to a credit at a 6-percent rate 
applied to $116,666.67 of additional qualified basis, which is reduced 
to reflect the first-year convention. D's total allowable low-income 
housing credit in 1988 is $21,000 (i.e., $14,000 with respect to 
original qualified basis + $7,000 with respect to 1988 additions to 
qualified basis). If the County L Housing Credit Agency had specified an 
8-percent credit percentage in 1988 with respect to the qualified basis 
not covered by the 1987 housing credit allocation to D, D's allowable 
credit with respect to the $233,333.33 of additions to qualified basis 
would not exceed, in

[[Page 159]]

1988 and subsequent years, an amount determined by applying a specified 
credit percentage of 5.33 percent (i.e., two-thirds of 8 percent). In 
1988, D's specified qualified basis amount would be adjusted for the 
first-year convention.

    (6) No carryover of unused aggregate housing credit dollar amount. 
Any portion of a State or local housing credit agency's aggregate 
housing credit dollar amount for any calendar year that is not used to 
make a housing credit allocation in such year may not be carried over to 
any other year, except as provided in paragraph (g) of this section. An 
agency may not permit owners of qualified low-income buildings to 
transfer housing credit allocations to other buildings. However, an 
agency may provide a procedure whereby owners may return to the agency, 
prior to the end of the calendar year in which housing credit 
allocations are made, unusable portions of such allocations. In such a 
case, an owner's housing credit allocation is deemed reduced by the 
amount of the allocation returned to the agency, and the agency may 
reallocate such amount to other qualified low-income buildings prior to 
the end of the year.
    (7) Effect of housing credit allocations in excess of an agency's 
aggregate housing credit dollar amount. In the event that a State or 
local housing credit agency makes housing credit allocations in excess 
of its aggregate housing credit dollar amount for any calendar year, the 
allocations shall be deemed reduced (to the extent of such excess) for 
buildings in the reverse order in which such allocations were made 
during such year.
    (8) Time and manner for making housing credit allocations--(i) Time. 
Housing credit allocations are effective for the calendar year in which 
made in the manner prescribed in paragraph (d)(8)(ii) of this section. A 
State or local housing credit agency may not make a housing credit 
allocation to a qualified low-income building prior to the calendar year 
in which such building is placed in service. An agency may adopt its own 
procedures for receiving applications for housing credit allocations 
from owners of qualified low-income buildings. An agency may provide a 
procedure for making, in advance of a building's being placed in 
service, a binding commitment (e.g., by contract, inducement, 
resolution, or other means) to make a housing credit allocation in the 
calendar year in which a qualified low-income building is placed in 
service or in a subsequent calendar year. Any advance commitment shall 
not constitute a housing credit allocation for purposes of this section.
    (ii) Manner. Housing credit allocations are deemed made when part I 
of IRS Form 8609, Low-Income Housing Credit Allocation Certification, is 
completed and signed by an authorized official of the housing credit 
agency and mailed to the owner of the qualified low-income building. A 
copy of all completed (as to part I) Form 8609 allocations along with a 
single completed Form 8610, Annual Low-Income Housing Credit Agencies 
Report, must also be mailed to the Internal Revenue Service not later 
than the 28th day of the second calendar month after the close of the 
calendar year in which the housing credit was allocated to the qualified 
low-income building. Housing credit allocations to a qualified low-
income building must be made on Form 8609 and must include--
    (A) The address of the building;
    (B) The name, address, and taxpayer identification number of the 
housing credit agency making the housing credit allocation;
    (C) The name, address, and taxpayer identification number of the 
owner of the qualified low-income building;
    (D) The date of the allocation of housing credit;
    (E) The housing credit dollar amount allocated to the building on 
such date;
    (F) The specified maximum applicable credit percentage allocated to 
the building on such date;
    (G) The specified maximum qualified basis amount;
    (H) The percentage of the aggregate basis financed by tax-exempt 
bonds taken into account for purposes of the volume cap under section 
146;
    (I) A certification under penalties of perjury by an authorized 
State or local housing credit agency official that the allocation is 
made in compliance with the requirements of section 42(h); and

[[Page 160]]

    (J) Any additional information that may be required by Form 8609 or 
by an applicable revenue procedure.

See paragraph (h) of this section for additional rules concerning filing 
of forms.
    (iii) Certification. The certifying official for the State or local 
housing credit agency need not perform an independent investigation of 
the qualified low-income building in order to certify on part I of Form 
8609 that the housing credit allocation meets the requirements of 
section 42(h). For example, the certifying official may rely on 
information contained in an application for a low-income housing credit 
allocation submitted by the building owner which sets forth facts 
necessary to determine that the building is eligible for the low-income 
housing credit under section 42.
    (iv) Fee. A State or local housing credit agency may charge building 
owners applying for housing credit allocations a reasonable fee to cover 
the agency's administrative expenses for processing applications.
    (v) No continuing agency responsibility. The State or local housing 
credit agency need not monitor or investigate the continued compliance 
of a qualified low-income building with the requirements of section 42 
throughout the applicable compliance period.
    (e) Housing credit allocation taken into account by owner of a 
qualified low-income building--(1) Time and manner for taking housing 
credit allocation into account. An owner of a qualified low-income 
building may not claim a low-income housing credit determined under 
section 42 in any year in excess of an effective housing credit 
allocation received from a State or local housing credit agency. A 
housing credit allocation made to a qualified low-income building is 
effective with respect to any owner of the building beginning with the 
owner's taxable year in which the housing credit allocation is received. 
A housing credit allocation is deemed received in a taxable year, except 
as modified in the succeeding sentence, if that allocation is made (in 
the manner described in paragraph (d)(8) of this section) not later than 
the earlier of (i) the 60th day after the close of the taxable year, or 
(ii) the close of the calendar year in which such taxable year ends. A 
housing credit allocation is deemed received in a taxable year ending in 
1987, if such allocation is made (in the manner described in paragraph 
(d)(8) of this section) on or before December 31, 1987. A housing credit 
allocation is not effective for any taxable year if received in a 
calendar year which ends prior to when the qualified low-income building 
is placed in service. A housing credit allocation made to a qualified 
low-income building remains effective for all taxable years in the 
compliance period.
    (2) First-year convention limitation on housing credit allocation 
taken into account. For purposes of the limitation that the allowable 
low-income housing credit may not exceed the effective housing credit 
allocation received from a State or local housing credit agency, as 
provided in paragraph (e)(1) of this section, the amount of the 
effective housing credit allocation shall be adjusted by applying the 
first-year convention provided in section 42(f)(2)(A) and (3)(B) and the 
percentage credit reduction provided in section 42(f)(3)(A). Under 
paragraphs (d) (2) and (5) of this section, the State or local housing 
credit agency must specify the credit percentage and qualified basis 
amount, the product of which is the amount of the housing credit 
allocation, without taking account of the first-year convention 
described in section 42(f)(2)(A) and (3)(B) or the percentage credit 
reduction prescribed in section 42(f)(3)(A). However, for purposes of 
the limitation on the amount of the allowable low-income housing credit, 
as provided in paragraph (e)(1) of this section, in a taxable year in 
which the first-year convention applies to the amount of credit 
determined under section 42(a), the specified qualified basis amount 
shall be adjusted by the first-year convention fraction which is equal 
to the number of full months (during the first taxable year) in which 
the building was in service divided by 12. In addition, for purposes of 
the limitation on the amount of the allowable low-income housing credit, 
as provided in paragraph (e)(1) of this section, in a taxable year in 
which the reduction in credit percentage applies to additions

[[Page 161]]

to qualified basis, as prescribed in section 42(f)(3), the specified 
credit percentage shall be reduced by one-third. See examples in 
paragraphs (d)(5)(ii) and (e)(3)(ii) of this section.
    (3) Use of excess housing credit allocation for increases in 
qualified basis--(i) In general. If the housing credit allocation made 
to a qualified low-income building exceeds the amount of credit 
allowable with respect to such building in any taxable year (without 
regard to the first-year conventions under section 42(f)), such excess 
is not transferable to another qualified low-income building. However, 
if in a subsequent year there are increases in the qualified basis for 
which an increased credit is allowable under section 42(f)(3) at a 
reduced credit percentage, the original housing credit allocation 
(including the specified credit percentage and qualified basis amount) 
would be effective with respect to such increased credit.
    (ii) Example. The provisions of this paragraph (e)(3) may be 
illustrated by the following example:

    Example. In 1987, a newly-constructed qualified low-income building 
receives a housing credit allocation of $90,000 based on a specified 
credit percentage of 9 percent and a specified qualified basis amount of 
$1,000,000. The building is placed in service in 1987, but the qualified 
basis in such year is only $800,000, resulting in an allowable credit in 
1987 (determined without regard to the first-year conventions) of 
$72,000. In 1988, the qualified basis is increased to $1,100,000, 
resulting in an additional credit allowable under section 42(f)(3) 
(without regard to the first-year conventions) of $18,000 (i.e., 
$300,000 x .06, or \2/3\ of .09). The unused portion of the 1987 housing 
credit allocation ($18,000) is effective in 1988 and in each subsequent 
year in the compliance period only with respect to the specified 
qualified basis for the 1987 housing credit allocation ($1,000,000). 
Thus, the owner is allowed to claim a credit in 1988 and in each 
subsequent year (without regard to the first-year conventions), based on 
the effective housing credit allocation from 1987, of $84,000 (i.e., 
$72,000 + ($200,000 x .06)). The owner of the qualified low-income 
building must obtain a new housing credit allocation in 1988 with 
respect to the additional $100,000 of qualified basis in order to claim 
a credit on such basis in 1988 and in each subsequent year. If the 
applicable first-year convention under section 42(f)(3)(B) entitled the 
owner in 1988 to only \1/2\ of the otherwise applicable credit for the 
additions to qualified basis, under paragraph (e)(2) of this section the 
owner is allowed to claim a credit in 1988, based on the effective 
housing credit allocation from 1987, of $78,000 (i.e., $72,000 + 
($200,000 x .06 x .5)).

    (4) Separate housing credit allocations for new buildings and 
increases in qualified basis. Separate housing credit allocations must 
be received for each building with respect to which a housing credit may 
be claimed. Rehabilitation expenditures with respect to a qualified low-
income building are treated as a separate new building under section 
42(e) and must receive a separate housing credit allocation. Increases 
in qualified basis in a qualified low-income building are not generally 
treated as a new building for purposes of section 42. To the extent that 
a prior housing credit allocation received with respect to a qualified 
low-income building does not allow an increased credit with respect to 
an increase in the qualified basis of such building, an additional 
housing credit allocation must be received in order to claim a credit 
with respect to that portion of increase in qualified basis. See 
paragraph (e)(3) of this section. The amount of credit allowable with 
respect to an increase in qualified basis is subject to the credit 
percentage limitation of section 42(f)(3)(A) and the first-year 
convention of section 42(f)(3)(B). See paragraph (d)(5) of this section 
for a rule requiring that the State or local housing credit agency count 
a housing credit allocation made with respect to an increase in 
qualified basis as if the specified credit percentage were unreduced in 
the manner prescribed in section 42(f)(3) and the specified basis amount 
were unreduced by the first-year convention prescribed in section 
42(f)(3)(B).
    (5) Acquisition of building for which a prior housing credit 
allocation has been made. If a carryover credit would be allowable to an 
acquirer of a qualified low-income building under section 42(d)(7), such 
acquirer need not obtain a new housing credit allocation with respect to 
such building. Under section 42(d)(7), the acquirer would be entitled to 
claim only such credits as would have been allowable to the prior owner 
of the building.
    (6) Multiple housing credit allocations. A qualified low-income 
building may

[[Page 162]]

receive multiple housing credit allocations from different housing 
credit agencies having overlapping jurisdictions. A qualified low-income 
building that receives a housing credit allocation set aside exclusively 
for projects involving a qualified nonprofit organization may also 
receive a housing credit allocation from a housing credit agency's 
aggregate housing credit dollar amount that is not so set aside.
    (f) Exception to housing credit allocation requirement--(1) Tax-
exempt bond financing--(i) In general. No housing credit allocation is 
required in order to claim a credit under section 42 with respect to 
that portion of the eligible basis (as defined in section 42(d)) of a 
qualified low-income building that is financed with the proceeds of an 
obligation described in section 103(a) (``tax-exempt bond'') which is 
taken into account for purposes of the volume cap under section 146. In 
addition, no housing credit allocation is required in order to claim a 
credit under section 42 with respect to the entire qualified basis (as 
defined in section 42(c)) of a qualified low-income building if 70 
percent or more of the aggregate basis of the building and the land on 
which the building is located is financed with the proceeds of tax-
exempt bonds which are taken into account for purposes of the volume cap 
under section 146. For purposes of this paragraph, ``land on which the 
building is located'' includes only land that is functionally related 
and subordinate to the qualified low-income building. See Sec. 1.103-
8(b)(4)(iii) for the meaning of the term ``functionally related and 
subordinate''. For purposes of this paragraph, the basis of the land 
shall be determined using principles that are consistent with the rules 
contained in section 42(d).
    (ii) Determining use of bond proceeds. For purposes of determining 
the portion of proceeds of an issue of tax-exempt bonds used to finance 
(A) the eligible basis of a qualified low-income building, and (B) the 
aggregate basis of the building and the land on which the building is 
located, the proceeds of the issue must be allocated in the bond 
indenture or a related document (as defined in Sec. 1.103-13(b)(8)) in 
a manner consistent with the method used to allocate the net proceeds of 
the issue for purposes of determining whether 95 percent or more of the 
net proceeds of the issue are to be used for the exempt purpose of the 
issue. If the issuer is not consistent in making this allocation 
throughout the bond indenture and related documents, or if neither the 
bond indenture nor a related document provides an allocation, the 
proceeds of the issue will be allocated on a pro rata basis to all of 
the property financed by the issue, based on the relative cost of the 
property.
    (iii) Example. The provisions of this paragraph may be illustrated 
by the following example:

    Example. In 1987, County K assigns $500,000 of its volume cap for 
private activity bonds under section 146 to a $500,000 issue of exempt 
facility bonds to provide a qualified residential rental project to be 
owned by A, an individual. The aggregate basis of the building and the 
land on which the building is located is $700,000. Under the terms of 
the bond indenture, the net proceeds of the issue are to be used to 
finance $490,000 of the eligible basis of the building. More than 70 
percent of the aggregate basis of the qualified low-income building and 
the land on which the building is located is financed with the proceeds 
of tax-exempt bonds to which a portion of the volume cap under section 
146 was allocated. Accordingly, A may claim a credit under section 42 
without regard to whether any housing credit dollar amount was allocated 
to that building. If, instead, the aggregate basis of the building and 
land were $800,000, A would be able to claim the credit under section 42 
without receiving a housing credit allocation for the building only to 
the extent that the credit was attributable to eligible basis of the 
building financed with tax-exempt bonds.

    (g) Termination of authority to make housing credit allocation--(1) 
In general. No State or local housing credit agency shall receive an 
apportionment of a State housing credit ceiling for calendar years after 
1989. Consequently, no housing credit allocations may be made after 
1989, except as provided in paragraph (g)(2) of this section. Housing 
credit allocations made prior to January 1, 1990, remain effective after 
such date.
    (2) Carryover of unused 1989 apportionment. Any State or local 
housing credit agency that has an unused portion of its apportionment of 
the State housing credit ceiling for 1989 from which housing credit 
allocations have not been

[[Page 163]]

made in 1989 may carry over such unused portion into 1990. Such 
carryover portion of the 1989 apportionment shall be treated as the 
agency's apportionment for 1990. From this 1990 apportionment, the State 
or local housing credit agency may make housing credit allocations only 
to a qualified low-income building meeting the following requirements:
    (i) The building must be constructed, reconstructed, or 
rehabilitated by the taxpayer seeking the allocation;
    (ii) More than 10 percent of the reasonably anticipated cost of such 
construction, reconstruction, or rehabilitation must have been incurred 
as of January 1, 1989; and
    (iii) The building must be placed in service before January 1, 1991.
    (3) Expiration of exception for tax-exempt bond financed projects. 
The exception to the requirement that a housing credit allocation be 
received with respect to any portion of the eligible basis of a 
qualified low-income building, as provided in paragraph (f) of this 
section, shall not apply to any building placed in service after 1989, 
unless such building is described in paragraphs (g)(2) (i), (ii), and 
(iii) of this section.
    (h) Filing of forms. For further guidance, see Sec. 1.42-1(h).
    (i) Transitional rules. The transitional rules contained in section 
252(f)(1) of the Tax Reform Act of 1986 are incorporated into this 
section of the regulations for purposes of determining whether a 
qualified low-income building is entitled to receive a housing credit 
allocation or is excepted from the requirement that a housing credit 
allocation be received. Housing credit allocations made to qualified 
low-income buildings described in section 252(f)(1) shall not count 
against the State or local housing credit agency's aggregate housing 
credit dollar amount. The transitional rules contained in section 
252(f)(2) of the Tax Reform Act of 1986 are incorporated into this 
section of the regulations for purposes of determining amounts available 
to certain State or local housing credit agencies for the making of 
housing credit allocations to certain qualified low-income housing 
projects. Amounts available to housing credit agencies under section 
252(f)(2) shall be treated as special apportionments unavailable for 
housing credit allocations to qualified low-income buildings not 
described in section 252(f)(2). Housing credit allocations made from the 
special apportionments shall not count against the State or local credit 
agency's aggregate housing credit dollar amount. The set-aside 
requirements shall not apply to these special apportionments. The 
transitional rules contained in section 252(f)(3) of the Tax Reform Act 
1986 are incorporated in this section of the regulations for purposes of 
determining the amount of housing credit allocations received by certain 
qualified low-income buildings. Housing credit allocations deemed 
received under section 252(f)(3) shall not count against the State or 
local housing credit agency's aggregate housing credit dollar amount.

[T.D. 8144, 52 FR 23433, June 22, 1987; 52 FR 24583, July 1, 1987, as 
amended by T.D. 9112, 69 FR 3827, Jan. 27, 2004]



Sec. 1.42-2  Waiver of requirement that an existing building eligible for the 

low-income housing credit was last placed in service more than 10 years prior 

to acquisition by the taxpayer.

    (a) Low-income housing credit for existing building. Section 42 
provides that, for purposes of section 38, new and existing qualified 
low-income buildings are eligible for a low-income housing credit. The 
eligibility rules for new and existing buildings differ. Under section 
42(d)(2), an existing building may be eligible for the low-income 
housing credit based upon the acquisition cost and amounts chargeable to 
capital account (to the extent properly included in eligible basis) if--
    (1) The taxpayer acquires the building by purchase (as defined in 
section 179(d)(2), as applicable under section 42(d)(2)(D)(iii)(I)),
    (2) There is a period of at least 10 years between the date of the 
building's acquisition by the taxpayer and the later of--(i) The date 
the building was last placed in service, or
    (ii) The date of the most recent nonqualified substantial 
improvement of the building, and
    (3) The building was not previously placed in service by the 
taxpayer, or by

[[Page 164]]

a person who was a related person (as defined in section 
42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the 
building was last previously placed in service.
    (b) Waiver of 10-year holding period requirement. Section 42(d)(6) 
provides that a taxpayer may apply for a waiver of the 10-year holding 
period requirement specified in paragraph (a)(2) of this section. The 
Internal Revenue Service will grant a waiver only if--
    (1) The existing building satisfies all of the requirements in 
paragraph (c) of this section, and
    (2) The taxpayer makes an application in conformity with the 
requirements in paragraph (d) of this section.
    (c) Waiver requirements--(1) Federally-assisted building. To satisfy 
the requirement of this paragraph, a building must be a Federally-
assisted building. The term ``Federally assisted building'' means any 
building which is substantially assisted, financed, or operated under 
section 8 of the United States Housing Act of 1937, section 221(d)(3) or 
236 of the National Housing Act, or section 515 of the Housing Act of 
1949, as such acts were in effect on October 22, 1986.
    (2) Federal mortgage funds at risk. To satisfy the requirement of 
this paragraph, Federal mortgage funds must be at risk with respect to a 
mortgage that is secured by the building or a project of which the 
building is a part. For purposes of this paragraph, Federal mortgage 
funds are at risk if, in the event of a default by the mortgagor on the 
mortgage secured by the building or the project of which the building is 
a part--
    (i) The mortgage could be assigned to the Department of Housing and 
Urban Development or the Farmers' Home Administration, or
    (ii) There could arise a claim against a Federal mortgage insurance 
fund (or such Department or Administration).
    (3) Statement by the Department of Housing and Urban Development or 
the Farmers' Home Administration. (i) To satisfy the requirement of this 
paragraph, a letter or other written statement must be made or received 
and approved by the national office of the Department of Housing and 
Urban Development or the Farmers' Home Administration (``the Federal 
agency''). This letter or statement shall include the following:
    (A) A statement that, as of the earlier of the time of the 
taxpayer's acquisition of the building or the taxpayer's application for 
a waiver, the building is a Federally-assisted building within the 
meaning of paragraph (c)(1) of this section and identifies the source of 
Federal assistance;
    (B) A statement that a waiver of the 10-year holding period 
requirement is necessary to avert Federal mortgage funds being at risk 
within the meaning of paragraph (c)(2) of this section; and
    (C) A statement that the Federal agency has taken a Federal agency 
action as described in paragraph (c)(3)(ii) of this section.
    (ii) The following specified Federal agency actions shall be the 
only means of satisfying the requirement of this paragraph:
    (A) The Federal agency intends to accept an assignment of a mortgage 
secured by the building or the project of which the building is a part, 
and such assignment requires payments by the agency or a mortgage 
insurance fund maintained by the agency to the prior mortgagee;
    (B) The Federal agency or a mortgage insurance fund maintained by 
the agency intends to accept, as a consequence of foreclosure 
proceedings or otherwise, conveyance of the building or the project of 
which the building is a part;
    (C) The Federal agency or a mortgage insurance fund maintained by 
the agency intends, as a consequence of default, to take possession of, 
hold title to, or otherwise assume ownership of the building or the 
project of which the building is a part; or
    (D) The Federal agency has designated the building or the project of 
which the building is a part as a troubled building or project. A 
designation of a troubled building or project must satisfy the following 
requirements:
    (1) Designation of troubled status must be based on a review by the 
Federal agency of the financial condition of the building or project and 
on a determination by the Federal agency of a history of financial 
distress or mortgage defaults;

[[Page 165]]

    (2) Designation of troubled status must be made or received and 
approved by the national office of the Federal agency; and
    (3) Federal agency regulations or procedures must provide that, in 
the event of transfer of the ownership of a designated troubled building 
or project, the building or project may be subject to continued review 
by the Federal agency. Each Federal agency may prescribe its own 
standards and procedures for designating a troubled building or project 
so long as such standards are consistent with the requirements of this 
paragraph (c)(3)(ii)(D).
    (4) No prior credit allowed. The requirement of this paragraph is 
satisfied only if no prior owner was allowed a low-income housing credit 
under section 42 for the building.
    (d) Application for waiver--(1) Time and manner. In order to receive 
a waiver of the 10-year holding period requirement specified in 
paragraph (a)(2) of this section, a taxpayer must file an application 
(including the applicable user fee) that complies with the requirements 
of this paragraph (d) and Rev. Proc. 90-1, 1990-1 I.R.B. 8 (or any 
subsequent applicable revenue procedure). The application must be filed 
by a taxpayer who has acquired the building by purchase or who has a 
binding contract to purchase the building. Such binding contract may be 
conditioned upon the granting of a waiver under this section. The 
application may be filed at any time after a binding contract has been 
entered into, but no later than 12 months after the taxpayer's 
acquisition of the building. An application for a waiver of the 10-year 
holding period requirement must not contain a request for a ruling on 
any other issue arising under section 42 or other sections of the 
Internal Revenue Code. An application for a waiver of the 10-year 
holding period requirement must be mailed or delivered to the address 
listed in section 3.01 of Rev. Proc. 90-1 (or any subsequent applicable 
revenue procedure).
    (2) Information required. An application for a waiver of the 10-year 
holding period requirement must contain the following information:
    (i) The taxpayer's name, address and taxpayer identification number;
    (ii) The name (if any) and address of the acquired building and the 
project (if any) of which it is a part;
    (iii) The date of acquisition or the date of the binding contract 
for acquisition of the building by the taxpayer and the expected date of 
acquisition, the amount of consideration paid or to be paid for the 
acquisition (including the value of any liabilities assumed by the 
taxpayer), and the taxpayer's certification that such acquisition is by 
purchase (as defined in section 179(d)(2), as applicable under section 
42 (d)(2)(D)(iii)(I));
    (iv) The identity of the person from whom the building is acquired, 
and whether such person is a Federal agency, a mortgagee holding title 
to the building, or the mortgagor or prior owner;
    (v) The date the building was last placed in service and the date of 
the most recent (if any) nonqualified substantial improvement of the 
building (as defined in section 42 (d)(2)(D)(i));
    (vi) The taxpayer's certification that the building was not 
previously placed in service by the taxpayer, or by a person who was a 
related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect 
to the taxpayer as of the time the building was last placed in service;
    (vii) The amount and disposition (e.g., discharge, assignment, 
assumption, or refinance) of the outstanding mortgage at the time of 
acquisition and the identities of the mortgagee and mortgagor;
    (viii) The taxpayer's certification that no prior owner was allowed 
a low-income housing credit under section 42 for the building (made to 
the best of the taxpayer's knowledge, with no documentation from other 
persons needed to be submitted); and
    (ix) The statement from the Federal agency required by paragraph 
(c)(3)(i) of this section.
    (3) Other rules. (i) In the event that an acquired building will be 
owned by more than one taxpayer, a single application for waiver may be 
filed by one taxpayer on behalf of the co-owners if the application 
contains the names, addresses and taxpayer identification numbers of the 
other owners. A general partner or a designated limited partner

[[Page 166]]

may file an application for waiver on behalf of a partnership.
    (ii) In the event that multiple Federally-assisted buildings in a 
project are being acquired by the taxpayer, a single application for 
waiver with respect to such buildings may be filed if the application 
contains the required information set out for the address of each 
Federally-assisted building involved.
    (iii) In the event that specific Federally-assisted buildings are 
being acquired by the taxpayer in a project consisting of multiple 
buildings that may or may not be Federally-assisted, a single 
application for waiver with respect to the Federally-assisted buildings 
being acquired may be filed if the application contains the required 
information set out for the address of each Federally-assisted building 
being acquired.
    (4) Effective date of waiver. A waiver will be effective when 
granted in writing by the Internal Revenue Service after submission of a 
completed application for waiver filed under this paragraph (d).
    (5) Attachment to return. A waiver letter granted by the Internal 
Revenue Service shall be filed with the taxpayer's Federal income tax 
return for the first taxable year the low-income housing credit is 
claimed by the taxpayer.
    (e) Effective date of regulations. The provisions of Sec. 1.42-2 
are effective for buildings placed in service by the taxpayer after 
December 31, 1986.

[T.D. 8302, 55 FR 21189, May 23, 1990; 55 FR 25973, June 26, 1990]



Sec. 1.42-3  Treatment of buildings financed with proceeds from a loan under 

an Affordable Housing Program established pursuant to section 721 of the 

Financial Institutions Reform, Recovery, and Enforcement Act of 1989 

(FIRREA).

    (a) Treatment under sections 42(i) and 42(b). A below market loan 
funded in whole or in part with funds from an Affordable Housing Program 
established under section 721 of FIRREA is not, solely by reason of the 
Affordable Housing Program funds, a below market Federal loan as defined 
in section 42(i)(2)(D). Thus, any building with respect to which the 
proceeds of the loan are used during the tax year is not, solely by 
reason of the Affordable Housing Program funds, treated as a federally 
subsidized building for that tax year and subsequent tax years for 
purposes of determining the applicable percentage for the building under 
section 42(b).
    (b) Effective date. The rules set forth in paragraph (a) of this 
section are effective for loans made after August 8, 1989.

[56 FR 48734, Sept. 26, 1991]



Sec. 1.42-4  Application of not-for-profit rules of section 183 to low-income 

housing credit activities.

    (a) Inapplicability to section 42. In the case of a qualified low-
income building with respect to which the low-income housing credit 
under section 42 is allowable, section 183 does not apply to disallow 
losses, deductions, or credits attributable to the ownership and 
operation of the building.
    (b) Limitation. Notwithstanding paragraph (a) of this section, 
losses, deductions, or credits attributable to the ownership and 
operation of a qualified low-income building with respect to which the 
low-income housing credit under section 42 is allowable may be limited 
or disallowed under other provisions of the Code or principles of tax 
law. See, e.g., sections 38(c), 163(d), 465, 469; Knetsch v. United 
States, 364 U.S. 361 (1960), 1961-1 C.B. 34 (``sham'' or ``economic 
substance'' analysis); and Frank Lyon Co. v. Commissioner, 435 U.S. 561 
(1978), 1978-1 C.B. 46 (``ownership'' analysis).
    (c) Effective date. The rules set forth in paragraphs (a) and (b) of 
this section are effective with respect to buildings placed in service 
after December 31, 1986.

[T.D. 8420, 57 FR 24729, June 11, 1992]



Sec. 1.42-5  Monitoring compliance with low-income housing credit 

requirements.

    (a) Compliance monitoring requirement--(1) In general. Under section 
42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains 
a procedure that the State or local housing credit agency (``Agency'') 
(or an agent of, or other private contractor hired

[[Page 167]]

by, the Agency) will follow in monitoring for noncompliance with the 
provisions of section 42 and in notifying the Internal Revenue Service 
of any noncompliance of which the Agency becomes aware. These 
regulations only address compliance monitoring procedures required of 
Agencies. The regulations do not address forms and other records that 
may be required by the Service on examination or audit. For example, if 
a building is sold or otherwise transferred by the owner, the transferee 
should obtain from the transferor information related to the first year 
of the credit period so that the transferee can substantiate credits 
claimed.
    (2) Requirements for a monitoring procedure--(i) In general. A 
procedure for monitoring for noncompliance under section 
42(m)(1)(B)(iii) must include--
    (A) The recordkeeping and record retention provisions of paragraph 
(b) of this section;
    (B) The certification and review provisions of paragraph (c) of this 
section;
    (C) The inspection provision of paragraph (d) of this section; and
    (D) The notification-of-noncompliance provisions of paragraph (e) of 
this section.
    (ii) Order and form. A monitoring procedure will meet the 
requirements of section 42 (m)(1)(B)(iii) if it contains the substance 
of these provisions. The particular order and form of the provisions in 
the allocation plan is not material. A monitoring procedure may contain 
additional provisions or requirements.
    (b) Recordkeeping and record retention provisions--(1) Recordkeeping 
provision. Under the recordkeeping provision, the owner of a low-income 
housing project must be required to keep records for each qualified low-
income building in the project that show for each year in the compliance 
period--
    (i) The total number of residential rental units in the building 
(including the number of bedrooms and the size in square feet of each 
residential rental unit);
    (ii) The percentage of residential rental units in the building that 
are low-income units;
    (iii) The rent charged on each residential rental unit in the 
building (including any utility allowances);
    (iv) The number of occupants in each low-income unit, but only if 
rent is determined by the number of occupants in each unit under section 
42(g)(2) (as in effect before the amendments made by the Omnibus Budget 
Reconciliation Act of 1989);
    (v) The low-income unit vacancies in the building and information 
that shows when, and to whom, the next available units were rented;
    (vi) The annual income certification of each low-income tenant per 
unit. For an exception to this requirement, see section 42(g)(8)(B) 
(which provides a special rule for a 100 percent low-income building);
    (vii) Documentation to support each low-income tenant's income 
certification (for example, a copy of the tenant's federal income tax 
return, Forms W-2, or verifications of income from third parties such as 
employers or state agencies paying unemployment compensation). For an 
exception to this requirement, see section 42(g)(8)(B) (which provides a 
special rule for a 100 percent low-income building). Tenant income is 
calculated in a manner consistent with the determination of annual 
income under section 8 of the United States Housing Act of 1937 
(``Section 8''), not in accordance with the determination of gross 
income for federal income tax liability. In the case of a tenant 
receiving housing assistance payments under Section 8, the documentation 
requirement of this paragraph (b)(1)(vii) is satisfied if the public 
housing authority provides a statement to the building owner declaring 
that the tenant's income does not exceed the applicable income limit 
under section 42 (g);
    (viii) The eligible basis and qualified basis of the building at the 
end of the first year of the credit period; and
    (ix) The character and use of the nonresidential portion of the 
building included in the building's eligible basis under section 42 (d) 
(e.g., tenant facilities that are available on a comparable basis to all 
tenants and for which no separate fee is charged for use of the 
facilities, or facilities reasonably required by the project).

