Hobby Farm Loss Rule

Overall the IRS really does allow a lot of benefits and deductions to Farmers and other business owners. As a business small-business owner, most expenses paid to earn a living are deductible, unlike being an employee of a business, whereas they are not.

One tax advantage presented to the self-employed is that they are allowed to deduct all losses they have from a business they are running while trying to make a profit. A loophole and something to watch out for is the IRS’ ability to investigate and re-categorize your business. What this means is that if your business continues to lose money and not turn a profit and the IRS determines that the owners are NOT trying to make it profitable, it can be deemed a “hobby loss” or labeled as an “activity not engaged in for profit.”

This is known as the Hobby Loss Rule. Some examples are provided below. :

  • Farmer Sue only farms—she has no other job. She starts growing heirloom greens on her 20-acre farm. The first year she earns $2,000, and has expenses of $3,000; her net loss is $1,000. Because she has no income to tax, her losses should be fully deductible.
  • Farmer John grows the same crop with same results. But he has a job in town that earned him an additional $1,000. When he adds his $1,000 earnings to his $1,000 loss, he has zero income for the year, so he should get a refund.
  • Farmer Anne grows the same crop and gets the same result as Farmer Sue. However, the IRS examines her return and concludes she is not really trying to make a profit and the hobby loss rule applies to her. Even though she had expenses of $3,000, the IRS only allows her to deduct $2,000 because this is the amount of her profits. She had a job in town that paid $1,000, as well, but she cannot offset all of that income with her full loss, so she has to pay income taxes on her in-town earnings.

Section 183 of the tax code states that if an activity shows a profit in three out of five tax years, then the taxpayer is engaged in it to make a profit. In terms of horse operations, the business must show a profit in two out of seven tax years.

Some Factors the IRS considers are:

  • The manner in which the taxpayer carries on the activity.
  • The expertise of the taxpayer or his or her advisors.
  • The time and effort expended by the taxpayer in carrying on the activity.
  • The expectations that the assets used in the activity may appreciate in value.
  • The success of the taxpayer in carrying on other similar or dissimilar activities.
  • The taxpayer’s history of income or losses with respect to the activity.
  • The amount of occasional profits, if any, which are earned.
  • The financial status of the taxpayer.
  • The elements of personal pleasure or recreation.

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