Yes, you can deduct the cost of goods sold from your hobby income – but only up to the amount of your hobby earnings, and no other hobby expenses can be written off under current tax law. According to a 2025 survey by Self Financial, 45% of Americans have a side hustle, and 16% have turned a hobby into an income source, yet many are unsure how to handle hobby expenses on their taxes. This article will demystify the rules, giving you an expert breakdown of when and how you can subtract your costs (like materials) from hobby earnings without running afoul of the IRS.
- 📜 IRS Hobby Rules Explained: Understand the hobby loss rule and why the IRS limits deductions – including how COGS (materials costs) can offset hobby earnings while other expenses cannot.
- 💡 COGS vs. Expenses: Learn how to calculate Cost of Goods Sold for hobby sales and why it’s treated differently from other expenses (with clear examples and simple formulas).
- 🚫 Avoid Costly Mistakes: Discover common tax pitfalls hobbyists face – from over-deducting expenses and misclassifying a hobby as a business, to poor record-keeping that can trigger an IRS audit.
- ⚖️ Hobby vs. Business: Compare the pros and cons of keeping your activity as a hobby versus turning it into a business, including federal vs. state tax nuances and real court rulings that shed light on grey areas.
- 🤓 Expert Q&A: Get quick answers to FAQs on hobby income, from reporting it on Form 1040 and dealing with losses, to understanding self-employment tax and when the hobby expense deductions might return.
Hobby Income and Cost of Goods Sold: The Main Answer
Can you deduct cost of goods sold from hobby income? In short, yes – you are allowed to subtract the cost of goods sold (COGS) from your hobby earnings to determine the taxable income from that hobby. The IRS permits hobbyists to offset their gross hobby receipts by the direct costs of the goods sold, effectively taxing you only on your net hobby profit. For example, if you sell handmade crafts (a hobby) for $500 and the materials cost you $300, you would only report $200 as taxable hobby income. By subtracting the $300 in material costs (COGS) from your $500 in sales, you’ve “deducted” those costs in the process of calculating income.
However, it’s crucial to understand the limits of this deduction. COGS is the only expense you can subtract from hobby income under current federal law. Unlike a business, a hobbyist cannot deduct other expenses such as tools, marketing, home office use, or travel related to the hobby – at least not until hobby deductions potentially return in 2026 (more on that later). In other words, you’re allowed to reduce your hobby revenue by the cost of the products you sold, but any additional hobby costs are nondeductible on your federal return. This rule is a direct result of tax reform changes that treat hobbies very differently from for-profit businesses.
Why does the IRS allow COGS but not other hobby expenses? Think of COGS as part of determining your true profit from selling goods. If you didn’t subtract the cost of the items or materials, you’d be taxed on more than you actually gained. The IRS essentially treats cost of goods sold as a necessary adjustment to your sales, even for hobby income, to arrive at a fair measure of income. On the other hand, ordinary and necessary expenses (beyond COGS) are only fully deductible if your activity is a genuine business. For a hobby (an activity not engaged in for profit), tax law disallows other expense deductions to prevent people from sheltering their regular income with hobby losses. This is known as the “hobby loss” rule.
In summary, the main answer is: You can subtract the direct cost of goods sold from hobby earnings, ensuring you only pay tax on your net profit from the hobby. But no additional hobby-related costs can be deducted to reduce that income (you can’t claim a loss from a hobby to offset other income). Next, we’ll explore this in detail, including examples of how to calculate COGS for a hobby and the critical distinctions between a hobby and a business for tax purposes.
What Qualifies as Cost of Goods Sold for a Hobby?
Before diving into examples, let’s clarify what “cost of goods sold” means in a hobby context. Cost of Goods Sold (COGS) generally refers to the direct costs of producing or acquiring the items you sell. In a hobby setting, this usually includes:
- Materials and supplies used to create your product (e.g. wood and paint for furniture, yarn for knitting, ingredients for baked goods).
- Purchase cost of items for resale (if your hobby is finding and flipping collectibles, the amount you paid for those items is COGS when you sell them).
- Packaging directly related to the product (e.g. bottles for home-brewed beverages, frames for photographs if sold framed).
COGS does not include your personal labor or time, nor does it include indirect expenses like your vehicle mileage to the craft fair, Etsy fees, or general equipment (tools, cameras, etc. that you also use personally). Those might be considered business expenses if you ran a business, but for a hobby, they are not deductible. Only the actual cost of the goods that were sold can be used to reduce hobby income.
