What Is a Tax Carryforward and How Does It Work?
Learn the principles of carrying unused tax benefits to future years. Understand the critical rules, limitations, and reporting needed to reduce future tax bills.
A tax carryforward allows a taxpayer to apply certain deductions, credits, or losses that could not be fully used in one tax year to a future year’s tax return. This mechanism prevents the permanent loss of a tax benefit when it exceeds an annual limit or there is not enough income to absorb it. Think of it as tax-related store credit; if you cannot use the full value of a benefit due to certain restrictions, a carryforward lets you save the remaining value for your next visit.
Common Types of Individual Carryforwards
When an individual sells a capital asset, like stocks or bonds, for less than its purchase price, a capital loss occurs. These losses first offset any capital gains realized during the year. If losses still remain, a taxpayer can deduct up to $3,000 of the net capital loss against other income. Any loss exceeding this $3,000 annual limit is carried forward to future tax years, where it can be used to offset future capital gains and the annual $3,000 of ordinary income.
Charitable contributions generate carryforwards when they exceed annual limits based on a taxpayer’s Adjusted Gross Income (AGI). Cash contributions to public charities are deductible up to 60% of AGI, while donations of appreciated property are limited to 30% of AGI. If a taxpayer’s donations surpass these percentages, the excess amount can be carried forward and deducted in subsequent years. If the carryforward is not fully used within that timeframe, any remaining amount expires.
The home office deduction can create a carryforward for self-employed individuals. The deduction is based on actual expenses like a portion of mortgage interest, utilities, and depreciation. The total deduction cannot exceed the gross income earned from the business use of the home. If home office expenses are greater than the business’s income, the excess is carried forward to the next tax year.
Common Types of Business Carryforwards
Businesses generate a Net Operating Loss (NOL) when their deductible expenses are greater than their income. Federal law allows most businesses to carry NOLs forward to offset future profits. However, the NOL deduction in a future year is restricted to 80% of that year’s taxable income. This means a business with a large NOL carryforward cannot completely eliminate its tax liability in a profitable year. For most businesses, the option to carry an NOL back to a prior tax year has been eliminated.
The General Business Credit is an umbrella term for a collection of individual business tax credits, like the Work Opportunity Credit and the Research Credit. If the total combined credit exceeds the taxpayer’s tax liability for the year, the unused portion is subject to carryover rules. The unused General Business Credit can be carried back one year and then carried forward.
Passive activity losses come from ventures where a taxpayer does not materially participate, such as rental real estate. Losses from passive activities can only be used to offset income from other passive activities. If a taxpayer has a net passive loss for the year, it is suspended and carried forward. This suspended loss can offset future passive income or be fully deducted when the taxpayer disposes of their entire interest in the activity that generated the loss.
Limitations and Ordering Rules
The use of carryforwards is governed by a framework of rules that dictate how and when they can be applied. Many carryforward deductions are subject to income-based limitations in the year of use. These rules prevent a carryforward from disproportionately reducing tax liability in a single profitable year.
When a taxpayer holds carryforwards of the same type from multiple years, the IRS requires a “First-In, First-Out” (FIFO) approach. This means the oldest carryforwards must be used before more recent ones. For example, with charitable contribution carryovers from different years, the carryover from the earliest year must be applied first. This ordering rule helps manage carryforwards that have an expiration date.
The lifespan of a carryforward varies by its type. Some, like those for capital losses and Net Operating Losses (NOLs), can be carried forward indefinitely. Others have a finite life, such as charitable contribution carryovers, which expire after five years, and most General Business Credits, which expire after 20 years. Taxpayers must track these expiration dates to prioritize using carryforwards that are closer to expiring.
Tracking and Reporting Carryforwards
The responsibility for tracking carryforward amounts rests with the taxpayer, not the IRS. Accurate record-keeping is required, as the amount available in one year is based on a prior year’s return. The source document for a carryforward is the tax return from the year it originated and each subsequent year it was carried to. These records should be retained for as long as the carryforward exists, plus three years after it is used or expires. A capital loss carryover from a prior year is found on Schedule D (Form 1040), while charitable contribution deductions, including carryovers, are on Schedule A.
Other carryforwards are reported on specific forms:
- A Net Operating Loss (NOL) carryforward is reported as a negative value on the “Other Income” line of Schedule 1 (Form 1040).
- The carryover for an unused home office deduction is calculated on Form 8829, Expenses for Business Use of Your Home.
- Unused General Business Credits are tracked on Form 3800, General Business Credit.
- Suspended passive activity losses are calculated and tracked on Form 8582, Passive Activity Loss Limitations.