Ep. 96 | Creative Ventures: Hobby vs. Business – Know the Difference

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Welcome to the Teaching Tax Flow podcast where the goal is to empower and educate you to legally and ethically minimize taxes paid over your lifetime.

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Everybody, welcome back to the Teaching Taxable podcast. Today, episode 96 says right now, 4 away. Well, technically, 5, 6. Whatever you wanna do. However you count, you can do the countdown.

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You can do the math to a 100. Again, we got a little special treat coming for you when we do click over to the triple digits on our podcast episode count. But today, we’re not there yet, but we are gonna talk about some hobby loss rules. So what exactly that is, if you’re afraid of any rules at all, not the podcast for you, and you probably should go hide under a rock. But before we get into that, as always, let’s take a brief moment and thank our episode sponsor.

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Alright, everybody. Here you are, hobby loss rules here on the TTF teaching tax flow podcast. Obviously, there, you probably heard me talk about rules. If you don’t like them, told you to kinda crawl under a rock, and I wasn’t joking. Go get under a rock if you don’t like rules because here’s another one for you.

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We have one rule here on the podcast. 1, maybe 2, but one I’m gonna throw at you. Subscribe. Press the subscribe button wherever you’re listening to this at. And while you’re at it, don’t be lazy.

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Give us a good review. There you go. There’s another rule. Now if you’re really not here for rules, now you can get off. Just don’t leave a bad review.

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Anyways, so hobby loss rules. Right? What is that? What does it sound like? It kind of is exactly what it sounds like for the most part.

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But as always, my brother from another mother, you like how he enunciated that a little bit, the smarter, better looking, yet a little bit older. Woah. Chris McHero. Welcome back to the show, buddy. A little older.

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I’m a

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lot older. 10 years older, but that’s not 10 years younger. I’m just kidding.

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There you go. You you you don’t act your age, and that is a compliment, sir.

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Well, it used to be a slap in the face, but now it’s a happy slap in the face. I appreciate that. Hobby loss rules. This is something that’s a little scary to a lot of people, but we’re gonna simplify it for everybody. We’re gonna talk through what the difference between a hobby and business are in the in in the mind of the IRS.

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We’re gonna talk about what can how you report hobby activity on your tax return and some rule changes that occurred with the Tax Cuts and Jobs Act of 2017, and we’re gonna finish with an example, practical example. The reason we picked this topic, few different things. Number 1, it’s something that’s been bandied about in defeating taxes private Facebook group, which is the private Facebook group posted by teaching tax flow. We had a lot of questions about that, especially with the onset of the 1099 k rules changing. We think there’ll be a lot of additional reporting.

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And, also, this topic was important enough to be a breakout session taught by a friend of mine at Taxposium. We mentioned attending that conference a few weeks ago in Orlando, Florida. Taxposium is the Super Bowl of tax conferences that’s put on by the National Association of Tax Professionals. So because of that, we felt that this is important to address. So let’s, let’s let’s jump in, John, because I know you have a lot of hobbies.

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Oh, yeah. Well, yeah, one of them is, you know, obviously, bothering the crap out of you with my dumb question. So and and when we hear hobby loss rule, right, so I would almost bet too with this that the term itself isn’t very familiar with people or to people, But the concepts, actions, whatever output, whatever we wanna call that probably is. Right? So let’s literally break break it down as far as for hobby loss.

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Right? So hobby, hobby business. Right? Loss, I’m gonna assume, right, that it’s hey. Is there a loss through your, quote, unquote, hobby business?

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Or am I completely wrong? It is hobby in no way, shape, or form considered a business when we look at this.

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That is correct. What happened previously is that there were taxpayers that were reporting an activity that had significant financial loss that upon IRS examination was determined that it was a glorified hobby. So, John, we know that, one of your hobbies. Oh, boy. Is that you’re very involved, you’re very involved in the canine industry, and you show dogs professionally.

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Oh, of course.

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Right? It’s a special breed that, oh gosh. I can’t even think of a little smart aleck response to this. Yeah.

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Well, let’s assume that you had a hobby. Right? And and that you you really enjoy doing.

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I like the dog one, though. That would be fun. That would be fun. I would enjoy

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you know? Basset hounds. We’ll show basset. Random tangent. One of the most underrated movies of all time.

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It’s a timeless movie. It’s called best in show. Best in show, it was a it’s a it’s a comedy and it has an all star cast. It’s an older movie. I’m not a big movie guy, but it this one was fabulous.

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So it’s it’s gosh. I think it was in 2010, this movie came out. But, anyway, it was it was fabulous. Just a lot of a lot of great actors, a lot of great actresses. So if you have a a spare minute or you have a flight coming up, just download it.

