Excess Business Loss, NOL, and the 80% Limit

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Before 2018, a business loss offset any other income in the year, and if it exceeded all income, the excess carried back two years for a refund. The 2017 act built a three-stage limit: §461(l) caps the business loss that can offset non-business income in the year; the excess becomes a net operating loss; and the NOL can offset only 80% of taxable income in any later year, with no carryback. The 2025 act made all of it permanent, reset the §461(l) threshold downward, and left the mechanics otherwise intact.

These rules hit the client who has a bad year in the business and a good year somewhere else: a stock sale, a spouse’s salary, a retirement distribution. The loss is still deductible, eventually. This is the procedure for computing what is deductible now, setting up what isn’t, and not losing track of it.

Step 1: What Reaches §461(l)

The excess business loss limit is the last of the loss limitations and applies to the aggregate of all the taxpayer’s business activities. Before it: basis (§1366(d), §704(d)), at-risk (§465), and passive activity (§469), each at the activity or entity level. A passive loss suspended on Form 8582 never reaches Form 461; a basis-limited loss never reaches Form 461. Only losses that are otherwise allowed this year are counted. The S corporation loss page has the full sequence.

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Step 2: The §461(l) Computation

• Add all business deductions and losses allowed for the year (after the earlier limits): Schedule C losses, Schedule F, business K-1 losses (1120-S, 1065), rental losses allowed under §469, business §1231 losses, business casualty losses, the deductible half of SE tax and SE health insurance and retirement contributions (treated as business deductions per the Form 461 instructions (verify the current instructions’ treatment of these items)).
• Add all business income and gains: Schedule C and F profit, business K-1 income, rental income, business §1231 gains (but net business capital gain is counted only to the extent of the lesser of capital gain net income attributable to business or total capital gain net income, §461(l)(3)(B)).
• Net them. If the loss exceeds the income by more than the threshold, the excess is the excess business loss.
• 2026 threshold: $256,000 single / head of household / MFS; $512,000 married filing jointly. The 2025 act re-based the inflation indexing, so the 2026 figure is below 2025’s $313,000 / $626,000; the limit got tighter, not looser. (verify against Rev. Proc. 2025-32 §3.59 or the Form 461 instructions when released)
• The excess is disallowed as a deduction for the year (Form 461, line 16, flows to Schedule 1 as a positive adjustment) and is treated as an NOL carryover to the following year under §172.
• Married filing jointly: one computation for the couple, one threshold; one spouse’s business loss and the other’s business income net before the threshold applies.
• Trusts and estates apply the single threshold. C corporations are not subject to §461(l).

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Step 3: What Is “Business”

Item	Business for §461(l)?
W-2 wages	No, by statute since the CARES Act technical correction (§461(l)(3)(A)(ii)): wages are not business income, so a $400,000 salary does not absorb a $600,000 K-1 loss. The 2025 act kept this rule (verify).
Schedule C / F profit or loss	Yes
K-1 ordinary income or loss (1120-S, 1065)	Yes, to the extent allowed after basis, at-risk, passive
Rental income and loss	Yes, if the rental is a trade or business; the Form 461 instructions treat Schedule E rentals as business activities (verify)
Capital gain on the sale of stock, a personal residence, investments	No
§1231 gain or loss on business property	Yes (gain counted subject to the §461(l)(3)(B) cap)
Gain on the sale of an S corporation interest or partnership interest	Capital gain, not business, except the §751 ordinary portion
Interest, dividends, retirement distributions, Social Security	No
Guaranteed payments	Yes (business income)
QBI deduction, standard deduction, itemized deductions	Not business deductions; not in the computation

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Step 4: The Disallowed Amount Becomes an NOL

• The excess business loss is “treated as a net operating loss carryover to the following taxable year” (§461(l)(2)). It does not go back through the §172 NOL computation for the current year; it is simply added to the carryover.
• Separately, the current year may also produce an NOL in the ordinary way if total deductions exceed total income after the §461(l) add-back (Schedule A of Form 1045 computes it; non-business deductions are allowed only to the extent of non-business income, the capital-loss and QBI deductions are excluded, and the personal exemption is zero).
• Post-2017 NOLs: no carryback (except farming losses, two years, and certain insurance companies), indefinite carryforward, and the 80% limit below. Pre-2018 NOLs still in the system keep their 20-year life and are not subject to the 80% limit; they are absorbed first.
• A farming loss retains the two-year carryback unless the taxpayer elects out (§172(b)(1)(B)); the election is irrevocable.
• The carryover is the taxpayer’s, not the entity’s; on a joint return it belongs to the spouse whose business generated it (Reg. §1.172-7), which matters in a later divorce or death.

