Carryover

What Is Carryover?

Carryover, in the context of finance and taxation, refers to the ability to apply certain deductions, credits, or losses from one tax period to a subsequent tax period. This mechanism allows individuals and businesses to utilize tax benefits that could not be fully consumed in the current year, potentially reducing future taxable income or tax liability. Common examples of carryover provisions include those related to capital losses, net operating loss (NOLs), and certain credits.

History and Origin

The concept of carrying over losses to offset income in different periods has a long history in U.S. tax law. The ability to use losses to offset income earned in other years can be traced back to the Revenue Act of 1918, which first allowed for a one-year carryback and one-year carryforward of net operating losses for businesses.⁹ Over the decades, the specific periods for carrybacks and carryforwards have varied significantly, reflecting changes in economic policy and legislative priorities.

For instance, prior to the Tax Cuts and Jobs Act (TCJA) of 2017, net operating losses could generally be carried back two years and carried forward for up to 20 years.⁸ The TCJA, however, largely eliminated the net operating loss carryback for most taxpayers and introduced an 80% taxable income limitation for net operating loss carryforwards. In response to the economic impact of the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily reinstated and extended net operating loss carryback periods for losses incurred between 2018 and 2020, allowing them to be carried back up to five years.⁷ These legislative adjustments highlight the dynamic nature of carryover rules within the tax code, as outlined in sections such as 26 U.S. Code § 172 concerning net operating loss deductions.
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Key Takeaways

Carryover provisions allow unused tax deductions, credits, or losses to be applied to future tax periods.
This mechanism is primarily found in tax law and aims to prevent undue tax burdens in years of significant losses.
Common types of carryovers include capital loss carryovers and net operating loss (NOL) carryovers.
The specific rules and limitations for carryovers are subject to change based on tax legislation.
Carryovers can reduce a taxpayer's future taxable income or tax liability.

Formula and Calculation

The calculation of a carryover amount depends on the specific type of loss or credit.

Capital Loss Carryover:
For individuals, if capital losses exceed capital gains in a given tax year, a taxpayer can deduct up to $$3,000$ (or $$1,500$ if married filing separately) of the net capital loss against other types of income. ⁵Any remaining capital loss that exceeds this limit can be carried forward indefinitely to offset future capital gains and, within limits, ordinary income. The carryover retains its character as short-term or long-term.

The capital loss carryover to the next year is calculated as:

\text{Capital Loss Carryover} = \text{Net Capital Loss (Current Year)} - \text{Deduction Limit}

Where:

(\text{Net Capital Loss (Current Year)}) is the excess of capital losses over capital gains for the current year.
(\text{Deduction Limit}) is $$3,000$ (or $$1,500$ if married filing separately), or your Adjusted Gross Income if it is less than $$3,000$ (or $$1,500$).

Net Operating Loss (NOL) Carryover:
For businesses, an NOL occurs when allowable deductions exceed gross income. The calculation of an NOL involves specific adjustments to taxable income. The amount of the NOL that can be carried over depends on the year the loss occurred and current tax laws, which have historically permitted carrying losses forward and, at times, backward.

The general principle for an NOL carryover is:

\text{NOL Carryover} = \text{NOL (Current Year)} - \text{NOL Used in Prior/Current Years}

For taxable years beginning after December 31, 2020, the net operating loss deduction is generally limited to 80% of taxable income (calculated without the NOL deduction), with indefinite carryforward.
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Interpreting the Carryover

Interpreting a carryover primarily involves understanding its potential to reduce future tax obligations. For individuals, a capital loss carryover means that current investment losses can soften the blow of future realized gains or incrementally reduce ordinary income. Businesses, particularly those experiencing significant downturns, view net operating loss carryovers as crucial mechanisms to smooth out their tax burden over economic cycles. It provides a means to recoup taxes paid in profitable years (via carryback, when allowed) or reduce taxes in future profitable years (via carryforward). The existence and size of a carryover balance are important considerations for financial planning and forecasting, impacting future cash flow and profitability.

Hypothetical Example

Consider an individual investor, Sarah, who had the following investment activity in 2024:

Capital gains: $$10,000$
Capital losses: $$18,000$

Sarah has a net capital loss of $$18,000 - $10,000 = $8,000$ for 2024.
According to the rules, she can deduct up to $$3,000$ of this loss against her ordinary income in 2024.
So, $$8,000 - $3,000 = $5,000$ is the remaining capital loss.
This $$5,000$ becomes a carryover to 2025. In 2025, if Sarah realizes $$4,000$ in capital gains, she can use $$4,000$ of her $$5,000$ carryover to offset those gains entirely, resulting in no taxable capital gains for 2025. The remaining $$1,000$ (($5,000 - $4,000)) would then be carried over to 2026, where it can again be used to offset gains or up to $$3,000$ of ordinary income.

