Welcome to Loss Limitations!

In the world of taxes, everyone loves a "deduction" because it lowers the amount of income you have to pay tax on. However, the IRS is very careful about letting people use business losses to wipe out their other income (like their salary). Think of Loss Limitations as a series of four "security checkpoints." To deduct a loss on your tax return, the loss must successfully pass through each gate in a specific order. If it gets stopped at Gate 1, it doesn't even get to try Gate 2!

Don't worry if this seems like a lot of rules at first. We are going to break down these four hurdles step-by-step so you can master them for the REG exam.

The Four Hurdles (In Order!)

To deduct a loss from a partnership, S-corporation, or a business activity, the loss must clear these hurdles in this exact order:

  1. Tax Basis Limitation
  2. At-Risk Limitation
  3. Passive Activity Loss Limitation
  4. Excess Business Loss Limitation

Memory Trick: Just remember "T-A-P-E" (Tax Basis, At-Risk, Passive, Excess). You have to "tape" your losses together before you can use them!


Hurdle 1: Tax Basis Limitation

The first rule is simple: You cannot deduct a loss that is greater than your "investment" in the activity. Your Tax Basis represents how much "skin in the game" you have from a tax perspective.

Apply loss limits in sequence: tax basis, at-risk amount, passive-activity rules, then other applicable individual limits such as excess business loss. Passing one limit does not establish deductibility under the others. Track each suspended-loss category separately.

Apply loss limits in sequence: tax basis, at-risk amount, passive-activity rules, then other applicable individual limits such as excess business loss. Passing one limit does not establish deductibility under the others. Track each suspended-loss category separately.

Quick Note: For partnerships, "Basis" includes your share of partnership debt. For S-Corps, "Basis" does not include bank loans made to the corporation—only loans you personally made to the S-Corp.


Hurdle 2: At-Risk Limitation

Even if you have enough Tax Basis, you might get stopped at the At-Risk hurdle. This rule asks: "If this business goes bankrupt tomorrow, how much money would you actually lose out of your own pocket?"

At-risk amounts generally include contributed cash and adjusted property basis and eligible personally liable borrowing, subject to loss-protection and related-lender restrictions. Ordinary nonrecourse debt generally does not count. Qualified nonrecourse financing under section 465(b)(6) can count for an activity holding real property when secured by real property, borrowed from a qualified person or government (or government-guaranteed), and satisfying the statutory nonliability and nonconvertibility conditions. Not every real-estate bank loan qualifies.

Losses disallowed by the at-risk limit generally carry forward until sufficient at-risk amount is available. They must still pass passive-activity and other applicable limits when released. Track them separately from basis-suspended and PAL-suspended losses.


Hurdle 3: Passive Activity Loss (PAL) Limitation

This is a big one for the CPA exam! The IRS divides income into three "buckets":

  1. Active Income: Wages, salary, bonuses, and profits from businesses you actively manage.
  2. Portfolio Income: Interest, dividends, and capital gains from stocks/bonds.
  3. Passive Income: Income from business activities in which you do not materially participate, and most rental activities.

Passive losses generally offset passive income, not wages or portfolio dividends/interest. Exceptions include the qualifying rental-real-estate allowance and release on a qualifying disposition. Publicly traded partnerships are generally tested separately, so a suspended PTP loss cannot simply offset income from a different PTP or ordinary passive activity. Unused PALs generally carry forward.

Passive losses generally offset passive income, not wages or portfolio dividends/interest. Exceptions include the qualifying rental-real-estate allowance and release on a qualifying disposition. Publicly traded partnerships are generally tested separately, so a suspended PTP loss cannot simply offset income from a different PTP or ordinary passive activity. Unused PALs generally carry forward.

What is Material Participation?

Material participation can be established under any applicable regulatory test; more than 500 hours is one test, not the only one. Other tests have their own conditions. Rental activities and limited-partner interests have special rules; working more than 500 hours does not alone override the rental rules.

Two Special Exceptions to the PAL Rules

For an eligible individual actively participating in rental real estate and owning at least 10%, the special allowance is generally up to $25,000, reduced by 50% of modified AGI above $100,000 and eliminated at $150,000. For MFS living apart all year, the allowance and thresholds are halved; MFS living with the spouse during the year generally gets none. Use statutory modified AGI, not ordinary AGI. Basis, at-risk and other limits still apply.

Real-estate-professional status requires both more than half of personal services and MORE THAN 750 hours in real-property trades or businesses in which the taxpayer materially participates. Employee services generally count only for a more-than-5% owner. Rental activity is nonpassive only if the professional also materially participates in that rental (or validly grouped rental activity). Basis, at-risk and other applicable loss limits remain: professional status does not allow unlimited deductions.

What happens to Suspended PALs?

Suspended PALs are generally released on disposition of the entire interest to an unrelated party in a fully taxable transaction recognizing all realized gain or loss. A related-party sale, gift, partial disposal, death or installment sale can have different rules. Released losses may offset nonpassive income, but their tax character and other applicable limits remain.


Hurdle 4: Excess Business Loss (EBL) Limitation

This is the final checkpoint. Even if you pass the first three rules, there is a "max cap" on how much total business loss an individual can take in a single year. This rule was created to prevent very wealthy taxpayers from using massive business losses to pay zero tax on their other income.

For tax years beginning in 2026, section 461(l)’s excess-business-loss threshold is $256,000 ($512,000 on a joint return). Apply it after the applicable basis, at-risk and passive-loss limits. Compute aggregate business deductions versus business income/gains plus the threshold under Form 461; wages are excluded from the business calculation. A disallowed excess business loss becomes an NOL carryforward subject to the later year’s NOL rules, not an unrestricted deduction.

For tax years beginning in 2026, section 461(l)’s excess-business-loss threshold is $256,000 ($512,000 on a joint return). Apply it after the applicable basis, at-risk and passive-loss limits. Compute aggregate business deductions versus business income/gains plus the threshold under Form 461; wages are excluded from the business calculation. A disallowed excess business loss becomes an NOL carryforward subject to the later year’s NOL rules, not an unrestricted deduction.


Common Mistakes to Avoid

Mixing up the Order: Students often jump straight to the Passive Activity rules. Remember, if a taxpayer doesn't have enough Tax Basis, the loss is stopped right there. You don't even check the PAL rules yet.

For an eligible individual actively participating in rental real estate and owning at least 10%, the special allowance is generally up to $25,000, reduced by 50% of modified AGI above $100,000 and eliminated at $150,000. For MFS living apart all year, the allowance and thresholds are halved; MFS living with the spouse during the year generally gets none. Use statutory modified AGI, not ordinary AGI. Basis, at-risk and other limits still apply.

S-Corp Debt: Remember that S-Corp shareholders only get basis for direct loans they made to the company, not for general bank loans the company took out.


Quick Review Box

Apply loss limits in sequence: tax basis, at-risk amount, passive-activity rules, then other applicable individual limits such as excess business loss. Passing one limit does not establish deductibility under the others. Track each suspended-loss category separately.

At-risk amounts generally include contributed cash and adjusted property basis and eligible personally liable borrowing, subject to loss-protection and related-lender restrictions. Ordinary nonrecourse debt generally does not count. Qualified nonrecourse financing under section 465(b)(6) can count for an activity holding real property when secured by real property, borrowed from a qualified person or government (or government-guaranteed), and satisfying the statutory nonliability and nonconvertibility conditions. Not every real-estate bank loan qualifies.

Don't worry if this seems tricky at first—practice identifying which "hurdle" a taxpayer is facing, and the logic will start to click!