High income tax got you down?

Although they tend to be specialized, complex, and sometimes even gimmicky, alternative investments can offer unique opportunities that are worth exploring. Some are just dumb fads, sure; but others are hidden gems given the right place and time.

One example I want to look at today is Master Limited Partnerships (MLPs), which can be a great source of income for investors who are currently in a high tax bracket but expect to be in a lower one down the road.  

What is an MLP?

Imagine you are a landlord. You own a rental property, you pay to fix it up when things break (operating expenses), and you collect rent from your tenants (income). But in addition, the IRS allows you to depreciate the property every year – which ultimately lowers your taxable income.

MLPs are exactly the same, except you do not have to answer calls from tenants on the weekend and, more importantly, your legal liability is limited only to what you invest. Not that MLPs are for real estate specifically; you can find an MLP for just about any type of business. But they are most effective in industries that depend a lot on depreciating assets: oil drilling, commodities, real estate, etc.

The bottom line is that, unlike traditional stock investments, MLPs let you invest in a business and get a share of its income. One big benefit of this arrangement is that in addition to sharing in the MLP’s income, you also get to share in the depreciation at your current tax rate.

To see why this is a big deal, we need to run some projections.

The MLP in action

Suppose you are looking for an investment with steady income and are currently in the 35% tax bracket (ouch) but expect to go down to the 22% bracket in five years.

You can either invest in an MLP, or purchase stock in Company X. Suppose that each will give you the exact same amount of income over the five-year period – so the big question is which investment will cost you more in taxes?

Hmmm… decisions, decisions. First, let’s see what happens if you go with Company X:

And now with the MLP:

MLPs can be a great way to mitigate the effects of a high income tax bracket

Because the MLP passes the depreciation to its investors (you), your tax burden in Years 1-4 stays very low in this scenario, making Year 5 a real bummer in comparison. But note that you still end up paying less tax overall in this scenario than with Company X.

The reason for this is that the MLP allows you to effectively (if not technically) defer paying some income tax until you sell your shares. So if you can wait to sell until you are in a lower income bracket, you will ultimately save on your taxes!

However, remember all that depreciation you took in the previous 4 years? It lowered your taxable income at the time, which was a very nice reprieve given your 35% tax bracket, but now the piper must be paid and since you sold your investment for a gain, the IRS wants you to pay it back at your current tax rate. Meaning if you can wait to sell until you are in a lower income bracket, you will ultimately save on your taxes!