[Federal Register Volume 60, Number 6 (Tuesday, January 10, 1995)]
[Rules and Regulations]
[Pages 2497-2509]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-172]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8586]
RIN 1545-AC35
Treatment of Gain From Disposition of Certain Natural Resource
Recapture Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document provides final regulations relating to the tax
treatment of gain from the disposition of certain natural resource
recapture property (section 1254 property after enactment of the Tax
Reform Act of 1986 and oil, gas, or geothermal property before
enactment of the Tax Reform Act of 1986). Changes to the applicable tax
law were made by the Tax Reform Act of 1986, the Tax Reform Act of
1984, the Energy Tax Act of 1978, the Tax Reform Act of 1976, the Tax
Reform Act of 1969, and the Act of September 12, 1966. The regulations
provide the public with guidance in complying with the changed tax
laws.
DATES: These regulations are effective January 10, 1995.
For dates of applicability, see Sec. 1.1254-6.
FOR FURTHER INFORMATION CONTACT: Brenda M. Stewart (202-622-3120, not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h))
under control number 1545-1352. The estimated annual burden per
respondent varies from four to six hours, depending on individual
circumstances, with an estimated average of five hours.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,
Washington, DC 20224, and to the Office of Management and Budget, Attn:
Desk Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503.
Background
On June 11, 1980, the IRS published proposed amendments to the
Income Tax Regulations (26 CFR part 1) under sections 170, 301, 312,
341, 453, 751, 1254, and 1502 of the Internal Revenue Code of 1954 in
the Federal Register (45 FR 39512). These amendments were proposed to
conform the regulations to section 205 (a), (b), and (c) (1) and (2) of
the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1533, and section
402(c) of the Energy Tax Act of 1978, Pub. L. 95-618, 92 Stat. 3202,
and to make certain other technical amendments to conform the
regulations to section 1(c) of the Act of September 12, 1966, Pub. L.
89-570, 80 Stat. 762, to section 211(b)(6) of the Tax Reform Act of
1969, Pub. L. 91-172, 83 Stat. 570, and to sections 1042(c)(2),
1101(d)(2), 1901(a)(93), and 2110(a) of the Tax Reform Act of 1976, 90
Stat. 1637, 1658, 1780, 1905). A public hearing was held on September
9, 1980. After considering all comments regarding the proposed
regulations, the proposed regulations (except for the provisions
relating to an electing small business corporation (hereinafter
referred to as an S corporation)), are adopted as revised by this
Treasury decision. The rules under Sec. 1.751-1(c)(6)(ii) are
clarified, but no substantive change is intended except to insert
additional recapture sections under the Internal Revenue Code of 1986
(Code).
Because of the substantial changes made to the tax treatment of S
corporations by section 5(a)(37) of the Subchapter S Revision Act of
1982, Pub. L. 97-354, 96 Stat. 1696, section 492 of the Tax Reform Act
of 1984, Pub. L. 98-369, 98 Stat. 853, and sections 411 and 413 of the
Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2225, 2227,
Sec. 1.1254-3 of the proposed regulations (relating to an electing
small business), [[Page 2498]] has not been adopted. Instead, a notice
of proposed rulemaking, designated as Sec. 1.1254-4, relating to the
recapture of natural resource recapture property by an S corporation
and its shareholders will be proposed to conform the regulations to
these laws.
I. Intangible Drilling and Development Costs Recapture in a Partnership
The proposed regulations require a partnership to compute the
amount of intangible drilling and development costs to be recaptured
(entity approach) and, subject to the substantial economic effect test,
to allocate that amount among the partners in accordance with their
respective distributive shares as provided in the partnership
agreement. Some commentators argue that the proposed regulations are
inconsistent with partner level (aggregate approach) computation of
depletion and gain upon the sale of partnership oil and gas property
under section 613A(c)(7)(D).
Under the entity approach of the proposed regulations, some
recapture of section 1254 costs may be shifted from the partners who
claimed the deductions to other partners who did not receive the
benefit of the deductions. Under the aggregate approach, depending on
the allocation of gain or amount realized upon sale, some section 1254
costs may not be recaptured though total partnership gain exceeds total
partnership section 1254 costs.
The commentators suggest that, consistent with section
613A(c)(7)(D), the final regulations should adopt the aggregate
approach. They argue that under the aggregate approach, a partner can
more readily compute both the extent of the deductions that were
previously allocated to the partner and the appropriate adjustment
required by section 1254(a)(4) (as in effect before enactment of the
Tax Reform Act of 1986). The commentators contend that it is difficult
for a partnership to obtain this information from the individual
partners. In addition, they cite section 58(i) (as in effect before
enactment of the Tax Reform Act of 1986), which allowed general
partners to elect to amortize intangible drilling and development costs
over a 5 year period and limited partners to elect to amortize
intangible drilling and development costs over a 10 year period.
Section 59(e) now provides an analogous amortization election.
Consistent with the commentators' suggestion, the final regulations
adopt the aggregate approach. Recapture is determined at the partner
level. However, the regulations contain an anti-abuse rule providing
that recapture is determined at the partnership level if the
Commissioner determines that the amount realized or gain recognized
from the disposition of section 1254 property is allocated to partners
with a principal purpose of avoiding recapture under section 1254.
II. Recapture of Distributions on the Liquidation of a Partnership
In general, the section 1254 recapture provisions override
nonrecognition provisions in the Code. However, section 1254 (b)(1)
states that rules similar to the rules of section 1245 (b) and (c)
shall be prescribed by regulation. Accordingly, the final regulations
limit the amount subject to recapture in certain tax-free transactions
to gain that would be recognized without regard to section 1254.
Section 1.1254-2(c)(3) lists the transfers in which recapture is
limited. All transfers listed involve transferred basis.
Commentators point out that under the proposed regulations
recapture is required upon the liquidation of a partnership interest
because section 732(b) provides that the basis of property received in
a liquidation is a substitute basis equal to the basis of the partner's
interest in the partnership. However, under section 1245(b)(6)(A),
recapture upon the distribution of partnership assets in liquidation is
limited. Accordingly, the commentators suggest that a similar rule
should be adopted for section 1254 purposes.
The final regulations adopt the commentators' suggestion. The basis
of natural resource recapture property distributed by a partnership to
a partner is deemed to be determined by reference to the adjusted basis
of the property to the partnership.
III. Recapture Reduction
Under section 1254(a)(4) (as in effect before enactment of the Tax
Reform Act of 1986), the amount of intangible drilling and development
costs subject to recapture is reduced by the amount, if any, by which
the ``deduction for depletion'' under section 611 ``would have been
increased'' if intangible drilling and development costs had been
charged to a capital account rather than currently expensed under
section 263(c). The proposed regulations, therefore, require taxpayers
to use the excess of the hypothetical cost or percentage depletion
deduction over the amount allowed under section 611 (either cost or
percentage depletion) in determining the constructive increase in
depletion.
By contrast, many commentators argued that, notwithstanding the
language of the statute, according to the legislative history, the
recapture amount should be reduced even in situations where expensing
intangible drilling and development costs did not result in decreased
depletion deductions.
The final regulations reject this view and instead continue to
follow the statute, which, as noted above, provides that recapturable
intangible drilling and development costs are reduced by the amount by
which the ``deduction for depletion'' claimed under section 611 ``would
have been increased.'' Thus, the amount of recapturable intangible
drilling and development costs is reduced by only the excess, if any,
of the hypothetical cost or percentage depletion deduction (computed as
if intangible drilling and development costs subject to depletion had
been capitalized) over the amount of the cost or percentage depletion
deduction the taxpayer actually claimed. Consequently, unless the
hypothetical cost or percentage depletion amount is greater than the
actual depletion deduction claimed, no depletion deduction is foregone,
and all intangible drilling and development costs attributable to the
property are recapturable.
The final regulations are clarified to remove uncertainties
regarding the method for calculating the reduction in the amount of
recapturable intangible drilling and development costs.
IV. Nonproductive Wells
Some commentators state that intangible drilling and development
costs allocable to nonproductive wells should not be subject to
recapture. They point out that, even if a taxpayer elects to capitalize
intangible drilling and development costs, intangible drilling and
development costs of nonproductive wells are not added to basis because
the operator normally deducts these amounts under Sec. 1.612-4(b)(4) on
the return for the first taxable year after abandonment of a
nonproductive well.
One reason for the enactment of section 1254 was to prevent the
conversion of intangible drilling and development costs currently
deducted against ordinary income into capital gain in certain limited
risk situations. See H.R. Rep. 94-658, 94th Cong., 1st Sess. 94 (1975).
For example, if a well proves to be nonproductive causing a nonrecourse
debt to become worthless, the taxpayer generally recognizes income that
is treated as capital gain upon foreclosure of the debt, because a
foreclosure is deemed to be a sale of the property. Consequently,
ordinary income deductions would be converted [[Page 2499]] into
capital gains to the extent of the leveraged amounts.
