What Is At-Risk Basis and How Does It Limit Losses?
Understand the tax principle that limits your deductible business or investment losses to the amount you are personally positioned to lose.
The at-risk rules, governed by Internal Revenue Code Section 465, limit a taxpayer’s deductible losses from an activity to the amount they are personally at risk of losing. This means you cannot deduct more than your actual financial exposure. These rules prevent taxpayers from using losses to offset other income unless they have an economic stake in the venture and apply to individuals, partners, S corporation shareholders, and certain closely held C corporations.
The concept was introduced to curb tax shelter strategies where investors claimed large losses from activities financed with nonrecourse debt, for which they had no personal liability. If an activity generates a loss, a taxpayer must determine their at-risk amount to see how much of that loss can be deducted in the current year.
Determining Your Initial At-Risk Amount
Your initial at-risk amount establishes the baseline for the maximum loss you can deduct. While not the same as your tax basis, the calculation begins with similar components: the cash and the adjusted basis of any property you contribute to the activity.
When property is contributed, its adjusted basis is used. Adjusted basis starts with the property’s original cost and is then modified for factors like depreciation or improvements. For example, contributing a building with an adjusted basis of $150,000 adds that amount to your at-risk total.
Borrowed funds are another component of your at-risk amount. You are at-risk for money you borrow if you are personally liable for its repayment, which is known as recourse debt. If the business fails, a lender can pursue your personal assets to satisfy a recourse loan. In contrast, nonrecourse debt does not increase your at-risk amount because the lender’s only remedy in a default is to seize the collateral securing the loan, not your personal assets.
Adjustments to Your At-Risk Amount
Your at-risk amount is not static; it fluctuates throughout the life of the activity. The balance is re-evaluated at the end of each tax year to determine the limit for that year’s losses. Certain events will increase your amount at risk, while others will decrease it.
Your at-risk amount increases when you contribute more personal funds or property to the activity. It is also increased by your share of the activity’s income. For instance, if you are a partner in a business that generates a profit, your share of that income will raise your at-risk amount.
Conversely, your at-risk amount is reduced by distributions of money or property you receive from the activity. When the business pays you, it is considered a return of your investment, which lowers your amount at risk. Your at-risk amount is also decreased by your share of the activity’s deductible losses. For example, if your at-risk amount is $20,000 and you deduct a $5,000 loss, your at-risk amount is reduced to $15,000.
Amounts Not Considered At-Risk
Certain financial arrangements are excluded from the at-risk calculation, even if they appear to create personal liability. These rules prevent taxpayers from artificially inflating their at-risk amount to deduct losses they are not economically bearing. The substance of an arrangement, rather than its form, dictates whether an amount is truly at risk.
Arrangements that protect you from loss are disregarded. This includes guarantees, stop-loss agreements, or similar agreements that limit your financial exposure. For example, if you are personally liable for a debt but have a side agreement with another partner for reimbursement, you are not considered at-risk for that debt.
Another exclusion applies to amounts borrowed from a person who has an interest in the activity other than as a creditor. If you borrow money from another owner of the business to fund your investment, those funds are not considered at-risk. The loan must be from a party whose only relationship to the activity is that of a lender.
The Role of Qualified Nonrecourse Financing
An exception to the at-risk rules exists for the activity of holding real property. This exception involves a type of debt known as “qualified nonrecourse financing” (QNF). If a loan meets the criteria for QNF, it is treated as an amount at-risk, even though it is nonrecourse.
To be considered QNF, the financing must meet several conditions. The loan must be obtained from a “qualified person,” such as a bank or other financial institution in the business of lending. Loans from a person related to the taxpayer can qualify only if the terms are commercially reasonable. The financing must also meet these requirements:
- It must be borrowed for the activity of holding real property.
- It must be secured by that real property.
- It cannot be convertible into an equity interest in the property.
- No person can be personally liable for repayment.
If these requirements are met, a taxpayer can include their share of the QNF in their at-risk amount. This allows real estate investors to increase their at-risk basis and potentially deduct losses that would otherwise be disallowed. For partnerships, a partner’s share of QNF is determined based on their share of the partnership’s liabilities, as defined under Internal Revenue Code Section 752.
Reporting and Carryover of Disallowed Losses
When you have a loss from an activity subject to the at-risk rules, the calculation is performed on IRS Form 6198, At-Risk Limitations. You must file Form 6198 with your tax return if you have a loss from an at-risk activity and have amounts invested that are not at risk.
Losses disallowed in one year are not permanently lost. Instead, they are suspended and carried forward to the next tax year. The disallowed loss from one year is treated as a deduction for the same activity in the following year. You can use these suspended losses in a future year if you have a sufficient at-risk amount in that year to absorb them.
The carryover continues indefinitely until you have enough at-risk basis to use the loss. Your at-risk amount can increase by contributing more cash or when the activity generates net income. For example, if you have a $10,000 suspended loss and your at-risk amount increases by $15,000 from profits, you can deduct the full $10,000 carryover loss.