How to Calculate NOL and Understand Carryover Options

A net operating loss (NOL) occurs when allowable tax deductions exceed taxable income in a given year. This can provide tax benefits by offsetting taxable income in other years, reducing overall tax liability. Understanding how to calculate an NOL and apply carryover options is essential for tax planning.

To use an NOL, taxpayers must determine eligible income, deductions, and necessary adjustments before calculating the total loss. Once calculated, they must decide whether to carry it forward to future years or, if applicable, carry it back to previous years.

Identifying Income and Deductions

Determining whether an NOL applies starts with identifying taxable income and deductible expenses. Taxable income includes revenue from business operations, wages, rental income, and investment earnings such as dividends and interest. Businesses must also consider gross receipts from sales, reduced by returns and allowances. Certain types of income, like tax-exempt interest from municipal bonds, should be excluded from calculations.

Deductions play a significant role in determining whether an NOL exists. Business expenses such as rent, utilities, employee wages, and the cost of goods sold (COGS) are deductible if they are necessary for operations. Depreciation on business assets, bad debt write-offs, and legal fees also qualify. For individuals, deductible expenses may include self-employment taxes, student loan interest, and contributions to retirement accounts, though these are subject to limitations.

Some deductions are restricted. The deduction for business interest expense is generally limited to 30% of adjusted taxable income under IRC Section 163(j), with exceptions for small businesses. Capital losses can only offset capital gains, with a maximum of $3,000 deductible against ordinary income per year. Any excess must be carried forward.

Making Adjustments for Nonbusiness Items

When determining an NOL, adjustments must be made for nonbusiness income and deductions. Some types of income, while taxable, do not originate from business activities and must be excluded from the NOL calculation. For example, taxable Social Security benefits, alimony received (for divorces finalized before 2019), and gambling winnings contribute to taxable income but are not considered business-related. Similarly, deductions tied to personal activities, such as medical expenses, charitable contributions, and mortgage interest, do not factor into the NOL calculation.

Losses from passive activities require further scrutiny. Under the passive activity loss (PAL) rules in IRC Section 469, losses from rental properties or businesses in which the taxpayer does not materially participate cannot offset non-passive income, such as wages or active business earnings. If these losses exceed passive income in a given year, they must be carried forward separately. Including passive losses in an NOL calculation incorrectly could lead to an IRS audit.

Nonbusiness capital losses also require attention. While capital losses exceeding capital gains can reduce taxable income up to $3,000 annually, they do not contribute to an NOL. Instead, excess capital losses must be carried forward to offset future capital gains. This prevents taxpayers from using investment losses to inflate an NOL and claim larger tax benefits than allowed.

Calculating the NOL

Once eligible income and deductions have been identified and necessary adjustments made, the NOL is determined by subtracting total allowable deductions from taxable income. If the result is negative, an NOL has occurred. However, not all losses reported on a tax return qualify, as certain limitations and modifications must be considered.

One modification involves the disallowance of the standard deduction or itemized deductions when calculating an NOL. While these deductions reduce taxable income for general tax purposes, they are not factored into the NOL calculation. Only business-related deductions and losses contribute to the final figure. Personal exemptions, which were eliminated under the Tax Cuts and Jobs Act (TCJA) for tax years 2018 through 2025, also do not impact the NOL computation.

Another adjustment applies to nonbusiness net operating losses, such as casualty and theft losses. While these losses may lower taxable income, they must be separated from business-related losses before determining the NOL. Only the portion of casualty or theft losses exceeding personal income sources can be included. This ensures that an NOL reflects actual business losses rather than personal financial setbacks.

Carryover or Carryback Options

After calculating an NOL, deciding how to apply it becomes a financial decision. Under current U.S. tax law, NOLs arising in tax years after December 31, 2017, generally cannot be carried back but can be carried forward indefinitely, subject to an 80% limitation on taxable income in future years under IRC Section 172. This means that while an NOL can reduce taxable income in subsequent years, it cannot fully eliminate it if the loss exceeds 80% of the taxable amount in a given year.

For businesses with cyclical earnings, carrying forward an NOL allows them to offset future profitable years, smoothing tax obligations over time. This is particularly beneficial for industries with fluctuating revenue, such as manufacturing or retail, where downturns in one year can be counterbalanced by gains in another. To maximize tax efficiency, businesses must project future earnings and determine the most advantageous way to apply the NOL while considering the impact on financial statements, particularly deferred tax assets under ASC 740.