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How noncash carryover losses DO impact cash flow

Josie’s question:

In a recent training, you said that Net Operating Loss carryovers are not a cash outflow, but might impact cash spent on taxes. So, are they cash or noncash?

Linda says:

Carryovers are non-cash in the year you spot them. That is true for Net Operating Loss carryovers, but also capital loss carryovers and passive loss carryovers. Let me run through a few quick carryover rules and then I’ll explain how these non-cash items impact cash flow anyway.

What are carryovers?

Carryovers come from losses or expenses that are limited by tax rules in a prior year. Some great examples:

  • Capital losses are limited to $3,000 on a 1040, no matter how big the loss. The result is a capital loss carryover.
  • Rental losses are limited based on the total amount of losses and the overall AGI of the taxpayer. The result is a passive loss carryover.
  • Business losses are limited based on ‘earned’ income in the same year. The result is a Net Operating Loss (NOL).

Each carryover has a different set of rules as to how you can use it and how long you can carry it forward. In the case of an NOL, most taxpayers can carry it back against the previous two years and then forward for twenty years. The net operating loss can be carried back up to 5 years if it is due to a casualty or is a farming loss. After twenty years, you are out of luck.

Why are carryovers always noncash?

By definition, the word carryover or carryforward indicates an expense or loss from a prior year. If you think of the borrower’s checkbook, a check was not written in the year you see the carryover so, for purposes of calculating this year’s cash flow, the carryover is noncash.

This also applies to ANY Net Operating Loss. The NOL is the only carryover that does not use the word ‘carryover’ in the name of the expense or loss. So you just need to remember it IS a carryover and treat it accordingly.

How do noncash carryovers impact cash flow?

This is the tricky part. If, in your calculation of recurring cash flow available to pay debt, you subtract federal taxes, then you must consider the reduction in taxes caused by the NOL carryover. This is only an issue if:

  • you subtract federal taxes
  • the NOL is significant
  • the NOL will be used up in the next year or so

If the NOL is almost gone, and it is significant enough that it has been suppressing federal taxes, then for your projection of cash flow in the near future, the federal taxes will go up. How far? To get a quick guess, divide the federal taxes by taxable income to get an estimated federal tax rate. Then apply that times the NOL to see what the taxes will be on the rest of the taxable income the NOL has been sheltering.

This is not exact as they may jump tax brackets as well, and if the total federal tax includes substantial self-employment taxes. But it should get you close enough to decide if this is an issue.

How do I find out how much longer the NOL will shelter taxes?

The taxpayer is required to attach a statement with ‘all required information’. At a minimum, this will include the year the NOL started, how much has been used up each year, and what is left. With that info you can guess as to how much longer the NOL will continue to shelter other income from taxes.

Online modules that cover carryovers

Carryovers are a great example of Noncash adjustments to get from taxable income to recurring cash flow available to pay debt. Check out these three modules and more at Lenders Online Training.

  • 1040 Analysis: Intro and Methods
  • Green Legos, Six Ns and a Map to Tax Return Analysis
  • Capital Gains and Losses

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.