At risk rules are tax laws limiting the amount of losses an investor (such as a limited partner) can claim. Only the amount actually at risk can be deducted.
Breaking Down At Risk Rules
Losses incurred from a business investment can be deducted to reduce the tax liability of an entity. For the losses to be deducted, the tax code stipulates that the investor must have risk in the investment. An investor that has no risk or limited risk in the business is limited in how much deduction he may claim on his return. For example, assume an individual invests $15,000 in a business that goes up in smoke after a couple of years. His risk in the investment, $15,000, can be recognized as a loss on his tax return. If the individual falls in the 24% ordinary income tax bracket at the federal level and 6% at the state level, then he can reduce his tax liability by (24% + 6%) x $15,000 = $4,500.
To ensure that losses claimed on returns are valid, at-risk rules were created and added to Section 465 of the Internal Revenue Code. At risk rules are special rules that prevent investors from writing off more than the amount they invested in a business, generally a flow-through entity. Businesses structured as flow-throughs include S corporations, partnerships, trusts, and estates. The at risk rules limit any deductions to the amount of money that the taxpayer had at risk at the end of the tax year in any activity for which the taxpayer was not a material participant.
A taxpayer can only deduct amounts up to the at risk limitations in any given tax year. Any unused portion of losses can be carried forward until the taxpayer has enough positive at risk income to allow the deduction. For example, assume an investor invests $15,000 in limited partnership units or LP units. The investor shares the profits or losses of the business pro-rata with other partners and owners, as is characteristic of investing in flow-through entities. Let’s assume the business goes downhill, and the investor’s share of the loss incurred is $19,000. Since he is only able to deduct his initial investment in the first year, he will have an excess loss which will be suspended and carried forward. His excess loss is his share in the limited partnership’s loss minus his initial investment, that is, $4,000. If he puts more money in the investment the following year, say $10,000, his at risk limit will be $6,000, because the suspended loss is subtracted from the additional investment.