IRC 183 IRS Business Hobby Loss Tax Rule
Many people have hobbies that also earn income. That includes stamp collecting, making crafts, horsemanship, and multiple other activities. The IRS requires you to report hobby income on your tax return, but you can also deduct some expenses.
It can be a bit confusing to distinguish between a hobby and a business, especially because these categories overlap in a lot of ways. However, if you have an income-generating hobby, you need to understand a few basics.
What Is the Difference Between a Business and a Hobby?
The IRS takes several factors into account when classifying activities as hobbies or businesses. The main issue is the relationship to profit. To help decide if your activity is a hobby or a business, consider the following questions:
- Are you trying to make a profit?
- Do you make a profit some years?
- Do you depend on the income from that activity?
- Have you made changes to your process to increase how much profit you make?
- Have you made a profit from similar activities in the past?
- Do you have adequate knowledge to turn the hobby into a business?
If you answered “yes” to all or most of those questions, you have a business. “No” answers indicate you have a hobby.
What Does the IRS Consider Profitable?
In a nutshell, profit is when your income exceeds your expenses. To give you a simple example, imagine you spend $100 buying craft supplies to make bracelets, and you sell the bracelets for $800. Your profit is $700.
Basically, according to the IRS’s hobby business tax rules, if profit is rare, you have a hobby, but if you regularly earn a profit, you have a business. Specifically, if you turned a profit in three of the last five years, you probably have a business.
When it comes to breeding, showing, training, or racing horses, you only need to make a profit in two of the last seven years for the IRS to consider your hobby a business.
Can You Write Off Expenses for Your Hobby?
In some cases, you may be eligible to claim a hobby tax deduction. That means you can write off some expenses related to the hobby, but you cannot write off more than you earn.
In addition, you can only write hobby expenses if you itemize your deductions. If you claim the standard deduction, you can’t write off expenses for your hobby.
The IRS loses about $40 billion per year in unpaid taxes due to people deducting hobby expenses that aren’t eligible. To qualify as deductible, hobby expenses must be useful and necessary. For example, if you show horses, a saddle is a useful expense. If you collect stamps, a book to store them in is a useful and necessary expense.
Other eligible hobby expenses include advertising, insurance premiums, and wages paid to people who help with the hobby. You can also claim hobby deductions for depreciation related to property used in your hobby. For example, if you have a desk that you only use for your jewelry making hobby, you can depreciate that asset over time and claim part of its value as a hobby deduction. But, again, in all these cases, you cannot deduct more than you earn from the hobby.
What If You Experience a Loss From a Hobby?
If your expenses are more than your income, you have a hobby loss, but you can’t deduct that from your income. In contrast, if you have a business loss, you usually can deduct that from income in another year. If you want to dive deeper into the law, IRC 183 explains the IRS hobby loss rules in detail.
How Do You Deduct Expenses for a Hobby?
To deduct hobby expenses, you need to use Schedule A of Form 1040. This is the same schedule that you use to claim mortgage interest, charitable deductions, medical expenses, and other itemized deductions on your tax return.
What If the IRS Classifies Your Hobby as a Business?
If the IRS classifies your hobby as a business, you’re in luck. You have a lot more freedom to claim expenses, and you can deduct those expenses whether you claim the standard deduction or not.
With a business, you report income and expenses on Schedule C or C-EZ. As an added bonus, if you have a loss, there are ways to roll the loss backward or forward and claim it against profits in another year.
What if the IRS Classifies Your Business as a Hobby?
If the IRS thinks your business is a hobby, that means you have to follow the IRC 183 hobby loss rules. Namely, you don’t get to claim the loss against income in another year. If your activities are really a business, you don’t want them classified as a hobby, because that increases your tax liability.
Besides the profit element discussed above, the IRS looks at how you treat the activities. To make the case that your hobby is a business, you need to treat the activities like a business. Keep organized and detailed records, invoice clients, consider advertising, and write a business plan that outlines your intent to make a profit.