Section 183 of the United States

United States

The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 Internal Revenue Code

Internal Revenue Code

The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...

 , sometimes referred to as the "hobby loss rule", limits the losses that can be deducted from income which are attributable to hobbies and other not-for-profit activities. Generally, losses which occur in for-profit activities are not limited and can be used to offset other income from other activities. But the § 183 limitation curtails those deductions when the activity is deemed a hobby.

Application

The hobby loss rule breaks down into four requirements: not engaged in for profit, deductions otherwise allowable, sections 162 and 212 would have applied, but only up to the corresponding gains.

Not Engaged in "For Profit"

Section 183(c) defines an "activity not engaged in for profit" to be any activity other than those that would have expenses allowed as a "trade or business" (§ 162) or an "investment" (§ 212).

There is a presumption that the activity is "for profit" created in § 183(d) by the "three out of five year" rule. Gross income from the activity must exceed deductions from the activity in three out of the previous five years. If it does then the activity is likely presumed to be an activity engaged in for profit. The taxpayer must show a "primary, predominant, or principal purpose" of creating a profit. This topic is further explored in the 26 Code of Federal Regulations § 1.183-2

Treasury Regulation 1.183-2

Treasury Regulation 1.183-2 is a Treasury Regulation in the United States, outlining the taxes owed from income deriving from non-business, non-investment activity. Expenses relating to for profit activities, such as business and investment activities, are generally tax deductible under sections...

Deductions Otherwise Allowable

Some deductions, such as those in § 164 that allow for the deduction of certain taxes, are allowable without regard to whether the activity is engaged in for profit. These are not limited.

Section 162 and 212 Would Have Applied

On the other hand, those deductions that would be allowable if this were a trade or business or an investment are still allowable here except that they are limited as below.

But Only Up to the Corresponding Gains

This last phrase, reflected in § 183(b)(2), requires that losses from these activities are limited to just the gains created by the same activities.

This means, for example, a knitter who does not qualify to call knitting a "trade or business," can only deduct the expenses of the hobby up to the amount gained by the hobby. The cost of yarn and other expenses as well as depreciation on a knitting machine may be deducted against the sale price of the scarf sold, but not against the income the knitter makes at a day job.

Practical Considerations

For a business (activity engaged in for profit), income and expenses are listed on Schedule C (and the net income result carries to line 12 of the Form 1040). All expenses are used, even if they create a net loss. For a hobby (activity not engaged in for profit), income and expenses are listed separately. The income is included on line 21 of the Form 1040 (Other income). So the hobbyist is required to file the long form, Form 1040 (as the other Forms 1040A and 1040EZ have no lines to include "other incomee". However, the expenses are listed on line 23 of the Schedule A (Other expenses). This leads to a couple of hidden consequences. Firstly, the taxpayer must add these expenses to his other job expenses (as well as investment expenses and tax preparation costs) and reduce the sum by 2% of the Adjusted Gross Income (AGI). Only that part more than 2% of the AGI is deductible. Secondly, the taxpayer must itemize his deductions on the Schedule A, or the hobby expenses are not deductible at all. If the taxpayer is already itemizing deductions, with adequate job or investment expenses, then the hobby expenses will be fully deductible.