Do you have a hobby? In the age of Netflix and social media, it may seem like hobbies are a dying breed. Unless of course, you are an IRS agent reviewing tax returns, then you might see dozens of pesky and very expensive hobbies. Hobbies are legitimate (and healthy!) but too often they are abused as tax shelters by those who do not understand the tax code. Let’s take a deeper dive into hobby loss rules.
Firstly, what do hobbies have to do with taxes? It’s wrongfully assumed that there is a tax benefit to classifying some of your income as a “hobby” and then writing off large expenses for it. Someone might start a fake business (or even a real hobby like raising horses) and then declare huge losses in order to offset their other income.
The IRS is very strict however on defining what constitutes a hobby versus a for-profit enterprise. They look at many different facets around the circumstances of your “hobby” and its profitability, time commitment, percentage of your income, etc. If you’ve made a profit in the last 3 of 5 years, they assume it’s a profit-making activity and thus is not subject to hobby loss rules. If it’s not profitable – here are some of the other key questions they will ask:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
Another thing to consider is that running a business as a hobby could likely trigger an IRS audit. You will need to keep detailed and extensive records to prove whether or not your business is a for-profit company or a hobby. If the IRS does classify your business as a hobby, you generally won’t be able to take any losses and only deduct expenses up to the income you have so there are really no tax benefits to hobby losses.
In summary, in order to take a loss on a business activity, the activity needs to be engaged in as a for-profit venture – even if it is not profitable yet. There is no great tax incentive for hobby losses and they tend to be difficult to prove with the IRS. But don’t let that stop you from engaging in your favorite hobbies like – *googles list of hobbies* – archery, gardening or stand-up comedy. If you have any questions about hobbies, feel free to reach out to a ClarkSilva team member!