At-Risk Rules: How §465 Limits Real Estate and K-1 Losses
The at-risk rules in §465 limit a loss to the amount you could actually lose. If you put in $100,000 and borrowed nothing you are liable for, you generally cannot deduct more than $100,000 of losses from that activity, no matter what the depreciation schedule says. Disallowed losses are not lost; they carry to the next year (§465(a)(2)).
For real estate, a special rule usually solves the problem: bank mortgages that are nonrecourse still count if they are "qualified nonrecourse financing." That is why most landlords and syndication investors clear the at-risk test and then get stuck at the next gate, the passive activity rules.
The rule in the statute
§465(a)(1): a loss from an activity "shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk ... for such activity at the close of the taxable year."
You are at risk for (§465(b)(1)-(2)):
- Money and the adjusted basis of property you contribute to the activity.
- Borrowed amounts for the activity to the extent you are personally liable for repayment, or you pledged other property (not used in the activity) as security, up to its net value.
You are not at risk for (§465(b)(3)-(4)):
- Amounts "protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements."
- In general, amounts borrowed from someone who has an interest in the activity, or from a person related to such a person.
Each year, allowed losses reduce your amount at risk going forward (§465(b)(5)). Income and new contributions increase it.
The real estate exception: qualified nonrecourse financing
Most commercial and many residential loans are nonrecourse in substance. Without a special rule, rental real estate would fail the at-risk test constantly. §465(b)(6)(A) fixes that: "in the case of an activity of holding real property, a taxpayer shall be considered at risk with respect to the taxpayer's share of any qualified nonrecourse financing which is secured by real property used in such activity."
Qualified nonrecourse financing (QNF) must meet all four tests in §465(b)(6)(B):
| Test | What it means |
|---|---|
| Borrowed for the activity of holding real property | The loan finances the real estate activity |
| From a qualified person or a government | A lender "actively and regularly engaged in the business of lending money," or a loan from, or backed by, a federal, state or local government |
| No one personally liable | Except as regulations provide |
| Not convertible debt | No conversion into equity |
The "qualified person" definition (§49(a)(1)(D)(iv), borrowed by §465(b)(6)(D)) excludes a related person, "a person from which the taxpayer acquired the property," and "a person who receives a fee with respect to the taxpayer's investment in the property." A related-party lender can still qualify if the loan is commercially reasonable and on substantially the same terms as loans between unrelated persons (§465(b)(6)(D)(ii)).
For partnerships, a partner's share of QNF follows the partner's share of the liability under §752 (§465(b)(6)(C)).
Real property placed in service before 1987, and pre-1987 interests in pass-throughs already holding real property, are not affected by the at-risk rules (Form 6198 instructions).
Where at-risk actually bites in real estate
Because of QNF, the at-risk rules rarely bind a plain bank-financed rental. They bite in a few recognizable patterns:
- Seller financing on the purchase. A nonrecourse note to the seller is not QNF, because the seller is the person you acquired the property from. If you did not sign personally, that debt does not put you at risk.
- Loans from a promoter or sponsor that earns fees on your investment.
- Protected amounts, such as a stop-loss arrangement or a buyback promise.
- Mineral property. The QNF rule does not cover holding mineral property (§465(b)(6)(E)(ii)).
- Large distributions that pull your amount at risk below zero (see recapture below).
A simple example: An investor buys a rental for $1,000,000 with $200,000 down and an $800,000 nonrecourse note to the seller. Nothing else secures the note. A cost segregation study produces a $300,000 first-year loss. The investor is at risk for $200,000 (the cash). The seller's note is not QNF, so $100,000 of the loss is suspended under §465 and carried to next year. The $200,000 that clears at-risk then faces the passive activity rules. Had the $800,000 come from a bank on the same nonrecourse terms, it would be QNF and the whole $300,000 would clear at-risk.
K-1 investors: at-risk, then passive
For limited partners in real estate syndications, the typical K-1 loss comes from depreciation, often accelerated with cost segregation. Your amount at risk is your cash contributed plus your share of the partnership's QNF, adjusted each year. Because the properties usually carry bank debt, most syndication losses clear at-risk.
Then they hit §469. A limited partner is presumed not to materially participate (§469(h)(2)), so the loss is passive and goes to Form 8582. That is the reservoir the book is about. See syndication K-1 losses and Form 8582 explained.
The order of the gates
The Form 461 instructions state the order: "First, apply the at-risk rules; next, apply the passive activity loss rules; and then apply the excess business loss rules." For partners and S corporation shareholders, basis limits apply as well.
| Gate | Rule | Form | Suspended loss carries to |
|---|---|---|---|
| At-risk | §465 | Form 6198 | Next year, same activity (§465(a)(2)) |
| Passive | §469 | Form 8582 | Next year, until passive income or a full disposition |
| Excess business loss | §461(l) | Form 461 | Next year as an NOL |
The Form 6198 instructions also note that a loss allowed under at-risk is reported "subject to any other limitations such as the passive activity and capital loss limitations." A loss suspended at the at-risk gate never reaches Form 8582 that year. The last gate is covered in the excess business loss limitation.
At-risk recapture
If your amount at risk falls below zero at year end, §465(e)(1) requires you to include the negative amount in gross income. The recaptured amount is limited to losses previously allowed (reduced by earlier recaptures) and becomes a deduction allocable to the activity in the next year.
The usual trigger is a cash distribution financed with debt that is not QNF, or a change that converts recourse or qualified debt into debt that no longer counts. Refinancing with a bank loan that is QNF generally increases your amount at risk rather than lowering it.
At-risk losses when you sell
Losses suspended under §465 are allowed in a later year to the extent you have amounts at risk, and gain on disposing of the property is income from the activity that can support them (the Form 6198 instructions include gain from the disposition of assets used in the activity in Part I). After at-risk, any remaining loss still faces §469; a sale of your entire interest to an unrelated buyer in a taxable transaction releases suspended passive losses under §469(g). How those released losses meet the gain, and why an installment sale can pace them, is in suspended passive losses when you sell.
Bottom line
The at-risk rules limit losses to what you can actually lose. For bank-financed real estate, qualified nonrecourse financing counts as at risk, so most landlords and syndication LPs pass this gate and get stopped at the passive rules instead. Watch for seller financing on a purchase, sponsor loans, stop-loss protection and big distributions, where §465 does bind. The free book covers what to do with the passive losses that pile up next.
Questions to ask your CPA
- Is any of my debt nonrecourse and not qualified nonrecourse financing?
- For each K-1, what is my amount at risk at year end, and has any loss been suspended on Form 6198?
- Could a planned distribution or refinance push my amount at risk below zero?
- If I buy with seller financing, should I sign personally or add bank debt to stay at risk?
- When I sell, how will any at-risk carryforward and my passive carryforward be released?
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Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.