[Federal Register Volume 67, Number 1 (Wednesday, January 2, 2002)]
[Rules and Regulations]
[Pages 8-17]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-31969]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8975]
RIN 1545-BA21


Certain Transfers of Property to Regulated Investment Companies 
[RICs] and Real Estate Investment Trusts [REITs]

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations that apply to 
certain transactions or events that result in a Regulated Investment 
Company [RIC] or a Real Estate Investment Trust [REIT] owning property 
that has a basis determined by reference to a C corporation's basis in 
the property. These regulations affect RICs, REITs, and C corporations 
and clarify the tax treatment of transfers of C corporation property to 
a RIC or REIT. The text of the temporary regulations also serves as the 
text of the proposed regulations set forth in the notice of proposed 
rulemaking on this subject in the Proposed Rules section of this issue 
of the Federal Register.

DATES: Effective Date: These regulations are effective January 2, 2002.
    Applicability Dates: For dates of applicability, see 
Secs. 1.337(d)-6T(e) and 1.337(d)-7T(f).

FOR FURTHER INFORMATION CONTACT: Lisa A. Fuller, (202) 622-7750 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    These temporary regulations are being issued without prior notice 
and public procedure pursuant to the Administrative Procedure Act (5 
U.S.C. 553). For this reason, the collection of information contained 
in these regulations has been reviewed and, pending receipt and 
evaluation of public comments, approved by the Office of Management and 
Budget under control number 1545-1672. Responses to this collection of 
information are required to obtain a benefit, i.e., to elect to 
recognize gain as if the C corporation had sold the property at fair 
market value or to elect section 1374 treatment.
    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.
    For further information concerning this collection of information, 
and where to submit comments on the collection of information and the 
accuracy of the estimated burden, and suggestions for reducing this 
burden, please refer to the preamble to the cross-referencing notice of 
proposed rulemaking published in the Proposed Rules section of this 
issue of the Federal Register.
    Books or records relating to a 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. 
section 6103.

Background

    Sections 631 and 633 of the Tax Reform Act of 1986 (the 1986 Act) 
(Public Law 99-514, 100 Stat. 2085, 2272), as amended by section 
1006(e) and (g) of the Technical and Miscellaneous Revenue Act of 1988 
(the 1988 Act) (Public Law 100-647, 102 Stat. 3342, 3400-01), amended 
the Internal Revenue Code (Code) to repeal the General Utilities 
doctrine. In particular, the 1986 Act amended sections 336 and 337 to 
require corporations to recognize gain or loss on the distribution of 
property in connection with complete liquidations other than certain 
subsidiary liquidations. Section 337(d) directs the Secretary to 
prescribe regulations as may be necessary to carry out the purposes of 
General Utilities repeal, including rules to ``ensure that such 
purposes may not be circumvented * * * through the use of a regulated 
investment company, a real estate investment trust, or tax-exempt 
entity * * *'' Absent special rules, the transfer of property owned by 
a C corporation to a RIC or REIT could result in permanently removing 
the property's built-in gain from tax at the corporate level, because 
RICs and REITs generally are not subject to tax on income that is 
distributed to their shareholders.
    On February 4, 1988, the IRS issued Notice 88-19 (1988-1 C.B. 486) 
announcing its intention to promulgate regulations under the authority 
of section 337(d) with respect to transactions or events that result in 
a RIC or REIT owning property that has a basis determined by reference 
to a C corporation's basis (a carryover basis). Notice 88-19 provided 
that the regulations would apply with respect to the net built-in gain 
of C corporation assets that become assets of a RIC or REIT by the 
qualification of a C corporation as a RIC or REIT or by the transfer of 
assets of a C corporation to a RIC or REIT (a conversion transaction). 
The Notice further provided that, where the regulations apply, the C 
corporation would be treated, for all purposes, as if it had sold all 
of its assets at their respective fair market values and immediately 
liquidated. The Notice provided, however, that the regulations would 
not allow the recognition of a net loss and that, except as provided in 
the Notice, the regulations would not affect the characterization for 
tax purposes of, or the tax treatment of parties to, any transactions 
to which they apply. For example, shareholders of a C corporation who 
received RIC shares in a transaction that qualified as a reorganization 
under section 368(a)(1)(C) would not recognize gain or loss solely 
because the C corporation was subject to tax. The Notice also provided 
that immediate gain recognition could be avoided if the C corporation 
that qualified as a RIC or REIT or the transferee RIC or REIT, as the 
case may have been, elected to be subject to tax under section 1374 
with respect to the C corporation property. Notice 88-19 also indicated 
that the regulations would apply retroactively to June 10, 1987. Notice 
88-96 (1988-2 C.B. 420), amplifies Notice 88-19 by

[[Page 9]]

providing that the regulations described in Notice 88-19 would provide 
an exception to the general gain recognition rules for any C 
corporation that qualified to be taxed as a RIC for at least one 
taxable year, then failed to so qualify for one taxable year, and then 
requalified to be taxed as a RIC in the next taxable year.
    On February 7, 2000, Treasury and the IRS published temporary 
regulations [TD 8872] (the 2000 temporary regulations) reflecting the 
principles set forth in Notice 88-19 and Notice 88-96, a notice of 
proposed rulemaking by cross-reference to temporary regulations, and a 
notice of public hearing [REG-209135-88]. The 2000 temporary 
regulations apply retroactively to June 10, 1987.
    Treasury and the IRS have received a number of comments, both 
written and oral, on the 2000 temporary regulations. A public hearing 
was held on May 10, 2000. After considering these comments, Treasury 
and the IRS have decided to issue two new sets of temporary 
regulations, one that will apply to conversion transactions occurring 
on or after June 10, 1987 and before January 2, 2002 (the -6T 
regulations), and another that will apply to conversion transactions 
occurring on or after January 2, 2002 (the -7T regulations). 
Alternatively, taxpayers generally may apply the 2000 temporary 
regulations in lieu of the -6T regulations to any conversion 
transaction that occurred on or after June 10, 1987 and before January 
2, 2002. However, RICs and REITs that rely on the 2000 temporary 
regulations and that are subject to section 1374 treatment may not rely 
on certain provisions in the 2000 temporary regulations, but instead 
must apply certain provisions of the -6T regulations, with respect to 
built-in gains and losses recognized in taxable years beginning on or 
after January 2, 2002. Furthermore, taxpayers are not prevented from 
relying on the 2000 temporary regulations merely because they elect 
section 1374 treatment in the manner described in the -6T regulations 
rather than in the manner described in the 2000 temporary regulations.

Explanation of Provisions

    This preamble first discusses the -6T regulations and how the -6T 
regulations differ from the 2000 temporary regulations. This preamble 
then explains the differences between the -7T regulations and the -6T 
regulations.

Summary of -6T Regulations

    The -6T regulations provide that, if property of a C corporation 
that is not a RIC or REIT becomes the property of a RIC or REIT in a 
conversion transaction, then the C corporation is subject to deemed 
sale treatment, unless the RIC or REIT elects to be subject to section 
1374 treatment. Thus, the C corporation generally recognizes gain and 
loss as if it sold the property converted to RIC or REIT property or 
transferred to the RIC or REIT (the converted property) to an unrelated 
party at fair market value immediately before the conversion 
transaction. If the C corporation recognizes net gain on the deemed 
sale, then the basis of the converted property in the hands of the RIC 
or REIT is adjusted to its fair market value immediately before the 
conversion transaction. The -6T regulations do not permit a C 
corporation to recognize a net loss on the deemed sale. For this 
purpose, net loss is defined as the excess of aggregate losses over 
aggregate gains (including items of income), without regard to 
character. Where there is a net loss, the C corporation recognizes no 
gain or loss on the deemed sale, and the C corporation's basis in the 
converted property carries over to the RIC or REIT.

