CHAPTER 10
LIMITATIONS ON THE DEDUCTIBILITY OF
PARTNERSHIP LOSSES
THREE DEDUCTIBILITY LIMITATIONS

The deductibility of partnership losses passed
through to a partner is subject to three separate
limitations:
First, the loss may not exceed the partner’s tax basis
in the partnership interest-§704(d)
 Second, any losses surviving the tax basis limit are
subject to the at-risk limitation- §465
 Finally, losses may be disallowed under the passive
loss limitations - §469

DISALLOWED LOSSES ARE CARRIED
FORWARD

Carryforwards Under §704(d):
 Loss passed through to a partner in excess of tax
basis is carried forward indefinitely until the
partner obtains additional basis sufficient to allow
the deduction
 Carryforward losses unused as of the date of any
sale or disposition of the partnership interest are
lost (because they did not reduce the basis of the
interest, and therefore any gain/loss from the sale
is already reduced/increased by the amount of the
carryforward)


Do not carry over to the transferee
Do not explicitly offset the gain or increase the loss recognized
DISALLOWED LOSSES ARE CARRIED
FORWARD (CONT.)

Carryforwards Under §465
Losses disallowed under the at-risk rules are carried
forward indefinitely just as are those denied under
tax basis limitation
 A partner’s tax basis in her partnership interest is
reduced by losses even if they are disallowed under
the at-risk rules

DISALLOWED LOSSES ARE CARRIED
FORWARD (CONT.)

Carryforwards Under §465

When a partner sells her interest in the partnership,
losses carried forward under the at-risk limitation
are deductible in full regardless of the amount of gain
or loss recognized by the partner/member on the
transaction

Losses carried forward under the tax basis limitation are
not deductible on sale of a partnership interest
DISALLOWED LOSSES ARE CARRIED
FORWARD (CONT.)

Carryforwards Under §469
For individuals, losses from passive activities are
only deductible to the extent of income from other
passive activities
 Losses disallowed under the passive loss limitations
are carried forward indefinitely until the partnership
has sufficient passive income from other sources to
absorb the carryforward

DISALLOWED LOSSES ARE CARRIED
FORWARD (CONT.)

Carryforwards Under §469

If the partner completely disposes of the partnership
interest, any passive loss carryforward is deductible
in full in the year of disposition
THE BASIS LIMITATIONS UNDER §704(D)

Losses Cannot Exceed Tax Basis

•
A partner cannot deduct partnership losses that
exceed the tax basis of the partnership interest
Accounting for Debt

A partner’s risk of loss in a partnership interest
includes not only direct investment made in the
partnership interest, but also includes debt which the
partner is obligated to pay in future
THE BASIS LIMITATIONS UNDER §704(D)
(CONT. )

Nonrecourse Debt
 Definition: debt for which the borrower has no
individual responsibility to repay the lender,
and for which the lender solely looks to the
property serving as collateral for the debt in
the event of default
 If the loan is a legitimate economic liability, it
will be included in the borrower’s tax basis for
the property

A nonrecourse debt is considered legitimate if it was
borrowed from an unrelated lender, or if the borrower can
demonstrate that the FMV the property exceeded the
principal balance of the loan at the time the loan was made
AT-RISK RULES OF §465

Under §465, a taxpayer may not claim deductions
for losses in excess of the amount that the
taxpayer actually has “at risk” with respect to the
activity generating the losses

§465 applies to individuals and closely held
corporations only
AT-RISK RULES OF §465 (CONT.)

A taxpayer’s amount at risk is computed in the
same manner as is tax basis except that it
excludes nonqualified nonrecourse debt

A qualified nonrecourse debt is one which:
Is borrowed for the activity of holding real property (very
broadly defined), and is secured by that property
 Is borrowed from a lender who is in the business of lending
money and who has no interest in the activity for which the
money is borrowed, other than as a creditor
 Is not convertible into stock or other securities

PASSIVE LOSS LIMITATIONS OF §469

General

Deductions for net losses (income minus losses) from
“passive” activities are not allowed


Passive loss is loss realized from rental activities and loss
“allocated” to nonparticipatory partners (i.e., limited
partners) in partnership activities
Disallowed losses are carried forward and can be
deducted only against net passive income in future
years or when the taxpayer fully disposes of the
interest in the passive activity
PASSIVE LOSS LIMITATIONS OF §469
(CONT.)

The passive loss limitation is applied after
application of the at-risk loss limitation
CLASSIFICATION OF INCOME
UNDER §469

General

Passive activity income includes all income from
passive activities, including gain from disposition of
an interest in a passive activity or from disposition of
property used in a passive activity
CLASSIFICATION OF INCOME
UNDER §469 (CONT.)

Gain from Sale of an Interest in a Partnership

If the partnership was engaged in a passive activity,
any gain or loss recognized on the sale or disposition
of the partner’s interest in the entity will be classified
as passive gain or loss
CLASSIFICATION OF INCOME
UNDER §469 (CONT.)

