Mortgage Interest Deduction for Tax-Exempt Housing Allowances

§ 265. Expenses and interest relating to tax-exempt income(a) General ruleNo deduction shall be allowed for—(1) ExpensesAny 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. (2) InterestInterest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle. (3) Certain regulated investment companiesIn 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)). (4) Interest related to exempt-interest dividendsInterest 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. (5) Special rules for application of paragraph (2) in the case of short salesFor purposes of paragraph (2)—(A) In generalThe term “interest” includes any amount paid or incurred—(i) by any person making a short sale in connection with personal property used in such short sale, or (ii) by any other person for the use of any collateral with respect to such short sale. (B) Exception where no return on cash collateralIf—(i) the taxpayer provides cash as collateral for any short sale, and (ii) the taxpayer receives no material earnings on such cash during the period of the sale, subparagraph (A)(i) shall not apply to such short sale. (6) Section not to apply with respect to parsonage and military housing allowancesNo 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—(A) a military housing allowance, or (B) a parsonage allowance excludable from gross income under section 107. (b) Pro rata allocation of interest expense of financial institutions to tax-exempt interest(1) In generalIn 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.