Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.163-5   Denial of interest deduction on certain obligations issued after December 31, 1982, unless issued in registered form.
(a)-(b) [Reserved]
(c) Obligations issued to foreign persons after September 21, 1984 —(1) In general. A determination of whether an obligation satisfies each of the requirements of this paragraph shall be made on an obligation-by-obligation basis. An obligation issued directly (or through affiliated entities) in bearer form by, or guaranteed by, a United States Government-owned agency or a United States Government-sponsored enterprise, such as the Federal National Mortgage Association, the Federal Home Loan Banks, the Federal Loan Mortgage Corporation, the Farm Credit Administration, and the Student Loan Marketing Association, may not satisfy this paragraph (c). An obligation issued after September 21, 1984 is described in this paragraph if—
(i) There are arrangements reasonably designed to ensure that such obligation will be sold (or resold in connection with its original issuance) only to a person who is not a United States person or who is a United States person that is a financial institution (as defined in § 1.165-12(c)(1)(v)) purchasing for its own account or for the account of a customer and that agrees to comply with the requirements of section 165(j)(3) (A), (B), or (C) and the regulations thereunder, and
(ii) In the case of an obligation which is not in registered form—
(A) Interest on such obligation is payable only outside the United States and its possessions, and
(B) Unless the obligation is described in subparagraph (2)(i)(C) of this paragraph or is a temporary global security, the following statement in English either appears on the face of the obligation and on any interest coupons which may be detached therefrom or, if the obligation is evidenced by a book entry, appears in the book or record in which the book entry is made: “Any United States person who holds this obligation will be subject to limitations under the United States income tax laws, including the limitations provided in sections 165(j) and 1287(a) of the Internal Revenue Code.” For purposes of this paragraph, the term “temporary global security” means a security which is held for the benefit of the purchasers of the obligations of the issuer and interests in which are exchangeable for securities in definitive registered or bearer form prior to its stated maturity.
(2) Rules for the application of this paragraph —(i) Arrangements reasonably designed to ensure sale to non-United States persons. An obligation will be considered to satisfy paragraph (c)(1)(i) of this section if the conditions of paragraph (c)(2)(i) (A), (B), (C), or (D) of this section are met in connection with the original issuance of the obligation. An exchange of one obligation for another is considered an original issuance if and only if the exchange constitutes a disposition of property for purposes of section 1001 of the Code. However, an exchange of one obligation for another will not be considered a new issuance if the obligation received is identical in all respects to the obligation surrendered in exchange therefor, except that the obligor of the obligation received need not be the same obligor as the obligor of the obligation surrendered. Obligations that meet the conditions of paragraph (c)(2)(i) (A), (B), (C) or (D) of this section may be issued in a single public offering. The preceding sentence does not apply to certificates of deposit issued under the conditions of paragraph (c)(2)(i)(C) of this section by a United States person or by a controlled foreign corporation within the meaning of section 957(a) that is engaged in the active conduct of a banking business within the meaning of section 954(c)(3)(B) as in effect prior to the Tax Reform Act of 1986, and the regulations thereunder. A temporary global security need not satisfy the conditions of paragraph (c)(2)(i) (A), (B) or (C) of this section, but must satisfy the applicable requirements of paragraph (c)(2)(i)(D) of this section.
(A) In connection with the original issuance of an obligation, the obligation is offered for sale or resale only outside of the United States and its possessions, is delivered only outside the United States and its possessions and is not registered under the Securities Act of 1933 because it is intended for distribution to persons who are not United States persons. An obligation will not be considered to be required to be registered under the Securities Act of 1933 if the issuer, in reliance on the written opinion of counsel received prior to the issuance thereof, determines in good faith that the obligation need not be registered under the Securities Act of 1933 for the reason that it is intended for distribution to persons who are not United States persons. Solely for purposes of this subdivision (i)(A), the term “United States person” has the same meaning as it has for purposes of determining whether an obligation is intended for distribution to persons under the Securities Act of 1933. Except as provided in paragraph (c)(3) of this section, this paragraph (c)(2)(i)(A) applies only to obligations issued on or before September 7, 1990.
(B) The obligation is registered under the Securities Act of 1933, is exempt from registration by reason of section 3 or section 4 of such Act, or does not qualify as a security under the Securities Act of 1933; all of the conditions set forth in paragraph (c)(2)(i)(B) ( 1 ), ( 2 ), ( 3 ), ( 4 ), and ( 5 ) of this section are met with respect to such obligations; and, except as provided in paragraph (c)(3) of this section, the obligation is issued on or before September 7, 1990.
( 1 ) In connection with the original issuance of an obligation in bearer form, the obligation is offered for sale or resale only outside the United States and its possessions.
( 2 ) The issuer does not, and each underwriter and each member of the selling group, if any, covenants that it will not, in connection with the original issuance of the obligation, offer to sell or resell the obligation in bearer form to any person inside the United States or to a United States person unless such United States person is a financial institution as defined in § 1.165-12(c)(v) purchasing for its own account or for the account of a customer, which financial institution, as a condition of the purchase, agrees to provide on delivery of the obligation (or on issuance, if the obligation is not in definitive form) the certificate required under paragraph (c)(2)(i)(B)(4).
( 3 ) In connection with its sale or resale during the original issuance of the obligation in bearer form, each underwriter and each member of the selling group, if any, or the issuer, if there is no underwriter or selling group, sends a confirmation to the purchaser of the bearer obligation stating that the purchaser represents that it is not a United States person or, if it is a United States person, it is a financial institution as defined in § 1.165-12(c)(v) purchasing for its own account or for the account of a customer and that the financial institution will comply with the requirements of section 165(j)(3) (A), (B), or (C) and the regulations thereunder. The confirmation must also state that, if the purchaser is a dealer, it will send similar confirmations to whomever purchases from it.
( 4 ) In connection with the original issuance of the obligation in bearer form it is delivered in definitive form (or issued, if the obligation is not in definitive form) to the person entitled to physical delivery thereof only outside the United States and its possessions and only upon presentation of a certificate signed by such person to the issuer, underwriter, or member of the selling group, which certificate states that the obligation is not being acquired by or on behalf of a United States person, or for offer to resell or for resale to a United States person or any person inside the United States, or, if a beneficial interest in the obligation is being acquired by a United States person, that such person is a financial institution as defined in § 1.165.12(c)(1)(v) or is acquiring through a financial institution and that the obligation is held by a financial institution that has agreed to comply with the requirements of section 165(j)(3) (A), (B), or (C) and the regulations thereunder and that is not purchasing for offer to resell or for resale inside the United States. When a certificate is provided by a clearing organization, it must be based on statements provided to it by its member organizations. A clearing organization is an entity which is in the business of holding obligations for member organizations and transferring obligations among such members by credit or debit to the account of a member without the necessity of physical delivery of the obligation. For purposes of paragraph (c)(2)(i)(B), the term “delivery” does not include the delivery of an obligation to an underwriter or member of the selling group, if any.
( 5 ) The issuer, underwriter, or member of the selling group does not have actual knowledge that the certificate described in paragraph (c)(2)(i)(B)( 4 ) of this section is false. The issuer, underwriter, or member of the selling group shall be deemed to have actual knowledge that the certificate described in paragraph (c)(2)(i)(B)( 4 ) of this section is false if the issuer, underwriter, or member of the selling group has a United States address for the beneficial owner (other than a financial institution as defined in § 1.165-12(c)(v) that represents that it will comply with the requirements of section 165(j)(3) (A), (B), or (C) and the regulations thereunder) and does not have documentary evidence as described in § 1.6049-5(c)(1) that the beneficial owner is not a United States person.
(C) The obligation is issued only outside the United States and its possessions by an issuer that does not significantly engage in interstate commerce with respect to the issuance of such obligation either directly or through its agent, an underwriter, or a member of the selling group. In the case of an issuer that is a United States person, such issuer may only satisfy the test set forth in this paragraph (c)(2)(i)(C) if—
( 1 ) It is engaged through a branch in the active conduct of a banking business, within the meaning of section 954(c)(3)(B) as in effect before the Tax Reform Act of 1986, and the regulations thereunder, outside the United States;
( 2 ) The obligation is issued outside of the United States by the branch in connection with that trade or business;
( 3 ) The obligation that is so issued is sold directly to the public and is not issued as a part of a larger issuance made by means of a public offering; and
( 4 ) The issuer either maintains documentary evidence as described in subdivision (iii) of A-5 of § 35a.9999-4T that the purchaser is not a United States person (provided that the issuer has no actual knowledge that the documentary evidence is false) or on delivery of the obligation the issuer receives a statement signed by the person entitled to physical delivery thereof and stating either that the obligation is not being acquired by or on behalf of a United States person or that, if a beneficial interest in the obligation is being acquired by a United States person, such person is a financial institution as defined in § 1.165-12(c)(v) or is acquiring through a financial institution and the obligation is held by a financial institution that has agreed to comply with the requirements of 165(j)(3) (A), (B) or (C) and the regulations thereunder and that it is not purchasing for offer to resell or for resale inside the United States (provided that the issuer has no actual knowledge that the statement is false).
(D) The obligation is issued after September 7, 1990, and all of the conditions set forth in this paragraph (c)(2)(i)(D) are met with respect to such obligation.
( 1 ) Offers and sales —( i ) Issuer. The issuer does not offer or sell the obligation during the restricted period to a person who is within the United States or its possessions or to a United States person.
( ii ) Distributors. ( A ) The distributor of the obligation does not offer or sell the obligation during the restricted period to a person who is within the United States or its possessions or to a United States person.
( B ) The distributor of the obligation will be deemed to satisfy the requirements of paragraph (c)(2)(i)(D)( 1 )( ii )( A ) of this section if the distributor of the obligation convenants that it will not offer or sell the obligation during the restricted period to a person who is within the United States or its possessions or to a United States person; and the distributor of the obligation has in effect, in connection with the offer and sale of the obligation during the restricted period, procedures reasonably designed to ensure that its employees or agents who are directly engaged in selling the obligation are aware that the obligation cannot be offered or sold during the restricted period to a person who is within the United States or its possessions or is a United States person.
( iii ) Certain rules. For purposes of paragraph (c)(2)(i)(D)( 1 ) ( i ) and ( ii ) of this section:
( A ) An offer or sale will be considered to be made to a person who is within the United States or its possessions if the offeror or seller of the obligation has an address within the United States or its possessions for the offeree or buyer of the obligation with respect to the offer or sale.
( B ) An offer or sale of an obligation will not be treated as made to a person within the United States or its possessions or to a United States person if the person to whom the offer or sale is made is: An exempt distributor, as defined in paragraph (c)(2)(i)(D)( 5 ) of this section; An international organization as defined in section 7701(a)(18) and the regulations thereunder, or a foreign central bank as defined in section 895 and the regulations thereunder; or The foreign branch of a United States financial institution as described in paragraph (c)(2)(i)(D)( 6 )( i ) of this section.
( C ) A sale of an obligation will not be treated as made to a person within the United States or its possessions or to a United States person if the person to whom the sale is made is a person described in paragraph (c)(2)(i)(D)( 6 )( ii ) of this section.
( 2 ) Delivery. In connection with the sale of the obligation during the restricted period, neither the issuer nor any distributor delivers the obligation in definitive form within the United States or it possessions.
( 3 ) Certification —( i ) In general. On the earlier of the date of the first actual payment of interest by the issuer on the obligation or the date of delivery by the issuer of the obligation in definitive form, a certificate is provided to the issuer of the obligation stating that on such date:
( A ) The obligation is owned by a person that is not a United States person:
( B ) The obligation is owned by a United States person described in paragraph (c)(2)(i)(D)( 6 ) of this section; or
( C ) The obligation is owned by a financial institution for purposes of resale during the restricted period, and such financial institution certifies in addition that it has not acquired the obligation for purposes of resale directly or indirectly to a United States person or to a person within the United States or its possessions.
( ii ) Electronic certification. The certificate required by paragraph (c)(2)(i)(D)( 3 )( i ) of this section (including a statement provided to a clearing organization by a member organization) may be provided electronically, but only if the person receiving such electronic certificate maintains adequate records, for the retention period described in paragraph (c)(2)(i)(D)( 3 )( i ) of this section, establishing that such certificate was received in respect of the subject obligation, and only if there is a written agreement entered into prior to the time of certification (including the written membership rules of a clearing organization) to which the sender and recipient are subject, providing that the electronic certificate shall have the effect of a signed certificate described in paragraph (c)(2)(i)(D)( 3 )( i ) of this section.
( iii ) Exception for certain obligations. This paragraph (c)(2)(i)(D)( 3 ) shall not apply, and no certificate shall be required, in the case of an obligation that is sold during the restricted period and that satisfies all of the following requirements:
( A ) The interest and principal with respect to the obligation are denominated only in the currency of a single foreign country.
( B ) The interest and principal with respect to the obligation are payable only within that foreign country (according to rules similar to those set forth in § 1.163-5(c)(2)(v)).
( C ) The obligation is offered and sold in accordance with practices and documentation customary in that foreign country.
( D ) The distributor covenants to use reasonable efforts to sell the obligation within that foreign country.
( E ) The obligation is not listed, or the subject of an application for listing, on an exchange located outside that foreign country.
( F ) The Commissioner has designated that foreign country as a foreign country in which certification under paragraph (c)(2)(i)(D)( 3 )( i ) of this section is not permissible.
( G ) The issuance of the obligation is subject to guidelines or restrictions imposed by governmental, banking or securities authorities in that foreign country.
( H ) More than 80 percent by value of the obligations included in the offering of which the obligation is a part are offered and sold to non-distributors by distributors maintaining an office located in that foreign country. Foreign currency denominated obligations that are convertible into U.S. dollar denominated obligations or that by their terms are linked to the U.S. dollar in a way which effectively converts the obligations to U.S. dollar denominated obligations do not satisfy the requirements of this paragraph (c)(2)(i)(D)( 3 )( iii ). A foreign currency denominated obligation will not be treated as linked, by its terms, to the U.S. dollar solely because the obligation is the subject of a swap transaction.
( 4 ) Distributor. For purposes of this paragraph (c)(2)(i)(D), the term “distributor” means:
( i ) A person that offers or sells the obligation during the restricted period pursuant to a written contract with the issuer;
( ii ) Any person that offers or sells the obligation during the restricted period pursuant to a written contract with a person described in paragraph (c)(2)(i)(D) ( 4 ) ( i ); and
( iii ) Any affiliate that acquires the obligation from another member of its affiliated group for the purpose of offering or selling the obligation during the restricted period, but only if the transferor member of the group is the issuer or a person described in paragraph (c)(2)(i)(D) ( 4 )( i ) or ( ii ) of this section. The terms “affiliate” and “affiliated group” have the same meanings as in section 1504(a) of the Code, but without regard to the exceptions contained in section 1504(b) and substituting “50 percent” for “80 percent” each time it appears.
( 5 ) Exempt distributor. For purposes of this paragraph (c)(2)(i)(D), the term “exempt distributor” means a distributor that convenants in its contract with the issuer or with a distributor described in paragraph (c)(2)(i)(D)( 4 )( i ) that it is buying the obligation for the purpose of resale in connection with the original issuance of the obligation, and that if it retains the obligation for its own account, it will only do so in accordance with the requirements of paragraph (c)(2)(i)(D)( 6 ) of this section. In the latter case, the convenant will constitute the certificate required under paragraph (c)(2)(i)(D)( 6 ). The provisions of paragraph (c)(2)(i)(D)( 7 ) governing the restricted period for unsold allotments or subscriptions shall apply to any obligation retained for investment by an exempt distributor.
( 6 ) Certain United States persons. A person is described in this paragraph (c)(2)(i)(D)( 6 ) if the requirements of this paragraph are satisfied and the person is:
( i ) The foreign branch of a United States financial institution purchasing for its own account or for resale, or
( ii ) A United States person who acquired the obligation through the foreign branch of a United States financial institution and who, for purposes of the certification required in paragraph (c)(2)(i)(D)( 3 ) of this section, holds the obligation through such financial institution on the date of certification.
( 7 ) Restricted period. For purposes of this paragraph (c)(2)(i)(D), the restricted period with respect to an obligation begins on the earlier of the closing date (or the date on which the issuer receives the loan proceeds, if there is no closing with respect to the obligation), or the first date on which the obligation is offered to persons other than a distributor. The restricted period with respect to an obligation ends on the expiration of the forty day period beginning on the closing date (or the date on which the issuer receives the loan proceeds, if there is no closing with respect to the obligation). Notwithstanding the preceding sentence, any offer or sale of the obligation by the issuer or a distributor shall be deemed to be during the restricted period if the issuer or distributor holds the obligation as part of an unsold allotment or subscription.
( 8 ) Clearing organization. For purposes of this paragraph (c)(2)(i)(D), a “clearing organization” is an entity which is in the business of holding obligations for member organizations and transferring obligations among such members by credit or debit to the account of a member without the necessity of physical delivery of the obligation.
(ii) Special rules. An obligation shall not be considered to be described in paragraph (c)(2)(i)(C) of this section if it is—
(A) Guaranteed by a United States shareholder of the issuer;
(B) Convertible into a debt or equity interest in a United States shareholder of the issuer; or
(C) Substantially identical to an obligation issued by a United States shareholder of the issuer.
(iii) Interstate commerce. For purposes of this paragraph, the term “interstate commerce” means trade or commerce in obligations or any transportation or communication relating thereto between any foreign country and the United States or its possessions.
(A) An issuer will not be considered to engage significantly in interstate commerce with respect to the issuance of an obligation if the only activities with respect to which the issuer uses the means or instrumentalities of interstate commerce are activities of a preparatory or auxiliary character that do not involve communication between a prospective purchaser and an issuer, its agent, an underwriter, or member of the selling group if either is inside the United States or its possessions. Activities of a preparatory or auxiliary character include, but are not limited to, the following activities:
( 1 ) Establishment or participation in establishment of policies concerning the issuance of obligations and the allocation of funding by a United States shareholder with respect to obligations issued by a foreign corporation or by a United States office with respect to obligations issued by a foreign branch;
( 2 ) Negotiation between the issuer and underwriters as to the terms and pricing of an issue;
( 3 ) Transfer of funds to an office of an issuer in the United States or its possessions by a foreign branch or to a United States shareholder by a foreign corporation;
( 4 ) Consultation by an issuer with accountants and lawyers or other financial advisors in the United States or its possessions regarding the issuance of an obligation;
( 5 ) Document drafting and printing; and
( 6 ) Provision of payment or delivery instructions to members of the selling group by an issuer's office or agent that is located in the United States or its possessions.
(B) Activities that will not be considered to be of a preparatory or auxiliary character include, but are not limited to, any of the following activities:
( 1 ) Negotiation or communication between a prospective purchaser and an issuer, its agent, an underwriter, or a member of the selling group concerning the sale of an obligation if either is inside the United States or its possessions;
( 2 ) Involvement of an issuer's office, its agent, an underwriter, or a member of the selling group in the United States or its possessions in the offer or sale of a particular obligation, either directly with the prospective purchaser, or through the issuer in a foreign country;
( 3 ) Delivery of an obligation in the United States or its possessions; or
( 4 ) Advertising or otherwise promoting an obligation in the United States or its possessions.
(C) The following examples illustrate the application of this subdivision (iii) of § 1.163-5(c)(2).
(iv) Possessions. For purposes of this section, the term “possessions” includes Puerto Rico, the U.S. Virgin Islands, Guam, American Samoa, Wake Island, and Northern Mariana Islands.
