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Using tax losses as a tax strategy: A primer

Individuals 01.21.2019 3 MIN READ

Tax loss realization allows for a reduction in tax liability by divesting interest in master limited partnerships (MLPs). But the process is extremely complex. This guide is intended as a primer into this strategy.

As the value in MLPs starts to decline, many investors are considering ways to divest their interests in those partnerships and use potential losses to reduce their tax burdens.

While that may sound simple enough, the tax law on selling interest in an MLP and creating a tax loss realization is complex. And absent the proper strategy, it’s possible that those who sell their interests could face tax loss deferrals or worse, realization of gain.

Ordinary income problems

Chief among the concerns with reducing or selling interest in an MLP is ordinary income and its impact on a tax return.

Current tax law requires that MLP interest sales be treated the same as when a traditional partnership interest is sold. That means any gains sellers have will be subject to capital gain and their share of partnership ordinary income will be taxed as their own ordinary income.

In the event of a capital loss, sellers must still report their share of ordinary income, which cannot be offset by the capital loss. So, in the event ordinary income outpaces the capital loss, overall seller personal income will rise, causing a higher tax burden.

It’s important then, for sellers to first evaluate an MLP’s ordinary income and their share of that before deciding whether to divest.

Basis concerns

A seller’s basis in an MLP is calculated differently than it would in a stock or standard asset disposition. And that can cause fundamental problems in calculating an accurate capital gain or loss.

In an MLP sale, cost basis is determined by evaluating profits and losses during the time the interest was held. Profits add to an owner’s basis, while losses reduce it. Similarly, distributions made to partners will also reduce basis. 

If an MLP has been making distributions to partners over the years, there’s a strong chance that the seller’s basis is significantly lower than he or she might expect. And if that’s the case, the amount of loss―if there is a loss at all―would be reduced.

In some cases, therefore, it’s possible that a seeming capital loss translates to a capital gain because the cost-basis analysis reveals a much lower figure than anticipated.

An eye on partial dispositions

When an MLP is taxed as a partnership, its losses can only be used to offset its own income. Investors cannot use a loss in one MLP to offset income in another.

Any excess losses that cannot be used are suspended until the seller sells all of his or her interest in the MLP. Therefore, those expecting to sell a portion of their interest still will not be able to use their suspended losses.

Moreover, any losses incurred by sellers in a partial disposition be suspended until the entire position is sold. 

Therefore, when considering an MLP sale, consider a full disposition rather than engaging in a partial sale of interest.

A reacquisition discussion

There will be occasions when sellers might want to reacquire interests they’ve already sold. In those cases, there are some factors to consider.

For one, when a new interest is reacquired after an entire interest is disposed, it’s possible the investor will receive one K-1 form from that partnership. It’s critical for recordkeeping and tax implications to ask for two K-1s: one that discloses the sale and another that identifies the reacquisition.

In the event of a reacquisition, it’s advisable that sellers wait at least 31 days before buying a new interest to avoid any potential wash sale problems.

If you have Ayco as a company benefit, contact your Ayco advisor to discuss tax loss realization as a tax strategy.

Neither Goldman Sachs & Co. LLC nor Ayco provide legal advice to their clients, and all clients should consult with their own legal advisor regarding any potential strategy, investment, financial plan, estate plan or with respect to their interest in any employee benefit or retirement plan.  All clients should be aware that tax treatment is subject  to change by law, in the future or retroactively, and clients should consult with their tax advisors regarding any potential strategy, investment or transaction. \

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