By: Gregory Carnes, Contributor to the South-Western Federal Taxation series
For individual taxpayers, what is worse than having a revenue-generating hobby? Nothing!! This is even more true after the Tax Cuts and Jobs Act of 2017. If an activity is determined to be a hobby, rather than a business, there are a number of deduction limitations placed on activity. These limitations, which have been in place for many years, include the following:
- The amount of expenses deducted cannot exceed the revenues earned
- Expenses must be deducted in a particular order:
- Items that would be deductible even without the hobby
- Cash expenses
- Depreciation and amortization
- Items that would be deductible even without the hobby
- Expenses in categories two and three are miscellaneous itemized deductions subject to the 2%-of-AGI floor
Before 2018, these rules made it very difficult to receive a tax benefit from deductions related to a hobby. Items in category one produced no tax benefit, because they were deductible even without the hobby. Further, since the total expenses were limited to the revenues earned, placing these items in category one made it more difficult to receive a benefit from categories two and three. Additionally, taxpayers that took the standard deduction received no benefit from categories two and three. For taxpayers that did itemize, the benefit from categories two and three depended on the extent to which the total miscellaneous itemized deductions exceeded 2% of AGI.
As challenging as these rules were for taxpayers, things are now worse. The Tax Cuts and Jobs Act of 2017 suspended (from 2018 through 2025), the deduction for miscellaneous itemized deductions subject to the 2%-of-AGI floor. As a result, taxpayers will not receive any tax benefit from deductions in categories two and three, above. This means that a taxpayer with a hobby must report 100% of the revenues, while no deductions are allowed for expenses that were incurred to earn the revenue.
For example, assume a taxpayer, Amanda, earns $8,000 of revenue from a hobby in 2019. She also incurs $12,000 of cash expenses while earning the revenue (none of which are otherwise deductible). She will report $8,000 of income and have no deductions, even though her cashflow is ($4,000).
Here are some ideas about topics you and your students might find fruitful for discussion.
- Do the current rules for hobby losses create an equitable result for taxpayers such as Amanda in the above example?
- What are the rules for deductions related to gambling income? What are the rules for deductions related to operating an illegal business? How do these rules differ from the rules for hobby deductions? Are these differences justified?
- What is an alternative policy for deductions related to hobbies that you would recommend to Congress?
Ideas for Class Assignments
- Have students write a paper that describes the similarities and differences in the deduction rules for hobbies, gambling, and illegal businesses.
- Assign a student or a group to debate one side of the following issue with another student or group: Taxpayers with losses from hobbies are treated equitably in relationship to taxpayers with gambling losses or illegal businesses.
- Have the students write a letter to Congress explaining their concern(s) for the current rules for hobby losses, and a proposed alternative for these rules.
Resources
SWFT Chapters
