Section 467 Rental Agreements; Treatment of Rent &
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

TITLE: 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.

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 (Public Law 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
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 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 §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, 98 Cong., 2d Sess. 893 (1984). Under the th
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 A
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 A 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 Ab - a@ 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 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 A 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 b - a 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 b - a test may, in
some cases, result in substantial decreases in rent. Thus, the b - a
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 §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 §1.467-6 will be separately proposed, and continue to invite
comments regarding the treatment of contingent rent and the
application of the §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
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 §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.

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 A lease
strips @ or A 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 * * *

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

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

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

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

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

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

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

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

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

Par. 2. In §1.61-8, the first sentence of paragraph (b) is revised
to read as follows:

§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 §1.451-1, paragraph (g) is added to read as follows:

§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:

§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 §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:

§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 §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:

§1.467-0 Table of contents.

This section lists the captions that appear in §§1.467-1 through
1.467-9.

§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.

(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.

§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.

§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.

§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 §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 valU.S. (d) Contingent payments.

(e) Section 467 rental agreements that call for payments before or
after the lease term.

(f) Examples. §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.

§1.467-6 Section 467 rental agreements with contingent payments.

[Reserved] §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.

(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.

§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.

§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.

§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 §§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, §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 §§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.

(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. The following rules apply in determining the
amount described in paragraph (c)(4)(i) of this section:

(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 §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
§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 §1.467-3(b)), the
fixed rent for a rental period is the constant rental amount (as
determined under §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 §1.467-2(b)), the fixed rent for a rental
period is the proportional rental amount (as determined under
§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
§1.467-5(b)(1)(ii), the interest on fixed rent for a rental period
is equal to the product of B

(A) The principal balance of the section 467 loan (as described in
§1.467-4(b)) at the beginning of the rental period; and

(B) The yield of the section 467 loan (as described in §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 §1.467- 2(b)(1)(i)
(agreements with no deferred or prepaid rent) or §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 §1.467-3, and whether it is
entered into after the applicable effective date in §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
§1.467-7(g).

(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 occ U.S.

(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
§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 §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 §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 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 §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 §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
§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 §§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 §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 §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:

(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 §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 §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 §§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 §§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.

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 §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.

§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 §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 §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 §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 §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 §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 §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 §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 §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 §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 §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
§1.1272-1(j), Example 1.

(3) 110 percent of applicable Federal rate. For purposes of
§1.467-1, this section and §§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 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
§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 §1.1274-4(c)(2)(ii), the rental agreement provides for
a qualified floating rate (as defined in §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 §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) = $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:

$379,078.68 = $100,000 x 1-(1.10) -5 .10

(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 §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 §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 §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:

$2,348,724.30 = $3,000,000 (1 + .085) 3 (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:

$2,526,272.20 = $800,000 +$1,000,000 +$1,200,000 (1 + .085) (1 +
.085) (1 + .085) 2 3

(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 §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)
§1.467-3 Disqualified leasebacks and long-term agreements.

(a) General rule. Under §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. 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
§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 §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 A 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 §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 A 15 percent @ for A 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 §1.856-3(d)).

(iii) Operating rules. In determining whether the uneven rent test
has been met, the following rules apply:

(A) Any contingent rent attributable to a provision set forth in
§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 §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 §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 occU.S. (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
§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 §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
§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 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 §1.446-3(c)
(3)) at a qualified floating rate (as defined in §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:

$21,051,536 = $17,500,000 + $17,500,000 (1.12) (1.12) 4 5 (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:

$5,839,901 = $21,051,536
3.6047762
§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
payable under the rental agreement on or before the first day and
the amount of fixed rent required to be accrued in accordance with
§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 §1.467- 2(b)(1)(i)
(agreements with no deferred or prepaid rent) or §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 §1.467-3 (relating to disqualified leasebacks or long-
term agreements).

(4) Special rule in applying the provisions of §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 §1.467-3 and that provide adequate interest under §1.467-2(b)
(1)(i) or (ii), but only for purposes of applying the provisions of
§1.467-7(e) (relating to dispositions of property subject to a
section 467 rental agreement), §1.467- 7(f) (relating to assignments
by lessees and lessee-financed renewals), and §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 §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
§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
§1.467-1(j)(2)(i)(B) through (E) and §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 §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 §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 §1.467-7(e)(2)(i))
is positive and the beginning section 467 loan balance of the
transferee (as described in §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 §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 §1.467-1(j)(5).

(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 §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
§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 §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 §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, §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:

Calendar Section 467  Section 467   Section 467
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.

§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 §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 §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 §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 §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 §1.467-2(c), the constant rental
amount under §1.467-3(d), the principal balance of a section 467
loan under §1.467-4(b), and the yield of a section 467 loan under
§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 §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 have accrued during the rental period under the terms of the
section 467 rental agreement using the fixed rate substitutes
determined under paragraph (b)(1)(i) of this section in place of the
variable interest rates called for by the rental agreement.

(ii) Positive or negative adjustment. If the amount determined under
paragraph (b)(2)(i)(A) of this section is greater than the amount
determined under paragraph (b)(2)(i)(B) of this section, the
variable interest adjustment amount is positive. If the amount
determined under paragraph (b)(2)(i)(A) of this section is less than
the amount determined under paragraph (b)(2)(i)(B) of this section,
the variable interest adjustment amount is negative.

(3) Section 467 loan balance. The variable interest adjustment
amount is not taken into account in determining the principal
balance of a section 467 loan under §1.467-4(b).

Instead, the section 467 loan balance is computed as if all amounts
payable under the section 467 rental agreement were based on the
fixed rate substitutes determined under paragraph (b)(1)(i) of this
section.

(c) Examples. The following examples illustrate the application of
this section:

Example 1. (i) X and Y enter into a section 467 rental agreement for
the lease of personal property beginning on January 1, 2000, and
ending on December 31, 2002. The rental agreement allocates $100,000
of rent to 2000, $200,000 to 2001, and $100,000 to 2002, and
requires the lessee to pay all $400,000 of rent on December 31,
2002. The rental agreement requires the accrual of interest on
unpaid accrued rent at two different qualified floating rates (as
defined in §1.1275-5(b)), one for 2001 and the other for 2002, such
interest to be paid on December 31 of the year it accrues. The
rental agreement provides that the qualified floating rate is set at
a current value within the meaning of §1.1275-5(a)(4). Assume that
on the agreement date, 110 percent of the applicable Federal rate is
10 percent, compounded annually. Assume also that the agreement is
not a leaseback or long-term agreement and, therefore, is not
subject to constant rental accrual.

(ii) To determine if the section 467 rental agreement provides for
adequate interest under §1.467-2(b), §1.467-2(b)(2) requires the use
of fixed rate substitutes (in this example determined in the same
manner as under §1.1275-5(e)(3)(i) treating the agreement date as
the issue date) in place of the variable rates called for by the
rental agreement. Assume that on the agreement date the qualified
floating rates, and therefore the fixed rate substitutes, relating
to 2001 and 2002 are 10 and 15 percent compounded annually. Taking
into account the fixed rate substitutes, the sum of the present
values of all amounts payable by the lessee as fixed rent and
interest thereon is greater than the sum of the present values of
the fixed rent allocated to each rental period. Accordingly, the
rental agreement provides adequate interest under §1.467-2(b)(1)
(iii) and the fixed rent accruing in each calendar year during the
rental agreement is the fixed rent allocated under the rental
agreement.

(iii) Because the section 467 rental agreement provides for variable
interest on unpaid accrued fixed rent at qualified floating rates
and the qualified floating rates are set at a current value, the
requirements of §1.1275-5(a)(3)(i)(A) and (4) are met and the rental
agreement provides for variable interest within the meaning of
paragraph (a)(1) of this section.

Therefore, under paragraph (b)(1)(i) of this section, the yield of
the section 467 loan is computed based on the fixed rate
substitutes. Under §1.467-4(c), the constant yield (rounded to two
decimal places) equals 13.63 percent compounded annually.

