Beyond Basis: Understanding At-Risk Limits on Loss Deductions

03 Nov 2025 Beyond Basis: Understanding At-Risk Limits on Loss Deductions

Most business owners and investors are familiar with the concept of tax basis – the figure used to determine how much loss they can deduct and how distributions are treated. But basis is only part of the story. Even when a taxpayer has sufficient basis, the IRS may still deny a loss deduction under the more restrictive at-risk rules.

In this article, we’ll examine how the at-risk rules operate, how they differ from basis, and why these distinctions matter in pass-through arrangements.

Basis: the starting point

In a pass-through entity, a taxpayer’s basis generally reflects their investment in the business. It starts with amounts contributed and is adjusted over time to reflect additional contributions, income, losses, and distributions.

Partnerships

In a partnership, each partner maintains an outside basis, representing their interest in the partnership. This includes cash or property contributed, allocated share of partnership liabilities (recourse and qualified nonrecourse), and adjustments for income and losses allocated, or distributions received.

Let’s say you contribute $50,000 in cash to a new partnership and are allocated $20,000 of partnership liabilities. Your initial outside basis is $70,000.

S Corporations

For S corp shareholders, basis is similarly adjusted for income, losses, and distributions, but with a key difference: shareholders cannot include entity-level liabilities in their basis unless they personally loan funds to the corporation.

Let’s say you contribute $30,000 to your S corporation. The corporation later borrows $100,000 from a bank. Even if you personally guarantee the loan, your basis does not increase because you haven’t made an actual outlay of funds. Unless you personally loan money directly to the S corporation, your basis remains $30,000.

Basis matters because it determines how much loss a taxpayer can deduct and whether distributions are tax-free. If a distribution exceeds basis, it typically triggers a capital gain. And if a loss exceeds basis, it is suspended until more basis is restored.

But having basis isn’t the end of the story. Just because a taxpayer has basis doesn’t mean they’re entitled to deduct a loss. To actually use that basis, the taxpayer must also be at risk for the amount being deducted.

Example: three partners, three tax outcomes

To illustrate how these rules work together, consider three people – Anna, Brian, and Claire – who form a limited partnership. Each partner contributes capital and is allocated a share of the project’s losses. However, the tax outcome for each partner differs based on how they funded their investment and their level of exposure.

• Anna contributes $100,000 in cash.
• Brian contributes $50,000 and personally guarantees a $50,000 loan used by the partnership.
• Claire contributes $30,000 and is allocated $70,000 of nonrecourse debt tied to the property.

On paper, they each begin with $100,000 of basis, but the IRS doesn’t stop there. To determine whether any losses are deductible, we need to ask: how much of that basis is actually at risk?

At-risk amounts: the second hurdle

The at-risk rules were designed to prevent taxpayers from claiming losses they aren’t truly exposed to. A taxpayer is considered “at risk” for amounts they have:

• Contributed in cash or property,
• Borrowed and for which they are personally liable, or
• Secured with property that is not used in the activity itself (e.g., pledging personal assets as collateral).

If you aren’t personally on the hook and the loss would ultimately fall on someone or something else, you’re not considered at risk, even if you have basis.

Recourse vs. nonrecourse debt

A common point of confusion is the distinction between recourse and nonrecourse debt.

Recourse debt means you are personally responsible for repayment. If the business or investment can’t repay the loan, the lender can pursue your personal assets. Because you stand to lose personally, recourse debt generally increases your at-risk amount.

Nonrecourse debt limits the lender’s claim to the collateral securing the loan, which is usually the business’s property or assets. If the borrower defaults, the lender can seize that collateral, but they can’t pursue your personal assets. Since you don’t bear personal exposure, nonrecourse debt generally does not increase your at-risk amount.

This distinction is fundamental to the at-risk rules. The law looks beyond whether someone is liable and asks whether you, personally, could suffer an economic loss if the business fails.

Important exception: in certain real estate activities, qualified nonrecourse financing may be treated as an amount at risk, even though it is nonrecourse. This exception typically applies to financing secured by real property, borrowed from certain institutional lenders. The rules surrounding qualified nonrecourse debt are highly specific, and a full discussion is beyond the scope of this article – but real estate investors should be aware that it can affect their at-risk analysis.

Unfortunately, loan documents don’t always include a bright-line label that says “recourse” or “nonrecourse.” The classification often depends on the actual language of the agreement, including terms related to collateral, guarantees, indemnification, or repayment obligations. Because of this ambiguity, it’s essential to consult with expert advisors when evaluating how liabilities impact your basis and at-risk position.

How these debts affect each partner

Let’s return to Anna, Brian, and Claire – applying what we now know about at-risk limitations. Although each of them started with $100,000 of basis in the partnership, basis alone doesn’t determine whether a loss is deductible.

