Net Operating Loss
A net operating loss (NOL) occurs when a taxpayer's allowable tax deductions from a trade or business exceed their gross income for the tax year, resulting in negative taxable income that can be carried forward to reduce taxable income in future years. Under current law as modified by the Tax Cuts and Jobs Act of 2017, NOLs from 2018 and later may be carried forward indefinitely but can only offset up to 80% of taxable income in any single carryforward year.
A net operating loss arises when business deductions exceed business income, creating a negative taxable income figure. For individuals, business income and losses from sole proprietorships (Schedule C), rental activities (subject to the passive activity loss rules), partnerships, and S corporations can contribute to an NOL. Not all losses qualify for NOL treatment — capital losses, for example, have their own carryforward rules and do not contribute to an NOL.
Before the Tax Cuts and Jobs Act of 2017, taxpayers could carry back an NOL two years to offset income in prior years (potentially generating refunds) and carry forward the unused portion for 20 years. The TCJA eliminated the two-year carryback for NOLs arising in tax years beginning after December 31, 2017 (with a temporary exception for certain farm losses), and extended the carryforward period to indefinite. However, the TCJA also limited the NOL deduction in any carryforward year to 80% of taxable income (computed before the NOL deduction), meaning NOLs can no longer fully eliminate taxable income in a given year.
The CARES Act, enacted in 2020, temporarily restored the two-year carryback for NOLs arising in 2018, 2019, and 2020, and suspended the 80% limitation for those years. These temporary provisions allowed businesses and individuals affected by the COVID-19 pandemic to apply losses against pre-TCJA income and potentially obtain cash refunds.
For individual investors, an NOL is most commonly generated in the context of self-employment, real estate, farming, or pass-through business ownership. A real estate professional with large depreciation deductions in excess of rental income, or a self-employed individual in a startup phase with expenses exceeding revenues, may generate an NOL. Suspended passive activity losses that are released upon sale of a passive activity can contribute to an NOL if they exceed other income.
NOLs are tracked on Form 1045 (for quick refund claims) or Form 1040-X (amended returns). Carryforward NOLs are tracked on the taxpayer's own records and claimed on Schedule 1 (Form 1040) in future years. The 80% limitation is applied against adjusted taxable income for the year, meaning taxpayers with large NOL carryforwards will always have some residual taxable income each year until the NOL is fully exhausted.
State NOL rules often differ from federal rules — many states conform to the TCJA changes, but some states maintain their own carryback provisions, different carryforward periods, or different percentage limitations.