Is Your Sideline Activity a Business or a Hobby?

Do you have a sideline activity that you think of as a business?

From this sideline activity, are you claiming tax losses on your Form 1040? Will the IRS consider your sideline a business and allow your loss deductions?

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. The federal income tax rules for hobbies have been anti-taxpayer for years, and now an unfavorable change enacted in the Tax Cuts and Jobs Act (TCJA) made things even worse for 2018-2025.

If you have such an activity, we should have your attention.

Here’s the deal: if you can show a profit motive for your now-money-losing sideline activity, you can classify that activity as a business for tax purposes and deduct the losses.

Factors that can prove (or disprove) such intent include:

·       Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies.

·       Having expertise in the activity or hiring advisors who do.

·       Spending enough time to justify the notion that the activity is a business and not just a hobby.

·       Expectation of asset appreciation: this is why the IRS will almost never claim that owning rental real estate is a hobby, even when tax losses are incurred year after year.

·       Success in other ventures, which indicates that you have business acumen.

·       The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or just plain bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.

·       Your financial status: “rich” folks can afford to absorb ongoing losses (which may indicate a hobby), while ordinary folks are usually trying to make a buck (which indicates a business).

·       Elements of personal pleasure: breeding race horses is lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.

Self-Directed IRAs

Tax-advantaged retirement accounts such as IRAs are a great way to save for retirement.

But when you establish a traditional IRA with a bank, a brokerage, or a trust company, you are ordinarily limited to a narrow range of investment options, such as CDs and publicly traded stocks, bonds, mutual funds, and ETFs. The IRA custodian will not permit you to invest in alternative investments such as real estate, precious metals, or cryptocurrency.

A self-directed IRA could be for you if you want to walk on the wild side and invest your retirement money in assets such as real estate or cryptocurrency.

You can invest in almost anything other than collectibles such as art or rare coins, life insurance, or S corporation stock with a self-directed IRA. Investment options include, but are not limited to, the following:

·       Real estate

·       Private businesses

·       Trust deeds and mortgages

·       Tax liens

·       Precious metals such as gold, silver, or platinum

·       Private offerings

·       LLCs and limited partnerships

·       REITs

·       Livestock 

·       Oil and gas interests

·       Franchises

·       Hedge funds

·       Cryptocurrency

·       Promissory notes

Aside from the vast array of investment options, a self-directed IRA is the same as a traditional IRA and subject to the same rules. The income the investments in your IRA earn is not taxed until you take distributions, but distributions before age 59 1/2 are subject to a 10 percent penalty unless an exception applies.

You can also have a self-directed Roth IRA for which distributions are tax-free after five years.

But you must avoid self-dealing and other prohibited transactions or your self-directed IRA could lose its tax-advantaged status.

Establishing a self-directed IRA need not be too difficult. You first open an account with a custodian that offers self-directed investments. You can also acquire checkbook control over your self-directed IRA by forming a limited liability company to own all the IRA investments.

Investing in alternative assets such as cryptocurrency is riskier than stocks, bonds, and mutual funds.

·       The rewards can be great, as you’ve seen with recent returns for cryptocurrency investors.

·       And the damage to your investment portfolio can be substantial, as we’ve also seen over the years.

When it comes to alternative investments, you need to know what you are doing or have an investment professional you trust to do this for you.

Questions? You can reach us HERE.

Sincerely,

Shapiro Tax Group LLP