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.
Definition of 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.
Business vs Hobby?
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:
- Have you made a profit at this activity for at least 3 out of the last 5 years (including the current year)?
- Are there indications that you intend to make a profit from the activity (for example, enough time and energy are put into the venture to show that you intend to make a profit)?
- Do you depend on the income made from your activity?
- Can you explain losses from this activity?
- Are you qualified to be doing the activity in a way to be making a profit from it?
- Do you expect to make money from this activity in the future?
Hobby Tax Deduction Rules
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).
- You may deduct what taxpayers deduct from certain personal expenses such as home mortgage interest and taxes.
- Next you can take deductions that don’t result in an adjustment to the basis of property (advertising, insurance premiums and wages).
- Finally, you can next take deductions that reduce the basis of property, such as depreciation and amortization.
Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. For more information on business deductions, check out IRS Publication 535.
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From your latest blog on IRS Rules for Hobbies I have a question. Is sports officiating considered a business or a hobby? Because after allowed IRS deductions for car expenses there are many years where a profit is not made because of these allowable deductions. Therefore will the IRS say this activity should be considered a hobby?
Hello Jf Bill!
From my research (and I am not a tax professional, so please seek their advice as well), making a profit is not the only test the IRS uses in order to determine if you have a business or if your activity is a hobby. Intention is important as well, meaning do you intend to make a profit from sports officiating? What are your answers to the other questions above?