Monday, December 17, 2012

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.)

Wednesday, December 12, 2012

NYRA's Quarterly Results: Transparency Plus Good News

For the first time in living memory, the New York Racing Association (NYRA) has voluntarily released its financial data. The NYRA balance sheet as of September 30, 2012, plus the quarterly results for July through September of this year can be found here.

Historically, NYRA has strenuously resisted disclosing its finances. Both former CEO Charlie Hayward and the current incumbent, Ellen McClain, initially responded to to earlier state government requests for finances by saying no way, only to reverse themselves soon after, under public and political pressure. But now, on the eve of the first meeting of the "New NYRA" Board of Directors, with a majority appointed by New York Governor Andrew Cuomo and other state politicos, NYRA has released to the public something that looks very much like an ordinary corporate quarterly report. High time, and let's hope the practice continues.

The report itself is full of positive news, and in particular shows the positive effect of video lottery terminals, which opened last November, on NYRA's financial health.

Despite a doubling of legal costs, largely attributable to the Pick Six takeout scandal that cost Charlie Hayward and General Counsel Pat Kehoe their jobs, NYRA's operating income for this year's 3rd quarter was $24.8 million, more than double the figure for last year's 3rd quarter, whiuch was the last before the arrival of VLT money. But even without the VLT funds, NYRA turned in an improved performance. Here are some of the specifics:

  • NYRA purses, fueled by the slots, increased from $37 million in last year's 3rd quarter to $55 million. That 48% increase means it's no longer impossible for a horse owner to break even -- just difficult. But it's a huge plus. And, although NYRA accounted for only 4% of US race days in the quarter, it offered 16% of all the purse money on offer nationally. In other words, racing your horse in New York is four times more lucrative than the US average. Wondering why every stall at Belmont and Aqueduct isn't filled.
  • Total handle, including on-track, OTB, account wagering, simulcastiung, etc. jumped to $839 million from last year's $737 million. That's a healthy 13.9% increase in handle, at a time when handle in the rest of the US is flat or declining.  The increase was fueled in part by a gain in average field size, from 8.08 horses per race last year to 8.47 this year. The 3rd quarter, of course, includes Saratoga and the Belmont Fall meet, the highlights of the season, son these numbers won't necessarily repeat in the Aqueduct quarters, but still, the gain in year-to-year comparable numbers is impressive. NYRA's handle represented almost 30% of all betting on US Thoroughbreds during the quarter, even though NYRA had only 4% of US race days. NYRA's is clearly the industry's premier racing product.
  • in the "bang for a buck" category, each dollar of purses offered at NYRA generated $15 of handle. That's nearly double the national average of $8 in handle for each dollar of purse money.
  • The Aqueduct VLTs, running at a "net win" of $388 per machine per day, generated $23.8 million for racing during the quarter -- $11.4 million for purses, $5.3 million for NYRA's operating budget, and $7.0 million for NYRA's capital budget.
  • On the capital-investment front, NYRA spent $3.5 million during the 3rd quarter. A good chunk of that went to concrete wash pads in the barn areas, to comply with environmental rules. Also, there was spending for some "patron area improvements" at all tracks (though on a recent visit to Aqueduct, I'm not sure that the closing of the Man 'O War Room and related areas, albeit for asbestos removal, and some new paint and chairs really merits the name "improvement"). Installing wi-fi at all three tracks is certainly useful, and the front-side improvements at Saratoga should yield results next year.
  • NYRA Rewards account wagering continued to gain slowly, rising 13% compared to last year. This is important because all the takeout from NYRA Rewards wagering goes back to NYRA and to the purse account, while takeout from other wagering platforms (e.g., Churchill's Twin Spires) has to be shared with them. I'd love to see even more aggressive promotion of NYRA Rewards in the future.
  • For those who still think the New York OTB system ihas anything to do with racing, the report is instructive. Total revenue to NYRA from all five surviving OTB systems in the state was a mere $8.4 million for the quarter, a mere 9% of NYRA's total revenue from wagering. In contrast, On-track (including NYRA Rewards) wagering accounted for almost 50%, and other simulcast-based revenue for 40%. The OTBs are of no value to racing; rather than let Catskill OTB into New York City, as a pending bill would do, it would be better to shut down the whole patronage-laden system and use NYRA as the platform for all horse-race betting in the state. As of September 30, the OTB system was $8.0 million in arrears to NYRA, the biggest chunk of that attributable to the twice-bankrupt Suffolk County OTB operation.
  • Of particular concern to horsemen is NYRA's "purse cushion." That's the amount of money that NYRA has earned from betting and is designated by state law for purses, but has not yet been paid. When NYRA went into bankruptcy some years ago, the "cushion" exceeded $20 million; in other words, NYRA had been taking money earmarked for purses and using it to pay salaries and turn on the lights. One result of the bankruptcy proceeding was an agreement with the horsemen, subsequently enacted into law, calling for a gradual reduction in the cushion. The 3rd quarter financial report shows that NYRA, to its credit, is way ahead of schedule. As of September 30th, the "cushion was down to $4.5 million. Kudos to NYRA for that.
  • The report also shows that NYRA has achieved a measure of stability, at least compared to the bad old bankruptcy days, in its cash position. This important measure of liquidity is leveling off around $20 million, probably still too low for a corporation of NYRA's size, but a great improvement on prior years.
So, while there's still much to be done on the operating side, NYRA, and especially its financial team, including Ellen McClain, Susanne Stover and Dave O'Rourke, deserve credit for turning things around financially. Yes, the VLTs were a necessary part of that turnaround, but the new financial report shows that someone is, in fact, minding the store.

And it's nice to see the information out there in public, where it belongs.