Is your favorite pastime classified as a business or a hobby? Here’s how the IRS sees it.
Millions of people enjoy having hobbies — whether it’s photography, antiquing, craft making, collecting coins, or breeding horses. It usually costs money to support a hobby, but in some cases, your hobby can also make you money.
If you have a hobby that is also a source of income, you’re required to report the income on your Federal tax return. In order to properly report your income and expenses to the IRS, you must ascertain whether the activity is classified as a hobby or a business.
This article explains the IRS rules for determining if an activity qualifies as a business, and what restrictions apply if the activity is not a business.
Hobby vs. Business
For tax purposes, a hobby is defined as an activity that you engage in “for sport or recreation, not to make a profit.” Even if you earn occasional income from doing such an activity, the primary purpose must be something other than making a profit.
To distinguish between a hobby and a business, you must take into account all the facts and circumstances of your situation. The IRS lays out the following 9 factors that should be considered when establishing if an activity is a business engaged in making a profit:
- Whether you carry on the activity in a businesslike manner
- Whether the time and effort you put into the activity indicate that you intend to make it profitable
- Whether you depend on income from the activity for your livelihood
- Whether your losses are due to circumstances beyond your control, or are normal in the startup phase of your type of business
- Whether you adjust your methods of operation in an attempt to improve profitability
- Whether you (or your advisors) have the knowledge needed to carry on the activity as a successful business
- Whether you were successful in making a profit in similar activities in the past
- Whether the activity makes a profit in some years, and how much profit it makes
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity
According to the IRS, an activity is deemed as a business if it makes a profit during at least 3 of the last 5 tax years, including the current year — or at least 2 of the last 7 years if the activities mainly consist of breeding, showing, training, or racing horses.
Tax Deductions for Hobby Expenses
In general, you are allowed to deduct ordinary and necessary hobby expenses (with certain limitations). An “ordinary” expense is one that’s considered common and accepted for the activity. A “necessary” expense is one that’s considered helpful and appropriate for the activity.
Since a hobby is not a business, hobbyists are not entitled to the same tax deductions that businesspeople can claim. As a hobbyist, you can usually deduct your hobby expenses up to the amount of your hobby income. But any expenses that exceed your hobby income are considered personal losses and are not deductible from your other income.
How to Deduct Hobby Expenses
In order to deduct your hobby expenses, you must itemize deductions on your income tax return. There are 3 categories of deductions that your hobby expenses may fall into, and these deductions must be taken in the following order:
- Category 1: Deductions you can take for personal as well as business activities are allowed in full. For individuals, all non-business deductions (such as those for home mortgage interest, taxes, and casualty losses) belong in this category.
- Category 2: Deductions that don’t result in an adjustment to the basis of property are allowed next, but only to the extent that your gross income from the activity exceeds your deductions under the first category.
- Category 3: Business deductions that decrease the basis of property are allowed last, but only to the extent that your gross income from the activity exceeds your deductions from the first 2 categories.
Use Schedule A (Form 1040) to claim your itemized deductions. Any amounts from categories 2 and 3 are considered miscellaneous deductions and are subject to the 2% AGI (adjusted gross income) limit.
If you haven’t filed your 2014 tax return yet, you can use E-file to complete your taxes online.
For more information about hobby rules and allowable deductions, please refer to IRS Publication 535 (Business Expenses).