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Lessons from the Tax Court: Limits under ‘hobby loss’ rules

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in Small Business Tax,Small Business Tax Deduction Strategies

To qualify for business loss deductions, you must show that you’re engaging in the activity to generate a profit. Otherwise, the amount you can write off is limited to the amount of your income from the activity, under the “hobby loss” rules.

That doesn’t mean you can’t deduct losses. However, if you show losses year-in and year-out for an extended period of time, the IRS is likely to become suspicious.    

New case: A taxpayer managed his construction activity from an office in his home. The business was listed in the local telephone directory, but it had no bank account or online site. Because he wasn’t licensed as a general contractor, the taxpayer could not undertake large construction jobs.

The taxpayer owned a tractor, four trailers, power tools and other machinery. He charged lower rates than other contractors in the area. Most of his jobs were free projects for family members and his church. He used the same tools and machinery for these jobs as he did for paid construction projects.

Significantly, the taxpayer claimed losses for 17 years in a row.

For the three tax years in question, he reported construction activity income of $3,400, $4,000 and $13,395 and expenses of $31,757, $36,152 and $30,174, respectively.

Based on the relevant factors in this case, the Tax Court limited the deductions to the income from the construction activities. It noted that a for-profit enterprise would not repeatedly and consistently generate losses without changing its practices. (Verrett, TC Memo 2012-223)

Tip: Generally, an activity is presumed not to be a hobby if you show a profit in any three of the past five years. But the IRS can rebut this presumption through proof that the activity is actually a hobby.

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