Posts Tagged ‘hobby losses’

Recovering From Financial Mistakes Like the Wealthy

Financial losses are hard to take. This is how the wealthy deal with financial hardships and mistakes.Regardless how experienced or educated you are you will still make financial mistakes, some of them humdingers. Personal finance blogs and media outlets frequently share basic financial mistakes to avoid: spend less than you earn, invest in index funds, avoid debt and so forth. All this is good advice, but it goes a lot deeper than this.

There are financial mistakes that involve much larger sums of money that can cause permanent damage to your financial situation. To top it off we are in a much different economic environment than ever before. 

Side hustles are more common than ever and no matter what kind of activity you consider a side hustle it is still a business. And business can inflict as much, and even more, pain than student loans, credit card debt or job loss. 

Today we will move beyond the basic advice and delve deep into the financial mistakes that are harder to plan for and hence avoid; the financial mistakes that can not only surprise, but destroy a fortune of any size. 

To help you understand the seriousness of these mistakes I will use examples from my past. The good news is I recovered from each disaster much wiser, using the new-found experience and knowledge to push profits to greater heights.

Some of the issues we will touch on are foreign ideas compared to the “spend less” advice. For example, you will see how over-confidence and arrogance caused me plenty of pain throughout my life. What seemed like a great idea was anything but, and I walked into it eyes wide open because of that pair of rose-colored glasses I like to keep handy.

Worse, I should know better. As a tax accountant with a history as a financial adviser, I should have know better. The things that got me were not alien concepts. And if they can get me they can get you no matter how smart you think you are.

My goal is to give you the tools to avoid these errors in thinking that virtually guarantee financial disaster. I will also share how I recovered from each event and grew from it. Hopefully you recognize the patterns of my errors in your behavior and make corrections before you suffer the same results.

 

Young and Dumb

In my younger days I made a lot of solid financial decisions. I also got lucky. 

I avoided the over spending and debt issues that plague so many and I never put any of my education, formal or informal, on the credit card. That means I was able to invest in mutual funds (I used actively managed funds back then) and individual stocks. 

Growing up in the backwoods of Nowhere, Wisconsin had its advantages. I never made a lot of money, but had nowhere to spend it even if I did. I was on a sort or forced frugality diet so don’t think I was somehow smarter than you. I wasn’t! 

Those first years of adulthood were formative years. I grew up on a farm and knew of nothing else. Then the family farm went teats up (we were dairy farmers) just under six months after I graduated from high school. Now what was I going to do with my life?

Growing up rural and poor meant I dreamed of wealth. I wanted to be the richest man alive some day and go to the moon, too. To farm, of course. I was an even mixture of Elon Musk and Warren Buffett.

Things didn’t pan out as planned, but I did better than most, so no complaints. I was also on the cuff of my first of many significant financial mistakes.

The family farm was gone, but the dream lingered on. It must have been about 1984 when I decided I would move my investing horizons to something that could grow wealth faster than the red-hot stock market of the mid 1980s. 

I kept money in individual stocks and mutual funds, but I was ready to tackle commodities. Soybean futures to be exact. 

Well, I had a farming background! I knew (I thought I knew) more than those pinheads sitting in an office about farming and soybeans. So I started trading soybeans and (OMG!) soybean options. 

10 success lessons taught by the rich. Turn failure into success! Your response to failure determines your level of success. Recover from financial mistakes like the wealthy.As with most financial disasters, things started out promising. I had the golden touch and don’t think for a moment people weren’t noticing. 

I knew farming and I knew soybeans, though we never grew soybeans on our family farm. 

I turned a small investment of a few thousand dollars into nearly $40,000. And that is when this poor farm boy started to experience an inflated skull.

I had managed to accumulate other investments (mutual funds and stocks) of nearly $100,000. Not bad for a 20 year old that started out with maybe a thousand or so when he turned 18.

Now that I had another $40k to grace my net worth ledger I wanted to get serious about this soybeans thing. I sold only mutual funds at the time to fund my next big push. However, family noticed my talents, too, and dear old dad thought he would hitch a ride to the tune of $9,000.

Well, if I hadn’t made every possible move to hex my parade I don’t know what else I could have done to accomplish it. 

And wouldn’t you know it. Now that I was all in I started to believe in my infallibility. I made a risky (all commodity trades are risky by nature unless you are hedging: buying and selling commodities as a producer or consumer of said commodities) all or none trade. If it worked there would have been a six figure gain. If it failed I would lose most of my account value.

