Hello and welcome to the session in which we will discuss what is a hobby versus a business from a tax perspective. Let's start with a business. What is a business? Well, for tax purposes, anytime an individual or a company, you could be an individual or a partnership or a C corporation, S corporation, engage in an activity, the primary purpose, the goal of this activity to do what? To make a profit. Then you have a business. So what is a hobby? Well, a hobby is an activity that an individual engages in for personal enjoyment and recreation. You like to do it. You're not looking to make a profit. The reason you are undertaking this activity like painting is to for your own enjoyment. And you'll do this during your leisure time. That's the assumption. And it's not for a financial profit. That's generally speaking what a hobby is. Now, sometimes, not sometimes, oftentimes you will make some money, some revenue from a hobby. Is revenue taxable? Of course it's taxable. Of course it's taxable. When you generate revenues, any type of revenue it's taxable unless it's executed. So hobby revenue is taxable. The question becomes that we need to answer is how about the related expenses? As you're undertaking this hobby, you have to buy a frame, you have to buy supplies for your painting. Are these expenses deductible? So hobbies can cover a wide range of activities. You could have you could have a farming as a hobby, painting, fishing, horse breeding, photography, dog breeding, you could have all sorts of hobbies. So in this session, we're going to be discussing what happened to the losses or expenses when it comes to a hobby. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Let's start with hobby and hobby expenses and losses. Now whether we say expenses and losses, they mean the same thing because both expenses and losses reduce your income. Starting with the business, when you have a business and you have expenses, what do we do with those expenses? As long as they are ordinary, necessary and reasonable, we deduct them on schedule C and they are deducted for AGI. And we like deductions. Deductions for taxes is good. We want to deduct our expenses. Also, if you have a business, a business can have a net loss. What is a net loss? It means you could have expenses that are greater than income. If you have expenses greater than income, you have an NOL or net operating loss. And not operating loss itself could be deductible. So we could deduct it against, if it's active, we could deduct it against some other active income, like our W2. So this is when it comes to businesses. And we should know this. Businesses, we can deduct the expenses, we could have a net loss. How about when we incur expenses for hobby? This is what we need to learn about specifically. Well, remember, hobby is for your own enjoyment. So you can deduct expenses to the extent of hobby income. Because you're doing this for enjoyment, not to make a profit. Also, you cannot incur a net loss. You cannot have a negative. You cannot take more expenses than income when it comes to a hobby, if you have a hobby. Let me ask you this. As a taxpayer, would you prefer for your activity to be classified as a hobby? Or would you prefer for your activity to be classified as a business? Well, what do I mean by this? Simply put, do you want to treat your activity, whatever that activity is, whether it's painting, auto racing or whatever activity you have, do you want it to be as a hobby or as a business? Well, of course, you want it as a business because you can deduct your expenses. So the question becomes, how do you classify? How do you know whether an activity is a hobby or whether an activity is a business? Well, we have something called the profit rule. Simply put, if the activity does not show a profit at some point, so we keep on operating this thing, whatever that thing is, and we don't make a profit. So simply put, it's probably a hobby because the assumption of a business after a period of time, you should earn a profit. Specifically, the IRS gives us some rules. The assumption is that an activity is pursued for profit, is that if the taxpayer records earning from it in the three of the five consecutive years. So we look at five consecutive years here, one, two, three, four, and five. The assumption is if you can show profit in three of the five consecutive years, they don't have to be consecutive years, three of the five consecutive years, then it's a business. And you can say, treat me as a business. Now, bear in mind this rule, three of the five years is not absolute. So that's not how exactly work. Simply meeting the three out of the five years does not necessarily secure a taxpayer position. It's a business. If the profit of those three years are minor compared to the losses in other years, or if the profit aren't derived from the regular business operation, the taxpayer claim could still be challenged. What are we looking at here? Let me show you the scenario. Year one, you made a profit of 4,000. I'm sorry, 1,400 in year one. This is a profit. Year two, you made a profit of 800. Year three, you made a profit of 1760. Well, look, you have three consecutive years of profit. This looks like a business. Year four, you incurred the loss of 42,000. In year five, let me change the color. You incurred another loss of 50,000. Well, this looks like your gains are relatively small to your losses. So what does that mean? It means the IRS might question you. They might be saying, I don't think you have a business here. Most likely you have a hobby. Why? Because your losses in relationship, first of all, your profit is minor in relationship to the losses. And this should be treated as a hobby. And if it's a hobby, then you cannot take those, you cannot take those deductions. You could be challenged. It doesn't mean it's going to work or not. But we have to look at some common questions that the IRS might ask you or ask themselves about your business. So I'm going to list those questions and go over them briefly until we get how to compute expenses. So they don't only look at numbers, they want to see whether the activity is conducted in a business-like manner. What is a business-like manner? If you have a business, you might keep track of your books and records separately. Are you keeping track of this? You might have to buy insurance. You might have to buy a license. Do you have a written business plan? This would look like if we have those, it looks like a business. But that's only one factor. What is your expertise in this business of the taxpayer? Does this taxpayer have relevant education, relevant training, relevant experience in this business? If not, then it's a hobby. Does the taxpayer prepare the activity by conducting research on an extensive study as it's accepted business practice? Or it's just they carry this as just as a hobby. That's what they have to ask themselves. How much time do you spend on this? How many hours per day? How many days per week, per month, per year? Who's involved in the day-to-day operation? Where were the assets? Were the assets held prior to starting the business? So did you purchase them for this business? Or did you have them and transfer them into a business or a hobby? So those questions will help the IRS determine whether you have a hobby or a business. Also, your