It’s also important to calculate COGS correctly and consistently. The IRS expects hobbyists to follow reasonable accounting methods when subtracting COGS from hobby receipts. This means:
- If you have inventory of goods (items or materials not all used/sold in the same year), you should consistently apply a method to track inventory cost. For example, if you buy $1,000 of craft supplies but only use half this year, you shouldn’t deduct the full $1,000 against this year’s hobby sales. Instead, only count the cost for the portion of materials used to make the items you actually sold.
- Use a consistent method each year (like FIFO or specific identification for inventory) if applicable, so you’re not alternating methods just to maximize deductions. Consistency avoids raising red flags.
- Keep receipts and records of all your costs. In case of an audit, you’ll need to substantiate the cost of goods sold that you claimed (for example, receipts for the raw materials or the purchase price of items you resold).
By treating your hobby’s COGS calculation somewhat “business-like”, you ensure that you’re compliant. Essentially, determine your hobby’s gross income by subtracting COGS from gross receipts in a logical way, and do it every year you have hobby income. The IRS explicitly allows this practice for hobbies, but it must be done properly and not exceed the actual direct costs.
Now, let’s move on to some concrete examples that illustrate how hobby income and cost of goods sold work in various scenarios.
Examples: How to Calculate Taxable Hobby Income (With COGS)
To cement the concepts, here are three common scenarios you might face with hobby income, showing how to handle cost of goods sold in each case. These examples will help you see what you report as income and why you can or cannot deduct certain costs.
Scenario 1: Hobby with a Profit (Income exceeds costs)
Imagine you have a woodworking hobby. This year, you built furniture and sold it at local fairs:
- Total sales receipts from your hobby: $5,000
- Cost of goods sold (wood, hardware, paint used for those sold pieces): $2,000
- Other hobby-related expenses (tool purchases, booth fees, mileage): $1,000 (non-deductible)
In this scenario, your sales were higher than your direct costs, so you made a net profit from the hobby. Here’s how it breaks down:
| Hobby Profit Scenario | Amount (USD) |
|---|---|
| Gross hobby sales (income) | $5,000 |
| Minus: Cost of goods sold (COGS) | – $2,000 |
| Equals: Net hobby income (taxable) | $3,000 |
Tax result: You would report $3,000 as taxable income from the hobby. The $2,000 of material costs are effectively deducted (subtracted) as COGS, but you cannot deduct the additional $1,000 of other expenses. You’ll pay income tax on $3,000. The good news is you only pay tax on the real profit, not on the full $5,000 gross. The bad news is that the $1,000 of other hobby expenses can’t reduce your taxable income – they’re essentially personal costs in the eyes of the IRS.
(Internal note: If you find your hobby consistently turning a profit like this, you might wonder if it’s time to treat it as a business. We’ll cover the hobby-versus-business decision in a later section.)
Scenario 2: Breaking Even (Hobby income equals costs)
Now consider a hobby scenario where you roughly break even. Perhaps you do photography as a hobby and sell a few prints occasionally:
- Total sales from hobby: $500
- Cost of goods sold (printing, framing for those sold prints): $500
- Other expenses (new lens, travel to scenic locations): $800 (non-deductible)
In this case, your hobby brought in $500 and the direct costs of those items were also $500. You neither profited nor incurred a net gain when considering COGS.
| Hobby Break-Even Scenario | Amount (USD) |
|---|---|
| Gross hobby sales (income) | $500 |
| Minus: Cost of goods sold | – $500 |
| Equals: Net hobby income | $0 |
Tax result: You would report $0 of hobby income in this scenario. By subtracting the $500 COGS from $500 sales, there’s no taxable hobby profit left. Essentially, the cost of your prints fully offset the earnings. No tax is due on hobby income because you didn’t have a net profit.
However, note that you also spent an extra $800 on things like equipment and travel for your photography hobby. Those extra expenses are not deductible at all. You can’t claim a $800 loss or carry anything forward – they’re simply personal expenses. The IRS only allows you to zero out your hobby income, not dip into a negative. So while you broke even for tax purposes, you did spend more out-of-pocket than you made. From a tax perspective, though, you’re just at zero, and you won’t owe tax on that hobby for the year.
