Be ready to prove that your hobby is a business if you want to write off your hobby losses.

Often a person's hobby or sideline business is a labor of love rather than a reliable source of income. This is most often the case when the business owner or freelancer has other means of financial support -- such as a regular job or a working spouse -- that effectively underwrites the microbusiness. These types of tiny businesses are usually run from home (renting an office would be too expensive) and are often based on semi-recreational activities near and dear to the owner, which has earned them the nickname "hobby businesses."

There are as many types of hobby businesses as there are hobbies. A basement jewelry studio, a jazz band for hire, or an antique refinishing business might all qualify. The owners would probably continue to make jewelry, play jazz, or restore antiques without making money, but they are trying to turn their hobbies into profitable businesses (or at least deduct their hobby-related expenses or losses from their income to lower their tax bill!).

Deducting Hobby Losses From Your Income

For most business owners, losing money for more than a year or so is a cue to close up shop. But if you love what you're doing, it might make sense for you to stick with your losing business even though it makes little or no money. That's because an unprofitable business can be a tax shelter: If you have another source of income, you may be able to use the losses from your hobby business -- including your expenses and depreciation on assets you purchase -- to offset your other taxable income. Deducting these losses can not only lower the amount of income on which taxes are owed, but may also drop you into a lower tax bracket.

The catch is that only bona fide businesses can deduct their losses from their other income -- you're not allowed to deduct losses from your favorite activities, only from a legitimate, profit-motivated business. If the IRS decides that you are indulging a hobby rather than trying to earn a profit, it won't allow you to deduct your business losses.