by David Fessler. Energy & Infrastructure Strategist, The Oxford Club Thursday, May 22, 2014. Issue #2297 Wisdom of Wealth

Readers of my work know that I often recommend master limited partnerships (MLPs). These income-generating investment vehicles are common in the energy industry, and they have a huge tax advantage.

But I’ve noticed that investors are increasingly making a big mistake in the way they buy MLPs. This one error virtually eliminates their advantage over other investments.

A brief primer: MLP units are as liquid as shares of common stock. Investors receive income that’s passed through from the MLP. Because of this, the MLP pays no taxes. Thus investors generally receive big, fat distributions.

Even better, the IRS treats MLP income as return of capital, making it nontaxable. This feature is unique to MLPs.

How Not to Buy an MLP

By my count, there are 53 MLPs associated with the energy business, most of them involved in the movement, processing and storage of oil and natural gas. Because the energy industry is growing so fast, new MLPs are forming all the time.

With MLPs getting more popular with investors, it’s no surprise that Wall Street has begun offering MLP-based mutual funds and ETFs. As least 25 MLP mutual funds have sprung up since 2010.

Fund-based MLPs do offer the advantage of simplifying your taxes. There’s no need to fill out a K-1 form, as there is when you invest directly in a partnership. But that’s because they don’t offer the same tax advantage.

The IRS doesn’t allow mutual funds to have more than 25% of their assets invested in MLPs while still being classified as a registered investment company. Once that number is exceeded, the fund becomes a corporation and is then subject to a 35% tax rate.

Robert Gordon, president of Twenty-First Securities Corp. said recently that about three-quarters of MLP mutual funds flunk the test.

That can be a big surprise for investors when tax time rolls around: ETFs, ETNs and mutual funds don’t pass through the MLPs’ income to you.

Take, for example, the ALPS Alerian MLP ETF (NYSE: AMLP), one of the more popular MLP ETFs.

The fund holds 25 different MLPs, and nothing else. So it flunks the 25% rule. That makes it a corporation, not a registered investment company.

That means the investor loses the pass through effect of the MLP.

The Right Way to Buy MLPs

The best way to buy MLPs is just to buy units of them directly from your taxable brokerage account.

Sure, you’ll have to fill out a K-1 form for each MLP when tax time rolls around. But that’s a small price to pay for the tax benefit, and K-1s are relatively easy to handle even for do-it-yourself filers using tax-preparation software.

The bigger hurdle is the research involved to find the best ones. My Peak Energy Strategist advisory service makes this easy, too. Every single one of the 17 open positions I’ve held since at least the beginning of the year is currently in the black, and 15 of them are double- or triple-digit winners.

But whatever you do, be careful when someone recommends a hot MLP mutual fund, ETF or ETN to you. Your big yield may turn out to not be so big after all.

Good investing,

Dave Fessler

P.S. Dave’s recent column revealing the efforts to transition America’s transportation fleet to cheap, clean natural gas generated a huge response. And he now has a report that details a pact among six companies to make it happen. When they succeed, they stand to make investors very, very wealthy. Just click here .