A limit exists on the amount of loss deductions that a partner can take in a taxable year. Specifically, an MLP owner's basis in his MLP interest determines his allowable loss deductions. This article explains the loss limitation imposed by the code. It also explores what happens when a partner's losses are limited, but he has both capital and ordinary losses. In other words, how is the character of allowable and carryover losses determined in those instances? Finally, this article gives a few tax planning tips to use when investing, based on the loss limitation.
What is the Limit on Loss Deductions?
The basic rule seems simple. A partner cannot be allocated losses in excess of his basis in the partnership (I.R.C. 704(d)). Disallowed losses are carried over to subsequent years, until the partner has enough basis to take them (1.704-1(d)). The basis that matters, for loss limitation purposes, is the partner's basis at the end of the taxable year in which the loss occurred (1.704-1(d)). This means that the partner's basis will reflect the downward adjustments of cash distributions during the year. As a result, all else equal, distributions of cash to a partner decrease the amount of loss deductions that he can take that year. Alternatively, when the partner receives his share of income for the year (or contributes more to the MLP), this will increase the amount of loss deductions that he can take for the year. Underlying these statements, of course, is the effect that distributions, contributions, and allocations of income have on a partner's basis. Distributions decrease a partner's basis in his partnership. Contributions and allocations of income increase his basis in the partnership.
Now, suppose a partner receives distributions and his share of income and buys more of the MLP in a single year. What happens then? How are each of these events taken into account, for basis (and loss limitation) purposes? In that case, the stacking rules of I.R.C. 705(a) govern (1.704-1(d)(2)). First, the partner will increase his basis by the amount of his contributions and by his share of income (705(a)). Second, the partner will decrease his basis by his share of distributions (705(a)). If distributions exceed his basis, he recognizes capital gain under 731(a)(1). Third, the balance is available for loss deductions (704[d]).
A thorny issue remains, regarding how to determine the character of allowed and disallowed losses. For example, suppose that a partner's basis in the MLP is $100 at year's end, taking into account all distributions, contributions, and allocations of income for the year. Now, suppose that he has $200 of possible loss deductions: $100 of long-term capital loss and $100 of ordinary losses. 704(d) makes clear he can only take $100 worth of losses this year. But what is the character of this allowable loss? Fortunately, the Treasury addresses this issue in the regulations (1.704-1(d)(2)). The partner will allocate the losses proportionately, between the allowed and disallowed portions (1.704-1(d)(2)). Here, there are $200 of total losses. 50% of these losses are long-term capital losses and 50% are ordinary losses (i.e. 100/200). Apply these percentages to the portion of allowed losses and disallowed losses to determine the character. As a result, 50% of the $100 of allowed losses will be capital and 50% will be ordinary. The same goes for the $100 of disallowed losses. And so he can take $50 worth of long-term capital losses this year and $50 worth of ordinary losses; in this example, the remaining $100 has a similar character breakdown and is disallowed and carried over to subsequent years.
The Loss Limitation in Practice: Tax Planning
Once you understand how the loss limitation works, you can structure your investments and time your sales in a way that best minimizes taxes. Specifically, consider (1) keeping track of your basis in the MLP, (2) increasing your basis in the MLP to take the entire loss deduction, when necessary, and (3) using the tax loss deductions strategically. Of course, these three suggestions are merely suggestions. Consult a tax professional and/or do your own research, before making any investment decisions.
First, keep track of your basis in the MLP. As this article shows, knowing your basis in the MLP is crucial. It lets you know the extent of allowable loss deductions for the current taxable year. It also lets you know the character of those loss deductions, which aids in tax planning. (Knowing your basis in the MLP also helps you make other investment decisions, such as whether to sell some or all of the MLP interest itself).
Second, if your low basis in the MLP risks preventing you from taking loss deductions for the current year, consider buying more shares of the MLP. This should increase your basis in the MLP, thereby increasing the amount of loss deductions that you can take this year (this assumes, of course, that your allowable share of the MLP's losses--once you increase your interest in the MLP--does not offset the increase in your basis due from buying more shares of the MLP). Of course, this decision turns on many factors, such as how long you want to continue to hold onto the MLP, your tax bracket, your allocatable share of the MLP's income, the total amount of losses generated by the MLP this taxable year, the presence of any carryover losses, etc.
Third, consider using the loss deduction to offset some or all of the gain from other assets in your portfolio. This is akin to tax loss harvesting. For example, if you know that a portion of your MLP loss deduction will be characterized as a long term capital loss, you might sell an equivalent amount of another security in your portfolio for a long term capital gain (assuming you wanted to sell that security).
The tax rules surrounding MLPs are tricky, and the loss limitation rule is no exception. Understanding it not only helps with tax planning, but it helps with investing in MLPs in the first place. While this article provides a basic overview, it is merely an introduction into a morass of regulations and rules. Consult a tax advisor, tax attorney, or other tax professional for more detailed and personalized advice.
Additional disclosure: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner or advisor. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author.