When the coronavirus pandemic hit the U.S., millions found themselves either temporarily or permanently unemployed due to the mandated lockdowns. Stuck at home with nothing to do, many Americans turned to their hobby interests to help keep their minds active and to generate some much-needed income. Sewing fabric masks, for example, became a booming side hustle. In 2020, Etsy sold an incredible $743 million worth of masks in just 9 months. Many others earned extra cash by baking, making jewelry, and selling other crafts. In some cases, hobbies even turned into full-fledged businesses, and that’s where things can get complicated.
If you were one of the millions who earned money through a hobby this past year, be sure you know the rules regarding hobby income and taxes.
Is It a Hobby or a Business?
When it comes to hobby income and taxes, the first step is to understand the distinction between hobby income and business income. Determining whether you are earning money from a hobby or operating a business is not always black and white. Per the IRS, a hobby is something you engage in for sport or recreation. You run a business to make a profit. So, what happens if you start making a profit from doing something for fun? There are nine questions the IRS considers when determining whether an activity is a hobby or a business.
- Do you maintain accurate books and records?
- Do you have personal motivation for carrying on the activity?
- Does the time and effort you put into the activity show intent for making a profit?
- Do you depend on income from the activity for your livelihood?
- Are your losses due to circumstances beyond your control?
- Do you have enough knowledge to turn it into a successful business?
- Have you made a profit doing similar activities in the past?
- Did you make a consistent profit, or did it vary from year to year?
- Do you expect to make a profit in the future?
If you answered “yes” to most of these, you’re probably running a business and not participating in a hobby. The IRS will also consider it a business if you made a profit in three of the last five years. In addition, they will look at the number of hours spent working on the activity to determine if it’s more a business than a hobby. Should the IRS deem your hobby income to be business income, the tax rules will change.
Reporting Hobby Income on Tax Returns
Income earned from a hobby must be reported to the IRS, regardless of how much you made. You’ll report the amount you earned from your hobby as “other income” on line 8 of Form 1040. The income is subject to income tax, but you will not be required to pay any self-employment tax.
From a tax standpoint, the main difference between a business and a hobby is the ability to deduct your expenses. Before 2018, you could deduct your hobby expenses up to the amount you earned in hobby income. Under the Tax Cuts and Jobs Act of 2017, however, hobby-related expenses can no longer be deducted due to the elimination of miscellaneous itemized deductions.
Tax Tips for Hobbyists
Managing tax obligations related to your hobby income requires proactive planning and attention to detail. To effectively navigate the intersection of passion and taxes, consider the following tax tips tailored to hobbyists:
- Maintain Accurate Records: Keep detailed records of income and expenses related to your hobby to support accurate tax reporting.
- Stay Informed About Tax Regulations: Stay up to date with IRS guidelines and regulations pertaining to hobby income to ensure compliance and avoid potential penalties.
- Consider Potential Business Designation: Assess the criteria for distinguishing a hobby from a business to accurately determine your tax obligations and potential tax benefits.
- Seek Professional Tax Advice: Consult with a tax professional or accountant to obtain personalized guidance and optimize your tax strategy based on your specific circumstances.
Earning money from something you love to do feels wonderful, but don’t make the mistake of hiding your hobby income from the IRS. It’s equally important to make sure your hobby is not a business. If the IRS believes you have misclassified your activities or neglected to disclose your income, you could face an audit, or additional taxes, penalties, and interest.