(v) Interest payable outside of the United States. Interest will be considered payable only outside the United States and its possessions if payment of such interest can be made only upon presentation of a coupon, or upon making of any other demand for payment, outside of the United States and its possessions to the issuer or a paying agent. The fact that payment is made by a draft drawn on a United States bank account or by a wire or other electronic transfer from a United States account does not affect this result. Interest payments will be considered to be made within the United States if the payments are made by a transfer of funds into an account maintained by the payee in the United States or mailed to an address in the United States, if—
(A) The interest is paid on an obligation issued by either a United States person, a controlled foreign corporation as defined in section 957 (a), or a foreign corporation if 50 percent or more of the gross income of the foreign corporation from all sources of the 3-year period ending with the close of its taxable year preceding the original issuance of the obligation (or for such part of the period that the foreign corporation has been in existence) was effectively connected with the conduct of a trade or business within the United States; and
(B) The interest is paid to a person other than—
( 1 ) A person who may satisfy the requirements of section 165 (j)(3) (A), (B), or (C) and the regulations thereunder; and
( 2 ) A financial institution as a step in the clearance of funds and such interest is promptly credited to an account maintained outside the United States for such financial institution or for persons for which the financial institution has collected such interest.
(vi) Rules relating to obligations issued after December 31, 1982 and on or before September 21, 1984. Whether an obligation originally issued after December 31, 1982 and on or before September 21, 1984, or an obligation originally issued after September 21, 1984 pursuant to the exercise of a warrant or the conversion of a convertible obligation, which warrant or obligation (including conversion privilege) was issued after December 31, 1982 and on or before September 21, 1984, is described in section 163(f)(2)(B) shall be determined under the rules provided in § 5f.163-1(c) as in effect prior to its removal. Notwithstanding the preceding sentence, an issuer will be considered to satisfy the requirements of section 163(f)(2)(B) with respect to an obligation issued after December 31, 1982 and on or before September 21, 1984 or after September 21, 1984 pursuant to the exercise of a warrant or the conversion of a convertible obligation, which warrant or obligation (including conversion privilege) was issued after December 31, 1982 and on or before September 21, 1984, if the issuer substantially complied with the proposed regulations provided in § 1.163-5(c), which were published in the Federal Register on September 2, 1983 (48 FR 39953) and superseded by temporary regulations published in the Federal Register on August 22, 1984 (49 FR 33228).
(3) Effective date —(i) In general. These regulations apply generally to obligations issued after January 20, 1987. A taxpayer may choose to apply the rules of § 1.163-5(c) with respect to an obligation issued after December 31, 1982 and on or before January 20, 1987. If this choice is made, the rules of § 1.163-5(c) will apply in lieu of § 1.163-5T(c) except that the legend requirement under § 1.163-5(c)(l)(ii)(B) does not apply with respect to a bearer obligation evidenced exclusively by a book entry and that the certification requirement under § 1.163-5T(c)(2)(B)( 4 ) applies in lieu of the certification under § 1.163-5(c)(2)(i)(B)(4).
(ii) Special rules. If an obligation is originally issued after September 7, 1990 pursuant to the exercise of a warrant or the conversion of a convertible obligation, which warrant or obligation (including conversion privilege) was issued on or before May 10, 1990, then the issuer may choose to apply either the rules of § 1.163-5(c)(2)(i)(A) or § 1.163-5(c)(2)(i)(B), or the rules of § 1.163-5(c)(2)(i)(D). The issuer of an obligation may choose to apply either the rules of § 1.163-5(c)(2)(i) (A) or (B), or the rules of § 1.163-5(c)(2)(i)(D), to an obligation that is originally issued after May 10, 1990, and on or before September 7, 1990. However, any issuer choosing to apply the rules of § 1.163-5(c)(2)(i)(A) must apply the definition of United States person used for such purposes on December 31, 1989, and must obtain any certificates that would have been required under applicable law on December 31, 1989.
§ 1.163-5T   Denial of interest deduction on certain obligations issued after December 31, 1982, unless issued in registered form (temporary).
(a)-(c) [Reserved]
(d) Pass-through certificates. (1) A pass-through or participation certificate evidencing an interest in a pool of mortgage loans which under subpart E of subchapter J of the Code is treated as a trust of which the grantor is the owner (or similar evidence of interest in a similar pooled fund or pooled trust treated as a grantor trust) (“pass-through certificate”) is considered to be a “registration-required obligation” under section 163(f)(2)(A) and § 1.163-5(c) if the pass-through certificate is described in section 163(f)(2)(A) and § 1.163-5(c) without regard to whether any obligation held by the fund or trust to which the pass-through certificate relates is described in section 163(f)(2)(A) and § 1.163-5(c). A pass-through certificate is considered to be described in section 163(f)(2)(B) and § 1.163-5(c) if the pass-through certificate is described in section 163(f)(2)(B) and § 1.163-5(c) without regard to whether any obligation held by the fund or trust to which the pass-through certificate relates is described in section 163(f)(2)(B) and § 1.163-5(c).
(2) An obligation held by a fund or trust in which ownership interests are represented by pass-through certificates is considered to be in registered form under section 149(a) and the regulations thereunder or to be described in section 163(f)(2) (A) or (B), if the obligation held by the fund or trust is in registered form under section 149(a) and the regulations thereunder or is described in section 163(f)(2) (A) or (B), respectively, without regard to whether the pass-through certificates are so considered.
(3) For purposes of section 4701, a pass-through certificate is considered to be issued solely by the recipient of the proceeds from the issuance of the pass-through certificate (hereinafter the “sponsor”). The sponsor is therefore liable for any excise tax under section 4701 that may be imposed with reference to the principal amount of the pass-through certificate.
(4) In order to implement the purpose of section 163, § 1.163-5(c) and this section, the Commissioner may characterize a certificate or other evidence of interest in a fund or trust which under subpart E of subchapter J of the Code is treated as a trust of which the grantor is the owner and any obligation held by such fund or trust in accordance with the substance of the arrangement they represent and may impose the penalties provided under sections 163(f)(1) and 4701 in the appropriate amounts and on the appropriate persons. This provision may be applied, for example, where a corporation issues obligations purportedly in registered form, contributes them to a grantor trust as its only assets, and arranges for the sale to investors of bearer certificates of interest in the trust which do not meet the requirements of section 163(f)(2)(B). If this provision is applied, the obligations held by the fund or trust will not be considered to be issued in registered form or to meet the requirements of section 163(f)(2)(B). The corporation will not be allowed a deduction for the payment of interest on the obligations held by the trust, and the excise tax under section 4701, calculated with reference to the principal amount of the obligations held by the trust will be imposed on the corporation may be collected from the corporation and its agents. This paragraph (d)(4) will not be applied so as to alter the tax consequences of transactions as to which rulings have been issued by the Internal Revenue Service prior to September 19, 1985.
(5) The rules set forth in this paragraph (d) apply solely for purposes of sections 4701, 163(f)(2)(A), 163(f)(2)(B), § 1.163-5(c), and any other section that refers to this section for the definition of the term “registration-required obligation” (such as the regulations under sections 871(h) and 881(c)). The treatment of obligations described in this paragraph (d) for purposes of section 163(f)(2) (A) and (B) does not affect the determination of whether bearer obligations that are issued or guaranteed by the United States Government, a United States Government-owned agency, a United States Government sponsored enterprise (within the meaning of § 1.163-5(c)(1)) or that are backed (as described in the Treasury Department News Release R-2835 of September 10, 1984 and Treasury Department News Release R-2847 of September 14, 1984) by obligations issued by the United States Government, a United States Government-owned agency, or a United States Government sponsored enterprise comply with the requirements of section 163(f)(2)(B) and the regulations thereunder.
(6) The provisions of paragraphs (d) (1) through (5) may be illustrated by the following example:
Commercial Bank K forms a pool of 1000 residential mortgage loans, each made to a different individual homeowner, by assigning them to Commercial Bank L, an unrelated entity serving as trustee of the pool. Commercial Bank L immediately sells in a public offering certificates of interest in the trust of a maturity of 10 years in registered form. Commercial Bank L transfers the cash proceeds of the offering to Commercial Bank K. The certificates of interest in the trust are of a type offered to the public and are not described in section 163(f)(2)(B). Pursuant to paragraph (d)(1), the certificates of interest in the pool are registration-required obligations without regard to the fact that the obligations held by the trust are not registration-required obligations.
(e) Regular interests in REMICS. (1) A regular interest in a REMIC, as defined in sections 860D and 860G and the regulations thereunder, is considered to be a “registration-required obligation” under section 163(f)(2)(A) and § 1.163-5(c) if the regular interest is described in section 163(f)(2)(A) and § 1.163-5(c), without regard to whether any obligation held by the REMIC to which the regular interest relates is described in section 163(f)(2)(A) and § 1.163-5(c). A regular interest in a REMIC is considered to be described in section 163(f)(2)(B) and § 1.163-5(c), if the regular interest is described in section 163(f)(2)(B) and § 1.163(c), without regard to whether any obligation held by the REMIC to which the regular interest relates is described in section 163(f)(2)(B) and § 1.163-5(c).
(2) An obligation held by a REMIC is considered to be described in section 163(f)(2) (A) or (B) if such obligation is described in section 163(f)(2) (A) or (B), respectively, without regard to whether the regular interests in the REMIC are so considered.
(3) For purposes of section 4701, a regular interest is considered to be issued solely by the recipient of the proceeds from the issuance of the regular interest (hereinafter the “sponsor”). The sponsor is therefore liable for any excise tax under section 4701 that may be imposed with reference to the principal amount of the regular interest.
(4) In order to implement the purpose of section 163, § 1.163-5(c), and this section, the Commissioner may characterize a regular interest in a REMIC and any obligation held by such REMIC in accordance with the substance of the arrangement they represent and may impose the penalties provided under sections 163(f)(1) and 4701 in the appropriate amounts and on the appropriate persons. This provision may be applied, for example, where a corporation issues an obligation that is purportedly in registered form and that will qualify as a “qualified mortgage” within the meaning of section 860G(a)(3) in the hands of a REMIC, contributes the obligation to a REMIC as its only asset, and arranges for the sale to investors of regular interests in the REMIC in bearer form that do not meet the requirements of section 163(f)(2)(B). If this provision is applied, the obligation held by the REMIC will not be considered to be issued in registered form or to meet the requirements of section 163(f)(2)(B). The corporation will not be allowed a deduction for the payment of interest on the obligation held by the REMIC, and the excise tax under section 4701, calculated with reference to the principal amount of the obligation held by the REMIC, will be imposed on the corporation and may be collected from the corporation and its agents.
§ 1.163-6T   Reduction of deduction where section 25 credit taken (temporary).
(a) In general. The amount of the deduction under section 163 for interest paid or accrued during any taxable year on a certified indebtedness amount with respect to a mortgage credit certificate which has been issued under section 25 shall be reduced by the amount of the credit allowable with respect to such interest under section 25 (determined without regard to section 26).
(b) Cross reference. See §§ 1.25-1T through 1.25-8T with respect to rules relating to mortgage credit certificates.
§ 1.163-7   Deduction for OID on certain debt instruments.
(a) General rule. Except as otherwise provided in paragraph (b) of this section, an issuer (including a transferee) determines the amount of OID that is deductible each year under section 163(e)(1) by using the constant yield method described in § 1.1272-1(b). This determination, however, is made without regard to section 1272(a)(7) (relating to acquisition premium) and § 1.1273-1(d) (relating to de minimis OID). An issuer is permitted a deduction under section 163(e)(1) only to the extent the issuer is primarily liable on the debt instrument. For certain limitations on the deductibility of OID, see sections 163(e) and 1275(b)(2). To determine the amount of interest (OID) that is deductible each year on a debt instrument that provides for contingent payments, see § 1.1275-4.
(b) Special rules for de minimis OID —(1) Stated interest. If a debt instrument has a de minimis amount of OID (within the meaning of § 1.1273-1(d)), the issuer treats all stated interest on the debt instrument as qualified stated interest. See §§ 1.446-2(b) and 1.461-1 for the treatment of qualified stated interest.
(2) Deduction of de minimis OID on other than a constant yield basis. In lieu of deducting de minimis OID under the general rule of paragraph (a) of this section, an issuer of a debt instrument with a de minimis amount of OID (other than a de minimis amount treated as qualified stated interest under paragraph (b)(1) of this section) may choose to deduct the OID at maturity, on a straight-line basis over the term of the debt instrument, or in proportion to stated interest payments. The issuer makes this choice by reporting the de minimis OID in a manner consistent with the method chosen on the issuer's timely filed Federal income tax return for the taxable year in which the debt instrument is issued.
(c) Deduction upon repurchase. Except to the extent disallowed by any other section of the Internal Revenue Code (e.g., section 249) or this paragraph (c), if a debt instrument is repurchased by the issuer for a price in excess of its adjusted issue price (as defined in § 1.1275-1(b)), the excess (repurchase premium) is deductible as interest for the taxable year in which the repurchase occurs. If the issuer repurchases a debt instrument in a debt-for-debt exchange, the repurchase price is the issue price of the newly issued debt instrument (reduced by any unstated interest within the meaning of section 483). However, if the issue price of the newly issued debt instrument is determined under either section 1273(b)(4) or section 1274, any repurchase premium is not deductible in the year of the repurchase, but is amortized over the term of the newly issued debt instrument in the same manner as if it were OID.
(d) Choice of accrual periods to determine whether a debt instrument is an applicable high yield discount obligation (AHYDO). Section 163(e)(5) affects an issuer's OID deductions for certain high yield debt instruments that have significant OID. For purposes of section 163(i)(2), which defines significant OID, the issuer's choice of accrual periods to determine OID accruals is used to determine whether a debt instrument has significant OID. See § 1.1275-2(e) for rules relating to the issuer's obligation to disclose certain information to holders.
(e) Qualified reopening —(1) In general. In a qualified reopening of an issue of debt instruments, if a holder pays more or less than the adjusted issue price of the original debt instruments to acquire an additional debt instrument, the issuer treats this difference as an adjustment to the issuer's interest expense for the original and additional debt instruments. As provided by paragraphs (e)(2) through (5) of this section, the adjustment is taken into account over the term of the instrument using constant yield principles.
(2) Positive adjustment. If the difference is positive (that is, the holder pays more than the adjusted issue price of the original debt instrument), then, with respect to the issuer but not the holder, the difference increases the aggregate adjusted issue prices of all of the debt instruments in the issue, both original and additional.
(3) Negative adjustment. If the difference is negative (that is, the holder pays less than the adjusted issue price of the original debt instrument), then, with respect to the issuer but not the holder, the difference reduces the aggregate adjusted issue prices of all of the debt instruments in the issue, both original and additional.
(4) Determination of issuer's interest accruals. As of the reopening date, the issuer must redetermine the yield of the debt instruments in the issue for purposes of applying the constant yield method described in § 1.1272-1(b) to determine the issuer's accruals of interest expense over the remaining term of the debt instruments in the issue. This redetermined yield is based on the aggregate adjusted issue prices of the debt instruments in the issue (as determined under this paragraph (e)) and the remaining payment schedule of the debt instruments in the issue. If the aggregate adjusted issue prices of the debt instruments in the issue (as determined under this paragraph (e)) are less than the aggregate stated redemption price at maturity of the instruments (determined as of the reopening date) by a de minimis amount (within the meaning of § 1.1273-1(d)), the issuer may use the rules in paragraph (b) of this section to determine the issuer's accruals of interest expense.
(5) Effect of adjustments on issuer's adjusted issue price. The adjustments made under this paragraph (e) are taken into account for purposes of determining the issuer's adjusted issue price under § 1.1275-1(b).
(6) Definitions. The terms additional debt instrument, original debt instrument, qualified reopening, and reopening date have the same meanings as in § 1.1275-2(k).
(f) Effective dates. This section (other than paragraph (e) of this section) applies to debt instruments issued on or after April 4, 1994. Taxpayers, however, may rely on this section (other than paragraph (e) of this section) for debt instruments issued after December 21, 1992, and before April 4, 1994. Paragraph (e) of this section applies to qualified reopenings where the reopening date is on or after March 13, 2001.
§ 1.163-8T   Allocation of interest expense among expenditures (temporary).
(a) In general —(1) Application. This section prescribes rules for allocating interest expense for purposes of applying sections 469 (the “passive loss limitation”) and 163 (d) and (h) (the “nonbusiness interest limitations”).
(2) Cross-references. This paragraph provides an overview of the manner in which interest expense is allocated for the purposes of applying the passive loss limitation and nonbusiness interest limitations and the manner in which interest expense allocated under this section is treated. See paragraph (b) of this section for definitions of certain terms, paragraph (c) for the rules for allocating debt and interest expense among expenditures, paragraphs (d) and (e) for the treatment of debt repayments and refinancings, paragraph (j) for the rules for reallocating debt upon the occurrence of certain events, paragraph (m) for the coordination of the rules in this section with other limitations on the deductibility of interest expense, and paragraph (n) of this section for effective date and transitional rules.
(3) Manner of allocation. In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures.
(4) Treatment of interest expenses —(i) General rule. Except as otherwise provided in paragraph (m) of this section (relating to limitations on interest expense other than the passive loss and nonbusiness interest limitations), interest expense allocated under the rules of this section is treated in the following manner:
(A) Interest expense allocated to a trade or business expenditure (as defined in paragraph (b)(7) of this section) is taken into account under section 163 (h)(2)(A);
(B) Interest expense allocated to a passive activity expenditure (as defined in paragraph (b)(4) of this section) or a former passive activity expenditure (as defined in paragraph (b)(2) of this section) is taken into account for purposes of section 469 in determining the income or loss from the activity to which such expenditure relates;
(C) Interest expense allocated to an investment expenditure (as defined in paragraph (b)(3) of this section) is treated for purposes of section 163(d) as investment interest;
(D) Interest expense allocated to a personal expenditure (as defined in paragraph (b)(5) of this section) is treated for purposes of section 163(h) as personal interest; and
(E) Interest expense allocated to a portfolio expenditure (as defined in paragraph (b)(6) of this section) is treated for purposes of section 469(e)(2)(B)(ii) as interest expense described in section 469(e)(1)(A)(i)(III).
(ii) Examples. The following examples illustrate the application of this paragraph (a)(4):
(iii) Since M is a closely held C corporation, its passive activity loss is allowable under section 469(e)(2)(A) as a deduction from net active income. Under section 469(e)(2)(B) and this paragraph (a)(4), the $5,000 interest expense allocated to other expenditures is taken into account in computing M's net active income, but the interest expense allocated to the passive activity expenditure and the portfolio expenditure is not taken into account for such purposes.
(iv) Since M is a corporation, the $3,000 interest expense allocated to the portfolio expenditure is allowable without regard to section 163(d). If M were an individual, however, the interest expense allocated to the portfolio expenditure would be treated as investment interest for purposes of applying the limitation of section 163(d).
(b) Definitions. For purposes of this section—
(1) “Former passive activity” means an activity described in section 469(f)(3), but only if an unused deduction or credit (within the meaning of section 469(f)(1) (A) or (B)) is allocable to the activity under section 469(b) for the taxable year.
(2) “Former passive activity expenditure” means an expenditure that is taken into account under section 469 in computing the income or loss from a former passive activity of the taxpayer or an expenditure (including an expenditure properly chargeable to capital account) that would be so taken into account if such expenditure were otherwise deductible.
(3) “Investment expenditure” means an expenditure (other than a passive activity expenditure) properly chargeable to capital account with respect to property held for investment (within the meaning of section 163(d)(5)(A)) or an expenditure in connection with the holding of such property.
(4) “Passive activity expenditure” means an expenditure that is taken into account under section 469 in computing income or loss from a passive activity of the taxpayer or an expenditure (including an expenditure properly chargeable to capital account) that would be so taken into account if such expenditure were otherwise deductible. For purposes of this section, the term “passive activity expenditure” does not include any expenditure with respect to any low-income housing project in any taxable year in which any benefit is allowed with respect to such project under section 502 of the Tax Reform Act of 1986.
(5) “Personal expenditure” means an expenditure that is not a trade or business expenditure, a passive activity expenditure, or an investment expenditure.
(6) “Portfolio expenditure” means an investment expenditure properly chargeable to capital account with respect to property producing income of a type described in section 469(e)(1)(A) or an investment expenditure for an expense clearly and directly allocable to such income.