Clarification of Deemed Sale Treatment

    The 2000 temporary regulations provide that, unless a section 1374 
election is made, a C corporation that elects RIC or REIT status or 
transfers property to a RIC or REIT is ``treated for all purposes, 
including recognition of net built-in gain, as if it had sold all of 
its assets at their respective fair market values on the deemed 
liquidation date * * * and immediately liquidated.'' Commentators 
objected to this provision on two grounds. First, they argued that the 
provision is overly broad, because it treats the C corporation that is 
transferring property to a RIC or REIT as having sold all of its 
property, even where all of its property may not have been transferred 
to the RIC or REIT. Second, they argued that the ``for all purposes'' 
language could be read to suggest that the deemed liquidation results 
in the imposition of a shareholder tax, a result that they view as 
inconsistent with Notice 88-19 and the purposes of section 337(d). 
Commentators also argued that deemed liquidation treatment would 
inappropriately eliminate the C corporation's tax attributes, such as 
net operating loss carryforwards and earnings and profits, to which the 
RIC or REIT might otherwise succeed.
    Treasury and the IRS agree with these comments. Accordingly, the -
6T regulations clarify that the C corporation is treated as having sold 
only that property actually transferred to the RIC or REIT and that a 
shareholder-level tax is not imposed. In addition, the deemed 
liquidation construct has been eliminated.

Deemed Sale Loss Disallowance

    The 2000 temporary regulations do not permit a C corporation to 
recognize a net loss on a conversion transaction. Some commentators 
argued that loss disallowance is inappropriate, noting that a net loss 
can be recognized under section 336 and Sec. 1.337(d)-4, which governs 
certain transfers of property from taxable to tax-exempt entities.
    Treasury and the IRS believe that loss disallowance is appropriate 
in the context of the -6T regulations for two reasons. First, Treasury 
and the IRS are concerned that a C corporation may selectively 
contribute loss property to a RIC or REIT in a section 351 transaction, 
generating an immediate loss. Because section 336 and Sec. 1.337(d)-4 
apply only where a C corporation transfers substantially all of its 
assets, selective contribution concerns are minimal in those contexts. 
Second, section 336 and Sec. 1.337(d)-4 require C corporations to 
recognize both gains and losses immediately, whereas the -6T 
regulations allow taxpayers to defer the recognition of net gain on a 
conversion transaction by making an election to be subject to tax under 
section 1374. Allowing immediate net loss recognition while allowing 
deferral of net gain would provide C corporations engaging in 
conversion transactions with an inappropriate degree of selectivity. 
Taxpayers that otherwise would recognize a net gain on a conversion 
transaction would likely elect section 1374 treatment. Taxpayers that 
would recognize a net loss on a conversion transaction would likely 
choose deemed sale treatment. For these reasons, the -6T regulations 
disallow recognition of a net loss on a conversion transaction.

Section 1374 Double Tax Issue

    Some commentators argued that conversion transactions do not 
implicate concerns regarding avoidance of General Utilities repeal to 
the extent that the RIC or REIT has C corporations as shareholders 
after the conversion transaction. The commentators explained that, if a 
C corporation continues to own stock in the RIC or REIT after a 
conversion transaction, then the built-in gain attributable to the 
transferred property is preserved in the basis of the C corporation's 
RIC or REIT stock. Further, the C corporation generally will be fully 
taxable on dividends distributed by the RIC or REIT, even where the RIC 
or REIT pays

[[Page 10]]

tax on built-in gains. Accordingly, the commentators requested that the 
2000 temporary regulations be modified to mitigate the combined impact 
of tax at the RIC or REIT level under section 1374 and tax at the C 
corporation shareholder level on RIC and REIT dividends.
    Treasury and the IRS considered several approaches suggested by 
commentators for mitigating this double corporate tax. These approaches 
include: (1) Exempting section 351 transfers of property by a C 
corporation to a RIC or REIT from the scope of these regulations, (2) 
removing the requirement that RICs and REITs distribute recognized 
built-in gains, and (3) allowing C corporation shareholders of RICs and 
REITs to claim a dividends received deduction for built-in gains 
distributed by the RIC or REIT.
    After consideration, Treasury and the IRS decided that it could not 
accept any of these approaches. The first two approaches were not 
accepted because they could create opportunities to avoid corporate-
level tax on built-in gains. The third approach was not accepted 
because the dividends received deduction is only available for 
distributions characterized as ordinary income, not distributions 
characterized as capital gains. As explained below, under the -6T 
regulations, RICs and REITs may characterize most distributions of 
built-in gains as capital gain dividends. Moreover, all three 
approaches would give rise to administrative difficulties that could be 
addressed only through extensive rulemaking.

