Treatment of Gain From Disposition of Certain Natural Resource Recapture Property

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8586]

RIN 1545-AC35

Treatment of Gain From Disposition of Certain Natural Resource

Recapture Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document provides final regulations relating to the tax

treatment of gain from the disposition of certain natural resource

recapture property (section 1254 property after enactment of the Tax

Reform Act of 1986 and oil, gas, or geothermal property before

enactment of the Tax Reform Act of 1986). Changes to the applicable tax

law were made by the Tax Reform Act of 1986, the Tax Reform Act of

1984, the Energy Tax Act of 1978, the Tax Reform Act of 1976, the Tax

Reform Act of 1969, and the Act of September 12, 1966. The regulations

provide the public with guidance in complying with the changed tax

laws.

DATES: These regulations are effective January 10, 1995.

For dates of applicability, see Sec. 1.1254-6.

FOR FURTHER INFORMATION CONTACT: Brenda M. Stewart (202-622-3120, 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. 3504(h))

under control number 1545-1352. The estimated annual burden per

respondent varies from four to six hours, depending on individual

circumstances, with an estimated average of five 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, PC:FP,

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.

Background

On June 11, 1980, the IRS published proposed amendments to the

Income Tax Regulations (26 CFR part 1) under sections 170, 301, 312,

341, 453, 751, 1254, and 1502 of the Internal Revenue Code of 1954 in

the Federal Register (45 FR 39512). These amendments were proposed to

conform the regulations to section 205 (a), (b), and (c) (1) and (2) of

the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1533, and section

402(c) of the Energy Tax Act of 1978, Pub. L. 95-618, 92 Stat. 3202,

and to make certain other technical amendments to conform the

regulations to section 1(c) of the Act of September 12, 1966, Pub. L.

89-570, 80 Stat. 762, to section 211(b)(6) of the Tax Reform Act of

1969, Pub. L. 91-172, 83 Stat. 570, and to sections 1042(c)(2),

1101(d)(2), 1901(a)(93), and 2110(a) of the Tax Reform Act of 1976, 90

Stat. 1637, 1658, 1780, 1905). A public hearing was held on September

9, 1980. After considering all comments regarding the proposed

regulations, the proposed regulations (except for the provisions

relating to an electing small business corporation (hereinafter

referred to as an S corporation)), are adopted as revised by this

Treasury decision. The rules under Sec. 1.751-1(c)(6)(ii) are

clarified, but no substantive change is intended except to insert

additional recapture sections under the Internal Revenue Code of 1986

(Code).

Because of the substantial changes made to the tax treatment of S

corporations by section 5(a)(37) of the Subchapter S Revision Act of

1982, Pub. L. 97-354, 96 Stat. 1696, section 492 of the Tax Reform Act

of 1984, Pub. L. 98-369, 98 Stat. 853, and sections 411 and 413 of the

Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2225, 2227,

Sec. 1.1254-3 of the proposed regulations (relating to an electing

small business), [[Page 2498]] has not been adopted. Instead, a notice

of proposed rulemaking, designated as Sec. 1.1254-4, relating to the

recapture of natural resource recapture property by an S corporation

and its shareholders will be proposed to conform the regulations to

these laws.

I. Intangible Drilling and Development Costs Recapture in a Partnership

The proposed regulations require a partnership to compute the

amount of intangible drilling and development costs to be recaptured

(entity approach) and, subject to the substantial economic effect test,

to allocate that amount among the partners in accordance with their

respective distributive shares as provided in the partnership

agreement. Some commentators argue that the proposed regulations are

inconsistent with partner level (aggregate approach) computation of

depletion and gain upon the sale of partnership oil and gas property

under section 613A(c)(7)(D).

Under the entity approach of the proposed regulations, some

recapture of section 1254 costs may be shifted from the partners who

claimed the deductions to other partners who did not receive the

benefit of the deductions. Under the aggregate approach, depending on

the allocation of gain or amount realized upon sale, some section 1254

costs may not be recaptured though total partnership gain exceeds total

partnership section 1254 costs.

The commentators suggest that, consistent with section

613A(c)(7)(D), the final regulations should adopt the aggregate

approach. They argue that under the aggregate approach, a partner can

more readily compute both the extent of the deductions that were

previously allocated to the partner and the appropriate adjustment

required by section 1254(a)(4) (as in effect before enactment of the

Tax Reform Act of 1986). The commentators contend that it is difficult

for a partnership to obtain this information from the individual

partners. In addition, they cite section 58(i) (as in effect before

enactment of the Tax Reform Act of 1986), which allowed general

partners to elect to amortize intangible drilling and development costs

over a 5 year period and limited partners to elect to amortize

intangible drilling and development costs over a 10 year period.

Section 59(e) now provides an analogous amortization election.

Consistent with the commentators' suggestion, the final regulations

adopt the aggregate approach. Recapture is determined at the partner

level. However, the regulations contain an anti-abuse rule providing

that recapture is determined at the partnership level if the

Commissioner determines that the amount realized or gain recognized

from the disposition of section 1254 property is allocated to partners

with a principal purpose of avoiding recapture under section 1254.

II. Recapture of Distributions on the Liquidation of a Partnership

In general, the section 1254 recapture provisions override

nonrecognition provisions in the Code. However, section 1254 (b)(1)

states that rules similar to the rules of section 1245 (b) and (c)

shall be prescribed by regulation. Accordingly, the final regulations

limit the amount subject to recapture in certain tax-free transactions

to gain that would be recognized without regard to section 1254.

Section 1.1254-2(c)(3) lists the transfers in which recapture is

limited. All transfers listed involve transferred basis.

Commentators point out that under the proposed regulations

recapture is required upon the liquidation of a partnership interest

because section 732(b) provides that the basis of property received in

a liquidation is a substitute basis equal to the basis of the partner's

interest in the partnership. However, under section 1245(b)(6)(A),

recapture upon the distribution of partnership assets in liquidation is

limited. Accordingly, the commentators suggest that a similar rule

should be adopted for section 1254 purposes.

The final regulations adopt the commentators' suggestion. The basis

of natural resource recapture property distributed by a partnership to

a partner is deemed to be determined by reference to the adjusted basis

of the property to the partnership.

III. Recapture Reduction

Under section 1254(a)(4) (as in effect before enactment of the Tax

Reform Act of 1986), the amount of intangible drilling and development

costs subject to recapture is reduced by the amount, if any, by which

the ``deduction for depletion'' under section 611 ``would have been

increased'' if intangible drilling and development costs had been

charged to a capital account rather than currently expensed under

section 263(c). The proposed regulations, therefore, require taxpayers

to use the excess of the hypothetical cost or percentage depletion

deduction over the amount allowed under section 611 (either cost or

percentage depletion) in determining the constructive increase in

depletion.

By contrast, many commentators argued that, notwithstanding the

language of the statute, according to the legislative history, the

recapture amount should be reduced even in situations where expensing

intangible drilling and development costs did not result in decreased

depletion deductions.

The final regulations reject this view and instead continue to

follow the statute, which, as noted above, provides that recapturable

intangible drilling and development costs are reduced by the amount by

which the ``deduction for depletion'' claimed under section 611 ``would

have been increased.'' Thus, the amount of recapturable intangible

drilling and development costs is reduced by only the excess, if any,

of the hypothetical cost or percentage depletion deduction (computed as

if intangible drilling and development costs subject to depletion had

been capitalized) over the amount of the cost or percentage depletion

deduction the taxpayer actually claimed. Consequently, unless the

hypothetical cost or percentage depletion amount is greater than the

actual depletion deduction claimed, no depletion deduction is foregone,

and all intangible drilling and development costs attributable to the

property are recapturable.

The final regulations are clarified to remove uncertainties

regarding the method for calculating the reduction in the amount of

recapturable intangible drilling and development costs.

IV. Nonproductive Wells

Some commentators state that intangible drilling and development

costs allocable to nonproductive wells should not be subject to

recapture. They point out that, even if a taxpayer elects to capitalize

intangible drilling and development costs, intangible drilling and

development costs of nonproductive wells are not added to basis because

the operator normally deducts these amounts under Sec. 1.612-4(b)(4) on

the return for the first taxable year after abandonment of a

nonproductive well.

One reason for the enactment of section 1254 was to prevent the

conversion of intangible drilling and development costs currently

deducted against ordinary income into capital gain in certain limited

risk situations. See H.R. Rep. 94-658, 94th Cong., 1st Sess. 94 (1975).

For example, if a well proves to be nonproductive causing a nonrecourse

debt to become worthless, the taxpayer generally recognizes income that

is treated as capital gain upon foreclosure of the debt, because a

foreclosure is deemed to be a sale of the property. Consequently,

ordinary income deductions would be converted [[Page 2499]] into

capital gains to the extent of the leveraged amounts.

Aside from foreclosure of a nonrecourse debt, however, a

nonproductive well provides no opportunity for converting an ordinary

income stream into capital gain. Accordingly, the final regulations

provide that section 1254 costs attributable to nonproductive wells are

not recapturable, except in certain limited risk situations.

