Hobby Loss
A loss from a business that the Internal Revenue Service (IRS) considers to be a hobby or recreational activity.
What Is a Hobby Loss?
A loss from a business that the Internal Revenue Service considers a hobby or recreational activity is called a "hobby loss" (IRS). When the agency claims that the funds were used to pursue a hobby, taxpayers cannot claim and recover these funds.
Losses are not permitted for expenses that exceed the income from a hobby. Thus, they are not tax-deductible in the same way that business expenses are. Therefore, any loss sustained while a taxpayer engages in an activity the IRS deems to be a hobby is referred to as a hobby loss.
According to the IRS, a hobby is any activity carried out for enjoyment rather than financial gain. Therefore, all income, including that earned from pastimes, must be reported to the IRS.
Before 2018, taxpayers could file losses as long as they didn't exceed the activity's gross itemized miscellaneous deductions between the 2018 and 2025 tax years that were abolished by the Tax Cuts and Jobs Act.
In U.S. Code IRC 183 describes the Activities Not Engaged In for Profit, the IRS specifies its position on what activities are or are not regarded as hobbies. That being said, knowing a specific tax code section is one thing.
Another fully comprehends it, and the other uses it in each circumstance. Therefore, we have created this concise guide to help you comprehend and apply IRC 183 to the unique situations of each of your clients.
There is no denying that a client's hobby loss can result in significant tax savings. However, if used incorrectly and challenged by the IRS, it can also lead to trouble. That is why it is crucial to understand how it functions thoroughly.
You might become their hero when you help a client avoid paying thousands of dollars in back taxes. However, giving a client bad advice could get them into trouble.
Understanding Hobby Loss
In the world of taxes and accounting, the term "hobby loss" refers to a particular kind of loss for tax purposes. In general, when an expense is connected to the pursuit of a specific hobby or it as a "hobby loss" (in other words, some recreational activity).
The fact that no money was recovered after that expenditure is what makes it a loss. These costs, however, can only be deducted in connection with a recreational activity if that same recreational activity generates income, according to the IRS.
In other words, losses that exceed the actual income related to a hobby cannot be claimed.
Here's the thing: every business incurs expenses. According to the Internal Revenue Service, it is not unusual for a business to report a loss. Moreover, businesses frequently report losses in their first year of operation and occasionally even longer.
Remember that roughly 20% of businesses fail in their first year of operation, 30% close their doors in year two, and approximately 50% close their doors in year five. Therefore, claiming a loss on a business is not inherently suspicious in the eyes of the IRS.
That loss against unrelated income can then offset your federal income taxes. But the real question is whether and to what extent a hobby can be viewed as a business. There are different restrictions on what can be claimed as a loss if your hobby is a legitimate business.
However, if your hobby is merely a hobby—not pursued primarily for financial gain—then your deductions are constrained by the hobby income rule and subject to the hobby loss rule.
Further Reading On Hobby Loss
Although the IRS's handling of such losses can be complicated, the fundamentals of calculating hobby losses are quite straightforward.
Essentially, a person who qualifies as a "hobbyist" is permitted to write off expenses related to their hobby as long as that hobby generates some gross income during a tax year.
The IRS even goes so far as to provide a hobby loss guide online that explains precisely what qualifies as "engaging in an activity for profit" in terms of recreational pursuits.
IRC 183 was created by the IRS to reduce the number of taxpayers who attempted to claim ineligible expenses as business losses when they were just costs associated with purely recreational, non-profit activities.
IRC 183 was intended to apply to trusts, estates, partnerships, individuals, and S corporations to concentrate specifically on abuses by hobbyists. However, C corporations are not covered by it.
The IRS went to great lengths to clarify its intentions when it issued IRC 183. For example, they stated that they would forbid taxpayers from writing off alleged losses (above and beyond income earned) for undertakings that were undertaken without the intent to make a profit.
They used specific examples to make their point even more clear, citing yacht operation, fishing, racing cars, writing, filmmaking, and horse breeding as some examples of pastimes that are frequently pursued for pure enjoyment and with no thought of making a profit.
How a Hobby Loss Works
Costs are a normal part of operating a business because you must spend money to earn money. The costs incurred to generate income, carry on a trade or business, or cover investments in your business are all deductible.
The loss can be used to offset unrelated income if, despite having a profit motive, your overall expenses are higher than your earnings. However, even if it doesn't come from your employer, any income you receive is taxable and needs to be reported.
This includes any temporary or part-time employment, side hustles, and pastime activities that generate income for you. In general, losses from these activities result in deductible expenses. That is unless the IRS views your activity as a hobby.
