Gambling Losses Deduction Tax Reform

You can't reduce your gambling winnings ($500) by your gambling losses ($400) and only report the difference ($100) as income. If you itemize, you can claim a $400 deduction for your losses, but. Losses are allowed as an itemized deduction dollar for dollar against the gain. Gambling losses cannot be greater than gambling wins for the tax year. Example: John wins $23,500 during the year playing slots and other casino games. His gambling losses are $37,900.

The ability to deduct expenses was curtailed by last year’s tax overhaul.

By Wei-Chih Chiang, CPA, DBA; Yingxu Kuang, DBA; and Xiaobo Dong, Ph.D.

Professional gamblers' decadelong streak of being able to deduct a net loss from gambling as a trade or business was ended this year by P.L. 115-97, known as the Tax Cuts and Jobs Act of 2017 (TCJA). Although a relatively minor facet of the wide-ranging tax reform package, the TCJA's amendment to Sec. 165 overturning a 2011 Tax Court decision and 2008 IRS memo is momentous for taxpayers who claim to be engaged in the trade or business of gambling by virtue of their participation at card tables, racetracks, or other wagering venues, real or virtual.

CHANGING FORTUNES

While all taxpayers are required to report gambling winnings in gross income, what related deductions they can claim and in what way depends on whether their gambling rises to the level of a trade or business. A gambler not in the trade or business of gambling (a 'casual gambler') can deduct wagering losses as a deduction not subject to the 2%-of-adjusted-gross-income threshold (i.e., not among miscellaneous itemized deductions the TCJA suspended for tax years 2018 through 2025) on Schedule A, Itemized Deductions, but only to the extent of the winnings. On the other hand, a gambler engaged in the trade or business of gambling ('professional gambler') can net gambling winnings against losses and business expenses on Schedule C, Profit or Loss From Business.

Before amendment by the TCJA, Sec. 165(d) stated only, 'Losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.' For many years before 2008, the IRS interpreted 'losses from wagering transactions' to include professional gamblers' business expenses, so that they were deductible, along with wagering losses, only to the extent of gambling winnings. Consequently, professional gamblers were not allowed to generate a net operating loss (NOL) from gambling activities. The Tax Court in Offutt, 16 T.C. 1214 (1951), sustained the IRS's perspective and followed this ruling in subsequent cases.

But the Tax Court did not do so consistently, as discussed below. Meanwhile, the Supreme Court in Sullivan, 356 U.S. 27 (1958), allowed business deductions of an illegal gambling enterprise (generally denied previously on public policy grounds). Then, in Groetzinger, 480 U.S. 23 (1987), the Supreme Court distinguished between Sec. 165(d) wagering losses and Sec. 162(a) business expenses of a taxpayer in the trade or business of gambling.

In 2008, the IRS in Chief Counsel Advice Memorandum AM 2008-013 concluded that the IRS should no longer follow Offutt. The Tax Court in Mayo, 136 T.C. 81 (2011), then likewise abandoned its Offutt holding, allowing a professional gambler to deduct business expenses in excess of net gambling winnings (while maintaining that direct wagering losses could still be deducted only to the extent of wagering gains under Sec. 165(d)). Therefore, professional gamblers were able to generate an NOL from gambling activities — until the TCJA amended Sec. 165(d). (For more on Mayo and factors by which courts determine whether gambling is a trade or business, see 'Better Odds for Pro Gamblers' Business Deductions,' JofA, April 2012.)

TAX REFORM RESETS THE RULES

The TCJA, however, put an end to professional gamblers' ability to deduct nonwagering business expenses in excess of net wagering income. It amended Sec. 165(d) by inserting the following sentence after the original one:

For purposes of the preceding sentence, in the case of taxable years beginning after December 31, 2017, and before January 1, 2026, the term 'losses from wagering transactions' includes any deduction otherwise allowable under this chapter incurred in carrying on any wagering transaction.

The House of Representatives described this provision in its committee report (H.R. Rep't No. 115-409, 115th Cong., 1st Sess. 167 (Nov. 13, 2017)):

The provision is intended to clarify that the limitation on losses from wagering transactions applies not only to the actual costs of wagers incurred by an individual, but to other expenses incurred by the individual in connection with the conduct of that individual's gambling activity. The provision clarifies, for instance, an individual's otherwise deductible expenses in traveling to or from a casino are subject to the limitation under section 165(d). [footnote omitted]

The report further noted that the provision was intended to reverse Mayo (id., fn. 135). Consequently, the deduction of professional gamblers' nonwagering business expenses is limited by Sec. 165(d) under the new law. The following example and the chart, 'Before and After the TCJA,' illustrate the amendment's effects.

