By Richard B. Gardner, EA, CPA
When a tax practitioner reviews a client’s K-1 that passes through losses from a partnership, one of the primary considerations that comes (or should come) to the practitioner’s mind is, “Does the partner have enough basis to take this loss?”
Adequate basis, however, is only one sieve through which a pass-through loss must flow before determining its deductibility. Subsequent to passing the basis test, the next test to be applied is that of the “at-risk” test of Sec. 465. After all, a partner may have sufficient basis for taking a loss but may not have a sufficient amount at risk for the loss to be deductible.
An overview of the at-risk provisions
Congress originally enacted the at-risk provisions as part of the Tax Reform Act of 1976 to deter deductions from losses generated by tax shelters. Prior to the enactment, a taxpayer could deduct losses to the extent of his or her basis in the partnership. Non-recourse loans provided additional basis against which losses could be taken while limiting the partner’s economic risk. Although IRS attempted to limit this practice, its attempts were only marginally effective until the enactment of IRC Sec. 465.
As they currently stand, the at-risk rules apply to all activities with the exception of equipment leasing by a qualified C corporation.1 In regard to activities carried on by a partnership, the Sec. 465 provisions are applicable at the partner level rather than at the partnership level.2
Determining the partner’s amount at-risk
For purposes of Sec. 465, a partner is considered at risk with respect to an activity for:
- The amount of money and the adjusted basis of other property contributed to the activity;
- Amounts borrowed for use in the activity if the partner is personally liable for repayment of the borrowed amount or has pledged property, other than property that is used in the activity, as security for the borrowed amount.3 If property is pledged as security for a borrowed amount, the partner’s at-risk amount is limited to the net fair market value of the partner’s interest in the pledged property.4
Example 1: Partner A of the ABC Partnership contributes $1,000 cash and land with a fair market value of $10,000 and a basis of $5,000. Although Partner A’s partnership interest is worth $11,000, Partner A’s at-risk amount is only $6,000.
Example 2: In addition to Example 1 above, the ABC Partnership also borrows $30,000 from the local bank. In order to obtain the loan, Partners A, B, and C must personally guarantee $10,000 each. Partner A’s at-risk amount is now increased to $16,000.
When it comes to borrowed amounts, there are certain factors that must be considered in determining the amount at risk. For instance, protective arrangements such as nonrecourse financing or stop-loss agreements will limit the partner’s at-risk amount. The Internal Revenue Code does, however, provide an exception for “qualified nonrecourse financing” which is discussed later in this article. While borrowed amounts may be included in the borrower’s amount at risk, the borrowed amounts are not considered at-risk to the other partners if the lender is a person who has an interest in the activity other than as a creditor.5
Example 3: Partner A, a one-third partner in the ABC Partnership, loans the partnership $30,000 on a fully recourse basis. As a result of this loan, Partner A’s at-risk amount is increased by $10,000 but Partners B and C’s at-risk amounts are not increased because the loan came from Partner A, a person having an interest in the activity other than as a creditor.
Furthermore, a partner’s at-risk amount is not increased by amounts borrowed from a related party6 if the related party has an interest in the activity other than as a creditor. This, nevertheless, does not exclude the partner from borrowing from a family member or an entity in which the partner owns an interest. It should be noted that entities under common control are considered related parties.
It is important to recognize that Example 3 illustrates a case in which Partners B and C respective bases are increased but their amounts at-risk are not increased. This is a prime example of a partner having sufficient basis to cover a loss but not having enough of an at-risk amount to deduct the loss.
