Municipal bond investors usually focus on one number: the tax-free yield. But as yields have climbed this year, and especially since the Fed raised rates last week for the first time since 2023, a growing number of older municipal bonds are trading below their face value. That creates a tax wrinkle that catches a lot of investors off guard. Part of the return on a discounted muni may not be tax-free at all.
The issue is called the de minimis rule, and it’s worth understanding before you buy individual munis in the secondary market or evaluate the after-tax yield of a muni fund right now.
Here’s the basic idea. When you buy a bond for less than its par value in the secondary market, the difference between what you paid and the par amount you receive at maturity is called market discount. For municipal bonds, the interest coupon is generally exempt from federal income tax, but market discount is not. It’s taxable, and the question is how.
The de minimis rule sets a threshold. If the discount is small, it’s treated as a capital gain when the bond matures or is sold. If the discount is larger than the threshold, the entire discount is taxed as ordinary income, at rates that can reach 37% at the federal level for top earners, plus the 3.8% net investment income tax where it applies.
The threshold itself is simple to calculate. Take 0.25% of the bond’s par value and multiply it by the number of full years remaining until maturity. For a bond with 10 years left, that’s 2.5 points, so the de minimis price would be 97.5. Buy the bond at 98, and the two-point discount is a capital gain. Buy it at 96, and the full four-point discount is ordinary income.
That jump is what makes the rule matter. A bond that crosses below its de minimis price becomes noticeably less attractive to many buyers, particularly high-bracket individuals. Because demand drops, those bonds often trade at a further discount and offer higher quoted yields. But a good part of that extra yield can be eaten up by the tax on the discount at maturity.
Why is this coming up now? Much of the municipal market was issued when rates were lower. Bonds with 2% or 3% coupons issued in 2020 and 2021 are worth well below par when comparable new bonds are paying substantially more. Every time yields rise, more of those older bonds slide below their de minimis thresholds. Muni supply has also been running at a record pace this year, which adds to the pressure on prices.
For investors buying individual bonds, the practical rule is to calculate the after-tax yield, not just the stated yield. A discount bond quoted at an attractive yield to maturity needs to be compared on an after-tax basis with a bond priced at or near par, or at a premium. Many brokerage platforms don’t make this easy, so it’s worth asking whoever is selling you the bond to show the after-tax yield explicitly, or running the numbers yourself.
The de minimis trap isn’t always a reason to avoid discount bonds. Sometimes the market overcorrects, and the extra yield more than compensates for the tax. Investors in lower brackets, or those holding munis in situations where the ordinary income tax matters less, may find value there. The point is to price it deliberately rather than by accident.
Premium bonds, which trade above par, are the flip side. They often carry higher coupons and have historically held up better when rates rise, because their shorter effective duration and higher cash flow make them less sensitive to rate moves. The premium is amortized over the life of the bond rather than creating a tax problem at maturity. Many experienced muni investors lean toward premium structures for exactly this reason, although a premium callable bond carries its own risk of being redeemed early.
For muni fund investors, the issue works a little differently. Funds that buy discounted bonds recognize the market discount as taxable income over time or when bonds are sold or mature, and that income can show up as a taxable distribution even from a fund marketed as tax-exempt. In most years it’s a small share of the total, but in periods like this one, when more holdings are trading below par, it can grow. Check the fund’s year-end tax information and its historical breakdown of distributions to see how much has been taxable in the past.
A few questions help sort this out. For individual bonds, what’s the de minimis price, and how far below it is the bond trading? What is the after-tax yield compared with a par or premium bond of similar maturity and credit quality? For funds, how much of recent distributions has been taxable, and does the manager actively avoid or target discounted bonds?
The broader picture for munis remains supportive. Tax-equivalent yields are high, and credit quality at the state level has held up. But in a rising-rate year, the headline yield on a discounted bond isn’t the whole story. Knowing where the de minimis line is can be the difference between a truly tax-free return and one that quietly hands part of the gain back to the IRS.
