Hobbies like card collecting, craft-making, embroidery and other activities may just seem like another productive way for others to use their free time. But, by engaging in these activities, they also have the potential to earn a little extra income. There’s an existing IRS requirement that encourages hobbyists to state these income earnings on their tax returns. However, expenses can also be deducted.
There might be a bit of misunderstanding and confusion as to what really distinguishes a hobby from an actual business. The categories seem to overlap in a variety of ways. Let’s just say that if your hobby generates some income, there are a few basic guidelines that need to be understood in the IRS Business Hobby Loss Tax Rule:
What qualifies a certain endeavor as a business and what differentiates this from a hobby?
For the IRS, there are several factors that are taken into consideration when classifying activities considered either as a business or a hobby. It’s that critical relationship to profit, which becomes one of those determining factors. Here are some questions to ponder on which can help you decide if what you are doing is mainly a business or just a hobby:
- Do you make a sizeable profit from what you are currently engaged in?
- Is the profit consistent over a number of years?
- With that income generated from the activity, are you dependent on that for living expenses?
- Are there any changes implemented in your process to increase your profit?
- In your past experiences when you were engaged in similar activities, did you get any profit?
- Would you be able to transform your hobby into a business with the knowledge and experience that you have gained?
Answering in the affirmative to a good number of these questions means that you are engaging in a business. A negative response will indicate that you still have a hobby.
What does the IRS consider a profitable hobby?
When your income is able to exceed your expenses, that’s when a profit is declared. So, let’s say you make unique trinkets and your capital for the materials was only $100. People admired your creations and you were able to sell your trinkets for $800. The profit you made is equal to $700.
The IRS has hobby business tax rules that basically say: if profits are few and far between, you have a hobby; but if the profit comes in regularly, that only means you have a business. If this profit has been consistent for about three to five years, then most probably you have a business.
For breeding horses, showing and training them to even racing them, if a profit was made in two of the last seven years, the IRS considers this particular hobby a business.
For your hobby, are you able to write off expenses?
Expenses related to your hobby can be written off, but these shouldn’t exceed what you bring in. These deductions must be itemized. To claim the standard deduction, this means expenses for your hobby cannot be written off.
Unpaid taxes amounting to about $40 billion per year is a huge loss for the IRS because there are some hobby expenses that aren’t eligible. To qualify as a deductible, the hobby expense should be necessary and useful. A book to organize your stamp collection is a qualified expense.
If you’re paying people to help you with your hobby, or advertise and apply for insurance premiums, then all these fall under the expenses for your hobby. The desk or furniture and equipment you use for your hobby can be considered as depreciating assets. You can claim part of that value as a hobby deduction. Be careful that your expenses do not go beyond what you earn from your hobby.
If you lose money because of a hobby, what should you do?
Because of the expenditures incurred from your hobby, your profit gets all eaten up, technically that cannot be deducted from your income. If it was a business loss, that can be deducted from income in another year. The IRC 183 can give a more detailed explanation of the IRS hobby loss rules.
For a hobby, how do you go about deducting expenses?
Use Schedule A of Form 1040 to deduct hobby expenses. Mortgage interest, charitable deductions, medical expenses, other itemized deductions on your tax return are also part of this schedule.
What happens when the IRS decides to classify your hobby as a business?
That would be a good thing when the IRS thinks that your hobby should be classified as a business. There’s more freedom to claim expenses and these expenses can be deducted whether or not you decide to claim the standard deduction.
Schedule C or C-EZ is the form you use for a business to report income and expenses. The added bonus is that for a loss, there are options to roll the loss backward or forward in order to claim it against profits in another year.
If the opposite occurs, what happens when the IRS classifies your business as a hobby?
The IRC 183 hobby loss rules come into effect should the IRS determine that your business should be classified as a hobby. That means that you will be unable to claim a loss against income in another year. Because your activities should be considered as a business, having them classified as a business will probably make your tax liability go up.
Aside from looking into profitability, the IRS delves deeper into how these activities are treated. For the IRS to consider your hobby as a business, you have to keep the activities like it’s a real business. Organized and detailed records will definitely support this. Invoices to clients, advertising budgets, a business plan produced in writing only prove that you have a business aimed at making a profit.