Are Municipal Bond Investors Sitting on a Ticking Tax Bomb?

By Edward P. Mahaffy, MBA, CFP®, ChFC®

Year-end tax planning conversations often center on capital gains harvesting, retirement plan contributions, charitable gifting, and business deductions. One strategy rarely discussed—yet increasingly important—involves municipal bonds purchased at a discount.

With interest rates rising sharply in 2022–2023 and bond prices falling, many investors purchased municipal bonds at significant discounts, believing they were capturing attractive yields. However, the IRS de minimis rule may convert what appears to be tax-exempt income into unexpected ordinary income at maturity or sale.

For CPAs serving high-net-worth clients and trust accounts, understanding this rule is essential as year-end planning approaches.

A Quick Review of the De Minimis Rule

Under the de minimis market discount rule, municipal bonds purchased at a discount greater than 0.25% per year to maturity lose the favorable capital gains tax treatment ordinarily associated with market discounts. Instead, the entire discount becomes taxable as ordinary income when the bond is sold or matures.

A Texas Example

Consider a Dallas Independent School District bond:

• Coupon: 2.00%
• Maturity: 5 years
• Issued at par (100)
• Purchased in the secondary market at 86.00

Although the yield to maturity appears attractive at 5.10%, the de minimis threshold for this bond is 1.25% (0.25% × 5 years), meaning the minimum purchase price to avoid ordinary income taxation is 98.75.

Because the discount exceeds that threshold, the entire market discount will be taxed as ordinary income—reducing the investor’s true after-tax yield to approximately 4.00%.

What looked like a bargain turns into a yield mirage, with the tax bill deferred until maturity or disposition.

Why This Catches Investors Off Guard

Monitoring municipal bond purchase pricing relative to the de minimis threshold typically falls outside a CPA’s engagement scope. Investors may assume tax-exempt means tax-exempt, and many wealth advisors have not revisited this rule since the last significant rate shock decades ago.

With the Federal Reserve raising rates more than 500 basis points in a short period, the bond market experienced one of its steepest declines in modern history, and deeply discounted municipal bonds became far more common. The risk is real for clients who loaded up on “cheap” tax-free income.

What CPAs and Advisors Should Do Now

For clients holding individual municipal bonds:

1. Identify bonds purchased at discounts potentially subject to de minimis treatment.
2. Evaluate the after-tax yield relative to similar higher-coupon bonds trading near par.
3. Coordinate with the client’s wealth advisor to determine whether a tax-efficient bond swap is prudent.

Selling now and reinvesting in higher-coupon bonds can prevent future ordinary income recognition. Though accrued ordinary income to date cannot be avoided, the strategy may still materially reduce the total tax burden.

A Timely Opportunity to Add Value

This environment presents a rare planning window. In many cases, discounted bonds can still be sold near accreted cost, minimizing tax friction while repositioning into more tax-efficient holdings.

More broadly, this issue underscores the importance of collaboration between CPAs and financial advisors. When tax and investment teams work together, clients benefit, particularly in complex fixed-income environments.

We Can Help You Manage Municipal Bonds Wisely

The de minimis rule represents a meaningful—yet often overlooked—tax risk for municipal bond investors in a rising-rate environment. With proper communication and proactive planning, CPAs and advisors can help clients avoid unwelcome surprises and enhance after-tax returns.

Our team at ClientFirst Wealth, Legacy & Estate Planning is here to help. Reach out to me at (501) 603-0406 or ed@clientfirstwm.com and be sure to download a copy of my book, How to Select a Financial Advisor: The Least You Should Know.

About Edward P. Mahaffy, MBA, CFP®, ChFC®

Ed Mahaffy founded ClientFirst Wealth, Legacy & Estate Planning in 2007, after more than 23 years in the wealth management industry. Prior to launching ClientFirst, he spent 6 years as a portfolio manager and branch manager with Raymond James, 6 years as a vice president and portfolio manager with Merrill Lynch, and over 11 years as a financial advisor and fixed-income portfolio manager with Stephens, Inc. 

At ClientFirst, Ed is president and senior portfolio manager. As a fiduciary, fee-only advisor, Ed is committed to putting clients’ interests first and providing objective, client-centered guidance. He takes pride in helping families enjoy financial peace and confidence through comprehensive services including financial planning, retirement planning, investment management, tax-advantaged strategies, and retirement plan advisory.

Designated as a CERTIFIED FINANCIAL PLANNER® and Chartered Financial Consultant®, Ed holds a Bachelor of Science in Business Administration from The Citadel and earned his MBA from the University of Arkansas. He has had articles published in numerous publications, including Barron’s magazine. He enjoys spending time with his family, outdoor activities, reading, and exercising. To learn more about Ed, connect with him on LinkedIn.

This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice. 

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