A hobby loss is a financial loss that cannot be claimed as a business tax deduction, as it is the result of an activity that was not intended to earn a profit. The exact definition of “hobby loss” varies by jurisdiction. While the term is most commonly used in the United States, other countries may likewise have tax policies that restrict the ability to claim tax deductions on expenses for endeavors that are not true businesses. The hobby loss rule helps to prevent tax fraud by disallowing tax deductions for expenses that are not truly related to the operation of a for-profit business. If the activities of an individual aren’t considered to be those necessary to the operation of a legitimate business, the project can be classified by a taxing agency as a hobby, and expenses related to hobbies are often severely limited by tax codes. For example, in the United States, a hobby expense can be taken only as an itemized deduction.
In the United States as well as other countries, individuals who operate businesses can deduct the costs of running the business from their gross income. These expenses, such as travel, entertainment, and the cost of maintaining an office or other facility, can be considerable. As a result, the business owner may be able to severely limit his or her tax liability by deducting these costs. Government tax agencies, such as the Internal Revenue Service (IRS), are aware of how these limitations can reduce tax revenues and so have set up hobby loss policies that define the nature of a legitimate business activity for taxation purposes.
In situations where a business owner claims various expenses and losses as tax deductions, the tax collection agency may investigate, or audit, the claims of the taxpayer, applying the hobby loss rules to ensure that the deductions were legitimate. In the United States, a tax examiner will investigate details about the business and its owner to determine whether the business is a true enterprise or a hobby for its owner. Considerations include whether the owner relies on income from the business and whether any losses were the result of unplanned events or were incurred during the initial stages of the business. An investigator may also review the financial records of the business that cover the past several years. In situations where the business has made a profit in years prior to the current audit, the investigator may be more likely to regard the business deductions as legitimate.