At-Risk Limitations: IRC Section 465 for CPA REG Candidates

At-Risk Limitations Under IRC Section 465

The at-risk rules under Section 465 limit a taxpayer's deductible losses from a trade or business or income-producing activity to the amount the taxpayer has "at risk" in that activity. These rules prevent taxpayers from deducting losses in excess of their actual economic investment, particularly in situations involving nonrecourse financing where the taxpayer has no personal liability. For CPA REG candidates, the at-risk rules represent one of several loss limitation layers that must be applied in a specific order.

The Loss Limitation Hierarchy

Losses from pass-through entities (partnerships and S corporations) are subject to four sequential limitations, applied in this order:

Basis limitation (Sections 704(d) and 1366(d)): Losses cannot exceed the partner's/shareholder's outside basis.
At-risk limitation (Section 465): Losses passing the basis test are then limited to the amount at risk.
Passive activity loss limitation (Section 469): Losses passing the at-risk test are limited if the activity is passive.
Excess business loss limitation (Section 461(l)): Aggregate business losses exceeding the threshold are converted to NOL carryforwards.

Losses disallowed at any level are suspended and carried forward indefinitely until the taxpayer increases the relevant limitation amount.

Computing the At-Risk Amount

Amounts Considered At Risk

A taxpayer's at-risk amount includes: cash contributed to the activity, the adjusted basis of property contributed to the activity, amounts borrowed for use in the activity for which the taxpayer is personally liable (recourse debt), and amounts borrowed for use in the activity that are secured by the taxpayer's property (other than property used in the activity). The at-risk amount also includes the taxpayer's share of recourse debts of a partnership.

Amounts Not At Risk

The following amounts are generally not considered at risk: nonrecourse loans (except qualified nonrecourse financing for real estate), amounts protected against loss through guarantees, stop-loss agreements, or similar arrangements, and amounts borrowed from persons with an interest in the activity (other than as a creditor) or from related persons.

Adjustments to the At-Risk Amount

The at-risk amount is increased by income from the activity and additional contributions, and decreased by losses allowed, distributions, and withdrawals. If the at-risk amount is reduced below zero (which can happen when debt is refinanced as nonrecourse or when guarantee arrangements change), the taxpayer must recapture previously allowed losses as income under Section 465(e).

Qualified Nonrecourse Financing: The Real Estate Exception

For real estate activities, Section 465(b)(6) provides an important exception. "Qualified nonrecourse financing" is treated as an amount at risk, even though the taxpayer is not personally liable. To qualify, the financing must be: (1) borrowed from a qualified lender (a bank, savings institution, or any person who regularly engages in the business of lending money, but not the seller of the property or a person related to the seller); (2) secured by real property used in the activity; and (3) not convertible debt. This exception is critical because most commercial real estate is financed with nonrecourse loans.

Aggregation and Separation of Activities

The at-risk rules generally apply on an activity-by-activity basis. Each separate trade or business is treated as a distinct activity. However, for purposes of determining the at-risk amount, activities may be grouped together under certain circumstances, subject to the passive activity grouping rules under Regulation Section 1.469-4.

Interaction with Other Provisions

Passive Activity Loss Rules

Losses that survive the at-risk limitation are then subject to the passive activity loss (PAL) rules under Section 469. The two provisions work sequentially: a loss must first be within the at-risk amount and then must be allowable under the PAL rules. A loss suspended under the at-risk rules is not tested under the PAL rules until it is released from the at-risk suspension.

S Corporation and Partnership Basis

For S corporation shareholders, the at-risk amount is similar to, but can differ from, the shareholder's stock and debt basis. Notably, S corporation shareholders are not at risk for entity-level debt (only for direct loans from the shareholder to the corporation). For partners, the at-risk amount includes the partner's share of partnership recourse debt and qualified nonrecourse financing, which may differ from the partner's outside basis.

CPA Exam Tips

Apply loss limitations in order: basis, at-risk, passive activity, excess business loss.
At-risk amounts include cash, property basis, recourse debt, and qualified nonrecourse financing (real estate only).
Nonrecourse debt is generally not at risk unless it qualifies under the real estate exception.
S corporation shareholders are not at risk for entity-level debt; only direct loans from shareholder to corporation count.
If the at-risk amount goes negative, previously allowed losses are recaptured as income.