Aside from foreclosure of a nonrecourse debt, however, a
nonproductive well provides no opportunity for converting an ordinary
income stream into capital gain. Accordingly, the final regulations
provide that section 1254 costs attributable to nonproductive wells are
not recapturable, except in certain limited risk situations.
V. Depreciation
Some commentators argue that depreciable costs associated with
drilling should not be separated from depletable costs in calculating
the hypothetical depletion deduction. Commentators also point out that
it is difficult to identify the amount of intangible drilling and
development costs that could have been deducted as depreciation,
because it is not current industry practice to separate depreciable
costs from depletable costs. In response to these comments, the final
regulations do not require depreciable costs to be separated from
depletable costs in calculating the hypothetical depletion deduction.
VI. Property Interest Subject to Recapture
Under the proposed regulations, each operating mineral interest in
an ``oil, gas, or geothermal property,'' as well as any nonoperating
mineral interest retained by a lessor or sublessor of a property to
which intangible drilling and development costs were properly
chargeable when held by such person prior to the creation of the lease
or sublease, is subject to recapture.
In Houston Oil and Minerals Corp. v. Commissioner, 92 T.C. 1331
(1989), aff'd, 922 F.2d 283 (5th Cir. 1991), Louisiana Land and
Exploration Co. v. Commissioner, 92 T.C. 1340 (1989), and Southland
Royalty Co. v. United States, 91-1 U.S.T.C. 50,083 (Cls. Ct. 1991),
the Internal Revenue Service took the position that section 1254
requires recapture of intangible drilling and development costs upon
the disposition of a nonoperating mineral interest carved out of an
operating mineral interest. The courts, however, held instead that the
disposition of an overriding royalty interest carved out of an
operating mineral interest to which intangible drilling and development
costs were charged does not trigger recapture because the overriding
royalty interest is not ``oil, gas, or geothermal property'' within the
meaning of section 1254(a)(3).
The Tax Court in Houston Oil and Minerals Corp., 92 T.C. at 1339,
and Louisiana Land and Exploration Co., 92 T.C. at 1348, and the Claims
Court in Southland Royalty Co., 91-1 U.S.T.C. at 87,337, noted that
because the Tax Reform Act of 1986 amended section 1254 to include
within the definition of ``oil, gas, or geothermal property'' property
the basis of which has been adjusted for depletion, nonoperating
mineral interests come within the ambit of section 1254 after 1986.
Consequently, the courts reasoned, the issue considered in these cases
would arise only with respect to property placed in service before
1987.
The regulations have been amended to treat a nonoperating mineral
interest carved out of an operating mineral interest with respect to
which section 1254 costs have been deducted as property to which
section 1254 costs are properly chargeable. Thus, the final regulations
make clear that natural resource recapture property includes a
nonoperating mineral interest if the nonoperating mineral interest was
carved out of an operating mineral interest to which section 1254 costs
were properly chargeable by the holder of the operating mineral
interest. See Sec. 1.1254-1(b)(2). Consistent with the opinions in the
litigated cases, however, this provision will be effective only with
respect to property placed in service after December 31, 1986.
VII. Disposition
Commentators urge that the regulations state who is liable for
recapture if an operating mineral interest shifts automatically or at
the option of the person who will receive the interest, as, for
example, a farm-out. In response to these comments, the final
regulations provide that liability for potential recapture of
intangible drilling and development costs attributable to the entire
operating mineral interest held by the carrying party prior to
reversion or conversion remains attributable to the reduced operating
mineral interest retained by the carrying party after a portion of the
operating mineral interest has reverted to the carried party or after
the conversion of an overriding royalty interest that converts, at the
option of the grantor or successor in interest, to an operating mineral
interest after a certain amount of production.
VIII. Like Kind Exchanges and Involuntary Conversions
Commentators state that under Sec. 1.1254-4(d) of the proposed
regulations liability for recapture of intangible drilling and
development costs remains with the property with respect to which the
costs were incurred and does not transfer to the property received in a
like kind exchange or involuntary conversion. However, under the final
regulations recapture liability transfers to the property received by
the transferor who received the benefit of the deductions for section
1254 costs. This result is consistent with the section 1245(b)(4) and
Sec. 1.1245-2(c)(4) rules for recapture of depreciation. Because
section 1254(b)(1) states that the regulations should prescribe rules
similar to rules in section 1245 (b) and (c) for like kind exchanges,
involuntary conversions, and other nontaxable transfers, the final
regulations more closely mirror the section 1245 recapture rules for
such transactions.
IX. Filing Requirements
The proposed regulations provide allocation rules for the recapture
of section 1254 costs on the sale of a portion of, or an undivided
interest in, natural resource recapture property. Under the proposed
regulations, a taxpayer is required to attach to the tax return
documents sufficient to establish allocation of intangible drilling and
development costs to the disposed of portion or undivided interest,
notwithstanding that the intangible drilling and development costs do
not in fact relate to that portion or undivided interest. Commentators
suggest that it is more practical simply to require a taxpayer to state
on the tax return that the section 1254 costs do not relate to the
property disposed of and to retain verifying documentation. In response
to the commentators' suggestion, the final regulations contain a book
and records retention requirement.
Effective dates: These regulations are effective January 10, 1995
and Secs. 1.1254-1 through 1.1254-3 and Sec. 1.1254-5 apply to any
disposition of natural resource recapture property occurring after
March 13, 1995. The rule in Sec. 1.1254-1(b)(2)(iv)(A)(2), concerning a
nonoperating mineral interest carved out of an operating mineral
interest with respect to which an expenditure has been deducted,
applies to any disposition occurring after March 13, 1995 of property
(within the meaning of section 614) that is placed in service by the
taxpayer after December 31, 1986. For dispositions of natural resource
recapture property occurring on or before March 13, 1995, taxpayers
must take reasonable return positions taking into consideration the
statute and its legislative history.
Special Analyses
It has been determined that this Treasury decision is not a
significant [[Page 2500]] 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) and the Regulatory Flexibility Act (5 U.S.C. chapter
6) do not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, the notice of proposed rulemaking preceding
these regulations was submitted to the Small Business Administration on
its impact on small business.
Drafting Information
The principal author of these final regulations is Brenda M.
Stewart, Office of Assistant Chief Counsel (Passthroughs and Special
Industries), IRS. However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are 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 as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1254-1 also issued under 26 U.S.C. 1254(b).
Section 1.1254-2 also issued under 26 U.S.C. 1254(b).
Section 1.1254-3 also issued under 26 U.S.C. 1254(b).
Section 1.1254-4 also issued under 26 U.S.C. 1254(b).
Section 1.1254-5 also issued under 26 U.S.C. 1254(b).
Section 1.1254-6 also issued under 26 U.S.C. 1254(b). * * *
Sec. 1.301-1 [Amended]
Par. 2. Section 1.301-1 is amended as follows:
1. Paragraph (d)(1)(iii) is amended by removing the language ``or
1252(a)'' and adding ``1252(a), or 1254(a)'' in its place.
2. Paragraph (h)(2)(ii)(b) is amended by removing the language ``or
section 1252(a) (relating to gain from disposition of farm land)'' and
adding ``section 1252(a) (relating to gain from disposition of farm
land), or section 1254(a) (relating to gain from disposition of
interest in natural resource recapture property)'' in its place.
3. Paragraph (j)(1) is amended by removing the language ``or
1252(a)'' and adding ``1252(a), or 1254(a)'' in its place.
Sec. 1.312-3 [Amended]
Par. 3. Section 1.312-3 is amended by removing ``or 1252(a)'' and
adding ``1252(a), or 1254(a)'' in its place.
Sec. 1.341-6 [Amended]
Par. 4. Section 1.341-6 is amended as follows:
1. In paragraph (b)(1), the last sentence is amended by removing
the language ``and 1252 (relating to gain from disposition of farm
land)'' and adding ``1252 (relating to gain from disposition of farm
land), and 1254 (relating to gain from disposition of interest in
natural resource recapture property)'' in its place.
2. In paragraph (b)(2)(i), the first sentence is amended by
removing ``or 1252)'' and adding ``1252, or 1254)'' in its place.
3. In paragraph (b)(2)(iii), the second sentence is amended by
removing ``or 1252)'' and adding ``1252, or 1254)'' in its place.
4. In paragraph (b)(3), the first sentence is amended by removing
``or 1252)'' and adding ``1252, or 1254)'' in its place.
5. In paragraph (h)(4), the first sentence is amended by removing
``or 1252)'' and adding ``1252, or 1254)'' in its place.
6. Paragraph (n) is amended by:
a. Removing the language ``and 1252'' from the paragraph heading
and adding ``1252, and 1254'' in its place.
b. Removing from the text the language ``and 1252(a) (relating to
gain from disposition of farm land)'' and adding ``1252(a) (relating to
gain from disposition of farm land), and 1254(a) (relating to gain from
disposition of interest in natural resource recapture property)'' in
its place.
Sec. 1.453-9 [Amended]
Par. 5. Section 1.453-9, paragraph (c)(1)(ii) is amended by:
1. Removing from the second sentence the language ``or 1252(a)(1)''
and adding ``1252(a)(1), or 1254(a)(1)'' in its place.
