Hobbies are a great way to get away from day-to-day hustle and bustle and relax. They can also be a way to earn some extra money, but be aware that once your hobby produces income, you are required to pay taxes on that income.
Hobby or business?
A hobby, as defined by the IRS, is an activity you pursue without expecting to make a taxable profit. In other words, you do it regardless of the cost because it’s something you enjoy doing.
If you find yourself making money on your hobby, it may be time to turn it into a business and deduct your expenses from your taxable income. If you can demonstrate that you are involved in your hobby with the expectation of making money on it, the IRS will consider it a business. You can operate as a sole proprietor, which gives you more options when it comes to deducting your expenses. Just be sure to report your income on your Form 1040 tax return.
Keep in mind that you can only deduct expenses up the amount you make on the hobby and your expenses, along with any other miscellaneous deductions you claim, must add up to more than 2 percent of your adjusted gross income. To claim your deductions, you simply need to itemize your expenses on Schedule A.
To do this, you need to convince the IRS that your hobby is “actively engaged in for profit”. In other words, you need to show that you are in business.
The IRS considers the following factors to determine if you are running a business.
Does the time and effort put into the activity indicate an intention to make a profit?
Do you depend on income from the activity?
If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
Have you changed methods of operation to improve profitability?
Do you have the knowledge needed to carry on the activity as a successful business?
Have you made a profit in similar activities in the past?
Does the activity make a profit in some years?
Do you expect to make a profit in the future from the appreciation of assets used in the activity?
This list isn’t all-inclusive, so you may be able to show you are a business in other ways.
The IRS presumes an activity is for profit if it makes a profit in “at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses)”.
The IRS says they take all facts into account when determining whether you are carrying on your activity for profit, and that no one factor is decisive, so it’s a good idea to have your bases covered for a few of these factors.
If you find that your hobby has in fact turned into a business, it may be time to talk to an accountant to be sure you are keeping the records required to file your deductions.