The Internal Revenue Service has a very definitive answer to help determine the difference between genuine business losses or losses that occur as part of your favorite hobby.
Simply put, according to Section 183 of the IRS Code, you can only deduct a loss that happens when participating in activities that are intended to generate a profit. Anything else is considered a hobby and not tax deductible. This rule applies to sole proprietorships as well as partnerships, Chapter S corporations, estates and trusts.
For further clarification, the IRS considers anything that has produced a profit three out of the past five years as a “for profit” (unless it’s a horse business, in which case it’s two years out of seven).
Make no mistake, you can’t just make a loss on paper and think the IRS will buy it. You must be putting forth an effort in tasks that will generate either a profit or a loss. If your situation comes to the point of an audit, the IRS will want to know if you are working on your business enough that it will actually turn a profit and that your efforts will eventually turn a profit under normal conditions. You must document your income and expenses meticulously in order for the IRS to consider your loss statement.
If you’re unsure of whether or not your loss is a tax deductible or not, you’ll want to enlist the help of a certified accountant to help you make the determination.
If you are doing your own taxes and are unsure of whether you have a deduction or not, it’s better to err on the side of caution and avoid the hassle of an audit later on.