Understanding Basis and Other Limits on Loss Deductions
Posted on March 02, 2026
There are many layers to the deductibility of losses. While many taxpayers are familiar with the concept of tax basis, it is only the first of several layers that must be peeled back (like an onion) before a loss can be deducted. The at-risk rules, passive activity loss (PAL) limitations, and the excess business loss limitation (EBL) add further layers of restriction, each with its own calculation and impact. Whether you’re an investor, business owner, or real estate professional these loss limitations determine if and when one can deduct a loss on his or her tax return.
What Is Tax Basis
Basis is a fundamental tax concept that applies to nearly every type of investment or business activity. In simple terms, your basis is the amount you have invested in an asset or activity, adjusted over time for additional investments, income, losses, changes in debt and distributions. For example, if you purchase stock, your basis is generally what you paid for it. If you invest directly in real estate, your tax basis starts with the purchase price and is adjusted for improvements, depreciation, and other factors. Again, why does tax basis matter? The IRS limits your ability to deduct losses to the amount of your basis. If your losses exceed your basis, the excess is not deductible in the current year but may be carried forward until you restore your basis through additional investment or income.
At-Risk Limitations
Meanwhile, the at-risk rules add another layer of limitation. The at-risk rules further limit loss deductions by allowing taxpayers to deduct losses only to the extent they are truly exposed to economic loss.
A taxpayer’s at-risk amount generally includes cash and property contributed, as well as recourse debt. Recourse debt are liabilities for which the taxpayer is personally responsible and whose personal assets are at risk. Nonrecourse debt, which limits the lender’s recovery to the collateral, generally does not increase the at-risk amount, except for certain qualified nonrecourse financing in real estate that meets specific requirements.
The Passive Activity Loss Limitation
Even if a taxpayer has sufficient Tax and at-risk basis, he or she may still face the passive activity loss limitation. The PAL rules restrict the deduction of losses from activities in which one does not materially participate, such as rental real estate or investments where the taxpayer is not typically actively involved. Passive losses can only offset passive income, not wages, interest, dividends, or other non-passive income. Any unused passive losses are suspended and carried forward until the taxpayer has sufficient passive income or the taxpayer disposes of the activity.
Excess Business Loss Limitation
In addition to the tax basis, at-risk, and passive activity loss rules, individual taxpayers and other noncorporate filers must also consider the excess business loss (EBL) limitation. This rule places a cap on the amount of business losses that can be deducted in a single tax year.
For 2026, the EBL threshold is $512,000 for joint filers and $256,000 for all other filers, with these amounts adjusted annually for inflation. If net business income from all sources exceeds the threshold amount, the excess is not deductible in the current year. Instead, any disallowed loss is carried forward as part of your net operating loss (NOL) to future tax years.
The EBL limitation applies after all other loss limitation rules have been considered. This means that only losses that have already cleared the tax basis, at-risk, and passive activity loss hurdles are subject to the EBL cap. Losses suspended under any of the earlier rules are not counted toward the EBL limitation until they become released in a future year.
Example:
When determining whether a loss is deductible in the current year, apply the limitations discussed herein in this specific order:
- Tax Basis limitation – Losses are limited to the basis in the activity or asset.
- At-risk limitation – Losses are further limited to the at-risk amount.
- Passive activity loss limitation – Losses are finally limited to the amount of passive income available.
- Excess business loss limitation – Any remaining allowable loss is subject to the annual EBL cap, with any excess carried forward as a net operating loss.
Suppose Byron invests $50,000 in a real estate venture, personally guarantees a $20,000 loan, and his share of nonrecourse debt is $30,000. Byron’s basis is $100,000, but his at-risk amount is only $70,000 (his cash investment plus the guaranteed loan). If the activity generates a $90,000 loss, he can only deduct $70,000 due to the at-risk limitation; the remaining $20,000 is suspended. If the activity is passive and Byron has no passive income, even the $70,000 loss is suspended under the passive activity loss rules until he generates passive income or disposes of the investment.
If Byron were to be an active real estate professional, he must then apply the excess business loss limitation. The EBL threshold for 2026 is $256,000 and Byron’s total allowable business losses (from all sources) were $300,000, $44,000 is not deductible in the current year but is carried forward as a net operating loss to be released in 2027.
Understanding tax basis, at-risk, passive activity, and excess business loss rules is essential for all taxpayers.
These rules affect a wide range of investments and activities, from stocks and real estate to closely held businesses and beyond. Proactive planning can help you structure your investments and financing to maximize the deductibility of losses and avoid unexpected tax consequences. Consult with your Topel Forman advisor if you have any questions on these limitations.
