[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.48-4]

[Page 338-346]
 
                       TITLE 26--INTERNAL REVENUE
 
     CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
 
PART 1--INCOME TAXES--Table of Contents
 
Sec. 1.48-4  Election of lessor of new section 38 property to treat lessee as purchaser.

    (a) In general--(1) Lessee treated as purchaser. Under section 
48(d), a lessor of property may elect to treat the lessee of such 
property as having purchased such property (or, in the case of short-
term lease property described in subparagraph (2) of this paragraph, a 
portion of such property) for purposes of the credit allowed by section 
38 if the following conditions are satisfied:
    (i) The property must be ``section 38 property'' in the hands of the 
lessor; that is, it must be property with respect to which depreciation 
(or amortization in lieu of depreciation) is allowable to the lessor, it 
must have a useful life of 3 years (4 years in the case of property 
which is not described in section 50) or more in his hands, and in every 
other respect it must meet the requirements of Sec. 1.48-1. Thus, for 
example, property leased by a municipality to a taxpayer for use in what 
is commonly known as an ``industrial park'' is not eligible for the 
election since, under paragraph (k) of Sec. 1.48-1, property used by a 
governmental unit is not section 38 property. In addition, property used 
by the lessee predominantly outside the United States is not eligible 
for the election since, under paragraph (g) of Sec. 1.48-1, such 
property is not section 38 property. For purposes of this subdivision, 
if the lessor is an estate or trust, depreciation (or amortization in 
lieu of depreciation) will be considered allowable to the estate or 
trust even if it is apportioned to the beneficiaries or other persons.
    (ii) The property must be ``new section 38 property'' (within the 
meaning of Sec. 1.48-2) in the hands of the lessor, and the original use 
of such property must commence with the lessor. See paragraph (b) of 
this section for the application of the rules relating to ``original 
use'' in the case of leased property.
    (iii) The property would constitute ``new section 38 property'' to 
the lessee if such lessee had actually purchased the property. Thus, the 
election is not available if the lessee is not the original user of the 
property. See paragraph (b) of this section for the application of the 
rules relating to ``original use'' in the case of leased property. See 
paragraph (d) of this section for the determination of the estimated 
useful life of leased property in the hands of the lessee.
    (iv) A statement of election to treat the lessee as a purchaser has 
been filed in the manner and within the time provided in paragraph (f) 
or (g) of this section.
    (v) The lessor is not a person referred to in section 46(d)(1), that 
is, a mutual

[[Page 339]]

savings bank, cooperative bank, or domestic building and loan 
association to which section 593 applies; a regulated investment company 
or real estate investment trust subject to taxation under subchapter M, 
chapter 1 of the Code; or a cooperative organization described in 
section 1381(a).

The election may be made on a property-by-property basis or a general 
election may be made with respect to each taxable year of a particular 
lessee. If the conditions of this subparagraph have been met, the lessee 
shall be treated as though he were the actual owner of all or a portion 
of the property for purposes of the credit allowed by section 38. Thus, 
the lessee shall be entitled to a credit allowed by section 38 with 
respect to such property for the taxable year in which he places such 
property in service, and the lessor shall not be entitled to a credit 
allowed by section 38 with respect to such property unless the property 
is short-term lease property (as defined in subparagraph (2) of this 
paragraph). Moreover, if the leased property is disposed of, or if it 
otherwise ceases to be section 38 property, the property will be subject 
to the provisions of section 47 (relating to early dispositions, etc.).
    (2) Short-term lease property. For purposes of this section, the 
term ``short-term lease property'' means property which--
    (i) Is new section 38 property;
    (ii) Has a class life (determined under section 167(m)) in excess of 
14 years;
    (iii) Is leased under a lease entered into after November 8, 1971, 
for a period which is less than 80 percent of the class life of such 
property; and
    (iv) Is not leased subject to a net lease within the meaning of 
section 57(c)(1)(B) and the regulations thereunder.

