A tax loss is what you have when your allowable deductions and expenses for the year add up to more than your income. It isn’t just a bad result on paper. A recognized loss can lower the tax you owe this year, next year, or years down the road, depending on where it came from and which federal limits apply. The rules differ sharply between losses from running a business and losses from selling investments, and several overlapping restrictions decide how much of the loss you actually get to use.
The Two Kinds of Tax Losses
Losses split into two categories, and the category controls almost everything else.
An ordinary loss comes from the day-to-day operations of a business. When deductible business expenses exceed business income, you have a net operating loss (NOL). Ordinary losses can offset ordinary income like wages, interest, and self-employment earnings, which is the income taxed at your highest rates.
A capital loss comes from selling or exchanging a capital asset — stocks, bonds, investment real estate — for less than your adjusted basis.1Internal Revenue Service. Topic No. 409, Capital Gains and Losses Capital losses are either short-term (asset held one year or less) or long-term (held more than a year), and that classification controls how they interact with your gains. If stock you own becomes completely worthless, the IRS treats it as sold on the last day of the tax year for zero, producing a capital loss whose character depends on your holding period.2eCFR. 26 CFR 1.165-5 – Worthless Securities
The word “allowable” does real work in the definition. Spending money isn’t the same as generating a deductible loss. The expense has to fit a category the Internal Revenue Code recognizes — for a business, that means ordinary and necessary costs of the trade like payroll, rent, supplies, and depreciation3Office of the Law Revision Counsel. 26 US Code 162 – Trade or Business Expenses — and it has to survive the limitation rules below.
How Much of a Capital Loss You Can Deduct
Capital losses go 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. Whatever remains in one bucket then offsets gains in the other.1Internal Revenue Service. Topic No. 409, Capital Gains and Losses
If your total capital losses still exceed your total capital gains after netting, you can deduct up to $3,000 of the excess against ordinary income. Married filing separately cuts that in half, to $1,500.4Office of the Law Revision Counsel. 26 US Code 1211 – Limitation on Capital Losses That ceiling has stood since 1978 and isn’t indexed for inflation.
Carrying the Rest Forward
Anything above the $3,000 annual limit carries forward to the following year, keeping its original character — short-term stays short-term, long-term stays long-term.5Office of the Law Revision Counsel. 26 USC 1212 – Capital Loss Carrybacks and Carryovers There’s no expiration date. Each year you apply the carried-over loss first against that year’s capital gains, then deduct up to $3,000 against ordinary income, and roll any remainder forward again. A $30,000 net capital loss with no offsetting gains takes roughly a decade to fully use.
Watch for the Wash Sale Rule
You can’t lock in a capital loss while effectively keeping the same investment. If you sell a security at a loss and buy a substantially identical one within 30 days before or 30 days after the sale, the loss is disallowed for that tax year.6Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities Acquiring a contract or option to buy the same security inside that 61-day window counts too.7Investor.gov. Wash Sales
The disallowed loss isn’t permanently gone. It gets added to the cost basis of the replacement shares, deferring the tax benefit until you sell those new shares in a transaction that doesn’t trigger another wash sale. The holding period of the original shares also carries over, which can change whether a future gain or loss is long-term or short-term.
How Business Losses Actually Get Used
Business losses have to clear a stack of limits, and the order is fixed. For pass-through entities like S corporations and partnerships, the IRS applies restrictions in this sequence: basis, then at-risk, then passive activity, then the excess business loss limitation.8Internal Revenue Service. S Corporation Stock and Debt Basis – Section: Shareholder Loss Limitations A loss blocked at any stage is suspended until you meet that limit’s requirements in a later year.
Basis
If you’re a partner or S corporation shareholder, you can’t deduct losses larger than your financial basis in the entity. Basis generally equals your initial investment plus additional contributions and your share of entity income, reduced by distributions and prior losses.8Internal Revenue Service. S Corporation Stock and Debt Basis – Section: Shareholder Loss Limitations
At-Risk
Losses that clear basis next face the at-risk rules. You can only deduct up to the amount you genuinely have at stake: cash and property you contributed, plus money you borrowed if you’re personally liable to repay it. Non-recourse debt generally doesn’t count. The exception is qualified non-recourse financing secured by real property used in the activity, which is treated as an amount at risk.9Office of the Law Revision Counsel. 26 US Code 465 – Deductions Limited to Amount at Risk That carveout is a big part of why real estate investors can often deduct larger losses than investors in other assets.
