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Basis is nice, but only 'at-risk' basis gives you a deductible loss

April 03, 2009

You have to have basis in your partnership or S corporation to deduct losses on your K-1. That's just your first hurdle. Your basis also has to be "at risk."

The at-risk rules were originally enacted to deal with the first wave of marketed tax shelters in the 1970s. They are overshadowed by the "passive loss" rules of 1986, but they were never repealed. In fact, your losses don't even get to the "passive loss" rules unless they are "at-risk." Losses that aren't at-risk are disallowed until they can offset future income from the activity, or until the taxpayer gets other "at-risk" basis.

What "at-risk" means

The at-risk rules arise from Code Section 465. In very simplified terms, they only let you deduct losses attributable to borrowed funds if you are on the hook for them. For example, should you borrow money to buy some cattle, and the bank can come after you personally for the funds if the loan isn't paid, you are likely "at-risk." If the bank's only recourse if you skip out on the loans is to repossess the animals, you aren't at-risk. The rules are quite complex; the tax law can treat loans from a related party, a promoter or your business partner as not at-risk, even if they can take everything you own if you default. Loans for which you are at-risk are typically called "recourse" loans; if you aren't at risk, the debt is "non-recourse."

So what does this have to do with your K-1? If your K-1 comes from an S corporation, not a lot. If you borrow money on a non-recourse basis to buy S corporation stock, you may have an at-risk rule problem, but nothing on your K-1 will tell you that.

Partnerships are different. A partner's basis includes his share of borrowings by the partnership. In contrast, corporate shareholders get no basis for borrowings incurred by the corporation with third parties, even if shareholders guarantee the debt.

Your partnership K-1 has a section to show you your share of partnership debt, and whether it is at-risk: Part II, Line K.

You can see that there is space for the "recourse" and "nonrecourse" liabilities of the partnership that we've mentioned. You'll also see a space for "qualified non-recourse filing." Nonrecourse debt that meets certain conditions - mostly secured real-estate debt from commercial lenders or government agencies - is "qualified nonrecourse financing" and is deemed to be "at-risk" under the tax law, even if it isn't in real life.

So when you are looking to see whether you have enough basis to deduct your partnership losses, you start with your "outside" basis, -- your investment, adjusted for income, losses, and distributions. You add your share of your line K liabilities in determining your total basis, but only the "recourse" and "qualified nonrecourse financing" lines to see whether you have enough "at-risk" basis to deduct your losses. The computations are done on Form 6198.

Tomorrow we continue our thrilling series on reading K-1s by by tying this together with an example.

This is another installment in our daily series of 2008 filing season tips running through April 15. Don't miss any!

Tags: at-risk rules.tip.