[Federal Register Volume 69, Number 248 (Tuesday, December 28, 2004)]
[Rules and Regulations]
[Pages 77625-77636]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-28325]



[[Page 77625]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9171]
RINs 1545-AY87; 1545-BC03


New Markets Tax Credit

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: These regulations finalize the rules relating to the new 
markets tax credit under section 45D and replace the temporary 
regulations which expire on December 23, 2004. A taxpayer making a 
qualified equity investment in a qualified community development entity 
that has received a new markets tax credit allocation may claim a 5-
percent tax credit with respect to the qualified equity investment on 
each of the first 3 credit allowance dates and a 6-percent tax credit 
with respect to the qualified equity investment on each of the 
remaining 4 credit allowance dates.

DATES: Effective Date: These regulations are effective December 22, 
2004.
    Date of Applicability: For date of applicability see Sec.  1.45D-
1(h).

FOR FURTHER INFORMATION CONTACT: Paul F. Handleman or Lauren R. Taylor, 
(202) 622-3040 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1765. Responses to this collection of information 
are mandatory so that a taxpayer may claim a new markets tax credit on 
each credit allowance date during the 7-year credit period and report 
compliance with the requirements of section 45D to the Secretary.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent varies from 15 minutes 
to 5 hours, depending on individual circumstances, with an estimated 
average of 2.5 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP Washington, DC 20224, and to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document amends 26 CFR part 1 to provide rules relating to the 
new markets tax credit under section 45D of the Internal Revenue Code 
(Code). On December 26, 2001, the IRS published in the Federal Register 
temporary and proposed regulations (the 2001 temporary regulations) (66 
FR 66307, 66 FR 66376). On March 11, 2004, the IRS published in the 
Federal Register temporary and proposed regulations revising and 
clarifying the 2001 temporary regulations (the 2004 temporary 
regulations) (69 FR 11507; 69 FR 11561). On March 14, 2002, and June 2, 
2004, the IRS and Treasury Department held public hearings on the 2001 
temporary regulations and the 2004 temporary regulations, respectively. 
Written and electronic comments responding to the temporary regulations 
and notices of proposed rulemaking were received. After consideration 
of all the comments, the proposed regulations are adopted as amended by 
this Treasury decision, and the corresponding temporary regulations are 
removed. The revisions are discussed below.
    Section 45D was added to the Code by section 121(a) of the 
Community Renewal Tax Relief Act of 2000 (Pub. L. 106-554). The 
Secretary has delegated certain administrative, application, 
allocation, monitoring, and other programmatic functions relating to 
the new markets tax credit program to the Under Secretary (Domestic 
Finance), who in turn has delegated those functions to the Community 
Development Financial Institutions Fund.
    Sections 221 and 223 of the American Jobs Creation Act of 2004 
(Pub. L. 108-357) amended the definition of a low-income community 
under section 45D(e). This document does not provide guidance on these 
amendments. The IRS and Treasury Department are studying the amendments 
for guidance in the near future.

Explanation of Provisions

General Overview

    Taxpayers may claim a new markets tax credit on a credit allowance 
date in an amount equal to the applicable percentage of the taxpayer's 
qualified equity investment in a qualified community development entity 
(CDE). The credit allowance date for any qualified equity investment is 
the date on which the investment is initially made and each of the 6 
anniversary dates thereafter. The applicable percentage is 5 percent 
for the first 3 credit allowance dates and 6 percent for the remaining 
credit allowance dates.
    A CDE is any domestic corporation or partnership if: (1) The 
primary mission of the entity is serving or providing investment 
capital for low-income communities or low-income persons; (2) the 
entity maintains accountability to residents of low-income communities 
through their representation on any governing board of the entity or on 
any advisory board to the entity; and (3) the entity is certified by 
the Secretary for purposes of section 45D as being a CDE.
    The new markets tax credit may be claimed only for a qualified 
equity investment in a CDE. A qualified equity investment is any equity 
investment in a CDE for which the CDE has received an allocation from 
the Secretary if, among other things, the CDE uses substantially all of 
the cash from the investment to make qualified low-income community 
investments. Under a safe harbor, the substantially-all requirement is 
treated as met if at least 85 percent of the aggregate gross assets of 
the CDE are invested in qualified low-income community investments.
    Qualified low-income community investments consist of: (1) Any 
capital or equity investment in, or loan to, any qualified active low-
income community business; (2) the purchase from another CDE of any 
loan made by such entity that is a qualified low-income community 
investment; (3) financial counseling and other services to businesses 
located in, and residents of, low-income communities; and (4) certain 
equity investments in, or loans to, a CDE.
    In general, a qualified active low-income community business is a 
corporation or a partnership if for the taxable year: (1) At least 50 
percent of the total gross income of the entity is derived from the 
active conduct of a qualified business within any low-income community; 
(2) a substantial portion of the use of the tangible property of the 
entity is within any low-income community; (3) a substantial portion of 
the services performed for the

[[Page 77626]]

entity by its employees is performed in any low-income community; (4) 
less than 5 percent of the average of the aggregate unadjusted bases of 
the property of the entity is attributable to certain collectibles; and 
(5) less than 5 percent of the average of the aggregate unadjusted 
bases of the property of the entity is attributable to certain 
nonqualified financial property.
    A recapture event requiring an investor to recapture credits 
previously taken occurs for an equity investment in a CDE if the CDE: 
(1) Ceases to be a CDE; (2) ceases to use substantially all of the 
proceeds of the equity investment for qualified low-income community 
investments; or (3) redeems the investor's equity investment. In 
addition, the investor's basis in any qualified equity investment is 
reduced by the amount of the new markets tax credit.

Substantially All

    As indicated above, a CDE must use substantially all of the cash 
from a qualified equity investment to make qualified low-income 
community investments. Section 1.45D-1T(c)(5)(i) provides that the 
substantially-all requirement is treated as satisfied for an annual 
period if either the direct-tracing calculation under Sec.  1.45D-
1T(c)(5)(ii), or the safe harbor calculation under Sec.  1.45D-
1T(c)(5)(iii), is performed every six months and the average of the two 
calculations for the annual period is at least 85 percent. The final 
regulations clarify that a CDE may choose the same two testing dates 
for all qualified equity investments regardless of the date each 
qualified equity investment was initially made. To conform the annual 
testing requirement with the 12-month time limit for making qualified 
low-income community investments, the final regulations provide that 
for the first annual period, the substantially-all calculation may be 
performed on a single testing date. The final regulations also amend 
the beginning of the 12-month period for making qualified low-income 
community investments to provide that the 12-month period begins on the 
same date as the beginning of the first annual period of the 7-year 
credit period.
    Section 1.45D-1T(d)(3) provides that reserves (not in excess of 5 
percent of the taxpayer's cash investment under Sec.  1.45D-1T(b)(4)) 
maintained by the CDE for loan losses or for additional investments in 
existing qualified low-income community investments are treated as 
invested in a qualified low-income community investment. In response to 
comments, the final regulations provide that reserves include fees paid 
to third parties to protect against loss of all or a portion of the 
principal of, or interest on, on a loan that is a qualified low-income 
community investment.

Qualified Active Low-Income Community Business

    As indicated above, qualified low-income community investments 
include any capital or equity investment in, or loan to, any qualified 
active low-income community business. Under Sec.  1.45D-1T(d)(4)(i)(B), 
an entity is a qualified active low-income community business only if, 
among other requirements, at least 40 percent of the use of the 
tangible property of such entity (whether owned or leased) is within 
any low-income community. In response to comments, the final 
regulations provide an example of how the tangible property test 
applies to property that is used both outside and inside a low-income 
community. The example demonstrates that use is measured based on the 
entity's business hours of operation and does not include non-business 
hours.
    Under section 45D(d)(2)(C), a qualified active low-income community 
business includes any trade or business that would qualify as a 
qualified active low-income community business if such trade or 
business were separately incorporated. Commentators requested 
clarification of how this rules applies.
    The final regulations provide that a CDE may treat any trade or 
business (or portion thereof) as a qualified active low-income 
community business if the trade or business (or portion thereof) would 
meet the requirements to be a qualified active low-income community 
business if the trade or business (or portion thereof) were separately 
incorporated and a complete and separate set of books and records is 
maintained for that trade or business (or portion thereof). The final 
regulations further provide, however, that under this rule a CDE's 
capital or equity investment or loan is not a qualified low-income 
community investment to the extent the proceeds of the investment or 
loan are not used for the trade or business (or portion thereof) that 
is treated as a qualified active low-income community business.
    Section Sec.  1.45D-1T(d)(4)(iv) provides that an entity will be 
treated as engaged in the active conduct of a trade or business if, at 
the time the CDE makes a capital or equity investment in, or loan to, 
the entity, the CDE reasonably expects that the entity will generate 
revenues (or, in the case of a nonprofit corporation, receive 
donations) within 3 years after the date the investment or loan is 
made. The final regulations amend this rule with respect to a nonprofit 
corporation by providing that the nonprofit corporation must be engaged 
in an activity that furthers its purpose as a nonprofit corporation 
within the 3-year period.
    Under Sec.  1.45D-1T(d)(4)(i)(E), an entity is a qualified active 
low-income community business only if, among other requirements, less 
than 5 percent of the average of the aggregate unadjusted bases of the 
property of such entity is attributable to nonqualified financial 
property (as defined in section 1397C(e)). Section 1397C(e)(1) contains 
an exception to the definition of nonqualified financial property for 
reasonable amounts of working capital held in cash, cash equivalents, 
or debt instruments with a term of 18 months or less. The final 
regulations provide that, for these purposes, the proceeds of a capital 
or equity investment or loan by a CDE that will be expended on 
construction of real property within 12 months after the date the 
investment or loan is made qualify as a reasonable amount of working 
capital.
    Section 45D(d)(3)(A) provides that the rental to others of real 
property located in any low-income community is treated as a qualified 
business only if, among other requirements, there are substantial 
improvements located on such property. Commentators requested 
clarification of the term substantial improvements. The final 
regulations provide that the term substantial improvements means 
improvements the cost basis of which equals or exceeds 50 percent of 
the cost basis of the land on which the improvements are located and 
the costs of which are incurred after the date the CDE makes the 
investment or loan. In addition, the final regulations provide that a 
CDE's investment in or loan to a business engaged in the rental of real 
property is not a qualified low-income community investment to the 
extent any lessee of the real property is not a qualified business.

