Tax breaks for hobbyists. Does your hobby qualify?

Hobbies provide a great way to unwind from your “day job.” They can also turn into second careers or side businesses for some. But be aware: When your hobby produces income, you owe tax on it.

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The Internal Revenue Service (IRS) defines a hobby as an activity you pursue without expecting to make a taxable profit. To put it simply, you do it for enjoyment—not money. However, if you are involved in an activity with the expectation of making money on it, the IRS will consider it a business. For instance, you’ll probably never make a living playing recreational softball, even with corporate sponsors and prize money. But if woodworking is your thing, you have opportunity to sell what you build. Or, if you like to fly small unmanned aircraft (or drones) in your spare time, new Federation Aviation Administration regulations are making it easier to put your equipment and skills to commercial use.

The good news is, if you are earning money through your hobby, you can reduce your taxable hobby income by deducting your hobby expenses. Or, you can turn your hobby into a business and deduct even more.

How to deduct hobby expenses

  • You can deduct hobby-related expenses up to the amount of money you earn on the hobby.

  • To do so, hobby expenses, along with other miscellaneous expenses you itemize on Schedule A (Form 1040), must amount to more than two percent of your adjusted gross income (Form 1040, line 38).

How to turn a hobby into a business

If you find you are regularly making money from your hobby, it might be to your tax advantage to turn your passion into a business. To do this, you’ll want to operate as a sole proprietor and report the income on your Form 1040 tax return. This way, you’ll have more options when it comes to deducting your expenses, such as:

  • Deducting expenses directly from your income on Schedule C or C-EZ without worrying about the minimum two-percent of income limitation.

  • Deducting overall business losses (when related expenses exceed income) in the years you don’t turn a profit—which, in turn, helps reduce your other income to lower your tax bill.

  • Deducting a home office used for administrative chores related to your hobby.

To determine if your hobby qualifies as a business, ask yourself this: Have you earned money on the activity in three out of five years, including the current year? If so, you’ve got yourself a business!

If you are still unsure, the IRS advises you to answer the following questions:

  • Did you carry on the activity in a businesslike manner? (This includes detailed bookkeeping and promoting your business.)

  • How much time and effort do you devote to making your hobby profitable?

  • Do you depend on income from the activity for your livelihood?

  • Are your losses due to circumstances beyond your control or are they normal for a business in its startup phase?

  • Do you change your methods of operation in an attempt to improve profitability?

  • Do you (or your advisors) have the knowledge and background necessary to run such a business successfully?

  • Were you successful in making a profit in similar activities in the past?

  • Did your hobby make a profit in some years and, if so, how much?

  • Do you expect to make a future profit from the appreciation of the assets used in the activity?

Your answers should make obvious whether your fun pastime has turned—or is turning—into a taxable business venture. If you have further questions about your hobby-related income and taxes, feel free to contact us.

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Brady Ramsay

About Brady Ramsay

Brady is the owner of Ramsay & Associates. He specializes in financial statement preparation and personal, fiduciary and corporate tax and accounting. His professional experience includes seven years' experience for local and national CPA firms before joining Ramsay & Associates in 2006. He has a Bachelor of Accounting degree from the University of Minnesota Duluth. He is a Certified Public Accountant, a member of the Minnesota Society of CPA's, an Eagle Scout, as well as an active volunteer in the community.