If you’re like some taxpayers, you have a pastime that brings in cash but produces a loss after you deduct your expenses.

Example: an amateur artist who spends money for paint and canvas but who only occasionally sells a painting. If you could deduct “hobby” losses on your tax return, you could reduce taxes owed on your salary or other income.

Actually, you can deduct your losses, but only if you establish that you are carrying on your pastime with the motive of making a profit.

If you can’t prove you have a profit motive, the IRS views your activity as a hobby, not as a business. Expenses of a hobby can be deducted only up to the amount of income from the hobby. You can’t deduct hobby losses from your salary or other income.

You can help establish your profit motive in one of two ways. If you show a profit in three out of five years (two out of seven years for horse activities), the IRS will presume you’ve got a business and not a hobby. However, you can’t simply manipulate deductions and income to create profit years.

The other way to demonstrate that you’re operating with a profit motive is to conduct your activity in a business-like manner.

Get advice from an accountant to assist with keeping accurate books and records. Maintain a separate checking account, advertise your services or products, and get a business phone listing.

If you have losses, try to turn your business around by taking classes, consulting with experts, and changing your methods of operation.
Be sure you spend enough time at your activity to demonstrate that you’re serious about profits.

Remember, you don’t have to earn a profit, but you must try to do so. If you don’t have profits in three out of five years, the burden of proof will be on you to show the IRS that this activity is a business and not a hobby.

Khorshed Alam is a practicing CPA and business valuation analyst. He is the President and CEO of Alam Accountancy Corporation. Check outhttp://alamcpatax.com or call (408) 445-1120.

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