The court, in Jimmie L Clemons, T.C. Summary Opinion 2005-109, upheld the IRS position that gross gambling winnings must be reported as income on Page 1 of the tax return, with losses, to the extent of winnings, allowed as an itemized deduction, which is not subject to the 2% of AGI exclusion.
While Jimmie was able to deduct $44,800 in losses to wipe out his $44,800.00 of income, the fact that the $44,800 in winnings was included in his Adjusted Gross Income caused 85% of his Social Security benefits to be taxed!
I have seen many examples where a client with net gambling losses for the year is royally screwed by "Sam" -
* Just like in the case of Jimmie Clemons, because of the way Social Security and Railroad Retirement benefits are taxed, there often exists a situation where an individual is taxed on $1.85 for every additional $1.00 in income. A taxpayer in such a situation who has $3,000 in gambling winnings reported on a Form 1099, and $4,000 in substantiated gambling losses, ends us increasing his AGI by $5,500 ($3000 x 185%). Even if he can take full advantage of an itemized deduction of $3,000 in losses, he still ends up paying $383 in federal income taxes in the 15% bracket, or $638 in the 25% bracket - all on net losses for the year of $1,000!
* Even if a taxpayer can deduct enough losses to wipe out his gambling income, the increase in AGI caused by reporting gross winnings on Page 1 of the Form 1040 can reduce or even wipe out a multitude of deductions and credits that are affected by AGI, and could even cause one to fall victim to the dreaded Alternative Minimum Tax (AMT).
* One can only receive the full tax benefit of deducting gambling losses if the total of his other “itemizable” deductions equals or exceeds the allowable standard deduction. What if a single taxpayer with $5,000 in winnings and $6,000 in losses in 2008 only has $2,000 in other itemized deductions (i.e. state and local income taxes and charitable contributions). While he can deduct $5,000 in gambling losses, he only gets a tax benefit on $1,550 of the losses ($5,000 losses + $2,000 other deductions = $7,000 Schedule A - $5,450 standard deduction = $1,550). If he is in the 25% bracket, he ends up paying $863 in federal income tax on $1,000 of losses!
* While New Jersey allows one to "net" gambling winnings and losses on the state income tax return (a person with $5,000 in winnings and $6,000 in losses would have "0" taxable income), most states follow the federal return, which will increase the total tax cost of gambling losses. FYI, since NJ state lottery winnings are exempt from NJ state income tax, NJ state lottery losses cannot be deducted against other gambling winnings in calculating the net amount taxed by NJ. If, in the above example, $2,000 of the $6,000 in losses represents NJ state lottery tickets, the taxpayer must report a net of $1,000 in gambling winnings on his NJ-1040.
I should point out that losses from any type of wagering transaction can be deducted against your gambling winnings. If you win in the slots your deduction is not limited to losses from slot machines. You can deduct losses from the lottery, 50-50s, bingo, table games such as poker and blackjack, charity raffles, horse racing, keno, etc., up to the amount of your winnings. It is a good idea to keep your losing lottery, raffle and racetrack tickets for the year, and keep track of slot activity by using a player’s card, in case you make a big score. If you are unlucky enough to be chosen for an audit of your losses here is a word of advice – make sure your losing racetrack tickets do not have footprints on them.
You should also know that winnings from a “no purchase necessary” marketing sweepstakes or contest are not considered to be gambling winnings for the purpose of calculating deductible gambling losses. The IRS defines gambling winnings as winnings from a “wagering transaction”. A recent IRS “Technical Advice Memorandum” (TAM 200417004 ) states that such winnings are not gains from a “wagering transaction” because the winner did not furnish “consideration” for the chance to win the prize. If you win the Publishers’ Clearing House sweepstakes, or a trip to Club Med by being the 10th caller to a radio station, you must report the winnings, or the market value of the trip, as income on your Form 1040, but you cannot deduct any losing lottery tickets, slot machine losses, or any other kind of gambling losses against this income.
So who said the Tax Code had to be fair?