For a lot of retirees, having a meaningful hobby after your career has ended is a crucial part of an enjoyable retirement. It’s a concept we talk about a lot with our clients: It’s more than what you’re retiring from, it’s what you’re retiring to.
For some, their hobbies can turn into more than just a pastime. Maybe your small woodshop has turned out a few pieces that people want to buy, or maybe your knack for restoring old cars leads to a paid project.
So you’re retired and you find your little hobby is earning you a little cash – how does that affect your taxes? Let’s take a look.
Income & Expenses: Hobby vs Business
First off, anything you earn from your hobby must show up on your 1040 as income – there’s no escaping that reality.
But what about your expenses – can they be deducted? That’s where things get interesting.
The IRS defines a hobby as an activity that you pursue without expecting to make a profit. As such, you are only allowed to deduct expenses of a hobby up to the money that you earned. Even then, they are only counted a miscellaneous deductions on your Schedule A, subject to the 2% threshold.
If you are regularly making money from your hobby, it might behoove you tax-wise to treat what you do as a business. By operating as a business with a profit motive, your ability to earn income remains unchanged, however, your power to harness deductions will greatly improve.
Rather than being limited to the Schedule A 2% limitation, your business-related expenses are not bound by a percentage limitation on Schedule C. Not to mention the most important benefit – on the off year when you lose money, those deductions can offset other income, helping to lower your overall tax burden.
Am I A Business?
So you may be thinking – well this is a no-brainer, why wouldn’t everyone just call their side a hobby a business and be rolling in deductions?
Well the IRS has some rules for what they are willing to constitute as a business.
If you have made a profit at least 3 out of the last 5 years, the IRS is safely assuming you operate with a business mentality. However, if you fail to meet that test, you should be prepared to answer these IRS provided questions about determining your eligibility as a business venture.
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
Though the IRS looks at a bevy of things to confirm your hobby is actually a business, no one element is more important than another – so rest assured that if you are indeed making the good-faith effort to operate like a business, the IRS will treat you as such.