What Is a Loss Carryforward and How Does It Work?

A loss carryforward is a tax provision allowing individuals and businesses to utilize a tax loss incurred in one year to reduce taxable income in future tax years. This mechanism enables taxpayers to offset current losses against future profits, thereby lowering their overall tax obligations over time. It serves as a tool for managing taxable income across different periods, providing financial relief.

Basic Principles of Tax Losses

When a taxpayer incurs financial losses, their allowable deductions may exceed their gross income in a given tax year, resulting in a net loss. If insufficient current income exists to offset the full loss, a mechanism is needed to preserve their value. This allows them to be applied against income generated in subsequent years.

If losses surpass current income, the excess cannot simply disappear. Tax regulations provide a pathway for these unutilized losses to be carried forward, ensuring that taxpayers receive the benefit of their economic downturns. This carryforward capability helps to balance the tax burden over fluctuating income cycles, preventing an inequitable outcome where taxes are paid on profits without considering periods of significant loss. The system recognizes that a business or individual might have an unprofitable year but could be profitable in the future, and aims to average out the taxable income over time.

Specific Loss Categories for Carryforward

Several types of losses are eligible for carryforward treatment, with distinct rules governing their application. Two common categories are Net Operating Losses and Capital Losses.

Net Operating Losses (NOLs)

A Net Operating Loss (NOL) occurs when a taxpayer’s allowable business deductions exceed their taxable revenues for a given tax year. This loss can be incurred by various entities, including individuals with business income, C corporations, estates, and trusts. Common expenses contributing to an NOL include ordinary business operating expenses and depreciation. While partnerships and S corporations do not incur NOLs at the entity level, their partners or shareholders can use their share of the business’s losses to calculate their individual NOLs.

Capital Losses

A capital loss arises when a capital asset, such as stocks, bonds, or investment property, is sold for less than its original purchase price. Losses are realized only upon actual sale. Capital losses are first used to offset capital gains incurred in the same tax year; short-term losses against short-term gains, and long-term losses against long-term gains. If capital losses exceed capital gains, individuals can deduct up to $3,000 per year ($1,500 if married filing separately) against their ordinary income. Any remaining capital losses can be carried forward indefinitely to future tax years, retaining their original short-term or long-term character.

Applying Loss Carryforwards to Future Income

Once a loss carryforward amount has been determined, it can be used to reduce taxable income in subsequent tax years. This application process is subject to specific statutory limitations that dictate how much of the carryforward can be deducted in any single year.

For Net Operating Losses (NOLs) generated in tax years after 2017, the deduction is generally limited to 80% of taxable income in the year the NOL is used. This means a taxpayer cannot reduce their taxable income to zero solely with post-2017 NOLs. Current rules generally eliminate carrybacks, allowing NOLs to be carried forward indefinitely. Noncorporate taxpayers also face an “excess business loss” limitation, where business losses exceeding a certain threshold are treated as an NOL carryforward.

Capital loss carryforwards are applied first to offset capital gains in the carryforward year. After offsetting any capital gains, individuals can deduct up to $3,000 ($1,500 for married filing separately) of the remaining capital loss against their ordinary income. Unused portions continue to be carried forward indefinitely, allowing taxpayers to benefit from prior capital losses until the entire amount has been applied to reduce future taxable income.

Documentation for Loss Carryforwards

Maintaining accurate records is important for substantiating and tracking loss carryforwards. Taxpayers must retain specific documentation to support the initial loss calculation and to accurately apply the carryforward amount in future years. This record-keeping is important for audit purposes and ensures correct calculation of the remaining carryforward balance.

Necessary documentation includes:
Original tax returns for the year the loss was incurred, along with any supporting schedules and forms, such as Schedule C for business income or Schedule D for capital gains and losses.
Detailed financial statements, ledgers, and supporting documents for business expenses.
Records of asset purchases, sales, and any related costs for capital losses.
Worksheets or schedules used to calculate the loss carryforward amount, whether generated manually or by tax software.

The Internal Revenue Service generally recommends keeping tax records for three years after filing a return. However, for loss carryforwards, a longer retention period is often advisable. Consistent tracking of the carryforward balance year-over-year is important, as the amount available for deduction decreases with each year it is utilized.