In my prior article, I wrote about dividends at a very basic level, including what they are and why they are important. I mentioned in that article that the next article would be about master limited partnerships (MLPs), real estate investment trusts (REITs) and business development corporations (BDCs), so I put myself in a bit of a corner here. Here are the 5 things you need to know about them.
- Other than stocks, MLPs, REITs and BDCs are the three primary publicly traded ownership interests on stock markets, like the NASDAQ and NYSE. Just as you can buy 100 shares of Apple stock through Scottrade or any other brokerage for just a few dollars a trade, you can also buy interests or units in MLPs, REITs and BDCs.
- MLPs, REITs and BDCs operate very differently from each other and from traditional stocks. MLPs must receive their income from the coal, oil and gas industries, so they tend to own pipelines, mines, refineries and transportation facilities. REITs were created to provide an investment structure similar to mutual funds for income producing real estate. BDCs make loans to and investments in smaller companies, so they are more like publicly traded venture capital funds.
- MLPs, REITs and BDCs have special rules that effect their tax treatment. MLPs, as partnerships, do not pay corporate taxes, but all of their income or losses are allocated to their partners regardless of how much money is actually distributed to the partners. Often, the cash distributions to the partners is more than the income allocated on the tax return, and the excess distribution is not taxable when received, but rather considered a return of capital that usually results in capital gains taxes upon selling the MLP. REITs and BDCs fit within particular parts of the Internal Revenue Code in order to not pay a corporate level of tax. In exchange, they must pay dividends of at least 90% of their income but in many cases the dividends are taxed as ordinary income instead of getting the qualified dividend tax rate.
- As a result of their differing tax treatment, you need to pay close attention to what type of account you use to hold MLPs, REITs and BDCs. The income allocated to partners from MLPs (which show up in a form K-1) can cause UBIT, or unrelated business income tax, to accounts such as IRAs, Roth IRAs, 401ks, and HSAs. The whole goal of those accounts is to defer or avoid income tax, so those are not good places for MLPs to be held. Rather, just hold them in a taxable brokerage account and make sure you have a good accountant to help you deal with the K-1s. REITs and BDCs are the exact opposite, in that they are best held in an IRA, Roth IRA, 401k or HSA because they tend to pay large amounts of dividends that are subject to ordinary income tax rates.
- Due to the differing tax treatment and the importance of putting MLPs, REITs, and BDCs in the correct type of account, you need to keep track of those types of investments. That said, it is hard to know if what you are buying (or what you already own) is stock of a corporation, MLP, REIT or BDC. Start by looking at the full name of the company. If it ends with “LLC”, “partners” or “partnership”, then it is likely a MLP. REITs are harder, since they can end in “Corporation” or “Inc.” much like a regular corporation. Perhaps start with this list to see if a company is a REIT. BDCs can also end with Inc., Corp. or Corporation as with stocks and REITs, but if the company name has the words “Capital”, “Finance” or “Investment”, then it is more likely to be a BDC. I do not know if this list of BDCs is comprehensive, but it is a good place to start.
MLPs, REITs and BDCs can be appealing compared to traditional stocks because they usually pay higher dividends and provide some diversification. However, because they are tied to very specific industries, some of which are very cyclical, its is best to keep your exposure to each of these fairly low. How low is a matter of risk tolerance, financial goals and many other factors, but I would not feel very comfortable if more than 10% of my stock investments were in MLPs or REITs, and perhaps 5% as a limit on BDCs. If you work in the oil and gas industry, then your MLP exposure should be lower since your employment income is already tied to the same industry. Similarly, if you are a real estate agent or own a significant amount of land, then you do not need much REIT exposure.