(7) “Trade or business expenditure” means an expenditure (other than a passive activity expenditure or an investment expenditure) in connection with the conduct of any trade or business other than the trade or business of performing services as an employee.
(c) Allocation of debt and interest expense —(1) Allocation in accordance with use of proceeds. Debt is allocated to expenditures in accordance with the use of the debt proceeds and, except as provided in paragraph (m) of this section, interest expense accruing on a debt during any period is allocated to expenditures in the same manner as the debt is allocated from time to time during such period. Except as provided in paragraph (m) of this section, debt proceeds and related interest expense are allocated solely by reference to the use of such proceeds, and the allocation is not affected by the use of an interest in any property to secure the repayment of such debt or interest. The following example illustrates the principles of this paragraph (c)(1):
(2) Allocation period —(i) Allocation of debt. Debt is allocated to an expenditure for the period beginning on the date the proceeds of the debt are used or treated as used under the rules of this section to make the expenditure and ending on the earlier of—
(A) The date the debt is repaid; or
(B) The date the debt is reallocated in accordance with the rules in paragraphs (c)(4) and (j) of this section.
(ii) Allocation of interest expense —(A) In general. Except as otherwise provided in paragraph (m) of this section, interest expense accruing on a debt for any period is allocated in the same manner as the debt is allocated from time to time, regardless of when the interest is paid.
(B) Effect of compounding. Accrued interest is treated as a debt until it is paid and any interest accruing on unpaid interest is allocated in the same manner as the unpaid interest is allocated. For the taxable year in which a debt is reallocated under the rules in paragraphs (c)(4) and (j) of this section, however, compound interest accruing on such debt (other than compound interest accruing on interest that accrued before the beginning of the year) may be allocated between the original expenditure and the new expenditure on a straight-line basis ( i.e. , by allocating an equal amount of such interest expense to each day during the taxable year). In addition, a taxpayer may treat a year as consisting of 12 30-day months for purposes of allocating interest on a straight-line basis.
(C) Accrual of interest expense. For purposes of this paragraph (c)(2)(ii), the amount of interest expense that accrues during any period is determined by taking into account relevant provisions of the loan agreement and any applicable law such as sections 163(e), 483, and 1271 through 1275.
(iii) Examples. The following examples illustrate the principles of this paragraph (c)(2):
(ii) Under this paragraph (c)(2) and paragraph (j) of this section, the $1,000 debt is allocated to the investment expenditure for the period from January 1 through June 30, and to the passive activity expenditure from July 1 through December 31. Interest expense accruing on the $1,000 debt is allocated in accordance with the allocation of the debt from time to time during the year even though the debt was allocated to the passive activity expenditure on the date the interest was paid. Thus, the $55 interest expense for the period from January 1 through June 30 is allocated to the investment expenditure. In addition, during the period from July 1 through December 31, the interest expense allocated to the investment expenditure is a debt, the proceeds of which are treated as used to make an investment expenditure. Accordingly, an additional $3 of interest expense for the period from July 1 through December 31 ($55 × .055) is allocated to the investment expenditure. The remaining $55 of interest expense for the period from July 1 through December 31 ($1,000 × .055) is allocated to the passive activity expenditure.
(iii) Alternatively, under the rule in paragraph (c)(2)(ii)(B) of this section, B may allocate the interest expense on a straight-line basis and may also treat the year as consisting of 12 30-day months for this purpose. In that case, $56.50 of interest expense (180/360 × $113) would be allocated to the investment expenditure and the remaining $56.50 of interest expense would be allocated to the passive activity expenditure.
(3) Allocation of debt; proceeds not disbursed to borrower —(i) Third-party financing. If a lender disburses debt proceeds to a person other than the borrower in consideration for the sale or use of property, for services, or for any other purpose, the debt is treated for purposes of this section as if the borrower used an amount of the debt proceeds equal to such disbursement to make an expenditure for such property, services, or other purpose.
(ii) Debt assumptions not involving cash disbursements. If a taxpayer incurs or assumes a debt in consideration for the sale or use of property, for services, or for any other purpose, or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer, the debt is treated for purposes of this section as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to make an expenditure for such property, services, or other purpose.
(4) Allocation of debt; proceeds deposited in borrower's account —(i) Treatment of deposit. For purposes of this section, a deposit of debt proceeds in an account is treated as an investment expenditure, and amounts held in an account (whether or not interest bearing) are treated as property held for investment. Debt allocated to an account under this paragraph (c)(4)(i) must be reallocated as required by paragraph (j) of this section whenever debt proceeds held in the account are used for another expenditure. This paragraph (c)(4) provides rules for determining when debt proceeds are expended from the account. The following example illustrates the principles of this paragraph (c)(4)(i):
(ii) Expenditures from account; general ordering rule. Except as provided in paragraph (c)(4)(iii) (B) or (C) of this section, debt proceeds deposited in an account are treated as expended before—
(A) Any unborrowed amounts held in the account at the time such debt proceeds are deposited; and
(B) Any amounts (borrowed or unborrowed) that are deposited in the account after such debt proceeds are deposited.
The following example illustrates the application of this paragraph (c)(4)(ii):
(iii) Expenditures from account; supplemental ordering rules —(A) Checking or similar accounts. Except as otherwise provided in this paragraph (c)(4)(iii), an expenditure from a checking or similar account is treated as made at the time the check is written on the account, provided the check is delivered or mailed to the payee within a reasonable period after the writing of the check. For this purpose, the taxpayer may treat checks written on the same day as written in any order. In the absence of evidence to the contrary, a check is presumed to be written on the date appearing on the check and to be delivered or mailed to the payee within a reasonable period thereafter. Evidence to the contrary may include the fact that a check does not clear within a reasonable period after the date appearing on the check.
(B) Expenditures within 15 days after deposit of borrowed funds. The taxpayer may treat any expenditure made from an account within 15 days after debt proceeds are deposited in such account as made from such proceeds to the extent thereof even if under paragraph (c)(4)(ii) of this section the debt proceeds would be treated as used to make one or more other expenditures. Any such expenditures and the debt proceeds from which such expenditures are treated as made are disregarded in applying paragraph (c)(4)(ii) of this section. The following examples illustrate the application of this paragraph (c)(4)(iii)(B):
(C) Interest on segregated account. In the case of an account consisting solely of the proceeds of a debt and interest earned on such account, the taxpayer may treat any expenditure from such account as made first from amounts constituting interest (rather than debt proceeds) to the extent of the balance of such interest in the account at the time of the expenditure, determined by applying the rules in this paragraph (c)(4). To the extent any expenditure is treated as made from interest under this paragraph (c)(4)(iii)(C), the expenditure is disregarded in applying paragraph (c)(4)(ii) of this section.
(iv) Optional method for determining date of reallocation. Solely for the purpose of determining the date on which debt allocated to an account under paragraph (c)(4)(i) of this section is reallocated, the taxpayer may treat all expenditures made during any calendar month from debt proceeds in the account as occurring on the later of the first day of such month or the date on which such debt proceeds are deposited in the account. This paragraph (c)(4)(iv) applies only if all expenditures from an account during the same calendar month are similarly treated. The following example illustrates the application of this paragraph (c)(4)(iv):
(v) Simultaneous deposits —(A) In general. If the proceeds of two or more debts are deposited in an account simultaneously, such proceeds are treated for purposes of this paragraph (c)(4) as deposited in the order in which the debts were incurred.
(B) Order in which debts incurred. If two or more debts are incurred simultaneously or are treated under applicable law as incurred simultaneously, the debts are treated for purposes of this paragraph (c)(4)(v) as incurred in any order the taxpayer selects.
(C) Borrowings on which interest accrues at different rates. If interest does not accrue at the same fixed or variable rate on the entire amount of a borrowing, each portion of the borrowing on which interest accrues at a different fixed or variable rate is treated as a separate debt for purposes of this paragraph (c)(4)(v).
(vi) Multiple accounts. The rules in this paragraph (c)(4) apply separately to each account of a taxpayer.
(5) Allocation of debt; proceeds received in cash —(i) Expenditure within 15 days of receiving debt proceeds. If a taxpayer receives the proceeds of a debt in cash, the taxpayer may treat any cash expenditure made within 15 days after receiving the cash as made from such debt proceeds to the extent thereof and may treat such expenditure as made on the date the taxpayer received the cash. The following example illustrates the rule in this paragraph (c)(5)(i):
(ii) Other expenditures. Except as provided in paragraphs (c)(5) (i) and (iii) of this section, any debt proceeds a taxpayer (other than a corporation) receives in cash are treated as used to make personal expenditures. For purposes of this paragraph (c)(5), debt proceeds are received in cash if, for example, a withdrawal of cash from an account is treated under the rules of this section as an expenditure of debt proceeds.
(iii) Special rules for certain taxpayers. [Reserved]
(6) Special rules —(i) Qualified residence debt. [Reserved]
(ii) Debt used to pay interest. To the extent proceeds of a debt are used to pay interest, such debt is allocated in the same manner as the debt on which such interest accrued is allocated from time to time. The following example illustrates the application of this paragraph (c)(6)(ii):
(iii) Debt used to pay borrowing costs —(A) Borrowing costs with respect to different debt. To the extent the proceeds of a debt (the “ancillary debt”) are used to pay borrowing costs (other than interest) with respect to another debt (the “primary debt”), the ancillary debt is allocated in the same manner as the primary debt is allocated from time to time. To the extent the primary debt is repaid, the ancillary debt will continue to be allocated in the same manner as the primary debt was allocated immediately before its repayment. The following example illustrates the rule in this paragraph (c)(6)(iii)(A):
(B) Borrowing costs with respect to same debt. To the extent the proceeds of a debt are used to pay borrowing costs (other than interest) with respect to such debt, such debt is allocated in the same manner as the remaining debt is allocated from time to time. The remaining debt for this purpose is the portion of the debt that is not used to pay borrowing costs (other than interst) with respect to such debt. Any repayment of the debt is treated as a repayment of the debt allocated under this paragraph (c)(6)(iii)(B) and the remaining debt is the same proportion as such amount bear to each other. The following example illustrates the application of this paragraph (c)(6)(iii)(B):
(ii) Assume that J repays $50,000 of the debt. The repayment is treated as a repayment of $2,941 ($50,000 × $5,000/$85,000) of the debt used to pay borrowing costs and a repayment of $47,059 ($50,000 × $80,000/$85,000) of the remaining debt. Under paragraph (d) of this section, J is treated as repaying the $42,500 of debt allocated to the personal expenditure ($2,500 of debt used to pay borrowing costs and $40,000 of remaining debt). In addition, assuming that under paragraph (d)(2) J chooses to treat the allocation to the passive activity expenditure as having occurred before the allocation to the investment expenditure, J is treated as repaying $7,500 of debt allocated to the passive activity expenditure ($441 of debt used to pay borrowing costs and $7,059 of remaining debt).
(iv) Allocation of debt before actual receipt of debt proceeds. If interest properly accrues on a debt during any period before the debt proceeds are actually received or used to make an expenditure, the debt is allocated to an investment expenditure for such period.
(7) Antiabuse rules. [Reserved]
(d) Debt repayments —(1) General ordering rule. If, at the time any portion of a debt is repaid, such debt is allocated to more than one expenditure, the debt is treated for purposes of this section as repaid in the following order:
(i) Amounts allocated to personal expenditures;
(ii) Amounts allocated to investment expenditures and passive activity expenditures (other than passive activity expenditures described in paragraph (d)(1)(iii) of this section);
(iii) Amounts allocated to passive activity expenditures in connection with a rental real estate activity with respect to which the taxpayer actively participates (within the meaning of section 469(i));
(iv) Amounts allocated to former passive activity expenditures; and
(v) Amounts allocated to trade or business expenditures and to expenditures described in the last sentence of paragraph (b)(4) of this section.
(2) Supplemental ordering rules for expenditures in same class. Amounts allocated to two or more expenditures that are described in the subdivision of paragraph (d)(1) of this section (e.g., amounts allocated to different personal expenditures) are treated as repaid in the order in which the amounts were allocated (or reallocated) to such expenditures. For purposes of this paragraph (d)(2), the taxpayer may treat allocations and reallocations that occur on the same day as occurring in any order (without regard to the order in which expenditures are treated as made under paragraph (c)(4)(iii)(A) of this section).
(3) Continuous borrowings. In the case of borrowings pursuant to a line of credit or similar account or arrangement that allows a taxpayer to borrow funds periodically under a single loan agreement—
(i) All borrowings on which interest accrues at the same fixed or variable rate are treated as a single debt; and
(ii) Borrowings or portions of borrowings on which interest accrues at different fixed or variable rates are treated as different debts, and such debts are treated as repaid for purposes of this paragraph (d) in the order in which such borrowings are treated as repaid under the loan agreement.
(4) Examples. The following examples illustrate the application of this paragraph (d):
(ii) If the prime lending rate plus two percentage points was the same on both the date of Borrowing #1 and the date of Borrowing #2, the borrowings are treated for purposes of this paragraph (d) as a single debt, and A is treated as having repaid $35,000 of debt allocated to personal expenditure #1 and personal expenditure #2, and $5,000 of debt allocated to trade or business expenditure #1.
(iii) If the prime lending rate plus two percentage points was different on the date of Borrowing #1 and Borrowing #2, the borrowings are treated as two debts, and, in accordance with the loan agreement, the $40,000 repaid amount is treated as a repayment of Borrowing #1 and $10,000 of Borrowing #2. Accordingly, A is treated as having repaid $20,000 of debt allocated to personal expenditure #1, $10,000 of debt allocated to trade or business expenditure #1, and $10,000 of debt allocated to personal expenditure #2.
(e) Debt refinancings —(1) In general. To the extent proceeds of any debt (the “replacement debt”) are used to repay any portion of a debt, the replacement debt is allocated to the expenditures to which the repaid debt was allocated. The amount of replacement debt allocated to any such expenditure is equal to the amount of debt allocated to such expenditure that was repaid with proceeds of the replacement debt. To the extent proceeds of the replacement debt are used for expenditures other than repayment of a debt, the replacement debt is allocated to expenditures in accordance with the rules of this section.
(2) Example. The following example illustrates the application of this paragraph (e):
(f) Debt allocated to distributions by passthrough entities. [Reserved]
(g) Repayment of passthrough entity debt. [Reserved]
(h) Debt allocated to expenditures for interests in passthrough entities. [Reserved]
(i) Allocation of debt to loans between passthrough entities and interest holders. [Reserved]
(j) Reallocation of debt —(1) Debt allocated to capital expenditures —(i) Time of reallocation. Except as provided in paragraph (j)(2) of this section, debt allocated to an expenditure properly chargeable to capital account with respect to an asset (the “first expenditure”) is reallocated to another expenditure on the earlier of—
(A) The date on which proceeds from a disposition of such asset are used for another expenditure; or
(B) The date on which the character of the first expenditure changes (e.g., from a passive activity expenditure to an expenditure that is not a passive activity expenditure) by reason of a change in the use of the asset with respect to which the first expenditure was capitalized.
(ii) Limitation on amount reallocated. The amount of debt reallocated under paragraph (j)(1)(i)(A) of this section may not exceed the proceeds from the disposition of the asset. The amount of debt reallocated under paragraph (j)(1)(i)(B) of this section may not exceed the fair market value of the asset on the date of the change in use. In applying this paragraph (j)(1)(ii) with respect to a debt in any case in which two or more debts are allocable to expenditures properly chargeable to capital account with respect to the same asset, only a ratable portion (determined with respect to any such debt by dividing the amount of such debt by the aggregate amount of all such debts) of the fair market value or proceeds from the disposition of such asset shall be taken into account.
(iii) Treatment of loans made by the taxpayer. Except as provided in paragraph (j)(1)(iv) of this section, an expenditure to make a loan is treated as an expenditure properly chargeable to capital account with respect to an asset, and for purposes of paragraph (j)(1)(i)(A) of this section any repayment of the loan is treated as a disposition of the asset. Paragraph (j)(3) of this section applies to any repayment of a loan in installments.
(iv) Treatment of accounts. Debt allocated to an account under paragraph (c)(4)(i) of this section is treated as allocated to an expenditure properly chargeable to capital account with respect to an asset, and any expenditure from the account is treated as a disposition of the asset. See paragraph (c)(4) of this section for rules under which debt proceeds allocated to an account are treated as used for another expenditure.
(2) Disposition proceeds in excess of debt. If the proceeds from the disposition of an asset exceed the amount of debt reallocated by reason of such disposition, or two or more debts are reallocated by reason of the disposition of an asset, the proceeds of the disposition are treated as an account to which the rules in paragraph (c)(4) of this section apply.
(3) Special rule for deferred payment sales. If any portion of the proceeds of a disposition of an asset are received subsequent to the disposition—
(i) The portion of the proceeds to be received subsequent to the disposition is treated for periods prior to the receipt as used to make an investment expenditure; and
(ii) Debt reallocated by reason of the disposition is allocated to such investment expenditure to the extent such debt exceeds the proceeds of the disposition previously received (other than proceeds used to repay such debt).
(4) Examples. The following examples illustrate the application of this paragraph (j):
(k) Modification of rules in the case of interest expense allocated to foreign source income. [Reserved]
(l) [Reserved]
(m) Coordination with other provisions —(1) Effect of other limitations —(i) In general. All debt is allocated among expenditures pursuant to the rules in this section, without regard to any limitations on the deductibility of interest expense on such debt. The applicability of the passive loss and nonbusiness interest limitations to interest on such debt, however, may be affected by other limitations on the deductibility of interest expense.
(ii) Disallowance provisions. (Interest expense that is not allowable as a deduction by reason of a disallowance provision (within the meaning of paragraph (m)(7)(ii) of this section) is not taken into account for any taxable year for purposes of applying the passive loss and nonbusiness interest limitations.
(iii) Deferral provisions. Interest expense that is not allowable as a deduction for the taxable year in which paid or accrued by reason of a deferral provision (within the meaning of paragraph (m)(7)(iii) of this section) is allocated in the same manner as the debt giving rise to the interest expense is allocated for such taxable year. Such interest expense is taken into account for purposes of applying the passive loss and nonbusiness interest limitations for the taxable year in which such interest expense is allowable under such deferral provision.
(iv) Capitalization provisions. Interest expense that is capitalized pursuant to a capitalization provision (within the meaning of paragraph (m)(7)(i) of this section) is not taken into account as interest for any taxable year for purposes of applying the passive loss and nonbusiness interest limitations.
(2) Effect on other limitations —(i) General rule. Except as provided in paragraph (m)(2)(ii) of this section, any limitation on the deductibility of an item (other than the passive loss and nonbusiness interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section.
(ii) Exception. Capitalization provisions (within the meaning of paragraph (m)(7)(i) of this section) do not apply to interest expense allocated to any personal expenditure under the rules of this section.
(3) Qualified residence interest. Qualified residence interest (within the meaning of section 163(h)(3)) is allowable as a deduction without regard to the manner in which such interest expense is allocated under the rules of this section. In addition, qualified residence interest is not taken into account in determining the income or loss from any activity for purposes of section 469 or in determining the amount of investment interest for purposes of section 163(d). The following example illustrates the rule in this paragraph (m)(3):
(4) Interest described in section 163(h)(2)(E). Interest described in section 163(h)(2)(E) is allowable as a deduction without regard to the rules of this section.
(5) Interest on deemed distributee debt. [Reserved]
(6) Examples. The following examples illustrate the relationship between the passive loss and nonbusiness interest limitations and other limitations on the deductibility of interest expense:
(7) Other limitations on interest expense —(i) Capitalization provisions. A capitalization provision is any provision that requires or allows interest expense to be capitalized. Capitalization provisions include sections 263(g), 263A(f), and 266.
