The Hobby Loss Rules, Or How Your Hobby Can Hurt You Come Tax Time

Let’s say you have a side-project that throws off a little revenue from time to time. Maybe you make jewelry and sell it at craft fairs, or you hang your paintings for sale in a local coffee shop, or you refurbish classic cars and sell them to collectors. Maybe you don’t even think of it as a hobby, maybe you think of it as a business or a side-hustle. Well, if the expenses from this activity exceed the gross income (aka it generates a loss), the IRS may not agree with your classification of your side hustle as business, and if they consider it to be a hobby, you can be in for a rough surprise come tax time.

Why should I care if the IRS considers my side-project to be a business or a hobby?

You should care because the income or loss generated by an activity is treated very differently if the activity is considered to be a hobby as opposed to a business. Specifically, the losses from a business can be deducted against other income (e.g. wages or profits from another business you own), whereas losses from a hobby cannot be deducted against other income.

But wait, it gets worse…

Not only are hobby losses not deductible against other sources of income, the way in which the loss is calculated and taxed is also different from the way a business calculates its profit or loss, and the way in which hobby losses is calculated can be very painful for the taxpayer. Specifically, businesses are taxed on their net profit, which is calculated as gross income minus total expenses. For example:

  • We Design LLC is a web design company that is organized as a single member LLC
  • In 2017 We Design generated a net profit of $50,000 (we’ll cover this more later, but the fact that We Design generated a profit, not a loss, in the prior year means that is automatically treated as a business and not as a hobby for this year)
  • In 2018 We Design generated $100,000 in gross income by designing websites for its clients
  • We Design also had $120,000 of expenses, such as the cost of rent, utilities, subcontractors, office supplies, etc.
  • We Design’s net loss for the year is $100,000 – $120,000 = ($20,000)
  • The owner of We Design can deduct the $20,000 loss against the wages that she earned from her day job as a developer for a big software company, which decreases her taxable income and therefore decreases her taxes

How is it different for an activity that is considered to be a hobby? Let’s look at another example:

  • NYCFashionLyfe LLC is a fashion and lifestyle blog that is organized as a single member LLC
  • NYCFashionLyfe has never generated a net profit in any of the four years it’s been operating
  • In 2018, NYCFashionLyfe generated $150 in gross income by advertising on its website
  • NYCFashionLyfe also had expenses of $1,000, such as the cost of hosting the website, purchasing articles of clothing to blog about, and traveling to cultural events around the city
  • NYCFashionLyfe’s net loss for the year is $150 – $1,000 = ($850)
  • However, because it is considered to be a hobby (and not a business), the owner of NYCFashionLyfe cannot deduct this loss against the wages she earned from her day job as a food critic for a local newspaper

It gets worse still…

Not only can the owner of NYCFashionLyfe not deduct the loss from her blog against her wages, she has to treat the gross income and expenses from the blog in a way that is unique and special to hobbies:

  • The gross income (not the profit) is taxable on her personal tax return as if it were profit
  • Prior to 2018, the expenses were deductible as miscellaneous itemized deductions, which were only deductible when they exceed 2% of the taxpayer’s total income, but,

It gets even worse…

  • Starting in 2018, thanks to the new tax law, miscellaneous itemized deductions are no longer a thing, so while the hobby’s gross income is taxable, the hobby’s expenses are not deductible at all, anywhere
  • Translation: NYCFashionLyfe’s gross income, $150, is taxable, but the expenses are not deductible, so even though the hobby had a net loss of $850, it is taxed as if it had a net profit of $150. This means that your hobby could have cost you $850 (which is okay, it’s a hobby and is, in theory, something you enjoy doing), but you can be taxed as if it was a business that made $150

One small consolation…

The definition of gross income for a hobby leaves a little bit of wiggle room that can help hobbyists who are selling a product with associated cost of goods sold. According to 2017 Publication 535 (page 7), “You can determine gross income from any not-for-profit activity [such as a hobby] by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting.”

What this means is that, if you design jewelry and you spend $15 on materials for a necklace and sell the necklace for $20, you can show your gross income as $20 – $15 = $5 instead of as the $20 of gross receipts (or gross revenue) that you actually collect from your customer. For hobbyists selling high-dollar value items (such as a classic car), whose cost of goods sold may even exceed the gross revenue, calculating the gross income this way instead of just using gross receipts can have a substantial effect on the taxpayer’s tax liability.

How do I determine if my side hustle is a business or a hobby?

First, there are two safe-harbor rules (i.e. criteria that, if met, mean you’re automatically a business and don’t need to worry about being tested further):

  1. An activity is presumed to be a for-profit business if generates a taxable net profit for at least three out of every five years
  2. A horse racing, breeding, training, or showing activity is presumed to be a for-profit business if it generates a taxable net profit in two out of every seven years

If you meet either of these rules, congratulations, you’re a business! You avoid the painful hobby loss rules and can deduct a loss generated this year against your other sources of income.

If you don’t meet one of these safe harbors, you’re not out of luck, but it is now a little more open-ended. In order to be considered a business, you need to demonstrate an honest intent to make a profit. The IRS evaluates several factors to prove (or disprove) such intent, including, but not limited to, the following:

  • Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies
  • Having expertise in the activity or hiring advisers who do
  • Spending enough time to justify the notion that the activity is a business and not just a hobby
  • Expectation of asset appreciation (this factor is why the IRS will almost never claim that owning rental real estate is a hobby, even though tax losses may be incurred for many years in a row)
  • Success in other ventures, which indicates business savvy
  • The history and magnitude of income and losses from the activity, meaning that occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept
  • The taxpayer’s financial status. In other words, “wealthy” taxpayers can afford to absorb continuing losses (which may indicate a hobby), whereas “non-wealthy” taxpayers may not be able to afford such losses and are genuinely trying to make a profit (which may indicate a business)
  • Elements of personal pleasure – traveling the world and blogging about your adventures is more fun than doing tax returns (except if you’re me, I love doing tax returns), so the IRS is more likely to claim that the blog is a hobby if the taxpayer claims a loss on her tax return

If this seems somewhat subjective, that’s because it is, and generating losses year after year can put you in a risky position with regards to the hobby loss rules.

A few important notes:

  • Deductions that could have been claimed whether or not they were associated with a hobby (e.g. taxes, certain interest expense, mortgage interest) can be deducted, even if they exceed the hobby’s gross income
  • The fact that an activity is in an entity, such as an LLC, does not mean that is automatically a business, and the hobby loss rules may still apply

In Conclusion

These rules leave a lot to be desired, especially following the changes in the 2018 tax law, but for now, we’re stuck with them. If you think you may have a hobby or aren’t sure about something you read here, let us know, we can help you sort through the mess that is the hobby loss rules.

As always, the topics discussed in this article are complex, and individual circumstances can vary drastically. You should always consult your tax advisor about your specific situation and circumstances before making any tax planning decisions.