In this article, you will learn what is the meaning of the de minimis tax rule. One of the main advantages of municipal securities is that, in most cases, the coupon income is not subject to federal income tax. However, it's crucial to remember that the increase in the value of assets acquired at a discount on the secondary market may be subject to taxation. The de minimis tax rule is a law that governs the treatment and accounting of small market discounts.
What is the Meaning of the De Minimis Tax Rule?
The de minimis tax rule sets the threshold at which a discount bond should be taxed as a capital gain rather than as ordinary income. The rule states that a discount that is less than a quarter-point per full year between its time of acquisition and its Maturity is too small to be considered a market discount for tax purposes. Instead, the accretion from the purchase price to the par value should be treated as a capital gain, if it is held for more than one year.
De minimis is Latin for "about minimal things."
Under the de minimis tax rule, if a municipal bond is purchased for a minimal discount, it is subject to capital gains tax rather than the (usually higher) ordinary income tax rate.
According to the Internal Revenue Service (IRS), a minimal discount–defined as an amount less than a quarter of a percent of the par value multiplied by the number of complete years between the purchase date of the bond and its maturity date–is too Small to be considered a market discount for income tax purposes.
How to Calculate De Minimis?
To determine whether a municipal bond is subject to the 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 of full years between the discounted bond's purchase date and the Maturity date. Subtract the derived de minimis amount from the bond's par value.
If this amount is higher than the purchase price of the discount bond, the purchased bond is subject to the ordinary income tax rate. If the purchase price is above the de minimis threshold, capital gains tax is due.
In other words, if the market discount is less than the de minimis amount, the discount on the bond is generally treated as a capital gain upon its sale or redemption rather than as ordinary income.
Bottom Line
The de minimis tax rule defines when a municipal bond redemption is a capital gain rather than ordinary income. The cutoff for treatment as a capital gain is one-quarter point per full year between acquisition and maturity. The de minimis tax rule generally is relevant only in an environment of rising interest rates. This article is about what is the meaning of the de minimis tax rule.
