Dana F. Cole & Company LLP
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Mar 9, 2026
3 min read

Demystifying the Tax Rules for Net Operating Losses

Taxpayers who suffered net operating losses (NOLs) in the 2025 tax year may hope to take advantage of them to reduce future tax bills. However, various limits determine eligibility for NOL deductions and the size of those tax breaks. In short, the rules can be confusing. To help demystify them, let's explore the key details.

Ground Rules

The NOL deduction was designed to reduce tax inequities between businesses with stable year-to-year income and those with fluctuating profits. Essentially, it allows net losses in one year to offset taxable income in other years.

An NOL can arise when tax deductions for the year exceed gross income. To qualify as a deductible NOL, the loss generally must be attributable to deductions related to a 1) trade or business, 2) rental property, or 3) casualty or theft loss resulting from a qualified disaster. According to the IRS, a business loss is the most common reason for an NOL.

Owners of pass-through entities claim NOL deductions on their individual tax returns because losses from these entities flow through to the owners rather than being deducted at the entity level. (Such owners include S corporation shareholders, partners in partnerships and members of limited liability companies treated as partnerships for tax purposes.) Sole proprietors also claim NOL deductions on their individual returns. The following generally aren't allowed when determining an individual's NOL:

  • Capital losses that exceed capital gains,
  • The exclusion for gains from the sale or exchange of qualified small business stock,
  • Nonbusiness deductions (for example, the standard deduction or itemized deductions such as the charitable contribution deduction and the mortgage interest deduction) that exceed nonbusiness income,
  • The Section 199A qualified business income deduction, or
  • The NOL deduction itself.

Noncorporate taxpayers may also be subject to excess business loss limitations. Consult your tax advisor for more information about these.

C corporations may claim NOL deductions at the entity level. For such companies, NOLs are determined without considering 1) the dividends-received deductions (calculated without regard to the aggregate limitations that typically apply to the deductions), 2) the deduction for foreign-derived deduction-eligible income, or 3) the NOL deduction itself.

Deduction Limits

The 2017 Tax Cuts and Jobs Act (TCJA) significantly changed the NOL rules, and the One Big Beautiful Bill Act, enacted in July 2025, retained those changes. Before the TCJA, you could carry back NOLs two years and carry them forward 20 years — that is, deduct them from your taxable income for years within those boundaries. You could also apply your NOLs against 100% of your taxable income, potentially reducing it to zero.

The TCJA eliminated the carryback of NOLs (except for certain farming losses, which can be carried back two years), though it did allow NOLs to be carried forward indefinitely. The TCJA also generally limited the NOL deduction to 80% of taxable income for a tax year. So, even if you have enough NOL carryforwards to offset all of your taxable income for a particular tax year, you can apply only the amount that will offset 80% of that income. You still must pay taxes on 20% of that year's taxable income.

The pandemic prompted some short-term changes to the TCJA rules, leading to lingering confusion among some taxpayers. The CARES Act of 2020 temporarily loosened the TCJA's restrictions. It permitted taxpayers with NOLs arising in 2018, 2019 or 2020 to carry them back five years and removed the taxable income limitation for years beginning before 2021. As a result, those NOLs could completely offset income.

When the pandemic provisions expired, the 80% income limitation resumed for NOLs arising in 2021 and beyond. In addition, you generally can only carry forward — not back — NOLs arising in tax years after 2020 (with the exception of certain farming losses).

If your NOL carryforward exceeds the amount you're allowed to deduct in a given year, you may continue to carry forward the unused portion until it's used up. If you have NOLs arising from multiple years, you must apply them in the order they were incurred, beginning with the earliest loss.

Leave Nothing on the Table

Because you can carry forward NOLs indefinitely, it pays to use them judiciously. They might come in handy for improving cash flow and hedging against future income volatility. Conversely, the inability to carry back most NOLs means you can't count on a refund from a previous tax year to help you out during a downturn.

Whether filing your 2025 tax return or developing tax-planning strategies for 2026 and beyond, don't overlook the strategic importance of NOLs. They can affect both your short- and long-term liability. Work closely with your tax advisor to ensure you leave nothing on the table.