IRS Issues Guidance On New Capital Gains Rules For RICs And REITs.

Notice 97-64

SECTION 1. PURPOSE

[1] This notice describes temporary regulations that will be issued under section 1(h) of the Internal Revenue Code, effective for taxable years ending on or after May 7, 1997, and provides guidance that regulated investment companies ("RICs"), real estate investment trusts ("REITs"), and their shareholders must use in applying section 1(h) until further guidance is issued.

SECTION 2. BACKGROUND

[2] For individuals, estates, and trusts, section 1(h), as amended by the Taxpayer Relief Act of 1997 (the "1997 Act"), Pub. L. No. 105-34, 111 Stat. 788, imposes differing rates of tax on various transactions giving rise to long-term capital gains or losses. For transactions taken into account during taxable years ending on or after May 7, 1997, a taxpayer's long-term capital gains and losses are separated into three tax rate groups: a 20-percent group, a 25- percent group, and a 28-percent group. See Notice 97-59, 1997-45 I.R.B. 7.

[3] The Secretary has authority to issue regulations concerning the application of section 1(h) to long-term gains from sales or exchanges by (or of interests in) pass-through entities, including RICs and REITs.

[4] To the extent that a RIC or a REIT has net capital gain for a taxable year, dividends that it pays during the year (or that it is deemed to pay during the year under section 855, section 858, or section 860) may be designated by it as capital gain dividends. In general, a capital gain dividend is treated by the shareholders as a gain from the sale or exchange of a capital asset held for more than one year.

SECTION 3. BASIC DESIGNATION RULE

[5] Subject to the limitations in section 5, if a RIC or REIT designates a dividend as a capital gain dividend for a taxable year ending on or after May 7, 1997, it may also designate the dividend as a 20% rate gain distribution, an unrecaptured section 1250 gain distribution, or a 28% rate gain distribution. If no additional designation is made regarding a capital gain dividend, it is a 28% rate gain distribution. If a dividend was designated as a capital gain dividend in a written notice mailed to shareholders on or before December 31, 1997, the additional designations permitted by this paragraph may be effected by a written notice, mailed to all shareholders not later than February 2, 1998.

[6] If any capital gain dividend is received on or after May 7, 1997, but is treated under section 855, section 858, or section 860 as being paid during a taxable year that ends on or before that date, the dividend is a 28% rate gain distribution.

[7] For purposes of this notice, a designation of undistributed capital gains under section 852(b)(3)(D) or section 857(b)(3)(D) is considered to be the designation of a dividend as a capital gain dividend.

SECTION 4. SHAREHOLDER TREATMENT OF CAPITAL GAIN DIVIDENDS

[8] A capital gain dividend received from a RIC or REIT in a taxable year of the shareholder ending on or after May 7, 1997, is treated as follows:

.01 A 20% rate gain distribution is an amount of long-term capital gain in the 20-percent group;

.02 An unrecaptured section 1250 gain distribution is an amount of long-term capital gain in the 25-percent group; and

.03 A 28% rate gain distribution is an amount of long-term capital gain in the 28-percent group.

SECTION 5. LIMITATIONS ON DESIGNATIONS OF CAPITAL GAIN DIVIDENDS

[9] Additional designations of capital gain dividends for a taxable year are effective only to the extent that they do not exceed the limitations stated below and only to the extent that they comply with the principles of Rev. Rul. 89-81, 1989-1 C.B. 226, which requires that distributions made to different classes of shares not be composed disproportionately of dividends of a particular type. Designations of capital gain dividends must also comply with section 852(b)(3)(C) or section 857(b)(3)(C) (as appropriate), which make designations ineffective to the extent they exceed the net capital gain for the year.