The guarantee of partnership debt does not increase a partner’s at-risk amount until the partner actually pays the obligation and there are no remaining rights of reimbursement from other parties7 or it can be shown that the partner bears the ultimate risk of loss.8 In one interesting case the taxpayer claimed an amount at-risk based upon the deficit restoration obligation (DRO) in the partnership agreement. The Tax Court held, however, that the taxpayer was not at risk for a DRO because the taxpayer was not the “payor of last resort.”9
Aggregating Partnership Activities Under IRC Sec. 465
Net profit (loss)
At-risk basis at end of Year 1
Net profit (loss)
Disallowed at-risk loss
At-risk basis at end of Year 2
Aggregating partnership activities under IRC Sec. 465
The at-risk rules generally require that the determination of amounts at risk be made on an activity-by-activity basis. As such, the at-risk rules apply separately to each of the following activities: (1) film or video tape, (2) equipment leasing (Sec. 1245 property), (3) farming, (4) oil and gas property, and (5) geothermal property.10 Except for the activity of leasing Sec. 1245 property, a partner may, however, choose to aggregate properties within an activity and treat the aggregation as a single activity.11
For instance, if the partnership is engaged in the activity of farming and holds two or more farms, the partner may aggregate the farms and treat the aggregated farming activities as a single separate activity. With regard to the activity of leasing Sec. 1245 property, a special exception in Sec. 465(c)(2)(B)(i) for partnerships and S-corporation shareholders allows all activities with respect to leased Sec. 1245 property to be treated as a single activity.”
If a partnership engages in activities not specifically listed above, then those activities are aggregated as one activity if they constitute a trade or business, and sixty-five percent or more of the losses for the tax year are allocated to partners who actively participate in the management of the activity.12 Factors that indicate active participation include: (1) decision-making involvement in the operation or management of the activity, (2) providing services for the activity, or (3) hiring or terminating employees.
Example 4: Roy and Phillip are equal partners in the Roy-Phil Partnership. The partnership consists of two activities, a lawn care activity and a pest control activity. Roy manages both activities while Phillip is only an investor and provides no services to the partnership. Each partner contributed $250,000 to the partnership and the funds were split equally between the two activities.13
During Year 1, the lawn care activity generates a $200,000 profit while the pest control activity incurs a $150,000 loss. Year 2 reports a $300,000 profit for the lawn care activity while the pest control activity incurs a loss of $120,000.
Although Roy and Phillip each have enough basis to cover the losses from the partnership activities, because of the aggregation rules of Sec. 465(c) each partner can only take $50,000 of his respective $60,000 loss in the pest control activity and will have a disallowed loss of $10,000. Moreover, the practitioner will need to be cognizant of the passive activity loss rules under Sec. 469 which may further limit any loss.
Example 5: Same facts as Example 4 except that Roy and Phil hold sixty-five percent and thirty-five percent interests, respectively, of the capital, profits, and losses. Under this scenario, the lawn care and pest control activities would be aggregated as one activity and there would be no disallowed loss under Sec. 465.
The ordering rules for losses subject to the at-risk provisions
When deductions are limited under the at-risk rules, the regulations provide an ordering rule for those deductions that can be taken.14 The ordering rules for those deductions are:
- Capital losses;
- Sec. 1231 losses;
- All deductions that do not constitute tax preference items for AMT purposes (Sec. 57) and are not included in 1) or above; and
- All tax preference items for AMT purposes (Sec. 57) that are not included in 1) and 2) above.
Surprisingly, this ordering rule stands in contrast to Temp. Reg. Sec. 1.469-2T(d)(6)(iii) which states that a ratable portion of the sum of all deductions from the activity may be taken for the taxable year.
Carrying over disallowed at-risk losses
When an activity’s loss is disallowed in the current year because of the at-risk limitations, that loss “shall be treated as a deduction allocable to such activity in the first succeeding taxable year.”15 While the IRC states that the carryover deduction is to be used in the first succeeding taxable year, it does not limit the taxpayer to that first year only. Any unused losses may be carried over to subsequent years and used when the taxpayer’s amount at risk increases.16 These carryover losses retain their original character, i.e., capital loss, Sec. 1231 loss, ordinary loss, etc.
