What is Hobby Loss?

Hobby Loss CPE Webinars: Understanding IRC 183 

We all have hobbies. They’re an important part of maintaining a health work-life balance, after all. Some people play chess, others go mountain biking, and some people play music as part of a weekly Saturday night open mic. There are literally millions of hobbies out there, and most of us don’t take them all that seriously. Unless we’re deeply interested in something ourselves, we tend to think of hobbies as idle preoccupations that some people have — but that’s the extent of it. If you’re an accountant or tax professional, though, things are different. It doesn’t matter whether you’re a CPA, EA, certified tax preparer, or tax attorney. Regardless, the notion of what exactly a hobby is happens to be quite important to your day-to-day interactions with certain clients. That’s because the distinction between a hobby and business could in some cases mean the difference between thousands of dollars in taxes saved — or even more in taxes owed.

Sometimes, a hobby is obviously just a hobby. If you put together model airplanes in your basement, there’s little question that you’re engaging in a hobby rather than running a business. But imagine that you’re a musician with a weekly gig at a local bar. One day, the owner approaches you at the end of the night and offers you a cut of the entry fee. Are you now engaging in a business? If so, how will you determine what taxes you might owe on the money you’ve just earned?

Some examples are especially difficult to sort out, and that’s where the expert advice of an accountant or tax professional comes into play. If you have clients who engage in borderline hobbies that may or may not be businesses, they may seek your assistance in determining whether or not they can claim certain expenditures as business losses — or whether they need to report some form of income they’ve received from something that they consider to be a hobby. In the former scenario, a client may want to claim those losses in order to reduce their tax burden. But if the IRS determines that those losses are associated with a hobby rather than a proper business, they could owe quite a bit in taxes.

The IRS outlines its policy regarding what is or is not considered a hobby in U.S. Code IRC § 183: Activities Not Engaged In for Profit. That said, having a section of the tax code on hand is one thing. Fully understanding it and applying it on a case by case basis is another. That’s why we’ve put together this quick guide to understanding and using IRC § 183 in each of your clients’ individual cases.

There’s no question about it: hobby loss can mean major tax savings for your clients. But, it can also spell trouble if used incorrectly and challenged by the IRS. That’s why having a thorough understanding of how it works is so important. You could be a client’s hero when you save them thousands of dollars in taxes owed. At the same time, though, ill-informed advice could land a client in hot water.

While this guide is intended to be as comprehensive as possible, it’s important to keep in mind that the subject of hobby loss and IRC § 183 is incredibly complex. For this reason, we highly recommend signing up for a tax CPE webinar focused specifically on tax tips related to hobby loss and IRC § 183. Live CPE webinars are a great way to learn more about a specific tax topic. They’re convenient, as you can do them from your home or office. But they’re also highly effective as compared to a video or correspondence course, as you have the opportunity to ask questions whenever something is unclear. Take a look at the upcoming Basics & Beyond™ CPE webinar schedule here.

Still, it’s possible to refresh your memory and learn a few new tips about how to differentiate between a hobby and a business. That’s why we’ve created this guide. We’ll discuss each of the following topics below:

• What is hobby loss?
• Understanding hobby loss
• Rules for claiming losses on a hobby

Ready to learn more? Let’s get started.

What Is Hobby Loss?

In the world of taxes and accounting, hobby loss is a phrase used to describe a specific type of loss for tax purposes. Generally speaking, we refer to a particular expenditure as a “hobby loss” when it’s associated with the pursuit a specific hobby (in other words, some sort of recreational activity). That expenditure is then not recouped, which is what makes it a loss. However, according to the IRS, those expenses can only be claimed in connection with a recreational activity insofar as that same recreational activity earns income. In other words, it’s not possible to claim losses beyond the scope of the actual income associated with a hobby.

Here’s the thing: expenses come along with every business. From the perspective of the Internal Revenue Service, there’s nothing unusual about a business reporting a loss. In fact, it’s quite common for businesses to report a lost their first year in operation, and sometimes beyond that. Remember that roughly 20% of business fail in their first year operation, with 30% closing shop by year two and about 50% shutting down by year five.

So as far as the IRS is concerned, there’s nothing inherently fishy about claiming a loss on a business. That loss can then offset unrelated income on your federal income taxes. The question, though, is whether and to what extent a hobby can actually be considered a business. If your hobby is a legitimate business, there are different limitations to what can be claimed as a loss. If your hobby is just a hobby, though — meaning it’s not engaged in with profit as the primary goal — then your deductions are subject to the hobby loss rule and limited to the amount of income generated by the hobby.

Understanding Hobby Loss

While the IRS’s treatment of hobby loss can be quite complex, the idea of how to calculate hobby loss is fairly simple at its core. Essentially, a so-called “hobbyist” is allowed to deduct expenses associated with their hobby insofar as that hobby results in some sort of gross income over the course of a tax year.

