At-Risk Rules — §465

At-Risk Rules Overview

The at-risk rules under §465 limit a taxpayer's deductible losses from an activity to the amount the taxpayer has at risk in that activity. The rules were enacted in 1976 to prevent taxpayers from deducting losses in excess of their economic investment in tax shelter activities. The at-risk rules apply to most activities, including partnerships, S-Corps, and sole proprietorships, but not to C-Corps (other than closely held C-Corps).

The at-risk amount is generally the taxpayer's cash investment plus the adjusted basis of property contributed plus amounts borrowed for use in the activity for which the taxpayer is personally liable. The at-risk amount is reduced by losses deducted in prior years and increased by income from the activity. If the at-risk amount goes negative (because the taxpayer has received distributions in excess of their investment), previously deducted losses must be recaptured as income.

What Is Included in the At-Risk Amount

The at-risk amount includes: (1) cash and the adjusted basis of property contributed to the activity; (2) amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged property (other than property used in the activity) as security; and (3) the taxpayer's share of qualified nonrecourse financing (real estate only).

Qualified Nonrecourse Financing (Real Estate Exception)

The most important exception to the at-risk rules is qualified nonrecourse financing (QNF) for real estate activities. Under §465(b)(6), a taxpayer's share of nonrecourse financing secured by real property used in the activity is included in the at-risk amount if: (1) the financing is from a qualified lender (a bank, savings institution, or other commercial lender); (2) the financing is not convertible debt; and (3) no person is personally liable for repayment.

The QNF exception is critical for real estate investors who finance properties with nonrecourse mortgages. Without the exception, a real estate investor who purchases a $1,000,000 property with $200,000 down and an $800,000 nonrecourse mortgage would have an at-risk amount of only $200,000 — limiting deductible losses to $200,000. With the QNF exception, the at-risk amount is $1,000,000 (the full purchase price), allowing the investor to deduct losses up to $1,000,000.

Interaction with Passive Activity Loss Rules

The at-risk rules and the passive activity loss (PAL) rules under §469 are two separate limitations on loss deductions. A taxpayer must clear both limitations to deduct a loss. The at-risk rules are applied first: if the loss exceeds the at-risk amount, the excess is suspended. The remaining loss (up to the at-risk amount) is then tested against the PAL rules: if the activity is passive, the loss is suspended until the taxpayer has passive income or disposes of the activity.

Practitioners must track both the at-risk amount and the PAL basis for each client activity. The at-risk amount and the PAL basis are not the same: the at-risk amount includes QNF for real estate, while the PAL basis does not. A real estate investor with a $1,000,000 at-risk amount may still have losses suspended under the PAL rules if the investor does not materially participate in the activity.

Frequently Asked Questions