You can’t deduct hobby related expenses under the new tax law—but don’t give up hope
Article Published by: marketwatch.com
Say you have an unincorporated sideline activity that you think of as a business. If your expenses from the activity exceed your revenues, you have a net loss. You may think you can deduct that loss on your personal federal income tax return. Not so fast. The IRS likes to claim that money-losing sidelines are hobbies rather than businesses—because the federal income tax rules for hobbies are not in your favor.
Thanks to an unfavorable change included in the new Tax Cuts and Jobs Act (TCJA), the rules are even worse for 2018-2025.
But don’t give up hope. If you can show a profit motive for your activity, you can deduct the losses. And history shows that the IRS loses about as many court cases on this issue as it wins. Here’s what you need to know about the TCJA change for hobby-related deductions and what to do about it if you have a money-losing sideline activity.
Already-unfavorable tax rules for hobby-related deductions just got worse
If you operate an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), you can generally deduct the full amount of the loss on your federal income tax return. That means the loss can be used to offset income from other sources and reduce your federal income tax bill accordingly. On the other hand, the tax results are not good if your money-losing sideline activity must be treated as a not-for-profit hobby.
Under prior law (before the TCJA), you could potentially deduct hobby-related expenses up to the amount of income from the hobby. However, you had to treat those expenses as miscellaneous itemized deduction items that could only be written off to the extent they exceeded 2% of adjusted gross income (AGI). And, if you were a victim of the dreaded alternative minimum tax (AMT) for the year, your otherwise-allowable hobby deductions were completely disallowed under the AMT rules.
TCJA Effect: For 2018–2025, the TCJA eliminates write-offs for miscellaneous itemized deduction items that under prior law were subject to the 2%-of-AGI deduction threshold. This change wipes out any deductions from hobby activities. So under the new law, you cannot deduct any hobby-related expenses, but you still must report 100% of any revenue from the hobby activity as income and pay tax on it. Yikes! So you can now expect IRS auditors to focus even more attention on folks with money-losing sideline activities. That means it’s now more important than ever to establish that a money-losing activity is actually a for-profit business that has simply not yet become profitable. Please keep reading.
Deciding if your activity is a business or a hobby
Now that you understand why hobby status is unfavorable and for-profit business status is helpful, the next step is determining if your money-losing sideline activity should be classified as a hobby or a business.
IRS Safe-Harbor Rules
Helpfully enough, there are two 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 (revenues in excess of deductions) for at least three out of every five years. Losses from the other years can be deducted because they are considered to be business losses as opposed to hobby losses.
- A horse racing, breeding, training, or showing activity is presumed to be a for-profit business if it produces positive taxable income in two out of every seven years.
Taxpayers who can plan ahead to qualify for these safe-harbor rules earn the right to deduct their losses in unprofitable years.
Intent to make profit
Even if you cannot qualify for one of the aforementioned safe-harbor rules, you may still be able to treat the activity as a for-profit business and rightfully deduct the losses. Basically, you must demonstrate an honest intent to make a profit. Factors that can prove (or disprove) such intent include:
- Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies.
- Having expertise in the activity or hiring advisers who do.
- Spending enough time to justify the notion that the activity is a business and not just a hobby.
- Expectation of asset appreciation (this is why the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).
- Success in other ventures, which indicates business acumen.
- The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
- Your financial status: “rich” folks can afford to absorb ongoing losses (which may indicate a hobby) while ordinary folks are usually trying to make a buck (which indicates a business).
- Elements of personal pleasure: breeding race horses is more fun than digging post holes for fences, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.
The bottom line
Business status is good is for deducting losses. Hobby status is bad, especially after the TCJA. The good news is that, over the years, the Tax Court has concluded that a number of pleasurable but money-losing activities could be classified as for-profit businesses rather than hobbies, based on evaluating the factors listed earlier. So there is often reason for hope. That said, the hobby loss issue has always been a hot issue for the IRS, and the new tax law adds fuel to the fire. So it’s important for you to be on the right side of as many of the factors as possible. Your tax pro may be able to help you create documentation to prove that that you are, in fact, on the right side.
ABOUT MICHAEL SMERIGLIO:
Michael Smeriglio III is a financial specialist. A licensed CPA since 1985, Mike has been providing tax preparation services to individuals and businesses for more than 30 years through his firm located in Greenwich, CT.