At-Risk and Excess Business Loss Limits

The passive rules get the most attention, but they are not the only limits on losses. At-risk rules and the excess business loss limit can also restrict how much of a study's deductions you use in a year. This page introduces them.

At-risk rules

Section 465 limits losses to the amount you have at risk in an activity. Amounts at risk generally include cash you contributed, the adjusted basis of property you contributed, and certain borrowed amounts for which you are personally liable. For real estate, there is a special rule that includes certain qualified nonrecourse financing, such as commercial financing from a qualified lender, in the at-risk amount. That rule is why many real estate owners with nonrecourse mortgages can still satisfy at-risk requirements. Not all financing qualifies. Financing from related parties or from sellers can raise issues.

For a study, the point is that a large first-year loss might exceed your at-risk amount in some structures, such as a partnership with little equity and nonqualified financing. Ask your preparer to confirm. Losses disallowed by at-risk rules generally carry forward.

Basis limits

Owners of partnership and S corporation interests also face basis limits. A loss allocated to you generally can be deducted only to the extent of your basis in the entity. Excess is suspended. See Entities and Who Gets the Deduction.

Order of limits

Losses generally must pass through the limits in a specific order: basis, at-risk, passive activity, and then the excess business loss limit. A deduction could be allowed at one stage and limited at the next. Preparers work through the stack.

Excess business loss limit

Section 461(l) limits the amount of net business losses an individual can deduct in a year against nonbusiness income. Losses above a threshold amount, which is set by law, adjusted for inflation, and different for joint filers, are disallowed for the year and carry forward as net operating losses. The details and dollar amounts have been subject to change by legislation, and the limit's future should be verified.

For a study, this limit matters when you have large nonpassive business or rental losses against wages or other income. A large bonus deduction on nonpassive property could push you past the threshold. In that case, part of the loss would be carried forward. See Tax Bracket and Whether Deductions Are Usable.

Net operating losses

Carryforwards of disallowed excess business losses are treated as net operating losses in the following year, which come with their own limitations, such as a percentage of taxable income limit. Do not assume they can be used at full value in the next year.

How these interact with a study

• A study increases early deductions.
• Those deductions may hit basis, at-risk, passive, or excess business loss limits.
• What is disallowed carries forward, at a delay.

Model your whole return. See Cost Versus Benefit Without Guarantees.

Planning ideas to discuss

Some owners consider whether to elect out of bonus depreciation to manage the size of the loss in a particular year, whether to adjust the timing of the study, or whether to increase basis through contributions. Each has costs and requirements, and you should discuss them with an advisor. Do not do anything solely for tax purposes without understanding its consequences.

Recordkeeping

Track basis, at-risk amounts, and carryforwards by year. See Audit Defense and Documentation for Cost Segregation.

Illustrative situation in words

Consider an investor in a partnership that owns an apartment building financed with a bank loan that qualifies as qualified nonrecourse financing. The investor's share of the loan is part of the at-risk amount. A large bonus deduction in the first year could produce a loss allocation. The investor must then check basis, at-risk, passive, and excess business loss limits in that order. If the investor is a passive investor without passive income, the passive limit binds and the loss is suspended. If the investor were a real estate professional with large wage income, the excess business loss limit could bind.

Why order matters

Because each limit reduces the loss that reaches the next, the order determines which limit binds and which carryforward is created. That affects how and when the loss will eventually be used. Ask your preparer to show each layer so you understand where the loss is stuck, if it is.

Recordkeeping

Keep partnership or S corporation basis schedules, statements of financing, and prior year computations. Errors in basis and at-risk records are common in entities that have been in place for years.

Verification

Thresholds and rules for these limits have been subject to legislative change. Verify the current law and numbers.

Questions for your preparer

Does my financing count as qualified nonrecourse financing? What is my at-risk amount? Do I have basis limits in my entities? Would the study push me past the excess business loss threshold? How would carryforwards be treated? Ask for a projection.

Next steps

Review The Passive Activity Loss Rules and Cost Segregation for the passive limit, and Questions to Ask Your CPA Before Ordering a Study for how to raise these topics.