Based on the fixed rate substitutes, the fixed rent, interest on
fixed rent, and the principal balance of the section 467 loan, for
each calendar year during the lease term, are as follows:

     Accrued  Accrued  Projected Cumulative
     Rent     Interest Payment   Loan
2000 $100,000     $0         $0  $100,000
2001  200,000 13,630    (10,000)  303,630
2002  100,000 41,370   (445,000)        0

(iv) To compute the actual reported interest on fixed rent for each
calendar year, the variable interest adjustment amount, as described
in paragraph (b)(2) of this section, must be added to the accrued
interest determined in paragraph (iii) of this Example 1. Assume
that the variable rates for 2001 and 2002 are actually 11 and 14
percent, respectively. Without regard to section 467, the interest
that would have accrued during each calendar year under the terms of
the section 467 rental agreement, and the interest that would have
accrued under the terms of the rental agreement using the fixed rate
substitutes determined under paragraph (b)(1)(i) of this section are
as follows:

     Accrued Interest   Accrued Interest
     Under Rental       Using Fixed 
     Agreement          Rate Substitutes
2000     $0                 $0
2001 11,000             10,000
2002 42,000             45,000

(v) Under paragraph (b)(2) of this section, the variable interest
adjustment amount is $1,000 ($11,000 - $10,000) for 2001 and is
-$3,000 ($42,000 - $45,000) for 2002. Thus, under paragraph (b)(1)
(ii) of this section, the actual interest on fixed rent for 2001 is
$14,630 ($13,630 + $1,000) and for 2002 is $38,370 ($41,370 -
$3,000).

Example 2. (i) The facts are the same as in Example 1 except that
110 percent of the applicable Federal rate is 15 percent compounded
annually and the section 467 rental agreement does not provide
adequate interest under §1.467-2(b).

Consequently, the fixed rent for each calendar year during the lease
is the proportional rental amount.

(ii) The sum of the present values of the fixed rent provided for
each calendar year during the lease term, discounted at 15 percent
compounded annually, equals $303,936.87.

(iii)(A) Paragraph (b)(1)(i) of this section requires the
proportional rental amount to be computed based on the assumption
that interest will accrue and be paid based on the fixed rate
substitutes. Thus, the sum of the present values of the projected
payments under the section 467 rental agreement equals $300,156.16,
computed as follows:

$ 10,000/(1.15) = $ 7,561.44

445,000/(1.15) = 292,594.72

$300,156.16

(B) The fraction for computing the proportional rental amount equals
.9875609 ($300,156.16/$303,936.87).

(iv) Based on the fixed rate substitutes, the fixed rent, interest
on fixed rent, and the balance of the section 467 loan for each
calendar year during the lease term are as follows:

     Proportional  Accrued   Projected  Cumulative
     Rent          Interest  Payment    Loan
2000 $98,756.09        $0.00       $0   $98,756.09
2001 197,512.18    14,813.41  (10,000)  301,081.68
2002  98,756.09    45,162.23 (445,000)        0.00

(v) The variable interest adjustment amount in this example is the
same as in Example 1. Under paragraph (b)(1)(ii) of this section,
the actual interest on fixed rent for 2001 is $15,813.41 ($14,813.41
+ $1,000) and for 2002 is $42,162.23 ($45,162.23 -$ 3,000).

§1.467-6 Section 467 rental agreements with contingent payments.
[Reserved].

§1.467-7 Section 467 recapture and other rules relating to
dispositions and modifications.

(a) Section 467 recapture. Notwithstanding any other provision of
the Internal Revenue Code, except as provided in paragraph (c) of
this section, a lessor disposing of property in a transaction to
which this paragraph (a) applies must recognize the recapture amount
(determined under paragraph (b) of this section) and treat that
amount as ordinary income. This paragraph (a) applies to any
disposition of property subject to a section 467 rental agreement
that--

(1) Is a leaseback (as defined in §1.467-3(b)(2)) or a long-term
agreement (as defined in §1.467-3(b)(3));

(2) Is not disqualified under §1.467-3(b)(1); and

(3) Allocates to any rental period fixed rent that, when annualized,
exceeds the annualized fixed rent allocated to any preceding rental
period.

(b) Recapture amount--(1) In general. The recapture amount for a
disposition is the lesser of--

(i) The prior understated inclusion (determined under paragraph (b)
(2) of this section); or

(ii) The section 467 gain (determined under paragraph (b)(3) of this
section).

(2) Prior understated inclusion. The prior understated inclusion is
the excess (if any) of--

(i) The aggregate amount of section 467 rent and section 467
interest for the period during which the lessor held the property,
determined as if the section 467 rental agreement were a
disqualified leaseback or long-term agreement subject to constant
rental accrual under §1.467-3; over

(ii) The aggregate amount of section 467 rent and section 467
interest accrued by the lessor during that period.

(3) Section 467 gain--(i) In general. Except as otherwise provided
in paragraph (b)(3)(ii) of this section, the section 467 gain is the
excess (if any) of--

(A) The amount realized from the disposition; over

(B) The sum of the adjusted basis of the property and the amount of
any gain from the disposition that is treated as ordinary income
under any provision of subtitle A of the Internal Revenue Code other
than section 467(c) (for example, section 1245 or 1250).

(ii) Certain dispositions. In the case of a disposition that is not
a sale or exchange, the section 467 gain is the excess (if any) of
the fair market value of the property on the date of disposition
over the amount determined under paragraph (b)(3)(i)(B) of this
section.

(c) Special rules--(1) Gifts. Paragraph (a) of this section does not
apply to a disposition by gift. However, see paragraph (c)(4) of
this section for dispositions by transferees.

If a disposition is in part a sale or exchange and in part a gift,
paragraph (a) of this section applies to the disposition but the
prior understated inclusion is determined by taking into account
only section 467 rent and section 467 interest properly allocable to
the portion of the property not disposed of by gift.

(2) Dispositions at death. Paragraph (a) of this section does not
apply to a disposition if the basis of the property in the hands of
the transferee is determined under section 1014(a).

This paragraph (c)(2) does not apply to property which constitutes a
right to receive an item of income in respect of a decedent. See
sections 691 and 1014(c).

(3) Certain tax-free exchanges--(i) In general. The recapture amount
in the case of a disposition to which this paragraph (c)(3) applies
is limited to the amount of gain recognized to the transferor
(determined without regard to paragraph (a) of this section),
reduced by the amount of any gain from the disposition that is
treated as ordinary income under any provision of subtitle A of the
Internal Revenue Code other than section 467(c). However, see
paragraph (c)(4) of this section for dispositions by transferees.

(ii) Dispositions covered--(A) In general. Except as provided in
paragraph (c)(3)(ii)(B) of this section, this paragraph (c)(3)
applies to a disposition of property if the basis of the property in
the hands of the transferee is determined by reference to its basis
in the hands of the transferor by reason of the application of
section 332, 351, 361, 721, or 731.

(B) Transfers to certain tax-exempt organizations. This paragraph
(c)(3) does not apply to a disposition to an organization (other
than a cooperative described in section 521) which is exempt from
tax imposed by chapter 1, subtitle A of the Internal Revenue Code (a
tax-exempt entity) except to the extent the property is used in an
activity the income from which is subject to tax under section
511(a) (a section 511(a) activity). However, if assets used to any
extent in a section 511(a) activity are disposed of by the tax-
exempt entity, then, notwithstanding any other provision of law
(except section 1031 or section 1033) the recapture amount with
respect to such disposition, to the extent attributable under
paragraph (c)(4) of this section to the period of the transferor's
ownership of the property prior to the first disposition, shall be
included in the tax-exempt entity's unrelated business taxable
income. To the extent that the tax-exempt entity ceases to use the
property in a section 511(a) activity, the entity will be treated
for purposes of this paragraph (c)(3) and paragraph (c)(4) of this
section as having disposed of the property to such extent on the
date of the cessation.

(4) Dispositions by transferee. If the recapture amount with respect
to a disposition of property (the first disposition) is limited
under paragraph (c)(1) or (3) of this section and the transferee
subsequently disposes of the property in a transaction to which
paragraph (a) of this section applies, the prior understated
inclusion determined under paragraph (b)(2) of this section is
computed by taking into account the amounts attributable to the
period of the transferor's ownership of the property prior to the
first disposition. Thus, for example, the section 467 rent and
section 467 interest that would have been taken into account by the
transferee if the section 467 rental agreement were a disqualified
leaseback or long-term agreement subject to constant rental accrual
include the amounts that would have been taken into account by the
transferor, and the aggregate amount of section 467 rent and section
467 interest accrued by the transferee includes the aggregate amount
of section 467 rent and section 467 interest that was taken into
account by the transferor. The prior understated inclusion
determined under this paragraph (c)(4) must be reduced by any
recapture amount taken into account under paragraph (a) of this
section by the transferor.

(5) Like-kind exchanges and involuntary conversions. If property is
disposed of or converted and, before the application of paragraph
(a) of this section, gain is not recognized in whole or in part
under section 1031 or 1033, then the amount of section 467 gain
taken into account by the lessor is limited to the sum of--

(i) The amount of gain recognized on the disposition or conversion
of the property (determined without regard to paragraph (a) of this
section); and

(ii) The fair market value of property acquired that is not subject
to the same section 467 rental agreement and that is not taken into
account under paragraph (c)(5)(i) of this section.

