Basis, At-Risk and Passive Loss Limitations: The Order and a Worked Example

For an individual partner or S corporation shareholder, the loss-limitation order is basis, at risk, passive activity, then excess business loss. Apply each test only to the amount allowed through the previous one. A loss suspended for insufficient basis does not also become a passive loss.

The example below follows a $60,000 partnership loss through $50,000 of basis, $30,000 at risk and $12,000 of available passive income. It shows why $12,000 is deductible under the stated assumptions and why the remaining amounts must be tracked as separate carryforwards.

The ordering follows IRS Publication 925. Use the rules and thresholds for the relevant tax year; the figures in this article are an educational example.

Why the order is the whole question

Test	What it asks	Computed on
1. Basis	Have you invested enough to have something to deduct against?	The owner's basis schedule; Form 7203 for an S corporation
2. At risk	Of that, how much could you actually lose?	Form 6198
3. Passive activity	Do you materially participate, and if not, is there passive income to absorb it?	Form 8582
4. Excess business loss	Across all your businesses, is the total above this year's threshold?	Form 461

Each test runs on what survived the one before. An item of deduction disallowed under the basis or at-risk limitations, Publication 925 says, "isn't a passive activity deduction for the tax year": a loss killed by basis never reaches Form 8582.

One fact pattern runs through what follows. An individual holds an interest in an equipment leasing partnership that is not publicly traded. Assume average customer use is seven days or less, so the activity is not classified as a rental activity for the passive activity rules. After the year's income, distributions and nondeductible expenses, her outside basis before losses is 50,000, of which 20,000 is her share of a nonrecourse bank loan. She works about 60 hours a year in the business and does not meet any material-participation test. She has 12,000 of net income from another non-PTP passive business activity, no other business income or losses, and is allocated an ordinary loss of 60,000.

First: basis, and what it lets through

A loss in excess of the owner's adjusted basis is not deductible. For a partner the figure is outside basis, which includes a share of partnership liabilities; for an S corporation shareholder it is stock basis and then basis in direct loans, and corporate debt never enters it. Both are set out in Partnership Basis vs S Corporation Basis.

Basis is adjusted in its own fixed order before the loss is applied: up for income including tax-exempt income, down for distributions, then for nondeductible expenses, then for losses. Apply the loss before the distribution and step one is wrong, along with every step after it.

In the example, 50,000 of the 60,000 clears this test and 10,000 is suspended.

Second: at risk, and what the owner could actually lose

Section 465 asks what the owner would lose if the activity failed tomorrow. You are at risk for money and the basis of property you contribute, and for amounts borrowed for the activity if you are personally liable or have pledged property not used in it. You are not at risk for nonrecourse financing, for amounts protected by a stop-loss or reimbursement arrangement, or for amounts borrowed from someone holding an interest in the activity.

The exception covers the commonest case. Qualified nonrecourse financing is at risk. Publication 925 defines it as financing for which nobody is personally liable, borrowed in connection with holding real property, secured by real property used in the activity, not convertible into an ownership interest, and lent or guaranteed by a government or borrowed from a qualified person, which means a bank rather than the seller, a related party or anyone earning a fee on your investment. So the flat claim that nonrecourse debt is never at risk fails in the setting where nonrecourse debt is most common, and a question that mortgages a rental building is usually testing that.

The partnership leases equipment, not real property, so the 20,000 nonrecourse share does not qualify. The amount at risk is 30,000: of the 50,000 that cleared basis, 30,000 clears this test and 20,000 is suspended. The figure moves both ways, and if a distribution drives it below zero the recapture rule adds the shortfall back to income.

Third: passive activity, and material participation

An activity is passive if it is a trade or business in which you do not materially participate, or a rental activity, which is passive whether or not you participate. A passive loss may be deducted only against passive income: not against salary, not against a business you run, and not against portfolio income, which Publication 925 defines as interest, dividends, annuities and royalties not earned in the ordinary course of a trade or business.

Material participation has seven tests and any one is enough. Three carry most of the questions: more than 500 hours in the activity; participation that was substantially all the participation by anyone; or more than 100 hours where nobody else, owner or not, participated more. The others turn on combined hours across significant participation activities, on material participation in five of the last ten years or in three prior years of a personal service activity, and on facts and circumstances, a test closed to anyone at 100 hours or less. A limited partner is generally treated as not materially participating unless the 500-hour, five-of-ten or personal service test is met.

Our partner does not meet any material-participation test, so this nonrental business activity is passive. The 30,000 that cleared the at-risk test is netted against her 12,000 of passive income. She deducts 12,000 and 18,000 is suspended. If she instead participated for more than 500 hours, this nonrental activity would not be passive and the 30,000 would pass this test, subject to the excess business loss limitation. Working 60 hours alone does not establish that an activity is passive.

The rental exceptions

Two routes out. An individual who actively participates in rental real estate, a lower standard met by decisions such as approving tenants and setting rental terms, may deduct up to 25,000 of the loss against nonpassive income; it falls by 50 cents per dollar of modified adjusted gross income above 100,000 and is gone at 150,000. A real estate professional, who performed more than half of their personal services, and more than 750 hours, in real property trades or businesses in which they materially participated, treats rental real estate in which they materially participate as nonpassive.