(ii) Disallowance provisions. A disallowance provision is any provision (other than the passive loss and nonbusiness interest limitations) that disallows a deduction for interest expense for all taxable years and is not a capitalization provision. Disallowance provisions include sections 163(f)(2), 264(a)(2), 264(a)(4), 265(a)(2), 265(b)(2), 279(a), 291(e)(1)(B)(ii), 805(b)(1), and 834(c)(5).
(iii) Deferral provisions. A deferral provision is any provision (other than the passive loss and nonbusiness interest limitations) that disallows a deduction for interest expense for any taxable year and is not a capitalization or disallowance provision. Deferral provisions include sections 267(a)(2), 465, 1277, and 1282.
(n) Effective date —(1) In general. This section applies to interest expense paid or accrued in taxable years beginning after December 31, 1986.
(2) Transitional rule for certain expenditures. For purposes of determining whether debt is allocated to expenditures made on or before August 3, 1987, paragraphs (c)(4)(iii)(B) and (c)(5)(i) of this section are applied by substituting “90 days” for “15 days.”
(3) Transitional rule for certain debt —(i) General rule. Except as provided in paragraph (n)(3)(ii) of this section, any debt outstanding on December 31, 1986, that is properly attributable to a business or rental activity is treated for purposes of this section as debt allocated to expenditures properly chargeable to capital account with respect to the assets held for use or for sale to customers in such business or rental activity. Debt is properly attributable to a business or rental activity for purposes of this section (regardless of whether such debt otherwise would be allocable under this section to expenditures in connection with such activity) if the taxpayer has properly and consistently deducted interest expense (including interest subject to limitation under section 163(d) as in effect prior to the Tax Reform Act of 1986) on such debt on Schedule C, E, or F of Form 1040 in computing income or loss from such business or rental activity for taxable years beginning before January 1, 1987. For purposes of this paragraph (n)(3), amended returns filed after July 2, 1987 are disregarded in determining whether a taxpayer has consistently deducted interest expense on Schedule C, E, or F of Form 1040 in computing income or loss from a business or rental activity.
(ii) Exceptions —(A) Debt financed distributions by passthrough entities. [Reserved]
(B) Election out. This paragraph (n)(3) does not apply with respect to debt of a taxpayer who elects under paragraph (n)(3) (viii) of this section to allocate debt outstanding on December 31, 1986, in accordance with the provisions of this section other than this paragraph (n)(3) ( i.e. , in accordance with the use of the debt proceeds).
(iii) Business or rental activity. For purposes of this paragraph (n)(3), a business or rental activity is any trade or business or rental activity of the taxpayer. For this purpose—
(A) A trade or business includes a business or profession the income and deductions of which (or, in the case of a partner or S corporation shareholder, the taxpayer's share thereof) are properly reported on Schedule C, E, or F of Form 1040; and
(B) A rental activity includes an activity of renting property the income and deductions of which (or, in the case of a partner or S corporation shareholder, the taxpayer's share thereof) are properly reported on Schedule E of Form 1040.
(iv) Example. The following example illustrates the circumstances in which debt is properly attributable to a business or rental activity:
(v) Allocation requirement —(A) In general. Debt outstanding on December 31, 1986, that is properly attributable (within the meaning of paragraph (n)(3)(i) of this section) to a business or rental activity must be allocated in a reasonable and consistent manner among the assets held for use or for sale to customers in such activity on the last day of the taxable year that includes December 31, 1986. The taxpayer shall specify the manner in which such debt is allocated by filing a statement in accordance with paragraph (n)(3)(vii) of this section. If the taxpayer does not file such a statement or fails to allocate such debt in a reasonable and consistent manner, the Commissioner shall allocate the debt.
(B) Reasonable and consistent manner—examples of improper allocation. For purposes of this paragraph (n)(3)(v), debt is not treated as allocated in a reasonable and consistent manner if—
( 1 ) The amount of debt allocated to goodwill exceeds the basis of the goodwill; or
( 2 ) The amount of debt allocated to an asset exceeds the fair market value of the asset, and the amount of debt allocated to any other asset is less than the fair market value (lesser of basis or fair market value in the case of goodwill) of such other asset.
(vi) Coordination with other provisions. The effect of any events occurring after the last day of the taxable year that includes December 31, 1986, shall be determined under the rules of this section, applied by treating the debt allocated to an asset under paragraph (n)(3)(v) of this section as if proceeds of such debt were used to make an expenditure properly chargeable to capital account with respect to such asset on the last day of the taxable year that includes December 31, 1986. Thus, debt that is allocated to an asset in accordance with this paragraph (n)(3) must be reallocated in accordance with paragraph (j) of this section upon the occurrence with respect to such asset of any event described in such paragraph (j). Similarly, such debt is treated as repaid in the order prescribed in paragraph (d) of this section. In addition, a replacement debt (within the meaning of paragraph (e) of this section) is allocated to an expenditure properly chargeable to capital account with respect to an asset to the extent the proceeds of such debt are used to repay the portion of a debt allocated to such asset under this paragraph (n)(3).
(vii) Form for allocation of debt. A taxpayer shall allocate debt for purposes of this paragraph (n)(3) by attaching to the taxpayer's return for the first taxable year beginning after December 31, 1986, a statement that is prominently identified as a transitional allocation statement under § 1.163-8T(n)(3) and includes the following information:
(A) A description of the business or rental activity to which the debt is properly attributable;
(B) The amount of debt allocated;
(C) The assets among which the debt is allocated;
(D) The manner in which the debt is allocated;
(E) The amount of debt allocated to each asset; and
(F) Such other information as the Commissioner may require.
(viii) Form for election out. A taxpayer shall elect to allocate debt outstanding on December 31, 1986, in accordance with the provisions of this section other than this paragraph (n)(3) by attaching to the taxpayer's return (or amended return) for the first taxable year beginning after December 31, 1986, a statement to that effect, prominently identified as as election out under § 1.163-8T(n)(3).
(ix) Special rule for partnerships and S corporations. For purposes of paragraph (n)(3)(ii)(B), (v), (vii) and (viii) of this section (relating to the allocation of debt and election out), a partnership or S corporation shall be treated as the taxpayer with respect to the debt of the partnership or S corporation.
(x) Irrevocability. An allocation or election filed in accordance with paragraph (n)(3) (vii) or (viii) of this section may not be revoked or modified except with the consent of the Commissioner.
§ 1.163-9T   Personal interest (temporary).
(a) In general. No deduction under any provision of Chapter 1 of the Internal Revenue Code shall be allowed for personal interest paid or accrued during the taxable year by a taxpayer other than a corporation.
(b) Personal interest —(1) Definition. For purposes of this section, personal interest is any interest expense other than—
(i) Interest paid or accrued on indebtedness properly allocable (within the meaning of § 1.163-8T) to the conduct of trade or business (other than the trade or business of performing services as an employee),
(ii) Any investment interest (within the meaning of section 163(d)(3)),
(iii) Any interest that is taken into account under section 469 in computing income or loss from a passive activity of the taxpayer,
(iv) Any qualified residence interest (within the meaning of section 163(h)(3) and § 1.163-10T), and
(v) Any interest payable under section 6601 with respect to the unpaid portion of the tax imposed by section 2001 for the period during which an extension of time for payment of such tax is in effect under section 6163, 6166, or 6166A (as in effect before its repeal by the Economic Recovery Tax Act of 1981).
(2) Interest relating to taxes —(i) In general. Except as provided in paragraph (b)(2)(iii) of this section, personal interest includes interest—
(A) Paid on underpayments of individual Federal, State or local income taxes and on indebtedness used to pay such taxes (within the meaning of § 1.163-8T), regardless of the source of the income generating the tax liability;
(B) Paid under section 453(e)(4)(B) (interest on deferred tax resulting from certain installment sales) and section 1291(c) (interest on deferred tax attributable to passive foreign investment companies); or
(C) Paid by a trust, S corporation, or other pass-through entity on underpayments of State or local income taxes and on indebtedness used to pay such taxes.
(ii) Example. A, an individual, owns stock of an S corporation. On its return for 1987, the corporation underreports its taxable income. Consequently, A underreports A's share of that income on A's tax return. In 1989, A pays the resulting deficiency plus interest to the Internal Revenue Service. The interest paid by A in 1989 on the tax deficiency is personal interest, notwithstanding the fact that the additional tax liability may have arisen out of income from a trade or business. The result would be the same if A's business had been operated as a sole proprietorship.
(iii) Certain other taxes. Personal interest does not include interest—
(A) Paid with respect to sales, excise and similar taxes that are incurred in connection with a trade or business or an investment activity;
(B) Paid by an S corporation with respect to an underpayment of income tax from a year in which the S corporation was a C corporation or with respect to an underpayment of the taxes imposed by sections 1374 or 1375, or similar provision of State law; or
(C) Paid by a transferee under section 6901 (tax liability resulting from transferred assets), or a similar provision of State law, with respect to a C corporation's underpayment of income tax.
(3) Cross references. See § 1.163-8T for rules for determining the allocation of interest expense to various activities. See § 1.163-10T for rules concerning qualified residence interest.
(c) Effective date —(1) In general. The provisions of this section are effective for taxable years beginning after December 31, 1986. In the case of any taxable year beginning in calendar years 1987 through 1990, the amount of personal interest that is nondeductible under this section is limited to the applicable percentage of such amount.
(2) Applicable percentages. The applicable percentage for taxable years beginning in 1987 through 1990 are as follows:
§ 1.163-10T   Qualified residence interest (temporary).
(a) Table of contents. This paragraph (a) lists the major paragraphs that appear in this § 1.163-10T.
(a) Table of contents.
(b) Treatment of qualified residence interest.
(c) Determination of qualified residence interest when secured debt does not exceed the adjusted purchase price.
(1) In general.
(2) Examples.
(d) Determination of qualified residence interest when secured debt exceeds adjusted purchase price—Simplified method.
(1) In general.
(2) Treatment of interest paid or accrued on secured debt that is not qualified residence interest.
(3) Example.
(e) Determination of qualified residence interest when secured debt exceeds adjusted purchase price—Exact method.
(1) In general.
(2) Determination of applicable debt limit.
(3) Example.
(4) Treatment of interest paid or accrued with respect to secured debt that is not qualified residence interest.
(i) In general.
(ii) Example.
(iii) Special rule of debt is allocated to more than one expenditure.
(iv) Example.
(f) Special rules.
(1) Special rules for personal property.
(i) In general.
(ii) Example.
(2) Special rule for real property.
(i) In general.
(ii) Example.
(g) Selection of method.
(h) Average balance.
(1) Average balance defined.
(2) Average balance reported by lender.
(3) Average balance computed on a daily basis.
(i) In general.
(ii) Example.
(4) Average balance computed using the interest rate.
(i) In general.
(ii) Points and prepaid interest.
(iii) Examples.
(5) Average balance computed using average of beginning and ending balance.
(i) In general.
(ii) Example.
(6) Highest principal balance.
(7) Other methods provided by the Commissioner.
(8) Anti-abuse rule.
(i) [Reserved]
(j) Determination of interest paid or accrued during the taxable year.
(1) In general.
(2) Special rules for cash-basis taxpayers.
(i) Points deductible in year paid under section 461(g)(2).
(ii) Points and other prepaid interest described in section 461(g)(1).
(3) Examples.
(k) Determination of adjusted purchase price and fair market value.
(1) Adjusted purchase price.
(i) In general.
(ii) Adjusted purchase price of a qualified residence acquired incident to divorce.
(iii) Examples.
(2) Fair market value.
(i) In general.
(ii) Examples.
(3) Allocation of adjusted purchase price and fair market value.
(l) [Reserved]
(m) Grandfathered amount.
(1) Substitution for adjusted purchase price.
(2) Determination of grandfathered amount.
(i) In general.
(ii) Special rule for lines of credit and certain other debt.
(iii) Fair market value limitation.
(iv) Examples.
(3) Refinancing of grandfathered debt.
(i) In general.
(ii) Determination of grandfathered amount.
(4) Limitation on terms of grandfathered debt.
(i) In general.
(ii) Special rule for nonamortizing debt.
(iii) Example.
(n) Qualified indebtedness (secured debt used for medical and educational purposes).
(1) In general.
(i) Treatment of qualified indebtedness.
(ii) Determination of amount of qualified indebtedness.
(iii) Determination of amount of qualified indebtedness for mixed-use debt.
(iv) Example.
(v) Prevention of double counting in year of refinancing.
(vi) Special rule for principal payments in excess of qualified expenses.
(2) Debt used to pay for qualified medical or educational expenses.
(i) In general.
(ii) Special rule for refinancing.
(iii) Other special rules.
(iv) Examples.
(3) Qualified medical expenses.
(4) Qualified educational expenses.
(o) Secured debt.
(1) In general.
(2) Special rule for debt in certain States.
(3) Time at which debt is treated as secured.
(4) Partially secured debt.
(i) In general.
(ii) Example.
(5) Election to treat debt as not secured by a qualified residence.
(i) In general.
(ii) Example.
(iii) Allocation of debt secured by two qualified residences.
(p) Definition of qualified residence.
(1) In general.
(2) Principal residence.
(3) Second residence.
(i) In general.
(ii) Definition of residence.
(iii) Use as a residence.
(iv) Election of second residence.
(4) Allocations between residence and other property.
(i) In general.
(ii) Special rule for rental of residence.
(iii) Examples.
(5) Residence under construction.
(i) In general.
(ii) Example.
(6) Special rule for the time-sharing arrangements.
(q) Special rules for tenant-stockholders in cooperative housing corporations.
(1) In general.
(2) Special rule where stock may not be used to secure debt.
(3) Treatment of interest expense of the cooperative described in section 216(a)(2).
(4) Special rule to prevent tax avoidance.
(5) Other definitions.
(r) Effective date.
(b) Treatment of qualified residence interest. Except as provided below, qualified residence interest is deductible under section 163(a). Qualified residence interest is not subject to limitation or otherwise taken into account under section 163(d) (limitation on investment interest), section 163(h)(1) (disallowance of deduction for personal interest), section 263A (capitalization and inclusion in inventory costs of certain expenses) or section 469 (limitations on losses from passive activities). Qualified residence interest is subject to the limitation imposed by section 263(g) (certain interest in the case of straddles), section 264(a) (2) and (4) (interest paid in connection with certain insurance), section 265(a)(2) (interest relating to tax-exempt income), section 266 (carrying charges), section 267(a)(2) (interest with respect to transactions between related taxpayers) section 465 (deductions limited to amount at risk), section 1277 (deferral of interest deduction allocable to accrued market discount), and section 1282 (deferral of interest deduction allocable to accrued discount).
(c) Determination of qualified residence interest when secured debt does not exceed adjusted purchase price —(1) In general. If the sum of the average balances for the taxable year of all secured debts on a qualified residence does not exceed the adjusted purchase price (determined as of the end of the taxable year) of the qualified residence, all of the interest paid or accrued during the taxable year with respect to the secured debts is qualified residence interest. If the sum of the average balances for the taxable year of all secured debts exceeds the adjusted purchase price of the qualified residences (determined as of the end of the taxable year), the taxpayer must use either the simplified method (see paragraph (d) of this section) or the exact method (see paragraph (e) of this section) to determine the amount of interest that is qualified residence interest.
(2) Examples.
(d) Determination of qualified residence interest when secured debt exceeds adjusted purchase price—Simplified method —(1) In general. Under the simplified method, the amount of qualified residence interest for the taxable year is equal to the total interest paid or accrued during the taxable year with respect to all secured debts multiplied by a fraction (not in excess of one), the numerator of which is the adjusted purchase price (determined as of the end of the taxable year) of the qualified residence and the denominator of which is the sum of the average balances of all secured debts.
(2) Treatment of interest paid or accrued on secured debt that is not qualified residence interest. Under the simplified method, the excess of the total interest paid or accrued during the taxable year with respect to all secured debts over the amount of qualified residence interest is personal interest.
(3) Example.
(e) Determination of qualified residence interest when secured debt exceeds adjusted purchase price—Exact method —(1) In general. Under the exact method, the amount of qualified residence interest for the taxable year is determined on a debt-by-debt basis by computing the applicable debt limit for each secured debt and comparing each such applicable debt limit to the average balance of the corresponding debt. If, for the taxable year, the average balance of a secured debt does not exceed the applicable debt limit for that debt, all of the interest paid or accrued during the taxable year with respect to the debt is qualified residence interest. If the average balance of the secured debt exceeds the applicable debt limit for that debt, the amount of qualified residence interest with respect to the debt is determined by multiplying the interest paid or accrued with respect to the debt by a fraction, the numerator of which is the applicable debt limit for that debt and the denominator of which is the average balance of the debt.
(2) Determination of applicable debt limit. For each secured debt, the applicable debt limit for the taxable year is equal to
(i) The lesser of—
(A) The fair market value of the qualified residence as of the date the debt is first secured, and
(B) The adjusted purchase price of the qualified residence as of the end of the taxable year,
(ii) Reduced by the average balance of each debt previously secured by the qualified residence.
(3) Example. (i) R's principal residence has an adjusted purchase price on December 31, 1988, of $105,000. R has two debts secured by the residence. The average balances and interest payments on each debt during 1988 and fair market value of the residence on the date each debt was secured are as follows:
(ii) The amount of qualified residence interest for 1988 under the exact method is determined as follows. Because there are no debts previously secured by the residence, the applicable debt limit for Debt 1 is $100,000 (the lesser of the adjusted purchase price as of the end of the taxable year and the fair market value of the residence at the time the debt was secured). Because the average balance of Debt 1 ($80,000) does not exceed its applicable debt limit ($100,000), all of the interest paid on the debt during 1988 ($8,000) is qualified residence interest.
(iii) The applicable debt limit for Debt 2 is $25,000 ($105,000 (the lesser of $140,000 fair market value and $105,000 adjusted purchase price) reduced by $80,000 (the average balance of Debt 1)). Because the average balance of Debt 2 ($40,000) exceeds its applicable debt limit, the amount of qualified residence interest on Debt 2 is determined by multiplying the amount of interest paid on the debt during the year ($4,800) by a fraction equal to its applicable debt limit divided by its average balance ($25,000/$40,000 = 0.625). Accordingly, $3,000 ($4,800 × 0.625) of the interest paid in 1988 on Debt 2 is qualified residence interest. The character of the remaining $1,800 of interest paid on Debt 2 is determined under the rules of paragraph (e)(4) of this section.
(4) Treatment of interest paid or accrued with respect to secured debt that is not qualified residence interest —(i) In general. Under the exact method, the excess of the interest paid or accrued during the taxable year with respect to a secured debt over the amount of qualified residence interest with respect to the debt is allocated under the rules of § 1.163-8T.
(ii) Example. T borrows $20,000 and the entire proceeds of the debt are disbursed by the lender to T's broker to purchase securities held for investment. T secures the debt with T's principal residence. In 1990, T pays $2,000 of interest on the debt. Assume that under the rules of paragraph (e) of this section, $1,500 of the interest is qualified residence interest. The remaining $500 in interest expense would be allocated under the rules of § 1.163-8T. Section 1.163-8T generally allocates debt (and the associated interest expense) by tracing disbursements of the debt proceeds to specific expenditures. Accordingly, the $500 interest expense on the debt that is not qualified residence interest is investment interest subject to section 163(d).
(iii) Special rule if debt is allocated to more than one expenditure. If—
(A) The average balance of a secured debt exceeds the applicable debt limit for that debt, and
(B) Under the rules of § 1.163-8T, interest paid or accrued with respect to such debt is allocated to more than one expenditure,
(iv) Example. ( i ) C borrows $60,000 secured by a qualified residence. C uses (within the meaning of § 1.163-8T) $20,000 of the proceeds in C's trade or business, $20,000 to purchase stock held for investment and $20,000 for personal purposes. In 1990, C pays $6,000 in interest on the debt and, under the rules of § 1.163-8T, $2,000 in interest is allocable to trade or business expenses, $2,000 to investment expenses and $2,000 to personal expenses. Assume that under paragraph (e) of this section, $2,500 of the interest is qualified residence interest and $3,500 of the interest is not qualified residence interest.
