Thinking about buying a municipal bond at a price below its par value? You may want to think twice, because if it’s acquired at too deep a discount it could be subject to an additional tax, known as the de minimis tax, which would take a bite out of the after-tax return.
In short: The larger the discount, the greater the risk that an investor will face a higher tax rate. Here are some issues to consider.
What is a discount?
Municipal bonds, or munis, are usually issued with a $1,000 par value, which is the amount you can expect to receive when the bond matures. However, after the initial issuance date, a muni’s value can rise and fall in the secondary market. Events such as rising interest rates or deteriorating credit quality can cause the value of the bond to fall below $1,000. When that happens, the bond is trading at a discount.
Do I have to pay taxes on the discount?
In most cases, yes. If you acquire a muni at a discount, you may have to pay taxes on the difference between the par value and the acquisition price. Generally, the taxes are due in the tax year the bond matures, is sold, or is transferred to another entity or person, but you may also choose to pay the tax annually.
The purchase date matters: If you acquired a discount muni before April 1993, you’ll have to pay capital gains tax only. For discount bonds acquired after that, you could be subject to the capital gains tax, ordinary income taxes (which are generally higher) or a combination of both.