Master limited partnerships are taxed as pass-through entities, so the partnership itself pays no federal income tax and you report your share of its income, deductions, and credits each year on a Schedule K-1. Most of the cash you receive along the way is treated as a return of capital rather than immediately taxable income, which reduces your cost basis and defers tax until you sell. When you do sell, part of the gain is taxed as ordinary income to recapture those basis reductions, and the rest is capital gain. That is the shape of how MLPs are taxed; the details below fill it in.
What You Receive Each Year Instead of a 1099
Owning MLP units does not produce a Form 1099-DIV. You get a Schedule K-1 generated from the partnership’s Form 1065.1Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income The K-1 lists your fractional share of the partnership’s operating income, capital gains, depreciation, and other items for the year.
Timing is the first practical problem. Brokerages send most 1099s by the end of January, but MLPs typically need until March or sometimes mid-April to finalize K-1s.2Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC (04/2025) If you file early, a single MLP position can push your return back by months.
The second is multi-state exposure. Pipelines and processing facilities are spread across many states, and because the partnership’s income passes through to you, each state where the MLP earned money can treat you as having earned income there. More than 20 states require a nonresident return for any in-state income regardless of amount. Your K-1 includes a state-by-state allocation so you can see where obligations may fall.
To keep its pass-through status, an MLP must draw at least 90% of its gross income from qualifying sources, chiefly natural resources, real estate, and commodities.3Office of the Law Revision Counsel. 26 U.S. Code 7704 – Certain Publicly Traded Partnerships Treated as Corporations In practice, most MLPs are midstream energy operators.
Why Distributions Usually Aren’t Taxed When You Receive Them
The cash distributions from an MLP are rarely ordinary dividends. A large portion, often the majority, is classified as a return of capital, which is not taxable when paid. Instead, it lowers your adjusted cost basis in the units.
Buy units at $50, take $5 in return-of-capital distributions over time, and your adjusted basis becomes $45. The K-1 may also carry positive and negative adjustments from partnership operations that further move your basis, so year-by-year tracking is essential. Lose track and you risk either overpaying at sale or underreporting and drawing penalties. Every K-1 you receive over the life of the investment feeds into that running number.
The Tax Bill When You Sell
Selling MLP units triggers two layers of tax. The first recaptures all the deferred income that accumulated through years of basis reductions, and that cumulative amount is taxed as ordinary income at your marginal rate, which can reach 37% for a single filer with taxable income above $640,600 in 2026.4Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Investors who assumed distributions were tax-free rather than tax-deferred are often surprised by this.
The second layer covers appreciation above your original purchase price. Buy at $50, sell at $60, and that $10 of true appreciation is taxed at long-term capital gains rates if you held for more than a year.
A concrete example. You buy 100 units at $50 each for $5,000. Over 10 years, $2,000 of return-of-capital distributions drop your basis to $3,000. You sell for $6,000. Your total gain is $3,000, but $2,000 of it is ordinary income recapture and only $1,000 is capital gain. The recapture portion is taxed at your top marginal rate, not the preferential capital gains rate.
The 20% Deduction on MLP Income
Section 199A lets individual taxpayers deduct 20% of qualified income from publicly traded partnerships.5Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income The deduction was scheduled to expire after 2025, but the One Big Beautiful Bill Act made it permanent in July 2025. For MLP investors, it effectively lowers the tax rate on the qualifying portion of K-1 income.
The information you need appears in Box 20, Code Z of the K-1.6Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) You claim the deduction on Form 8995 or Form 8995-A. Unlike other pass-through businesses, the 20% deduction on qualified PTP income is not subject to the W-2 wage and capital limitations, and it applies regardless of your income level. The overall deduction is capped at 20% of your taxable income above net capital gains.
Passive Losses Are Trapped Inside the Same MLP
Your MLP interest is treated as a passive activity because you are a limited partner with no operational role. Passive losses can normally offset passive income from other sources, but publicly traded partnerships get a special rule: losses from one MLP can only offset income from that same MLP.7Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited You cannot net a loss from MLP-A against income from MLP-B, rental real estate, or any other passive investment.