Passive Activity
Losses that survive basis and at-risk hit the passive activity rules. A passive activity is any trade or business in which you don’t materially participate, and rental activities are treated as passive by default regardless of how involved you are.10Office of the Law Revision Counsel. 26 US Code 469 – Passive Activity Losses and Credits Limited Passive losses can only offset passive income. Any excess is suspended until you have enough passive income to absorb it or until you dispose of the entire activity in a taxable transaction.
Two notable carveouts exist for real estate: a limited allowance of up to $25,000 for active participants in rental real estate (phased out between $100,000 and $150,000 of modified AGI), and a full exemption for taxpayers who qualify as real estate professionals under the hours tests in Publication 925.11Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules
Excess Business Loss
Even after clearing the first three, non-corporate taxpayers face one more cap. For 2026, total business losses can’t exceed total business income plus $256,000 ($512,000 on a joint return). Anything above that threshold is an excess business loss, disallowed for the year, and converted into an NOL carryforward.12Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction Under current law, this limitation is scheduled to expire after 2026.
Net Operating Loss Carryforwards
When business losses exceed income after all current-year deductions, you have a net operating loss. For NOLs arising in tax years beginning after December 31, 2017, the carryforward is indefinite. The catch is that the deduction in any future year is capped at 80% of that year’s taxable income computed before the NOL deduction. You can’t use an NOL carryforward to zero out your tax; the remaining 20% stays taxable.13Office of the Law Revision Counsel. 26 US Code 172 – Net Operating Loss Deduction
Carrybacks are no longer available for most taxpayers. General business NOLs arising after 2017 only go forward. Two exceptions remain: farming losses and certain insurance company losses can be carried back two years.
One point that catches self-employed taxpayers off guard: an NOL carryforward reduces income tax but not self-employment tax. SE tax is calculated on the current year’s net earnings from self-employment, and the statute specifically excludes the NOL deduction from that calculation. Direct business expenses in the year they’re incurred reduce both; a carryforward from a prior year only helps on the income tax side.
When the IRS Calls It a Hobby Instead
If the IRS decides your activity isn’t actually a business, the hobby loss rules block you from using losses from it to offset other income. The IRS presumes a profit motive if the activity turned a profit in at least three of the past five tax years. For activities that primarily involve breeding, training, showing, or racing horses, the standard is two of the past seven.14Office of the Law Revision Counsel. 26 USC 183 – Activities Not Engaged in for Profit Failing the test doesn’t automatically make the activity a hobby, but the burden shifts to you to prove a profit motive through factors like how you run the operation, your expertise, the time you invest, and changes you’ve made to improve profitability.15Internal Revenue Service. Is Your Hobby a For-Profit Endeavor?
The 2026 tax year brings a change here. From 2018 through 2025, the Tax Cuts and Jobs Act suspended all miscellaneous itemized deductions, which left hobby expenses completely nondeductible even against hobby income. Starting in 2026, hobby expenses are once again deductible as itemized deductions, but only up to the amount of hobby income for the year. You still cannot generate a net loss from a hobby to reduce wages or other income, and hobby income remains fully taxable.
Recordkeeping for Losses That Live for Years
Loss carryovers can stretch across many tax years, and you need documentation for every year the loss is still in play. The general IRS retention period is three years from the filing date for most returns.16Internal Revenue Service. How Long Should I Keep Records A worthless securities deduction extends that period to seven years. For capital losses and NOLs that carry forward, keep the original records for as long as any portion of the loss remains unused, plus the statute of limitations for the final return on which the loss is claimed. A ten-year capital loss carryover means hanging onto the purchase and sale records for the original transaction the whole time.
One final point worth planning around: capital loss and NOL carryovers generally expire when the taxpayer dies. They can be claimed on the decedent’s final return, and a surviving spouse filing a joint final return can use them, but unused carryovers don’t pass to heirs. Carryovers held by an estate or trust at termination do pass to the beneficiaries who succeed to the property.17eCFR. 26 CFR 1.642(h)-1 – Unused Loss Carryovers on Termination of an Estate or Trust For anyone sitting on large accumulated losses, that’s a reason to think about accelerating income or gains in later years rather than letting the carryovers go unused.