Hobbies provide a great way to relax from the daily grind. For many people, they also offer a way to make extra spending money.

In this tax tip: • Allowable hobby deductions   • Hobby vs. business   • What constitutes a business   • IRS looks at everything

Be aware, however, when your hobby produces income, you owe tax on it.

Allowable hobby deductions
You can reduce your taxable hobby income by deducting your hobby expenses, but this tax break is limited.

You can only deduct expenses up to the amount of money you make on the hobby. Even then, hobby expenses, along with other miscellaneous expenses you itemize on Schedule A, must come to more than 2 percent of your adjusted gross income before you can deduct them.

If you find your hobby is regularly making money, it might be to your tax advantage to turn the sideline into a business.

It's not as difficult as you might think. If you operate as a sole proprietor, you report the income on your 1040 tax return and you have more options when it comes to deducting your expenses.

But if you demonstrate that you are involved in an activity with the expectation of making money on it, the IRS will consider it a business. As such, you'll be able to deduct expenses directly from your income. You even can deduct overall business losses in the years you don't turn a profit.

You must, however, make the right moves to convince the IRS that your sideline is a legitimate business.

What constitutes a business
The IRS uses two tests in determining whether your activity is a business rather than a hobby.

First, the profit test demands that you show you earned money on the activity in three out of five years.

If you can't meet the profits test, you get another chance to convince the IRS that you are running a business by passing the factors-and-circumstance test. Here, the tax agency takes a subjective, individualized look at your pursuit. Basically, the IRS examines:

• Whether you carry on the activity in a businesslike manner. This includes, for example, keeping good books and records, promoting your business and holding down costs where possible.
• How much time and effort you devote to the enterprise.
• Whether you depend on income from the activity for your livelihood.
• If your losses are due to circumstances beyond your control or are normal for a business in its startup phase.
• Whether you change your methods of operation in an attempt to improve profitability.
• The knowledge and background you (or your advisers) have in running such a business.
• If you were successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and, if so, how much.
• Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
• The element of personal pleasure involved in the activity. That doesn't mean you can't enjoy your new business, but you better be getting more out of it than just a good time.

By successfully transforming your hobby into a business, you'll be able to deduct your associated expenses on Schedule C or C-EZ without worrying about a percentage limitation. You might even find a few more you can take, such as one for the home office you set up to take care of your new endeavor's administrative chores.

And if you have an occasional year where you lose money, the loss can help reduce your other income and lower your tax bill.

Freelance writer Kay Bell writes Bankrate's tax stories from her home in Austin,
Texas, and blogs on tax topics at Don't Mess with Taxes.