Sharon is single and a data-processing manager for the phone company. She also owns and operates a sports memorabilia store. Sharon goes to shows, subscribes to numerous magazines on sports memorabilia, and maintains a Web page on the Internet. She has been engaged in the activity for the last 5 years. During that time, she reported a net loss in two of the years and net income in the other three. Overall, her sports memorabilia activity has shown a slight loss, but the value of her collection over the 5 years has increased by 20%. Sharon rents a 600-square-foot storefront for $500 a month. Although the store is open only on Saturdays, she is usually in her office at the store 2 or 3 nights a week buying and selling sports memorabilia over the Internet. For the current year, she has an adjusted gross income of $42,000 before considering the following income and expenses related to her sports memorabilia activity:
Sale of memorabilia $11,500
Cost of items sold 3,725
Cost of new memorabilia acquired 1,500
Registration and booth fees 750
Transportation to memorabilia shows 600
Meals attending shows 250
Cost of magazines 280
Cost of Internet connection 240
Office utilities 800
Phone 400
Depreciation on computer 200
- What is the proper tax treatment of these items if Sharon is engaged in a trade or business?
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b. What is the proper tax treatment of these items if she is engaged in a hobby?
- What factors (e.g., facts, aspects) of Sharon’s sports memorabilia activity indicate that it is a hobby? a trade or business?
- What is the proper tax treatment of these items if Sharon is engaged in a trade or business?
If Sharon is engaged in a trade or business, she is allowed to deduct all ordinary, necessary and reasonable expenses in determining her business income. Without considering whether Sharon can deduct any home office expenses, her loss from the card collecting activity is $1,620:
Sales of cards $ 11,500
Cost of cards sold $ 3,725
Rent ($500 x 12) 6,000
Registration and booth fees 750
Transportation to card shows 600
Meals attending shows ($250 x 50%) 125
Cost of magazines 280
Cost of Internet connection 240
Office utilities 800
Phone 400
Depreciation on computer 200 (13,120)
Net income from business $ (1,620)
The $1,500 of memorabilia Sharon acquires is inventory and has been included in the calculation of cost of goods sold.
- What is the proper tax treatment of these items if she is engaged in a hobby?
Sharon must include the $11,500 in gross income. She is allowed to deduct up to $11,500 of expenses. The expenses must be taken in a specified order: with interest and taxes first, expenses other than depreciation second, and depreciation last. The deductions are from adjusted gross income and not deductions for adjusted gross income. In addition, for Sharon to receive any benefit for the expenses, she will have to be able to itemize her deductions. A further restriction is that the expenses are considered miscellaneous itemized deductions and are reduced by 2% of Sharon’s adjusted gross income. Sharon is allowed to deduct only $10,430 of the expenses.
Adjusted gross income before hobby $ 42,000
Hobby income 11,500
New adjusted gross income $ 53,500
Hobby expenses $ 11,500
Less: 2% of AGI ($53,500 x .02) (1,070)
Miscellaneous itemized deduction $ 10,430
- What factors (e.g., facts, aspects) of Sharon’s sports memorabilia activity indicate that it is a hobby? a trade or business?
In determining whether Sharon’s memorabilia activity is a trade business or a hobby, the IRS will examine the following nine factors:
- Whether the taxpayer carries on the activity in a business-like manner
- The expertise of the taxpayer or her reliance on expertise
- The history of income and profits
- The time and effort spent on the activity
- The taxpayer’s success in similar activities
- Whether the activity is engaged in for personal pleasure or recreation
- The taxpayer’s financial condition
- The expectation that the assets used in the business will appreciate
- The amount, if any, of occasional profits