prior success in conducting similar activities. Did you have any prior success? Or were they all incurring losses? Was any of these activities profitable? Also, they would look at the history of income or losses from the activity. Is there a history towards profitability or is it always losses? Also, the relationship a profit earned compared to losses. And I told you about this. How much profit relative to losses? We looked at numbers. Is this business highly speculative? Okay, what amount did you invest in this business? So all these questions, they will need to be examined by the IRS to determine whether you have a hobby or a business. The financial status of the taxpayer. Do you have other sources of income or is this your only source of income? If that's the case, then it must be your business. You're not running it well if you're incurring losses, but that could be your business. Or do you have other sources of income like interest dividend? You're living off that and you're carrying this as a hobby. So they would look at those factors. Also, the elements of personal pleasure. How much personal pressure are you enjoying from this activity? Is this pleasure limited to your family and friends? Well, if that's the case, if the pleasure is limited to your family and friends, then most likely this is a hobby. You're only enjoying this with your family and friends. Again, those questions, they don't look at one or two questions. They look at the whole thing. Then they determine whether you have a hobby or a loss. But the first thing you want to prove to them that in five consecutive years, you reported a profit, this shift the burden to them. Now, when it comes to expenses, we have to learn about deductions. What are the deduction sequence for hobby expenses? First, we're going to start with sales. So sales obviously or revenue, then we're going to deduct from this any cost of goods sold. So you are allowed to deduct cost of goods sold. For example, your supplies. So sales minus cost of goods sold equal to the gross profit. The gross profit is taxable. Then you have other expenses operating the business. Now you can deduct expenses related to the hobby, but only to the amount of gross income it generates. So the maximum expenses you can take is basically to eliminate gross profit. Or if you don't have cost of goods sold, eliminate sales. But expenses have to be deducted in a specific order. So you're going to just take your expenses and deduct them randomly. They have to be in a specific order. The first one, the first type of expenses you can deduct are property taxes and home mortgage interest. The assumption here is you are conducting a hobby. You are conducting a hobby from your own home. And because of that you incur property taxes and interests as a result, you can deduct part of that. And the reason you will deduct those first because those expenses are deductible regardless on schedule A. So if you take them on schedule A, you can no longer, no longer take them for hobby, hobby purposes. But the assumption is if you're not taking them, you will take them here. But if an individual prepares schedule A, then he or she no longer have property taxes or mortgage interest deductible because they are already used up. If they are not used up, you can deduct them here as a percentage of whatever size square footage of the home you are using. Then you can deduct expenses. Expenses that would be deductible if the activity was for profit seeking, like maintenance for your home utilities, percentage of those because you're not using the whole home. And finally, you will deduct items such as depreciation and amortization. So it has to be in this order. Again, once you get to zero, you can no longer deduct. Now bear in mind, bear in mind between 2018 and 2025. Number two and three, expenses that are deductible if the activity was for profit seeking and depreciation, those are deductible as a miscellaneous deduction on schedule A, subject to 2%. It doesn't matter. What you need to know for this, what you need to know for now is this. Miscellaneous deductions are suspended from 2018 to 2025. Therefore, those expenses are not even available for a person who are conducting a hobby, a hobby, who are engaging in a hobby. What does that mean? It means whatever income you have, you know, sales minus cost of goods sold, you can only deduct property taxes and mortgage interest. And if you take those, those are not even available. If you take those, those are not even available. So we end up with a sales minus cost of goods sold and it's taxable. The best way to illustrate this is to look at an example. Luke, who serves as a VP of a software company and has an adjusted gross income of 220 chooses to take up painting as a pastime, just for a hobby. He dedicates a home studio, he's operating from his home, solely for his arts, which takes up 5% of the total area of his home. Just to kind of look at some numbers, painting sales, he generated sales of 7100 frames, 4400, art supplies 1200 and those are part of his cost of goods sold. The home studio at his home, the total property taxes for the total home is 7000, mortgage interest 16000, total home maintenance and utilities 3200 and the depreciation is calculated to be 600. How do we compute this hobby? We're going to assume this is a hobby. Well, under other revenue, we're going to have the revenues minus cost of goods sold. So under other revenue, Luke would report 1500 and other revenue. Then what's left are the taxes, mortgage. Let's assume we can make both assumptions. What's going to happen next is this. He's going to take the taxes and the mortgage and the interest, it's going to add them up and they'll add up to 23000. We multiply them by 5% and the portion of this amount, 5% of interest and taxes is deductible next 1150, assuming he is not using them for schedule A. If he is then they can no longer be deducted twice. So 1500 minus 1150, the remainder is 350. Then Luke can deduct 3200 times 5% of the utilities, which will be $320. Now remember this $320 is subject to the 2% miscellaneous deduction. In other words, it cannot be used between 2018 and 2025. But let's assume we are outside those period then Luke can deduct another 320. What he's left with is $30. He still has $30 and the depreciation, the amount of depreciation allocated for from his house for his portion of the house is 600. How much of that can he deduct? Only $30. Again, this $30 will be listed as a miscellaneous expense, which is not deductible between the year 2018-2025. So his net income would be zero, assuming he is operating in year 2026. Otherwise, his income will be 1500, assuming he used his taxes and mortgage interest on schedule A. If he did not, his income would be 350 and the other two utilities and maintenance, we're going to assume they are not deductible. They are suspended until the year 2025. So you need to know how hobby losses are treated for tax purposes, whether you are a CPA candidate, enrolled agent or an accounting student, go to Farhat Lectures, look at additional MCQs, true, false, additional resources that's going to help you understand the rule for hobby or hobby loss for tax purposes. Invest in yourself. Good luck, study hard and of course, stay safe.


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