Question

Last year, Bill paid $4,000 in investment interest on funds borrowed to purchase tax-free municipal bonds. If he had $6,000 of tax-exempt interest last year, how much of his investment interest may he deduct on his federal income tax return

Answer 1

While tax exempt securities offer an investor the opportunity to generate tax free income, they also create problems under section 265 of the internal revenue code if an investor wants to deduct interest expense. Section 265 disallows the deduction of interest expense on debt incurred to buy tax exempt securities or mutual fund stock which distribute tax exempt interest.

The purpose of section 265 is to prevent tax payer from obtaining a double tax benefit by deducting interest on borrowed funds that enable her to purchase or carry securities generating tax exempt interest

In conclusion he cannot deduct any of the interest expense incurred.

So interest deductible =$ 0