IRS Hobby-Loss Rules

How to Protect Your Business From Being Labeled a Hobby

If your business loses money for too many years in a row or even during the first year of operation, the IRS may claim the business is really a hobby and disallow your expenses.

In theory, the line between a business and a hobby is pretty straightforward – the purpose of a business is to make a profit, and the purpose of a hobby is enjoyment. However, in practice, the distinction can be a bit murky, and making a mistake can lead to disallowed deductions, penalties, and other issues.

Business losses can be valuable at tax time. They can reduce taxable income from other businesses and even from earned income to a certain extent. They can also roll to future years, helping to reduce your income during more profitable years. But if the IRS decides that your business is really just a hobby, they will disallow the losses.

This post outlines the IRS hobby-loss rules, safe harbor methods, the 2025 rules for claiming deductions against hobby income, and other critical points on the differences between hobbies and for-profit activities.

If the IRS has already selected you for an audit, disallowed your losses, or assessed taxes against you, Seattle Legal Services can help. We can also provide guidance if you have general tax concerns or questions. Contact us today to learn more.

What Are the IRS Hobby Loss Rules?

The IRS’s hobby-loss rules state that you cannot claim a loss for expenses incurred due to a hobby.

Covered in Section 183 of the Internal Revenue Code, the hobby-loss rules do not actually mention the word hobbies. Instead, Section 183 refers to “activities not engaged in for profit” and explains that you may be able to claim some deductions as long as they don’t exceed the amount earned from the activity.

Section 183 also says that if you have a profit in three of the last five years, the IRS will presume that you have a profit motive, and by extension, that you’re running a business not claiming hobby losses. If you’re dealing with horse racing, breeding, showing, or training, you only have to show a profit in two of the last seven years to have a presumed profit motive.

However, the three-of-five test is more complicated than it sounds, and it doesn’t guarantee that the IRS will classify your activities as a business. If you meet this standard, it just shifts the burden of proof to the IRS. As explained below, the IRS may use other methods to determine whether or not you’re engaged in a for-profit activity (business) or not-for-profit activity (hobby).

Hobby vs. Business: Factors the IRS Considers

To determine whether an activity is a hobby or a business, the IRS considers the following types of elements:

• Operations – Do you conduct this activity like a business? Do you keep accurate books and records?
• Improving profitability – Do you take actions to improve profitability? For example, do you advertise the activity or work closely with vendors and suppliers?
• Expertise – Have you studied the practices necessary to run a profitable business in this niche? Do you consult with experts in the industry?
• Main source of income – Do you spend a lot of time on the activity, especially if it’s not recreational in nature? Do you employ qualified people to help you? Do you eventually plan to rely on this activity for income?
• Expectation of a profit – Are you likely to make a profit? Have you engaged in similar activities and made them profitable in the past? Do you intend to profit from assets used in the activity?
• Losses – Are the losses outside of your control? Are the losses incurred usual or ordinary in the start-up phase for this type of business? Do the losses continue past the phase where most businesses would be profitable?
• Recreation – Does the taxpayer have personal motives (besides profit) for engaging in the activity? Is the activity primarily recreational?

To give you an example of the distinction between a hobby and a business, imagine someone has a barn full of horses that they primarily use for recreational riding with friends and family. However, they also give lessons to one person for approximately $200 per month. They decide to file a Schedule C showing $2400 in income and claiming $100,000 in losses related to the horses, the barn, and related equipment.

If the IRS selects this taxpayer’s return for an audit, they will consider the elements listed above. In this case, they note that the taxpayer does not advertise riding lessons, doesn’t keep books related to the activity, and has no expectations of ever relying on the income from this activity. The IRS determines that the taxpayer is engaged in a not-for-profit activity (aka a hobby), and they disallow the losses.

However, the case could go another way if the facts were different. Now, consider that the taxpayer just bought the barn and the horses this year. They actively advertise for new riding students, keep extremely detailed records, and have a plan to rely on the income from this enterprise in the future. Although they use some of the horses for personal use, this is reflected on their Schedule C. In this situation, the IRS may decide that the activity is a business and allow the losses to stand.

Do You Have to Report Income From Hobbies?

You must report income from hobbies. You can report this income on Line 8, Schedule 1 of your 1040 Individual Income Tax Return.

To return to the above example, the taxpayer who was giving riding lessons must report the $2400 they earned during the year on their tax return.

How Many Years Can You Show a Loss Before an Audit?

There is no set number of years that you can show losses before the IRS audits you. In some cases, the IRS may select your return for an audit the very first year you show losses on your return, or you may file multiple years of returns showing losses and never be selected for an audit.

