What is the 'De Minimis Tax Rule'
The De Minimis tax rule states a price threshold to determine whether a discount bond should be taxed as capital gain or ordinary income. It states that if a discount is less than a quarter point per full year between the time of acquisition and maturity, then it 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 held for greater than one year.
De minimis is a Latin expression for "about minimal things."
BREAKING DOWN 'De Minimis Tax Rule'
Under the de minimis tax rule, if a municipal bond is purchased for a minimal discount, it is subject to capital gains tax. According to the IRS, a minimal discount â€“ an amount less than a quarter percent of the par value multiplied by the number of complete years between the purchase date of the bond and its maturity date â€“ is too small to be 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 amount 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 sale or redemption rather than as ordinary income.
For example, if you are looking at a 10year 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 â€“ 1.25. This is the lowest price the bond the bond can be purchased for in order for the IRS to treat the discount as a capital gain. 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, an 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 â€“ 95 = 5 is higher than the de minimis amount of 1.25, hence, the profit on the sale of the bond is income.
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 a rising interest rate environment which sees the price of bonds fall and offered at discounts or deep discounts to par.

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