Section 467 Rental Agreements; Treatment of Rent and Interest Under Certain Agreements for the Lease of Tangible Property

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8820]

RIN 1545-AU11

Section 467 Rental Agreements; Treatment of Rent and Interest

Under Certain Agreements for the Lease of Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

treatment of rent and interest under certain agreements for the lease

of tangible property. The regulations apply to certain rental

agreements that provide increasing or decreasing rents, or deferred or

prepaid rent, and provide guidance for lessees and lessors of tangible

property.

DATES: Effective Date: These regulations are effective on May 18, 1999.

Applicability Date: For dates of applicability of these

regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Forest Boone of the Office of

Assistant Chief Counsel (Income Tax and Accounting) at (202) 622-4960

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 467 was added to the Internal Revenue Code by section 92(a)

of the Tax Reform Act of 1984 (Pub. L. 98-369 (98 Stat. 609)). On June

3, 1996, the IRS and Treasury Department issued a notice of proposed

rulemaking (61 FR 27834 [IA-292-84, 1996-2 C.B. 462]) relating to

section 467. The proposed regulations provide guidance regarding the

applicability of section 467, and the amount of rent and interest

required to be accrued under section 467. Comments responding to the

notice were received, and a public hearing was held on September 25,

1996.

The IRS and Treasury Department issued interim guidance in Notice

97-72 (1997-2 C.B. 334), which informed taxpayers of certain conditions

under which a refinancing of indebtedness incurred by a lessor to

acquire property that is the subject of a rental agreement will not be

considered a substantial modification of that agreement for purposes of

section 467. After considering the comments that were received in

response to the notice of proposed rulemaking and the statements made

at the public hearing, the proposed regulations are adopted as revised

by this Treasury decision. The significant comments and revisions are

discussed below.

Explanation of Provisions

1. Section 467 Rental Agreements

Under the proposed and final regulations, section 467 applies to

any rental agreement with increasing or decreasing rent and aggregate

rental payments or other consideration of more than $250,000. A rental

agreement has increasing or decreasing rents if the annualized fixed

rent allocated to any rental period exceeds the annualized fixed rent

allocated to any other rental period in the lease term.

In determining whether a rental agreement has increasing or

decreasing rent, the proposed regulations provide that a rent holiday

at the beginning of the lease term is disregarded if the rent holiday

period is three months or less. Several commentators requested that the

rent holiday period be lengthened, arguing that it should be the same

as the rent holiday period permitted for determining whether a

leaseback or long-term agreement has tax-motivated increasing rents

(the lesser of 24 months or 10 percent of the lease term). The final

regulations do not adopt this suggestion.

Section 467(d)(1)(B) provides that a rental agreement will be

treated as a section 467 rental agreement if there are increases in the

amount to be paid as rent under the agreement. Except for the $250,000

de minimis exception set forth in section 467(d)(2), section 467 does

not contain any exceptions to the rule that rental agreements with

increasing rent are section 467 rental agreements. The three-month rent

holiday exception was added in the proposed regulations to prevent

relatively insubstantial rent holidays from causing a rental agreement

to be treated as a section 467 rental agreement. Accordingly, the

three-month rent holiday exception is intended merely as a de minimis

exception and a rule of administrative convenience. In contrast,

Congress specifically directed that a rent holiday safe harbor should

be provided for

[[Page 26846]]

normal commercial practices in determining whether a leaseback or long-

term agreement has tax-motivated increasing rents. Thus, since the

policies that support a rent holiday exception for disqualified

leasebacks and long-term agreements are clearly not the same as the

policies that support a rent holiday exception for whether an agreement

has increasing rent and is therefore a section 467 rental agreement,

the IRS and Treasury Department do not believe the rent holiday periods

should be the same.

The proposed regulations also provide that a rental agreement has

increasing or decreasing rent if it requires (or may require) the

payment of contingent rent, other than contingent rent that is

contingent due to (a) a provision computing rent based on a percentage

of the lessee's gross or net receipts (but only if the percentage does

not vary throughout the term of the lease); (b) adjustments based on a

reasonable price index; or (c) a provision requiring the lessee to pay

real estate taxes, insurance premiums, maintenance costs, or any other

cost (other than a debt service cost) that relates to the leased

property and is not within the control of the lessor or lessee or a

person related to the lessor or lessee. Several commentators requested

additional exceptions for other types of payments, as well as an

expansion of the existing exceptions.

The final regulations provide several additional types of

contingent payments that will not be taken into account in determining

whether a rental agreement has increasing or decreasing rent. Because

of the relationship between these contingent rent provisions and the

contingent rent provisions that are disregarded in determining whether

an agreement is a disqualified leaseback or long-term agreement, the

new contingent rent exceptions will be discussed below in connection

with the discussion of disqualified leasebacks and long-term

agreements.

2. Section 467 Rent

Under the proposed and final regulations, the section 467 rent for

a taxable year is the sum of the fixed rent for any rental periods that

begin and end in the taxable year, a ratable portion of the fixed rent

for other rental periods beginning or ending in the taxable year, and

any contingent rent that accrues in the taxable year. The amount of

fixed rent for a rental period depends on the terms of the rental

agreement and, under the regulations, will be either the amount of

fixed rent allocated to the period under the agreement, the constant

rental amount, or the proportional rental amount.

A. Disqualified Leaseback or Long-term Agreement

The proposed regulations provide that (a) the Commissioner, rather

than the parties to the rental agreement, will determine whether a

rental agreement is a disqualified leaseback or long-term agreement and

(b) a rental agreement will not be a disqualified leaseback or long-

term agreement unless it requires more than $2,000,000 in rental

payments and other consideration. The proposed regulations also provide

that, if either the lessor or the lessee is not subject to Federal

income tax on its income or is a tax-exempt entity (within the meaning

of section 168(h)(2)), the rental agreement will be closely

scrutinized, and clear and convincing evidence will be required to

establish that tax avoidance is not a principal purpose for providing

increasing or decreasing rent. The proposed regulations include as safe

harbors only the provisions set forth in section 467(b)(5) and an

uneven rent test based on Rev. Proc. 75-21 (1975-1 C.B. 715). Other

factors that would be considered as evidence of tax avoidance were not

provided.

Several commentators requested additional safe harbors for other

types of payments, as well as an expansion of the existing safe

harbors. In response to these comments, several changes have been made

in the final regulations to the tax avoidance and safe harbor

provisions.

(i) Determining tax avoidance. The proposed regulations do not

provide any substantive rules for determining tax avoidance because a

leaseback or long-term agreement will not be treated as disqualified in

the absence of an affirmative determination by the Commissioner. As a

result, the objective of consistency of treatment between the lessee

and lessor would have been met without the need to promulgate factors

or other rules that taxpayers could use to determine whether tax

avoidance was present. While the final regulations retain the rule that

only the Commissioner may make a tax avoidance determination, the IRS

and Treasury Department believe that the combination of substantive

guidance on tax avoidance and additional safe harbors will permit

taxpayers to determine more readily whether their leasebacks or long-

term agreements will be determined to be disqualified by the

Commissioner. Accordingly, substantive provisions have been added to

the final regulations prescribing the circumstances in which Federal

income tax avoidance will be treated as a principal purpose for

providing increasing or decreasing rent.

The final regulations provide that, if a significant difference

between the marginal Federal income tax rates of the lessor and lessee

can reasonably be expected at some time during the lease term, the

agreement will be closely scrutinized and clear and convincing evidence

will be required to establish that tax avoidance is not a principal

purpose for providing increasing or decreasing rent. The regulations

provide rules to determine when there is a significant difference in

marginal tax rates of the lessor and lessee. Under these rules, the

marginal tax rates are determined not only by reference to the Federal

income tax status of the taxpayer (for example, as a corporation,

partnership, or individual), but also to the specific circumstances of

the taxpayer. Thus, if a corporation either is subject to the

alternative minimum tax or has available net operating losses or

credits to carry forward from an earlier taxable year, the

corporation's marginal tax rate will differ from other corporations not

subject to the alternative minimum tax and not having available net

operating losses or credits. Further, in the case of an S corporation

or partnership, the marginal tax rate will be determined by taking into

account the amounts of income or deduction allocable to its

shareholders or partners, respectively, and the marginal tax rates of

the shareholders or partners.

Finally, as noted above, the final regulations retain the rule of

the proposed regulations that only the Commissioner may determine that

a section 467 rental agreement should be treated as a disqualified

leaseback or long-term agreement. The final regulations also provide

that such determination may be made either on a case-by-case basis or

in regulations or other guidance published by the Commissioner

providing that a certain type or class of leaseback or long-term

agreement will be treated as disqualified and subject to constant

rental accrual.

(ii) Safe harbors. In response to comments, the final regulations

include several safe harbor provisions not included in the proposed

regulations. The new safe harbors are intended to cover a variety of

payments that could be made under the terms of a rental agreement.

Under the final regulations, tax avoidance is not considered a

principal purpose for providing increasing or decreasing rent if the

increase or decrease in rent is described in one of the contingent rent

safe harbor provisions. The IRS and Treasury Department believe that

these additional safe harbors and the expansion of the

[[Page 26847]]

existing safe harbors appropriately balance the need to provide a

degree of certainty for taxpayers with the need to limit the potential

for tax avoidance.

The final regulations add several safe harbors for various types of

contingent payments that either are intended to compensate the lessor

for costs unrelated to the lessor's continuing investment in the leased

property or are so contingent that they should not be taken into

account for purposes of section 467 until the liability for such

payment becomes fixed. Accordingly, subject to the limitations in the

regulations, safe harbors are provided for payments required to be made

by the lessee: in the event of damage, destruction, or loss of the

leased property; in the case of a qualified motor vehicle operating

agreement within the meaning of section 7701(h)(2)(A), for the failure

of the property to maintain a specified residual value; for the failure

of the property to be returned to the lessor at the end of the lease

term in the condition specified in the agreement; or for the failure of

the lessor to obtain the income tax benefits contemplated by the

agreement. In addition, a provision requiring late payment charges is

also not taken into account in determining whether tax avoidance is

present in a leaseback or long-term agreement. Limitations on the scope

of these safe harbors are provided in order to ensure that these

provisions are included in the agreement for a valid business purpose

and that the provisions are not used to achieve tax avoidance.

Several commentators suggested that rent adjustments based on the

lessor's indebtedness, which itself bears interest at a variable rate,

are not tax motivated. In response, a safe harbor has also been added

for certain variable interest rate provisions. Under this safe harbor,

a rent adjustment provision will be disregarded if it is based solely

on the dollar amount of changes in the lessor's interest costs, and

only if the lessor and the lender are not related and the indebtedness

is evidenced by a variable rate debt instrument (within the meaning of

Sec. 1.1275-5(a)(1)). However, no inference may be drawn from this safe

harbor (or any other provision of the regulations relating to a

variable interest rate adjustment) concerning the effect of such an

adjustment on the classification of the rental agreement as a lease for

Federal income tax purposes.

In addition, the final regulations expand the scope of the safe

harbors provided in the proposed regulations relating to percentage

rents, inflation adjustments, and reasonable rent holidays. A provision

in a lease will not fail to qualify for the percentage rent safe harbor

because, for example, it applies to receipts or sales after making

certain limited deductions, it applies different percentages to

different departments or floors, or it applies to receipts or sales in

excess of a determinable amount. In addition, a provision will not fail

to qualify as an increase based on a reasonable price index because it

may limit the adjustment to a fixed percentage in some years. However,

this inflation adjustment safe harbor will not apply if the limitation

in the rental agreement represents, in substance, a series of fixed

increases in rent. For example, if the limitation on an annual

inflation adjustment is substantially below the level of inflation

reasonably expected during the lease term, the limitation is, in

substance, a series of fixed increases in rent.

The proposed regulations include a rent holiday safe harbor for the

determination of tax avoidance, which provision applies only if there

is a substantial business purpose for the rent holiday. Commentators

objected to this requirement because the requirement of a business

purpose was not set forth in the legislative history accompanying the

enactment of section 467. The final regulations delete the requirement

that there be a substantial business purpose for the rent holiday, but

add the requirement that was set forth in the legislative history. H.R.

Conf. Rep. No. 861, 98th Cong., 2d Sess. 893 (1984). Under the

additional rule in the final regulations, the reasonableness of the

rent holiday is determined by reference to the commercial practice (as

of the agreement date) in the locality where the use of the property

occurs. This commercial reasonableness requirement does not apply,

however, in the case of a rent holiday of three months or less at the

beginning of the lease term.

The proposed regulations also limit the rent holiday safe harbor to

rent holidays at the beginning of the lease term. The final regulations

remove this limitation and permit one consecutive period at any point

during the lease term to qualify for the rent holiday safe harbor if

the commercial reasonableness requirement is satisfied and the rent

holiday period does not exceed the lesser of 24 months or 10 percent of

the lease term.

Finally, except in the case of the rent holiday safe harbor, the

safe harbor provisions discussed above also apply in determining

whether a rental agreement has increasing or decreasing rent and is

thus subject to section 467. Accordingly, if a type of contingent rent

in a rental agreement meets the requirements of the applicable safe

harbor provision, it is not taken into account in determining whether

the agreement has increasing or decreasing rent for purposes of both

the application of section 467 and the determination of whether the

agreement is a disqualified leaseback or long-term agreement.

(iii) Uneven rent test. The proposed regulations contain a safe

harbor providing that tax avoidance will not be considered to be a

principal purpose for providing increasing or decreasing rents if the

rents allocable to each calendar year of the lease do not vary from the

average annual rents over the entire lease term by more than 10

percent. This ``uneven rent test'' is derived from the Conference

Committee Report, which stated that the Committee anticipated that

regulations under section 467 would adopt standards under which leases

providing for fluctuations in rents by no more than a reasonable

percentage above or below the average rent over the term of the lease

will be deemed not to be motivated by tax avoidance. The report cited

the standards for advance rulings on leveraged lease transactions in

Rev. Proc. 75-21, and stated that such standards may not be appropriate

for real estate leases. H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess.

893 (1984). The proposed regulations do not provide a safe harbor

specifically applicable to real estate leases but comments were

requested on whether a different uneven rent test should be established

for real estate leases.

Commentators requested that the basic ``90-110'' test in Rev. Proc.

75-21 be adopted without modification. The principal modification to

the basic 90-110 test in the proposed regulations identified by the

commentators was the use of the calendar year rather than the lease

year to test for uneven rents. These commentators also requested that

the alternate uneven rent test (sometimes referred to as the ``\2/3\-

\1/3\'' test) be adopted as an additional safe harbor. Finally, these

commentators requested clarification of the application of these uneven

rent tests in certain circumstances.

In response to these comments, the final regulations expand and

clarify the scope of the uneven rent test in the proposed regulations.

First, the final regulations allow a rent holiday period at the

beginning of the lease term to be ignored in applying the uneven rent

test if its duration is not more than three months. Further, all but

two of the contingent rent provisions ignored for purposes of

determining tax avoidance are also disregarded in applying the uneven

rent test. Rules are also

[[Page 26848]]

provided to assist taxpayers in applying the uneven rent test if the

rental agreement contains a variable rent provision.

For long-term leases of real estate, the final regulations provide

a modified uneven rent test. Under the final regulations, all of the

rules relating to the uneven rent test will be applied to long-term

leases of real estate, except that a 15 percent variance will be

permitted in lieu of the 10 percent variance (the ``85-115'' test) and

a rent holiday will be disregarded if it is commercially reasonable and

its duration does not exceed the lesser of 24 months or 10 percent of

the lease term.

The final regulations do not adopt the suggestion that the

alternative \2/3\-\1/3\ test also be made available as an additional

safe harbor. Section 467 evidences recognition that tax avoidance may

result from the use of either increasing or decreasing rents in a

section 467 rental agreement, depending on the circumstances of the

lessor and lessee in the particular transaction. The IRS and Treasury

Department believe that the use of the \2/3\-\1/3\ test may, in some

cases, result in substantial decreases in rent. Thus, the \2/3\-\1/3\

test is not included in the final regulations.

