At one time or the other, most of us get involved in one kind of venture or another, sort of trying your hand at something different. Sometimes we make money in these ventures and the IRS can be counted on to expect its share of the profits. But what if you lose money in the venture, will you be entitled to a deduction on your return for the loss?
Such questions devolve to one of whether you were engaged in a business or a hobby. As one can imagine, losses from hobbies are not deductible, only business losses are. But, a lot of taxpayers are shocked to find out at the most inopportune time that their venture is classified as a hobby for tax purposes, making the losses non-deductible (though the profits remain taxable).
Is it possible to make sure your venture is classified as a business and not a hobby? Yes, in some cases. What is sometimes helpful is knowing the rules in advance. With knowledge of the rules governing deductibility of business losses, you might be able to properly position yourself to take deductions in case of a loss.
A determination of whether a particular activity is a business or a hobby hinges on several factors. All of the factors are considered in reaching a conclusion. Some of the factors include:
- The manner in which you carried on the activity – did you carry on the business as if you were intending to make a profit or you were merely enjoying yourself without expectation of a profit?
- Your expertise or that of your advisors – reasonably, if you were getting into a business, you are likely to have significant familiarity with the business, or hire seasoned advisors who are able to lend their expertise. Failure to either have familiarity with the business, or hire advisors who do, may be construed as engaging in a hobby.
- Amount of time and effort you expended in carrying on the activity – while not determinative in of itself, the amount of time and effort you expend in carrying out the activity may be an indication of your seriousness in the engagement.
- The expectation that assets used in the activity may appreciate in value – generally, even if you have limited current income from the venture, a reasonable expectation that assets used in the activity will appreciate over time may suggest an expectation of profit.
- Your success in carrying on other similar or dissimilar activities – if the records show that you have tried this particular venture several times in the past without being able to turn a profit, the IRS may conclude that your expectation to turn a profit this time around was unreasonable.
- Your history of income or losses with respect to the activity – similarly, if you have a history of turning a profit from a particular activity, even though it may sound like a hobby, the IRS may be forced to classify the activity as a business and allow you to deduct the losses.
- The amount of occasional profits, if any, which are earned – You are reasonably expected to be turning a profit in the activity for the losses sustained to be deductible. If you are not even occasionally turning a profit, the IRS is likely to deny you loss deductions.
- The presence of personal pleasure or recreation – Especially when you are not turning a profit, evidence of excessive personal pleasure or recreation in the activity will likely lead the IRS to deny your business losses from the activity.
