The IRS’s ‘Hobby Loss Rule’: How to Avoid Paying Taxes on Unprofitable Side Hustles

As a business owner or side hustler, you’ve probably heard about the importance of keeping track of your expenses and income for tax purposes. But what happens if your side gig or small business isn’t turning a profit? Can you still claim those losses to reduce your overall tax burden? This is where the IRS’s Hobby Loss Rule comes into play — and it’s something every entrepreneur should be aware of.

What is the Hobby Loss Rule?

A tax provision that the IRS uses to determine whether an activity is a legitimate business or a hobby. Business can deduc operating losses for their taxable income - hobbies cannot.

How Does the IRS Determine Whether it’s a Hobby or a Business?

The IRS uses a series of guidelines to determine if your activity is a legitimate business or a hobby. These guidelines focus on whether you have a profit motive and if your activity is being conducted in a businesslike manner. Here are some key factors that the IRS considers:

Profit Motive

If you consistently generate profits, it’s a clear indicator that your activity is a business. According to the IRS, businesses are expected to show a profit in at least three out of five years.

Businesslike Operations

Are you keeping detailed records? Are you marketing your product or service? Do you have a business plan and an effort to grow your revenue?

Dependence on Income

The IRS also looks at whether you rely on the income from the activity. If you depend on the side gig for your livelihood, that’s a strong indicator it’s a business.

What Happens if the IRS Classifies Your Activity as a Hobby?

If your side hustle is classified as a hobby, you won’t be able to deduct losses. For example, if your hobby generates $1,000 in income but you have $2,500 in expenses, the IRS only allows you to deduct $1,000, the amount of income you earned. You cannot claim a $1,500 loss to offset other taxable income.

Additionally, hobby losses can’t be deducted beyond the income generated by the hobby itself. This limitation can significantly affect your overall tax liability if you’re relying on tax deductions to reduce your taxable income.