Message Font: Serif | Sans-Serif
No. of Recommendations: 1
I am aware of the IRS reporting requirements for UBTI in excess of $1000 held within an IRA. However, I did not know about an additional recapture tax calculation required upon the sale of the MLP as noted in the following article.

This is the first I've heard of this recapture calculation! Can this be correct? I would sincerely appreciate an answer from our PIP Team (Peter, Ira, Phil)



When an IRA buys units in an MLP it becomes a partner in the MLPs business. Though the units may be a very small minority interest, it is an interest nonetheless. As a result a proportionate share of the MLP’s net earnings are taxed to the IRA. There is a $1,000 annual exclusion that helps somewhat.

Many readers that have MLPs in their IRAs noted that they don’t seem to have much of an income to report. As a result they conclude it is not so much of a problem. That conclusion does not tell the whole story. Let’s look a little closer.

Let’s say that $25,000 is invested in an MLP. The distribution (return of capital) is 6% per year ($1,500). This is not subject to UBTI as return of capital is not taxable income. Now, the MLP does make money from its operations. The net income represents a “pass-through” to the unit holder. Your share of the gross income might be $5,000 and your share of cash expenses (salaries, interest, etc.) might be $3,500. So far, the share of the net income is $1,500. This is before application of certain accounting adjustments.

You won’t see this $1,500 reported on the K-1 as net income subject to UBTI. That’s because the MLP has some “accounting tools”, namely depreciation, depletion allowances and similar tools that further reduce currently taxable income.

Assuming these “tools” provide another $1,400 in expense deductions, your taxable earnings are reduced to just $100. It is this amount that is reported on the K-1 and is within the $1,000 annual limit.

Unfortunately, there is a catch. This additional $1,400 is recaptured when you dispose of the units and classified as ordinary income. That means that though the current MLP earnings are shielded, the “shield” is taken off at disposition and all previous earnings that were shielded are now brought back in as ordinary income. It is this income that is now subject to UBTI.

Let’s say that you held your units for 10 years and the MLP had $15,000 in earnings. Of those earnings $14,000 was shielded by these “tools” and is now subject to recapture.

Let’s say that you then sell the units for $35,000. In your mind you have a $10,000 capital gain which is not taxed to the IRA.

In fact that’s not how the IRS tallies the transaction. They would consider $14,000 as “recapture” subject to ordinary income and therefore UBTI. Only the balance is either capital gain or cost basis and not subject to tax. If you now withdraw these after UBTI-taxed amounts from your IRA they will be taxed again. This is not the result most people would want.
Print the post  


In accordance with IRS Circular 230, you cannot use the contents of any post on The Motley Fool's message boards to avoid tax-related penalties under the Internal Revenue Code or applicable state or local tax law provisions.
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.