At-risk and passive activity loss limits

Where this sits on the exam

Blueprint Area I.B (excluding credits) is computational: calculate the at-risk limit, the passive activity loss limit and the losses freed on a disposition, and review a client's basis schedules to see how much of a pass-through loss is allowed and where the rest is suspended. Expect K-1s and schedules in task-based simulations.

Four gates, in order

A loss from a business or rental activity must pass four gates, in this order (Publication 925; Instructions for Form 461):

Order	Limit	What it measures	Where a disallowed loss goes
1	Basis (partner IRC §704(d); S shareholder IRC §1366(d))	the owner's tax investment in the entity	suspended until basis is restored
2	At risk (IRC §465; Form 6198)	the owner's economic exposure in the activity	suspended until the amount at risk increases
3	Passive activity (IRC §469; Form 8582)	whether the owner materially participates	suspended until passive income or a disposition
4	Excess business loss (IRC §461(l); Form 461)	whether net business losses exceed a threshold	becomes a net operating loss carryforward

A loss suspended at an earlier gate never reaches the later ones that year. Each suspended amount carries forward with its label, so in a later year it re-enters at the gate that stopped it.

Gate 2: amounts at risk

The at-risk rules apply to individuals (and closely held C corporations) in almost any business or income-producing activity. A taxpayer is at risk for (Publication 925; IRC §465(b)):

• money and the adjusted basis of property contributed;
• amounts borrowed for the activity for which the taxpayer is personally liable, or that are secured by property not used in the activity;
• for an activity of holding real property, qualified nonrecourse financing: nonrecourse debt from a bank or similar commercial lender (or a government), secured by the real property;
• plus income from the activity, less losses allowed and withdrawals.

Not at risk: ordinary nonrecourse debt, amounts protected by guarantees or stop-loss arrangements, and amounts borrowed from someone with an interest in the activity (other than as a creditor) or related to such a person.

If distributions or a debt conversion push the amount at risk below zero, losses previously allowed are recaptured into income to that extent (IRC §465(e)).

Gate 3: passive activities

A passive activity is a trade or business in which the taxpayer does not materially participate, or any rental activity (with exceptions) (IRC §469(c)). Passive losses offset only passive income; the excess is suspended (IRC §469(a), (b)). Portfolio income (interest, dividends, gains on investments) and wages are not passive income.

Material participation. A taxpayer materially participates if any one of seven tests is met, including: more than 500 hours in the activity during the year; substantially all the participation in the activity; more than 100 hours and not less than anyone else; material participation in 5 of the last 10 years; or, for a personal service activity, in any 3 prior years (Temp. Treas. Reg. §1.469-5T(a); Publication 925). A spouse's participation counts. A limited partner generally materially participates only through the 500-hour, 5-of-10 or 3-prior-years tests.

Rental real estate: the $25,000 allowance. An individual who actively participates (owns at least 10% and makes management decisions such as approving tenants and expenditures) may deduct up to $25,000 of rental real estate losses against nonpassive income. The allowance is reduced by 50% of modified AGI over $100,000, so it disappears at $150,000 (IRC §469(i); Publication 925). These amounts are fixed in the statute, not indexed. Married filing separately: $12,500 if the spouses lived apart all year, otherwise nothing.

Real estate professionals. If more than half of a taxpayer's personal services are in real property trades or businesses in which the taxpayer materially participates, and those services exceed 750 hours, the taxpayer's rental real estate activities in which the taxpayer materially participates are not passive (IRC §469(c)(7); Publication 925).

Example. Lee, single, MAGI $120,000, actively participates in a rental house that loses $20,000 in 2026; she has no passive income.

Step	Computation	Amount
Phase-out	50% × ($120,000 − $100,000)	$10,000
Allowance	$25,000 − $10,000	$15,000
Loss deducted against wages	lesser of $20,000 or $15,000	$15,000
Suspended passive loss	$20,000 − $15,000	$5,000

Netting. Passive income and losses from all activities are netted first; the rental allowance applies to any remaining net loss from actively managed rental real estate. Disallowed losses are allocated among the loss activities in proportion to their losses (Instructions for Form 8582), which matters later, when one activity is sold.