Furthermore, the final regulations retain the use of the calendar

year as the basis for applying the uneven rent test. The IRS and

Treasury Department believe that use of the calendar year is most

consistent with the structure of section 467, which provides the

calendar year as the basis for determining whether rent is deferred.

Some commentators requested additional safe harbors and other

special rules for leases of real estate, including the allowance of

fixed increases that approximate the parties' expectations of general

price increases during the lease term. The final regulations do not

provide any additional provisions relating to real estate leases except

for the modified 85-115 uneven rent test and the expanded rent holiday

safe harbor. The IRS and Treasury Department believe that any fixed

increases in a real estate lease that exceed the permitted variance

under the relaxed safe harbor should be tested for tax avoidance under

the general standards.

(iv) The $2,000,000 limitation. The proposed regulations provide

that, among other limitations, a rental agreement will not be treated

as a disqualified leaseback or long-term agreement unless it requires

more than $2,000,000 in rental payments and other consideration.

Although the $2,000,000 limitation has been retained in the final

regulations, the IRS and Treasury no longer believe such a limitation

is appropriate. Accordingly, the IRS and Treasury are issuing proposed

regulations that would eliminate the $2,000,000 limitation on a

prospective basis.

B. Rental Agreement Accrual

Under the proposed and final regulations, if neither the constant

rental amount nor the proportional rental amount is required to be

accrued, the rent to be accrued for a rental period is the rent

allocated to that rental period in accordance with the section 467

rental agreement. The amount of rent allocated to a rental period by

the rental agreement depends on whether the agreement provides a

specific allocation of fixed rent. If a rental agreement provides a

specific allocation of fixed rent, the amount of rent allocated to each

rental period during the lease term is the amount of fixed rent

allocated to that period by the agreement. In general, a rental

agreement specifically allocates fixed rent if the agreement

unambiguously specifies, for periods of no longer than a year, a fixed

amount of rent for which the lessee becomes liable on account of the

use of the property during that period.

The proposed regulations provide that, in the absence of a specific

allocation of fixed rent, the amount of rent allocated to each rental

period during the lease term is the amount of fixed rent payable during

that rental period. A number of commentators requested that the rule

for allocating rent in the absence of a specific allocation of fixed

rent be amended. The commentators stated that, if a rental agreement

contains only a rent payment schedule without a separate rent

allocation schedule, the agreement should be treated as one that does

not provide for an allocation of rents. In these circumstances, the

commentators contend that the agreement should be subject to constant

rental accrual under section 467(b)(3)(B).

The final regulations do not adopt this suggestion. Instead, the

final regulations, like the proposed regulations, provide that, in the

absence of a specific allocation of fixed rent, the amount of fixed

rent allocated to a rental period is the amount of fixed rent payable

during that rental period. The IRS and Treasury Department believe that

it is inappropriate to apply the constant rental accrual rules solely

because a rental agreement does not include a specific allocation of

fixed rent, whether as a result of inadvertence, failure to obtain

professional tax advice, or otherwise. Further, while the constant

rental accrual method is not available unless the Commissioner makes a

tax avoidance determination, parties wishing to accrue rent in

accordance with the constant rental accrual method may provide for an

allocation schedule in their rental agreement with tax consequences

that approximate the use of the constant rental accrual method.

C. Other Applicable Limitations

Some commentators suggested that the final regulations provide that

rental agreements will be closely scrutinized for substantial economic

effect in appropriate cases. For example, a rental agreement may

provide a specific allocation of fixed rent (or no specific allocation

of fixed rent) that, under the regulations, would result in significant

back-loaded or front-loaded rent, but would not be subject to constant

rental accrual because it is not a leaseback or long-term agreement. In

general, the rules of section 467 represent exceptions to the general

rules of tax accounting applicable to income and expense associated

with rental agreements. However, the IRS and Treasury Department do not

believe that section 467 and the regulations thereunder override other

principles of Federal tax law in the case of income and expense

associated with rental agreements. Thus, the final regulations

explicitly provide that the Commissioner may apply authorities other

than section 467 and the regulations thereunder, such as section 446(b)

clear-reflection-of-income principles, section 482, and the substance-

over-form doctrine, to determine the income and expense from a rental

agreement (including the proper allocation of fixed rent under a rental

agreement).

3. Rental Agreements With Contingent Payments

The proposed regulations reserve guidance on the section 467

treatment of contingent rent, indicating that regulations addressing

this issue would provide rules for contingent rent similar to those

provided for computing original issue discount for contingent payment

debt instruments in Sec. 1.1275-4. The final regulations continue to

reserve on the section 467 treatment of contingent payments. The IRS

and Treasury Department expect that regulations under Sec. 1.467-6 will

be separately proposed, and continue to invite comments regarding the

treatment of contingent rent and the application of

[[Page 26849]]

the Sec. 1.1275-4 rules to section 467 rental agreements.

4. Recapture on Sale or Other Disposition of Property

Some commentators requested certain modifications and further

clarification of the recapture rules under section 467(c) in the case

of dispositions by gift, transfers at death, and certain tax-free

transactions. In response to these comments, additional rules and

examples illustrating those rules are provided in the final

regulations.

The purpose of the additional rules is to place the transferee in

the same tax position upon the subsequent disposition of the leased

property as the transferor would have been in if the transferor had not

transferred the property to the transferee. For example, if property

subject to a section 467 rental agreement is transferred in a

transaction subject to section 351, and if the transferor would have

recognized section 467(c) recapture upon a taxable disposition of the

property, the transferee may be subject to recapture upon a subsequent

taxable disposition of the property. The amount of the recapture upon

the subsequent taxable disposition will be determined by taking into

account the section 467 rent and section 467 interest relating to the

period of the transferor's ownership of the property. Thus, if a

leaseback or long-term agreement provides for increasing rent but is

not a disqualified leaseback or long-term agreement, a taxable

disposition of the property by the transferee on or after the

expiration of the lease term will not be subject to section 467(c)

recapture. Alternatively, a taxable disposition of the property by the

transferee before the expiration of the lease term will be subject to

the same amount of section 467(c) recapture that would have applied if

the transferor had continued to own the property.

5. Other Disposition Rules

The proposed regulations reserve guidance on whether special rules

should be provided for transfers of property and leasehold interests in

transactions in which gain or loss is not recognized in whole or in

part. The IRS and Treasury Department believe, however, that special

rules are not necessary in the case of nonrecognition transactions. As

a general matter, because a section 467 loan is treated as indebtedness

for all purposes of the Internal Revenue Code, the rules that apply to

each of the nonrecognition provisions in cases where the property

transferred is encumbered by indebtedness will apply to the transfer of

property or a leasehold interest subject to a section 467 loan.

Further, if the section 467 loan represents an additional asset of the

transferor, it is unlikely that any gain will be realized by the

transferor because, in most cases, the basis of the loan will be equal

to the sum of the principal amount of the loan and the accrued interest

thereon. Thus, the provisions of the proposed regulations relating to

special rules for transfers in nonrecognition transactions have been

deleted.

6. Treatment of Modifications

The proposed regulations provide that, if the lessor and lessee

agree to a substantial modification of the terms of an existing lease,

the modified lease is generally treated as a new rental agreement for

purposes of section 467. Thus, if the modified lease provides for

increasing or decreasing rent, or deferred or prepaid rent, and the

rent exceeds $250,000, it is treated under the proposed regulations as

a section 467 rental agreement, even if the pre-modification lease was

not a section 467 rental agreement.

Some commentators requested additional guidance regarding whether a

substantial modification of a lease has occurred, in view of the

significant potential consequences of such a modification. In addition,

the commentators suggested several types of modifications that, in

their view, should not be treated as a substantial modification.

Other commentators indicated that the proposed regulations did not

clarify whether only the remaining portion of the modified lease is to

be taken into account for purposes of determining the section 467 rent

and interest for rental periods following the modification.

The final regulations retain the general rule of the proposed

regulations under which a rental agreement would be treated as a new

lease for purposes of section 467 if the parties agreed to a

substantial modification. Under the final regulations, if a substantial

modification of a rental agreement occurs after June 3, 1996, the post-

modification agreement is treated as a new agreement for purposes of

determining whether the agreement is a section 467 rental agreement or

a disqualified leaseback or long-term agreement and for purposes of

applying the effective date provisions of the section 467 regulations.

These rules do not apply, however, to a modification occurring on or

before May 18, 1999, unless the rental agreement being modified is a

post-June 3, 1996, disqualified leaseback or long-term agreement or the

post-modification agreement is a disqualified leaseback or long-term

agreement.

In general, in determining whether a modified agreement is a

section 467 rental agreement, or a disqualified leaseback or long-term

agreement, the modified agreement is considered to consist only of the

terms that relate to post-modification items (as described below).

However, if a principal purpose of the modification is to avoid the

purpose or intent of section 467 or the regulations thereunder, the

Commissioner may treat the entire agreement (as modified) as a single

agreement for purposes of section 467. The final regulations also

provide that the post-modification agreement, notwithstanding its

treatment as a new agreement, will be characterized, in certain cases,

in the same manner as the agreement in effect before the modification.

For example, if an agreement was a leaseback or was subject to constant

rental accrual before its modification, the post-modification agreement

will generally be treated as a leaseback or as subject to constant

rental accrual. Similarly, if the agreement was a long-term agreement

before its modification and the entire agreement (as modified) is a

long-term agreement, the post-modification agreement will be treated as

a long-term agreement.

The final regulations also provide rules for accounting for the

effects of modifications occurring after May 18, 1999. In the case of a

substantial modification, the lessor and lessee must take pre-

modification items (generally, rent for periods before the

modification, interest thereon, and payments allocable thereto (whether

made before or after the modification)) into account under the method

of accounting used before the modification. In computing section 467

rent, section 467 interest, and the amount of the section 467 loan with

respect to post-modification items, only post-modification items are

taken into account. In addition, the parties to the agreement are

required to take into account adjustments necessary to prevent

duplications and omissions resulting from the modification.

In the case of a modification that is not substantial, section 467

rent and interest for periods affected by the modification are

determined under the terms of the entire agreement (as modified). In

addition, the parties to the agreement are required to recompute the

balance of the section 467 loan under the new terms and to take into

account (as either additional rent or a reduction in rent previously

taken into account) the change in the loan balance resulting from the

modification. They are also required to take into account any

[[Page 26850]]

amount necessary to prevent duplications or omissions resulting from

the modification.

The final regulations also provide additional guidance for

determining whether a substantial modification of a lease has occurred,

adopting some of the principles applicable to the modification of debt

instruments under Sec. 1.1001-3. Under the final regulations, all of

the facts and circumstances will be examined to determine whether a

substantial modification has occurred. Because this determination is

inherently factual, the regulations do not provide more specific

criteria for making this determination. However, in order to ensure

that relatively insubstantial changes to the terms of a lease agreement

and changes that do not implicate the policies of section 467 are not

treated as substantial modifications under this rule, safe harbor

provisions have been added.

In general, the modifications that are likely to affect the

character of a rental agreement for purposes of section 467 are those

that change the amount or timing of rent allocated or rent payable for

the use of the property, or the identity of the taxpayer taking those

amounts into account. Thus, a substantial modification will not result

from changes in any provision for the payment of third-party costs or

any other provision that is ignored for purposes of determining whether

the agreement provides for contingent rents. In addition, the

refinancing of a lessor's indebtedness on a leveraged lease will

generally not be treated as a substantial modification of the lease,

subject to compliance with certain conditions and limitations. These

conditions and limitations are intended to permit refinancings to avoid

classification as a substantial modification in circumstances where the

primary objective of the lessee is to take advantage of favorable

changes in interest rates.

In the case of a transfer of leased property by a lessor or a

substitution of a lessee, the final regulations provide that the

transfer or substitution will be treated as a substantial modification

only if a principal purpose of the transaction is the avoidance of

Federal income tax. In determining whether a transfer or substitution

should be treated as a substantial modification, the safe harbors and

other principles that generally apply in tax avoidance determinations

are taken into account and the Commissioner may treat the post-

modification agreement as a new agreement or treat the entire agreement

(as modified) as a single agreement.

7. Definition of Lease Term

The proposed regulations provide that an option period, whether

exercisable by the lessor or the lessee, is included in the lease term

only if it is reasonably expected, as of the agreement date, that the

option will be exercised. In contrast, Rev. Proc. 75-21 provides a

comparable rule only for options that are exercisable by the lessee,

while including the duration of all lessor renewal options in the lease

term. The IRS and Treasury Department believe that nothing in section

467 justifies a deviation from the rule of Rev. Proc. 75-21 in this

instance. Accordingly, for purposes of determining the term of a lease,

the final regulations retain the rule of the proposed regulations only

for lessee options, and treat all lessor options as if they had been

exercised.

8. Effective Dates

The regulations are applicable for (1) disqualified leasebacks and

long-term agreements entered into after June 3, 1996, and (2) other

rental agreements entered into after May 18, 1999. No inference should

be drawn concerning the treatment of rental agreements entered into

before the regulations are applicable. Moreover, the IRS will, in

appropriate circumstances, apply the provisions of section 467

requiring constant rental accrual to rental agreements entered into on

or before June 3, 1996.

Some commentators requested that the effective date for

disqualified leasebacks and long-term agreements be deferred so that

the regulations would apply only to agreements entered into after the

date on which final regulations are published in the Federal Register.

The final regulations do not adopt this suggestion. The IRS and

Treasury Department believe that the additional safe harbors provided

in these regulations will prevent leasebacks and long-term agreements

entered into after June 3, 1996, and on or before May 18, 1999 (the

interim period), from being inappropriately disqualified in cases where

the increasing or decreasing rents have not been motivated by tax

avoidance. Some of these commentators also requested that the

regulations not be applied to rental agreements entered into pursuant

to a contract that was binding on the applicable effective date. The

effective dates have been clarified in response to these comments.

Other commentators requested that taxpayers be permitted to rely on

the provisions of the proposed regulations in the case of leasebacks

and long-term agreements entered into during the interim period.

According to these commentators, the terms of certain leasebacks and

long-term agreements entered into during the interim period were

structured so as to comply with the safe harbors and other provisions

of the proposed regulations in order to ensure that these agreements

would not be treated as disqualified leasebacks or long-term

agreements. In the absence of a provision permitting taxpayers to rely

on the provisions of the proposed regulations in these cases, these

agreements might lose their safe-harbor protection because of changes

made in the final regulations. Accordingly, the final regulations

permit taxpayers to rely on the provisions of the proposed regulations

in the case of any leaseback or long-term agreement entered into during

the interim period. No specific election is required in the case of an

agreement subject to this provision.

9. Special Transitional Rule

Although the regulations do not apply to any rental agreement

entered into on or before June 3, 1996, and do not apply to any rental

agreement other than a disqualified leaseback or long-term agreement

entered into on or before May 18, 1999, some commentators requested

that they be allowed to change their method of accounting to the

constant rental accrual method for rental agreements involving certain

types of property financed by tax-exempt bonds where the agreements

were entered into prior to the issuance of the section 467 regulations.

The special rule was requested because, prior to the issuance of

regulations, lessees had entered into rental agreements providing for

disproportionately large payments of rent in the later years of the

lease term, but without specific allocations of rents. In the view of

the commentators, the circumstances in which a schedule of rent

payments would be treated as a rent allocation schedule were not fully

addressed by the legislative history.

In response to the comments, the final regulations contain a

special transitional rule under which lessees may change their method

of accounting for certain agreements to the constant rental accrual

method. With respect to this special transitional rule, a lessee's

change in its method of accounting for a rental agreement does not

affect the method of accounting used by the lessor for the same

agreement. In the case of similar rental agreements entered into after

May 18, 1999, lessees will be able to obtain results comparable to the

constant rental accrual method only by providing a specific allocation

schedule that differs from the rent payment schedule.