At the time I didn’t realize how much I was putting on the line. I was too arrogant to see it. In three days it was over. Soybeans locked limit (the maximum move a commodity can move in one trading day) and it wasn’t going my way. 

I was actually lucky! When a commodity locks limit against you it is impossible to close your position. The losses can mount fast and the leverage is massive. 

Dad did not get much of his $9,000 back and most of my $40,000 was gone. I will never forget that feeling. It took a long time to recover emotionally. Good thing dad accepted what happened. He doesn’t talk about it all these years later.

 

Lesson 1: Commodities are not an investment!

I know this is a hard concept for people to understand, but commodities, along with land and other such so-called investments, are not real investments. 

Land is not an investment unless you intend to improve said land, creating value, the basis of investing. Gold, corn, pork bellies (bacon) and soybeans are NOT investments; they are speculative tools unless you are hedging your production or consumption of the underlying commodity. And if you are hedging it is a business tool to control costs; still not an investment.

Lesson 2: Don’t get cocky!

Just because you are on a roll doesn’t mean you are right. I thought I was so smart as every trade went my way. Then I lost all those gains and more in one stupid trade thinking I was smarter than everyone else. (Remember those office pinheads this farm boy was smarter than?)

Whether it be in business or any other endeavor in life, always know it might be luck working your way temporarily. Luck is a fickle creature and only a fool relies on such a fickle beast. Caution is warranted at all times when investing and in business.

Lesson 3: Don’t borrow to invest!

While I didn’t borrow from the bank, I did take money from dad (actually an equity investment) to increase the size of my trade. Both choices (bank loans or an equity investment from dad) are incredibly bad.

Lesson 4: You can’t consistently trade profitably!

I know, I know. Everyone thinks they can do it. We hear about money-center banks earning gazzions every quarter trading. Except they are hedging more than speculating. And when they decide to speculate we remember their name as Lehman Brothers: 158 years of conservative investments pissed away in a breath. 

Back when I was young I didn’t have the experience I have today. Now, after all these years as a tax accountant, I can show you an endless list of clients who have traded their way poor. I’m trying to recall even a single client who traded his way to a fortune and coming up blank. I do have several in mind who lost a life of work “playing the market”. 

Lesson 5: You don’t “play” the market!

Enough said.

Lessons Learned

The all or none mindset died for me that day. I never again bet the farm on a flyer. 

The loss also instilled in me a deep desire to research investments before investing or adding to an investment. I have made investing mistakes over the years, but nothing like that fateful day in 1984 when soybeans were going to send Hillbilly Accountant to the promised land. 

When it sounds too good to be true it probably is. I missed plenty of deals due to my caution. I also missed a fair number of blood-lettings, too.

Over-confidence, cockiness and arrogance are hard to avoid when enjoying a temporary visit from Midas. Controlling emotions are more important than almost any other factor when investing. People want to buy a “hot” market and get scared out of a bear market. Buying high and selling low has never been a good strategy. I have trained myself to react emotionally the opposite of normal human nature. When a great company is on sale I buy (after adequate research). I only sell if it makes sense in my personal situation. The “market” has nothing to do with my decision process.

 

Changing the World

Now I will share a business disaster from the archive. 

When it comes to business, including side gigs or side hustles, mistakes will happen and there is always a cost. A well thought out plan has half a chance of creating a profit. Then there are those times when we are introduced to humility.

Sometimes an opportunity that looks incredibly good fails miserably. Usually rose-colored glasses were involved.

You can reach your financial and retirement goals. See what this child does that virtually assures he will be a success in life.In this situation I was going to change the world and challenge the Big Guys.

You might have noticed the 1040.com banners on this blog where you can prepare your own tax return. Well, back when that program was just beginning (it was in beta the first year offered to the public) I saw an opportunity to create a massive platform. 

My professional tax software provider created the 1040 environment. I wanted to capitalize on this as soon as possible as other clients of the software provider had the same chance I did. I had to move quick to lock up market share.

To do this I developed a large advertising campaign: television mostly. My ad schedule was aggressive, especially for such a test idea. But I wanted to get a jump on the competition.

Long story short, I spent $80,000 in advertising before I pulled the plug early in the tax season. The revenue: $3,000. 

Yes, I lost $77,000 is a few weeks. Thank God I didn’t get caught in the sunk-cost fallacy! It was also a good thing my tax practice was established. I still had a profitable year, just $77,000 smaller.

