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"You've got to be very careful if you don't know where you are going, because you might not get there." Yogi Berra

MLPs have had quite a run and those that had the foresight to invest in them are a pretty happy group. Whenever there is a big run-up it begs the quintessential question...

Is it time to buy, time to sell or time to hold?

Before I attempt to answer this, let's try to put a face on the big run-up.

It is rooted in three reasons...

  1. MLPs are in the energy space. 80% of their growth over the last 3-5 years can be attributed to growth in this sector. Let's face it, most everything has gone up, but MLPs have led the pack.
  2. MLPs provide high yields in a yield-starved world. I follow MLPs closely and the dominate reason investors are buying MLPs is for yield. Can't say that I blame them. Good companies, in a secure sector, with stable, ever-increasing yields...well...just hard to beat. As long as interest rates remain low, the yield differential will continue to attract investors. This should last at least a few more years.
  3. Perceived Tax Advantages. With tax rates going up, every tax saving scheme gets increased attention. I have written many articles [here, here and here] illustrating that the tax savings are, at best, overstated and, most likely tax problems, not solutions.

This is so, since much of the MLP gains will ultimately be exposed to ordinary income tax instead of capital gains tax. The spread in these two rates means the MLP needs to outperform or be held for time frames in excess of 10-20 years. The bigger the spread, the greater the outperformance or holding period needs to be. But, every investment is driven more by perception than reality.

Now, I respect all the authors that write articles on MLPs and provide information such as number of wells drilled, cubic feet of reserves, foot-cost of pipeline, hedges and financials. But, for the typical investor, I think it's more than they can handle. So, let me share, instead, my view as an investor searching for a clear path.

  1. I think the energy sector is a good long-term sector. So this provides me some comfort.
  2. I think interest rates will stay low for a couple of more years...short-term comfort.
  3. Taxes, well, that's another issue. The continued under-performance of MLPs (such as Kinder Morgan (KMP) and Linn Energy (LINE)) relative to their non-MLP offshoots (KMR) and (LNCO) indicates a loss of favor with the MLP structure. There is no other explanation.

But to really understand the tax implications, let's look at some reality.

I bought Enterprise Products Partners (EPD) eight years ago for $28 and Linn Energy four years ago for about $16. Inasmuch as my recent K-1s indicate cost basis approaching zero, I have received almost all my initial investment back PLUS the share price has more than doubled. Count me in that happy group...or maybe, NOT SO MUCH.

Here's what I'm facing, and every long-term holder of a MLP will someday face...a Tax Nightmare. Let me explain...

Yearly distributions reduce cost basis and as the cost basis reaches zero, distributions start being taxed at a combination of ordinary income rates and Capital Gains rates (Return of Capital--ROC). The average MLP will see about 80% ROC and 20% ordinary income. That means, going forward, the "free ride" is over, but that isn't too bad--- after all capital gains is a reduced tax. Hold your horses; there is a ticking time bomb.

The "quirkiness" of MLPs means that, when units are sold, the cumulative distributions not previously taxed at ordinary rates will now be taxed at ordinary rates (recapture).

The nightmare is that this extends to distributions previously taxed at capital gains rates as a result of ROC. That's right, ROC distributions will be subject to capital gains tax as received and taxed again as ordinary income when units are sold. Welcome to the world of double taxation!

Let me give a simplified numeric example...

  1. Purchase $100,000 MLP, this is your cost basis
  2. Receive $100,000 distributions as ROC. No current tax, but reduces your basis to zero
  3. Next $75,000 in distributions taxed, when received, as cap-gain ROC
  4. Sell for $200,000 ---Taxed as follows $100,000 untaxed distributions taxed at ordinary rates, $75,000 cap-gain ROC distribution taxed at ordinary rates (recapture) and $25,000 Capital Gains.

If the MLP is in an IRA, Roth, HR10 or Pension, the ROC will not be taxed when received, but upon sale approximately all the previous distributions, including these ROCs will be subject to tax as UBTI.

Many MLP investors put their head in the sand with the rationale that they will keep the MLP until they die. Well certainly they can do this. But, if you approach it that way, in essence, the tax nightmare has removed the liquidity from the investment.

