Ask the Tax Editor: Is it a Hobby or a Business?

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Each week in our Ask the Editor series, Joy Taylor, The Kiplinger Tax Letter editor, answers questions on topics submitted by readers. This week, she's looking at four tax questions from readers pertaining to whether an activity is a hobby or a Schedule C business engaged in for profit. (Get a free issue of The Kiplinger Tax Letter or subscribe.)

1. Hobby income and expenses

Question: I like to knit hats. Lately, I have started selling some of the hats that I knit at craft shows. I have a full-time job, and my hat knitting is just a fun extracurricular activity that I engage in sporadically. It's not a business. Do I have to report the sales proceeds I get from selling my hats on my Form 1040? And can I deduct my expenses?

Joy Taylor: You will have to report the sales proceeds on your Form 1040. Since you said your hat knitting activity is not a business, but a fun activity that you engage in sporadically, the activity is likely considered a hobby. You would report your hobby revenue as other income on Schedule 1 of the 1040.

Unfortunately, you will not be able to deduct your expenses. The 2017 Tax Cuts and Jobs Act temporarily eliminated, through 2025, all miscellaneous itemized deductions previously subject to the 2%-of-adjusted-gross-income threshold. That includes hobby expenses. Last year's One Big Beautiful Bill permanently ended this tax write-off.

2. Hobby versus business

Question: My spouse and I both work full-time. I also have a dog-breeding activity that I run in my spare time. Can I deduct the losses from my dog-breeding activity on Schedule C of my Form 1040?

Joy Taylor: It depends. You can deduct the loss on Schedule C only if your dog-breeding activity is a business. The activity must be conducted with continuity and regularity in a businesslike manner, and you must have a reasonable, good-faith objective of making a profit from it.

If your activity rises to the level of a business, then yes, you can deduct the losses on Schedule C. If not, then you would report revenues from the activity on Schedule 1 of your Form 1040, and you cannot deduct your expenses.

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3. Hobby-versus-business factors

Question: What factors does the IRS look at in determining whether losses reported on Schedule C are from a business or a hobby?

Joy Taylor: The IRS and the courts look at many factors in determining whether the reported Schedule C activity is a hobby or instead rises to the level of a business/for-profit activity.

IRS regulations provide a safe harbor. If your activity generates a profit in three out of five consecutive years, or two out of seven years for horse breeding, the law presumes you're in business to make a profit unless the IRS establishes otherwise.

The hobby-business analysis is trickier if you can't meet the safe harbor. That's because the determination of whether an activity is properly categorized as a hobby or a business is then based on each taxpayer's facts and circumstances, with the IRS and the courts generally looking at the following nine factors:

Expertise of the taxpayer and advisers
Manner in which one carries on the activity
Time and effort devoted to the venture
Expectation that assets from the activity may appreciate
History of income and losses (the more years of large consecutive losses, the harder it is to show a profit motive, unless the activity is still in its start-up stage)
The amount of occasional profits
Success in carrying out other activities
Elements of personal pleasure or recreation
Whether the taxpayer has substantial income from other sources, such as wages or investment income

4. Audit red flag

Question: I keep reading that claiming losses on Schedule C from an activity that sounds like a hobby is an IRS audit red flag. Is this true?

Joy Taylor: Yes. Claiming large hobby losses on Schedule C is a perennial audit red flag. The IRS is on the hunt for taxpayers who year after year report large losses from hobby-sounding activities on Schedule C or F of the 1040 to help offset wages, business or investment earnings, or other income.

The hobby loss rules are often litigated in the Tax Court. When people think of hobby losses, horse, cattle and/or dog breeding generally comes to mind. Of course, the Tax Court has addressed those ventures. But other cases involve activities as varied as ecotourism, rodeo events, acting, writing and researching, flying antique fighter jets, poker playing, collecting law enforcement badges, donkey breeding and restoring old cars. The IRS usually wins these cases, partly because it tends to settle cases in which it doesn't believe it can prevail. But taxpayers have also pulled off a victory in a number of cases.

About Ask the Editor, Tax Edition

Subscribers of The Kiplinger Tax Letter, The Kiplinger Letter and The Kiplinger Retirement Report can ask Joy questions about tax topics. You'll find full details of how to submit questions in each publication. Subscribe to The Kiplinger Tax Letter, The Kiplinger Letter or The Kiplinger Retirement Report.

We have already received many questions from readers on topics related to tax changes in the One Big Beautiful Bill, retirement accounts and more. We will continue to answer these in future Ask the Editor roundups. So keep those questions coming!

Disclaimer

Not all questions submitted will be published, and some may be condensed and/or combined with other similar questions and answers, as required editorially. The answers provided by our editors and experts, in this Q&A series, are for general informational purposes only. While we take reasonable precautions to ensure we provide accurate answers to your questions, this information does not, and is not intended to, constitute independent financial, legal, or tax advice. You should not act, or refrain from acting, based on any information provided in this feature. You should consult with a financial or tax advisor regarding any questions you may have in relation to the matters discussed in this article.