It’s my annual “Taxes from A to Z” series! If you’re wondering whether you can claim home office expenses or whether to deduct a capital loss, you won’t want to miss a single letter.
H is for Hobby Loss Rules.
At tax time, some choices are easier than others. That form W-2, for example? That almost always means that you’re an employee and you’ll report that income on line 1 of your tax return.
But what about that form 1099-MISC? Or that form 1099-K? It’s not always obvious where to report income that you receive throughout the year through freelancing, a side hustle or a part-time gig. And while it may be tempting to guess (Income is income, right?), it’s important to understand not only what it means to you but where to report it – because the tax consequences can be very different depending on your answer.
Business income is reported on a Schedule C and is subject to self-employment tax.
Hobby income is reported on line 21 as other income (like found money) and is not subject to self-employment tax. But that’s not the only distinction. What tends to set a hobby apart from a bona fide business is this: If you earn income in the pursuit of a hobby, you can offset the income with deductions but you cannot claim deductions that exceed your income – there’s no loss for a hobby. If, however, you earn income in the pursuit of a business, you can offset the income with deductions – and take advantage of any excess. These rules are called the “hobby loss rules.”
I know what you’re thinking: You don’t want to focus on losing money, you want to make money. That’s a good start. The Internal Revenue Service (IRS) considers profit motive a primary consideration when determining whether you’re engaged in a hobby or a business. But statistically, not everybody makes money with a new venture. Many businesses spend more than they make when they’re just getting started. If you lose money, it’s useful to be able to offset income with those losses.
Here’s an example.
Let’s say that you make $5,000 in your side hustle as a dog walker. Let’s say that you spent $7,000 in the first year on advertising, accounting fees, insurance, and other costs.
If dog walking is your hobby – and not a business – you report the $5,000 as other income (line 21). For 2017, you can claim up to $5,000 of your expenses (that’s the amount of your income). That’s the good news. But that “extra” $2,000 in expenses is lost forever. Additionally, you can only claim expenses if you itemize your deductions on Schedule A, where many expenses may be considered miscellaneous deductions subject to the 2% of your adjusted gross income (AGI) floor.
(Note that the calculations could be very different in 2018 because of Schedule A changes following tax reform.)
If, however, dog walking is your business, you report the $5,000 as other income on a Schedule C. You can claim all of your expenses, or $7,000. You don’t need to itemize to claim the expenses and the expenses are not limited by your reportable income.
Sounds like being a business is generally more tax-favored, right? Before you paint your front door red, you should familiarize yourself with some key factors that IRS considers in the hobby versus business equation:
- Your business manner. Do you keep good records? Do you work at promoting your business? A real business runs like a business.
- How much time and effort you spend. Only spending minimal time and effort on your business sends a message that you may not be serious.
- Your expertise. How much do you know about your business? Trying your hand at something new isn’t a deal breaker but the more experience and education in the business you have, the more likely you are to be successful.
- Your track record. What success or failure have you had in other similar endeavors?
- Your financial picture. The IRS expects that you’re going to make money eventually. If you’re not, the IRS may question your profit motive. As a rule of thumb, you should show a profit for at least three of the last five tax years.
- Whether you change your business practices. When things aren’t going so well, business owners switch gears. Repeatedly doing the same thing while you’re losing money sends a signal that you don’t care about the long-term.
- The nature of your losses. Start-ups expect a few bumps. And sometimes, you have bad luck or bad timing (or both). However, losses that appear to be within your control can raise some eyebrows.
- Whether you expect your business to grow. In some industries, even when you’re not turning a profit, you have the potential to accumulate appreciating assets (real estate, for example). If you’re losing money and not banking assets, the IRS may question how you plan to sustain the business.
- How much fun you’re having. Weird, right? Believe it or not, the IRS does look at whether you enjoy yourself. There’s nothing wrong with liking what you do, but if you like it so much that it’s not really work (especially if you’re putting little effort into the business or not making money), you may be sending the wrong message.
You can find more details in the Regs at Section 1.183-2(b).
Running a business requires some effort and some serious record-keeping. When you’re successful, you’ll have extra cash to show for it, and when you’re not so successful, you can take advantage of those tax losses until you can bounce back.
But if your side hustle really is just that – a way to pick up some extra cash – and you’re not interested in growing it as a business, then don’t. Remember that so long as you make money, the federal income tax consequences are pretty much the same for a business as for a hobby (self-employment income notwithstanding). Don’t feel pressure to make it bigger than it is.
For your taxes from A to Z, here’s the rest of the series: