The author would like to thank Andy Almonte, a JD candidate at the University of Maine School of Law, for his assistance with writing this article.
If you’ve ever been unsure about how and when to take deductions for expenses related to a side hustle or hobby, you’re not alone. The rules surrounding this topic are complex, and the analysis is heavily fact dependent.
This article provides an overview of the Hobby Loss Rule, explains how the Internal Revenue Service (“IRS”) determines whether deductions may be taken for expenses paid or incurred in conducting an activity, and addresses the impact of the Tax Cuts and Jobs Act of 2018 (the “TCJA”) on the deductibility of such expenses.
The Hobby Loss Rule
United States taxpayers are required to report all income from whatever sources derived. This includes payments received in connection with their hobbies. Section 162(a) of the Internal Revenue Code (the “Code”) permits deductions against income for the ordinary and necessary expenses paid or incurred in carrying on a “trade or business.” Code Section 183, the so-called “Hobby Loss Rule,” clarifies that not all activities that result in income qualify as a “trade or business” and prohibits taxpayers from taking deductions against income for expenses related to activities “not engaged in for profit.” Therefore, it is critical for taxpayers not only to be aware of the Hobby Loss Rule but also to consider whether it prohibits them from taking deductions for expenses paid or incurred in conducting a side hustle or hobby.
The Hobby Loss Rule provides criteria that helps taxpayers determine whether an activity qualifies as a “trade or business” under Code Section 162(a) or whether it amounts to an activity “not engaged in for profit” under Code Section 183. Whether an activity is undertaken with a profit seeking motive is a question of fact, without regard to what the taxpayer believes in their heart about their motives for engaging in such conduct. The Code identifies nine factors, which the IRS uses to determine whether an activity is undertaken with for-profit motives. These factors are: (1) the extent to which the taxpayer carries on the activity in a businesslike manner; (2) the taxpayer’s expertise or reliance on the advice of experts; (3) the time and effort the taxpayer expends in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the taxpayer’s success in similar activities; (6) the taxpayer’s history of income or loss from the activity; (7) the amount of occasional profits, if any; (8) the taxpayer’s financial status; and (9) the elements of personal pleasure or recreation. Thus, when a taxpayer is preparing their annual income tax return and considering whether they are able to take deductions for expenses paid or incurred in conducting an activity, they must consider the facts and circumstances of their conduct against these nine factors.
Code Section 183(d) introduces certain “safe harbors” that, if met, presume an activity to be engaged in for profit. Under the first safe harbor test, an activity is presumed to be operated for profit if it generates profit for three or more of the five most recent consecutive taxable years. It’s important to note that the IRS can rebut these presumptions if the overall facts and circumstances of a taxpayer’s activities warrant doing so.
Impact of The TCJA
The TCJA introduced substantial modifications to the deductibility of expenses incurred in conducting hobbies. Prior to the TCJA, taxpayers could take deductions for expenses incurred in conducting hobbies as Miscellaneous Itemized Expenses even in circumstances where the taxpayer’s conduct did not demonstrate a for-profit motive to the extent required to satisfy the Hobby Loss Rule. The TCJA suspended Miscellaneous Itemized Deductions for tax years 2018 through 2025, and, therefore, taxpayers may not take deductions for hobby-related expenses during this period, rendering the recognition of profit motives even more critical.
The Hobby Loss Rule establishes a practical standard for differentiating business activities from hobbies, and the safe harbor rules offer a degree of predictability. However, it’s important for taxpayers to be mindful of these rules and consult with their tax advisors if they are unsure about how to report expenses paid or incurred in carrying out their hobbies.