Qualified Nonrecourse Financing and Qualified Person Rules

Qualified nonrecourse financing is real estate debt that no one is personally liable to repay but that still counts toward a taxpayer’s at-risk amount under Section 465 of the Internal Revenue Code. That matters because Section 465 generally caps deductible losses from an activity at whatever the taxpayer has personally on the line. Real property gets a targeted exception: if a nonrecourse loan meets four statutory tests and comes from the right kind of lender, the borrower gets the same deduction capacity as if the money were their own.¹

The Four Requirements

Under Section 465(b)(6), a loan qualifies only if every one of these conditions is true at the same time:²

The financing is borrowed for use in the activity of holding real property.
The lender is either a qualified person or a federal, state, or local government or an instrumentality of one.
No person is personally liable for repayment. The property itself secures the debt.
The lender has no right to convert the debt into an ownership interest in the property.

The convertibility rule catches instruments designed to become equity if the project performs well. Once that option exists, the arrangement looks more like an investment than a loan, and the statute excludes it.

Bad-Boy Carve-Outs and Personal Liability

Commercial real estate loans routinely include so-called bad-boy guarantees that make the borrower personally liable for specific wrongful acts, such as fraud, unauthorized bankruptcy filings, or failure to maintain the property. The Treasury Regulations treat those contingent obligations as essentially irrelevant unless the facts establish that the triggering event is reasonably certain to occur.² A typical loan with standard carve-outs still qualifies. What matters is that the primary obligation for principal and interest runs against the property, not the borrower.

Who Counts as a Qualified Lender

Section 465 defines a qualified person by cross-reference to Section 49(a)(1)(D)(iv), which requires the lender to be actively and regularly engaged in the business of lending money.³ The point is to screen out private arrangements built for tax benefits and to confirm the debt reflects market terms.

National and state-chartered banks, savings institutions, federal and state credit unions, regulated insurance companies, and pension trusts all routinely satisfy the test. Two categories are specifically disqualified even if they otherwise lend money for a living:

The seller of the property. Seller-financed notes are legal, but they do not produce qualified nonrecourse financing.
Anyone who receives a fee, commission, or other compensation tied to the taxpayer’s investment. This sweeps in promoters, syndicators, and investment brokers who arrange or market the deal.

The reasoning behind both exclusions is the same. When the lender has a financial stake in the sale itself, the incentive to structure legitimate debt on market terms weakens.

Government Lenders and Guarantees

Federal, state, and local governments and their instrumentalities qualify automatically. They do not need to satisfy the “actively and regularly engaged in lending” test. A loan guaranteed by a government entity also qualifies.⁴ This is significant for affordable housing and economic development deals, where a state housing authority or municipal agency may lend directly or back the financing.

Related-Party Loans

Related parties are not categorically barred from being qualified persons, but they face a higher bar. Under Section 465(b)(6)(D)(ii), the general exclusion lifts if the financing is commercially reasonable and on substantially the same terms as loans between unrelated parties.³

The IRS looks at whether the loan functions as real debt. The interest rate should reflect market conditions for comparable properties. The repayment schedule should follow industry norms rather than be built around the borrower’s tax situation. A fixed maturity date is expected, and repeated extensions without a documented business reason point toward equity. The lender must actually enforce the terms. Waived interest, ignored deadlines, and no collection activity make the arrangement look like a capital contribution wearing the label of a loan.

The taxpayer carries the burden of proof. That means a signed promissory note, a recorded security instrument, and records showing actual debt service payments. If the IRS successfully challenges commercial reasonableness, the debt reverts to ordinary nonrecourse financing and stops increasing the at-risk amount.

What Counts as Holding Real Property

Qualified nonrecourse financing only works for the activity of holding real property. The statute defines that activity to include owning land and permanent structures but explicitly excludes mineral property.⁵ Investors in oil, gas, and mining cannot use this exception, even where real property is involved in the operation.

Personal property and services that are incidental to making real property available as living accommodations are included within the activity.⁵ An apartment building with in-unit appliances, a maintenance staff, and laundry facilities still counts.

The 10 Percent Rule for Secured Personal Property

When the loan is secured by property that is not all real estate, the regulations provide a tolerance. Property incidental to the real property activity is disregarded entirely for the security test. For non-incidental personal property that also secures the loan, the financing still qualifies as long as the total fair market value of that non-incidental property is less than 10 percent of the fair market value of all property securing the debt.⁶ The regulations list office equipment, trucks, and maintenance equipment as examples of property that would typically be incidental to a real property holding activity.

