Chapter 22 - § 22.7 • BANKS AS BONDHOLDERS

• Jurisdiction: Colorado

§ 22.7 • BANKS AS BONDHOLDERS

I.R.C. § 163 generally allows taxpayers to deduct non-personal interest paid or accrued within a taxable year on indebtedness. I.R.C. § 163(h) generally disallows the deduction of personal interest. However, I.R.C. § 265(a)(2) disallows any deduction otherwise allowable for "[i]nterest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by [Subtitle A of Title 26 of the United States Code]," and I.R.C. § 265(b)(1) disallows any deduction for the portion of a financial institution's interest expense allocable to tax-exempt interest income. The term "financial institution" for purposes of this interest expense disallowance provision is defined in I.R.C. § 265(b)(5). More specifically, the rule is that financial institutions may take no deduction for the portion of their interest expense that is calculated by taking their total interest expenses times a fraction, (1) the numerator of which is the average adjusted bases of the taxpayer's tax-exempt obligations acquired after August 7, 1986, and (2) the denominator of which is the average adjusted bases of all assets of the financial institution. I.R.C. § 265(b)(2). In other words, this general rule has the effect of depriving financial institutions of a ratable portion of their interest expense deduction for each tax-exempt bond investment they purchase or carry. The inability to deduct interest paid on indebtedness incurred to purchase or carry tax-exempt bonds may make purchasing tax-exempt bonds less attractive to financial institutions. See Patricia A. Trujillo, Note, "Municipal Bond Financing After South Carolina v. Baker and the Tax Reform Act of 1986: Can State Sovereignty Reemerge?," 42...