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Maximize Your Tax Savings by Understanding the Hobby Loss Rules

Written by Kohari Gonzalez Oneyear & Brown | Oct 11, 2024 1:30:00 PM

Article Highlights:

  • Hobby Loss Rules Overview
  • Impact of the Tax Cuts and Jobs Act (TCJA) on Deductions
  • Nine Factors to Determine Profit Motive
  • Presumptions of Profit Motive
  • Election to Delay Determination of Profit Intent
  • Sequence of Deductions to the Extent of Income
  • Hobby Income and Self-Employment Tax
  • Examples of Hobby vs. Business

It's critical to comprehend how the IRS categorizes income-generating activities for tax reasons while participating in such activities. The difference between a company and a hobby might have a big effect on your tax responsibilities. The Tax Cuts and Jobs Act (TCJA) and its effects on deductions, the hobby loss regulations, the IRS's nine-factor test to evaluate whether an activity is done for profit, and court decisions with a profit motivation are all covered in this article.

Hobby Loss Rules Overview

To decide if an activity qualifies as a business or a hobby, the IRS applies the hobby loss standards. If an activity is considered a hobby, the money made from it is taxed, but the costs paid are not deductible from 2018 to 2025. This implies that you cannot deduct hobby costs from other sources of income.

Impact of the Tax Cuts and Jobs Act (TCJA) on Deductions

The Tax Code Judicial Reform Act (TCJA) of 2017 brought about a number of important changes, one of which was the suspension of many itemized deductions subject to the floor of 2% of adjusted gross income (AGI) for tax years 2018 through 2025. Due to this suspension, all hobby income is taxed during these years since hobby costs are not deductible.

Nine Factors to Determine Profit Motive

The IRS considers nine factors to determine whether an activity is engaged in for profit. No single factor is decisive; instead, all factors must be considered together:

1. Businesslike Manner: Is the activity carried out in a businesslike manner? This includes maintaining complete and accurate books and records.

2. Expertise: Does the taxpayer have the necessary expertise or consult with experts to carry out the activity successfully?

3. Time and Effort: How much time and effort does the taxpayer put into the activity? Significant time and effort may indicate a profit motive.

4. Expectation of Asset Appreciation: Does the taxpayer expect the assets used in the activity to appreciate in value?

5. Success in Similar Activities: Has the taxpayer succeeded in similar activities in the past?

6. History of Income or Losses: What is the history of income or losses from the activity? Consistent losses may indicate a lack of profit motive.

7. Amount of Occasional Profits: Are there occasional profits, and if so, how substantial are they?

8. Financial Status: Does the taxpayer have substantial income from other sources? If so, the activity may be more likely to be considered a hobby.

9. Elements of Personal Pleasure: Does the activity involve elements of personal pleasure or recreation?

Presumptions of Profit Motive

If an activity makes money in at least three of the previous five years—including this one—the IRS will presume that it has a profit motivation. The assumption is applicable to operations that include breeding, training, displaying, or racing horses if a profit is made in two or more of the previous seven years.

Election to Delay Determination of Profit Intent

In order to postpone the assessment of whether an activity is carried out for profit, taxpayers must file Form 5213, "Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit." By making this option, taxpayers can postpone making the decision until the conclusion of the activity's first full tax year, or their sixth tax year if it involves horses. This option cannot be made if the taxpayer has been involved in the activity for more than five years (seven years for activities linked to horses), and it should not be made unless the person is the subject of an IRS audit and the IRS is denying their deductions due to hobby loss restrictions.

Sequence of Deductions to the Extent of Income for years before 2018 and after 2025

(if Congress permits the TCJA regulations to expire) - Deductions are only permitted for activities that qualify as hobbies if the activity generates money. The following is the order in which deductions are permitted:

  • Home Mortgage Interest, Taxes, and Casualty Losses: These deductions are allowed first.
  • Deductions That Do Not Reduce Basis: These include expenses such as advertising, insurance, and wages.
  • Deductions That Reduce Basis: These include depreciation and amortization.

Hobby Income and Self-Employment Tax

After using the nine criteria to assess whether an activity is conducted for profit, revenue that is judged to be hobby income rather than trade or business income is liable to income tax but not self-employment tax. This distinction is important since self-employment taxes can raise a person's tax liability if they are involved in commerce or trade.

Court Cases Involving Profit Motive

The question of profit motive has been the subject of various court decisions, which have shed important light on how the IRS and courts distinguish between activities that qualify as hobbies and businesses.

  • Groetzinger v. Commissioner (1987) : The Supreme Court held that a full-time gambler who bet solely on his own account was engaged in a trade or business of gambling. This prevented his gambling losses from being tax preference items for the purpose of computing minimum tax.
  • Gajewski v. Commissioner (1983) : The court held that a taxpayer who did not hold himself out to others as offering goods or services was not in a trade or business. The taxpayer was a professional gambler who bet solely for his own account, and the denial of his business deductions turned the expenses into Schedule A deductions.
  • Ditunno v. Commissioner (1983) : The court ruled that the proper test of whether an individual was carrying on a trade or business required examination of all facts involved. In this case, a full-time gambler was determined to be in a trade or business of gambling, and his gambling losses were business expenses, even though they were not related to offering goods and services.

Examples of Hobby vs. Business

To illustrate the distinction between a hobby and a business, consider the following examples:

  • Example 1: The Amateur Photographer: Jane loves to take pictures and occasionally sells them online. She doesn't spend a lot of time on her photographs, contact specialists, or keep thorough records. It's probable that Jane's activities will be categorized as a hobby, meaning her costs won't be deductible.

  • Example 2: The Professional Photographer – John works as a professional photographer, keeping thorough records, consulting with specialists, and dedicating a lot of time to his company. He has a track record of making money, therefore he anticipates that the value of his photographic gear will increase. John's actions will probably be categorized as business-related, and his out-of-pocket costs will be written off.

  • Example 3: The Horse Breeder - Sarah breeds and trains horses. She has generated profits in two of the last seven years and maintains detailed records. Sarah's activity is likely to be classified as a business, and her expenses will be deductible.

For taxpayers involved in income-generating activities, it is essential to comprehend the hobby loss regulations and how the TCJA affects deductions. Taxpayers can more accurately identify whether their activities are likely to be categorized as companies or hobbies by taking into account the nine elements that the IRS uses to determine profit motive. Taxpayers can also make more informed judgments about their operations by knowing the order in which deductions are permitted, whether deductions are allowed at all, and the consequences for self-employment tax. Lastly, examining court cases pertaining to profit motivation offers insightful perspectives on how the IRS and courts make these decisions.

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