In general, a hobby can be defined as what one does regularly for pleasure in their leisure time. The IRS, however defines a hobby as a revenue generating activity that lacks a profit motive.
Any profits from hobbies are subject to income tax. These profits are reported on Line 21, of Form 1040 under “other income”. Hobbies can only deduct associated expenses to the extent of profits; therefore hobbies cannot generate a loss. In contrast, a trade or business can deduct expenses in excess of profits, thus generating a loss. These losses can be useful in offsetting income from a regular job and decreasing tax liability.
So what’s to stop a person from reporting their hobby as a business, thereby creating a tax beneficial loss? Quite a bit. When the IRS determines whether a business is in fact a hobby, they will consider the following:
Does the time and effort the taxpayer puts in, indicate an intention to make a profit?
Does the taxpayer rely on income generated?
Does the taxpayer have the expertise to run the business?
Does the taxpayer maintain complete and accurate records?
Does the business generate a profit?
If the answers to the above were “no”, then the taxpayers activity will be considered a hobby. If the IRS believes your activity is a hobby, they will disallow business losses.