Do you have a hobby that has started earning money? Maybe you’re a photography enthusiast and landed a job shooting a wedding. Maybe you Gumbiner Savett to paint, and have been asked to teach a local art class. Or maybe you love to cook, and have been asked to cater a dinner party.

The good news!

Most hobbies have some potential for earning money, given that many hobbies can be an endless drain on finances.

The bad news.

You very well may have some tax reporting to do. Monies you earn, even from a hobby, should be reported on your tax return. The response I hear most often when counseling clients to report this income is “great, that means I can deduct all of my hobby expenses”. Be ready for some disappointment, because there are some pretty definite rules on reporting hobby expenses.

Expenses related to hobby income cannot exceed the income reported. A loss cannot be generated. If you earned $1,000 for photographing a wedding, but spent $1,200 on new equipment for the job, you can only deduct $1,000 of that expense.

Further limiting the benefit, hobby income is reported as Other Income on the front of your 1040, but your expenses are claimed as miscellaneous itemized deductions. If you do not itemize deductions, then you do not get to take the deduction. If you do itemize, this deduction is reported as Miscellaneous Itemized Deductions, and Miscellaneous Itemized Deductions are subject to the “2% haircut”. This means they must first be reduced by two percent of your Adjusted Gross Income. For example, if your Adjusted Gross Income is $80,000, you must first subtract $1,600 (2% of $80,000) before any of your Miscellaneous Itemized Deductions count.

When does your hobby cross the line and become a business? The IRS considers the following in order to make that determination:

  • 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 made a profit in similar activities in the past?
  • Does the activity make a profit in some years? The IRS is looking for profit during at least three of the last five years.
  • Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

If your hobby income can meet at least some of these criteria, congratulations, your passion has now become a business. Once the activity can be classified as a for-profit endeavor, the hobby loss limitations no longer apply. The income, and related expenses, are now reported on Schedule C of the Form 1040, and the rules for deducting expenses are much more friendly. Expenses generally must be “Ordinary and Necessary” for your trade or profession, and can generate a loss in some years if circumstances dictate.

A good reference is Internal Revenue Service Publication 535, which deals with the topic of business expenses and details the types of expenses you can deduct. Your tax professional will also be able to assist you with these questions.