{"id":867,"date":"2019-08-11T14:58:42","date_gmt":"2019-08-11T14:58:42","guid":{"rendered":"https:\/\/wcginc.com\/?p=867"},"modified":"2026-01-26T16:37:02","modified_gmt":"2026-01-26T16:37:02","slug":"avoid-hobby-loss-rule","status":"publish","type":"post","link":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/","title":{"rendered":"Avoid the Hobby Loss Rules"},"content":{"rendered":"<div class=\"wpb-content-wrapper\"><p>[vc_row][vc_column]\t\t\t<div class=\"info-box-wrapper\">\n\t\t\t\t<div id=\"wd-68b58efc1643c\" class=\" wd-rs-68b58efc1643c wd-info-box wd-wpb text-left box-icon-align-top box-style- color-scheme- wd-bg-none border-btm-title \">\n\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-content\">\n\t\t\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-inner reset-last-child\"><\/p>\n<div class=\"overview\">\n<h2><span class=\"ez-toc-section\" id=\"Key_Takeaways\"><\/span>Key Takeaways<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<ul>\n<li>Side hustles can be exciting, but without a <b>documented profit motive<\/b>, the IRS may classify them as a hobby.<\/li>\n<li><b>Hobby Loss Rules (IRC Section 183)<\/b> determine if your activity is a business or a hobby, including a \u201csafe harbor\u201d test: profit in <b>3 of 5 consecutive years<\/b> generally qualifies as a business.<\/li>\n<li>Even if classified as a hobby, you can <b>deduct hobby expenses<\/b>, but not losses against other income.<\/li>\n<li>Factors the IRS considers for a business vs. hobby include: time and effort spent, expertise, profit history, steps to improve profitability, financial dependence, and personal enjoyment.<\/li>\n<li>Demonstrating a <b>profit motive<\/b> involves showing regular, intentional actions to earn money, such as advertising, tracking operations, and improving skills.<\/li>\n<li><b>Separate records<\/b> for income, expenses, and banking strengthen your case as a legitimate business.<\/li>\n<li>The IRS allows losses in startup or challenging phases, provided they are for legitimate business reasons, not personal hobbies.<\/li>\n<li><b>Dealing with audits:<\/b> maintain good documentation, advertising proof, licenses, and follow IRC 1.183-2(b) guidelines.<\/li>\n<\/ul>\n<\/div>\n<p>\n<\/div>\n\n\t\t\t\t\t\t\t\t\t\t\t<\/div>\n\n\t\t\t\t\t\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t<\/div>\n\t\t\t\t\t<div class=\"info-box-wrapper\">\n\t\t\t\t<div id=\"wd-67330b55b4154\" class=\" wd-rs-67330b55b4154 wd-info-box wd-wpb text-left box-icon-align-top box-style- color-scheme- wd-bg-none border-btm-title img-right \">\n\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-content\">\n\t\t\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-inner reset-last-child\"><p><img decoding=\"async\" class=\"alignnone size-medium wp-image-23697\" src=\"https:\/\/wcginc.com\/wp-content\/uploads\/rave-300x183.jpg\" alt=\"\" width=\"300\" height=\"183\" srcset=\"https:\/\/wcginc.com\/wp-content\/uploads\/rave-300x183.jpg 300w, https:\/\/wcginc.com\/wp-content\/uploads\/rave.jpg 328w\" sizes=\"(max-width: 300px) 100vw, 300px\" \/>We are living in the age of the \u201cside hustle.\u201d Talk to ten of your friends and colleagues, and chances are at least half of them are building a little something on the side. Side hustles can be incredible. They give you a way to outlet your passions and hopefully make a little money outside of your 9-to-5 j-o-b. However, if you don\u2019t have a business plan, specifically a documented profit motive, your side hustle could quickly become classified a hobby by the IRS, and that doesn\u2019t sound nearly as cool.<\/p>\n<p>The Hobby Loss Rules are governed by\u00a0<a href=\"https:\/\/www.law.cornell.edu\/uscode\/text\/26\/183\" target=\"_blank\" rel=\"noopener\">Internal Revenue Code Section 183<\/a>\u00a0and include what\u2019s called a Safe Harbor test to determine if your business is really a hobby. It relies on how many years you report a profit versus a loss on your tax returns (Schedule C). In general, it is assumed if you have profit 3 out of 5 consecutive years, you are engaged in a for-profit activity and therefore not a hobby. If you have more years of losses, you have to prove you are involved in operations for profit, not just for fun. Don\u2019t worry! Profit can still be fun! We are continuously amazed at what people do for a living. Amazing!