IRS Hobby Loss: What You Need to Know

A lot of times, our hobbies often lead us to new doors. You somehow end up making profits while enjoying your hobby. If you have a hobby that you enjoy and sometimes extract profits from, you might wonder if it affects your taxes. Do you have to report your hobby income? Can you deduct your hobby expenses? What are the rules and limits for hobby losses? How did the Tax Cuts and Jobs Act (TCJA) change the tax treatment of hobbies? And most importantly, how can you avoid hobby loss and turn your hobby into a profitable business? It is very important for you to know these basic details about Hobby loss, to prevent it from happening in your life.

In this blog post, we will answer these questions and provide some tips and resources to help you with your hobby tax issues.

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).

The IRS defines a hobby as any activity that you do for fun and not for profit. This means that if you engage in an activity that is not intended to make money, or that consistently loses money, it is considered a hobby and not a business.

Why does this matter? Because the tax rules for hobbies and businesses are very different. If you have a hobby, you must report any income you earn from it, but you cannot deduct any expenses you incur from it. If you have a business, you can deduct your ordinary and necessary expenses from your income, and potentially reduce your taxable income and tax liability.

Key Takeaways

• A hobby is usually a loss that occurs while a taxpayer handles a business that is a hobby according to the IRS.
• Any activity that is done for pleasure and not revenue would be called a hobby.
• The entire sum of your income, even the hobby income must be reported to the IRS.
• Before 2018, when the TCJA was not signed, there was a scope of deductions from the gross income.
• With the existence of TCJA, all mixed itemized deductions are eliminated. (2018-2025)

How Hobby Loss Works?

Before the TCJA, which was enacted in 2017 and took effect in 2018, taxpayers were allowed to claim itemized deductions for some of their hobby expenses, as long as they did not exceed their hobby income. These deductions were subject to the 2% of adjusted gross income (AGI) floor, meaning that only the amount of expenses that exceeded 2% of your AGI could be deducted. These deductions were also part of the miscellaneous itemized deductions category, which was subject to the overall limitation on itemized deductions based on your income level.

However, the TCJA changed the rules for hobby losses significantly. The new law eliminated all miscellaneous itemized deductions, including hobby losses, until after 2025. This means that starting from 2018, you cannot deduct any of your hobby expenses at all, even if they are less than or equal to your hobby income.

This change can have a big impact on your taxes if you have a hobby that generates some income but also incurs a lot of expenses. For example, suppose you have a hobby of making and selling jewelry online. In 2017, you made $5,000 in sales and spent $6,000 on materials, tools, fees, advertising, etc. Your net loss from your hobby was $1,000. Under the old rules, you could deduct $1,000 of your hobby expenses from your income as an itemized deduction (assuming you met the 2% AGI floor and the overall limitation). Under the new rules, you cannot deduct any of your hobby expenses. You still have to report your $5,000 of income, but you cannot offset it with any of your expenses. This means that your taxable income will increase by $5,000, and so will your tax liability.

Tax Cuts and Job Acts (TCJA)

The Tax Cuts and Job Acts is a 200-page law implemented on Jan 1, 2018 by president Donald Trump. This law brought major changes in the tax law spectrum. There was a change in the tax bracket, mortgage deductions, medical expenses, and many other personal expenses.

This affected a lot of hobby business owners. Once this law was signed and implemented, the entire claim of reducing one’s income was no longer allowed. This rule was applicable to all the taxpayers of 2018-2025.

Business or Hobby?

The IRS or the Internal Revenue Service provides many benefits. However, under a hobby, those benefits are usually limited. For instance, your business claims a big net loss for several years and then fails to meet the IRS requirements. In this case, the IRS may claim your business as a hobby. This means you cannot claim the deductions under this scheme. In order to claim the mixed itemized deductions, you will have to prove your business.

How to Determine if Your Activity is a Business or Hobby?

The IRS has given nine set rules to determine if your activity is a business or a hobby. All nine factors collectively determine the criteria of your business.

It is the IRS’s main job to look for reasons that you are making a profit. Only when you fulfill most of their requirements, you be considered someone with a business. Here we are stating those nine requirements for you:

• The time and money you’re investing into your activity, does that give any signs of a profit?
• Do you run your activity in an organized manner?
• Are you educated enough to turn your activity into a successful business? You are required to have expertise in the given sector.
• Is there any scope for profit in some years? Usually according to the IRS guidelines, if your activity has not made any kind of profit in the last three to four years, it will automatically be claimed as a hobby. In this case, you cannot claim the deductions from itemized funds.
• Is there any profit made in the past years in the same niche?
• With the assets you used in setting up your activity, do you expect it to be profitable soon?
• In case your activity consists of losses in the initial phase, it will be labeled as a hobby. Even though there is scope for losses in the activity, a loss in the initial phase would be a bad impression.
• How often do you need the income generated from the activity?
• To seek profits, how comfortable are you in changing your strategies?

