Your body language can decide a hobby loss audit
Your body movement can decide a tax liability.
That sounds like an exaggeration. It isn't. The IRS issues Audit Technique Guides to the agents who run audits. There are guides for a lot of industries, and each one has its own rules and strategies for how examiners look for extra income or disallowed deductions.
There's a specific guide for hobby loss audits. One line in it really surprised me, and it's the reason I wrote this article.
What a hobby loss audit is
A hobby loss audit asks one question: were you really trying to make a profit, or is this a hobby that happens to show losses on your return?
The rule is in section 183 of the Internal Revenue Code. If an activity isn't engaged in for profit, its losses can't be used to offset your wages, your business income or anything else.
Some of the activities I see questioned most:
horse breeding, training and showing
farms and ranches run alongside a full-time career
photography, music, art and writing
boats and yachts that are "chartered" now and then
side businesses that lose money year after year
The 3-of-5-year rule (2 of 7 for horses)
Section 183 gives you a presumption. If the activity shows a profit in at least 3 of 5 consecutive years, it's presumed to be engaged in for profit, unless the IRS shows otherwise. For an activity that's mostly breeding, training, showing or racing horses, it's 2 of 7 years.
Two things people misunderstand:
Missing the 3 of 5 doesn't make it a hobby. It just means you don't get the presumption. You can still prove a profit motive with the facts.
Meeting it doesn't end the conversation. It's a presumption, and the IRS can try to rebut it.
A new activity can file Form 5213 to postpone the IRS's decision until it has 5 years (7 for horses) of history. It's generally due within 3 years after the due date of the return for the first year of the activity. The trade-off: it keeps the assessment period open on that activity for those years, generally until 2 years after the due date of the return for the last year in the period. I don't recommend it automatically. Sometimes it just flags the activity.
The line that surprised me
The IRS guide for these audits is called Activities Not Engaged in for Profit (Publication 5558). It says that, because of the nature of the issue, the examiner should interview the taxpayer in person. Not by phone, not by video, and not with written questions.
The reason it gives: so the examiner can ask follow-up questions and visually observe the taxpayer's demeanor and body language.
The guide also tells examiners to ask questions that need a full answer, not a yes or no, to ask how you know what you're stating as fact, and to keep following up on any incomplete answer until they have everything they can reasonably get.
Anyone can read these guides for free on the IRS website. Now picture reading that line the night before your own audit. How calm would you be walking in?
The nine factors the examiner is weighing
The Treasury regulations, section 1.183-2(b), list nine factors. No single one decides the case, and you don't win just by having more than half on your side.
How you run the activity. Separate bank account, real books, a budget, a business plan, and changes when something isn't working.
Your expertise, or your advisors'. Did you study the business or hire people who know it?
Time and effort. How many hours you put in, and whether you hired competent help.
Expected appreciation of assets. Land or other assets you expect to go up in value can count toward an overall profit.
Your track record. Have you turned other activities into profitable businesses?
History of income or losses. Losses in the start-up years are normal. Losses that never stop are not.
Occasional profits. How big any profits were compared with the losses and the money invested.
Your financial status. If you have large income from other sources, the losses look more like a tax benefit.
Personal pleasure. Enjoying your work is fine. But the more recreation involved, the harder the IRS looks.
Why your conduct matters more than your words
Here's what most people miss. The regulations say more weight goes to objective facts than to what you say your intent was. So when the examiner watches how you answer, they're comparing your answers to how you actually ran the activity.
If you say "of course I'm in it to make money," but there's no budget, no plan, no separate account, and nothing changed after years of losses, your answer won't carry much weight. If you can walk the examiner through your records, the changes you made and why, the answers line up with the facts.
The biggest case I know of shows how this plays out. In Skolnick v. Commissioner (T.C. Memo. 2021-139), a family ran a Standardbred horse breeding operation in Hopewell, New Jersey. It lost more than $11.4 million from 1998 through 2013, including more than $3.5 million in the four years under audit. They had written four business plans. They had seven to ten employees. None of those employees had a budget.
The Tax Court held the activity wasn't engaged in for profit and disallowed the losses. The Third Circuit affirmed in 2023. The court called the history of losses "by far" the most important factor. It also noted that the profits the family pointed to came after the IRS had already selected the return for examination, so they didn't help much.
Business plans on paper weren't enough. What mattered was how the business was actually run.
What it costs if the IRS calls it a hobby
The losses are gone. They can't offset your wages or other income, and the IRS can go back through the open years.
The hobby expenses are gone too. Before 2018, hobby expenses could be deducted up to hobby income as a miscellaneous itemized deduction. For 2018 through 2025, that deduction was suspended. The 2025 tax law (often called the OBBBA) made the suspension permanent, so it still applies for 2026 and later years.
The income is still taxable. Hobby income is reported on Schedule 1 of Form 1040. A few deductions allowed no matter what, like mortgage interest and property taxes, can still be taken on their own terms.
Penalties and interest. The deficiency usually comes with interest, and often an accuracy-related penalty.
What I'd do before a hobby loss audit
Read the guide yourself. Knowing what the examiner is looking for takes some of the fear out of it.
Organize the objective facts. Books, bank statements, the business plan, contracts, marketing, advice you got from experts, and a written history of what you changed and why.
Be ready to talk about each factor. In your own words, backed by documents.
Don't fix it after the fact. New plans and new records created after the audit letter arrives look exactly like what they are.
Bring a licensed representative. Under section 7521, a representative with a power of attorney can deal with the examiner for you, and the IRS generally can't require you to come along unless it issues a summons. In a hobby loss case the examiner will push to hear from you directly, so whether you attend, and how, is something to decide with your representative before the meeting.
Regardless of my business's profitability, I personally would not want to walk into that interview alone. That's another reason to hire a licensed professional to represent you in a hobby loss audit.
Related: Shifting the burden of proof to the IRS: why messy books don't qualify · Who has to show proof for a tax bill? IRS Appeals vs. Tax Court · Lowering your taxes is legal. A sham real estate deal isn't.
Short FAQ
What is the IRS hobby loss rule? Section 183. If an activity isn't engaged in for profit, its losses can't offset your other income.
If I made a profit in 3 of the last 5 years, am I safe? You get a presumption that it's a business (2 of 7 years for horses). The IRS can still try to rebut it, so keep your records.
Can I deduct hobby expenses in 2026? Generally no. The deduction was suspended for 2018 through 2025, and the 2025 tax law made that permanent. Hobby income is still taxable.
Does the IRS really want to meet me in person? Its audit guide for these cases says the examiner should interview the taxpayer in person, to ask follow-up questions and observe demeanor and body language.
Do I have to go to the interview? Generally, if you have a representative with a power of attorney, the IRS can't require you to attend without a summons. Talk it through with your representative first.
Facing a hobby loss audit?
We'll go through the audit letter, your records and the nine factors, and I'll tell you honestly what I see. I represent taxpayers in audits and tax problems with the IRS, New York, New Jersey, Connecticut and Pennsylvania.
General info, not advice for your specific case.
