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

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

Current Hobby Loss Rules under the TCJA

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: