Side Hustle or Hobby? How IRC Section 183 Decides Whether Your Losses Count

You make jewelry and sell it online. You shoot weddings on weekends. You restore furniture and flip it. Some years you make a little money. Most years, with equipment, supplies, and travel, you lose some.

As long as those losses reduce your other income, the IRS may eventually ask a pointed question: is this a business, or is it a hobby you happen to get paid for sometimes? The answer decides whether your deductions count at all.

The rule

IRC Section 183(a) says that if an individual's activity is not engaged in for profit, no deduction attributable to the activity is allowed except as Section 183 provides. Section 183(c) defines an activity not engaged in for profit as any activity other than one for which deductions are allowed under Section 162, the trade or business section, or Section 212, the investment section.

Treas. Reg. 1.183-2(a) adds the standard: the question is decided by objective standards, looking at all the facts and circumstances. You do not need a reasonable expectation of profit, but the facts must show you entered into or continued the activity with the objective of making a profit. And the regulation says greater weight is given to objective facts than to your statement of intent.

Translation: saying "I'm trying to make money" does not settle it. How you run the activity does.

The nine factors

Treas. Reg. 1.183-2(b) lists factors that should normally be considered. No single factor decides the case, and it is not a matter of counting them up.

1. How you carry on the activity. A businesslike manner and complete, accurate books and records point toward profit. So does changing methods to improve profitability.
2. Your expertise, or your advisors'. Studying the business or consulting people who know it, and then following their advice, suggests a profit motive.
3. Time and effort. Devoting substantial personal time, especially to an activity without much recreational appeal, points toward profit.
4. Expected appreciation of assets used in the activity.
5. Your success in other activities, including turning unprofitable ventures into profitable ones.
6. History of income or losses. Start-up losses are normal. Losses that go on beyond the customary start-up period without explanation are not. Losses from circumstances beyond your control do not count against you.
7. Occasional profits and their size relative to your losses and investment.
8. Your financial status. Substantial income from other sources, particularly when the losses generate tax benefits, can point away from a profit motive.
9. Personal pleasure or recreation. Enjoying the work is fine. The regulation says personal pleasure alone does not make an activity a hobby if other factors show a profit objective.

The IRS does not ask whether you love what you do. It asks whether you run it like a business that intends to make money.

The presumption: 3 profitable years out of 5

Section 183(d) gives you a presumption. If the activity produced gross income greater than its deductions in 3 or more of the 5 consecutive tax years ending with the year in question, it is presumed to be engaged in for profit unless the IRS establishes otherwise. For horse breeding, training, showing, or racing, the test is 2 out of 7 years.

A presumption is helpful but not a requirement. Plenty of real businesses do not hit 3 profitable years out of 5, especially in the early years. If you miss it, you are judged on the nine factors.

For a new activity, Section 183(e) lets you elect to postpone the determination of whether the presumption applies until the close of the fourth tax year after the year you first engage in the activity. The election is made on Form 5213. There is a cost: under Section 183(e)(4), the statute of limitations on assessing deficiencies attributable to the activity is extended until two years after the due date of the return for the last year in the 5-year period. That keeps the early years open longer. Think before you elect.

What happens if it is a hobby

This is where people get hurt.

• The income is still taxable. Gross income under IRC Section 61 includes income from all sources. Hobby income is reported on your return.
• The expenses are effectively gone. Section 183(b)(2) allows expenses that would be deductible only if the activity were for profit, up to the activity's gross income. But those deductions are not on the list of exceptions in Section 67(b), which makes them miscellaneous itemized deductions. Section 67(h) disallows miscellaneous itemized deductions for tax years beginning after December 31, 2017, and Public Law 119-21 made that disallowance permanent.

So a hobby with $5,000 of sales and $8,000 of costs is not a $3,000 loss. It is $5,000 of income with no offsetting deduction for those hobby expenses. That is worse than breaking even.

There is one consolation. Because a hobby is not a trade or business, hobby income generally is not net earnings from self-employment. IRC 1402(c) defines "trade or business" for self-employment tax by reference to Section 162.

Gig workers and Section 183

Most driving, delivery, and freelance service work is plainly done for profit. Nobody drives strangers to the airport for fun. Section 183 tends to come up with activities that have a personal or creative element: crafts, art, photography, music, collecting and reselling, content creation, and horses.

It also comes up when a W-2 earner with a solid salary reports a side activity with large, repeated losses. That fits the financial status factor in the regulation, and it is the profile that draws attention in a Schedule C audit.

How to look like a business, because you are one

• Separate bank account and card. Commingling looks like a hobby.
• Real books. Income and expenses tracked monthly. See recordkeeping rules.
• A written plan. Pricing, target customers, and how you will reach profitability.
• Change what is not working. The regulation specifically mentions abandoning unprofitable methods as evidence of a profit motive. Raise prices, cut costs, drop losing product lines, and document why.
• Marketing. A website, listings, advertising, business cards. People with hobbies do not usually advertise.
• Licenses and registrations required in your area.
• Time logs showing the hours you put in.

And if you sell your own used belongings rather than running a resale operation, that is not a hobby or a business. It is personal property, with its own rules. See selling personal items on a 1099-K.