[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2000 Edition]
[From the U.S. Government Printing Office]



[[Page i]]

          

                    26


          Part 1 (Secs. 1.0-1 to 1.60)

                         Revised as of April 1, 2000

Internal Revenue





          Containing a Codification of documents of general 
          applicability and future effect
          As of April 1, 2000
          With Ancillaries
          Published by
          Office of the Federal Register
          National Archives and Records
          Administration

As a Special Edition of the Federal Register



[[Page ii]]

                                      




                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2000



               For sale by U.S. Government Printing Office
 Superintendent of Documents, Mail Stop: SSOP, Washington, DC 20402-9328



[[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........................     527
      Alphabetical List of Agencies Appearing in the CFR......     545
      Table of OMB Control Numbers............................     555
      List of CFR Sections Affected...........................     573



[[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, 2000), 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, 1986, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, or 1973-1985, published in seven separate volumes. For 
the period beginning January 1, 1986, a ``List of CFR Sections 
Affected'' is published at the end of each CFR volume.

CFR INDEXES AND TABULAR GUIDES

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

REPUBLICATION OF MATERIAL

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

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-523-5227 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, Washington, DC 20408.

SALES

    The Government Printing Office (GPO) processes all sales and 
distribution of the CFR. For payment by credit card, call 202-512-1800, 
M-F 8 a.m. to 4 p.m. e.s.t. or fax your order to 202-512-2233, 24 hours 
a day. For payment by check, write to the Superintendent of Documents, 
Attn: New Orders, P.O. Box 371954, Pittsburgh, PA 15250-7954. For GPO 
Customer Service call 202-512-1803.

ELECTRONIC SERVICES

    The full text of the Code of Federal Regulations, the LSA (List of 
CFR Sections Affected), The United States Government Manual, the Federal 
Register, Public Laws, Weekly Compilation of Presidential Documents and 
the Privacy Act Compilation are available in electronic format at 
www.access.gpo.gov/nara (``GPO Access''). For more information, contact 
Electronic Information Dissemination Services, U.S. Government Printing 
Office. Phone 202-512-1530, or 888-293-6498 (toll-free). E-mail, 
[email protected]

[[Page vii]]

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

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

April 1, 2000.



[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of nineteen volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2000. The first twelve volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1-1.60; 
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850; 
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400 and 
Sec. 1.1401 to end. The thirteenth 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, Bonnie J. Fritts was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of 
Frances D. McDonald, assisted by Alomha S. Morris.

[[Page x]]





[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




            (This book contains Part 1, Secs. 1.0-1 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, Secs. 1.0-1 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(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

1.21-1  Changes in rate during a taxable year.
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).
1.28-0  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

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.
1.32-3T  Eligibility requirements (Temporary).
1.34-1  Credit against tax and exclusion from gross income in case of 
          dividends received by individuals.
1.34-2  Limitations on amount of credit.
1.34-3  Dividends to which the credit and exclusion apply.
1.34-4  Taxpayers not entitled to credit and exclusion.
1.34-5  Effective date; taxable years ending after July 31, 1954, 
          subject to the Internal Revenue Code of 1939.
1.34-6  Dividends received after December 31, 1964.
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).

             Taxable Years Beginning After December 31, 1986

1.41-0  Table of contents.
1.41-1  Introduction to regulations under section 41.
1.41-2  Qualified Research Expenses.
1.41-3  Base period research expense.
1.41-4  Qualified research for taxable years beginning after December 
          31, 1985. [Reserved]
1.41-5  Qualified research for taxable years beginning before January 1, 
          1986.
1.41-6  Basic research for taxable years beginning after December 31, 
          1985. [Reserved]

[[Page 6]]

1.41-7  Basic research for taxable years beginning before January 1, 
          1986.
1.41-8  Aggregation of expenditures.
1.41-9  Special rules.

             Taxable Years Beginning Before January 1, 1987

1.41-0  A Credit or deduction for political and newsletter fund 
          contributions--scope and note.
1.41-1A  Same--definitions of certain items.
1.41-2A  Same--limitations and special rules.
1.41-3A  Same--unspent contributions.
1.41-4A  Same--procedure for electing a credit or deduction.
1.41-5A  Same--verifications.
1.41-6A  Same--taxation of certain organizations.
1.41-7A  Same--transitional rule for past contributions.
1.41-8A  Same--effective dates.
1.42-0  Table of contents.
1.42-1  [Reserved]
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-1989 State housing credit ceiling 
          amounts.
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.
1.44A-1  Expenses for household and dependent care services necessary 
          for gainful employment.
1.44A-2  Limitations on amount creditable.
1.44A-3  Special rules applicable to married individuals.
1.44A-4  Other special rules relating to employment-related expenses.
1.44B-1  Credit for employment of certain new employees.

    rules for computing credit for investment in certain depreciable 
                                property

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.
1.48-4  Election of lessor of new section 38 property to treat lessee as 
          purchaser.

[[Page 7]]

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.
1.48-12T  Tax-exempt entity leasing (Temporary).
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--1.60  [Reserved]

    Authority: 26 U.S.C 7805, unless otherwise noted.
    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.
    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).
    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 is also issued under 26 U.S.C. 42(n);

[[Page 8]]

    Section 1.42-4 is also issued under 26 U.S.C. 42(n);
    Section 1.42-5 is 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 through 1.43-7 also issued under section 26 U.S.C. 
43;
    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 is 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 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

[[Page 9]]

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 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

[[Page 10]]

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 Puerto Rico during the entire taxable 
year is, except as provided in section 933 with respect to Puerto Rican 
source income, subject to taxation in the same manner as a resident 
alien individual. As to tax on nonresident alien individuals, see 
sections 871 and 877.
    (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.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 
44216, Dec. 23, 1974]



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-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

[[Page 11]]

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(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.

                           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 
($500 x 15%). The allocable parental tax is $1,225, the excess of 
$16,957.50 (the tax on $74,000, the parent's taxable income plus D's net 
unearned income) over $15,732.50 (the tax on $70,000, the parent's 
taxable income). 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

[[Page 12]]

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 
(5,00010,000 x 3,300) and B and C's share of the tax is $825 
(2,50010,000 x 3,300) 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 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

[[Page 13]]

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 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

[[Page 14]]

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 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

[[Page 15]]

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?
    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

[[Page 16]]

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........................................
                                                 -----------------------
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

[[Page 17]]

    (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 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

[[Page 18]]

    (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).
    (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

[[Page 19]]

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 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.

[[Page 20]]

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 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

[[Page 21]]

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 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]

[[Page 22]]



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 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

[[Page 23]]

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.
    (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

[[Page 24]]

business in the United States shall be taxable under section 11 only on 
their taxable income which is effectively connected with the conduct of 
a trade or business in the United States (see section 882(a)(1)). For 
definition of the terms ``corporations,'' ``domestic,'' and ``foreign,'' 
see section 7701(a) (3), (4), and (5), respectively. It is immaterial 
that a domestic corporation, and for taxable years beginning after 
December 31, 1966, a foreign corporation engaged in trade or business in 
the United States, which is subject to the tax imposed by section 11 may 
derive no income from sources within the United States. The tax imposed 
by section 11 is payable upon the basis of the returns rendered by the 
corporations liable thereto, except that in some cases a tax is to be 
paid at the source of the income. See subchapter A (sections 6001 and 
following), chapter 61 of the Code, and section 1442.
    (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 Secs. 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

[[Page 25]]

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]

                 Changes in Rates During a Taxable Year



Sec. 1.21-1  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

[[Page 26]]

of 1969 repealed section 1562, which imposed a 6 percent additional tax 
on controlled corporations electing multiple surtax exemptions, 
effective for taxable years beginning after December 31, 1974. For such 
controlled corporations having taxable years beginning in 1974 and 
ending in 1975, the rate for the period ending before January 1, 1975, 
would be 6 percent; the rate for the period beginning after December 31, 
1974, would be zero. However, subject to the rules stated in this 
section, section 21 does not apply to the imposition of a new tax. For 
example, if a new tax is imposed for taxable years beginning on or after 
July 1, 1972, a computation under section 21 would not be required with 
respect to such new tax in the case of taxable years beginning before 
July 1, 1972, and ending on or after that date. If the effective date of 
the imposition of a new tax and the effective date of a change in rate 
of such tax fall in the same taxable year, section 21 is not applicable 
in computing the taxpayer's liability for such tax for such year unless 
the new tax is expressly imposed upon the taxpayer for a portion of his 
taxable year prior to the change in rate.
    (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

[[Page 27]]

specified, with corresponding changes being made in subsequent brackets, 
section 21 would be applicable. The enactment of sections 1561 and 1562 
is considered a change in section 11(d) which constitutes a change in 
rate for the period ending after December 31, 1963. The amendment of 
section 1561 and the repeal of section 1562 by the Tax Reform Act of 
1969 is considered a change in section 11(d) which constitutes a change 
in rate for the period ending after December 31, 1974. The repeal of the 
2 percent additional tax imposed under section 1503 on corporations 
filing consolidated returns constitutes a change in rate for the period 
ending after December 31, 1963. The addition to the Code of section 1348 
(relating to 50 percent maximum rate on earned income) is a change in 
rate to which section 21(a) is applicable. The amendment of section 
11(d) by the Tax Reduction Act of 1975 which increases to $50,000 the 
surtax exemption for a taxable year ending during 1975 constitutes a 
change in rate for such portion of the taxable year (if less than the 
entire taxable year) as follows December 31, 1974. Similarly, the return 
of the surtax exemption to $25,000 for a taxable year ending during 1976 
constitutes a change in rate for such portion of the taxable year (if 
less than the entire taxable year) as follows December 31, 1975.
    (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

[[Page 28]]

be one of several taxes, the basis of selection being the tax that is 
greater or lesser. See, for example, sections 821 and 1201. If in any 
such case the rate of any one of these taxes changes, then the tentative 
taxes computed as provided by section 21 for each period shall be 
computed employing the tax selected in accordance with the general rule 
of selection for such a case, at the rate of tax in effect for such 
period. Thus, if a change in the rate of the alternative tax under 
section 1201 is such that the alternative tax under section 1201 is 
applicable if the old rate is used and is not applicable if the new rate 
is used, one tentative tax will consist of the alternative tax under 
section 1201 and the other tentative tax will consist of the tax imposed 
by the other applicable sections of chapter 1 of the Code. The two 
tentative taxes so computed are then prorated in accordance with section 
21(a)(2) and the sum of the proportionate amounts is the tax imposed for 
the taxable year under chapter 1 of the Code. See the examples in 
paragraph (n) of this section.
    (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).
                                     ------------

[[Page 29]]

 
                                          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
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
                                                             ===========

[[Page 30]]

 
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..........
                                                 =============
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:
  ($215,350 x
  $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

[[Page 31]]

 
  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 
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 ($25,0005). 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..................
                                         =================

[[Page 32]]

 
                           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
                                         =================
 

    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]



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,

[[Page 33]]

but not in excess of $2,000 of such expenditures. See Sec. 1.23-2(a) for 
the definition of energy conservation expenditures.
    (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

[[Page 34]]

amount of such grants is taxable as gross income to the taxpayer under 
section 61 (relating to the definition of gross income) and the 
regulations thereunder. In the case of taxable years beginning after 
December 31, 1980, qualified expenditures made from subsidized energy 
financing (as defined in 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

[[Page 35]]

    (J) Section 44B (relating to employment of certain new employees).
    (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

[[Page 36]]

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

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 37]]

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 38]]

    (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 39]]

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 40]]

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 41]]

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 42]]

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 43]]


    (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 44]]

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

[[Page 45]]

(or would be assessed in the case where expenditures are from general 
funds) by the association as a result of such expenditures. The 
residential energy credit for a qualified expenditure is allowable for 
the year in which the association or corporation has completed original 
installation of the item (or has paid or incurred the expenditure, if 
later). For purposes of this paragraph, the term ``condominium 
management association'' means an organization meeting the requirements 
of section 528(c)(1) of the Code (other than subparagraph (E) of that 
section), with respect to a condominium project substantially all the 
units of which are used as residences.
    (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 46]]



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 47]]

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 48]]

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 49]]

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 50]]

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 51]]

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 Secs. 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 52]]

    (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 Secs. 1.25-1T through 1.25-8T, an 
affidavit filed in connection with the requirements of Secs. 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 
Secs. 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 53]]

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 ((.3 x $50,000) + (.25 x $100,000) + (.1 x $50,000) + 
(.1 x $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 54]]

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) through (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) through (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

[[Page 55]]

would otherwise have been allowable by multiplying the interest that was 
scheduled to have been paid on the refinanced loan by the certificate 
rate of the existing certificate. In the case of a series of 
refinancings, the tax credit that would otherwise have been allowable is 
determined from the amount of interest that was scheduled to have been 
paid on the original loan and the certificate rate of the original 
certificate.
    (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

[[Page 56]]

    (2) Obtaining the amount of interest, and calculating the amount of 
credit that would have been available, from the schedule of equal 
payments that fully amortize a hypothetical loan with the principal 
amount equal to the remaining outstanding balance of the certified 
mortgage indebtedness specified on the existing certificate, the 
interest equal to the annual percentage rate (APR) of the refinancing 
loan, and the maturity equal to that of the refinanced loan.
    (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 Secs. 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

[[Page 57]]

from the holder of the certificate an affidavit stating that he had no 
present ownership interest in a principal residence at any time during 
the 3-year period prior to the date of which the certificate is issued 
and the issuer or its agent obtains from the applicant copies of the 
applicant's Federal tax returns for the preceding 3 years and examines 
each statement to determine whether the applicant has claimed a 
deduction for taxes on property which was the applicant's principal 
residence pursuant to section 164(a)(1) or a deduction pursuant to 
section 163 for interest paid on a mortgage secured by property which 
was the applicant's principal residence. Where the mortgage is executed 
during the period between January 1 and February 15 and the applicant 
has not yet filed has Federal income tax return with the Internal 
Revenue Service, the issuer may, with respect to such year, rely on an 
affidavit of the applicant that the applicant is not entitled to claim 
deductions for taxes or interest on indebtedness with respect to 
property constituting his principal residence for the preceding calendar 
year. In the alternative, when applicable, the holder may provide an 
affidavit stating that one of the exceptions provided in paragraph 
(e)(2) applies.
    (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

[[Page 58]]

103A(j)(1) and the regulations thereunder for examples illustrating the 
application of these requirements.
    (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

[[Page 59]]

basis for such limitation if the issuer establishes to the satisfaction 
of the Commissioner that it will result in a significant economic 
benefit to the holders of mortgage credit certificates (e.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.

[[Page 60]]

    (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 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 Secs. 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

[[Page 61]]

the authority to issue qualified mortgage bonds.
    (c) Election not to issue qualified mortgage bonds--(1) In general. 
A program meets the requirements of this paragraph only if the issuer 
elects, in the time and manner specified in this paragraph, not to issue 
an amount of qualified mortgage bonds that it may otherwise issue during 
the calendar year under section 103A and the regulations thereunder.
    (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

[[Page 62]]

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.
    (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

[[Page 63]]

format set forth in this paragraph and contains the information required 
by this paragraph. The report must be titled ``Mortgage Credit 
Certificate Information Report'' and must include the name, address, and 
TIN of the issuer, the reporting period for which the information is 
provided, and the following tables containing information concerning the 
holders of certificates issued during the reporting period for which the 
report is filed:
    (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

[[Page 64]]

of the certified indebtedness amount with respect to such certificates, 
and the sum of the products of the certified indebtedness amount and the 
certificate credit rate for each certificate; the information contained 
in the table must also be categorized according to whether the 
residences with respect to which the certificates were provided are 
located in targeted areas.
    (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 65]]


                                                              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 66]]


     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 67]]

    (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 68]]

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 69]]

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 70]]

    (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 (2,000 x 
(.2 x $50,000)). Since this amount does not exceed 20 percent of the 
nonissued bond amount (.2 x $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 (.2 x $100 million); the excess credit

[[Page 71]]

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 72]]

    (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 73]]

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. 1.28-0  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.
    (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.

[[Page 74]]

    (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 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

[[Page 75]]

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 (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.

[[Page 76]]

    (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 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

[[Page 77]]

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 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

[[Page 78]]

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).
    (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,

[[Page 79]]

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.
    (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.

[[Page 80]]

    (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--
    (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.

[[Page 81]]

    (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 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



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

[[Page 82]]

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.
    (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.

[[Page 83]]

    (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 ($2,000 x 66 \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, 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

[[Page 84]]

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 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) Allowance of credit. For taxable years beginning after December 
31,

[[Page 85]]

1978, subject to the limitations of paragraph (b) of this section, an 
eligible individual (as defined in paragraph (c)(1) of this section) is 
allowed as a credit against the tax imposed by subtitle A of the Code 
for the taxable year, an amount equal to 10 percent of the first $5,000 
of earned income (as defined in paragraph (c)(2) of this section) for 
the taxable year. For earlier taxable years beginning before January 1, 
1979, see Sec. 1.43-1.
    (b) Limitations--(1) Amount of credit. The amount of the credit 
allowed by section 43 and paragraph (a) of this section for the taxable 
year must not exceed the excess, if any, of $500 over 12.5 percent of 
that amount of the adjusted gross income (or, if greater, the earned 
income) of the taxpayer for the taxable year which exceeds $6,000. For 
the meaning of the term ``earned income,'' see paragraph (c)(2) of this 
section. Adjusted gross income is determined under section 62 and the 
regulations thereunder. If an individual has adjusted gross income or 
earned income of $10,000 or more, the individual is not entitled to the 
credit.
    (2) Married individuals. No credit is allowed by section 43 and 
paragraph (a) of this section in the case of an eligible individual who 
is married (within the meaning of section 143 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 143(b) and the regulations thereunder (relating to certain 
married individuals living apart).
    (3) Length of taxable year. No credit is allowed by section 43 and 
paragraph (a) of this section 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) Eligible individual. For purposes of this 
section, an eligible individual is an individual who meets the following 
requirements of this paragraph (c)(1).
    (i) For the taxable year the individual must meet any one of the 
following three requirements set forth, respectively, in (A), (B), and 
(C) of this subdivision (i).
    (A) The individual must be married (within the meaning of section 
143 and the regulations thereunder) and be entitled to a deduction under 
section 151 for a child (within the meaning of section 151(e)(3) and the 
regulations thereunder). The child must have the same principal place of 
abode (as defined in Sec. 1.2-2(c)) as the individual and that principal 
place of abode must be in the United States for the entire taxable year.
    (B) The individual must qualify as a surviving spouse (as determined 
under section 2(a) and the regulations thereunder). Thus, the spouse of 
the individual must have died within the period of the 2 taxable years 
immediately preceding the individual's taxable year. Also, the 
individual must have furnished over half the cost of maintaining as the 
individual's home a household in the United States for the entire 
taxable year which is the principal place of abode of a child of the 
individual who qualifies as a dependent for whom the individual is 
entitled to a deduction under section 151.
    (C) The individual must qualify as a head of household (as 
determined under section 2(b) and the regulations thereunder but without 
regard to section 2(b)(1)(A)(ii) and (B) and the regulations, 
thereunder). Thus, the individual cannot be married as of the close of 
the taxable year and also cannot qualify as a surviving spouse under 
section 2(a). Also, the individual must have furnished over half the 
cost of maintaining as the individual's home a household in the United 
States for the entire taxable year which is the principal place of abode 
of a child or descendant of the individual who is unmarried or who 
qualifies as a dependent for whom the individual is entitled to a 
deduction under section 151.
    (ii) For the entire taxable year, the individual must not be 
entitled to exclude any amount from gross income under section 911 
(relating to earned income by individuals in certain camps outside the 
United States) or section

[[Page 86]]

931 and the regulations thereunder (relating to income from sources 
within the possessions of the United States).
    (iii) The rules of this paragraph (c)(1) are illustrated by the 
following examples:

    Example 1. A, who is married and a member of the United States Armed 
Forces, maintains his household outside the United States for part of 
the taxable year. A is not an eligible individual. However, if A 
maintains his household inside the United States for the entire taxable 
year and is only temporarily absent therefrom by reason of military 
service and if the household is his principal place of abode and the 
principal place of abode of his child who receives over half of his 
support from the taxpayer for the calendar year in which the taxable 
year of the taxpayer begins and who either has less than $1,000 of gross 
income for the calendar year in which the individual's taxable year 
begins or who has not attained the age of 19 at the close of the 
calendar year in which the individual's taxable year begins or is a 
student, then the individual is an eligible individual if he meets the 
requirements of subdivision (ii) of this paragraph.
    Example 2. B's wife died in 1975 and B has not remarried. For his 
entire taxable year beginning January 1, 1979, B maintains his household 
inside the United States. The household is, for the entire taxable year, 
B's principal place of abode and the principal place of abode of B's 
unmarried grandchild whose natural parents are deceased. Thus B 
qualifies as a head of household (as determined under section 2(b) 
without regard to subparagraphs (A)(ii) and (B) of section 2(b)(1)). In 
these circumstances, regardless of whether B provides sufficient support 
to claim the grandchild as a dependent, B is an eligible individual if 
he meets the requirements of subdivision (ii) of this paragraph.
    Example 3. C is married and maintains his household inside the 
United States for the entire taxable year. The household is his 
principal place of abode and, for the entire year, is also the principal 
place of abode of a 12 year old child whose natural parents are deceased 
and who is placed with C by a State agency to provide the child with 
foster care. C receives compensation from the State agency to cover all 
of the cost of maintaining the child in his home. The child is in C's 
care and is cared for as C's own child. In these circumstances, the 
child is C's foster child, but C is not able to claim the child as a 
dependent since C did not provide half the child's support for the year. 
C is not eligible for the earned income credit.
    Example 4. Assume the same facts as in example (3) except that C 
receives no compensation from the State agency, and C provides over half 
the child's support and is able to claim the child as a dependent. C is 
an eligible individual if he meets the requirements of subdivision (ii) 
of this paragraph.
    Example 5. D's husband died in 1974 and D has not remarried. For the 
entire taxable year beginning January 1, 1979, D maintains her household 
inside the United States. The household is D's principal place of abode 
and, for the entire taxable year, is also the principal place of abode 
of D's unmarried son. D cares for her son in all respects except that 
her parents provide over half of the son's support. D qualifies as a 
head of household (as determined under section 2(b) without regard to 
subparagraph (A)(ii) and (B) of section 2(b)(1)). D is an eligible 
individual if D meets the requirements of subdivision (ii) of this 
paragraph.
    Example 6. Assume the same facts as in example 5 except that D is 
married. Since D cannot qualify as a head of household, and D's son 
cannot be claimed as D's dependent, D is not an eligible individual.

    (2) Earned income. For purposes of this section, earned income 
means--
    (i) Wages, salaries, tips, other employee compensation, and
    (iii) Net earnings from self-employment (within the meaning of 
section 1402(a) and the regulations thereunder).

Earned income includes compensation excluded from gross income, such as 
disability income excluded under section 105(d), the rental value of a 
parsonage excluded under section 107, and the value of meals and lodging 
furnished for the convenience of the employer excluded under section 
119. 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) Examples. The application of this section is illustrated by the 
following examples. For purposes of these examples, assume that the 
eligible individual does not receive a pension, an annuity, or an amount 
to which section 871(a), 911, or 931 applies.

    Example 1 . A and B (married individuals) maintain a household 
inside the United

[[Page 87]]

States which is their principal place of abode and the principal place 
of abode of their two children who are 12 and 14 years old. A and B are 
calendar year taxpayers and, for 1979, they file a joint return. A and B 
have a total earned income of $7,600 (computed without regard to any 
community property laws) and have adjusted gross income of less than 
$7,600. The earned income credit of $300 is determined as follows:

Basic credit (10 percent of $5,000 under    ........  ........      $500
 paragraph (a) of this section)...........
Initial limitation amount.................  ........      $500  ........
Less: Reduction under paragraph (b)(1) of
 this section:
Earned income for taxable year............    $7,600  ........  ........
Less......................................    $6,000  ........  ........
                                           ----------
Excess over $6,000........................     1,600  ........  ........
                                           ==========
12\1/2\ percent of excess ($1,600)........  ........      $200  ........
                                                               ---------
Maximum credit (if less than basic credit)  ........  ........      $300
 

    Example 2 . Assume the same facts as in example 1 except that A and 
B have earned income of $4,000 and adjusted gross income of $7,000. The 
earned income credit of $375 is determined as follows:

Basic credit (10 percent of $4,000 under    ........  ........      $400
 paragraph (a) of this section)...........
Initial limitation amount.................  ........      $500  ........
Less: Reduction under paragraph (b)(1) of
 this section:
Adjusted gross income for taxable year....    $7,000  ........  ........
Less......................................     6,000  ........  ........
                                           ----------
Excess over $6,000........................     1,000  ........  ........
                                           ==========
12\1/2\ percent of excess ($1,000)........  ........       125  ........
                                                               ---------
Maximum credit (if less than basic credit)  ........  ........       375
 


    (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 Code for purposes of 
determining the amount of any credit (other than the earned income 
credit) allowable under subpart A, part IV, subchapter A, chapter 1 of 
the Code.

[T.D. 7683, 45 FR 16175, Mar. 13, 1980. Redesignated by T.D. 8448, 57 FR 
54923, Nov. 23, 1992]



Sec. 1.32-3T  Eligibility requirements (Temporary).

    (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.
    (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, no claim for the EIC filed subsequent to the denial 
is allowed unless the taxpayer properly completes Form 8862, Information 
To Claim Earned Income Credit After Disallowance, 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 attach Form 8862 to the 
taxpayer's first income tax return on which the taxpayer claims the EIC 
after the EIC has been denied as a result of the deficiency procedures.

[[Page 88]]

    (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)(J) [(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. 8773, 63 FR 34596, June 25, 1998]



Sec. 1.34-1  Credit against tax and exclusion from gross income in case of dividends received by individuals.

    (a) In general. (1) Section 34 provides a credit against the income 
tax of an individual for certain dividends received after July 31, 1954, 
and on or before December 31, 1964. The credit, subject to the 
limitations provided in section 34(b), is equal to 4 percent of the 
dividends received before January 1, 1964, and 2 percent of the 
dividends received during the calendar year 1964. The credit is 
allowable with respect to dividends received in any taxable year ending 
after July 31, 1954, but applies only to dividends received on or before 
December 31, 1964. The credit applies only to dividends which are 
received from domestic corporations and which are included in the gross 
income of the taxpayer. Section 116 provides for the exclusion from 
gross income of the first $100 ($50 for dividends received in taxable 
years beginning before January 1, 1964) of certain dividends received by 
an individual. See Sec. 1.116-1. In determining which dividends are 
entitled to the credit against income tax provided by section 34, the 
exclusion from gross income provided in section 116 is applied to the 
first dividends received in the taxable year. Since the exclusion 
applies to dividends received at any time during a taxable year ending 
after July 31, 1954, dividends received before August 1, 1954, may be 
taken into account in determining the exclusion from gross income under 
section 116 but do not constitute dividends for which a credit is 
allowed.
    (2) The application of section 34 (without regard to the limitations 
provided in section 34(b)) may be illustrated by the following example:

    Example. A, an individual who makes his return on the basis of the 
calendar year, receives in the year 1954 the following dividends: $100 
on March 1, $100 on June 1, $100 on September 1, and $100 on December 1. 
$50 of the dividends received by A on March 1, 1954, is excluded from 
gross income under section 116. The balance of the dividends received in 
1954, amounting to $350, is includible in the gross income of A. Subject 
to the limitation in section 34(b) a credit of $8 is allowed under 
section 34 (4 percent of $200, the amount of the dividends received 
after July 31, 1954, that is, $100 received on September 1, 1954, and 
$100 received on December 1, 1954).

    (b) Tax credit. The credit is used to reduce the tax imposed by 
Subtitle A of the Code, including the alternative tax under section 1201 
in the case of capital gains and the self-employment tax under chapter 2 
of the Code; however, it may not be used by the taxpayer as a credit 
against penalties, additions to the tax, or interest on delinquent 
taxes.
    (c) Joint return of husband and wife. (1) In the case of a joint 
return the credit is determined on the basis of the dividends received 
by both the husband and wife after taking into account the exclusion 
allowed by section 116. See Sec. 1.116-1. The credit is allowable in the 
case of a joint return on account of the dividends received by each 
spouse without regard to whether the spouse would be liable for the tax 
imposed by Subtitle A if the joint return had not been filed. However, 
the limitations on amount of credit in section 34(b) are determined by 
reference to the tax and the credit under section 33 required to be 
shown on the joint return and to the combined taxable income of husband 
and wife. For this purpose, it makes no difference whether the tax, the 
credit, or the taxable income is attributable to one or the other 
spouse. If both the husband and wife are entitled to the

[[Page 89]]

credit, their combined credit shall not exceed the amount so computed.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following examples:

    Example 1. H and W, husband and wife, make a joint return for the 
calendar year 1954. The only dividend received by either of them during 
the year is a dividend received by H on September 1 in the amount of 
$400. Subject to the limitations of section 34(b), the credit amounts to 
$14 (4 percent of $350, the dividends included in gross income after 
allowance of the exclusion of $50 under section 116).
    Example 2. The facts are the same as in example (1) except that W 
also received a dividend on September 1 of $30. Since this dividend 
(being less than the maximum amount allowable as an exclusion under 
section 116(a)) is excluded from W's gross income, it does not affect 
the computation of the tax credit and the tax credit is the same as in 
example (1).
    Example 3. H and W, husband and wife, make a joint return for the 
calendar year 1954. H and W each received a $400 dividend on September 
1, 1954, and these were the only dividends received by them in 1954. 
Since H and W may each exclude $50 of the dividends received by them, 
$700 of dividend income is included in gross income. Subject to the 
limitations in section 34(b), the credit against the tax of H and W 
amounts to $28 (4 percent of $700).

    (d) Individuals receiving dividends. Where two or more persons hold 
stock as tenants in common, as joint tenants, or as tenants by the 
entirety, the dividends received with respect to such stock shall be 
considered as being received by each tenant to the extent that he is 
entitled under local law to a share of such dividends. Where dividends 
constitute community property under local law each spouse shall be 
considered as receiving one-half of such dividends.
    (e) Time dividends are received. In cases where it is necessary to 
determine the time of receipt of dividends, the rules established to 
determine in which taxable year dividends must be included in gross 
income apply, including the rules relating to constructive receipt. See 
section 451 and regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6777, 29 FR 
17806, Dec. 16, 1964]



Sec. 1.34-2  Limitations on amount of credit.

    (a) Under section 34(b) the credit may not exceed the lesser of 
either--
    (1) The amount of the tax imposed by chapter 1 of the Code for the 
taxable year reduced by the foreign tax credit allowable under section 
33, or
    (2) Whichever of the following is applicable:
    (i) In the case of a taxable year ending before January 1, 1955, or 
beginning after December 31, 1963, 2 percent of the taxable income for 
such taxable year;
    (ii) In the case of a taxable year ending after December 31, 1954, 
and beginning before January 1, 1964, 4 percent of the taxable income 
for such taxable year. In the case of a taxpayer who computes his tax 
under section 3 or who uses the standard deduction provided by section 
141, the taxable income for the taxable year is the adjusted gross 
income for the taxable year reduced by the standard deduction prescribed 
in section 141 and the deductions for personal exemptions provided in 
section 151. Where the alternative tax on capital gains is imposed under 
section 1201(b), the taxable income for such taxable year is the taxable 
income as defined in section 63, which includes 50 percent of the excess 
of net long-term capital gain over net short-term capital loss.
    (b) The application of the limitations in paragraph (a) of this 
section may be illustrated by the following example:

    Example. Assume the following facts in the case of an individual 
whose taxable year is the calendar year:

                                  1954

    Computation of tax liability without regard to the dividend received 
credit:

(1) Gross income............................................      $7,500
(2) Deductions..............................................       2,900
(3) Taxable income..........................................       4,600
(4) Income tax liability....................................         996
(5) Foreign tax credit......................................          16
(6) Income tax liability minus foreign tax credit...........         980
 

    Computation of limitation under section 34(b)(1):

(7) Dividends for which credit is allowable.................      $2,500
(8) Dividends received credit under section 34(a); (2,500 x          100
 0.04)......................................................
(9) Dividends received credit, as limited by section                 100
 34(b)(1); (item (6) or item (8) whichever is lesser).......
 

