https://www.forbes.com/sites/baldwin/2014/12/18/how-to-profit-from-return-of-capital/2/#1927ffe2f524 Suppose you put $100 into a pipeline partnership like Enterprise Products Partners (EPD). Your piece of the master limited partnership earns $3 after operating costs (janitors and compressors) but before depreciation. The depreciation on the buried steel, let us suppose, comes to $3. Then the taxable income will be $0. But the enterprise has $3 on hand, and it sends you that. Your taxable income is $0 because the business’s taxable income is $0. The effect of the $3 is to reduce your tax basis in the business from $100 to $97. The tax code, that is, treats the cash you’re pulling out as a return of capital, even though in economic terms it’s a profit. If you sell your share for $110 your capital gain is not $10 but $13. At this point the story veers off from the happy ending of Chapter I. When you sell, only $10 of the taxable gain will be eligible for the reduced rates on long gains. The other $3 will be “recaptured” and turned into ordinary income. You have no inkling of this when you look at the unrealized appreciation column on your brokerage account. You find out about it months after the sale, in a supplement to the K-1 income statement sent by the MLP. It gets messier if the depreciation charges exceed the operating income. If they had been $5 in our hypothetical, then your taxable income would be -$2 and your tax basis would go down to $95. You are not permitted to deduct the $2 because it’s a “passive loss.” It goes into suspended animation. Now when you sell your taxable gain is $15, of which $10 can qualify for a low rate and the other $5 of which is ordinary. At this point the $2 comes out of suspension and you wind up with a net $3 of ordinary income. The excess depreciation, that is, washes out and leaves you in the same position you’d be in if your depreciation was just enough to erase your operating income. It’s hard to know, before you buy an MLP, how much of its distributions are getting sheltered by depreciation charges. The company won’t tell you because there is no one correct answer to the question. Your depreciation depends on the date on which and the price at which you joined. It is often said that MLP dividends are about 80% tax-sheltered, but I suspect that the correct number for many recent buyers has been closer to 100%. A shareholder in EPD showed me his K-1 for 2012. His dividend was $1.25 a share (adjusted for a split) and his ordinary income was -$1.43. The MLP dividends reduce your tax basis. What if they take it all the way to zero? From that point on you are likely to wind up with ordinary income, not the long gains you would have had with a REIT. Gifts to charity don’t work for MLPs. But leaving the shares in your estate does work; heirs don’t owe income tax on either the share price appreciation or the recapture. The lesson from this chapter is that a return of capital from an MLP is nice, but not as nice as from a REIT. You get a deferral of income tax but not a conversion of ordinary income into capital gain
https://www.schwab.com/active-trader/insights/content/etfs-and-taxes-what-you-need-to-know I haven't really looked into it yet. It seems K-1 and 1099 is a major difference between holding via ETF or underlyings. K1 is much more complex due to being considered as ownership/partnership, but besides the complexity, where is the source of tax rate differentials?
For the record, MLP distributions should fall under this https://www.irs.gov/individuals/international-taxpayers/partnership-withholding