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Hobby Loss Rule

If you have an activity that you do for sport or recreation that you earn money from, you must declare that income. The Internal Revenue Service (IRS) distinguishes between businesses and hobbyists for the purposes of tax deductions, but sometimes the line between the two isn't always clear.

An experienced California business attorney can answer your questions about the difference between running a business and engaging in a hobby.

What Is the Hobby Loss Rule?

When you spend money on a hobby that isn't recovered, it's known as hobby loss. IRS hobby loss rules in Internal Revenue Code (IRS) §183 allow you to deduct some of these expenses, as long as they don't exceed your hobby income.

The IRS has strict rules about hobby loss to prevent hobbyists from starting “businesses” so that they can deduct expenses on their tax returns. Generally, if your income outstrips your expenses and you make a profit, the IRS considers you a business. If your activity consistently turns a loss, then the IRS classifies you as a hobbyist.

The Difference Between a Business and a Hobby

For the IRS to consider your activity a for-profit business and allow you to make business expense deductions, your activity must have been profitable three out of the last five years.

The IRS considers you a legitimate business if your primary purpose is income or profit. You must also engage in your activity with continuity and regularity. The IRS uses nine factors to further distinguish between a business and a hobby.

9 questions to ask to know if it's a business or hobby

  1. Do you treat your activity as a business by keeping accurate books and records?
  2. Do you put in enough time and effort to make the activity profitable?
  3. Does your livelihood depend on the income from this activity?
  4. Are the losses beyond your control or part of the normal startup phase of a business?
  5. Do you change or improve your methods of operation to increase profitability?
  6. Are you knowledgeable enough about the activity to earn money from it?
  7. Did you make a profit with similar activities in the past?
  8. Does the activity turn a profit in some years, and if so, how much?
  9. Will the assets you're using appreciate so much that you expect to make a future profit from them?

If you're a hobbyist, the only reason you'd need to worry about the hobby loss rule is if you try to deduct your hobby expenses on your taxes.

How Do I Declare My Activity as a Business or a Hobby?

You can't declare your expense deductions as business or hobby costs yourself. The IRS will determine if your activity is a business or hobby based on your profitability or lack thereof after several years. The IRS reviews businesses on a case-by-case basis.

Questions About the Hobby Loss Rule?

The rules on hobby loss can be difficult to decipher, but they're essential for hobbyists, small businesses, and entrepreneurs to understand. If you have questions about whether your activity is for profit or not, contact a California Tax Attorney today to set up a consultation. 

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