Can Net Operating Losses Offset Capital Gains?

Net Operating Losses (NOLs) and capital gains have specific rules governing their treatment under tax law. Understanding their interaction is important for determining overall tax liability. This article clarifies when an NOL can be used to reduce capital gains tax obligations.

Understanding Net Operating Losses

A Net Operating Loss (NOL) arises when a taxpayer’s allowable business deductions exceed their gross income for a given tax year. This occurs when a business experiences significant expenses or downturns, resulting in a negative taxable income. The primary purpose of an NOL is to allow taxpayers to “smooth out” their income and losses over multiple tax years.

This mechanism helps to alleviate the tax burden that might otherwise fall disproportionately on a business experiencing a loss in one year and profits in another. NOLs are available to individuals who incur losses from business activities, as well as corporations. The ability to utilize an NOL allows for a reduction in taxable income in past or future profitable years, reflecting the economic reality of the business’s overall performance.

Understanding Capital Gains

Capital gains represent the profit realized from the sale or exchange of a capital asset. Common examples include stocks, bonds, real estate, and certain collectibles. The tax treatment of these profits depends on how long the asset was held before its sale.

Profits from assets held for one year or less are classified as short-term capital gains. These gains are taxed at the taxpayer’s ordinary income tax rates, which are the same rates applied to wages, salaries, and other regular income. In contrast, profits from assets held for more than one year are considered long-term capital gains. Long-term capital gains benefit from preferential, lower tax rates compared to ordinary income rates, making their tax implications distinct.

How Net Operating Losses Interact with Capital Gains

Net Operating Losses are primarily designed to offset a taxpayer’s ordinary income. This means an NOL reduces income from sources such as wages, business profits, and interest. This fundamental principle guides how NOLs interact with different types of capital gains.

Short-term capital gains are taxed as ordinary income, so an NOL can be used to offset these gains. For instance, if a taxpayer has an NOL of $50,000 and short-term capital gains of $20,000, the NOL would reduce the $20,000 short-term capital gain along with other ordinary income.

Long-term capital gains, however, are treated differently. Because they receive preferential tax rates, NOLs cannot directly offset long-term capital gains that are taxed at these lower rates. While an NOL reduces a taxpayer’s overall taxable income, it does not directly reduce the amount of the long-term capital gain itself. For example, an NOL would not reduce a $100,000 long-term capital gain to $50,000.

For NOLs arising in tax years beginning after December 31, 2017, an 80% taxable income limitation applies, as outlined in Internal Revenue Code Section 172. This rule means an NOL deduction carried forward cannot reduce taxable income by more than 80% of the taxable income (calculated before the NOL deduction). For example, if a taxpayer has $100,000 in taxable income before applying an NOL, the NOL deduction for that year would be limited to $80,000, even if the available NOL is higher.

Key Considerations for Taxpayers

Taxpayers dealing with Net Operating Losses and capital gains should be aware of several practical considerations regarding how NOLs can be applied. The rules for carrying NOLs forward or back have changed over time, impacting how losses can be used across different tax periods. For NOLs arising in tax years beginning after December 31, 2017, the rule is that they can be carried forward indefinitely.

Historically, NOLs could be carried back to prior tax years, but for most NOLs arising after 2017, there is no carryback period. Temporary exceptions, such as the CARES Act, allowed a five-year carryback for certain NOLs arising in 2018, 2019, and 2020. Understanding the specific year the NOL arose is important for determining its applicable carryforward or carryback period.

While NOL utilization principles apply broadly, differences exist in how NOLs are calculated for individuals versus C-corporations. Individuals, including those with income from pass-through businesses, aggregate all their income and deductions to determine if an overall NOL exists. Corporations have specific corporate tax rules that govern their NOL calculations and deductions. Due to the complexity of these tax rules, consulting with a qualified tax professional is often advisable for specific situations.