[[Page 26851]]

10. Issues Not Addressed

The final regulations do not address the application of section 467

to payments for services. With respect to the possible application of

section 467 to transactions sometimes referred to as ``lease strips''

or ``stripping transactions'', as described in Notice 95-53 (1995-2

C.B. 334), regulations under section 7701(l) were proposed after the

issuance of the proposed regulations under section 467 setting forth

the treatment of such transactions. Consequently, the IRS and Treasury

Department believe that no specific guidance on the treatment of such

transactions under section 467 is necessary.

The final regulations also do not provide guidance concerning the

applicability of penalties or additions to tax when the Commissioner

determines that a section 467 rental agreement should be treated as a

disqualified leaseback or long-term agreement. No inference should be

drawn from the failure to address the issue in these regulations

concerning the Commissioner's authority to impose applicable penalties

and additions to tax in such circumstances.

Special Analyses

It has been determined that this Treasury decision is not a

significant 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)

does not apply to these regulations, and, because the regulations do

not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Pursuant to section 7805(f) of the Internal Revenue Code, the notice of

proposed rulemaking preceding these regulations was submitted to the

Chief Counsel for Advocacy of the Small Business Administration for

comment on their impact on small businesses.

Drafting Information: The principal author of these regulations is

Forest Boone of the Office of Assistant Chief Counsel (Income Tax and

Accounting). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is 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, in part, as follows:

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

Sec. 1.467-1 is also issued under 26 U.S.C. 467.

Sec. 1.467-2 is also issued under 26 U.S.C. 467.

Sec. 1.467-3 is also issued under 26 U.S.C. 467.

Sec. 1.467-4 is also issued under 26 U.S.C. 467.

Sec. 1.467-5 is also issued under 26 U.S.C. 467.

Sec. 1.467-6 is also issued under 26 U.S.C. 467.

Sec. 1.467-7 is also issued under 26 U.S.C. 467.

Sec. 1.467-8 is also issued under 26 U.S.C. 467.

Sec. 1.467-9 is also issued under 26 U.S.C. 467. * * *

Par. 2. In Sec. 1.61-8, the first sentence of paragraph (b) is

revised to read as follows:

Sec. 1.61-8 Rents and royalties.

* * * * *

(b) * * * Except as provided in section 467 and the regulations

thereunder, gross income includes advance rentals, which must be

included in income for the year of receipt regardless of the period

covered or the method of accounting employed by the taxpayer. * * *

* * * * *

Par. 3. In Sec. 1.451-1, paragraph (g) is added to read as follows:

Sec. 1.451-1 General rule for taxable year of inclusion.

* * * * *

(g) Timing of income from section 467 rental agreements.

For the timing of income with respect to section 467 rental

agreements, see section 467 and the regulations thereunder.

Par. 4. Section 1.461-1 is amended by:

1. Adding a sentence at the end of paragraph (a)(1).

2. Adding paragraph (a)(2)(iii)(E).

The additions read as follows:

Sec. 1.461-1 General rule for taxable year of deduction.

(a) * * *

(1) * * * See section 467 and the regulations thereunder for rules

under which a liability arising out of the use of property pursuant to

a section 467 rental agreement is taken into account.

(2) * * *

(iii) * * *

(E) Except as otherwise provided by regulations or other published

guidance issued by the Commissioner (See Sec. 601.601(b)(2) of this

chapter), in the case of a liability arising out of the use of property

pursuant to a section 467 rental agreement, the all events test

(including economic performance) is considered met in the taxable year

in which the liability is to be taken into account under section 467

and the regulations thereunder.

* * * * *

Par. 5. Section 1.461-4 is amended by:

1. Redesignating the text of paragraph (d)(3)(ii) following the

heading as paragraph (d)(3)(ii)(A) and adding a heading for newly

designated paragraph (d)(3)(ii)(A).

2. Adding paragraph (d)(3)(ii)(B).

3. Adding two sentences at the end of the introductory text of

paragraph (d)(7).

The additions read as follows:

Sec. 1.461-4 Economic performance.

* * * * *

(d) * * *

(3) * * *

(ii) Exceptions--(A) Volume, frequency of use, or income. * * *

(B) Section 467 rental agreements. In the case of a liability

arising out of the use of property pursuant to a section 467 rental

agreement, economic performance occurs as provided in Sec. 1.461-

1(a)(2)(iii)(E).

* * * * *

(7) * * * Assume further that the examples do not involve section

467 rental agreements and, therefore, section 467 is not applicable.

The examples are as follows:

* * * * *

Par. 6. Sections 1.467-0 through 1.467-9 are added to read as

follows:

Sec. 1.467-0 Table of contents.

This section lists the captions that appear in Secs. 1.467-1

through 1.467-9.

Sec. 1.467-1 Treatment of lessors and lessees generally.

(a) Overview.

(1) In general.

(2) Cases in which rules are inapplicable.

(3) Summary of rules.

(i) Basic rules.

(ii) Special rules.

(4) Scope of rules.

(5) Application of other authorities.

(b) Method of accounting for section 467 rental agreements.

(c) Section 467 rental agreements.

(1) In general.

(2) Increasing or decreasing rent.

(i) Fixed rent.

(A) In general.

(B) Certain rent holidays disregarded.

(ii) Fixed rent allocated to a rental period.

(A) Specific allocation.

(1) In general.

(2) Rental agreements specifically allocating fixed rent.

[[Page 26852]]

(B) No specific allocation.

(iii) Contingent rent.

(A) In general.

(B) Certain contingent rent disregarded.

(3) Deferred or prepaid rent.

(i) Deferred rent.

(ii) Prepaid rent.

(iii) Rent allocated to a calendar year.

(iv) Examples.

(4) Rental agreements involving total payments of $250,000 or

less.

(i) In general.

(ii) Special rules in computing amount described in paragraph

(c)(4)(i) of this section.

(d) Section 467 rent.

(1) In general.

(2) Fixed rent for a rental period.

(i) Constant rental accrual.

(ii) Proportional rental accrual.

(iii) Section 467 rental agreement accrual.

(e) Section 467 interest.

(1) In general.

(2) Interest on fixed rent for a rental period.

(i) In general.

(ii) Section 467 rental agreements with adequate interest.

(3) Treatment of interest.

(f) Substantial modification of a rental agreement.

(1) Treatment as new agreement.

(i) In general.

(ii) Limitation.

(2) Post-modification agreement; in general.

(3) Other effects of a modification.

(4) Special rules.

(i) Carryover of character; leasebacks.

(ii) Carryover of character; long-term agreements.

(iii) Carryover of character; disqualified agreements.

(iv) Allocation of rent.

(v) Difference between aggregate rent and interest and aggregate

payments.

(A) In general.

(B) Constant rental accrual prior to the modification.

(C) Agreements described in this paragraph (f)(4)(v)(C).

(vi) Principal purpose of tax avoidance.

(5) Definitions.

(6) Safe harbors.

(7) Special rules for certain transfers.

(i) In general.

(ii) Exception.

(g) Treatment of amounts payable by lessor to lessee.

(1) Interest.

(2) Other amounts. [Reserved]

(h) Meaning of terms.

(i) [Reserved]

(j) Computational rules.

(1) Counting conventions.

(2) Conventions regarding timing of rent and payments.

(i) In general.

(ii) Time amount is payable.

(3) Annualized fixed rent.

(4) Allocation of fixed rent within a period.

(5) Rental period length.

Sec. 1.467-2 Rent accrual for section 467 rental agreements

without adequate interest.

(a) Section 467 rental agreements for which proportional rental

accrual is required.

(b) Adequate interest on fixed rent.

(1) In general.

(2) Section 467 rental agreements that provide for a variable

rate of interest.

(c) Computation of proportional rental amount.

(1) In general.

(2) Section 467 rental agreements that provide for a variable

rate of interest.

(d) Present value.

(e) Applicable Federal rate.

(1) In general.

(2) Source of applicable Federal rates.

(3) 110 percent of applicable Federal rate.

(4) Term of the section 467 rental agreement.

(i) In general.

(ii) Section 467 rental agreements with variable interest.

(f) Examples.

Sec. 1.467-3 Disqualified leasebacks and long-term agreements.

(a) General rule.

(b) Disqualified leaseback or long-term agreement.

(1) In general.

(2) Leaseback.

(3) Long-term agreement.

(i) In general.

(ii) Statutory recovery period.

(A) In general.

(B) Special rule for rental agreements relating to properties

having different statutory recovery periods.

(c) Tax avoidance as principal purpose for increasing or decreasing

rent.

(1) In general.

(2) Tax avoidance.

(i) In general.

(ii) Significant difference in tax rates.

(iii) Special circumstances.

(3) Safe harbors.

(4) Uneven rent test.

(i) In general.

(ii) Special rule for real estate.

(iii) Operating rules.

(d) Calculating constant rental amount.

(1) In general.

(2) Initial or final short periods.

(3) Method to determine constant rental amount; no short

periods.

(i) Step 1.

(ii) Step 2.

(iii) Step 3.

(e) Examples.

Sec. 1.467-4 Section 467 loan.

(a) In general.

(1) Overview.

(2) No section 467 loan in the case of certain section 467

rental agreements.

(3) Rental agreements subject to constant rental accrual.

(4) Special rule in applying the provisions of Sec. 1.467-7 (e),

(f), or (g).

(b) Principal balance.

(1) In general.

(2) Section 467 rental agreements that provide for prepaid fixed

rent and adequate interest.

(3) Timing of payments.

(c) Yield.

(1) In general.

(i) Method of determining yield.

(ii) Method of stating yield.

(iii) Rounding adjustments.

(2) Yield of section 467 rental agreements for which constant

rental amount or proportional rental amount is computed.

(3) Yield for purposes of applying paragraph (a)(4) of this

section.

(4) Determination of present values.

(d) Contingent payments.

(e) Section 467 rental agreements that call for payments before or

after the lease term.

(f) Examples.

Sec. 1.467-5 Section 467 rental agreements with variable interest.

(a) Variable interest on deferred or prepaid rent.

(1) In general.

(2) Exceptions.

(b) Variable rate treated as fixed.

(1) In general.

(2) Variable interest adjustment amount.

(i) In general.

(ii) Positive or negative adjustment.

(3) Section 467 loan balance.

(c) Examples.

Sec. 1.467-6 Section 467 rental agreements with contingent

payments. [Reserved]

Sec. 1.467-7 Section 467 recapture and other rules relating to

dispositions and modifications.

(a) Section 467 recapture.

(b) Recapture amount.

(1) In general.

(2) Prior understated inclusion.

(3) Section 467 gain.

(i) In general.

(ii) Certain dispositions.

(c) Special rules.

(1) Gifts.

(2) Dispositions at death.

(3) Certain tax-free exchanges.

(i) In general.

(ii) Dispositions covered.

(A) In general.

(B) Transfers to certain tax-exempt organizations.

(4) Dispositions by transferee.

(5) Like-kind exchanges and involuntary conversions.

(6) Installment sales.

(7) Dispositions covered by section 170(e), 341(e)(12), or

751(c).

(d) Examples.

(e) Other rules relating to dispositions.

(1) In general.

(2) Treatment of section 467 loan.

(3) [Reserved]

(4) Examples.

(f) Treatment of assignments by lessee and lessee-financed renewals.

(1) Substitute lessee use.

(2) Treatment of section 467 loan.

(3) Lessor use.

(4) Examples.

(g) Application of section 467 following a rental agreement

modification.

(1) Substantial modifications.

(i) Treatment of pre-modification items.

(ii) Computations with respect to post-modification items.

(iii) Adjustments.

(A) Adjustment relating to certain prepayments.

(B) Adjustment relating to retroactive beginning of lease term.

[[Page 26853]]

(iv) Coordination with rules relating to dispositions and

assignments.

(A) Dispositions.

(B) Assignments.

(2) Other modifications.

(i) Computation of section 467 loan for modified agreement.

(ii) Change in balance of section 467 loan.

(iii) Section 467 rent and interest after the modification.

(iv) Applicable Federal rate.

(v) Modification effective within a rental period.

(vi) Other adjustments.

(vii) Coordination with rules relating to dispositions and

assignments.

(viii) Exception for agreements entered into prior to effective

date of section 467.

(3) Adjustment by Commissioner.

(4) Effective date of modification.

(5) Examples.

(h) Omissions or duplications.

(1) In general.

(2) Example.

Sec. 1.467-8 Automatic consent to change to constant rental

accrual for certain rental agreements.

(a) General rule.

(b) Agreements to which automatic consent applies.

Sec. 1.467-9 Effective dates and automatic method changes for

certain agreements.

(a) In general.

(b) Automatic consent for certain rental agreements.

(c) Application of regulation project IA-292-84 to certain

leasebacks and long-term agreements.

(d) Entered into.

(e) Change in method of accounting.

(1) In general.

(2) Application of regulation project IA-292-84.

(3) Automatic change procedures.

Sec. 1.467-1 Treatment of lessors and lessees generally.

(a) Overview--(1) In general. When applicable, section 467 requires

a lessor and lessee of tangible property to treat rents consistently

and to use the accrual method of accounting (and time value of money

principles) regardless of their overall method of accounting. In

addition, in certain cases involving tax avoidance, the lessor and

lessee must take rent and stated or imputed interest into account under

a constant rental accrual method, pursuant to which the rent is treated

as accruing ratably over the entire lease term.

(2) Cases in which rules are inapplicable. Section 467 applies only

to leases (or other similar arrangements) that constitute section 467

rental agreements as defined in paragraph (c) of this section. For

example, a rental agreement is not a section 467 rental agreement, and,

therefore, is not subject to the provisions of this section and

Secs. 1.467-2 through 1.467-9 (the section 467 regulations), if it

specifies equal amounts of rent for each month throughout the lease

term and all payments of rent are due in the calendar year to which the

rent relates (or in the preceding or succeeding calendar year). In

addition, the section 467 regulations do not apply to a rental

agreement that requires total rents of $250,000 or less. For purposes

of determining whether the agreement has total rents of $250,000 or

less, certain specified contingent rent is disregarded.

(3) Summary of rules--(i) Basic rules. Paragraph (c) of this

section provides rules for determining whether a rental agreement is a

section 467 rental agreement. Paragraphs (d) and (e) of this section

provide rules for determining the amount of rent and interest,

respectively, required to be taken into account by a lessor and lessee

under a section 467 rental agreement. Paragraphs (f) through (h) and

(j) of this section provide various definitions and special rules

relating to the application of the section 467 regulations. Paragraph

(i) of this section is reserved.

(ii) Special rules. Section 1.467-2 provides rules for section 467

rental agreements that have deferred or prepaid rents without providing

for adequate interest. Section 1.467-3 provides rules for application

of the constant rental accrual method, including criteria for

determining whether an agreement is subject to this method. Section

1.467-4 provides rules for establishing and adjusting a section 467

loan (the amount that a lessor is deemed to have loaned to the lessee,

or vice versa, pursuant to the application of the section 467

regulations). Section 1.467-5 provides rules for applying the section

467 regulations where a rental agreement requires payments of interest

at a variable rate. Section 1.467-6, relating to the treatment of

certain section 467 rental agreements with contingent payments, is

reserved. Section 1.467-7 provides rules for the treatment of

dispositions by a lessor of property subject to a section 467 rental

agreement and the treatment of assignments by lessees and certain

lessee-financed renewals of a section 467 rental agreement. Section

1.467-7 also provides rules for the treatment of modified rental

agreements. Section 1.467-8 provides special transitional rules

relating to the method of accounting for certain rental agreements

entered into on or before May 18, 1999. Finally, Sec. 1.467-9 provides

the effective date rules for the section 467 regulations.

(4) Scope of rules. No inference should be drawn from any provision

of this section or Secs. 1.467-2 through 1.467-9 concerning whether--

(i) For Federal tax purposes, an arrangement constitutes a lease;

or

(ii) For Federal tax purposes, any obligation of the lessee under a

rental agreement is treated as rent.