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But let’s assume let’s assume, John, that you enjoy doing something as a hobby. Let’s and you liked knitting While I’m showing ducks. These beautiful af cans that you would give out to everyone. And you would sell them occasionally. So you you would make maybe a $100 a year.

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But because you love knitting, you spent $3,000 a year on supplies and and what have you. And you said, nah. I sold a $100 worth of my Afghans. I’m gonna take a $29100 loss on my tax return. Well, the IRS would say, John, this is not a business.

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This is a hobby. You cannot take a loss on your tax return from a hobby activity. You cannot offset your other income. So that’s a pretty basic example, but let’s dive into the main issue of when you look at an activity, is it a hobby or business? Some of the more popular activities that are deemed hobby would be, oh, charter boat fishing, sport card sports card collecting, trying to figure some you know, arts and crafts.

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I mean, there are some talented people that do it professionally, but some people just have a hobby. Pickleball. And what if what if I, you know, what if I gave 5 lessons to someone for $20 a lesson and reported that I am some type of pickle professional pickleball instructor and tried to deduct all of my pickleball equipment and all of my travel to anywhere I go. Now football is a hobby

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for me. I guess this is a question for you too, like, based out of your your experience, right, in the the private practice world for, you know, teen years. So some people probably look at it as, oh, no. No. It’s a business.

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I I bill and I, you know, I generated revenue. How can they tell me that it’s not a business? Does the IRS almost and I guess there’s probably not an exact definition, you know, of this, like, a checklist. May maybe there is. But would it almost come down to a little bit of a debate, little bit of an argument between them and the IRS if they ever really did look into it.

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And you would almost have to say, well, hey, look. You know, I I have a separate office. I have a warehouse for this. You know, it’s not a hobby. It’s a business.

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I’m just a really crappy business person. Has that ever happened with with, you know, one of your clients where, you know, they’re they’re trying to show, like, hey, we’re in the early stages of this. We have a lot of losses, but, you know, we’re setting things up the way any business would be, and the IRS still coming

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in and saying no. There’s There’s nothing wrong with having a loss from a business, but, ultimately, you are correct. There are tests that the IRS has to determine if an activity is a hobby or a business. So these factors, we’re gonna talk about those factors, but in general, here the IRS will look at an activity. So personally, in our private practice, I’ve yet to have a a loss from an activity be deemed a hobby and the and the taxpayer lose.

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K. But it happens all the time. So the IRS is gonna evaluate several factors to determine. The first thing is regardless of of loss or profit, is this activity actually a business? So what IRS is gonna look at is, is there a profit motive?

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Do you have the expertise to even conduct this business? Are you putting the time and effort into it into carrying on the activity that that a business would require? Do you have an expectation that assets used in the activity are gonna are gonna appreciate in value? So for instance, a lot of times people try to try to disguise an a major purchase of an asset as a business asset when it’s really a hobby asset. Has the taxpayer carried on similar activities successfully?

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Does activity have a history of income or losses? You know, what’s the financial status of the taxpayer? Does the taxpayer rely on this income to live? If the taxpayer relies on the income to live, then you can make the argument that it’s a business. But if the taxpayer has other substantial income and other sources of income, then it would be more likely that the activity would be a hobby.

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And is it of personal pleasure or recreation? Of course, I absolutely love what I’m doing, but as I just said, some of these more sexy or fun activities like charter boat fishing and pickleball and for you quilting and knitting, though those not too many people. I’d love to know, John, actually, has a has a CPA ever lost deductions because what they were doing was deemed a hobby? Not too many people go into tax planning, tax preparation, and it’s deemed a hobby, but I I

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I actually kinda I kinda like it. So those are all the factors. I mean, I could I could see it happening. Like, another example of it might be you know, I know some guys that, you know, they work on cars because they really, really like it. It’s not their primary job.

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They might be in construction or anything like that. But

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John, you actually have a good example now. Hey. Take that. Actually, that’s a motor pull example.

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Put put that one in the coffer of John’s knowledge bombs.

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So here’s an example, John. Let’s say you have a buddy that works on vehicles. He he does it on the side. He just has a passion for it. He fixes your vehicle.

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You give him $500. He that’s only he but he tinkers around with things. That 500, that’s probably a hobby. Right? Let’s say he has a full time job somewhere else.

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Let’s say he’s an engineer somewhere at General Motors. He just likes tinkering with vehicles. In that case, I would deem that to a hobby, but where where things get abused is him saying, well, I I’m I’m a mechanic, so I went and bought a I’ve just bought a, you know, a Corvette kit, and I constructed it myself. So I’m gonna deduct the entire Corvette because I was training on this vehicle. I was training on this kit.