    Computation of limitation under section 34(b)(2):

[[Page 90]]



(10) Taxable income.........................................      $4,600
(11) Dividends received credit under section 34(b)(2);                92
 (4,600 x 0.02).............................................
 

    Dividends received credit allowable:

Item (6), item (9), or item (11), whichever is lesser.......         $92
 

                                  1955

    Computation of tax liability without regard to the dividend received 
credit:

(12) Gross income...........................................      $7,500
(13) Deductions.............................................       2,900
(14) Taxable income.........................................       4,600
(15) Income tax liability...................................         996
(16) Foreign tax credit.....................................         816
(17) Income tax liability minus foreign tax credit..........         180
 

    Computation of limitation under section 34(b)(1):

 
 
 
(18) Dividends for which credit is allowable................      $2,500
(19) Dividends received credit under section 34(a); (2,500 x         100
 0.04)......................................................
(20) Dividends received credit as limited by section                 100
 34(b)(1); (item (17) or item (19) whichever is lesser).....
 

    Computation of limitation under section 34(b)(2):

 
 
 
(21) Taxable income.........................................      $4,600
(22) Dividends received credit under section 34(b)(2);               184
 (4,600 x 0.04).............................................
 

    Dividends received credit allowable:

 
 
 
Item (17), item (19), or item (22), whichever is lesser.....        $100
 


[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6777, 29 FR 
17807, Dec. 16, 1964]



Sec. 1.34-3  Dividends to which the credit and exclusion apply.

    (a) General rule. The credit under section 34 and the exclusion 
under section 116 apply only to distributions of property defined as 
dividends by section 316. Thus, the credit and the exclusion are not 
allowed with respect to patronage dividends paid by either exempt or 
taxable farm cooperatives. Nor are they allowed for distributions to 
nonstockholding policyholders by an insurance company having shares of 
stock or for any distribution by a mutual insurance company. See 
paragraph (b) of this section for an additional restriction with respect 
to stock life insurance companies. The credit and the exclusion are, 
however, allowed with respect to dividends paid on capital stock by 
nonexempt cooperatives and with respect to dividends paid on capital 
stock by building and loan associations. However, see paragraph (b) of 
this section with respect to so-called dividends paid by building and 
loan associations ineligible for the credit and the exclusion. The 
credit and the exclusion are allowed with respect to distributions from 
any organization taxed as a corporation if the distribution falls within 
the definition of a dividend in section 316.
    (b) Dividends from certain corporations. (1) Section 34 (c) and (d) 
contains further restrictions on the type of distributions which are 
treated as dividends for purposes of the credit and exclusion. Thus, no 
credit or exclusion is applicable with respect to dividends received 
from a corporation organized under the China Trade Act, 1922; from stock 
life insurance companies before January 1, 1959, in taxable years ending 
before such date; from corporations which during their taxable year of 
the distribution or their preceding taxable year were corporations to 
which section 931 applies (relating to income from sources within 
possessions of the United States); from corporations which during the 
taxable year of the distribution or the preceding taxable year are 
corporations exempt from tax either under section 501, relating to 
charitable, etc., organizations, or under section 521, relating to 
farmers' cooperative associations.
    (2) So-called dividends paid by mutual savings banks, cooperative 
banks, and building and loan associations which are allowed as a 
deduction under section 591 are ineligible for the credit and exclusion.
    (3) For special rules as to the limitation on the amount of 
dividends for which a credit and exclusion are allowable in the case of 
dividends paid by a regulated investment company, see section 854 and 
the regulations thereunder.
    (4) See section 857(c) and paragraph (d) of Sec. 1.857-4 for special 
rules which deny a credit under section 34 and exclusion under section 
116 in the case of dividends received from a real estate

[[Page 91]]

investment trust with respect to a taxable year for which such trust is 
taxable under part II, subchapter M, chapter 1 of the Code.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4092, Apr. 28, 1962; T.D. 6625, 27 FR 12541, Dec. 19, 1962]



Sec. 1.34-4  Taxpayers not entitled to credit and exclusion.

    (a) The credit or exclusion is not available to nonresident aliens 
with respect to whom a tax is imposed for the taxable year under section 
871(a). If the taxpayer elects under section 6014 to have the Government 
compute his tax, the credit is not taken into account in such 
computation although the taxpayer is allowed the exclusion under section 
116.
    (b) For treatment of dividends received by estates or trusts, and 
the allocation of such dividends between an estate or trust and the 
beneficiary thereof, see sections 642, 652, and 662 and the regulations 
thereunder. 3
    (c) For treatment of dividends received by a partnership see section 
702 and the regulations thereunder.
    (d) For treatment of dividends received by a common trust fund, see 
section 584 and the regulations thereunder.



Sec. 1.34-5  Effective date; taxable years ending after July 31, 1954, subject to the Internal Revenue Code of 1939.

    Pursuant to section 7851(a)(1)(C), the regulations prescribed in 
Secs. 1.34-1 to 1.34-4, inclusive, shall also apply to taxable years 
beginning before January 1, 1954, and ending after July 31, 1954, and to 
taxable years beginning after December 31, 1953, and ending after July 
31, 1954, but before August 17, 1954, though such years are subject to 
the Internal Revenue Code of 1939.



Sec. 1.34-6  Dividends received after December 31, 1964.

    In the case of dividends received after December 31, 1964, section 
34 and the regulations issued thereunder do not apply.

[T.D. 6777, 29 FR 17807, Dec. 16, 1964]



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
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.

[[Page 92]]



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 Secs. 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 Secs. 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
 


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

[[Page 93]]

 
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 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

[[Page 94]]

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.

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.

[[Page 95]]

    (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
                                                             ===========
  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

[[Page 96]]

 
      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 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]

[[Page 97]]

             Taxable Years Beginning After December 31, 1986

    Source: Sections 1.41-0--1.41-9 appear by T.D. 8251, 54 FR 21204, 
May 17, 1989, unless otherwise noted.



Sec. 1.41-0  Table of contents.

    This section lists the paragraphs contained in Secs. 1.41-0 through 
1.41-9.

                     Sec. 1.41-0  Table of Contents.

       Sec. 1.41-1  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 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. 1.41-4  Qualified research for taxable years beginning after 
                      December 31, 1985. [Reserved]

   Sec. 1.41-5  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 arts 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. 1.41-6  Basic research for taxable years beginning after December 
                          31, 1985. [Reserved]

 Sec. 1.41-7  Basic research for taxable years beginning before January 
                                 1, 1986

    (a) In general.
    (b) Trade or business requirement.
    (c) Prepaid amounts.
    (1) In general.
    (2) Transfers of property.
    (d) Written research agreement.
    (1) In general.
    (2) Agreement between a corporation and a qualified organization 
after June 30, 1983.
    (i) In general.
    (ii) Transfers of property.
    (3) Agreement between a qualified fund and a qualified educational 
organization after June 30, 1983.
    (e) Exclusions.
    (1) Research conducted outside the United States.
    (2) Research in the social sciences or humanities.
    (f) Procedure for making an election to be treated as a qualified 
fund.

                Sec. 1.41-8  Aggregation of expenditures.

    (a) Controlled group of corporations; trade or businesses under 
common control.
    (1) In general.
    (2) Definition of trade or business.
    (3) Determination of common control.
    (4) Examples.
    (b) Minimum base period research expenses.
    (c) Tax accounting periods used.
    (1) In general.
    (2) Special rule where timing of research is manipulated.

[[Page 98]]

    (d) Membership during taxable year in more than one group.
    (e) Intra-group transactions.
    (1) In general.
    (2) In-house research expenses.
    (3) Contract research expenses.
    (4) Lease Payments.
    (5) Payment for supplies.

                       Sec. 1.41-9  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. 1.41-1  Introduction to regulations under section 41.

    Sections 1.41-2 through 1.41-9 deal only with certain provisions of 
section 41. The following table identifies the provisions of section 41 
that are dealt with, and lists each with the section of the regulations 
in which it is covered:


------------------------------------------------------------------------
        Section of the regulations               Section of the Code
------------------------------------------------------------------------
1.41-2....................................  41(b)(1)
                                            41(b)(2)(A)(ii)
                                            41(b)(2)(A)(iii)
                                            41(b)(2)(B)
                                            41(b)(3)
1.41-3....................................  41(c)(2)
                                            41(f)(4)
1.41-5....................................  41(d)
1.41-7....................................  41(e)
1.41-8....................................  41(f)(1)
1.41-9....................................  41(f)(2)
                                            41(f)(3)
                                            41(g)
------------------------------------------------------------------------


Sections 1.41-4 and 1.41-6 deal with the definition of qualified 
research and basic research for taxable years beginning after December 
31, 1985. Section 1.41-3 also deals with 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 sections 30 and 44F. The regulations refer to these 
sections as section 41 for conformity purposes. Of course, whether 
section 41, 30 or 44F applies to a particular expenditure depends upon 
when the expenditure was paid or incurred.



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

[[Page 99]]

of another person and retains no substantial rights in the research, 
that research shall not be taken into account by the taxpayer for 
purposes of section 41. See Sec. 1.41-5(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. 1.41-5(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. 1.41-9(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

[[Page 100]]

joint venture cannot claim the research credit for such expenses because 
it is not carrying on the trade or business to which the research 
relates. In addition A, B, and C are all entitled to make independent 
use of the results of the research. First, the amount of qualified 
research expenses of the joint venture is $l00x. Second, this amount is 
reduced by the proportionate share of such expenses allocable to C, the 
venturer which would not have been able to claim such expenses as 
qualified research expenditures if it had paid or incurred them 
directly, C's proportionate share of such expenses is $40x (40% of 
$100x). The reduced amount is $60x. Third, the remaining $60x of 
qualified research expenses is allocated between A and B in the relative 
proportions that A and B share deductions for expenses under section 
174. A is entitled to treat $30x ((30%/(30%+30%)) $60x) as a qualified 
research expense. B is also entitled to treat $30x ((30%/(30%+30%)) 
$60x) as a qualified research expense.
    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.

[[Page 101]]

    (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 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. 1.41-5, or

[[Page 102]]

    (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 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,

[[Page 103]]

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.

    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.



Sec. 1.41-3  Base period research expense.

    (a) Number of years in base period. The term ``base period'' 
generally means the 3 taxable years immediately preceding the year for 
which a credit is being determined (``determination year''). However, if 
the first taxable year of the taxpayer ending after June 30, 1981, ends 
in 1981 or 1982, then with respect to that taxable year the term ``base 
period'' means the immediately preceding taxable year. If the second 
taxable year of the taxpayer ending after June 30, 1981, ends in 1982 or 
1983, then with respect to that taxable year the term ``base period'' 
means the 2 immediately preceding taxable years.
    (b) New taxpayers. If, with respect to any determination year, the 
taxpayer has not been in existence for the number of preceding taxable 
years that are included under paragraph (a) of this section in the base 
period for that year, then for purposes of paragraph (c)(1) of this 
section (relating to the determination of average qualified research 
expenses during the base period), the taxpayer shall be treated as--
    (1) Having been in existence for that number of additional 12-month 
taxable years that is necessary to complete the base period specified in 
paragraph (a) of this section, and
    (2) Having had qualified research expenses of zero in each of those 
additional years.
    (c) Definition of base period research expenses. For any 
determination year, the term ``base period research expenses'' means the 
greater of--
    (1) The average qualified research expenses for taxable years during 
the base period, or
    (2) Fifty percent of the qualified research expenses for the 
determination year.
    (d) Special rules for short taxable years--(1) Short determination 
year. If the determination year for which a research credit is being 
taken is a short taxable year, the amount taken into account under 
paragraph (c)(1) of this section 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 base period year. For purposes of paragraph (c)(1) of this 
section, if a year in the base period is a short taxable year, the 
qualified research expenses paid or incurred in the short taxable year 
are deemed to be equal to the qualified research expenses actually paid 
or incurred in that year multiplied by 12 and divided by the number of 
months in that year.
    (3) Years overlapping the effective dates of section 41 (section 
44F)--(i) Determination years. If a determination year includes months 
before July 1981, the determination year is deemed to be a short taxable 
year including only the months after June 1981. Accordingly, paragraph 
(d)(1) of this section is applied for purposes of determining the base 
period expenses for such year. See section 221(d)(2) of the Economic 
Recovery Tax Act of 1981.
    (ii) Base period years. No adjustment is required in the case of a 
base period year merely because it overlaps June 30, 1981.
    (4) Number of months in a short taxable year. The number of months 
in a short taxable year is equal to the number of whole calendar months 
contained in the year plus fractions for any partially included months. 
The fraction for a partially included month is equal to the number of 
days in the month that are included in the short taxable year divided by 
the total number of

[[Page 104]]

days in that month. Thus, if a short taxable year begins on January 1, 
1982, and ends on June 9, 1982, it consists of 5 and 9/30 months.
    (e) Examples. The following examples illustrate the application of 
this section.

    Example 1. X Corp., an accrual-method taxpayer using the calendar 
year as its taxable year, is organized and begins carrying on a trade or 
business during 1979 and subsequently incurs qualified research expenses 
as follows:

1979...........................................................     $10x
1980...........................................................     150x
1/1/81-6/30/81.................................................      90x
7/1/81-12/31/81................................................     110x
1982...........................................................     250x
1983...........................................................     450x
 

    (i) Determination year 1981. For determination year 1981, the base 
period consists of the immediately preceding taxable year, calendar year 
1980. Because the determination year includes months before July 1981, 
paragraph (d)(3)(i) of this section requires that the determination year 
be treated as a short taxable year. Thus, for purposes of paragraph 
(c)(1) of this section, as modified by paragraph (d)(1) of this section, 
the average qualified research expenses for taxable years during the 
base period are $75x ($150x, the average qualified research expenses for 
the base period, multiplied by 6, the number of months in the 
determination year after June 30, 1981, and divided by 12). Because this 
amount is greater than the amount determined under paragraph (c)(2) of 
this section (50 percent of the determination year's qualified research 
expense of $110x, or $55x), the amount of base period research expenses 
is $75x. The credit for determination year 1981 is equal to 25 percent 
of the excess of $110x (the qualified research expenditures incurred 
during the determination year including only expenditures accrued on or 
after July 1, 1981, through the end of the determination year) over $75x 
(the base period research expenses).
    (ii) Determination year 1982. For determination year 1982, the base 
period consists of the 2 immediately preceding taxable years, 1980 and 
1981. The amount determined under paragraph (c)(1) of this section (the 
average qualified research expenses for taxable years during the base 
period) is $175x (($150x+$90x+$110x)/2). This amount is greater than the 
amount determined under paragraph (c)(2) of this section, (50 percent of 
$250x, or $125x). Accordingly, the amount of base period research 
expenses is $175x. The credit for determination year 1982 is equal to 25 
percent of the excess of $250x (the qualified research expenses incurred 
during the determination year) over $175x (the base period research 
expenses).
    (iii) Determination year 1983. For determination year 1983, the base 
period consists of the 3 immediately preceding taxable years 1980, 1981 
and 1982. The amount determined under paragraph (c)(1) of this section 
(the average qualified research expenses for taxable years during the 
base period) is $200x (($150x+$200x+$250x)/3). The amount determined 
under paragraph (c)(2) of this section is $225x (50 percent of the $450x 
of qualified research expenses in 1983). Accordingly, the amount of base 
period research expenses is $225x. The credit for determination year 
1983 is equal to 25 percent of the excess of $450x (the qualified 
research expenses incurred during the determination year) over $225x 
(the base period research expenses).

    Examp1e 2. Y, an accrual-basis corporation using the calendar year 
as its taxable year comes into existence and begins carrying on a trade 
or business on July 1, 1983. Y incurs qualified research expenses as 
follows:

7/1/83--12/31/83...............................................     $80x
1984...........................................................     200x
1985...........................................................     200x
 

    (i) Determination year 1983. For determination year 1983, the base 
period consists of the 3 immediately preceding taxable years: 1980, 1981 
and 1982. Although Y was not in existence during 1980, 1981 and 1982, Y 
is treated under paragraph (b) of this section as having been in 
existence during those years with qualified research expenses of zero. 
Thus, the amount determined under paragraph (c)(1) of this section (the 
average qualified research expenses for taxable years during the base 
period) is $0x (($0x+$0x+$0x)/3). The amount determined under paragraph 
(c)(2) of this section is $40x (50 percent of $80x). Accordingly, the 
amount of base period research expenses is $40x. The credit for 
determination year 1983 is equal to 25 percent of the excess of $80x 
(the qualified research expenses incurred during the determination year) 
over $40x (the base period research expenses).
    (ii) Determination year 1984. For determination year 1984, the base 
period consists of the 3 immediately preceding taxable years: 1981, 
1982, and 1983. Under paragraph (b) of this section, Y is treated as 
having been in existence during years 1981 and 1982 with qualified 
research expenses of zero. Because July 1 through December 31, 1983 is a 
short taxable year, paragraph (d)(2) of this section requires that the 
qualified research expenses for that year be adjusted to $160x for 
purposes of determining the average qualified research expenses during 
the base period. The $160x results from the actual qualified research 
expenses for that year ($80x) multiplied by 12 and divided by 6 (the 
number of months in the short taxable year). Accordingly, the amount 
determined under paragraph (c)(1) of this section (the average qualified 
research expenses for taxable years during the base period) is $53\1/3\x 
(($0x+$0x+$160x)/3). The

[[Page 105]]

amount determined under paragraph (c)(2) of this section is $100x (50 
percent of $200x). The amount of base period research expenses is $100x. 
The credit for determination year 1984 is equal to 25 percent of the 
excess of $200x (the qualified research expenses incurred during the 
determination year) over $100x (the base period research expenses).
    (iii) Determination year 1985. For determination year 1985, the base 
period consists of the 3 immediately preceding taxable years: 1982, 
1983, and 1984. Pursuant to paragraph (b) of this section, Y is treated 
as having been in existence during 1982 with qualified research expenses 
of zero. Because July 1 through December 31, 1982, is a short taxable 
year, paragraph (d)(2) of this section requires that the qualified 
research expense for that year be adjusted to $160x for purposes of 
determining the average qualified research expenses for taxable years 
during the base period. This $160x is the actual qualified research 
expense for that year ($80x) multiplied by 12 and divided by 6 (the 
number of months in the short taxable year). Accordingly, the amount 
determined under paragraph (c)(1) of this section (the average qualified 
research expenses for taxable years during the base period) is $120x 
(($0x+$160x+$200x)/3). The amount determined under paragraph (c)(2) of 
this section is $100x (50 percent of $200x). The amount of base period 
research expenses is $120x. The credit for determination year 1985 is 
equal to 25 percent of the excess of $200x (the qualified research 
expenses incurred during the determination year) over $120x (the base 
period research expenses).



Sec. 1.41-4  Qualified research for taxable years beginning after December 31, 1985. [Reserved]



Sec. 1.41-5  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

[[Page 106]]

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. 1.41-8(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.
    (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

[[Page 107]]

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 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.



Sec. 1.41-6  Basic research for taxable years beginning after December 31, 1985. [Reserved]



Sec. 1.41-7  Basic research for taxable years beginning before January 1, 1986.

    (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

[[Page 108]]

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 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. 1.41-5(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

[[Page 109]]

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.



Sec. 1.41-8  Aggregation of expenditures.

    (a) Controlled group of corporations; trades or businesses under 
common control--(1) In general. In determining the amount of research 
credit allowed with respect to a trade or business that at the end of 
its taxable year is a member of a controlled group of corporations or a 
member of a group of trades or businesses under common control, all 
members of the group are treated as a single taxpayer and the credit (if 
any) allowed to the member is determined on the basis of its 
proportionate share (if any) of the increase in qualified research 
expenses of the aggregated group.
    (2) Definition of trade or business. For purposes of this section, a 
trade or business is a sole proprietorship, a partnership, a trust, an 
estate, or a corporation that is carrying on a trade or business (within 
the meaning of section 162). For purposes of this section, any 
corporation that is a member of a commonly controlled group shall be 
deemed to be carrying on a trade or business if any other member of that 
group is carrying on any trade or business.
    (3) Determination of common control. For rules for determining 
whether trades or businesses are under common control, see paragraphs 
(b) through (g) of Sec. 1.52-1 except that the words ``singly or'' in 
Sec. 1.52-1(d)(1)(i) shall be treated as deleted.
    (4) Examples. The following examples illustrate provisions of this 
paragraph.

    Example 1. (i) Facts. A controlled group of four corporations (all 
of which are calendar-year taxpayers) had qualified research expenses 
(``research expenses'') during the base period and taxable year as 
follows:

------------------------------------------------------------------------
                                        Base period   Taxable
              Corporation                (average)      year     Change
------------------------------------------------------------------------
A.....................................          $60        $40     ($20)
B.....................................           10         15         5
C.....................................           30         70        40
D.....................................           15         25        10
------------------------------------------------------------------------

    (ii) Total credit. Because the research expenses of the four 
corporations are treated as if made by one taxpayer, the total amount of 
incremental expenses eligible for the credit is $35 ($55 increase 
attributable to B, C, and D less $20 decrease attributable to A). The 
total amount of credit allowable to members of the group is 20% of the 
incremental amount or $7.00.
    (iii) Allocation of credit. No amount of credit is allocated to A 
since A's research expenses did not increase in the taxable year. The 
$7.00 credit is allocated to B, C, and D, the members of the group that 
increased their research expenses. This allocation is made on the basis 
of the ratio of each corporation's increase in its research expenses to 
the sum of increases in those expenses. Inasmuch as the total increase 
made by those members of the group whose research expenses rose (B, C, 
and D) was $55, B's share of the $7.00 credit is 5/55; C's share is 40/
55; and D's share is 10/55.

    Example 2. The facts are the same as in example (1) except that A 
had zero research expenses in the taxable year. Thus, the controlled 
group had a decrease rather than an increase in aggregate research 
expenses. Accordingly, no amount of credit is allowable to any member of 
the group even though B, C, and D actually increased their research 
expenses in comparison with their own base period expenses.

    (b) Minimum base period research expenses. For purposes of this 
section, the rule in section 41(c)(3) (pertaining to minimum base period 
research expenses) shall be applied only to the aggregate amount of base 
period research

[[Page 110]]

expenses. See the treatment of corporation C in example (1) of paragraph 
(a)(4) of this section.
    (c) Tax accounting periods used--(1) In general. The credit 
allowable to a member of a controlled group of corporations or of a 
group of trades or businesses under common control is that member's 
share of the aggregate credit computed as of the end of such member's 
taxable year. In computing the aggregate credit in the case of a group 
whose members have different taxable years, a member shall generally 
treat the taxable year of another member that ends with or within the 
determination year of the computing member as the determination year of 
that other member. The base period research expenses taken into account 
with respect to a determination year of another member shall be the base 
period research expenses determined for that year under Sec. 1.41-3, 
except that Sec. 1.41-3(c)(2) shall be applied only at the aggregate 
level.
    (2) Special rule where 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, the district director may require each member of the group to 
calculate the credit in the current taxable year and all future years as 
if all members of the group had the same taxable year and base period as 
the computing member.
    (d) 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 June 30, 1983. If the business 
does not so designate, then the district director with audit 
jurisdiction of the return will determine the group in which the 
business is to be included.
    (e) 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 qualified research expenses any in-
house research expenses for that work and shall not treat any amount 
received or accrued as funding the research. Conversely, the member for 
whom the research is performed shall not treat any part of any amount 
paid or incurred as a contract research expense. For purposes of 
determining whether the in-house research for that work is qualified 
research, the member performing the research shall be treated as 
carrying on any trade or business carried on by the member on whose 
behalf the research is performed.
    (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 qualified research expenses. However, if the expenses 
are not paid or incurred in carrying on any trade or business of that 
member, those expenses may be taken into account as contract research 
expenses by another member of the group provided that the other member--
    (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

[[Page 111]]

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.



Sec. 1.41-9  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.
    (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

[[Page 112]]

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.

             Taxable Years Beginning Before January 1, 1987



Sec. 1.41-0A  Credit or deduction for political and newsletter fund contributions--scope and note.

    Section 41 allows a limited credit against the income tax for 
political and newsletter fund contributions. Section 218 allows a 
limited deduction for contributions. The Revenue Act of 1978, however, 
increases the maximum annual credit under section 41 and repeals section 
218. These changes are effective for political and newsletter fund 
contributions payment of which is made in taxable years of the 
contributor beginning after December 31, 1978. Sections 1.41-1A through 
1.41-8A apply to both sections 41 and 218.

[T.D. 7603, 44 FR 18222, Mar. 27, 1979. Redesignated and amended by T.D. 
8251, 54 FR 21204, May 17, 1989]



Sec. 1.41-1A  Same--definitions of certain items.

    (a) Campaign committee. A ``campaign committee'' is any group 
described in section 41(c)(1)(B). Thus, to be a campaign committee a 
group must be organized and operated exclusively to further the 
nomination or election of one or more candidates. That means it may not, 
except as otherwise provided in Sec. 1.41-3A(a), spend any money for any 
other purpose. Therefore, a group that engages in any general political, 
educational, or legislative activities is not a campaign committee. Such 
a group may, however, organize a separate campaign committee exclusively 
to further the nomination or election of one or more candidates.
    (b) Candidate. A ``candidate'' is an individual described in section 
41 (c)(2). A candidate remains a candidate until enough money has been 
raised to pay the debts incurred in a previous campaign for elective 
public office. For example, A, a candidate for Senator from State X in 
1977, is elected to that office in 1978. A sustains a campaign debt with 
respect to A's Senatorial campaign. A remains a candidate solely for the 
purpose of soliciting contributions to extinguish the campaign debt.
    (c) Elective public office. An ``elective public office'' is any 
governmental position for which one must be directly chosen by the 
casting of votes by the general public or the Electoral College. It does 
not, however, include any office or position in any national, state, or 
local political party or similar organization, or membership in the 
Electoral College.
    (d) Furthering a candidacy. Expenditures further a candidacy within 
the meaning of section 41(c)(1) (A) and (B) if they are directly related 
to, and are intended to support, a candidate's campaign for elective 
public office. Examples include payments for--
    (1) Researching and polling campaign issues;
    (2) Trips in connection with campaigning by the candidate or persons 
acting on his or her behalf;
    (3) Raising funds; and
    (4) Campaign-related debts left over from a previous political 
campaign.
    (e) Meets the qualifications. An individual ``meets the 
qualifications prescribed by law'' to hold an elective public office if 
the individual can be reasonably expected to meet those qualifications 
on or before the date the office is to be filled.
    (f) Newsletter fund contribution. The term ``newsletter fund 
contribution'' means a contribution of money or gift of money directly 
to a fund described in section 527(g) (relating to the treatment of 
newsletter funds as political organizations).
    (g) Political contribution. A ``political contribution'' is a 
contribution of money or gift of money directly to a person described in 
section 41(c)(1). A political contribution is not limited to

[[Page 113]]

that portion of the contribution or gift that is eligible as a credit 
under section 41(b) or deduction under section 218(b).
    (h) Publicly announces. An individual ``publicly announces'' that he 
or she is a candidate by making a positive statement available for media 
distribution that he or she is seeking nomination or election to a 
specific elective public office. An example is a news release or other 
statement by an individual intended for distribution via television, 
radio, newspapers, or magazines within the geographic area associated 
with the elective public office being sought which states that he or she 
seeks nomination or election to the office. Incumbency in an office does 
not constitute a public announcement that one is seeking reelection to 
that office. Furthermore, if because of death or any other reason an 
individual does not make a public announcement, the individual is not a 
candidate even though the individual was about to make a public 
announcement.

[T.D. 7603, 44 FR 18222, Mar. 27, 1979. Redesignated and amended by T.D. 
8251, 54 FR 21204, May 17, 1989]



Sec. 1.41-2A  Same--limitations and special rules.

    (a) When payment must be made. A taxpayer may elect the credit under 
section 41 or the deduction under section 218 only if a political or 
newsletter fund contribution is actually paid within the taxable year 
for which the taxpayer claims the credit or deduction. The method of 
accounting the taxpayer uses and the date the contribution is pledged 
are irrelevant. Where a partnership makes a political or newsletter fund 
contribution, each partner is considered as having paid his or her 
distributive share of the political or newsletter fund contribution.
    (b) Campaign committee supporting more than one individual. A 
section 41 credit or section 218 deduction may be available for a 
contribution of money to a campaign committee that supports, or intends 
to support, more than one candidate if at least one individual it 
supports is a candidate for the calendar year in which the contribution 
is made. However, if a taxpayer indicates at the time the contribution 
is made that it is for a specific individual, and that individual is not 
a candidate for the calendar year in which the contribution is made, no 
credit or deduction is available.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. B, an individual, makes a contribution of money in 1977 
to the Good Government Committee, which is a campaign committee. The 
Good Government Committee supports C and D in 1977. C is a candidate for 
1977. D is not a candidate for 1977. B may elect the credit under 
section 41 or deduction under section 218 for the contribution in 1977.

    Example 2. Assume the same facts as in example (1), except that B 
earmarks the contribution solely to further the candidacy of D. B may 
not elect the credit under section 41 or deduction under section 218 for 
the 1977 contribution.

FT.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.41-3A  Same--unspent contributions.

    (a) General rule. Except as provided in paragraph (b) of this 
section, all unspent political contributions must be used within a 
reasonable period of time to make a deposit or contribution described in 
section 527 (d).
    (b) Special rules--(1) Candidates. An individual who was a candidate 
may retain unspent political contributions in reasonable anticipation of 
using them solely to support his or her future candidacy for any 
Federal, State, or local elective public office.
    (2) Campaign committee. A campaign committee may retain unspent 
political contributions in reasonable anticipation of using them to 
support the future candidacy of any individual for any Federal, State, 
or local elective public office.

[T.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.41-4A  Same--procedure for electing a credit or deduction.

    (a) Scope note. This section prescribes procedures for making the 
election under sections 41 and 218 to take either a credit or deduction 
for political and newsletter contributions.

[[Page 114]]

    (b) How to elect. A taxpayer elects the credit or deduction by 
making the appropriate entries on his or her income tax return for the 
taxable year in which the contribution is made.
    (c) Changing or revoking one's election. The election may be changed 
or revoked. Thus, a taxpayer may change an election from credit to 
deduction or vice versa. In addition, if a taxpayer elects a credit or 
deduction for a particular taxable year to which, it later turns out, he 
or she is not entitled, the taxpayer must pay any additional tax that is 
due as a result. A taxpayer may change or revoke the election by use of 
an amended return.

[T.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.41-5A  Same--verifications.

    This section prescribes rules under sections 41(b)(3) and 218(b)(2) 
to tell a taxpayer how to verify political and newsletter fund 
contributions for which a credit or deduction is claimed. A taxpayer 
must have a written receipt to substantiate any claim that a 
contribution was made. A cancelled check, the payee of which is a person 
or fund described in section 41(c) (1) or (5), ordinarily meets this 
requirement. However, in appropriate cases, the Internal Revenue Service 
may require a taxpayer to furnish additional proof that the payee was a 
person or fund described in section 41(c) (1) or (5), or that the 
purpose of the payment was to make a political or newsletter fund 
contribution.

[T.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.41-6A  Same--taxation of certain organizations.

    See section 527 and the regulations thereunder for the tax treatment 
of a person or fund described in section 41(c) (1) or (5) that is 
treated as a section 527(e)(1) political organization.

[T.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.41-7A  Same--transitional rule for past contributions.

    A credit or deduction for a political contribution the payment of 
which was made before January 1, 1980 will be allowed if it meets the 
requirements for a credit or deduction under the notice of proposed 
rulemaking published on September 19, 1972 (37 FR 19140).

[T.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.41-8A  Same--effective dates.

    (a) Political contributions. Except as otherwise provided, these 
regulations apply to political contributions made in taxable years of 
the contributor beginning after December 31, 1971.
    (b) Newsletter fund contributions. These regulations apply to 
newsletter fund contributions made in taxable years of the contributor 
beginning after December 31, 1974.

