Art, Craft, or Business? A Business of Hobby Loss Rules

Art, Craft, or Business? A Breakdown of Hobby Loss Rules

Reading, exercise, fishing, art, gardening… we all have hobbies, and we usually aren’t thinking about tax law as we do them. However, the IRS takes a more technical approach. The rules around income and hobby loss can be complex, but let’s start with the basics: what is a “hobby?”

What does the IRS consider a Hobby?

According to IRS Tax Tip 2022-57, a hobby is “any activity that a person pursues because they enjoy it and with no intention of making a profit.” While this seems straightforward on the surface, as a hobby grows the line at which it turns into a business being to blur.

To help simplify this, the IRS has given an 11-item set of criteria to help taxpayers in making this determination. Answering “yes” to these questions would indicate a business activity, while “no” would indicate a hobby:

Does the taxpayer carry out their activity as if it were a business, maintaining accurate books and records?
Does the taxpayer put time and money into the activity in an effort to generate more profit?
Does the taxpayer depend on income from the activity?
Does the taxpayer have a profit motive for carrying out their activity, as opposed to personal motives (such as general enjoyment or relaxation)?
Does the activity generate enough income to fund itself, as opposed to the taxpayer needing income from other sources?
Are any losses normal for the start-up phase of such an activity?
Have there been changes to the methods of operation in an attempt to improve profitability?
Does the taxpayer have the knowledge necessary to carry out such a business?
Has the taxpayer had success in generating profits from similar activities in the past?
Does the activity generate a profit in most years?
Can the taxpayer expect to make a profit in the future due to appreciation of the activity’s assets?

No single criteria bears any more importance than another, but this guideline can still help taxpayers make the hobby vs. business determination. This brings us to our next question: how is hobby income taxed?

The Hobby Loss Trap

Prior to 2018, hobby expenses were considered “2% miscellaneous itemized deductions” – meaning, they could be included in your itemized deductions on Schedule A to the extend they exceeded 2% of your adjusted gross income.

As a result of the Tax Cuts and Jobs Act (TCJA) in 2017, all such 2% deductions are disallowed entirely until 2025. This has created what many call the Hobby Loss Trap. The new treatment of hobby expenses and revenue are as follows:

Expenses from a hobby are disallowed entirely.
Gross revenue from a hobby is subject to ordinary income tax. However, it is not subject to self-employment tax.

A taxpayer falls into the hobby loss trap when they partake in a hobby with a net loss but still end up having to pay tax due to an inability to deduct any expenses. These changes have brought about additional considerations that were rarely an issue before: is the lack of self-employment tax worth giving up the ability to deduct expenses? Is it worthwhile to start expanding your hobby into a business, or is an activity I am already treating as a business actually a hobby?

Conclusion

Hobby loss rules already required a lot of nuanced analysis before the TCJA, and now they require even more.

Reach out to Associate Manager Tyler Sauve, CPA for more information on hobby rules and whether taking a closer look at your hobby might benefits your unique tax situation.