• Anna contributed $100,000 in cash, so she is at risk for the full $100,000.
• Brian is also at risk for $100,000, because he contributed $50,000 in cash and personally guaranteed $50,000 in debt (secured by his personal assets).
• Claire, however, is only at risk for her initial $30,000 cash contribution. The $70,000 in nonrecourse debt she was allocated increased her basis, but not her at-risk amount, since she isn’t personally liable.

Now, suppose the partnership incurs a $120,000 loss and allocates $40,000 to each partner. Anna and Brian can deduct their full $40,000 share because they are at risk for at least that amount. Claire, however, can deduct only $30,000 – the amount she’s actually at risk for. The remaining loss is suspended and carried forward until her at-risk amount increases.

How the at-risk rules work

Under IRC §465, the IRS has broad authority to disallow loss deductions in cases where arrangements create the appearance of risk without true exposure.

And the rules apply on an activity-by-activity basis. That means taxpayers may need to assess their at-risk amount on a per-project or investment basis within a single entity, depending on how the activities are defined under the tax law. This can quickly become complex in real estate, energy investments, and other sectors where a single partnership might have multiple operating segments.

And remember, the at-risk limitation is not a one-time test but a living number that evolves with the activity.

Passive activity: the third hurdle

Even if you clear the first two thresholds – your losses don’t exceed basis, and you’re truly at risk – you may still face one more barrier: the passive activity loss limitation. This rule was designed to stop taxpayers from using losses from passive investments to offset income from unrelated, active sources like wages or business income where they materially participate.

An activity is generally considered passive if you don’t materially participate in the business or rental activity and the activity is not a trade or business in which you’re actively involved. In practice, this typically includes most real estate ventures (unless you qualify as a real estate professional) and businesses where you’re merely an investor, not an operator.

If an activity is passive, losses can only be deducted to the extent of passive income. You can’t use a passive loss to offset salary, capital gains, or portfolio income. Just like with basis and at-risk limitations, passive losses are suspended and carried forward indefinitely until you generate enough passive income to absorb the losses or dispose of the entire interest in the passive activity in a taxable transaction.

Applying the passive activity rules to our example

Let’s return to Anna, Brian, and Claire, who were each allocated a $40,000 loss from their partnership. Anna and Brian had sufficient basis and at-risk amounts to deduct the full $40,000 loss, but Claire was already limited to deducting $30,000 (with $10,000 suspended under the at-risk rules).

Anna spends 25 hours a week managing construction and lease negotiations. She likely qualifies as a material participant, meaning she passes all three hurdles (basis, at-risk, and material participation), so her $40,000 loss is fully deductible.

Brian doesn’t engage in day-to-day operations and doesn’t meet the material participation threshold. His activity is likely passive. He can deduct the $40,000 loss only if he has sufficient passive income from other sources.

Claire plays no role in operations. Her loss was already limited to $30,000, but even that figure must now pass the passive activity test. And because Claire does not materially participate, her deductibility depends on available passive income. If she has none, the loss is suspended, even though it already cleared basis and partially cleared at-risk.

Practical takeaways

The at-risk rules aren’t just a compliance matter. A working knowledge of the rules also enables more strategic planning.

Documentation matters

To ensure deductibility, keep detailed records of how liabilities are structured and who bears the economic burden.  This includes loan agreements, guarantee documentation, and evidence of any pledged collateral.

Track at-risk amounts

Many tax software systems don’t automatically track at-risk amounts, and suspended losses may not appear on your K-1. Maintain your own records or coordinate with your tax advisor to monitor at-risk amounts at least annually.

Plan before you deduct or sell

If you’re planning to take considerable losses or exit an investment, your at-risk position can significantly affect the tax outcome. Suspended losses can often be deducted upon a fully taxable sale, but may be lost if the interest is disposed of in a non-taxable transaction or partial transfer.

Carefully time capital contributions, debt restructuring, and loss deductions with an eye on your at-risk position. Work with advisors to ensure you’re adequately categorizing recourse vs. nonrecourse liabilities. And be particularly vigilant about reviewing at-risk exposure whenever there’s a change in financing or ownership structure.

Staying compliant and strategic

For anyone investing through a partnership, S corporation, or similar vehicle, the message is clear: don’t stop at basis. Understand your at-risk position, track it carefully, and plan accordingly.

If you’re unsure whether your losses are truly deductible or how your financing arrangements affect your at-risk amount, it’s time for a closer look. A qualified advisor can help you ensure compliance while optimizing your tax position.

This article is intended to provide a brief overview of at-risk rules. It is not exhaustive, nor is it a substitute for speaking with one of our expert advisors. For more personalized guidance, please contact our office.

Contact The Haynie & Company CPA Firm For Tax Advisor Services