Beware Taxes on Discounted Munis

Investors in higher tax brackets often buy municipal bonds for the tax benefits: Their interest is generally exempt from federal tax and may be exempt from state and local taxes. However, munis aren't exempt from all taxes.

For example, when a muni trades below its par value—the amount it will pay at maturity—it's referred to as a discount. A muni may trade at a discount for many reasons, such as changes in interest rates or credit conditions. And while you may prefer buying a muni at a discount because you're spending less money upfront, you may incur an unexpected tax surprise.

Here's what to know before you buy a muni at a discount.

Let's say you want to buy a $10,000 muni currently trading at $9,750—a $250 discount. When the bond matures in five years, barring default, you would receive the full par value of $10,000, meaning you would earn $250 on the bond plus the coupon income. What many investors may not realize is that they could owe taxes on that $250 discount.

Discounts are taxed using the de minimis rule, which uses the size of the discount to determine whether it will be taxed as capital gains¹ or ordinary income:

• A discount of less than 0.25% for each full year from the time of purchase to maturity is taxed as a capital gain.
• A discount of 0.25% or more for each full year from the time of purchase to maturity is taxed as ordinary income.

Returning to our example, you'd multiply the par value by the percentage threshold of 0.25% and the number of full years to maturity ($10,000 x 0.25% x 5), which gives you a dollar threshold of $125. Therefore:

• Purchasing the bond at a discount of less than $125 means the discount will be taxed at a capital gains rate of 0%, 15%, or 20%, depending on your income.²
• Purchasing the bond at a discount of $125 or more—as in the example above—means the discount will be taxed at your ordinary income rate, which could be as high as 40.8%.

You can choose to pay a portion of that tax each year or all at once when the bond matures. The route you select will ultimately depend on your individual tax situation, so it's best to discuss with a qualified tax advisor before deciding.  

We generally suggest holding bonds until maturity. However, if you sell earlier and receive a price that's greater than your original cost basis, the gain will be subject to capital gains tax. You also may have to pay ordinary income tax on the accretion of the discount, which is the annualized increase in the bond's value as it approaches maturity. 

Liquidity is also a consideration when selling a discounted muni before maturity. If interest rates rise, the bond may cross the de minimis threshold, making it less attractive to potential buyers because of the added tax obligation. In such instances, you may have to accept a lower price, which could be a loss, to compensate buyers for their potentially larger tax bill.

When deciding whether a discounted muni is right for you:

• Assess the benefit: Always calculate the de minimis thresholds on all prospective bonds, as the taxes owed on more deeply discounted munis could at least partially offset their tax-exempt interest. In some cases, your after-tax return will be better if you go with a less discounted or even a newly issued muni, all else being equal. Indeed, purchasing a muni that's priced above its par value—known as a premium—can sometimes make sense. In exchange for a higher purchase price, you'll usually receive a high coupon payment—and you'll avoid the de minimis tax.
• Think ahead: If there's a chance you'll sell before maturity, consider where interest rates might go in the future. A bond with an already lower price could cross the de minimis threshold if rates continue to rise, making it difficult to sell at the price you want.
• Consider an original-issue-discount muni: Occasionally, a municipality will issue bonds at a discounted price, known as an original issue discount (OID). For such bonds, the OID is treated as part of the bonds' interest income and is usually exempt from capital gains and ordinary income taxes. (An OID bond trading in the secondary market, on the other hand, is subject to all the rules of a regular bond.)

Given the tax considerations, it's wise to check in with your tax advisor before adding discounted munis to your bond holdings.