[T.D. 7603, 44 FR 18223, Mar. 27, 1979. Redesignated by T.D. 8251, 54 FR 
21204, May 17, 1989]



Sec. 1.42-0  Table of contents.

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

                         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  [Reserved]



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

[[Page 115]]

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 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

[[Page 116]]

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 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''.

[[Page 117]]

    (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 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

[[Page 118]]

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 
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

[[Page 119]]

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 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

[[Page 120]]

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 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. Tne 
building is not Federally subsidized within the meaning of section 
42(i)(2). As of the end of 1987, the building has eligible basis under 
section 42(d) of $1 million. Thus, the qualified basis of the building 
determined without regard to the first-year convention provided in 
section 42(f) is $166,666.67 (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., .08 x $100,000 x (\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

[[Page 121]]

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., .08 x $100,000, the 1987 credit 
alllocation, +.09 x $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 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

[[Page 122]]

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
    (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

[[Page 123]]

the compliance period. A taxpayer is required to complete the Form 8609 
on which a housing credit agency made the applicable housing credit 
allocation and submit a copy of such Form 8609 with its Federal income 
tax return for each year in the compliance period. Failure to comply 
with the requirement of the preceding sentence with respect to any 
taxable year after the first taxable year in the credit period shall be 
treated as a mathematical or clerical error for purposes of the 
provisions of section 6213 (b)(1) and (g)(2).
    (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 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,

[[Page 124]]

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 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

[[Page 125]]

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 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 and special rules--(1) Completed form. For 
purposes of this section, a form shall be treated as completed if the 
State or local housing credit agency or the building owner has made a 
good faith effort to complete the form in accordance with the form and 
the instructions for the form.
    (2) Manner of filing. A completed Form 8586, Low-Income Housing 
Credit, shall be filed with the owner's Federal income tax return for 
each taxable year the owner of a qualified low-income building is 
claiming the low-income housing credit during the 10-year credit period. 
A completed Form 8609 (or copy thereof) shall be filed with the owner's 
Federal income tax return for each of the 15 taxable years in the 
compliance period. If a housing credit allocation is not required to be 
received by an owner under paragraph (f) of this section, the owner 
shall obtain a blank copy of Form 8609 and fill in the address of the 
building and the name and address of the owner in part I. Part II of 
Form 8609 shall be completed by the owner of the qualified low-income 
building only for the first year the low-

[[Page 126]]

income housing credit is claimed by the building owner. Part III of Form 
8609 (Statement of Qualification) shall be completed by the owner of the 
qualified low-income building for each year of the 15-year compliance 
period.
    (3) Revised or renumbered forms. If any form is revised or 
renumbered, any reference in this section to the form shall be treated 
as a reference to the revised or renumbered form.
    (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]



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 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

[[Page 127]]

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;
    (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

[[Page 128]]

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 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

[[Page 129]]

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 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

[[Page 130]]

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).
    (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

[[Page 131]]

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 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;

[[Page 132]]

    (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 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

[[Page 133]]

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.
    (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.

[[Page 134]]

    (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 
(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

[[Page 135]]

(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]

    Effective Date Note 1: By T.D. 8859, 65 FR 2326, Jan. 14, 2000, 
Sec. 1.42-5 was amended by removing the word ``Revenue'' in paragraph 
(b)(1)(iv) and adding ``Omnibus Budget'' in its place; adding paragraph 
(b)(3); revising paragraphs (c)(1)(v), (c)(1)(vi), (c)(1)(xi), 
(c)(2)(ii), and (c)(2)(iii); removing the word ``project'' in paragraph 
(c)(1)(x) and adding ``building'' in its place; removing the word 
``and'' at the end of paragraph (c)(1)(x); adding paragraph (c)(1)(xii); 
removing the language ``paragraph (c)(2)(ii)(A), (B), and (C) of this 
section'' from the first sentence in paragraph (c)(4)(i) and adding 
``paragraph (c)(2)(ii) of this section'' in its place; removing the 
language ``Farmers Home Administration (FmHA)'' in the first sentence in 
paragraph (c)(4)(i) and adding ``Rural Housing Service (RHS), formerly 
known as Farmers Home Administration,'' in its place; removing the 
language ``FmHA'' in paragraph (c)(4)(ii) and adding ``RHS'' in its 
place in each place it appears; removing the language ``An Agency 
chooses the review requirement of paragraph (c)(2)(ii)(A) of this 
section and some of the buildings selected for review are'' from the 
first sentence in the example in paragraph (c)(4)(iii) and adding ``An 
Agency selects for review'' in its place; removing the language ``FmHA'' 
in paragraph (c)(4)(iii) Example and adding ``RHS'' in its place in each 
place it appears; revising paragraph (d); removing the language 
``(c)(2)(ii)(A), (B), or (C) of this section (whichever is applicable)''

[[Page 136]]

from paragraph (e)(2) and adding the language ``(c)(2)(ii) of this 
section'' in its place; removing the language ``paragraph (e)(3) of this 
section'' in the third sentence in paragraph (f)(1)(i) and adding 
``paragraphs (c)(5) and (e)(3) of this section'' in its place; adding 
three sentences at the end of paragraph (h), effective Jan. 1, 2001. For 
the convenience of the user, the superseded text is set forth as 
follows:

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

                                * * * * *

    (c) * * * (1) * * *
    (v) All units in the project were for use by the general public and 
used on a nontransient basis (except for transitional housing for the 
homeless provided under section 42 (i)(3)(B)(iii));
    (vi) Each building in the project was suitable for occupancy, taking 
into account local health, safety, and building codes;

                                * * * * *

    (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 Revenue Reconciliation Act of 1989).
    (2) * * *
    (ii) Contain at least one of the following requirements:
    (A) The owners of at least 50 percent of all low-income housing 
projects in the Agency's jurisdiction must submit to the Agency for 
compliance review a copy of the annual income certification, the 
documentation the owner has received to support that certification, and 
the rent record for each low-income tenant in at least 20 percent of the 
low-income units in their projects;
    (B) The Agency must inspect at least 20 percent of low-income 
housing projects each year and must inspect the low-income 
certification, the documentation the owner has received to support that 
certification, and the rent record for each low-income tenant in at 
least 20 percent of the low-income units in those projects; or
    (C) The owners of all low-income housing projects must submit to the 
Agency each year information on tenant income and rent for each low-
income unit, in the form and manner designated by the Agency, and the 
owners of at least 20 percent of the projects must submit to the Agency 
for compliance review a copy of the annual income certification, the 
documentation the owner has received to support that certification, and 
the rent record for each low-income tenant in at least 20 percent of the 
low-income units in their projects; and
    (iii) Require that the Agency determine which tenants' records are 
to be inspected or submitted by the owners for review. If a monitoring 
procedure includes the review provision described in paragraph 
(c)(2)(ii)(B) of this section, the records to be inspected must be 
chosen in a manner that will not give owners of low-income housing 
projects advance notice that their records for a particular year will or 
will not be inspected. However, an Agency may give an owner reasonable 
notice that an inspection will occur so that the owner may assemble 
records (for example, 30 days notice of inspection). See paragraph (d) 
of this section for the inspection provision that is required to be 
included in all monitoring procedures.
    (d) Inspection provision. 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 separate from any review of low-income certifications, supporting 
documents, and rent records under paragraph (c)(2)(ii) of this section.

    Effective Date Note 2: By T.D. 8859, 65 FR 16317, Mar. 28, 2000, 
Sec. 1.42-5 was corrected by removing the language ``1437s'' in 
paragraph (c)(1)(xi) and adding ``1437f'' in its place, effective Jan. 
1, 2001.



Sec. 1.42-6  Buildings qualifying for carryover allocations.

    (a) Carryover allocations. A carryover allocation is an allocation 
that meets the requirements of section 42(h)(1) (E) or (F). If the 
requirements of section 42(h)(1) (E) or (F) that are required to be 
satisfied by the close of the calendar year are not satisfied, the 
allocation is treated as if it had not been made. For example, if the 
taxpayer's basis in the project as of the close of the calendar year of 
allocation is not more than 10 percent of the taxpayer's reasonably 
expected basis in the project as of the close of the second calendar 
year following the year of allocation, the carryover allocation is not 
valid and is treated as if it had not been made.
    (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

[[Page 137]]

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.
    (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 
September of 1993. As of that date, C has not begun construction of the 
low-income housing building C plans to build. However, C has owned the 
land on which C plans to build the building since 1985. C's basis in the 
land is $100,000. C reasonably expects that by the end of 1995, C's 
basis in the project of which the building is to be a part will be 
$2,000,000. C also expects that because the project is located in a 
qualified census tract, C will be able to increase its basis in the 
project to $2,600,000. Before the close of 1993, C incurs $150,000 of 
costs for architects' fees and site preparation. C properly accrues

[[Page 138]]

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, receives a 
carryover allocation from Agency, the state housing credit agency, on 
September 11, 1993. As of that date, D has not begun construction of the 
low-income housing building D plans to build and D does not have basis 
in the land on which D plans to build the building. In 1993, D incurs 
some costs related to the planned building, including architects' fees. 
However, at the close of 1993, these costs do not exceed 10 percent of 
D's reasonably expected basis in the project.
    (ii) Determination of whether building is qualified. Because D's 
carryover-allocation basis is not more than 10 percent of D's reasonably 
expected basis in the project of which the building is a part, the 
building for which D received a carryover allocation is not a qualified 
building for purposes of section 42(h)(1)(E)(ii) and paragraph (a) of 
this section. The carryover allocation to D is not valid, and is treated 
as if it had not been made.

    (c) Verification of basis by Agency--(1) Verification requirement. 
An Agency that makes a carryover allocation to a taxpayer must verify 
that, as of the close of the calendar year of allocation, the taxpayer 
has incurred more than 10 percent of the reasonably expected basis in 
the project (land and depreciable basis).
    (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 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.
    (3) Time of verification. An Agency may require that the basis 
certification be submitted to or received by the Agency prior to the 
close of the calendar year of allocation or within a reasonable time 
after the close of the calendar year of allocation. The Agency will need 
to verify basis in order to accurately complete the Form 8610, `Annual 
Low-Income Housing Credit Agencies Report,' for the calendar year. If 
certification is not timely made, or supporting documentation is 
lacking, inadequate, or does not actually support the certification, the 
Agency should notify the taxpayer and try to get adequate documentation. 
If the Agency cannot verify before the Form 8610 is filed that the 
taxpayer has satisfied the basis requirement for a carryover allocation, 
the allocation is treated as if it had not been made and the carryover 
allocation document should not be filed with the Form 8610.
    (d) Requirements for making carryover allocations--(1) In general. 
Generally, an allocation is made when an Agency issues the Form 8609, 
`Low-Income

[[Page 139]]

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) The taxpayer's basis in the project (land and depreciable 
basis) as of the close of the calendar year in which the allocation is 
made and the percentage that basis bears to the reasonably expected 
basis in the project (land and depreciable basis) as of the close of the 
second following calendar year;
    (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 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 and file an additional copy with the 
Form 8609 that is

[[Page 140]]

issued to the taxpayer for a building after the building is placed in 
service. The taxpayer need only file a copy of the allocation document 
with the Form 8609 for the building for the first year the credit is 
claimed. However, the Form 8609 must be filed for the first taxable year 
in which the credit is claimed and for each taxable year thereafter 
throughout the compliance period, whether or not a credit is claimed for 
the taxable year.
    (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), ``Carryover Allocation of the Low-Income Housing 
Credit,'' with the Agency's Form 8610 for the year the allocation is 
made. The Agency must also retain a copy of the Form 8609 that is issued 
to the taxpayer and file the original with the Agency's Form 8610 that 
reflects the year the form is issued.
    (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, 
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]

    Effective Date Note 1: By T.D. 8859, 65 FR 2328, Jan. 14, 2000, 
Sec. 1.42-6 was amended by removing the language ``Annual Low-Income 
Housing Credit Agencies Report'' in paragraph (c)(3), second sentence, 
and adding the language `` `Annual Low-Income Housing Credit Agencies 
Report' '' in its place; by removing the language ``Low-Income Housing 
Credit Allocation Certification,'' in paragraph (d)(1), first sentence, 
and adding the language `` `Low-Income Housing Credit Allocation 
Certification,' '' in its place; effective Jan. 1, 2001.

    Effective Date Note 2: By T.D. 8859, 65 FR 16317, Mar. 28, 2000, 
Sec. 1.42-6 was corrected by removing the language ``Report''' in 
paragraph (c)(3), second sentence, and replacing it with ``Report,''', 
effective Jan. 1, 2001.



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

[[Page 141]]

    (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 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

[[Page 142]]

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 following the end of the month in which the binding 
agreement is made. The taxpayer must retain a copy of the binding 
agreement and the election statement and must file an additional copy of 
each with the taxpayer's Form 8609, Low-Income Housing Credit Allocation 
Certification, for the first taxable year in which credit is claimed for 
the building.
    (ii) Agency. The Agency must file with the Internal Revenue Service 
the original of the binding agreement and the election statement with 
the Agency's Form 8610, Annual Low-Income Housing Credit Agencies 
Report, that accounts for the year the allocation is actually made. The 
Agency must also retain a copy of the binding agreement and the election 
statement.
    (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 1993, X and Agency enter into an agreement 
that Agency will allocate $100,000 of housing credit dollar amount for 
the low-income housing building X is constructing. The agreement is 
binding and meets all the requirements of paragraph (a)(1) of this 
section. The agreement is a reservation of credit, not an allocation, 
and therefore, has no effect on the state housing credit ceiling. On or 
before September 5, 1993, X signs and has notarized a written election 
statement that meets the requirements of paragraph (a)(3) of this 
section. The applicable percentage for the building is the appropriate 
percentage for the month of August 1993.
    (ii) Agency makes a carryover allocation of $100,000 of housing 
credit dollar amount for the building on October 2, 1993. The carryover 
allocation reduces Agency's state housing credit ceiling for 1993. Due 
to unexpectedly high construction costs, when X places the building in 
service in July 1994, the product of the building's qualified basis and 
the applicable percentage for the building (the appropriate percentage 
for the month of August 1993) is $150,000, rather than $100,000. 
Notwithstanding that only $100,000 of credit was allocated for the 
building in 1993, Agency may allocate an additional $50,000 of housing 
credit dollar amount for the building from its state housing credit 
ceiling for 1994. The appropriate percentage for the month of August 
1993 is the applicable percentage for the building for the entire 
$150,000 of credit allocated for the building, even though separate 
allocations were made in 1993 and 1994. Because allocations were made 
for the building in two separate calendar years, Agency must issue two 
Forms 8609 to X. One Form 8609 must reflect the $100,000 allocation made 
in 1993, and the other Form 8609 must reflect the $50,000 allocation 
made in 1994.
    (iii) X gives the original notarized statement to Agency on or 
before September 5, 1993, and retains a copy of the binding agreement, 
election statement, and carryover allocation document. X files a copy of 
the binding agreement, election statement, and carryover allocation 
document with X's Form 8609 for the first taxable year in which X claims 
credit for the building.
    (iv) Agency files the original of the binding agreement, election 
statement, and 1993 carryover allocation document with its 1993 Form 
8610. Agency retains a copy of the binding agreement, election 
statement, and carryover allocation document. After the building is 
placed in service in 1994, Agency issues to X a copy of the Form 8609 
reflecting the 1993 carryover allocation of $100,000 and files the 
original of that form with its 1994 Form 8610. Agency also files the 
original of the 1994 Form 8609 reflecting the $50,000 allocation with 
its 1994 Form 8610 and issues to X a copy of the 1994 Form 8609. Agency 
retains copies of the Forms 8609 that are issued to X.

    Example 2. (i) In September 1993, X and Agency enter into an 
agreement that Agency will allocate $70,000 of housing credit dollar 
amount for rehabilitation expenditures that X is incurring and that X 
will treat as a new low-income housing building under section 42(e)(1). 
The agreement is binding and meets all the requirements of paragraph 
(a)(1) of this section. The agreement is a reservation of credit, not an 
allocation, and therefore, has no effect on Agency's state housing 
credit ceiling. On or before October 5, 1993, X signs and has notarized 
a written election statement that meets the requirements of

[[Page 143]]

paragraph (a)(3) of this section. The applicable percentage for the 
building is the appropriate percentage for the month of September 1993. 
Agency makes a carryover allocation of $70,000 of housing credit dollar 
amount for the building on November 15, 1993. The carryover allocation 
reduces by $70,000 Agency's state housing credit ceiling for 1993.
    (ii) In October 1994, X and Agency enter into another binding 
agreement meeting the requirements of paragraph (a)(1) of this section. 
Under the agreement, Agency will allocate $50,000 of housing credit 
dollar amount for additional rehabilitation expenditures by X that 
qualify as a second separate new building under section 42(e)(1). On or 
before November 5, 1994, X signs and has notarized a written election 
statement meeting the requirements of paragraph (a)(3) of this section. 
On December 1, 1994, X receives a carryover allocation under section 
42(h)(1)(E) for $50,000. The carryover allocation reduces by $50,000 
Agency's state housing credit ceiling for 1994. The applicable 
percentage for the rehabilitation expenditures treated as the second 
separate new building is the appropriate percentage for the month of 
October 1994, not September 1993. The appropriate percentage for the 
month of September 1993 still applies to the allocation of $70,000 for 
the rehabilitation expenditures treated as the first separate new 
building. Because allocations were made for the building in two separate 
calendar years, Agency must issue two Forms 8609 to X. One Form 8609 
must reflect the $70,000 allocation made in 1993, and the other Form 
8609 must reflect the $50,000 allocation made in 1994.
    (iii) X gives the first original notarized statement to Agency on or 
before October 5, 1993, and retains a copy of the first binding 
agreement, election statement, and carryover allocation document issued 
in 1993. X gives the second original notarized statement to Agency on or 
before November 5, 1994, and retains a copy of the second binding 
agreement, election statement, and carryover allocation document issued 
in 1994. X files a copy of the binding agreements, election statements, 
and carryover allocation documents with X's Forms 8609 for the first 
taxable year in which X claims credit for the buildings.
    (iv) Agency retains a copy of the binding agreements, election 
statements, and carryover allocation documents. Agency files the 
original of the first binding agreement, election statement, and 1993 
carryover allocation document with its 1993 Form 8610. Agency files the 
original of the second binding agreement, election statement, and 1994 
carryover allocation document with its 1994 Form 8610. After X notifies 
Agency of the date each building is placed in service, the Agency will 
issue copies of the respective Forms 8609 to X, and file the originals 
of those forms with the Agency's Form 8610 that reflects the year each 
form is issued. The Agency also retains copies of the Forms 8609.

    (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

[[Page 144]]

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 file 
a copy of the election statement with the taxpayer's Form 8609 for the 
first taxable year in which credit is claimed for the building. The 
taxpayer must also retain a copy of the election statement.
    (ii) Agency. The Agency must file with the Internal Revenue Service 
the original of the election statement and the corresponding Form 8609 
for the building with the Agency's Form 8610 that reflects the year the 
Form 8609 is issued. The Agency must also retain a copy of the election 
statement and the Form 8609.

[T.D. 8520, 59 FR 10071, Mar. 3, 1994]



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 utilities (other than telephone) for a residential rental unit are 
paid directly by the tenant(s), the gross rent for that unit includes 
the applicable utility allowance determined under this section. This 
section only applies for purposes of determining gross rent under 
section 42(g)(2)(B)(ii) as to rent-restricted units.
    (b) Applicable utility allowances--(1) FmHA-assisted buildings. If a 
building receives assistance from the Farmers Home Administration (FmHA-
assisted building), the applicable utility allowance for all rent-
restricted units in the building is the utility allowance determined 
under the method prescribed by the Farmers Home Administration (FmHA) 
for the building. For example, if a building receives assistance under 
FmHA's section 515 program (whether or not the building or its tenants 
also receive other state or federal assistance), the applicable utility 
allowance for all rent-restricted units in the building is determined 
using Exhibit A-6 of 7 CFR part 1944, subpart E (or a successor method 
of determining utility allowances).
    (2) Buildings with FmHA assisted tenants. If any tenant in a 
building receives FmHA rental assistance payments (FmHA tenant 
assistance), the applicable utility allowance for all rent-restricted 
units in the building (including any units occupied by tenants receiving 
HUD rental assistance

[[Page 145]]

payments) is the applicable FmHA utility allowance.
    (3) HUD-regulated buildings. If neither a building nor any tenant in 
the building receives FmHA housing assistance, and the rents and utility 
allowances of the building are reviewed by HUD on an annual basis (HUD-
regulated building), the applicable utility allowance for all rent-
restricted units in the building is the applicable HUD utility 
allowance.
    (4) Other buildings. If a building is neither an FmHA-assisted nor a 
HUD-regulated building, and no tenant in the building receives FmHA 
tenant assistance, the applicable utility allowance for rent-restricted 
units in the building is determined under the following methods.
    (i) Tenants receiving HUD rental assistance. The applicable utility 
allowance for any rent-restricted units occupied by tenants receiving 
HUD rental assistance payments (HUD tenant assistance) is the applicable 
Public Housing Authority (PHA) utility allowance established for the 
Section 8 Existing Housing Program.
    (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.
    (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. 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) Changes in applicable utility allowance. If at any time during 
the building's extended use period (or, if the building does not have an 
extended use period, the building's compliance period), the applicable 
utility allowance for a unit changes, the new utility allowance must be 
used to compute gross rents of rent-restricted units due 90 days after 
the change. For example, if rent must be lowered because a local utility 
company estimate is obtained that shows a higher utility cost than the 
otherwise applicable PHA utility allowance, the lower rent must be in 
effect for rent due more than 90 days after the date of the local 
utility company estimate.

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



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

[[Page 146]]

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]

    Effective Date Note: By T.D. 8859, 65 FR 2328, Jan. 14, 2000, 
Sec. 1.42-11 was amended by revising the last sentence in paragraph 
(b)(3)(ii)(A), effective Jan. 1, 2001. For the convenience of the user, 
the superseded text is set forth as follows:

Sec. 1.42-11  Provision of services.

                                * * * * *

    (b) * * *
    (3) * * *
    (ii) * * * (A) * * * For a building described in section 
42(i)(3)(B)(iii) (relating to transitional housing for the homeless), a 
supportive service includes any service provided to assist tenants in 
locating and retaining permanent housing.

                                * * * * *



Sec. 1.42-12  Effective dates and transitional rules.

    (a) Effective date. The rules set forth in Secs. 1.42-6 and 1.42-8 
through 1.42-12 are effective May 2, 1994. However, binding agreements, 
election statements, and carryover allocation documents entered into 
before May 2, 1994, that follow the guidance set forth in Notice 89-1, 
1989-1 C.B. 620 (see Sec. 601.601(d)(2)(ii)(b) of this chapter) need not 
be changed to conform to the rules set forth in Secs. 1.42-6 and 1.42-8 
through 1.42-12.
    (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]

    Effective Date Note: By T.D. 8859, 65 FR 2328, Jan. 14, 2000, 
Sec. 1.42-12 was amended by adding paragraph (c), effective Jan. 1, 
2001.



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

[[Page 147]]

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 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--

[[Page 148]]

    (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 
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

[[Page 149]]

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 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-1989 State housing credit ceiling amounts.

    (a) In general. The State housing credit ceiling for a State for any 
calendar year after 1989 is comprised of four components. The four 
components are--
    (1) $1.25 multiplied by the State population (the population 
component);
    (2) The unused State housing credit ceiling, if any, of the State 
for the preceding calendar year (the unused carryforward component);
    (3) The amount of State housing credit ceiling returned in the 
calendar year (the returned credit component); plus
    (4) The amount, if any, allocated to the State by the Secretary 
under section 42(h)(3)(D) from a national pool of

[[Page 150]]

unused credit (the national pool component).
    (b) 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)).
    (c) The unused carryforward component. The unused carryforward 
component of the State housing credit ceiling of a State for any 
calendar year is the excess, if any, of the sum of the population and 
returned credit components, over the aggregate housing credit dollar 
amount allocated for the year. Any credit amounts attributable to the 
national pool component of the State housing credit ceiling that remain 
unallocated at the close of a calendar year are not carried forward to 
the succeeding calendar year; instead, the credit expires and cannot be 
reallocated by any Agency.
    (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 the calendar year that 
the credit was returned.

[[Page 151]]

    (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.
    (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 this 
section for rules regarding the National Pool and the description of a 
qualified State.) Credit from the national pool component of a State 
housing credit ceiling must be allocated prior to the close of the 
calendar year or the credit expires and cannot be reallocated by any 
Agency. A national pool component credit that is allocated during a 
calendar year and returned

[[Page 152]]

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. Under section 42(h)(3)(C), credit is treated as 
allocated from the various components of the State housing credit 
ceiling in the following order. The first credit allocated for any 
calendar year is treated as credit from the sum of the population and 
returned credit components of the State housing credit ceiling. Once all 
of the credit in these components has been allocated, the next credit 
allocated is treated as credit from the unused carryforward component of 
the State housing credit ceiling. Finally, after all of the credit from 
the population component, returned credit component, and unused 
carryforward component has been allocated, any further credit allocated 
is treated as credit from the national pool component.
    (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 the 
unused carryforward component of the State housing credit ceiling for 
the calendar year over the excess, if any, of--
    (i) The total housing credit dollar amount allocated for the year; 
over
    (ii) The sum of the population and returned credit components of the 
State housing credit ceiling for the 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

[[Page 153]]

unallocated at the close of a calendar year is only a de minimis amount 
of credit, the State is a qualified State eligible to participate in the 
National Pool. For that purpose, a credit amount is de minimis if it 
does not exceed 1 percent of the aggregate State housing credit ceiling 
of the State for the calendar year.
    (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) Examples. (1) The operation of the rules of this section may be 
illustrated by the following examples. Unless otherwise stated in an 
example, Agency A is the sole Agency authorized to make allocations of 
housing credit dollar amounts in State M, all of Agency A's allocations 
are valid, and for calendar year 1994 Agency A has available for 
allocation a State housing credit ceiling consisting of the following 
housing credit dollar amounts:

A. Population component........................................     $100
B. Unused carryforward component...............................       50
C. Returned credit component...................................       10
D. National pool component.....................................        0
                                                                --------
      Total....................................................      160
 

    (2) In addition, the $10 of returned credit component was returned 
before October 1, 1994.

    Example 1 (i) Additional facts. By the close of 1994, Agency A had 
allocated $80 of the State M housing credit ceiling. Of the $80 
allocated, $16 was allocated to projects involving qualified nonprofit 
organizations.
    (ii) Application of stacking rules. The first credit allocated is 
treated as allocated from the population and returned credit components 
of the State housing credit ceiling, to the extent of those components. 
In this case, the $80 of credit allocated is less than the sum of the 
population and returned credit components. The excess of the sum of the 
population and returned credit components over the total amount 
allocated for the calendar year ($110-80=$30) becomes the unused 
carryforward component of State M's 1995 State housing credit ceiling. 
Because Agency A did not allocate credit in excess of the sum of the 
population and returned credit components, no credit is treated as 
allocated from State M's $50 unused carryforward component in 1994. 
Because none of this component may be carried forward, all $50 is 
assigned to the Secretary for inclusion in the National Pool. Under 
paragraph (i)(3) of this section, State M does not qualify for credit 
from the National Pool for the 1995 calendar year.
    (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 ($16, 10% of the 
$160 ceiling).

    Example 2 (i) Additional facts. By the close of 1994, Agency A had 
allocated $130 of the State M housing credit ceiling. Of the $130 
allocated, $20 was allocated to projects involving qualified nonprofit 
organizations.

[[Page 154]]

    (ii) Application of stacking rules. The first $110 of credit 
allocated is treated as allocated from the population and returned 
credit components. In this case, because all of the population and 
returned credit components are allocated, no amount is included in State 
M's 1995 State housing credit ceiling as an unused carryforward 
component. The next $20 of credit allocated is treated as allocated from 
the $50 unused carryforward component. The $30 remaining in the unused 
carryforward component is assigned to the Secretary for inclusion in the 
National Pool for the 1995 calendar year. Under paragraph (i)(3) of this 
section, State M does not qualify for credit from the National Pool for 
the 1995 calendar year.
    (iii) Nonprofit set-aside. Agency A allocated $4 more credit to 
projects involving qualified nonprofit organizations than necessary to 
meet the nonprofit set-aside requirement. This does not reduce the 
application of the 10% nonprofit set-aside requirement to the State M 
housing credit ceiling for the succeeding year.

    Example 3 (i) Additional fact. None of the applications for credit 
that Agency A received for 1994 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 $144 of the $160 
State housing credit ceiling for calendar year 1994 ($160-16=$144). If 
Agency A allocates $144 of credit, the credit is treated as allocated 
$110 from the population and returned credit components and $34 from the 
unused carryforward component. The $16 of unallocated credit that is set 
aside for projects involving qualified nonprofit organizations is 
treated as the balance of the unused carryforward component, and is 
assigned to the Secretary for inclusion in the National Pool. Under 
paragraph (i)(3) of this section, State M does not qualify for credit 
from the National Pool for the 1995 calendar year.

    Example 4 (i) Additional facts. The $10 of returned credit component 
was returned prior to October 1, 1994. However, a $40 credit that had 
been allocated in calendar year 1993 to a project involving a qualified 
nonprofit organization was returned to the Agency by a mutual consent 
agreement dated November 15, 1994. By the close of 1994, Agency A had 
allocated $160 of the State M housing credit ceiling, including $16 of 
credit to projects involving qualified nonprofit organizations.
    (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, 1995. 
If Agency A treats all of the $40 amount as having been returned in 
calendar year 1995, the State M housing credit ceiling for 1994 is $160. 
This entire amount, including the $16 nonprofit set-aside, has been 
allocated in 1994. Under paragraph (i)(3) of this section, State M 
qualifies for the National Pool for the 1995 calendar year.
    (iii) If three-month rule not used. If Agency A treats all of the 
$40 of previously allocated credit as returned in calendar year 1994, 
the State housing credit ceiling for the 1994 calendar year will be $200 
of which $50 will be attributable to the returned credit component 
($10+$40=$50). Because credit amounts allocated in a prior calendar year 
that are returned in a subsequent calendar year do not retain their 
nonprofit character, the nonprofit set-aside for calendar year 1994 is 
$20 (10% of $200). The $160 that Agency A allocated during 1994 is first 
treated as allocated from the population and returned credit components, 
which total $150. The next $10 of credit allocated is treated as 
allocated from the unused carryforward component. The $40 of unallocated 
credit from the unused carryforward component includes the $4 of 
unallocated nonprofit set-aside. The entire $40 of credit from the 
carryforward component is assigned to the Secretary for inclusion in the 
National Pool for the 1995 calendar year. State M does not qualify for 
credit from the National Pool for the 1995 calendar year.

    Example 5 (i) (A) Additional facts. For calendar year 1994, Agency A 
has a State housing credit ceiling that consists of the following 
housing credit dollar amounts:

 
 
 
A. Population component........................................     $100
B. Unused carryforward component...............................        0
C. Returned credit component...................................       20
D. National pool component.....................................       10
                                                                --------
      Total....................................................      130
Minimum nonprofit set-aside....................................       13
Ceiling amount not set-aside...................................      117
 

    In addition, the $20 of returned credit component was returned 
before October 1, 1994. By the close of 1994, Agency A had allocated 
$100 of the State housing credit ceiling.
    (ii) Application of stacking rules. The $20 excess of the sum of the 
population component and the returned credit component over the total 
amount allocated for the calendar year ($120-100=$20) becomes the unused 
carryforward component of the State housing credit ceiling for the 1995 
calendar year. The $10 of unallocated credit from the national pool 
component expires and cannot be reallocated. This amount is neither 
carried over to 1995 by State M nor assigned to the Secretary for 
inclusion in the National Pool. Under paragraph (i)(3) of this section, 
State M does not qualify for credit from the National Pool for the 1995 
calendar year.


[[Page 155]]


    (l) Effective date. The rules set forth in Sec. 1.42-14 are 
effective January 1, 1994.

