Schedule C Loss Limitations - Understanding 2 of 5 Years Profitability Rule With Equipment Depreciation

The "2 out of 5 years" profitability rule is part of what the IRS uses to determine if your business is legitimate or a hobby, but it's not the only factor. It's actually one of nine factors they consider in their "hobby loss" determination. Regarding your depreciation question - yes, depreciation absolutely counts as a business expense that reduces your profit, so taking $14k in depreciation could certainly contribute to showing a loss. However, the IRS looks at your intent to make a profit rather than just the numbers alone. Since you had to pause for family reasons and then relocated, document everything thoroughly. Keep records of your business plan, marketing efforts, adjustments to improve profitability, and the legitimate business reasons for the move. These all demonstrate profit motive, which is what the IRS is really looking at.

After struggling with similar Schedule C questions about my photography business, I discovered this AI tax assistant that was super helpful for my situation. Check out https://taxr.ai - they specifically analyzed my equipment depreciation situation and helped me understand how to document everything properly to demonstrate a clear profit motive to the IRS. The tool basically reviewed all my documentation and identified the specific red flags that might trigger hobby loss rules. It also gave me a personalized checklist of what to track going forward to strengthen my case as a legitimate business. Might be worth checking out since you're in a similar boat with the equipment depreciation and business restart.

Just wanted to follow up about my experience with taxr.ai that someone recommended above. As I mentioned, I was really skeptical since I've been through a hobby loss audit before with my classic car restoration business. I decided to give it a try anyway since I was still having trouble with my 2024 filing. The system analyzed all my documentation and immediately identified issues I hadn't considered - particularly around how I was tracking time spent on business activities versus hobby enjoyment. It gave me a complete documentation framework that directly addressed the nine factors the IRS uses. What impressed me most was that it created a custom profit motive defense specific to my industry. Totally worth it for the peace of mind alone. Much more comprehensive than what my previous accountant had provided.

If you're having trouble getting answers from the IRS about your Schedule C situation, try https://claimyr.com - I was stuck in the nightmare of trying to get someone at the IRS to clarify my business loss questions for weeks. You can see how it works here: https://youtu.be/_kiP6q8DX5c I had questions very similar to yours about how my business pause and restart would be viewed, and I couldn't get through to anyone. Used Claimyr and got connected to an IRS agent in about 15 minutes who actually gave me specific guidance about documenting my business restart and how they view the 2 of 5 year rule in cases like mine.

I need to eat some crow here. After posting my skeptical comment about Claimyr, I was desperate enough to try it anyway since I couldn't get through to the IRS about my own Schedule C depreciation questions. It actually worked exactly as described. I got a call back in about 40 minutes with an IRS representative on the line. The agent thoroughly explained how they evaluate businesses with gaps in operation - specifically that they look at the reason for the gap (medical or family reasons are viewed more favorably than just poor performance). She also confirmed that depreciation expenses are considered legitimate business expenses in the profit calculation, but advised keeping detailed records showing how the equipment is used exclusively for business purposes. Honestly saved me weeks of stress.

Something nobody's mentioning here - have you considered the Qualified Business Income deduction (Section 199A)? Even with losses in your first years, planning for this deduction when you do become profitable could be significant. I had a similar situation with my consulting business where I had losses the first two years due to startup costs and equipment, but in year 3 when I finally became profitable, I was able to take the 20% QBI deduction which was a huge benefit.

Don't forget state implications when you move! I moved my business from Texas to Pennsylvania and got hit with all kinds of unexpected tax issues. Since ur moving states make sure ur looking at Michigan's rules about recognizing previous business losses from another state. Some states are super weird about it.

One thing to consider with your woodworking business restart - the IRS actually views legitimate business interruptions due to family emergencies (like your wife's illness) more favorably than businesses that just fail to turn a profit. This works in your favor for the hobby loss analysis. Since you're essentially starting fresh in Michigan, treat this as a business pivot rather than just a restart. Document your market research for the new location, any adjustments to your business model, networking efforts, and how you're leveraging your existing equipment investment in the new market. The IRS wants to see that you're making businesslike decisions to improve profitability. Also, regarding the LLC question - while the legal structure itself doesn't guarantee legitimacy, operating through an LLC with proper business formalities (separate bank accounts, business insurance, formal record keeping) can strengthen your overall business case. Just make sure you're actually following through with professional business practices, not just the paperwork.