Millions of people enjoy hobbies that are also a source of income. Some examples include stamp and coin collecting, craft making, and horsemanship.
You must report on your tax return the income you earn from a hobby. The rules for how you report the income and expenses depend on whether the activity is a hobby or a business. There are special rules and limits for deductions you can claim for a hobby.
Is it a Business or a Hobby? A key feature of a business is that you do it to make a profit. You often engage in a hobby for sport or recreation, not to make a profit. You should consider certain factors when you determine whether your activity is a hobby. Make sure to base your determination on all the facts and circumstances of your situation. Factors to consider include:
- Whether you carry on the activity in a businesslike manner.
- 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.
Allowable Deductions. Within certain limits, you can usually deduct ordinary and necessary hobby expenses or business expenses. An ordinary expense is one that is common and accepted for the activity. A necessary expense is one that is appropriate for the activity.
The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.
If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income.
Limits on Hobby Expenses. Generally, you can only deduct your hobby expenses up to the amount of hobby income. If your hobby expenses are more than your hobby income, you have a loss from the activity. You can’t deduct the loss from your other income.
How to Deduct Hobby Expenses. Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order and only to the extent stated in each of three categories:
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Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
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Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
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Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
In summary, we often hear about the allowable expenses you can deduct when running a business, but hobbies are not mentioned as regularly. After determining if your hobby is considered a business or hobby in the eyes of the IRS, there are certain rules that apply to what is deductible and how it may be deducted. As always, we are happy to assist you if you have any questions pertaining to your hobby income and how it may affect your taxes.
