Par. 2. Section 1.475-0 is added to read as follows:
(a) Overview. This section provides rules for taking into account interest accruals and gain and loss on a debt instrument to which section 475(a) applies. Paragraph (b) of this section clarifies that the mark-to-market computation affects neither the amount treated as interest earned from a debt instrument nor the taxable year in which that interest is taken into account. Paragraph (c) of this section prescribes general rules. Paragraph (d) of this section prescribes additional rules for instruments acquired with market discount. Paragraph (e) of this section provides rules for taking into account market discount that accrued on a bond before the bond became subject to the mark-to-market requirements. Paragraph (f) of this section prescribes rules for computing the mark-to-market gain or loss on partially or wholly worthless debts, and paragraph (g) provides rules for dealers accounting for bad debts using a reserve method of accounting.
(b) No effect on amount of market discount, acquisition premium, or bond premium. Marking a debt instrument to market does not create, increase, or reduce market discount, acquisition premium, or bond premium, nor does it affect the adjusted issue price of, or accruals of original issue discount (OID) on, a bond issued with OID.
(c) Accrual of interest, discount, and premium. In general, the amount of gain or loss from marking a debt instrument to market is computed after adjustments to basis for accruals of stated interest, discount, and premium.
(1) Qualified stated interest. Immediately before a debt instrument is marked to market under section 475(a), the holder of the instrument must take any unpaid accrued qualified stated interest into account and must correspondingly increase the basis of the instrument. The holder must later decrease the basis of the instrument when accrued qualified stated interest is actually received. (See Sec. 1.1273-1(c) for the definition of qualified stated interest and Sec. 1.446-2(b) for the rule governing its accrual.)
(2) General rule regarding accrual of discount. If a bond that was acquired with OID or market discount is marked to market under section 475(a), then, immediately before the bond is marked to market, the discount accrued through that date (determined under section 1272, 1275(d), or 1276, as applicable) is included in gross income, to the extent not previously included, and the bond's basis is correspondingly increased for amounts so included. (Because accrued OID is determined under all of the rules of section 1272 and the regulations thereunder, it is computed taking into account the reduction for acquisition premium that is required by section 1272(a)(7).) See paragraph (d) of this section, which requires the current inclusion in income of market discount on bonds marked to market. See paragraph (e) of this section for exceptions, and additional rules, for market discount bonds that become subject to section 475(a) after acquisition.
(3) Bond premium. If a debt instrument that is subject to the basis adjustment required by section 1016(a) (5) or (6) is marked to market under section 475(a), then, immediately before the debt instrument is marked to market, the required basis adjustment must be made. Accordingly, the mark-to-market adjustment is computed after the basis of the debt instrument has been adjusted under section 1016(a) (5) or (6) for disallowed amortizable bond premium (in the case of tax-exempt bonds) or deductible bond premium (in the case of taxable bonds). If an election under section 171(c) is made after the first taxable year in which section 475(a) applies to the bond, the amount of bond premium is determined under section 171(b)(1) without regard to any basis adjustments that may have been required as a result of the bond being marked to market in prior taxable years. See paragraph (b) of this section for the rule that marking a debt instrument to market does not affect bond premium.
(d) Mandatory current inclusion of market discount--(1) General rule. If section 475(a) applies to a bond during any portion of a taxable year, gross income for that taxable year includes the market discount attributable to the portion of the year to which section 475(a) applies (as determined under section 1276(b)). Section 1276 does not apply to the bond except with respect to market discount, if any, that accrued before the bond became subject to section 475(a). Similarly, section 1277 does not apply to the bond except with respect to any net direct interest expense (as defined in section 1277(c)) that accrued before the bond became subject to section 475(a). See paragraph (e) of this section for additional rules governing this situation. For purposes of the Code other than the purposes described in the last sentence of section 1278(b)(1), any amount included in gross income under this paragraph (d)(1) is treated as interest. The bond's basis is correspondingly increased for any amount so included in gross income.