Recapture

    As indicated above, there is a recapture event with respect to an 
equity investment in a CDE if such investment is redeemed by the CDE. 
Commentators requested clarification of when distributions by a CDE to 
its investors will be treated as redemptions. The final regulations 
provide guidance on when a distribution by a CDE that is a corporation 
for Federal tax purposes will be treated as a redemption.
    Some commentators suggested that, in the case of a CDE that is 
treated as a partnership for Federal tax purposes, a redemption should 
be limited to purchases by the CDE of a partner's

[[Page 77627]]

capital interest. Alternatively, commentators requested guidance on how 
to distinguish between a return of capital and a distribution of 
profits if a return of capital is treated as a redemption. In response 
to comments, the final regulations provide a safe harbor under which 
cash distributions by a partnership will not be treated as a 
redemption. Under the safe harbor, a pro rata cash distribution by the 
CDE to its partners based on each partner's capital interest in the CDE 
during the taxable year will not be treated as a redemption if the 
distribution does not exceed the CDE's operating income (as defined in 
the final regulations) for the taxable year. In addition, a non-pro 
rata de minimis cash distribution by a CDE to a partner or partners 
during the taxable year will be not treated as a redemption. A non-pro 
rata de minimis cash distribution may not exceed the lesser of 5 
percent of the CDE's operating income for that taxable year or 10 
percent of the partner's capital interest in the CDE.
    Commentators suggested that cure periods be provided to enable CDEs 
to correct any noncompliance with the requirements under section 45D. 
One commentator suggested that a cure period be provided to allow an 
investment that no longer qualifies as a qualified low-income community 
investment to be replaced with a qualifying investment by the end of 
the calendar year following the year the original investment lost its 
status as a qualified low-income community investment. Other 
commentators suggested that, if a qualified equity investment fails the 
substantially-all requirement, the failure should not be a recapture 
event if the CDE corrects the failure within 6 months after the date 
the CDE discovers (or reasonably should have discovered) the failure. 
The final regulations provide that, if a qualified equity investment 
fails the substantially-all requirement, the failure is not a recapture 
event if the CDE corrects the failure within 6 months after the date 
the CDE becomes aware (or reasonably should have become aware) of the 
failure. Only one correction is permitted for each qualified equity 
investment during the 7-year credit period.

Other Issues

    Section 45D(i)(1) authorizes the Secretary to prescribe regulations 
as may be appropriate to carry out section 45D including regulations 
that limit the new markets tax credit for investments that are directly 
or indirectly subsidized by other Federal tax benefits (including the 
low-income housing credit under section 42 and the exclusion from gross 
income under section 103). The final regulations do not prohibit a CDE 
from purchasing tax-exempt bonds because tax-exempt financing provides 
a subsidy to borrowers and not bondholders. However, the final 
regulations provide that if a CDE makes a capital or equity investment 
or loan with respect to a qualified low-income building under section 
42, the investment or loan is not a qualified low-income community 
investment to the extent the building's eligible basis under section 
42(d) is financed by the proceeds of the investment or loan.

Effective Dates

    The final regulations are effective December 22, 2004, and may be 
applied by taxpayers before December 22, 2004. However, both the 
definition of the term substantial improvements and the requirement 
that each lessee be a qualified business apply to qualified low-income 
community investments made on or after February 22, 2005.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that any burden on 
taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not 
required. Pursuant to section 7805(f) of the Code, the notices of 
proposed rulemaking preceding these regulations were submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Paul F. Handleman, 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries), IRS. However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.45D-1 also issued under 26 U.S.C. 45D(i); * * *


0
Par. 2. Section 1.45D-1 is added to read as follows:


Sec.  1.45D-1  New markets tax credit.

    (a) Table of contents. This paragraph lists the headings that 
appear in Sec.  1.45D-1.

(a) Table of contents
(b) Allowance of credit
(1) In general
(2) Credit allowance date
(3) Applicable percentage
(4) Amount paid at original issue
(c) Qualified equity investment
(1) In general
(2) Equity investment
(3) Equity investments made prior to allocation
(i) In general
(ii) Exceptions
(A) Allocation applications submitted by August 29, 2002
(B) Other allocation applications
(iii) Failure to receive allocation
(iv) Initial investment date
(4) Limitations
(i) In general
(ii) Allocation limitation
(5) Substantially all
(i) In general
(ii) Direct-tracing calculation
(iii) Safe harbor calculation
(iv) Time limit for making investments
(v) Reduced substantially-all percentage
(vi) Examples
(6) Aggregation of equity investments
(7) Subsequent purchasers
(d) Qualified low-income community investments
(1) In general
(i) Investment in a qualified active low-income community business
(ii) Purchase of certain loans from CDEs
(A) In general
(B) Certain loans made before CDE certification
(C) Intermediary CDEs
(D) Examples
(iii) Financial counseling and other services
(iv) Investments in other CDEs
(A) In general
(B) Examples
(2) Payments of, or for, capital, equity or principal
(i) In general

[[Page 77628]]

(ii) Subsequent reinvestments
(iii) Special rule for loans
(iv) Example
(3) Special rule for reserves
(4) Qualified active low-income community business
(i) In general
(A) Gross-income requirement
(B) Use of tangible property
(1) In general
(2) Example
(C) Services performed
(D) Collectibles
(E) Nonqualified financial property
(1) In general
(2) Construction of real property
(ii) Proprietorships
(iii) Portions of business
(A) In general
(B) Examples
(iv) Active conduct of a trade or business
(A) Special rule
(B) Example
(5) Qualified business
(i) In general
(ii) Rental of real property
(iii) Exclusions
(A) Trades or businesses involving intangibles
(B) Certain other trades or businesses
(C) Farming
(6) Qualifications
(i) In general
(ii) Control
(A) In general
(B) Definition of control
(C) Disregard of control
(7) Financial counseling and other services
(8) Special rule for certain loans
(i) In general
(ii) Example
(e) Recapture
(1) In general
(2) Recapture event
(3) Redemption
(i) Equity investment in a C corporation
(ii) Equity investment in an S corporation
(iii) Capital interest in a partnership
(4) Bankruptcy
(5) Waiver of requirement or extension of time
(i) In general
(ii) Manner for requesting a waiver or extension
(iii) Terms and conditions
(6) Cure period
(7) Example
(f) Basis reduction
(1) In general
(2) Adjustment in basis of interest in partnership or S corporation
(g) Other rules
(1) Anti-abuse
(2) Reporting requirements
(i) Notification by CDE to taxpayer
(A) Allowance of new markets tax credit
(B) Recapture event
(ii) CDE reporting requirements to Secretary
(iii) Manner of claiming new markets tax credit
(iv) Reporting recapture tax
(3) Other Federal tax benefits
(i) In general
(ii) Low-income housing credit
(4) Bankruptcy of CDE
(h) Effective dates
(1) In general
(2) Exception for certain provisions

