Tax Matters

A net operating loss requires special treatment

By David Katzman

Did your 2007 losses and deductions exceed your income? Then you may have a net operating loss (NOL), as defined by the Internal Revenue Service (IRS).  If your excess losses and deductions qualify as a NOL, you may be able to claim a refund of previous year’s taxes or lower or even eliminate tax on future income.

Generally a NOL results from business operations, but there are other circumstances that could create a NOL for taxpayers who are not business owners.  For example, it is possible for qualifying moving expenses or other deductible losses to create a NOL for an individual who is not self-employed. Casualty, theft or rental losses can also create a NOL for both business owners and individuals.

In most cases, you would apply a NOL to your federal tax return by looking back two years. For example, if you have a NOL in 2007, you would first apply it to your 2005 federal tax return. Any remaining NOL deductions would apply to your 2006 return. After that, you may apply any excess NOL to future returns for up to 20 years or until your NOL has been exhausted.

Properly filing a NOL for a previous year requires somewhat complex calculations as discussed below, as well as completing the appropriate IRS form. There are some exceptions. Qualifying farming losses can be carried back five years and some other specific types of losses provide different look-back periods. You can also elect to carry your NOL forward, foregoing the look-back period, but doing this requires the timely filing of notification with the IRS, and your decision is irrevocable.

Determining if you are eligible for a NOL deduction is complicated because there are numerous restrictions and exclusions regarding which deductions can be used to create a NOL. Here is a list of the restrictions and qualifications surrounding NOL deductions:

• Personal or dependency exemptions cannot be included.
• If you already have a NOL deduction, you cannot use it to help establish a new NOL for another year.
• Capital losses considered non-business, which includes losses outside your trade, business or employment, can be used only to offset non-business capital gains.
• Likewise, non-business deductions, such as charitable donations, mortgage interest or other such expenses, can only be used to offset like non-business income, such as interest or dividend income. However, if you have non-business capital gains that exceed your non-business capital losses you can use your “excess” non-business deductions against these gains.
• Generally, business capital losses must offset business capital gains. If you still have remaining non-business capital gains—after offsetting them against both non-business capital losses and excess non-business deductions—then you can apply your business capital losses against them.

David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.