Let’s say you have an unincorporated sideline activity that you think of as a business, including an activity involving horses. If you have a net loss (deductible expenses exceed revenue) on that activity and you think you can deduct that loss on your personal federal income tax return, think again!
In IRS audits and in court cases involving money-losing sidelines, the tax agency frequently argues the activities are hobbies, rather than businesses. Be aware that the federal income tax rules for hobby losses aren’t in your favor. It can be difficult to prove an activity is a bona fide business. And now, due to a change included in the Tax Cuts and Jobs Act (TCJA), the rules are even less favorable for 2018 to 2025.
But don’t give up hope on claiming losses. If you can show a profit motive for your sideline activity, you can deduct the losses. And history shows that the IRS loses about as many court cases on this issue as it wins. Here’s what you need to know about the TCJA change for hobby losses and what to do if you have a money-losing sideline activity.
If you operate an unincorporated for-profit business that generates a net tax loss for the year, you can generally deduct the full amount of the loss on your federal income tax return. That means the loss can be used to offset income from other sources and reduce your federal income tax bill. On the other hand, the tax results aren’t good if your money-losing sideline activity must be treated as a not-for-profit hobby.
Before the TCJA, you could potentially deduct hobby-related expenses up to the amount of income from the activity. However, you had to treat those expenses as miscellaneous itemized deductions that could be written off only to the extent they exceeded 2% of adjusted gross income (AGI). And, if you were subject to the alternative minimum tax (AMT) for the year, your otherwise-allowable hobby deductions were disallowed under the AMT rules.
TCJA effect: For 2018 to 2025, the TCJA eliminates write-offs for the miscellaneous itemized deductions that had been subject to the 2%-of-AGI threshold. This wipes out deductions from hobby activities.
So, under the new law, hobby-related deductions are disallowed for regular tax purposes as well as for AMT purposes. Expect IRS auditors to focus even more attention on taxpayers with money-losing sideline activities. That means it’s now more important than ever to establish that a money-losing activity is a for-profit business that has simply hasn’t yet become profitable. We’ll explain more about how to do that below.
The next step is to determine if your money-losing sideline activity is a hobby or a business.
Fortunately, there are two safe-harbor rules for determining if you have a for-profit business.
1. An activity is presumed to be a for-profit business if it produces positive taxable income (revenues exceed deductions) for at least three out of every five years. Losses from the other years can be deducted because they are business losses as opposed to hobby losses.
2. A horse racing, breeding, training, or showing activity is presumed to be a for-profit business if it produces positive taxable income in two out of every seven years.
Taxpayers who can plan ahead to qualify for these safe-harbor rules can deduct their losses in unprofitable years.
Intent to Make Profit
Even if you can’t qualify for one of the safe-harbor rules, you still may able to treat the activity as a for-profit business and rightfully deduct the losses. Basically, you must demonstrate an honest intent to make a profit. Factors that can prove (or disprove) such intent include:
- 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 is the reason the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years.)
- Success in other ventures, which indicates business acumen.
- The history and magnitude of income and losses from the activity. 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.
- Your financial status. In the eyes of the IRS, “rich” folks can afford to absorb ongoing losses (which may indicate a hobby) while ordinary folks are usually trying to make a buck (which indicates a business).
- Elements of personal pleasure. Racing horses is a lot more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.
Some Good News
Being able to claim business status is helpful for deducting losses. Hobby status is not, especially under the TCJA.
The good news is that, over the years, the U.S. Tax Court has concluded that several pleasurable activities could be classified as for-profit businesses rather than hobbies, based on evaluating the factors listed in this article. So, there’s often reason for hope.
That said, hobby loss deductions have been a hot issue for the IRS, and the new tax law adds fuel to the fire. So, it’s important for you to be on the correct side of as many of the factors as possible. Your tax advisor can help you create documentation to prove that that you are, in fact, on the right side.