Hobby or business? Taxes either way

NOTE: This post was updated Aug. 9, 2017.

In tough economic times, a lot of folks look for ways to supplement their incomes. One of the most popular options is to put your hobby skills to work.

If you have a hobby that lends itself to making money, go for it. But don't forget the tax implications.

Any money you make off your hobby must be reported as income. The amount of, in IRS' words, "income from an activity not engaged in for profit" goes on line 21 of Form 1040.

You might, however, be able to reduce that taxable amount. You can deduct legitimate expenses you incurred in connection with making that hobby money.

For example, your neighbors paid you for taking pictures of their son's college graduation ceremony. You bought a new lens for your camera and several rolls of film, not to mention the supplies to develop the prints. (Yeah, I know, digital and all that. But in some cases, old-school pictures are still the best.)

You can deduct those photography costs ... as long as you meet two requirements.

First, your hobby-related deductions are limited to the amount of hobby income you report on your tax return. If you made $1,000 on the photo shoot and spent $1,200 for the supplies, you can only count $1,000 of your expenses.

Second, you have to itemize to claim the expenditures. They are counted as part of any miscellaneous expenses you have on Schedule A. And your miscellaneous expenses must exceed 2 percent of your adjusted gross income before you can deduct them.

Go the business route: OK. So the tax breaks associated with reducing hobby income aren't that great. Maybe you should consider turning your hobby into a business.

I'm not saying quit your wage-paying job. I am saying that if your hobby is a viable money maker, operate it as a side businesses on weekends or evenings. As long as it's a sole proprietorship, you can include the income as part of your regular personal income tax return by filing Schedule C or C-EZ.

And here's the best part. When it's a business, your legitimate expenses can directly reduce your taxable income from your hobby-turned-business.

So what happens when you do declare your hobby a business, but lose money? That could work out tax-wise, too. You can claim your losses. It says so, again on Form 1040, line 12. That's where you enter the business profit or loss amount you calculated on your Schedule C.

But be careful. You can't just go around merrily snapping photos, enjoying the activity on your days off and writing off business losses year after year. In fact, the IRS expects any business to make a profit in at least three of its last five years of operation.

Proving you're in it for profit: One of my favorite tax phrases, facts and circumstances, also comes into play when the IRS looks at whether your activity is a business.

The key here is not that you necessarily make money, but that you have a profit motive. You need to show the IRS that you're really trying to squeeze some bucks out of the endeavor. You can persuade the IRS of that by demonstrating, for example, that:

• Losses are common in the start-up phase of your type of business,
• You spent considerable time in the activity,
• You kept business-like records,
• You have assets you expect to appreciate in value, and
• You got expert advice on how to conduct the business.

Be realistic here. Remember that facts and circumstances standard. You can't claim $5,000 in losses for two straight years, then report a couple hundred in earnings for the next three. The tax man is not the only person who might find such amounts just a tad too convenient.

Of course, if your side income is nominal and you don't have that many expenses, you can go ahead and keep earning a few extra bucks off your hobby. No need to hassle with extra tax forms, added record keeping and other business concerns.

But do report your earnings as other income.

And you can get additional hobby vs. business info at:

• Turning hobby into business means tax breaks
• Tax tips for self-employed small business owner
• Some yummy hobby tax tips on National Cookie Day
• What are ordinary and necessary business expenses?
• How to Calculate Taxes for Hobby Expenses and Income 

Get your own hobby horse,
like the one pictured above, at Holz Toys

Comments

[Rick]

Thanks for the tip! Would you recommend me talking to a financial advisor before trying to start my own side business? Thanks!

[Famous entrepreneurs]

In this economy one big advantage of having a side venture though is that if you lose you’re primary employment, you’re side venture can become the full time effort, at least until a new full time situation arises. In the meantime, you might be able to move the side business much farther along than would be the case when trying to juggle two situations at the same time.

[TaxRascal]

Can you alternate? Business for three years, hobby for a year, business for three years, etc.?

Or does the IRS attach a friendly "That was cute!" note to the request for massive fines and interest.