track depreciation on hobby equipment?

[Kea]

In 2010 client started buying supplies for making jewelry. In 2011 she bought some expensive equipment and more supplies. She started selling a few pieces in October 2011. In 2012 she had a baby and put the jewelry making on a temporary hold. Income less COGS is $150. But she has around $2000 in equipment and supplies. She can't itemized for 2011, but might for 2012. Still may not meet the 2% misc deduction hurdle.

Do I need to set up to track depreciation on the equipment that she can't deduct in 2011? Her supply cost is more than the $150, so no depreciation would be allowed for 2011 even if she could itemizie and meet the 2% test. If I start depreciation, does the basis get reduced by the 1st year depreciation even if it can't be used?

I've never had a hobby with depreciation!

Thanks.

[Medlin Software, Dennis]

Can;t answer your question, but your last line caught me. "All" of my "hobbies" depreciate my bank account... :P

[OldJack]

>> She started selling a few pieces in October 2011. <<

Did the taxpayer declare this was a hobby or did you?

[Kea]

>>Did the taxpayer declare this was a hobby or did you?<<

We discussed the facts and circumstances. It may become a business in the future. But for now, it's just something she's doing in her spare time. She has a "real job" as a computer tech for the local University. It's on hiatus for 2012 due to the new baby.

After discussing how IRS looks as hobbies vs. self-employment, we agreed that it was more of a hobby at this time. We will re-assess each year.

[OldJack]

>>She has a "real job"<<

Other employment is irrelevant to if this is a business or hobby. She has a substantial investment in materials and was intending to make a profit and probable did make a profit on each item sold. A business has 3-5 years before the IRS can question if it is a hobby. Then it only has to show a profit in 3 years out of 5 years to prove it is not a hobby. Even if it fails the 3 of 5 test there can be other reason for continued losses if there is a plan that should result in future profit. I expect you have convinced you client it is a hobby when it may not need have that awful status. Remember who you work for.

[jainen]

>>Other employment is irrelevant to if this is a business or hobby.<<

Based only on the original post, I'd guess that this was a business started in or before October 2011. But OldJack's reasons are misleading. According to Pub 535, factors to consider include how much time is spent and how important the income is. Therefore a full-time job is very relevant. It is also backwards to say the IRS can't question it for 3 to 5 years, or that some years of profit will prove it's not a hobby. The law presumes it is NOT for profit unless it satisfies 3 out of 5, but no presumption otherwise.

I would also not be quick to say hobby is an "awful status." You must consider the rest of the tax return, such as the effect of taking assets out of service in 2012. Not to mention that for $150 you might rather not attract a closer look, if you know what I mean. Local issues may be important too, like sales tax and business license requirements. There may even be personal issues, like the baby, that makes a business too much trouble.

So my answer to the original question is that depreciation can not be deducted on hobby assets at all. And even if they are later converted to business use, depreciation would be based on the lower of FMV or cost, which would mean she never recovers the full expense.

[Jack from Ohio]

I don't understand the logic of continuing a course of action that keeps losing money year after year. I thought the idea of a business is to produce income, not spend more resources.

[OldJack]

@jainen >>The law presumes it is NOT for profit unless it satisfies 3 out of 5, but no presumption otherwise.<<

According to IRC sec. 183:

>>(d) Presumption

If the gross income derived from an activity for 3 or more of the

taxable years in the period of 5 consecutive taxable years which

ends with the taxable year exceeds the deductions attributable to

such activity (determined without regard to whether or not such

activity is engaged in for profit), then, unless the Secretary

establishes to the contrary, such activity shall be presumed for

purposes of this chapter for such taxable year to be an activity

engaged in for profit. In the case of an activity which consists in

major part of the breeding, training, showing, or racing of horses,

the preceding sentence shall be applied by substituting "2" for "3"

and "7" for "5".

(e) Special rule

(1) In general

A determination as to whether the presumption provided by

subsection (d) applies with respect to any activity shall, if the

taxpayer so elects, not be made before the close of the fourth

taxable year (sixth taxable year, in the case of an activity

described in the last sentence of such subsection) following the

taxable year in which the taxpayer first engages in the activity.

