CARL WATTS & ASSOCIATES

July 30, 2018

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Is it a Hobby or a Business?
From scrapbooking to glass blowing, many Americans enjoy hobbies that are also a source of income. As a taxpayer, you must report income on your tax return even if it is made from a hobby. If you are not sure whether yours is a hobby or a business, here is some useful info regarding tax implications when your hobby generates income

A hobby is generally considered to be a regular activity that is done for enjoyment, typically during one's leisure time, and not as a main occupation.


Hobbies can include collecting themed items and objects, engaging in creative and artistic pursuits, playing sports, or pursuing other amusements. Any list of potential hobbies would be quite lengthy and always changing, as interests and fashions change. So, while some hobbies have become less popular, like stamp collecting, others have been created following technological advances, like video games.

Apart from the joy of engaging in a pleasant activity, hobbyists can acquire substantial skill and knowledge in their particular area, as well as substantial income. Which brings us to the subject of this newsletter, what if your hobby earns you money?

First of all, you need to determine if a certain activity qualifies as a hobby or a business. The main factors to consider are revealed by answering the following nine questions:

  1. Do you carry on this activity in a businesslike manner?

  2. Does the time and effort put into the activity indicate an intention to make a profit?

  3. Do you depend on income from this activity?

  4. If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?

  5. Have you changed methods of operation to improve profitability?

  6. Do you or your advisors have the knowledge needed to carry on the activity as a successful business?

  7. Have you made a profit in similar activities in the past?

  8. Does the activity make a profit in some years?

  9. Can you expect to make a profit in the future from the appreciation of assets used in the activity?


It is important to determine whether a certain activity is a hobby or a business enterprise because of the tax implications. You can take tax deductions on business income and not on hobby income, but, at the same time, you may have to pay higher taxes on it as well.

One key advantage of hobby income is that, since you are not running a business, hobby income is not subject to self-employment tax, you are only subject to your regular tax rates.

Because hobbies are not businesses, hobbyists have never been allowed to take the tax deductions to which businesspeople are entitled.

However, for decades the tax law did permit hobbyists to claim as an itemized deduction their hobby-related expenses up to the amount of income the hobby earned during the year. This was not a very generous deduction because of the limitations on itemized deductions, but it was better than nothing.

Unfortunately for people who earn income from hobbies, the Tax Cuts and Jobs Act completely eliminates the itemized deduction for hobby expenses, along with all other miscellaneous itemized deductions. The prohibition on deducting these expenses goes into effect for 2018 and continues through 2025.


This means that taxpayers will not be able to deduct any expenses they earn from hobbies during these years, but they still have to report and pay tax on any income they earn from a hobby!

The deduction is scheduled to return in 2026.

If you engage in an expensive activity like raising horses and want to be able to deduct your expenses, you should take steps to convert the activity into a business for tax purposes.

An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year.

The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.

If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death.

If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply.

You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.


If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.

You can elect to do this by filing Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.

The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years.

If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period.

Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.

Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories.

Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category.



Maybe not all hobbies are a form of art, but they are all a source of personal joy, and sometimes they become a source of income too. Remember, whatever the case may be, seek advice from a professional in all your dealings with the IRS.
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