Tax Loss
A tax loss, also known as a “tax loss carryforward” or “net operating loss (NOL)” in the context of businesses, refers to a situation where a taxpayer’s total tax deductions exceed their total taxable income in a given tax year. This results in a negative taxable income for that year.
Tax losses can arise from various sources:
- Operating Losses: These are common for businesses, especially startups. In the early years, a company might incur higher expenses compared to revenues, leading to an operating loss.
- Capital Losses: These occur when an asset (e.g., stocks, real estate) is sold for less than its purchase price.
- Rental Property Losses: These can arise from deductible expenses related to a rental property exceeding the rental income.
- Casualty and Theft Losses: Unreimbursed losses from casualties or thefts can create a tax loss.
The importance of a tax loss lies in its potential future tax benefits:
- Carryforwards and Carrybacks: Depending on the jurisdiction, taxpayers (both individuals and corporations) might be allowed to carry forward the tax loss to offset future taxable income, or carry it back to recover taxes paid in prior years. The rules, time limits, and procedures can vary.For example, in the U.S., prior to the Tax Cuts and Jobs Act (TCJA) of 2017, corporations could carry back net operating losses two years and carry them forward for twenty years. Post-TCJA, the carryback provision was eliminated (with some temporary exceptions due to COVID-19 related legislation), but NOLs can be carried forward indefinitely. However, the NOL deduction is limited to 80% of taxable income for losses arising in tax years beginning after December 31, 2017.
- Liquidity Benefits: For businesses, the ability to carryback a tax loss might result in a tax refund for prior years, providing immediate liquidity.
- Tax Planning: Understanding how to utilize tax losses can be a critical component of an individual’s or business’s tax planning strategy.
Example of Tax Loss
Let’s delve deeper with a detailed example to better understand the concept of tax loss, specifically with an individual taxpayer focusing on capital losses.
Scenario:
Jane is an individual investor who invests in stocks. In 2022, she sells two stocks:
- Stock A: She bought for $10,000 and sold for $7,000, incurring a loss of $3,000.
- Stock B: She bought for $5,000 and sold for $8,000, realizing a gain of $3,000.
From these two transactions, her capital gain and loss offset each other, resulting in a net capital gain of $0 for the year.
However, later in 2022, Jane sells Stock C that she had bought for $12,000 at a price of $9,000, incurring a further loss of $3,000.
For the year 2022, Jane’s total capital transactions result in a net capital loss of $3,000.
Tax Implications:
- Offsetting Other Gains: If Jane had other capital gains in 2022, either short-term or long-term, the $3,000 loss could be used to offset those gains.
- Deducting from Ordinary Income: In the U.S., if an individual has a net capital loss for the year, they can use up to $3,000 of that loss to offset their ordinary income. So, if Jane had a salary of $50,000 in 2022, she could use the capital loss to reduce her taxable income to $47,000.
- Carrying Forward Excess Losses: If Jane’s capital loss was more than $3,000, she would be able to carry forward the excess to future years. For instance, if her net capital loss was $5,000, she could deduct $3,000 from her 2022 income and carry forward the remaining $2,000 to offset gains or income in 2023.
Outcome:
By realizing a capital loss in 2022, Jane can potentially lower her tax liability for that year. If she’s unable to utilize the entire loss amount in 2022, she can carry it forward to future years, offering potential tax benefits in subsequent years. This ability to offset gains or deduct a portion from ordinary income can be a strategic tool for taxpayers when managing their investments and financial planning.
