[Code of Federal Regulations]
[Title 26, Volume 6]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.446-2]

[Page 61-62]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.446-2  Method of accounting for interest.

    (a) Applicability--(1) In general. This section provides rules for 
determining the amount of interest that accrues during an accrual period 
(other than interest described in paragraph (a)(2) of this section) and 
for determining the portion of a payment that consists of accrued 
interest. For purposes of this section, interest includes original issue 
discount and amounts treated as interest (whether stated or unstated) in 
any lending or deferred payment transaction. Accrued interest determined 
under this section is taken into account by a taxpayer under the 
taxpayer's regular method of accounting (e.g., an accrual method or the 
cash receipts and disbursements method). Application of an exception 
described in paragraph (a)(2) of this section to one party to a 
transaction does not affect the application of this section to any other 
party to the transaction.
    (2) Exceptions--(i) Interest included or deducted under certain 
other provisions. This section does not apply to interest that is taken 
into account under--
    (A) Sections 1272(a), 1275, and 163(e) (income and deductions 
relating to original issue discount);
    (B) Section 467(a)(2) (certain payments for the use of property or 
services);
    (C) Sections 1276 through 1278 (market discount);
    (D) Sections 1281 through 1283 (discount on certain short-term 
obligations);
    (E) Section 7872(a) (certain loans with below-market interest 
rates); or
    (F) Section 1.1272-3 (an election by a holder to treat all interest 
on a debt instrument as original issue discount).
    (ii) De minimis original issue discount. This section does not apply 
to de minimis original issue discount (other than de minimis original 
issue discount treated as qualified stated interest) as determined under 
Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment of de minimis 
original issue discount by the issuer and Sec. Sec. 1.1273-1(d) and 
1.1272-3 for the treatment of de minimis original issue discount by the 
holder.
    (b) Accrual of qualified stated interest. Qualified stated interest 
(as defined in Sec. 1.1273-1(c)) accrues ratably over the accrual 
period (or periods) to which it is attributable and accrues at the 
stated rate for the period (or periods).
    (c) Accrual of interest other than qualified stated interest. 
Subject to the modifications in paragraph (d) of this section, the 
amount of interest (other than qualified stated interest) that accrues 
for any accrual period is determined under rules similar to those in the 
regulations under sections 1272 and 1275 for the accrual of original 
issue discount. The preceding sentence applies regardless of any 
contrary formula agreed to by the parties.
    (d) Modifications--(1) Issue price. The issue price of the loan or 
contract is equal to--
    (i) In the case of a contract for the sale or exchange of property 
to which section 483 applies, the amount described in Sec. 1.483-
2(a)(1)(i) or (ii), whichever is applicable;
    (ii) In the case of a contract for the sale or exchange of property 
to which section 483 does not apply, the stated principal amount; or
    (iii) In any other case, the amount loaned.
    (2) Principal payments that are not deferred payments. In the case 
of a contract to which section 483 applies, principal payments that are 
not deferred payments are ignored for purposes of determining yield and 
adjusted issue price.
    (e) Allocation of interest to payments--(1) In general. Except as 
provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each 
payment under a loan (other than payments of additional interest or 
similar charges provided with respect to amounts that are not paid when 
due) is treated as a payment of interest to the extent of the accrued 
and unpaid interest determined under paragraphs (b) and (c) of this 
section as of the date the payment becomes due.
    (2) Special rule for points deductible under section 461(g)(2). If a 
payment of points is deductible by the borrower under section 461(g)(2), 
the payment is