[[Page 168]]

    (2) Record retention provision. Under the record retention 
provision, the owner of a low-income housing project must be required to 
retain the records described in paragraph (b)(1) of this section for at 
least 6 years after the due date (with extensions) for filing the 
federal income tax return for that year. The records for the first year 
of the credit period, however, must be retained for at least 6 years 
beyond the due date (with extensions) for filing the federal income tax 
return for the last year of the compliance period of the building.
    (3) Inspection record retention provision. Under the inspection 
record retention provision, the owner of a low-income housing project 
must be required to retain the original local health, safety, or 
building code violation reports or notices that were issued by the State 
or local government unit (as described in paragraph (c)(1)(vi) of this 
section) for the Agency's inspection under paragraph (d) of this 
section. Retention of the original violation reports or notices is not 
required once the Agency reviews the violation reports or notices and 
completes its inspection, unless the violation remains uncorrected.
    (c) Certification and review provisions--(1) Certification. Under 
the certification provision, the owner of a low-income housing project 
must be required to certify at least annually to the Agency that, for 
the preceding 12-month period--
    (i) The project met the requirements of:
    (A) The 20-50 test under section 42 (g)(1)(A), the 40-60 test under 
section 42 (g)(1)(B), or the 25-60 test under sections 42 (g)(4) and 142 
(d)(6) for New York City, whichever minimum set-aside test was 
applicable to the project; and
    (B) If applicable to the project, the 15-40 test under sections 
42(g)(4) and 142 (d)(4)(B) for ``deep rent skewed'' projects;
    (ii) There was no change in the applicable fraction (as defined in 
section 42(c)(1)(B)) of any building in the project, or that there was a 
change, and a description of the change;
    (iii) The owner has received an annual income certification from 
each low-income tenant, and documentation to support that certification; 
or, in the case of a tenant receiving Section 8 housing assistance 
payments, the statement from a public housing authority described in 
paragraph (b)(1)(vii) of this section. For an exception to this 
requirement, see section 42(g)(8)(B) (which provides a special rule for 
a 100 percent low-income building);
    (iv) Each low-income unit in the project was rent-restricted under 
section 42(g)(2);
    (v) All units in the project were for use by the general public (as 
defined in Sec. 1.42-9), including the requirement that no finding of 
discrimination under the Fair Housing Act, 42 U.S.C. 3601-3619, occurred 
for the project. A finding of discrimination includes an adverse final 
decision by the Secretary of the Department of Housing and Urban 
Development (HUD), 24 CFR 180.680, an adverse final decision by a 
substantially equivalent state or local fair housing agency, 42 U.S.C. 
3616a(a)(1), or an adverse judgment from a federal court;
    (vi) The buildings and low-income units in the project were suitable 
for occupancy, taking into account local health, safety, and building 
codes (or other habitability standards), and the State or local 
government unit responsible for making local health, safety, or building 
code inspections did not issue a violation report for any building or 
low-income unit in the project. If a violation report or notice was 
issued by the governmental unit, the owner must attach a statement 
summarizing the violation report or notice or a copy of the violation 
report or notice to the annual certification submitted to the Agency 
under paragraph (c)(1) of this section. In addition, the owner must 
state whether the violation has been corrected;
    (vii) There was no change in the eligible basis (as defined in 
section 42(d)) of any building in the project, or if there was a change, 
the nature of the change (e.g., a common area has become commercial 
space, or a fee is now charged for a tenant facility formerly provided 
without charge);
    (viii) All tenant facilities included in the eligible basis under 
section 42(d) of

[[Page 169]]

any building in the project, such as swimming pools, other recreational 
facilities, and parking areas, were provided on a comparable basis 
without charge to all tenants in the building;
    (ix) If a low-income unit in the project became vacant during the 
year, that reasonable attempts were or are being made to rent that unit 
or the next available unit of comparable or smaller size to tenants 
having a qualifying income before any units in the project were or will 
be rented to tenants not having a qualifying income;
    (x) If the income of tenants of a low-income unit in the building 
increased above the limit allowed in section 42(g)(2)(D)(ii), the next 
available unit of comparable or smaller size in the building was or will 
be rented to tenants having a qualifying income;
    (xi) An extended low-income housing commitment as described in 
section 42(h)(6) was in effect (for buildings subject to section 
7108(c)(1) of the Omnibus Budget Reconciliation Act of 1989, 103 Stat. 
2106, 2308-2311), including the requirement under section 
42(h)(6)(B)(iv) that an owner cannot refuse to lease a unit in the 
project to an applicant because the applicant holds a voucher or 
certificate of eligibility under section 8 of the United States Housing 
Act of 1937, 42 U.S.C. 1437f (for buildings subject to section 
13142(b)(4) of the Omnibus Budget Reconciliation Act of 1993, 107 Stat. 
312, 438-439); and
    (xii) All low-income units in the project were used on a 
nontransient basis (except for transitional housing for the homeless 
provided under section 42(i)(3)(B)(iii) or single-room-occupancy units 
rented on a month-by-month basis under section 42(i)(3)(B)(iv)).
    (2) Review. The review provision must--
    (i) Require that the Agency review the certifications submitted 
under paragraph (c)(1) of this section for compliance with the 
requirements of section 42;
    (ii) Require that with respect to each low-income housing project--
    (A) The Agency must conduct on-site inspections of all buildings in 
the project by the end of the second calendar year following the year 
the last building in the project is placed in service and, for at least 
20 percent of the project's low-income units, inspect the units and 
review the low-income certifications, the documentation supporting the 
certifications, and the rent records for the tenants in those units; and
    (B) At least once every 3 years, the Agency must conduct on-site 
inspections of all buildings in the project and, for at least 20 percent 
of the project's low-income units, inspect the units and review the low-
income certifications, the documentation supporting the certifications, 
and the rent records for the tenants in those units; and
    (iii) Require that the Agency randomly select which low-income units 
and tenant records are to be inspected and reviewed by the Agency. The 
review of tenant records may be undertaken wherever the owner maintains 
or stores the records (either on-site or off-site). The units and tenant 
records to be inspected and reviewed must be chosen in a manner that 
will not give owners of low-income housing projects advance notice that 
a unit and tenant records for a particular year will or will not be 
inspected and reviewed. However, an Agency may give an owner reasonable 
notice that an inspection of the building and low-income units or tenant 
record review will occur so that the owner may notify tenants of the 
inspection or assemble tenant records for review (for example, 30 days 
notice of inspection or review).
    (3) Frequency and form of certification. A monitoring procedure must 
require that the certifications and reviews of paragraph (c)(1) and (2) 
of this section be made at least annually covering each year of the 15-
year compliance period under section 42(i)(1). The certifications must 
be made under penalty of perjury. A monitoring procedure may require 
certifications and reviews more frequently than on a 12-month basis, 
provided that all months within each 12-month period are subject to 
certification.
    (4) Exception for certain buildings--(i) In general. The review 
requirements under paragraph (c)(2)(ii) of this section may provide that 
owners are not required to submit, and the Agency is

[[Page 170]]

not required to review, the tenant income certifications, supporting 
documentation, and rent records for buildings financed by the Rural 
Housing Service (RHS), formerly known as Farmers Home Administration, 
under the section 515 program, or buildings of which 50 percent or more 
of the aggregate basis (taking into account the building and the land) 
is financed with the proceeds of obligations the interest on which is 
exempt from tax under section 103 (tax-exempt bonds). In order for a 
monitoring procedure to except these buildings, the Agency must meet the 
requirements of paragraph (c)(4)(ii) of this section.
    (ii) Agreement and review. The Agency must enter into an agreement 
with the RHS or tax-exempt bond issuer. Under the agreement, the RHS or 
tax-exempt bond issuer must agree to provide information concerning the 
income and rent of the tenants in the building to the Agency. The Agency 
may assume the accuracy of the information provided by RHS or the tax-
exempt bond issuer without verification. The Agency must review the 
information and determine that the income limitation and rent 
restriction of section 42 (g)(1) and (2) are met. However, if the 
information provided by the RHS or tax-exempt bond issuer is not 
sufficient for the Agency to make this determination, the Agency must 
request the necessary additional income or rent information from the 
owner of the buildings. For example, because RHS determines tenant 
eligibility based on its definition of ``adjusted annual income,'' 
rather than ``annual income'' as defined under Section 8, the Agency may 
have to calculate the tenant's income for section 42 purposes and may 
need to request additional income information from the owner.
    (iii) Example. The exception permitted under paragraph (c)(4)(i) and 
(ii) of this section is illustrated by the following example.

    Example. An Agency selects for review buildings financed by the RHS. 
The Agency has entered into an agreement described in paragraph 
(c)(4)(ii) of this section with the RHS with respect to those buildings. 
In reviewing the RHS-financed buildings, the Agency obtains the tenant 
income and rent information from the RHS for 20 percent of the low-
income units in each of those buildings. The Agency calculates the 
tenant income and rent to determine whether the tenants meet the income 
and rent limitation of section 42 (g)(1) and (2). In order to make this 
determination, the Agency may need to request additional income or rent 
information from the owners of the RHS buildings if the information 
provided by the RHS is not sufficient.

    (5) Agency reports of compliance monitoring activities. The Agency 
must report its compliance monitoring activities annually on Form 8610, 
``Annual Low-Income Housing Credit Agencies Report.''
    (d) Inspection provision--(1) In general. Under the inspection 
provision, the Agency must have the right to perform an on-site 
inspection of any low-income housing project at least through the end of 
the compliance period of the buildings in the project. The inspection 
provision of this paragraph (d) is a separate requirement from any 
tenant file review under paragraph (c)(2)(ii) of this section.
    (2) Inspection standard. For the on-site inspections of buildings 
and low-income units required by paragraph (c)(2)(ii) of this section, 
the Agency must review any local health, safety, or building code 
violations reports or notices retained by the owner under paragraph 
(b)(3) of this section and must determine--
    (i) Whether the buildings and units are suitable for occupancy, 
taking into account local health, safety, and building codes (or other 
habitability standards); or
    (ii) Whether the buildings and units satisfy, as determined by the 
Agency, the uniform physical condition standards for public housing 
established by HUD (24 CFR 5.703). The HUD physical condition standards 
do not supersede or preempt local health, safety, and building codes. A 
low-income housing project under section 42 must continue to satisfy 
these codes and, if the Agency becomes aware of any violation of these 
codes, the Agency must report the violation to the Service. However, 
provided the Agency determines by inspection that the HUD standards are 
met, the Agency is not required under this paragraph (d)(2)(ii) to 
determine by inspection whether the project meets local health, safety, 
and building codes.

[[Page 171]]

    (3) Exception from inspection provision. An Agency is not required 
to inspect a building under this paragraph (d) if the building is 
financed by the RHS under the section 515 program, the RHS inspects the 
building (under 7 CFR part 1930), and the RHS and Agency enter into a 
memorandum of understanding, or other similar arrangement, under which 
the RHS agrees to notify the Agency of the inspection results.
    (4) Delegation. An Agency may delegate inspection under this 
paragraph (d) to an Authorized Delegate retained under paragraph (f) of 
this section. Such Authorized Delegate, which may include HUD or a HUD-
approved inspector, must notify the Agency of the inspection results.
    (e) Notification-of-noncompliance provision--(1) In general. Under 
the notification-of-noncompliance provisions, the Agency must be 
required to give the notice described in paragraph (e)(2) of this 
section to the owner of a low-income housing project and the notice 
described in paragraph (e)(3) of this section to the Service.
    (2) Notice to owner. The Agency must be required to provide prompt 
written notice to the owner of a low-income housing project if the 
Agency does not receive the certification described in paragraph (c)(1) 
of this section, or does not receive or is not permitted to inspect the 
tenant income certifications, supporting documentation, and rent records 
described in paragraph (c)(2)(ii) of this section, or discovers by 
inspection, review, or in some other manner, that the project is not in 
compliance with the provisions of section 42.
    (3) Notice to Internal Revenue Service--(i) In general. The Agency 
must be required to file Form 8823, ``Low-Income Housing Credit Agencies 
Report of Noncompliance,'' with the Service no later than 45 days after 
the end of the correction period (as described in paragraph (e)(4) of 
this section, including extensions permitted under that paragraph) and 
no earlier than the end of the correction period, whether or not the 
noncompliance or failure to certify is corrected. The Agency must 
explain on Form 8823 the nature of the noncompliance or failure to 
certify and indicate whether the owner has corrected the noncompliance 
or failure to certify. Any change in either the applicable fraction or 
eligible basis under paragraph (c)(1)(ii) and (vii) of this section, 
respectively, that results in a decrease in the qualified basis of the 
project under section 42 (c)(1)(A) is noncompliance that must be 
reported to the Service under this paragraph (e)(3). If an Agency 
reports on Form 8823 that a building is entirely out of compliance and 
will not be in compliance at any time in the future, the Agency need not 
file Form 8823 in subsequent years to report that building's 
noncompliance. If the noncompliance or failure to certify is corrected 
within 3 years after the end of the correction period, the Agency is 
required to file Form 8823 with the Service reporting the correction of 
the noncompliance or failure to certify.
    (ii) Agency retention of records. An Agency must retain records of 
noncompliance or failure to certify for 6 years beyond the Agency's 
filing of the respective Form 8823. In all other cases, the Agency must 
retain the certifications and records described in paragraph (c) of this 
section for 3 years from the end of the calendar year the Agency 
receives the certifications and records.
    (4) Correction period. The correction period shall be that period 
specified in the monitoring procedure during which an owner must supply 
any missing certifications and bring the project into compliance with 
the provisions of section 42. The correction period is not to exceed 90 
days from the date of the notice to the owner described in paragraph 
(e)(2) of this section. An Agency may extend the correction period for 
up to 6 months, but only if the Agency determines there is good cause 
for granting the extension.
    (f) Delegation of Authority--(1) Agencies permitted to delegate 
compliance monitoring functions--(i) In general. An Agency may retain an 
agent or other private contractor (``Authorized Delegate'') to perform 
compliance monitoring. The Authorized Delegate must be unrelated to the 
owner of any building that the Authorized Delegate monitors. The 
Authorized Delegate may be delegated all of the functions of the Agency, 
except for the responsibility of notifying the Service under paragraphs

[[Page 172]]

(c)(5) and (e)(3) of this section. For example, the Authorized Delegate 
may be delegated the responsibility of reviewing tenant certifications 
and documentation under paragraph (c) (1) and (2) of this section, the 
right to inspect buildings and records as described in paragraph (d) of 
this section, and the responsibility of notifying building owners of 
lack of certification or noncompliance under paragraph (e)(2) of this 
section. The Authorized Delegate must notify the Agency of any 
noncompliance or failure to certify.
    (ii) Limitations. An Agency that delegates compliance monitoring to 
an Authorized Delegate under paragraph (f)(1)(i) of this section must 
use reasonable diligence to ensure that the Authorized Delegate properly 
performs the delegated monitoring functions. Delegation by an Agency of 
compliance monitoring functions to an Authorized Delegate does not 
relieve the Agency of its obligation to notify the Service of any 
noncompliance of which the Agency becomes aware.
    (2) Agencies permitted to delegate compliance monitoring functions 
to another Agency. An Agency may delegate all or some of its compliance 
monitoring responsibilities for a building to another Agency within the 
State. This delegation may include the responsibility of notifying the 
Service under paragraph (e)(3) of this section.
    (g) Liability. Compliance with the requirements of section 42 is the 
responsibility of the owner of the building for which the credit is 
allowable. The Agency's obligation to monitor for compliance with the 
requirements of section 42 does not make the Agency liable for an 
owner's noncompliance.
    (h) Effective date. Allocation plans must comply with these 
regulations by June 30, 1993. The requirement of section 42 
(m)(1)(B)(iii) that allocation plans contain a procedure for monitoring 
for noncompliance becomes effective on January 1, 1992, and applies to 
buildings for which a low-income housing credit is, or has been, 
allowable at any time. Thus, allocation plans must comply with section 
42(m)(1)(B)(iii) prior to June 30, 1993, the effective date of these 
regulations. An allocation plan that complies with these regulations, 
with the notice of proposed rulemaking published in the Federal Register 
on December 27, 1991, or with a reasonable interpretation of section 
42(m)(1)(B)(iii) will satisfy the requirements of section 
42(m)(1)(B)(iii) for periods before June 30, 1993. Section 
42(m)(1)(B)(iii) and these regulations do not require monitoring for 
whether a building or project is in compliance with the requirements of 
section 42 prior to January 1, 1992. However, if an Agency becomes aware 
of noncompliance that occurred prior to January 1, 1992, the Agency is 
required to notify the Service of that noncompliance. In addition, the 
requirements in paragraphs (b)(3) and (c)(1)(v), (vi), and (xi) of this 
section (involving recordkeeping and annual owner certifications) and 
paragraphs (c)(2)(ii)(B), (c)(2)(iii), and (d) of this section 
(involving tenant file reviews and physical inspections of existing 
projects, and the physical inspection standard) are applicable January 
1, 2001. The requirement in paragraph (c)(2)(ii)(A) of this section 
(involving tenant file reviews and physical inspections of new projects) 
is applicable for buildings placed in service on or after January 1, 
2001. The requirements in paragraph (c)(5) of this section (involving 
Agency reporting of compliance monitoring activities to the Service) and 
paragraph (e)(3)(i) of this section (involving Agency reporting of 
corrected noncompliance or failure to certify within 3 years after the 
end of the correction period) are applicable January 14, 2000.

[T.D. 8430, 57 FR 40121, Sept. 2, 1992; 57 FR 57280, Dec. 3, 1992; 58 FR 
7748, Feb. 9, 1993; T.D. 8563, 59 FR 50163, Oct. 3, 1994; T.D. 8859, 65 
FR 2326, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000]



Sec. 1.42-6  Buildings qualifying for carryover allocations.

    (a) Carryover allocations--(1) In general. A carryover allocation is 
an allocation that meets the requirements of section 42(h)(1)(E) or (F). 
If the requirements of section Sec. 42(h)(1)(E) or (F) that are 
required to be satisfied by the close of a calendar year are not 
satisfied, the allocation is not valid and is treated as if it had not 
been made for that calendar year. For example, if a carryover

[[Page 173]]

allocation fails to satisfy a requirement in Sec. 1.42-6(d) for making 
an allocation, such as failing to be signed or dated by an authorized 
official of an allocating agency by the close of a calendar year, the 
allocation is not valid and is treated as if it had not been made for 
that calendar year.
    (2) 10 percent basis requirement. A carryover allocation may only be 
made with respect to a qualified building. A qualified building is any 
building which is part of a project if, by the date specified under 
paragraph (a)(2)(i) or (ii) of this section, a taxpayer's basis in the 
project is more than 10 percent of the taxpayer's reasonably expected 
basis in the project as of the close of the second calendar year 
following the calendar year the allocation is made. For purposes of 
meeting the 10 percent basis requirement, the determination of whether a 
building is part of a single-building project or multi-building project 
is based on whether the carryover allocation is made under section 
42(h)(1)(E) (building-based allocation) or section 42(h)(1)(F) (project-
based allocation). In the case of a multi-building project that receives 
an allocation under section 42(h)(1)(F), the 10 percent basis 
requirement is satisfied by reference to the entire project.
    (i) Allocation made before July 1. If a carryover allocation is made 
before July 1 of a calendar year, a taxpayer must meet the 10 percent 
basis requirement by the close of that calendar year. If a taxpayer does 
not meet the 10 percent basis requirement by the close of the calendar 
year, the carryover allocation is not valid and is treated as if it had 
not been made.
    (ii) Allocation made after June 30. If a carryover allocation is 
made after June 30 of a calendar year, a taxpayer must meet the 10 
percent basis requirement by the close of the date that is 6 months 
after the date the allocation was made. If a taxpayer does not meet the 
10 percent basis requirement by the close of the required date, the 
carryover allocation must be returned to the Agency. Unlike a carryover 
allocation made before July 1, if a taxpayer does not meet the 10 
percent basis requirement by the close of the required date, the 
carryover allocation is treated as a valid allocation for the calendar 
year of allocation, but is included in the ``returned credit component'' 
for purposes of determining the State housing credit ceiling under 
section 42(h)(3)(C) for the calendar year following the calendar year of 
the allocation. See Sec. 1.42-14(d)(1).
    (b) Carryover-allocation basis--(1) In general. Subject to the 
limitations of paragraph (b)(2) of this section, a taxpayer's basis in a 
project for purposes of section 42(h)(1) (E)(ii) or (F) (carryover-
allocation basis) is the taxpayer's adjusted basis in land or 
depreciable property that is reasonably expected to be part of the 
project, whether or not these amounts are includible in eligible basis 
under section 42(d). Thus, for example, if the project is to include 
property that is not residential rental property, such as commercial 
space, the basis attributable to the commercial space, although not 
includible in eligible basis, is includible in carryover-allocation 
basis. The adjusted basis of land and depreciable property is determined 
under sections 1012 and 1016, and generally includes the direct and 
indirect costs of acquiring, constructing, and rehabilitating the 
property. Costs otherwise includible in carryover-allocation basis are 
not excluded by reason of having been incurred prior to the calendar 
year in which the carryover allocation is made.
    (2) Limitations--For purposes of determining carryover-allocation 
basis under paragraph (b)(1) of this section, the following limitations 
apply.
    (i) Taxpayer must have basis in land or depreciable property related 
to the project. A taxpayer has carryover-allocation basis to the extent 
that it has basis in land or depreciable property and the land or 
depreciable property is reasonably expected to be part of the project 
for which the carryover allocation is made. This basis includes all 
items that are properly capitalizable with respect to the land or 
depreciable property. For example, a nonrefundable downpayment for, or 
an amount paid to acquire an option to purchase, land or depreciable 
property may be included in carryover-allocation basis if properly 
capitalizable into the basis of land or depreciable property that is 
reasonably expected to be part of a project.

[[Page 174]]

    (ii) High cost areas. Any increase in eligible basis that may result 
under section 42(d)(5)(C) from a building's location in a qualified 
census tract or difficult development area is not taken into account in 
determining carryover-allocation basis or reasonably expected basis.
    (iii) Amounts not treated as paid or incurred. An amount is not 
includible in carryover-allocation basis unless it is treated as paid or 
incurred under the method of accounting used by the taxpayer. For 
example, a cash method taxpayer cannot include construction costs in 
carryover-allocation basis unless the costs have been paid, and an 
accrual method taxpayer cannot include construction costs in carryover- 
allocation basis unless they have been properly accrued. See paragraph 
(b)(2)(iv) of this section for a special rule for fees.
    (iv) Fees. A fee is includible in carryover-allocation basis only to 
the extent the requirements of paragraph (b)(2)(iii) of this section are 
met and--
    (A) The fee is reasonable;
    (B) The taxpayer is legally obligated to pay the fee;
    (C) The fee is capitalizable as part of the taxpayer's basis in land 
or depreciable property that is reasonably expected to be part of the 
project;
    (D) The fee is not paid (or to be paid) by the taxpayer to itself; 
and
    (E) If the fee is paid (or to be paid) by the taxpayer to a related 
person, and the taxpayer uses the cash method of accounting, the 
taxpayer could properly accrue the fee under the accrual method of 
accounting (considering, for example, the rules of section 461(h)). A 
person is a related person if the person bears a relationship to the 
taxpayer specified in sections 267(b) or 707(b)(1), or if the person and 
the taxpayer are engaged in trades or businesses under common control 
(within the meaning of subsections (a) and (b) of section 52).
    (3) Reasonably expected basis. Rules similar to the rules of 
paragraphs (a) and (b) of this section apply in determining the 
taxpayer's reasonably expected basis in a project (land and depreciable 
basis) as of the close of the second calendar year following the 
calendar year of the allocation.
    (4) Examples. The following examples illustrate the rules of 
paragraphs (a) and (b) of this section.

    Example 1. (i) Facts. C, an accrual-method taxpayer, receives a 
carryover allocation from Agency, the state housing credit agency, in 
May of 2003. As of that date, C has not begun construction of the low-
income housing building C plans to build. However, C has owned the land 
on which C plans to build the building since 1985. C's basis in the land 
is $100,000. C reasonably expects that by the end of 2005, C's basis in 
the project of which the building is to be a part will be $2,000,000. C 
also expects that because the project is located in a qualified census 
tract, C will be able to increase its basis in the project to 
$2,600,000. Before the close of 2003, C incurs $150,000 of costs for 
architects' fees and site preparation. C properly accrues these costs 
under its method of accounting and capitalizes the costs.
    (ii) Determination of carryover-allocation basis. C's $100,000 basis 
in the land is includible in carryover-allocation basis even though C 
has owned the land since 1985. The $150,000 of costs C has incurred for 
architects' fees and site preparation are also includible in carryover-
allocation basis. The expected increase in basis due to the project's 
location in a qualified census tract is not taken into account in 
determining C's carryover-allocation basis. Accordingly, C's carryover-
allocation basis in the project of which the building is a part is 
$250,000.
    (iii) Determination of whether building is qualified. C's reasonably 
expected basis in the project at the close of the second calendar year 
following the calendar year of allocation is $2,000,000. The expected 
increase in eligible basis due to the project's location in a qualified 
census tract is not taken into account in determining this amount. 
Because C's carryover-allocation basis is more than 10 percent of C's 
reasonably expected basis in the project of which the building is a 
part, the building for which C received the carryover allocation is a 
qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph 
(a) of this section.
    Example 2. (i) Facts. D, an accrual-method taxpayer, received a 
carryover allocation from Agency, the state housing credit agency of 
State X, on September 12, 2003. As of that date, D has not begun 
construction of the low-income housing building D plans to build and D 
does not have basis in the land on which D plans to build the building. 
From September 12, 2003, to the close of March 12, 2004, D incurs some 
costs related to the planned building, including architects' fees. As of 
the close of March 12, 2004, these costs do not exceed 10 percent of D's 
reasonably expected basis in the single-building project as of the close 
of 2005.

[[Page 175]]

    (ii) Determination of whether building is qualified. Because D's 
carryover-allocation basis as of the close of March 12, 2004, is not 
more than 10 percent of D's reasonably expected basis in the single-
building project, the building is not a qualified building for purposes 
of section 42(h)(1)(E)(ii) and paragraph (a) of this section. 
Accordingly, the carryover allocation to D must be returned to the 
Agency. The allocation is valid for purposes of determining the amount 
of credit allocated by Agency from State X's 2003 State housing credit 
ceiling, but is included in the returned credit component of State X's 
2004 housing credit ceiling.

