Today, many people sell homemade products online or work on some unincorporated sideline venture outside of their regular day jobs. Such activities can generate extra spending money. This can be especially helpful for retired people and stay-at-home parents — or for those who been laid off or taken a pay cut, during the COVID-19 crisis.
For example, suppose you've turned a love for woodworking or crafting into an Etsy site that sells custom furniture or face masks. Or maybe you've started playing violin in the parking lot of your local grocery store. Should these activities be reported as for-profit business activities or nondeductible hobbies under the tax law? Here's why it matters for federal income tax purposes and how to make the distinction.
Comparing the Tax Treatment
In general, you must report all sources of income on your federal income tax return (Form 1040), including revenue from hobby and business activities. But the extent to which you can deduct the related expenses depends on how the activity is classified under the tax code.
Expenses related to a legitimate, for-profit business activity generally are deductible under the tax law. So, 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.
On the other hand, the tax results are less favorable if your money-losing sideline activity is classified as a hobby, which essentially means an activity that lacks a profit motive. And the rules have gotten less favorable, thanks to an unfavorable provision of the Tax Cuts and Jobs Act (TCJA).
Old rules. Under the old rules that were in effect before the Tax Cuts and Jobs Act (TCJA), you were required to report all revenue for hobby activities on your tax return, and your allowable deductions from the activity were limited to that revenue. In other words, you could never have an overall tax loss from an activity that was treated as a hobby, even if you lost money.
You were allowed to deduct hobby-related expenses that could be written off in any event, such as itemized deductions for allocable home mortgage interest and property taxes. Your other hobby-related expenses (limited to income) were claimed as a miscellaneous itemized deduction item. That means you got no write-off unless you itemized. And, even if you itemized, the write-off for miscellaneous deduction items was limited to the excess of those items over 2% of your adjusted gross income (AGI). The higher your AGI was, the less you could deduct. High-income taxpayers often found their allowable hobby activity deductions limited to little or nothing. Finally, if you were subject to the individual alternative minimum tax (AMT), miscellaneous itemized deductions for hobby expenses were completely disallowed for AMT purposes.
New rules. For 2018 through 2025, the TCJA suspends write-offs for miscellaneous itemized deduction items that, under prior law, were subject to the 2%-of-AGI deduction threshold. That change eliminates all deductions for hobby-related expenses, except for expenses that you can write off in any event, such as itemized deductions for allocable mortgage interest and property taxes.
So, under the current law, you simply can't deduct most hobby-related expenses for federal income tax purposes. As under prior law, you still must report 100% of hobby-related income on your tax return. As a result, it's more important than ever to establish that a money-losing activity is actually a for-profit business venture that hasn't yet become profitable.
Qualifying for Safe Harbors
There's a glimmer of hope for people engaged in sideline activities: If you can show a profit motive for your activity, you can generally write off all expenses as the cost of doing business — even if that results in a net tax loss. Though this issue has been an IRS hot button, the U.S. Tax Court has ruled in favor of taxpayers in cases where the facts and circumstances supported a profit motive even though the activity in question was pleasurable.
To make the determination between business and hobby activities, first, consider the following two safe harbors that automatically qualify an activity as a for-profit business:
1. The activity produces positive taxable income (revenues in excess of deductions) for at least three out of every five years.
2. You're engaged in a horse racing, breeding, training or showing activity, and it produces positive taxable income in at least two out of every seven years.
Taxpayers who can plan ahead to qualify for these safe harbors earn the right to deduct their losses in unprofitable years.
Demonstrating Your Profit Motive
If you can't qualify for one of the safe harbors, you may still be able to treat your activity as a for-profit business and deduct any losses. How? Basically, you must demonstrate an honest intent to make a profit. Factors that can demonstrate such intent include the following:
•You conduct the activity in a businesslike manner by keeping good records and searching for profit-making strategies.
•You have expertise in the activity or hire expert advisors.
•You spend enough time to justify that the activity is a business, not just a hobby.
•You've been successful in other ventures, suggesting that you have business acumen.
•The assets used in the activity are expected to appreciate in value. For example, the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years.
The U.S. Tax Court also considers the history and magnitude of income and losses from an activity. In general, occasional large profits hold more weight than more frequent small profits. Likewise, losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
Another consideration is your financial status. If you earn a large income or most of your income from a full-time job or another business you own, an unprofitable sideline activity is more likely to be considered a hobby.
The degree of personal pleasure you derive from the activity is also a factor. For example, most people would say that photography is more fun than working in a high-stress executive position — so the IRS is far more likely to claim the former is a hobby if you start claiming recurring losses on your tax returns.
Supporting Your Determination
Business status is good for deducting losses. Hobby status is bad for federal income tax purposes, especially after the TCJA. On the bright side, the Tax Court has over the years concluded that pleasurable activities could be classified as for-profit business ventures.
The hobby loss issue has always been a hot button for the IRS — and the unfavorable TCJA change just adds fuel to the fire. Your tax advisor at HK can explain the current tax rules and, if your sideline activity qualifies as a for-profit business, help compile the necessary documentation to prove it.