Is Your Hobby a Business to the IRS?
You say you have a business, but does the IRS? Why is this even an issue? It all has to do with how many expenses you can deduct, and the rules are quite different for hobbies and businesses.
With a hobby, you can deduct your hobby expenses, but you can't deduct more than you earned. You also can't claim negative hobby income on your tax return. That's called the hobby loss rule – and the rule is, there's no such thing as a hobby loss, at least on your tax return.
You can have negative business income though, which can offset other taxable income, such as from a spouse's job or other income, and this is called a net loss. So it can be tempting to try to pass a hobby off as a business. That's why the IRS looks carefully at whether you have a true business or only a hobby.
Your Hobby Deductions
Here's how you should handle your deductions for a hobby. Deductions can be taken on our Job, Tax, and Miscellaneous Deductions screen, but they should be taken in the following order. And the IRS is pretty specific on how much of each deduction you can attribute to your hobby:
Step 1: Deductions for certain personal expenses, such as home mortgage interest or taxes, may be taken in full.
Step 2: Deductions that do not result in an adjustment to the basis of property – advertising, insurance premiums and the like – can be taken next, but only if there’s gross income for the activity left over from Step 1.
Step 3: Deductions that reduce the basis of property, like depreciation and amortization, can be taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two steps.
In other words, if your deductions in Step 1 are equal to the gross income you had for the hobby, you’re done; you can’t take any more deductions on the hobby for the year.
So How Does the IRS Determine a Business?
The IRS has a list of factors for determining whether your pastime is more business than hobby. No one factor is decisive. The IRS says all facts and circumstances are taken into account. Here are the most common factors:
- Do you carry on the activity in a businesslike manner?
- Do the time and effort you put into the activity indicate that you intend to make it profitable?
- Do you depend on the income from the activity for your livelihood?
- Are your losses due to circumstances beyond your control, or are they normal in the startup phase of your type of business?
- Do you change your methods of operation in an attempt to improve profitability?
- Do you, or your advisors, have the knowledge needed to carry on the activity as a successful business?
- Were you successful in making a profit in similar activities in the past?
- Does the activity make a profit in some years? If so, how much?
- Can you expect to make a future profit from the appreciation of the assets used in the activity?
The IRS assumes that an activity is for-profit if it makes a profit in at least three of the last five tax years, including the current year. (If you're breeding, showing, training or racing horses, that range is two of the last seven years.)
Report business income and expenses on Schedule C, Profit and Loss from Business.