How to Play All the Right Tax Angles for Hobbies

Millions of people enjoy hobbies that also provide a source of income. From catering to cupcake baking, crafting homemade jewelry to glass blowing – no matter what your passion is, there will likely be tax repercussions.

Some taxpayers are surprised to learn that they must report income earned from hobbies on their tax return. The exact rules for reporting income, as well as deducting expenses, depending on whether the activity is a hobby or a business. In fact, you may bump up against obstacles in this area.

Accordingly, the IRS has focused on the following points for hobby enthusiasts to consider:

Business vs. Hobby
If an activity is a hobby, not a business, your deductions are generally limited to the amount of hobby income. Conversely, a business might be able to claim a loss. The key distinction is often whether you’re engaging in the activity to turn a profit.

Traditionally, the IRS and the courts have relied on nine factors to make this determination:

1. The manner in which the taxpayer carries on the activity.
2. The taxpayer’s expertise.
3. The time and effort expended by the taxpayer in carrying out the activity.
4. Any expectation that assets used in the activity (e.g., land) may appreciate in value.
5. The taxpayer’s success in other activities.
6. The taxpayer’s history of income or losses from the activity.
7. The relative amounts of the profits and losses.
8. The taxpayer’s financial status.
9. Whether the activity provides recreation or involves personal motives.

Don’t discount any of these factors. All nine of them may come into play.

Allowable Hobby Deductions
Within certain limits, taxpayers can usually deduct “ordinary and necessary” hobby expenses to offset hobby income. An ordinary expense is one that is common and accepted for the activity, while a necessary expense is one that is appropriate for the activity. Typically, your deductible expenses might include production and advertising costs.

Limits on Hobby Expenses
Generally, taxpayers can only deduct hobby expenses up to the amount of hobby income. If hobby expenses exceed the income, taxpayers have a loss from the activity. However, a hobby loss can’t be deducted from other income like a business loss can.

Method of Deducting Hobby Expenses
Taxpayers must itemize deductions on their tax return in order to deduct their hobby expenses. Generally, hobby expenses are deducted on Schedule A of Form 1040 as miscellaneous expenses, subject to the usual limits. Thus, if you do not itemize deductions, or if your expenses fall below the threshold for deducting miscellaneous expenses, you may get no tax benefit from your hobby.

Note that the IRS follows a special presumption when determining whether an activity is a business or a hobby. If an activity turns a profit in three of five consecutive years, the activity is presumed to be a business, although this presumption can be rebutted by evidence.

The presumption applies if you show a profit in only two out of seven years for activities related to the breeding, training, showing, or racing of horses.