Subpart A.-Income Taxes Chapter 1.-Normal Taxes and Surtaxes Section 38.-Investment in Certain Depreciable Property 26 CFR 1.38-1: Investment in certain depreciable property. Whether an aircraft used for testing by the manufacturer to obtain required federal certification prior to delivery is new section 38 property when placed in service by the purchaser. See Rev. Rul. 78-433, page 121. Section 43.-Earned Income Earned income credit; net earnings from self-employment. Earned income, for purposes of the earned income credit under section 43 of the Code, includes the amount properly reported on Schedule SE as net earnings from self-employment by a taxpayer who earned no net income but qualified for the election to treat $1,600.00 as earned income under section 1402(a). Rev. Rul. 78-313 ISSUE Is a farmer considered to have "earned income" for purposes of the earned income credit under section 43 of the Internal Revenue Code of 1954, when there is no actual net income? FACTS A farmer, who is otherwise eligible for the earned income credit, received $20,000 in gross income from farm operations. However, for the taxable year the farmer sustained a net loss of $5,000. The farmer had no other income that year. Since the gross income from farming was more than $2,400, the farmer exercised the option available in section 1402 (a) of the Code to deem net earnings from self-employment to be $1,600. LAW AND ANALYSIS Section 43(a) of the Code provides that for certain taxable years an eligible individual shall be allowed a refundable credit against tax of an amount equal to ten percent of so much of the individual's earned income for the year as does not exceed $4,000. The amount of the credit allowable to an eligible individual shall be reduced (but not below zero) by an amount equal to ten percent of so much of the individual's adjusted gross income (or, if greater, the earned income) for the taxable year as exceeds $4,000. Section 43 (c) (2) (A) of the Code defines earned income as wages, salaries, tips and other employee compensation, plus the amount of the taxpayer's net earnings from self-employment for the taxable year within the meaning of section 1402(a). Section 1402 (a) of the Code provides that in the case of any trade or business which is carried on by an individual or by a partnership and in which, if such trade or business were carried on exclusively by employees, the major portion of the services would constitute agricultural labor as defined in section 3121(g)... (ii) in the case of an individual, if the gross income derived by him from such trade or business is more than $2,400 and the net earnings from selfemployment derived by him from such trade or business (computed . . . without regard to this sentence) are less. than $1,600, the net earnings from self-employment derived by him from such trade or business may, at his option, be deemed to be $1,600. Section 1402(a) also makes this election available under certain instances to taxpayers engaged in a business other than farming. For purposes of the credit under section 43 of the Code, earned income includes any amount reported on line 13 of Schedule SE of Form 1040 as net earnings from self-employment. Net earnings from self-employment are to be taken into account even though they are less than $400 (and not subject to the self-employment tax). See S. Rep. No. 94-36, 94th Cong., 1st Sess. 34 (1975), 1975-1 C.B. 590, 604. HOLDING The $1,600 deemed to be net earnings from self-employment under section 1402(a) of the Code and reported on line 13 of Schedule SE of Form 1040 is considered "earned income" for purposes of the earned income credit under section 43 of the Code. The conclusion of this Revenue Rul ing also applies to taxpayers involved in businesses other than farming, provided they qualify for the election under section 1402 (a) of the Code. 26 CFR 1.43-1: Earned income credit. (Also Section 7701; 301.7701-16.) Earned income credit; household in Puerto Rico. An individual, who maintains a household in Puerto Rico that is the principal place of abode for that individual and a qualified child of that individual, cannot qualify for the earned income credit. Rev. Rul. 78-400 Section 43 (a) of the Internal Revenue Code of 1954 provides that in the case of an eligible individual, there is allowed as a credit against the federal income tax for the taxable year an amount equal to 10 percent of so much of the earned income for the taxable year as does not exceed $4,000. Section 43 (c) (1) of the Code defines an eligible individual as an individual who for the taxable year maintains a household in the United States which is the principal place of abode of that individual and a child of that individual who is under 19 years of age or a full-time student (whether or not that individual is entitled to claim the child as a dependent) or that individual's adult disabled child whom the individual is entitled to claim as a dependent. Section 7701 (a) (9) of the Code provides that the term "United States" when used in a geographical sense includes only the States and the District of Columbia. Held, the term "United States" as used in section 43 of the Code includes only the States and the District of Columbia and does not include Puerto Rico. Therefore, an individual, who maintains a household in Puerto Rico that is the principal place of abode of that individual and a qualified child of that individual, cannot qualify for the earned income credit under section 43 of the Code. Section 44.