2. Removing from the third sentence the language ``and paragraph
(d)(3) of Sec. 1.1252-1'' and adding in its place ``paragraph (d)(3) of
Sec. 1.1252-1, and paragraph (d) of Sec. 1.1254-1''.
Par. 6. Section 1.751-1, paragraphs (c)(4), (c)(5), and (c)(6) are
revised to read as follows:
Sec. 1.751-1 Unrealized receivables and inventory items.
* * * * *
(c) * * *
(4)(i) With respect to any taxable year of a partnership ending
after September 12, 1966 (but only in respect of expenditures paid or
incurred after that date), the term unrealized receivables, for
purposes of this section and sections 731, 736, 741, and 751, also
includes potential gain from mining property defined in section
617(f)(2). With respect to each item of partnership mining property so
defined, the potential gain is the amount that would be treated as gain
to which section 617(d)(1) would apply if (at the time of the
transaction described in section 731, 736, 741, or 751, as the case may
be) the item were sold by the partnership at its fair market value.
(ii) With respect to sales, exchanges, or other dispositions after
December 31, 1975, in any taxable year of a partnership ending after
that date, the term unrealized receivables, for purposes of this
section and sections 731, 736, 741, and 751, also includes potential
gain from stock in a DISC as described in section 992(a). With respect
to stock in such a DISC, the potential gain is the amount that would be
treated as gain to which section 995(c) would apply if (at the time of
the transaction described in section 731, 736, 741, or 751, as the case
may be) the stock were sold by the partnership at its fair market
value.
(iii) With respect to any taxable year of a partnership beginning
after December 31, 1962, the term unrealized receivables, for purposes
of this section and sections 731, 736, 741, and 751, also includes
potential gain from section 1245 property. With respect to each item of
partnership section 1245 property (as defined in section 1245(a)(3)),
potential gain from section 1245 property is the amount that would be
treated as gain to which section 1245(a)(1) would apply if (at the time
of the transaction described in section 731, 736, 741, or 751, as the
case may be) the item of section 1245 property were sold by the
partnership at its fair market value. See Sec. 1.1245-1(e)(1). For
example, if a partnership would recognize under section 1245(a)(1) gain
of $600 upon a sale of one item of section 1245 property and gain of
$300 upon a sale of its only other item of such property, the potential
section 1245 income of the partnership would be $900. [[Page 2501]]
(iv) With respect to transfers after October 9, 1975, and to sales,
exchanges, and distributions taking place after that date, the term
unrealized receivables, for purposes of this section and sections 731,
736, 741, and 751, also includes potential gain from stock in certain
foreign corporations as described in section 1248. With respect to
stock in such a foreign corporation, the potential gain is the amount
that would be treated as gain to which section 1248(a) would apply if
(at the time of the transaction described in section 731, 736, 741, or
751, as the case may be) the stock were sold by the partnership at its
fair market value.
(v) With respect to any taxable year of a partnership ending after
December 31, 1963, the term unrealized receivables, for purposes of
this section and sections 731, 736, 741, and 751, also includes
potential gain from section 1250 property. With respect to each item of
partnership section 1250 property (as defined in section 1250(c)),
potential gain from section 1250 property is the amount that would be
treated as gain to which section 1250(a) would apply if (at the time of
the transaction described in section 731, 736, 741, or 751, as the case
may be) the item of section 1250 property were sold by the partnership
at its fair market value. See Sec. 1.1250-1(f)(1).
(vi) With respect to any taxable year of a partnership beginning
after December 31, 1969, the term unrealized receivables, for purposes
of this section and sections 731, 736, 741, and 751, also includes
potential gain from farm recapture property as defined in section
1251(e)(1) (as in effect before enactment of the Tax Reform Act of
1984). With respect to each item of partnership farm recapture property
so defined, the potential gain is the amount which would be treated as
gain to which section 1251(c) (as in effect before enactment of the Tax
Reform Act of 1984) would apply if (at the time of the transaction
described in section 731, 736, 741, or 751, as the case may be) the
item were sold by the partnership at its fair market value.
(vii) With respect to any taxable year of a partnership beginning
after December 31, 1969, the term unrealized receivables, for purposes
of this section and sections 731, 736, 741, and 751, also includes
potential gain from farm land as defined in section 1252(a)(2). With
respect to each item of partnership farm land so defined, the potential
gain is the amount that would be treated as gain to which section
1252(a)(1) would apply if (at the time of the transaction described in
section 731, 736, 741, or 751, as the case may be) the item were sold
by the partnership at its fair market value.
(viii) With respect to transactions which occur after December 31,
1976, in any taxable year of a partnership ending after that date, the
term unrealized receivables, for purposes of this section and sections
731, 736, 741, and 751, also includes potential gain from franchises,
trademarks, or trade names referred to in section 1253(a). With respect
to each such item so referred to in section 1253(a), the potential gain
is the amount that would be treated as gain to which section 1253(a)
would apply if (at the time of the transaction described in section
731, 736, 741, or 751, as the case may be) the items were sold by the
partnership at its fair market value.
(ix) With respect to any taxable year of a partnership ending after
December 31, 1975, the term unrealized receivables, for purposes of
this section and sections 731, 736, 741, and 751, also includes
potential gain under section 1254(a) from natural resource recapture
property as defined in Sec. 1.1254-1(b)(2). With respect to each
separate partnership natural resource recapture property so described,
the potential gain is the amount that would be treated as gain to which
section 1254(a) would apply if (at the time of the transaction
described in section 731, 736, 741, or 751, as the case may be) the
property were sold by the partnership at its fair market value.
(x) For purposes of section 751(c) and this paragraph (c)(4), any
arm's-length agreement between the buyer and seller, or between the
partnership and distributee partner, will generally establish the fair
market value of the property described in this paragraph (c)(4).
(5) For purposes of subtitle A of the Internal Revenue Code, the
basis of any potential gain described in paragraph (c)(4) of this
section is zero.
(6)(i) If (at the time of any transaction referred to in paragraph
(c)(4) of this section) a partnership holds property described in
paragraph (c)(4) of this section and if--
(A) A partner had a special basis adjustment under section 743(b)
in respect of the property;
(B) The basis under section 732 of the property if distributed to
the partner would reflect a special basis adjustment under section
732(d); or
(C) On the date a partner acquired a partnership interest by way of
a sale or exchange (or upon the death of another partner) the
partnership owned the property and an election under section 754 was in
effect with respect to the partnership, the partner's share of any
potential gain described in paragraph (c)(4) of this section is
determined under paragraph (c)(6)(ii) of this section.
(ii) The partner's share of the potential gain described in
paragraph (c)(4) of this section in respect of the property to which
this paragraph (c)(6)(ii) applies is that amount of gain that the
partner would recognize under section 617(d)(1), 995(c), 1245(a),
1248(a), 1250(a), 1251(c) (as in effect before the Tax Reform Act of
1984), 1252(a), 1253(a), or 1254(a) (as the case may be) upon a sale of
the property by the partnership, except that, for purposes of this
paragraph (c)(6) the partner's share of such gain is determined in a
manner that is consistent with the manner in which the partner's share
of partnership property is determined; and the amount of a potential
special basis adjustment under section 732(d) is treated as if it were
the amount of a special basis adjustment under section 743(b). For
example, in determining, for purposes of this paragraph (c)(6), the
amount of gain that a partner would recognize under section 1245 upon a
sale of partnership property, the items allocated under Sec. 1.1245-
1(e)(3)(ii) are allocated to the partner in the same manner as the
partner's share of partnership property is determined. See Sec. 1.1250-
1(f) for rules similar to those contained in Sec. 1.1245-1(e)(3)(ii).
* * * * *
Par. 7. Sections 1.1254-0 through 1.1254-6 are added to read as
follows:
Sec. 1.1254-0 Table of contents for section 1254 recapture rules.
This section lists the major captions contained in Secs. 1.1254-1
through 1.1254-6.
Sec. 1.1254-1 Treatment of gain from disposition of natural
resource recapture property.
(a) In general.
(b) Definitions.
(1) Section 1254 costs.
(2) Natural resource recapture property.
(3) Disposition.
(c) Disposition of a portion of natural resource recapture property.
(1) Disposition of a portion (other than an undivided interest)
of natural resource recapture property.
(2) Disposition of an undivided interest.
(3) Alternative allocation rule.
(d) Installment method.
Sec. 1.1254-2 Exceptions and limitations.
(a) Exception for gifts and section 1041 transfers.
(1) General rule.
(2) Part gift transactions.
(b) Exception for transfers at death.
(c) Limitation for certain tax-free transactions.
(1) General rule. [[Page 2502]]
(2) Special rule for dispositions to certain tax exempt
organizations.
(3) Transfers described.
(4) Special rules for section 332 transfers.
(d) Limitation for like kind exchanges and involuntary conversions.
(1) General rule.
(2) Disposition and acquisition of both natural resource
recapture property and other property.
Sec. 1.1254-3 Section 1254 costs immediately after certain
acquisitions.
