What to Know About the IRS Hobby Loss Rules

When you earn money from an activity you enjoy, it raises a question for tax purposes: is it a hobby or a business? The Internal Revenue Service (IRS) has specific rules for this distinction. How the IRS classifies your activity determines whether you can deduct related expenses, which affects your tax liability.

The primary issue is whether you are engaging in the activity with the intention of making a profit. If the IRS views your venture as a hobby, you must report all income, but your ability to deduct expenses is limited. If the activity qualifies as a for-profit business, the tax treatment is more favorable. This distinction is based on established criteria that examine the facts and circumstances of the activity.

Distinguishing a Hobby from a Business

The IRS uses a nine-factor test to evaluate whether an activity is a business or a hobby, focusing on the intent to make a profit. One factor is operating in a businesslike manner, which includes keeping accurate books and a separate bank account. Another is the expertise of the taxpayer or their advisors, as relying on expert advice indicates a for-profit intent. The time and effort spent on the activity is also reviewed; spending significant personal time to make it profitable points toward a business.

The expectation that assets like land may appreciate in value can support a profit motive. Your history of success in turning other ventures into profitable enterprises is also considered. An activity’s history of income or losses is another factor, as continuous losses might suggest a hobby, while substantial occasional profits can indicate a business.

The IRS also reviews your financial status. If you depend on the income from the activity for your livelihood, it is more likely to be a business. Finally, while you can enjoy your work, an activity engaged in primarily for personal pleasure or recreation may be classified as a hobby.

The Presumption of Profit Motive

The tax code includes a “safe harbor” rule in Internal Revenue Code Section 183 that creates a presumption of profit motive. An activity is presumed to be for-profit if it has been profitable in at least three of the last five consecutive tax years, which includes the current year. For activities consisting of breeding, training, showing, or racing horses, the rule is two of the last seven consecutive tax years.

Meeting this test shifts the burden of proof to the IRS, meaning they would have to prove you did not engage in the activity for profit. However, the IRS can still challenge the activity’s status based on the overall facts and circumstances.

If an activity is new, a taxpayer can file Form 5213, Election to Postpone Determination. This election gives you until the end of the fourth tax year (or sixth for horse-related activities) to meet the profit test.

Tax Treatment of a Hobby

If an activity is classified as a hobby, you are required to report all income you receive on your tax return. This income is reported as “Other Income” on Form 1040.

Following the Tax Cuts and Jobs Act of 2017 (TCJA), the rules for deducting hobby expenses were changed for tax years 2018 through 2025. Hobby expenses are currently not deductible at the federal level.

This means you cannot use expenses to offset your hobby income or any other income. For example, if you earn $1,000 from selling jewelry but spend $1,500 on materials, you must report the $1,000 as income and cannot deduct any of the $1,500 in expenses.

Tax Treatment of a For-Profit Business

In contrast to a hobby, a for-profit business receives more favorable tax treatment. You can deduct all “ordinary and necessary” expenses you incur in carrying on that business. An ordinary expense is one that is common in your type of business, while a necessary expense is one that is helpful and appropriate.

This means you can deduct costs such as advertising, supplies, insurance, and wages. Unlike a hobby, the deductions for a business are not limited to the amount of income it generates. If your business expenses exceed your business income, you have a net operating loss (NOL).

This business loss can be used to offset other income you may have, such as wages, which can lower your overall tax bill. If the loss is greater than your other income, it may be carried forward to future years.

Reporting to the IRS

The way you report income and expenses depends on whether your activity is a hobby or a business. If your activity is determined to be a hobby, you must report the income on Schedule 1 (Form 1040), “Additional Income and Adjustments to Income.” The income is entered on the line for “Other income.” As hobby expenses are not currently deductible, there is no form to report these costs.

If your activity qualifies as a for-profit business and you are a sole proprietor, you will report your income and expenses on Schedule C (Form 1040), “Profit or Loss from Business.” This form allows you to list your gross receipts and then subtract deductible expenses. The net profit or loss from Schedule C is then reported on your Form 1040 and used to calculate your income and self-employment taxes.