    (c) Verification of basis by Agency--(1) Verification requirement. 
An Agency that makes a carryover allocation to a taxpayer must verify 
that the taxpayer has met the 10 percent basis requirement of paragraph 
(a)(2) of this section.
    (2) Manner of verification. An Agency may verify that a taxpayer has 
incurred more than 10 percent of its reasonably expected basis in a 
project by obtaining a certification from the taxpayer, in writing and 
under penalty of perjury, that the taxpayer has incurred by the close of 
the calendar year of the allocation (for allocations made before July 1) 
or by the close of the date that is 6 months after the date the 
allocation is made (for allocations made after June 30) more than 10 
percent of the reasonably expected basis in the project. The 
certification must be accompanied by supporting documentation that the 
Agency must review. Supporting documentation may include, for example, 
copies of checks or other records of payments. Alternatively, an Agency 
may verify that the taxpayer has incurred adequate basis by requiring 
that the taxpayer obtain from an attorney or certified public accountant 
a written certification to the Agency, that the attorney or accountant 
has examined all eligible costs incurred with respect to the project and 
that, based upon this examination, it is the attorney's or accountant's 
belief that the taxpayer has incurred more than 10 percent of its 
reasonably expected basis in the project by the close of the calendar 
year of the allocation (for allocations made before July 1) or by the 
close of the date that is 6 months after the date the allocation is made 
(for allocations made after June 30).
    (3) Time of verification--(i) Allocations made before July 1. For a 
carryover allocation made before July 1, an Agency may require that the 
basis certification be submitted to or received by the Agency prior to 
the close of the calendar year of allocation or within a reasonable time 
following the close of the calendar year of allocation. The Agency will 
need to verify basis as provided in paragraph (c)(2) of this section to 
accurately complete the Form 8610, ``Annual Low-Income Housing Credit 
Agencies Report,'' and the Schedule A (Form 8610), ``Carryover 
Allocation of Low-Income Housing Credit,'' for the calendar year of the 
allocation. If the basis certification is not timely made, or supporting 
documentation is lacking, inadequate, or does not actually support the 
certification, the Agency should notify the taxpayer and try to get 
adequate documentation. If the Agency cannot verify before the Form 8610 
is filed that the taxpayer has satisfied the 10 percent basis 
requirement for a carryover allocation made before July 1, the 
allocation is not valid and is treated as if it had not been made and 
the carryover allocation should not be reported on the Schedule A (Form 
8610).
    (ii) Allocations made after June 30. An Agency may require that the 
basis certification be submitted to or received by the Agency prior to 
the close of the date that is 6 months after the date the allocation was 
made or within a reasonable period of time following the close of the 
date that is 6 months after the date the allocation was made. The Agency 
will need to verify basis as provided in paragraph (c)(2) of this 
section. If the basis certification is not timely made, or supporting 
documentation is lacking, inadequate, or does not actually support the 
certification, the Agency should notify the taxpayer and try to get 
adequate documentation. If the Agency cannot verify that the taxpayer 
has satisfied the 10 percent basis requirement for a carryover 
allocation made after June 30, the allocation must be returned to the 
Agency. The carryover allocation is a valid allocation for the calendar 
year of the allocation, but is included in the returned credit component 
of the State housing

[[Page 176]]

credit ceiling for the calendar year following the calendar year of the 
allocation.
    (d) Requirements for making carryover allocations--(1) In general. 
Generally, an allocation is made when an Agency issues the Form 8609, 
`Low-Income Housing Credit Allocation Certification,' for a building. 
See Sec. 1.42-1T(d)(8)(ii). An Agency does not issue the Form 8609 for 
a building until the building is placed in service. However, in cases 
where allocations of credit are made pursuant to section 42(h)(1)(E) 
(relating to carryover allocations for buildings) or section 42(h)(1)(F) 
(relating to carryover allocations for multiple-building projects), Form 
8609 is not used as the allocating document because the buildings are 
not yet in service. When an allocation is made pursuant to section 
42(h)(1) (E) or (F), the allocating document is the document meeting the 
requirements of paragraph (d)(2) of this section. In addition, when an 
allocation is made pursuant to section 42(h)(1)(F), the requirements of 
paragraph (d)(3) of this section must be met for the allocation to be 
valid. An allocation pursuant to section 42(h)(1) (E) or (F) reduces the 
state housing credit ceiling for the year in which the allocation is 
made, whether or not the Form 8609 is also issued in that year.
    (2) Requirements for allocation. An allocation pursuant to section 
42(h)(1) (E) or (F) is made when an allocation document containing the 
following information is completed, signed, and dated by an authorized 
official of the Agency--
    (i) The address of each building in the project, or if none exists, 
a specific description of the location of each building;
    (ii) The name, address, and taxpayer identification number of the 
taxpayer receiving the allocation;
    (iii) The name and address of the Agency;
    (iv) The taxpayer identification number of the Agency;
    (v) The date of the allocation;
    (vi) The housing credit dollar amount allocated to the building or 
project, as applicable;
    (vii) The taxpayer's reasonably expected basis in the project (land 
and depreciable basis) as of the close of the second calendar year 
following the calendar year in which the allocation is made;
    (viii) For carryover allocations made before July 1, the taxpayer's 
basis in the project (land and depreciable basis) as of the close of the 
calendar year of the allocation and the percentage that basis bears to 
the reasonably expected basis in the project (land and depreciable 
basis) as of the close of the second calendar year following the 
calendar year of allocation;
    (ix) The date that each building in the project is expected to be 
placed in service; and
    (x) The Building Identification Number (B.I.N.) to be assigned to 
each building in the project. The B.I.N. must reflect the year an 
allocation is first made to the building, regardless of the year that 
the building is placed in service. This B.I.N. must be used for all 
allocations of credit for the building. For example, rehabilitation 
expenditures treated as a separate new building under section 42(e) 
should not have a separate B.I.N. if the building to which the 
rehabilitation expenditures are made has a B.I.N. In this case, the 
B.I.N. used for the rehabilitation expenditures shall be the B.I.N. 
previously assigned to the building, although the rehabilitation 
expenditures must have a separate Form 8609 for the allocation. 
Similarly, a newly constructed building that receives an allocation of 
credit in different calendar years must have a separate Form 8609 for 
each allocation. The B.I.N. assigned to the building for the first 
allocation must be used for the subsequent allocation.
    (3) Special rules for project-based allocations--(i) In general. An 
allocation pursuant to section 42(h)(1)(F) (a project-based allocation) 
must meet the requirements of this section as well as the requirements 
of section 42(h)(1)(F), including the minimum basis requirement of 
section 42(h)(1)(E)(ii).
    (ii) Requirement of section 42(h)(1)(F)(i)(III). An allocation 
satisfies the requirement of section 42(h)(1)(F)(i)(III) if the Form 
8609 that is issued for each building that is placed in service in the 
project states

[[Page 177]]

the portion of the project-based allocation that is applied to that 
building.
    (4) Recordkeeping requirements--(i) Taxpayer. When an allocation is 
made pursuant to section 42(h)(1)(E) or (F), the taxpayer must retain a 
copy of the allocation document. The Form 8609 that reflects the 
allocation must be filed for the first taxable year that the credit is 
claimed and for each taxable year thereafter throughout the compliance 
period, whether or not a credit is claimed for the taxable year.
    (ii) Agency. The Agency must retain the original carryover 
allocation document made under paragraph (d)(2) of this section and file 
Schedule A (Form 8610) with the Agency's Form 8610 for the year the 
allocation is made. The Agency must also retain a copy of the Form 8609 
that is issued to the taxpayer and file the original with the Agency's 
Form 8610 that reflects the year the form is issued.
    (5) Separate procedure for election of appropriate percentage month. 
If a taxpayer receives an allocation under section 42(h)(1) (E) or (F) 
and wishes to elect under section 42(b)(2)(A)(ii) to use the appropriate 
percentage for a month other than the month in which a building is 
placed in service, the requirements specified in Sec. 1.42-8 must be 
met for the election to be effective.
    (e) Special rules. The following rules apply for purposes of this 
section.
    (1) Treatment of partnerships and other flow-through entities. With 
respect to taxpayers that own projects through partnerships or other 
flow-through entities (e.g., S corporations, estates, or trusts), 
carryover-allocation basis is determined at the entity level using the 
rules provided by this section. In addition, the entity is responsible 
for providing to the Agency the certification and documentation required 
under the basis verification requirement in paragraph (c) of this 
section.
    (2) Transferees. If land or depreciable property that is expected to 
be part of a project is transferred after a carryover allocation has 
been made for a building that is reasonably expected to be part of the 
project, but before the close of the calendar year of the allocation 
(for allocations made before July 1) or by the close of the date that is 
6 months after the date the allocation is made (for allocations made 
after June 30), the transferee's carryover-allocation basis is 
determined under the principles of this section and section 42(d)(7). 
See also Rev. Rul. 91-38, 1991-2 C.B. 3 (see Sec. 601.601(d)(2)(ii)(b) 
of this chapter). In addition, the transferee is treated as the taxpayer 
for purposes of the basis verification requirement of this section, and 
therefore, is responsible for providing to the Agency the required 
certifications and documentation.

[T.D. 8520, 59 FR 10069, Mar. 3, 1994, as amended by T.D. 8859, 65 FR 
2328, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000; T.D. 9110, 69 FR 502, 
Jan. 6, 2004]



Sec. 1.42-7  Substantially bond-financed buildings. [Reserved]



Sec. 1.42-8  Election of appropriate percentage month.

    (a) Election under section 42(b)(2)(A)(ii)(I) to use the appropriate 
percentage for the month of a binding agreement--(1) In general. For 
purposes of section 42(b)(2)(A)(ii)(I), an agreement between a taxpayer 
and an Agency as to the housing credit dollar amount to be allocated to 
a building is considered binding if it--
    (i) Is in writing;
    (ii) Is binding under state law on the Agency, the taxpayer, and all 
successors in interest;
    (iii) Specifies the type(s) of building(s) to which the housing 
credit dollar amount applies (i.e., a newly constructed or existing 
building, or substantial rehabilitation treated as a separate new 
building under section 42(e));
    (iv) Specifies the housing credit dollar amount to be allocated to 
the building(s); and
    (v) Is dated and signed by the taxpayer and the Agency during the 
month in which the requirements of paragraphs (a)(1) (i) through (iv) of 
this section are met.
    (2) Effect on state housing credit ceiling. Generally, a binding 
agreement described in paragraph (a)(1) of this section is an agreement 
by the Agency to allocate credit to the taxpayer at a future date. The 
binding agreement may include a reservation of credit or a binding 
commitment (under section

[[Page 178]]

42(h)(1)(C)) to allocate credit in a future taxable year. A reservation 
or a binding commitment to allocate credit in a future year has no 
effect on the state housing credit ceiling until the year the Agency 
actually makes an allocation. However, if the binding agreement is also 
a carryover allocation under section 42(h)(1) (E) or (F), the state 
housing credit ceiling is reduced by the amount allocated by the Agency 
to the taxpayer in the year the carryover allocation is made. For a 
binding agreement to be a valid carryover allocation, the requirements 
of paragraph (a)(1) of this section and Sec. 1.42-6 must be met.
    (3) Time and manner of making election. An election under section 
42(b)(2)(A)(ii)(I) may be made either as part of the binding agreement 
under paragraph (a)(1) of this section to allocate a specific housing 
credit dollar amount or in a separate document that references the 
binding agreement. In either case, the election must--
    (i) Be in writing;
    (ii) Reference section 42(b)(2)(A)(ii)(I);
    (iii) Be signed by the taxpayer;
    (iv) If it is in a separate document, reference the binding 
agreement that meets the requirements of paragraph (a)(1) of this 
section; and
    (v) Be notarized by the 5th day following the end of the month in 
which the binding agreement was made.
    (4) Multiple agreements--(i) Rescinded agreements. A taxpayer may 
not make an election under section 42(b)(2)(A)(ii)(I) for a building if 
an election has previously been made for the building for a different 
month. For example, assume a taxpayer entered into a binding agreement 
for allocation of a specific housing credit dollar amount to a building 
and made the election under section 42(b)(2)(A)(ii)(I) to apply the 
appropriate percentage for the month of the binding agreement. If the 
binding agreement subsequently is rescinded under state law, and the 
taxpayer enters into a new binding agreement for allocation of a 
specific housing credit dollar amount to the building, the taxpayer must 
apply to the building the appropriate percentage for the elected month 
of the rescinded binding agreement. However, if no prior election was 
made with respect to the rescinded binding agreement, the taxpayer may 
elect the appropriate percentage for the month of the new binding 
agreement.
    (ii) Increases in credit. The election under section 
42(b)(2)(A)(ii)(I), once made, applies to any increase in the credit 
amount allocated for a building, whether the increase occurs in the same 
or in a subsequent year. However, in the case of a binding agreement (or 
carryover allocation that is treated as a binding agreement) to allocate 
a credit amount under section 42(e)(1) for substantial rehabilitation 
treated as a separate new building, a taxpayer may make the election 
under section 42(b)(2)(A)(ii)(I) notwithstanding that a prior election 
under section 42(b)(2)(A)(ii)(I) is in effect for a prior allocation of 
credit for a substantial rehabilitation that was previously placed in 
service under section 42(e).
    (5) Amount allocated. The housing credit dollar amount eventually 
allocated to a building may be more or less than the amount specified in 
the binding agreement. Depending on the Agency's determination pursuant 
to section 42(m)(2) as to the financial feasibility of the building (or 
project), the Agency may allocate a greater housing credit dollar amount 
to the building (provided that the Agency has additional housing credit 
dollar amounts available to allocate for the calendar year of the 
allocation) or the Agency may allocate a lesser housing credit dollar 
amount. Under section 42(h)(7)(D), in allocating a housing credit dollar 
amount, the Agency must specify the applicable percentage and maximum 
qualified basis of the building. The applicable percentage may be less, 
but not greater than, the appropriate percentage for the month the 
building is placed in service, or the month elected by the taxpayer 
under section 42(b)(2)(A)(ii)(I). Whether the appropriate percentage is 
the appropriate percentage for the 70-percent present value credit or 
the 30-percent present value credit is determined under section 42(i)(2) 
when the building is placed in service.
    (6) Procedures--(i) Taxpayer. The taxpayer must give the original 
notarized election statement to the Agency before the close of the 5th 
calendar day

[[Page 179]]

following the end of the month in which the binding agreement is made. 
The taxpayer must retain a copy of the binding agreement and the 
election statement.
    (ii) Agency. The Agency must retain the original of the binding 
agreement and election statement and, to the extent required by Schedule 
A (Form 8610), ``Carryover Allocation of Low-Income Housing Credit,'' 
account for the binding agreement and election statement on that 
schedule.
    (7) Examples. The following examples illustrate the provisions of 
this section. In each example, X is the taxpayer, Agency is the state 
housing credit agency, and the carryover allocations meet the 
requirements of Sec. 1.42-6 and are otherwise valid.

    Example 1. (i) In August 2003, X and Agency enter into an agreement 
that Agency will allocate $100,000 of housing credit dollar amount for 
the low-income housing building X is constructing. The agreement is 
binding and meets all the requirements of paragraph (a)(1) of this 
section. The agreement is a reservation of credit, not an allocation, 
and therefore, has no effect on the state housing credit ceiling. On or 
before September 5, 2003, X signs and has notarized a written election 
statement that meets the requirements of paragraph (a)(3) of this 
section. The applicable percentage for the building is the appropriate 
percentage for the month of August 2003.
    (ii) Agency makes a carryover allocation of $100,000 of housing 
credit dollar amount for the building on October 2, 2003. The carryover 
allocation reduces Agency's state housing credit ceiling for 2003. Due 
to unexpectedly high construction costs, when X places the building in 
service in July 2004, the product of the building's qualified basis and 
the applicable percentage for the building (the appropriate percentage 
for the month of August 2003) is $150,000, rather than $100,000. 
Notwithstanding that only $100,000 of credit was allocated for the 
building in 2003, Agency may allocate an additional $50,000 of housing 
credit dollar amount for the building from its state housing credit 
ceiling for 2004. The appropriate percentage for the month of August 
2003 is the applicable percentage for the building for the entire 
$150,000 of credit allocated for the building, even though separate 
allocations were made in 2003 and 2004. Because allocations were made 
for the building in two separate calendar years, Agency must issue two 
Forms 8609, ``Low-Income Housing Credit Allocation Certification,'' to 
X. One Form 8609 must reflect the $100,000 allocation made in 2003, and 
the other Form 8609 must reflect the $50,000 allocation made in 2004.
    (iii) X gives the original notarized statement to Agency on or 
before September 5, 2003, and retains a copy of the binding agreement, 
election statement, and carryover allocation document.
    (iv) Agency retains the original of the binding agreement, election 
statement, and 2003 carryover allocation document. Agency accounts for 
the binding agreement, election statement, and 2003 carryover allocation 
on the Schedule A (Form 8610) that it files for the 2003 calendar year. 
After the building is placed in service in 2004, and assuming other 
necessary requirements for issuing a Form 8609 are met (for example, 
taxpayer has certified all sources and uses of funds and development 
costs for the building under Sec. 1.42-17), Agency issues to X a copy 
of the Form 8609 reflecting the 2003 carryover allocation of $100,000. 
Agency files the original of this Form 8609 with the Form 8610, ``Annual 
Low-Income Housing Credit Agencies Report,'' that it files for the 2004 
calendar year. Agency also issues to X a copy of the Form 8609 
reflecting the 2004 allocation of $50,000 and files the original of this 
Form 8609 with the Form 8610 that it files for the 2004 calendar year. 
Agency retains copies of the Forms 8609 that are issued to X.
    Example 2. (i) In September 2003, X and Agency enter into an 
agreement that Agency will allocate $70,000 of housing credit dollar 
amount for rehabilitation expenditures that X is incurring and that X 
will treat as a new low-income housing building under section 42(e)(1). 
The agreement is binding and meets all the requirements of paragraph 
(a)(1) of this section. The agreement is a reservation of credit, not an 
allocation, and therefore, has no effect on Agency's state housing 
credit ceiling. On or before October 5, 2003, X signs and has notarized 
a written election statement that meets the requirements of paragraph 
(a)(3) of this section. The applicable percentage for the building is 
the appropriate percentage for the month of September 2003. Agency makes 
a carryover allocation of $70,000 of housing credit dollar amount for 
the building on November 15, 2003. The carryover allocation reduces by 
$70,000 Agency's state housing credit ceiling for 2003.
    (ii) In October 2004, X and Agency enter into another binding 
agreement meeting the requirements of paragraph (a)(1) of this section. 
Under the agreement, Agency will allocate $50,000 of housing credit 
dollar amount for additional rehabilitation expenditures by X that 
qualify as a second separate new building under section 42(e)(1). On or 
before November 5, 2004, X signs and has notarized a written election 
statement meeting the requirements of paragraph (a)(3) of this section. 
On December 1, 2004, X receives a carryover allocation under section 
42(h)(1)(E) for

[[Page 180]]

$50,000. The carryover allocation reduces by $50,000 Agency's state 
housing credit ceiling for 2004. The applicable percentage for the 
rehabilitation expenditures treated as the second separate new building 
is the appropriate percentage for the month of October 2004, not 
September 2003. The appropriate percentage for the month of September 
2003 still applies to the allocation of $70,000 for the rehabilitation 
expenditures treated as the first separate new building. Because 
allocations were made for the building in two separate calendar years, 
Agency must issue two Forms 8609 to X. One Form 8609 must reflect the 
$70,000 allocation made in 2003, and the other Form 8609 must reflect 
the $50,000 allocation made in 2004.
    (iii) X gives the first original notarized statement to Agency on or 
before October 5, 2003, and retains a copy of the first binding 
agreement, election statement, and carryover allocation document issued 
in 2003. X gives the second original notarized statement to Agency on or 
before November 5, 2004, and retains a copy of the second binding 
agreement, election statement, and carryover allocation document issued 
in 2004.
    (iv) Agency retains the original of the binding agreements, election 
statements, and carryover allocation documents. Agency accounts for the 
binding agreement, election statement, and 2003 carryover allocation on 
the Schedule A (Form 8610) that it files for the 2003 calendar year. 
Agency also accounts for the binding agreement, election statement, and 
2004 carryover allocation on the Schedule A (Form 8610) that it files 
for the 2004 calendar year. After each separate new building is placed 
in service, and assuming other necessary requirements for issuing a Form 
8609 are met (for example, taxpayer has certified all sources and uses 
of funds and development costs for the building under Sec. 1.42-17), 
the Agency will issue to X a copy of the Form 8609 reflecting the 2003 
carryover allocation of $70,000 and a copy of the Form 8609 reflecting 
the 2004 carryover allocation of $50,000, respectively. Agency files the 
original of each Form 8609 with the Form 8610 that reflects the calendar 
year each Form 8609 is issued. Agency retains copies of the Forms 8609 
that are issued to X.

    (b) Election under section 42(b)(2)(A)(ii)(II) to use the 
appropriate percentage for the month tax-exempt bonds are issued--(1) 
Time and manner of making election. In the case of any building to which 
section 42(h)(4)(B) applies, an election under section 
42(b)(2)(A)(ii)(II) to use the appropriate percentage for the month tax-
exempt bonds are issued must--
    (i) Be in writing;
    (ii) Reference section 42(b)(2)(A)(ii)(II);
    (iii) Specify the percentage of the aggregate basis of the building 
and the land on which the building is located that is financed with the 
proceeds of obligations described in section 42(h)(4)(A) (tax-exempt 
bonds);
    (iv) State the month in which the tax-exempt bonds are issued;
    (v) State that the month in which the tax-exempt bonds are issued is 
the month elected for the appropriate percentage to be used for the 
building;
    (vi) Be signed by the taxpayer; and
    (vii) Be notarized by the 5th day following the end of the month in 
which the bonds are issued.
    (2) Bonds issued in more than one month. If a building described in 
section 42(h)(4)(B) (substantially bond-financed building) is financed 
with tax-exempt bonds issued in more than one month, the taxpayer may 
elect the appropriate percentage for any month in which the bonds are 
issued. Once the election is made, the appropriate percentage elected 
applies for the building even if all bonds are not issued in that month. 
The requirements of this paragraph (b), including the time limitation 
contained in paragraph (b)(1)(vii) of this section, must also be met.
    (3) Limitations on appropriate percentage. Under section 
42(m)(2)(D), the credit allowable for a substantially bond- financed 
building is limited to the amount necessary to assure the project's 
feasibility. Accordingly, in making the determination under section 
42(m)(2), an Agency may use an applicable percentage that is less, but 
not greater than, the appropriate percentage for the month the building 
is placed in service, or the month elected by the taxpayer under section 
42(b)(2)(A)(ii)(II).
    (4) Procedures--(i) Taxpayer. The taxpayer must provide the original 
notarized election statement to the Agency before the close of the 5th 
calendar day following the end of the month in which the bonds are 
issued. If an authority other than the Agency issues the tax-exempt 
bonds, the taxpayer must also give the Agency a signed statement from 
the issuing authority that certifies the information described in 
paragraphs (b)(1)(iii) and (iv) of this section. The taxpayer must also

[[Page 181]]

retain a copy of the election statement.
    (ii) Agency. The Agency must retain the original of the election 
statement and a copy of the Form 8609 that reflects the election 
statement. The Agency must file an additional copy of the Form 8609 with 
the Agency's Form 8610 that reflects the calendar year the Form 8609 is 
issued.

[T.D. 8520, 59 FR 10071, Mar. 3, 1994, as amended by T.D. 9110, 69 FR 
504, Jan. 6, 2004]



Sec. 1.42-9  For use by the general public.

    (a) General rule. If a residential rental unit in a building is not 
for use by the general public, the unit is not eligible for a section 42 
credit. A residential rental unit is for use by the general public if 
the unit is rented in a manner consistent with housing policy governing 
non-discrimination, as evidenced by rules or regulations of the 
Department of Housing and Urban Development (HUD) (24 CFR subtitle A and 
chapters I through XX). See HUD Handbook 4350.3 (or its successor). A 
copy of HUD Handbook 4350.3 may be requested by writing to: HUD, 
Directives Distribution Section, room B-100, 451 7th Street, SW., 
Washington, DC 20410.
    (b) Limitations. Notwithstanding paragraph (a) of this section, if a 
residential rental unit is provided only for a member of a social 
organization or provided by an employer for its employees, the unit is 
not for use by the general public and is not eligible for credit under 
section 42. In addition, any residential rental unit that is part of a 
hospital, nursing home, sanitarium, lifecare facility, trailer park, or 
intermediate care facility for the mentally and physically handicapped 
is not for use by the general public and is not eligible for credit 
under section 42.
    (c) Treatment of units not for use by the general public. The costs 
attributable to a residential rental unit that is not for use by the 
general public are not excludable from eligible basis by reason of the 
unit's ineligibility for the credit under this section. However, in 
calculating the applicable fraction, the unit is treated as a 
residential rental unit that is not a low-income unit.

[T.D. 8520, 59 FR 10073, Mar. 3, 1994]



Sec. 1.42-10  Utility allowances.

    (a) Inclusion of utility allowances in gross rent. If the cost of 
any utility (other than telephone, cable television, or Internet) for a 
residential rental unit is paid directly by the tenant(s), and not by or 
through the owner of the building, the gross rent for that unit includes 
the applicable utility allowance determined under this section. This 
section only applies for purposes of determining gross rent under 
section 42(g)(2)(B)(ii) as to rent-restricted units.
    (b) Applicable utility allowances--(1) Buildings assisted by the 
Rural Housing Service. If a building receives assistance from the Rural 
Housing Service (RHS-assisted building), the applicable utility 
allowance for all rent-restricted units in the building is the utility 
allowance determined under the method prescribed by the Rural Housing 
Service (RHS) for the building (whether or not the building or its 
tenants also receive other state or federal assistance).
    (2) Buildings with Rural Housing Service assisted tenants. If any 
tenant in a building receives RHS rental assistance payments (RHS tenant 
assistance), the applicable utility allowance for all rent-restricted 
units in the building (including any units occupied by tenants receiving 
rental assistance payments from the Department of Housing and Urban 
Development (HUD)) is the applicable RHS utility allowance.
    (3) Buildings regulated by the Department of Housing and Urban 
Development. If neither a building nor any tenant in the building 
receives RHS housing assistance, and the rents and utility allowances of 
the building are reviewed by HUD on an annual basis (HUD-regulated 
building), the applicable utility allowance for all rent-restricted 
units in the building is the applicable HUD utility allowance.
    (4) Other buildings. If a building is neither an RHS-assisted nor a 
HUD-regulated building, and no tenant in the building receives RHS 
tenant assistance, the applicable utility allowance for rent-restricted 
units in the building is determined under the following methods.
    (i) Tenants receiving HUD rental assistance. The applicable utility 
allowance for any rent-restricted units occupied

[[Page 182]]

by tenants receiving HUD rental assistance payments (HUD tenant 
assistance) is the applicable Public Housing Authority (PHA) utility 
allowance established for the Section 8 Existing Housing Program.
    (ii) Other tenants--(A) General rule. If none of the rules of 
paragraphs (b)(1), (2), (3), and (4)(i) of this section apply to any 
rent-restricted units in a building, the appropriate utility allowance 
for the units is the applicable PHA utility allowance. However, if a 
local utility company estimate is obtained for any unit in the building 
in accordance with paragraph (b)(4)(ii)(B) of this section, that 
estimate becomes the appropriate utility allowance for all rent-
restricted units of similar size and construction in the building. This 
local utility company estimate procedure is not available for and does 
not apply to units to which the rules of paragraphs (b) (1), (2), (3), 
or (4)(i) of this section apply. However, if a local utility company 
estimate is obtained for any unit in the building under paragraph 
(b)(4)(ii)(B) of this section, a State or local housing credit agency 
(Agency) provides a building owner with an estimate for any unit in a 
building under paragraph (b)(4)(ii)(C) of this section, a cost estimate 
is calculated using the HUD Utility Schedule Model under paragraph 
(b)(4)(ii)(D) of this section, or a cost estimate is calculated by an 
energy consumption model under paragraph (b)(4)(ii)(E) of this section, 
then the estimate under paragraph (b)(4)(ii)(B), (C), (D), or (E) 
becomes the applicable utility allowance for all rent-restricted units 
of similar size and construction in the building. Paragraphs 
(b)(4)(ii)(B), (C), (D), and (E) of this section do not apply to units 
to which the rules of paragraphs (b)(1), (2), (3), or (4)(i) of this 
section apply.
    (B) Utility company estimate. Any interested party (including a low-
income tenant, a building owner, or an Agency) may obtain a local 
utility company estimate for a unit. The estimate is obtained when the 
interested party receives, in writing, information from a local utility 
company providing the estimated cost of that utility for a unit of 
similar size and construction for the geographic area in which the 
building containing the unit is located. In the case of deregulated 
utility services, the interested party is required to obtain an estimate 
only from one utility company even if multiple companies can provide the 
same utility service to a unit. However, the utility company must offer 
utility services to the building in order for that utility company's 
rates to be used in calculating utility allowances. The estimate should 
include all component deregulated charges for providing the utility 
service. The local utility company estimate may be obtained by an 
interested party at any time during the building's extended use period 
(see section 42(h)(6)(D)) or, if the building does not have an extended 
use period, during the building's compliance period (see section 
42(i)(1)). Unless the parties agree otherwise, costs incurred in 
obtaining the estimate are borne by the initiating party. The interested 
party that obtains the local utility company estimate (the initiating 
party) must retain the original of the utility company estimate and must 
furnish a copy of the local utility company estimate to the owner of the 
building (where the initiating party is not the owner), and the Agency 
that allocated credit to the building (where the initiating party is not 
the Agency). The owner of the building must make available copies of the 
utility company estimate to the tenants in the building.
    (C) Agency estimate. A building owner may obtain a utility estimate 
for each unit in the building from the Agency that has jurisdiction over 
the building provided the Agency agrees to provide the estimate. The 
estimate is obtained when the building owner receives, in writing, 
information from the Agency providing the estimated per-unit cost of the 
utilities for units of similar size and construction for the geographic 
area in which the building containing the units is located. The Agency 
estimate may be obtained by a building owner at any time during the 
building's extended use period (see section 42(h)(6)(D)). Costs incurred 
in obtaining the estimate are borne by the building owner. In 
establishing an accurate utility allowance estimate for a particular 
building, an Agency (or an agent or other private contractor of the 
Agency that is a qualified professional within

[[Page 183]]

the meaning of paragraph (b)(4)(ii)(E) of this section) must take into 
account, among other things, local utility rates, property type, climate 
and degree-day variables by region in the State, taxes and fees on 
utility charges, building materials, and mechanical systems. If the 
Agency uses an agent or other private contractor to calculate the 
utility estimates, the agent or contractor and the owner must not be 
related within the meaning of section 267(b) or 707(b). An Agency may 
also use actual utility company usage data and rates for the building. 
However, use of the Agency estimate is limited to the building's 
consumption data for the twelve-month period ending no earlier than 60 
days prior to the beginning of the 90-day period under paragraph (c)(1) 
of this section and utility rates used for the Agency estimate must be 
no older than the rates in place 60 days prior to the beginning of the 
90-day period under paragraph (c)(1) of this section. In the case of 
newly constructed or renovated buildings with less than 12 months of 
consumption data, the Agency (or an agent or other private contractor of 
the Agency that is a qualified professional within the meaning of 
paragraph (b)(4)(ii)(E) of this section) may use consumption data for 
the 12-month period of units of similar size and construction in the 
geographic area in which the building containing the units is located.
    (D) HUD Utility Schedule Model. A building owner may calculate a 
utility estimate using the ``HUD Utility Schedule Model'' that can be 
found on the Low-Income Housing Tax Credits page at http://
www.huduser.org/datasets/lihtc.html (or successor URL). Utility rates 
used for the HUD Utility Schedule Model must be no older than the rates 
in place 60 days prior to the beginning of the 90-day period under 
paragraph (c)(1) of this section.
    (E) Energy consumption model. A building owner may calculate utility 
estimates using an energy and water and sewage consumption and analysis 
model (energy consumption model). The energy consumption model must, at 
a minimum, take into account specific factors including, but not limited 
to, unit size, building orientation, design and materials, mechanical 
systems, appliances, and characteristics of the building location. The 
utility consumption estimates must be calculated by either a properly 
licensed engineer or a qualified professional approved by the Agency 
that has jurisdiction over the building (together, qualified 
professional), and the qualified professional and the building owner 
must not be related within the meaning of section 267(b) or 707(b). Use 
of the energy consumption model is limited to the building's consumption 
data for the twelve-month period ending no earlier than 60 days prior to 
the beginning of the 90-day period under paragraph (c)(1) of this 
section, and utility rates used for the energy consumption model must be 
no older than the rates in place 60 days prior to the beginning of the 
90-day period under paragraph (c)(1) of this section. In the case of 
newly constructed or renovated buildings with less than 12 months of 
consumption data, the qualified professional may use consumption data 
for the 12-month period of units of similar size and construction in the 
geographic area in which the building containing the units is located.
    (c) Changes in applicable utility allowance--(1) In general. If, at 
any time during the building's extended use period (as defined in 
section 42(h)(6)(D)), the applicable utility allowance for units 
changes, the new utility allowance must be used to compute gross rents 
of the units due 90 days after the change (the 90-day period). For 
example, if rent must be lowered because a local utility company 
estimate is obtained that shows a higher utility cost than the otherwise 
applicable PHA utility allowance, the lower rent must be in effect for 
rent due at the end of the 90-day period. A building owner using a 
utility company estimate under paragraph (b)(4)(ii)(B) of this section, 
the HUD Utility Schedule Model under paragraph (b)(4)(ii)(D) of this 
section, or an energy consumption model under paragraph (b)(4)(ii)(E) of 
this section must submit copies of the utility estimates to the Agency 
that has jurisdiction over the building and make the estimates available 
to all tenants in the building at the beginning of the 90-day period 
before the utility allowances

[[Page 184]]

can be used in determining the gross rent of rent-restricted units. An 
Agency may require additional information from the owner during the 90-
day period. Any utility estimates obtained under the Agency estimate 
under paragraph (b)(4)(ii)(C) of this section must also be made 
available to all tenants in the building at the beginning of the 90-day 
period. The building owner must pay for all costs incurred in obtaining 
the estimates under paragraphs (b)(4)(ii)(B), (C), (D), and (E) of this 
section and providing the estimates to the Agency and the tenants. The 
building owner is not required to review the utility allowances, or 
implement new utility allowances, until the building has achieved 90 
percent occupancy for a period of 90 consecutive days or the end of the 
first year of the credit period, whichever is earlier.
    (2) Annual review. A building owner must review at least once during 
each calendar year the basis on which utility allowances have been 
established and must update the applicable utility allowance in 
accordance with paragraph (c)(1) of this section. The review must take 
into account any changes to the building such as any energy conservation 
measures that affect energy consumption and changes in utility rates.
    (d) Record retention. The building owner must retain any utility 
consumption estimates and supporting data as part of the taxpayer's 
records for purposes of Sec. 1.6001-1(a).

[T.D. 8520, 59 FR 10073, Mar. 3, 1994, as amended by T.D. 9420, 73 FR 
43867, July 29, 2008]



Sec. 1.42-11  Provision of services.

