Hobby Loss Rules: Can You Deduct Hobby Expenses?

The Internal Revenue Service (IRS) has specific rules regarding the deductibility of hobby expenses, known as the Hobby Loss Rules. These rules are designed to prevent taxpayers from claiming deductions for expenses related to activities that are not engaged in for profit. Taxpayers can deduct hobby expenses, but only if they meet certain criteria.

To qualify for deductions, the activity must be engaged in for profit. This means that the taxpayer must demonstrate a genuine intention to make a profit from the activity, rather than merely pursuing it for personal pleasure or recreation. The IRS scrutinizes various factors to determine whether an activity is profit-oriented, ensuring that only legitimate business expenses are deductible.

The Basics of the Hobby Loss Rules

The IRS expects businesses to make a profit. However, if a business operates at a loss, the loss is generally deductible to the owners of the business. One only has to open the newspaper to learn about well-known, legitimate businesses that have losses.

Business losses, also called net operating losses, are deductible for tax purposes. That means that the business loss may be used to offset other sources of income, such as wages from a job or income from another business. Unused losses must be carried forward indefinitely, to be deducted against future income.

However, deductions for losses are not allowed for hobbies. Hobbies are not considered to be businesses at all. Multiple years of losses are the primary sign that an activity is a hobby. In fact, repeated losses, year after year, are red flags to the IRS, increasing the chance of an IRS audit.

What is the IRS thinking? Multiple years of losses suggest that your activity is actually a hobby, intended for personal enjoyment, rather than a for-profit business enterprise. And the IRS is not going to allow deductions for personal enjoyment.

Hobby Losses: 3 of 5 Years

The IRS applies a “3 of 5 years” rule to determine whether an activity is engaged in for profit. If an activity generates a profit in at least three out of five consecutive years, it is presumed to be engaged in for profit. However, if an activity fails to meet this test, it may be considered a hobby, and expenses related to that activity may not be deductible.

This rule serves as a benchmark for taxpayers to evaluate the profitability of their activities. Consistent profitability over the specified period strengthens the case for the activity being a legitimate business, allowing for the deduction of expenses incurred.

Do You Have a Business or a Hobby? Understanding the Profit Motive

The three out of every five year rule is not the only indication of a hobby under the IRS hobby loss rules. The tax code provides a list of characterizes that are meant to distinguish between for-profit businesses and hobbies that are conducted for fun or entertainment. These characteristics focus on whether or not the activity has a profit motive and is run like a real business. The Internal Revenue Code outlines specific criteria for distinguishing between a business and a hobby.

The IRS expects a business with a for profit motive to have the following attributes:

1. The owner maintains complete and accurate books and records
2. Time and effort is put into the activity to make it profitable.
3. The owner depends on income from the activity for a livelihood.
4. The taxpayer’s financial status is considered by the IRS when determining profit motive.
5. Losses are due to circumstances beyond the taxpayer’s control. Losses are considered to be normal during the startup phase of a business.
6. Methods of operation are modified as necessary to improve profitability.
7. The owner has the required knowledge to carry out the activity as a successful business.
8. The taxpayer was successful in making a profit in similar activities in the past.
9. The taxpayer’s history of income or loss from similar activities is reviewed by the IRS to assess the likelihood of future profitability.
10. The activity makes a profit in some years. The magnitude of profit is also considered.
11. It is reasonable to expect a future profit from the appreciation of the assets used in the activity.

Examples of a Hobby Losses

Here are a few examples of actual businesses that ran afoul of the IRS hobby loss rules:

• A ranch that was consistently unprofitable, year after year.  Williams, T.C. Memo. 2018-48.
• A club where the expenses consistently exceeded the revenue from admission.   Ford, T.C. Memo. 2018-8.
• Individuals that owned racing horses, resulting in yearly losses.  Carmody, T.C. Memo. 2016-225.

Tax Implications of Hobby Classification

If an activity is classified by the IRS as a hobby, taxpayers may still be required to report income from that activity on their tax return. However, expenses related to that activity are not deductible, except for a limited amount of miscellaneous itemized deductions. This means that while you must report any gross income generated from your hobby, you cannot offset this income with the full range of expenses that a business might deduct, which can result in a higher taxable income.