V. Depreciation

Some commentators argue that depreciable costs associated with

drilling should not be separated from depletable costs in calculating

the hypothetical depletion deduction. Commentators also point out that

it is difficult to identify the amount of intangible drilling and

development costs that could have been deducted as depreciation,

because it is not current industry practice to separate depreciable

costs from depletable costs. In response to these comments, the final

regulations do not require depreciable costs to be separated from

depletable costs in calculating the hypothetical depletion deduction.

VI. Property Interest Subject to Recapture

Under the proposed regulations, each operating mineral interest in

an ``oil, gas, or geothermal property,'' as well as any nonoperating

mineral interest retained by a lessor or sublessor of a property to

which intangible drilling and development costs were properly

chargeable when held by such person prior to the creation of the lease

or sublease, is subject to recapture.

In Houston Oil and Minerals Corp. v. Commissioner, 92 T.C. 1331

(1989), aff'd, 922 F.2d 283 (5th Cir. 1991), Louisiana Land and

Exploration Co. v. Commissioner, 92 T.C. 1340 (1989), and Southland

Royalty Co. v. United States, 91-1 U.S.T.C. 50,083 (Cls. Ct. 1991),

the Internal Revenue Service took the position that section 1254

requires recapture of intangible drilling and development costs upon

the disposition of a nonoperating mineral interest carved out of an

operating mineral interest. The courts, however, held instead that the

disposition of an overriding royalty interest carved out of an

operating mineral interest to which intangible drilling and development

costs were charged does not trigger recapture because the overriding

royalty interest is not ``oil, gas, or geothermal property'' within the

meaning of section 1254(a)(3).

The Tax Court in Houston Oil and Minerals Corp., 92 T.C. at 1339,

and Louisiana Land and Exploration Co., 92 T.C. at 1348, and the Claims

Court in Southland Royalty Co., 91-1 U.S.T.C. at 87,337, noted that

because the Tax Reform Act of 1986 amended section 1254 to include

within the definition of ``oil, gas, or geothermal property'' property

the basis of which has been adjusted for depletion, nonoperating

mineral interests come within the ambit of section 1254 after 1986.

Consequently, the courts reasoned, the issue considered in these cases

would arise only with respect to property placed in service before

1987.

The regulations have been amended to treat a nonoperating mineral

interest carved out of an operating mineral interest with respect to

which section 1254 costs have been deducted as property to which

section 1254 costs are properly chargeable. Thus, the final regulations

make clear that natural resource recapture property includes a

nonoperating mineral interest if the nonoperating mineral interest was

carved out of an operating mineral interest to which section 1254 costs

were properly chargeable by the holder of the operating mineral

interest. See Sec. 1.1254-1(b)(2). Consistent with the opinions in the

litigated cases, however, this provision will be effective only with

respect to property placed in service after December 31, 1986.

VII. Disposition

Commentators urge that the regulations state who is liable for

recapture if an operating mineral interest shifts automatically or at

the option of the person who will receive the interest, as, for

example, a farm-out. In response to these comments, the final

regulations provide that liability for potential recapture of

intangible drilling and development costs attributable to the entire

operating mineral interest held by the carrying party prior to

reversion or conversion remains attributable to the reduced operating

mineral interest retained by the carrying party after a portion of the

operating mineral interest has reverted to the carried party or after

the conversion of an overriding royalty interest that converts, at the

option of the grantor or successor in interest, to an operating mineral

interest after a certain amount of production.

VIII. Like Kind Exchanges and Involuntary Conversions

Commentators state that under Sec. 1.1254-4(d) of the proposed

regulations liability for recapture of intangible drilling and

development costs remains with the property with respect to which the

costs were incurred and does not transfer to the property received in a

like kind exchange or involuntary conversion. However, under the final

regulations recapture liability transfers to the property received by

the transferor who received the benefit of the deductions for section

1254 costs. This result is consistent with the section 1245(b)(4) and

Sec. 1.1245-2(c)(4) rules for recapture of depreciation. Because

section 1254(b)(1) states that the regulations should prescribe rules

similar to rules in section 1245 (b) and (c) for like kind exchanges,

involuntary conversions, and other nontaxable transfers, the final

regulations more closely mirror the section 1245 recapture rules for

such transactions.

IX. Filing Requirements

The proposed regulations provide allocation rules for the recapture

of section 1254 costs on the sale of a portion of, or an undivided

interest in, natural resource recapture property. Under the proposed

regulations, a taxpayer is required to attach to the tax return

documents sufficient to establish allocation of intangible drilling and

development costs to the disposed of portion or undivided interest,

notwithstanding that the intangible drilling and development costs do

not in fact relate to that portion or undivided interest. Commentators

suggest that it is more practical simply to require a taxpayer to state

on the tax return that the section 1254 costs do not relate to the

property disposed of and to retain verifying documentation. In response

to the commentators' suggestion, the final regulations contain a book

and records retention requirement.

Effective dates: These regulations are effective January 10, 1995

and Secs. 1.1254-1 through 1.1254-3 and Sec. 1.1254-5 apply to any

disposition of natural resource recapture property occurring after

March 13, 1995. The rule in Sec. 1.1254-1(b)(2)(iv)(A)(2), concerning a

nonoperating mineral interest carved out of an operating mineral

interest with respect to which an expenditure has been deducted,

applies to any disposition occurring after March 13, 1995 of property

(within the meaning of section 614) that is placed in service by the

taxpayer after December 31, 1986. For dispositions of natural resource

recapture property occurring on or before March 13, 1995, taxpayers

must take reasonable return positions taking into consideration the

statute and its legislative history.

Special Analyses

It has been determined that this Treasury decision is not a

significant [[Page 2500]] regulatory action as defined in EO 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) and the Regulatory Flexibility Act (5 U.S.C. chapter

6) do not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, the notice of proposed rulemaking preceding

these regulations was submitted to the Small Business Administration on

its impact on small business.

Drafting Information

The principal author of these final regulations is Brenda M.

Stewart, Office of Assistant 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

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

entries in numerical order to read as follows:

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

Section 1.1254-1 also issued under 26 U.S.C. 1254(b).

Section 1.1254-2 also issued under 26 U.S.C. 1254(b).

Section 1.1254-3 also issued under 26 U.S.C. 1254(b).

Section 1.1254-4 also issued under 26 U.S.C. 1254(b).

Section 1.1254-5 also issued under 26 U.S.C. 1254(b).

Section 1.1254-6 also issued under 26 U.S.C. 1254(b). * * *

Sec. 1.301-1 [Amended]

Par. 2. Section 1.301-1 is amended as follows:

1. Paragraph (d)(1)(iii) is amended by removing the language ``or

1252(a)'' and adding ``1252(a), or 1254(a)'' in its place.

2. Paragraph (h)(2)(ii)(b) is amended by removing the language ``or

section 1252(a) (relating to gain from disposition of farm land)'' and

adding ``section 1252(a) (relating to gain from disposition of farm

land), or section 1254(a) (relating to gain from disposition of

interest in natural resource recapture property)'' in its place.

3. Paragraph (j)(1) is amended by removing the language ``or

1252(a)'' and adding ``1252(a), or 1254(a)'' in its place.

Sec. 1.312-3 [Amended]

Par. 3. Section 1.312-3 is amended by removing ``or 1252(a)'' and

adding ``1252(a), or 1254(a)'' in its place.

Sec. 1.341-6 [Amended]

Par. 4. Section 1.341-6 is amended as follows:

1. In paragraph (b)(1), the last sentence is amended by removing

the language ``and 1252 (relating to gain from disposition of farm

land)'' and adding ``1252 (relating to gain from disposition of farm

land), and 1254 (relating to gain from disposition of interest in

natural resource recapture property)'' in its place.

2. In paragraph (b)(2)(i), the first sentence is amended by

removing ``or 1252)'' and adding ``1252, or 1254)'' in its place.

3. In paragraph (b)(2)(iii), the second sentence is amended by

removing ``or 1252)'' and adding ``1252, or 1254)'' in its place.

4. In paragraph (b)(3), the first sentence is amended by removing

``or 1252)'' and adding ``1252, or 1254)'' in its place.

5. In paragraph (h)(4), the first sentence is amended by removing

``or 1252)'' and adding ``1252, or 1254)'' in its place.

6. Paragraph (n) is amended by:

a. Removing the language ``and 1252'' from the paragraph heading

and adding ``1252, and 1254'' in its place.

b. Removing from the text the language ``and 1252(a) (relating to

gain from disposition of farm land)'' and adding ``1252(a) (relating to

gain from disposition of farm land), and 1254(a) (relating to gain from

disposition of interest in natural resource recapture property)'' in

its place.

Sec. 1.453-9 [Amended]

Par. 5. Section 1.453-9, paragraph (c)(1)(ii) is amended by:

1. Removing from the second sentence the language ``or 1252(a)(1)''

and adding ``1252(a)(1), or 1254(a)(1)'' in its place.

