Podcast Summary: How Tax Works

Episode 14: At Risk Limitations under IRC 465
Host: Matthew Foreman, Co-Chair, Falcon Rappaport & Berkman’s Taxation Practice Group
Date: December 9, 2024

Overview

This episode of "How Tax Works" explores the at risk loss limitations under Section 465 of the Internal Revenue Code (IRC). Host Matthew Foreman demystifies the concept of "at risk," breaks down the mechanics of loss deductions for partnerships and S Corporations, and clarifies how taxpayers can determine the amount they're truly "at risk" for tax deduction purposes. Using real-world scenarios and plain language, Matt aims to help listeners—lawyers, accountants, business owners—understand how at risk rules impact tax planning and loss utilization.

Key Discussion Points & Insights

1. Introduction to "At Risk" Rules

[02:05]

• The at risk limitations were established by Congress to prevent taxpayers from deducting losses for which they have no true economic exposure, particularly in instances involving non-recourse debt (where lenders can only claim the collateral, not personal assets).
• “If you're not really at risk for the money ... why can you deduct a loss?” — Matt Foreman [02:30]

2. Basis vs. At Risk: The Distinction

[04:20]

• Basis is considered before at risk in the ordering rules. A taxpayer may have basis in an asset (enough for a deduction) but not necessarily be at risk.
• Recourse debt (where the borrower is personally liable) is clearly at risk, while non-recourse debt generally is not.

“You can have non recourse debt to the partnership, but one of the partners may have given their own pledge ... it’s recourse to the partner and that’s what matters.”
— Matt Foreman [05:45]

3. Special Focus: Partnerships and S Corporations

[06:55]

• Partnerships: Common issue arises when non-recourse debt is used to buy equipment or real estate. Losses may be suspended if not at risk.
• S Corporations: Typically more limited by basis compared to partnerships. S Corps operate with "stock basis" and often have less available basis.

4. Activities Subject to §465

[11:07]

• Not every activity is covered. The catch-all provision applies to “any activity where the taxpayer carries on a trade or business for the production of income.”
• Investment vs. trade/business: Timing and context matter for deduction eligibility.

5. Computing the Amount At Risk

[12:45]

• Three core items:
  • Cash actually contributed.
  • Basis of property contributed (less depreciation).
  • Amount of recourse debt to the taxpayer.
• “That’s the amount at risk. Cash, basis of property, recourse debt. That’s what you’re looking for.” — Matt Foreman [13:05]

6. Qualified Non-Recourse Financing (QNRF)

[20:10]

• QNRF expands at risk basis in certain cases, primarily with real property.
• Requirements ([22:02]):
  1. Borrowed to hold real property (not personal property like tractors/cars).
  2. Lender cannot be the seller or a related person.
  3. Must be from a qualified person (usually a commercial lender, or government-guaranteed loan).
  4. No one is personally liable—must be non-recourse to every taxpayer.

"If anyone has to pay under any circumstances out of their own pocket, it is not qualified non recourse financing."
— Matt Foreman [23:15]

• QNRF allows all partners to increase at risk amounts, not just those individually guaranteeing the loan.
• The rule is largely a result of real estate industry lobbying.

7. Real-World Context and Policy Background

[27:50]

• Passive activity loss rules (IRC §469) and at risk rules (IRC §465) were “sledgehammers” enacted in response to widespread tax shelter abuses in the 1980s.
• Famous case: Jeb Bush’s old tax returns included now-disallowed passive losses.

“You have to be willing to take audit risk ... you have to put in time, you have to put in money. There’s some sort of real risk, and that’s the important thing.”
— Matt Foreman [29:23]

8. Other Means of Creating At Risk Amounts

[30:15]

• General Partners: Personally liable, thus at risk.
• Deficit Restoration Obligation (DRO): If a partner must repay negative capital accounts, it creates at risk amounts ([Hubert TC Memo 2008-46]).
• Qualified Income Offset: Usually does not create at risk amounts (merely recognizes income, not a true risk/liability).

9. Ordering Rules for Limitations

[39:10]

1. Basis limitation
2. At risk limitation
3. Passive activity loss limitation
4. Excess business loss (§461(l))

• The IRS tends to audit passive activity loss rules first, though at risk limitations are more mechanical and arguably should be tackled first.

10. Practical Advice: Documentation & Compliance

[41:05]

• Keep thorough documentation and workpapers to substantiate both basis and at risk computations.
• “If you don’t have [workpapers], they’re just going to disallow [your loss].” — Matt Foreman [42:10]
• QNRF is not a high bar—ensure the documentation meets the requirements.

Notable Quotes & Memorable Moments

• On At Risk vs. Basis
  “How can you have basis, right, but not at risk? ... Recourse debt, even if no, no basis is clearly at risk.”
  — Matt Foreman [04:45]

• On Qualified Non-Recourse Financing
  “Why does qualified non recourse financing exist? The answer is lobbying. Anyone who says, ‘Oh, it’s done for this reason.’ ... No, that’s nice. There’s a thousand industries that would like to have it.”
  — Matt Foreman [25:35]

• On Practical Compliance
  “You need to keep work papers, you need to keep your documents. And I think that's really important. Whenever you get an IDR … if you don’t have them, they're just going to disallow.”
  — Matt Foreman [42:10]

Timestamps for Important Segments

• Intro & Why At Risk Rules Matter – [00:00]–[04:00]
• Basis vs. At Risk: Mechanics – [04:00]–[07:30]
• Partnerships vs. S Corporations – [07:30]–[10:00]
• Which Activities Are Covered – [11:07]–[12:45]
• What Increases Amount At Risk – [12:45]–[15:00]
• Qualified Non-Recourse Financing: Rules & Examples – [20:10]–[28:40]
• Why QNRF Exists: Policy & History – [24:50]–[28:40]
• Deficit Restoration & Other At Risk Methods – [30:15]–[34:10]
• Ordering of Limitations & Audit Tips – [39:10]–[43:10]

Takeaways

• The at risk limitation restricts loss deductions to amounts for which a taxpayer has genuine economic exposure.
• Qualified non-recourse financing is a key (and narrowly available) tool for increasing at risk basis—especially in real estate.
• Documentation is vital—the IRS expects detailed workpapers supporting basis and at risk positions.
• These rules are nuanced and require careful planning and tracking, but they’re generally easier for real estate ventures to navigate thanks to special provisions rooted in industry lobbying.

Next Episode Teaser:
The next show will address tax issues in divorce, promising to tackle both common and “hidden” issues that tend to surprise clients and advisors alike.