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Hobby or Business

Date: 7/1/2017

Author: Financial Hotline

The IRS defines a hobby as an activity that is not pursued for profit. A business, on the other hand, is an activity that is carried out with the reasonable expectation of earning a profit. The tax considerations are different for each activity, so it’s important for taxpayers to determine whether an activity is engaged in for profit as a business or is just a hobby for personal enjoyment.

Of course, you must report and pay tax on income from almost all sources, including hobbies. But when it comes to deductions such as expenses and losses, the two activities differ in their tax implications.

If you’re not sure whether you’re running a business or simply enjoying a hobby, here are nine factors you should consider:

1. Do you carry on the activity in a businesslike manner?

2. Does the time and effort you put into the activity indicate you intend to make it profitable?

3. Do you depend on income from the activity for your livelihood?

4. Are your losses due to circumstances beyond your control (or are normal in the startup phase of your type of business)?

5. Do you change your methods of operation to improve profitability?

6. Do you, or your advisors, have the knowledge needed to carry on the activity as a successful business?

7. Were you successful in making a profit in similar activities in the past?

8. Does the activity make a profit in some years?

9. Can you expect to make a future profit from the appreciation of the assets used in the activity?

The IRS looks at all factors but the primary test is whether or not you made a profit. If you made a profit at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses) then your hobby can be considered a business.

If the activity is determined to be a business, you can deduct ordinary and necessary expenses for the operation of the business on a Schedule C or C-EZ on your Form 1040 without considerations for percentage limitations. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is appropriate for your business.

If an activity is a hobby, not for profit, losses from that activity may not be used to offset other income. You can only deduct expenses up to the amount of income earned from the hobby. These expenses, with other miscellaneous expenses, are itemized on Schedule A and must also meet the two percent limitation of your adjusted gross income to be deducted.

The following deductions can be claimed for a hobby as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order and only to the extent stated in each of three categories:

1. Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.

2. Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.

3. Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

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