The class life of property shall be determined under section 167(m) and 
the regulations prescribed in connection with that section, except that 
such class life shall be determined without regard to any variance from 
the class life permitted under such section. If a class life has not 
been prescribed for property under section 167(m) on the date such 
property is leased, the class life of the property shall be the 
estimated useful life used to compute the allowance for depreciation 
with respect to such property under section 167. For purposes of 
subdivision (iii) of this subparagraph, the period for which a lease is 
entered into shall be determined without regard to any option on the 
part of the lessee to extend or renew such lease, and without regard to 
any option on the part of the lessee to cancel the lease after a 
specified period if under the terms of such lease, such a cancellation 
would result in the imposition of a substantial penalty upon the lessee. 
Generally, a penalty equal to 25 percent of the total remaining rental 
payments due under the lease will be regarded as substantial.
    (b) Original use. For purposes of this section only, the lessor and 
the lessee may both be considered as the original users of an item of 
leased property. The determination of whether the lessor qualifies as 
the original user of leased property shall be made under paragraph 
(b)(7) of Sec. 1.48-2. The determination of whether the lessee qualifies 
as the original user of leased property shall be made, under paragraph 
(b)(7) of Sec. 1.48-2, as if the lessee actually purchased the property. 
Thus, the lessee would not be considered the original user of the 
property if it has been previously used by the lessor or another person, 
or if it is reconstructed, rebuilt, or reconditioned property. However, 
the lessee would be considered the original user if he is the first 
person to use the property for its intended function. Thus, the fact 
that the lessor may have, for example, tested, stored, or attempted to 
lease the property to other persons will not preclude the lessee from 
being considered the original user.
    (c) Qualified investment--(1) In general. If a valid election is 
made under this section, the amount of qualified investment under 
section 46(c) with respect to the leased property shall be determined 
under this paragraph and paragraphs (d) and (e) of this section.
    (2) Nonshort-term lease property. In the case of property which is 
not short-term lease property, the lessee is treated as having acquired 
the entire property for an amount equal to--
    (i) The fair market value of such property on the date possession is 
transferred to the lessee, or

[[Page 340]]

    (ii) If the property is leased by a component member of a controlled 
group to another component member of the same controlled group (within 
the meaning of paragraph (f)(4) of Sec. 1.46-1) on the date possession 
of the property is transferred to the lessee, the basis of the property 
in the hands of the lessor.
    (3) Short-term lease property. (i) In the case of short-term lease 
property, the lessee is treated as having acquired a portion of such 
property. The amount for which the lessee is treated as having acquired 
such portion is an amount equal to a fraction, the numerator of which is 
the term of the lease and the denominator of which is the class life of 
the property leased, of the amount for which the lessee would be treated 
as having acquired the property under subparagraph (2) of this paragraph 
if the property were not short-term lease property.
    (ii) In the case of short-term lease property, the qualified 
investment of the lessor is an amount equal to his qualified investment 
in such property determined under section 46(c) multiplied by a 
fraction, the numerator of which is the class life of the property 
leased minus the term of the lease and the denominator of which is the 
class life of such property.
    (4) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. (a) On December 1, 1971, X corporation completed 
construction of an item of new section 38 property with a basis of 
$10,000. Under section 167(m), the property has a class life of 16 
years. On December 1, 1971, X leases the property to individual A for 4 
years and A immediately places the property in service. The lease is not 
a net lease within the meaning of section 57(c)(1)(B). On the date of 
the lease, the fair market value of the property is $12,000. The 
property would qualify as new section 38 property in A's hands if it had 
been purchased by A. Under this section, the property is short-term 
lease property. X makes the election under this section to treat A as 
having acquired a portion of the property.
    (b) A is treated as having acquired from X a portion of the property 
for $3,000 (the fair market value of the property, $12,000, multiplied 
by a fraction, 4/16 , the numerator of which is the term of the lease 
and the denominator of which is the class life of the leased property). 
Since under paragraph (d) of this section the useful life of such 
property in the hands of A is the same as the useful life of such 
property in the hands of X, and such useful life is at least 7 years, 
A's qualified investment with respect to the property is $3,000.
    (c) The qualified investment of X is $7,500 (the qualified 
investment of X under section 46(c), $10,000, multiplied by a fraction, 
\12/16\, the numerator of which is the class life of the leased 
property, 16, minus the term of the lease, 4, and the denominator of 
which is the class life of the property).

