From the Nolo Business & Human Resources Center
Hobby Business Tax Rules
Be ready to prove that your hobby is a business if you
want to write off your losses.
Often a person's hobby or sideline business is a labor of love rather than a
reliable source of income. This is most often the case when the business owner
or freelancer has other means of financial support -- such as a regular job or a
working spouse -- that effectively underwrites the microbusiness. These types of
tiny businesses are usually run from home (renting an office would be too
expensive) and are often based on semi-recreational activities near and dear to
the owner, which has earned them the nickname "hobby businesses."
There are as many types of hobby businesses as there are hobbies. A basement
jewelry studio, a jazz band for hire, or an antique refinishing business might
all qualify. The owners would probably continue to make jewelry, play jazz, or
restore antiques without making money, but they are trying to turn their hobbies
into profitable businesses -- or at least deduct their hobby-related expenses or
losses from their income to lower their tax bill!
Deducting Hobby Losses From Your Income
For most business owners, losing money for more than a year or so is a cue to
close up shop. But if you love what you're doing, it might make sense for you to
stick with your business even though it makes little or no money. That's because
an unprofitable business can be a tax shelter: If you have another source of
income, you may be able to use the losses from your hobby business -- including
your expenses and depreciation on assets you purchase -- to offset your other
taxable income. Deducting these losses can not only lower the amount of income
on which taxes are owed, but also drop you into a lower tax bracket.
The catch is that only bona fide businesses can deduct their losses from
their other income -- you're not allowed to deduct losses from your favorite
activities, only from a legitimate, profit-motivated business. If the IRS
decides that you are indulging a hobby rather than trying to earn a profit, it
won't allow you to deduct your business losses.
| Example |
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Reza earns a salary as a chef in a local restaurant, and his wife Kay has no
outside income. They file a joint tax return. Kay has a passion for plants, and
decides to try making a business of selling some of the hundreds of plants she
grows and propagates in her backyard greenhouse. After she spends thousands of
dollars on exotic plants, better lighting equipment, and permits, the greenhouse
heater goes on the fritz and many of her plants die. Her expenses for the year
total $10,000, and she has sold only $200 worth of plants.
The silver lining for Kay and Reza comes at tax time, when they deduct the
$9,800 loss from their joint taxable income of $65,000. By reducing their joint
taxable income to $55,200, they not only are taxed on less income, but their tax
bracket is reduced from 25% to 15%.
Here's the catch: If Kay had not intended to make a profit -- that is, if she
wasn't trying to run a business -- the IRS would not have allowed Kay to use the
loss to offset any income, except against the $200 revenue she received from
plant sales.
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