Do you have a hobby that actually makes you some money? Perhaps you craft and sell jewelry or pottery, blog about travel or help friends breed dogs.
Did you know that hobby income is taxable?
Before 2018, any expenses associated with a hobby were deductible – subject to certain limitations. Unfortunately, the 2017 Tax Cuts and Jobs Act eliminated the hobby expense deduction but retained the income reporting requirement.
Not fair, you say? Go complain to Donald Trump.
But there is a way to start getting those deductions again. Simply report your hobby as a business. That would allow you not only to reduce taxes on the hobby income, but also possibly even deduct hobby losses from your overall taxes.
Sound enticing?
Be careful.
The key difference between a business and a hobby is that the business is expected to make a profit. The IRS does not appreciate taxpayers pretending their hobbies are businesses just to be able to write off the expenses. So, before taking such a step, be aware of nine factors the IRS will consider in determining whether or not you are operating a truly qualified business.
1. Do you operate the business in a businesslike manner and maintain complete and accurate books and records?
2. Can you demonstrate domain expertise in being able to profitably operate such a business?
3. Do you spend a significant amount of personal time and effort in the business?
4. Is there an expectation that assets used in the business may appreciate in value?
5. Have you profitably engaged in similar businesses in the past?
6. If there are losses, are they occurring for a shorter period of time than what is customarily needed to bring such a business to profitability?
7. Are profits becoming substantially greater than losses over time?
8. Are you financially dependent on generating profits from the business?
9. Are you doing it more for income than for any personal pleasure or recreation?
The more “yes” answers, the better. To its credit, the IRS does not require you to be able to answer every one of these questions satisfactorily to prove your business is legitimate. And it understands that losses are common during the early years of a new business startup. But the bureau’s patience wears thin if losses drag on for too many years. It is especially unfriendly to taxpayers who, after incurring multiple years of losses without having achieved any profit at all, choose to exit the business. That’s a formula for getting hit with back taxes and possibly even fraud penalties.
If you can figure out a way to turn your hobby into a profitable business, by all means report it as such so that you can take advantage of all the tax deductions you’re legally entitled to. You can use the above questions as a guide to determine if the IRS will buy into what you’re doing. But just in case you do get audited, make sure to have a good supply of Tylenol available. (Whether or not you deduct the cost of the pills as a business expense is up to you.)
Los Altos resident Artie Green is a Certified Financial Planner and founder of Cognizant Wealth Advisors. For more information, visit cognizantwealth.com.
