Tax-Exempt Interest Income on Form 1040

We recently received a call to the Bukers Hotline from a banker who was analyzing her borrowers 2020 Form 1040.  She noted the whitepaper detail for Line 2a Tax-Exempt Interest listed a partnership that the borrower was a partner in as the source for the tax-exempt interest income.  Is it cash flow?  It depends.

The face page of the Form 1040 reports the tax-exempt interest income earned by the individual during the year. The most common type of tax-exempt interest is interest income earned from municipal bonds. While tax-exempt interest income is not included on Schedule B, we include this income in our borrower’s total Schedule B cash flow as a ready source of cash. This makes sense when our borrower receives interest income from their municipal bond since the investment is yielding tax-exempt interest income that they receive each year.

However, if the whitepaper detail of the Form 1040 shows that the tax-exempt interest income is instead coming from a K-1, this does not represent cash received by our borrower. Like taxable interest and dividend income from a K-1 (reported on the Schedule B) which we do not include in our borrower’s Schedule B cash flow, we also should not include tax-exempt interest income from a K-1 (reported on page one of the Form 1040) in our borrower’s Schedule B cash flow.

In the case of our caller, the tax-exempt interest income was flowing through to the individual’s return from a K-1.  This represents non-cash income that must be backed out of her borrower’s total Schedule B cash flow.

For more information about this topic or any other issues you may encounter in your cash flow analysis, feel free to contact our Bukers Hotline at (503) 520-1303. As a reminder, this is a complimentary service that we provide to all Bukers software users.

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