Thank you. That's helpful. Based on your comment I did some additional research and found that the US Supreme Court ruled on this very topic in December 1994 (Nebraska v. Loewenstein, No. 93-823) and confirmed it. Not sure how the US Supreme Court can rule on a state income tax issue, but I don't plan on wasting the time on that one.
The last question on this topic relates to repurchase agreements with the Federal Reserve. The Federal Reserve is an agency of the United States like the Federal Home Loan Bank. So it would make sense that interest the Federal Reserve pays the MMF under a repo agreement should be exempt, while interest that a corporate bank pays to the MMF under a repo would not.
