Can a Net Operating Loss (NOL) Offset Capital Gains?

Net operating losses (NOLs) and capital gains are distinct tax concepts that can significantly impact a taxpayer’s financial position. Understanding their definitions and how they interact is important for effective tax planning. This interaction allows a taxpayer to potentially reduce their tax liability by using losses from one area to offset gains in another.

Defining Net Operating Losses

A net operating loss (NOL) occurs when a taxpayer’s allowable deductions exceed their gross income for a tax year. NOLs provide tax relief by allowing taxpayers to use these losses to offset taxable income in other years, smoothing out income volatility over time.

NOLs generated after 2020 must be carried forward indefinitely until fully utilized. NOLs arising after 2017 can only offset up to 80% of taxable income in any given carryforward year.

Both individuals and businesses can incur NOLs. For individuals, an NOL might arise when nonbusiness deductions exceed nonbusiness income, or when business deductions exceed gross income.

Defining Capital Gains

Capital gains represent the profit realized from the sale or exchange of a capital asset. A capital asset generally includes most types of property owned for personal use or investment, such as stocks, bonds, real estate, and collectibles. When a capital asset is sold for more than its adjusted basis, a capital gain occurs.

Capital gains are categorized based on the asset’s holding period. A short-term capital gain arises from the sale of an asset held for one year or less. These gains are taxed at ordinary income tax rates, which can range from 10% to 37% depending on the taxpayer’s income and filing status.

Conversely, a long-term capital gain results from the sale of an asset held for more than one year. Long-term capital gains benefit from lower tax rates, which are currently 0%, 15%, or 20% for most taxpayers, based on their taxable income. Higher-income earners may also be subject to an additional 3.8% Net Investment Income Tax (NIIT) on both short-term and long-term capital gains.

The Interaction of Net Operating Losses and Capital Gains

Net operating losses can indeed be used to offset capital gains, though the application follows specific rules within the tax framework. When an NOL is carried to a year with capital gains, those gains are considered part of the overall taxable income that the NOL can reduce. This means that the NOL first reduces any ordinary income, and then any remaining NOL can be applied against capital gains. This sequential application ensures that the most heavily taxed income (ordinary income) is offset first.

The 80% taxable income limitation for post-2017 NOLs also applies when capital gains are present. For example, if a taxpayer has $100,000 of taxable income, including capital gains, the maximum NOL deduction from post-2017 losses would be $80,000. Any capital losses incurred in the year the NOL is being applied can affect the amount of taxable income available for the NOL offset. When calculating an NOL, capital losses can only offset capital gains, and any excess nonbusiness capital losses cannot be deducted beyond nonbusiness capital gains when figuring the NOL itself.

This interaction allows taxpayers to significantly reduce their overall tax liability in profitable years by leveraging prior-year losses. The ability to offset capital gains with NOLs is a fundamental aspect of the U.S. tax code, providing a mechanism for businesses and individuals to manage fluctuating income and losses over time. This strategic application can result in substantial tax savings, particularly for those with significant capital gains in a given year.

Applying the Offset

Applying an NOL deduction on a tax return involves specific procedural steps and the use of relevant tax forms. For individuals, the Net Operating Loss deduction is typically listed as a negative figure on Schedule 1 (Form 1040), line 8a, for the year to which the NOL is carried. Corporations report NOLs on their respective income tax returns, such as Form 1120.

Taxpayers with capital gains and losses generally report these transactions on Schedule D (Form 1040). Before reporting on Schedule D, individual capital transactions are detailed on Form 8949, Sales and Other Dispositions of Capital Assets. When an NOL is used to offset income, including capital gains, a statement showing all important facts about the NOL and its computation should be attached to the tax return.

For carrybacks, individuals might use Form 1045, Application for Tentative Refund, or file an amended return using Form 1040-X, Amended U.S. Individual Income Tax Return. Corporations seeking a carryback refund would typically use Form 1139, Corporation Application for Tentative Refund. It is crucial for taxpayers to maintain thorough records of the NOL calculation and its carryforward amounts to ensure accurate reporting in subsequent tax years. This meticulous tracking is necessary because NOLs can be carried forward indefinitely, requiring careful management over many years.