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The Tax Benefits and Disadvantages of Investing in MLP Funds

NEW YORK ( MainStreet) --The first open end mutual fund that invested in master limited partnerships (MLP) was launched on March 30, 2010, and their popularity have been on the rise ever since. The tax benefits of the limited partnership combined with the liquidity of public securities has served as the foundation for the appeal.

Inflows into MLP funds have grown from $580 million in 2010 to $2.5 billion in 2012, according to Morningstar.

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"Investors are interested in MLP funds because of their high yield," said Morningstar's Abby Woodham. "MLP companies are fairly sturdy, so you can expect 4 to 6% yield without the volatility of investing in oil futures. "They work well as a component of a fixed income portfolio for investors that are positive on energy production in the U.S."

Like a REIT, an MLP is a publicly traded partnership that owns and operates infrastructure mostly related to the production and processing of energy and natural resources.

The down side of MLP Funds is that they are structured as corporations in order to be primarily invested in master limited partnerships, which requires the fund to pay taxes at the corporate level.

"Because these funds are corporations, they must pay corporate taxes," Woodham said. "That tax liability is passed through to investors and can negatively impact return. On the upside, investors also share in the beneficial tax treatment of MLP distributions."

Another negative of investing in MLPs is filing a K-1 tax form instead of the usual 1099, which can be complicated. "If you buy MLPs in the wrapper of a mutual fund, you don't have to deal with a K-1 form and you still get tax deferred distributions," Woodham said.

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The upside that keeps investors coming back is that any depreciation on infrastructure assets is classified as return of capital and not immediately taxable.

"Taxes on any return of capital received by investors will be payable when they sell the fund, so there's a significant tax deferral feature in the yield," said Quinn Kiley, managing director and senior portfolio manager at FAMCO. "When a long-term investor in an MLP Fund sells their shares, they pay capital gains on the difference between the price of the fund shares at sale and the basis they have in those shares, which is adjusted for any return of capital they have received during their holding period."

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