Do you have a hobby or pastime that brings you incredible joy? Maybe it even earns you a few bucks here and there. It could be painting, photography, gardening, sailing, or flying. Hobbies are a wonderful way to unwind, express creativity, and indulge in a personal interest.

Did you know that, in certain circumstances, your beloved pastime could lead to some unexpected tax implications?

Make sure you are aware of the Hobby Loss Rule. It is a set of regulations designed to prevent individuals from claiming excessive losses from activities that the IRS deems to be hobbies rather than legitimate businesses. When it comes to taxation, distinguishing between a hobby and a business is critical, and the IRS has guidelines to make that determination.

Key Factors

The key factors include:

1. Your Goals – If you are using the activity primarily for tax benefits or to offset income from other sources, it may be considered a business.
2. Profitability – If you continually incur losses in your activity for an extended period without a clear plan for profitability, the IRS may view it as a hobby.
3. Business-like Activities – Engaging in activities typically associated with running a business, like keeping detailed financial records, creating a business plan, and seeking ways to expand and grow your operation, will demonstrate your intent to run a business.
4. Having expertise or prior experience in a field can also help establish the legitimacy of your venture as a business rather than a hobby.
5. Time and Effort. If you devote a substantial amount of time and effort to your hobby, it may be looked upon as a business. A casual commitment may indicate a hobby.

If the IRS deems your sideline to be a hobby rather than a business, it could result in owing taxes earned from your hobby, but being unable to claim any financial losses involved.

Let’s say you earn $200,000 from a hobby but incurred expenses of $350,000. The Hobby Loss Rule would require payment of taxes on the $200,000 of hobby income, even though you suffered a net loss of $150,000. Your pastime isn’t fun anymore when you owe taxes on $200,000 and are still out of pocket $150,000!

Remember, the Hobby Loss Rule can have profound tax implications for individuals, partners, and S corporations involved in activities that produce a tax loss, and it applies regardless of the income generated—whether it’s $15,000 or in the millions.

You cannot deduct any hobby expenses other than the cost of sales. In contrast, legitimate business expenses are deductible. If the IRS reclassifies your hobby as a business, you’ll be able to claim these deductions.

To avoid issues with the Hobby Loss Rule, consider the following:

1. Maintain detailed records of income and expenses
2. Develop a business plan outlining your goals, strategies, and expected profitability
3. Seek expert advice and consult with professionals who can guide you in making decisions

What Should You Do?

Pursuing your passions and hobbies is commendable. But understanding the Hobby Loss Rule is critical. The line between a hobby and a business can be fine, and it’s vital to approach it with proper knowledge, planning, and execution.

If you want to learn more about the Hobby Loss Rule, please contact us.