The hobby loss rules limit the deductibility of expenses related to activities not engaged in for a profit; determining this is based on the facts and circumstances of each situation, but regulations under IRC Sec. 183 provide a safe harbor rule. If an activity turns a profit in three to five consecutive years, the safe harbor is met, and it is presumed to be a business instead of a hobby. Avoiding the hobby status means any losses generated by the activity can be used against other income on the tax return.
Prior to the passage of the Tax Cuts and Jobs Act (TCJA), if an activity was designated a hobby, expenses related to the hobby could only be deducted if the taxpayer itemized expenses to the extent those expenses and certain other miscellaneous itemized deductions exceeded 2 percent of the taxpayer’s adjusted gross income. With the passage of the TCJA, the 2 percent miscellaneous deduction was eliminated as an itemized deduction, meaning activities designated as hobbies are taxed on their gross income, with zero deductions allowed.
Given this rather draconian result, a closer review of the definition of a business versus a hobby is warranted. Beyond the safe harbor rule, the regulations spell out under Sec. 183 how the determination of hobby versus a business is made. While these other factors do not carry the certainty of a safe harbor, if proper documented action is taken, they may keep the taxpayer out of the hobby loss trap.
The regulations under Sec. 183 focus on determination of “profit motive,” making it clear that the probability of a profit does not dictate whether a profit motive exists. One example given in the regulations is that of an investor in a wildcat oil well, where the chances of a profit are low, but the potential payout is very high. The investor may not be likely to make a profit, but enters the endeavor with the intention of making a profit.
A taxpayer statement that they are entering an activity for profit is not sufficient to prove profit motive. Instead, greater weight is given to object facts. Several relevant factors are listed in the regulations:
- The manner in which the taxpayer carries on the activity. The carrying on of the activity in a businesslike manner and maintenance of books and accurate records may be proof that the activity is engaged in for a profit. Operating the activity in a manner similar to other profitable businesses can be proof of a profit motive. The regulations state that a change of operating methods can be viewed as an intent of profit motive. For a taxpayer trying to show a profit motive, it may be wise to meet with other profitable businesses and document any learnings and changes in operating procedures.
- The expertise of the taxpayer or their advisers. Preparation for the activity by extensive study and consultation with experts may indicate profit motive. If the taxpayer has extensive preparation and expertise, but does not comply with the standard practices of the business, it may be viewed as proof of lack of profit motive, unless the taxpayer is attempting to develop superior methods. Well-documented procedures and those that comply with industry standards may be helpful.
- The time and effort expended by the taxpayer in carrying on the activity. It is viewed favorably if a taxpayer spends a significant amount of time on the endeavor. The fact that the taxpayer devotes a limited amount of time to an activity does not indicate lack of profit motive if they employ a competent and qualified person to carry on the activity.
- Expectations that assets used in the activity may appreciate in value. A taxpayer’s “profit” expectation may include appreciation of the value of assets used in the activity, such as land. Use of this factor in proving profit motive hinges on whether the operation of the activity and the holding of the asset are considered separate or single activities. According to IRS publications, IRS auditors will compute the current operating income by taking gross receipts minus expenses, excluding depreciation and interest. If a loss results, they will assume the holding of the appreciating asset to be a separate activity, meaning the hobby loss rules apply. IRS publications also indicate that a taxpayer’s intention to retire on the property is evidence that no future gain will be realized, so as a result, hobby loss rules apply.
- The success of the taxpayer in carrying on other activities. It can be viewed favorably if the taxpayer previously engaged in similar activities and moved them from unprofitable to profitable.
- The taxpayer’s history of income or losses with respect to the activity. Start-up losses that extend beyond what is customary for the industry can be viewed unfavorably, unless extenuating circumstances such as a drought, fire, depressed market conditions, or something similar, can be shown.
- The amount of occasional profits, if any, that are earned. If the occasional profits are small and the losses large, a lack of profit motive may be presumed. This presumption may be offset, however, if the venture is highly speculative and the profits are only occasional, but large.
- The financial status of the taxpayer. It may be viewed as a profit motive if the taxpayer does not have substantial income or capital from other sources.
- Elements of personal pleasure or recreation. This factor gets very close scrutiny from the IRS, which will weigh the impact of personal pleasure or recreation from the activity based on an IRS examiner’s conversation with the taxpayer.
It is important to note that the burden of proof in all of the above is on the taxpayer. If the safe harbor rule is invoked, the burden is shifted to the IRS. If the taxpayer is in the first five years of an activity and would like to delay the determination of whether an activity is a business or hobby, they can file Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in for Profit. Since this form puts the IRS on notice that hobby loss rules may apply, in practice, it is best to only file this form after the hobby loss rules have been applied by the IRS. If the safe harbor rules cannot be used, specific and well-documented action on the part of the taxpayer may be of great benefit.