[Code of Federal Regulations]
[Title 26, Volume 4]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.337(d)-7]

[Page 92-96]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.337(d)-7  Tax on property owned by a C corporation that becomes 
property of a RIC or REIT.

    (a) General rule--(1) Property owned by a C corporation that becomes 
property of a RIC or REIT. If property owned by a C corporation (as 
defined in paragraph (a)(2)(i) of this section) becomes the property of 
a RIC or REIT (the converted property) in a conversion transaction (as 
defined in paragraph (a)(2)(ii) of this section), then section 1374 
treatment will apply as described in paragraph (b) of this section, 
unless the C corporation elects deemed sale treatment with respect to 
the conversion transaction as provided in paragraph (c) of this section. 
See paragraph (d) of this section for exceptions to this paragraph (a).
    (2) Definitions--(i) C corporation. For purposes of this section, 
the term C corporation has the meaning provided in section 1361(a)(2) 
except that the term does not include a RIC or REIT.
    (ii) Conversion transaction. For purposes of this section, the term 
conversion transaction means the qualification of a C corporation as a 
RIC or REIT or the transfer of property owned by a C corporation to a 
RIC or REIT.
    (b) Section 1374 treatment--(1) In general--(i) Property owned by a 
C corporation that becomes property of a RIC or REIT. If property owned 
by a C corporation becomes the property of a RIC or REIT in a conversion 
transaction, then the RIC or REIT will be subject to tax on the net 
built-in gain in the converted property under the rules of section 1374 
and the regulations thereunder, as modified by this paragraph (b), as if 
the RIC or REIT were an S corporation.
    (ii) Property subject to the rules of section 1374 owned by a RIC, 
REIT, or S corporation that becomes property of a RIC or REIT. If 
property subject to the rules of section 1374 owned by a RIC, a REIT, or 
an S corporation (the predecessor) becomes the property of a RIC or REIT 
(the successor) in a continuation transaction, the rules of section 1374 
apply to the successor to the same extent that the predecessor was 
subject to the rules of section 1374 with respect to such property, and 
the 10-year recognition period of the successor with respect to such 
property is reduced by the portion of the 10-year recognition period of 
the predecessor that expired before the date of the continuation 
transaction. For this purpose, a continuation transaction means the 
qualification of the predecessor as a RIC or REIT or the transfer of 
property from the predecessor to the successor in a transaction in which 
the successor's basis in the transferred property is determined, in 
whole or in part, by reference to the predecessor's basis in that 
property.
    (2) Modification of section 1374 treatment--(i) Net recognized 
built-in gain for REITs--(A) Prelimitation amount. The prelimitation 
amount determined as provided in Sec. 1.1374-2(a)(1) is reduced by the 
portion of such amount, if any, that is subject to tax under section 
857(b)(4), (5), (6), or (7). For this purpose, the amount of a REIT's 
recognized built-in gain that is subject to tax under section 857(b)(5) 
is computed as follows:
    (1) Where the tax under section 857(b)(5) is computed by reference 
to section 857(b)(5)(A), the amount of a REIT's recognized built-in gain 
that is subject to tax under section 857(b)(5) is the tax imposed by 
section 857(b)(5) multiplied by a fraction the numerator of which is the 
amount of recognized built-in gain (without regard to recognized built-
in loss and recognized built-in gain from prohibited transactions) that 
is not derived from sources referred to in section 856(c)(2) and the 
denominator of which is the gross income (without regard to gross income 
from

[[Page 93]]

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

[[Page 94]]

during such taxable year. The character of the loss is determined by 
allocating the tax proportionately (based on recognized built-in gain) 
among the items of recognized built-in gain included in net recognized 
built-in gain. With respect to RICs, the tax imposed under this 
paragraph (b) on net recognized built-in gain is treated as attributable 
to the portion of the RIC's taxable year occurring after October 31.
    (4) Example. The rules of this paragraph (b) are illustrated by the 
following example:

