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💰 Hobby Loss Rule Under OBBBA — Tax Course

Duration: 11:58 1979 transcript words EN summary

Video summary

The video explains that under current tax law, activities driven by personal enjoyment rather than profit are classified as hobbies, which fundamentally differ from businesses due to the lack of record-keeping and a dedicated business account. While hobby income remains fully taxable, the rules governing expenses have undergone significant changes recently. Specifically, Section 183 regarding the definition of a hobby and the requirement for a profit motive has remained untouched by recent legislation like the One Big Beautiful Act (OBBBA). However, the treatment of deductions has shifted dramatically because the Tax Cuts and Jobs Act permanently suspended the ability to deduct miscellaneous itemized expenses subject to the two-percent floor on Schedule A. This means that operating expenses such as supplies, advertising, tool repairs, and depreciation can no longer be claimed for hobby activities, effectively reducing the deductible amount from these categories to zero. Despite this suspension of operating expenses, certain costs associated with a hobby are still allowed to reduce taxable income because they fall outside the suspended category or are not subject to the two-percent floor at all. The most important distinction made in the lecture is between "costs of goods sold" and general "operating expenses." Costs directly tied to producing an item for sale, such as wood and screws used to build tables, are considered costs of goods sold and remain fully deductible against hobby income before Section 183 limits apply. Additionally, Tier One items like home mortgage interest and real estate taxes continue to be deductible on Schedule A if the taxpayer chooses to itemize their deductions, provided they were never subject to the two-percent floor in the first place. To illustrate these rules with a concrete example, consider a hobbyist who earns $9,000 from selling furniture but incurs total expenses of $11,000. If this activity is classified as a hobby under Section 183, the taxpayer can only deduct the costs of goods sold; all other operating expenses are disallowed because there is no longer a place to list them on Schedule A after the permanent deletion of that section. Consequently, even though the total spending exceeded income by $2,000, the taxable income remains at $9,000 since the loss cannot be generated or carried forward as a net operating loss (NOL). This stands in sharp contrast to how a business would be treated, where such expenses could offset other W-2 wages subject to passive activity and at-risk limitations. In conclusion, while the core definition of what constitutes a hobby versus a business remains unchanged, the practical impact on tax liability has been altered by making the suspension of miscellaneous itemized deductions permanent under OBBBA. Taxpayers must now carefully separate their direct costs of goods sold from general operating expenses when filing returns for hobbies to avoid claiming disallowed deductions. The lecture emphasizes that while hobby income is still taxable and no losses can be reported, specific allowable deductions like cost of goods sold and home-related taxes provide some relief. Students preparing for the CPA or Enrolled Agent exams are reminded to focus on these nuances, as questions will likely test whether they understand which expenses survive the suspension versus those that have been permanently erased from Schedule A.

