What is the De Minimis tax rule?
The De Minimis tax rule establishes a price threshold to determine whether a discount bond should be taxed as capital gain or ordinary income. It indicates that if a discount is less than a quarter point per full year between the time of acquisition and the due date, then it is too low to be considered a market discount for tax purposes. Instead, the increase in the purchase price at face value should be treated as a capital gain, if held for more than a year.
De minimis is a Latin expression for “about minimal things”.
Explanation of the De Minimis tax rule
Under the de minimis tax rule, if a municipal bond is purchased at a minimum discount, it is subject to capital gains tax. According to the IRS, a minimum discount – an amount less than a quarter percent of the face value multiplied by the number of full years between the date of purchase of the bond and its maturity date – is too low for be a market discount for income tax purposes.
To determine if a municipal bond is subject to capital gains tax or ordinary income tax using the de minimis tax rule, multiply the face value by 0.25% and multiply the result by the number full years between the date of purchase of the discounted bond and the maturity date. Subtract the de minimis amount derived from the face value of the bond. If this amount is greater than the purchase price of the discount bond, the bond purchased is subject to the ordinary tax rate. If the purchase price is above the de minimis threshold, a capital gains tax is due. In other words, if the market discount is less than the de minimis amount, the bond discount is generally treated as a capital gain on sale or redemption rather than ordinary income.
For example, if you are considering a 10-year municipal bond with a face value of 100 and five years to maturity, the de minimis discount is 100 face value x 0.0025 x 5 years = 1.25. You then subtract 1.25 from the nominal value to get the de minimis threshold, which in this example is 98.75 = 100 – 1.25. This is the lowest price for which the bond can be purchased so that the IRS treats the discount as a capital gain. If the price of the discount bond you purchased is less than 98.75 per cent of the face value, you will be subject to ordinary income tax under the de minimis tax rule. So, if you bought this bond for $ 95, an ordinary income tax will apply when the bond is redeemed at par, since $ 95 is less than $ 98.75. Another way of looking at it is that the market discount of 100 – 95 = 5 is greater than the de minimis amount of 1.25, so the profit on the sale of the bond is income.
A basic principle of bond pricing is that when interest rates rise, bond prices fall, and vice versa. The de minimis tax rule generally applies in an environment of rising interest rates which sees the price of bonds fall and offered at discount or equal discount.