Before and after the TCJA

Example

Assume that G had the following expenses related to his gambling activities in both tax years 2017 and 2018:

Gambling winnings: $10,000

Losing wagers: $12,000

Transportation: $3,000

Meals and entertainment: $1,500

Legal and professional services: $1,000

Lodging: $2,500

Subscriptions and books: $900

Telephone and online charges: $600

Depending on whether G is a professional or casual gambler, either of two tax treatments could result for each year. If G is a casual gambler, the amendment of Sec. 165(d) has no effect on him. He should report his gambling income of $10,000 on Form 1040, U.S. Individual Income Tax Return, and $10,000 of his wagering losses on Schedule A in both 2017 and 2018. If G is a professional gambler, he could claim an NOL of $9,500 from gambling activities in 2017, as shown in the chart. However, under the amended Sec. 165(d), G may deduct his wagering losses and nonwagering gambling-related business expenses only to the extent of his gambling winnings, for a net zero income from gambling activities in 2018.

GAINS FROM WAGERING TRANSACTIONS

Amended Sec. 165(d) changes the definition of 'losses from wagering transactions' but not the meaning of 'gains from wagering transactions,' which may not always be clear. Courts generally have held that 'gains from wagering transactions' within the meaning of Sec. 165(d) must be the actual product of wagers entered by the taxpayer.

Gross income does not include the return of capital (Doyle v.Mitchell Bros. Co., 247 U.S. 179 (1918)). A gambler thus would be entitled to exclude the cost of a winning ticket from its associated gross winnings. Nevertheless, such recovery of capital could not include the cost of tickets that did not win (Hochman, T.C. Memo. 1986-24). In the past, courts have considered various items as gains from wagering transactions. The annual payments lottery winners receive are treated as their gambling winnings in the year the payments are received (Rusnak, T.C. Memo. 1987-249). However, an excess gambling gain in one year cannot be offset by an excess gambling loss in another year (Skeeles, 118 Ct. Cl. 362 (1951)).

The Fifth Circuit in Humphrey,162 F.2d 853 (5th Cir. 1947), held that wagering transactions include all gambling activities, regardless of whether they are legal or illegal, or whether they are business or personal. As long as the losses derive from wagering transactions, they could be used to offset gains from any such transaction.

It is not necessary for the wagering gains to be related in any way to the losses (Scott-Nickels Bus Co., T.C. Memo. 1956-120). For example, the taxpayer in Presley, T.C. Memo. 1979-339, an owner of an illegal casino, was allowed to use the losses from his other personal gambling activities to offset his gains from the casino (see also Jennings, 110 F.2d 945 (5th Cir. 1940), and Joseph, 43 B.T.A. 273 (1941)).

Gamblers could use gambling losses to offset the value of complimentary goods and services ('comps') they receive from a casino. Comps constitute gains from wagering transactions because the relation between the comps and the gambler's wagering is 'close, direct, evident, and strong' (Libutti, T.C. Memo. 1996-108).

INCOME THAT IS NOT GAINS FROM WAGERING TRANSACTIONS

In addition, courts have considered the following income sources to not be gains from wagering transactions:

Tokes

Traditionally, casino dealers receive 'tokes' from patrons who play at their tables, in the form of bets the patron places for the dealer's benefit. Tokes are considered compensation for the recipient's services and, thus, should be treated as ordinary income rather than either wagering gains or gifts (Bevers, 26 T.C. 1218 (1956); Allen, 976 F.2d 975 (5th Cir. 1992); Olk, 536 F.2d 876 (9th Cir. 1976); and Williams, T.C. Memo. 1980-494).

Take-offs

A take-off is the fee that the house charges card players to play poker at the casino. Because take-offs serve as seat rental charges, those the house receives are not gains from wagering transactions and cannot be used to offset the house's losses from such transactions (Nitzberg, 580 F.2d 357 (9th Cir. 1978)). Similarly, the taxpayer in Boyd, 762 F.2d 1369 (9th Cir. 1985), ran the poker room in a casino that awarded him a portion of the take-off collected in the card room. The contractual share of take-offs the taxpayer received was not his gains from wagering transactions and could not be offset by his losses from those transactions.