[T.D. 8563, 59 FR 50163, Oct. 3, 1994; 60 FR 3345, Jan. 17, 1995]



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 156]]

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 157]]

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 158]]

    (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]

    Effective Date Note: By T.D. 8859, 65 FR 2329, Jan. 14, 2000, 
Sec. 1.42-17 was added, effective Jan. 1, 2001.



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--

[[Page 159]]

    (i) 2 percent of so much of the individual's taxable income for the 
taxable year, reduced by the zero bracket amount determined under 
section 63 (d), as does not exceed $9,000, or
    (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

[[Page 160]]

bankruptcy or to an estate of a deceased individual. However, in the 
case of a deceased individual, the credit shall be allowed on the 
decedent's final return filed by his executor or other representative. 
Also, the credit provided by section 42 and this section shall be 
allowed in the case of a return filed by an estate of an infant, 
incompetent, or an individual under a disability.
    (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]

[[Page 161]]



Sec. 1.43-0  Table of contents.

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

      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

[[Page 162]]

(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 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 -

[[Page 163]]

$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 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

[[Page 164]]

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 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

[[Page 165]]

project that commences after December 31, 1990. Notwithstanding the 
provisions of the preceding sentence, if a project implemented prior to 
January 1, 1991, is terminated for less than 36 months before 
implementing an enhanced oil recovery project that commences after 
December 31, 1990, a taxpayer may request permission to treat the 
project that commences after December 31, 1990, as a significant 
expansion. Permission will not be granted if the Internal Revenue 
Service determines that a project was terminated to make an otherwise 
nonqualifying project eligible for the credit. For purposes of section 
43, a qualified tertiary recovery method terminates at the point in time 
when the method no longer results in more than an insignificant increase 
in the amount of crude oil that ultimately will be recovered. All the 
facts and circumstances determine whether a tertiary recovery method has 
terminated. Among the factors considered is the project plan, the unit 
plan of development, or other similar plan. A tertiary recovery method 
is not necessarily terminated merely because the injection of the 
tertiary injectant has ceased. For purposes of this paragraph (d)(1), a 
project is implemented when costs that will be taken into account in 
determining the credit with respect to the project are paid or incurred.
    (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

[[Page 166]]

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.
    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

[[Page 167]]

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 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

[[Page 168]]

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]



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

[[Page 169]]

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
    (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]

[[Page 170]]



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 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

[[Page 171]]

oil recovery project if the property is used directly in the project and 
is essential to the completeness of the project. All the facts and 
circumstances determine whether tangible property is used directly in a 
qualified enhanced oil recovery project and is essential to the 
completeness of the project. Generally, property used to acquire or 
produce the tertiary injectant or property used to transport the 
tertiary injectant to a project site is property that is an integral 
part of the project.
    (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

[[Page 172]]

process gas produced in the project is located on C's property. The gas 
processing plant is not used directly in the project and is not 
essential to the completeness of the project. Therefore, the gas 
processing plant is not an integral part of the enhanced oil recovery 
project.
    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

[[Page 173]]

drilled for the primary purpose of implementing an enhanced oil recovery 
project is not considered to be used for primary or secondary recovery, 
notwithstanding that some primary or secondary production may result 
when the well is drilled, provided that such primary or secondary 
production is consistent with the unit plan of development or other 
similar plan. All the facts and circumstances determine whether primary 
or secondary recovery is consistent with the unit plan of development or 
other similar plan.
    (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

[[Page 174]]

the case of a Coordinated Examination 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

[[Page 175]]

connection with the project from an unrelated equipment dealer in an 
arm's length transaction. The equipment is used for the primary purpose 
of implementing the project. Some of the equipment acquired by O is used 
equipment. The costs paid by O for the used equipment are qualified 
enhanced oil recovery costs. O does not need to determine whether the 
equipment has been previously used in an enhanced oil recovery project.
    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

[[Page 176]]

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 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 Secs. 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]

[[Page 177]]



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 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

[[Page 178]]

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. 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.)


[[Page 179]]



However, any written certification filed by the taxpayer will be 
accepted provided that such certification is signed by the seller and 
states that 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

[[Page 180]]

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 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

[[Page 181]]

property. The fair market value of any excluded property is to be 
determined at the time of the prior offer, while all 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

[[Page 182]]

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 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

[[Page 183]]

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 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

[[Page 184]]

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 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--

[[Page 185]]

    (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
    (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. 1.44A-1  Expenses for household and dependent care services necessary for gainful employment.

    (a) In general. (1) This section applies only for expenses incurred 
in taxable years beginning after December 31, 1975. For deductibility of 
expenses incurred in taxable years beginning before January 1, 1972, see 
Sec. 1.214-1. For deductibility of expenses incurred in taxable years 
beginning after December 31, 1971, and before January 1, 1976, see 
Secs. 1.214A-1 through 1.214A-5.
    (2) Section 44A allows a credit against the tax imposed by chapter 1 
of the Code to an individual who maintains a household (within the 
meaning of paragraph (d) of this section) which includes as a member one 
or more qualifying individuals (as defined in paragraph (b) of this 
section). The amount of the credit is equal to the applicable percentage 
of the employment-related expenses (as defined in paragraph (c) of this 
section) paid by the individual during the taxable year (but subject to 
the limits prescribed in Sec. 1.44A-2(a)). However, the credit cannot 
exceed the tax imposed by chapter 1, reduced by the sum of the allowable 
credits enumerated in section 44A(b). The term ``applicable percentage'' 
means 30 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 $10,000, but in no event shall the percent be less 
than 20 percent. Thus, for example, if a taxpayer's adjusted gross 
income is over $10,000, but less than $12,000.01, the applicable 
percentage is 29 percent. (For expenses incurred in taxable years 
beginning before January 1, 1982, the applicable percentage is a flat 20 
percent).
    (3) Generally, the credit for employment-related expenses is 
allowable, regardless of the taxpayer's method of accounting, only for 
expenses which are actually paid during the taxable year and which are 
incurred during the taxable year or were incurred during a prior taxable 
year beginning after December 31, 1975. If the expenses are incurred but 
not paid during the taxable year, no credit may be taken for that year 
on account of those expenses. Thus, if an expense is incurred in the 
last month of a taxable year but not paid until the following taxable 
year, a credit for the expense is not allowed for the earlier taxable 
year but is allowed for the following taxable year. However, if an 
expense is incurred in a taxable year beginning before January 1,

[[Page 186]]

1976, and paid in a later taxable year, no credit is allowed with 
respect to the expense under section 44A. Section 214 and the 
regulations thereunder are applicable in determining whether a deduction 
for the expense is allowed in the year of payment.
    (4) Since an expense cannot be an employment-related expense until 
the services for which the expense was incurred are performed (see 
paragraph (c) of this section), prepaid expenses may be claimed only in 
the taxable year in which the services are performed.
    (5) The requirements of section 44A, this section and Secs. 1.44A-2 
through 1.44A-4 are applied to expenses as of the time they are incurred 
regardless of when they are paid.
    (6) For special rules relating to employment-related expenses which 
also qualify as medical expenses deductible under section 213, see 
Sec. 1.44A-4(b).
    (7) For substantiation of the credit, see paragraph (e) of this 
section.
    (b) Qualifying individual--(1) In general. A person is considered to 
be a qualifying individual if he or she is--
    (i) The taxpayer's dependent who is under the age of 15 and is an 
individual for whom the taxpayer is entitled to a deduction for a 
personal exemption under section 151(e);
    (ii) The taxpayer's dependent (not described in subdivision (i)) who 
is physically or mentally incapable of self-care; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care.

The term ``dependent,'' as used in this paragraph (b)(1), includes any 
individual who is a dependent within the meaning of section 152. 
However, see paragraph (b)(2) of this section for special rules for 
determining which parent may treat a child as a qualifying individual 
where the parents are divorced, legally separated, or separated under a 
written separation agreement.
    (2) Special dependency test in case of divorced or separated 
parents. A child (as defined in section 151(e)(3)) who--
    (i) Is under age 15 or is physically or mentally incapable of self-
care,
    (ii) Receives over half of his or her support during the calendar 
year from his or her parents who are divorced or legally separated under 
a decree of divorce or separate maintenance or who are separated under a 
written separation agreement, and
    (iii) Is in the custody of one or both of his or her parents for 
more than one-half of the calendar year,

is treated for any taxable year beginning in the calendar year as a 
qualifying individual (described in subdivision (i) or (ii), as the case 
may be, of paragraph (b)(1) of this section) of that parent who has 
custody for a longer period during the calendar year than the other 
parent. Accordingly, a child may be treated as a qualifying individual 
of a parent even though the parent is not entitled to a dependency 
exemption for the child. The child cannot be treated as a qualifying 
individual with respect to more than one parent.
    (3) Qualification on a daily basis. The status of a person as a 
qualifying individual is determined on a daily basis. Thus, if a 
dependent or spouse of a taxpayer ceases to be a qualifying individual 
on September 16, the dependent or spouse is treated as a qualifying 
individual through September 15 only.
    (4) Physical or mental incapacity. An individual is considered to be 
physically or mentally incapable of self-care if as a result of a 
physical or mental defect the individual is incapable of caring for his 
or her hygienical or nutritional needs, or requires full-time attention 
of another person for his or her own safety or the safety of others. The 
fact that an individual, by reason of a physical or mental defect, is 
unable to engage in any substantial gainful activity, or is unable to 
perform the normal household functions of a homemaker or to care for 
minor children, does not of itself establish that the individual is 
physically or mentally incapable of self-care. An individual who is 
physically handicapped or is mentally defective, and for such reason 
requires constant attention of another person, is considered to be 
physically or mentally incapable of self-care.
    (c) Employment-related expenses--(1) Gainful employment--(i) In 
general. Expenses are considered to be employment-related expenses only 
if they are incurred to enable the taxpayer to be gainfully employed and 
are paid for household services or for the care of one or more 
qualifying individuals. The

[[Page 187]]

expenses must be incurred while the taxpayer is gainfully employed or is 
in active search of gainful employment. The employment may consist of 
service either within or without the home of the taxpayer and may 
include self-employment. An expense is not considered to be employment-
related merely because it is incurred while the taxpayer is gainfully 
employed. The purpose of the expense must be to enable the taxpayer to 
be gainfully employed. Volunteer work for a nominal salary does not 
constitute gainful employment. Whether the purpose of an expense is to 
enable the taxpayer to be gainfully employed depends upon the facts and 
circumstances of the particular case. Any tax required to be paid by the 
taxpayer under section 3111 (relating to the Federal Insurance 
Contributions Act) and 3301 (relating to the Federal Unemployment Tax 
Act), or under similar State payroll taxes, in respect of any wages 
which otherwise constitute employment-related expenses is considered to 
be an employment-related expense.
    (ii) Determination of period of employment on a daily basis. An 
allocation of expenses is required on a daily basis when the expenses 
cover any period during part of which the taxpayer is gainfully employed 
or is in active search of gainful employment and during the other part 
of which there is no employment or active search for gainful employment. 
Thus, for example, if a taxpayer incurs during each month of the taxable 
year $60 of expenses which would be employment-related if he or she were 
gainfully employed all year, and the taxpayer is gainfully employed, or 
in active search of gainful employment, for only 2 months and 10 days 
during such year, the amount of employment-related expenses is limited 
to $140.
    (2) Household services. Expenses are considered to be paid for 
household services if they are paid for the performance in and about the 
taxpayer's home of ordinary and usual services necessary to the 
maintenance of the household. However, expenses are not considered as 
paid for household services unless the expenses are attributable in part 
to the care of the qualifying individual. Thus, amounts paid for the 
services of a domestic maid or cook are considered to be expenses paid 
for household services if a part of those services is provided to the 
qualifying individual. Amounts paid for the services of an individual 
who is employed as a chauffeur, bartender, or gardener, however, are not 
considered to be expenses paid for household services.
    (3) Care of qualifing individual--(i) In general. The primary 
purpose of expenses for the care of a qualifying individual must be to 
assure that individual's well-being and protection. Not all benefits 
bestowed upon a qualifying individual are considered as provided for the 
individual's care. Accordingly, amounts paid to provide food, clothing, 
or education are not expenses paid for the care of a qualifying 
individual. However, where the manner of providing care is such that the 
expense which is incurred includes expenses for other benefits which are 
incident to and inseparably a part of the care, the full amount of the 
expense is considered to be incurred for care. Thus, for example, the 
full amount paid to a nursery school in which a qualifying child is 
enrolled is considered as being for the care of the child, even though 
the school also furnishes lunch and educational services. Educational 
expenses incurred for a child in the first or higher grade level are not 
expenses incurred for the care of a qualifying individual. Expenses 
incurred for transportation of a qualifying individual described in 
paragraph (b)(1)(i) of this section between the taxpayer's household and 
a place outside the taxpayer's household where services for the care of 
the qualifying individual are provided are not incurred for the care of 
a qualifying individual.
    (ii) Manner of providing care. The manner of providing the care need 
not be the least expensive alternative available to the taxpayer. For 
example, the taxpayer's mother may reside at the taxpayer's home and be 
available to provide adequate care at no cost for the taxpayer's wife 
who is physically or mentally incapable of caring for herself. 
Nevertheless, the expenses incurred in providing a nurse for the wife 
may be an expense for the care of the wife. See paragraph (c)(1)(i) of 
this section with respect to the requirement

[[Page 188]]

that the expense must be for the purpose of permitting the taxpayer to 
be gainfully employed.
    (4) Services outside the taxpayer's household. The credit is allowed 
under section 44A with respect to employment-related expenses incurred 
for services performed outside the taxpayer's household only if those 
expenses are incurred for the care of--
    (i) One or more qualifying individuals who are described in 
paragraph (b)(1)(i) of this section; or
    (ii) One or more qualifying individuals (as to expenses incurred for 
taxable years beginning after December 31, 1981) who are described in 
paragraph (b)(1) (ii) or (iii) of this section and who regularly spend 
at least 8 hours each day in the taxpayer's household.
    (5) Dependent care centers. The credit is allowed under section 44A 
with respect to employment-related expenses incurred in taxable years 
beginning after December 31, 1981, for services provided outside the 
taxpayer's household by a dependent care center only if--
    (i) The center complies with all applicable laws and regulations of 
a State or unit of local government (e.g., State or local requirements 
for licensing, if applicable, and building and fire Code regulations); 
and
    (ii) The requirement provided in paragraph (c)(4)(i) or (ii) of this 
section is met.

The term ``dependent care center'' means any facility that provides 
full-time or part-time care for more than six individuals (other than 
residents of the facility) on a regular basis during the taxpayer's 
taxable year, and receives a fee, payment, or grant for providing 
services for any such individuals (regardless of whether such facility 
is operated for profit). For purposes of the preceding sentence, a 
facility will be presumed to provide full-time or part-time care for six 
or less individuals on a regular basis during the taxpayer's taxable 
year if the facility has six or less individuals (including the 
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 in the case where the 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.
    (6) Allocation of expenses. Where a portion of an expense is for 
household services or for the care of a qualifying individual and a 
portion of such expense is for other purposes, a reasonable allocation 
must be made and only the portion of the expense paid which is 
attributable to such household services or care is considered to be an 
employment-related expense. No allocation is required to be made, 
however, if the portion of expense for the other purpose is minimal or 
insignificant. An allocation must be made, for example, if a servant 
performs household duties, cares for the qualifying children of the 
taxpayer, and also performs social services for the taxpayer (for which 
a deduction is not allowable) or clerical services in the office of the 
taxpayer outside the home (for which a deduction may be allowable under 
section 162). Employment-related expenses include household service 
expenses which are provided in conjunction with the care of a qualifying 
individual. Thus, if an expense is in part attributable to the care of a 
qualifying individual and in part to household services, no allocation 
is required.
    (7) Illustrations. The application of this paragraph (c) may be 
illustrated by the following examples:

    Example 1. The taxpayer lives with her mother who is physically 
incapable of caring for herself. In order to be gainfully employed the 
taxpayer hires a practical nurse whose sole duty consists of providing 
for the care of the mother in the home while the taxpayer is at work. 
All amounts spent for the services of the nurse are employment-related 
expenses.

    Example 2. The taxpayer has a dependent child 10 years of age who 
has been attending public school. The taxpayer, who has been working 
part time, is offered a position involving full-time employment which 
she can accept only if the child is placed in a boarding school. The 
taxpayer accepts the position and the child is sent to a boarding 
school. The expenses paid to the school must be allocated between that 
part of the expenses which represents care for the child and that part 
which represents tuition for education.

[[Page 189]]

The part of the expense representing care of the child is incurred for 
the purpose of permitting the taxpayer to be gainfully employed.

    Example 3. The taxpayer, in order to be gainfully employed, employs 
a full-time housekeeper who cares for the taxpayer's two children, aged 
9 and 15 years, respectively, performs regular household services of 
cleaning and cooking, and chauffeurs the taxpayer to and from his place 
of employment. The chauffeuring service never requires more than 30 
minutes out of the total period of employment each day. No allocation is 
required for purposes of determining the portion of the expense 
attributable to the chauffeuring (not a household service expense) since 
it is de minimis. Further, no allocation is required for the purpose of 
determining the portion of the expense attributable to the care of the 
15-year-old child (not a qualifying individual) since the household 
expense is in part attributable to the care of the 9-year-old child, who 
is a qualifying individual. Accordingly, the entire expense of employing 
the housekeeper is an employment-related expense. However, the total 
amount of employment-related expenses taken into account would be 
limited to the amount allowable for one qualifying individual.

    (d) Maintenance of a household--(1) In general. An individual is 
considered to have maintained a household for the taxable year (or 
lesser period) only if the individual (and his or her spouse if the 
individual is married) have furnished over one-half of the cost incurred 
for such taxable year (or lesser period) in maintaining the household. 
The household must actually constitute for the taxable year the 
principal place of abode of the taxpayer and the qualifying individual 
or individuals described in paragraph (b) of this section. It is not 
sufficient that the taxpayer maintain the household without being its 
occupant. A physical change in the location of the home does not, 
however, prevent the home from constituting the principal place of abode 
of the taxpayer and a qualifying individual. The fact that an individual 
is born or dies during the taxable year does not prevent a home from 
constituting his or her principal place of abode for such year. An 
individual is not considered to have terminated a household as his or 
her principal place of abode merely by reason of temporary absences 
therefrom by reason of illness, education, business, vacation, military 
service, or a custody agreement.
    (2) Two or more families. Solely for purposes of section 44A and 
this section, if two or more families occupy living quarters in common, 
each of the families is treated as constituting a separate household, 
and the taxpayer who provides more than one-half of the costs of 
maintaining such a separate household is treated as maintaining that 
household. Thus, for example, if two unrelated taxpayers each with 
children occupy living quarters in common and each taxpayer pays more 
than one-half of the household costs incurred by each respective family, 
each taxpayer will be treated as maintaining a separate household.
    (3) Costs of maintaining a household. The costs of maintaining a 
household are the expenses incurred for the mutual benefit of the 
occupants thereof by reason of its operation as the principal place of 
abode of the occupants. 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. These 
expenses do not include the cost of clothing, education, medical 
treatment, vacations, life insurance, or transportation or payments on 
mortgage principal or for the purchase, permanent improvement, 
betterment, or replacement of property. Further, the costs of 
maintaining a household do not include the value of services performed 
in the household by a qualifying individual described in paragraph (b) 
of this section. An expense incurred by a taxpayer which is paid or 
reimbursed by another is not considered as a cost of maintaining a 
household.
    (4) Monthly proration of annual costs. In determining the cost 
incurred for a period of less than a taxable year in maintaining a 
household, the cost incurred during the entire taxable year must be 
prorated on the basis of the number of calendar months within such 
lesser period. For this purpose a period of less than a calendar month 
will be treated as a calendar month. Thus, for example, if the cost of 
maintaining a household for a taxable year is $6,600, and the period in 
respect of which a determination is being made

[[Page 190]]

under section 44A is from June 20 to December 31, the taxpayer must 
furnish more than $1,925 ([$6,600 x \7/12\] x 50 percent) in maintaining 
the household from June 1 to December 31.
    (e) Substantiation. A taxpayer claiming a credit under paragraph (a) 
of this section for employment-related expenses must substantiate by 
adequate records or other sufficient evidence any credit taken under 
this section. For example, if requested, the taxpayer must furnish 
information as to the nature and period of the physical or mental 
incapacity of any dependent or spouse in respect of whom a credit is 
claimed, including necessary information from the attending physician as 
to the nature of the physical or mental incapacity.

(Secs. 44A(g) and 7805 of the Internal Revenue Code of 1954 (90 Stat. 
1565, 26 U.S.C. 44A(g); 68A Stat. 917, 26 U.S.C. 7805))

[T.D. 7643, 44 FR 50332, Aug. 28, 1979, as amended by T.D. 7951, 49 FR 
18091, Apr. 27, 1984]



Sec. 1.44A-2  Limitations on amount creditable.

    (a) Annual dollar limit on amount creditable. The amount of the 
employment-related expenses incurred during any taxable year which may 
be taken into account under Sec. 1.44A-1 (a) cannot exceed--
    (1) $2,400 ($2,000 in the case of expenses incurred in taxable years 
beginning before January 1, 1982) if there is one qualifying individual 
with respect to the taxpayer at any time during the taxable year, or
    (2) $4,800 ($4,000 in the case of expenses incurred in taxable years 
beginning before January 1, 1982) if there are two or more qualifying 
individuals with respect to the taxpayer at any one time during the 
taxable year.

For example, a calendar year taxpayer whose only qualifying individual 
reaches age 15 on April 1, 1982, is subject for 1982 to the entire 
annual dollar limit of $2,400, without proration of the $2,400 limit. 
However, only expenses incurred prior to the child's 15th birthday may 
be employment-related expenses.
    (b) Earned income limitation--(1) In general. The amount of 
employment-related expenses incurred during any taxable year which may 
be taken into account under Sec. 1.44A-1(a) cannot exceed--
    (i) For an individual not married at the close of the year, the 
individual's earned income for the year, or
    (ii) For an individual married at the close of the year, the lesser 
of the individual's earned income or the earned income of his or her 
spouse for the year.

For purposes of this paragraph (b)(1), the earned income of only the 
spouse to whom the taxpayer is married at the close of the year is taken 
into account (and not the earned income of another spouse who died or 
was divorced from the taxpayer during the year). Further, the spouse's 
earned income for the entire year is taken into account, even though the 
taxpayer and his or her spouse were married for only a part of the year. 
For purposes of this paragraph (b), certain married individuals legally 
separated or living apart are treated as not married (see Sec. 1.44A-3 
(b) and (c), respectively).
    (2) Earned income. For purposes of this section, earned income 
means--
    (i) Wages, salaries, tips, other employee compensation, and
    (ii) Net earnings from self-employment (within the meaning of 
section 1402(a) and the regulations thereunder).

For taxable years beginning before January 1, 1979, earned income 
includes only amounts described in subdivision (i) or (ii) of this 
paragraph (b)(2) which are includible in the eligible individual's gross 
income for the taxable year of the individual in which the credit is 
claimed. For all taxable years, however, 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 or an annuity 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).
    (3) Special rule for spouse who is a student or incapable of self-
care. (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

[[Page 191]]

Sec. 1.44A-1(b)(1)(iii), to be gainfully employed and to have earned 
income of not less than--
    (A) $200 ($166 for taxable years beginning before January 1, 1982) 
if there is one qualifying individual with respect to the taxpayer at 
any one time during the taxable year, or
    (B) $400 ($333 for taxable years beginning before January 1, 1982), 
if there are two or more qualifying individuals with respect to the 
taxpayer at any one time during the taxable year.

However, in the case of any husband and wife, this subparagraph shall 
apply with respect to only one spouse for any one month.
    (ii) A ``full-time student'' is an individual who is enrolled at and 
attends and educational institution during each of 5 calendar months of 
the taxable year of the taxpayer for the number of course hours which is 
considered to be a full-time course of study. The enrollment for 5 
calendar months need not be consecutive. School attendance exclusively 
at night does not constitute a full-time course of study. However, a 
full-time course of study may include some attendance at night.
    (iii) For the definition of ``educational institution'', see 
Sec. 1.151-3(c).
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. During the 1982 taxable year, A, a married taxpayer, 
incurs and pays employment-related expenses of $4,000 for the care of a 
qualifying individual. A's earned income for the taxable year is $20,000 
and his wife's earned income is $1,500. Under these circumstances, the 
amount of employment-related expenses for the year which may be taken 
into account under Sec. 1.44A-1(a) is $1,500, determined as follows:

Employment-related expenses incurred during taxable year ($4,000, but 
limited to $2,400 by paragraph (a)(1) of this section), . . . . . . 
$2,400
Application of paragraph (b)(1)(ii) of this section (employment-related 
expenses, may not exceed wife's earned income of $1,500 . . . . . $1,500
Employment-related expenses taken into account . . . . . $1,500

    Example 2. Assume the same facts as in Example 1 except that A's 
wife is a full-time student for nine months of the taxable year and 
earns no income for the year. Under these circumstances, the amount of 
employment-related expenses for the year which may be taken into account 
under Sec. 1.44A-1(a) is $1,800, determined as follows:

Employment-related expenses incurred during taxable year ($4,000, but 
limited to $2,400 by paragraph (a)(1) of this section . . . . . $2,400
Application of paragraph (b)(3) of this section [employment-related 
expenses may not exceed wife's earned income of $1,800 (200 x 9) . . 
$1,800
Employment-related expenses taken into account . . . .$1,800

(Secs. 44A(g) and 7805 of the Internal Revenue Code of 1954 (90 Stat. 
1565, 26 U.S.C. 44A(g); 68A Stat. 917, 26 U.S.C. 7805))

[T.D. 7643, 44 FR 50334, Aug. 28, 1979, as amended by T.D. 7951, 49 FR 
18092, Apr. 27, 1984]



Sec. 1.44A-3  Special rules applicable to married individuals.

    (a) Joint return requirement. This section applies only if the 
taxpayer is married at the close of a taxable year in which employment-
related expenses are paid. In such a case the credit provided by section 
44A with respect to employment-related expenses is allowed only if for 
the taxable year the taxpayer and his or her spouse file a joint return. 
If either spouse dies during the taxable year and a joint return may be 
made for the year under section 6013(a)(2) for the survivor and the 
deceased spouse, the credit is allowed for the year only if a joint 
return is made. If, however, the surviving spouse remarries before the 
end of the taxable year in which his or her first spouse dies, a credit 
is allowed on the separate return which is made for the decedent spouse. 
For purposes of this section, certain married individuals legally 
separated or living apart are treated as not married, as provided in 
paragraphs (b) and (c), respectively, of this section.
    (b) Marital status. For purposes of section 44A, an individual 
legally separated from his or her spouse under a decree of divorce or of 
separate maintenance is not considered as married.
    (c) Certain married individuals living apart. For purposes of 
section 44A, an individual who is married within the meaning of section 
143(a) is treated as not married for the entire taxable year, if the 
individual--
    (1) Files a separate return for the year,

[[Page 192]]

    (2) Maintains as his or her home a household which constitutes for 
more than one-half of the taxable year the principal place of abode of a 
qualifying individual, and
    (3) Furnishes over one-half of the cost of maintaining the household 
for the year,

and if the individual's spouse is not a member of the household at any 
time during the last 6 months of the year. Thus for example, an 
individual who is married during the taxable year, but is treated as not 
married by reason of this paragraph, may determine the earned income 
limitation upon the amount of employment-related expenses without taking 
into account the earned income of his or her spouse under Sec. 1.44A-
2(b).

[T.D. 7643, 44 FR 50335, Aug. 28, 1979]



Sec. 1.44A-4  Other special rules relating to employment-related expenses.

    (a) Payments to related individuals--(1) Taxable years beginning 
after December 31, 1978. For taxable years beginning after December 31, 
1978, a credit is not allowed under section 44A with respect to the 
amount of any employment-related expenses paid by the taxpayer to an 
individual--
    (i) With respect to whom for the taxable year a deduction under 
section 151(e) (relating to deduction for personal exemptions for 
dependents) is allowable either to the taxpayer or his or her spouse, or
    (ii) Who is a child of the taxpayer (within the meaning of section 
151(e)(3)) who is under age 19 at the close of the taxable year.

For purposes of this paragraph (a)(1), the term ``taxable year''means 
the taxable year of the taxpayer in which the service is performed. 
(1943)
    (2) Taxable years beginning before January 1, 1979. For taxable 
years beginning before January 1, 1979, except as otherwise provided in 
paragraph (a)(3) of this section, a credit is not allowed under section 
44A with respect to the amount of any employment-related expenses paid 
by the taxpayer to an individual who bears to the taxpayer any 
relationship described in section 152(a) (1) through (8). These 
relationships are those of a son or daughter or descendant thereof; a 
stepson or stepdaughter; a brother, a sister, stepbrother, or 
stepsister; a father or mother or an ancestor, of either; a stepfather 
or stepmother; a nephew or niece; an uncle or aunt; or a son-in-law, 
daughter-in-law, father-in-law, mother-in-law, brother-in-law, or 
sister-in-law. In addition, no credit is allowed with respect to the 
amount of any employment-related expenses paid by the taxpayer to an 
individual who qualifies as a dependent of the taxpayer for the taxable 
year within the meaning of section 152(a)(9), which relates to an 
individual (other than the taxpayer's spouse) whose principal place of 
abode for the taxable year is the home of the taxpayer and who is a 
member of the taxpayer's household.
    (3) Exception for payments to certain related individuals. For 
taxable years beginning before January 1, 1979, a credit is allowed for 
the amount of any employment-related expenses paid by the taxpayer to an 
individual provided that neither the taxpayer nor his or her spouse is 
entitled to a deduction under section 151(e) (relating to deduction for 
personal exemptions for dependents) with respect to such individual for 
the taxable year in which the service is performed; and the service with 
respect to which the amount is paid constitutes employment within the 
meaning of section 3121(b). The following services performed for a 
taxpayer by a relative who is an employee of the taxpayer may qualify as 
employment within the meaning of section 3121(b):
    (i) Services performed by the taxpayer's child age 21 or over.
    (ii) Domestic services in the taxpayer's home performed by the 
taxpayer's parent if--
    (A) The taxpayer has living in his or her home a child (as defined 
in section 151(e)(3)) who is under age 18 or who has a physical or 
mental condition requiring the personal care of an adult during at least 
4 continuous weeks in the calendar quarter, and
    (B) The taxpayer is a widow or widower or is divorced, or has a 
spouse living in the home who, because of a physical or mental 
condition, is incapable of caring for his or her child during at

[[Page 193]]

least 4 continuous weeks in the calendar quarter in which services are 
rendered.
    (iii) Services of all relatives other than a child, spouse, or 
parent of the taxpayer.

For taxable years beginning before January 1, 1979, a credit is not 
allowed under section 44A with respect to employment-related expenses 
paid by the taxpayer to a relative for services which do not constitute 
employment under section 3121(b). Services performed by a relative do 
not constitute employment if they relate to the relative's trade or 
business the income from which is includible in computing the relative's 
net earnings for purposes of the self-employment tax under section 1401.
    (4) Payments to entities or partnerships. If the services are 
performed by an entity or partnership, paragraph (a) (1) and (2) of this 
section is normally not applicable. If, however, the entity or 
partnership is established or maintained primarily to avoid the 
application of paragraph (a) (1) or (2) in order to permit the taxpayer 
to obtain the credit with respect to employment-related expenses, for 
purposes of this paragraph (a), the payments of employment-related 
expenses shall be treated as made directly to each owner of the entity 
or partner in proportion to his or her share of the entity or 
partnership. A factor to consider for purposes of determining whether an 
entity or partnership is so established or maintained is whether the 
entity or partnership is set up solely to care for the taxpayer's 
qualifying individual and to provide household services to the taxpayer.
    (5) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. For A's taxable year ending December 31, 1978, A, a 
divorced taxpayer, pays $5,000 of employment-related expenses to his 
mother for the care of his child age 5. A's mother cares for the child 
in her home. The services performed by A's mother do not constitute 
employment under section 3121(b). Accordingly, A is not allowed a credit 
with respect to the amounts paid to the mother for the care of his 
child.

