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How Will Hobby Loss Rules Affect My Taxes: Where Does The IRS Draw The Line?
How Will Hobby Loss Rules Affect My Taxes: Where Does The IRS Draw The Line?
You may have started crocheting to take your mind off your 9-5, but does selling a few hats mean you have to report the money you earned to the IRS? If we know tax law (and we do), it's never that simple.
If you sold three hats in an entire year, your crocheting is still a hobby. But, if you start to get frequent orders, it no longer counts as hobby income. This is when you might want to start thinking about either becoming a sole proprietor or registering as an LLC.
The IRS views any activity carried out with an intent to make a profit as a business. While this comes with its own tax benefits like claiming business expenses as tax deductions, or carrying any losses over to the next year, reporting too many losses in a row may get your business classified as a hobby. This rule was put in place to prevent people from using their hobbies to get tax deductions.
Key takeaways:
- Only business-related losses and expenses can be deducted from your taxes
- Multiple losses in a row will result in the IRS classifying your business as a hobby (along with a few other factors)
Table of contents
Do I have to pay taxes on my hobby income?
Any income earned through your hobby will need to be reported on the Schedule 1 form (Additional Income and Adjustments to Income) of your 1040. You will only be required to pay taxes on this hobby income if it puts your gross income for the year above the IRS threshold of $400 or more.
And there are advantages to continuing your activities as a hobby. There's less pressure to make a profit, you don’t need a business license and you’re having fun.
What do hobby tax rules say about hobby expenses?
The next question you might be asking yourself is ‘Are hobby expenses deductible?’ and the answer to that is unfortunately: no. With the Tax Cuts and Jobs Act passed in 2017, you can no longer deduct any miscellaneous itemized deductions. So any hobby expense deductibles you were hoping to use to lower your tax bill go right out the window.
Let’s say you started flower arranging as a hobby in 2021. The Instagram page you use to showcase your work starts to get more traction, and two of your friends say they would pay you to send them some flower arrangements. Suddenly, you made $300. If that’s all the income you earned from this hobby that year, you would report it along with your regular income on your tax form. But you would not have to pay any income or self-employment taxes on it.
Even if you spent $400 on flowers and supplies, you still cannot deduct those hobby expenses you spent in 2021 because of the tax law we mentioned earlier. But in 2022, your Instagram page really takes off and you start getting weekly orders. You could then decide to turn this hobby into a business and become a independent contractor. Doing this will mean you might need to pay estimated taxes.
Then you no longer earn hobby income in 2022 and will only report and pay taxes on your business income as per the IRS guidelines. If you use an app like Flyfin, where all you have to do is link your expenses, the A.I. tax-engine can review your transactions and find all potential deductions, saving you time and money every tax season. You can even reach out to our expert team of CPAs who specialize in 1099 tax and are available 24/7 if you have any specific questions – free of charge!
How many years can a business show a loss?
To answer this question, we have to first identify what qualifies as a business. Along with the IRS guidelines we mentioned earlier, there is also the "safe harbor" rule. If you have managed to earn a profit three out of five years, the IRS will assume that you are operating as a business.
Business losses are natural in the first few years, and the IRS allows you to use your losses as a tax deduction. But this is only available to non-corporations (LLC, partnerships, sole proprietors).
And there is a loss limit: $262,000 if you’re filing as an individual and $524,000 if you’re filing jointly. A business loss limit is the maximum amount of loss you are allowed to deduct from your net loss in a year. You can also carry forward your loss to the next tax year, meaning you can count it as an expense and deduct it. But you can only do this for up to 80% of your taxable income.
So, if you had a loss of $400,000 in 2022, and your taxable income was $300,000. You are allowed to deduct $262,000 of your loss due to the limit, so your new taxable income becomes $38,000 ($300,000 - $262,000). The remaining loss of $138,000 can be carried forward to the next year.
The IRS allows for carried forward business losses to be written off only up to 80% of taxable income. In this case, if you made $300,000 in 2023, you can write off the entire amount as an expense as it does not exceed 80% of your income (80/100 x 300,000 = 240,000). This makes your new taxable income for the next year $162,000 ($300,000 - $138,000).
While this sounds great, there is a limit to how many losses a business can incur. There's no set number, but if the IRS sees too many in a row, there is a risk they will classify it as a hobby, meaning any money spent on supplies or transportation is now hobby expenses that are not deductible.
If this happens, you can still claim the loss as a deduction provided you keep accurate records of your transactions and are able to show clear intent to make a profit. You can also use the above-mentioned IRS guidelines to help your case.
As you can now see, there are pros and cons to both hobbies and businesses. What you’re looking to get out of the activity you are doing is a good first step in deciding whether you want to make the switch to becoming a business. Make sure to also research hobby loss rules and your estimated costs thoroughly before taking the plunge.
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