Daily Deduction: Is it a Hobby or a Business?

Have you ever considered turning your hobby into a business on the side so that you could deduct the expenses? For instance, if you become an aspiring professional rock climber, actress or weekend charter boat captain, can you deduct the cost of your life jacket, cleats and theater lessons? Most people think so, but Daily Deduction readers should know a “too good to be true” tax break when they see one. If your splashy new venture will never turn a profit, you shouldn’t deduct the cost of your personal fishing gear to cover the loss.

In general, you can deduct ordinary expenses associated with running a business even if those expenses exceed the amount of money that your venture earns. If your alleged business is really a hobby, though, stricter rules apply. Instead of being able to deduct all of the costs associated with your activity, you can only deduct them to the extent that they don’t exceed your profit. For example, if it costs $3,000 to keep your pet alpacas fuzzy and fed, and you earn $1,000 by selling their wool, you can deduct $1,000 of your $3,000 expense. But you can’t deduct the other $2,000, because your activity is a hobby rather than a business.

(Read this story about how one guy turned a frustrating commute and an interest in technology into a profitable small business.)

How can you tell the two apart? An activity usually qualifies as a business if it has reasonable chance of making a profit. The IRS uses a number of distinguishing factors to make the difference clear. Your activity is probably a business, rather than a hobby, if some of the following things are true:

  • You put a significant amount of time and effort into your activity.
  • You depend on your activity for income.
  • Losses from your activity are due to circumstances beyond your control, or they are a natural result of your business’s startup period.
  • You change your operations in response to losses in order to make your activity more profitable.
  • You consult advisers about how to improve your profitability.
  • You have made a profit from similar activities in the past.
  • Your activity makes a profit in some years, even if it doesn’t do so well in others. In other words, your business is not completely hopeless.

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