    (b) Allowance of credit--(1) In general. For purposes of the 
general business credit under section 38, a taxpayer holding a 
qualified equity investment on a credit allowance date which occurs 
during the taxable year may claim the new markets tax credit determined 
under section 45D and this section for such taxable year in an amount 
equal to the applicable percentage of the amount paid to a qualified 
community development entity (CDE) for such investment at its original 
issue. Qualified equity investment is defined in paragraph (c) of this 
section. Credit allowance date is defined in paragraph (b)(2) of this 
section. Applicable percentage is defined in paragraph (b)(3) of this 
section. A CDE is a qualified community development entity as defined 
in section 45D(c). The amount paid at original issue is determined 
under paragraph (b)(4) of this section.
    (2) Credit allowance date. The term credit allowance date means, 
with respect to any qualified equity investment--
    (i) The date on which the investment is initially made; and
    (ii) Each of the 6 anniversary dates of such date thereafter.
    (3) Applicable percentage. The applicable percentage is 5 percent 
for the first 3 credit allowance dates and 6 percent for the other 4 
credit allowance dates.
    (4) Amount paid at original issue. The amount paid to the CDE for a 
qualified equity investment at its original issue consists of all 
amounts paid by the taxpayer to, or on behalf of, the CDE (including 
any underwriter's fees) to purchase the investment at its original 
issue.
    (c) Qualified equity investment--(1) In general. The term qualified 
equity investment means any equity investment (as defined in paragraph 
(c)(2) of this section) in a CDE if--
    (i) The investment is acquired by the taxpayer at its original 
issue (directly or through an underwriter) solely in exchange for cash;
    (ii) Substantially all (as defined in paragraph (c)(5) of this 
section) of such cash is used by the CDE to make qualified low-income 
community investments (as defined in paragraph (d)(1) of this section); 
and
    (iii) The investment is designated for purposes of section 45D and 
this section by the CDE on its books and records using any reasonable 
method.
    (2) Equity investment. The term equity investment means any stock 
(other than nonqualified preferred stock as defined in section 
351(g)(2)) in an entity that is a corporation for Federal tax purposes 
and any capital interest in an entity that is a partnership for Federal 
tax purposes. See Sec. Sec.  301.7701-1 through 301.7701-3 of this 
chapter for rules governing when a business entity, such as a business 
trust or limited liability company, is classified as a corporation or a 
partnership for Federal tax purposes.
    (3) Equity investments made prior to allocation--(i) In general. 
Except as provided in paragraph (c)(3)(ii) of this section, an equity 
investment in an entity is not eligible to be designated as a qualified 
equity investment if it is made before the entity enters into an 
allocation agreement with the Secretary. An allocation agreement is an 
agreement between the Secretary and a CDE relating to a new markets tax 
credit allocation under section 45D(f)(2).
    (ii) Exceptions. Notwithstanding paragraph (c)(3)(i) of this 
section, an equity investment in an entity is eligible to be designated 
as a qualified equity investment under paragraph (c)(1)(iii) of this 
section if--
    (A) Allocation applications submitted by August 29, 2002.
    (1) The equity investment is made on or after April 20, 2001;
    (2) The designation of the equity investment as a qualified equity 
investment is made for a credit allocation received pursuant to an 
allocation application submitted to the Secretary no later than August 
29, 2002; and
    (3) The equity investment otherwise satisfies the requirements of 
section 45D and this section; or
    (B) Other allocation applications.
    (1) The equity investment is made on or after the date the 
Secretary publishes a Notice of Allocation Availability (NOAA) in the 
Federal Register;
    (2) The designation of the equity investment as a qualified equity 
investment is made for a credit allocation received pursuant to an 
allocation application submitted to the Secretary under that NOAA; and
    (3) The equity investment otherwise satisfies the requirements of 
section 45D and this section.
    (iii) Failure to receive allocation. For purposes of paragraph 
(c)(3)(ii)(A) of this section, if the entity in which the equity 
investment is made does not receive an allocation pursuant to an 
allocation application submitted no later than August 29, 2002, the 
equity investment will not be eligible to be designated as a qualified 
equity investment. For purposes of paragraph (c)(3)(ii)(B) of this 
section, if the entity

[[Page 77629]]

in which the equity investment is made does not receive an allocation 
under the NOAA described in paragraph (c)(3)(ii)(B)(1) of this section, 
the equity investment will not be eligible to be designated as a 
qualified equity investment.
    (iv) Initial investment date. If an equity investment is designated 
as a qualified equity investment in accordance with paragraph 
(c)(3)(ii) of this section, the investment is treated as initially made 
on the effective date of the allocation agreement between the CDE and 
the Secretary.
    (4) Limitations--(i) In general. The term qualified equity 
investment does not include--
    (A) Any equity investment issued by a CDE more than 5 years after 
the date the CDE enters into an allocation agreement (as defined in 
paragraph (c)(3)(i) of this section) with the Secretary; and
    (B) Any equity investment by a CDE in another CDE, if the CDE 
making the investment has received an allocation under section 
45D(f)(2).
    (ii) Allocation limitation. The maximum amount of equity 
investments issued by a CDE that may be designated under paragraph 
(c)(1)(iii) of this section by the CDE may not exceed the portion of 
the limitation amount allocated to the CDE by the Secretary under 
section 45D(f)(2).
    (5) Substantially all--(i) In general. Except as provided in 
paragraph (c)(5)(v) of this section, the term substantially all means 
at least 85 percent. The substantially-all requirement must be 
satisfied for each annual period in the 7-year credit period using 
either the direct-tracing calculation under paragraph (c)(5)(ii) of 
this section, or the safe harbor calculation under paragraph 
(c)(5)(iii) of this section. For the first annual period, the 
substantially-all requirement is treated as satisfied if either the 
direct-tracing calculation under paragraph (c)(5)(ii) of this section, 
or the safe-harbor calculation under paragraph (c)(5)(iii) of this 
section, is performed on a single testing date and the result of the 
calculation is at least 85 percent. For each annual period other than 
the first annual period, the substantially-all requirement is treated 
as satisfied if either the direct-tracing calculation under paragraph 
(c)(5)(ii) of this section, or the safe harbor calculation under 
paragraph (c)(5)(iii) of this section, is performed every six months 
and the average of the two calculations for the annual period is at 
least 85 percent. For example, the CDE may choose the same two testing 
dates for all qualified equity investments regardless of the date each 
qualified equity investment was initially made under paragraph 
(b)(2)(i) of this section, provided the testing dates are six months 
apart. The use of the direct-tracing calculation under paragraph 
(c)(5)(ii) of this section (or the safe harbor calculation under 
paragraph (c)(5)(iii) of this section) for an annual period does not 
preclude the use of the safe harbor calculation under paragraph 
(c)(5)(iii) of this section (or the direct-tracing calculation under 
paragraph (c)(5)(ii) of this section) for another annual period, 
provided that a CDE that switches to a direct-tracing calculation must 
substantiate that the taxpayer's investment is directly traceable to 
qualified low-income community investments from the time of the CDE's 
initial investment in a qualified low-income community investment. For 
purposes of this paragraph (c)(5)(i), the 7-year credit period means 
the period of 7 years beginning on the date the qualified equity 
investment is initially made. See paragraph (c)(6) of this section for 
circumstances in which a CDE may treat more than one equity investment 
as a single qualified equity investment.
    (ii) Direct-tracing calculation. The substantially-all requirement 
is satisfied if at least 85 percent of the taxpayer's investment is 
directly traceable to qualified low-income community investments as 
defined in paragraph (d)(1) of this section. The direct-tracing 
calculation is a fraction the numerator of which is the CDE's aggregate 
cost basis determined under section 1012 in all of the qualified low-
income community investments that are directly traceable to the 
taxpayer's cash investment, and the denominator of which is the amount 
of the taxpayer's cash investment under paragraph (b)(4) of this 
section. For purposes of this paragraph (c)(5)(ii), cost basis includes 
the cost basis of any qualified low-income community investment that 
becomes worthless. See paragraph (d)(2) of this section for the 
treatment of amounts received by a CDE in payment of, or for, capital, 
equity or principal with respect to a qualified low-income community 
investment.
    (iii) Safe harbor calculation. The substantially-all requirement is 
satisfied if at least 85 percent of the aggregate gross assets of the 
CDE are invested in qualified low-income community investments as 
defined in paragraph (d)(1) of this section. The safe harbor 
calculation is a fraction the numerator of which is the CDE's aggregate 
cost basis determined under section 1012 in all of its qualified low-
income community investments, and the denominator of which is the CDE's 
aggregate cost basis determined under section 1012 in all of its 
assets. For purposes of this paragraph (c)(5)(iii), cost basis includes 
the cost basis of any qualified low-income community investment that 
becomes worthless. See paragraph (d)(2) of this section for the 
treatment of amounts received by a CDE in payment of, or for, capital, 
equity or principal with respect to a qualified low-income community 
investment.
    (iv) Time limit for making investments. The taxpayer's cash 
investment received by a CDE is treated as invested in a qualified low-
income community investment as defined in paragraph (d)(1) of this 
section only to the extent that the cash is so invested within the 12-
month period beginning on the date the cash is paid by the taxpayer 
(directly or through an underwriter) to the CDE.
    (v) Reduced substantially-all percentage. For purposes of the 
substantially-all requirement (including the direct-tracing calculation 
under paragraph (c)(5)(ii) of this section and the safe harbor 
calculation under paragraph (c)(5)(iii) of this section), 85 percent is 
reduced to 75 percent for the seventh year of the 7-year credit period 
(as defined in paragraph (c)(5)(i) of this section).
    (vi) Examples. The following examples illustrate an application of 
this paragraph (c)(5):

