Recreation or business?
First, ask yourself if your hobby is a recreational pursuit or a profit-making endeavor. Earning a living doing something you love is a natural goal, but you need to be clear about your intentions to claim expenses come tax time.
The IRS defines a hobby as an activity that a person pursues because they enjoy it and have no intention of making a profit.
This doesn't mean you're prohibited from earning any money or actually making a profit. For example, if you tinker with cars, it's okay for a friend to pay you for an occasional oil change. This would be hobby income.
Generally speaking, your hobby is a business if:
- Some or all of your income comes from the hobby. For example, you sell handmade candy on an e-commerce store, and the earnings account for half of your annual income.
- Your hobby experiences profits and losses. For example, you earn significant profits from Valentine's Day sales, but you've spent too much on a flavor of Halloween candy that didn't sell.
Hobby income and expenses
Beginning in 2018, the IRS doesn't allow you to deduct hobby expenses from hobby income. you must claim all hobby income and are not permitted to reduce that income by any expenses.
For tax years prior to 2018, you can deduct hobby expenses as an itemized deduction subject to 2% of your adjusted gross income. Also, the amount that you claim as an expense cannot be greater than your income from the hobby. In other words, your hobby cannot generate a loss. For example, if you're a knitter and spent $300 on yarn and other supplies, and sold one sweater for $150, you can use only up to $150 in expenses ($300-$150 = $150). But, if you spent $300 on your knitting hobby and earned $300 from the sale of two sweaters, you can use the full amount of your expenses. The expenses you can deduct are called "ordinary expenses" and "necessary expenses."
- Ordinary expenses are those required to carry out the hobby, such as fabric and thread for a quilter.
- Necessary expenses are those that help you develop the skills your hobby requires, like attending a quilting class.
Itemized deductions and the standard tax deduction
Taxpayers can choose to itemize deductions on their tax returns or take the Standard Deduction. Hobby expenses can only be deducted if you itemize your deductions for tax years prior to 2018.
If you’re taking the Standard Deduction:
- Select the appropriate Standard Deduction you qualify for from the chart provided by the IRS. This amount is based mostly on your age and filing status, such as married, single or widower. Additions to the Standard Deductions are included if you or your spouse are blind.
- Enter the amount on your tax form along with other required information.
If you're itemizing deductions for years 2017 and earlier:
- List your hobby expenses on Schedule A.
- Note the total of your hobby expenses.
- Calculate 2% from your adjusted gross income.
- Subtract the 2% amount from your hobby expenses to arrive at the amount you can deduct as an itemized deduction.
For example:
- $48,000 (your AGI) x 2% = $960
- $4,000 (your hobby expenses) - $960 = $3,040.
- $3,040 is the amount of hobby expenses you can deduct as an itemized deduction provided you had at least $4,000 in hobby income.
From hobby to business
Keep records if your hobby becomes more of a business than a recreational pursuit. Business owners typically use Schedule C to report profits and losses and to deduct a broad range of deductions not available to hobbyists. The IRS might consider your hobby a business when any or all of the following apply:
- The things you do to run your hobby-business, like hiring knowledgeable employees and advertising, point to your intent to make a profit.
- You earn your livelihood from the hobby.
- You've made a profit for at least three of the past five years.
- You hope to make a profit from some of your business assets down the road, like animals for breeding.
- You've made a profit from a similar business in the past.
Because the responsibility is on you to show that your hobby-business is entitled to business tax breaks, keeping detailed records will come in handy in case the IRS asks you to substantiate that you have a business rather than a hobby.
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