Td 9013

Section 469.— Passive
Activity Losses and Credits
Limited
26 CFR 1.469–7: Treatment of self-charged items
of interest income and deduction.

T.D. 9013
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Limitations on Passive Activity
Losses and Credits—
Treatment of Self-charged
Items of Income and Expense
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: These regulations provide
guidance on the treatment of self-charged
items of income and expense under section 469. The regulations recharacterize a
percentage of certain portfolio income and
expense as passive income and expense
(self-charged items) when a taxpayer engages in a lending transaction with a partnership or an S corporation (passthrough
entity) in which the taxpayer owns a direct or indirect interest and the loan proceeds are used in a passive activity. Similar
rules apply to lending transactions between
two identically owned passthrough entities. These final regulations affect taxpayers subject to the limitations on passive
activity losses and credits.
DATES: Effective Date:These regulations
are effective August 21, 2002.
Applicability Date:For dates of applicability of these regulations, see § 1.469–11
of these regulations.
FOR
FURTHER
INFORMATION
CONTACT: Danielle M. Grimm at (202)
622–3070 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in these final regulations has been reviewed

September 23, 2002

and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507)
under control number 1545–1244. Responses to this collection of information are
required to obtain the benefit of self-charged
treatment of income and expense under section 469.
An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless
the collection of information displays a valid
control number assigned by the Office of
Management and Budget.
The estimated annual burden per respondent varies from 5 minutes to 15 minutes, depending on individual circumstances,
with an estimated average of 6 minutes.
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, W:CAR:MP:FP:S 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.
Books or records relating to this collection of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required by
26 U.S.C. 6103.
Background
Section 469(a)(1)(A) of the Internal Revenue Code (Code) provides that if aggregate losses from passive activities exceed
aggregate income from passive activities for
the taxable year, the excess losses are not
allowable for that taxable year. Under section 469(e)(1), passive activity income does
not include income from interest, dividends, annuities, and royalties not derived
in the ordinary course of a trade or business. However, under the rules of § 1.163–
8T, if borrowed funds are used in a passive
activity, the interest expense is treated as
a passive activity deduction. Consequently,
in certain lending transactions, a taxpayer
may have interest income that is characterized as portfolio income under section
469(e)(1) and interest expense that is characterized as a passive activity deduction under § 1.163–8T. The legislative history of
section 469 indicates that this result is in-

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appropriate because the items of interest income and expense are essentially “selfcharged” and thus lack economic
significance.
On April 5, 1991, the IRS published in
the Federal Register a notice of proposed
rulemaking (PS–39–89, 1991–1 C.B. 983
[56 FR 14034]) proposing amendments to
26 CFR part 1 under section 469 of the
Code relating to the treatment of selfcharged items of income and expense for
purposes of applying the limitations on passive activity losses and passive activity credits.
A number of public comments were received and a public hearing was held on
September 6, 1991. Given the significant
period of time that had elapsed since the
former comment period, additional comments were solicited in Notice 2001–47
(2001–36 I.R.B. 212). After consideration
of all of the comments received, the proposed regulations are adopted, as revised by
this Treasury decision.
Explanation of Revisions and
Summary of Comments
The proposed regulations provide selfcharged treatment for items of interest income and interest expense in lending
transactions between a taxpayer and a
passthrough entity in which the taxpayer
holds a direct or qualifying indirect interest. Several commentators suggested that the
regulations should also apply to lending
transactions between related passthrough entities such as brother-sister entities in which
the taxpayer owns interests because such
transactions also may result in mismatched
income and expense for purposes of section 469. In response to the suggestions, the
self-charged rules are extended to identically owned passthrough entities. This extension is limited to identically owned
entities because of concerns regarding the
difficulty of identifying self-charged items
in transactions between less closely related or unrelated entities.
Certain commentators requested the removal of the qualifying indirect interest rule
in the proposed regulations. The qualifying indirect interest rule provides that a taxpayer must have at least a 10-percent
indirect interest in a passthrough entity to
qualify for self-charged treatment. Commentators noted that a taxpayer that owns
less than a 10 percent interest nevertheless may receive large amounts of self-

2002–38 I.R.B.

charged income and expense. This
suggestion has been adopted. Accordingly,
the regulations no longer contain the qualifying indirect interest rule.
Noting that Congress authorized the Secretary to identify other situations in which
self-charged treatment is appropriate, several commentators suggested that selfcharged treatment be extended to other
transactions involving rental real estate activities, such as the payment of management fees and salaries. After publication of
the proposed regulations, Congress considered the impact of section 469 on rental
real estate transactions and enacted specific relief in section 469(c)(7) for certain
real estate professionals for taxable years
beginning after 1993. There was no indication in the legislative history of section
469(c)(7) that Congress considered additional relief for real estate transactions necessary or desirable. Moreover, there is less
justification for the complexity of a selfcharged rule in this area after the enactment of section 469(c)(7) because that
change substantially reduced the number of
real estate transactions that would benefit
from a self-charged rule. Accordingly, the
regulations do not extend the self-charged
treatment to other transactions involving
rental real estate. A number of comments
suggested that the regulations clarify
whether the self-charged rules apply to guaranteed payments to a partner for the use of
capital. Section 1.469–2(e)(2)(ii) of the regulations treats these payments as interest income. Accordingly, the regulations clarify
that lending transactions include guaranteed payments for the use of capital under section 707(c).
Some comments requested clarification on the types of interest eligible for selfcharged treatment. The comments noted that
the examples in the regulations may be interpreted as precluding certain types of interest because the introductory language
states that the lending transactions described
in the examples do not result in foregone
interest (within the meaning of section
7872(e)(2)), original issue discount (within
the meaning of section 1273), or total unstated interest (within the meaning of section 483(b)). Accordingly, the regulations
clarify that the examples assume, solely for
purposes of simplifying the presentation,
that the lending transactions do not involve foregone interest, original issue discount, or total unstated interest.

2002–38 I.R.B.

A few comments responded to the notice of proposed rulemaking’s solicitation
for suggestions on the proper treatment of
items recognized in different taxable years.
One comment suggested the use of a suspense account. Under this suggestion, in the
year in which the taxpayer identifies the
corresponding item of self-charged income
or expense, that item would be netted
against the self-charged item in the suspense account. Another comment suggested
that where the recognition of passive interest expense precedes the recognition of
passive income, the taxpayer could elect to
treat the income as passive when ultimately
recognized. Another suggestion was to allow the taxpayer to recharacterize interest income or expense equal to the amount
calculated on a cumulative basis. The commentators recognize that to implement the
above methods would require more complex regulations.
After consideration of these comments,
the final regulations adopt the rule of the
proposed regulations that the self-charged
rules apply only to self-charged items recognized in the same taxable year. This rule
is consistent with the legislative history and
avoids the complexity of the other suggested methods. For similar reasons, comments suggesting special rules for
capitalized expenses are not adopted.
Certain commentators requested that the
regulations be extended to apply to transactions between taxpayers and their trusts,
estates, REMICs and housing cooperatives. The regulations address the transactions identified by Congress involving S
corporations and partnerships (including entities classified as partnerships for federal
tax purposes). Application of the selfcharged rules to other types of entities
would require a significant expansion of the
scope of these regulations to address broader
issues concerning the manner in which section 469 applies to those entities.
The applicability date of the final regulations is consistent with the applicability
date as proposed. However, certain clarifications have been made to the transition
rule. In the transition period, a taxpayer may
use any reasonable method to offset items
of interest income and interest expense from
lending transactions.
Effective Date
These regulations are applicable for taxable years beginning after December 31,

543

1986. However, for taxable years beginning before June 4, 1991, a taxpayer that
owns an interest in a passthrough entity is
not required to apply these provisions and
may use any reasonable method to offset
items of interest income and interest expense from lending transactions between the
passthrough entity and its owners or between certain passthrough entities. Items
from nonlending transactions cannot be offset under the self-charged rules.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order
12886. 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 Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business
Administration for comment on its impact on small business.
Drafting Information
The principal author of these regulations is Danielle M. Grimm, Office of the
Associate Chief Counsel (Passthroughs and
Special Industries), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and
Treasury Department participated in their
development.
*****
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 an entry in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.469–7 also issued under 26
U.S.C. 469(l). * * *
Par. 2. Section 1.469–0 is amended by:
1. Revising the entry for § 1.469–7.

September 23, 2002

2. Adding entries for § 1.469–7(a)
through (h).
3. Revising the entries for § 1.469–
11(c)(1) and (c)(1)(i).
4. Adding an entry for § 1.469–11, paragraph (c)(1)(iii).
The additions and revisions read as
follows:

Par. 3. Section 1.469–7 is amended by:
(3) Revising the section heading.
(4) Adding paragraphs (a) through (h).
The revision and additions read as
follows:

§ 1.469–0 Table of contents.

(a) In general—(1) Applicability and effect of rules. This section sets forth rules
that apply, for purposes of section 469 and
the regulations thereunder, in the case of a
lending transaction (including guaranteed
payments for the use of capital under section 707(c)) between a taxpayer and a
passthrough entity in which the taxpayer
owns a direct or indirect interest, or between certain passthrough entities. The rules
apply only to items of interest income and
interest expense that are recognized in the
same taxable year. The rules—
(i) Treat certain interest income resulting from these lending transactions as passive activity gross income;
(ii) Treat certain deductions for interest expense that is properly allocable to the
interest income as passive activity deductions; and
(iii) Allocate the passive activity gross
income and passive activity deductions resulting from this treatment among the taxpayer’s activities. (2) Priority of rules in this
section. The character of amounts treated
under the rules of this section as passive activity gross income and passive activity deductions and the activities to which these
amounts are allocated are determined under the rules of this section and not under
the rules of §§ 1.163–8T, 1.469–2(c) and
(d), and 1.469–2T(c) and (d).
(b) Definitions. The following definitions set forth the meaning of certain terms
for purposes of this section:
(1) Passthrough entity. The term
passthrough entity means a partnership or
an S corporation.
(2) Taxpayer’s share. A taxpayer’s share
of an item of income or deduction of a
passthrough entity is the amount treated as
an item of income or deduction of the taxpayer for the taxable year under section 702
(relating to the treatment of distributive
shares of partnership items as items of partners) or section 1366 (relating to the treatment of pro rata shares of S corporation
items as items of shareholders).