The Internal Revenue Code's (IRC) hobby loss rule aims to prevent perceived abuses of the loss deduction by hobbyists. This loss rule covers individuals, corporations, trusts, estates, and partnerships, but corporations do not.
Therefore, deductions are only allowed for activities not carried out for profit.
The IRS claims that it applies the loss rule to disallow losses associated with activities it believes are likely not being made for profit. Three of the last five tax years' worth of profit must be shown.
There are a few activities with slightly different requirements, like horse racing. To get around such loss restrictions, taxpayers who engage in these activities must demonstrate a profit motive.
Receipts and thorough recordkeeping, which is a good idea for every taxpayer in any circumstance, are proof of profit motives. Before the 2025 tax year, the Tax Cuts and Jobs Act eliminated itemized miscellaneous deductions, including hobby losses.
Example Of A Hobby Loss
Say, for instance, that you carve wood in your spare time and recently decided to start selling them. Unfortunately, you incur a $5,000 loss in the first year you sell these carvings.
This $5,000 in losses can reduce other income if the IRS determines that you are a business (e.g., salaries, investments, etc. However, you cannot use those losses to reduce other inver if the IRS classifies your activity as a hobby.
Previously, you could only use a hobby to offset your expenses by earning money from it. Unfortunately, taxpayers are no longer permitted to deduct any hobby-related expenses following the passage of the 2017 Tax Cuts and Jobs Act.
However, they still have to report their income, which makes these rule changes even more painful. It's crucial to comprehend these regulations if you're thinking about turning a hobby into a side business to prevent the IRS from classifying your endeavor as a hobby.
The IRS lists nine individual factors that should be considered to determine whether your hobby activity can be considered to have a profit motive (and thus be considered a business rather than a hobby).
Explanation Of The Hobby Loss Rules
The profitability of your activity is the most important consideration, even though the IRS lays out specific criteria for hobbies.
The IRS has a rule that applies to hobby losses that reads as follows: An activity is presumed to be profitable if it has generated a profit in at least three of the previous five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses)
Using the wood carving example from earlier, suppose that over the previous five years, your activity produced the following operating results
| Year | Amount | Loss/Profit |
|---|---|---|
| Year 1 | $100 | Loss |
| Year 2 | $100 | Loss |
| Year 3 | $100 | Profit |
| Year 4 | $200 | Profit |
| Year 5 | $300 | Profit |
You would comply with the IRS hobby loss rule in this case. In addition, your activity would be considered a for-profit business since it generated a profit in three of the previous five years.
As a result, your other taxable income may be reduced by the losses from the first two years of operations.
Assume now that you got the results listed below for the same activity:
| Year | Amount | Loss/Profit |
|---|---|---|
| Year 1 | $100 | Loss |
| Year 2 | $100 | Loss |
| Year 3 | $100 | Loss |
| Year 4 | $200 | Profit |
| Year 5 | $300 | Profit |
Your wood carving endeavor would fail this test in this instance. The IRS would classify your activity as a hobby rather than a business because you didn't profit in three of the previous five years.
As a result, you could not use your losses from the first three years to reduce other income. In addition, if the IRS conducted an audit, those claimed losses would be rejected, and you would be responsible for paying the related taxes.
Relevant factors
Let's take a look at each of these individually:
1. How does the taxpayer's activity take place?
One of the first things to consider when determining whether one of your clients is engaged in a hobby or a business is how the taxpayer carries out the activities associated with the hobby/business.
Are they professionally conducting these activities? For example, keeping a separate bank account for the business, keeping detailed records of their accounts, and doing other things that for-profit businesses do are examples of businesslike behavior (such as advertising).
2. Is the taxpayer a professional?
If the taxpayer in question is engaged in legitimate business activity, they should be able to demonstrate their knowledge and expertise in that regard. For example, have they taken any related courses or worked with other experts in the field? Are they attempting to improve their level of expertise?
3. How much time does the taxpayer devote to the activity?
Is the taxpayer devoting a substantial amount of time and energy to an activity? If a client spends very little time on something, it's difficult for them to claim that it's a legitimate business with profit as its primary goal.
4. Is the activity involving the creation of valuable assets?
If a taxpayer's activity generates an appreciable asset, it is easier to demonstrate that profit is the primary motivation. According to IRC 183, appreciable assets can be considered in determining another overall profit motive rather than focusing solely on current profitability.
5. Is the taxpayer involved in any other profitable venture taxpayer's current activity may be losing money?
However, suppose your client has a track record of turning an unprofitable hobby into a profitable business. In that case, it will be easier for them to demonstrate a profit motive with their current activity.
