De Minimus Rule

While one of the benefits of buying municipal bonds is the federally tax-free status of their interest, there are circumstances where a buyer could be subject to taxes.

Tax-exempt municipal bonds are subject to market discount rules established by the IRS. The most common tax situation regarding market discounts arises when an investor purchases a bond at a price below face value, known as a discount.

The tax consideration for discount buyers is called The De Minimis Tax.

The de minimis tax rule states that a bond bought at a discount of more than a quarter point per year from the purchase date to maturity would be subject to ordinary income tax on the gain. This ordinary income tax rate is typically higher than the capital gains rate.

For example:

A $1,000.00 bond maturing in 10 years purchased at $97.50 ($975.00) per bond would not be subject to the de minimis tax.

$1,000. - (.25% x 10 yrs.) = $975.00 or $97.50

In this example, the buyer would not be subject to the de minimis tax.

Another example:

If you bought the same bond at a $90.00 or ($900.00) per bond, the calculation would be the same, but since the purchase price is below the threshold of $97.50 ($975.00), there would be a de minimis tax on the $75.00 gain.

To avoid the de minimis tax, purchase bonds close to par/face value, at a premium (more than face value), or stay within the de minimis threshold price when purchasing.

In addition to the de minimis, individual investors may be subject to Federal Capital Gains Tax if they sell a bond earlier than maturity at a price greater than cost.

Lastly, while the above examples reference Federal taxation, some investors subject to state income taxes could be taxed on the interest earned on out-of-state bond purchases.

The bottom line is that municipal bonds offer a significant tax advantage for investors looking for tax-free income. However, there are circumstances where an individual may be subject to taxation. We suggest you speak with your tax professional concerning these matters.