The hobby loss rules say that if the IRS decides you are not carrying on an activity to make a profit, you cannot use its losses to offset other income. You still report every dollar the activity earns. For 2026, the expenses of a hobby are not deductible on a federal return, so the stakes of the label are higher than they were before 2018. This guide shows how the IRS makes the call, what protects you, and what to put in place if your side business, practice or investment activity is losing money on paper.
TL;DR
- Under IRC § 183, an activity run without a profit motive is a hobby: income is taxable and the losses do not offset your other income.
- The IRS weighs nine factors on the facts. No single factor decides the outcome, and records matter more than your stated intentions.
- Profit in 3 of 5 consecutive years (2 of 7 for horse activities) creates a presumption of profit motive. Form 5213 can postpone the test.
- Hobby expenses are not deductible in 2026, and forming an S corporation does not create a safe harbor.
- Businesslike records, a written plan and a separate bank account are the practical way to document profit intent.
Table of Contents
- What the hobby loss rules actually say
- What changed for 2026 deductions
- The nine factors the IRS uses
- The 3-of-5-year presumption
- Worked example: a clinical side practice
- How to show you operate for profit
- Does high income, W-2 pay or an S corporation change the test?
- Perspective: why we treat this as a planning question
- If you get an IRS notice about a hobby
- How we can help
- FAQ
- Sources
What the hobby loss rules actually say
Section 183 of the Internal Revenue Code limits deductions for an activity "not engaged in for profit." The test is not whether you enjoy the work or whether you lost money. It is whether you are doing it with an actual and honest objective of making a profit. The IRS puts it plainly: if you are not trying to make a profit, you cannot use a loss from the activity to offset other income.
The rules reach far beyond crafts and collectibles. They apply to a consulting practice that never took off, a rental property run casually, a farm, a podcast, a side clinic or a second company that has not yet found customers. Anything that looks like a business, an investment or a pastime can be tested.
Two consequences follow when the IRS wins:
- Income is taxable. Hobby income is reported in full.
- Losses are not usable. The costs of the activity do not reduce your wages, your other business income or your investment income.
There is one small upside. If an activity is classified as a hobby, self-employment tax does not apply to its income. That rarely outweighs losing the deductions, but it explains why the classification is not always bad on the income side.
What changed for 2026 deductions
Before 2018, a hobbyist could deduct expenses as a miscellaneous itemized deduction, up to the amount of hobby income and only above a 2% of adjusted gross income floor. The Tax Cuts and Jobs Act suspended those deductions for 2018 through 2025. The One Big Beautiful Bill Act then permanently eliminated miscellaneous itemized deductions, according to the House Ways and Means Committee's section-by-section summary.
The practical result for 2026:
- Hobby income goes on your return in full.
- Hobby expenses give you no deduction.
- Items such as cost of goods sold can still reduce gross receipts, because they are an offset to income and not a deduction.
That last point matters. A person who sells handmade goods as a hobby is taxed on receipts minus the direct cost of the goods sold, but not on receipts minus rent, advertising, software and travel. If the same person is a business, every ordinary and necessary expense is in play.
The nine factors the IRS uses
The regulation behind the test, Treas. Reg. § 1.183-2, directs an objective look at all the facts and circumstances and lists nine non-exclusive factors. The IRS summarizes the same list in its guidance on hobbies versus businesses. Here is what each one means in practice.
