Whether you’re into painting, writing, cars or stamp collecting, there’s a hobby for everyone.
Unfortunately, the Tax Cuts and Jobs Act gave its best shot at completely annihilating the hobby activity tax deduction. However, they did leave a bit of hope for those of us who are passionate about a hobby.
We’re going to jump right into this.
NERD LANGUAGE: IRS Regulation 1.183-1(e) states, “The taxpayer may determine gross income from any activity by subtracting the cost of goods sold from the gross receipts so long as he consistently does so and follows generally accepted methods of accounting in determining such gross income.”
So, what exactly does this mean?
Let’s assume your hobby activity involves selling homemade quilts on Etsy, IRS regulations allow you to determine your gross income from your hobby activity by taking your gross receipts and subtracting your cost of goods sold.
There are two rules you need to follow to use this opportunity:
- You need to be consistent by using this method
- You need to use generally accepted methods of accounting to determine your cost of goods sold and gross income.
I’m sure you’re wondering, what is your cost of goods sold and gross income?
To get that, you’ll just need to follow these steps:
- Start with the beginning inventory (actual cost of items on hand at the beginning of the year)— for instance, let’s say this is $3,500.
- Add items purchased for sale during the year— for this example we’ll do $5,000.
- Subtract ending inventory (actual cost of items on hand at the end of the year)—$2,500.
- This gives you the cost of goods sold: $6,000 = ($3,500 + $5,000 – $2,500).
Looking back on our example of an etsy shop. Let’s say In 2018, you earn $10,000 in hobby income from product sales. You spent $8,000 to buy the products you need to make the quilts. And you have other expenses totalling an extra $3,000. What would be the right way, and the wrong way of calculating these expenses?
Hobby gross receipts
Hobby cost of goods sold
Hobby gross income
That’s $8,000 in unnecessary taxable income, which is a big difference! This just goes to show you how tax knowledge helps you win with your businesses. So keep those hobbies going!