When a partner has suspended at-risk losses and disposes of the partnership interest, those losses are deductible against the gain from the disposition. Unfortunately, any suspended at-risk loss not used will be lost.
Income caused by recapture of the at-risk losses
A partner’s allowed losses are not permitted to reduce his at-risk amount below zero.17 Once the at-risk amount reaches zero, any additional losses are then suspended until the partner’s at-risk amount is increased. However, certain transactions can cause this amount at risk to be reduced below zero. Such transactions may include a distribution of cash or property, a reduction in liabilities for which the partner has assumed personal liability, or agreements protecting the partner against loss.
Example 6: In looking at Example 4, we note that Roy has sufficient basis to take a cash distribution but his amount at-risk in the pest control activity is zero (with an additional $10,000 in suspended at-risk losses). The operating agreement provides that cash distributions must be allocated evenly over all activities. Roy takes a $40,000 cash distribution, with $20,000 being allocated to each of the two activities. Although Roy’s at-risk amount in the pest control activity was zero before the distribution, the $20,000 cash distribution allocated to that activity brings Roy’s at-risk amount into a $20,000 negative status. Because Roy’s at-risk amount has now been reduced below zero, Roy will need to include the $20,000 in gross income.18
The recapture provision of Sec. 465(e) essentially prevents partners from taking a loss during years that they have adequate at-risk amounts and then reducing those at-risk amounts in later years. This recaptured amount, however, generates a suspended loss equal to the amount recaptured and is treated as a deduction for that activity in the next succeeding tax year to the extent the partner has an increase in his at-risk amount.19
At-risk rules and real estate
The Tax Reform Act of 1986 extended the at-risk rules to cover real estate activities. However, the extension of these rules encompassing the holding of real estate is only applicable to losses where the property was acquired after December 31, 1986. If the real property was in-service prior to January 1, 1987, the at-risk rules do not apply to losses incurred after December 31, 1986. But, there is a caveat here. The at-risk rules still apply where a partnership interest was acquired after 1986 regardless of when the partnership placed the property into service.
As noted in Aggregating Partnership Activities Under IRC Sec. 465 above, an activity that does not conform to the five original activities described in Sec. 465(c) (2)(A) may still constitute a separate activity under the provisions of Sec. 465(c)(3). This holds true with real estate activities. A real estate activity may be considered a separate activity and subject to the aggregation rules. Where a partner actively participates in the management of multiple partnerships, each of which is engaged in a real estate activity, the partner may aggregate the partnership activities into one activity.20
In 1998, the Treasury Department issued the taxpayer-friendly qualified nonrecourse financing rules of Reg. Sec. 1.465-27. While generally effective for financing on or after August 4, 1998, a taxpayer was entitled to elect retroactive application.21
In order to meet the provisions of the qualified nonrecourse rules, the financing must meet the following tests:
- The loan must be incurred with respect to the activity of holding real property.22
- The loan must be obtained from a qualified person or a federal, state, or local government instrumentality.23
- No person may be personally liable for repayment of the loan.24
- The loan does not constitute convertible debt.25
- The loan must be secured only by the real property used in the activity (excluding certain incidental and de minimis exceptions).26
Holding real property
Reg. Sec. 1.465-27(b)(1)(i) specifies that the loan must be incurred with respect to the activity of “holding” real property. This does not mean that personal property cannot be involved. In fact, the holding of real property may include personal property (e.g., furnishings) and the providing of services so long as they are incidental to the activity of holding real property.27 This provision is not applicable to the holding of mineral property.28
Additionally, a de minimis rule applies to this aspect of holding real property. Where property held in the activity is neither real property nor incidental property, it may still be considered as part of the qualified nonrecourse financing if its aggregate fair market value is less than ten percent of the aggregate fair market value of all property securing the financing.29 For example, this rule may apply to a vehicle that is used in the activity but is not real property nor incidental property in respect to the activity of holding real property.