    (a) General rule. The furnishing to tenants of services other than 
housing (whether or not the services are significant) does not prevent 
the units occupied by the tenants from qualifying as residential rental 
property eligible for credit under section 42. However, any charges to 
low-income tenants for services that are not optional generally must be 
included in gross rent for purposes of section 42(g).
    (b) Services that are optional--(1) General rule. A service is 
optional if payment for the service is not required as a condition of 
occupancy. For example, for a qualified low-income building with a 
common dining facility, the cost of meals is not included in gross rent 
for purposes of section 42(g)(2)(A) if payment for the meals in the 
facility is not required as a condition of occupancy and a practical 
alternative exists for tenants to obtain meals other than from the 
dining facility.
    (2) Continual or frequent services. If continual or frequent 
nursing, medical, or psychiatric services are provided, it is presumed 
that the services are not optional and the building is ineligible for 
the credit, as is the case with a hospital, nursing home, sanitarium, 
lifecare facility, or intermediate care facility for the mentally and 
physically handicapped. See also Sec. 1.42-9(b).
    (3) Required services--(i) General rule. The cost of services that 
are required as a condition of occupancy must be included in gross rent 
even if federal or state law requires that the services be offered to 
tenants by building owners.
    (ii) Exceptions--(A) Supportive services. Section 42(g)(2)(B)(iii) 
provides an exception for certain fees paid for supportive services. For 
purposes of section 42(g)(2)(B)(iii), a supportive service is any 
service provided under a planned program of services designed to enable 
residents of a residential rental property to remain independent and 
avoid placement in a hospital, nursing home, or intermediate care 
facility for the mentally or physically handicapped. For a building 
described in section 42(i)(3)(B)(iii) (relating to transitional housing 
for the homeless) or section 42(i)(3)(B)(iv) (relating to single-room 
occupancy), a supportive service includes any service provided to assist 
tenants in locating and retaining permanent housing.
    (B) Specific project exception. Gross rent does not include the cost 
of mandatory meals in any federally-assisted project for the elderly and 
handicapped (in existence on or before January 9, 1989) that is 
authorized by 24 CFR 278 to provide a mandatory meals program.

[T.D. 8520, 59 FR 10074, Mar. 3, 1994, as amended by T.D. 8859, 65 FR 
2328, Jan. 14, 2000]

[[Page 185]]



Sec. 1.42-12  Effective dates and transitional rules.

    (a) Effective dates--(1) In general. Except as provided in 
paragraphs (a)(2) and (a)(3) of this section, the rules set forth in 
Sec. Sec. 1.42-6 and 1.42-8 through 1.42-12 are applicable on May 2, 
1994. However, binding agreements, election statements, and carryover 
allocation documents entered into before May 2, 1994, that follow the 
guidance set forth in Notice 89-1, 1989-1 C.B. 620 (see Sec. 
601.601(d)(2)(ii)(b) of this chapter) need not be changed to conform to 
the rules set forth in Sec. Sec. 1.42-6 and 1.42-8 through 1.42-12.
    (2) Community Renewal Tax Relief Act of 2000-(i) In general. Section 
1.42-6 (a), (b)(4)(iii) Example 1 and Example 2, (c), (d)(2)(viii), and 
(e)(2) are applicable for housing credit dollar amounts allocated after 
January 6, 2004. However, the rules in Sec. 1.42-6 (a), (b)(4)(iii) 
Example 1 and Example 2, (c), (d)(2)(viii), and (e)(2) may be applied by 
Agencies and taxpayers for housing credit dollar amounts allocated after 
December 31, 2000, and on or before January 6, 2004. Otherwise, subject 
to the applicable effective dates of the corresponding statutory 
provisions, the rules that apply for housing credit dollar amounts 
allocated on or before January 6, 2004, are contained in Sec. 1.42-6 in 
effect on and before January 6, 2004 (see 26 CFR part 1 revised as of 
April 1, 2003).
    (3) Electronic filing simplification changes. Sections 1.42-6(d)(4) 
and 1.42-8(a)(6)(i), (a)(6)(ii), (a)(7) Example 1 and Example 2, 
(b)(4)(i), and (b)(4)(ii) are applicable for forms filed after January 
6, 2004. The rules that apply for forms filed on or before January 6, 
2004, are contained in Sec. 1.42-6 and Sec. 1.42-8 in effect on and 
before January 6, 2004 (see 26 CFR part 1 revised as of April 1, 2003).
    (4) Utility allowances. The first sentence in Sec. 1.42-10(a), 
Sec. 1.42-10(b)(1), (2), (3), and (4), the last two sentences in Sec. 
1.42-10(b)(4)(ii)(A), the third, fourth, and fifth sentences in Sec. 
1.42-10(b)(4)(ii)(B), Sec. 1.42-10(b)(4)(ii)(C), (D), and (E), and 
Sec. 1.42-10(c) and (d) are applicable to a building owner's taxable 
years beginning on or after July 29, 2008. Taxpayers may rely on these 
provisions before the beginning of the building owner's taxable year 
beginning on or after July 29, 2008 provided that any utility allowances 
calculated under these provisions are effective no earlier than the 
first day of the building owner's taxable year beginning on or after 
July 29, 2008. The utility allowances provisions that apply to taxable 
years beginning before July 29, 2008 are contained in Sec. 1.42-10 (see 
26 CFR part 1 revised as of April 1, 2008).
    (b) Prior periods. Notice 89-1, 1989-1 C.B. 620 and Notice 89-6, 
1989-1 C.B. 625 (see Sec. 601.601(d)(2)(ii)(b) of this chapter) may be 
applied for periods prior to May 2, 1994.
    (c) Carryover allocations. The rule set forth in Sec. 1.42-
6(d)(4)(ii) relating to the requirement that state and local housing 
agencies file Schedule A (Form 8610), ``Carryover Allocation of the Low-
Income Housing Credit,'' is applicable for carryover allocations made 
after December 31, 1999.

[T.D. 8520, 59 FR 10074, Mar. 3, 1994; 59 FR 15501, Apr. 1, 1994, as 
amended by T.D. 8859, 65 FR 2328, Jan. 14, 2000; T.D. 9110, 69 FR 504, 
Jan. 6, 2004; T.D. 9420, 73 FR 43868, July 29, 2008]



Sec. 1.42-13  Rules necessary and appropriate; housing credit agencies' 

correction of administrative errors and omissions.

    (a) Publication of guidance. Under section 42(n), the Secretary has 
authority to prescribe regulations as may be necessary or appropriate to 
carry out the purposes of section 42. The Secretary may also provide 
guidance through various publications in the Internal Revenue Bulletin. 
(See Sec. 601.601(d)(2)(ii)(b) of this chapter.)
    (b) Correcting administrative errors and omissions--(1) In general. 
An Agency may correct an administrative error or omission with respect 
to allocations and recordkeeping, as described in paragraph (b)(2) of 
this section, within a reasonable period after the Agency discovers the 
administrative error or omission. Whether a correction is made within a 
reasonable period depends on the facts and circumstances of each 
situation. Except as provided in paragraph (b)(3)(iii) of this section, 
an Agency need not obtain the prior approval of the Secretary to correct 
an administrative error or omission, if the correction is made in 
accordance with

[[Page 186]]

paragraph (b)(3)(i) of this section. The administrative errors and 
omissions to which this paragraph (b) applies are strictly limited to 
those described in paragraph (b)(2) of this section, and, thus, do not 
include, for example, any misinterpretation of the applicable rules and 
regulations under section 42. Accordingly, an Agency's allocation of a 
particular calendar year's low-income housing credit dollar amount made 
after the close of that calendar year, or the use of an incorrect 
population amount in calculating a State's housing credit ceiling for a 
calendar year are not administrative errors that can be corrected under 
this paragraph (b).
    (2) Administrative errors and omissions described. An administrative 
error or omission is a mistake that results in a document that 
inaccurately reflects the intent of the Agency at the time the document 
is originally completed or, if the mistake affects a taxpayer, a 
document that inaccurately reflects the intent of the Agency and the 
affected taxpayer at the time the document is originally completed. 
Administrative errors and omissions described in this paragraph (b)(2) 
include the following--
    (i) A mathematical error;
    (ii) An entry on a document that is inconsistent with another entry 
on the same or another document regarding the same property, or 
taxpayer;
    (iii) A failure in tracking the housing credit dollar amount an 
Agency has allocated (or that remains to be allocated) in the current 
calendar year (e.g., a failure to include in its State housing credit 
ceiling a previously allocated credit dollar amount that has been 
returned by a taxpayer);
    (iv) An omission of information that is required on a document; and
    (v) Any other type of error or omission identified by guidance 
published in the Internal Revenue Bulletin (see Sec. 
601.601(d)(2)(ii)(b) of this chapter) as an administrative error or 
omission covered by this paragraph (b).
    (3) Procedures for correcting administrative errors or omissions--
(i) In general. An Agency's correction of an administrative error or 
omission, as described in paragraph (b)(2) of this section, must amend 
the document so that the corrected document reflects the original intent 
of the Agency, or the Agency and the affected taxpayer, and complies 
with applicable rules and regulations under section 42.
    (ii) Specific procedures. If a document corrects a document 
containing an administrative error or omission that has not yet been 
filed with the Internal Revenue Service, the Agency, or the Agency and 
the affected taxpayer, should complete and file the corrected document 
as the original. When a document containing an administrative error or 
omission has already been filed with the Service, the Agency, or the 
Agency and the affected taxpayer, should refile a copy of the document 
containing the administrative error or omission, and prominently and 
clearly note the correction thereon or on an attached new document. The 
Agency should indicate at the top of the document(s) that the correction 
is being made under Sec. 1.42-13 of the Income Tax Regulations.
    (iii) Secretary's prior approval required. Except as provided in 
paragraph (b)(3)(vi) of this section, an Agency must obtain the 
Secretary's prior approval to correct an administrative error or 
omission, as described in paragraph (b)(2) of this section, if the 
correction is not made before the close of the calendar year of the 
error or omission and the correction--
    (A) Is a numerical change to the housing credit dollar amount 
allocated for the building or project;
    (B) Affects the determination of any component of the State's 
housing credit ceiling under section 42(h)(3)(C); or
    (C) Affects the State's unused housing credit carryover that is 
assigned to the Secretary under section 42(h)(3)(D).
    (iv) Requesting the Secretary's approval. To obtain the Secretary's 
approval under paragraph (b)(3)(iii) of this section, an Agency must 
submit a request for the Secretary's approval within a reasonable period 
after discovering the administrative error or omission, and must agree 
to any conditions that may be required by the Secretary under paragraph 
(b)(3)(v) of this section. When requesting the Secretary's approval, the 
Agency, or the Agency and the affected taxpayer, must file an

[[Page 187]]

application that complies with the requirements of this paragraph 
(b)(3)(iv). For further information on the application procedure see 
Rev. Proc. 93-1, 1993-1 I.R.B. 10 (or any subsequent applicable revenue 
procedure). (See Sec. 601.601(d)(2)(ii)(b) of this chapter.) The 
application requesting the Secretary's approval must contain the 
following information--
    (A) The name, address, and identification number of each affected 
taxpayer;
    (B) The Building Identification Number (B.I.N.) and address of each 
building or project affected by the administrative error or omission;
    (C) A statement explaining the administrative error or omission and 
the intent of the Agency, or of the Agency and the affected taxpayer, 
when the document was originally completed;
    (D) Copies of any supporting documentation;
    (E) A statement explaining the effect, if any, that a correction of 
the administrative error or omission would have on the housing credit 
dollar amount allocated for any building or project; and
    (F) A statement explaining the effect, if any, that a correction of 
the administrative error or omission would have on the determination of 
the components of the State's housing credit ceiling under section 
42(h)(3)(C) or on the State's unused housing credit carryover that is 
assigned to the Secretary under section 42(h)(3)(D).
    (v) Agreement to conditions. To obtain the Secretary's approval 
under paragraph (b)(3)(iii) of this section, an Agency, or the Agency 
and the affected taxpayer, must agree to the conditions the Secretary 
considers appropriate.
    (vi) Secretary's automatic approval. The Secretary grants automatic 
approval to correct an administrative error or omission described in 
paragraph (b)(2) of this section if--
    (A) The correction is not made before the close of the calendar year 
of the error or omission and the correction is a numerical change to the 
housing credit dollar amount allocated for the building or multiple-
building project;
    (B) The administrative error or omission resulted in an allocation 
document (the Form 8609, ``Low-Income Housing Credit Allocation 
Certification,'' or the allocation document under the requirements of 
section 42(h)(1)(E) or (F), and Sec. 1.42-6(d)(2)) that either did not 
accurately reflect the number of buildings in a project (for example, an 
allocation document for a 10-building project only references 8 
buildings instead of 10 buildings), or the correct information (other 
than the amount of credit allocated on the allocation document);
    (C) The administrative error or omission does not affect the 
Agency's ranking of the building(s) or project and the total amount of 
credit the Agency allocated to the building(s) or project; and
    (D) The Agency corrects the administrative error or omission by 
following the procedures described in paragraph (b)(3)(vii) of this 
section.
    (vii) How Agency corrects errors or omissions subject to automatic 
approval. An Agency corrects an administrative error or omission 
described in paragraph (b)(3)(vi) of this section by--
    (A) Amending the allocation document described in paragraph 
(b)(3)(vi)(B) of this section to correct the administrative error or 
omission. The Agency will indicate on the amended allocation document 
that it is making the ``correction under Sec. 1.42-13(b)(3)(vii).'' If 
correcting the allocation document requires including any additional 
B.I.N.(s) in the document, the document must include any B.I.N.(s) 
already existing for buildings in the project. If possible, the 
additional B.I.N.(s) should be sequentially numbered from the existing 
B.I.N.(s);
    (B) Amending, if applicable, the Schedule A (Form 8610), ``Carryover 
Allocation of the Low-Income Housing Credit,'' and attaching a copy of 
this schedule to Form 8610, ``Annual Low-Income Housing Credit Agencies 
Report,'' for the year the correction is made. The Agency will indicate 
on the schedule that it is making the ``correction under Sec. 1.42-
13(b)(3)(vii).'' For a carryover allocation made before January 1, 2000, 
the Agency must complete Schedule A (Form 8610), and indicate on the 
schedule that it is making the ``correction under Sec. 1.42-
13(b)(3)(vii)'';
    (C) Amending, if applicable, the Form 8609 and attaching the 
original of this amended form to Form 8610 for the

[[Page 188]]

year the correction is made. The Agency will indicate on the Form 8609 
that it is making the ``correction under Sec. 1.42-13(b)(3)(vii)''; and
    (D) Mailing or otherwise delivering a copy of any amended allocation 
document and any amended Form 8609 to the affected taxpayer.
    (viii) Other approval procedures. The Secretary may grant automatic 
approval to correct other administrative errors or omissions as 
designated in one or more documents published either in the Federal 
Register or in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of 
this chapter).
    (c) Examples. The following examples illustrate the scope of this 
section:

    Example 1. Individual B applied to Agency X for a reservation of a 
low-income housing credit dollar amount for a building that is part of a 
low-income housing project. When applying for the low-income housing 
credit dollar amount, B informed Agency X that B intended to form 
Partnership Y to finance the project. After receiving the reservation 
letter and prior to receiving an allocation, B formed Partnership Y and 
sold partnership interests to a number of limited partners. B 
contributed the low-income housing project to Partnership Y in exchange 
for a partnership interest. B and Partnership Y informed Agency X of the 
ownership change. When actually allocating the housing credit dollar 
amount, Agency X sent Partnership Y a document listing B, rather than 
Partnership Y, as the building's owner. Partnership Y promptly notified 
Agency X of the error. After reviewing related documents, Agency X 
determined that it had incorrectly listed B as the building's owner on 
the allocation document. Since the parties originally intended that 
Partnership Y would receive the allocation as the owner of the building, 
Agency X may correct the error without obtaining the Secretary's 
approval, and insert Partnership Y as the building's owner on the 
allocation document.
    Example 2. Agency Y allocated a lower low-income housing credit 
dollar amount for a low-income housing building than Agency Y originally 
intended. After the close of the calendar year of the allocation, B, the 
building's owner, discovered the error and promptly notified Agency Y. 
Agency Y reviewed relevant documents and agreed that an error had 
occurred. Agency Y and B must apply, as provided in paragraph (b)(3)(iv) 
of this section, for the Secretary's approval before Agency Y may 
correct the error.

    (d) Effective date. This section is effective February 24, 1994. 
However, an Agency may elect to apply these regulations to 
administrative errors or omissions that occurred before the publication 
of these regulations. Any reasonable method used by a State or local 
housing credit agency to correct an administrative error or omission 
prior to February 24, 1994, will be considered proper, provided that the 
method is consistent with the rules of section 42. Paragraphs 
(b)(3)(vi), (vii), and (viii) of this section are effective January 14, 
2000.

[T.D. 8521, 59 FR 8861, Feb. 24, 1994, as amended by T.D. 8859, 65 FR 
2328, Jan. 14, 2000]



Sec. 1.42-14  Allocation rules for post-2000 State housing credit ceiling 

amount.

    (a) State housing credit ceiling--(1) In general. The State housing 
credit ceiling for a State for any calendar year after 2000 is comprised 
of four components. The four components are--
    (i) The unused State housing credit ceiling, if any, of the State 
for the preceding calendar year (the unused carryforward component);
    (ii) The greater of--
    (A) $1.75 ($1.50 for calendar year 2001) multiplied by the State 
population; or
    (B) $2,000,000 (the population component);
    (iii) The amount of State housing credit ceiling returned in the 
calendar year (the returned credit component); plus
    (iv) The amount, if any, allocated to the State by the Secretary 
under section 42(h)(3)(D) from a national pool of unused credit (the 
national pool component).
    (2) Cost-of-living adjustment--(i) General rule. For any calendar 
year after 2002, the $2,000,000 and $1.75 amounts in paragraph 
(a)(1)(ii) of this section are each increased by an amount equal to--
    (A) The dollar amount; multiplied by
    (B) The cost-of-living adjustment determined under section 1(f)(3) 
for the calendar year by substituting ``calendar year 2001'' for 
``calendar year 1992'' in section 1(f)(3)(B).
    (ii) Rounding. Any increase resulting from the application of 
paragraph (a)(2)(i) of this section which, in the case of the $2,000,000 
amount, is not a multiple of $5,000, is rounded to the next lowest 
multiple of $5,000, and which, in the case of the $1.75 amount,

[[Page 189]]

is not a multiple of 5 cents, is rounded to the next lowest multiple of 
5 cents.
    (b) The unused carryforward component. The unused carryforward 
component of the State housing credit ceiling for any calendar year is 
the unused State housing credit ceiling, if any, of the State for the 
preceding calendar year. The unused State housing credit ceiling for any 
calendar year is the excess, if any, of--
    (1) The sum of the population, returned credit, and national pool 
components for the calendar year; over
    (2) The aggregate housing credit dollar amount allocated for the 
calendar year reduced by the housing credit dollar amounts allocated 
from the unused carryforward component for the calendar year.
    (c) The population component. The population component of the State 
housing credit ceiling of a State for any calendar year is determined 
pursuant to section 146(j). Thus, a State's population for any calendar 
year is determined by reference to the most recent census estimate, 
whether final or provisional, of the resident population of the State 
released by the Bureau of the Census before the beginning of the 
calendar year for which the State's housing credit ceiling is set. 
Unless otherwise prescribed by applicable revenue procedure, 
determinations of population are based on the most recent estimates of 
population contained in the Bureau of the Census publication, Current 
Population Report, Series P-25; Population Estimates and Projections, 
Estimates of the Population of States. For convenience, the Internal 
Revenue Service publishes the population estimates annually in the 
Internal Revenue Bulletin. (See Sec. 601.601(d)(2)(ii)(b)).
    (d) The returned credit component--(1) In general. The returned 
credit component of the State housing credit ceiling of a State for any 
calendar year equals the housing credit dollar amount returned during 
the calendar year that was validly allocated within the State in a prior 
calendar year to any project that does not become a qualified low-income 
housing project within the period required by section 42, or as required 
by the terms of the allocation. The returned credit component also 
includes credit allocated in a prior calendar year that is returned as a 
result of the cancellation of an allocation by mutual consent or by an 
Agency's determination that the amount allocated is not necessary for 
the financial feasibility of the project. For purposes of this section, 
credit is allocated within a State if it is allocated from the State's 
housing credit ceiling by an Agency of the State or of a constitutional 
home rule city in the State.
    (2) Limitations and special rules. The following limitations and 
special rules apply for purposes of this paragraph (d).
    (i) General limitations. Notwithstanding any other provision of this 
paragraph (d), returned credit does not include any credit that was--
    (A) Allocated prior to calendar year 1990;
    (B) Allowable under section 42(h)(4) (relating to the portion of 
credit attributable to eligible basis financed by certain tax-exempt 
bonds under section 103); or
    (C) Allocated during the same calendar year that it is received back 
by the Agency.
    (ii) Credit period limitation. Notwithstanding any other provision 
of this paragraph (d), an allocation of credit may not be returned any 
later than 180 days following the close of the first taxable year of the 
credit period for the building that received the allocation. After this 
date, credit that might otherwise be returned expires, and cannot be 
returned to or reallocated by any Agency.
    (iii) Three-month rule for returned credit. An Agency may, in its 
discretion, treat any portion of credit that is returned from a project 
after September 30 of a calendar year and that is not reallocated by the 
close of the calendar year as returned on January 1 of the succeeding 
calendar year. In this case, the returned credit becomes part of the 
returned credit component of the State housing credit ceiling for the 
succeeding calendar year. Any portion of credit that is returned from a 
project after September 30 of a calendar year that is reallocated by the 
close of the calendar year is treated as part of the returned credit 
component of the State housing credit ceiling for

[[Page 190]]

the calendar year that the credit was returned.
    (iv) Returns of credit. Subject to the limitations of paragraphs 
(d)(2) (i) and (ii) of this section, credit is returned to the Agency in 
the following instances in the manner described in paragraph (d)(3) of 
this section.
    (A) Building not qualified within required time period. If a 
building is not a qualified building within the time period required by 
section 42, it loses its credit allocation and the credit is returned. 
For example, a building is not qualified within the required time period 
if it is not placed in service within the period required by section 42 
or if the project of which the building is a part fails to meet the 
minimum set-aside requirements of section 42(g)(1) by the close of the 
first year of the credit period. Also, a building that has received a 
post-June 30 carryover allocation is not qualified within the required 
time period if the taxpayer does not meet the 10 percent basis 
requirement by the date that is 6 months after the date the allocation 
was made (as described in Sec. 1.42-6(a)(2)(ii)).
    (B) Noncompliance with terms of the allocation. If a building does 
not comply with the terms of its allocation, it loses the credit 
allocation and the credit is returned. The terms of an allocation are 
the written conditions agreed to by the Agency and the allocation 
recipient in the allocation document.
    (C) Mutual consent. If the Agency and the allocation recipient 
cancel an allocation of an amount of credit by mutual consent, that 
amount of credit is returned.
    (D) Amount not necessary for financial feasibility. If an Agency 
determines under section 42(m)(2) that an amount of credit allocated to 
a project is not necessary for the financial feasibility of the project 
and its viability as a qualified low-income housing project throughout 
the credit period, that amount of credit is returned.
    (3) Manner of returning credit--( i) Taxpayer notification. After an 
Agency determines that a building or project no longer qualifies under 
paragraph (d)(2)(iv)(A), (B), or (D) of this section for all or part of 
the allocation it received, the Agency must provide written notification 
to the allocation recipient, or its successor in interest, that all or 
part of the allocation is no longer valid. The notification must also 
state the amount of the allocation that is no longer valid. The date of 
the notification is the date the credit is returned to the Agency. If an 
allocation is cancelled by mutual consent under paragraph (d)(2)(iv)(C) 
of this section, there must be a written agreement signed by the Agency, 
and the allocation recipient, or its successor in interest, indicating 
the amount of the allocation that is returned to the Agency. The 
effective date of the agreement is the date the credit is returned to 
the Agency.
    (ii) Internal Revenue Service notification. If a credit is returned 
within 180 days following the close of the first taxable year of a 
building's credit period as provided in paragraph (d)(2)(ii) of this 
section, and a Form 8609, Low-Income Housing Credit Allocation 
Certification, has been issued for the building, the Agency must notify 
the Internal Revenue Service that the credit has been returned. If only 
part of the credit has been returned, this notification requirement is 
satisfied when the Agency attaches to an amended Form 8610, Annual Low- 
Income Housing Credit Agencies Report, the original of an amended Form 
8609 reflecting the correct amount of credit attributed to the building 
together with an explanation for the filing of the amended Forms. The 
Agency must send a copy of the amended Form 8609 to the taxpayer that 
owns the building. If the building is not issued an amended Form 8609 
because all of the credit allocated to the building is returned, 
notification to the Internal Revenue Service is satisfied by following 
the requirements prescribed in Sec. 1.42-5(e)(3) for filing a Form 
8823, Low-Income Housing Credit Agencies Report of Noncompliance.
    (e) The national pool component. The national pool component of the 
State housing credit ceiling of a State for any calendar year is the 
portion of the National Pool allocated to the State by the Secretary for 
the calendar year. The national pool component for any calendar year is 
zero unless a State is a qualified State. (See paragraph (i) of

[[Page 191]]

this section for rules regarding the National Pool and the description 
of a qualified State.) A national pool component credit that is 
allocated during a calendar year and returned after the close of the 
calendar year may qualify as part of the returned credit component of 
the State housing credit ceiling for the calendar year that the credit 
is returned.
    (f) When the State housing credit ceiling is determined. For 
purposes of accounting for the State housing credit ceiling on Form 8610 
and for purposes of determining the set-aside apportionment for projects 
involving qualified nonprofit organizations described in section 
42(h)(5) and Sec. 1.42-1T(c)(5), the State housing credit ceiling for 
any calendar year is determined at the close of the calendar year.
    (g) Stacking order. Credit is treated as allocated from the various 
components of the State housing credit ceiling in the following order. 
The first credit allocated for any calendar year is treated as credit 
from the unused carryforward component of the State housing credit 
ceiling for the calendar year. After all of the credit in the unused 
carryforward component has been allocated, any credit allocated is 
treated as allocated from the sum of the population, returned credit, 
and national pool components of the State housing credit ceiling.
    (h) Nonprofit set-aside--(1) Determination of set-aside. Under 
section 42(h)(5) and Sec. 1.42-1T(c)(5), at least 10 percent of a State 
housing credit ceiling in any calendar year must be set aside 
exclusively for projects involving qualified nonprofit organizations 
(the nonprofit set-aside). However, credit allocated from the nonprofit 
set-aside in a calendar year and returned in a subsequent calendar year 
does not retain its nonprofit set-aside character. The credit becomes 
part of the returned credit component of the State housing credit 
ceiling for the calendar year that the credit is returned and must be 
included in determining the nonprofit set-aside of the State housing 
credit ceiling for that calendar year. Similarly, credit amounts that 
are not allocated from the nonprofit set-aside in a calendar year and 
are returned in a subsequent calendar year become part of the returned 
credit component of the State housing credit ceiling for that year and 
are also included in determining the set-aside for that year.
    (2) Allocation rules. An Agency may allocate credit from any 
component of the State housing credit ceiling as part of the nonprofit 
set-aside and need not reserve 10 percent of each component for the 
nonprofit set-aside. Thus, an Agency may satisfy the nonprofit set-aside 
requirement of section 42(h)(5) and Sec. 1.42-1T(c)(5) in any calendar 
year by setting aside for allocation an amount equal to at least 10 
percent of the total State housing credit ceiling for the calendar year.
    (i) National Pool--(1) In general. The unused housing credit 
carryover of a State for any calendar year is assigned to the Secretary 
for inclusion in a national pool of unused housing credit carryovers 
(National Pool) that is reallocated among qualified States the 
succeeding calendar year. The assignment to the Secretary is made on 
Form 8610.
    (2) Unused housing credit carryover. The unused housing credit 
carryover of a State for any calendar year is the excess, if any, of--
    (i) The unused carryforward component of the State housing credit 
ceiling for the calendar year; over
    (ii) The total housing credit dollar amount allocated for the 
calendar year.
    (3) Qualified State--(i) In general. The term qualified State means, 
with respect to any calendar year, any State that has allocated its 
entire State housing credit ceiling for the preceding calendar year and 
for which a request is made by the State, not later than May 1 of the 
calendar year, to receive an allocation of credit from the National Pool 
for that calendar year. Except as provided in paragraph (i)(3)(ii) of 
this section, a State is not a qualified State in a calendar year if 
there remains any unallocated credit in its State housing credit ceiling 
at the close of the preceding calendar year that was apportioned to any 
Agency within the State for the calendar year.
    (ii) Exceptions--(A) De minimis amount. If the amount remaining 
unallocated at the close of a calendar year is only a de minimis amount 
of

[[Page 192]]

credit, the State is a qualified State eligible to participate in the 
National Pool. For that purpose, a credit amount is de minimis if it 
does not exceed 1 percent of the aggregate State housing credit ceiling 
of the State for the calendar year.
    (B) Other circumstances. Pursuant to the authority under section 
42(n), the Internal Revenue Service may determine that a State is a 
qualified State eligible to participate in the National Pool even though 
the State's unallocated credit is in excess of the 1 percent safe harbor 
set forth in paragraph (A) of this section. The Internal Revenue Service 
will make this determination based on all the facts and circumstances, 
weighing heavily the interests of the States who would otherwise qualify 
for the National Pool. The Internal Revenue Service will generally grant 
relief under this paragraph only where a State's unallocated credit is 
not substantial.
    (iii) Time and manner for making request. For further guidance as to 
the time and manner for making a request of housing credit dollar 
amounts from the National Pool by a qualified State, see Rev. Proc. 92-
31, 1992-1 C.B. 775. (See 601.601(d)(2)(ii)(b)).
    (4) Formula for determining the National Pool. The amount allocated 
to a qualified State in any calendar year is an amount that bears the 
same ratio to the aggregate unused housing credit carryovers of all 
States for the preceding calendar year as that State's population for 
the calendar year bears to the population of all qualified States for 
the calendar year.
    (j) Coordination between Agencies. The Agency responsible for filing 
Form 8610 on behalf of all Agencies within a State and making any 
request on behalf of the State for credit from the National Pool (the 
Filing Agency) must coordinate with each Agency within the State to 
ensure that the various requirements of this section are complied with. 
For example, the Filing Agency of a State must ensure that all Agencies 
within the State that were apportioned a credit amount for the calendar 
year have allocated all of their respective credit amounts for the 
calendar year before the Filing Agency can make a request on behalf of 
the State for a distribution of credit from the National Pool.
    (k) Example. (1) The operation of the rules of this section is 
illustrated by the following examples. Unless otherwise stated in an 
example, Agency A is the sole Agency authorized to make allocations of 
housing credit dollar amounts in State M, all of Agency A's allocations 
are valid, and for calendar year 2003, Agency A has available for 
allocation a State housing credit ceiling consisting of the following 
housing credit dollar amounts:

A. Unused carryforward component..............................       $50
B. Population component.......................................       110
C. Returned credit component..................................        10
D. National pool component....................................         0
                                                               ---------
    Total.....................................................       170
                                                               =========
 

    (2) In addition, the $10 of returned credit component was returned 
before October 1, 2003.