(6) Installment sales. In the case of an installment sale of
property to which paragraph (a) of this section applies--

(i) The recapture amount is recognized and treated as ordinary
income in the year of the disposition; and

(ii) Any gain in excess of the recapture amount is reported under
the installment method of accounting if and to the extent that
method is otherwise available under section 453.

(7) Dispositions covered by section 170(e), 341(e)(12), or 751(c).
For purposes of sections 170(e), 341(e)(12), and 751(c), amounts
treated as ordinary income under paragraph (a) of this section must
be treated in the same manner as amounts treated as ordinary income
under section 1245 or 1250.

(d) Examples. The following examples illustrate the application of
paragraphs (a), (b), and (c) of this section. In each of these
examples the transferor of property subject to a section 467 rental
agreement is entitled to the rent for the day of the disposition.
The examples are as follows:

Example 1. (i)(A) X and Y enter into a section 467 rental 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 calendar year will be the rental period and that rents
accrue and are paid in the following pattern:

     Allocation Payment
2000     $0          $0
2001 87,500           0
2002 87,500     175,000
2003 87,500     175,000
2004 87,500           0

(B) Assume that both X and Y are calendar year taxpayers and that
110 percent of the applicable Federal rate is 11 percent, compounded
annually. Assume also that the rental agreement is a long-term
agreement (as defined in §1.467- 3(b)(3)), but it is not a
disqualified leaseback or long-term agreement. Further, because the
agreement does not provide prepaid or deferred rent, proportional
rental accrual is not applicable. (See §1.467-2(b)(1)(i)).
Therefore, the rent taken into account under §1.467-1(d)(2) is the
fixed rent allocated to the rental periods under §1.467-1(c)(2)(ii).

(ii) On December 31, 2000, X sells the property subject to the
section 467 rental agreement to an unrelated person for $575,000. At
the time of the sale, X's adjusted basis in the property is
$175,000. Thus, X's gain on the sale of the property is $400,000.
Assume that $175,000 of this gain would be treated as ordinary
income under provisions of the Internal Revenue Code other than
section 467(c). Under paragraph (a) of this section, X is required
to take the recapture amount into account as ordinary income. Under
paragraph (b) of this section, the recapture amount is the lesser of
the prior understated inclusion or the section 467 gain.

(iii)(A) In computing the prior understated inclusion under
paragraph (b)(2) of this section, assume that the section 467 rent
and section 467 interest (based on constant rental accrual) would be
taken into account as follows if the section 467 rental agreement
were a disqualified long-term agreement:

     Section 467 Rent  Section 467 Interest
2000 $65,812.55            $0
2001  65,812.55         7,239.38
2002  65,812.55        15,275.09
2003  65,812.55         4,944.73
2004  65,812.55        (6,521.95)

(B) The total amount of section 467 rent and section 467 interest
for 2000, based on constant rental accrual, is $65,812.55. Since X
did not take any section 467 rent or section 467 interest into
account in 2000, the prior understated inclusion is also $65,812.55.
X's section 467 gain is $225,000, which is the excess of the gain
realized ($400,000) over the amount of that gain treated as ordinary
income under non-section 467 provisions ($175,000). Accordingly, the
recapture amount (the lesser of the prior understated inclusion or
the section 467 gain) treated as ordinary income is $65,812.55.

Example 2. (i) The facts are the same as in Example 1, except that
the section 467 rental agreement specifies that rents accrue and are
paid in the following pattern:

     Allocation Payment
2000 $60,000         $0
2001  65,000          0
2002  70,000    175,000
2003  75,000    175,000
2004  80,000          0

(ii)(A) Assume the section 467 rental agreement does not provide for
adequate interest under §1.467-2(b), and, therefore, the fixed rent
for a rental period is the proportional rental amount. See
§1.467-1(d)(2)(ii). Under §1.467-2(c), the following amounts would
be required to be taken into account: Section 467 Rent Section 467
Interest

2000 $57,260.43     $0
2001  62,032.13  6,298.65
2002  66,803.83 13,815.03
2003  71,575.53  3,433.11
2004  76,347.23 (7,565.94)

(B) The amount of section 467 rent and section 467 interest taken
into account by X for 2000 is $57,260.43. Thus, the prior
understated inclusion is $8,552.12 (the excess of the amount of
section 467 rent and section 467 interest based on constant rental
accrual for 2000, $65,812.55, over the amount of section 467 rent
and section 467 interest actually taken into account, $57,260.43).
Since the prior understated inclusion is less than the section 467
gain ($225,000, as determined in Example 1(iii)(B)), the recapture
amount treated as ordinary income is also $8,552.12.

Example 3. (i) The facts are the same as in Example 1, except that,
instead of selling the property, X transfers the property to S on
December 31, 2002, in exchange for stock of S in a transaction that
meets the requirements of section 351(a).

Under paragraph (c)(3) of this section, because of the application
of section 351, X is not required to take into account any section
467 recapture.

(ii) On December 31, 2003, S sells the property subject to the
section 467 rental agreement to an unrelated person for $450,000. At
the time of the sale, S's adjusted basis in the property is
$105,000. Thus, S's gain on the sale of the property is $345,000.
Assume that $245,000 of this gain would be treated as ordinary
income under provisions of the Internal Revenue Code other than
section 467(c). Under paragraph (a) of this section, S is required
to take the recapture amount into account as ordinary income which,
under paragraph (b) of this section, is the lesser of the prior
understated inclusion or the section 467 gain.

(iii) S owned the property in 2003 and, under paragraph (c)(4) of
this section, for purposes of determining S's prior understated
inclusion, S is treated as if it had owned the property during the
years 2000 through 2002. In computing S's prior understated
inclusion under paragraph (b)(2) of this section, the section 467
rent and section 467 interest based on constant rental accrual are
the same as the amounts set forth in the schedule in Example 1(iii)
(A). Thus, the constant rental amount for 2000, 2001, 2002, and 2003
is $290,709.40 ((4 x $65,812.55) + $7,239.38 + $15,275.09 +
$4,944.73). The section 467 rent and section 467 interest actually
taken into account prior to the disposition is $262,500. Thus, S's
prior understated inclusion is $28,209.40 ($290,709.40 minus
$262,500 (3 x $87,500)). S's section 467 gain is $100,000, the
difference between the gain realized on the disposition ($345,000)
and the amount of gain that is treated as ordinary income under non-
section 467 Code provisions ($245,000). Accordingly, S's recapture
amount, the lesser of the prior understated inclusion or the section
467 gain, is $28,209.40.

(e) Other rules relating to dispositions--(1) In general.

If there is a sale, exchange, or other disposition of property
subject to a section 467 rental agreement (the transfer), the
section 467 rent and, if applicable, section 467 interest for a
period are taken into account by the owner of the property during
the period. The following rules apply in determining the section 467
rent and section 467 interest for the portion of the rental period
ending immediately prior to the transfer:

(i) The section 467 rent and section 467 interest for the portion of
the rental period ending immediately prior to the transfer are a pro
rata portion of the section 467 rent and the section 467 interest,
respectively, for the rental period. Such amounts are also taken
into account in determining the transferor's section 467 loan
balance, prior to any adjustment thereof that may be required under
paragraph (h) of this section, immediately before the transfer.

(ii) If the transferor of the property is entitled to the rent for
the day of transfer, the transfer is treated as occurring at the end
of the day of the transfer.

(iii) If the transferee of the property is entitled to the rent for
the day of transfer, the transfer is treated as occurring at the
beginning of the day of the transfer.

(2) Treatment of section 467 loan. If there is a transfer described
in paragraph (e)(1) of this section, the following rules apply in
determining the transferor's and the transferee's section 467 loans
for the period after the transfer, the amount realized by the
transferor, and the transferee's basis in the property:

(i) The beginning balance of the transferor's section 467 loan is
equal to the net present value at the time of the transfer (but
after giving effect to the transfer) of all subsequent amounts
payable as fixed rent and interest on fixed rent to the transferor
and all subsequent amounts payable as interest on prepaid fixed rent
by the transferor. The transferor must continue to take into account
interest on the transferor's section 467 loan balance after the date
of the transfer.

(ii) The beginning balance of the transferee's section 467 loan is
equal to the principal balance of the transferor's section 467 loan
immediately before the transfer reduced (below zero, if appropriate)
by the beginning balance of the transferor's section 467 loan.
Amounts payable to the transferor are not taken into account in
adjusting the transferee's section 467 loan balance.

