If you are operating an activity that you think is a business but generates a loss each year, you may think you can deduct that loss on your personal federal income tax return. However, that may not be the case. The Internal Revenue Service (“IRS”) likes to claim that money-losing sidelines are hobbies rather than businesses—because the federal income tax rules for hobbies are not in the taxpayer’s favor.
Furthermore, due to an unfavorable change included in the new Tax Cuts and Jobs Act (TCJA), the hobby rules are even worse for 2018-2025.
If you operate a 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. However, the tax results are not good if your money-losing sideline activity is treated as a not-for-profit hobby.
Under prior law, you could potentially deduct hobby-related expenses up to the amount of income from the hobby. However, those expenses were treated as miscellaneous itemized deduction items that could only be written off to the extent they exceeded 2% of adjusted gross income (AGI).
The TCJA eliminates write-offs for miscellaneous itemized deduction items that under prior law were subject to the 2%-of-AGI deduction threshold. This change wipes out any deductions from hobby activities. So, under the new law, you cannot deduct any hobby-related expenses, but you still must report 100% of any revenue from the hobby activity as income and pay tax on it. So, as you can see you do not want a business activity classified as a hobby.
The good news is that there are two safe-harbor rules to determine if you have a for-profit business.
- An 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. Losses from the other years can be deducted because they are considered to be business losses as opposed to hobby losses.
- 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.
Taxpayers who can plan ahead to qualify for these safe-harbor rules earn the right to deduct their losses in unprofitable years.
However, even if you cannot qualify for one of the aforementioned safe-harbor rules, you may still be able to treat the activity as a for-profit business and rightfully deduct the losses. You need to show that you intend to make a profit. The factors that the IRS considers to determine this are as follows:
- Whether you carry on the activity in a business-like manner and maintain complete and accurate books and records.
- Whether the time and effort you put into the activity indicate you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
The bottom line
Business status is good is for deducting losses. Hobby status is bad, especially after the TCJA. The good news is that, over the years, the Tax Court has concluded that a number of pleasurable but money-losing activities could be classified as for-profit businesses rather than hobbies, based on evaluating the factors listed above.