If you are engaged in an activity that produces income, the big tax question is whether the activity is a hobby or a business. The tax treatment of your income or loss from this endeavor hinges on the answer. The tax code (Section 183 – the so-called “hobby loss rule”) limits deductions when an activity is not engaged in for profit, resulting in no loss being deductible for a hobby.
A hobby is any activity that a person pursues because they enjoy it and with no intention of making a profit. This differs from operating a business with the intention of making a profit.
That being said, it isn’t always clear-cut whether the activity is a hobby or undertaken to make a profit. The IRS has guidelines for determining whether an activity is carried on for profit, such as a business or investment activity, or if it is a hobby.
This article provides information that is helpful in determining if an activity qualifies as an activity engaged in for-profit and what limitations apply if the activity is considered a not-for-profit hobby.
Is your hobby really an activity engaged in for-profit? In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business or for the production of taxable income. Trade or business activities and activities engaged in for the production of income are activities engaged in for profit.
The following factors, although not all inclusive, may help you determine the status of your activity– is it for profit or a hobby?
- Does the time and effort you put into the activity indicate an intention to make a profit?
- Do you depend on the income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the normal start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is presumed to be engaged in for-profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses).
An activity produces a loss when related expenses exceed income. If an activity is not for profit, losses from that activity cannot be used to offset other income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
Hobby deductions – Prior to 2018, deductions for hobby activities, up to the amount of hobby income, could be claimed as miscellaneous itemized deductions on Schedule A, subject to a 2% of AGI (adjusted gross income) reduction. But the law was changed as part of the Tax Cuts and Jobs Act that was passed in 2017. That change, for years 2018 through 2025, prohibits any deduction for the types of miscellaneous deductions that were subject to the 2% of AGI haircut. So, if your activity is a hobby, this means that none of your hobby-related expenses can be deducted. But income you receive from the activity is still taxable and must be reported on your Form 1040, Schedule 1, line 8, for the year in which the income is received.
Sales from collections – If you collect stamps, coins, or other items as a hobby for recreation and pleasure, and you sell any of the items, your gain is taxable as a capital gain, reportable on Form 8949 for Schedule D. However, if you sell items from your collection at a loss, you can’t deduct the loss.
If you have questions related to your specific business or hobby circumstances, please give our office a call.