8006 / What losses will be disallowed by the at risk rules? May disallowed losses be carried over to other years?

“Loss” is given a special meaning for purposes of applying the at risk limitations. “At risk loss,” otherwise known as an IRC Section 465(d) loss, is the excess of the income tax deductions (including deductions normally accorded special treatment, such as tax preferences, short-term loss, long-term loss) attributable to the covered activity over the income received or accrued during the year from the activity. (Both deductions and income are determined without regard to the at risk provisions at this point.) Thus, otherwise allowable deductions may be taken freely against income generated by the activity regardless of the taxpayer’s amount at risk in the activity. The at risk provisions act only to deny a deduction when the taxpayer attempts to use a loss incurred in the covered activity to offset income received by the taxpayer from a separate source.¹

Planning Point: A Section 465(d) loss is determined without regard to the amount at risk.² Thus, even if the taxpayer has no amount at risk in the activity, deductions are allowable under Section 465 for a taxable year to the extent there is income from the activity in that taxable year.

Example: Before taking into account any gain or loss during the year, the amount that C, a calendar year taxpayer, is at risk in an activity described in IRC Section 465(c)(1) is equal to minus $20,000. During the year, C has deductions of $10,000 allocable to the activity and income of $15,000 from the activity. Because the income from the activity exceeds the amount of allocable deductions from the activity, there is no Section 465(d) loss in the year to be disallowed under Section 465(a). Thus, although C has a negative amount at risk, C is permitted to take deductions in the amount of $10,000 for the year.³

Losses disallowed because of the at risk rules may be carried forward indefinitely and deducted in future years to the extent that the activity produces net income for that year, or to the extent the taxpayer’s amount at risk has been increased by additional contributions, etc. to the activity.⁴ However, because “at risk loss” is made up of various deductions (including some normally accorded special tax treatment), the proposed regulations provide ordering rules that allocate the items of deductions between the current and carryover years. Items disallowed in the current tax year will retain their character when treated as deductions in succeeding years.⁵

The proposed regulations provide that when only a portion of “at risk loss” is allowed as a deduction for the tax year, the individual items of deduction making up the “at risk loss” will be allowed in the following order: (1) capital losses are allowed first; (2) all items entering into computation of “IRC Section 1231” property (see Q 7834) come next; (3) deductible items to the extent they are not tax preference items and are not described in (1) or (2) above follow; (4) all items of deduction that are tax preference items not allowed under (1) or (2) above come last. Furthermore, items of deduction described in (4), that are disallowed by reason of the at risk rules must be further subdivided according to the tax year in which they were originally paid or accrued; when such deductions are eventually allowed, those deductions paid or accrued earliest will be allowed first.⁶

Example: A, an individual calendar year taxpayer, is engaged in an activity described in IRC Section 465(a) (see Q 8004). At the close of 2023, A is at risk $1,000 in the activity. During 2024, A had $3,000 of income from the activity and $7,500 of deductions allocated to the activity. Of the $7,500 of the deductions, $2,500 are of the type described (3) and $5,000 are of the type described (4). Assuming nothing else has occurred during 2024 to affect A’s amount at risk, A will be allowed $4,000 of deductions and $3,500 of deductions will be disallowed. Since A has no deductions described in (1) or (2), the $4,000 of allowed deductions will consist of the entire $2,500 described in (3) and $1,500 of the $5,000 deductions described in (4). The $3,500 deductions disallowed will consist of deductions in (4).⁷