What is hobby loss?
When you are in a business, you need to spend money to make your products and services. Even if it is just a small business, it is inevitable to spend. Expenses are there so that a trade or a business will continue. They are incurred to make income. They are also paid to invest. So even if one means well and wants to gain profit, if the expenses are more than the earnings, losses will overpower your unrelated income.
If you earn your income, there will always be taxes, and you may claim it even though it is not from your employer. When we say income, this does not only include full-time jobs. It also includes part-time jobs, freelance work, recreational pursuits, and the like that generate profit. Hence, all expenses involved with these activities that end up in losses can be deducted. But there is an exception. If the IRS states that your activity is a hobby, then it is not deductible.
So, many people abuse this. Many hobbyists take advantage of perceived loss deduction. So, Internal Revenue Code made the hobby loss rule to prevent this. This rule applies to many entities, including individuals, trusts, partnerships, estates, S corporations, but not C corporations. It means that deductions can only be applied to activities that are not related to profit.
In a nutshell, hobby loss is a loss that you get if Internal Revenue Service considers your recreational activity a hobby. If this happens, you cannot claim or get back this money because the agency says it was used for a hobby. Losses are prohibited for expenses in excess of income from a hobby. Hence, whatever you spend for a hobby or an activity that the IRS considers as a hobby is not deductible.
What does the IRS have to say about this?
IRS says that the hobby loss rule prohibits activity losses that it deems not involved in profits. Tax demonstration should be three out of five consecutive tax years. Different activities have different requirements. For instance, we have horse racing. Taxpayers into horse racing must make it clear that they aim for profits to avoid hobby loss limitations. They need to collect proof of profit motives like receipts and record keeping. In fact, this does not only apply to taxpaying horse racers. This is an excellent idea for every taxpayer in every situation.
The IRS tip sheet
IRS prepared a tip sheet for taxpayers to ensure that their business operations are not hobbies. Before the 2018 tax year, you can still claim the itemized deduction even when you engaged in a hobby. Taxpayers should take the deductions like the following enumerations and only to the extent state in these categories:
- There are some personal expenses that a taxpayer can claim. Taxpayers can fully claim some like home mortgage interests and taxes.
- Deductions that do not end up in an adjustment to the property’s basis like advertising, premiums, wages, and the like can be taken next. This is to the activity’s extent gross income is higher than the first category deductions.
- Take basis-reducing deductions like depreciation and amortization last. This is only to the extent that the activity’s gross income is higher than the deductions taken in the two initial categories.
A hobby loss is a loss incurred when IRS considers the taxpayer’s activity as a hobby. IRS says that a hobby is any activity done for pleasure and not for profit. Before 2018, taxpayers can deduct losses from activities that did not go beyond the activity’s gross income.