Understanding IRS Hobby Loss Rules

July 24, 2026/ Brett Hess / Tax

Dear Client,

We want to highlight an important IRS rule that may affect taxpayers who report business losses on Schedule C.

If your business shows a loss in a given year, the IRS applies what is commonly referred to as the “hobby loss” rule to determine whether the activity qualifies as a legitimate business.

What to know:

The IRS generally expects a business to show a profit in at least 3 out of 5 consecutive years.
If this threshold is not met, the IRS may reclassify the activity as a hobby rather than a business.

Why this matters:

Business losses can offset other income.

Hobby losses cannot be deducted, even though any income earned must still be reported and taxed (though not subject to self-employment tax).

Special Situations:

If your activity has incurred losses in its first two years, it’s important to understand that if the following three years do not show a profit, the IRS may ultimately disallow those earlier losses.

Important Considerations:

The profit test is often the first and easiest factor the IRS reviews, but it is not the only factor used to determine whether an activity qualifies as a business. Other elements such as intent, effort, and how the activity is conducted may also be considered.

However, repeated losses can raise red flags and increase the likelihood of IRS scrutiny.

A note on compliance:

If the IRS determines that a return was filed fraudulently with intent to evade tax, there is no statute of limitations, meaning prior years can be reviewed indefinitely.

What you should do: