Hobbies are a great way to occupy your free time. If you’re lucky, you may earn a few bucks in the process and if you’re even luckier, you may earn enough to offset some or all the costs of your hobby. The IRS has strict rules about what is a hobby and what is a business and those rules matter now more than ever.
Before the Tax Cuts and Jobs Act (“TCJA”) you could deduct hobby expenses you incurred pursing your hobby up to the amount of earnings as a miscellaneous itemized deduction if your total miscellaneous itemized deductions exceeded 2% of your adjusted gross income (“AGI”). Now, things have changed.
What’s the difference between a hobby and a business?
Two words, profit intent. If an activity is conducted with a “for-profit motive” it is not, by definition, a hobby. If profit intent is absent an activity is considered a hobby and subject to the hobby loss rules under IRC Section 183. Put another way, generally people engage in hobbies for sport or recreation, not for profit. There is a statutory safe harbor that assumes profit intent based on the number of years an activity is profitable. Consult with your tax advisor to see if you meet that safe harbor.
The gray area.
Let’s be honest, there is a lot of gray area around what is or isn’t a hobby. The IRS has a long list of factors that need to be considered in making a final determination if an activity is a hobby or not. You can find that list summarized here. If you are unsure if your activity will be considered a hobby, you should consult with your tax advisor.
What hasn’t changed?
If you earn gross income relating to a hobby, the income is taxable. Any allowable expenses are limited to the gross income earned from the hobby. If you sell goods as part of your hobby, cost-of-goods-sold is deductible, subject to the gross income limitation.
What changed with TCJA?
The TCJA suspended miscellaneous itemized deductions until 2026, removing the ability to deduct hobby activity expenses, other than cost of goods sold.
Prior to the TCJA there was limit on non-cost-of-goods-sold deductions for hobby activity expenses incurred in pursuit of a hobby. Specifically, those expenses were claimed as miscellaneous deductions on Schedule A (itemized deductions) and this were only deductible if they did not exceed the gross income from the activity and you 1) itemized your deductions and 2) could overcome the 2%-of-adjusted -gross-income limit on miscellaneous itemized deductions.
Tax Warrior Perspective
If your activity fits firmly in the “gray area” and you believe you could structure it to more clearly show profit intent, now is a good time to establish that profit motive. Why? Expenses incurred for an activity engaged in for profit are deductible and reduce your ordinary income, while expenses incurred for a hobby no longer have a chance at deductibility after TCJA.
Some of the factors the IRS will consider when determining if you have a profit motive for your activity are: your level of expertise, the time and effort put into the activity, and your history of income and expenses from the activity. Although no one factor is more important than another, the IRS will look at all of them collectively to determine if you have profit intent.
While changing the status of your hobby to a business seems like an easy way to receive a tax benefit from your expenses, you should not simply assume the IRS will accept your new classification. You must make a careful assessment of your activity. We suggest reviewing in detail the IRS Regulations and drafting a memo (or having your tax advisor draft a memo) addressing each of the determinative factors and how they apply to your facts and circumstances. This memo should be kept in your tax files and reviewed annually for any changes that may apply.
Understanding the differences between a hobby and a business is crucial to determining if you can deduct the relevant expenses. At Drucker & Scaccetti we are here to help! Contact us if you have any questions or concerns regarding the impact of the TCJA on your hobbies!