    (d) Estimated useful life of leased property. The estimated useful 
life to the lessee of property subject to the election shall be deemed 
to be the estimated useful life in the hands of the lessor for purposes 
of computing depreciation, regardless of the term of the lease. The 
lessor shall determine the estimated useful life of each leased property 
on an individual basis even though multiple asset accounts are used. 
However, in the case of assets similar in kind contained in a multiple 
asset account, the lessor shall assign to each of such assets the 
average useful life of such assets used in computing depreciation. Thus, 
for example, if during a taxable year a lessor leases 10 similar trucks 
with an average estimated useful life for depreciation purposes of 6 
years, based on an estimated range of 5 to 7 years, he must assign a 
useful life of 6 years to each of the 10 trucks.
    (e) Lessor itself a lessee--(1) In general. If the lessee of 
property is treated, under this section, as having purchased all or a 
portion of such property and if such lessee leases such property to a 
sublessee, the qualified investment with respect to such property in the 
hands of the sublessee shall be determined under paragraphs (c) and (d) 
of this section as if the original lessor had leased the property 
directly to the sublessee for the term of the sublessee's lease on the 
date possession of the property is transferred to the sublessee. For 
this purpose, property which is short-term lease property in the hands 
of the lessee shall be treated as short-term lease property in the hands 
of the sublessee regardless of whether such property is leased to the 
sublessee subject to a net lease (within the meaning of section 
57(c)(1)(B)). In the case of property which is short-term lease property 
in the hands of the sublessee, the amount for which the lessee is

[[Page 341]]

treated as having acquired such property under paragraph (c) of this 
section shall be reduced by an amount equal to such amount multiplied by 
a fraction, the numerator of which is the term of the lease of the 
sublessee and the denominator of which is the term of the lease of the 
lessee.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. (a) On December 1, 1971, corporation X completes 
construction of a machine at a cost of $10,000. The machine has a class 
life under section 167(m) of 20 years. On December 1, 1971, X leases the 
machine to corporation Y for 12 years, and Y immediately subleases the 
machine to individual A for 8 years. X and Y are component members of 
the same controlled group. The lease between X and Y is not a net lease 
within the meaning of section 57(c)(1)(B). The fair market value of the 
property on December 1, 1971, is $16,000. Both X and Y make valid 
elections under this section.
    (b) The property is short-term lease property and this paragraph 
applies.
    (c) The qualified investment of A is $6,400. Such amount is 
determined by multiplying $16,000, the amount for which A would be 
treated under paragraph (c)(2) of this section as having acquired the 
property if it were not short-term lease property, by \8/20\.
    (d) The qualified investment of Y is $2,000. Such amount is 
determined by multiplying $10,000, the amount for which Y would be 
treated under paragraph (c)(2) of this section as having acquired the 
property if it were not short-term lease property, by \12/20\, and by 
reducing the amount so determined ($6,000) by \8/12\ of such amount 
($4,000) to $2,000.
    (e) The qualified investment of X is $4,000. Such amount is 
determined by multiplying the amount of X's qualified investment 
determined under section 46(c) without regard to this section ($10,000) 
by \8/20\.

    (f) Property-by-property election-- (1) Manner of making election. 
The election of a lessor with respect to a particular property (or 
properties) shall be made by filing a statement with the lessee, signed 
by the lessor and including the written consent of the lessee, 
containing the following information:
    (i) The name, address, and taxpayer account number of the lessor and 
the lessee;
    (ii) The district director's office with which the income tax 
returns of the lessor and the lessee are filed;
    (iii) A description of each property with respect to which the 
election is being made;
    (iv) The date on which possession of the property (or properties) is 
transferred to the lessee;
    (v) The estimated useful life category of the property (or 
properties) in the hands of the lessor, that is, 3 years or more but 
less than 5 years, 5 years or more but less than 7 years, or 7 years or 
more;
    (vi) The amount for which the lessee (or sublessee) is treated as 
having acquired the leased property under paragraph (c)(2) or (3) of 
this section; and
    (vii) If the lessor is itself a lessee, the name, address, and 
taxpayer account number of the original lessor, and the district 
director's office with which the income tax return of such original 
lessor is filed.
    (2) Time for making election. The statement referred to in 
subparagraph (1) of this paragraph shall be filed with the lessee on or 
before the due date (including any extensions of time) of the lessee's 
return for the lessee's taxable year during which possession of the 
property is transferred to the lessee, except that if such taxable year 
ends after March 31, 1971, and before December 11, 1971, the statement 
shall be filed with the lessee on or before the due date (including any 
extensions of time) of the lessee's return for such taxable year, or on 
or before October 24, 1972, whichever is later.
    (3) Election is irrevocable. An election under this paragraph shall 
be irrevocable as of the time the statement referred to in subparagraph 
(1) of this paragraph is filed with the lessee.
    (g) General election--(1) In general. In lieu of making elections on 
a property-by-property basis in the manner and time prescribed in 
paragraph (f) of this section, a lessor may, with respect to a 
particular taxable year of a particular lessee, make a general election 
to treat such lessee as having purchased all properties possession of 
which is transferred under lease by the lessor to the lessee during such 
taxable year of the lessee.
    (2) Manner and time for making general election. The general 
election of a lessor with respect to a taxable year of a lessee shall be 
made by filing a statement