(5) Application of other authorities. Notwithstanding section 467

and the regulations thereunder, other authorities such as section

446(b) clear-reflection-of-income principles, section 482, and the

substance-over-form doctrine, may be applied by the Commissioner to

determine the income and expense from a rental agreement (including the

proper allocation of fixed rent under a rental agreement).

(b) Method of accounting for section 467 rental agreements. If a

rental agreement is a section 467 rental agreement, as described in

paragraph (c) of this section, the lessor and lessee must each take

into account for any taxable year the sum of--

(1) The section 467 rent for the taxable year (as defined in

paragraph (d) of this section); and

(2) The section 467 interest for the taxable year (as defined in

paragraph (e) of this section).

(c) Section 467 rental agreements--(1) In general. Except as

otherwise provided in paragraph (c)(4) of this section, the term

section 467 rental agreement means a rental agreement, as defined in

paragraph (h)(12) of this section, that has increasing or decreasing

rents (as described in paragraph (c)(2) of this section), or deferred

or prepaid rents (as described in paragraph (c)(3) of this section).

(2) Increasing or decreasing rent--(i) Fixed rent--(A) In general.

A rental agreement has increasing or decreasing rent if the annualized

fixed rent, as described in paragraph (j)(3) of this section, allocated

to any rental period exceeds the annualized fixed rent allocated to any

other rental period in the lease term.

(B) Certain rent holidays disregarded. Notwithstanding the

provisions of paragraph (c)(2)(i)(A) of this section, a rental

agreement does not have increasing or decreasing rent if the increasing

or decreasing rent is solely attributable to a rent holiday provision

allowing reduced rent (or no rent) for a period of three months or less

at the beginning of the lease term.

(ii) Fixed rent allocated to a rental period--(A) Specific

allocation--(1) In general. If a rental agreement provides a specific

allocation of fixed rent, as described in paragraph (c)(2)(ii)(A)(2) of

this section, the amount of fixed rent allocated to each rental period

during the lease term is the amount of fixed rent allocated to that

period by the rental agreement.

[[Page 26854]]

(2) Rental agreements specifically allocating fixed rent. A rental

agreement specifically allocates fixed rent if the rental agreement

unambiguously specifies, for periods no longer than a year, a fixed

amount of rent for which the lessee becomes liable on account of the

use of the property during that period, and the total amount of fixed

rent specified is equal to the total amount of fixed rent payable under

the lease. For example, a rental agreement providing that rent is

$100,000 per calendar year, and providing for total payments of fixed

rent equal to the total amount specified, specifically allocates rent.

A rental agreement stating only when rent is payable does not

specifically allocate rent.

(B) No specific allocation. If a rental agreement does not provide

a specific allocation of fixed rent (for example, because the total

amount of fixed rent specified is not equal to the total amount of

fixed rent payable under the lease), the amount of fixed rent allocated

to a rental period is the amount of fixed rent payable during that

rental period. If an amount of fixed rent is payable before the

beginning of the lease term, it is allocated to the first rental period

in the lease term. If an amount of fixed rent is payable after the end

of the lease term, it is allocated to the last rental period in the

lease term.

(iii) Contingent rent--(A) In general. A rental agreement has

increasing or decreasing rent if it requires (or may require) the

payment of contingent rent (as defined in paragraph (h)(2) of this

section), other than contingent rent described in paragraph

(c)(2)(iii)(B) of this section.

(B) Certain contingent rent disregarded. For purposes of this

paragraph (c)(2)(iii), rent is disregarded to the extent it is

contingent as the result of one or more of the following provisions--

(1) A qualified percentage rents provision, as defined in paragraph

(h)(8) of this section;

(2) An adjustment based on a reasonable price index, as defined in

paragraph (h)(10) of this section;

(3) A provision requiring the lessee to pay third-party costs, as

defined in paragraph (h)(15) of this section;

(4) A provision requiring the payment of late payment charges, as

defined in paragraph (h)(4) of this section;

(5) A loss payment provision, as defined in paragraph (h)(7) of

this section;

(6) A qualified TRAC provision, as defined in paragraph (h)(9) of

this section;

(7) A residual condition provision, as defined in paragraph (h)(13)

of this section;

(8) A tax indemnity provision, as defined in paragraph (h)(14) of

this section;

(9) A variable interest rate provision, as defined in paragraph

(h)(16) of this section; or

(10) Any other provision provided in regulations or other published

guidance issued by the Commissioner, but only if the provision is

designated as contingent rent to be disregarded for purposes of this

paragraph (c)(2)(iii).

(3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement

has deferred rent under this paragraph (c)(3) if the cumulative amount

of rent allocated as of the close of a calendar year (determined under

paragraph (c)(3)(iii) of this section) exceeds the cumulative amount of

rent payable as of the close of the succeeding calendar year.

(ii) Prepaid rent. A rental agreement has prepaid rent under this

paragraph (c)(3) if the cumulative amount of rent payable as of the

close of a calendar year exceeds the cumulative amount of rent

allocated as of the close of the succeeding calendar year (determined

under paragraph (c)(3)(iii) of this section).

(iii) Rent allocated to a calendar year. For purposes of this

paragraph (c)(3), the rent allocated to a calendar year is the sum of--

(A) The fixed rent allocated to any rental period (determined under

paragraph (c)(2)(ii) of this section) that begins and ends in the

calendar year;

(B) A ratable portion of the fixed rent allocated to any other

rental period that begins or ends in the calendar year; and (C) Any

contingent rent that accrues during the calendar year.

(iv) Examples. The following examples illustrate the application of

this paragraph (c)(3):

Example 1. (i) A and B enter into a rental agreement that

provides for the lease of property to begin on January 1, 2000, and

end on December 31, 2003. The rental agreement provides that rent of

$100,000 accrues during each year of the lease term. Under the

rental agreement, no rent is payable during calendar year 2000, a

payment of $100,000 is to be made on December 31, 2001, and December

31, 2002, and a payment of $200,000 is to be made on December 31,

2003. A and B both select the calendar year as their rental period.

Thus, the amount of rent allocated to each rental period under

paragraph (c)(2)(ii) of this section is $100,000. Therefore, the

rental agreement does not have increasing or decreasing rent as

described in paragraph (c)(2)(i) of this section.

(ii) Under paragraph (c)(3)(i) of this section, a rental

agreement has deferred rent if, at the close of a calendar year, the

cumulative amount of rent allocated under paragraph (c)(3)(iii) of

this section exceeds the cumulative amount of rent payable as of the

close of the succeeding year. In this example, there is no deferred

rent: the rent allocated to 2000 ($100,000) does not exceed the

cumulative rent payable as of December 31, 2001 ($100,000); the rent

allocated to 2001 and preceding years ($200,000) does not exceed the

cumulative rent payable as of December 31, 2002 ($200,000); the rent

allocated to 2002 and preceding years ($300,000) does not exceed the

cumulative rent payable as of December 31, 2003 ($400,000); and the

rent allocated to 2003 and preceding years ($400,000) does not

exceed the cumulative rent payable as of December 31, 2004

($400,000). Therefore, because the rental agreement does not have

increasing or decreasing rent and does not have deferred or prepaid

rent, the rental agreement is not a section 467 rental agreement.

Example 2. (i) A and B enter into a rental agreement that

provides for a 10-year lease of personal property, beginning on

January 1, 2000, and ending on December 31, 2009. The rental

agreement provides for accruals of rent of $10,000 during each month

of the lease term. Under paragraph (c)(3)(iii) of this section,

$120,000 is allocated to each calendar year. The rental agreement

provides for a $1,200,000 payment on December 31, 2000.

(ii) The rental agreement does not have increasing or decreasing

rent as described in paragraph (c)(2)(i) of this section. The rental

agreement, however, provides prepaid rent under paragraph (c)(3)(ii)

of this section because the cumulative amount of rent payable as of

the close of a calendar year exceeds the cumulative amount of rent

allocated as of the close of the succeeding calendar year. For

example, the cumulative amount of rent payable as of the close of

2000 ($1,200,000 is payable on December 31, 2000) exceeds the

cumulative amount of rent allocated as of the close of 2001, the

succeeding calendar year ($240,000). Accordingly, the rental

agreement is a section 467 rental agreement.

(4) Rental agreements involving total payments of $250,000 or

less--(i) In general. A rental agreement is not a section 467 rental

agreement if, as of the agreement date (as defined in paragraph (h)(1)

of this section), it is not reasonably expected that the sum of the

aggregate amount of rental payments under the rental agreement and the

aggregate value of all other consideration to be received for the use

of property (taking into account any payments of contingent rent, and

any other contingent consideration) will exceed $250,000.

(ii) Special rules in computing amount described in paragraph

(c)(4)(i) of this section of this section. The following rules apply in

determining the amount described in paragraph (c)(4)(i) of this

section:

[[Page 26855]]

(A) Stated interest on deferred rent is not taken into account.

However, the Commissioner may recharacterize a portion of stated

interest as additional rent if a rental agreement provides for interest

on deferred rent at a rate that, in light of all of the facts and

circumstances, is clearly greater than the arm's-length rate of

interest that would have been charged in a lending transaction between

the lessor and lessee.

(B) Consideration that does not involve a cash payment is taken

into account at its fair market value. A liability that is either

assumed or secured by property acquired subject to the liability is

taken into account at the sum of its remaining principal amount and

accrued interest (if any) thereon or, in the case of an obligation

originally issued at a discount, at the sum of its adjusted issue price

and accrued qualified stated interest (if any), within the meaning of

Sec. 1.1273-1(c)(1).

(C) All rental agreements that are part of the same transaction or

a series of related transactions involving the same lessee (or any

related person) and the same lessor (or any related person) are treated

as a single rental agreement. Whether two or more rental agreements are

part of the same transaction or a series of related transactions

depends on all the facts and circumstances.

(D) If an agreement includes a provision increasing or decreasing

rent payable solely as a result of an adjustment based on a reasonable

price index, the amount described in paragraph (c)(4)(i) of this

section must be determined as if the applicable price index did not

change during the lease term.

(E) If an agreement includes a variable interest rate provision (as

defined in paragraph (h)(16) of this section), the amount described in

paragraph (c)(4)(i) of this section must be determined by using fixed

rate substitutes (determined in the same manner as under Sec. 1.1275-

5(e), treating the agreement date as the issue date) for the variable

rates of interest applicable to the lessor's indebtedness.

(F) Contingent rent described in paragraphs (c)(2)(iii)(B)(3)

through (8) of this section is not taken into account.

(d) Section 467 rent--(1) In general. The section 467 rent for a

taxable year is the sum of--

(i) The fixed rent for any rental period (determined under

paragraph (d)(2) of this section) that begins and ends in the taxable

year;

(ii) A ratable portion of the fixed rent for any other rental

period beginning or ending in the taxable year; and

(iii) In the case of a section 467 rental agreement that provides

for contingent rent, the contingent rent that accrues during the

taxable year.

(2) Fixed rent for a rental period--(i) Constant rental accrual. In

the case of a section 467 rental agreement that is a disqualified

leaseback or long-term agreement (as described in Sec. 1.467-3(b)), the

fixed rent for a rental period is the constant rental amount (as

determined under Sec. 1.467-3(d)).

(ii) Proportional rental accrual. In the case of a section 467

rental agreement that is not described in paragraph (d)(2)(i) of this

section, and does not provide adequate interest on fixed rent (as

determined under Sec. 1.467-2(b)), the fixed rent for a rental period

is the proportional rental amount (as determined under Sec. 1.467-

2(c)).

(iii) Section 467 rental agreement accrual. In the case of a

section 467 rental agreement that is not described in either paragraph

(d)(2)(i) or (ii) of this section, the fixed rent for a rental period

is the amount of fixed rent allocated to the rental period under the

rental agreement, as determined under paragraph (c)(2)(ii) of this

section.

(e) Section 467 interest--(1) In general. The section 467 interest

for a taxable year is the sum of--

(i) The interest on fixed rent for any rental period that begins

and ends in the taxable year;

(ii) A ratable portion of the interest on fixed rent for any other

rental period beginning or ending in the taxable year; and

(iii) In the case of a section 467 rental agreement that provides

for contingent rent, any interest that accrues on the contingent rent

during the taxable year.

(2) Interest on fixed rent for a rental period--(i) In general.

Except as provided in paragraph (e)(2)(ii) of this section and

Sec. 1.467-5(b)(1)(ii), the interest on fixed rent for a rental period

is equal to the product of--

(A) The principal balance of the section 467 loan (as described in

Sec. 1.467-4(b)) at the beginning of the rental period; and

(B) The yield of the section 467 loan (as described in Sec. 1.467-

4(c)).

(ii) Section 467 rental agreements with adequate interest. Except

in the case of a section 467 rental agreement that is a disqualified

leaseback or long-term agreement, if a section 467 rental agreement

provides adequate interest under Sec. 1.467-2(b)(1)(i) (agreements with

no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements with

adequate interest stated at a single fixed rate), the interest on fixed

rent for a rental period is the amount of interest provided in the

rental agreement for the period.

(3) Treatment of interest. If the section 467 interest for a rental

period is a positive amount, the lessor has interest income and the

lessee has an interest expense. If the section 467 interest for a

rental period is a negative amount, the lessee has interest income and

the lessor has an interest expense. Section 467 interest is treated as

interest for all purposes of the Internal Revenue Code.

(f) Substantial modification of a rental agreement--(1) Treatment

as new agreement--(i) In general. If a substantial modification of a

rental agreement occurs after June 3, 1996, the post-modification

agreement is treated as a new agreement and the date on which the

modification occurs is treated as the agreement date in applying

section 467 and the regulations thereunder to the post-modification

agreement. Thus, for example, the post-modification agreement is

treated as a new agreement entered into on the date the modification

occurs for purposes of determining whether it is a section 467 rental

agreement under this section, whether it is a disqualified leaseback or

long-term agreement under Sec. 1.467-3, and whether it is entered into

after the applicable effective date in Sec. 1.467-9.

(ii) Limitation. In the case of a substantial modification of a

rental agreement occurring on or before May 18, 1999, this paragraph

(f) applies only if--

(A) The rental agreement was a disqualified leaseback or long-term

agreement before the modification and the agreement date, determined

without regard to the modification, is after June 3, 1996; or

(B) The post-modification agreement would, after application of the

rules in this paragraph (f) (other than the special rule for

disqualified agreements in paragraph (f)(4)(iii) of this section), be a

disqualified leaseback or long-term agreement.

(2) Post-modification agreement; in general. For purposes of

determining whether a post-modification agreement is a section 467

rental agreement or a disqualified leaseback or long-term agreement

under paragraph (f)(1) of this section, the terms of the post-

modification agreement are, except as provided in paragraph (f)(4) of

this section, only those terms that provide for rights and obligations

relating to post-modification items (within the meaning of paragraph

(f)(5)(iv) of this section).

(3) Other effects of a modification. For rules relating to amounts

that must be taken into account following certain modifications, see

Sec. 1.467-7(g).

[[Page 26856]]

(4) Special rules--(i) Carryover of character; leasebacks. If an

agreement is a leaseback prior to its modification and the lessee prior

to the modification (or a related person) is the lessee after the

modification, the post-modification agreement is a leaseback even if

the post-modification lessee did not have an interest in the property

at any time during the two-year period ending on the date on which the

modification occurs.

(ii) Carryover of character; long-term agreements. If an agreement

is a long-term agreement prior to its modification and the entire

agreement (as modified) would be a long-term agreement, the post-

modification agreement is a long-term agreement.

(iii) Carryover of character; disqualified agreements. If an

agreement (as in effect before its modification) is a disqualified

leaseback or long-term agreement as the result of a determination

(whether occurring before or after the modification) under Sec. 1.467-

3(b)(1)(ii) and the post-modification agreement is a section 467 rental

agreement (or the entire agreement (as modified) would be a section 467

rental agreement), the post-modification agreement will,

notwithstanding its treatment as a new agreement under paragraph

(f)(1)(i) of this section, be subject to constant rental accrual unless

the Commissioner determines that, because of the absence of tax

avoidance potential, the post-modification agreement should not be

treated as a disqualified leaseback or long-term agreement.