( ii ) Under paragraph (e)(4)(iii) of this section, C may allocate up to $2,000 of the interest that is not qualified residence interest to any of the three categories of expenditures up to a total of $3,500 for all three categories. Therefore, for example, C may allocate $2,000 of such interest to C's trade or business and $1,500 of such interest to the purchase of stock.
(f) Special rules —(1) Special rules for personal property —(i) In general. If a qualified residence is personal property under State law (e.g., a boat or motorized vehicle)—
(A) For purposes of paragraphs (c)(1) and (d)(1) of this section, if the fair market value of the residence as of the date that any secured debt (outstanding during the taxable year) is first secured by the residence is less than the adjusted purchase price as of the end of the taxable year, the lowest such fair market value shall be substituted for the adjusted purchase price.
(B) For purposes of paragraphs (e)(2)(i)(A) and (f)(1)(i)(A) of this section, the fair market value of the residence as of the date the debt is first secured by the residence shall not exceed the fair market value as of any date on which the taxpayer borrows any additional amount with respect to the debt.
(ii) Example. D owns a recreational vehicle that is a qualified residence under paragraph (p)(4) of this section. The adjusted purchase price and fair market value of the recreational vehicle is $20,000 in 1989. In 1989, D establishes a line of credit secured by the recreational vehicle. As of June 1, 1992, the fair market value of the vehicle has decreased to $10,000. On that day, D borrows an additional amount on the debt by using the line of credit. Although under paragraphs (e)(2)(i) and (f)(1)(i)(A) of this section, fair market value is determined at the time the debt is first secured, under paragraph (f)(1)(i)(B) of this section, the fair market value is the lesser of that amount or the fair market value on the most recent date that D borrows any additional amount with respect to the line of credit. Therefore, the fair market value with respect to the debt is $10,000.
(2) Special rule for real property —(i) In general. For purposes of paragraph (e)(2)(i)(A) of this section, the fair market value of a qualified residence that is real property under State law is presumed irrebuttably to be not less than the adjusted purchase price of the residence as of the last day of the taxable year.
(ii) Example. ( i ) C purchases a residence on August 11, 1987, for $50,000, incurring a first mortgage. The residence is real property under State law. During 1987, C makes $10,000 in home improvements. Accordingly, the adjusted purchase price of the residence as of December 31, 1988, is $60,000. C incurs a second mortgage on May 19, 1988, as of which time the fair market value of the residence is $55,000.
( ii ) For purposes of determining the applicable debt limit for each debt, the fair market value of the residence is generally determined as of the time the debt is first secured. Accordingly, the fair market value would be $50,000 and $55,000 with respect to the first and second mortgage, respectively. Under the special rule of paragraph (f)(2)(i) of this section, however, the fair market value with respect to both debts in 1988 is $60,000, the adjusted purchase price on December 31, 1988.
(g) Selection of method. For any taxable year, a taxpayer may use the simplified method (described in paragraph (d) of this section) or the exact method (described in paragraph (e) of this section) by completing the appropriate portion of Form 8598. A taxpayer with two qualified residences may use the simplified method for one residence and the exact method for the other residence.
(h) Average balance —(1) Average balance defined. For purposes of this section, the term “average balance” means the amount determined under this paragraph (h). A taxpayer is not required to use the same method to determine the average balance of all secured debts during a taxable year or of any particular secured debt from one year to the next.
(2) Average balance reported by lender. If a lender that is subject to section 6050H (returns relating to mortgage interest received in trade or business from individuals) reports the average balance of a secured debt on Form 1098, the taxpayer may use the average balance so reported.
(3) Average balance computed on a daily basis —(i) In general. The average balance may be determined by—
(A) Adding the outstanding balance of a debt on each day during the taxable year that the debt is secured by a qualified residence, and
(B) Dividing the sum by the number of days during the taxable year that the residence is a qualified residence.
(ii) Example. Taxpayer A incurs a debt of $10,000 on September 1, 1989, securing the debt with A's principal residence. The residence is A's principal residence during the entire taxable year. A pays current interest on the debt monthly, but makes no principal payments. The debt is, therefore, outstanding for 122 days with a balance each day of $10,000. The residence is a qualified residence for 365 days. The average balance of the debt for 1989 is $3,342 (122 × $10,000/365).
(4) Average balance computed using the interest rate —(i) In general. If all accrued interest on a secured debt is paid at least monthly, the average balance of the secured debt may be determined by dividing the interest paid or accrued during the taxable year while the debt is secured by a qualified residence by the annual interest rate on the debt. If the interest rate on a debt varies during the taxable year, the lowest annual interest rate that applies to the debt during the taxable year must be used for purposes of this paragraph (h)(4). If the residence securing the debt is a qualified residence for less than the entire taxable year, the average balance of any secured debt may be determined by dividing the average balance determined under the preceding sentence by the percentage of the taxable year that the debt is secured by a qualified residence.
(ii) Points and prepaid interest. For purposes of paragraph (h)(4)(i) of this section, the amount of interest paid during the taxable year does not include any amount paid as points and includes prepaid interest only in the year accrued.
(iii) Examples.
(5) Average balance computed using average of beginning and ending balances —(i) In general. If—
(A) A debt requires level payments at fixed equal intervals (e.g., monthly, quarterly) no less often than semi-annually during the taxable year,
(B) The taxpayer prepays no more than one month's principal on the debt during the taxable year, and
(C) No new amounts are borrowed on the debt during the taxable year,
(ii) Example. C borrows $10,000 in 1988, securing the debt with a second mortgage on a principal residence. The terms of the loan require C to make equal monthly payments of principal and interest so as to amortize the entire loan balance over 20 years. The balance of the debt is $9,652 on January 1, 1990, and is $9,450 on December 31, 1990. The average balance of the debt during 1990 may be computed as follows:
(6) Highest principal balance. The average balance of a debt may be determined by taking the highest principal balance of the debt during the taxable year.
(7) Other methods provided by the Commissioner. The average balance may be determined using any other method provided by the Commissioner by form, publication, revenue ruling, or revenue procedure. Such methods may include methods similar to (but with restrictions different from) those provided in paragraph (h) of this section.
(8) Anti-abuse rule. If, as a result of the determination of the average balance of a debt using any of the methods specified in paragraphs (h) (4), (5), or (6) of this section, there is a significant overstatement of the amount of qualified residence interest and a principal purpose of the pattern of payments and borrowing on the debt is to cause the amount of such qualified residence interest to be overstated, the district director may redetermine the average balance using the method specified under paragraph (h)(3) of this section.
(i) [Reserved]
(j) Determination of interest paid or accrued during the taxable year —(1) In general. For purposes of determining the amount of qualified residence interest with respect to a secured debt, the amount of interest paid or accrued during the taxable year includes only interest paid or accrued while the debt is secured by a qualified residence.
(2) Special rules for cash-basis taxpayers —(i) Points deductible in year paid under section 461(g)(2). If points described in section 461(g)(2) (certain points paid in respect of debt incurred in connection with the purchase or improvement of a principal residence) are paid with respect to a debt, the amount of such points is qualified residence interest.
(ii) Points and other prepaid interest described in section 461(g)(1). The amount of points or other prepaid interest charged to capital account under section 461(g)(1) (prepaid interest) that is qualified residence interest shall be determined under the rules of paragraphs (c) through (e) of this section in the same manner as any other interest paid with respect to the debt in the taxable year to which such payments are allocable under section 461(g)(1).
(3) Examples.
( ii ) W is entitled to treat the following amounts of the points as interest paid on a debt secured by a qualified residence—
(k) Determination of adjusted purchase price and fair market value —(1) Adjusted purchase price —(i) In general. For purposes of this section, the adjusted purchase price of a qualified residence is equal to the taxpayer's basis in the residence as initially determined under section 1012 or other applicable sections of the Internal Revenue Code, increased by the cost of any improvements to the residence that have been added to the taxpayer's basis in the residence under section 1016(a)(1). Any other adjustments to basis, including those required under section 1033(b) (involuntary conversions), and 1034(e) (rollover of gain or sale of principal residence) are disregarded in determining the taxpayer's adjusted purchase price. If, for example, a taxpayer's second residence is rented for a portion of the year and its basis is reduced by depreciation allowed in connection with the rental use of the property, the amount of the taxpayer's adjusted purchase price in the residence is not reduced. See paragraph (m) of this section for a rule that treats the sum of the grandfathered amounts of all secured debts as the adjusted purchase price of the residence.
(ii) Adjusted purchase price of a qualified residence acquired incident to divorce. [Reserved]
(iii) Examples.
(2) Fair market value —(i) In general. For purposes of this section, the fair market value of a qualified residence on any date is the fair market value of the taxpayer's interest in the residence on such date. In addition, the fair market value determined under this paragraph (k)(2)(i) shall be determined by taking into account the cost of improvements to the residence reasonably expected to be made with the proceeds of the debt.
(ii) Example. In 1988, the adjusted purchase price of P's second residence is $65,000 and the fair market value of the residence is $70,000. At that time, P incurs an additional debt of $10,000, the proceeds of which P reasonably expects to use to add two bedrooms to the residence. Because the fair market value is determined by taking into account the cost of improvements to the residence that are reasonably expected to be made with the proceeds of the debt, the fair market value of the residence with respect to the debt incurred in 1988 is $80,000 ($70,000 + $10,000).
(3) Allocation of adjusted purchase price and fair market value. If a property includes both a qualified residence and other property, the adjusted purchase price and the fair market value of such property must be allocated between the qualified residence and the other property. See paragraph (p)(4) of this section for rules governing such an allocation.
(l) [Reserved]
(m) Grandfathered amount —(1) Substitution for adjusted purchase price. If, for the taxable year, the sum of the grandfathered amounts, if any, of all secured debts exceeds the adjusted purchase price of the qualified residence, such sum may be treated as the adjusted purchase price of the residence under paragraphs (c), (d) and (e) of this section.
(2) Determination of grandfathered amount —(i) In general. For any taxable year, the grandfathered amount of any secured debt that was incurred on or before August 16, 1986, and was secured by the residence continuously from August 16, 1986, through the end of the taxable year, is the average balance of the debt for the taxable year. A secured debt that was not incurred and secured on or before August 16, 1986, has no grandfathered amount.
(ii) Special rule for lines of credit and certain other debt. If, with respect to a debt described in paragraph (m)(2)(i) of this section, a taxpayer has borrowed any additional amounts after August 16, 1986, the grandfathered amount of such debt is equal to the lesser of—
(A) The average balance of the debt for the taxable year, or
(B) The principal balance of the debt as of August 16, 1986, reduced (but not below zero) by all principal payments after August 16, 1986, and before the first day of the current taxable year.
(iii) Fair market value limitation. The grandfathered amount of any debt for any taxable year may not exceed the fair market value of the residence on August 16, 1986, reduced by the principal balance on that day of all previously secured debt.
(iv) Examples.
(ii) Because T has borrowed additional amounts on the line of credit after August 16, 1986, the grandfathered amount for that debt must be determined under the rules of paragraph (m)(2)(ii) of this section. Accordingly, the grandfathered amount for the line of credit is equal to the lesser of $45,000, the average balance of the debt in 1987, and $35,000, the principal balance on August 16, 1986, reduced by all principal payments between August 17, 1986, and December 31, 1986 ($40,000-$5,000). The sum of the grandfathered amounts with respect to the residence is $108,000 ($73,000 + $35,000). Because the sum of the grandfathered amounts exceeds the adjusted purchase price ($50,000), T may treat the sum as the adjusted purchase price in determining the qualified residence interest for 1987.
(3) Refinancing of grandfathered debt —(i) In general. A debt incurred and secured on or before August 16, 1986, is refinanced if some or all of the outstanding balance of such a debt (the “original debt”) is repaid out of the proceeds of a second debt secured by the same qualified residence (the “replacement debt”). In the case of a refinancing, the replacement debt is treated as a debt incurred and secured on or before August 16, 1986, and the grandfathered amount of such debt is the amount (but not less than zero) determined pursuant to paragraph (m)(3)(ii) of this section.
(ii) Determination of grandfathered amount —(A) Exact refinancing. If—
( 1 ) The entire proceeds of a replacement debt are used to refinance one or more original debts, and
( 2 ) The taxpayer has not borrowed any additional amounts after August 16, 1986, with respect to the original debt or debts,
(B) Refinancing other than exact refinancings —( 1 ) Year of refinancing. In the taxable year in which an original debt is refinanced, the grandfathered amount of the original and replacement debts is equal to the lesser of—
( i ) The sum of the average balances of the original debt and the replacement debt, and
( ii ) The principal balance of the original debt as of August 16, 1986, reduced by all principal payments on the original debt after August 16, 1986, and before the first day of the current taxable year.
( 2 ) In subsequent years. In any taxable year after the taxable year in which an original debt is refinanced, the grandfathered amount of the replacement debt is equal to the least of—
( i ) The average balance of the replacement debt for the taxable year,
( ii ) The amount of the replacement debt used to repay the principal balance of the original debt, reduced by all principal payments on the replacement debt after the date of the refinancing and before the first day of the current taxable year, or
( iii ) The principal balance of the original debt on August 16, 1986, reduced by all principal payments on the original debt after August 16, 1986, and before the date of the refinancing, and further reduced by all principal payments on the replacement debt after the date of the refinancing and before the first day of the current taxable year.
(C) Example. ( i ) Facts. On August 16, 1986, T has a single debt secured by a principal residence with a balance of $150,000. On July 1, 1988, T refinances the debt, which still has a principal balance of $150,000, with a new secured debt. The principal balance of the replacement debt throughout 1988 and 1989 is $150,000. The adjusted purchase price of the residence is $100,000 throughout 1987, 1988 and 1989. The average balance of the original debt was $150,000 in 1987 and $75,000 in 1988. The average balance of the replacement debt is $75,000 in 1988 and $150,000 in 1989.
( ii ) Grandfathered amount in 1987. The original debt was incurred and secured on or before August 16, 1986 and T has not borrowed any additional amounts with respect to the debt. Therefore, its grandfathered amount in 1987 is its average balance ($150,000). This amount is treated as the adjusted purchase price for 1987 and all of the interest paid on the debt is qualified residence interest.
( iii ) Grandfathered amount in 1988. Because the replacement debt was used to refinance a debt incurred and secured on or before August 16, 1986, the replacement debt is treated as a grandfathered debt. Because all of the proceeds of the replacement debt were used in the refinancing and because no amounts have been borrowed after August 16, 1986, on the original debt, the grandfathered amount for the original debt is its average balance ($75,000) and the grandfathered amount for the replacement debt is its average balance ($75,000). Since the sum of the grandfathered amounts ($150,000) exceeds the adjusted purchase price of the residence, the sum of the grandfathered amounts may be substituted for the adjusted purchase price for 1988 and all of the interest paid on the debt is qualified residence interest.
( iv ) Grandfathered amount in 1989. The grandfathered amount for the placement debt is its average balance ($150,000). This amount is treated as the adjusted purchase price for 1989 and all of the interest paid on the mortgage is qualified residence interest.
(4) Limitation on term of grandfathered debt —(i) In general. An original debt or replacement debt shall not have any grandfathered amount in any taxable year that begins after the date, as determined on August 16, 1986, that the original debt was required to be repaid in full (the “maturity date”). If a replacement debt is used to refinance more than one original debt, the maturity date is determined by reference to the original debt that, as of August 16, 1986, had the latest maturity date.
(ii) Special rule for nonamortizing debt. If an original debt was actually incurred and secured on or before August 16, 1986, and if as of such date the terms of such debt did not require the amortization of its principal over its original term, the maturity date of the replacement debt is the earlier of the maturity date of the replacement debt or the date 30 years after the date the original debt is first refinanced.
(iii) Example. C incurs a debt on May 10, 1986, the final payment of which is due May 1, 2006. C incurs a second debt on August 11, 1990, with a term of 20 years and uses the proceeds of the second debt to refinance the first debt. Because, under paragraph (m)(4)(i) of this section, a replacement debt will not have any grandfathered amount in any taxable year that begins after the maturity date of the original debt (May 1, 2006), the second debt has no grandfathered amount in any taxable year after 2006.
(n) Qualified indebtedness (secured debt used for medical and educational purposes) —(1) In general —(i) Treatment of qualified indebtedness. The amount of any qualified indebtedness resulting from a secured debt may be added to the adjusted purchase price under paragraph (e)(2)(i)(B) of this section to determine the applicable debt limit for that secured debt and any other debt subsequently secured by the qualified residence.
(ii) Determination of amount of qualified indebtedness. If, as of the end of the taxable year (or the last day in the taxable year that the debt is secured), at least 90 percent of the proceeds of a secured debt are used (within the meaning of paragraph (n)(2) of this section) to pay for qualified medical and educational expenses (within the meaning of paragraphs (n)(3) and (n)(4) of this section), the amount of qualified indebtedness resulting from that debt for the taxable year is equal to the average balance of such debt for the taxable year.
(iii) Determination of amount of qualified indebtedness for mixed-use debt. If, as of the end of the taxable year (or the last day in the taxable year that the debt is secured), more than ten percent of the proceeds of a secured debt are used to pay for expenses other than qualified medical and educational expenses, the amount of qualified indebtedness resulting from that debt for the taxable year shall equal the lesser of—
(A) The average balance of the debt, or
(B) The amount of the proceeds of the debt used to pay for qualified medical and educational expenses through the end of the taxable year, reduced by any principal payments on the debt before the first day of the current taxable year.
(iv) Example. ( i ) C incurs a $10,000 debt on April 20, 1987, which is secured on that date by C's principal residence. C immediately uses (within the meaning of paragraph (n)(2) of this section) $4,000 of the proceeds of the debt to pay for a qualified medical expense. C makes no principal payments on the debt during 1987. During 1988 and 1989, C makes principal payments of $1,000 per year. The average balance of the debt during 1988 is $9,500 and the average balance during 1989 is $8,500.
( ii ) Under paragraph (n)(1)(iii) of this section, C determines the amount of qualified indebtedness for 1988 as follows:
( iii ) C determines the amount of qualified indebtedness for 1989 as follows:
(v) Prevention of double counting in year of refinancing —(A) In general. A debt used to pay for qualified medical or educational expenses is refinanced if some or all of the outstanding balance of the debt (the “original debt”) is repaid out of the proceeds of a second debt (the “replacement debt”). If, in the year of a refinancing, the combined qualified indebtedness of the original debt and the replacement debt exceeds the combined qualified expenses of such debts, the amount of qualified indebtedness for each such debt shall be determined by multiplying the amount of qualified indebtedness for each such debt by a fraction, the numerator of which is the combined qualified expenses and the denominator of which is the combined qualified indebtedness.
(B) Definitions. For purposes of paragraph (n)(1)(v)(A) of this section—
( 1 ) The term “combined qualified indebtedness” means the sum of the qualified indebtedness (determined without regard to paragraph (n)(1)(v) of this section) for the original debt and the replacement debt.
( 2 ) The term “combined qualified expenses” means the amount of the proceeds of the original debt used to pay for qualified medical and educational expenses through the end of the current taxable year, reduced by any principal payments on the debt before the first day of the current taxable year, and increased by the amount, if any, of the proceeds of the replacement debt used to pay such expenses through the end of the current taxable year other than as part of the refinancing.
(C) Example. ( i ) On August 11, 1987, C incurs a $8,000 debt secured by a principal residence. C uses (within the meaning of paragraph (n)(2)(i) of this section) $5,000 of the proceeds of the debt to pay for qualified educational expenses. C makes no principal payments on the debt. On July 1, 1988, C incurs a new debt in the amount of $8,000 secured by C's principal residence and uses all of the proceeds of the new debt to repay the original debt. Under paragraph (n)(2)(ii) of this section $5,000 of the new debt is treated as being used to pay for qualified educational expenses. C makes no principal payments (other than the refinancing) during 1987 or 1988 on either debt and pays all accrued interest monthly. The average balance of each debt in 1988 is $4,000.
