When the De Minimis Rule Applies
Understand possible taxation on municipal bonds purchased at a discount
While one of the benefits of buying municipal bonds is the federally tax-free status of their interest, there are circumstances where a buyer could be subject to taxes. Tax-exempt municipal bonds are subject to market discount rules established by the IRS. The most common tax situation regarding market discounts arises when an investor purchases a bond at a price below face value, known as a discount. The tax consideration for discount buyers is called The De Minimis Tax.
Here’s How it Works
The de minimis tax rule states that a bond bought at a discount of more than a quarter point per year from the purchase date to maturity would be subject to ordinary income tax on the gain. This ordinary income tax rate is typically higher than the capital gains rate.
Here are two examples that illustrate how the de minimis tax may apply:
Years to maturity: 10
De minimis threshold = $1,000 – (.25% x 10 yrs to maturity.) = $975.00 or $97.50
A bond purchased BELOW de minimis tax threshold
Purchase Price: $980.00 ($98.00) per bond
$975 – $980 = -5
The discounted bond is not greater than the threshold.
Not subject to the de minimis tax.
Example #1
A bond purchased ABOVE de minimis tax threshold
Purchase Price: $900.00 ($90.00) per bond
$975 – $900 = $75
$75 gain per bond is subject to the de minimis tax.
Example #2
To avoid de minimis tax
To avoid the de minimis tax, purchase bonds close to par/face value, at a premium (more than face value), or stay within the de minimis threshold price when purchasing.
Note on possible taxation on capital gains and out-of-state bond purchases:
In addition to the de minimis, municipal bonds may be subject to Federal Capital Gains Tax if you sell a bond earlier than maturity at a price greater than cost.
The above examples reference Federal taxation. Investors subject to state income taxes could be taxed on the interest earned on out-of-state bond purchases.
The Bottom Line
Municipal bonds offer a significant tax advantage for investors looking for tax-free income. However, there are circumstances where an individual may be subject to taxation. We suggest you speak with your tax professional concerning these matters.
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