Understanding Loss Limitations on Individual Returns
When a taxpayer owns a business or investment activity that reports a loss, not all of that loss may be currently deductible. The Internal Revenue Code applies several limitation layers to determine whether and how much of a loss can be used. Understanding these limits—basis, at-risk, passive activity, and excess business losses—helps business owners plan and avoid surprises at tax time.
1. Basis Limitation — IRC §704(d) and §1366(d)
The basis limitation is the first hurdle. A partner or S corporation shareholder may deduct losses only up to their basis in the entity. Basis generally includes capital contributed, income retained in the entity, and debt personally guaranteed. If your basis is exhausted, the excess loss is suspended until you add more capital or the entity earns income in a later year.
2. At-Risk Limitation — IRC §465
Even if you have basis, you can deduct losses only to the extent you are financially at risk. The at-risk rules prevent taxpayers from deducting losses funded by nonrecourse debt or other amounts they are not personally liable to repay. At-risk limitations are applied separately for each activity. Any disallowed loss carries forward until your at-risk amount increases.
3. Passive Activity Loss Limitation — IRC §469
The passive activity rules divide income and losses into “passive” and “non-passive” categories. Generally, income from activities in which you do not materially participate is passive. Losses from these activities can offset only passive income, not wages or business income from active operations. Unused passive losses are suspended and can be released when you dispose of the activity in a taxable transaction.
- Material participation means regular, continuous, and substantial involvement.
- Common passive activities include rental real estate and limited partnerships.
- Real estate professionals may qualify for exceptions under §469(c)(7).
4. Excess Business Loss Limitation — IRC §461(l)
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Bringing It Together
In order, the rules apply as follows:
- First, check your basis — you cannot deduct more than you’ve invested or are owed back.
- Then, apply the at-risk rules to exclude losses you aren’t personally exposed to.
- Next, determine if the activity is passive — suspended losses may carry forward.
- Finally, consider the excess business loss cap to limit large net deductions in a single year.
These layers can create frustration for taxpayers who “lose” deductions temporarily, but they’re designed to align loss recognition with real economic exposure. With proper entity structure and planning, many business owners can manage timing differences and eventually realize the full benefit of their losses.