IRS Hobby Loss Audits

What the IRS checks in a hobby loss audit

The usual starting point is a pattern: a Schedule C or Schedule F that shows a loss year after year, often next to wages or other income that the loss reduces. The IRS Audit Technique Guide on activities not engaged in for profit (Publication 5558, September 2021) tells examiners to prepare an analysis of the activity’s income, expenses and profit or loss for the year under audit “including any prior and subsequent years that may be involved.” Expect questions about the whole history of the activity, not only the year in the letter.

The same guide shows how examiners build the case:

• Information Document Requests. The first Form 4564 request usually asks for basic books and records; a later one can target the profit-motive question.
• An in-person interview. The guide says it is “imperative” that the taxpayer be interviewed in person, not by phone, video or written questions, because the examiner is trying to judge your intentions.
• A tour and third parties. Examiners may tour the site and contact advisors you say you relied on.
• Personal costs. Before arguing hobby, examiners are told to check whether each expense would be deductible at all or is personal. The guide lists warning signs such as paying family members for household chores and deducting personal furniture.

The guide also lists why Appeals did not support some hobby loss adjustments, including that the nine factors were not addressed and the facts were not developed. That shows what a well-built answer covers. For audit formats, see types of IRS audits; for business audits generally, see self-employed audits.

The rules: IRC 183, the presumption and what a hobby can deduct

IRC 183(a) says that if an activity of an individual or S corporation “is not engaged in for profit,” no deduction attributable to it is allowed except as section 183 provides. Treasury Regulation 1.183-2(a) adds two points that matter in an audit: “a reasonable expectation of profit is not required,” but the facts must show you entered or continued the activity “with the objective of making a profit,” and “it may be sufficient that there is a small chance of making a large profit.”

The presumption. Under IRC 183(d), if the activity’s gross income exceeds its deductions in 3 or more of the 5 consecutive tax years ending with the year in question, it is presumed to be for profit “unless the Secretary establishes to the contrary.” For breeding, training, showing or racing horses the test is 2 of 7 years. Missing it does not make an activity a hobby; the nine factors still decide.

Current law on hobby expenses. The IRS Audit Technique Guide says deductions allowed under IRC 183 are “generally allowable as miscellaneous itemized deductions,” and that the 2017 tax law suspended them through 2025. Public Law 119-21 (July 4, 2025) rewrote IRC 67(h) so that no miscellaneous itemized deduction is allowed “for any taxable year beginning after December 31, 2017,” with no end date. So for 2026 returns, as for 2018 through 2025, the practical result of a hobby finding is that the activity’s business-type expenses produce no deduction.

The nine factors and the evidence that answers each one

Treasury Regulation 1.183-2(b) says “no one factor is determinative,” and the decision is not made by counting factors. The evidence columns below are practical guidance built on the regulation, not an IRS checklist.

Enjoying the work does not by itself defeat a profit motive. The regulation says an activity need not be pursued “with the exclusive intention of deriving a profit or with the intention of maximizing profits.” The key questions in IRS fact sheet FS-2022-38 make a good self-check.

Form 5213: postponing the presumption, and what it costs

Form 5213 (Rev. 2-2006), Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit, lets a new activity wait until it has a full presumption period before the IRS decides. Under IRC 183(e) and the form’s instructions:

• What it does. The determination is postponed until the close of the 4th tax year after the year you first engaged in the activity (the 6th for horse activities). If the activity shows a profit in 3 of those 5 years (2 of 7 for horses), the presumption applies to each year in the period.
• When to file. Within 3 years after the due date of the return, without extensions, for the first year of the activity. If you received a written notice that the IRS proposes to disallow deductions under section 183, you must file within 60 days after receiving it, and the instructions say this 60-day period “does not extend the 3-year period.”
• Who can’t use it. Anyone in the activity for more than 5 years (7 for horses). On a joint return, both spouses must elect.
• The cost. Filing it automatically extends the period for assessing any deficiency attributable to the activity until 2 years after the due date of the return for the last year in the presumption period (IRC 183(e)(4)).

If an audit has started and you are still within the windows above, weigh the election with a professional: it can protect early-year losses, but it keeps those years open for longer. For how assessment periods work in general, see how long an audit takes and the separate consent on Form 872.

Records that work and records that fail

This table is practical guidance, not an IRS list. Rebuilding a timeline or a profit and loss statement from bank records and emails is fine if you label it as prepared later and show what it is based on. Creating a plan or log and presenting it as one written at the time is false evidence; see audits with missing records for where the line is.

Common adjustments, penalties and a worked example

If the examiner concludes the activity is not for profit, the IRS guide’s computation steps are to remove the activity’s income and expenses from the business schedule, report the income as other income on Schedule 1, and then allow only the deductions section 183(b) permits. Examiners may also disallow specific personal or unproven expenses as an alternative position.

Penalties. The accuracy-related penalty is 20% (IRS.gov, 2026) of the part of the underpayment caused by negligence or by a substantial understatement. The IRS says an individual’s understatement is substantial if it exceeds the greater of 10% of the tax required to be shown or $5,000. Negligence “includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly” (Treas. Reg. 1.6662-3(b)(1)). Interest runs on any added tax at the federal short-term rate plus 3 percentage points, reset quarterly (7% (IRS.gov, Jul-Dec 2026) this quarter).

How to respond to a hobby loss challenge

1. Read exactly what is asked. Note the years, items and response date.
2. Write a short history of the activity. When and why you started, what you invested, how you planned to make money, what went wrong and what you changed. Tie each point to a document.
3. Answer each of the nine factors. Collect evidence for every factor, including the ones that hurt.
4. Prove the expenses separately. Even a business must substantiate each expense; remove anything personal.
5. Prepare for the interview. You can bring or send a representative under a Form 2848; see audit representation.
6. Send copies with a cover letter. Number each enclosure to the request; our audit response cover letter is a starting point.
7. If you disagree with the report, use the 30-day letter to request Appeals (see agree or appeal). If a notice of deficiency arrives, the Tax Court deadline on it cannot be extended (see notice of deficiency).

A representative is most useful when several years of losses are at stake, the activity has a large personal element, or you are deciding on Form 5213. Free help: Low Income Taxpayer Clinics represent eligible taxpayers in audits, and the Taxpayer Advocate Service helps when an IRS problem causes hardship, 877-777-4778 (IRS.gov, 2026).

Global Gate Tax Relief’s team includes licensed tax attorneys, enrolled agents and CPAs. It offers a free consultation and, if it takes the case, quotes a flat fee upfront; it does not promise outcomes. Request a free case review or call 1-877-800-8180.

Frequently asked questions

Keep reading in the IRS Audit Guide

• Self-employed and small business auditsWhat examiners check on Schedule C, from income probes to expenses.
• Audit with missing recordsHow to rebuild evidence honestly when receipts are gone.
• Form 4564: Information Document RequestHow to answer the examiner's written requests.
• Agree or appealDeciding whether to accept the examiner's findings.
• Audit response cover letterA template for sending records to the IRS.
• Audits by issueOther items the IRS commonly examines.