Hobby Loss Rules

Do you have a hobby or business?

If you have a hobby, you do not have all deductions available to use on your return. If you have a business, there are more deductions you can take.

How can you tell if you have a side gig?

The IRS states businesses operate to make a profit.

Hobbies are for pleasure or recreation.

Whether you have a hobby or business, if you earn more than $600 for goods or services using an online marketplace or payments apps, you should receive a Form 1099-K. Profits from the sale of goods (including personal items) and services are taxable income. The income must be reported on your tax return.

How to decide if you have a business or hobby for tax purposes? (From the IRS)

  • Do they carry out the activity in a businesslike manner and keep complete and accurate books and records?
  • Does the time and effort they put into the activity show they intend to make a profit?
  • Does the activity make a profit in some years – if so, how much profit does it make?
  • Can they expect to make a future profit from the appreciation of the assets used in the activity?
  • Do they depend on income from the activity for their livelihood?
  • Are any losses due to circumstances beyond their control or are the losses normal for the startup phase of their type of business?
  • Do they change their methods of operation to improve profitability?
  • Do the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business?

 

With a business, as a sole proprietor you would report your business income and expenses on Schedule

  1. If you have a loss (expenses exceed income), then you can take it to reduce your taxable income.

Why would the IRS reclassify a business return as a hobby?

  • A business claims a loss for too many years
  • Business fails to meet other requirements including profit motive

It is important to maintain accurate and extensive records to prevent classification of your business as a

hobby. Showing too many years in a row with losses will trigger an audit. Good records to show you have a business include:

  • Records and receipts of expenses
  • A written business plan indicating intent for profit
  • Steps taken to make the business profitable if there are losses
  • Time and effort put in to make the business profitable
  • Expertise in activity of business
  • Have you previously made a profit?
  • Did you depend on the income made from the business?
  • Expectation that assets used in activity may appreciate in value

 

The IRS audits your return and reclassifies your business as a hobby. How does that affect your tax return?

Occasional profits from hobby activities are not subject to self-employment tax and losses from hobby

activities cannot be used to offset other income.

Gross hobby income would be reported on Schedule 1, Additional Income and Adjustment to Income. Hobby income is required to be reported. Hobby expenses are limited to the amount of gross income

from the activity known as Cost of Goods Sold. Other operating expenses are not deductible as would have been reported on Schedule A as miscellaneous itemized deductions, which have been temporarily repealed from 2018-2025.

An example:

$7,000 of income

$3,200 cost of goods sold

$3,800 other expenses

Amount reported is $3,800 on Schedule 1: ($7,000 income – $3,200 COGS). The remaining $3,800 of other expenses cannot be taken as a deduction on the tax return.

It is important to keep good records of your business and to try to make a profit. Do not make unnecessary expenses to keep taking losses or you can trigger an audit.