Taxes and Hobbies—The Hobby-loss Rules
Generally, when individuals have a hobby, they pursue it because they enjoy it, not with the goal of making money. In fact, most hobbies never make money or even create any income, for that matter. Some hobbyists try to get a tax deduction for their hobby expenses by treating their hobby as a trade or a business. By disguising hobbies as a trade or business (and if the hobby expenses exceed the hobby income), they think they can report the difference between hobby income and expenses as a deductible business loss. Not in this case!
Any Fiducial tax professional can explain these rules to you, but we’ll start with this: Tax law generally does not allow deductions for personal expenses except those allowed as itemized deductions on the 1040 Schedule A, and this also applies to hobby expenses. To curtail hobbies being treated as businesses, the tax code includes rules that do not permit losses for not-for-profit activities such as hobbies. The not-for-profit rules are often referred to as the hobby-loss rules.
Hobby or Business?
The distinction between a hobby and a trade or business sometimes becomes blurred, and the determination depends upon a series of factors, with no single factor being decisive. All of these factors have to be considered when making the determination:
- Is the activity carried out in a businesslike manner?
- How much time and effort does the taxpayer spend on the activity?
- Does the taxpayer depend on the activity as a source of income?
- Are losses from the activity the result of sources beyond the taxpayer’s control?
- Has the taxpayer changed business methods in attempts to improve profitability?
- What is the taxpayer’s expertise in the field?
- What success has the taxpayer had in similar operations?
- What is the possibility of profit?
- Is profit from asset appreciation possible?
Because making a determination using these factors is so subjective, the IRS regulations provide that the taxpayer has a presumption of profit motive if an activity shows a profit for any three or more years during a period of five consecutive years. (*A brief aside for our horse aficionados out there: If the activity (hobby) involves breeding, training, showing, or racing horses, then the period is two out of seven consecutive years.)
Making the proper determination is important because of the differences in tax treatment for hobbies versus trades or businesses. If an activity is determined to be a trade or business in which the owner materially participates, then the owner can deduct a loss on his or her tax return, and it is not uncommon for a business to show a loss in the startup years. If you have questions about these factors, Fiducial can sit down with you and help you determine the answers.
However, hobbies (not-for-profit activities) have special, unfavorable rules for reporting income and expenses, which have been exacerbated by the 2017 passage of the Tax Cuts and Jobs Act (tax reform). These rules are:
- The income is reported directly on the hobbyist’s 1040;
- The expenses, not exceeding the income, are deducted as a miscellaneous itemized deduction. Thus, the expenses are only allowed if a taxpayer is itemizing deductions, rather than taking the standard deduction; and
- Due to tax reform, for tax years 2018 through 2025, miscellaneous itemized deductions that must be reduced by 2% of the taxpayer’s adjusted gross income – which is the category into which the hobby expenses fall – have been suspended (are not deductible). Thus, for those years, there is no deduction at all for hobby expenses, and any hobby income will be fully taxable.
Example: Marcia has income of $750 from her hobby (a not-for-profit activity) of coin collecting and expenses of $500. So, Marcia must include the $750 on her 1040. But because miscellaneous itemized deductions are currently suspended, she will not be able to deduct her $500 in expenses, leaving the full $750 as taxable income.
Another concern for hobbyists who are reporting income from their hobby on their 1040 is whether or not that income is subject to self-employment tax. Luckily, there is an exception for sporadic or one-shot deals and hobbies, which are not subject to self-employment tax.
Trying to claim deductions for hobbies can be confusing, and, with the new rules of 2017, sometimes it can be an unfavorable endeavor for the hobbyist. If you have questions related to how the not-for-profit rules may apply to your activity, please call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our locations to talk about how the hobby-loss rules might affect you.