What Section 465 does
Section 465 of the Internal Revenue Code limits deductible losses from a business or investment activity to the amount the taxpayer has at risk in that activity. You are at risk for: cash you invested, the fair market value of property you contributed, and recourse debt for which you are personally liable. If you invest $50,000 and borrow $200,000 on a recourse loan (you personally guarantee the debt), your at-risk amount is $250,000 — and losses up to that amount are potentially deductible (subject also to passive-activity rules). Losses exceeding your at-risk amount are suspended until you increase your at-risk basis.
The concern for real estate: most income-producing real estate is financed with non-recourse debt — the lender can foreclose on the property but cannot come after you personally. Under general at-risk rules, non-recourse debt does NOT count as at risk, which would dramatically limit deductible losses for most leveraged investors.
The qualified non-recourse financing exception
Congress created a critical exception in Section 465(b)(6): qualified non-recourse financing for real property counts as at risk. To qualify, the loan must: (1) be secured by real property used in the activity; (2) be borrowed from a qualified person — a commercial lender acting at arm's length (bank, S&L, insurance company, pension fund), not the seller, promoter, or a related party; (3) no person is personally liable for repayment other than through the real property collateral.
A standard commercial mortgage from a bank — even a non-recourse one — satisfies all three conditions. This is why the at-risk rules are rarely a binding constraint for investors using conventional bank financing.
When the at-risk rules do bite
The at-risk rules become a real obstacle when financing comes from a seller, a related party, or a promoter — situations where the economic risk is different from a conventional bank loan. Non-recourse seller financing, credit-enhanced debt structures where a third party guarantees repayment, or equity contributions with guaranteed returns can all fail the qualified non-recourse exception, leaving those amounts off the at-risk base and suspending losses. Always analyze both the at-risk rules and the passive activity rules when evaluating a leveraged real estate investment.
Frequently asked questions
Do the at-risk rules prevent deducting losses from a rental with a regular bank mortgage?
Generally no. Qualified non-recourse financing from a bank or institutional lender counts as at risk under Section 465(b)(6), so most conventionally financed rentals are unaffected by the at-risk limitation.
What is qualified non-recourse financing?
A loan from an arm's-length qualified lender (a bank or similar institution) secured by real property used in the activity, where no one is personally liable beyond the collateral. These loans count as at risk for real property activities.
How do the at-risk rules and passive activity rules interact?
They are two separate limitations applied in sequence: a loss must first survive the at-risk test, and then must satisfy the passive-activity rules to be currently deductible. You must pass both.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.