| Factor | What the IRS looks at | What helps you |
|---|---|---|
| Manner of operation | Whether you run the activity in a businesslike way | Separate books, a business bank account, a written plan, changes when results are poor |
| Expertise | Your knowledge, or that of your advisors | Training, licenses, consulting with people who know the field |
| Time and effort | Hours you put in, or staff you hire to do the work | A schedule, time logs, delegation to qualified people |
| Appreciation of assets | Whether property used in the activity may rise in value | Land, real estate or equipment with realistic appreciation |
| Success in similar activities | Whether you have turned other ventures profitable | A track record in related businesses |
| History of income or losses | Whether losses are normal startup losses or continue year after year | Losses that shrink, or a clear startup period |
| Occasional profits | The size of any profits against the size of losses | Profit potential that is realistic, even if uncertain |
| Financial status | Whether you have other income that the loss shelters | Reliance on the activity's income |
| Personal pleasure | Whether the work is recreational | Work that is plainly not recreation, or enjoyment that is incidental |
The IRS also notes that losses caused by circumstances beyond your control, or normal for the start-up phase of your type of business, point toward a real business. High income elsewhere is not disqualifying, but it does invite a closer look, because the IRS asks whether the activity is mainly a way to reduce tax on that income.
Objective facts beat stated intent
The regulation gives greater weight to objective facts than to your statement of intent. Saying "I always planned to make money" counts for little if there is no plan, no ledger, no pricing logic and no change after three loss years. IRS Publication 5558, a training publication for examiners, repeats that hobby status is judged by objective standards.
The 3-of-5-year presumption
The law offers a helpful shortcut. Under IRC § 183(d), an activity is presumed to be for profit if it produces a profit in at least 3 of 5 consecutive tax years, or 2 of 7 years for activities consisting primarily of breeding, training, showing or racing horses.
Three points to understand:
- It is a presumption, not a guarantee. The IRS can still rebut it with facts.
- Missing it does not make you a hobbyist. Many legitimate businesses lose money for years. The nine factors still apply.
- It looks at taxable profit. Counting the years correctly, and counting from the year you started, is part of the analysis, so keep a clear start date in your records.
Form 5213: postponing the question
If you are early in the five-year window and do not yet have the profit years, you can elect to postpone the determination by filing Form 5213. As The Tax Adviser explains, the election delays the question until the end of the 5-year (or 7-year) period and extends the statute of limitations for the activity. That trade-off is real: you buy time to turn a profit, and in exchange the IRS has longer to review those years. Whether the election fits depends on your facts, so it is a decision to make with a tax professional before you file, not after a notice arrives.
Worked example: a clinical side practice
Consider a nurse practitioner who earns W-2 wages and starts a telehealth consulting company on the side. In year one she spends $18,000 on software, marketing, a part-time assistant and licensing, and bills $6,000.
Two versions of the same facts lead to very different outcomes:
Version A. She uses her personal checking account, keeps receipts in a folder, has no pricing plan, and does the same marketing for three years without changing it. Losses grow. If the IRS examines the activity, the factors lean toward a hobby, and the $12,000 loss could be disallowed against her wages.
Version B. She opens a business account, writes a one-page plan with revenue targets, tracks time and expenses monthly, raises her rates after a first-year review, and drops a marketing channel that did not convert. Losses shrink in year two. The same dollar loss now sits on a record that shows a person trying to earn a profit, which is what the regulation asks the IRS to look at.
Nothing about the numbers changed between the two versions. The documentation and the response to results did.
How to show you operate for profit
The IRS examiner training material points to the same habits again and again. Publication 5558 highlights accurate books and records, a written business plan, a separate business bank account, and adjusting methods to improve profitability. In practice:
- Open a separate bank account and card for the activity and run every transaction through them.
- Keep monthly books. Categorize income and expenses consistently. A clean chart of accounts also makes it easier to see which costs are ordinary business expenses, which is covered in this overview of how small business expenses are categorized.
- Write a plan with numbers. Include pricing, expected customers, a break-even point and a date by which you expect profit.
- Record changes you make. If sales are weak, note what you tried next. Adjusting methods is evidence of profit intent.
- Log your time and your outside advice. Notes from calls with an advisor, mentor or industry expert support the expertise and effort factors.
- Market the work. A website, licenses, insurance, contracts and invoices show a commercial activity.
- Keep personal use separate. Mixed personal and business use of assets is one of the first things examiners probe.
Does high income, W-2 pay or an S corporation change the test?
High earners ask this most often, and the answer is mostly no.
