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Typically people spend money in order to pursue their hobby: equipment for a sport, ticket fees to events, materials such as yarn and needles for knitting, seeds for a part-time farm, etc. But some hobbies have the added perk of making you money. You have to be careful with this earned income come tax time because unlike with business income, you cannot claim a loss from this activity or deduct certain expenses (in accordance with Internal Revenue Code Section 183, Activities Not Engaged in for Profit, or the “hobby loss rule”). In 2007, the IRS estimated that $30 billion of tax revenue was lost due to the misunderstanding among taxpayers between business vs hobby.
For clarification, the IRS defines a hobby as an activity that is not pursued for profit, and defines a business as an activity that is carried out with the reasonable expectation of earning a profit.
First you need to determine if your activity is a business or a hobby. Here are some questions that the IRS gives in order to help you determine whether or not your activity can be considered a hobby:
If you answered “no” to several of the questions above, or if you just know for certain that the activity you make money from is a hobby, then there are certain rules for expenses and deductions you need to know. As mentioned above, you are not allowed to deduct most of the expenses you incur from your income earned from a hobby. You also are not allowed to show a tax loss from a hobby (i.e. allowable deductions cannot exceed the gross receipts for the activity). However, you are allowed to take the following deductions (only in the order of these categories; as soon as a loss is shown no other deductions may be taken).