When your business expenses exceed your income, the resulting loss can offset other taxable income like wages, interest, or a spouse’s salary — but only after federal tax law puts it through several limitations in a fixed order. The IRS first asks whether the activity is a real business or a hobby. If it clears that bar, the loss still has to survive basis rules, at-risk rules, the passive activity rules, and an annual cap on how much business loss you can deduct against nonbusiness income. Whatever remains becomes a net operating loss you carry into future years, subject to its own ceiling.
Is It Actually a Business?
Everything downstream depends on this. If the IRS treats your activity as a hobby rather than a business, you owe tax on every dollar of income it produces and cannot deduct a single dollar of expense against it. The Tax Cuts and Jobs Act suspended hobby expense deductions starting in 2018, and the One Big Beautiful Bill Act of 2025 made that suspension permanent.1Internal Revenue Service. Heres How to Tell the Difference Between a Hobby and a Business for Tax Purposes Sell $8,000 of handmade furniture as a hobby after spending $12,000 on materials, and you owe tax on the full $8,000.
The threshold question is whether you’re operating with a genuine profit motive. You don’t have to actually earn a profit every year, but the facts have to show real intent. Treasury regulations weigh nine factors together, no single one decisive:
- How businesslike your operation is (books, records, marketing, pricing)
- Your expertise or use of qualified advisors
- Time and effort you put in
- Whether assets used in the activity are appreciating
- Your track record turning similar ventures profitable
- The activity’s own history of income and losses
- Occasional profits, even small ones
- Your financial status and other income sources
- Personal pleasure or recreation involved
A meticulous horse breeder with a written plan and expert consultants can claim losses during lean years. A weekend photographer with no pricing, no marketing, and no records will have a much harder time.
The Three-of-Five-Year Presumption
If your activity shows a profit in at least three of the last five consecutive tax years (two of seven for horse breeding, training, showing, or racing), the law presumes you’re in it for profit and shifts the burden to the IRS to prove otherwise.2Internal Revenue Service. Publication 535 – Business Expenses Without that safe harbor, you’re the one carrying the burden if the IRS challenges the classification.
Startup Costs in a Year You Have No Revenue
New businesses often spend heavily before earning anything, which is the classic case of expenses exceeding income. You can deduct up to $5,000 in startup costs in the year the business begins active operations. That $5,000 phases out dollar-for-dollar once total startup costs pass $50,000 and disappears at $55,000. A separate $5,000 allowance with the same phase-out covers organizational costs for LLCs and corporations.3Office of the Law Revision Counsel. 26 USC 195 – Start-Up Expenditures
Anything you can’t deduct immediately gets amortized over 180 months starting with the month the business opens. Spend $40,000 getting off the ground, and you deduct $5,000 up front plus roughly $194 a month for the remaining $35,000. Those deductions can push you into a net loss for year one and beyond.
The Loss Limitation Stack
Once your activity is a real business, a net loss still doesn’t automatically reduce your other income. Federal law runs the loss through filters in a specific order, and it has to survive each one before advancing.
Basis
If you operate through an S corporation, you cannot deduct losses beyond your combined stock and loan basis in the company. Excess losses are suspended and carried forward, but if you sell all your stock while losses are still suspended, they’re gone.4Internal Revenue Service. S Corporation Stock and Debt Basis Partners face a parallel rule: partnership losses are deductible only up to your adjusted basis in the partnership interest at year-end, with the excess suspended until your basis rises.5Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share Sole proprietors don’t have a separate basis limitation, but they still face everything below.
At-Risk
The at-risk rules cap your deductible loss at what you could actually lose financially. Your at-risk amount includes cash you’ve contributed, the adjusted basis of property you’ve contributed, and money you’ve borrowed for the activity if you’re personally liable or have pledged personal assets as collateral. Nonrecourse debt secured only by business assets generally doesn’t count.6Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
A real estate investor who puts in $50,000 cash and finances the rest with a nonrecourse bank loan is at-risk for $50,000, and that’s the ceiling on the deductible loss. Amounts trapped by this rule carry forward indefinitely until your at-risk amount grows.
Passive Activity
Losses that clear the at-risk filter next hit the passive activity rules. A passive activity is any business in which you don’t materially participate, and rental activities are treated as passive by default regardless of your involvement. Passive losses can only offset passive income. They cannot reduce wages, self-employment income, interest, or dividends.7Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
You qualify as a material participant if you meet any one of seven tests. The most common: working more than 500 hours in the activity during the tax year.8eCFR. 26 CFR 1.469-5T – Material Participation (Temporary) Suspended passive losses aren’t lost. They carry forward and offset future passive income, and when you dispose of your entire interest in the activity in a fully taxable transaction, all accumulated suspended losses are released and can offset any type of income.
Rental investors get a carve-out. If you qualify as a real estate professional (more than 750 hours in real property businesses where you materially participate, and that time is more than half of all personal services you perform anywhere), your rentals are no longer automatically passive. On a joint return, only one spouse needs to meet both tests. The IRS frequently challenges these claims, so contemporaneous time logs matter.
The Excess Business Loss Cap
Even after a loss survives everything above, one more limit applies before it becomes a net operating loss. The excess business loss rule caps the total business losses a noncorporate taxpayer can deduct against nonbusiness income in a single year. For 2026, the threshold is $256,000 for single filers and $512,000 for joint filers. Anything above the cap converts into a net operating loss carryforward. The One Big Beautiful Bill Act of 2025 made this limitation permanent; it had previously been scheduled to expire after 2028.9Internal Revenue Service. Instructions for Form 461
Concrete case: a single filer with $400,000 in wages and $500,000 in business losses can only use $256,000 against wages in 2026. The remaining $244,000 becomes an NOL.
What Happens to the Loss That’s Left Over
Whatever survives the stack is your net operating loss. For NOLs arising in tax years after 2020, you carry the loss forward indefinitely, and you generally cannot carry it back. Farming losses are the main exception, with a two-year carryback available.10Office of the Law Revision Counsel. 26 USC 172 – Net Operating Loss Deduction
The binding constraint in each future year is the 80% rule: your NOL deduction cannot exceed 80% of taxable income calculated before the NOL itself.11Internal Revenue Service. Instructions for Form 172 You will always pay tax on at least 20% of your income in a year you’re using an NOL.
Say you have $100,000 of taxable income and a $200,000 NOL carryforward. You deduct $80,000, pay tax on the remaining $20,000, and carry $120,000 forward. Large accumulated losses get used up gradually over several profitable years rather than all at once.
State Rules Don’t Have to Match
Federal survival isn’t the whole story. States often depart from federal rules, sometimes imposing stricter caps on NOL deductions, shorter carryforward periods, or different conformity to the 80% ceiling. Some states charge minimum franchise taxes or fees regardless of whether you report a loss, so a zero federal bill doesn’t mean zero state liability. If you operate in more than one state or you’ve relocated, check each state’s conformity rules; a loss that’s fully usable federally may be blocked at the state level.