( ii ) Under paragraph (n)(1)(iii) of this section, the amount of qualified indebtedness for 1988 with respect to the original debt is $4,000 (the lesser of its average balance ($4,000) and the amount of the debt used to pay for qualified medical and educational expenses ($5,000)). Similarly, the amount of qualified indebtedness for 1988 with respect to the replacement debt is also $4,000. Both debts, however, are subject in 1988 to the limitation in paragraph (n)(1)(v)(A) of this section. The combined qualified indebtedness, determined without regard to the limitation, is $8,000 ($4,000 of qualified indebtedness from each debt). The combined qualified expenses are $5,000 ($5,000 from the original debt and $0 from the replacement debt). The amount of qualified indebtedness from each debt must, therefore, be reduced by a fraction, the numerator of which is $5,000 (the combined qualified expenses) and the denominator of which is $8,000 (the combined qualified indebtedness). After application of the limitation, the amount of qualified indebtedness for the original debt is $2,500 ($4,000 × × 5/8 ). Similarly, the amount of qualified indebtedness for the replacement debt is $2,500. Note that the total qualified indebtedness for both the original and the replacement debt is $5,000 ($2,500 + $2,500). Therefore, C is entitled to the same amount of qualified indebtedness as C would have been entitled to if C had not refinanced the debt.
(vi) Special rule for principal payments in excess of qualified expenses. For purposes of paragraph (n)(1)(iii)(B), (n)(1)(v)(B)( 2 ) and (n)(2)(ii) of this section, a principal payment is taken into account only to the extent that the payment, when added to all prior payments, does not exceed the amount used on or before the date of the payment to pay for qualified medical and educational expenses.
(2) Debt used to pay for qualified medical or educational expenses —(i) In general. For purposes of this section, the proceeds of a debt are used to pay for qualified medical or educational expenses to the extent that—
(A) The taxpayer pays qualified medical or educational expenses within 90 days before or after the date that amounts are actually borrowed with respect to the debt, the proceeds of the debt are not directly allocable to another expense under § 1.163-8T(c)(3) (allocation of debt; proceeds not disbursed to borrower) and the proceeds of any other debt are not allocable to the medical or educational expenses under § 1.163-8T(c)(3), or
(B) The proceeds of the debt are otherwise allocated to such expenditures under § 1.163-8T.
(ii) Special rule for refinancings. For purposes of this section, the proceeds of a debt are used to pay for qualified medical and educational expenses to the extent that the proceeds of the debt are allocated under § 1.163-8T to the repayment of another debt (the “original debt”), but only to the extent of the amount of the original debt used to pay for qualified medical and educational expenses, reduced by any principal payments on such debt up to the time of the refinancing.
(iii) Other special rules. The following special rules apply for purposes of this section.
(A) Proceeds of a debt are used to pay for qualified medical or educational expenses as of the later of the taxable year in which such proceeds are borrowed or the taxable year in which such expenses are paid.
(B) The amount of debt which may be treated as being used to pay for qualified medical or educational expenses may not exceed the amount of such expenses.
(C) Proceeds of a debt may not be treated as being used to pay for qualified medical or educational expenses to the extent that:
( 1 ) The proceeds have been repaid as of the time the expense is paid;
( 2 ) The proceeds are actually borrowed before August 17, 1986; or
( 3 ) The medical or educational expenses are paid before August 17, 1986.
(iv) Examples —
(3) Qualified medical expenses. Qualified medical expenses are amounts that are paid for medical care (within the meaning of section 213(d)(1) (A) and (B)) for the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer (within the meaning of section 152), and that are not compensated for by insurance or otherwise.
(4) Qualified educational expenses. Qualified educational expenses are amounts that are paid for tuition, fees, books, supplies and equipment required for enrollment, attendance or courses of instruction at an educational organization described in section 170(b) (1)(A)(ii) and for any reasonable living expenses while away from home while in attendance at such an institution, for the taxpayer, the taxpayer's spouse or a dependent of the taxpayer (within the meaning of section 152) and that are not reimbursed by scholarship or otherwise.
(o) Secured debt —(1) In general. For purposes of this section, the term “secured debt” means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract)—
(i) That makes the interest of the debtor in the qualified residence specific security for the payment of the debt,
(ii) Under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and
(iii) That is recorded, where permitted, or is otherwise perfected in accordance with applicable State law.
(2) Special rule for debt in certain States. Debt will not fail to be treated as secured solely because, under an applicable State or local homestead law or other debtor protection law in effect on August 16, 1986, the security interest is ineffective or the enforceability of the security interest is restricted.
(3) Times at which debt is treated as secured. For purposes of this section, a debt is treated as secured as of the date on which each of the requirements of paragraph (o)(1) of this section are satisfied, regardless of when amounts are actually borrowed with respect to the debt. For purposes of this paragraph (o)(3), if the instrument is recorded within a commercially reasonable time after the security interest is granted, the instrument will be treated as recorded on the date that the security interest was granted.
(4) Partially secured debt —(i) In general. If the security interest is limited to a prescribed maximum amount or portion of the residence, and the average balance of the debt exceeds such amount or the value of such portion, such excess shall not be treated as secured debt for purposes of this section.
(ii) Example. T borrows $80,000 on January 1, 1991. T secures the debt with a principal residence. The security in the residence for the debt, however, is limited to $20,000. T pays $8,000 in interest on the debt in 1991 and the average balance of the debt in that year is $80,000. Because the average balance of the debt exceeds the maximum amount of the security interest, such excess is not treated as secured debt. Therefore, for purposes of applying the limitation on qualified residence interest, the average balance of the secured debt is $20,000 (the maximum amount of the security interest) and the interest paid or accrued on the secured debt is $2,000 (the total interest paid on the debt multiplied by the ratio of the average balance of the secured debt ($20,000) and the average balance of the total debt ($80,000)).
(5) Election to treat debt as not secured by a qualified residence —(i) In general. For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.
(ii) Example. T owns a principal residence with a fair market value of $75,000 and an adjusted purchase price of $40,000. In 1988, debt A, the proceeds of which were used to purchase the residence, has an average balance of $15,000. The proceeds of debt B, which is secured by a second mortgage on the property, are allocable to T's trade or business under § 1.163-8T and has an average balance of $25,000. In 1988, T incurs debt C, which is also secured by T's principal residence and which has an average balance in 1988 of $5,000. In the absence of an election to treat debt B as unsecured, the applicable debt limit for debt C in 1988 under paragraph (e) of this section would be zero dollars ($40,000−$15,000−$25,000) and none of the interest paid on debt C would be qualified residence interest. If, however, T makes or has previously made an election pursuant to paragraph (o)(5)(i) of this section to treat debt B as not secured by the residence, the applicable debt limit for debt C would be $25,000 ($40,000−$15,000), and all of the interest paid on debt C during the taxable year would be qualified residence interest. Since the proceeds of debt B are allocable to T's trade or business under § 1.163-8T, interest on debt B may be deductible under other sections of the Internal Revenue Code.
(iii) Allocation of debt secured by two qualified residences. [Reserved]
(p) Definition of qualified residence —(1) In general. The term “qualified residence” means the taxpayer's principal residence (as defined in paragraph (p)(2) of this section), or the taxpayer's second residence (as defined in paragraph (p)(3) of this section).
(2) Principal residence. The term “principal residence” means the taxpayer's principal residence within the meaning of section 1034. For purposes of this section, a taxpayer cannot have more than one principal residence at any one time.
(3) Second residence —(i) In general. The term “second residence” means—
(A) A residence within the meaning of paragraph (p)(3)(ii) of this section,
(B) That the taxpayer uses as a residence within the meaning of paragraph (p)(3)(iii) of this section, and
(C) That the taxpayer elects to treat as a second residence pursuant to paragraph (p)(3)(iv) of this section.
(ii) Definition of residence. Whether property is a residence shall be determined based on all the facts and circumstances, including the good faith of the taxpayer. A residence generally includes a house, condominium, mobile home, boat, or house trailer, that contains sleeping space and toilet and cooking facilities. A residence does not include personal property, such as furniture or a television, that, in accordance with the applicable local law, is not a fixture.
(iii) Use as a residence. If a residence is rented at any time during the taxable year, it is considered to be used as a residence only if the taxpayer uses it during the taxable year as a residence within the meaning of section 280A(d). If a residence is not rented at any time during the taxable year, it shall be considered to be used as a residence. For purposes of the preceding sentence, a residence will be deemed to be rented during any period that the taxpayer holds the residence out for rental or resale or repairs or renovates the residence with the intention of holding it out for rental or resale.
(iv) Election of second residence. A taxpayer may elect a different residence (other than the taxpayer's principal residence) to be the taxpayer's second residence for each taxable year. A taxpayer may not elect different residences as second residences at different times of the same taxable year except as provided below—
(A) If the taxpayer acquires a new residence during the taxable year, the taxpayer may elect the new residence as a taxpayer's second residence as of the date acquired;
(B) If property that was the taxpayer's principal residence during the taxable year ceases to qualify as the taxpayer's principal residence, the taxpayer may elect that property as the taxpayer's second residence as of the date that the property ceases to be the taxpayer's principal residence; or
(C) If property that was the taxpayer's second residence is sold during the taxable year or becomes the taxpayer's principal residence, the taxpayer may elect a new second residence as of such day.
(4) Allocations between residence and other property —(i) In general. For purposes of this section, the adjusted purchase price and fair market value of property must be allocated between the portion of the property that is a qualified residence and the portion that is not a qualified residence. Neither the average balance of the secured debt nor the interest paid or accrued on secured debt is so allocated. Property that is not used for residential purposes does not qualify as a residence. For example, if a portion of the property is used as an office in the taxpayer's trade or business, that portion of the property does not qualify as a residence.
(ii) Special rule for rental of residence. If a taxpayer rents a portion of his or her principal or second residence to another person (a “tenant”), such portion may be treated as used by the taxpayer for residential purposes if, but only if—
(A) Such rented portion is used by the tenant primarily for residential purposes,
(B) The rented portion is not a self-contained residential unit containing separate sleeping space and toilet and cooking facilities, and
(C) The total number of tenants renting (directly or by sublease) the same or different portions of the residence at any time during the taxable year does not exceed two. For this purpose, if two persons (and the dependents, as defined by section 152, of either of them) share the same sleeping quarters, they shall be treated as a single tenant.
(iii) Examples.
(5) Residence under construction —(i) In general. A taxpayer may treat a residence under construction as a qualified residence for a period of up to 24 months, but only if the residence becomes a qualified residence, without regard to this paragraph (p)(5)(i), as of the time that the residence is ready for occupancy.
(ii) Example. X owns a residential lot suitable for the construction of a vacation home. On April 20, 1987, X obtains a mortgage secured by the lot and any property to be constructed on the lot. On August 9, 1987, X begins construction of a residence on the lot. The residence is ready for occupancy on November 9, 1989. The residence is used as a residence within the meaning of paragraph (p)(3)(iii) of this section during 1989 and X elects to treat the residence as his second residence for the period November 9, 1989, through December 31, 1989. Since the residence under construction is a qualified residence as of the first day that the residence is ready for occupancy (November 9, 1987), X may treat the residence as his second residence under paragraph (p)(5)(i) of this section for up to 24 months of the period during which the residence is under construction, commencing on or after the date that construction is begun (August 9, 1987). If X treats the residence under construction as X's second residence beginning on August 9, 1987, the residence under construction would cease to qualify as a qualified residence under paragraph (p)(5)(i) on August 8, 1989. The residence's status as a qualified residence for future periods would be determined without regard to paragraph (p)(5)(i) of this section.
(6) Special rule for time-sharing arrangements. Property that is otherwise a qualified residence will not fail to qualify as such solely because the taxpayer's interest in or right to use the property is restricted by an arrangement whereby two or more persons with interests in the property agree to exercise control over the property for different periods during the taxable year. For purposes of determining the use of a residence under paragraph (p)(3)(iii) of this section, a taxpayer will not be considered to have used or rented a residence during any period that the taxpayer does not have the right to use the property or to receive any benefits from the rental of the property.
(q) Special rules for tenant-stockholders in cooperative housing corporations —(1) In general. For purposes of this section, a residence includes stock in a cooperative housing corporation owned by a tenant-stockholder if the house or apartment which the tenant-stockholder is entitled to occupy by virtue of owning such stock is a residence within the meaning of paragraph (p)(3)(ii) of this section.
(2) Special rule where stock may not be used to secure debt. For purposes of this section, if stock described in paragraph (q)(1) of this section may not be used to secure debt because of restrictions under local or State law or because of restrictions in the cooperative agreement (other than restrictions the principal purpose of which is to permit the tenant-stockholder to treat unsecured debt as secured debt under this paragraph (q)(2)), debt may be treated as secured by such stock to the extent that the proceeds of the debt are allocated to the purchase of the stock under the rules of § 1.163-8T. For purposes of this paragraph (q)(2), proceeds of debt incurred prior to January 1, 1987, may be treated as allocated to the purchase of such stock to the extent that the tenant-stockholder has properly and consistently deducted interest expense on such debt as home mortgage interest attributable to such stock on Schedule A of Form 1040 in determining his taxable income for taxable years beginning before January 1, 1987. For purposes of this paragraph (q)(2), amended returns filed after December 22, 1987, are disregarded.
(3) Treatment of interest expense of the cooperative described in section 216(a)(2). For purposes of section 163(h) and § 1.163-9T (disallowance of deduction for personal interest) and section 163(d) (limitation on investment interest), any amount allowable as a deduction to a tenant-stockholder under section 216(a)(2) shall be treated as interest paid or accrued by the tenant-stockholder. If a tenant-stockholder's stock in a cooperative housing corporation is a qualified residence of the tenant-shareholder, any amount allowable as a deduction to the tenant-stockholder under section 216(a)(2) is qualified residence interest.
(4) Special rule to prevent tax avoidance. If the amount treated as qualified residence interest under this section exceeds the amount which would be so treated if the tenant-stockholder were treated as directly owning his proportionate share of the assets and liabilities of the cooperative and one of the principal purposes of the cooperative arrangement is to permit the tenant-stockholder to increase the amount of qualified residence interest, the district director may determine that such excess is not qualified residence interest.
(5) Other definitions. For purposes of this section, the terms “tenant-stockholder,” “cooperative housing corporation” and “proportionate share” shall have the meaning given by section 216 and the regulations thereunder.
(r) Effective date. The provisions of this section are effective for taxable years beginning after December 31, 1986.
§ 1.163-11   Allocation of certain prepaid qualified mortgage insurance premiums.
(a) Allocation —(1) In general. As provided in section 163(h)(3)(E), premiums paid or accrued for qualified mortgage insurance during the taxable year in connection with acquisition indebtedness with respect to a qualified residence (as defined in section 163(h)(4)(A)) of the taxpayer shall be treated as qualified residence interest (as defined in section 163(h)(3)(A)). If an individual taxpayer pays such a premium that is properly allocable to a mortgage the payment of which extends to periods beyond the close of the taxable year in which the premium is paid, the taxpayer must allocate the premium to determine the amount treated as qualified residence interest for each taxable year. The premium must be allocated ratably over the shorter of—
(i) The stated term of the mortgage; or
(ii) A period of 84 months, beginning with the month in which the insurance was obtained.
(2) Limitation. If a mortgage is satisfied before the end of its stated term, no deduction as qualified residence interest shall be allowed for any amount of the premium that is allocable to periods after the mortgage is satisfied.
(b) Scope. The allocation requirement in paragraph (a) of this section applies only to mortgage insurance provided by the Federal Housing Administration or private mortgage insurance (as defined by section 2 of the Homeowners Protection Act of 1998 (12 U.S.C. 4901) as in effect on December 20, 2006). It does not apply to mortgage insurance provided by the Department of Veterans Affairs or the Rural Housing Service. Paragraph (a) of this section applies whether the qualified mortgage insurance premiums are paid in cash or are financed, without regard to source.
(c) Limitation on the treatment of mortgage insurance premiums as interest. This section applies to prepaid qualified mortgage insurance premiums described in paragraph (a) of this section that are paid or accrued on or after January 1, 2011, and during periods to which section 163(h)(3)(E) is applicable. This section does not apply to any amount of prepaid qualified mortgage insurance premiums that are allocable to any periods to which section 163(h)(3)(E) is not applicable.
(d) Effective/applicability date. This section is applicable on and after January 1, 2011. For regulations applicable before January 1, 2011, see § 1.163-11T in effect prior to January 1, 2011 (§ 1.163-11T as contained in 26 CFR part 1 edition revised as of April 1, 2011).
§ 1.163-12   Deduction of original issue discount on instrument held by related foreign person.
(a) General rules —(1) Deferral of deduction. Except as provided in paragraph (b) of this section, section 163(e)(3) requires a taxpayer to use the cash method of accounting with respect to the deduction of original issue discount owed to a related foreign person. A deduction for an otherwise deductible portion of original issue discount with respect to a debt instrument will not be allowable as a deduction to the issuer until paid if, at the close of the issuer's taxable year in which such amount would otherwise be deductible, the person holding the debt instrument is a related foreign person. For purposes of this section, a related foreign person is any person that is not a United States person within the meaning of section 7701(a)(30), and that is related (within the meaning of section 267(b)) to the issuer at the close of the taxable year in which the amount incurred by the taxpayer would otherwise be deductible. Section 267(f) defines “controlled group” for purposes of section 267(b) without regard to the limitations of section 1563(b). An amount is treated as paid for purposes of this section if the amount is considered paid for purposes of section 1441 or section 1442 (including an amount taken into account pursuant to section 871(a)(1)(C), section 881(a)(3), or section 884(f)). The rules of this paragraph (a) apply even if the original issue discount is not subject to United States tax, or is subject to a reduced rate of tax, pursuant to a provision of the Internal Revenue Code or a treaty obligation of the United States. For purposes of this section, original issue discount is an amount described in section 1273, whether from sources inside or outside the United States.
(2) Change in method of accounting. A taxpayer that uses a method of accounting other than that required by the rules of this section must change its method of accounting to conform its method to the rules of this section. The taxpayer's change in method must be made pursuant to the rules of section 446(e), the regulations thereunder, and any applicable administrative procedures prescribed by the Commissioner. Because the rules of this section prescribe a method of accounting, these rules apply in the determination of a taxpayer's earnings and profits pursuant to § 1.312-6(a).
(b) Exceptions and special rules —(1) Effectively connected income. The provisions of section 267(a)(2) and the regulations thereunder, and not the provisions of paragraph (a) of this section, apply to an amount of original issue discount that is income of the related foreign person that is effectively connected with the conduct of a United States trade or business of such related foreign person. An amount described in this paragraph (b)(1) thus is allowable as a deduction as of the day on which the amount is includible in the gross income of the related foreign person as effectively connected income under sections 872(a)(2) or 882(b) (or, if later, as of the day on which the deduction would be so allowable but for section 267(a)(2)). However, this paragraph (b)(1) does not apply if the related foreign person is exempt from United States income tax on the amount owed, or is subject to a reduced rate of tax, pursuant to a treaty obligation of the United States (such as under an article relating to the taxation of business profits).
(2) Certain obligations issued by natural persons. This section does not apply to any debt instrument described in section 163(e)(4) (relating to obligations issued by natural persons before March 2, 1984, and to loans between natural persons).
(3) Amounts owed to a foreign personal holding company, controlled foreign corporation, or passive foreign investment company —(i) Foreign personal holding companies. If an amount to which paragraph (a) of this section otherwise applies is owed to a related foreign person that is a foreign personal holding company within the meaning of section 552, then the amount is allowable as a deduction as of the day on which the amount is includible in the income of the foreign personal holding company. The day on which the amount is includible in income is determined with reference to the method of accounting under which the foreign personal holding company computes its taxable income and earnings and profits for purposes of sections 551 through 558. See section 551(c) and the regulations thereunder for the reporting requirements of the foreign personal holding company provisions (sections 551 through 558).
