Today, many people sell homemade products online or work on some unincorporated sideline venture outside of their regular day jobs. Such activities can generate extra spending money. This can be especially helpful for retired people and stay-at-home parents — or for those who been laid off or taken a pay cut, during the COVID-19 crisis.
For example, suppose you’ve turned a love for woodworking or crafting into an Etsy site that sells custom furniture or face masks. Or maybe you’ve started playing violin in the parking lot of your local grocery store. Should these activities be reported as for-profit business activities or nondeductible hobbies under the tax law? Here’s why it matters for federal income tax purposes and how to make the distinction.
Comparing the Tax Treatment
In general, you must report all sources of income on your federal income tax return (Form 1040), including revenue from hobby and business activities. But the extent to which you can deduct the related expenses depends on how the activity is classified under the tax code.
Expenses related to a legitimate, for-profit business activity generally are deductible under the tax law. So, if you operate an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), you can generally deduct the full amount of the loss on your federal income tax return. That means the loss can be used to offset income from other sources and reduce your federal income tax bill.
On the other hand, the tax results are less favorable if your money-losing sideline activity is classified as a hobby, which essentially means an activity that lacks a profit motive. And the rules have gotten less favorable, thanks to an unfavorable provision of the Tax Cuts and Jobs Act (TCJA).
Old rules
Under the old rules that were in effect before the Tax Cuts and Jobs Act (TCJA), you were required to report all revenue for hobby activities on your tax return, and your allowable deductions from the activity were limited to that revenue. In other words, you could never have an overall tax loss from an activity that was treated as a hobby, even if you lost money.
You were allowed to deduct hobby-related expenses that could be written off in any event, such as itemized deductions for allocable home mortgage interest and property taxes. Your other hobby-related expenses (limited to income) were claimed as a miscellaneous itemized deduction item. That means you got no write-off unless you itemized. And, even if you itemized, the write-off for miscellaneous deduction items was limited to the excess of those items over 2% of your adjusted gross income (AGI). The higher your AGI was, the less you could deduct. High-income taxpayers often found their allowable hobby activity deductions limited to little or nothing. Finally, if you were subject to the individual alternative minimum tax (AMT), miscellaneous itemized deductions for hobby expenses were completely disallowed for AMT purposes.
New rules
For 2018 through 2025, the TCJA suspends write-offs for miscellaneous itemized deduction items that, under prior law, were subject to the 2%-of-AGI deduction threshold. That change eliminates all deductions for hobby-related expenses, except for expenses that you can write off in any event, such as itemized deductions for allocable mortgage interest and property taxes.
So, under the current law, you simply can’t deduct most hobby-related expenses for federal income tax purposes. As under prior law, you still must report 100% of hobby-related income on your tax return. As a result, it’s more important than ever to establish that a money-losing activity is actually a for-profit business venture that hasn’t yet become profitable.
News Source：【BRADY WARE CPAs 2020/07/13】
