Yesterday I attended the National Association of Publicly Traded Partnerships’ (NAPTP) annual conference in Stamford, CT. It was well attended as is normal, and it provided a welcome opportunity to see presentations by several of our portfolio names. The long run prospects remain attractive although we’ve had two years’ worth of return in less than five months of 2013.
Given the strong performance of MLPs so far this year, not surprisingly there was a certain amount of chatter about taxes. Buy and hold MLP investors have certainly seen their unrealized gains grow and consequently so has their associated tax liability. A high class problem no doubt.
Earlier this year I heard of an MLP asset manager who was advising clients that they should cut back their exposure because the market was overextended. With the benefit of hindsight it was poor advice, but even at the time it was of dubious value. Few money managers publish or even care about their clients’ after tax returns. But consider an MLP investor holding a portfolio worth $100 and a cost basis of $40 (believe me, there are many). Liquidating the portfolio to profit from an anticipated near term decline in prices results in a $60 taxable gain. Some of this gain will be subject to ordinary income tax (coming as it has from the tax-deferred nature of the distributions). The Federal Capital Gains tax rate is now 20%, while the top marginal ordinary income rate is 39.6%. Many states impose taxes as well, and investment income tax in support of Obamacare can also apply, so let’s assume that the mix of taxable income is approximately evenly split between ordinary income and capital gains, and it subject to a 30% Federal tax plus 5% state. The $60 in taxable income will throw off a $21 tax bill.
What this means is that the liquidated portfolio needs to be reinvested at prices of 79% (i.e. $100-$21) of its pre-tax value just in order to break even. The manager needs to accurately forecast a 25%+ drop in prices and be sufficiently nimble to get back in to justify such a move.
However, performance is normally reported pre-tax, since everybody’s tax situation is different. The tax drag from this attempt to time the market doesn’t show up. If the market does drop 10%, the manager may look good even though he has left his clients poorer. MLPs are a great example of inaction often being more profitable than action. Although there is invariably liquidity to sell what you want, staying with a diverse set of names you’d like to own for years is the best way to maximize the after-tax wealth creation that is possible from the sector.