How MLP Dividends Are Taxed: Basis, Phantom Income, and Section 751

Cash from a Master Limited Partnership is taxed very differently from a stock dividend, and understanding how MLP distributions are taxed starts with one fact: most of what lands in your account each quarter is treated as a return of your own invested capital, not current income. That portion is not taxed the year you receive it. Instead, it reduces your cost basis in the units, and the deferred tax comes due when you sell. The rest of the distribution is a mix of ordinary business income and capital gains passed through from the partnership, reported to you on a Schedule K-1 rather than a 1099-DIV.

Why an MLP Payout Is Not a Dividend

An MLP is a pass-through entity. It pays no corporate tax; every dollar of income, deduction, gain, and loss flows through to the unitholders. The IRS does not treat MLP distributions as qualified dividends, and they are not taxed under the dividend rules.

A typical quarterly distribution has three components: ordinary income from the partnership’s operations, capital gains from any asset sales inside the partnership, and a return of capital. The return-of-capital piece usually dominates, often making up the vast majority of the payout. That is the part that is not currently taxable. Rather than owing tax the quarter you receive the check, you reduce your basis in the units by the same amount. As long as your basis stays above zero, those cash distributions are tax-free in the year you receive them.¹

Instead of a 1099-DIV, you receive a Schedule K-1 (Form 1065) reporting your share of the partnership’s income, deductions, credits, and distributions for the year.² Two boxes carry the weight for routine tracking:

Box 1, Ordinary Business Income or Loss, shows your share of the MLP’s operating profit or loss. It is taxed at your regular income tax rate.
Box 19, Distributions, shows the total cash the MLP actually paid you during the year. This number is not your taxable income; most of it is return of capital.

The K-1 also carries your share of Section 1231 gains, interest income, and various deductions, all of which feed into your annual basis calculation. K-1s typically arrive in late March or even mid-April, well after brokerage 1099s.

Tracking Your Basis Year by Year

Basis tracking is the single most important compliance task for an MLP investor, and it is entirely your responsibility. Neither the MLP nor your broker maintains an official running basis. Get this wrong and your gain calculation at sale will be wrong, potentially by thousands of dollars.

Your starting basis is what you paid for the units, including brokerage commissions. From there it adjusts every year:

Increases: your share of the partnership’s taxable income (Box 1 ordinary income, capital gains, and other K-1 income items) and any additional capital you contribute.
Decreases: cash distributions you receive, your share of losses and deductions, and any non-deductible expenses passed through.

Because the return-of-capital portion of distributions is usually large, the annual decreases typically outpace the increases. Over a long holding period, basis steadily erodes toward zero. Once it hits zero, further return-of-capital distributions stop being deferred and become immediately taxable as capital gains.¹ Long-time holders sometimes cross this line without noticing.

Keep a year-by-year ledger with your original cost, each K-1’s income and loss allocations, and every distribution. You will need the whole history when you sell, and reconstructing a decade of K-1 data after the fact is painful and sometimes impossible.

Phantom Income

The flip side of tax-deferred cash is phantom income. If the MLP has a profitable year but cuts or suspends its cash distributions, your K-1 still reports your allocated share of taxable income. You owe tax on it even though no cash arrived. This shows up most often when the partnership is reinvesting heavily or paying down debt, and in smaller amounts whenever the ordinary-income portion of your K-1 exceeds the year’s distribution.

The Passive Loss Rule Specific to MLPs

MLP income and losses are passive activity items for almost every unitholder. Federal tax law imposes a stricter rule for publicly traded partnerships than for other passive investments: losses from a particular MLP can only offset income from that same MLP.³ A loss from MLP A cannot reduce income from MLP B, from a rental property, or from your wages.

When a K-1 shows a net loss larger than your income from the same MLP, the unused portion becomes a suspended loss. It carries forward indefinitely, waiting to offset future income from that same partnership. The suspended losses are released when you sell your entire interest; at that point they become fully deductible against any type of income, including wages, investment income, and gains from other MLPs.⁴ That release is one of the most valuable and most overlooked features of MLP investing.

The 20 Percent Deduction on Ordinary Income

From 2018 through 2025, MLP investors could claim a deduction equal to 20 percent of their qualified publicly traded partnership income under Section 199A. It applied to the ordinary income reported on the K-1 and effectively dropped the top federal rate on that income from 37 percent to roughly 29.6 percent.⁵

Under the most recent IRS guidance, this deduction was available only for tax years ending on or before December 31, 2025. Congress considered an extension as part of broader 2025 tax legislation. Before filing a 2026 return, confirm whether an extension was enacted. If the deduction expired, K-1 ordinary income is taxed at your full marginal rate with no 20 percent offset, which makes after-tax MLP yields noticeably lower than in prior years.