Section 1374  Operational Rules

    The 2000 temporary regulations provide that the built-in gain of a 
RIC or REIT electing section 1374 treatment and the corporate-level tax 
imposed on that gain are subject to rules similar to the rules relating 
to net income from foreclosure property (NIFP) of REITs. The comments 
pointed out certain differences between the section 1374 rules and the 
NIFP rules. For example, under section 1374, any recognized built-in 
gain retains its character as capital gain or ordinary income. In 
contrast, NIFP is always treated as ordinary income. In addition, net 
operating losses of a C corporation can offset recognized built-in 
gains of an S corporation but cannot offset NIFP. Similarly, business 
credit carryforwards from a C corporation can reduce the tax on the net 
recognized built-in gain of an S corporation but cannot reduce the tax 
on NIFP.
    In light of these differences, Treasury and the IRS have adopted an 
alternative approach that does not rely on the NIFP rules for 
coordinating the built-in gains tax imposed by this section with the 
provisions of subchapter M. Unlike the NIFP rules, this approach 
generally preserves the character of recognized built-in gains and 
recognized built-in losses. Under this approach, recognized built-in 
gains and recognized built-in losses that have been taxed in accordance 
with these regulations are treated like other gains and losses of RICs 
and REITs that are not subject to tax under these regulations. Thus, 
they are included in computing investment company taxable income for 
purposes of section 852(b)(2), real estate investment trust taxable 
income for purposes of section 857(b)(2), net capital gain for purposes 
of sections 852(b)(3) and 857(b)(3), gross income derived from sources 
within any foreign country or possession of the United States for 
purposes of section 853, and the dividends paid deduction for purposes 
of sections 852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B), and 857(b)(3)(A).
    In addition, consistent with section 1374, the -6T regulations 
generally allow RICs and REITs to use loss carryforwards and credits 
and credit carryforwards arising in taxable years for which the 
corporation that generated the attribute was a C corporation (and not a 
RIC or REIT) to reduce net recognized built-in gain and the tax 
thereon, subject to the limitations imposed by sections 1374(b)(2) and 
(b)(3) and Secs. 1.1374-5 and 1.1374-6. In addition, the -6T 
regulations provide an ordering rule for applying loss carryforwards, 
credits, and credit carryforwards to reduce net recognized built-in 
gain (and the tax thereon) and RIC or REIT taxable income (and the tax 
thereon). Under this ordering rule, loss carryforwards of a RIC or REIT 
must be used to reduce net recognized built-in gain for a taxable year 
to the greatest extent possible before such losses can be used to 
reduce investment company taxable income for purposes of section 852(b) 
or real estate investment trust taxable income for purposes of section 
857(b) for that taxable year. Similarly, credits and credit 
carryforwards of a RIC or REIT must be used to reduce the tax on net 
recognized built-in gain imposed under this section for the taxable 
year to the greatest extent possible before such credits and credit 
carryforwards can be used to reduce the tax, if any, on investment 
company taxable income for purposes of section 852(b) or on real estate 
investment trust taxable income for purposes of section 857(b) for that 
taxable year.
    The -6T regulations also make adjustments to the taxable income 
limitation of section 1374 to take into account items that are unique 
to REITs. Under the -6T regulations, taxable income of a RIC or REIT is 
initially computed under sections 1374(d)(2) and 1375(b)(1)(B) as if 
the RIC or REIT were an S corporation. Thus, the RIC's or REIT's 
taxable income is its taxable income under section 63(a) without regard 
to--(i) deductions allowed by part VIII of subchapter B (other than the 
deduction allowed by section 248, relating to organizational 
expenditures), and (ii) the deduction under section 172. In addition, 
the RIC or REIT would not be allowed a deduction for dividends paid, as 
the dividends paid deduction is not available to S corporations. Under 
the -6T regulations, this amount is then reduced for REITs by certain 
items that are subject to a 100-percent penalty tax. Items subject to a 
100-percent penalty tax, along with net income from foreclosure 
property, are also excluded in computing a REIT's net recognized built-
in gain.
    In response to comments, the -6T regulations also provide that the 
entity-level tax imposed on net recognized built-in gain is treated as 
a loss that reduces the RIC's or REIT's taxable income and earnings and 
profits. The character of the loss attributable to the tax on net 
recognized built-in gain is determined by allocating the tax 
proportionately (based on recognized built-in gain) among the items of 
recognized built-in gain included in net recognized built-in gain. With 
respect to RICs, the tax imposed on net recognized built-in gain is 
treated as attributable to the portion of the RIC's taxable year 
occurring after October 31.
    Commentators also requested that built-in gain recognized by a RIC 
or REIT that is subject to section 1374 treatment generate subchapter M 
earnings and profits. They explained that a RIC or REIT cannot qualify 
as such under subchapter M if it retains any subchapter C earnings and 
profits. Thus, if earnings and profits attributable to recognized 
built-in gain were subchapter C earnings and profits, a RIC or REIT 
would retain its qualification only if it distributed 100 percent of 
the net recognized built-in gain in excess of the entity-level tax. In 
response to these comments, the examples in the -6T regulations clarify 
that earnings and profits attributable to built-in gain recognized by a 
RIC or REIT are subchapter M earnings and profits.

Electing Section 1374  Treatment

    The 2000 temporary regulations provide that a RIC or REIT makes a 
section 1374 election by attaching a statement to its Federal income 
tax

[[Page 11]]

return for the first taxable year in which the assets of a C 
corporation become assets of the RIC or REIT. The 2000 temporary 
regulations also provide a special rule for making a section 1374 
election where the first taxable year in which the assets of a C 
corporation became the assets of a RIC or REIT ends after June 10, 
1987, but before March 8, 2000 (an interim period election). Under the 
2000 temporary regulations, a RIC or REIT may file an interim period 
election with its first Federal income tax return filed after March 8, 
2000.
    Commentators expressed concern that the rule applicable to interim 
period elections required a RIC or REIT to make an election on its 
first Federal income tax return filed after March 8, 2000, even if the 
RIC or REIT previously had made a section 1374 election. They also 
expressed concern that RICs and REITs were not given sufficient time 
after the promulgation of the 2000 temporary regulations to make 
interim period elections. In response to these comments, the -6T 
regulations allow a RIC or REIT that converted from a C corporation or 
acquired property with a carryover basis from a C corporation before 
January 2, 2002, to make a section 1374 election with any Federal 
income tax return filed by the RIC or REIT on or before March 15, 2003, 
provided that the RIC or REIT has reported consistently with such 
election for all periods. In addition, under the -6T regulations, an 
interim period election is not necessary if the RIC or REIT can 
demonstrate that it has previously informed the IRS of its intent to 
make a section 1374 election.
    Some commentators also requested that Treasury and the IRS clarify 
that a RIC or REIT must make a separate section 1374 election for each 
conversion transaction in which it participates. The -6T regulations 
make this clarification. Thus, a RIC or REIT can elect section 1374 
treatment for one conversion transaction and not elect section 1374 
treatment for another conversion transaction.

Exception for Re-Election of RIC or REIT Status

    Under the 2000 temporary regulations, the rule requiring 
recognition of gain on a conversion transaction does not apply to a C 
corporation that qualified to be a RIC for at least one taxable year, 
then failed to so qualify for a period not in excess of one taxable 
year, and then requalifies as a RIC. Although this exception implements 
Notice 88-96, the language of the 2000 temporary regulations differs 
slightly from the language used in Notice 88-96. Some commentators have 
noted that the change in language might be misinterpreted as a 
substantive change where none was intended. In response to these 
comments, this language has been clarified in the -6T regulations.
    In addition, some commentators requested that the exception be 
expanded to cover periods longer than one taxable year. They argued 
that a corporation that fails to meet the RIC qualification 
requirements for as short a period as 6 months could be taxed as a C 
corporation for two taxable years. This could happen where a RIC fails 
the quarterly diversification test for the last quarter of one calendar 
year and the first quarter of the subsequent calendar year.
    Other commentators requested that this exception be expanded to 
cover REITs. They noted that Congress generally treats RICs and REITs 
similarly and that there is no justification for excluding REITs from 
the benefit of this exception.
    The -6T regulations incorporate these comments by extending the 
exception to REITs and the maximum period for loss of RIC or REIT 
status from one taxable year to two taxable years.

Retention of Retroactive Effective Date

    Commentators argued that, due to the 12-year gap between the 
promulgation of Notice 88-19 and the issuance of the regulations 
implementing Notice 88-19, the regulations should not apply 
retroactively.
    Notice 88-19 notified taxpayers that the section 337(d) regulations 
would apply as of June 10, 1987. The 2000 temporary regulations, which 
were published on February 7, 2000, do, in fact, apply as of June 10, 
1987. Moreover, since February 7, 2000, taxpayers have relied on the 
2000 temporary regulations. For these reasons, the 2000 temporary 
regulations and the -6T regulations retain the June 10, 1987, 
applicability date.

Summary of -7T Regulations

    The -7T regulations follow the -6T regulations in most respects. 
However, certain changes were included in the -7T regulations that were 
not included in the -6T regulations, because Treasury and the IRS were 
concerned that these changes, if made retroactively, could have an 
adverse impact on taxpayers that have relied on the 2000 temporary 
regulations. The following sections highlight these differences between 
the -6T regulations and the -7T regulations.