[[Page 342]]

with the lessee, signed by the lessor and including the written consent 
of the lessee, on or before the due date (including any extensions of 
time) of the lessee's return for such taxable year, except that if such 
taxable year ends after March 31, 1971, and before December 11, 1971, 
the statement shall be filed with the lessee on or before the due date 
(including any extensions of time) of the lessee's return for such 
taxable year, or on or before October 24, 1972, whichever is later. Such 
statement of general election shall contain:
    (i) The name, address, and taxpayer account number of the lessor and 
the lessee;
    (ii) The taxable year of the lessee with respect to which such 
general election is made;
    (iii) The district director's office with which the income tax 
returns of the lessor and the lessee are filed;
    (iv) If the lessor is itself a lessee, the name, address, and 
taxpayer account number of the original lessor, and the district 
director's office with which the income tax return of such original 
lessor is filed.
    (3) Election is irrevocable. A general election under this paragraph 
shall be irrevocable as of the time the statement referred to in 
subparagraph (2) of this paragraph is filed with the lessee and shall be 
binding on the lessor and the lessee for the entire taxable year of the 
lessee with respect to which such general election is made.
    (4) Information requirement. If a lessor, with respect to a taxable 
year of the lessee, makes a general election under this paragraph, such 
lessor shall provide such lessee, on or before the date required for 
filing the statement under subparagraph (2) of this paragraph, with a 
statement (or statements) containing the information required by 
paragraphs (f)(1) (iii), (iv), (v), and (vi) of this section with 
respect to all properties possession of which is transferred under lease 
by the lessor to the lessee during such taxable year.
    (h) Signature. The statement referred to in paragraph (f)(1) or 
(g)(2) of this section shall not be valid unless signed by both the 
lessor and the lessee. The signature of the lessee shall constitute the 
consent of the lessee to the election. The statement shall be signed by 
the taxpayer or a duly authorized agent of the taxpayer. For purposes of 
this section, a facsimile signature may be used in lieu of a signature 
manually executed and, if used, shall be as binding as a signature 
manually executed.
    (i) [Reserved]
    (j) Record requirements. The lessor and the lessee shall keep as a 
part of their records the statement referred to in paragraph (f)(1), or 
the statements referred to in paragraphs (g)(2) and (g)(4), of this 
section. The lessor shall attach to his income tax return a summary 
statement of all property leased during his taxable year with respect to 
which an election is made. In the case of a taxable year ending after 
March 31, 1971, and before December 11, 1971, a summary statement may be 
filed on or before the due date (including any extensions of time) of 
the return or on or before October 24, 1972, whichever is later, with 
the Internal Revenue Service Center with which the return has been 
filed. Such summary statement shall contain the following information: 
(1) The name, address, and taxpayer account number of the lessor; and 
(2) in numerical account number order, each lessee's account number, 
name, and address, the estimated useful life category of the property 
(or, if applicable, the estimated useful life expressed in years), and 
the basis or fair market value of the property, whichever is applicable.
    (k) Adjustment of rental deductions--(1) In general. The rules of 
this paragraph apply only to section 38 property placed in service 
before January 1, 1964, and with respect to any such property only for 
taxable years of a lessee beginning before January 1, 1964. If a lessor 
makes a valid election under this section with respect to property 
placed in service by the lessee before January 1, 1964, section 48(g) 
and Sec. 1.48-7 (relating to adjustments to basis of property) shall not 
apply to the lessor with respect to such property. Thus, the lessor is 
not required to reduce under section 48(g)(1) the basis of such 
property. However, if such an election is made, the deductions otherwise 
allowable under section 162 to the lessee for amounts paid or accrued to 
the lessor under the lease shall be adjusted in the manner provided in 
this paragraph. For

