We’d all make our incomes doing something we love if it were a perfect world. Whether you enjoy breeding puppies, making kites, or coaching young athletes, there’s nothing quite like collecting a paycheck for doing something you’d do anyway just for the fun of it. But every dime you collect from it is taxable income as far as the IRS is concerned.
The federal tax code used to allow you to take a hobby tax deduction for your costs, but the Tax Cuts and Jobs Act (TCJA) changed that in 2018. You can only claim deductions for hobby expenses from 2018 through at least 2025 if you turn your hobby into a business.
When Your Enterprise Is a Hobby
The best you could do before the Tax Cuts and Jobs Act went into effect was to deduct your costs up to the amount of money you earned from your hobby. Maybe you sold your purebred puppies for $6,000, but it cost you $7,500 in breeding fees and veterinary bills to produce those cute little babies. Your deduction was limited to the $6,000 you earned, and the additional $1,500 was left on the table.
And you could only deduct a portion of that $6,000 because then another rule kicked in. This was a miscellaneous itemized deduction, so it was limited to the portion that exceeded 2% of your adjusted gross income (AGI). This would be $1,200 if your AGI was $60,000 that year. So you had to further reduce that $6,000 by subtracting this amount. You would have been left with a deduction of $4,800 after all these calculations.
Then the TCJA eliminated the hobby expense deduction entirely in 2018. You must claim all your hobby income without getting any corresponding tax break at all as of the 2020 tax year...unless it qualifies as a business.
When Your Hobby Is a Business
The IRS defines a hobby as something you do for pleasure without expecting to earn a profit from it. You’d do it regardless of whether it ever yielded any income. Your income becomes eligible for much better tax treatment if you change that mindset.
You can claim your expenses on Schedule C—the tax form that calculates net taxable income for sole proprietors, independent contractors, and some business owners—if you treat your hobby as a business. This method means that you don’t have to worry about that 2% rule you would have had to deal with in tax years before 2018. And you can show a loss on Schedule C that can offset other income.
In the case of those $6,000 puppies and your $7,500 in expenses, you could use the difference of $1,500 to offset your income from a regular job. Just like that, you'd reduce your overall tax bill doing something you love.
And you’re not limited to deducting just those breeding fees and vet bills. You can deduct a portion of your mortgage and utilities as well if you use part of your home solely to deal with the administrative duties of running your business. You can deduct travel expenses and mileage related to doing business. You can deduct all “necessary” and “ordinary” expenses incurred when that hobby of yours becomes a money-making enterprise.
How to Turn a Hobby into a Business
You can’t simply tell the IRS, “OK, this is a business now,” and be done with it. Your activities must reflect your goal.
You must demonstrate to the IRS that you’re breeding those puppies because you expect to earn a profit from doing so. This means one of two things:
- You've made a profit from your pursuit in at least three of the last five years, or
- You can pass the IRS “factors and circumstance” test.
You might not have turned a profit yet, particularly in the first year, but the IRS will agree that you’re running a business when it looks at the big picture.
The IRS considers several factors when it's judging that big business picture. They'll want to know whether you keep detailed and accurate financial records. You might want to establish a separate bank account for your endeavor, and do not allow any overlap between business and personal expenses. Don’t make your car payment from the business account.
It’s OK to pay yourself weekly or monthly—in fact, it shows that you depend on the money you’re earning to pay your bills—but the line between your personal expenses and your business expenses should be black, not gray.
The IRS will review whether you have the training, education, knowledge, or skill to make your endeavor profitable. You should hire or at least consult with someone who does have the necessary know-how if you don't.
The IRS also wants to know that you depend on the income from your enterprise for at least a portion of your livelihood. You'll have to show that you devote a fairly substantial amount of time to it. This requirement doesn’t mean that you have to quit your day job, but be prepared to burn a fair amount of midnight oil and sacrifice your weekends if you don't.
Something else the IRS looks at is whether you spend money on things like advertising and promotion, or to attend conferences, trade shows, and other networking activities. Finally, they'll want to see that you’ve made adjustments and changes to your operation to turn those losses into profits.
The IRS doesn’t expect you to earn a profit right out of the box. It’s understandable if you suffer a loss for a year or two—many startups and new businesses do. But if you at least come close to covering your expenses, that can be a good indicator that you’re indeed operating to earn a profit.
It's even better if you incorporate or take steps to form some other business structure, such as an LLC. Consider putting together a formal business plan, too, even if you decide to operate as a sole proprietor.
Pay the Appropriate Taxes
Filing Schedule C with your 1040 tax return because you’re running a business comes with an additional responsibility or two.
You’ll have to pay self-employment tax on this income—Social Security and Medicare. Yes, you pay these taxes as an employee, too, but you would only pay half in this case, and your employer would contribute the other half. You’re considered both employer and employee when you’re running a business, so you have to pay both halves. The IRS lets you take a deduction for half these taxes when you file your return, however.
The IRS doesn’t want to wait until you file your tax return to begin collecting taxes from you, either. You must pay estimated income taxes and self-employment taxes quarterly as the year goes on. Otherwise, you’ll end up paying interest and possibly penalties.
What If the IRS Asks for Proof?
The need for keeping meticulous records can’t be overstated. A lot more taxpayers can be expected to make this transition while the TCJA remains in effect, and hobby expenses are no longer deductible through at least 2025. The IRS will keep a close eye on this situation going forward, so be ready to prove that you mean business.
NOTE: The Balance does not provide tax or investment advice. This information is presented without consideration of the risk tolerance or financial circumstances of any specific taxpayer and might not be suitable for everyone. Consider consulting with a tax professional if you're considering launching your own business.