Section 1374  Treatment as Default Rule

    A number of commentators, particularly REIT commentators, expressed 
the view that, when a C corporation engages in a conversion 
transaction, section 1374 treatment should apply automatically and 
taxpayers that desire deemed sale treatment should be allowed to elect 
such treatment. They pointed out that the automatic application of a 
section 1374 regime is consistent with the treatment of C corporations 
that elect S status. Further, they argued that most taxpayers would 
prefer to be subject to section 1374 treatment than to deemed sale 
treatment. If section 1374 treatment is the default treatment, then the 
incidence of inadvertent failures to make elections will be reduced. 
However, to protect the expectations of taxpayers that engaged in 
conversion transactions prior to the promulgation of these regulations, 
the commentators recommended that section 1374 treatment be adopted as 
the default treatment on a prospective basis. In accordance with these 
comments, the -7T regulations provide that section 1374 treatment 
applies unless the C corporation elects deemed sale treatment.

Anti-Stuffing Rule for Taxpayers Electing Deemed Sale Treatment

    Treasury and the IRS are concerned that taxpayers electing deemed 
sale treatment might attempt to decrease net gains on conversion 
transactions by stuffing loss property into a C corporation prior to a 
conversion transaction. Treasury and the IRS note that section 336 and 
Sec. 1.337(d)-4 both have anti-stuffing rules. Accordingly, the -7T 
regulations include an anti-stuffing rule applicable to transactions 
taxed under the deemed sale approach. The anti-stuffing rule is similar 
to those contained in section 336 and Sec. 1.337(d)-4.

Aggregate Principles To Apply to Partnership Transactions

    Treasury and the IRS believe that a partnership with C corporation 
partners should be treated as an aggregate for purposes of applying 
these regulations. Accordingly, the -7T regulations provide that these 
regulations apply to property transferred by a partnership to a RIC or 
REIT to the extent of any C corporation partner's proportionate share 
of the transferred property. For example, if a C corporation owns a 20 
percent interest in a partnership and that partnership contributes an 
asset to a REIT in a section 351 transaction, then the partnership 
shall be treated as a C corporation with respect to 20 percent of the 
asset contributed to the REIT. If the partnership were to elect deemed 
sale treatment with respect to such

[[Page 12]]

transfer, then any gain recognized by the partnership on the deemed 
sale must be specially allocated to the C corporation partner.

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. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
refer to the Special Analyses section of the preamble to the cross-
reference notice of proposed rulemaking published in the Proposed Rules 
section in this issue of the Federal Register. Pursuant to section 
7805(f) of the Code, these temporary regulations will be 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 Lisa A. Fuller of the 
Office of Associate Chief Counsel (Corporate). Other personnel from 
Treasury Department and the IRS 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

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

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.337(d)-6T also issued under 26 U.S.C. 337.
    Section 1.337(d)-7T also issued under 26 U.S.C. 337. * * *


    Par. 2. Sec. 1.337(d)-5T is amended by:
    1. Revising the section heading.
    2. Revising paragraph (d).
    The revisions read as follows:


Sec. 1.337(d)-5T  Old transitional rules imposing tax on property owned 
by a C corporation that becomes property of a RIC or REIT (temporary).

* * * * *
    (d) Effective date. In the case of carryover basis transactions 
involving the transfer of property of a C corporation to a RIC or REIT, 
the regulations apply to transactions occurring on or after June 10, 
1987, and before January 2, 2002. In the case of a C corporation that 
qualifies to be taxed as a RIC or REIT, the regulations apply to such 
qualifications that are effective for taxable years beginning on or 
after June 10, 1987, and before January 2, 2002. However, RICs and 
REITs that are subject to section 1374 treatment under this section may 
not rely on Sec. 1.337(d)-5T(b)(1), but must apply paragraphs 
(c)(1)(i), (c)(2)(i), (c)(2)(ii), and (c)(3) of Sec. 1.337(d)-6T, with 
respect to built-in gains and losses recognized in taxable years 
beginning on or after January 2, 2002. In lieu of applying this 
section, taxpayers may rely on Sec. 1.337(d)-6T to determine the tax 
consequences (for all taxable years) of any conversion transaction. For 
transactions and qualifications that occur on or after January 2, 2002, 
see Sec. 1.337(d)-7T.

    Par. 3. Sections 1.337(d)-6T and 1.337(d)-7T are added immediately 
after Sec. 1.337(d)-5T to read as follows:


Sec. 1.337(d)-6T  New transitional rules imposing tax on property owned 
by a C corporation that becomes property of a RIC or REIT (temporary).

    (a) General Rule--(1) Property owned by a C corporation that 
becomes property of a RIC or REIT. If property owned by a C corporation 
(as defined in paragraph (a)(2)(i) of this section) becomes the 
property of a RIC or REIT (the converted property) in a conversion 
transaction (as defined in paragraph (a)(2)(ii) of this section), then 
deemed sale treatment will apply as described in paragraph (b) of this 
section, unless the RIC or REIT elects section 1374 treatment with 
respect to the conversion transaction as provided in paragraph (c) of 
this section. See paragraph (d) of this section for exceptions to this 
paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Deemed Sale Treatment--(1) In general. If property owned by a C 
corporation becomes the property of a RIC or REIT in a conversion 
transaction, then the C corporation recognizes gain and loss as if it 
sold the converted property to an unrelated party at fair market value 
on the deemed sale date (as defined in paragraph (b)(3) of this 
section). This paragraph (b) does not apply if its application would 
result in the recognition of a net loss. For this purpose, net loss is 
the excess of aggregate losses over aggregate gains (including items of 
income), without regard to character.
    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (b)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC 
or REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year before the first taxable year in which 
it qualifies to be taxed as a RIC or REIT.
    (ii) Other conversion transactions. If the conversion transaction 
is a transfer of property owned by a C corporation to a RIC or REIT, 
then the deemed sale date is the end of the day before the day of the 
transfer.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example. Deemed sale treatment on merger into RIC. (i) X, a 
calendar-year taxpayer, has qualified as a RIC since January 1, 
1991. On May 31, 1994, Y, a C corporation and calendar-year 
taxpayer, transfers all of its property to X in a transaction that 
qualifies as a reorganization under section 368(a)(1)(C). X does not 
elect section 1374 treatment under paragraph (c) of this section and 
chooses not to rely on Sec. 1.337(d)-5T. As a result of the 
transfer, Y is subject to deemed sale treatment under this paragraph 
(b) on its tax return for the short taxable year ending May 31, 
1994. On May 31, 1994, Y's only assets are Capital Asset, which has 
a fair market value of $100,000 and a basis of $40,000 as of the end 
of May 30, 1994, and $50,000 cash. Y also has an unrestricted net 
operating loss carryforward of $12,000 and accumulated earnings and 
profits of $50,000. Y has no taxable income for the short taxable 
year ending May 31, 1994, other than gain recognized under this 
paragraph (b). In 1997, X sells Capital Asset for $110,000. Assume 
the applicable corporate tax rate is 35%.
    (ii) Under this paragraph (b), Y is treated as if it sold the 
converted property (Capital Asset and $50,000 cash) at fair market 
value on May 30, 1994, recognizing $60,000 of gain ($150,000 amount 
realized--$90,000 basis). Y

