California business owners reporting substantial losses in 2026 may receive a different deduction on their federal and California income tax returns. The California Franchise Tax Board confirmed in its November 2026 Tax News that the state's excess business loss thresholds are $320,000 for most individual filing statuses and $640,000 for married or registered domestic partner taxpayers filing jointly.
The corresponding federal limits for tax year 2026 are considerably lower: $256,000 and $512,000, respectively.
This difference is especially important for S corporation shareholders, partners, sole proprietors, and investors with significant qualifying business losses. A business loss that is restricted on the federal return may receive different treatment on the California return.
The federal and state rules also differ in how disallowed losses are carried forward. Those differences can affect not only the 2026 return, generally filed in 2027, but future taxable years as well.
Key takeaway:
For 2026, California's excess business loss threshold exceeds the federal threshold by $64,000 for nonjoint filers and $128,000 for joint filers.
However, these are thresholds used in the Section 461(l) calculation, not automatic deductions or guaranteed tax savings. The actual federal and California results depend on the taxpayer's qualifying business income, allowable losses, prior carryovers, and other applicable limitations.
What Is the Excess Business Loss Limitation?
Internal Revenue Code Section 461(l) limits the current year deduction of certain excess business losses for taxpayers other than corporations.
In general, an excess business loss exists when deductions attributable to the taxpayer's trades or businesses exceed the sum of qualifying business gross income and gains plus the applicable annual threshold.
The limitation is determined by considering the taxpayer's aggregate qualifying business activities rather than applying a separate threshold to each business.
An individual who owns several S corporations, partnerships, or other business activities generally must evaluate the applicable income and losses together after applying other required limitations.
The threshold also should not be confused with a restriction on the deduction of ordinary business expenses inside an operating corporation or partnership. The excess business loss limitation generally applies at the noncorporate taxpayer level after the relevant amounts are otherwise allowable.
Can Business Losses Offset W-2 Wages?
Yes, but subject to the applicable limitations.
A qualifying business loss may offset wages and other nonbusiness taxable income up to the extent permitted by Section 461(l) and the other relevant tax rules.
However, wages earned as an employee are not treated as business income when calculating the excess business loss threshold.
For example, receiving substantial W-2 compensation does not allow a taxpayer to increase the statutory excess business loss limit simply because the wages exceed the loss.
This distinction matters for professionals and business owners who have both employment income and substantial losses from separately owned businesses.
Federal vs. California Excess Business Loss Limits for 2026
The differences are summarized below.
| Filing status | Federal 2026 limit | California 2026 limit |
|---|---|---|
| Single | $256,000 | $320,000 |
| Married filing jointly | $512,000 | $640,000 |
| Married filing separately | $256,000 | $320,000 |
| Head of household | $256,000 | $320,000 |
The federal amounts are established by Revenue Procedure 2025-32, Section 4.31. The California amounts were confirmed in the FTB's November 2026 Tax News.
California also applies its joint threshold to registered domestic partner taxpayers who file a qualifying joint California return.
For comparison, the federal limitation in 2025 was $313,000 for nonjoint filers and $626,000 for joint filers. The 2026 federal thresholds therefore declined substantially even though many other tax thresholds increased with inflation.
California's 2026 limits instead increased from the corresponding 2025 thresholds.
Why Are California's 2026 Limits Higher Than the Federal Limits?
The difference arises from federal legislation enacted in 2025 and California's separate conformity rules.
The Federal One Big Beautiful Bill Act Changed Section 461(l)
Section 70601 of Public Law 119-21, enacted July 4, 2025, made the federal excess business loss limitation permanent and changed the inflation adjustment calculation.
For taxable years beginning after December 31, 2025, the federal indexing rules use 2024 as the relevant base year.
This produced a lower inflation adjusted threshold for 2026 than the prior federal indexing methodology would have produced.
The federal rule remains applicable in 2027 and subsequent years under the permanent statutory framework, unless Congress subsequently changes the law.
California Did Not Adopt the Federal Changes
California Revenue and Taxation Code Section 17560.5 establishes modified conformity to the federal excess business loss limitation.
California generally follows the applicable limitation for noncorporate taxpayers, but it maintains several statutory modifications.
Most importantly, California did not conform to the changes made by Public Law 119-21 that reset federal inflation indexing.
The FTB therefore announced separate California limits of $320,000 and $640,000 for 2026.
California's broader conformity rules were also affected by Senate Bill 711 and Senate Bill 1435. Those developments are explained in my California tax conformity guide covering SB 711 and SB 1435.
Example: A California Business Owner With a $700,000 Loss
Assume a married couple filing jointly has the following 2026 tax situation:
- $900,000 of W-2 wages.
- $700,000 of aggregate qualifying business losses from an active business.
- No other qualifying business income or gains.
- No prior California excess business loss carryover.
- The $700,000 loss is otherwise deductible under both federal and California law before applying Section 461(l).
The results would be:
| Calculation | Federal | California |
|---|---|---|
| Qualifying business loss | $700,000 | $700,000 |
| Applicable 2026 threshold | $512,000 | $640,000 |
| Current loss allowed before other income tax calculations | $512,000 | $640,000 |
| Excess business loss disallowed in 2026 | $188,000 | $60,000 |
In this simplified example, the California calculation allows $128,000 more of the current year business loss than the federal calculation.
That does not mean the taxpayer automatically saves California income tax on $128,000 of additional deductions. The actual tax effect depends on taxable income, state adjustments, other deductions, credits, and the character of the losses.
This example also assumes the qualifying loss is identical for federal and California purposes. In practice, federal bonus depreciation, California depreciation differences, basis adjustments, and other conformity provisions may produce substantially different amounts.
Which Business Losses Are Subject to Section 461(l)?
The limitation can affect otherwise allowable losses from several types of business activities, including:
- S corporation business losses reported to shareholders on Schedule K-1.
- Partnership losses reported to individual partners.
- Sole proprietorship losses reported on Schedule C.
- Qualifying business losses reported on Schedule F.
- Eligible rental real estate or other business activity losses that have passed the applicable passive activity restrictions.
- Applicable ordinary gains and losses from business asset transactions, subject to the statutory classification rules.
The calculation must distinguish income attributable to a trade or business from other income.
For example, employee wages generally are excluded from the business income component. Portfolio interest, investment dividends, and capital gains from property held solely for investment ordinarily do not become business income merely because the taxpayer also operates a business.
Section 461(l)(3)(B) also contains special rules governing capital gains and losses. Consequently, a gain on the sale of business property should not automatically be included in the calculation without determining its federal tax character and the applicable statutory treatment.
Other Loss Limitations Apply Before Section 461(l)
The excess business loss limitation generally is one of the final restrictions evaluated when determining how much business loss an individual can deduct.
The analysis may involve the following sequence:
- Tax basis: Determine whether the taxpayer has adequate basis to deduct the loss under the applicable entity rules.
- At risk limitation: Apply Section 465 when the taxpayer is not economically at risk for the entire amount.
- Passive activity limitation: Apply Section 469 to determine whether otherwise allowable losses are suspended because the activity is passive.
- Excess business loss limitation: Apply Section 461(l) to the qualifying amounts remaining after the other applicable restrictions.
This ordering matters because a loss disallowed under an earlier rule generally is not also treated as a current excess business loss.
A passive rental loss suspended under Section 469, for example, does not automatically become an excess business loss carryover merely because it arose during a year in which the taxpayer had an overall economic loss.
See my article on suspended passive rental losses and the requirements for using them for a more detailed explanation.
Federal and California Excess Business Loss Carryforwards Are Different
The distinction between federal and California treatment continues after the loss is disallowed.
Federal: Disallowed Loss Becomes an NOL Carryover
Under federal Section 461(l)(2), an excess business loss disallowed in the current taxable year generally is treated as a net operating loss carryover to the following taxable year under Section 172.
The resulting NOL is then subject to the applicable federal net operating loss provisions, including the limitation generally restricting the deduction of many post 2017 NOLs to 80% of taxable income in a subsequent year.
The amount and timing of the federal deduction may therefore be affected by income and other tax attributes in the year the NOL is used.
California: Disallowed Loss Remains an Excess Business Loss Carryover
California Revenue and Taxation Code Section 17560.5(b)(3) expressly changes the federal carryforward treatment.
Instead of treating the disallowed amount as a California NOL carryover under Section 172, California treats it as an excess business loss carryover.
The prior California carryover is included in the state's subsequent year excess business loss calculation under the applicable statutory modifications.
That distinction affects how the carryover is used, particularly when the taxpayer has business income in a later year.
California's separate net operating loss suspension rules also must be considered when applicable. The Section 461(l) carryover should not be confused with a conventional California NOL.
This is one reason federal and California business loss carryforward schedules should be maintained separately rather than assuming the federal NOL schedule also establishes the California amount.
Why Real Estate Investors Need a Separate Calculation
Real estate investors frequently encounter several overlapping tax limitations.