[[Page 62]]

treated by the borrower as a payment of interest.
    (3) Allocation respected in certain small transactions. [Reserved]
    (4) Pro rata prepayments. Accrued but unpaid interest is allocated 
to a pro rata prepayment under rules similar to those for allocating 
accrued but unpaid original issue discount to a pro rata prepayment 
under Sec. 1.1275-2(f). For purposes of the preceding sentence, a pro 
rata prepayment is a payment that is made prior to maturity that--
    (i) Is not made pursuant to the contract's payment schedule; and
    (ii) Results in a substantially pro rata reduction of each payment 
remaining to be paid on the contract.
    (f) Aggregation rule. For purposes of this section, all contracts 
calling for deferred payments arising from the same transaction (or a 
series of related transactions) are treated as a single contract. This 
rule, however, generally only applies to contracts involving a single 
borrower and a single lender.
    (g) Debt instruments denominated in a currency other than the U.S. 
dollar. This section applies to a debt instrument that provides for all 
payments denominated in, or determined by reference to, the functional 
currency of the taxpayer or qualified business unit of the taxpayer 
(even if that currency is other than the U.S. dollar). See Sec. 1.988-
2(b) to determine interest income or expense for debt instruments that 
provide for payments denominated in, or determined by reference to, a 
nonfunctional currency.
    (h) Example. The following example illustrates the rules of this 
section.

    Example. Allocation of unstated interest to deferred payments--(i) 
Facts. On July 1, 1996, A sells his personal residence to B for a stated 
purchase price of $1,297,143.66. The property is not personal use 
property (within the meaning of section 1275(b)(3)) in the hands of B. 
Under the loan agreement, B is required to make two installment payments 
of $648,571.83 each, the first due on June 30, 1998, and the second due 
on June 30, 2000. Both A and B use the cash receipts and disbursements 
method of accounting and use a calendar year for their taxable year.
    (ii) Amount of unstated interest. Under section 483, the agreement 
does not provide for adequate stated interest. Thus, the loan's yield is 
the test rate of interest determined under Sec. 1.483-3. Assume that 
both A and B use annual accrual periods and that the test rate of 
interest is 9.2 percent, compounded annually. Under Sec. 1.483-2, the 
present value of the deferred payments is $1,000,000. Thus, the 
agreement has unstated interest of $297,143.66.
    (iii) First two accrual periods. Under paragraph (d)(1) of this 
section, the issue price at the beginning of the first accrual period is 
$1,000,000 (the amount described in Sec. 1.483-2(a)(1)(i)). Under 
paragraph (c) of this section, the amount of interest that accrues for 
the first accrual period is $92,000 ($1,000,000x.092) and the amount of 
interest that accrues for the second accrual period is $100,464 
($1,092,000x.092). Thus, $192,464 of interest has accrued as of the end 
of the second accrual period. Under paragraph (e)(1) of this section, 
the $648,571.83 payment made on June 30, 1998, is treated first as a 
payment of interest to the extent of $192,464. The remainder of the 
payment ($456,107.83) is treated as a payment of principal. Both A and B 
take the payment of interest ($192,464) into account in 1998.
    (iv) Second two accrual periods. The adjusted issue price at the 
beginning of the third accrual period is $543,892.17 
($1,092,000+$100,464-$648,571.83). The amount of interest that accrues 
for the third accrual period is $50,038.08 ($543,892.17x.092) and the 
amount of interest that accrues for the final accrual period is 
$54,641.58, the excess of the amount payable at maturity ($648,571.83), 
over the adjusted issue price at the beginning of the accrual period 
($593,930.25). As of the date the second payment becomes due, 
$104,679.66 of interest has accrued. Thus, of the $648,571.83 payment 
made on June 30, 2000, $104,679.66 is treated as interest and 
$543,892.17 is treated as principal. Both A and B take the payment of 
interest ($104,679.66) into account in 2000.

    (i) [Reserved]
    (j) Effective date. This section applies to debt instruments issued 
on or after April 4, 1994, and to lending transactions, sales, and 
exchanges that occur on or after April 4, 1994. Taxpayers, however, may 
rely on this section for debt instruments issued after December 21, 
1992, and before April 4, 1994, and for lending transactions, sales, and 
exchanges that occur after December 21, 1992, and before April 4, 1994.

[T.D. 8517, 59 FR 4804, Feb. 2, 1994]