Theft income from stolen betting tickets

The taxpayer in Collins, T.C. Memo. 1992-478, aff'd,3 F.3d 625 (2d Cir. 1993), worked as a ticket seller at an off-track betting station. Without making any payment, he placed several personal bets that had a fair market value of $80,280 and resulted in winnings of $42,175 (for a net loss of $38,105). He returned the entire winnings to his employer and turned himself in at the end of the day. The Tax Court ruled that the taxpayer should recognize net theft income of $38,105. Further, the court held that the theft income from the stolen tickets was ordinary income and not gain from a wagering transaction. Therefore, the taxpayer could not use his losses from wagering transactions to offset his theft income.

LOSSES FROM WAGERING TRANSACTIONS

Professional gamblers can deduct business expenses against their gains from wagering transactions (again, subject now to limitation under the TCJA) even if illegal gambling activities are involved. For example, in Harbin, T.C. Memo. 1958-190, the owner and operator of an illegal lottery business was allowed to deduct gambling losses, business expenses, and the federal excise tax on gambling against his income from the gambling operations. When the losses from wagering transactions exceed the gains, the excess losses cannot be carried back to previous years (Estate of Todisco, T.C. Memo. 1983-247). Casual gamblers cannot claim a gambling loss deduction for nonwagering expenses, such as transportation, meals, and lodging (Whitten, T.C. Memo. 1995-508).

Courts have considered the following items losses from wagering transactions, such that their deduction is limited to wagering gains:

Unsold tickets

The taxpayer in Miller, 792 F.2d 392 (3d Cir. 1986), was a lottery dealer in the Virgin Islands, where the lottery distribution system did not allow dealers to return unsold tickets. The Third Circuit noted that the taxpayer retained the tickets and continued to buy more tickets than he could sell, indicating that he was betting that one or more of the unsold tickets would be drawn. Therefore, the cost of these unsold tickets should be treated as gambling losses rather than ordinary business expenses, the court held.

Losses by shills

Typically, casinos engage persons referred to as 'shills' to whom they agree to provide a certain sum of money or chips to play. The casino will absorb any loss, but gains are split between the shill and the casino. The Tax Court in Nitzberg, T.C. Memo. 1975-228, held that when shills' losses were greater than their winnings, the net loss was deductible as the casino's ordinary and necessary business expense under Sec. 162. However, on appeal, the Ninth Circuit (Nitzberg, 580 F.2d 357 (9th Cir. 1978)) reversed the ruling, noting that shills acted on the casino's behalf when placing bets and, therefore, the casino's losses were losses from wagering transactions.

State tax assessment

A state income tax assessment on gambling income of an individual in the trade or business of gambling is tied directly to a taxpayer's gambling activities and, hence, is subject to the limitation of Sec. 165(d) (Estate of Todisco, 757 F.2d 1 (1st Cir. 1985)).

Buy-in and rake

Tournament poker players are required to pay the tournament organizer a 'buy-in,' or entrance fee. The casino retains a portion of this amount as an administrative fee, and the remainder goes directly into the prize fund 'pot' that will be paid out to the tournament's winners. The Tax Court in Tschetschot, T.C. Memo. 2007-38, considered tournament poker a wagering activity and treated poker players' loss of the buy-in as losses from wagering transactions. However, the IRS in Hom, T.C. Memo. 2013-163, conceded that poker entry fees and rake fees (charged per hand to play poker online) were business expenses of a professional gambler. While the Tschetschot and Hom cases are inconsistent, this inconsistency is irrelevant under amended Sec. 165(d). Regardless of the nature of buy-in and rake fees, both are subject to the Sec. 165(d) limitation under the TCJA.

Takeout

In horse-race betting, 'takeout' refers to the share of the entire betting pool that the event manager (the track) is specified to receive. The track uses the takeout to pay its expenses, such as purse money for the horse owners, taxes, license fees, and other state-mandated amounts, and keeps any remaining amount as its profit. As a professional gambler, the taxpayer in Lakhani, 142 T.C. 151 (2014), aff'd, Nos. 14-72576, 14-72577 (9th Cir. 5/10/18), argued that his pro rata share of the takeout the track remitted to the state and local tax authorities constituted his business expense and was not a loss from wagering transactions. The Tax Court noted that the taxes, license fees, and other expenses discharged from the takeout were expenses imposed upon the track, not the bettors. Therefore, the taxpayer was not allowed to deduct his share of the takeout.

POTENTIAL ISSUES

Taxpayers should be aware of the following potential issues, some of which may require more clarification by either courts or the IRS:

Treatment of 'fee to play'

The courts treat the 'fee to play' inconsistently, as it may be referred to as take-off, buy-in, or rake. The Ninth Circuit in Boyd held that take-offs the casino received or awarded to a contract player were not gains from wagering transactions. The Tax Court in Mayo implied that take-offs gamblers paid were nonwagering business expenses. On the other hand, the Tax Court in Tschetschot considered poker players' losses of the buy-in as losses from wagering transactions, while in Hom, rake was treated as a business expense.

