Hobby Loss Rule
The hobby loss rule prevents you from deducting a business or investment loss on the ground that you did not have a profit motive for the particular activity.1
For example, if you have a highly profitable business (or you earn a high salary from a full-time job) and an unprofitable second business, the IRS might treat the unprofitable business as a hobby and claim you cannot offset the one business's profits (or your salary income) with the second business's losses.
This IRS attitude is especially likely if the unprofitable business looks like fun (e.g., owning race horses) or you just do it in your spare time (e.g., restoring old cars and selling them or puttering around on the farm on weekends).
To avoid being victimized by the hobby loss rule, you must be able to show, by reference to objective factors, that you expected to make a profit.2
Factors. The IRS is likely to ask the following questions in evaluating whether you have a profit motive. A Yes answer cuts in your favor:3
Do you expect to make a profit in the future from the appreciation of assets used in the activity? E.g., you may have annual losses from a rental property that you can ultimately sell at a profit.
Does the time and effort you put into the activity indicate an intention to make a profit?
Do you depend on income from the activity?
If there are losses, are they due to circumstances beyond your control? Did they occur in the start-up phase of the business?
Have you changed methods of operation to improve profitability?
Do you have the expertise to be successful? Are you working to acquire the necessary expertise? Do you have advisors or consultants with the necessary expertise?
Have you made a profit in similar activities in the past?
Does the activity make a profit in some years?
The final factor is “[e]lements of personal pleasure or recreation.”4 This is the factor that puts the “hobby” in the hobby loss rule. But this factor won't usually have a big impact unless you fall short on several of the other factors. Tax law doesn't require you to dislike your work.
Risk vs. reward. The IRS concedes that you may establish a profit motive by showing that although the venture may have a small chance of success, the potential profit is high.5
Bright-line rule. An activity is presumed to be carried on for profit if it makes a profit in at least three of the last five tax years, including the current year. If the activity is breeding, training, showing, or racing horses, you only need to show profit in two of the last seven years.6
1 IRC Section 183.
2 Reg. Section 1.183-2(a).
3 Reg. Section 1.183-2(b).
4 Reg. Section 1.183-2(b)(9).
5 Reg. Section 1.183-2(a).
6 IRC Section 183(d).