| IntroductionThis article provides
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| | unreasonable, but which offset income
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| guidance to those concerned that their
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| | from other sources, are immediately
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| profit motivated trade or business
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| | suspected as recreational or
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| activities remain deductible,
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| | hobby-related. The continuation of such
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| particularly in those cases where losses
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| | unprofitable activities (when they have
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| have been generated in the past and/or
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| | not proven successful in reducing losses
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| are expected to continue to be generated
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| | or generating profits in the past)
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| in the future.The 3-out-of-5 year rule
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| | provides very strong evidence of the
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| and taxpayer misconceptionsThe Internal
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| | absence of profit motive. However,
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| Revenue Service (IRS) has established an
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| | increasing gross profits, even when
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| administrative rule regarding their
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| | combined with increasing expenses of
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| presumption of profit:An activity is
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| | operation, may provide sufficient
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| presumed to have a profit motive if it
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| | evidence of profit motive.Credentials,
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| produces a profit in at least 3 of the
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| | publications, previous successes in
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| past 5 tax years including the current
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| | similar or related activities or other
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| year.
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| | evidence of expertise (or the hiring of
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| -Publication 535: Business Expenses,
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| | experts) provides strong evidence of
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| IRS, p. 6.This is merely an
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| | profit motive.
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| administrative rule used internally by
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| | Generally, the more time and effort put
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| the IRS. It does not have the effect of
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| | into the activity, the greater the
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| statutory law and it does not follow that
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| | perception and presumption of profit
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| an activity failing to produce a profit
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| | motive. When a taxpayer is employed in a
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| in at least 3 out of 5 years will be
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| | non-related activity as well, it is
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| presumed to be a not-for-profit activity.
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| | useful to maintain some form of written
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| Yet many taxpayers have this
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| | evidence of the dates and hours spent on
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| misconception.No single factor
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| | the activity. (Such logs need not be
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| constitutes evidence of profit motive,
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| | terribly detailed.) Dependence or
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| although some have evolved from case law
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| | reliance on income from the activity
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| and have been adopted by the IRS.What is
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| | implies an absence of hobby or
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| a hobby?A hobby is an activity not
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| | recreational involvement, particularly
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| engaged in for profit. The term hobby
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| | when other taxable income items (e.g.,
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| suggests an activity that is personal and
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| | salaries) are not significantly
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| recreational in nature. It is unlikely
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| | offset.The purchase of activity-related
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| that an electrician would be concerned
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| | assets expected to appreciate implies
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| about having his/her business classified
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| | investment. Investment expenses do not
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| as a hobby. Alternatively, a skydiving
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| | warrant the generation of allowable trade
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| instructor, who also engages in this
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| | or business losses, but require
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| sport for personal pleasure or
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| | capitalization or the accumulation of
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| recreation, may be a more likely
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| | costs to eventually calculate the gain or
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| candidate for IRS scrutiny and hobby loss
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| | loss from the investment when the sale of
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| classification.10 determining factors for
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| | the asset takes place. Reclassification
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| profit motive10 factors are used to
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| | of the activity as investment-related
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| determine profit motive and include the
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| | will result in the disallowance of
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| following:
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| | (interim) operating losses.A checklist
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| 1. Is the activity carried on in a
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| | approach
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| business-like manner?
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| | Use the above, 10 factors, as a "hobby
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| 2. Does the time and effort expended on
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| | loss checklist" to review your exposure
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| the activity suggest profit-motive?
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| | to hobby loss or not-for-profit
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| 3. Does the taxpayer depend on the
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| | classification. Generally, a "yes"
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| activity for his/her livelihood?
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| | response on all or most of the 10 factors
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| 4. Are losses due to circumstances
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| | contained in this article would suggest
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| beyond taxpayer control?
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| | clear compliance with a factor and
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| 5. Has the taxpayer modified operating
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| | overall support for the evidentially
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| methods to improve profitability?
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| | supporting position of profit motive. A
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| 6. Does the taxpayer (or advisors)
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| | "no" response on a factor identifies a
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| possess expertise sufficient for success?
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| | weakness.Weaknesses should be pursued, if
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| 7. Has the taxpayer experienced success
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| | possible, to upgrade the response to an
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| profits in similar past activities?
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| | "uncertain" or "yes" response. Finally,
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| 8. Has the activity generated a profit
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| | an "uncertain" response should pursued by
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| (and how much) in past years?
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| | the taxpayer, with the objective of
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| 9. Can the taxpayer anticipate
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| | upgrading or strengthening the
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| appreciation of assets used in the
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| | evidentiary requirements for this factor
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| activity?
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| | to a "yes" response. Of course, if your
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| 10. Does the activity have elements of
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| | self-employment trade or business results
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| personal pleasure or recreation?Evolution
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| | in net earnings or contributes to
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| of the hobby loss classificationThe above
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| | increased taxable profits, you need not
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| are factors that have evolved from tax
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| | be concerned with this checklist.Summary
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| court cases and the need to ascertain the
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| | These factors are only relevant to the
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| motives of taxpayers who were
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| | self-employed taxpayer (1) with a tax
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| self-employed and using small business
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| | loss from self-employment endeavors and
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| losses to offset high income from other
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| | only become critical (2) if audited by
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| sources. This offsetting strategy
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| | the IRS. However, to the extent
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| results in lower taxable income and tax
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| | practicable, all factors should be
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| rates or brackets. The classic example
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| | pursued with the intention of
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| is that of the highly compensated
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| | strengthening your position in the event
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| business executive. He wants a second
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| | of a loss from self-employment or an IRS
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| home/ranch in the country, but would like
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| | audit. Taxpayers should not be dissuaded
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| to (inappropriately) deduct all or a
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| | from deducting their legitimate, ordinary
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| portion of this second home in the form
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| | and necessary trade or business losses,
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| of interest, depreciation, stables,
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| | simply out of fear of an IRS audit.Feel
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| horses, utilities, maintenance, etc. The
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| | free to publish or reproduce anywhere, as
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| objective is to reduce the after-tax cost
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| | long as you provide a copy to and/or
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| of this second residence.
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| | notify the author .A.J. Cataldo II, Ph.D.
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| Losses that are excessive and
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