What Are Tax Loss Carryforwards, and How Can They Help You?

If you’re an email subscriber or a follower of this blog, you’ve heard us mention tax loss carryforwards before. A tax loss carryforward (also known as a carryover) can be an important part of your tax strategy, and it’s one of the big reasons that a tax specialist can help you save money on your taxes even if your business is operating at a loss. Simply put, a tax loss carryforward allows you to carryover a tax loss from one year to the next. This means that you can offset future profit with this year’s losses, reducing your future tax payments. It’s important to note that you can claim the carryforward as an individual or as a business.  

Tax Loss Carryforward at a Glance:

  • By using a tax loss carryforward, taxpayers can use a taxable loss in the current period and apply it to a future tax period.
  • You can offset ordinary taxable income with capital losses that exceed capital gains. You can use up to $3,000 in any future tax year, indefinitely, up the total amount of the loss.
  • Business losses—called net operating losses (NOLs)—can be carried forward indefinitely as a result of the Tax Cuts and Jobs Act (TCJA). These losses are limited to 80% of the taxable income in the year you use the carryforward.
  • The rules around NOLS were modified in 2020 by the CARES Act. These modifications affected tax years 2018 – 2020.

How Do Tax Loss Carryforwards Work?

Negative profit (loss) happens when expenses are greater than revenue, or when capital losses are greater than capital gains. When your expenses are greater than your revenue, you can take advantage of a net operating loss (NOL) carryforward. If your capital losses exceed your capital gains, you can apply a capital loss carryforward. 

What is a Net Operating Loss?

Your expenses include all costs to run your business. These can be all of the obvious costs such as salaries, rent, and costs to acquire inventory. Other costs such as marketing and advertising, insurance, educational expenses, business mileage, and software are also considered business expenses. Basically, anything you have to spend to run your business counts as a business expense. At the end of each tax year, you will deduct your expenses from your revenue. If that number is positive, you have a profit, and you must pay taxes on that amount. If that number is negative, you have a net operating loss (NOL).

What is a Capital Loss?

When you sell a capital asset for less than its original purchase price, the result is a capital loss. Conversely, a capital gain occurs when you sell the asset for more than its purchase price. Capital assets include financial securities (stocks and bonds), precious metals, jewelry, and real estate.

Net Operating Loss Carryforward 

If you are a business owner, it’s important to know about NOLs, which result when a company’s allowable deductions exceed its taxable income within a tax period. If you find yourself with a net operating loss, you can use this NOL to offset the company’s tax payments in other tax periods through an Internal Revenue Service (IRS) tax provision called an NOL carryforward. Basically, an NOL carryforward applies the current year’s NOL against future years’ net income to reduce the total tax liability (the amount you owe) in future tax periods.

The NOL carryforward provision is intended to help businesses whose profits are cyclical or variable in nature. Farmers are subject to variability in weather patterns, real estate investors can fall prey to changes in demand for housing or mortgage interest rates, and retailers are beholden to consumer demand and trends. Each of these businesses can benefit from the NOL carryforward provision, which allows them to smooth the tax burden and offset future profit with current loss.

Recent Legislation That Affects Net Operating Loss Carryforwards 

The Tax Cuts and Jobs Act (TCJA) of 2018

The Tax Cuts and Jobs Act (TCJA) of 2018 changed some of the rules around NOL carryforwards. Before the TCJA, 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. Under these older years, any losses that remained unused after 20 years would “expire” and could no longer be used to reduce taxable income.

For tax years beginning Jan. 1, 2018 or later, the two-year carryback provision no longer applies. (There are a few very specific exceptions to this, mainly with farming losses and certain types of insurance companies.) While the carryback provision is gone, the new rules now allow for an indefinite carryforward period. This means your losses never expire, but there is a catch: carryforwards are now limited to 80% of each subsequent year’s net income. This means that you cannot reduce your future income to zero by applying an NOL carryforward. Losses occurring in tax years beginning prior to Jan. 1, 2018 are still subject to the former tax rules, so they can be used to offset 100% of a future year’s earnings, but they will expire after 20 years. 

The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020

Two years after the TCJA changed the carryforward rules, the Covid pandemic hit the world like a sledgehammer, and the federal government began scrambling to provide aid and relief in a myriad of ways. From a tax perspective, the IRS wanted to delay the implementation of the new carryforward rules, and allow for greater flexibility in applying the large losses they expected businesses to sustain. 

The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 provided some of this flexibility by effectively delaying the application of the TCJA amendments until Jan. 1, 2021. The CARES Act also revives the carryback provision, and extends it to five years. So for taxable years beginning after Dec. 2017 and before Jan. 1, 2021, businesses can claim a refund for prior year tax returns by applying the NOL as a carryback, up to five tax years preceding the tax year of the loss. 

This five year carryback provision is a valuable form of aid for struggling businesses, as the time value of money makes an immediate refund of past taxes paid more valuable than receiving the same amount of money sometime in the future. 

Capital Loss Carryforward 

As we discussed earlier, capital gains and losses arise when you sell capital assets such as stocks, bonds, jewelry, precious metals, and real estate. For your average taxpayer, their primary residence is their most significant capital asset. When you sell a capital asset, the gain (or loss) on the sale is the difference between its selling price and its tax basis. (The tax basis is generally the purchase price plus the cost of any improvements.) If the selling price is more than the tax basis, the result is a capital gain. If the selling price is less than the tax basis, the result is a loss.

Example of a Capital Gain

Let’s take a look at an example of a capital gain that explains the concept of “tax basis.” If you purchase your home for $200,000 in 2017, spend $100,000 on a new addition in 2019, and sell it in 2022 for $600,000, you will have a taxable capital gain for that year of $300,000. The $100,000 you spent on improving the home gets added to the original purchase price so that you’re not double taxed on the money you spent. 

 

Example of a Capital Loss

In this example, let’s say you purchased a piece of art from an avant-garde new artist in 2008 for $20,000. You think that this artist is going to be the next Picasso, but the market doesn’t agree, and by 2019, the painting is only worth $10,000. If you sell it for $10,000 in 2019, you will incur a $10,000 capital loss that can be used to offset any profits and capital gains incurred in that tax year, or carried forward to offset future tax liabilities. 

 

What Are the Rules Regarding Capital Loss Carryforwards?

In any given year, net capital losses can only be deducted up to a maximum of $3,000 ($1,500 for married filing separately). If you have net capital losses that exceed this $3,000 threshold, you can carry them forward to future tax years until they are exhausted. Net capital losses do not expire, and there is no limit to the number of years there might be a capital loss carryover.

 

Questions About Tax Loss Carryforwards?

Do you still have questions about tax loss carryforwards, or other ways you can reduce your taxable income and keep more of your money? Our PRIME advisors are always available for a free consultation, and our tax prep package is second to none. And if we’re doing your business taxes, we’ll even handle your personal tax return for free! Give us a call today at 855-442-3515 or schedule a consult easily on our site! Remember, when it comes to business success, it’s not what you make, it’s what you keep. Keep more with PRIME.