2. Removing from the third sentence the language ``and paragraph

(d)(3) of Sec. 1.1252-1'' and adding in its place ``paragraph (d)(3) of

Sec. 1.1252-1, and paragraph (d) of Sec. 1.1254-1''.

Par. 6. Section 1.751-1, paragraphs (c)(4), (c)(5), and (c)(6) are

revised to read as follows:

Sec. 1.751-1 Unrealized receivables and inventory items.

* * * * *

(c) * * *

(4)(i) With respect to any taxable year of a partnership ending

after September 12, 1966 (but only in respect of expenditures paid or

incurred after that date), the term unrealized receivables, for

purposes of this section and sections 731, 736, 741, and 751, also

includes potential gain from mining property defined in section

617(f)(2). With respect to each item of partnership mining property so

defined, the potential gain is the amount that would be treated as gain

to which section 617(d)(1) would apply if (at the time of the

transaction described in section 731, 736, 741, or 751, as the case may

be) the item were sold by the partnership at its fair market value.

(ii) With respect to sales, exchanges, or other dispositions after

December 31, 1975, in any taxable year of a partnership ending after

that date, the term unrealized receivables, for purposes of this

section and sections 731, 736, 741, and 751, also includes potential

gain from stock in a DISC as described in section 992(a). With respect

to stock in such a DISC, the potential gain is the amount that would be

treated as gain to which section 995(c) would apply if (at the time of

the transaction described in section 731, 736, 741, or 751, as the case

may be) the stock were sold by the partnership at its fair market

value.

(iii) With respect to any taxable year of a partnership beginning

after December 31, 1962, the term unrealized receivables, for purposes

of this section and sections 731, 736, 741, and 751, also includes

potential gain from section 1245 property. With respect to each item of

partnership section 1245 property (as defined in section 1245(a)(3)),

potential gain from section 1245 property is the amount that would be

treated as gain to which section 1245(a)(1) would apply if (at the time

of the transaction described in section 731, 736, 741, or 751, as the

case may be) the item of section 1245 property were sold by the

partnership at its fair market value. See Sec. 1.1245-1(e)(1). For

example, if a partnership would recognize under section 1245(a)(1) gain

of $600 upon a sale of one item of section 1245 property and gain of

$300 upon a sale of its only other item of such property, the potential

section 1245 income of the partnership would be $900. [[Page 2501]]

(iv) With respect to transfers after October 9, 1975, and to sales,

exchanges, and distributions taking place after that date, the term

unrealized receivables, for purposes of this section and sections 731,

736, 741, and 751, also includes potential gain from stock in certain

foreign corporations as described in section 1248. With respect to

stock in such a foreign corporation, the potential gain is the amount

that would be treated as gain to which section 1248(a) would apply if

(at the time of the transaction described in section 731, 736, 741, or

751, as the case may be) the stock were sold by the partnership at its

fair market value.

(v) With respect to any taxable year of a partnership ending after

December 31, 1963, the term unrealized receivables, for purposes of

this section and sections 731, 736, 741, and 751, also includes

potential gain from section 1250 property. With respect to each item of

partnership section 1250 property (as defined in section 1250(c)),

potential gain from section 1250 property is the amount that would be

treated as gain to which section 1250(a) would apply if (at the time of

the transaction described in section 731, 736, 741, or 751, as the case

may be) the item of section 1250 property were sold by the partnership

at its fair market value. See Sec. 1.1250-1(f)(1).

(vi) With respect to any taxable year of a partnership beginning

after December 31, 1969, the term unrealized receivables, for purposes

of this section and sections 731, 736, 741, and 751, also includes

potential gain from farm recapture property as defined in section

1251(e)(1) (as in effect before enactment of the Tax Reform Act of

1984). With respect to each item of partnership farm recapture property

so defined, the potential gain is the amount which would be treated as

gain to which section 1251(c) (as in effect before enactment of the Tax

Reform Act of 1984) would apply if (at the time of the transaction

described in section 731, 736, 741, or 751, as the case may be) the

item were sold by the partnership at its fair market value.

(vii) With respect to any taxable year of a partnership beginning

after December 31, 1969, the term unrealized receivables, for purposes

of this section and sections 731, 736, 741, and 751, also includes

potential gain from farm land as defined in section 1252(a)(2). With

respect to each item of partnership farm land so defined, the potential

gain is the amount that would be treated as gain to which section

1252(a)(1) would apply if (at the time of the transaction described in

section 731, 736, 741, or 751, as the case may be) the item were sold

by the partnership at its fair market value.

(viii) With respect to transactions which occur after December 31,

1976, in any taxable year of a partnership ending after that date, the

term unrealized receivables, for purposes of this section and sections

731, 736, 741, and 751, also includes potential gain from franchises,

trademarks, or trade names referred to in section 1253(a). With respect

to each such item so referred to in section 1253(a), the potential gain

is the amount that would be treated as gain to which section 1253(a)

would apply if (at the time of the transaction described in section

731, 736, 741, or 751, as the case may be) the items were sold by the

partnership at its fair market value.

(ix) With respect to any taxable year of a partnership ending after

December 31, 1975, the term unrealized receivables, for purposes of

this section and sections 731, 736, 741, and 751, also includes

potential gain under section 1254(a) from natural resource recapture

property as defined in Sec. 1.1254-1(b)(2). With respect to each

separate partnership natural resource recapture property so described,

the potential gain is the amount that would be treated as gain to which

section 1254(a) would apply if (at the time of the transaction

described in section 731, 736, 741, or 751, as the case may be) the

property were sold by the partnership at its fair market value.

(x) For purposes of section 751(c) and this paragraph (c)(4), any

arm's-length agreement between the buyer and seller, or between the

partnership and distributee partner, will generally establish the fair

market value of the property described in this paragraph (c)(4).

(5) For purposes of subtitle A of the Internal Revenue Code, the

basis of any potential gain described in paragraph (c)(4) of this

section is zero.

(6)(i) If (at the time of any transaction referred to in paragraph

(c)(4) of this section) a partnership holds property described in

paragraph (c)(4) of this section and if--

(A) A partner had a special basis adjustment under section 743(b)

in respect of the property;

(B) The basis under section 732 of the property if distributed to

the partner would reflect a special basis adjustment under section

732(d); or

(C) On the date a partner acquired a partnership interest by way of

a sale or exchange (or upon the death of another partner) the

partnership owned the property and an election under section 754 was in

effect with respect to the partnership, the partner's share of any

potential gain described in paragraph (c)(4) of this section is

determined under paragraph (c)(6)(ii) of this section.

(ii) The partner's share of the potential gain described in

paragraph (c)(4) of this section in respect of the property to which

this paragraph (c)(6)(ii) applies is that amount of gain that the

partner would recognize under section 617(d)(1), 995(c), 1245(a),

1248(a), 1250(a), 1251(c) (as in effect before the Tax Reform Act of

1984), 1252(a), 1253(a), or 1254(a) (as the case may be) upon a sale of

the property by the partnership, except that, for purposes of this

paragraph (c)(6) the partner's share of such gain is determined in a

manner that is consistent with the manner in which the partner's share

of partnership property is determined; and the amount of a potential

special basis adjustment under section 732(d) is treated as if it were

the amount of a special basis adjustment under section 743(b). For

example, in determining, for purposes of this paragraph (c)(6), the

amount of gain that a partner would recognize under section 1245 upon a

sale of partnership property, the items allocated under Sec. 1.1245-

1(e)(3)(ii) are allocated to the partner in the same manner as the

partner's share of partnership property is determined. See Sec. 1.1250-

1(f) for rules similar to those contained in Sec. 1.1245-1(e)(3)(ii).

* * * * *

Par. 7. Sections 1.1254-0 through 1.1254-6 are added to read as

follows:

Sec. 1.1254-0 Table of contents for section 1254 recapture rules.

This section lists the major captions contained in Secs. 1.1254-1

through 1.1254-6.

Sec. 1.1254-1 Treatment of gain from disposition of natural

resource recapture property.

(a) In general.

(b) Definitions.

(1) Section 1254 costs.

(2) Natural resource recapture property.

(3) Disposition.

(c) Disposition of a portion of natural resource recapture property.

(1) Disposition of a portion (other than an undivided interest)

of natural resource recapture property.

(2) Disposition of an undivided interest.

(3) Alternative allocation rule.

(d) Installment method.

Sec. 1.1254-2 Exceptions and limitations.

(a) Exception for gifts and section 1041 transfers.

(1) General rule.

(2) Part gift transactions.

(b) Exception for transfers at death.

(c) Limitation for certain tax-free transactions.

(1) General rule. [[Page 2502]]

(2) Special rule for dispositions to certain tax exempt

organizations.

(3) Transfers described.

(4) Special rules for section 332 transfers.

(d) Limitation for like kind exchanges and involuntary conversions.

(1) General rule.

(2) Disposition and acquisition of both natural resource

recapture property and other property.

Sec. 1.1254-3 Section 1254 costs immediately after certain

acquisitions.

(a) Transactions in which basis is determined by reference to cost

or fair market value of property transferred.

(1) Basis determined under section 1012.

