How do net operating loss carryforwards work and how long can they reduce taxable income?
Executive summary
Net operating loss (NOL) carryforwards let a business or non‑corporate taxpayer apply a prior year’s deductible losses against future taxable income to reduce taxes; under current federal law most NOLs can be carried forward indefinitely but each year’s use is limited to 80% of taxable income (post‑2020 rules) [1] [2] [3]. The option to carry NOLs back to prior years was largely eliminated by the 2017 Tax Cuts and Jobs Act but was temporarily restored for certain years by the CARES Act and remains subject to nuanced statutory and agency rules [4] [5] [3].
1. What an NOL carryforward actually does: smoothing taxable income across years
A net operating loss arises when allowable deductions exceed gross income for a tax year; a carryforward applies that excess as a deduction against future taxable income so businesses with volatile results are taxed on a more averaged profit stream rather than year‑by‑year spikes [3] [2]. The mechanics require “modifying” taxable income in the carryforward year — taxpayers must compute a modified taxable income and the carryover equals the excess of the NOL deduction over that modified taxable income, with worksheets and IRS publications to guide the calculation (IRS Publication 536 explains the modification process and carryover computation) [6].
2. How long NOLs can be used at the federal level: indefinite carryforwards, with limits
The post‑2017 statutory regime removed the former 20‑year expiration for most NOLs and generally allows indefinite carryforwards, but it capped annual NOL offset to 80% of taxable income for tax years after 2020 — meaning an NOL cannot fully eliminate taxable income in a single year (TaxEDU, Investopedia, IRC §172 summaries) [1] [2] [3]. Prior to these changes taxpayers could carry NOLs forward for a fixed 20‑year window and in earlier eras had shorter carryback/forward rules, illustrating how Congress has reshaped timing rules for revenue and policy reasons [4] [7].
3. Exceptions, temporary rules and carrybacks: the CARES Act and special categories
The CARES Act temporarily allowed a five‑year carryback for NOLs arising in taxable years beginning after 2017 and before 2021, effectively reversing the TCJA rule for those years and generating possible refunds; IRS guidance and FAQs explain how to claim those carrybacks and the filing mechanics [5] [4]. Special sectors and circumstances retain different rules: certain farming losses, insurance companies, and other defined categories may have distinct carryback or carryforward treatments, and the 80% limitation can be inapplicable or modified under narrow statutory provisions [8].
4. State and local deviations — not all NOLs are treated the same
States and municipalities routinely carve their own path: California suspended the NOL deduction for 2024–2026 though it allows computation and carryover to preserve future use, and local jurisdictions such as Portland or Massachusetts can impose entirely different carryforward windows or caps (FTB California; Portland policy; Massachusetts regulation) [9] [10] [11]. That means an NOL that survives indefinitely at the federal level may still face state expiration, suspension, or percentage caps that materially change its tax planning value [9] [10].
5. Policy tradeoffs and practical tax planning implications
Policymakers altered NOL rules to raise revenue and limit the ability of losses to erase taxable income immediately — the Joint Committee and Congress cited revenue effects when changing carryforward length and the 80% usage cap — so the current mix of indefinite carryforwards and annual limits reflects a compromise between business smoothing and fiscal discipline [12] [7]. For taxpayers the practical takeaway is to track NOL origins, amounts used each year, and applicable federal and state rules because timing choices (carryback elections when available, or deferral of use) and sector exceptions can materially affect cash flow and refunds [6] [5].