Partner Loss Limitations: Basis, At-Risk, and Passive Activity Rules

Your partnership or LLC had a bad year and your Schedule K-1 shows a loss. Plenty of people assume that number goes straight onto their Form 1040 and cuts their tax bill. Sometimes it does. Often it does not.

A partner's share of a loss has to get through a series of limitations before any of it is deductible. If you deduct a loss that should have been suspended, the IRS can disallow it years later, with interest and possibly penalties. If you never track the suspended amounts, you can lose deductions you were entitled to. Neither outcome is good.

The three gates, in order

The IRS's own instructions for the partner's Schedule K-1 (Form 1065) list the limitations that can apply to a partner's losses: the basis rules, the at-risk rules, the passive activity rules, and the excess business loss limitation. The order matters, and it is set by regulation.

Treas. Reg. 1.469-2T(d)(6)(i) says an item of deduction from a passive activity that is disallowed under IRC 704(d) (partner basis), IRC 1366(d) (S corporation shareholder basis), or IRC 465 (at-risk) is not a passive activity deduction for that year. So the sequence is:

1. Basis under IRC 704(d)
2. At-risk under IRC 465
3. Passive activity under IRC 469

A loss that is stopped at gate one never reaches gate two. A loss that clears all three may still run into the excess business loss limitation of IRC 461(l), which applies to noncorporate taxpayers and is beyond the scope of this page.

Gate one: your basis in the partnership

IRC 704(d)(1) allows a partner's distributive share of partnership loss only to the extent of the adjusted basis of the partner's interest at the end of the partnership year in which the loss occurred. Under IRC 704(d)(2), the excess carries forward and is allowed in a later year when basis is available.

How outside basis is built

Your basis in a partnership interest (often called outside basis) starts with what you paid or contributed, and IRC 705(a) adjusts it each year. It goes up by your share of partnership taxable income and tax-exempt income. It goes down, but not below zero, by distributions and by your share of losses and nondeductible expenses.

Partnership debt matters here in a way it does not for S corporations. Under IRC 752(a), an increase in your share of partnership liabilities is treated as a contribution of money by you, which increases basis. Under IRC 752(b), a decrease in your share of liabilities is treated as a distribution of money to you. Your share of liabilities is reported in Item K1 of your Schedule K-1.

Your capital account is not your basis

This is the most common mistake we see. Item L of the K-1 reports your capital account using the tax-basis method. The 2025 Instructions for Schedule K-1 (Form 1065) say that number may not equal your adjusted basis, largely because capital accounts do not include your share of partnership liabilities. The instructions say it plainly: you are responsible for maintaining an annual record of your adjusted tax basis, and they point to Treas. Reg. 1.705-1(a)(1), which requires a partner to determine basis when necessary to figure tax liability.

The instructions include a Worksheet for Adjusting the Basis of a Partner's Interest in the Partnership. Use it, and keep it every year. If you have an S corporation instead of a partnership, the parallel rules are in IRC 1366(d) and the form is Form 7203. See our guide to Form 7203 and S corp basis limitations.

Gate two: the at-risk rules

IRC 465(a) limits losses for individuals (and certain closely held C corporations) to the amount the taxpayer is "at risk" in the activity at the close of the year. Disallowed losses carry forward to the next year under IRC 465(a)(2).

Under IRC 465(b), you are generally at risk for:

• money and the adjusted basis of property you contribute to the activity, and
• amounts borrowed for the activity to the extent you are personally liable for repayment, or have pledged property not used in the activity as security.

You are not at risk for amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or similar arrangements, under IRC 465(b)(4). Amounts borrowed from a person with an interest in the activity, or from a related person, are also generally excluded under IRC 465(b)(3).

This is where basis and at-risk diverge. Nonrecourse partnership debt can increase your outside basis under IRC 752 but leave your at-risk amount unchanged. The big exception is for real estate: IRC 465(b)(6) treats a taxpayer as at risk for its share of "qualified nonrecourse financing" secured by real property used in an activity of holding real property. For partnerships, IRC 465(b)(6)(C) measures each partner's share under the IRC 752 liability rules.

At-risk recapture

The at-risk amount can go negative, for example when distributions or a change in debt reduce it after losses were deducted. IRC 465(e) then requires you to include the excess in income, limited to the losses previously deducted. That amount becomes a suspended deduction allocable to the activity for the next year.

The K-1 instructions say that if you have a loss from an activity and amounts for which you are not at risk, you generally must complete Form 6198, At-Risk Limitations.

Gate three: the passive activity rules

IRC 469(a) disallows the passive activity loss for individuals, estates, trusts, closely held C corporations, and personal service corporations. Under IRC 469(c), a passive activity is a trade or business in which you do not materially participate, and rental activity is generally passive.

IRC 469(h)(1) says you materially participate only if you are involved in the operations on a basis that is regular, continuous, and substantial. IRC 469(h)(2) adds that, except as provided in regulations, an interest as a limited partner is not treated as one in which you materially participate. Owners who invest in a business but do not work in it are usually passive.

What happens to passive losses

• They carry forward. IRC 469(b) treats a disallowed loss as a deduction allocable to the activity in the next year.
• They offset passive income. Passive losses can be used against income from other passive activities.
• They are released on a full disposition. IRC 469(g) allows suspended losses when you dispose of your entire interest in a fully taxable transaction, though a sale to a related party does not trigger the release until the interest is acquired by an unrelated person.
• The rental real estate allowance. IRC 469(i) lets a natural person who actively participates in rental real estate deduct up to $25,000 of passive losses from those activities, reduced by 50 percent of the amount by which adjusted gross income exceeds $100,000.

Passive losses are figured on Form 8582. Each activity's carryforward needs to be tracked separately.

Why this becomes an IRS problem

These limitations live on the partner's return, not the partnership's. The partnership reports your share of the loss, your liabilities, and your capital account. The partnership does not decide how much of the loss you can deduct. You do.

That creates exposure in a few predictable ways:

• Deducting losses with no basis computation at all, often by assuming the capital account equals basis.
• Counting nonrecourse debt for at-risk purposes when it does not qualify.
• Treating a business you do not work in as nonpassive.
• Losing track of suspended losses after a preparer change, then forgetting to claim them when the interest is sold.
• A late or amended K-1 that changes the loss after you filed. See what to do with an amended or late K-1.

Inconsistencies between your return and the partnership's K-1 can also generate IRS correspondence. Our guide to K-1 mismatch notices covers that. And if the partnership is under the BBA audit regime, you generally must report K-1 items consistently with the partnership return or disclose the difference on Form 8082, discussed in consistent reporting under Section 6222.

What to do if your loss history is a mess

• Rebuild outside basis year by year from the first K-1, using the basis worksheet in the K-1 instructions.
• Separate recourse, nonrecourse, and qualified nonrecourse debt using K-1 Item K1 to support the at-risk calculation.
• Document your participation in each activity for each year.
• Reconstruct each suspended loss by limitation type, because each one is released by a different event.
• If losses were overclaimed in open years, address it before an examiner does.

If the IRS is already questioning your partnership losses, the Law Offices of Darrin T. Mish, P.A. in Tampa can be reached at 813-229-7100.

The loss on your K-1 is a starting point. What you can actually deduct is a calculation you have to be able to prove.