(Keep in mind: If you consistently break even or lose money in your activity and continue it for enjoyment, the IRS will view it as a hobby. If your goal is to profit and you start making consistent gains, you might have a business on your hands instead.)
Scenario 3: Hobby Operating at a Loss (Costs exceed income)
Lastly, consider a scenario where your hobby costs you more than you earned – a common situation for many passion projects. Let’s say you have a small-scale jewelry-making hobby:
- Total sales from hobby: $1,000
- Cost of goods sold (beads, silver, clasps used in pieces sold): $600
- Other expenses (tools, craft show fees, unsold inventory materials): $1,000 (non-deductible)
Here, you actually spent more on your hobby than you made back in sales. Economically, you have a $600 direct cost against $1,000 income, and an additional $1,000 in other costs, meaning you’re $600 in the hole overall. But how does this play out for taxes?
| Hobby Loss Scenario | Amount (USD) |
|---|---|
| Gross hobby sales (income) | $1,000 |
| Minus: Cost of goods sold | – $600 |
| Equals: Initial net income | $400 |
| Minus other hobby expenses | – $0<sup>¹</sup> |
| Final taxable hobby income | $400 |
<sup>¹</sup>Other hobby expenses beyond COGS are not deductible, so they cannot be subtracted.
Tax result: Even though you lost money in actuality (your total costs $1,600 exceeded $1,000 revenue), you still must report $400 of taxable hobby income. This might seem unfair – you didn’t truly come out ahead, so why is there taxable income? The reason is that the IRS only allowed the $600 of COGS to offset your sales. Once you’ve subtracted direct costs, you had $400 left, and no further deductions are permitted to eliminate that profit for tax purposes. You’re not allowed to claim the extra $1,000 of hobby expenses to create a loss or offset other income. Essentially, the IRS says “too bad” – in a hobby loss situation, you get taxed as if you made $400 profit, even though overall you didn’t profit when all costs are considered.
This scenario underscores why many hobbyists find the rules harsh. Prior to 2018, you could at least deduct hobby expenses (like tools and fees) up to the amount of hobby income, which would have wiped out that $400 in this example. But under current law, hobby losses are not recognized for tax purposes. You can reduce your hobby income to zero with COGS, but no further. The “loss” portion simply isn’t deductible anywhere.
(Insight: If you routinely find yourself in Scenario 3, spending more than you earn year after year, you might consider turning your hobby into a bona fide business if you have intentions of eventually profiting. As a business, losses could be deductible – but you must truly run it for profit and not just for fun, or else the IRS can still label it a hobby. We’ll discuss how the IRS differentiates them next.)
Common Mistakes Hobbyists Should Avoid (Tax Pitfalls)
Handling hobby income on your tax return can be tricky, and there are several common mistakes and misconceptions that can cost you. Here are some major pitfalls to avoid:
1. Failing to Report Hobby Income:
A lot of people mistakenly believe that “small” hobby earnings don’t need to be reported. In reality, all income is taxable unless a specific law exempts it – and hobby income has no special exemption. Whether you made $100 selling baked goods at a farmers market or $5,000 from art commissions on the side, you are required to report it on your tax return. Don’t assume the IRS won’t notice just because you didn’t get a 1099 form. Underreporting income – even from a casual hobby – is a mistake that could trigger penalties or an audit.
2. Deducting All Hobby Expenses (Overstepping the Rules):
Another common error is trying to write off every expense related to your hobby on your taxes. You might be tempted to deduct your hobby equipment, travel, classes, or other costs as if it were a business. This is not allowed for a hobby. Post-2018, hobby expenses (beyond COGS) cannot be deducted on your federal return. Some taxpayers attempt to sneak these costs in as other deductions, but that violates IRS rules. It’s a costly mistake – if caught, those deductions will be disallowed, and you could face back taxes and interest. Remember, only COGS can offset hobby earnings, nothing more. So avoid the trap of claiming personal hobby costs as if they were business write-offs.
