At-Risk Limitation Rules
A prominent feature of tax shelters in the past was that they allowed taxpayers to deduct losses that were greater than their investment in the activity. Furthermore, most of these activities had no real economic value — their purpose was simply to allow these so-called investors to deduct more from their taxes than what they actually lost. To prevent this abuse, there are 2 sets of rules that limit the deductibility of any losses from a trade, business, rental, or other income-producing activity: at-risk rules and passive activity rules. Another limitation is that deductions from a pass-through entity cannot exceed the taxpayer's cost basis in the business. What is deductible must first be determined by applying the at-risk rules. Any remaining losses are then subject to the passive activity rules.
The Internal Revenue Service (IRS) lists several activities that are covered by the at-risk rules, including farming, exploring or exploiting oil and gas or geothermal deposits, but then it lists a much more general rule that simply includes any activity for the production of income. There are also some exceptions to the at-risk limits, including equipment leasing by closely held corporations or for the holding of real property placed in service before 1987.
At-risk limitation rules limit any deductions to the amount of money that the taxpayer actually had at-risk at the end of the tax year in any activity for which the taxpayer was not a material participant. At-risk limit rules also apply to individuals with interests in closely held corporations, including S corporations or partnerships, that allow pass-through losses to offset active and portfolio income of the investors. Besides the at-risk and passive activity rules, losses from a partnership or S corporation are limited to the adjusted basis of the partnership interest or shareholder's stock plus any loans by the shareholder to the corporation. Nonrecourse liabilities are excluded from the tax basis of the interest. Nonrecourse financing for real estate qualifies as an exception if the real estate collateralized the loan, which is usually the case.
What is considered at-risk is the amount of cash or the adjusted basis of property contributed to the activity or money borrowed for which the taxpayer is personally liable or has pledged property that is not used in the activity as security for the loan. Amounts not at risk include nonrecourse financing, or guarantees or agreements that limit the losses of the taxpayer. Nonrecourse financing is financing secured by property for which the taxpayer has no liability. Any loans to the taxpayer from a person having an interest in the activity or who is related to someone who has an interest in the activity is also not considered at risk unless it is from someone who is merely a shareholder of the corporation or a creditor of the activity.
Each year, the at-risk limitation increases by the taxpayer's share of income and is decreased by the taxpayer's share of losses or withdrawals from the venture. Increases in recourse loans increases the amount at-risk while conversion from recourse to nonrecourse loans for which the taxpayer no longer has any liability decreases the amount at-risk, so at-risk limits are not increased by debts unless the taxpayer is personally liable for repayment of the debt or the lender has an interest in the activity other than as a creditor.
A taxpayer can only deduct amounts up to the at-risk limitations in any given tax year. Any unused portion of losses can be carried forward until the taxpayer has enough positive at-risk income to allow the deduction.
Example: Unused Losses Due To At-Risk Limitations May Be Carried Forward
- You invest $30,000 in a partnership, but suffer $50,000 of your share of the partnership's losses in the 1st year.
- For the 1st year, you can only deduct your initial investment. However, your suspended loss of $20,000 can be carried forward.
- If you invest an additional $30,000 in the next year, then your at-risk limit is $10,000, because the $20,000 loss carried forward is subtracted from the additional $30,000 that you invested.
Whenever the at-risk limit decreases below zero because of excess distributions to the taxpayers or because the type of debt has been changed from recourse to nonrecourse, then previous allowable losses may have to be recaptured.
If the taxpayer has amounts that are not at risk, then Form 6198, At-Risk Limitations must be filed for each activity to calculate the deductible loss. The at-risk limitation does not apply to deductions that are disallowed by other provisions of the law, such as prepaid interest expenses. For investments that are subject to both at-risk rules and passive activity rules, the at-risk rules are applied first, which are calculated on Form 6198. If there is any deductible loss at risk, then that is carried over to Form 8582, Passive Activity Loss Limitations to figure the passive activity loss.
Generally, losses from at-risk investments can only be deducted against the income generated by that activity. At-risk limitation losses for that particular activity are restricted to the income, which does not include the recapture of previous losses, earned by that activity. However, activities in which the taxpayer actively participates can be aggregated. Moreover, activities by a partnership, limited liability company, or S corporation in which the taxpayer has made an investment can also be aggregated if the pass-through entity suffered losses:
- where 65% or more of its losses are allocable to persons who actively manage the business
- from producing or distributing films and videotapes
- from exploring or exploiting oil or gas properties, or geothermal properties
- from farming, except for forestry
- from leasing depreciable business equipment (§1245 property)
Disallowed losses limited by the at-risk limitations may be carried over to future years, becoming deductible if the taxpayer increases the investment or if the activity earns income that is not distributed to the taxpayer. If the activity is sold at a gain, then the gain is treated as income from which carryover losses can be deducted.