QUESTION: Last year I lost $4,000 in FX trading using my home computer as a side "hobby". How do I account for that during tax time? What line, how does it affect my taxes, and is the whole amount a deduction from my regular income as an employee?
ANSWER: Hobbies are not deductible.
No accounting necessary.
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QUESTION: My intention was to have it as a viable income source in addition to my full time job as an employee. I did it during my free time away from work. Can't that be put in line 13 as a capital loss?
I would caution against a casual approach to business. People get wiped out.
Let me describe the real world results and provide the details that would lead you there.
First, if you go to IRS.gov and do a search for "hobby" (your description) you'll find in every reference, as I said that hobbies and any related costs are not deductible. In fact legitimate businesses are often reclassified as hobbies and all previous deductions are disallowed.
While not all, many of these were strident efforts by good people to take some control of their own destiny and threw themselves into a business. And yet, because they did not have a strong understanding of the IRS rules that were stacked against them they lost; possibly everything. So if you are not really committed to the business as a business, and aren't willing to do all that it takes to succeed, then it is better to not jump in at all.
Even if you agreed to never use the word hobby again in describing your efforts. Even if your accounting is impeccable, your record keeping exceptional, and your diligence commendable, that is not enough for you to not get shattered by IRS code.
Let's take a look:
You decide to make trading your "business" not necessarily full time, but a real business. You have a $4000 capital loss (yes that can be put on line 13) but you also then keep track of the cost of your trading software and Internet service, you subscribe to some services to be better informed, etc. This year you make $1000 in gains, but have close to that in costs, next year you, make $4000 in gains, have another $1500 in expenses and you close out the year at just under breaking even.
You have just failed the first threshold for the IRS. You see the IRS has the 1 in 3, 2 in 5, rule. If you do not make a profit at least one out of three years and 2 out of the first five, then the IRS can recharacterize your entire business as a hobby and disallow all of your deductions. In those years you might have taken a 25% tax break on your expenses. At $2500 the tax savings would have been a total for all years, of $625. But this is now a hobby, that 625 was owed in those years, unpaid taxes incur penalties and interest, could be 50% in penalties and interest for a few years. You'll owe better than $1000.
That is if you are caught at the end of the third year, what happens if you don't get audited until year 4 or 5 when you have leveraged up and really pumping some money into the business?
There are other gottchas that are set up for unsuspecting future entrepreneurs, like payroll taxes. Are you a qualified trader that will be deducting trading education? Oops, needed to pay self employment tax on those gains. That is 15.3% on the gross. How can you make money with that kind of a draw down?
Okay, reality check over. If you want to be in business, and I love business and would encourage all (that are willing to do what it takes) to get into business, any business, it is an incredible journey; whether you make a living or not. But you have to do it right. Regulation and Administration are set to cut you off at the knees at the first opportunity. Taxation and Litigation are realities so close you can feel them breathing down your neck.
If you are getting in, then do so being prepared. Business structuring, understanding the entirety of management, All things that we do with business owners to make sure they remain successful and not simply become a statistic because they were blindsided.