(iii) If the beginning balance of the transferee's section 467 loan
is negative, the transferor and transferee must treat the balance as
a liability that is either assumed in connection with the transfer
of the property or secured by the property acquired subject to the
liability. If the beginning balance of the transferee's section 467
loan is positive, the transferor and transferee must treat the
balance as an additional asset acquired in connection with the
transfer of the property. In the case of a positive beginning
balance of the transferee's section 467 loan, the transferee will
have an initial cost basis in the section 467 loan equal to the
lesser of the beginning balance of the loan or the aggregate
consideration for the transfer of the property subject to the
section 467 rental agreement and the transfer of the transferor's
interest in the section 467 loan.

(3) [Reserved].

(4) Examples. The following examples illustrate the application of
this paragraph (e). In each of these examples the transferor of
property subject to a section 467 rental agreement is entitled to
the rent for the day of the transfer. The examples are as follows:

Example 1. (i) Q and R enter into a section 467 rental 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
$0 of rent is allocated to 2000, 2001, and 2002, and $1,750,000 is
allocated to each of the years 2003 and 2004. The rental agreement
provides that the calendar year will be the rental period and that
the rent allocated to each calendar year is payable on the last day
of that calendar year.

Assume that both Q and R are calendar year taxpayers and that 110
percent of the applicable Federal rate is 11 percent, compounded
annually. Assume further that the rental agreement is a disqualified
long-term agreement (as defined in §1.467-3(b)(3)) and that the
section 467 rent, the section 467 interest, and the section 467 loan
balance would be the following amounts:

Calendar Section 467  Section 467  Section 467
Year     Payment      Interest     Rent          Loan Balance
2000            $0         $0      $592,905.87    $592,905.87
2001             0     65,219.65    592,905.87   1,251,031.39
2002             0    137,613.45    592,905.87   1,981,550.71
2003     1,750,000.00 217,970.58    592,905.87   1,042,427.16
2004     1,750,000.00 114,666.97    592,905.87           0

(ii) On December 31, 2002, Q sells the property subject to the
section 467 rental agreement to P, an unrelated person, for
$3,000,000. Q does not retain the right to receive any amounts
payable by R under the rental agreement after the date of sale, but
the agreement is not otherwise modified. At the time of the sale,
Q's adjusted basis in the property is $975,000. Assume that, under
§1.467-1(f)(7), the disposition is not a substantial modification.
Further, the Commissioner does not determine that the treatment of
the agreement as a disqualified long-term agreement should be
changed and, under §1.467-1(f)(4)(iii), the agreement remains
subject to constant rental accrual. Thus, under paragraph (g)(2)
(iii) of this section, section 467 rent and section 467 interest for
periods after the disposition will be taken into account on the
basis of constant rental accrual applied to the terms of the entire
agreement (as modified).

(iii) Under paragraph (e)(2)(ii) of this section, the beginning
balance of P's section 467 loan is $1,981,550.71. P's section 467
loan balance is computed by reducing the balance of the section 467
loan immediately before the transfer ($1,981,550.71) by the
beginning balance of the transferor's section 467 loan ($0 because Q
does not retain the right to receive any amounts payable under the
rental agreement subsequent to the transfer).

(iv) Q will be treated as if it had received $1,981,550.71 from the
disposition of the section 467 loan and $1,018,449.29 from the sale
of the property subject to the rental agreement.

Thus, Q's gain on the sale of the property is $43,449.29
($1,018,449.29 amount realized less $975,000 adjusted basis).

Q's gain is not subject to the recapture provisions of section
467(c) and paragraph (a) of this section because the rental
agreement was disqualified under §1.467-3(b)(1) and, thus, the
requirement of paragraph (a)(2) of this section is not met. Q
recognizes no gain on the disposition of the section 467 loan
because Q's basis in the loan equals the amount considered received
for the loan. Further, Q does not take into account any of the
section 467 rent or section 467 interest attributable to periods
after the transfer of the property.

(v) P is treated as if it had acquired the property and the positive
balance in the transferee's section 467 loan. P's cost basis in the
property is $1,018,449.29, and its cost basis in the section 467
loan immediately following the transfer is $1,981,550.71. P takes
section 467 rent and section 467 interest into account for the
calendar years 2002 and 2003 under the constant rental accrual
method and, accordingly, treats payments received under the rental
agreement as recoveries of the principal balance of the section 467
loan (as adjusted from time to time).

Example 2. (i) The facts are the same as Example 1, except that on
December 31, 2002, Q transfers the property to P in exchange for
stock of P having a fair market value of $3,000,000 and the
transaction meets the requirements of section 351(a).

(ii) Q is treated as having transferred two assets to P, the
property subject to the rental agreement and the positive balance of
the section 467 loan. Under section 351(a), because only stock of P
is received by Q, Q does not recognize any of the gain realized on
the transaction. Pursuant to section 358(a), the basis of Q in the P
stock received in the exchange is the same as the aggregate basis of
the property exchanged, or $2,956,550.71 (the sum of the balance of
the section 467 loan, $1,981,550.71, and the adjusted basis of the
property, $975,000).

Q does not take into account any of the section 467 rent or section
467 interest attributable to periods after the transfer of the
property.

(iii) P is treated as if it had acquired the property and the
positive balance in the transferee's section 467 loan in the
transaction. Pursuant to section 362(a), P's basis in each asset is
the same as the basis of Q immediately preceding the transfer.

Thus, the basis of P in the property subject to the rental agreement
is $975,000, and the basis of P in the section 467 loan immediately
following the transfer is $1,981,550.71. P takes section 467 rent
and section 467 interest into account for the calendar years 2003
and 2004 under the constant rental accrual method and, accordingly,
treats payments received under the rental agreement as recoveries of
the principal balance of the section 467 loan (as adjusted from time
to time).

(f) Treatment of assignments by lessee and lessee-financed
renewals--(1) Substitute lessee use. If a lessee assigns its
interest in a section 467 rental agreement to a substitute lessee,
or if a period when a substitute lessee has the use of property
subject to a section 467 rental agreement is otherwise included in
the lease term under §1.467-1(h)(6), the section 467 rent for a
period is taken into account by the person having the use of the
property during the period. The following rules apply in determining
the section 467 rent and section 467 interest for the portion of the
rental period ending immediately prior to the assignment:

(i) The section 467 rent and section 467 interest for the portion of
the rental period ending immediately prior to the assignment are a
pro rata portion of the section 467 rent and the section 467
interest, respectively, for the rental period. Such amounts are also
taken into account in determining the lessee's section 467 loan
balance, prior to any adjustment thereof that may be required under
paragraph (h) of this section, immediately before the substitute
lessee first has use of the property.

(ii) If the lessee is liable for the rent for the day that the
substitute lessee first has use of the property, the substitute
lessee's use shall be treated as beginning at the end of that day.

(iii) If the substitute lessee is liable for the rent for the day
that the substitute lessee first has use of the property, the
substitute lessee's use shall be treated as beginning at the
beginning of that day.

(2) Treatment of section 467 loan. If, as described in paragraph (f)
(1) of this section, a lessee assigns its interest in a section 467
rental agreement to a substitute lessee or a period when a
substitute lessee has the use of property subject to a section 467
rental agreement is otherwise included in the lease term under
§1.467-1(h)(6), the following rules apply in determining the amount
of the lessee's and the substitute lessee's section 467 loans for
the period when the substitute lessee has use of the property and in
computing the taxable income of the lessee and substitute lessee:

(i) The beginning balance of the lessee's section 467 loan is equal
to the net present value, as of the time the substitute lessee first
has use of the property (but after giving effect to the transfer of
the right to use the property), of all amounts subsequently payable
by the lessee as fixed rent and interest on fixed rent and all
amounts subsequently payable as interest on prepaid fixed rent to
the lessee. For purposes of this paragraph (f), any amount otherwise
payable by the lessee is not treated as an amount subsequently
payable by the lessee to the extent that such payment, if made by
the lessee, would give rise to a right of contribution or other
similar claim against the substitute lessee or any other person. The
lessee must continue to take into account interest on the lessee's
section 467 loan balance after the substitute lessee first has use
of the property.

(ii) The beginning balance of the substitute lessee's section 467
loan is equal to the principal balance of the lessee's section 467
loan immediately before the substitute lessee first has use of the
property reduced (below zero, if appropriate) by the beginning
balance of the lessee's section 467 loan. Amounts payable by the
lessee to any person other than the substitute lessee (or a related
person) or payable to the lessee by any person other than the
substitute lessee (or a related person) are not taken into account
in adjusting the substitute lessee's section 467 loan balance.

