It’s important to know whether your venture is a true profit-making operation or just a hobby. (iStock/iStock)
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You may be planning to start a business after you retire from your 9-to-5 job, but it’s important to know whether your venture is a true profit-making operation or just a hobby.

“It’s always been important to determine whether an activity is a business or a hobby because, by law, hobby income is taxable, but you can’t deduct losses,” said Eric Smith, a spokesman for the Internal Revenue Service.

A lot has changed this tax season, specifically what taxpayers’ can deduct. Changes under the 2017 Tax Cuts and Jobs Act mean knowing the difference between a hobby and a legitimate profit-making enterprise is crucial.

“In the past, you could claim hobby expenses as part of the class of miscellaneous itemized deductions that needed to exceed 2 percent of adjusted gross income,” Smith said. “But that category of deductions was eliminated under tax reform.”

Previously, you could deduct expenses from a hobby up to the income it generated as personal itemized deductions, as long as you met the 2 percent threshold. However, starting in 2018 and up until 2025, this deduction is no longer allowed.

“Typically, the IRS presumes the activity to be a business, rather than a hobby, if a person makes a profit in three out of five years,” Smith said.

There is an exception to this rule. If you’re involved in the breeding, training, showing or racing of horses, you must show a profit in at least two of the last seven tax years, including the current year.

To help steer clear of trouble with the IRS, you’ll find much of what you need to know on this issue in IRS “Publication 535 (2018), Business Expenses.”

“If you consistently use your business as a tax shelter, deducting your losses from your other income year after year, you’ll probably attract the attention of the IRS,” attorney Stephen Fishman wrote for the online legal website Nolo. “Make sure that the IRS will consider your endeavor a real business before you start claiming deductions for the costs of your art projects or toy car collection.”

If audited or questioned by the IRS, you must prove you are trying to run a profitable business.

So is your business really a hobby?

The following questions can help you and the IRS determine whether a venture is a business or a hobby.

— Are you conducting yourself in a businesslike manner?

— Are you maintaining complete and accurate financial records?

— Are you putting in the time it takes to make your business profitable?

— Do you depend on income from the venture for your livelihood?

— Are the losses you’re trying to claim due to circumstances beyond your control?

— Do you have the knowledge and skills that can help your enterprise be successful?

— Have you made money in areas similar to the current activity?

— Has your venture made a profit in some years and if so how much?

“There have been many tax court cases over the years where what are really hobby losses are being claimed as business losses,” Smith said. “But if an activity is truly a business, eligible taxpayers should take advantage of any legitimate deduction or credit the law allows.”

The IRS has online publications and resources available if you’re looking to start a business, even if it’s just a part-time or sideline activity to supplement your retirement income.

Read: Publication 583 “Starting a Business and Keeping Records”

And: Publication 334 “Tax Guide for Small Business”

Here’s the bottom line from the IRS: “If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income.”

Read more:

The April 15 tax deadline is close. Why you should file on time.

What to do with your tax refund

What to do right now to improve your 2019 tax return

Your Thoughts

Have you been successful creating a stream income in retirement from a business activity? What tips can you share for other aspiring entrepreneurs in the second half of their lives? Send your comments to colorofmoney@washpost.com.

Retirement Rants and Raves

I’m interested in your experiences or concerns about retirement or aging. What do you like about retirement? What came as a surprise?

If you haven’t retired yet, what concerns you financially?

You can rant or rave. This space is yours. It’s a chance for you to express what’s on your mind. Send your comments to colorofmoney@washpost.com. Please include your name, city and state. In the subject line, put “Retirement Rants and Raves.”

Last week, I discussed a situation concerning one reader who felt he made the wrong choice investing in his workplace retirement account rather than diverting some of that money to buy a home. He wondered whether renting hurt his retirement.

Read: I live in a high-cost area. Was I wrong to save in my 401(k) rather than buy a home?

I asked: Are you a renter and now regret buying a home as you get closer to retirement? What’s your perspective on saving for retirement versus buying a home?

“We own one house in a ‘hot’ downtown area that Zillow claims has appreciated by about 75 percent,” wrote A.S. from Tuscaloosa, Ala. I have never seen the house as an investment and would be glad to get a bit above our outlay over the years.”

Bev from Pagosa Springs, Colo., wrote, “I’m close to retirement and realizing that my husband and I may need to sell our home and rent. First, the upkeep is more than we can do ourselves (snow removal and yard work) as well as repairs. Next, the raise in insurance and in taxes this year is putting affordability higher than what retirement income can handle. On the other hand, we bought this home four years ago and will make between 35 percent to 40 percent return on our investment. My husband and I have owned homes since we were 23 years old. We have owned eight homes in 42 years, and we never lost money on any of them — occasionally we have broken even because of bad realtor advice — but never lost money, and generally prospered. We don’t want to stay in the current town because of poor choices in local health care. We are considering our options. We are considering a low-maintenance homeownership, which might be our better option to control housing costs. When I talk to friends and family, I have never had anyone regret buying a house; I’ve heard plenty of complaints on [returns] in 401(k)s.”

Finally, one reader said she learned a lot about the financial burdens of homeownership by renting other people’s houses.

“I have wrestled with this conundrum over the years and had many discussions with friends, my accountant and people who are homeowners from all walks of life,” wrote Tony Award-winning actress Rondi Reed, who played Peggy Biggs on the CBS sitcom “Mike & Molly.”

I have to pause to say I’m a huge fan of Reed’s work. She’s so talented and funny.

Anyway, Reed, continue, “My circumstances are a bit different, but there remains a loud drumbeat for homeownership that always makes me question the scenario. I am 66, divorced, a fairly successful actress, no children, and have always rented. Not yet fully retired, I work when I want. I am very lucky. I have also lived in three sublet houses over 10 years in California that I have ’managed.’ That gave me a hands-on educational experience I never could have had elsewhere, especially after living in apartments. I landed a TV job in L.A. and relocated while keeping my apartment in Chicago. The first house I leased was only a four-month rental. The house had squirrels and rats in the walls, intermittent electrical problems and a thermostat that refused to run the A/C. I have been given a unique scenario wherein I’ve gone through much of the homeownership practicality with the owners footing the bills. I have also learned that it never ends with a house. Ever. It’s either the roof, the HVAC, termites (recently had that experience), alarm systems, etc.”

Read: Why you’re often better off saving for retirement than buying a home

Reed went on to write, “Real estate prices in California are pure insanity. My accountant put it succinctly by telling me he had owned three houses over his life plus a farm/second home and ended up selling them all and renting because his kids were grown and the work/upkeep/money on a house was so time consuming, and he thought he would have more fun traveling and having financial freedom. I feel that, for all the yearnings I had to be a homeowner, I have had the BEST education for making an informed decision on the topic, and that is: Nope, not going to do it.”

Read: Being a renter doesn’t make you a financial failure

Carl Danner of Alamo, Calif., wrote, “My sense after decades of homeownership is that if you can swing it without preempting all other savings and if you can stay in place for several years at least, homeownership can still be a better deal than renting for most people.”

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