3. Misclassifying a Hobby as a Business (or Vice Versa):
Classification confusion is a big pitfall. If you have a money-making hobby, you might incorrectly file a Schedule C (business) to deduct losses, thinking it will save you money. But if the IRS determines you didn’t have a profit motive and it was actually a hobby, they can reclassify it and deny all those expense deductions – leaving you owing more tax (and possibly penalties). Conversely, some people who actually are running a profit-driven side business mistakenly treat it as “just a hobby” and don’t take legitimate deductions or pay self-employment tax when they should. Misclassification can either cause you to overpay or underpay taxes. The safest approach is to accurately assess your activity: if it’s primarily for pleasure without a profit motive, it’s a hobby (deductions limited). If you’re actively trying to make money and behave like a business, then report it as a business. We’ll provide guidance on distinguishing the two in the next section.
4. Not Keeping Receipts or Proof of COGS:
Even though hobby expenses (except COGS) aren’t deductible, you still need to keep good records – especially of your cost of goods sold. A mistake is to treat hobby income casually and not document your costs. If you get audited, the IRS may ask you to substantiate the COGS you claimed. If you said you sold $5,000 of crafts and claimed $3,000 of materials, be prepared to show receipts for those materials. Without proof, the IRS could disallow your COGS deduction, meaning they’d tax you on the full $5,000. Also, records help you calculate COGS accurately each year (tracking inventory, etc.). Save those receipts and keep a simple ledger of income and expenses. It doesn’t need to be fancy – even a spreadsheet or notebook works – but documentation is your defense if questions arise.
5. Ignoring State Tax Differences:
Some hobbyists forget that state tax rules can differ from federal rules. This is less a “mistake” you make on the federal return, but it could be a mistake when filing your state tax return. Many states use federal taxable income as a starting point, so generally they’ll also tax hobby income that was reported federally. But a few states still allow certain deductions that the federal government does not. For instance, California (as of now) does not conform to the federal suspension of miscellaneous itemized deductions – which means California taxpayers can still deduct hobby expenses (up to hobby income) on their state return if they itemize. If you live in a non-conformity state and you had significant hobby expenses, failing to take them on your state return is leaving money on the table. On the flip side, in states that fully follow federal law, trying to deduct hobby costs will be disallowed just like on the federal. The key is to know your state’s stance on hobby expenses. We’ll discuss federal vs. state nuances more shortly, but don’t assume the rules are identical – do a quick check or consult a tax professional to avoid mistakes.
By steering clear of these common errors – reporting all your income, respecting the limits on deductions, classifying correctly, keeping records, and checking state rules – you’ll handle your hobby income in a way that keeps the IRS happy and your tax bill as accurate as possible. Next, let’s delve deeper into how the IRS distinguishes a hobby from a business, and what that means for you, including some telling court rulings and official guidelines.
Hobby or Business? Understanding the Difference (and Why It Matters)
One of the most critical aspects of this topic is determining whether your activity is a hobby or a business for tax purposes. The distinction isn’t just semantic – it carries huge implications for what you can deduct, how you report income, and even whether you pay self-employment tax. Let’s explore how the IRS draws the line and what it means for deducting costs:
The IRS “Profit Motive” Test:
The IRS uses a set of guidelines (sometimes called the hobby loss factors) to evaluate whether you’re running a business (engaged in for profit) or a hobby (an activity for pleasure). The core question is: Are you intending to make a profit? To answer that, the IRS and courts look at many factors, including:
- Businesslike Manner: Do you keep books and records? Do you carry on the activity in a serious, professional way? If you have a separate business bank account, a business plan, or you make changes to improve profitability, it points to a business.
- Expertise and Effort: Do you have the knowledge in this field or consult experts? Do you spend a lot of time and effort on it as you would to make it profitable? A significant commitment of time (beyond casual hobby hours) can indicate a business intent.
- History of Income or Losses: Do you actually make a profit in some years? The IRS has a safe harbor: if you show a profit in 3 out of 5 years (or 2 out of 7 for horse breeding activities), the law presumes you’re running a for-profit business. Continuous losses are a red flag for hobby classification unless there’s a good reason (like a reasonable startup period or unforeseen circumstances).
- Dependency on Income: Are you depending on this income to pay your bills, or is it just extra pocket money? If your livelihood or significant financial benefit rides on the activity, it’s more likely a business.
- Elements of Personal Pleasure: Is this something you do mainly for fun or recreation (like a leisure pastime)? If yes, that leans toward hobby – though it’s understood you can enjoy your business too, it just can’t be primarily for enjoyment with money being secondary.
No single factor is decisive; the IRS looks at the overall picture. But profit motive is king – essentially, if you’re trying to make money and have evidence to back that up, it’s a business. If you’re mainly doing it for enjoyment and the money is incidental or consistently not there, it’s likely a hobby.