This inconsistency raises two issues. First, there is no statute or theory to support the different tax treatments of the entry fees based simply on whether the taxpayer is the recipient or the payer. Second, for professional gamblers, the inconsistency between the Tschetschot and Hom cases does not matter under Sec. 165(d) as amended by the TCJA. For casual gamblers, however, this inconsistency has created chaos. Naturally, casual gamblers prefer to follow the Tschetschot case and treat their fees to play as losses from wagering transactions, as they are not allowed to deduct any gambling-related nonwagering expense.

Treatment of tokes

Are tokes that dealers receive considered the giver's winnings and losses? The courts have held that tokes are not dealers' gains from wagering transactions, as noted above. However, there is no precedential ruling with respect to the giver's treatment of the toke. As a toke belongs to the giver until the bet is won (Bevers, 26 T.C. at 1219), theoretically, the loss or winning of the toke should be considered the giver's gambling loss or winning.

Reportable gambling winnings

In Regs. Sec. 1.6041-10, the definition of 'reportable gambling winnings' for information-reporting purposes depends on the type of game. In bingo and slot machines, the amount of the reportable gambling winnings includes the amount wagered. Conversely, it is reduced by the amount wagered for keno. Taxpayers should be aware of this difference when they receive Form W-2G, Certain Gambling Winnings.

AN END TO NOLs

Before the TCJA, under the Tax Court's holding in Mayo, professional gamblers were allowed to fully deduct their nonwagering business expenses beyond wagering gains. By amending Sec. 165(d) in the TCJA, Congress reversed Mayo, allowing professional gamblers to deduct their wagering losses and nonwagering business expenses only to the extent of their gambling winnings, and no longer allowing them to generate an NOL from their gambling activities. Although, under the TCJA, the amendment to Sec. 165(d) is scheduled to expire at the end of 2025 along with most of its other provisions affecting individual taxpayers, Congress may extend it further. In the meantime, professional gamblers' winning streak apparently has come to an end.

About the authors

Wei-Chih Chiang, CPA, DBA; Yingxu Kuang, DBA; and Xiaobo Dong, Ph.D., are all associate professors of accounting in the School of Business Administration, University of Houston—Victoria at Katy, Texas.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.

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Article Highlights:

Gambling Deductions 2018 Tax Bill

• Deductions The Proposal Retains
• Itemized Deductions The Proposal Eliminates
• Other Deductions The Proposal Eliminates

One of President Trump’s key tax reforms is to eliminate all individual tax deductions except for those that incentivize home ownership, charitable contributions and retirement contributions. Although the administration’s one-page outline of the proposed tax reforms provides little detail, if all of the deductions except those noted are eliminated, the reform will impact both itemized deductions and income adjustments. This article will explore the deductions that the president’s proposal retains and those that it would eliminate, so you will be able to see how these changes could play out for your particular circumstances.

Deductions the Proposal Retains

Deduction Gambling Losses

Incentives for Home Ownership – Although Trump’s proposal provides no details about what “incentives for home ownership” means, this category would presumably include deductions for home-mortgage interest and property taxes. However, it is unknown if the plan will include the existing restrictions that limit the home-mortgage interest deduction to $1 million of home-acquisition debt and $100,000 of equity debt. It is also unclear if the incentives for home ownership would include second homes.

Charitable Contributions – Presumably, the plan would continue to be subject the 50%, 30% and 20% adjusted gross income (AGI) limits. The proposal does not address one of the most complicated areas (and one that is significantly abused) –contributions of overly valued property.

Retirement Contributions – Retirement contributions are deducted as an adjustment to income; this is frequently referred to as an above-the-line-deduction. Presumably, in the new plan, this still would include traditional IRAs and self-employed retirement plan contributions.

Gambling Loss Deduction Tax Reform

Itemized Deductions the Proposal Eliminates

Medical Itemized Deductions – Currently, medical deductions are already limited to those that exceed 10% of a taxpayer’s AGI. The Trump plan eliminates the medical deduction altogether, which would significantly impact senior citizens, especially those requiring significant elder care, and taxpayers who have incurred extraordinary medical expenses. What is curious about the elimination of the medical deduction is that, just a couple of months ago, as part of the failed ACA repeal, the administration wanted to reduce the medical AGI limitation and allow larger medical deductions. Now, it wants to eliminate them altogether.

