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Income-hungry investors have turned to a number of previously unknown investments in the search for bigger payouts. In many cases, they've been successful in finding some lucrative opportunities. In the process, though, they've also unearthed some complicated issues to resolve, especially on the tax front.
One of the best examples of this phenomenon is the master limited partnership. MLPs have some very attractive attributes, most notably the huge distribution yields that many of them offer. But those distributions come at a price, and if you don't want to deal with the complications, it'll cost you.
The best of MLPs
It's no secret why MLPs have attracted so much attention. On one hand, the huge amount of energy-related activity in the U.S. has led to a big expansion in the need for the sort of commercial projects that MLPs often take on. For instance, major MLPs Kinder Morgan Energy Partners (NYSE: KMP ) and Energy Transfer Partners (NYSE: ETP ) both specialize in midstream energy operations, including pipeline transmission and storage facilities, which have become increasingly important as oil and gas production levels throughout the country have risen.
More importantly from an investor's perspective, these activities produce substantial profit and cash flow, and thanks to special treatment from the IRS, MLPs are able to distribute the lion's share of their income out to investors. That's why Kinder Morgan yields about 6%, while Energy Transfer and Enbridge Energy Partners (NYSE: EEP ) weigh in at around 7.5% to 8%.
The yields that MLPs pay compare very favorably with those of traditional energy companies. Most of the major integrated oil and gas companies have dividends in the 3% to 5% range. Downstream refining companies often have even lower yields, with HollyFrontier (NYSE: HFC ) paying just 1.5%, while Valero (NYSE: VLO ) yields 2.4%. Because those corporations have to pay taxes at the corporate level, they can't afford to distribute as much money to their shareholders as MLPs do.
The tax twist
In fact, in some cases, MLPs give their investors an added bonus. Even though MLPs make large distributions, not all of what investors receive from their MLPs' units is subject to current tax. Typically, MLPs have cash flow that exceeds their taxable net income, because MLPs enjoy deductions for depreciation for equipment and depletion allowances. Those deductions reduce taxable income, saving you money when you file your taxes.
But if you think that money is tax-free forever, think again. The IRS treats the amount of money that you receive from an MLP that isn't taxed as a return of your capital. In most cases, you won't have an immediate tax problem, but down the road, those distributions can catch up with you.
What return-of-capital distributions do is reduce your tax basis in your MLP units. As your basis drops, the amount of potential taxable gain when you sell your units goes up, as the IRS will effectively recapture that lost tax liability when you decide to get out of your investment. Even worse, if you use up all of your tax basis before you sell, then any excess money you get from the MLP is treated as ordinary income to you.
As if that weren't bad enough, it can be difficult to figure out what type of gain you have when you sell. Typically, if you have a gain on a regular stock, you'll pay favorable capital-gain tax rates when you sell. But with MLPs, a portion of your overall gain that results from the reductions in your tax basis may be subject to ordinary income tax rates for things like depreciation recapture.
Simplicity at a price
What all those complex provisions boil down to is that MLPs can be a pain at tax time. Yet while you can avoid those hassles by using other investment vehicles like exchange-traded products, some of them cause you to lose many of the tax benefits that MLPs offer. Whether that turns out to cost less than what your accountant charges is an important question to ask.
MLPs can be useful for income investors, but they're far from simple. Whether they're worth the extra hassle depends on your level of tax expertise and how willing you are to deal with special rules to reap lucrative benefits.
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