A hobby may be a profitable activity, without profit being the principal reason for engaging in the hobby. And a business may start out as a hobby and turn into a profitable activity. For U.S. federal income tax purposes, a distinction is made between a hobby and an activity you carry on with the expectation to make a profit. There are limits on the amount of hobby losses and deductions you can take for federal income tax purposes.
For tax purposes, a hobby is an activity you carry on without expecting to earn a profit. If you do earn a profit, it is taxable income. But losses from not-for profit activities cannot be used to offset other taxable income. These not-for-profit activities also include investment activities, or tax shelters, that are mainly intended to produce tax losses to offset other taxable income of the investor.
Determining Whether an Activity is for Profit or Not-for-Profit
Whether a hobby or other activity is being carried on for a profit will depend on the circumstances. One factor alone is not necessarily decisive, therefore all the facts should be taken into consideration. Some of the factors mentioned by the Internal Revenue Service (IRS) that contribute to determining that an activity is intended as a profitable venture as opposed to a not-for-profit hobby include the following:
You carry on the activity in a “business-like manner”, put in time and effort to make the activity profitable, and adapt the operation to improve profitability.
You depend on income from the activity for your livelihood.
Losses are normal in the start-up phase of the type of activity you are engaged in, or the losses are due to circumstances beyond your control.
You, or your advisors, have the knowledge required to turn the activity into a successful business.
You have been successful in generating a profit from similar activities in the past.
The activity does not consistently generate losses - in some years it has a profit. (Another factor will be the relative amounts of the profits and losses.)
You expect to be able to profit in the future from the appreciation of the assets you use in the activity.
Presuming that an Activity is for Profit
If an activity actually shows a profit, this may be the determining factor in establishing it as an activity engaged in for profit and not as a hobby or to generate tax losses. The IRS will presume that an activity is engaged in for profit if it has generated profits in 3 of the last 5 years, including the current year. The activity must be substantially the same each year in order to meet this test. For activities involving the breeding, training, showing, or racing of horses, the test is profitability in 2 out of 7 years.
If this test is met, the IRS will presume that the activity is engaged in for profit and the limitation on deductions and losses will not apply. You will be able to take all your allowable deductions for the activity in the future, even during years in which you have a loss.
Form 5213
During the first years of carrying on your activity (5 or 7 years, as applicable), until you meet the test for presuming that your activity is being carried on for profit, you can file Form 5213 with the IRS. Form 5213 is called “Election to Postpone Determination As To Whether the Presumption Applies That an Activity is Engaged in for Profit”. This will postpone an IRS determination that your activity is not being carried on for profit and therefore disallowing your deductions or losses related to the activity. By filing Form 5213 you are effectively gaining time to show that your activity can generate a profit and that your losses in the initial years should be allowable losses for tax purposes.
The benefit of filing Form 5213 is that the IRS will not question whether your activity is a not-for-profit activity during that period, and will therefore not immediately disallow the deductions and losses you claim related to that activity.
If at the end of the presumption period, you have met the test of profitability in either 3 out of 5 years, or 2 out of 7 years, as applicable, the deductions you claimed during that period will be allowed. On the contrary, if at the end of the presumption period, you have not shown the activity to have been profitable in the required number of years, the limitations on losses will be applied retroactively.
Filing Form 5213 automatically extends the period of limitations (the period for which the IRS can question your returns) for any year within the 5 or 7-year period to 2 years after the due date for filing a tax return for the final year of the presumption period. The period of limitations is extended only with respect to deductions for the activity in question and any related deductions that are affected, and not other, unrelated items reported on your tax return.
If you intend to use the presumption rule, you must file Form 5213 within 3 years after the due date for the first year in which you carried on the activity. But if before that time, the IRS has proposed disallowing deductions related to the activity, you must file Form 5213 within 60 days after receiving written notice from the IRS, in order to postpone the IRS determination.
The use of Form 5213 and the presumption test of 3 out of 5, or 2 out of 7 years of profitable activity is one way to show that your hobby or other activity is an activity that is engaged in for profit, but it is not the only way. If based on the other factors described above, you can support the fact that your activity should be considered as an activity entered into for profit rather than a non-profit activity, you can claim your deductions and losses related to the activity, and you should be able to defend your position in the event the activity is questioned by the IRS.
Limit on Deductions if Your Activity is Not-for-Profit
If your hobby or other activity is not carried on for profit, you can claim deductions in a certain order, and only if you itemize deductions on Schedule A of Form 1040.
The order in which deductions can be taken, and the extent to which they can be taken, are broken down into three categories, as follows:
Category 1: Deductions that you could take as itemized deductions whether they are personal or business expenses, are always deductible in full. These include mortgage interest on a home loan, taxes, and casualty losses. Deductions in this category are subject to the same rules that apply to personal itemized deductions.
Category 2: This category includes deductions that do not affect the basis of property, such as expenses for wages, utilities, advertising, insurance, and interest. Expenses in this category are deductible only to the extent there is gross income from the activity in excess of category 1 deductions.
Category 3: Business deductions that affect the basis of property, such as depreciation, and amortization are allowed last, but only if there is still gross income left to cover these expenses after taking the category 1 and 2 deductions. This category also includes casualty losses other than those in category 1.
If there is more than one asset on which depreciation or amortization is being taken, and there is not sufficient gross income left after taking category 1 and 2 deductions to cover the entire amount of depreciation, the remaining deductible amount available must be prorated based on the relative amounts of depreciation on each asset.
Itemized Deductions
The deductions in category 1 are taken as itemized deductions in the corresponding categories on Schedule A (mortgage interest, taxes, casualty losses). The deductions in categories 2 and 3 are taken as miscellaneous itemized deductions subject to the 2% of adjusted gross income limit.
Example
You have a small farm that you run as a hobby. You had gross income of $7,600 for the year. Your expenses related to your farm were mortgage interest of $3,000, real estate taxes of $1,500, materials and supplies of $2,000, maintenance expense of $500, insurance expense of $200, utilities expense of $100, depreciation on a tractor for $400, and depreciation on machinery of $200.
Your total expenses related to the not-for-profit activity are $7,900, resulting in a net loss of $300. Your deductions are limited to $7,600, the amount of your gross income. Since the activity is not-for-profit, you cannot report a loss.
Your category 1 deductions are $4,500, the home mortgage interest of $3,000 plus real estate taxes of $1,500, which would be itemized deductions in any case.
Your category 2 deductions are $2,800, the materials and supplies, maintenance, insurance, and utilities. You can deduct these expenses in full because the total of the category 1 and category 2 expenses ($4,500 + $2,800 = $7,300) is still below the maximum allowable deduction amount of $7,600.
That leaves a total of $300 for category 3 expenses (that affect the basis of assets), the total allowable deductions of $7,600 minus category 1 expenses of $4,500 and minus category 2 expenses of $2,800.
The category 3 expenses of $300 are allocated as follows:
Depreciation on tractor = $400 / $600 (total depreciation) x $300 = $200.
Depreciation on machinery = $200 / $600 x $300 = $100.
More Than One Activity
If you are carrying on two or more activities, whether for profit or as a hobby, you should keep track of revenues and expenses by activity. You can then figure the net income on each activity separately, and if an activity is not-for-profit, you will be able to determine the limits that apply on that activity.