There’s a reclassification the IRS can make that costs more than almost any deduction they can disallow. They don’t say your expenses were wrong. They say your business isn’t a business.
It’s called the hobby loss rule — Section 183 — and starting in 2026 the penalty for landing on the wrong side of it got permanently worse.
The math, plainly
Say you run a photography business on the side. This year you brought in $18,000 and spent $26,000 on gear, travel, software, and insurance. You reported an $8,000 loss on Schedule C.
If it’s a business: that $8,000 loss offsets your other income. If you’re in the 24% federal bracket and paying New York tax on top, that loss is worth roughly $2,400 in federal savings plus another $500 or so at the state level.
If the IRS calls it a hobby: you still report the full $18,000 as income. You deduct none of the $26,000. Your tax bill on an activity that lost you $8,000 in real money is about $4,300 federal and $1,100 to New York.
That’s a swing of roughly $8,300 on a single activity — and the money is already gone. You spent it. You just can’t deduct it.
What changed on January 1, 2026
Before 2018, a hobby wasn’t a total loss. You could deduct hobby expenses up to the amount of hobby income as a miscellaneous itemized deduction. It was a bad deal, but it was something.
The 2017 tax law suspended miscellaneous itemized deductions through 2025. The One Big Beautiful Bill Act made that suspension permanent starting January 1, 2026, with a narrow carve-out for educator expenses that doesn’t help you here.
Translation: hobby expenses are now deductible in exactly zero circumstances. The old ceiling is gone because the floor is gone.
Two things that do still work in your favor. If your activity sells physical goods, cost of goods sold reduces gross receipts before you ever get to the income line — that’s not a deduction, it’s a subtraction, and it survives. And hobby income isn’t subject to the 15.3% self-employment tax. Small consolation on a bill you shouldn’t be paying at all.
The nine factors
The IRS doesn’t decide this on gut feel. Regulation 1.183-2(b) lists nine factors, and an examiner weighs all of them:
- How you run the activity. Separate bank account, real books, a written plan, changes made in response to losses.
- Your expertise. Training, credentials, time spent learning the field or consulting people who know it.
- Time and effort. Hours you actually put in, especially if you gave up something else to do it.
- Whether the assets are appreciating. Land, equipment, or inventory that gains value counts toward profit motive.
- Your track record in similar ventures. Have you built and sold something before?
- Your history of income and losses. Losses in the startup years are normal. Losses in year nine are not.
- The size of any profits you did make. An occasional large profit weighs more than a string of tiny ones.
- Your financial situation. If the activity is your main source of income, that helps. If you have a large W-2 and this conveniently generates losses, that hurts.
- Personal pleasure or recreation. This is the one that sinks people. Horses, boats, aviation, wineries, photography, car restoration — anything genuinely fun draws attention.
No single factor decides it. But factor nine is why the audit started, and factor one is usually why you win or lose.
The three-out-of-five safe harbor
There’s a presumption in your favor: if the activity showed a profit in at least three of the last five years (three of seven for horse breeding, training, showing, or racing), the IRS is presumed to accept it as a business, and the burden shifts to them to prove otherwise.
That presumption is rebuttable, not bulletproof. But it’s a real line, and it’s worth planning around. If you’re at two profitable years out of four and you can accelerate a little revenue or defer a little spending to land the third, that’s a legitimate move — not a gimmick.
What actually protects you
I’ve sat through these examinations. The owners who come out fine have paperwork that looks like a business, not a spreadsheet built the week the notice arrived.
A separate business bank account and credit card. This is the first thing an examiner looks for and the cheapest thing on this list to fix. If you’re running personal and business money through one account, that’s a problem well beyond hobby loss — see why commingling funds costs you.
A written business plan. It does not need to be forty pages. It needs to state what you sell, who buys it, what it costs, and how you expect to get to profit. Date it.
Evidence you changed course after losses. This is the single most persuasive factor. Raised prices in year two. Dropped the unprofitable product line. Switched suppliers. Cut the trade show that didn’t produce. Write it down when you do it — a dated note in your files is worth more later than a memory.
Real marketing. A website, ads you paid for, a customer list, invoices with terms on them.
Contemporaneous records. Mileage logged when you drove, not reconstructed in March. Receipts kept. Time tracked. The IRS’s automated review systems flag returns where Schedule C losses repeat against strong wage income, and once you’re in the file, the quality of your records is the whole argument.
Separation from personal use. If the boat charters, it charters to strangers who pay market rates. If the truck is a business vehicle, the family isn’t driving it to Jones Beach on Saturday.
Where the real risk sits
Three profiles draw this more than any others.
High W-2 income plus a persistent Schedule C loss. A $300,000 salary alongside a consulting sideline that loses $30,000 a year for five years is the textbook fact pattern. It isn’t automatically wrong, and I’ve defended plenty of them successfully — but you need the file.
Anything recreational. Horses, boats, planes, wine, art, racing. The regulations name some of these directly.
Rentals and content businesses. A vacation property that “rents” mostly to family, or a creator account with real expenses and negligible revenue. Related traps show up in why rental losses get trapped and writing off clothes and luxury purchases.
The thing to understand is that this isn’t about whether you’re sincere. It’s about whether you can demonstrate profit motive with documents. Plenty of real businesses lose money for years. The ones that survive an examination are the ones that look, on paper, like they were trying to stop.
This post is for general informational purposes only and does not constitute tax, legal, or financial advice. Section 183 determinations are highly fact-specific, and the examples above are illustrative estimates, not projections for any individual. Consult a qualified tax professional about your own circumstances before acting on this content. Geiger Tax & Accounting, Amityville, NY · (631) 532-5622 · info@geigertax.com.