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The recent economic distress has led many bankers to reconsider investing in municipal bonds in order to obtain the benefit of earning interest that is exempt from Federal income taxation. 

In general with the passage of the Tax Reform Act of 1986, now under Section 265(b) of the Internal Revenue Code of 1986, as amended (the “Code”), banks are prohibited from deducting the carrying cost (interest expense incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds.  An exception is included in the Code that allows banks to deduct 80% of the carrying cost of a “qualified tax-exempt obligation.”  In order for bonds to be qualified tax-exempt obligations the bonds must be (i) issued by a “qualified small issuer,” (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations.  A “qualified small issuer” is (with respect to bonds issued during any calendar year) an issuer that issues no more than $10 million of tax-exempt bonds during the calendar year ($30 million during calendar year 2009 and 2010).  Qualified tax-exempt obligations are commonly referred to as “bank qualified bonds.”

The American Recovery and Investment Act of 2009 created several changes for tax-exempt securities issued in 2009 and 2010.  A temporary safe harbor was created that permits financial institutions to deduct 80% of the cost of buying and carrying tax-exempt bonds to the extent their tax-exempt holdings do not exceed 2% of their assets.  The $10 million bank qualified bond limit was also changed to $30 million.  Borrower that participate in a pool or borrow through a conduit issuer issuing more than $30 million in a calendar year will be entitled to bank qualification as long as the borrower’s tax-exempt financings are under $30 million in the calendar year.

If your bank is considering the benefits of investing in tax-exempt obligations our banking tax professionals are ready to help with your planning needs.    

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The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Condley and Company, L.L.P. to the reader.  The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated.  The reader should contact his or her Condley and Company, L.L.P. or other tax professional prior to taking any action based upon this information.  Condley and Company, L.L.P. assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.