If you are an investor in tax-exempt municipal bonds, I want to make you aware of a tax rule that has become important again after not being a factor for many years. It’s called the de minimis tax rule, and it can result in an investor having to pay income tax rates on muni bond price appreciation. This rule is especially important now with so many municipal bonds trading at deep discount prices because of the rising interest rate environment.
Table of Contents
- What is the De Minimis Rule?
- Calculating the Threshold Price
- How to Determine the De Minimis Impact
- The De Minimis Rule & Deeply Discounted Bonds
- What If You’re Holding Muni Bonds?
- What If You’re Buying Muni Bonds?
- Bloomberg Resources for De Minimis Rule Questions
What is the De Minimis Rule?
With tax-exempt munis, the income received is not taxable at the Federal level, and possibly at the state level as well. However, the price appreciation is taxable if you pay below par for a muni bond.
Usually, the appreciation amount would be taxable at the prevailing capital gains tax rate. However, there may be circumstances where the price appreciation is taxed at current income tax rates instead. That’s where the de minimis rule comes into play. The de minimis tax rule determines whether the price appreciation of a municipal bond purchased at a discount is taxed as a capital gain or income.
Calculating the Threshold Price
To determine whether the rule applies, we need to calculate the de minimis threshold price. To calculate the threshold price, we simply multiply the years until the bond’s maturity by 0.25%. Then, we subtract that number from par, or 100, which gives us the threshold price.
For example, if we have a five-year tax-exempt muni, we multiply 0.25% by 5 to get 1.25%. If we subtract 1.25 from 100, we get 98.75, which is the threshold price.
The one exception to this formula is when a bond is issued at a price below par, otherwise known as an “original issue discount.” In that case, we’d subtract the amount we calculate from the discounted price instead of par. So if a muni bond was originally issued at a price of 98, we’d subtract the amount we calculated (number of years to maturity times 0.25%) from 98 instead of 100.
How to Determine the De Minimis Impact
Once we know the threshold price, how do we use it? If you purchase a tax-exempt muni bond at a discount, and that discount is above the threshold price, then the accretion of that discount will be taxed at the capital gains tax rate if the investor holds the investment for more than one year.
On the other hand, if the discount price is below the threshold price, then the entire price accretion from the purchase price to par would be taxed at the ordinary income tax rate.
The De Minimis Rule & Deeply Discounted Bonds
Buying a deeply discounted tax-exempt municipal bond can create a greater tax impact, with the degree of impact depending on the investor’s income tax rate. This is especially true for S-corp banks, where the income passes through to shareholders at their respective individual tax rates, which can be much higher than the corporate income tax rate paid by C-corp institutions.
So why is this tax rule back on the front burner again? With the significant increase in interest rates over the past few months, and given the inverse relationship between interest rates and bond prices, many existing municipal bonds are trading at discounts.
Given the large shift in interest rates, bond prices have fallen sharply, with some bonds trading at prices in the 80s and low 90s. That puts the discounts well below the threshold prices determined by the de minimis rule.
When such a situation occurs, as we’ve seen over the past couple of months, it can affect the muni market in several ways. First, it can cause the number of buyers to dry up as they become less interested in muni bonds with deep discounts, given the higher tax impact. Those buyers that stick around tend to desire a better price to compensate them for the effect of the de minimis tax rule. That means they’ll want a lower price to produce a higher overall after-tax return that offsets the higher capital gains tax rate.
What If You’re Holding Muni Bonds?
What does all this mean for community bank investors holding tax-exempt municipal bonds with deep discounts? First, the liquidity for these bonds has become much lower. With less liquidity, pricing becomes sloppier, and bids typically become lower.
I know of bankers that tried to sell positions after rates rose and were surprised by how low the bids they received were. The prices were driven by the lack of buyers, as well as bond traders bidding a little wide to provide some wiggle room in the volatile market.
In addition, the lower liquidity and required lower prices from buyers to offset the higher tax impact caused tax-exempt muni bond prices to drop further. It caught some investors off guard, as a sudden whoosh in prices happened after prices had already declined in the higher rate environment.
If your bank is holding muni bonds now trading at deep discounts, it’s important to understand that pricing could continue to be messy for a while. Unless you need to liquidate a position, you may need to sit tight, at least for now.
What If You’re Buying Muni Bonds?
What about if you’re buying tax-exempt munis? Then, it’s essential to keep in mind the de minimis tax rule and the threshold price calculation. Remember, any municipal bond purchased at a discount below the threshold price will have its price accretion taxed at ordinary income tax rates.
One way to manage the price is to buy municipal bonds with higher coupon rates. To the degree that you can find them, the higher coupon rate will provide a little bit of a cushion and result in a higher price that may be above the de minimis threshold price. Keep in mind that the shorter the bond’s maturity, the closer that discount would need to be to par.
Bloomberg Resources for De Minimis Rule Questions
Bloomberg has a couple of resources that help make sure you know how a discount bond will be treated under the de minimis tax rules. The first resource is a Bloomberg quick reference known as QTAX, which will provide the threshold cutoff price for the de minimis rule. QTAX will tell you what that price level is so you know where a bond’s price would be in comparison.
In addition, Bloomberg’s FTAX screen will give you detailed Federal tax information on a tax-exempt municipal bond. After you enter purchase and maturity information on a bond, the FTAX screen provides a breakout of the tax treatment, including whether the price accretion is taxable as a capital gain or ordinary income.
If you don’t have access to a Bloomberg, your broker can run the screen and grab a copy for you. It’s good information to have if you’re in the market for tax-exempt muni bonds trading at discounts.
Of course, I would be remiss if I didn’t mention that you should check with your tax accountant if you need more formal guidance. I’m not a tax advisor, and I don’t play one on TV, so please make sure you check with the experts if needed beforehand.
Understanding the de minimus tax rule and how it operates is essential for investors in tax-exempt municipal bonds. It can help ensure you don’t pay any unexpected income taxes on bonds you purchase at a discount, especially in the current rate environment.