Most people are probably familiar with the general tax rule about hobbies: You can deduct expenses only to the extent that you have income from the hobby.

This rule applies to individuals, S corporations, partnerships, estates and trusts.

There is a certain pecking order in deducting these expenses:

1. Deductions a taxpayer can claim whether or not they are incurred with a hobby. Some examples are taxes and interest. These expenses are allowed even if they exceed hobby income.
2. Deductions not resulting in an adjustment to the property’s basis. These are the hobby’s operating-type expenses. An example is supplies. These expenses are allowed to the extent that the gross income from the hobby exceeds the deductions under No. 1.
3. Deductions resulting in an adjustment to the basis of property. Depreciation and amortization deductions are allowed but only to the extent that gross income from the hobby exceeds deductions under both No. 1 and No. 2.

The income from the hobby activity is picked up on line 21 on page 1 of the Form 1040 return. This income is not subject to self-employment tax but is subject to federal income tax.

No. 1 deductions are Schedule A-type itemized deductions not subject to the 2-percent-of-adjusted-gross-income limitation. To take advantage of these deductions, you must itemize your deductions.

Nos. 2 and 3 deductions are Schedule A-type itemized deductions, but they are subject to the 2-percent-of-AGI limitation. To take advantage of these deductions, you must itemize your deductions. But even if you itemize your deductions, a portion of the expense deduction is lost because of the 2 percent rule.

Hobbies are considered to be activities engaged in without a profit motive. Whether an activity is engaged in for profit is determined by a facts-and-circumstances test.

Here are a couple of general rules:

• An activity is presumed not to be a hobby if it produced a profit in any three of five consecutive tax years ending with the tax year in question.
• An activity involving the breeding, training, showing or racing of horses is presumed not to be a hobby if it produced a profit in two out of seven consecutive tax years.

© 2015 CPAmerica International

A recent Tax Court decision serves to re-emphasize that, when the owner of a hobby-like activity meets the requisite profit motive in one year, the courts may not necessarily apply that profit motivation to other years. Each year will be tested on its own.

Merrill Roberts is a former nightclub owner who became a horse breeder. Despite his rudimentary recordkeeping system and history of large losses, his profit objective was shown by the following facts:

➤ He liquidated his old, unsuitable facility and moved his activity to new property on which he built a premier training facility.

➤ He hired an assistant trainer.

➤ His accounting methods allowed him to make informed business decisions.

➤ He consulted with bloodstock agents and respected trainers on various business aspects.

Further, Roberts was asked by peers to run for leadership roles in professional horse racing organizations and lobbied for horse racing interests. He spent substantial time on business and was successful in his prior business ventures.

However, the court found that Roberts did not engage in the activity with the required profit motive during the earliest two years involved in the case. The court determined that his primary motivation in those years was as an investor in real estate.

The court said that Roberts’ participation in horse-related activities during those two years was equally divided between the social aspects and the business aspects of horse racing (Merrill C. Roberts v. Commissioner, TC Memo 2014-74, April 29, 2014).

Roberts avoided accuracy-related penalties during the earlier years by demonstrating reasonable cause/good faith for his tax positions. ■

©2014 CPAmerica International

In order to have your “hobby” considered a business, you must be pursuing the activity with the intent of making a profit. If this is not the case, the activity will be subject to the IRS hobby loss rules, which provide that such losses are generally deductible only to the extent of income produced by the activity. Furthermore, hobby expenses (only to the extent of hobby income) are deductible as a miscellaneous itemized deduction and are subject to the two-percent-of-adjusted-gross-income floor.

Referencing a recent article in The Tax Adviser, the determination of whether or not your hobby can be classified as a business involves a number of considerations.

• Are you conducting the activity in a businesslike manner and keeping separate books and records?
• Do you have the appropriate knowledge and expertise that would be required to make the business profitable?
• Do you spend substantial time pursuing the activity?
• Even if the activity does not produce a profit currently, is there a reasonable expectation that it can in the future, or that the assets involved will appreciate in value?
• Do you have a long series of losses from the activity that might cast doubt on your intention to eventually make a profit?
• Does the activity involve “personal” motives or provide recreation that may indicate a lack of profit motive?

These and other relevant facts and circumstances must all be considered in determining whether any particular activity is a hobby or a business.

But to end on a positive note, an activity is generally presumed NOT to be a hobby if net profits result in any three of five consecutive tax years ending with the tax year in question.