Let us suppose you sometimes make paintings at a nearby rented studio as a hobby, and you occasionally sell those paintings at a local marketplace. You also took a membership of a local trade organization to promote your paintings. How would your revenues be taxed? Would you get removal of the rent of the studio and the membership fees of the local trade organization?
Before having a discussion on the tax treatment, let us first understand what a hobby is as per the IRS. A hobby is an activity mainly done for recreation or pleasure that is not entered into for profit. In other words, there is no profit motive and instead the taxpayer may be deriving personal pleasure or enjoyment for engaging in this activity. The hobby may turn to be a profitable one, but it’s not the primary goal. Some examples are nurturing plants at home & selling them occasionally at a local marketplace, raising animals, catching fish and selling them at a local market, renting out your caravan for outings, collecting coins and stamps, horse racing, etc.
Coming to the tax treatment of hobbies, the hobby income is includable in gross income similar to other types of business income. But hobby expenses are treated differently. So, before the recent changes to the tax code and starting again when this provision expires in 2026, hobby expenses are limited to the extent of hobby income, and further limited to 2% of Adjusted Gross Income.
Let us now see how treatment of hobby expenses changed after the recent changes to the tax law in Dec 2017. Currently, income from hobby forms part of gross income, however, the recent changes removed all miscellaneous itemized deductions subject to the 2% of AGI floor making hobby expenses mostly non deductible from hobby income. But, if the taxpayer’s hobby involves an activity related to manufacturing, merchandising or mining, then the taxpayer can claim a deduction for the Cost of the Goods sold, which includes direct costs like material & labour costs. For example, in the case of selling paintings as mentioned in the first paragraph, the cost of canvas & cost of oil paints can be deducted against painting income, even though other costs like rent of studio and membership fees of local trade organisations may not be deducted. If the taxpayer was in the business of selling paintings, then all expenses would be allowed as a subtraction and the excess of expenses over income (business loss) can also be offset against other income or be carried forward, subject to some rules. So, if the hoby is classified as a business rather than a hobby, the taxpayer can get favourable tax benefits.
As per the IRS, the taxpayer must consider these factors in determining whether an activity is a business or a hobby –
The IRS section on tax treatment hobbies can be found at https://www.irs.gov/spanish/hobby-or-business-irs-offers-tips-to-decide.
So with tax treatment in favour of businesses rather than hobbies, taxpayers may need to understand the difference between the two, depending on the above factors, which may vary based upon each taxpayer’s individual facts and circumstances. The taxpayer is not required to pass all nine criteria in order to have an activity classified as a business. Instead, all nine factors must be given relative weights because of their importance on a case to case basis. For instance, it may happen that four factors which point in the direction of a trade or business may be overshadowed by one other single factor that heavily points in the direction of a hobby. To help in understanding whether an activity is a hobby or a business, the Internal Revenue Code section 183(d) has created a rebuttable presumption that, if a hobby has generated a profit for three of the last five years, then the hobby is presumed to be a trade or business. As this presumption is rebuttable, the IRS can challenge the presumption by looking into the facts of the case with the burden of proof falling on the IRS rather than taxpayers in this case.
WhatsApp us