-Purchase of New 26 CFR 1.44-4: Recapture for certain dispositions. Housing credit; recapture; husband and wife separated. Married taxpayers who purchased a new residence, claimed the housing credit on their joint return, and, in the following year, separated and agreed to live apart and sold the residence are treated separately in applying the recapture provisions of section 44(d)(1) and (2) of the Code. Rev. Rul. 78-259 Advice has been requested whether, under the circumstances described below, taxpayers must recapture all or a portion of the credit claimed for the purchase of a new principal residence under section 44 of the Internal Revenue Code of 1954. On April 1, 1975, A and B, married taxpayers, purchased a new principal residence for $50,000. They took title to the property as tenants by the entirety. In all respects, the transaction entitled the taxpayers to the housing credit pursuant to section 44 of the Code. They filed a joint income tax return for 1975 and claimed the credit in the amount of $2,000. In 1976, A and B separated and agreed to live apart. They sold their principal residence on March 1, 1976. The adjusted sales price for their principal residence was $60,000. Under state law, A and B were each entitled to one-half of the proceeds from the sale of the residence. A separately purchased and occupied a new principal residence on July 1, 1976, that had not been previously occupied. The purchase price of the new residence was $35,000. A continued to own and occupy the new residence through April 1, 1978. As of September 1, 1977, B had not purchased or commenced construction of a separate new replacement residence. A and B were not legally separated under a decree of divorce or separate maintenance on the last day of the taxable years 1976 and 1977 and filed joint income tax returns for both of those years. Section 44(a) of the Code provides the general rule that in the case of an individual there is allowed, as a credit against the tax imposed by chapter 1 for the taxable year, an amount equal to 5 percent of the purchase price of a new principal residence purchased or constructed by the taxpayer. Section 44(b) (1) provides that the credit allowed may not exceed $2,000. Section 44(d) (1) of the Code provides that if the taxpayer disposes of property with respect to the purchase of which a credit was allowed under section 44(a) at any time within 36 months after the date on which the taxpayer acquired the property as a principal residence, then the federal income tax for the taxable year in which the replacement period described in section 44 (d) (2) terminates is increased by an amount equal to the amount allowed as a credit for the purchase of such property. Section 44(d) (2) of the Code provides that if the taxpayer purchases or constructs a new principal residence within the replacement period prescribed in section 1034, the provisions of section 44(d) (1) shall not apply. Instead the tax imposed by chapter 1 for the taxable year following the taxable year during which disposition occurs is increased by an amount that bears the same ratio to the amount allowed as a credit for the purchase of the old residence as (A) the adjusted sales price of the old residence (within the meaning of section 1034) reduced (but not below zero) by the taxpayer's cost of purchasing the new residence (within the meaning of section 1034) bears to (B) the adjusted sales price of the old residence. Rev. Rul. 74-250, 1974-1 C.B. 202, holds that the nonrecognition provisions of section 1034(a) of the Code apply separately to the gains realized by a husband and wife from the sale of their principal residence where they have agreed to live apart and each timely purchased and occupied a separate replacement residence. In the instant case, the taxpayers disposed of their principal residence acquired on April 1, 1975, prior to the expiration of the 36-month holding period required under the provisions of section 44(d) (1) of the Code. Because A and B agreed to live apart, they are treated separately in the application of the recapture provisions under section 44(d) (1) and (2) similar to the separate application of the provisions of section 1034 illustrated in Rev. Rul. 74-250. A and B are considered to be equal owners of the principal residence sold and a housing credit of $1,000 is considered to have been claimed by each taxpayer. Because A separately purchased a replacement residence within the 18month replacement period prescribed by section 1034, the recapture rules of section 44(d) (2) apply. The price of the replacement residence ($35,000) is in excess of one-half of the adjusted sales price of the principal residence. sold ($30,000). Therefore, none of A's previously claimed credit of $1,000 26 CFR 1.48-1: Definition of section 38 property. Investment credit; seed trees; timber producer. Trees comprising a timber producer's seed orchard that are used to produce genetically superior seedlings for the producer's timber growing operation are section 38 property. They are placed in service when they bear sufficient seed to warrant harvesting. Rev. Rul. 78-264 Advice has been requested whether, under the circumstances described below, the trees comprising the taxpayer's seed orchard are "section 38 property" within the meaning of section 48(a) of the Internal Revenue Code of 1954. The taxpayer is in the business of growing timber for use in its lumber, plywood, and wood pulp plants. In order to grow more high quality timber in a shorter time the taxpayer, after harvesting a tract of timber, reforests it with genetically improved seedlings. The large quantity of genetically improved seedlings used by the taxpayer for this purpose each year are not available by purchase from tree nurseries. To assure a supply of genetically improved seedlings for its reforestation needs, the taxpayer established a seed orchard. Rootstock grown from ordinary forest tree seed of the proper species are planted. Scionwood (small branchwood) is collected from parent trees that exhibit certain characteristics that make them superior timberproducing trees. After the rootstock is established, a scion from one of the parent trees is grafted onto each rootstock. After several years, the grafted trees begin to bear cones that are harvested and the seed extracted. The trees produced from this seed generally exhibit the superior growth and form of the parent trees. This genetically superior seed is sown in nursery beds and the genetically improved seedlings produced therefrom are used to reforest the tax payer's land. The selection of superior parent trees is ongoing. By the time the grafted trees are 20 years old, a replacement orchard will be ready to produce seed genetically superior to the trees in the original seed orchard. At that time, the original seed orchard will be abandoned and the trees removed. Section 48(a) (1) of the Code provides that the term "section 38 property" means property that is tangible personal property or other tangible property if such other property is used as an integral part of manufacturing, production, or extraction. Such term includes only property that is depreciable and has a useful life of 3 years or more. Section 167 (a) of the Code provides that a reasonable allowance for exhaustion, wear and tear, and obsolescence of property used in the trade or business shall be allowed as a depreciation deduction. Section 263 (a) of the Code provides that generally no deduction shall be allowed for capital expenditures. A capital expenditure is one that creates, or results in the permanent improvement or betterment of an asset that has a useful life greater than 1 year. Citrus trees growing in an orchard are section 38 property within the meaning of section 48(a) (1) of the Code and they qualify for the investment credit provided by section 46(a). Rev. Rul. 65-104, 1965-1 C.B. 28, and Rev. Rul. 69-249, 1969-1 C.B. 31. Trees growing in fruit orchards and held for the production of income are "other tangible property" within the meaning of section 48(a) (1) of the Code. Rev. Rul. 67-51, 1967-1 C.B. 68. To establish a seed orchard for the production of superior tree seed, the taxpayer paid or incurred certain costs, such as those for the acquisition and planting of seedlings to be used as rootstock, selecting parent trees, collecting scionwood from the parent trees, and grafting a scion to each rootstock. These costs, along with any others that are properly includible, are capital costs of establishing the seed orchard in accordance with section 263 of the Code and the regulations thereunder. Rev. Rul. 75-405, 1975-2 C.B. 64, holds that the costs of raising pistachio seedlings from seed through grafting the rootstock, similar to the costs in the instant case, are capital costs rather than deductible business expenses. The trees in the seed orchard are depreciable property, an integral part of the taxpayer's production of