    Example 2. Assume the same facts as in Example 1 except that A's 
taxable year under consideration begins after December 31, 1978. A is 
not entitled to a deduction under section 151(e) for his mother. 
Accordingly, A is allowed a credit with respect to the amounts paid to 
the mother for the care of his child even though the services performed 
by A's mother do not constitute employment under section 3121(b).

    Example 3. For B's taxable year ending December 31, 1978, B, a 
divorced taxpayer, pays $6,000 of employment-related expenses to his 
sister (who is not a dependent of the taxpayer) for the care of his 
child. The services performed by B's sister in the care of his child 
constitute a trade or business the income from which is includible in 
computing net earnings for purposes of the self-employment tax under 
section 1401. Accordingly, B is not allowed a credit with respect to the 
amounts paid to the sister for the care of his child.

    Example 4. Assume the same facts as in Example 3 except that B's 
taxable year under consideration begins after December 31, 1978. B is 
allowed a credit with respect to the amounts paid to the sister for the 
care of his child, even though the services performed by B's sister do 
not constitute employment under section 3121(b).

    (b) Expenses qualifying as medical expenses. An expense which may 
constitute an amount otherwise deductible under section 213, relating to 
medical, etc., expenses, may also constitute an expense with respect to 
which a credit is allowable under section 44A. In such a case, that part 
of the amount with respect to which a credit is allowed under section 
44A will not be considered as an expense for purposes of determining the 
amount deductible under section 213. On the other hand, where an amount 
is treated as a medical expense under section 213 for purposes of 
determining the amount deductible under that section, it may not be 
treated as an employment-related expense for purposes of section 44A. 
The application of this paragraph may be illustrated by the following 
examples:

    Example 1. In 1982, a calendar year taxpayer incurs and pays $5,000 
of employment-related expenses during the taxable year for the care of 
his child when the child is physically incapable of self-care. These 
expenses are incurred for services performed in the taxpayer's household 
and are of a nature which qualify as medical expenses under section 213. 
The taxpayer's adjusted gross income for the taxable year is $100,000. 
Of the total expenses, the taxpayer may take $2,400 into account under 
section 44A; the balance of the

[[Page 194]]

expenses, or $2,600, may be treated as medical expenses to which section 
213 applies. However, this amount does not exceed 3 percent of the 
taxpayer's adjusted gross income for the taxable year and is thus not 
allowable as a deduction under section 213.

    Example 2. Assume the same facts as in Example 1. It is not proper 
for the taxpayer first to determine his deductible medical expenses of 
$2,000 ($5,000--[$100,000 x 3 percent]) under section 213 and then claim 
the $3,000 balance as employment-related expenses for purposes of 
section 44A. This is because the $3,000 balance has been treated as a 
medical expense in computing the amount deductible under section 213.

    Example 3. In 1982, a calendar year taxpayer incurs and pays $12,000 
of employment-related expenses during the taxable year for the care of 
his child. These expenses are incurred for services performed in the 
taxpayer's household, and they also qualify as medical expenses under 
section 213. The taxpayer's adjusted gross income for the taxable year 
is $18,000. The taxpayer takes $2,400 of such expenses into account 
under section 44A. The balance, or $9,600, he treats as medical expenses 
for purposes of section 213. The allowable deduction under section 213 
for the expenses is limited to the excess of the balance of $9,600 over 
$540 (3 percent of the taxpayer's adjusted gross income of $18,000), or 
$9,060.

(Secs. 44A(g) and 7805 of the Internal Revenue Code of 1954 (90 Stat. 
1565, 26 U.S.C. 44A(g); 68A Stat. 917, 26 U.S.C. 7805))

[T.D. 7643, 44 FR 50335, Aug. 28, 1979, as amended by T.D. 7951, 49 FR 
18092, Apr. 27, 1984]



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 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]

[[Page 195]]

    rules for computing credit for investment in certain depreciable 
                                property



Sec. 1.46-1  Determination of amount.

    (a) Effective dates--(1) In general. This section is effective for 
taxable years beginning after December 31, 1975. However, transitional 
rules under paragraph (g) of this section are effective for certain 
earlier taxable years.
    (2) Acts covered. This section reflects changes made by the 
following Acts of Congress:

                             Act and Section

Tax Reduction Act of 1975, section 301.
Tax Reform Act of 1976, sections 802, 1701, 1703.
Revenue Act of 1978, sections 311, 312, 315.
Energy Tax Act of 1978, section 301.
Economic Recovery Tax Act of 1981, section 212.
Technical Corrections Act of 1982, section 102(f).
Tax Reform Act of 1986, section 251.

    (3) Prior regulations. For taxable years beginning before January 1, 
1976, see 26 CFR 1.46-1 (Rev. as of April 1, 1979). Those regulatons do 
not reflect changes made by Pub. L. 89-384, Pub. L. 89-389, and Pub. L. 
91-172.
    (b) General rule. The amount of investment credit (credit) allowed 
by section 38 for the taxable year is the portion of credit available 
under section 46(a)(1) that does not exceed the limitation based on tax 
under section 46(a)(3).
    (c) Credit available. The credit available for the taxable year is 
the sum of--
    (1) Unused credit carried over from prior taxable years under 
section 46(b) (carryovers).
    (2) Amount of credit determined under section 46(a)(2) for the 
taxable year (credit earned), and
    (3) Unused credit carried back from succeeding taxable years under 
section 46(b) (carrybacks).
    (d) Credit earned. The credit earned for the taxable year is the sum 
of the following percentages of qualified investment (as determined 
under section 46 (c) and (d))--
    (1) The regular percentage (as determined under section 46),
    (2) For energy property, the energy percentage (as determined under 
section 46), and
    (3) For the portion of the basis of a qualified rehabilitated 
building (as defined in Sec. 1.48-12(b)) that is attributable to 
qualified rehabilitation expenditures (as defined in Sec. 1.48-12(c)), 
the rehabilitation percentage (as determined under section 46(b)(4)).
    (e) Designation of credits. The credit available for the taxable 
year is designated as follows:
    (1) The credit attributable to the regular percentage is the 
``regular credit''.
    (2) The credit attributable to the ESOP percentage is the ``ESOP 
credit''.
    (3) The credit attributable to the energy percentage for energy 
property other than solar or wind is the ``nonrefundable energy 
credit''.
    (4) The credit attributable to the energy percentage for solar or 
wind energy property is the ``refundable energy credit''.
    (5) The credit attributable to the rehabilitation percentage for 
qualified rehabilitation expenditures is the rehabilitation investment 
credit.
    (f) Special rules for certain energy property. Energy property is 
defined in section 48(l). Under section 46(a)(2)(D), energy property 
that is section 38 property solely by reason of section 48(l)(1) 
qualifies only for the energy credit. Other energy property qualifies 
for both the regular credit (and, if applicable, the ESOP credit) and 
the energy credit. For limitation on the energy percentage for property 
financed by industrial development bonds, see section 48(l)(11).
    (g) Transitional rule for regular and ESOP credit--(1) In general. 
Although section 46(a)(2) was amended by section 301(a)(1) of the Energy 
Tax Act of 1977 to eliminate the transitional rules under section 
46(a)(2)(D), those rules still apply in certain instances. Section 
46(a)(2)(D) was added by section 301(a) of the Tax Reduction Act of 1975 
and amended by section 802(a) of the Tax Reform Act of 1976.
    (2) Regular credit. Under section 46(a)(2)(D), the regular credit is 
10 percent and applies for the following property:
    (i) Property to which section 46 (d) does not apply, the 
construction, reconstruction, or erection of which is completed by the 
taxpayer after January 21, 1975, but only to the extent of

[[Page 196]]

basis attributable to construction, reconstruction, or erection after 
that date.
    (ii) Property to which section 46(d) does not apply, acquired by the 
taxpayer after January 21, 1975.
    (iii) Qualified progress expenditures (as defined in section 46(d)) 
made after January 21, 1975.
    (3) ESOP credit. See section 48(m) for transitional rules limiting 
the period for which the ESOP percentage under section 46(a)(2)(E) 
applies. For prior statutes, see section 46(a)(2) (B) and (D), as added 
by section 301 of the Tax Reduction Act of 1975 and amended by section 
802 of the Tax Reform Act of 1976.
    (4) Cross reference. (i) The principles of Sec. 1.48-2 (b) and (c) 
apply in determining the portion of basis attributable to construction, 
reconstruction, or erection after January 21, 1975, and in determining 
the time when property is acquired.
    (ii) Section 311 of the Revenue Act of 1978 made the 10 percent 
regular credit permanent.
    (5) Seven percent credit. To the extent that, under paragraph (g)(1) 
of this section, the 10 percent does not apply, the regular credit, in 
general, is 7 percent. For a special limitation on qualified investment 
for public utility property (other than energy property), see section 
46(c)(3)(A).
    (6) Qualified progress expenditures. For progress expenditure 
property that is constructed, reconstructed, or erected by the taxpayer 
within the meaning of Sec. 1.48-2(b), the ten-percent credit applies in 
the year the property is placed in service to the portion of the 
qualified investment that remains after reduction for qualified progress 
expenditures under section 46(c)(4), but only to the extent that the 
remaining qualified investment is attributable to construction, 
reconstruction, or erection after January 21, 1975. For progress 
expenditure property that is acquired by the taxpayer (within the 
meaning of Sec. 1.48-2(b)) after January 21, 1975, and placed in service 
after that date, the ten-percent credit applies in the year the property 
is placed in service to the entire portion of qualified investment that 
remains after reduction for qualified progress expenditures.
    (h) Tax liability limitation--(1) In general. Section 46(a)(3) 
provides a tax liability limitation on the amount of credit allowed by 
section 38 (other than the refundable energy credit) for any taxable 
year. See section 46(a)(10)(C)(i). Tax liability is defined in paragraph 
(j) of this section. The excess of available credit over the applicable 
tax liability limitation for the year is an unused credit which may be 
carried forward or carried back under section 46(b).
    (2) Regular and ESOP tax liability limitation. In general, the tax 
liability limitation for the regular and ESOP credits is the portion of 
tax liability that does not exceed $25,000 plus a percentage of the 
excess, as determined under section 46(a)(3)(B).
    (3) Nonrefundable energy credit tax liability limitation. (i) For 
nonrefundable energy credit carrybacks to a taxable year ending before 
October 1, 1978, the tax liability limitation is the portion of tax 
liability that does not exceed $25,000 plus a percentage of the excess, 
as determined under section 46(a)(3)(B).
    (ii) For a taxable year ending after September 30, 1978, the tax 
liability limitation for available nonrefundable energy credit is 100 
percent of the year's tax liability.
    (4) Alternative limitations. Alternative limitations apply for 
certain utilities, railroads, and airlines in determining the regular 
tax liability limitation and, for nonrefundable energy credit carrybacks 
to taxable years ending before October 1, 1978, the nonrefundable energy 
credit tax liability limitation. These alternative limitations do not 
apply in determining the energy tax liability limitation for a taxable 
year ending after October 1, 1978. The provisions listed below set forth 
the alternative limitations:

------------------------------------------------------------------------
     Code section                Type                Years applicable
------------------------------------------------------------------------
46(a)(6) \1\           Utilities                 Taxable years ending in
                                                  1975-1978
46(a)(7) \2\           Utilities                 Taxable year ending in
                                                  1979
46(a)(8)               Railroads and Airlines    Taxable year ending in
                                                  1979 or 1980
46(a)(8) \3\           Railroads                 Taxable years ending in
                                                  1977 or 1978
46(a)(9) \3\           Airlines                  Taxable years ending in
                                                  1977 or 1978
------------------------------------------------------------------------
\1\ Section 46(a)(6) was added by section 301(b)(2) of the Tax Reduction
  Act of 1975 and redesignated as section 46(a)(7) by section 302(a)(1)
  of the Tax Reform Act of 1976.

[[Page 197]]

 
\2\ Section 46(a)(7) was amended by section 312(b)(1) of the Revenue Act
  of 1978.
\3\ These provisions were repealed by section 312(b)(2) of the Revenue
  Act of 1978.


    (i) [Reserved]
    (j) Tax liability--(1) In general. ``Tax liability'' for purposes of 
the regular and ESOP credit and carrybacks of nonrefundable energy 
credit to a taxable year ending before October 1, 1978, means the 
liability for tax as defined in section 46(a)(4). For ordering of 
regular, ESOP, and nonrefundable energy credits, see paragraph (m) of 
this section. In addition to taxes excluded under section 46(a)(4), tax 
liability does not include tax resulting from recapture of credit under 
section 47 and the alternative minimum tax imposed by section 55. See 
sections 47(c) and 55(c)(1).
    (2) Certain nonrefundable energy credit. For a taxable year ending 
after September 30, 1978, ``tax liability'' for purposes of the 
nonrefundable energy credit is liability for tax, as defined in section 
46(a)(4) and paragraph (j)(1) of this section, reduced by the regular 
and ESOP credit allowed for the taxable year. Thus, carrybacks of 
regular or ESOP credit to a taxable year may displace nonrefundable 
energy carryovers or credit earned taken into account in that year. 
However, carrybacks of regular, ESOP, or nonrefundable energy credit do 
not affect refundable energy credit which is treated as an overpayment 
of tax under section 6401(b). See paragraph (k) of this section.
    (k) Special rule for refundable energy credit. The amount of the 
refundable energy credit is determined under the rules of section 46 
(other than section 46(a)(3)). However, to permit the refund, the 
refundable energy credit for purposes of the Internal Revenue Code 
(other than section 38, part IVB, and chapter 63 of the Code) is treated 
as allowed by section 39 and not by section 38. The refundable credit is 
not applied against tax liability for purposes of determining the tax 
liability limitation for other investment credits. Rather, it is treated 
as an overpayment of tax under section 6401(b).
    (l) FIFO rule. If the credit available for a taxable year is not 
allowed in full because of the tax liability limitation, special rules 
determine the order in which credits are applied. Under the first-in-
first-out rule of section 46(a)(1) (FIFO), carryovers are applied 
against the tax liability limitation first. To the extent the tax 
liability limitation exceeds carryovers, credit earned, and carrybacks 
are then applied.
    (m) Special ordering rule--(1) In general. Under section 
46(a)(10)(A), the FIFO rule applies separately--
    (i) First, with respect to regular and ESOP credits, and
    (ii) Second, with respect to nonrefundable energy credit.
    (2) Regular and ESOP credit. Under Sec. 1.46-8(c)(9)(ii), regular 
and ESOP credits available are applied in the following order:
    (i) Regular carryovers;
    (ii) ESOP carryovers;
    (iii) Regular credit earned;
    (iv) ESOP credit earned;
    (v) Regular carrybacks; and
    (vi) ESOP carrybacks.
    (3) Example. For an example of the order of application of regular 
and ESOP credits, see Sec. 1.46-8(c)(9)(iii).
    (n) Examples. The following examples illustrate paragraphs (a) 
through (m) of this section.

    Example 1. (a) Corporation M's regular credit available for its 
taxable year ending December 31, 1979 is as follows:

 
 
 
Regular carryovers...........................................     $5,000
Regular credit earned........................................     10,000
Regular carrybacks...........................................     15,000
                                                              ----------
    Credit available.........................................     30,000
 

    (b) M's ``tax liability'' for 1979 is $30,000. M's tax liability 
limitation for 1979 for the regular credit is $28,000, consisting of 
$25,000 plus 60 percent of the $5,000 of ``tax liability'' in excess of 
$25,000.
    (c) The regular carryovers and credit earned are allowed in full. 
However, only $13,000 of the regular carryback is allowed for 1979. The 
remaining $2,000 must be carried to the next year to which it may be 
carried under section 46(b).

    Example 2. (a) For its taxable year ending December 31, 1980, 
corporation N has $30,000 regular credit earned and $9,000 nonrefundable 
energy credit earned. N has no carryovers to 1980 and no ``tax 
liability'' for pre-1980 years.
    (b) N's ``tax liability'' for 1980 for the regular credit is 
$35,000. N's tax liability limitation for 1980 for the regular credit is 
$32,000, consisting of $25,000 plus 70 percent of the $10,000 of ``tax 
liability'' in excess of $25,000.

[[Page 198]]

    (c) The entire regular credit is allowed in 1980.
    (d) N's ``tax liability'' for 1980 for the nonrefundable energy 
credit is $5,000, consisting of $35,000 less $30,000 regular credit 
allowed for 1980. N's tax liability limitation for 1980 for the 
nonrefundable energy credit is 100 percent of $5,000.
    (e) $5,000 of the nonrefundable energy credit is allowed for 1980. 
The remaining $4,000 energy credit is an unused nonrefundable energy 
credit which must be carried to the next year to which it may be carried 
under section 46(b).

    Example 3. (a) Assume the same facts as in Example 2 except that in 
its taxable year ending December 31, 1981, N earns a regular credit of 
which it may carry back $2,000 to 1980.
    (b) The $30,000 regular credit earned and $2,000 of the regular 
carryback is allowed for 1980. N's ``tax liability'' for 1980 for the 
nonrefundable energy credit is reduced to $3,000, consisting of $35,000 
less $32,000 regular credit allowed for 1980. The nonrefundable energy 
credit allowed for 1980 is reduced to $3,000. The remaining $6,000 is an 
unused nonrefundable energy credit which must be carried to the next 
year to which it may be carried under section 46(b).

    Example 4. (a) For its taxable year ending December 31, 1980, 
corporation P's regular credit earned is $20,000. P also has a $9,000 
refundable energy credit for 1980. There are no carryovers or carrybacks 
to 1980.
    (b) P's ``tax liability'' for 1980 for the regular credit is $25,000 
which is also the tax liability limitation for the regular credit.
    (c) The entire $20,000 regular credit is allowed for 1980. The 
entire $9,000 refundable energy credit is treated as an overpayment of 
tax under section 6401(b), even though ``tax liability'' remains.

    Example 5. Assume the same facts as in Example 4, except that in the 
following year P earns a regular credit, $5,000 of which it may carry 
back to 1980. The $5,000 carryback is allowed in full in 1980.

    Example 6. (i) Corporation X, a calendar year taxpayer, constructs a 
ship on which it begins construction on January 1, 1973, and which, when 
placed in service on December 31, 1980, has a basis of $450,000. Of that 
amount, $100,000 is attributable to construction before January 22, 
1975. X makes an election under section 46(d) (qualified progress 
expenditures) for taxable years after 1975.
    (ii) For 1976, 1977, 1978, and 1979, qualified progress expenditures 
total $200,000. The ten-percent credit applies to those expenditures.
    (iii) For 1980, qualified investment for the ship is $450,000. Under 
section 46(c)(4), X must reduce this amount by $200,000, the amount of 
qualified progress expenditures taken into account. The ten-percent 
credit applies to the portion of the remaining qualified investment 
attributable to construction after January 21, 1975 ($150,000). The 
seven-percent credit applies to the portion of qualified investment 
attributable to construction before January 22, 1975 ($100,000).

    Example 7. (i) Corporation Y agrees to build a ship for Corporation 
X, which uses the calendar year. In 1973, Y begins construction of the 
ship which X acquires and places in service on December 31, 1980. X 
makes an election under section 46(d) for taxable years after 1974. The 
contract price is $400,000.
    (ii) For 1975, 1976, 1977, 1978, and 1979, qualified progress 
expenditures total $250,000. The ten-percent credit applies to those 
expenditures.
    (iii) For 1980, qualified investment for the ship is $400,000, which 
is the contract price. X must reduce qualified investment by $250,000, 
the amount of qualified progress expenditures. The ten-percent credit 
applies to the $150,000 of qualified investment that remains after 
reduction for qualified progress expenditures.

    (o) Married individuals. If a separate return is filed by a husband 
or wife, the tax liability limitation is computed by substituting a 
$12,500 amount for the $25,000 amount that applies under section 
46(a)(3). However, this reduction of the $25,000 amount to $12,500 
applies only if the taxpayer's spouse is entitled to a credit under 
section 38 for the taxable year of such spouse which ends with, or 
within, the taxpayer's taxable year. The taxpayer's spouse is entitled 
to a credit under section 38 either because of investment made in 
qualified property for such taxable year of the spouse (whether directly 
made by such spouse or whether apportioned to such spouse, for example, 
from an electing small business corporation, as defined in section 
1371(b)), or because of an investment credit carryback or carryover to 
such taxable year. The determination of whether an individual is married 
shall be made under the principles of section 143 and the regulations 
thereunder.
    (p) Apportionment of $25,000 amount among component members of a 
controlled group--(1) In general. In determining the tax liability 
limitation under section 46(a)(3) for corporations that are component 
members of a controlled group on December 31, only one $25,000 amount is 
available to those component members for their taxable years

[[Page 199]]

that include that December 31. See subparagraph (2) of this paragraph 
for apportionment of such amount among such component members. See 
subparagraph (3) of this paragraph for definition of ``component 
member''.
    (2) Manner of apportionment. (i) In the case of corporations which 
are component members of a controlled group on a particular December 31, 
the $25,000 amount may be apportioned among such members for their 
taxable years that include such December 31 in any manner the component 
members may select, provided that each such member less than 100 percent 
of whose stock is owned, in the aggregate, by the other component 
members of the group on such December 31 consents to an apportionment 
plan. The consent of a component member to an apportionment plan with 
respect to a particular December 31 shall be made by means of a 
statement, signed by a person duly authorized to act on behalf of the 
consenting member, stating that such member consents to the 
apportionment plan with respect to such December 31. The statement shall 
set forth the name, address, employer identification number, and taxable 
year of each component member of the group on such December 31, the 
amount apportioned to each such member under the plan, and the location 
of the Service Center where the statement is to be filed. The consent of 
more than one component member may be incorporated in a single 
statement. The statement shall be timely filed with the Service Center 
where the component member having the taxable year first ending on or 
after such December 31 files its return for such taxable year and shall 
be irrevocable after such filing. If two or more component members have 
the same such taxable year, a statement of consent may be filed by any 
one of such members. However, if the due date (including any extensions 
of time) of the return of such member is on or before December 15, 1971, 
the required statement shall be considered as timely filed if filed on 
or before March 15, 1972. Each component member of the group on such 
December 31 shall keep as a part of its records a copy of the statement 
containing all the required consents.
    (ii) An apportionment plan adopted by a controlled group with 
respect to a particular December 31 shall be valid only for the taxable 
year of each member of the group which includes such December 31. Thus, 
a controlled group must file a separate consent to an apportionment plan 
with respect to each taxable year which includes a December 31 as to 
which an apportionment plan is desired.
    (iii) If the apportionment plan is not timely filed, the $25,000 
amount specified in section 46(a)(3) shall be reduced for each component 
member of the controlled group, for its taxable year which includes a 
December 31, to an amount equal to $25,000 divided by the number of 
component members of such group on such December 31.
    (iv) If a component member of the controlled group makes its income 
tax return on the basis of a 52-53-week taxable year, the principles of 
section 441(f)(2)(A)(ii) and paragraph (b)(1) of Sec. 1.441-2 apply in 
determining the last day of such taxable year.
    (3) Definitions of controlled group of corporations and component 
member of controlled group. For the purpose of this paragraph, the terms 
``controlled group of corporations'' and ``component member'' of a 
controlled group of corporations shall have the same meaning assigned to 
those terms in section 1563 (a) and (b). For purposes of applying 
Sec. 1.1563-1(b)(2)(ii)(c), an electing small business corporation shall 
be treated as an excluded member whether or not it is subject to the tax 
imposed by section 1378.
    (4) Members of a controlled group filing a consolidated return. If 
some component members of a controlled group join in filing a 
consolidated return pursuant to Sec. 1.1502-3(a)(3), and other component 
members do not join, then, unless a consent is timely filed apportioning 
the $25,000 amount among the group filing the consolidated return and 
the other component members of the controlled group, each component 
member of the controlled group (including each component member which 
joins in filing the consolidated return) shall be treated as a separate 
corporation for purposes of equally apportioning the $25,000 amount 
under subparagraph (2)(iii) of this paragraph. In

[[Page 200]]

that case, the tax liability limitation for the group filing the 
consolidated return is computed by substituting for the $25,000 amount 
under section 46(a)(3) the total amount apportioned to each component 
member that joins in filing the consolidated return. If the affiliated 
group filing the consolidated return and the other component members of 
the controlled group adopt an apportionment plan, the affiliated group 
shall be treated as a single member for the purpose of applying 
subparagraph (2)(i) of this paragraph. Thus, for example, only one 
consent executed by the common parent to the apportionment plan is 
required for the group filing the consolidated return. If any component 
member of the controlled group which joins in the filing of the 
consolidated return is an organization to which section 593 applies or a 
cooperative organization described in section 1381(a), see paragraph 
(a)(3)(ii) of Sec. 1.1502-3.
    (5) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. At all times during 1976 Smith, an individual, owns all 
the stock of corporations X, Y, and Z. Corporation X files an income tax 
return on a calendar year basis. Corporation Y files an income tax 
return on the basis of a fiscal year ending June 30. Corporation Z files 
an income tax return on the basis of a fiscal year ending September 30. 
On December 31, 1976, X, Y, and Z are component members of the same 
controlled group. X, Y, and Z all consent to an apportionment plan in 
which the $25,000 amount is apportioned entirely to Y for its taxable 
year ending June 30, 1977 (Y's taxable year which includes December 31, 
1976). Such consent is timely filed. For purposes of computing the 
credit under section 38, Y's tax liability limitation for its taxable 
year ending June 30, 1977, is so much of Y's tax liability as does not 
exceed $25,000, plus 50 percent of Y's tax liability in excess of 
$25,000. X's and Z's limitations for their taxable years ending December 
31, 1976, and September 30, 1977, respectively, are equal to 50 percent 
of X's tax liability for 50 percent of Z's tax liability. On the other 
hand, if an apportionment plan is not timely filed, X's limitation would 
be so much of X's tax liability as does not exceed $8,333.33, plus 50 
percent of X's liability in excess of $8,333.33, and Y's and Z's 
limitations would be computed similarly.

    Example 2. At all times during 1976, Jones, an individual, owns all 
the outstanding stock of corporations P, Q, and R. Corporations Q and R 
both file returns for taxable years ending December 31, 1976. P files a 
consolidated return as a common parent for its fiscal year ending June 
30, 1977, with its two wholly-owned subsidiaries N and O. On December 
31, 1976, N, O, P. Q, and R are component members of the same controlled 
group. No consent to an apportionment plan is filed. Therefore, each 
member is apportioned $5,000 of the $25,000 amount ($25,000 divided 
equally among the five members). The tax liability limitation for the 
group filing the consolidated return (P, N, and O) for the year ending 
June 30, 1977 (the consolidated taxable year within which December 31, 
1976, falls) is computed by using $15,000 instead of the $25,000 amount. 
The $15,000 is arrived at by adding together the $5,000 amounts 
apportioned to P, N, and O.

    (q) Rehabilitation percentage--(1) General rule--(i) In general. Due 
to amendments made by the Tax Reform Act of 1986, different rules apply 
depending on when the property attributable to the qualified 
rehabilitated expenditures (as defined in Sec. 1.48-12(c)) is placed in 
service. Paragraph (q)(1)(ii) of this section contains the general rule 
relating to property placed in service after December 31, 1986. 
Paragraph (q)(1)(iii) of this section contains rules relating to 
property placed in service before January 1, 1987. Paragraph (q)(1)(iv) 
of this section contains rules relating to property placed in service 
after December 31, 1986, that qualifies for a transition rule.
    (ii) Property placed in service after December 31, 1986. Except as 
otherwise provided in paragraph (q)(1)(iv) of this section, in the case 
of section 38 property described in section 48(a)(1)(E) placed in 
service after December 31, 1986, the term ``rehabilitation percentage'' 
means--
    (A) 10 percent in the case of qualified rehabilitation expenditures 
with respect to a qualified rehabilitated building other than a 
certified historic structure, and
    (B) 20 percent in the case of qualified rehabilitation expenditures 
with respect to a certified historic structure.
    (iii) Property placed in service before January 1, 1987. For 
qualified rehabilitation expenditures (as defined in Sec. 1.48-12(c)) 
with respect to property placed in service before January 1, 1987, 
section 46(b)(4)(A) as in effect prior to the enactment of the Tax 
Reform Act

[[Page 201]]

of 1986 provided for a three-tier rehabilitation percentage. The 
applicable rehabilitation percentage for such expenditures depends on 
whether the qualified rehabilitated building is a ``30-year building,'' 
a ``40-year building,'' or a certified historic structure (as defined in 
section 48(g)(3) and Sec. 1.48-12(d)(1)). The rehabilitation percentage 
for such qualified rehabilitation expenditures incurred with respect to 
a qualified rehabilitated building is 15 percent to the extent that the 
building is a 30-year building (i.e., at least 30 years, but less than 
40 years, has elapsed between the date the physical work on the 
rehabilitation began and the date the building was first placed in 
service), 20 percent to the extent that the building is a 40-year 
building (i.e., at least 40 years has so elapsed), and 25 percent for 
certified historic structures, regardless of age. See paragraph 
(q)(2)(ii) of this section for rules concerning buildings to which 
additions have been added.
    (iv) Property placed in service after December 31, 1986, that 
qualifies under the transition rules. In the case of section 38 property 
described in section 48(a)(1)(E) placed in service after December 31, 
1986, and to which the amendments made by section 251 of the Tax Reform 
Act of 1986 do not apply because the transition rules in section 251(d) 
of that Act and Sec. 1.48-12(a)(2)(iv)(B) or (C) apply, the 
rehabilitation percentage for a ``30-year building'' (within the meaning 
of paragraph (q)(1)(iii) of this section) shall be 10 percent, the 
rehabilitation percentage for a ``40-year building'' (within the meaning 
of paragraph (q)(1)(iii) of this section) shall be 13 percent, and the 
rehabilitation percentage for a certified historic structure shall be 25 
percent.
    (2) Special rules--(i) Moved buildings. With respect to paragraph 
(q)(1)(ii) of this section, Sec. 1.48-12(b)(5) provides that a building 
(other than a certified historic structure) is not a qualified 
rehabilitated building unless it has been at the location where it is 
being rehabilitated since January 1, 1936. In addition, for purposes of 
paragraph (q)(1) (iii) and (iv) of this section, a building is not a 
``30-year building'' unless it has been at the location where it is 
being rehabilitated for the thirty-year period immediately preceding the 
beginning of the rehabilitation process, and is not a ``40-year 
building'' unless it has been at the location where it is being 
rehabilitated for the forty-year period immediately preceding the 
beginning of the rehabilitation process.
    (ii) Building to which additions have been added--(A) Property 
placed in service after December 31, 1986. For purposes of paragraph 
(q)(1)(ii) of this section, if part of a building meets the definition 
of a qualified rehabilitated building, and part of the building does not 
meet the definition of a qualified rehabilitated building because such 
part is an addition that was placed in service after December 31, 1935, 
the qualified rehabilitation expenditures made to the building must be 
allocated to the pre-1936 portion of the building and the post-1935 
portion of the building using the principles in Sec. 1.48-12(c)(10)(ii). 
Qualified rehabilitation expenditures attributable to the post-1935 
addition shall not qualify for the 10 percent rehabilitation percentage.
    (B) Property placed in service before January 1, 1987, and property 
qualifying for a transitional rule. For purposes of paragraphs (q)(1) 
(iii) and (iv) of this section, if part of a building meets the 
definition of a ``40-year building'' and part of the building is an 
addition that was placed in service less than forty years before 
physical work on the rehabilitation began but more than thirty years 
before such date, then the qualified rehabilitation expenditures made to 
the building shall be allocated between the forty year old portion of 
the building and the thirty year old portion of the building, and a 20 
percent rehabilitation percentage shall be applied to the forty year old 
portion of the building and a 15 percent rehabilitation percentage shall 
be applied to the thirty year old portion. This allocation shall be made 
using the principles in Sec. 1.48-12(c)(10)(ii). If an allocation cannot 
be made between the expenditures to the forty year old portion of the 
building and the thirty year old portion of the building, then the 
building will be considered to be a 30-year building. Furthermore, for 
purposes of this paragraph (q), a building (other than a certified 
historic structure) is not a qualified rehabilitated building

[[Page 202]]

to the extent of that portion of the building that is less than 30 years 
old. If rehabilitation expenditures are incurred with respect to an 
addition to a qualified rehabilitated building, but the addition is not 
considered to be part of the qualified rehabilitated building because 
the addition does not meet the age requirement in section 48(g)(1)(B) 
(as in effect prior to its amendment by the Tax Reform Act of 1986) and 
Sec. 1.48-12(b)(4)(i)(B), then no rehabilitation percentage will be 
applied to the expenditures attributable to the rehabilitation of the 
addition. Thus, for purposes of paragraphs (q)(1) (iii) and (iv) of this 
section, it may be necessary to allocate rehabilitation expenditures 
incurred with respect to a building between the original portion of the 
building and the addition.
    (iii) Mixed-use buildings. If qualified rehabilitation expenditures 
are incurred for property that is excluded from section 38 property 
described in section 48(a)(1)(E) (because, for example, they are made 
with respect to a portion of the building used for lodging within the 
meaning of section 48(a)(3) and Sec. 1.48-1(h)), an allocation of the 
expenditures must be made between the expenditures that result in an 
addition to basis that is section 38 property and the expenditures that 
result in an addition to basis that is excluded from the definition of 
section 38 property since the rehabilitation percentage is applicable 
only to section 38 property. These allocations should be made using the 
principles contained in Sec. 1.48-12(c)(10)(ii).
    (3) Regular and energy percentages not to apply. The regular 
percentage and the energy percentage shall not apply to that portion of 
the basis of any building that is attributable to qualified 
rehabilitation expenditures (as defined in Sec. 1.48-12(c)).
    (4) Effective date. The rehabilitation percentage is applicable only 
to qualified rehabilitation expenditures (as defined in Sec. 1.48-
12(c)). For rules relating to applicability of the regular percentage to 
qualified rehabilitation expenditures (as defined in Sec. 1.48-11(c)), 
see Sec. 1.48-11.

