If you have a hobby that produces income, your hobby income is taxable. But what about hobby expenses and losses? Whether or not you can deduct hobby expenses and losses depends on whether you pass the IRS hobby vs. business test. Here’s what you need to know to avoid getting caught by the hobby trap.
Do you have a hobby you enjoy? If you’re good at it, you may have found a way to make the hobby produce some income, and if that’s the case, the IRS expects you to pay taxes on the income. The problem? Unless you can prove to the IRS that your hobby is a real business, you won’t be able to deduct any of your hobby expenses.
The IRS has always had different rules for the deduction of business expenses and hobby expenses.
Business Deductions
If you’re running a business, most ordinary and necessary business expenses are deductible from your business income. Additionally, if you’re operating as a sole proprietor and the direct costs of doing business exceed your income from the business, you can use the resulting loss to offset (reduce) other income reported on Form 1040.
Hobby Deductions
The IRS has different rules for activities it considers hobbies. The main difference is that hobby expenses are no longer deductible even when you make some income from your hobby.
Before the Tax Cuts and Jobs Act of 2017 (which went into effect in 2018), people who weren’t running a business but who were making some income from a hobby could deduct their hobby-related expenses as miscellaneous deductions on Form 1040 Schedule A.
Unfortunately, under the Tax Cuts and Jobs Act, that’s no longer true. Under the current law, if your income-producing activity is considered a hobby by the IRS, you have to report the hobby income, but can’t deduct any of the expenses.
Hobby vs. Business
The question of whether an activity is a business or a hobby has always been problematic for people who make money from activities that are usually done for sport or pleasure, such as photography, painting and drawing, soap making, or jewelry making. That’s because some people try to claim their hobbies are businesses just so they can deduct the costs of enjoying that hobby.
On the other hand, it’s common for people who are good at hobbies to turn their hobby into a business. And, like starting or running any business, there can be years when you don’t make a profit.
So, what can you do to keep the IRS from declaring your hobby-related business a hobby?
Profit motive is critical
How does the IRS decide whether something is a business or a hobby? The key is whether you can show the IRS that you have a profit motive for engaging in the income-producing activity. If your business involves something others do as a hobby and you lose money year after year, you could have your business deductions disallowed.
How to Avoid the Hobby Trap
The IRS generally will presume your activity is a business if you show a profit in three of the last five years including the current year. (Businesses involved with racehorses have to show a profit in two of seven years.)
If your activity fails this three-of-five-year test, you may still be allowed to declare your expenses as business deductions if you can prove a profit motive. Here are some of the key factors the IRS will look at:
- Do you carry out the activity in a business-like manner?
- Do you maintain complete and accurate books and records?
- Does the time and effort you devote to the activity indicate your intention to make it profitable?
- Do you have expertise in the activity and knowledge to carry out the activity as a business?
- Are the losses due to circumstances beyond your control, or are they normal for starting your type of business?
- Have you tried to increase the profitability of the activity by changing your methods of operation?
- Do you depend on income from the activity for your livelihood?
- Have you made a profit on similar activities in the past?
- Can you expect to make a future profit from the appreciation of the assets used in the activity?
When a business deduction is challenged on the basis of profitability, decisions are made on a case-by-case basis. But the more ways you can prove your profit motive, the better.
Suppose you’re in business selling hand-painted decorative items, and the business fails the profitability test. The IRS might consider it a business if you:
- have little or no other income;
- regularly work at the business;
- regularly have your items on sale at craft shows, craft malls, consignment shops, or through other means;
- keep accurate and complete records of your costs, inventory, and sales;
- have a separate bank account for your business activities;
- or have made changes in your business to try to counteract the losses.
On the other hand, if you only work sporadically at the business, decorate your own home with your handiwork or give them as gifts, don’t keep good records, don’t regularly offer your products for sale to the public, or never analyze income and expenditures or make and carry out plans to increase profitability, the IRS is likely to declare that your “business” is a hobby.
For more information, see the Not-for-Profit Activities section under the Deducting Business Expenses chapter of the IRS Publication 535.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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