Excess Business Loss Carryforward: What Happens to the Disallowed Loss Next Year

A cost segregation study plus 100% bonus depreciation can give a real estate professional a rental loss bigger than the section 461(l) cap. The part over the cap is not deductible this year. It is not lost either. On your federal return it turns into a net operating loss (NOL) that carries forward.

Most investors stop reading there. The carryforward year has its own rules, and California handles the same loss a different way. This page covers what happens after the loss year.

For how REPS, cost segregation, and the cap stack in the year of the loss, see REPS, cost segregation, and the 2026 excess business loss cap. For REPS basics, see REPS and passive losses.

The short answer

On the federal return, section 461(l)(2) says a disallowed excess business loss is treated as a net operating loss for purposes of figuring your NOL carryover under section 172(b). In plain terms:

• It carries forward to later years. For losses arising in tax years beginning after 2017, there is no expiration date.
• It does not carry back, unless part of it is a farming loss.
• In the carryforward year it can offset up to 80% of your taxable income, figured before the NOL deduction and the QBI deduction.
• It is not tested against the excess business loss cap a second time.
• You do not need to qualify for REPS again to use it.

California is different. California treats the disallowed amount as an excess business loss carryover, not an NOL. It can only offset future business income.

Step by step on the federal return

Year 1: the loss year

Section 461(l) applies after the passive activity rules. So the loss first has to clear section 469. For a rental loss to offset wages, that usually means one spouse qualifies for REPS and you materially participate in the rental activity.

Whatever business loss clears section 469 then runs through Form 461. Business deductions above business income plus the threshold are the excess business loss. For tax years beginning in 2026, the threshold is $256,000, or $512,000 on a joint return (Rev. Proc. 2025-32). Wages don't count as business income for this math.

The IRS instructions for Form 461 tell you to keep a record of the excess business loss from each year, because it becomes an NOL carryover. The carryover itself is figured on Form 172, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.

Year 2 and later: using the NOL

The carryover is now an NOL under section 172. Three rules matter.

The 80% limit. Under section 172(a)(2), NOLs that arose in tax years beginning after 2017 can offset only 80% of taxable income in the year you use them. Taxable income here is figured without the NOL deduction itself and without the section 199A QBI deduction. Anything the 80% limit blocks carries forward again.

No second pass through the cap. The excess business loss formula in section 461(l)(3)(A)(i) leaves out any deduction allowable under section 172. So the NOL is not counted as a business deduction in year 2 and cannot be cut down by the cap again.

No REPS test. Under Treas. Reg. §1.469-2(d)(2)(ix), an item of loss or deduction carried to the year under section 172(a) is not a passive activity deduction. The loss already cleared the passive rules in the year it arose. If you drop below 750 hours in year 2, the NOL is still usable.

That last point is where this carryover differs from a suspended passive loss. A passive loss that never cleared section 469 stays tied to the activity and generally waits for passive income or a full disposition. For that path, see suspended passive losses when you become a real estate professional.

A plain-numbers example

These figures are an illustration, not a client result.

You file jointly. In 2026 one spouse qualifies for REPS, you materially participate, and cost segregation plus 100% bonus depreciation produces a $700,000 net rental loss. You have no other business income or loss.

Now two versions of 2027.

In both versions it doesn't matter whether either spouse is a real estate professional in 2027. The $188,000 is an NOL by then.

California handles it differently

California does not follow the federal treatment of the carryover. The FTB's 2025 instructions for Form FTB 3461 say that for California purposes, a disallowed excess business loss is treated as an excess business loss carryover instead of an NOL carryover.

What that means in practice:

• The California carryover offsets business income in later years. It does not offset wages the way the federal NOL does.
• If later business income is not enough to absorb it, the rest keeps carrying forward.
• It is reported on Form FTB 3461 (line 14b for the prior-year carryover) and on Schedule CA (540), line 8z, column B.
• California's 2025 threshold is $313,000, or $626,000 on a joint return. California did not conform to the federal extensions of the limit under the American Rescue Plan Act and the Inflation Reduction Act.

There is a step before any of that. California did not adopt the federal real estate professional rule, so for California purposes rental activities are generally passive. California applies at-risk, then passive, then excess business loss rules, in that order. For many Los Angeles investors, a federal REPS loss is still a passive loss on the California return and is suspended on Form FTB 3801 before Form 3461 ever comes into play. See does California recognize real estate professional status.

California also does not follow federal bonus depreciation, so the California loss is often smaller to begin with. See California bonus depreciation nonconformity.

The result is that you can end up tracking three different balances for one building: a federal NOL, a California passive loss carryover, and possibly a California excess business loss carryover. Each one gets used under its own rules.

What to plan for before you commission the study

• Project year 2 and year 3 taxable income, not only the loss year. The 80% limit decides how fast the federal NOL comes back.
• Run the California return separately. A big federal benefit can have little or no California benefit for years.
• Keep the Form 461 and Form 172 worksheets with your permanent records. The carryover can last many years.
• If the loss is far above the cap, look at spreading placed-in-service dates. The REPS year-end checklist for 2026 covers the timing steps that have to happen before December 31.

Frequently asked questions

Does an excess business loss carry forward?

Yes. On the federal return, section 461(l)(2) treats the disallowed amount as a net operating loss for purposes of the NOL carryover rules in section 172(b). For losses arising in tax years beginning after 2017, the NOL carries forward with no expiration date.

What is the difference between an excess business loss and an NOL?

An excess business loss is the part of your net business loss above the section 461(l) threshold in the year it happens. You can't deduct it that year. In later years it is treated as an NOL carryover and follows the NOL rules, including the 80% of taxable income limit.

Do I need to qualify for REPS again to use the carryforward?

No. Under Treas. Reg. §1.469-2(d)(2)(ix), a deduction carried to the year under section 172(a) is not a passive activity deduction. The loss already cleared the passive rules in the year it arose, so you can use the NOL in a year you don't meet the REPS tests.

Is the carryforward limited by the excess business loss cap again?

No. Section 461(l)(3)(A)(i) leaves any section 172 deduction out of the excess business loss computation. The NOL is limited by the 80% of taxable income rule in section 172(a)(2), not by the cap a second time.

Can I carry an excess business loss back to an earlier year?

Generally no. NOLs arising in tax years beginning after 2017 carry forward only. The main exception is a farming loss, which can be carried back two years under section 172(b)(1)(B).

How does California treat an excess business loss carryover?

California treats it as an excess business loss carryover, not an NOL carryover, per the FTB's Form 3461 instructions. It offsets future business income only. California also treats most rental losses as passive because it did not adopt the federal REPS rule, so many federal REPS losses are suspended on Form FTB 3801 first.

Talk it through with us

Bring the cost segregation proposal or study, last year's federal and California returns, and any Form 461 from a prior year. We'll map how much of the loss clears the cap, how fast the federal NOL comes back under the 80% limit, and what the California return shows. Book a new client introduction.

LaviCPA is a Los Angeles CPA firm for real estate investors. Shawn Lavi, CPA, is the firm's principal. Elias Lavi, CPA, is its founder and co-owner.