Do you have a hobby that creates a bit of cash flow? In this post we explore the gray area between a hobby and business and the tax considerations both situations.

From baking to knitting to woodworking to selling homemade crafts on Etsy, there are many ways to turn your hobby into a steady stream of income. But, since you’re making money, the IRS is involved too. Many taxpayers may ask:

• Q: “When does my simple hobby turn into an actual business? 
  A: It depends, read on.
   
• Q: “Can I write off or deduct my hobby expenses?”
  A:  Again, it depends, but probably not unless you keep records and are able to itemize deductions.
   
• Q: “When will I get taxed on my hobby income”?
  A: The IRS will consider it taxable income if it goes beyond an “occasional garage or yard sale”.
   

Hobby vs. Business: How to Decide

When making the distinction between a hobby and a business, the IRS provides a few questions to help tell the difference. Typically, a hobby is done with the sole purpose of recreation or pleasure. But there’s no single deciding factor that determines if your hobby is a business or just a fun activity. 

If you are keeping records, intend to make a profit, depend on the income from the hobby, then you are probably running a business in the eyes of the IRS.

On the flip side, if you are running a business, but you have lost money in three of the last five years, the IRS may re-classify your activity as a hobby. This prevents you from using the losses to offset other income.
 

Tax Considerations for Hobbyist

The bad news is, income is taxable per the IRS (from a hobby, business, or pretty much anything). In the cases of businesses the IRS taxes profit (which is income minus expenses).  For hobbyists the IRS taxes income. They do allow deductions for certain hobby expenses but there are limits and strings attached. Hobbyists can deduct expenses up to 2% of their adjusted gross income but they must also itemize deductions (which adds complexity and isn't worth it for a lot of people). 

The only income that doesn’t need to be reported is from garage sales (virtual or in your driveway), but generally you’d be taking a loss on those items anyway.
 

The Biggest Differences Between a Business and a Hobby for Tax Purposes

Businesses enjoy special tax treatment in terms of a wide range of things they can deduct.  Losses can be used to offset other income. With a hobby that is different. If you are running a hobby that generates a loss you cannot use that loss to offset other income.

With a business there is also the possibility of taking a home office deduction or contributing to a tax sheltered retirement account. The downside to operating a business vs a hobby for tax purposes is the hefty self employment tax.  Local taxes may also be levied on self employment income.

Here is a breakdown of the differences between a hobby and a business:

Be Aware of Auto Reporting

If your hobby activity is generating a lot of revenue through PayPal or Amazon, the IRS is watching.

PayPal and Amazon are required to send you a 1099-K if your gross sales on the platform go above $20,000 in a given tax year $600 in a given year starting 2022 (thanks to section 9674 of the 3rd round stimulus bill of 2021). It will be linked to your tax ID number, so the IRS will expect you to claim this amount as income on your taxes, or have proof of offsets, cost of goods sold, etc. Unfortunately Paypal and Amazon don’t help you when it comes to reporting deductions against that income. It is up to you to have documentation to prove the expenses were legitimate if you want to use them to offset the income come tax time.
 

The Bottom Line

If you feel as though your hobby is toeing the line of a business, it may be wise to claim it as one. Starting a business can be complex, so hiring a tax advisor to guide you with any tax implications of your business can help you avoid penalties and audits.