Hobby Losses – Important Items to Understand

Key Takeaways:

• The Hobby Loss rules limit the deductibility of expenses incurred during activities not engaged in for profit.
• Section 183 of the Internal Revenue Code along with the related Treasury Regulations outline the factors used to determine whether an activity was engaged in for profit.
• The determination of whether an activity was engaged in for profit is fact intensive and looks to the taxpayer’s intent to determine whether a profit intent exists. 

Do you have an expensive hobby that you are thinking about turning into a business endeavor? If so, it is important to understand the Hobby Loss limitations so you can navigate pitfalls and maximize available deductions.

Deductible Expenses

The Internal Revenue Code allows deductions for ordinary and necessary business expenses incurred in a trade or business. Additionally, deductions are available for the ordinary and necessary expenses incurred for the production of income, for the management of property held for the production of income, or in connection with the determination, collection or refund of any tax.

The deductions listed above may be used to offset the taxpayer’s income from other sources. Additionally, excess losses may be carried forward as net operating losses to offset income in other taxable years.

"Ordinary and necessary” are key terms when deducting business expenses under the Internal Revenue Code.

Hobby Losses

Section 183 of the internal revenue code limits deductions from being used to offset income from other sources when the expenses/deductions are incurred during activities not engaged in for profit. Treasury Regulations outline nine factors used to determine whether an activity was engaged in for profit. The factors are as follows:

1. The extent to which the taxpayer carries on the activity in a business-like manner;
2. The taxpayer’s expertise or reliance on the advice of experts;
3. The time and effort the taxpayer expends in carrying on the activity;
4. The expectation that the assets used in the activity may appreciate in value;
5. The taxpayer’s success in similar activities;
6. The taxpayer’s history of income or loss from the activity;
7. The amount of occasional profits, if any;
8. The taxpayer’s financial status; and
9. The elements of personal pleasure or recreation

Presumption of Profit Intent

There is a rebuttable presumption of profit intent for activities that generate gross income in excess of the deductions claimed in at least three of the five prior taxable years ending with the taxable year in question.

Application to Each Activity

Taxpayers engaged in multiple activities of differing characters or natures will have to establish profit intent for each activity. Taxpayers engaged in multiple interrelated activities can be classified as a single activity. The IRS will generally accept the taxpayer’s characterization of the activities as multiple activities or a single activity if the facts support this characterization.

Make sure you have documentation to support any characterization of profit.

Examples of Activities Subject to the Hobby Loss Rules

The following activities are examples of activities subject to the Hobby Loss limitations. The application of the Hobby Loss rules to each of these examples was based on a fact- intensive inquiry as to the taxpayer’s profit intent.

• Auto racing
• Dog breeding
• Horse breeding
• Cattle ranching
• Farming
• Boat racing
• Fishing
• Golfing
• Various forms of collecting

Conclusion

Losses from activities not engaged in for profit, or Hobby Losses, are subject to limits on deductibility. Determining profit intent is a fact- heavy analysis and it is important to consult with accounting and legal professionals when determining what losses can be claimed as deductions.

When it comes to understanding how hobby losses may impact you, its best to confer with your professional tax advisors, but Comerica is here to help. Contact your Comerica Relationship Manager today or request to speak to a Comerica Wealth Advisor near you. 

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sources: https://www.irs.gov/pub/irs-pdf/p5558.pdf