*****
§ 1.469–7 Treatment of self-charged
items of interest income and deduction.
(a) In general.
(1) Applicability and effect of rules.
(2) Priority of rules in this section.
(b) Definitions.
(1) Passthrough entity.
(2) Taxpayer’s share.
(3) Taxpayer’s indirect interest.
(4) Entity taxable year.
(5) Deductions for a taxable year.
(c) Taxpayer loans to passthrough entity.
(1) Applicability.
(2) General rule.
(3) Applicable percentage.
(d) Passthrough entity loans to taxpayer.
(1) Applicability.
(2) General rule.
(3) Applicable percentage.
(e) Identically-owned passthrough entities.
(1) Applicability.
(2) General rule.
(3) Example.
(f) Identification of properly allocable deductions.
(g) Election to avoid application of the rules
of this section.
(1) In general.
(2) Form of election.
(3) Period for which election applies.
(4) Revocation.
(h) Examples.
§ 1.469–11 Effective date and transition
rules.
*****
(c) * * *
(1) Application of certain income recharacterization rules and self-charged rules.
(i) Certain recharacterization rules inapplicable in 1987.
*****
(iii) Self-charged rules.
*****

September 23, 2002

§ 1.469–7 Treatment of self-charged
items of interest income and deduction.

544

(3) Taxpayer’s indirect interest. The taxpayer has an indirect interest in an entity
if the interest is held through one or more
passthrough entities.
(4) Entity taxable year. In applying this
section for a taxable year of a taxpayer, the
term entity taxable year means the taxable year of the passthrough entity for
which the entity reports items that are taken
into account under section 702 or section
1366 for the taxpayer’s taxable year.
(5) Deductions for a taxable year. The
term deductions for a taxable year means
deductions that would be allowable for the
taxable year if the taxpayer’s taxable income for all taxable years were determined
without regard to sections 163(d), 170(b),
469, 613A(d), and 1211.
(c) Taxpayer loans to passthrough
entity—(1) Applicability. Except as provided in paragraph (g) of this section, this
paragraph (c) applies with respect to a taxpayer’s interest in a passthrough entity (borrowing entity) for a taxable year if—
(i) The borrowing entity has deductions for the entity taxable year for interest charged to the borrowing entity by
persons that own direct or indirect interests in the borrowing entity at any time during the entity taxable year (the borrowing
entity’s self-charged interest deductions);
(ii) The taxpayer owns a direct or an indirect interest in the borrowing entity at any
time during the entity taxable year and has
gross income for the taxable year from interest charged to the borrowing entity by the
taxpayer or a passthrough entity through
which the taxpayer holds an interest in the
borrowing entity (the taxpayer’s income
from interest charged to the borrowing entity); and
(iii) The taxpayer’s share of the borrowing entity’s self-charged interest deductions includes passive activity
deductions.
(2) General rule. If any of the borrowing entity’s self-charged interest deductions are allocable to an activity for a
taxable year in which this paragraph (c) applies, the passive activity gross income and
passive activity deductions from that activity are determined under the following
rules—
(i) The applicable percentage of each
item of the taxpayer’s income for the taxable year from interest charged to the borrowing entity is treated as passive activity
gross income from the activity; and

2002–38 I.R.B.

(ii) The applicable percentage of each
deduction for the taxable year for interest
expense that is properly allocable (within
the meaning of paragraph (f) of this section) to the taxpayer’s income from the interest charged to the borrowing entity is
treated as a passive activity deduction from
the activity.
(3) Applicable percentage. In applying
this paragraph (c) with respect to a taxpayer’s interest in a borrowing entity, the
applicable percentage is separately determined for each of the taxpayer’s activities. The percentage applicable to an activity
for a taxable year is obtained by dividing—
(i) The taxpayer’s share for the taxable year of the borrowing entity’s selfcharged interest deductions that are treated
as passive activity deductions from the activity by
(ii) The greater of—
(A) The taxpayer’s share for the taxable year of the borrowing entity’s aggregate self-charged interest deductions for all
activities (regardless of whether these deductions are treated as passive activity deductions); or
(B) The taxpayer’s aggregate income for
the taxable year from interest charged to the
borrowing entity for all activities of the borrowing entity.
(d) Passthrough entity loans to
taxpayer—(1) Applicability. Except as provided in paragraph (g) of this section, this
paragraph (d) applies with respect to a taxpayer’s interest in a passthrough entity
(lending entity) for a taxable year if—
(i) The lending entity has gross income
for the entity taxable year from interest
charged by the lending entity to persons that
own direct or indirect interests in the lending entity at any time during the entity taxable year (the lending entity’s self-charged
interest income);
(ii) The taxpayer owns a direct or an indirect interest in the lending entity at any
time during the entity taxable year and has
deductions for the taxable year for interest charged by the lending entity to the taxpayer or a passthrough entity through which
the taxpayer holds an interest in the lending entity (the taxpayer’s deductions for interest charged by the lending entity); and(iii)
The taxpayer’s deductions for interest
charged by the lending entity include passive activity deductions.
(2) General rule. If any of the taxpayer’s deductions for interest charged by the

