Understanding the De Minimis Tax Rule: Definitions & Examples

Overview

The de minimis tax rule determines whether the gain on a bond bought at a discount is taxed as a capital gain or as ordinary income. For municipal bonds, the IRS treats a very small market discount as insignificant (de minimis). If the discount is below the de minimis threshold, the gain when the bond is sold or redeemed is treated as a capital gain rather than ordinary income.

This rule is most relevant when bond prices fall—commonly in rising interest rate environments—so investors who buy discount bonds should understand how the threshold is calculated and applied.

The rule in plain terms

• “De minimis” means the discount is so small it is not treated as a market discount for income tax purposes.
• If the market discount is less than the de minimis amount, any accretion from the purchase price to par is taxed as a capital gain (if applicable).
• If the market discount equals or exceeds the de minimis amount, the excess discount is generally treated as ordinary income when realized.

How to calculate the de minimis amount

1. Identify the bond’s par (face) value.
2. Use 0.25% as the annual rate (0.0025 in decimal form).
3. Multiply the par value by 0.0025 and then by the number of full years between purchase and maturity.

Formula:
de minimis amount = par value × 0.0025 × full years to maturity

Calculate the cutoff price:
cutoff price = par value − de minimis amount

Compare the bond’s purchase price to the cutoff:
– If purchase price < cutoff price → discount exceeds de minimis → ordinary income treatment.
– If purchase price ≥ cutoff price → discount is de minimis → capital gains treatment.

Example

A municipal bond has:
– Par value = $100
– 5 years to maturity

Step 1: de minimis amount = 100 × 0.0025 × 5 = 1.25
Step 2: cutoff price = 100 − 1.25 = 98.75

Interpretation:
– If you bought the bond at $99 (above 98.75), the $1 discount is less than 1.25 → treated as a capital gain on sale/redemption.
– If you bought the bond at $95 (below 98.75), the $5 discount exceeds 1.25 → ordinary income treatment on the discount portion.

When this matters

• Rising interest rates often push bond prices below par, creating discounts. The de minimis rule determines whether those discounts result in capital gains or ordinary income.
• The rule applies specifically to market discount situations; different tax rules apply to original issue discount (OID) and premium bonds.

Key takeaways

• The de minimis rule uses a 0.25% per-year threshold to decide tax treatment for bond discounts.
• Compute de minimis = par × 0.0025 × full years to maturity and compare the purchase price to par minus that amount.
• Purchase price below the cutoff typically leads to ordinary income tax on the discount; purchase price at or above the cutoff leads to capital gains treatment.
• Understand this rule to anticipate tax consequences when buying discounted municipal bonds.