De Minimis Tax Rule Definition

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De Minimis Tax Rule Definition

The De Minimis Tax Rule: An Overview

The de minimis tax rule determines whether a discount bond is taxed as a capital gain rather than ordinary income. According to the regulation, a discount of less than a quarter-point each full year between purchase and maturity is too tiny to be deemed a market discount for tax reasons. Instead, if held for more than a year, the accretion from the purchase price to the par value should be recognized as a capital gain.

De minimis is Latin for “about minimal things.”

De Minimis Tax Rule Explained

If a municipal bond is acquired at a low discount, it is liable to capital gains tax rather than the (typically higher) regular income tax rate.

Key Takeaways

  • When a municipal bond redemption is treated as a capital gain rather than ordinary income, the de minimis tax rule applies.
  • The threshold for capital gain treatment is one-quarter point each full year between purchase and maturity.
  • In general, the de minimis tax rule is only important when interest rates are increasing.

A minor discount, defined as less than a quarter of a percent of the par value multiplied by the number of full years between the bond’s purchase date and maturity date, is too tiny to be deemed a market discount for income tax purposes, according to the Internal Revenue Service (IRS).

How to Calculate De Minimis

To calculate whether a municipal bond is liable to capital gains tax or ordinary income tax under the de minimis tax rule, multiply the face value by 0.25% and multiply the result by the number of complete years between the purchase date of the discounted bond and the maturity date. Subtract the determined de minimis amount from the par value of the bond.

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If this sum exceeds the purchase price of the discount bond, the bond is taxed at the regular income tax rate. Capital gains tax is imposed if the acquisition price exceeds the de minimis level.

“De minimis” implies “concerning the bare necessities.” A little markdown is not considered a capital gain.

In other words, if the market discount is less than the de minimis amount, the bond discount is normally recognized as a capital gain rather than ordinary income upon sale or redemption.

Example of the De Minimis Rule

Consider a 10-year municipal bond with a par value of 100 and five years to maturity. 100 par value x 0.0025 x 5 years = 1.25 is the de minimis discount.

The de minimis cut-off amount is then calculated by subtracting 1.25 from the par value, which in this case is 98.75 = 100 – 1.25. This is the cheapest price at which the bond may be acquired in order for the IRS to consider the discount a capital gain.

In this case, if the price of the discount bond you bought is less than 98.75 cents on the dollar, you will be liable to ordinary income tax under the de minimis tax rule.

So, if you paid $95 for this bond, ordinary income tax will apply when it is redeemed at par, since $95 is less than $98.75.

To put it another way, the market discount of 100 – 95 = 5 is more than the de minimis amount of 1.25. As a result, the profit on the sale of the bond is income rather than capital gains.

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Bond prices decline when interest rates increase and vice versa, according to a fundamental bond pricing theory. In most cases, the de minimis tax rule applies while interest rates are increasing. Bond prices decline at such times, and they are sold at discounts or substantial discounts to par.

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