Hobby Loss

Hobby Loss: Definition, How It Works, and How to Avoid It

What is a hobby loss?
A hobby loss occurs when the Internal Revenue Service (IRS) classifies an activity as a hobby (an activity pursued for pleasure rather than for profit) and disallows deductions for expenses that exceed income from that activity. Hobby income must be reported, but losses from hobby activities generally are not deductible the way business losses are.

Who the rule affects
The hobby loss rules apply to individuals, S corporations, trusts, estates, and partnerships. They do not apply to C corporations.

How the hobby loss rule works
– Business expenses that are ordinary, necessary, and paid to produce income are generally deductible when an activity is conducted with a profit motive.
– The IRS applies section 183 of the Internal Revenue Code to disallow losses for activities it believes are not engaged in for profit.
– There is a presumption of profit if the activity shows a profit in at least three of five consecutive tax years (two of seven years for horse-related activities). If that presumption isn’t met, the taxpayer must demonstrate a profit motive.
– Good recordkeeping (receipts, logs, documentation) is essential to support a profit motive.

Effect of the Tax Cuts and Jobs Act (TCJA)
The Tax Cuts and Jobs Act suspended miscellaneous itemized deductions, including hobby-loss deductions, for tax years 2018 through 2025. That means taxpayers cannot currently offset other income with hobby losses during this period, even if the activity would previously have qualified for limited deductions.

How deductions used to be handled (pre-2018)
Before TCJA, deductions related to hobby activities were subject to an order-of-priority rule:
1. Personal itemized deductions (e.g., certain mortgage interest and taxes) were taken first.
2. Deductions that didn’t adjust property basis (advertising, insurance, wages) were taken next, but only to the extent hobby gross income exceeded the first category.
3. Deductions that reduced property basis (depreciation, amortization) were taken last, again limited by hobby gross income after the first two categories.

Nine IRS factors used to determine profit motive
The IRS evaluates the totality of circumstances to decide whether an activity is for profit. Important factors include:
– Whether the activity is carried out in a businesslike manner.
– The taxpayer’s expertise or reliance on experts.
– The time and effort devoted to the activity.
– Expectation that assets used may appreciate in value.
– Success in similar activities.
– History of income or losses from the activity.
– Occasional profits.
– The taxpayer’s financial status (is the activity primarily for personal pleasure or for income?).
– Whether the activity is undertaken for personal pleasure or recreation.

Practical steps to avoid a hobby-loss classification
– Aim to show a profit in at least three of five years (or two of seven for horse activities).
– Operate in a businesslike manner: keep a business plan, maintain separate bank accounts, advertise, and implement changes intended to increase profitability.
– Keep meticulous records: receipts, invoices, contracts, and documentation of business decisions.
– Devote appropriate time and effort and demonstrate steps taken to generate profit (pricing, marketing, cost controls).
– Consult a tax professional if classification is unclear or if substantial losses are involved.

Reporting obligations
All income, including income from hobbies, must be reported on your tax return. If the activity qualifies as a business, ordinary and necessary business expenses may be deductible. If it’s a hobby, losses generally cannot offset other income (subject to the TCJA suspension through 2025).

Bottom line
To avoid hobby-loss limitations, treat the activity like a business when a profit is the objective: plan, document, and act to generate profits. If you’re unsure whether your activity qualifies as a business or a hobby, seek guidance from a tax professional.