Hobby Losses and Other Non-Deductible Items

16.4 Hobby Losses and Other Non-Deductible Items

Among the many intricacies of the U.S. tax system, determining whether an individual’s activity is a genuine profit-driven venture—or merely a hobby—remains critical. The distinction has significant tax consequences. Under Internal Revenue Code (IRC) Section 183, often called the “Hobby Loss Rule,” taxpayers who engage in certain activities without the primary objective of profit often cannot deduct losses in the same manner as a true for-profit business.

This section dives deep into the concept of “hobby losses,” reviews the nine factors (drawn from case law and IRS guidelines) used to determine whether an activity is engaged in for profit, and explores the rules concerning partial deductions for these activities. We also address other non-deductible items to give you a complete picture of what falls within and outside of allowable deductions.

Understanding Hobby vs. For-Profit Activities

Generally, business activities that generate profit (or have a strong intent to operate with a profit motive) are allowed to take advantage of deductions under IRC §§ 162 and 212. However, if an activity is classified as a hobby, potential deductions are severely limited. Historically, individuals used certain “hobby losses” to offset other income, thus reducing their overall tax burden. In response, the tax code specifically limits or disallows such losses if the primary purpose of an activity is not profit-seeking.

Key Consequences of a Hobby Classification

1. Expenses are deductible only to the extent of gross income from the hobby.
2. Deductions are generally claimed as miscellaneous itemized deductions (subject to certain restrictions), rather than business deductions.
3. Losses that exceed income generated by the hobby cannot be used to offset other sources of income (e.g., wages, investment returns).

Changes introduced by the 2017 Tax Cuts and Jobs Act (TCJA) impacted many itemized deductions, significantly limiting certain miscellaneous itemized deductions. Nevertheless, for CPA candidates and practitioners, understanding the pre-2018 treatment (and the continuing interplay of current law) is still essential. The Uniform CPA Examination may test both historical and modern contexts of these limitations.

The Nine Factors for Determining a Hobby (From Case Law and Regulation)

To discourage taxpayers from labeling leisure or recreational activities as “businesses” to claim unwarranted tax deductions, the IRS relies on a multi-factor test derived from case law and embedded in regulations under IRC § 183. No single factor is conclusive on its own; instead, the total picture depends on the relative weight of each factor under a given set of facts and circumstances.

Below are the nine primary factors considered:

1. Manner in Which the Activity Is Carried On
   If an activity is carried on in a businesslike manner, with complete and accurate books, a written business plan, and appropriate recordkeeping, the IRS is more inclined to deem it a for-profit venture. Conversely, informal and poorly documented operations weaken the legitimacy of a profit motive.

2. Taxpayer’s Expertise or Adviser’s Expertise
   Developing or obtaining expertise in the activity indicates an intent to make it profitable. Consulting professionals, researching industry trends, and refining methods to enhance profitability all weigh in favor of a for-profit classification.

3. Time and Effort Expended
   Substantial time and effort can signal a genuine profit motive, particularly if the taxpayer significantly scales back on other activities (like a separate full-time job) to focus on this enterprise.

4. Expectation That Assets May Appreciate
   Even if the immediate revenues are modest, anticipating growth or asset appreciation (e.g., land, real estate, or specialized equipment) can indicate profit intent. For example, a small farm that has not turned a profit might still be considered a for-profit venture if there is a reasonable expectation that the land will appreciate or that breeding stock will yield valuable offspring.

5. Success in Carrying On Similar or Dissimilar Activities
   A proven track record of success in similar (or even unrelated) businesses can suggest that the taxpayer has a systematic approach to making ventures profitable. Past achievements can bolster the argument that a new activity is also undertaken with a profit motive.

6. History of Income or Losses
   A history of continued losses raises suspicion about the viability of a for-profit classification, though startups and certain industries (e.g., thoroughbred horse breeding) often carry significant upfront costs. Occasional or consistent net profit can be strong evidence supporting a profit motive.

7. Amount of Occasional Profits
   Even modest or sporadic profits can demonstrate an intent to make money, especially if those profits compare favorably to the magnitude of losses or the scale of the operation.

8. Financial Status of the Taxpayer
   If the taxpayer has significant income from other sources and uses the so-called “hobby” for recreation or aesthetics—rather than to generate meaningful profit—this can tilt the classification toward a non-profit hobby.

9. Elements of Personal Pleasure or Recreation
   If an activity inherently provides substantial personal or recreational enjoyment (e.g., yacht racing, coin collecting, or horse breeding purely for passion), the IRS will question the profit motive. However, deriving personal enjoyment does not automatically preclude the activity from being considered for profit, as many successful entrepreneurs also enjoy their work.

