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Master limited partnerships (MLPs) and real estate investment trusts (REITs) are two popular high-yield investment vehicles. They’re popular for an obvious reason: Income yields of 8%, 9%, and 10% are readily found.
MLPs and REITs are both pass-through entities under the U.S. federal tax code. They’re labeled “pass- through” because they pass their income to their investors. By doing so, they avoid paying federal income taxes at the business level.
REITs and MLPs for Income Investment
Even though REITs and MLPs are both pass-through entities, they are not the same entities. There are differences. The differences are worth knowing.
REITs are corporations. MLPs are partnerships. REITs have a regular corporate management structure. MLPs, in contrast, are managed by general partners. The general partners are responsible for running the partnership. REITs have shareholders. MLPs have unitholders, which are limited partners.
REIT investors own shares in a corporation. MLP investors own units in a partnership.
REITs come in two varieties: equity REITs and mortgage REITs.
Equity REITs own physical property. They actively manage their portfolio of properties. Equity REITs generate income primarily through rents. Additional income is realized through monetizing the capital appreciation of the underlying properties.
Mortgage REITs are financial investments. A mortgage REIT borrows money at a lower rate. It invests the proceeds in higher-rate mortgage-backed securities. Income is generated from the spread between interest paid and interest received.
MLPs are found mostly in the energy sector, and for a good reason. To qualify for the pass-through income-tax benefit, 90% of an MLP’s income must be derived from real estate, commodities, or natural resources. Most MLPs focus on energy – oil and natural gas.
The composition of the income to investors differs with each income investment.
For REITs, dividend distributions can be composed of earned income, capital gains, and return of capital. All public companies, including REITs, are required early in the year to provide shareholders with information to clarify how the prior year’s dividends should be allocated for tax reporting.
The common wisdom is that REIT distributions are taxed as ordinary income. This means they are taxed at the investor’s highest income tax rate. But that’s not always the case. Some REITs distribute no taxable income. The dividend is considered a return of capital, which lowers the cost basis.
It’s also possible that a portion of the dividend can be considered “qualified,” This means it would be subject to the lower dividend-tax rate, which ranges from 0% to 23.8%.
As for MLPs, nearly all – 80% to 90% – of the distribution paid to unitholders is considered a return of capital. Like the return of capital portion of a REIT dividend, investors don’t pay taxes immediately on this portion of the distribution.
Return of capital reduces the cost basis in the MLP like with the REIT. Investors aren’t taxed on the return of capital until they sell the units. The remainder of an MLP distribution is taxed at normal income tax rates.
Because MLP distributions aren’t dividends, MLP unitholders don’t receive a form 1099. Instead, MLP unitholders receive a form K-1, a standard partnership form that’s typically mailed to unitholders in March. The form K-1 is more complicated than a form 1099. There are a lot more moving parts to a form K-1 compared to a 1099.
Retirement accounts are another difference worth noting.
REITs can be held in a tax-deferred retirement account. MLPs can be held in a tax-deferred retirement account, with a caveat. Partnership income may be considered unrelated business taxable income (UBTI). This is can be subject to a tax if UBIT exceeds $1,000 in a year. The custodian of the retirement will be responsible for filing an IRS Form 990T and paying the taxes (which the investor ultimately pays).
Most Important Difference
Here’s the most important difference for income investment: consistency of income.
REITs – equity REITs, specifically – are generally more reliable income vehicles. Rents are predictable. They display little volatility. REIT prices are stable over time.
MLP distributions are backed by commodities whose prices are volatile. MLP distributions are frequently volatile. As the distribution goes, so goes the unit price. MLP prices are more volatile than REIT prices. MLPs are more volatile income investments.
If income stability is the goal in your income investment, go with the equity REIT. If higher yield is the goal, go with the MLP. But know that MLP’s high-yield distribution is a less secure, more volatile income source.