    Example 1:  (i) Additional facts. By the close of 2003, Agency A had 
allocated $80 of the State M housing credit ceiling. Of the $80 
allocated, $17 was allocated to projects involving qualified nonprofit 
organizations.
    (ii) Application of stacking rules. The $80 of allocated credit is 
first treated as allocated from the unused carryforward component of the 
State housing credit ceiling. The $80 of allocated credit exceeds the 
$50 attributable to the unused carryforward component by $30. Because 
the unused carryforward component is fully utilized no credit will be 
forfeited by State M to the 2004 National Pool. The remaining $30 of 
allocated credit will next be treated as allocated from the $120 in 
credit determined by aggregating the population, returned credit, and 
national pool components ($110 + 10 + 0 = $120). The $90 of unallocated 
credit remaining in State M's 2003 State housing credit ceiling ($120 - 
30 = $90) represents the unused carryforward component of State M's 2004 
State housing credit ceiling. Under paragraph (i)(3) of this section, 
State M does not qualify for credit from the 2004 National Pool.
    (iii) Nonprofit set-aside. Agency A allocated exactly the amount of 
credit to projects involving qualified nonprofit organizations as 
necessary to meet the nonprofit set-aside requirement ($17, 10% of the 
$170 ceiling).
    Example 2: (i) Additional facts. By the close of 2003, Agency A had 
allocated $40 of the State M housing credit ceiling. Of the $40 
allocated, $20 was allocated to projects involving qualified nonprofit 
organizations.
    (ii) Application of stacking rules. The $40 of allocated credit is 
first treated as allocated from the unused carryforward component of the 
State housing credit ceiling. Because the

[[Page 193]]

$40 of allocated credit does not exceed the $50 attributable to the 
unused carryforward component, the remaining components of the State 
housing credit ceiling are unaffected. The $10 remaining in the unused 
carryforward component is assigned to the Secretary for inclusion in the 
2004 National Pool. The $120 in credit determined by aggregating the 
population, returned credit, and national pool components becomes the 
unused carryforward component of State M's 2004 State housing credit 
ceiling. Under paragraph (i)(3) of this section, State M does not 
qualify for credit from the 2004 National Pool.
    (iii) Nonprofit set-aside. Agency A allocated $3 more credit to 
projects involving qualified nonprofit organizations than necessary to 
meet the nonprofit set-aside requirement. This does not reduce the 
application of the 10% nonprofit set-aside requirement to the State M 
housing credit ceiling for calendar year 2004.
    Example 3: (i) Additional fact. None of the applications for credit 
that Agency A received for 2003 are for projects involving qualified 
nonprofit organizations.
    (ii) Nonprofit set-aside. Because at least 10% of the State housing 
credit ceiling must be set aside for projects involving a qualified 
nonprofit organization, Agency A can allocate only $153 of the $170 
State housing credit ceiling for calendar year 2003 ($170 -17 = $153). 
If Agency A allocates $153 of credit, the credit is treated as allocated 
$50 from the unused carryforward component and $103 from the sum of the 
population, returned credit, and national pool components. The $17 of 
unallocated credit that is set aside for projects involving qualified 
nonprofit organizations becomes the unused carryforward component of 
State M's 2004 State housing credit ceiling. Under paragraph (i)(3) of 
this section, State M does not qualify for credit from the 2004 National 
Pool.
    Example 4: (i) Additional facts. The $10 of returned credit 
component was returned prior to October 1, 2003. However, a $40 credit 
that had been allocated in calendar year 2002 to a project involving a 
qualified nonprofit organization was returned to the Agency by a mutual 
consent agreement dated November 15, 2003. By the close of 2003, Agency 
A had allocated $170 of the State M's housing credit ceiling, including 
$17 of credit to projects involving qualified nonprofit organizations.
    (ii) Effect of three-month rule. Under the three-month rule of 
paragraph (d)(2)(iii) of this section, Agency A may treat all or part of 
the $40 of previously allocated credit as returned on January 1, 2004. 
If Agency A treats all of the $40 amount as having been returned in 
calendar year 2004, the State M housing credit ceiling for 2003 is $170. 
This entire amount, including the $17 nonprofit set-aside, has been 
allocated in 2003. Under paragraph (i)(3) of this section, State M 
qualifies for the 2004 National Pool.
    (iii) If three-month rule not used. If Agency A treats all of the 
$40 of previously allocated credit as returned in calendar year 2003, 
the State housing credit ceiling for the 2003 calendar year will be $210 
of which $50 will be attributable to the returned credit component ($10 
+ $40 = $50). Because credit amounts allocated to a qualified nonprofit 
organization in a prior calendar year that are returned in a subsequent 
calendar year do not retain their nonprofit character, the nonprofit 
set-aside for calendar year 2003 is $21 (10% of the $210 State housing 
credit ceiling). The $170 that Agency A allocated during 2003 is first 
treated as allocated from the unused carryforward component of the State 
housing credit ceiling. The $170 of allocated credit exceeds the $50 
attributable to the unused carryforward component by $120. Because the 
unused carryforward component is fully utilized no credit will be 
forfeited by State M to the 2004 National Pool. The remaining $120 of 
allocated credit will next be treated as allocated from the $160 in 
credit determined by aggregating the population, returned credit, and 
national pool components ($110 + 50 + 0 = $160). The $40 of unallocated 
credit (which includes $4 of unallocated credit from the $21 nonprofit 
set-aside) remaining in State M's 2003 housing credit ceiling ($160-120 
= $40) represents the unused carryforward component of State M's 2004 
housing credit ceiling. Under paragraph (i)(3) of this section, State M 
does not qualify for credit from the 2004 National Pool.

    (l) Effective dates--(1) In general. Except as provided in paragraph 
(l)(2) of this section, the rules set forth in Sec. 1.42-14 are 
applicable on January 1, 1994.
    (2) Community Renewal Tax Relief Act of 2000 changes. Paragraphs 
(a), (b), (c), (e), (i)(2) and (k) of this section are applicable for 
housing credit dollar amounts allocated after January 6, 2004. However, 
paragraphs (a), (b), (c), (e), (i)(2) and (k) of this section may be 
applied by Agencies and taxpayers for housing credit dollar amounts 
allocated after December 31, 2000, and on or before January 6, 2004. 
Otherwise, subject to the applicable effective dates of the 
corresponding statutory provisions, the rules that apply for housing 
credit dollar amounts allocated on or before January 6, 2004, are 
contained in this section in effect on and before January

[[Page 194]]

6, 2004 (see 26 CFR part 1 revised as of April 1, 2003).

[T.D. 8563, 59 FR 50163, Oct. 3, 1994; 60 FR 3345, Jan. 17, 1995, as 
amended by T.D. 9110, 69 FR 504, Jan. 6, 2004; 69 FR 8331, Feb. 24, 
2004]



Sec. 1.42-15  Available unit rule.

    (a) Definitions. The following definitions apply to this section:
    Applicable income limitation means the limitation applicable under 
section 42(g)(1) or, for deep rent skewed projects described in section 
142(d)(4)(B), 40 percent of area median gross income.
    Available unit rule means the rule in section 42(g)(2)(D)(ii).
    Comparable unit means a residential unit in a low-income building 
that is comparably sized or smaller than an over-income unit or, for 
deep rent skewed projects described in section 142(d)(4)(B), any low-
income unit. For purposes of determining whether a residential unit is 
comparably sized, a comparable unit must be measured by the same method 
used to determine qualified basis for the credit year in which the 
comparable unit became available.
    Current resident means a person who is living in the low-income 
building.
    Low-income unit is defined by section 42(i)(3)(A).
    Nonqualified resident means a new occupant or occupants whose 
aggregate income exceeds the applicable income limitation.
    Over-income unit means a low-income unit in which the aggregate 
income of the occupants of the unit increases above 140 percent of the 
applicable income limitation under section 42(g)(1), or above 170 
percent of the applicable income limitation for deep rent skewed 
projects described in section 142(d)(4)(B).
    Qualified resident means an occupant either whose aggregate income 
(combined with the income of all other occupants of the unit) does not 
exceed the applicable income limitation and who is otherwise a low-
income resident under section 42, or who is a current resident.
    (b) General section 42(g)(2)(D)(i) rule. Except as provided in 
paragraph (c) of this section, notwithstanding an increase in the income 
of the occupants of a low-income unit above the applicable income 
limitation, if the income of the occupants initially met the applicable 
income limitation, and the unit continues to be rent-restricted--
    (1) The unit continues to be treated as a low-income unit; and
    (2) The unit continues to be included in the numerator and the 
denominator of the ratio used to determine whether a project satisfies 
the applicable minimum set-aside requirement of section 42(g)(1).
    (c) Exception. A unit ceases to be treated as a low-income unit if 
it becomes an over-income unit and a nonqualified resident occupies any 
comparable unit that is available or that subsequently becomes available 
in the same low-income building. In other words, the owner of a low-
income building must rent to qualified residents all comparable units 
that are available or that subsequently become available in the same 
building to continue treating the over-income unit as a low-income unit. 
Once the percentage of low-income units in a building (excluding the 
over-income units) equals the percentage of low-income units on which 
the credit is based, failure to maintain the over-income units as low-
income units has no immediate significance. The failure to maintain the 
over-income units as low-income units, however, may affect the decision 
of whether or not to rent a particular available unit at market rate at 
a later time. A unit is not available for purposes of the available unit 
rule when the unit is no longer available for rent due to contractual 
arrangements that are binding under local law (for example, a unit is 
not available if it is subject to a preliminary reservation that is 
binding on the owner under local law prior to the date a lease is signed 
or the unit is occupied).
    (d) Effect of current resident moving within building. When a 
current resident moves to a different unit within the building, the 
newly occupied unit adopts the status of the vacated unit. Thus, if a 
current resident, whose income exceeds the applicable income limitation, 
moves from an over-income unit to a vacant unit in the same building, 
the newly occupied unit is treated as an over-income unit. The vacated

[[Page 195]]

unit assumes the status the newly occupied unit had immediately before 
it was occupied by the current resident.
    (e) Available unit rule applies separately to each building in a 
project. In a project containing more than one low-income building, the 
available unit rule applies separately to each building.
    (f) Result of noncompliance with available unit rule. If any 
comparable unit that is available or that subsequently becomes available 
is rented to a nonqualified resident, all over-income units for which 
the available unit was a comparable unit within the same building lose 
their status as low-income units; thus, comparably sized or larger over-
income units would lose their status as low-income units.
    (g) Relationship to tax-exempt bond provisions. Financing 
arrangements that purport to be exempt-facility bonds under section 142 
must meet the requirements of sections 103 and 141 through 150 for 
interest on the obligations to be excluded from gross income under 
section 103(a). This section is not intended as an interpretation under 
section 142.
    (h) Examples. The following examples illustrate this section:

    Example 1. This example illustrates noncompliance with the available 
unit rule in a low-income building containing three over-income units. 
On January 1, 1998, a qualified low-income housing project, consisting 
of one building containing ten identically sized residential units, 
received a housing credit dollar amount allocation from a state housing 
credit agency for five low-income units. By the close of 1998, the first 
year of the credit period, the project satisfied the minimum set-aside 
requirement of section 42(g)(1)(B). Units 1, 2, 3, 4, and 5 were 
occupied by individuals whose incomes did not exceed the income 
limitation applicable under section 42(g)(1) and were otherwise low-
income residents under section 42. Units 6, 7, 8, and 9 were occupied by 
market-rate tenants. Unit 10 was vacant. To avoid recapture of credit, 
the project owner must maintain five of the units as low-income units. 
On November 1, 1999, the certificates of annual income state that annual 
incomes of the individuals in Units 1, 2, and 3 increased above 140 
percent of the income limitation applicable under section 42(g)(1), 
causing those units to become over-income units. On November 30, 1999, 
Units 8 and 9 became vacant. On December 1, 1999, the project owner 
rented Units 8 and 9 to qualified residents who were not current 
residents at rates meeting the rent restriction requirements of section 
42(g)(2). On December 31, 1999, the project owner rented Unit 10 to a 
market-rate tenant. Because Unit 10, an available comparable unit, was 
leased to a market-rate tenant, Units 1, 2, and 3 ceased to be treated 
as low-income units. On that date, Units 4, 5, 8, and 9 were the only 
remaining low-income units. Because the project owner did not maintain 
five of the residential units as low-income units, the qualified basis 
in the building is reduced, and credit must be recaptured. If the 
project owner had rented Unit 10 to a qualified resident who was not a 
current resident, eight of the units would be low-income units. At that 
time, Units 1, 2, and 3, the over-income units, could be rented to 
market-rate tenants because the building would still contain five low-
income units.
    Example 2. This example illustrates the provisions of paragraph (d) 
of this section. A low-income project consists of one six-floor 
building. The residential units in the building are identically sized. 
The building contains two over-income units on the sixth floor and two 
vacant units on the first floor. The project owner, desiring to maintain 
the over-income units as low-income units, wants to rent the available 
units to qualified residents. J, a resident of one of the over-income 
units, wishes to occupy a unit on the first floor. J's income has 
recently increased above the applicable income limitation. The project 
owner permits J to move into one of the units on the first floor. 
Despite J's income exceeding the applicable income limitation, J is a 
qualified resident under the available unit rule because J is a current 
resident of the building. The unit newly occupied by J becomes an over-
income unit under the available unit rule. The unit vacated by J assumes 
the status the newly occupied unit had immediately before J occupied the 
unit. The over-income units in the building continue to be treated as 
low-income units.

    (i) Effective date. This section applies to leases entered into or 
renewed on and after September 26, 1997.

[T.D. 8732, 62 FR 50505, Sept. 26, 1997]



Sec. 1.42-16  Eligible basis reduced by federal grants.

    (a) In general. If, during any taxable year of the compliance period 
(described in section 42(i)(1)), a grant is made with respect to any 
building or the operation thereof and any portion of the grant is funded 
with federal funds (whether or not includible in gross income), the 
eligible basis of the building for the taxable year and all succeeding 
taxable years is reduced by

[[Page 196]]

the portion of the grant that is so funded.
    (b) Grants do not include certain rental assistance payments. A 
federal rental assistance payment made to a building owner on behalf or 
in respect of a tenant is not a grant made with respect to a building or 
its operation if the payment is made pursuant to--
    (1) Section 8 of the United States Housing Act of 1937 (42 U.S.C. 
1437f)
    (2) A qualifying program of rental assistance administered under 
section 9 of the United States Housing Act of 1937 (42 U.S.C. 1437g); or
    (3) A program or method of rental assistance as the Secretary may 
designate by publication in the Federal Register or in the Internal 
Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
    (c) Qualifying rental assistance program. For purposes of paragraph 
(b)(2) of this section, payments are made pursuant to a qualifying 
rental assistance program administered under section 9 of the United 
States Housing Act of 1937 to the extent that the payments--
    (1) Are made to a building owner pursuant to a contract with a 
public housing authority with respect to units the owner has agreed to 
maintain as public housing units (PH-units) in the building;
    (2) Are made with respect to units occupied by public housing 
tenants, provided that, for this purpose, units may be considered 
occupied during periods of short term vacancy (not to exceed 60 days); 
and
    (3) Do not exceed the difference between the rents received from a 
building's PH-unit tenants and a pro rata portion of the building's 
actual operating costs that are reasonably allocable to the PH-units 
(based on square footage, number of bedrooms, or similar objective 
criteria), and provided that, for this purpose, operating costs do not 
include any development costs of a building (including developer's fees) 
or the principal or interest of any debt incurred with respect to any 
part of the building.
    (d) Effective date. This section is effective September 26, 1997.

[T.D. 8731, 62 FR 50503, Sept. 26, 1997]



Sec. 1.42-17  Qualified allocation plan.

    (a) Requirements--(1) In general. [Reserved]
    (2) Selection criteria. [Reserved]
    (3) Agency evaluation. Section 42(m)(2)(A) requires that the housing 
credit dollar amount allocated to a project is not to exceed the amount 
the Agency determines is necessary for the financial feasibility of the 
project and its viability as a qualified low-income housing project 
throughout the credit period. In making this determination, the Agency 
must consider--
    (i) The sources and uses of funds and the total financing planned 
for the project. The taxpayer must certify to the Agency the full extent 
of all federal, state, and local subsidies that apply (or which the 
taxpayer expects to apply) to the project. The taxpayer must also 
certify to the Agency all other sources of funds and all development 
costs for the project. The taxpayer's certification should be 
sufficiently detailed to enable the Agency to ascertain the nature of 
the costs that will make up the total financing package, including 
subsidies and the anticipated syndication or placement proceeds to be 
raised. Development cost information, whether or not includible in 
eligible basis under section 42(d), that should be provided to the 
Agency includes, but is not limited to, site acquisition costs, 
construction contingency, general contractor's overhead and profit, 
architect's and engineer's fees, permit and survey fees, insurance 
premiums, real estate taxes during construction, title and recording 
fees, construction period interest, financing fees, organizational 
costs, rent-up and marketing costs, accounting and auditing costs, 
working capital and operating deficit reserves, syndication and legal 
fees, and developer fees;
    (ii) Any proceeds or receipts expected to be generated by reason of 
tax benefits;
    (iii) The percentage of the housing credit dollar amount used for 
project costs other than the costs of intermediaries. This requirement 
should not be applied so as to impede the development of projects in 
hard-to-develop areas under section 42(d)(5)(C); and

[[Page 197]]

    (iv) The reasonableness of the developmental and operational costs 
of the project.
    (4) Timing of Agency evaluation--(i) In general. The financial 
determinations and certifications required under paragraph (a)(3) of 
this section must be made as of the following times--
    (A) The time of the application for the housing credit dollar 
amount;
    (B) The time of the allocation of the housing credit dollar amount; 
and
    (C) The date the building is placed in service.
    (ii) Time limit for placed-in-service evaluation. For purposes of 
paragraph (a)(4)(i)(C) of this section, the evaluation for when a 
building is placed in service must be made not later than the date the 
Agency issues the Form 8609, ``Low-Income Housing Credit Allocation 
Certification.'' The Agency must evaluate all sources and uses of funds 
under paragraph (a)(3)(i) of this section paid, incurred, or committed 
by the taxpayer for the project up until date the Agency issues the Form 
8609.
    (5) Special rule for final determinations and certifications. For 
the Agency's evaluation under paragraph (a)(4)(i)(C) of this section, 
the taxpayer must submit a schedule of project costs. Such schedule is 
to be prepared on the method of accounting used by the taxpayer for 
federal income tax purposes, and must detail the project's total costs 
as well as those costs that may qualify for inclusion in eligible basis 
under section 42(d). For projects with more than 10 units, the schedule 
of project costs must be accompanied by a Certified Public Accountant's 
audit report on the schedule (an Agency may require an audited schedule 
of project costs for projects with fewer than 11 units). The CPA's audit 
must be conducted in accordance with generally accepted auditing 
standards. The auditor's report must be unqualified.
    (6) Bond-financed projects. A project qualifying under section 
42(h)(4) is not entitled to any credit unless the governmental unit that 
issued the bonds (or on behalf of which the bonds were issued), or the 
Agency responsible for issuing the Form(s) 8609 to the project, makes 
determinations under rules similar to the rules in paragraphs (a) (3), 
(4), and (5) of this section.
    (b) Effective date. This section is effective on January 1, 2001.

[T.D. 8859, 65 FR 2329, Jan. 14, 2000]



Sec. 1.42A-1  General tax credit for taxable years ending after December 31, 

1975, and before January 1, 1979.

    (a)(1) Allowance of credit for taxable years ending after December 
31, 1975, and beginning before January 1, 1977. Subject to the special 
rules of paragraphs (b)(1), (c) and (d) and the limitation of paragraph 
(e)(1) of this section, an individual is allowed as a credit against the 
tax imposed by chapter 1 for the taxable year in the case of taxable 
years ending after December 31, 1975, and beginning before January 1, 
1977, an amount equal to the greater of--
    (i) 2 percent of so much of the individual's taxable income as does 
not exceed $9,000, or
    (ii) $35 multiplied by the total number of deductions for personal 
exemptions to which the individual is entitled for the taxable year 
under section 151 (b) and (e) and the regulations thereunder (relating 
to allowance of deductions for personal exemptions with respect to the 
individual, the individual's spouse, and dependents).

For purposes of applying subdivision (ii) of this paragraph (a)(1), the 
total number of deductions for personal exemptions shall not include any 
additional exemptions to which the individual or his spouse may be 
entitled based upon age of 65 or more or blindness under section 151 (c) 
or (d) and the regulations thereunder.y
    (2) Allowance of credit for taxable years beginning after December 
31, 1976, and ending before January 1, 1979. Subject to the special 
rules of paragraphs (b)(2), (c) and (d) and the limitation of paragraph 
(e)(2) of this section, an individual is allowed as a credit against the 
tax imposed by section 1, or against the tax imposed in lieu of the tax 
imposed by section 1, for the taxable year in the case of taxable years 
beginning after December 31, 1976, and ending before January 1, 1979, an 
amount equal to the greater of--
    (i) 2 percent of so much of the individual's taxable income for the 
taxable year, reduced by the zero bracket

[[Page 198]]

amount determined under section 63 (d), as does not exceed $9,000, or
    (ii) $35 multiplied by the total number of deductions for personal 
exemptions to which the individual is entitled for the taxable year 
under section 151 and the regulations thereunder (relating to allowance 
of deductions for personal exemptions).
    (b) Married individuals filing separate returns--(1) For taxable 
years ending after December 31, 1975, and beginning before January 1, 
1977. In the case of taxable years ending after December 31, 1975, and 
beginning before January 1, 1977, a married individual who files a 
separate return for the taxable year is allowed as a credit for the 
taxable year an amount equal to either--
    (i) 2 percent of so much of the individual's taxable income as does 
not exceed $4,500, or
    (ii) $35 multiplied by the total number of deductions for personal 
exemptions to which the individual is entitled for the taxable year 
under section 151 (b) and (e) and the regulations thereunder, but only 
if both the individual and the individual's spouse elect to have the 
credit determined in the manner described in this subdivision (ii) for 
their corresponding taxable years. The elections shall be made by both 
married individuals separately calculating and claiming the credit in 
the manner and amount described in this subdivision (ii) on their 
separate returns for their corresponding taxable years. The rules of 
section 142 (a) and the regulations thereunder (relating to individuals 
not eligible for the standard deduction) in effect for taxable years 
beginning before January 1, 1977, apply to determine whether the taxable 
years of the individual and the individual's spouse correspond to each 
other. For purposes of applying this subdivision (ii), the total number 
of deductions for personal exemptions shall not include any additional 
exemptions to which the individual may be entitled based upon age of 65 
or more or blindness under section 151 (c) or (d) and the regulations 
thereunder.
    (2) For taxable years beginning after December 31, 1976, and ending 
before January 1, 1979. In the case of taxable years beginning after 
December 31, 1976, and ending before January 1, 1979, a married 
individual who files a separate return for the taxable year shall 
determine the amount of the credit for the taxable year under section 
42(a)(2) and Sec. 1.42A-1(a)(2)(ii).
    (3) Determination of marital status. For purposes of this paragraph, 
the determination of marital status shall be made as provided by section 
143 and the regulations thereunder (relating to the determination of 
marital status).
    (c) Return for short period on change of annual accounting period. 
In computing the credit provided by section 42 and this section for a 
period of less than 12 months (hereinafter referred to as a ``short 
period''), where income is to be annualized under section 443(b)(1) in 
order to determine the tax--
    (1) The credit allowed by paragraphs (a) (1)(i) and (2)(i) of this 
section shall be computed based upon the amount of the taxable income 
annualized under the rules of section 443(b)(1) and Sec. 1.443-1(b)(1), 
or
    (2)(i) The credit allowed by paragraph (a)(1)(ii) of this section 
shall be computed based upon the total number of deductions for personal 
exemptions to which the individual is entitled for the short period 
under section 151 (b) and (e) and the regulations thereunder (relating 
to allowance of deductions for personal exemptions with respect to the 
individual, the individual's spouse, and dependents), and
    (ii) The credit allowed by paragraph (a)(2)(ii) of this section 
shall be computed based upon the total number of deductions for personal 
exemptions to which the individual is entitled for the short period 
under section 151 and the regulations thereunder (relating to allowance 
of deductions for personal exemptions).

As so computed, the credit allowed by section 42 and this section shall 
be allowed against the tax computed on the basis of the annualized 
taxable income. See Sec. 1.443-1(b)(1)(vi).
    (d) Certain persons not eligible--(1) Estates and trusts. The credit 
provided by section 42 and this section shall not be allowed in the case 
of any estate or trust. Thus, the credit shall not be allowed to an 
estate of an individual in bankruptcy or to an estate of a deceased 
individual. However, in the case of a deceased individual, the credit

[[Page 199]]

shall be allowed on the decedent's final return filed by his executor or 
other representative. Also, the credit provided by section 42 and this 
section shall be allowed in the case of a return filed by an estate of 
an infant, incompetent, or an individual under a disability.
    (2) Nonresident alien individuals. The credit provided by section 42 
and this section shall not be allowed in the case of any nonresident 
alien individual. As used in this subparagraph, the term ``nonresident 
alien individual'' has the meaning provided by Sec. 1.871-2. See, 
however, section 6013(g) for election to treat nonresident alien 
individual as resident of the United States. The credit shall be allowed 
to an alien individual who is a resident of the United States for part 
of the taxable year. See Sec. 1.871-2(b) for rules relating to the 
determination of residence of an alien individual. For purposes of 
paragraphs (a) (1)(i) and (2)(i) of this section, the credit allowed 
shall be computed by taking into account only that portion of the 
individual's taxable income which is attributable to the period of his 
residence in the United States. For purposes of paragraph (a)(1)(ii) of 
this section, the credit allowed shall be computed by taking into 
account only the total number of deductions for personal exemptions to 
which the individual is entitled under section 151 (b) and (e) for the 
period of his residence in the United States. For purposes of paragraph 
(a)(2)(ii) of this section, the credit allowed shall be computed by 
taking into account only the total number of deductions for personal 
exemptions to which the individual is entitled under section 151 for the 
period of his residence in the United States. See Sec. 1.871-13 for 
rules relating to changes of residence status during a taxable year.
    (e) Limitation--(1) For taxable years ending after December 31, 
1975, and beginning before January 1, 1977. For taxable years ending 
after December 31, 1975, and beginning before January 1, 1977, the 
credit allowed by section 42 and this section shall not exceed the 
amount of tax imposed by chapter 1 for the taxable year. In the case of 
an alien individual who is a resident of the United States for a part of 
the taxable year, the credit allowed by section 42 and this section 
shall not exceed the amount of tax imposed by chapter 1 for that portion 
of the taxable year during which the alien individual was a resident of 
the United States. See Sec. 1.871-13.
    (2) For taxable years beginning after December 31, 1976, and ending 
before January 1, 1979. For taxable years beginning after December 31, 
1976, and ending before January 1, 1979, the credit allowed by section 
42 and this section shall not exceed the amount of tax imposed by 
section 1, or the amount of tax imposed in lieu of the tax imposed by 
section 1, for the taxable year. In the case of an alien individual who 
is a resident of the United States for a part of the taxable year, the 
credit allowed by section 42 and this section shall not exceed the 
amount of tax imposed by section 1, or the amount of tax imposed in lieu 
of the tax imposed by section 1, for that portion of the taxable year 
during which the alien individual was a resident of the United States. 
See Sec. 1.871-13.
    (f) Application with other credits. In determining the credits 
allowed under--
    (1) Section 33 (relating to foreign tax credit),
    (2) Section 37 (relating to credit for the elderly),
    (3) Section 38 (relating to investment in certain depreciable 
property),
    (4) Section 40 (relating to expenses of work incentive programs), 
and
    (5) Section 41 (relating to contributions to candidates for public 
office),

the tax imposed for the taxable year shall first be reduced (before any 
other reduction) by the credit allowed by section 42 and this section 
for the taxable year.
    (g) Income tax tables to reflect credit. The tables prescribed under 
section 3 shall reflect the credit allowed by section 42 and this 
section.
    (h) Effective dates. The credit allowed by section 42 and this 
section applies only for taxable years ending after December 31, 1975, 
and before January 1, 1979.

[T.D. 7547, 43 FR 19653, May 8, 1978]



Sec. 1.43-0  Table of contents.

    This section lists the captions contained in Sec. Sec. 1.43-0 
through 1.43-7.

[[Page 200]]

      Sec. 1.43-1 The enhanced oil recovery credit--general rules.

(a) Claiming the credit.
    (1) In general.
    (2) Examples.
(b) Amount of the credit.
(c) Phase-out of the credit as crude oil prices increase.
    (1) In general.
    (2) Inflation adjustment.
    (3) Examples.
(d) Reduction of associated deductions.
    (1) In general.
    (2) Certain deductions by an integrated oil company.
(e) Basis adjustment.
(f) Passthrough entity basis adjustment.
    (1) Partners' interests in a partnership.
    (2) Shareholders' stock in an S corporation.
(g) Examples.

          Sec. 1.43-2 Qualified enhanced oil recovery project.

(a) Qualified enhanced oil recovery project.
(b) More than insignificant increase.
(c) First injection of liquids, gases, or other matter.
    (1) In general.
    (2) Example.
(d) Significant expansion exception.
    (1) In general.
    (2) Substantially unaffected reservoir volume.
    (3) Terminated projects.
    (4) Change in tertiary recovery method.
    (5) Examples.
(e) Qualified tertiary recovery methods.
    (1) In general.
    (2) Tertiary recovery methods that qualify.
    (3) Recovery methods that do not qualify.
    (4) Examples.

                       Sec. 1.43-3 Certification.

(a) Petroleum engineer's certification of a project.
    (1) In general.
    (2) Timing of certification.
    (3) Content of certification.
(b) Operator's continued certification of a project.
    (1) In general.
    (2) Timing of certification.
    (3) Content of certification.
(c) Notice of project termination.
    (1) In general.
    (2) Timing of notice.
    (3) Content of notice.
(d) Failure to submit certification.
(e) Effective date.

           Sec. 1.43-4 Qualified enhanced oil recovery costs.

(a) Qualifying costs.
    (1) In general.
    (2) Costs paid or incurred for an asset which is used to implement 
more than one qualified enhanced oil recovery project or for other 
activities.
(b) Costs defined.
    (1) Qualified tertiary injectant expenses.
    (2) Intangible drilling and development costs.
    (3) Tangible property costs.
    (4) Examples.
(c) Primary purpose.
    (1) In general.
    (2) Tertiary injectant costs.
    (3) Intangible drilling and development costs.
    (4) Tangible property costs.
    (5) Offshore drilling platforms.
    (6) Examples.
(d) Costs paid or incurred prior to first injection.
    (1) In general.
    (2) First injection after filing of return for taxable year costs 
are allowable.
    (3) First injection more than 36 months after close of taxable year 
costs are paid or incurred.
    (4) Injections in volumes less than the volumes specified in the 
project plan.
    (5) Examples.
(e) Other rules.
    (1) Anti-abuse rule.
    (2) Costs paid or incurred to acquire a project.
    (3) Examples.

                    Sec. 1.43-5 At-risk limitation.

                Sec. 1.43-6 Election out of section 43.

(a) Election to have the credit not apply.
    (1) In general.
    (2) Time for making the election.
    (3) Manner of making the election.
(b) Election by partnerships and S corporations.

               Sec. 1.43-7 Effective date of regulations.

[T.D. 8448, 57 FR 54923, Nov. 23, 1992]



Sec. 1.43-1  The enhanced oil recovery credit--general rules.

