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.