(ii) Controlled foreign corporations. If an amount to which paragraph (a) of this section otherwise applies is owed to a related foreign person that is a controlled foreign corporation within the meaning of section 957, then the amount is allowable as a deduction as of the day on which the amount is includible in the income of the controlled foreign corporation. The day on which the amount is includible in income is determined with reference to the method of accounting under which the controlled foreign corporation computes its taxable income and earnings and profits for purposes of sections 951 through 964. See section 6038 and the regulations thereunder for the reporting requirements of the controlled foreign corporation provisions (sections 951 through 964).
(iii) Passive foreign investment companies. If an amount to which paragraph (a) of this section otherwise applies is owed to a related foreign person that is a passive foreign investment company within the meaning of section 1296, then the amount is allowable as a deduction as of the day on which amount is includible in the income of the passive foreign investment company. The day on which the amount is includible in income is determined with reference to the method of accounting under which the earnings and profits of the passive foreign investment company are computed for purposes of sections 1291 through 1297. See sections 1291 through 1297 and the regulations thereunder for the reporting requirements of the passive foreign investment company provisions. This exception shall apply, however, only if the person that owes the amount at issue has made and has in effect an election pursuant to section 1295 with respect to the passive foreign investment company to which the amount at issue is owed.
(c) Application of section 267. Except as limited in paragraph (b)(1) of this section, the provisions of section 267 and the regulations thereunder shall apply to any amount of original issue discount to which the provisions of this section do not apply.
(d) Effective date. The rules of this section are effective with respect to all original issue discount on debt instruments issued after June 9, 1984.
§ 1.163-13   Treatment of bond issuance premium.
(a) General rule. If a debt instrument is issued with bond issuance premium, this section limits the amount of the issuer's interest deduction otherwise allowable under section 163(a). In general, the issuer determines its interest deduction by offsetting the interest allocable to an accrual period with the bond issuance premium allocable to that period. Bond issuance premium is allocable to an accrual period based on a constant yield. The use of a constant yield to amortize bond issuance premium is intended to generally conform the treatment of debt instruments having bond issuance premium with those having original issue discount. Unless otherwise provided, the terms used in this section have the same meaning as those terms in section 163(e), sections 1271 through 1275, and the corresponding regulations. Moreover, unless otherwise provided, the provisions of this section apply in a manner consistent with those of section 163(e), sections 1271 through 1275, and the corresponding regulations. In addition, the anti-abuse rule in § 1.1275-2(g) applies for purposes of this section. For rules dealing with the treatment of bond premium by a holder, see §§ 1.171-1 through 1.171-5.
(b) Exceptions. This section does not apply to—
(1) A debt instrument described in section 1272(a)(6)(C) (regular interests in a REMIC, qualified mortgages held by a REMIC, and certain other debt instruments, or pools of debt instruments, with payments subject to acceleration); or
(2) A debt instrument to which § 1.1275-4 applies (relating to certain debt instruments that provide for contingent payments).
(c) Bond issuance premium. Bond issuance premium is the excess, if any, of the issue price of a debt instrument over its stated redemption price at maturity. For purposes of this section, the issue price of a convertible bond (as defined in § 1.171-1(e)(1)(iii)(C)) does not include an amount equal to the value of the conversion option (as determined under § 1.171-1(e)(1)(iii)(A)).
(d) Offsetting qualified stated interest with bond issuance premium —(1) In general. An issuer amortizes bond issuance premium by offsetting the qualified stated interest allocable to an accrual period with the bond issuance premium allocable to the accrual period. This offset occurs when the issuer takes the qualified stated interest into account under its regular method of accounting.
(2) Qualified stated interest allocable to an accrual period. See § 1.446-2(b) to determine the accrual period to which qualified stated interest is allocable and to determine the accrual of qualified stated interest within an accrual period.
(3) Bond issuance premium allocable to an accrual period. The bond issuance premium allocable to an accrual period is determined under this paragraph (d)(3). Within an accrual period, the bond issuance premium allocable to the period accrues ratably.
(i) Step one: Determine the debt instrument's yield to maturity. The yield to maturity of a debt instrument is determined under the rules of § 1.1272-1(b)(1)(i).
(ii) Step two: Determine the accrual periods. The accrual periods are determined under the rules of § 1.1272-1(b)(1)(ii).
(iii) Step three: Determine the bond issuance premium allocable to the accrual period. The bond issuance premium allocable to an accrual period is the excess of the qualified stated interest allocable to the accrual period over the product of the adjusted issue price at the beginning of the accrual period and the yield. In performing this calculation, the yield must be stated appropriately taking into account the length of the particular accrual period. Principles similar to those in § 1.1272-1(b)(4) apply in determining the bond issuance premium allocable to an accrual period.
(4) Bond issuance premium in excess of qualified stated interest —(i) Ordinary income. If the bond issuance premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is treated as ordinary income by the issuer for the accrual period. However, the amount treated as ordinary income is limited to the amount by which the issuer's total interest deductions on the debt instrument in prior accrual periods exceed the total amount treated by the issuer as ordinary income on the debt instrument in prior accrual periods.
(ii) Carryforward. If the bond issuance premium allocable to an accrual period exceeds the sum of the qualified stated interest allocable to the accrual period and the amount treated as ordinary income for the accrual period under paragraph (d)(4)(i) of this section, the excess is carried forward to the next accrual period and is treated as bond issuance premium allocable to that period. If a carryforward exists on the date the debt instrument is retired, the carryforward is treated as ordinary income on that date.
(e) Special rules —(1) Variable rate debt instruments. An issuer determines bond issuance premium on a variable rate debt instrument by reference to the stated redemption price at maturity of the equivalent fixed rate debt instrument constructed for the variable rate debt instrument. The issuer also allocates any bond issuance premium among the accrual periods by reference to the equivalent fixed rate debt instrument. The issuer constructs the equivalent fixed rate debt instrument, as of the issue date, by using the principles of § 1.1275-5(e).
(2) Inflation-indexed debt instruments. An issuer determines bond issuance premium on an inflation-indexed debt instrument by assuming that there will be no inflation or deflation over the term of the instrument. The issuer also allocates any bond issuance premium among the accrual periods by assuming that there will be no inflation or deflation over the term of the instrument. The bond issuance premium allocable to an accrual period offsets qualified stated interest allocable to the period. Notwithstanding paragraph (d)(4) of this section, if the bond issuance premium allocable to an accrual period exceeds the qualified stated interest allocable to the period, the excess is treated as a deflation adjustment under § 1.1275-7(f)(1)(ii). See § 1.1275-7 for other rules relating to inflation-indexed debt instruments.
(3) Certain debt instruments subject to contingencies —(i) In general. Except as provided in paragraph (e)(3)(ii) of this section, the rules of § 1.1272-1(c) apply to determine a debt instrument's payment schedule for purposes of this section. For example, an issuer uses the payment schedule determined under § 1.1272-1(c) to determine the amount, if any, of bond issuance premium on the debt instrument, the yield and maturity of the debt instrument, and the allocation of bond issuance premium to an accrual period.
(ii) Mandatory sinking fund provision. Notwithstanding paragraph (e)(3)(i) of this section, if a debt instrument is subject to a mandatory sinking fund provision described in § 1.1272-1(c)(3), the issuer must determine the payment schedule by assuming that a pro rata portion of the debt instrument will be called under the sinking fund provision.
(4) Remote and incidental contingencies. For purposes of determining the amount of bond issuance premium and allocating bond issuance premium among accrual periods, if a bond provides for a contingency that is remote or incidental (within the meaning of § 1.1275-2(h)), the issuer takes the contingency into account under the rules for remote and incidental contingencies in § 1.1275-2(h).
(f) Example. The following example illustrates the rules of this section:
(ii) Amount of bond issuance premium. The issue price of the debt instrument is $110,000. Because the interest payments on the debt instrument are qualified stated interest, the stated redemption price at maturity of the debt instrument is $100,000. Therefore, the amount of bond issuance premium is $10,000 ($110,000−$100,000).
(iii) Bond issuance premium allocable to the first accrual period. Based on the payment schedule and the issue price of the debt instrument, the yield of the debt instrument is 8.07 percent, compounded annually. (Although, for purposes of simplicity, the yield as stated is rounded to two decimal places, the computations do not reflect this rounding convention.) The bond issuance premium allocable to the accrual period ending on February 1, 2000, is the excess of the qualified stated interest allocable to the period ($10,000) over the product of the adjusted issue price at the beginning of the period ($110,000) and the yield (8.07 percent, compounded annually). Therefore, the bond issuance premium allocable to the accrual period is $1,118.17 ($10,000−$8,881.83).
(iv) Premium used to offset interest. Although X makes an interest payment of $10,000 on February 1, 2000, X only deducts interest of $8,881.83, the qualified stated interest allocable to the period ($10,000) offset with the bond issuance premium allocable to the period ($1,118.17).
(g) Effective date. This section applies to debt instruments issued on or after March 2, 1998.
(h) Accounting method changes —(1) Consent to change. An issuer required to change its method of accounting for bond issuance premium to comply with this section must secure the consent of the Commissioner in accordance with the requirements of § 1.446-1(e). Paragraph (h)(2) of this section provides the Commissioner's automatic consent for certain changes.
(2) Automatic consent. The Commissioner grants consent for an issuer to change its method of accounting for bond issuance premium on debt instruments issued on or after March 2, 1998. Because this change is made on a cut-off basis, no items of income or deduction are omitted or duplicated and, therefore, no adjustment under section 481 is allowed. The consent granted by this paragraph (h)(2) applies provided—
(i) The change is made to comply with this section;
(ii) The change is made for the first taxable year for which the issuer must account for a debt instrument under this section; and
(iii) The issuer attaches to its federal income tax return for the taxable year containing the change a statement that it has changed its method of accounting under this section.
§ 1.163-15   Debt proceeds distributed from any taxpayer account or from cash.
(a) In general. Regardless of paragraphs (c)(4) and (5) of § 1.163-8T, in the case of debt proceeds deposited in an account, a taxpayer that is applying § 1.163-8T or § 1.163-14 may treat any expenditure made from any account of the taxpayer, or from cash, within 30 days before or 30 days after debt proceeds are deposited in any account of the taxpayer as made from such proceeds to the extent thereof. Similarly, in the case of debt proceeds received in cash, a taxpayer that is applying § 1.163-8T or § 1.163-14 may treat any expenditure made from any account of the taxpayer, or from cash, within 30 days before or 30 days after debt proceeds are received in cash as made from such proceeds to the extent thereof. For purposes of this section, terms used have the same meaning as in § 1.163-8T(c)(4) and (5).
(b) Applicability date. This section applies to taxable years beginning on or after March 22, 2021. However, taxpayers and their related parties, within the meaning of sections 267(b) (determined without regard to section 267(c)(3)) and 707(b)(1), may choose to apply the rules in this section to a taxable year beginning after December 31, 2017, and before March 22, 2021, provided that those taxpayers and their related parties consistently apply all of the rules in this section to that taxable year and each subsequent taxable year.
§ 1.163(d)-1   Time and manner for making elections under the Omnibus Budget Reconciliation Act of 1993 and the Jobs and Growth Tax Relief Reconciliation Act of 2003.
(a) Description. Section 163(d)(4)(B)(iii), as added by section 13206(d) of the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66, 107 Stat. 467), allows an electing taxpayer to take all or a portion of certain net capital gain attributable to dispositions of property held for investment into account as investment income. Section 163(d)(4)(B), as amended by section 302(b) of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (Pub. L. 108-27, 117 Stat. 762), allows an electing taxpayer to take all or a portion of qualified dividend income, as defined in section 1(h)(11)(B), into account as investment income. As a consequence, the net capital gain and qualified dividend income taken into account as investment income under these elections are not eligible to be taxed at the capital gains rates. An election may be made for net capital gain recognized by noncorporate taxpayers during any taxable year beginning after December 31, 1992. An election may be made for qualified dividend income received by noncorporate taxpayers during any taxable year beginning after December 31, 2002, but before January 1, 2009.
(b) Time and manner for making the elections. The elections for net capital gain and qualified dividend income must be made on or before the due date (including extensions) of the income tax return for the taxable year in which the net capital gain is recognized or the qualified dividend income is received. The elections are to be made on Form 4952, “Investment Interest Expense Deduction,” in accordance with the form and its instructions.
(c) Revocability of elections. The elections described in this section are revocable with the consent of the Commissioner.
(d) Effective date. The rules set forth in this section regarding the net capital gain election apply beginning December 12, 1996. The rules set forth in this section regarding the qualified dividend income election apply to any taxable year beginning after December 31, 2002, but before January 1, 2009.
§ 1.163(j)-0   Table of contents.
This section lists the table of contents for §§ 1.163(j)-1 through 1.163(j)-11.
§ 1.163(j)-1 Definitions.
(a) In general.
(b) Definitions.
(1) Adjusted taxable income.
(i) Additions.
(ii) Subtractions.
(iii) Depreciation, amortization, or depletion capitalized under section 263A.
(iv) Application of § 1.163(j)-1(b)(1)(ii)(C), (D), and (E).
(A) Sale or other disposition.
( 1 ) In general.
( 2 ) Intercompany transactions.
( 3 ) Deconsolidations.
( 4 ) Nonrecognition transactions.
(B) Deductions by members of a consolidated group.
( 1 ) In general.
( 2 ) Application of the alternative computation method.
(C) Successor rules.
( 1 ) Successor assets.
( 2 ) Successor entities.
(D) Anti-duplication rule.
( 1 ) In general.
( 2 ) Adjustments following deconsolidation.
(E) Alternative computation method.
( 1 ) Alternative computation method for property dispositions.
( 2 ) Alternative computation method for dispositions of member stock.
( 3 ) Alternative computation method for dispositions of partnership interests.
(F) Cap on negative adjustments.
( 1 ) In general.
( 2 ) Example.
(G) Treatment of depreciation, amortization, or depletion capitalized under section 263A.
(v) Other adjustments.
(vi) Additional rules relating to adjusted taxable income in other sections.
(vii) ATI cannot be less than zero.
(viii) Examples.
(2) Applicable CFC.
(3) Business interest expense.
(i) In general.
(ii) Special rules.
(4) Business interest income.
(i) In general.
(ii) Special rules.
(5) C corporation.
(6) Cleared swap.
(7) Consolidated group.
(8) Consolidated return year.
(9) Current-year business interest expense.
(10) Disallowed business interest expense.
(11) Disallowed business interest expense carryforward.
(12) Disallowed disqualified interest.
(13) Electing farming business.
(14) Electing real property trade or business.
(15) Excepted regulated utility trade or business.
(i) In general.
(A) Automatically excepted regulated utility trades or businesses.
(B) Electing regulated utility trades or businesses.
(C) Designated excepted regulated utility trades or businesses.
(ii) Depreciation and excepted and non-excepted utility trades or businesses.
(A) Depreciation.
(B) Allocation of items.
(iii) Election to be an excepted regulated utility trade or business.
(A) In general.
(B) Scope and effect of election.
( 1 ) In general.
( 2 ) Irrevocability.
(C) Time and manner of making election.
( 1 ) In general.
( 2 ) Election statement contents.
( 3 ) Consolidated group's or partnership's trade or business.
( 4 ) Termination of election.
( 5 ) Additional guidance.
(16) Excess business interest expense.
(17) Excess taxable income.
(18) Floor plan financing indebtedness.
(19) Floor plan financing interest expense.
(20) Group.
(21) Intercompany transaction.
(22) Interest.
(i) In general.
(ii) Swaps with significant nonperiodic payments.
(A) In general.
(B) Exception for cleared swaps.
(C) Exception for non-cleared swaps subject to margin or collateral requirements.
(iii) Other amounts treated as interest.
(A) Treatment of premium.
( 1 ) Issuer.
( 2 ) Holder.
(B) Treatment of ordinary income or loss on certain debt instruments.
(C) Substitute interest payments.
(D) Section 1258 gain.
(E) Factoring income.
(F) Section 163(j) interest dividends.
( 1 ) In general.
( 2 ) Limitation on amount treated as interest income.
( 3 ) Conduit amounts.
( 4 ) Holding period.
( 5 ) Exception to holding period requirement for money market funds and certain regularly declared dividends.
(iv) Anti-avoidance rules.
(A) Principal purpose to reduce interest expense.
( 1 ) Treatment as interest expense.
( 2 ) Corresponding treatment of amounts as interest income.
(B) Interest income artificially increased.
(C) Principal purpose.
(D) Coordination with anti-avoidance rule in § 1.163(j)-2(j).
(v) Examples.
(23) Interest expense.
(24) Interest income.
(25) Member.
(26) Motor vehicle.
(27) Old section 163(j).
(28) Ownership change.
(29) Ownership date.
(30) Real estate investment trust.
(31) Real property.
(32) Regulated investment company.
(33) Relevant foreign corporation.
(34) S corporation.
(35) Section 163(j) interest dividend.
(i) In general.
(ii) Reduction in the case of excess reported amounts.
(iii) Allocation of excess reported amount.
(A) In general.
(B) Special rule for noncalendar year RICs.
(iv) Definitions.
(A) Reported section 163(j) interest dividend amount.
(B) Excess reported amount.
(C) Aggregate reported amount.
(D) Post-December reported amount.
(E) Excess section 163(j) interest income.
(v) Example.
(36) Section 163(j) limitation.
(37) Section 163(j) regulations.
(38) Separate return limitation year.
(39) Separate return year.
(40) Separate tentative taxable income.
(41) Tax-exempt corporation.
(42) Tax-exempt organization.
(43) Tentative taxable income.
(i) In general.
(ii) [Reserved]
(iii) Special rules for defining tentative taxable income.
(44) Trade or business.
(i) In general.
(ii) Excepted trade or business.
(iii) Non-excepted trade or business.
(45) Unadjusted basis.
(46) United States shareholder.
(c) Applicability date.
(1) In general.
(2) Anti-avoidance rules.
(3) Swaps with significant nonperiodic payments.
(i) In general.
(ii) Anti-avoidance rule.
(4) Paragraphs (b)(1)(iv)(A)( 2 ) through ( 4 ), (B) through (G), (b)(22)(iii)(F), and (b)(35).
(a) Overview.
(b) General rule.
(1) In general.
(2) 50 percent ATI limitation for taxable years beginning in 2019 or 2020.
(3) Election to use 2019 ATI in 2020.
(i) In general.
(ii) Short taxable years.
(iii) Transactions to which section 381 applies.
(iv) Consolidated groups.
(4) Time and manner of making or revoking the elections.
(c) Disallowed business interest expense carryforward.
(1) In general.
(2) Coordination with small business exemption.
(3) Cross-references.
(d) Small business exemption.
(1) Exemption.
(2) Application of the gross receipts test.
(i) In general.
(ii) Gross receipts of individuals.
(iii) Partners and S corporation shareholders.
(iv) Tax-exempt organizations.
(3) Determining a syndicate's loss amount.
(e) REMICs.
(f) Trusts.
(i) Calculation of ATI with respect to certain trusts and estates.
(ii) Calculation of ATI with respect to certain beneficiaries.
(g) Tax-exempt organizations.
(h) Examples.
(i) [Reserved]
(j) Anti-avoidance rule.
(1) In general.
(2) Examples.
(k) Applicability dates.
(1) In general.
(2) Paragraphs (b)(3)(iii), (b)(3)(iv), and (d)(3).
§ 1.163(j)-3 Relationship of the section 163(j) limitation to other provisions affecting interest.
(a) Overview.
(b) Coordination of section 163(j) with certain other provisions.
(1) In general.
(2) Disallowed interest provisions.
(3) Deferred interest provisions.
(4) At risk rules, passive activity loss provisions, and limitation on excess business losses of noncorporate taxpayers.
(5) Capitalized interest expenses.
(6) Reductions under section 246A.
(7) Section 381.
(8) Section 382.
(c) Examples.
(d) Applicability date.
