Hobby Loss Rules: IRC Section 183 for CPA REG Candidates

Hobby Loss Rules Under IRC Section 183

Section 183 governs activities that are "not engaged in for profit," commonly known as hobbies. If an activity is classified as a hobby rather than a trade or business, the taxpayer's deductions are severely limited, while income from the activity remains fully taxable. For CPA REG candidates, the hobby loss rules require understanding of the profit motive test, the nine factors used to determine profit motive, and the impact of the TCJA on hobby deductions.

The Profit Motive Test

General Rule

An activity is considered a trade or business only if the taxpayer engages in it with an actual and honest objective of making a profit. The taxpayer does not need to have a reasonable expectation of profit; a genuine profit motive is sufficient, even if the chance of profit is small. The determination is based on all facts and circumstances, and no single factor is determinative.

The Presumption of Profit Motive

Section 183(d) provides a presumption that an activity is engaged in for profit if it produces a net profit in at least three out of five consecutive taxable years (two out of seven years for horse breeding, training, showing, or racing activities). This is a rebuttable presumption: the IRS can still challenge the activity as a hobby even if the presumption is met, and the taxpayer can still establish profit motive even if the presumption is not met. The taxpayer can elect under Section 183(e) to postpone the determination until the end of the five-year (or seven-year) period.

The Nine-Factor Test

Treasury Regulation Section 1.183-2(b) sets forth nine factors that courts and the IRS consider when determining whether an activity is engaged in for profit:

1. Manner in which the activity is carried on: Does the taxpayer maintain complete books and records, operate in a businesslike manner, and change methods to improve profitability?
2. Expertise of the taxpayer or advisors: Has the taxpayer studied the activity and consulted with experts?
3. Time and effort expended: Does the taxpayer devote substantial time and effort, particularly if the activity has no substantial personal or recreational elements?
4. Expectation that assets may appreciate: Even if current operations are unprofitable, will appreciation of assets used in the activity produce an overall profit?
5. Success in similar activities: Has the taxpayer engaged in similar activities profitably in the past?
6. History of income or losses: Are losses due to startup expenses and customary in the early years of the activity type?
7. Amount of occasional profits: Does the activity occasionally generate substantial profits relative to losses and investment?
8. Financial status of the taxpayer: Does the taxpayer have substantial income from other sources that the losses offset? If so, this may suggest a lack of profit motive.
9. Elements of personal pleasure or recreation: Does the activity involve significant personal pleasure? However, this factor alone does not disqualify profit motive.

Deduction Limitations for Hobby Activities

Pre-TCJA Rules (Tax Years Before 2018)

Before the TCJA, hobby expenses were deductible as miscellaneous itemized deductions subject to the 2% of AGI floor, in the following order: (1) deductions allowable regardless of profit motive (property taxes, mortgage interest); (2) deductions that do not reduce basis (operating expenses); (3) deductions that reduce basis (depreciation). Total deductions could not exceed gross income from the activity.

TCJA Changes (Tax Years 2018-2025)

The TCJA suspended all miscellaneous itemized deductions subject to the 2% floor for tax years 2018 through 2025. This means that for hobby activities during this period, the only deductions available are those allowable regardless of whether the activity is for profit (such as property taxes, subject to the $10,000 SALT cap). Operating expenses and depreciation on hobby activities are not deductible at all. Income from the hobby remains fully taxable. This makes the hobby versus business classification even more significant during this period.

Common Hobby Activities Under Scrutiny

Activities frequently challenged by the IRS as hobbies include horse breeding and racing, farming and ranching (especially by taxpayers with substantial non-farming income), art and antiques collecting, car racing, boat chartering, dog breeding, and writing. The common thread is that these activities often have significant personal pleasure elements and recurring losses.

CPA Exam Tips

• The profit motive determination is based on all facts and circumstances; know the nine factors.
• The presumption is three profitable years out of five (two of seven for horses).
• Under TCJA (2018-2025), hobby expenses other than those deductible regardless of profit motive are completely nondeductible.
• Hobby income is always fully taxable, even when expenses are nondeductible.
• The classification as hobby versus business affects self-employment tax treatment as well.