Pursuing a passion in your spare time can be enormously rewarding. But will Uncle Sam help you pay for your hobby when you file your 2011 taxes?
The answer may well be yes, if you adhere to the IRS’s complicated hobby rules
, says Gil Charney, principal tax researcher at the Tax Institute of H&R Block. But if you don’t want to trigger an audit, you’d better follow those rules carefully.
The Hobby Loss Rule
The key to whether you can or can’t write off your hobby comes down to what’s known as the IRS’s “hobby loss rule.”
Basically, you can’t deduct your expenses if the hobby is “not engaged in for profit.” In other words, if you pursue a hobby — say, collecting old Lionel trains or doing needlepoint — purely for pleasure, you can’t write off anything you spend on the pastime.
If, however, you try to make money from a passion you pursue while holding down a full-time job that’s your main source of income, you may be able to write off some of your expenses. “What’s a hobby to one person could be a business — and a serious one — to someone else,” Charney says. “It all depends on your profit motive.”
How Much You Can Claim
If you want to write off hobby expenses, the size of your deduction depends on how much money the hobby brings in and how its expenses compare with your total income. (You can’t deduct losses from a hobby.)
Here’s the math: If you make money from a hobby — selling jewelry at the local craft fair once a year, for instance — you may be able to claim your expenses as miscellaneous deductions on your 1040, up to the amount you earned from the hobby. But the IRS only lets you claim miscellaneous deductions exceeding 2 percent of your adjusted gross income. So it’s possible that your hobby expenses won’t be high enough to cross the deductibility threshold.
Let’s say your adjusted gross income was $80,000 and your hobby brought in $10,000 but cost you $4,000. In this case, you can write off only $2,400 of the expenses (that’s the difference between the $4,000 in expenses and the $1,600 you’d get multiplying $80,000 by 2 percent).
An Alternative Way To Write Off a Hobby
But tax experts say there’s a better way to write off your hobby, if you’re eligible: Declare your pastime a business, and file a Schedule C (Profit or Loss From a Business) for it.
This way, you can deduct other business expenses — like equipment, raw materials, business-related travel and trade association dues — without having to meet the 2 percent miscellaneous deduction threshold. If you lost money on the business, you can write off the loss against your other income from your job or your investments, because it’s not considered a hobby.
But you need to be careful taking write-offs this way, Charney warns.
Danger: Tax Audit Trigger
Schedule Cs often trigger IRS audits, especially if they’re for hobbies. So to claim write-offs this way, you’ll need to be able to show that your hobby was truly a business.
It helps if you have professional experience (if you’re a mechanic who fixes up antique cars and sells them on the side, for example) and can demonstrate a serious effort toward making a profit (like writing a business plan or regularly soliciting clients).
The IRS lists nine factors
that determine whether an activity is a business or a hobby, including how much time and effort you put in and whether you’ve made a profit in the past. The more you can prove that you’re serious about the business, the better your chance of keeping the tax breaks.
Three Tips to Avoid an Audit
Here are three tips to keep in mind before you try writing off your hobby:
1. Keep excellent records. This is important no matter which of the two methods you use to deduct your hobby expenses, because it helps prove to the IRS that you were trying to make a profit. Plus, a careful accounting of all your hobby’s expenses and income will help when it’s time to prepare your taxes.
2. Be sure you have a profit in some years if you plan to file a Schedule C. Otherwise, you’ll be ringing a big warning bell to the IRS, Charney says. If your hobby teeters between annual profits and losses, you may want to shift expenses from year to year to make sure you’re not always in the red. “There’s a presumption that if you show a profit in three out of the last five years, the IRS will give you the benefit of the doubt,” Chaney says.
3. Don’t let taxes ruin what you love. Remember: The main reason to pursue a hobby is for enjoyment, not to save on taxes. If you’re knocking yourself out just to get a write-off and enjoying your pastime less as a result, the tax break probably isn’t worth it.
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