Determining Whether an Activity is Subject to the Hobby Loss Rules

  • General Rule: Deductibility of losses is limited by the Hobby Loss rules only when the activity does not qualify as an activity engaged in for profit. A taxpayer must use Schedule C to report income and expenses from an activity qualifying as a business. An activity is a business when
    • The primary purpose is to gain income or profit and
    • The taxpayer is involved in the activity with continuity and regularity.
  • While the Regulations do not require a reasonable expectation of profit, the facts and circumstances must indicate that the taxpayer entered into the activity or continued the activity with the objective of making a profit it to be a “for-profit” business. This is objectively determined by weighing of factors. While there are many factors listed in the Regulations and IRS publications, the following appear to be the most critical:

    1)Making a profit from the activity in the past
    2)Time and effort put into activity indicate an intention to make a profit
    3)If there are losses, they were due to circumstances beyond your control or they occurred in the start-up phase of the business
    4)Changing methods of operation to improve profitability
    5)Having the knowledge needed to carry on the activity as a profitable business
  • Regardless of the above factors, an activity will be presumed “for-profit” by the IRS if the activity makes a profit in at least 3 of the last 5 tax years (including the current tax year).
  • If the activity is for-profit, then :
    • The expenses are not subject to the Hobby Loss Rules.
    • The income and expenses are reported as normal (i.e, on Schedule C).
  • If the activity is NOT for-profit, then:
    • The expenses are reported on Schedule A.
    • Expenses are subject to the special Hobby Loss Rules below.

Hobby Loss Rules:

General Rule: taxpayer can only deduct expenses from a not-for-profit activity to the extent of gross income of that activity. Expenses cannot be applied to income from any other activity.