You see, MLPs combine the tax benefits of a traditional limited partnership with the liquidity of a publicly traded company.
MLPs have a partnership structure, but they issue units that trade on an exchange like common stocks. They differ significantly from stocks in their tax implications and advantages.
Like other limited partnerships, there is no tax at the company level. This lowers MLP's cost of capital, thus eliminating the problem of double taxation on dividends. Instead of paying a corporate income tax, the MLP's tax liability is passed on to unit holders, which is then taxed at the investor's individual tax rate.
But unlike dividends, distributions aren't taxed when received. They are considered reductions in the MLP investment's cost basis and generate a tax liability that's deferred until the investment is sold.
MLPs typically have a much higher distributable cash flow than they have taxable income. Thus, investors receive higher cash payments than the amount which they are taxed. The result is an efficient means of tax deferral.
A Wells Fargo Securities (NYSE: WFC) report found an MLP investor will typically receive a tax shield, in most cases, equivalent to 80%-90% of cash distributions in a given year.
Investing in MLPs: Better than the Alternatives
In a sluggish economy, MLPs are particularly attractive. They provide reduced downside risks and returns that beat average dividend stocks.
Meanwhile, in robust economic environments, MLPs provide the opportunity for significant capital appreciation. That's on top of hearty and increasing distributions.
MLPs tend to carry solid yields around 5%. That makes them kind of like owning a municipal bond paying double the typical rate.
However, a big but less evident benefit of MLPs over munis, Forbes notes, is that bond values tumble when inflation heats up because of the so-called "interest rate and duration risk."
While all yield-backed investments are adversely subjected to rising rates to some degree, MLPs are somewhat sheltered in that their payouts are generally increased over time. That explains why MLPs have historically turned in better performances than fixed income instruments during periods of rising interest rate.
Investing in MLPs in 2013: Growing in Appeal
Over the last decade, industry figures show MLP market's cap has mushroomed from $25 billion to $350 billion.
"Over the next 20 years, this could become a trillion dollar asset class, from $5 billion in the early 1990s," David Schuringa, founder of Yorkville Capital Management recently told Barron's. "There is a great amount of infrastructure needed in the United States to bring on new oil and gas production in unconventional shale plays [those that require fracturing techniques to extract hydrocarbon]-MLPs are the primary source of capital for the infrastructure."
In 2013, amid an insatiable appetite for yield, MLPs have stood out. Year-to-date, MLPs total returns have surpassed 20%. And, they still look attractive.
"You are locking in 6% upfront in current income and you are getting, let's say 6% to 8% growth rates. [This] asset class is still going to provide mid-teen returns going forward just based on the fundamentals. That drives price appreciation," Schuringa continued.
That's why Money Morning just uncovered three of the best choices for investing in MLPs in 2013.
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MLPs: High After-Tax Income But Avoid A Common Mistake
- Wells Fargo Securities:
MLP Primer: Fourth Edition
- National Association of Publicly Traded Partnerships:
MLP Basics for Investors
Where to Find Value, Yield