Tax Tips To Report Your Hobby Income

Is your favorite pastime classified as a business or a hobby? Here’s how the IRS sees it.

Millions of people enjoy having hobbies — whether it’s photography, antiquing, craft making, collecting coins, or breeding horses, and even those that fall into the more bizarre side of things, but to each their own! The thing is, it usually costs money to support a hobby, but in some cases, your hobby can also make you money. This is informally known as “hobby income” and it can be a source of confusion for a few people. In short, the truth about hobby income isn’t taxed like regular business income, but it is taxable.

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If you have a hobby that is also a source of income, you’re required to report the income on your Federal tax return. In order to properly report your income and expenses to the IRS, you must ascertain whether the activity is classified as a hobby or a business; you’d be surprised at how effective the IRS can be at differentiating those (or scary, if you’re a hobbyist).

This article explains the IRS rules for determining if an activity qualifies as a business, and what restrictions apply if the activity is not a business. Also, we will include some tips for people who make income with their hobby to avoid any issues with the IRS.

Hobby vs. Business: What’s The Difference?

Let’s start with the basics: For tax purposes, a hobby is defined as an activity that you engage in “for sport or recreation, not to make a profit.” Even if you earn occasional income from doing such an activity, the primary purpose must be something other than making a profit. Now, that “other” is not clearly defined, but consider that under IRS scrutiny, your hobby pursuits should be about leisure and recreation and not specifically making a profit.

To distinguish between a hobby and a business, you must take into account all the facts and circumstances of your situation. The IRS lays out the following 9 factors that should be considered when establishing if an activity is a business engaged in making a profit:

• Whether you carry on the activity in a businesslike manner
• Whether the time and effort you put into the activity indicate that you intend to make it profitable
• Whether you depend on income from the activity for your livelihood
• Whether your losses are due to circumstances beyond your control, or are normal in the startup phase of your type of business
• Whether you adjust your methods of operation in an attempt to improve profitability
• Whether you (or your advisors) have the knowledge needed to carry on the activity as a successful business
• Whether you were successful in making a profit in similar activities in the past
• Whether the activity makes a profit in some years, and how much profit it makes
• Whether you can expect to make a future profit from the appreciation of the assets used in the activity

According to the IRS, an activity is deemed as a business if it makes a profit during at least 3 of the last 5 tax years, including the current year — or at least 2 of the last 7 years if the activities mainly consist of breeding, showing, training, or racing horses.

Minimum Thresholds And Reporting Requirements

It’s important to remember that there are no minimum thresholds for reporting your hobby income: As long as you earn enough income to file a tax return, you have to report your hobby income along with it. Failure to do so will result in accuracy related penalties, which is 20% of the portion of the underpayment.

Things get worse if you earn a substantial amount through your hobby, since the IRS might look at the underpayment penalties and inquire about the status of your hobby and whether it has to be legally considered a business.

Tax Deductions for Hobby Expenses

In general, you are allowed to deduct ordinary and necessary hobby expenses (with certain limitations). An “ordinary” expense is one that’s considered common and accepted for the activity. A “necessary” expense is one that’s considered helpful and appropriate for the activity.

Since a hobby is not a business, hobbyists are not entitled to the same tax deductions that businesspeople can claim. As a hobbyist, you can usually deduct your hobby expenses up to the amount of your hobby income. But any expenses that exceed your hobby income are considered personal losses and are not deductible from your other income.

For more information about hobby rules and allowable deductions, please refer to IRS Publication 535 (Business Expenses).

How to Deduct Hobby Expenses

In order to deduct your hobby expenses, you must itemize deductions on your income tax return. There are 3 categories of deductions that your hobby expenses may fall into, and these deductions must be taken in the following order:

• Category 1: Deductions you can take for personal as well as business activities are allowed in full. For individuals, all non-business deductions (such as those for home mortgage interest, taxes, and casualty losses) belong in this category.
• Category 2: Deductions that don’t result in an adjustment to the basis of property are allowed next, but only to the extent that your gross income from the activity exceeds your deductions under the first category.
• Category 3: Business deductions that decrease the basis of property are allowed last, but only to the extent that your gross income from the activity exceeds your deductions from the first 2 categories.

Use Schedule A (Form 1040) to claim your itemized deductions. Any amounts from categories 2 and 3 are considered miscellaneous deductions and are subject to the 2% AGI (adjusted gross income) limit.

Keeping Records Of Your Hobby Income

Keeping accurate records of all your expenses and income is essential for hobbyists. If your hobby gives you any amount of income and you want to keep a good record of tax compliance with the IRS, here are some things you should consider:

• Tracking your income: Make sure to keep a complete log of all your hobby earnings. Documents such as sales receipts, invoices, bank deposits, or digital payment records will be important in the face of any inquiries by the IRS. Go a step further and categorize all your income to ensure you’re reporting accurately.

