Losses from a hobby aren't deductible
By Luis I Ingles III, CPA • Bankrate.com

March 19, 1999 -- Did you lose money this year in activities such as collecting stamps or training horses? This tax tip describes the circumstances that transform these losses into tax allowable losses.

Losses from activities conducted as "for-profit" businesses are allowed for income tax purposes. These losses can offset other income from wages, interest, dividends, etc. Losses from an activity that isn't conducted for-profit, known as hobby losses, aren't deductible against other income.

This tip will help you determine the tax status of losses incurred from your activities. Besides considering whether the activity generated a profit, you will also find out how the IRS applies the "facts and circumstances" test to determine the for-profit status of your activity. Even if your activity simply qualifies as a hobby, you need to follow the procedure described in this tax tip to deduct expenses related to the activity. You will also find out the steps you can take today that will transform your hobby into a "for-profit" business.

For-profit activities
Your activity automatically qualifies as "for profit" if its gross income exceeds its deductions for at least three out of five consecutive years. This rule converts to at least two out of seven consecutive years for horse breeding, training, showing or racing.

However, failing to meet this net income requirement doesn't automatically deem the activity a hobby. You can still prove that the business is conducted for-profit and thereby deduct losses if you pass the "facts and circumstances" test.

Facts and circumstances test
The following factors have been used regularly by the IRS in determining whether an activity is carried on for profit:

1. Manner in which you carry on the activity.
2. Expertise of you and/or your advisers.
3. Time and effort personally spent on the activity.
4. Expectation that assets used in the business will appreciate in value.
5. Your success in carrying on other business activities.
6. Your history of income or loss with respect to the activity.
7. Your financial status.
8. Elements of personal pleasure or recreation.
9. Amount of occasional profits, if any.

While these are the details considered in the "facts and circumstances" test, these aren't the only factors involved in the profit or hobby determination. Also, the activity's status isn't always determined by satisfying a simple majority of the indicators above. The side supported by five or more of the above factors doesn't always determine the outcome of the argument.

Your activity could theoretically show a for-profit motive under eight of the above nine tests, but the ninth factor could so overwhelmingly indicate a hobby that the activity would be categorized as a hobby. On the other hand, a strong hint of a for-profit motive in one of the above tests could override the fact that the other eight tests imply hobby.

This test is called "the facts and circumstances test" because the facts and circumstances surrounding each specific case are unique and must be scrutinized carefully before determining whether the activity is for profit or a hobby.

Would you like more information about deducting expenses from your activities? Consult "Not For-Profit-Activities" in Chapter One of IRS Publication 535: Business Expenses. If you are uncertain about the status of your particular activity, talk to a professional tax adviser before proceeding.

Reporting hobby income and expenses
Even if your activity qualifies as a hobby instead of "for-profit", your income and expenses must be reported in the appropriate manner. Taxpayers selling products such as stamps, arts and crafts, etc., should report the net gain from these sales on Schedule D, Capital Gains. If your hobby is rendering services, you report the gross income on line 21 of Form 1040 and the expenses on Schedule A, Itemized Deductions.

Since you can't take a loss from the hobby, you can only deduct expenses up to the amount of income reported. Any excess disallowed hobby expenses can't be carried forward. According to IRS Publication 535, you should take these deductions:

• Only in the order of the three categories below,
• Only to the extent stated in the three categories, and,
• If you are an individual, only if you itemize them on Schedule A of Form 1040.

Are you confused about how to deduct hobby losses? Refer to category descriptions in the following table and paragraphs.

Category 1: Deductions taken for personal activities are allowed in full. This category includes all non-business deductions for individual. These include home mortgage interest, taxes and casualty losses. There are two limits that apply to this category. First, you can only deduct a non-business casualty loss to the extent it exceeds $100. Second, the sum of these losses must exceed 10 percent of your adjusted gross income. Consult IRS Publication 547 for more information on casualty losses. For the limits that apply to mortgage interest, see Publication 936.

Category 2: Deductions that don't adjust your property basis are allowed next, but only to the extent that your gross income from the activity is more than the deductions possible under the first category. This category includes most standard business deductions, such as those for advertising, insurance premiums, interest, utilities, wages, etc.

Category 3: Business deductions that decrease the basis of property are allowed last. However, they are allowed only to the extent the activity's gross income exceeds deductions allowed for it under the first two categories. Depreciation and amortization deductions, as well as any part of casualty losses that aren't deducted in Category (1), belong in this category. When considering more than one asset in this category, divide depreciation and these other deductions proportionally among those assets.

You must claim the amounts in Categories (2) and (3) as miscellaneous deductions on Schedule A of Form 1040. They also are subject to the 2 percent-of-adjusted-gross-income limit. If you have questions regarding this limit, refer to IRS Publication 529.

Some helpful hints
Is your activity is currently categorized as a hobby? Have you started an activity that you would like to qualify as a trade or business? There are actions you can take that will convey a for-profit motive. Here are some suggestions:

Implement structured bookkeeping:

• Keep thorough and business-like books.
• Use a separate business checking account and business credit card.
• Record business and personal use of assets in a log-book.

Operate like a professional:

• Obtain the proper license, insurance, registration, certification, etc. needed for that type of business.
• Maintain a qualified home office and a second telephone listing strictly for the business.

Look forward:

• Make periodic changes in business operations to increase profit potential.
• Research current market trends and technology used in similar businesses.

Conclusion
This tax tip explains how to determine the tax status of losses incurred from your activities. Besides considering whether the activity generated a profit, you will also find out how the IRS applies the "facts and circumstances" test determine the for-profit status of your activity. Even if your activity simply qualifies as a hobby, you need to follow the procedure described in this tax tip to deduct expenses related to the activity. You will also find out the steps you can take today that will transform your hobby into a "for-profit" business.

Luis I. Ingles III is a certified public accountant based in Louisiana

-- Posted March 19, 1999