Call it a business, and collecting offers a variety of tax deductions. Call it a hobby, and the IRS is likely to be much more restrictive. Their guideline is called “the hobby loss rule” and here’s why it matters
With uncertainty surrounding the U.S. dollar, many high-net worth individuals are purchasing rare and collectible items such as high-priced art, race cars and race horses to protect their wealth from market fluctuations.
What some collectors buy, sell and consider a business, the IRS may consider a hobby, impacting a person’s tax status.Â And it is the IRS, not the taxpayer, who makes the determination. A person’s only recourse is to appeal to the federal government.
Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule.”
The IRS reminds collectors to follow appropriate guidelines when determining whether their collecting will be considered a business or a hobby, which is defined as an activity not engaged in for profit.
In order to defend a business vs. a hobby, a person should consider the following factors:
- Does the time and effort you put into the hobby indicate an intention to make a profit?
- Do you depend on the income from the activity for day-to-day living?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of becoming a collector?
- Have you changed methods of operation to improve profitability of a transaction?
- Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years and not other years?
- Can you expect to make a profit in the future from the appreciation of assets used in the activity?
The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current yearÂ —Â at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.
If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order and only to the extent stated in each of three categories:
- Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
- Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
- Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
For additional information, reference IRS article http://www.irs.gov/newsroom/article/0,,id=169490,00.html