• Expense documentation: While hobby expenses cannot be deducted from your taxable income in a traditional manner, it’s still important to keep records of costs associated with your hobby. That way you’ll have an easier time if you decide to transition your hobby into a full business down the line.
• Separate finances: Use a separate bank account (or digital wallet at the very least) for all your hobby-related income and expenses. This tactic will help you avoid mixing personal and hobby-related transactions, making recordkeeping more straightforward.
• Use the right tools: Consider using financial tracking software, spreadsheets, or even apps tailored for small-scale earners to organize your records. Update them regularly to avoid any complications during tax season (or worse, having to “guesstimate”).
• Keep your records for a while: Even after tax season, keep all relevant records for at least three years from the date you file your tax return, including proof of income, correspondence, and any other documentation related to your hobby.

Tips To Transition Your Hobby Into A Business

Whether you choose to transform your hobby into a fully-fledged business (or are required by the IRS to do so), the journey can be arduous. You will need to be careful during the planning phase and adhere to many guidelines and rules, some by the IRS and others by the federal, state, and even municipal governments themselves.

The following tips will help you make this transition as smoothly as possible:

1. Establish Clear Intent: The intent to make money is one of the key distinctions between a hobby and a business—make your profit motive evident by maintaining detailed records of your operations and set clear financial goals.
2. Keep Separate Finances: Opening a dedicated business bank account to keep your personal expenses separate from business-related transactions not only aids in financial management; it also helps your case if the IRS questions your business status.
3. Create a Business Plan: Develop a business plan that outlines your objectives, target audience, marketing strategies, income goals, etc. A solid business plan demonstrates professionalism and makes your profit motive clear.
4. Keep Accurate Records: A thorough documentation of income, expenses, and receipts not only helps with tax filings but also provides evidence of a profit-driven approach. Remember to keep your business documents for at least three years after your file the corresponding taxes.
5. Market Your Business: This is mostly to show that you’re actively trying to promote your products or services instead of relying on word-of-mouth. Whether through social media, a professional website, or local advertising, any sort of marketing signals that you’re operating a business, not just pursuing a hobby.
6. Understand Tax Implications: Now that you’re a business owner and not just a hobbyist, you can deduct expenses related to your operations (finally!), but you’re also subject to self-employment tax. Read about these tax obligations to make sure your business doesn’t falter and maximize tax advantages.
7. Consult Professionals: Even if your business is small or simple enough that you can handle it all on your own, you should still seek advice from accountants, lawyers, or business consultants to ensure your transition is smooth and aligns with legal and financial requirements.

Tax Tips For People Who Earn Income From Their Hobby: FAQ

1. Is income from my hobby taxable?

Yes, income earned from your hobby is taxable. Even if it’s not your primary source of income, you must report all earnings from your hobby on your tax return. This applies whether the income is cash, checks, or payments received through online platforms.

2. How do I report hobby income on my tax return?
Use Form 1040, Schedule 1, under “Additional Income.” The total amount must be listed, and, unlike a regular business, most hobby expenses are not tax deductible so you will get taxed on the whole amount. The only way to deduct hobby expenses from you income is through specific items when you itemize your deductions at the end of the tax year.

3. How do I know if my hobby qualifies as a business?
Sometimes, if it gets big enough, the line between a hobby and a self-owned business might get blurry. Therefore, the IRS uses several factors to determine if your hobby will start counting as a business (and taxed accordingly):

• Your intent to make a profit.
• If you treat the whole operation in a businesslike manner.
• The entire profit-loss history in your activities.
• How much time and effort you put into the whole thing. By putting in enough hours, showing a consistent profit, or just by operating in a professional enough manner, the IRS might start considering it a full on business.

4. What records should I keep if I earn income from my hobby?
Keep detailed records of all income and expenses related to your hobby, including receipts, invoices, bank statements, and any other documentation that supports your earnings and expenditures. Good recordkeeping will make your life much easier if the IRS requests clarification.

5. Do I need to pay self-employment taxes on hobby income?
No. Fortunately, self-employment taxes do not apply to hobby income. On the other hand, if your activity qualifies as a business, self-employment taxes may be required. Make sure that your activity is squarely in “hobby” territory to determine your tax obligations accurately.

6. Are there any thresholds for reporting hobby income?
No, there is no minimum threshold for reporting hobby income. You have to report even the smallest amounts, such as occasional sales at craft fairs or online marketplaces, as part of your regular income. Not doing so could result in penalties or additional taxes owed.

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