Hobby or business: how the IRS decides

Selling crafts, photography or collectibles on the side is common, and so are losses. Whether the IRS sees the activity as a business decides whether those losses are deductible. This guide explains how the test works and how to show you are running a business.

By Hamza Fida, Chartered Accountant. Reviewed by Muhammad Bilal, Chartered Accountant. Checked against official sources on . 2 minute read.

Short answer

The IRS treats an activity as a business if you run it with a real intention of making a profit, judged by nine factors such as how businesslike you are, your expertise, your time and your history of profits and losses. Profit in three of the last five years creates a presumption of a business. Hobby income is taxable, but hobby expenses are not deductible.

At a glance

Test
Real intention of making a profit
Factors
Nine, weighed together
Presumption
Profit in 3 of the last 5 years
Horse breeding and racing
2 of 7 years
Hobby income
Taxable
Hobby expenses
Not deductible
Hobby or business: how the IRS decidesTest: Real intention of making a profit; Factors: Nine, weighed together; Presumption: Profit in 3 of the last 5 years; Horse breeding and racing: 2 of 7 years; Hobby income: Taxable; Hobby expenses: Not deductible.KEY FACTS AT A GLANCEHobby or business: how the IRS decidesTestReal intention of makinga profitFactorsNine, weighed togetherPresumptionProfit in 3 of the last 5yearsHorse breeding and racing2 of 7 yearsHobby incomeTaxableHobby expensesNot deductibleChecked against official sourcesTax BakersHobby or business: how the IRS decidesTest: Real intention of making a profit; Factors: Nine, weighed together; Presumption: Profit in 3 of the last 5 years; Horse breeding and racing: 2 of 7 years; Hobby income: Taxable; Hobby expenses: Not deductible.KEY FACTS AT A GLANCEHobby or business: how the IRSdecidesTestReal intention of making a profitFactorsNine, weighed togetherPresumptionProfit in 3 of the last 5 yearsHorse breeding and racing2 of 7 yearsHobby incomeTaxableHobby expensesNot deductibleChecked against official sourcesTax Bakers
Key facts at a glance, as set out in this guide.

What are the nine factors?

  1. Businesslike manner

    Separate accounts, accurate records, changes to improve profit.

  2. Expertise

    Your knowledge, or advice you sought.

  3. Time and effort

    How much you devote, or whether you hire competent help.

  4. Expected appreciation of assets

    Such as land or collections.

  5. Success in other activities

    Your track record with similar ventures.

  6. History of income or losses

    Start-up losses are normal; long unbroken losses are not.

  7. Occasional profits

    Their size and frequency.

  8. Financial status

    Whether you rely on the income, or use losses to offset other income.

  9. Personal pleasure

    Enjoyment does not rule out a business, but weighs in the balance.

How does the profit presumption work?

If an activity made a profit in at least three of the last five years, two of seven for horse breeding, training, showing or racing, it is presumed to be engaged in for profit, and the IRS must show otherwise. A new activity can elect on Form 5213 to postpone the decision until five years have passed.

How are hobbies and businesses taxed?

BusinessHobby
IncomeTaxable, on Schedule CTaxable, as other income
ExpensesDeductible, including losses against other incomeNot deductible
Self-employment taxOn net profitNone

The cost of items you sell is still subtracted from hobby income as cost of goods sold.

How do you show it is a business?

  • Keep separate bank accounts and proper books. See bookkeeping basics.
  • Write a simple business plan with a path to profit.
  • Change what is not working, and document why.
  • Register the business where required. See business licenses and permits.

See side hustle taxes and deducting business losses.

Repeated losses are also a common audit trigger. See IRS audit triggers for small businesses.

Side activity making a loss?

We help you set it up as a business, keep the records that show profit intent, and claim the deductions you are entitled to.

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Questions people ask

How does the IRS decide if something is a hobby or a business?

By whether you have a real intention of making a profit, judged by nine factors including how businesslike you are and your history of profits and losses.

Is hobby income taxable?

Yes. Hobby income must be reported.

Can I deduct hobby expenses?

No. Hobby expenses are not deductible, though the cost of items sold reduces hobby income.

What is the 3 out of 5 years rule?

An activity with a profit in at least three of the last five years is presumed to be a business.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. IRS: Know the difference between a hobby and a business
  2. Treasury Regulations section 1.183-2: activity not engaged in for profit
  3. IRS: About Form 5213

Rules and fees change. If you are reading this long after October 1, 2026, confirm the figures with the source before you rely on them.

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This guide is general information. It is not tax or legal advice for your situation.