Tips For Investors Looking To Save Taxes- Part II

Master Limited Partnerships (MLPs)

Another financial instrument which is getting popular when it comes to saving taxes in the current low interest rate regime is master limited partnerships (MLPs). These instruments have also become popular because of the higher yield in comparison to other instruments like treasury bonds, bank CDs, or money-market accounts. MLP’s can operate at a loss particularly in the first few years particularly in industries like developing oil and gas pipelines due to high depreciation and hence reduced net earnings.  However after the initial phase MLP’s will in probability generate free cash flow in excess of earnings on which taxes are not levied until the owner sells the unit as it is treated as a return on capital. Approximately 80% of MLP distributions are labelled as return on capital.

High yields on MLP’s is another factor that makes this an important tax deterring instrument. Yields on pipeline MLP’s is as high as 7% to 8% in comparison to yields on around 2% to 4% yield on real estate investment trust which is also very popular when it comes to saving taxes. Also the yield on MLP’s have more than doubled in the past one year. Yield spreads on MLPs in comparison to the 10-year Treasury note has more than doubled to approximately 5.75% in 2009 from 2% in 2008. Also MLP’s have experienced less market volatility in comparison to the 10-year note.

The main tax benefit of owning an MLP is that though the entire annual distribution is received tax payment on the same is deferred to the extent it is classified as return on capital. For instance if an investor’s total annual distribution is say $2 per unit of which 80% is classified as return on capital, which is deferred, then his tax payment is  only on 40¢ of each unit’s income. These distributions are taxed like ordinary income on which normal income tax is levied. Also tax experts feel that by deferring the taxes to the future and by holding the unit for a long time you would end up in the lower tax bracket and hence be taxed lower.

Also if you are looking for investing in fixed income market minus the low yields or interest rate risk associated with treasury bonds then MLPs are the right instrument for you. However stock performance of these partnerships is correlated to the return on the 10-year Treasury bond.

One main problem with MLP’s is that under the US tax code any net loss that results when they are sold is taken to be inert and hence cannot be used to compensate for income from other sources. Accounting wise this loss has to be taken forward and netted off only against future income from the same partnership.

Ofcourse the performance of MLP’s is dependent on the sector they are investing. For instance MLPs that are involved in building natural gas and oil pipelines or storage facilities are considered to be better than MLP’s that invest in oil or gas production as pipeline and storage capacity are let out at fixed rates through long-term contracts and hence generate cash irrespective of the change in energy prices. MLP’s that invest in energy production are exposed to fluctuation in energy prices and hence rise or fall according to oil or gas prices. When energy prices increase energy MLP yields increase and vice versa.

In addition to the above discussed financial instruments, dividend paying stocks are also good investment options when it comes to saving taxes as the income stream from the same is taxed at the dividend rate of 15% which is the equivalent to capital gains rate.

Last but not the least the most important rule for investors looking to save taxes is to keep their eyes and ears open for developments in order to maximise return and save taxes. In all probability in 2011 tax rates on both dividends and capital gains are likely to increase and return to the pre Bush tax cuts. With this the whole financial environment will change and the current options for tax saving may become redundant.

Read more at: Tips For Investors Looking To Save Taxes- Part I