26 U.S.C. § 265 — Expenses and interest relating to tax-exempt income

(a) General rule. No deduction is allowed for: (1) Expenses. Any deduction otherwise allowed that is tied to one or more classes of income (other than interest) that is fully exempt from federal income tax — whether or not any of that income is actually received or accrued that year — and any deduction otherwise allowed under section 212 (for producing income) that is tied to interest that is fully tax-exempt. (2) Interest. Interest on debt taken out or kept in order to buy or hold bonds or other obligations whose interest is fully tax-exempt. (3) Certain regulated investment companies. If a regulated investment company (such as a mutual fund) pays out an "exempt-interest dividend" during the year — including dividends paid soon after year-end, as section 855 describes — it cannot deduct the share of its expenses matching the share of its income that is tax-exempt. Figure that share this way: divide the company's tax-exempt income by the sum of that tax-exempt income plus its other gross income (leaving net capital gain out of that calculation). (4) Interest tied to exempt-interest dividends. Interest on debt taken out or kept to buy or hold shares of such a fund, if the fund pays out exempt-interest dividends during the shareholder's tax year. (5) Short sales. For rule (2), "interest" also includes amounts paid or incurred by a person doing a short sale of personal property, in connection with that sale, and amounts paid to someone else for the use of collateral in that short sale. But if the taxpayer put up cash as collateral for the short sale, and earned no meaningful return on that cash while the sale was open, that particular payment is not treated as interest. (6) Parsonage and military housing. No deduction is denied under this section for mortgage interest, or property tax, on the taxpayer's home just because the taxpayer also received a tax-free military housing allowance or a tax-free parsonage allowance. (b) Splitting a financial institution's interest expense between taxable and tax-exempt income. (1) In general. A financial institution cannot deduct the part of its interest expense that is tied to tax-exempt interest. (2) How to figure that part. Take the ratio of: the institution's average adjusted basis in tax-exempt bonds bought after August 7, 1986, divided by the average adjusted basis of all of the institution's assets. Apply that ratio to the institution's total interest expense — that share is not deductible. (3) Exception for certain small-issue tax-exempt bonds ("qualified tax-exempt obligations"). A bond bought after August 7, 1986, that meets the tests below is treated, for the ratio in (2), as though it had been bought back on August 7, 1986 — so it doesn't count against the institution. To qualify, the bond must: be issued after August 7, 1986, by a "qualified small issuer"; not be a "private activity bond" as section 141 defines it (most qualified 501(c)(3) bonds, and most bonds refunding older non-private-activity bonds, do not count as private activity bonds for this test); and be designated by its issuer for this purpose. A "qualified small issuer" is one that reasonably expects to issue no more than $10,000,000 of tax-exempt bonds during the calendar year, not counting certain bonds — mainly private activity bonds other than qualified 501(c)(3) bonds, certain 1986 transition-rule bonds, and refunding bonds that don't exceed the amount of debt being refunded. When one bond issue benefits more than one government entity, and all of them agree in advance, in writing, on how to split the issue's amount based on the benefit each actually receives, each entity's agreed share — and only that share — counts toward that entity's own $10,000,000 limit. No issuer may designate more than $10,000,000 of bonds this way in a calendar year. A refunding bond generally counts as newly designated against that cap, but a bond that refunds an already-qualified tax-exempt obligation keeps its qualified status without using up more of the cap if: it wasn't excluded to begin with as too large a refunding; its average maturity date is no later than the original bond's; and it matures no more than 30 years after the original bond was first issued — though this maturity-matching test doesn't apply if the original issue's average maturity was 3 years or less. A bond cannot be designated, or treated as automatically designated, if it's part of an issue that refunds another obligation and the total face amount of that issue is over $10,000,000. For these dollar limits: an issuer and any entity issuing bonds on its behalf count as a single issuer; a subordinate entity's bonds count toward the entity above it; and any entity set up mainly to get around these caps — along with everyone who benefits from that setup — is treated as one issuer. A bond that is part of a larger, combined ("composite") issue only qualifies if the whole composite issue meets these rules, and each separate piece of it meets them too. Special temporary rules applied to bonds issued in 2009 or 2010: the $10,000,000 caps described above became $30,000,000; a qualified 501(c)(3) bond was treated as issued by the nonprofit organization it benefited, rather than by the government issuer; and for a "qualified financing issue" — one that pools money to lend to multiple "qualified borrowers" (a state, a political subdivision, or a 501(c)(3) organization) — each borrower's slice of the pooled bond was tested separately against these rules, instead of testing the whole pooled issue together. (4) Definitions. "Interest expense" means the institution's total allowable interest deduction for the year, figured without regard to this subsection, section 264, or section 291 — and here "interest" also includes amounts paid on deposits, investment certificates, or withdrawable or repurchasable shares, even if not formally labeled interest. A "tax-exempt obligation" is any bond whose interest is fully exempt from federal income tax, including shares of a fund that pays out exempt-interest dividends. (5) "Financial institution" means a person who takes deposits from the public as an ordinary part of their trade or business and is regulated as a financial institution by a federal or state authority, or a corporation described in section 585(a)(2). (6) Coordination rules. If interest on a debt is already disallowed under (a) with respect to a tax-exempt bond, it is not counted again under this subsection — and, for the ratio in (2), that bond's adjusted basis is reduced, but not below zero, by the amount of that disallowed debt. This subsection is applied before section 263A, which requires capitalizing certain costs when a taxpayer produces property. (7) A temporary break for bonds issued in 2009 or 2010. When figuring the ratio in (2)(A), the institution could leave out tax-exempt bonds issued during 2009 or 2010 — but only up to 2 percent of the amount otherwise counted under (2)(B). A refunding bond, whether a current or advance refunding, is treated as issued on the date its original bond was issued, for purposes of this break.