Understanding the De Minimis Tax Rule
Municipal securities offer a significant advantage: the interest income, in most cases, is exempt from federal income taxation. However, it's crucial to be aware that if you purchase securities at a discount in the secondary market, the price appreciation can potentially be subject to taxation. The tax rate applied to these discounted securities hinges on a somewhat obscure section of the Internal Revenue Code known as the de minimis tax rule.
In an environment where interest rates are rising, the de minimis rule introduces a potential tax risk. This risk can impact not only the after-tax returns of investors in higher tax brackets but also influence the pricing of municipal securities. In this discussion, we delve into the fundamentals of the de minimis rule and explore its potential importance for municipal bond investors.
Understanding the Fundamentals of the De Minimis Rule
Essentially, the de minimis rule plays a pivotal role in determining whether the price appreciation, also known as price accretion, of securities purchased at a discount will be subject to taxation at the ordinary income tax rate or the capital gains tax rate. Before the early 1990s, this accretion was categorized as a capital gain. However, in 1993, revisions were made to the federal tax code, resulting in the treatment of discounted municipal bond accretion as ordinary income, with certain specific exceptions applicable to smaller market discounts.
The de minimis rule stipulates that if a discount amounts to less than 0.25% of the face value for each full year from the date of purchase to maturity, it is deemed too insignificant (i.e., de minimis) to be considered a market discount for tax purposes. Instead, the accretion should be treated as a capital gain.
The de minimis threshold price is the determining factor for whether the market discount accretion is subject to taxation at the ordinary income or the capital gains tax rate. Its definition is as follows.
For certain municipal investors, especially those in higher tax brackets, the taxation of a bond's market discount can significantly affect their after-tax returns. In the case of a municipal security purchased at a discounted price below the de minimis threshold, the price accretion is subject to the ordinary income tax rate (43.4% for top earners1). In contrast, if a security is acquired at a discount but at a price above the de minimis threshold, the accretion is subject to a much lower capital gains tax rate (23.8% for top earners) when the bond is held for more than one year.2
The Effects of Market Discounts in a Rising Interest Rate Environment
In a scenario where interest rates are on the rise, the decline in bond prices could lead to more municipal securities dropping below the de minimis threshold. As higher interest rates cause bond prices to decrease, those securities issued at or near par may now face heightened vulnerability to the negative tax and liquidity implications associated with the de minimis rule.
- Tax Impact: Due to the elevated tax rate that buyers would face when acquiring bonds below the de minimis threshold, securities trading close to or below this threshold are expected to trade at a reduced price (and higher yield) to offset the tax-related impact on investors.
- Liquidity Impact: The potential taxes linked to the de minimis rule can result in disruptions in market demand due to a smaller pool of potential buyers. Even when yields adequately compensate investors for the higher tax treatment, traditional tax-sensitive municipal buyers may avoid securities with any tax implications.
Indeed, these dynamics have the potential to give rise to what is often referred to as a "price cliff" when bonds approach the de minimis cutoff. The consequence of higher taxes and reduced market liquidity may lead to a swifter deterioration in bond prices than would occur if the prices were higher and more distant from this threshold.
The Impact of Rising Interest Rates: An Illustrative Example
Let's examine the following scenario involving municipal security issued at par with a 10-year maturity:
- In case the security was acquired for less than $97.50, the entirety of the accretion from the purchase price to $100 would be subject to the ordinary income tax rate (43.4% for top earners).
- If the security was bought at a price ranging from $97.50 to $100, the complete accretion from the purchase price to $100, as per the de minimis rule, would be subject to the capital gains tax rate (23.8% for top earners) if held for more than one year.
How We Help Investors Manage These Potential Tax Consequences
While many investors may consider their municipal bond allocations as long-term buy-and-hold investments until maturity, it's crucial to recognize that unforeseen factors such as credit deterioration or unexpected liquidity needs could necessitate bond sales in even the most buy-and-hold portfolios. Therefore, it remains important to consider the potential impact of the de minimis rule when choosing between par bonds.
In an environment where interest rates are on the rise, selling market discount securities can become more challenging due to the tax and liquidity implications associated with the de minimis rule. Our approach involves maintaining a focus on after-tax returns, aimed at safeguarding municipal portfolios against the potential adverse effects of the de minimis market discount rule.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
1Tax rate is determined using the top Federal Marginal Tax Rate of 39.6% plus a Medicare Tax of 3.8% for top earners.
2Note that the de minimis rule would generally apply to individual holders – institutional investors, such as mutual funds, generally amortize market discount into current income as taxable income. Tax rate includes Medicare Tax of 3.8% for top earners.