§ 1.163(j)-4 General rules applicable to C corporations (including REITs, RICs, and members of consolidated groups) and tax-exempt corporations.
(a) Scope.
(b) Characterization of items of income, gain, deduction, or loss.
(1) Interest expense and interest income.
(2) Adjusted taxable income.
(3) Investment interest, investment income, investment expenses, and certain other tax items of a partnership with a C corporation partner.
(i) Characterization as expense or income properly allocable to a trade or business.
(ii) Effect of characterization on partnership.
(iii) Separately stated interest expense and interest income of a partnership not treated as excess business interest expense or excess taxable income of a C corporation partner.
(iv) Treatment of deemed inclusions of a domestic partnership that are not allocable to any trade or business.
(4) Application to RICs and REITs.
(i) In general.
(ii) Tentative taxable income of RICs and REITs.
(iii) Other adjustments to adjusted taxable income for RICs and REITs.
(5) Application to tax-exempt corporations.
(6) Adjusted taxable income of cooperatives.
(7) Examples.
(c) Effect on earnings and profits.
(1) In general.
(2) Special rule for RICs and REITs.
(3) Special rule for partners that are C corporations.
(4) Examples.
(d) Special rules for consolidated groups.
(1) Scope.
(2) Calculation of the section 163(j) limitation for members of a consolidated group.
(i) In general.
(ii) Interest.
(iii) Calculation of business interest expense and business interest income for a consolidated group.
(iv) Calculation of adjusted taxable income.
(v) Treatment of intercompany obligations.
(A) In general.
(B) Repurchase premium.
(3) Investment adjustments.
(4) Examples.
(e) Ownership of partnership interests by members of a consolidated group.
(1) [Reserved]
(2) Change in status of a member.
(3) Basis adjustments under § 1.1502-32.
(4) Excess business interest expense and § 1.1502-36.
(f) Cross-references.
(g) Applicability date.
(1) In general.
(2) [Reserved]
§ 1.163(j)-5 General rules governing disallowed business interest expense carryforwards for C corporations.
(a) Scope and definitions.
(1) Scope.
(2) Definitions.
(i) Allocable share of the consolidated group's remaining section 163(j) limitation.
(ii) Consolidated group's remaining section 163(j) limitation.
(iii) Remaining current-year interest ratio.
(b) Treatment of disallowed business interest expense carryforwards.
(1) In general.
(2) Deduction of business interest expense.
(3) Consolidated groups.
(i) In general.
(ii) Deduction of business interest expense.
(A) General rule.
(B) Section 163(j) limitation equals or exceeds the current-year business interest expense and disallowed business interest expense carryforwards from prior taxable years.
(C) Current-year business interest expense and disallowed business interest expense carryforwards exceed section 163(j) limitation.
(iii) Departure from group.
(iv) Example: Deduction of interest expense.
(c) Disallowed business interest expense carryforwards in transactions to which section 381(a) applies.
(d) Limitations on disallowed business interest expense carryforwards from separate return limitation years.
(1) General rule.
(A) Cumulative section 163(j) SRLY limitation.
(B) Subgrouping.
(2) Deduction of disallowed business interest expense carryforwards arising in a SRLY.
(3) Examples.
(e) Application of section 382.
(1) Pre-change loss.
(2) Loss corporation.
(3) Ordering rules for utilization of pre-change losses and for absorption of the section 382 limitation.
(4) Disallowed business interest expense from the pre-change period in the year of a testing date.
(5) Recognized built-in loss.
(f) Overlap of SRLY limitation with section 382.
(g) Additional limitations.
(h) Applicability date.
(a) Overview.
(b) Definitions.
(1) Section 163(j) items.
(2) Partner basis items.
(3) Remedial items.
(4) Excess business interest income.
(5) Deductible business interest expense.
(6) Section 163(j) excess items.
(7) Non-excepted assets.
(8) Excepted assets.
(c) Business interest income and business interest expense of the partnership.
(1) Modification of business interest income for partnerships.
(2) Modification of business interest expense for partnerships.
(3) Transition rule.
(4) Character of business interest expense.
(d) Adjusted taxable income of a partnership.
(1) Tentative taxable income of a partnership.
(2) Section 734(b), partner basis items, and remedial items.
(3) Section 743(b) adjustments and publicly traded partnerships.
(4) Modification of adjusted taxable income for partnerships.
(5) Election to use 2019 adjusted taxable income for taxable years beginning in 2020.
(e) Adjusted taxable income and business interest income of partners.
(1) Modification of adjusted taxable income for partners.
(2) Partner basis items and remedial items.
(3) Disposition of partnership interests.
(4) Double counting of business interest income and floor plan financing interest expense prohibited.
(5) Partner basis items, remedial items, and publicly traded partnerships.
(6) [Reserved]
(f) Allocation and determination of section 163(j) excess items made in the same manner as nonseparately stated taxable income or loss of the partnership.
(1) Overview.
(i) In general.
(ii) Relevance solely for purposes of section 163(j).
(iii) Exception applicable to publicly traded partnerships.
(2) Steps for allocating deductible business interest expense and section 163(j) excess items.
(i) Partnership-level calculation required by section 163(j)(4)(A).
(ii) Determination of each partner's relevant section 163(j) items.
(iii) Partner-level comparison of business interest income and business interest expense.
(iv) Matching partnership and aggregate partner excess business interest income.
(v) Remaining business interest expense determination.
(vi) Determination of final allocable ATI.
(A) Positive allocable ATI.
(B) Negative allocable ATI.
(C) Final allocable ATI.
(vii) Partner-level comparison of 30 percent of adjusted taxable income and remaining business interest expense.
(viii) Partner priority right to ATI capacity excess determination.
(ix) Matching partnership and aggregate partner excess taxable income.
(x) Matching partnership and aggregate partner excess business interest expense.
(xi) Final section 163(j) excess item and deductible business interest expense allocation.
(g) Carryforwards.
(1) In general.
(2) Treatment of excess business interest expense allocated to partners.
(3) Excess taxable income and excess business interest income ordering rule.
(4) Special rule for taxable years beginning in 2019 and 2020.
(h) Basis adjustments.
(1) Section 704(d) ordering.
(2) Excess business interest expense basis adjustments.
(3) Partner basis adjustment upon disposition of partnership interest.
(4)-(5) [Reserved]
(i)-(j) [Reserved]
(k) Investment items and certain other items.
(l) S corporations.
(1) In general.
(i) Corporate level limitation.
(ii) Short taxable periods.
(2) Character of deductible business interest expense.
(3) Adjusted taxable income of an S corporation.
(4) Adjusted taxable income and business interest income of S corporation shareholders.
(i) Adjusted taxable income of S corporation shareholders.
(ii) Disposition of S corporation stock.
(iii) Double counting of business interest income and floor plan financing interest expense prohibited.
(iv) [Reserved]
(5) Carryforwards.
(6) Basis adjustments and disallowed business interest expense carryforwards.
(7) Accumulated adjustment accounts.
(8) Termination of qualified subchapter S subsidiary election.
(9) Investment items.
(10) Application of section 382.
(m) Partnerships and S corporations not subject to section 163(j).
(1) Exempt partnerships and S corporations.
(2) Partnerships and S corporations engaged in excepted trades or businesses.
(3) Treatment of excess business interest expense from partnerships that are exempt entities in a succeeding taxable year.
(4) S corporations with disallowed business interest expense carryforwards prior to becoming exempt entities.
(n) Treatment of self-charged lending transactions between partnerships and partners.
(o) Examples.
(p) Applicability dates.
(1) In general.
(2) Paragraphs (c)(1) and (2), (d)(3) through (5), (e)(5), (f)(1)(iii), (g)(4), (n), and (o)(24) through (29), and (34) through (36).
(a) Overview.
(b) General rule regarding the application of section 163(j) to relevant foreign corporations.
(c) Application of section 163(j) to CFC group members of a CFC group.
(1) Scope.
(2) Calculation of section 163(j) limitation for a CFC group for a specified period.
(i) In general.
(ii) Certain transactions between CFC group members disregarded.
(iii) [Reserved]
(iv) [Reserved]
(3) Deduction of business interest expense.
(i) CFC group business interest expense.
(A) In general.
(B) Modifications to relevant terms.
(ii) Carryforwards treated as attributable to the same taxable year.
(iii) Multiple specified taxable years of a CFC group member with respect to a specified period.
(iv) Limitation on pre-group disallowed business interest expense carryforward.
(A) General rule.
( 1 ) CFC group member pre-group disallowed business interest expense carryforward.
( 2 ) Subgrouping.
( 3 ) Transition rule.
(B) Deduction of pre-group disallowed business interest expense carryforwards.
(4) Currency translation.
(5) Special rule for specified periods beginning in 2019 or 2020.
(i) 50 percent ATI limitation applies to a specified period of a CFC group.
(ii) Election to use 2019 ATI applies to a specified period of a CFC group.
(A) In general.
(B) Specified taxable years that do not begin in 2020.
(d) Determination of a specified group and specified group members.
(1) Scope.
(2) Rules for determining a specified group.
(i) Definition of a specified group.
(ii) Indirect ownership.
(iii) Specified group parent.
(iv) Qualified U.S. person.
(v) Stock.
(vi) Options treated as exercised.
(vii) When a specified group ceases to exist.
(3) Rules for determining a specified group member.
(e) Rules and procedures for treating a specified group as a CFC group.
(1) Scope.
(2) CFC group and CFC group member.
(i) CFC group.
(ii) CFC group member.
(3) Duration of a CFC group.
(4) Joining or leaving a CFC group.
(5) Manner of making or revoking a CFC group election.
(i) In general.
(ii) Revocation by election.
(iii) Timing.
(iv) Election statement.
(v) Effect of prior CFC group election.
(6) Annual information reporting.
(f) Treatment of a CFC group member that has ECI.
(1) In general.
(2) [Reserved]
(g) Rules concerning the computation of adjusted taxable income of a relevant foreign corporation.
(1) Tentative taxable income.
(2) Treatment of certain dividends.
(3) Treatment of certain foreign income taxes.
(4) Anti-abuse rule.
(i) In general.
(ii) ATI adjustment amount.
(A) In general.
(B) Special rule for taxable years or specified periods beginning in 2019 or 2020.
(iii) Applicable partnership.
(h) Election to apply safe-harbor.
(1) In general.
(2) Eligibility for safe-harbor election.
(i) Stand-alone applicable CFC.
(ii) CFC group.
(iii) Currency translation.
(3) Eligible amount.
(i) Stand-alone applicable CFC.
(ii) CFC group.
(iii) Additional rules for determining an eligible amount.
(4) Qualified tentative taxable income.
(5) Manner of making a safe-harbor election.
(i) In general.
(ii) Election statement.
(6) Special rule for taxable years or specified periods beginning in 2019 or 2020.
(i)-(j) [Reserved]
(k) Definitions.
(1) Applicable partnership.
(2) Applicable specified taxable year.
(3) ATI adjustment amount.
(4) [Reserved]
(5) [Reserved]
(6) CFC group.
(7) CFC group election.
(8) CFC group member.
(9) [Reserved]
(10) Cumulative section 163(j) pre-group carryforward limitation.
(11) Current group.
(12) Designated U.S. person.
(13) ECI deemed corporation.
(14) Effectively connected income.
(15) Eligible amount.
(16) Former group.
(17) Loss member.
(18) Payment amount.
(19) Pre-group disallowed business interest expense carryforward.
(20) Qualified tentative taxable income.
(21) Qualified U.S. person.
(22) Relevant period.
(23) Safe-harbor election.
(24) Specified borrower.
(25) Specified group.
(26) Specified group member.
(27) Specified group parent.
(28) Specified lender.
(29) Specified period.
(i) In general.
(ii) Short specified period.
(30) Specified taxable year.
(31) Stand-alone applicable CFC.
(32) Stock.
(l) Examples.
(m) Applicability dates.
(1) General applicability date.
(2) Exception.
(3) Early application.
(i) Rules for paragraphs (b) and (g)(1) and (2) of this section.
(ii) Rules for certain other paragraphs in this section.
(4) Additional rules that must be applied consistently.
(5) Election for prior taxable years.
§ 1.163(j)-8 [Reserved]
§ 1.163(j)-9 Elections for excepted trades or businesses; safe harbor for certain REITs.
(a) Overview.
(b) Availability of election.
(1) In general.
(2) Special rules.
(i) Exempt small businesses.
(ii) Section 162 trade or business not required for electing real property trade or business.
(c) Scope and effect of election.
(1) In general.
(2) Irrevocability.
(3) Depreciation.
(d) Time and manner of making election.
(1) In general.
(2) Election statement contents.
(3) Consolidated group's trade or business.
(4) Partnership's trade or business.
(e) Termination of election.
(1) In general.
(2) Taxable asset transfer defined.
(3) Related party defined.
(4) Anti-abuse rule.
(f) Additional guidance.
(g) Examples.
(h) Safe harbor for REITs.
(1) In general.
(2) REITs that do not significantly invest in real property financing assets.
(3) REITs that significantly invest in real property financing assets.
(4) REIT real property assets, interests in partnerships, and shares in other REITs.
(i) Real property assets.
(ii) Partnership interests.
(iii) Shares in other REITs.
(A) In general.
(B) Information necessary.
(iv) Tiered entities.
(5) Value of shares in other REITs.
(i) In general.
(ii) Information necessary.
(iii) Tiered REITs.
(6) Real property financing assets.
(7) Application of safe harbor for partnerships controlled by REITS.
(8) REITs or partnerships controlled by REITs that do not apply the safe harbor.
(i) [Reserved]
(j) Special anti-abuse rule for certain real property trades or businesses.
(1) In general.
(2) Exceptions.
(i) De minimis exception.
(ii) Look-through exception.
(iii) Inapplicability of exceptions to consolidated groups.
(iv) Exception for certain REITs.
(3) Allocations.
(4) Examples.
(k) Applicability date.
(a) Overview.
(1) In general.
(i) Purposes.
(ii) Application of section.
(2) Coordination with other rules.
(i) In general.
(ii) Treatment of investment interest, investment income, investment expenses, and certain other tax items of a partnership with a C corporation or tax-exempt corporation as a partner.
(3) Application of allocation rules to foreign corporations and foreign partnerships.
(4) Application of allocation rules to members of a consolidated group.
(i) In general.
(ii) Application of excepted business percentage to members of a consolidated group.
(iii) Basis in assets transferred in an intercompany transaction.
(5) Tax-exempt organizations.
(6) Application of allocation rules to disallowed disqualified interest.
(7) Examples.
(b) Allocation of tax items other than interest expense and interest income.
(1) In general.
(2) Gross income other than dividends and interest income.
(3) Dividends.
(i) Look-through rule.
(ii) Inapplicability of the look-through rule.
(4) Gain or loss from the disposition of non-consolidated C corporation stock, partnership interests, or S corporation stock.
(i) Non-consolidated C corporations.
(ii) Partnerships and S corporations.
(5) Expenses, losses, and other deductions.
(i) Expenses, losses, and other deductions that are definitely related to a trade or business.
(ii) Other deductions.
(6) Treatment of investment items and certain other items of a partnership with a C corporation partner.
(7) Examples: Allocation of income and expense.
(c) Allocating interest expense and interest income that is properly allocable to a trade or business.
(1) General rule.
(i) In general.
(ii) De minimis exception.
(2) Example.
(3) Asset used in more than one trade or business.
(i) General rule.
(ii) Permissible methodologies for allocating asset basis between or among two or more trades or businesses.
(iii) Special rules.
(A) Consistent allocation methodologies.
( 1 ) In general.
( 2 ) Consent to change allocation methodology.
(B) De minimis exception.
(C) Allocations of excepted regulated utility trades or businesses.
( 1 ) In general.
( 2 ) Permissible method for allocating asset basis for utility trades or businesses.
( 3 ) De minimis rule for excepted utility trades or businesses.
( 4 ) Example.
(D) Special allocation rule for real property trades or business subject to special anti-abuse rule.
( 1 ) In general.
( 2 ) Allocation methodology for real property.
( 3 ) Example.
(4) Disallowed business interest expense carryforwards; floor plan financing interest expense.
(5) Additional rules relating to basis.
(i) Calculation of adjusted basis.
(A) Non-depreciable property other than land.
(B) Depreciable property other than inherently permanent structures.
(C) Special rule for land and inherently permanent structures.
(D) Depreciable or amortizable intangible property and depreciable income forecast method property.
(E) Assets not yet used in a trade or business.
(F) Trusts established to fund specific liabilities.
(G) Inherently permanent structure.
(ii) Partnership interests; stock in non-consolidated C corporations.
(A) Partnership interests.
( 1 ) Calculation of asset basis.
( 2 ) Allocation of asset basis.
( i ) In general.
( ii ) De minimis rule.
( iii ) Partnership assets not properly allocable to a trade or business.
( iv ) Inapplicability of partnership look-through rule.
(B) Stock in domestic non-consolidated corporations.
( 1 ) In general.
( 2 ) Domestic non-consolidated C corporations.
( i ) Allocation of asset basis.
( ii ) De minimis rule.
( iii ) Inapplicability of corporate look-through rule.
( iv ) Use of inside basis for purposes of C corporation look-through rule.
( 3 ) S corporations.
( i ) Calculation of asset basis.
( ii ) Allocation of asset basis.
( iii ) De minimis rule.
( iv ) Inapplicability of S corporation look-through rule.
(C) Stock in relevant foreign corporations.
( 1 ) In general.
( 2 ) Special rule for CFC utilities.
(D) Limitations on application of look-through rules.
( 1 ) Inapplicability of look-through rule to partnerships or non-consolidated C corporations to which the small business exemption applies.
( 2 ) Limitation on application of look-through rule to C corporations.
(D) Inapplicability of look-through rule to partnerships or non-consolidated C corporations to which the small business exemption applies.
(E) Tiered entities.
(iii) Cash and cash equivalents and customer receivables.
(iv) Deemed asset sale.
(v) Other adjustments.
(6) Determination dates; determination periods; reporting requirements.
(i) Determination dates and determination periods.
(A) Quarterly determination periods.
(B) Annual determination periods.
(ii) Application of look-through rules.
(iii) Reporting requirements.
(A) Books and records.
(B) Information statement.
(iv) Failure to file statement.
(7) Ownership threshold for look-through rules.
(i) Corporations.
(A) Asset basis.
(B) Dividends.
(ii) Partnerships.
(iii) Inapplicability of look-through rule.
(8) Anti-abuse rule.
(d) Direct allocations.
(1) In general.
(2) Qualified nonrecourse indebtedness.
(3) Assets used in more than one trade or business.
(4) Adjustments to basis of assets to account for direct allocations.
(5) Example: Direct allocation of interest expense.
(e) Examples.
(f) Applicability dates.
(1) In general.
(2) Paragraph (c)(5)(ii)(D)( 2 ).
§ 1.163(j)-11 Transition rules.
(a) Overview.
(b) Application of section 163(j) limitation if a corporation joins a consolidated group during a taxable year of the group beginning before January 1, 2018.
(1) In general.
(2) Example
(c) Treatment of disallowed disqualified interest.
(1) In general.
(2) Earnings and profits.
(3) Disallowed disqualified interest of members of an affiliated group.
(i) Scope.
(ii) Allocation of disallowed disqualified interest to members of the affiliated group.
(A) In general.
(B) Definitions.
( 1 ) Allocable share of the affiliated group's disallowed disqualified interest.
( 2 ) Disallowed disqualified interest ratio.
( 3 ) Exempt related person interest expense.
(iii) Treatment of carryforwards.
(4) Application of section 382.
(i) Ownership change occurring before November 13, 2020.
(A) Pre-change loss.
(B) Loss corporation.
(ii) Ownership change occurring on or after November 13, 2020.
(A) Pre-change loss.
(B) Loss corporation.
(5) Treatment of excess limitation from taxable years beginning before January 1, 2018.
(6) Example: Members of an affiliated group.
(d) Applicability date.