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There has been a lot of discussion in the Comments of a couple of my recent articles about the problems associated with holding a Master Limited Partnership [MLP] in an IRA account. While MLPs can be a great source of income, they really are not designed to be held in a tax-deferred vehicle, something, I was not aware of when I added several of them to my IRA last year.

A lot of folks are aware of the possible tax consequences of having Unrelated Business Taxable Income [UBTI] reported by the MLPs they hold (in any account) exceed the $1,000 annual exclusion each of us are allowed every year. Many are also concerned with the headaches of working with the K-1 forms that MLPs use for tax reporting to unit holders.

Investopedia defines UBTI as:

Income regularly generated by a tax-exempt entity by means of taxable activities. This income is not related to the main function of the entity, but is needed to generate a small portion of income.

And goes on to state that:

If an investor holds an Individual Retirement Arrangement (IRA), and the fund generates income which qualifies as UBTI, the fund may be subject to taxation.

Now, I'm certainly no tax expert, but I've been filing my own taxes for over 20 years with no issues, and I really wasn't concerned about how to handle the dreaded K-1s that will be coming to me this tax season for holding some MLPs in my IRA last year.

However, some of the discussions in a couple of my recent articles brought to light a potentially bigger problem with holding an MLP in one's IRA: The possibility of being double-taxed or, worse, having to pay more in taxes after disposing of an MLP in your IRA than you made in gains and distributions from having that MLP in your IRA. The issue is referred to as "recapture", and the amount that the IRS will require from you after you sell off an MLP, especially one that you've held in your IRA for a number of years, could be alarmingly high.

Seeking Alpha member and commenter rlp2451 posted a lengthy comment in my recent article, "My Mad Method: What Next To Buy, And Why - January, 2013" which helped shed light on the real problem of holding MLPs in an IRA. After providing an example of how in any given tax year the risk of having to pay UBTI above the $1,000 exclusion is usually not an issue for most holders of an MLP in an IRA, he goes on to say the following (emphasis added):

Unfortunately, there is a catch. This additional [expense reduction] is recaptured when you dispose of the units and [is] classified as ordinary income. That means that though the current MLP earnings are shielded, the "shield" is taken off at disposition and all previous earnings that were shielded are now brought back in as ordinary income. It is this income that is now subject to UBTI.

Let's say that you held your units for 10 years and the MLP had $15,000 in earnings. Of those earnings $14,000 was shielded by these [accounting] "tools" and is now subject to recapture.

Let's say that you then sell the units for $35,000. In your mind you have a $10,000 capital gain which is not taxed to the IRA.

In fact that's not how the IRS tallies the transaction. They would consider $14,000 as "recapture" subject to ordinary income and therefore UBTI. Only the balance is either capital gain or cost basis and not subject to tax. If you now withdraw these after UBTI-taxed amounts from your IRA they will be taxed again. This is not the result most people would want.

Worse yet, ordinary income can be MORE than the total gain, for which you then get a capital loss - the worst of both worlds.

UBTI taxes are also higher than ordinary income tax rates. Roth IRAs are not exempt from UBTI.

(Note: rlp2451 may have been quoting the above information from another author's article, or he may have hand-written this example in his comment himself; I'm not certain, as he mentions an article but does not include a reference to any article or author in his comment, which I have quoted here.)

After further discussion in the comments section of this and another of my recent articles, and after a great deal of thought and research on my part for alternative investments, I came to the conclusion that MLPs should be held in a taxable account, "where they belong", as another frequent Seeking Alpha commenter, chowder, stated in a another comment in that January article of mine.

So I decided that now was the time to sell off the MLPs that I held in my IRA, before too much more time passed, and with it, any more possible exposure to recapture taxation. Since I didn't want to reduce the number of positions that I held in my IRA, I decided to replace the MLPs with other stocks that would, hopefully, yield as much in dividend/distribution income as the MLPs have and could have continued to, if I kept them around.

The MLPs that I had left in my IRA last week, and their yields at the time I sold them, were the following:

  • Alliance Resource Partners, L.P. (NASDAQ:ARLP) - 7.01%
  • BreitBurn Energy Partners, L.P. (NASDAQ:BBEP) - 8.78%
  • Linn Energy, LLC (NASDAQ:LINE) - 7.68%
  • Vanguard Natural Resources (NASDAQ:VNR) - 8.73%

Those were some nice yields, and I knew I'd be hard pressed to find safe, Dividend Growth Investing [DGI] oriented stocks to replace them. On the other hand, the percent allocation of some of these MLP positions were much higher than the 3.57% "parity" that I've been trying to achieve for all of the 28 positions (currently) in my IRA, and some were even above the 5% "threshold" that I try to keep any one position below, so that I'm not too exposed to any one position either taking a hit in share price or cutting its dividend.

For example, before I sold them, ARLP represented 5.53% of my IRA's total value, and BBEP had a 5.28% allocation. Selling these four MLPs meant that I could potentially kill several birds with one proverbial stone, by not only replacing these four MLPs as positions in my IRA, but also using the excess funds to try to bring other positions up to or above the parity level of a 3.57% allocation.

So I worked out some basic objectives for myself to guide my search for stocks to replace the MLPs (and their yields) in my IRA:

  1. Go back to the "roots" of My Mad Method [MyMM] and try to pick replacement stocks that ranked well in terms of the average of the 17 metrics that I currently use in MyMM.
  2. Try to diversify the positions in my portfolio a bit more by selecting (or adding to) stocks from industries that are under-represented.
  3. Consult David Van Knapp's eBook "Top 40 Dividend Stocks for 2013" to see if there are any candidates from Dave's list that score well in terms of MyMM and fit my other objectives.
  4. Replace the 4 MLPs with 4 new positions.
  5. Try to bring as many of my other positions up to or above an 3.57% allocation parity level as possible.
  6. Try to get as close as possible to replacing the yield that would be lost by selling the 4 MLPs with the yield of the new positions and the positions brought up to parity.

Armed with these objectives and my trusty MyMM spreadsheet, I sold the 4 MLPs that remained in my IRA last week and prepared to replace them with some fresh blood.

(I should note here that, including dividends, I realized a healthy profit on the sale of all of the MLPs except for LINE, in which I realized a slight loss.)

In Part 2 of this 2-part article, I will detail the four stocks that I purchased to replace the four MLPs that I sold, as well as which of my existing positions I was able to bring up to parity, and what it took to get them there.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am not a professional investment advisor or financial analyst; I’m just a guy who likes to crunch numbers and can make an Excel spreadsheet do pretty much whatever I want it to do, and I’m doing my best to manage my own portfolio. This article is in no way an endorsement of any of the stocks discussed in it, and as always, you need to do your own research and due diligence before you decide to trade any securities or other products.

Source: My Mad Method: Replacing The MLPs In My IRA, Part 1