David,

Thanks for reading. In my example, I stipulated that 80 percent of the distribution was tax-deferred “return of capital,” and this depreciation offset is recaptured at sale at the personal income tax rate, not the long-term capital gains rate. See here for the basics of MLP taxation: http://naptp.org/PTP101/Print/Basic_Tax_Principles.pdf

As for the 3.8% Medicare surcharge, I chose not to use it because on investment income it applies only to the extent that modified adjusted gross income (MAGI) exceeds $200,000 for individuals or $250,000 for married couples filing jointly. In other words, if you’re married and filing jointly on MAGI of $300,000, you would only owe the 3.8% Medicare tax on the lower of your actual investment income or $50,000. Furthermore, earned income was already subject to a 2.9% Medicare tax, of which half was/is being paid by the employer. So the actual increase on earned income for high earners is 0.9%, and again only on the slice of MAGI above $200K for individuals and $250K for couples. Fidelity has a good primer on the Medicare tax changes here: https://www.fidelity.com/viewpoints/personal-finance/new-medicare-taxes

If you hold your MLPs for the balance of your life, your heirs will inherit a stepped up basis and will not owe recapture on your past distrubutions. If you do sell, however, expect to be taxed at the personal income tax rate on the portion (usually most of) past distributions that were tax-deferred because of depreciation,

Hope this helps.

Best,
Igor

I maintain that distributions after the zero basis is reached are taxed as capital gains in the year received, as indicated in the industry link I pasted above, but ultimately at a personal income rate upon sale to the degree that they increase the recapture liability. As for how quickly the zero basis is reached relative to distributions, I’ve made no claims on that score and it would vary with the partnership obviously.

The correct answer may be that the cash distributions and/or sales proceeds received after a zero cost basis are subject to BOTH capital gains and ordinary income tax rates, depending on the character/source of the distribution or sales proceeds:

“When the cash distribution exceeds the owner’s outside basis, it is treated as a capital gain as if the partnership interest were sold (IRC sections 731 and 741; IRC section 751 is discussed below).

IRC section 751 (sales and exchanges). As with traditional partnerships, MLPs are not immune to IRC section 751. MLP investors cannot escape taxation on their share of ordinary income. The general rule for the sale of a partnership ownership interest is that sales in excess of basis result in capital gain; however, IRC section 751 subjects a portion of the realized gain to ordinary income treatment. Both sales and exchanges result in ordinary income to the extent the sale proceeds are attributable to the owner’s proportionate share of unrealized receivables and inventory. Both unrealized receivables and inventory are liberally construed [IRC sections 751(c) and 751(d)]. This means that unrecaptured depreciation for realty (IRC section 1250) and personalty (IRC section 1245) will be considered ordinary income, as well as recapture of intangible drilling and development costs of oil and gas wells, and mining development and exploration expenditures (IRC section 1254).

Example 3. At the end of 10 years, Owner X has outside basis of $80,000 (original cost basis $50,000). Owner X sells all the Petra MLP units for $100,000. The realized gain is $20,000 ($100,000 -$80,000). Generally, the gain would be treated as capital (IRC section 741), but $10,000 of the sales amount is attributable to recapture and considered IRC section 751 property. The $80,000 basis must be allocated between capital gains and ordinary income. Ninety percent ([$100,000 -$10,000] ÷ $100,000) of the sale proceeds and basis is allocated as LRC section 741 capital gain, and 10% ($10,000 ÷ $100,000) as IRC section 751 property. The capital gain is $18,000 [$90,000 (90% × $100,000 sale proceeds) – $72,000 (90% × $80,000 basis)] and the ordinary income is $2,000 [$10,000 (10% × $100,000 sale proceeds) – $8,000 (10% × $80,000 basis)].

Individual taxpayers would apply the appropriate preferential capital gains tax rate (0/15%) to the $18,000 capital gain and their marginal tax rate to the $2,000 ordinary income.”

http://viewer.zmags.com/publication/bd37ce6f#/bd37ce6f/1 (pages 50-51)

“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.”

http://seekingalpha.com/article/1300561-mlps-a-reality-check

Best,

Jim (not a tax expert)

Hi Ralph,

The relevant internal revenue code (IRC) provision appears to be 26 U.S.C. Section 731(a), which states:

“Any gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner.”

Since the sale of a partnership interest is a capital gain or loss, so too is the cash distribution.

http://www.justanswer.com/tax/3t8rw-mlp-investment-cost-basis-reaches-zero-after.html

http://www.law.cornell.edu/uscode/text/26/731

http://www.law.cornell.edu/cfr/text/26/1.1223-3

The exceptions to capital gains treatment appear to relate to cash distributions involving an “unrealized receivable (as defined in section 751 (c)) or an inventory item (as defined in section 751 (d)),” which are taxed as ordinary income. See 26 U.S.C. Section 731(c)(6):

“(6) Character of gain recognized

In the case of a distribution of a marketable security which is an unrealized receivable (as defined in section 751 (c)) or an inventory item (as defined in section 751 (d)), any gain recognized under this subsection shall be treated as ordinary income to the extent of any increase in the basis of such security attributable to the gain described in paragraph (4)(A)(ii).”

Best,

Jim (not a tax expert)

Ray,

Thanks very much for subscribing. Unfortunately, MLP investments in IRAs are subject to something called Unrelated Business Income Tax on income above $1,000. This would be owed by your IRA rather than you directly. This is in part why some MLPs like Linn Energy have set-up taxable corporate proxies, which are not subject to UBIT and therefor more suitable for an IRA. For more on this issue see this from the MLP industry group: http://www.naptp.org/PTP101/MLPs_Retirement_Accounts.htm

Ray,

On

1. I don’t think it’s practical or especially worthwhile to attempt to predict UBIT reporting by MLPs

2. The $1,000 exemption applies in the aggregate, not for each partnership

and

3. MLPs really work best in terms of tax planning when you hold them as long as possible, so that the value of the tax deferral ultilmately exceeds the cost of paying recapture at personal income tax rate upon sale. Better still is to die holding them and pass them on to heirs who get a stepped up basis, so tthat your recapture liability is wiped clean. Churning MLP holdings is a not a viable tax strategy, in my opinion.

Hi Ralph,

Barclays may have the final word on this subject in a January 2013 white paper which states in endnote 16 (pages 9, 20):

“There is disagreement among advisors regarding the nature of this taxation. Some tax professionals believe that this taxation should occur at long-term capital gains rates while more conservative advisors believe that ordinary income characterization should apply.”

http://www.barclayswealth.com/Images/Organizing_Your_Wealth_-_Tax-related_Considerations_and_Strategies_for_MLPs.pdf

Best,

Jim (not a tax expert)

P.S. The article by Aaron Levitt simply says that distributions become “fully taxable” after the cost basis becomes zero, but he doesn’t say whether the tax rate is capital gains or ordinary.