2002–38 I.R.B.

lending entity are allocable to an activity
for a taxable year in which this paragraph
(d) applies, the passive activity gross income and passive activity deductions from
that activity are determined under the following rules—
(i) The applicable percentage of the taxpayer’s share for the taxable year of each
item of the lending entity’s self-charged interest income is treated as passive activity gross income from the activity.
(ii) The applicable percentage of the taxpayer’s share for the taxable year of each
deduction for interest expense that is properly allocable (within the meaning of paragraph (f) of this section) to the lending
entity’s self-charged interest income is
treated as a passive activity deduction from
the activity.
(3) Applicable percentage. In applying
this paragraph (d) with respect to a taxpayer’s interest in a lending entity, the applicable percentage is separately determined
for each of the taxpayer’s activities. The
percentage applicable to an activity for a
taxable year is obtained by dividing—
(i) The taxpayer’s deductions for the taxable year for interest charged by the lending entity, to the extent treated as passive
activity deductions from the activity; by
(ii) The greater of—
(A) The taxpayer’s aggregate deductions for all activities for the taxable year
for interest charged by the lending entity
(regardless of whether these deductions are
treated as passive activity deductions); or
(B) The taxpayer’s aggregate share for
the taxable year of the lending entity’s selfcharged interest income for all activities of
the lending entity.
(e) Identically-owned passthrough
entities—(1) Applicability. Except as provided in paragraph (g) of this section, this
paragraph (e) applies with respect to lending transactions between passthrough entities if each owner of the borrowing entity
has the same proportionate ownership interest in the lending entity.
(2) General rule. To the extent an owner
shares in interest income from a loan between passthrough entities described in
paragraph (e)(1) of this section, the owner
is treated as having made the loan to the
borrowing passthrough entity and paragraph (c) of this section applies to determine the applicable percentage of portfolio
income or properly allocable interest expense that is recharacterized as passive.

545

(3) Example. The following example illustrates the application of this paragraph
(e):
Example. (i) A and B, both calendar year taxpayers, each own a 50-percent interest in the capital and
profits of partnerships RS and XY, both calendar year
partnerships. Under the partnership agreements of RS
and XY, A and B are each entitled to a 50-percent distributive share of each partnership’s income, gain, loss,
deduction, or credit. RS makes a $20,000 loan to XY
and XY pays RS $2,000 of interest for the taxable year.
A’s distributive share of interest income attributable
to this loan is $1,000 (50 percent x $2,000). XY uses
all of the proceeds received from RS in a passive activity. A’s distributive share of interest expense attributable to the loan is $1,000 (50 percent x $2,000).
(ii) This paragraph (e) applies in determining A’s
passive activity gross income because RS and XY are
identically-owned passthrough entities as described in
paragraph (e)(1) of this section. Under paragraph (e)(2)
of this section, the RS-to-XY loan is treated as if A
made the loan to XY. Therefore, A must apply paragraph (c) of this section to determine the applicable
percentage of portfolio income that is recharacterized as passive income.
(iii) Paragraph (c) of this section applies in determining A’s passive activity gross income because:
XY has deductions for interest charged to XY by RS
for the taxable year (XY’s self-charged interest deductions); A owns an interest in XY during XY’s taxable year and has gross income for the taxable year
from interest charged to XY by RS; and A’s share of
XY’s self-charged interest deductions includes passive activity deductions. See paragraph (c)(1) of this
section.
(iv) Under paragraph (c)(2)(i) of this section, the
applicable percentage of A’s interest income is recharacterized as passive activity gross income from
the activity. Paragraph (c)(3) of this section provides that the applicable percentage is obtained by dividing A’s share for the taxable year of XY’s selfcharged interest deductions that are treated as passive
activity deductions from the activity ($1,000) by the
greater of A’s share for the taxable year of XY’s selfcharged interest deductions ($1,000), or A’s income
for the year from interest charged to XY ($1,000).
Thus, A’s applicable percentage is 100 percent ($1,000/
$1,000), and $1,000 (100 percent x $1,000) of A’s income from interest charged to XY is treated as passive
activity gross income from the passive activity.

(f) Identification of properly allocable
deductions. For purposes of this section, interest expense is properly allocable to an
item of interest income if the interest expense is allocated under §1.163–8T to an
expenditure that—
(1) Is properly chargeable to capital account with respect to the investment producing the item of interest income; or
(2) May reasonably be taken into account as a cost of producing the item of interest income.
(g) Election to avoid application of the
rules of this section—(1) In general. Paragraphs (c),(d) and (e) of this section shall
not apply with respect to any taxpayer’s in-

