June 22, 2012 at 06:00 AM EDT
Investing in Master Limited Partnerships: Earn Higher Returns and Beat the IRS
Contrary to popular belief, you can earn higher returns and pay lower taxes. All you need to do is make one simple move. It's achieved by investing in master limited partnerships, or MLPs for short. Due to an obscure law passed during the Reagan era, companies that service the oil and energy sector are allowed to funnel profits directly to their investors. And because of a unique tax loophole, investors who hold MLPs for the long term can completely avoid paying taxes on 80%-90% of all of their earnings. For MLP investors, those returns can be substantial. First, there are the hefty "distributions" MLPs pay out year after year. In fact, several of the 50 companies in the benchmark Alerian MLP Index offer yields of 7.5% or higher. Second, there is price appreciation which accounted for about 32% of the gain the index has generated since the end of 2007, according to Investing Daily . Altogether, that gave the Alerian MLP Index a total return of 66.6%. Meanwhile, the S&P 500 Index lost 1.55% over the same period. What is a Master Limited Partnership? Most MLPs are involved in the business of connecting energy producing fields with refineries, distribution, and retail sales centers. But, despite popular belief, most have limited exposure to commodity prices. That's because most MLPs own midstream energy assets such as feeder pipelines and storage and transport facilities. It's a great business model because MLPs don't actually take ownership of the commodities. They transport, store and process them. Doing so, they simply act as gate-keepers, extracting a heavy toll every time a transaction takes place. So when oil or gas is moved from Point A to Point B, MLP pipeline owners get paid. Or when oil moves through the system and has to be stored, MLPs get paid. In fact, almost anytime anything happens in the energy sector, MLPs get paid. It all adds up to healthy profits that, by law, are passed on to investors. To continue reading, please click here...
Contrary to popular belief, you can earn higher returns and pay lower taxes.

All you need to do is make one simple move. It's achieved by investing in master limited partnerships, or MLPs for short.

Due to an obscure law passed during the Reagan era, companies that service the oil and energy sector are allowed to funnel profits directly to their investors.

And because of a unique tax loophole, investors who hold MLPs for the long term can completely avoid paying taxes on 80%-90% of all of their earnings.

For MLP investors, those returns can be substantial.

First, there are the hefty "distributions" MLPs pay out year after year. In fact, several of the 50 companies in the benchmark Alerian MLP Index offer yields of 7.5% or higher.

Second, there is price appreciation which accounted for about 32% of the gain the index has generated since the end of 2007, according to Investing Daily.

Altogether, that gave the Alerian MLP Index a total return of 66.6%. Meanwhile, the S&P 500 Index lost 1.55% over the same period.

What is a Master Limited Partnership? Most MLPs are involved in the business of connecting energy producing fields with refineries, distribution, and retail sales centers.

But, despite popular belief, most have limited exposure to commodity prices.

That's because most MLPs own midstream energy assets such as feeder pipelines and storage and transport facilities.

It's a great business model because MLPs don't actually take ownership of the commodities. They transport, store and process them.

Doing so, they simply act as gate-keepers, extracting a heavy toll every time a transaction takes place. So when oil or gas is moved from Point A to Point B, MLP pipeline owners get paid.

Or when oil moves through the system and has to be stored, MLPs get paid. In fact, almost anytime anything happens in the energy sector, MLPs get paid.

It all adds up to healthy profits that, by law, are passed on to investors.

But here's what's really great...
Master Limited Partnerships Beat the Tax Man Unlike ordinary stocks, MLPs offer a significant tax shield for investors.

You see, like real estate investment trusts, MLPs are pass-through entities that transfer profits and losses to individual unit holders.

But, because of depreciation allowances, 80% - 90% of the distribution you receive is considered a return of capital by the IRS. So you don't pay taxes immediately on that portion of the distribution.

In other words, 80% - 90% of the distribution you receive is tax-deferred. The remaining 10% -20% is taxed as regular income.

But here's the kicker.

You're not taxed on the return of capital until you sell the units. What's more, those payments are used to reduce your cost basis on the MLP.

Let's suppose you purchase an MLP for $50 and receive $5 in distribution payments, $4.50 of which is considered a return of capital. You pay no income tax on that $4.50.

In this case, only the remaining 50 cents is taxed as regular income. Meanwhile, after one year, your cost basis drops to $45.50 ($50 minus $4.50).

Assuming the distribution remains the same the next year, your cost basis would drop again to $41.00. And so on...and so on.

Eventually, your cost basis could go to zero, leaving you with zero tax liability on 80% -90% of your returns.

And if you decide to sell the units sooner, the capital gains are taxed at the more favorable long-term capital gains tax rate-a tremendous benefit, especially for older investors.

MLPs do complicate your tax preparations, so you may find it easier to consult a tax professional. But the additional expense should be well worth it.

Investing in Master Limited Partnerships

Explosive growth in shale and other unconventional gas production has given MLP investors a wave of new opportunities. That should allow them to continue to expand distributions to investors.

However, the two most popular exchange-traded funds (ETFs) available - the Alerian MLP ETF (NYSE: AMLP) and JPMorgan Alerian MLP Index ETN (NYSE: AMJ) - pass their profits through as ordinary dividends, so you lose the big tax advantages.

Instead, you're better off taking a look at one of the following high-yielding MLPs:

Enterprise Products Partners LP(NYSE: EPD) just raised its distribution for the 30th consecutive quarter. Growth in the Rocky Mountains and the Eagle Ford Shale has pushed natural gas production to record levels. Its current yield of 5.26% and steady record of boosting distributions makes it an attractive target for long-term investors.

Linn Energy (Nasdaq: LINE)is involved in the actual production of oil and gas and has around 2.8 trillion cubic feet of gas-equivalent reserves, assuring future production growth. Best of all, Linn is fully hedged through the end of 2013 and more than two-thirds hedged through 2014-2015. Whether gas is at $2 or $15, the company should be able to maintain its payout of 8.06%.

Investors should also consider: Plains All American Pipeline LP (NYSE: PAA), Enduro Royalty Trust (NYSE: NDRO), and Magellan Midstream Partners (NYSE: MMP).

Either way, investing in master limited partnerships is hard to beat.

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