I want to bring to your attention some recent developments regarding the “hobby loss rule.”
Given that many of my clients have diverse sources of income, some of which might be considered hobbies, I believe this information could be of great importance to you.
What Is the Hobby Loss Rule?
The hobby loss rule might apply to you if you have any activity that results in a tax loss. Under this rule, you might lose out on your deductions and end up paying taxes on the income you earned from the hobby.
For instance, if you earned $200,000 from a hobby and incurred expenses of $350,000, the rule would lead you to pay taxes on the $200,000 of hobby income, even though you suffered a net loss of $150,000. That would be awful, since you would be out of pocket $150,000 and paying taxes on $200,000!
A significant recent case resolved in 2023 involves Carl and Leila Gregory, who chartered their yacht, Lady Leila, in 2014 and 2015, not for profit but as a hobby. Even though they generated income from this activity, they also had significant expenses. The IRS denied the deductions, and the courts agreed, which resulted in the Gregorys owing an additional $267,221 in taxes!
The takeaways from this case are:
- Depth of Impact. The hobby loss rule can have profound tax implications for individuals, partners, and S corporations if they are involved in activities that produce a tax loss.
- Income Irrespective. The hobby loss rule applies irrespective of the income generated—be it $20,000 or in the hundreds of millions.
- Understanding Is Crucial. The Gregory case applied to 2014 and 2015 when the hobby loss rule allowed hobby deductions up to the amount of hobby income but made the expenses itemized deductions subject to the 2 percent of adjusted gross income floor. Things are worse today: you can’t deduct any hobby expenses other than the cost of sales.
What Should You Do?
If you have any activity that might be considered a hobby from a tax perspective, book a call and let’s discuss it an make sure your business losses don’t turn in to a “hobby” in the eyes of the IRS.