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Hello and welcome to the session. This is Professor Farhat in which we will discuss the hobby loss rule. Now, first we need to understand what is a hobby and how is it different from a business? Now, the IRS, they will have a specific rules what's considered a hobby or a business, but we will discuss this very shortly just to differentiate what's a hobby from a business. When you have a hobby, like what? Like you would you're a photographer, you like to take pictures and sell them portrait or you like to make tables in your garage and sometime you sell them. But you do this not with a profit motive. You do this for your personal enjoyment enjoyment. You like this. You don't keep track of your expenses. In other words, you don't keep track of your expenses for that hobby separately. You don't have a separate business account. So, that's why we call it a hobby because if it's treated like a business, you will need to have record keeping. You need to have you need to devote substantial amount of time for it, time and effort. You have to have a profit motive in a sense you are doing this not from an enjoyment perspective, but a business-like manner. But having settled what a hobby loss is, we need to understand what happen if you incur a loss. What's a loss? Well, sometime with those hobbies, you might have some income and sometime you might not sometime you might also incur expenses. What can you do with the expenses? Because if we take the income minus the expenses, you could have a profit or a loss. Here's what I'm going to tell you to make it simple. Hobby income is taxable. So, that's that's easy, right? So, what we need to focus on is expenses, not hobby income. We need to focus on expenses. And we need to see what happened to this rule throughout the recent history because the rule have changed a little bit over time. So, we need to understand what happened to that rule. This topic, you will see it on the CPA exam. As a student, you will need to be comfortable with it and on the enrolled agent exam. Now, the law with the one big beautiful act, which is the most recent tax changes, did not touch the hobby rules that section 183. So, when we say section 183, it's the hobby rules. The hobby rules with the the tax law did not touch this. Not one word change in that. One word means nothing have changed on how we define what's a hobby. The profit motive, there are nine factors that last and the three out of five-year rule that are fully intact. So, you have to make a profit three of the five three of the past five years for your hobby to be considered to treat it as a business. So, those rules did not change. We untouched them. What the law changed is section 67, the 2% floor. And that had the ripple effect that affected the deduction. So, what is that? Well, we amended we edited section 67 to make the suspension of the 2% floor miscellaneous permanent. What does that mean? Well, let me show you. Let let let's take a look at this itemize itemize deduction schedule A from the year 2016 and you will see why I'm selecting 2016. There's one section called job expense and certain miscellaneous expense. It sits right here. Now, this section, and you will see on the next slide, it was suspended from 2018 to 2025. It was suspended under the Tax Cuts and Jobs Act. And this is where you take your expenses for the hobby loss. This is where you take your expenses. So, the income, it's still taxable, that's why nothing have changed. The income is still taxable. Expenses used to be here, but this section, basically, if you look at a at a form in 2018, 2019, this section does not exist because it was suspended. And it was supposed to be suspended and returned starting 2026, which is after 2025. Guess what? The Tax Cuts and Jobs Act basically deleted this section permanently. So, what happened is that that opportunity to deduct your expenses from a hobby, specifically your operating expenses, so the income you need to remember hobby operating expenses sits sit in section 183B section 2, but could be claimed only as a 2% floor miscellaneous expense itemized deduction. So, the expense sits in schedule 67. So, if section 67 of the schedule A is gone, the expenses are gone with it. So, simply put, think about we took a pen and we deleted this section. And if we deleted this section, there is nowhere to put the expenses, because this is where you would you would have put the expenses. For one thing, they would have to exceed the 2% of your AGI, which is we don't want to get into that because we no longer have to worry about this. So, the point is the hobby rules did not change. What was changed is schedule A, the 2% floor section, where that section is permanently gone. So, let's let's go ahead and dive a little bit more from a history perspective, then we will explain the rule using an example. Let's go ahead and get started. >> Before we proceed any further, I have a public announcement about my company, farhatlectures.com. >> My AI turns any lecture into a complete study system. You can create summary table, formulas, and example from each lecture. Flash card builds from the lesson itself. A quiz built on the lesson. And as a bonus, convert any lecture into a portable short audio on the go. So, it helps you with the retention. No noise, no generic responses, and just clarity based on that specific lecture. Don't just watch, interact, test yourself, and retain the material using Farhat AI. Now, go to farhatlectures.com now and see how the AI can help