Many taxpayers conduct activities related to a personal passion, such as raising animals, painting, cooking, or woodworking that can generate large losses. How these losses are deducted has always been dependent on properly classifying the activity as either a hobby or a business. The Tax Cuts and Jobs Act of 2017 (TCJA) has made additional changes to taxation of these activities. The income generated is fully taxable, but if your activity is hobby, expenses, with the exception of Cost of Goods Sold, are no longer deductible.
Factors to consider
IRS Code Section 1.183-2(b) identifies several factors that courts have considered when deciding whether an activity is conducted as a hobby or a business:
- How the taxpayer carries out the activity – are you operating the activity with the intent of making a profit?
- Experience and expertise of taxpayer in this area.
- Time and effort expended operating the business.
- Success in prior similar or dissimilar activities.
- History of income and losses for the activity – were losses due to factors beyond your control or did they occur during the start-up phase of your business?
- The amount of profit if any, and when incurred.
- Financial situation of taxpayer – do you depend on the business for your livelihood?
- Elements of pleasure or recreation from the activity.
- Likelihood that assets held by the business may appreciate.
The greater the extent to which these factors apply, the more likely your activity will be deemed a business. Final determination by the IRS is based on the facts and circumstances of your specific situation.
The IRS does provide a safe harbor rule under IRC §183(d) that allows taxpayers a little time to support a claim that an activity is profit motivated. If your activity generates a profit for three out of the last five years, including the most recent tax year, then the activity is presumed to be an activity engaged in for profit for the taxable year. Activities related to breeding, training, showing, or racing of horses, must generate a profit in two of the most recent seven years, including the current tax year. There is no guidance on the level of profit needed, just a requirement that a profit be realized.
Changes under the TCJA
Before TCJA, taxpayers could often deduct hobby expenses on Schedule A as Miscellaneous Itemized Deduction, so the amount written off was limited to expenses that exceeded 2% of adjusted gross income (AGI).
Starting in 2018 and continuing through 2025, TCJA eliminated write-offs for Schedule A Miscellaneous Itemized Deductions. If your activity is a hobby, you will not be able to deduct most expenses associated with it. You are, however, still required to report all income and can take a deduction for Cost of Goods Sold.
If the activity is considered a business, you can deduct the expenses associated with it and if business activity results in a loss, you may be able to deduct the loss from other income in the same tax year.
This information is provided for general information only and should not be construed as specific tax advice as your situation may vary.
Karen Schwimmer, CPA, EA works with small business owners to reduce taxes, improve profits and manage cash flow. She can be reached at 303-642-0628 or Karen@SchwimmerCPA.com