Tax Analysis

The facts of your case are as following states. You started investing in real estate several years ago and currently own buildings and land. You own all of the stock in Valley Hardware Store as well as the land and building in which the store is housed. Additionally you have constructed apartment buildings and improvements throughout the Moscow-Viola area. Two of the apartment houses are fully paid, while the other three have mortgage balances. The financing for all of the buildings came from bank loans secured by Deeds of Trust on the parcels of real property. There is a note on the store building that states that there can be no prepayment on it. The notes on the apartment house buildings do not have a penalty for prepayment, however.

Presently, you have accumulated nearly $700,000 in cash and have about $375,000 invested in state and municipal bonds. For these state and municipal bonds, the interest rate varies from 4.2%-6%. Rich Broker, employed by Big Investment Company, recommended you take the cash invested in the Certificates of Deposit with the Viola Second National Bank and purchase more state and municipal bonds with it. Another recommendation by Mr. Broker is for you to borrow an additional $800,000 on one of the unencumbered apartment houses, and then use this loan to purchase more state and municipal bonds.

Three issues present themselves in your case. First, if you borrow the $800,000 loan to purchase more municipal bonds, can you deduct the interest on the $800,000 loan? Then, if you purchase more municipal bonds with the money, will you still be able to deduct the interest on your present mortgage loans? Additionally, will you be able to continue to make deductions on the tax-exempt bonds and debt you have if you take heed of Mr. Broker’s advice?

26 USC § 103 states, “gross income does not include interest on any State or local bonds.” The interest income from municipal bonds is exempt from federal income tax and state and local income tax since you live in the state of issue, which is Idaho in this case. No deduction shall be allowed for interest on indebtedness incurred or continued to a purchase or obligation on that interest. This according to I.R.C Sec 265 (2) is wholly exempt from the taxation.

If you borrow an $800,000 loan and invest in the municipal bond, exempt under I.R.C Sec 103, can you deduct the interest on the said loan? You cannot because the purpose of borrowing that loan is to purchase more municipal bonds. The $800,000 indebtedness is incurred, and you continue to purchase municipal bonds. This makes the interest on the $800,000 loan not deductible under I.R.C Sec 265 (2).

Mr. Broker recommends you take $700,000 cash that is invested in the Certificates of Deposit to purchase more municipal bonds. At the same time, you have $88,610 deducted interest on your present mortgage which is applied to I.R.C Section 163. If more municipal bonds are acquired, can you deduct interest on the present mortgage? The Bishop v. Commissioner case, 15 AFTR 2d 620, 342 F2d 757, 65-1 USTC P 9304, states that a taxpayer selling the non-tax-exempt obligation, which purchased with the proceeds of the loan, within a month he purchased more tax-exempt obligation. It provides the evidence that the taxpayer uses the loan and continues to purchase tax-exempt obligation. So the court decides that the interest on the loan cannot be deducted. In your case, is there sufficient evidence proving the loan is used to continue to purchase municipal bonds? Why not use that cash to pay off your loans? The interest on the present mortgage cannot be deducted under section 265(2).