Hobby or a Business?

Hobby or a Business – The IRS is Watching You!

Income from a hobby may be taxable incomeDid you know that if you earn income from your favorite hobby, you’re required to report it on your tax return? I didn’t think so. Most individuals aren’t aware of this and fail to report this income on their tax returns.

There are literally millions of American taxpayers that enjoy a hobby. Most of them, including myself, have only expenses connected with our hobbies. However, many others are able to generate a net profit.

As an example, let’s look at a coin collector. They may be fortunate and come across a rare coin they acquired at a very low cost. They sell the coin to another collector at a high price and this results in a net profit in their favorite pastime for the year.

The seller didn’t receive a Form 1099-Misc for this transaction, so there’s no need to report it, right? The IRS says yes, it must be reported on your tax return. In addition to the reporting requirement, there are special rules as to how it must be reported. Unfortunately, the rules aren’t in our favor.

One of the first questions that comes to mind is, if we have to report hobby income, then we must be able to deduct a loss? Nope. Wow, some of these special tax rulings can be very confusing. If you’re going to be involved in one of these spare-time activities that has a shot of making money, then set it up properly at the beginning. Once again, those special hobby rules come into play. Be certain that you are aware of the rules that are very special when it comes to a spare-time activity, and do your due diligence. Here are four informative tips that you need to consider if you have a hobby. If you have a spare time activity that generates income, be sure that you understand the rules, and comply accordingly. Should the IRS discover this during an audit, it could be very costly with interest and penalties.

A hobby versus a business enterprise

The IRS has published Publication 535 that lists nine various factors for you to determine if you are a hobbyist or involved in a legitimate business venture. As you read those factors, I would suggest writing them down. After each one, write an honest opinion based on the facts of your situation. Don’t change any facts and make your decision based on them.

Deductions allowable to a hobby

The IRS doesn’t like to get very specific, and uses generalization. They say that you MAY be able to deduct those expenses that are necessary and ordinary to that particular interest. Really clear isn’t it? They go on to say that an ordinary expense is one that is common and acceptable for your favorite pastime. An expense that is necessary is defined as one that is appropriate or helpful. WOW, how simple! You can do a search on the internet and will usually find various types of expenses that can be used for your part time activity. Other individuals that have been audited share their results.

Expenses are limited 

The IRS rules for a hobby say that you can deduct those allowable expenses only up to the amount of income generated. What this means is that if your expenses for this interest are more than your income generated, you have a net loss. That loss cannot be used as a deduction against other income on your tax return. In contrast, if you have a net business loss on a Schedule C, it can usually be deducted against other income on your return.

How to deduct allowable hobby expenses

This is where the “other shoe” drops. Income from your favorite pastime is reported on Line 21 on page 1 of your tax return. Your allowable expenses are reported on Schedule A under miscellaneous deductions, subject to the 2% floor. If your total deductions in this category aren’t high enough to get past the 2% floor, you lose them, and all of the spare-time activity income is taxed. The only break is that this income isn’t subject to the self-employment tax. In addition, the expenses for your activity may be classified into three types of expenses, and again, special rules apply. See Publication 535 for these special rules.

As you can see, the rules for hobbyists can be very complex, and to say the least, vague. If you have substantial income from your favorite hobby, I would suggest that you consult a qualified tax professional.

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