We know taxpayers are generally allowed to deduct the ordinary and necessary expenses needed to conduct a trade or business or for the production of income. These activities are intended to make a profit. However, taxpayers must understand how to determine whether an activity is engaged in for profit or as a hobby. There are tax implications for incorrectly treating hobby activities as activities engaged in for profit. Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions for non-business activities, and is sometimes referred to as the “hobby loss rule.”
An activity is presumed 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).
Some factors strongly indicate that your engagement in the activity is for profit and not a hobby, such as your dependence on income from the activity. You should be qualified and have the knowledge needed to run the activity as a successful business. The time and effort you put into the activity should show intention to make a profit. Any business losses should occur during a business’ start-up phase or be due to circumstances beyond the business’ control. And a business should show past profit or future profitability, or you may even have changed methods of operation to improve profitability. Another indication would be if you have made a profit from similar activities in the past.
If an activity is determined to not be for profit, losses may not exceed the gross receipts for the activity. The limit for not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations, but not to other kinds of corporations.
Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order:
- Personal deductions, such as home mortgage interest and taxes, may be taken in full.
- Deductions that do not change the basis of property, such as advertising, insurance premiums and wages, may be taken next.
- Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent that gross income for the activity exceeds the previous deductions.
Additional information can be found at www.irs.gov.