Tax Year Prior to 2020: Schedule C or Hobby?

[Nightagna]

So I have filed a Schedule C for a Website/Photo business for 3 years, it made money (like $1000 the first year), but lost money due to depreciation (writing off new camera gear) the last two years, losses totaled under $2000.  This business is over as of today as it is not worth the effort, I told my remaining client ( a friend ) I will do the basic work he needs for free because in the end it will save me money and hassle to not be self employed anymore for such a minor profit or loss.  So in 2019 I have a $900 1099-misc that I need to deal with for 2019 tax year.  

I have 3 options (I think) , but do not know which one is correct,  

Option one file Schedule C again this year, $900 income and I did buy a new lens I used for the business in 2019 that cost $1300 that I can write off as depreciation like I did last year, so claim a $400 loss for the 3rd year in a row due to depreciation, (is this an audit flag?)

Option two, can I claim this as simply hobby income this year, pay the tax on the $900 but not get hit with SE employment tax and write nothing off,

Option three, I claim it as a Schedule C take no deductions and pay the highest tax amount of all three options to avoid any red flags,  

I don't have any intentional errors in any tax returns, but the tax code is not simple so I don't want to deal with an audit to find out I messed up something 7 years ago and now ow $5000. lol

[WKins2]

Based on the facts listed in your post, the correct option is option one; file Schedule C  reporting the $900 of income and the $1,300 lens purchase.

It is not a red flag to report losses in 3 consecutive years as long as you intended to make a profit (the IRS calls this a profit motive). If the IRS does question the profit motive, you would have to be able to show that you did operate the business as a business and not as a hobby. 

To determine if your business is a hobby, the IRS looks at numerous factors, including the following:

• Do you put in the necessary time and effort to turn a profit?
• Have you made a profit in this activity in the past, or can you expect to make one in the future?
• Do you have the necessary knowledge to succeed in this field?
• Do you depend on income from this activity?
• Are your losses beyond your control?

See When the IRS Classifies Your Business as a Hobby

As a side note, you can not just close the business and keep the assets (camera gear, etc.). You will need to sell those assets to a 3rd party or treat them as if they were sold by the business to you at fair market value. This will most likely result in a taxable gain to the business due to depreciation recapture. If that gain results in a net profit to the company, it is highly unlikely that the IRS will consider the activity to be a hobby. 

[Nightagna]

okay. but since I will not file on this business in 2020 tax year I can't depreciate the lens as I would at the same time have to sell it and claim it so that seems like a bad idea,

So you are saying I need to file schedule C claim full profit with no expenses (other than the lens I have none this year) and then add in the income for fair market value for everything I ever depreciated (last 2 years) as additional profit and pay taxes on all that too?

[WKins2]

In order to keep people from buying assets, writing them off for business use, and then transferring them to personal use (thus getting a depreciation deduction for personal-use assets), the IRS imposed "depreciation recapture" rules. For any asset for which the depreciated deduction (or Section 179 deduction) was taken, and that asset is subsequently sold or transferred to personal use, you must "recapture" that depreciation. 

With that said, you may opt not to take depreciation, or any other expense, on the asset you purchased in 2019 and just consider that a personal asset from its purchase date. But failure to include depreciation recapture for assets transferred to personal use which were previously depreciated would constitute tax avoidance. 

For more information, please see the Depreciation Recapture section of Publication 544.

[Nightagna]

Thank you for your response, I get the whole recapture in principal,  I will admit it is clear as mud in the IRS publications.  

So I will retain the property for personal use, I can go to a website that buys/sells used cameras and get a instant quote for what they would give me for the items, This is around 50-60% of what I paid for them (which makes sense as they are no longer new,)  I assume that would be acceptable to use as fair market value if I do not actually sell them?

for example in 2018 I claimed a new camera body for $1999  and used 179 deduction,  quote is for $980 right now on website,  Do I need to be concerned that it depreciated quicker than 7 years the 179 would indicate?  Also I did use for some personal use so I used 90% business use on the 179 deduction (so it shows just under $1800 depreciated). does that mean I would use 90% of fair market value?  or since the value is less than 90% already is that irrelevant?

[WKins2]

Yes, going to a website that buys/sells used cameras to get an instant quote should be acceptable by the IRS. I recommend you print the screen as documentation. It would probably also be best practice to get multiple quotes (2 or 3) and average them together. 

Because you took the Section 179 deduction, you do not need to be concerned with the 7-year IRS property life. And if you originally considered the asset 90% business use and 10% personal use, you would multiply the fair market value by 90%.