Why Classification Matters:
We’ve hinted at this, but let’s spell it out. If your activity is deemed a business, you:
- Report income and expenses on Schedule C (if a sole proprietorship), or appropriate business tax forms for other structures.
- Deduct all ordinary and necessary expenses (including cost of goods, supplies, home office, vehicle expenses, etc.) without the hobby limits. This can significantly reduce taxable income and even produce a net loss.
- If a net loss occurs, that loss can offset other income (with some limitations for very large losses due to at-risk and passive activity rules, but generally, yes).
- Pay self-employment tax on any net profit (15.3% for Social Security/Medicare) because you’re effectively self-employed.
- Need to possibly make estimated tax payments if the profits are significant, to avoid underpayment penalties.
- Have the burden to show profit motive if the IRS questions the losses – i.e., you may have to defend that it’s a real business.
If your activity is deemed a hobby, you:
- Report income on Schedule 1 (Form 1040) as “Other Income” (just one line for the net income after COGS).
- Cannot deduct expenses beyond cost of goods sold. No Schedule C for it, no losses to claim. You pay tax on every dollar above COGS.
- Do not pay self-employment tax on hobby earnings (that’s one benefit – saving that 15.3% tax).
- Don’t need to pay estimated self-employment taxes, but you still might adjust your withholding or estimates for income tax if the hobby income is substantial.
- Essentially have a simpler reporting process, but potentially a higher tax bill on profits since you can’t write off anything else.
A quick comparison in table form:
| Factor | Hobby (Not-for-Profit Activity) | Business (For-Profit Activity) |
|---|---|---|
| Deductible expenses | Only COGS (materials) can offset income; all other expenses are non-deductible. | Almost all ordinary & necessary expenses are deductible (materials, supplies, marketing, home office, etc.), allowing full reduction of income (even to a loss). |
| Reporting | Report net income (after COGS) on Form 1040, Other Income (no separate schedule for expenses). | Report income & expenses on Schedule C (or appropriate business form); requires detailed expense reporting and possibly additional forms (self-employment tax, etc.). |
| Profit/Loss Treatment | No losses allowed for tax purposes. Income can be reduced to $0 (break-even) at best, but not below. Losses can’t offset other income. | Net losses allowed (if genuinely a business). A business loss can offset other income (with some limits), potentially reducing overall tax. Consistent losses, however, may invite IRS scrutiny under hobby loss rules. |
| Self-Employment Tax | Not applicable – hobby earnings are not subject to SE tax. This saves ~15.3% tax on profit, but… | Applicable – must pay 15.3% self-employment tax on net profit (since you’re effectively your own employer). This is in addition to income tax, though half of SE tax is deductible. |
| Audit Scrutiny | Risk if large income not reported or if you try to deduct expenses illegally. Generally, as long as you only subtract COGS, hobby income is straightforward. | Risk if you claim continuous losses or don’t follow business formalities. IRS may reclassify a “business” as a hobby if it looks suspect, disallowing deductions. Proper documentation and a profit motive are essential. |
| Flexibility & Growth | Limited tax flexibility. If the hobby grows, you might be paying more tax on it due to no deductions. | Greater flexibility. Can reinvest earnings, claim startup costs, and structure for growth. Also can later sell the business, etc. You can take steps to reduce taxes (retirement plans, etc. for self-employed). |
As you can see, there are trade-offs. Keeping something as a hobby means simpler tax handling and no SE tax, but you get no relief for your expenses. Operating as a business means tax complexity and extra taxes like SE tax, but you gain the ability to deduct everything and lower your taxable income, even use losses to your advantage.