(iii) If the beginning balance of the substitute lessee's section
467 loan is positive, the beginning balance is treated as--

(A) Gross receipts of the lessee for the taxable year in which the
substitute lessee first has use of the property; and

(B) A liability that is either assumed in connection with the
transfer of the leasehold interest to the substitute lessee or
secured by property acquired subject to the liability.

(iv) If the beginning balance of the substitute lessee's section 467
loan is negative, the following rules apply:

(A) If the principal balance of the lessee's section 467 loan
immediately before the substitute lessee first has use of the
property was negative, any consideration paid by the substitute
lessee to the lessee in conjunction with the transfer of the use of
the property shall be treated as a nontaxable return of capital to
the lessee to the extent that--

(1) The consideration does not exceed the amount owed to the lessee
under the lessee's section 467 loan balance immediately before the
substitute lessee first has use of the property; and

(2) The lessee has basis in the principal balance of the lessee's
section 467 loan immediately before the substitute lessee first has
use of the property.

(B) Except as provided in paragraph (f)(2)(iv)(D) of this section,
the excess, if any, of the beginning balance of the amount owed to
the substitute lessee under the section 467 loan, over any
consideration paid by the substitute lessee to the lessee in
conjunction with the transfer of the use of the property, is treated
as an amount incurred by the lessee for the taxable year in which
the substitute lessee first has use of the property.

(C) To the extent the beginning balance of the amount owed to the
substitute lessee under the section 467 loan exceeds any
consideration paid by the substitute lessee to the lessee in
conjunction with the transfer of the use of the property, repayments
of the beginning balance are items of gross income of the substitute
lessee in the taxable year in which repayment occurs (determined by
applying any repayment first to the beginning balance of the
substitute lessee's section 467 loan).

(D) Any amount incurred by the lessee under paragraph (f)(2)(iv)(B)
of this section with respect to a transfer of the use of property
(the current transfer) shall be reduced (but not below zero) to the
extent that the lessee, in its capacity, if any, as a substitute
lessee with respect to an earlier transfer of the use of the
property would have recognized additional gross income under
paragraph (f)(2)(iv)(C) of this section if the current transfer had
not occurred.

(v) For purposes of paragraph (f)(2)(iv)(C) of this section,
repayments occur as the negative balance is amortized through the
net accrual of rent and negative interest.

(3) Lessor use. If a period when the lessor has the use of property
subject to a section 467 rental agreement is included in the lease
term under §1.467-1(h)(6), the section 467 rent for the period is
not taken into account and the lessor is treated as a substitute
lessee for purposes of this paragraph (f).

(4) Examples. The following examples illustrate the application of
this paragraph (f). In each of these examples, the substitute lessee
is liable for the rent for the day on which the substitute lessee
first has use of the property subject to the section 467 rental
agreement. Further, assume that in each example the lessee
assignment is not a substantial modification under §1.467-1(f). The
examples are as follows:

Example 1. (i) The facts are the same as in Example 1 of paragraph
(e)(4) of this section, except that on December 31, 2001, R, the
lessee, contracts to assign its entire remaining interest in the
leasehold to S, a calendar year taxpayer. The assignment becomes
effective at the beginning of January 1, 2002.

Pursuant to the terms of the assignment, R agrees with S that R will
make $1,400,000 of the $1,750,000 rental payment required on
December 31, 2003.

(ii) Under paragraph (f)(2)(i) of this section, R's section 467 loan
balance as of the beginning of January 1, 2002, the time S first has
use of the property, is $1,136,271.41 ($1,400,000/(1.11) ). Under
paragraph (f)(2)(ii) of this 2 section, S's section 467 loan balance
as of the beginning of January 1, 2002, is $114,759.98 (the
principal balance of R's section 467 loan immediately before S has
use of the property ($1,251,031.39), less R's section 467 loan
balance at the beginning of January 1, 2002 ($1,136,271.41)).

(iii) Because S's $114,759.98 section 467 loan balance is positive,
under paragraph (f)(2)(iii)(A) of this section, such amount is
treated as gross receipts of R for 2002, R's taxable year in which S
first has use of the property. R will treat the $114,759.98 as an
amount received in exchange for the transfer of the leasehold
interest. Under paragraph (f)(2)(iii)(B) of this section, S will
treat that amount as a liability assumed in acquiring the leasehold
interest. Thus, S's cost basis in the leasehold interest is
$114,759.98.

(iv) Under paragraph (f)(1) of this section, S takes the section 467
rent attributable to the property into account for the period
beginning on January 1, 2002. For 2002, S takes section 467 interest
into account based on S's section 467 loan balance at the beginning
of 2002. S's amounts payable, section 467 rent, section 467
interest, and end-of-year section 467 loan balances for calendar
years 2002 through 2004 are as follows:

Calendar  Section 467  Section 467  Section 467
Year      Payment      Interest     Rent          Loan Balance
Beginning  $114,759.98
2002             $0    $12,623.60   $592,905.87     720,289.45
2003        350,000.00  79,231.83    592,905.87   1,042,427.15
2004      1,750,000.00 114,666.98    592,905.87           0

(v) Under paragraph (f)(2)(i) of this section, R must continue to
take into account section 467 interest on R's section 467 loan
balance after S first has use of the property. R's section 467 loan
balance beginning when S first has use of the property is
$1,136,271.41. R's section 467 interest and end-of-year section 467
loan balances for calendar years 2002 through 2003 are as follows:

Calendar    Section 467    Section 467
Year        Payment        Interest     Loan Balance
Beginning   $1,136,271.41
2002                $0     $124,989.85  1,261,261.26
2003        1,400,000.00    138,738.74          0

Example 2. (i) On January 1, 2000, B leases tangible personal
property from C for a period of five years. The rental agreement
provides that the rental period is the calendar year and that rent
payments are due at the end of the calendar year.

The rental agreement does not provide for interest on prepaid rent.
Assume that B and C are both calendar year taxpayers and that 110
percent of the applicable Federal rate is 10 percent, compounded
annually. The rental agreement allocates rents and provides for
payments of rent as follows: 

Calendar

Year Rent     Payments
2000 $200,000 $400,000
2001  200,000  300,000
2002  200,000  200,000
2003  200,000  100,000
2004  200,000        0

(ii) The rental agreement has prepaid rent within the meaning of
§1.467-1(c)(3)(ii) because the cumulative amount of rent payable
through the end of 2001 ($700,000) exceeds the cumulative amount of
rent allocated to calendar years 2000 through 2002 ($600,000).
Because the rental agreement does not provide for adequate interest
on prepaid fixed rent, the rent for each calendar year during the
lease term is the proportional rental amount, as described in
§1.467-2(c). The amounts payable, section 467 rent, section 467
interest, and end-of-year section 467 loan balances for each
calendar year are as follows:

Calendar  Section 467  Section 467  Section 467
Year      Payment      Interest     Rent         Loan Balance
2000      $400,000          $0      $218,987.40  ($181,012.60)
2001       300,000     (18,101.26)   218,987.40   (280,126.46)
2002       200,000     (28,012.64)   218,987.40   (289,151.70)
2003       100,000     (28,915.17)   218,987.40   (199,079.47)
2004             0     (19,907.93)   218,987.40          0

(iii) On December 31, 2001, B contracts to assign its entire
remaining interest in the leasehold to D, a calendar year taxpayer.
The assignment becomes effective at the beginning of January 1,
2002. D pays B $278,000 on January 1, 2002, in conjunction with the
assignment of the leasehold interest. Under the terms of the
assignment, B is not obligated to make any rental payments due after
the assignment.

(iv) Under paragraph (f)(2)(i) of this section, B's section 467 loan
balance as of the beginning of January 1, 2002, the time D first has
use of the property, is zero because D is obligated to make all rent
payments due after the assignment of the leasehold interest. Under
paragraph (f)(2)(ii) of this section, D's section 467 loan balance
as of the beginning of January 1, 2002, is negative $280,126.46 (the
principal balance of B's section 467 loan immediately before D has
use of the property (negative $280,126.46), less B's section 467
loan balance when D first has use of the property (zero)). Because
D's beginning section 467 loan balance is negative, paragraph (f)(2)
(iv) of this section applies.

