[Code of Federal Regulations]
[Title 26, Volume 3]
[Revised as of April 1, 2002]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.178-3]

[Page 215-216]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
COMPUTATION OF TAXABLE INCOME (Continued)--Table of Contents
 
Sec. 1.178-3  Reasonable certainty test.

    (a) In any case in which neither section 178 (a) nor (b) applies, 
the determination as to the amount of the deduction allowable to a 
lessee for any taxable year for depreciation or amortization in respect 
of any building erected, or other improvements made, on leased property, 
or in respect of any cost of acquiring a lease, shall be made with 
reference to the original term of the lease (excluding any period for 
which the lease may subsequently be renewed, extended, or continued 
pursuant to an option exercisable by the lessee) unless the lease has 
been renewed, extended, or continued, or the facts show with reasonable 
certainty that the lease will be renewed, extended, or continued. In a 
case in which the facts show with reasonable certainty that the lease 
will be renewed, extended, or continued, the term of the lease shall, 
beginning with the taxable year in which such reasonable certainty is 
shown, be treated as including the period or periods for which it is 
reasonably certain that the lease will be renewed, extended, or 
continued. If the lessee has given notice to the lessor of his intention 
to renew, extend, or continue a lease, the lease shall be considered as 
renewed, extended, or continued for the periods specified in the notice. 
See paragraph (c) of Sec. 1.178-1.
    (b) The reasonable certainty test is applicable to each option to 
which the lease is subject. Thus, in a case of two successive options, 
the facts in a particular taxable year may show with reasonable 
certainty that the lease will be renewed pursuant to an exercise of only 
the first option; and, beginning with such year, the term of the lease 
will be treated as including the first option, but not the second. If in 
a subsequent taxable year the facts show with reasonable certainty that 
the second option will also be exercised, the term of the lease shall, 
beginning with such subsequent taxable year, be treated as including 
both options. Although the related lessee and lessor rule of section 
178(b) and paragraph (d) of Sec. 1.178-1 does not apply in determining 
the period over which the cost of acquiring a lease may be amortized, 
the relationship between the lessee and lessor will be a significant 
factor in determining whether the ``reasonable certainty'' rule of 
section 178(c) and this section applies.
    (c) The application of the provisions of this section may be 
illustrated by the following examples:

    Example 1. Corporation A leases land from lessor B for a period of 
30 years beginning with January 1, 1958. Corporation A and lessor B are 
not related persons. The lease provides that Corporation A will have two 
renewal options of 5 years each at the same annual rental as specified 
in the lease for the initial 30 years. Corporation A constructs a 
factory building on the leased land at a cost of $100,000. Corporation A 
was not, on July 28, 1958, under a binding legal obligation to erect the 
building. The construction was commenced on August 1, 1958, and was 
completed and placed in service on December 31, 1958. On January 1, 
1959, Corporation A has 29 years remaining in the initial term of the 
lease. The estimated useful life of the building on January 1, 1959, is 
40 years. The location of the leased property is particularly suitable 
for Corporation A's business and the annual rental of the property is 
lower than A would have to pay for other suitable property. No factors 
are present which establish that these conditions will not continue to 
exist beyond the initial term of the lease. Since the period remaining 
in the initial term of the lease on January 1, 1959 (29 years) is not 
less than 60 percent of the estimated useful life of the building (60 
percent of 40 years, or 24 years), the provisions of section 178(a) and 
paragraph (b)(1) of Sec. 1.178-1 do not apply, and since Corporation A 
and lessor B are not related, section 178(b) and paragraph (d) of 
Sec. 1.178-1 do not apply. However, since the facts show with reasonable 
certainty that Corporation A will renew the lease for the period of the 
two options (10 years), the cost of the building shall be amortized over 
the term of the lease, including the two renewal options, or 39 years.
    Example 2. Assume the same facts as in Example (1), except that a 
term of 30 years is the longest period that lessor B is willing to lease 
the unimproved property; that there was no agreement that Corporation A 
will have any renewal options; and that any

[[Page 216]]

other location would be as suitable for Corporation A's business as the 
leased property. Since the facts do not show with reasonable certainty 
that the initial term of the lease will be renewed, extended, or 
continued, Corporation A shall amortize the cost of the building over 
the remaining term of the lease, or 29 years.

[T.D. 6520, 25 FR 13691, Dec. 24, 1960]