    (a) Claiming the credit--(1) In general. The enhanced oil recovery 
credit (the ``credit'') is a component of the section 38 general 
business credit. A taxpayer that owns an operating mineral interest (as 
defined in Sec. 1.614-2(b)) in a property may claim the credit for 
qualified enhanced oil recovery costs (as described in Sec. 1.43-4) 
paid or incurred by the taxpayer in connection with a qualified enhanced 
oil recovery project (as described in Sec. 1.43-2) undertaken with 
respect to the property. A taxpayer that does not own an operating 
mineral interest in a property may not claim the credit. To the extent a 
credit

[[Page 201]]

included in the current year business credit under section 38(b) is 
unused under section 38, the credit is carried back or forward under the 
section 39 business credit carryback and carryforward rules.
    (2) Examples. The following examples illustrate the principles of 
this paragraph (a).

    Example 1. Credit for operating mineral interest owner. In 1992, A, 
the owner of an operating mineral interest in a property, begins a 
qualified enhanced oil recovery project using cyclic steam. B, who owns 
no interest in the property, purchases and places in service a steam 
generator. B sells A steam, which A uses as a tertiary injectant 
described in section 193. Because A owns an operating mineral interest 
in the property with respect to which the project is undertaken, A may 
claim a credit for the cost of the steam. Although B owns the steam 
generator used to produce steam for the project, B may not claim a 
credit for B's costs because B does not own an operating mineral 
interest in the property.
    Example 2. Credit for operating mineral interest owner. C and D are 
partners in CD, a partnership that owns an operating mineral interest in 
a property. In 1992, CD begins a qualified enhanced oil recovery project 
using cyclic steam. D purchases a steam generator and sells steam to CD. 
Because CD owns an operating mineral interest in the property with 
respect to which the project is undertaken, CD may claim a credit for 
the cost of the steam. Although D owns the steam generator used to 
produce steam for the project, D may not claim a credit for the costs of 
the steam generator because D paid these costs in a capacity other than 
that of an operating mineral interest owner.

    (b) Amount of the credit. A taxpayer's credit is an amount equal to 
15 percent of the taxpayer's qualified enhanced oil recovery costs for 
the taxable year, reduced by the phase-out amount, if any, determined 
under paragraph (c) of this section.
    (c) Phase-out of the credit as crude oil prices increase--(1) In 
general. The amount of the credit (determined without regard to this 
paragraph (c)) for any taxable year is reduced by an amount which bears 
the same ratio to the amount of the credit (determined without regard to 
this paragraph (c)) as--
    (i) The amount by which the reference price determined under section 
29(d)(2)(C) for the calendar year immediately preceding the calendar 
year in which the taxable year begins exceeds $28 (as adjusted under 
paragraph (c)(2) of this section); bears to
    (ii) $6.
    (2) Inflation adjustment--(i) In general. For any taxable year 
beginning in a calendar year after 1991, an amount equal to $28 
multiplied by the inflation adjustment factor is substituted for the $28 
amount under paragraph (c)(1)(i) of this section.
    (ii) Inflation adjustment factor. For purposes of this paragraph 
(c), the inflation adjustment factor for any calendar year is a 
fraction, the numerator of which is the GNP implicit price deflator for 
the preceding calendar year and the denominator of which is the GNP 
implicit price deflator for 1990. The ``GNP implicit price deflator'' is 
the first revision of the implicit price deflator for the gross national 
product as computed and published by the Secretary of Commerce. As early 
as practicable, the inflation adjustment factor for each calendar year 
will be published by the Internal Revenue Service in the Internal 
Revenue Bulletin.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. Reference price exceeds $28. In 1992, E, the owner of an 
operating mineral interest in a property, incurs $100 of qualified 
enhanced oil recovery costs. The reference price for 1991 determined 
under section 29(d)(2)(C) is $30 and the inflation adjustment factor for 
1992 is 1. E's credit for 1992 determined without regard to the phase-
out for crude oil price increases is $15 ($100 x 15%). In determining 
E's credit, the credit is reduced by $5 ($15 x ($30 - ($28 x 1))/6). 
Accordingly, E's credit for 1992 is $10 ($15 - $5).
    Example 2. Inflation adjustment. In 1993, F, the owner of an 
operating mineral interest in a property, incurs $100 of qualified 
enhanced oil recovery costs. The 1992 reference price is $34, and the 
1993 inflation adjustment factor is 1.10. F's credit for 1993 determined 
without regard to the phase-out for crude oil price increases is $15 
($100 x 15%). In determining F's credit, $30.80 (1.10 x $28) is 
substituted for $28, and the credit is reduced by $8 ($15 x ($34 - 
$30.80)/6). Accordingly, F's credit for 1993 is $7 ($15 - $8).

    (d) Reduction of associated deductions--(1) In general. Any 
deduction allowable under chapter 1 for an expenditure taken into 
account in computing the amount of the credit determined

[[Page 202]]

under paragraph (b) of this section is reduced by the amount of the 
credit attributable to the expenditure.
    (2) Certain deductions by an integrated oil company. For purposes of 
determining the intangible drilling and development costs that an 
integrated oil company must capitalize under section 291(b), the amount 
allowable as a deduction under section 263(c) is the deduction allowable 
after paragraph (d)(1) of this section is applied. See Sec. 1.43-
4(b)(2) (extent to which integrated oil company intangible drilling and 
development costs are qualified enhanced oil recovery costs).
    (e) Basis adjustment. For purposes of subtitle A, the increase in 
the basis of property which would (but for this paragraph (e)) result 
from an expenditure with respect to the property is reduced by the 
amount of the credit determined under paragraph (b) of this section 
attributable to the expenditure.
    (f) Passthrough entity basis adjustment--(1) Partners' interests in 
a partnership. To the extent a partnership expenditure is not deductible 
under paragraph (d)(1) of this section or does not increase the basis of 
property under paragraph (e) of this section, the expenditure is treated 
as an expenditure described in section 705(a)(2)(B) (concerning 
decreases to basis of partnership interests). Thus, the adjusted bases 
of the partners' interests in the partnership are decreased (but not 
below zero).
    (2) Shareholders' stock in an S corporation. To the extent an S 
corporation expenditure is not deductible under paragraph (d)(1) of this 
section or does not increase the basis of property under paragraph (e) 
of this section, the expenditure is treated as an expenditure described 
in section 1367(a)(2)(D) (concerning decreases to basis of S corporation 
stock). Thus, the bases of the shareholders' S corporation stock are 
decreased (but not below zero).
    (g) Examples. The following examples illustrate the principles of 
paragraphs (d) through (f) of this section.

    Example 1. Deductions reduced for credit amount. In 1992, G, the 
owner of an operating mineral interest in a property, incurs $100 of 
intangible drilling and development costs in connection with a qualified 
enhanced oil recovery project undertaken with respect to the property. G 
elects under section 263(c) to deduct these intangible drilling and 
development costs. The amount of the credit determined under paragraph 
(b) of this section attributable to the $100 of intangible drilling and 
development costs is $15 ($100 x 15%). Therefore, G's otherwise 
allowable deduction of $100 for the intangible drilling and development 
costs is reduced by $15. Accordingly, in 1992, G may deduct under 
section 263(c) only $85 ($100 - $15) for these costs.
    Example 2. Integrated oil company deduction reduced. The facts are 
the same as in Example 1, except that G is an integrated oil company. As 
in Example 1, the amount of the credit determined under paragraph (b) of 
this section attributable to the $100 of intangible drilling and 
development costs is $15, and G's allowable deduction under section 
263(c) is $85. Because G is an integrated oil company, G must capitalize 
25.50 ($85 x 30%) under section 291(b). Therefore, in 1992, G may deduct 
under section 263(c) only $59.50 ($85 - $25.50) for these intangible 
drilling and development costs.
    Example 3. Basis of property reduced. In 1992, H, the owner of an 
operating mineral interest in a property, pays $100 to purchase tangible 
property that is an integral part of a qualified enhanced oil recovery 
project undertaken with respect to the property. The amount of the 
credit determined under paragraph (b) of this section attributable to 
the $100 is $15 ($100 x 15%). Therefore, for purposes of subtitle A, H's 
basis in the tangible property is $85 ($100 - $15).
    Example 4. Basis of interest in passthrough entity reduced. In 1992, 
I is a $50% partner in IJ, a partnership that owns an operating mineral 
interest in a property. IJ pays $200 to purchase tangible property that 
is an integral part of a qualified enhanced oil recovery project 
undertaken with respect to the property. The amount of the credit 
determined under paragraph (b) of this section attributable to the $200 
is $30 ($200 x 15%). Therefore, for purposes of subtitle A, IJ's basis 
in the tangible property is $170 ($200 - $30). Under paragraph (f) of 
this section, the amount of the purchase price that does not increase 
the basis of the property ($30) is treated as an expenditure described 
in section 705(a)(2)(B). Therefore, I's basis in the partnership 
interest is reduced by $15 (I's allocable share of the section 
705(a)(2)(B) expenditure ($30 x 50%)).

[T.D. 8448, 57 FR 54923, Nov. 23, 1992; 58 FR 7987, Feb. 11, 1993]



Sec. 1.43-2  Qualified enhanced oil recovery project.

    (a) Qualified enhanced oil recovery project. A ``qualified enhanced 
oil recovery project'' is any project that

[[Page 203]]

meets all of the following requirements--
    (1) The project involves the application (in accordance with sound 
engineering principles) of one or more qualified tertiary recovery 
methods (as described in paragraph (e) of this section) that is 
reasonably expected to result in more than an insignificant increase in 
the amount of crude oil that ultimately will be recovered;
    (2) The project is located within the United States (within the 
meaning of section 638(1));
    (3) The first injection of liquids, gases, or other matter for the 
project (as described in paragraph (c) of this section) occurs after 
December 31, 1990; and
    (4) The project is certified under Sec. 1.43-3.
    (b) More than insignificant increase. For purposes of paragraph 
(a)(1) of this section, all the facts and circumstances determine 
whether the application of a tertiary recovery method can reasonably be 
expected to result in more than an insignificant increase in the amount 
of crude oil that ultimately will be recovered. Certain information 
submitted as part of a project certification is relevant to this 
determination. See Sec. 1.43-3(a)(3)(i)(D). In no event is the 
application of a recovery method that merely accelerates the recovery of 
crude oil considered an application of one or more qualified tertiary 
recovery methods that can reasonably be expected to result in more than 
an insignificant increase in the amount of crude oil that ultimately 
will be recovered.
    (c) First injection of liquids, gases, or other matter--(1) In 
general. The ``first injection of liquids, gases, or other matter'' 
generally occurs on the date a tertiary injectant is first injected into 
the reservoir. The ``first injection of liquids, gases, or other 
matter'' does not include--
    (i) The injection into the reservoir of any liquids, gases, or other 
matter for the purpose of pretreating or preflushing the reservoir to 
enhance the efficiency of the tertiary recovery method; or
    (ii) Test or experimental injections.
    (2) Example. The following example illustrates the principles of 
this paragraph (c).

    Example. Injections to pretreat the reservoir. In 1989, A, the owner 
of an operating mineral interest in a property, began injecting water 
into the reservoir for the purpose of elevating reservoir pressure to 
obtain miscibility pressure to prepare for the injection of miscible gas 
in connection with an enhanced oil recovery project. In 1992, A obtains 
miscibility pressure in the reservoir and begins injecting miscible gas 
into the reservoir. The injection of miscible gas, rather than the 
injection of water, is the first injection of liquids, gases, or other 
matter into the reservoir for purposes of determining whether the first 
injection of liquids, gases, or other matter occurs after December 31, 
1990.

    (d) Significant expansion exception--(1) In general. If a project 
for which the first injection of liquids, gases, or other matter (within 
the meaning of paragraph (c)(1) of this section) occurred before January 
1, 1991, is significantly expanded after December 31, 1990, the 
expansion is treated as a separate project for which the first injection 
of liquids, gases, or other matter occurs after December 31, 1990.
    (2) Substantially unaffected reservoir volume. A project is 
considered significantly expanded if the injection of liquids, gases, or 
other matter after December 31, 1990, is reasonably expected to result 
in more than an insignificant increase in the amount of crude oil that 
ultimately will be recovered from reservoir volume that was 
substantially unaffected by the injection of liquids, gases, or other 
matter before January 1, 1991.
    (3) Terminated projects. Except as otherwise provided in this 
paragraph (d)(3), a project is considered significantly expanded if each 
qualified tertiary recovery method implemented in the project prior to 
January 1, 1991, terminated more than 36 months before implementing an 
enhanced oil recovery project that commences after December 31, 1990. 
Notwithstanding the provisions of the preceding sentence, if a project 
implemented prior to January 1, 1991, is terminated for less than 36 
months before implementing an enhanced oil recovery project that 
commences after December 31, 1990, a taxpayer may request permission to 
treat

[[Page 204]]

the project that commences after December 31, 1990, as a significant 
expansion. Permission will not be granted if the Internal Revenue 
Service determines that a project was terminated to make an otherwise 
nonqualifying project eligible for the credit. For purposes of section 
43, a qualified tertiary recovery method terminates at the point in time 
when the method no longer results in more than an insignificant increase 
in the amount of crude oil that ultimately will be recovered. All the 
facts and circumstances determine whether a tertiary recovery method has 
terminated. Among the factors considered is the project plan, the unit 
plan of development, or other similar plan. A tertiary recovery method 
is not necessarily terminated merely because the injection of the 
tertiary injectant has ceased. For purposes of this paragraph (d)(1), a 
project is implemented when costs that will be taken into account in 
determining the credit with respect to the project are paid or incurred.
    (4) Change in tertiary recovery method. If the application of a 
tertiary recovery method or methods with respect to an enhanced oil 
recovery project for which the first injection of liquids, gases, or 
other matter occurred before January 1, 1991, has not been terminated 
for more than 36 months, a taxpayer may request a private letter ruling 
from the Internal Revenue Service whether the application of a different 
tertiary recovery method or methods after December 31, 1990, that does 
not affect reservoir volume substantially unaffected by the previous 
tertiary recovery method or methods, is treated as a significant 
expansion. All the facts and circumstances determine whether a change in 
tertiary recovery method is treated as a significant expansion. Among 
the factors considered are whether the change in tertiary recovery 
method is in accordance with sound engineering principles and whether 
the change in method will result in more than an insignificant increase 
in the amount of crude oil that would be recovered using the previous 
method. A more intensive application of a tertiary recovery method after 
December 31, 1990, is not treated as a significant expansion.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (d).

    Example 1. Substantially unaffected reservoir volume. In January 
1988, B, the owner of an operating mineral interest in a property, began 
injecting steam into the reservoir in connection with a cyclic steam 
enhanced oil recovery project. The project affected only a portion of 
the reservoir volume. In 1992, B begins cyclic steam injections with 
respect to reservoir volume that was substantially unaffected by the 
previous cyclic steam project. Because the injection of steam into the 
reservoir in 1992 affects reservoir volume that was substantially 
unaffected by the previous cyclic steam injection, the cyclic steam 
injection in 1992 is treated as a separate project for which the first 
injection of liquids, gases, or other matter occurs after December 31, 
1990.
    Example 2. Tertiary recovery method terminated more than 36 months. 
In 1982, C, the owner of an operating mineral interest in a property, 
implemented a tertiary recovery project using cyclic steam injection as 
a method for the recovery of crude oil. The project was certified as a 
tertiary recovery project for purposes of the windfall profit tax. In 
May 1988, the application of the cyclic steam tertiary recovery method 
terminated. In July 1992, C begins drilling injection wells as part of a 
project to apply the steam drive tertiary recovery method with respect 
to the same project area affected by the cyclic steam method. C begins 
steam injections in September 1992. Because C commences an enhanced oil 
recovery project more than 36 months after the previous tertiary 
recovery method was terminated, the project is treated as a separate 
project for which the first injection of liquids, gases, or other matter 
occurs after December 31, 1990.
    Example 3. Change in tertiary recovery method affecting 
substantially unaffected reservoir volume. In 1984, D, the owner of an 
operating mineral interest in a property, implemented a tertiary 
recovery project using cyclic steam as a method for the recovery of 
crude oil. The project was certified as a tertiary recovery project for 
purposes of the windfall profit tax. D continued the cyclic steam 
injection until 1992, when the tertiary recovery method was changed from 
cyclic steam injection to steam drive. The steam drive affects reservoir 
volume that was substantially unaffected by the cyclic steam injection. 
Because the steam drive affects reservoir volume that was substantially 
unaffected by the cyclic steam injection, the steam drive is treated as 
a separate project for which the first injection of liquids, gases, or 
other matter occurs after December 31, 1990.

[[Page 205]]

    Example 4. Change in tertiary recovery method not affecting 
substantially unaffected reservoir volume. In 1988, E, the owner of an 
operating mineral interest in a property, undertook an immiscible 
nitrogen enhanced oil recovery project that resulted in more than an 
insignificant increase in the ultimate recovery of crude oil from the 
property. E continued the immiscible nitrogen project until 1992, when 
the project was converted from immiscible nitrogen displacement to 
miscible nitrogen displacement by increasing the injection of nitrogen 
to increase reservoir pressure. The miscible nitrogen displacement 
affects the same reservoir volume that was affected by the immiscible 
nitrogen displacement. Because the miscible nitrogen displacement does 
not affect reservoir volume that was substantially unaffected by the 
immiscible nitrogen displacement nor was the immiscible nitrogen 
displacement project terminated for more than 36 months before the 
miscible nitrogen displacement project was implemented, E must obtain a 
ruling whether the change from immiscible nitrogen displacement to 
miscible nitrogen displacement is treated as a separate project for 
which the first injection of liquids, gases, or other matter occurs 
after December 31, 1990. If E does not receive a ruling, the miscible 
nitrogen displacement project is not a qualified project.
    Example 5. More intensive application of a tertiary recovery method. 
In 1989, F, the owner of an operating mineral interest in a property, 
undertook an immiscible carbon dioxide displacement enhanced oil 
recovery project. F began injecting carbon dioxide into the reservoir 
under immiscible conditions. The injection of carbon dioxide under 
immiscible conditions resulted in more than an insignificant increase in 
the ultimate recovery of crude oil from the property. F continues to 
inject the same amount of carbon dioxide into the reservoir until 1992, 
when new engineering studies indicate that an increase in the amount of 
carbon dioxide injected is reasonably expected to result in a more than 
insignificant increase in the amount of crude oil that would be 
recovered from the property as a result of the previous injection of 
carbon dioxide. The increase in the amount of carbon dioxide injected 
affects the same reservoir volume that was affected by the previous 
injection of carbon dioxide. Because the additional carbon dioxide 
injected in 1992 does not affect reservoir volume that was substantially 
unaffected by the previous injection of carbon dioxide and the previous 
immiscible carbon dioxide displacement method was not terminated for 
more than 36 months before additional carbon dioxide was injected, the 
increase in the amount of carbon dioxide injected into the reservoir is 
not a significant expansion. Therefore, it is not a separate project for 
which the first injection of liquids, gases, or other matter occurs 
after December 31, 1990.

    (e) Qualified tertiary recovery methods--(1) In general. For 
purposes of paragraph (a)(1) of this section, a ``qualified tertiary 
recovery method'' is any one or any combination of the tertiary recovery 
methods described in paragraph (e)(2) of this section. To account for 
advances in enhanced oil recovery technology, the Internal Revenue 
Service may by revenue ruling prescribe that a method not described in 
paragraph (e)(2) of this section is a ``qualified tertiary recovery 
method.'' In addition, a taxpayer may request a private letter ruling 
that a method not described in paragraph (e)(2) of this section or in a 
revenue ruling is a qualified tertiary recovery method. Generally, the 
methods identified in revenue rulings or private letter rulings will be 
limited to those methods that involve the displacement of oil from the 
reservoir rock by means of modifying the properties of the fluids in the 
reservoir or providing the energy and drive mechanism to force the oil 
to flow to a production well. The recovery methods described in 
paragraph (e)(3) of this section are not ``qualified tertiary recovery 
methods.''
    (2) Tertiary recovery methods that qualify--(i) Thermal recovery 
methods--(A) Steam drive injection. The continuous injection of steam 
into one set of wells (injection wells) or other injection source to 
effect oil displacement toward and production from a second set of wells 
(production wells);
    (B) Cyclic steam injection--The alternating injection of steam and 
production of oil with condensed steam from the same well or wells; and
    (C) In situ combustion. The combustion of oil or fuel in the 
reservoir sustained by injection of air, oxygen-enriched air, oxygen, or 
supplemental fuel supplied from the surface to displace unburned oil 
toward producing wells. This process may include the concurrent, 
alternating, or subsequent injection of water.
    (ii) Gas Flood recovery methods--(A) Miscible fluid displacement. 
The injection of gas (e.g., natural gas, enriched natural gas, a 
liquified petroleum slug driven by natural gas, carbon dioxide, 
nitrogen, or flue gas) or alcohol into

[[Page 206]]

the reservoir at pressure levels such that the gas or alcohol and 
reservoir oil are miscible;
    (B) Carbon dioxide augmented waterflooding. The injection of 
carbonated water, or water and carbon dioxide, to increase waterflood 
efficiency;
    (C) Immiscible carbon dioxide displacement. The injection of carbon 
dioxide into an oil reservoir to effect oil displacement under 
conditions in which miscibility with reservoir oil is not obtained. This 
process may include the concurrent, alternating, or subsequent injection 
of water; and
    (D) Immiscible nonhydrocarbon gas displacement. The injection of 
nonhydrocarbon gas (e.g., nitrogen) into an oil reservoir, under 
conditions in which miscibility with reservoir oil is not obtained, to 
obtain a chemical or physical reaction (other than pressure) between the 
oil and the injected gas or between the oil and other reservoir fluids. 
This process may include the concurrent, alternating, or subsequent 
injection of water.
    (iii) Chemical flood recovery methods--(A) Microemulsion flooding. 
The injection of a surfactant system (e.g., a surfactant, hydrocarbon, 
cosurfactant, electrolyte, and water) to enhance the displacement of oil 
toward producing wells; and
    (B) Caustic flooding--The injection of water that has been made 
chemically basic by the addition of alkali metal hydroxides, silicates, 
or other chemicals.
    (iv) Mobility control recovery method--Polymer augmented 
waterflooding. The injection of polymeric additives with water to 
improve the areal and vertical sweep efficiency of the reservoir by 
increasing the viscosity and decreasing the mobility of the water 
injected. Polymer augmented waterflooding does not include the injection 
of polymers for the purpose of modifying the injection profile of the 
wellbore or the relative permeability of various layers of the 
reservoir, rather than modifying the water-oil mobility ratio.
    (3) Recovery methods that do not qualify. The term ``qualified 
tertiary recovery method'' does not include--
    (i) Waterflooding--The injection of water into an oil reservoir to 
displace oil from the reservoir rock and into the bore of the producing 
well;
    (ii) Cyclic gas injection--The increase or maintenance of pressure 
by injection of hydrocarbon gas into the reservoir from which it was 
originally produced;
    (iii) Horizontal drilling--The drilling of horizontal, rather than 
vertical, wells to penetrate hydrocarbon bearing formations;
    (iv) Gravity drainage--The production of oil by gravity flow from 
drainholes that are drilled from a shaft or tunnel dug within or below 
the oil bearing zones; and
    (v) Other methods--Any recovery method not specifically designated 
as a qualified tertiary recovery method in either paragraph (e)(2) of 
this section or in a revenue ruling or private letter ruling described 
in paragraph (e)(1) of this section.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (e).

    Example 1. Polymer augmented waterflooding. In 1992 G, the owner of 
an operating mineral interest in a property, begins a waterflood project 
with respect to the property. To reduce the relative permeability in 
certain areas of the reservoir and minimize water coning, G injects 
polymers to plug thief zones and improve the areal and vertical sweep 
efficiency of the reservoir. The injection of polymers into the 
reservoir does not modify the water-oil mobility ratio. Accordingly, the 
injection of polymers into the reservoir in connection with the 
waterflood project does not constitute polymer augmented waterflooding 
and the project is not a qualified enhanced oil recovery project.
    Example 2. Polymer augmented waterflooding. In 1993 H, the owner of 
an operating mineral interest in a property, begins a caustic flooding 
project with respect to the property. Engineering studies indicate that 
the relative permeability of various layers of the reservoir may result 
in the loss of the injectant to thief zones, thereby reducing the areal 
and vertical sweep efficiency of the reservoir. As part of the caustic 
flooding project, H injects polymers to plug the thief zones and improve 
the areal and vertical sweep efficiency of the reservoir. Because the 
polymers are injected into the reservoir to improve the effectiveness of 
the caustic flooding project, the project is a qualified enhanced oil 
recovery project.

[T.D. 8448, 57 FR 54925, Nov. 23, 1992; 58 FR 6678, Feb. 1, 1993]

[[Page 207]]



Sec. 1.43-3  Certification

    (a) Petroleum engineer's certification of a project--(1) In general. 
A petroleum engineer must certify, under penalties of perjury, that an 
enhanced oil recovery project meets the requirements of section 
43(c)(2)(A). A petroleum engineer's certification must be submitted for 
each project. The petroleum engineer certifying a project must be duly 
registered or certified in any State.
    (2) Timing of certification. The operator of an enhanced oil 
recovery project or any other operating mineral interest owner 
designated by the operator (``designated owner'') must submit a 
petroleum engineer's certification to the Internal Revenue Service 
Center, Austin, Texas, or such other place as may be designated by 
revenue procedure or other published guidance, not later than the last 
date prescribed by law (including extensions) for filing the operator's 
or designated owner's federal income tax return for the first taxable 
year for which the enhanced oil recovery credit (the ``credit'') is 
allowable. The operator may designate any other operating mineral 
interest owner (the ``designated owner'') to file the petroleum 
engineer's certification.
    (3) Content of certification--(i) In general. A petroleum engineer's 
certification must contain the following information--
    (A) The name and taxpayer identification number of the operator or 
the designated owner submitting the certification;
    (B) A statement identifying the project, including its geographic 
location;
    (C) A statement that the project involves a tertiary recovery method 
(as defined in section 43(c)(2)(A)(i)) and a description of the process 
used, including--
    (1) A description of the implementation and operation of the project 
sufficient to establish that it is implemented and operated in 
accordance with sound engineering practices;
    (2) If the project involves the application of a tertiary recovery 
method approved in a private letter ruling described in paragraph (e)(1) 
of Sec. 1.43-2, a copy of the private letter ruling, and
    (3) The date on which the first injection of liquids, gases, or 
other matter occurred or is expected to occur.
    (D) A statement that the application of a qualified tertiary 
recovery method or methods is expected to result in more than an 
insignificant increase in the amount of crude oil that ultimately will 
be recovered, including--
    (1) Data on crude oil reserve estimates covering the project area 
with and without the enhanced oil recovery process,
    (2) Production history prior to implementation of the project and 
estimates of production after implementation of the project, and
    (3) An adequate delineation of the reservoir, or portion of the 
reservoir, from which the ultimate recovery of crude oil is expected to 
be increased as a result of the implementation and operation of the 
project; and
    (E) A statement that the petroleum engineer believes that the 
project is a qualified enhanced oil recovery project within the meaning 
of section 43(c)(2)(A).
    (ii) Additional information for significantly expanded projects. The 
petroleum engineer's certification for a project that is significantly 
expanded must in addition contain--
    (A) If the expansion affects reservoir volume that was substantially 
unaffected by a previously implemented project, an adequate delineation 
of the reservoir volume affected by the previously implemented project;
    (B) If the expansion involves the implementation of an enhanced oil 
recovery project more than 36 months after the termination of a 
qualified tertiary recovery method that was applied before January 1, 
1991, the date on which the previous tertiary recovery method terminated 
and an explanation of the data or assumptions relied upon to determine 
the termination date;
    (C) If the expansion involves the implementation of an enhanced oil 
recovery project less than 36 months after the termination of a 
qualified tertiary recovery method that was applied before January 1, 
1991, a copy of a private letter ruling from the Internal Revenue 
Service that the project implemented after December 31, 1990 is treated 
as a significant expansion; or

[[Page 208]]

    (D) If the expansion involves the application after December 31, 
1990, of a tertiary recovery method or methods that do not affect 
reservoir volume that was substantially unaffected by the application of 
a different tertiary recovery method or methods before January 1, 1991, 
a copy of a private letter ruling from the Internal Revenue Service that 
the change in tertiary recovery method is treated as a significant 
expansion.
    (b) Operator's continued certification of a project--(1) In general. 
For each taxable year following the taxable year for which the petroleum 
engineer's certification is submitted, the operator or designated owner 
must certify, under penalties of perjury, that an enhanced oil recovery 
project continues to be implemented substantially in accordance with the 
petroleum engineer's certification submitted for the project. An 
operator's certification must be submitted for each project.
    (2) Timing of certification. The operator or designated owner of an 
enhanced oil recovery project must submit an operator's certification to 
the Internal Revenue Service Center, Austin, Texas, or such other place 
as may be designated by revenue procedure or other published guidance, 
not later than the last date prescribed by law (including extensions) 
for filing the operator's or designated owner's federal income tax 
return for any taxable year after the taxable year for which the 
petroleum engineer's certification is filed.
    (3) Content of certification. An operator's certification must 
contain the following information--
    (i) The name and taxpayer identification number of the operator or 
the designated owner submitting the certification;
    (ii) A statement identifying the project including its geographic 
location and the date on which the petroleum engineer's certification 
was filed;
    (iii) A statement that the project continues to be implemented 
substantially in accordance with the petroleum engineer's certification 
(as described in paragraph (a) of this section) submitted for the 
project; and
    (iv) A description of any significant change or anticipated change 
in the information submitted under paragraph (a)(3) of this section, 
including a change in the date on which the first injection of liquids, 
gases, or other matter occurred or is expected to occur.
    (c) Notice of project termination--(1) In general. If the 
application of a tertiary recovery method is terminated, the operator or 
designated owner must submit a notice of project termination to the 
Internal Revenue Service.
    (2) Timing of notice. The operator or designated owner of an 
enhanced oil recovery project must submit the notice of project 
termination to the Internal Revenue Service Center, Austin, Texas, or 
such other place as may be designated by revenue procedure or other 
published guidance, not later than the last date prescribed by law 
(including extensions) for filing the operator's or designated owner's 
federal income tax return for the taxable year in which the project 
terminates.
    (3) Content of notice. A notice of project termination must contain 
the following information--
    (i) The name and taxpayer identification number of the operator or 
the designated owner submitting the notice;
    (ii) A statement identifying the project including its geographic 
location and the date on which the petroleum engineer's certification 
was filed; and
    (iii) The date on which the application of the tertiary recovery 
method was terminated.
    (d) Failure to submit certification. If a petroleum engineer's 
certification (as described in paragraph (a) of this section) or an 
operator's certification (as described in paragraph (b) of this section) 
is not submitted in the time or manner prescribed by this section, the 
credit will be allowed only after the appropriate certifications are 
submitted.

[T.D. 8384, 56 FR 67177, Dec. 30, 1991; 57 FR 6074, Feb. 20, 1992; 57 FR 
6353, Feb. 24, 1992. Redesignated and amended by T.D. 8448, 57 FR 54927, 
Nov. 23, 1992]



Sec. 1.43-4  Qualified enhanced oil recovery costs.

