Many taxpayers start a side business to pursue their passion—crafting, breeding horses, fishing charters, or even gambling on dogs. But the IRS draws a bright line: if your activity is not engaged in for profit, you cannot use its losses to offset your other income. Cross that line and you could lose all your deductions, face steep penalties, and trigger an audit.
This post covers the hobby loss rules of IRC §183 in depth: the statutory framework, the nine‑factor test, the three‑year safe harbor, key court decisions (including very recent cases), and practical steps to protect yourself. By the end, you will have a roadmap to keep your passion from becoming a tax disaster.
- Key takeaway: Profit motive must be real and documented. The IRS looks at objective facts, not your intent alone.
- ⚠️ Warning: If you report losses from an activity for three or more years while having substantial other income, the IRS will almost certainly scrutinize your return.
The Core Rule: IRC §183 – “Activities Not Engaged in For Profit”
The hobby loss rule is codified in Internal Revenue Code §183. It says that if an activity is not engaged in for profit, no deduction attributable to that activity is allowed, except as specifically provided.
What deductions are allowed? Under §183(b), you can deduct:
- Category 1 – Expenses that are deductible regardless of the activity (e.g., mortgage interest, property taxes). These are allowed in full.
- Category 2 – Other expenses that do not affect basis (e.g., advertising, wages, repairs). These are allowed only to the extent that gross income from the hobby exceeds Category 1 deductions.
- Category 3 – Depreciation and amortization. These are allowed only if gross income exceeds the total of Category 1 and Category 2 deductions.
Even more important: For tax years 2018 through 2025, deductions under §183(b)(2) are miscellaneous itemized deductions suspended by §67(g). That means no hobby loss deduction at all during those years unless you can prove a profit motive and claim the expenses as business deductions on Schedule C. The Eleventh Circuit confirmed this treatment in Gregory v. Commissioner (Case No. 22‑10707), holding that §183(b)(2) deductions are miscellaneous itemized deductions and therefore subject to the suspension.
The Safe Harbor: Three Years of Profit
The most straightforward way to avoid hobby‑loss classification is to meet the statutory safe harbor of §183(d). An activity is presumed to be engaged in for profit if it shows a profit in:
- At least three of the last five consecutive tax years (including the current year), or
- At least two of the last seven consecutive tax years for activities that consist primarily of the breeding, training, showing, or racing of horses.
Meeting the safe harbor shifts the burden of proof to the IRS. The IRS can still rebut the presumption by showing that the profitable years were immaterial or that the activity is not truly for profit, but in most cases, this is difficult for them to do.
⏰ Important nuance: The safe harbor does not apply retroactively to loss years before the third profitable year. It starts with the first profitable year of the five‑year period and only protects years after the third profit. Example: T has losses in years 1,3,6 and profits in years 2,4,5. The safe harbor applies only to years 5 and 6, not to years 1 and 3.
If you have a new activity, you can file Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit, to delay the safe‑harbor determination until you have five (or seven) years of experience.
The Nine‑Factor Test (Treas. Reg. §1.183‑2(b))
If you cannot meet the safe harbor, the IRS and the courts will evaluate your profit motive under the nine non‑exclusive factors set out in Treasury Regulation §1.183‑2(b). No single factor is controlling; the court looks at all the facts and circumstances.
1. Manner in which you carry on the activity
You must operate in a businesslike manner: maintain complete and accurate books and records, have a written (or at least identifiable) business plan, use separate bank accounts, and make changes to improve profitability. In Golanty, the court stressed that records must be used to increase profitability through effective accounting controls. In Swanson, the taxpayer failed because he had no business plan, no separate bank account, and made changes only after an IRS audit to satisfy regulatory requirements, not to improve profit.
2. Expertise of you and your advisers
Demonstrate expertise: take courses, earn certifications, consult with experts, and follow their advice. In Blackwell, the taxpayer earned a bachelor’s degree in Equine Industry Management, and her husband prepared a detailed business plan. The court found this factor strongly in their favor.
3. Time and effort you expend
The more personal time you devote, the more likely you have a profit motive. However, if you lack time, you can hire competent people to operate the activity. In the miniature donkey case, the taxpayer employed a farm manager and outside experts, so the court still found a profit motive even though the taxpayer personally spent little time.
4. Expectation that assets will appreciate
If you intend to profit primarily from appreciation (e.g., real estate, collectibles, breeding stock), you must offer credible evidence that appreciation is likely. In Fredenberg v. Commissioner (2025 TCS 1), the court accepted the taxpayers’ reasonable expectation that their rental property would appreciate after repairs and renovations, and that expectation supported a profit motive even though rental income did not cover expenses.
5. Your success in other activities
If you have successfully turned similar activities into profitable enterprises, that indicates a profit motive for the current activity. The regulation specifically notes that converting unprofitable activities to profitable ones in the past counts in your favor.
6. History of income or loss
A long, uninterrupted series of losses weighs against a profit motive, but losses can be excused if they are due to start‑up costs, unforeseen events, or market downturns. In Engdahl v. Commissioner (72 T.C. 659 (1979)), the court allowed deductions despite continuous losses because the Engdahls made operational changes, consulted experts, and the losses stemmed from factors beyond their control (deaths of key horses, market shifts).
7. Amount of occasional profits
Small profits in relation to large losses can still indicate a profit motive, especially if the profits are consistent. In Engdahl, occasional small profits helped show a genuine profit objective.
8. Your financial status
If you have substantial income from other sources, the IRS is more likely to argue that you do not need the profit, and thus the activity is a hobby. But this factor alone is not determinative. In Engdahl, the taxpayers had an orthodontic practice, yet the court still found a profit motive based on the other factors.