    Example 1. X is a partnership and a CDE that has received a $1 
million new markets tax credit allocation from the Secretary. On 
September 1, 2004, X uses a line of credit from a bank to fund a $1 
million loan to Y. The loan is a qualified low-income community 
investment under paragraph (d)(1) of this section. On September 5, 
2004, A pays $1 million to acquire a capital interest in X. X uses 
the proceeds of A's equity investment to pay off the $1 million line 
of credit that was used to fund the loan to Y. X's aggregate gross 
assets consist of the $1 million loan to Y and $100,000 in other 
assets. A's equity investment in X does not satisfy the 
substantially-all requirement under paragraph (c)(5)(i) of this 
section using the direct-tracing calculation under paragraph 
(c)(5)(ii) of this section because the cash from A's equity 
investment is not used to make X's loan to Y. However, A's equity 
investment in X satisfies the substantially-all requirement using 
the safe harbor calculation under paragraph (c)(5)(iii) of this 
section because at least 85 percent of X's aggregate gross assets 
are invested in qualified low-income community investments.
    Example 2. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On August 1, 2004, 
A pays $100,000 for a capital interest in X. On August 5, 2004, X 
uses the proceeds of A's equity investment to make an equity 
investment in Y. X controls Y within the meaning of paragraph 
(d)(6)(ii)(B) of this section. For the annual period ending July

[[Page 77630]]

31, 2005, Y is a qualified active low-income community business (as 
defined in paragraph (d)(4) of this section). Thus, for that period, 
A's equity investment satisfies the substantially-all requirement 
under paragraph (c)(5)(i) of this section using the direct-tracing 
calculation under paragraph (c)(5)(ii) of this section. For the 
annual period ending July 31, 2006, Y no longer is a qualified 
active low-income community business. Thus, for that period, A's 
equity investment does not satisfy the substantially-all requirement 
using the direct-tracing calculation. However, during the entire 
annual period ending July 31, 2006, X's remaining assets are 
invested in qualified low-income community investments with an 
aggregate cost basis of $900,000. Consequently, for the annual 
period ending July 31, 2006, at least 85 percent of X's aggregate 
gross assets are invested in qualified low-income community 
investments. Thus, for the annual period ending July 31, 2006, A's 
equity investment satisfies the substantially-all requirement using 
the safe harbor calculation under paragraph (c)(5)(iii) of this 
section.
    Example 3. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On August 1, 2004, 
A and B each pay $100,000 for a capital interest in X. X does not 
treat A's and B's equity investments as one qualified equity 
investment under paragraph (c)(6) of this section. On September 1, 
2004, X uses the proceeds of A's equity investment to make an equity 
investment in Y and X uses the proceeds of B's equity investment to 
make an equity investment in Z. X has no assets other than its 
investments in Y and Z. X controls Y and Z within the meaning of 
paragraph (d)(6)(ii)(B) of this section. For the annual period 
ending July 31, 2005, Y and Z are qualified active low-income 
community businesses (as defined in paragraph (d)(4) of this 
section). Thus, for the annual period ending July 31, 2005, A's and 
B's equity investments satisfy the substantially-all requirement 
under paragraph (c)(5)(i) of this section using either the direct-
tracing calculation under paragraph (c)(5)(ii) of this section or 
the safe harbor calculation under paragraph (c)(5)(iii) of this 
section. For the annual period ending July 31, 2006, Y, but not Z, 
is a qualified active low-income community business. Thus, for the 
annual period ending July 31, 2006--
    (1) X does not satisfy the substantially-all requirement using 
the safe harbor calculation under paragraph (c)(5)(iii) of this 
section;
    (2) A's equity investment satisfies the substantially-all 
requirement using the direct-tracing calculation because A's equity 
investment is directly traceable to Y; and
    (3) B's equity investment does not satisfy the substantially-all 
requirement because B's equity investment is traceable to Z.
    Example 4. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On November 1, 
2004, A pays $100,000 for a capital interest in X. On December 1, 
2004, B pays $100,000 for a capital interest in X. On December 31, 
2004, X uses $85,000 from A's equity investment and $85,000 from B's 
equity investment to make a $170,000 equity investment in Y, a 
qualified active low-income community business (as defined in 
paragraph (d)(4) of this section). X has no assets other than its 
investment in Y. X determines whether A's and B's equity investments 
satisfy the substantially-all requirement under paragraph (c)(5)(i) 
of this section on December 31, 2004. The calculation for A's and 
B's equity investments is 85 percent using either the direct-tracing 
calculation under paragraph (c)(5)(ii) of this section or the safe 
harbor calculation under paragraph (c)(5)(iii) of this section. 
Therefore, for the annual periods ending October 31, 2005, and 
November 30, 2005, A's and B's equity investments, respectively, 
satisfy the substantially-all requirement under paragraph (c)(5)(i) 
of this section. For the subsequent annual period, X performs its 
calculations on December 31, 2005, and June 30, 2006. The average of 
the two calculations on December 31, 2005, and June 30, 2006, is 85 
percent using either the direct-tracing calculation under paragraph 
(c)(5)(ii) of this section or the safe harbor calculation under 
paragraph (c)(5)(iii) of this section. Therefore, for the annual 
periods ending October 31, 2006, and November 30, 2006, A's and B's 
equity investments, respectively, satisfy the substantially-all 
requirement under paragraph (c)(5)(i) of this section.

    (6) Aggregation of equity investments. A CDE may treat any 
qualified equity investments issued on the same day as one qualified 
equity investment. If a CDE aggregates equity investments under this 
paragraph (c)(6), the rules in this section shall be construed in a 
manner consistent with that treatment.
    (7) Subsequent purchasers. A qualified equity investment includes 
any equity investment that would (but for paragraph (c)(1)(i) of this 
section) be a qualified equity investment in the hands of the taxpayer 
if the investment was a qualified equity investment in the hands of a 
prior holder.
    (d) Qualified low-income community investments--(1) In general. The 
term qualified low-income community investment means any of the 
following:
    (i) Investment in a qualified active low-income community business. 
Any capital or equity investment in, or loan to, any qualified active 
low-income community business (as defined in paragraph (d)(4) of this 
section).
    (ii) Purchase of certain loans from CDEs--(A) In general. The 
purchase by a CDE (the ultimate CDE) from another CDE (whether or not 
that CDE has received an allocation from the Secretary under section 
45D(f)(2)) of any loan made by such entity that is a qualified low-
income community investment. A loan purchased by the ultimate CDE from 
another CDE is a qualified low-income community investment if it 
qualifies as a qualified low-income community investment either--
    (1) At the time the loan was made; or
    (2) At the time the ultimate CDE purchases the loan.
    (B) Certain loans made before CDE certification. For purposes of 
paragraph (d)(1)(ii)(A) of this section, a loan by an entity is treated 
as made by a CDE, notwithstanding that the entity was not a CDE at the 
time it made the loan, if the entity is a CDE at the time it sells the 
loan.
    (C) Intermediary CDEs. For purposes of paragraph (d)(1)(ii)(A) of 
this section, the purchase of a loan by the ultimate CDE from a CDE 
that did not make the loan (the second CDE) is treated as a purchase of 
the loan by the ultimate CDE from the CDE that made the loan (the 
originating CDE) if--
    (1) The second CDE purchased the loan from the originating CDE (or 
from another CDE); and
    (2) Each entity that sold the loan was a CDE at the time it sold 
the loan.
    (D) Examples. The following examples illustrate an application of 
this paragraph (d)(1)(ii):

    Example 1. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. Y, a corporation, 
made a $500,000 loan to Z in 1999. In January of 2004, Y is 
certified as a CDE. On September 1, 2004, X purchases the loan from 
Y. At the time X purchases the loan, Z is a qualified active low-
income community business under paragraph (d)(4)(i) of this section. 
Accordingly, the loan purchased by X from Y is a qualified low-
income community investment under paragraphs (d)(1)(ii)(A) and (B) 
of this section.
    Example 2. The facts are the same as in Example 1 except that on 
February 1, 2004, Y sells the loan to W and on September 1, 2004, W 
sells the loan to X. W is a CDE. Under paragraph (d)(1)(ii)(C) of 
this section, X's purchase of the loan from W is treated as the 
purchase of the loan from Y. Accordingly, the loan purchased by X 
from W is a qualified low-income community investment under 
paragraphs (d)(1)(ii)(A) and (C) of this section.
    Example 3. The facts are the same as in Example 2 except that W 
is not a CDE. Because W was not a CDE at the time it sold the loan 
to X, the purchase of the loan by X from W is not a qualified low-
income community investment under paragraphs (d)(1)(ii)(A) and (C) 
of this section.

