- 1 hobby income tax
- 2 How to Tax the Sale of Art as an Investment or a Collectible
- 3 Melanie Radcliff CPA, Inc.
- 4 Nine Factors Are Tested to Determine Profit Motive
hobby income tax
If the tax office assesses your activities to be a business, you can claim expenses as allowable deductions and claim depreciation on your equipment, on the other hand, you would pay tax on income earned.
If you are classed as a hobbyist you can not claim anything as a tax deductible expense or claim depreciation on your equipment and materials, but any income you generate will not be taxed either.
Obviously the tax office can't have it both ways, and deny you the opportunity to claim expenses as a business deduction while still taxing you on income, but they do try to figure out if something is a business or a hobby.
Obviously people in a profitable occupation would like to be classified as hobbyists, and people with an expensive loss making hobby would like to claim they are in business so other tax payers can subsidise their hobby. The Australian Tax Office would like to avoid these sorts of rorts if it can.
A typical example is the wealthy businessman that competes in sports car races in his expensive Porsche on the weekends. Although there may well be cash prizes for race winners, the level at which the businessman competes and the total expense and likelihood of actually making a profit will be taken into account. In most cases the tax office would regard weekend racing to be a hobby, and would disallow claims for deductions.
On the other hand if the businessman does win the season and gets a prize, the money would not be taxable.
- The size and commerciality of the activity.
- The frequency of the activity and transactions, though inactivity is not necessarily a barrier to being assessed as a business.
- The application of business principles.
- Whether there is a genuine profit motive.
- The amount of time devoted by the tax payer compared with other activities.
- The existence of arm's-length customers (as opposed to just selling your wares to family and friends).
- The characteristics or quantities of the commodities, for example if the goods are for domestic or non-commercial use, or if the quantities produced are well in excess of domestic needs.
Obviously these criterion are not black and white, and if the tax payer wishes to argue with a determination this sort of thing does often end up before the courts.
How to Tax the Sale of Art as an Investment or a Collectible
The profits you earn from the sale of art is certainly taxable. If you aren't the artist, and the sales aren't related to your business, how much tax you'll owe from annual art sales depends on whether you purchased the pieces as an investment or as a casual collector, as the classification dictates whether you can deduct all related expenses or not. The difference in tax that an investor and a collector owes on art sales can sometimes be substantial.
A principal factor that distinguishes art investors from casual collectors is the motive to earn future profits from their collection of paintings, sculptures and other artwork. Generally, if your main goal is to profit when the collection appreciates in value, you may be more like an investor than a collector. Despite a collector's understanding that their art is likely to increase in value, a collector's main reason for purchasing art is because of his hobby interest -- which means it's a leisure activity rather than an investment. Note, however, that if you earned a profit in three of the most recent five tax years -- counting the current year -- the Internal Revenue Service presumes that you're an investor.
Regardless of whether the art is treated as an investment or hobby activity, all profits are treated as capital gains that are taxed at the same rates. Pieces of art you own for one year or less at the time of sale are taxed at ordinary income tax rates, which are the same progressive tax rates that apply to your other income, such as the wages you earn at your job. When you own the art longer than one year, the profit is a long-term capital gain. A net long-term gain from the sale of any collectible is taxed at the special rate of 28 percent.
Casual collectors are subject to the tax rules that govern “hobby income.” As a result, a limited number of expenses related to art sales are deductible on Schedule A, but only to the extent that they don't create an overall loss for the year from all art sales. You must take deductions in a specific order, too. In the context of rare art, this means you must deduct expenses that don't affect your basis in the collection, like insurance premiums, before depreciation deductions are allowable for those pieces of art that decrease in value after you purchase them.
Investors are permitted to deduct more of their related expenses, such as the cost of preserving art and advertising a sale, regardless of whether it results in an overall gain or loss. If your expenses as an investor exceed all gains for the year -- which is calculated as the sales price minus your original cost in most cases – you can use the loss to offset the taxable gain from other types of investment gains you have, which isn't the case with the casual investor. One drawback to treating your art as an investment is that your gains may be subject to the 3.8-percent net investment income tax in addition to capital gains taxes.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.
