The tax on distributions to unit holders of MLPs and REITs depends on what each portion of the payment represents — ordinary income, a qualified dividend, a return of your invested capital, or a capital gain — not on the total cash that arrives in your account. Both structures avoid federal income tax at the entity level and pass their earnings through to you, so the bill lands on your personal return. The character of each dollar is set before the money reaches you, and that character controls the rate.
How a Distribution Gets Split Into Categories
The entity’s internal accounting divides each distribution based on where the money came from: operating profits, investment gains, or a return of what you originally put in. For REITs, the tax code applies a specific ordering: the portion coming from current or accumulated earnings is treated as a dividend, the next portion reduces your cost basis in the units, and anything left after basis hits zero is taxed as gain from selling property.1Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property
MLPs work differently because they are partnerships. Every item of income, loss, deduction, and credit keeps its original character as it flows through to your return. The partnership does not lump everything into a single “dividend” bucket the way a corporation might. You receive an annual breakdown that spells out exactly how much falls into each category. Either way, you cannot simply report the total cash you received and call it a day.
Ordinary Income
The portion classified as ordinary income is taxed at the same rates as wages or bank interest. For 2026, federal rates run from 10% on the lowest slice of taxable income up to 37% on income above roughly $640,600 for single filers and $768,700 for joint filers.2Internal Revenue Service. Federal Income Tax Rates and Brackets Most REIT distributions land in this bucket, since REITs typically earn rental income and mortgage interest rather than long-term capital gains.
MLP ordinary income is taxed the same way, but here’s the wrinkle: much of the cash you receive from an MLP may not be ordinary income at all. Because MLPs in energy and infrastructure own heavy fixed assets, the depreciation and depletion deductions they claim often shelter a large share of the cash distribution. That sheltered portion is reclassified as a return of capital rather than taxable income, which is why MLPs have a reputation for tax-deferred distributions. The gap between the cash you received and the taxable ordinary income that actually hits your return can be dramatic.
Qualified Dividends
Some REIT distributions qualify for the lower long-term capital gains rates of 0%, 15%, or 20% instead of ordinary income rates.3Internal Revenue Service. Topic No. 404, Dividends and Other Corporate Distributions For 2026, the 0% rate applies to taxable income up to $49,450 for single filers and $98,900 for joint filers. The 20% rate begins above $545,500 for single filers and $613,700 for joint filers.
To qualify, you have to hold the units for at least 61 days within the 121-day window that starts 60 days before the ex-dividend date.4Internal Revenue Service. IRS Gives Investors the Benefit of Pending Technical Corrections on Qualified Dividends The rule blocks investors from buying in right before a distribution and selling immediately after to capture the lower rate. Miss the threshold and the dividend is taxed as ordinary income regardless of how the REIT classified it.5Legal Information Institute. 26 USC 1(h)(11) – Dividends Taxed as Net Capital Gain
MLP distributions generally do not qualify as dividends at all. MLPs are partnerships, so the income keeps its partnership character and is reported on a K-1 rather than a 1099-DIV. Qualified dividend treatment is a REIT concern.
Return of Capital
A return of capital is not immediate income. It is treated as a partial refund of what you originally invested, so you owe no tax when you receive it.6Internal Revenue Service. Mutual Funds (Costs, Distributions, Etc.) – How Does the Return of Principal Payments Affect My Cost Basis Instead, each return-of-capital payment reduces your adjusted cost basis in the units. Buy a unit for $50, receive $5 classified as return of capital, and your basis drops to $45.
This matters more than most investors realize. A lower basis means a larger taxable gain when you eventually sell. You are not avoiding tax on that $5; you are deferring it. With MLPs, return of capital can represent the majority of your annual cash distributions because the partnership’s depreciation and depletion deductions often exceed its taxable income. Over years, the cumulative basis reduction is substantial.
If your basis hits zero, the deferral ends. Any additional return-of-capital payments after that point are taxed immediately as capital gains.6Internal Revenue Service. Mutual Funds (Costs, Distributions, Etc.) – How Does the Return of Principal Payments Affect My Cost Basis This catches long-term holders off guard, especially those who assumed MLP distributions were perpetually tax-free. Tracking your running basis year by year is the only way to see this coming.
Capital Gains Passed Through
When an MLP or REIT sells property, equipment, or other assets at a profit, those gains flow through to you. The rate depends on how long the entity held the asset. One year or less produces short-term gains taxed at your ordinary rate; longer than one year produces long-term gains taxed at 0%, 15%, or 20%.7Internal Revenue Service. Topic No. 409, Capital Gains and Losses The entity’s holding period controls the character, and it passes through intact. You do not need to have held the units for any particular length of time yourself.