    (a) Qualifying costs--(1) In general. Except as provided in 
paragraph (e) of this section, amounts paid or incurred

[[Page 209]]

in any taxable year beginning after December 31, 1990, that are 
qualified tertiary injectant expenses (as described in paragraph (b)(1) 
of this section), intangible drilling and development costs (as 
described in paragraph (b)(2) of this section), and tangible property 
costs (as described in paragraph (b)(3) of this section) are ``qualified 
enhanced oil recovery costs'' if the amounts are paid or incurred with 
respect to an asset which is used for the primary purpose (as described 
in paragraph (c) of this section) of implementing an enhanced oil 
recovery project. Any amount paid or incurred in any taxable year 
beginning before January 1, 1991, in connection with an enhanced oil 
recovery project is not a qualified enhanced oil recovery cost.
    (2) Costs paid or incurred for an asset which is used to implement 
more than one qualified enhanced oil recovery project or for other 
activities. Any cost paid or incurred during the taxable year for an 
asset which is used to implement more than one qualified enhanced oil 
recovery project is allocated among the projects in determining the 
qualified enhanced oil recovery costs for each qualified project for the 
taxable year. Similarly, any cost paid or incurred during the taxable 
year for an asset which is used to implement a qualified enhanced oil 
recovery project and which is also used for other activities (for 
example, an enhanced oil recovery project that is not a qualified 
enhanced oil recovery project) is allocated among the qualified enhanced 
oil recovery project and the other activities to determine the qualified 
enhanced oil recovery costs for the taxable year. See Sec. 1.613-5(a). 
Any cost paid or incurred for an asset which is used to implement a 
qualified enhanced oil recovery project and which is also used for other 
activities is not required to be allocated under this paragraph (a)(2) 
if the use of the property for nonqualifying activities is de minimis 
(e.g., not greater than 10%). Costs are allocated under this paragraph 
(a)(2) only if the asset with respect to which the costs are paid or 
incurred is used for the primary purpose of implementing an enhanced oil 
recovery project. See paragraph (c) of this section. Any reasonable 
allocation method may be used. A method that allocates costs based on 
the anticipated use in a project or activity is a reasonable method.
    (b) Costs defined--(1) Qualified tertiary injectant expenses. For 
purposes of this section, ``qualified tertiary injectant expenses'' 
means any costs that are paid or incurred in connection with a qualified 
enhanced oil recovery project and that are deductible under section 193 
for the taxable year. See section 193 and Sec. 1.193-1. Qualified 
tertiary injectant expenses are taken into account in determining the 
credit with respect to the taxable year in which the tertiary injectant 
expenses are deductible under section 193.
    (2) Intangible drilling and development costs. For purposes of this 
section, ``intangible drilling and development costs'' means any 
intangible drilling and development costs that are paid or incurred in 
connection with a qualified enhanced oil recovery project and for which 
the taxpayer may make an election under section 263(c) for the taxable 
year. Intangible drilling and development costs are taken into account 
in determining the credit with respect to the taxable year in which the 
taxpayer may deduct the intangible drilling and development costs under 
section 263(c). For purposes of this paragraph (b)(2), the amount of the 
intangible drilling and development costs for which an integrated oil 
company may make an election under section 263(c) is determined without 
regard to section 291(b).
    (3) Tangible property costs--(i) In general. For purposes of this 
section, ``tangible property costs'' means an amount paid or incurred 
during a taxable year for tangible property that is an integral part of 
a qualified enhanced oil recovery project and that is depreciable or 
amortizable under chapter 1. An amount paid or incurred for tangible 
property is taken into account in determining the credit with respect to 
the taxable year in which the cost is paid or incurred.
    (ii) Integral part. For purposes of this paragraph (b), tangible 
property is an integral part of a qualified enhanced oil recovery 
project if the property is used directly in the project and is essential 
to the completeness of the

[[Page 210]]

project. All the facts and circumstances determine whether tangible 
property is used directly in a qualified enhanced oil recovery project 
and is essential to the completeness of the project. Generally, property 
used to acquire or produce the tertiary injectant or property used to 
transport the tertiary injectant to a project site is property that is 
an integral part of the project.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (b). Assume for each of these examples that the qualified 
enhanced oil recovery costs are paid or incurred with respect to an 
asset which is used for the primary purpose of implementing an enhanced 
oil recovery project.

    Example 1. Qualified costs--in general. (i) In 1992, X, a 
corporation, acquires an operating mineral interest in a property and 
undertakes a cyclic steam enhanced oil recovery project with respect to 
the property. X pays a fee to acquire a permit to drill and hires a 
contractor to drill six wells. As part of the project implementation, X 
constructs a building to serve as an office on the property and 
purchases equipment, including downhole equipment (e.g., casing, tubing, 
packers, and sucker rods), pumping units, a steam generator, and 
equipment to remove gas and water from the oil after it is produced. X 
constructs roads to transport the equipment to the wellsites and incurs 
costs for clearing and draining the ground in preparation for the 
drilling of the wells. X purchases cars and trucks to provide 
transportation for monitoring the wellsites. In addition, X contracts 
with Y for the delivery of water to produce steam to be injected in 
connection with the cyclic steam project, and purchases storage tanks to 
store the water.
    (ii) The leasehold acquisition costs are not qualified enhanced oil 
recovery costs. However, the costs of the permit to drill are intangible 
drilling and development costs that are qualified costs. The costs 
associated with hiring the contractor to drill, constructing roads, and 
clearing and draining the ground are intangible drilling and development 
costs that are qualified enhanced oil recovery costs. The downhole 
equipment, the pumping units, the steam generator, and the equipment to 
remove the gas and water from the oil after it is produced are used 
directly in the project and are essential to the completeness of the 
project. Therefore, this equipment is an integral part of the project 
and the costs of the equipment are qualified enhanced oil recovery 
costs. Although the building that X constructs as an office and the cars 
and trucks X purchases to provide transportation for monitoring the 
wellsites are used directly in the project, they are not essential to 
the completeness of the project. Therefore, the building and the cars 
and trucks are not an integral part of the project and their costs are 
not qualified enhanced oil recovery costs. The cost of the water X 
purchases from Y is a tertiary injectant expense that is a qualified 
enhanced oil recovery cost. The storage tanks X acquires to store the 
water are required to provide a proximate source of water for the 
production of steam. Therefore, the water storage tank are an integral 
part of the project and the costs of the water storage tanks are 
qualified enhanced oil recovery costs.
    Example 2. Diluent storage tanks. In 1992, A, the owner of an 
operating mineral interest, undertakes a qualified enhanced oil recovery 
project with respect to the property. A acquires diluent to be used in 
connection with the project. A stores the diluent in a storage tank that 
A acquires for that purpose. The storage tank provides a proximate 
source of diluent to be used in the tertiary recovery method. Therefore, 
the storage tank is used directly in the project and is essential to the 
completeness of the project. Accordingly, the storage tanks is an 
integral part of the project and the cost of the storage tank is a 
qualified enhanced oil recovery cost.
    Example 3. Oil storage tanks. In 1992, Z, a corporation and the 
owner of an operating mineral interest in a property, undertakes a 
qualified enhanced oil recovery project with respect to the property. Z 
acquires storage tanks that Z will use solely to store the crude oil 
that is produced from the enhanced oil recovery project. The storage 
tanks are not used directly in the project and are not essential to the 
completeness of the project. Therefore, the storage tanks are not an 
integral part of the enhanced oil recovery project and the costs of the 
storage tanks are not qualified enhanced oil recovery costs.
    Example 4. Oil refinery. B, the owner of an operating mineral 
interest in a property, undertakes a qualified enhanced oil recovery 
project with respect to the property. Located on B's property is an oil 
refinery where B will refine the crude oil produced from the project. 
The refinery is not used directly in the project and is not essential to 
the completeness of the project. Therefore, the refinery is not an 
integral part of the enhanced oil recovery project.
    Example 5. Gas processing plant. C, the owner of an operating 
mineral interest in a property, undertakes a qualified enhanced oil 
recovery project with respect to the property. A gas processing plant 
where C will process gas produced in the project is located on C's 
property. The gas processing plant is not used directly in the project 
and is not essential to the completeness of the project.

[[Page 211]]

Therefore, the gas processing plant is not an integral part of the 
enhanced oil recovery project.
    Example 6. Gas processing equipment. The facts are the same as in 
Example 5 except that C uses a portion of the gas processing plant to 
separate and recycle the tertiary injectant. The gas processing 
equipment used to separate and recycle the tertiary injectant is used 
directly in the project and is essential to the completeness of the 
project. Therefore, the gas processing equipment used to separate and 
recycle the tertiary injectant is an integral part of the enhanced oil 
recovery project and the costs of this equipment are qualified enhanced 
oil recovery costs.
    Example 7. Steam generator costs allocated. In 1988, D, the owner of 
an operating mineral interest in a property, undertook a steam drive 
project with respect to the property. In 1992, D decides to undertake a 
steam drive project with respect to reservoir volume that was 
substantially unaffected by the 1988 project. The 1992 project is a 
significant expansion that is a qualified enhanced oil recovery project. 
D purchases a new steam generator with sufficient capacity to provide 
steam for both the 1988 project and the 1992 project. The steam 
generator is used directly in the 1992 project and is essential to the 
completeness of the 1992 project. Accordingly, the steam generator is an 
integral part of the 1992 project. Because the steam generator is also 
used to provide steam for the 1988 project, D must allocate the cost of 
the steam generator to the 1988 project and the 1992 project. Only the 
portion of the cost of the steam generator that is allocable to the 1992 
project is a qualified enhanced oil recovery cost.
    Example 8. Carbon dioxide pipeline. In 1992, E, the owner of an 
operating mineral interest in a property, undertakes an immiscible 
carbon dioxide displacement project with respect to the property. E 
constructs a pipeline to convey carbon dioxide to the project site. E 
contracts with F, a producer of carbon dioxide, to purchase carbon 
dioxide to be injected into injection wells in E's enhanced oil recovery 
project. The cost of the carbon dioxide is a tertiary injectant expense 
that is a qualified enhanced oil recovery cost. The pipeline is used by 
E to transport the tertiary injectant, that is, the carbon dioxide to 
the project site. Therefore, the pipeline is an integral part of the 
project. Accordingly, the cost of the pipeline is a qualified enhanced 
oil recovery cost.
    Example 9. Water source wells. In 1992, G the owner of an operating 
mineral interest in a property, undertakes a polymer augmented 
waterflood project with respect to the property. G drills water wells to 
provide water for injection in connection with the project. The costs of 
drilling the water wells are intangible drilling and development costs 
that are paid or incurred in connection with the project. Therefore, the 
costs of drilling the water wells are qualified enhanced oil recovery 
costs.
    Example 10. Leased equipment. In 1992, H, the owner of an operating 
mineral interest in a property undertakes a steam drive project with 
respect to the property. H contracts with I, a driller, to drill 
injection wells in connection with the project. H also leases a steam 
generator to provide steam for injection in connection with the project. 
The drilling costs are intangible drilling and development costs that 
are paid in connection with the project and are qualified enhanced oil 
recovery costs. The steam generator is used to produce the tertiary 
injectant. The steam generator is used directly in the project and is 
essential to the completeness of the project; therefore, it is an 
integral part of the project. The costs of leasing the steam generator 
are tangible property costs that are qualified enhanced oil recovery 
costs.

    (c) Primary purpose--(1) In general. For purposes of this section, a 
cost is a qualified enhanced oil recovery cost only if the cost is paid 
or incurred with respect to an asset which is used for the primary 
purpose of implementing one or more enhanced oil recovery projects, at 
least one of which is a qualified enhanced oil recovery project. All the 
facts and circumstances determine whether an asset is used for the 
primary purpose of implementing an enhanced oil recovery project. For 
purposes of this paragraph (c), an enhanced oil recovery project is a 
project that satisfies the requirements of paragraphs (a) (1) and (2) of 
section 1.43-2.
    (2) Tertiary injectant costs. Tertiary injectant costs generally 
satisfy the primary purpose test of this paragraph (c).
    (3) Intangible drilling and development costs. Intangible drilling 
and development costs paid or incurred with respect to a well that is 
used in connection with the recovery of oil by primary or secondary 
methods are not qualified enhanced oil recovery costs. Except as 
provided in this paragraph (c)(3), a well used for primary or secondary 
recovery is not used for the primary purpose of implementing an enhanced 
oil recovery project. A well drilled for the primary purpose of 
implementing an enhanced oil recovery project is not considered to be 
used for

[[Page 212]]

primary or secondary recovery, notwithstanding that some primary or 
secondary production may result when the well is drilled, provided that 
such primary or secondary production is consistent with the unit plan of 
development or other similar plan. All the facts and circumstances 
determine whether primary or secondary recovery is consistent with the 
unit plan of development or other similar plan.
    (4) Tangible property costs. Tangible property costs must be paid or 
incurred with respect to property which is used for the primary purpose 
of implementing an enhanced oil recovery project.
    If tangible property is used partly in a qualified enhanced oil 
recovery project and partly in another activity, the property must be 
primarily used to implement the qualified enhanced oil recovery project.
    (5) Offshore drilling platforms. Amounts paid or incurred in 
connection with the acquisition, construction, transportation, erection, 
or installation of an offshore drilling platform (regardless of whether 
the amounts are intangible drilling and development costs) that is used 
in connection with the recovery of oil by primary or secondary methods 
are not qualified enhanced oil recovery costs. An offshore drilling 
platform used for primary or secondary recovery is not used for the 
primary purpose of implementing an enhanced oil recovery project.
    (6) Examples. The following examples illustrate the principles of 
this paragraph (c).

    Example 1. Intangible drilling and development costs. In 1992, J 
incurs intangible drilling and development costs in drilling a well. J 
intends to use the well as an injection well in connection with an 
enhanced oil recovery project in 1994, but in the meantime will use the 
well in connection with a secondary recovery project. J may not take the 
intangible drilling and development costs into account in determining 
the credit because the primary purpose of a well used for secondary 
recovery is not to implement a qualified enhanced oil recovery project.
    Example 2. Offshore drilling platform. K, the owner of an operating 
mineral interest in an offshore oil field located within the United 
States, constructs an offshore drilling platform that is designed to 
accommodate the primary, secondary, and tertiary development of the 
field. Subsequent to primary and secondary development of the field, K 
commences an enhanced oil recovery project that involves the application 
of a qualified tertiary recovery method. As part of the enhanced oil 
recovery project, K drills injection wells from the offshore drilling 
platform K used in the primary and secondary development of the field 
and installs an additional separator on the platform.
    Because the offshore drilling platform was used in the primary and 
secondary development of the field and was not used for the primary 
purpose of implementing tertiary development of the field, costs 
incurred by K in connection with the acquisition, construction, 
transportation, erection, or installation of the offshore drilling 
platform are not qualified enhanced oil recovery costs. However, the 
costs K incurs for the additional separator are qualified enhanced oil 
recovery costs because the separator is used for the primary purpose of 
implementing tertiary development of the field. In addition, the 
intangible drilling and development costs K incurs in connection with 
drilling the injection wells are qualified enhanced oil recovery costs 
with respect to which K may claim the enhanced oil recovery credit.

    (d) Costs paid or incurred prior to first injection--(1) In general. 
Qualified enhanced oil recovery costs may be paid or incurred prior to 
the date of the first injection of liquids, gases, or other matter 
(within the meaning of Sec. 1.43-2(c)). If the first injection of 
liquids, gases, or other matter occurs on or before the date the 
taxpayer files the taxpayer's federal income tax return for the taxable 
year with respect to which the costs are allowable, the costs may be 
taken into account on that return. If the first injection of liquids, 
gases, or other matter is expected to occur after the date the taxpayer 
files that return, costs may be taken into account on that return if the 
Internal Revenue Service issues a private letter ruling to the taxpayer 
that so permits.
    (2) First injection after filing of return for taxable year costs 
are allowable. Except as provided in paragraph (d)(3) of this section, 
if the first injection of liquids, gases, or other matter occurs or is 
expected to occur after the date the taxpayer files the taxpayer's 
federal income tax return for the taxable year with respect to which the 
costs are allowable, the costs may be taken into account on an amended 
return (or in the case of a Coordinated Examination

[[Page 213]]

Program taxpayer, on a written statement treated as a qualified return) 
after the earlier of--
    (i) The date the first injection of liquids, gases, or other matter 
occurs; or
    (ii) The date the Internal Revenue Service issues a private letter 
ruling that provides that the taxpayer may take costs into account prior 
to the first injection of liquids, gases, or other matter.
    (3) First injection more than 36 months after close of taxable year 
costs are paid or incurred. If the first injection of liquids, gases, or 
other matter occurs more than 36 months after the close of the taxable 
year in which costs are paid or incurred, the taxpayer may take the 
costs into account in determining the credit only if the Internal 
Revenue Service issues a private letter ruling to the taxpayer that so 
provides.
    (4) Injections in volumes less than the volumes specified in the 
project plan. For purposes of this paragraph (d), injections in volumes 
significantly less than the volumes specified in the project plan, the 
unit plan of development, or another similar plan do not constitute the 
first injection of liquids, gases, or other matter.
    (5) Examples. The following examples illustrate the provisions of 
paragraph (d) of this section.

    Example 1. First injection before return filed. In 1992, L, a 
calendar year taxpayer, undertakes a qualified enhanced oil recovery 
project on a property in which L owns an operating mineral interest. L 
incurs $1,000 of intangible drilling and development costs, which L may 
elect to deduct under section 263(c) for 1992. The first injection of 
liquids, gases, or other matter (within the meaning of Sec. 1.43-2(c)) 
occurs in March 1993. L files a 1992 federal income tax return in April 
1993. Because the first injection occurs before the filing of L's 1992 
federal income tax return, L may take the $1,000 of intangible drilling 
and development costs into account in determining the credit for 1992 on 
that return.
    Example 2. First injection after return filed. In 1993, M, a 
calendar year taxpayer, undertakes a qualified enhanced oil recovery 
project on a property in which M owns an operating mineral interest. M 
incurs $2,000 of intangible drilling and development costs, which M 
elects to deduct under section 263(c) for 1993. The first injection of 
liquids, gases, or other matter is expected to occur in 1995. M files a 
1993 federal income tax return in April 1994. Because the first 
injection of liquids, gases, or other matter occurs after the date on 
which M's 1993 federal income tax return is filed in April 1994, M may 
take the $2,000 of intangible drilling and development costs into 
account on an amended return for 1993 after the earlier of the date the 
first injection of liquids, gases, or other matter occurs, or the date 
the Internal Revenue Service issues a private letter ruling that 
provides that M may take the $2,000 into account prior to first 
injection.
    Example 3. First injection more than 36 months after taxable year. 
N, a calendar year taxpayer, owns an operating mineral interest in a 
property on which N undertakes an immiscible carbon dioxide displacement 
project. In 1994, N incurs $5,000 in connection with the construction of 
a pipeline to transport carbon dioxide to the project site. The first 
injection of liquids, gases, or other matter is expected to occur after 
the pipeline is completed in 1998. Because the first injection of 
liquids, gases, or other matter occurs more than 36 months after the 
close of the taxable year in which the $5,000 is incurred, N may take 
the $5,000 into account in determining the credit only if N receives a 
private letter ruling from the Internal Revenue Service that provides 
that N may take the $5,000 into account prior to first injection.

    (e) Other rules--(1) Anti-abuse rule. Costs paid or incurred with 
respect to an asset that is acquired, used, or transferred in a manner 
designed to duplicate or otherwise unreasonably increase the amount of 
the credit are not qualified enhanced oil recovery costs, regardless of 
whether the costs would otherwise be creditable for a single taxpayer or 
more than one taxpayer.
    (2) Costs paid or incurred to acquire a project. A purchaser of an 
existing qualified enhanced oil recovery project may claim the credit 
for any section 43 costs in excess of the acquisition cost. However, 
costs paid or incurred to acquire an existing qualified enhanced oil 
recovery project (or an interest in an existing qualified enhanced oil 
recovery project) are not eligible for the credit.
    (3) Examples. The following examples illustrate the principles of 
paragraph (e) of this section.

    Example 1. Duplicating or unreasonably increasing the credit. O owns 
an operating mineral interest in a property with respect to which a 
qualified enhanced oil recovery project is implemented. O acquires 
pumping units, rods, casing, and separators for use in connection with 
the project from an unrelated equipment dealer in an arm's length 
transaction. The equipment is used for the primary purpose of 
implementing the

[[Page 214]]

project. Some of the equipment acquired by O is used equipment. The 
costs paid by O for the used equipment are qualified enhanced oil 
recovery costs. O does not need to determine whether the equipment has 
been previously used in an enhanced oil recovery project.
    Example 2. Duplicating or unreasonably increasing the credit. P and 
Q are co-owners of an oil property with respect to which a qualified 
enhanced oil recovery project is implemented. In 1992, P and Q jointly 
purchase a nitrogen plant to supply the tertiary injectant used in the 
project. P and Q claim the credit for their respective costs for the 
plant. In 1994, X, a corporation unrelated to P or Q, purchases the 
nitrogen plant and enters into an agreement to sell nitrogen to P and Q. 
Because this transaction duplicates or otherwise unreasonably increases 
the credit, the credit is not allowable for the amounts incurred by P 
and Q for the nitrogen purchased from X.
    Example 3. Duplicating or unreasonably increasing the credit. The 
facts are the same as in Example 2. In addition, in 1995, P and Q 
reacquire the nitrogen plant from X. This constitutes the acquisition of 
property in a manner designed to duplicate or otherwise unreasonably 
increase the amount of the credit. Therefore, the credit is not 
allowable for amounts incurred by P and Q for the nitrogen plant 
purchased from X.
    Example 4. Duplicating or unreasonably increasing the credit. R owns 
an operating mineral interest in a property with respect to which a 
qualified enhanced oil recovery project is implemented. R acquires a 
pump that is installed at the site of the project. After the pump has 
been placed in service for 6 months, R transfers the pump to a secondary 
recovery project and acquires a replacement pump for the tertiary 
project. The original pump is suited to the needs of the secondary 
recovery project and could have been installed there initially. The 
pumps have been acquired in a manner designed to duplicate or otherwise 
unreasonably increase the amount of the credit. Depending on the facts, 
the cost of one pump or the other may be a qualified enhanced oil 
recovery cost; however, R may not claim the credit with respect to the 
cost of both pumps.
    Example 5. Acquiring a project. In 1993, S purchases all of T's 
interest in a qualified enhanced oil recovery project, including all of 
T's interest in tangible property that is an integral part of the 
project and all of T's operating mineral interest. In 1994, S incurs 
costs for additional tangible property that is an integral part of the 
project and which is used for the primary purpose of implementing the 
project. S also incurs costs for tertiary injectants that are injected 
in connection with the project. In determining the credit for 1994, S 
may take into account costs S incurred for tangible property and 
tertiary injectants. However, S may not take into account any amount 
that S paid for T's interest in the project in determining S's credit 
for any taxable year.

[T.D. 8448, 57 FR 54927, Nov. 23, 1992; 58 FR 7987, Feb. 11, 1993]



Sec. 1.43-5  At-risk limitation. [Reserved]



Sec. 1.43-6  Election out of section 43.

    (a) Election to have the credit not apply--(1) In general. A 
taxpayer may elect to have section 43 not apply for any taxable year. 
The taxpayer may revoke an election to have section 43 not apply for any 
taxable year. An election to have section 43 not apply (or a revocation 
of an election to have section 43 not apply) for any taxable year is 
effective only for the taxable year to which the election relates.
    (2) Time for making the election. A taxpayer may make an election 
under paragraph (a) of this section to have section 43 not apply (or 
revoke an election to have section 43 not apply) for any taxable year at 
any time before the expiration of the 3-year period beginning on the 
last date prescribed by law (determined without regard to extensions) 
for filing the return for the taxable year. The time for making the 
election (or revoking the election) is prescribed by section 43(e)(2) 
and may not be extended under Sec. 1.9100-1.
    (3) Manner of making the election. An election (or revocation) under 
paragraph (a)(1) of this section is made by attaching a statement to the 
taxpayer's federal income tax return or an amended return (or, in the 
case of a Coordinated Examination Program taxpayer, on a written 
statement treated as a qualified amended return) for the taxable year 
for which the election (or revocation) applies. The taxpayer must 
indicate whether the taxpayer is electing to not have section 43 apply 
or is revoking such an election and designate the project or projects to 
which the election (or revocation) applies. For any taxable year, the 
last election (or revocation) made by a taxpayer within the period 
prescribed in paragraph (a)(2) of this section determines whether 
section 43 applies for that taxable year.
    (b) Election by partnerships and S corporations. For partnerships 
and S corporations, an election to have section

[[Page 215]]

43 not apply (or a revocation of an election to have section 43 not 
apply) for any taxable year is made, in accordance with the requirements 
of paragraph (a) of this section, by the partnership or S corporation 
with respect to the qualified enhanced oil recovery costs paid or 
incurred by the partnership or S corporation for the taxable year to 
which the election relates.

[T.D. 8448, 57 FR 54930, Nov. 23, 1992]



Sec. 1.43-7  Effective date of regulations.

    The provisions of Sec. Sec. 1.43-1, 1.43-2 and 1.43-4 through 1.43-
7 are effective with respect to costs paid or incurred after December 
31, 1991, in connection with a qualified enhanced oil recovery project. 
The provisions of Sec. 1.43-3 are effective for taxable years beginning 
after December 31, 1990. For costs paid or incurred after December 31, 
1990, and before January 1, 1992, in connection with a qualified 
enhanced oil recovery project, taxpayers must take reasonable return 
positions taking into consideration the statute and its legislative 
history.

[T.D. 8448, 57 FR 54931, Nov. 23, 1992]



Sec. 1.44-1  Allowance of credit for purchase of new principal residence after 

March 12, 1975, and before January 1, 1977.

    (a) General rule. Section 44 provides a credit against the tax 
imposed by chapter 1 of the Internal Revenue Code of 1954 in the case of 
an individual who purchases a new principal residence (as defined in 
paragraph (a) of Sec. 1.44-5) which is property to which section 44 
applies (as provided in Sec. 1.44-2). Subject to the limitations set 
forth in paragraph (b) of this section, the credit is in an amount equal 
to 5 percent of the purchase price (as defined in paragraph (b) of Sec. 
1.44-5).
    (b) Limitations--(1) Maximum credit. The credit allowed under 
section 44 and this section may not exceed $2,000.
    (2) Limitation to one residence. Such credit shall be allowed with 
respect to only one residence of the taxpayer; the combined purchase 
prices of more than one new principal residence cannot be aggregated to 
increase the credit allowed.
    (3) Married individuals. In the case of a husband and wife who file 
a joint return under section 6013, the maximum credit allowed on the 
joint return is $2,000. In the case of married individuals filing 
separate returns the maximum credit allowable to each spouse is $1,000. 
Where a husband and wife do not make equal contributions with respect to 
the purchase price of the new principal residence, allocation of the 
credit is to be made in proportion to their respective ownership 
interests in such residence. For this purpose, tenants by the entirety 
or joint tenants with right of survivorship are treated as equal owners.
    (4) Certain other taxpayers. Where a new principal residence is 
purchased by two or more taxpayers (other than a husband and wife), the 
amount of the credit allowed will be allocated among the taxpayers in 
proportion to their respective ownership interests in such residence, 
with the limitation that the sum of the credits allowed to all such 
taxpayers shall not exceed $2,000. For this purpose, joint tenants with 
right of survivorship are treated as equal owners. For an example of the 
operation of this provision see Example (2) of Sec. 1.44-5(b)(2)(ii).
    (5) Application with other credits. The credit allowed by this 
section shall not exceed the amount of the tax imposed by chapter 1 of 
the Code for the taxable year, reduced by the sum of the credits 
allowable under--
    (i) Section 33 (relating to taxes of foreign countries and 
possessions of the United States),
    (ii) Section 37 (relating to retirement income),
    (iii) Section 38 (relating to investment in certain depreciable 
property),
    (iv) Section 40 (relating to expenses of work incentive program),
    (v) Section 41 (relating to contributions to candidates for public 
office), and
    (vi) Section 42 (relating to personal exemptions).

[T.D. 7391, 40 FR 55851, Dec. 2, 1975]



Sec. 1.44-2  Property to which credit for purchase of new principal residence 

applies.

    The provisions of section 44 and the regulations thereunder apply to 
a new

[[Page 216]]

principal residence which satisfies the following conditions:
    (a) Construction. The construction of the residence must have begun 
before March 26, 1975. For this purpose construction is considered to 
have commenced in the following circumstances:
    (1)(i) Except as provided in subparagraph (2) of this paragraph, 
construction is considered to commence when actual physical work of a 
significant amount has occurred on the building site of the residence. A 
significant amount of construction requires more than drilling to 
determine soil conditions, preparation of an architect's sketches, 
securing of a building permit, or grading of the land. Land preparation 
and improvements such as the clearing and grading (excavation or 
filling), construction of roads and sidewalks, and installation of 
sewers and utilities are not considered commencement of construction of 
the residence even though they might involve a significant expenditure. 
However, driving pilings for the foundation, digging of the footings, 
excavation of the building foundation, pouring of floor slabs, or 
construction of compacted earthen pads when specifically prepared and 
designed for a particular residential structure and not merely as a part 
of the overall land preparation, constitute a significant amount of 
construction of the residence. In the case of a housing or condominium 
development construction of recreational facilities no matter how 
extensive does not by itself constitute commencement of construction of 
any residential unit. However, where residential units are part of a 
building structure, as in the case of certain condominium and 
cooperative housing units, then digging of the footings or excavation of 
the building foundation constitutes commencement of construction for all 
units in that building.
    (ii) The rules in subdivision (i) of this subparagraph are 
illustrated by the following examples:

    Example 1. A location chosen for a housing development has extremely 
hilly terrain. In order to make the location suitable for development, 
the builder moves large amounts of earth and places it elsewhere on the 
location. In addition, the earth material which has been moved must be 
compacted according to government specifications in order to provide a 
stable base. Such activities constitute land preparation and, therefore, 
do not constitute the commencement of construction.
    Example 2. A location chosen for a housing development has swampy 
and marshy terrain. In order to make the location suitable for 
development the builder utilizes large quantities of fill. This activity 
constitutes land preparation and does not constitute commencement of 
construction.
    Example 3. Assume the same facts as in either Example 1 or Example 2 
except that the builder also constructs an earthen pad of compacted fill 
specifically prepared for a particular residential structure and not 
merely as a part of the overall land preparation. Construction of the 
compacted earthen pad is considered in the same light as excavation of 
the building foundation and accordingly constitutes commencement of 
construction.

    (2) Construction of a factory-made home (as defined in paragraph (e) 
of Sec. 1.44-5) is considered to have commenced when construction of 
important parts of the factory-made home has commenced. For this 
purpose, commencement of construction of important parts means the 
cutting and shaping or welding of structural components for a specific 
identifiable factory-made home, whether the work was done by the 
manufacturer of the home or by a subcontractor thereof.
    (b) Acquisition and occupancy. The residence must be acquired and 
occupied by the taxpayer after March 12, 1975, and before January 1, 
1977. For this purpose a taxpayer ``acquires'' a residence when legal 
title to it is conveyed to him at settlement, or he has possession of it 
pursuant to a binding purchase contract under which he makes periodic 
payments until he becomes entitled under the contract to demand 
conveyance of title. A taxpayer ``occupies'' a residence when he or his 
spouse physically occupies it. Thus, for example, moving of furniture or 
other household effects into the residence or physical occupancy by a 
dependent child of the taxpayer is not ``occupancy'' for purposes of 
this paragraph. The credit may be claimed when both the acquisition and 
occupancy tests have been satisfied. Thus, where a taxpayer meets the 
acquisition and occupancy tests set forth above after March 12, 1975, 
and before January 1, 1976, the credit is allowable for 1975.