    (iii) Financial counseling and other services. Financial counseling 
and other services (as defined in paragraph (d)(7) of this section) 
provided to any qualified active low-income community business, or to 
any residents of a low-income community (as defined in section 45D(e)).
    (iv) Investments in other CDEs--(A) In general. Any equity 
investment in, or loan to, any CDE (the second CDE) by a CDE (the 
primary CDE), but only to the

[[Page 77631]]

extent that the second CDE uses the proceeds of the investment or 
loan--
    (1) In a manner--
    (i) That is described in paragraph (d)(1)(i) or (iii) of this 
section; and
    (ii) That would constitute a qualified low-income community 
investment if it were made directly by the primary CDE;
    (2) To make an equity investment in, or loan to, a third CDE that 
uses such proceeds in a manner described in paragraph (d)(1)(iv)(A)(1) 
of this section; or
    (3) To make an equity investment in, or loan to, a third CDE that 
uses such proceeds to make an equity investment in, or loan to, a 
fourth CDE that uses such proceeds in a manner described in paragraph 
(d)(1)(iv)(A)(1) of this section.
    (B) Examples. The following examples illustrate an application of 
paragraph (d)(1)(iv)(A) of this section:

    Example 1. X is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On September 1, 
2004, X uses $975,000 to make an equity investment in Y. Y is a 
corporation and a CDE. On October 1, 2004, Y uses $950,000 from X's 
equity investment to make a loan to Z. Z is a qualified active low-
income community business under paragraph (d)(4)(i) of this section. 
Of X's equity investment in Y, $950,000 is a qualified low-income 
community investment under paragraph (d)(1)(iv)(A)(1) of this 
section.
    Example 2. W is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On September 1, 
2004, W uses $975,000 to make an equity investment in X. On October 
1, 2004, X uses $950,000 from W's equity investment to make an 
equity investment in Y. X and Y are corporations and CDEs. On 
October 5, 2004, Y uses $925,000 from X's equity investment to make 
a loan to Z. Z is a qualified active low-income community business 
under paragraph (d)(4)(i) of this section. Of W's equity investment 
in X, $925,000 is a qualified low-income community investment under 
paragraph (d)(1)(iv)(A)(2) of this section because X uses proceeds 
of W's equity investment to make an equity investment in Y, which 
uses $925,000 of the proceeds in a manner described in paragraph 
(d)(1)(iv)(A)(1) of this section.
    Example 3. U is a partnership and a CDE that has received a new 
markets tax credit allocation from the Secretary. On September 1, 
2004, U uses $975,000 to make an equity investment in V. On October 
1, 2004, V uses $950,000 from U's equity investment to make an 
equity investment in W. On October 5, 2004, W uses $925,000 from V's 
equity investment to make an equity investment in X. On November 1, 
2004, X uses $900,000 from W's equity investment to make an equity 
investment in Y. V, W, X, and Y are corporations and CDEs. On 
November 5, 2004, Y uses $875,000 from X's equity investment to make 
a loan to Z. Z is a qualified active low-income community business 
under paragraph (d)(4)(i) of this section. U's equity investment in 
V is not a qualified low-income community investment because X does 
not use proceeds of W's equity investment in a manner described in 
paragraph (d)(1)(iv)(A)(1) of this section.

    (2) Payments of, or for, capital, equity or principal--(i) In 
general. Except as otherwise provided in this paragraph (d)(2), amounts 
received by a CDE in payment of, or for, capital, equity or principal 
with respect to a qualified low-income community investment must be 
reinvested by the CDE in a qualified low-income community investment no 
later than 12 months from the date of receipt to be treated as 
continuously invested in a qualified low-income community investment. 
If the amounts received by the CDE are equal to or greater than the 
cost basis of the original qualified low-income community investment 
(or applicable portion thereof), and the CDE reinvests, in accordance 
with this paragraph (d)(2)(i), an amount at least equal to such 
original cost basis, then an amount equal to such original cost basis 
will be treated as continuously invested in a qualified low-income 
community investment. In addition, if the amounts received by the CDE 
are equal to or greater than the cost basis of the original qualified 
low-income community investment (or applicable portion thereof), and 
the CDE reinvests, in accordance with this paragraph (d)(2)(i), an 
amount less than such original cost basis, then only the amount so 
reinvested will be treated as continuously invested in a qualified low-
income community investment. If the amounts received by the CDE are 
less than the cost basis of the original qualified low-income community 
investment (or applicable portion thereof), and the CDE reinvests an 
amount in accordance with this paragraph (d)(2)(i), then the amount 
treated as continuously invested in a qualified low-income community 
investment will equal the excess (if any) of such original cost basis 
over the amounts received by the CDE that are not so reinvested. 
Amounts received by a CDE in payment of, or for, capital, equity or 
principal with respect to a qualified low-income community investment 
during the seventh year of the 7-year credit period (as defined in 
paragraph (c)(5)(i) of this section) do not have to be reinvested by 
the CDE in a qualified low-income community investment in order to be 
treated as continuously invested in a qualified low-income community 
investment.
    (ii) Subsequent reinvestments. In applying paragraph (d)(2)(i) of 
this section to subsequent reinvestments, the original cost basis is 
reduced by the amount (if any) by which the original cost basis exceeds 
the amount determined to be continuously invested in a qualified low-
income community investment.
    (iii) Special rule for loans. Periodic amounts received during a 
calendar year as repayment of principal on a loan that is a qualified 
low-income community investment are treated as continuously invested in 
a qualified low-income community investment if the amounts are 
reinvested in another qualified low-income community investment by the 
end of the following calendar year.
    (iv) Example. The application of paragraphs (d)(2)(i) and (ii) of 
this section is illustrated by the following example:

    Example. On April 1, 2003, A, B, and C each pay $100,000 to 
acquire a capital interest in X, a partnership. X is a CDE that has 
received a new markets tax credit allocation from the Secretary. X 
treats the 3 partnership interests as one qualified equity 
investment under paragraph (c)(6) of this section. In August 2003, X 
uses the $300,000 to make a qualified low-income community 
investment under paragraph (d)(1) of this section. In August 2005, 
the qualified low-income community investment is redeemed for 
$250,000. In February 2006, X reinvests $230,000 of the $250,000 in 
a second qualified low-income community investment and uses the 
remaining $20,000 for operating expenses. Under paragraph (d)(2)(i) 
of this section, $280,000 of the proceeds of the qualified equity 
investment is treated as continuously invested in a qualified low-
income community investment. In December 2008, X sells the second 
qualified low-income community investment and receives $400,000. In 
March 2009, X reinvests $320,000 of the $400,000 in a third 
qualified low-income community investment. Under paragraphs 
(d)(2)(i) and (ii) of this section, $280,000 of the proceeds of the 
qualified equity investment is treated as continuously invested in a 
qualified low-income community investment ($40,000 is treated as 
invested in another qualified low-income community investment in 
March 2009).

    (3) Special rule for reserves. Reserves (not in excess of 5 percent 
of the taxpayer's cash investment under paragraph (b)(4) of this 
section) maintained by the CDE for loan losses or for additional 
investments in existing qualified low-income community investments are 
treated as invested in a qualified low-income community investment 
under paragraph (d)(1) of this section. Reserves include fees paid to 
third parties to protect against loss of all or a portion of the 
principal of, or interest on, a loan that is a qualified low-income 
community investment.
    (4) Qualified active low-income community business--(i) In general. 
The term qualified active low-income community business means, with 
respect to any taxable year, a

[[Page 77632]]

corporation (including a nonprofit corporation) or a partnership 
engaged in the active conduct of a qualified business (as defined in 
paragraph (d)(5) of this section), if the requirements in paragraphs 
(d)(4)(i)(A), (B), (C), (D), and (E) of this section are met. Solely 
for purposes of this section, a nonprofit corporation will be deemed to 
be engaged in the active conduct of a trade or business if it is 
engaged in an activity that furthers its purpose as a nonprofit 
corporation.
    (A) Gross-income requirement. At least 50 percent of the total 
gross income of such entity is derived from the active conduct of a 
qualified business (as defined in paragraph (d)(5) of this section) 
within any low-income community (as defined in section 45D(e)). An 
entity is deemed to satisfy this paragraph (d)(4)(i)(A) if the entity 
meets the requirements of either paragraph (d)(4)(i)(B) or (C) of this 
section, if ``50 percent'' is applied instead of 40 percent. In 
addition, an entity may satisfy this paragraph (d)(4)(i)(A) based on 
all the facts and circumstances. See paragraph (d)(4)(iv) of this 
section for certain circumstances in which an entity will be treated as 
engaged in the active conduct of a trade or business.
    (B) Use of tangible property--(1) In general. At least 40 percent 
of the use of the tangible property of such entity (whether owned or 
leased) is within any low-income community. This percentage is 
determined based on a fraction the numerator of which is the average 
value of the tangible property owned or leased by the entity and used 
by the entity during the taxable year in a low-income community and the 
denominator of which is the average value of the tangible property 
owned or leased by the entity and used by the entity during the taxable 
year. Property owned by the entity is valued at its cost basis as 
determined under section 1012. Property leased by the entity is valued 
at a reasonable amount established by the entity.
    (2) Example. The application of paragraph (d)(4)(i)(B)(1) of this 
section is illustrated by the following example:

