A net operating loss arises when your allowable deductions exceed your gross income for the year, so the business loss is bigger than everything else on the return can absorb. Under IRC Section 172, that unused loss becomes a carryforward that offsets taxable income in future years. NOLs matter most to founders and self-employed people in expensive early years, and to anyone whose accelerated depreciation deductions swamp a single year's income.
How Section 172 carryforwards work
For losses arising in 2021 and later, the rules are one-directional: no carryback to earlier years (farming losses keep a two-year carryback as a narrow exception), and an indefinite carryforward with no expiration date. In any carryforward year, the NOL deduction is limited to 80% of that year's taxable income computed before the NOL, so at least 20% of the year's income stays taxable no matter how large the carryforward is. Multiple years of NOLs are used oldest first.
For an individual, the NOL is not simply the negative number at the bottom of the Form 1040. A worksheet strips out nonbusiness items: the standard deduction and other personal deductions count only against nonbusiness income, and capital losses are limited to capital gains. What survives is the true business loss. Corporate NOLs live inside the corporation on Form 1120 and never reach the shareholders; after an ownership change, Section 382 caps how much of the old NOL the new owners can use each year, which is why acquirers price NOLs cautiously.
The four gates a pass-through loss clears first
Before a Schedule C, K-1 or rental loss can become an NOL, it must survive four limitations in order. First, basis: an S corporation shareholder or partner can deduct losses only up to stock and debt basis or outside basis. Second, the at-risk rules of Section 465, which limit losses to amounts genuinely at economic risk. Third, the passive activity rules of Section 469, which suspend losses from activities without material participation. Fourth, the excess business loss limitation of Section 461(l), which caps how much net business loss can offset nonbusiness income such as a spouse's wages or portfolio income; the excess is not lost but converts automatically into an NOL carryforward. A loss stopped at any earlier gate is suspended under that gate's own rules and is not an NOL yet.
2025 and 2026 figures
The excess business loss threshold is $313,000 for single filers and $626,000 for joint filers for 2025; the limitation is indexed annually and was made permanent by the 2025 tax legislation, so expect slightly higher 2026 numbers in the IRS's annual inflation release. The 80% of taxable income limit on NOL usage is statutory and unchanged for 2026. The most common NOL accelerator also got stronger: the 2025 legislation restored 100% bonus depreciation for qualifying property acquired after January 19, 2025, so a heavy equipment year can once again produce a first-year loss by design.
For creators and the self-employed
The classic creator NOL year looks like this: a studio build-out, cameras, editing rigs and software expensed through Section 179, bonus depreciation and the de minimis rules, while channel or client revenue is still ramping. The Schedule C loss first offsets everything else on the Form 1040, a spouse's W-2, a day job kept during the transition, interest and dividends; only what is left over becomes the NOL, subject to the excess business loss cap.
Two wrinkles are worth knowing. Self-employment tax runs on its own track: an NOL carryforward reduces income tax in future years but does not reduce Schedule SE self-employment tax, which is computed on that year's net earnings alone. And repeated losses draw hobby loss scrutiny under the nine-factor business-or-hobby analysis; a creator who loses money three years running should be able to show businesslike records, a profit plan, and real efforts to monetize, or the IRS can disallow the losses entirely rather than let them carry forward.
Operationally, treat the NOL like the asset it is. Keep a year-by-year schedule of each loss year, the amount generated, the amounts absorbed, and the balance remaining, because software handles this badly across preparer changes. Fold the carryforward into quarterly planning: a large NOL can legitimately shrink next year's Form 1040-ES payments. And loss years are planning gold for other moves: income recognized in a loss year, from a Roth conversion or from harvesting long-held gains, may simply soak into the loss at little or no tax cost.
Mistakes that cost money
- Losing the schedule. An NOL that nobody carries forward is pure overpaid tax. A missed deduction can generally be recovered only by amending within the three-year window; after that it is gone.
- Expecting a refund check. With carrybacks gone, a first-year loss produces no cash today, only a future deduction. Founders who budget a refund into their runway are planning with money that will not arrive.
- Projecting zero tax next year. The 80% limit means a profitable year always leaves at least 20% of income taxable. Modeling next year at zero understates the bill and can trigger an underpayment penalty.
- Skipping the gates. Deducting an S corporation loss with no basis, or a passive loss without material participation, invites disallowance on exam, plus interest and accuracy penalties, years after the return was filed.
- Burning the NOL on cheap income. Using carryforward against income that would have been taxed at 0% or 10% anyway, or triggering hobby reclassification with years of casual losses, wastes a deduction that could have offset 32% or 37% income later.
An NOL touches basis, passive, excess business loss and estimated tax rules all at once, so the year you generate one, and the first profitable year after it, are both worth a professional review rather than a software default.