The law regarding the deductibility of hobby losses is well settled. The court decisions are mainly a question of fact. Building upon a recent court case, this article points out tax planning to support your client’s ability to deduct the losses from their activity.
In Wondries v. Commissioner, T.C. Memo 2023-5, the California taxpayer was a successful businessman mainly in car dealerships. His total income for the years under audit was $11M, $12M, and $9M. Though he had no previous experience in ranching, he bought an 1,100-acre spread hoping to make money by raising cattle and guiding hunts. He hired an experienced foreman to run the ranch.
Early on, it became apparent that the ranch would not be profitable from an operational view, so the only way to make a profit would be to eventually sell the property for a gain. Generating very little gross income from operations, the net loss for each of the years under audit was $474,000, $223,000, and $229,000. Nice write offs.
The IRS disallowed the deductions, and the case went to court. In determining if there was a profit motive, the court looked at the nine objective factors spelled out in Regulation 1.183-2(b). The key is to turn as many factors as possible into a positive or neutral point. No one factor is determinative. The court weighs these out on the scale of judgement. We will go through these nine factors, pointing out tips along the way.
Using the 9 factors of determining for-profit activity to deduct hobby losses
- Manner in which the taxpayer carries on the activity. In addition to good books and records, you should have a plan in writing each year that shows how your client is going to make a profit.
- The expertise of the taxpayers or his advisors. You need two types of expertise: general business and activity specific. In this case, the expertise was ranching. If the taxpayer lacks the expertise, they can hire an expert. Wondries hired a ranch foreman, and that counted. If your clients lack business expertise, they can hire you as their accountant to advise, and that would count.
- The time and effort expended by the taxpayers in carrying on the activity. Part -time is okay. It’s also okay to hire someone to do the work, as Wondries did in hiring the foreman.
- Expectation that assets used in the activity may appreciate in value. Your client could lose money every year and deduct the losses if the property is expected to appreciate in value to cover the losses.
- The success of the taxpayer in carrying on similar or dissimilar activities. In Crile v. Commissioner, T. C Memo 2014-202, a self- employed artist was able to use her experience as an art teacher in winning this point. “Obtaining the teaching position . . . showed she had the skills, determination, and personal qualities that also might benefit her career as an artist." "She showed diligence, initiative, foresight, and other qualities that generally lead to success in other activities."
- The taxpayer’s history of income or losses with respect to the activity. If your client has continual losses, you will probably lose on this point. However, start-up losses are allowed. Also allowed for this point are losses that were unforeseen or out of the control of the taxpayer such as a drought, disease, fire, or depressed market.
- The amount of occasional profits, if any, which were earned. The Regulations provide that an occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit. For most clients, this is not a point easy to overcome.
- The financial status of the taxpayer. This is another point that may be difficult for most clients because they are benefitting from the loss deduction. As the Regulations provide, substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit especially if there are personal or recreational elements involved. However, in Huff v. Commissioner, T.C. Memo 2021-140, the court gave this point to the taxpayer. Why? Because the losses of under $100,000 a year were miniscule compared to their AGI of over $20M per year.
- Elements of personal pleasure or recreation. This factor can also be hard to turn into a positive point for many clients because they like doing the hobby (activity). However, this often-negative point may turn at least neutral by following Crile, the case mentioned in point 5. Though Crile loved to paint, she did not like the administrative work, so the court deemed this point neutral. It’s likely that a similar situation may exist for most taxpayers where there is an unenjoyable aspect of the activity making this at least a neutral point.
Wondries and Crile both won their cases. With a little planning, your clients could enjoy the same outcome.
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The content contained in this article is for informational purposes only and is not tax advice. You should consult a tax advisor for advice applicable to your situation.
