I like to play golf. If I were a little younger it might be something that I would take seriously and make an effort at being really good at. There are a lot of tournaments for people who aren’t good enough to become professionals but who are good enough to be successful amateurs. You can actually make money in those, perhaps even enough money to cover your expenses and have a little left over. But you’ve got to be good at it and you’ve got to be able to perform under pressure.
Of course this would be expensive. To be a good golfer you have to have good equipment, which can be costly unless you’re sponsored by someone or an equipment company. Travel and lodging can be expensive as well. Of course there are entrance fees, hotel rooms, food, etc.
So what is the point of all this?
The federal tax allows us to deduct expenses for activities in which we expect make a profit. That intent need not be reasonable, but it must be genuine. So the question is, am I able to deduct the expenses that I incur to become a better golfer? More broadly, can we deduct expenses for hobbies when we really do intend to make a profit?
So today were going to talk about hobby losses.
The first rule is – do you really intend to make a profit? The federal tax law provides that your intention does not need to be reasonable, it just needs to be genuine. I have had many people who intended to make a profit that seemed unreasonable. For example I’ve had clients who raised dogs, raced horses, flew airplanes, ran cattle ranches, etc. All of these people intended to make a profit, though most of them did not. In fact many of them had losses for as long as 10 or 12 years. However that is not the test under tax law. The test is whether you genuinely intended to make a profit. I’ve actually had clients who filed a fraudulent income tax returns that were able to prove that they intended to make a profit in the hobby and the IRS agreed.
To address the credibility issue, the IRS has issued regulations that are designed to figure out if you genuinely intended to make a profit by using objective criteria. For example:
- Good Records
People who intend to make a profit often try to keep good books and records. They typically keep track of their income and expenses. Often they will have an accountant or use accounting software to give regular updates on any profit and loss of the business.
The IRS will also look to your knowledge and experience in your hobby. Doctors who own racehorses typically don’t have much expertise in that field. However, if they consult with jockeys and trainers and breeders in order to make sure that they maximize their chance of profits, the IRS will consider that a good factor of intent to make a profit
- Appreciation in value
The IRS will also look to the possibility of the asset increasing in value. A cattle rancher may very well have years of gains and years of losses-a marginal undertaking. However, the farm or ranch that he is operating on may very well increase in value far beyond whatever losses he has incurred. The same could be true of buying a horse and training it to race. If it’s successful it could very well increase in value far beyond the expenses of buying and training.
- Historical losses
The IRS will also look to your history of gains and losses. If you have 15 years of consecutive losses that are being used to offset your other income , that would suggest to the IRS that it was a hobby. If you periodically make profits, that would be a factor favoring an intent to make a profit. If you have enough income in a few years, a legal presumption may actually arise that you did intend to make a profit.
5. Elements of Personal Pleasure
An important factor is whether or not there are elements of personal pleasure. A rich doctor who owns race horses that he follows throughout the country and gambles on at race tracks may be a hobby. However if he never goes to those races and sees it as an investment with other partners may be a factor of profit intent.
So folks here’s the deal. If you have a hobby and you genuinely intend to make a profit, it is possible and even likely that you can deduct the losses for several years. But in order to do so, you will have to arrange your affairs to generate evidence that you truly intended to make a profit. You would need to get with an accountant or a tax lawyer, learn more about these and other factors I’ve described in this article, and spend some time developing that evidence now should you get audited.
I began this article by addressing my golfing skills. While I might genuinely intend to make a profit, the reality is that my swing coach and a retired touring pro have both told me it is an unreasonable expectation considering my golf skills. I have therefore decided instead to buy a virtual reality headset and just imagine.
David Leeper is a Board Certified federal tax attorney with 38 years of experience. He can be reached at 581-8748, by email at firstname.lastname@example.org, or visit leepertaxlaw.com.