Christmas tree growers who show a business loss on their tax return should not be worried about the hobby loss rules, so long as their farm shows an overall net profit.
I’ve received a number of questions over the years dealing with the application of the hobby loss rules if a grower elects capital gain treatment (which will save most growers thousands of dollars in taxes).
Most of these questions go something like this:
“We’ve been using the capital gain method which has saved us thousands of dollars of taxes over the years. However, our tax preparer says if we show a loss every year on our Schedule F, then the IRS will reclassify our business as a hobby. Is this correct?”
Short answer: No! A Christmas tree grower should not be worried about showing a tax loss on their return due to capital gain method. Keep reading to learn why!
Hobby v. Business Refresher
As a quick refresher, a Christmas tree grower may owe additional taxes if the IRS classifies their Christmas tree farm as a “hobby” rather than a “business.”
A business is an activity that is (1) entered into primarily for profit and is (2) regularly and continuously carried on. Conversely, a hobby is an activity that is not engaged in for profit.
The benefit of a business classification is that any loss is fully deductible against other income, including wages or other business profits. However, a hobby classification results in no tax deduction for a loss. Any income from a hobby is taxable, while few, if any, tax deductions are permitted.
The IRS presumes an income-generating activity is a business if it shows a profit three out of five years.
Capital Gain Method & the Hobby Loss Rules
Christmas tree growers who elect capital gain treatment often show a business loss every year that is offset by a large long-term capital gain reported elsewhere on the tax return. This occurs because qualifying Christmas tree sales are taxed as long-term capital gains, while most expenses are deducted against ordinary income.
In applying the hobby loss rules to a Christmas tree farm that elects capital gain treatment, the IRS should combine the capital gains with the other business income and expenses to determine if a loss is generated.
Treas. Reg. § 1.183-1(e) includes capital gains in the definition of “gross income” for hobby loss purposes. Therefore, the capital gain and farm loss should be combined when applying the hobby loss rule.
When the capital gain and farm loss are combined, the Christmas tree farm often shows a net overall profit, which will avoid application of the hobby loss rules because IRC § 183 only applies to losses.
Conclusion
Christmas tree growers should not be concerned about the hobby loss rules if they elect capital gain treatment, so long as their Christmas tree farm shows an overall net profit. Even if their farm doesn’t show an overall profit, growers can avoid application of the hobby loss rules if by meeting as many of the nine factors detailed in this article.
Need more help with the hobby loss rules? Contact Andrew today!
