Side Gig or Hobby? How the IRS Decides Whether You Can Deduct Your Expenses
Written by Alex McGowin
Earning some income from a side gig doesn’t make it a business. Learn how the IRS hobby loss rules work, what the nine profit factors are, and how to protect your deductions.
Earning money from an activity you love does not automatically make it a business in the eyes of the IRS.
Many of us have an expensive passion: boating, photography, horses, woodworking, travel blogging. At some point the thought occurs: What if I took paying customers once a month? Then I could write off the gear, the repairs, even the travel.
It is a natural idea, and it is also one of the most common ways people stumble into the hobby loss rules. Whether you are a U.S. expat in Lisbon selling handmade goods on weekends, a digital nomad running a small consulting side project, or a stateside taxpayer with an expensive pastime, the distinction between a business and a hobby decides whether your expenses are deductible at all.
What the Hobby Loss Rules Say
Section 183 of the Internal Revenue Code governs activities "not engaged in for profit." If the IRS concludes your activity is a hobby, you cannot use its losses to offset other income, such as your salary or other business earnings.
Consider an example. Say you take friends and paying guests fishing on your boat and collect $5,000 over the year, but you spent $15,000 on fuel, gear, repairs, and supplies. If the activity is a real business, you report a $10,000 loss on Schedule C that may offset other income. If it is a hobby, the picture is very different.
How the Rules Changed After 2018
Before the Tax Cuts and Jobs Act (TCJA), a hobbyist could deduct expenses up to the amount of hobby income as a miscellaneous itemized deduction, subject to a 2% of adjusted gross income floor. The result was roughly break-even: you paid little or no tax on the $5,000, though you never got the loss.
Starting in 2018, those miscellaneous itemized deductions were suspended, and Congress has since made that elimination permanent. Under current law, if your activity is a hobby, you report the full $5,000 as income (on Schedule 1 of Form 1040) and deduct nothing. You pay tax on $5,000 of revenue while absorbing $15,000 of costs. That is why the "business versus hobby" label matters far more today than it once did.
Lessons from a Horse-Breeding Case
Horse activities generate more hobby loss litigation than almost anything else, and the IRS is aggressive about them. In a recent Tax Court case, a couple who had loved horses all their lives started a breeding and training operation. Over roughly 19 years they held 15 to 20 horses, spent hundreds of thousands of dollars, and never turned a profit.
The IRS recharacterized the activity as a hobby and pulled the losses back. Because the years straddled the 2018 law change, the court also had to sort out which years' deductions were affected by the old rules and which by the new ones. The couple still owed substantial tax.
The Penalty Lesson: Having a CPA Is Not Enough
The most useful takeaway from the case is about penalties. When the IRS wins on a position like this, it can add a 20% accuracy-related penalty on the underpaid tax. The couple avoided that penalty, but not simply because they used an accountant.
The court looked at whether they had specifically discussed the hobby loss rules with their CPA and relied on that advice. A preparer who simply puts the activity on Schedule C, with no conversation about whether it is truly a for-profit business, does not give you that protection. The same principle applies well beyond horses: penalty protection comes from a documented, specific discussion of the risky issue, not from the mere fact that a professional signed your return.
If you run an activity with recurring losses, raise the question with your tax advisor yourself, and keep a written record of the conversation.
The Nine Factors the IRS Weighs
Treasury Regulation 1.183-2 lists nine factors for deciding whether an activity is engaged in for profit. No single factor controls, and they are weighed together:
- The manner in which you carry on the activity
- Your expertise, or that of your advisors
- The time and effort you devote to it
- Whether you expect assets used in the activity to appreciate
- Your success in similar activities
- The history of income or losses
- The amount of occasional profits
- Your financial status
- Elements of personal pleasure or recreation
Several of these cut against someone with a long-standing recreational passion and plenty of other income. If you have always done the activity for fun and do not need its profits, the financial status and personal pleasure factors work against you.
The Three-out-of-Five-Year Safe Harbor
The closest thing to a bright line is the presumption in Section 183(d): if an activity turns a profit in at least three of the last five tax years, the IRS presumes it is a for-profit business. For horse breeding, training, showing, or racing, the test is more lenient on paper but longer: profit in two of the last seven years. (Some practitioners misremember this as a stricter test, but the horse test is two of seven.)
Meeting the presumption does not make you bulletproof, but it shifts the burden to the IRS. Missing it does not doom you either; it simply means the other factors carry the weight. Taxpayers who are uncertain can also file Form 5213 to postpone the IRS's determination, though that election has trade-offs worth discussing with a professional first.
How to Operate Like a Real Business
If you cannot yet show three profitable years, your best defense is to run the activity the way a profit-seeking business would. In practice, that means:
Separate the activity legally and financially. Form an LLC or other appropriate entity, open a dedicated business bank account, and never commingle personal funds.
Keep real books. Use QuickBooks or Xero and reconcile monthly, so you can show the numbers behind every decision.
Plan to make money. Write a business plan, research your market, and track whether pricing and costs can plausibly lead to profit. Losses cannot go on forever. At some point the plan has to produce income.
Get specialized help. In some industries, advisors with specific experience (a horse-industry accountant, for example) help demonstrate expertise, and your tax professional should be part of the conversation from the start.
An LLC, a bank account, bookkeeping software, a specialist advisor, and a credible plan will not guarantee a win, but together they put you in the strongest position to defend your deductions.
The Takeaway
Do not assume that earning some income converts a hobby into a business. A hobby that earns money still produces taxable income, and under current law it produces no deductions at all.
If you have a side gig, such as freelance work, an online shop, or a service you offer on the side, set your expectations early. Either treat the expenses as non-deductible, or be intentional about structuring and documenting the activity so you can defend it. This planning is especially valuable for expats and digital nomads, whose side income may already be complicated by foreign earned income rules, self-employment tax, and foreign reporting.
At McGowin Tax, we help clients structure side activities so they do not fall into the hobby loss trap, and we document those conversations so you are protected if questions arise later. If you are unsure whether your side gig counts as a business, reach out before filing, not after an IRS notice arrives.