Millions of Americans engage in hobbies that may also be a source of income. And it’s that last word – income – that raises the attention of the Internal Revenue Service. Any hobby – from quilting to computer repair to cake baking – can fall under the IRS standards for a business if the right set of standards are met.
First, the groundwork. Income from hobbies of any kind must be reported on the taxpayer’s return. How that income is reported depends on whether the activity qualifies as a business or a hobby. This matters because there are deduction limits and special rules that apply for taxpayers reporting hobby income.
Is it a Hobby or a Business?
One of the keys to determining the answer to this question is that businesses operate with the intent of making a profit. Taxpayers who engage in a hobby do so for sport or recreation, but not for profit. To determine whether an activity or pastime may be a business, the IRS looks at a number of questions:
- Whether you carry on the activity in a businesslike manner.
- Whether the time and effort you put into the activity indicate 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 change 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.
Check out IRS Publication 535, Business Expenses, for more on not-for-profit rules.
Hobby Expenses and Deductions
If the activity qualifies as a hobby, “ordinary and necessary” hobby expenses can usually be deducted (within certain limits). Ordinary expenses are common and accepted for that particular hobby; necessary expenses are those appropriate for the activity.
As with most deductions, there are limits the taxpayer may claim. Generally, expenses can only be deducted up to the amount of income from the hobby. If expenses outweigh income, the taxpayer has a loss – but the loss cannot be deducted from other income.
In order to claim hobby expenses as a deduction, the taxpayer has to itemize deductions. According to IRS Publication 535, expenses can fall into three types of deductions and special rules may apply:
- Category 1. Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). You can deduct a casualty loss on property you own for personal use only to the extent each casualty loss is more than $100, and the total of all casualty losses exceeds 10 percent of your adjusted gross income (AGI).
- Category 2. Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category.
- Category 3. Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in Category 1 belong in this category. Where more than one asset is involved, allocate depreciation and these other deductions proportionally.
For more resources in the hobby-versus-business debate, check out these IRS publications: