Investing in T-bills (Part 17)

Higher initial/maintenance margin requirements is one reason why option traders may choose [taxable] T-bills [interest] over tax-exempt munis. Another reason to favor T-bills is the muni bond de minimis rule.

I want to clarify interest on zero-coupon T-bills as discussed in the third-to-last full paragraph of Part 16. These are taxed as if interest income were being received even though no income is actually received until the bond matures. Whether price appreciation to par or a semi-annual coupon payment, both are taxable interest as far as Uncle Sam is concerned.

As far as munis (issued by state, city, and local governments) go, interest is generally free from federal taxes and is:

• Usually free from state tax in the state of issuance.
• Not taxed by some states regardless of the state of issuance.
• Sometimes exempt from state tax at the time of issuance by that same state even when said state usually taxes them.

Unlike muni interest, bond price appreciation is usually taxed in accordance with the de minimis rule. At issue is whether price appreciation will be taxed as ordinary income or as capital gains. This is done as follows:

1. Multiply the face value by 0.25%.
2. Multiply that result by number of full years between bond purchase and maturity date to get de minimis discount.
3. Subtract de minimis discount from muni par value to get the minimum purchase price.
4. If actual purchase price is less (equal to or greater) than the minimum purchase price, price appreciation on the bond is subject to ordinary income (capital gains) tax rates.

For example, imagine $97.75 purchase of 10-year muni paying 4.00% APY with par value of $99 and six years until maturity.

De minimis discount = $99 x (0.25% / 100) x 6 = $1.485

Minimum purchase price = $99 – $1.485 = $97.515

Because $97.75 > $97.515, price appreciation will be taxed as capital gains. If held for over one year (one year or less), then capital gains tax rates are lower than (equal to) ordinary income tax rates.

The de minimis risk [of having to pay ordinary tax rates on price appreciation] is greater in rising interest rate environments. Since interest rates are inversely proportional to bond prices, increasing rates are associated with decreased bond prices.

One case where price appreciation may be tax-exempt is a zero-coupon municipal bond. These are always bought at a discount since they make no interest/coupon payments and price appreciation to par value is usually not taxed. The biggest caveat seems to be selling before the maturity date. In this instance, any price change realized on zero-coupon munis will be treated as a [short- or long-term depending on holding period] capital gain or loss.

Is that light at the end of the tunnel I see?

I will continue next time.

* — The Part 11 disclaimer applies: please consult a tax advisor for the definitive word on these matters.