Avoiding the hobby loss trap after the TCJA.

• Author: Young, Patrick
• Position: Tax Cuts and Jobs Act of 2017

The Internal Revenue Code backs into the definition of activities not engaged in for profit (commonly referred to as "hobbies") by including all activities of the taxpayer other than those for which deductions are allowable under Sec. 162 (expenses of carrying on a trade or business) or Sec. 212 (expenses incurred for the production or collection of income or the management, conservation, or maintenance of property held for the production of income) (Sec. 183).

Law change alert: Due to the suspension of miscellaneous itemized deductions in the years 2018 through 2025, deductions for hobby expenses under Sec. 183 and investment expenses under Sec. 212 are not allowed in those years (Sec. 67(g), as added by the law known as the Tax Cuts and Jobs Act (TCJA), RL. 115-97).

The inability of a taxpayer to deduct even a portion of the hobby expenses while recognizing all the hobby income in adjusted gross income makes establishing a profit motive for a hobby activity even more desirable. The determination of whether an activity is engaged in for profit is based on the facts and circumstances of each case and can be very subjective; however, a statutory safe harbor is provided under Sec. 183(d) that, if met, causes a presumption that the activity is a for-profit endeavor.

To meet the safe harbor, an activity must generate a profit in at least three of five years (two of seven years for activities involving horse racing, breeding, or showing) ending with the tax year in question (Sec. 183(d)). If this safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The IRS can still rebut the profit motive presumption by proving that the activity is not engaged in for profit (e.g., by showing that the profitable years generated immaterial profits while the unprofitable years generated large losses). In most cases, if the safe harbor is met, the IRS will not attempt to rebut the presumption unless there are extenuating circumstances.

Applying the safe harbor

The safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year (Regs. Sec. 1.183-l(c)).

Example 1. Applying the safe harbor: T begins a new activity in year 1 and incurs losses from that activity in years 1,3, and 6. The activity is profitable in years 2,4, and 5. Assuming the five-year test applies to the activity, the five-year safe-harbor...