Gate 4: the excess business loss

After the first three gates, a noncorporate taxpayer's total business deductions may exceed total business income and gains by no more than a threshold: $313,000 ($626,000 joint) for 2025 and $256,000 ($512,000 joint) for 2026 (Rev. Proc. 2024-40, section 2.32; Rev. Proc. 2025-32, section 4.31). The excess becomes a net operating loss carryforward. Employee wages are left out of the computation (Instructions for Form 461). Public Law 119-21 §70601 made this limit permanent and reset its inflation base, which is why the 2026 threshold is lower than 2025's.

Putting the gates together: a K-1 review

Dana, single, is a limited partner in Harbor LLC (taxed as a partnership), a business in which she does not materially participate. Her 2026 K-1 shows a $30,000 ordinary loss. Her basis schedule, before the loss, shows:

Item	Amount
Cash contributed, net of prior losses and distributions	$14,000
Share of the LLC's nonrecourse debt (from an equipment seller, not qualified nonrecourse financing)	$8,000
Outside basis	$22,000
Amount at risk (the debt is nonrecourse and not qualified)	$14,000

She also has $5,000 of net income from another passive activity.

Gate	Loss arriving	Allowed through	Suspended here
1. Basis $22,000	$30,000	$22,000	$8,000 (§704(d))
2. At risk $14,000	$22,000	$14,000	$8,000 (§465)
3. Passive: $5,000 of passive income	$14,000	$5,000	$9,000 (§469)
4. Excess business loss	$5,000	$5,000	none

Only $5,000 is deductible in 2026. Her basis is reduced by the $22,000 that cleared gate 1 (to $0), and her amount at risk by the $14,000 that cleared gate 2 (to $0). The three suspended pieces, $8,000 basis, $8,000 at-risk and $9,000 passive, carry forward separately. A reviewer checks that the K-1 debt classification (recourse, qualified nonrecourse or other nonrecourse) matches the loan documents, because that single fact moves $8,000 between "at risk" and "not at risk".

Freeing suspended passive losses

Fully taxable disposition of the entire interest to an unrelated person. All suspended and current losses from that activity are allowed in full, first against income or gain from the activity, then against other passive income, then against nonpassive income (IRC §469(g)(1); Publication 925).

Example. Omar sells his entire interest in a passive rental activity to an unrelated buyer in 2026 for a $7,000 gain. The activity has $18,000 of suspended losses and a $2,000 current-year loss. All $20,000 of losses is deductible in 2026; his gain is taxed under the normal rules. If the suspended losses were also at-risk or basis-limited, those limits must be satisfied first.

Disposition	Treatment of suspended passive losses
Sale to an unrelated person, entire interest, gain or loss recognized	all allowed in the year of sale
Sale to a related party	stay suspended until the related party disposes of it to an unrelated person
Gift	never deductible; added to the donee's basis
Death	allowed on the final return only to the extent they exceed the step-up in basis
Installment sale	allowed each year in the ratio of gain recognized that year to total gain
Sale of part of an interest	not freed; losses wait for a complete disposition

Source: Publication 925, Dispositions. Example of the death rule: suspended losses $8,000, basis step-up $6,000, deduction on the final return $2,000.

Traps

• Basis comes first. A loss in excess of basis never reaches the at-risk computation.
• Nonrecourse seller financing is in basis but not at risk; qualified nonrecourse financing for real estate is both.
• Active participation (for the $25,000 allowance) is a lower bar than material participation, but it requires at least a 10% interest; limited partners generally cannot actively participate.
• The $25,000 allowance phases out using MAGI before passive losses; the thresholds are fixed, not indexed.
• Losses freed by a disposition are not passive, but a capital loss on the sale itself is still subject to the capital loss limits.
• A disposition to a family member or a controlled entity does not free anything.

Check yourself

• Why does Dana's $8,000 of seller-financed debt help at gate 1 but not at gate 2?
• With MAGI of $136,000, how much of an actively managed rental loss of $30,000 can be deducted?
• Which of the seven material participation tests can a limited partner use?
• What happens to suspended passive losses when the owner gives the activity to a child?
• After the first three gates, how does the 2026 excess business loss limit treat a disallowed amount?