[[Page 13]]

must report the gain on its tax return for the short taxable year 
ending May 31, 1994. Y may offset this gain with its $12,000 net 
operating loss carryforward and will pay tax of $16,800 (35% of 
$48,000).
    (iii) Under section 381, X succeeds to Y's accumulated earnings 
and profits. Y's accumulated earnings and profits of $50,000 
increase by $60,000 and decrease by $16,800 as a result of the 
deemed sale. Thus, the aggregate amount of subchapter C earnings and 
profits that must be distributed to satisfy section 852(a)(2)(B) is 
$93,200 ($50,000 + $60,000 - $16,800). X's basis in Capital Asset is 
$100,000. On X's sale of Capital Asset in 1997, X recognizes $10,000 
of gain, which is taken into account in computing X's net capital 
gain for purposes of section 852(b)(3).
    (c) Election of section 1374 treatment--(1) In general--(i) 
Property owned by a C corporation that becomes property of a RIC or 
REIT. Paragraph (b) of this section does not apply if the RIC or 
REIT that was formerly a C corporation or that acquired property 
from a C corporation makes the election described in paragraph 
(c)(4) of this section. A RIC or REIT that makes such an election 
will be subject to tax on the net built-in gain in the converted 
property under the rules of section 1374 and the regulations 
thereunder, as modified by this paragraph (c), as if the RIC or REIT 
were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a 
RIC, REIT, or S corporation that becomes property of a RIC or REIT. 
If property subject to the rules of section 1374 owned by a RIC, a 
REIT, or an S corporation (the predecessor) becomes the property of 
a RIC or REIT (the successor) in a continuation transaction, the 
rules of section 1374 apply to the successor to the same extent that 
the predecessor was subject to the rules of section 1374 with 
respect to such property, and the 10-year recognition period of the 
successor with respect to such property is reduced by the portion of 
the 10-year recognition period of the predecessor that expired 
before the date of the continuation transaction. For this purpose, a 
continuation transaction means the qualification of the predecessor 
as a RIC or REIT or the transfer of property from the predecessor to 
the successor in a transaction in which the successor's basis in the 
transferred property is determined, in whole or in part, by 
reference to the predecessor's basis in that property.
    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec. 1.1374-2(a)(1) is reduced by 
the portion of such amount, if any, that is subject to tax under 
section 857(b)(4), (5), (6), or (7). For this purpose, the amount of 
a REIT's recognized built-in gain that is subject to tax under 
section 857(b)(5) is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by 
reference to section 857(b)(5)(A), the amount of a REIT's recognized 
built-in gain that is subject to tax under section 857(b)(5) is the 
tax imposed by section 857(b)(5) multiplied by a fraction the 
numerator of which is the amount of recognized built-in gain 
(without regard to recognized built-in loss and recognized built-in 
gain from prohibited transactions) that is not derived from sources 
referred to in section 856(c)(2) and the denominator of which is the 
gross income (without regard to gross income from prohibited 
transactions) of the REIT that is not derived from sources referred 
to in section 856(c)(2).
    (2) Where the tax under section 857(b)(5) is computed by 
reference to section 857(b)(5)(B), the amount of a REIT's recognized 
built-in gain that is subject to tax under section 857(b)(5) is the 
tax imposed by section 857(b)(5) multiplied by a fraction the 
numerator of which is the amount of recognized built-in gain 
(without regard to recognized built-in loss and recognized built-in 
gain from prohibited transactions) that is not derived from sources 
referred to in section 856(c)(3) and the denominator of which is the 
gross income (without regard to gross income from prohibited 
transactions) of the REIT that is not derived from sources referred 
to in section 856(c)(3).
    (B) Taxable income limitation. The taxable income limitation 
determined as provided in Sec. 1.1374-2(a)(2) is reduced by an 
amount equal to the tax imposed under sections 857(b)(5), (6), and 
(7).
    (ii) Loss carryforwards, credits and credit carryforwards--(A) 
Loss carryforwards. Consistent with paragraph (c)(1)(i) of this 
section, net operating loss carryforwards and capital loss 
carryforwards arising in taxable years for which the corporation 
that generated the loss was not subject to subchapter M of chapter 1 
of the Code are allowed as a deduction against net recognized built-
in gain to the extent allowed under section 1374 and the regulations 
thereunder. Such loss carryforwards must be used as a deduction 
against net recognized built-in gain for a taxable year to the 
greatest extent possible before such losses can be used to reduce 
investment company taxable income for purposes of section 852(b) or 
real estate investment trust taxable income for purposes of section 
857(b) for that taxable year.
    (B) Credits and credit carryforwards. Consistent with paragraph 
(c)(1)(i) of this section, minimum tax credits and business credit 
carryforwards arising in taxable years for which the corporation 
that generated the credit was not subject to subchapter M of chapter 
1 of the Internal Revenue Code are allowed to reduce the tax imposed 
on net recognized built-in gain under this paragraph (c) to the 
extent allowed under section 1374 and the regulations thereunder. 
Such credits and credit carryforwards must be used to reduce the tax 
imposed under this paragraph (c) on net recognized built-in gain for 
a taxable year to the greatest extent possible before such credits 
and credit carryforwards can be used to reduce the tax, if any, on 
investment company taxable income for purposes of section 852(b) or 
on real estate investment trust taxable income for purposes of 
section 857(b) for that taxable year.
    (iii) 10-year recognition period. In the case of a conversion 
transaction that is a qualification of a C corporation as a RIC or 
REIT, the 10-year recognition period described in section 1374(d)(7) 
begins on the first day of the RIC's or REIT's first taxable year. 
In the case of other conversion transactions, the 10-year 
recognition period begins on the day the property is acquired by the 
RIC or REIT.
    (3) Coordination with subchapter M rules--(i) Recognized built-
in gains and losses subject to subchapter M. Recognized built-in 
gains and losses of a RIC or REIT are included in computing 
investment company taxable income for purposes of section 852(b)(2), 
real estate investment trust taxable income for purposes of section 
857(b)(2), capital gains for purposes of sections 852(b)(3) and 
857(b)(3), gross income derived from sources within any foreign 
country or possession of the United States for purposes of section 
853, and the dividends paid deduction for purposes of sections 
852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B), and 857(b)(3)(A).
    (ii) Treatment of tax imposed. The amount of tax imposed under 
this paragraph (c) on net recognized built-in gain for a taxable 
year is treated as a loss sustained by the RIC or the REIT during 
such taxable year. The character of the loss is determined by 
allocating the tax proportionately (based on recognized built-in 
gain) among the items of recognized built-in gain included in net 
recognized built-in gain. With respect to RICs, the tax imposed 
under this paragraph (c) on net recognized built-in gain is treated 
as attributable to the portion of the RIC's taxable year occurring 
after October 31.
    (4) Making the section 1374 election--(i) In general. A RIC or 
REIT makes a section 1374 election with the following statement: 
``[Insert name and employer identification number of electing RIC or 
REIT] elects under Sec. 1.337-6T(c) to be subject to the rules of 
section 1374 and the regulations thereunder with respect to its 
property that formerly was held by a C corporation, [insert name and 
employer identification number of the C corporation, if different 
from name and employer identification number of the RIC or REIT].'' 
However, a RIC or REIT need not file an election under this 
paragraph (c), but will be deemed to have made such an election if 
it can demonstrate that it informed the IRS prior to January 2, 
2002, of its intent to make a section 1374 election. An election 
under this paragraph (c) is irrevocable.
    (ii) Time for making the election. An election under this 
paragraph (c) may be filed by the RIC or REIT with any Federal 
income tax return filed by the RIC or REIT on or before March 15, 
2003, provided that the RIC or REIT has reported consistently with 
such election for all periods.
    (5) Example. The rules of this paragraph (c) are illustrated by 
the following example:

