Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order and only to the extent stated in each of the following three level categories.
Level 1 Deductions
Deductions that a taxpayer may claim for personal expenses, such as home mortgage interest, taxes, casualty and theft losses, bad debts, worthless securities, tax related expenses, qualified residence interest, medical expenses, charitable contributions, etc. may be taken in full. However, these expenses must be used to reduce the amount of hobby income from which the taxpayer’s other hobby expenses can be deducted.
Level 2 Deductions
These deductions are items that would be allowed if the activity were engaged in for profit and not just as a simple hobby. These deductions consist of items that do not result in an adjustment to the basis of the property. They include operating expenses, which would be deductible if the activity qualified as a trade or business under Code Section 162 or Code Section 212.
These items include rent, utilities, maintenance, labor costs, supplies, insurance, advertising, insurance premiums, etc. They may be taken to the extent gross income for the activity is more than the deductions from the items listed in Level 1 above.
Level 3 Deductions
Level 3 also includes deductions that are allowed if the activity was conducted for profit. These deductions, however, reduce the basis of a property used in the activity. They are only allowed to the extent of any gross income remaining after the deductions for Level 1 and Level 2 have been taken. These include deductions for depreciation, partial losses with respect to property, partially worthless debts, amortization and amortizable bond premium and amortization.
If the activity has more than one depreciable property, then Level 3 allocates the deduction and related basis adjustment to each asset. The regulations state that any deduction and adjustment to basis is proportional to the depreciation deduction contributed by each piece of property.
The total Level 3 deduction allowed is divided by the total deduction that would have been allowed for the Level 3 assets if the activity had been engaged in for profit and not as a simple hobby. The deduction that would have been allowed for a depreciable asset is multiplied by that fraction.