Let’s say you have an unincorporated sideline activity that you consider a business.
Perhaps you offer photography services, create custom artwork or sell handmade items online.
Will the IRS agree that your venture is a business, not a hobby?
It’s an essential question for tax purposes
. If the expenses from an activity exceed the revenues, you have a net loss.
You may think you can deduct that loss on your personal federal income tax return with no questions asked.
Not so fast!
The IRS often claims that money-losing sidelines are hobbies rather than businesses — and the federal income tax rules for hobbies aren’t in your favor.
TCJA made tax rules worse Old rules:
- Before the TCJA rules kicked in in 2018, if an activity was deemed to be a not-for-profit hobby, you had to report all the revenue on your Form 1040.
- You could deduct hobby-related expenses, such as itemized deductions for allocable home mortgage interest and property taxes.
- Other hobby-related expenses — up to the amount of revenue from the hobby — could potentially be written off.
- You had to treat those other outlays as miscellaneous itemized expenses that you could only deduct to the extent they exceeded 2% of your adjusted gross income (AGI).
Current rules:
- For 2018 through 2025, the TCJA suspends write-offs for miscellaneous itemized deduction items previously subject to the 2%-of-AGI deduction threshold.
- That change wipes all deductions for hobby-related expenses, except for expenses you can write off in any event (such as itemized deductions for allocable mortgage interest and property taxes).
- So, under current law, you can’t deduct any hobby-related expenses.
- As was the case before the TCJA, you must still report 100% of hobby-related income on your Form 1040.
- So, you’ll be taxed on all the income even if the activity loses money.
Determine if your activity is a business
- Now you understand why for-profit business status is more beneficial than hobby status.
- The next step is determining if your money-losing activity is a hobby or a business.
- There are two statutory safe-harbor rules for determining if you have a for-profit business
- : An activity is presumed to be a for-profit business if it produces positive taxable income in at least three out of every five years.
- You can deduct losses from the other years because they’re considered business losses
- . A horse racing, breeding, training or showing activity is presumed to be a for-profit business if it produces positive taxable income in at least two out of every seven years.
- If you don’t qualify for one of the safe-harbor rules, you may still be able to treat the activity as a for-profit business and rightfully deduct the losses.
- You must demonstrate an honest intent to make a profit.
- Here are some of the factors that can prove (or disprove) such intent:
- You conduct the activity in a business-like manner by keeping good records.
- You have expertise in the activity or hire advisers who do. You spend enough time to help show the activity is a business.
- There’s an expectation of asset appreciation.
- You’ve had success in other ventures, which indicates business acumen.
- The history and magnitude of income and losses from the activity help show it’s a business.
- Losses caused by unusual events are more justifiable than ongoing losses that only a hobbyist would endure. If
- you’re wealthy, it may look like you can afford to absorb ongoing losses, which may indicate a hobby.
- If the activity has elements of personal pleasure, it may appear to be a hobby.
Don’t be discouraged On the bright side, the U.S. Tax Court has, over the years, concluded that a number of pleasurable activities could be classified as for-profit business ventures rather than tax-disfavored hobbies.
We may be able to help you create documentation to prove that your money-losing activity is actually a for-profit business that hasn’t paid off yet. Contact us.
