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In a previous article, I wrote about the Treasury Department considering a plan to tax pass-through entities. As I noted in the article, the plan is unlikely to be passed as law. However, just the fear of it happening--combined with a few other factors, such as ex-dividend dates, lower oil prices, and historically high valuations--has motivated a major MLP sell-off.

Even if you think adverse tax changes are likely and MLPs are going to decline significantly, you should step back and consider carefully whether it makes sense to sell your MLPs at this point.

Note: I am simply providing a "heads-up" here. I am not a tax advisor (not even close). So I strongly recommend talking to one when you consider MLP sales.

Estimate the Taxes

Selling MLPs has implications that many investors don't fully understand. When you sell, depreciation, depletion and other expenses that deferred tax from the MLP's income and its wonderful distributions come back to haunt you as regular income on Form 4797. Here's the key takeaway:

  • If you have held an MLP for more than a year, expect to pay a lot more than long-term capital gains taxes when you sell.

As an example, let's look at an MLP I sold some of last year:

Sale Price: $69.65

Purchase price: $35.25

Tax breakdown:

Ordinary income gain: $42.08

LT Capital gain: $27.57

Federal and State Taxes due: $26.53

That's right, I paid almost 40% of the total sale price in taxes! This is a fairly extreme case: I held those units for a very long time and the adjusted cost basis had gone to 0. But even someone who has held for a few years is likely to face a similar (albeit not as dire) scenario.

It can actually get a lot worse than this. During the flash crash, I bought some units of this MLP at the blue-light special price of $50. I sold them later in the year for a 50% "gain." A great trade, right? Wrong! Here's the breakdown:

Sale Price: $77.52

Purchase price: $50.84

Tax breakdown: Ordinary gain: $42.60; ST Capital gain: $21.87

Federal and State Taxes due: $29.66

That's right. After taxes, this amazing trade, executed perfectly, actually lost me money! How could that happen? It comes down to subtleties in MLP accounting. When the MLP generates the sales schedule with your K-1, it uses a First-in-First-Out (FIFO) method by default. Most MLPs don't even care if you bought the units at different brokerages. All the units owned in taxable accounts under a Social Security number are pooled together and FIFO'ed. So the units I bought in the 2010 flash-crash got slapped with the basis adjustments and ordinary gain from some units I bought back in the 1990s. You can call the MLP tax package support people and ask them to re-allocate the tax lots for you. But the correct method is to use the average numbers for all the units you hold. In my case, that would only slightly lower the tax burden from the FIFO method shown above. Either way, it isn't pretty.

The bottom line is that MLPs are a sort of "golden handcuffs." They can provide you with a great income stream for a long time, with most of the taxes deferred. The longer you hold them, the greater the deferral advantage. If you sell them capriciously based on fears of what might happen with taxes, you reduce this advantage and risk a really big tax hit. Obviously taxes shouldn't be the only consideration when buying or selling an investment. But when it comes to MLPs--more than with most investments-- they can be a very important consideration.

Source: Think Twice Before You Sell Those MLPs