(v) Because B's $280,126.46 section 467 loan balance at the end of
2001 (that is, immediately before D has use of the property) is
negative, paragraph (f)(2)(iv)(A) of this section applies. B's loan
balance is the amount owed to B under the section 467 loan and
consists of the excess of B's payments to C over the net amount of
rent and negative interest B has taken into account through the end
of 2001. Thus, B's basis in the negative section 467 loan balance at
the end of 2001 is $280,126.46. Because the $278,000 paid by D to B
in conjunction with the transfer of the leasehold interest does not
exceed the amount owed to B under the section 467 loan at the end of
2001, and does not exceed B's basis in that loan balance, under
paragraph (f)(2)(iv)(A) of this section B treats the $278,000
payment from D as a nontaxable return of capital.

(vi) The beginning balance of the amount owed to D under the section
467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by D
to B in conjunction with the transfer of the leasehold interest.
Paragraph (f)(2)(iv)(B) of this section treats the $2,126.46 as an
amount incurred by B in 2002, B's taxable year in which D first has
use of the property. Paragraph (f)(2)(iv)(D) of this section does
not apply to reduce the amount incurred by B because B is the
original lessee under the section 467 rental agreement.

(vii) Under paragraph (f)(1) of this section, D takes the section
467 rent into account for the period beginning when D first has use
of the property. D takes section 467 interest into account based on
a beginning section 467 loan balance of negative $280,126.46.

(viii) The beginning balance of the amount owed to D under the
section 467 loan ($280,126.46) exceeds by $2,126.46 the $278,000
paid by D to B in conjunction with the transfer of the leasehold
interest. Under paragraph (f)(2)(iv)(C) of this section, D must
include this amount in gross income in 2002, the year in which this
amount of D's beginning section 467 loan balance is paid through the
net accrual of rent and negative interest. This inclusion in gross
income ensures that the reductions in D's taxable income
attributable to the section 467 rental agreement will not exceed the
actual amount of D's expenditures.

(g) Application of section 467 following a rental agreement
modification--(1) Substantial modifications. The following rules
apply to any substantial modification of a rental agreement
occurring after May 18, 1999, unless the entire agreement (as
modified) is treated as a single agreement under §1.467- 1(f)(4)
(vi):

(i) Treatment of pre-modification items. The lessor and lessee must
take pre-modification items (within the meaning of §1.467-1(f)(5)
(v)) into account under their method of accounting used before the
modification to report income and expense attributable to the rental
agreement.

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

In computing section 467 rent, section 467 interest, and the amount
of the section 467 loan with respect to post-modification items--

(A) Post-modification items are treated as provided under a rental
agreement (the post-modification agreement) separate from the
agreement under which pre-modification items are provided;

(B) The lease term of the post-modification agreement begins at the
beginning of the first period for which rent other than pre-
modification rent is provided; and

(C) The applicable Federal rate for the post-modification agreement
is the applicable Federal rate in effect on the day on which the
modification occU.S.

(iii) Adjustments--(A) Adjustment relating to certain prepayments.
If any payments before the beginning of the lease term of the post-
modification agreement are post-modification items, the lessor and
lessee must take into account, in the taxable year in which the
modification occurs, any adjustment necessary to prevent duplication
with respect to such payments or the omission of interest thereon
for periods before the beginning of the lease term.

(B) Adjustment relating to retroactive beginning of lease term. If
the lease term of a post-modification agreement begins before the
date on which the modification occurs, the lessor and lessee must
take into account in the taxable year in which the modification
occurs any amount necessary to prevent the duplication or omission
of rent or interest for the period after the beginning of the lease
term of the post-modification agreement and before the beginning of
the taxable year in which the modification occurs. For this purpose,
the amount necessary to prevent duplication or omission is
determined after taking into account any adjustments required by the
Commissioner for taxable years ending prior to the beginning of the
taxable year in which the modification occurs. In determining any
adjustments required by the Commissioner for taxable years ending
prior to the beginning of the taxable year in which the modification
occurs, the Commissioner will disregard the modification.

(iv) Coordination with rules relating to dispositions and
assignments--(A) Dispositions. If the modification involves a sale,
exchange, or other disposition of the property subject to the rental
agreement--

(1) Adjustments required under this paragraph (g) are taken into
account before applying paragraphs (a), (b), (c), and (e) of this
section;

(2) The prior understated inclusion for purposes of paragraph (b) of
this section is the sum of the prior understated inclusion with
respect to pre-modification items and the prior understated
inclusion with respect to post-modification items; and

(3) Paragraph (e) of this section applies separately with respect to
pre-modification items and post-modification items.

(B) Assignments. If the modification involves an assignment of the
lessee's interest in the rental agreement to a substitute lessee or
a substitute lessee having use of the property during a period
otherwise included in the lease term--

(1) Adjustments required under this paragraph (g) are taken into
account before applying paragraph (f) of this section; and

(2) Paragraph (f) of this section applies separately with respect to
pre-modification items and post-modification items.

(2) Other modifications. The following rules apply to a modification
(other than a substantial modification) of a rental agreement
occurring after May 18, 1999:

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

The amount of the section 467 loan relating to the agreement is
computed as of the effective date of the modification. The section
467 rent and section 467 interest for periods before the effective
date of the modification are determined, solely for purposes of
computing the amount of the section 467 loan, under the terms of the
entire agreement (as modified).

(ii) Change in balance of section 467 loan. (A) If the balance of
the section 467 loan determined under paragraph (g)(2)(i) of this
section is greater than the balance of the section 467 loan
immediately before the effective date of the modification, the
difference is taken into account, in the taxable year in which the
modification occurs, as additional rent.

(B) If the balance of the section 467 loan determined under
paragraph (g)(2)(i) of this section is less than the balance of the
section 467 loan immediately before the effective date of the
modification, the difference is taken into account, in the taxable
year in which the modification occurs, as a reduction of the rent
previously taken into account by the lessor and lessee.

(C) For purposes of this paragraph (g)(2)(ii), a negative balance is
less than a positive balance, a zero balance, or any other negative
balance that is closer to a zero balance.

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

The section 467 rent and section 467 interest for periods after the
effective date of the modification are determined under the terms of
the entire agreement (as modified).

(iv) Applicable Federal rate. The applicable Federal rate for the
agreement does not change as a result of the modification.

(v) Modification effective within a rental period. If the effective
date of a modification does not coincide with the beginning or end
of a rental period under the agreement in effect before the
modification, the section 467 rent and section 467 interest for the
portion of the rental period ending immediately prior to the
effective date of the modification are a pro rata portion of the
section 467 rent and the section 467 interest, respectively, for the
rental period. Such amounts are also taken into account in
determining the section 467 loan balance, prior to any adjustment
thereof that may be required under paragraph (h) of this section,
immediately before the effective date of the modification. Similar
rules apply with respect to the section 467 rent and section 467
interest determined under the terms of the entire agreement (as
modified) for purposes of computing the amount of the section 467
loan under paragraph (g)(2)(i) of this section and the section 467
rent and section 467 interest for a partial rental period beginning
on the effective date of the modification.

(vi) Other adjustments. The lessor and lessee must take into
account, in the taxable year in which a retroactive modification
occurs, any amount necessary to prevent the duplication or omission
of rent or interest for the period before the beginning of the
taxable year in which the modification occU.S.

(vii) Coordination with rules relating to dispositions and
assignments. If the modification involves a sale, exchange, or other
disposition of the property subject to the rental agreement, an
assignment of the lessee's interest in the rental agreement to a
substitute lessee or a substitute lessee having use of the property
during a period otherwise included in the lease term, adjustments
required under this paragraph (g) are taken into account before
applying paragraphs (a), (b), (c), (e), and (f) of this section.

(viii) Exception for agreements entered into prior to effective date
of section 467. This paragraph (g)(2) does not apply to a
modification of a rental agreement that is not subject to section
467 because of the effective date provisions of section 92(c) of the
Tax Reform Act of 1984 (Public Law 98-369 (98 Stat. 612)).

(3) Adjustment by Commissioner. If the entire agreement (as
modified) is treated as a single agreement under §1.467- 1(f)(4)
(vi), the Commissioner may require adjustments to taxable income to
reflect the effect of the modification, including adjustments that
are similar to those required under paragraph (g)(2) of this
section.

(4) Effective date of modification. The effective date of a
modification of a rental agreement occurs at the earliest of--

(i) The date on which the modification occurs;

(ii) The beginning of the first period for which the amount of rent
or interest provided under the entire agreement (as modified)
differs from the amount of rent or interest provided under the
agreement in effect before the modification;

(iii) The due date of the first payment, under either the entire
agreement (as modified) or the agreement in effect before the
modification, that is not identical, in due date and amount, under
both such agreements;

(iv) The date, in the case of a modification involving the
substitution of a new lessor, on which the property subject to the
rental agreement is transferred; or

(v) The date, in the case of a modification involving the
substitution of a new lessee, on which the substitute lessee first
has use of the property subject to the rental agreement.

