15.11 Debts To Carry Tax-Exempt Obligations

When you borrow money in order to buy or carry tax-exempt bonds, you may not deduct any interest paid on your loan. Application of this disallowance rule is clear where there is actual evidence that loan proceeds were used to buy tax-exempts or that tax-exempts were used as collateral. But sometimes the relationship between a loan and the purchase of tax-exempts is less obvious, as where you hold tax-exempts and borrow to carry other securities or investments. IRS guidelines explain when a direct relationship between the debt and an investment in tax-exempts will be inferred so that no interest deduction is allowed. The IRS will not infer a direct relationship between a debt and an investment in tax-exempts in these cases:

1. The investment in tax-exempts is not substantial. That is, it is not more than 2% of the adjusted basis of the investment portfolio and any assets held in an actively conducted business.
2. The debt is incurred for a personal purpose. For example, an investor may take out a home mortgage instead of selling his tax-exempts and using the proceeds to finance the home purchase. Interest on the mortgage is deductible subject to certain limitations (15.1).
3. The debt is incurred in connection with the active conduct of a business and does not exceed business needs. But if a person reasonably could have foreseen when the tax-exempts were purchased that he or she would have to borrow funds to meet ordinary and recurrent business needs, the interest expenses are not deductible.
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image Caution
Tax-Exempt Income From Mutual Fund
You may not deduct interest on loans used to buy or carry tax-exempt securities. If you receive exempt-interest dividends from a mutual fund during the year, you may deduct interest on a loan used to buy or carry the mutual-fund shares only to the extent that the proceeds can be allocated to taxable dividends you also receive.
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The guidelines infer a direct relationship between the debt and an investment in tax-exempts in this type of case: An investor in tax-exempts has outstanding debts not directly related to personal expenses or to his or her business. The interest will be disallowed even if the debt appears to have been incurred to purchase other portfolio investments. Portfolio investments include transactions entered into for profit, including investments in real estate, that are not connected with the active conduct of a business; see the Example below.

EXAMPLE
An investor owning $360,000 in tax-exempt bonds purchased real estate in a joint venture, giving a purchase money mortgage and cash for the price. He deducted interest on the mortgage. The IRS disallowed the deduction, claiming the debt was incurred to carry tax-exempts. A court allowed the deduction. A mortgage is the customary manner of financing such a purchase. Furthermore, since the purchase was part of a joint venture, the other parties’ desires in the manner of financing had to be considered.
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