You could run into the ugly hobby loss rule if you have an activity that creates a tax loss.
Why “ugly”? Because you could lose all your deductions and pay taxes on the income.
Example. Your activity income is $200,000, and expenses are $350,000. If the hobby loss rules apply, you could pay taxes on $200,000 of income.
Think of it:
- You lost $150,000 on the hobby—cash out of pocket ($350,000 - $200,000).
- And now, because of the rules, you pay taxes on $200,000 of income.
Yep, that’s ugly.
Know this. The ugly hobby loss rule applies to all taxpayers. Mary Kay consultants have suffered. Amway distributors have suffered. Dog breeders have suffered. Horse farm owners have suffered. No matter the profession, you can suffer the ugly result with either low or high income.
Your numbers and issues may be far different from those of Carl and Leila Gregory (the subjects of this article), but your results could be the same—no tax deductions for the hobby activity but taxation on the income.
The Law as It Is and Was
Although the Gregory court case was resolved in 2023, it involved tax years 2014 and 2015. The case has relevance today for two reasons:
- The 2014 and 2015 hobby loss rules that could allow hobby loss deductions up to the amount of hobby income are disallowed for tax years 2018-2025 but return in 2026.
- The rules in effect today deny all hobby loss deductions (other than the cost of sales) against hobby income, as you learned in the opening of this article.
Basic Facts
Carl and Leila Gregory chartered their yacht, Lady Leila, in 2014 and 2015. They did not conduct the chartering activity for profit—it was a hobby.
Though the hobby generated income, it also incurred sizable expenses each year.
The Gregorys deducted some of those expenses under IRC Section 183(b)(2) (the hobby loss section of the tax code) and placed them “above the line” to reduce their gross income.1
After an audit, the IRS determined that the Section 183(b)(2) deductions were miscellaneous itemized deductions under Section 67, meaning that they belonged “below the line” and reduced adjusted gross income, not gross income.
Tax Court
In summary judgment, the Tax Court ruled for the IRS and against the Gregorys. The Gregorys did not like that opinion, so they appealed it to the next higher court.
Appellate Court
The appellate court reviewed the Tax Court’s ruling de novo. It also reviewed the Tax Court’s application of statutes and conclusions of law de novo.
Key point. A “de novo” review means that the reviewing court examines the matter as a new case. It does not defer to the Tax Court’s findings or conclusions. Instead, it takes a fresh look at the issues and questions of law presented.
For techies. If you want a deep dive into the hobby loss rules under Section 183 and other tax code sections that relate to it, read this Gregory case. We will not get into the technical aspects in this article, because this court case did not change the law as we’ve written about it both in this article and previously.
The Appellate Court’s Decision
The appellate court agreed with the Tax Court’s finding that the Gregorys owed $267,221 in additional taxes because they could not deduct their hobby expenses.
The loss of the hobby deductions in this case is different from the 2023 example in the opening of this article, as we explain below.
It worked like this in tax years 2014 and 2015: The Gregorys had to deduct the hobby expenses as itemized deductions subject to the ceiling on this category of deductions: 2 percent of adjusted gross income. Because the Gregorys had income that reduced the 2 percent to zero, they had no tax deductions for the hobby.
Key point. Had the Gregorys incurred this loss deduction in 2023, the result would have been the same, because the Tax Cuts and Jobs Act made hobby loss expenses not deductible for the years 2018 through 2025.
Takeaways
The hobby loss rule can have significant tax implications for individuals, partners, and S corporations that engage in activities that produce a tax loss.
If you run afoul of the hobby loss rule (also known as the “not for profit rule”), you can suffer a financial burden: you not only lost money, but now you have to pay taxes on the gross income from the hobby. And you can run into this draconian rule irrespective of your income—whether it’s $20,000, $100,000, or in the hundreds of millions.
The 2023 court case involving Carl and Leila Gregory highlights the intricacies of this rule. They chartered their yacht, Lady Leila, as a hobby, generating income but also incurring substantial expenses.
The IRS moved the Gregorys’ hobby expense deductions to the correct itemized deduction category: more than 2 percent. Because of too much income, the 2 percent rule denied the expenses. The Tax Court and the appellate court upheld the excessive-income finding. Consequently, the Gregorys owed an additional $267,221 in taxes due to the ineligibility of their hobby expense deductions.
This article underscores the importance of understanding the hobby loss rule as it stood in 2014 and 2015, as it stands today, and as it will stand again in 2026.