Pros and Cons of Electing Business Status: If you’re on the fence, here’s a summary of pros and cons to consider in deciding whether to treat your money-making hobby as a business:
| Pros of Treating as a Business | Cons of Treating as a Business |
|---|---|
| Full Expense Deductions: You can write off all related costs (materials, tools, home office, etc.), which can significantly reduce taxable income. This is crucial if your expenses are high relative to income. | Self-Employment Tax: You’ll owe 15.3% SE tax on profits. Hobby income avoids this, so becoming a business can increase your tax burden if profits are modest. |
| Ability to Show a Loss: If expenses exceed income, you can claim a business loss to offset other income (subject to rules). This can lower your overall taxes in a bad year. | Profit Motive Requirement: You must genuinely pursue profit. Running at a loss for too long can trigger IRS scrutiny. You may need to show evidence of trying to turn a profit (which might mean changing how you operate). |
| Professional Credibility & Growth: Operating as a business can help you grow the activity (open a business bank account, market more, maybe qualify for business loans or licenses). It sets the stage for expansion and perhaps turning your passion into a full-time venture. | More Complexity: You’ll file a more complex tax return (Schedule C or even incorporate). This might mean higher bookkeeping burden, possibly hiring a tax preparer. You’ll also need to pay estimated taxes quarterly if you expect to owe a lot, to avoid penalties. |
| Retirement and Tax Benefits: As a self-employed individual, you can contribute to retirement plans like a SEP-IRA or Solo 401(k) to save on taxes, and deduct health insurance if you qualify. These are perks not available with hobby income. | Risk of Reclassification: If the IRS thinks it’s not really a business (no profit motive), they can disallow your deductions. You could end up owing back taxes on “hobby” years. It’s important to follow best practices (keep records, aim for profit) to defend your status. |
In essence, turning your hobby into a business has potential tax advantages (deductions, use of losses) but comes with additional tax responsibilities (SE tax, compliance). Many people choose to remain a hobby if their profits are small or inconsistent, just to avoid the paperwork and extra tax – they’d rather pay a bit of tax on the side income and keep it simple. Others opt to formalize their hobby into a business when their revenue grows or they want to invest more into it and reap tax benefits.
Internal link suggestion: (For a deeper dive, see our guide on “When Does a Hobby Become a Business?” which outlines the nine IRS factors and real examples to help you decide if it’s time to go pro.)
Next, we will look at how federal and state rules diverge in taxing hobby income and expenses, and mention a few court rulings and real cases that highlight how serious the hobby vs. business distinction can get.
Federal vs. State: How Hobby Income Rules Differ
Federal Tax Treatment (Overview): We’ve established that at the federal level, hobby income is reported fully, and only cost of goods sold can reduce it. No other expense deductions are allowed for 2018 through 2025 (thanks to the Tax Cuts and Jobs Act). All hobby income gets lumped into your taxable income and taxed at ordinary income rates. The hobby expense deductions that once existed (as a miscellaneous itemized deduction up to the amount of hobby income, subject to a 2% of AGI threshold) are suspended through 2025. In 2026, if the law isn’t changed, those miscellaneous deductions are scheduled to come back – which means hobby expenses could again be deductible (up to hobby income) as an itemized deduction. But that’s not guaranteed; Congress could extend the current rules. For now, assume no hobby write-offs beyond COGS on your federal return.
State Tax Treatment: The situation can change when it comes to state income taxes. Each state has its own tax code, though many start with federal income as a baseline. Here are key points on state nuances:
- Most states follow federal definitions of income. If you report $3,000 of hobby income federally (after netting COGS), that $3,000 will usually be part of your state taxable income too.
- Deductions for hobby expenses at the state level depend on state law. Some states automatically conform to federal law changes, which means they also disallowed hobby expense deductions from 2018–2025. Other states do not conform and kept the old rules.
- Example – California: California is a notable example of non-conformity. California did not adopt the federal suspension of miscellaneous itemized deductions. So, a California taxpayer with hobby income can still do what used to be allowed federally: deduct hobby expenses (as an itemized deduction on the CA return) up to the amount of hobby income. They’d have to exceed the 2% of AGI floor on miscellaneous deductions, and itemize rather than take the standard deduction, for it to matter. But if those conditions are met, California allows hobby expense deductions where the IRS would not. This means a CA hobbyist might pay less state tax on their hobby income than they do in federal tax.
- Example – New York (and others): New York State largely conforms to the federal tax law as well, meaning NY taxpayers also lost the hobby expense deduction in the same period. Each state is different: some piggyback entirely on the federal itemized deductions (so no hobby expenses allowed), while others like CA maintain their own rules.
The practical takeaway is: check your state’s tax guidelines or consult a CPA about hobby expenses. It’s possible that even though the IRS says “no deductions,” your state might give you a small break, or vice versa. If you live in a state with no income tax, this is moot for income tax purposes, though sales tax or other rules might apply if you sell products.
