 Hello and welcome to this session. This is Professor Farhad in which we will discuss net operating loss for short NOL. So what is net operating loss? Simply put, net operating loss is when the taxpayer annual business deduction, we know it as business expenses or business deduction are greater than the annual business income. Simply put, we have negative income. Negative income is the same thing as a loss. Therefore, what we have is a net operating loss. In this net operating loss is created from a trade or a business and casualty losses. Those are the items that generally create net operating loss, NOL. Now, why do we have this NOL? What is the benefit of it? What is the importance of it? Let me show you an example with two taxpayers to show you why Congress has this rule, net operating law. Let's assume two taxpayer, Adam and Avi, their single taxpayer, they started their business in year one, and they reported the following income. For Adam, Adam reported in year one taxable income of 20,000. In year two, a loss of 160,000. In year three, a taxable income of 170. In year four, a loss of 120. In year five, a taxable income of 150. On the other hand, Avi reported a taxable income each year for 12,000. Now, if we net those 20 minus 60 minus 160 plus 170 minus 120 plus 150, we should get a net of 60,000 over five years. And if we take 12,000, Avi's stable business times 5,000 equal to 60,000. So notice, over a period of five years, both Avi and Adam earned 60,000. The only difference is, Adam's business is cyclical, while Avi's business is not, is stable. Now, what I'm going to do, to illustrate the point, I'm going to use the 2022 tax rate for single taxpayer to compute their taxes. And this is what we come up with. If you compute their taxes, Adam's tax bill in year one is 2,195. Avi is 1,235. And it's the same for the next five years. Again, this is just for illustration. The tax rate may not stay the same. But to make the point, in year two, Adam did not have a tax bill because Adam generated a loss of 160. In year three, Adam made 170,000 and their tax bill is 34,000. Year four, nothing because a loss of negative 120. And in year five, 29,000. So as I stated, they both made 60,000 over five years, net of 60,000. Adam's tax bill is 66,667 dollars, while Avi's bill is 6,000 over five years, 175. What does that mean? It means because their business is cyclical, one was affected more than the other. Simply put, what the Congress says, if you generated losses in a particular year, you could use those losses in future years. So simply put, you have what's called NOL, net operating loss. And you can use this net operating loss to offset income from future years. That's the idea. And I hope you can see the importance of it. Now let me show you on the tax return specifically where this all fits. So simply put, we have something called schedule one. And on schedule one, you first include your NOL notice it's negative, then you compute schedule one. And at the end, you either get a positive or a negative number. Then this number, assuming it's the only thing is NOL, we have a 10,000 net operating loss. And basically you have a worksheet, you computed your net operating loss. You have a net operating loss of 10,000. Now this number will go to line eight, other income from schedule one line 10. But this will be a negative 10,000, negative 10,000. Now what I want you to notice that the NOL, this is where the NOL end up on your form 1040. NOL comes before your adjusted gross income, your AGI, which is we'll talk about this shortly. So it's very important to know that NOL is a deduction for AGI. It comes before AGI, for AGI. Now before we proceed any further, I would like to make an announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. NOL rules have changed over the years. Simply put, we're going to start by stating that anything prior to December 31st, 2017. So what we're going to do is this. We're going to look at a timeline. Let's draw the timeline here and we're going to say 2018. And the reason I say 2018, because the rule changed as of December 31st, 2017 for the Tax Cuts and Jobs Act. Before 2018, if you had NOL, you can carry back the NOL two years and you can carry it forward 20 years. Those are the old rules. And the reason I put the old rules in quote, because the old rules, the old rules could still be in effect for a certain period in the future. How? Well, the old rules allows you to deduct 100% of your taxable income. So the NOL allows you to do so. So if you have some NOL from 2016, let's assume you had an NOL from 2016, and you are using this NOL now, and now let's assume now is 2024. And you happen to have 60,000 of NOL in 2016. And in 2024, you also have a taxable income just to kind of keep it simple of 60,000. So if you have NOL of 60,000, and you have taxable income in 2024 of 60,000, you can use this NOL 100% of this NOL against your taxable income. And as a result, you will have a taxable income of zero after you deduct the NOL. Now, NOL arising after December 31st, 2017, simply put, after starting 2018, all the way until 2020. So this is 2020. So here we are discussing 2018, all of 2018, all of 2019 and all of 2020, three years, those NOL, they can be carried back five years. And they can be carried forward indefinitely. So those they have a special rule. Also, those NOLs arising after the end of 2017, which is 2018, 2019, and 2020, you can also deduct them up to 100% of those taxable year, obviously before the NOL deduction. However, NOL arising during those years 2018, 2019, and 2020, that they are used to offset income going forward after 2020, it means going forward means they are offsetting income in 2021, 2022, and in the