How to File Form 6198 for a Rental Property

The Internal Revenue Service’s at-risk rules ensure that deductions for losses from an investment do not surpass the amount an individual personally stands to lose. For rental property owners, these rules are applied using Form 6198, At-Risk Limitations, which prevents taxpayers from claiming losses larger than their actual financial stake. The at-risk rules are designed to prevent the use of accounting losses to generate tax benefits from ventures where there is little real financial exposure.

If a rental property generates a loss for the year and some of the investment is not considered at risk, Form 6198 is used to calculate the deductible portion of the loss. This process aligns the tax deduction with the taxpayer’s economic risk.

When to File Form 6198 for a Rental Property

The requirement to file Form 6198 for a rental property is triggered by a specific set of circumstances. You must file the form if your rental activity incurs a net loss for the tax year and you have amounts invested in the property for which you are not considered at risk. If the rental breaks even or generates a profit, Form 6198 is not required, as its purpose is to limit the deduction of losses.

The determination of whether an investment is “at risk” hinges on the nature of the financing. The most common situation that creates a non-at-risk investment is the use of nonrecourse debt. This type of loan is secured by the property, meaning that in a default, the lender can seize the property but cannot pursue the borrower’s other personal assets.

In contrast, recourse debt makes the borrower personally liable for the full amount of the loan. If the sale of the property is not sufficient to cover the debt, the lender can go after the borrower’s other assets. Because the borrower’s personal assets are on the line, amounts financed through recourse debt are considered at risk.

Calculating Your Amount At Risk

Calculating your at-risk investment involves summarizing all the capital you have personally exposed to loss in the rental activity. The process begins with an initial amount and is adjusted for financial events throughout your ownership of the property.

Initial At-Risk Amount

Your initial at-risk amount is established when you first acquire the rental property. This figure includes the cash you personally contributed, such as the down payment, and the adjusted basis of any other property you contributed to the activity. The adjusted basis is the original cost of the property, plus certain settlement fees and closing costs.

Increases to Your At-Risk Amount

Over the life of the rental property, several factors can increase your at-risk amount. Any additional cash you contribute for capital improvements or to cover operating deficits adds to your at-risk basis. The income generated and reported from the rental activity also increases your amount at risk. If you borrow additional funds for the property and are personally liable for the debt (recourse debt), these amounts increase your at-risk investment.

Decreases to Your At-Risk Amount

Conversely, certain events will decrease your at-risk amount. When you take withdrawals or distributions of cash or property from the rental activity, your at-risk investment is reduced. Any losses from the rental activity that were allowed as deductions in previous tax years also reduce your at-risk amount, as they represent a return of your at-risk capital.

The Qualified Nonrecourse Financing (QNF) Exception

A special provision in Internal Revenue Code Section 465 is relevant for real estate investors. This rule provides an exception for “qualified nonrecourse financing” (QNF), allowing it to be treated as an amount at risk. For financing to be considered QNF, it must be secured by the real property and borrowed from a “qualified person,” which is a bank, credit union, or other commercial lender. The loan cannot be from a person related to the taxpayer or the person from whom the property was acquired.

How to Complete Form 6198

Once you have calculated your total amount at risk, you can complete Form 6198. You will need information from your Schedule E (Supplemental Income and Loss) and your at-risk calculation.

Part I

Part I, “Current Year Profit (Loss) From the Activity,” summarizes the financial results of your rental property. You will enter the ordinary income or loss from the activity on line 1, a figure that comes from your Schedule E. The result on line 5 will show the net profit or loss for the year; if it shows a profit, you do not need to complete the rest of the form.

Part III (Detailed Computation)

While Part II offers a simplified computation, many taxpayers will use Part III, “Detailed Computation of Amount At Risk.” This section formally reports the components of your at-risk amount. You will enter your at-risk amount from the beginning of the year and then add increases, such as income, and subtract decreases, like distributions. If you have qualified nonrecourse financing, it is included in these calculations as an amount at risk.

Part IV (Deductible Loss)

Part IV, “Deductible Loss,” determines the amount of your rental loss you can claim. The form directs you to compare your current year loss from Part I with your end-of-year at-risk amount from Part III. Your deductible loss, reported on line 21, is limited to the smaller of these two figures. Any portion of the loss that is not allowed is suspended and carried forward to the next tax year.

Interaction with Passive Activity Loss Rules

Navigating the at-risk rules with Form 6198 is the first of two steps for deducting rental property losses. After determining the loss allowable under the at-risk rules, you must then apply the passive activity loss (PAL) rules. These two sets of rules are applied sequentially, with the at-risk limitations always addressed first. The deductible loss calculated on Form 6198 flows to Form 8582, Passive Activity Loss Limitations.

Rental activities are considered passive, regardless of your level of participation. The PAL rules, under Internal Revenue Code Section 469, prevent you from deducting losses from passive activities against your nonpassive income, such as wages or portfolio income. This means that even if your rental loss is fully deductible according to Form 6198, it may be further limited or disallowed for the current year by the PAL rules on Form 8582.

For example, if you have a $10,000 loss that is fully at risk but have no passive income from other sources, the entire $10,000 loss may be suspended. A special allowance may permit some taxpayers to deduct up to $25,000 of rental losses against nonpassive income, but this phases out as modified adjusted gross income increases. Any loss disallowed by the PAL rules is suspended and carried forward to future years, where it can be used to offset future passive income or be fully deducted when you sell the property.