Don’t Let Business Losses Surprise You: How to Plan for Excess Business Loss Rules

For many business owners, real estate investors, and pass-through entity owners, a large tax loss can be an important part of managing cash flow and overall tax liability. But for individual taxpayers and other noncorporate taxpayers, IRC §461(l) can limit how much current-year business loss may be used to offset wages, investment income, retirement income, and other nonbusiness income. 

The loss generally is not eliminated. Instead, the disallowed amount becomes a net operating loss carryforward, potentially delaying the tax benefit and subjecting it to additional limitations in future years. 

The excess business loss limitation is not new, but it has become more important because the 2025 Act made the limitation permanent and reset the inflation-adjustment methodology beginning in 2026. Taxpayers anticipating significant business losses should understand the potential impact before finalizing year-end decisions, and model related basis, at-risk, passive activity, depreciation, and net operating loss rules in addition to §461(l) limitations.  

Who Is Affected by the Excess Business Loss Rules?

The excess business loss limitation applies to taxpayers other than corporations. It is most relevant to: 

• Sole proprietors filing Schedule C 
• Farmers and ranchers filing Schedule F 
• Individual partners and LLC members receiving business losses on Schedule K-1 
• S corporation shareholders receiving business losses on Schedule K-1 
• Trusts and estates, depending on the facts 
• High-income individuals using business losses to offset nonbusiness income 

The rule limits a noncorporate taxpayer’s ability to offset nonbusiness income with an overall business loss, even where the taxpayer materially participates in the business.  

C corporations are not subject to IRC §461(l). However, owners of pass-through entities may be affected because partnership, LLC, and S corporation business items flow through to the owner and are tested at the owner level.  

How the Excess Business Loss Limitation Is Calculated

Under IRC §461(l), an “excess business loss” is generally the amount by which a taxpayer’s aggregate trade or business deductions exceed the sum of: 

1. The taxpayer’s aggregate gross income or gain attributable to trades or businesses plus 
2. The applicable annual threshold amount 

Excess Business Loss = Aggregate business deductions minus (Aggregate business income/gain + annual threshold amount) 

The calculation is made without regard to any net operating loss deduction under IRC §172 or qualified business income deduction under IRC §199A, and it is applied after the passive activity loss rules under IRC §469.  

Certain items are excluded or limited in the calculation. For example, employee wages are not treated as business income for this purpose, capital losses are excluded, and business capital gains are included only to a limited extent.  

2025 and 2026 Threshold Amounts

The threshold amount is indexed for inflation, but the 2025 Act changes the inflation adjustment base year after 2025.  

For 2025, the threshold amounts are $626,000 for married taxpayers filing jointly and $313,000 for all other filers. For 2026, the amounts are $512,000 for married taxpayers filing jointly and $256,000 for all other filers. Because the 2026 threshold is lower under the reset inflation methodology, timing decisions may be especially important for taxpayers with significant anticipated losses.  

Order Matters: Basis, At-Risk, Passive Loss, Then IRC §461(l)

IRC §461(l) is part of a broader sequence of loss limitation rules. Before applying the excess business loss limitation, taxpayers generally must consider: 

1. Basis limitations for partners and S corporation shareholders 
2. At-risk limitations 
3. Passive activity loss limitations under IRC §469 
4. Other potentially applicable limitations 

The §461(l) limitation applies after the passive activity loss rules under IRC §469. Editorial guidance also notes that the excess business loss rule applies after the at-risk limitation and, for partners and S corporation shareholders, after the rules limiting losses to the taxpayer’s basis in the ownership interest. 

This ordering can create unexpected results. For example, a passive loss that is suspended under IRC §469 generally is not currently included in the §461(l) calculation. However, if a passive activity is disposed of in a fully taxable transaction and suspended losses are released, those released losses may be subject to the excess business loss limitation.  

For high-net-worth individuals with interests in multiple businesses, real estate holdings, or other pass-through investments, that interaction reinforces the importance of evaluating the portfolio as a whole. 

What Happens to a Disallowed Excess Business Loss?

A disallowed excess business loss is not simply lost. Under IRC §461(l), the disallowed amount is treated as a net operating loss carryforward under IRC §172 for subsequent taxable years.  

