February 11, 2016
Most people are probably familiar with the general tax rule about hobbies: You can deduct expenses only to the extent that you have income from the hobby. This rule applies to individuals, S corporations, partnerships, estates and trusts. There is a certain pecking order in deducting these expenses:
1. Deductions a taxpayer can claim whether or not they are incurred with a hobby. Some examples are taxes, interest and casualty losses. These expenses are allowed even if they exceed hobby income.
2. Deductions not resulting in an adjustment to the property’s basis. These are the hobby’s operating-type expenses. An example is supplies. These expenses are allowed to the extent that the gross income from the hobby exceeds the deductions under No. 1.
3. Deductions resulting in an adjustment to the basis of property. Depreciation and amortization deductions are allowed but only to the extent that gross income from the hobby exceeds deductions under both No. 1 and No. 2.
The income from the hobby activity is picked up on line 21 on page 1 of the Form 1040 return. This income is not subject to self-employment tax but is subject to federal income tax. No. 1 deductions are Schedule A-type itemized deductions not subject to the 2-percent-of-adjusted-gross-income limitation. To take advantage of these deductions, you must itemize your deductions. Nos. 2 and 3 deductions are Schedule A-type itemized deductions, but they are subject to the 2-percent-of-AGI limitation. To take advantage of these deductions, you must itemize your deductions. But even if you itemize your deductions, a portion of the expense deduction is lost because of the 2 percent rule.
Hobbies are considered to be activities engaged in without a profit motive. Whether an activity is engaged in for profit is determined by a facts-and-circumstances test. Here are a couple of general rules:
1. An activity is presumed not to be a hobby if it produced a profit in any three of five consecutive tax years ending with the tax year in question.
2. An activity involving the breeding, training, showing or racing of horses is presumed not to be a hobby if it produced a profit in two out of seven consecutive tax years.