Understanding the De Minimis Tax Rule
One of the primary benefits of municipal securities is that coupon income received, in most instances, is exempt from federal income taxation. It’s important to remember, however, that the price appreciation of securities purchased at a discount in the secondary market can be taxable. The rate at which these discounted securities will be taxed depends on a somewhat obscure section of the Internal Revenue Code referred to as the de minimis tax rule.
In a rising interest-rate environment, the de minimis rule creates a potential tax risk that can have a meaningful impact not only on the after-tax returns of investors in the upper tax brackets, but also on how municipal securities are priced. Indeed, it is one of the reasons PIMCO’s municipal bond portfolio managers often prefer to buy bonds priced at a premium. Here we explain the basics of the de minimis rule and discuss its potential significance for municipal bond investors.
De minimis rule basics
Essentially, the de minimis rule determines whether the price appreciation (also referred to as price accretion) of securities purchased at a discount will be taxed at the ordinary income tax rate or the capital gains tax rate. Prior to the early 1990s, this accretion was treated as a capital gain. In 1993, however, the federal tax code was revised to treat the accretion of discounted municipal bonds as ordinary income, but with certain key exceptions applied to smaller market discounts.
The de minimis rule states that if a discount is less than 0.25% of the face value for each full year from the date of purchase to maturity, then it is too small (that is, de minimis) to be considered a market discount for tax purposes. Instead, the accretion should be treated as a capital gain.
The de minimis threshold price determines whether the accretion of the market discount is taxable at the ordinary income or the capital gains tax rate. It is defined as follows.
For some municipal investors – particularly those in higher tax brackets – taxation of bond’s market discount can have a noteworthy impact on after-tax returns. For a discounted municipal security purchased at a price below the de minimis threshold, price accretion is subject to the ordinary income tax rate (40.8% for top earnersFootnote1). Conversely, the accretion of a security purchased at a discount, but at a price above the de minimis boundary, is subject to a much lower capital gains tax rate (23.8% for top earners) if the bond is held for longer than one year.Footnote2
Impact of market discounts in a rising interest-rate environment
In the years following the 2008 financial crisis, through March 2022, the U.S. economy experienced an extraordinary period of declining and persistently low interest rates. As a consequence, municipal bond investing did not require careful consideration of the de minimis tax rule. The majority of the municipal market did not price below the de minimis threshold, and given low interest rates prior to 2022, most municipal securities traded at a significant premium.
This has changed after Fed raised rates from near zero in 2022. In a rising rate environment, declining bond prices implies that more municipal securities could fall below the de minimis threshold. Also, the prolonged low interest rate environment of the past contributed to an uptick in municipal issuance with lower-coupon bond structures at lower prices than their higher-coupon counterparts.
As higher interest rates drive bond prices lower, those securities issued at or near par may now be more vulnerable to negative tax and liquidity implications associated with the de minimis rule.
- Tax impact. Given the higher tax rate any buyer would incur as a result of purchasing bonds below the de minimis threshold, securities trading near or below the boundary will likely trade at an even lower price (and higher yield) to compensate investors for the impact of additional taxes.
- Liquidity impact. Potential taxes associated with the de minimis rule may also lead to demand distortions in the marketplace as the result of a reduced buyer base. The traditional tax-sensitive municipal buyer may shun securities with any tax consequences, even in instances when yields compensate investors for the higher tax treatment.
These dynamics, in effect, may create a “price cliff” as bonds approach the de minimis cutoff. The impact of higher taxes and diminished liquidity may cause bond prices to deteriorate more rapidly than they otherwise would if the price was higher and further from this threshold.
The significance of rising rates: an example
Consider the following example using a municipal security that was issued at par with 10 years to maturity:
- If the security was purchased below $97.50, the entire accretion from the purchase price to $100 would be subject to the ordinary income tax rate (40.8% for top earners)
- If the security was purchased at a price between $97.50 and $100, the entire accretion from purchase price to $100, under the de minimis rule, would be subject to the capital gains tax rate (23.8% for top earners) if held for greater than one year
- If the security was purchased at a premium ($100 or higher), there would not be accretion (or tax consequences) associated with the bond as it matures
How PIMCO helps investors manage these potential tax consequences
PIMCO favors municipal bonds priced at a premium, in part because they are less likely to be subject to the tax, liquidity and ultimately, price consequences associated with the market discount issue. In a rising rate environment, municipal bonds purchased at a premium should provide a greater cushion from the de minimis threshold compared to discount or par securities. Higher coupon premium securities may also offer additional cushion against rising rates since the front-loaded cash flows (via a higher coupon payment) reduce the security’s overall duration (or market sensitivity to interest rate changes).
Although many investors view their municipal allocation as buy and hold to maturity, credit deterioration or unforeseen cash requirements may necessitate future bond sales even in buy and hold portfolios. Therefore, the potential impact of the de minimis rule should still be considered when choosing between par and premium bonds.
In a rising rate environment, it may be more difficult to liquidate market discount securities because of the tax and liquidity implications associated with the de minimis rule. By maintaining an investment bias toward premium securities and focusing on after-tax returns, PIMCO seeks to protect municipal portfolios against the potentially adverse effects of the de minimis market discount rule.
To receive up-to-date municipal market insights from PIMCO,
subscribe to our Muni Insights list.
(Generally one to three key emails per quarter. Unsubscribe at any time.)
1 Tax rate is determined using the top Federal Marginal Tax Rate of 37.0% plus a Medicare Tax of 3.8% for top earners.Return to content
2 Note that the de minimis rule would generally apply to individual holders – institutional investors, such as mutual funds, generally amortize market discount into current income as taxable income. Tax rate includes Medicare Tax of 3.8% for top earners.Return to content
Disclosures
Unless stated otherwise, information contained herein is as of June 2024. The information may be stale and should not be relied upon.
PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, investment product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Investors should consult their investment professional prior to making an investment decision.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.
CMR2024-0611-3639047