8050 / Are expenses paid for the production of tax-exempt income deductible?
Any expense that would otherwise be deductible under any Internal Revenue Code section is not deductible if it is allocable to tax-exempt income other than tax-exempt interest.1 Expenses allocable to tax-exempt interest may be deductible if they are trade or business expenses, taxes, or depreciation, but the same expenses allocable to tax-exempt income other than interest are not deductible.
If an expense is allocable to both nonexempt income and exempt income, a reasonable proportion, determined in the light of all the facts and circumstances, is allocated to each.2 Legal fees incurred to collect Social Security benefits have been held deductible only to the extent that they were allocable to the portion of benefits that were includable in the taxpayer’s gross income.3 In the absence of evidence showing a more reasonable basis for allocation, the expense has been allocated between taxable and tax-exempt income in the proportion that each bears to the total taxable and nontaxable income in the year.4
1. IRC § 265(a)(1).