Individuals who claim a loss on Schedule C, Profit or Loss from Business, can use the loss to reduce their other taxable income. The IRS knows many people are not in a bona-fide business, but rather are using losses from their hobby to pay less income tax. Internal Revenue Code Section 183 (“IRC 183”) is known as the “hobby loss rule”; it limits deductions that can be claimed when a taxpayer is not operating an activity with a profit motive.
Are you really engaged in an activity for profit?
Taxpayers may generally deduct ordinary and necessary expenses to produce income. The IRS considers such trade or business activities are engaged in to make a profit. The following factors should be considered to determine if an activity is conducted for profit or hobby:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- Are losses due to circumstances beyond your control?
- Did losses occur in the start-up phase of a business?
- Have you made changes to improve profitability?
- Do you have the expertise or knowledge needed to conduct the activity as a successful business?
- Have you made a profit in similar activities in the past?
- What is the history of income vs. loss for the activity?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
Most activities that make a profit in at least three of the last five years are considered to be a business by the IRS. For activities that primarily involve breeding, showing, training or racing horses, the IRS will consider they are a legitimate business if there is a profit in two out of the last seven years. The IRS may conduct an audit to determine the business intent.
How are hobby transactions reported?
Hobby income will be reported on the tax return depending on how the income was derived (see our blog, Who Has to Pay Self-Employment Tax); individuals should not use Schedule C for any hobby income. Deductions for hobby expenses are limited to the activity’s gross income. Losses from a hobby are not allowed to offset other kinds of income, and disallowed hobby expenses may not be carried forward. Hobby expenses can only be reported on Schedule A, Itemized Deductions, and must follow these deduction ordering rules:
Category 1- Deduct normally itemized expenses such as mortgage interested and real estate taxes paid.
Category 2 – If Category 1 expenses don’t exceed hobby income, deduct expenses that don’t reduce the basis in assets. Examples of Category 2 expenses are advertising, utilities and insurance.
Category 3 – If the totals of Category 1 & 2 expenses don’t exceed hobby income, deduct expenses that reduce the basis in assets (e.g. depreciation, amortization).
Category 2 & 3 expenses are reported as miscellaneous deductions on Schedule A, subject to the 2% of AGI limitation.
Sometimes it takes more time for a legitimate business to turn a profit, especially in a bad economy. Gary Kaplan has the know-how to evaluate all your factors, and help you stay in compliance with the IRS.
