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Online Gambling Poses Tax Conundrum

11/23/09 - Wall Street Journal - View Source

By Eva Rosenberg

Los Angeles (MarketWatch) -- California resident J.D. won over $50,000 playing video poker online this year. Wow! She couldn't do that well in Las Vegas, and at home she can play anytime without having to drive for hours. Plus, she can play any number of different "machines" without waiting for one of them to be free. But J.D. spent over $40,000 before cashing out $50,000. Are her losses deductible?

First, a brief overview.

Online gambling offers advantages to both casual hobbyists and serious gamblers. After all, you never have to sit next to a smoker, you aren't subject to the casino cacophony, and you can take a break without worrying about someone stealing your machine.

But the legality of online gambling in the U.S. is not really clear. There is no overall federal law that defines illegal gambling. So whether your playing is legal is defined at the state level. Some states -- including Illinois, Indiana, Louisiana, South Dakota and Washington -- have explicitly outlawed online gambling or some form of it. Other states have no specific law addressing Internet gambling.

You've probably heard of the Unlawful Internet Gambling Enforcement Act and Regulation GG which became law in 2006 and become effective on Dec. 1. That certainly sounds like a federal law that makes Internet gambling illegal, doesn't it?

Ironically, this law turns bankers into policemen and forces them to enforce a non-law. Banks are required to return or block illegal-gambling deposits into their clients' accounts, or even to close accounts.

However, the UIGEA doesn't define unlawful Internet gambling. In fact, there is so much dispute over the definition that the House financial services committee wrote to Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke asking them to delay enforcement of the UIGEA for one year, until Dec. 1, 2010. See the letter.

Congress is battling over outlawing online gambling altogether, or limiting it to certain games. At present, the only thing that's clear is that online sports betting is illegal.

The tax issue

Generally, when you win money from gambling, you must report your winnings on your tax return. Is online gambling any different? No.

The IRS has not issued guidance dealing specifically with online gambling, said Bruce Friedland, an IRS spokesman. However, gains from wagering transactions, whether online or in person, are included in income.

Report your full gross winnings; don't deduct your losses. The losses get deducted on your Schedule A as miscellaneous deductions, on a special line -- Line 28 -- where the deduction is taken in full, without being reduced by 2% of your adjusted gross income. Your gambling deductions are limited to your winnings.

So, J.D. should be able to deduct the full $40,000 worth of bets, since her winnings are $50,000, right?

As far as the IRS is concerned, J.D. is entitled to the $40,000 deduction, provided she can substantiate the cost of her wagers. Since all the activity is online, it's not hard to get a printout to prove her deposits to her gambling account. In fact, IRS hints that even if the activity were illegal, the deductions are allowable.

So, J.D. is fine with the IRS. What about the State of California? A call to the California Franchise Tax Board results in this alarming response.

"The simple question you ask is actually quite complicated because for income-tax purposes there currently is no clear guidance of whether online poker in general is illegal or not," said Brenda Voet, a spokeswoman with the Franchise Tax Board.

"The taxpayer bears the burden of having to properly substantiate that a deduction is allowable under income-tax law. So, the taxpayer in this situation is placed in the position of having to determine if the online poker games are legal and the current year losses can offset their winnings, or if they are illegal and the losses may not be claimed."

This is a terrible burden to place on a taxpayer. Why should the taxpayer have to determine if an action is legal or not? Why can't the government define it for her? Isn't it enough of a burden to be required to provide substantiation for all expenses?

Next stop: the office of Jerry Brown, California's attorney general. According to Evan Westrup, deputy press secretary , California state law does not provide for legal online gambling. Whether federal law prohibits online gambling is not an issue within the purview of the state attorney general's office.

When asked whether there is a California law specifically outlawing online or Internet gambling, Westrup admits that there is none.

Again, not a very satisfactory answer. Taxpayers in California get no guidance from the folks they rely on in government. Why should it be a guessing game whether or not a deduction is legal?

As of right now, throughout most of the U.S., there is no federal or state definition of "illegal online gambling." That will be hammered out over the next 12 months, if the House financial services committee has its way.

Winner's strategy

In the meantime, what's a winner to do?

It would be remarkably unfair to pay taxes on $50,000 when your net winnings are only $10,000 -- or if you actually net out at a loss by the end of the year.

For the moment, report the income. Take the deduction as an itemized miscellaneous deduction, and pray that you're never audited by your state.

If you are, you can find a great deal of information Gambling-Law-US.com, a Web site operated by attorney Chuck Humphrey. See the Gambling Law site.

And you can raise these arguments:

- The online casino is based on an Indian reservation. In J.D.'s case, her online casino is hosted on a Mohawk reservation in Canada. They ensure the fairness of the games and that players are paid. In fact, many of the large, reputable online casinos are hosted at that same reservation operated by the Kahnawake Gaming Commission. Your state probably has arrangements with tribes that allow for legal gambling on reservations in your state. This is just another casino run by another tribe -- one that you can visit from the comfort of your home.

- Most state laws have a loophole for games of skill. Poker -- yes, even video poker -- are games of skill. The decisions you make affect the outcome of the game.

Or get an attorney.

And for now, stop gambling online because your bank may start rejecting your deposits as of Dec. 1, unless, of course, enforcement is delayed for a year.