Do you have a hobby that makes money, but costs more than it makes? If so, here is what you need to know before deducting the expenses on your tax return.
Business expenses are generally required to be reported on Schedule C, Profit or Loss from Business. A net loss from Schedule C is carried over to Line 12 of the Form 1040, U.S. Individual Income Tax Return, and it reduces your adjusted gross income and taxable income.
Expenses for a hobby are generally allowable up to the amount of income generated from the hobby. If the expenses for the hobby exceed the income from the hobby in any three out of five years (including the current year being considered), then there is an additional requirement that must be satisfied to be able to deduct the losses in the one or two unprofitable years.
This additional requirement is that the losses be incurred in an effort to earn a profit. The regulations provide nine factors that are to be considered in whether an activity is engaged in for a profit, which consider the:
- manner in which the taxpayers carry on the activity,
- expertise of the taxpayers or that of their advisers,
- time and effort expended on the activity,
- expectation that assets used in the activity may appreciate in value,
- success of the taxpayers in carrying on other similar or dissimilar activities,
- history of income or losses with respect to the activity,
- amount of occasional profits, if any, from the activity,
- financial status of the taxpayers, and any elements of personal pleasure or recreation.
The IRS generally asserts that these factors are not met when the last factor is present, i.e., there is some personal pleasure or recreation aspect to your hobby. For example, it is common for the IRS to deny losses for business activities involving gambling, personal travel, horse or car racing, or restoring antique cars.
Once the IRS asserts that there is no profit motive, you have the burden to show otherwise. It is up to you to marshall the evidence for each factor to show that the losses were incurred in an attempt to earn a profit.
Given these rules, you may be wondering whether you can forego claiming expenses for your hobby in certain years so that there is never a five year period with more than three years of losses, thereby not triggering these rules. You may be thinking that this is justified given that the IRS would be disallowing the expenses as hobby expenses anyway.
This is usually a bad idea. The IRS would no doubt zero in on this subterfuge as a means for deducting expenses in later tax years and it might assume the deduction was taken in the prior year in order to apply these rules to disallow losses in the current year. This could have the added effect of disallowing the expenses in the current year at a time when it may be too late for you to go back and claim the omitted deductions in the prior year or years.
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