16.2 Hobby, Wash-Sale, and Personal-Use Loss Disallowance
Key Takeaways
- Section 183 treats a not-for-profit activity as a hobby: nine nonexclusive factors decide profit motive, a profit in three of five years (two of seven for horses) creates a presumption, and a hobby cannot produce a net loss that offsets wages.
- A wash-sale loss under §1091 is disallowed currently; the replacement-share basis add-on and holding-period tack are the chapter 12 computation, not this year's Schedule D deduction.
- A loss on the sale of a personal-use asset — a personal car, furniture, or an unconverted personal residence — is not deductible.
- Section 121 is a gain-exclusion rule of up to $250,000 ($500,000 MFJ) when the ownership and use tests are met; it does not create a deductible loss on a personal residence.
- Section 267 disallows a loss on a sale to a related party; the buyer may later use that disallowed loss to offset gain on a disposition of the same property.
16.2 Hobby, Wash-Sale, and Personal-Use Loss Disallowance
REG Blueprint Area IV, Group D also asks you to calculate losses disallowed for tax purposes, such as from a hobby, a wash sale, or the sale of a personal-use asset. Netting and the $3,000 ordinary offset in 16.1 assume a loss that is otherwise allowable. This section is the screen that takes certain realized losses out of that netting.
Hobby losses — IRC §183
An activity is a hobby, not a trade or business, when the taxpayer does not engage in it for profit. Gross receipts are still income. Deductions attributable to the activity are limited. The activity cannot produce a net loss that offsets wages, portfolio income, or another business. Do not put a net Schedule C loss on Form 1040 for a not-for-profit activity.
Nine factors in Treas. Reg. §1.183-2(b) decide profit motive. No one factor controls; REG wants you to apply the catalog, not to recite a magic score:
| Factor | What REG is looking for |
|---|---|
| 1. Businesslike manner | Separate books, a plan, and conduct that looks like a business |
| 2. Expertise | The taxpayer's skill, or paid advisors the taxpayer actually uses |
| 3. Time and effort | Hours that are consistent with trying to make money |
| 4. Asset appreciation | A genuine expectation that assets used in the activity will rise in value |
| 5. Success in similar activities | A track record of turning other ventures profitable |
| 6. History of income or losses | Years of large losses with no realistic turnaround cut against profit motive |
| 7. Occasional profits | Size of profits relative to losses and to the investment |
| 8. Financial status | Substantial other income plus a pleasure activity cuts against profit motive |
| 9. Personal pleasure or recreation | Elements of sport or hobby weigh against a trade or business |
A presumption helps the taxpayer: if the activity shows a profit in three of the last five consecutive years, it is presumed to be for profit unless the IRS rebuts. For horse racing, breeding, training, or showing, the window is a profit in two of seven years. The presumption is not a safe harbor that ignores the nine factors when the years of profit are missing, and a single profitable year does not convert a recreational ranch into a Schedule C.
Wash-sale losses — IRC §1091
§1091 disallows a loss on stock or securities when the taxpayer acquires substantially identical stock or securities, or a contract or option to acquire them, within 30 days before or 30 days after the sale — a 61-day window. Gains are recognized even if the taxpayer rebuys the next morning. Dealers acting in the ordinary course are outside the disallowance.
The currently tested skill in this chapter is that the loss is not allowed now. What happens to the dollars is a basis computation: the disallowed loss is generally added to the basis of the replacement shares, and holding period tacks. That arithmetic is 12.1. Do not deduct the wash-sale loss on Schedule D this year, and do not treat it as permanently destroyed unless the replacement is inside an IRA (Rev. Rul. 2008-5), which is the one wash sale with no basis parking.
Personal-use assets and the §121 gain rule
A loss on the sale of a personal-use asset is not deductible. The taxpayer's car, furniture, jewelry worn personally, and personal residence are the classic list. Section 165 allows losses of property used in a trade or business or held for investment; it does not allow a personal-use sale loss (a narrow federally declared personal casualty is an itemized-deduction issue in 15.3, not a sale-loss deduction).
IRC §121 is a gain rule, not a loss-allowance rule. A taxpayer who owned and used the home as a principal residence for two of the five years ending on the sale date may exclude up to $250,000 of gain ($500,000 on a joint return if both spouses meet the use test and neither excluded gain on another home in the last two years). Those dollars are statutory. They do not create a deductible loss when the personal residence sells for less than adjusted basis. A $40,000 loss on a personal home is still zero. A $400,000 gain on a jointly filed sale that meets ownership and use is excluded up to $500,000; the same house sold at a loss never gets a "negative §121."
Conversion of a personal residence to rental before the sale can create an allowable loss measured from fair market value at conversion, which is a basis rule in 11.1. An unconverted personal home does not.
Related-party losses — IRC §267
§267 disallows a loss on a sale or exchange of property to a related person. Related persons include a spouse, siblings, ancestors, lineal descendants, and entities in which the taxpayer owns more than 50 percent. The loss is not currently deducted. It is not a capital-loss carryforward of the seller. The buyer's later gain on a disposition of the same property may be offset by that previously disallowed loss (the loss is preserved for the buyer, up to the later gain). Related-party gain is generally recognized; §267 is a loss statute.
Worked scenario: personal auto and a wash sale
Facts. Riley, a calendar-year individual, sells a personal-use automobile. Adjusted basis is $18,000; amount realized is $14,000. In the same year Riley sells 100 shares of listed common stock, held as an investment, at a $2,000 realized loss, and 10 days later buys 100 shares of the same common stock in a taxable brokerage account. Riley has no other capital transactions.
Analysis.
- Auto: realized loss $4,000. The automobile is a personal-use asset. The $4,000 is disallowed. It does not enter Schedule D. It is not a casualty deduction.
- Stock: the repurchase is inside the 61-day window and is the same class of the same issuer. The $2,000 loss is disallowed under §1091. Replacement basis increases by $2,000 in 12.1; this year's allowable capital loss from the wash sale is $0.
- Combined current-year allowed loss from these two facts: $0. Do not net $4,000 + $2,000 = $6,000, and do not allow the $3,000 ordinary offset against a disallowed loss.
If the automobile had been a delivery van used in Riley's Schedule C business, the $4,000 would be an allowable business loss, not a personal-use disallowance. If Riley had not replaced the stock inside 30 days, the $2,000 would be an allowable capital loss that would then enter 16.1 netting. If Riley had sold the stock to a sibling at a $2,000 loss and not replaced it, §267 — not §1091 — would disallow the $2,000, and the sibling would hold that disallowed loss as a potential offset against later gain.
Riley sells a personal-use automobile (adjusted basis $18,000, amount realized $14,000) and, in the same year, sells listed common stock at a $2,000 realized loss and buys 100 shares of the same common stock 10 days later in a taxable brokerage account. Riley has no other capital transactions. What amount of these losses is currently deductible?
Which statement correctly describes the hobby-loss rules of IRC §183?
Which statement correctly distinguishes the §121 principal-residence rule from related-party loss disallowance under §267?