De Minimis Tax Rule

A few steps to elucidate this one. First, think through the municipal bond market. When local governments need to fund projects (schools, community centers, chains of massage parlors, etc.) they issue bonds to pay for them. These are called municipal bonds, or muni bonds to their close friends and family.

These muni bonds have some market advantages compared to other fixed income investments (like corporate bonds, which carry full tax loads as opposed to muni bonds which are tax favored). Interest on muni bonds is exempt from federal (and most state) taxes.

Okay, we’re not quite there yet. Now a few words on bond pricing in general. When bonds are issued, they are sold at a certain price (based on the structure of the bond...like maturity date, interest rate, etc.). This initial price is know as "par."

From there, a bond’s price will move around, based on how overall rates look. A high-rate bond increases in value (sells above par) when overall rates fall. It becomes more valuable because you can get a better rate with that bond than new bonds being issued at the lower prevailing rates. And vice versa. A bond will sell below par in a rising rate environment.

If you buy a muni bond below par and hold onto it, you make a profit on that difference. But unlike the interest on the muni bond, you need to pay taxes on that profit.

Okay, we’re finally ready for the De Minimis Tax Rule. This determines whether this profit is taxed at the individual income level or the (usually lower) capital gains level. Basically, there is a line set by the rule. If the profit is below a certain amount (set by the rule, hence the catchy name "minimis"), the profit gets taxed as income. A profit above the line receives capital gains treatment.