If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.
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 corporations.
In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:
- You carry on the activity in a businesslike manner,
- The time and effort you put into the activity indicate you intend to make it profitable,
- You depend on the income for your livelihood,
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
- You change your methods of operation in an attempt to improve profitability,
- You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
- You were successful in making a profit in similar activities in the past,
- The activity makes a profit in some years, and
- You can expect to make a future profit from the appreciation of the assets used in the activity.
An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.
If a taxpayer dies before the end of the 5-year (or 7-year) period, the "test" period ends on the date of the taxpayer's death.
If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.taxmap/pubs/p535-004.htm#en_us_publink1000208645
If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.
You can elect to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.
The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period.
Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.
You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity.
If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. If you are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).taxmap/pubs/p535-004.htm#en_us_publink1000208648
Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). For taxable years beginning after Dec. 31, 2008, you can deduct a casualty loss on property you own for personal use only to the extent it is more than $500 and exceeds 10% of your adjusted gross income. The 10% AGI limitation does not apply to net disaster losses resulting from federally declared disasters in 2008 and 2009 and individuals are allowed to claim the net disaster losses even if they do not itemize their deductions. The reduction amount returns to $100 for taxable years beginning after Dec. 31, 2009. See Publication 547 for more information on casualty losses. For the limits that apply to home mortgage interest, see Publication 936. taxmap/pubs/p535-004.htm#en_us_publink1000208649
Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category. taxmap/pubs/p535-004.htm#en_us_publink1000208650
Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, allocate depreciation and these other deductions proportionally.
Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2%-of-adjusted-gross-income limit. See Publication 529 for information on this limit.
Ida is engaged in a not-for-profit activity. The income and expenses of the activity are as follows.
|Subtract:|| || |
|Real estate taxes||$700|| |
|Home mortgage interest||900|| |
|Depreciation on an automobile||600|| |
|Depreciation on a machine|| 200 || 3,700 |
| Loss || $(500) |
Ida must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3), as follows.
|Limit on deduction||$3,200|
|Category 1: Taxes and interest||$1,600|| |
|Category 2: Insurance, utilities, and maintenance|| 1,300 || 2,900 |
| Available for Category 3 || $ 300 |
The $800 of depreciation is allocated between the automobile and machine as follows.
| $600 $800||x||$300||=||$225||depreciation for the automobile|
| || || || || || |
| $200 $800||x|| $300||=||$75||depreciation for the machine|
The basis of each asset is reduced accordingly.
Ida includes the $3,200 of gross income on line 22 (total income) of Form 1040. The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Ida deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit.taxmap/pubs/p535-004.htm#en_us_publink1000208656
If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares. taxmap/pubs/p535-004.htm#en_us_publink1000208657
If you have several undertakings, each may be a separate activity or several undertakings may be combined. The following are the most significant facts and circumstances in making this determination.
- The degree of organizational and economic interrelationship of various undertakings.
- The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting.
- The similarity of the undertakings.
The IRS will generally accept your characterization if it is supported by facts and circumstances.
If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.