Tax Loss CarryforwardDefined with Steps and More

Written By:
Lisa Borga

What is a Tax Loss Carryforward?

A tax loss carryforward, or as it is often known, a net operating loss carryforward, is a rule that allows taxpayers to carry a tax loss from one year to a future year.

A tax loss carryforward can be used by individuals and companies of all sizes in order to reduce their tax liability.

Net Operating Loss Carryforward

When filing income taxes, a business has a net operating loss when its allowable deductions are greater than the taxable income it has for the relevant tax period.

The business can use this NOL to offset the taxes it owes in future tax years by taking advantage of a tax provision called NOL carryforward.

NOL carryforward allows businesses to take the non-operating loss from the current year and use it to reduce the business’s tax liability in future years.

An example of this would be a business that has a net operating loss in its first year and then has a positive net operating income in the ensuing years.

The business could use NOL carryforward to take the loss from its first year and use it to reduce its profits in the following years until the loss is entirely exhausted.

Doing this will lower a business’s taxable income in years in which it has a net operating income that is positive, thus reducing its taxes.

This tax provision was intended to provide businesses with some tax relief when they lose money during a tax period.

Due to the fact that businesses pay taxes to the government only when they have a positive net operating income for the year, the only means a company has to reduce the impact from the loss on taxes is to balance it against income earned in profitable years

The IRS is aware of the fact that some businesses have profits that do not conform very well with the normal tax year.

Farming is one of these businesses. It is very dependent on weather conditions and can easily have a net operating loss in one year and a large profit the next.

Therefore, a business can balance out its taxes by using the NOL carryforward provision.

This provision allows the business to use an NOL from one year to offset taxes in another year.

Net Operating Loss Carryforward Restrictions

Before the Tax Cuts and Jobs Act of 2018 took effect, businesses were only permitted to carry net operating losses forward for a period of 20 years to use against their future profits or for a period of two years backward in order to obtain a quick refund of the taxes they had previously paid.

At the end of the 20 year period, any losses that were not yet used would expire and no longer be available to reduce a business’s taxable income.

However, the Tax Cuts and Jobs Act (TCJA) does not include the provision limiting the carryback of tax losses to two years for tax years as of January 1^st, 2018 and onward.

Although this does not apply to some non-life insurance companies as well as some farming losses.

This act does now permit NOL’s to be carried forward indefinitely.

But, these carryforwards have changed and are restricted to 80% of the net income for each ensuing year.

For tax years occurring before January 1^st, 2018, the previous tax rules still apply, and losses that remain at the end of 20 years can no longer be applied to reduce net income.

According to the TCJA, farming losses are allowed to be carried back for a total of two years in order to obtain a prompt refund of the taxes that were previously paid.

Or, the farming losses can be carried forward for an indefinite period of time.

Whereas pre-TCJA rules apply to non-insurance companies.

These companies can either carry non-operating losses back for a period of two years or carry these losses forward for 20 years.

However, the 80% limit does not apply.

The CARES Act

In 2020, the rules concerning NOL carryforwards were modified temporarily by the Cares Act (the Coronavirus Aid, Relief, and Economic Security Act).

This act delays the Tax Cuts and Jobs Act amendments from taking effect before Jan. 1, 2021.

The Coronavirus Aid, Relief, and Economic Security Act also allows NOLs to be carried back for five years.

This includes farming losses as well as the non-operating losses incurred by non-life insurance companies as long as these losses occurred from Jan. 2018 up until Jan. 1, 2021.

Corporate taxpayers that have eligible NOLs that occurred in the tax years of 2018 to 2020 are permitted to apply their NOL to previous tax years as an NOL carryback in order to obtain a refund from a past tax return.

This can be done for a period of five previous tax years from the year in which the loss occurred.

Most companies prefer to use an NOL as a carryback instead of using it as a carryforward because of the time value of money.

Basically, a refund of taxes in the current tax year of taxes that were paid in the past provides a greater benefit for a company than a reduction of its future taxes unless the company has a particular reason for preferring the future reduction.

The 80% limitation that applied to any single year was also temporarily eliminated by the CARES Act.

However, it was reapplied as of 2021.

Net Operating Loss Carryforward Example

Let’s take a look at an example of how to use the post-TCJA NOL carryforward rules.

Suppose a business lost $10 million in 2021.

Then, in 2022, the business earns $12 million.

With an 80% carryover limit, the business can lower its 2022 taxable income by $9.6 million of its $12 million 2022 income by using the permitted NOL carryforward.

This means the business’s taxable income for 2022 will be $2.4 million.

This will leave the business with a $400,000 NOL carryforward, which it can use after 2022.

Capital Loss Carryforward

Capital losses and gains are incurred when investors sell a capital asset, such as a bond, real estate, jewelry, or stock.

If an investor sells a capital asset, the gain or loss that occurs is the result of any difference between the asset’s tax basis and its selling price.

The tax basis of a capital asset is typically its purchase price along with the cost of any improvements.

If the asset is sold for an amount that is greater than the tax basis, the investor will have a capital gain.

Whereas, if the asset is sold for an amount that is less than the tax basis, the sale results in a capital loss.

The IRS allows an investor to deduct net capital losses, which is the amount of total capital losses in excess of any capital gains to be deducted as an offset to ordinary income up to the $3000 maximum allowed for a single tax year or $1500 if the taxpayer files as married filing separately.

Any net capital losses that exceed the threshold of $3000 can be carried forward to be used in future tax years until the loss has been fully claimed.

The IRS does not place a limit on the number of years that the loss can be carried forward.

Investors that use these capital loss tax provisions can lessen the effect of investment losses.

It is important, however, for investors to consider the exceptions to these provisions.

One of these exceptions is the wash sale provision.

This provision bans an investor from repurchasing any investment that was sold for a loss for 30 days after the sale took place.

If an investor does repurchase the investment within this time period, the investor cannot apply the capital loss in their tax calculations.

The updated position gains this cost basis instead.

Capital Loss Carryforward Example

Suppose a taxpayer sold 5,000 shares of example stock that the taxpayer had for five years, and the sale resulted in a capital loss of $20,000.

Taxpayers need to report capital losses or gains on their tax return to the IRS using Schedule D of Form 1040.

If an individual has owned the stock for over a year, they are generally considered to have held the stock long term.

There are some exceptions to this for 2018 and later for certain applicable partnership interests, which are regarded as long-term once they have been held for three years.

Taxpayers can offset their long-term gains with their long-term losses.

Suppose that this taxpayer had $5,000 of long-term gains. This would reduce the taxpayer’s long-term capital loss to $15,000.

This taxpayer can also use $3,000 of their loss as a deduction which can then reduce their other income, meaning ordinary income, on their tax return for the current year.

The rest of their long-term capital loss of $12,000 can be carried forward to be used in the following tax year to offset ordinary income and capital gains up to the current limit of $3,000.

By using this tax policy, investors who have realized large losses in the stock market can reduce their recognized gains over a number of future years.

Key Takeaways

• A tax-loss carryforward permits taxpayers to carry a tax loss from one tax year to future tax years.
• A capital loss in excess of gains in a given year may be carried forward to offset a maximum of $3,000 in future tax periods for an indefinite period until it is exhausted.
• Due to the Tax Cuts and Jobs Act, business losses may be carried forward indefinitely. However, they cannot exceed 80% of taxable earnings in the period in which they are used. Before this, losses could be carried forward 20 years and back two without the 80% limit.