By James T. Connolly, CPA, Partner
What would life be like without hobbies? Most of us have at least one or more. Many enjoy fishing, golf, horseback riding, photography or birdwatching. Hobbies enrich our lives and provide rest and relaxation apart from our work and careers.
You may be asking, “What could these hobbies possibly have to do with taxes?” I’m glad you asked! The answer is quite a bit, actually. There is an entire Internal Revenue Code Section (Section 183 “Activities Not Engaged in for Profit”) dedicated to the so-called “hobby losses” topic. The problem is that the phrase “hobby loss” is a little bit of a misnomer. When the Internal Revenue Service (IRS) says ‘hobby losses’ (which in its legalese, it never really does), it isn’t thinking of birdwatching or golfing. It is thinking of “tax shelters.” Ugh. It is thinking about another way that some taxpayers attempt to shelter income through the creating of sham businesses that spit off losses.
IRC Section 183 substantially restricts the deduction for expenses in connection with such an activity. Unfortunately, the recent Tax Cuts and Jobs Act of 2017 (TCJA) only made things worse for tax years beginning in 2018. While there is a safe harbor under subsection (d) for activities making a profit in at least 3 of 5 years, the hobby loss rules are subjective and based on facts and circumstances. If you are not able to meet the safe harbor test, you must look to the underlying regulations and the nine ‘relevant factors’ provided in Regulation 1.183-2(b):
- Manner in which the taxpayer carries on the activity.
- The expertise of the taxpayer or his/her advisors.
- The time and effort expended by the taxpayer in carrying on the activity.
- Expectation that assets used in the activity may appreciate in value.
- The success of the taxpayer in carrying on other similar or dissimilar activities.
- The taxpayer’s history of income or losses with respect to the activity.
- The amount of occasional profits.
- The financial status of the taxpayer.
- Elements of personal pleasure or recreation.
“So, we simply need to apply the factors and whichever side comes out with the most is the winner, right?” Not exactly. The regulation explicitly states that these are not necessarily all of the factors and that it’s not a matter of adding them up and counting them. As the case may be, some factors may be more important than others.
Each year there are several court cases which unpack the above and provide additional clues as to how to avoid being tripped up by the hobby loss rules. Many of the cases go through the nine factors one by one in their analysis to determine whether an activity is a hobby or not. In addition to these factors, the courts consider whether the taxpayer has a ‘business plan’ and whether the taxpayer has taken additional steps in response to ongoing losses to change strategies in an attempt to become profitable.
If an activity is deemed “not engaged in for profit,” you end up with the worst of all scenarios: all income is taxable (IRC Section 61), and the expenses are either limited or disallowed. The former and current rules allow you to deduct items such as property taxes, which are allowed apart from the Section 183 rules. The problem is that these are now capped at $10,000 along with other state and local taxes.
Regarding other expenditures, prior to 2018, IRC Section 183 allowed deductions for these up to the point of any income earned less property taxes. The problem here is that these were considered “Miscellaneous Itemized Deductions” and had to clear a separate 2% income hurdle before being deductible, and were treated as an addback for Alternative Minimum Tax calculations. For 2018 through 2025, the TCJA eliminated the deduction for Miscellaneous Itemized Deductions.
“What should I do?” First of all, consider the nature of your activity. The IRS internal audit guide lists the following activities as being more susceptible to being considered hobbies: fishing (actually listed twice, so watchout), farming, craft sales, dog breeding, gambling, direct sales, entertainers, horse racing, motocross racing, bowling (also listed twice), yacht charter, photography, airplane charter, horse breeding, auto racing, stamp collecting, artists, writing, and rentals. “Am I ok if my activity was not listed?” Absolutely not. Even if you do not have a ‘high risk’ activity, any activity generating consistent losses could pose a threat.
What should you do if you find yourself with an activity that generates regular losses? First of all, make sure you have a current business plan. It’s not foolproof, but it’s a start. Secondly, if you have been experiencing regular losses, you need to update and change your business plan and strategies. This shows that you are taking the losses seriously and are taking steps to stop them. You also need to review the nine ‘relevant factors’ listed above and see which ones you can change in your favor.
Most importantly, you need to take these steps today. Do not wait for the IRS to come knocking. It will likely be too late by then. There are too many court cases where the taxpayers were harmed by putting off addressing these issues. If you should need more information about these rules, please reach out to your trusted tax advisor.
James T. Connolly Tax Partner, CPA
James is a tax partner at our firm with over 25 years of experience in public and private accounting. With a background in auditing and private accounting, James has spent the last 19 years in the tax world working with small businesses and individuals to meet their tax compliance and consulting needs. While he […]