(5) Examples. The following examples illustrate the application of
this paragraph (g):

Example 1. (i) F, a cash method lessor, and G, an accrual method
lessee, agree to a 7-year lease of tangible personal property for
the period beginning on January 1, 1998, and ending on December 31,
2004. The rental agreement allocates $100,000 of rent to each
calendar year during the lease term, such rent to be paid December
31 following the close of the calendar year to which it is
allocated. Because the rental agreement does not provide for
increasing rent, or deferred rent within the meaning of section
467(d)(1)(A), section 467 does not apply to the rental agreement.

(ii) Prior to January 1, 2001, G timely makes the $100,000 rental
payments required as of December 31, 1999, and December 31, 2000. On
January 1, 2001, F and G modify the rental agreement payment
schedule to provide for a single final payment of $500,000 on
December 31, 2004. Assume that the change is a substantial
modification within the meaning of §1.467- 1(f)(5)(ii). Because the
modification occurs after May 18, 1999, the post-modification
agreement is treated, under §1.467-1(f)(1), as a new agreement for
purposes of determining whether it is a section 467 rental
agreement.

(iii) Under §1.467-1(f)(5)(v), the $200,000 of rent allocated to
calendar years 1998 and 1999 (periods prior to the modification)
constitutes pre-modification rent, and the $100,000 rent payments
made on December 31, 1999, and December 31, 2000, constitute pre-
modification payments. Although calendar year 2000 is also prior to
the modification, the rent allocated to calendar year 2000 is not
pre-modification rent and the related payment is not a pre-
modification payment because the modification changed the time at
which that rent is payable. See §1.467-1(f)(5)(v)(A).

(iv) Under paragraph (g)(1)(i) of this section, F and G take pre-
modification rent and pre-modification payments into account under
the method of accounting they used to report income and deductions
attributable to the pre-modification agreement.

(v) Under §1.467-1(f)(1)(i), the post-modification agreement
providing rent for the period beginning on January 1, 2000, and
ending on December 31, 2004, is treated as a new rental agreement.
This rental agreement allocates $100,000 of rent to each of the
calendar years 2000 through 2004 and provides for a single rental
payment of $500,000 on December 31, 2004. Because the post-
modification agreement provides for deferred rent under §1.467-1(c)
(3)(i), section 467 applies. Further, the post-modification
agreement does not provide for adequate interest on fixed rent, and
therefore F and G must account for fixed rent and interest on fixed
rent using proportional rental accrual. Under paragraph (g)(1)(iii)
of this section, for their taxable years which include January 1,
2001, F and G must adjust reported rent for the difference between
the rent taken into account for the calendar year 2000 under the
unmodified agreement and the proportional rental amount for that
year under the post-modification agreement.

Example 2. (i) On January 1, 2000, X, lessee, and Y, lessor, enter
into a rental agreement for a 6-year lease of tangible personal
property beginning January 1, 2000, and ending December 31, 2005.
The agreement provides that the calendar year is the rental period
and all rent payments are due on July 15 of all years in which a
payment is required. Assume the agreement is not a disqualified
leaseback or long-term agreement within the meaning of §1.467-3(b),
and has the following allocation schedule and payment schedule:

Year  Allocation  Payment
2000  $800,000           $0
2001   900,000            0
2002 1,000,000    1,500,000
2003 1,000,000    1,500,000
2004 1,100,000    1,500,000
2005 1,200,000    1,500,000

(ii) The rental agreement has deferred rent within the
meaning of §1.467-1(c)(3)(i) because the rent allocated to 2000
is not payable until 2002 and some of the rent allocable to 2001
is not payable until 2003. Further, the rental agreement does
not provide adequate interest on fixed rent within the meaning of
§1.467-2(b). Therefore, the rent amount to be accrued by X and Y
for each rental period is the proportional rental amount, as
described in §1.467-2(c). Assuming 110 percent of the applicable
Federal rate is 10 percent compounded annually, the section 467
rent, interest, and loan balances are as follows:

Year Rent         Interest     Loan Balance
2000  $736,949.55      $0       $736,949.55
2001   829,068.24  73,694.96   1,639,712.75
2002   921,186.94 163,971.28   1,224,870.97
2003   921,186.94 122,487.10     768,545.01
2004 1,013,305.63  76,854.50     358,705.14
2005 1,105,424.33  35,870.53           0 

(iii)(A) On January 1, 2004, X and Y agree that the $1,500,000
payment scheduled for July 15, 2005, will be made in three equal
installments on June 15, 2005, July 15, 2005, and August 15, 2005.
Under §1.467-1(j)(2)(i)(C) (relating to timing conventions), the
payment to be made on June 15, 2005, is treated as if it were
payable on December 31, 2004, for purposes of determining present
values and yield of the section 467 loan.

Assume that this change, which results in the following allocation
schedule and payment schedule, is not a substantial modification
within the meaning of §1.467-1(f)(5)(ii):

Year Allocation Payment
2000  $800,000         $0
2001   900,000          0
2002 1,000,000  1,500,000
2003 1,000,000  1,500,000
2004 1,100,000  2,000,000
2005 1,200,000  1,000,000

(B) The agreement remains subject to proportional rental accrual
after the modification because it has deferred rent and does not
provide adequate interest on fixed rent within the meaning of
§1.467-2(b).

(iv) Because the modification occurs after May 18, 1999, and is not
substantial within the meaning of §1.467-1(f)(5)(ii), paragraph (g)
(2) of this section applies. Under paragraph (g)(2)(i) of this
section, the amount of the section 467 loan relating to the modified
agreement is computed as of the effective date of the modification,
and, solely for purposes of recomputing the amount of the section
467 loan, the section 467 rent and section 467 interest for periods
before the modification are determined under the terms of the entire
agreement (as modified). In addition, the applicable Federal rate
does not change as a result of the modification. Thus, the
recomputed section 467 rent, interest, and loan balances are as
follows:

Year Rent         Interest   Loan Balance
2000  $742,242.59      $0     $742,242.59
2001   835,022.91  74,224.26 1,651,489.76
2002   927,803.24 165,148.98 1,244,441.98
2003   927,803.24 124,444.20   796,689.42
2004 1,020,583.56  79,668.94  (103,058.08)
2005 1,113,363.88 (10,305.80)        0

(v) Under paragraph (g)(2)(ii) of this section, the difference
between the section 467 loan balance immediately before the
effective date of the modification and the recomputed section 467
loan balance as of the effective date of the modification is taken
into account. In this example, the loan balance immediately before
the effective date of the modification is $768,545.01 and the
recomputed loan balance as of the effective date of the modification
is $796,689.42. Thus, because the recomputed loan balance exceeds
the original loan balance, the difference ($28,144.41) is taken into
account, in the taxable year in which the modification occurs, as
additional rent.

Beginning on January 1, 2004, section 467 rent and interest are
taken into account by X and Y in accordance with the recomputed rent
schedule set forth in paragraph (iv) of this example.

(h) Omissions or duplications--(1) In general. In applying the rules
of this section in conjunction with the rules of §§1.467-1 through
1.467-5, adjustments must be made to the extent necessary to prevent
the omission or duplication of items of income, deduction, gain, or
loss. For example, if a transferee lessor acquires property subject
to a section 467 rental agreement at other than the beginning or end
of a rental period, and the transferee lessor's beginning section
467 loan balance differs from the transferor lessor's section 467
loan balance immediately prior to the transfer, it will be necessary
to treat the rental period that includes the day of transfer as
consisting of two rental periods, one beginning at the beginning of
the rental period that includes the day of transfer and ending with
or immediately prior to the transfer and one beginning with or
immediately after the transfer and ending immediately prior to the
beginning of the succeeding rental period. Because the substitution
of two rental periods for one rental period may change the
proportional rental amount or constant rental amount, the change in
rental periods should be treated as a modification of the rental
agreement that occurs immediately prior to the transfer. The change
in rental periods, by itself, is not treated as a substantial
modification of the rental agreement although the substitution of a
new lessor may constitute a substantial modification of the rental
agreement. Likewise, §1.467-1(j)(2), which provides rules regarding
when amounts are treated as payable, is designed to simplify
calculations of present values, section 467 loan balances, and
proportional and constant rental amounts. These simplifying
conventions assume that there will be no change in the lessor or
lessee under a section 467 rental agreement and that the terms of
the section 467 rental agreement will not be modified. Therefore, as
illustrated in the example in paragraph (h)(2) of this section, when
actual events do not reflect these assumptions, it may be necessary
to alter the application of these rules to properly reflect taxable
income.