<\/p>\n<p>The\u00a0<a href=\"https:\/\/www.irs.gov\/newsroom\/hobby-or-business-irs-offers-tips-to-decide\" target=\"_blank\" rel=\"noopener\">IRS\u2019s website<\/a>\u00a0has some excellent\u00a0<a href=\"https:\/\/www.irs.gov\/newsroom\/hobby-or-business-irs-offers-tips-to-decide\" target=\"_blank\" rel=\"noopener\">hobby loss rule<\/a>\u00a0resources as well, and explains how to deduct hobby expenses. Note that we said expenses and not necessarily losses. Yup! If you are deemed to have a hobby and not a business, you may still deduct the hobby expenses against the hobby revenue.<\/p>\n<p>Back to the issue at hand\u2026 wanting to deduct your business losses\u2026 just like your father might have said, your actions are going to speak much louder than your words. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, you should consider the following factors which are detailed in\u00a0<a href=\"https:\/\/www.law.cornell.edu\/cfr\/text\/26\/1.183-2\" target=\"_blank\" rel=\"noopener\">IRC Section 1.183-2(b)<\/a>\u2013<\/p>\n<ol>\n<li>The manner in which the taxpayer carries on the activity<\/li>\n<li>The expertise of the taxpayer or his advisers<\/li>\n<li>The time and effort expended by the taxpayer in carrying on the activity<\/li>\n<li>The expectation that assets used in the activity may appreciate in value<\/li>\n<li>The success of the taxpayer in carrying on other similar or dissimilar activities<\/li>\n<li>The taxpayer\u2019s history of income or losses with respect to the activity<\/li>\n<li>The amount of occasional profits, if any, which are earned<\/li>\n<li>The financial status of the taxpayer<\/li>\n<li>The elements of personal pleasure or recreation.<\/li>\n<\/ol>\n<p><strong>Warning:<\/strong>\u00a0this is not an all or nothing or weighted list. The Tax Court looks at the full picture and how each factor relates to the facts as a whole. For example, are you a concrete contractor waiting for the housing market to pick back up? Are you a tech start-up developing a new product that will take 5-7 years to bring to market.<\/p>\n<p>Thankfully, there are a few Tax Court cases that give us some foundation to fall back on to ensure that while figuring out the whole \u201cHow to Make a Profit\u201d thing, that we don\u2019t get dumped into the Hobby Loss pit of misery instead of bonafide Business Loss (which is equally miserable but at least tax deductible).<\/p>\n<\/div>\n\n\t\t\t\t\t\t\t\t\t\t\t<\/div>\n\n\t\t\t\t\t\n\t\t\t\t\t<style><\/style>\t\t\t\t<\/div>\n\t\t\t<\/div>\n\t\t\t\t\t<div class=\"info-box-wrapper\">\n\t\t\t\t<div id=\"wd-67330adfd298d\" class=\" wd-rs-67330adfd298d wd-info-box wd-wpb text-left box-icon-align-top box-style- color-scheme- wd-bg-none border-btm-title \">\n\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-content\">\n\t\t\t\t\t\t<h2 class=\"info-box-title title wd-font-weight-800 box-title-style-default font-primary wd-fontsize-m\"><span class=\"ez-toc-section\" id=\"Hobby_Loss_Questions\"><\/span>Hobby Loss Questions<span class=\"ez-toc-section-end\"><\/span><\/h2>\t\t\t\t\t\t<div class=\"info-box-inner reset-last-child\"><p>Generally, an activity qualifies as a business if it is carried on with the\u00a0<strong>reasonable expectation of earning a profit<\/strong>. Here are some questions to consider-<\/p>\n<p>Does the time and effort put into the activity indicate an intention to make a profit? If you only spend a few hours here and there, this might appear more like a hobby. Keeping a quick logbook or diary listing your hours might be helpful.<\/p>\n<p>Does the taxpayer depend on income from the activity? If you have another job that is your main source of income, and you do not rely on your business for your livelihood, the IRS might consider it a hobby. At some point there needs to be a detrimental reliance on the income to be considered a business.<\/p>\n<p>If there are losses, are they due to circumstances beyond the taxpayer\u2019s control or did they occur in the startup phase of the business? In other words, are you simply losing money to shelter other income or are you losing money for appropriate reasons? Did customers stop buying VHS in favor of DVDs, and you were invested heavily in the VHS business? Are your expenses considered start-up costs, or could they be considered daily operational expenditures which might be considered hobby expenses instead of business expenses.