    Example.  X is a corporation engaged in the business of moving 
and hauling scrap metal. X operates its business from a building and 
an adjoining parking lot that X owns. The building and the parking 
lot are located in a low-income community (as defined in section 
45D(e)). X's cost basis under section 1012 for the building and 
parking lot is $200,000. During the taxable year, X operates its 
business 10 hours a day, 6 days a week. X owns and uses 40 trucks in 
its business, which, on average, are used 6 hours a day outside a 
low-income community and 4 hours a day inside a low-income community 
(including time in the parking lot). The cost basis under section 
1012 of each truck is $25,000. During non-business hours, the trucks 
are parked in the lot. Only X's 10-hour business days are used in 
calculating the use of tangible property percentage under paragraph 
(d)(4)(i)(B)(1) of this section. Thus, the numerator of the tangible 
property calculation is $600,000 (\4/10\ of $1,000,000 (the $25,000 
cost basis of each truck times 40 trucks) plus $200,000 (the cost 
basis of the building and parking lot)) and the denominator is 
$1,200,000 (the total cost basis of the trucks, building, and 
parking lot), resulting in 50 percent of the use of X's tangible 
property being within a low-income community. Consequently, X 
satisfies the 40 percent use of tangible property test under 
paragraph (d)(4)(i)(B)(1) of this section.

    (C) Services performed. At least 40 percent of the services 
performed for such entity by its employees are performed in a low-
income community. This percentage is determined based on a fraction the 
numerator of which is the total amount paid by the entity for employee 
services performed in a low-income community during the taxable year 
and the denominator of which is the total amount paid by the entity for 
employee services during the taxable year. If the entity has no 
employees, the entity is deemed to satisfy this paragraph (d)(4)(i)(C), 
and paragraph (d)(4)(i)(A) of this section, if the entity meets the 
requirement of paragraph (d)(4)(i)(B) of this section if ``85 percent'' 
is applied instead of 40 percent.
    (D) Collectibles. Less than 5 percent of the average of the 
aggregate unadjusted bases of the property of such entity is 
attributable to collectibles (as defined in section 408(m)(2)) other 
than collectibles that are held primarily for sale to customers in the 
ordinary course of business.
    (E) Nonqualified financial property--(1) In general. Less than 5 
percent of the average of the aggregate unadjusted bases of the 
property of such entity is attributable to nonqualified financial 
property. For purposes the preceding sentence, the term nonqualified 
financial property means debt, stock, partnership interests, options, 
futures contracts, forward contracts, warrants, notional principal 
contracts, annuities, and other similar property except that such term 
does not include--
    (i) Reasonable amounts of working capital held in cash, cash 
equivalents, or debt instruments with a term of 18 months or less 
(because the definition of nonqualified financial property includes 
debt instruments with a term in excess of 18 months, banks, credit 
unions, and other financial institutions are generally excluded from 
the definition of a qualified active low-income community business); or
    (ii) Debt instruments described in section 1221(a)(4).
    (2) Construction of real property. For purposes of paragraph 
(d)(4)(i)(E)(1)(i) of this section, the proceeds of a capital or equity 
investment or loan by a CDE that will be expended for construction of 
real property within 12 months after the date the investment or loan is 
made are treated as a reasonable amount of working capital.
    (ii) Proprietorships. Any business carried on by an individual as a 
proprietor is a qualified active low-income community business if the 
business would meet the requirements of paragraph (d)(4)(i) of this 
section if the business were incorporated.
    (iii) Portions of business--(A) In general. A CDE may treat any 
trade or business (or portion thereof) as a qualified active low-income 
community business if the trade or business (or portion thereof) would 
meet the requirements of paragraph (d)(4)(i) of this section if the 
trade or business (or portion thereof) were separately incorporated and 
a complete and separate set of books and records is maintained for that 
trade or business (or portion thereof). However, the CDE's capital or 
equity investment or loan is not a qualified low-income community 
investment under paragraph (d)(1)(i) of this section to the extent the 
proceeds of the investment or loan are not used for the trade or 
business (or portion thereof) that is treated as a qualified active 
low-income community business under this paragraph (d)(4)(iii)(A).
    (B) Examples. The following examples illustrate an application of 
paragraph (d)(4)(iii) of this section:

    Example 1. X is a partnership and a CDE that receives a new 
markets tax credit allocation from the Secretary. A pays $1 million 
for a capital interest in X. Z is a corporation that operates a 
supermarket that is not in a low-income community (as defined in 
section 45D(e)). X uses the proceeds of A's equity investment to 
make a loan to Z that Z will use to construct a new supermarket in a 
low-income community. Z will maintain a complete and separate set of 
books and records for the new supermarket. The proceeds of X's loan 
to Z will be used exclusively for the new supermarket. Assume that 
Z's new supermarket in the low-income community would meet the 
requirements to be a qualified active low-income community business 
under paragraph (d)(4)(i) of this section if it were separately 
incorporated. Pursuant to paragraph (d)(4)(iii)(A) of this section, 
X treats Z's new supermarket as the qualified active low-income 
community business. Accordingly, X's loan to Z is a qualified low-
income community investment under paragraph (d)(1)(i) of this 
section.

[[Page 77633]]

    Example 2. X is a partnership and a CDE that receives a new 
markets tax credit allocation from the Secretary. A pays $1 million 
for a capital interest in X. Z is a corporation that operates a 
liquor store in a low-income community (as defined in section 
45D(e)). A liquor store is not a qualified business under paragraph 
(d)(5)(iii)(B) of this section. X uses the proceeds of A's equity 
investment to make a loan to Z that Z will use to construct a 
restaurant next to the liquor store. Z will maintain a complete and 
separate set of books and records for the new restaurant. The 
proceeds of X's loan to Z will be used exclusively for the new 
restaurant. Assume that Z's restaurant would meet the requirements 
to be a qualified active low-income community business under 
paragraph (d)(4)(i) of this section if it were separately 
incorporated. Pursuant to paragraph (d)(4)(iii) of this section, X 
treats Z's restaurant as the qualified active low-income community 
business. Accordingly, X's loan to Z is a qualified low-income 
community investment under paragraph (d)(1)(i) of this section.
    Example 3. X is a partnership and a CDE that receives a new 
markets tax credit allocation from the Secretary. A pays $1 million 
for a capital interest in X. Z is a corporation that operates an 
insurance company in a low-income community (as defined in section 
45D(e)). Five percent or more of the average of the aggregate 
unadjusted bases of Z's property is attributable to nonqualified 
financial property under paragraph (d)(4)(i)(E) of this section. Z's 
insurance operations include different operating units including a 
claims processing unit. X uses the proceeds of A's equity investment 
to make a loan to Z for use in Z's claims processing operations. Z 
will maintain a complete and separate set of books and records for 
the claims processing unit. The proceeds of X's loan to Z will be 
used exclusively for the claims processing unit. Assume that Z's 
claims processing unit would meet the requirements to be a qualified 
active low-income community business under paragraph (d)(4)(i) of 
this section if it were separately incorporated. Pursuant to 
paragraph (d)(4)(iii) of this section, X treats Z's claims 
processing unit as the qualified active low-income community 
business. Accordingly, X's loan to Z is a qualified low-income 
community investment under paragraph (d)(1)(i) of this section.

    (iv) Active conduct of a trade or business--(A) Special rule. For 
purposes of paragraph (d)(4)(i) of this section, an entity will be 
treated as engaged in the active conduct of a trade or business if, at 
the time the CDE makes a capital or equity investment in, or loan to, 
the entity, the CDE reasonably expects that the entity will generate 
revenues (or, in the case of a nonprofit corporation, engage in an 
activity that furthers its purpose as a nonprofit corporation) within 3 
years after the date the investment or loan is made.
    (B) Example. The application of paragraph (d)(4)(iv)(A) of this 
section is illustrated by the following example:

    Example. X is a partnership and a CDE that receives a new 
markets tax credit allocation from the Secretary on July 1, 2004. X 
makes a ten-year loan to Y. Y is a newly formed entity that will own 
and operate a shopping center to be constructed in a low-income 
community. Y has no revenues but X reasonably expects that Y will 
generate revenues beginning in December 2005. Under paragraph 
(d)(4)(iv)(A) of this section, Y is treated as engaged in the active 
conduct of a trade or business for purposes of paragraph (d)(4)(i) 
of this section.