High income elsewhere. It does not disqualify a real business, but it is one of the nine factors. A large W-2 salary alongside a loss-making side activity is a common examination pattern, so documentation matters more, not less.
Multiple businesses. Each activity is generally judged on its own facts, although related activities can sometimes be treated together. If you run several ventures, keep separate books for each so you can show which ones are profit-driven and why.
S corporations. Forming an entity does not make a hobby into a business. The Tax Adviser notes that S corporations are subject to the hobby loss rules, and that shareholders may deduct S corporation losses only if the corporation is in fact engaged in a for-profit trade or business. There is no automatic safe harbor for an S election.
If you do operate through an S corporation, loss deductions also depend on other limits. Our guides on S corporation basis and passive activity loss rules explain how those limits stack on top of the profit-motive question. If your losses come from renting property to your own business, see self-rental rules as well.
Perspective: why we treat this as a planning question
Most hobby loss problems we see are not about dishonest people. They are about capable owners and professionals who started something, kept the paperwork in a drawer, and learned in an examination that the facts looked like a pastime.
We approach it the way we approach all tax strategy: before the year closes, not after the notice. That means deciding whether an activity is a business, building the records that show it, and choosing the right structure for it. A new venture with a plan, a bank account and a monthly review is a stronger position than a clever deduction.
Our firm works with business owners, real estate investors and high-earning professionals who run more than one income stream. For them, a quarterly or monthly conversation about which activities are making money, which are in a startup phase, and what each needs to look like on paper is worth more than a once-a-year return.
Melissa
If you get an IRS notice about a hobby
A hobby loss challenge usually arrives as an examination letter asking about a specific activity. Respond by the date stated, and gather the documents listed above before you answer. Do not send a narrative alone: examiners weigh records. If an adjustment is proposed, you can disagree and explain the facts, and you may be able to appeal. Because audit defense turns on how the file is presented, it is wise to have a professional authorized to represent you, such as an enrolled agent, CPA or tax attorney, speak for you.
How we can help
If you run a business or a side activity and are not sure it would hold up under the nine factors, we start by sorting your activities into business, investment and personal, then build the records and structure around each. Our Monthly Tax Advisory is $11,997 per year, and our Quarterly Tax Strategy Sessions are $9,497 per year. If your question is mainly about an S corporation, the S-Corp Tax Strategy Accelerator is $997 one-off.
For return preparation, our fee schedule lists Self-Employed returns at $495, Investor or Rental Owner returns at $550, and Form 1065 and Form 1120-S returns at $1,800 each. If an examination notice has already arrived, we also offer IRS representation through our tax resolution service.
FAQ
Can I deduct hobby expenses in 2026?
No. Hobby expenses are not deductible on a federal return in 2026, because miscellaneous itemized deductions have been permanently eliminated. You still report hobby income in full, and items such as cost of goods sold can offset gross receipts. State rules differ, so check your state's treatment.
How do I avoid the hobby loss rule?
Operate the activity so the facts show a profit motive: separate bank account, accurate books, a written plan, time records and documented changes when results are poor. Profit in 3 of 5 consecutive years also creates a statutory presumption in your favor. Consider Form 5213 if you are still in the early years.
What does the IRS consider a hobby?
An activity you pursue mainly for enjoyment rather than to earn a profit. The IRS decides this by weighing nine factors, including how you operate, your expertise, your time and effort, your loss history and the personal pleasure you get from it. No single factor controls the result.
Does an S corporation protect me from the hobby loss rules?
No. Courts ask whether the corporation itself is engaged in a for-profit trade or business, and S corporations are subject to the rules. The entity should have its own books, bank account and business plan.
Sources
- Is that activity just a hobby or a business? (IRS)
- 26 CFR § 1.183-2, Activity not engaged in for profit (Cornell LII)
- IRS Publication 5558
- Avoiding the hobby loss trap after the TCJA (The Tax Adviser)
- Minimizing a hobby loss issue by electing S status (The Tax Adviser)
- One Big Beautiful Bill section-by-section summary (House Ways and Means Committee)