When Municipal Bonds are Not Tax-Exempt

As interest rates rise, the often-overlooked de minimis rule can create tax liabilities for income-seeking investors.

The primary benefits offered by municipal bonds are generally well known to investors. Chief among these benefits is steady, predictable income, which is typically exempt from federal income tax—and, in some cases, also exempt from state and local income tax, depending on whether you are a resident of the state in which the bonds are issued.

However, something that municipal bond investors may not be aware of is a potential tax liability as it pertains to discounted bonds. While income from municipal securities may be tax-exempt, price appreciation on a bond purchased at a discount in the secondary market is generally taxable. How this tax is treated pertains to the de minimis rule, a tax rule that defines when a municipal bond redemption may be considered a capital gain rather than ordinary income.

The de minimis rule does not affect the way original issue discount (“OID”) municipal bonds are treated. The term “OID” is a discount from par value at the time a bond is originally issued. There is no taxation of the original issue discount because the difference between the discount price and the matured value is considered interest, which is tax-exempt. However, if an OID municipal bond is purchased at a discount in the secondary market, the discount amount is generally taxed as ordinary income at the time the bond is sold or redeemed, as with other tax-exempt securities.

In this article, we’ll discuss the de minimis rule, along with key considerations for investors, particularly in periods of rising interest rates.

De Minimis Defined

The accrued market discount on a municipal bond is typically treated as ordinary income when it is sold or redeemed. An exception is a bond with a small discount, defined by the de minimis rule. According to this rule, if a discount is less than 0.25% of the face value of a bond for each full year from the time of purchase to maturity, then it is considered too small to be a market discount for tax purposes. It is then treated as a capital gain rather than ordinary income, thereby providing a tax advantage to investors.

For example, consider a hypothetical 10-year bond bought at $980, giving it a $20 discount (assuming a face value of $1,000). The de minimis “threshold” for this bond is computed by multiplying the face value of the bond by 0.25% (.0025) times the number of years to maturity. For this particular bond, the de minimis threshold is calculated using the following equation:

$1,000 (face value of the bond) x .0025 x 10 (years to maturity) = $25 (de minimis threshold)

In this example, the discount of $20 is less than the de minimis threshold of $25, so the de minimis exception — and, therefore, capital gain tax treatment (rather than ordinary income) — would apply.

Effects on Market Discounts

The consequence of a municipal bond “crossing the threshold” may affect its relative valuation and market liquidity. Once a bond’s price exceeds the de minimis threshold, it is generally considered less attractive on a relative basis, which may have a significant impact on prevailing bids in the marketplace and its daily pricing.

Additional Reading: Why Clients Need High-Quality Individual Bonds 

There are a number of important factors that go into determining the price and relative valuation of municipal bonds. These include the type of security (e.g., general obligation or revenue bond), credit rating of the issuer, maturity date, yield and expected liquidity, among others. The de minimis rule and its potential tax consequence can also influence the price of a bond in the secondary market.

In a rising interest rate environment, higher yields can result in deeper price discounts, and with them, the need for greater awareness of the de minimis rule. As higher interest rates drive bond prices lower, those securities issued at or near par may be more vulnerable to negative tax and liquidity implications associated with de minimis.

Although municipal bond investors often hold their bonds until the stated maturity, there may be reasons why they may choose to sell them prior to the maturity date. Keep in mind that if investors receive a price greater than their cost basis, the gain may be subject to capital gains tax (Cost basis is the acquisition price after adjusting for any premiums paid or discounts received, if not an original issue discount bond.).

Conclusion

While income from municipal bonds is generally exempt from federal income tax (and in some cases, exempt from state and local income tax), investors should carefully consider all aspects and characteristics, just as they would with any investment vehicle. The de minimis rule defines pricing parameters and potential tax treatment for municipal bonds subject to market discounts. The rule is of particular significance in periods of rising interest rates, as it can influence relative price valuations and market liquidity.

The de minimis rule is often overlooked, but may be an important consideration for some investors. To learn more, we strongly suggest consulting with a tax professional, especially as it pertains to individual investment goals.

James Thompson is portfolio manager at the Aquila Group of Funds.  He has over 30 years of experience in the municipal finance industry.

 

 

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