Avoiding the hobby loss trap after the TCJA

The Internal Revenue Code backs into the definition of activities not engaged in for profit (commonly referred to as “hobbies”) by including all activities of the taxpayer other than those for which deductions are allowable under Sec. 162 (expenses of carrying on a trade or business) or Sec. 212 (expenses incurred for the production or collection of income or the management, conservation, or maintenance of property held for the production of income) (Sec. 183).

Law change alert: Due to the suspension of miscellaneous itemized deductions in the years 2018 through 2025, deductions for hobby expenses under Sec. 183 and investment expenses under Sec. 212 are not allowed in those years (Sec. 67(g), as added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97).

The inability of a taxpayer to deduct even a portion of the hobby expenses while recognizing all the hobby income in adjusted gross income makes establishing a profit motive for a hobby activity even more desirable. The determination of whether an activity is engaged in for profit is based on the facts and circumstances of each case and can be very subjective; however, a statutory safe harbor is provided under Sec. 183(d) that, if met, causes a presumption that the activity is a for-profit endeavor.

To meet the safe harbor, an activity must generate a profit in at least three of five years (two of seven years for activities involving horse racing, breeding, or showing) ending with the tax year in question (Sec. 183(d)). If this safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The IRS can still rebut the profit motive presumption by proving that the activity is not engaged in for profit (e.g., by showing that the profitable years generated immaterial profits while the unprofitable years generated large losses). In most cases, if the safe harbor is met, the IRS will not attempt to rebut the presumption unless there are extenuating circumstances.

Applying the safe harbor

The safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year (Regs. Sec. 1.183-1(c)).

Example 1. Applying the safe harbor: T begins a new activity in year 1 and incurs losses from that activity in years 1, 3, and 6. The activity is profitable in years 2, 4, and 5. Assuming the five-year test applies to the activity, the five-year safe-harbor period begins with year 2 (because it is the first profitable year) and covers years 2-6. The safe harbor 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 for years 1-4.

Thus, the IRS can assert that the losses incurred in years 1 and 3 must be reported under the hobby loss rules (unless T can prove otherwise under the subjective factors mentioned in the regulations).

Because T cannot rely on the safe harbor before year 5, he will have to rely on facts and circumstances to establish a profit motive for years 1-4. Alternatively, T can make an election under Sec. 183(e) to postpone the safe-harbor determination (see discussion later in this section).

Observation: The safe harbor of Sec. 183(d) is not as helpful for loss years as it may first appear. Because the safe harbor applies only after a taxpayer incurs a third profitable year within the five-year testing period, only loss years arising after that time (and within the five-year period) are protected. Therefore, for a new activity, losses incurred in the first several years will never be protected under the safe harbor, whether or not the activity turns a profit in later years. In summary, taxpayers should be cautious relying on the safe harbor since it may not cover the loss years incurred in the testing period. Its use may be more beneficial for taxpayers who are racing, breeding, or showing horses since there are fewer required profitable years (two years) and a longer testing period (seven years).

Example 2. Three profitable years must precede safe-harbor loss year: At the end of year 3 in Example 1, T could not rely on the safe harbor at that time (presuming that year 3 is a profit-motive year) and report income and deductions for year 3 on his Schedule C, Profit or Loss From Business. Even if he knew what the future outcome would be for years 4-6, future years have no bearing on the ability to use the safe harbor for year 3 under the general presumptive rule of Sec. 183(d). (Also, three profitable years had not yet occurred at that time.) In fact, although two of the next three years did produce profits (thus producing an applicable safe-harbor five-year period containing three profitable years), the application of the safe harbor does not apply to a loss year until year 5.

Electing to postpone the safe-harbor presumption

A taxpayer may elect to delay a determination as to whether the safe harbor applies until the close of the fourth tax year (or sixth tax year, in the case of horse racing, breeding, or showing) after the tax year in which the taxpayer first engages in the activity (Sec. 183(e)(1)). The advantage of this election over the general presumptive rule of Sec. 183(d) is that losses from the activity during the five-year period are tentatively allowed during that period (as opposed to being disallowed until the activity has been profitable for three years) and reported on Schedule C. If the election is made and the activity is profitable for three or more of the five years, the activity is presumed engaged in for profit throughout the entire five-year period. The election shifts the timing of the ability to use the safe harbor to an earlier period. However, if the election is made and the taxpayer fails the three-out-of-five-year test, the taxpayer may be faced with a substantial tax deficiency for all years involved.

To make a valid election, the taxpayer must file Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit, and execute a waiver of the statute of limitation. The election of Form 5213 is filed, separate from any other form or return, with the IRS Service Center where the taxpayer files his or her tax return. Filing Form 5213 automatically extends the statute of limitation for any deficiency attributable to the activity. The statute extension runs until two years after the due date (without extensions) of the return for the last tax year in the five-year (or seven-year) presumption period.

Practice tip: While filing Form 5213 allows a taxpayer additional time to establish the existence of a trade or business activity, it also alerts the IRS to a possible hobby loss issue. Thus, as a practical matter, Form 5213 is rarely used until the taxpayer has been notified by the IRS that it proposes to disallow deductions related to an alleged hobby activity.

Example 3. Electing to postpone the safe-harbor profit presumption: Assume the same facts as in Example 1. Also assume that upon processing the return for year 1, the IRS proposes to disallow deductions related to the loss for that year. T timely files the election to postpone the determination of the safe-harbor profit presumption upon receiving the notice of deficiency for year 1 (of course, not knowing yet how subsequent years would turn out). By making this election, then in fact the losses could be taken for years 1 and 3, and the burden of proof would have been shifted to the IRS to disprove a profit-related activity for years 1-5. (The determination of the safe-harbor profit presumption is delayed until the end of the fourth year following the first year of the activity (i.e., year 5) and three of those five years produced net profit.)

Observation: The Tax Court previously held that Form 5213 not only extends the period for assessing deficiencies associated with an activity, but it also applies to a taxpayer’s right to make a claim for an overpayment. Accordingly, a taxpayer was allowed to claim refunds for additional deductions related to a horse-boarding and training activity during the two years for which the statute was extended by filing Form 5213 (Wadlow, 112 T.C. 247 (1999)).  

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 19th edition (March 2018), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).