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Because, if this activity you’re doing regularly in your own leisure time for pleasure turns a profit, then that is income and you have to pay taxes, it’s just as simple as that.
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It becomes a little more complicated when determining whether an activity is a business or a hobby.
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But don’t you worry, the IRS is there to provide us with rules and guidelines to help us determine if a certain activity qualifies as a hobby or a business!
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The main factors to consider are revealed by answering the following eight questions:
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- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from this activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can you expect to make a profit in the future from the appreciation of assets used in the activity?
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It is important to determine if an activity is a hobby or a business enterprise because of the tax implications.
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You can take greater tax deductions on business income than on hobby income, but, at the same time, you may have to pay higher taxes on it as well.
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One key advantage of hobby income is that, since you are not running a business, hobby income is not subject to self-employment tax, you are only subject to your regular tax rates.
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However, just like with reporting gambling losses and winnings, you can deduct hobby expenses to offset hobby income, but no more. You have to report hobby income and expenses separately on your tax return.
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If you dedicate a lot of time and resources to your hobby, it may be worth trying to qualify your activity as a business. It mostly comes down to profitability or the clear intent in making a profit.
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Hobbies are essentially not-for-profit activities, but if you conduct the activity in a business-like manner by keeping good records and searching for profit-making strategies, obtaining necessary local business licenses, opening a separate bank account and showing ongoing advertising and marketing, these are factors that prove your intent in making a profit.
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Washington DC
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tel/fax 202 350-9002 |
Is Your Hobby Profitable?
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The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year (at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses). And, by the way, it may be interesting to know that court decisions have declared drag racing, sailboat racing, and hosting fishing tournaments (among many other seemingly pleasurable activities) to be businesses instead of hobbies after evaluating some of the factors mentioned above.
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Also, apparently, nobody except a hobbyist would be willing to accept losses caused by unusual events and plain bad luck, as opposed to foreseeable ongoing losses that an experienced business person would include in their planning.
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If you have a high level of income you can more easily afford ongoing expenses and losses that usually incur with a hobby. If you’re one of the ordinary folks, the IRS considers you more inclined to make a profit, which indicates that you may have a business, not just a hobby.
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If you prefer to maintain the status of your activity as being a hobby and not a business, then here is what the IRS expects you to do.
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Hobby income must be reported on line 21 of Form 1040. You also need to write the description on that line and in this case you need to write “hobby income.”
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Hobby expenses are only deductible if you are itemizing your return. This means that if you are just claiming the standard deduction, then you cannot deduct any of your expenses at all.
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We mentioned this before, but it is worth reiterating, you can only deduct expenses up to the amount of the income. So, if the expenses exceed the income, you cannot claim the excess expenses on your tax return.
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Hobby expenses are included as part of the Miscellaneous Expenses and are subject to the 2% Adjusted Gross Income limitations.
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Let us not forget that even deductible hobby expenses must be ordinary, necessary and directly related to your hobby.
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If that is the case with your hobby related expenses, you must report them on Schedule A line 23 and write hobby expenses as the appropriate description.
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Maybe not all hobbies are a form of art, but they are certainly a source of personal joy, and it can’t hurt if they become a source of income either.
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