Additionally, taxpayers may be subject to self-employment tax on income from a hobby activity. This is particularly important to consider for those who have significant income from their hobby, as the self-employment tax can substantially impact the overall tax liability. The IRS requires that any hobby income be reported on the taxpayer’s tax return, and if the hobby is deemed to have a profit motive, it may trigger a closer examination of the taxpayer’s financial status and other income sources.

Taxpayers should also be aware that the classification of an activity as a hobby rather than a business can affect their ability to carry forward any losses to offset future income. Unlike business losses, which can be carried forward to future tax years, hobby losses are not deductible and therefore do not provide any tax relief in subsequent years. This can be a critical consideration for those who are on the cusp of turning their hobby into a business and are evaluating the potential for future profit.

Moreover, the IRS may scrutinize the taxpayer’s history of income and losses from similar activities to determine whether the activity is genuinely engaged in for profit. This evaluation includes assessing whether the taxpayer has made occasional profits in the past and whether there is a reasonable expectation of future income.

Be Ready for a Hobby Loss Audit

To be prepared for a hobby loss audit, taxpayers should maintain complete and accurate books and records, be able to demonstrate that they conduct their activity in a business-like manner, and be prepared to prove their profit motive.

Strategy for Side Gigs: Avoiding a Hobby Loss

New businesses often have losses in their early years, but taxpayers should not worry about deducting losses from their business in the first two years. Losses are normal and expected. However, if losses continue into year three and beyond, the IRS may challenge these deductions as hobby losses.

To avoid this, taxpayers should evaluate whether their side gig is going to turn the corner and start making money. If not, the business may not be viable, and it may be better to shut it down or cut back on expenses. Taxpayers should also consider seeking advice from a tax professional or accountant to ensure that their business is being run in a business-like manner and that they are taking advantage of all available deductions.

Taxpayers should also keep accurate records of income and expenses, create a written business plan and stick to it, set realistic goals and expectations, and keep their business organized and separate from their personal life. By following these tips, taxpayers can avoid the hobby loss rules and ensure that their side gig is treated as a legitimate business.

7 Tips to Turn Your Hobby Into a Business Engaged in for Profit

If you want to turn your hobby into a business, you need to run it in a business-like manner to avoid the hobby loss rules.  An appropriate goal is to make a profit by year three.

Here are 7 practical tips to keep you and your new business out of IRS trouble:

1. Open a separate bank account
2. Keep accurate accounting records. QuickBooks Online is a popular software used by millions of small businesses.  Your accounting records should be reconciled on a monthly basis.  This is the best way to maintain accuracy and ensure that your books are ready for taxes.
3. Make sure to pay your taxes quarterly.  This is super important and easy to forget.  Your CPA or tax preparer will provide you with the payment amounts, due dates and instructions.
4. Keep receipts.  In combination with good bookkeeping and accounting, this is the best way to “audit-proof” your business.
5. Track your auto mileage.  MileIQ is a great app that you can use.
6. Consider using an entity, such as an LLC.  While this does not necessarily save on taxes, it does help to limit liability.
7. Always maintain separate bank accounts for your business.  Do not comingle business and personal funds.

Conclusion

In conclusion, the IRS Hobby Loss Rules can be complex and nuanced, but by understanding the key factors that determine whether an activity is considered a trade or business, taxpayers can avoid the hobby loss rules and ensure that their business is treated as a legitimate business. Taxpayers should keep complete and accurate books and records, demonstrate a profit motive, and ensure that their deductions are ordinary and necessary expenses paid or incurred in carrying on the trade or business.

By following the tips outlined in this article, taxpayers can avoid the hobby loss rules and ensure that their side gig is treated as a legitimate business. Additionally, taxpayers should stay up-to-date with tax laws and regulations, seek professional advice from a tax professional or accountant, and be prepared to adapt and adjust their business plan as needed. By doing so, taxpayers can minimize their tax liability and ensure that their business is successful and profitable.

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Massey and Company CPA is a boutique tax and accounting firm serving individuals, small businesses and non-profits in Atlanta, Chicago and throughout the country.  Our Tax Department provides tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, and IRS audit services.  Our Accounting Department provides small business accounting and bookkeeping services using QuickBooks Online.

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