At-Risk Rules
The at-risk rules under IRC Section 465 limit the deductibility of losses from a business or investment activity to the amount a taxpayer has economically at risk, preventing the deduction of losses funded by nonrecourse financing for which the investor bears no true economic exposure.
The at-risk rules work in tandem with the passive activity loss rules but operate as a prior and independent limitation. Even if a loss would otherwise be allowed under the PAL rules, a taxpayer can only deduct an amount equal to their at-risk basis in the activity. At-risk basis includes cash contributed, the adjusted basis of property contributed, and amounts borrowed for which the taxpayer is personally liable or has pledged personal assets as security.
Nonrecourse debt — borrowing for which the lender's only recourse is the collateral itself, with no personal liability to the borrower — does not increase at-risk basis for most activities. An important exception exists for qualified nonrecourse financing in real estate: certain nonrecourse mortgage debt from commercial lenders on real property is treated as at-risk, which preserves the economic reality that real estate investors typically do bear meaningful risk through their equity investment even when leveraged.
When a taxpayer's at-risk amount is reduced to zero, further losses are suspended rather than permanently disallowed. The suspended losses carry forward and can be deducted in future years when at-risk basis is restored — for example, by contributing additional capital or converting nonrecourse debt to recourse debt.
A negative at-risk balance — which can occur if recourse debt is later converted to nonrecourse debt — triggers income recapture equal to the amount by which the at-risk amount goes below zero. Practitioners advise clients investing in leveraged real estate partnerships or oil and gas programs to carefully track both their at-risk basis and passive loss basis as separate records, since the two calculations differ.