<\/p>\n<p>Has the taxpayer changed methods of operation to improve profitability? Does the taxpayer or his\/her advisors have the knowledge needed to carry on the activity as a successful business? The IRS agent will ask about the steps you are taking to attract new customers, make sales, reduce costs, improve your knowledge of the industry, etc. If you can demonstrate that you are taking the necessary actions to earn a profit such as advertising activities and conference registrations, then your actions will suggest a legitimate business.<\/p>\n<p>Has the taxpayer made a profit in similar activities in the past? Does the activity make a profit in some years? The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year.<\/p>\n<p>Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity? Some taxpayers are involved in businesses that purchase property in hopes of increased value upon re-sale. Businesses involved in photography, art, music rights, automobiles, stocks, etc. who can demonstrate this connection will be considered a legitimate business.<\/p>\n<\/div>\n\n\t\t\t\t\t\t\t\t\t\t\t<\/div>\n\n\t\t\t\t\t\n\t\t\t\t\t<style><\/style>\t\t\t\t<\/div>\n\t\t\t<\/div>\n\t\t\t\t\t<div class=\"info-box-wrapper\">\n\t\t\t\t<div id=\"wd-67330b25d2a0a\" class=\" wd-rs-67330b25d2a0a wd-info-box wd-wpb text-left box-icon-align-top box-style- color-scheme- wd-bg-none border-btm-title \">\n\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-content\">\n\t\t\t\t\t\t<h2 class=\"info-box-title title wd-font-weight-800 box-title-style-default font-primary wd-fontsize-m\"><span class=\"ez-toc-section\" id=\"Philosophy_on_Hobby_Loss_Rules\"><\/span>Philosophy on Hobby Loss Rules<span class=\"ez-toc-section-end\"><\/span><\/h2>\t\t\t\t\t\t<div class=\"info-box-inner reset-last-child\"><p>As any politician and economist will tell you, the key to a healthy economy is the strength of small businesses. Small businesses innovate, are typically the first ones to hire and have a unique way of becoming major players in local communities. Therefore, the tax code allows you to deduct business losses from other sources of income as a way to encourage you to take the risk of starting a new business.<\/p>\n<p>In the same breath, politicians and economists will also say that the deduction of expenses for a venture that is a hobby does not help the economy and in some cases the venture might be a drain on society\u2019s resources. It makes sense that the tax benefits of running a business should only exist if you are actually trying to turn a profit.<\/p>\n<\/div>\n\n\t\t\t\t\t\t\t\t\t\t\t<\/div>\n\n\t\t\t\t\t\n\t\t\t\t\t<style><\/style>\t\t\t\t<\/div>\n\t\t\t<\/div>\n\t\t\t\t\t<div class=\"info-box-wrapper\">\n\t\t\t\t<div id=\"wd-67330bad4fb99\" class=\" wd-rs-67330bad4fb99 wd-info-box wd-wpb text-left box-icon-align-top box-style- color-scheme- wd-bg-none border-btm-title \">\n\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-content\">\n\t\t\t\t\t\t<h2 class=\"info-box-title title wd-font-weight-800 box-title-style-default font-primary wd-fontsize-m\"><span class=\"ez-toc-section\" id=\"Cannot_Pass_3_out_of_5_Rule\"><\/span>Cannot Pass 3 out of 5 Rule<span class=\"ez-toc-section-end\"><\/span><\/h2>\t\t\t\t\t\t<div class=\"info-box-inner reset-last-child\"><p>What if you cannot pass the 3 out of 5 test? Not to worry, you can still demonstrate a profit motive. Remember, the 3 out of 5 test presumes a business if there is profit. If you cannot pass the 3 out of 5 test, you are presumed by the IRS to be operating a hobby unless you can prove a profit motive.<\/p>\n<p>As mentioned earlier, there are several reasons why legitimate businesses might not be able to show a profit for 3 years- some businesses take more time to materialize their profit, and others might be victims of horrible economic conditions (e.g., a concrete contractor waiting for the housing industry to pick back up). Three choices exist:<\/p>\n<ol>\n<li>You could go dark, and stop deducting the business losses for a couple of years (this is not our recommendation), or<\/li>\n<li>Deduct your business expenses up to the amount of your business income for a net zero affect (this is similar to gambling losses, which can only be deducted to the amount of gambling winnings), or<\/li>\n<li>Press on and make your argument during a possible audit.