The 3.8% Net Investment Income Tax
Higher-income unit holders face an additional 3.8% surtax on net investment income, on top of whatever ordinary or capital gains rate already applies. It hits the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds the threshold for your filing status.8Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
The thresholds are $250,000 for joint filers, $200,000 for single filers, and $125,000 for married filing separately.8Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax They are not adjusted for inflation, so more investors cross them each year. MLP and REIT distributions typically count as either passive activity income or investment income, putting them within the surtax once you cross the threshold. A joint filer in the 37% bracket receiving REIT ordinary income could face a combined federal rate of 40.8% on those distributions.
The 20% Section 199A Deduction
Unit holders in both MLPs and REITs may be able to deduct up to 20% of their qualified distributions from taxable income under Section 199A. The deduction was scheduled to expire at the end of 2025 but has been made permanent.9Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income It applies to qualified REIT dividends and qualified publicly traded partnership income without being limited by the W-2 wage or property tests that constrain the general business income portion.10Internal Revenue Service. Qualified Business Income Deduction
The total deduction cannot exceed 20% of your taxable income minus net capital gains. The general QBI component begins to phase out at $201,750 for single filers and $403,500 for joint filers in 2026, but the REIT and publicly traded partnership component is not subject to those phase-out limits. That makes it particularly valuable for higher-income investors. The deduction reduces taxable income but does not affect adjusted gross income.
What Happens When You Sell
Selling MLP or REIT units triggers a capital gains calculation based on the difference between your sale price and your adjusted cost basis. Because return-of-capital distributions reduced your basis over time, the taxable gain on sale is often much larger than expected. An investor who bought units at $50, received $20 in cumulative return-of-capital distributions, and sells at $55 does not have a $5 gain. The adjusted basis is $30, making the taxable gain $25.
MLP sales add another layer. When you sell a partnership interest, any portion of the gain attributable to the partnership’s depreciation recapture, unrealized receivables, or certain inventory is reclassified as ordinary income instead of capital gain.11Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items Because energy and infrastructure MLPs own massive depreciable assets, recapture can convert a significant chunk of what looks like a long-term capital gain into ordinary income taxed at rates up to 37%. The K-1 you receive for the year of sale will include attachments breaking out the ordinary income portion from the capital gain portion.
MLP Units in Retirement Accounts
Holding MLP units inside an IRA, 401(k), or other tax-exempt retirement account seems like it would eliminate the tax complexity, but it can create a different problem. Operating income flowing through an MLP to a tax-exempt account is treated as unrelated business taxable income. If total UBTI across all investments in the account reaches $1,000 or more in a year, the account owes tax on the excess and must file Form 990-T.12Office of the Law Revision Counsel. 26 USC 512 – Unrelated Business Taxable Income
The tax comes out of the retirement account balance, not your personal funds. Your custodian typically handles the filing and payment, but the cost still erodes your savings. REIT distributions generally do not trigger UBTI because REITs are structured as corporations and pay dividends rather than passing through partnership operating income. If you want MLP exposure inside a retirement account without the UBTI issue, MLP-focused mutual funds and ETFs structured as C-corporations can serve as an alternative, since the fund itself absorbs the corporate-level tax.
Multistate Filing for MLP Holders
MLPs that operate across multiple states allocate income to each state where they do business, and that allocation flows through to you. In theory, you could owe state income tax in every state where the partnership has operations, even though you live in only one. Each state sets its own rules for when a nonresident must file, and thresholds vary.
A large MLP with pipelines or facilities in twenty or more states could trigger filing obligations across many jurisdictions. Some states allow composite returns, where the partnership files and pays on behalf of nonresident partners, which can spare you from filing individually. Check whether your MLP participates in composite filings before assuming you need to prepare returns in every operating state. Your home state will typically give you a credit for taxes paid to other states, so you are not taxed twice on the same income, but the paperwork takes effort. REIT investors generally avoid this issue because REIT distributions are sourced to the state where the investor lives, not where the properties sit.
Forms You’ll Receive and Estimated Tax
MLPs issue a Schedule K-1 (Form 1065), which reports your share of partnership income, deductions, and credits.13Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) K-1s are notorious for arriving late, often not until March or April, because the partnership must close its own books first. If you file your personal return before the K-1 arrives, you may need to amend later.
REITs issue Form 1099-DIV, which is simpler and arrives earlier. It shows total ordinary dividends, the qualified dividend portion eligible for lower rates, and nondividend distributions representing return of capital.14Internal Revenue Service. Instructions for Form 1099-DIV15Internal Revenue Service. Schedule B (Form 1040) – Interest and Ordinary Dividends16Internal Revenue Service. Schedule D Form 1040 Capital Gains and Losses
Because MLP and REIT distributions often lack federal withholding, you may need to make quarterly estimated tax payments if they generate a significant liability. The IRS charges an underpayment penalty when you owe $1,000 or more at filing time and haven’t paid enough through withholding or estimates. Investors holding large positions and relying solely on wage withholding to cover the total tax bill are the most likely to run into it.