Master Limited Partnerships

Skip, please refresh my memories on the tax changes to the LPs a couple decades ago. thanks.

I'm not Skip, but here is what happened. In 1986 Congress changed the law RETROACTIVELY such that non-cash expenses, such as depreciation, could not be used to create losses that would offset ordinary income. Lots of us bled from that, and now don't have much confidence in what Congress might do in the future.

Mike

I don't know about "Master" Limited Partnerships, but have had unpleasant experiences with ordinary run-of-the-mill Limited Partnerships. In the area where I live, they are reputed to be good money makers for the people who organize and sell them, but terrible investments for the people who buy them. When they are sold, their risk is underestimated, and the tax advantage is overestimated.

I would say they are definitely not suitable investments for conservative investors or for seniors seeking higher income in a time of low interest rates. As for more sophisticated people playing with money, I don't know.

One point that might be added is illiquidity. If one wants to sell and move the money invested elsewhere, it is not easy. I think a question that any investor should ask about any financial product is: "If I want to sell, how long does it take?" I am not referring to market value depending on the ups and downs but simply on the time it takes for the paper work to get processed and the transaction completed. If you can't get a straight answer to that question, don't buy.

ah, yes. But that applied not only to LPs, right?

Limited partnerships start with a general partner with experience and limited partners with money.

They end when the general partner has the money and the limited partners have the experience.

Dave

One of the best teachers is experience. Unfortunately, it also is one of the most expensive teachers.

Skip, my thoughts...

1. they do complicate your taxes, if held in a taxable account. Most people aren't used to dealing with a K-1 and tax software might not deal with the nuances. If you pay for tax prep, it's an additional cost. And there can be state income tax returns for MLPs operating in multiple states, as many do. You have to decide where to file, and understand the effects on your home-state tax return.
2. holding in IRAs can be a solution but you need to understand UBTI and know whether your specific MLP is going to cause problems.
3. I'm skeptical of newer issues because the tax aspects are hard to assess without a track record to look at. For other reasons too but that's a very practical one.
4. they seem to be incredibly illiquid at times, which (if temporary) is good if you want to buy and bad if you need to sell. And liquidity is an issue generally - low trading volume per day is common - which favors long-term holds and patient buying.
5. tax changes might not have a huge effect. My sense is people are often weighing these vs. income generating securities like corporate bonds, preferreds, REITs - which are all or part ordinary income anyway.
6. I personally think the more boring the business, the better. There isn't necessarily a tight relationship between MLP profit and energy prices...the core business might be charging tolls to get a product from point A to B with only slight variations in volume year to year.

-Tad

Anyone buying any financial product that delivers high interest based on flow-through of profit from a company directly to investors, needs to thoroiughly understand the concept of RETURN OF CAPITAL. The attractive interest rate may be misleading, especially at the time you want to sell. The tax advantages may be similarly misleading when return of capital is taken into consideration. If you do not understand the concept of return of capital and are comfortable with it, do not invest in a limited partnership, a master limited partnership, flow-through trusts, royalty trusts, or similar products, by whatever name they may be known!

That's a good point. The life cycle of owning an MLP starts with largely/completely tax-free distributions, until you use up all your cost basis. Then, you're taxed on distributions at the capital gains rate. If you sell, any gain that results from the adjustments to basis is taxed as ordinary income, even if you've held the MLP units more than a year. This is a simplification but that's the basic idea.

This tax profile favors (for example) someone in a higher tax bracket who wants income now, and either would hold "forever" or wouldn't mind a big ordinary-income item on their tax return many years from now when they sell units to raise cash. That implies that they expect a lower tax bracket in the future, than they have now.

Or, keep the position small enough that UBTI isn't an issue, hold in an IRA, and forget about the K-1 and basis problems.

-Tad

Yes! And there also depletion of one's equity in the venture as "capital is returned." That tends to lessen the value of the investment in the future if one wants to sell.

Along these lines, here is another question that might be interesting to ponder: Would a son or daughter expecting a large inheritance be pleased to learn that his or her aging parents had put a substantial part of their wealth into a Master Limited Partnership in order to increase monthly income in their old age?

Quite possibly, yes - in fact that could be an ideal case. The initial distributions are tax-free return of capital. After basis reaches $0, subsequent distributions are taxed at the capital gains rate (which might be 0% federal). So the parents get investment income at low/0 tax rates. At death, the heirs get basis step-up to fair market value.** The heirs sell the units and pay no tax.

Now of course if it's an MLP that isn't worth spit after making distributions, that's no benefit at all. If it's one that has unit values 2X that of a decade ago, and current basis of $0, much different story for an heir today. There are big variations, depending in part on the business the MLP is in.

-Tad

** verify the basis step-up of any specific MLP investment with a tax pro; this is not specific tax advice

I am wondering about the extent to which the attractive, tax-dvantaged case you mention is typical of the bulk of investments in Master Limited Partneships. I am not aware of details about these products, but I do know that in the area where I live, so called Royalty Trusts sometimes gain in value over time, but more often decrease in market value when they are sold. And the costs and management expenses are high.

For a senior citizen wanting to leave an inheritance, the degree of risk is a very important factor. Not many seniors would want to invest a lot of money in a single high dividend-paying stock, not even if the company were sound and the past track record were good. So one energy company of unknown prospects woud not generally be considered a good idea.

The higher the yield that is advertised, the more one begins to think of the slogan "If it seems too good to be true ...."

Many royalty trusts would not be good candidates for what I described. Such a trust owns the rights to royalties paid when some commodity is extracted from the ground. The tax code allows annual depletion deductions for owners of royalty rights, which then pass through to royalty-trust unit holders, so distributions received from the trust can be tax-free. Depletion reflects the reality that the stuff is going to run out someday - the well will run dry or vein of coal be completely extracted. Depletion isn't the fiction that depreciation can be - the eventual value of some streams of royalty income is $0, it's just a question of when.

That said...some royalties keep going so long that commodity price increases will make the royalty rights more valuable for many years, before the well runs dry. And even for short-lived rights, a big increase in the price of the commodity could make the royalties more valuable. It's essential to understand how fast the wick is burning, and the ties to commodity prices, when placing a value on royalties of any kind (and by extension, trusts owning rights to them).

Energy-transport assets (e.g. pipelines) don't have the same depletion aspect that natural resource extraction does. They can be more similar to rental real estate, where you take depreciation while the value is increasing over time.

But this discussion highlights a key point which is that MLPs (and the broader term, PTPs - publicly traded partnerships) include a wide range of businesses and as investments, vary tremendously. Some are complete garbage! These take work.

-Tad

On 2009-08-07 13:55:55 -0700, Tad Borek said.

Very interesting. I should think someone considering investing in a trust, be it royalty or MLP, would be well advised to caefully study the points you have just made. And also it would seem to me that anyone going this route should perhaps protect against the risk by investing in a diversified selection of MLP's, not just one that happens to be convenient and close at hand for some reason.

Paul Sturm, before he was replaced by Jack Hough, wrote many times in SmartMoney's StockScreen column about MLPs. The most recent one I could find was March, 2005:

Note that the five MLPs he recommends are all (except one) trading now, after a big up and down move like the rest of the markets - at around the same price as they were trading 4+ yrs ago. And have been paying out their yield (as we discussed here, mostly likely return-of-capital) all along. (The one exception is up 50% from '05 - though it peaked at over 100% up from then, about 2yrs ago).

Here:

Sturm also talks about some closed-end funds which had then only recently come out, holding MLPs and taking care of many of the tax-complicating issues related to holding them. I haven't spent any time investigating them yet, but they certainly hold the promise of possibly making these accessible without much complication.