Those figures are worth memorising and the excess business loss threshold below is not. The Blueprint's section assumptions for REG and TCP both say candidates "will not be tested on their knowledge of specific tax rate percentages, amounts or limitations that are indexed to inflation." The 25,000 allowance and its phaseout are fixed in the statute, not indexed: the 1997 edition of Publication 925 prints the same three numbers as the current one.

Fourth: the excess business loss cap

The fourth test is the only one that does not look at a single activity. Section 461(l) aggregates every trade or business of a noncorporate taxpayer and disallows the excess of total business deductions over total business gross income and gains plus a threshold amount, indexed for inflation and doubled on a joint return. Income and deductions from services performed as an employee are excluded. The trade or business determination is made at the entity's level for a partnership or S corporation interest, but the limitation is computed on your own return, across everything you own. The One Big Beautiful Bill Act made the disallowance permanent in July 2025.

The mechanic matters more than the number. The disallowed amount is not suspended in the ordinary sense: it "is treated as a net operating loss (NOL) carryover for subsequent years," and a post-2017 NOL carries forward indefinitely, with no carryback outside farming, capped each year at 80% of taxable income computed before the NOL deduction.

In this example, the 12,000 loss allowed by the passive activity rules offsets the 12,000 of income from the other business activity. With no other business income or losses assumed, there is no excess business loss. Check all business income and deductions before concluding that this final limit does not apply.

What happens to the amounts each test suspends

The 60,000 has been split four ways: 12,000 deducted, 10,000 held at basis, 20,000 held at risk, 18,000 held passive. Each suspended amount is released by a different event.

Suspended by	Carried as	Released by
Basis	A suspended loss, carried forward indefinitely	Basis restored: allocated income, a contribution, or a larger share of liabilities
At risk	A deduction from the same activity next year	The amount at risk rising: income, a contribution, recourse borrowing, or gain on a sale
Passive activity	A prior-year unallowed loss of that activity	Passive income in a later year, or a fully taxable disposition of the entire interest
Excess business loss	A net operating loss carryover	Later taxable income, capped at 80% of it

The disposition rule is narrow, and the Blueprint makes it a task of its own. Publication 925 allows unallowed passive losses "in full in the tax year in which you dispose of your entire interest," but only in "a transaction in which all realized gain or loss is recognized" and where "the person acquiring the interest from you must not be related to you." Three conditions, each of which a question can fail on its own: sell part of the interest, exchange it without recognising gain, or sell it to a brother, and nothing is released.

Suspended at-risk losses do not follow that rule. Nothing frees them on a disposition as such; gain recognised on the disposition raises the amount at risk, so they become deductible to that extent and no further. Apply the passive disposition rule to an at-risk carryforward and you release too much.

How TCP and REG ask it

This is a TCP topic. In the Blueprint effective January 2026 the words "at risk" and "passive" appear on two pages of the whole document, both in TCP, and nowhere in FAR, AUD, REG, BAR or ISC.

TCP Area I, Tax Compliance and Planning for Individuals and Personal Financial Planning, carries 30 to 40% of the section, and content group B is "Compliance for passive activity and at-risk loss limitations (excluding tax credit implications)." The parenthesis is a real exclusion: passive activity credits and Form 8582-CR sit outside it.

Skill	Representative task
Application	Calculate the at-risk loss limitation, including losses from pass-through entities and from rental real estate with active participation
Application	Calculate the passive activity loss limitations, including the netting of passive gains and losses
Application	Calculate utilisation of suspended losses on the disposition of a passive activity
Analysis	Review basis schedules and supporting documentation for a pass-through entity to confirm the allocation of a loss between amounts suspended for at-risk limitations, suspended for passive rules, and allowed

The last is this article as a simulation: the marks are in noticing which document moves which test.

REG asks something narrower, and the wording gives it away. Area IV, Federal Taxation of Individuals, 22 to 32% of the section, has a content group called Loss limitations whose pass-through task is to "calculate the amount of ordinary business loss allowed for an individual materially participating in the operations of a pass-through entity with sufficient basis in the entity." Read the qualifiers. Materially participating switches off the third test; sufficient basis switches off the first. REG hands you the fact pattern in which only the computation is left; TCP is where the qualifiers come off.

This example concerns an individual pass-through owner. C corporations are outside the excess business loss limitation in section 461(l). The at-risk rules can apply to certain closely held C corporations. The passive activity rules apply to both closely held corporations and personal service corporations.

Where to practise this

Try the free TCP practice questions and explanations for a sample of the course’s tax material.

The difficulty is in the sequence, so this is learned by running fact patterns rather than reading rules. Prepito's TCP course covers the at-risk and passive limitations, suspended losses and dispositions with practice questions and simulations that show the split line by line; the REG course covers the basis computation it starts from.

See also the TCP study guide, the REG study guide and the CPA programme.

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Sources: IRS Publication 925, IRS, S Corporation Stock and Debt Basis, Partner's Instructions for Schedule K-1 (Form 1065), Instructions for Form 461, Instructions for Form 6198, AICPA CPA Exam Blueprints. The worked figures are illustrative; threshold amounts are indexed annually and the Blueprint is revised, so confirm both for your filing year and testing window.