What Is a Hobby Loss?
Hobby loss is the term associated with funds spent to pursue a recreational activity that is not recouped.
These expenses, when paid in connection with a hobby, are deductible only to the extent of income earned by the hobby or recreational activity. A loss is not allowed for expenses in excess of hobby income.
- A hobby is defined by the IRS as an activity you undertake for pleasure and not for profit: "from painting and pottery to scrapbooking and soapmaking," according to the IRS factsheet.
- If you and your children set up a lemonade stand on a busy corner on a hot summer day and make money from it, you must report the profit on your 1040.
- You may be able to deduct some losses stemming from the activity if they don't exceed the gross income for the activity.
How Hobby Loss Works
Expenses are an expected part of running a business -- you have to spend money to make money. Expenses which are necessary to carry on a trade or business, incurred to produce income, or paid for investment in the company are deductible. When, despite a profit motive, your overall expenses exceed your earnings, the loss can offset unrelated income.
By way of contrast, hobbies are not considered a business, as several legal precedents show. If an activity is not conducted for profit, but you still earn money from it, that money is taxable. Expenses related to that activity that result in a loss are deductible.
A hobbyist may deduct hobby expenses only to the extent of the hobby’s gross income during a particular taxable year. Losses due to activities not engaged in for profit are disallowed, and they do not carry forward to the next taxable year.
The hobby loss rules of the Internal Revenue Code (IRC) §183 attempt to curb perceived loss deduction abuses by hobbyists. The hobby loss rules apply to individuals, S corporations, trusts, estates, and partnerships, but not to C corporations. These rules limit deductions for activities not engaged in for profit.
The Internal Revenue Service (IRS) warns that it will apply the hobby loss rules to disallow losses of activities it finds likely not to be engaged in for profit. It cited the following actions, among others: writing, auto racing, horse breeding, yacht chartering, and fishing. Taxpayers engaged in these activities must establish a profit motive to avoid the hobby loss limitations.
The IRS also publishes a tip sheet to help taxpayers distinguish between what's a hobby and what's a business. Assuming your hobby is a hobby and not a covert or nascent business, the IRS lists the following allowable deductions that can be claimed as itemized deductions on Schedule A, Form 1040. According to the IRS, "these deductions must be taken in the following order and only to the extent stated in each of three categories":
- Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
- Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
- Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
Real World Examples of Hobby Loss
The easiest way to avoid the hobby loss rules is to turn a profit more often than not. The hobby loss rules presume that an activity is for-profit if the operation was profitable for three out of the last five years ending with the current taxable year. For actions involving horses, the timeframe is two of the previous seven years.
If the presumption is not met, then the taxpayer must establish a profit motive. The following nine factors define hobby income and losses:
- Does the taxpayer, in carrying on the activity, have a businesslike manner
- Is the taxpayer an expert or an advisor
- Do they devote the necessary time and effort
- Is an appreciable asset created
- Are there success' in similar activities
- What is the history of activity income or loss
- Have there been occasional profits
- Is there a stable financial status?
- Is this activity undertaken for personal pleasure or recreation
A taxpayer that fails to turn a profit or to establish a profit motive is not engaged in the event for profit. The hobby loss rules will apply. Hobby expenses that fail its three-tier deduction system are not deductible. Hobby expenses that exceed hobby income are disallowed as non-deductible hobby losses.