(iv) Allocation of rent. If the entire agreement (as modified)

provides a specific allocation of fixed rent, as described in paragraph

(c)(2)(ii)(A)(2) of this section, the post-modification agreement is

treated as an agreement that provides a specific allocation of fixed

rent. If the entire agreement (as modified) does not provide a specific

allocation of fixed rent, the fixed rent allocated to rental periods

during the lease term of the post-modification agreement is determined

by applying the rules of paragraph (c)(2)(ii)(B) of this section to the

entire agreement (as modified).

(v) Difference between aggregate rent and interest and aggregate

payments--(A) In general. Except as provided in paragraph (f)(4)(v)(B)

of this section, a post-modification agreement described in paragraph

(f)(4)(v)(C) of this section is treated as a section 467 rental

agreement subject to proportional rental accrual (determined under

Sec. 1.467-2(c)).

(B) Constant rental accrual prior to the modification. A post-

modification agreement described in paragraph (f)(4)(v)(C) of this

section is treated as a section 467 rental agreement subject to

constant rental accrual if--

(1) Constant rental accrual is required under paragraph (f)(4)(iii)

of this section; or

(2) The post-modification agreement involves total payments of more

than $250,000 (as described in paragraph (c)(4) of this section), and

the Commissioner determines that the post-modification agreement is a

disqualified leaseback or long-term agreement.

(C) Agreements described in this paragraph (f)(4)(v)(C). A post-

modification agreement is described in this paragraph (f)(4)(v)(C) if

the aggregate amount of fixed rent and stated interest treated as post-

modification items does not equal the aggregate amount of payments

treated as post-modification items.

(vi) Principal purpose of tax avoidance. If a principal purpose of

a substantial modification is to avoid the purpose or intent of section

467 or the regulations thereunder, the Commissioner may treat the

entire agreement (as modified) as a single agreement for purposes of

section 467 and the regulations thereunder.

(5) Definitions. The following definitions apply for purposes of

this paragraph (f) and Sec. 1.467-7(g):

(i) A modification of a rental agreement is any alteration,

including any deletion or addition, in whole or in part, of a legal

right or obligation of the lessor or lessee thereunder, whether the

alteration is evidenced by an express agreement (oral or written),

conduct of the parties, or otherwise.

(ii) A modification is substantial only if, based on all of the

facts and circumstances, the legal rights or obligations that are

altered and the degree to which they are altered are economically

substantial. A modification of a rental agreement will not be treated

as substantial solely because it is not described in paragraph (f)(6)

of this section.

(iii) A modification occurs on the earlier of the first date on

which there is a binding contract that substantially sets forth the

terms of the modification or the date on which agreement to such terms

is otherwise evidenced.

(iv) Post-modification items with respect to any modification of a

rental agreement are all items (other than pre-modification items)

provided under the terms of the entire agreement (as modified).

(v) Pre-modification items with respect to any modification of a

rental agreement are pre-modification rent, interest thereon, and

payments allocable thereto (whether payable before or after the

modification.) For this purpose--

(A) Pre-modification rent is rent allocable to periods before the

effective date of the modification, but only to the extent such rent is

payable under the entire agreement (as modified) at the time such rent

was due under the agreement in effect before the modification; and

(B) Pre-modification items are identified by applying payments, in

the order payable under the entire agreement (as modified) unless the

agreement specifies otherwise, to rent and interest thereon in the

order in which amounts accrue.

(vi) The entire agreement (as modified) with respect to any

modification is the agreement consisting of pre-modification terms

providing for rights and obligations that are not affected by the

modification and post-modification terms providing for rights and

obligations that differ from the rights and obligations under the

agreement in effect before the modification. For example, if a 10-year

rental agreement that provides for rent of $25,000 per year is modified

at the end of the 5th year to provide for rent of $30,000 per year in

subsequent years, the entire agreement (as modified) provides for a 10-

year lease term and provides for rent of $25,000 per year in years 1

through 5 and rent of $30,000 per year in years 6 through 10. The

result would be the same if the modification provided for both the

increase in rent and the substitution of a new lessee.

(6) Safe harbors. Notwithstanding the provisions of paragraph

(f)(5) of this section, a modification of a rental agreement is not a

substantial modification if the modification occurs solely as the

result of one or more of the following--

(i) The refinancing of any indebtedness incurred by the lessor to

acquire the property subject to the rental agreement and secured by

such property (or any refinancing thereof) but only if all of the

following conditions are met--

(A) Neither the amount, nor the time for payment, of the principal

amount of the new indebtedness differs from the amount and time for

payment of the remaining principal amount of the refinanced

indebtedness, except for de minimis changes;

(B) For each of the remaining rental periods, the rent allocation

schedule, the payments of rent and interest, and the amount accrued

under section 467 are changed only to the extent necessary to take into

account the change in financing costs, and such changes are made

pursuant to the terms of the rental

[[Page 26857]]

agreement in effect before the modification;

(C) The lessor and the lessee are not related persons to each other

or to any lender to the lessor with respect to the property (whether

under the refinanced indebtedness or the new indebtedness); and

(D) With respect to the indebtedness being refinanced, the lessor

was granted a unilateral option (within the meaning of Sec. 1.1001-

3(c)(3)) by the creditor to repay the refinanced indebtedness,

exercisable with or without the lessee's consent;

(ii) A change in the obligation of the lessee to make any of the

contingent payments described in paragraphs (c)(2)(iii)(B)(3) through

(8) of this section; or

(iii) A change in the amount of fixed rent allocated to a rental

period that, when combined with all previous changes in the amount of

fixed rent allocated to the rental period, does not exceed one percent

of the fixed rent allocated to that rental period prior to the

modification.

(7) Special rules for certain transfers--(i) In general. For

purposes of this paragraph (f), a substitution of a new lessee or a

sale, exchange, or other disposition by a lessor of property subject to

a rental agreement will not, by itself, be treated as a substantial

modification unless a principal purpose of the transaction giving rise

to the modification is the avoidance of Federal income tax. In

determining whether a principal purpose of the transaction giving rise

to the modification is the avoidance of Federal income tax--

(A) The safe harbors and other principles of Sec. 1.467-3(c) are

taken into account; and

(B) The Commissioner may treat the post-modification agreement as a

new agreement or treat the entire agreement (as modified) as a single

agreement.

(ii) Exception. Notwithstanding the provisions of paragraph

(f)(7)(i) of this section, the continuing lessor and the new lessee (in

the case of a substitution of a new lessee) or the new lessor and the

continuing lessee (in the case of a sale, exchange, or other

disposition by a lessor of property subject to a rental agreement) may,

in appropriate cases, request the Commissioner to treat the transaction

as if it were a substantial modification in order to have the

provisions of paragraph (f)(4)(iii) of this section and Sec. 1.467-

7(g)(1) apply to the transaction.

(g) Treatment of amounts payable by lessor to lessee--(1) Interest.

For purposes of determining present value, any amounts payable by the

lessor to the lessee as interest on prepaid rent are treated as

negative amounts.

(2) Other amounts. [Reserved]

(h) Meaning of terms. The following meanings apply for purposes of

this section and Secs. 1.467-2 through 1.467-9:

(1) Agreement date means the earlier of the lease date or the first

date on which there is a binding written contract that substantially

sets forth the terms under which the property will be leased.

(2) Contingent rent means any rent that is not fixed rent,

including any amount reflecting an adjustment based on a reasonable

price index (as defined in paragraph (h)(10) of this section) or a

variable interest rate provision (as defined in paragraph (h)(16) of

this section).

(3) Fixed rent means any rent to the extent its amount and the time

at which it is required to be paid are fixed and determinable under the

terms of the rental agreement as of the lease date. The following rules

apply for the purpose of determining the extent to which rent is fixed

rent:

(i) The possibility of a breach, default, or other early

termination of the rental agreement and any adjustments based on a

reasonable price index or a variable interest rate provision are

disregarded.

(ii) Rent will not fail to be treated as fixed rent merely because

of the possibility of impairment by insolvency, bankruptcy, or other

similar circumstances.

(iii) If the lease term (as defined in paragraph (h)(6) of this

section) includes one or more periods as to which either the lessor or

the lessee has an option to renew or extend the term of the agreement,

rent will not fail to be treated as fixed rent merely because the

option has not been exercised.

(iv) If the lease term includes one or more periods during which a

substitute lessee or lessor may have use of the property, rent will not

fail to be treated as fixed rent merely because the contingencies

relating to the obligation of the lessee (or a related person) to make

payments in the nature of rent have not occurred.

(v) If either the lessor or the lessee has an unconditional option

or options, exercisable on one or more dates during the lease term,

that, if exercised, require payments of rent to be made under an

alternative payment schedule or schedules, the amount of fixed rent and

the dates on which such rent is required to be paid are determined on

the basis of the payment schedule that, as of the agreement date, is

most likely to occur. If payments of rent are made under an alternative

payment schedule that differs from the payment schedule assumed in

applying the preceding sentence, then, for purposes of paragraph (f) of

this section, the rental agreement is treated as having been modified

at the time the option to make payments on such alternative schedule is

exercised.

(4) Late payment charge means any amount required to be paid by the

lessee to the lessor as additional compensation for the lessee's

failure to make any payment of rent under a rental agreement when due.

(5) Lease date means the date on which the lessee first has the

right to use of the property that is the subject of the rental

agreement.

(6) Lease term means the period during which the lessee has use of

the property subject to the rental agreement, including any option to

renew or extend the term of the agreement other than an option,

exercisable by the lessee, as to which it is reasonably expected, as of

the agreement date, that the option will not be exercised. The lessor's

or lessee's determination that an option period is either included in

or excluded from the lease term is not binding on the Commissioner. If

the lessee (or a related person) agrees that one or both of them will

or could be obligated to make payments in the nature of rent (within

the meaning of Sec. 1.168(i)-2(b)(2)) for a period when another lessee

(the substitute lessee) or the lessor will have use of the property

subject to the rental agreement, the Commissioner may, in appropriate

cases, treat the period when the substitute lessee or lessor will have

use of the property as part of the lease term. See Sec. 1.467-7(f) for

special rules applicable to the lessee, substitute lessee, and lessor.

(7) A loss payment provision means a provision that requires the

lessee to pay the lessor a sum of money (which may be either a

stipulated amount or an amount determined by reference to a formula or

other objective measure) if the property subject to the rental

agreement is lost, stolen, damaged or destroyed, or otherwise rendered

unsuitable for any use (other than for scrap purposes).

(8) A qualified percentage rents provision means a provision

pursuant to which the rent is equal to a fixed percentage of the

lessee's receipts or sales (whether or not receipts or sales are

adjusted for returned merchandise or Federal, state, or local sales

taxes), but only if the percentage does not vary throughout the lease

term. A provision will not fail to be treated as a qualified percentage

rents provision solely by reason of one or more of the following

additional terms:

[[Page 26858]]

(i) Differing percentages of receipts or sales apply to different

departments or separate floors of a retail store, but only if the

percentage applicable to a particular department or floor does not vary

throughout the lease term.

(ii) The percentage is applied to receipts or sales in excess of

determinable dollar amounts, but only if the determinable dollar

amounts are fixed and do not vary throughout the lease term.

(9) A qualified TRAC provision means a terminal rental adjustment

clause (as defined in section 7701(h)(3)) contained in a qualified

motor vehicle operating agreement (as defined in section 7701(h)(2)),

but only if the adjustment to the rental price is based on a reasonable

estimate, determined as of any date between the agreement date and the

lease date (or, in the event the agreement date is the same as or later

than the lease date, determined as of the agreement date), of the fair

market value of the motor vehicle (including any trailer) at the end of

the lease term.

(10) An adjustment is based on a reasonable price index if the

adjustment reflects inflation or deflation occurring over a period

during the lease term and is determined consistently under a generally

recognized index for measuring inflation or deflation (for example, the

non-seasonally adjusted U.S. City Average All Items Consumer Price

Index for All Urban Consumers (CPI-U), which is published by the Bureau

of Labor Statistics of the Department of Labor). An adjustment will not

fail to be treated as one that is based on a reasonable price index

merely because the adjustment may be limited to a fixed percentage, but

only if the parties reasonably expect, as of any date between the

agreement date and the lease date (or, in the event the agreement date

is the same as the lease date, as of such date), that the fixed

percentage will actually limit the amount of the rent payable during

less than 50 percent of the lease term.

(11) For purposes of determining whether a section 467 rental

agreement is a leaseback within the meaning of Sec. 1.467-3(b)(2), two

persons are related persons if they are related persons within the

meaning of section 465(b)(3)(C). In all other cases, two persons are

related persons if they either have a relationship to each other that

is specified in section 267(b) or section 707(b)(1) or are related

entities within the meaning of sections 168(h)(4)(A), (B), or (C).

(12) Rental agreement includes any agreement, whether written or

oral, that provides for the use of tangible property and is treated as

a lease for Federal income tax purposes.

(13) A residual condition provision means a provision in a rental

agreement that requires a payment to be made by either the lessor or

the lessee to the other party based on the difference between the

actual condition of the property subject to the agreement, determined

as of the expiration of the lease term, and the expected condition of

the property at the expiration of the lease term, as set forth in the

rental agreement. The amount of any such payment may be determined by

reference to any objective measure relating to the use or condition of

the property, such as miles, hours or other duration of use, units of

production, or similar measure. A provision will be treated as a

residual condition provision only if the payment represents

compensation for the use of, or wear and tear on, the property in

excess of, or below, a standard set forth in the rental agreement, and

the standard is reasonably expected, as of any date between the

agreement date and the lease date (or, in the event the agreement date

is the same as or later than the lease date, as of the agreement date),

to be met at the expiration of the lease term.

(14) A tax indemnity provision means a provision in a rental

agreement that may require the lessee to make one or more payments to

the lessor in the event that the Federal, foreign, state, or local

income tax consequences actually realized by a lessor from owning the

property subject to the rental agreement and leasing it to the lessee

differ from the consequences reasonably expected by the lessor, but

only if the differences in such consequences result from a

misrepresentation, act, or failure to act on the part of the lessee, or

any other factor not within the control of the lessor or any related

person.

(15) Third-party costs include any real estate taxes, insurance

premiums, maintenance costs, and any other costs (excluding a debt

service cost) that relate to the leased property and are not within the

control of the lessor or lessee or any person related to the lessor or

lessee.

(16) A variable interest rate provision means a provision in a

rental agreement that requires the rent payable by the lessee to the

lessor to be adjusted by the dollar amount of changes in the amount of

interest payable by the lessor on any indebtedness that was incurred to

acquire the property subject to the rental agreement (or any

refinancing thereof), but--

(i) Only to the extent the changes are attributable to changes in

the interest rate; and

(ii) Only if the indebtedness provides for interest at one or more

qualified floating rates (within the meaning of Sec. 1.1275-5(b)), or

the changes are attributable to a refinancing at a fixed rate or one or

more qualified floating rates.

(i) [Reserved].

(j) Computational rules. For purposes of this section and

Secs. 1.467-2 through 1.467-9, the following rules apply--

(1) Counting conventions. Any reasonable counting convention may be

used (for example, 30 days per month/360 days per year) to determine

the length of a rental period or to perform any computation. Rental

periods of the same descriptive length, for example annual, semiannual,

quarterly, or monthly, may be treated as being of equal length.

(2) Conventions regarding timing of rent and payments--(i) In

general. For purposes of determining present values and yield only,

except as otherwise provided in this section and Secs. 1.467-2 through

1.467-8--

(A) The rent allocated to a rental period is taken into account on

the last day of the rental period;

(B) Any amount payable during the first half of the first rental

period is treated as payable on the first day of that rental period;

(C) Any amount payable during the first half of any other rental

period is treated as payable on the last day of the preceding rental

period;

(D) Any amount payable during the second half of a rental period is

treated as payable on the last day of the rental period; and

(E) Any amount payable at the midpoint of a rental period is

treated, in applying this paragraph (j)(2), as an amount payable during

the first half of the rental period.