    Example. Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as 
a REIT on its 1994 tax return, which it files on March 15, 1995. As 
a result, X is a REIT for its 1994 taxable year and would be subject 
to deemed sale treatment under paragraph (b) of this section but for 
X's timely election of section 1374 treatment under this paragraph 
(c). X chooses not to rely on Sec. 1.337(d)-5T. As of the beginning 
of the 1994 taxable year, X's property consisted of Real Property, 
which is not section 1221(a)(1) property and

[[Page 14]]

which had a fair market value of $100,000 and an adjusted basis of 
$80,000, and $25,000 cash. X also had accumulated earnings and 
profits of $25,000, unrestricted net operating loss carryforwards of 
$3,000, and unrestricted business credit carryforwards of $2,000. On 
July 1, 1997, X sells Real Property for $110,000. For its 1997 
taxable year, X has net income other than recognized built-in gain. 
Assume the highest corporate tax rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its 
$80,000 basis in Real Property and its $25,000 accumulated earnings 
and profits. X retains its $3,000 of net operating loss 
carryforwards and its $2,000 of business credit carryforwards. To 
satisfy section 857(a)(2)(B), X must distribute $25,000, an amount 
equal to its earnings and profits accumulated in non-REIT years, to 
its shareholders by the end of its 1994 taxable year.
    (iii) Upon X's sale of Real Property in 1997, X recognizes gain 
of $30,000 ($110,000-$80,000). X's recognized built-in gain for 
purposes of applying section 1374 is $20,000 ($100,000 fair market 
value as of the beginning of X's first taxable year as a REIT--
$80,000 basis). Because X has net income other than recognized 
built-in gain for its 1997 taxable year, the taxable income 
limitation does not apply. X, therefore, has $20,000 net recognized 
built-in gain for the year. Assuming that X has not used its $3,000 
of net operating loss carryforwards in a prior taxable year and that 
their use is allowed under section 1374(b)(2) and Sec. 1.1374-5, X 
is allowed a $3,000 deduction against the $20,000 net recognized 
built-in gain. X would owe tax of $5,950 (35% of $17,000) on its net 
recognized built-in gain, except that X may use its $2,000 of 
business credit carryforwards to reduce this tax, assuming that X 
has not used the credit carryforwards in a prior taxable year and 
that their use is allowed under section 1374(b)(3) and Sec. 1.1374-
6. Thus, X owes tax of $3,950 under this paragraph (c). For purposes 
of subchapter M, X's earnings and profits for the year increase by 
$26,050 ($30,000 capital gain on the sale of Real Property--$3,950 
tax under this paragraph (c)).
    (iv) To compute X's net capital gain for purposes of section 
857(b)(3) for the taxable year, the $20,000 of net recognized built-
in gain less the $3,950 of tax imposed on that gain is added to X's 
capital gain (or loss), if any, that is not recognized built-in gain 
(or loss).

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of 
this section does not apply to any conversion transaction to the extent 
that gain or loss otherwise is recognized on such conversion 
transaction. See, for example, sections 336, 351(b), 356, 357(c), 367, 
and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (iii) of this section, paragraph 
(a)(1) of this section does not apply to any corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT 
was subject to tax as a C corporation for a period not exceeding two 
taxable years; and
    (B) Immediately prior to being subject to tax as a C corporation 
was subject to tax as a RIC or REIT for a period of at least one 
taxable year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from another corporation (whether 
or not a C corporation) in a transaction that results in the acquirer's 
basis in the property being determined by reference to a C 
corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (c) of this 
section before the RIC or REIT became subject to tax as a C corporation 
as described in paragraph (d)(2)(i) of this section, then paragraph (c) 
of this section applies to the RIC or REIT upon its requalification as 
a RIC or REIT, except that the 10-year recognition period with respect 
to such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.
    (e) Effective date. This section applies to conversion transactions 
that occur on or after June 10, 1987, and before January 2, 2002. In 
lieu of applying this section, taxpayers generally may apply 
Sec. 1.337(d)-5T to determine the tax consequences (for all taxable 
years) of any conversion transaction that occurs on or after June 10, 
1987 and before January 2, 2002, except that RICs and REITs that are 
subject to section 1374 treatment with respect to a conversion 
transaction may not rely on Sec. 1.337(d)-5T(b)(1), but must apply 
paragraphs (c)(1)(i), (c)(2)(i), (c)(2)(ii), and (c)(3) of this 
section, with respect to built-in gains and losses recognized in 
taxable years beginning on or after January 2, 2002. Taxpayers are not 
prevented from relying on Sec. 1.337(d)-5T merely because they elect 
section 1374 treatment in the manner described in paragraph (c)(4) of 
this section instead of in the manner described in Sec. 1.337(d)-
5T(b)(3) and (c). For conversion transactions that occur on or after 
January 2, 2002, see Sec. 1.337(d)-7T. This section expires on December 
31, 2004.


Sec. 1.337(d)-7T  Tax on property owned by a C corporation that becomes 
property of a RIC or REIT (temporary).

    (a) General Rule--(1) Property owned by a C corporation that 
becomes property of a RIC or REIT. If property owned by a C corporation 
(as defined in paragraph (a)(2)(i) of this section) becomes the 
property of a RIC or REIT (the converted property) in a conversion 
transaction (as defined in paragraph (a)(2)(ii) of this section), then 
section 1374 treatment will apply as described in paragraph (b) of this 
section, unless the C corporation elects deemed sale treatment with 
respect to the conversion transaction as provided in paragraph (c) of 
this section. See paragraph (d) of this section for exceptions to this 
paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Section 1374 treatment--(1) In general--(i) Property owned by a 
C corporation that becomes property of a RIC or REIT. If property owned 
by a C corporation becomes the property of a RIC or REIT in a 
conversion transaction, then the RIC or REIT will be subject to tax on 
the net built-in gain in the converted property under the rules of 
section 1374 and the regulations thereunder, as modified by this 
paragraph (b), as if the RIC or REIT were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a RIC, 
REIT, or S corporation that becomes property of a RIC or REIT. If 
property subject to the rules of section 1374 owned by a RIC, a REIT, 
or an S corporation (the predecessor) becomes the property of a RIC or 
REIT (the successor) in a continuation transaction, the rules of 
section 1374 apply to the successor to the same extent that the 
predecessor was subject to the rules of section 1374 with respect to 
such property, and the 10-year recognition period of the successor with 
respect to such property is reduced by the portion of the 10-year 
recognition period of the predecessor that expired before the date of 
the continuation transaction. For this purpose, a continuation 
transaction means the qualification of the predecessor as a RIC or REIT 
or the transfer of property from the predecessor to the successor in a 
transaction in which the successor's basis in the transferred property 
is determined, in whole or in part, by reference to the predecessor's 
basis in that property.

