Taxes

Taxpayers may, in some instances, claim an interest deduction for debt that is incurred to purchase or carry investments. However, a taxpayer may not deduct interest on indebtedness incurred or continued to purchase or carry obligations that are exempt from federal income tax. Without this rule (the "interest disallowance rule"), taxpayers would realize a double tax benefit from using borrowed funds to purchase or carry tax-exempt bonds because the interest expense would be deductible, while the interest income would escape federal tax. The interest disallowance rule applies whenever a taxpayer uses borrowed funds to purchase or carry tax-exempt bonds.

Thus, if borrowed funds are used for, and directly traceable to, the purchase of tax-exempt bonds, or tax-exempt bonds are used as collateral for indebtedness, then no part of the interest paid or incurred on such indebtedness may be deducted. If borrowed funds are only partly or indirectly used to purchase or hold tax-exempt bonds, then the rule will disallow a deduction for that portion of the interest allocable to the tax-exempt bonds. While the interest disallowance rule is broad in scope, it does not automatically deny an interest deduction whenever a taxpayer simultaneously maintains debt and earns tax-exempt income.

For example, the rule generally will not apply if an individual, while holding tax-exempt bonds, takes out a mortgage to purchase a residence rather than selling the bonds to finance the purchase. In this circumstance, the personal purpose of the loan predominates, and the IRS considers it unreasonable to deny the mortgage interest deduction.

Similarly, the interest disallowance rule will not apply with respect to bona fide business loans unless the indebtedness is determined to be in excess of reasonable business needs. For example, the interest disallowance rule generally will not apply if a taxpayer that owns tax-exempt bonds borrows funds to finance a major capital improvement. In addition, a taxpayer may invest the proceeds of bona fide business indebtedness directly in short-term tax-exempt bonds for a temporary period while the borrowed funds await their intended use.

The Internal Revenue Service has issued a Revenue Procedure (Rev. Proc. 72-18) that permits individual and corporate taxpayers to avoid the effect of this disallowance rule where the taxpayer's investment in tax-exempt bonds is insubstantial. In the case of an individual, investment in tax-exempt obligations is considered insubstantial if the average amount of tax-exempt obligations (valued at their adjusted basis) is less than or equal to two percent (2%) of the average adjusted basis of all portfolio investments of the taxpayer. In the case of a corporation, investment in tax-exempt obligations is considered insubstantial if the average basis of such investments is less than or equal to two percent (2%) of the corporation's total assets.

The interest disallowance rule also prevents a bank or other financial institution from deducting that portion of its interest expense that is allocable to tax-exempt interest. The disallowed portion is determined by applying a ratio of the taxpayer's average for the tax year of the adjusted bases of tax-exempt bonds acquired after Aug. 7, 1986, to the average for the tax year of the adjusted bases of all assets of the taxpayer.

However, a financial institution may deduct 80 percent of its interest expense allocable to "qualified tax-exempt obligations," which are a special type of tax-exempt obligation issued by qualified small issuers that reasonably anticipate issuing no more than $10 million in tax-exempt obligations during the calendar year.