REG, Regulation
Sources for Loss Limitations: The Four Hurdles
Last reviewed
The standards and authorities behind PocketCPA's REG lessons on Loss Limitations: The Four Hurdles. The topic rests on IRC Secs. 465, 469, 461(l).
About this topic
A loss from a business or investment must survive four sequential tests before it can offset other income. A loss stopped at any level is suspended and carried forward.
The four tests are not four ways of asking the same question. Basis asks how much the taxpayer has invested. At-risk asks how much of that investment the taxpayer could actually lose. The passive rules ask what kind of income the loss may offset. The excess business loss rule asks how much business loss may reach nonbusiness income in one year. Because each screen measures something different, a loss can clear three and die at the fourth, and the carryforward that catches it differs depending on which one stopped it. That last point is where most of the exam's points live: candidates who memorize the order still lose the question about where the suspended loss goes.
Key points
- Losses must clear four hurdles in order: tax basis, at-risk amount, passive activity rules, and excess business loss limitation.
- The at-risk rules limit deductions to the amount the taxpayer stands to lose economically.
- Passive activity losses can only offset passive activity income; excess losses are suspended and carried forward.
- Rental activities are generally passive regardless of participation, with a $25,000 exception for active participants below the income phase-out.
What the lessons cover
- The ordering of the limitations
- Basis and at-risk (Sec. 465)
- Passive activity losses (Sec. 469)
- Excess business loss and capital losses (Sec. 461(l))
- The rental real estate exceptions (Secs. 469(i) and 469(c)(7))
- Net operating losses and hobby losses (Secs. 172 and 183)
- Wash sales and related party losses (Secs. 1091 and 267)
- Section 1244 small business stock
Authoritative references
Where these limits sit in the Code. Each entry names the section, then breaks out the subsections that carry separate rules.
- IRC Sec. 465 (deductions limited to amount at risk).
- (a)(1) year-end limitation and covered taxpayers, and (a)(2) activity-specific carryforward.
- (b)(1) money and adjusted basis of property, (b)(2) borrowed amounts, personal liability and pledged outside property, and (b)(3) borrowings from interested and related persons.
- (b)(4) amounts protected against loss, and (b)(5) reduction for allowed losses.
- (b)(6) qualified nonrecourse financing, its four requirements and the mineral property carve-out.
- (c)(1) the five listed activities, (c)(2) separate activities, and (c)(3) extension to all others.
- (d) definition of loss, and (e) recapture where the at-risk amount is negative.
- IRC Sec. 469 (passive activity losses and credits limited).
- (a) disallowance and covered persons, and (b) carryforward.
- (c)(1) passive activity defined, (c)(2) rental per se, (c)(3) oil and gas working interests, and (c)(4) participation irrelevant to (2) and (3).
- (c)(7) the real property business exception, both prongs and the employee rule.
- (d)(1) passive activity loss.
- (e)(1) portfolio income and working capital, and (e)(3) earned income.
- (g)(1) disposition of an entire interest and the related party postponement, (g)(2) death, and (g)(3) installment sales.
- (h)(1) regular, continuous and substantial, (h)(2) limited partners, and (h)(5) spousal participation.
- (i)(1) through (i)(6) the rental allowance, its phase-out, the AGI definition, the separate-filer substitutions and the 10 percent floor.
- (j)(6) gifts.
- Treas. Reg. Sec. 1.469-5T (material participation).
- (a) the seven alternative tests, any one of which is enough.
- (a)(1) more than 500 hours in the activity.
- (a)(2) participation that is substantially all of the participation in the activity.
- (a)(3) the 100-hour comparative test.
- (a)(4) significant participation activities aggregating past 500 hours.
- (a)(5) material participation in 5 of the 10 preceding taxable years.
- (e)(2) the three tests available to a limited partner.
- IRC Sec. 461(l) (excess business loss of noncorporate taxpayers).
- (l)(1) the limitation, now permanent, and (l)(2) recharacterization as a net operating loss.
- (l)(3)(A) the computation and the employee flush language.
- (l)(3)(B) the capital loss exclusion and the capital gain cap, and (l)(3)(C) the re-based inflation adjustment.