Rather than worrying about so-called audit red flags, it’s more important to understand the rules and only report losses from business activities. As long as you are running a legitimate business, you can legally claim losses every year.

However, as indicated above, if you do not show a profit for three of the last five years, you may have to prove that you are running a business if you are selected for an audit, and that process can get a bit murky.

What Happens During an IRS Hobby-Loss Audit?

Like any other audit, the IRS will want to see proof of your income and expenses. You will need to provide sales reports, receipts, bank statements, and other details to back up the claims on your return. Generally, the IRS will request this information through the mail, and you will send it to them through mail, fax, or electronically, but in some cases, you may meet with the auditor in person.

When dealing with hobby-loss rules, you will also have to provide additional information to help the IRS determine whether you’re running a business or engaging in a hobby. As indicated above, that includes information about how you operate, the way you maintain financial records, your expertise, what you do to improve the profitability of the operation, and your long-term goals in terms of relying on the business for income.

The auditor will review the information provided and make a determination. Hobby-loss audits may lead to one of the following results:

• Agreement that you’re running a business and no changes – If they agree that the activity is a business, the losses will stand, and there will be no changes to your tax return. The IRS accepts the return as filed.
• Agreement that you’re running a business and some changes – The auditor may agree that the activity is a business, but they may decide to disallow certain expenses for other reasons. For example, they may determine that a certain expense is personal and not business-related. Then, they will adjust your return accordingly, and you may owe money or receive a reduced tax refund.
• Disallowance of hobby losses – Finally, the auditor may determine that the activity is a hobby and that you’re not entitled to claim any losses. They will remove all of the losses, but if applicable, you will still have to report income earned from the hobby.

You can appeal the audit results, but you must do so by the deadline noted on the audit determination letter. During the appeal, you will be able to present any new information that will help sway the IRS’s decision. If you handled the audit on your own and failed, you should strongly consider working with a tax professional during the appeals process.

What If You Fail a Hobby-Loss Audit

If you fail the audit, the IRS will disallow the losses which will increase your tax liability or reduce your refund. You may also face penalties. At a minimum, you will incur interest and a failure-to-pay penalty. However, if the losses significantly understate your tax liability, you may incur an accuracy penalty of 20% of the unreported tax.

Here’s an example, say that you claimed $20,000 in losses and that artificially reduced your tax liability by $4,400. The accuracy penalty would be $880, but there may also be additional interest and penalties on top of this amount.

Strategies to Protect Your Business From IRS Reclassification

Having your business reclassified as a hobby can lead to significant tax liabilities and penalties. It can also prevent you from claiming future losses related to the activity. To protect yourself, keep these tips in mind:

• Develop a business plan with clear goals and profit objectives.
• Keep detailed records and operate professionally.
• Track your efforts to improve profitability – especially if you’re incurring repeated losses.
• Don’t rely on the three-of-five rule.
• Consult with a tax attorney as needed.

How Can a Tax Attorney Help?

A tax attorney can help you determine if your activity is a business or a hobby. If the distinction is unclear, they can advise you on how to distinguish the activity as a business, and they can help with other elements of business tax compliance on the state and federal levels. They can also help you determine if and when you should file From 5213 (Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit).

FAQs

What are the Hobby Loss Rules for 2025?

In 2025, you must report hobby income, but you cannot claim any losses related to hobby income. The ability to claim losses related to hobby income was suspended from 2018 to 2025 due to the Tax Cuts and Jobs Act (TCJA).

At the time of writing, the TCJA is set to expire, and barring any new legislative updates or an extension of the TCJA rules, taxpayers will be able to claim hobby losses in 2026 up to the amount of their hobby income if they itemize and only after claiming other allowable deductions (such as personal mortgage interest and local taxes).

How many years can a business show a loss before the IRS steps in?

There is no set formula for when the IRS contacts you about business losses. However, if you show a profit for three of the last five years, the IRS generally assumes that you’re running a for-profit business.

What’s the difference between a hobby and a business for tax purposes?

A business is carried on for profit. A hobby is an activity that you don’t engage in for profit. Taxpayers must report income from both hobbies and businesses, but they can only claim losses related to businesses.

What should I do if the IRS reclassifies my business as a hobby?

If the IRS reclassifies your business as a hobby, contact a tax attorney who is familiar with the hobby-loss rules and has experience representing clients in these types of cases.

Are you struggling with the hobby-loss rules? Facing an audit after claiming business losses? Dealing with other concerns? If you need help with any business tax problems, contact us at Seattle Legal Services today.