(2) Basis determined under section 301(d), 334(a), or 358(a)(2).

(3) Basis determined solely under former section 334(b)(2) or

former section 334(c).

(4) Basis determined by reason of the application of section

1014(a).

(b) Gifts and certain tax-free transactions.

(1) General rule.

(2) Transactions covered.

(c) Certain transfers at death.

(d) Property received in a like kind exchange or involuntary

conversion.

(1) General rule.

(2) Allocation of section 1254 costs among multiple natural

resource recapture property acquired.

(e) Property transferred in cases to which section 1071 or 1081(b)

applies.

Sec. 1.1254-4 Special rules for S corporations and their

shareholders. [Reserved].

Sec. 1.1254-5 Special rules for partnerships and their partners.

(a) In general.

(b) Determination of gain treated as ordinary income under section

1254 upon the disposition of natural resource recapture property by

a partnership.

(1) General rule.

(2) Exception to partner level recapture in the case of abusive

allocations.

(3) Examples.

(c) Section 1254 costs of a partner.

(1) General rule.

(2) Section 1254 costs of a transferee partner after certain

acquisitions.

(d) Property distributed to a partner.

(1) In general.

(2) Aggregate of partners' section 1254 costs with respect to

natural resource recapture property held by a partnership.

Sec. 1.1254-6 Effective date of regulations.

Sec. 1.1254-1 Treatment of gain from disposition of natural resource

recapture property.

(a) In general. Upon any disposition of section 1254 property or

any disposition after December 31, 1975 of oil, gas, or geothermal

property, gain is treated as ordinary income in an amount equal to the

lesser of the amount of the section 1254 costs (as defined in paragraph

(b)(1) of this section) with respect to the property, or the amount, if

any, by which the amount realized on the sale, exchange, or involuntary

conversion, or the fair market value of the property on any other

disposition, exceeds the adjusted basis of the property. However, any

amount treated as ordinary income under the preceding sentence is not

included in the taxpayer's gross income from the property for purposes

of section 613. Generally, the lesser of the amounts described in this

paragraph (a) is treated as ordinary income even though, in the absence

of section 1254(a), no gain would be recognized upon the disposition

under any other provision of the Internal Revenue Code. For the

definition of the term section 1254 costs, see paragraph (b)(1) of this

section. For the definition of the terms section 1254 property, oil,

gas, or geothermal property, and natural resource recapture property,

see paragraph (b)(2) of this section. For rules relating to the

disposition of natural resource recapture property, see paragraphs

(b)(3), (c), and (d) of this section. For exceptions and limitations to

the application of section 1254(a), see Sec. 1.1254-2.

(b) Definitions--(1) Section 1254 costs--(i) Property placed in

service after December 31, 1986. With respect to any property placed in

service by the taxpayer after December 31, 1986, the term section 1254

costs means--

(A) The aggregate amount of expenditures that have been deducted by

the taxpayer or any person under section 263, 616, or 617 with respect

to such property and that, but for the deduction, would have been

included in the adjusted basis of the property or in the adjusted basis

of certain depreciable property associated with the property; and

(B) The deductions for depletion under section 611 that reduced the

adjusted basis of the property.

(ii) Property placed in service before January 1, 1987. With

respect to any property placed in service by the taxpayer before

January 1, 1987, the term section 1254 costs means--

(A) The aggregate amount of costs paid or incurred after December

31, 1975, with respect to such property, that have been deducted as

intangible drilling and development costs under section 263(c) by the

taxpayer or any other person (except that section 1254 costs do not

include costs incurred with respect to geothermal wells commenced

before October 1, 1978) and that, but for the deduction, would be

reflected in the adjusted basis of the property or in the adjusted

basis of certain depreciable property associated with the property;

reduced by

(B) The amount (if any) by which the deduction for depletion

allowed under section 611 that was computed either under section 612 or

sections 613 and 613A, with respect to the property, would have been

increased if the costs (paid or incurred after December 31, 1975) had

been charged to capital account rather than deducted.

(iii) Deductions under section 59 and section 291. Amounts

capitalized pursuant to an election under section 59(e) or pursuant to

section 291(b) are treated as section 1254 costs in the year in which

an amortization deduction is claimed under section 59(e)(1) or section

291(b)(2).

(iv) Suspended deductions. If a deduction of a section 1254 cost

has been suspended as of the date of disposition of section 1254

property, the deduction is not treated as a section 1254 cost if it is

included in basis for determining gain or loss on the disposition. On

the other hand, if the deduction will eventually be claimed, it is a

section 1254 cost as of the date of disposition. For example, a

deduction suspended pursuant to the 65 percent of taxable income

limitation of section 613A(d)(1) may either be included in basis upon

disposition of the property or may be deducted in a year after the year

of disposition. See Sec. 1.613A-4(a)(1). If it is included in the basis

then it is not a section 1254 cost, but if it is deductible in a later

year it is a section 1254 cost as of the date of the disposition.

(v) Previously recaptured amounts. If an amount has been previously

treated as ordinary income pursuant to section 1254, it is not a

section 1254 cost.

(vi) Nonproductive wells. The aggregate amount of section 1254

costs paid or incurred on any property includes the amount of

intangible drilling and development costs incurred on nonproductive

wells, but only to the extent that the taxpayer recognizes income on

the foreclosure of a nonrecourse debt the proceeds from which were used

to finance the section 1254 costs with respect to the property. For

this purpose, the term nonproductive well means a well that does not

produce oil or gas in commercial quantities, including a well that is

drilled for the purpose of ascertaining the existence, location, or

extent of an oil or gas reservoir (e.g., a delineation well). The term

nonproductive well does not include an injection well (other than an

injection well drilled as part of a project that does not result in

production in commercial quantities).

(vii) Calculation of amount described in paragraph (b)(1)(ii)(B) of

this section (hypothetical depletion offset)--(A) In general. In

calculating the amount [[Page 2503]] described in paragraph

(b)(1)(ii)(B) of this section, the taxpayer shall apply the following

rules. The taxpayer may use the 65-percent-of-taxable-income limitation

of section 613A(d)(1). If the taxpayer uses that limitation, the

taxpayer is not required to recalculate the effect of such limitation

with respect to any property not disposed of. That is, the taxpayer may

assume that the hypothetical capitalization of intangible drilling and

development costs with respect to any property disposed of does not

affect the allowable depletion with respect to property retained by the

taxpayer. Any intangible drilling and development costs that, if they

had not been treated as expenses under section 263(c), would have

properly been capitalized under Sec. 1.612-4(b)(2) (relating to items

recoverable through depreciation under section 167 or cost recovery

under section 168) are treated as costs described in Sec. 1.612-4(b)(1)

(relating to items recoverable through depletion). The increase in

depletion attributable to the capitalization of intangible drilling and

development costs is computed by subtracting the amount of cost or

percentage depletion actually claimed from the amount of cost or

percentage depletion that would have been allowable if intangible

drilling and development costs had been capitalized. If the remainder

is zero or less than zero, the entire amount of intangible drilling and

development costs attributable to the property is recapturable.

(B) Example. The following example illustrates the principles of

paragraph (b)(1)(vii)(A).

Example. Hypothetical depletion offset. In 1976, A purchased

undeveloped property for $10,000. During 1977, A incurred $200,000

of productive well intangible drilling and development costs with

respect to the property. A deducted the intangible drilling and

development costs as expenses under section 263(c). Estimated

reserves of 150,000 barrels of recoverable oil were discovered in

1977 and production began in 1978. In 1978, A produced and sold

30,000 barrels of oil at $8 per barrel, resulting in $240,000 of

gross income. A had no other oil or gas production in 1978. A

claimed a percentage depletion deduction of $52,800 (i.e., 22% of

$240,000 gross income from the property). If A had capitalized the

intangible drilling and development costs, assume that $200,000 of

the costs would have been allocated to the depletable property and

none to depreciable property. A's cost depletion deduction if the

intangible drilling and development costs had been capitalized would

have been $42,000 (i.e., (($200,000 intangible drilling and

development costs + $10,000 acquisition costs) x 30,000 barrels of

production)/ 150,000 barrels of estimated recoverable reserves).

Since this amount is less than A's depletion deduction of $52,800

(percentage depletion), no reduction is made to the amount of

intangible drilling and development costs ($200,000). On January 1,

1979, A sold the oil property to B for $360,000 and calculated

section 1254 recapture without reference to the 65-percent-of-

taxable-income limitation. A's gain on the sale is the entire

$360,000, because A's basis in the property at the beginning of 1979

is zero (i.e., $10,000 cost less $52,800 depletion deduction for

1978). Since the section 1254 costs ($200,000) are less than A's

gain on the sale, $200,000 is treated as ordinary income under

section 1254(a). The remaining amount of A's gain ($160,000) is not

subject to section 1254(a).

(2) Natural resource recapture property--(i) In general. The term

natural resource recapture property means section 1254 property or oil,

gas, or geothermal property as those terms are defined in this section.