Special Cases that need to be considered:

In order to help taxpayers understand the difference between hobbies and businesses, the IRS made a set sheet of rules. Usually before the year of 2018 tax year, it was legal itemized deductions on Schedule A of Form 1040. The deductions were supposed to be taken in a correct format which is stated below.

• The taxpayer is allowed to ask for deductions in personal expenses, for example in cases like mortgage and taxes.
• When there are no deductions in adjustment on the basis of property, for instance, no insurance premiums or no wages. You can ask for deductions in the next cycle.
• In times when there is depreciation, deductions can happen from the gross income.

What is the IRS Hobby Loss Rule?

As someone who belongs to the world of business, you have first-hand experience in writing off business expenses and keeping a check on the tax. In order to have a fruitful result, it is important for you to manage your business well. A very easy way to bring out a successful business is by doing something you love and turn it into a business. By doing this, you can:

• Start making a profit by doing something you have an interest in and knowledge of.
• Try to lower your taxes by mentioning them as associated business expenses.

However, before falling into setting and managing a business, it is important for you to understand why and how business and hobby are two different things. As per the guidelines given by the IRS, any activity with the intention of making a profit can be called a business. Once your activity is claimed as a business, you are eligible to deduct the common expenses.

On the other hand, any activity which acts as a non-profit activity is called a hobby. As the IRS states, it is an activity when people engage for fun and socializing. There is no need for an organized setup or track records.

For Example

For example, let’s say in your free time you like knit clothes. Just recently, you decided that you’ll start selling them as a source of income. In the very first year of selling the knitted products, you face a loss of $6000. If the IRS labels you as a business, you can claim and use the $6000 for other expenses. However, if the IRS labels you as a hobby, you are not eligible to offset this income. After the amendment of TCJA, you cannot deduct any expense from a hobby.

If you are someone who is thinking of changing their hobby into a business, it is very important for you to understand this.

How to Avoid Hobby Loss?

The best way to avoid hobby loss is to turn your hobby into a business. If the IRS considers your activity to be a business rather than a hobby, you can deduct all of your ordinary and necessary expenses from your income, regardless of whether you make a profit or not.

But how do you convince the IRS that your activity is a business and not a hobby? There is no clear-cut answer to this question, as the IRS looks at each case individually and considers various factors. However, there are some general guidelines that can help you establish that your activity is conducted with a profit motive and not just for fun.

Some tips to help you demonstrate that your activity is a business and not a hobby are:

• Keep detailed and accurate records of your income and expenses, and use a separate bank account for your activity.
• Make a written business plan that outlines your goals, strategies, market analysis, financial projections, etc.
• Seek professional advice from experts or consultants who can help you. Improving your skills matters and a professional will help you sort that out.
• Even though it’s a hobby, in order to get revenue it is important for you to dedicate your time and effort.
• Adapt to changing market conditions and customer demands, and try new methods or techniques to increase your income potential.
• Avoid mixing personal and business elements in your activity, and limit the amount of personal pleasure or recreation involved.
• Try to make a profit in at least three out of five consecutive tax years (or two out of seven for certain activities such as horse racing or breeding). This is a safe harbor rule that presumes that your activity is a business if you meet this criterion.

Consequences of Hobby Classification

In cases when the IRS is claiming your activity as a hobby instead of a business, you are not allowed to take any expenses legally. However, in times when you have a hobby loss, it can be deducted in the name of personal expense.

The tax years preceding 2018, other expenses such as insurance, salaries, advertising, marketing can be used as a mixed itemized deduction with 2 percent gross income. However, a heavy hobby income needs to be there so that the deductions can take place.

From 2018, to the end of 2035, there can be no deductions in miscellaneous items. Therefore, no hobby expense means no hobby income deduction.

Does IRC 183 make you eligible for any kind of deductions?

If your activity is not making any such profit, there are deductions for that, though even in this situation they cannot exceed the gross income. Hobby deductions are usually claimed as IRS Form 1040 Itemized Deductions, Form A. There is a set format so they need to be taken in order:

• A few of your personal expenses can be taken in full expense such as mortgage, or wages etc.
• Other few deductions like advertising, insurance, premiums, do not need to be taken instantly. They can be accessed later as well but only to an extent based on your gross income.
• Only if the activity’s gross income is greater than the deductions, it can be adjusted on the property’s basis.

Conclusion

Hobby loss is a tax term that refers to a loss that results from an activity that is not engaged in for profit. The TCJA eliminated the deduction for hobby losses until after 2025, which means that hobbyists cannot deduct any of their expenses from their income. To avoid hobby loss and take advantage of the tax benefits of running a business, hobbyists should try to turn their hobbies into businesses by demonstrating a profit motive and following the IRS guidelines. By doing so, they can deduct their ordinary and necessary expenses from their income, reduce their taxable income and tax liability, and potentially make their hobbies more profitable and enjoyable.

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