This may seem esoteric, but I don't believe the market prices all this in. Lack of liquidity is a detracting factor in the valuation of any asset. Liquidity is always worth something. If the tax code locks out (or restricts) liquidity, then the asset should be devalued. We see this with KMP/KMR and LINE/LNCO.

Ah, but when I die, my heirs receive a step up in basis... freedom at last. I hate to burst this bubble, but this probably isn't so. Though any capital gain portion receives a step-up, items of ordinary income (Annuities, IRAs, Pensions, IRD, etc) are not stepped-up at death. This recapture avoidance "rumor" was started because the Tax Code provides that heirs will not incur the recapture tax when units are transferred to them from the estate. The Code never says recapture is stepped-up. It is silent on a subsequent sale by the heirs.

Of course, the heirs could just continue to collect the income and pay capital gains without ever selling. But, then, again, what good is the price appreciation?...is this realistic?

What about making a gift to charity? Once again, not so. The Code does not allow a charitable deduction for the ordinary income portion. So, your loss of the full deduction, effectively imputes the ordinary income portion.

So, where is all this leading?

My MLPs have treated me wonderfully. In fact, they are my best investment choice over the time frame. I'm currently facing what many MLP owners will eventually face. I do have some options.

  1. I could sell now, pay the tax, hope for a pullback and re-enter the space, this time buying the non-MLP versions of the companies, such as KMR or LNCO. Or just buy something else. A drop in price will mitigate the tax expenditure. The recent run-up is making a pullback look more likely and this option more attractive.
  2. I could decide I'm never going to sell. What difference does it make if the price falls 10%, 15% or more? It's all just paper, the hi-yielding distributions are the prize.

Here's why "holding-on" doesn't work for me. Dismissing the price appreciation of the units as not relevant, is the same as not being able to use the money. Writing a check and paying tax is not being able to use the money. Either way, I can't use the money. Except by paying the tax, I give up only 35%+ of the money, not all of it.

Of course, by selling, I give up the income stream, but if I realize, after tax, $38/unit for EPD (currently trading at $59), and the distribution, after tax, nets me about $2.12 it will be nearly 20 years before the distributions equal a "self-imposed moratorium" on selling.

I guess what I'm saying is, if one has so much money that $59 in share price can be forsaken, then certainly they have enough money that $2.12/ year can be forsaken. And the $2.12/year isn't really forsaken, only the difference between the distribution yield and what I could earn elsewhere.

Faced with what is a very hard choice, I've decided to sell now. Here's why...

  1. Taxes are the price paid for making money. I'd rather make money and pay tax, than lose money and not pay tax. The longer I delay, the worse the tax bite gets.
  2. I can find no sustaining reason to justify the recent MLP run-up. If everything is "up, up, up and away," from here on, well that's great and I'll gladly take that result for my portfolio. Besides, I obsess more about losses I could have avoided than gains I could have made. Furthermore, if I'm intent on never selling, a run-up is of no value to me anyway, so I've lost nothing.
  3. Most of all, I see MLPs as viable, not because of their structure, rather, because of the sector they're in (mostly energy). I can play stocks and ETFs in that sector with a great deal more flexibility than I can the MLPs.
  4. My "ace in the hole" is my IRA account, which has avoided MLPs because of the tax factors. I can sell cash secured puts and even buy calls to replicate my MLP performance without any tax hassles. I can go "in and out" as I deem necessary.

Wow, this is such a good option, it may be worth another article.

Conclusion: Whether one should buy or sell any asset, including MLPs, must take into account a variety of factors including risk tolerance, concentration risk, liquidity risk and financial goals.

The extraordinary run-up in MLPs has forced some hard choices. I'm not suggesting that my resolution is the right path for anyone. Those who own MLPs will face these hard choices at some time, maybe even now. By sharing my thinking, through this article, I hope to have provided the MLP investor some additional insight. For those who have yet to invest in MLPs, perhaps you could factor in my tough choice when making your choice.

Source: MLPs - A Reality Check ?