For net operating losses (NOL) incurred in tax years beginning after 2020, the NOL deduction is generally limited to 80% of taxable income, and NOLs generally cannot be carried back except for certain farming losses; they carry forward indefinitely.  

This distinction is important. A loss that would otherwise offset high-bracket income this year may instead provide a tax benefit over future years.  

Planning Opportunities for Individual Taxpayers

Independent mortgage lenders often operate as S Corporations, partnerships, or LLCs taxed as partnerships, making §461(l) an owner-level issue. For mortgage banks, several timing and character items can materially affect the owner’s annual net business loss.  

Good planning is not simply about trying to avoid IRC §461(l). In many cases, the transaction that creates the loss may still make economic sense. Instead, the goal is to understand when the tax benefit will be available and how different decisions affect the outcome. Will losses provide a current-year benefit or be deferred as an NOL carryforward?  

Several areas deserve particular attention. 

1. Time Business Income or Gain Where Practical

Because the limitation compares aggregate business deductions to aggregate business income and gain plus the threshold amount, accelerating business income or recognizing business gain in the same year as large deductions may reduce the excess business loss. 

Potential strategies include: 

• Accelerating billing or collections for cash-basis taxpayers 
• Closing a business asset sale before year-end 
• Reviewing installment sale treatment 
• Matching gain recognition with large deductions 
• Coordinating income across multiple businesses owned by the same taxpayer 

2. Defer Discretionary Deductions When Appropriate

If business deductions are expected to push the taxpayer over the §461(l) threshold, deferring discretionary deductions may preserve current-year deductibility. 

Items to review may include: 

• Repairs and maintenance 
• Prepaid expenses 
• Compensation or bonus accruals 
• Retirement plan contributions 
• Charitable commitments made through business entities 
• Other discretionary year-end expenditures 

The analysis should consider accounting method rules, economic performance, recurring item exceptions, and whether a deduction is truly deferrable. 

3. Evaluate Bonus Depreciation and Cost Recovery Choices Under IRC §168(k)

Accelerated depreciation can be valuable, but it can also create or increase an excess business loss. Guidance cautions that selecting the fastest depreciation method can create a loss limited under IRC §461(l), with the disallowed amount carried forward as part of the taxpayer’s NOL.  

Independent mortgage lenders frequently invest in loan origination systems (LOS), cybersecurity, hardware, furniture, and leasehold improvements, especially when scaling. In a loss environment, planning will be important to understand the best approach to these costs. 

Taxpayers should model the impact of: 

• Bonus depreciation under IRC §168(k) 
• Section 179 expensing 
• Regular MACRS depreciation 
• Elections out of bonus depreciation 
• Cost segregation studies 
• Placed-in-service timing 
• State tax conformity or decoupling 

Where a large depreciation deduction would be deferred under §461(l) and later limited under IRC §172, slower cost recovery may produce a better overall result. 

4. Owner Compensation Planning

Owner compensation choices can change the mix of pass-through income/loss items that flow into the owner-level §461(l) model. For S corporations, reasonable compensation remains essential for employment tax compliance, and unreasonably low compensation can recharacterize distributions as wages. At the same time, wages are not treated as business income for §461(l), so increasing W-2 wages generally will not increase “business income” that could absorb business deductions under the limitation. 

Practically, compensation (for S corporations) and guaranteed payments (for partnerships) may reduce entity-level ordinary income or increase entity-level loss, which can affect what is reported on K-1 and how much loss is potentially subject to §461(l) at the owner level. The planning focus should be: (i) confirm positions are technically supportable; and (ii) run owner-level projections that reflect compensation/guaranteed payment decisions alongside basis, at-risk, passive loss, and NOL considerations.  

5. Coordinate Passive Activity Dispositions

A fully taxable disposition of a passive activity can release suspended passive losses under IRC §469. That may be beneficial, but the released losses can also contribute to an excess business loss under IRC §461(l).  

Before selling a passive activity, model the suspended losses released, gain or loss on disposition, character of the gain or loss, capital loss carryovers, and future NOL usage. 

6. Consider Filing Status Implications

Filing status can materially affect the threshold. Married taxpayers filing jointly receive a threshold that is twice the amount available to other filers. If spouses file jointly, one spouse’s business losses may offset the other spouse’s nonbusiness income up to the applicable limitation. 