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So that’s where things get abused. And I’m

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sure there’s probably so much gray area in that. Right? Like, so much.

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Well, that’s why the IRS has identified 9 factors. Not one of them not one of them is is, quote, unquote, gospel for lack of a better term, but it’s a combination of these factors to determine it’s something a business or or more a pleasure or a hobby. So like we mentioned with the tinkering of cars, typically, the expertise of the taxpayer is important. In a hobby, there’s usually little effort to acquire the necessary expertise or to consult as a professional. But in a business, typically, there is.

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So that’s where, you know, there there are just tons of factors. There’s also one rule of thumb that I’m gonna point out that many people are familiar with in the term safe harbor. First of all, the term safe harbor means, in the tax world, kinda like being on being on go when you play monopoly, and you you or maybe I you know, it’s better better because, you know, I love Monopoly. It’s kinda like being on in the jail, but just visiting. There’s no benefit.

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There’s it’s just a safe harbor means okay. I’m comfortable with this position and the IRS will accept it. So the safe har the IRS provides a safe harbor guideline, and that’s known as the 3 out of 5 year rule. So in general, if an activity generates a profit at least 3 of the last 5 consecutive years, the IRS is gonna presume that there is some type of profit motive. A business needs an activity needs a profit motive to be a business, not a hobby.

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Now just because you have profit in 2 of the last 5 years doesn’t mean that you are ultimately a hobby no matter what. But it, again, it comes down to that safe harbor. So if you’ve got profit in 3 of the last 5 years, typically the IRS is not gonna push back on you and determine is it a business versus makes sense. So step 1, figure out if the activity we’re talking about is a business or a hobby. Now, if the activity is deemed to be a business and you’re the only owner, you got Johnny T’s Quilting in Afghans Oh, gosh.

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My grandmother made Afghans. I’m telling you what. There’s not there was not a more comforting feeling growing up, than having one of those. And she made them until her late, late years. She passed away quite a few years ago.

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And but she you know, that’s a great example. She would she would make them. She would sell them at the church art fair or craft fair and just donate the money, you know, to to the church. That was a hobby for her. She didn’t generate enough to put it on her tax return or anything.

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But but, anyway, let’s assume you are you are a knitter and an avid Afghan enthusiast. Well, if your if that activity for you, John, is deemed to be a business, we would report that on schedule c, that’s self employment income. We would we would report all of your revenue, and then when we would deduct all of your expenses. Shameless plug for a previous podcast, can’t remember the number. Also, humble brag that we can’t remember our podcast numbers for an episode.

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We’re getting up there in age.

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Oh, we are. We’re getting up there. But a for something to be a deduction on your tax return for a business, the expense has to be ordinary and necessary. So you would ultimately, in that case, you would you’d file schedule c, you’d report your income, and you deduct all of your ordinary necessary expenses, and, John, you’d pay tax on the net profit of the activity, and you’d also pay you’d be subject to self employment tax. If you had a loss from the business, let’s say that you had a modest $5,000 profit, this activity is a business, but but you got fat and sassy and you bought a $10,000 sewing machine or some type of knitting machine, some type of equipment that’s eligible for bonus depreciation and that caused you to have a loss, you would be able to take that loss on your tax return because you are deemed to be a business.

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So that’s if it’s a business. Now what if you’re a hobby? Well, if you are a hobby, you have to report all of your income on your personal tax return. Sound the bummer alarm. That’s reported on schedule 1 of the 10 40.

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That’s on line 8 just as other income. There’s no separate form for hobby, and you just report that as income. And unfortunately for you, John, all of that knitting, if you’re deemed a hobby, is gonna be fully taxable.

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Oh, man. Even all even all the yarn. It’s a lot a lot of yarn going to waste there. It’s a shame.

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Now But it happens. Under the Tax Cuts and Jobs Act of 2017, the deductions for hobby expenses changed. So now hobby expenses are not deductible. Before hobby expenses were deductible, as an item miscellaneous itemized deduction, subject to the 2% adjusted gross income threshold. But for 2018 to 2025 as it is now, you would not get a deduction for any of your hobby expenses.

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Previously, John, if you’ve made $500 knitting and you had $1,000 worth of expenses, you would be able to deduct the $500 of expenses, except you would only be able to deduct the amount that exceeds 2% of your income. So, ultimately, most people weren’t able to deduct those hobby expenses. Right.

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And I’m sure a lot of the industries too just throw out some more examples of this. I’m sure a lot of the, individuals that you might see at, like, farmers markets is probably, you know, probably fall into this. I know there’s a a friend of ours who makes soap, you know, that’s, I think a couple locations, candles, etcetera. So some of that stuff probably teeters a little bit, you know, we’ll call it more of a gray area. Right?