    Example. Section 1374 treatment on REIT election. (i) X, a C 
corporation that is a calendar-year taxpayer, elects to be taxed as a 
REIT on its 2004 tax return, which it files on March 15, 2005. As a 
result, X is a REIT for its 2004 taxable year and is subject to section 
1374 treatment under this paragraph (b). X does not elect deemed sale 
treatment under paragraph (c) of this section. As of the beginning of 
the 2004 taxable year, X's property consisted of Real Property, which is 
not section 1221(a)(1) property and which had a fair market value of 
$100,000 and an adjusted basis of $80,000, and $25,000 cash. X also had 
accumulated earnings and profits of $25,000, unrestricted capital loss 
carryforwards of $3,000, and unrestricted business credit carryforwards 
of $2,000. On July 1, 2007, X sells Real Property for $110,000. For its 
2007 taxable year, X has no other income or deduction items. Assume the 
highest corporate tax rate is 35%.
    (ii) Upon its election to be taxed as a REIT, X retains its $80,000 
basis in Real Property and its $25,000 accumulated earnings and profits. 
X retains its $3,000 of capital loss carryforwards and its $2,000 of 
business credit carryforwards. To satisfy section 857(a)(2)(B), X must 
distribute $25,000, an amount equal to its earnings and profits 
accumulated in non-REIT years, to its shareholders by the end of its 
2004 taxable year.
    (iii) Upon X's sale of Real Property in 2007, X recognizes gain of 
$30,000 ($110,000--$80,000). X's recognized built-in gain for purposes 
of applying section 1374 is $20,000 ($100,000 fair market value as of 
the beginning of X's first taxable year as a REIT--$80,000 basis). 
Because X's $30,000 of net income for the 2007 taxable year exceeds the 
net recognized built-in gain of $20,000, the taxable income limitation 
does not apply. X, therefore, has $20,000 net recognized built-in gain 
for the year. Assuming that X has not used its $3,000 of capital loss 
carryforwards in a prior taxable year and that their use is allowed 
under section 1374(b)(2) and Sec. 1.1374-5, X is allowed a $3,000 
deduction against the $20,000 net recognized built-in gain. X would owe 
tax of $5,950 (35% of $17,000) on its net recognized built-in gain, 
except that X may use its $2,000 of business credit carryforwards to 
reduce the tax, assuming that X has not used the credit carryforwards in 
a prior taxable year and that their use is allowed under section 
1374(b)(3) and Sec. 1.1374-6. Thus, X owes tax of $3,950 under this 
paragraph (b).
    (iv) For purposes of subchapter M of chapter 1 of the Internal 
Revenue Code, X's earnings and profits for the year increase by $26,050 
($30,000 capital gain on the sale of Real Property--$3,950 tax under 
this paragraph (b)). For purposes of section 857(b)(2) and (b)(3), X's 
net capital gain for the year is $23,050 ($30,000 capital gain reduced 
by $3,000 capital loss carryforward and further reduced by $3,950 tax).

    (c) Election of deemed sale treatment--(1) In general. Paragraph (b) 
of this section does not apply if the C corporation that qualifies as a 
RIC or REIT or transfers property to a RIC or REIT makes the election 
described in paragraph (c)(5) of this section. A C corporation that 
makes such an election recognizes gain and loss as if it sold the 
converted property to an unrelated party at fair market value on the 
deemed sale date (as defined in paragraph (c)(3) of this section). See 
paragraph (c)(4) of this section concerning limitations on the use of 
loss in computing gain. This paragraph (c) does not apply if its 
application would result in the recognition of a net loss. For this 
purpose, net loss is the excess of aggregate losses over aggregate gains 
(including items of income), without regard to character.
    (2) Basis adjustment. If a corporation recognizes a net gain under 
paragraph (c)(1) of this section, then the converted property has a 
basis in the hands of the RIC or REIT equal to the fair market value of 
such property on the deemed sale date.
    (3) Deemed sale date--(i) RIC or REIT qualifications. If the 
conversion transaction is a qualification of a C corporation as a RIC or 
REIT, then the deemed sale date is the end of the last day of the C 
corporation's last taxable year before the first taxable year in which 
it qualifies to be taxed as a RIC or REIT.
    (ii) Other conversion transactions. If the conversion transaction is 
a transfer of property owned by a C corporation to a RIC or REIT, then 
the deemed sale date is the end of the day before the day of the 
transfer.

