What to Do If Your Deductions Exceed Your Income

Businesses or individuals rarely end up with more deductions than income. But it happens. The Internal Revenue Service refers to this situation as a net operating loss. The way you deal with it depends on what caused the losses and how long the losses have been occurring.

For individuals, a net operating loss usually results from a catastrophic loss. Those affected by a hurricane, fire, flood or tornado could lose their home. The loss of a home that is worth more than the amount collected from the insurance company could easily result in a net operating loss for the year.

If the amount on line 41--your adjusted gross income--on IRS form 1040 is negative, you have a net operating loss. You must use a form 1045 to calculate the allowable net operating loss. If the loss is from a personally owned corporation, you must use form 1139. This calculation involves the removal of any non-business, work or trade-allowable losses that are normally considered allowable deductions. These include alimony payments, IRA deductions and your personal exemptions. If you still have a net operating loss once you remove these items, that is the amount you will claim.

The two-year carry-back rule allows you to carry back the losses for two years if your prior years did not have a net operating loss. You can then file an amended return for these two years and possibly receive a refund. Usually, individuals or companies who have had successful years in the past take this option.

If the net operating loss does not qualify for the carry-back periods of three, five or 10 years, you have the option of carrying the loss forward for 20 years. Only a portion of the loss may be either carried forward or backward. The portion you claim, however, can only be used to reduce your taxable income. If the prior years also resulted in net operating losses, you must use the prior years' losses up entirely before you can claim the current years' loss.

If you anticipate losses for the following year, be aware that the IRS deems any activity that has failed to produce a profit for the last two out of the previous five years as being a hobby--which would limit your ability to claim losses in the future.