If you've bought units in a master limited partnership, then you're a bit more than a shareholder -- you're a business partner. Your MLP may be leasing office buildings, drilling for gas, or exploring for natural gas. No matter what the business is, you're getting a share of the net income, as well as losses, deductions and credits. When you sell your units, a set of complicated IRS rules on MLP "share basis" comes into play.
Selling Your Units
Master limited partnerships sell on public stock exchanges. You can buy or sell your MLP units through a broker for a fee. You can also sell the units privately. You must endorse the certificates with your signature, the name of the buyer and the date. If you have invested through a mutual fund, you can redeem shares by contacting the fund manager and requesting a redemption. This alternative spares you the hassle of dealing with K-1 forms and doing several calculations for capital gains taxes. With mutual fund shares, you're simply buying and selling an ordinary investment asset, and not receiving different kinds of allocated income from a partnership.
Apples and Oranges
There's an important difference in the tax treatment of ordinary stock and units in a master limited partnership. You may or may not receive dividends from the stock; the MLP will pay you a share of its net income every year, according to how many units you own, and report that income to you on a Form K-1. The initial cost of the MLP is similar, taxwise, to your cost basis in stock, but the regular payouts from the MLP will affect your basis when it comes time to sell.
Capital Gains Treatment
You're not taxed on the regular income payments you receive from an MLP. Instead, the distributions the MLP pays over the quarters and years will reduce your basis in the investment. If you buy the units at $10, and receive $1 in payouts, then your basis goes down to $9 -- thus increasing your profit if and when you sell. If there's a loss, you can't use it to offset capital gains in other investments; you can only apply it to the MLP units that reported the loss (by raising the basis). If, over time, your basis goes all the way to zero, then you start receiving taxable income, and you'll have to report it.
Applicable Tax Rates
Your gain will be taxed at the capital gains rate for long- or short-term investments. A long-term gain is one that you've made over a year or longer; a short-term gain is earned on an investment held less than a year. There are important exceptions: if you've reduced your basis through depreciation, that portion is taxed at your ordinary income rate. The ordinary income tax rate also applies to gains on the rise in value of the MLP's inventory, as well as your share of the partnership's unrealized receivables. Your Form K-1 that arrives every year will break down these gains to help you sort it out.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.