Suppose you’ve turned a personal hobby into a money-making venture. The activity can provide some tax benefits if you can convince the IRS it’s now a for-profit business instead of a hobby.
Strategy: Operate in a business-like fashion in all respects. For instance, keep detailed records, maintain any licensing that is needed and fulfill similar responsibilities. Significantly, separate your business dealings from your personal pursuits.
If you qualify, you can deduct your bona fide expenses as a self-employed individual. Even better, you might use a business loss to offset highly taxed income.
Conversely, if the activity is treated as a hobby, your deductions for the activity are limited to the income received from the activity. Upshot: You can’t claim a net tax loss on your return. Also, hobby expenses must be deducted as miscellaneous expenses subject to a floor of 2% of adjusted gross income (AGI).
To determine if an activity is a “business” or a “hobby,” the IRS asks eight questions.
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his or her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity ever make a profit?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
The more “yes” answers you have, the more likely you will qualify for business deductions.
Nevertheless, this issue is often contested in the courts. Fortunately, an activity is presumed not to be a hobby if you show a profit in any three out of the last five consecutive years. (For activities involving breeding, training, showing or racing horses, the presumption applies if you show a profit in only two out of the last seven consecutive years.)
Tip: The IRS can rebut the presumption by producing evidence to the contrary.