The Tax Cut and Jobs Act made several important changes to the net operating loss (“NOL”) rules. The following is a brief discussion of these changes. Businesses that generate significant NOLs, such as real estate companies that have large depreciation deductions in early years, will see both a benefit and a detriment from these changes.
1. What is a NOL?
A taxpayer has a NOL to the extent his or her business deductions in a tax year exceed gross income. For example, if a taxpayer has $100 in depreciation deductions and $80 of gross income, the taxpayer would have $20 in NOLs.
2. How were NOLs treated before the Tax Cut and Jobs Act?
A taxpayer could offset past or future taxable income by carrying the NOLs back two years or carrying it forward 20 years as a deduction against income. However, if the taxpayer could not use the NOLs within that time period, the NOLs expire and disappear.
3. How does the Tax Cut and Jobs Act change the treatment of NOLs?
The treatment of NOLs changed in two important ways. First, a taxpayer is limited in how much gross income can be offset. A taxpayer can now only use NOLs to offset up to 80% of gross income. For example, a taxpayer with $100 of NOLs and $50 of gross income will only be able to utilize $40 of the NOLs to offset the $50 of gross income. The taxpayer will have to recognize $10 of taxable income and carry forward the remaining $60 of NOLs. This will have a negative impact on taxpayers as they will have to recognize and pay tax on at least a portion of their gross income even where they have large NOLs available.
The second change is more beneficial to taxpayers. Under the Tax Cut and Jobs Act, the NOLs will no longer expire. Taxpayers can carryforward their NOLs indefinitely.
4. To which NOLs does the Tax Cut and Jobs Act changes apply?
The changes apply only to NOLs arising in taxable years beginning after December 31, 2017. In other words, the prior rule will apply to any NOLs in existence in 2017 and the new rule will apply to any NOLs generated in 2018 or later. Taxpayers that went into 2018 with unexpired NOLs can still utilize those NOLs to offset 100% of gross income on their 2018 or later returns.