September 23, 2002

terest in a passthrough entity for a taxable year if the passthrough entity has made,
under this paragraph (g), an election that applies to the entity’s taxable year.
(2) Form of election. A passthrough entity makes an election under this paragraph (g) by attaching to its return (or
amended return) a written statement that includes the name, address, and taxpayer identification number of the passthrough entity
and a declaration that an election is being
made under this paragraph (g).
(3) Period for which election applies. An
election under this paragraph (g) made with
a return (or amended return) for a taxable
year applies to that taxable year and all subsequent taxable years that end before the
date on which the election is revoked.
(4) Revocation. An election under this
paragraph (g) may be revoked only with the
consent of the Commissioner.
(h) Examples. The following examples
illustrate the principles of this section. The
examples assume for purposes of simplifying the presentation, that the lending transactions described do not result in foregone
interest (within the meaning of section
7872(e)(2)), original issue discount (within
the meaning of section 1273), or total unstated interest (within the meaning of section 483(b)).
Example 1. (i) A and B, two calendar year individuals, each own 50-percent interests in the capital, profits and losses of AB, a calendar year
partnership. AB is engaged in a single rental activity within the meaning of § 1.469–1T(e)(3). AB borrows $50,000 from A and uses the loan proceeds in
the rental activity. AB pays $5,000 of interest to A for
the taxable year. A and B each incur $2,500 of interest expense as their distributive share of AB’s interest expense.
(ii) AB has self-charged interest deductions for the
taxable year (i.e., the deductions for interest charged
to AB by A); A owns a direct interest in AB during
AB’s taxable year and has income for A’s taxable year
from interest charged to AB; and A’s share of AB’s
self-charged interest deductions includes passive activity deductions. Accordingly, paragraph (c) of this
section applies in determining A’s passive activity gross
income. See paragraph (c)(1) of this section.
(iii) Under paragraph (c)(2)(i) of this section, the
applicable percentage of A’s interest income is recharacterized as passive activity gross income from
AB’s rental activity. Paragraph (c)(3) of this section
provides that the applicable percentage is obtained by
dividing A’s share for the taxable year of AB’s selfcharged interest deductions that are treated as passive activity deductions from the activity ($2,500) by
the greater of A’s share for the taxable year of AB’s
self-charged interest deductions ($2,500), or A’s income for the taxable year from interest charged to AB
($5,000). Thus, A’s applicable percentage is 50 percent ($2,500/$5,000), and $2,500 (50 percent x $5,000)
of A’s income from interest charged to AB is treated

September 23, 2002

as passive activity gross income from the passive activity A conducts through AB.
(iv) Because B does not have any gross income
for the year from interest charged to AB, this section does not apply to B. See paragraph (c)(1)(ii) of
this section.
Example 2. (i) C and D, two calendar year taxpayers, each own 50-percent interests in the capital
and profits of CD, a calendar year partnership. CD is
engaged in a single rental activity, within the meaning of § 1.469–1T(e)(3). C obtains a $10,000 loan from
a third-party lender, and pays the lender $900 in interest for the taxable year. C lends the $10,000 to CD,
and receives $1,000 of interest income from CD for
the taxable year. D lends $20,000 to CD and receives $2,000 of interest income from CD for the taxable year. CD uses all of the proceeds in the rental
activity. C and D are each allocated $1,500 (50 percent x $3,000) of interest expense as their distributive share of CD’s interest expense for the taxable year.
(ii) CD has self-charged interest deductions for the
taxable year (i.e., deductions for interest charged to
CD by C and D); C and D each own direct interests
in CD during CD’s taxable year and have gross income for the taxable year from interest charged to CD;
and both C’s and D’s shares of CD’s self-charged interest deductions include passive activity deductions. Accordingly, paragraph (c) of this section applies
in determining C’s and D’s passive activity gross income. See paragraph (c)(1) of this section.
(iii) Under paragraph (c)(2)(i) of this section, the
applicable percentage of each partner’s interest income is recharacterized as passive activity gross income from CD’s rental activity. Paragraph (c)(3) of
this section provides that C’s applicable percentage is
obtained by dividing C’s share for the taxable year of
CD’s self-charged interest deductions that are treated
as passive activity deductions from the activity ($1,500)
by the greater of C’s share for the taxable year of CD’s
self-charged interest deductions ($1,500), or C’s income for the taxable year from interest charged to CD
($1,000). Thus, C’s applicable percentage is 100 percent ($1,500/$1,500), and all of C’s income from interest charged to CD ($1,000) is treated as passive
activity gross income from the passive activity C conducts through CD. Similarly, D’s applicable percentage is obtained by dividing D’s share for the taxable
year of CD’s self-charged interest deductions that are
treated as passive activity deductions from the activity ($1,500) by the greater of D’s share for the taxable year of CD’s self-charged interest deductions
($1,500), or D’s income for the taxable year from interest charged to CD ($2,000). Thus, D’s applicable
percentage is 75 percent ($1,500/$2,000), and $1,500
(75 percent x $2,000) of D’s income from interest
charged to CD is treated as passive activity gross income from the rental activity.
(iv) The $900 of interest expense that C pays to
the third-party lender is allocated under § 1.163–
8T(c)(1) to an expenditure that is properly chargeable to capital account with respect to the loan to CD.
Thus, the expense is properly allocable to the interest income C receives from CD (see paragraph (f) of
this section). Under paragraph (c)(2)(ii) of this section, the applicable percentage of C’s deductions for
the taxable year for interest expense that is properly
allocable to C’s income from interest charged to CD
is recharacterized as a passive activity deduction from
CD’s rental activity. Accordingly, all of C’s $900 in-

