8693 / What rules apply in determining a taxpayer’s amount “at risk” when the taxpayer has borrowed the funds that have contributed to the activity?

In general, if an individual borrows the money contributed to an activity (or, in the case of a limited partnership, the money with which the interest is purchased), the individual is “at risk” only to the extent the individual is personally liable to repay such amounts, or to the extent property is pledged that is not otherwise used in the activity as security for the loan.¹

If the individual borrowed funds to purchase the property contributed to the activity, the individual is “at risk” with respect to such property only to the extent that the individual would have been “at risk” had the borrowed funds themselves been contributed instead of the purchased property.²

If an individual is personally liable for amounts borrowed in the conduct of the activity, the individual is “at risk” to the extent of such amounts even if property used in the activity is also pledged as security for such amounts.³ The fact that the partnership or other partners are in the chain of liability does not reduce the amount a partner is “at risk” if the partner bears ultimate responsibility.⁴

If the individual is initially personally liable for the borrowed amounts (i.e., as in recourse liabilities), but after the occurrence of some event or lapse of a period of time the liability will become nonrecourse, the individual is considered “at risk” during the period of recourse liability if both of the following are true:

(a)  the borrowing arrangement was motivated primarily for business reasons and not tax avoidance; and

(b)  the arrangement is consistent with the normal commercial practice of financing the activity for which the money was borrowed.⁵

If amounts are borrowed for use in the activity and the individual is not personally liable for repaying those amounts, but the individual pledges property that is not used in the activity as security for repayment, the individual is “at risk” only to the extent that the amount of the liability does not exceed the fair market value of the pledged property. If the fair market value of the security changes after the loan is made, the taxpayer must redetermine the amount at risk using the new fair market value.⁶

Property cannot be treated as security if such property itself is financed (directly or indirectly) by loans secured with property contributed to the activity.⁷

Even if an individual is personally liable or has pledged security for borrowed funds, borrowed amounts cannot (unless it is eventually provided in future regulations) be considered at risk (1) if they are borrowed from a person who has an interest (other than as a creditor) in the activity, or (2) if they are borrowed from a person who is related to another person (other than the taxpayer) having an interest in the activity.⁸

For this purpose, a “related” person includes the following: (1) members of a family (i.e., an individual and brothers, sisters, spouse, ancestors, and lineal descendants); (2) a partnership and any partner owning, directly or indirectly, 10 percent of the capital or profits interests in such partnership; (3) two partnerships in which the same persons own, directly or indirectly, more than 10 percent of the capital or profits interest; (4) an individual and a corporation in which such individual owns, directly or indirectly, more than 10 percent in value of the outstanding stock; (5) two corporations that are members of the same controlled group; (6) a grantor and a fiduciary of the same trust; (7) fiduciaries of trusts that have a common grantor; (8) a fiduciary of a trust and the beneficiaries of that trust, or beneficiaries of another trust if both trusts have the same grantor; (9) a fiduciary of a trust and a corporation if more than 10 percent in value of outstanding stock is owned, directly or indirectly, by the trust or by the grantor of the trust; (10) a person and a tax-exempt organization controlled by such person or family of such person; (11) a corporation and a partnership in which the same person owns a more-than-10 percent interest (by value of stock in the case of the corporation and by capital or profits interest in the case of the partnership); (12) two or more S corporations if more than 10 percent of the stock (by value) of each is owned by the same person; (13) an S corporation and a C corporation if more than 10 percent of the stock (by value) is owned by the same person; and (14) an executor of an estate and a beneficiary of such estate (except in the case of a sale or exchange in satisfaction of a pecuniary bequest).⁹

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Planning Point: Money borrowed to finance a contribution to an activity cannot increase the amount at risk by the contribution and by the amount borrowed to finance the contribution. The amount at risk may be increased only once.¹⁰

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See Q 8694 for the rules that apply when a taxpayer has obtained “qualified” nonrecourse financing with respect to an activity involving real property.