No, don't reduce the interest reported on your 1099-B. Rather, enter it as is and then make a negative corresponding entry that represents the interest you paid the other bond holder. To enter a corresponding negative amount, in TurboTax online, from the Wages & Income section scroll down to Less Common Income, then select Miscellaneous Income and then select Other Reportable Income. Enter a description for the adjustment (Adj for exempt interest) and then enter the adjustment as a negative figure.
If you are using TurboTax CD/download, the steps are essentially the same. Select the Personal tab, then Personal Income, and scroll down the screen to Less Common Income. Then continue as mentioned above.
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