future, then those will have to be limited to 80% of your taxable income. Let me explain this. So let's go back to this example here and let's assume in 2018, we had an NOL of 60,000. So forget about this 2016. Now the NOL arise in 2018. And in 2024, we had taxable income of 60,000. Same example. Here's what we have to do now. We can no longer take the full 60,000. What we're going to do, we're going to take 60,000 taxable income, multiply taxable income by 80%. And that's going to give us 48,000. Now we have NOL of 60,000. Well, although we have NOL of 60,000, and we have taxable income of 60,000, we cannot offset all of our taxable income. We can offset NOL can offset up to 80%. So simply put off the 60,000, we can only use 48,000. And that's going to reduce our taxable income to 12,000. However, we still have after we use the 60,000, we still have 12,000 of NOL to be used in the future. Now NOL after December 31, 2020. So this is basically the most current rule. It cannot be carried back anymore, but it can be carried forward indefinitely. Again, we still have the rule applies of 80% the limit. So it can only offset 80% of your taxable income. So anytime the carryback option is available, which is prior to 2018 and prior to 2020, the taxpayer may elect not to carry the carryback. So you don't have to, if the carryback is available, you are not required to use it. However, if you did use it, you have to go back to the oldest year first in the carryback period. So you have to do it in order starting with the oldest year. Now the best way to illustrate this is to look at an example. Let's assume John is a taxpayer, a single taxpayer started his business in 2017. And this is John's reported income, 2017 taxable income of 70,000, 2018 a loss, 2019 a taxable income of six, 2020 a taxable income of two, 2021 a taxable income of 10. And what is the amount of NOL carried forward 2022? So what is John going to do? So here we're going to assume, we're going to assume that John's going to take this 90,000 and that's the that's the most logical thing for John. First go back to 2017 and wipe out this taxable income, simply put file an amended return and whatever taxes I paid in 2017, get all my money back. Okay. So I'm going to go back because I'm allowed to go back five years if I generated NOL in 2018. So of the 90,000 I used up 70,000 of it. What do I have left? I still have 20,000 of NOL. What's going to happen in 2019? I generated a taxable income of 6,000. Excellent. In 2019, I can wipe out all of my taxable income because I'm allowed to do it 100%. I still have 14,000 of NOL. I have 2000 of taxable income in 2020. In 2020, there's no limitation. Also, I can go against 100% of my taxable income. I still have 12,000. I still have 12,000 and NOL. In 2021, I had 10,000 of taxable income. Remember 2021, what's going to happen is I'm going to have to slow down and think about it. Think about what think about the fact that I cannot offset this whole thing. How much can I offset? I can offset 80% of it. So that's going to give me 8,000. So I have 12,000 of NOL. I am going to use only 8,000. That's the maximum allowed. The maximum amount I'm allowed to use. And what I'm going to be left with is 4,000. Therefore, the NOL carried forward to 2022 is 4,000. And here's the solution. Here's the solution. So you can see what we did. The net operating loss is carried back to offset taxable income from 2017 first. The remaining 20,000 goes against full 2019, full 2020 and 80% of 2021. And here's the computation and what's left is 4,000. Now, remember what I said earlier when I showed you the tax form about NOL and adjusted gross income? And that operating loss carried forward is accounted for as a deduction to arrive to AGI. And I showed you it comes before AGI, deduction for AGI. That's important. Why that's important? Because you have to take NOL into account. Any deduction depends on the AGI, such that medical expenses, charitable contribution, casualty losses, must be determined on the basis that NOL is applied. So it does affect adjusted gross income. And that's why it's important to understand it comes before adjusted gross income, because many computations such as medical expenses, many deductions are dependent on AGI. So it does help in reducing your taxable income, you're reducing your AGI. What is not included in computing NOL? Now, at the beginning, we kept it simple, because to get to the big picture, and I said, NOL is basically generated from your business, from your trade, from your business. And that's usually the case for casualty losses. But we have to understand that certain items, they are considered income or deduction, that they are not included, because this NOL is for individual. We're going to look at the NOL for corporation later. The following item listed are not allowed when determining an individual's NOL. What are they? Access non-business deduction. So we're going to have certain deduction, but those deductions are non-business over non-business income. We're also going to have income, but that's non-business income. So we need to know what are the non-business income and non-business deduction. Well, anything that's non-business, like what? Non-business income will be interest income, dividend income. Those are not business income. Rental income is business income, but those are not. Example of non-business deduction. So those are deductions, but they are not business, so they cannot be included when you're computing NOL. Include, among others, contribution to your individual retirement account. You cannot say, well, I contributed to my IRA, this might create an NOL for me. That's not the case. Alimony payment. Standard or itemized