7935. Is interest on indebtedness incurred to purchase or carry tax-exempt obligations deductible?Nuco Employeercline202014-07-30T13:09:00Z2014-07-30T13:09:00Z411296437UMKC5315755114Site Map/General Income Taxation/Individuals/Deductions/Itemized/Interest/Investment InterestSite Map/Investments/Special Rules/Deduction of Interest and Expenses/Interest/Investment InterestTaxFactsDefaultArticle123361306-00-tf2.xml1306.00;#1738;#1953;#0x010100C568DB52D9D0A14D9B2FDCC96666E9F2007948130EC3DB064584E219954237AF3900242457EFB8B24247815D688C526CD44D009C4E67E972694125ABDA91AC61F5E51FTax Facts 2Is interest on indebtedness incurred to purchase or carry tax-exempt obligations deductible?
38500.0000000000TaxFactsDefaultArticleSBMEDIA\moss-admin2010-01-14T22:52:36Z7935. Is interest on indebtedness incurred to purchase or carry tax-exempt obligations deductible?No deduction is allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is tax-exempt.IRC Sec. 265(a)(2). (Where the obligation offers tax-exempt income other than interest, see Q 7941.) Whether debt was incurred to purchase or carry obligations on which interest is tax-exempt depends on the individual taxpayer’s purpose for borrowing.Rev. Proc. 72-18, 1972-1 CB 740, as clarified by Rev. Proc. 74-8, 1974-1 CB 419, and as modified by Rev. Proc. 87-53, 1987-2 CB 669. Where the necessary purpose to use borrowed funds to buy or carry tax-exempt interest obligations is shown, the interest deduction will be denied, even though no tax-exempt interest is currently being received.Clyde C. Pierce Corp. v. Comm., 120 F.2d 206 (5th Cir. 1941); Illinois Terminal R.R. Co. v. U.S., 375 F.2d 1016 (Ct. Cl. 1967). Furthermore, the deduction is denied even though the taxpayer’s motives are not tax avoidance but to realize a taxable profit from sale instead of interest.Denman v. Slayton, 282 U.S. 514 (1931).The taxpayer’s purpose in borrowing requires an examination of all the facts and circumstances involved.Indian Trail Trading Post, Inc. v. Comm., 60 TC 497 (1973), aff’d per curiam 503 F.2d 102 (6th Cir. 1974). Purpose can be established by direct or by circumstantial evidence. According to IRS guidelines, if the loan proceeds can be directly traced to the purchase, there is direct evidence of a purpose to purchase. Nonetheless, this evidence is not conclusive, as the IRS acknowledges in pointing out that the deduction is not denied where proceeds of bona fide business borrowing are temporarily invested in tax-exempt interest obligations.Rev. Rul. 55-389, 1955-1 CB 276.Use of tax-exempt interest obligations as collateral for debt is direct evidence of a purpose to carry the obligations.Wisconsin Cheesemen, Inc. v. U.S., 388 F.2d 420 (7th Cir. 1968); Rev. Proc. 72-18, above. The Tax Court has determined that the use of tax-exempt municipal bonds as collateral did not, of itself, establish the necessary purpose to carry the bonds.See Lang v. Comm., TC Memo 1983-318. However, in a later Tax Court decision, the use of tax-exempt municipal bonds as collateral did establish a direct relationship between the carrying of the bonds and the borrowing, even though the loan proceeds were used for an investment purpose.See Rifkin v. Comm., TC Memo 1988-255.Lacking direct evidence, if the facts and circumstances support a reasonable inference that the purpose of the borrowing was to purchase or carry tax-exempt interest obligations, the deduction will be denied. However, a deduction will not be denied merely because the investor also holds such tax-exempt obligations.Ball v. Comm., 54 TC 1200 (1970), nonacq. at 1972 AOD LEXIS 89 (IRS Jan. 14, 1972). Generally, the interest deduction will not be disallowed if borrowing is for a personal purpose (and the interest would otherwise be deductible). Thus, an individual who holds tax-exempt municipal bonds and takes out a mortgage to buy a residence is not required to sell his municipal bonds to finance the purchase.Rev. Proc. 72-18, Sec. 4.02, above.Similarly, the deduction will not generally be denied if the indebtedness is incurred or continued in connection with the active conduct of a trade or business (other than as a dealer in tax-exempt obligations) and the loan is not in excess of business needs. Nonetheless, if the business need could reasonably have been foreseen when the tax-exempt obligations were bought, a rebuttable presumption arises that there was a