Gain from Sale of an Interest in a Partnership

If the partnership is engaged in more than one
activity (e.g., a passive activity and a portfolio
activity) in one entity, the gain or loss must be
allocated between the activities based on the relative
gain or loss which would have been recognized if the
entity had sold its entire interest in each of its
activities just prior to the partner’s disposition of the
partnership interest
TAXPAYERS TO WHOM §469 APPLIES

The passive loss rules apply only to individuals,
certain trusts and estates, personal service
corporations and closely-held corporations

Unlike individuals, closely held corporations are
allowed to deduct net passive losses against active
income and offset the tax attributable to net active
income with passive activity credits

However, closely held corporations cannot offset portfolio
income with net passive losses
PASSIVE ACTIVITIES DEFINED
Definition: A passive activity is one in which the
taxpayer does not “materially participate” during
the taxable year
 Most rental activities are deemed to be passive
regardless of the taxpayer’s level of participation


A significant exception: for taxpayers who are
engaged primarily in the real estate business
PASSIVE ACTIVITIES DEFINED (CONT.)

Limited Partners
Limited partners generally are not treated as
material participants
 However, if the limited partner (or LLC member
treated as a limited partner) satisfies the
requirements of tests (1), (5), or (6) above, the partner
can be treated as a material participant

PASSIVE ACTIVITIES DEFINED (CONT.)

Rental Activities

§469 automatically classifies most rental activities as
passive activities, regardless of the taxpayer’s level of
participation
For this purpose, a rental activity is one involving the longterm rental of property and for which the taxpayer does not
provide substantial additional services
 Short term rental activities where substantial personal
services in connection with the rental are required (e.g.
operation of hotel) do not constitute a passive activity

PASSIVE ACTIVITIES DEFINED (CONT.)

Rental Activities

Exceptions to passive treatment:
1.
2.
3.
The average period of customer use of the property is
seven days or less (e.g., hotels, motels, short-term
equipment or vehicle rentals, etc.)
The average period of customer use of the property is
30 days or less and significant personal services are
provided with the rentals
Extraordinary personal services are provided by or on
behalf of the owner(s) of the property in making such
property available for customer use
PASSIVE ACTIVITIES DEFINED (CONT.)
4.
5.
6.
The rental is incidental to a non-rental activity
The rental property is customarily made available
during defined business hours for nonexclusive use by
various customers (e.g., health clubs)
The property is provided for use in a non-rental activity
in the owner’s capacity as an owner of an interest in a
partnership, S corporation, or joint venture conducting
that activity
PASSIVE ACTIVITIES DEFINED (CONT.)

Real Estate Professionals
Taxpayers in the “real property business” are not
subject to the passive loss restrictions
 A taxpayer is in the real property business if he/she:

Spends more than half of his/her time in real property
businesses in which he/she materially participates; and
 Performs more than 750 hours of services during the
taxable year in real property trades or businesses in which
he or she materially participates

PASSIVE ACTIVITIES DEFINED (CONT.)

Exemption for Real Estate Rental Activities in
which Taxpayer “Actively” Participates

For taxpayers who “actively participate in the
management of rental property, the first $25,000 of
net losses generated by such property are exempted
from Code Sec. 469
First, the losses are still passive losses, while not subject to
the passive loss limitations
 Second, the exemption applies only if the taxpayer
“actively” participates in management of the property

PASSIVE ACTIVITIES DEFINED (CONT.)

Exemption for Real Estate Rental Activities in
which Taxpayer “Actively” Participates (Cont.)

Active participation requires the following:
The taxpayer must have at least a 10% interest in the
rental activity
 The taxpayer must not own the interest as a limited
partner, and
 The taxpayer must participate in the activity in a
significant and bona fide manner (participate in
management decisions)

PASSIVE ACTIVITIES DEFINED (CONT.)

Exemption for Real Estate Rental Activities in
which Taxpayer “Actively” Participates (Cont.)
The exemption amount is reduced by 50 cents for
each dollar that the taxpayer’s “modified AGI”
exceeds $100,000
 Modified AGI is regular AGI, computed without
regard to various items, including taxable social
security, deductible IRA contributions, passive
activity income or loss, and one-half of selfemployment taxes

ACTIVITIES THAT ARE NOT PASSIVE
ACTIVITIES

Five categories of trade or business activities are
not treated as passive activities
Trade or business activities in which the taxpayer
materially participated for the tax year
 A working interest in an oil or gas well held by the
taxpayer directly or through an entity that does not
limit liability
 Rental of a vacation home

ACTIVITIES THAT ARE NOT PASSIVE
ACTIVITIES (CONT.)

Five categories of trade or business activities are
not treated as passive activities (Cont.)
Trading activities involving personal property traded
for the account of those who own interests in the
activity
 Rental real estate activities of real estate
professionals

OPERATING RULES

Calculation and Use of Carryforwards
First, total all income from passive activities
 Then, total all losses from passive activities
 If the total loss exceeds the total income, the
taxpayer has a net passive loss, which is disallowed
unless subject to the rules related to the taxpayer’s
active participation rental activities

OPERATING RULES (CONT.)

Calculation and Use of Carryforwards
The taxpayer then allocates the disallowed passive
loss back to the passive activities which generated
the loss (based on the relative amounts of the losses
they generated)
 These losses carry forward indefinitely, and can be
deducted if the taxpayer either earns net passive
income in a subsequent year or disposes of the entire
interest in the passive activity to which the loss has
been allocated

OPERATING RULES (CONT.)

Calculation and Use of Carryforwards

Under §469, the loss carryforward from a disposed
activity is applied against passive income from other
passive activities first, and any excess loss is then
characterized as loss from non-passive activities

However, passive loss carryovers from other passive
activities are applied against passive income from such
activities before application of the carryover from the
disposed activity. This tends to leave more of the loss from
the disposed activity to be treated as non-passive.