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KMR Promises Great Yield, No Tax Headaches

Distributions are taxed as long-term capital gains, not as income


Among the higher-yielding income vehicles, my favorites take advantage of twists in the tax law to deliver an extra punch.

Kinder Morgan Management (KMR) pays its quarterly distributions in additional shares of stock, rather than cash. The distributed shares’ value corresponds to the quarterly cash distribution of KMR’s twin, Kinder Morgan Energy Partners (KMP).

I’ve long been a fan of Kinder Morgan Energy Partners, a publicly traded master limited partnership that operates pipelines and related energy infrastructure. Regardless of the fluctuations of oil and natural gas prices, as a toll-taker business, KMP still generates cash flow well above its reported earnings. That’s because the deductions the IRS allows for depreciation don’t reduce cash available for distribution to the limited partners (you and me).

However, the downside of KMP (and MLPs like it) is that they create a paperwork headache at tax time. Each year, the limited partnership sends you a complicated form (K-1) detailing your share of the partnership’s income and deductions. Unless you’ve got a good accountant to crunch the numbers for you, you may not be happy with the extra work an MLP entails when you go to fill out your tax return.

To avoid that mess, I prefer KMR, whose primary asset is a block of KMP units.

Here’s the beauty of KMR: Say you need income. Hold your KMR units for at least a year and a day. Then you can sell as many units as you need to, and any profit will be taxed as a long-term capital gain (maximum Obama rate, 20%).

By contrast, when you sell KMP units, Uncle Sam forces you to treat part of any gain (over your tax cost, or “basis”) as ordinary income, and only part as a capital gain.

KMR, in short, is one of the very few investments still in existence that allow you to convert ordinary income into pure, tax-favored capital gains. Please, don’t tell your congressman about this loophole! KMR’s current cash-equivalent yield is 7.2% — generous for a stable business, and an investment that imposes no tax liability at all, until you sell.

The share price for both KMR and KMP has come down in recent months, but this was largely due to a selloff in the bond market, not to any change in Kinder Morgan’s business. The bright side of the selloff is that KMR at today’s levels is a “gimme” for tax-averse investors, and it should appreciate 20% or more in 2014.

Richard Band may hold some of the aforementioned securities in his Profitable Investing portfolio.

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