May 08, 2026
Are Municipal Bond Investors Sitting on a Ticking Tax Bomb?
How to determine if your clients are affected and how to address this issue
By Ed Mahaffy, MBA, CFP®, ChFC
Mitigating ordinary income tax liability on tax exempt municipal bonds is unlikely to appear on the typical list of tax mitigation strategies. Arguably, it should.
The so-called de minimis rule imposes ordinary income tax liability on tax exempt municipal bonds purchased at a discount exceeding 0.25% per year until maturity. Consider the following example:
A Dallas Independent School District featuring a 2.0% coupon and five-year maturity, issued at 100 and purchased at 86.00 to yield 5.10% to maturity and held to maturity by the purchaser. The lowest purchase price allowed on this bond before the de minimis rule is applied would be 98.75.
The bond in this example would appear to be subject to long-term capital gains tax, however, because the discount exceeds 0.25% per year; the entire discount is subject to ordinary income taxation, per the de minimis rule. Therefore, the “true yield” – the yield after all taxation, is only 4.00% versus 5.10%. Quite a difference – a yield mirage. And the tax bill is not due until maturity or disposition.
Monitoring clients’ purchase prices for individual municipal bonds is typically beyond the CPA’s scope of the engagement. This is information that the client’s financial advisor should communicate to their CPA. Of course, avoiding deeply discounted municipal bonds altogether may make the most sense. However, when the yield seems so attractive and the idea of scooping up bonds at 86 cents on the dollar is so compelling, it is easy to see how one might fall victim to the yield mirage described above.
The comparative analysis is simple. Compare the true yield of the discounted bond to that of similar bonds trading at or above 100.00, bonds that escape both de minimis as well as capital gains taxation.
The solution is equally simple. Sell the bonds subject to de-minimis treatment and purchase bonds with higher coupons – coupons generous enough to command prices that avoid de minimis treatment.
I have managed investment grade municipal bonds for individuals, trusts and financial institutions for decades. De minimis is an issue that typically materializes when the bond market experiences spikes in interest rates, most recently when the federal reserve rapidly hiked rates over 500 basis points in 2022-2023, causing bond prices to plummet and the worst bond market performance since the Civil War.
After years of near zero interest rates, advisors and investors alike have largely forgotten about the de minimis rule. Unfortunately, they will experience a rude awakening at maturity unless action is taken. At the present time, the bond market is providing a nice opportunity to sell bonds purchased at a deep discount at or near their purchase price or accreted cost basis, and to swap into higher coupon alternatives.
Unfortunately, there is no way to avoid the accretion of ordinary income tax liability that has already occurred between the purchase date and the present. However, this is a small price to pay to avoid the additional ordinary income tax liability associated with holding the bond until maturity. And the longer the maturity, the less onerous the accretion.
In short, the de minimis rule as it pertains to clients’ municipal bond holdings should be viewed as an opportunity for financial advisors and tax counsel alike to exercise leadership in disarming this ticking tax bomb. The situation described herein is a glaring example of the need for better communication among financial advisors and tax counsel.
Tax Liability on Municipal Bonds: What CPAs Need to Know
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About the Author: Edward P. Mahaffy, MBA, CFP®, ChFC® is co-founder of Fiduciary Wealth Management. He founded his own firm, ClientFirst Wealth Management, LLC., in 2007 after more than 23 years in the wealth management industry. Contact him at ed@clientfirstwm.com.
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