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

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle. Interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle. In the case of a regulated investment company which distributes during the taxable year an exempt-interest dividend (including exempt-interest dividends paid after the close of the taxable year as described in section 855), that portion of any amount otherwise allowable as a deduction which the amount of the income of such company wholly exempt from taxes under this subtitle bears to the total of such exempt income and its gross income (excluding from gross income, for this purpose, capital gain net income, as defined in section 1222(9)). Interest on indebtedness incurred or continued to purchase or carry shares of stock of a regulated investment company which during the taxable year of the holder thereof distributes exempt-interest dividends. by any person making a short sale in connection with personal property used in such short sale, or by any other person for the use of any collateral with respect to such short sale. the taxpayer provides cash as collateral for any short sale, and the taxpayer receives no material earnings on such cash during the period of the sale, a military housing allowance, or a parsonage allowance excludable from gross income under section 107. In the case of a financial institution, no deduction shall be allowed for that portion of the taxpayer’s interest expense which is allocable to tax-exempt interest. the taxpayer’s average adjusted bases (within the meaning of section 1016) of tax-exempt obligations acquired after August 7, 1986 , bears to such average adjusted bases for all assets of the taxpayer. Any qualified tax-exempt obligation acquired after August 7, 1986 , shall be treated for purposes of paragraph (2) and section 291(e)(1)(B) as if it were acquired on August 7, 1986 . which is issued after August 7, 1986 , by a qualified small issuer, which is not a private activity bond (as defined in section 141), and which is designated by the issuer for purposes of this paragraph. any qualified 501(c)(3) bond (as defined in section 145), or any obligation issued to refund (or which is part of a series of obligations issued to refund) an obligation issued before August 8, 1986 , which was not an industrial development bond (as defined in section 103(b)(2) as in effect on the day before the date of the enactment of the Tax Reform Act of 1986) or a private loan bond (as defined in section 103( o )(2)(A), as so in effect, but without regard to any exemption from such definition other than section 103( o )(2)(A)). For purposes of subparagraph (B), the term “qualified small issuer” means, with respect to obligations issued during any calendar year, any issuer if the reasonably anticipated amount of tax-exempt obligations (other than obligations described in clause (ii)) which will be issued by such issuer during such calendar year does not exceed $10,000,000. a private activity bond (other than a qualified 501(c)(3) bond, as defined in section 145), an obligation to which section 141(a) does not apply by reason of section 1312, 1313, 1316(g), or 1317 of the Tax Reform Act of 1986 and which would (if issued on August 15, 1986 ) have been an industrial development bond (as defined in section 103(b)(2) as in effect on the day before the date of the enactment of such Act) or a private loan bond (as defined in section 103( o )(2)(A), as so in effect, but without regard to any exception from such definition other than section 103( o )(2)(A)), or an obligation issued to refund (other than to advance refund within the meaning of section 149(d)(5)) 1 any obligation to the extent the amount of the refunding obligation does not exceed the outstanding amount of the refunded obligation. 1 See References in Text note below. all governmental entities receiving benefits from such issue irrevocably agree (before the date of issuance of the issue) on an allocation of the amount of such issue for purposes of this subparagraph, and such allocation bears a reasonable relationship to the respective benefits received by such entities, Not more than $10,000,000 of obligations issued by an issuer during any calendar year may be designated by such issuer for purposes of this paragraph. the refunding obligation was not taken into account under subparagraph (C) by reason of clause (ii)(III) thereof, the average maturity date of the refunding obligations issued as part of the issue of which such refunding obligation is a part is not later than the average maturity date of the obligations to be refunded by such issue, and the refunding obligation has a maturity date which is not later than the date which is 30 years after the date the original qualified tax-exempt obligation was issued. any obligation issued as part of such issue is issued to refund another obligation, and the aggregate face amount of such issue exceeds $10,000,000. an issuer and all entities which issue obligations on behalf of such issuer shall be treated as 1 issuer, all obligations issued by a subordinate entity shall, for purposes of applying subparagraphs (C) and (D) to each other entity to which such entity is subordinate, be treated as issued by such other entity, and an entity formed (or, to the extent provided by the Secretary, availed of) to avoid the purposes of subparagraph (C) or (D) and all entities benefiting thereby shall be treated as 1 issuer. the requirements of this paragraph are met with respect to such composite issue (determined by treating such composite issue as a single issue), and the requirements of this paragraph are met with respect to each separate lot of obligations which are part of the issue (determined by treating each such separate lot as a separate issue). In the case of obligations issued during 2009 or 2010, subparagraphs (C)(i), (D)(i), and (D)(iii)(II) shall each be applied by substituting “$30,000,000” for “$10,000,000”. In the case of a qualified 501(c)(3) bond (as defined in section 145) issued during 2009 or 2010, this paragraph shall be applied by treating the 501(c)(3) organization for whose benefit such bond was issued as the issuer. subparagraph (F) shall not apply, and any obligation issued as a part of such issue shall be treated as a qualified tax-exempt obligation if the