What Is the At-Risk Recapture Tax Rule?

The at-risk recapture rule is a tax provision ensuring that deductions for losses do not exceed a taxpayer’s financial stake in an activity. It prevents individuals from claiming losses for amounts they are not personally liable to lose. When a taxpayer’s amount at risk falls below zero, this rule requires them to include previously deducted losses as income on their current tax return. This process reverses prior tax benefits when a taxpayer’s economic exposure is reduced to a negative balance.

Understanding Your Amount At Risk

A taxpayer’s amount at risk represents their economic investment in an activity and is the ceiling for deducting losses. This figure is calculated annually. The initial at-risk amount combines cash contributed, the adjusted basis of any property provided, and funds borrowed for which the taxpayer is personally liable.

The distinction between different types of debt is important for this calculation. Recourse debt, for which a borrower is personally liable, increases the at-risk amount because the lender can pursue the borrower’s personal assets to satisfy the debt. In contrast, nonrecourse debt does not increase the at-risk amount because the lender’s only remedy in case of default is to seize the collateral securing the loan.

Throughout the life of the investment, additional capital contributions and the taxpayer’s share of the activity’s income will increase the amount at risk. Conversely, the at-risk amount is decreased by distributions of cash or property received from the activity and the cumulative amount of losses that have been deducted in prior years.

Consider an individual who invests $20,000 in cash into a partnership and signs for a $30,000 recourse loan, making their initial at-risk amount $50,000. In the first year, the activity generates a $15,000 loss, which the individual deducts. This deduction reduces their at-risk amount to $35,000. If in the second year they receive a $5,000 cash distribution, their at-risk amount would further decrease to $30,000.

Triggers for At-Risk Recapture

The at-risk recapture rule is activated when events cause a taxpayer’s previously positive at-risk amount to fall below zero. This negative balance signifies the taxpayer has withdrawn more economic value from the activity than they had at risk, often after deducting losses against their initial investment.

One of the most common triggers is receiving distributions from the activity in the form of cash or property. If these distributions exceed the remaining at-risk amount, the balance can become negative, prompting recapture of previously allowed losses.

Another trigger involves changes to the activity’s financing. If a debt that was originally recourse is converted to nonrecourse debt, the taxpayer is no longer personally liable. This change reduces their at-risk amount by the balance of the converted loan, and if this pushes the at-risk amount below zero, recapture is required.

Furthermore, entering into certain agreements that protect a taxpayer from loss can also trigger recapture. These arrangements, such as guarantees or stop-loss agreements, limit or eliminate the taxpayer’s personal liability. This reduces their economic risk, which in turn reduces their at-risk amount and can lead to a negative balance.

Calculating and Reporting Recapture Income

Once an event triggers the at-risk recapture rule, a specific calculation is required to determine the amount of income to be reported. The recaptured income is the lesser of two amounts: the negative at-risk amount at the end of the tax year (treated as a positive number) or the total losses from the activity deducted in previous years, reduced by any amounts previously recaptured.

For example, assume a taxpayer’s at-risk amount is negative $10,000 at year-end. In prior years, they had deducted a total of $40,000 in losses from this activity and had never previously recaptured any income. The recapture amount would be $10,000, as this is the lesser of the two amounts.

This recaptured income must be reported to the IRS on Form 6198, At-Risk Limitations. The calculation and reporting occur in Part III of the form. The final figure is then carried to the taxpayer’s main tax return and reported on Schedule 1 (Form 1040) as “Other income.”

Treatment of Recaptured Amounts

The amount that is recaptured and included in a taxpayer’s income is not permanently lost as a potential tax benefit. The tax code allows the recaptured amount to be treated as a suspended loss. This means it is carried forward and becomes a potential deduction allocable to the same activity in the following tax year.

This newly created deduction is not automatically allowed in the subsequent year, as it is subject to the same at-risk limitations. To claim this suspended loss, the taxpayer must first increase their amount at risk in the activity. This can be accomplished by contributing more cash or property or by taking on additional recourse debt.

For instance, if a taxpayer recaptures $10,000 of income, that $10,000 becomes a suspended loss carried forward. If, in the next year, the taxpayer contributes an additional $15,000 of cash to the activity, their at-risk amount increases. This positive at-risk balance would then allow them to deduct the $10,000 suspended loss, assuming the new at-risk amount is sufficient.