The Taxman Cometh

With the "fiscal cliff" looming in the not-so-distant future, Washington lawmakers' thoughts naturally turn to the most defenseless among us. As former Louisiana Senator Russell once famously said, "don't tax you, don't tax me, tax that fellow behind the tree." And, from inside the Beltway, that fellow behind the tree could well be a degenerate gambler.

Specifically, there seems to be a growing consensus that a "fiscal cliff" deal will involve some sort of cap or limitation for itemized deductions. Whether that cap takes the form of an absolute limit, barring deductions in excess of, say, $17,000, $25,000 or even $50,000, or whether it takes the somewhat more complicated form of allowing deductions to generate only 28% in tax benefits, even if a taxpayer is in the 35 or perhaps 39.6% bracket, the cap is bad news for horseplayers. In particular, it's bad news for those of us who play the horses at the track or online or who participate in handicapping tournaments, but still have a day job, or at least a regular retirement income. The rest of this post explains why.

The key provision, which has been a part of the Internal Revenue Code forever, and is now codified as IRC Section 165(d), provides that "losses from wagering transactions shall be allowed only to the extent of the gains from such transactions."

To understand that section, one has to understand what the Internal Revenue Service means by "gains" and "losses." If I bet $2 on a 4-1 shot to win and get back $10, my "gain" for tax purposes is $8. If I bet $2 on each of the next four races and lose, then I have an offsetting loss of $8 and I'm even, in both cash and for tax purposes.  Things get more complicated in exotic bets. If I put $1,500 (750 $2 bets) into a Pick Six carryover and hit it for, say, $20,000, then I have a gain of $19,998 on my one winning ticket and a partially offsetting loss of $1,498 for all the tickets that didn't hit (assuming, for simplicity, that I didn't have any five-winner consolation  tickets). In other words, each bet is a separate "wagering transaction" for tax purposes; 750 bets on my hypothetical Pick Six, six bets on a three-horse exacta box, and so on.

Now let's construct an Average Joe gambler. Joe runs a software company, which pays him a net $250,000. His office has three TV screens, tuned most afternoons to TVG, HRTV and the local NYRA racing channel. He makes his bets on the NYRA Rewards network, because he knows that way more of the takeout from his bets goes to the track and the purse account (did I mention that Average Joe is also a partner in my Castle Village Farm partnership operation, and very much wants his horses to earn as much purse money as possible?).

Let's say that Joe is a pretty good handicapper, but not quite good enough to beat the takeout.  In a typical year, he'll wager perhaps $50,000 and have net winnings of $45,000, for an overall loss of $5,000.

Because Joe is not in the "trade or business" of gambling, the tax rules require that he list his wagering gains -- all $45,000 -- as income and then take an itemized deduction for $45,000, thus eliminating any taxable income attributable to gambling, which, of course, he didn't have. So he gets no tax benefit from the net $5,000 loss for the year, but in Joe's view it's a reasonable outcome. And he can't escape reporting that income, because his wagering account keep strack of it in endless detail.

Now Joe also has some other itemized deductions. Let's say he pays $20,000 a year in mortgage interest, $20,000 in state income tax and local property taxes, $5,000 in charitable contributions and $5,000 in medical expenses above the statutory threshold. That's a total of $50,000 in itemized deductions before we even get to his gambling losses.

So, to take the simplest case, let's say that the "fiscal cliff" settlement raises Joe's marginal tax rate from 35% to 39.6% and, in addition, caps his itemized deductions at $50,000. All of a sudden, Joe has an extra $45,000 of income -- his winning bets -- that can no longer be offset by an itemized deduction for his losses. At the new 39.6% top marginal rate, Joe now has an additional tax bill of $17,820, attributable entirely to completely imaginary income.

Joe might have been content to lose $5,000 a year, but now he's losing almost $23,000. Wonder how long he's going to keep making those oh-so-reportable bets on his NYRA Rewards account?

Things are different if our hypothetical bettor -- let's call him Ernie Dahlmann -- is in the "trade or business" of gambling. In tax-speak, "trade or business" doesn't necessarily mean full-time, but it does mean something more than recreational betting. Being ensconced in a suite at a Las Vegas hotel and putting $50,000 or more through their race book every day probably qualifies. For these professional gamblers, wagering losses are not itemized deductions subject to whatever cap Washington eventually imposes. Instead, a professional gambler reports gambling activity as a trade or business on a Schedule C. Wagering losses can be deducted from wagering gains up to the point that the Schedule C reports zero net income, and the professional gambler can still take whatever other itemized deductions -- mortgage interest, state and local taxes, etc. -- are available. And if the professional gambler has a loss for the year that he can't deduct against other income, well, he's not much of a professional gambler.

The NTRA and the American Horse Council, the principal lobbying groups for the racing industry, have taken up the issue, but it's hard to tell if they, and Sen. Mitch McConnell (R-Horse Racing) have much influence in the "fiscal cliff" pressure cooker. If they don't succeed in carving out an exception from the deduction cap for wagering losses, it might be time to stop betting on the ponies and start betting on something where losses are fully deductible, like, say, pork bellies.

Gamblers may not be the powerful interest group that, say, assault-weapon owners are, but still, it couldn't hurt if we all get in touch with our Senators and Congress members on the deduction-cap issue. Just might mean the death knell for race track gambling if it passes.

(For those who want to explore the invidious tax treatment of gambling in more detail, I wrote about it in "The Federal Income Tax Treatment of Gambling," 49 Tax Lawyer 1 (1995). More recently, the February, 2001 Gaming Law Review has an article by Charles Blau on "Tax Treatment of Gambling: the Pros and Cons." Alas, neither of these articles seems to be available for free on the web. Consult your local friendly law library.)