<\/li>\n<\/ol>\n<p>Here are some suggestions for demonstrating that your business is for real and not a hobby-<\/p>\n<p><strong><img decoding=\"async\" class=\"alignnone size-full wp-image-26103\" src=\"https:\/\/wcginc.com\/wp-content\/uploads\/SECURE-Act-including-FCAA-200x300-2.jpg\" alt=\"\" width=\"200\" height=\"300\" \/>Keep Good Records.<\/strong>\u00a0The Tax Court relies heavily on your businesslike behaviors to help determine your profit motives, and one of those behaviors is record keeping. In their eyes, businesses with a profit motive maintain good records so you should track revenue and each expense with as much detail as possible. Maintain a separate checking account for your business related transactions. Were you once profitable, but are currently experiencing several years of challenging times? Be able to show your financial history beyond the five year mark.<\/p>\n<p><strong>Prove Your Advertising.<\/strong>\u00a0How many legitimate businesses don\u2019t advertise? Not many. So, keep copies of your advertisements, business cards, flyers, letterhead, logo artwork, etc., and all the associated expenses (web development, graphic artist fees, etc.).<\/p>\n<p><strong>Track Your Actions.<\/strong>\u00a0Use a business calendar app or something similar to show your actions, and how they are related to your eventual profitability. Who did you meet with? What publications did you read? Do you have a mentor? What type of training are you receiving? Conferences? How many hours per week are you spending on your activity?<\/p>\n<p><strong>Be Legit.<\/strong>\u00a0Make sure you have all the permits and licensing required for your business. Create an LLC (we can help). Register your business in local directories.<\/p>\n<p><strong>IRS Regs.<\/strong>\u00a0Review the items listed under\u00a0<a href=\"https:\/\/www.law.cornell.edu\/cfr\/text\/26\/1.183-2\" target=\"_blank\" rel=\"noopener\">Internal Revenue Code 1.183-2(b)<\/a>, and be in compliance with those items.<\/p>\n<\/div>\n\n\t\t\t\t\t\t\t\t\t\t\t<\/div>\n\n\t\t\t\t\t\n\t\t\t\t\t<style><\/style>\t\t\t\t<\/div>\n\t\t\t<\/div>\n\t\t\t\t\t<div class=\"info-box-wrapper\">\n\t\t\t\t<div id=\"wd-68b58f28cb2b8\" class=\" wd-rs-68b58f28cb2b8 wd-info-box wd-wpb text-left box-icon-align-top box-style- color-scheme- wd-bg-none border-btm-title faqs-wrap \">\n\t\t\t\t\t\t\t\t\t\t<div class=\"info-box-content\">\n\t\t\t\t\t\t<h2 class=\"info-box-title title box-title-style-default wd-fontsize-m\"><span class=\"ez-toc-section\" id=\"Frequently_Asked_Questions\"><\/span>Frequently Asked Questions<span class=\"ez-toc-section-end\"><\/span><\/h2>\t\t\t\t\t\t<div class=\"info-box-inner reset-last-child\"><\/p>\n<h3><span class=\"ez-toc-section\" id=\"What_is_the_Hobby_Loss_Rule\"><\/span>What is the Hobby Loss Rule?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Rules under IRC Section 183 that determine if an activity is a business or hobby for tax purposes.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"How_can_I_prove_my_side_hustle_is_a_business\"><\/span>How can I prove my side hustle is a business?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Show consistent profit motive, maintain records, advertise, and take steps to improve profitability.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"What_if_my_business_isnt_profitable_for_3_of_5_years\"><\/span>What if my business isn\u2019t profitable for 3 of 5 years?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>You can still prove a profit motive through records, effort, and operational evidence.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"Can_I_deduct_expenses_for_a_hobby\"><\/span>Can I deduct expenses for a hobby?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Yes, but only up to the amount of income generated by the hobby.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"What_factors_does_the_IRS_consider\"><\/span>What factors does the IRS consider?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Time spent, expertise, profit history, financial dependence, asset appreciation, and personal enjoyment.