[[Page 343]]

special adjustment for taxable years beginning after December 31, 1963, 
see paragraph (m) of this section.
    (2) Decrease in rental deduction. (i) The deductions otherwise 
allowable under section 162 to the lessee for amounts paid or accrued to 
the lessor under the lease with respect to leased property placed in 
service before January 1, 1964, shall be decreased under subdivision 
(ii) or (iii) of this subparagraph, whichever is applicable, by an 
amount determined by reference to the credit earned on the leased 
property. The ``credit earned'' on the leased property is determined by 
multiplying the qualified investment (as defined in section 46(c)) with 
respect to such property by 7 percent. Thus, the credit earned (and the 
decrease in deductions) is determined without regard to the limitation 
based on tax which, under section 46(a)(2), may limit the amount of the 
credit the lessee may take into account in any one year.
    (ii) If, in the case of property placed in service before January 1, 
1964, the lessor, under paragraph (f)(1)(v) of this section, supplies 
the lessee with the useful life of such property expressed in years, 
then for each taxable year beginning before January 1, 1964, any part of 
which falls within a period beginning with the month in which the leased 
property is placed in service by the lessee and ending with the close of 
the estimated useful life of such property (as determined under 
paragraph (d) of this section), the lessee shall decrease the deduction 
otherwise allowable under section 162 for each such taxable year with 
respect to such property. The decrease for each such taxable year shall 
be equal to (a) the credit earned, divided by (b) the estimated useful 
life of the property (expressed in months), multiplied by (c) the number 
of calendar months in which the leased property was held by the lessee 
during such taxable year. Thus, if leased property with a basis of 
$27,000 in the hands of a calendar-year lessee, and with an estimated 
useful life of 10 years, is placed in service by the lessee on July 15, 
1963, the lessee must decrease his section 162 deduction with respect to 
the leased property for the taxable year 1963 by $94.50 ($1,890 credit 
earned, divided by 120, multiplied by 6).
    (iii) If, in the case of property placed in service before January 
1, 1964, the lessor, under paragraph (f)(1)(v) of this section, supplies 
the lessee with the useful life category of such property, then for each 
taxable year beginning before January 1, 1964, during a period equal to 
the shortest life of the useful life category used by the lessee in 
computing qualified investment under section 46(c) with respect to the 
leased property, the lessee shall decrease the deduction otherwise 
allowable under section 162 for such taxable year with respect to such 
property. The decrease for each such taxable year shall be equal to the 
credit earned divided by such shortest life, that is, 4, 6, or 8. Such 
decreases shall begin with the taxable year during which the lessee 
places the property in service. Thus, if leased property with a basis of 
$30,000 to the lessee, and an estimated useful life falling within the 4 
years or more but less than 6 years useful life category, is placed in 
service by the lessee within the lessee's taxable year ending December 
31, 1962, the lessee must decrease his section 162 deduction with 
respect to the leased property for each of the taxable years 1962 and 
1963 by $175 ($700 credit earned divided by 4).
    (iv) To the extent that a required decrease, under subdivision (ii) 
or (iii) of this subparagraph, is not taken into account for any taxable 
year beginning before January 1, 1964, because the deduction otherwise 
allowable under section 162 for such taxable year with respect to the 
leased property is less than the required decrease for such taxable 
year, then the balance of the required decrease not taken into account 
for such taxable year shall decrease the amount otherwise allowable as a 
deduction under section 162 with respect to such property for the next 
succeeding taxable year (or years) beginning before January 1, 1964, if 
any, for which a deduction is allowable with respect to such property. 
Thus, if the required decrease with respect to leased property is $200 
for 1962 but the lessee's deduction otherwise allowable under section 
162 for such taxable year with respect to such property is only $50, the 
balance of $150 must be applied

[[Page 344]]