[T.D. 6731, 29 FR 6064, May 8, 1964]

    Editorial Note: For Federal Register citations affecting Sec. 1.46-
1, see the List of CFR Sections Affected in the Finding Aids section of 
this volume.



Sec. 1.46-2  Carryback and carryover of unused credit.

    (a) Effective date. This section is effective for taxable years 
beginning after December 31, 1975. For taxable years beginning before 
January 1, 1976, see 26 CFR 1.46-2 (Rev. as of April 1, 1979).
    (b) In general. Under section 46(b)(1), unused credit may be carried 
back and carried over. Carrybacks and carryovers of unused credit are 
taken into account in determining the amount of credit available and the 
credit allowed for the taxable years to which they may be carried. In 
general, the application of the rules of this section to regular and 
ESOP credits are separate from their application to nonrefundable energy 
credits. For example, the limitations on carrybacks and carryovers of 
unused nonrefundable energy credit under section 46(b) (2) and (3), 
respectively, differ in amount from the limitations on the regular and 
ESOP credits because the tax liability limitations for those credits 
differ. See Sec. 1.46-1(h). For a further example, see the special 
ordering rule in Sec. 1.46-1(m). Section 46(b) does not apply to the 
refundable energy credit.
    (c) Unused credit. If carryovers and credit earned (as defined in 
Sec. 1.46-1(c)(1)) exceed the applicable tax liability limitation, the 
excess attributable to credit earned is an unused credit. The taxable 
year in which an unused credit arises is referred to as the ``unused 
credit year''.
    (d) Taxable years to which unused credit may be carried. An unused 
credit is a carryback to each of the 3 taxable years preceding the 
unused credit year and a carryover to each of the 7 taxable years 
succeeding the unused credit year. An unused credit must be carried 
first to the earliest of those 10 taxable years. An unused credit then 
must be carried to each of the other 9 taxable years (in order of time) 
to the extent that the unused credit was not absorbed during a prior 
taxable year because of the limitations under section 46(b) (2) and (3).

[[Page 203]]

    (e) Special rule for pre-1971 years--(1) In general. For unused 
credit years ending before January 1, 1971, unused credit is allowed a 
10-year carryover rather than the 7-year carryover. The principles of 
paragraph (d) of this section apply to this 10-year carryover.
    (2) Cross reference. For limitations on the taxable years to which 
unused credit from pre-1971 credit years may be carried, see paragraph 
(g) of this section.
    (f) Limitations on carrybacks. Under the FIFO rule to section 
46(a)(1), carryovers and credit earned are applied against the tax 
liability limitation before carrybacks. Thus, carrybacks to a taxable 
year may not exceed the amount by which the applicable tax liability 
limitation for that year exceeds the sum of carryovers to and credit 
earned for that year. Carrybacks from an unused credit year are applied 
against tax liability before carrybacks from a later unused credit year. 
To the extent an unused credit cannot be carried back to a particular 
preceding taxable year, the unused credit must be carried to the next 
succeeding taxable year to which it may be carried.
    (g) Limitations on carryovers--(1) General rule. Carryovers to a 
taxable year may not exceed the applicable tax liability limitation for 
that year. Carryovers from an unused credit year are applied before 
carryovers from a later unused credit year.
    (2) Exception. A 10-year carryover from a pre-1971 unused credit 
year may, under certain circumstances, be postponed to prevent a later-
earned 7-year carryover from expiring. This exception does not extend 
the 10-year carryover period for pre-1971 unused credit. See section 
46(b)(1)(D).
    (h) Examples. The following examples illustrate paragraphs (a) 
through (g) of this section.

    Example 1. (a) Corporation M is organized on January 1, 1977 and 
files its income tax return on a calendar year basis. Assume the facts 
set forth in columns (1) and (2) of the following table. The 
determination of the regular credit allowed for each of the taxable 
years indicated is set forth in the remaining portions of the table.

----------------------------------------------------------------------------------------------------------------
                                    (1)        (2)        (3)         (4)         (5)         (6)         (7)
                                --------------------------------------------------------------------------------
                                                                      Tax
                                                                   liability
                                                                   limitation    Credit    Remaining    Unused
                                   Credit      Tax                 (remaining   allowed       tax       credit
                                 available  liability   Percent    from col.   (lower of   liability   ((1)-(5))
                                                                     (6) on      (1) or   limitation  or (amount
                                                                   preceding      (4))     ((4)-(5))   absorbed)
                                                                     line)
----------------------------------------------------------------------------------------------------------------
1977:
  A. Credit earned.............    $20,000    $45,000         50    $35,000      $20,000     $15,000          0
  B. Carryback from 1978.......    *15,000  .........  .........    [15,000]      15,000  ..........  ..........
1978:
  A. Credit earned.............     80,000     55,000         50     40,000       40,000           0    $20,000
    Carryback to 1977..........  .........  .........  .........  ...........  .........  ..........   (*15,000)
    Carryover to 1979..........  .........  .........  .........  ...........  .........  ..........    (*5,000)
1979:
  A. Carryover from 1978.......     *5,000     50,000         60     40,000        6,000      35,000  ..........
  B. Credit earned.............     50,000  .........  .........    [35,000]      35,000           0     15,000
    Carryover to 1980..........  .........  .........  .........  ...........  .........  ..........   (*15,000)
1980:
  A. Carryover from 1979.......    *15,000     55,000         70     46,000       15,000      31,000  ..........
  B. Credit earned.............     25,000  .........  .........    [31,000]      25,000       6,000          0
----------------------------------------------------------------------------------------------------------------
*For line ``A'' each year: Lesser of (1) tax liability or (2) $25,000 + (percentage in col. (3)  x  [col. (2) -
  $25,000]). See, Sec.  1.46-1(h). For other lines: Amount in col. (6) on preceding line.


    Example 2. (a) Assume the same facts as in Example 1 except for 1979 
M earns a $35,000 nonrefundable energy credit. The following table shows 
the determinations for each year.

[[Page 204]]



--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                           (1)                 (2)                (3)         (4)         (5)         (6)         (7)
                                                       -------------------------------------------------------------------------------------------------
                                                                          Tax liability                       Tax
                                                                  ----------------------------             liability
                                                                                                          limitation*    Credit    Remaining    Unused
                                                          Credit                                           (remaining   allowed       tax       credit
                                                        available     (a)        (b) Energy     Percent    from col.   (lower of   liability   ((1)-(5))
                                                                    Regular   ((2)(a)-(5)(R))                (6) on      (1) or   limitation  or (amount
                                                                                                           preceding      (4))     ((4)-(5))   absorbed)
                                                                                                             line)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1977:
  Regular:
    A. Credit earned..................................    $20,000    $45,000  ...............         50    $35,000     $20,000R     $15,000          0
    B. Carryback from 1978............................    *15,000  .........  ...............  .........    [15,000]     15,000R           0  ..........
1978:
  Regular:
    A. Credit earned..................................     60,000     55,000  ...............         50     40,000      40,000R           0    $20,000
      Carryback to 1977...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*15,000)
      Carryover to 1979...............................  .........  .........  ...............  .........  ...........  .........  ..........    (*5,000)
  Energy:
    A. Carryback from 1979............................    *15,000  .........       $15,000           100     15,000      15,000E           0  ..........
1979:
  Regular:
    A. Carryover from 1978............................     *5,000     50,000  ...............         60     40,000       5,000R      35,000  ..........
    B. Credit earned..................................     50,000  .........  ...............  .........    [35,000]     35,000R           0     15,000
      Carryover to 1980...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*15,000)
  Energy:
    A. Credit earned..................................     35,000  .........        10,000           100     10,000      10,000E           0     25,000
      Carryback to 1978...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*15,000)
      Carryover to 1980...............................  .........  .........  ...............  .........  ...........  .........  ..........   (*10,000)
1980:
  Regular:
    A. Carryover from 1979............................    *15,000     55,000  ...............         70     46,000      15,000R      31,000  ..........
    B. Credit earned..................................     25,000  .........  ...............  .........    [31,000]     25,000R       6,000          0
  Energy:
    A. Carryover from 1979............................    *10,000  .........        15,000           100     15,000      10,000E       5,000  ..........
--------------------------------------------------------------------------------------------------------------------------------------------------------
*See footnote to the chart in Example 1.

    (b) Although, in general, a nonrefundable energy credit may be 
carried back to taxable years ending before October 1, 1978, in this 
example the unused nonrefundable energy credit from 1979 may not be 
absorbed in 1977. The 1977 tax liability limitation for the 
nonrefundable energy credit is the same as it is for the regular credit, 
reduced by regular credit previously allowed for 1977. See Secs. 1.46-
1(h)(3) and 1.46-1(m).

    Example 3. (a) Assume the same facts as in Example 2 except M has 
regular credit of $37,000 for 1981 and M's tax liability for 1981 is 
$32,500. The determinations for 1980 and 1981 are set forth in the 
following table.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                              (1)               (2)               (3)         (4)         (5)         (6)         (7)
                                                          ----------------------------------------------------------------------------------------------
                                                                           Tax liability                      Tax
                                                                     -------------------------             liability
                                                                                                          limitation*    Credit    Remaining    Unused
                                                             Credit                                        (remaining   allowed       tax       credit
                                                           available     (a)      (b) Energy    Percent    from col.   (lower of   liability   ((1)-(5))
                                                                       Regular   ((2)-(5)(R))                (6) on      (1) or   limitation  or (amount
                                                                                                           preceding      (4))     ((4)-(5))   absorbed)
                                                                                                             line)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1979 (restated):
  Energy:
    To be carried over...................................  .........  .........  ............  .........  ...........  .........  ..........    $10,000
      Carryover to 1980..................................  .........  .........  ............  .........  ...........  .........  ..........    (*9,000)
      Carryover to 1981..................................  .........  .........  ............  .........  ...........  .........  ..........    (*1,000)
1980 (restated):
  Regular:
    A. Carryover from 1979...............................    $15,000    $55,000  ............         70    $46,000     $15,000R     $31,000  ..........
    B. Credit earned.....................................    *25,000  .........  ............  .........    [31,000]     25,000R       6,000          0
    C. Carryback from 1981...............................     *6,000  .........  ............  .........     [6,000]      6,000R           0  ..........
  Energy:
    A. Carryover from 1979...............................     *9,000  .........       $9,000         100      9,000       9,000E  ..........  ..........
1981: Regular:
    A. Credit earned.....................................     37,000     32,500  ............         80     31,000      31,000R           0      6,000

[[Page 205]]

 
      Carryback to 1980..................................  .........  .........  ............  .........  ...........  .........  ..........    (*6,000)
  Energy:
    A. Carryover from 1979...............................     *1,000  .........        1,500         100      1,500       1,000E         500          0
--------------------------------------------------------------------------------------------------------------------------------------------------------
*See footnote to chart under Example 1.

    (b) Allowance of the regular carryback in 1980 from 1981 requires 
that the computations for 1980 be restated. The energy tax liability 
limitation for 1980 is reduced from $15,000 (as determined in Example 2) 
to $9,000. Thus, $1,000 of the $10,000 energy credit allowed for 1980 is 
displaced by the regular carryback. That amount may not be carried back 
because there is no remaining energy tax liability limitation for the 
prior 3 years (see table in Example 2). It may be carried over to 1981 
and allowed in full in that year.

    (i) [Reserved]
    (j) Electing small business corporation. A shareholder of an 
electing small business corporation (as defined in section 1371(b)) may 
not take into account unused credit of the corporation attributable to 
unused credit years for which the corporation was not an electing small 
business corporation. However, a taxable year for which the corporation 
is an electing small business corporation is counted as a taxable year 
for determining the taxable years to which that unused credit may be 
carried.
    (k) Periods of less than 12 months. A fractional part of a year that 
is considered a taxable year under sections 441(b) and 7701(a)(23) is 
treated as a preceding or succeeding taxable year for determining under 
section 46(b) the taxable years to which an unused credit may be 
carried.
    (l) Corporate acquisitions. For carryover of unused credits in the 
case of certain corporate acquisitions, see section 381(c)(23).


(Secs. 7805 (68A Stat. 917, 26 U.S.C. 7805) and 38(b) (76 Stat. 962, 26 
U.S.C. 38))

[T.D. 7751, 46 FR 1679, Jan. 7, 1981]



Sec. 1.46-3  Qualified investment.

    (a) In general. (1) With respect to any taxable year, the qualified 
investment of the taxpayer is the aggregate (expressed in dollars) of 
(i) the applicable percentage of the basis of each new section 38 
property placed in service by the taxpayer during such taxable year, 
plus (ii) the applicable percentage of the cost of each used section 38 
property placed in service by the taxpayer during such taxable year. 
With respect to any section 38 property, qualified investment means the 
applicable percentage of the basis (or cost) of such property. Section 
38 property placed in service by the taxpayer during the taxable year 
includes the taxpayer's share of the basis (or cost) of section 38 
property placed in service by a partnership in the taxable year of such 
partnership ending with or within the taxpayer's taxable year. In the 
case of a shareholder of an electing small business corporation (as 
defined in section 1371(b)), or a beneficiary of an estate or trust, see 
Secs. 1.48-5 and 1.48-6, respectively, for apportionment of the basis 
(or cost) of section 38 property placed in service by such corporation, 
estate, or trust. For the definitions of new section 38 property and 
used section 38 property, see Secs. 1.48-2 and 1.48-3, respectively. See 
Sec. 1.46-5 for special rules for progress expenditure property.
    (2) The basis (or cost) of section 38 property placed in service 
during a taxable year shall not be taken into account in determining 
qualified investment for such year if such property is disposed of or 
otherwise ceases to be section 38 property during such year, except 
where Sec. 1.47-3 applies. Thus, if individual A places in service 
during a taxable year section 38 property and later in the same year 
sells such property, the basis (or cost) of such property shall not be 
taken into account in determining A's qualified investment.

[[Page 206]]

On the other hand, if A places in service section 38 property during a 
taxable year and dies later in the same year, the basis (or cost) of 
such property would be taken into account in computing qualified 
investment. Similarly, if section 38 property is destroyed by fire in 
the same year in which it is placed in service and paragraph (h) of this 
section applies to reduce the basis (or cost) of replacement property, 
the basis (or cost) of the destroyed property would be taken into 
account in computing qualified investment. In order to determine whether 
section 38 property is disposed of or otherwise ceases to be section 38 
property see Sec. 1.47-2.
    (3) Qualified investment is reduced in the case of property which is 
``public utility property'' (see paragraph (h) of this section), and in 
the case of property of organizations to which section 593 applies, 
regulated investment companies or real estate investment trusts subject 
to taxation under subchapter M, chapter 1 of the Code, and cooperative 
organizations described in section 1381(a) (see Sec. 1.46-4).
    (b) Applicable percentage. The applicable percentage to be applied 
to the basis (or cost) of property is 33\1/3\ percent if the estimated 
useful life of the property is 3 years or more but less than 5 years; 
66\2/3\ percent if the estimated useful life is 5 years or more but less 
than 7 years; or 100 percent if the estimated useful life is 7 years or 
more. In the case of property which is not described in section 50, the 
preceding sentence shall be applied by substituting ``4 years'' for ``3 
years'', ``6 years'' for ``5 years'', and ``8 years'' for ``7 years''. 
The provisions of this paragraph may be illustrated by the following 
example:

    Example. Corporation Y acquires and places in service during 1972 
the following new and used section 38 properties:

------------------------------------------------------------------------
                                                   Estimated
                                                     useful    Basis (or
                     Property                         life       cost)
                                                    (years)
------------------------------------------------------------------------
A (new)..........................................          4     $60,000
B (new)..........................................         10      90,000
C (new)..........................................          6     150,000
D (used).........................................          3      30,000
------------------------------------------------------------------------

    Corporation Y's qualified investment for 1972 is $220,000 determined 
in the following manner:

------------------------------------------------------------------------
                                    Basis (or    Applicable   Qualified
             Property                 cost)      percentage   investment
------------------------------------------------------------------------
A................................      $60,000      33\1/3\      $20,000
B................................       90,000        100         90,000
C................................      150,000      66\2/3\      100,000
D................................       30,000      33\1/3\       10,000
                                  --------------------------------------
  Total....................................................      220,000
------------------------------------------------------------------------


    (c) Basis or cost. (1) The basis of any new section 38 property 
shall be determined in accordance with the general rules for determining 
the basis of property. Thus, the basis of property would generally be 
its cost (see section 1012), unreduced by the adjustment to basis 
provided by section 48(g)(1) with respect to property placed in service 
before January 1, 1964, and any other adjustment to basis, such as that 
for depreciation, and would include all items properly included by the 
taxpayer in the depreciable basis of the property, such as installation 
and freight costs. However, for purposes of determining qualified 
investment, the basis of new section 38 property constructed, 
reconstructed, or erected by the taxpayer shall not include any 
depreciation sustained with respect to any other property used in the 
construction, reconstruction, or erection of such new section 38 
property. (See paragraph (b)(4) of Sec. 1.48-1.) If new section 38 
property is acquired in exchange for cash and other property in a 
transaction described in section 1031 in which no gain or loss is 
recognized, the basis of the newly acquired property for purposes of 
determining qualified investment would be equal to the adjusted basis of 
the other property plus the cash paid. See Sec. 1.48-4 for the basis of 
property to a lessee where the lessor has elected to treat such lessee 
as a purchaser.
    (2) The cost of any used section 38 property shall be determined in 
accordance with paragraph (b) of Sec. 1.48-3. However, the aggregate 
cost of used section 38 property which may be taken into account in any 
taxable year in computing qualified investment cannot exceed $50,000 
(see paragraph (c) of Sec. 1.48-3).

[[Page 207]]

    (3) For reduction in the basis (or cost) of certain property which 
replaces other property which was destroyed or damaged by fire, storm, 
shipwreck, or other casualty, or which was stolen, see paragraph (h) of 
this section.
    (d) Placed in service. (1) For purposes of the credit allowed by 
section 38, property shall be considered placed in service in the 
earlier of the following taxable years:
    (i) The taxable year in which, under the taxpayer's depreciation 
practice, the period for depreciation with respect to such property 
begins; or
    (ii) The taxable year in which the property is placed in a condition 
or state of readiness and availability for a specifically assigned 
function, whether in a trade or business, in the production of income, 
in a tax-exempt activity, or in a personal activity.

Thus, if property meets the conditions of subdivision (ii) of this 
subparagraph in a taxable year, it shall be considered placed in service 
in such year notwithstanding that the period for depreciation with 
respect to such property begins in a succeeding taxable year because, 
for example, under the taxpayer's depreciation practice such property is 
accounted for in a multiple asset account and depreciation is computed 
under an ``averaging convention'' (see Sec. 1.167(a)-10), or 
depreciation with respect to such property is computed under the 
completed contract method, the unit of production method, or the 
retirement method.
    (2) In the case of property acquired by a taxpayer for use in his 
trade or business (or in the production of income), the following are 
examples of cases where property shall be considered in a condition or 
state of readiness and availability for a specifically assigned 
function:
    (i) Parts are acquired and set aside during the taxable year for use 
as replacements for a particular machine (or machines) in order to avoid 
operational time loss.
    (ii) Operational farm equipment is acquired during the taxable year 
and it is not practicable to use such equipment for its specifically 
assigned function in the taxpayer's business of farming until the 
following year.
    (iii) Equipment is acquired for a specifically assigned function and 
is operational but is undergoing testing to eliminate any defects.
    (iv) Reforestation expenditures (as defined in Sec. 1.194-3(c)) are 
incurred during the taxable year in connection with qualified timber 
property (as defined in Sec. 1.194-3(a)).

However, fruit-bearing trees and vines shall not be considered in a 
condition or state of readiness and availability for a specifically 
assigned function until they have reached an income-producing stage. 
Moreover, materials and parts acquired to be used in the construction of 
an item of equipment shall not be considered in a condition or state of 
readiness and availability for a specifically assigned function.
    (3) Notwithstanding subparagraph (1) of this paragraph, property 
with respect to which an election is made under Sec. 1.48-4 to treat the 
lessee as having purchased such property shall be considered placed in 
service by the lessor in the taxable year in which possession is 
transferred to such lessee.
    (4)(i) The credit allowed by section 38 with respect to any property 
shall be allowed only for the first taxable year in which such property 
is placed in service by the taxpayer. The determination of whether 
property is section 38 property in the hands of the taxpayer shall be 
made with respect to such first taxable year. Thus, if a taxpayer places 
property in service in a taxable year and such property does not qualify 
as section 38 property (or only a portion of such property qualifies as 
section 38 property) in such year, no credit (or a credit only as to the 
portion which qualifies in such year) shall be allowed to the taxpayer 
with respect to such property notwithstanding that such property (or a 
greater portion of such property) qualifies as section 38 property in a 
subsequent taxable year. For example, if a taxpayer places property in 
service in 1963 and uses the property entirely for personal purposes in 
such year, but in 1964 begins using the property in a trade or business, 
no credit is allowable to the taxpayer under section 38 with respect to 
such property. See Sec. 1.48-1 for the definition of section 38 
property.

[[Page 208]]

    (ii) Notwithstanding subdivision (i) of this subparagraph, if, for 
the first taxable year in which property is placed in service by the 
taxpayer, the property qualifies as section 38 property but the basis of 
the property does not reflect its full cost for the reason that the 
total amount to be paid or incurred by the taxpayer for the property is 
indeterminate, a credit shall be allowed to the taxpayer for such first 
taxable year with respect to so much of the cost as is reflected in the 
basis of the property as of the close of such year, and an additional 
credit shall be allowed to the taxpayer for any subsequent taxable year 
with respect to the additional cost paid or incurred during such year 
and reflected in the basis of the property as of the close of such year. 
The estimated useful life used in computing each additional credit with 
respect to the property shall be the same as the estimated useful life 
used in computing the credit for the first taxable year in which the 
property was placed in service by the taxpayer. Assume, for example, 
that in 1964 X Corporation, a utility company which makes its return on 
the basis of a calendar year, enters into an agreement with Y 
Corporation, a builder, to construct certain utility facilities for a 
housing development built by Y. Assume further that part of the funds 
for the construction of the utility facilities is advanced by Y under a 
contract providing that X will repay the advances over a 10-year period 
in accordance with an agreed formula, after which no further amounts 
will be repayable by X even though the full amount advanced by Y has not 
been repaid. Assuming that the utility facilities are placed in service 
in 1964 and qualify as section 38 property, X is allowed a credit for 
1964 with respect to its basis in the utility facilities at the close of 
1964. For each succeeding taxable year X is allowed an additional credit 
with respect to the increase in the basis of the utility facilities 
resulting from the repayments to Y during such year.
    (e) Estimated useful life--(1)(i) In general. With respect to assets 
placed in service by the taxpayer during any taxable year, for the 
purpose of computing qualified investment the estimated useful lives 
assigned to all assets which fall within a particular guideline class 
(within the meaning of Revenue Procedure 62-21) may be determined, at 
the taxpayer's option, under either subparagraph (2) or (3) of this 
paragraph. Thus, the taxpayer may assign estimated useful lives to all 
the assets falling in one guideline class in accordance with 
subparagraph (2) of this paragraph, and may assign estimated useful 
lives to all the assets falling within another guideline class in 
accordance with subparagraph (3) of this paragraph. See subparagraphs 
(4) and (5) of this paragraph for determination of estimated useful 
lives of assets not subject to subparagraph (2) or (3) of this 
paragraph.
    (ii) Except as provided in subparagraph (7), this paragraph shall 
not apply to property described in section 50.
    (2) Class life system. The taxpayer may assign to each asset falling 
within a guideline class, which is placed in service during the taxable 
year, the class life of the taxpayer for the guideline class for such 
year as determined under section 4, part II of Revenue Procedure 62-21. 
The preceding sentence may be applied to the assets falling within a 
guideline class irrespective of whether the taxpayer uses single asset 
accounts or multiple asset accounts in computing depreciation with 
respect to such assets and irrespective of whether the taxpayer chooses 
to have his depreciation allowance with respect to such assets examined 
under the rules provided in Revenue Procedure 62-21.
    (3) Individual useful life system. (i) The taxpayer may assign an 
individual estimated useful life to each asset falling within a 
guideline class which is placed in service during the taxable year. With 
respect to the assets falling within the guideline class which are 
placed in single asset accounts for purposes of computing depreciation, 
the estimated useful life used for each asset for that purpose shall be 
used in determining qualified investment. With respect to the assets 
falling within the guideline class which are placed in multiple asset 
accounts (including a guideline class account described in Revenue 
Procedure 62-21) for which a group, classified, or composite rate is 
used in computing depreciation (or in single

[[Page 209]]

asset accounts for which an average life rate is used), the 
determination of estimated useful life for each asset in the account 
shall be made individually on the best estimate obtainable on the basis 
of all the facts and circumstances. The individual estimated useful 
lives used for all the assets placed in a multiple asset account, when 
viewed together, must be consistent with the group, classified, or 
composite life used for the account for purposes of computing 
depreciation.
    (ii) In determining the individual estimated useful lives of assets 
similar in kind contained in a multiple asset account (or in single 
asset accounts for which an average life rate is used), the taxpayer may 
(a) assign to each of such assets the average useful life of such assets 
used for purposes of computing depreciation, or (b) assign separate 
lives to such assets based on the estimated range of years taken into 
consideration in establishing the average useful life. Thus, for 
example, if a taxpayer places nine similar trucks with an average 
estimated useful life of 7 years, based on an estimated range of 6 to 8 
years (two trucks with a useful life of 6 years, five trucks with a 
useful life of 7 years, and two trucks with a useful life of 8 years), 
in a multiple asset account for which a group rate is used in computing 
depreciation, he may either assign a useful life of 6 years to two of 
the trucks, 7 years to five of the trucks, and 8 years to two of the 
trucks, or he may assign the average useful life of the trucks (7 years) 
to each of the nine trucks. Likewise, if a taxpayer places 100 similar 
telephone poles with an average useful life of 28 years, based on an 
estimated range of 3 to 40 years (two with a useful life of less than 4 
years, three with a useful life of 4 to 6 years, four with a useful life 
of 6 to 8 years, and 91 with a useful life of more than 8 years), in a 
multiple asset account for which a group rate is used in computing 
depreciation, he may either assign useful lives corresponding to the 
estimated range of years of the poles (i.e., a useful life of less than 
4 years to two of the poles, etc.), or he may assign the average useful 
life of the poles (28 years) to each of the poles.
    (iii) [Reserved]
    (iv) For purposes of subdivision (ii) of this subparagraph, assets 
(other than ``mass assets'') shall not be considered as ``similar in 
kind'' in respect of other assets unless all such assets are 
substantially of the same value, nor shall used section 38 property be 
considered as ``similar in kind'' to new section 38 property.
    (4) Useful life of property subject to amortization--(i) In general. 
In the case of property with respect to which amortization in lieu of 
depreciation is allowable, the term over which amortization deductions 
are taken shall be considered as the estimated useful life of such 
property.
    (ii) Qualified timber property. In the case of qualified timber 
property (within the meaning of section 194(c)(1)), the normal growing 
period of such property shall be considered its estimated useful life.
    (5) Useful life of property subject to certain methods of 
depreciation. If a taxpayer is using a method of depreciation, such as 
the unit of production or retirement method, which does not measure the 
useful life of the property in terms of years, he must estimate such 
useful life in years in order to compute his qualified investment.
    (6) Record requirements. The taxpayer shall maintain sufficient 
records to determine whether section 47 (relating to certain 
dispositions, etc., of section 38 property) applies with respect to any 
asset.
    (7) Section 50 property. (i) The provisions of this subparagraph and 
subparagraphs (4) and (6) of this paragraph shall apply to property 
which is described in section 50.
    (ii) The estimated useful life of property for purposes of computing 
qualified investment shall be the useful life used or to be used by the 
taxpayer in computing the allowance for depreciation with respect to 
such property under section 167 for the taxable year in which the 
property is placed in service. Thus, if property is placed in service by 
a taxpayer in a taxable year but the period for depreciation with 
respect to such property does not begin until a succeeding taxable year 
(see paragraph (d)(1) of this section), the estimated useful life for 
purposes of computing

[[Page 210]]

qualified investment must be the estimated useful life that the taxpayer 
uses in computing the allowance for depreciation. See subdivision (iv) 
of this subparagraph for rules for determining the estimated useful life 
of property with respect to which the allowance for depreciation under 
section 167 is computed under the unit of production method, the income-
forecast method, or any other method which does not measure the useful 
life of the property in terms of years.
    (iii)(a) The estimated useful life of any section 38 property to 
which an election under section 167(m) applies shall be the asset 
depreciation period selected for such property under Sec. 1.167(a)-
11(b)(4), whether or not such property constitutes mass assets (as 
defined in Sec. 1.47-1(e)(4)).
    (b) The estimated useful life of any section 38 property to which an 
election under section 167(m) does not apply and which is placed in a 
multiple asset account for which a group, classified, or composite rate 
is used in computing depreciation (or in single asset accounts for which 
an average life rate is used) shall be determined individually for each 
asset on the best estimate obtainable on the basis of all the facts and 
circumstances. The individual estimated useful life for each asset 
placed in a multiple asset account (including a mass asset account) must 
be the same as the useful life of such asset used in determining the 
group, classified, or composite life for the account for purposes of 
computing depreciation. The individual estimated useful lives of assets 
similar in kind may be determined in accordance with subdivisions (ii) 
and (iv) of subparagraph (3) of this paragraph. In the case of mass 
assets, subdivision (iii) of subparagraph (3) of this paragraph shall 
apply.
    (f) Partnerships--(1) In general. In the case of a partnership, each 
partner shall take into account separately, for his taxable year with or 
within which the partnership taxable year ends, his share of the basis 
of partnership new section 38 property and his share of the cost of 
partnership used section 38 property placed in service by the 
partnership during such partnership taxable year. Each partner shall be 
treated as the taxpayer with respect to his share of the basis of 
partnership new section 38 property and his share of the cost of 
partnership used section 38 property. The estimated useful life to each 
partner of such property shall be deemed to be the estimated useful life 
of the property in the hands of the partnership. Partnership section 38 
property shall not, by reason of each partner taking his share of the 
basis or cost into account, lose its character as either new section 38 
property or used section 38 property, as the case may be. For 
computation of each partner's qualified investment for the energy credit 
for a qualified intercity bus, see Sec. 1.48-9(q)(9)(iv).
    (2) Determination of partner's share. (i) Each partner's share of 
the basis (or cost) of any section 38 property shall be determined in 
accordance with the ratio in which the partners divide the general 
profits of the partnership (that is, the taxable income of the 
partnership as described in section 702(a)(9)) regardless of whether the 
partnership has a profit or a loss for its taxable year during which the 
section 38 property is placed in service. However, if the ratio in which 
the partners divide the general profits of the partnership changes 
during the taxable year of the partnership, the ratio effective for the 
date on which the property is placed in service shall apply.
    (ii) Notwithstanding subdivision (i) of this subparagraph, if all 
related items of income, gain, loss, and deduction with respect to any 
item of partnership section 38 property are specially allocated in the 
same manner and if such special allocation is recognized under section 
704 (a) and (b) and paragraph (b) of Sec. 1.704-1, then each partner's 
share of the basis of such item of new section 38 property or the cost 
of such item of used section 38 property shall be determined by 
reference to such special allocation effective for the date on which the 
property is placed in service.
    (iii) Notwithstanding subdivisions (i) and (ii) of this 
subparagraph, if with respect to a partnership's taxable year the 
conditions set forth in (a) through (c) of this subdivision are 
satisfied with respect to a partner, then such partner shall not take 
into account the basis (or cost) of any section 38 property

[[Page 211]]

placed in service by the partnership during such taxable year. The 
conditions referred to in the preceding sentence are:
    (a) Such partner's interest in the general profits of the 
partnership during the taxable year is 5 percent or less;
    (b) Under the partnership agreement, such partner will retire from 
the partnership during the taxable year or within 7 years after the end 
of such year; and
    (c) The partnership agreement provides that the basis (or cost) of 
section 38 property placed in service by the partnership during the 
taxable year shall not be taken into account by a partner described in 
(a) and (b) of this subdivision.