546

terest deduction is treated as a passive activity deduction from the rental activity.
Example 3. (i) E and F, calendar year taxpayers,
each own 50 percent of the stock of X, a calendar year
S corporation. E borrows $30,000 from X, and pays
X $3,000 of interest for the taxable year. E uses
$15,000 of the loan proceeds to make a personal expenditure (as defined in § 1.163–8T(b)(5)), and uses
$15,000 of loan proceeds to purchase a trade or business activity in which E does not materially participate (within the meaning of § 1.469–5T) for the taxable
year. E and F each receive $1,500 as their pro rata
share of X’s interest income from the loan for the taxable year.
(ii) X has gross income for X’s taxable year from
interest charged to E (X’s self-charged interest income); E owns a direct interest in X during X’s taxable year and has deductions for the taxable year for
interest charged by X; and E’s deductions for interest charged by X include passive activity deductions. Accordingly, paragraph (d) of this section applies
in determining E’s passive activity gross income. See
paragraph (d)(1) of this section.
(iii) Under the rules in paragraph (d)(2)(i) of this
section, the applicable percentage of E’s share of X’s
self-charged interest income is recharacterized as passive activity gross income from the activity. Paragraph (d)(3) of this section provides that the applicable
percentage is obtained by dividing E’s deductions for
the taxable year for interest charged by X, to the extent treated as passive activity deductions from the activity ($1,500), by the greater of E’s deductions for
the taxable year for interest charged by X, regardless of whether those deductions are treated as passive activity deductions ($3,000), or E’s share for the
taxable year of X’s self-charged interest income
($1,500). Thus, E’s applicable percentage is 50 percent ($1,500/$3,000), and $750 (50 percent x $1,500)
of E’s share of X’s self-charged interest income is
treated as passive activity gross income.
(iv) Because F does not have any deductions for
the taxable year for interest charged by X, this section does not apply to F. See paragraph (d)(1)(ii) of
this section.
Example 4. (i) This Example 4 illustrates the application of this section to a partner that has a different taxable year from the partnership. The facts are
the same as in Example 1 except as follows: Partnership AB has properly adopted a fiscal year ending June
30 for federal tax purposes; AB borrows the $50,000
from A on October 1, 1990; and under the terms of
the loan, AB must pay A $5,000 in interest annually, in quarterly installments, for a term of 2 years.
(ii) For A’s taxable years from 1990 through 1993
and AB’s corresponding entity taxable years (as defined in paragraph (b)(4) of this section) A’s interest
income and AB’s interest deductions from the loan are
as follows:
A’s Interest
Income

AB’s Interest
Deductions

1990

$1,250

0

1991

$5,000

$3,750

1992

$3,750

$5,000

1993

0

$1,250

(iii) For A’s taxable year ending December 31,
1990, the corresponding entity taxable year is AB’s
taxable year ending June 30, 1990. Because AB does
not have any deductions for the entity taxable year for

2002–38 I.R.B.

interest charged to AB by A, paragraph (c) of this section does not apply in determining A’s passive activity gross income for 1990 (see paragraph (c)(1)(i) of
this section). Accordingly, A reports $1,250 of portfolio income on A’s 1990 income tax return.
(iv) For A’s taxable year ending December 31,
1991, the corresponding entity taxable year ends on
June 30, 1991. AB has $3,750 of deductions for the
entity taxable year for interest charged to AB by A
(AB’s self-charged interest deductions); A owns a direct interest in AB during the entity taxable year and
has $5,000 of interest income for A’s taxable year from
interest charged to AB; and A’s share of AB’s selfcharged interest deductions includes passive activity
deductions. Accordingly, paragraph (c) of this section applies in determining A’s passive activity gross
income.
(v) Under paragraph (c)(2)(i) of this section, the
applicable percentage of A’s 1991 interest income is
recharacterized as passive activity gross income from
the activity. Paragraph (c)(3) of this section provides that the applicable percentage is obtained by dividing A’s share for A’s 1991 taxable year of AB’s selfcharged interest deductions that are treated as passive
activity deductions from the activity (50 percent x
$3,750 = $1,875) by the greater of A’s share for A’s
taxable year of AB’s self-charged interest deductions ($1,875), or A’s income for A’s taxable year from
interest charged to AB ($5,000). Thus, A’s applicable percentage is 37.5 percent ($1,875/$5,000), and
$1,875 (37.5 percent x $5,000) of A’s income from
interest charged to AB is treated as passive activity
gross income from the passive activity A conducts
through AB.
(vi) For A’s taxable year ending December 31,
1992, the corresponding entity taxable year ends on
June 30, 1992. AB has $5,000 of deductions for the
entity taxable year for interest charged to AB by A
(AB’s self-charged interest deductions); A owns a direct interest in AB during the entity taxable year and
has $3,750 of gross income for A’s taxable year from
interest charged to AB; and A’s share of AB’s selfcharged interest deductions includes passive activity
deductions. Accordingly, paragraph (c) of this section applies in determining A’s passive activity gross
income.
(vii) The applicable percentage for 1992 is obtained by dividing A’s share for A’s 1992 taxable year
of AB’s self-charged interest deductions that are treated
as passive activity deductions from the activity ($2,500)
by the greater of A’s share for A’s taxable year of AB’s
self-charged interest deductions ($2,500), or A’s income for A’s taxable year from interest charged to AB
($3,750). Thus, A’s applicable percentage is 66 2/3 percent ($2,500/$3,750), and $2,500 (66 2/3 percent x
$3,750) of A’s income from interest charged to AB is
treated as passive activity gross income from the passive activity A conducts through AB.
(viii) Paragraph (c) of this section does not apply in determining A’s passive activity gross income
for the taxable year ending December 31, 1993, because A has no gross income for the taxable year from
interest charged to AB (see paragraph (c)(1)(ii) of this
section). A’s share of AB’s self-charged interest deductions for the entity taxable year ending June 30,
1993 ($625) is taken into account as a passive activity deduction on A’s 1993 income tax return.
(ix) Because B does not have any gross income
from interest charged to AB for any of the taxable