Also, be aware of state business registration or tax requirements if your hobby grows. Some states require a business license or the collection of sales tax on goods you sell, even if it’s a hobby in IRS terms. “Hobby” is a federal income tax concept; your state might still consider you a small business for state law (for example, needing to charge sales tax on those craft sales once you cross a certain threshold of sales). Always consider both levels: federal income tax vs. state income tax vs. other state regulations.
Example scenario: Suppose you earned $5,000 net from a hobby in 2025 and had $5,000 of hobby-related expenses. Federally, you’d report $5,000 income and get zero deduction – paying tax on $5k. If you live in California and itemize, you could potentially deduct that $5,000 on your CA return (subject to the 2% rule and your other itemized deductions), meaning you might owe little to no state tax on the hobby money. In a fully conforming state, you’d get no deduction just like federal. The differences can be significant in such cases.
In summary, federal rules set the baseline: hobby income is taxable, only COGS reduces it, no losses allowed. State rules may soften the blow in some cases, so it’s worth looking into what your state permits. Always ensure you’re following federal law first (to avoid IRS trouble) and then optimize or comply with your state’s law as a separate layer.
Real-Life Rulings: How Courts Handle Hobby Losses
Tax courts have seen many cases of taxpayers arguing with the IRS about whether an activity is a hobby or a business, and the outcomes underscore the importance of the rules we’ve discussed. Here are a few insights drawn from real cases and IRS enforcement actions:
- The Classic “Horse Breeder” Scenario: A number of famous tax court cases involve taxpayers with horse-breeding or farming activities that generated perennial losses. Often these individuals had substantial other income and were suspected of using the farm/horses mainly as a tax write-off (perhaps also for personal enjoyment). The courts look closely at the facts – did the person have a business plan for the farm? Did they have expertise or hire experts? Did they try to improve profitability? In one notable case, a wealthy individual’s horse-breeding operation lost money 8 years in a row. The tax court agreed with the IRS that it was a hobby, not a business, largely because the person couldn’t demonstrate a genuine effort to make it profitable (no changes in operation, no formal records akin to a business, and significant personal pleasure derived from the activity). As a result, all those loss deductions were thrown out – the taxpayer had to restate income without the farm losses, owing back taxes and interest. The key lesson: If you truly want losses to be deductible, you must run the activity in a way that convincingly shows profit motive.
- Court Acknowledgement of COGS: Interestingly, even when disallowing hobby losses, courts (and the IRS) have consistently allowed that cost of goods sold is not considered a “deduction” but an adjustment to income. In other words, even if an activity is deemed a hobby, you’re still allowed to subtract the cost of the items sold. For example, in a tax court summary related to a craft-selling hobby, the court permitted the taxpayer to reduce her hobby gross receipts by the cost of materials for the items sold, but disallowed the rest of her claimed expenses like utilities, vehicle, etc. The result was that she had to report a smaller net income than she originally thought (because she had wrongly zeroed it out with excess expenses), but at least she wasn’t taxed on gross receipts. This aligns with IRS regulations: gross income from a not-for-profit activity can be determined by netting out cost of goods sold. So even in court, that principle holds up – COGS is your one lifeline if you get into a dispute over hobby income.
- The “Side Gig Gone Business” Cases: There have been cases where taxpayers started making good money from an activity but continued to call it a “hobby” to possibly avoid self-employment tax. In one scenario, a photographer treated her work as a hobby initially, but as her income grew and she started advertising and seeking profit, the IRS argued it was now a business (meaning she owed self-employment tax and should have been filing Schedule C). The court looked at when her intent shifted from recreation to profit. They ruled that once she started actively marketing her services and relying on the income, it became a business – and she had to retroactively pay SE tax on those earnings. The takeaway: If it quacks like a business, the IRS will tax it like a business. You can’t hide behind the “hobby” label to avoid certain taxes if the facts show you’re really pursuing income.
- IRS Crackdown after 2018: Since the tax law change in 2018 eliminated hobby expense deductions, the IRS has been extra vigilant for people trying to circumvent the rules. They’ve issued official reminders (fact sheets and Tax Tips) emphasizing that hobbies have no deductible expenses in these years. One IRS fact sheet in 2022 highlighted this, essentially warning taxpayers: “Know the difference between a hobby and a business; if it’s a hobby, you must report income but you cannot deduct expenses.” The IRS also signaled that examiners (auditors) have been instructed to look out for misclassified hobbies. If you file a Schedule C with years of losses and minimal income, expect the IRS to consider whether it’s really a business. And if you simply don’t report hobby income at all, that’s even riskier – it’s income under the law, period.
