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Hobby Losses: What You Need to Know to Maximize Savings Amid New Hobby Loss Rules

Classifying a side gig as a business or a hobby is a crucial distinction to the IRS. The tax code has historically treated businesses much more favorably than hobbies, and this discrepancy was amplified when Congress passed the Tax Cuts and Jobs Act (TCJA) at the end of 2017. Beginning in 2018, hobby losses became more difficult to deduct, and taxpayers continued to have a hard time qualifying their activities as legitimate businesses. Though the tax code appears to work against taxpayers, there are things you can help your clients do to ensure they receive all the deductions available to them under the law.

Tax Treatment of Businesses and Hobbies

All income-producing activities are taxable – period. This is true whether activities are carried on as businesses or as hobbies, and this is true even if those activities generate very little income. The true difference between hobbies and businesses is how losses are treated.

Business Losses

Sole proprietorships and single member LLCs report business income and expenses on Schedule C of their Form 1040. When business expenses exceed business income, those excess business losses flow to Page 1 of the tax return and can offset non-business income like wages, interest, and dividends. Excess business losses are generally fully deductible with a few major exceptions:

  • Passive Activity Losses

Losses from passive activities cannot offset earned or ordinary income; passive losses can only offset passive income from another business.

  • At-Risk Rules

Most business owners cannot deduct excess business losses that exceed their at-risk investment in the business. At-risk investment is calculated as the amount of cash or property initially invested plus any business liabilities for which the taxpayer is personally liable.

  • Rental Real Estate Losses

Because the tax code provides numerous opportunities to accelerate depreciation, many rental real estate businesses produce tax losses year after year. To prevent taxpayers with rental properties from offsetting ordinary income with tax losses from a rental business, the tax code places additional limits on rental real estate losses.

Passive real estate investors must abide by both the at-risk rules and the general passive activity loss rules.

Taxpayers who actively participate in their rental businesses can deduct up to $25,000 ($12,500 for married filing separately who live apart for the year) of rental losses against ordinary income, but only if their modified adjusted gross income (MAGI) is $150,000 or less and only if this amount does not violate at-risk loss rules.

Real estate professionals face the at-risk loss rules but can otherwise fully deduct rental losses. The definition of real estate professional is a bit narrow, so look to the IRS rules and keep good records of your client’s participation in the business (subject to phase out above $100,000).

  • Excess Business Loss Limitation

The TCJA created a new limitation on excess business losses. Regardless of whether they materially participate in their business(es), taxpayers can only deduct up to $250,000 ($500,000 for married taxpayers) in total business losses in a given tax year. This limitation is calculated using excess losses from Schedule C businesses, rental real estate businesses, farming enterprises, partnership losses, S corporation losses, and losses from generally any other noncorporate entity. The TCJA intended for these rules to become effective in 2018, but the Coronavirus Aid, Relief, and Economic Security (CARES) Act passed on March 27, 2020 retroactively (and temporarily) lifted this requirement. The excess business loss limitation is now effective beginning in the year 2021. Business owners whose business losses were limited in 2018 or 2019 can amend prior year returns and deduct all business losses.

Hobby Losses

Although hobby loss rules are much simpler, the outcome is less desired. In general, any expense related to a hobby is not deductible. This means that hobby expenses cannot even offset hobby income.

Prior to the TCJA, hobby expenses were deductible as miscellaneous itemized deductions. Taxpayers who itemized were permitted to deduct hobby expenses that exceeded 2% of their AGI. But the TCJA temporarily eliminated miscellaneous itemized deductions. This means that from 2018 through 2025, taxpayers must pay taxes on all hobby income they generate and cannot deduct any hobby-related expenses.

Hobby loss limitations disincentivize taxpayers from having income-producing hobbies. Many CPAs seek to have their clients’ businesses classified as legitimate, for-profit businesses instead.

Transforming a Hobby into a Business – Is It Doable?

For your client’s income-generating endeavor to be considered a legitimate business, they must be able to prove they have an intent to make a profit. Factors that the IRS will consider are:

  • The taxpayer’s expertise in the activity
  • Time spent on the activity
  • Whether the taxpayer conducts the activity in a business-like manner
  • What records the taxpayer keeps
  • The taxpayer’s success in other businesses
  • The taxpayer’s financial ability to sustain losses
  • Revenue history for the activity
  • How pleasurable the activity appears to be to the taxpayer

Because the determination is subjective, many CPAs rely on the IRS’s statutory safe harbor for determining whether an activity is a legitimate business. Taxpayers will be presumed to be carrying on a trade or business under the statutory safe harbor if they can prove their business made a profit in at least three of the last five years (or two of the last seven years for horse racing, breeding, or showing).

To rely on this safe harbor, your client’s business must have a financial history of at least three years. Because many businesses generate losses in their first few years of operation, most startups cannot rely on the safe harbor, and for those first few years they have the burden of proving they have a trade or business based on the subjective factors alone.

One way you can help your clients qualify under the safe harbor is to postpone the IRS’s safe harbor test. By filing Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity is Engaged in for Profit, the IRS will determine if taxpayers qualify under the safe harbor in Year 5 rather than Year 3. If three of those five years were profitable – even if those profitable years were in Years 3, 4, and 5, the activity is considered a business. Without making this election, the IRS would apply the safe harbor test after the third year. This simple election may help your clients qualify for business treatment rather than being subject to hobby loss limitations.

Tax Planning Software Gives You More Comprehensive Tax Savings Strategies

Understanding the hobby loss rules is important as an advisor, but having the best tax planning software is also important. This is because saving a client as much money in taxes as possible goes far beyond just considering hobby losses or business losses. This is why we recommend Corvee Tax Planning software, which can create comprehensive tax plan proposals and finalized tax plans for your clients in minutes. To learn more about our tax planning software, request a demo today.

Create comprehensive tax plans and proposals with Corvee Tax Planning software.

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