First, the bad news. If you make any money from a hobby, the total sales price is 100% taxable and you better believe the IRS is going to be tracking that one.
That means if you make crafts and sell them online through Etsy (or some other site) it’s 100% taxable. No expenses are allowed against the income. If you buy some furniture to repair and fix up to then sell, the sales price is 100% taxable. You can’t even deduct the cost of buying the furniture. If you show horses and win a saddle, the value is 100% taxable. You can’t take any deductions against the income.
Prior to the Tax Cuts and Jobs Act (Trump Tax Plan) effective 1/1/2018, you could take a deduction of hobby expenses against income as long as you itemized. After 1/1/2018, you can no longer take that deduction.
There is a strategy at the end of this article, so don’t panic just yet.
This hasn’t been a big target of the IRS in the past because most people with hobbies had losses, not income. But now that there are no deductions allowed, this has become a much bigger deal. The IRS knows that EVERYONE who has a hobby that they sometimes make money at (like Etsy, eBay, Facebook Marketplace or Craigs List) will have taxable income. And you can bet they’ll eventually get around to hobbies.
Just to be clear, you have never been able to take a deduction for hobby losses. But in the past, you could at least take expenses up to the amount of income you made. Now, you can’t. It’s ALL income.
If you are in an MLM or direct marketing company where you make a little bit of money but don’t worry about taking a deduction because you know it won’t qualify as a business, guess again. It’s either a hobby or a business.
And if it’s not a business, it’s a hobby. And that means you pay tax on the gross amount you receive. No deductions allowed.
What is the solution?
Turn that hobby into a business. There are 9 factors that the IRS looks at to verify it’s a business:
- How the taxpayer carries on the activity. You can establish this by maintaining separate personal and business bank accounts, keeping records and books, and acting like similar profitable, operational entities.
- The taxpayer’s expertise.You should have extensive knowledge of your profession or activity, showing that you have studied accepted business methods and sought advice from experts. If you don’t have the past success, make sure you have a coach, mentor, advisor or consultant who does!
- The taxpayer’s time and effort in carrying out the activity. In the Audit Technique Guide (ATG) that deals with hobby versus business question for MLMs (aka direct selling aka multi-level marketing), it’s determined that 2 nights a week and 2 weekends a month shows sufficient time and effort. It’s not engraved in stone, though, so make sure you talk to your tax pro about time and effort standards.
- An expectation that assets used in an activity, such as land, may appreciate in value. Regs. Sec. 1.183-2(b)(4) says such appreciation may be considered in lieu of current profits. This isn’t as easy to prove with some types of businesses, but if it fits – awesome!
- The taxpayer’s success in other activities.Even your activity is currently running at a loss, it may be for-profit if the taxpayer has been able to convert other activities from unprofitable to profitable in the past, especially ones similar to the current activity. Again, if you don’t have the past success, make sure the people you listen to and employ do.
- The taxpayer’s history of income or losses from the activity. A long series of losses warrants consideration. Is it ever going to profitable? Past income indicates a for-profit activity.
- The relative amounts of the profits and losses.Regs. Sec. 1.183-2(b)(7) states, “The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent.” However, the presumption of profit motive in Sec. 183(d) says that if an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit.This isn’t engraved in stone. It is possible to have a legitimate business that runs a loss for many years and still is obviously a business. Think Amazon in this case.
- The taxpayer’s financial status.If you have other substantial sources of income, it may tend to indicate that the activity is a hobby. However, if you can demonstrate that your current state of employment is tenuous (welcome to 2019 and job insecurity), you have a better case to prove you’re trying to ramp up a business for if or when you know longer have your job
- Whether the activity provides recreation or involves “personal motives.”This may, with other factors, indicate lack of a profit motive. If you’re doing something that is fun, it’s harder to prove it’s a business. It doesn’t mean you can’t enjoy what you’re doing, just remember that’s why the IRS has a tendency to target race cars owners and horse breeders that claim they are businesses.
Will your hobby qualify? Let’s chat about it at the next coaching session or Pop-Up Call. (Typically, there are 2 Pop-Up calls a month, usually scheduled on the weekend.) You need to be a member of the USTaxAid coaching class to join the Pop-Up calls and receive the twice monthly coaching and Home Study Courses. Sign up here now: https://www.ustaxaid.com/coaching-program/
Meanwhile, check out Tax Minutes at https://www.youtube.com/channel/UCB9uRGn96JwJQUAQwwwYOBg It’s 60 seconds of real-life actionable strategies you can use right now. One a day!