Investors may think of muni bonds as being tax-free because their interest payments are generally exempt from federal and possibly state income taxes, but buying munis at a discount could produce taxable gains.
Whether those gains are taxed as capital gains or as regular income depends in part on the size of the discount.
Investors should be aware of the difference before buying munis.
Investors may think of municipal bonds as being totally tax free because their interest payments are generally exempt from federal and, often, state income taxes. But those who buy munis at a discount to their redemption value could find themselves on the hook for taxes on any gains they accumulate as a result of that discount.
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.
Defining a discount
Munis are usually issued with a $1,000 par value, which is the amount you can expect to receive when the bond matures.1 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.
Taxes on the discount
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 bought a discount muni before April 1993, you'll have to pay capital gains tax only. For discount bonds bought after that, you could be subject to the capital gains tax, ordinary income taxes (which are generally higher) or a combination of both.
The de minimis rule
The de minimis rule says that for bonds purchased at a discount of less than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as capital gains rather than ordinary income. Larger discounts are taxed at the higher income tax rate.
Imagine you wanted to buy a discount muni that matured in five years at $10,000. The de minimis threshold would be $125 (10,000 x 0.25% x five years), putting the dividing line between the tax rates at $9,875 (the par value of $10,000, minus the de minimis threshold of $125).
For example, if you paid $9,900 for that bond, your $100 price gain would be taxed as a capital gain (at the top federal rate of 23.8%, that would be $23.80). If you received a bigger discount and paid $9,500, your $500 price gain would be taxed as ordinary income (at the top federal rate of 39.6%, that would be $198).
De minimis thresholds
Source: Schwab Center for Financial Research calculations, as of 1/2017
Bonds issued at a discount
Not all discount bonds are automatically subject to taxes, though. Occasionally, a municipality will issue bonds at a discounted price, known as an original issue discount, or OID. For such bonds, the OID is treated as part the bonds' interest income and is usually not subject to capital gains or ordinary income taxes. Investors can usually determine if a bond is an OID by looking at the offering statement or on the bond description page on Schwab.com.
However, once an OID bond is trading in the secondary market, additional price discounts will be subject to the discount rules and subsequent taxes.
Bonds sold prior to maturity
Generally, we suggest that individual investors hold their bonds until maturity. However, there may be reasons why many investors need, or choose, to sell bonds before maturity. If you sell earlier and you receive a price greater than your cost basis, the gain will be subject to capital gains tax. Cost basis is your acquisition price after adjusting for any premiums paid or discounts received. You may also have to pay ordinary income taxes on the accretion of the market discount as well.
Determining the cost basis of an individual bond can get complicated, as there are special reporting rules that govern the adjustments to a bond's acquisition price. For bonds held at Schwab, you can find your adjusted cost basis by logging into schwab.com/positions and clicking the "unrealized gain/loss" tab.
What to do now
Municipal bonds offer tax advantages and could make sense in the portfolios of many income-focused investors. However, the details of what municipal bonds you purchase matter because you could end up paying unexpected taxes. If you have questions about your portfolio, consult IRS Publication 550, "Investment Income and Expenses," or check in with your tax advisor.
1Generally speaking, municipal bonds can only be purchased in increments of $5,000 face value.
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