What Happens When You Sell

Selling MLP units is a two-part tax event, and the second part is where the surprise usually lives.

Capital Gain or Loss

First, compare your sale proceeds to your final adjusted basis. Units held more than a year produce a long-term capital gain or loss, reported on Form 8949 and Schedule D.⁶ Long-term gains are taxed at 0, 15, or 20 percent depending on your taxable income.⁷

Because years of return-of-capital distributions have reduced your basis, the taxable gain is almost always much larger than the difference between what you paid and what you sold for. An investor who bought at $30 and sold at $35 might expect a $5 gain per unit, but if distributions eroded basis to $10, the actual capital gain is $25 per unit. This is where the deferred tax catches up.

Section 751 Ordinary Income Recapture

The second component is ordinary income recapture under Section 751. Over your holding period, the MLP passed through depreciation and depletion deductions that reduced your taxable income. When you sell, the IRS recharacterizes the portion of your gain attributable to those prior deductions as ordinary income rather than capital gain.⁸ That recapture is taxed at your regular marginal rate, as high as 37 percent, and is reported on Form 4797.⁹

If your modified adjusted gross income exceeds the Net Investment Income Tax thresholds ($200,000 single, $250,000 married filing jointly), an additional 3.8 percent surtax can apply to the gain.¹⁰

The MLP will send a sales schedule with your final K-1 that separates the ordinary income recapture from the capital gain portion. Any accumulated suspended passive losses from that MLP become deductible in the year of sale and can offset both the recapture income and the capital gain.⁴

Holding Until Death

MLP units passed to heirs receive a stepped-up basis to fair market value as of the date of death.¹¹ That wipes out all the basis erosion built up during the original owner’s lifetime. Units with an adjusted basis of $3 and a market value of $40 at death give the heir a new basis of $40. The deferred capital gain and the Section 751 recapture that would have hit on a lifetime sale effectively disappear.

The combination of tax-deferred cash flow during the holding period and a full basis reset at death is one of the strongest estate-planning features in the tax code, and it is worth weighing against any decision to sell units with large embedded gains.

MLPs Inside a Retirement Account

Holding an MLP inside an IRA or 401(k) looks like a natural fit, since distributions would not be taxed currently anyway. It creates a different problem instead. Because an MLP is an operating business, the income allocated to a tax-exempt account is Unrelated Business Taxable Income. Once total UBTI in the account reaches $1,000 or more in a year, the account itself owes tax and the custodian must file Form 990-T.¹²

The $1,000 figure is a specific deduction written into the statute, not an inflation-adjusted threshold. Any UBTI above that amount is taxed at trust income tax rates, and the tax is paid out of the IRA’s own assets. That directly reduces the retirement balance and defeats the point of holding the investment in a sheltered account. If Box 1 on your K-1 shows significant ordinary income, the UBTI risk is real.

State and Cross-Border Wrinkles

MLPs that run interstate pipelines conduct business across many states, and unitholders are treated as partners doing business in each of them. Your K-1 package includes a state-by-state income allocation. Around 22 states set no minimum dollar threshold, meaning even a small allocation technically triggers a nonresident filing; others use a range of minimums. The actual tax owed is often minimal because passed-through deductions offset the income at the state level, and some MLPs file composite returns that cover nonresident unitholders. Check the K-1 package for composite filing information before assuming you need to file everywhere.

Non-U.S. investors face a further layer. When a foreign investor sells MLP units on the public market, the broker must withhold 10 percent of the gross amount realized, not just the gain.¹³ Any excess over the actual tax liability can be recovered by filing a U.S. return, but the upfront cash hit and the filing requirement make MLPs less straightforward for non-residents.

1
Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution
2
Internal Revenue Service. Partners Instructions for Schedule K-1 Form 1065 2025
3
Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited – Section (k)
4
Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited – Section (g)
5
Internal Revenue Service. Qualified Business Income Deduction
6
Internal Revenue Service. 2025 Instructions for Form 8949 – Sales and Other Dispositions of Capital Assets
7
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
8
Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items
9
Internal Revenue Service. 2025 Instructions for Form 4797 – Sales of Business Property
10
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
11
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
12
Office of the Law Revision Counsel. 26 U.S. Code 512 – Unrelated Business Taxable Income
13
eCFR. 26 CFR 1.1446(f)-4 – Withholding on the Transfer of a Publicly Traded Partnership Interest