What Is the IRS Hobby Loss Rule for Taxes?

The Internal Revenue Service (IRS) hobby loss rule provides a framework for determining if an activity is a business pursuing profit or a personal hobby. This distinction is important for federal tax purposes because it governs how income and expenses are reported and whether losses can be deducted. If an activity is deemed a business, its financial losses can offset other income, reducing a taxpayer’s overall tax liability. Conversely, if the activity is classified as a hobby, the ability to deduct expenses is restricted.

IRS Factors for Determination

The IRS uses nine factors, outlined in Internal Revenue Code (IRC) Section 183, to evaluate whether an activity is engaged in for profit. No single factor is controlling; the determination is based on an examination of all facts and circumstances. The agency considers the manner in which the taxpayer conducts the activity. Operating in a businesslike fashion, which includes maintaining accurate books, separate finances, and a business plan, suggests a profit motive.

Another consideration is the expertise of the taxpayer or their advisors. Extensive knowledge in the field or reliance on expert advice can indicate an intent to make the activity profitable. The time and effort expended are also scrutinized. Spending significant personal time on the activity, particularly when it is not for personal enjoyment, points toward a business intent.

The IRS also looks at the expectation that assets used in the activity may appreciate in value. A taxpayer might tolerate current losses with the belief that assets like land or equipment will increase in value, creating a future profit. The taxpayer’s history of success in other ventures can also lend credibility to their profit-seeking intentions.

An activity’s history of income and losses is an important factor. While a startup may incur initial losses, a continuous string of losses may suggest a lack of a profit motive. The amount of any occasional profits is also weighed, as substantial profits can support a for-profit argument.

The financial status of the taxpayer is another element. If a taxpayer has substantial income from other sources and the losses from the activity generate tax benefits, the IRS might infer the activity is not for profit. Finally, the presence of personal pleasure or recreation is considered. If the activity seems primarily for recreation, it may be viewed as a hobby.

Tax Consequences for a Hobby

When the IRS classifies an activity as a hobby, all income earned from it must be reported on the taxpayer’s return. This income is included on Schedule 1 of Form 1040 as “Other Income.”

The primary consequence relates to the deduction of expenses. Under the Tax Cuts and Jobs Act of 2017 (TCJA), hobby expenses are not deductible for tax years 2018 through 2025. This suspension means a hobbyist must report all income from their activity but cannot offset that income by deducting any associated costs. For example, if an individual earns $1,000 from selling crafts but spent $1,200 on materials, they must report the full $1,000 as income and cannot deduct the $1,200 in expenses.

Tax Consequences for a Business

If an activity is classified as a business, the tax treatment is more favorable. A business owner reports all income and expenses on Schedule C, “Profit or Loss from Business,” filed with their Form 1040. A business can deduct all expenses that are “ordinary and necessary” for its operation.

Ordinary expenses are common in the industry, while necessary expenses are helpful and appropriate. This can include costs such as advertising, supplies, rent, and depreciation on assets. If total deductible expenses exceed the business’s income, the result is a net operating loss (NOL). This loss can be used to offset other sources of income on the taxpayer’s return, such as wages, thereby lowering their total taxable income.

Establishing a Profit Motive

Taxpayers can take proactive steps to demonstrate that their activity is a business operated for profit. The primary strategy is to conduct the activity in a businesslike manner. This includes opening a separate bank account, keeping organized financial records, and developing a formal business plan.

A written plan outlining strategies for growth and financial projections serves as evidence of a profit-seeking intent. Obtaining required business licenses or permits also reinforces the commercial nature of the enterprise.

The IRS provides a “presumption of profit” safe harbor rule. An activity is presumed to be for-profit if it has generated a profit in at least three of the last five consecutive tax years. For activities involving horses, the requirement is profitability in two of the last seven years. Meeting this test shifts the burden of proof to the IRS.