Losses From Business Investments and Businesses

Activity not for profit. You must include on your return income from an activity from which you do not expect to make a profit. An example of this type of activity would be a hobby or a farm you operate mostly for recreation and pleasure. Enter this income on line 21 of Form 1040. Deductions for expenses related to the activity are limited. They cannot total more than the income you report, and can be taken only if you itemize deductions on Schedule A (Form 1040). See Not-for-Profit Activities in chapter 1 of Publication 535, Business Expenses, for information on whether an activity is considered carried on for a profit.

Hobby losses. Losses from a hobby are not deductible from other income. A hobby is an activity from which you do not expect to make a profit. See Activity not for profit.

CAUTION: If you collect stamps, coins, or other items as a hobby for recreation and pleasure, and you sell any of the items, your gain is taxable as a capital gain. (See chapter 17.) However, if you sell items from your collection at a loss, you cannot deduct a net loss.

Presumption of Profit
An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years including the current year. You have a profit when the gross income from an activity is more than the deductions for it.
If a taxpayer dies before the end of the 5-year (or 7-year) period, the period ends on the date of the taxpayer's death.

If your business or investment activity passes this 3- (or 2-) years-of-profit test, presume it is carried on for profit. This means it will not come under these limits. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption in every case, unless the IRS shows it is not valid.

Using the presumption later. If you are starting an activity and do not have 3 years (or 2 years) showing a profit, you may want to take advantage of this presumption later, after you have the 5 (or 7) years of experience allowed by the test.

You can choose to do this by filing Form 5213. Filing this form postpones any determination your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.
Tip: Form 5213 generally must be filed within 3 years of the due date of your return for the year in which you first carried on the activity.
The benefit gained by making this choice is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in 3 (or 2) out of the first 5 (or 7) years you carry on the activity. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 years (or 2 years) of profit, the limit can be applied retroactively to any year in the 5-year (or 7-year) period with a loss.

Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.

NOT-FOR-PROFIT ACTIVITIES
If you do not carry on your business or investment activity to make a profit, there is a limit on the deductions you can take. You cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, come under this limit. So does an investment activity intended only to produce tax losses for the investors.

The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

In determining whether you are carrying on an activity for profit, all the facts are taken into account. No one factor alone is decisive. Among the factors to be considered are:

1) Whether you carry on the activity in a businesslike manner.

2) Whether the time and effort you put into the activity indicate you intend to make it profitable.

3) Whether you are depending on income from the activity for your livelihood.

4) Whether your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business).

5) Whether you change your methods of operation in an attempt to improve profitability.

6) Whether you, or your advisors, have the knowledge needed to carry on the activity as a successful business.

7) Whether you were successful in making a profit in similar activities in the past.

8) Whether the activity makes a profit in some years, and how much profit it makes.

9) Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

Limit on Deductions and Losses
If your activity is not carried on for profit, take deductions only in the following order, only to the extent stated in the three categories, and, if you are an individual, only if you itemize them on Schedule A (Form 1040).

Category 1. Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). You can only deduct a nonbusiness casualty loss to the extent it is more than $100 and all these losses exceed 10% of your adjusted gross income. See Publication 547 for more information on casualty losses.
For the limits that apply to mortgage interest, see Publication 936.

Category 2. Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than the deductions you take (or could take) for it under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, wages, etc., belong in this category.

Category 3. Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity is more than deductions you take (or could take) for it under the first two categories. The deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, divide depreciation and these other deductions proportionally among those assets.

Tip: Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2% of adjusted gross income limit. See Publication 529 for information on this limit.
Example. Ida is engaged in a not-for-profit activity. The income and expenses of the activity are as follows:

Ida must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3), as follows:

 

 

The $300 for depreciation is divided between the automobile and machine, as follows:
$600/$800 x $300 = $225 depreciation for the automobile
$200/$800 x $300 = $75 depreciation for the machine

The basis of each asset is reduced accordingly.
The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Ida adds the remaining $1,600 (the total of categories (2) and (3)) to her other miscellaneous deductions on Schedule A (Form 1040) that are subject to the 2% of adjusted gross income limit.

Partnerships and S corporations. If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares.

More than one activity. If you have several undertakings, each may be a separate activity, or several undertakings may be one activity. The most significant facts and circumstances in making this determination are:

1) The degree of organizational and economic interrelationship of various undertakings,

2) The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting, and

3) The similarity of various undertakings.

The IRS will generally accept your characterization of several undertakings as one activity, or more than one activity, if supported by facts and circumstances.

Tip: If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.