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The IRS is scrutinizing tax returns reporting large losses from any activity that sounds like a hobby. Here is what you need to know about the hobby loss rules.
If you launch or engage in an activity that combines elements of work and play and generates losses, you need to figure out whether your activity is a business or a hobby. Business losses are generally deductible on Schedule C of your Form 1040. But there's a double-edged sword on the taxation of hobby income. Revenue that you collect from a hobby is taxable. But you cannot deduct your expenses. The 2017 tax law temporarily eliminated through 2025 all miscellaneous itemized deductions previously subject to the 2%-of-adjusted-gross-income threshold. That includes hobby expenses.
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Claiming big hobby losses on your Form 1040 is a prime audit red flag. The IRS is on the hunt for taxpayers who year after year deduct large losses from hobby-sounding activities on Schedule C of the 1040 to help offset other income, such as wages or retirement or investment income. The more consecutive years of losses reported on Schedule C, and the larger the amounts, the more likely it is that your tax return will be pulled for examination. And if on top of that, the activity sounds like a hobby, well, that's red meat for IRS agents. If you're audited, the IRS is going to make you prove that you have a legitimate business and not a hobby.
To deduct a Schedule C loss, you must show that the activity is a business. The primary test in distinguishing between a hobby and a business is whether you engage in the activity with a profit motive. For an activity to constitute a business for tax purposes, it needs to be conducted with continuity and regularity in a businesslike manner, and you must have a reasonable, good-faith objective of making a profit from it.
The IRS regulations provide a safe harbor. If your activity generates profit in three out of five consecutive years (or two out of seven years for horse breeding), the law presumes you are in business to make a profit unless the IRS establishes otherwise. The hobby-business analysis is trickier if you can't meet the safe harbor. That's because the determination of whether an activity is properly categorized as a hobby or a business is then based on each taxpayer's facts and circumstances, with the IRS and the courts generally taking the following nine factors into account:
- The manner in which the taxpayer carries on the activity
- The expertise of the taxpayer and/or his or her advisers
- The time and effort put into the venture by the taxpayer
- The expectation that assets used in the activity may appreciate
- Success in carrying on other activities
- History of income and losses (the more years of large, consecutive losses, the harder it is to demonstrate a profit motive unless the activity is still in its start-up stage)
- Amount of occasional profits
- Elements of personal pleasure or recreation that that the taxpayer gets from the activity
- Whether the taxpayer has substantial income from other sources, such as wages, other business income, retirement income or investment income
No one factor is determinative, but some are routinely given more weight by the IRS and the courts. For example, managing and operating your activity in a businesslike manner can be extremely helpful in demonstrating an honest intent to make a profit. Some tax professionals point to this as the most important of the nine factors. And, more importantly, this factor is under your control. You should open a separate bank account for the activity, maintain good records, keep receipts of all your expenses, advertise, have a business plan and revise it as needed, and change operating methods or adopt new techniques to turn your venture around.
Other factors that can help establish the requisite profit motive and are also within your control: Ensure that you have the knowledge, training or expertise to conduct the activity, or rely on the advice of industry experts. Also, devote lots of time and effort to the endeavor.
The hobby loss rules are often litigated in the Tax Court. When people think of hobby losses, horse and/or dog breeding generally comes to mind. Of course the Tax Court has addressed those ventures. But other cases involve activities as varied as ecotourism, rodeo events, acting, writing and researching, flying antique fighter jets, poker playing, collecting law enforcement badges, donkey breeding and restoring old cars. The IRS usually wins these cases, partly because it tends to settle cases in which it doesn't believe it can prevail. But taxpayers have also pulled out a victory in a number of cases.
This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of tax by keeping you up-to-date on new and pending changes in tax laws, providing tips to lower your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of The Kiplinger Tax Letter or subscribe.
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