Hobby versus Taxable Income

[Chief]

Is it true that a self-employed person may post losses each year but during a five-year period must post a gain for two years or the activity is classified as a hobby. I remember reading something to this effect sometime ago.

[Brian EA]

There is somewhat a grey area there but basically that is what it is. The type of business has a lot to do with it.

[jainen]

The underlying presumption

The underlying presumption is that business is based on a profit motive, so if you don't make a profit but you keep on doing the same thing, you must have a different motive.

[rosieea]

See pages 5-21 & 5-22 of The Tax Book for a good discussion of the hobby-vs-business question.

[Armando Beaujolais]

Is it true that a self-employed person may post losses each year but during a five-year period must post a gain for two years or the activity is classified as a hobby. I remember reading something to this effect sometime ago.

The three-of-five year rule is an assumption in the tax code, but it does not determine hobby status. If you make a profit 3 of 5 years (2 of 7 for horses), the activity will be presumed to be a profit-making activity.

The actual years of profit or loss mean nothing without the context of the facts and circumstances. There was a court case several years ago where a pet shop owner had losses for 12 years in a row. The IRS said "Hobby," the court said, "Business." Intent is the key factor. Even though the guy was losing money and was a poor businessman, he was nevertheless trying to make a profit.

Granted, most people will not intentionally lose money year after year, and if they start bleeding red ink they'll find a different profession. But there are plenty of professions where you could easily lose money for a long time before you started making a profit.

And if the losses are substantial, the IRS will audit those returns with multi-year losses. But fear of audit should not motivate any tax professional.