Borrowing to Buy Tax Exempt Bonds

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. That includes buying tax exempt bonds. 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, since 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 exempt to municipal tax, 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 bonds 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 tax exempt bonds to finance the purchase. In this circumstance, the personal purpose of the loan predominates, and the Service considers it unreasonable to deny the mortgage interest deduction.

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