[[Page 217]]

Where a taxpayer occupied a residence prior to March 13, 1975, without 
having acquired it (as where his occupancy was pursuant to a leasing 
arrangement pending settlement under a binding contract to purchase or 
pursuant to a leasing arrangement where a written option to purchase was 
contained in the original lease agreement) he will nonetheless satisfy 
the acquisition and occupancy tests set forth above if he acquires the 
residence and continues to occupy it after March 12, 1975, and before 
January 1, 1977.
    (c) Binding contract. Except in the case of self-construction, the 
new principal residence must be acquired by the taxpayer (within the 
meaning of paragraph (b) of this section) under a binding contract 
entered into by the taxpayer before January 1, 1976. An otherwise 
binding contract for the purchase of a residence which is conditioned 
upon the purchaser's obtaining a loan for the purchase of the residence 
(including conditions as to the amount or interest rate of such loan) is 
considered binding notwithstanding that condition.
    (d) Self-constructed residence. A self-constructed residence (as 
defined in paragraph (d) of Sec. 1.44-5) must be occupied by the 
taxpayer before January 1, 1977. Where self-construction of a principal 
residence was begun before March 13, 1975, only that portion of the 
basis of the property allocable to construction after March 12, 1975, 
and before January 1, 1977, shall be taken into consideration in 
determining the amount of the credit allowable. For this purpose, the 
portion of the basis attributable to the pre-March 13 period includes 
the total cost of land acquired (as defined in paragraph (b) of this 
section) prior to March 13, 1975, on which the new principal residence 
is constructed and the cost of expenditures with respect to construction 
work performed prior to March 13, 1975. The costs incurred in 
stockpiling materials for later stages of construction, however, are not 
allocated to the pre-March 13 period. Thus, for example, if prior to 
March 13, 1975, a taxpayer who qualifies for the credit has constructed 
a portion of a residence at a cost of $10,000 (including the cost of the 
land purchased prior to March 13, 1975) and the total cost of the 
residence is $40,000 and the taxpayer's basis after the application of 
section 1034(e) (relating to the reduction of basis of new principal 
residence where gain is not recognized upon the sale of the old 
residence) is $36,000, the amount subject to the credit will be $27,000:

($30,000/$40,000) x $36,000.

[T.D. 7391, 40 FR 55852, Dec. 2, 1975; 40 FR 58138, Dec. 15, 1975]



Sec. 1.44-3  Certificate by seller.

    (a) Requirement of certification by seller. Taxpayers claiming the 
credit should attach Form 5405, Credit for Purchase or Construction of 
New Principal Residence, to their tax returns on which the credit is 
claimed. Except in the case of self-construction (as defined in Sec. 
1.44-5(d)), taxpayers must attach a certification by the seller that 
construction of the residence began before March 26, 1975, and that the 
purchase price is the lowest price at which the residence was offered 
for sale after February 28, 1975. For purposes of section 44(e)(4) and 
this section, the term ``price'' generally does not include costs of 
acquisition other than the amount of the consideration from the 
purchaser to the seller. However, for rules relating to adjustments in 
price due to changes in financing terms and closing costs see paragraph 
(d)(2) of this section.
    (b) Form of certification. The following form of the certification 
statement is suggested:

    I certify that the construction of the residence at (specify 
address) was begun before March 26, 1975, and that this residence has 
not been offered for sale after February 28, 1975 in a listing, a 
written private offer, or an offer by means of advertisement at a lower 
purchase price than (state price), the price at which I sold the 
residence to (state name, present address, and social security number of 
purchaser) by contract dated (give date).
    (Date, seller's signature and taxpayer identification number.)


However, any written certification filed by the taxpayer will be 
accepted provided that such certification is signed by the seller and 
states that

[[Page 218]]

construction of the residence began before March 26, 1975, and that the 
purchase price of the residence is the lowest price at which the 
residence was offered for sale after February 28, 1975. With regard to 
factory-made homes the seller, in the absence of his own knowledge as to 
the commencement of construction, may attach to his own certification a 
certification from the manufacturer that construction began before March 
26, 1975, and may certify based on the manufacturer's certification. It 
is suggested that both certifications include the serial number, if any, 
of the residence.
    (c) Offer to sell. (1) For purposes of section 44(e)(4) and this 
section, an offer to sell is limited to an offer to sell a specified 
residence at a specified purchase price.
    (2) An ``offer'' includes any written offer, whether made to a 
particular purchaser or to the public, and any offer by means of 
advertising. Advertising includes an offer to sell published by 
billboards, flyers, brochures, price lists (unless the lists are 
exclusively for the internal use of the seller and are not made 
available to the public), mailings, newspapers, periodicals, radio, or 
television. The listing of a property with a real estate agency, the 
filing of a prospectus and the registration of construction plans and 
price lists with the appropriate authorities (in the case of 
condominiums or cooperative housing developments) are to be considered 
offers made to the public.
    (3) An offer to sell a specified residence includes:
    (i) Both an offer to sell an existing residence and an offer to 
build and sell a residence of substantially the same design or model as 
that purchased by the taxpayer on the same lot as that on which the 
taxpayer's new principal residence was constructed. It does not include 
an offer to sell the same model residence on a different lot. Where a 
residence of a particular design or model is offered at a specific base 
price, additions of property to the residence, no matter how extensive, 
will not result in the residence being treated as a different residence 
for the purpose of determining the lowest offer (as defined in paragraph 
(f) of Sec. 1.44-5).
    (ii) In the case of a condominium or cooperative housing development 
where units are offered for sale on the basis of models (e.g., all Model 
C two-bedroom apartments sell at a specified base price), an offer to 
sell a specified residence includes an offer to sell a specific type of 
unit (with appropriate adjustments to be made for the location of such 
unit and as provided in paragraph (d) of this section).
    (iii) In the case of a factory-made home, an offer to sell a 
specified residence includes an offer to sell the same model home as 
that purchased by the taxpayer, provided that the offer is made after 
the seller has the right to sell the home purchased by the taxpayer 
(i.e., has that specific home in his inventory). However, it does not 
include an offer to sell such home with land which is not included in 
the taxpayer's purchase nor an offer to sell such home without land 
which is included in the taxpayer's purchase. Appropriate adjustments to 
a prior offer shall be made as provided in paragraph (d) of this 
section, including adjustments for any delivery and installation charges 
as provided in paragraph (d)(3).
    (iv) The rules of this subparagraph may be illustrated by the 
following examples:

    Example 1. In March 1975 A advertised colonial-style homes on 
section I of subdivision C at a base price of $40,000. At the time none 
of the homes had been completed but construction of all homes on section 
I was commenced before March 26, 1975. After one-half of the homes were 
sold, A offers to sell the remaining homes in May 1975 at a base price 
of $45,000. Under the facts above the base price of $45,000 is not the 
lowest offer since the seller had offered to sell the same model home on 
the same lot at a lower purchase price after February 28, 1975.
    Example 2. In June 1975 A offers houses, otherwise qualifying, on 
section II for the first time for a base price of $50,000. They are 
colonial homes and substantially the same as the homes he previously 
offered on section I. Under the facts stated above the base price of 
$50,000 is the lowest offer since the same model home on the same lot 
was not previously offered for sale.
    Example 3. In March 1975 B, a condominium developer, offers to sell 
any two-bedroom unit in a particular high rise condominium for $45,000 
with an added $5,000 for units with a lakefront view and an additional 
$2,000 for units on higher floors. With regard to all two-bedroom units 
in the condominium an

[[Page 219]]

offer to sell a specified residence at a specified purchase price has 
been made. This is true even though at the time of the offer 
construction had not reached the floor on which the particular unit will 
be located.

    (4) A specified purchase price means a stated definite price for a 
particular residence or a specific base price for a residence of a 
particular model or design. An offer to sell for an indefinite price 
(e.g., an advertisement that all houses sell in the $40,000's) is not 
considered an offer to sell at a specified purchase price.
    (5) An offer to sell includes an offer to sell subject to special 
conditions imposed by the seller. Thus, if the lowest price at which a 
house was advertised was ``at $40,000 for March only'', the $40,000 
price would be the lowest offer. However, certain conditions may 
necessitate adjustments in determining the lowest offer. See paragraph 
(d) of this section.
    (6) An offer to sell two or more residences together as for example, 
in a bulk sale shall be disregarded, even though each residence is 
assigned a specific purchase price for the purpose of such a sale. With 
regard to factory-made homes an offer to sell does not include an offer 
made by the manufacturer to a dealer in such homes.
    (7)(i) Where new residences are purchased at a foreclosure sale 
(including a conveyance by the owner in lieu of foreclosure) and prior 
to the foreclosure sale such residences had been offered for sale by the 
foreclosure seller at specified prices, the foreclosure purchaser is 
bound by such prices in determining the lowest offer. He is not bound by 
the prices paid to the foreclosure seller since such prices do not 
constitute voluntary offers.
    (ii) For this purpose, if the foreclosure seller and foreclosure 
purchaser are not related parties (as defined in subdivision (iii) of 
this subparagraph), and if the foreclosure purchaser does not have 
knowledge of the date of commencement of construction and the lowest 
offer made by such seller with respect to each of the foreclosed 
residences, the foreclosure purchaser must request and try to obtain 
from the foreclosure seller a certificate specifying such facts. Upon a 
subsequent sale of a particular residence by the foreclosure purchaser, 
he must certify whether the price is the lowest offer for that 
particular residence based on the certification of the foreclosure 
seller, a copy of which must be attached to the certification of the 
foreclosure purchaser. If the foreclosure seller refuses to so certify, 
the foreclosure purchaser must make a reasonable effort to determine the 
date construction commenced and the lowest offer made by the foreclosure 
seller. For this purpose, reasonable effort includes the effort to 
locate and examine advertising and listings published or used by the 
foreclosure seller. If the foreclosure seller and foreclosure purchaser 
are related parties (as defined in subdivision (iii) of this 
subparagraph), the foreclosure purchaser will be considered as having 
knowledge of the date of the commencement of construction and the lowest 
offer made by such seller with respect to each of the foreclosed 
residences, and, upon a subsequent sale of a particular residence by the 
foreclosure purchaser, he must comply with the certification 
requirements prescribed by paragraphs (a) and (b) of this section.
    (iii) For purposes of this subparagraph related parties shall 
include the relationships described in subparagraph (2) of Sec. 1.44-
5(c), and the constructive ownership rules of section 318 shall apply, 
but family members for this purpose shall include spouses, ancestors, 
and lineal descendants.
    (d) Adjustments in determining lowest price. (1)(i) In determining 
whether a residence was sold at the lowest offer appropriate adjustment 
shall be made for differences in the property offered and in the terms 
of the sale. Where the sale to the taxpayer includes property which was 
not the subject of the prior offer or excludes property which was 
included in the prior offer, the amount of the prior offer shall be 
adjusted to reflect the fair market value of such property, provided 
that, in the case of property included in the sale which was not a part 
of the residence at the time of execution of the contract of purchase, 
the taxpayer had the option to require inclusion or exclusion of such 
property. The fair market value of any excluded property is to be 
determined at the time of the prior offer, while all

[[Page 220]]

additions are to be valued at their fair market value on the date of 
execution of the contract of sale. If a seller increases his present 
offer to include financing or other costs of the seller in connection 
with his ownership of the residence, the present offer does not qualify 
as being the lowest offer.
    (ii) The rules in subdivision (i) of this subparagraph are 
illustrated by the following examples:

    Example 1. A offered to sell a new home without a garage for 
$35,000. Having found no buyers A added a garage and sold the home for 
$40,000. At the time the contract of sale was executed the fair market 
value of the garage was $5,000. The offer to sell for $40,000 qualifies 
since it equals the seller's lowest offer plus the fair market value of 
the garage.
    Example 2. B, unable to sell colonial-style homes presently under 
construction and previously offered for sale for $40,000, makes 
extensive changes in decor and identifies the homes as his new 
Williamsburg model. The Williamsburg models are not different residences 
for purposes of this section. To the extent that the additions have not 
yet been added at the time of execution of a contract of sale, in order 
to qualify for the credit the taxpayer must have the option as to 
whether to include these additions, and if these additions are included 
B must charge no more than the fair market value of the additions on 
that date of execution of the contract of sale.

    (2) Appropriate adjustment to a prior offer to sell shall be made 
for differences in financing terms and closing costs which increase the 
seller's actual net proceeds and the purchaser's actual costs. A seller 
may pass on to the purchaser without affecting the purchase price only 
those additional amounts he is required to expend in connection with 
such differences. The seller may not by changing the financing terms or 
closing costs indirectly increase the purchase price. For these purposes 
closing costs include all charges paid at settlement for obtaining the 
mortgage loan and transferring real estate title. Thus, for example, 
where a seller previously offered a residence for sale for $40,000 and 
agreed to pay financing ``points'' required by the mortgagee, and now 
offers the same residence also for $40,000 but requires the purchaser to 
pay the points, the present offer does not constitute the lowest offer. 
On the other hand, a prior offer to sell based upon a large down payment 
by the prospective purchaser may be adjusted to reflect the additional 
costs to the seller of accepting a small down payment from the taxpayer. 
For purposes of determining the seller's net proceeds, proceeds received 
by all related parties within the meaning of section 318 must be taken 
into account. For purposes of determining the lowest offer, where an 
offer provided for a rebate (e.g., of cash or of a contribution toward 
mortgage payments) or included, without additional charge or at less 
than fair market value, property not normally included in the sale of a 
residence (e.g., an automobile), such offer must be reduced by the 
amount of such rebate or by the amount by which the fair market value of 
such property at the time of the offer exceeds the amount paid for it by 
the purchaser. Thus, where a residence was advertised for sale at 
$40,000, but the seller agreed to pay $200 a month on the purchaser's 
mortgage for 10 months, such residence is considered to have been 
offered for sale at $38,000.
    (3) In the case of a factory-made home, where delivery and 
installation costs are included in the specified base price of such home 
an appropriate adjustment is to be made in such specified base price for 
differences in the fair market value of the delivery and installation in 
determining the lowest offer.
    (e) Civil and criminal penalties. If a person certifies that the 
price for which the residence was sold does not exceed the lowest offer 
and if it is found that the price for which the residence was sold 
exceeded the lowest offer, then such person is liable (under section 
208(b) of the Tax Reduction Act of 1975) to the purchaser for damages in 
an amount equal to three times the excess of the certified price over 
the lowest offer plus reasonable attorney's fees. No income tax 
deduction shall be allowed for two-thirds of any amount paid or incurred 
pursuant to a judgment entered against any person in a suit based on 
such liability. However, attorney's fees, court costs, and other such 
amounts paid or incurred with respect to such suit which meet the 
requirements of section 162 are deductible under that section. In 
addition, an

[[Page 221]]

individual who falsely certifies may be subject to criminal penalties. 
For example, section 1001 of Title 18 of the United States Code provides 
as follows:
Sec. 1001
Statements or entries generally.
    Whoever, in any matter within the jurisdiction of any department or 
agency of the United States knowingly and willfully falsifies, conceals 
or covers up by any trick, scheme, or device a material fact, or makes 
any false, fictitious or fraudulent statements or representations, or 
makes or uses any false writing or document knowing the same to contain 
any false, fictitious or fraudulent statement or entry, shall be fined 
not more than $10,000 or imprisoned not more than five years, or both.


The treble damages and criminal sanctions provided under this paragraph 
apply only with regard to false certification as to the lowest offer, 
not to false certification as to commencement of construction. However, 
with regard to false certification as to commencement of construction 
there may exist contractual or tort remedies under State law.
    (f) Denial of credit. In the absence of the taxpayer's participation 
in, or knowledge of, a false certification by the seller, the credit is 
not denied to a taxpayer who otherwise qualifies for the credit solely 
because the seller has falsely certified that the new principal 
residence was sold at the lowest offer. However, if certification as to 
the commencement of construction is false, no credit is allowed since 
such residence does not qualify as a new principal residence 
construction of which began before March 26, 1975.

[T.D. 7391, 40 FR 55852, Dec. 2, 1975]



Sec. 1.44-4  Recapture for certain dispositions.

    (a) In general. (1) Under section 44(d) except as provided in 
paragraphs (b) and (c) of this section, if the taxpayer disposes of 
property, with respect to the purchase of which a credit was allowed 
under section 44(a), at any time within 36 months after the date on 
which he acquired it (or, in the case of construction by the taxpayer, 
the date on which he first occupied it as his principal residence), then 
the tax imposed under chapter 1 of the Code for the taxable year in 
which the replacement period (as provided under subparagraph (2) of this 
paragraph) terminates is increased by an amount equal to the amount 
allowed as a credit for the purchase of such property.
    (2) The replacement period is the period provided for purchase of a 
new principal residence under section 1034 of the Code without 
recognition of gain on the sale of the old residence. In the case of 
residences sold or exchanged after December 31, 1974, it is generally 18 
months in the case of acquisition by purchase and 2 years in the case of 
construction by the taxpayer provided, however, that such construction 
has commenced within the 18-month period. Thus, a calendar-year taxpayer 
who disposes of his old principal residence in December 1975 and does 
not qualify under paragraph (b) or (c) of this section will include the 
amount previously allowed as additional tax on his 1977 tax return.
    (3) Except as provided in paragraphs (b) and (c) of this section, 
section 44(d) applies to all dispositions of property, including sales 
(including foreclosure sales), exchanges (including tax-free exchanges 
such as those under sections 351, 721, and 1031), and gifts.
    (4) In the case of a husband and wife who were allowed a credit 
under section 44(a) claimed on a joint return, for the purpose of 
section 44(d) and this section the credit shall be allocated between the 
spouses in accordance with the provisions of paragraph (b)(3) of Sec. 
1.44-1.
    (b) Acquisition of a new residence. (1) Section 44(d)(1) and 
paragraph (a) of this section shall not apply to a disposition of 
property with respect to the purchase of which a credit was allowed 
under section 44(a) in the case of a taxpayer who purchases or 
constructs a new principal residence (within the meaning of Sec. 1.44-
5(a)) within the applicable replacement period provided in section 1034. 
In determining whether a new principal residence qualifies for purposes 
of this section the rules relating to construction, acquisition, and 
occupancy under Sec. 1.44-2 do not apply. Where a disposition has 
occurred and the taxpayer's purchase (or construction) costs of a new 
principal residence are less than the adjusted sales price (as defined 
in section 1034(b)) of the old residence, the tax imposed by chapter 1

[[Page 222]]

of the Code for the taxable year following the taxable year during which 
disposition occurs is increased by an amount which bears the same ratio 
to the amount allowed as a credit for the purchase of the old residence 
as (i) the adjusted sales price of the old residence (within the meaning 
of section 1034), reduced (but not below zero) by the taxpayer's cost of 
purchasing (or constructing) the new residence (within the meaning of 
such section) bears to (ii) the adjusted sales price of the old 
residence.
    (2) The rules of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example. On July 15, 1975, A purchases a new principal residence for 
a total purchase price of $40,000. The property meets the tests of Sec. 
1.44-2, and A is allowed a credit of $2,000 on his 1975 tax return. On 
January 15, 1977 (within 36 months after acquisition) A sells his 
residence for an adjusted sales price of $50,000 and on March 15, 1977, 
purchases a new principal residence at a cost of $40,000. Since the new 
principal residence was purchased within the 18-month replacement period 
(provided in section 1034), the amount recaptured is limited to $400, 
determined by multiplying the amount of the credit allowed ($2,000) by a 
fraction, the numerator of which is $10,000 (determined by reducing the 
adjusted sales price of the old residence ($50,000) by A's cost of 
purchasing the new principal residence ($40,000)) and the denominator of 
which is $50,000 (the adjusted sales price). Therefore, A's tax 
liability for 1978, the year following the taxable year in which the 
disposition occurred, is increased by $400.

    (c) Certain involuntary dispositions. Section 44(d)(1) and paragraph 
(a) of this section shall not apply to the following:
    (1) A disposition of a residence made on account of the death of any 
individual having a legal or equitable interest therein occurring during 
the 36-month period described in paragraph (a) of this section,
    (2) A disposition of the residence if it is substantially or 
completely destroyed by a casualty described in section 165(c)(3),
    (3) A disposition of the residence if it is compulsorily and 
involuntarily converted within the meaning of section 1033(a), or
    (4) A disposition of the residence pursuant to a settlement in a 
divorce or legal separation proceeding where the other spouse retains 
the residence as principal residence (as defined in Sec. 1.44-5(a)).

[T.D. 7391, 40 FR 55854, Dec. 2, 1975; 40 FR 58138, Dec. 15, 1975]



Sec. 1.44-5  Definitions.

    For purposes of section 44 and the regulations thereunder--
    (a) New principal residence. The term ``new principal residence'' 
means a principal residence, the original use of which commences with 
the taxpayer. The term ``principal residence'' has the same meaning as 
under section 1034 of the Code. For this purpose, the term ``residence'' 
includes, without being limited to, a single family structure, a 
residential unit in a condominium or cooperative housing project, a 
townhouse, and a factory-made home. In the case of a tenant-stockholder 
in a cooperative housing corporation references to property used by the 
taxpayer as his principal residence and references to the residence of a 
taxpayer shall include stock held by the tenant-stockholder in a 
cooperative housing project provided, however, that the taxpayer used as 
his principal residence the house or apartment which he was entitled as 
such stockholder to occupy. ``Original use'' of the new principal 
residence by the taxpayer means that such residence has never been used 
as a residence prior to its use as such by the taxpayer. For this 
purpose, a residence will qualify if the first occupancy was by the 
taxpayer pursuant to a lease arrangement pending settlement under a 
binding contract to purchase or pursuant to a lease arrangement where a 
written option to purchase the then existing residence was contained in 
the original lease agreement.

A renovated building does not qualify as new, regardless of the extent 
of the renovation nor does a condominium conversion qualify.
    (b) Purchase price--(1) General rule. For purposes of section 44(a) 
and Sec. 1.44-1, the term ``purchase price'' means the adjusted basis 
of the new principal residence on the date of acquisition and includes 
all amounts attributable to the acquisition or construction, but only to 
the extent that such amounts constitute capital expenditures and are

[[Page 223]]

not allowable as deductions in computing taxable income. Such capital 
expenditures include but are not limited to the cost of acquisition or 
construction, title insurance, attorney's fees, transfer taxes, and 
other costs of transfer. For these purposes the adjusted basis of a 
factory-made home includes the cost of moving the home and setting it up 
as the taxpayer's principal residence only where such cost is included 
in the base price of the residence; it also includes the purchase price 
of the land on which the home is located, but only if such land was 
purchased by the taxpayer after March 12, 1975 and only if the taxpayer 
acquired the land prior to or in conjunction with the acquisition of 
such factory-made home. However, the adjusted basis does not include any 
expenditures involved in connection with the leasing of land on which 
the factory-made home is located. In the case of factory-made homes the 
adjusted basis includes furniture only where it is included in the base 
price of the unit.
    (2) Sale of old principal residence. (i) The adjusted basis is 
reduced by any gain from the sale or involuntary conversion of an old 
principal residence, which is not recognized due to the application of 
section 1033 or section 1034. However, no reduction will be made for any 
gain excluded from tax by reason of the special treatment provided under 
the tax laws in the case of a sale by a taxpayer who has attained age 65 
(section 121 of the code).
    (ii) The rules in subdivision (i) of this subparagraph are 
illustrated by the following examples:

    Example 1. A sells an old principal residence for $30,000 which has 
an adjusted basis of $20,000. A reinvests the proceeds by purchasing a 
new principal residence for $40,000 (including settlement costs which 
are capital in nature), and this purchase satisfies the statutory 
criteria under section 1034 for nonrecognition of gain. The credit under 
section 44 applies with respect to $30,000 ($40,000 costs minus $10,000 
unrecognized gain) of the cost of the new principal residence.
    Example 2. B and C, two sisters, purchase a new principal residence 
as joint tenants with the right of survivorship for a total purchase 
price of $40,000. B has previously sold her old principal residence for 
$25,000 and a $10,000 gain on the sale has qualified for nonrecognition 
under section 1034. B contributes $25,000 and C contributes $15,000. The 
adjusted basis of the new principal residence is $30,000 representing 
the total purchase price of $40,000 less $10,000 representing 
unrecognized gain under section 1034. The total credit allowable, 
therefore, is $1,500. Since joint tenants are treated as equal owners 
and since allocation of the credit is made in proportion to the 
taxpayer's respective ownership interests in such residence B and C each 
will receive a credit of $750.
    Example 3. Taxpayer D is 65 years old and sells his old principal 
residence for $20,000 excluding all gain under section 121. He then 
purchases a new principal residence for $30,000. D's adjusted basis in 
his new principal residence is $30,000, and he is allowed a credit of 
$1,500.

    (3) Tie-in sales. In the case of a purchase of a new principal 
residence which is tied in to the transfer of other property by the 
seller to the purchaser, whether purportedly by sale or gift, the 
adjusted basis of the residence is reduced by the amount of the excess 
of the fair market value of such other property received over the 
amount, if any, purportedly paid for it by the purchaser of the 
residence. For example, if a taxpayer receives a new car with a fair 
market value of $2,500 upon the purchase of a condominium apartment for 
a total purchase price of $40,000 (including settlement costs which are 
capital in nature) his adjusted basis in the residence for computation 
of the credit is $37,500.
    (4) Basis of new principal residence. The taxpayer's basis in his 
new principal residence is not in any way affected by the allowance of 
the credit.
    (c) Purchase--(1) General rule. Except as provided in subparagraph 
(2) of this paragraph, the term ``purchase'' means any acquisition of 
property.
    (2) Exceptions. (i) An acquisition does not qualify as a purchase 
for the purpose of this paragraph if the property is acquired from a 
person whose relationship to the person acquiring it would result in the 
disallowance of losses under section 267 or 707(b). Such persons 
include--
    (A) The purchaser's spouse, ancestors and lineal descendants,
    (B) Related corporations as provided under section 267(b)(2),
    (C) Related trusts as provided under section 267(b), (4), (5), (6), 
and (7),
    (D) Related charitable organizations as provided under section 
267(b)(9), and

[[Page 224]]

    (E) Related partnerships as provided under section 707(b)(1).

For purposes of this subdivision the constructive ownership rules of 
section 267(c) shall apply except that paragraph (4) of section 267(c) 
shall be treated as providing that the family of an individual shall 
include only his spouse, ancestors, and lineal descendants.
    (ii) An acquisition does not qualify as a purchase for the purpose 
of this paragraph if the basis of the property in the hands of the 
person acquiring such property is determined--
    (A) In whole or in part by reference to the adjusted basis of such 
property in the hands of the person from whom acquired (e.g., a gift 
under section 1015), or
    (B) Under section 1014(a) (relating to property acquired from a 
decedent).
    (d) Self-construction. The term ``self-construction'' means the 
construction of a residence (other than a factory-made home) to the 
taxpayer's specifications on land already owned or leased by the 
taxpayer at the time of commencement of construction. Thus, where a 
taxpayer purchases land and either builds a residence himself or hires 
an architect and a contractor to build a residence on that land, the 
taxpayer has ``self-constructed'' the residence.
    (e) Factory-made home. The term ``factory-made homes'' includes 
mobile homes, houseboats and prefabricated and modular homes.
    (f) Lowest offer. The term ``lowest offer'' means the lowest price 
at which the residence was offered for sale after February 28, 1975.

[T.D. 7391, 40 FR 55855, Dec. 2, 1975]



Sec. 1.44B-1  Credit for employment of certain new employees.

    (a) In general--(1) Targeted jobs credit. Under section 44B a 
taxpayer may elect to claim a credit for wages (as defined in section 
51(c) paid or incurred to members of a targeted group (as defined in 
section 51(d)). Generally, to qualify for the credit, the wages must be 
paid or incurred to members of a targeted group first hired after 
September 26, 1978. However, wages paid of incurred to a vocational 
rehabilitation referral (as defined in section 51(d)(2)) hired before 
September 27, 1978, may qualify for the credit if a credit under section 
44B (as in effect prior to enactment of the Revenue Act of 1978) was 
claimed for the individual by the taxpayer for a taxable year beginning 
before January 1, 1979. The amount of the credit shall be determined 
under section 51. Section 280C(b) (relating to the requirement that the 
deduction for wages be reduced by the amount of the credit) and the 
regulations thereunder will not apply to taxpayers who do not elect to 
claim the credit.
    (2) New jobs credit. Under section 44B (as in effect prior to 
enactment of the Revenue Act of 1978) a taxpayer may elect to claim as a 
credit the amount determined under sections 51, 52, and 53 (as in effect 
prior to enactment of the Revenue Act of 1978). Section 280C(b) 
(relating to the requirement that the deduction for wages be reduced by 
the amount of the credit) and the regulations thereunder will not apply 
to taxpayers who do not elect to claim the credit.
    (b) Time and manner of making election. The election to claim the 
targeted jobs credit and the new jobs credit is made by claiming the 
credit on an original return, or on an amended return, at any time 
before the expiration of the 3-year period beginning on the last date 
prescribed by law for filing the return for the taxable year (determined 
without regard to extensions). The election may be revoked within the 
above-described 3-year period by filing an amended return on which the 
credit is not claimed.
    (c) Election by partnership, electing small business corporation, 
and members of a controlled group. In the case of a partnership, the 
election shall be made by the partnership. In the case of an electing 
small business corporation (as defined in section 1371(a)), the election 
shall be made by the corporation. In the case of a controlled group of 
corporations (within the meaning of section 52(a) and the regulations 
issued thereunder) not filing a consolidlated return under section 1501, 
the election shall be made by each member of the group. In the case of 
an affiliated group

[[Page 225]]

filing a consolidated return under section 1501, the election shall be 
made by the group.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954 (92 Stat. 
2834, 26 U.S.C. 44B; 91 Stat. 148, 26 U.S.C. 381(c)(26); 68A Stat. 917, 
26 U.S.C. 7805)

[T.D. 7921, 48 FR 52904, Nov. 23, 1983]

   Research Credit--For Taxable Years Beginning Before January 1, 1990



Sec. 1.41-0A  Table of contents.

    This section lists the paragraphs contained in Sec. Sec. 1.41-0A, 
1.41-3A, 1.41-4A and 1.41-5A.

Sec. 1.41-0A Table of contents.
Sec. 1.41-3A Base period research expense.
    (a) Number of years in base period.
    (b) New taxpayers.
    (c) Definition of base period research expenses.
    (d) Special rules for short taxable years.
    (1) Short determination year.
    (2) Short base period year.
    (3) Years overlapping the effective dates of section 41 (section 
44F).
    (i) Determination years.
    (ii) Base period years.
    (4) Number of months in a short taxable year.
    (e) Examples.
Sec. 1.41-4A Qualified research for taxable years beginning before 
          January 1, 1986.
    (a) General rule.
    (b) Activities outside the United States.
    (1) In-house research.
    (2) Contract research.
    (c) Social sciences or humanities.
    (d) Research funded by any grant, contract, or otherwise.
    (1) In general.
    (2) Research in which taxpayer retains no rights.
    (3) Research in which the taxpayer retains substantial rights.
    (i) In general.
    (ii) Pro rata allocation.
    (iii) Project-by-project determination.
    (4) Independent research and development under the Federal 
Acquisition Regulations System and similar provisions.
    (5) Funding determinable only in subsequent taxable year.
    (6) Examples.
Sec. 1.41-5A Basic research for taxable years beginning before January 
          1, 1987.
    (a) In general.
    (b) Trade or business requirement.
    (c) Prepaid amounts.
    (1) In general.
    (2) Transfers of property.
    (d) Written research agreemen