Filing status decisions should also consider brackets, credits, state tax effects, liability considerations, and other separate-return limitations. 

7. Practical Year-End Modeling Checklist for Mortgage Banking Owners

Because §461(l) is applied at the owner level and aggregates business items across activities, independent mortgage lender owners should model, —not guess—, how year-end moves affect taxable income and loss. Practical items to include: 

• Pipeline, lock commitments, and expected pull-through 
• Hedging gain or loss 
• Expected gain-on-sale margins and timing of loan sale closings 
• MSR servicing income streams, and planned MSR sales/retentions 
• Bonus depreciation elections and placed-in-service timing for systems, buildouts, and equipment 
• Timing of commission/bonus accruals 
• Internally developed software costs and potential credits 
• Pass-through owner data completeness and K-1 reporting accuracy, since owners need the right business-item detail to run §461(l) computations 

The overall objective is to coordinate mortgage-banking-specific tax timing items with the owner’s broader tax picture, so that deductions that are intended to create immediate tax benefit do not unintentionally become deferred by the excess business loss limitation. 

8. Model the NOL Carryforward Impact Under IRC §172

A disallowed excess business loss becomes an NOL carryforward under IRC §172, but future utilization may be limited. For post-2020 NOLs, the deduction is generally limited to 80% of taxable income, and most NOLs cannot be carried back. 

Before intentionally generating a large business loss, taxpayers should consider: 

• Expected taxable income in future years 
• Whether future income will be business or nonbusiness income 
• The taxpayer’s marginal rates in current and future years 
• State NOL conformity rules 
• Whether the NOL may take several years to absorb 
• Cash flow needs 
• Whether alternative timing choices improve the overall tax result 

In some cases, a deferred NOL benefit is acceptable. In others, a smaller current-year deduction may be preferable if it avoids pushing losses into a less valuable future-year carryforward. 

Example: Why Modeling Matters

Assume an unmarried individual owns several active pass-through businesses. In 2025, the taxpayer expects: 

The taxpayer’s excess business loss would generally be: 

$900,000 deductions – ($400,000 income/gain + $313,000 threshold) = $187,000 excess business loss 

The $187,000 disallowed amount would generally become an NOL carryforward under IRC §172 rather than offsetting current-year nonbusiness income. 

If the taxpayer could reasonably accelerate $187,000 of additional business income into 2025, defer $187,000 of deductions, or adjust depreciation elections to reduce the loss, the current-year §461(l) limitation may be reduced or avoided. However, each option could have other tax, cash flow, and business consequences, so the planning should be modeled before implementation. 

Year-End Planning Checklist

Before year-end, taxpayers expecting significant business losses should review the following: 

• Projected business income and deductions across all trades or businesses 
• 2026 threshold amount based on filing status 
• Basis, at-risk, and passive activity limitations before applying IRC §461(l) 
• Pass-through K-1 reporting and whether owners have sufficient information 
• Bonus depreciation and cost recovery choices under IRC §168(k) 
• Potential business asset sales or gain recognition events 
• Passive activity dispositions and release of suspended losses under IRC §469 
• Filing status effects, especially for married taxpayers 
• Interaction with IRC §199A, since the §461(l) calculation is made without regard to the qualified business income deduction 
• Taxable income/loss planning for lending pass-through entities 
• Future-year NOL usage under IRC §172. 

Connect Your Business Decisions to Your Financial Goals

The excess business loss limitation is more than a tax-return calculation. It can affect the timing and potential value of a business loss deduction and may influence decisions involving investments, compensation, depreciation, asset sales, and cash flow. 

Business owners and investors expecting significant losses should work with their tax advisors to model the interaction among IRC §461(l), basis, at-risk and passive activity limitations, depreciation elections, and future NOL usage before making significant year-end decisions. The right approach depends on the individual’s businesses, investments, income, cash-flow needs, and long-term plans. 

And that broader perspective matters beyond IRC §461(l). 

Tax planning works best when business decisions, tax strategy, and personal financial goals are considered together. 

This article is part of Richey May’s Aligning Your Business, Taxes & Personal Wealth series, which explores that intersection for business owners and executives. 

Continue the conversation by watching the Aligning Your Business, Taxes & Personal Wealth video series for additional insights on proactive tax planning, business exit planning, and strategies for connecting business decisions with long-term personal wealth. 

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