Well, it's that time of year when owners of MLPs have their K-1's in hand. If you are like most people, you probably just hand it over to your CPA or plug the numbers in TurboTax and forget about it.
In order to plan appropriately, this is just not enough. There are several things you need to know and keep track of. Here goes:
- The distributions (Part III, line 19 of the K-1) represents return of capital and are not currently taxed. They are again reflected in Part II line L as a reduction in basis. This is important, as basis is essential to determining your taxable gain on sale. The lower your basis, the more your taxable gain.
Various income items are reflected in Part III. This can vary depending upon the particular MLP. For instance, my K-1 for EPD shows an ordinary loss (line 1) of about $2 per share and gains (line 9 and 10) of about 50 cents a share. So my net loss is about $1.50 per share.
I also own LINE and their K-1 shows positive ordinary income. This will be taxed currently, but will increase my basis, and not be taxed again, at sale.
These are very important numbers. The EPD net loss is a Passive Loss and cannot offset income from other sources, including other MLPs. They are "suspended" losses and can only be applied against future gains from the MLP that gave rise to them. So, I can't offset LINE with EPD.
You absolutely need to write these "suspended loss" amounts down and keep track of them.
Here's why: When you ultimately sell your units, you will experience some capital gains and some ordinary income (recapture of depreciation and depletion, etc.).
Here's a link that you can navigate to find out how much of a hypothetical sale will be cap-gains and how much ordinary income. Follow the tabs to "other links, projected gain/loss calculator".
The reason you need to keep track of these "suspended passive losses" is that they can be used to offset the ordinary income on sale of your units. However, they don't seem to show up anywhere in the K-1's or the linked website. So you need to keep a running total or you won't know the cumulative amount. Hopefully your CPA has been keeping track.
Now, some bad news regarding these suspended losses. They can only be used to offset gains when you sell "substantially all" of your units.
So, if you have 1000 units and sell 500, you will recapture one-half of the depreciation/depletion ordinary income but can't apply any of the "suspended losses" against it. You will have to wait until you sell the remainder of your units, and then you can claim the "suspended loss" in full.
In my case, I have $125,000 of potential ordinary income recapture and $59,000 of suspended losses. If I sell three-quarters of my shares, I must report $94,000 as ordinary income ($125,000 times 75%) but my suspended loss offset is deferred until I sell the rest of my shares. What a disaster!
If, on the other hand, I sell all my shares, I need report only a net ordinary income of $66,000 ($125,000 minus $59,000). That means reporting $28,000 less in current income than the partial sale. So, it might make more sense to sell all of my shares and then buy another MLP. I think if I re-buy EPD in the same year it would be problematic. Any CPA's want to help with this?
Conclusion: The taxation of MLPs are complicated but need to be understood. It is not enough to just "plug-in" or "hand-over" your K-1's. They contain important information that can actually be a determinant of when and how many shares you may want or need to sell.
After all, what sense is there in purchasing an MLP to get favorable tax treatment then blow it away because you didn't sell enough shares when you "trimmed down"?