In certain circumstances, The De Minimis Rule enables bondholders to treat taxable interest as a capital gain instead of ordinary income. This is important because the federal income tax rate on long term capital gains is 15%. The top ordinary income tax rate is 35%, so being taxed at the long term capital gains rate is highly preferable for most people. The rule applies to both municipal bonds and corporate bonds, but in very different ways.
The rule does not apply to tax-free municipal bonds purchased at original issue. In this situation there is no-taxable interest income for the buyer, so there is no need to apply the rule.
The De Minimis rule applies to municipal bonds that are bought in the secondary market. If a municipal bond is bought below its tax basis, then there is a market discount. If the market discount is large, the owner of the bond is required to pay ordinary income taxes on the market discount. The bondholder can pay the income tax on an annual basis as it accrues, or when the bond is sold or matures.
If the market discount is less than .25% however, the bondholder will able to pay the capital gains rate on that income instead.
Market discount must less than (0.25%) x (Years to maturity) x (Face Value of the Bond)
For example, lets say you bought a bond with a $10,000 face value and 12 years to maturity.
(0.25% ) x 12 x ($10,000) = $300
If the market discount was below $300, you would pay capital gains tax when the bond is sold or matures instead of ordinary income tax.
In order to figure out the tax basis for a municipal bond see our article on municipal bond taxes.
The rule only applies to bonds sold at a discount to face value when originally issued. When applied to corporate bonds the rule is often referred to as De Minimis OID (original issue discount). The De Minimis rule does not apply to corporate bonds bought in the secondary market.
The calculation is exactly the same as above.