purpose to carry the tax-exempt obligations by means of borrowing.Wisconsin Cheesemen, Inc. v. U.S., above; Rev. Proc. 72-18, Sec. 4.03, above.On the other hand, where there is outstanding indebtedness not directly connected with personal expenditures and not incurred or continued in connection with the active conduct of a business, and the individual owns tax-exempt obligations, a purpose to carry the tax-exempt obligations will be inferred, but may be rebutted. The inference will be made even though the debt is ostensibly incurred or continued to purchase or carry other portfolio investments not connected with the active conduct of trade or business. Thus, deduction of interest on a margin account by an individual holding tax-exempt obligations was disallowed, even though only taxable securities were purchased in that account.McDonough v. Comm., 577 F.2d 234 (4th Cir. 1978). (The management of one’s personal investments is not considered a trade or business.)Higgins v. Comm., 312 U.S. 212 (1941). A limited partnership interest is generally considered a passive activity.Ann. 87-4, 1987-3 IRB 17. If the taxpayer borrows to buy such an interest while holding tax-exempts, it is possible that the IRS will infer an intent to carry tax-exempt obligations and will disallow the interest deduction.According to IRS guidelines, there will generally be a direct connection between borrowing and purchasing or carrying existing tax-exempt interest obligations if the debt is incurred to finance new portfolio investments. This presumption can be rebutted, the IRS says, by showing the taxpayer could not have sold his holdings of tax-exempt interest obligations. But it cannot be overcome by showing the tax-exempts could have been sold only with difficulty or at a loss, or that the investor owned other investment amounts that could have been liquidated, or that an investment adviser recommended that a prudent investor should maintain a particular percentage of assets in tax-exempt obligations.Rev. Proc. 72-18, Sec. 4.04, above.If a fractional part of the indebtedness is directly traceable to holding tax-exempt interest obligations, the same fractional part of interest paid will be disallowed. In any other case, where the interest deduction is to be disallowed, an allocable portion of the interest is disallowed. The portion is determined by multiplying the total interest on the debt by a fraction: the numerator is the average amount during the tax year of the taxpayer’s tax-exempt obligations (valued at adjusted basis), and the denominator is the average amount during the tax year of the taxpayer’s total assets (valued at adjusted basis) minus the amount of any indebtedness the interest on which is not subject to disallowance under IRC Section 265(a)(2).Rev. Proc. 72-18, Secs. 7.01, 7.02, above. See also McDonough v. Comm., TC Memo 1982-236.If a partnership incurs debt or holds tax-exempt obligations, the partners are treated as incurring or holding their partnership share of each such debt or tax-exempt obligation. The purposes of the partnership in borrowing are attributed to the general partners.Rev. Proc. 72-18, Sec. 4.05, above.However, if an individual’s investment in tax-exempt obligations is insubstantial, the requisite purpose will generally not be inferred in the absence of direct evidence. Investment will generally be considered insubstantial if the average amount of tax-exempt obligations (valued at their adjusted basis) is not more than 2 percent of the average adjusted basis of his portfolio investments and any assets held in the active conduct of a trade or business.Rev. Proc. 72-18, Sec. 3.05, above.The IRS has ruled that the interest deduction will be disallowed on a joint return if indebtedness that was incurred by one spouse is allocable to the acquisition of tax-exempt securities by the other.Rev. Rul. 79-272, 1979-2 CB 124.If the proceeds of a short sale are used (as determined under the foregoing rules) to purchase or carry tax-exempt obligations, certain expenses of that short sale (see Q 7528, Q 7529) may not be deducted.IRC Sec. 265(a)(5).See Q 7933 for the limit on allowable investment interest deductions and Q 7934 for rules relating to the allocation of interest expense for purposes of the limit. See also Q 7941 for limits on the deduction of expenses incurred in producing tax-exempt income other than interest.