Hidden Costs of MLP Investing
Master limited partnerships (MLPs) have been crushed in the stock market over the last year, with the Alerian MLP index down over 27% for the year ended August 19, 2015. Lower oil prices have led to distribution cuts or suspensions by some MLPs and, as a result, yield- conscious investors are taking their capital elsewhere of late.
If you don’t have any MLP exposure currently, the downtrend may present an attractive entry point in the near future. Your investment advisors may start pitching individual MLP investments or even managed account MLP portfolios.
This may represent an attractive investment opportunity, but be aware that there are some hidden costs to investing in MLPs that your advisor might not be aware of, or may neglect to mention:
- MLPs are limited partnership investments, and as such, you will receive a tax reporting statement, called a K-1, for each MLP that you invest in directly. If you invest in a managed portfolio of MLPs, you would receive a K-1 for each MLP investment. That could mean 10-15 K-1s in a diversified portfolio, and if the manager trades in-and-out of some positions it could be even more. Ultimately, this is going to cost you money when your tax preparer receives your K-1s and has to input them all individually. Figure that it will cost $50 – $100, or more, per K-1 depending on your accountant and how many other K-1s you have. If you have a dozen, this will result in some serious tax prep fees. And if you prepare your own taxes today, you’re likely going to need to enlist a tax preparer to handle the K-1s.
- One big advantage of MLPs is that like real estate investment trusts, they pass out distributions that are partly taxed and partly a return of your cost basis. An investor can use the distributions for cash flow and hold the shares for the long-term, getting a step-up in basis on the shares at death. This avoids tax forever on the non-taxable distributions received along the way, which is great in theory, but there are two pitfalls here.First, at the point your cost basis is reduced below $0 by distributions, taxable gains will be triggered to bring your tax basis back up to $0. Second, if the MLP you own sells out to another player in the space, you could be hit with a large taxable gain that you hoped you could avoid at death. This happened just last year when Kinder Morgan restructured, causing a taxable sales event for shareholders. Long-time holders of this successful company gave up a big piece of their shares to Uncle Sam as a result. Acquisitions are common in the MLP world, so this can be an issue.
- There are several exchange-traded funds and closed-end funds available in the marketplace that focus on MLP investing, and investment advisors will sometimes tout these as a way to invest in a diversified portfolio of MLPs while avoiding the receipt of the K-1s mentioned above. These points are accurate, but there is a cost to these structured MLP investments as well.First, you’re paying a management fee to the fund manager of at least 0.70%, and in some cases, much more than that. Second, most of these funds operate as taxable investment companies, such that the tax deferral advantage of owning MLPs is lost for you as an indirect investor.
- Be cautious of investing directly in MLPs within IRAs or other tax deferred accounts. MLPs generate unrelated business taxable income (UBTI), which is taxable income for your IRA if it exceeds $1,000 for any tax year. This is true even for a Roth IRA.