Practical Applications

Carryover provisions are integral to various aspects of financial planning and analysis:

Tax Planning: Both individuals and corporations leverage carryover rules to manage their tax liability across different years. This is particularly relevant in scenarios involving significant capital losses or business losses.
Investment Strategy: Understanding capital loss carryovers can influence investment decisions, as investors can use losses from underperforming assets to offset gains from profitable ones, a strategy often part of tax loss harvesting.
Business Operations: Companies facing volatile revenue streams or large one-time expenses (e.g., substantial amortization of assets) rely on net operating loss carryovers to stabilize their tax obligations and improve cash flow during challenging periods.
Estate and Gift Planning: While less common, certain carryover rules can apply to specific deductions or credits in estate tax or gift tax contexts, though these are typically handled under specific provisions.
Financial Reporting: Companies must accurately account for carryover tax assets (deferred tax assets) on their balance sheet, reflecting the future tax benefits derived from past losses or credits. This impacts financial statements and reflects adherence to accounting standards. The Internal Revenue Service (IRS) provides detailed guidance on reporting investment income and expenses, including capital gains and losses, in publications like IRS Publication 550.
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Limitations and Criticisms

While beneficial for taxpayers, carryover rules come with limitations and have faced criticism.

Complexity: The rules governing carryovers, especially for net operating losses, can be highly complex and are frequently modified by legislative changes. This complexity can make it challenging for taxpayers to accurately calculate and utilize their carryovers, often requiring professional tax advice.
Timing and Value: The benefit of a carryforward is realized in future years, meaning the present value of the tax saving is less than an immediate deduction. This timing difference can be a significant drawback, particularly for businesses in urgent need of liquidity.
Limitations on Use: For instance, net operating loss carryforwards are currently limited to 80% of taxable income for non-corporate taxpayers for years after 2020. ²This means a company cannot fully offset all future profits, potentially leaving a portion of income still subject to tax even with a large carryover.
Change in Ownership: Special rules under Internal Revenue Code Section 382 exist to limit the use of net operating loss carryforwards when there is a significant change in the ownership of a corporation. These anti-abuse rules prevent "trafficking" in loss corporations, where one company might acquire another primarily for its accumulated losses. This provision was significantly impacted by the Tax Reform Act of 1986.
¹* Regulatory Scrutiny: Taxpayers utilizing carryovers, particularly large amounts, may face increased scrutiny from tax authorities, requiring meticulous record-keeping and justification of the carried-over amounts.

Carryover vs. Tax Loss Harvesting

Carryover refers to the mechanism by which unused deductions, credits, or losses from one tax year are transferred and applied to future tax years. It is a procedural aspect of tax law that allows for the preservation of tax benefits. For example, if an investor has $$10,000$ in net capital losses and can only deduct $$3,000$ against ordinary income in the current year, the remaining $$7,000$ is a carryover to the next year.

In contrast, tax loss harvesting is an active investment strategy that involves intentionally selling investments at a loss to realize those losses. These realized losses can then be used to offset capital gains and, up to $$3,000$ annually, ordinary income. Tax loss harvesting often generates the losses that may then become carryovers if they cannot be fully utilized in the current tax year. The confusion arises because tax loss harvesting is a common practical application that results in the creation of losses that are often subject to carryover rules.

FAQs

What is the primary purpose of a carryover in taxation?

The primary purpose of a carryover is to allow taxpayers to smooth out their income and expenses over time for tax purposes. This helps prevent disproportionate tax burdens in years where significant losses or unused deductions occur, by letting them offset income in subsequent periods.

Can all types of losses be carried over indefinitely?

No, not all losses can be carried over indefinitely, and rules vary by type of loss and applicable tax laws. For example, while individual capital losses can be carried forward indefinitely, net operating loss carryforwards (for years after 2017, with some exceptions) are generally subject to an 80% taxable income limitation, though they can be carried forward indefinitely. It is always important to consult specific tax regulations for the relevant tax year.

How does a carryover benefit an investor?

A carryover benefits an investor by allowing them to use current investment losses to reduce their future taxable income. This can lead to lower taxes on future capital gains and, within limits, a reduction in ordinary income, effectively reducing their overall tax liability.