TCJA’s Continuing Impact on Hobby Related Deductions
Say you have an unincorporated sideline activity that you think of as a business. If expenses from the activity exceed revenues, you have a net loss, and you may think it can automatically be deducted on Form 1040. Not so fast! The IRS likes to claim that money-losing sidelines as hobbies rather than businesses-because the federal income tax rules for hobby losses are not in the taxpayer’s favor (see IRC Sec. 183 and related regulations).
Thanks to an unfavorable change included in the Tax Cuts and Jobs Act (TCJA), the tax rules for hobbies were worsened for 2018-2025. But, if you can show a profit motive for the activity, the losses can be deducted. And history shows that the IRS loses about as many court cases on this issue as it wins. Here is what you need to know about the TCJA’s impact on hobby-related deductions and what can be done to salvage better tax results for clients with money-losing sideline activities.
Information from the IRS, Is it a Hobby or a Business?
TCJA Made Already-Unfavorable Rules for Hobby-Related Deductions Worse
If you operate an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), 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 accordingly. On the other hand, the tax results are not good if your money-losing sideline activity must be treated as a not-for-profit hobby.
Under prior law (before the TCJA), you could potentially deduct hobby-related expenses up to the amount of income from the hobby. However, you had to treat those expenses as miscellaneous itemized deduction items that could only be written off to the extent the sum total of such items exceeded 2% of adjusted gross income (AGI). And, if you were a subject to the dreaded AMT for the year, your hobby deductions were completely disallowed under the AMT rules.
TCJA Effect. For 2018-2025, the TCJA suspends write-offs for miscellaneous itemized deduction items that under prior law were subject to the 2%-of-AGI deduction threshold. This change wipes out deductions for all hobby-related expenses except those that can be deducted in any event (such as mortgage interest and property taxes on space in the home used for the hobby activity). [See IRC Sec. 67(g).] But you still have to report 100% of hobby-related income on your return. Expect IRS auditors to focus even more attention on taxpayers with money-losing sideline activities. That means it is now more important than ever for taxpayers to establish that a money-losing activity is actually a for-profit business that has simply not yet become profitable. Please keep reading for how to do that.
Determining If Activity Is Business or Hobby
The next step is determining if your client’s money-losing sideline activity is a hobby or a business.
IRS Safe-Harbor Rules. Helpfully enough, there are two safe-harbor rules for determining if you have a for-profit business.
- An activity is presumed to be a for-profit business if it produces positive taxable income (revenues in excess of deductions) for at least three out of every five years. Losses from the other years can be deducted because they are considered to be business losses as opposed to hobby losses.
- 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.
- Clients who can plan ahead to qualify for these safe-harbor rules earn the right to deduct their losses in unprofitable years.
- Intent to Make Profit. Even if you cannot qualify for one of the aforementioned safe-harbor rules, you may still be 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. [See Reg. l.183-2(b).] Factors that can prove (or disprove) such intent include:
- Conducting the activity in a business-like manner by keeping good records and searching for profitmaking 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 why 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: “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: raising and training racehorses is lots 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.
Conclusion
Business status is good for deducting losses. Hobby status is bad, especially under the TCJA. The good news is that, over the years, the Tax Court has concluded that many pleasurable activities could be classified as for-profit businesses rather than hobbies, based on evaluating the factors listed in this analysis. So there is often reason for hope. That said, the hobby loss issue has been a hot issue for the IRS, and the TCJA change adds fuel to the fire. It’s important for your clients to be on the right side of as many of the factors as possible. You can help with that!