If the MLP posts a net loss for the year and there is no income from that same MLP to absorb it, the loss is suspended and carried forward. It sits unused until either the MLP generates enough future income to soak it up or you sell your entire interest in the partnership. On complete disposition, the accumulated suspended losses are released and can offset the gain and other income that year.8Internal Revenue Service. Passive Activities – Losses and Credits That makes a full exit a meaningful planning event.
The 3.8% Net Investment Income Tax
Higher-income investors owe an additional 3.8% surtax on net investment income. It applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers.9Internal Revenue Service. Net Investment Income Tax Those thresholds are not indexed for inflation, so more taxpayers cross them each year.
Because MLP income is passive for limited partners, it qualifies as net investment income under this surtax, and so do gains on sale. Combined with ordinary-income recapture at rates up to 37%, the effective federal rate on MLP gains at sale can exceed 40% for high earners.
Why an IRA Is Usually the Wrong Place for MLP Units
Holding MLP units directly in a traditional IRA, 401(k), or other tax-exempt account creates a problem many investors miss. Because an MLP is an operating business, the income it passes through to a tax-exempt account is unrelated business taxable income. If total UBTI across all sources exceeds $1,000 in a year, the account’s custodian must file Form 990-T and the account owes tax on the excess.10Internal Revenue Service. Unrelated Business Income Tax
That tax uses trust brackets, which compress fast. For 2026, the 37% rate hits trust income above just $16,000, so even modest UBTI in an IRA can be taxed at rates that would take hundreds of thousands of dollars of personal income to trigger. The tax is paid out of the account itself.
Partnership debt makes it worse. Most MLPs carry substantial debt to finance pipelines and storage, and the debt-financed income rules treat a portion of the income allocated to tax-exempt investors as additional UBTI based on the ratio of partnership debt to asset basis.11Internal Revenue Service. Publication 598 (03/2021), Tax on Unrelated Business Income of Exempt Organizations Even an MLP throwing off modest operating income can push past the $1,000 threshold once debt-financed income is layered in. Holding MLP units directly in a retirement account is generally inadvisable unless you are prepared for the filing and the erosion.
Step-Up in Basis at Death
One of the strongest features of MLP ownership only appears at death. Under IRC Section 1014, heirs take a basis equal to the fair market value of the units on the date of death. All of the accumulated ordinary-income recapture exposure built up through years of return-of-capital distributions is wiped out in a single event.
Consider an investor whose basis has been ground down from $50,000 to $12,000 through return-of-capital distributions. A lifetime sale would trigger $38,000 of ordinary income recapture at rates up to 37%. If the investor instead holds the units to death and they are worth $55,000, the heirs’ new basis is $55,000. The $38,000 recapture liability disappears, and the heirs can sell with little or no taxable gain. That is why some MLP investors treat units as hold-and-bequeath assets, collecting tax-deferred cash for life and passing the tax bill to the grave.
Getting MLP Exposure Without the K-1
If K-1s, multi-state filings, and UBTI sound like more than you want to manage, several fund structures preserve the economic exposure while stripping out the reporting.
Many ETFs and mutual funds that hold MLP units are organized as C-corporations, because a fund with more than 25% of assets in MLPs cannot qualify as a regulated investment company. The fund pays 21% federal corporate tax on net income before distributing anything, and you receive a Form 1099-DIV instead of a K-1.12Internal Revenue Service. About Form 1099-DIV, Dividends and Distributions UBTI is not your problem, so these funds work inside retirement accounts. The cost is the corporate tax drag, which compounds over long holding periods.
Exchange-traded notes take a different route. An ETN is unsecured bank debt that pays a return linked to an MLP index. There are no K-1s, no UBTI, and no basis tracking, and you get a Form 1099 for the income. The trade-off is credit risk: if the issuing bank fails, your investment can suffer losses unrelated to the energy sector. Lehman Brothers had outstanding ETNs when it collapsed in 2008.
Closed-end funds focused on MLPs generally work like the C-corp ETFs, holding units, paying corporate tax, and issuing 1099-DIVs. Because they trade at prices that can drift from net asset value, they sometimes trade at a discount, which introduces a different risk and opportunity than open-end funds that stay near NAV.