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Step 5: The 80% Limit in the Carryforward Year

In any year after 2020, the NOL deduction for post-2017 losses is limited to 80% of taxable income computed without the NOL deduction and without the QBI deduction (§172(a)(2), §172(d)(8)). Pre-2018 NOLs are deducted first and without limit; then post-2017 NOLs up to 80% of what remains. At least 20% of taxable income is taxed every year regardless of the size of the carryover.

Mechanics: taxable income before the NOL (and before QBI) × 80% = the maximum post-2017 NOL deduction this year. The unused portion carries forward again. Because the limit is computed on taxable income after the standard or itemized deduction, a taxpayer with a large NOL and little income wastes the standard deduction and the lowest brackets every year; there is no way to elect a smaller NOL deduction to preserve them. Roth conversions and gain recognition in NOL years are the standard response: fill the 20% at low rates.

The QBI deduction is computed after the NOL deduction reduces taxable income; a large NOL year often produces no QBI deduction, and the negative QBI carryover rules (§199A(c)(2)) run separately.

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Step 6: The NOL Schedule

Form 1040 has no NOL schedule. The preparer’s workpaper is the only record, and it has to survive a change of preparers.

• One line per vintage (year of origin): original amount; source (§461(l) excess, ordinary NOL, farming); pre-2018 or post-2017; amount absorbed each year; remaining balance.
• Absorption computed under §172(b)(2) using modified taxable income of the intervening year, which adds back the NOL deductions of later vintages and the capital-loss and QBI deductions; the amount absorbed can exceed the amount that actually reduced tax. Form 1045 Schedule B does this computation for carrybacks and is the model for carryforwards.
• Attach a statement to each return claiming an NOL deduction showing the computation by year (required by Reg. §1.172-1(c) (verify current attachment requirement)).
• Record the spouse to whom each vintage belongs.
• Record any §461(l) add-back year so the carryover can be traced to Form 461 line 16 of that year.
• Keep the originating-year return and workpapers until the NOL is fully used plus the statute; the IRS can examine the loss year’s computation in any year it is deducted.

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Interactions

• AMT: a separate alternative tax NOL (ATNOL) with its own 90% limit; compute both when the client is near AMT.
• §1231: a net §1231 loss is ordinary and business; a net §1231 gain is capital but counts as business income under §461(l)(3)(B) within the cap. The five-year §1231 lookback recharacterizes later gains as ordinary; those are business income too.
• Passive: a passive loss allowed this year because of passive income is a business loss for §461(l); the §25,000 rental allowance amounts are business losses.
• Disposition year: suspended passive losses released on a sale of the activity can produce a large business loss in one year that §461(l) then caps; the released losses don’t escape the limit. Plan sales accordingly.
• Charitable contributions are non-business deductions; they don’t enter §461(l) and are limited in the NOL computation to non-business income.
• Estimated tax safe harbors: a client whose loss was capped owes tax in April that the prior-year safe harbor may not have covered; the 100%/110% of prior year rule still protects against the penalty if met.

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A Worked Example

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Colorado

Colorado starts from federal taxable income, so the federal §461(l) add-back and the federal NOL deduction flow through automatically for individuals; Colorado has no separate individual NOL computation and no separate excess business loss rule. The Colorado modification that matters is for the 2020–2021 CARES Act years: Colorado decoupled from the temporary federal suspension of §461(l) and from the five-year carryback, requiring add-backs on Colorado returns for those years (HB20-1420), and those add-backs created Colorado-only subtractions in later years for taxpayers who had them (verify whether any 2026 subtraction remains for clients with 2020–2021 add-backs). C corporations have a separate Colorado NOL regime (C.R.S. 39-22-504) that doesn’t concern individual returns.

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Questions at the desk

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Written for the Tax Shop desk; figures are for the 2026 tax year as currently published. Items marked (verify) are to be confirmed against primary sources before the figures freeze in December. Last updated October 16, 2026.