deduction. Think about the standard deduction. Let's assume your standard deduction, I don't know, just for the sake of illustration, is 25,000. You really did not pay anything. This is just basically a phantom deduction given to you by the IRS. So you cannot say, this is a deduction and I want to use this deduction to create a net loss and take this net loss. You can do that. Those are not allowed when you're computing NOL. Again, when you think of NOL, think of business income and business expenses or itemized deduction other than casualty loss. Again, we said casualty losses and it has to be in federally declared area, but casualty losses are. NOL carried over from previous years. You cannot count it in computing your new NOL. So you cannot count it. Say, I'm carrying this NOL. Now I'm going to increase my NOL by this carried over NOL. Well, now you cannot compute your NOL using other years NOL. Then you will be double counting the NOL. Capital losses and access to capital gain. So if you incur capital losses and access of capital gain means you have more losses than gain, remember what you can do with capital losses. You can take 3,000 against ordinary income, but you cannot use capital losses when you have capital losses, net capital losses to increase your NOL. That's not part of your NOL. Section 1202 exclusion of gain from sale of qualified small business stock. If you incur any loss, you cannot use it in computing your NOL. If you have a qualified business income deduction, this is deduction, QBI, you cannot use it to create or increase NOL. Because again, the QBI, the qualified business income deduction is basically a phantom deduction. It's a deduction given to you by the IRS basically, because you have a qualified business. You cannot use it to create NOL to get more deduction. It doesn't work that way. As I mentioned, rental losses are business losses. So in contrast to interest, in contrast to dividend, if you have rental losses, those are business losses. They could generate NOL. Bear in mind, the NOL may not be used to reduce your self-employment tax. So self-employment tax is your social security and Medicare. You cannot use NOL to reduce those. If you have any self-employment tax, you are still responsible for those self-employment tax. NOL may not be deducted against taxpayer self-employment tax. Again, we're talking about social security and Medicare. You cannot use it against them. Let's work an example to illustrate the concept. Because on the CPA exam, they'll try to trick you. They will ask you to compute NOL and they're going to give you all sorts of different numbers. You have to know what numbers included in the computation and what number is not. I told you the shortcut is any business deduction, any business income, that's included in NOL plus casualty. Okay, so let's take a look at this number, this exercise. For the tax year 2022, Adam reported operating income and expenses of 250 and 290. Well, is this part of NOL? You bet. It is operating income from their business. So notice here, we have more expenses. So we have 290,000 of expenses and 250,000 of income. This is the expenses. This is the income. We already know that this business generated 40,000 of losses. Adam earned 2,200 of interest income. What should I do with this? I should ignore it. And 5,000 of capital gains from the sale of a business property. So this capital gain is not any sort of capital gain. It's from a business property. Well, if that's the case, I have an additional 5,000 of business property. Adam claimed standard deduction of 12,950. Well, that's great. The standard deduction is a deduction, but I cannot say, let me add my standard deduction here because I have a deduction and increase my NOL. Not at all. The standard deduction is something that's given to you. You did not even make any effort to generate the standard deduction. In other words, you did not spend money. It's not part of your business. So you should not use it. So simply put, we're going to have an NOL based on this of 35,000. Now, in many CPA review courses, what they do is they show you the whole thing. They will just kind of show you the whole thing. And what does it mean show you the whole thing? They would say, okay, let's look at your operating income, 250, all of your income plus your interest expense, plus your capital gain minus your expenses, minus your deduction. And this is your access deduction. So you have more expenses than income, but that's not your NOL. This is your access deduction. Now you need to back out. What do you need to back out? Well, I already told you that those two figures interest income and the standard deduction need to be backed out. They cannot be used in computing NOL. So what we do is we're going to have to add back the standard deduction. Why do we add it back? Because we subtracted it. If we're going backward, we have to add it. And what do we need to do with interest? Since we added it, we're going to have to deduct it. And if we do so, we're going to come up with 35,000. The same number I came up with here. So first understand the big picture. Follow your CPA review course. But remember, NOL is a business deduction. Generally speaking is a business deduction. But follow the rules. If they're giving you a specific formula, follow it, but make sure you understand it because the way I explain it could be a little bit different than your CPA review course or your income tax course. But the overall idea is the same. What should you do now? Go to farhatlectures.com and work MCQs through false questions that's going to help you solidify this knowledge and help you get ready for your CPA exam. Good luck, study hard, invest in yourself and stay safe.