40.10 Deducting Expenses of a Sideline Business or Hobby
There is a one-way tax rule for hobbies: Income from a hobby is taxable as “other income” on Form 1040; expenses are deductible only to the extent you report hobby income, and the deduction is limited on Schedule A by the 2% adjusted gross income (AGI) floor for miscellaneous itemized deductions. Hobby losses are considered nondeductible personal losses. A profitable sale of a hobby collection or activity held long term is taxable as capital gain; losses are not deductible.
Planning Reminder
How to deduct hobby expenses.
If the profit presumption discussed later does not apply and the activity is held not to be engaged in for profit, business operating expenses and depreciation are deductible only as miscellaneous itemized deductions and only up to the extent of income from the activity; a deduction for expenses exceeding the income is disallowed.
A special sequence is followed in determining which expenses are deductible from income. Deducted first on Schedule A are amounts allowable without regard to whether the activity is a business engaged in for profit, such as mortgage interest and state and local taxes, as well as casualty losses (after applying the dollar and percentage casualty floors (18.12)). These amounts are deductible in full on the appropriate lines of Schedule A without regard to income from the activity. However, they reduce gross income from the activity for purposes of figuring whether other deductions may be claimed. If after deducting these amounts from gross income there is any income remaining, “business” operating expenses such as wages, utilities, insurance premiums, interest, advertising, repairs, and maintenance may be claimed. Then deduct depreciation and excess casualty losses not allowed in the first step to the extent of remaining income. The “business” expenses, depreciation, and excess casualty losses are allowed only as miscellaneous itemized deductions subject to the 2% AGI floor (19.1). Thus, even if the expenses offset income from the activity, none of the expenses will be deductible unless your total miscellaneous expenses (including those from the activity) exceed 2% of your adjusted gross income.
Presumption of profit-seeking motive.
You are presumed to be engaged in an activity for profit if you can show a profit in at least three of the last five years, including the current year. If the activity is horse breeding, training, racing, or showing, the profit presumption applies if you show profits in two of the last seven (including current) years. The presumption does not necessarily mean that losses will automatically be allowed; the IRS may try to rebut the presumption. You would then have to prove a profit motive by showing these types of facts: You spend considerable time in the activity; you keep businesslike records; you have a written business plan showing how you plan to make a profit; you relied on expert advice; you expect the assets to appreciate in value; and losses are common in the start-up phase of your type of business.
Election postpones determination of profit presumption.
If you have losses in the first few years of an activity and the IRS tries to disallow them as hobby losses, you have this option: You may make an election on Form 5213 to postpone the determination of whether the above profit presumption applies. The postponement is until after the end of the fourth taxable year (sixth year for a horse breeding, training, showing, or racing activity) following the first year of the activity. For example, if you enter a farming activity in 2012, you can elect to postpone the profit motive determination until after the end of 2016. Then, if you have realized profits in at least three of the five years (2012–2016), the profit presumption applies. When you make the election on Form 5213, you agree to waive the statute of limitations for all activity-related items in the taxable years involved. The waiver generally gives the IRS an additional two years after the filing due date for the last year in the presumption period to issue deficiencies related to the activity.
To make the election, you must file Form 5213 within three years of the due date of the return for the year you started the activity. If before the end of this three-year period you receive a deficiency notice from the IRS disallowing a loss from the activity and you have not yet made the election, you can still do so within 60 days of receiving the notice. These election rules apply to individuals, partnerships, and S corporations. An election by a partnership or S corporation is binding on all partners or S corporation shareholders holding interests during the presumption period.