At Risk vs. Not At Risk: Tax Rules for Loss Limitations
Explore the tax principle that connects your deductible losses to your genuine economic risk, distinguishing between types of investment financing.
The at-risk rules in Section 465 of the Internal Revenue Code are a tax principle for individuals and certain closely held corporations. These regulations prevent taxpayers from deducting losses that exceed their actual financial stake in an activity. The rules were created to address tax shelters that generated large, artificial losses for investors with little personal economic risk, ensuring that deductible losses are tied to what a taxpayer could genuinely lose.
This framework applies to most business or income-producing ventures, including partnerships and S corporations. A loss is only deductible to the extent the taxpayer is personally exposed to a financial setback. If an investment is structured to protect an individual from any real economic consequence, the ability to deduct associated losses is restricted.
Defining Your Amount At Risk
A taxpayer’s amount at risk in an activity is the measure of their personal financial exposure and establishes the ceiling for deductible losses. This amount is calculated annually and is composed of specific types of contributions and liabilities.
The cash you personally contribute to the activity is a direct component of your at-risk amount. This includes personal funds used to purchase an interest in the venture or to fund its operations. For example, if you invest $20,000 of your own money into a partnership, your at-risk amount increases by that $20,000.
When property is contributed instead of cash, its adjusted basis, not its fair market value, increases your at-risk amount. The adjusted basis starts with the property’s original cost, is increased by capital improvements, and is decreased by any depreciation claimed. For instance, contributing a building with an original cost of $120,000 and accumulated depreciation of $30,000 would add $90,000 to your at-risk total.
Borrowed funds also increase your at-risk amount, but only if they are “recourse debt,” which means you are personally liable for repayment. If the business cannot pay back the debt, the lender has the legal right to pursue your personal assets to satisfy the obligation. This personal liability places you at direct economic risk for the borrowed amount.
Investments Not Considered At Risk
Certain financing arrangements are excluded from the at-risk calculation because they protect an investor from economic loss. These arrangements remove the personal risk that is central to the at-risk rules. Identifying these structures is important for correctly calculating your at-risk amount.
The most common financing that does not increase your at-risk amount is a nonrecourse loan. With nonrecourse financing, the lender’s only remedy in a default is to seize the collateral securing the loan; the lender cannot pursue the borrower’s other personal assets. For example, if you use a $200,000 nonrecourse loan to purchase equipment for a business that fails, the lender can take the equipment but not seek repayment from your personal bank accounts.
An exception exists for holding real property, which allows certain “qualified nonrecourse financing” to be included in your at-risk amount. To qualify, the financing must be secured by real property and borrowed from a “qualified person,” such as a bank or commercial lender engaged in the business of lending money. The loan must also be commercially reasonable and on terms similar to those for loans involving unrelated parties.
Other agreements that shield you from loss, such as guarantees or stop-loss agreements, also prevent the associated funds from being considered at risk. For instance, if you invest in an activity but have a side agreement with another party that guarantees to reimburse you for any losses, your investment is not at risk.
Money borrowed from a person who has an interest in the activity (other than as a creditor) or from a related party may also not be considered at risk. This rule prevents creating an artificial at-risk amount by borrowing from insiders who may not enforce the debt like an independent lender.
Calculating and Applying At-Risk Limitations
After determining your at-risk amount, you must apply it to any losses from the activity. The at-risk rules limit how much of a loss you can deduct in a given year. This calculation is performed using IRS Form 6198, At-Risk Limitations, which is filed with your tax return if you have a loss from an at-risk activity.
Your deductible loss from an activity for any tax year is restricted to the amount you have at risk at the end of the year. For example, if your at-risk amount in a business is $10,000, but the business generates a loss of $15,000, you can only deduct $10,000 on your current tax return. The remaining $5,000 is disallowed for the time being.
A loss disallowed by the at-risk limitation is not permanently lost but is suspended and carried forward to the following tax year. This suspended loss can be deducted in a future year if you increase your at-risk amount. You can increase your at-risk amount by contributing more cash or property to the activity, or when the activity generates net income.
Continuing the previous example, the $5,000 disallowed loss is carried forward. If, in the next year, you contribute an additional $8,000 to the business, your at-risk amount increases. This would allow you to deduct the $5,000 carryforward loss from the prior year, assuming you have sufficient at-risk basis to cover it and any new losses.