We will “confess” up front… We are not investment advisers. So we’re not qualified to tell you the merits of MLPs vs. other investments in terms of annual yield and appreciation in value. But we do know that, as tax professionals, we see many clients who are sold MLPs by their investment advisors without one or both parties having an adequate understanding of the tax consequences of these investments.
There are four things we want to make sure you understand when you invest in MLPs:
- These will complicate your tax situation and increase your tax preparation fees. The reason is that, although these are often held within your brokerage account, the nature of an MLP is that it is not taxed like a normal stock or mutual fund investment. Instead, you will receive a Schedule K-1, which generally has much more involved reporting than a Form 1099-DIV.
- The losses that are being generated are not currently tax deductible for you. Your K-1 from the MLP may show a loss of $5,000, so you would think this loss would be deductible and would decrease your income taxes. Actually, the loss isn’t deductible until you either have income from that same MLP in the future (unlikely) or you sell the MLP. If you own the MLP for 10 years, you’ll have significant tax losses from it, but it won’t be the tax shelter you thought it was, because all those losses will have just accumulated over the years.
- The cash distributions you are getting from the MLP aren’t tax-free, just tax-deferred. With yield generally being the big selling point of MLPs, it is worth knowing that you will ultimately owe tax on all that money you received. And, as opposed to stock dividends where you pay at a preferential rate as you receive the money, the tax-deferred nature of the MLP distributions and depreciation recapture rules might actually cause a big tax hit in the year you sell the MLP (even if you don’t sell it for any more than you bought for).
- MLPs should not be owned in IRAs. An IRA is a tax-exempt “entity,” and, as such, is subject to the Unrelated Business Income Tax on certain types of income. If you own an MLP within your IRA, you will likely have income, at least at the time the MLP is sold, and this could make it so the IRA has to file its own tax return and pay a tax at a rate that is probably higher than your personal rate.
Here is a simplified example to illustrate the above issues. Suppose you invest $50,000 into an MLP in 2015. You own the MLP for 10 years, and each year the MLP reports that your distributions are $6,500 and your share of the tax loss is $3,000. In 2025, you sell the MLP for $50,000. Economically, you have made $65,000 over 10 years, which is a 130% return on your investment. What are the tax consequences?
First, none of those losses are deductible until you sell. Second, none of the distributions are taxable until you sell. But when you sell for $50,000 in 2025, all the tax consequences will hit, and you will have a taxable gain of $65,000. Depending on the MLP and your particular tax circumstances, this gain will likely be about half capital gain and half ordinary income. If you are in the highest tax brackets, this would be tax of almost $25,000. This reduces your after-tax return on investment to 80% over 10 years.
We are not saying to not invest in MLPs, but we do think it is important to understand the tax consequences so that you have a clear picture of the after-tax return on these investments and you can properly compare it to a regular stock or mutual fund that may have lower yields but more attractive long-term tax consequences.