De Minimis Tax Rule
The De Minimis Tax Rule: An Overview
The de minimis tax rule sets the threshold at which a discount bond ought to be taxed as a capital gain instead of as ordinary income. The rule states that a discount that is under a quarter-point each full year between its season of acquisition and its maturity is too small to be considered a market discount for tax purposes. All things considered, the accretion from the purchase price to the par value ought to be treated as a capital gain, in the event that it is held for over one year.
De minimis is Latin for "about insignificant things."
De Minimis Tax Rule Explained
Under the de minimis tax rule, on the off chance that a municipal bond is purchased for a negligible discount, it is subject to capital gains tax instead of the (typically higher) ordinary income tax rate.
As indicated by the Internal Revenue Service (IRS), an insignificant discount-defined as an amount under a quarter of a percent of the par value duplicated 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.
Instructions to Calculate De Minimis
To determine whether a municipal bond is subject to the capital gains tax or ordinary income tax utilizing the de minimis tax rule, duplicate the face value by 0.25%, and increase the outcome by the number of full years between the discounted bond's purchase date and the maturity date. Take away the derived de minimis amount from the bond's par value.
On the off chance that this amount is higher than the purchase price of the discount bond, the purchased bond is subject to the ordinary income tax rate. Assuming the purchase price is over the de minimis threshold, capital gains tax is due.
"De minimis" means "about negligible things." A unimportant discount isn't treated as a capital gain.
At the end of the day, on the off chance that the market discount is not exactly the de minimis amount, the discount on the bond is generally treated as a capital gain upon its sale or redemption as opposed to as ordinary income.
Illustration of the De Minimis Rule
Let's assume you are taking a gander 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, at that point, take away the 1.25 from the par value to get the de minimis cut-off amount, which in this model is 98.75 = 100 - 1.25. This is the most minimal price at which the bond can be purchased for the IRS to regard the discount as a capital gain.
In this model, 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.
Thus, assuming you purchased this bond for $95, ordinary income tax will apply when the bond is redeemed at par, since $95 is under $98.75.
One more method for seeing it is the market discount of 100 - 95 = 5 is higher than the de minimis amount of 1.25. Subsequently, the profit on the sale of the bond is income, not capital gains.
A fundamental bond pricing principle is that when interest rates rise, bond prices fall, and vice versa. The de minimis tax rule commonly 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.
Features
- The de minimis tax rule generally is important just in an environment of rising interest rates.
- The cutoff for treatment as a capital gain is one-quarter point each full year among acquisition and maturity.
- The de minimis tax rule defines when a municipal bond redemption is a capital gain instead of ordinary income.
