The Hobby Loss Rule: What is the Hobby Loss Rule? Part I

From the Desk of Lauran L Stevenson

The Hobby Loss Rule: What is the Hobby Loss Rule? Part I

IRS Code Section 183, entitled Activities Not Engaged in for Profit, also known as the “hobby loss rule,” prohibits deductions for any expenditure attributable to an activity not engaged in for profit. This is a continuous issue for the U.S. Government and taxpayers; the question as to whether an activity is a business activity versus a hobby is frequently found in U.S. Tax Court calendars.

There is no hard and fast rule to determine whether a taxpayer engages in activity for profit. Activities that are “not engaged in for profit” are defined by reference to certain activities listed in other code sections for which deductions aren’t allowed.

The IRS does provide a safe-harbor presumption of when an activity is engaged in for profit. If the gross income derived from an activity exceeds the deductions attributable to the activity for three or more tax years during a consecutive five-year period then the activity is presumed to be engaged in for profit. This three out of five-year presumption is a changed to two out of seven-year presumption for activities relating to horses.

A taxpayer can elect to postpone the determination of whether their activity is engaged in for profit until after they have engaged in that activity for five or seven years. The postponement election is made by filing an IRS Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit.

Future posts will be addressing the factors considered by the Court in determining when an activity is engaged in for profit as well as minimizing risk of audit on this issue.