(a) Transactions in which basis is determined by reference to cost
or fair market value of property transferred.
(1) Basis determined under section 1012.
(2) Basis determined under section 301(d), 334(a), or 358(a)(2).
(3) Basis determined solely under former section 334(b)(2) or
former section 334(c).
(4) Basis determined by reason of the application of section
1014(a).
(b) Gifts and certain tax-free transactions.
(1) General rule.
(2) Transactions covered.
(c) Certain transfers at death.
(d) Property received in a like kind exchange or involuntary
conversion.
(1) General rule.
(2) Allocation of section 1254 costs among multiple natural
resource recapture property acquired.
(e) Property transferred in cases to which section 1071 or 1081(b)
applies.
Sec. 1.1254-4 Special rules for S corporations and their
shareholders. [Reserved].
Sec. 1.1254-5 Special rules for partnerships and their partners.
(a) In general.
(b) Determination of gain treated as ordinary income under section
1254 upon the disposition of natural resource recapture property by
a partnership.
(1) General rule.
(2) Exception to partner level recapture in the case of abusive
allocations.
(3) Examples.
(c) Section 1254 costs of a partner.
(1) General rule.
(2) Section 1254 costs of a transferee partner after certain
acquisitions.
(d) Property distributed to a partner.
(1) In general.
(2) Aggregate of partners' section 1254 costs with respect to
natural resource recapture property held by a partnership.
Sec. 1.1254-6 Effective date of regulations.
Sec. 1.1254-1 Treatment of gain from disposition of natural resource
recapture property.
(a) In general. Upon any disposition of section 1254 property or
any disposition after December 31, 1975 of oil, gas, or geothermal
property, gain is treated as ordinary income in an amount equal to the
lesser of the amount of the section 1254 costs (as defined in paragraph
(b)(1) of this section) with respect to the property, or the amount, if
any, by which the amount realized on the sale, exchange, or involuntary
conversion, or the fair market value of the property on any other
disposition, exceeds the adjusted basis of the property. However, any
amount treated as ordinary income under the preceding sentence is not
included in the taxpayer's gross income from the property for purposes
of section 613. Generally, the lesser of the amounts described in this
paragraph (a) is treated as ordinary income even though, in the absence
of section 1254(a), no gain would be recognized upon the disposition
under any other provision of the Internal Revenue Code. For the
definition of the term section 1254 costs, see paragraph (b)(1) of this
section. For the definition of the terms section 1254 property, oil,
gas, or geothermal property, and natural resource recapture property,
see paragraph (b)(2) of this section. For rules relating to the
disposition of natural resource recapture property, see paragraphs
(b)(3), (c), and (d) of this section. For exceptions and limitations to
the application of section 1254(a), see Sec. 1.1254-2.
(b) Definitions--(1) Section 1254 costs--(i) Property placed in
service after December 31, 1986. With respect to any property placed in
service by the taxpayer after December 31, 1986, the term section 1254
costs means--
(A) The aggregate amount of expenditures that have been deducted by
the taxpayer or any person under section 263, 616, or 617 with respect
to such property and that, but for the deduction, would have been
included in the adjusted basis of the property or in the adjusted basis
of certain depreciable property associated with the property; and
(B) The deductions for depletion under section 611 that reduced the
adjusted basis of the property.
(ii) Property placed in service before January 1, 1987. With
respect to any property placed in service by the taxpayer before
January 1, 1987, the term section 1254 costs means--
(A) The aggregate amount of costs paid or incurred after December
31, 1975, with respect to such property, that have been deducted as
intangible drilling and development costs under section 263(c) by the
taxpayer or any other person (except that section 1254 costs do not
include costs incurred with respect to geothermal wells commenced
before October 1, 1978) and that, but for the deduction, would be
reflected in the adjusted basis of the property or in the adjusted
basis of certain depreciable property associated with the property;
reduced by
(B) The amount (if any) by which the deduction for depletion
allowed under section 611 that was computed either under section 612 or
sections 613 and 613A, with respect to the property, would have been
increased if the costs (paid or incurred after December 31, 1975) had
been charged to capital account rather than deducted.
(iii) Deductions under section 59 and section 291. Amounts
capitalized pursuant to an election under section 59(e) or pursuant to
section 291(b) are treated as section 1254 costs in the year in which
an amortization deduction is claimed under section 59(e)(1) or section
291(b)(2).
(iv) Suspended deductions. If a deduction of a section 1254 cost
has been suspended as of the date of disposition of section 1254
property, the deduction is not treated as a section 1254 cost if it is
included in basis for determining gain or loss on the disposition. On
the other hand, if the deduction will eventually be claimed, it is a
section 1254 cost as of the date of disposition. For example, a
deduction suspended pursuant to the 65 percent of taxable income
limitation of section 613A(d)(1) may either be included in basis upon
disposition of the property or may be deducted in a year after the year
of disposition. See Sec. 1.613A-4(a)(1). If it is included in the basis
then it is not a section 1254 cost, but if it is deductible in a later
year it is a section 1254 cost as of the date of the disposition.
(v) Previously recaptured amounts. If an amount has been previously
treated as ordinary income pursuant to section 1254, it is not a
section 1254 cost.
(vi) Nonproductive wells. The aggregate amount of section 1254
costs paid or incurred on any property includes the amount of
intangible drilling and development costs incurred on nonproductive
wells, but only to the extent that the taxpayer recognizes income on
the foreclosure of a nonrecourse debt the proceeds from which were used
to finance the section 1254 costs with respect to the property. For
this purpose, the term nonproductive well means a well that does not
produce oil or gas in commercial quantities, including a well that is
drilled for the purpose of ascertaining the existence, location, or
extent of an oil or gas reservoir (e.g., a delineation well). The term
nonproductive well does not include an injection well (other than an
injection well drilled as part of a project that does not result in
production in commercial quantities).
(vii) Calculation of amount described in paragraph (b)(1)(ii)(B) of
this section (hypothetical depletion offset)--(A) In general. In
calculating the amount [[Page 2503]] described in paragraph
(b)(1)(ii)(B) of this section, the taxpayer shall apply the following
rules. The taxpayer may use the 65-percent-of-taxable-income limitation
of section 613A(d)(1). If the taxpayer uses that limitation, the
taxpayer is not required to recalculate the effect of such limitation
with respect to any property not disposed of. That is, the taxpayer may
assume that the hypothetical capitalization of intangible drilling and
development costs with respect to any property disposed of does not
affect the allowable depletion with respect to property retained by the
taxpayer. Any intangible drilling and development costs that, if they
had not been treated as expenses under section 263(c), would have
properly been capitalized under Sec. 1.612-4(b)(2) (relating to items
recoverable through depreciation under section 167 or cost recovery
under section 168) are treated as costs described in Sec. 1.612-4(b)(1)
(relating to items recoverable through depletion). The increase in
depletion attributable to the capitalization of intangible drilling and
development costs is computed by subtracting the amount of cost or
percentage depletion actually claimed from the amount of cost or
percentage depletion that would have been allowable if intangible
drilling and development costs had been capitalized. If the remainder
is zero or less than zero, the entire amount of intangible drilling and
development costs attributable to the property is recapturable.
(B) Example. The following example illustrates the principles of
paragraph (b)(1)(vii)(A).
Example. Hypothetical depletion offset. In 1976, A purchased
undeveloped property for $10,000. During 1977, A incurred $200,000
of productive well intangible drilling and development costs with
respect to the property. A deducted the intangible drilling and
development costs as expenses under section 263(c). Estimated
reserves of 150,000 barrels of recoverable oil were discovered in
1977 and production began in 1978. In 1978, A produced and sold
30,000 barrels of oil at $8 per barrel, resulting in $240,000 of
gross income. A had no other oil or gas production in 1978. A
claimed a percentage depletion deduction of $52,800 (i.e., 22% of
$240,000 gross income from the property). If A had capitalized the
intangible drilling and development costs, assume that $200,000 of
the costs would have been allocated to the depletable property and
none to depreciable property. A's cost depletion deduction if the
intangible drilling and development costs had been capitalized would
have been $42,000 (i.e., (($200,000 intangible drilling and
development costs + $10,000 acquisition costs) x 30,000 barrels of
production)/ 150,000 barrels of estimated recoverable reserves).
Since this amount is less than A's depletion deduction of $52,800
(percentage depletion), no reduction is made to the amount of
intangible drilling and development costs ($200,000). On January 1,
1979, A sold the oil property to B for $360,000 and calculated
section 1254 recapture without reference to the 65-percent-of-
taxable-income limitation. A's gain on the sale is the entire
$360,000, because A's basis in the property at the beginning of 1979
is zero (i.e., $10,000 cost less $52,800 depletion deduction for
1978). Since the section 1254 costs ($200,000) are less than A's
gain on the sale, $200,000 is treated as ordinary income under
section 1254(a). The remaining amount of A's gain ($160,000) is not
subject to section 1254(a).
(2) Natural resource recapture property--(i) In general. The term
natural resource recapture property means section 1254 property or oil,
gas, or geothermal property as those terms are defined in this section.
