The Hobby Loss Tax, 26 U.S.C. § 183, is a federal statute that requires an individual or an S corporation to report hobby income on their tax return. This statute is executed under the Internal Revenue Service (“IRS”) and allows one to deduct some of the expenses that arise from said hobby income. It is important to remember that the “activity” or hobby must not be engaged in “for profit.”
What Is A Hobby?
The IRS has stated many times that in order to qualify for the Hobby Loss Tax the activity must qualify as a hobby, not a business. To make this determination the IRS looks into several factors, such as:
- Whether you are trying to make a profit;
- Whether you make a profit some years;
- Whether you depend on the income from that hobby;
- Whether you have made changes to your process in order to increase how much profit you make;
- Whether you have made a profit from similar activities in the past; and
- Whether you have the adequate knowledge to turn the hobby into a business.
The IRS has concluded that if you answer yes to all or most of these questions, you have a business, otherwise, you have a hobby.
What Does It Mean To Be For Profit?
The IRS establishes a presumption that if the gross income derived from the hobby exceeds the deductions for the hobby, for three or more consecutive years from a 5-year period, the activity is presumed to be engaged in profit. However, the IRS makes an exception for hobbies related to breeding, training, showing, or racing horses. In this case, the period of time of profit must be two or more consecutive years for a 7-year period.
The IRS also considers other factors in discerning whether the hobby is “for profit”, such as:
- The manner in which the taxpayer carried on the hobby;
- The expertise of the taxpayer on their advisers;
- The time and effort taken by the taxpayer in carrying on the hobby;
- The expectation that the assets in the hobby may increase in value;
- The success of the taxpayer in carrying on other similar or different activities;
- The taxpayer’s history of income or loss with respect to the hobby;
- The amount of occasional profits, if any, which are earned;
- The financial status of the taxpayer; and
- The elements of personal pleasure or recreation.
If most of these factors are answered in a way that shows profit, it is likely that the IRS will consider the hobby to be “for profit”.
What Expenses Qualify For A Tax Deduction?
The IRS has allowed individuals and entities with hobbies to claim Hobby Tax deductions. This means that while one can claim deductions for expenses related to the hobby, one cannot claim deductions in amounts higher than what they earn. To ensure this, the IRS requires deductions to be listed. For expenses to qualify as deductible, they must be useful and necessary to that hobby; for example, if your hobby is fixing old sport cars, new mechanical tools are a useful expense.
The IRS has also included other eligible hobby expenses such as advertising, insurance premiums, and wages paid to people who help with the hobby. The IRS has also included property value depreciation, related to the hobby, as eligible hobby expenses. Once you have itemized your qualified expenses, you must file a Schedule A for Form 1040.