(ii) Time amount is payable. For purposes of this paragraph (j)(2),

an amount is payable on the last day for timely payment (that is, the

last day such amount may be paid without incurring interest, computed

at an arm's-length rate, a substantial penalty, or other substantial

detriment (such as giving the lessor the right to terminate the

agreement, bring an action to enforce payment, or exercise other

similar remedies under the terms of the agreement or applicable law)).

(3) Annualized fixed rent. Annualized fixed rent is determined by

multiplying the fixed rent allocated to the rental period under

paragraph (c)(2)(ii) of this section by the number of periods of the

rental period's length in a calendar year.

[[Page 26859]]

Thus, if the fixed rent allocated to a rental period is $10,000 and the

rental period is one month, the annualized fixed rent for that rental

period is $120,000 ($10,000 times 12).

(4) Allocation of fixed rent within a period. A rental agreement

that allocates fixed rent to any period is treated as allocating fixed

rent ratably within that period. Thus, if a rental agreement provides

that $120,000 is allocated to each calendar year in the lease term,

$10,000 of rent is allocated to each calendar month.

(5) Rental period length. Except as provided in Sec. 1.467-3(d)(1)

(relating to agreements for which constant rental accrual is required),

rental periods may be of any length, may vary in length, and may be

different as between the lessor and the lessee as long as--

(i) The rental periods are one year or less, cover the entire lease

term, and do not overlap;

(ii) Each scheduled payment under the rental agreement (other than

a payment scheduled to occur before or after the lease term) occurs

within 30 days of the beginning or end of a rental period; and

(iii) In the case of a rental agreement that does not provide a

specific allocation of fixed rent, the rental periods selected do not

cause the agreement to be treated as a section 467 rental agreement

unless all alternative rental period schedules would result in such

treatment.

Sec. 1.467-2 Rent accrual for section 467 rental agreements without

adequate interest.

(a) Section 467 rental agreements for which proportional rental

accrual is required. Under Sec. 1.467-1(d)(2)(ii), the fixed rent for

each rental period is the proportional rental amount, computed under

paragraph (c) of this section, if--

(1) The section 467 rental agreement is not a disqualified

leaseback or long-term agreement under Sec. 1.467-3(b); and

(2) The section 467 rental agreement does not provide adequate

interest on fixed rent under paragraph (b) of this section.

(b) Adequate interest on fixed rent--(1) In general. A section 467

rental agreement provides adequate interest on fixed rent if,

disregarding any contingent rent--

(i) The rental agreement has no deferred or prepaid rent as

described in Sec. 1.467-1(c)(3);

(ii) The rental agreement has deferred or prepaid rent, and--

(A) The rental agreement provides interest (the stated rate of

interest) on deferred or prepaid fixed rent at a single fixed rate (as

defined in Sec. 1.1273-1(c)(1)(iii));

(B) The stated rate of interest on fixed rent is no lower than 110

percent of the applicable Federal rate (as defined in paragraph (e)(3)

of this section);

(C) The amount of deferred or prepaid fixed rent on which interest

is charged is adjusted at least annually to reflect the amount of

deferred or prepaid fixed rent as of a date no earlier than the date of

the preceding adjustment and no later than the date of the succeeding

adjustment; and

(D) The rental agreement requires interest to be paid or compounded

at least annually;

(iii) The rental agreement provides for deferred rent but no

prepaid rent, and the sum of the present values (within the meaning of

paragraph (d) of this section) of all amounts payable by the lessee as

fixed rent (and interest, if any, thereon) is equal to or greater than

the sum of the present values of the fixed rent allocated to each

rental period; or

(iv) The rental agreement provides for prepaid rent but no deferred

rent, and the sum of the present values of all amounts payable by the

lessee as fixed rent, plus the sum of the negative present values of

all amounts payable by the lessor as interest, if any, on prepaid fixed

rent, is equal to or less than the sum of the present values of the

fixed rent allocated to each rental period.

(2) Section 467 rental agreements that provide for a variable rate

of interest. For purposes of the adequate interest test under paragraph

(b)(1) of this section, if a section 467 rental agreement provides for

variable interest, the rental agreement is treated as providing for

fixed rates of interest on deferred or prepaid fixed rent equal to the

fixed rate substitutes (determined in the same manner as under

Sec. 1.1275-5(e), treating the agreement date as the issue date) for

the variable rates called for by the rental agreement. For purposes of

this section, a rental agreement provides for variable interest if all

stated interest provided by the agreement is paid or compounded at

least annually at a rate or rates that meet the requirements of

Sec. 1.1275-5(a)(3)(i)(A) or (B) and (a)(4).

(c) Computation of proportional rental amount--(1) In general. The

proportional rental amount for a rental period is the amount of fixed

rent allocated to the rental period under Sec. 1.467-1(c)(2)(ii),

multiplied by a fraction. The numerator of the fraction is the sum of

the present values of the amounts payable under the terms of the

section 467 rental agreement as fixed rent and interest thereon. The

denominator of the fraction is the sum of the present values of the

fixed rent allocated to each rental period under the rental agreement.

(2) Section 467 rental agreements that provide for a variable rate

of interest. To calculate the proportional rental amount for a section

467 rental agreement that provides for a variable rate of interest, see

Sec. 1.467-5.

(d) Present value. For purposes of determining adequate interest

under paragraph (b) of this section or the proportional rental amount

under paragraph (c) of this section, the present value of any amount is

determined using a discount rate equal to 110 percent of the applicable

Federal rate. In general, present values are determined as of the first

day of the first rental period in the lease term. However, if a section

467 rental agreement calls for payments of fixed rent prior to the

lease term, present values are determined as of the first day a fixed

rent payment is called for by the agreement. For purposes of the

present value determination under paragraph (b)(1)(iv) of this section,

the fixed rent allocated to a rental period must be discounted from the

first day of the rental period. For other conventions and rules

relating to the determination of present value, see Sec. 1.467-1(g) and

(j).

(e) Applicable Federal rate--(1) In general. The applicable Federal

rate for a section 467 rental agreement is the applicable Federal rate

in effect on the agreement date. The applicable Federal rate for a

rental agreement means--

(i) The Federal short-term rate if the term of the rental agreement

is not over 3 years;

(ii) The Federal mid-term rate if the term of the rental agreement

is over 3 years but not over 9 years; and

(iii) The Federal long-term rate if the term of the rental

agreement is over 9 years.

(2) Source of applicable Federal rates. The Internal Revenue

Service publishes the applicable Federal rates, based on annual,

semiannual, quarterly, and monthly compounding, each month in the

Internal Revenue Bulletin (see Sec. 601.601(d) of this chapter).

However, the applicable Federal rates may be based on any compounding

assumption. To convert a rate based on one compounding assumption to an

equivalent rate based on a different compounding assumption, see

Sec. 1.1272-1(j), Example 1.

(3) 110 percent of applicable Federal rate. For purposes of

Sec. 1.467-1, this section and Secs. 1.467-3 through 1.467-9, 110

percent of the applicable Federal rate means 110 percent of the

applicable Federal rate based on semiannual compounding or any rate

based on a different compounding assumption that is equivalent to 110

percent of the applicable Federal rate based on

[[Page 26860]]

semiannual compounding. The Internal Revenue Service publishes 110

percent of the applicable Federal rates, based on annual, semiannual,

quarterly, and monthly compounding, each month in the Internal Revenue

Bulletin (see Sec. 601.601(d)(2) of this chapter).

(4) Term of the section 467 rental agreement--(i) In general. For

purposes of determining the applicable Federal rate under this

paragraph (e), the term of the section 467 rental agreement includes

the lease term, any period before the lease term beginning with the

first day an amount of fixed rent is payable under the terms of the

rental agreement, and any period after the lease term ending with the

last day an amount of fixed rent or interest thereon is payable under

the rental agreement.

(ii) Section 467 rental agreements with variable interest. If a

section 467 rental agreement provides variable interest on deferred or

prepaid fixed rent, the term of the rental agreement for purposes of

calculating the applicable Federal rate is the longest period between

interest rate adjustment dates, or, if the rental agreement provides an

initial fixed rate of interest on deferred or prepaid fixed rent, the

period between the agreement date and the last day the fixed rate

applies, if this period is longer. If, as described in Sec. 1.1274-

4(c)(2)(ii), the rental agreement provides for a qualified floating

rate (as defined in Sec. 1.1275-5(b)) that in substance resembles a

fixed rate, the applicable Federal rate is determined by reference to

the lease term.

(f) Examples. The following examples illustrate the application of

this section. In each of these examples it is assumed that the rental

agreement is not a disqualified leaseback or long-term agreement

subject to constant rental accrual. The examples are as follows:

Example 1. (i) C agrees to lease property from D for five years

beginning on January 1, 2000, and ending on December 31, 2004. The

section 467 rental agreement provides that rent of $100,000 accrues

in each calendar year in the lease term and that rent of $500,000

plus $120,000 of interest is payable on December 31, 2004. Assume

that the parties select the calendar year as the rental period and

that 110 percent of the applicable Federal rate is 10 percent,

compounded annually.

(ii) The rental agreement has deferred rent under Sec. 1.467-

1(c)(3)(i) because the fixed rent allocated to calendar years 2000,

2001, and 2002 is not paid until 2004. In addition, because the

rental agreement does not state an interest rate, the rental

agreement does not satisfy the requirements of paragraph (b)(1)(ii)

of this section.

(iii)(A) Because the rental agreement has deferred fixed rent

and no prepaid rent, the agreement has adequate interest only if the

present value test provided in paragraph (b)(1)(iii) of this section

is met. The present value of all fixed rent and interest payable

under the rental agreement is $384,971.22, determined as follows:

$620,000/(1.10) \5\ = $384,971.22. The present value of all fixed

rent allocated under the rental agreement (discounting the amount of

fixed rent allocated to a rental period from the last day of the

rental period) is $379,078.68, determined as follows:

[GRAPHIC] [TIFF OMITTED] TR18MY99.000

(B) The rental agreement provides adequate interest on fixed

rent because the present value of the single amount payable under

the section 467 rental agreement exceeds the sum of the present

values of fixed rent allocated.

(iv) For an example illustrating the computation of the yield on

the rental agreement and the allocation of the interest and rent

provided for under the rental agreement, see Sec. 1.467-4(f),

Example 2.

Example 2. (i) E and F enter into a section 467 rental agreement

for the lease of equipment beginning on January 1, 2000, and ending

on December 31, 2004. The rental agreement provides that rent of

$100,000 accrues for each calendar month during the lease term. All

rent is payable on December 31, 2004, together with interest on

accrued rent at a qualified floating rate set at a current value (as

defined in Sec. 1.1275-5(a)(4)) that is compounded at the end of

each calendar month and adjusted at the beginning of each calendar

month throughout the lease term. Therefore, the rental agreement

provides for variable interest within the meaning of paragraph

(b)(2) of this section.

(ii) On the agreement date the qualified floating rate is 7.5

percent, and 110 percent of the applicable Federal rate, as defined

in paragraph (e)(3) of this section, based on monthly compounding,

is 7 percent. Under paragraph (b)(2) of this section, the fixed rate

substitute for the qualified floating rate is 7.5 percent and the

agreement is treated as providing for interest at this fixed rate

for purposes of determining whether adequate interest is provided

under paragraph (b) of this section. Accordingly, the requirements

of paragraph (b)(1)(ii) of this section are satisfied, and the

rental agreement has adequate interest.

Example 3. (i) X and Y enter into a section 467 rental agreement

for the lease of real property beginning on January 1, 2000, and

ending on December 31, 2002. The rental agreement provides that rent

of $800,000 is allocable to 2000, $1,000,000 is allocable to 2001,

and $1,200,000 is allocable to 2002. Under the rental agreement, Y

must make a $3,000,000 payment on December 31, 2002. Assume that

both X and Y choose the calendar year as the rental period, X and Y

are calendar year taxpayers, and 110 percent of the applicable

Federal rate is 8.5 percent compounded annually.

(ii) The rental agreement fails to provide adequate interest

under paragraph (b)(1) of this section. Therefore, under Sec. 1.467-

1(d)(2)(ii), the fixed rent for each rental period is the

proportional rental amount.

(iii)(A) The proportional rental amount is computed under

paragraph (c) of this section. Because the rental agreement does not

call for any fixed rent payments prior to the lease term, under

paragraph (d) of this section, the present value is determined as of

the first day of the first rental period in the lease term. The

present value of the single amount payable by the lessee under the

rental agreement is computed as follows:

[GRAPHIC] [TIFF OMITTED] TR18MY99.001

(B) The sum of the present values of the fixed rent allocated to

each rental period (discounting the fixed rent allocated to a rental

period from the last day of such rental period) is computed as

follows:

[GRAPHIC] [TIFF OMITTED] TR18MY99.002

(C) Thus, the fraction for determining the proportional rental

amount is .9297194 ($2,348,724.30/$2,526,272.20). The section 467

interest for each of the taxable years within the lease term is

computed and taken into account as provided in Sec. 1.467-4. The

section 467 rent for each of the taxable years within the lease term

is as follows:

------------------------------------------------------------------------

Taxable year Section 467 rent

------------------------------------------------------------------------

2000............................. $743,775.52

($ 800,000 x .9297194).

2001............................. 929,719.40

($1,000,000 x .9297194).

2002............................. 1,115,663.28

($1,200,000 x .9297194).

------------------------------------------------------------------------

Sec. 1.467-3 Disqualified leasebacks and long-term agreements.

(a) General rule. Under Sec. 1.467-1(d)(2)(i), constant rental

accrual (as described under paragraph (d) of this section) must be used

to determine the fixed rent for each rental period in the lease term if

the section 467 rental agreement is a disqualified leaseback or long-

term agreement within the meaning of paragraph (b) of this section.

[[Page 26861]]

Constant rental accrual may not be used in the absence of a

determination by the Commissioner, pursuant to paragraph (b)(1)(ii) of

this section, that the rental agreement is disqualified. Such

determination may be made either on a case-by-case basis or in

regulations or other guidance published by the Commissioner (see

Sec. 601.601(d)(2) of this chapter) providing that a certain type or

class of leaseback or long-term agreement will be treated as

disqualified and subject to constant rental accrual.

(b) Disqualified leaseback or long-term agreement--(1) In general.

A leaseback (as defined in paragraph (b)(2) of this section) or a long-

term agreement (as defined in paragraph (b)(3) of this section) is

disqualified only if--

(i) A principal purpose for providing increasing or decreasing rent

is the avoidance of Federal income tax (as described in paragraph (c)

of this section);

(ii) The Commissioner determines that, because of the tax avoidance

purpose, the agreement should be treated as a disqualified leaseback or

long-term agreement; and

(iii) The amount determined with respect to the section 467 rental

agreement under Sec. 1.467-1(c)(4) (relating to the exception for

rental agreements involving total payments of $250,000 or less) exceeds

$2,000,000.

(2) Leaseback. A section 467 rental agreement is a leaseback if the

lessee (or a related person) had any interest (other than a de minimis

interest) in the property at any time during the two-year period ending

on the agreement date. For this purpose, interests in property include

options and agreements to purchase the property (whether or not the

lessee or related person was considered the owner of the property for

Federal income tax purposes) and, in the case of subleased property,

any interest as a sublessor.

(3) Long-term agreement--(i) In general. A section 467 rental

agreement is a long-term agreement if the lease term exceeds 75 percent

of the property's statutory recovery period.

(ii) Statutory recovery period--(A) In general. The term statutory

recovery period means--

(1) In the case of property depreciable under section 168, the

applicable period determined under section 467(e)(3)(A);

(2) In the case of land, 19 years; and

(3) In the case of any other tangible property, the period that

would apply under section 467(e)(3)(A) if the property were property to

which section 168 applied.

