puzzling loss on K-1

[evil_shenanigans]

I was a passive member of a K-1 for two years [simplifying my actual situation slightly]. I paid $2500 to join and got $2500 back when I left. No other money changed hands. The first year's K-1 shows a capital gain of $500 on line 17 of my 1040 (as figured by Turbotax). My final K-1 shows a loss of $1000 on the same line. Thus, over the lifetime of the K-1, it seems I've generated a total loss of $500.

As a layperson, I'm confused by this loss, since I did not actually gain or lose any real money; I got back my initial investment dollar-for-dollar. In the reverse scenario, if the final K-1 showed a net *gain* of $500, I presumably would not be ok paying income tax on that money I never actually got (and never will). So how can I be entitled to the (nonexistent) loss?

Can it be true that I'm actually entitled to take this loss on my 1040, or does this indicate a mistake somewhere on at least one of the K-1s?

[ThomasM125 · Accepted solution]

You cannot take the loss as you don't have that amount of money "at risk" in the company.

You are correct when you state that you did not gain or lose anything on the investment. The "At Risk" rules limit your overall deduction to not more that what  you have "at risk" in the venture.

What you have at risk is your contribution of $2,500, plus the income credited to you of $500, less the distribution of $2,500 and $500 of the loss. The other $500 loss reported on your k-1 schedule in 2020 is not deductible, since you don't have money at risk left over to absorb it.

If the company had earned $500 instead of losing that amount, you would have an additional $500 of basis in the company, that you could write off as a capital loss when you disposed of your interest in the company, thus balancing out the operating income you reported on your tax return.