Understanding the De Minimis Tax Rule: Definitions & Examples

The De Minimis Tax Rule: An Overview

The de minimis tax rule determines whether the gains on municipal bonds purchased at a discount are treated as capital gains or ordinary income tax. This rule sets the threshold at which a discount bond should be taxed as a capital gain rather than as ordinary income.

Regarding bonds and taxes, the IRS defines a discount of less than a quarter-point per full year between its time of acquisition and its maturity as too small to be considered a market discount for tax purposes. If held for over a year, the accretion from the purchase price to par value is treated as a capital gain.

This impacts bonds purchased at a discount, especially during periods of rising interest rates when bond prices typically decline.

Calculating and Applying the De Minimis Tax Rule

Under the de minimis rule, a municipal bond bought at a small discount is taxed as a capital gain, not as ordinary income.

The IRS defines a minimal discount as less than 0.25% of the par value multiplied by the complete years to maturity. It’s too small to be a market discount for income tax.

Calculating the De Minimis Amount

To calculate whether a municipal bond is subject to the capital gains tax or ordinary income tax, follow these steps:

1. Determine the Bond’s Face Value: Identify the face value of the bond.
2. Apply the Quarter-Point Formula: Multiply the face value by 0.25%.
3. Calculate Based on Time Frame: Multiply the result by the number of full years between the bond’s purchase date and maturity date.
4. Subtract the De Minimis Amount: Subtract the calculated de minimis amount from the bond’s par value.
5. Compare with Purchase Price: If the bond’s purchase price is below this calculated threshold, it is subject to ordinary income tax. Otherwise, it is subject to capital gains tax.

Simply put, if the market discount is below the de minimis amount, it’s treated as a capital gain when sold or redeemed, not as ordinary income.

Practical Example of Applying the De Minimis Rule

Imagine a 10-year municipal bond with a $100 par value and five years to maturity. The de minimis discount is 100 par value x 0.0025 x 5 years = 1.25.

You then subtract the 1.25 from the par value to get the de minimis cut-off amount, which in this example is 98.75 = 100 – 1.25. This is the lowest price at which the bond can be purchased for the IRS to treat the discount as a capital gain.

In this example, if the price of the discount bond you purchased is below 98.75 per 100 of par value, you will be subject to ordinary income tax under the de minimis tax rule.

So, if you purchased this bond for $95, ordinary income tax will apply when the bond is redeemed at par, since $95 is less than $98.75.

Another way to look at it is the market discount of 100 – 95 = 5 is higher than the de minimis amount of 1.25. Therefore, the profit on the sale of the bond is income, not capital gains.

A basic bond pricing principle is that when interest rates rise, bond prices fall, and vice versa. The de minimis tax rule typically applies in an environment of rising interest rates. During such periods, the price of bonds falls and they are offered at discounts or deep discounts to par.

The Bottom Line

The de minimis tax rule allows municipal bond investors to treat gains from minimally discounted bonds as capital gains rather than as income, provided they meet the quarter-point threshold. This tax treatment generally occurs during periods of rising interest rates. It is important for municipal bond investors to understand this rule so that they can avoid unexpected tax consequences.

To calculate whether a municipal bond meets the de minimis tax criteria, multiply the face value by 0.25%, and multiply the result by the number of full years between the discounted bond’s purchase date and the maturity date. Then, subtract that de minimis amount from the bond’s par value.