An individual taxpayer holds a limited partnership interest in a real estate venture in which they do not materially participate. Their outside basis, their amount at risk under IRC Section 465, and the passive activity loss rules under IRC Section 469 would each separately restrict how much of a large current-year loss allocated to them is currently deductible. In what order must these three limitations be applied?
- Passive activity limitation first, then at-risk limitation, then basis limitation, since the passive-loss rules were enacted most recently and take precedence
- At-risk limitation first, then passive activity limitation, then basis limitation, because economic risk is the most fundamental constraint on any deduction
- All three limitations are applied simultaneously to the same loss amount, and the taxpayer may deduct whichever result is most favorable
- Basis limitation first, then the at-risk limitation under IRC Section 465, then the passive activity limitation under IRC Section 469; a loss disallowed at an earlier stage never reaches the later test
Why D? And why not the others?
Correct answer: D. Basis limitation first, then the at-risk limitation under IRC Section 465, then the passive activity limitation under IRC Section 469; a loss disallowed at an earlier stage never reaches the later test
The established ordering rule requires that a partner's or shareholder's basis limitation be applied first, since a loss cannot be deducted beyond available basis in the first place; the at-risk rules under IRC Section 465 are then applied to whatever loss survives the basis limitation, disallowing any amount exceeding the taxpayer's economic exposure to the activity; and finally the passive activity loss rules under IRC Section 469 are applied only to the portion of the loss that has cleared both the basis and at-risk hurdles. A loss stopped at an earlier stage is suspended there and never reaches a later test. The option placing the passive activity limitation first inverts this sequence and supplies a rationale, that more recently enacted rules take precedence, that plays no role in how these provisions actually interact. The option placing the at-risk limitation first correctly emphasizes economic exposure but wrongly places it ahead of the basis test, which must be satisfied before at-risk rules are even relevant. The option treating all three tests as simultaneous, taxpayer-elected alternatives misdescribes a strictly sequential and mandatory framework as if it offered a choice.
Source: IRC Section 465; IRC Section 469; IRS Publication 925, Passive Activity and At-Risk Rules