(B) Special rule for rental agreements relating to properties

having different statutory recovery periods. In the case of a rental

agreement relating to two or more related properties that have

different statutory recovery periods, the statutory recovery period for

purposes of paragraph (b)(3)(ii)(A) of this section is the weighted

average, based on the fair market values of the properties on the

agreement date, of the statutory recovery periods of each of the

properties.

(c) Tax avoidance as principal purpose for increasing or decreasing

rent--(1) In general. In determining whether a principal purpose for

providing increasing or decreasing rent is the avoidance of Federal

income tax, all relevant facts and circumstances are taken into

account. However, an agreement will not be treated as a disqualified

leaseback or long-term agreement if either of the safe harbors set

forth in paragraph (c)(3) of this section is met. The mere failure of a

leaseback or long-term agreement to meet one of these safe harbors will

not, by itself, cause the agreement to be treated as one in which tax

avoidance was a principal purpose for providing increasing or

decreasing rent.

(2) Tax avoidance--(i) In general. If, as of the agreement date, a

significant difference between the marginal tax rates of the lessor and

lessee can reasonably be expected at some time during the lease term,

the agreement will be closely scrutinized and clear and convincing

evidence will be required to establish that tax avoidance is not a

principal purpose for providing increasing or decreasing rent. The term

``marginal tax rate'' means the percentage determined by dividing one

dollar into the amount of the increase or decrease in the Federal

income tax liability of the taxpayer that would result from an

additional dollar of rental income or deduction.

(ii) Significant difference in tax rates. A significant difference

between the marginal tax rates of the lessor and lessee is reasonably

expected if--

(A) The rental agreement has increasing rents and the lessor's

marginal tax rate is reasonably expected to exceed the lessee's

marginal tax rate by more than 10 percentage points during any rental

period to which the rental agreement allocates annualized fixed rent

that is less than the average rent allocated to all calendar years

(determined by taking into account the rules set forth in paragraph

(c)(4)(iii) of this section); or

(B) The rental agreement has decreasing rents and the lessee's

marginal tax rate is reasonably expected to exceed the lessor's

marginal tax rate by more than 10 percentage points during any rental

period to which the rental agreement allocates annualized fixed rent

that is greater than the average rent allocated to all calendar years

(determined by taking into account the rules set forth in paragraph

(c)(4)(iii) of this section).

(iii) Special circumstances. In determining the expected marginal

tax rates of the lessor and lessee, net operating loss and credit

carryovers and any other attributes or special circumstances reasonably

expected to affect the Federal income tax liability of the taxpayer

(including the alternative minimum tax) are taken into account. For

example, in the case of a partnership or S corporation, the amount of

rental income or deduction that would be allocable to the partners or

shareholders, respectively, is taken into account.

(3) Safe harbors. Tax avoidance will not be considered a principal

purpose for providing increasing or decreasing rent if--

(i) The uneven rent test (as defined in paragraph (c)(4) of this

section) is met; or

(ii) The increase or decrease in rent is wholly attributable to one

or more of the following provisions--

(A) A contingent rent provision set forth in Sec. 1.467-

1(c)(2)(iii)(B); or

(B) A single rent holiday provision allowing reduced rent (or no

rent) for one consecutive period during the lease term, but only if--

(1) The rent holiday is for a period of three months or less at the

beginning of the lease term and for no other period; or

(2) The duration of the rent holiday is reasonable, determined by

reference to commercial practice (as of the agreement date) in the

locality where the use of the property occurs, and does not exceed the

lesser of 24 months or 10 percent of the lease term.

(4) Uneven rent test--(i) In general. The uneven rent test is met

if the rent allocated to each calendar year does not vary from the

average rent allocated to all calendar years (determined in accordance

with the rules set forth in paragraph (c)(4)(iii) of this section) by

more than 10 percent.

(ii) Special rule for real estate. Paragraph (c)(4)(i) of this

section is applied by substituting ``15 percent'' for ``10 percent'' if

the rental agreement is a long-term agreement and at least 90 percent

of the property subject to the agreement (determined on the basis of

fair market value as of the agreement date) consists of real property

(as defined in Sec. 1.856-3(d)).

(iii) Operating rules. In determining whether the uneven rent test

has been met, the following rules apply:

[[Page 26862]]

(A) Any contingent rent attributable to a provision set forth in

Sec. 1.467-1(c)(2)(iii)(B)(3) through (9) is disregarded.

(B) If the lease term includes one or more partial calendar years

(a period less than a complete calendar year), the average rent

allocated to each calendar year is the total rent allocated under the

rental agreement, divided by the actual length (in years) of the lease

term. The rent allocated to a partial calendar year is annualized by

multiplying the allocated rent by the number of periods of the partial

calendar year's length in a full calendar year and the annualized rent

is treated as the amount of rent allocated to that year in determining

whether the uneven rent test is met.

(C) In the case of a rental agreement not described in paragraph

(c)(4)(ii) of this section, an initial rent holiday period and any rent

allocated to such period are disregarded for purposes of this paragraph

(c)(4) if taking such period and rent into account would cause the

agreement to fail to meet the uneven rent test. For purposes of this

paragraph (c)(4), an initial rent holiday period is any period of three

months or less at the beginning of the lease term during which

annualized fixed rent (determined by treating such period as a rental

period for purposes of Sec. 1.467-1(j)(3)) is less than the average

rent allocated to all calendar years (determined before the application

of this paragraph (c)(4)(iii)(C)).

(D) In the case of a rental agreement described in paragraph

(c)(4)(ii) of this section, one qualified rent holiday period and any

rent allocated to such period are disregarded for purposes of this

paragraph (c)(4) if taking such period and rent into account would

cause the agreement to fail the uneven rent test. For this purpose, a

qualified rent holiday period is a consecutive period that is an

initial rent holiday period or that meets the following conditions:

(1) The period does not exceed the lesser of 24 months or 10

percent of the lease term (determined before the application of this

paragraph (c)(4)(iii)(D)).

(2) Annualized fixed rent during the period (determined by treating

the period as a rental period for purposes of Sec. 1.467-1(j)(3)) is

less than the average rent allocated to all calendar years (determined

before the application of this paragraph (c)(4)(iii)(D)).

(3) Providing less than average rent for the period is reasonable,

determined by reference to commercial practice (as of the agreement

date) in the locality where the use of the property occurs.

(E) If the rental agreement contains a variable interest rate

provision, the uneven rent test is applied by treating the rent as

having been fixed under the terms of the rental agreement for the

entire lease term using fixed rate substitutes (determined in the same

manner as Sec. 1.1275-5(e), treating the agreement date as the issue

date) for the variable rates of interest provided under the terms of

the lessor's indebtedness.

(d) Calculating constant rental amount--(1) In general. Except as

provided in paragraph (d)(2) of this section, the constant rental

amount is the amount that, if paid at the end of each rental period,

would result in a present value equal to the present value of all

amounts payable under the disqualified leaseback or long-term agreement

as rent and interest. In computing the constant rental amount, the

rules for determining present value are the same as those provided in

Sec. 1.467-2(d) for computing the proportional rental amount. If

constant rental accrual is required, all rental periods (other than an

initial or final short period of not more than one month) must be equal

in length and satisfy the requirements of Sec. 1.467-1(j)(5).

(2) Initial or final short periods. If a disqualified leaseback or

long-term agreement has an initial or final short rental period, the

constant rental amount for the initial or final short period may be

determined under any reasonable method. However, the sum of the present

values of all the constant rental amounts must equal the present values

of all amounts payable under the disqualified leaseback or long-term

agreement as rent and interest. Any adjustment necessary to eliminate

the section 467 loan balance because of the method used to determine

the constant rental amount for short periods must be taken into account

as section 467 rent for the final rental period.

(3) Method to determine constant rental amount; no short periods--

(i) Step 1. Determine the present value of amounts payable under the

disqualified leaseback or long-term agreement as rent or interest.

(ii) Step 2. Determine the present value of $1 to be received at

the end of each rental period during the lease term as of the first day

of the first rental period during the lease term (or, if earlier, the

first day a rent payment is required under the rental agreement).

(iii) Step 3. Divide the amount determined in paragraph (d)(3)(i)

of this section (Step 1) by the number of dollars determined in

paragraph (d)(3)(ii) of this section (Step 2).

(e) Examples. The following examples illustrate the application of

this section:

Example 1. (i) K, lessor, and L, lessee, enter into a long-term

agreement for a 10-year lease of personal property beginning on

January 1, 2000. K and L are C corporations that use the calendar

year as their taxable year. K does not have any unused losses or

credits from taxable years preceding 2000. In addition, as of the

agreement date, K expects that it will be subject to the maximum

rate of tax imposed by section 11 in 2000 and that it will not be

limited in its ability to use any losses or credits. As of the

agreement date, L expects that it will be subject to the alternative

minimum tax imposed by section 55 in 2000. The rental agreement

provides for rent allocations in each year of the lease term, as

follows:

------------------------------------------------------------------------

Year Amount

------------------------------------------------------------------------

2000.................................................... $427,500

2001.................................................... 442,500

2002.................................................... 457,500

2003.................................................... 472,500

2004.................................................... 487,500

2005.................................................... 502,500

2006.................................................... 517,500

2007.................................................... 532,500

2008.................................................... 547,500

2009.................................................... 562,500

------------------------------------------------------------------------

(ii) As described in paragraph (c)(2) of this section, as of the

agreement date, a significant difference between the marginal tax

rates of the lessor and lessee can reasonably be expected at some

time during the lease term. First, the rental agreement has

increasing rents. Second, the lessor's marginal tax rate exceeds the

lessee's marginal tax rate by more than 10 percentage points during

a rental period to which the rental agreement allocates less than a

ratable portion of the aggregate amount of rent payable under the

agreement. For example, for the year 2000, the lessor's expected

marginal tax rate is 35 percent, the percentage determined by

dividing the increase in the Federal income tax liability of K that

would result from an additional dollar of rental income ($.35) by

$1. Because the lessee is subject to the alternative minimum tax,

the lessee's expected marginal tax rate for 2000 is 20 percent, the

percentage determined by dividing the decrease in the Federal income

tax liability (taking into account both the decrease in the lessee's

regular tax and the increase in the lessee's alternative minimum

tax) that would result from an additional dollar of rental deduction

($.20) by $1. Further, for the year 2000, the rent allocated in

accordance with the rental agreement is $427,500, which is less than

a ratable portion of the aggregate amount of rental payments,

$495,000, determined by dividing the total rents payable under the

agreement ($4,950,000) by the number of years in the lease term

(10). Thus, because a significant difference between the marginal

tax rates of the lessor and lessee can reasonably be expected during

the lease term, the agreement will be closely scrutinized and clear

and convincing evidence will be required to establish that tax

avoidance is not

[[Page 26863]]

a principal purpose for providing increasing rent.

Example 2. (i) A and B enter into a long-term agreement for a 5-

year lease of personal property beginning on July 1, 2000, and

ending on June 30, 2005. The rental agreement provides that the rent

is allocated to the calendar years in the lease term in accordance

with the following schedule and is paid at successive six-month

intervals (on December 31 and June 30) during the lease term:

------------------------------------------------------------------------

Year Amount

------------------------------------------------------------------------

2000.................................................... $450,000

2001.................................................... 900,000

2002.................................................... 900,000

2003.................................................... 1,100,000

2004.................................................... 1,100,000

2005.................................................... 550,000

------------------------------------------------------------------------

(ii) In determining whether the uneven rent test described in

paragraph (c)(4)(i) of this section is met, the total amount of rent

allocated under the rental agreement is $5,000,000, and the lease

term is five years. The average rent for each year is $1,000,000

(see paragraph (c)(4)(iii)(B) of this section), and the uneven rent

test is met if the rent for each year is not less than $900,000 and

not more than $1,100,000. The test is met for 2000 because the

annualized rent for that year is $900,000. The test is met for 2005

because the annualized rent for that year is $1,100,000. The test is

met for each of the years 2001 through 2004 because the rent for

each of these years is not less than $900,000 and not more than

$1,100,000. Accordingly, because the uneven rent test of paragraph

(c)(4)(i) of this section is met, the long-term agreement will not

be treated as disqualified.

Example 3. (i) C and D enter into a long-term agreement for a

lease of personal property beginning on October 1, 1999, and ending

on December 31, 2005. The rental agreement provides that the rent is

allocated to the calendar years in the lease term in accordance with

the following schedule and is paid at successive six-month intervals

(on December 31 and June 30) during the lease term:

------------------------------------------------------------------------

Year Amount

------------------------------------------------------------------------

1999.................................................... $0

2000.................................................... 900,000

2001.................................................... 900,000

2002.................................................... 900,000

2003.................................................... 1,100,000

2004.................................................... 1,100,000

2005.................................................... 1,100,000

------------------------------------------------------------------------

(ii) The three-month rent holiday period at the beginning of the

lease term is an initial rent holiday within the meaning of

paragraph (c)(4)(iii)(C) of this section. Moreover, the agreement

would fail the uneven rent test if the rent holiday period and the

rent allocated to the period were taken into account. Thus, under

paragraph (c)(4)(iii)(C) of this section, the period and the rent

allocated to the period are disregarded for purposes of applying the

uneven rent test. In that case, the lease term is six years, and the

uneven rent test is met because the average rent for each year in

the lease term is $1,000,000 and the rent for each calendar year in

the lease term is not less than $900,000 nor more than $1,100,000.

Accordingly, the long-term agreement will not be treated as

disqualified.

Example 4. (i) E and F enter into a long-term agreement for a 6-

year lease of personal property beginning on January 1, 2000, and

ending on December 31, 2005. The rental agreement provides that the

rent allocated to the calendar years in the lease term and paid at

successive six-month intervals (on June 30 and December 31) during

the lease term is the sum of the interest on the lessor's

indebtedness, in the amount of $4,637,577, and an amount determined

in accordance with the following schedule:

------------------------------------------------------------------------

Year Amount

------------------------------------------------------------------------

2000.................................................... $539,574

2001.................................................... 583,603

2002.................................................... 631,225

2003.................................................... 886,733

2004.................................................... 959,090

2005.................................................... 1,037,352

------------------------------------------------------------------------

(ii) Assume further that the lessor's indebtedness bears

interest at the rate of 2 percent in excess of the 6-month London

Interbank Offered Rate (LIBOR) in effect on the first day of the 6-

month period for each rental period and that, on the agreement date,

the interest rate under this formula would be 8 percent. If the

interest rate remained fixed during the entire lease term, the

formula for determining the rent payable by the lessee would result

in payments of rent in the amount of $450,000 for each six-month

period in 2000, 2001, and 2002, and $550,000 for each six-month

period in 2003, 2004, and 2005.

(iii) Under paragraph (c)(4)(iii)(E) of this section, the fixed

rate substitute for the variable interest rate provision produces a

schedule of fixed rents that meets the uneven rent test of paragraph

(c)(4)(i) of this section. Thus, even if the actual rents payable

under the rental agreement do not meet the uneven rent test because

of fluctuations in the 6-month LIBOR, the uneven rent test will be

treated as having been met, and the long-term agreement will not be

treated as disqualified.

Example 5. (i) G and H enter into a long-term agreement for a 5-

year lease of personal property beginning on January 1, 2000, and

ending on December 31, 2004. The rental agreement provides that the

rent is payable to G at the rate of $40,000 per month in arrears,

subject to an adjustment based on changes in prevailing interest

rates during the lease term. Under this adjustment, the lessor is

entitled to receive an amount equal to the sum of a specified dollar

amount, which increases each month as payments of rent are made, and

interest on a notional principal amount (as defined in Sec. 1.446-

3(c)(3)) at a qualified floating rate (as defined in Sec. 1.1275-

5(b)). The notional principal amount is initially established at 80

percent of the cost of the property. As each payment of rent is

made, the notional principal amount is reduced (but not below zero)

to an amount that would represent the outstanding principal balance

of a loan the payments on which are equal to the monthly payments of

rent. As of the agreement date, the value of the qualified floating

rate is 9 percent. Although G did not incur indebtedness

specifically for the purpose of acquiring the property, the parties

agreed to the adjustment provisions in order to compensate G for its

general costs of borrowing.

