Monday, March 12, 2018

Deduct Hobby Expenses? Not Really....

You really can't deduct hobby expenses, except up to the level of income, which means, really, you have no deduction.

A recent click-bait article from the click-bait site GoBankingRates, says you can deduct hobby expenses on your taxes!  Whoo-Whee!  I can buy a Porche as a "hobby" and deduct it from my income!

Not exactly.

The deal is, like any enterprise where you make money, you can deduct expenses.   And in the case of hobbies, only up to the level of income.   You can't create a "loss" from a hobby.  In fact, if you declare a loss in any business for more than a number of years, you may end up being audited by the IRS, as they may view your business as a "hobby business" as my late Mother found out when she declared five years of losses from her bookstore.   Hint:  Declare a small profit every few years, even if you don't have one - it is easier than being audited!

The click-bait article provides this unhelpful advice:
If your hobby ends up producing income, you can then deduct your expenses up to that amount.  So, if you enjoy woodworking and spend $2,000 on materials and equipment over the course of the year, but sell a handmade table for $1,000, you can deduct up to $1,000 of your expenses.
Gee!  I get a $1000 deduction!  This saves me money on my taxes!  Uh, not really.  Since you are reporting $1000 in income as well, the net effect is zero.  And for most hobbyists, you are not going to report that income anyway, as it will not rise to the level of reportable income.

For example, Mark makes pottery.   And this year, he sold nearly $2000 worth of pots.   Now that may sound like a lot of money, but bear in mind that a new kiln cost $2200, the clay costs $30 a lug, and then there are the glazes, the tools, the kick wheel, the electric wheel, and the pottery studio, which cost over $22,000He isn't making a profit here.

In previous years, he made even less - maybe $500 a year or so, well below the reporting requirements of the IRS.  No 1099 forms were issued.  And there is no obligation to report this "income" as the net income was in fact negative - in other words, a loss.  It is a hobby, not a line of work, and hobbies are not businesses.

Could he make a profit at this?  Perhaps.  Some do.  But in order to do so, you have to spend eight hours a day cranking out pots, firing them, and glazing them, and then go sell them at craft and art shows, at galleries, and so forth.   In other words, it becomes a job - and not a very high-paying one at that, unless you become an artiste and can command thousands of dollars for your work.   It is like your nephew who wants to become a rap star.  Sure he may get a few local gigs - but he isn't about to quit his day job just yet.   A few become famous (and then get shot).  The rest are just schmucks like you and me.

So if you have $500 in income and $700 in expenses for that year, you have no income and that doesn't even need to be reported to the IRS.   On the other hand, you can't deduct a $200 loss for a hobby.   Well, you can try, but odds are, you are setting yourself up for audit bait.

Now this year, Mark sold nearly $2000 in pots.  And if the gallery issues a form 1099-MISC, that amount is reported to the IRS.  And in that instance, he should deduct his expenses - which will far exceed his income, of course - so that he doesn't owe tax on any of it.  He doesn't get any advantage out of the deal, either.  It does not lower his taxes on his other income.   Yes you should make that deduction.   No, you are not coming out ahead by doing so, only accounting for your expenses to the IRS to show that you didn't make a profit on your hobby.

The click-bait article doesn't really make this clear, and it gives the impression to people that they can deduct hobby expenses and somehow "get ahead" when in fact all they are doing is red-flagging their return.   If you have $1000 in unreported income, you can go ahead and deduct $1000 in expenses, but you'd better report that income as well.   And when you do so, it washes out to zero income - so what't the point of even declaring it, unless it was reported on a 1099 form?   

But then again, that doesn't make for a compelling click-bait slide-show, right around tax time.   The problem with our tax system is that it creates a lot of FOMO anxiety and fear.   People fear "missing out" on some "hidden loophole" they could have taken advantage of.   People also fear being audited and going to jail.   The whole impetus behind this flat-tax, tax reform, and "tax returns on a post card" thing is based on these fears.  And fear is not an emotion to be trusted.

But the reality is, for most average citizens, these fears are unfounded.   Unless you make a shitload of money or have very, very complicated finances, odds are there are no "hidden loopholes" you are missing out on, and the odds of you going to jail for tax evasion are slim, unless you are as dumb as Wesley Snipes.