Hobby Loss Rule.
In plain English
The hobby loss rule is how the IRS separates a genuine business from a hobby for tax purposes. If your activity is a business, you can deduct its expenses and even report a loss that offsets other income. If the IRS treats it as a hobby, you must still report the income, but you generally cannot deduct the expenses to create a loss. The IRS looks at factors like whether you run it in a businesslike way and depend on the income, and there is a presumption that you are a business if you turned a profit in at least three of the last five years.
01Why it matters
If your side activity keeps losing money and the IRS reclassifies it as a hobby, you lose the ability to write those losses off against your other income, which can raise your tax bill and trigger back taxes.
02The math, step by step
You sell handmade furniture and lose $4,000 this year. If it is a real business, that $4,000 loss can offset your other income. If the IRS calls it a hobby, you still report any sales income but cannot deduct the $4,000 loss. Showing a profit in three of the last five years helps support that it is a business.
03What this is NOT
A real business is allowed to lose money, sometimes for years, as long as it is genuinely run for profit. The hobby loss rule only bites when the activity looks more like a personal pastime than a profit-seeking venture.
04Receipts
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Plain-English answers from our glossary. Receipts included. Never advice.
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