An IRS-designated hobby loss is a loss from an activity that the IRS classifies as more of a hobby than a business. In general, a trade or business is an activity conducted for the purpose of making a living or profit. The IRS may presume that an activity is a hobby if it has not generated a profit in at least three of the five most recent tax years, including the current year.
The IRS can make this determination in a number of ways: by sending a request for documentation, inspecting your records and prior tax returns, visiting the business, or using any other examination technique it deems appropriate. Once it determines that your business is merely a hobby, you will be required to report the income but will be unable to deduct any expenses related to the activity.
For tax years 2018 through 2025, any deductions or losses related to hobby income will be disallowed while your gross receipts from the hobby are taxable. To avoid the hobby loss rules, ensure you document how you plan on making a profit in all your business activities.
Examples of Activities Commonly Classified as Hobbies
The following list of activities are commonly scrutinized by the IRS to determine if they might be hobbies. If your activity is in one of these areas, then it is especially important for you to follow our tips in the next section and document that your activity is profit-motivated.
- Airplane charter
- Artists
- Auto racing
- Bed and breakfast
- Bowling
- Craft sales
- Direct sales
- Dog breeding
- Entertainment
- Farming
- Fishing
- Gambling
- Horse racing
- Horse breeding
- Motocross racing
- Photography
- Stamp collecting
- Writing
- Yacht charter
From collecting stamps and woodworking to crafting and quilting, people have all kinds of hobbies—and most of these will never turn a profit. If you concede that your hobby is not profit-motivated, you need to report the gross income on your tax return as other income on IRS Form 1040, Schedule 1, Line 8.
Tips To Avoid the IRS Hobby Loss Rules
To avoid the possibility of your business being declared a hobby, follow our tips below. You don’t have to comply with each tip, but each will help argue that the activity is a business and not a hobby.
1. Treat your activity as a business.
You should carry out your business activity in a businesslike manner and maintain complete and accurate books and records that indicate that your activity is engaged in for profit. Visit our guide to the best small business accounting software to find bookkeeping software to match your needs.
Opening and maintaining a separate business bank account and company credit card are signs that you are engaging in for-profit business activity. Many checking accounts for small businesses will have little to no fees for your everyday financial transactions.
You may also decide to establish a business line of credit or get a business credit card. A great business credit card has low to no finance charges and also gives your business the opportunity to earn rewards.
As a starting point, you may want to see our roundups of the:
- Top banks for small businesses
- Best checking accounts for small businesses
- Leading small business lines of credit
- Top-recommended small business credit cards
Additionally, to show that your activity is not being done as a hobby, you can get an employer identification number (EIN) from the IRS for the activity, register your business with your state’s department of assessment and taxation, and create an operating agreement if applicable.
2. Prepare a written business plan.
Having a business plan shows that you have, or plan to have, a profitable business. You will need to do some market research and prepare financial projections. If you need assistance, see our guide on how to write a business plan.
3. Show the time and effort that you used to carry out the activity.
You can show that you depend on the activity for your livelihood by documenting the time and effort that you spend on it. By keeping track of the time you spend on business activities, you can show how much time and work you put into the activity to generate an income.
You can do this with time tracking solutions. The best time tracking software helps you keep accurate records of the time you spend on clients and work. It also has good tools for billing, reporting, and managing projects. With it, you can be sure your numbers are correct, and it will be easier and faster to pay taxes and record income.
4. Show that you are not involved in the activity for personal pleasure.
A hobby is an activity done mainly for sport, recreation, or pleasure. If you get no personal pleasure from an activity, then it will be harder for the IRS to argue that the activity is not profit-motivated.
For example, if the activity is janitorial services, then it would be hard to argue you have any motivation other than profit. It’s perfectly fine and very common to enjoy your business activities, but if you don’t enjoy them, it makes it very hard for the IRS to disallow your deductions.
5. Prepare revenue and expense forecasts that show a profit.
A sales forecast allows business owners to make educated guesses about future income and performance by analyzing historical data and the present state of affairs. You can create a weekly, monthly, or annual forecast using Google Sheets or Excel.
You may be interested in our free sales forecast templates. Remember, with this step, the profit doesn’t have to be immediate, but in a reasonable number of years, you should expect to turn a profit.
6. Demonstrate that you depend on the income from the activity to survive.
If you can show the IRS that you need this activity to survive, it will likely be deemed a business activity and not a hobby. This activity need not be your livelihood, but you should produce enough income from it that it significantly contributes to your upkeep.
7. Show that assets used in your activity may increase in value.
When determining if your activity might generate a profit, you’re allowed to consider the appreciation of any assets used in the activity. For instance, if you raise horses, you can include the expected appreciation in the value of your stable and land in your profit projections.
8. Demonstrate that you have had success carrying out similar activities in the past.
If you have operated a business in the industry you are in before, you can demonstrate that you have been successful in the business activity by providing the books and records from the prior activity. This will help you show that the activity is not a mere hobby but one that you have shown the ability to make a profit.
9. Establish your expertise in the industry.
You can show that you have a for-profit motive if you have taken training classes, gotten a professional certification, or taken courses related to the business. This will help to establish that you are invested in the area of business and have a professional level of expertise to carry out the business activity in question.
10. Demonstrate that there has been a change to methods of operation to improve profitability.
If your business is not making money, one way that you can demonstrate that you have a profit motive is by formulating a new business model. Having a new business plan in place that revises the old is one way to show that you have a profit motive.
Hobby Loss 3 of 5 Years ‘Safe Harbor’ Rule
The IRS’s “safe harbor” rule says that if you’ve made money in at least three of the last five years, then you are doing it for profit. Generally, the safe harbor only applies to the third profitable year and all future years within a five-year safe-harbor period that starts with the first profitable year. If you elect to postpone the determination, then it could occur within a five-year period.
You can elect to postpone an IRS determination as to whether the activity is a hobby or a business by filing IRS Form 5213. You should file this form no later than three years after the original tax return filing deadline for the year in which the activity was initially performed.
Frequently Asked Questions (FAQs)
No. Your income derived from your hobby activity will be taxed as ordinary income but is not subject to self-employment tax.
No, you will be unable to claim the home office expense for a hobby. All expenses associated with a hobby are nondeductible.
When you file Form 5213, the statute of limitations is extended until two years after the return for the last tax year in the seven-year (instead of five-year) presumption period is due (without extensions).
Bottom Line
If your business hasn’t made a profit in three of the last five years, you’ll need to show that you have a “profit motive” to deduct the company loss. If your activity falls into this boat, follow our tips to avoid your business being declared a hobby.
