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Tax Guide To Master Limited Partnerships

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How would you like to have income and a tax shelter rolled into one investment? Consider buying some master limited partnerships. These are businesses that are organized as partnerships but act like corporations. You can buy units in an MLP just as easily as buying shares of stock in a corporation.

Most, but not all, MLPs are involved in resource production. Granddaddies of the genre: Enterprise Products Partners and Kinder Morgan, which transport and process fossil fuels.  Typical asset: a natural gas pipeline, thousands of miles long, leased out to energy producers and utilities under long-term contracts.

MLPs often pay nice dividends, in the neighborhood of 5%. That’s about what you might get on a real estate income trust. The MLP payout, however, has better tax attributes. Sheltered by heavy depreciation charges, much of the income from an MLP is likely to be treated as a tax-free “return of capital,” at least in the early years you own it.

If the tax accounting is already beginning to sound a little abstruse, get used to it. The price you pay for the tax benefit is complexity. Count on spending a few extra hours doing your taxes (or paying extra to your tax preparer) the year you start reporting MLP dividends. After that, the workload is more tolerable.

In place of the 1099 tax report you'd get on shares of a corporation, you'll get a much longer K-1 from your MLP. If you sell the MLP shares, you'll get a statement explaining how to handle the proceeds on your tax return. It will be a whole lot more complicated than reporting a gain or loss on 100 shares of Chevron.

MLP taxes are a headache, concedes Douglas Rachlin, who runs a portfolio of these investments for wealthy clients of money management firm Neuberger Berman. But worth it. In the 14 years since its inception, his Income Plus portfolio has delivered an 18% annual return, he says, triple that of the stock market.

The next decade probably won’t deliver the same kind of outperformance, given that MLPs, like a lot of income-flavored investments, are now richly priced. Still, Rachlin insists that returns in the range of 10% to 15% a year are plausible.

What about those weird taxes? Whether you do your own 1040 or hire it out, you should have an understanding of the concepts that underlie MLPs. Herewith, a guidebook.

The six topics to be covered:

Flow-through accounting. This is the lens through which the IRS sees partnerships.

Tax basis. This is accounting lingo for how you adjust the cost of an asset so you know what the gain is when you sell.

Return of capital. This explains how the check you get in the mail is not necessarily “income.”

Passive loss rules. These are Congress’s punishment for taxpayers with tax shelters.

Recapture. This beast arises from the IRS depreciation swamp when an asset is sold.

Zero basis. This explains the unexpected consequence of owning an MLP that performs too well for too long.

Flow through

Harry and Moe set up a partnership to buy a two-story building for $150,000. They take out a mortgage for $50,000 and they each put in $50,000 of cash. The partnership itself doesn’t pay any taxes. Instead, it comes up with income and expense numbers and then flows through half of each item to Harry and half to Moe. It’s almost as if Harry and Moe had made separate purchases, each for one floor, each costing $75,000, each financed with $50,000 of cash and a $25,000 mortgage.

Real estate investment trusts work something like this. They own buildings and flow through profits to their shareholders, who report their shares of the net on their own returns. The REIT doesn’t pay corporate tax.

But REIT flow-through is mere child’s play compared to what goes on in a partnership. The REIT flow-through is of a single item, net income. It can’t flow through any losses.

Not only do partnerships flow through losses, they flow through all manner of items that have special places on a tax return.  The special items range from net income to tax-exempt bond interest to gains on quasi-capital assets (“section 1231 property”).

What’s good about this: A lot of these items provide tax benefits of one sort or another. What’s bad: It’s complex. At year-end, your partnership K-1 form details your share of a dozen or more items that have to be carried over to particular places on your tax return.

One of the most important things to know: You owe tax on your share of the partnership’s profit, even if the money is retained in the business. There’s some logic to this. If you owned a building directly and made some nice rental income, you’d owe tax on that even if you left the cash in the business checking account.

Tax basis

This is a fancy way of saying “adjusted cost.”

Harry buys a building for $75,000 and claims $3,000 of depreciation. Now his basis is $72,000. If he sells for $73,000, he has a $1,000 gain, not a $2,000 loss.

When you buy into a partnership, your basis is increased by:

--your share of the profits.

--your share of the partnership’s debts.

--any additional money you put in.

Your basis is decreased by:

--your share of any losses.

--any reduction in your share of the debt. That could occur either when the partnership pays down its mortgage or when you sell out.

--any money you take out.

It’s all rather arcane, but there is a logic to each of these adjustments. Take that profit item (increases basis). You put in $50,000, and your share of the net the next year is $3,000. So you report the $3,000 on your tax return and pay tax on it. But you don’t see any of that money in a dividend check.

What’s going on? It’s as if the partnership sent you the $3,000, and then you sent it back. Now you have invested a total of $53,000.

How about that debt adjustment? At first, it’s counterintuitive to include an MLP’s debt in your “cost.” You sure don’t do that with your shares of Exxon Mobil. But there is a logic to the debt rule, at least if you buy into the abstract notion that a pipeline partnership is a collection of business owners who each have their own little piece of steel.

Say a partnership raises $10 billion in equity, and uses that plus $5 billion borrowed to purchase a $15 billion gas pipeline. You put in $100,000. Your tax basis will be $150,000. It’s as if you had bought your own 200-foot stretch of steel for $150,000, paying $100,000 of cash and financing the other $50,000.

This makes sense. When you buy a house your cost includes the amount you finance.

The as-if game goes on and on (maybe whoever wrote the tax code liked the movie “Clueless”?). Let’s say you sell that MLP for $110,000. Assuming the partnership made a so-called Section 754 election, the new buyer of these shares gets to use $160,000 as the basis for calculating depreciation, even though similar pieces of steel on either side are worth only $150,000 for tax purposes. It’s as if that new buyer had started his own pipeline business by acquiring $160,000 worth of steel.

