Your ability to deduct losses on Schedule C depends on whether the activity is a trade or business or a hobby operated primarily for your recreation and pleasure.

The IRS frequently audits taxpayers reporting losses on Schedule C to determine whether the hobby loss rules may apply. We recently discussed these rules with several taxpayers residing in Boca Raton and West Palm Beach.

In order to deduct losses from an activity it must be considered a trade or business and must have a profit motive. Generally, an activity is presumed to be for profit if it is profitable for three or more years during a five year period.

Example: You begin a new activity in Year 1 and incur losses in Years 1 and 3. The activity generates a profit in Years 2, 4, 5, and 6. If we apply the five year rule, the five year safe harbor period starts with Year 2 (as it is the first year with a profit) and spans Years 2-6. The safe harbor rules applies only for Years 5 and 6 (because Year 5 is the third profitable year after the start of the five year period), but does not apply to Years 1-4. The IRS may argue that the Year 1 and 3 losses are subject to the hobby loss rules.

However, if you do not meet this safe harbor rule, your activity may still be considered a trade or business carried on for profit based upon the following nine factors:

• The manner in which your carry on the activity;
• The expertise or experience of your advisors;
• The time and effort the you expend on the activity;
• The expectation that the assets used in the activity may appreciate in value;
• Your success in carrying on other similar or dissimilar activities;
• Your history of losses from the activity;
• The amount of occasional profits earned from the activity;
• Your financial status; and
• The elements of personal pleasure or recreation derived from the activity.

While the IRS takes all nine factors into account in determining whether your activity is subject to the hobby loss rules, no single factor is decisive. If your activity is found to be a hobby you must report the income received and generally may deduct related expenses (only to the extent of hobby income) as miscellaneous itemized deductions.

If you live or work in Boca Raton, West Palm Beach or elsewhere in Palm Beach County and are being audited by the IRS and find yourself subject to the hobby loss rules call East Coast Tax Consulting Group today at 561-826-9303 for a free consultation. If we find you have a reasonable position to rebut the IRS assertion that your activity is a hobby our tax professionals will aggressively argue your case before the IRS.