If you are in business with the objective of making a profit, you can generally claim all your business deductions. If your deductions exceed your income for the year, you can claim a loss for the year, up to the amount of your income from other activities. Remaining losses can be carried over into other years.
However, your ability to deduct these losses will be limited if the IRS considers your business to be a hobby.
Losses incurred by individuals, partnerships and S corporations in connection with a hobby are generally deductible only to the extent of the income produced by the hobby. In other words, you can't use a hobby to generate a tax loss that can be used to shelter your other income.
Some expenses that would be deductible on your individual income tax return regardless of whether they are incurred in connection with a hobby (such as real estate taxes, home mortgage interest, and casualty losses) are deductible even if they exceed your hobby income. However, these expenses must be used to reduce the amount of the hobby income from which your other hobby expenses can be deducted.
Every bit of your hobby income is reported as "other income" on Line 21 of your Form 1040, Individual Income Tax Return. However, expenses associated with the hobby are only deductible if you itemize your deductions. What's more, they are considered "miscellaneous itemized deductions" and you can only deduct the portion of them that, along with any other miscellaneous deductions, exceeds 2 percent of your adjusted gross income.
Although the IRS is not limited in the kind of businesses that it can challenge as being hobbies, businesses that look like traditional hobbies (such as "gentlemen farming" and craft businesses run from the home) generally face a greater chance of IRS scrutiny than other types of businesses.