(ii) Section 1254 property. The term section 1254 property means
any property (within the meaning of section 614) that is placed in
service by the taxpayer after December 31, 1986, if any expenditures
described in paragraph (b)(1)(i)(A) of this section (relating to costs
under section 263, 616, or 617) are properly chargeable to such
property, or if the adjusted basis of such property includes
adjustments for deductions for depletion under section 611.
(iii) Oil, gas, or geothermal property. The term oil, gas, or
geothermal property means any property (within the meaning of section
614) that was placed in service by the taxpayer before January 1, 1987,
if any expenditures described in paragraph (b)(1)(ii)(A) of this
section are properly chargeable to such property.
(iv) Property to which section 1254 costs are properly
chargeable.--(A) An expenditure is properly chargeable to property if--
(1) The property is an operating mineral interest with respect to
which the expenditure has been deducted;
(2) The property is a nonoperating mineral interest (e.g., a net
profits interest or an overriding royalty interest) burdening an
operating mineral interest if the nonoperating mineral interest is
carved out of an operating mineral interest described in paragraph
(b)(2)(iv)(A)(1) of this section;
(3) The property is a nonoperating mineral interest retained by a
lessor or sublessor if such lessor or sublessor held, prior to the
lease or sublease, an operating mineral interest described in paragraph
(b)(2)(iv)(A)(1) of this section; or
(4) The property is an operating or a nonoperating mineral interest
held by a taxpayer if a party related to the taxpayer (within the
meaning of section 267(b) or section 707(b)) held an operating mineral
interest (described in paragraph (b)(2)(iv)(A)(1) of this section) in
the same tract or parcel of land that terminated (in whole or in part)
without being disposed of (e.g., a working interest which terminated
after a specified period of time or a given amount of production), but
only if there exists between the related parties an arrangement or plan
to avoid recapture under section 1254. In such a case, the taxpayer's
section 1254 costs with respect to the property include those of the
related party.
(B) Example. The following example illustrates the provisions of
paragraph (2)(iv)(A)(4) of this section:
Example. Arrangement or plan to avoid recapture. C, an
individual, owns 100% of the stock of both X Co. and Y Co. On
January 1, 1998, X Co. enters into a standard oil and gas lease. X
Co. immediately assigns to Y Co. 1% of the working interest for one
year, and 99% of the working interest thereafter. In 1998, X Co. and
Y Co. expend $300 in intangible drilling and development costs
developing the tract, of which $297 are deducted by X Co. under
section 263(c). On January 1, 1999, Y Co. sells its 99% share of the
working interest to an unrelated person. Based on all the facts and
circumstances, the arrangement between X Co. and Y Co. is part of a
plan or arrangement to avoid recapture under section 1254.
Therefore, Y Co. must include in its section 1254 costs the $297 of
intangible drilling and development costs deducted by X Co.
(v) Property the basis of which includes adjustments for depletion
deductions. The adjusted basis of property includes adjustments for
depletion under section 611 if--
(A) The basis of the property has been reduced by reason of
depletion deductions; or
(B) The property has been carved out of or is a portion of property
the basis of which has been reduced by reason of depletion deductions.
(vi) Property held by a transferee. Property held by a transferee
is natural resource recapture property if the property was natural
resource recapture property in the hands of the transferor and the
transferee's basis in the property is determined with reference to the
transferor's basis in the property (e.g., a gift) or is determined
under section 732.
(vii) Property held by a transferor. Property held by a transferor
of natural resource recapture property is natural resource recapture
property if the transferor's basis in the property received is
determined with reference to the transferor's basis in the property
transferred by the transferor (e.g., a like kind exchange). For
purposes of this paragraph (b)(2), property described in this paragraph
(b)(2)(vii) is treated as placed in service at the time the
[[Page 2504]] property transferred by the transferor was placed in
service by the transferor.
(3) Disposition--(i) General rule. The term disposition has the
same meaning as in section 1245, relating to gain from dispositions of
certain depreciable property.
(ii) Exceptions. The term disposition does not include--
(A) Any transaction that is merely a financing device, such as a
mortgage or a production payment that is treated as a loan under
section 636 and the regulations thereunder;
(B) Any abandonment (except that an abandonment is a disposition to
the extent the taxpayer recognizes income on the foreclosure of a
nonrecourse debt);
(C) Any creation of a lease or sublease of natural resource
recapture property;
(D) Any termination or election of the status of an S corporation;
(E) Any unitization or pooling arrangement;
(F) Any expiration or reversion of an operating mineral interest
that expires or reverts by its own terms, in whole or in part; or
(G) Any conversion of an overriding royalty interest that, at the
option of the grantor or successor in interest, converts to an
operating mineral interest after a certain amount of production.
(iii) Special rule for carrying arrangements. In a carrying
arrangement, liability for section 1254 costs attributable to the
entire operating mineral interest held by the carrying party prior to
reversion or conversion remains attributable to the reduced operating
mineral interest retained by the carrying party after a portion of the
operating mineral interest has reverted to the carried party or after
the conversion of an overriding royalty interest that, at the option of
the grantor or successor in interest, converts to an operating mineral
interest after a certain amount of production.
(c) Disposition of a portion of natural resource recapture
property--(1) Disposition of a portion (other than an undivided
interest) of natural resource recapture property--(i) Natural resource
recapture property subject to the general rules of Sec. 1.1254-1. For
purposes of section 1254(a)(1) and paragraph (a) of this section,
except as provided in paragraphs (c)(1) (ii) and (3) of this section,
in the case of the disposition of a portion (that is not an undivided
interest) of natural resource recapture property, the entire amount of
the section 1254 costs with respect to the natural resource recapture
property is treated as allocable to that portion of the property to the
extent of the amount of gain to which section 1254(a)(1) applies. If
the amount of the gain to which section 1254(a)(1) applies is less than
the amount of the section 1254 costs with respect to the natural
resource recapture property, the balance of the section 1254 costs
remaining after allocation to the portion of the property that was
disposed of remains subject to recapture by the taxpayer under section
1254(a)(1) upon disposition of the remaining portion of the property.
For example, assume that A owns an 80-acre tract of land with respect
to which A has deducted intangible drilling and development costs under
section 263(c). If A sells the north 40 acres, the entire amount of the
section 1254 costs with respect to the 80-acre tract is treated as
allocable to the 40-acre portion sold (to the extent of the amount of
gain to which section 1254(a)(1) applies).
(ii) Natural resource recapture property subject to the exceptions
and limitations of Sec. 1.1254-2. For purposes of section 1254(a)(1)
and paragraph (a) of this section, except as provided in paragraph
(b)(3) of this section, in the case of the disposition of a portion
(that is not an undivided interest) of natural resource recapture
property to which section 1254(a)(1) does not apply by reason of the
application of Sec. 1.1254-2 (certain nonrecognition transactions), the
following rule for allocation of costs applies. An amount of the
section 1254 costs that bears the same ratio to the entire amount of
such costs with respect to the entire natural resource recapture
property as the value of the property transferred bears to the value of
the entire natural resource recapture property is treated as allocable
to the portion of the natural resource recapture property transferred.
The balance of the section 1254 costs remaining after allocation to
that portion of the transferred property remains subject to recapture
by the taxpayer under section 1254(a)(1) upon disposition of the
remaining portion of the property. For example, assume that A owns an
80-acre tract of land with respect to which A has deducted intangible
drilling and development costs under section 263(c). If A gives away
the north 40 acres, and if 60 percent of the value of the 80-acre tract
were attributable to the north 40 acres given away, 60 percent of the
section 1254 costs with respect to the 80-acre tract is allocable to
the north 40 acres given away.
(2) Disposition of an undivided interest--(i) Natural resource
recapture property subject to the general rules of Sec. 1.1254-1. For
purposes of section 1254(a)(1), except as provided in paragraphs
(b)(2)(ii) and (b)(3) of this section, in the case of the disposition
of an undivided interest in natural resource recapture property (or a
portion thereof), a proportionate part of the section 1254 costs with
respect to the natural resource recapture property is treated as
allocable to the transferred undivided interest to the extent of the
amount of gain to which section 1254(a)(1) applies. For example, assume
that A owns an 80-acre tract of land with respect to which A has
deducted intangible drilling and development costs under section
263(c). If A sells an undivided 40 percent interest in the 80-acre
tract, 40 percent of the section 1254 costs with respect to the 80-acre
tract is allocable to the transferred 40 percent interest in the 80-
acre tract. However, if the amount of gain recognized on the sale of
the 40 percent undivided interest were equal to only 35 percent of the
amount of section 1254 costs attributable to the 80-acre tract, only 35
percent of the section 1254 costs would be treated as attributable to
the undivided 40 percent interest. See paragraph (c)(3) of this section
for an alternative allocation rule.
