So you have a passion for shoes, panache for fixing things, or joy from cooking grandma's dessert recipes. And you decide to fuel your passion/panache/joy, and pay your bills, by selling or shall we say 'sharing' your love with others. Let's take cooking for example. You bake a cake and decorate it for the neighbor's child. The neighbor pays you something for your troubles. You in turn buy more ingredients and bake another decorated cake for a different neighbor's holiday party. And the cycle continues. Is this a hobby, or is it an activity engaged in for profit? Does it matter? Well yes, it matters greatly to the IRS at tax time.
The IRS lists the following factors to determine whether your activity is engaged for profit or hobby:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity that makes a profit for at least three of the last five tax years including the current year is considered a business, or activity engaged in to make a profit. For those in the breeding, showing, training of animals business, or those who race horses, the hobby becomes a business when profit is made in two of the last seven tax years.
So, what does that mean? Well, when you are doing an activity to make a profit, but you have a loss in the tax year, then you may use that loss to offset other income. However, if you are doing an activity as a hobby, then you may deduct expenses up the amount of income received only. This means that you cannot generate a loss, and thus not offset other income streams on your taxes.
For hobby income, the expenses associated with it become itemized deductions on Schedule A. Restrictions do apply though.
And of course, hobby income received must be reported on your taxes. Even if it is from a hobby and even if you do not itemize and therefore do not deduct expenses associated with the hobby income. Online auction participants may fall under this rule as well and provide sticky situations for tax preparers who may not consider their online sales a business nor a hobby. Still not clear if you should file, please contact your local income tax preparation office for assistance.
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.