Any basis (or cost) of section 38 property which is not taken into 
account by a partner because of the provisions of this subdivision shall 
be taken into account by the other partners in accordance with 
subdivision (i) of this subparagraph.
    (3) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. Partnership ABCD acquires and places in service on 
January 1, 1962, an item of new section 38 property, and acquires and 
places in service on September 1, 1962, another item of new section 38 
property. The ABCD partnership and each of its partners reports income 
on the basis of the calendar year. Partners A, B, C, and D share 
partnership profits equally. Each partner's share of the basis of each 
new partnership section 38 property is 25 percent.

    Example 2. Assume the same facts as in Example 1 and the following 
additional facts: A dies on June 30, 1962, and B purchases A's interest 
as of such date. Each partner's share of the profits from January 1 to 
June 30 is 25 percent. From July 1 to December 31, B's share of the 
profits is 50 percent, and C and D's share of the profits is 25 percent 
each. For A's last taxable year (January 1 to June 30, 1962), A shall 
take into account 25 percent of the basis of the section 38 property 
placed in service on January 1. B shall take into account 25 percent of 
the basis of the section 38 property placed in service on January 1 and 
50 percent of the basis of the section 38 property placed in service on 
September 1, C and D shall each take into account 25 percent of the 
basis of each new section 38 property placed in service by the 
partnership in 1962.

    Example 3. Partnership MR is engaged in the business of renting soda 
fountain equipment and icemakers to restaurants. The partnership makes 
no elections under Sec. 1.48-4 to treat its lessees as having purchased 
such property. Under the terms of the partnership agreement, the income, 
gain or loss on disposition, depreciation, and other deductions 
attributable to the icemakers are specially allocated 70 percent to 
partner M and 30 percent to partner R. In all other respects M and R 
share profits and losses equally. If the special allocation with respect 
to the icemakers is recognized under section 704 (a) and (b) and 
paragraph (b) of Sec. 1.704-1, the basis (or cost) of the icemakers 
which qualify as partnership section 38 property shall be taken into 
account 70 percent by M and 30 percent by R. The basis (or cost) of 
partnership section 38 property not subject to the special allocation 
shall be taken into account equally by M and R.

    Example 4. Assume the same facts as in Example 3 and the following 
additional facts: During November 1962, the partnership, which reports 
its income on the basis of a fiscal year ending May 31, acquires and 
places in service two items which qualify as new section 38 property, an 
icemaker and a soda fountain. The icemaker has an estimated useful life 
of 8 years to the partnership and a basis of $1,000. The soda fountain 
has an estimated useful life of 6 years to the partnership and a basis 
of $600. Partner M also owns and operates a business as a sole 
proprietorship and reports income on the calendar year basis. During 
1963, M acquires and places in service in his sole proprietorship a 
machine which qualifies as new section 38 property. This machine has an 
estimated useful life of 4 years and a basis of $300. M owns no interest 
in any other partnerships, electing small business corporations, 
estates, or trusts. M's total qualified investment for 1963 is $1,000, 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                     Estimated                     M's share of     Applicable       Qualified
            Property                useful life        Basis           basis        percentage      investment
----------------------------------------------------------------------------------------------------------------
         Partnership MR
Icemaker........................               8          $1,000            $700           100              $700
Soda fountain...................               6             600             300         66\2/3\             200
       Sole proprietorship
Machine.........................               4             300  ..............         33\1/3\             100
                                 -------------------------------------------------------------------------------
    Total.......................................................................................           1,000
----------------------------------------------------------------------------------------------------------------



[[Page 212]]

    (g) Public utility property--(1) In general--(i) Scope of paragraph. 
This paragraph only applies to property described in section 50. For 
rules relating to public utility property not described in section 50, 
see 26 CFR part 1, Sec. 1.46-3(g) (as revised April 1, 1977). This 
paragraph does not reflect amendments to section 46(c) made after 
enactment of the Revenue Act of 1971.
    (ii) Amount of qualified investment. A taxpayer's qualified 
investment in section 38 property that is public utility property is \4/
7\ of the amount otherwise determined under this section.
    (2) Meaning and uses of certain terms. For purposes of this 
paragraph--
    (i) Public utility property. ``Public utility property'' is property 
used by a taxpayer predominantly in a trade or business that is a public 
utility activity and property that is nonregulated communication 
property.
    (ii) Public utility activity. A ``public utility activity'' is any 
activity in which the goods or services described in section 46(c)(3)(B) 
(i), (ii), or (iii) are furnished or sold at regulated rates. If 
property is used by a taxpayer both in a public utility activity and in 
another activity, the characterization of such property is based on the 
predominant use of such property during the taxable year in which it is 
placed in service.
    (iii) Regulated rates. A taxpayer's rates are ``regulated'' if they 
are established or approved on a rate-of-return basis. Rates regulated 
on a rate-of-return basis are an authorization to collect revenues that 
cover the taxpayer's cost of providing goods or services, including a 
fair return on the taxpayer's investment in providing such goods or 
services, where the taxpayer's costs and investment are determined by 
use of a uniform system of accounts prescribed by the regulatory body. A 
taxpayer's rates are not ``regulated'' if they are established or 
approved on the basis of maintaining competition within an industry, 
insuring adequate service to customers of an industry, or charging 
``reasonable'' rates within an industry since the taxpayer is not 
authorized to collect revenues based on the taxpayer's cost of providing 
goods or services. Rates are considered to have been ``established or 
approved'' if a schedule of rates is filed with a regulatory body that 
has the power to approve such rates, even though the regulatory body 
takes no action on the filed schedule or generally leaves undisturbed 
rates filed by the taxpayer.
    (iv) Nonregulated communication property. ``Nonregulated 
communication property'' is property that is clearly the same type of 
property (and is used by the taxpayer predominantly for the same type of 
communication purposes) as communication property, but it is used by the 
taxpayer predominantly in a trade or business that is not a public 
utility activity. For purposes of this paragraph (g)(2)(iv), of this 
section, communication property is property ordinarily used for 
communication purposes by persons who provide regulated telephone or 
microwave communication services described in section 46(c)(3)(B)(iii). 
The determination of whether property is clearly of this same type and 
is used predominantly for these same communication purposes as 
communication property is made on the basis of the facts and 
circumstances of each particular case, including the current state of 
technology in the communications industry and the range and type of 
services permitted or required to be provided by the regulated telephone 
and microwave communication industry. As of 1978, wires or cables used 
predominantly to distribute to subscribers the signals of one or more 
television broadcast stations or cablecast stations (such as in a CATV 
system) are not used for the same type of communication purposes as 
communication property. Communication property includes microwave 
transmission equipment, private communication equipment (other than land 
mobile radio equipment for which the operator must obtain a license from 
the Federal Communications Commission), private switchboard (PBX) 
equipment, communications terminal equipment connected to telephone 
networks, data transmission equipment, and communications satellites. 
Communication property does not include (as of 1978) computer terminals 
or facsimile reproduction equipment that is connected to telephone lines 
to transmit data. It also does not include office furniture stands for 
communication property,

[[Page 213]]

tools, repair vehicles, and similar property, even if such property is 
exclusively used in providing regulated telephone or microwave 
communication services.
    (3) Leased property. Public utility property includes property which 
is leased to others by a taxpayer where the leasing of such property is 
part of the lessor's public utility activity. Thus, such leased property 
is public utility property even though the lessee uses such property in 
an activity which is not a public utility activity, and whether or not 
the lessor of such property makes a valid election under Sec. 1.48-4 to 
treat the lessee as having purchased such property for purposes of the 
credit allowed by section 38. Property leased by a lessor, where the 
leasing is not part of a public utility activity, to a lessee who uses 
such property predominantly in a public utility activity is public 
utility property for purposes of computing the lessor's or lessee's 
qualified investment with respect to such property.
    (4) Property used in both the production or transmission of gas and 
the local distribution of gas. (i) With respect to properties of a 
taxpayer engaged in both the production or transmission of gas and the 
local distribution of gas, section 38 property shall be considered as 
used predominantly in the trade or business of the furnishing or sale of 
gas through a local distribution system if expenditures for such 
property are chargeable to any of the following accounts under either 
the uniform system of accounts prescribed for natural gas companies 
(class A and class B) by the Federal Power Commission, effective January 
1, 1961, or the uniform system of accounts for class A and B gas 
utilities adopted in 1958 by the National Association of Railroad and 
Utility Commissioners (or would be chargeable to any of the following 
accounts if the taxpayer used either of such systems):
    (a) Accounts 360 through 363, inclusive (Local Storage Plant), or
    (b) Accounts 374 through 387, inclusive (Distribution Plant).
    (ii) If expenditures for section 38 property are chargeable (or 
would be chargeable) to any of the following accounts under either of 
the systems named in subdivision (i) of this subparagraph, the 
determination of whether or not such property is used predominantly in 
the trade or business of the furnishing or sale of gas through a local 
distribution system shall be made under all the facts and circumstances 
relating to the actual use of such property in the year such property is 
placed in service:
    (a) Accounts 304 through 320, inclusive (Manufactured Gas Production 
Plant), or
    (b) Accounts 389 through 399, inclusive (General Plant).

For example, if an office machine is used 55 percent of the time for 
billing customers of the taxpayer's local distribution system in the 
year in which it is placed in service, such office machine shall be 
considered as used predominantly in the trade or business of the 
furnishing or sale of gas through a local distribution system.
    (5) Certain submarine cable property. In the case of any interest in 
a submarine cable circuit which is property described in section 50 used 
to furnish telegraph service between the United States and a point 
outside the United States of a taxpayer engaged in furnishing 
international telegraph service (if the rates for such furnishing have 
been established or approved by a governmental unit, agency, 
instrumentality, commission, or similar body described in subparagraph 
(2) of this paragraph), the qualified investment shall not exceed the 
qualified investment attributable to so much of the interest of the 
taxpayer in the circuit as does not exceed 50 percent of all interests 
in the circuit.
    (h) Certain replacement property. (1)(i) If section 38 property is 
placed in service by the taxpayer to replace property (whether or not 
section 38 property) similar or related in service or use, which was 
destroyed or damaged before August 16, 1971, by fire, storm, shipwreck, 
or other casualty, or was stolen before such date, then for purposes of 
paragraph (a) of this section the basis (or cost) of the replacement 
section 38 property otherwise determined under paragraph (c) of this 
section shall be reduced by an amount equal to the lesser of--

[[Page 214]]

    (a) The amount of money, or the fair market value of other property, 
received as compensation, by insurance or otherwise, for the property 
which was destroyed, damaged, or stolen, or
    (b) The adjusted basis of such destroyed, damaged, or stolen 
property (immediately before such destruction, damage, or theft).
    (ii) For purposes of subdivision (i) of this subparagraph--
    (a) Section 38 property placed in service after the due date 
(including extensions of time thereof) for filing the taxpayer's income 
tax return for the taxable year in which the other property was 
destroyed, damaged, or stolen shall not be considered as replacement 
section 38 property, and
    (b) If the property which is destroyed, damaged, or stolen, is 
leased property, no other leased property shall be considered as 
replacement property with respect to the property destroyed, damaged, or 
stolen, in any case in which the lessor makes or made an election under 
section 48(d) (relating to election with respect to certain leased 
property) with respect to either the property destroyed, damaged, or 
stolen, the other leased property, or both.
    (2) Subparagraph (1) of this paragraph shall not apply to 
replacement property if the reduction, under such subparagraph (1), in 
the basis (or cost) of such replacement property is less than the excess 
of--
    (i) The qualified investment with respect to the destroyed, damaged, 
or stolen property, over
    (ii) The recomputed qualified investment with respect to such 
property (determined under the principles of paragraph (a) of Sec. 1.47-
1).
    (3) This paragraph may be illustrated by the following examples:

    Example 1. (i) A acquired and placed in service on January 1, 1962, 
machine No. 1, which qualified as section 38 property, with a basis of 
$30,000 and an estimated useful life of 6 years. The amount of qualified 
investment with respect to such machine was $20,000. On January 2, 1963, 
machine No. 1 is completely destroyed by fire. On January 1, 1963, the 
adjusted basis of such machine in A's hands is $24,500. On November 1, 
1963, A receives $23,000 in insurance proceeds as compensation for the 
destroyed machine, and on December 15, 1963, A acquires and places in 
service machine No. 2, which qualifies as section 38 property, with a 
basis of $41,000 and an estimated useful life of 6 years to replace 
machine No. 1.
    (ii) Under subparagraph (1) of this paragraph, the $41,000 basis of 
machine No. 2 is reduced, for purposes of paragraph (a) of this section, 
by $23,000 (that is, the $23,000 insurance proceeds since such amount is 
less than the $24,500 adjusted basis of machine No. 1 immediately before 
it was destroyed) to $18,000 since such reduction (that is, $23,000) is 
greater than the $20,000 reduction in qualified investment which would 
be made if paragraph (a) of Sec. 1.47-1 were to apply to machine No. 1 
($20,000 qualified investment less zero recomputed qualified 
investment).

    Example 2. (i) The facts are the same as in Example 1 except that on 
November 1, 1963, A receives only $19,000 in insurance proceeds as 
compensation for the destroyed machine.
    (ii) The $41,000 basis of machine No. 2 is not reduced, for purposes 
of paragraph (a) of this section, under this paragraph since the $19,000 
reduction which would have been made under this paragraph had it applied 
(that is, the $19,000 insurance proceeds since such amount is less than 
the $24,500 adjusted basis of machine No. 1 immediately before it was 
destroyed) is less than the $20,000 reduction in qualified investment 
which is made since paragraph (a) of Sec. 1.47-1 applies to machine No. 
1 ($20,000 qualified investment less zero recomputed qualified 
investment).

(Secs. 194 (94 Stat. 1989; 26 U.S.C. 194) and 7805 (68A Stat. 917, 26 
U.S.C. 7805) of the Internal Revenue Code of 1954; secs. 38(b) (76 Stat. 
963, 26 U.S.C. 38(b)), 48(l)(16) (94 Stat. 264, 26 U.S.C. 48(l)(16)), 
and 7805 (68A Stat. 917, 26 U.S.C. 7805)

[T.D. 6731, 29 FR 6068, May 8, 1964, as amended by T.D. 6931, 32 FR 
14026, Oct. 10, 1967; T.D. 7203, 37 FR 17125, Aug. 25, 1972; T.D. 7602, 
44 FR 17667, Mar. 23, 1979; T.D. 7927, 48 FR 55849, Dec. 16, 1983; T.D. 
7982, 49 FR 39541, Oct. 9, 1984; T.D. 8183, 53 FR 6618, Mar. 2, 1988; 
T.D. 8474, 58 FR 25557, Apr. 27, 1993]



Sec. 1.46-4  Limitations with respect to certain persons.

    (a) Mutual savings institutions. In the case of an organization to 
which section 593 applies (that is, a mutual savings bank, a cooperative 
bank, or a domestic building and loan association)--
    (1) The qualified investment with respect to each section 38 
property shall be 50 percent of the amount otherwise determined under 
Sec. 1.46-3, and
    (2) The $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax, shall be reduced by 50 percent of 
such amount.


[[Page 215]]



For example, if a domestic building and loan association places in 
service on January 1, 1963, new section 38 property with a basis of 
$30,000 and an estimated useful life of 6 years, its qualified 
investment for 1963 with respect to such property computed under 
Sec. 1.46-3 is $20,000 (66\2/3\ percent of $30,000). However, under this 
paragraph such amount is reduced to $10,000 (50 percent of $20,000). If 
an organization to which section 593 applies is a member of an 
affiliated group (as defined in section 46(a)(5)), the $25,000 amount 
specified in section 46(a)(2) shall be reduced in accordance with the 
provisions of paragraph (f) of Sec. 1.46-1 before such amount is further 
reduced under this paragraph.
    (b) Regulated investment companies and real estate investment 
trusts. (1) In the case of a regulated investment company or a real 
estate investment trust subject to taxation under subchapter M, chapter 
1 of the Code--
    (i) The qualified investment with respect to each section 38 
property otherwise determined under Sec. 1.46-3, and
    (ii) The $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax,

shall be reduced to such person's ratable share of each such amount. If 
a regulated investment company or a real estate investment trust is a 
member of an affiliated group (as defined in section 46(a)(5)), the 
$25,000 amount specified in section 46(a)(2) shall be reduced in 
accordance with the provisions of paragraph (f) of Sec. 1.46-1 before 
such amount is further reduced under this paragraph.
    (2) A person's ratable share of the amount described in subparagraph 
(1)(i) and the amount described in subparagraph (1)(ii) of this 
paragraph shall be the ratio which--
    (i) Taxable income for the taxable year, bears to
    (ii) Taxable income for the taxable year plus the amount of the 
deduction for dividends paid taken into account under section 
852(b)(2)(D) in computing investment company taxable income, or under 
section 857(b)(2)(B) (section 857(b)(2)(C), as then in effect, for 
taxable years ending before October 5, 1976) in computing real estate 
investment trust taxable income, as the case may be.

For purposes of the preceding sentence, taxable income means, in the 
case of a regulated investment company its investment company taxable 
income (within the meaning of section 852(b)(2)), and in the case of a 
real estate investment trust its real estate investment trust taxable 
income (within the meaning of section 857(b)(2)). In the case of a 
taxable year ending after October 4, 1976, real estate investment trust 
taxable income, for purposes of section 46(e) and this paragraph, is 
determined by excluding any net capital gain, and by computing the 
deduction for dividends paid without regard to capital gains dividends 
(as defined in section 857(b)(3)(C)). The amount of the deduction for 
dividends paid includes the amount of deficiency dividends (other than 
capital gains deficiency dividends) taken into account in computing 
investment company taxable income or real estate investment trust 
taxable income for the taxable year. See section 860(f) for the 
definition of deficiency dividends. For purposes of this paragraph only, 
in computing taxable income for a taxable year beginning before January 
1, 1964, a regulated investment company or a real estate investment 
trust may compute depreciation deductions with respect to section 38 
property placed in service before January 1, 1964, without regard to the 
reduction in basis of such property required under Sec. 1.48-7.
    (3) This paragraph may be illustrated by the following example:

    Example. (i) Corporation X, a regulated investment company subject 
to taxation under section 852 of the Code which makes its return on the 
basis of the calendar year, places in service on January 1, 1964, 
section 38 property with a basis of $30,000 and an estimated useful life 
of 6 years. Corporation X's investment company taxable income under 
section 852(b)(2) is $10,000 after taking into account a deduction for 
dividends paid of $90,000.
    (ii) Under this paragraph, corporation X's qualified investment for 
the taxable year 1964 with respect to such property is $2,000, computed 
as follows: (a) $20,000 (qualified investment under Sec. 1.46-3), 
multiplied by (b) $10,000 (taxable income), divided by (c) $100,000 
(taxable income plus the deduction for dividends paid). For 1964, the 
$25,000 amount specified in section 46(a)(2) is reduced to $2,500.


[[Page 216]]


    (c) Cooperatives. (1) In the case of a cooperative organization 
described in section 1381(a)--
    (i) The qualified investment with respect to each section 38 
property otherwise determined under Sec. 1.46-3, and
    (ii) The $25,000 amount specified in section 46(a)(2), relating to 
limitation based on amount of tax,

shall be reduced to such cooperative's ratable share of each such 
amount. If a cooperative organization described in section 1381(a) is a 
member of an affiliated group (as defined in section 46(a)(5)), the 
$25,000 amount specified in section 46(a)(2) shall be reduced in 
accordance with the provisions of paragraph (f) of Sec. 1.46-1 before 
such amount is further reduced under this paragraph.
    (2) A cooperative's ratable share of the amount described in 
subparagraph (1)(i) and the amount described in subparagraph (1)(ii) of 
this paragraph shall be the ratio which--
    (i) Taxable income for the taxable year, bears to
    (ii) Taxable income for the taxable year plus the sum of (a) the 
amount of the deductions allowed under section 1382(b), (b) the amount 
of the deductions allowed under section 1382(c), and (c) amounts similar 
to the amounts described in (a) and (b) of this subdivision the tax 
treatment of which is determined without regard to subchapter T, chapter 
1 of the Code and the regulations thereunder.

Amounts similar to deductions allowed under section 1382 (b) or (c) are, 
for example, in the case of a taxable year of a cooperative organization 
beginning before January 1, 1963, the amount of patronage dividends 
which are excluded or deducted and any nonpatronage distributions which 
are deducted under section 522(b)(1). In the case of a taxable year of a 
cooperative organization beginning after December 31, 1962, such amounts 
are the amount of patronage dividends and nonpatronage distributions 
which are excluded or deducted without regard to section 1382 (b) or (c) 
because they are paid with respect to patronage occurring before 1963. 
For purposes of this paragraph only, in computing taxable income for a 
taxable year beginning before January 1, 1964, a cooperative may compute 
depreciation deductions with respect to section 38 property placed in 
service before January 1, 1964, without regard to the reduction in basis 
of such property required under Sec. 1.48-7.
    (3) This paragraph may be illustrated by the following example:

    Example. (i) Cooperative X, an organization described in section 
1381(a) which makes its return on the basis of the calendar year, places 
in service on January 1, 1964, section 38 property with a basis of 
$30,000 and an estimated useful life of 6 years. Cooperative X's taxable 
income is $10,000 after taking into account deductions of $20,000 
allowed under section 1382(b), deductions of $60,000 allowed under 
section 1382(c), and deductions of $10,000 allowed under section 
522(b)(1)(B).
    (ii) Under this paragraph, cooperative X's qualified investment for 
the taxable year 1964 with respect to such property is $2,000, computed 
as follows: (a) $20,000 (qualified investment under Sec. 1.46-3), 
multiplied by (b) $10,000 (taxable income), divided by (c) $100,000 
(taxable income plus the sum of the deductions allowed under sections 
1382(b), 1382(c), and 522(b)(1)(B)). For 1964, the $25,000 amount 
specified in section 46(a)(2) is reduced to $2,500.

    (d) Noncorporate lessors. (1) In the case of a lease entered into 
after September 22, 1971, a credit is allowed under section 38 to a 
noncorporate lessor of property with respect to the leased property only 
if--
    (i) Such property has been manufactured or produced by the lessor in 
the ordinary course of his business, or
    (ii) The term of the lease (taking into account any options to 
renew) is less than 50 percent of the estimated useful life of the 
property (determined under Sec. 1.46-3(e)), and for the period 
consisting of the first 12 months after the date on which the property 
is transferred to the lessee the sum of the deductions with respect to 
such property which are allowable to the lessor solely by reason of 
section 162 (other than rents and reimbursed amounts with respect to 
such property) exceeds 15 percent of the rental income produced by such 
property.

In the case of property of which a partnership is the lessor, the credit 
otherwise allowable under section 38 with respect to such property to 
any partner which is a corporation shall be allowed notwithstanding the 
first sentence of this subparagraph. For purposes of this

[[Page 217]]

subparagraph, an electing small business corporation (as defined in 
section 1371) shall be treated as a person which is not a corporation. 
This paragraph shall not apply to property used by the taxpayer in his 
trade or business (other than the leasing of property) for a period of 
at least 24 months preceding the day on which any lease of such property 
is entered into.
    (2) For purposes of subparagraph (1)(ii) of this paragraph, if at 
the time the lessor files his income tax return for the taxable year in 
which the property is placed in service, the lessor is unable to show 
that the more-than-15-percent test has been satisfied, then no credit 
may be claimed by the lessor on such return with respect to such 
property unless (i) taking into account the lessor's obligations under 
the lease it is reasonable to believe that the more-than-15-percent test 
will be satisfied, and (ii) the lessor files a statement with his return 
from which it may be determined that he expects to satisfy the more-
than-15-percent test. If the more-than-15-percent test is not satisfied 
with respect to the property, the taxpayer must file an amended return 
for the year in which the property is placed in service.
    (3)(i) The more-than-15-percent test described in subparagraph 
(1)(ii) of this paragraph is based on the relationship of the expenses 
of the lessor relating to or attributable to the property to the gross 
income from rents of the taxpayer produced by the property. The test is 
applied with respect to such expenses and gross income as are properly 
attributable to the period consisting of the first 12 months after the 
date on which the property is transferred to the lessee. When more than 
one property is subject to a single lease and, pursuant to subparagraph 
(4) of this paragraph, the arrangement is considered to be a separate 
lease of each property, the test is applied separately to each such 
lease by making an apportionment of the payments received and expenses 
incurred with respect to each such property, considering all relevant 
factors. Such apportionment is made in accordance with any reasonable 
method selected and consistently applied by the taxpayer. For example, 
under subparagraph (4) of this paragraph, where a taxpayer leases an 
airplane which he owns to an airline along with a baggage truck, he is 
treated as having made two separate leases, one covering the airplane 
and one covering the baggage truck. Thus, the test will be applied by 
apportioning the related income and expenses between the two leases. 
Similarly, where a taxpayer leases a factory building erected by him 
containing section 38 property (machinery and equipment), the test will 
be applied to the taxpayer as though he had leased (to the lessee) the 
building and the section 38 property separately. Thus, the rental income 
and expenses are apportioned between the building and the section 38 
property.
    (ii) Only those deductions allowable solely by reason of section 162 
are taken into account in applying the more-than-15-percent test. Hence, 
depreciation allowable by reason of section 167 (including amortization 
allowable in lieu of depreciation); interest allowable by reason of 
section 163; taxes allowable by reason of section 164; and depletion 
allowable by reason of section 611 are examples of deductions which are 
not taken into account in applying the test. Moreover, rents and 
reimbursed amounts paid or payable by the lessor are not taken into 
account notwithstanding that a deduction in respect of such rents or 
reimbursed amounts is allowable solely by reason of section 162. For 
purposes of this paragraph, a reimbursed amount is any expense for which 
the lessee or some other party is obligated to reimburse the lessor. 
Section 162 expenses paid or payable by any person other than the lessor 
are not taken into account unless the lessor is obligated to reimburse 
the person paying the expense. Further, if the lessee is obligated to 
pay to the lessor a charge for services which is separately stated or 
determinable, the expenses incurred by the lessor with respect to those 
services are not taken into account.
    (iii) For purposes of the more-than-15-percent test, the gross 
income from rents of the lessor produced by the property is the total 
amount which is payable to the lessor by reason of the lease agreement 
other than reimbursements of section 162 expenses and

[[Page 218]]

charges for services which are separately stated or determinable. The 
fact that such amount depends, in whole or in part, on the sales or 
profits of the lessee or the performance of significant services by the 
lessor shall not affect the characterization of such amounts as gross 
income from rents for purposes of this paragraph. Gross income from 
rents also includes any taxes imposed on the lessor by local law but 
which are paid directly by the lessee on behalf of the lessor.
    (4) For purposes of determining under this paragraph whether 
property is subject to a lease, the provisions of Sec. 1.57-3(d)(1) 
(relating to definition of a lease) shall apply. If a noncorporate 
lessor enters into two or more successive leases with respect to the 
same or substantially similar items of section 38 property, the terms of 
such leases shall be aggregated and such leases shall be considered one 
lease for the purpose of determining whether the term of such leases is 
less than 50 percent of the estimated useful life of the property 
subject to such leases. Thus, for example, if an individual owns an 
airplane with an estimated useful life of 7 years and enters into three 
successive 3-year leases of such airplane, such leases will be 
considered to be one lease for a term of nine years for the purpose of 
determining whether the term of the lease is less than 3\1/2\ years (50 
percent of the 7-year estimated useful life).
    (5) The requirements of this paragraph shall not apply with respect 
to any property which is treated as section 38 property by reason of 
section 48(a)(1)(E).

(Sec. 860(e) (92 Stat. 2849, 26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 
2850, 26 U.S.C. 860(g)); and sec. 7805 (68A Stat. 917, 26 U.S.C. 7805))

[T.D. 6731, 29 FR 6071, May 8, 1964, as amended by T.D. 6958, 33 FR 
9170, June 21, 1968; T.D. 7203, 37 FR 17126, Aug. 25, 1972; T.D. 7767, 
46 FR 11262, Feb. 6, 1981; T.D. 7936, 49 FR 2105, Jan. 18, 1984; T.D. 
8031, 50 FR 26697, June 28, 1985]



Sec. 1.46-5  Qualified progress expenditures.

    (a) Effective date. This section applies to taxable years ending 
after December 31, 1974. This section reflects amendments to the 
Internal Revenue Code made only by the Tax Reduction Act of 1975, the 
Tax Reform Act of 1976, and the Revenue Act of 1978.
    (b) General rule. Under section 46(d), a taxpayer may elect to take 
the investment credit for qualified progress expenditures (as defined in 
paragraph (g) of this section). In general, qualified progress 
expenditures are amounts paid (paid or incurred in the case of self-
constructed property) for construction of progress expenditure property. 
The taxpayer must reasonably estimate that the property will take at 
least 2 years to construct and that the useful life of the property will 
be 7 years or more. Qualified progress expenditures may not be taken 
into account if made before the later of January 22, 1975, or the first 
taxable year to which an election under section 46(d) applies. In 
general, qualified progress expenditures are not allowed for the year 
property is placed in service, nor for the first year or any subsequent 
year recapture is required under section 47(a)(3). There is a percentage 
limitation on qualified progress expenditures for taxable years 
beginning before January 1, 1980. For a special rule relating to 
transfers of progress expenditure property, see paragraph (r) of this 
section.
    (c) Reduction of qualified investment. Under section 46(c)(4), a 
taxpayer must reduce qualified investment for the year property is 
placed in service by qualified progress expenditures taken into account 
by that person or a predecessor. A ``predecessor'' of a taxpayer is a 
person whose election under section 46(d) carries over to the taxpayer 
under paragraph (o)(3) of this section.
    (d) Progress expenditure property. Progress expenditure property is 
property constructed by or for the taxpayer, with a normal construction 
period of 2 years or more. The taxpayer must reasonably believe that the 
property will be new section 38 property with a useful life of 7 years 
or more when placed in service. Whether property is progress expenditure 
property is determined on the basis of facts know at the close of the 
taxable year of the taxpayer in which construction begins (or, if later, 
at the close of the first taxable year to which an election under 
section 46(d) applies). For purposes of this paragraph (d), property is

[[Page 219]]

constructed by or for the taxpayer only if it is built or manufactured 
from materials and component parts. Accordingly, progress expenditure 
property does not include property such as orchards, vineyards, 
livestock, or motion picture films or videotapes.
    (e) Normal construction period--(1) In general. (i) The normal 
construction period is the period the taxpayer reasonably expects will 
be required to construct the property. The period begins on the date 
physical work on construction of the property commences and ends on the 
date the property is available to be placed in service. The normal 
construction period does not include, however, construction before 
January 22, 1975, nor construction before the first day of the first 
taxable year for which an election under section 46(d) is in effect. 
Physical work on construction of property does not include preliminary 
activities such as planning, designing, preparing blueprints, exploring, 
or securing financing.
    (ii) The determination of the time when physical work on 
construction commences is based on the facts and circumstances of each 
case. Physical work on construction of property may include the physical 
work done by a subcontractor on a component specifically designated as 
part of the property. Also, the commencement of physical work on 
construction may occur at a site different from the main site of 
construction of the property. For example, if a shipyard orders a 
turbine before it begins work on building a ship, the normal 
construction period of the ship is measured from the time the 
subcontractor commences physical work on construction of the turbine (if 
it is normal for such work to precede the work of the main contractor).
    (iii) Generally, physical work on construction does not include 
physical activity that is not necessary to complete construction of the 
property, nor does it include physical work on construction of a 
building or other property that will not be new section 38 property when 
placed in service. Physical work on construction also does not include 
research and development activities in a laboratory or experimental 
setting.
    (iv) The normal construction period of property ends on the date it 
is expected the property will be available to be placed in service. 
Property is considered available to be placed in service when 
construction is completed and the property is available for delivery to 
the site of its assigned function. It is not necessary that property be 
in a state of readiness for a specifically assigned function. Nor is it 
necessary that it actually be delivered to the site of its assigned 
function.
    (2) Estimates. Taxpayers should refer to normal industry practice in 
estimating the normal construction period of particular items. A 
different period may be used if special circumstances exist making it 
impractical to make the estimate on the basis of normal industry 
practice. The estimate must be based on information available at the 
close of the taxable year in which physical work on construction of the 
property begins, or, if later, at the close of the first taxable year 
for which an election under section 46(d) is in effect for the taxpayer. 
If the estimate is reasonable when made, the actual time it takes to 
complete the work is, in general, irrelevant in determining whether 
property is progress expenditure property. However, if there is a 
significant error in estimating the normal construction period, it may 
be evidence that the estimate was unreasonable when made. For taxable 
years ending after April 1, 1988, a taxpayer not relying or normal 
industry practice to estimate the normal construction period of 
particular property must attach to the tax return for the taxable year 
in which physical work on construction of the property begins (or, if 
later, the first taxable year for which an election under section 46(d) 
is in effect) a statement of the basis relied upon in estimating the 
normal construction period of the property.
    (3) Integrated unit. (i) In determining whether property has a 
normal construction period of 2 years or more, property that will be 
placed in service separately is to be considered separately. For 
example, if two ships are contracted for at the same time, each ship is 
considered separately under this paragraph. However, for property that

[[Page 220]]

will be placed in service as an integrated unit, the taxpayer must 
determine the normal construction period of the integrated unit. If the 
normal construction period of the integrated unit is 2 years or more, 
the normal construction period of each item of new section 38 property 
that is a part of the integrated unit is considered to be 2 years or 
more. Thus, the normal construction period of an integrated unit may be 
2 years or more even if no part of the unit has a normal construction 
period of 2 years or more.
    (ii) Property is part of an integrated unit only if the operation of 
that item is essential to the performance of the function to which the 
unit is assigned. Property essential to the performance of the function 
to which the unit is assigned includes property the use of which is 
significantly connected to that function and which effects the safe, 
proper, or efficient performance of the unit. Generally, property must 
be placed in service at the same time to be considered part of the same 
integrated unit. Properties are not an integrated unit, however, solely 
because they are to be placed in service at the same time.
    (iii) The normal construction period for an integrated unit begins 
on the date the normal construction period of the first item of new 
section 38 property that is part of the unit begins. It is not necessary 
that physical work commence at the main construction site of the 
integrated unit.

The period ends on the date the last item of new section 38 property 
that is part of that unit is available to be placed in service. Property 
that is not new section 38 property, such as a building, is not 
considered part of an integrated unit for purposes of determining the 
normal construction period of that unit. For example, if a manufacturing 
plant has a normal construction period of two years or more but the 
equipment (i.e., new section 38 property) to be installed in the plant 
has a normal construction period of less than two years, the plant and 
the equipment do not constitute an integrated unit with a construction 
period of two years or more and the equipment is not progress 
expenditure property.
    (4) Examples. The following examples illustrate this paragraph (e).

    Example 1. On July 1, 1974, corporation X begins physical work on 
construction of a machine with an estimated useful life when placed in 
service of more than 7 years. For its taxable year ending June 30, 1975, 
X makes an election under section 46(d). For purposes of determining on 
June 30, 1975, whether the machine is ``progress expenditure property'', 
the normal construction period is treated as having begun on January 22, 
1975. Thus, the machine will be considered to be progress expenditure 
property on June 30, 1975, only if the estimated time required to 
complete construction after June 30 is at least 18 months and 22 days 
(i.e., 2 years less the period January 22, 1975, through June 30, 1975).

    Example 2. (i) Corporation X constructs a pipeline in two sections 
and simultaneously begins physical work on construction of each section 
on January 1, 1976. One section extends from city M to city N. The other 
extends from city N to city O. Oil will be transferred to storage tanks 
at both city N and city O. Corporation X also begins construction on 
January 1, 1976, of a pumping station necessary to the operation of the 
pipeline from city M to city N. Construction of a pumping station 
necessary to the operation of the pipeline from city N to city O begins 
on June 30, 1977. For 1976, corporation X makes an election under 
section 46(d).
    (ii) The section of pipeline from city M to city N and the 
associated pumping station will be available to be placed in service on 
January 1, 1977. Construction of the section of the pipeline from city N 
to city O will be completed on June 30, 1977. However, that section of 
the pipeline will not be available to be placed in service until 
completion of the associated pumping station on January 1, 1978.
    (iii) The section of pipeline from city M to city N and the section 
from city N to city O must be considered separately in determining the 
normal construction period of the property. Each section will be placed 
in service separately. However, each section of the pipeline and the 
associated pumping station may be considered an integrated unit. The 
pumping stations are essential to the operation of each section of 
pipeline. Each section of pipeline and the associated pumping station 
are placed in service at the same time.
    (iv) The section of pipeline from city M to city N and the 
associated pumping station are not progress expenditure property, 
because the normal construction period of that unit is only 1 year 
(January 1, 1976 to January 1, 1977).
    (v) The section of pipeline from city N to city O and the associated 
pumping station

[[Page 221]]

are progress expenditure property, because the normal construction of 
that integrated unit is 2 years (January 1, 1976 to January 1, 1978). It 
is immaterial that neither the construction period of that section of 
pipeline (January 1, 1976 to June 30, 1977) nor the construction period 
of the associated pumping station (June 30, 1977 to January 1, 1978) is 
2 years.
    (vi) Assume the pumping station associated with the pipeline from 
city N to city O includes backup pumping equipment that will be used 
only if the primary pumping equipment fails. The backup equipment is 
part of the integrated unit because it serves to effect the safe or 
efficient performance of the unit.

    (f) New section 38 property with a 7-year useful life--(1) In 
general. The taxpayer must determine if property will be new section 38 
property with a useful life of 7 years or more when placed in service. 
The determination must be made at the close of the taxable year in which 
construction begins or, if later, at the close of the first taxable year 
to which an election under section 46(d) applies for the taxpayer.
    (2) Determination based on reasonably expected use. The 
determination of whether property will be ``new section 38 property'' 
(within the meaning of Secs. 1.48-1 and 1.48-2 when placed in service 
must be based on the reasonably expected use of the property by the 
taxpayer. There is a presumption that property will be new section 38 
property if it would be new section 38 property if placed in service by 
the taxpayer when the determination is made. For example, in determining 
if property is an integral part of manufacturing under section 
48(a)(1)(B)(i), it will be presumed that property will be new section 38 
property if the taxpayer is engaged in manufacturing when the 
determination is made. Also, significant steps taken to establish a 
trade or business will be evidence the taxpayer will be engaged in that 
trade or business when the property is placed in service.
    (3) Estimated useful life. The determination of whether property 
will have an estimated useful life of 7 years or more when placed in 
service must be made by applying the principles of Sec. 1.46-3(e). If 
the estimated useful life is less than 7 years when the property is 
actually placed in service, the credit previously allowed under section 
46(d) must be recomputed under section 47(a)(3)(B).
    (g) Definition of qualified progress expenditures--(1) In general. A 
taxpayer's qualified progress expenditures are the sum of qualified 
progress expenditures for self-constructed property (determined under 
paragraph (h) of this section), plus qualified progress expenditures for 
non-self-constructed property (determined under paragraph (j) of this 
section). Only amounts includible under Sec. 1.46-3(c) in the basis of 
new section 38 property may be considered as qualified progress 
expenditures.
    (2) Excluded amounts. Qualified progress expenditures do not 
include:
    (i) In the case of non-self-constructed property, amounts incurred 
(whether or not paid)--
    (A) Before the normal construction period begins, or
    (B) Before the later of January 22, 1975, or the first day of the 
first taxable year for which an election under section 46(d) applies for 
the taxpayer;
    (ii) In the case of self-constructed property, amounts chargeable to 
capital account--
    (A) Before the normal construction period begins, or
    (B) Before the later of January 22, 1975, or the first day of the 
first taxable year for which an election under section 46(d) applies for 
the taxpayer,

(See, however, section 46(d)(4)(A) and paragraph (h)(3)(i) of this 
section, relating to the time when amounts for component parts and 
materials are properly chargeable to capital account);
    (iii) Expenditures with respect to particular property in the 
earlier of--
    (A) The taxable year in which the property is placed in service, or
    (B) The taxable year in which the taxpayer must recapture investment 
credit under section 47(a)(3) for the property or any subsequent year;
    (iv) Expenditures for construction, reconstruction, or erection of 
property that is not section 38 property; or
    (v) Amounts treated as an expense and deducted in the year paid or 
accrued.
    (h) Qualified progress expenditures for self-constructed property--
(1) In general. Qualified progress expenditures for self-constructed 
property (as defined in

[[Page 222]]

paragraph (k) of this section) are amounts properly chargeable to 
capital account in connection with that property. In general, amounts 
paid or incurred are chargeable to capital account if under the 
taxpayer's method of accounting they are properly includible in 
computing basis under Sec. 1.46-3. Qualified progress expenditures for 
self-constructed property include both direct costs (e.g., labor, 
material, parts) and indirect costs (e.g., overhead, insurance) 
associated with construction of property to the extent those costs are 
properly chargeable to capital account.
    (2) Property partially non-self constructed. If an item of property 
is self-constructed because more than half of the construction 
expenditures are made directly by the taxpayer, then any expenditures 
(whether or not made directly by the taxpayer) for construction of that 
item of property are not subject to the limitations of section 
46(d)(3)(B) and paragraph (j) of this section (relating to actual 
payment and progress in construction).
    (3) Time when amounts paid or incurred are properly chargeable to 
capital account. (i) In general, expenditures for component parts and 
materials to be used in construction of self-constructed property are 
not properly chargeable to capital account until consumed or physically 
attached in the construction process. Component parts and materials that 
have been neither consumed nor physically attached in the construction 
process, but which have been irrevocably allocated to construction of 
that property are properly chargeable to capital account. Component 
parts and materials designed specifically for the self-constructed 
property may be considered irrevocably allocated to construction of that 
property at the time of manufacture of the component parts and 
materials. Component parts and materials not designed specifically for 
the property may be considered irrevocably allocated to construction at 
the time of delivery to the construction site if they would be 
economically impractical to remove. For example, pumps delivered to 
sites of construction of a tundra pipeline may be treated as irrevocably 
allocated to that pipeline on the date of delivery, even if they would 
be usable, but for their location on the tundra, in connection with 
other property. Component parts and materials are not to be considered 
irrevocably allocated to use in self-constructed property until physical 
work on construction of that property has begun (as determined under 
paragraph (e)(1)(ii) of this section). Mere bookkeeping notations are 
not sufficient evidence that the necessary allocation has been made.
    (ii) A taxpayer's procedure for determining the time when an 
expenditure is properly chargeable to capital account for self-
constructed property is a method of accounting. Under section 446(e), 
the method of accounting, once adopted, may not be changed without 
consent of the Secretary.
    (4) Records requirement. The taxpayer shall maintain detailed 
records which permit specific identification of the amounts properly 
chargeable by the taxpayer during each taxable year to capital account 
for each item of self-constructed property.
    (i) [Reserved]
    (j) Qualified progress expenditures for non-self-constructed 
property--(1) In general. Qualified progress expenditures for non-self-
constructed property (as defined in paragraph (l) of this section) are 
amounts actually paid by the taxpayer to another person for construction 
of the property, but only to the extent progress is made in 
construction. For example, such expenditures may include payments to the 
manufacturer of an item of progress expenditure property, payments to a 
contractor building progress expenditure property, or payments for 
engineering designs or blueprints that are drawn up during the normal 
construction period.
    (2) Property partially self-constructed. If an item of property is 
non-self-constructed, but a taxpayer uses its own employees to construct 
a portion of the property, expenditures for construction of that portion 
are made directly by the taxpayer (see Sec. 1.46-5(h)(1)). Subject to 
the limitations of paragraph (g) of this section, those expenditures are 
qualified progress expenditures for non-self-constructed property if 
they satisfy the requirements of paragraphs (j) (4), (5), and (6) of 
this section. Wages

[[Page 223]]

actually paid to the taxpayer's employees are presumed to correspond to 
progress in construction. Other amounts, including expenditures for 
materials, parts, and overhead, must be actually paid, not borrowed from 
the payee, and attributable to progress made in construction by the 
taxpayer.
    (3) Property constructed by more than one person. The percentage of 
completion limitation (as prescribed in paragraph (j)(6) of this 
section), including the presumption of ratable progress in construction, 
applies to an item of progress expenditure property as a whole. However, 
if several manufacturers or contractors do work in connection with the 
same property, the progress that each person makes toward completion of 
construction of the property must be determined separately. Section 
46(d)(3)(B) is then applied separately to amounts paid to each 
manufacturer or contractor based on each person's progress in 
construction. For example, assume the taxpayer contracts with three 
persons to build an item of equipment. The taxpayer contracts with A to 
build the frame, B to build the motor, and C to assemble the frame and 
motor. Assume each contract represents 33\1/3\ percent of the 
construction costs of the property. If, within the taxable year in which 
construction begins, A and B each complete 50 percent of the 
construction of the frame and motor, respectively, amounts paid to A 
during that taxable year not in excess of 16\2/3\ percent of the overall 
cost of the property, and amounts paid to B during that taxable year not 
in excess of 16\2/3\ percent of the overall cost of the property, are 
qualified progress expenditures. Section 46(d)(3)(B) does not apply, 
however, to persons, such as lower-tier subcontractors, that do not have 
a direct contractual relationship with the taxpayer. If, in the above 
example, A engages a subcontractor to construct part of the frame, 
section 46(d)(3)(B) is applied only to amounts paid by the taxpayer to 
A, B, and C, but the portion of construction completed by A during a 
taxable year includes the portion completed by A's subcontractor.
    (4) Requirement of actual payment. Qualified progress expenditures 
for non-self-constructed property must be actually paid and not merely 
incurred. Amounts paid during the taxable year to another person for 
construction of non-self-constructed property may be in the form of 
money or property (e.g., materials). However, property given as payment 
may be considered only to the extent it will be includible under 
Sec. 1.46-3(c) in the basis of the non-self-constructed property when it 
is placed in service.
    (5) Certain borrowing disregarded. Qualified progress expenditures 
for non-self-constructed property do not include any amount paid to 
another person (the ``payee'') for construction if the amount is paid 
out of funds borrowed directly or indirectly from the payee. Amounts 
borrowed directly or indirectly from the payee by any person that is 
related to the taxpayer (within the meaning of section 267) or that is a 
member of the same controlled group of corporations (as defined in 
section 1563(a)) will be considered borrowed indirectly from the payee. 
Similarly, amounts borrowed under any financing arrangement that has the 
effect of making the payee a surety will be considered amounts borrowed 
indirectly by the taxpayer from the payee.
    (6) Percentage of completion limitation. (i) Under section 
46(d)(3)(B)(ii), payments made in any taxable year may be considered 
qualified progress expenditures for non-self-constructed property only 
to the extent they are attributable to progress made in construction 
(percentage of completion limitation). Progress will generally be 
measured in terms of the manufacturer's incurred cost, as a fraction of 
the anticipated cost (as adjusted from year to year). Architectural or 
engineering estimates will be evidence of progress made in construction. 
Cost accounting records also will be evidence of progress. Progress will 
be presumed to occur not more rapidly than ratably over the normal 
construction period. However, the taxpayer may rebut the presumption by 
clear and convincing evidence of a greater percentage of completion.
    (ii) If, after the first year of construction, there is a change in 
either the total cost to the taxpayer or the total cost of construction 
by another person,

[[Page 224]]

the taxpayer must recompute the percentage of completion limitation on 
the basis of revised cost. However, the recomputation will affect only 
amounts allowed as qualified progress expenditures in the taxable year 
in which the change occurs and in subsequent taxable years. The 
recomputation remains subject to the presumption of pro rata completion.
    (iii) If, for any taxable year, the amount paid to another person 
for construction of an item of property under section 46(d)(3)(B)(i) 
exceeds the percentage of completion limitation in section 
46(d)(3)(B)(ii), the excess is treated as an amount paid to the other 
person for construction for the succeeding taxable year. If for any 
taxable year the percentage of completion limitation for an item of 
property exceeds the amount paid to another during the taxable year for 
construction, the excess is added to the percentage of completion 
limitation for that property for the succeeding taxable year.
    (iv) The taxpayer must maintain detailed records which permit 
specific identification of the amounts paid to each person for 
construction of each item of property and the percentage of construction 
completed by each person for each taxable year.
    (7) Example. The following example illustrates paragraph (j)(6) of 
this section.

    Example. (i) Corporation X agrees to build an airplane for 
corporation Y, a calendar year taxpayer. The airplane is non-self-
constructed progress expenditure property. Physical work on construction 
begins on January 1, 1980. The normal construction period for the 
airplane is five years and the airplane is delivered and placed in 
service on December 31, 1984.
    (ii) The cost of construction to corporation X is $500,000. The 
contract price is $550,000. Corporation Y makes a $110,000 payment in 
each of the years 1980 and 1981, an $85,000 payment in 1982, a $135,000 
payment in 1983, and a $110,000 payment in 1984.
    (iii) For 1980, corporation Y makes an election under section 46(d). 
Progress is presumed to occur ratably over the 5-year construction 
period, which is 20 percent in each year. Twenty percent of the contract 
price is $110,000. The percentage of completion limitation for each 
year, thus, is $110,000.
    (iv) For each of the years 1980 and 1981, the $110,000 payments may 
be treated as qualified progress expenditures. The payments equal the 
percentage of completion limitation.
    (v) For 1982, the $85,000 payment may be treated as a qualified 
progress expenditure, because it is less than the percentage of 
completion limitation. The excess of the percentage of completion 
limitation ($110,000) over the 1982 payment ($85,000) is added to the 
percentage of completion limitation for 1983. One hundred and ten 
thousand dollars minus $85,000 equals $25,000. Twenty-five thousand 
dollars plus $110,000 equals $135,000, which is the percentage of 
completion limitation for 1983.
    (vi) For 1983, the entire $135,000 payment may be treated as a 
qualified progress expenditure. The payment equals the percentage of 
completion limitation for 1983.
    (vii) For 1984, no qualified progress expenditures may be taken into 
account, because the airplane is placed in service in that year.
    (viii) See example 2 of paragraph (r)(4) of this section for the 
result if Y sells its contract rights to the property on December 31, 
1982.

    (k) Definition of self-constructed property--(1) In general. 
Property is self-constructed property if it is reasonable to believe 
that more than half of the construction expenditures for the property 
will be made directly by the taxpayer. Construction expenditures made 
directly by the taxpayer include direct costs such as wages and 
materials and indirect costs such as overhead attributable to 
construction of the property. Expenditures for direct and indirect costs 
of construction will be treated as construction expenditures made 
directly by the taxpayer only to the extent that the expenditures 
directly benefit the construction of the property by employees of the 
taxpayer. Thus, wages paid to taxpayers's employees and expenditures for 
basic construction materials, such as sheet metal, lumber, glass, and 
nails, which are used by employees of the taxpayer to construct progress 
expenditure property, will be considered made directly by the taxpayer. 
Construction expenditures made by the taxpayer to a contractor or 
manufacturer, in general, will not be considered made directly by the 
taxpayer. Thus, the cost of component parts, such as boilers and 
turbines, which are purchased and merely installed or assembled by the 
taxpayer, will not be considered expenditures made directly by the 
taxpayer for construction. (See paragraph (h)(3) of this section to 
determine when such cost is

[[Page 225]]

properly chargeable to capital account.)
    (2) Time when determination made. The determination of whether 
property is self-constructed is to be made at the close of the taxable 
year in which physical work on construction of the property begins, or, 
if later, the close of the first taxable year to which an election under 
this section applies. Once it is reasonably estimated that more than 
half of construction expenditures will be made directly by the taxpayer, 
the fact the taxpayer actually makes half, or less than half, of the 
expenditures directly will not affect classification of the property as 
self-constructed property. Similarly, once a determination has been 
made, classification of property as self-constructed property is not 
affected by a change in circumstances in a later taxable year. However, 
a significant error unrelated to a change in circumstances may be 
evidence that the estimate was unreasonable when made.
    (3) Determination based on certain expenditures. For purposes of 
determining whether more than half of the expenditures for construction 
of an item of property will be made directly by the taxpayer, the 
taxpayer may take into account only expenditures properly includable by 
the taxpayer in the basis of the property under the provisions of 
Sec. 1.46-3(c). Thus, property is self-constructed property only if more 
than half of the estimated basis of the property to be used for purposes 
of determining the credit allowed by section 38 is attributable to 
expenditures made directly by the taxpayer.
    (l) Definition of non-self-constructed property. Non-self-
constructed property is property that is not self-constructed property. 
Thus, property is non-self-constructed property if it is reasonable to 
believe that only half, or less than half, of the expenditures for 
construction will be made directly by the taxpayer.
    (m) Alternative limitations for public utility, railroad, or airline 
property. The alternative limitations on qualified investment under 
section 46(a) (7) and (8) for public utility, railroad, or airline 
property (whichever applies) apply in determining the credit for 
qualified progress expenditures. The determination of whether progress 
expenditure property will be public utility, railroad, or airline 
property (whichever applies) when placed in service must be made at the 
close of the taxable year in which physical work on construction begins 
or, if later, at the close of the first taxable year for which an 
election under section 46(d) is in effect. If, at that time, the 
taxpayer is in a trade or business as a public utility, railroad, or 
airline (as described in section 46(c)(3)(B) and 46(a)(8) (D) and (E), 
respectively), it is evidence the property will be public utility, 
railroad, or airline property when placed in service.
    (n) Leased property. A lessor of progress expenditure property may 
not elect under section 48(d) to treat a lessee (or a person who will be 
a lessee) as having made qualified progress expenditures.
    (o) Election--(1) In general. The election under section 46(d)(6) to 
increase qualified investment by qualified progress expenditures may be 
made for any taxable year ending after December 31, 1974. Except as 
provided in paragraph (o)(2) of this section, the election is effective 
for the first taxable year for which it is made and for all taxable 
years thereafter unless it is revoked with the consent of the 
Commissioner. Except as provided in paragraphs (o) (2) and (3) of this 
section, the election applies to all qualified progress expenditures 
made by the taypayer during the taxable year for construction of any 
progress expenditure property. Thus, the taxpayer may not make the 
election for one item of progress expenditure property and not for other 
items. If progress expenditure property is being constructed by or for a 
partnership, S corporation (as defined in section 1361(a)), trust, or 
estate, an election under section 46(d)(6) must be made separately by 
each partner or shareholder, or each beneficiary if the beneficiary, in 
determining his tax liability, would be allowed investment credit under 
section 38 for property subject to the election. The election may not be 
made by a partnership or S corporation, and may be made by a trust or 
estate only if the trust or estate, in determining its tax liability, 
would be allowed investment credit under section 38 for property subject 
to

[[Page 226]]

the election. The election of any partner, shareholder, beneficiary, 
trust, or estate will be effective for that person, even if a related 
partner, shareholder, beneficiary, trust, or estate does not make the 
election. An election made by a partner, shareholder, beneficiary, 
trust, or estate applies to all progress expenditure property of that 
person. For example, an election made by corporation X, which is a 
partner in the XYZ partnership, applies to progress expenditure property 
the corporation holds in its own capacity and also to its interest in 
progress expenditure property of the partnership.
    (2) Time and manner of making election. An election under section 
46(d)(6) must be made on Form 3468 and filed with the original income 
tax return for the first taxable year ending after December 31, 1974 to 
which the election will apply. An election made before March 2, 1988, by 
filing a written statement (whether or not attached to the income tax 
return) will be considered valid. The election may not be made on an 
amended return filed after the time prescribed for filing the original 
return (including extensions) for that taxable year. However, an 
election under this section may be made or revoked by filing a statement 
with an amended return filed on or before May 31, 1988, if the due date 
for filing a return for the first taxable year to which the election 
applies is before May 31, 1988.
    (3) Carryover of election in certain transactions. In general, and 
election under section 46(d)(6) does not carry over to the transferee of 
progress expenditure property (or an interest therein). However, if 
under section 47(b) the property does not cease to be progress 
expenditure property because of the transfer, the election will carry 
over to the transferee. If so, the election will apply only to the 
property transferred. For rules relating to the determination of 
qualified progress expenditures of the transferee, see paragraph (r) of 
this section.
    (p) Partnerships, S corporations, trusts, or estates--(1) In 
general. Each partner, shareholder, trust, estate, or beneficiary of a 
trust or estate that makes an election under section 46(d) shall take 
into account its share of qualified progress expenditures (determined 
under paragraph (p)(2) of this section) made by the partnership, S 
corporation, trust, or estate. In determining qualified investment for 
the year in which the property is placed in service, the basis of the 
property is apportioned as provided in Secs. 1.46-3(f), 1.48-6, or 1.48-
5 (whichever applies). Each partner, shareholder, trust, estate, or 
beneficiary that made the election must reduce qualified investment 
under section 46(c)(4) for the year the property is placed in service by 
qualified progress expenditures taken into account by that person.
    (2) Determination of share of qualified progress expenditures. The 
share of qualified progress expenditures of each partner, shareholder, 
trust, estate, or beneficiary that makes an election under section 46(d) 
must be determined in accordance with the same ratio used under 
Secs. 1.46-3(f)(2), 1.48-5(a)(1), or 1.48-6(a)(1) (whichever applies) to 
determine its share of basis (or cost). The last sentence of Sec. 1.46-
3(f)(2)(i) must be applied by referring to the date on which qualified 
progress expenditures are paid or chargeable to capital amount 
(whichever is applicable).
    (3) Examples. The followng examples illustrate this paragraph (p).

    Example 1. (i) Corporation X contracts to build a ship for 
partnership AB that qualifies as progress expenditure property. The 
contract price is $100,000. Physical work on construction of the ship 
begins on January 1, 1980. The ship is placed in service on December 31, 
1983.
    (ii) The AB partnership reports income on the calendar year basis. 
Partners A and B share profits equally. For A's taxable year ending 
December 31, 1980, A makes an election under section 46(d) B does not 
make the election.
    (iii) For each of the years 1980, 1981, 1982, and 1983, the AB 
partnership makes $25,000 payments to corporation X. The payments made 
in 1980, 1981, and 1982 are qualified progress expenditures. The 1983 
payment is not a qualified progress expenditure, because the ship is 
placed in service in that year.
    (iv) For each of the years 1980, 1981, and 1982, A may take into 
account qualified progress expenditures of $12,500 because A had a 50 
percent partnership interest in each of those years.
    (v) For 1983, qualified investment for the ship is $100,000. A and 
B's share are $50,000 each, because each had a 50 percent partnership 
interest in 1983. However, A must reduce its $50,000 share for 1983 by 
$37,500, the

[[Page 227]]

amount of qualified progress expenditures taken into account by A. B's 
share is not reduced, because B did not take into account qualified 
progess expenditures.

    Example 2. (i) The facts are the same as in example 1 except that on 
June 30, 1983, the partnership agreement is amended to admit a new 
partner, C. The partners agree to share profits equally. There is no 
special allocation in effect under section 704 with respect to the ship.
    (ii) For each of the years 1980, 1981, and 1982, A may take into 
account qualified progress expenditures of $12,500 because A has a 50 
percent partnership interest in those years.
    (iii) For 1983, A, B, and C's share of qualified investment is 
$33,333 each, because each had a 33\1/3\ percent partnership interest in 
that year. A must reduce its share to zero, because it took $37,500 into 
account as qualified progress expenditures. In addition, the excess of 
the $37,500 over the $33,333 applied as a reduction is subject to 
recapture under section 47(a)(3)(B). B and C's shares are not reduced, 
because neither taxpayer took into account qualified progress 
expenditures.

    (q) Limitation on qualified progress expenditures for taxable years 
beginning before 1980--(1) In general. (i) Under section 46(d)(7), 
qualified progress expenditures for any taxable year beginning before 
January 1, 1980, are limited. The taxpayer must apply the limitation 
under section 46(d)(7) on an item by item basis. In general, the 
taxpayer may take into account the applicable percentage (as determined 
under the table in section 46(d)(7)(A)) of qualified progress 
expenditures for each of those years. In addition, the taxpayer may take 
into account for each of those years 20 percent of qualified investment 
for each of the preceding taxable years determined without applying the 
limitations of section 46(d)(7).

    (ii) The applicable percentage under section 46(d)(7)(A) may be 
applied only for one taxable year that ends within a calendar year in 
determining qualified investment for an item of progress expenditure 
property. For example, calendar year partners of a calendar year 
partnership may increase qualified investment for 1976 by 20 percent of 
qualified progress expenditures made in 1975 for an item of property. If 
the partnership incorporates in 1976 and the taxable year of the 
corporation begins on July 1, 1976, and ends on June 30, 1977, qualified 
investment of the corporation for its taxable year beginning on July 1, 
1976, cannot be increased by 20 percent of the 1975 expenditure.

    (2) Example. The following example illustrates this paragraph (q).

    Example. (i) Corporation X contracts with A on January 1, 1976, to 
build an electric generator that qualifies as non-self-constructed 
progress expenditure property. A will build the generator at a cost of 
$125,000. Corporation X agrees to pay A $150,000. Corporation X reports 
income on the calendar year basis. Corporation X makes an election under 
section 46(d) for 1976. Physical work on construction begins on January 
1, 1976. Corporation X makes payments of $30,000 to A for construction 
of the generator in each of the years 1976, 1977, 1978, 1979, and 1980. 
A incurs a cost of $25,000 in each of those years for construction of 
the property. The property is placed in service in 1980.
    (ii) For 1976, X may increase qualified investment by $12,000, 40 
percent of the payment made in 1976.
    (iii) For 1977, corporation X may increase qualified investment by 
$24,000. Eighteen thousand dollars of that amount is 60 percent of the 
1977 payment. The remaining $6,000 is 20 percent of the $30,000 payment 
made in 1976.
    (iv) For 1978, corporation X may increase qualified investment by 
$36,000. Twenty-four thousand dollars of that amount is 80 percent of 
the 1978 payment. The remaining $12,000 is 20 percent of the $30,000 
payment made in 1976, plus 20 percent of the $30,000 payment made in 
1977.
    (v) For 1979, corporation X may increase qualified investment by 
$48,000. Thirty thousand dollars of that amount is 100 percent of the 
1979 payment. The remaining $18,000 of that amount is 20 percent of the 
$30,000 payments made in each of the years 1976, 1977, and 1978.
    (vi) Qualified investment for corporation X for 1980 is $30,000. The 
$30,000 is the basis (or cost) of the generator ($150,000), reduced by 
qualified progress expenditures allowed with respect to that property 
($120,000).

    (r) Special rules for transferred property--(1) In general. A 
transfere