Have you thought of turning a hobby into a business? Whether you’re interested in photography, crafts, growing flowers, or something else entirely, the prospect of making money from an activity you enjoy may be very appealing. Since the prospect of paying taxes on your income is likely to be less appealing, you’ll naturally want to deduct all the expenses you can.

And that’s where some special federal income-tax rules come into play. For tax deduction purposes, it makes a difference whether an activity is considered a true business or only a hobby.

If It’s a Business

If your activity qualifies as a business, your business expenses will be deductible, even if they exceed your income from the activity. Not only will the expenses reduce your business income, if you don’t turn a profit, you may deduct the net operating loss, within tax law limits.

Hobby Deductions Are Limited

You also may deduct various expenses associated with pursuing a hobby, but generally only to the extent of your hobby income and only as miscellaneous expenses. You have to itemize deductions on your tax return to claim a deduction for miscellaneous expenses. And only the amount of expenses that, in the aggregate, exceeds 2% of your adjusted gross income is deductible.

The IRS’s View

Basically, a hobby is an activity that is not engaged in for profit. The IRS will presume that your activity is carried on for profit — and therefore is a bona fide business — if it shows a profit in three of the past five years (two out of seven years if your activity consists primarily of breeding, showing, training, or racing horses). If that isn’t the situation, more subjective factors are considered.

• Do the time and effort you put into the activity indicate a profit motivation?

• Do you depend on income from the activity?

• If your activity has produced losses, were they due to circumstances beyond your control or were they incurred during the start-up phase?

• Have you changed methods of operation to improve profitability?

• Do you or your advisors have the knowledge needed to carry on a successful business?

• Have you been profitable in similar activities?

• Do you make a profit from the activity in some years?

• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

If it looks like you are only trying to secure a tax benefit from deducting losses, the chances are good that the IRS will consider your activity a hobby, not a business.