Is Your Sideline Activity a Business or a Hobby?

Do you have a sideline activity that you think of as a business?

From this sideline activity, are you claiming tax losses on your Form 1040?

Will the IRS consider your sideline a business and allow your loss deductions?

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. The federal income tax rules for hobbies have been anti-taxpayer for years, and now an unfavorable change enacted in the Tax Cuts and Jobs Act (TCJA) made things even worse for 2018-2025.

If you have such an activity, we should have your attention.

Here’s the deal: if you can show a profit motive for your now-money-losing sideline activity, you can classify that activity as a business for tax purposes and deduct the losses.

In this blog, we give you what you need to know about the federal income tax rules for hobbies and how to tilt the playing field in your favor.

But first, let’s cover the necessary background information. Onward. 

Tax Rules for Hobbies

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 usually deduct the loss currently on your Form 1040.

The business loss deduction

• offsets taxable income from other sources;

• reduces your federal income tax bill accordingly; and

• reduces your state income tax bill too, if you have one.

On the other hand, if you must treat a money-losing activity as a not-for-profit hobby, the tax results are not good.

Hobby Loss Rules before the TCJA

• Before the TCJA, if your activity was deemed a not-for-profit hobby, you had to report all the revenue on Form 1040 as “other income.”

• You could deduct expenses that you could write off in any event, such as itemized deductions for home mortgage interest and property taxes allocable to space used for your hobby. But deductions for other expenses were limited to the amount of revenue, and those expenses were treated as itemized deduction items because they were not from a business activity.

• Worse yet, you had to treat allowable hobby expenses (other than expenses that you could write off in any event) as miscellaneous itemized deductions that were subject to a 2% of adjusted-gross-income (AGI) deduction threshold. Thus, you got no write-off unless you itemized. Even if you did itemize, your write-off for miscellaneous deductions was limited to the excess of those items over 2% of AGI. If you had a healthy AGI, your deduction for hobby expenses might have been little or nothing.

• Finally, if you were a victim of the dreaded alternative minimum tax (AMT), miscellaneous itemized deductions for hobby expenses and property taxes allocable to your hobby were completely disallowed for AMT purposes.

Current Hobby Loss Rules under the TCJA

• For 2018–2025, the TCJA eliminates regular federal income tax write-offs for miscellaneous itemized deduction items that were previously subject to the 2% of AGI deduction threshold.

• This change wipes out all deductions from hobby activities, other than expenses that you can write off in any event (such as itemized deductions for mortgage interest and property taxes allocable to space used for your hobby).

• So, under current law, hobby-related deductions are completely disallowed for regular federal income tax purposes as well as for AMT purposes.

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 your money-losing activity is actually a for-profit business that has simply not yet become profitable.

Determining whether the Activity Is a Business or a Hobby

Now that you understand why hobby status is bad and for-profit business status is good, the next step is determining whether your money-losing activity is a hobby or a business. Here’s how.

Take Advantage of Safe-Harbor Rules if Applicable

Helpfully enough, our beloved Internal Revenue Code has two statutory safe-harbor rules for determining whether you have a for-profit business.

1. Your 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. You can deduct losses from the other years because they are considered business losses rather than hobby losses.

2. 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. 

Key Point. If you can plan ahead to qualify for these safe-harbor rules, you earn the right to deduct your losses in unprofitable years.

Prove Intent to Make Profit

If you cannot qualify for one of the two safe-harbor rules above, 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 year after year.

• Success in other ventures, which indicates that you have 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 just plain 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 lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.