Beware of the Hobby Loss Rule

Barbara Weltman

As more people start sideline businesses in this tough economy to supplement their wages, create income protection if they lose their jobs, or just test the waters for a new venture, many are unaware of the IRS rules on the so-called hobby loss. This rule relates to deductions for business expenses in excess of income for an activity viewed as a hobby and can limit your write-offs.

Impact of the hobby loss rule

If the IRS determines that your activity is a "hobby," then deductoins for legitimate business expenses cannot be greater than the income from the activity for the year. The deductions can only be claimed as miscellaneous itemized deductions, not as business deductions, which means they must exceed 2% of adjusted gross income to actually be deductible (and they can't be deducted by those subject to the alternative minimum tax).

Income from a hobby activity remains fully taxable. Losses in excess of this income are lost and cannot be carried forward and used in future years.

Profit motive

Just because expenses exceed income from an activity doesn't automatically make the activity a hobby (after all, look at all the Fortune 500 companies experiencing losses today and they aren't hobby activities for their investors). To overcome an IRS charge that the activity is a hobby, plan to prove you engage in it with a reasonable expectation of making a profit ("profit motive"). You do this by showing:

  • Business plan: you have a formal plan explaining how and when you expect to show a profit
  • Books and records: you separate your business activity from you personal financial affairs, keeping good records of income and expenses (e.g., you use QuickBooks or another business accounting program for your recordkeeping) and retaining business-related receipts.
  • Bank account: you have a separate bank account and credit card for your activity and don't co-mingle your business finances with your personal finances.
  • Time and effort: you can demonstrate the time you devote to the activity and it's substantial.

Reliance on presumption

You can opt to rely on a presumption in the tax law that if you can show a profit in three of the first five years of operating the activity (two of seven years in the case of horse-related endeavors), you are presumed to have a profit motive and you don't have to prove anything to the IRS. However, filing the IRS form to rely on this profit motive virtually guarantees the IRS will examine your returns (the examination will be postponed until the end of the five-year or seven-year presumption period). Thus, it's usually not advisable to file the form, but talk this matter over with your tax advisor.

Home office deduction

Even if your activity isn't a hobby, your home office deduction can be limited if you are not profitable. The deduction for the year can't exceed "gross income" from the home-based activity. However, any excess amount can be carried forward and used in a future year in which there is gross income from a home-based business.

Barbara Weltman, author of several books including her most recent, 1001 Deductions & Tax Breaks 2009
Copyright 2009. All Rights Reserved.

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