A Hobby Can be a Perennial IRS Red Flag
Claiming large hobby losses on Schedule C. IRS is on the hunt for taxpayers who year after year report large losses from hobby-sounding activities on Schedule C or F of the 1040 to help offset wages, business or investment earnings, or other income. Revenue you collect from a hobby is taxable, reported as other income on Schedule 1 of the 1040. But you cannot deduct the related expenses. Before 2018, itemizers could deduct hobby expenses, up to the amount of their reported hobby income, as a miscellaneous deduction on Schedule A, and only to the extent that the total of all miscellaneous itemizations exceeded 2% of adjusted gross income. The 2017 tax law temporarily nixed through 2025 most miscellaneous itemizations, and last year’s “One Big Beautiful Bill” permanently ended this tax write-off.
To deduct a Schedule C loss, you must show the activity is a business. It needs to be conducted with continuity and regularity in a businesslike manner, and you must have a reasonable, good-faith objective in making a profit from it. IRS regulations provide a safe harbor. If your activity generates a profit in three out of five consecutive years, or two out of seven years for horse breeding, the law presumes you’re in business to make a profit unless IRS establishes otherwise. The hobby-business analysis is trickier if you can’t meet the safe harbor. That’s because the determination of whether an activity is properly categorized as a hobby or a business is then based on each taxpayer’s facts and circumstances.
IRS and the courts look at nine factors: Expertise of the taxpayer and advisers. Manner in which one carries on the activity. Time and effort devoted to the venture. Expectation that assets from the activity may appreciate. History of income and losses (the more years of large consecutive losses, the harder it is to show a profit motive, unless the activity is still in its start-up stage). The amount of occasional profits. Success in carrying out other activities. Elements of personal pleasure or recreation. And whether the taxpayer has substantial income from other sources, such as wages. No one factor is determinative. But some are routinely given more weight. For example, managing and operating your activity in a businesslike manner can be very helpful in demonstrating an honest intent to make a profit from a venture, even though the activity has so far been generating only losses. Some tax preparers point to this as the most important factor. And it is something that you can control. You should open a separate bank account for the activity, maintain good records, keep receipts of your expenses, advertise, have a business plan and revise as needed, and change operating methods or adopt new techniques to turn your venture around.
Other helpful factors to establish profit motive that are within your control: Ensure you have the knowledge, training or expertise to conduct the activity, or rely on the advice of industry experts. Also, devote lots of time and effort to the endeavor.
