A Taxing Question: An "Alternative Investment" or Just a Hobby?

July 22, 2010
Alan Olsen, CPA

Many wealthy investors are turning to rare and collectible items, such as art, race cars and race horses, to protect their wealth from financial market fluctuations. But what you consider an investment may be seen as just a hobby by the IRS -- and that can have serious tax consequences.

With uncertainty surrounding the U.S. dollar, many high-net-worth individuals are investing in rare and collectible items, such as high-priced art, race cars and race horses to protect their wealth from market fluctuations.

But what you consider an investment may be seen as merely a hobby by the IRS -- and that can have serious tax consequences. (And it is the IRS, not the taxpayer, who makes the determination.)

So investors need to follow the appropriate guidelines when determining whether their collecting will be considered a business or a hobby. Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) -- referred to as the “hobby loss rule” -- limits deductions that can be claimed when an activity is not engaged in for profit.

If you’re audited, you’ll need to defend your assertion that your collection constitutes a business instead of a hobby. Here are some of the factors to consider:

• Does the time and effort you put into the hobby indicate an intention to make a profit?

• Do you depend on the income from the activity for day-to-day living?

• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of becoming a collector?

• Have you changed methods of operation to improve profitability of a transaction?

• Do you or your advisors have the knowledge needed to carry on the activity as a successful business?

• Have you made a profit in similar activities in the past?

• Does the activity make a profit in some years and not other years?

• Can you expect to make a profit in the future from the appreciation of assets used in the activity?

The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year -- or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.

If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. 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 corps.)

Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order, and only to the extent stated in each of three categories:

• Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.

• Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.

• Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

If you’re uncertain whether your collection constitutes a business or a hobby, visit the IRS website for more information or contact your tax advisor for guidance.

Alan Olsen is Managing Partner, Greenstein, Rogoff Olsen & Co. LLP, CPAs. Alan is a former IRS auditor who now specializes in tax preparation and consulting for high-net-worth individuals. He has represented some of the most successful entrepreneurs in the world in IRS audits. Read more at http://www.GROCO.com.