Qualified Nonrecourse Financing and the At-Risk Rules

Qualified nonrecourse financing is a carve-out in the tax code that lets real estate investors count certain nonrecourse debt toward their at-risk basis, which in turn raises the ceiling on how much loss they can deduct. Normally, nonrecourse debt (debt where the lender’s only remedy is taking the property) doesn’t add to your at-risk amount because you have no personal skin in the game beyond your equity. Congress recognized that this rule would gut leveraged real estate investing, since commercial property is almost always financed without personal recourse, so it created an exception for debt that meets four specific tests.

Why Nonrecourse Debt Usually Blocks Loss Deductions

Under IRC Section 465, you can deduct losses from a business or investment activity only up to the amount you actually have at risk. That amount includes cash you’ve put in, the adjusted basis of contributed property, and debt you’re personally liable to repay.¹ Losses beyond your at-risk amount don’t disappear; they suspend and carry forward until your at-risk amount grows through additional investment, income, or new qualifying debt.

The reasoning is that you shouldn’t deduct losses on money you never actually risked. With recourse debt, the borrowed dollars are real exposure because the lender can pursue you personally. With nonrecourse debt, you can hand back the property and walk away. So the general rule keeps nonrecourse borrowings out of the at-risk figure.

That rule collides with how real estate actually gets financed. Banks routinely lend against buildings without demanding personal guarantees, especially on larger deals. If nonrecourse debt were fully excluded, most leveraged real estate would produce losses that investors couldn’t use. The QNF exception exists to bridge that gap.¹

The Four Requirements

All four tests must be met. Fail any one and the loan (or the failing portion) drops back to ordinary nonrecourse status with no at-risk benefit.²

The Loan Is for Holding Real Property

The money must be borrowed for the activity of holding real property. Incidental personal property and services tied to making real property available as living accommodations count too, so appliances in an apartment building or on-site management are fine.¹ Mineral property is explicitly out.

No One Is Personally Liable

No person can be personally liable on the loan. Partial personal liability doesn’t automatically ruin the whole loan, though. If a $1 million loan has $200,000 guaranteed and $800,000 secured only by the property, the $800,000 nonrecourse slice can still qualify.² A special partnership rule preserves QNF status when the only entities personally liable are partnerships holding qualifying real property.

The Lender Is a Qualified Person or Government

The loan has to come from a qualified person, from a federal, state, or local government, or be government-guaranteed. A qualified person is defined through Section 49(a)(1)(D)(iv): an unrelated party actively and regularly engaged in the business of lending money.¹ Banks, insurance companies, and pension funds fit; the person who sold you the property, anyone earning a fee from your investment, and their relatives don’t.

Related-party loans can still qualify if the financing is commercially reasonable and on substantially the same terms as loans between unrelated parties.¹ The rate, schedule, loan-to-value, and other material terms need to look like arm’s-length market terms, and you should document comparables at closing because the IRS will look hard at these arrangements.

The Debt Isn’t Convertible

The lender can’t have the right to convert the debt into equity in the borrower or the activity. Convertibility blurs the line between creditor and owner, and the exception is built for genuine lending.²

The Collateral Test

QNF must be secured only by real property used in the holding activity. Incidental personal property (like furniture in a rental unit) is disregarded. So is other non-real-property collateral, as long as its fair market value stays under 10% of the total fair market value of everything securing the loan.² Cross that 10% line and the loan fails the secured-by-real-property requirement.

Mixed-use deals or loans bundled with equipment financing are where this bites. Splitting off the non-real-property portion into a separate loan can preserve QNF treatment on the real estate piece.

How QNF Feeds Your At-Risk Amount

Once a loan qualifies, your share of it adds to your at-risk basis for the activity, which sets the deduction ceiling for the year.

Say you put $100,000 cash into a real estate partnership and your share of the partnership’s QNF is $400,000. Your at-risk amount is $500,000. A $150,000 loss for the year clears easily. Without QNF, your at-risk amount would be $100,000 and $50,000 of that loss would suspend.¹

For partnerships, each partner’s share of QNF tracks their share of partnership liabilities connected to the financing, calculated under Section 752.¹ How the partnership agreement allocates liabilities directly drives each partner’s at-risk amount, which is why real estate operating agreements spend so much ink on liability sharing.

S Corporation Shareholders Get Little Benefit

QNF works well for partners; it barely helps S corporation shareholders. A shareholder’s at-risk amount is limited to stock basis plus loans the shareholder personally makes to the corporation. Entity-level debt doesn’t lift that amount, and a personal guarantee of corporate debt doesn’t either.³ The only way a shareholder captures QNF benefit is by personally borrowing on qualified nonrecourse terms and lending the proceeds to the corporation, an awkward structure. This is a major reason real estate ventures are organized as partnerships or LLCs taxed as partnerships rather than S corporations.

When At-Risk Goes Negative: Recapture

Your at-risk amount can drop below zero. Unlike partnership tax basis, which floors at zero, at-risk has no floor. A large cash distribution, a refinancing that shrinks your QNF share, or a shift in partnership liability allocations can push it negative.

When that happens, Section 465(e) triggers recapture: you include in gross income the amount by which your at-risk figure fell below zero, capped at the total prior at-risk losses you’ve deducted (reduced by amounts previously recaptured).¹ If you never claimed at-risk losses from the activity, no recapture occurs even with a negative balance.

There’s a built-in offset. The recaptured amount is treated as a deduction from the activity in the following tax year, and the recapture income restores your at-risk figure to zero. The effect is to accelerate income into the current year while creating a matching loss carryforward.

Clearing At-Risk Isn’t the Same as Deducting the Loss

This is where investors get caught. The at-risk rules and the passive activity rules under Section 469 are separate hurdles, and both must be satisfied before a loss reaches your return. The order for pass-through losses is basis, then at-risk, then passive activity, then the excess business loss limitation under Section 461(l).⁴

Rental real estate is passive by default no matter how much time you spend on it. Two exceptions can free up losses: a $25,000 allowance for taxpayers who actively participate (phased out between $100,000 and $150,000 of AGI), and real estate professional status for taxpayers who log more than 750 hours in real property trades and spend more than half their personal services there.⁵

QNF sets how much loss the at-risk rules let through. The passive activity rules decide whether you can use it against wages or other non-passive income. A limited partner in a syndication can have a big at-risk cushion from QNF and still see every dollar of loss suspended until they sell the investment or generate passive income elsewhere.

Reporting on Form 6198

Report your at-risk calculation on Form 6198 (At-Risk Limitations), filed with your Form 1040. QNF amounts feed into the at-risk computation on that form, which also tracks suspended losses from year to year. File it whenever you have a loss from an at-risk activity. If the activity shows a net profit, you generally don’t file, but keep your at-risk records for years when losses come back. Estates, trusts, and certain closely held C corporations use the same form.⁶ Hold onto documentation of QNF qualification, especially proof of commercially reasonable terms on any related-party loans.

1
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
2
eCFR. 26 CFR 1.465-27 – Qualified Nonrecourse Financing
3
Internal Revenue Service. S Corporation Stock and Debt Basis
4
Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
5
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
6
Internal Revenue Service. Instructions for Form 6198