The IRS is closely scrutinizing taxpayers who report large, recurring losses from hobby-like activities on their Schedule C forms to offset wages, business earnings, or other income. Reporting these “hobby losses” is considered a red flag that can trigger an audit.
The tax law allows deductions for legitimate business activities conducted with the intent to generate a profit. However, expenses related to hobbies or activities not engaged in for profit cannot be deducted. The 2017 tax law temporarily suspended miscellaneous itemized deductions, including hobby losses, through 2025.
To claim a Schedule C loss as a business expense, the taxpayer must demonstrate that the activity is conducted in a continuous, regular, and business-like manner, with a reasonable expectation of earning a profit. The IRS has a “safe harbor” rule – if an activity generates a profit in 3 out of 5 consecutive years (or 2 out of 7 for horse breeding), it is presumed to be a business. Otherwise, the IRS examines various factors to determine if the activity is a hobby or a for-profit business.
The IRS and courts tend to rule against taxpayers on hobby loss issues, often assessing accuracy-related penalties. Key factors that can indicate a hobby include lack of a business plan, poor record-keeping, inability to show expertise or time commitment, and the presence of other substantial income sources. Taxpayers need to carefully document the business-like nature of their activities to overcome the hobby loss rules.