What Is a Tax Loss? Ordinary, Capital, and Carryforwards

A tax loss is what results when the deductions and expenses you’re allowed to claim for the year add up to more than the income you earned. Depending on where the loss comes from, it can reduce the tax you owe this year, roll into future years, or both. The two forms it takes are ordinary losses from operating a business and capital losses from selling investments, and each follows its own set of rules for how much you can actually use.

How the Loss Gets Calculated

Start with gross income: wages, interest, dividends, business revenue, everything reportable. Subtract every deduction the tax code allows. For a business, that means the “ordinary and necessary” costs of the trade, including payroll, rent, supplies, and depreciation.¹ A sole proprietor with $50,000 of revenue and $60,000 of expenses has a $10,000 loss.

The word “allowable” carries weight. Spending money isn’t enough on its own; the expense has to fit a recognized category and survive several limitation rules before it can reduce taxable income. A loss that looks clean on paper can be partially or fully blocked by the rules covered below.

Ordinary Losses From a Business

When a business’s deductible expenses exceed its income, the shortfall is an ordinary loss. If it exceeds all your other income too, the leftover is a net operating loss (NOL). Ordinary losses can offset ordinary income, which includes wages and interest, so they reduce income taxed at your highest marginal rate.

For NOLs arising in tax years beginning after December 31, 2017, there is no expiration on the carryforward. You can use the loss in any future year. But the amount you deduct in a given year is capped at 80% of that year’s taxable income calculated before the NOL deduction, so an NOL carryforward cannot wipe your tax bill out entirely.²

Carrybacks are mostly gone. General business NOLs arising after 2017 only go forward. Farming losses can be carried back two years, and certain insurance company losses also qualify for a two-year carryback.²

One trap for self-employed taxpayers: an NOL carryforward reduces income tax but not self-employment tax. Self-employment tax runs off your current-year net earnings from self-employment, and the law excludes the NOL deduction from that calculation. Current-year business expenses cut both taxes; a carryforward from a prior year only helps with income tax.

Capital Losses From Selling Investments

A capital loss arises when you sell or exchange a capital asset, such as stock, a bond, or investment real estate, for less than your adjusted basis.³ Losses are short-term if you held the asset a year or less and long-term if you held it longer, and that classification controls how they mix with your gains. Stock that becomes completely worthless is treated as sold on the last day of the tax year for zero, producing a capital loss whose character depends on your holding period.⁴

Losses run through a netting process before they touch any other income. Short-term losses first offset short-term gains, long-term losses first offset long-term gains, and whatever remains in one bucket offsets gains in the other.³

If your total capital losses exceed your total capital gains, you can deduct only $3,000 of the excess against ordinary income each year. Married filing separately? $1,500.⁵ That $3,000 figure has stood since 1978 and isn’t indexed to inflation.

Any net capital loss above the annual cap carries forward. Character travels with it, so short-term stays short-term and long-term stays long-term.⁶ There’s no expiration. Each year you apply the carryover to that year’s capital gains first, then take up to $3,000 against ordinary income, then carry the rest forward again. A $30,000 net loss with no future gains takes about a decade to fully deduct.

The Wash Sale Rule

Selling at a loss and quickly buying back the same investment doesn’t produce a usable loss. If you sell a stock or security at a loss and buy a substantially identical replacement within 30 days before or 30 days after the sale, the loss is disallowed for that tax year.⁷ Acquiring a contract or option to buy the security inside that 61-day window counts too.⁸

The disallowed loss isn’t lost forever. It’s added to the basis of the replacement shares, deferring the tax benefit until you sell those replacement shares in a transaction that doesn’t trigger another wash sale. The original holding period tacks onto the new shares as well.⁷

Extra Limits on Business Losses

Business owners face a stack of restrictions, and they have to be applied in order. For S corporation shareholders and partners, that order is: basis, then at-risk, then passive activity, then the excess business loss limitation.⁹ A loss blocked at any stage gets suspended until you satisfy that limitation in a later year.