(ii) Section 1254 property. The term section 1254 property means

any property (within the meaning of section 614) that is placed in

service by the taxpayer after December 31, 1986, if any expenditures

described in paragraph (b)(1)(i)(A) of this section (relating to costs

under section 263, 616, or 617) are properly chargeable to such

property, or if the adjusted basis of such property includes

adjustments for deductions for depletion under section 611.

(iii) Oil, gas, or geothermal property. The term oil, gas, or

geothermal property means any property (within the meaning of section

614) that was placed in service by the taxpayer before January 1, 1987,

if any expenditures described in paragraph (b)(1)(ii)(A) of this

section are properly chargeable to such property.

(iv) Property to which section 1254 costs are properly

chargeable.--(A) An expenditure is properly chargeable to property if--

(1) The property is an operating mineral interest with respect to

which the expenditure has been deducted;

(2) The property is a nonoperating mineral interest (e.g., a net

profits interest or an overriding royalty interest) burdening an

operating mineral interest if the nonoperating mineral interest is

carved out of an operating mineral interest described in paragraph

(b)(2)(iv)(A)(1) of this section;

(3) The property is a nonoperating mineral interest retained by a

lessor or sublessor if such lessor or sublessor held, prior to the

lease or sublease, an operating mineral interest described in paragraph

(b)(2)(iv)(A)(1) of this section; or

(4) The property is an operating or a nonoperating mineral interest

held by a taxpayer if a party related to the taxpayer (within the

meaning of section 267(b) or section 707(b)) held an operating mineral

interest (described in paragraph (b)(2)(iv)(A)(1) of this section) in

the same tract or parcel of land that terminated (in whole or in part)

without being disposed of (e.g., a working interest which terminated

after a specified period of time or a given amount of production), but

only if there exists between the related parties an arrangement or plan

to avoid recapture under section 1254. In such a case, the taxpayer's

section 1254 costs with respect to the property include those of the

related party.

(B) Example. The following example illustrates the provisions of

paragraph (2)(iv)(A)(4) of this section:

Example. Arrangement or plan to avoid recapture. C, an

individual, owns 100% of the stock of both X Co. and Y Co. On

January 1, 1998, X Co. enters into a standard oil and gas lease. X

Co. immediately assigns to Y Co. 1% of the working interest for one

year, and 99% of the working interest thereafter. In 1998, X Co. and

Y Co. expend $300 in intangible drilling and development costs

developing the tract, of which $297 are deducted by X Co. under

section 263(c). On January 1, 1999, Y Co. sells its 99% share of the

working interest to an unrelated person. Based on all the facts and

circumstances, the arrangement between X Co. and Y Co. is part of a

plan or arrangement to avoid recapture under section 1254.

Therefore, Y Co. must include in its section 1254 costs the $297 of

intangible drilling and development costs deducted by X Co.

(v) Property the basis of which includes adjustments for depletion

deductions. The adjusted basis of property includes adjustments for

depletion under section 611 if--

(A) The basis of the property has been reduced by reason of

depletion deductions; or

(B) The property has been carved out of or is a portion of property

the basis of which has been reduced by reason of depletion deductions.

(vi) Property held by a transferee. Property held by a transferee

is natural resource recapture property if the property was natural

resource recapture property in the hands of the transferor and the

transferee's basis in the property is determined with reference to the

transferor's basis in the property (e.g., a gift) or is determined

under section 732.

(vii) Property held by a transferor. Property held by a transferor

of natural resource recapture property is natural resource recapture

property if the transferor's basis in the property received is

determined with reference to the transferor's basis in the property

transferred by the transferor (e.g., a like kind exchange). For

purposes of this paragraph (b)(2), property described in this paragraph

(b)(2)(vii) is treated as placed in service at the time the

[[Page 2504]] property transferred by the transferor was placed in

service by the transferor.

(3) Disposition--(i) General rule. The term disposition has the

same meaning as in section 1245, relating to gain from dispositions of

certain depreciable property.

(ii) Exceptions. The term disposition does not include--

(A) Any transaction that is merely a financing device, such as a

mortgage or a production payment that is treated as a loan under

section 636 and the regulations thereunder;

(B) Any abandonment (except that an abandonment is a disposition to

the extent the taxpayer recognizes income on the foreclosure of a

nonrecourse debt);

(C) Any creation of a lease or sublease of natural resource

recapture property;

(D) Any termination or election of the status of an S corporation;

(E) Any unitization or pooling arrangement;

(F) Any expiration or reversion of an operating mineral interest

that expires or reverts by its own terms, in whole or in part; or

(G) Any conversion of an overriding royalty interest that, at the

option of the grantor or successor in interest, converts to an

operating mineral interest after a certain amount of production.

(iii) Special rule for carrying arrangements. In a carrying

arrangement, liability for section 1254 costs attributable to the

entire operating mineral interest held by the carrying party prior to

reversion or conversion remains attributable to the reduced operating

mineral interest retained by the carrying party after a portion of the

operating mineral interest has reverted to the carried party or after

the conversion of an overriding royalty interest that, at the option of

the grantor or successor in interest, converts to an operating mineral

interest after a certain amount of production.

(c) Disposition of a portion of natural resource recapture

property--(1) Disposition of a portion (other than an undivided

interest) of natural resource recapture property--(i) Natural resource

recapture property subject to the general rules of Sec. 1.1254-1. For

purposes of section 1254(a)(1) and paragraph (a) of this section,

except as provided in paragraphs (c)(1) (ii) and (3) of this section,

in the case of the disposition of a portion (that is not an undivided

interest) of natural resource recapture property, the entire amount of

the section 1254 costs with respect to the natural resource recapture

property is treated as allocable to that portion of the property to the

extent of the amount of gain to which section 1254(a)(1) applies. If

the amount of the gain to which section 1254(a)(1) applies is less than

the amount of the section 1254 costs with respect to the natural

resource recapture property, the balance of the section 1254 costs

remaining after allocation to the portion of the property that was

disposed of remains subject to recapture by the taxpayer under section

1254(a)(1) upon disposition of the remaining portion of the property.

For example, assume that A owns an 80-acre tract of land with respect

to which A has deducted intangible drilling and development costs under

section 263(c). If A sells the north 40 acres, the entire amount of the

section 1254 costs with respect to the 80-acre tract is treated as

allocable to the 40-acre portion sold (to the extent of the amount of

gain to which section 1254(a)(1) applies).

(ii) Natural resource recapture property subject to the exceptions

and limitations of Sec. 1.1254-2. For purposes of section 1254(a)(1)

and paragraph (a) of this section, except as provided in paragraph

(b)(3) of this section, in the case of the disposition of a portion

(that is not an undivided interest) of natural resource recapture

property to which section 1254(a)(1) does not apply by reason of the

application of Sec. 1.1254-2 (certain nonrecognition transactions), the

following rule for allocation of costs applies. An amount of the

section 1254 costs that bears the same ratio to the entire amount of

such costs with respect to the entire natural resource recapture

property as the value of the property transferred bears to the value of

the entire natural resource recapture property is treated as allocable

to the portion of the natural resource recapture property transferred.

The balance of the section 1254 costs remaining after allocation to

that portion of the transferred property remains subject to recapture

by the taxpayer under section 1254(a)(1) upon disposition of the

remaining portion of the property. For example, assume that A owns an

80-acre tract of land with respect to which A has deducted intangible

drilling and development costs under section 263(c). If A gives away

the north 40 acres, and if 60 percent of the value of the 80-acre tract

were attributable to the north 40 acres given away, 60 percent of the

section 1254 costs with respect to the 80-acre tract is allocable to

the north 40 acres given away.

(2) Disposition of an undivided interest--(i) Natural resource

recapture property subject to the general rules of Sec. 1.1254-1. For

purposes of section 1254(a)(1), except as provided in paragraphs

(b)(2)(ii) and (b)(3) of this section, in the case of the disposition

of an undivided interest in natural resource recapture property (or a

portion thereof), a proportionate part of the section 1254 costs with

respect to the natural resource recapture property is treated as

allocable to the transferred undivided interest to the extent of the

amount of gain to which section 1254(a)(1) applies. For example, assume

that A owns an 80-acre tract of land with respect to which A has

deducted intangible drilling and development costs under section

263(c). If A sells an undivided 40 percent interest in the 80-acre

tract, 40 percent of the section 1254 costs with respect to the 80-acre

tract is allocable to the transferred 40 percent interest in the 80-

acre tract. However, if the amount of gain recognized on the sale of

the 40 percent undivided interest were equal to only 35 percent of the

amount of section 1254 costs attributable to the 80-acre tract, only 35

percent of the section 1254 costs would be treated as attributable to

the undivided 40 percent interest. See paragraph (c)(3) of this section

for an alternative allocation rule.

(ii) Natural resource recapture property subject to the exceptions

and limitations of Sec. 1.1254-2. For purposes of section 1254(a)(1)

and paragraph (a) of this section, except as provided in paragraph

(b)(3) of this section, in the case of a disposition of an undivided

interest in natural resource recapture property (or a portion thereof)

to which section 1254 (a)(1) does not apply by reason of Sec. 1.1254-2,

a proportionate part of the section 1254 costs with respect to the

natural resource recapture property is treated as allocable to the

transferred undivided interest. See paragraph (c)(3) of this section

for an alternative allocation rule.

