We live in an age where anyone can be their own boss and turn their dreams and passions into a business. A lot of Americans have a ‘side hustle’ in addition to their traditional 9-5 job. These side hustles can be anything from teaching gym classes to selling skin care products. You can turn virtually any hobby into a side gig. But sometimes making the transition from hobby to business is tricky. The lines can become blurred. There are several steps you can take to determine whether your pursuit is a hobby or a business.
What is the difference between a hobby and a business?
In general, people have hobbies for recreation, not to make a profit. Businesses, on the other hand, usually operate at either a profit or a loss. It is important to figure out if your activity counts as a business because if you operate at a loss due to startup costs you can deduct these amounts to assist on your tax return.
How do I distinguish hobby income from self-employed income?
Start by asking yourself these 9 questions when determining if you have a business or a hobby:
- Do you keep accurate records?
- Do you intend for it to be profitable and does your time and effort reflect that?
- Do you depend on the income from the activity to survive?
- Do you alter your model to try to make your business more profitable?
- Do you have enough knowledge on the subject to turn it into a business?
- Are your losses a normal part of startup costs or are they due to circumstances you can’t control?
- Have you made a profit doing a similar activity in the past?
- Was this past profit consistent or did it see more activity in some years and less in others?
- Do you expect to make a profit from the activity in the future?
Try to answer these questions with facts and be honest with yourself. If you answered ‘yes’ to most of these questions, you probably have a business. If you answered ‘no’ to most of them, you probably have a hobby.
If answering these questions still leaves you confused, consider this. If you made a profit in three of the last five years, the IRS considers your activity for-profit and a business. This rule extends to two out of the last seven years for activities involving horses, like showing, breeding, and racing.
If you are on the verge of your business becoming a hobby due to lack of profitability, keep extensive records and receipts. Make a short-term business plan to try to increase profit. This is also good for your records in case you get audited.
Can I still use tax deductions for my hobby?
No. Under the Tax Cuts and Jobs Act of 2017, miscellaneous itemized deductions can no longer be deducted for tax years after 2017. This means no hobby-related expenses can be deducted.
For tax years prior to 2018, the IRS wouldn’t allow you to take any losses if your activity was categorized as a hobby. However, you could deduct hobby expenses and other itemized deductions on Schedule A, but only if it was more than 2% of your adjusted gross income – or your gross income minus adjustments to income. Additionally, the amount you claim on an expense could not exceed the total income from your hobby.
This article is up to date and accounts for tax law changes for tax year 2019 (tax returns filed in 2020). Learn more about tax reform enacted under the Tax Cuts and Jobs Act here.