The story is short, but the lessons many. Since the program is still around and much improved (one of the best, if not the best, in my opinion) you might surmise there is a happy ending to the story. There is, kinda.

 

Lesson 6: Don’t trick yourself into rushing a project!

It is tempting to forgo proper testing before a full product launch. The 1040 project had plenty of potential, but the program was still in beta. There were issues that first year of operation. And I had no exclusive. Even a jump-start on the competition didn’t guarantee I’d keep the clients.

The competition never materialized. Yes, the Big Guys were there and still are. But the worry other accountants might want to capitalize on this, squeezing me out of the market, never happened. I rushed for no reason and dropped a cool 77 grand for nothing. Plus all the aggravation!

Lesson 7: Sunk cost!

Good fortune smiled on me. This project was new enough and the capital invested didn’t cause a sunk-cost mindset to manifest itself. If it had the damages would have been multiple times larger. 

Lesson 8: Arrogance again!

I was so cock-fire sure I was right on this I was willing to go all in with a pair of twos. Stupid!

Liking an idea is NOT good enough! I needed to do market research and test the product more fully before unleashing such a large investment. I put the cart before the horse and paid the price.

Never fall in love with an idea or project. it’s business and nothing more.

Lessons Learned

Some mistakes are merely a lesson. In this case I knew I had a good idea on my hands, I just executed wrong. As 1040 improved their product, clients from the first year came back (at least a few did). So I had a quasi annuity on my hands. In 3 or 4 thousand years I might break even.

I continued to love the DIY tax preparation idea. Every year since that fateful first year I continued to promote the program with free promotional ideas. I published articles mostly with links to the platform. Growth was slow, but noticeable.

Then I had this idea to hook up with a popular blogger and sought an audience with Mr. Money Mustache. MMM didn’t care to partner with me on the idea, but gave it a push, which helped tremendously. 

This blog has also provided steady pressure on the growth trend. To date I have recouped nearly $40,000 of the original $80,000. At current rates I will break even in about six years; if it continues to grow, a bit faster.

Lesson 9: Never give up!

If the business plan is solid never give up. But always evaluate before leaping! And always test before spending. There are plenty of free opportunities to share information on your product or service. If I hadn’t sunk $80,000 into this beast I would already be profitable!

Lesson 10: Think before leaping!

As I already said. But it was worth repeating since this is the cause of a great many errors.

 

Coda

Of course I made many, many more than these two financial mistakes in my life. Thankfully most were small and I was a fast learner (maybe that should be Lesson 11). 

The biggest mistake you can ever make is to get gun shy after a financial disaster. Once you are too afraid to take action you are in a death spiral. 

You will make mistakes! Lots of them. Show me someone who never made a mistake and I’ll show you someone who never tried. 

All is not lost if you learn from your mistakes. 

Sometimes you even try something knowing it is a mistake just to gain the knowledge and experience! Keep the investment small so the damage is light, but do try. It is the only way to learn.

 

This post is the result of a question on Facebook. In the Choose FI group the question was asked about what our biggest financial mistake was. I commented tongue-in-cheek that I would need a few million words and plenty of time to explain the errors of my ways. A reader of this blog commented to me this would be a good blog post idea. I agreed and here we are.

(Tax season is getting long and fatigue is setting in. I didn’t want to research another tax issue to publish while swamped with tax issues at the office.)

We learn far more from our failures than our successes. Success convinces us we are right, like my original soybean trades. Of course we sometimes discover we were not as right as we thought we were. 

Failure on the other hand leaves its mark. We remember pain a lot longer than the pleasure. 

You will make mistakes, lots of them. I’ll make many more as well as my tax practice evolves along with this blog and the courses I plan on publishing soon. If any of these things fail they will only cause minor pain. 

I learned my lessons.

 

 

More Wealth Building Resources

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cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

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It Pays to Have a Hobby

The demographic reading this blog does the things necessary to retire early. The same demographic believes in a side hustle to retire even earlier or to fill time once work becomes an elective. These facts make hobby rules an important consideration. The tax law has a massive loophole few use.

Accountants in the room will understand what I say next. A client walks in the door and his hobby finally turned a few dollars of revenue. No worries, the client says, I can lose money in my business for three years before I have to shut it down and start over. The client actually thinks there is a rule saying you must make a profit 2 out of every five years. By this yardstick, Tesla, a publicly traded company, would have to shut down. (Tesla has a decade of loses as I write this.)

