As you likely know, tax reform killed the ability for you to deduct business expenses for your hobby activity.
But buried in IRS Regulation 1.183-1(e) is this sentence: “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.”
Let’s look closer. If your hobby activity involves selling items, 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 simple rules you need to follow to use this loophole:
- You need to consistently use this method.
- You need to use generally accepted methods of accounting to determine your cost of goods sold and gross income.
To find your cost of goods sold under generally accepted methods of accounting, follow this simple formula:
- Start with the beginning inventory (actual cost of items on hand at the beginning of the year)—say, $1,500.
- Add items purchased for sale during the year—say, $4,000.
- Subtract ending inventory (actual cost of items on hand at the end of the year)—say, $2,500.
- This gives you the cost of goods sold: $3,000 ($1,500 + $4,000 – $2,500).
Example. In 2018, you earn $10,000 in hobby income from product sales. You spent $8,000 to buy the products you sold and have other hobby expenses of $3,000 that are not category 1 expenses.
Here’s how you come out if you account for your inventory cost the right way or the wrong way under tax reform:
|Right Way||Wrong Way|
|Hobby gross receipts||$10,000||$10,000|
|Hobby cost of goods sold||-$8,000||$0|
|Hobby gross income||$2,000||$10,000|
That’s $8,000 in unnecessary taxable income—a big difference. It shows how tax knowledge helps you win when it comes to taxes.