See Part I

Treatment of Hobby Expenses

If activity is deemed to be a hobby a loss cannot be deducted. In determining the allowable expenses, three tiers of expenses must be considered.

Tier 1.

These expenses are those that are allowed as an itemized deduction-medical, contributions, state and local taxes, mortgage interest, and casualties. These expenses are allowable with out regard to income from the activity. They are reported on Schedule A of Form 1040 and are deductible to the extent they exceed 10% of AGI for medical and casualties and are allowable only if total itemized deductions exceed the standard deduction.

Tier II.

These are business related expenses directly attributable to the activity. Examples are salaries, utilities, advertising, supplies, accounting and legal fees, travel, meals and entertainment (after 50% reduction), repairs and maintenance, insurance, office expenses. If any income remains after deducting business related expenses These are reported as miscellaneous deductions on Schedule A of Form 1040.

Tier III

These are depreciation and amortization and are deductible to the extent of any remaining income after Tier II expenses.

Total Tier II and III expenses are deductible as a miscellaneous deduction to the extent they exceed 2% of AGI.

Example.

John works for a recording studio and earned $35,500 in 2013. He has a side job singing 60’s and 70’s rock and roll music for parties. He has a separate room in his house which is 10% of the total square feet and is used exclusively for recording and rehearsals. He earned $8,730 from singing. His itemized deductions are $800 medical, in excess of 10% of AGI, $2,500 charitable contributions, $10,500 mortgage interest and property taxes, Other household expenses are $800 for repairs and maintenance and $2,500 for utilities. Expenses related to his recording and singing activity are: directly business related $7,500, depreciation on room used for rehearsal $500 and recording and $800 for musical instruments. John’s taxable income will be:

If activity is deemed for-profit (reported on Schedule C)

Income from regular job 35,500

Business Net Income:

Fees from singing 8,730

Expenses:

Directly related 7,500

Equipment depreciation 800

Home office:

Repairs, maintenance and utilities ($3,300 x 10%) 330

Mortgage interest and taxes

(10% x $10,500) 1,050

Depreciation-music room 500 (10,180)

Net loss from business (1,450)

Personal exemption (3,900)

Itemized deductions:

Medical 800

Charity 2,500

Taxes and mortgage interest (10,500 – 1,050) 9,450 (12,750)

Taxable Income 17,400 ======

 

If activity is deemed a hobby:

Allowable expenses:

Income from singing 8,730

Expenses:

Tier I (NA-itemized)

Tier II:

Directly related 7,500

Repairs, maintenance and utilities ($3,300 x 10%) 330

(7,830) Income after Tier II expenses 920

Tier III expenses-depreciation [1,300, but limited to income after Tier II) (920)

Deducible loss from singing (not allowed if deemed a hobby) -0-

 

Taxable Income:

Regular job income 35,500

Singing income ### 8,730

AGI: 44,230

Deductions:

Personal exemption (3,900)

Itemized deductions:

Medical 800

Charity 2,500

Taxes and mortgage interest (10,500 – 1,050) 9,450 12,750

Miscellaneous-hobby expenses:

Tier II: 7,830

Tier III 920 8,750

Less 2% of AGI (885) 7,865

Total itemized deductions (20,580)

Taxable Income 27,580

======

### income from activity deemed a hobby is other income reported on form 1040, page 1,

Conclusion: John’s taxable income is greater if his activity is deemed a hobby because he could not deduct all the depreciation and “business” expenses had to be reported as a miscellaneous itemized deduction, reduced by 2% of AGI. All other itemized deductions were allowed in full.

Taxpayers who engage in an activity and want it to be considered by the IRS as a for-profit activity must be conducted in a business like manner. Taxpayers should follow the IRS guidelines for business-like practices or they risk the IRS deeming their activity a hobby. If the activity is deemed a hobby, taxpayers cannot deduct a loss and must treat all business expenses as a miscellaneous itemized deduction (reduced by 2% of AGI). However, if the taxpayer does have a loss, he may take advantage of the IRS “presumption of profit” time period to make the IRS prove the activity is a hobby.

In accordance with Circular 230 Disclosure