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"Do_I_need_separate_business_accounts\"><\/span>Do I need separate business accounts?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Yes, it helps demonstrate professionalism and a profit motive.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"Are_startup_losses_allowed\"><\/span>Are startup losses allowed?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Yes, as long as they are legitimate business expenses and not personal hobby losses.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"What_actions_demonstrate_a_profit_motive\"><\/span>What actions demonstrate a profit motive?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Advertising, training, tracking hours, attending conferences, and improving business operations.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"Do_I_need_permits_or_licenses\"><\/span>Do I need permits or licenses?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Yes, having all necessary legal registrations strengthens your business case.<\/p>\n<h3><span class=\"ez-toc-section\" id=\"Where_can_I_review_the_IRS_guidance\"><\/span>Where can I review the IRS guidance?<span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p>Internal Revenue Code 1.183-2(b) provides the official criteria for business vs. hobby classification.<\/p>\n<\/div>\n\n\t\t\t\t\t\t\t\t\t\t\t<\/div>\n\n\t\t\t\t\t\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t<\/div>\n\t\t[\/vc_column][\/vc_row]<\/p>\n<\/div>","protected":false},"excerpt":{"rendered":"<p>[vc_row][vc_column][\/vc_column][\/vc_row]<\/p>\n","protected":false},"author":6,"featured_media":62746,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[17],"tags":[],"class_list":["post-867","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-blog"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v27.8 (Yoast SEO v27.8) - 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Governed by Internal Revenue Code 183","description":"The Hobby Loss Rules are governed by Internal Revenue Code 183 and include what\u2019s called a Safe Harbor test to determine if your business is really a hobby.","robots":{"index":"index","follow":"follow","max-snippet":"max-snippet:-1","max-image-preview":"max-image-preview:large","max-video-preview":"max-video-preview:-1"},"canonical":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/","og_locale":"en_US","og_type":"article","og_title":"Avoid the Hobby Loss Rules","og_description":"The Hobby Loss Rules are governed by Internal Revenue Code 183 and include what\u2019s called a Safe Harbor test to determine if your business is really a hobby.","og_url":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/","og_site_name":"WCG CPAs &amp; Advisors","article_published_time":"2019-08-11T14:58:42+00:00","article_modified_time":"2026-01-26T16:37:02+00:00","og_image":[{"width":200,"height":300,"url":"https:\/\/wcginc.com\/wp-content\/uploads\/SECURE-Act-including-FCAA-200x300-2-1.jpg","type":"image\/jpeg"}],"author":"Jason Watson","twitter_card":"summary_large_image","twitter_misc":{"Written by":"Jason Watson","Est. reading time":"10 minutes"},"schema":{"@context":"https:\/\/schema.org","@graph":[{"@type":"Article","@id":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/#article","isPartOf":{"@id":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/"},"author":{"name":"Jason Watson","@id":"https:\/\/wcginc.com\/#\/schema\/person\/0225b77adcec813c7746e7806e0482f9"},"headline":"Avoid the Hobby Loss Rules","datePublished":"2019-08-11T14:58:42+00:00","dateModified":"2026-01-26T16:37:02+00:00","mainEntityOfPage":{"@id":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/"},"wordCount":2810,"publisher":{"@id":"https:\/\/wcginc.com\/#organization"},"image":{"@id":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/#primaryimage"},"thumbnailUrl":"https:\/\/wcginc.com\/wp-content\/uploads\/SECURE-Act-including-FCAA-200x300-2-1.jpg","articleSection":["Blog"],"inLanguage":"en-US"},{"@type":"WebPage","@id":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/","url":"https:\/\/wcginc.com\/blog\/avoid-hobby-loss-rule\/","name":"Avoid the Hobby Loss Rules - 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