2002–38 I.R.B.

years, this section does not apply to B. See paragraph (c)(1)(ii) of this section.
Example 5. (i) This Example 5 illustrates the application of the rules of this section in the case of a
taxpayer who has an indirect interest in a partnership. G, a calendar year taxpayer, is an 80-percent partner in partnership UTP. UTP owns a 25-percent interest
in the capital and profits of partnership LTP. UTP and
LTP are both calendar year partnerships. The partners of LTP conduct a single passive activity through
LTP. UTP obtains a $10,000 loan from a bank, and
pays the bank $1,000 of interest per year. G’s distributive share of the interest paid to the bank is $800
(80 percent x $1,000). UTP uses the $10,000 debt proceeds and another $10,000 of cash to make a loan to
LTP, and LTP pays UTP $2,000 of interest for the taxable year. G’s distributive share of interest income attributable to the UTP-to-LTP loan is $1,600 (80 percent
x $2,000). LTP uses all of the proceeds received from
UTP in the passive activity. UTP’s distributive share
of interest expense attributable to the UTP-to-LTP loan
is $500 (25 percent x $2,000). G’s distributive share
of interest expense attributable to the UTP-to-LTP loan
is $400 (80 percent x $500).
(ii) LTP has deductions for interest charged to LTP
by UTP for the taxable year (LTP’s self-charged interest deductions); G owns an indirect interest in LTP
during LTP’s taxable year and has gross income for
the taxable year from interest charged to LTP by a
passthrough entity (UTP) through which G owns an
interest in LTP; and G’s share of LTP’s self-charged
interest deductions includes passive activity deductions. Accordingly, paragraph (c) of this section applies in determining G’s passive activity gross income.
See paragraph (c)(1) of this section.
(iii) Under paragraph (c)(2)(i) of this section, the
applicable percentage of G’s interest income is recharacterized as passive activity gross income from
the activity. Paragraph (c)(3) of this section provides that the applicable percentage is obtained by dividing G’s share for the taxable year of LTP’s selfcharged interest deductions that are treated as passive
activity deductions from the activity ($400) by the
greater of G’s share for the taxable year of LTP’s selfcharged interest deductions ($400), or G’s income for
the year from interest charged to LTP ($1,600). Thus,
G’s applicable percentage is 25 percent ($400/$1,600),
and $400 (25 percent x $1,600) of G’s income from
interest charged to LTP is treated as passive activity
gross income from the passive activity that G conducts through UTP and LTP.
(iv) G’s $800 distributive share of the interest expense that UTP pays to the third-party lender is allocated under § 1.163–8T(c)(1) to an expenditure that
is properly chargeable to capital account with respect to the loan to LTP. Thus, the expense is a deduction properly allocable to the interest income that
G receives as a result of the UTP-to-LTP loan (see
paragraph (f) of this section). Under paragraph (c)(2)(ii)
of this section, the applicable percentage of G’s deductions for the taxable year for interest expense that
is properly allocable to G’s income from interest
charged by UTP to LTP is recharacterized as a passive activity deduction from LTP’s passive activity. Accordingly, $200 (25 percent x $800) of G’s interest
deduction is treated as a passive activity deduction
from LTP’s activity.
Example 6. (i) This Example 6 illustrates the application of the rules of this section in the case of a
taxpayer who conducts two passive activities through

