What Is a Tax Loss Carryforward?
A tax loss carryforward (or carryover) is an Internal Revenue Service (IRS) provision that allows businesses or individuals to carry a tax loss from one year into future years to offset a portion of their taxable income.
Key Takeaways:
- A tax loss carryforward allows taxpayers to use a loss from one year to offset income in future years.
- There are two types of tax loss carryforwards: net operating loss (NOL) carryforwards and capital loss carryforwards.
- Net operating loss carryforwards apply to businesses.
- Capital loss carryforwards can apply to either businesses or individuals, although the rules work differently.
How Tax Loss Carryforwards Work
There are two main types of tax loss carryforwards: net operating loss (NOL) carryforwards and capital loss carryforwards or carryovers.
Net Operating Loss (NOL) Carryforwards
A net operating loss or NOL occurs when a company's allowable deductions exceed its taxable income for a particular tax year. The amount of the NOL can be used to offset a portion of the company's taxable income in future tax years through anIRS provision called a carryforward. For example, if a company experiences negativenet operating income (NOI) in year one, but positive NOI in the two subsequent years, it can use its NOL carryforward to reduce its taxable income in the latter years.
The purpose behind this tax provision is to allow some form oftax reliefwhen a company loses money in a particular tax period. Because the company pays taxes only in years of positive NOI, the only way to minimize the tax impact of the loss is to offset income in positive NOI years.
The tax laws recognize that some businesses are cyclical in nature. For example, a tourism business is subject to weather conditions and may have significant profitsand a large tax obligation in one year, incur an NOL in the next, and then follow that with another profitable year. To smooth the tax burden, the loss carryforward provision allows for the NOL in the second year to offset taxes due in the third year.
Limitations on Net Operating Loss Carryforwards
Prior to the implementation of theTax Cuts and Jobs Act (TCJA) in 2018, the IRS allowed businesses to carry NOLs forward 20 years to net against future profits or backward two years for an immediate refund of previous taxes paid. After 20 years, any remaining losses expired and could no longer be used to reduce taxable income.
For tax years beginning Jan. 1, 2018, or later, the law removed the two-year carryback provision, except for certain farming losses, and instituted an indefinite carryforward period. However, carryforwards are now limited to 80% of each subsequent year's net income.
Example of a Net Operating Loss Carryforward
For a simple example of the NOL carryforward rules post-TCJA, suppose a company lost $5 million in 2022 and earned $6 million in 2023. Its carryforward limit for 2023 would be 80% of $6 million, or $4.8 million. That $4.8 million carryforward would lower the company's taxable income for 2023 to $1.2 million ($6 million minus $4.8 million).
That would still leave a $200,000 NOL carryforward(the company's $5 million 2022 NOL minus the $4.8 million NOL carryforward it used in 2023). The company could use the $200,000 carryforward in 2024 or later, depending on when it next turns a profit.
Capital Loss Carryforwards
Capital gains and losses result from the sale of capital assets, such as stocks, bonds, industrial equipment, and real estate. When capital assets are sold, the gain (or loss) on the sale is the difference between its selling price and its tax or cost basis (generally, the purchase price of the asset plus the cost of any improvements and minus any depreciation deductions taken in prior years). If the selling price is greater than the basis, the result is a capital gain. If the selling price is less than the basis, the result is a capital loss.
Both companies and individuals can have capital loss carryforwards, although the rules are different. In the case of a corporation, capital losses can be used only to offset capital gains. The company can carry its capital losses both forward and backward and must do so in this order: starting with the year three years prior, followed by two years prior, and then one year prior. If any loss remains after that, the company can carry it forward for the next five years.
For individuals, net capital losses (the amount by which total capital losses exceed total capital gains in a given year) can be used to offset ordinary income, but only up to a maximum of $3,000 in a tax year ($1,500 for married individuals filing separately). Losses exceeding the $3,000 threshold may be carried over to future tax years until they've been exhausted. There is no limit on the number of years that a taxpayer can carry a capital loss forward.
Example of a Capital Loss Carryforward
Here is a simplified example of how an individual taxpayer might use a capital loss carryforward. Assume the taxpayer sold 1,000 shares of XYZ stock for $10,000 less than their cost basis in the stock. They now have a $10,000 capital loss. If they also had a $2,000 capital gain from selling some other stock, their net capital loss for the year is $8,000.
They can take $3,000 of that loss as a deduction on their current year tax return. The remaining loss of $5,000 can be carried forward to the next tax year to offset another $3,000 in income. That leaves them $2,000 for the year after that.
How Is the Cost Basis of a Stock Determined?
The cost basis of a stock is generally the amount you paid for your shares plus any dividends that you reinvested. In addition, you can add in any commissions or fees you paid as a part of those transactions. If you inherited the stock, its basis is whatever it was worth when the person who left it to you died.
What Is Tax Loss Harvesting?
Tax loss harvesting is a strategy in which an investor sells an investment at a loss, replaces it in their portfolio with a similar investment, and uses the capital loss to offset their gains or other income. Tax loss harvesting is legal, but investors have to be careful not to run afoul of wash sale rules, which prohibit buying a "substantially similar" security within 30 days of selling.
Can a Business Claim an NOL Carryforward on Its State Taxes?
State laws on NOL carryforwards can vary. Some follow the federal rules, while others set different dollar caps or time limits for carryforwards. Similarly, state laws on capital loss carryforwards can differ from the federal ones.
The Bottom Line
Businesses and individuals typically prefer profits to losses. However, losses have one upside: the ability to use them to offset gains, sometimes years into the future, through a carryforward.