in 1963 to decrease the deduction otherwise allowable to the lessee with 
respect to the leased property for such taxable year.
    (v) See paragraph (b) of Sec. 1.48-7 for reduction of basis in the 
case of an actual purchase of leased property by a lessee (in a taxable 
year of such lessee beginning before January 1, 1964) who has been 
treated as a purchaser of such property under this section.
    (3) Increase in rental deductions on account of early disposition, 
etc. (i) If, as a result of an early disposition, etc., in a taxable 
year beginning before January 1, 1964, with respect to leased property 
placed in service before such date, the lessee's tax is increased under 
section 47(a) (1) or (2), or an adjustment in a carryback or carryover 
is made under section 47(a)(3) by reduction of an unused credit, the 
rental deductions (if any) otherwise allowable under section 162 to such 
lessee for amounts paid or accrued to the lessor under the lease with 
respect to such property shall be increased in an amount equal to the 
total decreases previously made in the lessee's rental deductions under 
subparagraph (2) of this paragraph.
    (ii) Except as provided in subdivision (iii) of this subparagraph, 
the increase in rental deductions described in subdivision (i) of this 
subparagraph shall be taken into account as an increase in rental 
deductions otherwise allowable under section 162 for the taxable year in 
which the early disposition, etc., occurred.
    (iii) If, after the event which caused section 47(a) (1), (2), or 
(3) to apply the lessee continues the use of the property in a trade or 
business or in the production of income, the increase in rental 
deductions described in subdivision (i) of this subparagraph shall be 
taken into account ratably over the remaining portion of the useful life 
of the property which was used in making the decreases in rental 
deductions with respect to the property under subparagraph (2) of this 
paragraph.
    (iv) If subdivision (iii) of this subparagraph applies, and if, 
prior to the expiration of the useful life of the property used in 
making the decreases in rental deductions, the lease is terminated other 
than by actual purchase of the property by the lessee, any increase in 
rental deductions not previously taken into account shall be taken into 
account as an increase in rental deductions for the taxable year in 
which the lease is terminated. In the case of an actual purchase of the 
property by the lessee, see paragraph (e) of Sec. 1.48-7.
    (l) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X Corporation is engaged in the business of manufacturing 
and leasing new and reconstructed equipment which in its hands has an 
estimated useful life of 12 years. After December 31, 1961, X 
Corporation constructs machine no. 1 at a cost of $20,000 and 
reconstructs machine no. 2 at a cost of $5,000. On February 15, 1962, Y 
Corporation, a calendar-year taxpayer, leases both machines from X 
Corporation and places them in service. The fair market value of machine 
no. 1 on the date on which possession is transferred to Y is $25,200. 
Machine no. 1 would qualify as new section 38 property in Y's hands if 
it had been purchased by Y. If X elects to treat Y as the purchaser of 
machine no. 1, under paragraph (c)(2)(ii) of this section such machine 
will have a basis of $25,200 in Y's hands. Under paragraph (f)(1)(v) of 
this section, X supplies Y with an estimated useful life of 12 years 
(expressed in years rather than useful life category) with respect to 
machine no. 1 for purposes of determining Y's qualified investment. Y's 
credit earned with respect to the property is $1,764 (7 percent of 
$25,200). Under paragraph (k)(2)(ii) of this section, Y's deduction 
attributable to the leased property for 1962 will be decreased by 
$134.75 (credit earned of $1,764, divided by 144, multiplied by 11), and 
for 1963 such deduction will be decreased by $147 ($1,764, divided by 
144, multiplied by 12). The election is not available with respect to 
machine no. 2 since a reconstructed machine would not constitute new 
section 38 property if Y had purchased it. In such case, while X cannot 
make the election to treat Y as a purchaser, X would be entitled to a 
credit under section 38 based on its expenditure of $5,000 as an 
investment in new section 38 property, since such amount represents cost 
of reconstruction after December 31, 1961.
    Example 2. Assume the same facts as in example 1 except that under 
paragraph (f)(1)(v) of this section, X supplies Y with an estimated 
useful life category of 8 years or more (rather than an estimated useful 
life expressed in years) with respect to machine no. 1 for purposes of 
determining Y's qualified investment. Under paragraph (k)(2)(iii) of 
this section, Y's deduction attributable to the leased property will be 
decreased by

[[Page 345]]

$220.50 (credit earned of $1,764, divided by 8) for each of its taxable 
years 1962 and 1963.
    Example 3. Assume the same facts as in example 1 except that the 
lessee disposes of his interest in the lease on January 1, 1963, and 
that there is an increase in Y's tax for 1963 under section 47(a)(1) in 
the amount of $1,764. Under paragraph (k)(2) of this section, Y's 
deductions attributable to the leased property are decreased only in 
1962, and the amount of such decrease is $134.75. In 1963 there shall be 
an increase of $134.75 in the deductions otherwise allowable under 
section 162 for such taxable year with respect to the leased property.
    Example 4. Assume the same facts as in example 1 except that during 
the year 1963 the property was used by Y predominantly outside the 
United States within the meaning of paragraph (g) of Sec. 1.48-1, and 
thereafter was used in Y's trade or business. Under paragraph (k)(3) of 
this section, the increase of $134.75 described in example 3 is taken 
into account ratably as an increase in rental deductions otherwise 
allowable under section 162 in the amount of $12.25 ($134.75 divided by 
11 years) for 1963 and each of the 10 succeeding years.

