Tax-exempt income received by an estate or trust requires an allocation of expenses between taxable income and tax-exempt income. The allocation must be included with the estate or trust tax return.
Per IRS Instructions for Form 1041 and Schedules A, B, G, J, and K-1 U.S. Income Tax Return for Estates and Trusts, on page 36:
If the estate or trust received tax-exempt income, figure the allocation of expenses between tax-exempt and taxable income on a separate sheet and attach it to the return. Enter only the deductible amounts on the return. Don't figure the allocation on the return itself. For more information, see the instructions for Allocation of Deductions for Tax-Exempt Income, earlier.
Report the amount of tax-exempt interest income received or accrued in the space provided below Question 1.
Also, include any exempt-interest dividends the estate or trust received as a shareholder in a mutual fund or other regulated investment company.
On page 21:
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:
Exception. State income taxes and business expenses that are allocable to tax-exempt interest are deductible.
On page 22:
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.
To access the Tax-Exempt Income Allocation of Expenses worksheet in TaxAct:
Note. If you see a message indicating you have not paid your return fees, click the View/Pay your return fees link, which will direct you through the Paper Filing steps. Continue through the screens until you have processed the payment for your product fees and then repeat the steps to print.
Note that any link in the information above is updated each year automatically and will take you to the most recent version of the document at the time it is accessed.