If an activity actually shows a profit, this may be the determining factor in establishing it as an activity engaged in for profit and not as a hobby or to generate tax losses. The IRS will presume that an activity is engaged in for profit if it has generated profits in 3 of the last 5 years, including the current year. The activity must be substantially the same each year in order to meet this test. For activities involving the breeding, training, showing, or racing of horses, the test is profitability in 2 out of 7 years.
If this test is met, the IRS will presume that the activity is engaged in for profit and the limitation on deductions and losses will not apply. You will be able to take all your allowable deductions for the activity in the future, even during years in which you have a loss.
Form 5213
During the first years of carrying on your activity (5 or 7 years, as applicable), until you meet the test for presuming that your activity is being carried on for profit, you can file Form 5213 with the IRS. Form 5213 is called “Election to Postpone Determination As To Whether the Presumption Applies That an Activity is Engaged in for Profit”. This will postpone an IRS determination that your activity is not being carried on for profit and therefore disallowing your deductions or losses related to the activity. By filing Form 5213 you are effectively gaining time to show that your activity can generate a profit and that your losses in the initial years should be allowable losses for tax purposes.
The benefit of filing Form 5213 is that the IRS will not question whether your activity is a not-for-profit activity during that period, and will therefore not immediately disallow the deductions and losses you claim related to that activity.
If at the end of the presumption period, you have met the test of profitability in either 3 out of 5 years, or 2 out of 7 years, as applicable, the deductions you claimed during that period will be allowed. On the contrary, if at the end of the presumption period, you have not shown the activity to have been profitable in the required number of years, the limitations on losses will be applied retroactively.
Filing Form 5213 automatically extends the period of limitations (the period for which the IRS can question your returns) for any year within the 5 or 7-year period to 2 years after the due date for filing a tax return for the final year of the presumption period. The period of limitations is extended only with respect to deductions for the activity in question and any related deductions that are affected, and not other, unrelated items reported on your tax return.
If you intend to use the presumption rule, you must file Form 5213 within 3 years after the due date for the first year in which you carried on the activity. But if before that time, the IRS has proposed disallowing deductions related to the activity, you must file Form 5213 within 60 days after receiving written notice from the IRS, in order to postpone the IRS determination.
The use of Form 5213 and the presumption test of 3 out of 5, or 2 out of 7 years of profitable activity is one way to show that your hobby or other activity is an activity that is engaged in for profit, but it is not the only way. If based on the other factors described above, you can support the fact that your activity should be considered as an activity entered into for profit rather than a non-profit activity, you can claim your deductions and losses related to the activity, and you should be able to defend your position in the event the activity is questioned by the IRS.