What’s the De Minimis Tax Rule?
The de minimis tax rule establishes when a bond’s discount is classified as a capital gain rather than ordinary income. Following this rule, minuscule discounts are treated more favorably. When a discount is less than a quarter-point per full year remaining until the bond’s maturity, it’s considered too minor to be deemed a market discount. Instead, any accretion from the purchase price to the par value is treated as a capital gain if held for more than a year.
“De minimis” translates from Latin to mean “about minimal things.”
De Minimis Tax Rule Detailed Explanation
According to the de minimis tax rule, municipal bonds bought at a minimal discount undergo capital gains tax instead of the usually higher ordinary income tax rate.
Essential Points to Know
- The de minimis tax rule specifies conditions for a bond’s redemption to be viewed as a capital gain instead of ordinary income.
- The critical threshold is a quarter-point per full year between the bond’s purchase and its maturity.
- This rule becomes particularly relevant during periods of rising interest rates.
The IRS identifies a minimal discount as one less than 0.25% of the bond’s par value, multiplied by the number of complete years between the purchase date and maturity date. This discount is too negligible to count as a market discount for income tax purposes.
Calculating De Minimis Threshold
Determining whether a municipal bond falls under capital gains tax or ordinary income tax using the de minimis rule is straightforward: multiply the face value by 0.25%, then multiply that result by the number of full years remaining until the bond’s maturity. Subtract this de minimis amount from the bond’s par value.
If the result is greater than the purchase price, the bond is taxed under the ordinary income rate. If above the threshold, capital gains tax applies instead.
In essence, if the market discount falls below the de minimis amount, it is generally treated as a capital gain upon redemption, not as ordinary income.
Applying the De Minimis Rule: An Example
Imagine you’re considering a 10-year municipal bond with a par value of 100 and five years left until maturity. First, calculate the de minimis discount: 100 par value \times 0.0025 \times 5 years = 1.25. Then, subtract 1.25 from the par value to get the de minimis cut-off amount, here being 98.75
If you purchase the bond for less than 98.75 per 100 of par value, you’ll be subject to ordinary income tax. For instance, buying the bond for $95 incurs ordinary income tax upon redemption, as $95 is less than 98.75. The discrepancy, equivalent to 100 par value - 95 = 5, exceeds the de minimis 1.25; thus, the profit from the bond sale is seen as income rather than capital gain.
A core bond pricing principle states that a rise in interest rates leads to a fall in bond prices. The de minimis tax rule becomes applicable predominantly in escalating interest environments, where bond prices drop and sell at discounts or deep discounts to par.
Related Terms: market discount, capital gains tax, ordinary income tax, par value, deep discount bond.