you understand, practice, and retain the material. >> So, pre-2018, we had this section called section itemized deduction subject to 2% floor clear- clearing expenses, specifically operating expenses, were deductible up to hobby income. So, if you have 10,000 in hobby income, let's assume you had 10,000 in hobby income, and you had 12,000 in expenses, those expenses would have been claimed on uh on Schedule A, and you would only deduct from that 10,000. Therefore, you'd have no taxable income for your hobby. So, you'll be able to deduct it up to income. That's the old rule. From 2018 to 2025, the Tax Cuts and Jobs Act suspended that, and we said, "We're going to go back and allow you to do this starting January 1st, 2026." Deduct those miscellaneous itemized deduction subject to 2% rule. Guess what? The OBBA make that rule permanent. So, the flight canceled, that rule that was never returned. Operating expenses now from a hobby activity is zero. That's basically what we're saying. So, it's easy. So, we no longer have to worry about keeping track of that. So, specifically, what survived and what's not? So, if you said all hobby losses or all hobby expenses are suspended, that's also incorrect. The OBBA did not blow up the whole building. It hit one room. It was a surgical It was a surgical deduction. Most of the maker's cost still reduce tax. What does that mean? What still reduce tax is the following: cost of goods sold. For example, if you're making a table, woods and screws are the return of capital. They cut gross receipts to gross income before section 183 even applies. So, what does that mean? It means you have to buy the wood. You have to buy the screws. Those are considered cost of goods sold. Well, you might have to take depreciation on that machines that you are cutting the wood with. That's not deductible. That's That's operating. You might need supplies. That's operating expenses. Operating expenses are suspended. Cost of goods sold still there. Also, we have something called Tier 1, which is don't worry about the name of it. If you're operating in your garage, the mortgage interest and certain taxes and casualty losses, because they are on Schedule A, they were never subject to to the 2% floor, those are still deductible assuming you itemize. >> [snorts] >> Then, what's permanently disallowed? So, what was really gone is your operating expenses, which is Tier 2 operating expenses, supply, like sandpapers, glue, advertisement, tool repair, depreciation on equipment. Those were the 2% floor miscellaneous itemized deduction that were erased under Section 67. Now, if you incurred them, they don't exist. You cannot claim them. You claim zero. Now, if you still have interest on your home and a certain real estate taxes, you will deduct them on Schedule A. You're allowed to do that. Also, cost of goods sold. So, let me show you. Let's assume the same furni- furniture activity, 9,000 in income, 11,000 of expenses. Let's assume if it's a classified under a hobby. If it's classified under a hobby, gross income is 9,000. We're assuming that's after cost of goods sold. How much of your expenses you can operate? Nothing. Taxable income is 9,000. So, if spent 11,000, earned nine, you have a real loss of two, you are taxed on on the 9,000. Simply put, you cannot take operating expenses. If this is a business, if this is classified as a business, you have gross income of nine, operating expenses of of 11, you have a net loss of two. Now, what can you do with that loss? That That net loss can offset your W-2 other income, subject obviously to the usual at-risk and passive activity limit. Let's test our knowledge by looking at this multiple-choice question. A taxpayer's activity is classified as a hobby. So, pretty straightforward, they're telling you it's a business, it's a hobby. Which of the following can still reduce the taxpayer taxable income from that activity. So, we have four option. Operating expenses such as supplies, advertisement, and repair. Is that acceptable? And the answer is no. That is technically suspended. How is it suspended? Once we removed from Schedule A, the itemized deduction schedule, job expenses and certain miscellaneous deductions subject to the 2% rule, the place to the place where you list those expenses is gone. Therefore, they are suspended, and that change is permanent. Permanent. B, can we deduct cost of goods sold plus tier one expenses such as home deductible mortgage and interest? And the answer is yes. You You are still allowed to deduct cost of goods sold from your business. Sorry, not from business. Whole thing, from your hobby. Hobby. Depreciation on equipment used in the activity. Depreciation is a form of operating expense, that's out. A net operating loss generated by a hobby. No, you you cannot even report a loss to have an NOL, net operating loss. Therefore, what's deductible is cost of goods sold. So, you have to be very careful on the CPA exam and enrolled agent exam, on your course exam, what are they asking? Operating expenses? Gone. There's no place to put them. Cost of goods sold? Yes, you can deduct it against the income and report your net income. Now, what should you do now? Whether you are a CPA exam candidate, enrolled agent, accounting student, go to Farhat lectures, look at additional resources, multiple choice, true false, simulations. The AI can help you understand the concept, explain the topic, explain the correct and incorrect answer, create a similar MCQ. The best investment you can make is invest in yourself and God bless.