- (l)(4) application at the partner and shareholder level, and (l)(6) coordination after Sec. 469.
- IRC Secs. 1211 and 1212 (capital loss limitation and carryovers).
- 1211(a) a corporation deducts capital losses against capital gains only.
- 1211(b) the $3,000 allowance, or $1,500 for a married individual filing separately.
- 1212(a)(1) the corporate 3-year carryback and 5-year carryover, converted to short-term and taken earliest year first.
- 1212(b)(1) the individual carryforward, which preserves character.
- 1212(b)(2) the allowance treated as a short-term capital gain in the loss year.
- IRC Sec. 172 (net operating loss deduction).
- (a)(2) the layered deduction and 80 percent cap.
- (b)(1)(A) carryback only as provided, unlimited carryforward post-2017.
- (b)(1)(B) the 2-year farming carryback, its coordination rule and the election out.
- (b)(1)(C) insurance companies, and (b)(1)(D) the 2018 through 2020 5-year carryback.
- (b)(2) earliest year first, and (b)(3) election to relinquish.
- (c) definition, and (d)(1), (d)(2) and (d)(4) the modifications.
- IRC Sec. 183 (activities not engaged in for profit).
- (a) the general disallowance of any deduction attributable to the activity.
- (b)(1) and (b)(2) the two tiers, with the activity's gross income as the ceiling.
- (c) the definition, by reference to Secs. 162 and 212.
- (d) the 3-of-5 presumption, and the 2-of-7 substitution for horses.
- (e) the election to postpone the determination, and the extended assessment period that pays for it.
- IRC Secs. 67(b) and 67(h) (miscellaneous itemized deductions).
- (b) the categories excluded from miscellaneous itemized deductions, including the educator carve-out at (b)(13).
- (h) the permanent disallowance for taxable years beginning after December 31, 2017.
- IRC Secs. 1091 and 1223(3) (wash sales).
- 1091(a) the 61-day window, substantially identical stock or securities, contracts and options, and the dealer exception.
- 1091(b) and (c) matching where the number acquired differs from the number sold.
- 1091(d) the basis of the replacement shares.
- 1091(e) losses on closing a short sale.
- 1223(3) tacking the holding period of the shares whose loss was disallowed.
- IRC Sec. 267 (related taxpayers).
- (a)(1) the loss disallowance, and the complete liquidation exception.
- (b) the thirteen relationships, notably (b)(1) family and (b)(2) a more-than-50-percent-owned corporation.
- (c)(1) through (c)(5) constructive ownership, including family attribution, partner attribution, and the no-re-attribution rule.
- (d)(1) the transferee's offset against later gain, with the exceptions at (d)(2) and (d)(3).
- IRC Sec. 1244 (losses on small business stock).
- (a) ordinary loss treatment for the original issuee.
- (b) the $50,000 and $100,000 annual ceilings.
- (c)(1) the definition, including the issued-for-money-or-property condition and the gross receipts condition.
- (c)(3)(A) the $1,000,000 capitalization test, measured at issuance.
- (d)(1)(A) the basis reduction for built-in-loss property.
- (d)(1)(B) the allocation of later basis increases.
- (d)(3) trade or business treatment for Sec. 172.
- (d)(4) the exclusion of trusts and estates.
- IRC Secs. 704(d) and 1366(d) (the two basis ceilings at the first hurdle).
- 704(d)(1) the partner's outside basis limitation, and 704(d)(2) its carryover.
- 1366(d)(1) the S shareholder's stock plus shareholder debt limitation.
- 1366(d)(2) the indefinite carryover.
- 1366(d)(3) the post-termination transition period.
- Pub. L. 119-21 (One Big Beautiful Bill Act, July 4, 2025).
- sec. 70601(a) strikes the Sec. 461(l) sunset.
- sec. 70601(b) re-bases the Sec. 461(l)(3)(C) inflation adjustment.
- sec. 70110(a) strikes the Sec. 67 sunset.
- sec. 70110(b)(1) adds Sec. 67(b)(13).
How PocketCPA uses these sources
Every lesson is written in original words and cites the paragraph each rule comes from. No standard's text is reproduced. How lessons and questions are written and checked is set out in our methodology.