    (m) Increase in rental deductions on account of section 203(a)(2)(B) 
of the Revenue Act of 1964--(1) In general. (i) Under section 
203(a)(2)(B) of the Revenue Act of 1964, if, for any taxable year of a 
lessee beginning before January 1, 1964, the rental deductions otherwise 
allowable under section 162 to such lessee for amounts paid or accrued 
to the lessor under the lease with respect to leased property placed in 
service before January 1, 1964, were decreased under paragraph (k)(2) of 
this section, such rental deductions shall be increased.
    (ii) The increase in rental deductions described in subdivision (i) 
of this subparagraph shall be in an amount equal to the total decreases 
in the lessee's rental deductions previously made under paragraph (k)(2) 
of this section less any increases in rental deductions made under 
paragraph (k)(3) of this section.
    (iii) Except as provided in subdivision (iv) of this subparagraph, 
the increase in rental deductions described in subdivision (i) of this 
subparagraph shall be taken into account ratably over the remaining 
portion of the useful life of the property commencing with the first day 
of the first taxable year beginning after December 31, 1963. For this 
purpose, the useful life of the property shall be the useful life used 
in making the decreases in rental deductions with respect to the 
property under paragraph (k)(2) of this section.
    (iv) If the lease is terminated other than by the lessee's actual 
purchase of the property during a taxable year beginning after December 
31, 1963, and before the end of the remaining useful life of the 
property used in making the decreases in rental deductions, the amount 
of the increase in rental deductions described in subdivision (i) of 
this subparagraph and not previously taken into account shall be allowed 
as a deduction for the taxable year in which such termination occurs.
    (v) The rental deductions with respect to any section 38 property 
are not to be increased under this paragraph if the lessee dies in a 
taxable year beginning before January 1, 1964.
    (vi) The increase in rental deductions described in subdivision (i) 
of this subparagraph shall ordinarily be taken into account by the 
lessee treated as the purchaser, that is, the lessee entitled to the 
credit. However, if the property under the lease is transferred by the 
lessee to a successor lessee in a transaction described in section 47(b) 
(other than a transfer by reason of death) under which the successor 
lessee assumes the lessee's obligations under the lease, such increase 
in rental deductions shall be taken into account by the successor lessee 
in the manner prescribed in this paragraph.
    (2) Examples. The operation of this paragraph may be illustrated by 
the following examples:

    Example 1. (a) X Corporation acquired on January 1, 1962, an item of 
new section 38 property with a basis of $24,000 and with a useful life 
to the lessor of 10 years. Y Corporation, which makes its returns on the 
basis of a calendar year, leased such property from X Corporation and 
placed it in service on January 2, 1962. Under this section, X 
Corporation made a valid election to treat Y Corporation as having 
purchased such property for purposes of the credit allowed by section 38 
and supplied the lessee with information that the property had a useful 
life of 10 years. The amount of the credit earned with respect to such 
property was $1,680 (7 percent of $24,000). For each of the taxable 
years 1962 and 1963, Y Corporation decreased, under paragraph (k)(2) of 
this section, its deductions otherwise allowable under section

[[Page 346]]

162 with respect to such property by $168 ($1,680 multiplied by \12/
120\).
    (b) For each of the taxable years 1964 through 1971, Y Corporation 
increases its deductions otherwise allowable under section 162 for 
amounts paid to X Corporation under the lease by $42 ($336 (that is, 
$168 multiplied by 2) divided by the remaining useful life of 8 years).
    Example 2. (a) The facts are the same as in example 1 except that 
the lease is terminated on January 3, 1965.
    (b) For the taxable year 1964, Y Corporation increases its 
deductions otherwise allowable under section 162 by $42.
    (c) For the taxable year 1965, Y Corporation increases its 
deductions otherwise allowable under section 162 for the portion of the 
increase which had not been taken into account as of the time of the 
termination of the lease. Thus, the amount of such increase for the 
taxable year 1965 is $294 ($336 minus $42).

(Sec. 38, 76 Stat. 963; 26 U.S.C. 38)

[T.D. 6731, 29 FR 6080, May 8, 1964; 29 FR 7671, June 16, 1964, as 
amended by T.D. 6838, 30 FR 9060, July 20, 1965; T.D. 7203, 37 FR 17131, 
17132, Aug. 25, 1972]