last update 12-10-02
Normally, when people think of a hobby, they think about an activity that
they derive pleasure from, and not about profits and losses. If someone
attmepts to make a living from the activity--even if that individual has
knowledge of and an interest in the activity--most people would characterize
it as a trade or business. However, the Internal Revenue Service's view
is somewhat broader. If the activity is not carried on in a professional
manner (from the IRS' viewpoint) and does not make a profit within a certain
period of time, the IRS will view it as a hobby, shifting the burden of proving
activity's bona fide business status to the taxpayer if he or she wishes to
deduct expenses or lossess from this activity.
The Hobby Loss subject comes about very often when a person is employed or
has a good source of income and then acquires farm property. He enjoys the
open air so he becomes a weekend, gentleman farmer. He may raise cattle,
plant a small crop, build a bran, pay for a new fence, etc. Some of these
expenditures may appear to be legitimate expenses for a farm. On the other
hand, they could just as easily be expenditures to prepare a country home for
his retirement years.
Since these Hobby Losses may result in a reduction of taxable income, the IRS
is always on guard to make sure that the activity is really a business with
a real expectation of a profit. If so, then it will
probably pass the test and be acceptable. However, if it does not look like,
walk like or quack like a real business, the IRS may likely disallow the losses.
Determining an Activity's Status
The Objective Test
Basically, the IRS uses two tests in evaluating a taxpayer's activities. First,
if a taxpayer can show that he or she realized a profit form the activity in
three out of the most recent five consecutirve years including the current
year, the service's objective test will be met and the activity will be
considered as engaged in for profit. If the activities consists primarily
of breeding, training, showing or racing horses, the presumption applies only
if the activity produced a profit in 2 of the last 7 tax years, including
the current year. You have a profit when the gross income form an activity
is more than the deductions for it.
If your hobby-business activity passes theis 3 year (or 2 year) years-of-profit
test, then it is presumed that it is carried on for profit. This means it will
not come under the scrutiny and limits imposed on hobby losses. You can deduct
all of your business deductions from the activity, even for the years that you
have a loss. You can rely on this presumption in every case, unless and until
the IRS shows it is not valid.
If a taxpayer cannot meet this three-out-of-five-year profit test, the activity
will be considered under subjective facts-and-circumstances test to
determine if it is a real business or simply a hobby. Basically, if a taxpayer
operates the activity in a businesslike manner, it will be considered a
business activity. However, the IRS has come up with a list of factors that
it initially uses in this determination:
The manner in which the taxpayer carries on the activity, including the
methods of operation and the proper maintenance of complete and accurate
records. Businesses are expected to be professional whereas hobbies are
expected to be casual.
The expertise of the taxpayer, including his experience and any knowledge
gained from experts in the activity. Obviously, experience of operating a
business of this nature in the past may indicate a business oriented intent.
The time and effort expended by the taxpayer in carrying on the activity,
including the time spent by employee hired by the taxpayer and whether the
taxpayer has another occupation. The fact that a taxpayer is employed full
time will not by itself preclude him from being engaged in another activity
for profit but it may cause the IRS to look at the situation a bit harder.
The expecation that the assets used in the activity may appreciate in
value, especially if there will be no immediate profit from the activity. For
instance, as a city expands outward, the "farm" could turn into a profitable
The taxpayer's prior success in the conduct of similar or dissimilar
activities. The goal of a business success may not be the same goal for a
hobbyist and that fact will normally be apparent.
The taxpayer's history of income or losses with respect to the activity.
If the activity is a business, it should have profits occasionally. Hobbies
seldom have profits.
The relationship of profits earned to losses incurred, if there is only
an occasional small profit realtive to large amounts of losses.
The taxpayer's financial status, especially if the taxpayer has substantial
income from other sources. If you are living on output of the farm, it is more
likely to be a busienss than if you are constantly supporting the farm.
The elements of personal pleasure or recreation involved in the activity.
a business will require work and a hobby is normally for pleasure. This does
not require that a person cannot enjoy his work but there should be a
realistic understanding of facts involved.
Consequences of Classification
If a taxpayer's activity is considered a hobby, he or she may deduct its expenses
only up to the amount of the hobby income; therefore, a loss from a hobby
cannot be deducted against other income. In addition, hobby expenses must be
taken as miscellaneous itemized deductions; as such, they will be subject to
the "two percent of adjusted gross income" floor, which will limit the amount
of the deduction further.
If the taxpayer's activity is considered a business, the deduction of expenses
and the claiming of losses are subject to the normal business expense and
business loss rules.
If you collect stamps, coins or other items as a hobby for recreation and
pleasure, and you sell any of the items, your gain is taxable as a capital
gain. However, if you sell items from your collection at a loss, you cannot
deduct a net loss.
Since the rules can be tricky, you may need to consult with a professional
before the IRS "comes-a-knocking."
======================== WARNING =======================
This information is provided for the reader's benefit in
becoming familiar with the legal matters discussed. Your
particular facts may be different from the points above.
You should not rely on the above data without consulting a
attorney to discuss the specific facts of your case
and the law of your state.
If you live in Louisiana and want to talk about your situation, please
call me at:
Marvin E. Owen
3036 Brakley Drive
Baton Rouge, La 70816
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