|Low Interest Rates And Uncertain Equities Markets: Could Master Limited Partnerships Be A Good Choice For Income And Diversification?|
|Wednesday, May 16, 2012 14:36|
The low interest rates and uncertain equities markets of 2011 were a great environment for MLPs. So good that they returned 6.1% for the year. 2012 began with equities jumping out of the chute. But the second quarter has shades of 2011 déjà vu.
Could it be time to take a second look at master limited partnerships (MLPs)? If so, what’s the best way to invest and what do you need to watch out for?
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MLPs offer income and diversification, usually through energy, real estate, or financial services. They’re also housed in an ownership structure that can add tax advantages to the mix.
Partnerships are taxed differently than corporations. They are flow-through investments so about 80% of partnership distributions are considered a return of principal. That leaves only 20% to be taxed at the investor’s ordinary income rate.
The cost basis of a partnership decreases with each distribution. So, if a client invests $30 into a partnership and receives a $5 distribution, the new cost basis is $25.
If the client sells the interest for $25, the $5 difference is considered both a capital loss and ordinary income. If the interest sells for $30, the sale is not considered a wash. The $5 is considered depreciation recapture. A capital gain would only result if the sale was for more than the $30 paid.
So, it's conceivable that an older client who continues to receive distributions may actually end up with a negative valuation by the time he dies. This could be advantageous from an estate tax perspective.
But there are some caveats. Investors who invest directly have to pay more attention to the creditworthiness of the issuer. They also may have to state taxes for every state in which the partnership is invested.
Keeping up with required documentation can be another challenge, especially if your client is older, has owned the partnership for a while, and hasn’t kept up with the cost basis over the years.
This happened to an 80-year-old who owned an MLP in his IRA. Twenty years ago, he invested $50,000. Last year, he sold the partnership to his wife for $500. But his IRA still shows a cost basis of $50,000.
And now, so does his wife’s. Since he’s older, he’s required to take a distribution. But the value of the partnership is lower than the $2000 he is required to take out. As well, the IRS frowns on selling pieces of an IRA to a spouse.
Responsibility for valuation is usually the client’s. Some firms won’t custody direct partnership interests just because of the headaches they can cause.
So it may be easier to invest through structures especially designed for retail investors, even though the tax structure reverts to the corporate level.
Investors can gain access to MLPs through exchange-traded funds (ETFs), exchange-traded notes (ETNs), closed-end funds, open end mutual funds, and options either on the MLP or on an ETF.
ETNs may offer an advantage because they distribute income more like a bond does. Instead of investing directly in the MLP index like an ETF does, they employ the investor’s money in a fashion that replicates the index’s performance.
For clients with the right risk parameters who seek above market total returns and investments that perform somewhat out of step with the economy, MLPs might be a reasonable way to go.