Net operating losses (NOLs) explained for tax professionals

Net operating losses (NOLs) raise more questions than most tax pros may expect.

You think you understand them. Then you inherit a return with a carryforward from three years ago, and suddenly you’re rebuilding history line by line. That’s where things get messy.

Know this: Using an NOL is neither optional nor flexible, and not something a taxpayer can choose to “save for later.” Once it exists, tax law dictates how it must be calculated, carried forward and applied.

Quick NOL takeaways for tax pros

• An NOL is not simply the negative taxable income shown on a Form 1040, U.S. Individual Income Tax Return
  • Required modifications change the amount that actually becomes an NOL
• NOLs must be used when taxable income exists
• Post-2017 NOLs carry forward indefinitely but are generally limited to 80% of taxable income
• Farming losses may be carried back two years, unless the taxpayer elects to waive the carryback
• Intervening years matter more than most practitioners realize  

What is an NOL, really?

An NOL occurs when deductions exceed income for the year, but not every loss becomes a full NOL.

Capital loss limits, nonbusiness deductions, excess business loss limitations along with other adjustments can reduce what ultimately becomes the NOL. That means the loss reflected on the return is often not the amount that carries forward.

For example, a taxpayer may show a $40,000 negative taxable income amount on the return, but after the required NOL adjustments, only $28,000 may be available as an NOL carryforward. 

The calculation is formally documented using Form 172, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, which is attached when applicable. 

NOL utilization is not a choice

This is one of the most misunderstood areas of NOLs.

If taxable income exists in a future year, the NOL must be applied. There is no election to preserve it for a “better” year. The law requires it to offset income, generally subject to the 80% limitation.

• That means planning flexibility with NOLs is limited. 
• Strategy happens at the creation stage, not at the utilization stage.

NOL carryforward miscalculations typically occur in intervening years

Every year, the loss in the previous year and the current year affect the remaining carryforward.

If a client had:

Year 1: $100,000 NOL
Year 2: $60,000 taxable income
Year 3: $40,000 taxable income
Year 4: You prepare the return

You cannot simply subtract $60,000 and $40,000 and assume the NOL is gone. The 80% taxable income limitation generally applies each year, and the math must be recomputed annually. 

If the taxpayer misses one intervening year, the carryforward schedule will collapse. Post-2017 NOLs generally carry forward indefinitely, but for tax years beginning after Dec. 31, 2020, the deduction attributable to those post-2017 NOLs is generally limited to 80% of taxable income.

Simple NOL-utilization example

Year 1
NOL created: $100,000

Year 2
Taxable income before the NOL deduction: $60,000
80% limitation: $60,000 x 80% = $48,000
NOL used in Year 2: $48,000
Remaining NOL carryforward: $100,000 - $48,000 = $52,000

Year 3
Taxable income before the NOL deduction: $40,000
80% limitation: $40,000 x 80% = $32,000
NOL used in Year 3: $32,000
Remaining NOL carryforward: $52,000 - $32,000 = $20,000

Year 4
Carryforward available entering the year: $20,000

This schedule must be preserved and supported each year. If one intervening year is missed or calculated incorrectly, the remaining carryforward will also be wrong, which can lead to amended returns, extra reconstruction work or even IRS correspondence.

Complicating the NOL landscape

Several provisions can reduce or defer losses before they ever become an NOL:

• Excess business loss (EBL) limitation
• Farming loss rules
• Changes in filing status that affect NOL use
• Trust and estate computations

Each can affect the amount entering the NOL calculation.

In practice, the most common cleanup issue is not miscalculating the original loss, it’s failing to track usage correctly over time.

When that happens, reconstruction may require revised carryforward schedules or other corrective steps, such as amending prior returns or using Form 1045, Application for Tentative Refund, where applicable.

What NOLs mean for your practice

Be aware that NOLs are not simply a line item. They are a multi-year compliance responsibility.

• Maintaining strong documentation throughout the entire life of the NOL protects your clients. 
• A clean annual carryforward schedule helps avoid downstream reconstruction work. 
• When inheriting a client file, review intervening years carefully.

NOLs can absolutely turn a down year into a long-term planning opportunity. But only if they are calculated correctly and tracked annually in accordance with the rules.

If you want a structured walk-through of the mechanics, including required modifications, the 80% limitation, EBL interaction and documentation best practices, attend NATP’s Working with Net Operating Losses webinar, May 21 or on demand.