Is your activity a business or a hobby? It’s important to know because if the IRS views your activity as a hobby rather than as a business, your tax deductions for business-type expenses are subject to certain limitations.
Business Versus Hobby
To qualify as a business, an activity must be conducted for the primary purpose of making a profit. Factors that are considered in determining whether you have a profit-making objective include:
- How the activity is conducted
- Your expertise and that of any advisors
- The time and effort put into the activity
- Whether you expect that assets used in the activity will appreciate in value
- Your success in other similar or dissimilar activities
- Your history of income/loss with respect to the activity
- The amount of any profit
- Your financial status
- The presence of personal pleasure or recreation
- Generally, the IRS presumes that an activity qualifies as a business if it shows a profit for three out of the last five years.
What’s Deductible?
If your activity is considered a hobby, two rules limit the amount of expenses you can deduct. First, your deduction for hobby expenses (such as rent and advertising) cannot exceed the activity’s gross income. So if your hobby income is $5,000 but your expenses are $6,000, you may take only $5,000 in expenses. You may not use the additional $1,000 to offset other income.
Second, hobby expenses are deductible only to the extent they (when combined with other miscellaneous expenses) exceed 2% of your adjusted gross income (AGI). So in the example above, if your AGI was $100,000, you would be able to deduct only $3,000 of the $5,000 in expenses.
Running your activity in a businesslike way can help you avoid the hobby-loss restrictions. Connect with our Orange County, CA CPA Firm at 949-759-5626 for all the latest and most current tax rules and regulations.