When Are Losses Deductible for Income Tax Purposes?

When you have a loss from a trade or business, from the rental of property, or from some other income-producing activity, the loss may serve to reduce your taxable income and therefore reduce your income taxes. But there are special rules that may limit the amount of loss you can claim. These rules are generally intended to discourage taxpayers from engaging in activities that are primarily intended to generate losses for purposes of reducing or avoiding taxation. The rules do this by limiting losses on activities in which your personal efforts are not a significant factor in producing the income or loss. These are referred to as the passive activity limits. The other set of rules limits losses on activities in which you do not have a personal stake in the endeavor. These are called the at-risk rules. Either one or both of these sets of rules may apply in each particular case, depending on the circumstances. 

At-Risk Rules

Activities that are subject to the passive activity limits may first be subjected to the at-risk rules. For most activities, these rules limit the amount of a deductible loss to the amount you have at-risk, or the amount of your personal stake in the activity. The same at-risk rules apply to various different types of taxpayers, including individuals, partners, shareholders in an S corporation, estates, trusts, and certain closely held corporations. 

When Do the At-Risk Rules Apply?

One of the activities subject to the at-risk rules is the leasing of what is referred to in the income tax code as section 1245 property. Section 1245 property includes personal property and other tangible property that is subject to depreciation or amortization.

In addition to the leasing of section 1245 property, other activities that are subject to the at-risk rules are the holding, production, or distribution of motion picture films or video tapes; farming; and exploring for, or exploiting oil and gas, or geothermal deposits.