The IRS goes so far as to offer a hobby loss guide on their website detailing exactly what constitutes “engaging in an activity for profit” when it comes to recreational activities. When the IRS created IRC § 183, the idea was to reduce the number of taxpayers attempting to deduct ineligible expenses as business losses that were, in fact, simply expenditures related to purely recreational, not-for-profit activities. With the idea of focusing specifically on abuses by hobbyists, IRC § 183 was designed to apply to trusts, estates, partnerships, individuals, and S corporations. However, it doesn’t apply to C corporations.

In issuing IRC § 183, the IRS went to some lengths to be clear about their intention. They declared that they would not allow taxpayers to deduct so-called losses (beyond income earned) for activities that were obviously not engaged in with the intention of earning a profit. Certain examples were cited to make their point even clearer: they named yacht operation, fishing, car racing, writing, filmmaking, and horse breeding as some prime examples of hobbies that are often purely recreation with no intention of earning a profit.

Rules for Claiming Losses Associated with a Hobby

With all of this in mind, you might be wondering: are there any hard and fast rules related to claiming losses and determining income associated with a hobby?

At the end of the day, one of the best ways to avoid the IRS determining your activity as purely a “hobby loss” is to ensure that you turn a profit — at least some of the time. Remember, an activity is considered “for profit” under the hobby loss rule if it was profitable for at least 3 out of the past 5 years, including the current tax year. There’s even a special rule when it comes to horses: as long as you were profitable in 2 out of the past 7 years, you can claim losses associated with your hobby beyond the income generated in a given tax year.

However, it’s often impossible for small, hobby-like businesses to use the above rule. Additionally, businesses that are just getting started won’t have the track record necessary to use this test as a means of demonstrating whether or not their hobby-business is aiming to earn a profit. When it’s not possible to prove your profit motive according to the rules above, you have to do it via other means.

To determine whether your hobby activity can be considered to have a profit motive (and therefore be considered a business rather than a hobby), the IRS lists nine individual factors that should be taken into account. Let’s take a look at each of these.

1. How is taxpayer’s activity carried out?

When determining whether one of your clients is engaging in a hobby or a business, one of the first things to consider is the way in which the taxpayer carries out the activities associated with the hobby/business. Are they engaging in these activities in a businesslike way? Some examples of businesslike behavior include things like keeping a separate bank account for the business, maintaining detailed records of their accounts, and doing other things that for-profit businesses do (such as advertising).

2. Is the taxpayer an expert?

If the taxpayer in question is engaging in genuine business activity, they ought to be able to demonstrate their knowledge and expertise as it relates to that activity. Have they taken courses related to the activity or worked with other experts in the field? Are they working to increase their level of expertise?

3. How much time is the taxpayer spending on the activity?

Is the taxpayer actually devoting a significant amount of time and energy to an activity? If the client in question spends very little of their time on something, it’s difficult for them to claim that it’s a legitimate business with profit as its primary motive.

4. Does the activity involve the creation of appreciable assets?

If a taxpayer’s activity creates an appreciable asset of some kind, it’s easier to demonstrate that the activity has profit as its primary motive. According to IRC § 183, appreciable assets can be taken into consideration in determining overall profit motive rather than focusing strictly upon current profitability.

5. Has the taxpayer engaged in other profitable activities?

It may be the case that a taxpayer’s activity is currently unprofitable. However, if your client can demonstrate a history of turning unprofitable, hobby-like activity into a profitable business, it’s easier for them to demonstrate profit motive with their current activity.

6. What is the history of income and loss associated with the activity?

This goes back to the rule outlined above. If a taxpayer’s activity can demonstrate a solid history of profitability, it can be classified as a for profit business. Remember, too: there’s nothing inherently wrong with reporting a loss in some years. Certain businesses are particularly susceptible to fluctuations in the economy, which may result in a loss, multiple years in a row. However, activity that consistently results in a loss is harder to claim as legitimate business activity.

7. What’s the relationship between profits and losses?

According to IRC § 183, the IRS may take the relationship between the total amount of losses incurred and the value of investments, assets, and profit into account when determining whether a given activity is profit motivated or not.

8. Are the taxpayer’s finances stable?

When attempting to determine whether or not an activity is profit motivated, it can be useful to consider how that activity fits into a taxpayer’s overall financial picture. For example, if the vast majority of a taxpayer’s income is derived from another business or job, that makes it more difficult to claim that another activity is purely profit motivated.

9. Is the taxpayer’s activity motivated by a desire for pleasure and recreation? 

This is one of the most important things to take into account. If an activity is engaged in with pleasure, recreation, and personal enjoyment in mind, it’s more difficult to argue that its primary motivation is profit.

Hobby Loss CPE Webinar

As you can see, the topic of hobby loss is fairly complex. While we hope this overview of the topic has been helpful, we highly recommend signing up for a focused, detailed tax CPE webinar on the topic. Hobby loss is an important area of the tax code to understand, and it’s a great place to focus some of your annual CPE credits. Basics & Beyond offers an engaging, informative take on hobby loss with one of our regularly scheduled webinars: click here to learn more.