[[Page 95]]

    (4) Anti-stuffing rule. A C corporation must disregard converted 
property in computing gain or loss recognized on the conversion 
transaction under this paragraph (c), if--
    (i) The converted property was acquired by the C corporation in a 
transaction to which section 351 applied or as a contribution to 
capital;
    (ii) Such converted property had an adjusted basis immediately after 
its acquisition by the C corporation in excess of its fair market value 
on the date of acquisition; and
    (iii) The acquisition of such converted property by the C 
corporation was part of a plan a principal purpose of which was to 
reduce gain recognized by the C corporation in connection with the 
conversion transaction. For purposes of this paragraph (c)(4), the 
principles of section 336(d)(2) apply.
    (5) Making the deemed sale election. A C corporation (or a 
partnership to which the principles of this section apply under 
paragraph (e) of this section) makes the deemed sale election with the 
following statement: ``[Insert name and employer identification number 
of electing corporation or partnership] elects deemed sale treatment 
under Sec. 1.337(d)-7(c) with respect to its property that was 
converted to property of, or transferred to, a RIC or REIT, [insert name 
and employer identification number of the RIC or REIT, if different from 
the name and employer identification number of the C corporation or 
partnership].'' This statement must be attached to the Federal income 
tax return of the C corporation or partnership for the taxable year in 
which the deemed sale occurs. An election under this paragraph (c) is 
irrevocable.
    (6) Examples. The rules of this paragraph (c) are illustrated by the 
following examples:

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

    (d) Exceptions--(1) Gain otherwise recognized. Paragraph (a) of this 
section does not apply to any conversion transaction to the extent that 
gain or loss otherwise is recognized on such conversion transaction. 
See, for example, sections 336, 351(b), 351(e), 356, 357(c), 367, 
368(a)(2)(F), and 1001.
    (2) Re-election of RIC or REIT status--(i) Generally. Except as 
provided in paragraphs (d)(2)(ii) and (iii) of this section, paragraph 
(a)(1) of this section

[[Page 96]]

does not apply to any corporation that--
    (A) Immediately prior to qualifying to be taxed as a RIC or REIT was 
subject to tax as a C corporation for a period not exceeding two taxable 
years; and
    (B) Immediately prior to being subject to tax as a C corporation was 
subject to tax as a RIC or REIT for a period of at least one taxable 
year.
    (ii) Property acquired from another corporation while a C 
corporation. The exception described in paragraph (d)(2)(i) of this 
section does not apply to property acquired by the corporation while it 
was subject to tax as a C corporation from any person in a transaction 
that results in the acquirer's basis in the property being determined by 
reference to a C corporation's basis in the property.
    (iii) RICs and REITs previously subject to section 1374 treatment. 
If the RIC or REIT had property subject to paragraph (b) of this section 
before the RIC or REIT became subject to tax as a C corporation as 
described in paragraph (d)(2)(i) of this section, then paragraph (b) of 
this section applies to the RIC or REIT upon its requalification as a 
RIC or REIT, except that the 10-year recognition period with respect to 
such property is reduced by the portion of the 10-year recognition 
period that expired before the RIC or REIT became subject to tax as a C 
corporation and by the period of time that the corporation was subject 
to tax as a C corporation.
    (e) Special rule for partnerships. The principles of this section 
apply to property transferred by a partnership to a RIC or REIT to the 
extent of any C corporation partner's distributive share of the gain or 
loss in the transferred property. If the partnership were to elect 
deemed sale treatment under paragraph (c) of this section in lieu of 
section 1374 treatment under paragraph (b) of this section with respect 
to such transfer, then any net gain recognized by the partnership on the 
deemed sale must be allocated to the C corporation partner, but does not 
increase the capital account of any partner. Any adjustment to the 
partnership's basis in the RIC or REIT stock as a result of deemed sale 
treatment under paragraph (c) of this section shall constitute an 
adjustment to the basis of that stock with respect to the C corporation 
partner only. The principles of section 743 apply to such basis 
adjustment.
    (f) Effective date. This section applies to conversion transactions 
that occur on or after January 2, 2002. For conversion transactions that 
occurred on or after June 10, 1987, and before January 2, 2002, see 
Sec. Sec. 1.337(d)-5 and 1.337(d)-6.

[T.D. 9047, 68 FR 12822, Mar. 18, 2003]