(ii) The adjustment provision produces a schedule of rent

payments that is virtually identical to the schedule that would have

resulted if G had actually borrowed money in an amount and on terms

identical to the terms used in determining interest on the notional

principal amount and the adjustment were based on that indebtedness.

An adjustment based on actual indebtedness of the lessor would have

been a variable interest rate provision eligible for a safe harbor

under paragraph (c)(3)(ii)(A) of this section. Accordingly, based on

all the facts and circumstances, the adjustment provision did not

have as one of its principal purposes the avoidance of Federal

income tax, and thus the long-term agreement will not be treated as

disqualified.

Example 6. (i) X and Y enter into a leaseback for a 5-year lease

of personal property beginning on January 1, 1998, and ending on

December 31, 2002. The rental agreement provides that $0 of rent is

allocated to years 1998, 1999, and 2000, and that rent of

$17,500,000 is allocated to years 2001 and 2002. The rental

agreement provides that the rent allocated to each year is payable

on December 31 of that year. Assume all rental periods are the

calendar year. Assume also that 110 percent of the applicable

Federal rate based on annual compounding is 12 percent.

(ii)(A) If the Commissioner determines that the leaseback is

disqualified, the constant rental amount is computed as follows:

(B) Step 1 in calculating the constant rental amount is to

determine the present value of the two payments due under the rental

agreement as follows:

[GRAPHIC] [TIFF OMITTED] TR18MY99.003

(iii) Because no amounts of rent are payable before the lease

term, Step 2 in calculating the constant rental amount is to

determine the present value as of the first day of the lease term of

$1 to be received at the end of each rental period during the lease

term. This results in a present value of $3.6047762. In Step 3 the

amount determined in Step 1 is divided by the number of dollars

determined in Step 2. Thus, the constant rental amount is $5,839,901

for each calendar year during the lease term computed as follows:

[GRAPHIC] [TIFF OMITTED] TR18MY99.004

Sec. 1.467-4 Section 467 loan.

(a) In general--(1) Overview. Except as provided in paragraph

(a)(2) of this section, the section 467 loan rules of this section

apply to a section 467 rental agreement if, as of the first day of a

rental period, there is a difference between the amount of fixed rent

[[Page 26864]]

payable under the rental agreement on or before the first day and the

amount of fixed rent required to be accrued in accordance with

Sec. 1.467-1(d)(2) before the first day. Paragraph (b) of this section

provides rules for computing the principal balance of a section 467

loan at the beginning of any rental period. The principal balance of a

section 467 loan may be positive or negative. For Federal tax purposes,

if the principal balance is positive, the amount represents a loan from

the lessor to the lessee, and if the principal balance is negative, the

amount represents a loan from the lessee to the lessor.

(2) No section 467 loan in the case of certain section 467 rental

agreements. Except as provided in paragraphs (a)(3) and (4) of this

section, this section does not apply to section 467 rental agreements

that provide adequate interest under Sec. 1.467-2(b)(1)(i) (agreements

with no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements

with deferred or prepaid rent that provide adequate stated interest at

a single fixed rate).

(3) Rental agreements subject to constant rental accrual.

Notwithstanding the provisions of paragraph (a)(2) of this section,

this section applies to rental agreements subject to constant rental

accrual under Sec. 1.467-3 (relating to disqualified leasebacks or

long-term agreements).

(4) Special rule in applying the provisions of Sec. 1.467-7(e),

(f), or (g). Notwithstanding the provisions of paragraph (a)(2) of this

section, section 467 loan balances must be computed for section 467

rental agreements that are not subject to constant rental accrual under

Sec. 1.467-3 and that provide adequate interest under Sec. 1.467-

2(b)(1)(i) or (ii), but only for purposes of applying the provisions of

Sec. 1.467-7(e) (relating to dispositions of property subject to a

section 467 rental agreement), Sec. 1.467-7(f) (relating to assignments

by lessees and lessee-financed renewals), and Sec. 1.467-7(g) (relating

to modifications of rental agreements).

(b) Principal balance--(1) In general. Except as provided in

paragraph (b)(2) of this section or in Sec. 1.467-7(e), (f), or (g),

the principal balance of the section 467 loan at the beginning of a

rental period equals--

(i) The fixed rent accrued in preceding rental periods;

(ii) Increased by the sum of--

(A) The interest on fixed rent includible in the gross income of

the lessor for preceding rental periods; and

(B) Any amount payable by the lessor on or before the first day of

the rental period as interest on prepaid fixed rent; and

(iii) Decreased by the sum of--

(A) The interest on prepaid fixed rent includible in the gross

income of the lessee for preceding rental periods; and

(B) Any amount payable by the lessee on or before the first day of

the rental period as fixed rent or interest thereon.

(2) Section 467 rental agreements that provide for prepaid fixed

rent and adequate interest. If a section 467 rental agreement calls for

prepaid fixed rent and provides adequate interest under Sec. 1.467-

2(b)(1)(iv), the principal balance of the section 467 loan at the

beginning of a rental period equals the principal balance determined

under paragraph (b)(1) of this section, plus the fixed rent accrued for

that rental period.

(3) Timing of payments. For purposes of this paragraph (b), the day

on which an amount is payable is determined under the rules of

Sec. 1.467-1(j)(2)(i)(B) through (E) and Sec. 1.467-1(j)(2)(ii).

(c) Yield--(1) In general--(i) Method of determining yield. Except

as provided in paragraphs (c)(2) and (3) of this section, the yield of

a section 467 loan is the discount rate at which the sum of the present

values of all amounts payable by the lessee as fixed rent and interest

on fixed rent, plus the sum of the present values of all amounts

payable by the lessor as interest on prepaid fixed rent, equals the sum

of the present values of the fixed rent that accrues in accordance with

Sec. 1.467-1(d)(2). The yield must be constant over the term of the

section 467 rental agreement and, when expressed as a percentage, must

be calculated to at least two decimal places.

(ii) Method of stating yield. In determining the section 467

interest for a rental period, the yield of the section 467 loan must be

stated appropriately by taking into account the length of the rental

period. Section 1.1272-1(j), Example 1, provides a formula for

converting a yield based on a period of one length to an equivalent

yield based on a period of a different length.

(iii) Rounding adjustments. Any adjustment necessary to eliminate

the section 467 loan because of rounding the yield to two or more

decimal places must be taken into account as an adjustment to the

section 467 interest for the final rental period determined as provided

in paragraph (e) of this section.

(2) Yield of section 467 rental agreements for which constant

rental amount or proportional rental amount is computed. In the case of

a section 467 rental agreement to which Sec. 1.467-1(d)(2)(i) or (ii)

applies, the yield of the section 467 loan equals 110 percent of the

applicable Federal rate (based on a compounding period equal to the

length of the rental period).

(3) Yield for purposes of applying paragraph (a)(4) of this

section. For purposes of applying paragraph (a)(4) of this section, the

yield of the section 467 loan balance of any party, or prior party, to

a section 467 rental agreement for a period is the same for all parties

and is the yield that results in the net accrual of positive or

negative interest for that period equal to the amount of such interest

that accrues under the terms of the rental agreement for that period.

For example, if property subject to a section 467 rental agreement is

sold (transferred) and the beginning section 467 loan balance of the

transferor (as described in Sec. 1.467-7(e)(2)(i)) is positive and the

beginning section 467 loan balance of the transferee (as described in

Sec. 1.467-7(e)(2)(ii)) is negative, the yield on each of these loan

balances for any period is the same for all parties and is the yield

that results in the net accrual of positive or negative interest,

taking into account the aggregate positive or negative interest on the

section 467 loan balances of both the transferor and transferee, equal

to the amount of such interest that accrues under the terms of the

rental agreement for that period.

(4) Determination of present values. The rules for determining

present value in computing the yield of a section 467 loan are the same

as those provided in Sec. 1.467-2(d) for computing the proportional

rental amount.

(d) Contingent payments. Except as otherwise required, contingent

payments are not taken into account in calculating either the yield or

the principal balance of a section 467 loan.

(e) Section 467 rental agreements that call for payments before or

after the lease term. If a section 467 rental agreement calls for the

payment of fixed rent or interest thereon before the beginning of the

lease term, this section is applied by treating the period beginning on

the first day an amount is payable and ending on the day before the

beginning of the first rental period of the lease term as one or more

rental periods. If a rental agreement calls for the payment of fixed

rent or interest thereon after the end of the lease term, this section

is applied by treating the period beginning on the day after the end of

the last rental period of the lease term and ending on the last day an

amount of fixed rent or interest thereon is payable as one or more

rental periods. Rental period length for the period before the lease

term or after the lease term is determined in accordance with the rules

of Sec. 1.467-1(j)(5).

[[Page 26865]]

(f) Examples. The following examples illustrate the application of

this section:

Example 1. (i)(A) A leases property to B for a three-year period

beginning on January 1, 2000, and ending on December 31, 2002. The

section 467 rental agreement has the following rent allocation

schedule and payment schedule:

------------------------------------------------------------------------

Rent

allocation Payment

------------------------------------------------------------------------

2000.......................................... $400,000 ...........

2001.......................................... 600,000 ...........

2002.......................................... 800,000 $1,800,000

------------------------------------------------------------------------

(B) The rental agreement requires a $1.8 million payment to be

made on December 31, 2002, but does not provide for interest on

deferred rent. Assume A and B choose the calendar year as the rental

period length and that 110 percent of the applicable Federal rate

based on annual compounding is 10 percent. Assume also that the

agreement is not a leaseback or long-term agreement and, therefore,

is not subject to constant rental accrual.

(ii) Because the section 467 rental agreement does not provide

adequate interest under Sec. 1.467-2(b) and is not subject to

constant rental accrual, the fixed rent that accrues during each

rental period is the proportional rental amount as described in

Sec. 1.467-2(c). The proportional rental amounts for each rental

period are as follows:

2000....................................................... $370,370.37

2001....................................................... 555,555.56

2002....................................................... 740,740.73

(iii) A section 467 loan arises at the beginning of the second

rental period because the rent payable on or before that day (zero)

is less than the fixed rent accrued under Sec. 1.467-1(d)(2) in all

preceding rental periods ($370,370.37). Under paragraph (c)(2) of

this section, the yield of the loan is equal to 110 percent of the

applicable Federal rate (10 percent compounded annually). Because no

payments are treated as made on or before the first day of the

second rental period, the principal balance of the loan at the

beginning of the second rental period is $370,370.37. The interest

for the second rental period on fixed rent is $37,037.04 (.10 x

$370,370.37) and, under Sec. 1.467-1(e)(3), is treated as interest

income of the lessor and as an interest expense of the lessee.

(iv) Because no payments are made on or before the first day of

the third rental period, the principal balance of the loan at the

beginning of the third rental period is equal to the fixed rent

accrued during the first and second rental periods plus the lessor's

interest income on fixed rent for the second rental period

($962,962.97 = $370,370.37 + $555,555.56 + $37,037.04). The interest

for the third rental period on fixed rent is $96,296.30 (.10 x

$962,962.97). Thus, the sum of the fixed rent and interest on fixed

rent for the three rental periods is equal to the total amount paid

over the lease term (first year fixed rent accrual, $370,370.37,

plus second year fixed rent and interest accrual, $555,555.56 +

$37,037.04, plus third year fixed rent and interest accrual,

$740,740.73 + $96,296.30, equals $1,800,000). B takes the amounts of

interest and rent into account as interest and rent expense,

respectively, and A takes such amounts into account as interest and

rent income, respectively, for the calendar years identified above,

regardless of their respective overall methods of accounting.

Example 2. (i) The facts are the same as in Example 1,

Sec. 1.467-2(f). C agrees to lease property from D for five years

beginning on January 1, 2000, and ending on December 31, 2004. The

section 467 rental agreement provides that rent of $100,000 accrues

in each calendar year in the lease term and that rent of $500,000

plus $120,000 of interest is payable on December 31, 2004. The

parties select the calendar year as the rental period, and 110

percent of the applicable Federal rate is 10 percent, compounded

annually. The rental agreement has deferred rent but provides

adequate interest on fixed rent.

(ii)(A) Pursuant to paragraph (c)(1) of this section, the yield

of the section 467 loan is 10.775078%, compounded annually. The

following is a schedule of the rent allocable to each rental period

during the lease term, the balance of the section 467 loan as of the

end of each rental period (determined, in the case of the calendar

year 2004, without regard to the single payment of rent and interest

in the amount of $620,000 payable on the last day of the lease

term), and the interest on the section 467 loan allocable to each

rental period:

----------------------------------------------------------------------------------------------------------------

Section 467 Section 467 Section 467

Calendar year interest rent loan balance

----------------------------------------------------------------------------------------------------------------

2000............................................................ $0 $100,000.00 $100,000.00

2001............................................................ 10,775.08 100,000.00 210,775.08

2002............................................................ 22,711.18 100,000.00 333,486.26

2003............................................................ 35,933.41 100,000.00 469,419.67

2004............................................................ 50,580.33 100,000.00 620,000.00

----------------------------------------------------------------------------------------------------------------

(B) C takes the amounts of interest and rent into account as

expense and D takes such amounts into account as income for the

calendar years identified above, regardless of their respective

overall methods of accounting.

Sec. 1.467-5 Section 467 rental agreements with variable interest.

(a) Variable interest on deferred or prepaid rent--(1) In general.

This section provides rules for computing section 467 rent and interest

in the case of section 467 rental agreements providing variable

interest. For purposes of this section, a rental agreement provides for

variable interest if the rental agreement provides for stated interest

that is paid or compounded at least annually at a rate or rates that

meet the requirements of Sec. 1.1275-5(a)(3)(i)(A) or (B) and (a)(4).

If a section 467 rental agreement provides for interest that is neither

variable interest nor fixed interest, the agreement provides for

contingent payments.

(2) Exceptions. This section is not applicable to section 467

rental agreements that provide adequate interest under Sec. 1.467-

2(b)(1)(i) (agreements with no deferred or prepaid rent) or (b)(1)(ii)

(rental agreements with stated interest at a single fixed rate). The

exceptions in this paragraph (a)(2) do not apply to rental agreements

subject to constant rental accrual under Sec. 1.467-3.

(b) Variable rate treated as fixed--(1) In general. If a section

467 rental agreement provides variable interest--

(i) The fixed rate substitutes (determined in the same manner as

under Sec. 1.1275-5(e), treating the agreement date as the issue date)

for the variable rates of interest on deferred or prepaid fixed rent

provided by the rental agreement must be used in computing the

proportional rental amount under Sec. 1.467-2(c), the constant rental

amount under Sec. 1.467-3(d), the principal balance of a section 467

loan under Sec. 1.467-4(b), and the yield of a section 467 loan under

Sec. 1.467-4(c); and

(ii) The interest on fixed rent for any rental period is equal to

the amount that would be determined under Sec. 1.467-1(e)(2) if the

section 467 rental agreement did not provide variable interest, using

the fixed rate substitutes determined under paragraph (b)(1)(i) of this

section in place of the variable rates called for by the rental

agreement, plus the variable interest adjustment amount provided in

paragraph (b)(2) of this section.

(2) Variable interest adjustment amount--(i) In general. The

variable interest adjustment amount for a rental period equals the

difference between--

(A) The amount of interest that, without regard to section 467,

would have accrued during the rental period under the terms of the

section 467 rental agreement; and

(B) The amount of interest that, without regard to section 467,

would

[[Page 26866]]

have accrued during the rental period under the terms of the section

467 rental agreement using the fixed rate substitutes determined under

paragr

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