Investing: Tools for Tempering Taxes

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One other tax-advantaged vehicle finding favor: master limited partnerships (MLPs), which have become more popular in these ultralow interest rate times due to the higher yields investors can earn vs. those on Treasury bonds, bank CDs, or money-market accounts.

In developing oil and gas pipelines and other assets, MLPs may operate at a loss for the first few years and incur a lot of depreciation costs, which reduce net earnings.As a result, MLPs are likely to generate free cash flow in excess of earnings, which is treated as a return of capital, on which taxes are deferred until the owner sells the units. Roughly 80% of MLP distributions generally are classified as returns of capital.

MLP Yield Spreads

And where yields on another popular tax-advantaged vehicle, real estate investment trusts, are currently at around 2% to 4%, yields on pipeline MLPs are 7% to 8%, having doubled over the past year, says Charles Goldblum, president of New York investment firm Hurley Capital. Yield spreads on MLPs vs. the 10-year Treasury note have widened from 2% in late 2008 to about 5.75% recently, while historically MLPs have traded with less market turmoil than the 10-year note.

The primary tax benefit of owning an MLP is that you defer payment of taxes on the portion of the annual distribution that's considered return of capital but receive the entire annual distribution to offset living expenses or invest in other assets. Each distribution lowers the owner's cost basis on the MLP.

If an investor's total annual distribution is $2 per unit and 80% of that is return of capital, which is deferred, he pays taxes only on 40¢ of each unit's income right now. Unlike capital gains, these distributions are taxed as ordinary income. The advantage is that by deferring the bulk of the taxes into the future, if you hold the units for a very long time you're likely to be in a lower tax bracket and taxed accordingly, says John Cusick, an analyst at Oppenheimer (OPY) who covers MLPs.

MLPs are a preferred way to get exposure to the fixed-income market without being saddled with low yields or undue interest rate risk that comes with Treasury bonds. That said, the stock performance of these partnerships is linked to the return on the 10-year Treasury bond more than anything else, adds Goldblum at Hurley.

Loss Drawback

One drawback of MLPs is that any net loss when they're sold is considered passive under the U.S. tax code, which means it can't be used to offset income from other sources but must be carried forward and offset against future income from the same partnership.

MLPs that build natural gas and oil pipelines or storage facilities are a safer bet than those that actually produce oil or gas because pipeline and storage capacity is leased at fixed rates through long-term contracts that generate cash regardless of fluctuations in energy prices. The cash flow of energy-producing MLPs rises or falls according to oil or gas prices. When energy prices go up, MLP yields typically follow, says Goldblum.

Tax benefits of MLPs are even better when it comes to estate planning since on the owner's death they receive a step-up in cost basis where the value of the unit becomes the market value on the date of death. This eliminates capital-gains and deferred taxes on previous distributions when the assets pass to the owner's beneficiaries.

Outside of MLPs and REITs, dividend-paying stocks offer investors tax-advantaged income, too, since their payouts are taxed at the qualified dividend rate of 15%, the same as capital gains.

As always, tax-conscious investors must track developments in Washington, D.C. As of 2011, tax rates on both dividends and capital gains are scheduled to go back up to where they were before the Bush tax cuts of earlier this decade. That means that the window of opportunity for investors looking for a break could be closing soon.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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