When I sell my shares, I realize that my basis has been reduced by the distributions that are mostly return of capital. But isn't the difference between my new reduced basis and the amount I sell shares for considered a capital gain? I understand the difference between capital gain and ordinary income. But I have seen some people refer to ordinary income and I am not sure what they mean by this at the sale?
When you sell, you will pay tax at two different rates.
1) All of the deferred income (i.e., total of the “Cash Distributions” you received over the years) you have received will be taxed at your income tax rate in the year you sell. Your deferred income is not taxed at a capital gains rate. The K-1 reports this amount.
2) Any capital gains on the increase in price (i.e., increase over your basis) is taxed at capital gains tax. We all hope we will have a lot of taxable capital gains to be taxed when we sell...meaning we hope we the price will increase a lot by then. Some hope the capital gains tax will be low at that time.
If you only sell a portion of or mlp you will make your accountant very happy.
Never sell a portion of your position. Sell it all or sell none of it. This is critical to 'release' your suspended passive losses (treated as ordinary not capital losses) that you want to offset your ordinary gain recapture (due to accelerated depreciation) and likely capital gains (due to your reduced basis created by prior losses (practically guaranteed) and distributions).
"But isn't the difference between my new reduced basis and the amount I sell shares for considered a capital gain?"
Nope. Very roughly, the component that comes from increase in unit price since your purchase is capital gain, while the portion that comes from reduction of basis due to distributions is recaptured as ordinary income. It is not the same as selling a stock. If you have held for a number of years the deferred taxes can be very significant. And if you only sell a portion rather than all of your position it is even worse since that will not unlock passive losses which will offset some of the taxable income.