In summary, court rulings have reinforced the IRS’s stance:
- You can subtract cost of goods sold from hobby receipts, but nothing more, when it’s truly a hobby.
- The profit motive test is real – you must demonstrate intent to profit to claim business treatment. Having some profit in at least 3 of 5 years is a good defense; lacking that, you need other strong factors in your favor.
- The IRS and courts won’t hesitate to reclassify your activity if the facts support it, and the financial consequences can be painful (losing deductions, owing back taxes).
- Conversely, if you are genuinely running a business, courts will uphold your deductions – but you need proof (records, a businesslike approach, evidence of trying to turn things around if losses occur).
Understanding these enforcement patterns should encourage you to be honest and prudent in how you handle your hobby or side activity. If it’s a hobby, enjoy it and report the income correctly, using the COGS offset as allowed. If it’s becoming a business, formalize it and take the deductions – but run it like a business. In either case, following the rules will keep you out of trouble and optimize your tax outcome as much as possible under the law.
(Internal link suggestion: If you’re interested, check out “How to Prove Your Hobby is a Business” for tips on documenting profit motive – drawn from real tax court cases.)
Frequently Asked Questions (FAQ)
Q: Where do I report hobby income on my tax return?
A: Report hobby income on Schedule 1 (Form 1040), Line 8 (Other Income). List it as “hobby income” and report the net amount (after subtracting any cost of goods sold).
Q: Do I have to pay taxes on small hobby earnings (like $100)?
A: Yes. All hobby income is taxable, no matter how small. If you have to file a tax return for the year (due to other income), you must include hobby earnings.
Q: Can I deduct any hobby expenses on my federal return?
A: Only the cost of goods sold can reduce hobby income. You cannot deduct other hobby expenses (supplies, travel, etc.) on your federal tax return for 2018–2025 under current law.
Q: What happens if my hobby expenses are more than my hobby income?
A: You cannot claim a loss. You can reduce your hobby income to zero with cost of goods sold, but any excess expenses are not deductible. You simply report no taxable income from that hobby.
Q: Do I need to pay self-employment tax on hobby income?
A: No. Hobby income is not subject to self-employment tax. Only income from a trade or business (including gig work for profit) faces the 15.3% self-employment tax on earnings.
Q: How can I tell if my activity is a hobby or a business for tax purposes?
A: Intent and profit motive are key. If you run it in a businesslike manner and aim to make a profit (especially with profits in 3 out of 5 years), it’s likely a business. If it’s mainly for fun with no real expectation of profit, it’s a hobby.
Q: Is there a certain income threshold when a hobby becomes a business?
A: Not a specific dollar amount. It’s more about consistency of profit and behavior. Even a small venture can be a business if you treat it like one; a large-scale activity can be a hobby if done for enjoyment without profit motive.
Q: Will hobby expense deductions ever come back?
A: Possibly. The law that removed hobby expense deductions expires after 2025. If Congress does nothing, hobby expenses up to income could be deductible again in 2026 (as a misc. itemized deduction). This is uncertain and subject to future tax law changes.
Q: Can I switch my hobby to a business to deduct expenses?
A: Yes, if your intent changes. Start operating for profit – keep records, maybe register a business name, etc. Once you truly engage in it for income, you can file as a business and deduct expenses moving forward (past hobby years remain treated as hobby).
Q: Do I need to make estimated tax payments for hobby income?
A: It depends. If the hobby income is significant and no taxes are withheld (which is common), you may need to adjust your wage withholding or pay quarterly estimated taxes to avoid underpayment penalties at year-end.
Q: Are state taxes different for hobby income?
A: Generally, states tax hobby income similarly. But some states allow hobby expense deductions at the state level. Check your state’s rules – you might get a deduction on your state return even though you can’t on the federal return.
Q: If I form an LLC for my hobby, will that avoid the hobby loss rules?
A: No. Simply forming an LLC or corporation doesn’t override the hobby loss rules. The IRS looks at your activity’s substance. Only a regular C-corporation isn’t subject to hobby loss rules, but creating one solely for a hobby isn’t practical for most. Focus on profit motive and operation to be seen as a business.