Melanie Radcliff CPA, Inc.
The IRS has defined a hobby as an activity you engage in “for sport or recreation, not to make a profit.” Should you turn your hobby into a business and bare your books to the IRS? Not necessarily, or perhaps not yet. The IRS allows some leeway when it comes to hobbies–unless you’re in the business of raising, training, racing or generally dealing with horses, in which case, here you go…
You can generally deduct expenses for those cute little doggie accessories. Things like fabric, labels and scissors. You might need a sewing machine if you get real creative and all sorts of other bandana producing stuff “for recreation, not to make a profit.” These are expenses considered ordinary and necessary for the particular hobby (do kibbles for the models count?) The IRS even allows you a bit of “hobby income.”
But, as a hobby, any expenses in excess of income are considered personal losses and not deductible from other income. So watch out, don’t purchase fabric to make a hundred big dog bandanas when your customers showed up with little lap dogs. That could become a non-deductible personal loss!
So, when is this a taxable business or hobby? Will the IRS let you know?
It’s best you recognize your hobby as a business before the IRS shows up to inform you. Are you making money, are you finding yourself worrying about taxable income? Are you spending what should be Quality Family Time in front of your computer with QuickBooks? These are clues that you’re well on your way to becoming a successful small business owner, and you need to start acting like one. Call it what it is. A business. Enjoy your business passion. Feel your inner puppy. Make bandanas and toss the dog a kibble. Get some help with your accounting and tax preparation.
What does the IRS have to say about your business or hobby?
The IRS would consider your passion as a business or hobby based on whether it makes a profit during at least three of the last five tax years, including the current year. They also like for you to be able to prove it. Let’s ask the IRS how they distinguish between whether what you do is a business or hobby, and their answer is here . Also a portion of their answer below:
In making the distinction between a hobby or business activity, take into account all facts and circumstances with respect to the activity. No one factor alone is decisive. You must generally consider these factors to establish that 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 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 change 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.
Enjoy your business passion and enjoy your business success. If you’re doing what you love (feeding kibbles to your models while making bandanas) keep it up, and…
Nine Factors Are Tested to Determine Profit Motive
Even if an activity is not profitable over a number of years, it can still be considered a business if the "nine-factor" test reveals evidence of a profit motive. However, if the activity is found to be a hobby, then the hobby loss rules apply.
The IRS evaluates nine critical factors to determine whether an activity is run for profit (even if losses have resulted), or as a hobby. It's important to realize that these factors are open to interpretation. Moreover, while a "yes" answer supports a finding of a profit motive, no one factor settles the matter.
How the business is run. Are you running the activity in a businesslike manner? Do you keep complete and accurate business records and books? Have you changed the way you operate the activity in order to increase profits or to become profitable?
Expertise. Do you have the necessary expertise to run the business? If not, do you seek (and follow) expert advice?
Time and effort. Do you spend the time and effort needed for the business to succeed? (Be forewarned, however. If the activity has significant personal or recreational aspects, simply spending a great deal of time on it, will not prove a profit motive.)
Asset appreciation. Is it likely that your business assets will appreciate in value over time? A profit motive can exist if gain from the eventual sale of assets, plus any other income, would result in an overall profit even if there's no profit from current operations.
Track record of success. Have you engaged in similar (or dissimilar) activities in the past and converted them from unprofitable to profitable enterprises?
History of income or loss. Did the business losses occur because the business was still in a start-up phase, or because of unforeseen circumstances? Many businesses that were started with high hopes in 2007 floundered in the 2008 economic downturn despite the owner's best efforts. However, if you continue the activity despite continuing losses for many years, it may indicate that the activity is a hobby.
Occasional profits. Are the amounts of occasional profits insignificant when compared to the size of your investment in the activity, and the amounts of losses suffered in other years? An occasional small profit for an activity generating large losses, or in which the owner has a large investment, will not establish a for-profit objective.
Owner's financial status. Is the business activity your only source of income? Few people base their continued economic survival on the happenstance of a hobby.
Personal pleasure or recreation. Is the business of a type that is not usually considered to have elements of personal pleasure or recreation?
The following two cases illustrate how these factors are applied. In one case, the required profit motive was found. In the other, the activity as a hobby.