The rule people think applies to small businesses actually is a hobby rule meant to serve the IRS, not you. If the rule wasn’t there, people like me would have a field day. Self-employment tax would be a thing you only read about.

People want to be a business when they lose money and a hobby (if they knew the rules) when they have a profit. Race car drivers want to write-off $48,721 of expenses because they won $2,100 of prize money racing. Sorry, it doesn’t work that way.

But there is a strategy here you can use to seriously reduce your tax burden.

Why You Want to be a Hobby

Hobby can be a four-letter word coming out of your accountant’s mouth. Hobby income is reported on the front page of Form 1040 as Other Income; Line 21 on the 2016 return. Expenses are deductible on Schedule A, subject to 2%. That means for you need to itemize before any hobby expenses actually reduce any of the hobby income. If you don’t have enough to itemize, all the deductions are lost. It also means the first 2% of your AGI doesn’t count either. A lot of stuff gets shoved into the subject to 2% line. Tax preparation fees, safe deposit boxes and work related expenses also go on the same line. All these items added together have to exceed 2% of your adjusted gross income before it counts.

Example:  If you have a $100,000 AGI, the first $2,000 you claim on Schedule A, subject to 2%, will not help you. If you have $2,000 of hobby income and more than $2,000 of hobby expenses, you have a problem. You can only claim hobby expenses up to the amount of hobby income. In this example, hobby income is $2,000 (claimed on Line 21 of Form 1040) and expenses of $2,000 (the maximum you can claim in this example) do you no good unless there are other deductions to claim, subject to 2%, and if you itemize.

But there is one advantage hobbies have over every sole proprietorship: self-employment taxes. Remember when I said clients with losses want to be a business and clients with profits want to be hobbies? Self-employment tax is the reason why. When you have more expenses than revenue you want to deduct everything so you want to be called a business. When you have profits, you want to avoid the dreaded 15.3% self-employment tax. The only way to do that is to be a hobby. Now you know why the IRS has the three out of five year rule for profits. It is not to determine if you can deduct business expenses; it is to determine if you are a business when you claim to be a hobby. Too many years of profits and the IRS can sock you with self-employment taxes.

Now you know the rules. And if you think about it, you also know how to game the system. But first we need to lay out the rules for determining what a business is before we attempt to game said system (and to keep you reading to the end of the post).

Business versus Hobby

There are nine factors in determining if you are a business:

  • The manner in which you carry on the activity.
  • Your expertise or that of your advisors in the activity.
  • Time and effort spent by you in carrying on the activity.
  • Your success or lack thereof in similar or dissimilar activities.
  • Expectations assets will appreciate in value.
  • Your history of income or losses with respect to the activity.
  • Amount of occasional profits, if any.
  • Your financial status.
  • Elements of personal pleasure or recreation.

Certain actions make it clear you are a business. Your actions play a large role in determining if you are a business or engaged in a hobby. There are reasons to want to be a hobby and times when you want to be a business as fast as possible.

Now I will show you how to put $10,000 or so of side hustle money in your pocket and pay $1,500 less in taxes. You will want to scroll back to the bullet points above as we work through a couple ways to game the tax code.

Make It a Hobby

For all our examples we will assume the same parameters. You have $10,000 of side hustle income with few, if any, expenses. You can play with the numbers on your own to include expenses. Remember, hobby expenses are claimed on Schedule A, subject to 2% of AGI and you can only deduct only up to the hobby income level. My examples are simple so we can work through them easily and compare each situation. (Note: The TCJA eliminated all Schedule A deductions, subject to 2%, including hobby expenses. See note at the end of this post.)

We will start with two examples combined: race car drivers and taxpayers in fishing tournaments. If you have one of these on your tax return, don’t call my office. I don’t want to do the return. You have a hobby and you don’t want to hear that from me. The $842 of income does not allow you to call yourself a business and deduct a $62,000 bass boat, trailer and SUV to haul it. If you won every race or every fishing tournament it would not be enough to turn a profit. If it is impossible to turn a profit you are a hobby. The end.

Look at the list above. You might have expertise, but you get a lot of pleasure from the activity. Pleasure is not an overriding factor. I love doing tax work. My tax practice is NOT a hobby. (Not legally, at least. If they let me call it a hobby I would kill’em on taxes.) There are no profits ever! You lose money fishing or racing and always will. Yes, yes. I know. You think you are Rick Clunn or Richard Petty. For everybody else you are a hobby. Suck it up.

