We all have hobbies; hobbies like photography and knitting are usually just for fun, and we don’t anticipate making any money from doing them.
Did you know that you may be able to turn your hobby into a business and get generous tax breaks? Or, if you are doing a hobby that is not a business, did you know that the IRS requires that you declare your hobby income?
It’s true. You are required to report any income that you make from a hobby, and unfortunately, after 2018, the rules changed, and you can no longer deduct any hobby expenses. However, you can deduct business expenses if you are indeed running a business rather than having fun with a hobby.
So, how does it all work? Well, first, you need to determine whether your hobby is a hobby or a business. Then, if you find that you do have a hobby and not a business, you will need to report any hobby income you make. If you determine that you are running a legitimate business, you may get nice tax breaks!
Is My Business a Hobby?
Are you trying to start your own business? Have you just started making a little extra income from your hobby? For example, are you starting a website to make handknitted sweaters and hiring knitters to help you make them? Your intentions would be considered a business in that case, because you are trying to make a profit, and you are most certainly incurring expenses that would be considered business expenses.
However, are you just happening to knit baby blankets and getting people who want them to pay for them? In other words, are you doing something for fun without the intention of turning a profit? That would be more in line with a hobby because you are just making something for sport or pleasure, not with the goal of a profit in mind.
Some other questions you may want to ask yourself when trying to determine if your hobby is a business or for pleasure include:
- Do you depend on the income from your hobby?
- Do you consider your hobby to be a profit-making endeavor or an enjoyable sport or activity?
- What are your intentions with your hobby?
- Are you treating your hobby as a business, keeping receipts, records, and other paperwork in anticipation of a profitable business venture?
- Are you trying to turn a profit when you perform your hobby rather than just doing it for fun?
Now, just because you are making a living doing something you love doesn’t mean that it is a hobby. When your hobby becomes a business, you should treat it like one – regardless of how much you love doing it. You can take business deductions and all sorts of tax breaks if it is a business, but it’s treated differently than if it is just a hobby.
The key difference between a hobby and a business is your intent. Do you want to make money? Is that your goal? Or are you doing something you love, expecting no profit in return?
The IRS considers nine factors when deciding if an activity or sport is a hobby. According to the IRS, “A hobby activity is done mainly for recreation or pleasure. No one factor alone is decisive. You must generally consider these factors in determining whether an activity is a business engaged in making a profit:
- Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
- Whether the time and effort you put into the activity indicate you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were 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 you can expect to make a future profit from the appreciation of the assets used in the activity.”
Reporting Hobby Income
Do that sound like what you are doing? If so, you are required to declare hobby income. Even if it is not much money, you must report it. If you use IRS Form 1040 to file your taxes, you will indicate your hobby income as “Other Income.”
If you are a collector and your hobby income comes from selling collectibles, you should report that income on Schedule D. When reporting on Schedule D, you may be required to be taxed at capital gains rates rather than ordinary tax rates.
Before 2018, you were permitted to deduct hobby expenses up to the amount of your hobby income, but once the law changed, this tax break was gone. So, you are required to report all hobby income, and you cannot deduct hobby expenses. But what if your hobby is a business?
Is My Hobby a Business?
If a hobby makes a profit during at least three of the last five years, generally, the IRS considers it a business. However, you should proceed with caution because of the strict rules the IRS has on declaring a sport or pleasurable activity a hobby.
A hobby is considered a business if some or all of your income comes from the profit of the hobby, and you experience regular business profits and losses like a business does. Of course, use the above nine criteria of the IRS to determine whether you are making money with a hobby or turning a profit doing something you enjoy doing.
If you have determined that your hobby is indeed a business, you can report your profits and losses on Schedule C. This is good news because there is a slew of business deductions that you can take that are not available if you are reporting a hobby.
When reporting your business income and expenses on your taxes, it’s vital that you understand what to report and how to report it. You want to get the maximum tax benefit that you can, but you also need to make sure that you are claiming business income and expenses that you actually did incur in the event of an audit. You need to do it right to avoid an unexpected tax bill after an IRS audit.
Business income is any income you receive that is related to your business. In other words, income is the profit that you have earned from your small business or self-employed activity. While you must claim business income, just as you must claim hobby income, you do have the advantage of deducting business expenses.
Business expenses are any expenses related to your business that are both necessary and ordinary. Expenses must meet both criteria to be claimed as business expenses on your taxes. It’s essential that you understand what business expenses are in order to deduct them on your taxes.
Examples of business expenses include home offices, business meals, mortgage interest, and mileage. There are specific rules to follow when taking business deductions, and it’s important to know the difference between business and personal expenses.
Some things are fully deductible while others have specific guidelines. For example, the home office deduction allows you to take itemized deductions for things like office supplies and even partial expenses related to rent, mortgage, and other costs.
It’s important to keep detailed records, receipts, sales reports, expense reports, and other business records in the case of an audit. You need to be able to prove you are running a business and that it’s not just a hobby in the event of an audit. Detailed records are vital if you are running a business, so don’t leave anything out when practicing good record-keeping.
Check out the IRS’s Small Business and Self-Employed Tax Center for valuable resources and information such as publications, schedules, and tax forms – everything you need to prepare your business taxes as well as information for small business owners from everything you need to know about starting and closing a small business to everything you should know in between that time.
When doing something you love and making money from it, it’s important to distinguish whether that something is a hobby or a business. The IRS has very specific guidelines that should help you determine the difference between the two. If you do find that you have a hobby, you must report that income on your tax return. Luckily, it’s pretty easy to do; it’s just unfortunate that taxpayers can no longer deduct hobby expenses.
If you find that you are instead running a small business, participating in an activity that is turning a profit intentionally, you should be able to deduct your business expenses on your tax return. This can prove to be very lucrative if you have incurred many business or self-employed expenses. There are specific rules that go along with it; check out the IRS’s small business and self-employed center. It has valuable resources that can get you started with your new business.
If you are unsure as to whether you have a hobby or a business, it may be in your best interest to hire a tax accountant or specialist to help you get the best tax breaks. When hiring a tax professional, it’s important to find the right fit. A tax professional understands the tax code and how to file taxes correctly. Find an excellent tax accountant who will look out for your best interests.
The process of reporting business income and expenses on Schedule C may seem overwhelming at first, but since it can save you money on your taxes, you should take the extra time to do it right. Since it’s crucial that you follow the tax code precisely to prevent an unexpected tax bill, you should either make sure you know your stuff or hire someone who does. When in doubt, consult with a tax specialist.
At Borshoff Consulting, we know what qualifies as a hobby versus a business, and we can help you get the most out of your business venture. The rules on business tax deductions are often hard to digest. We can help you with every part of your taxes – from your initial tax preparation to audit representation should you need it.
We specialize in tax returns, financial planning, and more. To see how we can help with your tax returns, contact us today! Borshoff Consulting can help you with one-on-one audit assistance, tax support, and IRS audit representation. You can trust Indiana’s tax expert!