Most income investors are familiar with the tax treatment of common distributions like qualified and unqualified dividends. But before jumping into high-yield investments like master limited partnerships (MLPs), it's best to understand the ins and outs of its complex distributions.

Issue #1: Return of Capital

MLP distributions are a different beast. A small portion of the distribution may include earnings taxable as ordinary income, but the lion's share (80% to 90%) is going to be considered 'return of capital.'It's important to note this isn't the same return of capital that closed-end funds distribute when they don't have the earnings to cover the fund's scheduled distribution. Instead, MLP return of capital (ROC) is essentially cash flow. In the case of MLPs, return of capital is not taxed when received, but reduces your cost base when you sell your units.

Here's an example...

Say you originally bought 1,000 units of an MLP at $35 each and you decide to sell them a year later. During the year, you received $5,000 in ROC, so your reduced cost basis is $35,000 - $5,000 = $30,000.

When you sell your units, the $5,000 difference between your purchase price and the reduced cost base is taxed as ordinary income at your marginal tax rate. So if your marginal tax rate is 28%, then you would pay $1,400 in taxes.

In contrast, if you bought an ordinary stock that paid $5,000 in dividends taxable at the dividend tax rate of 15%, you would pay only $750 in taxes. MLPs are not tax-free, as some commentators suggest. But they do allow you to defer taxes until they are sold.

Note that in the example above, the only reason we paid taxes on the $5,000 difference between the purchase price and the reduced cost basis is because we sold the units. If you buy and hold an MLP, you can postpone the tax bite for a long time. Furthermore, the cost basis resets to the current market price on your death, making MLPs an attractive long-term hold for your estate.

As with other investments, you also are taxed on the difference between your sales price and your purchase price at the long-term capital gains rate currently at 15%. If you sell your 1,000 units at $39, you will be taxed 15% on the $4,000 gain, or $600.

Another way to think of it is that you paid taxes on the $5,000 attributable to ROC at your marginal tax rate, and you paid taxes attributable to the $4,000 increase in the stock price at the long-term capital gains rate.

Issue #2: UBTI in IRAs

Recently, one of my subscribers, D.S. told me he was nearing retirement. He added that he prefers to hold his income securities in a tax-deferred IRA. That way his dividends can compound without being taxed until he starts making post-retirement withdrawals.

After some recent profit-taking, D.S., had about $100,000 of capital to invest in his IRA. He had heard, however, that it wasn't a good idea to hold individual MLPs in an IRA or 401(k). He wanted to know if that was true, and if so, could I suggest any alternatives.

Before I answered his question, I told him, as I do all subscribers, that I cannot address all aspects of taxation that may be relevant to individual subscribers. It would be wise to consult a tax advisor before adding any type of MLP investment to your account.

That said, the short answer to D.S.'s question is, there's no IRS rule against holding MLPs in an IRA type of tax-deferred account. Still, most financial advisors counsel against doing so.

Here's why.

Partnerships do not pay corporate income tax. Instead, you as a partner and unitholder are responsible for the taxes their business operations incur. The company reports your taxable income and return of capital on a Schedule K-1 that you will receive in late February or early March.

Given this K-1 tax filing, you need to be careful about holding a large portfolio of MLPs in a tax-sheltered IRA-type of account. This is because some of the MLPs' taxable earnings may be considered unrelated business taxable income (UBTI), or income unrelated to the primary purpose of your tax-sheltered account.

If an investor receives more than $1,000 in UBTI in his/her tax-advantaged account in one year, the account could owe federal income tax to the IRS, which defeats the whole purpose of housing your investments in a tax-advantaged account. Each tax-deferred account is allowed a $1,000 deduction on UBTI. After that, UBTI is taxable as ordinary income. That tax bite can reduce returns sharply, especially considering the additional taxes you pay when you withdraw the cash distributions from your account on retirement.

You might think, 'Well, I see a solution. I'll just open several IRAs.' Sorry. The IRS thought of that too, and limits UTBI to $1,500 total across all of your tax-deferred accounts, no matter how many you have.

Further, if you do go over the $1,000 limit on UBTI, your IRA custodian will need to file IRS Form 990-T on your behalf. The distributions will be taxed at corporate rates, since it's the tax-deferred account that's taxed, not you personally. Moreover, a typical charge for the paperwork is about $200 for each MLP you own.

You must have some liquid cash in your account to pay the taxes due and preparation fees. Otherwise, if you pay these charges out-of-pocket, your payment will be considered a contribution to your account, which could result in penalties if you've already topped off your contributions for the year. State taxes can also add a layer of complexity to the filing.

Long story short, talk to your tax accountant or attorney to see if your portfolio of MLPs is large enough to put you at risk for owing taxes from UBTI.

The Investing Answer: The rules surrounding MLP taxes are intricate, but don't let that stop you from making a worthwhile investment decision. MLPs offer some of the highest yields around and most are designed to grow their distributions. A history of growing income plus capital gains makes select MLPs worth the extra effort at tax time.

About the Author: Carla Pasternak serves as Director of Income Research for High-Yield Investing and Dividend Opportunities. Together, these newsletters put her expertise in the hands of more than 200,000 subscribers each month. Click here to learn more...