If you generate a side income from a passion like cooking, woodworking or bookselling — or anything else — you should be aware of the tax implications of earning this money. These will vary depending on whether the activity is treated as a hobby or a business.
The bottom line: The income generated by your activity is taxable. But different rules apply to how income and related expenses are reported.
Factors to consider
The IRS has identified several factors that should be considered when making the hobby vs. business distinction. The greater the extent to which these factors apply, the more likely your activity will be considered a business:
The IRS stresses that the final determination should be based on all of the relevant facts and circumstances related to your activity.
Limitations for hobby deductions
If the activity is a hobby, you’ll still generally be allowed to deduct ordinary and necessary expenses associated with it. But you can deduct hobby expenses only up to the total amount of the hobby’s income.
That is, if you have a loss from the hobby, you won’t be able to deduct it from your other income. In fact, having a money-losing hobby could actually increase your taxable income. How? You must report all income from your hobby — but, to the extent allowed, deductions are itemized. Conversely, if you don’t itemize you’ll be unable to use the expenses to offset the income.
If, instead, the activity is considered a business, you can deduct a loss from your other income in the same tax year or even carry that loss back to a previous tax year or forward to a future tax year.
Incorrect deduction of hobby expenses leads to up to $30 billion in unpaid taxes every year, according to the IRS. Keep on top of the rules; the agency is watching carefully.