Tax options for your poker winnings

As we all know, April 15th is right around the corner... and you know what that means... yes, the dreaded tax day. Well, actually, I guess this year, we have an extra day since the 15th falls on a Sunday. Anyways, I've already done my taxes (I'm sure those of us that are expecting refunds will complete their returns early) but when I was preparing my own tax returns (using TurboTax), I did wonder how to report my poker winnings. So, for those of you that may not be quite as familiar about how to report gambling gains and loss, let me break it down really quickly (as a disclaimer: I am a CPA but I DO NOT do any taxes so even though I put in a good faith effort in researching what I disclose below, please verify with a tax professional... taking my word is like asking a divorce lawyer what to do if you are charged with homicide):

Basically, you have to report your gross gambling gains on Form 1040, line 21. That's GROSS gambling gains. So, let's say you pay $200 to enter a tournament (including fees for simplicity) and win $5,000. Then you have to report $5,000 on line 21. So where does the $200 go since your net gain in this transaction is only $4,800? Well, the $200 can only be deducted if you itemize your deductions. In other words, unless you own a house and have a mortgage to go along with it or something along those lines, and you just go by standard deduction, the government doesn't allow you to net your winnings.

Well, the above example is pretty simple if all you do is play tournaments and you actually track them. But then the whole "gross gambling winnings" gets tricky when you play cash games as well. Plus, if you don't keep track of your tournament winnings or how much you pay to enter, how can you realistically say this is how much I won?

This was a question I struggled with, a lot. And then I found an article that I believe on www.money.cnn.com that mentioned what the IRS looks for during an audit. And one of the most important things is to make sure that you can explain all your deposits into your bank account for the year. That makes sense because they want to make sure that all your income is accounted for. So, with no better alternative, I thought that maybe a good way to track my gross winnings was to actually see the amount that I withdrew from my poker account. I basically treated my poker account like an investment. If the money in my poker account grew, I considered that as "unrealized gain" much like your gain on portfolio until you actually sell your stock. So, once I withdraw money, that was how much I "realized" ie sale of a stock. So I took the total amount I withdrew as my "gross winnings" because I couldn't think of a better way to handle that. I am not sure that IRS agrees with my evaluation but I'm pretty sure that this would be considered a reasonable method. I'm not sure how else to track these things, short of being a ridiculously meticulous record keeper, tracking gains and losses separately especially when I jump in and out of cash game tables. I mean that's just unreasonable.

Well, this really sucks because based on this tax rate schedule, most of us will probably fall under the 25-33% rate and that's how much you will get taxed for your winnings. Assuming 28%, that's $1,400 that you have to pay in taxes on the $5,000 tournament win. Brutal. Well, another thing I considered was to claim the poker winnings as a self employment income. I don't know what the process of setting up a self employment is but I don't think it's actually that complicated. And even if you have a job and you get a W-2, you can still file self employment income as well.

So, what's the benefit of the self-employment income and how does that work? Well, first of all, if you consider your poker playing to be "self employment", then you can net all your expenses with the income. And in this instance, the expenses can be very liberal as long as they are legitimate. In other words, trips to Vegas or AC where you ended up playing poker are certainly includable as well as maybe a portion of the cost of your internet expense if you play online poker. However, there's a breakeven point where it's not necessarily beneficial to claim self employment income because you also have to pay taxes there so the expenses need to be enough to sufficiently bring down your net income. Ok, I know this sounds like mumbo jumbo so let me illustrate with an example...

Assume here that a) you are single and b) you can only claim one exemption and c) you normally would not itemize your deductions. This is for illustration only but the same concept applies even if you are married or if you itemize (granted, if you itemize, it might be a little more complex).

Let's also bump up the amount so that we actually have something substantial to talk about here. Let's say that this year, your gross poker winnings were $50,000. Let's say that you accumulated a portion of that by playing cash games and winning a few tournaments. And let's say you can quantify the $ amount for the tournaments... say $2,000.If you just file a regular 1040, you will claim the gross winnings ($50,000) on line 21 of your 1040. Then, with the standard deduction and exemption ($5,150 and $3,300, respectively), your taxable income is $41,550. Multiply that by the 28% as per the tax schedule and your tax due on your poker winnings alone is $11,634.

In the same example above, let's say you chose to go with the self employment route. As such, you decide to start quantifying all the expenses including tournament fees for the year, trips to Vegas or AC including meals, hotels and flights, approximate internet usage that is poker related, subscription to any poker related publications, etc. If you could find enough expenses to reach $16,000, then you will end up paying less than the $11,634 above... and this is why:

Your net income that you will report on Schedule C will be $34,000. Once you complete Schedule C, then you fill out Schedule SE which is the self employment tax form. On that form, you will follow the instructions so you bring the net income amount of $34,000 to this form and multiply by .9235 as instructed to come to $31,399 which is what's considered the "net earnings from self-employment tax." Then you multiply this amount by 15.3% (.153) which comes to $4,804 which is the self employment tax that you owe. Now, half of this is deductible from the AGI (adjusted gross income) as seen on line 27 of the form 1040 so then you will take the $34,000 that you report on line 12 of the form 1040, deduct the half of self employment tax ($2,402) and then deduct your standard deduction and exemption like above (totals $8,450) and you will now have a taxable income of $23,148. That amount will be multiplied by 28% to come up with $6,481 which is your tax personal income tax. (One assumption I'm also adding is that even though this new taxable income drops you to a 15% bracket, for this illustration, I won't change it because I don't want to further complicate what's already quite confusing and I'm also assuming that you might have another job so all in all, the tax bracket might not change). Add the self employment tax that we already computed which was $4,804 and the total taxes you owe is now $11,285. Not a significant difference from above but I think this illustrates the point. If you can find even more in expenses, this will clearly be beneficial. And if it does drop you into a lower tax bracket, I can't imagine how this would not be beneficial. However, if you don't have enough, then you will end up overpaying because you will pay self employment tax as well as your personal income tax.

As I mentioned in the disclaimer above, I'm pretty sure that this is a very very generalized view so you definitely want to get with a tax professional to discuss this as well as what type of items could be considered expenses. I think many of you would be surprised as to how liberal an interpretation the tax professionals can make. If this doesn't apply to you for 2006, well, start keeping records of any expenses that you may think is remotely related to poker for 2007 and you might be able to save some money come tax time next year.