Example One: Ron could not establish that his drag racing activity was engaged in for profit.
He did not have a written business plan and did not maintain a general ledger, annual budget, expense forecasts or a separate bank account for his drag racing activity. He did not consult a business advisor about ways to make his drag racing activity profitable and all winnings from race events were used to maintain the cars and transporter.
Although Ron saved receipts for his expenses, there was no evidence that he used those receipts as a management tool to reduce expenses or increase profitability and the individual offered no evidence of how comparable businesses operated. In addition, his drag racing activity allowed him to spend a significant amount of time with his children, which brought him personal pleasure. Based upon these factor, the Tax Court upheld the IRS's finding the drag racing was a hobby. As a result, his losses were not deductible.
Example Two: William's high-performance glider flight instruction and glider rides was a business.
He actively promoted his business through a web site to secure clients. Although his records weren't the best, the efforts he undertook to be financially successful tended to demonstrate a profit motive. In addition, he secured the appropriate licenses and training to meet requisite FAA requirements. Although the business was only part-time, he devoted all of his weekends to the glider activities.
His business losses during the first four years reflected the depreciation of the glider, the only asset of the business. William worked in the aviation field before and after he started the glider business, and his enjoyment of flying did not change the result of whether he was in the trade or business providing glider activities. Therefore, the Tax Court concluded that engaged in the glider activities with the primary purpose and intent of realizing an economic profit independent of tax savings for the years at issue.
How you go about showing that your activity is operated for profit will depend, in large part, on whether you expect it to profit over either the short run or long run.
Profit possible over short term. Try to maximize your income (and minimize deductions) in at least three years (the "profit" years), and maximize deductions (and minimize income) in the remaining two years (the "loss" years.) You can do this by planning when to receive income and when to purchase items that generate deductions. This may allow you to qualify for the presumption of profit motive. Bear in mind, that if your business continues to show a loss year after year and you don't abandon it, the IRS is likely to find you are motivated by something other than a profit motive.
Profit possible only over long term. If it appears that the business will not be profitable for some years, you won't be able to come within the presumption of profit motive. You'll have to rely on qualifying under the IRS's nine-point inquiry to establish profit motive.
No possibility of profit. Face it. What you have is a hobby. You can try to argue that you qualify under the IRS's nine-point inquiry, but in all likelihood you'll fail. If you want to continue this activity, you may as well either resign yourself to the limitation on hobby losses, or figure out a way to operate that generates profits.
What happens if your activity doesn't qualify as a trade or business? You are earning some money and you are also incurring some expenses. Are you required to report that income? And, can you deduct the expenses associated with earning it?
All Hobby Income Must Be Reported. A basic rule of tax law is that all income must be reported to the IRS. This is true even if you only earn occasional income from your hobby. Hobby income must be reported on Form 1040: you can not use the shorter forms, Form 1040A or Form 1040-EZ. All of your hobby income is reported as "other income" on your Form 1040, Individual Income Tax Return.
Hobby expenses are miscellaneous itemized deductions. You can only deduct expenses associated with the hobby as itemized expenses. Even worse, hobby expenses are considered "miscellaneous itemized deductions." This means that you can deduct only the amount that exceeds two percent of your adjusted gross income. (All you miscellaneous expenses are combined together and the total amount is subject to the two-percent floor.) This also means that these expenses are subject to the phase out of miscellaneous itemized deductions that will hit higher-income taxpayers starting in 2013.
Some expenses are deductible on your individual income tax return regardless of whether they are incurred in connection with a hobby. For example, real estate taxes, home mortgage interest, and casualty losses are deductible by virtue of being a home owner. Therefore, these amounts are not considered miscellaneous deduction and are not limited by the amount of your hobby income.
Hobby losses are limited to hobby income. If your activity is a hobby, rather than a business, your ability to deduct your expenses and carryover your losses will be limited. You can only offset hobby expenses against hobby income. Losses incurred by individuals, partnerships and S corporations in connection with a hobby are generally deductible only to the extent of the income produced by the hobby. In other words, you can't use a hobby to generate a tax loss that can be used to shelter your other income.