Exempt Income

Exempt income is any income that is not subject to taxation by federal, state or local taxing authorities. Examples of exempt income include welfare benefits, Social Security benefits, nontaxable pensions and certain life insurance benefits. Income from city and county municipal bonds are also a common form of exempt income. Expenses incurred to gain exempt income are not deductible. If funds are borrowed to purchase tax-exempt municipal bonds, the interest paid on the borrowed funds is not deductible. Circumstances exist in which expenses are incurred to gain both taxable income and exempt income. In this instance, one can reasonably divide the expenses based upon the facts of the situation. However, an explanation of the percentages used must be attached to the filed taxes. A statement must also be attached stating that no expense deductions were made from the gain of exempt income. Regarding deduction of state income tax on a federal taxes, if a taxpayer itemizes deductions, state income tax on interest income considered exempt income from federal income tax can be deducted. This does not apply to other exempt income.