REG CPA Practice Questions Explained: Understanding Losses from Hobbies and the Sale of Personal-Use Assets

Understanding Losses from Hobbies and the Sale of Personal-Use Assets

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In this video, we walk through 3 REG practice questions to help in understanding losses from hobbies and the sale of personal-use assets. These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.

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Understanding Losses from Hobbies and the Sale of Personal-Use Assets

Hobby Losses

Definition and Tax Implications: Hobby losses refer to expenses exceeding income from activities not conducted for profit—hobbies. The IRS differentiates between activities done for profit (businesses) and hobbies based on various factors, including the activity’s profitability, the taxpayer’s expertise, and the time and effort invested.

Disallowance of Deductions: Under the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers are no longer allowed to deduct expenses related to hobbies to the extent of hobby income. Previously, such expenses could be itemized on Schedule A, subject to certain limitations.

Reporting Income: Income generated from a hobby must still be reported on your tax return. However, because the activity is not considered a for-profit business, expenses related to the hobby—such as materials, travel, or marketing—cannot be deducted from the income the hobby generates.

Safe Harbor Provision: The IRS presumes an activity is for profit if it makes a profit in at least three out of the last five years, or two out of the last seven years for certain activities like horse racing. If this presumption is not met, the activity is typically considered a hobby unless the taxpayer can prove a profit motive using other criteria.

Example of a Hobby Loss:

Emma enjoys photography and occasionally sells her prints at art fairs. In the current tax year, she made $1,000 from selling her prints. However, her expenses for camera equipment, travel, and fair fees totaled $2,500. Under the current tax rules, Emma must report the $1,000 income but cannot deduct the $2,500 in expenses, resulting in a non-deductible hobby loss.

Losses from the Sale of Personal-Use Assets

Definition and Tax Treatment: Personal-use assets are items owned for personal enjoyment or use, not for business or investment purposes. These include things like a home, car, or furniture. When a personal-use asset is sold at a loss, the tax code does not allow you to deduct this loss on your tax return.

Sale of Personal-Use Assets: If a personal-use asset is sold for more than its adjusted cost basis (usually the purchase price plus improvements and minus depreciation if applicable), the result is a capital gain, which must be reported as income. However, if the asset is sold for less than the adjusted basis, the loss is considered a personal loss and is disallowed for tax deduction purposes.

Capital Gains and Losses: Losses from personal-use property sales cannot offset capital gains from the sale of other assets. The IRS only allows the deduction of losses from the sale of assets held for investment or business purposes.

Considerations for Collectibles: Some personal-use assets, like collectibles or antiques, may appreciate in value. If such items are sold for a gain, the gain may be taxed as a capital gain. However, the loss remains nondeductible if the item is sold for less than the purchase price.

No Carryover: There is no provision to carry over the loss from a personal-use asset to future tax years, as there might be with capital losses from investments. Each sale of a personal-use asset is considered independently, and any loss simply reduces the individual’s economic wealth but not their taxable income.

Example of Loss from Personal-Use Asset:

Jacob purchased a truck for personal recreation for $20,000. Years later, he sells the truck for $12,000. The $8,000 loss is a personal loss and is not deductible against Jacob’s other income on his tax return.

In summary, while hobby income must be reported for tax purposes, related expenses are not deductible. For personal-use assets, only gains are taxable; losses cannot reduce taxable income. Both sets of rules aim to prevent taxpayers from using personal activities to generate tax benefits not aligned with the actual economic gains and losses.

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