(ii) Natural resource recapture property subject to the exceptions
and limitations of Sec. 1.1254-2. For purposes of section 1254(a)(1)
and paragraph (a) of this section, except as provided in paragraph
(b)(3) of this section, in the case of a disposition of an undivided
interest in natural resource recapture property (or a portion thereof)
to which section 1254 (a)(1) does not apply by reason of Sec. 1.1254-2,
a proportionate part of the section 1254 costs with respect to the
natural resource recapture property is treated as allocable to the
transferred undivided interest. See paragraph (c)(3) of this section
for an alternative allocation rule.
(3) Alternative allocation rule--(i) In general. The rules for the
allocation of costs set forth in section 1254(a)(2) and paragraphs
(c)(1) and (2) of this section do not apply with respect to section
1254 costs that the taxpayer establishes to the satisfaction of the
Commissioner do not relate to the transferred property. Except as
provided in paragraphs (c)(3)(ii) and (iii) of this section, a taxpayer
may satisfy this requirement only by receiving a private letter ruling
from the Internal Revenue Service that the section 1254 costs do not
relate to the transferred property.
(ii) Portion of property. Upon the transfer of a portion of a
natural resource recapture property (other than an undivided interest)
with respect to which section 1254 costs have been incurred, a taxpayer
may treat section 1254 costs as not relating to the transferred portion
if the transferred portion does not include any part of any
[[Page 2505]] deposit with respect to which the costs were incurred.
(iii) Undivided interest. Upon the transfer of an undivided
interest in a natural resource recapture property with respect to which
section 1254 costs have been incurred, a taxpayer may treat costs as
not relating to the transferred interest if the undivided interest is
an undivided interest in a portion of the natural resource recapture
property, and the portion would be eligible for the alternative
allocation rule under paragraph (c)(3)(ii) of this section.
(iv) Substantiation. If a taxpayer treats section 1254 costs
incurred with respect to a natural resource recapture property as not
relating to a transferred interest in a portion of the property, the
taxpayer must indicate on his or her tax return that the costs do not
relate to the transferred portion and maintain the records and
supporting evidence that substantiate this position.
(d) Installment method. Gain from a disposition to which section
1254(a)(1) applies is reported on the installment method if that method
otherwise applies under section 453 or 453A of the Internal Revenue
Code and the regulations thereunder. The portion of each installment
payment as reported that represents income (other than interest) is
treated as gain to which section 1254(a)(1) applies until all of the
gain (to which section 1254(a)(1) applies) has been reported, and the
remaining portion (if any) of the income is then treated as gain to
which section 1254(a)(1) does not apply. For treatment of amounts as
interest on certain deferred payments, see sections 483, 1274, and the
regulations thereunder.
Sec. 1.1254-2 Exceptions and limitations.
(a) Exception for gifts and section 1041 transfers--(1) General
rule. No gain is recognized under section 1254(a)(1) upon a disposition
of natural resource recapture property by a gift or by a transfer in
which no gain or loss is recognized pursuant to section 1041 (relating
to transfers between spouses). For purposes of this paragraph (a), the
term gift means, except to the extent that paragraph (a)(2) of this
section applies, a transfer of natural resource recapture property
that, in the hands of the transferee, has a basis determined under the
provisions of sections 1015(a) or (d) (relating to basis of property
acquired by gift). For rules concerning the potential reduction in the
amount of the charitable contribution in the case of natural resource
recapture property, see section 170(e) and Sec. 1.170A-4. See
Sec. 1.1254-3(b)(1) for determination of potential recapture of section
1254 costs on property acquired by gift. See Sec. 1.1254-1(c)(1)(ii)
and (c)(2)(ii) for apportionment of section 1254 costs on a gift of a
portion of natural resource recapture property.
(2) Part gift transactions. If a disposition of natural resource
recapture property is in part a sale or exchange and in part a gift,
the gain that is treated as ordinary income pursuant to section
1254(a)(1) is the lower of the section 1254 costs with respect to the
property or the excess of the amount realized upon the disposition of
the property over the adjusted basis of the property. In the case of a
transfer subject to section 1011(b) (relating to bargain sales to
charitable organizations), the adjusted basis for purposes of the
preceding sentence is the adjusted basis for determining gain or loss
under section 1011(b).
(b) Exception for transfers at death. Except as provided in section
691 (relating to income in respect of a decedent), no gain is
recognized under section 1254(a)(1) upon a transfer at death. For
purposes of this paragraph, the term transfer at death means a transfer
of natural resource recapture property that, in the hands of the
transferee, has a basis determined under the provisions of section
1014(a) (relating to basis of property acquired from a decedent)
because of the death of the transferor. See Sec. 1.1254-3(a)(4) and (c)
for the determination of potential recapture of section 1254 costs on
property acquired in a transfer at death.
(c) Limitation for certain tax-free transactions--(1) General rule.
Upon a transfer of property described in paragraph (c)(3) of this
section, the amount of gain treated as ordinary income by the
transferor under section 1254(a)(1) may not exceed the amount of gain
recognized to the transferor on the transfer (determined without regard
to section 1254). In the case of a transfer of both natural resource
recapture property and property that is not natural resource recapture
property in one transaction, the amount realized from the disposition
of the natural resource recapture property is deemed to be equal to the
amount that bears the same ratio to the total amount realized as the
fair market value of the natural resource recapture property bears to
the aggregate fair market value of all the property transferred. The
preceding sentence is applied solely for purposes of computing the
portion of the total gain (determined without regard to section 1254)
that may be recognized as ordinary income under section 1254(a)(1).
(2) Special rule for dispositions to certain tax-exempt
organizations. Paragraph (c)(1) of this section does not apply to a
disposition of natural resource recapture property to an organization
(other than a cooperative described in section 521) that is exempt from
the tax imposed by chapter I of the Internal Revenue Code. The
preceding sentence does not apply to a disposition of natural resource
recapture property to an organization described in section 511 (a)(2)
or (b)(2) (relating to imposition of tax on unrelated business income
of charitable, etc., organizations) if, immediately after the
disposition, the organization uses the property in an unrelated trade
or business as defined in section 513. If any property with respect to
which gain is not recognized by reason of the exception of this
paragraph (c)(2) ceases to be used in an unrelated trade or business of
the organization acquiring the property, that organization is, for
purposes of section 1254, treated as having disposed of the property on
the date of the cessation.
(3) Transfers described. The transfers referred to in paragraph
(c)(1) of this section are transfers of natural resource recapture
property in which the basis of the natural resource recapture 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 any of
the following provisions:
(i) Section 332 (relating to certain liquidations of subsidiaries).
See paragraph (c)(4) of this section.
(ii) Section 351 (relating to transfer to a corporation controlled
by transferor).
(iii) Section 361 (relating to exchanges pursuant to certain
corporate reorganizations).
(iv) Section 721 (relating to transfers to a partnership in
exchange for a partnership interest).
(v) Section 731 (relating to distributions by a partnership to a
partner). For purposes of this paragraph, the basis of natural resource
recapture property distributed by a partnership to a partner is deemed
to be determined by reference to the adjusted basis of such property to
the partnership.
(4) Special rules for section 332 transfers. In the case of a
distribution in complete liquidation of a subsidiary to which section
332 applies, the limitation provided in this paragraph (c) is confined
to instances in which the basis of the natural resource recapture
property in the hands of the transferee is determined, under section
334(b)(1), by reference to its basis in the hands of the transferor.
Thus, for example, the limitation may apply in respect of a liquidating
distribution of natural resource recapture property by a subsidiary
corporation to the parent corporation, but does not apply in
[[Page 2506]] respect of a liquidating distribution of natural resource
recapture property to a minority shareholder. This paragraph (c) does
not apply to a liquidating distribution of natural resource recapture
property by a subsidiary to its parent if the parent's basis for the
property is determined under section 334(b)(2) (as in effect before
enactment of the Tax Reform Act of 1986), by reference to its basis for
the stock of the subsidiary. This paragraph (c) does not apply to a
liquidating distribution under section 332 of natural resource
recapture property by a subsidiary to its parent if gain is recognized
and there is a corresponding increase in the parent's basis in the
property (e.g., certain distributions to a tax-exempt or foreign
corporation).
(d) Limitation for like kind exchanges and involuntary
conversions--(1) General rule. If natural resource recapture property
is disposed of and gain (determined without regard to section 1254) is
not recognized in whole or in part under section 1031 (relating to like
kind exchanges) or section 1033 (relating to involuntary conversions),
the amount of gain taken into account by the transferor under section
1254(a)(1) may not exceed the sum of--
(i) The amount of gain recognized on the disposition (determined
without regard to section 1254); plus
(ii) The fair market value of property acquired that is not natural
resource recapture property and is not taken into account under
paragraph (d)(1)(i) of this section (that is, qualifying property under
section 1031 or 1033 that is not natural resource recapture property).
