Q&A With Bill: Are Expenses From a Hobby Tax Deductible?
After getting hit with an unexpected tax bill in 2018, a client recently decided she would start taking extra deductions by claiming expenses from her jewelry making hobby on next year’s tax return. While this may sound like a great idea, the Internal Revenue Service (IRS) has some pretty strict guidelines on what hobby expenses are considered deductible – and whether or not her “hobby” may actually be a legitimate business!
From painting and pottery to car racing and horse breeding, many people enjoy hobbies that put a few extra bucks in their pocket. However, taxpayers who make money from a hobby must not only report that income on their tax return, they must understand that many expense deductions available to actual businesses might not apply.
The first thing we would advise this client on was to determine whether her jewelry making was simply a hobby or perhaps something a bit more. To do that, we went through the following list of nine questions the IRS uses to make this determination:
Does she carry on her jewelry making in a businesslike manner and maintain complete and accurate books and records?
Does the time and effort she puts into her jewelry making suggest she intends to make it profitable?
Does she depend on income from her jewelry making for her livelihood?
Are any losses due to circumstances beyond her control (or normal in the startup phase of her type of business)?
If she's been losing money has she changed her methods of operation in an attempt to improve profitability?
Does she or her advisors have the knowledge needed to carry on her jewelry making as a successful business?
Was she successful in making a profit in similar activities in the past?
Did her jewelry making turn a profit in 3 out of 5 consecutive years and if so, how much profit did it make?
Can she expect to make a future profit from the appreciation of the assets used in jewelry making?
The biggest tax limitation for a hobby is that you can’t deduct a loss from its activities. Most hobbies come with some sort of expense – be it equipment, supplies or educational fees. But the law says you can’t deduct those expenses beyond the amount of income you generate from your hobby.
For example, in the case of our jewelry maker, her supplies (metals, beads, tools, etc.) obviously cost money. Until she starts making some money from her jewelry, she can’t deduct these expenses on her tax return. However, when she starts to make money, she can deduct these expenses – but only up to the amount of income she generates from her jewelry. This means that until she starts to treat her hobby as a business, she won’t be able to claim a loss on her taxes.
Allowable Hobby Deductions. In general, you are allowed to deduct ordinary and necessary hobby expenses (with certain limitations). An “ordinary” expense is one that’s considered common and accepted for the activity. A “necessary” expense is one that’s considered helpful and appropriate for the activity. Since a hobby is not a business, hobbyists are not entitled to the same tax deductions that businesses can claim. As a hobbyist, you can usually deduct your hobby expenses up to the amount of your hobby income. But any expenses that exceed your hobby income are considered personal losses and are not deductible from your other income.
Limits on Hobby Expenses. Generally, taxpayers can only deduct hobby expenses up to the amount of hobby income. If hobby expenses are more than its income, taxpayers have a loss from the activity. However, a “hobby loss” can’t be deducted from other income.
How to Deduct Hobby Expenses. In order to deduct your hobby expenses, you must itemize deductions on your income tax return. There are 3 categories of deductions that your hobby expenses may fall into, and these deductions must be taken in the following order:
Category 1: Deductions you can take for personal as well as business activities are allowed in full. For individuals, all non-business deductions (such as those for home mortgage interest, taxes, and casualty losses) belong in this category.
Category 2: Deductions that don’t result in an adjustment to the basis of property are allowed next, but only to the extent that your gross income from the activity exceeds your deductions under the first category.
Category 3: Business deductions that decrease the basis of property are allowed last, but only to the extent that your gross income from the activity exceeds your deductions from the first 2 categories.
As you can see, claiming expenses from a hobby can be a bit tricky. It’s also very important you understand the advantages and disadvantages of turning your hobby into a small business.
William D. Truax, E.A. and his friendly team of licensed tax preparers have been helping entrepreneurs and small business owners with their tax returns for over 40 years. He is admitted to represent taxpayers before the IRS and is also a member of the Bar of the United States Tax Court.
If you need assistance or have questions about what deductions you can claim for your hobby, please contact us today for a FREE consultation. We’re here to help!