The De Minimis Tax Rule: An Overview

The De Minimis Tax Rule: An Overview

Let me walk you through the de minimis tax rule, which establishes the point at which a discount on a bond gets taxed as a capital gain rather than ordinary income. According to this rule, if the discount is less than a quarter-point per full year from when you acquire the bond to its maturity, it's deemed too minor to count as a market discount for tax purposes. In that case, the increase from your purchase price to the par value is handled as a capital gain, provided you've held it for more than one year.

You might be wondering about the term itself—de minimis is Latin for 'about minimal things,' which fits perfectly here.

De Minimis Tax Rule Explained

Under the de minimis tax rule, when you buy a municipal bond at a small discount, it falls under capital gains tax instead of the typically higher ordinary income tax rate. The IRS specifies that a minimal discount—less than a quarter of a percent of the par value multiplied by the number of complete years from your purchase date to maturity—isn't treated as a market discount for income tax. This rule mainly comes into play when interest rates are rising, as that's when bond prices drop and discounts become common.

How to Calculate De Minimis

To figure out if your municipal bond qualifies for capital gains tax or ordinary income tax under this rule, start by multiplying the face value by 0.25%, then multiply that by the number of full years from the purchase date to maturity. Subtract this de minimis amount from the bond's par value. If the result is higher than what you paid for the discount bond, you'll owe ordinary income tax. But if your purchase price is above that threshold, it's capital gains tax that applies.

Remember, 'de minimis' translates to 'about minimal things,' so an insignificant discount isn't treated as ordinary income—it's a capital gain if the market discount is below the de minimis amount upon sale or redemption.

Example of the De Minimis Rule

Consider this scenario: you're eyeing a 10-year municipal bond with a par value of 100, but it has five years left to maturity. The de minimis discount calculates as 100 par value times 0.0025 times 5 years, which equals 1.25. Subtract that from the par value, and you get the cutoff of 98.75. This is the minimum price where the IRS would treat the discount as a capital gain.

If you buy this bond below 98.75 per 100 of par—say, at $95—ordinary income tax kicks in at redemption because $95 is under 98.75. Put another way, the market discount of 5 (100 minus 95) exceeds the de minimis of 1.25, so your profit is taxed as income, not capital gains.

Keep in mind a fundamental bond pricing rule: rising interest rates push bond prices down, and that's when the de minimis tax rule often applies, as bonds sell at discounts in those conditions.