Profit vs. Pleasure: IRS Rules Are Strict on Losses

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Americans who followed the presidential election were incessantly reminded that the tax code allows businesses that incur net operating losses to deduct them over multiple years. But hobby losses are another story.

Those obliging folks at the IRS allow write-offs to ease the pain for losses suffered by freelance writers, artists, and other self-employed individuals in ventures entered into to make “profits.” But long-standing rules severely limit what they’re able to deduct for losses incurred in pursuing “hobbies.”

Because of those restrictions, the feds program their computers to bounce returns that show full-time salaries and other sources of income offset by losses from sideline undertakings that turn out to be hobbies – writing (especially travel writing), photography, and painting, to cite just some of the activities that are likely to draw the attention of the tax collectors.

How do IRS examiners determine whether your intention is to turn a business profit from, say, your writing, or just to have fun? They get their cues from Internal Revenue Code Section 183, which provides guidelines on how to distinguish between a hobby and a business. To take advantage of Section 183, you have to establish a profit motive.

To cut down on disputes, the law presumes that you’re engaging in a business rather than a hobby – with the IRS as partner that is entitled to a portion of your profits – as long as you’ve a net profit (excess of receipts over expenses) in any three out of the last five consecutive years.

So, usually, not to worry when you’ve at least three profitable years during the last four. Satisfy that stipulation and you’re entitled to fully deduct your expenses this year, even if this is a loss year.

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Julian Block
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