(2) Example. The following example illustrates an application of
this paragraph (h):

Example. (i) J leases tangible personal property from K for five
years beginning on January 1, 2000, and ending on December 31, 2004.
Under the rental agreement, rent is payable on July 15 of the
calendar year to which it is allocated. Both J and K treat the
calendar year as the rental period. The allocation of rent and
payments of rent required under the rental agreement are as follows:

Calendar
Year       Rent      Payments
2000       $200,000  $450,000
2001        200,000   250,000
2002        200,000   200,000
2003        200,000   100,000
2004        200,000         0

(ii) The rental agreement does not provide for interest on prepaid
rent. The rental agreement has prepaid rent under §1.467-1(c)(3)(ii)
because the rent payable at the end of 2000 exceeds the cumulative
amount of rent allocated to 2000 and 2001.

Therefore, J and K must take section 467 rent into account under the
proportional rental method of §1.467-2(c). Assume that 110 percent
of the applicable Federal rate is 10 percent, compounded annually.
The section 467 rent, section 467 interest, amounts payable, and
section 467 loan balances for each of the calendar years under the
terms of the rental agreement are as follows:

Calendar  Section 467 Section 467  Section 467
Year      Rent        Interest     Payments    Loan Balance
2000      $220,077.48      $0      $450,000    $(229,922.52)
2001       220,077.48 (22,992.25)   250,000     (282,837.29)
2002       220,077.48 (28,283.73)   200,000     (291,043.54)
2003       220,077.48 (29,104.35)   100,000     (200,070.41)
2004       220,077.48 (20,007.07)         0            0

(iii) On January 1, 2002, J and K amend the terms of the rental
agreement to advance the due date of the $200,000 payment originally
due on July 15, 2002, to June 15, 2002. This change in the payment
schedule constitutes a modification of the terms of the rental
agreement within the meaning of §1.467-1(f)(5)(i).

Assume, however, that the change is not a substantial modification
within the meaning of §1.467-1(f)(5)(ii). Because the modification
occurs after May 18, 1999, and is not substantial, paragraph (g)(2)
of this section applies. Thus, the section 467 loan balance at the
beginning of 2002 must be recomputed as if the June 15, 2002,
payment date had been included in the terms of the pre-modification
rental agreement.

If this had been the case, the section 467 rent, section 467
interest, amounts payable, and section 467 loan balances for each of
the calendar years under the terms of the rental agreement would
have been as follows:

Calendar  Section 467 Section 467  Section 467
Year      Rent        Interest     Payments    Loan Balance
2000      $224,041.38      $0      $450,000    $(225,958.62)
2001       224,041.38 (22,595.86)   450,000     (474,513.10)
2002       224,041.38 (47,451.31)         0     (297,923.03)
2003       224,041.38 (29,792.30)   100,000     (203,673.95)
2004       224,041.38 (20,367.43)         0            0

(iv) Section 1.467-4(b)(3) incorporates the conventions of
§1.467-1(j)(2) in determining when amounts are treated as payable
for purposes of determining the section 467 loan balance.

Section 1.467-1(j)(2)(i)(C) treats amounts payable during the first
half of any rental period except the first rental period as payable
on the last day of the preceding rental period.

Therefore, because June 15, 2002, occurs in the first half of 2002,
in determining the section 467 loan balance at the beginning of 2002
under the amended terms of the rental agreement, the $200,000
payment due on June 15, 2002, is treated as payable on December 31,
2001.

(v) Under paragraph (g)(2)(ii)(B) of this section, if the recomputed
section 467 loan balance is less than the section 467 loan balance
immediately before the modification, the difference is taken into
account as a reduction of the rent previously taken into account by
the lessor and the lessee. In this example, the recomputed section
467 loan balance immediately after the modification is negative
$474,513.10 and the section 467 loan balance immediately before the
modification is negative $282,837.29. However, the section 467 loan
balance immediately before the modification does not take into
account the $200,000 payment originally payable on July 15, 2002,
whereas, under the conventions of §1.467-1(j)(2)(i)(C), the
recomputed section 467 loan balance immediately after the
modification takes into account that $200,000 payment because it is
now payable in the first half of the rental period (June 15). Under
these circumstances, if the recomputed section 467 loan balance
immediately after the modification is treated as negative
$474,513.10 for purposes of applying paragraph (g)(2)(ii)(B) of this
section, K's gross income and J's deductions attributable to the
section 467 rental agreement will be understated by $200,000.

Therefore, under paragraph (h)(1) of this section, only for purposes
of applying paragraph (g)(2)(ii)(B) of this section, the $200,000
payment due on June 15, 2002, should not be taken into account in
determining the recomputed section 467 loan balance immediately
after the modification.

§1.467-8 Automatic consent to change to constant rental accrual for
certain rental agreements.

(a) General rule. For the first taxable year ending after May 18,
1999, a taxpayer may change to the constant rental accrual method,
as described in §1.467-3, for all of its section 467 rental
agreements described in paragraph (b) of this section.

A change to the constant rental accrual method is a change in method
of accounting to which the provisions of sections 446 and 481 and
the regulations thereunder apply. A taxpayer changing its method of
accounting in accordance with this section must follow the automatic
change in accounting method provisions of Rev. Proc. 98-60 (see
§601.601(d)(2) of this chapter) except, for purposes of this
paragraph (a), the scope limitations in section 4.02 of Rev. Proc.
98-60 are not applicable. Taxpayers changing their method of
accounting in accordance with this section must do so for all of
their section 467 rental agreements described in paragraph (b) of
this section.

(b) Agreements to which automatic consent applies. A section 467
rental agreement is described in this paragraph (b) if B

(1) The property subject to the section 467 rental agreement is
financed with an A exempt facility bond @ within the meaning of
section 142;

(2) The facility subject to the section 467 rental agreement is
described in section 142(a)(1), (2), (3), or (12);

(3) The section 467 rental agreement does not include a specific
allocation of fixed rent within the meaning of §1.467- 1(c)(2)(ii)
(A)(2); and

(4) The section 467 rental agreement was entered into on or before
May 18, 1999.

§1.467-9 Effective dates and automatic method changes for certain
agreements.

(a) In general. Sections 1.467-1 through 1.467-7 are applicable
for--

(1) Disqualified leasebacks and long-term agreements entered into
after June 3, 1996; and

(2) Rental agreements not described in paragraph (a)(1) of this
section that are entered into after May 18, 1999.

(b) Automatic consent for certain rental agreements.

Section 1.467-8 applies only to rental agreements described in
§1.467-8.

(c) Application of regulation project IA-292-84 to certain
leasebacks and long-term agreements. In the case of any leaseback or
long-term agreement (other than a disqualified leaseback or long-
term agreement) entered into after June 3, 1996, and on or before
May 18, 1999, a taxpayer may choose to apply the provisions of
regulation project IA-292-84 (1996-2 C.B.

462)(see §601.601(d)(2) of this chapter).

(d) Entered into. For purposes of this section and §1.467-8, a
rental agreement is entered into on its agreement date (within the
meaning of §1.467-1(h)(1) and, if applicable, §1.467-1(f)(1)(i)).

(e) Change in method of accounting--(1) In general. For the first
taxable year ending after May 18, 1999, a taxpayer is granted
consent of the Commissioner to change its method of accounting for
rental agreements described in paragraph (a)(2) of this section to
comply with the provisions of §§1.467-1 through 1.467-7.

(2) Application of regulation project IA-292-84. For the first
taxable year ending after May 18, 1999, a taxpayer is granted
consent of the Commissioner to change its method of accounting for
any rental agreement described in paragraph (c) of this section to
comply with the provisions of regulation project IA-292-84 (1996-2
C.B. 462)(see §601.601(d)(2) of this chapter).

(3) Automatic change procedures. A taxpayer changing its method of
accounting in accordance with this paragraph (e) must follow the
automatic change in accounting method provisions of Rev. Proc. 98-60
(see §601.601(d)(2) of this chapter) except, for purposes of this
paragraph (e), the scope limitations in section 4.02 of Rev.Proc.
98-60 are not applicable. A method change in accordance with
paragraph (e)(1) of this section is made on a cut-off basis so no
adjustment under section 481(a) is required.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: May 5, 1999
Donald C. Lubick
Assistant Secretary of the Treasury

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