The four key limitations on loss deductions for high-net-worth individuals include the basis limitation, at-risk limitation, passive activity loss limitation, and the excess business loss limitation. Each of these restrictions is grounded in specific sections of the Internal Revenue Code (IRC) and plays a crucial role in determining how and when individuals can deduct losses on their tax returns.
The basis limitation is found in IRC §§ 704(a) and 1367(a) and restricts the deductibility of losses to the taxpayer’s adjusted basis in a partnership or S corporation. If a taxpayer's basis is insufficient to absorb the loss, that loss is suspended and can only be deducted when additional basis becomes available. This basis can be increased through capital contributions, direct loans made to the entity (in the case of S corporations), recourse and non-recourse debts in the case of partnerships or earnings that increase the partner’s share of the entity’s value. In situations where a taxpayer’s basis is too low to deduct current losses, a strategic infusion of capital or loans could unlock those suspended losses.
The at-risk limitation, under IRC § 465, limits the amount of losses a taxpayer can deduct to the extent they are economically at risk in the activity. This typically includes the amount of money invested or any loans for which the taxpayer is personally liable. Non-recourse loans, where the taxpayer is not personally liable, do not increase the at-risk amount, thus restricting the ability to deduct losses. Yet the qualified non-recourse or recourse debts increase at-risk limitation. To navigate this limitation, one could convert non-recourse loans into recourse loans or increase equity contributions, thereby raising the at-risk amount and unlocking the ability to deduct more losses.
The passive activity loss limitation, as laid out in IRC § 469, prevents taxpayers from offsetting passive activity losses against non-passive income. A passive activity is one in which the taxpayer does not materially participate, such as rental real estate or limited partnerships. Losses from these activities can only be used to offset income from other passive activities. To avoid this limitation, a taxpayer could materially participate in the business or activity, making it "active" rather than passive, which would allow the losses to be deducted against non-passive income. Grouping certain activities together under the aggregation rules could help meet material participation requirements, which would increase the likelihood of deducting those losses. Additionally, some sophisticated individuals with large volume of investment in real properties can explore a tax strategy provided for ‘real estate professionals.’
The excess business loss limitation, governed by IRC § 461(l), applies to noncorporate taxpayers and limits the amount of aggregate business losses that can be deducted. For 2023, the deductible loss is capped at $305,000 for individuals, or $610,000 for married couples filing jointly. Losses that exceed this threshold are carried forward as part of a net operating loss for use in future tax years. One potential strategy to mitigate this limitation involves spreading out deductible losses across multiple years, thereby avoiding triggering the threshold in any one year.
Overall, these limitations are designed to prevent taxpayers from taking excessive deductions in a single year and to ensure that loss deductions are grounded in the economic reality of the taxpayer’s involvement and investment in the activity. However, with careful planning, high-net-worth individuals can often structure their investments, participation, and financing in a way that maximizes the deductibility of losses while staying compliant with tax regulations.