(2) Interaction with section 1278(b). Paragraph (d)(1) of this section applies to a dealer, even if the dealer has not elected under section 1278(b) to include market discount currently. If the dealer has not made that election, however, this paragraph (d) does not require current inclusion of market discount on any bond to which section 475(a) does not apply. [[Page 403]]
(e) Recognition of market discount that accrued before section 475(a) applies to a market discount bond--(1) General rule. In the case of a debt instrument that is acquired with market discount, that is not subject to an election under section 1278(b), and that first becomes subject to section 475(a) in the taxpayer's hands on a date after its acquisition, this paragraph (e) governs the recognition of market discount that is attributable (as determined under section 1276(b)) to any period before section 475(a) applies to the debt instrument. To the extent that the market discount described in the preceding sentence is greater than the excess, if any, of the fair market value of the debt instrument at the time it became subject to section 475(a) over its adjusted basis at that time, section 1276(a)(1) applies to any gain recognized under section 475(a). To the extent of any remaining market discount that had accrued before section 475(a) became applicable, section 1276(a) applies no later than it would have applied if section 475(a) did not apply to the bond. For example, section 1276(a) applies to the previously accrued market discount as partial principal payments are made. Except as provided in the preceding sentences, gain recognized under section 475(a) is not recharacterized as interest by section 1276(a).
(2) Examples. The rules of paragraphs (d) and (e) of this section are illustrated by the following examples:
Example 1.
(i) Facts. Bond X was issued on January 1, 1996, for $1,000. Bond X matures on December 31, 2005, provides for a principal payment of $1,000 on the maturity date, and provides for interest payments at a rate of 8%, compounded annually, on December 31 of each year. D is a dealer in securities within the meaning of section 475(c)(1). On January 1, 1997, D purchased bond X for $955. D had not elected under section 1278(b) to include market discount in gross income currently. Under section 475(b), section 475(a) did not apply to bond X until January 1, 1999, at which time bond X had a fair market value of $961. On December 31, 1999, bond X had a fair market value of $980.
(ii) Holdings. In the absence of an election under section 1276(b)(2), market discount on bond X accrues under section 1276(b)(1) at the rate of $5 per year. On January 1, 1999, when bond X became subject to section 475(a), $10 of market discount had accrued, but the excess of the bond's fair market value on January 1, 1999, over its adjusted basis on that date (the built-in gain) was only $6 ($961--$955). During 1999, D is required to include as interest income the $5 of market discount that accrues during that year, and D increases by that amount its basis in the bond and the amount to be used in computing mark-to-market gain or loss. On December 31, 1999, B must mark bond X to market and recognize a gain of $14 ($980--[$961 + $5]). Under section 1276(a)(1) and (4) and paragraph (e)(1) of this section, $4 of that $14 gain is treated as interest income. The $4 is the amount by which the market discount of $10 that had accrued on January 1, 1999, exceeded the $6 built-in gain on that date.
Example 2.
(i) Facts. The facts are the same as in Example 1, except that, in addition, D sells bond X for its fair market value of $1,000 on June 30, 2000.
(ii) Holdings. Immediately before the sale, D is required to include as interest income the $2.50 of market discount that accrued during the portion of the year through June 30, and D increases by that amount its basis in the bond and the amount to be used in computing mark-to-market gain or loss. Also, under Sec. 1.475(a)-2, immediately before the sale, D recognizes $17.50 of mark-to-market gain (the increase in value since the preceding mark to market, less the basis increase of $2.50 from the market discount accrual. See Sec. 1.475(a)-2). On the sale, D also recognizes the $6 of built-in gain, all of which is recharacterized as ordinary interest income under section 1276(a)(4).
Example 3.
(i) Facts. The facts are the same as in Example 1, except that, during 2001, the issuer of bond X made a partial principal payment in the amount of $20.
(ii) Holdings. Under paragraph (e)(1) of this section and section 1276(a)(4), $6 of the partial principal payment is included in D's 2001 income as interest income. The $6 is the portion of the $10 of market discount that had accrued at the time bond X became subject to section 475(a) and that had not previously caused gain or a partial principal payment to be treated as interest income.
