the de minimis tax rule an overview
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 de minimis tax rule explainedunder 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 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 de minimis means about minimal things an insignificant discount is not treated as a capital gain 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 say you are looking at a 10 year municipal bond with a par value of 100 and five years left until maturity the de minimis discount is 100 par value x 0 0025 x 5 years 1 25 you then subtract the 1 25 from the par value to get the de minimis cut off amount which in this example is 98 75 100 1 25 this is the lowest price at which the bond can be purchased for the irs to treat the discount as a capital gain in this example if the price of the discount bond you purchased is below 98 75 per 100 of par value you will be subject to ordinary income tax under the de minimis tax rule so if you purchased this bond for 95 ordinary income tax will apply when the bond is redeemed at par since 95 is less than 98 75 another way to look at it is the market discount of 100 95 5 is higher than the de minimis amount of 1 25 therefore the profit on the sale of the bond is income not capital gains a basic bond pricing principle is that when interest rates rise bond prices fall and vice versa the de minimis tax rule typically applies in an environment of rising interest rates during such periods the price of bonds falls and they are offered at discounts or deep discounts to par 