requirements of this paragraph are met with respect to each qualified portion of the issue (determined by treating each qualified portion as a separate issue which is issued by the qualified borrower with respect to which such portion relates). For purposes of this subparagraph, the term “qualified financing issue” means any composite, pooled, or other conduit financing issue the proceeds of which are used directly or indirectly to make or finance loans to 1 or more ultimate borrowers each of whom is a qualified borrower. For purposes of this subparagraph, the term “qualified portion” means that portion of the proceeds which are used with respect to each qualified borrower under the issue. For purposes of this subparagraph, the term “qualified borrower” means a borrower which is a State or political subdivision thereof or an organization described in section 501(c)(3) and exempt from taxation under section 501(a). The term “interest expense” means the aggregate amount allowable to the taxpayer as a deduction for interest for the taxable year (determined without regard to this subsection, section 264, and section 291). For purposes of the preceding sentence, the term “interest” includes amounts (whether or not designated as interest) paid in respect of deposits, investment certificates, or withdrawable or repurchasable shares. The term “tax-exempt obligation” means any obligation the interest on which is wholly exempt from taxes imposed by this subtitle. Such term includes shares of stock of a regulated investment company which during the taxable year of the holder thereof distributes exempt-interest dividends. accepts deposits from the public in the ordinary course of such person’s trade or business, and is subject to Federal or State supervision as a financial institution, or is a corporation described in section 585(a)(2). such disallowed interest shall not be taken into account for purposes of applying this subsection, and for purposes of applying paragraph (2), the adjusted basis of such tax-exempt obligation shall be reduced (but not below zero) by the amount of such indebtedness. This section shall be applied before the application of section 263A (relating to capitalization of certain expenses where taxpayer produces property). In applying paragraph (2)(A), there shall not be taken into account tax-exempt obligations issued during 2009 or 2010. The amount of tax-exempt obligations not taken into account by reason of subparagraph (A) shall not exceed 2 percent of the amount determined under paragraph (2)(B). For purposes of this paragraph, a refunding bond (whether a current or advance refunding) shall be treated as issued on the date of the issuance of the refunded bond (or in the case of a series of refundings, the original bond). In the case of any obligation issued after August 7, 1986 , and before January 1, 1987 , the time for making a designation with respect to such obligation under section 265(b)(3)(B)(i)(III) of the 1986 Code shall not expire before January 1, 1989 . an obligation is issued on or after January 1, 1986 , and on or before August 7, 1986 , when such obligation was issued, the issuer made a designation that it intended to qualify under section 802(e)(3) of H.R. 3838 of the 99th Congress as passed by the House of Representatives [H.R. 3838 was enacted as Pub. L. 99–514 ], and the issuer makes an election under this subparagraph with respect to such obligation, subparagraph (C)(ii)(III), clauses (ii) and (iii) of subparagraph (D), and subparagraphs (E) and (F). At the election of an issuer (made at such time and in such manner as the Secretary of the Treasury or his delegate may prescribe), the provisions referred to in clause (i) shall apply to such issuer as if included in the amendments made by section 902(a) of the Tax Reform Act of 1986 [ section 902(a) of Pub. L. 99–514 , amending this section].” Except as provided in this subsection, the amendments made by this section [amending this section and sections 163, 291, and 1277 of this title] shall apply to taxable years ending after December 31, 1986 . to purchase or repurchase such obligation, and entered into on or before September 25, 1985 , Park Forest, Illinois, redevelopment project. Clinton, Tennessee, Carriage Trace project. Savannah, Georgia, Mall Terrace Warehouse project. Chattanooga, Tennessee, Warehouse Row project. Dalton, Georgia, Towne Square project. Milwaukee, Wisconsin, Standard Electric Supply Company—distribution facility. Wausau, Wisconsin, urban renewal project. Cassville, Missouri, UDAG project. Outlook Envelope Company—plant expansion. Woodstock, Connecticut, Crabtree Warehouse partnership. Louisville, Kentucky, Speed Mansion renovation project. Charleston, South Carolina, 2 Festival Market Place projects at Union Pier Terminal and 1 project at the Remount Road Container Yard, State Pier No. 15 at North Charleston Terminal. New Orleans, Louisiana, Upper Pontalba Building renovation. Woodward Wight Building. Minneapolis, Minnesota, Miller Milling Company—flour mill project. Homewood, Alabama, the Club Apartments. Charlotte, North Carolina—qualified mortgage bonds acquired by NCNB bank ($5,250,000). Grand Rapids, Michigan, Central Bank project. building project. Bellows Falls, Vermont—building project. East Broadway Project, Louisville, Kentucky. O.K. Industries, Oklahoma. Obligations issued pursuant to an allocation of a State’s volume limitation for private activity bonds, which allocation was made by Executive Order 25 signed by the Governor of the State on May 22, 1986 (as such order may be amended before January 1, 1987 ), and qualified 501(c)(3) bonds designated by such Governor for purposes of this paragraph, shall be treated as acquired on or before August 7, 1986 , in the hands of the first and any subsequent financial institution acquiring such obligation. The aggregate face amount of obligations to which this paragraph applies shall not exceed $200,000,000.” Except as provided in paragraph (2), the amendments made by this section [enacting section 128 of this title and amending this section and sections 584, 643, and 702 of this title] shall apply to taxable years ending after September 30, 1981 . The amendments made by subsection (b)(6) [amending sections 584, 643, and 702 of this title] shall apply to taxable years beginning after December 31, 1981 .”