Allocation of Deductions for Tax-Exempt Income
Generally, no deduction that would otherwise be allowable is allowed for any expense (whether for business or for the production of income) that is allocable to tax-exempt income. Examples of tax-exempt income include:
Certain death benefits (section 101),
Interest on state or local bonds (section 103),
Compensation for injuries or sickness (section 104), and
Income from discharge of indebtedness in a title 11 case (section 108).
Expenses that are directly allocable to tax-exempt income are allocated only to tax-exempt income. A reasonable proportion of expenses indirectly allocable to both tax-exempt income and other income must be allocated to each class of income.