Net Operating Loss Rules Under the CARES Act

The effects of COVID-19 on businesses have been staggering, particularly in sectors such as hospitality, dining, and entertainment. It seems that no company has been untouched by the pandemic. So, on March 27, 2020, the CARES Act was enacted to buffer the financial hits that companies and their employees were taking. 

As part of the CARES Act, the net operating loss (NOL) rules were temporarily and retroactively changed. Let’s look at the net operating loss rules and how the CARES Act has affected them and your business.

What is a Net Operating Loss (NOL)?

An NOL is the excess of a business’s tax deductions for the tax year above and beyond its taxable income for that year.

Example. For tax year 1, Company A has $100,000 of gross income and $150,000 of tax deductions. Company A has a net operating loss of $50,000 for tax year 1.

How Do NOLs Affect Your Business?

Many businesses have inconsistent income, with plenty of money coming in one year and a tremendous loss the next. Other companies have consistent income from year to year. Net operating losses are deductions that can help businesses with inconsistent income to reduce income volatility, particularly when it comes to paying their taxes. 

A business can carry back an NOL to a previously profitable year and obtain a refund for taxes paid in that year. How much can be carried back and how far it can be carried back depend on the current tax law. 

The Recent History of NOLs

Before 2017, NOLs were fully deductible. They could be carried back two years and forward 20 years.

Then, in 2017, the Tax Cuts and Jobs Act (TCJA) changed the NOL rules. It:

  • Limited NOL deductions to 80% of taxable income
  • Disallowed NOL carrybacks
  • Lifted the 20-year limit on NOL carryovers

How Did the CARES Act Affect NOLs?

Under the CARES Act, a Net Operating Loss from the tax year 2018, 2019, or 2020 can be carried back five years if the taxpayer chooses to do so. Taxpayers do not have to carry back their 2018, 2019, and 2020 NOLs. They can waive the carryback period and only carry their NOLs forward to future years.

If the taxpayer chooses to carry back their net operating losses, they must use the entire five-year carryback period. They can’t decide to only use a three-year carryback period instead of the five-year carryback period for their 2018, 2019, and 2020 NOLs.

This five-year carryback provision goes away in 2021 (unless the law is changed).

The CARES Act has also suspended the 80% taxable income limitation for NOLs through 2020.

These changes allow for net operating losses incurred in 2018, 2019, and 2020 to be carried back five years to reduce income in previous, profitable years. This can result in the business receiving a tax refund.

Cost Segregation Studies

Cost Segregation Studies can increase NOL’s by increasing depreciation deductions from income and creating more considerable losses.  Cost Segregation Studies can be completed for retroactive years in what is commonly called a “Look Back” study.

To take advantage of the new provisions, taxpayers should file amended and original tax returns by October 15, 2021, understanding that any election to forgo the carryback is irrevocable.

Correction – Qualified Improvement Property (QIP) 

The CARES Act also corrected a drafting error in the Tax Cuts and Jobs Act (TCJA) at the end of 2017. The initial intention of the TCJA was to combine leasehold improvement property, retail improvement property, and restaurant property into Qualified Improvement Property (QIP) and make it eligible for 15-Year depreciation and 100% Bonus Depreciation. However, the language error in the act resulted in QIP property only qualifying as 39-year property.

The CARES Act has corrected the error and intent by changing Qualified Improvement Property (QIP) to 15-Year property that qualified for 100% Bonus Depreciation. The change is retroactive to property acquired after September 27, 2017, and placed into service after December 31, 2017, in tax years ending in 2018, 2019, 2020, and 2021.

What is Qualified Improvement Property (QIP)

The IRS defines qualified Improvement Property (QIP) as any improvement made by the taxpayer to an interior portion of a building which is a nonresidential real property if such improvement is placed in service after the date such a building was first placed in service.

It does not qualify as QIP if the improvement is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.

However, many items that would not typically qualify for short life can be eligible as QIP property. This includes ceilings, lighting, walls, paint, interior doors, all interior electrical, plumbing including domestic use, interior HVAC ducting, etc.

Important – Residential Apartment Buildings, Assisted Living Facilities, Nursing Homes, and any other residential rental properties do not qualify for QIP and must depreciate interior improvements over 27.5 years.

Who Can Take Advantage of the CARES Act NOL Carryback?

  • C Corporations 
  • Individuals
  • Estates 
  • Trusts
  • Tax-Exempt Organizations with unrelated business taxable income 
  • Some Partnerships and S Corporations (There are different rules for passthrough entities)

Note: Real estate investment trusts (REITs) can’t carry back an NOL to any preceding tax year. 

How Do You Apply an NOL Carryback to Get a Refund?

You have two choices: you may amend returns for all the carryback years or file for a tentative refund claim. Filing for a tentative refund claim usually yields a faster refund.

  • A corporate taxpayer can apply for a refund by filing Corporation Application for Tentative Refund Form 1139. 
  • Noncorporate taxpayers can apply for a refund by filing Application for Tentative Refund Form 1045.

These forms should be filed within 12 months of the end of the tax year that generated the NOL, not before you file the return for the tax year that generated the NOL.

The IRS has 90 days to review the application for omissions or errors and either allow or deny the application.

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