How the De Minimis Tax Rule Affects Municipal Bonds
The tax treatment of a market discount on a municipal bond affects your net return. Learn how the de minimis rule determines if this gain is taxed as capital or ordinary income.
Municipal bonds, issued by state and local governments, offer interest income that is typically exempt from federal taxes. When these bonds are purchased in the secondary market for a price lower than their face value, this difference is known as a market discount. The tax treatment of this discount when the bond is sold or redeemed is determined by a specific IRS provision, the de minimis rule. This rule dictates how the gain is classified, which can impact an investor’s tax liability.
Understanding Market Discount on Municipal Bonds
Market discount arises when a bond’s value decreases in the secondary market after it has been issued. This often occurs when prevailing interest rates rise, making new bonds with higher rates more attractive. As a result, existing bonds with lower fixed rates see their market price fall below face value to offer a competitive yield. This difference between the lower purchase price and the bond’s face value is the market discount.
It is important to distinguish market discount from Original Issue Discount (OID). OID occurs when a bond is first sold to the public for less than its face value, and its tax rules are different. Market discount applies only to bonds purchased in the secondary market.
The De Minimis Rule Explained
The de minimis rule is a tax provision that establishes a threshold to determine if a market discount is small enough to be considered negligible. If the discount falls below this threshold, the IRS allows the gain to be treated as a capital gain, which is often taxed at lower rates than ordinary income. A discount that exceeds this calculated amount receives less favorable tax treatment.
The threshold is determined by taking one-quarter of one percent (0.25% or 0.0025) of the bond’s stated redemption price at maturity. That figure is then multiplied by the number of full years from the date the investor acquires the bond until its maturity date.
Calculating the De Minimis Threshold
To apply the de minimis rule, an investor needs the bond’s face value, its purchase date, and its maturity date. The first step is to determine the number of full years remaining until the bond matures from the purchase date. For example, if a bond is purchased on July 1, 2025, and it matures on December 31, 2033, there are eight full years to maturity.
Next, multiply the bond’s face value by 0.0025. If a bond has a face value of $10,000, this step yields $25. The final step is to multiply that result by the number of full years to maturity. Continuing the example, multiplying $25 by 8 years gives a de minimis threshold of $200. The investor must then compare their actual market discount to this calculated threshold.
Tax Implications Based on the De Minimis Rule
The tax consequences depend on comparing the actual market discount to the calculated de minimis threshold. The primary difference is whether the gain is classified as a capital gain or as ordinary income.
If the market discount is less than or equal to the de minimis threshold, the entire discount is treated as a capital gain. Using the previous example, if the investor bought the $10,000 face value bond for $9,850, the market discount is $150. Since $150 is less than the $200 de minimis threshold, the entire $150 gain is a capital gain.
Conversely, if the market discount is greater than the threshold, the tax treatment is different. If the bond is held to maturity, the entire market discount is treated as ordinary income. For instance, if an investor bought the same bond for $9,700, the $300 market discount exceeds the $200 threshold and is taxed as ordinary income.
If the bond is sold before maturity, only the portion of the discount that has accrued is taxed as ordinary income, with any remaining gain treated as a capital gain. The IRS allows the accrued market discount to be calculated using either a ratable (straight-line) or constant yield method.
Reporting on Your Tax Return
When reporting the sale or redemption of a municipal bond, the transaction is reported on Form 8949, Sales and Other Dispositions of Capital Assets, with totals carrying over to Schedule D (Form 1040). If the market discount exceeds the de minimis threshold, different reporting is required.
The portion of your gain treated as ordinary income must be reported as interest income on Schedule B (Form 1040). To separate this from the capital gain, you must make an adjustment on Form 8949. Your broker will typically report the amount of accrued market discount on Form 1099-B, which helps with this calculation.