The at-risk concept was introduced into the tax code in 1976 but did not apply to real estate investments until 1986. Essentially, the at-risk rules limit the amount of losses that can be deducted by an investor to the amount of capital that he/she actually has at risk. Once aggregate losses equal to the amount of risk capital have been deducted, no further deductions can be taken, even though the investment (or the investor's share of it as in a partnership) has been financed with additional funds on a non-recourse basis. The at-risk rules apply to individuals, partnerships, S corporations, and certain closely held corporations (IRC § 465).

Extent of Investment Risk
The amount at risk in a real estate investment (and hence the total amount of losses that can be deducted by the investor) generally is the sum of the following:

• The investor's cash contributions to the activity;
• The adjusted tax basis of other property contributed;
• Amounts borrowed for the activity with respect to which the investor has personal liability or has pledged property not used in the activity; and
• Amounts borrowed for use in the activity for which the investor has no personal liability (i.e., non-recourse debt) subject to certain conditions.

At-Risk Non-Recourse Financing
Non-recourse financing, common in real estate, is treated as an amount at risk when it is "qualified financing," which includes:

• A loan from a qualified lender, i.e., one engaged in the business of making loans, or any government or instrumentality, provided the lender is not the promoter or seller of the property or a party related to either; or
• A loan from a qualified lender (as above) having an equity interest in the venture, so long as the terms of the financing are commercially reasonable (see below) and are substantially the same as loans involving lenders having no equity interest.

A lender is a "promoter" (and hence cannot be a qualified lender) if it receives a fee based on the borrower's investment. Consequently, care must be exercised in the way fees are paid to the lender.

Commercially Reasonable Terms
The terms of non-recourse financing are commercially reasonable if:

• The borrower executes a written unconditional promise to pay on demand or on a specified date.
• The amount to be paid is a fixed sum in money.
• The interest rate is a reasonable market rate of interest, taking into account the maturity of the debt.

Generally, an interest rate is not considered commercially reasonable if any one of the following conditions exists:

• The interest rate is significantly below or above the market rate on comparable loans by qualified persons not related to the borrower.
• The interest rate is contingent. However, the interest rate may be adjustable or variable provided that the interest is calculated with respect to a market interest index such as the prime rate charged by a major commercial bank, the London InterBank offered rate (LIBOR), the rate on government securities, or the applicable federal rate (AFR). For example, an interest rate floating at one point above the prime rate charged by a major commercial bank would not be considered contingent.
• The term of the loan exceeds the useful life of the property, or the right to foreclose or collect the debt is limited.

Recourse Seller Financing
Non-recourse seller financing is not included in the purchaser's amount at risk. However, recourse seller financing (i.e., where the purchaser is personally liable on the note) is included in the amount at risk. The elimination of non-recourse seller financing from the buyer's basis for losses was the main purpose of the at-risk provision. Prior to 1986, buyers and sellers often utilized inflated mortgages to permit the buyer to deduct large depreciation and interest expenses that had no relationship to true economic costs.

Convertible Debt
Debt that is convertible into equity at the option of the lender is not treated as qualified non-recourse financing with respect to the borrower. Taxpayers are not to be treated as at risk (and hence able to deduct losses) for amounts representing another's right to an equity investment.

Loss Carryovers
Any loss not deductible in a given year because it is in excess of the amount by which the taxpayer is at risk is carried forward and may be used in a subsequent year in which the loss does not exceed the amount at risk. This may occur, for example, if the investor makes additional cash investments or becomes personally liable under new financing.

Allocation of Loss Not Required
The at-risk rules do not require that a tax loss be allocated between the amount of the investment at risk and the amount not at risk. For example, assume an investor buys real estate for $1 million, putting up $500,000 in cash and borrowing $500,000 with a non-qualified non-recourse loan. If the investor incurs a tax loss of $100,000 the first year, the at-risk rules do not require an allocation of 50 percent of the loss to the nonqualified financing and 50 percent to the cash investment. Instead, the entire $100,000 loss is deductible (as far as the at-risk rules are concerned). The remaining $400,000 loss is then carried forward.

Effect on Distress Sales
One consequence of the at-risk rules is that it is more difficult for sellers (including banks and insurance companies) to dispose of distressed properties. In such dispositions, the seller frequently takes back a large non-recourse mortgage as an inducement to the buyer to take the property. If the property is operating at a loss, the buyer expects to recoup a portion of his investment by deducting the losses until the property can be turned around. However, under the at-risk rule, the buyer cannot include the non-recourse loan in his basis for deducting losses.