Expenses and interest relating to tax-exempt income

No deduction shall be allowed for— 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. For purposes of paragraph (2)— The term “interest” includes any amount paid or incurred— If— No deduction shall be denied under this section for interest on a mortgage on, or real property taxes on, the home of the taxpayer by reason of the receipt of an amount as— 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. For purposes of paragraph (1), the portion of the taxpayer’s interest expense which is allocable to tax-exempt interest is an amount which bears the same ratio to such interest expense as— 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. For purposes of subparagraph (A), the term “qualified tax-exempt obligation” means a tax-exempt obligation— For purposes of clause (i)(II), there shall not be treated as a private activity bond— 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. For purposes of clause (i), an obligation is described in this clause if such obligation is— In the case of an issue under which more than 1 governmental entity receives benefits, if— 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. Except as provided in clause (iii), in the case of a refunding (or series of refundings) of a qualified tax-exempt obligation, the refunding obligation shall be treated as a qualified tax-exempt obligation (and shall not be taken into account under clause (i)) if— No obligation issued as part of an issue may be designated under this paragraph (or may be treated as designated under clause (ii)) if— For purposes of subparagraphs (C) and (D)— In the case of an obligation which is issued as part of a direct or indirect composite issue, such obligation shall not be treated as a qualified tax-exempt obligation unless— 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. In the case of a qualified financing issue issued during 2009 or 2010— 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). For purposes of this subsection— 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. For purposes of this subsection, the term “financial institution” means any person who— If interest on any indebtedness is disallowed under subsection (a) with respect to any tax-exempt obligation— 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).