Turning hobby into business means tax breaks

Hobbies provide a great way to relax from the daily grind. For many people, they also offer a way to make extra spending money.

Be aware, however, when your hobby produces income, you owe tax on it.

You can reduce your taxable hobby income by deducting your hobby expenses, but this tax break is limited.

Allowable hobby deductions

You can only deduct expenses up to the amount of money you make on the hobby. Even then, hobby expenses, along with other miscellaneous expenses you itemize on Schedule A, must come to more than 2 percent of your adjusted gross income before you can deduct them.

If you find you are regularly making money from your hobby, it might be to your tax advantage to turn the sideline into a business.

It's not as difficult as you might think. If you operate as a sole proprietor, you report the income on your 1040 tax return and you have more options when it comes to deducting your expenses.

Hobby vs. business

The Internal Revenue Service defines a hobby as an activity you pursue without expecting to make a taxable profit. Basically, you do it because you like it, regardless of the cost.

But if you demonstrate that you are involved in an activity with the expectation of making money on it, the IRS will consider it a business. As such, you'll be able to deduct expenses directly from your income. You even can deduct overall business losses in the years you don't turn a profit.

You must, however, make the right moves to convince the IRS that your sideline is a legitimate business.

What constitutes a business

The IRS uses two tests in determining whether your activity is a business rather than a hobby.

First, the profit test demands that you show you earned money on the activity in three out of five years.

If you can't meet the profit test, you get another chance to convince the IRS that you are running a business by passing the factors-and-circumstance test. Here, the tax agency takes a subjective, individualized look at your pursuit.

IRS looks at everything

In determining whether you are carrying on an activity for profit, the IRS says all the facts are taken into account. No one factor alone is decisive. So be prepared to come through in several areas to convince the IRS that you're making a good-faith attempt to run a business and not just looking to illegally claim the more-expansive business tax breaks.

By successfully transforming your hobby into a business, you'll be able to deduct your associated expenses on Schedule C or C-EZ without worrying about a percentage limitation. You might even find a few more you can take, such as one for the home office you set up to take care of your new endeavor's administrative chores.

And if you have an occasional year where you lose money, the loss can help reduce your other income and lower your tax bill.

By Kay Bell, Bankrate — 03/03/11