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.