[[Page 15]]

    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec. 1.1374-2(a)(1) is reduced by the 
portion of such amount, if any, that is subject to tax under section 
857(b)(4), (5), (6), or (7). For this purpose, the amount of a REIT's 
recognized built-in gain that is subject to tax under section 857(b)(5) 
is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(A), the amount of a REIT's recognized built-in 
gain that is subject to tax under section 857(b)(5) is the tax imposed 
by section 857(b)(5) multiplied by a fraction the numerator of which is 
the amount of recognized built-in gain (without regard to recognized 
built-in loss and recognized built-in gain from prohibited 
transactions) that is not derived from sources referred to in section 
856(c)(2) and the denominator of which is the gross income (without 
regard to gross income from prohibited transactions) of the REIT that 
is not derived from sources referred to in section 856(c)(2).
    (2) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(B), the amount of a REIT's recognized built-in 
gain that is subject to tax under section 857(b)(5) is the tax imposed 
by section 857(b)(5) multiplied by a fraction the numerator of which is 
the amount of recognized built-in gain (without regard to recognized 
built-in loss and recognized built-in gain from prohibited 
transactions) that is not derived from sources referred to in section 
856(c)(3) and the denominator of which is the gross income (without 
regard to gross income from prohibited transactions) of the REIT that 
is not derived from sources referred to in section 856(c)(3).
    (B) Taxable income limitation. The taxable income limitation 
determined as provided in Sec. 1.1374-2(a)(2) is reduced by an amount 
equal to the tax imposed under section 857(b)(5), (6), and (7).
    (ii) Loss carryforwards, credits and credit carryforwards--(A) Loss 
carryforwards. Consistent with paragraph (b)(1)(i) of this section, net 
operating loss carryforwards and capital loss carryforwards arising in 
taxable years for which the corporation that generated the loss was not 
subject to subchapter M of chapter 1 of the Code are allowed as a 
deduction against net recognized built-in gain to the extent allowed 
under section 1374 and the regulations thereunder. Such loss 
carryforwards must be used as a deduction against net recognized built-
in gain for a taxable year to the greatest extent possible before such 
losses can be used to reduce investment company taxable income for 
purposes of section 852(b) or real estate investment trust taxable 
income for purposes of section 857(b) for that taxable year.
    (B) Credits and credit carryforwards. Consistent with paragraph 
(b)(1)(i) of this section, minimum tax credits and business credit 
carryforwards arising in taxable years for which the corporation that 
generated the credit was not subject to subchapter M of chapter 1 of 
the Internal Revenue Code are allowed to reduce the tax imposed on net 
recognized built-in gain under this paragraph (b) to the extent allowed 
under section 1374 and the regulations thereunder. Such credits and 
credit carryforwards must be used to reduce the tax imposed under this 
paragraph (b) on net recognized built-in gain for a taxable year to the 
greatest extent possible before such credits and credit carryforwards 
can be used to reduce the tax, if any, on investment company taxable 
income for purposes of section 852(b) or on real estate investment 
trust taxable income for purposes of section 857(b) for that taxable 
year.
    (iii) 10-year recognition period. In the case of a conversion 
transaction that is a qualification of a C corporation as a RIC or 
REIT, the 10-year recognition period described in section 1374(d)(7) 
begins on the first day of the RIC's or REIT's first taxable year. In 
the case of other conversion transactions, the 10-year recognition 
period begins on the day the property is acquired by the RIC or REIT.
    (3) Coordination with subchapter M rules--(i) Recognized built-in 
gains and losses subject to subchapter M. Recognized built-in gains and 
losses of a RIC or REIT are included in computing investment company 
taxable income for purposes of section 852(b)(2), real estate 
investment trust taxable income for purposes of section 857(b)(2), 
capital gains for purposes of sections 852(b)(3) and 857(b)(3), gross 
income derived from sources within any foreign country or possession of 
the United States for purposes of section 853, and the dividends paid 
deduction for purposes of sections 852(b)(2)(D), 852(b)(3)(A), 
857(b)(2)(B), and 857(b)(3)(A).
    (ii) Treatment of tax imposed. The amount of tax imposed under this 
paragraph (b) on net recognized built-in gain for a taxable year is 
treated as a loss sustained by the RIC or the REIT during such taxable 
year. The character of the loss is determined by allocating the tax 
proportionately (based on recognized built-in gain) among the items of 
recognized built-in gain included in net recognized built-in gain. With 
respect to RICs, the tax imposed under this paragraph (b) on net 
recognized built-in gain is treated as attributable to the portion of 
the RIC's taxable year occurring after October 31.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example.  Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as 
a REIT on its 2004 tax return, which it files on March 15, 2005. As 
a result, X is a REIT for its 2004 taxable year and is subject to 
section 1374 treatment under this paragraph (b). X does not elect 
deemed sale treatment under paragraph (c) of this section. As of the 
beginning of the 2004 taxable year, X's property consisted of Real 
Property, which is not section 1221(a)(1) property and which had a 
fair market value of $100,000 and an adjusted basis of $80,000, and 
$25,000 cash. X also had accumulated earnings and profits of 
$25,000, unrestricted net operating loss carryforwards of $3,000, 
and unrestricted business credit carryforwards of $2,000. On July 1, 
2007, X sells Real Property for $110,000. For its 1997 taxable year, 
X has net income other than recognized built-in gain. Assume the 
highest corporate tax rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its 
$80,000 basis in Real Property and its $25,000 accumulated earnings 
and profits. X retains its $3,000 of net operating loss 
carryforwards and its $2,000 of business credit carryforwards. To 
satisfy section 857(a)(2)(B), X must distribute $25,000, an amount 
equal to its earnings and profits accumulated in non-REIT years, to 
its shareholders by the end of its 2004 taxable year.
    (iii) Upon X's sale of Real Property in 2007, X recognizes gain 
of $30,000 ($110,000--$80,000). X's recognized built-in gain for 
purposes of applying section 1374 is $20,000 ($100,000 fair market 
value as of the beginning of X's first taxable year as a REIT--
$80,000 basis). Because X has net income other than recognized 
built-in gain for its 2007 taxable year, the taxable income 
limitation does not apply. X, therefore, has $20,000 net recognized 
built-in gain for the year. Assuming that X has not used its $3,000 
of net operating loss carryforwards in a prior taxable year and that 
their use is allowed under section 1374(b)(2) and Sec. 1.1374-5, X 
is allowed a $3,000 deduction against the $20,000 net recognized 
built-in gain. X would owe tax of $5,950 (35% of $17,000) on its net 
recognized built-in gain, except that X may use its $2,000 of 
business credit carryforwards to reduce the tax, assuming that X has 
not used the credit carryforwards in a prior taxable year and that 
their use is allowed under section 1374(b)(3) and Sec. 1.1374-6. 
Thus, X owes tax of $3,950 under this paragraph (b). For purposes of 
subchapter M, X's earnings and profits for the year increase by 
$26,050 ($30,000 capital gain on the sale of Real Property--$3,950 
tax under this paragraph (b)).
    (iv) To compute X's net capital gain for purposes of section 
857(b)(3) for the taxable year, the $20,000 of net recognized built-
in

[[Page 16]]

gain less the $3,950 of tax imposed on that gain is added to X's 
capital gain (or loss), if any, that is not recognized built-in gain 
(or loss).