Now it gets interesting. What if you are an Uber driver? Interesting, right? Would you buy a $20,000 car just to earn $10,000 on the side? Probably not. The expense is too much compared to the revenue. And many Uber drivers do it for a while very part-time and then quit. You even get a 1099-MISC telling you you have business income. But do you really?

Picking up strangers for chump change is not conducting yourself in a businesslike manner. Unless you are also a taxi driver it is doubtful you have prior expertise. Sure you know how to drive and have a driver’s license, but you are acting like someone out to make chump change on the side and move on. You already have more than enough money to retire so you are not doing it to feed the wife and kids. I think many Uber drivers overpay their tax as business owners when they are really carrying on a hobby. Then they stop. They don’t carry on the activity for three years and therefore can’t turn a profit three out of five years. (I see some people leaving the room to call their tax professional right now.)

I could go on, but you get the idea.

Two Problems Solved

There are still two problems to deal with: the pesky 1099-MISC telling you and the IRS you have business income subject to self-employment tax and how to figure out if you will actually turn a profit three out of five years. The future is only clear after it happens.

The 1099-MISC is an easy fix. We will use our Uber drivers again. Uber does their patriotic duty by telling you how much income to report to the IRS. They also tell the IRS in case it slips your mind. The IRS expects to see that income on Schedule C where they can tax the daylight out of it. It is best to tell the IRS computer what it wants to hear. Claim the income on Schedule C and under other expenses list the entire revenue as an expense, listing the item as Hobby Income Reported on Form 1040, Line 21. The Schedule C will have zero profit or loss. Then report the entire income on Line 21 on the front for Form 1040. Any expenses can go on Schedule A subject to 2%. The revenue/profits are only subject to income tax since there is no self-employment tax on hobby income.

The last problem to solve requires you to see the future with absolute clarity. I don’t know about you, but I am darn good at predicting the future. My day trading skills (okay, bad example) proves how well I can see future events.

How do you know if you will turn a profit three out of five years? Heck, when you start you don’t even know if you will want to do it for three years, not to mention five. The last thing you want is the IRS giving you a proctology exam over $1,500. It’ll take more than $1,500 before I allow anyone to probe my backside!

The solution is simple, kind of. You can postpone determination of your activity as a business or hobby by filing Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in for Profit. (Only the government can create a form with a name like that.) The form is simple to fill out and simple means the statuette of limitations is extended for the hobby issue. A lot of tax software does not have Form 5213. Some hide the form on the Elections screen. You can also scan the completed Form 5213 and attach it to the return. When you efile the return, Form 5213 will go along with it.

Filing Form 5213 starts the clock. You can have two years of hobby gains without a problem. If you have three you need to go back and amend the return because you will file as a hobby while time determines if you are a hobby or business.

Nothing says you must continue an activity. After two years it might be in your best interest to do something else. There are plenty of other side hustles out there. There is also no rule that says you can’t start another hobby. Maybe you try Uber for a year or two and then quit for a side gig preparing taxes for a spell. This could go on forever. (Note on the tax preparation thing: Expertise is one of the determining factors in determining if you are a business. Certain professional businesses walk closer to the line when claimed as a hobby. If you do a handful of returns for friends it is probably a hobby; preparing a hundred for the general public might be a hard sell.)

If you discover you enjoy the profitable hobby enough to continue you will have to file as a business and amend prior returns to reflect the hobby income as business income. You will also have to pay the back tax. The IRS will probably assess an interest penalty, but should not assess any other penalties since you filed the required forms.

I dropped a lot on you guys today. You have enough information to make a solid decision in gaming the tax code to your advantage. Those near or in retirement can kick the crap out of Revenue. Be careful. People like to push this too far. Follow the rules and your side hustle can be a lot less taxing without self-employment tax. Cross the line and a friendly IRS auditor might remind you of the rules I informed you of here.

Most of all, have fun. It’s a hobby.

 

Note: The TCJA enacted in late 2017 changed the rules for hobbies starting January 1, 2018. Hobby expenses used to be deductible up to hobby income on Schedule A, subject to 2%, but no longer. Business income also gets the new Qualified Business Income Deduction and hobby income does not. Also, only business income is earned income, available to invest in a retirement account. Hobby income does not qualify for retirement accounts.