When Services Push the Property Out of the Activity

The activity can be reclassified if services provided to occupants become significant enough to turn the operation into a service business. Full-service hotels, healthcare facilities, and resorts with extensive amenities can cross that line. Once the activity is no longer viewed as holding real property, the exception evaporates and ordinary at-risk limits apply to all of the entity’s debt.

Basis Is Not the Same as At-Risk

Most investment real estate sits inside a partnership or LLC, and the entity-level debt gets divided among the partners so each one can run their own numbers. Two different frameworks apply, and this is where investors most often get tripped up.

For outside basis, nonrecourse liabilities, including qualified nonrecourse financing, are allocated under Treasury Regulation Section 1.752-3 through a three-tier system that first assigns debt to partnership minimum gain, then to Section 704(c) built-in gain, and finally distributes the remainder based on profit shares or another regulatory method.⁷ Each partner’s allocated share appears on Schedule K-1.⁸

The at-risk amount is calculated separately. Basis includes all allocated liabilities. The at-risk amount only includes liabilities for which the partner bears economic risk plus any share of qualified nonrecourse financing.¹ Ordinary nonrecourse debt that fails the qualified financing tests increases basis but not the at-risk amount. Having enough basis to receive an allocation of losses is not the same as having enough at-risk amount to deduct them.

Where At-Risk Fits Among the Loss Rules

The at-risk limitation is one of several hurdles a real estate loss has to clear. They apply in a fixed order:⁹

Basis limitation first. A partner or S corporation shareholder cannot deduct losses beyond their adjusted basis in the entity.
At-risk limitation next. Losses that survive the basis test are capped by the taxpayer’s at-risk amount. This is where qualified nonrecourse financing does its work.
Passive activity rules under Section 469. Losses that survive at-risk may still be suspended if the taxpayer does not materially participate.
The excess business loss cap under Section 461(l), which applies to whatever survives the earlier steps.

Qualifying as a real estate professional under Section 469 can eliminate the passive activity barrier, but it does nothing to change the at-risk calculation. A real estate professional still needs sufficient at-risk amount to take the deduction. The at-risk rules apply to all individuals regardless of professional status.⁹

When a Loan Loses Qualified Status

If a loan that previously qualified fails one of the four requirements, the taxpayer’s at-risk amount drops by the full amount of that debt. A conversion feature added through a loan modification, a change in the lender’s status, or a shift in property use can each trigger this. When the at-risk amount goes below zero, Section 465(e) requires the taxpayer to include the negative amount in gross income for that year.¹

The recapture is limited to the total losses previously deducted under the at-risk rules for that activity, minus amounts already recaptured in prior years. The amount included in income is then treated as a deduction for the following year, so it can be used again if the at-risk amount recovers. In the year the recapture hits, though, it creates taxable income that cannot be offset by the same activity’s losses.

Form 6198 and What to Keep on File

Taxpayers claiming losses from an at-risk activity file Form 6198 (At-Risk Limitations) with their return. The form works out the current-year profit or loss, the at-risk amount, and the deductible loss after the limitation.¹⁰ For partnerships and S corporations, the at-risk calculation happens at the individual partner or shareholder level using Schedule K-1 information, not at the entity.

Beyond the form, keep the loan agreement, the recorded security instrument, documentation that the lender meets the qualified person standard, and evidence that no one is personally liable beyond permitted carve-outs. For related-party loans the record needs to be heavier: market-rate comparisons, a formal promissory note, evidence of actual debt service payments, and a business rationale for the arrangement. On audit, the taxpayer has to be able to reconstruct the qualified status of every dollar of nonrecourse debt included in the calculation.

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
Legal Information Institute. 26 USC 465 – Deductions Limited to Amount at Risk
4
Legal Information Institute. 26 USC 465 – Deductions Limited to Amount at Risk
5
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
6
eCFR. 26 CFR 1.465-27 – Qualified Nonrecourse Financing
7
eCFR. 26 CFR 1.752-3 – Partners Share of Nonrecourse Liabilities
8
Internal Revenue Service. Determining Liability Allocations
9
Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
10
Internal Revenue Service. About Form 6198, At-Risk Limitations