Hobby Losses

The distinction between a business and a hobby is significant for taxpayers because it affects the deductibility of expenses. The IRS scrutinizes this distinction to prevent taxpayers from deducting hobby expenses from their income, which would reduce their taxable income.

This has been a hot issue for the IRS for decades.  Taxpayers who have the financial means to pursue a favorite pasttime (such as showing horses, racing cars, and other activies that for many are pursued solely for personal pleasure) attempt to have those expenses covered by tax deductions.  Congress addressed this potential abuse by passing Code Section 183 which essentially disallows expenses for any actiivity not pursued for profit.

IRS Guidelines on Hobby Losses

The IRS outlines specific guidelines to determine whether an activity is for profit or a hobby. According to IRS Publication 535, if an activity is not engaged in for profit, losses from that activity cannot be used to offset other income. To decide whether an activity is a hobby, the IRS considers several factors, collectively known as the "hobby loss rule," derived from Section 183 of the Internal Revenue Code (IRC).

Factors Determining Business vs. Hobby

The IRS uses nine factors to assess whether an activity is conducted for profit:

1. Manner of Carrying on the Activity: The taxpayer conducts the activity in a businesslike manner, maintaining complete and accurate books and records, and adopting new techniques or abandoning unprofitable methods.
2. Expertise of the Taxpayer and Their Advisors: The taxpayer studies accepted business and economic practices, or consults experts.
3. Time and Effort Spent on the Activity: Significant time and effort spent may indicate a profit motive, particularly if there are no substantial personal or recreational aspects associated with it.
4. Expectation That Assets Will Appreciate in Value: The expectation that assets used in the activity will increase in value, providing an overall profit, may indicate a profit motive.
5. Success in Other Activities: A history of converting similar activities from unprofitable to profitable enterprises suggests a profit motive.
6. History of Income or Losses: An activity that generates profits in some years, even if losses occur in others, may indicate a profit motive.
7. Amount of Occasional Profits: Substantial occasional profits tend to indicate a profit motive.
8. Financial Status of the Taxpayer: If the taxpayer has substantial income from other sources, it could indicate that the activity is a hobby, especially if there are significant elements of personal pleasure or recreation.
9. Elements of Personal Pleasure or Recreation: The presence of personal pleasure or recreation in the activity may indicate it is a hobby rather than a business.

Tax Implications

For tax years prior to 2018, taxpayers could deduct hobby expenses up to the amount of hobby income as itemized deductions on Schedule A. However, the Tax Cuts and Jobs Act (TCJA) of 2017 suspended the deduction for miscellaneous itemized deductions subject to the 2% floor, which includes hobby expenses. This suspension is in effect from 2018 through 2025, meaning that during this period, hobby expenses cannot be deducted at all.  However, all income received MUST be reported as miscellaneous income.  Since the activity is not deemed to be a trade of business, no self-employment tax would be due.

Safe Harbor Rule

The IRS has a "safe harbor" rule under which an activity is presumed to be for profit if it produces a profit in at least three of the last five tax years, including the current year. For activities involving horse racing, breeding, or showing, the activity is presumed for profit if it shows a profit in two of the last seven tax years. Taxpayers who meet this requirement can avoid the presumption that their activity is a hobby.  That means that the IRS must carry the burden of proof in alleging that a venture was not pursued for profit.  What Agents look for in examining returns of impacted taxpayers are instances where expenses incurred in pursuing the activity are intentionally not included in the deductions solely to show a profit was made.

Reporting and Record-Keeping

Taxpayers engaged in activities that could be classified as hobbies should maintain detailed records to substantiate their profit motive. This includes keeping track of income, expenses, time spent, and any changes made to improve profitability. Accurate and thorough record-keeping can support the taxpayer's position in the event of an IRS audit.

Conclusion

Understanding the IRS guidelines on hobby losses is crucial for taxpayers engaging in activities that may not consistently generate a profit. By adhering to the IRS criteria and maintaining detailed records, taxpayers can better position themselves to demonstrate a profit motive and potentially deduct expenses. The suspension of miscellaneous itemized deductions under the TCJA adds another layer of complexity, emphasizing the importance of clarity in distinguishing between a business and a hobby.