547

a passthrough entity. J, a calendar year taxpayer, is the
100-percent shareholder of Y, a calendar year S corporation. J conducts two passive activities through Y:
a rental activity and a trade or business activity in
which J does not materially participate. Y borrows
$80,000 from J, and uses $60,000 of the loan proceeds in the rental activity and $20,000 of the loan
proceeds in the passive trade or business activity. Y
pays $8,000 of interest to J for the taxable year, and
J incurs $8,000 of interest expense as J’s distributive share of Y’s interest expense.
(ii) Y has self-charged interest deductions for the
taxable year (i.e., the deductions for interest charged
to Y by J); J owns a direct interest in Y during Y’s
taxable year and has gross income for J’s taxable year
from interest charged to Y; and J’s share of Y’s selfcharged interest deductions includes passive activity
deductions. Accordingly, paragraph (c) of this section applies in determining J’s passive activity gross
income. See paragraph (c)(1) of this section.
(iii) Under paragraph (c)(2)(i) of this section, the
applicable percentage of J’s interest income is recharacterized as passive activity gross income attributable to the rental activity. Paragraph (c)(3) of this
section provides that the applicable percentage is obtained by dividing J’s share for the taxable year of Y’s
self-charged interest deductions that are treated as passive activity deductions from the rental activity
($6,000) by the greater of J’s share for the taxable year
of Y’s self-charged interest deductions ($8,000), or J’s
income for the taxable year from interest charged to
Y ($8,000). Thus, J’s applicable percentage is 75 percent ($6,000/$8,000), and $6,000 (75 percent x $8,000)
of J’s income from interest charged to Y is treated as
passive activity gross income from the rental activity J conducts through Y.
(iv) Under paragraph (c)(2)(i) of this section, the
applicable percentage of J’s interest income is recharacterized as passive activity gross income attributable to the passive trade or business activity. Paragraph
(c)(3) of this section provides that the applicable percentage is obtained by dividing J’s share for the taxable year of Y’s self-charged interest deductions that
are treated as passive activity deductions from the passive trade or business activity ($2,000) by the greater
of J’s share for the taxable year of Y’s self-charged
interest deductions ($8,000), or J’s income for the taxable year from interest charged to Y ($8,000). Thus,
J’s applicable percentage is 25 percent ($2,000/$8,000),
and $2,000 of J’s income from interest charged to Y
is treated as passive activity gross income from the
passive trade or business activity J conducts through
Y.

Par. 4. Section 1.469–11 is amended as
follows:
1. Paragraph (a)(3) is amended by removing the language “and” at the end of
the paragraph.
2. Paragraph (a)(4) is redesignated as
paragraph (a)(5) and a new paragraph (a)(4)
is added.
3. The paragraph headings for (c)(1) and
(c)(1)(i) are revised.
4. Paragraph (c)(1)(iii) is added.
5. The added and revised provisions read
as follows:

September 23, 2002

§ 1.469–11 Effective date and transition
rules.
(a) * * *
(4) The rules contained in § 1.469–7 apply for taxable years ending after December 31, 1986; and
*****
(c) * * *
(1) Application of certain income recharacterization rules and self-charged
rules—(i) Certain recharacterization rules
inapplicable in 1987.* * *
*****

(iii) Self-charged rules. For taxable years
beginning before June 4, 1991—
(1) A taxpayer is not required to apply
the rules in § 1.469–7 in computing the taxpayer’s passive activity loss and passive activity credit; and
(2) A taxpayer that owns an interest in
a passthrough entity may use any reasonable method of offsetting items of interest income and interest expense from
lending transactions between the
passthrough entity and its owners or between identically-owned passthrough entities (as defined in § 1.469–7(e)) to
compute the taxpayer’s passive activity loss
and passive activity credit. Items from nonlending transactions cannot be offset under the self-charged rules.

*****
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 5. The authority citation for the part
602 continues to read:
Authority: 26 U.S.C. 7805.
Par. 6. In § 602.101, paragraph (b) is
amended by adding the following entry in
numerical order to the table to read as
follows:
§ 602.101 OMB Control Numbers.
*****
(b) * * *

CFR part or section where identified
and described

Current OMB
control number

*****
1.469–7 ................................................................................................................................................................

1545–1244

*****
Robert E Wenzel,
Deputy Commissioner
of Internal Revenue.
Approved July 31, 2002.
Pamela F. Olson,
Acting Assistant Secretary
of the Treasury.
(Filed by the Office of the Federal Register on August 20,
2002, 8:45 a.m., and published in the issue of the Federal Register for August 21, 2002, 67 F.R. 54087)

Section 6321.—Lien for Taxes
Ct. D. 2075
SUPREME COURT OF THE
UNITED STATES
No. 00–1831
UNITED STATES v. CRAFT
CERTIORARI TO THE
UNITED STATES COURT
OF APPEALS FOR
THE SIXTH CIRCUIT
April 17, 2002
Syllabus
When respondent’s husband failed to pay
federal income tax liabilities assessed
against him, a federal tax lien attached to
“all [of his] property and rights to property.” 26 U.S.C. Sec. 6321. After the notice of the lien was filed, respondent and
her husband jointly executed a quitclaim
deed purporting to transfer to her his interest in a piece of real property in Michigan that they owned as tenants by the
entirety. Subsequently the Internal Rev-

September 23, 2002

548

enue Service (IRS) agreed to release the lien
and allow respondent to sell the property
with half the net proceeds to be held in escrow pending determination of the Government’s interest in the property. She
brought this action to quiet title to the escrowed proceeds. The Government claimed,
among other things, that its lien had attached to the husband’s interest in the tenancy by the entirety. The District Court
granted the Government summary judgment, but the Sixth Circuit held that no lien
attached because the husband had no separate interest in the entireties property under Michigan law, and remanded the case
for consideration of an alternative claim not
at issue here. In affirming the District
Court’s decision on remand, the Sixth Circuit held that its prior opinion on the issue whether the lien attached to the
husband’s entireties property was the law
of the case.
Held: the husband’s interests in the entireties property constitute “property” or
“rights to property” to which a federal tax
lien may attach. Pp. 3–15.
(a) Because the federal tax lien statute itself creates no property rights, UnitedStates v. Bess, 357 U.S. 51, 55, this Court
looks initially to state law to determine what

2002–38 I.R.B.