From:  Mike
Date:  Wed, 08 Jun 2005

Hi Michael:

I have a muni bond portfolio generating tax-exempt interest income. I'd like to borrow against the portfolio and use the proceeds to start a business. My financial advisor says the interest expense would be non-deductible. I feel that under the tracing rules it should be deductible.

What do you think?

Thanks a million and keep giving great sound advice!

Best regards,

Mike

Answer

Date:  Fri, 01 Jul 2005

Hello Mike,

There is a separate internal revenue code section that applies to "indebteness incurred to purchase or carry tax-exempt obligations". (Section 265(a)(2).) Interest paid relating to such debt isn't deductible.

The courts have ruled that the use of tax-exempt interest obligations as collateral for debt is direct evidence of a purpose to carry the obligations. The reason is the taxpayer could have simply sold the securities to raise the cash.

Good luck!
Mike Gray

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