Hobby Loss Rules — You Probably Can’t Deduct That

When it comes to taking a loss on a business activity for tax purposes, it’s important to understand that the activity must be engaged in as a for-profit venture, with a profit motive behind it. However, some wealthy individuals try to use hobbies as a way to create abusive tax shelters, running a fake business or using a legitimate hobby, like raising horses, to create huge losses and offset other income. In the crypto economy, this issue comes into play around certain activities like mining, running nodes, and even staking.

To determine whether an activity is truly a hobby or a business, the IRS considers many factors which are discussed in Reg. §1.183-2. If the activity has made a profit in at least three of the past five years, it’s assumed to be a profit-making activity and is not subject to hobby loss rules. However, if it’s not profitable, the IRS will look at other factors, such as:

  • whether the owner treated the activity as a business (i.e. keeping accurate books, having separate bank accounts, etc.)
  • the time and effort put into the activity,
  • whether you depend on income from the activity,
  • whether losses are due to circumstances beyond your control or occurred during the start-up phase of the business,
  • whether you’ve changed methods of operation to improve profitability, and
  • whether you have the knowledge needed to carry on the activity as a successful business.

If the IRS determines that your “business” is a hobby, you won’t be able to take any losses, so there is no tax benefit to having losses in your hobby. Worse yet, under the Tax Cuts and Jobs Act (2017), expenses related to hobby income — which were previously reported as miscellaneous itemized deductions on Schedule A — are no longer deductible. This means that if you carry on a hobby, you need to recognize income from the activity but do not get the benefit of deducting any expenses.

Overall, it’s important to understand the difference between a hobby and a business, and to ensure that you’re engaging in activities with a genuine profit motive if you want to take advantage of tax benefits. While the line between a hobby and a business can be blurry, careful consideration of the factors outlined by the IRS can help you determine which category your activity falls into.

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