[10] Subject to a deferral adjustment or bifurcation adjustment discussed in section 6, a RIC or REIT determines the maximum amounts which may be designated in each class of capital gains dividends by performing the computation required by section 1(h) as if the RIC or REIT were an individual whose ordinary income is subject to a marginal tax rate of at least 28 percent. Then, the maximum distributable 20% rate gain is equal to the amount multiplied by 20% in performing that computation and the maximum distributable unrecaptured section 1250 gain is equal to the amount multiplied by 25% in performing that computation. The maximum distributable 28% rate gain is the net capital gain minus the amount of unrecaptured section 1250 gain distributions and 20% rate gain distributions that have been properly designated. For example, if a RIC has net capital gain in the tax year of $100, of which $60 would be multiplied by 20% and $5 would be multiplied by 25% in performing the computations required by section 1(h), then the maximum distributable 20% rate gain is $60 and the maximum unrecaptured section 1250 gain is $5. If the RIC properly designates the maximum permissible unrecaptured section 1250 gain distribution and 20% rate gain distribution, then the RIC's maximum distributable 28% rate gain is $35; i.e., the net capital gain of $100 less the properly designated unrecaptured section 1250 gain distribution of $5 and 20% rate gain distribution of $60.

SECTION 6. DEFERRAL ADJUSTMENT AND BIFURCATION ADJUSTMENT

[11] The adjustment (a deferral adjustment) required by section 852(b)(3)(C) and section 1.852-11(e) for a RIC with post-October capital losses or by section 857(b)(3)(C) for a fiscal year REIT with post-December capital losses must be made before calculating the limitations on the various classes of capital gain dividends for the RIC's or REIT's taxable year. The deferral adjustment is disregarded in determining the group in which any deferred gain or loss belongs, however, if the group depends on whether an item of gain or loss is taken into account before May 7, 1997, after July 28, 1997, or between those dates. For example, if a RIC's sale of a capital asset held for 19 months occurs before May 7, 1997, but is treated under section 852(b)(3)(C) and section 1.852-11(e) as arising after that date, the sale gives rise to capital gain in the 28-percent group.

[12] A RIC or REIT must make the bifurcation adjustment described in the next paragraph if: (1) its taxable year is not the period used to determine capital gain net income for purposes of the excise tax imposed by section 4982 or section 4981 (that is, it is a RIC with a taxable year that does not end on October 31 and that has not made an election under section 4982(e)(4) or it is a REIT whose taxable year is not the calendar year); (2) it has a net capital gain during the pre-November (for a RIC) or pre-January (for a REIT) portion of its taxable year; and (3) it is not required to make the deferral adjustment.

[13] If a RIC or REIT is required to make a bifurcation adjustment, it must calculate the maximum distributable 20% rate gain and the maximum distributable unrecaptured section 1250 gain separately for the pre-November (pre-January for REITs) portion of the year and for the post-October (post-December for REITs) portion of the year, as if the two portions of the year were separate taxable years. Then, the maximum distributable 20% rate gain and the maximum distributable unrecaptured section 1250 gain for the taxable year equals the sum of the maximum distributable amounts for gains in that group determined for each portion of the year.

SECTION 7. EXAMPLES

(1) Example 1.

[14] RIC X's taxable year ends on July 31. RIC X has only the following capital gains and losses for the periods indicated:

 _____________________________________________________________________

(2) Example 2.

[16] RIC Y's taxable year ends on July 31. RIC Y has only the following capital gains and losses for the periods indicated:

 _____________________________________________________________________

SECTION 8. SECTION 1202 GAIN

[17] In the future, RICs may recognize gain from the sale or exchange of qualified small business stock held for more than 5 years that may be distributed to shareholders subject to certain limitations provided by section 1202(g). It is expected that the temporary regulations will provide guidance on how RICs may designate dividends as "section 1202 gain distributions." This guidance is expected to provide that: (1) section 1202 gain distributions will be designated separately for different issuers of qualified small business stock; (2) the exclusion from income permitted by section 1202 will be determined at the shareholder level not the RIC level; and (3) the maximum distributable section 1202 gain for each issuer will be calculated separately from limitations on all other classes of capital gain dividends but in the aggregate will not exceed the RIC's net capital gain.

