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What is a 'Loss Carryforward'

Loss carryforward refers to an accounting technique that applies the current year's net operating losses to future years' profits to reduce tax liability and track profits accurately. Generally accepted accounting principles (GAAP) specify that loss carryforwards can be used in any one of the seven years following the loss, but tax collection agencies allow varying amounts of time for loss carryforwards depending on the tax entity, the type of loss and other factors.

BREAKING DOWN 'Loss Carryforward'

For example, if a company experiences negative net operating income (NOI) in year one but positive NOI in one of the next few years, it can reduce its future profits on paper using a loss carryforward. Imagine a company lost $5 million one year and earned $6 million the next. Including the previous year's loss on its current balance sheets lowers the profits for that year to $1 million, a more accurate assessment of the company's overall state.

Loss Carryforward and the Internal Revenue Service

In addition to using loss carryforwards on their balance sheets, companies can also use them to reduce their tax expense. The Internal Revenue Service (IRS) allows businesses to carry net operating losses (NOL) forward 20 years. At that point, the losses expire. Individuals with capital losses can only claim up to $3,000 in capital losses against their income, but if they have losses greater than this amount, they may carry them forward to future years. For example, if an individual has $9,000 in capital losses, he may claim $3,000 the current tax year, $3,000 the following year and the final $3,000 the year after that.

Loss Carryforward vs. Loss Carryback

Loss carryback works the same way as loss carryforward. Essentially, the taxpayer applies losses from one year against gains or profits from another year. However, loss carrybacks are applied to past years' earnings, while carryforwards apply to future years' earnings.

The IRS also allows businesses and individuals to carry losses back against previous years' earnings to retroactively reduce their tax liabilities for those years, but the agency has different carryback rules for different types of losses. For example, most losses, including personal capital gains losses, can be carried back for only two years, but farm losses can be carried back for five years. Similarly, specified liability losses can be carried back for 10 years. In most cases, to carry forward a loss, the tax filer must waive his right to carry back the loss.

Using Loss Carryforwards Effectively

To use loss carryforwards effectively, businesses should claim them as soon as possible. The losses are not indexed with inflation, and as a result, each year the claim effectively becomes smaller. For example, if a business loses $100,000 in 2010, it may carry the loss forward for the next 20 years. If it claims the loss in 2011, it is likely to have a larger impact than claiming it in 2030. Presumably, by 2030, $100,000 will have less buying power and less real value compared to previous years.

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