last update 12-10-02

Hobby Losses

Background

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 the 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.

Subjective Test

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 subdivision.

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  =======================
                      AND DISCLAIMER
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.
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last update 12-10-02

Hobby Losses

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