A large rental property deduction may be limited by passive activity rules before the excess business loss limitation becomes relevant.
However, an otherwise deductible loss from a qualifying nonpassive rental business or business property disposition may still be subject to Section 461(l).
The federal and California amounts can differ because the two jurisdictions do not always permit the same depreciation deductions.
For example, federal bonus depreciation under Section 168(k) generally is not available in computing California taxable income.
An investor who generates substantial federal losses through qualifying accelerated depreciation may therefore have a smaller California loss before Section 461(l) is even considered.
The ordinary character of a loss from qualifying property under Section 1231 also does not eliminate the need to evaluate the other loss restrictions.
See my discussion of Section 1231 losses on rental and business property for the distinction between ordinary loss character and current deductibility.
How Should Business Owners Plan for the 2026 Limits?
The higher California threshold may provide a more favorable current year deduction in some circumstances, but it should not be viewed independently of the taxpayer's overall federal and state positions.
Before the end of 2026, business owners should consider:
- Projecting federal and California business income separately: Do not assume that the taxable income or loss shown on the federal Schedule K-1 will be identical for California.
- Reviewing prior loss carryovers: Identify suspended basis losses, at risk losses, passive losses, federal NOL carryovers, and California excess business loss carryovers.
- Evaluating major capital expenditures: Section 179 and bonus depreciation decisions may affect the timing of deductions differently for federal and California purposes.
- Considering anticipated business gains: Income from a qualifying business or asset transaction can affect how the excess business loss calculation applies.
- Reviewing the timing of losses: A deduction may have different current and future values depending on the taxpayer's projected income and other limitations.
The appropriate analysis is a multiyear projection that tracks federal and California deductions independently.
These issues are part of my proactive federal and California tax planning for business owners and high income individuals, particularly where a significant business loss, asset purchase, or change in income is expected.
Schedule a Consultation to evaluate the timing of a business deduction, the effect of Section 461(l), and the treatment of existing loss carryovers before the tax year ends.
What Happens to the Limits in 2027?
The IRS has already established the federal excess business loss thresholds for taxable years beginning in 2027 through Revenue Procedure 2026-35.
The 2027 federal thresholds are $264,000 for nonjoint filers and $528,000 for married taxpayers filing jointly.
Those federal figures do not establish California's 2027 thresholds.
As of November 9, 2026, the California FTB's November Tax News identifies the California limits for 2026 and indicates that the amounts will be included in future indexing memoranda. California's corresponding 2027 figures should be confirmed separately when published.
For a broader review of the announced federal changes, see my 2027 federal tax brackets and inflation adjustments guide.
Frequently Asked Questions
Does California follow the federal excess business loss limit in 2026?
No. California has its own 2026 thresholds of $320,000 for most nonjoint filers and $640,000 for joint filers. The corresponding federal thresholds are $256,000 and $512,000.
Does the limitation apply separately to each S corporation or partnership?
Generally, no. Section 461(l) evaluates the noncorporate taxpayer's aggregate qualifying business income, gains, and deductions, subject to the applicable rules. Each activity may have its own basis, at risk, and passive activity restrictions before the aggregate limitation is calculated.
Are W-2 wages included as business income under Section 461(l)?
No. Income and deductions attributable to performing services as an employee generally are excluded from the business income and deduction components used to calculate the excess business loss.
Do federal and California disallowed losses carry forward in the same way?
No. A federal excess business loss generally becomes a federal NOL carryover. California instead treats the disallowed amount as an excess business loss carryover under Revenue and Taxation Code Section 17560.5.
Does the California limit guarantee a larger state tax deduction?
No. The higher California threshold may permit a larger current deduction, but the result depends on the loss otherwise allowable under California law. Depreciation, basis, passive activity, and other tax adjustments can change the amount before the excess business loss limitation applies.
Final Takeaway
California's newly confirmed 2026 excess business loss thresholds create an important distinction between federal and state income tax calculations.
For married taxpayers filing jointly, the federal threshold is $512,000 while California's threshold is $640,000. The two jurisdictions also use different rules to carry forward losses disallowed under Section 461(l).
For individuals with substantial S corporation, partnership, sole proprietorship, or qualifying real estate business losses, the difference can affect current taxable income, future loss utilization, and the value of various tax planning decisions.
The most reliable approach is to determine which losses are otherwise allowable, prepare separate federal and California Section 461(l) calculations, and preserve accurate carryforward schedules for future years.
See current federal rates on the Economic Dashboard.
