Borrowing to Buy Tax Exempt Bonds continued...

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 bonds or obligations is considered insubstantial if the average amount of tax exempt bonds 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 bonds or 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 bonds interest. The disallowed portion is determined by applying a ratio of

the taxpayer's average for the tax year of the adjusted bases of bonds exempt to municipal tax acquired after August 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 bonds obligation issued by qualified small issuers that reasonably anticipate issuing no more than $10 million in tax exempt bonds obligations during the calendar year.

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