Hobby Loss Safe Harbor: How to Prove Profit Motive

The Internal Revenue Service (IRS) draws a distinction between a business and a hobby based on the operator’s primary motivation. A business is an activity carried on with the intent to generate a profit, while a hobby is an activity not engaged in for profit, often pursued for personal enjoyment. This classification is important because taxpayers operating a business can deduct their ordinary and necessary expenses and report a loss if those expenses exceed income.

For an activity classified as a hobby, all income must be reported, but the ability to deduct expenses is limited. Due to changes from the Tax Cuts and Jobs Act, from 2018 through 2025, no expenses related to a hobby can be deducted from its income. This means that if an activity is deemed a hobby, any losses it incurs cannot be used to offset other income.

The Presumption of Profit Motive

The tax code provides a “safe harbor” rule that allows an activity to be presumed to be for profit. This presumption is established under Internal Revenue Code Section 183. If an activity meets this test, the IRS will assume it is a business, not a hobby, which protects the taxpayer’s ability to deduct losses.

The primary test states that an activity is presumed to be carried on for profit if it has been profitable in three of the last five consecutive tax years, including the current year. The five-year period is a rolling window that ends with the tax year in question. An activity is considered “profitable” when its gross income exceeds its deductions for that year.

A special rule applies to activities that consist mainly of breeding, training, showing, or racing horses. Recognizing the longer startup periods inherent in these activities, the law provides a more lenient test. For these endeavors, the activity is presumed to be for profit if it was profitable in just two of the last seven consecutive tax years.

Making the Safe Harbor Election

For new activities that have not yet had the chance to establish a history of profitability, taxpayers can request that the IRS postpone any determination of profit motive. This is accomplished by filing Form 5213, Election to Postpone Determination. Filing this form notifies the IRS of the taxpayer’s intent to have the activity treated as a business and asks the agency to wait until the five-year (or seven-year for horse activities) test period is complete.

To make the election, the taxpayer must complete and file Form 5213. The form requires basic information such as the taxpayer’s name, address, and identifying number, along with a clear description of the activity and the first tax year it began. If a joint return is filed, both spouses must sign the election.

The deadline for filing Form 5213 is within three years after the due date of the tax return for the first year of the activity, not including extensions. An exception exists if the IRS sends a notice proposing to disallow deductions; in that case, the taxpayer has 60 days from receiving the notice to file the form. Filing Form 5213 extends the statute of limitations for the IRS to assess tax deficiencies related to the activity’s deductions for all years within the test period.

The Nine Factors Test for Profit Motive

When an activity does not meet the safe harbor presumption, or if a taxpayer chooses not to make the election, the determination of profit motive falls to a subjective analysis based on facts and circumstances. The IRS uses a framework of nine factors, outlined in Treasury Regulation Section 1.183-2, to evaluate whether a taxpayer has an objective of making a profit. No single factor is decisive, and the determination is made by weighing all relevant information.

The first factor is the manner in which the taxpayer carries on the activity. Operating in a businesslike fashion, which includes maintaining complete and accurate books and records, having a separate bank account, and changing methods to improve results, suggests a profit motive.

A second factor is the expertise of the taxpayer or their advisors. A taxpayer who prepares by studying the business or consults with experts is more likely to be considered to have a profit motive.

The time and effort expended by the taxpayer is another consideration. Devoting substantial personal time to the activity, especially when it is not primarily for recreation, indicates an intent to make it profitable.

A fourth factor is the expectation that assets used in the activity may appreciate in value. Even if an activity generates operating losses, an expectation that the underlying assets, such as land or specialized equipment, will increase in value can support a profit motive.

The taxpayer’s success in carrying on other similar or dissimilar activities is also relevant. A history of turning unprofitable ventures into profitable ones can demonstrate business acumen and a profit-seeking intent.

The activity’s own history of income or losses is reviewed as well. While initial startup losses are common, a long history of continuous losses without a clear path to profitability may indicate a lack of profit motive.

The amount of occasional profits, if any, that are earned is another factor. Earning a profit in some years, even if not enough to meet the 3-of-5-year test, can be an indication of a profit motive.

The financial status of the taxpayer is also considered. If a taxpayer has substantial income from other sources and the losses from the activity generate significant tax benefits, the IRS may scrutinize the profit motive more closely.

Finally, the IRS looks at elements of personal pleasure or recreation. While deriving pleasure from an activity does not automatically negate a profit motive, a strong recreational component may suggest the activity is a hobby.