There is a class of high-yield investment you might not have heard about: master limited partnerships, or MLPs. This kind of investment is renowned for its high and potentially fast-growing yield, and it can also return superior total returns over time. However, before investing in this asset class there are certain tax ramifications, both good and bad, that potential MLP investors need to be aware of. Let’s review what they are and how you can adjust your portfolio accordingly to build both wealth and income over time.

Sources: Morningstar.com, Investopedia.

MLPs are pass-through entities, meaning they don’t pay taxes on their earnings as long as they pass the vast majority of them on to investors as distributions. Typically 80% to 90% of the distribution is in the form of return of capital, or ROC, which is a fancy way of saying that, thanks to numerous write-offs and depreciations the partnership takes on its equipment, most of your payout is tax deferred. The exact breakdown of taxable income versus ROC is shown in the K-1 form, which the partnership sends out to all investors annually.

Since the biggest differences between corporations and MLPs comes at tax time to decide whether MLPs are right for you, there are three things you need to consider.

Fact one: More complicated tax preparation

The K-1 is often considered a major downside to owning MLPs, because it can complicate tax preparation. Fortunately, accountants and software such as TurboTax can make this process far less arduous.

Another thing to know about MLP taxes is that owning one in a tax-deferred account such as an IRA can be suboptimal because of UBTI, or unrelated business taxable income, which is something MLPs can sometimes generate during their operations. If your holdings are big enough that your total UBTI tax bill (per your K-1) is over $1,000, then you’ll need to pay taxes on that UBTI income, even though the MLP is held in a tax-deferred account.

Fact two: Major tax benefits

You might be wondering, with all the added tax hassles, why anyone invests in MLPs. Well, for two main reasons. First, they’re known for high, growing, and sustainable yields — as high as 13% and some MLPs, such as Linn Energy. ( NASDAQ: LINE ) pay monthly distributions.

The second reason has to do with the tax benefits of MLPs. The way ROC works is that rather than pay taxes right away, you deduct them from your cost basis. Then when you sell units of MLPs, you pay taxes on your units sold. This can have a powerful long-term benefit. For example, say you invested $10,000 in an MLP. If you hold the units long enough, eventually your cost basis will go to $0. As long as you don’t sell, then $10,000 of otherwise taxable income will be permanently deferred from the IRS. You can pass on MLP units to your heirs, and as long as they don’t sell them, they don’t have to pay taxes, either. However, this only applies as long as your cost basis is above zero.

As a result of these tax benefits, MLPs get a bit more complicated. For example, if you do sell your units of an MLP, some of the profit will be taxed as long-term capital gains, and some will be recaptured (taxed as ordinary income). This includes things like depreciation, inventory appreciation, and unrealized receivables. This information can be found in the annual K-1 your MLP will send you.

What about after your cost basis has hit zero? Then most of the ROC is taxed as long-term capital gains. Herein lies the true benefit of MLPs, because long-term capital gains taxes are much lower than regular income tax levels.