9. Personal pleasure or recreation
This factor cuts both ways. If you derive significant personal pleasure from the activity, it suggests a hobby. But the regulation recognizes that an activity can be enjoyable and still be for profit. The Engdahls won partly because they derived no substantial personal pleasure from the horse‑breeding operation; they performed all the hard labor themselves and did not use the horses for recreation.
Key Cases That Define the Law
- Commissioner v. Groetzinger, 480 U.S. 23 (1987) – The taxpayer gambled on dog races 60‑80 hours per week with the intent to earn a living. The Supreme Court held that he was engaged in a trade or business, not a hobby, because his primary purpose was profit.
- Engdahl v. Commissioner, 72 T.C. 659 (1979) – The Tax Court allowed deductions for a horse‑breeding operation that lost money every year for over a decade. The key factors: businesslike conduct, reliance on experts, substantial time investment, and no personal pleasure from the activity.
- Nickerson v. Commissioner, 700 F.2d 402 (6th Cir. 1983) – A dairy farm that suffered continuous losses was still engaged in for profit because the taxpayer made operational changes, sought advice, and had a reasonable expectation of future profitability. The court gave little weight to the history of losses when other factors were strong.
- Himmel v. Commissioner, T.C. Memo. 2025‑35 – A very recent case: the taxpayers bred and showed Arabian horses for over 20 years, reporting losses in most years. The Tax Court held the activity no profit motive because, among other things, they made only two horse sales in 14 years, did not adjust their business plan despite persistent losses, and the husband’s involvement as a judge was tainted by a scandal. This case shows that the IRS is actively litigating hobby loss issues.
- Bucci v. Commissioner, appeal to the Second Circuit (2023‑2024) – A wealthy salt magnate lost his hobby loss appeal because the court found that his thoroughbred racing operation lacked a genuine profit motive. The court even noted that retiring horses to pasture rather than selling them indicated a lack of profit motive—a controversial but instructive point.
Recent Developments & Current Law Landscape
Loper Bright Enterprises v. Raimondo (2024) – The Supreme Court overruled Chevron deference, which may affect how courts review IRS regulations, including the nine‑factor regulation under §1.183‑2(b). Going forward, courts may be less inclined to defer to IRS interpretations. But the nine factors themselves are long‑standing and likely to remain the benchmark.
TCJA suspension of miscellaneous itemized deductions (2018‑2025) – As noted, for tax years 2018 through 2025, hobby expenses that are not business expenses are not deductible at all. This makes proving a profit motive more critical than ever.
IRS enforcement priority – The IRS continues to audit taxpayers who claim large Schedule C losses while having substantial wage or investment income. In Himmel, the IRS litigated the issue over a period of years, and the taxpayers lost not only the deductions but also faced additions to tax for failure to file timely returns.
Practical Strategies to Avoid the Hobby Loss Trap
✅ Write a business plan – Include market analysis, financial projections, marketing strategies, and a timeline to profitability. Update it annually and follow it.
✅ Keep complete and accurate books – Use separate bank accounts and credit cards. Use accounting software (QuickBooks, BarnPro, etc.) and generate regular financial statements. The court in Blackwell was impressed by the use of BarnPro software.
✅ Separate personal from business – Do not intermingle personal and business funds. Pay business expenses from the business account.
✅ Document expertise – Take courses, earn certifications, join professional associations, and consult with experts. Follow their advice and document that you did so.
✅ Spend significant time – Track your hours. If you cannot devote full time, hire competent employees and document their work.
✅ Make operational changes to improve profit – Show that you responded to losses by changing methods, cutting costs, or exploring new revenue streams. Do not wait for an IRS audit to make changes; do it proactively.
✅ Do not rely solely on depreciation – A business that shows a profit before depreciation is in a stronger position. The IRS is suspicious when the only “profit” comes from non‑cash deductions.
✅ File Form 5213 for new activities – This postpones the safe‑harbor determination until you have five (or seven) years of operations, giving you time to turn a profit.
✅ Consult a tax professional – The rules are complex, and court decisions continue to refine them. An experienced practitioner can help you structure your activity to withstand IRS scrutiny.
What to Do if the IRS Challenges Your Activity
If you receive an IRS notice disallowing your losses under §183:
- Gather your documentation – business plan, books, records, contracts, advertising materials, licenses, correspondence with experts, and evidence of changes you made to improve profit.
- Determine whether you meet the safe harbor – If you have profits in three of five years, the IRS has the burden to rebut the presumption.
- Consider a protest or an appeal – You can challenge the determination with the IRS Office of Appeals before going to Tax Court.
- If you go to court, be prepared to present the nine factors in your favor, supported by objective evidence, not just your own testimony.
🧑⚖️ Remember: Your subjective intent is not enough. The IRS and courts will judge you by what you did, not what you say you intended.
Conclusion
The hobby loss trap is real and can result in disallowed deductions, tax deficiencies, penalties, and a prolonged audit. But with careful planning, business‑like conduct, and proper documentation, you can prove a profit motive and keep your losses where they belong: reducing your taxable income.
Do not wait until you are audited to start acting like a business. Start today.
📢 Disclosure
This content is for informational purposes only and does not constitute legal or tax advice. Tax laws, regulations, and judicial interpretations change frequently, and the information presented here may not reflect the most current legal developments. You should consult a qualified tax professional regarding your specific situation.
For questions or for assistance with hobby loss issues, please contact Alan Goldstein.
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