When an activity is determined to be a hobby and not a for profit business activity, special reporting rules apply.
Gross income - The gross income from the activity is reported on line 21 on the taxpayer’s 1040.
Expenses - Expenses, to the extent of the income reported on line 21, are deductible as an itemized deduction but only in the following order:
Category 1. This category includes deductions for home mortgage interest, taxes, and casualty losses. Report them on the appropriate lines of Schedule A.
Category 2. Deductions that don’t result in an adjustment to the basis of property are allowed next, but only to the extent gross income from the activity is more than the deductions under Category1. This category includes most business deductions, such as those for advertising, insurance premiums, interest, utilities, wages, etc.
Category 3. Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity is more than the deductions under the first two categories. The deductions for depreciation and amortization belong in this category.
Additional limit - Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A, subject to the 2% of AGI reduction, and as a result, those expenses could get wiped out by the AGI limitation, and then even those that do make the AGI cut are not deductible for alternative minimum tax purposes.
Self-Employment Tax – A trade or business for purposes of determining whether an individual has self-employment income, subject to the self-employment (SE) tax, has the same meaning as when used for federal income tax purposes in allowing trade or business expenditures under Code Sec. 162 (i.e., a continuous, regular activity engaged in with a profit motive (Code Sec. 1402(c); Reg § 1.1402(c)-1).
However, since the gross income is reported on line 21 and the expenses on Schedule A, make sure your software does not assess SE tax when the activity isn’t a trade or business.