Moral of the Story: Guys, you don't get to deduct your losses; Gals, you have to report your income.
7. Claiming a loss for a hobby activity. Your chances of "winning" the audit lottery increase if you have wage income and file a Schedule C with large losses. And, if your Schedule C loss-generating activity sounds like a hobby -- horse breeding, car racing and such -- the IRS pays even more attention. It's issued guidelines to its agents on how to sniff out those who improperly deduct hobby losses. Large Schedule C losses are audit bait, but reporting losses from activities in which it looks like you might be having a good time is just asking for IRS scrutiny.
Tax laws don't allow you to deduct hobby losses on Schedule C. However, you do have to report any income earned from your hobbies. In order to claim a hobby loss, your activity must be entered into and conducted with the reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes you're in business to make a profit, unless the IRS establishes to the contrary. If audited, the IRS is going to make you prove you have a legitimate business and not a hobby. So, make sure you run your activity in a business-like manner and can provide supporting documents for all expenses.