(f) Worthless debts--(1) Computation of mark-to-market gain or loss. This paragraph (f) applies to any dealer that, under section 475(a)(2), marks to market either a debt that was charged off during the year because it became partially worthless or a debt that became wholly worthless during the taxable year (without regard to whether the debt was charged off). Any gain or loss attributable to marking a debt to market is determined by deeming the debt's adjusted basis to be the debt's adjusted basis under Sec. 1.1011-1, less the amount charged off during the taxable year or during any prior taxable year, to the extent that amount has not previously reduced tax basis. A debt that becomes wholly worthless is deemed to have an adjusted basis of zero. The deemed adjusted basis, however, is used solely for this paragraph (f). Thus, any portion of a loss attributable to a bad debt continues to be accounted for under the bad debt provisions of the Code, and the basis of the debt continues to be adjusted as otherwise required under the Code.
(2) Treatment of mark-to-market gain or loss. To the extent that a debt has been previously charged off, mark-to-market gain is treated as a recovery. Thus, for example, a dealer using the section 585 reserve method of accounting for bad debts must credit to the reserve any portion of mark-to-market gain that is treated as a recovery of a bad debt previously charged to the reserve account, and the dealer must include any excess in gross income as required by Sec. 1.585-3(a). Similarly, if a dealer is a large bank that changed to the specific charge-off method of accounting for bad debts using the elective cut- off procedures described in Sec. 1.585-7, the dealer must charge to the reserve for pre-disqualification loans all losses recognized as a result of marking to market a debt that is a pre-disqualification loan within the meaning of Sec. 1.585-7(b)(2). Marking a pre- disqualification loan to market, however, is not a disposition of that loan under Sec. 1.585-7(d).
(g) Additional rules applicable to reserve-method taxpayers. If a dealer accounts for bad debts using the reserve method of accounting under section 585 or 593, the following additional rules apply in computing a reasonable addition to a reserve--
(1) To determine the amount of total loans outstanding, the outstanding balance on a debt that is marked to market is increased or decreased by the amount of any mark-to-market gain or loss recognized, except that the outstanding balance of the debt may never exceed the actual balance currently due; and
(2) If the reasonable addition to the reserve is computed based on a percentage of taxable income, any gain or loss attributable to marking a debt to market must be taken into account in computing taxable income.
(h) Example. This example illustrates paragraphs (f) and (g) of this section.
Example.
(i) B, a calendar year taxpayer, is a dealer that marks some of its debts to market under section 475(a)(2). Additionally, B is a bank that accounts for bad debts using the section 585 reserve method of accounting. B has not made an election to use the conformity method of accounting described in Sec. 1.166-2(d)(3).
(ii) On December 31, 1995, B has total loans outstanding of $1,000,000 and a bad debt reserve balance of $1000. Among the loans that B marks to market is loan X. On January 1, 1995, loan X had a book and tax basis of $100. During the taxable year, loan taxable became partially worthless, and B charged off the loan by $5. Thus, loan X had a book basis of $95 and a tax basis of $100. The fair market value of loan X was $94 on December 31, 1995.
(iii) B computes the amount of gain or loss to be taken into account under section [[Page 404]] 475(a)(2) with respect to loan X using the rules of paragraph (f) of this section. Under paragraph (f)(1) of this section, B treats the adjusted tax basis of loan X as having been reduced by the $5 charge-off. Thus, B determines that it is required to take into account a $1 mark-to-market loss based on the difference between B's adjusted basis in loan X of $95, as determined under paragraph (f)(1) of this section, and loan X's fair market value of $94.
(iv) Further, B decides to claim a bad debt deduction with respect to loan X in 1995, rather than waiting until loan X becomes totally worthless. Thus, B charges the $5 of partial worthlessness to its reserve for bad debts. In computing a reasonable addition to the reserve under section 585(b), B reduces the amount of its total loans outstanding by $6 ($5 charged to the reserve for bad debts, plus $1 mark-to-market loss).
(v) On December 31, 1997, loan X has a fair market value of $93 and an adjusted basis (and outstanding principal balance) of $90. No additional worthlessness occurred with respect to loan X in 1996 or 1997. B determines that it is required to recognize a $3 mark-to- market gain with respect to loan X. Because B previously charged $5 to the bad debt reserve with respect to loan X, the entire $3 is a recovery item and must be credited to the bad debt reserve. See paragraph (f)(2) of this section. In computing a reasonable addition to the reserve for 1997, B does not increase the balance of its total loans outstanding by the $3 mark-to-market gain, because that adjustment would increase the balance to an amount in excess of the actual outstanding principal balance of $90. See paragraph (g)(1) of this section.