Business or Hobby? How the IRS Views Your Money-Making Venture

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Hobby IncomeThese days, there is a lot being said about side hustles. If you are looking for a little extra cash, you could try to make money from your hobby, or even start a side business. When tax time rolls around, though, it’s important to understand how the IRS views you. You want to make sure that you know the difference, in tax terms, between a business and a hobby.

With a hobby, you can deduct your expenses to offset your income (you are supposed to be reporting your income), but only the income from your hobby. You can’t claim losses related to your hobby. A business, though, is another matter. Your business loses are deductible against other types of income. So it’s important to be able to differentiate between a business and a hobby for tax purposes.

Show that Your Business is Really a Business

If you want the IRS to consider your business as a for-profit venture, there are certain conditions that should be met. The IRS offers the following list of questions to help you determine whether or not you are engaging in business activities or participating in a hobby:

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Do you depend on income from the activity?
  • If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
  • Have you changed methods of operation to improve profitability?
  • Do you have the knowledge needed to carry on the activity as a successful business?
  • Have you made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Do you expect to make a profit in the future from the appreciation of assets used in the activity?

If you answer “no” to most of the above questions, the IRS is likely to view your business as a hobby. Additionally, your activity needs to result in a profit in at least three of the last five years. If you are constantly claiming losses for a “business” that hasn’t been profitable in years (there are exceptions in cases that involve showing, breeding, and racing horses), the IRS may come after you for back taxes owed. Without some level of profitability, the IRS classifies your activity as a hobby, no matter how you view it. Your business losses are deductible against other income, but hobby income is not.

Deducting Hobby Expenses

Your hobby expenses are deducted on Schedule A of your Form 1040. If you have a hobby, don’t use Schedule C — that’s for businesses. You will need to track all of your expenses related to the hobby, as well as all of the income. You will need to report the income on Form 1040 if you want to deduct your expenses on Schedule A. It is even possible to deduct depreciation and amortization on property used for your hobby. However, realize that you can only deduct up to what you earned on a hobby. If you spent $2,000 last year on your hobby, but only made $1,300, you can only deduct $1,300.

Before you deduct hobby expenses, it’s a good idea to consult with a knowledgeable tax professional about your options.

(Photo: adamknits)

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3 Responses to “Business or Hobby? How the IRS Views Your Money-Making Venture”

  1. Long says:

    I never knew hobby expenses were deductible. Thanks for the info.

    It’s important to note for small businesses that you need to pass the “3 of 5 test.” If you’re not profitable in any 3 years of the past 5 consecutive years, the IRS considers your activities to be a hobby and not a business. It could potentially raise a red flag for an IRS audit.

  2. Jerry Chin says:

    Great post on hobby income! The questions on determining hobby vs. business income is a great resource. The link you posted was busted. If you want to read more about the hobby income the IRS publication is Pub 535 Chapter 1 page 5. Maybe I’m assuming that people actually “want” to read more about it because I am a income tax nerd and love reading about this stuff.

  3. The IRS is really cracking down on this, so it’s important to be aware of the rules if they apply to you.

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