(3) Alternative allocation rule--(i) In general. The rules for the

allocation of costs set forth in section 1254(a)(2) and paragraphs

(c)(1) and (2) of this section do not apply with respect to section

1254 costs that the taxpayer establishes to the satisfaction of the

Commissioner do not relate to the transferred property. Except as

provided in paragraphs (c)(3)(ii) and (iii) of this section, a taxpayer

may satisfy this requirement only by receiving a private letter ruling

from the Internal Revenue Service that the section 1254 costs do not

relate to the transferred property.

(ii) Portion of property. Upon the transfer of a portion of a

natural resource recapture property (other than an undivided interest)

with respect to which section 1254 costs have been incurred, a taxpayer

may treat section 1254 costs as not relating to the transferred portion

if the transferred portion does not include any part of any

[[Page 2505]] deposit with respect to which the costs were incurred.

(iii) Undivided interest. Upon the transfer of an undivided

interest in a natural resource recapture property with respect to which

section 1254 costs have been incurred, a taxpayer may treat costs as

not relating to the transferred interest if the undivided interest is

an undivided interest in a portion of the natural resource recapture

property, and the portion would be eligible for the alternative

allocation rule under paragraph (c)(3)(ii) of this section.

(iv) Substantiation. If a taxpayer treats section 1254 costs

incurred with respect to a natural resource recapture property as not

relating to a transferred interest in a portion of the property, the

taxpayer must indicate on his or her tax return that the costs do not

relate to the transferred portion and maintain the records and

supporting evidence that substantiate this position.

(d) Installment method. Gain from a disposition to which section

1254(a)(1) applies is reported on the installment method if that method

otherwise applies under section 453 or 453A of the Internal Revenue

Code and the regulations thereunder. The portion of each installment

payment as reported that represents income (other than interest) is

treated as gain to which section 1254(a)(1) applies until all of the

gain (to which section 1254(a)(1) applies) has been reported, and the

remaining portion (if any) of the income is then treated as gain to

which section 1254(a)(1) does not apply. For treatment of amounts as

interest on certain deferred payments, see sections 483, 1274, and the

regulations thereunder.

Sec. 1.1254-2 Exceptions and limitations.

(a) Exception for gifts and section 1041 transfers--(1) General

rule. No gain is recognized under section 1254(a)(1) upon a disposition

of natural resource recapture property by a gift or by a transfer in

which no gain or loss is recognized pursuant to section 1041 (relating

to transfers between spouses). For purposes of this paragraph (a), the

term gift means, except to the extent that paragraph (a)(2) of this

section applies, a transfer of natural resource recapture property

that, in the hands of the transferee, has a basis determined under the

provisions of sections 1015(a) or (d) (relating to basis of property

acquired by gift). For rules concerning the potential reduction in the

amount of the charitable contribution in the case of natural resource

recapture property, see section 170(e) and Sec. 1.170A-4. See

Sec. 1.1254-3(b)(1) for determination of potential recapture of section

1254 costs on property acquired by gift. See Sec. 1.1254-1(c)(1)(ii)

and (c)(2)(ii) for apportionment of section 1254 costs on a gift of a

portion of natural resource recapture property.

(2) Part gift transactions. If a disposition of natural resource

recapture property is in part a sale or exchange and in part a gift,

the gain that is treated as ordinary income pursuant to section

1254(a)(1) is the lower of the section 1254 costs with respect to the

property or the excess of the amount realized upon the disposition of

the property over the adjusted basis of the property. In the case of a

transfer subject to section 1011(b) (relating to bargain sales to

charitable organizations), the adjusted basis for purposes of the

preceding sentence is the adjusted basis for determining gain or loss

under section 1011(b).

(b) Exception for transfers at death. Except as provided in section

691 (relating to income in respect of a decedent), no gain is

recognized under section 1254(a)(1) upon a transfer at death. For

purposes of this paragraph, the term transfer at death means a transfer

of natural resource recapture property that, in the hands of the

transferee, has a basis determined under the provisions of section

1014(a) (relating to basis of property acquired from a decedent)

because of the death of the transferor. See Sec. 1.1254-3(a)(4) and (c)

for the determination of potential recapture of section 1254 costs on

property acquired in a transfer at death.

(c) Limitation for certain tax-free transactions--(1) General rule.

Upon a transfer of property described in paragraph (c)(3) of this

section, the amount of gain treated as ordinary income by the

transferor under section 1254(a)(1) may not exceed the amount of gain

recognized to the transferor on the transfer (determined without regard

to section 1254). In the case of a transfer of both natural resource

recapture property and property that is not natural resource recapture

property in one transaction, the amount realized from the disposition

of the natural resource recapture property is deemed to be equal to the

amount that bears the same ratio to the total amount realized as the

fair market value of the natural resource recapture property bears to

the aggregate fair market value of all the property transferred. The

preceding sentence is applied solely for purposes of computing the

portion of the total gain (determined without regard to section 1254)

that may be recognized as ordinary income under section 1254(a)(1).

(2) Special rule for dispositions to certain tax-exempt

organizations. Paragraph (c)(1) of this section does not apply to a

disposition of natural resource recapture property to an organization

(other than a cooperative described in section 521) that is exempt from

the tax imposed by chapter I of the Internal Revenue Code. The

preceding sentence does not apply to a disposition of natural resource

recapture property to an organization described in section 511 (a)(2)

or (b)(2) (relating to imposition of tax on unrelated business income

of charitable, etc., organizations) if, immediately after the

disposition, the organization uses the property in an unrelated trade

or business as defined in section 513. If any property with respect to

which gain is not recognized by reason of the exception of this

paragraph (c)(2) ceases to be used in an unrelated trade or business of

the organization acquiring the property, that organization is, for

purposes of section 1254, treated as having disposed of the property on

the date of the cessation.

(3) Transfers described. The transfers referred to in paragraph

(c)(1) of this section are transfers of natural resource recapture

property in which the basis of the natural resource recapture property

in the hands of the transferee is determined by reference to its basis

in the hands of the transferor by reason of the application of any of

the following provisions:

(i) Section 332 (relating to certain liquidations of subsidiaries).

See paragraph (c)(4) of this section.

(ii) Section 351 (relating to transfer to a corporation controlled

by transferor).

(iii) Section 361 (relating to exchanges pursuant to certain

corporate reorganizations).

(iv) Section 721 (relating to transfers to a partnership in

exchange for a partnership interest).

(v) Section 731 (relating to distributions by a partnership to a

partner). For purposes of this paragraph, the basis of natural resource

recapture property distributed by a partnership to a partner is deemed

to be determined by reference to the adjusted basis of such property to

the partnership.

(4) Special rules for section 332 transfers. In the case of a

distribution in complete liquidation of a subsidiary to which section

332 applies, the limitation provided in this paragraph (c) is confined

to instances in which the basis of the natural resource recapture

property in the hands of the transferee is determined, under section

334(b)(1), by reference to its basis in the hands of the transferor.

Thus, for example, the limitation may apply in respect of a liquidating

distribution of natural resource recapture property by a subsidiary

corporation to the parent corporation, but does not apply in

[[Page 2506]] respect of a liquidating distribution of natural resource

recapture property to a minority shareholder. This paragraph (c) does

not apply to a liquidating distribution of natural resource recapture

property by a subsidiary to its parent if the parent's basis for the

property is determined under section 334(b)(2) (as in effect before

enactment of the Tax Reform Act of 1986), by reference to its basis for

the stock of the subsidiary. This paragraph (c) does not apply to a

liquidating distribution under section 332 of natural resource

recapture property by a subsidiary to its parent if gain is recognized

and there is a corresponding increase in the parent's basis in the

property (e.g., certain distributions to a tax-exempt or foreign

corporation).

(d) Limitation for like kind exchanges and involuntary

conversions--(1) General rule. If natural resource recapture property

is disposed of and gain (determined without regard to section 1254) is

not recognized in whole or in part under section 1031 (relating to like

kind exchanges) or section 1033 (relating to involuntary conversions),

the amount of gain taken into account by the transferor under section

1254(a)(1) may not exceed the sum of--

(i) The amount of gain recognized on the disposition (determined

without regard to section 1254); plus

(ii) The fair market value of property acquired that is not natural

resource recapture property and is not taken into account under

paragraph (d)(1)(i) of this section (that is, qualifying property under

section 1031 or 1033 that is not natural resource recapture property).