    (5) Qualified business--(i) In general. Except as otherwise 
provided in this paragraph (d)(5), the term qualified business means 
any trade or business. There is no requirement that employees of a 
qualified business be residents of a low-income community.
    (ii) Rental of real property. The rental to others of real property 
located in any low-income community (as defined in section 45D(e)) is a 
qualified business if and only if the property is not residential 
rental property (as defined in section 168(e)(2)(A)) and there are 
substantial improvements located on the real property. For purposes of 
the preceding sentence, the term substantial improvements means 
improvements the cost basis of which equals or exceeds 50 percent of 
the cost basis of the land on which the improvements are located and 
the costs of which are incurred after the date the CDE makes the 
investment or loan. However, a CDE's investment in or loan to a 
business engaged in the rental of real property is not a qualified low-
income community investment under paragraph (d)(1)(i) of this section 
to the extent any lessee of the real property is not a qualified 
business under this paragraph (d)(5).
    (iii) Exclusions--(A) Trades or businesses involving intangibles. 
The term qualified business does not include any trade or business 
consisting predominantly of the development or holding of intangibles 
for sale or license.
    (B) Certain other trades or businesses. The term qualified business 
does not include any trade or business consisting of the operation of 
any private or commercial golf course, country club, massage parlor, 
hot tub facility, suntan facility, racetrack or other facility used for 
gambling, or any store the principal business of which is the sale of 
alcoholic beverages for consumption off premises.
    (C) Farming. The term qualified business does not include any trade 
or business the principal activity of which is farming (within the 
meaning of section 2032A(e)(5)(A) or (B)) if, as of the close of the 
taxable year of the taxpayer conducting such trade or business, the sum 
of the aggregate unadjusted bases (or, if greater, the fair market 
value) of the assets owned by the taxpayer that are used in such a 
trade or business, and the aggregate value of the assets leased by the 
taxpayer that are used in such a trade or business, exceeds $500,000. 
For purposes of this paragraph (d)(5)(iii)(C), two or more trades or 
businesses will be treated as a single trade or business under rules 
similar to the rules of section 52(a) and (b).
    (6) Qualifications--(i) In general. Except as provided in paragraph 
(d)(6)(ii) of this section, an entity is treated as a qualified active 
low-income community business for the duration of the CDE's investment 
in the entity if the CDE reasonably expects, at the time the CDE makes 
the capital or equity investment in, or loan to, the entity, that the 
entity will satisfy the requirements to be a qualified active low-
income community business under paragraph (d)(4)(i) of this section 
throughout the entire period of the investment or loan.
    (ii) Control--(A) In general. If a CDE controls or obtains control 
of an entity at any time during the 7-year credit period (as defined in 
paragraph (c)(5)(i) of this section), the entity will be treated as a 
qualified active low-income community business only if the entity 
satisfies the requirements of paragraph (d)(4)(i) of this section 
throughout the entire period the CDE controls the entity.
    (B) Definition of control. Control means, with respect to an 
entity, direct or indirect ownership (based on value) or control (based 
on voting or management rights) of more than 50 percent of the entity. 
For purposes of the preceding sentence, the term management rights 
means the power to influence the management policies or investment 
decisions of the entity.
    (C) Disregard of control. For purposes of paragraph (d)(6)(ii)(A) 
of this section, the acquisition of control of an entity by a CDE is 
disregarded during the 12-month period following such acquisition of 
control (the 12-month period) if--
    (1) The CDE's capital or equity investment in, or loan to, the 
entity met the requirements of paragraph (d)(6)(i) of this section when 
initially made;
    (2) The CDE's acquisition of control of the entity is due to 
financial difficulties of the entity that were unforeseen at the time 
the investment or loan described in paragraph (d)(6)(ii)(C)(1) of this 
section was made; and
    (3) If the acquisition of control occurs before the seventh year of 
the 7-year

[[Page 77634]]

credit period (as defined in paragraph (c)(5)(i) of this section), 
either--
    (i) The entity satisfies the requirements of paragraph (d)(4) of 
this section by the end of the 12-month period; or
    (ii) The CDE sells or causes to be redeemed the entire amount of 
the investment or loan described in paragraph (d)(6)(ii)(C)(1) of this 
section and, by the end of the 12-month period, reinvests the amount 
received in respect of the sale or redemption in a qualified low-income 
community investment under paragraph (d)(1) of this section. For this 
purpose, the amount treated as continuously invested in a qualified 
low-income community investment is determined under paragraphs 
(d)(2)(i) and (ii) of this section.
    (7) Financial counseling and other services. The term financial 
counseling and other services means advice provided by the CDE relating 
to the organization or operation of a trade or business.
    (8) Special rule for certain loans--(i) In general. For purposes of 
paragraphs (d)(1)(i), (ii), and (iv) of this section, a loan is treated 
as made by a CDE to the extent the CDE purchases the loan from the 
originator (whether or not the originator is a CDE) within 30 days 
after the date the originator makes the loan if, at the time the loan 
is made, there is a legally enforceable written agreement between the 
originator and the CDE which--
    (A) Requires the CDE to approve the making of the loan either 
directly or by imposing specific written loan underwriting criteria; 
and
    (B) Requires the CDE to purchase the loan within 30 days after the 
date the loan is made.
    (ii) Example. The application of paragraph (d)(8)(i) of this 
section is illustrated by the following example:

    Example. (i) X is a partnership and a CDE that has received a 
new markets tax credit allocation from the Secretary. On October 1, 
2004, Y enters into a legally enforceable written agreement with W. 
Y and W are corporations but only Y is a CDE. The agreement between 
Y and W provides that Y will purchase loans (or portions thereof) 
from W within 30 days after the date the loan is made by W, and that 
Y will approve the making of the loans.
    (ii) On November 1, 2004, W makes a $825,000 loan to Z pursuant 
to the agreement between Y and W. Z is a qualified active low-income 
community business under paragraph (d)(4) of this section. On 
November 15, 2004, Y purchases the loan from W for $840,000. On 
December 31, 2004, X purchases the loan from Y for $850,000.
    (iii) Under paragraph (d)(8)(i) of this section, the loan to Z 
is treated as made by Y. Y's loan to Z is a qualified low-income 
community investment under paragraph (d)(1)(i) of this section. 
Accordingly, under paragraph (d)(1)(ii)(A) of this section, X's 
purchase of the loan from Y is a qualified low-income community 
investment in the amount of $850,000.

    (e) Recapture--(1) In general. If, at any time during the 7-year 
period beginning on the date of the original issue of a qualified 
equity investment in a CDE, there is a recapture event under paragraph 
(e)(2) of this section with respect to such investment, then the tax 
imposed by Chapter 1 of the Internal Revenue Code for the taxable year 
in which the recapture event occurs is increased by the credit 
recapture amount under section 45D(g)(2). A recapture event under 
paragraph (e)(2) of this section requires recapture of credits allowed 
to the taxpayer who purchased the equity investment from the CDE at its 
original issue and to all subsequent holders of that investment.
    (2) Recapture event. There is a recapture event with respect to an 
equity investment in a CDE if--
    (i) The entity ceases to be a CDE;
    (ii) The proceeds of the investment cease to be used in a manner 
that satisfies the substantially-all requirement of paragraph 
(c)(1)(ii) of this section; or
    (iii) The investment is redeemed or otherwise cashed out by the 
CDE.
    (3) Redemption--(i) Equity investment in a C corporation. For 
purposes of paragraph (e)(2)(iii) of this section, an equity investment 
in a CDE that is treated as a C corporation for Federal tax purposes is 
redeemed when section 302(a) applies to amounts received by the equity 
holder. An equity investment is treated as cashed out when section 
301(c)(2) or section 301(c)(3) applies to amounts received by the 
equity holder. An equity investment is not treated as cashed out when 
only section 301(c)(1) applies to amounts received by the equity 
holder.
    (ii) Equity investment in an S corporation. For purposes of 
paragraph (e)(2)(iii) of this section, an equity investment in a CDE 
that is an S corporation is redeemed when section 302(a) applies to 
amounts received by the equity holder. An equity investment in an S 
corporation is treated as cashed out when a distribution to a 
shareholder described in section 1368(a) exceeds the accumulated 
adjustments account determined under Sec.  1.1368-2 and any accumulated 
earnings and profits of the S corporation.
    (iii) Capital interest in a partnership. In the case of an equity 
investment that is a capital interest in a CDE that is a partnership 
for Federal tax purposes, a pro rata cash distribution by the CDE to 
its partners based on each partner's capital interest in the CDE during 
the taxable year will not be treated as a redemption for purposes of 
paragraph (e)(2)(iii) of this section if the distribution does not 
exceed the CDE's operating income for the taxable year. In addition, a 
non-pro rata de minimis cash distribution by a CDE to a partner or 
partners during the taxable year will not be treated as a redemption. A 
non-pro rata de minimis cash distribution may not exceed the lesser of 
5 percent of the CDE's operating income for that taxable year or 10 
percent of the partner's capital interest in the CDE. For purposes of 
this paragraph (e)(3)(iii), with respect to any taxable year, operating 
income is the sum of:
    (A) The CDE's taxable income as determined under section 703, 
except that--
    (1) The items described in section 703(a)(1) shall be aggregated 
with the non-separately stated tax items of the partnership; and
    (2) Any gain resulting from the sale of a capital asset under 
section 1221(a) or section 1231 property shall not be included in 
taxable income;
    (B) Deductions under section 165, but only to the extent the losses 
were realized from qualified low-income community investments under 
paragraph (d)(1) of this section;
    (C) Deductions under sections 167 and 168, including the additional 
first-year depreciation under section 168(k);
    (D) Start-up expenditures amortized under section 195; and
    (E) Organizational expenses amortized under section 709.
    (4) Bankruptcy. Bankruptcy of a CDE is not a recapture event.
    (5) Waiver of requirement or extension of time--(i) In general. The 
Commissioner may waive a requirement or extend a deadline if such 
waiver or extension does not materially frustrate the purposes of 
section 45D and this section.
    (ii) Manner for requesting a waiver or extension. A CDE that 
believes it has good cause for a waiver or an extension may request 
relief from the Commissioner in a ruling request. The request should 
set forth all the relevant facts and include a detailed explanation 
describing the event or events relating to the request for a waiver or 
an extension. For further information on the application procedure for 
a ruling, see Rev. Proc. 2005-1 (2005-1 I.R.B. 1) or its successor 
revenue procedure (see Sec.  601.601(d)(2) of this chapter).
    (iii) Terms and conditions. The granting of a waiver or an 
extension to a CDE under this section may require adjustments of the 
CDE's requirements

[[Page 77635]]

under section 45D and this section as may be appropriate.
    (6) Cure period. If a qualified equity investment fails the 
substantially-all requirement under paragraph (c)(5)(i) of this 
section, the failure is not a recapture event under paragraph 
(e)(2)(ii) of this section if the CDE corrects the failure within 6 
months after the date the CDE becomes aware (or reasonably should have 
become aware) of the failure. Only one correction is permitted for each 
qualified equity investment during the 7-year credit period under this 
paragraph (e)(6).
    (7) Example. The application of this paragraph (e) is illustrated 
by the following example:

    Example. In 2003, A and B acquire separate qualified equity 
investments in X, a partnership. X is a CDE that has received a new 
markets tax credit allocation from the Secretary. X uses the 
proceeds of A's qualified equity investment to make a qualified low-
income community investment in Y, and X uses the proceeds of B's 
qualified equity investment to make a qualified low-income community 
investment in Z. Y and Z are not CDEs. X controls both Y and Z 
within the meaning of paragraph (d)(6)(ii)(B) of this section. In 
2003, Y and Z are qualified active low-income community businesses. 
In 2007, Y, but not Z, is a qualified active low-income community 
business and X does not satisfy the substantially-all requirement 
using the safe harbor calculation under paragraph (c)(5)(iii) of 
this section. A's equity investment satisfies the substantially-all 
requirement of paragraph (c)(1)(ii) of this section using the 
direct-tracing calculation of paragraph (c)(5)(ii) of this section 
because A's equity investment is traceable to Y. However, B's equity 
investment fails the substantially-all requirement using the direct-
tracing calculation because B's equity investment is traceable to Z. 
Therefore, under paragraph (e)(2)(ii) of this section, there is a 
recapture event for B's equity investment (but not A's equity 
investment).

    (f) Basis reduction--(1) In general. A taxpayer's basis in a 
qualified equity investment is reduced by the amount of any new markets 
tax credit determined under paragraph (b)(1) of this section with 
respect to the investment. A basis reduction occurs on each credit 
allowance date under paragraph (b)(2) of this section. This paragraph 
(f) does not apply for purposes of sections 1202, 1400B, and 1400F.
    (2) Adjustment in basis of interest in partnership or S 
corporation. The adjusted basis of either a partner's interest in a 
partnership, or stock in an S corporation, must be appropriately 
adjusted to take into account adjustments made under paragraph (f)(1) 
of this section in the basis of a qualified equity investment held by 
the partnership or S corporation (as the case may be).
    (g) Other rules--(1) Anti-abuse. If a principal purpose of a 
transaction or a series of transactions is to achieve a result that is 
inconsistent with the purposes of section 45D and this section, the 
Commissioner may treat the transaction or series of transactions as 
causing a recapture event under paragraph (e)(2) of this section.
    (2) Reporting requirements--(i) Notification by CDE to taxpayer--
(A) Allowance of new markets tax credit. A CDE must provide notice to 
any taxpayer who acquires a qualified equity investment in the CDE at 
its original issue that the equity investment is a qualified equity 
investment entitling the taxpayer to claim the new markets tax credit. 
The notice must be provided by the CDE to the taxpayer no later than 60 
days after the date the taxpayer makes the investment in the CDE. The 
notice must contain the amount paid to the CDE for the qualified equity 
investment at its original issue and the taxpayer identification number 
of the CDE.
    (B) Recapture event. If, at any time during the 7-year period 
beginning on the date of the original issue of a qualified equity 
investment in a CDE, there is a recapture event under paragraph (e)(2) 
of this section with respect to such investment, the CDE must provide 
notice to each holder, including all prior holders, of the investment 
that a recapture event has occurred. The notice must be provided by the 
CDE no later than 60 days after the date the CDE becomes aware of the 
recapture event.
    (ii) CDE reporting requirements to Secretary. Each CDE must comply 
with such reporting requirements to the Secretary as the Secretary may 
prescribe.
    (iii) Manner of claiming new markets tax credit. A taxpayer may 
claim the new markets tax credit for each applicable taxable year by 
completing Form 8874, ``New Markets Credit,'' and by filing Form 8874 
with the taxpayer's Federal income tax return.
    (iv) Reporting recapture tax. If there is a recapture event with 
respect to a taxpayer's equity investment in a CDE, the taxpayer must 
include the credit recapture amount under section 45D(g)(2) on the line 
for recapture taxes on the taxpayer's Federal income tax return for the 
taxable year in which the recapture event under paragraph (e)(2) of 
this section occurs (or on the line for total tax, if there is no such 
line for recapture taxes) and write NMCR (new markets credit recapture) 
next to the entry space.
    (3) Other Federal tax benefits--(i) In general. Except as provided 
in paragraph (g)(3)(ii) of this section, the availability of Federal 
tax benefits does not limit the availability of the new markets tax 
credit. Federal tax benefits that do not limit the availability of the 
new markets tax credit include, for example:
    (A) The rehabilitation credit under section 47;
    (B) All deductions under sections 167 and 168, including the 
additional first-year depreciation under section 168(k), and the 
expense deduction for certain depreciable property under section 179; 
and
    (C) All tax benefits relating to certain designated areas such as 
empowerment zones and enterprise communities under sections 1391 
through 1397D, the District of Columbia Enterprise Zone under sections 
1400 through 1400B, renewal communities under sections 1400E through 
1400J, and the New York Liberty Zone under section 1400L.
    (ii) Low-income housing credit. If a CDE makes a capital or equity 
investment or a loan with respect to a qualified low-income building 
under section 42, the investment or loan is not a qualified low-income 
community investment under paragraph (d)(1) of this section to the 
extent the building's eligible basis under section 42(d) is financed by 
the proceeds of the investment or loan.
    (4) Bankruptcy of CDE. The bankruptcy of a CDE does not preclude a 
taxpayer from continuing to claim the new markets tax credit on the 
remaining credit allowance dates under paragraph (b)(2) of this 
section.
    (h) Effective dates--(1) In general. Except as provided in 
paragraph (h)(2) of this section, this section applies on or after 
December 22, 2004, and may be applied by taxpayers before December 22, 
2004. The provisions that apply before December 22, 2004, are contained 
in Sec.  1.45D-1T (see 26 CFR part 1 revised as of April 1, 2003, and 
April 1, 2004).
    (2) Exception for certain provisions. Paragraph (d)(5)(ii) of this 
section as it relates to the definition of the term substantial 
improvements and the requirement that each lessee must be a qualified 
business applies to qualified low-income community investments made on 
or after February 22, 2005.


Sec.  1.45D-1T  [Removed]

0
Par. 3. Section 1.45D-1T is removed.

[[Page 77636]]

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 4. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

0
Par. 5. In Sec.  602.101, paragraph (b) is amended by removing the 
entry for ``1.45D-1T'' from the table.
0
Par. 6. In Sec.  602.101, paragraph (b) is amended by adding an entry 
to the table in numerical order to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
 
                                * * * * *
1.45D-1....................................................    1545-1765
 
                                * * * * *
------------------------------------------------------------------------


Mark E. Mathews,
Deputy Commissioner for Services and Enforcement.
    Approved: December 21, 2004.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 04-28325 Filed 12-22-04; 12:38 pm]
BILLING CODE 4830-01-P