(2) Disposition and acquisition of both natural resource recapture
property and other property. For purposes of this paragraph (d), if
both natural resource recapture property and property that is not
natural resource recapture property are acquired as the result of one
disposition in which both natural resource recapture property and
property that is not natural resource recapture property are disposed
of--
(i) The total amount realized upon the disposition is allocated
between the natural resource recapture property and the property that
is not natural resource recapture property disposed of in proportion to
their respective fair market values;
(ii) The amount realized upon the disposition of the natural
resource recapture property is deemed to consist of so much of the fair
market value of the natural resource recapture property acquired as is
not in excess of the amount realized from the natural resource
recapture property disposed of, and the remaining portion (if any) of
the amount realized upon the disposition of such property is deemed to
consist of so much of the fair market value of the property that is not
natural resource recapture property acquired as is not in excess of the
remaining portion; and
(iii) The amount realized upon the disposition of the property that
is not natural resource recapture property is deemed to consist of so
much of the fair market value of all the property acquired which was
not taken into account under paragraph (d)(2)(ii) of this section.
Except as provided in section 1060 and the regulations thereunder, if a
buyer and seller have adverse interests as to such allocation of the
amount realized, any arm's-length agreement between the buyer and
seller is used to establish the allocation. In the absence of such an
agreement, the allocation is made by taking into account the
appropriate facts and circumstances.
Sec. 1.1254-3 Section 1254 costs immediately after certain
acquisitions.
(a) Transactions in which basis is determined by reference to cost
or fair market value of property transferred--(1) Basis determined
under section 1012. If, on the date a person acquires natural resource
recapture property, the person's basis for the property is determined
solely by reference to its cost (within the meaning of section 1012),
the amount of section 1254 costs with respect to the natural resource
recapture property in the person's hands is zero on the acquisition
date.
(2) Basis determined under section 301(d), 334(a), or 358(a)(2).
If, on the date a person acquires natural resource recapture property,
the person's basis for the property is determined solely by reason of
the application of section 301(d) (relating to basis of property
received in a corporate distribution), section 334(a) (relating to
basis of property received in a liquidation in which gain or loss is
recognized), or section 358(a)(2) (relating to basis of other property
received in certain exchanges), the amount of the section 1254 costs
with respect to the natural resource recapture property in the person's
hands is zero on the acquisition date.
(3) Basis determined solely under former section 334(b)(2) or
former section 334(c). If, on the date a person acquires natural
resource recapture property, the person's basis for the property is
determined solely under the provisions of section 334(b)(2) (prior to
amendment of that section by the Tax Equity and Fiscal Responsibility
Act of 1982) or (c) (prior to repeal of that section by the Tax Reform
Act of 1986) (relating to basis of property received in certain
corporate liquidations), the amount of section 1254 costs with respect
to the natural resource recapture property in the person's hands is
zero on the acquisition date.
(4) Basis determined by reason of the application of section
1014(a). If, on the date a person acquires natural resource recapture
property from a decedent, the person's basis is determined, by reason
of the application of section 1014(a), solely by reference to the fair
market value of the property on the date of the decedent's death or on
the applicable date provided in section 2032 (relating to alternate
valuation date), the amount of section 1254 costs with respect to the
natural resource recapture property in the person's hands is zero on
the acquisition date. See paragraph (c) of this section for the
treatment of certain transfers at death.
(b) Gifts and certain tax-free transactions--(1) General rule. If
natural resource recapture property is transferred in a transaction
described in paragraph (b)(2) of this section, the amount of section
1254 costs with respect to the natural resource recapture property in
the hands of the transferee immediately after the disposition is an
amount equal to--
(i) The amount of section 1254 costs with respect to the natural
resource recapture property in the hands of the transferor immediately
before disposition; minus
(ii) The amount of any gain taken into account as ordinary income
under section 1254(a)(1) by the transferor upon the disposition.
(2) Transactions covered. The transactions to which paragraph
(b)(1) of this section apply are--
(i) A disposition that is a gift or in part a sale or exchange and
in part a gift;
(ii) A transaction described in section 1041(a); or
(iii) A disposition described in Sec. 1.1254-2(c)(3) (relating to
certain tax-free transactions).
(c) Certain transfers at death. If natural resource recapture
property is acquired in a transfer at death, the amount of section 1254
costs with respect to the natural resource recapture property in the
hands of the transferee immediately after the transfer includes the
amount, if any, of the section 1254 costs deducted by the transferee
before the decedent's death, to the extent that the basis of the
natural resource recapture property (determined under section 1014(a))
is required to be reduced under the second sentence of section
1014(b)(9) (relating to adjustments to basis where the property
[[Page 2507]] is acquired from a decedent prior to death).
(d) Property received in a like kind exchange or involuntary
conversion--(1) General rule. If natural resource recapture property is
disposed of in a like kind exchange under section 1031 or involuntary
conversion under section 1033, then immediately after the disposition
the amount of section 1254 costs with respect to any natural resource
recapture property acquired for the property transferred is an amount
equal to--
(i) The amount of section 1254 costs with respect to the natural
resource recapture property disposed of; minus
(ii) The amount of any gain taken into account as ordinary income
under section 1254(a)(1) by the transferor upon the disposition.
(2) Allocation of section 1254 costs among multiple natural
resource recapture properties acquired. If more than one parcel of
natural resource recapture property is acquired at the same time from
the same person in a transaction referred to in paragraph (d)(1) of
this section, the total amount of section 1254 costs with respect to
the parcels is allocated to the parcels in proportion to their
respective adjusted bases.
(e) Property transferred in cases to which section 1071 or 1081(b)
applies. Rules similar to the rules of section 1245(b)(5) shall apply
under section 1254.
Sec. 1.1254-4 Special rules for S corporations and their shareholders.
[Reserved].
Sec. 1.1254-5 Special rules for partnerships and their partners.
(a) In general. This section provides rules for applying the
provisions of section 1254 to partnerships and their partners upon the
disposition of natural resource recapture property by the partnership
and certain distributions of property by a partnership. See section 751
and the regulations thereunder for rules concerning the treatment of
gain upon the transfer of a partnership interest.
(b) Determination of gain treated as ordinary income under section
1254 upon the disposition of natural resource recapture property by a
partnership--(1) General rule. Upon a disposition of natural resource
recapture property by a partnership, the amount treated as ordinary
income under section 1254 is determined at the partner level. Each
partner must recognize as ordinary income under section 1254 the lesser
of--
(i) The partner's section 1254 costs with respect to the property
disposed of; or
(ii) The partner's share of the amount, if any, by which the amount
realized upon the sale, exchange, or involuntary conversion, or the
fair market value of the property upon any other disposition, exceeds
the adjusted basis of the property.
(2) Exception to partner level recapture in the case of abusive
allocations. Paragraph (b)(1) of this section does not apply in
determining the amount treated as ordinary income under section 1254
upon a disposition of section 1254 property by a partnership if the
partnership has allocated the amount realized or gain recognized from
the disposition with a principal purpose of avoiding the recognition of
ordinary income under section 1254. In such case, the amount of gain on
the disposition recaptured as ordinary income under section 1254 is
determined at the partnership level.
(3) Examples. The provisions of paragraphs (a) and (b) of this
section are illustrated by the following examples which assume that
capital accounts are maintained in accordance with section 704(b) and
the regulations thereunder:
Example 1. Partner level recapture--In general. A, B, and C,
have equal interests in capital in Partnership ABC that was formed
on January 1, 1985. The partnership acquired an undeveloped domestic
oil property on January 1, 1985, for $120,000. The partnership
allocated the property's basis to each partner in proportion to the
partner's interest in partnership capital, so each partner was
allocated $40,000 of basis. In 1985, the partnership incurred
$60,000 of productive well intangible drilling and development costs
with respect to the property. The partnership elected to deduct the
intangible drilling and development costs as expenses under section
263(c). Each partner deducted $20,000 of the intangible drilling and
development costs. Assume that depletion allowable under section
613A(c)(7)(D) for each partner for 1985 was $10,000. On January 1,
1986, the partnership sold the oil property to an unrelated third
party for $210,000. Each partner's allocable share of the amount
realized is $70,000. Each partner's basis in the oil property at the
end of 1985 is $30,000 ($40,000 cost--$10,000 depletion deductions
claimed). Each partner has a gain of $40,000 on the sale of the oil
property ($70,000 amount realized--$30,000 adjusted basis in the oil
property). Assume that each partner's depletion allowance would not
have been increased if the intangible drilling and development costs
had been capitalized. Each partner's section 1254 costs with respect
to the property are $20,000. Thus, A, B, and C each must treat
$20,000 of gain recognized as ordinary income under section 1254(a).
Example 2. Special allocation of intangible drilling and
development costs. K and L form a partnership on January 1, 1997, to
acquire and develop a geothermal property as defined under section
613(e)(2). The partnership agreement provides that all intangible
drilling and development costs will be allocated to partner K, and
that all other items of income, gain, or loss will be allocated
equally between the two partners. Assume these allocations have
substantial economic effect under section 704(b) and the regulations
thereunder. The partnership acquires a lease covering undeveloped
acreage located in the United States for $50,000. In 1997, the
partnership incurs $50,000 of intangible drilling and development
costs that are allocated to partner K. The partnership also has
$30,000 of depletion deductions, which are allocated equally between
K and L. On January 1, 1998, the partnership sells the geothermal
property to an unrelated third party for $160,000 and recognizes a
gain of $140,000 ($160,000 amount realized less $20,000 adjusted
basis ($50,000 unadjusted basis less $30,000 depletion deductions)).
