Tax on my Hobby Income ? Hardly any expense deductions ? Read to know more

Lets suppose you occasionally 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 to be taxed ? Would you get deduction of the rent of the studio and the membership fees of the local trade organization ?

Before discussing the tax treatment, let us first understand what is a hobby as per the IRS. A hobby is an activity done mainly 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 the activity. The activity may turn to be a profitable one, but it’s not the primary motive. Some examples include growing plants at home & selling them occasionally at a local marketplace, raising animals, catching fish and selling them at a local carnival, renting out your caravan for local excursions, 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. However, 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 1^st 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 organisation may not be deducted. If the taxpayer was in the business of selling paintings, then all expenses would be allowed as a deduction 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 activity 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 –

• Whether the taxpayer carries on the activity in a business like manner and maintains complete and accurate books and records.
• Whether the time and effort put into the activity by the taxpayer indicates that he/she intends to make it profitable
• Whether the taxpayer actually depends upon income from the activity for your livelihood or just undertakes it for pleasure
• Whether the losses from the activity are due to circumstances beyond  control of the taxpayer (or are normal in the startup phase of your type of business)
• Whether the taxpayer changes methods of operation in an attempt to improve profitability.
• Whether the taxpayer or his/her advisers have the knowledge needed to carry on the activity as a successful business.
• Whether the taxpayer was successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and how much profit it makes.
• Whether the taxpayer expects to make a future profit from the appreciation of the assets used in the activity.

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 distinction between the two based on the above factors, which may vary depending upon each taxpayer’s individual facts and circumstances. The taxpayer is not require to pass all nine criteria in order to have an activity classified as a business.  Instead, all nine factors must be given relative weights in light of their importance on a case to case basis. For instance, it may happen that 4 factors which point in the direction of a trade or business may be outweighed by one other single factor that heavily points in the direction of a hobby.  To help in the determination of whether an activity is a hobby or a business, the Internal Revenue Code section 183(d) has created a a rebuttable presumption that, if an activity has generated a profit for three of the last five years. then the activity is presumed to be a trade or business rather than a hobby. 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 taxpayer in this case.