Net Operating Loss (NOL)

A net operating loss is, in the words of section 172(c) of the Internal Revenue Code, "the excess of the deductions allowed by this chapter over the gross income", computed with a set of modifications that strip out items not tied to economic loss. The deduction for using it in another year is the net operating loss deduction, and the amount not yet used is the NOL carryover.

An NOL is different from a capital loss carryover. A capital loss beyond capital gains is limited to a small annual deduction against ordinary income and carries forward on its own track, and capital losses are excluded from an individual's NOL computation except to the extent of capital gains.

What can create one. An individual's NOL generally comes from deductions attributable to a trade or business, rental property, or a deductible casualty or theft loss, such as one from a declared disaster. A sole proprietor's Schedule C loss is the most common source. A partnership or S corporation does not have an NOL of its own; each owner uses their share of the business's income and deductions in figuring their own.

The modifications. Section 172(d) prevents the computation from producing a loss out of items that are not losses:

• No NOL deduction from another year is allowed in figuring this year's NOL.
• Capital losses count only up to capital gains, and the section 1202 small business stock exclusion is not allowed.
• The qualified business income deduction is not allowed, nor is a personal exemption.
• Nonbusiness deductions count only up to nonbusiness income. Nonbusiness deductions include the standard deduction, most itemized deductions, IRA and HSA deductions and contributions to the owner's own retirement plan. Interest, dividends and nonbusiness capital gains are nonbusiness income; wages are treated as business income.
• Casualty and theft losses deductible under section 165(c)(2) or (3) are treated as business deductions, which is why a large uninsured disaster loss can create an NOL for someone who is not in business at all.

Carryforward and carryback. For a loss arising in a tax year beginning after 2017, section 172(b)(1)(A) makes it a carryover "to each taxable year following the taxable year of the loss", with no expiration, but there is no general carryback. The exception is a farming loss, which goes back two years first unless the taxpayer elects to waive the carryback. Losses from tax years before 2018 follow the older rules, including a 20-year carryforward, and are rare by now.

The 80% limit. Under section 172(a)(2), for tax years beginning after 2020, carryovers of post-2017 losses can reduce taxable income by no more than 80% of taxable income computed without the NOL deduction and without the qualified business income deduction. So a large carryover takes at least several years to use, and some tax is due each year the limit binds.

Excess business losses. A noncorporate taxpayer whose business losses exceed business income by more than an inflation-indexed threshold cannot deduct the excess this year under section 461(l); the disallowed amount becomes part of the NOL carryover to the next year. The One Big Beautiful Bill Act made that limit permanent.

Corporations. A C corporation's NOL follows the same carryforward and 80% rules but without the individual modifications, and it belongs to the corporation, not its shareholders. State income tax rules on NOLs are set by each state and can differ from the federal rules.

1. Complete the year's return. If taxable income is negative, there may be an NOL.

2. Figure the NOL on Form 172. Start from the return, add back the modifications (the standard deduction or itemized deductions above nonbusiness income, capital losses above capital gains, the qualified business income deduction, any NOL carried in), and include any disallowed excess business loss.

3. Decide on a carryback. Only a farming loss can be carried back, and a farmer can waive the two-year carryback by a statement with a timely return. A carryback is claimed on Form 1045 (generally within a year after the loss year ends) or on amended returns.

4. Deduct it in later years. Each year, the deduction for post-2017 losses is the lesser of the remaining carryover and 80% of taxable income figured before the NOL deduction and the qualified business income deduction. Track what is left.

Take an example. In 2026, Keiko, who is single, has $20,000 of wages from a part-time job, $1,000 of interest, and a $150,000 loss from her bakery on Schedule C. For the NOL computation her wages count as business income, so her business items net to a $130,000 loss ($20,000 minus $150,000). Her standard deduction is a nonbusiness deduction and counts only up to her $1,000 of interest, so the nonbusiness items net to zero. Her NOL is $130,000.

In 2027 her taxable income before any NOL deduction is $100,000, with no qualified business income deduction. The 80% limit caps her NOL deduction at $80,000, which brings her taxable income to $20,000, and $50,000 carries to 2028 ($130,000 minus $80,000).

Pros

• A bad year's loss is not wasted: it reduces tax in the profitable years that follow, smoothing tax over the life of a business.
• Post-2017 losses never expire, so a carryover survives a long slump.
• A large uninsured disaster loss can produce an NOL even for someone with no business.

Cons

• Except for farming losses, there is no carryback, so the tax benefit waits for future profits that may never come.
• The 80% limit means tax is owed in a recovery year even while carryovers remain.
• The computation is technical: standard and itemized deductions, capital losses and the qualified business income deduction must be stripped out, and an error carries forward into every later year.
• Canceled debt excluded from income in bankruptcy or insolvency reduces an NOL first, so a carryover can shrink before it is ever used.