6. What is the activity's track record of profit and loss?
This is related to the preceding rule. A taxpayer's activity can be classified as a for-profit business if it can demonstrate a solid history of profitability. Also, remember that there is nothing inherently wrong with reporting a loss in some years.
Certain businesses are especially vulnerable to economic fluctuations, which can result in a loss of multiple years. On the other hand, activity consistently results in a and is more difficult to justify as legitimate business activity.
7. What is the connection between profits and losses?
According to IRC 183, when determining whether a given activity is profit-motivated, the IRS may consider the relationship between the total amount of losses incurred and the value of investments, assets, and profit.
8. Are the taxpayers' finances in good shape?
When attempting to determine whether or not an activity is profit-motivated, it can be helpful to consider how that activity fits into the overall financial picture of a taxpayer.
For example, if the vast majority of a taxpayer's income is derived from another business or job, claiming that another activity is purely profit-motivated becomes more difficult.
9. Is the taxpayer's activity motivated by a desire for recreation and pleasure?
This is one of the most important factors to consider. It's more difficult to argue that an activity's primary motivation is profit if it's done for pleasure, recreation, or personal enjoyment.
How To Avoid Hobby Losses
As the preceding should clarify, you do not want your activity to be classified as a hobby by the IRS. You can deduct regular and necessary costs for running a second business, and losses can be applied to other income.
However, you cannot currently deduct any costs associated with a hobby. The following is how we advise avoiding a hobby designation for your new company:
Earn Income
Making money is, without a doubt, the best way to avoid being labeled as a hobby. Therefore, the IRS will accept your new business classification as a business if it complies with the aforementioned rule.
In contrast, failing to turn a profit ensures that you will be given the dreaded hobby label, invalidating all of your prior deductions.
Create A Different Legal Entity
The IRS stresses the significance of conducting your activity professionally to avoid hobby designation in the aforementioned hobby criteria. Creating a distinct legal entity to conduct your business is one way to achieve this.
The IRS treats single-member LLCs as sole proprietorships rather than disregarding them in terms of taxes. But when activity is evaluated based on the facts and circumstances, creating a separate LLC supports the notion of conducting business professionally.
Maintain Distinct Accounting Records
Separate accounting records are kept, which exhibit a professional attitude. To avoid mixing personal and business funds, you should first open a separate business bank account if you want to avoid the hobby classification.
While doing this, you should keep separate accounting records with thorough breakdowns of your company's earnings and outlays. These separate books will further support a business-not-hobby designation for your activity in the event of an IRS audit.
Special Considerations
The IRS published a tip sheet to assist taxpayers in differentiating between hobbies and authorized business activities.
Before the 2018 tax year, if you were involved in a hobby and not a clandestine or fledgling business, you were permitted to claim itemized deductions as itemized on Schedule A of Form 1040.
The following deductions had to be made, but only to the extent specified in the categories listed below:
- Taxpayers may deduct their eligible personal expenses, including home mortgage interest and taxSuppose.
- If the gross income for the activity exceeds the deductions from the first case. In that case, deductions that do not affect the basis of property, such as advertising, insurance premiums, and wages, may be made.
- Deductions that lower the basis of property, like depreciation and amortization, are only taken if the activity's gross income exceeds the deductions made under the first two headings.
Tax Cuts and Jobs Act (TCJA)
The Tax Cuts and Jobs Act was enacted by President Donald Trump in 2017. On January 1st, 2018, the 200-page law took effect, making significant changes to the tax code, including adjustments to the tax bracket, mortgage interest deductions, medical expenses, other expenses, and itemized deductions.
How does this impact hobbyists, then? After the TCJA was passed, taxpayers were no longer permitted to deduct any costs or losses from their hobby income from the prior tax year is applicable for tax returns submitted between the 2018 and 2025 tax payable.
Rules For Claiming Losses Caused By A Hobby
With all of this in mind, you may wonder if there are any hard and fast rules for claiming losses and determining income from a hobby.
Finally, one of the best ways to avoid the IRS classifying your activity as a "hobby loss" is to make a profit — at least sometimes. Remember that under the rule, an activity is considered "for-profit."
Suppose it was profitable for at least three of the previous five years, including the current tax year. There is even a special rule for horses. If you were profitable in two of the previous seven years, you could claim losses associated with your hobby over the income generated in a given tax year.
The above rule, however, is frequently inapplicable to small, hobby-like businesses. Furthermore, new businesses will lack the track record required to use this test to demonstrate whether or not their hobby business is attempting to earn a profit.
When it is not possible to prove your profit motive using the rules outlined above, you must use another method.
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