SECTION 9. USE OF SUBSTITUTE FORMS 1099-DIV FOR 1997

[18] The rules set forth in this section and in section 10 previously have been published in Announcement 97-109, 1997-45 I.R.B. 12.

[19] RICs, REITs, brokers, and others reporting capital gain distributions on the 1997 Form 1099-DIV must provide additional information with their statements to recipients. Payers must continue to report the total capital gain distributions in box 1c. Payers should also advise recipients that they cannot report capital gain distributions on Form 1040, line 13, as stated in the official 1997 Form 1099-DIV. Rather, they must report the distributions on Schedule D (Form 1040), line 13, column (f).

[20] In addition, payers must provide to recipients information sufficient to determine the following:

.01 The amount of 28% rate gain distributions. Payers should advise recipients to report this amount on Schedule D (Form 1040), line 13, column (g).

.02 The amount of unrecaptured section 1250 gain distributions. Payers should advise recipients to report this amount on Schedule D (Form 1040), line 25.

[21] Payers may provide this additional information to recipients on a substitute statement or on a separate statement. Payers are not required to report the additional information to the IRS.

SECTION 10. USE OF SUBSTITUTE FORMS 2439 FOR 1996-1997

[22] RICs and other filers completing the 1996 Form 2439 for fiscal years ending after May 6, 1997, must provide additional information with their notices to shareholders. Filers must continue to report the total undistributed long-term capital gains for the year on line 1 of Form 2439. Filers should also advise individual shareholders that they cannot report the amount on line 1 on Schedule D (Form 1040), Part II, line 12, as stated in the official 1996 Form 2439 instructions. Rather, they must report the amount on line 1 on the 1997 Schedule D (Form 1040), line 11, Column (f).

[23] In addition, filers must provide to shareholders information sufficient to determine the following:

.01 The amount of 28% rate gain included on line 1 of Form 2439. Filers should advise recipients to report this amount on Schedule D (Form 1040), line 11, column (g).

.02 The amount of unrecaptured section 1250 gain included on line 1 of Form 2439. Filers should advise recipients to report this amount on Schedule D (Form 1040), line 25.

[24] Filers may provide this additional information to shareholders on a substitute statement or on a separate statement. Filers are not required to report this additional information on Forms 2439 filed with the IRS.

SECTION 11. SUBMISSION OF COMMENTS

[25] Comment are requested on the subject matter of this notice and, additionally, on the proper treatment of a loss on the sale of a RIC or REIT share held for six months or less that is recharacterized under section 852(b)(4)(A) or section 857(b)(7) as a long-term capital loss. Taxpayers may submit comments to: CC:DOM:CORP:R (OGI- 117972-97), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20022. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (OGI-117972-97), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the "Tax Regs" option of the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.ustreas.gov/prod/tax_regs/ comments.html. Comments will be available for public inspection.

SECTION 12. PAPERWORK REDUCTION ACT

[26] The collections of information contained in this notice have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1565.

[27] 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 OMB control number.

[28] The collections of information in this notice are in sections 3, 9 and 10. This information is required to permit RIC and REIT shareholders to properly report income following the amendment of section 1(h) by the 1997 Act. The information collected will be used by RIC and REIT shareholders reporting income. The collection of information is mandatory. The likely respondents are businesses and other for-profit institutions.

[29] The burden for the collections of information in section 3 is as follows:

[30] The estimated total annual reporting and/or recordkeeping burden is 1500 hours.

[31] The estimated annual burden per respondent varies from 1/4 hour to 10 hours, depending on individual circumstances, with an estimated average of 1/2 hour. The estimated number of respondents is 3,000.

[32] The estimated annual frequency of responses is annually.

[33] The burden for the collection of information in sections 9 and 10 is reflected in the burden for Form 1099-DIV and Form 2439.

[34] Books or records relating to a 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.

DRAFTING INFORMATION

[35] The principal author of this notice is Kenneth Christman of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this notice contact Kenneth Christman on (202) 622-3950 (not a toll-free call).