But things aren’t so simple from a tax perspective.
Strategy: Turn your dream into reality, but prepare to prove that you intend to turn a profit from the activity.
Why? Because, if you’re not careful, the “hobby loss” rules can trip you. In effect, you won’t be able to deduct the expenses exceeding the income from the activity.
Here’s the whole story: So long as you’re running a legit business, you can generally deduct all of your ordinary and necessary expenses, even if you show a loss for the year. In fact, this is pretty common in the early years of ownership. But deductions are limited if the IRS considers the activity to be a hobby rather than a business.
You can deduct the expenses attributable to a hobby only up to the amount of the income that the hobby generates. But certain expenses—such as property tax, mortgage interest and casualty losses— may be deductible, anyway. The expenses reduce the amount of hobby income that may be offset by other expenses.
Although each case is decided on its own merits, the courts have traditionally considered the following nine factors to distinguish a business from a hobby:
1. The manner in which the activity is carried out.
2. The expertise of the taxpayer or his or her advisers.
3. The time and effort expended carrying on the activity.
4. The expectation that assets of the activity may appreciate in value.
5. Any success the taxpayer had with similar or related activities.
6. The activity’s history of income or loss.
7. The amount of occasional profits, if any, that are earned.
8. The taxpayer’s financial status.
9. Whether the activity involves any elements of personal pleasure or recreation.
Of course, certain factors might tip the scales one way or another, but you can generally benefit from this:
Tax law presumption: If you show a profit in any three of the five previous years, the activity is presumed not to be a hobby. So, you may avoid hassles from the IRS if you stick to that guideline.
The presumption is even better for an activity involved in the breeding, training, showing or racing of horses. In that case, the IRS presumes the activity is not a hobby if it shows a profit in only two of the previous seven years.
Tip: If the IRS rules your activity a hobby, you can lump deductible expenses in with your other miscellaneous expenses. You can deduct the total only to the extent that it exceeds 2 percent of your adjusted gross income.
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