Normally, this blog won’t touch a topic like Donald Trump’s net operating loss deduction. This editorial tactic isn’t because we support Mr. Trump or his opponent. Rather, we try to keep the discussion here focused on the “how to.”

However, because the journalists writing about Trump’s net operating loss deduction display again and again their misunderstanding of how the tax accounting works for a net operating loss, I want to explain what’s up with the deduction.

How a Net Operating Loss Deduction Works

Okay in a nutshell: If you lose money in a business, Internal Revenue Code Sec. 172 says you can deduct that loss—which is called a net operating loss or NOL–against any of your other income.

For example, if you lose $10,000 in a business and you earn or you’re married to someone who earns $40,000, you can deduct the $10,000 loss from the $40,000 of income and then only pay taxes on the net $30,000. That’s what’s going on here.

Let’s make it little more complicated. Say you lose $100,000 in a business and you’re married to someone who makes $40,000 a year. In this case, your $100,000 loss wipes out your spouse’s $40,000 of income for the year. But then you can take that remaining $60,000 of net operating loss and either use it to erase income in a previous year or income in some future year.

For example, suppose that you did have a $60,000 net operating loss leftover after doing your accounting for the current year. Further suppose that your spouse also made $40,000 two years ago and then $40,000 again last year too. In this case, you could use the $60,000 to wipe out all of the oldest year’s $40,000 of income and then half of the previous year’s $40,000 of income.

If you don’t “use up” all of a net operating loss when you carry the loss back, you can carry the remaining net operating loss forward.

If your net operating  loss was $1,000,000 and not $100,000 and your spouse earned $40,000 every year like clockwork, you could wipe out the income from two years ago, from last year and for this year. And then you would still have an $880,000 net operating loss to carry forward and wipe out income for the next twenty years.

Note: Under current law you can only carry a loss forward for twenty years, so if you had $40,000 a year of income and an $880,000 carry forward, you would not end up using all of the carry forward.

Deeper into the Weeds about Net Operating Losses

Now that we’ve covered the basics, let me go a little deeper into the weeds on this thing partly because of the hullabaloo about Donald Trump’s net operating loss but also so that you understand how to use a NOL deduction in case you need to do that.

First, while today the law says you can carry a loss back two years and forward twenty years, the law changes every so often. When the economy gets bad, for example, Congress often loosens the rules for using a net operating loss deduction as a way to help businesses, big and small. (In recent history, the carry back period has been longer than two years.) Further, just so you know, in a handful of special situations, you can carry back a loss to the three previous years (see IRC Sec. 172(b)(E) via that link I provided earlier.)

Second, large refund claims due to net operating loss carry backs tend to trigger audits. Further, they require going back and either amending a previous year’s return using a 1040X form or filing a refund claim using a 1045 form. For these reasons, someone might choose not to carry back a net operating loss but rather carry it forward. (And there’s a special election you can make to forego the carry back and instead just carry forward.)

Third, alternative minimum tax laws muddy the waters on net operating loss deductions. But to give you birds-eye view, you can only use a net operating loss to wipe out 90% of your AMT income. Which means you can sometimes eliminate your ordinary income taxes but not all of your AMT taxes.

Note: The IRS actually provides a pretty good write-up here.

Are Net Operating Loss Deductions a Loophole?

Well, here we risk getting a little political, but I think it’s fair to say that many tax accountants don’t think the net operating loss deduction represents a loophole. Or at least not in the same way that something like mortgage interest or tax-free fringe benefits represent a loophole.

But maybe think about the NOL deduction this way. You can’t lose money in a job. You wouldn’t get to the end of some year of work and learn that, actually, your employer was not going to pay you wages. That rather, you would need to fork over money to your employer to pay for business losses.

In a big or small business, however, that sort of craziness can happen. You might make $100,000 some year and then lose $100,000 the next year. People have thought it makes sense to let the business owner net the profit and loss. This netting is what the net operating loss deduction does.

Final Comments about Trump’s Net Operating Loss

Three other comments about the net operating loss deduction, too, that undermine the notion that this deduction represents a loophole…

First, as a generalization, you only get the deduction for real economic losses. You’ve maybe read the news accounts of Donald Trump’s net operating loss that suggest you can borrow money, lose it, deduct the borrowed money you lost and then via bankruptcy sidestep repayment. The laws don’t work that way. (How they do work is more complicated than can be quickly explained here–and sadly more complicated apparently that most journalists can understand.)

Second, if you or I have debt cancelled by some lender, that cancellation of debt counts as income and we’re taxed on it unless we can exclude it because we’re in bankruptcy or insolvent.

Third, and finally, while you or I can sidestep cancellation of debt income if we’re going through a bankruptcy as noted, in a bankruptcy, you and I lose what tax law calls ”tax attributes”—the first one of which is your net operating loss and any carry forwards.

Summing Up

You don’t ever want to find yourself in a situation where you’ve got big net operating loss carry forwards appearing on your tax return year after year. That carry forward gives evidence to a catastrophic business failure. But if an entrepreneur experiences such a failure, the net operating loss deduction at least means that the federal and state governments aren’t collecting income taxes from someone who hasn’t actually earned income.