(2) Disposition and acquisition of both natural resource recapture

property and other property. For purposes of this paragraph (d), if

both natural resource recapture property and property that is not

natural resource recapture property are acquired as the result of one

disposition in which both natural resource recapture property and

property that is not natural resource recapture property are disposed

of--

(i) The total amount realized upon the disposition is allocated

between the natural resource recapture property and the property that

is not natural resource recapture property disposed of in proportion to

their respective fair market values;

(ii) The amount realized upon the disposition of the natural

resource recapture property is deemed to consist of so much of the fair

market value of the natural resource recapture property acquired as is

not in excess of the amount realized from the natural resource

recapture property disposed of, and the remaining portion (if any) of

the amount realized upon the disposition of such property is deemed to

consist of so much of the fair market value of the property that is not

natural resource recapture property acquired as is not in excess of the

remaining portion; and

(iii) The amount realized upon the disposition of the property that

is not natural resource recapture property is deemed to consist of so

much of the fair market value of all the property acquired which was

not taken into account under paragraph (d)(2)(ii) of this section.

Except as provided in section 1060 and the regulations thereunder, if a

buyer and seller have adverse interests as to such allocation of the

amount realized, any arm's-length agreement between the buyer and

seller is used to establish the allocation. In the absence of such an

agreement, the allocation is made by taking into account the

appropriate facts and circumstances.

Sec. 1.1254-3 Section 1254 costs immediately after certain

acquisitions.

(a) Transactions in which basis is determined by reference to cost

or fair market value of property transferred--(1) Basis determined

under section 1012. If, on the date a person acquires natural resource

recapture property, the person's basis for the property is determined

solely by reference to its cost (within the meaning of section 1012),

the amount of section 1254 costs with respect to the natural resource

recapture property in the person's hands is zero on the acquisition

date.

(2) Basis determined under section 301(d), 334(a), or 358(a)(2).

If, on the date a person acquires natural resource recapture property,

the person's basis for the property is determined solely by reason of

the application of section 301(d) (relating to basis of property

received in a corporate distribution), section 334(a) (relating to

basis of property received in a liquidation in which gain or loss is

recognized), or section 358(a)(2) (relating to basis of other property

received in certain exchanges), the amount of the section 1254 costs

with respect to the natural resource recapture property in the person's

hands is zero on the acquisition date.

(3) Basis determined solely under former section 334(b)(2) or

former section 334(c). If, on the date a person acquires natural

resource recapture property, the person's basis for the property is

determined solely under the provisions of section 334(b)(2) (prior to

amendment of that section by the Tax Equity and Fiscal Responsibility

Act of 1982) or (c) (prior to repeal of that section by the Tax Reform

Act of 1986) (relating to basis of property received in certain

corporate liquidations), the amount of section 1254 costs with respect

to the natural resource recapture property in the person's hands is

zero on the acquisition date.

(4) Basis determined by reason of the application of section

1014(a). If, on the date a person acquires natural resource recapture

property from a decedent, the person's basis is determined, by reason

of the application of section 1014(a), solely by reference to the fair

market value of the property on the date of the decedent's death or on

the applicable date provided in section 2032 (relating to alternate

valuation date), the amount of section 1254 costs with respect to the

natural resource recapture property in the person's hands is zero on

the acquisition date. See paragraph (c) of this section for the

treatment of certain transfers at death.

(b) Gifts and certain tax-free transactions--(1) General rule. If

natural resource recapture property is transferred in a transaction

described in paragraph (b)(2) of this section, the amount of section

1254 costs with respect to the natural resource recapture property in

the hands of the transferee immediately after the disposition is an

amount equal to--

(i) The amount of section 1254 costs with respect to the natural

resource recapture property in the hands of the transferor immediately

before disposition; minus

(ii) The amount of any gain taken into account as ordinary income

under section 1254(a)(1) by the transferor upon the disposition.

(2) Transactions covered. The transactions to which paragraph

(b)(1) of this section apply are--

(i) A disposition that is a gift or in part a sale or exchange and

in part a gift;

(ii) A transaction described in section 1041(a); or

(iii) A disposition described in Sec. 1.1254-2(c)(3) (relating to

certain tax-free transactions).

(c) Certain transfers at death. If natural resource recapture

property is acquired in a transfer at death, the amount of section 1254

costs with respect to the natural resource recapture property in the

hands of the transferee immediately after the transfer includes the

amount, if any, of the section 1254 costs deducted by the transferee

before the decedent's death, to the extent that the basis of the

natural resource recapture property (determined under section 1014(a))

is required to be reduced under the second sentence of section

1014(b)(9) (relating to adjustments to basis where the property

[[Page 2507]] is acquired from a decedent prior to death).

(d) Property received in a like kind exchange or involuntary

conversion--(1) General rule. If natural resource recapture property is

disposed of in a like kind exchange under section 1031 or involuntary

conversion under section 1033, then immediately after the disposition

the amount of section 1254 costs with respect to any natural resource

recapture property acquired for the property transferred is an amount

equal to--

(i) The amount of section 1254 costs with respect to the natural

resource recapture property disposed of; minus

(ii) The amount of any gain taken into account as ordinary income

under section 1254(a)(1) by the transferor upon the disposition.

(2) Allocation of section 1254 costs among multiple natural

resource recapture properties acquired. If more than one parcel of

natural resource recapture property is acquired at the same time from

the same person in a transaction referred to in paragraph (d)(1) of

this section, the total amount of section 1254 costs with respect to

the parcels is allocated to the parcels in proportion to their

respective adjusted bases.

(e) Property transferred in cases to which section 1071 or 1081(b)

applies. Rules similar to the rules of section 1245(b)(5) shall apply

under section 1254.

Sec. 1.1254-4 Special rules for S corporations and their shareholders.

[Reserved].

Sec. 1.1254-5 Special rules for partnerships and their partners.

(a) In general. This section provides rules for applying the

provisions of section 1254 to partnerships and their partners upon the

disposition of natural resource recapture property by the partnership

and certain distributions of property by a partnership. See section 751

and the regulations thereunder for rules concerning the treatment of

gain upon the transfer of a partnership interest.

(b) Determination of gain treated as ordinary income under section

1254 upon the disposition of natural resource recapture property by a

partnership--(1) General rule. Upon a disposition of natural resource

recapture property by a partnership, the amount treated as ordinary

income under section 1254 is determined at the partner level. Each

partner must recognize as ordinary income under section 1254 the lesser

of--

(i) The partner's section 1254 costs with respect to the property

disposed of; or

(ii) The partner's share of the amount, if any, by which the amount

realized upon the sale, exchange, or involuntary conversion, or the

fair market value of the property upon any other disposition, exceeds

the adjusted basis of the property.

(2) Exception to partner level recapture in the case of abusive

allocations. Paragraph (b)(1) of this section does not apply in

determining the amount treated as ordinary income under section 1254

upon a disposition of section 1254 property by a partnership if the

partnership has allocated the amount realized or gain recognized from

the disposition with a principal purpose of avoiding the recognition of

ordinary income under section 1254. In such case, the amount of gain on

the disposition recaptured as ordinary income under section 1254 is

determined at the partnership level.

(3) Examples. The provisions of paragraphs (a) and (b) of this

section are illustrated by the following examples which assume that

capital accounts are maintained in accordance with section 704(b) and

the regulations thereunder:

Example 1. Partner level recapture--In general. A, B, and C,

have equal interests in capital in Partnership ABC that was formed

on January 1, 1985. The partnership acquired an undeveloped domestic

oil property on January 1, 1985, for $120,000. The partnership

allocated the property's basis to each partner in proportion to the

partner's interest in partnership capital, so each partner was

allocated $40,000 of basis. In 1985, the partnership incurred

$60,000 of productive well intangible drilling and development costs

with respect to the property. The partnership elected to deduct the

intangible drilling and development costs as expenses under section

263(c). Each partner deducted $20,000 of the intangible drilling and

development costs. Assume that depletion allowable under section

613A(c)(7)(D) for each partner for 1985 was $10,000. On January 1,

1986, the partnership sold the oil property to an unrelated third

party for $210,000. Each partner's allocable share of the amount

realized is $70,000. Each partner's basis in the oil property at the

end of 1985 is $30,000 ($40,000 cost--$10,000 depletion deductions

claimed). Each partner has a gain of $40,000 on the sale of the oil

property ($70,000 amount realized--$30,000 adjusted basis in the oil

property). Assume that each partner's depletion allowance would not

have been increased if the intangible drilling and development costs

had been capitalized. Each partner's section 1254 costs with respect

to the property are $20,000. Thus, A, B, and C each must treat

$20,000 of gain recognized as ordinary income under section 1254(a).

Example 2. Special allocation of intangible drilling and

development costs. K and L form a partnership on January 1, 1997, to

acquire and develop a geothermal property as defined under section

613(e)(2). The partnership agreement provides that all intangible

drilling and development costs will be allocated to partner K, and

that all other items of income, gain, or loss will be allocated

equally between the two partners. Assume these allocations have

substantial economic effect under section 704(b) and the regulations

thereunder. The partnership acquires a lease covering undeveloped

acreage located in the United States for $50,000. In 1997, the

partnership incurs $50,000 of intangible drilling and development

costs that are allocated to partner K. The partnership also has

$30,000 of depletion deductions, which are allocated equally between

K and L. On January 1, 1998, the partnership sells the geothermal

property to an unrelated third party for $160,000 and recognizes a

gain of $140,000 ($160,000 amount realized less $20,000 adjusted

basis ($50,000 unadjusted basis less $30,000 depletion deductions)).

