How the IRS Views You: Home Business or Hobby?

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Many budding entrepreneurs are interested in the ability to take a tax deduction for expenses related to home business activities. Even hobbyists can claim deductions on their tax returns. However, it's important to realize that the IRS recognizes a difference between a home business and a hobby. You need to know the difference as well, if you don't want to run afoul of the IRS.

Tax Advantage of a Home Business

One of the great things about home business income is that it is deductible against other types of income. If you come up with a loss, you can deduct that from other income that you have. With a hobby, though, you can only deduct up to the amount you actually earn. So, if you are into fly tying, and sell your fishing flies for a little extra cash, you can't deduct all your expenses. If you spend $200 on supplies, but only make $150 from the flies you sell, as a hobbyist your deduction is limited to $150.

If you have an actual home business, though, you can deduct your full expenses. If your fly tying is considered a full-fledged business, you can deduct that remaining $50 from other income that you have. Being able to “prove” to the IRS that you are running a bona fide home business can mean a larger tax advantage. This becomes more important as you spend more money.

What Makes It a Home Business?

So, how do you convince the IRS that you are running a home business, and not just dabbling in a hobby? The IRS has some guidelines that it uses to determine whether or not something qualifies as a home business or whether it is actually a hobby. Some of the items considered include:

  • Profitability: Are you starting to report profits? If you claim losses more than twice in the past five years, you could be classified as a hobby. So, you can claim losses two years in a row, but if you try to claim them for a third year, you might instead be demoted to hobby status, and unable to deduct those losses further. (There is an exception for horse breeding, but not to farming.)
  • Time Spent: Even if you keep claiming losses, you might be able to make a case to the IRS if you are putting sufficient time in. Show that you are working hard to make the business succeed, and that you put in extra time (even on top of your day job), and the IRS might decide you have a home business. Just dabbling on the weekends, or puttering around a couple evenings a week, won't cut it.
  • Money Invested: Are you putting in a significant amount of money into your venture? Are you paying for advertising, and using your own money to help your business succeed? Show that you're truly invested in the success of your business, and you are more likely to avoid being labeled as a hobbyist.
  • Business Credentials: If you can show a business plan, or show how your business model is likely to yield profits, or if you have experience as a manager, you might be able to prove that you have a home business, and not a hobby.

In the end, you have to start making money, though. If you want the IRS to take you seriously as a home business owner, and allow more deductions, you need to get serious about your situation, and really try to turn a profit at some point.

Larry Ludwig

Larry Ludwig was the founder and editor in chief of Investor Junkie. He graduated from Clemson University with a bachelor of science in computers and a minor in business. Back in the ’90s, I helped create some of the first financial websites for firms like Chase, T. Rowe Price, and ING Bank, and later went on to work for Nomura Securities. He’s had a passion for investing since he was 20 years old and has owned multiple businesses for over 20 years. He currently resides in Long Island, New York, with his wife and three children.

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