More than ever, taxpayers are engaging in hobbies that bring in extra income to the household. There’s no limit to the creativity of humans, and hobbies run the gamut from painting, ceramics, baking, photography, weaving, blogging, coin collecting and more. The IRS classifies hobby activities differently, particularly when it comes to tax liabilities. If you have hobby income, it’s crucial to understand the potential tax implications. The best idea is to consult with your CPA for advice about your hobby income. In the meantime, here’s what you should know.
Is it Hobby Income or is it Business Income?
The differences between hobby income and business income lies at the heart of how the IRS views your earnings. According to IRS guidelines, a business exists to make a profit, while a hobby is done mainly for personal recreation or pleasure. However, in reality, the line between the two can easily blur, and the classification ultimately depends on several factors, such as the time and effort invested in the activity, the level of income generated, and the manner in which the activities are conducted.
In simpler terms, if you engage in a hobby mainly for the love of it, but you wouldn’t mind making a little bit of money from it, it's still considered a hobby. But if your goal is to consistently generate income, it would be seen as a business. Still, regardless of the classification, you must report all income earned from your hobby or business to the IRS. The difference is how it’s reported and whether related expenses are tax deductible.
The Taxation of Hobby Income
It's essential to understand that hobby income is taxable. Even if your hobby is not a business, the IRS still expects you to report the income you generate from it. Your CPA can take care of reporting the hobby income as such, when they do your annual tax return. But you have to tell your CPA about the income. Remember, failure to report hobby income could potentially lead to penalties.
Hobby Expenses Aren’t Deductible
Taxpayers cannot claim deductions for hobby expenses to offset hobby income. This means that while hobby income is fully taxable, the costs incurred to generate that income are not deductible. If you think that’s not ideal, you’re not wrong. Still, that’s the way it is for now. And it’s a compelling reason for taxpayers to consider converting their hobby into a business. In fact, your CPA has probably already suggested that you consider it.
Turning Your Hobby Into a Business: The Benefits and the IRS' Criteria
Converting your hobby into a business can open up new avenues for tax deductions. As a business, you're permitted to deduct "ordinary and necessary" expenses you incur to conduct the activity. Ordinary expenses are those that are common in your line of business, while necessary expenses are those that are helpful and appropriate.
However, making the leap from hobby to business isn't just about declaring it so. The IRS will consider several factors when determining whether your activity qualifies as a business or hobby, such as:
- The manner in which you conduct your activities, including keeping detailed records and operating in a business-like manner
- Your expertise and that of your partners, if any
- The time and effort you invest in the activity
- Whether you partially depend on the income for your livelihood
- The potential for profit and your history of profit or loss
Notably, to satisfy the IRS that your activity is a business and not a hobby, you must demonstrate that you have profited in at least three of the past five tax years, excluding the current year (or at least two of the last seven years for certain horse-related activities).
Keeping Detailed Records: A Key Practice
Whether you classify your hobby as a business or not, maintaining detailed records of income and expenses related to your activity is crucial. These records will not only help you during tax season but may also prove invaluable should the IRS ever question your reported income or deductions. If you have a CPA preparing your tax return and advising you on how to qualify your hobby as a business, you will have fewer concerns, though.
Reporting Income: What Counts and What Doesn't
When it comes to reporting income from your hobby or business, it's essential to remember that all forms of payment, including cash, digital transactions, barter exchanges, goods, and services, should be reported as income. Even if you don't receive a 1099 form from the person or company that paid you, you're still legally obligated to report the income, as your CPA can tell you.
Enlisting the Help of a CPA: When and Why
If your hobby generates a substantial income or if you plan to transition from a hobby to a business, it might be prudent to consult a CPA. Tax laws are complex, and understanding how they apply to your situation can be a challenging task. A CPA can provide specific advice tailored to your circumstances, helping you make informed decisions and potentially saving you money in the process.
Enjoying Your Hobby While Navigating the Tax Landscape
Engaging in a hobby that produces income can be a rewarding experience, but it also introduces additional considerations when it comes to your taxes. The keys to successfully navigating this landscape include understanding the differences between a hobby and a business, keeping detailed records of income and expenses, reporting all income, and seeking advice from a tax professional when necessary.
By following these tips, you can keep enjoying your favorite pastime while responsibly managing the associated tax obligations with the help of your CPA. And, if your hobby transitions into a business, you'll be well-prepared to meet the tax-related challenges that come with it. With careful planning and diligence, you can enjoy the fruits of your hobby without worry, knowing you're meeting your tax responsibilities fully and accurately.