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Don't Buy An MLP Without Reading This

By: Carla Pasternak
Posted: 7/18/2012 10:00:00 AM
Referenced Stocks: ETP;MMP;MWE;TYG

They are masterpieces of the income investment universe.

Each one is specially designed to throw off secure income, steadily grow distributions and bring above-average returns.

They're master limited partnerships (MLPs).

In the past 10 years, MLPs have been on a tear. Magellan Midstream Partners (NYSE: MMP ) , MarkWest Energy Partners (NYSE: MWE ) and Energy Transfer Partners (NYSE: ETP ) -- three of the largest MLPs -- are all up more than 450% since 2002.

But despite their popularity as of late, there is one caveat when it comes to investing in MLPs: taxes can be complicated.

Because of their unique tax structure, you generally don't want to hold MLPs in tax-sheltered IRA or 401(k) types of accounts. If your MLPs throw off more than $1,000 of combined unrelated business taxable income (UBTI) -- income that's not related to the tax-exempt purpose of your account -- then your account could suffer some severe penalties.

But fortunately for us, there is a loophole .

Unlike individual MLPs, MLP-focused funds let you own as many MLPs as you want in your tax-sheltered account without creating a potential tax liability .

Usually, funds are regulated investment corporations (RICs), but a regulated investment company by law can't have more than 25% of its portfolio in MLPs. So to keep their fund structure, many of these MLP-focused funds opt to be treated as an ordinary "C" corporation for tax purposes.

As a regular corporation, the fund is taxed at the 35% marginal rate on the earnings portion of the MLP distribution. Then, you the investor are taxed again at the currently reduced 15% dividend tax rate .

Now, here's where it gets interesting.

The fund, like an individual investor, is not taxed on the return of capital portion of the MLP distribution when received. Instead, taxes accrue until the security is sold. These accrued taxes make up a portion of what's called deferred tax liability (DTL).

This DTL is reported in the balance sheet , which for a fund is called a statement of assets and liabilities. The assets less the liabilities equal the fund's net asset value .

As the name implies, DTL is on the liability side of the books, along with long-term debt obligations. That's because DTL is the amount of taxes the fund may need to pay at some future time when it sells its MLP holdings.

But DTL isn't a liability in the same sense as debt obligations. DTL is a non-cash accounting item, like depreciation . It doesn't affect the fund's future earnings potential like debt obligations. It reflects future payments, but only if the assets are sold. If a fund has a very low portfolio turnover rate of, say, less than 25% of its holdings each year, the fund is not likely to incur that liability for a long time, if ever.

With low turnover portfolios, then, DTL acts more like an asset that keeps growing than a liability that the fund owes.

Therefore, adding back DTL to the latest reported net asset value, instead of subtracting it, gives a more accurate measure of the fund's underlying value when compared with non-MLP focused funds.

I'llcall this measure Pasternak's "normalized net asset value" (NNAV) because it allows us to compare MLP funds with normal closed-end funds that typically don't carry DTL on the books. In other words, Pasternak's NNAV allows us to compare apples with apples.

Using Pasternak's NNAV, I unlocked the hidden value in MLP-focused funds. Funds that may appear to be selling at a steep premium to their asset value now look to be attractively valued.

First, I screened for funds with a low portfolio turnover rate of 25% or below. Then, I calculated the DTL per share based on information provided in the statement of assets and liabilities in the latest 10-K ( annual report ).

I ranked the remaining funds by the greatest amount of DTL on their books, then selected the top five. In the list below, I compare each fund's price to the reported NAV and the NNAV as ag June 8. As you see, once DTL is added back so as to normalize the net asset value, some real bargains emerge.

All of these funds carry rich yields of around 6% to 7% based on the past year's payouts. And, as noted before, you can hold these funds in a tax-sheltered account without tax liability concerns.

Each of these funds warrants a closer look at their portfolio holdings, distribution history, portfolio management , and returns. I am especially intrigued by Tortoise Energy Infrastructure (NYSE: TYG ) , since adding back its deferred tax liability has the most dramatic effect on valuations among the five funds listed.

Risks to Consider: Let me warn you, though, if you're thinking about investing here, then most MLP-focused closed-end funds take on leverage , which can make returns more volatile than with an individual MLP investment.

Action to Take -- > But if you've ever wanted to invest in MLPs but you're worried about the tax implications, then consider investing in an MLP focused closed-end fund. It's one of the easiest ways to simplify the headache, and still gain exposure to these high-yield masterpieces.

-- Carla Pasternak

Carla Pasternak does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.