For purposes of the preceding sentence, a taxpayer shall be

treated as not having engaged in an activity during any taxable

year beginning before January 1, 1970.<<

[OldJack]

@jainen >> Not to mention that for $150 you might rather not attract a closer look<<

@original post >> She can't itemized for 2011, but might for 2012<<

This taxpayer at income level and deduction level is a very unlikely candidate for an audit. It should not matter if it is $150 or $1500 the tax return should be prepared correctly for the facts and document the business transactions that took place.

[SaraEA]

The 3 out of 5 year opinion is a common belief but it is no hard and fast rule. Treasury Reg 1.183–2 lists a slew of indicators that an activity is engaged in for profit or not. Substantial income from other sources is certainly one of them (like making $60k at an IT job and $150 from the business). Others concern whether the activity is run in a business-like manner, e.g., state registration, sales tax #, advertising, separate business checking account, written business plan, consult with experts for ideas on how to be profitable, and changing things around in an effort to turn a profit after losing money. The indicator that often lands these activities in court is the element of personal pleasure or recreation involved. Rich people who like to build and race fast cars, and physicians who turn some land into vineyards to make wine, are typical of those who have some 'splaining to do in courts.

Maybe some of you folks who have been in this business for a long time will know where the 3 out of 5 misconception came from. I know an older preparer who reclassified as a hobby a storage rental business that had lost money for over 3 years. The owner bought land, constructed storage units, put in security systems, ran ads, etc. and had no other job. I bet he didn't find any amount of pleasure in sitting in the office chasing people who hadn't paid their monthly rent.

[OldJack]

>>The 3 out of 5 year opinion is a common belief but it is no hard and fast rule.<<

Its not just a common belief. I think USC code sec. 183 (quoted above) makes it a law which is better than a hard fast rule!

[kcjenkins]

I know an older preparer who reclassified as a hobby a storage rental business that had lost money for over 3 years. The owner bought land, constructed storage units, put in security systems, ran ads, etc. and had no other job. I bet he didn't find any amount of pleasure in sitting in the office chasing people who hadn't paid their monthly rent.

That preparer should have retired sooner. That shows he/she did not understand what they were applying.

[joanmcq]

Jack, the problem with the 3 out of 5 rule is that if she is not actively working currently to grow the business, it's not likely she'll meet the 3 out of 5 rule, and according to the OP she is not. If you don't meet it, then the previous years run the risk of being reclassified as hobbies. If it is truly a hobby at the current time, then it's a hobby.

[Jack from Ohio]

The "3 out of 5" rule is a one way rule. If an activity shows profit in 3 of 5 years, it qualifies as a business.

However, if it does NOT show profit 3 of 5, then the other tests, facts and circumstances come into play to determine if the activity is a business or hobby.

Not rocket science to see this one. Make profit 3 out of 5, the activity is a business.

[OldJack]

If it is truly a hobby at the current time, then it's a hobby.

>>COGS is $150<<

I would bet that first year sales was more than the cost of supplies used or she would not have sold the jewelry. Her supplies are inventory and should not be deducted until used. She has a tax gain in the first year and no income in the second year. Hobby status is only if there is a loss. An old saying "A bird in the hand is worth two in the bush". Why declare a hobby if it was a profit year and the preparer does not have a Cristal Ball?

[Kea]

Equipment was over $1000, Supplies (gloves and other items not sold as part of the jewelry) were over $1000; Sales were around $700; COGS were around $550. She also made some jewelry for personal use, but kept COGS (what she called "supplies") separate. No tracking fo equipment use % business (or hobby) vs personal.

I am familiar with the various general components of what goes into determing hobby vs business and discussed in detail with client. My question was about the depreciation not the hobby determination. That's why I didn't go into detail as to our determination. I guess I should not have made any comments that since no one example is enough to determine hobby / business.

I knew the depreciation would not affect the 2011 return. I was just trying to figure out if I should start tracking it in the software. I decided to leave it off the 2011 return. If / when she continues this as a hobby or as a business, I'll start the depreciation then using the FMV at that time.

Thanks for all the comments. I knew about the 3 out of 5 "rule," but did not know the details around it. It's been an interesting discussion.