Keeping track of separate capital accounts for thousands of investors keeps many a computer whirring in Houston. It’s all in pursuit of a good cause, reducing what the IRS takes out of the economy.

Return of capital

Let’s say you invest $100,000 in something called Pipelines LP. Your piece of steel clears $5,000 the next year in cash profit. But, because of a $5,000 depreciation deduction, the taxable income is $0. You get a check for $5,000. Is this money taxable?

No, it’s a “return of capital.” It’s as if you had put $100,000 in a savings account and then, before collecting any interest income, you withdrew $5,000.

This is why people buy MLPs. They get nice dividend checks and, if the depreciation is high enough, pay little or no tax on the dividends.

Eventually, though, there’s a day of reckoning with the tax collector. Remember how money taken out reduces your tax basis? In this case you’d mark down the basis in the MLP shares to $95,000.

Now let’s say you sell the Pipelines LP shares at the same price you got in at. You think you’ve broken even, but the IRS thinks you have a gain of $5,000.

Understand what is going on here. When cash in your mailbox gets classified as a return of capital, it is not exactly tax exempt. It is merely tax deferred.

So, don’t sell MLPs without thinking about the tax consequences.  If you buy at $50 a share and sell at $50 a share, you may think you are breaking even. But when you go to do your taxes you may discover that the transaction results in a gain.

Passive loss rules

Let’s say that the $100,000 partnership investment with the $5,000 cash profit was sheltered not by $5,000 of depreciation but by $8,000. Your K-1 will show a $3,000 operating loss. Can you deduct this $3,000 against your salary? Nope.

Operating losses can be deducted only on businesses in which you are actively engaged. That would mean flying down to Texas and oiling the compressors.  In fact, you are collecting the dividend checks from the comfort of your Park Avenue co-op.

You are a “passive” investor.  “Passive” is tax code terminology for “fat cat.”

Although you can’t deduct this $3,000 passive loss right now, it goes into suspension and can be used at a later date, when you have a passive gain.

In general, a passive loss from one investment (like a cattle tax shelter) can be netted against a gain from another passive activity (that strip mall project you're in on). However, there’s a more restrictive rule that applies only to publicly traded partnerships like Enterprise and Kinder Morgan. This rule says that a loss on Partnership A can’t be used against a gain on Partnership B.

The $3,000 loss comes out of suspension only when either (a) you have otherwise taxable income from this same partnership or (b) you depart the partnership.

In the case of Pipelines LP you’d get a K-1 that shows the following: $100,000 initial tax basis (assuming the pipeline hasn’t borrowed any money), less $3,000 of loss, less $5,000 of money distributed. End of year tax basis: $92,000.

If you exit, selling for $100,000, you have what appears to be an $8,000 gain. But then you whip out the $3,000 of suspended losses. Bottom line: a gain of only $5,000.

This is fair. You put in $100,000 and took out $105,000. At some point you should be paying tax on $5,000.

But what kind of income is this $5,000? Is it a capital gain, as if you had bought a piece of land for $100,000 and sold for $105,000? Or more like a dividend? This matters, because (at least when the Bush tax cuts expire), dividends get taxed at twice the rate on long-term capital gains.

To answer the question we have to consider the next chapter in this account of partnership accounting: recapture.

Recapture

The tax code, in all its majesty, allows depreciation on things that do not depreciate: the Empire State Building, for example, or gas pipelines. As long as they are not maintained by BP, pipelines last indefinitely. The depreciation deductions on them are simply a form of subsidy.

But too great a subsidy cannot  be tolerated. The Internal Revenue Code takes back some of the benefit when you sell a depreciated asset at a profit. It undoes your earlier deduction by calling the depreciation a form of ordinary income.

Go back to our Pipelines LP. When you sell for $100,000, your entire $5,000 in net return is covered by past depreciation deductions. So the whole $5,000 will be taxed at high, ordinary income rates.

If you had sold for $140,000, you’d have had $5,000 in ordinary income and $40,000 in capital gain.

Zero basis

You put $100,000 into an investment and collect $5,000 a year of payouts, every penny sheltered by depreciation . This goes on for 20 years. All your payouts have been tax free as a return of capital.

Now what? Nobody is allowed to have a negative basis for anything. So further distributions have to be handled in some other fashion. Alicia Silverstone surfaces again. In year 21, it’s as if you had sold a piece of your investment for $5,000.

If the investment in question is a real estate investment trust, your 5K “sale” gets treated as a long-term capital gain. If it’s an MLP, however, then the payout is subject to recapture as depreciation.

So here’s the bottom line on cash flows and taxes. When your cumulative tax free payouts just about add up to what you spent buying the MLP, you will be near the zero-basis point, and after that your payouts will be fully taxable.

This is only a rough approximation, because your accounts will be complicated by the partnership’s debts and business expansions. The good MLPs are constantly adding new properties.

Think about your end game. After recovering your purchase price in tax free dividends, you start getting taxable ones. But resist the temptation to sell and start over. That would trigger belated ordinary income treatment of all those dividends.

Don’t donate depleted MLPs to charity. Since they are pregnant with ordinary income, your deduction would be limited to the stock market appreciation in the shares. (Buy at $50, let the basis run down to $0, donate when the share is worth $52: Your charitable deduction is $2).

You’d be better off donating appreciated shares of Exxon; provided you’ve held them more than a year, you will get a deduction for their current market value and the appreciation is never taxed.

Leaving MLPs in your estate is a good choice. The step-up at death causes the recapture liability to be forgiven. It’s as if your heirs were buying the steel from you at full market value. That value will be used for depreciation, giving them  a nice shelter for years.