Here's One Way to Beat the Looming Dividend Tax Hike

Investors looking to avoid tax increases associated with the "fiscal cliff" negotiations are turning to the often-misunderstood world of master limited partnerships.

Here's One Way to Beat the Looming Dividend Tax Hike

A sharp selloff earlier in the month of MLPs has boosted the curiosity of bargain hunters who believe that negotiations in Washington will not result in the partnerships losing their preferred tax status.

The fiscal cliff involves a series of tax increases and spending cuts that will take effect automatically if Congress fails to hit deficit-reduction targets. Economists fear going over the cliff will tip the country back into recession due to the austerity measures involved.

As long as they comply with regulations, MLPs don't pay taxes on profit. Investors in the partnerships pay on distributions, but even then they usually only are treated as return of capital rather than as a dividend, a critical issue with most investors expecting to pay higher dividend taxes next year. (Read More: Companies Shelling Out Billions to Beat the 'Fiscal Cliff')

"This is like a massive tax shelter," said Michael Cohn, chief market strategist at Atlantis Asset Management in New York. "The perception is that they're going to change all the rules on these things. That's an idiotic assumption."

MLPs must be structured so that they derive at least 90 percent of their cash flow from real estate, natural resources or commodities.

In addition to capitalizing on the energy exploration boom, the partnerships hold two pivotal advantages: They provide a steady stream of income and can be bought and sold like stocks.

Earlier this month, a popular exchange-traded fund that tracks the space, the Alerian MLP, slumped on fears of cliff-related tax consequences and a warning from Morningstar, the widely followed fund rating site.

The ETF is up about 4.4 percent in 2012 and yields a healthy 6.12 percent, near the current level of junk bonds.

In the past two weeks, the Alerian fund has rebounded as investors like Cohn see the value in a security that could fill the need of those looking for income but prepared to flee dividend-payers. (Read More: Worried About 'Fiscal Cliff'? Look Out for 'Income Cliff')

Unless negotiators in Washington take action, dividends will go from the preferential 15 percent tax rate instituted in 2003 to that of ordinary income, which could reach 43.4 percent for top earners.

That's all the more reason to take the MLP bait.

"I'm making a bet that they're not going to touch these. It's too complicated," Cohn said. "It's small potatoes in the grand scheme of things. To have to go through the machinations of changing partnership rules and all kinds of other stuff just to gain a couple billion in income is not what they're really going after at this point."

In a recent note to investors, Credit Suisse analysts said they, too, don't see anything happening regarding to the MLP tax treatment.

"Looking past the fears that have enveloped the MLP space...regarding the fiscal cliff, we continue to believe that an increased focus on crude-oil infrastructure should drive performance given the coming boom in North American crude-oil production," the firm said.

Among Credit Suisse's top picks in the space are those with "substantial exposure to the coming oil boom": Plains All American Pipeline, Magellan Midstream Partners and Kinder Morgan Management.

"As a group, MLPs remain undervalued relative to other yield-oriented securities such as the U.S. 10-year Treasury and investment-grade and high-yield bonds and fairly valued from the standpoint of overall yield," the firm said.

Credit Suisse notes that there "have been no specific proposals" regarding changing MLP tax status.

Investors appear most interested in "midstream" MLPs, such as those involved with pipelines, rather than "upstream" partnerships such as energy producers.

"They can't kill the space," Keith Springer, head of Springer Investment Advisory in Sacramento, Calif., said of the cliff negotiations. "They can't go out and kill all incentive for energy exploration and production."

Springer is active in MLPs, favoring Vanguard Natural Resouces, Legacy Reserves and Breitburn Energy Partners.

"Everyone thinks everything is going to happen at once. My feeling is everything will be gradual. Even the tax increases are going to be maybe next year," he said. "We're not in a position where we can afford to (change the MLP status). We're not energy-efficient yet."