What Is the Hobby Loss Rule?
The IRS Hobby Loss Rule (Internal Revenue Code §183) is the legal line between a hobby and a business. If the IRS decides your activity is a hobby — not a real business — it disallows your expense deductions entirely under post-TCJA rules. That means you owe taxes on gross revenue, not net profit.
This is one of the most consequential distinctions in the tax code for side-hustlers, Etsy sellers, and independent creators.
The 3-of-5 Year Safe Harbor Test
The IRS offers a Safe Harbor: if your activity shows a profit in at least 3 of the last 5 consecutive tax years, the IRS presumes your activity is a business. You don’t have to prove anything further.
| Years Profitable (of last 5) | IRS Status | Risk Level |
|---|---|---|
| 4–5 years | ✅ Presumed Business | Safe |
| 3 years | ✅ Safe Harbor met | Safe |
| 2 years | ⚠️ Critical — 2026 is your last chance | High Risk |
| 0–1 years | 🚨 Likely Hobby | Audit Risk |
The 2-of-5 Warning: If you have exactly 2 profitable years in your last 5, you are in a “Critical Year.” You must show a profit in 2026 to avoid losing your Safe Harbor.
What Counts as a “Profit”?
For §183 purposes, a profit year is any year where your gross revenue exceeds your total deductible expenses. Even a profit of $1 counts.
Keep meticulous records:
- Receipts for all business expenses
- Income statements (Etsy dashboard exports, PayPal records, etc.)
- A dedicated business bank account (this is the #1 signal the IRS looks for)
What Happens If the IRS Classifies You as a Hobby?
Under the Tax Cuts and Jobs Act (TCJA) rules still in effect for 2026:
- ❌ Zero deductions allowed for hobby expenses (miscellaneous itemized deductions are suspended through 2025, extended through 2026)
- ✅ All revenue is still taxable
- 💸 You could owe taxes on your full gross revenue, not your profit
Example:
- Etsy seller: $3,000 revenue, $2,500 in materials and fees
- As a business: taxable on $500 profit
- As a hobby: taxable on the full $3,000 → potentially hundreds of dollars more in taxes
The 9-Factor IRS Audit Test
Even without the 3-of-5 safe harbor, you can argue your activity is a business using the IRS’s 9-factor test from Treasury Regulation §1.183-2:
- The manner in which you carry on the activity (businesslike?)
- Your expertise and time devoted to it
- Time and effort you put into the activity
- Expectation that assets will appreciate
- Your success in similar activities
- Your history of income or losses
- Amount of occasional profits (if any)
- Your financial status (is this your main income?)
- Elements of personal pleasure or recreation
The more of these factors you can demonstrate, the stronger your case for business status — even without 3 profitable years.
Practical Tips to Protect Your 2026 Status
- Open a business checking account — even a free one. The IRS weighs this heavily.
- Write a simple business plan — even a one-page document showing your revenue goals.
- Track and categorize every expense — use a spreadsheet or free tool like Wave.
- Show consistent effort — work on your activity regularly, not just seasonally.
- Document pricing research — show you are trying to be profitable.
- File Schedule C (not Schedule A) — this signals to the IRS that you treat it as a business.
Use Our Free 2026 Tax Estimator
Not sure where you stand? Our Hobby-to-Pro Tax Estimator calculates your SE tax exposure, evaluates your §183 Safe Harbor status, and tells you whether forming an LLC makes financial sense for your specific state.
It’s free, anonymous, and takes less than 2 minutes.
This article is for general informational purposes only and does not constitute legal or tax advice. Consult a licensed CPA or tax attorney for guidance specific to your situation.