    (c) Election of deemed sale treatment--(1) In general. Paragraph 
(b) of this section does not apply if the C corporation that qualifies 
as a RIC or REIT or transfers property to a RIC or REIT makes the 
election described in paragraph (c)(5) of this section. A C corporation 
that makes such an election recognizes gain and loss as if it sold the 
converted property to an unrelated party at fair market value on the 
deemed sale date (as defined in paragraph (c)(3) of this section). See 
paragraph (c)(4) of this section concerning limitations on the use of 
loss in computing gain. This paragraph (c) does not apply if its 
application would result in the recognition of a net loss. For this 
purpose, net loss is the excess of aggregate losses over aggregate 
gains (including items of income), without regard to character.
    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (c)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC 
or REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year before the first taxable year in which 
it qualifies to be taxed as a RIC or REIT.
    (ii) Other conversion transactions. If the conversion transaction 
is a transfer of property owned by a C corporation to a RIC or REIT, 
then the deemed sale date is the end of the day before the day of the 
transfer.
    (4) Anti-stuffing rule. A C corporation must disregard converted 
property in computing gain or loss recognized on the conversion 
transaction under this paragraph (c), if--
    (i) The converted property was acquired by the C corporation in a 
transaction to which section 351 applied or as a contribution to 
capital;
    (ii) Such converted property had an adjusted basis immediately 
after its acquisition by the C corporation in excess of its fair market 
value on the date of acquisition; and
    (iii) The acquisition of such converted property by the C 
corporation was part of a plan a principal purpose of which was to 
reduce gain recognized by the C corporation in connection with the 
conversion transaction. For purposes of this paragraph (c)(4), the 
principles of section 336(d)(2) apply.
    (5) Making the deemed sale election. A C corporation makes the 
deemed sale election with the following statement: ``[Insert name and 
employer identification number of electing corporation] elects deemed 
sale treatment under Sec. 1.337(d)-7T(c) with respect to its property 
that was converted to property of, or transferred to, a RIC or REIT, 
[insert name and employer identification number of the RIC or REIT, if 
different from the name and employer identification number of the C 
corporation].'' This statement must be attached to the Federal income 
tax return of the C corporation for the taxable year in which the 
deemed sale occurs. An election under this paragraph (c) is 
irrevocable.
    (6) Examples. The rules of this paragraph (c) are illustrated by 
the following examples:

    Example 1. Deemed sale treatment on merger into RIC. (i) X, a 
calendar-year taxpayer, has qualified as a RIC since January 1, 
2001. On May 31, 2004, Y, a C corporation and calendar-year 
taxpayer, transfers all of its property to X in a transaction that 
qualifies as a reorganization under section 368(a)(1)(C). As a 
result of the transfer, Y would be subject to section 1374 treatment 
under paragraph (b) of this section but for its timely election of 
deemed sale treatment under this paragraph (c). As a result of such 
election, Y is subject to deemed sale treatment on its tax return 
for the short taxable year ending May 31, 2004. On May 31, 2004, Y's 
only assets are Capital Asset, which has a fair market value of 
$100,000 and a basis of $40,000 as of the end of May 30, 2004, and 
$50,000 cash. Y also has an unrestricted net operating loss 
carryforward of $12,000 and accumulated earnings and profits of 
$50,000. Y has no taxable income for the short taxable year ending 
May 31, 2004, other than gain recognized under this paragraph (c). 
In 2007, X sells Capital Asset for $110,000. Assume the applicable 
corporate tax rate is 35%.
    (ii) Under this paragraph (c), Y is treated as if it sold the 
converted property (Capital Asset and $50,000 cash) at fair market 
value on May 30, 2004, recognizing $60,000 of gain ($150,000 amount 
realized-$90,000 basis). Y must report the gain on its tax return 
for the short taxable year ending May 31, 2004. Y may offset this 
gain with its $12,000 net operating loss carryforward and will pay 
tax of $16,800 (35% of $48,000).
    (iii) Under section 381, X succeeds to Y's accumulated earnings 
and profits. Y's accumulated earnings and profits of $50,000 
increase by $60,000 and decrease by $16,800 as a result of the 
deemed sale. Thus, the aggregate amount of subchapter C earnings and 
profits that must be distributed to satisfy section 852(a)(2)(B) is 
$93,200 ($50,000 + $60,000 - $16,800). X's basis in Capital Asset is 
$100,000. On X's sale of Capital Asset in 2007, X recognizes $10,000 
of gain which is taken into account in computing X's net capital 
gain for purposes of section 852(b)(3).
    Example 2. Loss limitation. (i) Assume the facts are the same as 
those described in Example 1, but that, prior to the reorganization, 
a shareholder of Y contributed to Y a capital asset, Capital Asset 
2, which has a fair market value of $10,000 and a basis of $20,000, 
in a section 351 transaction.
    (ii) Assuming that Y's acquisition of Capital Asset 2 was made 
pursuant to a plan a principal purpose of which was to reduce the 
amount of gain that Y would recognize in connection with the 
conversion transaction, Capital Asset 2 would be disregarded in 
computing the amount of Y's net gain on the conversion transaction.

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of 
this section does not apply to any conversion transaction to the extent 
that gain or loss otherwise is recognized on such conversion 
transaction. See, for example, sections 336, 351(b), 356, 357(c), 367, 
and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (d)(2)(iii) of this section, 
paragraph (a)(1) of this section does not apply to any corporation 
that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT 
was subject to tax as a C corporation for a period not exceeding two 
taxable years; and
    (B) Immediately prior to being subject to tax as a C corporation 
was subject to tax as a RIC or REIT for a period of at least one 
taxable year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from another corporation (whether 
or not a C corporation) in a transaction that results in the acquirer's 
basis in the property being determined by reference to a C 
corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (b) of this 
section before the RIC or REIT became subject to tax as a C corporation 
as described in paragraph (d)(2)(i) of this section, then paragraph (b) 
of this section applies to the RIC or REIT upon its requalification as 
a RIC or REIT, except that the 10-year recognition period with respect 
to such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.

[[Page 17]]

    (e) Special rule for partnerships. The principles of this section 
apply to property transferred by a partnership to a RIC or REIT to the 
extent of any C corporation partner's proportionate share of the 
transferred property. For example, if a C corporation owns a 20 percent 
interest in a partnership and that partnership contributes an asset to 
a REIT in a section 351 transaction, then the partnership shall be 
treated as a C corporation with respect to 20 percent of the asset 
contributed to the REIT. If the partnership were to elect deemed sale 
treatment under paragraph (c) of this section with respect to such 
transfer, then any gain recognized by the partnership on the deemed 
sale must be specially allocated to the C corporation partner.
    (f) Effective date. This section applies to conversion transactions 
that occur on or after January 2, 2002. For conversion transactions 
that occurred on or after June 10, 1987 and before January 2, 2002, see 
Sec. 1.337(d)-5T and Sec. 1.337(d)-6T. This section expires on December 
31, 2004.

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

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

    Authority: 26 U.S.C. 7805.

    Par. 5. In Sec. 602.101, paragraph (b) is amended by adding an 
entry in numerical order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
    CFR part or section where identified or described       control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.337(d)-6T.............................................       1545-1672
1.337(d)-7T.............................................       1545-1672
                  *        *        *        *        *
------------------------------------------------------------------------


    Approved: December 20, 2001.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Mark Weinberger,
Assistant Secretary of the Treasury.
[FR Doc. 01-31969 Filed 12-31-01; 8:45 am]
BILLING CODE 4830-01-P