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Because there are you know, they are distributing it for sake. So that’s probably more of a business. But, you know, some of these other people, like, if my daughter decided that she wanted to grow tomatoes and go sell them at the farmer’s market, but she does it one day out of the year, but tries to, you know, poor dad, tries to ex tries to expense. You know, hey. I need a new truck to move my tomatoes one Saturday out of the year.

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Doesn’t exactly fly. You are correct. That’s

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and and that’s where I think that there’s going to be more hobby activity reported. You always should report all your income, but with those 10.99 k changes that are coming eventually coming down the pipeline, you will see people that truly have a hobby. If if they go to 1 or 2 farmers markets a year, John, let’s say they’re they they enjoy going up to Mackinac, Michigan and Mackinac Island or Mackinac, and they do 2 2 shows a year, They basically just wanna pay for their trip up there and sell some homemade home goods or maybe they bake pies. That would be considered a hobby. And now they would they would have to report the income and they would not get any deduction.

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So we’re gonna close on an example, though, practical example. We’re gonna bring back Johnny t, you the the show dog the show dog walker, and dog breeder.

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Oh, now now I’m a breeder. Alright. Let’s do this. Okay.

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Yeah. Why not? We’re gonna yeah. Exactly.

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So now I’m out there breeding these dogs, these fine specimens, and now we’re out there strutting our stuff on the the the

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damn floor. You’re strutting that you’ve never strut before. You’d be considered a business if you maintain detailed records. You invested significant time, you consulted breeding experts, you had some profitable years, and you relied someone on that income for your living expenses and had a profit motive. It’d be considered a hobby if you just like prancing around with the dogs and and and, you know, you don’t put a lot of time into it.

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You rarely sell dogs because you just wanna deduct them, and you really don’t have good records. And you’re not depending on that income to live on and you really don’t have a profit motive. It’s truly a hobby. So that’s just

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But yet the expense category of meals and entertainment is 1,000 of dollars, right?

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Well, it could be if you have a business. It could be, but entertainment’s not deductible. If it

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if it’s a hobby. Right? The if the IRS seemed to be like, really? Like, okay.

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Well, if yeah. If it’s a hobby, then there’s no deduction available at all. You you just pay tax on but now here’s the the positive of the hobby is this. Yes. All your income is taxable, but it’s not subject to self employment tax, that’s at 15.3% tax, because you’re not in in a business.

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Self employment tax is only charged when you’re in a business. So to so to really kinda put a bow on this, no pun intended, but the dog showing, there are 9 there are 9 factors. Not one of them is singularly decisive. You have to consider each factor. And if you are a business, you report schedule c typically, pay tax, pay self employment tax, but get to deduct all your expenses.

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Could take a loss on your tax return. A hobby, you’re gonna pay tax on your gross income, no deductions, but no self employment tax. And I forgot to say this in the beginning. You know, I feel like we haven’t said this in a while, Johnny t. We do really appreciate our listeners.

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I mean, we are coming up on the 100th episode. It’s humbling. It’s just it truly is humbling to see see how many tens of thousands of people have listened to this podcast. And if you’re listening to this podcast, 1, we appreciate you. 2, take that next step and reach out to us.

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All of our best show ideas come from the listeners. Jump in at our defeating taxes private Facebook group. Ask the questions. We’re here to help. We don’t do this for, you know, the any type of financial reward.

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We really enjoy being part of the Teaching Dash Flow community. And And it keeps them out

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of the doghouse. If you don’t listen to it, you’re going to the doghouse.

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We don’t wanna be in the doghouse. Don’t yeah. Get yourself out of

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the dog house. You know what? Chris too kinda you know, more dad jokes. Well, you know, sitting really a dad joke, but it’s just kinda funny that it’s ironic. Right?

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You have those 9, those 9 tests. Well, k nine. You know, there’s another one. So this is

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a dog gone.

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This is a great show. Anyways, we’ll back down to seriousness. Again, kinda echoing what Chris said there. Thank you everybody for always joining us here on the podcast. We are growing our numbers all the time on just the engagement we get from this.

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It’s great being at these events and people saying, hey. You know what? I I heard you guys did this show. It is it is kinda funny because I feel like some people actually know our shows and show numbers way better than we do, Chris, but, you know, that’s you know, we got we must put out some decent content every once in a while, and, you know, it must make sense to some people. So we appreciate it.

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Keep those ideas coming.

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Yeah, John. You’re the only one that’s been identified as as a celebrity from the show.

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So Well, you know, my witness protection program account manager must be, you know, scared. So anyways, back back down to earth and reality, we will see everybody back here again on the Teaching Taxable podcast roughly same time next week, different topic.

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