Hobby or Business DeductionsTax Professionals' Resource
November 16, 2012 — 1,223 views
Hobby or Business Deductions
Taxpayers often wonder about the deductibility of losses from activities that are not their primary source of income. The Internal Revenue Service differentiates between losses incurred in a business activity from losses associated with a hobby. The question is how to define business activities and hobbies.
According to IRS Section 183 losses are only deductible for activities the taxpayer engages in with the intent to generate a profit. Losses in activities not intended to produce a profit are considered hobby losses and not deductible. These regulations apply to individual taxpayers as well partnerships, trusts, estates and Chapter S corporations. All activities of any other corporation are considered to be for profit.
The IRS considers any activity that makes a profit at least three years of the last five as for profit. The exception to this is the horse business where the test is profits two years in seven. However, there are other considerations the IRS may take into account when reviewing a loss.
Is a business-like effort expended in the tasks that generated the loss? Does the taxpayer expend enough time and effort to make the project profitable under normal conditions? Is the taxpayer working on the business with the intention to turn a profit? If the taxpayer can convince the IRS that a yeas answer is appropriate for these questions, they may rule the losses are deductible business losses.
The IRS might also question the deductibility of losses in consecutive years. Business managers commonly discontinue operations that are consistently generating losses. If the taxpayer can convince the IRS changes were made to the operation in hopes of reducing or eliminating losses they may be able to continue to deduct the loss.
The IRS does allow some deductibility for hobby losses but limits the hobby deductions to the amount of any hobby related income. For example, someone who raises flowers as a hobby could deduct the expenses of raising the flowers up to the amount of income generated from the sale of flowers. These deductions can include a portion of the home mortgage interest, property insurance and taxes associated with the garden operation.
If the garden generated an income that exceeded all possible deductions for the garden for two out of five years it would be considered a for-profit business activity and the expenses would be fully deductible in the other three years of the operation.