A “hobby loss” occurs when the Internal Revenue Service (IRS) determines that an activity you pursue is a hobby or recreational activity—not a bona fide business—and disallows deductions for losses that exceed the income the hobby generates. In practical terms, you must report any income from the activity, but you generally cannot deduct expenses that create an overall loss for tax years when the hobby-loss rules apply. (IRS; Investopedia)
How the hobby-loss rule works — the essentials
– Who it applies to: Individuals, S corporations, partnerships, trusts and estates. It does not apply to C corporations. (26 U.S.C. §183; IRS)
– Income: Any income from the activity must be reported on your tax return. You cannot ignore hobby receipts. (IRS Tips for Taxpayers)
– Deductions when activity = hobby: Expenses are limited. Historically hobby expenses could be deducted only as miscellaneous itemized deductions and only to the extent of hobby income. However, those miscellaneous itemized deductions were suspended by the Tax Cuts and Jobs Act (TCJA) for tax years 2018 through 2025, so hobby expenses that would have been itemized generally cannot be deducted during that period. (IRS; TCJA summary)
– Presumption of profit: The IRS presumes an activity is engaged in for profit if it shows a profit in at least 3 of the last 5 consecutive tax years (including the current year). For certain activities (e.g., horse racing), a different test applies (2 of 7 years). If that presumption isn’t met, the taxpayer must prove a profit motive. (26 U.S.C. §183; IRS)
The IRS’s nine factors to determine “for-profit” status
The IRS doesn’t rely on a single test. Instead it uses a facts-and-circumstances approach, guided by nine factors in its guidance and regulations. No one factor is decisive; the totality of the facts matters. The factors include:
1) Manner in which the taxpayer carries on the activity (businesslike recordkeeping, business plan, advertising, etc.)
2) Expertise of the taxpayer or advisors (education, experience, consultations)
3) Time and effort the taxpayer puts into the activity
4) Expectation that assets used may appreciate in value (capital gains potential)
5) Success in carrying on similar or dissimilar activities (prior profitable ventures)
6) History of income or losses with respect to the activity
7) Amount of occasional profits, if any, and their magnitude relative to losses
8) Financial status of the taxpayer — whether the taxpayer has substantial income from other sources (losses reasonable if hobby)
9) Elements of personal pleasure or recreation (greater personal pleasure weighs against profit motive)
(IRS “Is Your Hobby a For-Profit Endeavor?”; 26 C.F.R. §1.183-2)
Special considerations and practical implications
– Reporting: Report hobby income on your federal tax return (generally as “other income”). Even if expenses are non-deductible, the income is taxable. (IRS)
– No offset of hobby losses: You cannot use hobby losses to offset other income (wages, investment income, etc.). There is no carryforward of hobby losses.
– Entities: The hobby-loss rules apply to individuals, S corporations, partnerships, trusts and estates; they do not apply to C corporations. (26 U.S.C. §183)
– TCJA effect (2018–2025): The Tax Cuts and Jobs Act suspended miscellaneous itemized deductions subject to the 2% of AGI floor—this generally prevents deduction of hobby expenses for tax years 2018 through 2025. If TCJA’s suspension is not extended or modified after 2025, the prior itemized-deduction rules would again apply, subject to the hobby-income cap. (TCJA; IRS)
– Certain activities (horses): The IRS has special rules for horse-related activities that extend the period used to apply the profit presumption. (IRS)
Practical steps to avoid being classified as a hobby (checklist)
1. Aim for profits over time
• Target profitability in at least 3 of 5 consecutive years. If you cannot achieve that, be prepared to document a credible profit plan and the steps you’ve taken to achieve profit. (IRS)
2. Act like a business
• Keep a written business plan with projections and strategies to increase profits.
• Maintain separate bank and credit-card accounts for the activity.
• Use formal invoices, contracts and receipts.
• Advertise and market your products/services; show evidence of sales efforts.
• Invest in necessary equipment and improvements when appropriate. (IRS)
3. Keep thorough records
• Track gross receipts, all expenses, dates, business purpose, and supporting invoices/receipts.
• Keep logs for time spent on the activity when that supports the business purpose.
• Save correspondence with customers, vendors and advisors. (IRS Publication 535)
4. Use outside expertise
• Consult accountants, attorneys or industry experts, and document the advice and actions taken in response. Demonstrable reliance on expertise supports a profit motive. (IRS)
5. Scale operations when appropriate
• If possible, grow the activity in ways that increase the potential for profit (expand distribution, improve pricing, find new markets). Showing reasonable, good-faith steps to become profitable is important.
6. Reevaluate and limit losses
• If losses persist, reduce the scale of the activity or stop. Repeated losses without a credible plan to become profitable strengthen a hobby determination.
7. Consider entity choice carefully
• Forming an entity (LLC, S corp) won’t automatically solve a hobby issue — IRS looks through formalities to the substance of operations — but a properly run business entity can help demonstrate a businesslike approach. Consider tax and legal advice before changing structure.
What to do if the IRS treats your activity as a hobby
– Pay what’s owed: Report and pay taxes on hobby income for the years in question. If you receive an audit notice or proposed adjustments, respond promptly and provide the requested documentation.
– Gather documentation: Business plan, correspondence, receipts, bank statements, tax preparer notes, and any evidence of attempts to make a profit.
– Consider amending returns or appealing: If you discover you misreported income or missed deductions in prior years (pre-TCJA periods), consult a tax professional about amendments or appeals.
– Consult a tax professional or attorney: Hobby-loss issues can be complicated and can lead to audit adjustments; professional representation is often worthwhile.
Recordkeeping essentials (what to save)
– Sales records (invoices, payment records)
– Receipts, vendor invoices and canceled checks for expenses
– Bank and credit-card statements for the activity
– Contracts, leases, advertising and promotional documents
– Business-plan documents, market analysis and correspondence with advisors
– Logs for mileage, hours worked, and other time-based measures (if relevant)
When to get professional help
– If you’re audited or receive a notice about hobby classification.
– If you’ve had persistent losses and want structured tax and business advice to change the outcome.
– If you’re unsure how to report activity income or whether to change entity structure.
Key takeaways
– Income from hobbies is taxable; losses from hobbies generally are not deductible. (IRS)
– The IRS presumes profit when an activity shows profit in 3 of 5 consecutive years (special rules for some activities). (26 U.S.C. §183)
– For 2018–2025, the TCJA suspended miscellaneous itemized deductions, effectively preventing the deduction of many hobby expenses during those years. (TCJA; IRS)
– To avoid a hobby loss classification, operate in a businesslike manner, keep strong records, seek outside expertise, and strive for a consistent profit record. (IRS; Investopedia)
Sources and further reading
– IRS, “Tips for Taxpayers Who Make Money from a Hobby.”
• IRS, “Is Your Hobby a For-Profit Endeavor?”
• Internal Revenue Code, 26 U.S.C. §183, “Activities Not Engaged in for Profit.”
• IRS Publication 535, “Business Expenses.”
• Investopedia, “Hobby Loss.”
– Review a short description of your activity and give practical suggestions for documentation and business changes to strengthen a profit-motive case, or
– Provide a sample business-plan checklist tailored to a hobby-turned-business (e.g., crafts, photography, breeding/showing animals).