Deduction for State And Local Taxes – Currently, deductions are allowed for state income tax, city and other income taxes, real and personal property taxes and (under certain circumstances) sales taxes.

Eliminating this deduction would have the most significant impact on taxpayers living in states that have income taxes. Taxpayers residing in those states would no longer be able to deduct their state and local income taxes and thus would be double-taxed on the same income. All but seven states have income tax, with California, New York and New Jersey imposing the highest rates. Support for this change is questionable, even among Republican senators, as representatives from states with income taxes will certainly want to retain the state income-tax deduction for their constituents.

Investment Interest Deduction – Currently, a deduction is allowed for investment interest in the amount of net investment income (investment income minus investment expenses). This means that the interest taxpayers pay on money that they borrow to purchase investments would no longer be deductible.

Casualty & Theft Losses – Every year, Americans deal with casualty losses from accidents, fires, floods, tornados, hurricanes, earthquakes and other natural disasters. Currently, those taxpayers can deduct casualty losses – generally to the extent that they exceed $100 per event and 10% of their AGI. Under Trump’s plan, this deduction would be eliminated, which penalizes taxpayers who are in the greatest need – those who are recovering from a disaster.

Employee Business Expenses – Currently, employee business expenses, including the home-office deduction for employees who work out of their own homes, are deductible as miscellaneous itemized deductions, but these deductions are limited to those expenses that exceed 2% of AGI. Under the Trump plan, this deduction would be eliminated. This could pose a serious handicap for telecommuting employees, who would then have the bear the cost of their own offices, office equipment and supplies. Another example are mechanics who must pay for their own (expensive) tools.

Legal Fees – Currently, legal fees are deductible when they are incurred for the protection or production of taxable income. This includes taxable awards as a result of winning or settling a lawsuit. Typically, legal fees are contingent upon the taxpayer winning the suit; they often represent a large percentage of the award. Without this deduction, the taxpayer would have to pay taxes on the entire award even though a significant portion went toward attorneys’ fees.

Gambling Losses – Currently, gambling losses are only deductible in an amount equal to gambling winnings. Under Trump’s plan, these losses would no longer be deductible, meaning that taxpayers would have to pay taxes on all their winnings – even if they have net losses. Senior citizens and others who gamble recreationally could be hit with significant taxes even when they actually lose money.

Other Deductions the Proposal Eliminates

The following deductions are not itemized deductions but are considered adjustments to income. This includes retirement-plan deductions (such as those for IRAs and self-employed retirement plans, including SEPs, SIMPLE and other qualified plans); all of these deductions would be retained. However, if all other deductions are eliminated, the eliminated deductions would include:

Teacher’s Expenses – This is the educator’s deduction for classroom supplies (up to $250 per year). The 2015 PATH Act recently made this deduction permanent.

Health Savings Account (HSA) Deduction – Individuals with high-deductible health insurance can currently deduct contributions to HSA plans when the funds are used to pay qualified medical expenses. It is doubtful that this deduction will actually be eliminated, as HSAs are a key element of the administration’s plan to replace Obamacare.

Moving Expenses – Individuals who move over 50 miles as a result of a change in work location and who work at the new location for a minimum period of time can deduct the cost of the move.

Self-Employed Health-Insurance Deduction – Self-employed individuals, including partners and those who hold more than 2% of an S corporation’s shares, can deduct the cost of their own medical insurance as well as that of their spouse and dependents, subject to certain conditions.

Penalty for Early Withdrawal of Savings – When taxpayers withdraw from term savings accounts, they may incur interest penalties, which are deductible. This deduction was implemented to avoid having taxpayers pay taxes on interest income that they did not receive.

Alimony Paid – When a taxpayer pays alimony to a former spouse, that alimony is taxable for the recipient. To avoid taxing both parties on the same income, the one who makes the payments is allowed to deduct the alimony paid. Eliminating this deduction would have a significant impact on taxpayers who pay alimony.

Student-Loan Interest Deduction – This rules allows for a deduction of up to $2,500 for interest paid on student loans.

Domestic-Production Activities Deduction – Tax law includes a special tax deduction that encourages domestic production (as opposed to foreign production). C-corporations take this deduction on their corporate tax returns; self-employed individuals, partners and S-corporation shareholders must take this deduction on their 1040. It is doubtful that Congress would continue to allow this deduction for corporations while also discriminating against self-employed taxpayers by not allowing them to take the deduction.

We can only wonder if the president expects all of these deductions to be eliminated; perhaps he only proposed the eliminations as a tool to start negotiations with Congress. Details are not promised to arrive until June, so we will have to wait and see how this plays out.