What Is Hobby Loss?

There’s no question about it: hobby loss can mean major tax savings for your clients. But, it can also spell trouble if used incorrectly and challenged by the IRS. That’s why having a thorough understanding of how it works is so important. You could be a client’s hero when you save them thousands of dollars in taxes owed. At the same time, though, ill-informed advice could land a client in hot water.

Hobby Loss

What Is Hobby Loss?

In the world of taxes and accounting, hobby loss is a phrase used to describe a specific type of loss for tax purposes. Generally speaking, we refer to a particular expenditure as a “hobby loss” when it’s associated with the pursuit of a specific hobby (in other words, some sort of recreational activity). That expenditure is then not recouped, which is what makes it a loss. However, according to the IRS, those expenses can only be claimed in connection with a recreational activity insofar as that same recreational activity earns income. In other words, it’s not possible to claim losses beyond the scope of the actual income associated with a hobby.

Here’s the thing: expenses come along with every business. From the perspective of the Internal Revenue Service, there’s nothing unusual about a business reporting a loss. In fact, it’s quite common for businesses to report a loss in their first year in operation, and sometimes beyond that. Remember that roughly 20% of businesses fail in their first-year operation, with 30% closing shop by year two and about 50% shutting down by year five.

How Hobby Loss Works

Expenses are an expected part of running a business—you have to spend money to make money. Expenses that are necessary to carry on a trade or business, incurred to produce income, or paid for investments in your company are deductible. When, despite a profit motive, your overall expenses exceed your earnings, the loss can offset unrelated income.

Any income you earn is taxable and must be claimed, even if it doesn’t come from your employer. This includes any part-time and temporary work, side gigs, and recreational pursuits that lead you to make a profit. Expenses related to these activities that result in a loss are generally deductible. That is, of course, unless the IRS considers your activity to be a hobby.

How Hobby Loss Works

What is a Hobby in Taxation Terms

For tax purposes, a hobby is an activity you engage in primarily for a purpose other than to make a profit. The IRS commonly classifies inherently “fun” activities like creating art, photography, crafts, writing, antique or stamp collecting, or training and showing dogs or horses as hobbies. Even if you occasionally make money doing such an activity, it is a hobby if your prime motivation is having fun, not earning a profit.

Because hobbies are not businesses, hobbyists have never been allowed to take the tax deductions to which business people are entitled. However, for decades the tax law did permit hobbyists to claim as an itemized deduction their hobby-related expenses up to the amount of income the hobby earned during the year. This was not a very generous deduction because of the limitations on itemized deductions, but it was better than nothing.

Unfortunately for people who earn income from hobbies, the TCJA completely eliminates the itemized deduction for hobby expenses, along with all other miscellaneous itemized deductions. The prohibition on deducting these expenses goes into effect for 2018 and continues through 2025. This means that taxpayers will not be able to deduct any expenses they earn from hobbies during these years, but they still have to report and pay tax on any income they earn from a hobby! The deduction is scheduled to return in 2026.

WHAT IS THE HOBBY LOSS RULE? 

Under the Internal Revenue Code § 183, if an activity is not engaged in for profit, no deduction attributable to such activity shall be allowed, except as provided. Many people are engaged in an activity as an individual, or corporation, that they treat as a business. However, the IRS may disagree and claim the business is actually a hobby and cannot take advantage of the beneficial tax treatment. 

There are some “safe harbors” that taxpayers can use where their activity will presumptively be treated as a for-profit business. However, the IRS can overcome this presumption. There are a number of relevant factors used to evaluate whether an activity is engaged in for profit. 

Hobby in Taxation Terms

Allowable Deductions

For taxpayers whose activities do indeed constitute a hobby, the IRS has outlined the following sequence of allowable deductions that can be claimed and recorded as itemized deductions:

  • “Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.”
  • “Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.”
  • “Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.”

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