Making Judgments in Applying Hobby Loss Rules
This is how much blanket advice can harm you and your client. The general rule of Hobby Loss Rules is that you can only take losses for three years. We have all heard that and have even given that advice. Where that advice is true is when a client has zero income and a bunch of expenses on a Schedule C for over three years. However, there is one situation that you may not be taking into account.
The Hobby Loss Rule has an exception: What if the client is “aggressively pursuing” income? What is meant by aggressively pursuing income? They have gross income and are just, through the normal course of business, losing money. What can the IRS say about that?
I had an audit in which a client had losses for five years. The agent tried to employ the Hobby Loss Rules and disallow the losses that the client incurred. From the returns you could see that the client was not only aggressively pursuing income but that their loss was due to the depreciation laws.
This is where you need to make a judgment call. If a client has had no income and a lot of expenses for over three years, then they are not aggressively pursuing income. A few years ago, there was an IRS warning about tax preparers fraudulently stating that their clients had at-home businesses. The problem was that their clients never earned any income and just had expenses. This lowered their taxable income, inflating refunds.
I was doing a tax return for a client this year. I received tax returns from 2014 to 2016, all of which showed no income on a Schedule C but included a bunch of expenses. He gave me a W-2 and a spreadsheet listing home-office deductions. Forget the fact that he had no income but had a home office, where he was supposed to produce income. I emailed him and stated that I couldn’t take the deduction for the home office. I told him that taking the home office deduction, along with no income, was odd. However, the clincher was I told him this was his fourth year of taking expenses, with no income, and that would set him up for an audit. He seemed to understand that.
The point that I am trying to make is that just because a client loses money for over three years doesn’t mean that they are falling into the Hobby Loss Rule. The crux of the rule is whether the client aggressively pursued income. If they have zero income and a bunch of expenses for three years, then you have to make a judgment call. In my humble opinion, in the situation above, there is no aggressive pursuit of income.
In another case, I had a client who was a real estate agent during the downturn in the housing market. He spent a lot of money on advertising, paid desk fees, and took classes to further his knowledge of the industry. For three years he had no income, only expenses. The fourth year his gross income was $4,000, and his expenses were higher than his income. The question was, did he aggressively pursue income?
For those years when he had no income and a lot of expenses, he paid a lot in advertising, he paid desk fees to his broker, and he expanded his knowledge of the real estate market. The reason he didn’t have any income was that there was a downturn in the market. Homes were being foreclosed on, there were short sales, and he didn’t want to be a part of that. His business plan was to find the low-cost jewels for his clients, but the real estate market was going crazy, and he could not do that.
I was not concerned with him losing money for four years, because in year five, the real estate market rebounded, and he started to make money hand over fist.
The point I am getting at, is that we have had it engraved in our brain that more than three years of losses is the Hobby Loss Rule. However, you have to analyze every situation and make a judgment call.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...