Mind Map of the Nine Hobby Factors

Below is a Mermaid.js diagram illustrating the interplay among these nine factors:

    flowchart LR
	   A["Start: Evaluate <br/>the Activity"] --> B["Factor 1: Manner of Operation"]
	   A --> C["Factor 2: Expertise of <br/>Taxpayer or Advisers"]
	   A --> D["Factor 3: Time <br/>and Effort Expended"]
	   A --> E["Factor 4: Expectation <br/>of Asset Appreciation"]
	   A --> F["Factor 5: Past Success in <br/>Similar Activities"]
	   A --> G["Factor 6: History of <br/>Income/Loss"]
	   A --> H["Factor 7: Amount of <br/>Occasional Profits"]
	   A --> I["Factor 8: Financial <br/>Status of Taxpayer"]
	   A --> J["Factor 9: Personal Pleasure <br/>Element"]
	   B --> K["Overall Determination:"]
	   C --> K
	   D --> K
	   E --> K
	   F --> K
	   G --> K
	   H --> K
	   I --> K
	   J --> K
	   K["Is the Activity a <br/>Hobby or For-Profit?"]

In practice, the IRS and the courts will weigh each factor, evaluate the pattern of behavior, and either accept or challenge the taxpayer’s characterization of the activity as a business. Some activities are inherently entertainment- or leisure-oriented, requiring especially stringent recordkeeping and business structuring to justify a profit motive classification.

Presumption of Profit and Rebuttable Presumptions

The tax code provides a helpful “safe harbor” presumption: if an activity shows a net profit in three of the past five years (or two of the past seven years for certain activities like horse racing, breeding, or training), it is ordinarily presumed to be a for-profit activity. This presumption can be rebutted by the IRS if there is evidence suggesting the activity is not undertaken in good faith for profit. Conversely, failing to meet the “3/5 rule” is not automatically decisive against profit motive—some business ventures simply have delayed profitability. In such cases, you must gather and present persuasive support to prove your profit motive.

Partial Deductions for Hobbies

When an activity is classified as a hobby, the general rule under Section 183 is that expenses can be deducted only to the extent of hobby income. Before the TCJA changes, a taxpayer could generally report the expenses (which exceeded the income) as miscellaneous itemized deductions subject to the 2% AGI threshold. However, post-TCJA, many previously allowed miscellaneous itemized deductions are suspended (or severely curtailed) for tax years 2018 through 2025 (unless extended or changed by subsequent legislation).

Nevertheless, for examination and planning purposes, understanding the “partial deduction” hierarchy is essential:

1. Expenses That Would Be Deductible Anyway
   Certain expenses, such as mortgage interest and property taxes, remain deductible regardless of whether the activity is deemed a hobby or a for-profit endeavor. Accordingly, these expenses are claimed first.

2. Expenses That Do Not Affect Basis
   Ordinary and necessary operational costs—like supplies, utilities, and advertising—are allowed to the extent that they do not exceed the hobby gross income remaining after deducting items in Category 1.

3. Expenses That Reduce the Basis of Property
   Depreciation and any other capital expenditures fall into this final category. They are taken last and can only be deducted up to the remainder of hobby income after subtracting Category 1 and Category 2 expenses.

Under current law, many of these hobby expenses (particularly in Category 2 and Category 3) are not deductible because they must be claimed only as miscellaneous itemized deductions, which have been largely disallowed (through 2025). If the law reverts in the future (or for the exam’s historical coverage perspective), the above hierarchy remains instructive for analyzing partial deductions.

Simple Example of Partial Deductions

Assume you earn $2,500 of gross income from selling artisan pottery pieces. You also incur $3,000 of expenses, including $1,000 of material costs, $500 of property taxes, and $1,500 of depreciation on pottery equipment.

1. Deduct Category 1: Property taxes ($500) are deductible entirely (although they may be subject to other SALT limitations).
2. Deduct Category 2: Materials ($1,000) are next in line. However, the maximum remaining hobby income available after Category 1 is $2,000 ($2,500 – $500). Materials cost $1,000, so you can deduct the full $1,000. Now, you have $1,000 leftover ($2,000 – $1,000).
3. Deduct Category 3: Depreciation ($1,500) can only be deducted to the extent of the remaining $1,000 in hobby income. Therefore, you are limited to a $1,000 depreciation deduction.

