Engaged in an activity that produces income? If so, the big question is whether the activity is a hobby or for profit. The tax treatment of your income or loss from your endeavor hinges on the answer. The tax code, Section 183 limits deductions when an activity is not engaged in for profit. The result? If it’s a hobby, you can not deduct any loss.
Is your endeavor a hobby, or for profit? Defining both.
A hobby is any activity that a person pursues because they enjoy it. A hobby has no intention of making a profit. This differs from operating a business where the intention and the goal is to profit.
That being said, it isn’t always obvious when activities are considered a hobby or a business.
How to determine the status of your activity, and whether is it a hobby or for profit
In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business to produce taxable income. Trade or business activities and activities engaged in to create income are considered for profit.
The following factors, although not all inclusive, may help you determine the status of your activity:
- Does the time and effort you put into the activity indicate an intention to make a profit?
- Do you depend on the income from the activity?
- If there are losses, are they due to circumstances beyond your control? Did they occur in the normal start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is considered for profit if it makes a profit in three of the last five tax years. This includes the current year. There is one notable exception for activities that consist primarily of breeding, showing, training, or racing horses.
An activity produces a loss when related expenses exceed income. If an activity is not for profit, losses from that activity cannot be used to offset other income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
Hobby deductions
Prior to 2018, deductions for hobby activities could be claimed as miscellaneous itemized deductions on Schedule A. Subject to a 2% of AGI (adjusted gross income) reduction. However, the law changed in 2017 as part of the Tax Cuts and Jobs Act. That change prohibits any deduction for the types of miscellaneous deductions that were subject to the 2% of AGI reduction. So, this means that none of your hobby-related expenses can be deducted. However, income you receive from the activity is still taxable. This income must be reported on your Form 1040 for the year in which the income is received.
Sales from collections
Collect stamps, coins, or other items as a hobby? When you sell any of the items from a hobby, your gain is taxable as a capital gain. This means the money is reportable on Form 8949 for Schedule D. However, if you sell items from your collection at a loss, you can’t deduct the loss.
If you have questions related to your specific business or hobby circumstances, please give this office a call.
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