If you receive income from a hobby (a not-for-profit activity), it is taxable, but you can only deduct your expenses related to that hobby to the extent of the income. Moreover, because the deduction is a miscellaneous itemized deduction taken on your Schedule A, it will be subject to an adjusted gross income limitation. Any losses realized from a hobby are considered personal losses and thus not deductible, while losses from for-profit activities are generally fully deductible. For this reason, the IRS will look closely at an activity you claim to be for-profit if that activity continuously shows losses.
What Is a “For-Profit” Activity?
If an activity you are engaged in shows a profit for a minimum of three out of the last five years, this activity will be presumed by the IRS to be engaged in for-profit.
Caution: If the activity is related to the breeding, racing, showing, or training of horses, you must show a profit in two out of the last seven years to be presumed to be in a for-profit activity.
Is the “For-Profit Test” Automatic?
No. The fact that you make a profit on an activity for the minimum three out of five years (or two out of seven for horse-related activities) does not automatically mean the IRS will treat the activity as engaged in for profit. In some cases, the IRS may claim the activity is still a hobby. In making a determination between profit and not-for-profit activity designation, the IRS will look at questions and issues such as the following:
- Do you run the activity like a business (keeping records, setting up a business bank account, and the like)?
- How much time do you spend on the activity?
- How much personal pleasure or recreation does the activity provide you?
- Do you expect that the assets related to the activity will increase in value?
- What is your overall financial status? For example, if you have income, especially a lot of income, from other sources, it may lead the IRS to the assumption that this activity is not for profit.
- Have you made a profit before in similar activities?
- What degree of expertise related to the activity do you have?
- Do you hire experts in the field to advise you in the activity?
- Is it normal to have losses for a number of years in the start-up phase of the type of activity/business you are engaged in?
What if the IRS Disallows Your Claim of For-Profit Activity?
If the activity suffers losses in the first number of years you are engaged in it, the IRS may not allow you to deduct them, claiming they are nondeductible hobby losses. In such a case, you can file an election on a Form 5213 to delay the determination of whether the activity is for-profit or a hobby. If you do so, the determination is delayed until after the fourth taxable year (sixth, for horse-related activities) after the year you began engaging in the activity.
Example(s): Suppose you began buying and selling sports memorabilia in 2009 and have suffered losses in each year since. You file a Form 5213 election to delay the determination of whether this activity is for-profit or a hobby. The determination won’t be made until after 2013. If you then can show that you made a profit in at least three of the five years (2009-2013), the presumption that your activity is for-profit will apply.
Caution: By filing a Form 5213, you automatically agree that the statute of limitations on issues related to the activity is extended for two years, which means the IRS may be able to collect additional taxes (if it disallows the losses as hobby losses) for two additional years.
Caution: Recognize that if you do file a Form 5213 delay of determination, the following may occur:
- You are almost guaranteeing that the IRS will look extremely closely at your tax returns related to this issue
- There is a good chance the IRS will reach the same determination they originally did, or would have, reached—that the losses are nondeductible hobby losses
Accordingly, before filing a Form 5213, consult with your accountant and/or tax attorney.
How Long Do You Have to Elect the Delay?
You can file a Form 5213 anytime within three years of the due date for filing your tax return for the year the activity began. For example, if you started to buy and sell sports memorabilia in 2009, you would have until April 15, 2013 to file a Form 5213.
Caution: If you receive a notice from the IRS disallowing a loss deduction you took because it has determined your activity is a hobby, you have 60 days from your receipt of the notice to file a Form 5213 (although this 60-day period does not extend the three-year period described previously).
How Do You Handle Deductions for an Activity that Is Not-For-Profit?
If, either due to your decision or because the IRS later challenges your return, the IRS determines your activity is not engaged in for profit, then you deduct expenses related to the activity as follows:
- First, you deduct (against income you received from the activity) expenses that would be deductible in full whether or not the activity is for-profit (e.g., mortgage interest payments and taxes)
- Next, if income still remains, you can deduct operating expenses, such as utilities, advertising, and maintenance
- If assets in the activity are depreciable, you can deduct depreciation up to the amount of any remaining income
- Any remaining expenses in excess of the above deductions are considered personal losses and therefore are not deductible
Caution: Because these deductions must be taken as miscellaneous itemized deductions on your Schedule A, Form 1040, they are subject to the 2 percent adjusted gross income floor and, as a result, are further limited.
Caution: In 2013, itemized deductions are subject to phaseout based on adjusted gross income.
If you have questions or need assistance, contact the Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