Loans from a qualified person
One of the elements which financing must conform to is that the loan must be obtained from a qualified person.30 To be considered a qualified person, the following criteria must be satisfied:
- The lender must be actively and regularly engaged in the business of lending money. This may include banks, savings and loan institutions, commercial credit companies, etc.
- The property generally may not be acquired from the lender or a person related to the lender; but there is an exception to this. The loan may be obtained from a related party if the loan is considered commercially reasonable and has substantially the same terms as loans involving unrelated parties.
- The lender cannot receive a fee with respect to the investment in the property (e.g., a broker or promoter) or be related to a person receiving such a fee.
Personal liability for payment
While no person can assume liability for a debt that is considered qualified non-recourse financing, if a debt is bifurcated and one partner assumes a portion of the liability for the debt, the portion of the debt for which there is no guarantee of personal liability may still be considered qualified nonrecourse financing.31
In determining if there is a personal liability for repayment of the loan, the qualified nonrecourse status of the loan will not be disturbed if a partnership is liable for the debt and none of the partners is liable. In this instance, the only assets of the partnership must be the real property used as security for the qualified nonrecourse financing.32
There are numerous aspects of Sec. 465 that are not mentioned in this article. The purpose of this composition is not meant to be an exhaustive treatise of IRC Sec. 465, but rather to focus the reader’s attention on the at-risk rules as they pertain to partnerships and their partners. The article should serve as a foundation for more in-depth research as may be warranted in particular cases.
About the author: Richard Gardner is an enrolled agent and certified public accountant. He holds a Master’s in taxation and is admitted to practice before the United States tax Court. Gardner is a tax manager at the accounting firm of HoganTaylor LLP in Tulsa, Oklahoma, and also serves as one of two tech reviewers for the EA Journal. He can be reached at firstname.lastname@example.org .
1 IRC Sec. 465(c)(7)(A)(ii).
2 IRC Sec. 465(a)(1).
3 IRC Sec. 465(b)(1).
4 IRC Sec. 465(b)(2)(B).
5 IRC Sec. 465(b)(3).
6 As defined in Secs. 267(b) or 707(b)(1), but substituting ten percent for fifty percent.
7 Prop. Reg. Sec. 1.465-6(d).
8 Pritchett v. Commissioner, 827 F.2d 644 (9th Cir., 1987); Abramson v. Commissioner, 86 T.C. 360 (1986).
9 Hubert Enterprises, Inc. v. Commissioner, 125 T.C. 72 (2005); 230 Fed. Appx. 526 (6th Cir. 2007); TC Memo 2008-46.
10 IRC Sec. 465(c)(2)(A).
11 Reg. Sec. 1.465-1T.
12 IRC Sec. 465(c)(3)(B)(ii).
13 The Regulations do not specify how funds are to be allocated between activities.
14 Prop. Reg. § 1.465-38.
15 IRC Sec. 465(a)(2).
16 Prop. Reg. Sec. 1.465-2(b).
17 Prop. Reg. Sec. 1.465-3(a).
18 IRC Sec. 465(e).
19 IRC Sec. 465(e)(1)(B).
20 Committee Reports on P.L. 99-514 (Tax Reform Act of 1986).
21 Reg. Sec. 1.465-27(c).
22 Reg. Sec. 1.465-27(b)(1)(i).
23 Reg. Sec. 1.465-27(b)(1)(ii).
24 Reg. Sec. 1.465-27(b)(1)(iii).
25 Reg. Sec. 1.465-27(b)(1)(iv).
26 Reg. Sec. 1.465-27(b)(2)(i).
27 IRC Sec. 465(b)(6)(E)(i)
28 IRC Sec. 465(b)(6)(E)(ii)
29 Reg. Sec. 1.465-27(b)(2)(i).
30 IRC Sec. 465(b)(6).
31 Reg. Sec. 1.465-27(b)(3).
32 Reg. Sec. 1.465-27(b)(4).