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

(a) General rule. You may not deduct: any expense otherwise deductible that's allocable to income wholly exempt from federal tax (other than interest), whether or not you actually received that exempt income that year, or any section 212 investment-expense deduction allocable to interest that's wholly tax-exempt; interest on debt taken out or kept to buy or carry obligations whose interest is wholly tax-exempt; for a regulated investment company (a mutual fund^*) that pays an "exempt-interest dividend" during the year, the portion of its otherwise-allowable deductions equal to the same share that its wholly tax-exempt income is of its total exempt income plus its gross income (not counting net capital gain); interest on debt taken out or kept to buy or carry shares^* of a mutual fund that pays exempt-interest dividends that year. For short sales, "interest" under the bond-interest rule above includes amounts a short-seller pays in connection with the personal property used in the sale, and amounts anyone pays for the use of collateral posted for that sale — except that if the taxpayer^* posts cash as collateral and earns no real return on it during the sale, that cash-collateral payment is not treated as interest. Finally, this section does not block a deduction for mortgage interest or property taxes on your home just because you received a military housing allowance or a tax-excludable parsonage allowance.

(b) Financial institutions must give up part of their interest deduction too. A "financial institution" — someone who takes deposits from the public in the normal course of business and is regulated as a financial institution by a federal or state authority, or a certain kind of corporation^* described in section 585(a)(2) — may not deduct the part of its interest expense allocable to tax-exempt interest. To find that part: take the ratio of the institution's average adjusted basis (under section 1016) of tax-exempt obligations bought after August 7, 1986, to the average adjusted basis of all the institution's assets, and apply that ratio to its total interest expense. "Interest expense" here means the institution's total interest deduction for the year, figured without this subsection or sections 264 and 291, and it includes amounts paid on deposits, investment certificates, or withdrawable or repurchasable shares, whatever they're labeled. A "tax-exempt obligation" is any obligation whose interest is wholly exempt from federal tax, including mutual fund shares that pay exempt-interest dividends.

There's an exception for a "qualified tax-exempt obligation": for the ratio above, and for a related capitalization rule, it's treated as if it were bought on August 7, 1986 — so it doesn't count against the institution. To qualify, a bond must be issued after August 7, 1986 by a "qualified small issuer," must not be a private activity bond^*, and must be designated by the issuer for this purpose (certain 501(c)(3) bonds and refundings of specific older, non-private-activity bonds are not treated as private activity bonds for this test). A "qualified small issuer" is one that doesn't reasonably expect to issue more than $10,000,000 of tax-exempt obligations in a calendar year, not counting most private activity bonds, certain bonds covered by 1986 tax-reform transition rules, and refunding bonds that don't exceed the amount they refund. If one bond issue benefits more than one government and all of them agree in advance on a reasonable allocation of the issue, each government's allocated share counts toward its own $10,000,000 limit. An issuer can designate at most $10,000,000 of its bonds per year as "qualified" this way; refunding bonds generally keep qualified status if their maturity doesn't run past what's needed (capped at 30 years after the original bond, with an exception for issues that mature within 3 years), but bonds cannot be designated if they're part of an issue containing a refunding bond and the whole issue exceeds $10,000,000. Related issuers are combined for these limits: an issuer and anyone issuing bonds on its behalf count as one; bonds from a subordinate entity count toward the entity above it; and any entity structured mainly to get around these limits, plus everyone who benefits from that, count as a single issuer. A bundled ("composite") bond issue only qualifies if the whole issue meets these rules and each separate piece of it does too. For bonds issued during 2009 or 2010, the $10,000,000 limits are raised to $30,000,000; a qualified 501(c)(3) bond is treated as issued by the nonprofit organization it benefits rather than the government issuer; and for a "qualified financing issue" — a composite or pooled bond funding loans to multiple "qualified borrowers" (governments or 501(c)(3) organizations) — each borrower's portion of the issue is tested separately instead of testing the whole composite issue together.

If interest is already disallowed under (a) for a tax-exempt obligation, it isn't counted again under this subsection, and the obligation's adjusted basis used in the ratio above is reduced by that disallowed debt; this subsection is applied before section 263A's rules on capitalizing certain costs. There's also a temporary exception: tax-exempt obligations issued in 2009 or 2010 are left out of the ratio's numerator, but only up to 2% of the ratio's denominator amount; a refunding bond, for this purpose, is treated as issued on the date the original bond it refunds was issued (or, for a chain of refundings, the date of the very first bond).