Basis and At-Risk

You can’t deduct losses that exceed your financial basis in the entity. Basis generally starts with your investment, grows with contributions and your share of income, and drops with distributions and prior losses.⁹

Losses that clear basis then face the at-risk rules. You can deduct only up to what you genuinely have at stake: cash and property you contributed, plus borrowed amounts if you’re personally on the hook. Non-recourse debt generally doesn’t count, with one exception. Qualified non-recourse financing secured by real property used in the activity is treated as at-risk.¹⁰ That’s a big reason real estate investors can often deduct larger losses than investors in other asset classes.

Passive Activity Losses

Losses that survive basis and at-risk then hit the passive activity rules. A passive activity is any trade or business you don’t materially participate in, and rental activities are generally treated as passive no matter how involved you are.¹¹ Passive losses can only offset passive income. Anything extra is suspended until you generate passive income or dispose of the whole activity in a taxable transaction.

Two exceptions matter for real estate. Active participants in rental real estate with modified AGI of $100,000 or less can deduct up to $25,000 of rental losses against non-passive income, with that allowance phasing out completely by $150,000 of modified AGI. And taxpayers who qualify as real estate professionals under the 750-hour test aren’t treated as passive in rental activities they materially participate in.¹²

Excess Business Loss

Non-corporate taxpayers face one more ceiling. For 2026, total business losses can’t exceed total business income plus $256,000 ($512,000 on a joint return). Anything over that is an “excess business loss,” disallowed for the current year and converted into an NOL carryforward.¹³ Under current law, this limitation is scheduled to expire after the 2026 tax year.

What Doesn’t Count: Hobby Losses

If the IRS decides an activity isn’t a genuine business, you can’t use its losses to offset your other income. The presumption runs in your favor if the activity showed a profit in at least three of the past five tax years (two of the past seven for horse breeding, training, showing, or racing).¹⁴ Failing that test doesn’t automatically make it a hobby, but it shifts the burden to you to show a profit motive through how you run it, your expertise, your time invested, and the changes you’ve made to improve results.¹⁵

Starting in 2026, the Tax Cuts and Jobs Act suspension of miscellaneous itemized deductions expires. Hobby expenses become deductible again as itemized deductions, but only up to hobby income for the year.¹⁴ A hobby still can’t produce a net loss against wages, and hobby income remains fully taxable.

Recordkeeping When Losses Carry Forward

Loss carryovers can run for many years, and you need documentation for every year the loss is still in play. The general rule ties recordkeeping to the statute of limitations, which for most returns is three years from filing. A worthless securities deduction extends the retention period to seven years.¹⁶ For a large capital loss or NOL you’re carrying forward, keep the original records until the loss is fully used, plus the statute period for the last return that claims it. A decade-long capital loss carryover means holding the original purchase and sale records the entire time.

Carryovers also don’t outlive the taxpayer. Capital loss and NOL carryovers can be claimed on the decedent’s final return, and a surviving spouse filing a joint final return can use them, but unused carryovers do not pass to heirs. Carryovers still held by an estate or trust at termination do pass to the beneficiaries who succeed to the property.¹⁷ For anyone sitting on significant accumulated losses, that’s a reason to think about accelerating gains in later years rather than letting the carryovers expire with the return.

1
Office of the Law Revision Counsel. 26 US Code 162 – Trade or Business Expenses
2
Office of the Law Revision Counsel. 26 US Code 172 – Net Operating Loss Deduction
3
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
4
eCFR. 26 CFR 1.165-5 – Worthless Securities
5
Office of the Law Revision Counsel. 26 US Code 1211 – Limitation on Capital Losses
6
Office of the Law Revision Counsel. 26 USC 1212 – Capital Loss Carrybacks and Carryovers
7
Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities
8
Investor.gov. Wash Sales
9
Internal Revenue Service. S Corporation Stock and Debt Basis – Section: Shareholder Loss Limitations
10
Office of the Law Revision Counsel. 26 US Code 465 – Deductions Limited to Amount at Risk
11
Office of the Law Revision Counsel. 26 US Code 469 – Passive Activity Losses and Credits Limited
12
Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules
13
Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction
14
Office of the Law Revision Counsel. 26 USC 183 – Activities Not Engaged in for Profit
15
Internal Revenue Service. Is Your Hobby a For-Profit Endeavor?
16
Internal Revenue Service. How Long Should I Keep Records
17
eCFR. 26 CFR 1.642(h)-1 – Unused Loss Carryovers on Termination of an Estate or Trust