Part of the joy of living an affluent life is having more free time to enjoy your personal interests, passions and hobbies, such as photography, woodworking, horseback riding, and the list goes on.
However, there’s an aspect of enjoying your favorite hobby (or hobbies) that you may not be aware of, and which could end up costing thousands of dollars, and causing far more stress than you bargained for: deducting hobby losses on your tax return.
According to the Law Offices of Jeffrey B. Kahn, whose principal Jeffrey Kahn is certified to appear before U.S. Federal tax court, the IRS has what it calls “hobby-loss rules.” These are nine factors the IRS uses to determine whether a hobby is also a legitimate business activity, and therefore eligible for valid deductions. These factors include:
- If a taxpayer treats the hobby like a business by (for example) keeping and updating a complete set of books, maintaining records to analyze and improve financial performance, etc.
- Whether a taxpayer is an expert and is therefore engaged as a professional (e.g. does a taxpayer just ride a hose, or does a taxpayer have the expertise/advisors to invest in a horse with the goal of generating profit in some manner?).
- The time invested by a taxpayer to carry out the activity. All else being equal, the more allocated, the more likely the IRS is to see it as a business activity than a hobby.
- The reasonable expectation of a taxpayer that their efforts will be profitable (this can include the expectation that assets will appreciate in value over time).
- The successful track record of a taxpayer in carrying on the same or similar activities.
- A taxpayer’s previous income or losses with respect to the same or similar activities.
- The amount of “occasional profits.” As indicated by this IRS bulletin, generally this means profits in three of the last five years. However, in some cases, even a single year of profitability can be a strong indication of legitimate business activity.
- Whether a taxpayer has other sources of income (which are being offset by the losses of the activity).
- The extent to which the activity has significant personal elements (i.e. recreational in nature or primarily delivering personal pleasure).
The Bottom Line
The IRS has decades of experience rooting out invalid, or in some cases, illicit hobby-loss deductions (they are particularly skeptical about anything involving horses and yachts). Your best advice is to consult with a qualified tax attorney before you file. You’ll sleep better at night!