Key Takeaways
- Hobby = no profit motive. Business = profit motive.
- Hobby income fully taxable; hobby expenses NOT deductible.
- 3-of-5 rule: Profit 3 of 5 years = presumption of business.
- Horse activities: 2-of-7 year rule.
- IRS uses nine factors from Reg. §1.183-2 to determine profit motive.
- Hobby income reported on Schedule 1, Other Income.
Hobby Loss Rules
Why This Matters for the Exam
Hobby loss rules create a significant tax trap. The exam tests the 3-of-5 rule, the nine factors, and the tax consequences.
Expect at least 2-3 questions on hobby losses.
Business vs. Hobby: Why It Matters
| Classification | Income | Expenses | SE Tax |
|---|---|---|---|
| Business | Schedule C | Deductible | Yes |
| Hobby | Schedule 1 | NOT deductible | No |
The Hobby Trap
| Effect | Result |
|---|---|
| Report 100% of income | Fully taxable |
| Deduct 0% of expenses | No deduction whatsoever |
| Net effect | Gross receipts tax |
The 3-of-5 Presumption (Safe Harbor)
| Rule | Description |
|---|---|
| Presumption | Profit 3 of last 5 years = business |
| Effect | Burden shifts to IRS to prove hobby |
| Horse activities | 2-of-7 years instead |
Nine Factors (Reg. §1.183-2)
The IRS considers these factors if 3-of-5 is not met:
| Factor | Question |
|---|---|
| 1. Manner of conduct | Business-like books and records? |
| 2. Expertise | Knowledge in the field? |
| 3. Time and effort | Substantial time devoted? |
| 4. Asset appreciation | Expect assets to increase in value? |
| 5. Prior success | Profitable in similar activities before? |
| 6. History | Start-up losses or sustained losses? |
| 7. Occasional profits | Any profitable years? |
| 8. Financial status | Other income to fund losses? |
| 9. Personal pleasure | Inherently fun or recreational? |
Factor Analysis
| Indicates Business | Indicates Hobby |
|---|---|
| Professional books/records | Sloppy or no records |
| Expert knowledge | No relevant expertise |
| Full-time effort | Weekends only |
| Assets appreciating | Assets depreciating |
| Prior business success | No prior business experience |
| Losses during start-up only | Sustained large losses |
| Occasional profitable years | Never profitable |
| Relies on this income | Has "day job" funding losses |
| Activity is work-like | Activity is inherently fun |
Reporting Hobby Income
| Item | Location |
|---|---|
| Income | Schedule 1, Part I (Other Income) |
| Expenses | Nowhere (not deductible) |
| SE Tax | Not applicable |
Hobby Example
| Item | Amount |
|---|---|
| Hobby income | $5,000 |
| Hobby expenses | $8,000 |
| Taxable income from hobby | $5,000 |
| Deductible expenses | $0 |
| Net tax effect | +$5,000 taxable income |
Real-World Scenario
Scenario: Taxpayer breeds rare birds as a "business." They have lost money every year for 6 years. They have a full-time job as an accountant. They spend weekends on the activity and find it relaxing.
- 3-of-5 test: Failed (no profits in 5 years).
- Nine factors: Many indicate hobby (losses, other income, personal pleasure, part-time effort).
- Likely classification: Hobby.
- Tax result: All income taxable, no expenses deductible.
On the Exam
Expect 2-3 questions on hobby losses, typically:
- Presumption Questions: "What is the 3-of-5 rule?"
- Horse Activity Questions: "What is the rule for horse activities?"
- Consequence Questions: "What happens to hobby expenses?"
- Reporting Questions: "Where is hobby income reported?"
The key is to remember: 3-of-5 = presumption of business. Horses = 2-of-7. Hobby = income taxable, expenses NOT deductible. Report on Schedule 1.
Taxpayer: Stamp collecting earned $2,000, spent $3,500. Classified as hobby. Taxable income effect?
Which activity has a 2-of-7 profit presumption?
Where is hobby income reported?