Contributed by: Phillip FreeTaxUSA Agent, Tax Pro
Many hobbies can earn money. Whether you’re making handicrafts you’re able to sell, competing in an activity that awards cash prizes, selling animals you’ve raised, or creating YouTube videos while doing your favorite pastime, any activity that earns money and is done for enjoyment rather than for your livelihood can be considered an income-producing hobby.
Gross hobby income is reported as other income. The income is reported in our software by following this menu path: Income > Other Income and answering “Yes” to the question under the Hobby Income section. Unfortunately, hobby expenses are currently nondeductible (although they may be deductible up to the amount of your total hobby income if the Tax Cuts and Jobs Act of 2017 expires in 2025). Hobby income isn’t self-employment income and is only subject to income taxes.
Generally, you are the one that needs to decide if a money-making activity is a hobby or a business before you file your return. Guidelines have been provided by the IRS to help you make that decision. Follow the guidelines carefully since the IRS has a timing rule and can (although very rare) recharacterize a business into a hobby (thus limiting losses) if you don’t adhere to the rules and claim losses year after year.
Guidelines to make the decision if you have a hobby or business
The IRS provides several resources to help you make the right determination before you file your return, including the information in this list of questions and explanations. Here are some factors to consider with answers that may indicate you have a business (B) vs a hobby (H).
- Is the activity conducted like a business?
- B) You maintain complete and accurate bookkeeping and other business-type records. The activity is operated in the same manner as other profitable businesses doing the same activity.
- H) You usually just gather receipts and 1099 forms to know what the income and expenses were for the prior year.
- Do you change your methods of operation to improve profitability?
- B) There’s advertising or promotion to increase income potential. There’s analysis of business results, and changes are implemented to improve profitability. Work is being done to make business relationships that will improve income.
- H) Advertising isn’t needed as most work comes by word of mouth and the work is for the enjoyment of the hobby. If you have a paying customer, great! If not, you have something to do.
- What is your (or your advisors’) expertise in the activity?
- B) You’re well educated or proficient in the activity. If not, you’ve hired or contracted with advisors who are proficient. Accepted business methods are used in the activity, and / or the advice of advisors is implemented in a timely fashion.
- H) You’re learning as you go. You can’t really afford to hire help for this.
- Is the activity a main source of income?
- B) You spend a great deal of time and effort in the activity on a regular basis --especially if the activity isn’t usually considered recreational. You’re doing the activity full time (i.e., 40 hours a week or more) or part time (i.e., at least 20 hours a week). If needed, you utilize expert help to do the activity properly.
- H) You work 40 hours a week as a software engineer and do your activity on the weekends or more often as opportunities arise. You aren’t dependent on this income for your livelihood.
- Have you made, or do you have an expectation to make, a profit?
- B) You have done the activity as a business in the past and the activity was profitable. The profit expected is from working in the activity, and not in the appreciation of the assets related to the activity.
- H) You’re retired, but you always wanted to do this while you were working in your career.
- Is the activity profitable in some years?
- B) There would be net income if not for the depreciation of assets related to the activity. There’s a potential for (highly speculative) massive profits if successful.
- H) Doing this is expensive, and you usually spend way more money than you make.
- Are the losses expected in the early years of the activity, and are the losses out of your control?
- B) Most people doing this activity are still having losses. Profit is expected after a certain number of years. Losses are caused by weather conditions, and other natural problems with the activity. There was a series of a few good years in the past.
- H) You had hoped to start making a little profit by now.
- Does the activity have elements of personal pleasure or recreation?
- B) The activity is something you wouldn’t do if it weren’t for the money.
- H) This is your favorite activity, and you love doing this activity in your free time.
Remember, none of these questions alone are definitive, and all circumstances should be considered in making the decision whether to report a money-making activity as a business or a hobby on your tax return.
The timing rule
The IRS is cautious of taxpayers who claim deductions for an activity that it considers to be more of a hobby than a business. If they review your return and disagree with your choice to claim business income, they have a timing rule that allows them to recharacterize your business income and expenses as hobby income and expenses (making it so you can’t deduct your expenses or claim a loss).
The timing rule is based on the presumption that a business operates with the intention of making a profit. If the activity makes a profit in at least three out of the five prior years, then it will be viewed as a business.
This period may be extended to two out of the seven preceding years for activities involving the breeding, showing, or training of racehorses. If these criteria aren’t met, and your business claims a net loss for too many years, it may be classified as a hobby by the IRS.
The timing rule is generally only applied if the IRS audits your return or questions the income and expenses reported on your Schedule C. To avoid this, ensure you report the income accurately and keep good records.
Additional related articles:
Should I report my new business if I did not open for business this year?
I have a 1099-NEC with nonemployee compensation, but I don't have a business. Why do I need a Schedule C?
What records do I need to keep for business expenses?
