What is a Net Operating Loss (NOL)?
A Net Operating Loss is when your business deductions or personal deductions exceed income for the tax year. In other words, the deductions that are allowable on an NOL are greater than the income that was earned, thus resulting in negative taxable income. Entering such losses into an NOL means the taxpayer may get to save on taxes since this loss can be moved to some other year, and thus taxes for those years may get lowered or taxes previously paid may get refunded.
Types of Net Operating Losses (NOLs)
There are two basic applications for taxpayers to reduce their taxes by using this Net Operating Loss: carryback and carryforward.
- NOL Carryforward: After 2020, the carryforward of an NOL against future taxable income is the only option for most taxpayers. The NOL can be then applied to income for the following taxable years from the year it was incurred until being used up in this manner.
- NOL Carryback: Prior to the enactment of the TCJA, an NOL could be carried back to offset taxes paid in past years. Generally speaking, however, most taxpayers cannot carry back NOLs now, unless in the event of certain farming losses.
What Kinds of Events Can Trigger NOL?
The first thing that triggers an NOL on this scale would be really bad years in terms of heavy losses.
- Losses By Business: An NOL might result if the expenses of running the business exceed income.
- Casualty And Theft Losses: in specific cases, losses resulting from federally declared disasters can also cause an NOL.
- Rental Property Losses: When expenses created from rental properties exceed rental income, this is a certain calculation for an NOL.
- Excess Business Loss: For noncorporate taxpayers, certain business losses exceeding a limit may also create a resulting NOL if such losses are limited by the TCJA.
What Happens in an NOL Calculation?
During an NOL calculation, taxpayers determine their deductions and income for the year, whereby an NOL has occurred if deductions exceed income. The following steps are involved:
- Tallying the Total Income and Deductions: All sources of income are included in total income-wages earned, business income, and other sources of income. Deductions include business expenses, casualty losses, and any other allowable tax deductions.
- Calculate the NOL: If deductions exceed income, the taxpayer has an NOL for the year, which can be carried forward to offset taxes for the upcoming taxable income in the years applied.
- File IRS Forms: Taxpayers must use IRS forms, such as IRS Form 1045 or 1040-X, to forward or back the NOL to other tax years.
What Are the Possible Outcomes Of An NOL?
Upon computation of the NOL, one of the following outcomes is likely to occur:
- NOL Carryforward: The NOL is carried into the next years so as to minimize taxable income, thus lowering the tax bill for that particular year possibly.
- Tax Refund: This will be true only if the NOL has been carried back to a previous year and a tax refund has been claimed for taxes paid in that previous year.
- Tax Adjustment: If the IRS detects any mistakes in the calculation of the NOL, the taxpayer may be obliged to make some adjustments and pay any taxes that they may now owe.
Preparing for an NOL
Taxpayers can minimize the impact of an NOL by preparing ahead of time:
- Maintain Detailed Records: It’s essential to keep accurate records of income and expenses for at least three years, as the IRS may audit returns from the past several years.
- Understand NOL Carryforwards: Make sure you understand how to carry forward NOLs to future years and track how much of the loss remains to apply against future income.
- Seek Professional Help: For complex NOL calculations, especially if you are dealing with significant losses or complicated tax situations, it’s beneficial to consult a tax professional for guidance.
For further guidance on NOLs, visit the IRS Publication 536: Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.