Retirement may finally give you the free time you need to pursue your passions. But whether your pursuit is in the form of a business or a hobby makes a big difference come tax time.
If you launch or otherwise engage in a venture that combines elements of work and play and generates losses, you need to figure out whether your activity is a business or a hobby. Business losses are generally deductible on Schedule C of your federal tax return.
But there’s a double-edged sword on the taxation of hobby losses. Revenue from a hobby is taxable, but you can’t write off expenses. Through 2025, tax reform eliminates all miscellaneous itemized deductions previously subject to the 2% of adjusted gross income threshold. That includes hobby expenses.
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Taxpayers who report multiple years of losses on Schedule C, run an activity that sounds like a hobby, and have a lot of income from wages or other sources are a prime IRS audit target. So it’s no surprise that the hobby loss rules are often litigated in the Tax Court. The cases involve activities as varied as horse breeding, poker playing, flying antique fighter jets, collecting law enforcement badges, restoring old cars and hair braiding. The IRS usually wins hobby loss cases in court, partly because the IRS tends to settle cases in which it doesn’t believe it can prevail. But taxpayers have also pulled out a victory in a number of cases.
A Key Hurdle
The primary test in distinguishing between a business and a hobby is whether you engage in the activity with a profit motive. For an activity to constitute a business for tax purposes, it must be conducted with continuity and regularity and with the primary purpose of realizing income or profit. On the profit motive test, courts look to whether the taxpayer has a good-faith objective of making a profit. IRS regulations provide a safe harbor: If your activity generates profit in three out of every five years (or two out of seven years for horse breeding), the law presumes that you’re in business to make a profit, unless the IRS establishes otherwise.
If you can’t meet the safe harbor, the analysis of whether your loss-generating activity is a for-profit business gets more complicated because it’s based on each taxpayer’s facts and circumstances, with IRS and the courts generally taking nine factors into account (see below). The more years of large consecutive losses, the harder it is to demonstrate a profit motive unless the activity is still in its start-up stage. And the IRS is on the hunt for taxpayers who year after year use large losses from hobby-sounding activities to help offset other income.
No one factor is solely determinative, but some factors are routinely given more weight by the courts and are within a taxpayer’s control. For example, managing and operating your activity in a businesslike manner can be extremely helpful in demonstrating an honest intent to make a profit. Some tax professionals point to this as the most important of the nine factors.
What can you do to strengthen your case that you’re carrying on the activity in a businesslike manner? Open a separate bank account, and maintain good records. Keep supporting documents to substantiate all your expenses. Advertise or market your activity. Have a business plan and revise it as needed. Also, change operating methods or adopt new techniques to turn your venture around, and abandon unprofitable methods.
Other helpful factors to establish profit motive that are within your control: Ensure you have the knowledge, training or expertise to conduct the activity, or rely on the advice of industry experts. Also, devote substantial time and effort to the endeavor.
9 Factors IRS Analyzes
➜ Manner in which the taxpayer carries on the activity
➜ Expertise of the taxpayer and advisers
➜ Time and effort put into the venture
➜ Expectation assets used in activity may appreciate
➜ Success in carrying on other activities
➜ History of income and losses
➜ Amount of occasional profits
➜ Elements of personal pleasure or recreation one gets from the activity
➜ Whether the taxpayer has substantial income from other sources, such as wages or retirement income
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