The 200-page report by accountants PricewaterhouseCoopers (PwC) published on Tuesday said the council handed out hundreds of thousands of pounds in public money to local bodies that were not eligible for the money.
It also criticised the east London council for “failing in its duty to acquire best value for local taxpayers”.
Rahman, an independent politician popular with the Bangladeshi community, was re-elected in May but his victory has been challenged in the High Court amid charges that the vote was riddled with fraud.
Communities Secretary Eric Pickles ordered the PwC in April to investigate allegations of poor governance, financial mismanagement and fraud.
At an hour-long hearing on Tuesday, he told MPs that there was evidence of “cronyism”.
Controversial Mayor Lutfur Rahman, who has been holding office after being directly elected in the Bangladeshi-dominated area since 2010, is accused of corruption and fraud.
He claims the PwC report did not support “wild claims about fraud” and that it merely "highlights flaws in processes".
But Cabinet minister Pickles said the report portrayed a clear picture of a fundamental breakdown of governance there.
The six-month investigation, costing £1 million, blamed Rahman's administration for non-cooperation.
The report found what Pickles called a “worrying pattern of divisive community politics and alleged mismanagement of public money by the mayoral administration”.
Pickles, addressing the House of Commons, further said there were "widespread allegations of extremism, homophobia and anti-Semitism being allowed to fester without proper challenge".
"The abuse of taxpayers' money and culture of cronyism reflects a partisan community politics that seeks to trade favours and spread division on the rates," he said, according to the Telegraph.
The report said the Tower Hamlets authorities would dub allegations baseless and politically motivated without looking into them.
It found a “lack of transparency" in the process of awarding grants.
In one case, the council awarded more than £400,000 in grants to “ineligible organisations” after intervention by a council member.
“Grants have been awarded to organisations which were ruled ineligible or which did not meet the required evaluation score,” the report says.
A team of three commissioners will take over the power to give grants and approve property sales. They will decide on appointments or suspensions of senior council officer.
The commissioners will be there until March 2017 and will report every six months, Pickles said.
"There can be no place for rotten boroughs in this country," he added.
Among the report's key findings are:
Sale of the Poplar Town Hall building at a lower price to one of Rahman's political supporters;
Handing out grants to organisations that failed to meet the council's minimum criteria;
'Inappropriate expenditure' of public money on his political advertising;
Improper investigation of claims that he intervened to increase grants paid to some Bangladeshi organisations;
And showing a tendency of "denial or obfuscation" instead of investigating allegations.
“It (the report) paints a deeply concerning picture of obfuscation, denial, secrecy, the breakdown of democratic scrutiny and accountability, a culture of cronyism risking the corrupt spending of public funds,” Pickles was quoted as telling the Commons by London Evening Standard.