As a result, the total permitted expenses match the total hobby income ($2,500), leaving you with zero net profit. Any excess depreciation (that extra $500 you could not deduct) is lost under hobby-loss rules—it cannot offset other forms of income.

Other Non-Deductible Items

In addition to hobby losses, there are many categories of personal expenditures and specific payments disallowed for tax purposes:

• Personal, Living, or Family Expenses (IRC § 262): Everyday costs like groceries, clothing, personal insurance, and household utility bills are non-deductible unless specifically allowed (e.g., certain health insurance premiums for self-employed individuals).
• Fines and Penalties: Payments made to government entities for legal violations (e.g., speeding tickets, occupational safety fines) are disallowed (IRC § 162(f)).
• Political Contributions and Lobbying: Generally, no deduction is allowed for political contributions, campaign donations, or lobbying efforts (with limited exceptions for local legislation, under IRC § 162(e)).
• Commuting Expenses: The cost of traveling to and from your regular place of employment is non-deductible commuting expense. However, traveling between two business locations might be deductible if each site meets certain requirements for a place of business.
• Personal Interest Expenses: Except for qualified home mortgage interest and certain higher education loan interest, personal interest (such as credit card finance charges on personal spending) is not deductible.

Practical Scenarios and Case Studies

Below are more practical scenarios to reinforce how these rules might apply:

Case Study 1: The Horse Enthusiast

Sarah, an avid horse enthusiast, races her personal horses on weekends. She rarely wins prize money, and her expenses consistently outweigh any winnings. She meticulously tracks her horse-related expenditures but has not created a comprehensive business plan. She also has substantial income from her medical practice, so horse racing is more of an avocation than a necessity.
• Analysis: The IRS or tax courts would examine the nine factors. Sarah’s inability to show profits, the significant personal enjoyment factor, and minimal effort to truly run this as a business might classify this as a hobby. Consequently, Sarah may deduct only up to her annual horse racing income and in the correct order, subject to miscellaneous itemized deduction limits (if allowed under future law).

Case Study 2: The Weekend Artist Turned Professional

James has been painting for years as a hobby. Recently, he invested significantly in a professional gallery space, hired a marketing consultant, and opened an online store. He’s read extensively about profitable art businesses and adjusted his product line for commercial success. The first two years are unprofitable, but he tracks his earnings and modifies his strategies in hopes of turning a profit in year three or four.
• Analysis: Despite no immediate profit, James has documented his business approach meticulously (books and records, a business plan, marketing efforts). He seems to follow a for-profit model, suggesting that, even though the venture is new and still unprofitable, the IRS is more likely to treat it as a business with valid deductions. His robust recordkeeping and demonstration of serious intent weigh in his favor against the “hobby” classification.

Best Practices and Recommendations

• Maintain Detailed Records: Keep a separate bank account, track all income and expenses, and store receipts and invoices carefully. This helps demonstrate a professional approach and readiness for an IRS audit.
• Create a Business Plan: Even a concise, one-page business plan clarifies goals, strategies, and relevant milestones to support a for-profit motive.
• Seek Professional Advice: Consult with experienced advisers, accountants, or attorneys, especially for complex or evolving business models.
• Review the Safe Harbor: If your activity can meet the “3 out of 5 years” profitability test (or “2 out of 7” for horse-related endeavors), it’s advantageous—but do not rely solely on this. Ensure your operations truly support a profit motive.
• Stay Informed on Law Changes: Tax legislation frequently evolves. Monitor relevant provisions and updates, as certain miscellaneous itemized deductions disallowed under the TCJA might return.
• Document Changes and Improvements: If you pivot strategies to increase profitability—e.g., switching sales channels, scaling marketing, or refining product lines— keep evidence of these actions, as it supports your claim of pursuing profit.

References for Further Exploration

Below are some resources to delve deeper:

• IRS Publication 535, “Business Expenses”
• IRS Publication 334, “Tax Guide for Small Business”
• IRC § 183 (Activities Not Engaged in For Profit)
• Treasury Regulations § 1.183-2 (Factors for Determining Profit Motive)
• Most recent version of IRS Schedule C Instructions
• AICPA Tax Section resources (various articles on hobby loss rules)
• IRS Website – Hobby or Business?

Staying current with IRS directives and published rulings is vital; professional responsibilities, as discussed in Chapter 3 (Ethics and Responsibilities in Tax Practice), demand due diligence and informed professional judgment.

Quiz Title

Maximize Your Understanding: Hobby Losses and Non-Deductible Expenses Quiz

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