seed for use in its timber growing operations, and "other tangible property" within the meaning of section 48(a)(1) of the Code. They are placed in service. when they bear cones in a quantity sufficient to warrant harvesting for seed. They will have a remaining useful life to the taxpayer of more than 3 years at that time. Accordingly, the trees comprising the taxpayer's seed orchard are "section 38 property" within the meaning of section 48 (a) of the Code. 26 CFR 1.48-1: Definition of section 38 property. (Also Section 761, 1.761-1.) Investment credit; facility jointly owned with city and cooperative. The portion of an electric generating facility owned by two investorowned utilities as tenants in common with a municipally-owned utility and a tax-exempt cooperative may qualify as section 38 property. Rev. Rul. 78-2681 ISSUE Whether ownership by a municipally-owned utility or an electric cooperative exempt from tax under section 501 (c) (12) of the Internal Revenue Code of 1954 of an interest in an electric generating facility disqualifies the entire facility as section. 38 property by reason of the application of section 48(a) (4) or (5). FACTS An electric generating facility is owned as a tenancy in common under an arrangement classified as a partnership for Federal income tax purposes. There is no special allocation of partnership income, deductions, or credits among the partners. The participants are investor-owned utilities (Company M and Company X), a municipally-owned utility (the City), and a tax-exempt electric cooperative (the Cooperative). The respective interests of the participants are: each is required to take in kind a share of the electricity produced by the facility corresponding to its percentage interest. Pursuant to an operating agreement among the parties, Company M will operate the facility on behalf of the participants. Pursuant to the agreement, Company M is paid an amount not in excess of the fair market value of its services. Any sales of electricity by one participant to another must be made at a fair market price for such electricity. LAW partners as tenants in common or is in the partnership. The above conclusions also apply even though the partners have elected, pursuant to section 761(a), to be excluded from the application of subchapter K of the Code. 26 CFR 1.48-1: Definition of section 38 property. Investment credit; lodging facilities; furniture leased to tenants. Furniture that is leased by a taxpayer to tenants in apartment build The applicable section of the Code ings, duplex houses, and similar is 48 (a) (4) and (5). Section 48(a) of the Code defines section 38 property. Section 48(a) (4) provides that property used by certain tax-exempt organizations shall be treated as section 38 property only if such property is used predominantly in an unrelated trade or business the income from which is subject to tax under section 511. Section 48 (a) (5) of the Code provides that property used by the United States, or by any State or political subdivision thereof, shall not treated as section 38 property. HOLDING be Held, the interests of the Cooperative and of the City do not qualify as section 38 property by reason of the application of sections 48(a) (4) and 48(a) (5) of the Code, respectively. Held further, the disallowance of the investment credit in respect of the interests of the Cooperative and of the City does not render the investments in the facility of Company M and Company X ineligible for the investment credit. Company M and Company X may claim the investment credit provided that they are otherwise entitled to the credit under applicable provisions of the Code and regulations. The above conclusions apply whether title to the facility is in the establishments that lease to tenants for periods of more than 30 days is property used in connection with the furnishing of lodging and is not section 38 property for investment tax credit purposes. Rev. Rul. 78-438 ISSUE Is furniture leased to tenants in lodging facilities property used in connection with the furnishing of lodging and, therefore, not "section 38 property" for investment tax credit purposes? FACTS The taxpayer is in the business of leasing furniture. It leases furniture to tenants in apartment buildings, duplex houses, and similar establishments that lease to tenants for periods of more than 30 days. LAW AND ANALYSIS Section 1.48-1 (h) (1) (i) of the regulations provides that the term "section 38 property" does not include property that is used predominantly to furnish lodging or used predominantly in connection with the furnishing of lodging during the taxable year. Property used in the living quarters of a lodging facility, including beds, and other furniture, refrigerators, ranges, and other equipment, shall be considered as used predominantly to fur |