Hobby vs. Business: What’s the Difference?

Are you unsure whether your favorite pastime qualifies as a hobby or a business? It’s essential to understand the distinction because it can significantly impact your taxes. If your activity isn’t conducted as a for-profit business, expenses (other than the cost of goods sold) aren’t deductible. However, if it’s considered a business, you can deduct expenses and even offset other income with any resulting loss. Let’s dive into how you can determine whether your activity is a hobby or a business.

Determining Hobby or Business

Firstly, consider how you conduct the activity. Do you maintain complete and accurate records, and do you operate similarly to other profitable businesses in the same field? If you adapt your methods to improve profitability, this suggests you’re running a business.

Next, look at your expertise or that of your advisors. Do you possess substantial knowledge about the industry, or do you consult with experts? Applying this knowledge to make a profit points to a business.

Also, examine the time and effort you put into the activity. Spending significant time and effort, especially if the activity lacks substantial personal or recreational aspects, indicates a business. Even if you have another job, devoting considerable time to your activity shows a profit motive.

Additionally, consider whether the assets used in the activity might appreciate in value. If you expect assets like land to increase in value, leading to an overall profit upon sale, you’re likely running a business.

Your track record matters too. If you’ve successfully turned unprofitable ventures into profitable ones in the past, your current activity may also be a business, even if it hasn’t yet made a profit.

Moreover, your history of income or losses with the activity is crucial. Early losses during the start-up phase won’t count against you, but continuous unexplained losses after the customary start-up period might indicate a hobby. Profitable years, however, strongly suggest a business.

Furthermore, consider the amount of occasional profits. If you make small profits sporadically amidst large losses or significant investments, it might be a hobby. Conversely, substantial occasional profits amidst frequent small losses indicate a business.

Your financial status plays a role as well. If you rely on the activity for substantial income, you likely have a profit motive. However, if you have significant income from other sources and your activity generates substantial tax benefits through losses, it might be a hobby.

Lastly, evaluate the elements of personal pleasure or recreation in the activity. If the activity has a significant recreational or personal aspect and lacks profits, it’s probably a hobby. But if you derive little pleasure beyond possible profits, it suggests a business. Remember, enjoying the activity doesn’t automatically make it a hobby if other factors indicate it’s a business.

Presumption of Profit

The IRS presumes your activity is for profit if it’s profitable in three of the last five tax years, including the current year. For activities like breeding, training, showing, or racing horses, the presumption applies if you show a profit in at least two of the last seven tax years.

Reporting Hobby Income and Expenses

Reporting hobby income is straightforward. Occasional profits aren’t subject to self-employment tax and should be reported as Other Income on Schedule 1 (Form 1040). Hobby income equals gross receipts minus the cost of goods sold. Unfortunately, from 2018 through 2025, you cannot deduct operating expenses associated with hobby income.

IRS Examination

IRS examiners analyze several factors to determine whether an activity is engaged in for profit. They look at whether the activity has large expenses and little or no income, if losses offset other income on the tax return, if the activity generates substantial tax benefits, and if the activity has a history of profitability.

Common hobby activities include airplane charter, art, auto racing, bed and breakfasts, boating, bowling, collecting, cooking, craft sales, direct sales, dog breeding, entertainment, farming, fishing, fishkeeping, gambling, games, gardening, horse breeding, horse racing, jewelry making, knitting, motocross racing, music, outdoor recreation, photography, rentals, stamp collecting, woodworking, writing, and yacht charter.

Understanding whether your activity is a hobby or a business is crucial for tax purposes. By considering these factors and criteria, you can better determine your activity’s status and ensure proper tax reporting.

Please contact us with further questions.

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