This gain is allocated equally between K and L. Because K's section
1254 costs are $65,000 and L's section 1254 costs are $15,000, K
recognizes $65,000 as ordinary income under section 1254(a) and L
recognizes $15,000 as ordinary income under section 1254(a). The
remaining $5,000 of gain allocated to K and $55,000 of gain
allocated to L is characterized without regard to section 1254.
Example 3. Section 59(e) election to capitalize intangible
drilling and development costs. Partnership DK has 50 equal
partners. On January 1, 1995, the partnership purchases an
undeveloped oil and gas property for $100,000. The partnership
allocates the property's basis equally among the partners, so each
partner is allocated $2,000 of basis. In January 1995, the
partnership incurs $240,000 of intangible drilling and development
costs with respect to the property. The partnership elects to deduct
the intangible drilling and development costs as expenses under
section 263(c). Each partner is allocated $4,800 of intangible
drilling and development costs. One of the partners, H, elects under
section 59(e) to capitalize his $4,800 share of intangible drilling
and development costs. Therefore, H is permitted to amortize his
$4,800 share of intangible drilling and development costs over 60
months. H takes a $960 amortization deduction in 1995. Each of the
remaining 49 partners deducts his $4,800 share of intangible
drilling and development costs in 1995. Assume that depletion
allowable for each partner under section 613A(c)(7)(D) for 1995 is
$1,000. On December 31, 1995, the partnership sells the property for
$300,000. Each partner is allocated $6,000 of amount realized. Each
partner that deducted the intangible drilling and development costs
has a basis in the oil property at the end of 1995 of $1,000 ($2,000
cost - $1,000 depletion deductions claimed). Each of these partners
has a gain of $5,000 on the sale of the oil property ($6,000 amount
realized - $1,000 adjusted basis in the property). The section 1254
costs of each partner that deducted intangible drilling and
development costs are $5,800 ($4,800 intangible drilling and
development costs deducted + $1,000 depletion deductions claimed).
Because each partner's section 1254 costs ($5,800) exceed each
partner's share of amount realized less each [[Page 2508]] partner's
adjusted basis ($5,000), each partner must treat his $5,000 gain
recognized on the sale of the oil property as ordinary income under
section 1254(a). Because H elected under section 59(e) to capitalize
the $4,800 of intangible drilling and development costs and
amortized only $960 of the costs in 1995, the $3,840 of unamortized
intangible drilling and development costs are included in H's basis
in the oil property. Therefore, at the end of 1995 H's basis in the
oil property is $4,840 (($2,000 cost + $4,800 capitalized intangible
drilling and development costs) - ($960 intangible drilling and
development costs amortized + $1,000 depletion deduction claimed)).
H's gain on the sale of the oil property is $1,160 ($6,000 amount
realized - $4,840 adjusted basis). H's section 1254 costs are $1,960
($960 intangible drilling and development costs amortized + $1,000
depletion deductions claimed). Because H's section 1254 costs
($1,960) exceed H's share of amount realized less H's adjusted basis
($1,160), H must treat the $1,160 of gain recognized as ordinary
income under section 1254(a).
(c) Section 1254 costs of a partner--(1) General rule. A partner's
section 1254 costs with respect to property held by a partnership
include all of the partner's section 1254 costs with respect to the
property in the hands of the partnership. In the case of property
contributed to a partnership in a transaction described in section 721,
a partner's section 1254 costs include all of the partner's section
1254 costs with respect to the property prior to contribution. Section
1.1254-1(b)(1)(iv), which provides rules concerning the treatment of
suspended deductions, applies to amounts not deductible pursuant to
section 704(d).
(2) Section 1254 costs of a transferee partner after certain
acquisitions--(i) Basis determined under section 1012. If a person
acquires an interest in a partnership that holds natural resource
recapture property (transferee partner) and the transferee partner's
basis for the interest is determined by reference to its cost (within
the meaning of section 1012), the amount of the transferee partner's
section 1254 costs with respect to the property held by the partnership
is zero on the acquisition date.
(ii) Basis determined by reason of the application of section
1014(a). If a transferee partner acquires an interest in a partnership
that holds natural resource recapture property from a decedent and the
transferee partner's basis is determined, by reason of the application
of section 1014(a), solely by reference to the fair market value of the
partnership interest on the date of the decedent's death or on the
applicable date provided in section 2032 (relating to alternate
valuation date), the amount of the transferee partner's section 1254
costs with respect to property held by the partnership is zero on the
acquisition date.
(iii) Basis determined by reason of the application of section
1014(b)(9). If an interest in a partnership that holds natural resource
recapture property is acquired before the death of the decedent, the
amount of the transferee partner's section 1254 costs with respect to
property held by the partnership shall include the amount, if any, of
the section 1254 costs deducted by the transferee partner before the
decedent's death, to the extent that the basis of the partner's
interest (determined under section 1014(a)) is required to be reduced
under section 1014(b)(9) (relating to adjustments to basis when the
property is acquired before the death of the decedent).
(iv) Gifts and section 1041 transfers. If an interest in a
partnership is transferred in a transfer that is a gift, a part sale or
exchange and part gift, or a transfer that is described in section
1041(a), the amount of the transferee partner's section 1254 costs with
respect to property held by the partnership immediately after the
transfer is an amount equal to--
(A) The amount of the transferor partner's section 1254 costs with
respect to the property immediately before the transfer; minus
(B) The amount of any gain recognized as ordinary income under
section 1254 by the transferor partner upon the transfer.
(d) Property distributed to a partner--(1) In general. The section
1254 costs for any natural resource recapture property received by a
partner in a distribution with respect to part or all of an interest in
a partnership include--
(i) The aggregate of the partners' section 1254 costs with respect
to the natural resource recapture property immediately prior to the
distribution; reduced by
(ii) The amount of any gain taken into account as ordinary income
under section 751 by the partnership or the partners (as constituted
after the distribution) on the distribution of the natural resource
recapture property.
(2) Aggregate of partners' section 1254 costs with respect to
natural resource recapture property held by a partnership--(i) In
general. The aggregate of partners' section 1254 costs is equal to the
sum of each partner's section 1254 costs. The partnership must
determine each partner's section 1254 costs under either paragraph
(d)(2)(i)(A) (written data) or paragraph (d)(2)(i)(B) (assumptions) of
this section. The partnership may determine the section 1254 costs of
some of the partners under paragraph (d)(2)(i)(A) of this section and
of others under paragraph (d)(2)(i)(B) of this section.
(A) Written data. A partnership may determine a partner's section
1254 costs by using written data provided by a partner showing the
partner's section 1254 costs with respect to natural resource recapture
property held by the partnership unless the partnership knows or has
reason to know that the written data is inaccurate. If a partnership
does not receive written data upon which it may rely, the partnership
must use the assumptions provided in paragraph (d)(2)(i)(B) of this
section in determining a partner's section 1254 costs.
(B) Assumptions. A partnership that does not use written data
pursuant to paragraph (d)(2)(i)(A) of this section to determine a
partner's section 1254 costs must use the following assumptions to
determine the partner's section 1254 costs:
(1) The partner deducted his or her share of deductions under
section 263(c), 616, or 617 for the first year in which the partner
could claim a deduction for such amounts, unless in the case of
expenditures under section 263(c) or 616, the partnership elected to
capitalize such amounts;
(2) The partner was not subject to the following limitations with
respect to the partner's depletion allowance under section 611, except
to the extent a limitation applied at the partnership level: the
taxable income limitation of section 613(a); the depletable quantity
limitations of section 613A(c); or the limitations of section
613A(d)(2), (3), and (4) (exclusion of retailers and refiners).
Sec. 1.1254-6 Effective date of regulations.
Sections 1.1254-1 through 1.1254-3 and Sec. 1.1254-5 are effective
with respect to any disposition of natural resource recapture property
occurring after March 13, 1995. The rule in Sec. 1.1254-
1(b)(2)(iv)(A)(2), relating to a nonoperating mineral interest carved
out of an operating mineral interest with respect to which an
expenditure has been deducted, is effective with respect to any
disposition occurring after March 13, 1995 of property (within the
meaning of section 614) that is placed in service by the taxpayer after
December 31, 1986.
Sec. 1.1502-14 [Amended]
Par. 8. In Sec. 1.1502-14, the first sentence of paragraph (c)(1)
is amended by removing the language ``or 1250(a)(1)'' and adding ``1250
(a)(1) or 1254(a)(1)'' in its place. [[Page 2509]]
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 9. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 10. Section 602.101 (c) is amended by adding the following
entries in numerical order to the table to read as follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control
number
------------------------------------------------------------------------
* * * * *
1.1254-1(c)(3)............................................. 1545-1352
1.1254-5(d)(2)............................................. 1545-1352
* * * * *
------------------------------------------------------------------------
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: November 22, 1994.
Leslie B. Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-172 Filed 1-9-95; 8:45 am]
BILLING CODE 4830-01-U
