A loss carryforward lets a taxpayer use a loss incurred in one year to reduce tax obligations in a future year. Businesses and business owners can carry forward net operating losses when expenses exceed income. Individual investors can carry forward capital losses after selling investments for less than they paid. For help with taxes and all other financial planning questions, consider working with a financial advisor.
Loss Carryforward Basics
Two types of losses can be carried forward. Businesses can use net operating loss carryforwards, while individual investors may be able to use capital loss carryforwards.
Net operating losses happen when a business’s allowable deductions exceed the amount of taxable income it reports for a year. This technique provides a useful way for businesses to get some value out of losses incurred in a particular year.
For example, a small business with $100,000 of income has $110,000 in deductions for the year. This produces a net operating loss of $10,000 that can be carried forward. If the business has $7,500 in taxable net income for the following year, the $10,000 tax loss carryforward can be used to reduce taxable income for that year to $2,500.
Individual investors who are not business owners can carry forward capital losses on money-losing investments. Capital losses only can be generated when money-losing investments are actually sold. This is why investors sometimes sell investments at yearend, harvesting the tax losses to apply to income that year or, if losses exceed capital gains for the year, to the following year.
As an example, an investor who purchased 1,000 shares of ABC for $10 per share and then sold them for $7 per share has a capital loss of $3,000. If the investor gains $3,000 on investments the following year, the prior year’s losses may be able to shield those gains from income taxes.
Tax Loss Carryforward Limitations
Businesses aren’t restricted to using net operating loss carryforwards to reduce taxes in the year after the losses were generated. Net operating loss carryforwards can be used at any time in the future. However, net operating loss carryforwards can only used in an amount equal to 80% of the business’s taxable income for that year.
Any excess tax loss carryforward can still be used. The business doesn’t have to apply the entire tax loss carryforward generated in a given year to profits from a single year. When a tax loss carryforward is partially applied to a given year, the excess tax loss carryforward available to use in additional future years is called a carryover.
Net operating losses can’t be used by businesses organized as flow-through entities, such as S corps and partnerships. These businesses’ gains and losses flow directly through to owners rather than being taxed at the business level. Although the business can’t use the tax loss carryforward, owners of businesses like these can apply the losses to their own personal tax returns.
Caps also apply to capital loss carryforwards. Investors can only apply $3,000 in tax loss carryforwards from one year to shield gains in any future year. However, any excess tax loss carryforward isn’t lost. In subsequent years, the investor can similarly use $3,000 in tax loss carryforwards until the entire tax loss carryforward is used up.
The restrictions depend on whether capital losses are short short-term capital losses, meaning the investment was held for less than a year, or long-term, for investments held more than a year. Investors can only use short-term capital losses to shield short-term capital gains, and long-term capital losses to shield long-term capital gains.
The wash sale rule is another important restriction. This rule states that investors can’t get a tax loss carryforward by selling a money-losing security if they then buy back the security, or one that is essentially the same, within 30 days.
Finally, states have a variety of ways for dealing with tax loss carryforwards. Different states may not allow some types or amounts of carryforwards.
Tax loss carryforwards can help businesses and individual investors pay fewer taxes in future years. Businesses can use net operating losses as tax loss carryforwards, while capital losses from investing activities can be carried forward by individual investors. While tax loss carryforwards don’t expire, there are limits the amount of tax loss carryforwards that can be used in a given year.
Tax Planning Tips
- A financial advisor can help investors and business owners decide how to use tax loss carryforwards to best advantage. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s free income tax calculator to get a sense of what you might owe Uncle Sam in a given year.
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