What Is Section 183’s Hobby Loss Rule?

Internal Revenue Code Section 183 provides a framework for determining if an activity is a business or a hobby. This distinction is important because it governs whether you can deduct losses. If an activity is classified as a business and incurs a loss, that loss can often be used to offset other income, such as wages.

The rule, often called the “hobby loss rule,” prevents taxpayers from subsidizing personal pastimes with tax deductions. When an activity is deemed a hobby, you must still report all income you receive from it, but the associated expenses are not deductible. This rule applies to individuals, S corporations, trusts, estates, and partnerships.

The Presumption of Profit Motive

The tax code provides an objective test that, if met, creates a presumption that you are engaged in an activity to make a profit. This test, sometimes called a safe harbor, removes the need for a subjective analysis of your intent. To meet this standard, the activity must have generated a profit in at least three of the last five consecutive tax years. A profit is achieved when the activity’s gross income is greater than its total deductions.

If you meet this requirement, your activity is assumed to be a for-profit business, and the Internal Revenue Service (IRS) would have to prove that you did not have a profit motive.

A special variation of this rule exists for activities that primarily involve the breeding, training, showing, or racing of horses. For these activities, the presumption of profit motive is met if a profit is shown in at least two of the last seven consecutive tax years.

Factors for Determining Profit Intent

When an activity does not meet the safe harbor presumption, the IRS applies a subjective analysis based on nine factors to determine if a profit motive exists. The determination is based on all the facts and circumstances, focusing on whether you have a genuine intention of making a profit.

The first factor is the manner in which you carry on the activity. Operating in a businesslike way, such as by keeping complete and accurate books, maintaining a separate bank account, and having a business plan, suggests a profit motive.

Another consideration is the expertise of the taxpayer or their advisors. Possessing knowledge about the activity or seeking expert advice can indicate an intent to be profitable. The time and effort you expend on the activity is also reviewed, as devoting substantial personal time points toward a profit motive.

An expectation that assets used in the activity may appreciate in value can support a profit motive. The IRS also looks at your success in carrying on other similar or dissimilar activities, as a history of turning ventures into profitable enterprises can indicate business acumen.

The activity’s history of income or losses is another point of analysis. A string of losses during a start-up phase is acceptable, but continued losses may suggest a hobby. The amount of any occasional profits is also weighed, as large profits could indicate a genuine business intent.

Your financial status is considered because an activity is more likely to be seen as for-profit if you do not have substantial income from other sources. Finally, the IRS examines elements of personal pleasure. An activity that is highly recreational may face more scrutiny if it consistently generates losses.

Required Documentation and Recordkeeping

To demonstrate a profit motive when the safe harbor is not met, maintaining meticulous records is necessary. A foundational document is a formal business plan that outlines your strategy for achieving profitability, including market analysis and financial projections. This document should be periodically updated to show an ongoing effort to improve.

Separating the activity’s finances from your personal funds is a fundamental step. This requires opening and using a dedicated business bank account for all income and expenditures. Commingling funds makes it difficult to track financial performance and can suggest the venture is an extension of your personal finances.

Detailed financial books are another requirement. This means using an accounting system to record every transaction and produce financial statements. All receipts, invoices, and bank statements must be saved and organized to substantiate the figures in your books.

Beyond financial data, you should maintain logs that document the time and effort you invest. A detailed calendar showing dates, hours, and tasks performed can be powerful evidence. You should also keep copies of any marketing materials, advertisements, or a professional website to show you are actively trying to attract customers.

Electing to Postpone Determination

Taxpayers starting a new venture can delay an IRS determination of their profit motive by filing Form 5213, Election to Postpone Determination. This form informs the IRS that you are electing to wait until the conclusion of the test period before your activity is evaluated against the profit presumption rules. This gives a new activity time to establish a track record of profitability.

To make the election, you must file Form 5213 separately from your tax return. The form requires your name, address, identifying number, a description of the activity, and the first tax year it began. If you file a joint return, both spouses must sign the form.

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. An exception exists if you receive a notice from the IRS proposing to disallow deductions for the activity. In that case, you must file the form within 60 days of receiving the notice.