This gain is allocated equally between K and L. Because K's section

1254 costs are $65,000 and L's section 1254 costs are $15,000, K

recognizes $65,000 as ordinary income under section 1254(a) and L

recognizes $15,000 as ordinary income under section 1254(a). The

remaining $5,000 of gain allocated to K and $55,000 of gain

allocated to L is characterized without regard to section 1254.

Example 3. Section 59(e) election to capitalize intangible

drilling and development costs. Partnership DK has 50 equal

partners. On January 1, 1995, the partnership purchases an

undeveloped oil and gas property for $100,000. The partnership

allocates the property's basis equally among the partners, so each

partner is allocated $2,000 of basis. In January 1995, the

partnership incurs $240,000 of intangible drilling and development

costs with respect to the property. The partnership elects to deduct

the intangible drilling and development costs as expenses under

section 263(c). Each partner is allocated $4,800 of intangible

drilling and development costs. One of the partners, H, elects under

section 59(e) to capitalize his $4,800 share of intangible drilling

and development costs. Therefore, H is permitted to amortize his

$4,800 share of intangible drilling and development costs over 60

months. H takes a $960 amortization deduction in 1995. Each of the

remaining 49 partners deducts his $4,800 share of intangible

drilling and development costs in 1995. Assume that depletion

allowable for each partner under section 613A(c)(7)(D) for 1995 is

$1,000. On December 31, 1995, the partnership sells the property for

$300,000. Each partner is allocated $6,000 of amount realized. Each

partner that deducted the intangible drilling and development costs

has a basis in the oil property at the end of 1995 of $1,000 ($2,000

cost - $1,000 depletion deductions claimed). Each of these partners

has a gain of $5,000 on the sale of the oil property ($6,000 amount

realized - $1,000 adjusted basis in the property). The section 1254

costs of each partner that deducted intangible drilling and

development costs are $5,800 ($4,800 intangible drilling and

development costs deducted + $1,000 depletion deductions claimed).

Because each partner's section 1254 costs ($5,800) exceed each

partner's share of amount realized less each [[Page 2508]] partner's

adjusted basis ($5,000), each partner must treat his $5,000 gain

recognized on the sale of the oil property as ordinary income under

section 1254(a). Because H elected under section 59(e) to capitalize

the $4,800 of intangible drilling and development costs and

amortized only $960 of the costs in 1995, the $3,840 of unamortized

intangible drilling and development costs are included in H's basis

in the oil property. Therefore, at the end of 1995 H's basis in the

oil property is $4,840 (($2,000 cost + $4,800 capitalized intangible

drilling and development costs) - ($960 intangible drilling and

development costs amortized + $1,000 depletion deduction claimed)).

H's gain on the sale of the oil property is $1,160 ($6,000 amount

realized - $4,840 adjusted basis). H's section 1254 costs are $1,960

($960 intangible drilling and development costs amortized + $1,000

depletion deductions claimed). Because H's section 1254 costs

($1,960) exceed H's share of amount realized less H's adjusted basis

($1,160), H must treat the $1,160 of gain recognized as ordinary

income under section 1254(a).

(c) Section 1254 costs of a partner--(1) General rule. A partner's

section 1254 costs with respect to property held by a partnership

include all of the partner's section 1254 costs with respect to the

property in the hands of the partnership. In the case of property

contributed to a partnership in a transaction described in section 721,

a partner's section 1254 costs include all of the partner's section

1254 costs with respect to the property prior to contribution. Section

1.1254-1(b)(1)(iv), which provides rules concerning the treatment of

suspended deductions, applies to amounts not deductible pursuant to

section 704(d).

(2) Section 1254 costs of a transferee partner after certain

acquisitions--(i) Basis determined under section 1012. If a person

acquires an interest in a partnership that holds natural resource

recapture property (transferee partner) and the transferee partner's

basis for the interest is determined by reference to its cost (within

the meaning of section 1012), the amount of the transferee partner's

section 1254 costs with respect to the property held by the partnership

is zero on the acquisition date.

(ii) Basis determined by reason of the application of section

1014(a). If a transferee partner acquires an interest in a partnership

that holds natural resource recapture property from a decedent and the

transferee partner's basis is determined, by reason of the application

of section 1014(a), solely by reference to the fair market value of the

partnership interest on the date of the decedent's death or on the

applicable date provided in section 2032 (relating to alternate

valuation date), the amount of the transferee partner's section 1254

costs with respect to property held by the partnership is zero on the

acquisition date.

(iii) Basis determined by reason of the application of section

1014(b)(9). If an interest in a partnership that holds natural resource

recapture property is acquired before the death of the decedent, the

amount of the transferee partner's section 1254 costs with respect to

property held by the partnership shall include the amount, if any, of

the section 1254 costs deducted by the transferee partner before the

decedent's death, to the extent that the basis of the partner's

interest (determined under section 1014(a)) is required to be reduced

under section 1014(b)(9) (relating to adjustments to basis when the

property is acquired before the death of the decedent).

(iv) Gifts and section 1041 transfers. If an interest in a

partnership is transferred in a transfer that is a gift, a part sale or

exchange and part gift, or a transfer that is described in section

1041(a), the amount of the transferee partner's section 1254 costs with

respect to property held by the partnership immediately after the

transfer is an amount equal to--

(A) The amount of the transferor partner's section 1254 costs with

respect to the property immediately before the transfer; minus

(B) The amount of any gain recognized as ordinary income under

section 1254 by the transferor partner upon the transfer.

(d) Property distributed to a partner--(1) In general. The section

1254 costs for any natural resource recapture property received by a

partner in a distribution with respect to part or all of an interest in

a partnership include--

(i) The aggregate of the partners' section 1254 costs with respect

to the natural resource recapture property immediately prior to the

distribution; reduced by

(ii) The amount of any gain taken into account as ordinary income

under section 751 by the partnership or the partners (as constituted

after the distribution) on the distribution of the natural resource

recapture property.

(2) Aggregate of partners' section 1254 costs with respect to

natural resource recapture property held by a partnership--(i) In

general. The aggregate of partners' section 1254 costs is equal to the

sum of each partner's section 1254 costs. The partnership must

determine each partner's section 1254 costs under either paragraph

(d)(2)(i)(A) (written data) or paragraph (d)(2)(i)(B) (assumptions) of

this section. The partnership may determine the section 1254 costs of

some of the partners under paragraph (d)(2)(i)(A) of this section and

of others under paragraph (d)(2)(i)(B) of this section.

(A) Written data. A partnership may determine a partner's section

1254 costs by using written data provided by a partner showing the

partner's section 1254 costs with respect to natural resource recapture

property held by the partnership unless the partnership knows or has

reason to know that the written data is inaccurate. If a partnership

does not receive written data upon which it may rely, the partnership

must use the assumptions provided in paragraph (d)(2)(i)(B) of this

section in determining a partner's section 1254 costs.

(B) Assumptions. A partnership that does not use written data

pursuant to paragraph (d)(2)(i)(A) of this section to determine a

partner's section 1254 costs must use the following assumptions to

determine the partner's section 1254 costs:

(1) The partner deducted his or her share of deductions under

section 263(c), 616, or 617 for the first year in which the partner

could claim a deduction for such amounts, unless in the case of

expenditures under section 263(c) or 616, the partnership elected to

capitalize such amounts;

(2) The partner was not subject to the following limitations with

respect to the partner's depletion allowance under section 611, except

to the extent a limitation applied at the partnership level: the

taxable income limitation of section 613(a); the depletable quantity

limitations of section 613A(c); or the limitations of section

613A(d)(2), (3), and (4) (exclusion of retailers and refiners).

Sec. 1.1254-6 Effective date of regulations.

Sections 1.1254-1 through 1.1254-3 and Sec. 1.1254-5 are effective

with respect to any disposition of natural resource recapture property

occurring after March 13, 1995. The rule in Sec. 1.1254-

1(b)(2)(iv)(A)(2), relating to a nonoperating mineral interest carved

out of an operating mineral interest with respect to which an

expenditure has been deducted, is effective with respect to any

disposition occurring after March 13, 1995 of property (within the

meaning of section 614) that is placed in service by the taxpayer after

December 31, 1986.

Sec. 1.1502-14 [Amended]

Par. 8. In Sec. 1.1502-14, the first sentence of paragraph (c)(1)

is amended by removing the language ``or 1250(a)(1)'' and adding ``1250

(a)(1) or 1254(a)(1)'' in its place. [[Page 2509]]

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

Par. 9. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 10. Section 602.101 (c) is amended by adding the following

entries in numerical order to the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

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

Current OMB

CFR part or section where identified and described control

number

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

* * * * *

1.1254-1(c)(3)............................................. 1545-1352

1.1254-5(d)(2)............................................. 1545-1352

* * * * *

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

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: November 22, 1994.

Leslie B. Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-172 Filed 1-9-95; 8:45 am]

BILLING CODE 4830-01-U